Wednesday, December 16, 2009

Mutual Funds in the Next Year

The difference between 2009 and 2010 will be dramatic. Investors, always looking for the next big move will unwind their positions in conservative funds - albeit late - and move into equity income funds that provide some stability (from large companies that are well-established) and income (through dividends).

The real winners for 2010 will be in dividends and the funds that invest in them. Often referred to as equity income investments, these funds will begin to shine as businesses begin to increase their profit sharing (which is what dividends are) even if they have not begun hiring.

More here.

Wednesday, December 9, 2009

Mutual Funds Explained: Topic of Fees

Mutual fund investing should be a simple process. It should be straightforward and easy to understand. Unfortunately, once we get involved, we bring our own set of behaviors to the process.

In our first discussion about performance comparisons for mutual funds, we looked at the downside of simply comparing side-by-side an actively managed fund with one of the indexes that are published. These indexes span a wide variety of categories in order to help investors understand how the broader market has done in relation to the fund they own.

Trouble is, no fund, not even index funds are able to buy in total, all of the stocks in a particular index. Yet, index funds are designed to come as close to the index they mimic. Any wide discrepancies, either higher than the index or lower than the index should raise a warning sign to current and new investors. This could point to a style drift, a process whereby the fund manager looks to stocks outside the parameters of the index to beef up returns. because in the world of mutual funds, one-hundredth of a percentage point can often sway the investor's decision of which fund to choose.

Often, this focus on returns drives the investor to funds that are the wrong ones for a long-term approach. Even almost five years since the publication of the paper b the Wharton School :"Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," by Madrian, James J. Choi, professor of finance at Yale, and David Laibson, economics professor at Harvard, folks still do not adequately take these costs into account.

In their experiment, they used index funds as the sole investment. The S&P 500 index, which tracks the 500 largest companies trading on the US exchanges should all have identical returns over the same period. The only difference lies in the fees the fund charges the investor. These fees are often touted as the lowest available and with good reason. The investment itself is passive. Managers buy and hold any underlying stocks in the portfolio until the index itself is readjusted.

Their concern before the experiment was based in the question: why, if index funds outperform actively managed mutual funds most of the time when held over long periods of time, such as twenty years or more, would an investor pay higher fees when index funds charge so much less? They pointed out that when an investor considers fees to relative performance, say when an actively managed fund matches the returns of a passively managed index, the investor will not consider fees as an important factor in the process. If both of the funds in this paragraph earned the same 10% over that twnety years, the difference in real dollars would be over $11,000.

To conduct their experiment, the chose only four funds, all S&P 500 index fund. They all varied slightly in overall fees with the performance of these funds almost identical. They could invest all of the hypothetical $10,000 in one fund, or divide the investment among many funds. The reward for outperforming their cohorts was an actual cash prize: the profits generated by the best performance over the course of a year.

They broke the students in the experiment into three groups: one received a prospectus accompanied by a returns sheet, one a prospectus accompanied by a fee sheet, and the last group, the control group, received only a prospectus. In each case, the prospectus was the same as the one any investor might receive upon request.

The result of the experiment indicated that disclosure did have an effect on the students in all three groups. The group with the returns sheet did the worst. Those that received fee information did better. What was most curious about the results: the students with the fee sheets could clearly see that one fund among the four offered the lowest fees yet not one student put all of their money i that fund despite the relative identical natures of the overall investments.

By no means does this say that fees are or should be the only force in your decision to buy a certain fund. But they should enter into the discussion at a much higher level that that of overall performance.

Next up, the role of the manager.

Paul Petillo is the Managing Editor of

Monday, December 7, 2009

A Performance Discussion on Mutual Funds

The last lines of Matthew P. Fink's book, "The Rise of the Mutual Fund" suggest that although he is a "worrier; nonetheless, I am optimistic". This speaks volumes to the "extraordinary success of mutual funds". Mr. Fink believes that despite the speculation about the maturity of the industry, it is far from falling from its exalted position. This elevated status is due, he writes "to adherence to high standards of fiduciary behavior".

Yet the mutual fund industry continues to be attacked for any number of reasons. The largest component of your 401(k) plan, your IRAs and the driving force behind numerous college savings plans, these investments are often questioned on their transparency, why they charge what they charge and even more commonly, why, if you win one quarter, can you not win the game.

Comparing Mutual Funds
There are numerous ways to compare mutual funds and none of them good. The rule of thumb for a fund is relatively straightforward: look for long-term performance (I have suggested that you also look to how well the fund manager did in poor markets rather than how they did during the good times), the cost of the fund (fees and expenses do not often tell the whole story but offer a telling sign of how much the fund manager trades and why), and the tenure of the manager in charge (an ever shifting picture as fund managers come and go and new managers look to put their investment stamp on the portfolio).

The subject of performance is often more confusing when actively managed funds are compared to indexes. These passive measures are poor indicators of what an active manager holds. This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they increase returns by limiting exposure to unnecessary risk. Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic. And actively managed funds hold even less.

Looking at Past Performance
Performance also comes to the forefront when we look backwards. For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future. While this has been disclaimed as a method of disclosure, it is still one of the default guides for new and even seasoned investors when making the choice for which fund to buy.

Over the last decade we have had two bubbles and two market reactions to those events. Had you purchased a mutual fund, any fund as a bubble reached its peak, the previous five years would not have reflected the previous bull market's demise. I clearly remember the sigh of relief as the year 2001 was dropped from the 5 year returns in 2007. No longer would the bad bets made during the internet bubble show up as a stain on the investor information sheets. Ironically, even as some funds dove into the depths, they took the whole market down with them. (As did happen recently in 2008.)

Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. Averages suggest some odd things. A line-up of one hundred persons, ninety-eight of whom are six feet tall would not change the average if the person on one end was ten feet tall and the one on the other end was three feet in height.

But stock markets rarely have a peak that moves quickly from the bottom to the top whereas the bottom is often reached in less than six months. The top of a bull market takes five years, at least as witnessed over the last decade, to attain. This is not the case for any period prior to this. Bottoms were reached quickly while the top of the market was often a slow slog.

So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws. And past performance leaving us with no real picture of the future based on the past, how does one judge performance? Without considering fees, the worst day of a fund. Based on the simple idea that, if mutual funds are the primary holding in a retirement account and at one point in time, you will be begin to drawdown that account, picking the worst day to do so gives you a valuable peek at a worst case scenario. That is probably a truer indication of performance that averaging it our over a period in time. You can read more about low-mark performance here.

Next, a discussion about fees.

Paul Petillo is the Managing Editor of

Wednesday, November 18, 2009

Mutual Funds are Different than ETFs

The argument is never clear. When we compare mutual funds to ETFs, we often miss the differences between the two in large part because we are discussing two different types of investments, how they should be used and what they are. Folks on the ETF side of the disagreement point out a variety of plus while conveniently leaving the minuses out of the conversation. People who argue for mutual funds are looking for something other than a simple index fund.

The Pluses of ETFs (with the minuses)
The tax benefits that are often touted by the ETF camp rely on the buy-and-hold strategy that index funds offer. It should be noted that when comparing these two investments, one should drop the vast majority of mutual funds from the argument and concentrate only on the index mutual fund.

With any investment, capital gains are a consideration. The only way these two can be compared on a tax basis is when there is a sale. While funds held outside of a 401(k) or other retirement account distribute capital gains on a regular basis, ETFs do so only when sold. An actively managed mutual fund (which is what numerous ETF supporters believe is a fair comparison) can generate a capital gains even if the fund losses money. Actively managed mutual funds shift the holdings in the fund during the course of the year and this does present the possibility that you will need to pay taxes on those transactions. But like index funds, ETFs only shift holdings when the index fund it tracks shifts holdings.

So in this argument, ETFs and index funds are similar in tax efficiency. But when ETFs are compared to actively managed funds, ETFs seem the better choice.

Are ETFs a more simple investment?
While you buy an ETF at a set price (which can also be done with index funds, the main difference is the when the price is fixed - in mutual funds it is at the four o'clock close; ETFs reprice throughout the day depending on how well the underlying portfolio has done) that price can gyrate wildly throughout the day. In fact, much of the last minute swings in the overall market are due to ETF positioning and may offer you a false picture of the underlying worth of the ETF.

Those for ETFs suggest that this one price, one trade principle makes these investments better. But the cost of that one trade can be much higher than the purchase of a mutual fund (actively managed or indexed) and that trade, which is whatever your brokerage account charges, is also a factor in the sale. If you add those two transaction to the cost and the fact that many mutual funds do not charge for the purchase of their shares, the argument about simplicity falls flat.

So in this argument, on the surface, ETFS seem less expensive but only as long as you buy and hold which is not what professionals do with this investment.

Perhaps ETFs are more cost-effective
Once again, ETFs cost you dollars to trade. While this is a fixed cost that can be calculated, mutual funds charge expenses against portfolio balances. This makes any mutual fund purchase, even index fund investments, subject to fee considerations. The lower the fee, the greater the cost-effectiveness. With ETFs, you do pay an underlying fee which when compared to index funds is often higher and you pay commissions on the purchase and sale.

One percent is one percent no matter who charges it but if you can buy one for nothing compared to the cost of a brokerage fee both in and out, the ETF argument runs into problems.

The ETF option
While there are numerous types of ETFs available there are also numerous types of mutual funds tracking essentially the same markets. Mutual funds offer sector investments just as ETFs do. Here ETFs are probably better. The simple reason is the ability to allow you to get in and out of a hot sector without any pain other than the cost of the trade. But for the vast majority of investors, their style is passive. They really want to do the research, make the decision and then let the money and the investment ride.

ETF investors crave action even if they do it under the guise of flexibility. They are essentially chasing the next hot corner of the market while mutual fund investors leave the pursuit up to the professional manager they hired.

So in this argument, ETFs play nicely to the investor who wants to move quickly in and out of a hot sector.

Are ETFs easier to transfer
Of course they are easier to transfer. Held in your brokerage account, the shares are yours to take wherever you want. Transferring assets in a mutual fund (index or actively managed) does require a bit of work and there may be a slight charge for the effort but this argument also falls flat. When moving a fund, those shares must be sold and there is a cost in doing so. But most mutual fund investors spend a great deal of time researching their investments (manager tenure, fees, performance and underlying holdings/investment style) and if they desire to move, it is because something has gone wrong with the fund. In this instance, moving a fund is worth the cost incurred. ETF investors move based on price value alone. And they move to another ETF.

So in this argument, the better research you do the more likely you are to buy an index fund and hold it or buy an actively managed fund and monitor it. Owning an ETF is always a temporary investment and the investor is always looking for another ETF to suit their needs.

Wednesday, November 11, 2009

Investing in Mutual Funds: The Mean Reversion

I'll admit as should everyone who writes about investing, there is no silver bullet, no perfect scenario, no predictable table you can follow when it comes to investing. Some suggest that the only way to come close to a comfortable retirement is to invest in stocks. But they have a limited historic return, somewhere in the vicinity of about 6.3%.

Stock funds do worse according to available statistics. The comparisons here get a bit sketchy. In almost every instance, a stock fund, no matter what it invests in, how well it has done, is compared to the Wilshire 5000, an index that represents the whole of the stock market universe.

But in truth, it doesn't even come close. Any sort of index fund that attempts to mimic that index is unable to buy all of the stocks and some buy less than a fourth of what is available. The reason is easy to see and generally accepted: some stocks are simply to small to buy and any investment of any size by any index fund would drive the price of those stocks up. There simply aren't enough shares available (liquidity) to buy.

This comparison suggests that the real rate of return in stock funds is about 3.9% in part, as some suggest, because of fees. And that is if you are fortunate to have the iron-will to stay invested through thick and thin, ups and downs. Sadly, most of us don't.

Our Investment Expectations
We expect everything that is up to stay up and everything that is down to stay down. This leads us to believe that selling a stock fund as it begins to lose share value in favor of a stock fund that is on the top ten lists for the previous quarter or year. Oddly enough, and this is why economist refer to it as the mean reversion, selling on the way down eliminates the opportunity to buy additional shares and a reduced price because we do not expect the fund to recover.

The real trouble is buying a fund at the top with the expectations that there is still additional upside potential. the knee jerk reaction to such a dilemma is to simply buy an index fund and let it ride. The Bogleheads will love this idea. For those of you who are unfamiliar with this emphatic group, they swear by the index fund. It was not a some might think, created by John Bogle of Vanguard but when the age of computers advanced far enough, he became its leading disciple.

Mutual funds present an interesting opportunity even as they seem to offer you more volatility. Even index funds, left alone from the date of your initial purchase, will suffer fits and starts as it lumbers across a thirty or forty year investment career.

Some of us writing about finance will offer you the realistic possibility that a Treasury Inflation Protected Security (TIPS) could do as well as any investor who bought stocks or stock mutual funds. Fine if you are good with 2.6% over a working career.

Because folks usually purchase stocks and stock funds in the hope they will provide some additional growth and risk that will help fund their retirement, pursuing that path might leave you struggling.

The Best Investment Option
The best option remains the hardest one to execute. Ignore the markets in the short-term and invest across a wide variety of investments. begin with actively managed funds. As your wage increases, add more money in the form of index funds that drill into various sectors deeper than a total market index fund might. As you continue to age, add a bond fund or two, domestic and international.

The key is to find low fee funds as compared to their peer group - not to an index. Find a manager who has navigated rough water in the past and emerged with better than average returns. You will have to go back a few years for that. Keep in mind, you are not looking for an average that is comparable when the fund may have lower lows that the funds in its group and an occasional brush with the top ten performers.

In the case of mutual funds, average is good. It avoids the mean reversion problem that many investors have and keeps your risk level at a much higher rate than fixed income. According to Simon Johnson and James Kwak, writing in the Washington Post recently, the goal is to have enough money to buy an annuity upon retirement, in large part because the gamble of outliving your money is simply too great.

Tuesday, November 3, 2009

When to Buy a Mutual Fund: Tax Advantaged Mutual Fund Investing

Most of us who write about retirement planning and investing all focus on getting in as soon as possible and staying invested as long as you can.

And to do this, we use mutual funds. Now we all know that mutual funds have their faults. Some drift in style exposing us to the possibility that we will hold too much of the same underlying investment. Some simply charge too much compared to their peer group. And others simply cannot find the right investments to boost their performance and keep the investors they already have, interested in staying for the long-term.

Attracting new investors and keeping legacy shareholders happy is the real key to the success of the mutual fund. You do not have to be represented by a large mutual fund company to be a very good mutual fund. Not only does the availability of invest-able funds grow, making growth opportunities increase, but the potential for the worst possible problem for a fund, redemptions, stay at a minimum.

Redemptions cause two things to happen. First, the fund manager is forced to sell some of the fund's underlying holdings to satisfy your fellow shareholder's exit. A lot of these types of transactions makes the fund vulnerable and adds to the grief experienced by fund shareholder who believe that the fund is a good one, even if the markets as a whole are suffering.

The second thing it does is force a taxable event. Whether you defer the taxes in your 401(k) or hold the mutual fund outside in a taxable account, this is perhaps one of the worst things that can happen to a future or current shareholder.

Mutual Funds and Taxes
Taxable events are unavoidable in any investment. In fact, it acts as a confirmation that you have made money - in most instances. But in a mutual fund, the tax event might come as a surprise even if the fund will or has posted a loss.

Read the full article here.

Friday, October 30, 2009

Let's Talk Target Date Funds: Investing While Hiding the Risk

On this weeks MomsMakingaMillion radio broadcast, the topic of target date funds is front and center.

The hosts Gina Robison-Billups of and Kat Belucchi of PensionsInc. asked the following question: Almost every 401(k) now has these funds. Many are used as default investments for new employees. But you have a long-standing problems with them Paul. Care to our audience why?

I have been on the record, with some decidedly trash talk centered thoughts about target dated funds in the past. Why do I think these are quite possibly the worst investment idea ever?

Let me explain what these funds are suggesting they can do and why, under the guise of protecting your assets as you grow older, they might not do as promised.

Shooting for a Distant Promise
A target dated mutual fund picks a date in the future that coincides with the year you would like to retire. So far so good. We all want to retire and we all have some idea when that time will be. For most, it it the arbitrary time picked for you by Social Security. For others it might be the moment, at age 59 1/2 when you can first tap those tax-deferred 401(k)s and IRAs.

Suppose you are 40 years old, your target date might be somewhere around 2030 or 2040, depending on what you do and whether you think you can do it for that long. You direct your money to a fund in your 401(k) that offers this date. These are in almost every tax-deferred account due to the Pension Protection Act of 2006 (perhaps one of the worst named pieces of legislation ever).

The fund prospectus suggests (you do read the prospectus, don't you?) that the fund will gradually shift from stocks to bonds over the course of that time frame, growing less aggressive as your account grows. This seems to fall into lockstep with what you have always heard about asset allocation and diversification. And it will be done automatically. No hassle investing for those who feel as though the whole process is too difficult to understand.

But what you fail to realize is that this is uncharted territory that has never really been navigated. Balanced funds offer something of a similar type of investing but usually hold steady at a 60/40 split between stocks and mutual funds. These investments however offer an actively managed approach to the process, a continuing shift in how the fund is invested.

The Success is Hard to Determine
This has not been done with any success in the past and may prove more costly - and more risky - than some investors realize. Some of these newly created funds hold orphan funds that, although they have not closed completely, would have had the fund family not stepped in to save it. This is out-sized risk that other investors have left for good reasons.

Many of these fund managers are entering into fixed income investing world with the idea that this might provide less risk. They may be incorrect in this assumption as bonds may see more problems down the road with inflation and deficit spending by the government, here and abroad.

There is also the question of performance as judged by the benchmarks. Many compare how well they have done against the S&P 500. But the need for new benchmarks still won't mean that these funds will be comparable. Ron Surz, president of Target Date Analytics suggested "The current practices [meaning investment styles] are all over the map. You could have 2010 funds with 90% equity to 20% equity. Any investor looking at the whole landscape is going to be challenged to what they like and what they don’t." And what they understand and don't.

Provider Accountability and Investor Assumptions
In a paper published by Vanguard Group that explored this problem, they describe benchmarks as holding "the provider accountable for the appropriateness of the return assumptions used in constructing the funds." They also suggest that historic returns are a reasonable guide for future results. If that is the case, many of us are in for a disappointment.

Currently, these types of funds employ a glide-path style of investing. But a paper published by Wilshire Funds Management believes this method needs to be rethought. In fact, they believe that a fund - and this might sound even more confusing - need multiple glide-path plans in order to make the fund work. If that happens, the "one-stop shopping" approach that these funds were advertised as doing, no longer works.

So what is an investor to do? While the industry struggles with the idea - and the SEC questions their methods and exposure to stocks - it is best to stay with a broad range of indexed funds across several market sectors or use the actively managed funds that do the same thing. Stocks still rule for the vast majority of us in large part because we simply haven't been investing that long to get any real benefit.

If you have to use target date funds, pick a date that is ten or twenty years beyond when you want to retire so you can get more exposure to stocks longer.

Tuesday, October 27, 2009

Closing the Doors on Return Chasers: Mutual Fund Inflows Create Problems

Like a torrential downpour can overwhelm gutters, flood streets and generally create the kind of havoc only water can, too much money flowing into mutual funds can also leave a mark on both new investors and those of record.

Now that the markets seem to be hellbent on leading the recovery (although there is still a popular consensus that this is not the real thing without jobs and earnings that are built on growth rather than cost-cutting), you have to wonder what is going on? Why is being asked quite frequently these days and many of the answers point to too much money on the sidelines suddenly feeling better about the opportunities and the fear of missing the recovery.

Investors who may have sold their stakes in funds that had done well for them in the past and then hurt them dramatically over the last part of 2008 are eyeballing this return to glory, ignoring the recent past at little more suddenly that I would have anticipated they would. Rushing back into the market is not what mutual funds need right now.

The Upside is the Downside
When investors flee, the remaining shareholders pay the price of staying. There are transaction costs and taxes to be paid (if the fund is forced to sell winning stocks to pay for redemptions) that are left for the fund to pay, passing on those costs. But those shareholders might benefit in the long run if their fund has positioned itself for the recovery. In fact, many investors are finding that staying put has them very close to the even point of where they closed the 2007 investment year.

But the problem with this rush is that it too causes an increase in costs for transactions and creates the possibility that too much money chasing too few stocks begins to artificially inflate those shares and we are off to the bubble races again. Some funds are so narrowly focused that the securities they need are being overbought.

This leaves investor money on the sideline, the exact place that it was before but no longer is. So fund managers are beginning to, at least temporarily close some of the hottest funds with the best year-to-date or quarterly returns. While this doesn't have any effect on shareholders currently in the fund, the problem of a deluge of new investors does not go away; it simply goes somewhere else.

This is especially problematic in the case of bond funds. Chasing performance while eluding risk is what bond investors have always sought. That and a return of their investment. Unless you own individual bonds, and plan on holding them to maturity, you may be unwittingly facing the same problem that mutual fund bondholders might be facing. Credit markets are still tight, the dollar is still weak and the economy has not yet fully embraced the enthusiasm of the stock markets. This makes bonds risky and increases the chances of default (which you will see in the increased yields).

When Fools Rush In
Overexposure and increased investments push bond prices higher and make profitable yields harder to find. This in itself, creates risk that many conservative and asset protection minded investors may not be willing to (or knowingly) assume.

At the same time, an opposite problem is looming for fixed income investors. Bonds are poised for difficulties in the coming years as inflation begins to rear its ugly head and deficit spending, necessary to facilitate the recovery begins to whittle away the current returns. For these investors, what would seem like a win-win situation might turn out to be something entirely the opposite.

Balanced funds and lifecycle funds may also be facing similar dangers as they try to increase bond exposure over time but are finding the endeavor more expensive than they would like. With fewer desirable bonds to purchase, these managers may be left with taking on more risk than the stocks in their portfolio have.

This imbalance could lead to more problems in the near term as investors seek out underinvested corners of the marketplace. The return chaser will simply head (or better, herd) for whatever is available. And a new cycle begins. Despite whatever notion of moving to a lower risk portfolio might provide, long-term investing still points to stocks as a safer haven. Which stocks is open for debate and future market gyrations. Yet, as fixed income portfolio managers try and warn their shareholders that this recovery is unlike any other, those looking for the safest of havens might not find what they are looking for in bond funds.

Paul Petillo is the Managing Editor of

Friday, October 16, 2009

DiWorsifying: The Art of Looking at the Downside

Most of us now realize that our mutual fund investments, particularly those in our retirement accounts, can go down, often dramatically. Until recently, we paid little attention to how bad a fund can perform, focusing instead on how well it can do.

We make random estimates of how much money will be in the account when we choose to begin drawing it down. And as we now know, this can be less than we anticipated (just ask anyone who has postponed their retirement because of a lower than expected balances). So how do you determine the performance of a fund, or better, the risk that the fund will do what you intended it to do?

Some hedge fund managers think they have the answer. It is complicated? Yes. Is it impossible for the average investor to determine? Not if you consider the manager as the sole blame for the fund's performance.

Mutual fund managers are part of the equation you use to pick a fund. Tucked in amongst the performance of the fund, the underlying holdings and the fees, we look at the fund manager's tenure. The assumption being that the fund manager will do much better the longer s/he has been at the helm. tenure also assumes that the fund will have stabilized over the period that the manager is in control.

Fund managers as we (should) know must follow the charter of the fund, avoiding style drift (a notoriously common occurrence whereby the fund manager tries to imitate whatever index works, in the hope of mimicking the return of the benchmark it will compare itself to at the quarter's end). This is managing for the upside, often shifting holdings at or near the quarter's end to give the appearance of better-than-average performance.

Some fund watchers suggest that this is not only the wrong thing to look at when choosing where to invest you fund but can cause you to assume that good times are part of the continuing experience of investing. But markets go down. How the fund manager did during this peak to valley performance is, some are beginning to realize, might be a better indication of how well the fund has done and the manager has performed.

Richard Gates, portfolio manager for TFS Capital thinks "the best way to estimate risk is to try to quantify a portfolio's downside volatility. In other words, how much money can I lose in a given period of time?"

Volatility is an excellent measure of the fund's performance during certain periods. But few of us look at the way the fund manager managed the portfolio (during her/his current tenure and better, their performance in the past) as the indication that your fund will do as expected in the future.

Fund managers are awash in information and you rely on their ability to parse this information, apply it to where you would like the fund to go in the future, and limit the downside risk. Your fund may have lost money; but did it lose as much as comparable funds (benchmarks excluded)?

Some analysts suggest that instead of looking at the best day and make withdrawal assumptions, you should look at the worst day, the moment when your portfolio looks its weakest. If is better than most, you have hooked your fortune to the right manager. But don't limit your assumptions with the current fund under management. Look at all of the performance results from every fund they have managed.

No easy task, and we will talk more about in future posts. But is another piece of the puzzle we should consider. Past results, it seems, matter more than you might expect.

Thursday, October 8, 2009

Green; Not so Green: The Pluses and Minuses of Socially Responsible Mutual Funds

You have changed all of the light bulbs in your house, disconnected all of the energy draining electronic cords and insulated your abode in an effort to not only conserve. But to go green. Have your investments taken a similar path? Are your efforts at finding a mutual fund that ascribes to your values proving difficult? Perhaps it is time to look at socially responsible mutual funds.

While these types of funds have been around for decades, the attractiveness of them has been thwarted by some extra considerations that most investors don't feel is worth the cost. And there are costs.

But first, let's discuss what these funds are and what they are try to do for the investor. Mutual fund managers do not have an easy time finding the companies they need to create an efficient (tax-wise and fee-wise) portfolio of stocks and securities. The reasons are simple: not that many companies comply with the strict definition of what a socially responsible mutual fund is.

One of the attributes is Corporate governance and ethics. While most companies say they act ethically and govern their shareholder's investment with care, far too many fall short. Add to that the issue of how they treat their workers, the quality of the products they produce, which can lead to yet more concerns about the environmental and how what they do impacts the community around them.

A great many businesses have made strides in all of these issues but progress is slow and sometimes scattershot. More difficulties arise when these companies deal with people and workers living overseas. Not only is the politics of the country in which these employees might work at issue but so is how the indigenous people are being treated.

These qualifiers leave the choices dramatically whittled down. Some funds take the list even further, culling out those companies that don't share moral or religious beliefs. But socially responsible investors are on the right track and through their efforts over the years, many disclosures about how proxy votes (those done by your fund manager with your permission) are cast. Also eveidence of this movement has forced many major corporations to begin to "clean-up their acts".

These are all pluses. What about the minuses? Many of the funds who invest in this way use the KLD400 index as a guide, much like the Standard & Poors company provides for index funds less focused on these concerns. That index, according their site looks for "Companies involved beyond specific thresholds in alcohol, tobacco, firearms, gambling, nuclear power and military weapons are not eligible for the KLD400. Companies that do not meet KLD’s financial screens (market capitalization, earnings, liquidity, stock price and debt to equity ratio) are also ineligible for inclusion."

The company tracks numerous other sectors, indexing sustainable companies from the total market down to small caps, Catholic to Select Social Indexes. The cost for research for these funds, even when using the index as a guide tends to be higher than for other actively managed or indexed funds. That would be a minus.

Yet, closer examination of these indexes finds that what usually haunted potential investors, overall return has improved dramatically, in many cases, beating comparable indexes published by S&P or the FTSE (an independent company jointly owned by The Financial Times and the London Stock Exchange).

If you approach these investments in the same way you do other investments, with an eye on cost, performance, tenure of the fund manager and low overall turnover in the portfolio, you will get good results from your flight to value. In fact, you will find many of the indexes listed below actually did better than their less-researched, less sector constrained counterparts.

Socially Responsible funds are sector funds in the purest sense of the word but in many instances lack the volatility of other sector funds. And considering the values these underlying companies are trying to achieve, some on their own, others at the behest and urging of the communities in which they operate, this movement isn't leaving any time soon. And that should have a positive effect on returns and ultimately, as demand grows, the fees.

Returns on the the following indexes and comparable indexes are as of 09.30.09 for a one year period (which includes one of the more devastating years for the stock market):

FTSE KLD 400 Social Index (KLD400) -3.69%
S&P 500 -6.91%
FTSE KLD Catholic Values 400 Index (CV400) -3.55%
FTSE All World USA -6.44%
FTSE KLD US All Cap Sustainability Index (USSA) -6.04%
FTSE US All Cap -6.30%
FTSE KLD US Large Cap Sustainability Index (USSL) -6.81%
FTSE US Large Cap -7.31%
FTSE KLD US Mid Cap Sustainability Index (USSM) -1.14%
FTSE US Mid Cap -3.49%
FTSE KLD US Small Cap Sustainability Index (USSS) -6.92%
FTSE US Small Cap -5.53%
FTSE KLD US Large-Mid Cap Sustainability Index (USSLM) -6.65%
FTSE US 500 -6.57%
FTSE KLD US Small-Mid Cap Sustainability Index (USSSM) -3.29%
FTSE US Mid Cap -3.49%
FTSE KLD Select Social Index (SSI) -6.65%
FTSE US 500 -6.57%

Addditional info for you, the greening investor, can be found here.

Thursday, September 10, 2009

A Look Outside of the S&P 500

I have been on the offensive lately. Actively managed mutual funds, which if you have followed what was written here, are taking quite a lot of criticism from the index camp. Attempting to twist their argument in as many directions as possible, refining the debate to include survivor fund rates and using numbers that skew how actively managed funds compare to their inactively managed cohorts.

I argue that the benchmark is wrong. But to get a broader look at how different categories are doing, indexes do provide a good overview of performance. Some actually come very close to doing what actively managed funds attempt in those categories; others do not.

Here is a list of how these categories did through the end of August 31st. Keep in mind, the year-to-date performance of the S&P 500 is 18.2% to the plus side. Do you know where your risk is?

Latin America Stock/62.3%
Diversified Emerging Mkts/47.9%
Pacific/Asia ex-Japan Stk/45.7%
Foreign Small/Mid Growth/34.7%
Bank Loan/33.6%
Foreign Small/Mid Value/33.2%
Europe Stock/32.3%
High Yield Bond/32.2%
Miscellaneous Sector/30.7%
Equity Precious Metals/26.4%
Diversified Pacific/Asia/25.7%
Global Real Estate/25.3%
Foreign Large Growth/25.0%
Equity Energy/24.6%
Mid-Cap Blend/24.3%
Mid-Cap Growth/23.9%
Emerging Markets Bond/23.8%
Natural Res/23.7%
Consumer Discretionary/23.4%
Foreign Large Value/22.6%
World Stock/22.5%
High Yield Muni/22.2%
Foreign Large Blend/21.8%
Mid-Cap Value/21.6%
Small Growth/21.1%
Large Growth/21.1%
Target Date 2050+/20.7%
Target Date 2036-2040/19.9%
Target Date 2041-2045/19.5%
Small Value/19.4%
Small Blend/19.2%
Multisector Bond/19.2%
Target Date 2031-2035/19%
Target Date 2026-2030/18.7%
Target Date 2021-2025/18.2%
Large Blend/16.7%
World Allocation/16.5%
Target Date 2016-2020/16.1%
Moderate Allocation/15.6%
Target Date 2011-2015/15.5%
Target Date 2000-2010/15%
Muni Single State Long/14.9%
Large Value/14.5%
Consumer Staples/14.3%
Muni New York Long/14.1%
Muni New Jersey/13.9%
Conservative Allocation/13.8%
Muni National Long/13.5%
Retirement Income/13.3%
Muni California Long/13.1%
Real Estate/13%
Muni Massachusetts/13%
Muni Pennsylvania/12.9%
Muni Minnesota/12%
Japan Stock/11.9%
Long-Term Bond/11.9%
Intermediate-Term Bond/10.6%
World Bond/10.3%
Muni Ohio/9.8%
Muni Single State Interm/9%
Muni National Interm/8.7%
Muni New York Int/Sh/8.6%
Muni California Int/Sh/8.1%
Short-Term Bond/7.4%
Inflation-Protected Bond/6.9%
Ultrashort Bond/6%
Muni Single State Short/4.7%
Muni National Short/4.3%
Intermediate Government/3.7%
Short Government/2.6%
Long Government/-11.3%
Bear Market/-27.2%

Tuesday, September 8, 2009

Good Idea No Matter How You Shake It!

Can President Obama do anything with the GOP jumping down his neck, throwing outrageous accusations and false conclusions? No president will make every constituent happy. There is always bound to be someone, somewhere, most likely on Fox News, to make the argument that the intention of whatever the president plans is against some sort of inalienable right.

In the case of his retirement plan suggestion, the best move in quite a while, the right has paraded all sorts of nationalization rhetoric out, town-hall style to impede the plan.

First, the Plan
In order to get people to invest in their future, something 75 million Americans have failed to do or have done so inconsistently, the president is picking the low hanging fruit first. Most 401(k) plans were designed to allow employees to opt-in. This allowed those who understood what these plans provided to take advantage of them, often to the fullest while leaving those who had no or only rudimentary understanding of the value of these plans on the sidelines.

Creating an opt-out plan will net many of those who have failed to make the effort. By making the contribution to the plan 3%, the tax-deferred investment will not have any impact on an employees take-home pay. If they can see the value of not losing and pay as a result of the effort, there is a good chance they will stay with the plan.

President Obama made no direct calls to Wall Street or to the businesses that offer these plans to simplify them. This is probably, at least in the short-term, a good thing. Oversimplification of these plans will lead to less-risk in an effort to assure these new investors that their money invested will not be lost. This would be too bad and easily rectified by suggesting that these plans invest in the future, not save for it.

Second the Contribution
As many swords are, this one is double edged. Allowing you to put unused vacation pay into the plan may see less vacation time being taken. But I doubt it. The increased pressures in this sort of economy (ramped up production, less workers with the same work load) make vacation a necessity as never before. But squirreling some away, added to your regular payroll contributions and not going over the annual contribution limits would allow a worker to grab a few more investable dollars that they may not have had. Some companies have a "use it or lose it" policy when it comes to this type of pay. Investing would be a big plus for these folks.

Third, the Tax-Refund
I suspect that this idea will not be used by many people who look forward to that big tax rebate. Often poor and always unprepared, these people have too much income taken from their paycheck each week. Then, as soon as the new year turns, they are pre-spending this false savings, paying off Christmas excesses or simply splurging on something they could otherwise not have afforded. But for those that do take advantage of the plan, this is a golden opportunity to make some money. You do not need a Treasury account or even a bank account; simply check the box on your income tax form.

Fourth, the Rollover Roadmap
Numerous individuals do not understand the importance of a rollover. When it comes to retirement planning, taking a former 401(k) plan and choosing between a rollover to an IRA or taking a lump sum, far too many people take the cash. Economic reasons aside, this is a bad idea. The penalties and taxes seriously diminish the net proceeds and put you years behind when it comes to pinpointing a date when you would like to retire. With any luck, the effort to explain the consequences will mean less folks will do the wrong thing.

Fifth, the Approval
The upsides are numerous. Better access to plans with newer options to put away money for the future coupled with some straightforward talk may just do the trick. There will be resistance, as there always is. But if these folks take advantage of these new options, they, and the country will be set on the right course. The other upside, it can be enacted with Congressional approval.

Wednesday, September 2, 2009

Mutual Funds Explained: Options in Your Retirement Plan

No doubt about it, your options in your retirement plan are about to change. There could be some questions about whether they need to or not. But rest assured, the effort is under way and many of these changes will not be seen as beneficial for the majority of us.

Cost cutting is one of the ways businesses had hoped to survive the economic downturn that is now a year old. Payroll has been chopped (including paychecks), inventories have been reduced (to accommodate the skeptical and mostly unwilling buyer at the retail level) and in many instances, the matching contribution that so many companies offered as an incentive has been greatly reduced or eliminated (and there is no expectation that this will change before 2011 0 if ever).

All of these moves have resulted in a stock market that has risen since the turn of the calendar year (the Dow is up 3,000 points since January). This vote of confidence by investors has encouraged companies to continue to trim any portion of their balance sheet that might be too costly. Keep in mind that these moves do not grow a business; they merely sustain it. Keeping it propped up in this way is a topic for another discussion. But the trend is alarming.

This cost-cutting mentality has found its way into your 401(k). In the coming months, expect the recent trend to continue. One way of doing this is to add funds with lower costs. According to survey conducted with 85 senior level executives (downloadable pdf), whose jobs require them to find every nickel and dime on the balance sheet, the change is just beginning.

Over half of those surveyed have or plan to make changes to their 401(k) offering by the end of 2009. Those changes will result in less equity funds available than there were just two years ago. What they plan no adding is more funds with longer durations, such as bond funds with long maturities.

This change has resulted in the firing (and in some cases the hiring) of different fund managers. This change has seen a net decrease in the equity side of their offerings in favor of fixed income. Domestic equity funds were reduced as a result of such moves by almost 20%.

These changes have also impacted the default investment side of the equation. Ninety-three percent of those surveyed now offer a default plan for those who have not signed up with 71% of those plans directing their employees to target-dated funds.

These execs also plan on implementing a stress test to these plans in an attempt to insure that certain predetermined funding requirements are met. This move does not necessarily offer additional disclosures for plan participants, ebven as Congress is looking into requiring such actions.

While taking fiduciary responsibility has been lax in the past, numerous companies are looking at adding some sort of monitoring system to protect their risk of liability for not doing so. According to Carl Hess, global director of investment consulting at Watson Wyatt “The uptick in activity could be a sign that many funds were caught off guard by the crisis and are now trying to mitigate their risk exposure."

Wednesday, August 26, 2009

Understanding Money Market Funds

Paul Volker doesn't like them much. Institutional investors use them frequently. And individual investors, particularly those of the smaller variety don't really understand what they do and in many instances, use them for the wrong reasons. They are like banks but are not regulated as such. The Securities and Exchange Commission oversees their activity as per the Investment Company Act of 1940.

The question is: Do we need money market mutual funds?

Money market funds, first created in 1971 offer an investor, institutional or otherwise the opportunity to maintain the asset value of their investment - these funds offer a stable $1 net asset value or NAV - and make a little money in the process. For someone saving for their retirement, it is very little money and should not be part of the plan. But for the investor sitting on a pile of cash and not seeing any other good place to put, the money market fund is as good as any place - in the short term.

Are Money Market Mutual Funds a Shadow Bank?
Yes and no. By design, they are short-term debt instruments. Cash comes in and is lent to commercial borrowers in need of a short-term loan - usually less than thirteen months. This activity, according to former Federal Reserve chairman Paul Volker, who now works as an economic adviser to President Obama is done without the regulation needed to protect the consumer should a large lender default on that loan.

The overall worth of money market funds is around $3.5 trillion. Because the loans these funds offer thousands of borrowers are at a lower rate than those offered by banks and often for a shorter term, Mr. Volker believes that the industry needs to be insured much the same way banks are.

Volker has His Reasons
Back in September of 2008, just as Lehman Brothers and Bear Stearns shook the financial world, one with a bailout the other with a failure. a money market fund made headlines when it "broke the buck".

Money market funds seek to maintain that net asset value of one dollar, offering investors an assurance that whatever they place in the fund will still be there when they withdraw it. Some short-term (often minuscule) return is offered but the safety of that dollar is why investors park cash in these types of instruments.

When the Reserve Primary Fund wrote off the debt that was issued by Lehman Brothers on September 16, 2008, the oldest money fund broke the buck when its shares fell to 97 cents. This incident threatened to collapse the commercial paper market, essentially freezing the ability of many businesses to obtain short-term loans. Some of those loans were made so these businesses could make their payroll.

A Year Later
The President's Working Group on Financial Markets is expected to issue a statement on this part of the industry on September 15th. Although the SEC has not moved to change any of the liquidity requirements (the ability to tap reserves or insurance, such as the FDIC), Volker's suggestion would practically dissolve the money market as it is now known and add regulations that banks currently have in place. I say "practically" because if these regulations were in place, the popularity of these funds would be greatly diminished.

The real question is: can the FDIC handle the increased participation when (and if) money market funds were added to the list of lenders it insures? Even as the FDIC has been forced to bailout numerous banks over the last year, reducing its reserves to $13 billion - its lowest point - it still has access to over $100 billion from the Treasury, and if needed $500 billion.

The FDIC is suggesting that foreign banks be allowed to takeover troubled banks. This would be an interesting maneuver. With a 101 banks having failed since the crisis in financial markets began and the possibility that another 150 to 200 banks may still be at risk of failure, allowing foreign banks to enter into the marketplace might be the only alternative.

There is a decision expected today (08.26.09)to allow private equity to step in a purchase some of these troubles banks. Richard Bove of Rochdale Securities believes "The difficulty at the moment is finding enough healthy banks to buy the failing banks."

If any of these suggestions take hold, Volker's wish to regulate the money market funds, the FDIC opening the door to private equity or the allowing foreign banks (those with a presence here in the US), we might well see the recovery take a firm footing. Until then, we are simply playing the waiting game, hoping the proverbial "other shoe" doesn't drop.

Wednesday, August 19, 2009

The High Cost of Regulation

By now, the Madoff name, synonymous with theft and deceit on a scale so grand that Ponzi would be envious, is known worldwide. Although his actions (and those of his cohorts) did not trickle down to the vast majority of Americans, watching well-to-do people trust vast amounts of money to one person’s assurance and phony returns did not go unnoticed.

And although that wealth is gone for the most part, one thing remains certain, how it happened will force regulators such as the SEC to reexamine the rules that were bent into origami by Madoff’s scheme. What is deeply problematic, and is at the heart of the SEC’s desire to change certain rules could be based almost solely on one statement.

Stephen Harbeck, President and CEO, SIPC, testified before the Senate Banking Committee on the subject of this fraud on January 27th of this year. He suggested: “The prospect of stealing $10 million from a brokerage firm has only happened 10 times in 39 years. The regulators do a good job, generally speaking, of finding these kinds of actions."

Do they? Or is the tangled web of who holds what where, who is accountable, and just how much accounting for their client’s funds can be taken at the word of investment advisers and broker-dealers in need of repair? Securities Industry and Financial Markets Association doesn’t think so and in a letter to the SEC, gives the average investor a peek into why they object to any actions.

SIFMA, the lobby group for the securities industry seems to debunk what has happened to investors like those who believed in Madoff as incidental.

At the heart of SIFMA’s objection is the cost of what the SEC is proposing. The SEC wants to subject registered advisers, broker-dealers, custodians and everyone tangled in the massive web that investing has become (and to a lesser degree, what is your 401(k)) to a surprise audit. The SEC suggests that this type of auditing would cost these entities about $8100. SIFMA believes that it could rise to over a million dollars, calling the SEC’s estimation unrealistic.

Similar objections were raised when Sarbanes-Oxley was introduced following scandals at Enron and Worldcom. But the world of accounting managed to drive those initial costs down significantly as it developed methods to do this monumental task that streamlined the process. Members of SIFMA were surveyed about this proposal for surprise examinations and it was these members who offered their own cost of untangling the mess.

At the heart of the matter is who pays for what and are the protections that SIFMA believes are currently have in place, enough to satisfy the Commission and the investors who worry that they have no idea who or what has their hands in their accounts? The SEC would like the chief compliance officer to step up and certify compliance with the SEC’s request. SIFMA believes that the role of the CCO should be “to confirm that the adviser's compliance procedures regarding custody are reasonably designed and function appropriately. A CCO could, for example, review the adviser's reconciliation procedures, and compare the adviser's and custodian's records to client account statements” and they should not act as an accountant.

What the SEC wants can best be described as transparency. The Commission has suggested that the purpose of the surprise examinations is an effort to “confirm with the custodian all cash and securities held by the custodian, including physical examination of securities if applicable" and to "reconcile all such [assets] to the books and records of client accounts maintained by the adviser, and (ii) verify the books and records of client accounts maintained by the adviser by examining the security records and transactions since the last examination and by confirming with clients [emphasis added] all funds and securities in client accounts."

SIFMA points out the 100% examination may not be possible. Rule or no rule, the organization points out that “an accountant seeking to verify these assets must contact each issuer; if a single issuer is uncooperative or dilatory, the surprise examination may be delayed or even left incomplete.” Does this suggest stronger wording to force compliance, fines or both for those proving uncooperative?

The confirmation of all assets should not be that difficult. Except that in many instances, numerous parties handle these assets. This dilution of blame and accountability is what the SEC wants to improve. SIFMA seems to want business as usual and let the markets and the investors take of itself.

In a comment letter to the Commission, SIFMA asks what would happen if the adviser had no access to custodial rights? Does advice obligate them to have the same descriptive powers as the custodian does, simply for their role as a client’s adviser? There are affiliations to consider between the adviser, the custodian and sometimes the broker-dealer. It is this web of interactive handling of a client’s assets that presents the biggest challenge for SIFMA to rebut.

The SEC would like to untangle this by forcing advisers to independent custodians. To unwrap these wrap clients would incur costs but in the end offer an additional layer of assurance for those interested in retaining as much control with as few hands collecting fees for the service.

In light of the billions of dollars lost by investors over the last several years and the role the financial industry played in keeping that money safe, the SEC is on the right track to improve the standards of accounting, the accountability of the numerous parties involved and by giving them notice that business as usual will not be the best way to conduct business moving forward, it is doing the job they were supposed to do.

As I said, the cost of a surprise examination and a fully completed one will have costs. But those will go down as these wrapped accounts find a way to streamline their management efforts. One of the possible results of these types of rules will be less hidden fees, with less hands in the client’s assets.

Sunday, August 16, 2009

Mutual Funds Explained: The Index Fund Argument

This argument is getting tedious. I goes something like this: Index funds have outperformed actively managed funds about 75% of the time. Those that cite that tedious fact, suggest that the next logical step an investor can make is to invest in index funds. Not so fast.

I have heard this index fund argument so often that I am concerned some folks may think that this is how to build wealth - at least enough for retirement. It's not.

Retirement accounts need actively managed funds to succeed. These types of accounts are tax-deferred (meaning that the taxes you would have paid on any growth are not paid until you begin drawing on the account and to continue the theory just a little further, you pay them when your tax bracket is lower). This is my primary argument for why retirement accounts should not have index funds in them. Index funds are simply too tax efficient.

Actively managed funds, provided you invest in the least expensive, the funds that beat their peer group - not some index - and offer a broad market style belong where risk is spread out over a long period of time. The problem with indexers, those who believe that the low fees are worth the low risk, is a need to embrace the set-it-and-forget-it style of investing. Could they just be lazy?

This belief - that index funds are better - can be blamed on the actively managed funds themselves. They have used indexes, often the wrong ones, to compare their performance. Side by side, this just doesn't work. No actively managed fund can offer 500 companies in its portfolio at any one time. Their goal is to pick the best from a group and run with it. They become investors, just like us only with far more market savvy than the guy sitting at his laptop in the coffee shop.

Actively managed mutual funds need monitoring in part because it is investing - not saving. With a good basket of actively managed funds, you can better diversify your risk and still avoid investment overlap (which, if one of your funds is an index fund, you are doing).

Keep actively managed mutual funds in a tax-deferred account. Keep index funds on the outside of these accounts and pay the taxes on any gains you have made (the tax on long-term capital gains is still low enough to make this an attractive strategy).

Investing is risk management. Remove the risk and you will pay with far less long-term reward.

Saturday, August 1, 2009

What's a Mutual Fund Manager To Do?

This debate will never end. Actively managed mutual funds are not the easiest of animals to tame. Performance relies on a series of variables that few of us could deal with on a day-to-day basis. And in their defense, I want to offer some alternative thoughts to what you might be forming as an opinion.

Not all Index Funds or their counterparts, the ETF, are created equal.

I cringe every time I hear the description of who you are as 'the average investor'. To achieve average, you must have some comparative tool by which to determine better or best, and on the flip side, worse and worst. And of course, index funds have risen to the challenge. They pose a poor comparative tool at best. In Ruth Chang's "Making Comparisons Count" she begins with the philosophical difference between incomparability and incommensurability.

They are in fact, one in the same. These terms are often used when describing different values. In truth though, it is not the value but items that bear value. The problem is, how do you compare alternatives when you need to make a choice only to find out that the comparison of these alternatives, say Fund A, B, and C are not really comparable at all. This would leave you with no tool to make the decision.

When comparing two funds, which is more often the case - more than that and the differences become diluted - investors unwittingly employ the Trichotomy Thesis. Ms. Chang offers the following when making a comparison, "the first must be better than the second, worse than it, or the items must be equally good".

She also suggests that all comparisons may have an element of bidirectionality, a feature that allows some [of the mutual fund] to be better and some of it to be worse.

Comparing Likes

Index funds and the numerous ETFs or Exchange Traded Funds that plumb every corner of the invest-able marketplace with their version of indexing are not worthy comparisons for actively managed mutual funds.

Index funds essentially are trade-less platforms in theory and adjustable ones when the index creator decides to alter the make-up of the index. This keeps the costs down and fund in a passive state. When the whole of the market goes down, the index follows in lock-step. Sometimes. And this is where you compare likes. If the index falls and your index mutual funds falls more, you do not have the index you thought you did. If it costs more than next to zero, you do not have an index fund. If it costs more than $100 to gain access, it is not worth buying. (Note on this last item: Vanguard Group will charge you a fee if your fund falls below $3,000 in value and will continue to do so until the balance has regained that threshold.)

This is how you compare likes - similar products with near-identical traits and in the case of funds, underlying investments.

Since indexes are, for lack of a better term, alike, comparing actively managed funds to them is not only foolhardy, but a waste of time. No actively managed fund is identical to any other fund. Each is a species unto itself with the only similarities that they possess to other mutual funds is where they exist. Both humans and geckos share the same planet, but the comparisons more or less end right there.

The problems facing actively managed funds come from numerous directions. And most, if not all of these problems are a result of shareholder involvement.

Consider this problem specific to actively managed funds: The market goes up and the value of the companies in your portfolio does likewise, and because you have positioned your shareholder's money well, it does better than the whole of the market or any index. Now what? Chances are, the amount of money invested in your fund will increase, coming from current investors looking to make more than they already have and from new money. And the question might seem simple enough to answer: buy more stocks. But where?

Buying more of your winners will only propel the winner's higher. Buying an undervalued stock will also have the same effect and may, in the short-term distract your new investors when the cost of buying-in seems to be higher than they anticipated. These investors will squawk when they do not get the same returns from the previous quarter, received by the investors who were there at the beginning.

The fund has a charter and that should be followed. It is an outline of the fund's strategy and if it is a growth fund, they must find undervalued growth stocks in order to continue to... grow. What happens when they have no real good prospects? They often drift and purchase a value play or simply begin to become an index. Both are lazy moves on the manager's part but it is the investor who is forcing him in those directions.

The SEC does limit the amount of cash a fund can hold. So, it must be invested. This also generates costs in trading and research. Is it bad? Not if the fund has beat its peers. It is against similar type funds that we should compare actively managed funds.

Until that is done, the comparison between actively managed funds and index funds in simply incomparable.

Tuesday, July 21, 2009

Mutual Funds Explained: What Do Mutual Fund Directors Do?

If you listen to John Bogle, founder of the Vanguard group and index fund advocate extraordinaire the answer is not enough and not enough for the money they are being paid. While index funds need little in the way of director input and the manager need only track the index they are assigned, actively managed mutual funds are a different story.

Mutual fund directors are supposed to be independent of the fund family they work for and the managers they oversee. They have enormous fiduciary responsibilities and some take this very seriously. Some, not so much.

There is the possibilities that those who do a job that is not in the shareholders best interest may be compromised by the not only the amount of money they earn from each fund board they sit on but the sheer number of funds they are charged with overseeing.

Bogle raised some eyebrows when he compared the average salary of a board director in the corporate sector ($48,000 per year per board - many who qualify sit on numerous boards) and those in the mutual fund industry ($386,000 per year per board - nearly eight times the corporate average). He more or less called this kind of pay disparity bribery suggesting that the director could not possibly do his job effectively with those kinds of compensation packages being doled out by the fund family.

In essence, Bogle suggested that the director, rather than working for the shareholder is merely a fund manager's stamp of approval. Can a mutual fund director do his job effectively without jeopardizing his lucrative compensation?

Possibly. But could someone like Lee A. Ault, 73, whose name turned up in 371 SEC required filings in the past year? Possibly not. The answer is left to the SEC. Currently, the level of responsibility that these fund directors must assume is really quite low. New regulations would allow the directors to better monitor decisions and performance, set fees that do not unduly impact the returns of the shareholders and keep track of how soft money is spent.

Thursday, July 16, 2009

Mutual Funds Explained: Why Portfolio Turnover Matters

I discuss in my book, Mutual Funds for the Utterly Confused (McGraw-Hill 2008), the differences between the various expenses that impact an investors interest and return in a mutual fund. Among the sneakiest of these fees, is the turnover ratio. Why do investors still use funds that consistently report high turnover of the stocks in the fund's portfolio can be answered two ways. But first, what is a turnover ratio and how is it determined?

The Turnover Ratio is the result of the fund manager repositioning the portfolio. This is done much more often in a growth fund, where the manager may be looking for fund appreciation and to take advantage of this, they must sell some of what they hold in order to buy stocks that they feel will benefit their shareholders.

To determine the ratio on your own, investors will need to divide the value of both the purchase and sale transactions for the period by two and then, divide that figure by the total holdings of the fund. The higher the trading activity, which usually takes place in a growth fund more than in a value fund, the higher the turnover ratio.

If the turnover ratio is 100%, the fund has changed the underlying portfolio completely over the given the period. Less than 100% turnover, the fund's expenses for trading are lower than a fund that has exceed that number. Questions is: why would a fund manager trade so much if they knew that the cost of this activity creates a tax implication (in a retirement account, this tax consequence is deferred until you actually begin to draw on the funds)?

There are several reasons. New managers, of which there are many new faces in the mutual fund world after 2008, like to find better opportunities than their predecessors. Older managers may be attempting to restructure their portfolio to take advantage of newer opportunities that would redeem their fund's less than stellar performance during the height of the downturn. neither of these reasons though are very good.

You pay for research and subscribe to a charter (what your fund's investment focus is) and expect your fund manager to use these costs wisely. A high turnover ratio basically puts the spotlight on poor decisions followed by poorer, more costly revisions of those decisions. The higher the turnover, the more these managers have ignored research offered by their fund family or found that what you already paid for was somehow flawed. The higher the turnover ratio, the greater the resemblance a fund manager has to a day trader.

Even in a growth fund, these costs can be kept down and thoughtful and prudent trading can help a great deal. Believe it or not, there is a limited number of stocks available at any one time. To buy, you need a seller. As all investors know, the seller must know something that the buyer does not. In the small-cap arena, the number of stocks is much smaller because of liquidity (the number of shares available at any one time). Too few shares means that nay activity will drive the price up on the share price, create unnecessary costs, and in many instances, void any potential the stock might have in the near future.

This doesn't mean you should run for an index fund or even a value fund just because of fees. It does pay to consider them though and whether the fund's performance will be great enough to overcome the higher costs.

In a fund held outside of a retirement account, turnover ratios are essentially a taxable event (selling something profitable always creates taxes) and this is often taxed at the short-term rate. If you are using growth fund in your retirement portfolio (and I highly recommend that this is where they should be held) this tax is deferred. But that is not a reason to hold a fund that turns over its portfolio too much in any given period. For a growth fund, the portfolio turnover should not exceed 50-75%. If it exceeds this, something might be wrong.

Be sure to check out our all important examination of why investors do what they do.

Monday, July 13, 2009

Mutual Funds Explained: Prepping for the Third Quarter and Beyond

No market appreciates the beginning of a new quarter when it coincides with a holiday. No market enjoys bad economic news either. So, as earning season begins on Wall Street, a time of speculation, expectations and often dashed hopes and dreams, I want to take a moment and cover some of the behaviors that investors need to come to grips with.

Our sister blog has been reviewing some of the investor habits that are worth noting. You have just watched the recovery of many of your mutual funds, especially of you were not in index funds but allocated in growth both domestically and abroad.

Before You Buy: Why Investors Do What They Do

Loss Aversion begins the discussion with "Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made."

Investors are also guilty of narrow framing. "Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk."

Many of our beliefs about investing revolve around another bad habit: anchoring. Investors "may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring."

Mental accounting affects how we invest as well. "Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past."

Diversification is not what you think it is. "These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In the first part of 2008, billions of dollars were being invested in a market near it top. In the second half of 2008, billions were withdrawn. This is herding at its best and worst. "It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder."

And then there is regret. "One of the basic assumption in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret."

Nothing has impacted your investment style and direction and is in fact least suited to do so, than the media. "Has the hype in the media over the last several months had an effect on how your invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television."

And lastly, there is optimism, that feel good, I want to invest emotion that often gives us reason to engage in all of the previously mentioned investor behaviors. "In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior."

So before you get back into a market (that I hope you never left), take the time to examine the investor in the mirror.

Friday, July 10, 2009

Mutual Funds Explained: Measuring Mutual Fund Performance Using a Rolling Average

In a previous post on performance, I wondered if there was a way for investors to measure how well a mutual fund has done. Mutual fund managers often use comparison to less risky indexes as the benchmark for their own performance. This, we all know, enhances how the fund appears to have done. Right or wrong, I suggested that the ultimate guide to performance may lie in the investor; the person in the mirror who must assess their risk, their goals, and their expectations.

Richard Gates, portfolio manager for TFS Capital agrees. Interviewed recently at Forbes, he said: "I think the root of the problem is not really how returns are measured and presented. Rather, I think the basic problem is that investors just shouldn't be so fickle about short-term performance." And that accounting of performance is what we are faced with, almost daily.

The short-term also presents other problems. For instance, how can you tell whether a mutual fund manager simply has lost her/his/their touch even as the market declined for every fund? In other words, is bad really the fund manager's fault? Or is doing bad something entirely different?

It would be nice to throw 2008 out of the equation. But for the next five years, that year will show every fund as underperforming even as we forget about what happened in 2008, probably soon after we turn the calendar on 2010. The real test is how well they have done since March of this year (2009). But that would be looking to the short-term in the hope of finding some long-term potential. Is it possible?

Is it right to do so? Possibly not. If you are an investor, 2008 looked really bad. Yet, never have investors had such a clear understanding of what worst-case scenario looks like. Bear markets toughen investor hides across the board. Sure, many run for cover. But those that understand that bad can be turned into good, relish the opportunity to grab a once in a lifetime (or perhaps once in a five year cycle would be more like it) chance at finding out what worked and what didn't and even more importantly, why.

Keep in mind, even as funds fell, so did their comparable benchmarks. Were they still able to match, even beat those benchmarks in a down year? Did the fund family pursue a cost-cutting, fee stripping strategy to help boost your return, however meager? Did they look out of house for a different manager to run a fund that was really beaten down?

If your fund manager is still at the helm as I write this, look at their performance over the past ten years to get what is called a rolling average. Compare that number with the benchmark's rolling average over the same period. Then compare it to the peer group, using the same investment style as a comparison.

Then look at your risk factor again. The investor in the mirror will need to make some choices as well. And whatever you do, do not eliminate too much risk. Let your fund manager do what he can to mitigate out-sized risk as they struggle to regain your confidence and at the same time, increase their performance.

Tuesday, July 7, 2009

Mutual Funds: Some Terms, Some TIPS, Some Bond Funds

Let's take a moment and clarify a few terms. Lately, investors and non-investors have heard some terminology being batted around, much of which all sounds the same. Inflation, deflation, hyperinflation, disinflation, stagflation. What do they mean and how do they ultimately effect your investments? Are TIPS the answer? Are bond funds protected?

We are all familiar with inflation. The term simply means that as long as your dollar stays in your pocket (or in the cookie jar or stuffed under the mattress) it is losing value. Often expressed as a percentage, it relates to the buying power of your money. In other words, if inflation is at 3% (for example) your dollar is actually worth less and when you eventually do decide to spend it, you will have to pony up an additional three cents to cover the costs.

Deflation is the opposite of inflation and much more troublesome. To be in deflationary environment is to see prices falling because there is no spending. Unemployment might be the cause. Tight credit might be the cause. Lack of government spending might also contribute. It has a spiraling downward effect that can be hard to change. Once folks stop spending, stop borrowing and basically hunker down, businesses react by layoff workers and producing less. Incomes shrink and the economy tanks. The Federal Reserve usually steps in making money available to borrow and increasing the supply of money available. Sometimes this is all that is needed; sometimes, as in the case of Japan in the nineties and through to 2006, it does not.

Disinflation is not to be confused with deflation. It is actually a good thing in many instances and can signal a reduction in inflation rates, which has the net effect of increasing the worth of the dollar in your pocket.

Hyperinflation is basically runaway inflation. The economy is out of balance. The country's currency has no real value and the balance between supply and demand is thrown out-of-whack.

Stagflation occurs when prices rise as manufacturers attempt to continue to profit but the job's market doesn't improve with those price increases. High prices and unemployment make for an unsavory pair and the result fo this often triggers inflation as well. When oil prices rise for instance but the economy has not provided enough jobs to absorb the increases, stagflation is often cited as the problem.

In tough economic times and with scary terms like the aforementioned get tossed around, investors look for some safety. Treasury Inflation Protected Securities are often where folks turn to cover their assets.

TIPS protect your principal and pay you a dividend (or coupon) every six months. That coupon is adjusted for inflation based on the Consumer Price Index or CPI. This is a survey of goods and their costs used to determine how much these items impact the average income.

And although this sounds like a good way to protect your money, the best way to do it is to buy those TIPS individually and not through a bond fund or ETF. Prices on these types of securities do change and you may lose money when you buy them in a fund.

Mutual funds will try to find bonds in which to invest. And while this is better achieved through a fund - they get better prices and are able to spread the risk among varying maturities - buying TIPS this way is not one of them.

Monday, July 6, 2009

Mutual Funds: Measuring Performance May Not Be Worth The Effort

Point A to Point B. Simple. Clean. Understandable. Investing is none of that yet it is more or less how we approach the subject. This is particularly true of mutual fund investing, where performance falls at the top of the list. Unfortunately, it may not be as measurable (even worth measuring) as we had thought.

The Mirror Effect
Mutual fund investors often fail to correlate the actual returns on their investments for two reasons. The portfolio they own is subject to constant investment and sometimes, if the fund is held outside of a retirement account, withdrawals. The return on your mutual fund statement does not reflect any of those transactions. Instead, it would mirror your portfolio had you done nothing at all.

This of course is virtually impossible to do. Oliver L. Velez and Greg Capra identify this mirror effect in their book "Tools and Tactics for the Master Day Trader" when they write: "Every consistently losing trader sees the market as this angry foe that must be overcome, tricked or even conquered. In the loser's mind", they warn begins to believe "the market is out to get them."

They point out that once this begins to dominate the traders mind, "the market, being the perfect mirror that it is, cast that very perception back, in every detail." The winning trader ironically sees the same market differently, not surprisingly as friendly, warm and welcome, willing to bend to her/his every move.

Measuring Mutual Fund Performance
We have looked at numerous ways to determine a mutual fund's performance from weighing the manager's tenure and experience against a group of his peers. Newer managers realign portfolios and attempt to regain investor confidence with their skills mostly designed to gain in the short-term. But often what they do is lumped together and left to the investor to sort out.

Mutual funds are often guided by a charter that we have all found, is only a loose interpretation in many cases of exactly where the fund is headed. Barriers between growth and value styles of investing drop and the blurry boundaries between what is a mid-cap and what is a small-cap, what is a large-cap and what is a mid-cap, often add to the confusion. Last minute window dressing at the end of a quarter also creates a distortion that the average investor often cannot measure. Most professionals have a difficult time with "noise" as well.

One other thing that cannot be successfully unraveled is the relationship between luck and skill in the fund manager's results from one year to the next, one quarter to the next. In many cases, there is simply not enough time to make good judgments even though a decision must be made. So comparisons must be made and this is where the errors begin to surface. Most funds will chose a measurement that carries less risk and therefore less in potential returns.

This is the point in the discussion where you come down on one side or the other. Many market measurements still point to the success of index fund investing over actively managed funds. In the long-term, indexes do win. But they win because they are tax-efficient and because they cost less.

Here is the problem. If you are investing in a tax-deferred account, the chances of winning in a more actively managed fund, one that is reexamined each year for performance and expectations should provide you with a better need of the working cycle return that an index fund in the same place. Actively managed funds take more work while index funds do not. But removing risk does not replace returns evenly. And in many cases, fees have also dropped considerably as well.

To measure how well your fund is doing, perhaps the only way that you can successfully do it means that you should look in the mirror first and ask yourself the same question.