Seeing but Not Seeing: How What You Own May Not Be What You Want.

Diversification is what we are told to do. What we usually end up doing is owning a wide variety of funds and making the assumption that we are diversified. In many instances, we could not be farther from the truth.

The problem with mutual funds, more specifically with actively managed funds is the available basket of stocks to purchase is much smaller than you might imagine. While there are thousands of companies available to buy on any one day, the majority of those companies are too small to buy in a large enough quantity and be able to do so without forcing the price of that equity higher.

This has to do with liquidity. If there are not enough shares available, a fund manager's purchase might actually increase the stock price simply because of interest in the equity. So, by default, many fund managers who look for price stability must by much larger companies. This increases the chance that your portfolio, the one with several mutual funds may actually be invested in the same stocks. This defeats the diversification opportunity and makes all of the funds you own susceptible to the same market changes.

There are some simple rules for you to follow in order to diversify your portfolio.

The easiest way to do this is to purchase funds that invest across a variety of asset classes. To cover all of the available asset classes may create diversity, it is best to focus on just three or four and stick with them. Aside from large-cap stocks, small caps and international stock funds spread the equity risk. Mid-cap funds also do this as well. But during tough economic times, the line between mid-cap and large-cap can often blur, where a large-cap might be beaten down enough that it actually qualifies as a potential purchase in the mid-cap range.

Inside a a defined contribution plan such as a 401(k) sponsored by your employer, numerous fund families are not always offered. By when they are, you should take advantage of the opportunity. In numerous instances, the cost of research is often prohibitively high. Because of that, research may be shared among fund managers within the same family increasing the chances that your fund will carry similar, if not exact holdings in different funds.

Mutual fund managers all come with a different set of investing ideas that need to form fit within the fund's charter. Once again, look for fund managers that offer you some track record, good benchmark comparisons for their performance and tenure.Use different fund companies.

Avoid filling your portfolio with winners. This type of investor behavior is often called herding and is more common than you think. All markets sectors do not perform the same at any one given time. Spread the risk among growth and value, domestic and international and large-cap and small cap funds. This will require a little due diligence on your part. In other words, open those statements. Compare the holdings side-by-side and consider the overlapping investments carefully.

I often suggest that S&P 500 index funds be owned outside a retirement account (better to pay those taxes now while the tax break is still good and because these funds do not have much in the way of turnover or high fees), freeing those investments for increased diversity and better tax-deferment. It will also allow you exposure to a little more risk (which is needed for sustained growth) and better fund diversification (across all the available asset classes).

Trash Talking Target Dated Mutual Funds

I am on the record about target-dated mutual funds with comments that suggest that this could possibly be the worst investment idea ever. That is a bold statement. But the way these funds play to the inexperienced (and sometimes more savvy) retirement investor is downright despicable.

First, why do I despise this type of investment? Target-dated mutual funds have gained enormous ground over the last several years. Enrollment in these funds have grown 25% since 2005, in part due to the federal government's (pre-Obama) strategy of getting more folks into a plan for retirement. On the surface, as with many initiatives started with that administration, the truth is veiled behind what appears to be straightforward good sense.

Wall Street lobbied heavily for this type of fund and managed to get it crowned as the default fund for those who would not enroll in their company's 401(k) plan. On the surface, this seems like a good idea considering that numerous investors simply allowed the previous default option to kick in with enrollment. That option, usually a money market fund would not, according to retirement experts provide the growth and income that workers would need when they retired.

To get them involved, the creation of this set-and-go investment was granted the status of default in part because the investing public was not capable of making good, age appropriate adjustments to their portfolios (aggressive to conservative) and because of that, would take on more risk than necessary or would do the opposite, not take any risk, stifling the potential growth in those portfolios that could have been achieved.

Folks were not good at rebalancing, a much advised method of fixing your portfolio to align itself with your proximity to retirement. The question of whether rebalancing was any good at all has come under attack with folks like index icon John Bogle suggesting that even though he speaks the gospel of rebalancing, does in fact not do it.

Target-dated mutual funds were supposed to fix this problem. Fund managers would readjust the underlying holdings in an attempt to keep in line with the target for retirement. Fund families scrambled to create funds with a wide range of dates, from funds with a maturity of 2010 on out to beyond 2050.

But without a track record and no empirical proof that these managers could do as they suggested, how was an investor to know that the fund would perform as promised, do as it suggested and retain the same fund manager for the duration. Worse, could it do it cost effectively?

What these funds developed into was a fund family dumping ground. Laggard funds or orphaned funds that investors lost interest in but were still viable enough to hold on were simply enveloped by the target-dated manager. If an aggressive growth fund was faltering, it was invested in by the target-dated fund and added as a percentage of the growth side. Sounds unseemly doesn't it? Even a little deceptive.

The second problem I have with these funds is transparency. While the aforementioned fund dumping is problematic, the fund manager's ability to invest wisely in all markets is always a problem. Proof after the 2008 market meltdown shows a wide range of returns, all with losses and some with so much, a standard S&P 500 index would have handily beat them.

The shortest termed funds, those with a target date of 2010, actually did better but only marginally. These funds lost only 22% of their value during the last year while some with dates as far out as 2050, lost considerably more. Fund managers will point out that the more aggressive underlying holdings in these future dated funds pulled their returns down yet a fund with a mix of stocks and bonds.

Consider the one year return for the Vanguard Target Retirement 2050 (VFIFX). It lost 29.24% over the last year (it has no information prior to that date due to its recent creation - another warning sign of possible problems determining who is the best and who is not). Whereas a fund in the moderate allocation category like Sierra Core Retirement R (SIRRX) actually posted a 13% gain for the same period. While not as inexpensive fee-wise, it also invests in other funds, stocks and bonds both here at home and internationally.

Because investors panic, usually after the fact, these funds have gained a good deal of popularity. This action will come back to haunt these investors. The best solution to this problem - if you insist on investing in these funds is to pick a date for your retirement ten-to-twenty years beyond what you might think of as your retirement. This will allow for some additional growth in the fund and not allow the fund manager to go too conservative too soon. If he/she is doing their job correctly, that is. And that has yet to be proven.

Rebuilding Your Portfolio: What's Hot in Mutual Funds

Aside from what investors have moved into of late (largely a combination target-dated funds, index funds and money market/bond funds) the only way an investor could successfully rebuild their portfolio to what it may have been is with risk. Assuming no risk leaves you watching a very safe investment grow at a safe investment pace. That pace is unfortunately not moving as fast as some of our plans.

Risk, as we have discussed so many times in the past has no obtained a sort of disreputable mantle, one that automatically assumes that loss is the greater part of the equation that it should be. If you have been following our conversation about some of these risks on our retirement planning blog, you will understand that not only is this kind of thinking perfectly normal (albeit not well understood by the folks that have tested these concepts) it can cripple your efforts to move ahead at a swift enough pace to overcome inflation and taxes.

So the question of why investors do what they do remains viable and subject to each individual's predisposition. But there are things you can do to help boost your earning potential while you begin to readjust your risk outlook.

Over the next several posts, we will be looking at the different types of markets that will offer you some of this potential. Emerging markets are offering just such a possibility.

What are emerging markets?
First, lets identify the risks involved with these types funds. The countries that are usually associated with these types of investments seldom have strong banking systems, stable governments that ensure the success of the business interests it protects, and relative overall economic predictability. Those risks can take an investment on a wild ride depending on the as little as change of the wind.

But what is currently be labeled as emerging might surprise you. China, Russia and India can fall easily into this category and have begun to make up a large portion of the more successful emerging market funds. The problem most investors have when choosing an emerging market fund is how to benchmark them.

The real questions is: do they need to be benchmarked? It is difficult enough to apply benchmarks to actively managed funds in the US for two reasons. Actively managed funds want to be benchmarked against the most attractive index possible while index funds do little to reflect the underlying holdings of all but the largest funds that are actively managed.

This becomes doubly difficult for index funds that track emerging markets. Including those three giants into the emerging market index could greatly skew how these markets are performing when looking for funds that consider diversification what they are seeking to achieve.

Consider Vanguard's Emerging Market ETF (VWO), an exchange traded funds that acts like an index fund but trades openly throughout the day. As of a year ago May 31st, the fund held 11.1% of its total holdings (of eight hundred companies) in China. A year later, the holding has grown to 18.6%. Brazil, the economic superpower of South America makes up a total of 15% of the fund, down from 16.9% a year ago. Other major holdings in the ETF include Korea (12.4%) Taiwan (12.4%) and India (7.7% - up 1.2% over the previous year).

Now consider what Vanguard holds in its Vanguard Total International Stock Index Fund (VGTSX). An index such as this spreads the risk of international investing into many of these emerging markets but does so in a much more broad style. With 1752 companies in the index (and ridiculously low expenses - 0.34%) your exposure to risk is lessened but not avoided completely.

The lesson to be learned here is simple: as with all of your stock funds, diversification begins when you own dissimilar holdings. When too many stocks in a fund begin showing up in other funds you own, you risk having too much exposure to one type of investment. This can be one of the major pitfalls of international investing and funds that are considered emerging markets.

Emerging market funds should not contain well-developed nations outside of the US and European such as India, China or Russia and in many instances, Brazil can be included in this group. Although these countries often play a role in the developing nations they are closest to, they in themselves are not emerging (and because of that, can and should be purchased for less than emerging market funds often charge).

(Note to Reader: I do not often suggest indexing funds inside of a retirement portfolio. But in this case, it is prudent. The tax gains can be large and worth keeping in these types of funds. US stock indexes, in particular the index that tarcks the S&P 500 should be kept outside of your retirement accounts.)

The Deep End of a Dark Pool

There was some speculation that the financial markets in this country would suddenly stagnate after the most recent downturn. The innovation of products that used an ever-increasing and more complicated methodology to make money would stop, paving the way for dull and boring, over-regulated markets that offered so much oversight as to slow the growth of the country. To hear some Wall Streeters talk, the end of an era was upon us.

Not so fast.
Financial markets and those that look for ever smaller ways to extract a decimal from these tough times have rediscovered a product called dark pools. These are ways to trade electronically using the money from a bank, doing so without publicizing the trade until well after it had been executed and even more sinister, allowing traders to see in advance what orders are being placed.

In other words, while we rely on live quotes, these dark pool traders are able to purchase an equity without needing to publicize what the actual quote was. These types of pools have been around for over a decade but were largely underused. There were simply too many other tools of the trade to be utilized while the Bush administration's crippled S.E.C. looked the other way. As long as the market escalated, there was little or no need to decimalize each trade.

But that has changed and the numbers of large and institutional traders that now tap this type of trading platform has increased at a frightening rate of 17% over the last year (from 58% to 70%). While you may say to yourself, what mutual funds, pension funds and hedge funds do to enhance their return is okay by you, some of which you may have an interconnected interest in, the idea that the equity markets may not be fair to all players is not right.

Individual investors have known of these disparities for some time. Beginning of the day and end of the day volumes and volatility have increased to the point that many people could never predict where the market is going to end the day. (Exchange Traded Funds have been to blame for frenzied trading as well.)

Now this subject of who and how these dark pools are being used seems to be getting a little light shed on it from the new chair of the S.E.C. Mary Shapiro. In a recent keynote address at the 2009 SIFMA Market Structure Conference, James A. Brigagliano Co-Acting Director, Division of Trading and Markets U.S. Securities and Exchange Commission wondered if "there is any compelling reason for dark pools to object to improved post-trade transparency." Acknowledging the need for these trades to be dark prior to execution as part of the success of these pools, he couldn't see why "some form of improved post-trade transparency would be likely to interfere with their business models."

The Downside of Speed.
This darkness is however not complete, coming in different shades. Often called indications of interest, these so-called messages done in advance of the trade itself, offering a look to other traders of a trade about to happen, whether it be executed or canceled may resemble a quote too closely.

Because these trades are able to get done very quickly, these "actionable order messages could create the potential for significant private markets to develop that exclude public investors" according to Brigagliano suggesting that because of this "the public does not have fair access."

Mr. Brigagliano has no real beef with the huge block trades that are conducted between institutional investor, often trading in excess of 50,000 shares. But smaller order systems could make the general investing public less likely to want to trade if they feel as though some select individuals get orders processed at a better price based on a quote the general public was unable to see. If that were to happen, the markets would essentially freeze.

He is correct in assuming that "any practice that significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility."

At the heart of this reform is a newly energized SEC. So far, they are looking at regulation with a realization that too much regulation would have long-range effects that we would have to live with for years to come and the lack of regulation they inherited needs revamping. Cleaning up the dark pools is one of the ways they hope to do this. Expect Wall Street to resist.

Any transparency is better than none and Ms. Shapiro is making this a focus of her approach to getting the investor’s trust in the US equity markets back on track. The "gaps" in regulation have allowed too many innovators to slip through with products that might make money for some, but threaten the long-term goals of some investors and challenging the trust of others.

A Target-Dated Mutual Fund Critic

John Bogle, father of the index fund and founder of the Vanguard Group, keeps his portfolio allocated based on his age, believes that buy and hold is still relevant, and does not feel as though target-dated mutual funds represent stewardship (instead he suggests they represent salesmanship).

Calling what he does the Bogle Age Allocation, he actually believes that Social Security is enough of a bond fund for the average investor. Build your own target-dated fund he tells us largely because he worries that these funds are not what they seem and as I have suggested numerous times, they are as yet proven.

Index Funds: Not an Option if it is Mandatory

The wide world of investing is still so little understood by so many people, the government feels as though they need to step in a make the easy easier, the cheap, cheaper, and the option of choosing, no longer an option. Of course I speaking about the recent efforts to declare passive investing (index funds) the winner for all investors, knowledgeable or otherwise, over actively managed funds.

Do Fees Matter If They Are Cheap?
At the heart of every index funds are best argument is the cost. In the land of I don't want to take any risks anymore, passively managed mutual funds have been touted as the way out. More importantly, because the risk is mostly removed from these funds, the cost is as well.

But it is balance that has to be struck. How much risk is worth paying for? Or how much is no risk worth?

Index funds have always been the cheaper option. They trade less, adjusting the fund when needed, often as little as once a year when the index it attempts to mimic changes. This passivity creates fewer fees with the exception of 12b-1 fees, used to attract investors.

Actively managed funds are managed, traded more frequently and can, if done correctly, allow you greater gains for your investment. Comparisons are what is most difficult. Actively managed funds are compared to indexes and when this happens, investors suggest, why both with fees if I can get the same results from an index fund.

Since Vanguard Group pioneered the index fund, the field has become crowded with imitators looking to cash in on what John Bogle saw as the only way to diversify. The idea of the index has been revamped (some fund families employ different types of indexes based on dividend payments, different types of weighting, etc.) and with it, the costs and fees. In most cases, the buyer should be conscious of these subtleties and understand that the more effort that is put into the fund, the more costlier it will be.

Exchange Traded Funds have also entered the fray, claiming that they too are index funds that can be traded as needed. In other words, you become the active manager, paying the fees, doing the research, pulling the trigger on the trade. You incur the costs that were otherwise the fund family's responsibility. ETFs have gotten more sector specific and because of that, the risks have increased significantly. Plus, ETFs are also susceptible to style drift and in some cases, end up looking like a mid-cap fund.

But they should not be made mandatory inside a retirement account for two reasons. First, they are too tax efficient. When you are deferring taxes, it is best to have least tax efficient investment in those types of funds. Secondly, index funds move slowly through good times and suffer just like the average investor does during bad times. This lack of risk and flexibility could put the average retirement age far off into the distant future, further along than most would have anticipated. And that will give the illusion that your money was safer, when in fact yo simply put more in, receieved less in returns and waited longer to tap what you have earned.

Mutual Fund Fees: Value When Needed the Most

When Lipper Inc. conducted its survey of mutual fund expenses as compared to previous years, the firm found that fees for passively managed funds actually fell significantly from 2007 levels. The report, which also found that actively managed fund's expense ratio increased slightly from the previous levels (from an average of -.93% to 0,94%), it was lower cost of index funds (including ETFs - exchange traded funds) that caught everyone's attention.

According to Sue Asci at InvestmentNews.com: "The expense ratio of the average actively managed mutual fund dropped to 0.712% in 2008 from 0.748% in 2007" leading to the savings of "$3 billion less than they would have paid compared with 2007 expense levels." These fees have fallen for four straight years.

It should also be noted that the inclusion and explosion of ETFs in the report were the main drivers of this lower cost. It is a sad statement and one every investor should be wary of: not all indexes are created equally. In a previous post on the costs that index funds charge, I noted that what you pay depends largely on how much you are willing to commit to the purchase. Many fund families charge much higher fees for those with little to invest.

On the other hand, the case I have been making for years on where to put index funds presents another problem. I have suggested on numerous occasions that index funds are best kept outside of retirement accounts that defer taxes. The thinking is that these tax efficient funds and current capital gains rate are worth taking advantage of rather than putting off the payment of those taxes to the future.

That said, actively managed funds, the higher cost and less tax efficient (due to increased trading costs, research and managerial fees) should kept inside tax deferred accounts. This raises the risk question, something that is on everyone's mind these days.

We should be far more risky in these accounts that we seem to be (in light of the stock market drop-off we have recently experienced). The only way to reap reward over the long-term is with risk and although that risk comes with a cost, I really believe that reward is to take the chance.

The report also predicts that increased competition in the index fund arena will keep costs lower than in previous years and that actively managed funds are likely to increase (repositioning of funds increases trading costs, 12b-1 fees, used to advertise the fund and lure investors back into these investments will likely increase, and the fees managers charge compared to successes of those funds are likely to seem greater than they would had the fund been on a long-term roll).

And while we are looking for the lowest cost when we come to investing, the rewards that accompany that lower cost may be just as low as the fees you pay. I'm banking on the old adage: "you get what you pay for"