Index Man

Index Man

FINANCE by Jean Gruss | Editor/Lee-Collier

A heretic among his professional investing peers, Dan Solin recommends that most people put their money in index funds to outperform most investment managers.

You won't find Daniel Solin hanging his shingle on Fifth Avenue in Naples, where wealth management firms line the tony street alongside international jewelers and antiques dealers.

Solin is a financial advisor who recently opened the Naples office of Index Funds Advisors, a California-based fee-only money management firm that has nearly $1 billion invested in funds that track market indexes. His office is tucked away in a small office park away from glitzy downtown Naples.

Financial advisors such as Solin are considered heretics in the world of wealth management. Backed by stacks of academic research that show most money managers don't outperform stock and bond markets over the long term, Solin and others like him believe investors are better off simply parking their money in mutual funds that track indexes such as the Standard and Poor's 500-stock index.

Indexers are the bane of stockbrokers who depend on trading commissions for their livelihood as well as money management firms that believe they can outperform the indexes by actively picking stocks and industry sectors such as technology or energy.

What's more, Solin until recently made a good living suing brokers who swindled their clients. He's the author of "Does Your Broker Owe You Money?" which guides investors through the inner workings of brokerage firms and advises them on how to recover losses.

"The single greatest threat to peoples' wealth is their investment advisors," Solin says. His answer: get rid of them, sell your individual stocks and bonds, pay your taxes and put your money instead in low-cost index funds that you'll hold for a long period.

This is no easy thing to do, Solin concedes. "You're taking Santa Claus away," he says. After all, why settle for the market's returns when wealth managers suggest they can beat them? "The message has no sizzle," he concedes.

Allocate your assets

Solin and other indexers hew to the theory that more than 90% of an investor's returns are the result of how they divide up their portfolio among different types of investments. Over decades, stock picking accounts for very little of an investor's returns for the risk they take, studies show.

"We have no insight into what sector will do better," Solin says. Instead, Solin divides his clients' money among different baskets of stocks and bonds with the assurance that one type will be doing better at any given moment.

Using mathematical formulas, his firm calculates a portfolio's market swings based on historical returns. Using that data, Solin can show customers how volatile a portfolio can be over time.

That's useful because investors can choose a portfolio of index funds that suits their appetite for risk. Knowing that markets rise and fall, investors can determine how much of a decline in the value of their portfolio they can comfortably handle.

Most investors have no idea how volatile their portfolio is, Solin says. But any stockbroker or financial planner should be able to calculate how much an investor could stand to lose during a nasty bear market.

Solin says his firm evaluates a customer's appetite for risk and constructs a portfolio of index funds that will deliver the best risk-adjusted returns based on years of historical data. That's where Solin says his firm can add value.

On average, Index Funds Advisors charges 1.25% of a customer's assets annually. That includes the firm's fee plus the fees of the index-fund manager, Chicago-based Dimensional Fund Advisors. DFA boasts two Nobel laureates on its board and manages $136 billion in index funds for individual and institutional investors.

Solin points to historical data that shows his firm's portfolios of DFA index funds have performed one- to three-percentage points better annually than a portfolio of index funds from firms such as Vanguard. That's because most of the DFA portfolios include index funds that invest in stocks of small domestic and foreign companies, which over the long haul have outperformed the stocks of medium-sized and large companies.

In addition, Solin says DFA's index funds immediately dump stocks that don't fit in its index category, such as when a small-sized company becomes larger. Other firms do this less frequently, which skews their performance lower.

In some cases, DFA offers low-cost index funds that aren't available elsewhere, such as those that invest in the stocks of the smallest companies. Because of its size, Solin says DFA can use its heft to lower the usually high trading costs of thinly traded small-company stocks.

Trading costs may keep investors from replicating Solin's portfolios using exchange-traded funds (ETFs), which are similar to index mutual funds but trade on an exchange. There are hundreds of ETFs that slice and dice nearly every segment of the market, but they can be more expensive for individuals to buy and manage than traditional mutual funds.

What's more, Solin says his firm's mathematical formulas can squeeze the most amount of performance for the precise level of risk a customer is comfortable taking. The firm's 20 portfolios contain as many as 10 funds each that focus on different asset classes, ranging from short-term bonds to emerging markets, small and large stocks.

The minimum to invest with Index Funds Advisors is $100,000. In some cases, Solin may turn down business. For example, ultra-conservative investors who want to invest only in bonds are likely better off investing in Vanguard funds to keep costs low.

And investors who doubt Solin's strategy will be turned away. He says one investor recently offered to invest half his money with Index Funds Advisors and the other half with a stockbroker to see who could come out ahead. Solin declined the money.

Networking online

You probably won't meet Solin schmoozing potential clients at chamber of commerce functions in Naples. "That way of doing business is an anachronism," he says. "I don't belong to the country club."

Instead, Solin relies on the Internet to spread the word. His firm has an elaborate Web site that's loaded with data about indexed portfolios and the pros of investing in index funds (www.ifa.com). Customers who are interested in speaking with Solin won't get the hard sell. "We follow up in a low-key way," he says.

Solin is the author of "The Smartest Investment Book You'll Ever Read," which made BusinessWeek's best-seller list and sold 60,000 copies. However, he says he doesn't use the book to market his business. "I didn't write it to generate assets," he says.

However, Solin plans to be more aggressive in pursuing the market for 401(k) employer-sponsored retirement plans. He says many companies have plans that are dominated by high-expense funds with poor returns, exposing employers to potential liability. "There are now major lawsuits on this issue," he says.

Still, Solin expects money from individuals will make up 75% of the firm's assets with the remainder from 401(k) investors. "It shouldn't be too hard to have a couple hundred million [dollars in assets] in Florida," Solin says.

REVIEW SUMMARY

Industry. Financial planning

Company. Index Funds Advisors

Key. Most money managers can't outperform the markets over the long term.

By the numbers

Index portfolios

More than 90% of your portfolio's returns will be determined by how you spread your money among different kinds of assets, argues Daniel Solin, senior vice president with Index Funds Advisors in Naples. Solin builds portfolios based on his clients' tolerance for volatility, especially in bear markets. Here are three IFA portfolios that show what percentage is invested in various index funds according to an investor's tolerance for swings in the portfolio's value:

Portfolio One Portfolio Two Portfolio Three

Index fund (low volatility) (average volatility) (high volatility)

US large company 4% 12% 20%

US large cap value 4 12 20

US micro cap 2 6 10

US small cap value 2 6 10

Real estate 2 6 10

International value 2 6 10

International small company 1 3 5

International small cap value 1 3 5

Emerging markets 0.6 1.8 3

Emerging markets value 0.6 1.8 3

Emerging markets small cap 0.8 2.4 4

One-year fixed income 20 10 0

Two-year global fixed income 20 10 0

Five-year gov't income 20 10 0

Five-year global fixed income 20 10 0