Bucket Fund

[KenBob]

My wife doesn't want to manage individual stocks, so our portfolios will be transitioning to ETFs for retirement.

The big issue I always had with index funds is that an index fund buys all stocks in the index whether they are overvalued or not. Why can't an index be split into an undervalued bucket and an overvalued bucket? With a "bucket fund", all purchases are made for the undervalued bucket, while sales are made from the overvalued bucket. At the very least, this should improve capital gains.

Stock prices are strongly correlated with the forward price to earnings ratio. Using the median forward price to earnings ratio, an index can be split into the two buckets.

I have started an experiment comparing an index fund versus a bucket fund using the same dividend stocks. I have 20 stocks and assume a starting portfolio value of $200,000 and equal weighting. This provides $10,000 per stock in the index fund and $20.000 per stock in the undervalued bucket. Over time, the dividends will be used for purchases for each fund. The market value and annual dividend for each fund will be compared over time.

Just by splitting the stocks into two value buckets, the initial annual dividend was increased 3%. Not too surprising, but the primary purpose of the bucket fund is to improve capital gains.

[earthtodan]

Are you doing this for real or virtual? There are some brokerages where you can create virtual portfolios to play around with ideas. OptionsHouse is one of them.

[KenBob]

(10-25-2014, 08:13 PM)earthtodan Wrote: Are you doing this for real or virtual? There are some brokerages where you can create virtual portfolios to play around with ideas. OptionsHouse is one of them.

This is not a real portfolio; however, I do use the same stocks as my own portfolio to ease the data gathering. It is an exercise that uses real stock market data on an excel spreadsheet.

[Kerim]

(10-25-2014, 07:04 PM)KenBob Wrote: Why can't an index be split into an undervalued bucket and an overvalued bucket? With a "bucket fund", all purchases are made for the undervalued bucket, while sales are made from the overvalued bucket.

The glib answer to this question is that then it would not be an index fund. One of the main appeals of indexing is the removal of subjective buy and sell decisions, which allows the fund to track the underlying index closely with very low costs (that is, low expense ratio).

There are passively managed index funds that track an underlying value index, such as the Vanguard Value Index Fund. But since the underlying index is already constructed with a certain valuation profile, the index fund itself does not need to be separated into buckets; it simply tracks its benchmark. (And of course whoever is constructing the benchmark is making the decisions as to what constitutes a "value" stock.)

There are plenty of actively managed mutual funds that do exactly what you are saying. They may not use the "buckets" concept that you describe, but they have their team of analysts looking to buy undervalued stocks and sell overvalued ones. They may or may not succeed, but you'll pay for those services via a higher expense ratio.

[KenBob]

Your right that a bucket fund would no longer be an index fund; however, it could share the characteristics of low expenses, a diverse set of stocks, and a weighting strategy. An index fund adds or subtracts capital using a given weighting strategy over the entire fund, keeping the relationship with the index. A bucket fund adds or subtracts capital from half of the fund at a time with stocks moving between buckets over time; therefore, it can not match the index. The hope is that the bucket fund would improve on the performance of an index.