Saturday, May 30, 2009

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)


You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."

Wednesday, May 27, 2009

Mutual Funds for the Utterly Confused: Blind Ambition

Sir Isaac Newton once said after a failed investment: “I can calculate the movement of the stars, but not the madness of men.” Do mutual funds change this madness into profits for the average investor? Had Newton invested in a fund instead of chasing an individual investment (like the one he purchased in the South Sea Company) would his money have been safer?

To answer these questions, it is important to understand some of the basics of what a mutual fund is and why it works for those who seek a longer range opportunity and lack the financial savvy to speculate (gamble is actually a better word).

First off, a mutual funds gathers like minded investors to a strategy that employs a manager, a team of investment managers and sometimes even a computer to look at stocks and bonds that fit the goals of its investors. This sounds simple but the "madness of men [and women]" can often play a much larger role in whether this goal is achieved. Mutual fund investors are looking for three basic properties: achievable gains, avoidable losses and control of that mental maniac that wants us to sell on the way down and buy on the way up.

Because funds are populated by the human factor, this madness is not often easy for the fund to control. No (actively managed) fund begins its existence with the goal of losing money. They gather information about investments, take positions in as little as twenty companies and as many as a thousand (often more with index funds, but that is another story) and allow the market to do whatever it may.

Does this mean that you relinquish some control over the day-to-day fluctuations of the market? Yes. And if that is the case, how should you react when the market turns ugly?

The stock market offers the opportunity to gain on the belief that the investment will perform better than it is at the point of purchase. When you buy a stock individually, this gain is realized in plain numbers. Conversely, any losses are also realized in plain numbers as well. In a mutual fund, because there is a huge number of shares in a large number of companies, a gain is diluted (just like any loss).

Unfortunately, mutual fund investors do not always embrace this idea of diversity. They often see the fund's failures as much more individual and its gains as much more muted. If the market surges, and it will, the fund is usually moving in a slower lane, getting there eventually but traveling at a more measured pace. If the market stumbles, and it will and has, investors are reluctant to embrace the possibilities that their investment, because it is diverse by nature, will protect them better than had they invested individually.

The comparisons with broader markets, such an index that tracks 500 of the largest companies, is not well placed. The fund managers have made decision to purchase only a portion of those companies and comparing their efforts against such a broad market is unfair. Yet it is done and often. How your fund performed against an index fund, how much you paid for the services of the fund manager and lastly, how well the fund has sold its philosophy all play a role in how you might react.

Funds have been positioned inside the our retirement plans for a good reason. 401(K) plans offer us the opportunity to invest evenly and consistently over time. This removes the buy on the way up and the sell on the way down problem that plagues individual investor psyche. The approach is called by several names: defined contribution is often used by perhaps more aptly, it is dollar cost averaging.

Once you determine how much of your paycheck will be contributed to this plan pre-tax, you have employed dollar cost averaging. This method uses a fixed dollar amount to purchase shares. Sometimes, when the market is on the rise, you buy fewer shares; when the market is on the way down, you are able to purchase more.

Sounds counterintuitive but it is exactly this method of buying that removes that mental maniac. Had you remained in the fund of your choice when the market was on the way down, made no moves to stop or limit your defined contribution, you will have benefited over the long-term.

But what if you panicked and sold those actively managed fund, opting for something like a target-dated fund, one that readjusts its investment goals over time to account for your age? Did you make the right move? Not necessarily. If you had picked one of these types of funds for the safety it offered, the hands off approach to investing, you would have done well to choose a fund whose target was twenty-years beyond the year you picked.

(Just a reminder about index funds: You will be tempted to use these funds if you know little about the way funds work, But don't. These are tax efficient and belong outside your retirement plan.)

Thursday, May 21, 2009

Bond Funds Make PPIP-ing Noise

I must first begin by bringing you up to speed on a couple of terms that have been added to our financial lexicon. TARP was introduced last year as a way to finance troubled banks, keeping the largest financial institutions afloat while they worked out their problems. Dubbed TARP (Troubled Asset Relief Program), money was more or less forced on banks to instill not only confidence in the system but to give the lenders money to get the credit markets moving again.

The TARP program has shown signs of success. Critics have attacked the banks for not lending enough of the money or making the standards for lending far too tough for the average borrower. Some banks have attempted to give the money back, somewhat prematurely and long before they have shown that the problems on their balance sheets have been addressed. Another version of this program is about to be extended to smaller banks and commercial lenders.

One of the other challenges facing the Treasury is the problem assets that caused this financial meltdown. By soliciting private equity money to help and guaranteeing or matching private investment, the Public Private Investment Plan or PPIP was developed. While the economy is showing the initial signs of recovery, there are still a great deal of mortgage backed securities (MBS) and asset backed securities (ABS) floating around on various balance sheets with a need to be priced and sold. PPIP is offering private investors (more specifically, some of the largest fixed income mutual funds and hedge funds in the investment world) the opportunity to purchases these at a reduced risk.

Along with PPIP the Term Asset-Backed Securities Loan Facility, or TALF, will give some investors the opportunity to purchase securities that may prove to be bargain basement priced. Once these big investors (PIMCO, BlackRock, or Western Asset Management) begin to see some profits, the trickle down effect will take hold.

Who might this trickle down effect help? Right now, it is difficult to tell. There is still a long way to go yet if the program works, some funds that use bonds to offset risk might see some recovery in their portfolios. because these funds will likely be sold as closed end funds and not necessarily priced for the average investor, target-dated funds might find the opportunity to good to pass up.

According to Morningstar, the risks are still very real and may even be underestimated. They reported that "If asset managers get the impression that the government is unwilling or unable to guarantee contracts of mortgage-backed securities or protect asset managers from attempts to claw back some of the profits made through PPIP, we wouldn't be surprised to see managers back away from the program en masse."

When reviewing your fixed income portfolio, look for transparency on this particular side of the coin. The risk may be worth taking. But just as possible, it might not.

Sunday, May 17, 2009

The Curious Case of (Index Fund) Fees

There is a simple idea behind the index fund. You create a fund that mimics an index, often published by some other investment company. In doing so, you basically purchase a broad swath of the marketplace, whether it is the top 500 companies, the whole of the marketplace or some other sliced portion of the stock or bond markets. The idea is designed to be cost-effective, in part because once the index is purchased, you basically employ the buy-and-hold strategy until the index itself changes.

So why do the fee vary so widely when it comes to something as simple as an S&P 500 index fund? The answer is they shouldn't. But the truth is, they do. And some are so high, they begin the approach to the fees levied in actively managed funds.

Consider the case (and the motive) for Charles Schwab's recent decision to lower the fees charged to retail investors in their index funds. Any time you lower a fund's fee, it is cause for celebration. Perhaps it is the skeptic in me that asks the question: why were they so high in the first place?

The fee reductions were most noticeable in its two largest index funds. The $4.59 billion Schwab S&P 500 Index Fund (SWPPX) which at one point before the change charged its shareholders 0.19%. Dropping it to 0.9% now positions the fund to take shareholders from the other index funds. But probably not from Vanguard or Fidelity.

Fidelity is selling some of its index funds for 0.1%, while Vanguard Index funds charge around 0.18%. So why care about what Schwab is doing? Low fees are great but to entry level purchases into either of the Fidelity or Vanguard funds can be prohibitive for new investors. Fidelity can charge, in some cases $100,000 minimum investment to get that rate, while Vanguard puts its minimum initial investment at $3,000. Schwab wants only a hundred dollars to open the account.

So should you change for a lesser fee? Yes if the fund is also doing what it intends to do. Numerous index funds drift away from their intended purpose and this error can be costly for investors.

If you are using index funds as they should be (we have often discussed this in our retirement planning blog suggesting that because of the tax efficiency of these funds, it would be somewhat foolish to defer paying the taxes on these types of funds) outside of your defined contribution plan such as 401(k) or IRA, then shopping around and choosing the Schwab alternative might be a very good move.

Monday, May 11, 2009

A Stern Warning From the SEC - Just in Time

In a recent address at the Mutual Fund Directors Forum Ninth Annual Policy Conference, Mary Shapiro, SEC Chairperson announced her problems with target date funds. As you know from previous posts here, at the previous address of this blog, on my website and on our retirement blog, these funds are not as yet advisable alternatives to a portfolio built on your own. And even if the temptation to allow these types of funds, which in short look to some far-off future date that you pick for your retirement and readjust your risk and holdings to make sure that you grow increasingly conservative with your investment dollar, turn out to be what they sy they will do, there are far too many issues right now.

In her address to these fund managers, the much tougher than the previous eight years of SEC chairpersons told them of her concerns. She said: "Growth in target date fund assets is likely to continue since these funds can be default investments in 401(k) retirement plans under the Pension Protection Act of 2006. More than 60 percent of employers now use target date funds as a default contribution option, compared with just 5 percent in 2005.

"However, target date funds have produced some troubling investment results. The average loss in 2008 among 31 funds with a 2010 retirement date was almost 25 percent. In addition, varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6% to minus 41 percent."

This single acknowledgment should send alarms ringing throughout the mutual fund world. No longer is business as usual, I'll-turn-my-head-and-let-you-do-what-you-want-to type of enforcement. No longer is this simply the wishes of Wall Street over the fiduciary responsibility of those managers, who lobbied mightily for the Pension Protection Act of 2006, which more or less mandates the use of these funds.

She offered a clear cut objective instead for her agency "that SEC staff is closely reviewing target date funds’ disclosure about their glide paths and asset allocations. The staff also is examining whether the same target date funds underlie both retirement and college savings plans. The staff has been working closely with the Department of Labor in light of target date funds’ prevalence in participant-directed retirement funds. This important issue has also been an area of focus for Chairman Kohl and the Senate Special Committee on Aging."

As I have mentioned before, many of these funds lack clear transparency of just how they plan on achieving their promised results. I have accused the industry of dumping orphan and unwanted funds into the portfolio of these funds to keep some investor's money on the table while sacrificing others in the process. The fees are still much higher than they need to be. Ideally, they should be closer to the index level, charge no 12b-1 fees, and offer more succinct projections of what is to come. Mae West once suggested that “An ounce of performance is worth pounds of promises.” Ms. Shapiro, to her credit wants more.

Her final warning: "While you do your part, we at the SEC will do ours. We will consider whether additional measures are needed to better align target date funds’ glide paths and asset allocations with investor expectations. Among other issues, we will consider whether the use of a particular target date in a fund’s name may be misleading or confusing to investors and whether there are additional controls the SEC should impose to govern the use of a target date in a fund’s name. As we pursue this analysis, we will have a special focus on the expectations of the millions of everyday Americans who use target date funds to invest for retirement and educational needs."

Good luck Ms. Shapiro but I believe the wind is at your back on this one.

Wednesday, May 6, 2009

Mutual Funds: The Alternate Universe

Numerous investors are now seeking safety in their strategies, foregoing risk in favor of what is often referred to as value. Warren Buffet is often considered one of the great value investors, specifically looking for what is known as absolute value.

The strategy employed by fund managers in these types of funds does, in fact come with some risk, although the name suggests otherwise. Buying value is not as easy as it appears, requiring the fund manager to look at certain key aspects of the companies they are investing in before making a decision.

Absolute value funds look for stock prices that are selling for substantially less than what they perceive the company to be worth. This is no easy feat. It involves not just looking at the relation of the company's stock price relative to its peers on the S&P 500 but using a view of the assets involved, the business's balance sheet and the overall growth prospects. To do this might mean that a great deal of potential earnings in the share's price will be ignored in favor of the safety of basic material type investments. (A good example is the avoidance of tech stocks in the late nineties.)

Absolute Value fund managers pride themselves on ignoring market fads. Looking instead for out-of-favor p=companies, the manager of an absolute value fund will look to a long-term outlook as opposed to the short-term gains a market might offer.

Relative Value funds do something similar by looking at the dividend payouts for funds and using them to bolster the often slow rise of the company's share price. Dividends provide a big safety net for investors in these types of funds, even as a good many of the S&P500 companies cut them. Most fund managers will set a 2% dividend threshold when looking a dividend paying shares. (Rule of thumb for the average investor: a dividend in excess of 5% is often a warning sign of trouble ahead, even for value managers.)

Jean-Luc Nouzille, Portfolio Manager and Founder of Bristlecone Value
Partners, LLC offers this take on value investing: "The key emphasis for every absolute value investor is definitely the idea of investing when the
risk/reward situation is attractive. We believe that our first layer of risk management is the analytical work that we do on a company that we consider for
investment — looking at the balance sheet and the competitive situation and buying them at a big discount to what we think they are worth. Historically when you do that, the downside risk of those types of investments tends to be lower than the upside potential. So this emphasis on protecting your principal when you invest at a discount is a key to our process.

Be aware that this is not a stand alone strategy - a worry that many who look at the name, the idea of protecting principal, and the philosophy of this investment style - is not the only fund you should hold in your retirement portfolio. Newer funds claiming to be absolute value investments have seen huge inflows of mutual fund money. Some funds, like those recently launched at Putnam have offered targeted returns of up to seven percentage points over US Treasury bills.

Monday, May 4, 2009

Sidestepping Risk: Bond Funds Offer More of Less

It is an act of faith to invest. Michel Eyquem de Montaigne (1533–1592), credited with the invention of the essay once suggested "How many things which served us yesterday as articles of faith, are fables for us today" would not be surprised by how investors are looking at their options. No more do investors believe that they can beat the market. No longer do they see risk as something will always play in their favor, rewarding them year over year with riches and gain simply by believing in forces many have no idea about. It seems that they no longer have faith.

We don't need to rehash old news about how far the market has fallen and even as it picks itself up, there are doubts that the once glorious years are well past us. Mutual fund outflows compared to the years prior see a steady rise, enable by the number of people who, for one reason or another think that selling at the bottom (or near bottom) is still far better than taking a long-term approach.

Wall Street and those that report on the happenings there see investor sentiment shift from stocks to bonds and like all good industries, they are moving with the crowd. This is the same crowd who shifted $25.7 billion in assets out of mutual funds in march even as the S&P 500 posted hefty gains. The were undeterred by the fact that there will eventually be a recovery, perhaps, as I mentioned in another post, in as little as four to five years. The folks making the shift have time to wait. But choose instead, to head for the doors.

On the flip side, bond funds gained. The Investment Company Institute, a mutual fund trade group that tracks these sorts of trends noted that the current bond market investment now totals almost $4 trillion, almost a 50% increase over the year earlier (a time when investors still had faith).

Some of that money is headed into target-dated funds, an unproven investment vehicle that promises to gradually shift an investor's money from stocks and bonds to bonds and stocks as they age and become closer to what the fund calls the target. That target, suggested by the fund's name and more importantly, the estimated tolerance of risk as they head toward retirement, has seen net inflows of over $10 billion in the first three months of the year.

This is in part due to the default option in 401(K) plans, where the employer, as directed by the Pension Protection Act of 2006, may invest on the employees behalf in such a fund. And once that happens, studies on investor habits have shown, the employee is not likely to change where their money is headed.

(It has been well-noted here that target-dated funds are an even bigger leap of faith than actively managed stock funds may be, an argument that suggests that these funds are often a mix of bedraggled and failing funds the fund family is keeping alive, albeit in a resuscitative form. Also problematic is the idea that these funds will perform as promised any better than if you had done it yourself, for lesser fees and only an annual revisiting and adjustment of holdings. And one last thing: will the fund manager at the helm be the same one five, ten, or twenty years down the road, perhaps the single biggest factor in the long-term success of the fund?)

There has been an interest in index funds as well. The argument against these in a retirement account is simple: taxes. These funds trade little and because of that lack of activity, their tax implications are very low. If you want to hold an index fund, do so outside of your retirement account where you can still take advantage of the low capital gains taxes. Adding to their attractiveness and your profits in the long=term is the low cost of owning an index fund, which, for the investor means more money in their pocket at the end of the line.

Driven by the need to protect what is invested, even the investment grows at a much slower pace, bind funds have become resurgent. For the younger investor, this type of investment is closer to stashing money under the mattress. For the older investor, it should part of, not the whole of their portfolio. But right now, lack of faith, a downturn in optimism, and the long range outlook focused on short-term results, will drive an increasing number of investors to give up potential gains in favor of not losing.


We have moved to this blog from our previous location on April 10th. You can find numerous additional articles along with notes from the book "Mutual Funds for the Utterly Confused" (McGraw-Hill, 2008) by clicking here.