What Fund Companies Don't Want You to Know - TheStreet

What Fund Companies Don't Want You to Know

Most investors can build a cheap, manageable portfolio with three -- or fewer -- of the thousands of available funds.
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Fund marketers have to make a living like the rest of us, but like most shiny-toothed advertising types, they're often trying to sell you something you just don't need.

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From 1995 through 1999, the stock market had its best five-year stretch ever. In that span, the number of stock funds more than doubled, while their assets more than tripled. But lost among the thousands of ads for sizzling funds was the simple fact that most of us don't need them.

If you're investing for a goal that's at least 10 years away and don't want your investments to consume your fleeting free time, you only need two or three funds to build a low-maintenance, cheap, diversified portfolio that will keep up with the market's indices.

Most fund companies don't bother telling you this because it's better for them if you slosh your money among a long menu of good, bad and ugly funds trying (often in vain) to top the

S&P 500

. Let's just review a couple of low-maintenance portfolios we've

built in the past to see how simple this can be.

If you want to build a diversified, low-maintenance stock fund portfolio that gives you access to U.S. and foreign markets, you might put 80% of the portfolio in a broad index fund like the no-load

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Vanguard Total Stock Market Index fund. It's designed to track the

Wilshire 5000

, essentially a basket of every large-, mid- and small-cap stock traded in the U.S.

To get some foreign exposure, you could simply put the other 20% of the portfolio into a foreign stock fund that has consistently topped its peers with less risk. We'd pick the price-conscious

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Tweedy, Browne Global Value fund. Its veteran management team avoids highflying darlings but has beaten more than 95% of foreign stock funds over the past one, three and five years.

Because both funds are less than 10 years old, we can only track their returns over the past five years. However, the past five years aren't a bad barometer given their tumultuous nature. Over that stretch, this humble little portfolio would've been about even or ahead of the S&P 500 through Dec. 1, according to the latest data from Morningstar.

We also held it up against a portfolio with half its money in the S&P 500 and the other half in the average large-cap growth fund. Our low-maintenance portfolio tops it over the past one, three and five years.

Keep It Simple
You don't need a lot of funds to get performance

In addition, the low-maintenance portfolio's route to those gains was less rocky. Its worst 12-month loss was 25%, compared with 37% for the growth-heavy portfolio. Its best 12-month gain was 45%, only narrowly behind the growth portfolio's 47%. To top it all off, the portfolio's average annual expenses are just 0.44%, compared with 0.82% for the growth portfolio and 1.43% for the average U.S. stock fund.

Index-like returns with lower volatility and more modest expenses? Sounds pretty good.

"I think this is quite a bit more sensible than what people actually do with their portfolios," says Scott Cooley, a senior fund analyst at Morningstar. "If you stuck to these allocations and rebalanced over time, you'd be keeping up with the index and avoid performance-chasing. Your portfolio would also be more tax-efficient than most."

Another plus is that it's easy to keep this portfolio's asset allocation in line. Rather than sifting through a dozen growth, value and sector funds to figure out where you're under- or overweighted, just consider how much you need in each bucket to maintain an 80%/20% split.

"You can just sell the better-performing asset class quarterly or annually to get back to your target allocation," says Steve Henningsen of Boulder, Colo.-based financial adviser The Wealth Conservancy. "That's buying low and selling high. If you'd done that in 1999, you would've done great over the last couple of years. You can just build a portfolio like this and go skiing if you like."

Of course, this slim portfolio could be tweaked several ways.

If you wanted to focus more on big-cap stocks, you could replace the Total Stock Market fund with the

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Vanguard 500 Index fund. We're sticking with Vanguard's index funds because portfolio manager Gus Sauter has the process down to a science, and it charges ultra-low expenses.

You might also choose a foreign fund with more small-cap exposure because foreign big-caps are more likely move in tandem with their U.S. peers, offering less diversification. That might make the

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T. Rowe Price International Discovery or

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First Eagle SoGen Overseas fund worth a look.

To fold in bond exposure, you could take 5% from each of the two stock funds in your portfolio and put it in a core U.S. bond fund. Our choice is the no-load, intermediate-term

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Vanguard Total Bond Market Index fund, which tracks the Lehman Brothers Aggregate Bond Index. For other choices, check out this recent

screen of core bond funds.

This only slightly more complex portfolio would've also kept up with the S&P 500 and topped a growth-heavy portfolio over the past one, three and five years. It was less volatile, too: This portfolio's worst one-year loss was 22% over the past five years, compared with 37% for the growthier portfolio.

Bonding
How bonds can fit in a portfolio

Need more simplification? Shop for a good balanced fund that blends stock and bond investments, says the Wealth Conservancy's Henningsen. He suggests the value-oriented Dodge & Cox Balanced. Here's a

screen of other solid choices in that category.

Some investors might opt for exchange-traded funds, or ETFs, which are essentially funds that trade like stocks. You have to pay a commission each time you buy them, but they typically carry lower expense ratios than traditional mutual funds.

Vanguard Total Stock Market VIPERs

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tracks the Wilshire 5000. You can find broad foreign stock exposure via the

iShares MSCI EAFE

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. That fund is designed to track Morgan Stanley's Europe, Australasia and Far East Index, the benchmark of most diversified foreign funds.

So why don't more investors build slimmer portfolios based on cheap, broad index funds? For one, fund companies don't make much from passively managed index funds, so they don't promote them much. Plus, few people felt a need to diversify their portfolios when growth and tech funds acted like cash machines in the late '90s.

"Diversification was a bad word in the 1990s, and it's back now," says Henningsen. "It will go out of favor again, but those who stick with it are the ones who'll make money in the long run."

We agree.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.