The Plight of the Savvy Investor and the Goldilocks Mutual Fund

We are a fickle bunch. We think of ourselves as savvy investors, although there is a great deal of room for improvement among all investors to which degree of savviness. Yet we are in almost every instance our own worst enemy. Victoria Holt is quoted as saying: "Never regret. If it's good, it's wonderful. If it's bad, it's experience". Yet still, after several decades of behaviorists studying our actions in the marketplace like so many mice in a lab, we still do the same predictable things time and again.

And perhaps the first emotion we feel once we begin to second guess each of our "investment" decisions is regret. And if the recent selling of actively managed mutual funds by investors over the last year or so is any indication, regret for past decisions is in full swing.

Adding to the chatter that actively managed mutual funds and by default the managers who stand at the helm, is John Bogle, chanting the mantra he has carried since the late seventies. Why, he has asked, would anyone choose to look for more than what an index fund can provide? And as we begin to acknowledge the pull and tug, feel the most susceptible to such cost savings as a lower fees, which is always good, index funds begin to come to the front of our thinking about which investment is best.

But once you begin to believe that getting mediocre returns in the equity markets is the "new" goal, the attempt at saving some money in terms of the fees charged by actively managed funds in exchange for the smaller returns that index funds offer becomes the overall focus. And if that is the sight path you choose, index funds are definitely the right fund to use.

In a recent report in the NYTimes on the subject of this exodus from highly regarded performers over decades to index funds in search of lower fees, one thing stands out in the numbers. This is simply a beast feeding upon itself.

Consider this: You own X amount of shares in an actively managed mutual fund and you sell. But rarely do investors act alone. They are signalled by some change in the wind, some report drilled over and over or perhaps, it is from the suggestion of a colleague. Suddenly, fear sets in and you begin to think that you have the wrong investments. The fees are too high, you think and then anything that resembles a stick snapping alarms you and your fellow investors and you run.  And then you regret.

The selling prompts the redemption of shares, which when enough investors sell simultaneously, and enough shareholders accounts need to be made whole as they leave, markets move. And if the movement is great enough, the equities drop. And so do the indexes. So you sell at a loss only to buy shares in a fund you just, via the herd, lowered.

In many instances, the outflows are no reason to believe that the actively managed mutual fund world will implode. In fact, according to Brian Reid, the Investment Company Institute’s chief economist, 93% of the investment assets stayed right where they were as the remainder moved to other investments. Among those investments - more than just index funds reaped the benefit of this change in loyalty to actively managed funds - overseas funds gained as well as funds focused on commodities. Bond fund outflows also helped boost the index fund profile.

And what did this sell-off net the exiting investors? What were they looking for? Believe it or not, index funds that are actively managed. This surprising move has some folks, including myself, scratching our collective heads.

True, the fee structure of index funds is far cheaper that that of the actively managed fund (index funds average about .16% while actively managed funds average about .97% - with many load and closed end funds added into that average and increasing it as a result). But once you let a broker enter the mix, the fee structure changes, coming closer to the cost of the actively managed fund and at a lesser overall return.

Index funds because of the tax efficient structure belong in taxable accounts - as long as the capital gains tax remains historically low. Inside a tax deferred account such as a 401(k) or an IRA, the effect is lost. This is and should be the domain of the actively managed mutual fund. And while you should never lose sight of the role fees play in the long-term performance of your investments, believing that fees are the only driver in achieving steady returns is misplaced.

And while I have nothing against index funds, the growing number of funds  that slice and dice the markets do not always lead to lower fees for investors. But talk about index funds enough, and investors won't notice nor take the time to compare one index to another.

Are Actively Managed ETFs (Exchange Traded Funds) Worth a Look?

Investors are divided into two groups: those that see themselves as investors and those that use their 401(k) accounts to invest for their retirement. The latter group tends to refer to this activity as savings, a word that has long since distressed me for its inaccuracy. The other group, the ones who think they can invest, tend to fall prey to the next new thing or on the flip side, spend a great deal of time and money trying to mimic an index fund. This group wants to be their own mutual fund manager and does everything but charge the trailing fees that a mutual fund does.



So we have one group who "invests" and the other who "save".Both use essentially the same tools and with any luck, practice the same prudent practices. Tempting both groups is the ETF or exchange traded fund. When these we first introduced, about a $1 trillion worth of investments ago, they were heralded as the one thing investors needed to keep their assets where they could get to them, when they needed them.

Trading like stocks, you could buy an ETF in the morning, sell it if you wanted to at noon, and buy it back before the end of the day. This was a genius move on the part of Wall Street and began generating buckets of cash via trades. Mutual fund companies wanted a piece of the action and jumped in as well with ETFs that looked eerily similar to index funds they were already selling.

The cost of the trade was about the only thing you could toy with. So they eliminated that fee. But not to be allowing you to do something for free, they found another way to charge you. Back on January 6th, 2011, I wrote: "a Vanguard spokesman said the company believed “that the ability to attract and retain clients, particularly high-net-worth clients, will improve the bottom line and ultimately result in lower fund expense ratios.” The truth is that instead of charging for the trade, they charge you to hold the ETF in your account."


Now, three years into the first appearance of the actively managed ETF, we wonder if this will be as wildly popular as the indexed ETF (which has sliced and diced the market in such a way that no corner of the investment world is un-indexed and because of that, has added to the volatility in the marketplace, particularly at the close of trading). Perhaps but the wary investor and more than one "saver" should approach these tools with caution.

Does an actively managed ETF cost less than a actively managed mutual fund? The short answer is yes. Mutual funds bought outside of your 401(k) - where fees tend be lower and in some cases, different - have fees for distributions and marketing. While these fees are annoying and do take away from your returns, they are needed to attract new investors, pay for research into which stock is next on the buy or sell list and to pay for the services of the fund manager. Could they be lower? Yes. Have they dropped significantly? Over the last several years, yes. But what about their ETF counterpart?

Without many of those "trailing fees", actively managed ETFs are less expensive. But few people add in the cost of the trade when they think of purchasing an ETF and each time you buy or sell, this acts as a fee - albeit right up front.


Several other comparisons come to mind. The transparency of ETFs, which must disclose what they hold everyday seems on the surface like it would be a grand idea. But when it comes to this type of investment, transparency and rules for trading tend to make this a dangerous place. In an index fund or ETF, the investments mimic an index, set and left alone for a year, sometimes longer.

In an actively managed ETF, which discloses its holdings and must disclose its building or restructured portfolio almost as it executes the trade, it allows investors outside of the ETF to "front-run" the fund and buy at a cheaper price than the fund would pay. This is not good for the ETF manager if the stock they are buying is somewhat illiquid.


Taxes are another issue. Mutual funds tax you quarterly and yearly. Index ETFs tax you only when you trade them and because they don't turnover (trade their securities often) as much, the taxes, once levied are less. Actively managed ETFs only charge you taxes when you sell the fund but, because they trade often, the taxes you will pay will be higher than indexed ETFs.

Now there is little I can say that will dissuade you from buying an actively managed ETF once they become more widely available and have logged a track record (currently, they have less than three years under their belts). If you find them in your 401(k) and they are cheaper than actively managed mutual funds, they might be worth looking at if you are looking at adding some risk.


This investor tool is not going away. And it will add to some additional volatility as traders in these funds move around much more than those that hold individual stocks and/or mutual funds. And that can't be good no matter how you view who you are: and "investor" or a "saver".