The Fairholme fund is an actively managed mutual fund run by a fellow named Bruce Berkowitz. Since the fund’s inception in 1999, Berkowitz has had an impressive run. According to Morningstar, the Fairholme fund is in the top 1% of funds in its category (large-cap value funds) for both 5-year and 10-year annualized returns. That’s quite an achievement!

However, as esteemed investment author Taylor Larimore recently pointed out, the fund’s performance has been rather lacking over the last year. In fact, it’s been pretty bad. For the twelve months ending 4/29/2011, Fairholme is in the bottom 1% of funds in its category. Yikes.

So what does that mean for investors in that fund? Is Berkowitz’s hot streak over? Or is this just a short-term hiccup in what will turn out to be another decade of superstar performance?

I have no idea.

And that’s the point.

Actively Manged Funds: You Can Never Be Sure.

When you own an actively managed fund, there will be periods during which your fund underperforms its benchmark and its peers–sometimes dramatically. When that happens, you have to decide whether or not you want to continue holding the fund, which means trying to determine whether:

1. The poor performance is just a fluke and your actively managed fund’s performance will soon pick back up,
2. The fund manager has “lost his touch.” (For example, he had previously succeeded by exploiting a particular market inefficiency, but that inefficiency has now become public knowledge, rendering it ineffective and leaving your manager scrambling to find a new trick.),
3. The fund has grown so large that the fund manager can no longer handle it effectively, or
4. The fund manager was never anything but lucky in the first place, and his luck has now run out.

Years later, with the benefit of hindsight, you may be able to tell which of those scenarios was actually the case. But while it’s actually happening, all you can know with certainty is that your fund is losing money and falling behind its peers.

Yet Another Reason I Like Index Funds

When you invest in index funds, the overwhelming majority of your funds’ performance will be explained by two things:

1. The performance of the underlying indexes, and
2. The funds’ costs. (Lower costs = better returns.)

As a result, you don’t have to spend time researching fund managers. You don’t have to spend time trying to determine whether a particular manager is skillful rather than just lucky. And you don’t have to spend time worrying about whether your fund’s manager has “lost his touch.”

Truth be told, I don’t even know the names of the people who run the funds I own. It’s not that I don’t appreciate their work. It’s just that the information isn’t particularly relevant to what I do with my portfolio.

If you’re an index fund investor, management risk–the risk that your fund’s performance will be harmed by the manager’s poor decisions–is one thing you don’t have to worry about.

Over the last few years, I’ve had accounts at just about every brokerage firm you can name–Schwab, Fidelity, Vanguard, ETrade, Scottrade, TradeKing, and a whole list of others.*

And over the last year, I’ve consolidated everything at Vanguard.

To be clear, Vanguard is not the only reasonable choice. Low-cost, diversified portfolios can be built just about anywhere these days. So, while my own portfolio consists of Vanguard index funds, I’d be perfectly happy with this portfolio of commission-free ETFs at Schwab, for example:

• Schwab U.S. Broad Market ETF
• Schwab International Equity ETF
• Schwab Short-Term (or Intermediate-Term) U.S. Treasury ETF

…or this index fund portfolio at Fidelity:

• Spartan Total Market Index Fund
• Spartan International Index Fund
• Spartan Short-Term (or Intermediate) Treasury Index Fund.

So Why Do I Use Vanguard?

I prefer Vanguard because of their unique ownership structure. You see, Vanguard is owned by the mutual funds it runs. (This is in contrast with other brokerage firms and fund companies, which are owned by third-party shareholders.)

Believe it or not, this isn’t just trivia. It has important ramifications.

Low Costs

First and most obviously: It makes their funds very inexpensive. All of Vanguard’s services are provided “at cost” to investors. And why wouldn’t they be? The investors essentially own the company.

Cost Reduction (rather than Profit-Maximization)

Second, it means that Vanguard is always looking for ways to reduce costs even further. Contrast this with other brokerage firms, and you see a big difference.

For example, discount brokerage firm Zecco became known for offering commission-free trades to people with accounts of $25,000 or more. They recently announced, however, that they’re ending that program completely. Tough luck to everybody who opened accounts for exactly that reason.

With Vanguard, you don’t have to worry about bait-and-switch tactics like that. You don’t have to worry about them roping you in with a low-cost promotion, then jacking up prices to increase their profit margin (because, again, there is no profit margin).

Elimination of Conflicts of Interest

Finally, Vanguard’s unique ownership structure means that the information investors receive from them is not polluted by conflicts of interest.

As a contrasting example, with my account at Schwab, I frequently received emails (as well as their quarterly On Investing publication) that encouraged me to seek above-market returns by trading individual stocks or selecting actively managed mutual funds. I daresay it’s not a coincidence that frequently trading stocks and investing in high-cost funds happen to be strategies that are more profitable for Schwab than buying and holding index funds.

My experience was similar with other brokerage firms: They consistently encourage their clients to use investment strategies that are most profitable for the brokerage firm, regardless of how likely those strategies are to be successful for the investor.

At Vanguard, it’s different. I don’t agree with every piece of information they put out, but at least I don’t have to worry that they’re trying to get me to do something just because it’s more profitable for Vanguard.

*I do not recommend having accounts at several places. I did it for business purposes–so that I could write intelligently about several different companies–rather than investment purposes. As an investment decision, it makes little sense.

I write a lot about how index funds are great tools for constructing a portfolio. Interestingly, one of the most common objections I hear against index funds is, “I don’t want to invest in the stock market.”

I’m not sure where the idea that index funds only own stocks came from, but it’s complete nonsense. There are numerous bond index funds, and they come in a wide variety of flavors–investment-grade corporate bonds, short-term Treasury bonds, mortgage-backed bonds, and so on.

An all-index-fund portfolio could just as easily be 100% bonds as 100% stocks. And the benefits of index funds (low-costs and diversification within the asset class in question) are just as important with bonds as they are for stocks.

Diversification Is Important for Bonds

In much the same way that it’s beneficial to diversify your stock holdings across numerous companies, it’s beneficial to diversify your bond holdings across numerous borrowers. With corporate bonds, it’s best to own bonds from a variety of companies in a variety of industries. And with municipal bonds, it’s best to own bonds from a variety of states/cities from around the country.

Noteworthy exception #1: There’s no need to diversify among different Treasury bonds. It’s perfectly OK to pick the most appropriate maturity for your purposes and stick with that.

Noteworthy exception #2: If you’re a muni bond investor who lives in a state that exempts in-state muni bonds from state income taxes, it likely makes sense to sacrifice some degree of diversification by overweighting in-state bonds in your asset allocation.

Costs Matter with Bond Funds Too

As important as it is to keep costs low when investing in stocks, it’s even more important when investing in bonds. The expected return of bonds is lower than that of stocks, so every tenth of a percent that goes to pay the fund manager takes a proportionally larger bite out of your final returns.

Unsurprisingly, if you browse the history of Standard & Poors Indices vs. Active Scorecards, you can see that actively managed bond funds have an even lower chance of outperforming their benchmark than actively managed stock funds do. (And that’s saying something!)

Diversifying Your Index Fund Portfolio

When financial advisors or writers suggest owning index funds, it’s unlikely that they’re recommending an index fund portfolio consisting exclusively of stocks. While stock index funds do provide a great deal of diversification across companies, it’s still important to include other asset classes.

Fortunately, the principles of keeping costs low and diversifying apply just as well to bonds as they do to stocks.

A friend of mine recently told me that she was about to start using a new financial advisor, but she wanted to ask me what I thought of the advisor’s company before she wrote him a check.

The short version is that the advisor was a broker who was trying to sell her a portfolio of super-expensive, actively managed mutual funds. She explained:

“I asked him about index funds, since I know that’s what you and a lot of other people recommend. He said that index funds are mediocre because there’s no chance that they’ll outperform the market.”

The cynic in me couldn’t help but chuckle a bit. “Index funds are mediocre.” It’s a staple soundbite for brokers. Back when I was a broker, I used it all the time.

Hearing that phrase again got me thinking about all the ways that index funds are mediocre. I thought I’d share a few here.

Index Funds are Mediocre

Index funds are mediocre…if mediocrity means being able to obtain extreme diversification with as few as three holdings.

Index funds are mediocre…if mediocrity means being significantly more tax-efficient than almost every actively managed mutual fund on the market.

Index funds are mediocre…if mediocrity means outperforming 60% of U.S. equity funds over the last 5 year period, 60% over the period before that, and 66% over the period before that. (The results are even more impressive for bond funds and international stock funds.)

Index funds are mediocre…if mediocrity means never needing to check your funds to see if any of their managers retired or went to other firms.

Index funds are mediocre…if mediocrity means knowing how your money is invested because your fund company has no reason to keep the fund’s holdings a secret.

Index funds are mediocre…if mediocrity means never having to look at stock charts, watch for earnings reports, or read financial statements.

Index funds are mediocre…if mediocrity means being able to retire with 25% less money (because you’re not spending a quarter of your 4% withdrawal rate just to pay your fund manager).

Index funds are mediocre…if mediocrity means never having to worry that your (seemingly) skilled fund manager will turn out to have just been lucky…and that you won’t find out until his luck runs out.

Index funds are mediocre…if mediocrity means knowing with mathematical certainty that your money will outperform the average actively-managed dollar over every period.

Mediocre sounds pretty good to me.

I like target date funds, a.k.a. target retirement funds. (More precisely, I like Vanguard’s target date funds. Every other fund company charges too much. In fact, according to Morningstar, the next-cheapest provider charges more than three-times what Vanguard does.)

With just one fund, you get all of the following:

• Diversification across the three most important asset classes: domestic stocks, international stocks, and bonds.
• Extremely broad diversification within each of those asset classes, and
• Automatic rebalancing, so you don’t have to worry about it.

Not bad!

But target date funds have their flaws too. And this last week was a perfect example.

The Risk of Target Date Funds

Vanguard recently announced that they’ll be increasing the international allocation of their target retirement funds from 20% of the stock portion of the portfolio to 30%.

This isn’t a huge change. And I’m inclined to say it isn’t a bad change either. (In fact, it puts the portfolios closer to what I’d usually recommend.)

But it is a change. And unless you’re paying attention, you wouldn’t know about it.

And therein lies the danger: The entire point of target date funds is that they’re for investors who don’t want to pay attention to their portfolios.  They want a hands-off, automated solution.

Doing Your Homework

Before investing in a target-date fund, it’s absolutely essential to check its current asset allocation as well as its glide path (that is, the way in which the fund will shift its allocation in the future).

But that’s not enough. The glide path described in the prospectus is not a contract. The prospectus may tell you that, ten years from now, the fund will have X% of the portfolio in bonds, but that’s not necessarily true. Any time between now and then, the portfolio manager could change his/her mind.

In short, target date funds are actively managed mutual funds (even though they may be super-low-cost and composed of index funds). There’s somebody at the helm making decisions about what allocation the fund has.

The takeaway: Target date funds are a low-maintenance approach to investing, but they’re not a no-maintenance approach. Be sure to read any communications you receive from your fund company, and be sure to check your fund’s allocation on a regular basis to minimize surprises.

Vanguard recently released a new mutual fund: Vanguard Target Retirement 2055. As you might imagine, it’s basically the same as their existing 2050 fund, but with each of the asset allocation changes scheduled to occur five years further into the future.

For the most part, I like Vanguard’s target retirement funds. But I’ve got one big question, especially regarding this new one: Why not get rid of the $3,000 minimum investment?

If you’re not planning on retiring until 45 years from now, you’re obviously quite young. In fact, there’s a very good chance you’re still in school.

It’s been a few years since I was in school, but I suspect that one aspect of college hasn’t changed: Most college students (even those interested in investing) don’t have $3,000 sitting around.

What’s the Point of the $3,000 Minimum?

Was the $3,000 minimum initially intended to discourage people from trying to pick a whole slew of different funds rather than a simple, 3-4 fund portfolio of diversified, low-cost index funds? If so, that seems like a non-issue in this case. Most investors interested in target retirement funds like the idea of investing in just one fund — that’s the whole point.

Or, perhaps, does the $3,000 minimum exist simply to ensure that Vanguard receives a certain level of revenue per new investor?

Would You Pay $4.75 for a New Client?

Vanguard Target Retirement 2055 has an expense ratio of 0.19%. That means that an investor with $3,000 in the fund would provide Vanguard with $5.70 in annual revenue. If Vanguard were to cut the minimum investment down to, say, $500, the revenue per new investor would decline by $4.75. And in the process, they’d become accessible to many more student-investors.

Yes, Vanguard would almost certainly be losing money on each investor who only invested $500, as there would still be administrative expenses associated with their accounts.

But Vanguard would have a new customer — one interested in hands-off, index investing.  (Essentially the ideal Vanguard client, no?) And, in just a few years, that investor will likely be out in the workforce. She’ll have more money to invest. And she’ll already have an account with Vanguard.

I could be wrong, but I’d suspect that Vanguard’s current marketing strategy (i.e., advertising in mainstream media) results in an average cost of far more than $4.75 per new client.

I like Vanguard a lot. Most of our own retirement savings are invested through them. But with that $3,000 minimum, Vanguard seems to be saying that they’re not particularly interested in having the business of young investors. Instead, when I get emails from college-age investors, I typically recommend Schwab because of their no-commission, low-cost ETFs.