Friday, April 30, 2010

Comparing Mutual Funds to ETFs

If you wonder whether the comparisons most often made between ETFs (exchange traded funds) and mutual funds are done without bias, you would be wrong.  To understand why these traded index funds continue sell their attributes based on cost alone is to miss the point.  While they do have very low fees, as all passively traded funds should, the believers in this investment tool trumpet their attributes but do so not by comparing them to the benchmarks they mimic but to a completely different type of mutual fund, the actively traded variety.
The actively traded mutual fund can be costly.  The reasons for these costs are often quite simple to grasp.  Actively traded mutual funds incur additional costs due to trading more frequently, the research required to make those trades, the assumed risk involved and of course the increased management of those portfolios.  Although it is common practice to use benchmarks as a way of determining performance of actively managed mutual funds, it is not often indicative of what the fund is attempting to accomplish and how many underlying securities are in the portfolio.
Actively traded mutual funds own only a portion of the benchmark (indexes such as the Russell 2000 or 3000, the S&P 500, or total market). More on this unfair comparison.

Friday, April 23, 2010

Make Your Retirement Work the Way You Want: Self-Directed IRAs

Many Boomers may have rolled their 401(k) in an IRA (I hoping you didn't cash it out) and in doing so, was faced with which investments were best.  Some of us already have IRAs but still crave a little more control and possibly, greater returns.  There is a way to do all of these things.

Today we are going to tackle the self-directed IRA. We all know what an Individual Retirement Account or IRA is. Briefly, it is the retirement tool for those of us who may not have access to a 401(k) that defers taxes for retirement. The deferring part is not really as complicated as it seems. In a 401(k), you have your contribution taken out before you pay taxes; in an IRA, you pay with after-tax money and then take the deduction when you file, basically subtracting the taxes from your contribution to be paid later.

How is a regular IRA different than a self-directed IRA?
The differences are not as obvious as the title of these products sounds. An IRA is an investment chosen by you and you direct the funds to it for your retirement. It seems like this should be called self-directed but in reality, it is very different from what the IRS views as a self-directed IRA.

In a self-directed IRA, you become the manager of the whole process. Rather than simply sending money to a mutual, fund company, the most common sponsors of IRAs, you direct the underlying investments. In the previous example, the institution is the middleman. In a self-directed IRA, the institution, whomever or whatever one you chose, does what you tell them to do.

While it might seem complicated and finding good help at a reasonable cost is not that easy, the rules are relatively straightforward. Following to the letter is something you have assumed was done for you in the past; not it is up to you.

Find a Trustee for your Self-Directed IRA
A person looking to open a self-directed IRA is in the same position as someone who is opening a Solo 401(k), which we discussed a couple months ago in our retirement planning for small business owners. You need to find a company that will open the self-directed IRA and act as a Trustee, essentially doing whatever you tell them to do. Then you sign broker-to-broker papers and you are done.

Keep in mind, that if you have a Solo 401(k) for self-employed investors, this process was already completed. If you have what is known as Customized Business Pension, you are also ready to take the next step. Sometimes, a self-directed IRA is referred to as checkbook IRA and the rules may require you to open an LLC or limited liability company. Either of these plans removes the custodian and that makes the investment possibilities immediate and up-to-you.

This is relatively easy and worth the effort. But you do have to be careful. Be sure that whatever the self-directed IRA profits from is paid to the trust and not to you directly. This will be the same as a distribution before they are done without penalty. This means that any gains in the IRA will be tax-deferred. So what you are doing is making your money work harder for you now than it might have been in the past.

You can invest it virtually anywhere: a franchise, rental property, annuities, you name it. You are in charge. The only two things you cannot invest in are life insurance and collectibles.

The Rules
There are few rules to follow when choosing your investments. One, you can’t invest in yourself or the spouse of the IRA owner. For that matter, the Internal Revenue Code or IRC prohibits you from investing with any of your lineal descendants and ascendants. This also includes an entity with combined ownership greater than 50% by a disqualified person(s), a 10% owner, officer, director or highly compensated employee of such entity or a fiduciary of the IRA or person providing services to the IRA.

You can’t sell your assets to the IRA either. You can’t use it to loan money to your kids or pay yourself fees for the work you have done. And you can’t use it to buy the home you live in now.

Opportunities for the Post-Recession World
This types of retirement plans opens a whole slew of possibilities for someone who as an IRA or possibly has been rolled over into one because of a job loss. There are some hard fast rules, which you can check last week’s show link to hear about, but done right, this can create outsized gains your plan may not have created otherwise.
First off, I want to caution you. Not so much about following the rules, but understanding right away, that every investment involves risk and investing in real estate can involve quite a lot of it.

The money in this IRA can be used to buy anything from Single family and multi-unit homes, apartment buildings, co-ops, condominiums, commercial property or land, improved or unimproved, leveraged or not.

The goal here is to find income producing property and have it pay your IRA. Whether you buy the property outright or finance it, the IRA owns the asset, not you.

Can You Finance this sort of loan with your IRA?
Because the IRA owns the property and the property’s value is the collateral for the loan, the only thing you have to figure out is how to pay off the loan. If the property is producing income, it pays the IRA which in turn pays the mortgage holder. Sometimes you can use other assets in the IRA or permissible contributions can be made. This is what is known as a non-recourse loan because you cannot extend credit to your own IRA.

The whole transaction needs to flow through the IRA as if it were separate from you, which it sort of is.
The cost is broken down into two categories. Management fees that the custodian charges. Not all firms who manage retirement accounts can so your choices are limited. I’ve included a few links to begin your research but by no means are these companies recommended. This is relatively small, niche market with only about 2% of the almost $4 trillion invested in IRAs under management.

And the cost of property management, taxes, and repairs is another fee the IRA must pay. With any luck, the property will be able to cover these costs with the rental or lease payments.

Some might say “buyer beware”.
Whenever you have such a small marketplace, oversight is not always done the same way it is done among bigger segments of the investment world. I expect that this particular segment of the world will begin to grow rapidly as folks realize that their old job isn’t coming back, their unemployment insurance is about to run out and they haven’t borrowed from their IRA – so far.

Another reason you should be careful is more about what you know. Buying real estate with your retirement money is actually done best by folks who have some prior knowledge about what they are getting into. Perhaps they were involved in the business before. That doesn’t mean it can’t be done, but the more you bring to the game, the better your chances of winning.

You might also look into a franchise with this money. You can also buy debt. Your IRA can become a lender of sorts buying notes on cars, Treasury bills, even lending money to companies looking to raise capital. Always wanted to invest in a hedge fund, with a self-directed IRA, it can invest. Want to invest in precious metals, foreign stock or partnerships and/or joint ventures; your IRA can do this as well.

A couple of simple pieces of adviceObviously there is the risk factor, which makes this not the be-all-to-end-all for all investors. But if you know what you are investing in and the pitfalls of that investment, you can calculate the costs in advance, this can be like heaven-sent. If you are looking at real estate, the potential is there for people who have the money to pursue some amazing bargains. 

Paul Petillo is the Managing Editor of