This is the mutual fund: There was a time when the art of a fallen empire portrayed something opposite of the reality. In an exhibition at the Asia Society in New York, images from a period in India's past, when the Mughal ruled an empire that spanned from 1707 to 1857, offer the viewer a look at a facade of peacefulness. You are forced to avoid looking at the reality of life in those pre-British days by focusing on images of receptions, celebrations of holidays and the opulence of serenity. While beneath the surface an empire was crumbling under the rule of these princes on palanquins, the art suggests otherwise. We derived the word mogul from these rulers who dressed in pearl-embroidered shoes and decorative tunics.
This is the mutual fund in 2012. The facade belies the undercurrent of decline. It is a time when what was is slowly being replaced by another ruling party, a new-comer to the scene of investing: the ETF. This investment, like the invasion of this nineteenth century country by the British, is on the cusp of replacing the empire of the mutual fund. If you are paying even passing attention to the world of investing, this displacement comes with a price.
The exchange traded fund or ETF is slowly moving to the forefront of our investment options. The question for you, the one you will ask yourself: is this an investment worthy of my attention? Should I look at the picture the enthusiasts of this financial product paint for you and simply admire the brush stroke and the nuance or should you instead focus on the placard alongside the painting for a deeper understanding of the product?
The ETF is building an enviable empire based on the decline of the mutual fund. Largely made of the same materials, the ETF offers many of the same attributes as a run-of-the-mill index fund with several exceptions. Those differences are part of the marketing strategy proponents of this investment push to the forefront. The decision, they suggest goes beyond the what traditional indexed mutual funds offer, giving the investor a different sort of control.
They will tell you that these funds can be bought throughout the trading day. For the average investor, this added ability to buy and sell a fund like a stock on an exchange only leads to more questions. What does this attribute mean to you? Why should this mean anything at all?
Most mutual fund investors are of the buy and hold variety. We use them largely in our defined contribution plans or 401(k)s. They populate a world that is bound by the whim of our plan providers and sponsors. And inside that world, they offer a vision of retirement that is directed by you for you. And while ETFs are making inroads into this closed circle, your current exposure to this investment is largely on the outside of these plans.
The exchange traded fund offers additional options than simple tradability. It offers lower fees in many instances when compared side-by-side with the mutual fund. The difference can be slight but noteworthy over long periods of time. So it may be the best buy-and-hold option for the investor with that mindset. If that is the case, then actively trading ETFs is not a selling point and the fractionally lower fees may make them not worth the effort - or cost.
What does set this investment apart is the construction of the fund itself. Unlike the mutual fund, which is built (or deconstructed) with every contribution (or withdrawal). A mutual fund must sell shares to pay for those exiting the fund and buy shares with new money. ETFs buy a basket of stocks in advance of you ever investing a single dollar. And that dollar doesn't impact the overall "basket" one iota whether you invest in or out. This attribute leads to more stability in the investment, less price variation and more transparency.
But like the Mughal painters whose courtly portrayal of an empire in decline, whose story is masked by opulence and celebration, the artist of the ETF may be masking some truths as well.
The ETF offers a new empire. While the definition of empire is based on how much geographic impact the rulers had at a particular time, the ETF empire is still growing, grabbing investor real estate at an enviable rate. If history offers any indication, the ETF empire will continue to grow, amassing population and expanding boundaries.
And as they do, the territory they claim as their own will be like all empires, hard to rule, sparsely inhabited and lorded over by tribes that only offer allegiance in passing. This will be where ETFs are tested. Not in the traditional and heavily populated markets; but on the fringes.
And this is where you should exercise caution. Like all expansive empires, the rules change the farther one travels from the most populated places. You may think that you are still in the ETF empire and from all indications on the map you are. But the danger in this investment grows with every footfall beyond the center of the empire. This is how the mutual fund began its decline, as fund families looked for more arcane offerings further afield. Will ETFs suffer the same fate, offering the rule of law where law is not always embraced?
Quite possibly. To use ETFs, one must stay close to the glow, the core of the investment idea. Because the farther out you venture, the more likely you will find investment options with higher risks and less transparency, higher fees and more narrow focus. So as ETFs make their land grab be cautious of what the ETF actually is. It is an investment. It does cost less. The risk seems to be lower.
But venture into the hinterlands of this growing empire and you will see the dangers increase, the risk become more apparent and while the names of these far flung locales will always suggest ETF, it won't be the same ETF. It is on the fringes that the mutual fund has begun its decline. It will be the same for the ETF if history is any indication.
Showing posts with label indexed approach to investing. Show all posts
Showing posts with label indexed approach to investing. Show all posts
Wednesday, April 4, 2012
Thursday, April 14, 2011
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.
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.
Wednesday, March 16, 2011
Is Average Good Enough?
There is absolutely no doubt in an index investor's head that those who chase actively managed funds are fools. Not the Motley type, because those guys think much the same about those types of fund investors as well. But the sort of fools you suffer because you know they should know better, you know they are smart enough to do the math and lastly, you think chasing average with a index fund entitles you to a degree of smug for know how inefficient the market is.
And that's fine. An index investors is supremely confident that all will be well with their investment choice. The fact that they were able to purchase it for far less than what the actively invested mutual fund charges and that argument is always pointed out in every conversation about index funds makes the debate somewhat one-sided. Yes it is true that buying something for less is advantageous when it comes to investing. Low turnover (index funds readjust their holdings when the index they track changes) mean lower taxes (an interesting event because index funds sell losers and buy winners when they do readjust) and the combination of all of this seems to satisfy even the most average investor.
But I'm not so sure that actively managed mutual fund investors consider themselves average. Nor do they pursue such a state. In large part, because they already have it. As I mentioned earlier index fund investors like the concept of average. They embrace the inefficiencies in the market and defer the thinking about where the market will move next to the idea that spreading the risk is far more essential to protecting the underlying investment. But that protection comes with a cost.
If index funds are so much better for the investor than those of the active sort, why aren't these the only investments in use. When you look at the differences in investment styles, you find that index fund investors tend to only own index funds whereas actively managed mutual fund investors own both.
Perhaps it is the very nature of index funds. Where in almost every instance, the traditional index fund is employed, the reality of how these funds allocate the money, with the 10 companies in the index usually garnering the top 20% of the indexed dollars might lead those active investors to think that there is a chance that the remaining 490 companies in a typical S&P500 index might offer something of an opportunity.
Investing outside of index funds had been referred to investor ignorance. Betting against what are seemingly long odds of success has a certain attractiveness to the process. Call it the "what if" approach. Back in August of 2010, Lubos Pastor of the Chicago Booth School of Business and Roger Stambaugh of the Wharton School of Business wondered why do actively managed investors continue to chase these funds when the statistics offer evidence that the returns in these investments will be subpar.
To invest is to embrace the knowledge that in every investment there are two players: the one with the reason to sell and the one with the reason to buy. Trusting that a fund manager can determine which is the better side of that purchase is why actively managed funds remain more popular than index funds. True, few are skilled enough to find that pivot point but the professors have found that movement in and out of these funds, based on decreasing performance might have something to do with why they stay in these funds at all.
These investors, at least according to the professors take dispassionate rather than long look at where a fund is headed and readjust their investments accordingly. Nathan Hale of MoneyWatch believes that it instead "represents a fundamental misunderstanding of how investing works". He argues that even though actively managed investors think the additional research they do, the faith in those that they have hired because of their expertise and the fact that they have to work harder to get the returns needed to keep investors investing, Mr. Hale writes that this will "inevitably detract from the returns you earn in the markets".
As long as the comparison of performance is skewed - benchmarks are always used when comparing the two types of investments when few if any actively managed funds hold 500 stocks in their portfolio - the proof of who is right depends on how fully you embrace the concept.
Active investors don't suggest that indexing is wrong and may have been the result of an increase in net inflows to index funds over the last several years as they moved to protect some of their portfolios. They just believe that the opportunity to do better is worth the cost, adjusting their holdings to react to lack of or increased opportunity. Mr. Hale sees this shift as the embracing of index wisdom.
Is it a "recognition of the benefits of an indexed approach" as he suggests? Or is it perhaps the simple fact that using actively managed investments are more involved, intellectually stimulating and make the investor feel like an investor? Is it an understanding that to live as a investor (using every means possible) better than simply chasing average?
Use of index funds will increase as new investors come into the marketplace, uneducated or perhaps under-educated. Auto-enrollment may add to the involvement. The use of these funds by Baby Boomers looking for some equity allocation in the final years of their work-life, realizing that some exposure is better than none may also contribute to the increased use of this passive investment. Time will tell. But actively managed mutual funds, even though maligned by index investors, will always be available to the investor.
And that's fine. An index investors is supremely confident that all will be well with their investment choice. The fact that they were able to purchase it for far less than what the actively invested mutual fund charges and that argument is always pointed out in every conversation about index funds makes the debate somewhat one-sided. Yes it is true that buying something for less is advantageous when it comes to investing. Low turnover (index funds readjust their holdings when the index they track changes) mean lower taxes (an interesting event because index funds sell losers and buy winners when they do readjust) and the combination of all of this seems to satisfy even the most average investor.
But I'm not so sure that actively managed mutual fund investors consider themselves average. Nor do they pursue such a state. In large part, because they already have it. As I mentioned earlier index fund investors like the concept of average. They embrace the inefficiencies in the market and defer the thinking about where the market will move next to the idea that spreading the risk is far more essential to protecting the underlying investment. But that protection comes with a cost.
If index funds are so much better for the investor than those of the active sort, why aren't these the only investments in use. When you look at the differences in investment styles, you find that index fund investors tend to only own index funds whereas actively managed mutual fund investors own both.
Perhaps it is the very nature of index funds. Where in almost every instance, the traditional index fund is employed, the reality of how these funds allocate the money, with the 10 companies in the index usually garnering the top 20% of the indexed dollars might lead those active investors to think that there is a chance that the remaining 490 companies in a typical S&P500 index might offer something of an opportunity.
Investing outside of index funds had been referred to investor ignorance. Betting against what are seemingly long odds of success has a certain attractiveness to the process. Call it the "what if" approach. Back in August of 2010, Lubos Pastor of the Chicago Booth School of Business and Roger Stambaugh of the Wharton School of Business wondered why do actively managed investors continue to chase these funds when the statistics offer evidence that the returns in these investments will be subpar.
To invest is to embrace the knowledge that in every investment there are two players: the one with the reason to sell and the one with the reason to buy. Trusting that a fund manager can determine which is the better side of that purchase is why actively managed funds remain more popular than index funds. True, few are skilled enough to find that pivot point but the professors have found that movement in and out of these funds, based on decreasing performance might have something to do with why they stay in these funds at all.
These investors, at least according to the professors take dispassionate rather than long look at where a fund is headed and readjust their investments accordingly. Nathan Hale of MoneyWatch believes that it instead "represents a fundamental misunderstanding of how investing works". He argues that even though actively managed investors think the additional research they do, the faith in those that they have hired because of their expertise and the fact that they have to work harder to get the returns needed to keep investors investing, Mr. Hale writes that this will "inevitably detract from the returns you earn in the markets".
As long as the comparison of performance is skewed - benchmarks are always used when comparing the two types of investments when few if any actively managed funds hold 500 stocks in their portfolio - the proof of who is right depends on how fully you embrace the concept.
Active investors don't suggest that indexing is wrong and may have been the result of an increase in net inflows to index funds over the last several years as they moved to protect some of their portfolios. They just believe that the opportunity to do better is worth the cost, adjusting their holdings to react to lack of or increased opportunity. Mr. Hale sees this shift as the embracing of index wisdom.
Is it a "recognition of the benefits of an indexed approach" as he suggests? Or is it perhaps the simple fact that using actively managed investments are more involved, intellectually stimulating and make the investor feel like an investor? Is it an understanding that to live as a investor (using every means possible) better than simply chasing average?
Use of index funds will increase as new investors come into the marketplace, uneducated or perhaps under-educated. Auto-enrollment may add to the involvement. The use of these funds by Baby Boomers looking for some equity allocation in the final years of their work-life, realizing that some exposure is better than none may also contribute to the increased use of this passive investment. Time will tell. But actively managed mutual funds, even though maligned by index investors, will always be available to the investor.
Subscribe to:
Posts (Atom)
