Wednesday, September 29, 2010

The Old Mutual Fund vs ETF Argument or An Investment Stranger than Truth

Mark Twain once submitted an essay to a contest about the art of falsehood.  In it, he suggested that only children and fools tell the truth, citing what he thought of as an old proverb.  What really dismayed him wasn't the actual lie, he described that as: "as a Virtue, A Principle, is eternal; the Lie, as a recreation, a solace, a refuge in time of need, the fourth Grace, the tenth Muse, man's best and surest friend, is immortal, and cannot perish from the earth while this club remains" , it was instead the ability to deliver in a successful way. A noble art he called it. Which makes theETF lie all the more true.

What do we know about ETFs? We know they are low cost. But perhaps not as low cost as they might seem.  For the investor moving millions of shares, or even thousands, the costs are just as low for them as it is for the investor owning a single share.  They are basically index funds.  But they are also stocks.  And the lie that owning a single share is just as costly as owning a million or so is told so often, individual investors often become dismayed, even disillusioned by the security when they purchase or sell it.

ETFs are not meant to be a buy-and-hold investment. This is actually a truth designed to look like a lie. Folks who buy ETFs intend on selling them, sometimes at the close of the trading day only to buy them again at the beginning. You can do this when the quantities are huge.  But when they are small, you are left with some tough decisions.  Wait it out and hope that the big investors jump back in or sell on the movement?  Either way, you have bought and are left holding.

ETFs have made the market more democratic and safer. On the other hand, ETFs are responsible for the flash crash where the Dow dropped a 1000 points and regained 650 points. Perhaps not directly, but indirect selling in those ETFs and of those ETFs created more volatility than was needed. According to Chuck Jaffe at Marketwatch: "Many ETF investors set stop-loss orders — pre-scheduling a sale to protect profits if the share price drops to some pre-determined level — but that didn’t minimize their pain in the flash crash, as the market busted many of those orders, flying past the limits because there were no buyers at those prices." The truth was that just because you have something to sell, there will be buyers.  The lie: someone always wants what you have unless everyone is selling the same thing.

ETFs are not mutual funds. Except when they are. If it looks like a basket of stocks or bonds or whatever is popular and you can't afford to buy each and every company in the sector, you look to make a purchase as a group. That is a fund with a mutual benefit.  The fund goes down and everyone loses except when the smart ones get out first. And that is the peril with a fund acting like a stock and trading openly throughout the day.
Some folks just know more than you do and benefit from that. No, they are necessarily seers or prognosticators or even forecasters.  They are just intuitive and quick and you are at work and busy and about to lose more than you thought you could.

Markets are not scary, therefore ETFs aren't scary - its investors who are scary.  Investors often don't have time to be scared before they are scarred by their own inaction. ETFs create volatility because that is how they are designed. Suppose you knew that something big was about to happen in technology or pharmaceuticals. You being a smart investor wouldn't look for an individual stock; you would buy a basket. And soon as the news panned out, or didn't, out you would go.

ETFs in your 401(k) are a good idea. Perhaps one of the single biggest lies being told by retirement planners.  They tout the low-cost, the employee demand and anything else they think the poor guy or gal in HR or in the CFO's chair wants to hear.  But ETFs in a 401(k) drips commissions and fees to the plan sponsor and gives the employee the illusion of doing something they really aren't doing.

The ETF lie is true. Odysseus told numerous fictions to a wide variety of people, each crafted to the circumstance of the one receiving the falsehood. The Greeks may have given the liar his due, even their admiration of a lie well-told. But when it comes to your portfolio, when it comes to your circumstance and your willingness to hear what you need to hear, the ETF is crafty fiction indeed. Good for some who understand it. But for those who think they do, it is simply a deception.

This article originally appeared at and was written by Paul Petillo

Thursday, September 9, 2010

Which Mutual Fund is Better?

The world of conservative investing that has developed over the last couple of years has done so with sound reasoning.  People who buy fixed income believe that in doing so they are protecting their investments in the safety of debt.  That debt, be it from Treasuries or corporate bond issues has seen prices rise while yields drop.  yet they continue to put money in what many are now seeing as the next bubble.  But many equity fund managers are now suggesting that this bull market in bonds is about to end as unemployment continues and economies around the world still struggle.  Are equity funds worried about the investor or the fees they are (or are not) generating?

David Pauly, writing in Bloomberg pointed out that "These managers are concerned about their fees: On a dollar- weighted basis, stock funds on average collect 76 cents in fees for each $100 invested compared with 61 cents at bond funds." Even as money flowing into bond funds increases, PIMCO, the world's largest bond fund company predicts that this bull market in bonds is poised for collapse. When is subject to debate.

We have near zero interest rates, the housing market continues to see price stagnation and there doesn't seem to be any concerted effort by the government to get back into the stimulus game.  Unfortunately, it is the stimulus provided by government that has allowed us to get this far, even if "this far" is still short of where we should be in this economic recovery.

Because investors still see the potential for yet another slide into recession, bond fund inflows have increased as a compared to their equity counterparts.  While these investors are doing so because the believe that bonds still are far less risky than stocks, they may simply be kidding themselves.  Risk, the much needed element in any portfolio seeking to grow, is not something bond investors necessarily believe they are taking when they channel their money into these investments.

That risk is the price.  Bonds are priced based on the willingness of investor to pay for safety and the more they believe this, the higher the price goes.  As the price goes up, the yield falls.

Should the economy double dip, this bet will be worth taking.  But if investors (even if they are prompted by their money managers to get back into the stock market - as Mr. Pauly suggests because of better fees charged by the equity funds they represent) decide at some point that the economy is improving, the sell-off will leave a lot of late-to-the-game investors holding losses they didn't think possible.

Mark Trumball, writing in the CSMonitor outlines this risk: "It's hard to predict when a shift will occur, but at some point, many investment strategists warn, Treasury bonds will become the worst-performing bonds of all. That's precisely because these bonds are considered to be among the safest investor havens during hard times. If a crisis mind-set eases, Treasuries have run up so far in price that they have the furthest to fall."  Should this shift occur suddenly, not only will individual investors be in trouble, but large pensions funds who have difficulty moving quickly, will also suffer.

Inflation also plays a role.  Bond investors will demand some compensation for the increase in inflation, something that has been so far, benign. Robust recoveries usually indicate an increase in inflationary pressures and there is no indication that this recovery could be described that way. Bond gurus also point out that if the bond bubble should burst, should inflation suddenly spike, the retreat away from bonds will not mirror that sudden retreat investors in equities often exhibit.

Vanguard points out that the safety in bonds is likely to be less dramatic in large part because as bond prices drop, yield will increase. And this will keep many investors with a choice: keep the bonds they have flocked to or sell them for the rising opportunities in the equity markets. But Vanguard's prediction that investors will simply freeze may not take into account the nature of investor behavior. They are in bonds because they were frightened of losing their hard-earned money.  But if they see a return to out-sized gains in the stock markets, they may just vote with their feet again.

Vanguard argues that in no matter what happens, bond investors will still do good. In a bad economic situation, the point to historic likelihoods by suggesting the investors who stayed in bonds saw a high relative return.  In a good one, they point out the higher nominal returns will occur. They point out that the rise in interest rates will affect the short-term bond more than the long-term.  Their analysts see a rise (over the next five years) in 2-year Treasuries from 0.81% to 5.28% (rates for longer termed bonds will rise less dramatically from 4.43% to 5.56% over the same five year period).

But this depends on numerous factors including a steady inflation rate, the continued purchase of US debt by foreign banks, predictable increases in the Feds fund rates, modest GDP increases and you. If you hold steady, these predictions will probably come to fruition.  But if things improve in the equity markets and you panic, the bond bubble will burst, albeit slowly, in spite of Vanguard's argument that you will still do okay if you had done nothing.

Paul Petillo is the managing editor of