Mutual Fund Investing: Can You Be Blamed for the Global Crisis?

It is in our natures to place blame. As Doug Copland once quipped: “Blame is just a lazy person’s way of making sense of chaos.” That said, have mutual funds played a larger role in the ongoing crisis globally? And if so, why do we look to much smaller elements of the equation when the sheer size of these “investment communities” might be responsible, all be it unwittingly, for keeping the embers of (a global) recession burning?

Mutual funds as we all know are investment communities, an organized structure of similarly minded individuals (or as similarly minded as any large group can be) who seek to in many instances, lower the risk of investing by investing as one. With one theoretical manager at the helm, although we know that it can be many managers, we tend to think of them as one unit in most cases, the community gathers around their expertise and know-how in part because we believe we have limited expertise and know-how. We defer the heavy lifting and decision making to someone else. But mutual fund managers also fear us as investors. In part because we blame.

Now, this group think, achieved with only limited knowledge of what is really going on, and the fear of blame, which signals the herd that something is amiss may actually be responsible in a much greater way than previously considered, to have prolonged the fears of additional global slowing even as it should be plateauing, if not showing signs of recuperation. While the evidence to back this thinking is just emerging, the dynamics of the mutual fund do add credence to the theories being developed by Claudio Raddatz, Senior Economist in the Macroeconomics and Growth Unit of the World Bank’s Development Economics Research Group and Sergio Schmukler, Lead Economist at the World Bank.

First, what do we know about mutual funds and those that invest in them. Every mutual fund manager does what she/he can do to keep their finger on the pulse of those who have entrusted their money to her/his expertise. No easy task when the group is numbered among the tens of thousands. This group can find favor with the manager and inject money into the fund at such a rapid pace as to overwhelm the fund or on the flip side, pull so much of their investment out as to make the fund weaker for those who remain.

Although there has been some evidence of late that suggests that funds size has little to do with its overall returns and performance, any moves in either direction add pressure to the fund manager and their investment goals. Add to that the reasons why – disturbing financial news for instance and the pressure compounds. So we have one root cause: investors either looking to increase their exposure in one fund as they escape the other.

This creates the second reason that mutual funds play a bigger role in what the authors of a recent paper suggest: the portfolio adjustments that need to be made because of what the underlying investors are doing. Think of a bad movie, where the audience begins to head for the doors. Those remaining wonder if they should leave as well, even though many will stay for one reason or the other. In a mutual fund, the manager doesn’t necessarily bar the exits so much as adjust the portfolio in the hopes of retaining those that have remained in their seats. And we have this shift occurring to add to the problem.

The last problem is what those remaining investors say to the managers. Their input is sacrosanct and although not necessarily embraced, it is heeded. According to Radditz and Schumkler: “We find that both the underlying investors and managers of mutual funds are behind their large investment fluctuation across countries, retrenching from countries in bad times and investing more in good times.” They posit that unlike investors, the single minded type who understand that when markets sell it is because either the seller has information that no one else does or that the seller doesn’t have the information needed as simply wants out because they see danger on the horizon.

Mutual funds cannot act as agents at a equity fire-sale. They rely on the manager to do as chartered and this is often contrary to what she/he would like to do: bulk up on bargains that they know are selling at less than their true market value. They have information that you may have acquiesced by joining the fund but you simply won’t let them react. So they do what you want even if it does not seem to be in your best, long-term interest, and they sell. They sell to fund redemptions and they sell to retrench. But the key here is they sell.

While the authors of the paper point their evidence on international funds, the ripple effect is felt even in domestic, US-based funds as well that hold companies doing business on an international scale. In “normal times” the authors point out can be simply a retrenchment based on the inability of some countries to do as expected, abnormal times force a larger scale move that impacts the whole of the marketplace.

The information that investors in the these funds creates an imperative for the managers to make some sort of move to retain those investors while catering to those who have left the theater. This creates a supply-side shock to not only the fund but also to the banks of countries these funds might invest in. Call it idiosyncratic risk.

Should we blame te mutual fund? Quite possibly in part because of the mutualized investor is actually in the driver’s seat. They vote with their investable dollars and walk if there isn’t an expected return on their money. The real question lies not so much in the risk that the investors in the fund have or do not want but whether the fund is a bargain even as the risk of what it owns, increased by the departing shareholders, creates. And where does the money go? Into money market investments that benefit banks in the US while taking money from the countries who may need their borrowing/lending increased to help alleviate the crisis.

Mutual Funds and Performance: At the Half Way Point for 2011

For the vast majority of investors - mutual fund investors in particular, watching the major indices and judging your performance against them distorts the reality of not only where you should be but where you could have been. If you were to look only at the difference between the former highs the markets hit in October 2007 and those at the most recent close on Thursday (the Dow Jones Industrial Average DJIA +1.36% is around 12% below its all-time high of 14,165, and the S&P 500 index SPX +1.44% is nearly 16% below its October 2007 high of 1,565.) you might be considering jumping back in.

But you would have been much better off had you done absolutely nothing. Back in those desperate times, many people did what the rest of the herd did as stocks began to tumble. You sold. But three years later, that would have proved to be the wrong thing to do. During that period, most folks fled the actively managed mutual fund, particularly the domestic issues in favor of bond funds and in far too many instances, to target date funds.

Let's consider the indices that are often compared to the riskier funds, a benchmark that has proven to be less than accurate in terms of performance. The Dow and the S&P 500 track the largest companies, a group that has struggled to assure the investor that dividends and size were enough to best the market. Turns out, that picking and choosing, as actively managed funds do, would have been the better approach.

Two things come into play. One, these funds tend to have higher fees. Less those fees, you would have still found yourself in a better position than had you simply put your money in a benchmark S&P 500 index.

And secondly, there is the liquidity issue that comes with buying mid-cap and small-cap companies. Liquidity refers to the amount of stock available in smaller companies weighed against the amount of stock held by the principals. This makes these companies more volatile and even under-purchased in indexes that track those larger markets (the Wilshire 5000 for instance may track all available stocks but the indexes crafted based on this index only own.

To complicate matters somewhat, the Wilshire 5000 actually has 5700 stocks in the index, Wilshire 4500 is the Wilshire 5000 without the S&P 500 stocks in it. A Wilshire 5000 index fund (usually called total market index) will probably own around 4000 stocks. A Wilshire 4500 index contains those same stocks less the top 500 companies.

As Mark Hulbret noted in a recent column for Marketwatch, "According to a report produced earlier this week by Lipper (a Thomson Reuters company), 45% of the domestic-equity funds for which they have data back to October 2007 were, as of the end of May, ahead of where they were on the date of the stock market’s all-time high."

So the indexes are lower than where you would have been had you stayed put - of course this is based on the assumption that many of you where using actively managed funds in your 401(k) plans, that many of those funds did not have indexes available and the post 2007 products such as target date funds or even ETFs, weren't a consideration or even an option during those days. You embraced risk and ignored fees and looking at your portfolio, that was probably seen as a good thing.

Does that mean index funds shouldn't be part of your portfolio? The simplest answer is no. Index funds still provide a low cost and low turnover environment to invest in. More importantly, the largest cap indexes add dividends to the mix. This brings these investments closer to the domestic out-performance over the last half of the year.

Diversity in this investment environment, which is still far more volatile than anyone would like it to be, with global issues remaining a major concern, means taking a little less - in terms of performance. You should be in index funds now. To do this would be considered a defensive move for those that kept the actively managed faith.

A portfolio of five, perhaps six index funds, tracking sectors from the S&P 500, a mid-cap index, a fund tracking the small-cap, an international index (which tracks the companies of what is considered the developed world), an emerging markets index (contains investments from countries like China, India, Russia, Brazil and others) along with a bond index.  This sort of diversification keeps the low cost features of index funds and avoids any crossover investment (owning the same stocks in different funds).

You can be proud of your investment accumen in getting back to those 2007 highs and perhaps beyond. But show your real prudence and protect what you have done. This economy, both domestic and globally is far from recovered and the stock market is painting a better picture than reality suggests. Being a little defensive at this juncture will keep you in the game without risking what you have gained.

Are Mutual Funds that Short a Good Idea?

Most investors don't understand the idea of a shorting an investment. The concept is relatively straightforward: an investor essentially bets that a stock will go down and if it does, profits from the fall. Going long does the opposite, wagering that a stock will move higher. This was formally the purview of the hedge fund, those high dollar investor clubs with equally high fees, that sought to use every market strategy available to gain ground for those investors.

As I said, this was formerly something of an investment style that was not available to mutual fund investors. But this is a different investment world and the mutual fund industry, in its own way, acknowledges that trend with a group of funds that offer a defensive footprint in the market. In other words, rather than simply assuming that all stocks will go higher, they believe their research and expertise can locate stocks that move in the opposite direction.

Studying an online MBA with an emphasis on finance can get you up to speed on mutual funds. If you don't have such a background, this information will help you understand shorting your investments.

The question is: is this a good investment for your portfolio and more specifically, how do you avoid the lure of their promise to do better than traditional funds or even ETFs? It's no easy feat launching a mutual fund and even though some appear new, they can take a year or more to hurdle regulatory requirements before the first share is offered.


In almost every instance, when it comes to investing in mutual funds, the basis for your decision rests on not only the tenure of the fund manager, but the length of the fund's performance. This backward looking approach doesn't always serve the investor well when it comes to picking a fund based on what it has done compared to where it is now, nor does this sort of comparison reveal the true nature of the fund's ability to best the overall marketplace, a field now numbering over 8,000 potential offerings.

When times are bad, as was the case twice during the last decade, good years can be wiped from the investors view, replaced with averages that make the fund appear lackluster.

New funds don't have that sort of problem. They're new, with no history and no track record. Just a charter and a manager. So new investors are forced to look at the fund family (which provides research and oversight) and the previous experience of the person(s) at the helm. This is no easy trick and requires a leap of faith. Not the soundest of advice; more like a word or two of caution.

According to Dan Culloton, associate director of fund analysis with Morningstar: "They're [long-short mutual funds] responding to the market fears and frustrations over the past 10 years. A lot of it is just pure-and-simple rearview mirror product management." One hundred and fifty new funds have decided that this is a market worth exploring.

Among the new offerings, seventeen are focused on emerging markets. This particular sector is teeming with potential and just as many problems. It is those problems, which can range from anything like political unrest to poor financial infrastructure are widely thought to be the main drivers in such an investment space. And the risks in some of those bets were indeed high. These new funds (some of which can be found here and do not constitute any recommendation to buy) have done quite well for themselves in the years following the downturn in the US stock market.

There is also opportunities to play both sides of the extremely volatile commodities markets. Many of us have watched with great interest the demand for some commodities and understand the risks involved. Yet we a lured by the potential returns this sector can offer, looking for some way to mediate those risks.

Enter the commodity mutual fund designed to play off of those investor fears, the world-wide demand for many commodities in short supply, and the ability to find profit where other investors may not yet be. And because they short securities as well, they bet some investors will not be there for long (the reasons vary from currency policy changes to the perception that something may be overbought and ripe for a bubble pop). You can find a list here.


But are these funds right for you? Yes and no. Yes if you are looking to fill a small corner of your portfolio, perhaps as little as 5-10%. There are great deal of more traditional investments that allow you to see where the fund has been and where it is headed. These still remains the best tools for making a decision on where to invest your money. And no, if you are easily swayed by the relatively high returns these funds have been providing investors over their short-life spans. That temptation can easily allow you to increase those percentages to too high a portion of your portfolio, eliminating the best diversity plans.

And since a vast majority of us will be using or retirement portfolios (401(k)s and IRAs) to do this sort of investing, special caution is worth considering.

Keeping that Balance and Maintaining It: Asset Allocation

Dan Solin is right when he suggests that no one ever brags about their ability to achieve optimum asset allocation. Its not all that sexy and quite frankly, lacks the sexiness that doing something extreme often nets you.  Something like not using asset allocation.

Asset allocation is something of a mystery to most of us although no writer worth her/his mettle would bypass the opportunity to tell you it is one of the keys to investment success.  You will hear those who use index funds as a primary driver in their portfolios selling the notion that once you embrace this passive sort of investment, asset allocation becomes second nature. It certainly becomes easier.

To allocate assets is to take and spread risk across many different stocks and bonds.  The idea here is that no market performs in tandem.  Some corners will remain sluggish while others shoot for the moon.  Asset allocation keeps you in both but keeps you involved in a measured way.

Too much of any asset class usually means that asset is doing really well. This is where the tough part comes in.  If that asset is doing so well, you probably should begin selling some of it in favor of the assets in your portfolio that aren't doing so well. This sounds sort of counterintuitive and I'll explain why it shouldn't.  Even if afterwards, it still does.

Because we are talking mutual funds and not individual stocks, and we will for the sake of the argument, use index funds as an example.  A large cap index fund may be in favor with investors because investors are looking favorably upon the companies in the index. But you also hold an index of small-cap companies that seem to be lagging behind - at least as a comparison. To continue to send money to the ever-rising fund, you should take some of the profit off the table and transfer it to your other allocations, balancing your investments at the point you began.

But, you stammer, that fund could go higher. Why sell a winner? Because that is what you do to make money: sell winners.  But in order to keep your allocation in balance you shift those dollars to the other funds in your portfolio, buying shares in those funds when they are less expensive.

Should you consider using actively managed funds in this process? Depends on your age and whether you plan on focusing on the balance among the funds in your portfolio. If you have a fifteen year or longer time horizon until you estimate you will begin to tap your account for income, feel free to take your chances.

Index fund users will never stop stressing the importance of fees and the low cost index funds have. And this is important.  But fans of the actively traded mutual fund are also focused on fees and equate performance against this measure. But the comparisons are difficult and calling this type of investing successful depends on numerous variables. (From which benchmark is being used to how many funds are spread across how many asset classes, the variables can astound and compound.)

The importance lies in keeping that balance and maintaining it. The only risk you can add to your portfolio is not adjusting your allocations at lest once a year. We are in for a volatile decade, as unemployment strings out, debt continues to be an issue and the tax debates continue and that is not without some pressures in the stock and bond markets.  This balancing act wil take time and effort.  But the person who bothers will end up with more years of positive returns than someone who fails at this decidedly unsexy task.

Which Mutual Fund is Better?

The world of conservative investing that has developed over the last couple of years has done so with sound reasoning.  People who buy fixed income believe that in doing so they are protecting their investments in the safety of debt.  That debt, be it from Treasuries or corporate bond issues has seen prices rise while yields drop.  yet they continue to put money in what many are now seeing as the next bubble.  But many equity fund managers are now suggesting that this bull market in bonds is about to end as unemployment continues and economies around the world still struggle.  Are equity funds worried about the investor or the fees they are (or are not) generating?

David Pauly, writing in Bloomberg pointed out that "These managers are concerned about their fees: On a dollar- weighted basis, stock funds on average collect 76 cents in fees for each $100 invested compared with 61 cents at bond funds." Even as money flowing into bond funds increases, PIMCO, the world's largest bond fund company predicts that this bull market in bonds is poised for collapse. When is subject to debate.

We have near zero interest rates, the housing market continues to see price stagnation and there doesn't seem to be any concerted effort by the government to get back into the stimulus game.  Unfortunately, it is the stimulus provided by government that has allowed us to get this far, even if "this far" is still short of where we should be in this economic recovery.

Because investors still see the potential for yet another slide into recession, bond fund inflows have increased as a compared to their equity counterparts.  While these investors are doing so because the believe that bonds still are far less risky than stocks, they may simply be kidding themselves.  Risk, the much needed element in any portfolio seeking to grow, is not something bond investors necessarily believe they are taking when they channel their money into these investments.

That risk is the price.  Bonds are priced based on the willingness of investor to pay for safety and the more they believe this, the higher the price goes.  As the price goes up, the yield falls.

Should the economy double dip, this bet will be worth taking.  But if investors (even if they are prompted by their money managers to get back into the stock market - as Mr. Pauly suggests because of better fees charged by the equity funds they represent) decide at some point that the economy is improving, the sell-off will leave a lot of late-to-the-game investors holding losses they didn't think possible.

Mark Trumball, writing in the CSMonitor outlines this risk: "It's hard to predict when a shift will occur, but at some point, many investment strategists warn, Treasury bonds will become the worst-performing bonds of all. That's precisely because these bonds are considered to be among the safest investor havens during hard times. If a crisis mind-set eases, Treasuries have run up so far in price that they have the furthest to fall."  Should this shift occur suddenly, not only will individual investors be in trouble, but large pensions funds who have difficulty moving quickly, will also suffer.

Inflation also plays a role.  Bond investors will demand some compensation for the increase in inflation, something that has been so far, benign. Robust recoveries usually indicate an increase in inflationary pressures and there is no indication that this recovery could be described that way. Bond gurus also point out that if the bond bubble should burst, should inflation suddenly spike, the retreat away from bonds will not mirror that sudden retreat investors in equities often exhibit.

Vanguard points out that the safety in bonds is likely to be less dramatic in large part because as bond prices drop, yield will increase. And this will keep many investors with a choice: keep the bonds they have flocked to or sell them for the rising opportunities in the equity markets. But Vanguard's prediction that investors will simply freeze may not take into account the nature of investor behavior. They are in bonds because they were frightened of losing their hard-earned money.  But if they see a return to out-sized gains in the stock markets, they may just vote with their feet again.

Vanguard argues that in no matter what happens, bond investors will still do good. In a bad economic situation, the point to historic likelihoods by suggesting the investors who stayed in bonds saw a high relative return.  In a good one, they point out the higher nominal returns will occur. They point out that the rise in interest rates will affect the short-term bond more than the long-term.  Their analysts see a rise (over the next five years) in 2-year Treasuries from 0.81% to 5.28% (rates for longer termed bonds will rise less dramatically from 4.43% to 5.56% over the same five year period).

But this depends on numerous factors including a steady inflation rate, the continued purchase of US debt by foreign banks, predictable increases in the Feds fund rates, modest GDP increases and you. If you hold steady, these predictions will probably come to fruition.  But if things improve in the equity markets and you panic, the bond bubble will burst, albeit slowly, in spite of Vanguard's argument that you will still do okay if you had done nothing.

Paul Petillo is the managing editor of Target2025.com

Do You Know Where Your Muni Bond Fund is?

The vast majority of us who own municipal bonds, do so inside of a mutual fund.  But munis may be in a bot of trouble with more on the horizon.

We want to believe it simply isn’t so. Municipal bonds or munis, those hometown or home state, often tax exempt debt instruments which are favored among the retired, the soon-to-be retired or those looking for a conservative but well-paid return may be facing a little headwind. But truth be told, you should have noticed.

When you buy a municipal bond, you are essentially buying a project believed to be worthwhile for the city, county or state issuing the debt. They are rated in much the same way as a corporate bond is with a single exception worth noting. If a municipality issues a bond and has difficulty paying the coupon, they often simply raise the local tax rate to cover the shortfall. But like all sorts of funding, the increased tax revenue that would pay for the bond payment shortfall is also in short supply.

More on municipal bonds and risk here.