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.

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.

It's 2011: Do You Know Where Your Bond Mutual Fund Is?

Almost every investor in the country owns a bond. This ownership might be via bond mutual funds, investments in individual bonds be it corporate, government or municipal, or through the widely used target date funds. Each is prone to its own troubles.

Bond mutual funds, even though they are managed by expert managers, may be so burdened by the underlying investments as to hide or mask the trouble that may be brewing in this market.

Individual bonds are influenced by the health of a company, the ability of the government to retain its high credit rating or in the case of the municipality, pay off the debt it is owed to those who invested.

Target date funds, the darling of the auto-enrolled 401(k) participant may contain the most trouble in part because you don't have a good bead on what is owned and in many cases, in what proportion.

There are some essential elements of a bond that many simply do not grasp to its fullest. Not the least of which is the effect that interest rates have on these investments. In short, bonds are loans and the way these borrowers pay you back is with the agreed upon interest. Many bond issuers simply refinance those bonds to pay that interest. But what if the interest rate isn't favorable to such financial restructuring?

So let's talk interest rates for a moment and some of the assumed beliefs you may have.


The trickle up effect
We often put a good deal of the emphasis on the Federal Reserve bank and their presumed control over all interest rates. They lend to the largest banks in what is called an overnight rate. Banks increase that rate to consumers at each level of lending, the last rung being the consumer loan for a mortgage or a personal loan.

Those rates are determined by demand, the market forces at play and in many instances, inflation and/or governmental budgetary needs (deficits). The Fed looks at money supply, the other half of the demand equation and depending on how much is circulating - too much and the interest rates remain low, too little and they increase. Sometimes.

Sometimes fear increases those rates as well. Growth forecasts and a strengthening economy normally lead to more demand for capital which leads to higher interest rates. Add to that the increasing possibility that inflation will rise as well. gives everyone who borrows the jitters. They know, should these things happen, the Fed will raise interest rates in the name of stabilizing the economy.


The emerging market conundrum
The world is global - while an oxymoron as a stand alone phrase, it represents a growth not previously seen in the decades prior to this one. Emerging economies are building at a pace that is much faster than anyone anticipated. Much of this growth is coming from China but there are numerous other economies doing the same thing on a slightly smaller scale.

The flip side of that growth is investment and investment needs money and countries, faced with growing populations who no longer worry about saving, instead shifting to spending, force borrowing. This will increase interest rates - probably sooner than we expect. many of us have experienced low interest rates for so long, we consider it to be the norm.


Consumers: should you save or should you spend?
The most common answer is to spend. Popular economic theory is that if consumers fail to spend, the economy will languish. This is actually not the whole truth. If interest rates are low, it would pay for infrastructure improvements much more cheaply than otherwise - and these improvements are necessary if corporations expect to become more efficient in their production of goods and services.
The bottom line, a healthy savings rate actually adds to the improvements that need to be made. It doesn't suggest that folks won't spend. But it does prompt companies - at least in theory to do a better job enticing you to do so.


Is mortgage deductibility important?
Possibly but the impact is lower and more specific than many suggest. Lower interest rates on home loans entice borrowers to buy more house than they need, refinance to increase their debt and those actions pour more money into the economy. Yet at the same time, estimates of lost revenue to the federal government have been estimated to be as high as $104 billion a year.


Raise those interest rates
No doubt, we expect interest rates to remain low. But they should be inching up. According toRichard Dobbs, director in McKinsey’s Seoul office and a director of the McKinsey Global Institute (MGI) and Susan Lund is director of research at MGI, higher interest rates would "also limit financial bubbles, restraining speculative and heavily leveraged investment while encouraging more investment that would actually raise the economy’s potential growth rate, such as expanding the country’s broadband network, developing new green technologies, and rebuilding aging infrastructure."

The authors of that report also suggest, a rightly so, that "higher rates would also focus executives’ attention on the return that companies earn on their capital, prodding them to make sure they get more bang for each buck. This could boost the nation’s productivity, which is the key to raising standards of living over time."

Does this point to a bond bubble?

Not necessarily so. What it does however is seduce investors into thinking that all is well and bonds do not come with risks. Gus Sauter, chief investment officer of The Vanguard Group, the largest U.S. bond mutual fund manager with $413.6 billion of fixed income assets as of Dec. 31 wrote that he is "increasingly worried that people aren’t aware of the risks in the bond market. The problem is that when you’re at historically low rates, as we are now … yields aren’t likely to go significantly lower, and at some point when the economy does strengthen, they’re likely to push higher.”

This does suggest that bond investors are overbought, denying the risks involved and ignoring the potential, even probable readjustment in this corner of the market. Will it burst as a bubble might? Not likely but the slow hiss will take the least experienced investors by surprise and it may be too late by the time it happens for them to do much of anything.

With one exception, possibly two. Increase your equity exposure is one. The other, buy short maturities. This last one might make it difficult for individual bond holders to ladder their portfolios. But at least you won't be stuck with bonds that are worth less in an inflationary period.

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

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

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

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


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


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

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

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


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

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

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


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

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


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

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


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

To Index or Not: Mutual Fund Investors still ask

It isn't like this would be a fair fight. But get two investors who believe in one or the other in the same room, and the index fund investor would declare their style the winner, based on low cost alone. While fees play an important role in the long-term objectives of any investor, particularly those using mutual funds for retirement, the idea of long-term has seen its day come and go. As Tom Lydon of ETFTrends suggested recently: "The notion of buy-and-hold investing shows signs of falling out of favor. Ten years ago, 80% of advisors’ portfolios were buy-and-hold. Today, that’s 30%."

Which leaves the actively managed mutual fund investor, often described as a resident of Lake Wobegon (where everyone is above average) as the beneficiary of this shift ininvestment style. The question that every index fund investor will ask every opportunity they get: how do you pick an actively managed mutual fund if so many underperform?

And it is a good question. But the problem is, how do you make that call if you are essentially comparing these sorts of funds to those that buy across a broad market? An index fund, for the sake of argument we'll use the S&P500 index as an example, buys the top 500 companies. These companies are in the top 500 due to market capitalization. But index funds don't buy all 500 equally, weighting their funds based on numerous criteria.

Among those are as I mentioned, market cap. To be eligible for this index, a company must have $5 billion of market worth (issued stock) with 50% of that stock available for the public to buy. They must be based in the US - it doesn't matter where they do business as long as the headquarters are on US soil, follow GAAP reporting practices and offer sector representation.

The weighting of an index like this, which many investors assume is done much more evenly, actually gives the top ten companies based on market cap, over 20% of the index, leaving the 490 remaining companies to fill out the rest of the index. How would this sort of style compare to a actively managed mutual fund that owns less than one hundred stocks in their fund? Talk to an indexer or as they often refer to their group as Bogleheads, after the man who brought the index fund into existence (there were attempts made earlier than Mr. Bogle's but the ability to do it correctly was dependent on the advent of the computer) and they would quip, there is no comparison.

Yet, this is the very comparison they make, time and again. Their argument does hold some merit. Index funds have lower fees because they trade only when the index changes. (This is an irony lost on many indexers as the these funds must divest any interest they might have in a stock taken from the index and purchase any security the index has added - a sort of counterintuitive move of selling losers and buying winners.) Many still charge 12b-1 fees even if they are in company sponsored plans and act as the default investment. Over five years, performance of the S&P500 index has been north of 15% and that was due to the large amount of value given those top stocks in the index and the dividends paid by many of these large businesses.

Actively managed funds do have more to contend with in terms of trading (more frequently but the best funds do so prudently without changing their whole portfolio in a given year) research (they aren't given a group of stocks to buy as the index publishers do) and their are management fees (the cost of hiring a professional to wade into the marketplace for you). Yes these do impact the overall returns of a fund and as investors focus more on these items, they have dropped significantly in recent years.

So what do you get with an actively managed fund that isn't there for indexers. Obviously, a bit more nimbleness, less buy-and-hold and if your fund manager is good, acceptable returns. Most investors do still look to the performance - and too often in the short-term, as in a year or even a quarter just past - as the tool most likely in their portfolio picks. Doing this at the exclusion of tenure - how long the manager has been at the helm - the fees - they should be low, under 1% with a portfolio turnover in any given year of less than 60% - and should be able to best their peers in both categories, if not the index they are often compared to, over five years or longer.

Indexed funds have pluses that seem outsized compared to actively managed funds. But too often, a one size fits all approach to investing is not suited for everyone and this is where actively managed funds fill the void left by that sort of approach.

More than Just Mutual Funds: A Peek Inside your 401(k)

There is no such thing as a simple choice.  We may be very familiar with the options available and we may know a large amount of details about those choices.  But when faced with making the decision, we often freeze, unable to decide and even questioning the whole process.

Just get behind someone at a fast food drive-up window and wonder how long does it take to order from a menu that rarely changes. Your 401(k), the defined contribution plan that many of us have, puts us in the retirement planning drive-up lane and forces us to make a choice.

Few people ever decide to drive on through without making a selection.  Once in the line, you are sandwiched in by the person in front of you, the car behind you and the prohibitive curb. This is your 401(k). This is your 401(k) menu.  Order now, pick-up at the second window, pay at the first and be satisfied with your choice in large part because there is no going back, no changing your mind or adding something else on to the pick you have made (without exiting your vehicle, which defeats the whole purpose).

This is where almost every 401(k) plan in this great nation fails.  Once you have been put in the drive-up lane, you are stuck. You are essentially given a select number of choices, many of which are easy to determine how much they cost in part because your plan is now loaded with index funds, which basically resembles your dollar menu.  Cheap and (portfolio) filing without a lot of extras.

Then the seniors portion of the menu, also bland (and bond-like), suggests that you can get value from your invested money by making sure you get your dollar back - or at least in theory. The kids menu has gotten smaller over the years your plan has existed because there is fear that if this portion of the menu were too large, you might find the restaurant liable for (actively managed mutual funds) choices that were too expensive and fraught with risk.  They could throw in a toy but you would want proof that you could purchase this item without ever being dissatisfied.

So they offer you menu items that you wouldn't expect.  These are items that would be better suited at a sit-down establishment where the big spenders go - not because they want to spend more, they just want to think they are more sophisticated than the general population.  This is the ETF (Echange Traded Funds) choice.

And then we have the value meals.  This portion of the menu dominates the process and in effect, bogs most of the line down if there should be someone who is indecisive. These are your target date funds, a combination of mutual funds tucked under one banner which suggest that you can pick a year in which to retire and the item you choose will not only be worthwhile, but will also fulfill its promise.

Everyday, folks drive up to their 401(k) plan and are forced to make a choice.  Everyday, your 401(k) plan is scrutinized by regulators. Everyday, 300,000 advisers go out to the field and, well for lack of a better word, advise.  That's 300,000 different drive-up windows, sponsored by just as many employers for millions of employees.  A daunting task indeed.  Which is why you are dissatisfied with the choices: you think that there is a better drive-up window someplace else.

Of those 300,000 advisers, the vast majority of them, according to Fred Barstein, the president of 401k Exchange "half have one employer plan. Half of those have at least three plans. Fifteen thousand or so, or about 5%, have at least five plans. Then there's the 5,000 or so elite advisers, who have at least 10 plans, $30 million and at least three years experience."  Mr. Barstein, who is also columnist for the Employee Benefits Adviser site, suggests that the fees that these advisers charge have dropped significantly in the past several years, which is good for the participants but makes it doubly difficult to make a living doing this sort of work.

Not only is the competition stiff, the drive towards least expensive and lowest risk has sliced the revenue stream in half. You might think this would be good for you, the 401(k) plan participant. Turns out, it hasn't been as good as you thought it was.  In this particular scenario, these sorts of plans have become more generic, less customized and inelegant.

When an adviser approaches your employer, the sell goes something like this: You want almost zero liability, almost zero costs, and near zero effort on your part and I, the adviser, will do this by offering target date funds and perhaps a huge basket of index funds and, if we can figure out how to squeeze one in, an annuity.  None of these offers your employees any guarantees, the adviser might suggest ,except for the annuity, which illustrates a distribution of retirement income and unfortunately comes with a cost (a trade-off of sorts).

Is it any wonder why you sit at the drive-up menu for longer than you should?  All of the choices look the same. And then there is the problem of getting you to order the product best suited for you. Here is where they suggest a sort of buy one get one free (or the matching contribution). By the time you get to the drive-up window, you may been sitting in line, waiting your turn for almost a year.  Then to get the other half of the buy one, get one free offer, you may have to wait an additional period of time (a vesting period that can be more time than you planned on staying with the company to get).

Then there is the super-fast lane where you are essentially put on a bus, driven through without access to the window at all.  The driver, your employer in this example, orders what they believe is best suited for you - take it or leave it. In this situation, you will be dropped into a target date fund and told that you can opt out (go hungry) or stay in and believe that this menu choice is probably the best one for you because someone thought it might be.  That someone is the adviser.

Now Mr. Barstein does suggest that at its rawest, it is about selling. Selling a plan involves training, partnering and a constant source of information. Much like fast food drive-up windows, who might consider your health as a passing interest in order to get you to come back, increase their bottom line with a salad and offset fears that their choices are not the best ones available (doing it yourself will always be more satisfying but more time consuming as well), your 401(k) plan is designed to fill you up.

The adviser and the plan sponsor hope you drive off happy and satisfied.  As long as you drive off and don't sue them.

Not Paying Attention to the Cost

“To live is to choose,” writes Kofi Annan adding that “to choose well, you must know who you are and what you stand for, where you want to go and why you want to get there”.  No, Mr. Annan wasn’t trying to offer suggestions on how to run a 401(k) plan for his employees or even what to do when faced with a plan that suggests you can be somewhere it has no intentions of taking you to in retirement. Yet we repeat this thought when we approach our retirement options: choice is good, regardless.

We all understand the importance of preparing for retirement and using the tools at our disposal in our 401(k) is often placing at our efforts at risk in the markets.  What we don’t understand is the cost of that risk.  More here.

Supreme Court Rules for the Mutual Fund Industry

If you are not happy with the way your 401(k) plan adviser has invested your money, then, according to the recent Supreme Court ruling, you should invest somewhere else.  In a decision that is clearly a victory for the mutual fund industry and a loss for investor trying to keep fees from overtaking their investment returns, this ruling turns the responsibility of who to invest with back to the individual.


Sound like a loss for the little guy? Read more here.

Look for Actively Managed Funds to Achieve Retirement Success

We have eliminated risk in many of our 401(k) portfolios.  We have taken a flight to safety away from the very investments that could have propelled us, at least in the early years of our participation in our defined contribution plans, to the successes we should have had.  We turned our backs on the actively managed mutual fund and in doing so, put our retirement plan at risk.

A great number of investors reacted in a very predictable fashion as the Great Recession took hold.  They sold their holdings on the way down, in large part because no one could predict how far down would actually be and stopped contributing to their 401(k) plans.  Employers, as we have discussed here, suspended their matching contributions for several reasons (no need to spend money where it didn't need to be spent and there was no longer any reason to offer this as an incentive to keep or hire new employees).

Adding to the mad dash to protect dwindling balances, target date funds and bond funds swelled with new contributions. This was, in many instances, akin to stuffing money under the mattress.  Not that some these funds did poorly or had mediocre performance, although many did, investors felt protected or at least safe from the chaos and volatility of the open markets.  It was a flight to risk-free, or at least, invest-and-forget investments.

Once-Bitten

Historically, the bad news of a falling stock market lasts about six months.  This quick, fall-off-a-cliff drop to the bottom is often followed by a market where investors find innumerable bargains. Over the last decade, unlike all of the previous data on the equities market, recent recoveries, this one included have come at record speed.  Five years in-between market drops and recoveries is not the norm.  But possibly, could be.

This may have something to do with a much larger segment of the investment market coming from 401(k) investments. Although these plans have been around for thirty years, they have not really caught on until recently and even that trend is not fully employed by those who have access to these types of plans.  Pensions may have gone away but 401(k) plans have not fully replaced them with the working public.

That fact leaves many investors vulnerable to their emotions and to the forces that promote the marketplace.  A recent study done by Hewitt Associates found that the vast majority, or what they termed typical, investor under the age of forty had moved some or all of their retirement funds into target date funds.  Those over the age of forty found the move to bond funds more appealing.  Both of these investments, albeit conservative in nature, were forgivable. They were doing what any "once bitten" investor would do.

Read more here.

Paul Petillo is the Managing Editor of Target2025.com and BlueCollarDollar.com 

Let's Talk Target Date Funds: Investing While Hiding the Risk

On this weeks MomsMakingaMillion radio broadcast, the topic of target date funds is front and center.

The hosts Gina Robison-Billups of MIBN.org and Kat Belucchi of PensionsInc. asked the following question: Almost every 401(k) now has these funds. Many are used as default investments for new employees. But you have a long-standing problems with them Paul. Care to our audience why?

I have been on the record, with some decidedly trash talk centered thoughts about target dated funds in the past. Why do I think these are quite possibly the worst investment idea ever?

Let me explain what these funds are suggesting they can do and why, under the guise of protecting your assets as you grow older, they might not do as promised.

Shooting for a Distant Promise
A target dated mutual fund picks a date in the future that coincides with the year you would like to retire. So far so good. We all want to retire and we all have some idea when that time will be. For most, it it the arbitrary time picked for you by Social Security. For others it might be the moment, at age 59 1/2 when you can first tap those tax-deferred 401(k)s and IRAs.

Suppose you are 40 years old, your target date might be somewhere around 2030 or 2040, depending on what you do and whether you think you can do it for that long. You direct your money to a fund in your 401(k) that offers this date. These are in almost every tax-deferred account due to the Pension Protection Act of 2006 (perhaps one of the worst named pieces of legislation ever).

The fund prospectus suggests (you do read the prospectus, don't you?) that the fund will gradually shift from stocks to bonds over the course of that time frame, growing less aggressive as your account grows. This seems to fall into lockstep with what you have always heard about asset allocation and diversification. And it will be done automatically. No hassle investing for those who feel as though the whole process is too difficult to understand.

But what you fail to realize is that this is uncharted territory that has never really been navigated. Balanced funds offer something of a similar type of investing but usually hold steady at a 60/40 split between stocks and mutual funds. These investments however offer an actively managed approach to the process, a continuing shift in how the fund is invested.

The Success is Hard to Determine
This has not been done with any success in the past and may prove more costly - and more risky - than some investors realize. Some of these newly created funds hold orphan funds that, although they have not closed completely, would have had the fund family not stepped in to save it. This is out-sized risk that other investors have left for good reasons.

Many of these fund managers are entering into fixed income investing world with the idea that this might provide less risk. They may be incorrect in this assumption as bonds may see more problems down the road with inflation and deficit spending by the government, here and abroad.

There is also the question of performance as judged by the benchmarks. Many compare how well they have done against the S&P 500. But the need for new benchmarks still won't mean that these funds will be comparable. Ron Surz, president of Target Date Analytics suggested "The current practices [meaning investment styles] are all over the map. You could have 2010 funds with 90% equity to 20% equity. Any investor looking at the whole landscape is going to be challenged to what they like and what they don’t." And what they understand and don't.

Provider Accountability and Investor Assumptions
In a paper published by Vanguard Group that explored this problem, they describe benchmarks as holding "the provider accountable for the appropriateness of the return assumptions used in constructing the funds." They also suggest that historic returns are a reasonable guide for future results. If that is the case, many of us are in for a disappointment.

Currently, these types of funds employ a glide-path style of investing. But a paper published by Wilshire Funds Management believes this method needs to be rethought. In fact, they believe that a fund - and this might sound even more confusing - need multiple glide-path plans in order to make the fund work. If that happens, the "one-stop shopping" approach that these funds were advertised as doing, no longer works.

So what is an investor to do? While the industry struggles with the idea - and the SEC questions their methods and exposure to stocks - it is best to stay with a broad range of indexed funds across several market sectors or use the actively managed funds that do the same thing. Stocks still rule for the vast majority of us in large part because we simply haven't been investing that long to get any real benefit.

If you have to use target date funds, pick a date that is ten or twenty years beyond when you want to retire so you can get more exposure to stocks longer.

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.

Mutual Funds for the Utterly Confused: Blind Ambition

Sir Isaac Newton once said after a failed investment: “I can calculate the movement of the stars, but not the madness of men.” Do mutual funds change this madness into profits for the average investor? Had Newton invested in a fund instead of chasing an individual investment (like the one he purchased in the South Sea Company) would his money have been safer?

To answer these questions, it is important to understand some of the basics of what a mutual fund is and why it works for those who seek a longer range opportunity and lack the financial savvy to speculate (gamble is actually a better word).

First off, a mutual funds gathers like minded investors to a strategy that employs a manager, a team of investment managers and sometimes even a computer to look at stocks and bonds that fit the goals of its investors. This sounds simple but the "madness of men [and women]" can often play a much larger role in whether this goal is achieved. Mutual fund investors are looking for three basic properties: achievable gains, avoidable losses and control of that mental maniac that wants us to sell on the way down and buy on the way up.

Because funds are populated by the human factor, this madness is not often easy for the fund to control. No (actively managed) fund begins its existence with the goal of losing money. They gather information about investments, take positions in as little as twenty companies and as many as a thousand (often more with index funds, but that is another story) and allow the market to do whatever it may.

Does this mean that you relinquish some control over the day-to-day fluctuations of the market? Yes. And if that is the case, how should you react when the market turns ugly?

The stock market offers the opportunity to gain on the belief that the investment will perform better than it is at the point of purchase. When you buy a stock individually, this gain is realized in plain numbers. Conversely, any losses are also realized in plain numbers as well. In a mutual fund, because there is a huge number of shares in a large number of companies, a gain is diluted (just like any loss).

Unfortunately, mutual fund investors do not always embrace this idea of diversity. They often see the fund's failures as much more individual and its gains as much more muted. If the market surges, and it will, the fund is usually moving in a slower lane, getting there eventually but traveling at a more measured pace. If the market stumbles, and it will and has, investors are reluctant to embrace the possibilities that their investment, because it is diverse by nature, will protect them better than had they invested individually.

The comparisons with broader markets, such an index that tracks 500 of the largest companies, is not well placed. The fund managers have made decision to purchase only a portion of those companies and comparing their efforts against such a broad market is unfair. Yet it is done and often. How your fund performed against an index fund, how much you paid for the services of the fund manager and lastly, how well the fund has sold its philosophy all play a role in how you might react.

Funds have been positioned inside the our retirement plans for a good reason. 401(K) plans offer us the opportunity to invest evenly and consistently over time. This removes the buy on the way up and the sell on the way down problem that plagues individual investor psyche. The approach is called by several names: defined contribution is often used by perhaps more aptly, it is dollar cost averaging.

Once you determine how much of your paycheck will be contributed to this plan pre-tax, you have employed dollar cost averaging. This method uses a fixed dollar amount to purchase shares. Sometimes, when the market is on the rise, you buy fewer shares; when the market is on the way down, you are able to purchase more.

Sounds counterintuitive but it is exactly this method of buying that removes that mental maniac. Had you remained in the fund of your choice when the market was on the way down, made no moves to stop or limit your defined contribution, you will have benefited over the long-term.

But what if you panicked and sold those actively managed fund, opting for something like a target-dated fund, one that readjusts its investment goals over time to account for your age? Did you make the right move? Not necessarily. If you had picked one of these types of funds for the safety it offered, the hands off approach to investing, you would have done well to choose a fund whose target was twenty-years beyond the year you picked.

(Just a reminder about index funds: You will be tempted to use these funds if you know little about the way funds work, But don't. These are tax efficient and belong outside your retirement plan.)

The Curious Case of (Index Fund) Fees

There is a simple idea behind the index fund. You create a fund that mimics an index, often published by some other investment company. In doing so, you basically purchase a broad swath of the marketplace, whether it is the top 500 companies, the whole of the marketplace or some other sliced portion of the stock or bond markets. The idea is designed to be cost-effective, in part because once the index is purchased, you basically employ the buy-and-hold strategy until the index itself changes.

So why do the fee vary so widely when it comes to something as simple as an S&P 500 index fund? The answer is they shouldn't. But the truth is, they do. And some are so high, they begin the approach to the fees levied in actively managed funds.

Consider the case (and the motive) for Charles Schwab's recent decision to lower the fees charged to retail investors in their index funds. Any time you lower a fund's fee, it is cause for celebration. Perhaps it is the skeptic in me that asks the question: why were they so high in the first place?

The fee reductions were most noticeable in its two largest index funds. The $4.59 billion Schwab S&P 500 Index Fund (SWPPX) which at one point before the change charged its shareholders 0.19%. Dropping it to 0.9% now positions the fund to take shareholders from the other index funds. But probably not from Vanguard or Fidelity.

Fidelity is selling some of its index funds for 0.1%, while Vanguard Index funds charge around 0.18%. So why care about what Schwab is doing? Low fees are great but to entry level purchases into either of the Fidelity or Vanguard funds can be prohibitive for new investors. Fidelity can charge, in some cases $100,000 minimum investment to get that rate, while Vanguard puts its minimum initial investment at $3,000. Schwab wants only a hundred dollars to open the account.

So should you change for a lesser fee? Yes if the fund is also doing what it intends to do. Numerous index funds drift away from their intended purpose and this error can be costly for investors.

If you are using index funds as they should be (we have often discussed this in our retirement planning blog suggesting that because of the tax efficiency of these funds, it would be somewhat foolish to defer paying the taxes on these types of funds) outside of your defined contribution plan such as 401(k) or IRA, then shopping around and choosing the Schwab alternative might be a very good move.