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 ETF Temptation

The new next best thing is not as new as you might think. In the long-term picture, the birth of the leveraged ETF is a mere infant among other ETFs and in terms of investment interest, a mere mote in the eye of mutual funds. But the fact that they exist; the fact that they seem alluring; the fact that they promise, at least on the surface a double, sometimes triple return on the index they follow, makes them worthy of our concern.

Exchange Traded Funds have been around for years, offering investors a short-term opportunity to play a specific index without exposing the investor to many of the individual companies within. Meant to be something short-term, the costs are mostly assumed by the investor with each trade in and out. Because the ETF is indexed, the costs remain low.

But leveraged ETFs are something entirely different. In many instances, leverage is done on margin, borrowing shares and paying interest on the loan. In a leveraged ETF, the leverage comes from derivatives like index options, index futures and equity swaps. The fund promises to double the return by exposing the investor to the possibility that the should the index go up, the underlying fund, because it has twice (and sometimes triple) the exposure to that particular index, will go up twice as much. A one percent gain in an index will give the investor a two percent gain.

On the flip side, a one percent loss will also expose the investor to twice the downside return. This has created a last hour of trading concern as these funds attempt to make their leveraged position do what it was intended to do. But what many investors do not realize is the volatility these funds create - rapid rebalancing to keep the fund exposed has super-charged that last hour of trading.

The risk here is referred to as counter party risk. In short, counter party risk in mutual funds and ETFs is as follows: In a mutual fund, the manager may buy a security that is a repurchase agreement whereby a seller agrees to a price for security and the commitment that they will repurchase that security at set price and time. The risk here is you are never quite sure what kind of commitment the other party has with other investors. This creates the illusion that, should the other party default, the investors standing in line will be you alone.

There are several things you should be aware of in these funds. According to NobelTrading, "The daily rebalancing of leverage results in extra trading, interest and management costs, which can eat up the profit. This make leveraged ETFs unsuitable for long-term profiting."

If these types of funds are showing up in your retirement plan (offered in your 401(k)) it is important that you understand the potential risk. Some have suggested that this is the new threat to the markets as banks and trading firms distribute last hour last minute news items that force the markets in one direction or another. For the individual investor, these often sharp moves can be incredibly frustrating. A single days gains can be wiped out in a matter of minutes and for no apparent reason. This makes for a very uneven playing field, tipping the advantage in the wrong direction.

Now it should be noted that some mutual funds use this technique as well. And although they do, the differences are magnified in ETFs because of the rebalancing done throughout the day. Unlike buying on margin (which has limits to the amount of shares that can be bought at 25-50% and charging interest for the service) the type of purchase ETFs often use is called an option.

Simply put, an option allows the investor, in this instance the fund manager to buy a security at a set price (option is an instrument that allows you to lock in a price for shares of a particular company which gives the investor the "option" of actually buying those shares at that price at some future date). If the price of the underlying stock increases, then the fund manager will have a much lower price paid for the option than the stock is now worth and it was done with money they did not already have. This creates an outsized profit that would have been unrealized had the fund manager simply kept the shares in the portfolio.

In ETFs, these options are often of the short-term variety. And while this type of transaction can magnify profits, the losses also suffer a doubling (or tripling) effect. Should those options expire while the share prices is low, they essentially become worthless. Add to that, the index you are invested with may have created a taxable event, a higher than index averaged trading costs and fees, and headaches for the rest of us.

To add to the confusion, the leveraged ETF makes little sense to those who ascribe to the old adage: sell high, buy low. The daily rebalancing will often find the funds that hold them buying into a rising market and selling assets as the market declines. And this is not the kind of rebalancing the average investor can wrap themselves around.


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