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.