Thursday, December 30, 2010

Mutual Fund Investing: So what are mutual funds and how can they improve your life in 2011?

You have mutual funds if you have a 401(k). Individual Retirement Accounts (IRAs)hold mutual funds as the primary investment and despite their use throughout the world of investment and retirement planning, too few people have a positive attitude about what this tool can do for them. Most of the negative propaganda comes in spite of the ease of use, often lower expenses than any other investment tool, accessibility, better transparency (or well on the way to providing better insight) and often, tax efficiency. Some do this with great effort; others revamp their portfolio only when an index is restructured.

So what are mutual funds and how can they improve your life in 2011? There are only two types: actively managed or those indexed to a specific grouping of investments. From there, it gets complicated but getting from there is where the whole traffic jam of ideas begins. It makes no matter, which school of thought you ascribe to if you do at all: everyone needs and actively managed group of mutual funds and a passive group if you expect to do anything worthwhile in 2011.

In the coming year, one which is predicted to be quite good despite my doubts, which I will put forth in couple of days with my year-end look at 2011, diversity will deliver more than simply chasing one ideology of the other. The "indexers believe that these sorts of funds are all you need to succeed in any year. Offset by relatively low costs, these funds make up for hoping that that through diversity they can achieve better than average returns for those who invest in them.

As a group, index investors are a fervent bunch. They espouse this investment as the be-all-to-end-all tool and in doing so, give those who chose the other camp - the actively invested mutual fund - to wonder if they may be right. There are reams of research that indexers point to as the reason why they believe this approach. But passively sitting back and letting the market determine your investment outcome is not for everyone.

Actively managed mutual funds are structured in the same way as index funds: a portfolio of investments (stocks, bonds or both), a manager (be it one, more than one or a computer), disclosure and regulatory rules that they must abide by, and performing as billed, if not better. The difference in who picks what is in the fund. Index funds are determined by an index published by such notables as Standard and Poors or Russell or Wilshire. Actively managed funds contain investments picked by management.

Both bring like-minded investors together to pool their money and in doing so, offset the risk and cost of having to build a similar portfolio on your own. Actively managed funds try and outperform their index counterparts in large part because it is these indexes, right or wrong, in which their performance is gauged and graded. If they do better than an index, investors notice, add their money and create increased opportunities for the fund manager to increase those returns with additional acquisitions.

It doesn't always work and some comparisons are unjust (how can you compare a fund with fewer than 100 holdings to one where 500 are held?) and do not paint a true picture of performance. But in tandem, they might work for different reasons for everyone interested in a more profitable 2011.

In times of turmoil, everyone feels pain. When the whole of the marketplace dropped precipitously in 2008, no investor escaped. Some were damaged more than others but as a group, we all felt pain in some form almost at the same time. Investors who simply plowed money into a 401(k) or loaded up on their own company's stock and thought that investing was a world of do-no-wrong, were given a rude awakening. Those that traded actively on their own and were beginning to feel some invincibility creep into their results were caught unaware as well.

And in the past year, investors in US stock funds did what they had done in the previous three, withdrew more than they invested, Called outflows, they impact mutual funds harder than the selling of shares from your own portfolio. These outflowing funds are produced with the sales of a portion of the portfolio. And every such move impacts the remaining shareholders in the mutual fund.

Inflows, or your money pouring into a mutual fund comes automatically in a 401(k), through deductions into an IRA and self-deposited by individual investors. Yet only a handful of people I speak with everyday likes the idea of a mutual fund as an investment and if last year was any indication, think fund focused on the US stock market alone is not the path to financial success.

Why? We want simple things to work extraordinarily well. Nothing does but we expect it of mutual funds. We want low fees, we want moderate risk and we want to know that our money is safe from market interruptions and taxes. And at the same time, we want growth, to retire early and to have our investments perform without hiccup for decades. Only mutual funds can do this - even if we dislike the idea.

Low fees, moderate risk, safety and tax efficiency is a tall order with three of the four fitting the index fund bill. Safety is subjective and safer, even more so. But no equity index fund alone can do this. No bond index fund alone can do it either. Target date funds, hybrids of other equity and bond funds (and often a basket of such funds from the fund family) promise all of the above but have yet to prove they can deliver.

Yet three out of four isn't bad. Put this type of fund in a Roth IRA and put as much as you can in it, consistently over 2011 and you will do as well as this year has done (which looks to be two back-to-back years of double digit gains for the S&P500 index). Even if you do half as well as the 20% plus gain in 2009, you'll be way ahead of where you'd be otherwise.

In the other group, looking for growth, outsized returns and freedom from hiccups, look to your 401(k) where your employer may be retuning to offering a match in 2011. If they do, this is not so much free money as hedged money. A 6% match added to your 6% contribution gives you a lot more room to assume risk that you probably are. Retiring early is a dream even as we acquiesce to work longer. But it can be closer to a reality if two things happen: you invest more and use actively managed funds in your 401(k) to get there and the market corrects a little in the first half of the year. This means buying more for less and positioning yourself for a good 2011. Not 2010, but close.

Whatever your outlook for 2011, a tandem approach to investing - using index funds and actively managed mutual funds might be the best approach in the next year. Be cautious of only two things: this isn't advise and be careful you don't over-expose yourself in any one sector.

Wednesday, December 15, 2010

Are you asking the right questions about your portfolio?

Most questions you should ask yourself about your retirement you do not ask. It isn't because you don't have the question in hand. In many instances you do but you simply fail to seek the answer. For example: when would like to retire is much different that when will you retire. Both queries speak to the same time in your life when your current working career shifts into another realm. But the answers, like the questions, are different.

Target date funds, the darlings of the skittish post-2008 investor, the new-hire and the plan sponsor who believes they are doing the right thing by their employees, the funds that pick a date in the far-off distant future, a point in time when your retirement is supposed to happen don't answer the question the way we all assume. In fact, they may not answer it at all.

Target date funds are designed with, among the obvious pick-a-date moniker, an asset allocation shift over time. If you buy into a fund, such as one that picks 2040 or 2050 as a retirement date, you will have, at least according to the sales pitch, an aggressive to conservative journey spanning the next 30 to 40 years. The idea is that your fund will find the right investments to gradually ease you from being exposed to equities and the potential growth they offer to fixed income and the protection they offer over that time period.

So which fund do you pick if you can't or won't answer the either question? Imagine a 25-year old entering the workforce. They have the opportunity to pick a fund that reflects an investment arc spanning 40 years. Even if they don't understand how to invest or what to invest in, there is little likelihood that this employee will stick with this plan and this fund over that period. Few people buy any mutual fund and devote that sort of loyalty to a fund that almost predicts diminishing returns (all in the name of capital preservation).

As the worker ages, things change. Life happens and in the process, you become more educated, perhaps more risk tolerant (or averse), and you understand the markets better. This changes your investor approach to these funds. You begin to question their strategies, how they allocate the money you dutifully send each paycheck, and whether the fund is doing as advertised. And after all of that, you would have to aks yourself, when will I retire? And if I do, will I keep this fund?

Target date funds come with risks. Many of which are well-known even if they are not well understood. The Labor Department is looking to clear up this confusion for target date investors even if the information is already available - if under used.

Among those risks are disclosure of the fund's asset allocation. Depending on your time horizon, the fund you pick and how that mix of assets changes over time, every target date fund differs in their approach. Now keep in mind, most of us will encounter these funds in a 401(k) plan and have little ability to shop around for a target date fund that does better. Also keep in mind that "better" is a tough call. Any comparisons made between two similarly named funds ends right there.

The Labor Department would also like the the significance of the target date explained. Even the most novice of investors can grasp the target. What they can't wrap themselves around is the fund's investment policy. Few can and because of this, even fewer read this already published information. And what troubles the Labor Department the most about these funds, often given set-it-and-forget-it status in the minds of many of these investors is the inclusion of a including a statement that the fund could lose money - and it might happen close to retirement.

How could something so simple become so complicated? You pick a retirement year (simple) and the fund matures with you (simple) and because there are no guarantees (complicated) and no way of telling whether this is the right fund on the day you put your first dollar in it (even more complicated), how do you know?
Charles Jaffe of Marketwatch believes it is a "to or through" question. Will you have the fund at retirement invested as conservatively as possible or will you be keeping a couple of decades after you retire? Something this simple should be this complicated. The question is really to or through but "why bother"?

I have no problem with auto-enrollment of new hires. I have no problem with educating and offering these new employees some insight on how their 401(k) operates and what it offers. I do however have a problem with the perceived safety of the target date fund in the plan and the seemingly risk-free idea that this is a fund you keep  even if the employee will not stay with the company - or that particular fund - forever or at least until that retirement date.

Making target date fund reporting more transparent as the Labor Department proposes is not going to make the task of choosing easier for those considering this type of fund or who have been auto-enrolled in one. Most mutual fund investors know that there is risk - some can even describe it. Most know that there are no guarantees. Yet target date funds seem to offer a false assurance that time is on your side in a way that is not so for other retirement investors. And that is a problem.