Tuesday, December 20, 2011

Investing in the New Year: Are Mutual Funds Important in 2012?

This article originally appeared at BlueCollarDollar.com and was written by Paul Petillo

"Time is free, but it's priceless. You can't own it, but you can use it. You can't keep it, but you can spend it. Once you've lost it you can never get it back." Harvey MacKay

One of the key elements in any financial transaction is time. If you want to retire, you must consider the amount of time. If you want to borrow, how long you have to pay it back can be translated into dollars and cents. Investing; timing they suggest can't be down but is important nonetheless.

If you are twenty, time is on your side. If you are thirty, there is time left. If you are forty, time is of the essence. If you are fifty, time is running out. If you are sixty, where has the time gone. And older than that, time is no longer on your side. It accompanies us through life like some dark passenger. It reflect back on us from the mirror. And when we look at our retirement plan, it stares at us without guilt or shame. Time is the truth.

When I first began writing these predictions, and I've been churning out these year end ditties for over a decade, many were laced with optimism, some with an urging that we learn the lesson and move forward armed with knowledge of past mistakes, and still others were exercises in reality. In 2012, we have some opportunities and some problems awaiting us, left on the table as we symbolically turn the calendar wiping out 2011. But it won't leave quietly.

So I have a few thoughts about what you can do - resolutions of sorts but not the drastic sort we make and break almost within hours of promising ourselves at midnight.

Increase your contribution I start with this obvious chant for two reasons: you aren't making a large enough contribution and two, I would be remiss in not telling you this right from the start. And I'm not just speaking to those with a 401(k).

There are the millions of you who are forced to (and because of that are not likely to) finance your own retirement through an individual retirement account. We lament at the worker who literally only has to sign up at his workplace and doesn't. And far too often, we say little about the person who has to sign-up (after finding a fund), commit with a fortitude that is somewhat lacking and to contribute some of their paycheck via direct deposit every week or month. That effort, it seems is a much more involved hurdle.

In 2012, the investment world will be little changed. It will roil and confuse and gyrate and possibly even nose dive - just as it has for decades. It will react to news - if not from Europe form China or even the presidential elections (which ironically tend to be excellent years to invest). This will have you second-guessing your investments. But this will only apply if you have no idea how much risk you can take.

Pay attention to diversification You may not be capable of rebalancing, the act of making sure that your investments are directed evenly across many investments. This is much harder than it seems. As long as you are involved - and that is YOU in capitals - the struggle to keep balance will not get any easier.

For the vast majority of us, mutual funds will be the investment vehicle of choice. These investments will see more movement towards fee reductions. Which is a good thing. Fees will and always have been a subtraction of gains. This makes an excellent argument for indexing.

Choosing six index funds across the following cross-sections of the markets will not solve the problem of rebalancing (some will do better than others) but it will provide diversification. Index the largest companies (an S&P 500 fund), a mid-cap fund (the next 400 companies in size), small-caps (the next 2000), an international fund (an index of the largest countries (those with established banking systems even if they are currently troubled and will continue to be so in 2012), an emerging market fund (after international funds, the most risky) and a bond index (one that covers as much fixed income as possible).

Some of you will wonder if exchange traded funds (ETF) wouldn't be just as good if not better than simple indexing. In 2012, ETFs will continue to drill down ever deeper into sectors of the markets that add risk along with the illusion of an index. ETFs will become more actively managed in 2012 offering you more risk at a lower cost. Cheap doesn't mean better. 2012 will be year of the ETF. If you are unsure what these investments are, consider this conversation I had with David Abner of Financial Impact Factor Radio recently to help explain what these investments are and how they work.

Focus on your financial well-being This refers to your credit score. It continues to impact your financial future and will become increasingly harder to ignore. A new credit rating service agency will add to the difficulty in 2012 and not only will the current scoring impact costs such as insurance, it will seek to trace the breadcrumbs of your financial life more thoroughly that the big three do.

There is little likelihood that the job market will increase as many of our returning troops will flood the marketplace, taking numerous jobs from your kids just out of college. Which means another year with your kids at home. The only answer to this problem is to continue to tighten down your budgets in 2012. As I mentioned earlier: "If you are forty, time is of the essence. If you are fifty, time is running out. If you are sixty, where has the time gone."

And you must do this understanding that inflation - not the reported number but the real number in your grocery bill - will still chip away at your wealth. This means you will move in two opposite directs in 2012: saving and investing more for your fleeting future (at least 6% but 10% would be best) and spending less in the present (easy of you don't use credit).

And the housing market will improve for those who have repaired any damaged credit or who have saved enough of a down payment to buy a house. people are still buying and selling. These people have found that while the market is not accessible to all, it is for those that have done right by their personal finances.

Do all of that this may not seem like a new year - but it will be a better year!

Tuesday, November 15, 2011

Don't Know ETFs: Here's the Expert

This past week, on the Financial Impact Factor with Paul Petillo, Dave Kittredge and Dave Ng we had David J. Abner. He is the Director for Institutional Sales and Trading at Wisdom Tree and the author of The ETF Handbook: How to Value and Trade Exchange Traded Funds (Wiley Finance) These funds, that trade like stocks have been coming to the forefront of the investment world for almost a decade. But even after all that time, their purpose isn't clearly understood, their benefits less so and the media, suggesting volatility has dampened our enthusiasm towards them. Mr. Abner discusses these products, what they are and why they are important. ETFs will begin showing up in your 401(k) as investor demand and plan administrator's fiduciary responsibility tightens. This increase exposure is good for the funds; but are the good for you?

Wednesday, November 9, 2011

Melville's Mutual Fund Advice

There is a passage in Moby Dick where Ishmael reflects on the sight from the masthead. He could have been speaking to the world of investing in mutual funds as much as he was discussing the meditative sights below his perch. Melville writes that from that vantage “you stand, a hundred feet above the silent decks, as if the masts were gigantic stilts, while beneath you and between your legs, as it were, swim the hugest monsters of the sea… The tranced ship indolently rolls; the drowsy trade winds blow; everything resolves you into langour.” And from our desks we watch our investments swim below us, our mutual funds existing in a world of murky depth, and our distance providing perspective on how well they are doing and giving us, at the same time, no perspective at all.
Melville writes a cautionary tale with a well-known outcome. And as we enter the fourth quarter of what is turning out to be one of the more volatile years for investors, where advice on what to do has mostly proved wrong (move to cash, they said to avoid, as Melville writes “the universal cannibalism of the sea”) and to coin a nautical term “stay the course” has proved profitable. We set sail and hope for the best and yet are wary at every change in the investment weather while we worry about what swims beneath the surface.
Such events leave us wanting to gain some control over where we are and what we determined as the course we’ve set. No one enters the ocean of investment choices without wondering if the plot we have set in motion will be the right one. One of the monsters of the deep however may breach the surface of your calm sea and take back the adventure. This will happen if you are not careful. But even care may not help.
It is often recommended that you watch over your investments, periodically rebalancing and adjusting your portfolio to follow the course you may have set. You can, as many do in the final months of the year, increase our contributions to your 401(k)s and IRAs to grab the tax advantage. But that act might not turn out as expected; particularly when the funds you invest in may also be considering a chart change as well.
You can’t invest without considering the tax consequences. You invest, often in a pre-tax way to capitalize on the advantage your plan offers. And when you invest otherwise, you sell what you own to grab the gains you have made and if you are tax-savvy, sell the losers in order to offset those profits. But what if you have no losers? What if the year was good enough to book the profits? What if you are a mutual fund manager and those profits need to be sold despite your best efforts, to satisfy the redemption of less confident investors who may have heard the siren song of another investment opportunity?
Several things you need to consider in the coming months as you contemplate what to do with the investments you own. When Melville wrote: “We cannot live only for ourselves. A thousand fibers connect us with our fellow men; and among those fibers, as sympathetic threads, our actions run as causes, and they come back to us as effects” he was not writing about mutual fund investors and the thousand fibers that this sort of investment connects us to others like us.  Yet mutual fund investors simply can’t and in many instances, won’t consider the group as a whole when making investment decisions – and they shouldn’t. But what you do and how the fund manager reacts matters.
The fourth quarter as I mentioned is often the time when you consider changing your investment balance. And this consideration is often recommended. But the fourth quarter may very well be the worst time to do what would seem to be the right thing to do. The tax implications of selling shares in one fund and buying those of another may give you the very thing you don’t want: capital gains without the capital gain.
Investors looking to purchase shares in another fund might find the fund manager has the same motive: rebalancing. had you been in that fund for the whole year or longer, the capital gains is welcome. Enter the fund in the weeks prior to this event, and you get all of the taxable downside and none of the profit.
It isn’t s if this comes without a warning. A fund’s website will often estimate these distributions and your research (you do research right?) should give you reason to hesitate. What is often less clear, is the fund manager’s reason when it is due to redemptions. Redemptions in mutual funds trigger a series of events. The exiting shareholder must be paid and to pay them, something must be sold. When the redemptions are small, the event is almost unnoticeable. When the exits are packed however, the selling impacts the remaining investors. If it was good year, then gains are sold.
According to Christine Benz, Morningstar’s director of personal finance “The strong market rebound since early 2009 means that many funds now have more gains than losses on their books: In fact, fully half of the equity mutual funds in our database have positive potential capital gains exposure, meaning that they have gains on their books that they haven’t yet paid out to shareholders, and more than 200 stock funds have potential capital gains exposure of more than 50%.”
While a domestic mutual fund may have large profits that may or may not be realized before years end, some emerging markets and International funds will need to satisfy exiting shareholders in greater numbers than in years past. Many of the funds concentrated in areas like China, Brazil or even Latin America are on the small side. The smaller the fund, the greater the impact of an investor exodus. With Europe hanging in the balance, many small and mid-cap funds may find their ship sailing in choppier waters than the previous three quarters.
Of course, if you need to rebalance, do so. But do so with a word of caution. If you can wait, that would be wise and even prudent. But do your homework well in advance of any sudden changes. While you can’t time markets, you can time these distributions. And failing to do so could cost you dearly. As Melville points out: “Ignorance is the parent of fear…”

Wednesday, September 28, 2011

Mutual Fund Investing: Can You Be Blamed for the Global Crisis?

It is in our natures to place blame. As Doug Copland once quipped: “Blame is just a lazy person’s way of making sense of chaos.” That said, have mutual funds played a larger role in the ongoing crisis globally? And if so, why do we look to much smaller elements of the equation when the sheer size of these “investment communities” might be responsible, all be it unwittingly, for keeping the embers of (a global) recession burning?
Mutual funds as we all know are investment communities, an organized structure of similarly minded individuals (or as similarly minded as any large group can be) who seek to in many instances, lower the risk of investing by investing as one. With one theoretical manager at the helm, although we know that it can be many managers, we tend to think of them as one unit in most cases, the community gathers around their expertise and know-how in part because we believe we have limited expertise and know-how. We defer the heavy lifting and decision making to someone else. But mutual fund managers also fear us as investors. In part because we blame.
Now, this group think, achieved with only limited knowledge of what is really going on, and the fear of blame, which signals the herd that something is amiss may actually be responsible in a much greater way than previously considered, to have prolonged the fears of additional global slowing even as it should be plateauing, if not showing signs of recuperation. While the evidence to back this thinking is just emerging, the dynamics of the mutual fund do add credence to the theories being developed by Claudio RaddatzSenior Economist in the Macroeconomics and Growth Unit of the World Bank’s Development Economics Research Group and Sergio SchmuklerLead Economist at the World Bank.
First, what do we know about mutual funds and those that invest in them. Every mutual fund manager does what she/he can do to keep their finger on the pulse of those who have entrusted their money to her/his expertise. No easy task when the group is numbered among the tens of thousands. This group can find favor with the manager and inject money into the fund at such a rapid pace as to overwhelm the fund or on the flip side, pull so much of their investment out as to make the fund weaker for those who remain.
Although there has been some evidence of late that suggests that funds size has little to do with its overall returns and performance, any moves in either direction add pressure to the fund manager and their investment goals. Add to that the reasons why – disturbing financial news for instance and the pressure compounds. So we have one root cause: investors either looking to increase their exposure in one fund as they escape the other.
This creates the second reason that mutual funds play a bigger role in what the authors of a recent paper suggest: the portfolio adjustments that need to be made because of what the underlying investors are doing. Think of a bad movie, where the audience begins to head for the doors. Those remaining wonder if they should leave as well, even though many will stay for one reason or the other. In a mutual fund, the manager doesn’t necessarily bar the exits so much as adjust the portfolio in the hopes of retaining those that have remained in their seats. And we have this shift occurring to add to the problem.
The last problem is what those remaining investors say to the managers. Their input is sacrosanct and although not necessarily embraced, it is heeded. According to Radditz and Schumkler: “We find that both the underlying investors and managers of mutual funds are behind their large investment fluctuation across countries, retrenching from countries in bad times and investing more in good times.” They posit that unlike investors, the single minded type who understand that when markets sell it is because either the seller has information that no one else does or that the seller doesn’t have the information needed as simply wants out because they see danger on the horizon.
Mutual funds cannot act as agents at a equity fire-sale. They rely on the manager to do as chartered and this is often contrary to what she/he would like to do: bulk up on bargains that they know are selling at less than their true market value. They have information that you may have acquiesced by joining the fund but you simply won’t let them react. So they do what you want even if it does not seem to be in your best, long-term interest, and they sell. They sell to fund redemptions and they sell to retrench. But the key here is they sell.
While the authors of the paper point their evidence on international funds, the ripple effect is felt even in domestic, US-based funds as well that hold companies doing business on an international scale. In “normal times” the authors point out can be simply a retrenchment based on the inability of some countries to do as expected, abnormal times force a larger scale move that impacts the whole of the marketplace.
The information that investors in the these funds creates an imperative for the managers to make some sort of move to retain those investors while catering to those who have left the theater. This creates a supply-side shock to not only the fund but also to the banks of countries these funds might invest in. Call it idiosyncratic risk.
Should we blame te mutual fund? Quite possibly in part because of the mutualized investor is actually in the driver’s seat. They vote with their investable dollars and walk if there isn’t an expected return on their money. The real question lies not so much in the risk that the investors in the fund have or do not want but whether the fund is a bargain even as the risk of what it owns, increased by the departing shareholders, creates. And where does the money go? Into money market investments that benefit banks in the US while taking money from the countries who may need their borrowing/lending increased to help alleviate the crisis.

Saturday, July 2, 2011

Mutual Funds and Performance: At the Half Way Point for 2011

For the vast majority of investors - mutual fund investors in particular, watching the major indices and judging your performance against them distorts the reality of not only where you should be but where you could have been. If you were to look only at the difference between the former highs the markets hit in October 2007 and those at the most recent close on Thursday (the Dow Jones Industrial Average DJIA +1.36% is around 12% below its all-time high of 14,165, and the S&P 500 index SPX +1.44% is nearly 16% below its October 2007 high of 1,565.) you might be considering jumping back in.

But you would have been much better off had you done absolutely nothing. Back in those desperate times, many people did what the rest of the herd did as stocks began to tumble. You sold. But three years later, that would have proved to be the wrong thing to do. During that period, most folks fled the actively managed mutual fund, particularly the domestic issues in favor of bond funds and in far too many instances, to target date funds.

Let's consider the indices that are often compared to the riskier funds, a benchmark that has proven to be less than accurate in terms of performance. The Dow and the S&P 500 track the largest companies, a group that has struggled to assure the investor that dividends and size were enough to best the market. Turns out, that picking and choosing, as actively managed funds do, would have been the better approach.

Two things come into play. One, these funds tend to have higher fees. Less those fees, you would have still found yourself in a better position than had you simply put your money in a benchmark S&P 500 index.

And secondly, there is the liquidity issue that comes with buying mid-cap and small-cap companies. Liquidity refers to the amount of stock available in smaller companies weighed against the amount of stock held by the principals. This makes these companies more volatile and even under-purchased in indexes that track those larger markets (the Wilshire 5000 for instance may track all available stocks but the indexes crafted based on this index only own.

To complicate matters somewhat, the Wilshire 5000 actually has 5700 stocks in the index, Wilshire 4500 is the Wilshire 5000 without the S&P 500 stocks in it. A Wilshire 5000 index fund (usually called total market index) will probably own around 4000 stocks. A Wilshire 4500 index contains those same stocks less the top 500 companies.

As Mark Hulbret noted in a recent column for Marketwatch, "According to a report produced earlier this week by Lipper (a Thomson Reuters company), 45% of the domestic-equity funds for which they have data back to October 2007 were, as of the end of May, ahead of where they were on the date of the stock market’s all-time high."

So the indexes are lower than where you would have been had you stayed put - of course this is based on the assumption that many of you where using actively managed funds in your 401(k) plans, that many of those funds did not have indexes available and the post 2007 products such as target date funds or even ETFs, weren't a consideration or even an option during those days. You embraced risk and ignored fees and looking at your portfolio, that was probably seen as a good thing.

Does that mean index funds shouldn't be part of your portfolio? The simplest answer is no. Index funds still provide a low cost and low turnover environment to invest in. More importantly, the largest cap indexes add dividends to the mix. This brings these investments closer to the domestic out-performance over the last half of the year.

Diversity in this investment environment, which is still far more volatile than anyone would like it to be, with global issues remaining a major concern, means taking a little less - in terms of performance. You should be in index funds now. To do this would be considered a defensive move for those that kept the actively managed faith.

A portfolio of five, perhaps six index funds, tracking sectors from the S&P 500, a mid-cap index, a fund tracking the small-cap, an international index (which tracks the companies of what is considered the developed world), an emerging markets index (contains investments from countries like China, India, Russia, Brazil and others) along with a bond index.  This sort of diversification keeps the low cost features of index funds and avoids any crossover investment (owning the same stocks in different funds).

You can be proud of your investment accumen in getting back to those 2007 highs and perhaps beyond. But show your real prudence and protect what you have done. This economy, both domestic and globally is far from recovered and the stock market is painting a better picture than reality suggests. Being a little defensive at this juncture will keep you in the game without risking what you have gained.

Friday, June 24, 2011

The Lure of ETFs

I know two things about exchange traded funds (ETFs). There is a high degree of likelihood that your 401(k) will soon have these investments available to you and that some of the basic selling points of why they might be a good choice will be too tempting to pass up. But you should consider the consequences of biting that ETF apple, not just from the consideration of whether the investment is worth the effort, but also from whether you are the investor you think you might be.

So let's first ask whether you understand what ETFs are. At first glance, they seem to be a good choice. They, at least on the surface offer exactly what index funds do and at times, a great deal more. They claim to be less expensive and more tax efficient that actively managed mutual funds and they are. Actively managed mutual funds, even as they have reduced their overall fees in order to placate those who worry that cost is an issue, still charge more than ETFs.

Actively managed mutual funds still dominate the 401(k) world and with good reason. Investors seem to understand, even after several years of concerted efforts by the investment community, that some risk is worth paying for. This is not always the case. The deduction of those fees against any returns you may have had illustrate why these funds are often criticized. Comparing them to an index fund, while often not necessarily fair, further shows that had you paid less in fees using an passively managed index fund you probably would have been a little bit closer to what you think of as profitable.

Passively managed funds such as index funds have passionate advocates. They believe that investing in the low-cost (because they rarely trade and do so only rebalance when the index changes) and in the case of the S&P 500 index, reinvest dividends (over 350 companies in the 500 index do) you have achieved the tax advantage, the fee advantage and because of that, a more profitable retirement dollar.

Both of the descriptions of the two most commonly used types of funds in a retirement account portray the investment possibilities facing most investors. It should be noted that not all 401(k) plans have index funds available to their participants, the option is growing. But also entering the fray is the exchange traded fund.

Now these investments will be tempting. They tout their tax efficiency suggesting that it is even better than an index fund offers. They advertise their transparency and ease of trading (they trade on an exchange just like a stock). And they never fail to tell you that these investment offer the world in a way that has never before been offered to 401(k) investors, a chance to invest in commodities, emerging markets and anything in-between. And because of this ease of maneuvering in and out on a whim, they claim to lower risk as well.

But do they do what they claim they will do? This is debatable. First, they are not index funds. They do not necessarily purchase all of the stocks in an index even as they suggest they might. Instead, many ETFs create their own indexes to follow and seek to invest in places where indexes have yet to trod. Mark P. Cussen, a financial planner for the military wrote recently about a little understood method employed by ETFs to get gains that seem better than the index they are suggesting they mimic. He wrote: "Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry." Leverage is another word for borrowing.

If there is an asset class, there is an ETF looking to exploit it. if you are hearing a lot about a certain class, such as precious metals, the temptation to join in the fray might be too hard to avoid. ETFs allow you to jump in "with the herd" and sell "with the herd". neither are necessarily a good idea and if you keep in mind, the low cost and tax efficiency of doing so are mostly wiped away. In order for ETFs to be both of those, you need to buy in large lots, offsetting the cost of the trade (commission) and you need to hold them for over a year. Small traders, which is the vast majority of us do neither - and won't if you buy them.

I mention "the herd". This mentality os what will drive you to consider this investment once it makes its debut in your plan. Instead, consider the vanilla index fund and what has become known as the tactical strategy. This employs a portion of your plan to just such whims while keeping the larger portion in the funds that will do the best with the least cost.

A tactical strategy might look something like this for young to middle aged investors: seventy percent of your assets in three to six index funds and thirty percent allocated to ETFs or even actively managed funds. Older investors might do the same but keep in mind that many major economic watchdog groups have warned that ETFs could be the next global financial troublemaker. And if that happens and happens quickly, the losses on that side of your portfolio close to retirement might find you less likely to retire when you want.

You will be tempted. And many of you will bite. But don't think that this investment can't bite back. It can and it might and unless you plan for such an occurance, the teethmarks it leaves in your plan might be long-term and scarring.

Saturday, June 4, 2011

TDF: Still not Convinced about Target Date Funds

I have a box and it is blue. By description you can imagine exactly what you need to understand that what I have, although key details about size and shape are left blank and the shade of blue is not fully described. But you get the idea that there is a container and the color is one of the primary ones evoked by light having a spectrum dominated by energy with a wavelength of roughly 440–490 nm.

Suppose I have a target date fund and it suggests I will retire in 20-years. Much like the blue box, most of what you need to know about this mutual fund is essentially portrayed in the name. Unlike other mutual funds, whose name seeks to tell you how the fund manager(s) will invest your hard-earned cash in a confusing jumble of confusing terms, target date funds convey a simple message of here and then. Here is the fund you want to get you to a then you need.

Unlike the blue box, there is far more at stake and because of that, a simple title for the investment is easy to understand but at the same time, so deeply layered and nuanced, that it makes the real investors wary and new investors complacent. Recently, Scott Holsople, president and CEO of Smart 401(k) wished that something as simple as a name could do it all for everyone. he wrote: "At Smart401k, we spend much of our time thinking about how to explain things in a manner that’s relatable to the average participant (i.e., someone who doesn’t live and breathe investing and its terminology)."

Don't be jealous Scott. I have yet to find a single redeeming quality in TDFs. Cobbled together and containing questionable funds, they are hoisted on the 401(k) public as the be-all-to-end-all investment, making not only the plan sponsor feel a fiduciarially warm and fuzzy but giving the plan participant the impression that they need do nothing more.

Three things wrong with target date funds that folks choose to ignore.
1. The target is often wrong. If you are young, just starting out and auto-enrolled (which is how these things became popular and abundant in the first place), the target date you choose has little to do with your actual retirement date. It still hinges on the seemingly outdated 65 years old-and-done thinking. Which leads me to...

2. Everybody's target is different. If you are a blue-collar worker for example, the target might be accurate; but not so if you can work beyond. So the glide path, a nice word for "we don't know what we are doing and it has never been done before so use this imagery to explain it how we're going to get you from point A to point B", doesn't apply. Which leads me to...

3. What these fund managers do, none of whom will stay with the fund until it reaches retirement, none of whom invest in the fund and none of whom can explain exactly where the fund is relative to the benchmark (that doesn't really exist) is charge more than a similar portfolio of index funds or even a balanced fund and do so without a track record. Give us your underinvested, your newbies and your (by-choice) dumb investors and we will give them the way and the light, they seem to suggest. Suppose twenty years done the road you find yourself with far less than you assume. What then?

Only a few people have the nerve to speak out against these investment because they seem okay on the surface, they do get folks involved and the risks seem low. But they are going to disappoint more people than they help and I'd be willing to wager that in the next 10-years, folks will sour on the notion and realize that investing in the markets needs to be as simple and as low cost as possible and while TDFs seem simple, they are really just dumbed down versions of what could be something far more engaging. TDFs are an excuse for not educating yourself about where your money is going. Which in and of itself is a bit of a shocker.

Monday, May 30, 2011

Heard about Herds?

It has been decades since behavioral economics took hold as a science of investor actions. Designed to study the irrational decisions that we all are apparently hard-wired to make, the field grew into a respectable and well-quoted discipline. Which is fine. We know we have incredibly limited potential to redesign ourselves, despite the pushing and prodding in one direction, the look-in-the-mirror study of our own foibles and the instructions on how to improve this very human lot in life. But we muster on. And this is why, even despite the improved access to our 401(k) plans does our retirement still suffer.

Studies done quite recently suggested that most folks will simply accept the status quo if given a confusing situation. Investing is just such a case-study in chaos, less so for the experienced investor, but even for that group, a churning pool of information keeps them struggling to keep up. But the behavioralists  insisted that auto-enrollment in a retirement plan would create great strides for the plan and even greater rewards for those who may have - and still do have the option of - opting out.

Auto-enrollment we have found out is a trip through the wardrobe. We may all have taken the first step. But what awaits us on the other side, in almost every instance, is our irrational mind. And in almost every instance as well, a less-than-wonderful 401(k) plan. But more on the plan later. Let's just focus on what we have done recently as we embrace our biases, follow our illusions and believe in the fallacies.

There have been several alarms ringing on Wall Street and those who invest in mutual funds have turned a deaf ear. Herd mentality, the primitive instinct to follow the herd because doubt in the face of danger can present death was considered a valuable possession. Somewhere along the line though, things changed.

In our wonderful modern brains, this instinct has evolved into a trait, or so say the behavioralists, the makes us run towards the danger because everyone else is. What once once a survival instinct is now a suicidal tendency, at least in the world of investing. (Look at it this way: It would be similar to seeing a crash on the highway and deciding that driving your car into the pile would be in everyone's best interest, including your own.) Evidence of this is beginning to crop up and our big "modern" brains are at fault.

There are three types of mutual funds or mutual fund investment strategies that have shown a tendency to attract these kinds of investors: emerging markets, commodities and a category I'd be willing to wager you didn't realized existed, floating rate funds. (Amy Or of Marketwatch.com describes them as "Unlike fixed-rate loans, floating-rate loans can capture rising interest rates and are deemed a good inflation hedge" and with some uncertainty about when if sooner-not-later, interest rates begin to rise, these funds will be able to capture the change in market conditions.

Recent herd-like inflows of over $14B suggest that the usually high load fees and the underperformance of late matter little. It is where, these investors believe they should be. But because, as so often is the case with herds like this, so many have heard the siren's call, the opportunity to make any more moves to the upside have been hampered. That means a lot of people will eventually follow the herd off the cliff, ost of whom bought at the top.

When they aren't betting on debt, they are looking at commodities. These funds, focused on such tangibles as oil, silver and gold will to most of us, seem to be destined to go higher. And if you bought into this sector recently, you have  high hopes that it wasn't at the top. But silver suggested it was, as did oil, and the drop in prices found those same people scrambling to get out. Most bought in with expanded exposure in their supposedly well-balanced portfolios and are now paying the price for having believed that diversity was just another word for profit.

And emerging market investors are beginning to realize that perhaps they too have been failing to listen to the global heartbeat. Europe is not finished with its economic woes. Commodity prices may have fallen but they still remain uncomfortably high for countries looking to emerge and now, predictions of slowing growth at expanding powerhouses like China have begun to worry the savvy investor. You newbies are deeply embedded in the herd still.

You may have been auto-enrolled, but the walk through the wardrobe left you in the middle of the Serengeti. And you probably won't get the memo that you are in danger until it is too late. This thinking about getting you in, attempting to educate you, guide you, slip you into an ill-suited target date fund came by way of Thaler and Sunstein's book called Nudge: Improving Decisions About Health, Wealth and Happiness. In is not the same as knowing what to do or how to act when you arrive. The information tsunami hasn't lessened and may have even gained strength over the last several years and investors, particularly the neophytes, will still drown before they learn to swim.

How running with the herd once saved you only to become the complete opposite will remain a mystery. And getting people into these plans by using science to study our unpredictable-ness is still a good idea, even if it seems suspect. But once there, the status quo is good. But who says what the status quo is? You may never get a clear bead on the answer,  Until you realize the herd is leaving the room.

Friday, May 20, 2011

Good news/Bad news

While we have all been, on occasion, asked to choose between the good news and the bad news, when it comes to your 401(k), both sides of the question mean something. Today, I'd like to look at some of the good news, bad news that has been coming out of the world of the 401(k).

Good news: People continue to contribute to their 401(k). A recent Investment Company Institute report found that only 2.4% of investors using this sort of plan did not contribute in 2010. This is considered a generally good statistic for two reasons: the resurgence of the company match may have prompted more people to begin to contribute more in 2010 than they did in 2009 (3.4% ceased contributing) and two, the stock market rewarded these folks for doing so. This means that account balances also increased.

Bad news: Those who did continue to invest actually pulled money from the equity side of the investment equation. The ICI was confused by the pattern, which typically dictates that when the stock market does well, investors tend to increase their holdings rather than withdraw. The shift they suggest may point to a lower risk tolerance which doesn't necessarily explain why there was an increase in international exposure.

Good news: There is a much clearer understanding of the risks involved in the investment world. Although there are still a sizable number of senior investors (those at least 65-years-old) who are willing to take above average risks with their portfolios, most recognize the danger in doing so.

Bad news: too many younger folks are unwilling to assume risk via equity investments. While 10% of the 65-year-olds reported they take on above average risk, their counterparts in the  35-to-49 age group admitted that they do as well. Defining above average risk is often difficult to do. Related to a balance of investments, with popular sentiment suggesting a gradual decrease in more volatile investments (equities) to more conservative ones (bonds, fixed income), this group may be making these adjustments too soon in their investment lives. If, as popular sentiment suggests that we will work longer, a 35-to-49 age group could possibly be leaving a certain amount of aggressiveness untapped. If you are thinking that you will work until 70[years-old and beyond, a 35-year old should invest in much the same way as 25 year-old would have just ten-years ago.

Better 401(k) choices
Good news: There has been over the last several years, an acknowledgement of sorts from the plan sponsor world that better choices for their participants is directly correlated to the types funds offered. Fees dominated the conversations held by plan sponsors and administrators as those that used their plans turned their focus on how much each investment was costing them. Plan costs eat away at potential returns. So many plans reduced the number of funds offered and with those reductions, the types of funds offered. The shift to a larger selection of index funds and target date funds may have helped create a better investment environment for those using the plans.

Bad news: As fees were lowered amongst the plan's offering, the plan itself became more expensive. This change in how the fees are levied make both the newly low-cost funds offered simply appear as if this were a bait and switch. Fee disclosure will only increase in the coming years as the Department of Labor looks to better reporting of these costs. The trouble is you may not where to look and may be able to little about these costs. You can sue over poor investment choices. But unless you actually leave the company you work for, the 401(k) you have is what you are stuck with.
Good news: The turnover rate in the mutual funds offered by your company's 401(k) has dropped somewhat over the years. This is reflective in the choices. Index funds have near zero turnover, rebalancing only when the index shifts. Target date funds tend to shift in a similar way but don't offer the investor anyway of knowing how much is being turned over in the funds within the funds.

Bad news: While turnover is often equated with higher fees, a certain amount of this activity is generally considered acceptable if the rate of return is increased as a result. Most investors will shift their money into a fund based on the size. And the larger the fund, the more cumbersome investing becomes and because of that, the lower the turnover.

Target Date Funds
Good news: Target date funds have increased in plan usage from a scant $57 billion in 2000 to almost a trillion dollars invested in 2010. The good news here is limited to the success of the fund families marketing strategies and the required auto-enrollment of new hires. Add to that the financial debacle of 2007-2008 and numerous investors in 401(k)s simply saw the risk in these self-directed plans as too confusing. Turning to target date funds seemed on the surface to be the most logical conclusion for most.

Bad news: Target date funds still have some hurdles to jump through before they gain my seal of approval - no that they are necessarily currying my favor. They remain murky at best. Most target date funds, with the exclusion of those that comprise of index funds only, are a fund of funds. This suggests that a fund family, rather than close a poorly performing mutual fund, simply roll the fund into a target date fund. Because of this, there are still transparency issues. Add to that the suggested target date may not be your target, that no two target date funds are at the same point in investment holdings (risk) as a similarly dated cohort, that there is no fund manager who can offer conclusive evidence that this is the best method of rebalancing and lastly, that most users tend to set-it-and-forget-it.

Good news: As I mentioned, they have dropped over the last several years. But most investors still make assumptions that fall squarely into the "if it is an index fund, then it must cost less". This lower cost is mostly true and is  normally attributed to index funds, even though some smaller index funds that track the S&P 500 charge considerably more than their larger counterparts for the same investment. Even with that in mind, an investor can build not only a well-balanced portfolio using index funds alone, they will do so at a much lower cost than any other investment portfolio in their plan.

Bad news: Most target date funds act as if they can do what they do for less, they don't. Some target date funds have expenses and fees that are well north of 0.80%.

Good news: more folks are using their options across more age groups and accessibilities. Most mutual funds are held inside 401(k)s by twice compared to those held outside. Add to that the growing number of average to lower income households entering this market for the first time using this sort of investment.

Bad news: Education still has a long way to go. Trusting, finding or using an advisor is still the purview of the more affluent investor. The average balances in these plans increased but it suggests that was a result of an increase in the stock market value rather than an increase in participation or contributions.

Wednesday, May 4, 2011

Mutual Funds and You: Not Always an Easy Relationship

Even if there wasn’t so much emphasis on the Baby Boomers with the threat that they will upset the whole of the investment apple cart by suddenly taking everything they have accumulated for retirement and flee the markets, mutual funds would still be what they are. In fact, they will always be what you believe they they are.
So what is the attraction? Convenience plays a huge role in why we continue to use this investment. These funds still play a major role in our retirement plans because of access via our 401(k) plans and Individual Retirement Accounts (IRA). The mainstay of these plans give the average investor, the one who knows they need the markets but are still unsure about the concept of investing, the potential of growing their retirement contributions.
Acting as a collective, mutual funds give these investors broad access to investments they would otherwise not have been able to build on their own. The confusion begins with which mutual fund suits our needs.
In almost every 401(k) plan, even the ones deemed as not so good, the investor has access to index funds (tracking broad markets), target date funds (which target a retirement age or goal and invest using an aggressive to conservative approach) and actively managed mutual funds (those that employ a fund manager to find investments that seek to best the indexes or benchmarks and provide better growth). In a growing number of 401(k) plans, access to ETFs (exchange traded funds that trade like a stock but are essentially index funds) and stocks (individual equity investments) have allowed investors to pursue different investment strategies based on their own assessment of risk.
The ability to use these plans to allocate money towards future retirement goals on a pre-tax basis simply means that this investment will not go away anytime soon. The mutual fund market is considered mature by most standards. It has adjusted to investor concerns about fees (index funds and ETFs offer the lowest costs to investors but are often seen as a slower, or better, a vehicle with more steady growth), the ability to serve those retirement goals by creating built in diversity, and increased transparency. In doing so, they have recognized the threat that index funds and ETFs can do much of the same without the cost.
Behavioral finance, a two decade old study of why we do what we do, has increased our own awareness of risk. This academic and economic examination of us has uncovered numerous biases, the embracing of fallacies and of course or tendency to harbor illusions. This look at the investor mind hasn’t changed what we do all that much. In part because looking at ourselves in the mirror, identifying why we still follow the herd, still have loss aversions, understanding why we still think the past is some sort of indication of the future and continue to delude ourselves with what our concept of reality is rather than what it actually is (think of a mime), is not as easy as they portray it to be.
In other words we sell too late, buy too late, fail to understand that we believe what we see and hear, and attempt to translate those feelings into investment actions. Seasoned investors have a better grip on this inner investor; new investors bring most if not all of the problems investors want to avoid to every action they make.
Mutual funds offer a comfort zone of sorts. Even as we seek to embrace the simplest fallacy: that mutual fund managers know what they are doing because they are in charge of hundreds of millions of dollars. Mutual funds offer us a set-it-and-forget opportunity to participate in the activity of investing without bringing vast storehouses of knowledge about the markets or even ourselves to the experience.
But do they produce as promised? Not always and not always enough of what we expect. Our anticipation of future growth – often based on what has happened – tends to be the first mistake we make. We look at the past performance, the stars a rating agency such as Morningstar might give a fund, the tenure of the fund manager, the turnover (how many times in a given year the fund trades its portfolio; the higher the turnover the higher the costs) and the fees against those returns and make decisions. And then we hope.
Should hope even enter into the equation? It does because of who we are. We have no idea what inflation will offer in the years ahead. Taxes will increase as Social Security benefits may decrease. Which leaves us with two options: invest more and hope for the best. This means that we are using a current self-sacrifice as the template for future returns. I have suggested this on numerous occassions: if you want the “current” lifestyle you lead to be the lifestyle you have in retirement you can either increase your contributions significantly (which impacts how much you have to live on now) or expect to live on less.
So how do we invest using mutual funds? The quick and easy answer is use index funds, spread these investments out across as many varied sectors as your 401(k) offers and increase you contributions.
But you will still look at actively managed mutual funds with a wanton eye. You can buy these as well but do so with great care not to cross-invest. In other words, owning an S&P 500 fund and a large-cap growth fund would give you the same category of investments and the same underlying investments. You might look to making your small cap and mid-cap investments in actively managed funds, where managers tend to be more nimble in volatile markets.
Yet, as in many things in life, there is a bottom line. In mutual funds, it involves education. You should learn what your plan offers and why. You should understand how long you have to invest and for what goals (even if they are far-off in the future and can’t be quantified let alone verbalized). And lastly, that lackluster contributions will most certainly provide you with lackluster retirement benefits. Mutual funds may be what you believe they are but not knowing can cost you.

Saturday, April 23, 2011

Do You Know How to Invest?

There is no easy answer to this question. But in the following three part series, we will take a look at one of the more successful investors to come along in the past century. A humble man prone to self-examination and reflection. Most investors never take the time to do what is necessary to achieve this sort of inner investor peacefulness. 

In part one of this review on one of the greatest investors, Bernard Baruch, titled "Notes on Investing: Baruch and Lessons Learned", we looked at what he has learned from his own mistakes, errors that we all make and of which numerous books have been written in anattempt to correct our own investor and totally human fallibilities on the subject. 

In part two, we looked at, among other things, the art of investing and getting a good night's sleep.

In part three of this series, we take a look at Baruch, the behavioralist, predating the science and doing so by examining how people react to markets, how he responded to his own inner biases and why stepping back for a spell gives one new and better perspective. 

Thursday, April 14, 2011

The Plight of the Savvy Investor and the Goldilocks Mutual Fund

We are a fickle bunch. We think of ourselves as savvy investors, although there is a great deal of room for improvement among all investors to which degree of savviness. Yet we are in almost every instance our own worst enemy. Victoria Holt is quoted as saying: "Never regret. If it's good, it's wonderful. If it's bad, it's experience". Yet still, after several decades of behaviorists studying our actions in the marketplace like so many mice in a lab, we still do the same predictable things time and again.

And perhaps the first emotion we feel once we begin to second guess each of our "investment" decisions is regret. And if the recent selling of actively managed mutual funds by investors over the last year or so is any indication, regret for past decisions is in full swing.

Adding to the chatter that actively managed mutual funds and by default the managers who stand at the helm, is John Bogle, chanting the mantra he has carried since the late seventies. Why, he has asked, would anyone choose to look for more than what an index fund can provide? And as we begin to acknowledge the pull and tug, feel the most susceptible to such cost savings as a lower fees, which is always good, index funds begin to come to the front of our thinking about which investment is best.

But once you begin to believe that getting mediocre returns in the equity markets is the "new" goal, the attempt at saving some money in terms of the fees charged by actively managed funds in exchange for the smaller returns that index funds offer becomes the overall focus. And if that is the sight path you choose, index funds are definitely the right fund to use.

In a recent report in the NYTimes on the subject of this exodus from highly regarded performers over decades to index funds in search of lower fees, one thing stands out in the numbers. This is simply a beast feeding upon itself.

Consider this: You own X amount of shares in an actively managed mutual fund and you sell. But rarely do investors act alone. They are signalled by some change in the wind, some report drilled over and over or perhaps, it is from the suggestion of a colleague. Suddenly, fear sets in and you begin to think that you have the wrong investments. The fees are too high, you think and then anything that resembles a stick snapping alarms you and your fellow investors and you run.  And then you regret.

The selling prompts the redemption of shares, which when enough investors sell simultaneously, and enough shareholders accounts need to be made whole as they leave, markets move. And if the movement is great enough, the equities drop. And so do the indexes. So you sell at a loss only to buy shares in a fund you just, via the herd, lowered.

In many instances, the outflows are no reason to believe that the actively managed mutual fund world will implode. In fact, according to Brian Reid, the Investment Company Institute’s chief economist, 93% of the investment assets stayed right where they were as the remainder moved to other investments. Among those investments - more than just index funds reaped the benefit of this change in loyalty to actively managed funds - overseas funds gained as well as funds focused on commodities. Bond fund outflows also helped boost the index fund profile.

And what did this sell-off net the exiting investors? What were they looking for? Believe it or not, index funds that are actively managed. This surprising move has some folks, including myself, scratching our collective heads.

True, the fee structure of index funds is far cheaper that that of the actively managed fund (index funds average about .16% while actively managed funds average about .97% - with many load and closed end funds added into that average and increasing it as a result). But once you let a broker enter the mix, the fee structure changes, coming closer to the cost of the actively managed fund and at a lesser overall return.

Index funds because of the tax efficient structure belong in taxable accounts - as long as the capital gains tax remains historically low. Inside a tax deferred account such as a 401(k) or an IRA, the effect is lost. This is and should be the domain of the actively managed mutual fund. And while you should never lose sight of the role fees play in the long-term performance of your investments, believing that fees are the only driver in achieving steady returns is misplaced.

And while I have nothing against index funds, the growing number of funds  that slice and dice the markets do not always lead to lower fees for investors. But talk about index funds enough, and investors won't notice nor take the time to compare one index to another.

Friday, April 8, 2011

Do You Know Where Your Value Fund Is?

Last week the topic of emerging markets came up on a radio show I host every Friday. Although we only skirt the issue on many occasions, this week the term "emerging markets" kept popping up during the course of conversation with Lauren Templeton and her husband Scott Phillips, both of Templeton Capital Management. These two are value investors and if you have never met one (or two), they offer an unique perspective on the world of investing that is counter to what many of us think it is.

Now I often mention that emerging markets are often mature well before they lose the emergent title. In fact, the grey area between when they cease to emerge and the point when they are considered developed is often prolonged, with noticeably slowing growth and maturing markets. But even then, the unrest that signals investors that there is still significant (and sometimes worthwhile) risk makes the investment worthwhile well past its prime.

For most investors these days, emerging markets are usually considered as the economies of Brazil, Russia, India and China, or what has become known as amongst investors, the BRIC countries. Many of the four nations have growing GDPs, some doubling every six to ten years. Compared to countries like the US, where GDP doubles about once a generation, it is easy to see why this fast past growth adds to the risk factors.

Growing pains aside, many of these nations still have governments that are either over-involved or not involved enough. Depending on who you speak with, this can be both a good thing and a bad thing. As David Brooks of the NYTimes recently suggested: "emergent systems are bottoms-up and top-down simultaneously". As long as we can't predict with any accuracy which will prevail or better which should prevail given our predisposition to the investment, emerging will always signify opportunity somewhere for the nimble footed investor.

The BRIC countries all run the risk of slowing down with the brakes of banking and government concern with growth and its stepchild inflation pushing hard on the pedal. Some see this as the initial signs that regulation will swoop in eventually, followed by over-regulation and that, value investors feel is the death knell for emergence. What makes a country emerge in the first place?

Chuan Li writing for the University of Iowa Center for International Finance and Development breaks it down into four simple, and easy enough for the average investor to understand. He writes: "Emerging markets stand out due to four major characteristics. First, they are regional economic powerhouses with large populations, large resource bases, and large markets. Second, they are transitional societies that are undertaking domestic economic and political reforms. Third, they are the world's fastest growing economies, contributing to a great deal of the world's explosive growth of trade. Fourth, they are critical participants in the world's major political, economic, and social affairs."

In other words, they have all been bitten by the capitalist bug. In the past, countries emerged with assistance. Now they emerge with investment. Companies swoop in and entice governments with their investment approach, the benefits that their involvement in the country will have on its people and that the system works best where the regulation hasn't yet developed to the point of constraint.

But that bug bite doesn't necessarily mean that the country will ever fully emerge. Political systems are delicate beasts that needs to be groomed and sold to the growing economic classes in many of these countries and even after decades of what appears to be peaceful expansion, the simple cost of producing enough to eat can bring the whole of this effort down. By this time, the emerging market investors have left the building. Confidence is a risky business in and of itself and needs to be sold to the growing middle class who for the first time, may have the feeling that they deserve even more.

As Investopedia describes the risks: "The possibility for some economies to fall back into a not-completely-resolved civil war or a revolution sparking a change in government could result in a return to nationalization, expropriation and the collapse of the capital market." Now you may ask, why bring up value investors?

For two reasons: First I always saw them as the patient investor, willing to research and parse every bit of information available, make a decision and quite possibly never see the need to rethink their position. Once made, value investors held their decision sacrosanct, quite possibly putting more money into the investment if the cost fell farther. And two, they always invoked the names of those who pioneers (Ben Graham, David Dodd, Sir John Templeton and most recently and possibly even more famous, Warren Buffet) as their only mentors; all other discussions were off the table.

The lines were blurred when the stocks they picked rose, turning their investments into profits and prompting their exit from the investment. And even though they considered what they did fundamentally sound, they chuckled albeit under their breath as they sold to new buyers. To find value, you must find someone who is willing to sell what you know is worthwhile. To sell that investment, you need to find a buyer who sees only the increased worth of the stock and makes the assumption that it is indeed a good buy if it is now worth more than it previously was.

It makes a growth investor think twice, an index investor think less, a technical investor to wonder what's next for the stock and to the portfolio investor an opportunity to add risk or as they prefer, diversify. But value investors seem to snub the rest of us a merely fools.

Here's a little quiz to help you decide where you fall on the investment curve. Consider Japan. The markets that track Japan have seen net outflows steadily increase over the last several weeks since the earthquake, tsunami and nuclear reactor problems swept its way into the world's focus. If the markets are as Jeff Sommers of the NYTimes recently described it: "It’s as if the world’s markets have been responding to the baton of a mercurial but authoritarian maestro, who changes direction often, but insists that all orchestra members play together as one" and Warren Buffet is spending time touting the investment opportunities in Japan, does investing there suggest value or virtuousness?

Japan is hardly considered emerging, even as they consider nationalizing their utilities, a hallmark of what is considered risk in emerging markets. Can rushing in at the point of this orchestrated exit be virtuous as some value investors suggest, infusing capital as a sign of their belief that the sell-off has gone too far? At what point can this sort of risk be explained away as "doing the right thing"?

Opportunity has often be the domain of the growth investor. Risk is why growth investors do what they do: selling when they perceive the risk to be too great and buying at the point where the risk subsides. Yet value investors claim to do the same sort of maneuvering. Acting less like the lion in pursuit of the wounded zebra and more like the vulture preparing to clean the carcass left behind, value investors create the illusion of running counter to the herd. Or in the orchestration of the markets, playing an instrument that doesn't jive with the whole.

While every investors plays a role in the orchestrated market, value investors seem to want no part of this group. Even as they write the next score for the investor musicians, they refuse to consider themselves for what they are. Backing their decisions with the fundamentals of research is not an excuse nor is it virtuous. It is simply embracing risk differently. Yes, Japan offers opportunities. But to suggest these opportunists are focused on the virtue rather than the profits masks the underlying bug bite: we are all in for the profit and with value investors, that profit is once again, based on your mistakes.