O HOW'D YOUR STOCKS DO LAST year? Unless you're a deep value investor, you probably saw some negative numbers, but what does that really mean?

Certainly it's not what you'd want in absolute terms, but that's not the only measure of a portfolio. When you invest in equities, you've got to realize there's going to be some down years.

Perhaps a better yardstick is the relevant benchmark. In other words, your grade as a stock picker should be based on your performance vs. the appropriate benchmark. If you beat it -- even if your overall return was negative -- you've added value.

But what's the appropriate benchmark? If you're investing in large cap stocks you might use the Dow Jones Industrials or the S&P 500. If you're a tech person, you'll probably use the Nasdaq, even though it isn't purely tech. If you're a small stock investor, you're probably using the Russell 2000.

There's no question these are the most popular benchmark indexes, but do you really understand them? This is actually an important question, since you can't know if your benchmark is appropriate unless you understand its composition. The Russell 2000 is a great example.

Small Isn't All

There are several reasons for this. First, while the Russell 2000 is composed of the bottom two thirds of the largest 3000 publicly traded companies, they aren't necessarily small.

Same Universe, Different Returns

Source: Ibbotson Associates From its creation in 1984 until 1990, the S&P 600 was outperformed by the Russell 2000. After that, the pattern reversed. By the end of 2000, the returns of both indexes were virtually the same.

Also, contrary to its name, the index usually holds less than 2000 stocks. These quirks are functions of the index's annual rebalancing.

The index is maintained by the Frank Russell Co., which rebalances the index once a year on June 30 based on market values as of May 31. By the time June 30 rolls around, many of its constituents have been acquired, gone bankrupt, or have grown to the extent they are no longer small caps. For example, in early February of this year, the index only had 1898 constituents. There won't be 2000 again until June 30th.

Secondly, the 2000 typically carries a relatively high percentage of Real Estate Investment Trusts (REITS). When last reconstituted in June of 2000, they constituted 5.3% of the index. Most folks think REITS represent an asset class (real estate, duh!), not sector. As a small stock investor, do you plan to devote this much of your portfolio to REITS? For that matter, do you plan to devote any of your portfolio to them?

Finally, again because of its annual rebalancing, the index capitalization usually trends up as the year progresses. While any index's capitalization changes on a day to day basis, in an up market -- and over time the equity market does trend up -- the Russell 2000 may start as a small cap index but by the time of its summer rebalancing, it's a mid cap index. Is this how you manage you small cap holdings? Probably not.

There's Another Alternative

Although we've complained that the folks at S&P have gotten a little too active in the management of their indexes (see Unmanaged Index?), the Russell 2000 actually has more turnover than the 600. According to Prudential Securities' Quantitative Research Group, as of June 30, 2000 (the date of its last rebalancing) the Russell 2000 had one year turnover of 34.3% and three year average turnover of 27.7% vs. 20.7% and 17.2% for the 600.

Also, the 600 is a capitalization weighted index like the S&P 500. The Russell weights are determined by "float" -- the number of outstanding shares not owned by other companies or insiders. We'll take market cap, thank you very much.

Same Universe, Different Performance

The accompanying table shows the one, three, five and ten year returns for the eleven year period 1990-2000. In all but two years, the 600 came out on top.

There are several reasons for this:

• The past decade was not kind to real estate investments. Given the Russell 2000's healthy dose of REITs, it was penalized in regard to the REIT-less S&P 600.

• Each year a number of the Russell 2000's best performers are purchased or merged into other companies, leaving the under performers behind. In essence, by the time annual rebalancing comes around, the surviving constituents are the poorest performers. When a company leaves the S&P 600 -- for whatever reason -- it is immediately replaced, often with a better company in another sector.

• When the powers that be at S&P do add new stocks, they've had a bias toward growth issues. In light of the fact that growth outperformed value throughout the '90s, it's no wonder the 600 bested the Russell 2000's surviving dogs.

In selecting a benchmark for a small cap portfolio, the choice boils down to this: Which index will you most closely approximate? If you want a cap-weighted index like you probably use for your large cap benchmark, you need the S&P 600. If you don't plan to invest in REITS, you need the S&P 600. If you want relative consistency in your benchmark, one that doesn't change radically every summer, you need the S&P 600.

Come to think of it, why would you need the Russell 2000?

Mutual Cash

"The people like to be humbugged."

-- P.T. Barnum

 

CADEMIC STUDIES HAVE SHOWN THAT THE most important determinant of portfolio performance isn't market timing or even stock selection. It's asset allocation. Your most important investment decision is your choice of asset classes and the way you weight them.

Unless you can devote enough cash to adequately diversify each asset class, you're better off using mutual funds for at least some classes. Not only do funds provide immediate diversification, they also allow you to easily rebalance and adjust your allocation.

Unfortunately the way most funds are managed, they can also work to undo your asset allocation. Cash is the culprit.

The Way It's Supposed to Work

As your portfolio grows, you can create your own allocation by owning funds representing different asset classes. (Don't confuse this with the usual hodgepodge of funds brokers push. Most of those "portfolios" result from an attempt to fatten brokers' wallets, not create a coherent asset allocation.)

The goal in a well-devised portfolio is to hold different funds representing various asset classes. At the very least, you'd start with a

If you think this is a good time to lighten up on stocks, your fund managers probably do, too.

stock fund, a bond fund and a money market. As your investments grow, you can add further diversification by holding large, mid and small cap stock funds or perhaps growth and value funds. Holding government, corporate and junk funds can diversify bonds.

The amount you allocate to each fund should represent how you feel that asset class will perform over your time horizon. Your time horizon is determined by how frequently you plan to rebalance the portfolio. When your economic outlook changes, you can alter your mix.

For example, suppose you have portfolio consisting of 40% in a corporate bond fund, 40% in a domestic stock fund, 15% in a foreign stock fund, and 5% in a money market (cash). This is a pretty standard "balanced" asset allocation and should work well in most markets.

But what if you're faced with a situation like last year: The stock market is overvalued, interest rates are rising, and the economy is starting to slow? Given these conditions, you might want to lighten your exposure to stocks.

In this example, you can go to 20% cash by reducing domestic stocks to 30% and foreign stocks to 10%. This takes you to a more conservative mix of 40% stocks, 40% bonds and 20% cash. It's easy to do this with a mutual fund portfolio. All you have to do is sell a portion of your stock funds and put the proceeds into cash.

The Way It Really Happens

When Stock is Cash

If you want to raise cash and lighten stocks, chances are your mutual fund managers are doing the same thing. When that happens, your asset allocation won't be what you want.

To return to the earlier example, suppose your two equity fund managers both decided to raise 20% cash. Further suppose they started out 100% in equities (as they are supposed to be).

In this case, you wouldn't have 20% in cash; you'd have 28%. You wouldn't have 40% in equities; you'd have 32%. So much for your asset allocation.

If you could predict with any accuracy how your fund managers would react, you could adjust your cash position to produce your desired allocation. But you can't know what they'll do in advance, and you can't count on them doing the same thing as we assumed in our example.

When you pick a stock fund you want it to represent stocks, not some combination of stocks and cash. The same holds for your bond funds: You want them to represent bonds, not bonds and cash. You want to adjust the cash level at the portfolio level.

That suggests at least a partial solution to the problem. When you select a fund you should check the prospectus to see what management says about its investment philosophy. Those that fit best into asset allocation are those that profess to always remain fully invested in the asset class they represent.

Sure they have to have a small cash position from new shareholders or to meet redemptions, but those funds that at least make an effort to remain fully invested will work much better in your asset allocation. At least their managers won't be working against you.

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