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.

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