Thursday, March 31, 2011

Mutual Funds and SIFI

Are mutual funds a systemically important financial risk? It seems that so far, the answer is no. To explain what this dreaded SIFI label actually means, the NYU Stern School of Business has developed a risk indicator and alist of the top banks and CEOs capable of bringing the whole system down should their activities run into problems.

Senator Chris Dodd and Rep. Barney Frank, authors of the Dodd-Frank comprehensive financial reform law began identifying which institutions could be the most troublesome for the economy as a whole should they fail. It was one thing suggesting that all banks with $50 billion plus in assets be labeled as SIFI. But other institutions could also create risk and in the time since the creation of the reform law, other large entities have scrambled to get out of the way. Ideally, the right balance, not too many and not too few, something the Brookings Institute suggests as a Goldilocks problem, is what the law is aiming to create.

At a recent conference held in February, Doug Elliot asked the question: "So, if you’re going to define systemically important financial institutions you have to have some concept of what systemic risk is.  And you have to have some way of measuring it, at least in some subjective manner.  And are then setting a threshold to say where does something go from having too little systemic risk to worry about to enough that it should be treated separately here?" Mr. Elliot is well known as a former investment banker, former head and founder of COFFI, his own think tank, and a very prolific and insightful writer on financial reform issues with a book soon to be published titled "Uncle Sam in Pinstripes".

The biggest fear is what is known as a domino effect. Essentially, if a number of SIFI act in unison or a number of institutions engage in the same financial activities with an SIFI labeled entity, failure would knock one, then the next over, creating a systematic breakdown. But identifying who is at the greatest risk is a lot tougher than it sounds. Mr. Elliot points out that both irrational panic, such as a run on a bank creates, and rational panic, such as identifying the problem but making a wrongheaded assumption that whatever the problem is, it isn't really that bad, can both add to the systematic tumbling of one institution, and then another.

The recent crisis had a component about it that it turns out isn't all that unusual. In fact, most of the problems in the recent history all possess the same problems: assets that were overvalued and folks knew it and leverage that was chasing it, even if it knew it was overvalued. This embracing of risk is what causes systems to break and in some cases, have the potential for bringing the whole of the economy down with it.

Given their size, mutual funds were considered as well in the discussion (which can be found here). They are not directly leveraged nor are they intermediaries (such as insurers and re-insurers) or affiliates of larger financial institutions. In fact, mutual funds are generally referred to as pass-through entities. But some funds have worried regulators based on their size. But that size is not threatening if it isn't used as leverage.

The one exception Mr. Elliot pointed out was the money market mutual fund, an entity that many believe is, or should I say, was, as a safe as a bank - at least in the mind of the average investor. A buck, they thought was always a buck, until one moment during the financial crisis, when a MMF declared ti wasn't. Investors were told that there was risk. But with this sort of situation having never occurred, the risk was set aside for most investors.

While mutual funds may have escaped the scrutiny of those studying these financial risks, hedge funds, institutional investors (pensions) and some investment firms have not. Just because some funds fit some of the criteria, of which six are listed, doesn't mean that the Frank-Dodd regulations would necessarily miss this group altogether. They do have size but because of the number of funds available, they provide numerous substitutes for the services and products they provide investors.

There is an adequate degree of separation from other financial firms, an borrowing that they may do (leverage) is clearly stated by most funds in their charter. While many of the largest funds do face some liquidity risk if investors lose faith in the ability of the fund to perform, it usually occurs as a dribble of discontent rather than a one day sell-off. Mutual funds tend to keep a limited amount of cash on hand so a sell-off would be something that whole of the marketplace would be experiencing rather than just a handful of large funds (which all tend to be indexed to the market and not actively managed entities. In truth, funds that become too large, tend to lumber when attempting to move in either direction.

Those large index funds are passive. But some large bond funds may not be but their size keeps any sort of maturity mismatch from occurring. And the existing level of regulatory oversight provided by the SEC is seen as adequate to protect the overall system from any imminent problems.

Although MMF aren't necessarily problematic, as the Investment Company Institute, the lobby arm of the industry points out: "a liquidity backstop could provide reassurance to investors and thereby limit the risk that liquidity concerns in a single fund might spur in-creased redemptions".  There is a possibility that hedge funds might see this as an opportunity to roll what they do into into mutual funds. But the regulations provided by the SEC make this not as attractive.

It may be too soon for the mutual fund industry to breath a sigh of relief. While one or more of the 243 rules and 59 studies commissioned by Dodd-Frank may still find mutual funds in the crosshairs of the reform law, the industry believes that this will not happen.

Thursday, March 24, 2011

Hope for the Best: Picking Mutual Fund Winners

Picking winners is an exercise in hope. Picking winners amongst the thousands of mutual funds available in the actively traded world requires more than just hope. Mutual funds, for those of you who may not be well-versed in the subject, offer investors an opportunity to ride with a fund manager to investment success. To determine this success, the fund manager must beat the benchmark that the fund is best judged. These benchmarks are index funds.

Now I have mentioned here before, this is a less than perfect way to determine success. But it is all we have. No actively managed mutual fund owns, in the same proportion, the underlying portfolio of the index fund. Index fund advocates suggest that index funds offer the wide diversification needed to get investors from point A to point B and do so in a passive manner.

Actively managed mutual funds do something quite different. And investors who use them know this. Investors looking for just a little more from their investment dollar believe that there is always the chance that the fund they pick will outperform the index fund benchmark. Few do. But the effort is worth the gamble. So why is it that we look backwards in order to move forward? Is what happened important to what might happen?

When an investor buys an actively managed fund, they have two choices to help enable their decision. The first is what the focus of the fund is. Understanding the underlying investments, how the manager approaches the fund's individual charter, how often the fund needs to readjust to complete that task and whether the fund manager can accomplish this in a cost-effective manner all play into the decision of whether or not to buy in. These are forward looking mechanisms designed to give us some level of expectation.

The second tool we use in the decision making process uses the exact opposite methodology: where has the fund been. By no means is this a necessary tool. Yet it is often employed by index fund advocates to point out the error of the actively managed mutual funds. Based on where these funds have been, indexers point out that had these same investors used an index fund, they would have been better off.

But this is not why people invest in actively managed funds. They do so to fulfill some inner need to do better than average. So why if that is this case, do these same investors, who see themselves as better than average and more savvy than the rest, look in their rearview mirror to get some indication of what the road ahead holds for them?

What was will never be again. None of the fund screeners offered around the web, from CNBC's to Forbes to the brokerages to the Persistence Scorecard offered by the Standard and Poors give you any idea whether the fund you are considering will do good in the next quarter, the next year or even the next ten-years. In fact, all of these screeners suggesting who won in the previous time periods would be useless in picking the next benchmark beating fund.

There are several things to consider when looking to invest in an actively managed fund. At the moment right before purchase, every one is on equal footing. This is referred to as the initial opportunity set. Every fund manager is equally skilled and/or prone to the same luck. The differences lie in the cost of the fund in terms of administrative costs. This is somewhat similar to suggesting that every horse in the race has four legs.

Yet unlike a horse race, where lineage, training and numerous other factors come into play, at the beginning of the race, all mutual funds are essentially equal. Once the new quarter begins, the race is on to beat not only what the benchmark might achieve but what other funds might do as well. At the end of the race, unlike horse racing, the gamblers place their bets. Sounds odd when considered like that, but it is essentially what happens. When the quarter is complete, new investors look for the winners, something that has already occurred and buy in.

The S&P Persistence Scorecard suggests that you will be right about 25% of the time employing a method of picking past winners over the previous five years (a period that seems to be quite a long time). You would have done slightly worse trying to pick a long-term winner amongst the mid-cap sector; slightly better with a small-cap fund. What the Scorecard does not suggest is the shifts among the stocks in the small cap to mid cap to large cap arenas during that period depending on capitalization (a shift that can change with each bull or bear market, mergers and acquisitions or simply with bankruptcies).

In fact, the Persistence Scorecard suggest that the middle of the pack might be a better indicator of what might come. If the top quartile is predicted to not repeat and the bottom quartile should be not considered as potential winners in the future (most at the bottom of the scorecard will probably merge or be liquidated in the future because of this underperformance), that leaves the second and third tier funds as the next winners.

If past indicators tell us anything, it might be to look the other way. Or, they might suggest that last quarter's average will be the next quarter's winner. Whatever it is, some skill and a lot of luck keep the current winners at the top of the rankings. Which is why few do with any success. If you are picking your next opportunity based on what happened, you would be better off with an index fund. I say this because average in the actively managed mutual fund world is a bit more expensive than simply buying the index.

But if you think you know the future, your ability to pick the next winner will make the envy of your fellow investors. And considering the odds, you have about a one-in-four chance of doing so.

Wednesday, March 16, 2011

Is Average Good Enough?

There is absolutely no doubt in an index investor's head that those who chase actively managed funds are fools. Not the Motley type, because those guys think much the same about those types of fund investors as well. But the sort of fools you suffer because you know they should know better, you know they are smart enough to do the math and lastly, you think chasing average with a index fund entitles you to a degree of smug for know how inefficient the market is.

And that's fine. An index investors is supremely confident that all will be well with their investment choice. The fact that they were able to purchase it for far less than what the actively invested mutual fund charges and that argument is always pointed out in every conversation about index funds makes the debate somewhat one-sided. Yes it is true that buying something for less is advantageous when it comes to investing. Low turnover (index funds readjust their holdings when the index they track changes) mean lower taxes (an interesting event because index funds sell losers and buy winners when they do readjust) and the combination of all of this seems to satisfy even the most average investor.

But I'm not so sure that actively managed mutual fund investors consider themselves average. Nor do they pursue such a state. In large part, because they already have it. As I mentioned earlier index fund investors like the concept of average. They embrace the inefficiencies in the market and defer the thinking about where the market will move next to the idea that spreading the risk is far more essential to protecting the underlying investment. But that protection comes with a cost.

If index funds are so much better for the investor than those of the active sort, why aren't these the only investments in use. When you look at the differences in investment styles, you find that index fund investors tend to only own index funds whereas actively managed mutual fund investors own both.

Perhaps it is the very nature of index funds. Where in almost every instance, the traditional index fund is employed, the reality of how these funds allocate the money, with the 10 companies in the index usually garnering the top 20% of the indexed dollars might lead those active investors to think that there is a chance that the remaining 490 companies in a typical S&P500 index might offer something of an opportunity.

Investing outside of index funds had been referred to investor ignorance. Betting against what are seemingly long odds of success has a certain attractiveness to the process. Call it the "what if" approach. Back in August of 2010, Lubos Pastor of the Chicago Booth School of Business and Roger Stambaugh of the Wharton School of Business wondered why do actively managed investors continue to chase these funds when the statistics offer evidence that the returns in these investments will be subpar.

To invest is to embrace the knowledge that in every investment there are two players: the one with the reason to sell and the one with the reason to buy. Trusting that a fund manager can determine which is the better side of that purchase is why actively managed funds remain more popular than index funds. True, few are skilled enough to find that pivot point but the professors have found that movement in and out of these funds, based on decreasing performance might have something to do with why they stay in these funds at all.

These investors, at least according to the professors take dispassionate rather than long look at where a fund is headed and readjust their investments accordingly. Nathan Hale of MoneyWatch believes that it instead "represents a fundamental misunderstanding of how investing works". He argues that even though actively managed investors think the additional research they do, the faith in those that they have hired because of their expertise and the fact that they have to work harder to get the returns needed to keep investors investing, Mr. Hale writes that this will  "inevitably detract from the returns you earn in the markets".

As long as the comparison of performance is skewed - benchmarks are always used when comparing the two types of investments when few if any actively managed funds hold 500 stocks in their portfolio - the proof of who is right depends on how fully you embrace the concept.

Active investors don't suggest that indexing is wrong and may have been the result of an increase in net inflows to index funds over the last several years as they moved to protect some of their portfolios. They just believe that the opportunity to do better is worth the cost, adjusting their holdings to react to lack of or increased opportunity. Mr. Hale sees this shift as the embracing of index wisdom.

Is it a "recognition of the benefits of an indexed approach" as he suggests? Or is it perhaps the simple fact that using actively managed investments are more involved, intellectually stimulating and make the investor feel like an investor? Is it an understanding that to live as a investor (using every means possible) better than simply chasing average?

Use of index funds will increase as new investors come into the marketplace, uneducated or perhaps under-educated. Auto-enrollment may add to the involvement. The use of these funds by Baby Boomers looking for some equity allocation in the final years of their work-life, realizing that some exposure is better than none may also contribute to the increased use of this passive investment. Time will tell. But actively managed mutual funds, even though maligned by index investors, will always be available to the investor.

Sunday, March 6, 2011

Target Date Funds: The Downsides of Bundled Investments

Here’s the three main problems with target date funds.
One, they are funds of funds, a collection ofmutual funds that do various things in different ways. Unfortunately, very few mutual fund families are rolling their best performing funds into these retirement tools. And in truth, why should they? If the investment public is buying a fund without too much effort, why throw it into a target date fund.
Two, target date funds are often found and the most heavily used in a 401(k) plan. They have been deigned the fund of the auto-enrolled, the new hire who for whatever reason doesn’t have a clue about how a 401(k) works, wouldn’t use it if they did (statistically, this is why these plans are underused and auto-enrollment has helped boost participation with few people opting out once they were in) and probably owns no other investment. If you have found yourself in this type of fund it is because your employer has done a little napkin math and determined when you will retire based on historic norms for retirement (i.e.65 years old). Those historic norms may not be all that accurate, but it is better than nothing.
Third, because 401(k) plans, at least the vast majority of them don’t allow you to do too much shopping around, you are stuck with the fund that your 401(k) is offering. And this is where we run into trouble.
These funds are designed, at least on that napkin, to do what most of us are not too well versed in doing: asset allocation over time. The idea is that we want to go from aggressively invested in our youth to a more conservative approach in our later years. This journey from capital growth to capital appreciation inside one fund has no real track record to speak of. So at any given time, a handful of target date funds with the same target date could be at different points on this aggressive to conservative investment journey.
Enter the Government Accountability Office or GAO. In a recent report, the GAO was asked (it does not say by whom) to answer the following questions about this investment: (1) To what extent do the investment compositions of TDFs vary; (2) what is known about the performance of TDFs; (3) how do plan sponsors select and monitor TDFs that are chosen as the plan’s default investment, and what steps do they take to communicate information on these funds to their participants; and (4) what steps have DOL and the Securities and Exchange Commission (SEC) taken to ensure that plan sponsors appropriately select and use TDFs?
Without going too deeply into the 59 page report, I’ll briefly answer some of the questions. The investments can vary wildly. In one fund they examined, 65% of its assets were still in common stocks in the year prior to the target date. If the goal is to get your money to a safer place over time, this fund failed to do what it promised to do. But they can’t be faulted for trying to get the biggest return for the investment dollar – and to do that you need to take risks – and hey, their are no guidelines to follow, just a sort of linear point A to point B path.
Performance is indeed an issue. We look back on mutual fund performance three, five, even ten years to glean some information about how the mutual fund performed in good markets and bad, how long the fund manager has been at the helm and how they have weathered the various storms that blow across the investment landscape. Target date funds have no track record to boast about – some have good returns, as much as 28% from 2005 to 2009. Others have lost more than 30% of their value in the same time period. Some have only been around for five years or less.
Chances are, because auto-enrollment put you in that fund and you have nothing to compare it to, in large part because auto-enrollment might make you an auto-investor, it doesn’t make auto-smart about investments. To their mutual benefit, plan sponsors are doing what they can to educate their participants. Some do better than others. But the worker is the one who has to show some interest in where their money is going in order for those educational efforts to work.
The last question the GAO attempted to answer about target date funds, the one about the involvement of the Department of Labor and the Securities and Exchange Commission in the process presents the most problems. A plan sponsor knows their fiduciary responsibility to offer good investments at the best cost accompanied with access to information. It comes down to all parties talking about you in the following way: You can lead a horse to water but you can’t make it a duck.
You have to take an active role in what your plan has to offer. Yes, the improvements in how target date funds operate will happen, and possibly without your knowledge. But this is your money that you are counting on in retirement. Do you really believe that anything in this day and age can be set on a path that lasts 30, sometimes 40 years and not need some attending to?

Friday, March 4, 2011

Mutual Funds Inside a Small Company 401K

It is a fairly safe assumption that big means cumbersome. We often don’t think of large objects as nimble and marvel at them when they are. When it comes to 401(k) plans however, the smaller the plan the greater the issues facing it. Consider a plan like the one IBM offers. They have four tiers of investments for every level of participant expertise. A plan with as many options as this plan offers might seem as though it would be extremely difficult to navigate the problems that often plague 401(k) plans (compliance and management, fees and overseeing the fiduciary responsibilities). Turns out it is quite the opposite.
In many instances, it is the largest plans that have the most people dedicated to making sure that the liabilities that could occur in these plans, do not. That leaves most smaller plans suspect and your retirement dollars in trouble. Let’s break it down in simple terms.
Who’s in Charge?
The larger the firm the greater the chances you will have someone who is dedicated to the plan. They may actually be a retirement specialist, even an attorney who is well versed in ERISA law and compliance. A smaller company will have a greater likelihood of delegating the responsibility to their HR department. The difference in execution can be vast. The larger firm who has experienced people understand the need to review what the plan provider is doing on a regular basis, ensure that the plan is in compliance and the offerings in the plan are suitable for the workforce that use them.
The smaller plan may have too direct a link to the owners of the company. Not that a relationship with the owner has its problems with intimacy, but simply handing down the plan to a staff that might not be as knowledgeable as they should be but versed in the costs of running the business makes for bad bedfellows.
These plans can come with some big problems if this group does two things: relies on the plan provider to check itself for accuracy and execution and believe that they can shave a few pennies off the bottom line. This is not the place to do either of these and failure to do what the plan should can cost the business a great deal more than it would have cost had they done it right in the first place.
You might think that, at least on an economic scale, that if you get everything as package, you will save money. In 401(k) plans, this isn’t necessarily the case. When a large firm goes shopping for a plan provider, it knows who its employees are and is concerned with keeping the best for as long as possible. Statistics have proven that the better educated you might be, the greater the use of the plan. Larger companies have a much greater stake in keeping employees using their benefits than do smaller firms. Smaller firms generally try to retain employees through potential.
But when they shop, the don’t go directly to the plan provider as smaller companies do. They enlist the help of a third party administrator or TPA. Yes this adds a layer of costs to the plan but this group also adds an indispensable layer of protection.
With less emphasis on the plan itself, and looking for ways to maximize limited cash resources, smaller firms will often look for bundled type plans. These are bought direct or through an insurance company. And although the emphasize that the products they offer don’t come with the fiduciary responsibility that these plans must have, most small employers and the departments they assigned the plan to, assume they do.
The “Get What You Paid For” Advisor
Small companies, as I mentioned more than once so far, look to cut costs wherever they can. Its understandable. But efficiencies have their limits and those limits can have negative effects in the 401(k). True, they need to manage the costs of the plan so as to make it more attractive to their employees. And true, free seems like a good price. The belief that they can eliminate some fo the costs by not hiring a plan administrator often finds them paying more in fees for the plan that they would have had they simply spent the money in the first place.
Financial advisors need to have experience. If they do not or only have a few plans under their supervision, this is a red flag. In all likelihood, this will lead to compliance problems for the participants, particularly the highest paid employees who tend to use these plans the most.
Why Do I Tell You This?
If you are working at a company with less than 100 employees, the chances are excellent that your boss has failed to do everything she/he could have done to protect the plan and its assets. All you have to do is ask. Ask if there is a third party administrator in place. Ask if there is a financial advisor looking after the investments and is not affiliated with the TPA. Ask if there is attorney involved who is versed in compliance and auditing. these three resources, while on the surface might seem to cost more than they might be worth, act as a system of checks and balances. Call them the product testing team.
If your plan does not have these entities in place, there is a good chance that once the company begins to grow, the plan will begin costing more in the way of employee retention and fees that should have been reduced as the plan grew.
Most folks do not usually think about their 401(k) plan when they look for a job. And once they get it, they often fail to realize some of these problems which could be shaving off potential earnings from the plan. A surprising amount of people don’t even know what or when their vesting in the plan takes place and the smaller the company, the less likely anyone will be able to explain these issues.
Yes, small business is the engine of opportunity in the country and when they grow, all boats rise so to speak. But unless the ship is seaworthy, your “vested” interest in the business could be costing you more than you think.