Wednesday, April 4, 2012
This is the mutual fund in 2012. The facade belies the undercurrent of decline. It is a time when what was is slowly being replaced by another ruling party, a new-comer to the scene of investing: the ETF. This investment, like the invasion of this nineteenth century country by the British, is on the cusp of replacing the empire of the mutual fund. If you are paying even passing attention to the world of investing, this displacement comes with a price.
The exchange traded fund or ETF is slowly moving to the forefront of our investment options. The question for you, the one you will ask yourself: is this an investment worthy of my attention? Should I look at the picture the enthusiasts of this financial product paint for you and simply admire the brush stroke and the nuance or should you instead focus on the placard alongside the painting for a deeper understanding of the product?
The ETF is building an enviable empire based on the decline of the mutual fund. Largely made of the same materials, the ETF offers many of the same attributes as a run-of-the-mill index fund with several exceptions. Those differences are part of the marketing strategy proponents of this investment push to the forefront. The decision, they suggest goes beyond the what traditional indexed mutual funds offer, giving the investor a different sort of control.
They will tell you that these funds can be bought throughout the trading day. For the average investor, this added ability to buy and sell a fund like a stock on an exchange only leads to more questions. What does this attribute mean to you? Why should this mean anything at all?
Most mutual fund investors are of the buy and hold variety. We use them largely in our defined contribution plans or 401(k)s. They populate a world that is bound by the whim of our plan providers and sponsors. And inside that world, they offer a vision of retirement that is directed by you for you. And while ETFs are making inroads into this closed circle, your current exposure to this investment is largely on the outside of these plans.
The exchange traded fund offers additional options than simple tradability. It offers lower fees in many instances when compared side-by-side with the mutual fund. The difference can be slight but noteworthy over long periods of time. So it may be the best buy-and-hold option for the investor with that mindset. If that is the case, then actively trading ETFs is not a selling point and the fractionally lower fees may make them not worth the effort - or cost.
What does set this investment apart is the construction of the fund itself. Unlike the mutual fund, which is built (or deconstructed) with every contribution (or withdrawal). A mutual fund must sell shares to pay for those exiting the fund and buy shares with new money. ETFs buy a basket of stocks in advance of you ever investing a single dollar. And that dollar doesn't impact the overall "basket" one iota whether you invest in or out. This attribute leads to more stability in the investment, less price variation and more transparency.
But like the Mughal painters whose courtly portrayal of an empire in decline, whose story is masked by opulence and celebration, the artist of the ETF may be masking some truths as well.
The ETF offers a new empire. While the definition of empire is based on how much geographic impact the rulers had at a particular time, the ETF empire is still growing, grabbing investor real estate at an enviable rate. If history offers any indication, the ETF empire will continue to grow, amassing population and expanding boundaries.
And as they do, the territory they claim as their own will be like all empires, hard to rule, sparsely inhabited and lorded over by tribes that only offer allegiance in passing. This will be where ETFs are tested. Not in the traditional and heavily populated markets; but on the fringes.
And this is where you should exercise caution. Like all expansive empires, the rules change the farther one travels from the most populated places. You may think that you are still in the ETF empire and from all indications on the map you are. But the danger in this investment grows with every footfall beyond the center of the empire. This is how the mutual fund began its decline, as fund families looked for more arcane offerings further afield. Will ETFs suffer the same fate, offering the rule of law where law is not always embraced?
Quite possibly. To use ETFs, one must stay close to the glow, the core of the investment idea. Because the farther out you venture, the more likely you will find investment options with higher risks and less transparency, higher fees and more narrow focus. So as ETFs make their land grab be cautious of what the ETF actually is. It is an investment. It does cost less. The risk seems to be lower.
But venture into the hinterlands of this growing empire and you will see the dangers increase, the risk become more apparent and while the names of these far flung locales will always suggest ETF, it won't be the same ETF. It is on the fringes that the mutual fund has begun its decline. It will be the same for the ETF if history is any indication.
Thursday, March 15, 2012
The nineteenth century was a time when philosophers were wondering what exactly was free will. To these thinkers, it was a concept that needed help to achieve what they believed was control over your soul. Identifying the seven deadly sins were a product of this effort, blocking their passage into your life allowed your free will to soar where they thought it ought to go.
But often, in this day and age, the exercise is also pressured by more than those temptations of sloth and greed, wrath, pride, lust, envy and gluttony. It is a social one that makes us look to our peers for guidance in what is right and what is wrong. This is certainly true of investors. And because our free will is actually more bound than footloose, this becomes a conundrum of sorts for those inside their company's 401(k) plan.
Call them schools of social thought, call them religion, but once an idea makes sense it becomes the must-have. This is certainly true of exchange traded funds, which have very smart people in this investment's corner. And with good reason that we'll discuss in a future post. For now, it is the mutual fund, that stalwart investment inside those 401(k) plans that is the focus. Why has it lost its luster? In my opinion, the downturn of several years past had a great deal to do with it but something else changed in those fateful months in 2008. But what?
Mutual funds are what we have to work with at the moment. Although you will begin seeing the addition of ETFs to the mix of options available, and there might even be an all-ETF plan coming to your workplace in the future, the mutual fund will reign supreme inside this bounded world of free will investing. You have the right to choose which investments you want. You have the right to contribute as much as the IRS allows. You have the right to make your retirement possible.
And yet, few of you do what is necessary to achieve the goal, a point in life that might be aptly referred to as "from the free choices of your working life" to the "free choices in retirement." Both are bounded by the amount of money you have. You also have the right to choose how tight those bounds will be.
You will soon find out how much everything costs within this plan. It will be a dry read without a doubt but if it does what it is supposed to do, it will shed some light on how much every dollar you invest in your plan is divvied up amongst the providers of the plan. It might be 1% of $100 or a dollar for every contribution of that amount. You can use this as a benchmark on whether your plan is expensive or not.
But what if it's higher than one percent? Fleeing is not an option (in the free will scenario). What that one percent actually does is begins to limit your investment options in two ways. All of the funds in your 401(k) will charge a fee of their own. So the higher the plan's cost, the more higher priced mutual funds as a result becomes unattractive - if inly from the fee perspective. And for some investors, this removes some of the risk they might have found worth taking. What you are left with, and this is in no way a criticism of this kind of investment, is the index fund.
Index funds are incredibly inexpensive. The fund manager is almost non-existent and the stock (or bonds) in the fund are tracking a predetermined basket of stocks (or bonds). The risk is still there but it is greatly underplayed by the those who are fans of this type of fund. The risk however is, as they say, much less than any actively managed mutual fund available. This is a truism with caveats.
When an index fund is created, the real decision is built on how much of which stock will be bought to mimic the index. An S&P 500 index fund may hold 500 stocks. The question is the proportion or as they refer to it, weighting. The risk is also in the lockstep with that decision. If the market goes up, so does your index fund. If the market goes down, you will also shadow the drop in your index fund. If you index didn't keep pace withe index it is mimicking, then weighting is to blame or credit. Not all indexes are created the same.
In some instances, diversification across a basket of index funds helps offset this sort of risk but if the drop is comprehensive, involving all sorts of regions and investments, this will be of little comfort. So you will pay less for an index but not fully eliminate the risk of owning it.
If your plan costs less than 1%, you have some wiggle room, the opportunity to take on a little more risk than you might have otherwise considered. The smaller more drilled down index funds can provide some of this risk at a lower cost. But some funds who may be benchmarked to the indexes of smaller sized companies and off-shore regions, even some alternative type investments, might seem appealing in small portions.
The best 401(k) is one that mimics your life, the boundaries you have set or have been set for you. You can follow some simple rules here than should reflect the basis of that life.
First: take care of your business. In real life this is paying the bills (on time) and making the money you earn part of a budget. In your 401(k), this means making the matching contribution or 5% if your employer doesn't match. Both numbers have little or no impact on that fragile take home pay and huge difference in your future.
Second: taking care of your retirement. The brutality of numbers suggests that even if you maximize your contribution, putting as much as the law allows, you will only end up with 75% of your current income in retirement. This simply means that if you can live on 75% of what you make now (ideally socking the rest away for retirement), the transition will be a breeze. You will have lived within that 19th century thinking: your free will will have a budget.
Third: the fun part of the plan. Boring leads to angst and takes away our human-ness. This ignores who we are and the habits we have. If we like to "cut loose" on occasion, our investments should reflect a little of that habit as well. Your "bad habits" or the fun things you do take up less than 10% of your time in real life. Your retirement plan should have 10% devoted to something less conservative, something a little more risky.
I see it as a way to keep you engaged (you will check your plan more often) and to learn balance. Keep that "risky" portion at 10% and the other ninety percent nicely indexed across five or six categories, and you will begin to watch what you are doing in this "retirement life" more closely.
One final word on the lost luster of mutual funds. They have gotten cheaper since the Great Recession and probably will continue to do so. Some will shine, some will falter and others will follow the markets. We provide the luster and if we fail to use the tools we have, we won't be able to see our reflection in the shine.
Next up: The Glow of Exchange Traded Funds
Sunday, February 26, 2012
Those mirror conversations are often forgotten as soon as you walk away from your own reflection. And with good reason. Only when you are looking directly at yourself do you see someone who has made these types of promises before. Once the two of you part ways, the reality of past decisions thwarts many of these well-intentioned pledges to do better. The question isn't what is better - that answer we know - it is more like how can you do better?
Improving your personal finances is much easier than you might imagine. So let's look at why your reflection is suggesting an overhaul in the first place. You can't avoid the idea that retirement or at least the time of retirement is closing in, often quickly. You can't dodge the fact that in order to retire at all, let alone comfortably, you need to set aside larger portions of your paycheck. No one has ever told anyone they are saving too much. Everyone, on the other hand will suggest that you and millions of others just like you, aren't saving enough.
In this scenario, they will tell you to max out your 401(k). To do this, the average American with the average paycheck in the average 401(k) can set aside $17,000. This number for this average person amounts to almost a third of their paycheck. And most will agree, this is an austerity measure that will not happen no matter how much the financial profession points out its wisdom. The over 50 crowd can toss another $5,500 into these accounts in order to play catch-up pushing the total contribution in this "maxed-out" situation to almost half of the average wage earners paycheck.
Knowing you are under-contributing often is the first roadblock in doing what you've told yourself you need to do. Resignation sets in and the next time you are in front of that reflection you quip: "I'll never retire" or "I'll just have to work longer". These will, without any argument help you achieve your retirement goals. But in suggesting that lengthening your work life is an adequate solution, you are subtracting from your retirement life. Think of it this way: If the speed limit is 55 mph and you drive 45, you will arrive at your destination; it will simply take longer as as you watch your fellow cohorts pass you, you will become discouraged and this will begin to weigh on the journey.
So forget the limits. Instead focus on the percentages: five percent (5%) of your paycheck contributed and producing a modest return will net you about 25% of the income you currently own, ten percent (10%) will get you about 50% of your current wage while fifteen percent (15%) will get you very close to 75% of what your current income is. Of course you will need to contribute and do so over a span of at least 20-years. But is much more do-able that the whole number that is the maximum contribution.
But even if that is do-able, as I suggest it is, something will have to give. A recent New York Life survey, done as they suggested, across the kitchen table, portrays the average American as someone who will try and manage their debt better. This is translated into spending less. Debt as we all know works against you in many different ways. More than simply spending what you don't have and exceeding what your paycheck brings, the cost of servicing that debt acts as a direct subtracting to that 15% and any return you might get in your plan.
So not only will you need to contribute more but at the same time, you will need to draw down that debt faster. What that reflection in the mirror is suggesting is often too austere for even the most parsimonious among us. Who looks at themselves in the mirror and says: "this year, I live on 30% less." While this might be excellent practice for the retirement you probably will experience, it is quickly dismissed.
Fourteen percent of those surveyed in the New York Life conversation with an agent revealed you will seek help. What you are doing is trading the reflection for a person who will tell you what you have told yourself. Of course this suggests that this financial professional has access to better tools to do what you have promised yourself to do. Ironically, they don't. For a fee, they will tell you what you already know.
Fear might be a motivator and many have taken to making these threats. But fear also brings a natural human reaction: to run in the opposite direction. Comparing where you are now with where you will be because you have done so little so far is a from of this fear. So is comparing you to your cohorts.
The simplest solution: 5, 10, 15. Contribute 5% to your retirement, 10% to your debts and 15% to your mortgage. A five percent contribution to your 401(k) will not impact your take home pay and will probably meet your companies matching contribution. A ten percent increase in payments to your debts will shave years and hundreds of dollars off of the interest you might pay. A fifteen percent payment towards the mortgage principal will reduce the length of your loan by as much as ten years. Doing this will have you arriving at the point of retirement with no debt and no mortgage.
Once the plan is in place and you have done this for five years, begin increasing the contribution by a single percentage point each year. This will be much easier to do as the debt you own is paid off and once the mortgage is satisfied, you will find your reflection congratulating you. This is far better than the criticism it once offered.
Sunday, January 29, 2012
As Jeffrey Kluger writes: “We’re suckers for scale. Things that last for a long time impress us more than things that don’t, things that scare us by their sheer size strike us more than things we dwarf. We grow hushed,” he writes in his book Simplexity “at say, a star and we shrug at a guppy. And why not?” he asks. “A guppy is cheap, fungible, eminently disposable, a barely conscious clump of proteins that coalesce, swim about for a few months, and then expire entirely unremarked upon.” He then suggests that “a star roars and burns across the epochs, birthing planets, consuming moons, sending showers of energy to the limits of its galaxy.” Yet, he points out, “the guppy is where the magic lies.” A star is just a furnace whereas a guppy is a symphony of systems. So it is with the world of finance.
And joining us today on the Financial Impact Factor Radio we have Roger Wohlner, Certified Financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Roger also blogs at Chicago Financial Planner and columnist for USNews and World Report. He has been kind enough to join us today to help us sort through the complexity, the scale we are so impressed with.
That scale, that complex mechanism that Roger has agreed to speak about is the target date fund. If you use one, you should listen to this explanation. If you invest, you should tune in as well.
Monday, January 23, 2012
Today on our daily radio show Financial Impact Factor we visit elocution corner, a feature on this show that deals with a phrase or word that we toss about with great ease without any real foundation in definition. Today’s catch phrase: set-it-and-forget-it.
- “First, secular stock market cycles deliver returns in chunks, not streams." This refers to the volatility that makes news on a day-to-day basis and the fact that these swings are often much more dramatic that the overall span of an investor's plan.
- "Second, most investors live long enough to have the relevant investment period extend across both secular bulls and secular bears." This is the time span contingent that suggest that the longer you remain invested, the higher the likelihood you will benefit from those swings.
- "Third, investors do not get to pick which type of cycle comes first." Although you may think you can time the market, our emotions still play a role in how we place our goals and what, if any role the media plays in our decision.
- "Fourth, investors need to be aware that they will likely encounter both types of cycles." To this dollar-cost averaging creates a way to master the market swings by purchasing your investments over time and doing so in an even manner.
Sunday, January 1, 2012
This article written by Paul Petillo originally appeared at Target2025.com