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.