Sunday, October 31, 2010

The One Fee You don't need in your Mutual Fund

Mutual funds, as we all know, are a group effort. The thinking goes something like this: the more investors in the fund, the higher pool of available cash for investments. To attract this pool of investors, mutual funds advertise. A 12b-1 fee is essentially the cost of this advertisement. If you are buying a fund from a broker, chances are they were compensated by this fee. On the surface, this costs seems to be one of those cost-of-doing-business fees that for the greater good of the investor pool is levied on all the owners of the fund.

But what if the fund is charging you this fee inside your 401(k)? Should you pay for something that has already been marketed to your employer? This sort of fee was first introduced in the late seventies when investor distrust of the stock market was at an all-time high. Mutual fund companies argued that in order to keep their product viable, they needed to increase the number of investors and the only way to do this was to advertise their product.

Fast forward thirty some odd years later, past the greatest bull market, past the introduction of the 401(k), past the two big bubbles of the first decade of the 21st century, past the default investment in our retirement plans, and the fees still exist. According to SEC Chairman Mary L. Schapiro, the reasoning for these fees, which are paid by the investors in these funds has passed. In a press release detailing the SEC's examination of this fee, Ms. Schapiro writes: “Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating.” That lack of transparency at a time when we want to see what our fund dollars are doing when they are not generating returns is troubling.

So the SEC believes that the need for 12b-1 fees has passed. “Our [SEC] proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.” Yet, like all decisions of this nature, there are bound to be casualties. 12b-1 fees are still used by smaller fund families for the very reasons they were initially adopted: to grow the pool of investors. Larger funds families, who have household names and a firm foothold among investors still levy this cost on its shareholders.

Inside a 401(k), where you are essentially a captive audience, these fees offer no benefit. According to BIll Barker, writing for the Motley Fool "They are not used to improve the research of stocks bought for the fund, nor in any way to improve the performance of the money already invested in the fund." And because of that, he opposes them. So do I.

Without any identifiable benefit to existing and often long-term shareholder, the cost of this fee, often $2 on every $1,000 invested should go away. Inside a 401(k), this fee is something bordering on criminal. In a closed fund, one where the fund is no longer accepting new shareholder but still allows current shareholders to contribute to the fund, 12b-1 fees are an abomination, costing their fund participants millions of dollars. (A mutual fund can close for a variety of reasons, the most popular being that they simply have too many shareholders which makes investing according to the charter difficult.)

If you have funds in your 401(k), tell your plan sponsor to do something about it. This is fiduciary responsibility they may not have been aware they had. If your mutual funds still charge these fees and you agree with the investment community - the folks who put their hard-earned dollars in, not the people who sell these products, let the SEC know. You have until November 5th to voice your opinion. You can do so here.

Wednesday, October 27, 2010

The Overvalued Emerging Market

It is easy to be attracted to emerging market mutual funds in your portfolio. If you are investing through a 401(k), you have noticed in your last statement how well they have been doing. Your US equity funds have done well over the same quarter or even perhaps YTD. But the contrast with the mutual funds that might be available to you that invest in other countries might have caught your eye.

Return envy is still one of the primary weakness that investors have. They see a fund that has done well, in this case, almost the entire sector, and we jump, feet first without knowing whether there is a shallow bottom or not. In the world of emerging market mutual funds, that bottom might be closer than you realize.
Emerging market mutual funds have a great deal of headwind to navigate as they get those returns. And just like the days of yore - only two years ago or so - risk is the reason why. Those risks are numerous.

First is the money issue. No country can be considered a viable investment unless they have a good banking system. That statement could be the reason why many stateside investors have looked to other countries for their investment needs. But in truth, the US does have a better banking system than most countries abroad. In its defense, it is able to survive a serious economic blow, put together a plan to recover from it and, although it can be criticized for many of its moves of late, it will still survive even if it is has already shown much of its financial hand. The simplest way to do this si compare a developed and mostly mature system such as that of the US and those in that outperforming emerging market fund.

The second issue is politics. We might have what seems to be a chaotic and disagreeable political system. But because of that robustness, we can be assured that even though we don't know what taxes will be, the discourse on how much we pay will be discussed at length and resolved with compromise. In addition to how the government operates, it is still a business-centric governing body that even when it falters in doing what it considers right, it does what it considers best for the creation of jobs. And even if the US seems to be burdened with regulations, many of which are direct and legislative reactions to abuses, countries overseas have placed these sorts of restrictions before the fact. This keeps investments and innovation under the control and purview of whomever is in charge at the time.

The third issue is economic freedom. While we take capitalism for granted, it si not the case in the largest emerging markets. It is often difficult to comprehend that a country the size of China or India could be considered emerging. But the definition of emerging suggests that while growth seems to be on pace and often well-beyond that of the US and Europe, it is done without the transparency that we enjoy. If China has the ability to drop a trillion dollars in cash into its economy - something a developed country would need to borrow to do - this offers a glimpse of instability.

The fourth issue is risk. By risk I mean your ability to predict and project how much you might make and how much you might lose. Most of us don't do this sort of metric exercise prior to shifting our money from one place to another. We look at all of the basics: return, tenure, return, cost, return, risk, return. And then we buy.

Understanding the risk in an emerging market mutual fund is much harder because of the reasons I have already discussed. But risk comes in numerous forms and the one most likely to derail you is diversity. You may, through your target date funds, your index funds, and even your bond funds, all of which may bill themselves as domestic, may have placed some of your money in markets your are currently looking at with envious eyes. Diversity in a portfolio simply suggests that of there is trouble in one place, not all of the investments you own will be impacted the same. Some will fair better than others.

The fifth issue is investor impatience. Most emerging markets are not near maturity and therefore have a period of time to traverse before they become more reliable. Political unrest needs to be quelled, businesses need to feel as though their investments are safe from political unrest, money needs to be available to be borrowed and infrastructures are solid enough to make it all possible. This is difficult feat in developed and relatively stable economies. Imagine a country on less solid footing, unable to embrace different political outcomes and survive them more or less intact. Which means, the investor who is willing to pay the higher-than-normal fees for such funds, need to wait a much longer time to get back what they have invested in portfolio risk and cost.

This is not to say you shouldn't have emerging market funds. Ten to even twenty percent of a portfolio would be acceptable in most instances. Just be prepared for cloudy days and they will come and you will want to sell. But the developed world needs emerging countries to buy their goods. In that sense, the investment becomes symbiotic and over the long term, you will probably be pleased. But be warned.

(One final note: the exchange traded fund - ETF - market for emerging market investments has grown substantially. In this author's opinion, the risk of selling too frequently and chasing minute returns, as ETF investors are more likely to do,  poses just as much a risk as you would face if you simple held this investment for a longer period of time.)

Friday, October 15, 2010

More than Just Mutual Funds: A Peek Inside your 401(k)

There is no such thing as a simple choice.  We may be very familiar with the options available and we may know a large amount of details about those choices.  But when faced with making the decision, we often freeze, unable to decide and even questioning the whole process.

Just get behind someone at a fast food drive-up window and wonder how long does it take to order from a menu that rarely changes. Your 401(k), the defined contribution plan that many of us have, puts us in the retirement planning drive-up lane and forces us to make a choice.

Few people ever decide to drive on through without making a selection.  Once in the line, you are sandwiched in by the person in front of you, the car behind you and the prohibitive curb. This is your 401(k). This is your 401(k) menu.  Order now, pick-up at the second window, pay at the first and be satisfied with your choice in large part because there is no going back, no changing your mind or adding something else on to the pick you have made (without exiting your vehicle, which defeats the whole purpose).

This is where almost every 401(k) plan in this great nation fails.  Once you have been put in the drive-up lane, you are stuck. You are essentially given a select number of choices, many of which are easy to determine how much they cost in part because your plan is now loaded with index funds, which basically resembles your dollar menu.  Cheap and (portfolio) filing without a lot of extras.

Then the seniors portion of the menu, also bland (and bond-like), suggests that you can get value from your invested money by making sure you get your dollar back - or at least in theory. The kids menu has gotten smaller over the years your plan has existed because there is fear that if this portion of the menu were too large, you might find the restaurant liable for (actively managed mutual funds) choices that were too expensive and fraught with risk.  They could throw in a toy but you would want proof that you could purchase this item without ever being dissatisfied.

So they offer you menu items that you wouldn't expect.  These are items that would be better suited at a sit-down establishment where the big spenders go - not because they want to spend more, they just want to think they are more sophisticated than the general population.  This is the ETF (Echange Traded Funds) choice.

And then we have the value meals.  This portion of the menu dominates the process and in effect, bogs most of the line down if there should be someone who is indecisive. These are your target date funds, a combination of mutual funds tucked under one banner which suggest that you can pick a year in which to retire and the item you choose will not only be worthwhile, but will also fulfill its promise.

Everyday, folks drive up to their 401(k) plan and are forced to make a choice.  Everyday, your 401(k) plan is scrutinized by regulators. Everyday, 300,000 advisers go out to the field and, well for lack of a better word, advise.  That's 300,000 different drive-up windows, sponsored by just as many employers for millions of employees.  A daunting task indeed.  Which is why you are dissatisfied with the choices: you think that there is a better drive-up window someplace else.

Of those 300,000 advisers, the vast majority of them, according to Fred Barstein, the president of 401k Exchange "half have one employer plan. Half of those have at least three plans. Fifteen thousand or so, or about 5%, have at least five plans. Then there's the 5,000 or so elite advisers, who have at least 10 plans, $30 million and at least three years experience."  Mr. Barstein, who is also columnist for the Employee Benefits Adviser site, suggests that the fees that these advisers charge have dropped significantly in the past several years, which is good for the participants but makes it doubly difficult to make a living doing this sort of work.

Not only is the competition stiff, the drive towards least expensive and lowest risk has sliced the revenue stream in half. You might think this would be good for you, the 401(k) plan participant. Turns out, it hasn't been as good as you thought it was.  In this particular scenario, these sorts of plans have become more generic, less customized and inelegant.

When an adviser approaches your employer, the sell goes something like this: You want almost zero liability, almost zero costs, and near zero effort on your part and I, the adviser, will do this by offering target date funds and perhaps a huge basket of index funds and, if we can figure out how to squeeze one in, an annuity.  None of these offers your employees any guarantees, the adviser might suggest ,except for the annuity, which illustrates a distribution of retirement income and unfortunately comes with a cost (a trade-off of sorts).

Is it any wonder why you sit at the drive-up menu for longer than you should?  All of the choices look the same. And then there is the problem of getting you to order the product best suited for you. Here is where they suggest a sort of buy one get one free (or the matching contribution). By the time you get to the drive-up window, you may been sitting in line, waiting your turn for almost a year.  Then to get the other half of the buy one, get one free offer, you may have to wait an additional period of time (a vesting period that can be more time than you planned on staying with the company to get).

Then there is the super-fast lane where you are essentially put on a bus, driven through without access to the window at all.  The driver, your employer in this example, orders what they believe is best suited for you - take it or leave it. In this situation, you will be dropped into a target date fund and told that you can opt out (go hungry) or stay in and believe that this menu choice is probably the best one for you because someone thought it might be.  That someone is the adviser.

Now Mr. Barstein does suggest that at its rawest, it is about selling. Selling a plan involves training, partnering and a constant source of information. Much like fast food drive-up windows, who might consider your health as a passing interest in order to get you to come back, increase their bottom line with a salad and offset fears that their choices are not the best ones available (doing it yourself will always be more satisfying but more time consuming as well), your 401(k) plan is designed to fill you up.

The adviser and the plan sponsor hope you drive off happy and satisfied.  As long as you drive off and don't sue them.

Monday, October 4, 2010

Keeping that Balance and Maintaining It: Asset Allocation

Dan Solin is right when he suggests that no one ever brags about their ability to achieve optimum asset allocation. Its not all that sexy and quite frankly, lacks the sexiness that doing something extreme often nets you.  Something like not using asset allocation.

Asset allocation is something of a mystery to most of us although no writer worth her/his mettle would bypass the opportunity to tell you it is one of the keys to investment success.  You will hear those who use index funds as a primary driver in their portfolios selling the notion that once you embrace this passive sort of investment, asset allocation becomes second nature. It certainly becomes easier.

To allocate assets is to take and spread risk across many different stocks and bonds.  The idea here is that no market performs in tandem.  Some corners will remain sluggish while others shoot for the moon.  Asset allocation keeps you in both but keeps you involved in a measured way.

Too much of any asset class usually means that asset is doing really well. This is where the tough part comes in.  If that asset is doing so well, you probably should begin selling some of it in favor of the assets in your portfolio that aren't doing so well. This sounds sort of counterintuitive and I'll explain why it shouldn't.  Even if afterwards, it still does.

Because we are talking mutual funds and not individual stocks, and we will for the sake of the argument, use index funds as an example.  A large cap index fund may be in favor with investors because investors are looking favorably upon the companies in the index. But you also hold an index of small-cap companies that seem to be lagging behind - at least as a comparison. To continue to send money to the ever-rising fund, you should take some of the profit off the table and transfer it to your other allocations, balancing your investments at the point you began.

But, you stammer, that fund could go higher. Why sell a winner? Because that is what you do to make money: sell winners.  But in order to keep your allocation in balance you shift those dollars to the other funds in your portfolio, buying shares in those funds when they are less expensive.

Should you consider using actively managed funds in this process? Depends on your age and whether you plan on focusing on the balance among the funds in your portfolio. If you have a fifteen year or longer time horizon until you estimate you will begin to tap your account for income, feel free to take your chances.

Index fund users will never stop stressing the importance of fees and the low cost index funds have. And this is important.  But fans of the actively traded mutual fund are also focused on fees and equate performance against this measure. But the comparisons are difficult and calling this type of investing successful depends on numerous variables. (From which benchmark is being used to how many funds are spread across how many asset classes, the variables can astound and compound.)

The importance lies in keeping that balance and maintaining it. The only risk you can add to your portfolio is not adjusting your allocations at lest once a year. We are in for a volatile decade, as unemployment strings out, debt continues to be an issue and the tax debates continue and that is not without some pressures in the stock and bond markets.  This balancing act wil take time and effort.  But the person who bothers will end up with more years of positive returns than someone who fails at this decidedly unsexy task.