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.

The Lure of ETFs

I know two things about exchange traded funds (ETFs). There is a high degree of likelihood that your 401(k) will soon have these investments available to you and that some of the basic selling points of why they might be a good choice will be too tempting to pass up. But you should consider the consequences of biting that ETF apple, not just from the consideration of whether the investment is worth the effort, but also from whether you are the investor you think you might be.

So let's first ask whether you understand what ETFs are. At first glance, they seem to be a good choice. They, at least on the surface offer exactly what index funds do and at times, a great deal more. They claim to be less expensive and more tax efficient that actively managed mutual funds and they are. Actively managed mutual funds, even as they have reduced their overall fees in order to placate those who worry that cost is an issue, still charge more than ETFs.

Actively managed mutual funds still dominate the 401(k) world and with good reason. Investors seem to understand, even after several years of concerted efforts by the investment community, that some risk is worth paying for. This is not always the case. The deduction of those fees against any returns you may have had illustrate why these funds are often criticized. Comparing them to an index fund, while often not necessarily fair, further shows that had you paid less in fees using an passively managed index fund you probably would have been a little bit closer to what you think of as profitable.

Passively managed funds such as index funds have passionate advocates. They believe that investing in the low-cost (because they rarely trade and do so only rebalance when the index changes) and in the case of the S&P 500 index, reinvest dividends (over 350 companies in the 500 index do) you have achieved the tax advantage, the fee advantage and because of that, a more profitable retirement dollar.

Both of the descriptions of the two most commonly used types of funds in a retirement account portray the investment possibilities facing most investors. It should be noted that not all 401(k) plans have index funds available to their participants, the option is growing. But also entering the fray is the exchange traded fund.

Now these investments will be tempting. They tout their tax efficiency suggesting that it is even better than an index fund offers. They advertise their transparency and ease of trading (they trade on an exchange just like a stock). And they never fail to tell you that these investment offer the world in a way that has never before been offered to 401(k) investors, a chance to invest in commodities, emerging markets and anything in-between. And because of this ease of maneuvering in and out on a whim, they claim to lower risk as well.

But do they do what they claim they will do? This is debatable. First, they are not index funds. They do not necessarily purchase all of the stocks in an index even as they suggest they might. Instead, many ETFs create their own indexes to follow and seek to invest in places where indexes have yet to trod. Mark P. Cussen, a financial planner for the military wrote recently about a little understood method employed by ETFs to get gains that seem better than the index they are suggesting they mimic. He wrote: "Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry." Leverage is another word for borrowing.

If there is an asset class, there is an ETF looking to exploit it. if you are hearing a lot about a certain class, such as precious metals, the temptation to join in the fray might be too hard to avoid. ETFs allow you to jump in "with the herd" and sell "with the herd". neither are necessarily a good idea and if you keep in mind, the low cost and tax efficiency of doing so are mostly wiped away. In order for ETFs to be both of those, you need to buy in large lots, offsetting the cost of the trade (commission) and you need to hold them for over a year. Small traders, which is the vast majority of us do neither - and won't if you buy them.

I mention "the herd". This mentality os what will drive you to consider this investment once it makes its debut in your plan. Instead, consider the vanilla index fund and what has become known as the tactical strategy. This employs a portion of your plan to just such whims while keeping the larger portion in the funds that will do the best with the least cost.

A tactical strategy might look something like this for young to middle aged investors: seventy percent of your assets in three to six index funds and thirty percent allocated to ETFs or even actively managed funds. Older investors might do the same but keep in mind that many major economic watchdog groups have warned that ETFs could be the next global financial troublemaker. And if that happens and happens quickly, the losses on that side of your portfolio close to retirement might find you less likely to retire when you want.

You will be tempted. And many of you will bite. But don't think that this investment can't bite back. It can and it might and unless you plan for such an occurance, the teethmarks it leaves in your plan might be long-term and scarring.

Mutual Funds and You: Not Always an Easy Relationship

Even if there wasn’t so much emphasis on the Baby Boomers with the threat that they will upset the whole of the investment apple cart by suddenly taking everything they have accumulated for retirement and flee the markets, mutual funds would still be what they are. In fact, they will always be what you believe they they are.

So what is the attraction? Convenience plays a huge role in why we continue to use this investment. These funds still play a major role in our retirement plans because of access via our 401(k) plans and Individual Retirement Accounts (IRA). The mainstay of these plans give the average investor, the one who knows they need the markets but are still unsure about the concept of investing, the potential of growing their retirement contributions.

Acting as a collective, mutual funds give these investors broad access to investments they would otherwise not have been able to build on their own. The confusion begins with which mutual fund suits our needs.

In almost every 401(k) plan, even the ones deemed as not so good, the investor has access to index funds (tracking broad markets), target date funds (which target a retirement age or goal and invest using an aggressive to conservative approach) and actively managed mutual funds (those that employ a fund manager to find investments that seek to best the indexes or benchmarks and provide better growth). In a growing number of 401(k) plans, access to ETFs (exchange traded funds that trade like a stock but are essentially index funds) and stocks (individual equity investments) have allowed investors to pursue different investment strategies based on their own assessment of risk.

The ability to use these plans to allocate money towards future retirement goals on a pre-tax basis simply means that this investment will not go away anytime soon. The mutual fund market is considered mature by most standards. It has adjusted to investor concerns about fees (index funds and ETFs offer the lowest costs to investors but are often seen as a slower, or better, a vehicle with more steady growth), the ability to serve those retirement goals by creating built in diversity, and increased transparency. In doing so, they have recognized the threat that index funds and ETFs can do much of the same without the cost.

Behavioral finance, a two decade old study of why we do what we do, has increased our own awareness of risk. This academic and economic examination of us has uncovered numerous biases, the embracing of fallacies and of course or tendency to harbor illusions. This look at the investor mind hasn’t changed what we do all that much. In part because looking at ourselves in the mirror, identifying why we still follow the herd, still have loss aversions, understanding why we still think the past is some sort of indication of the future and continue to delude ourselves with what our concept of reality is rather than what it actually is (think of a mime), is not as easy as they portray it to be.

In other words we sell too late, buy too late, fail to understand that we believe what we see and hear, and attempt to translate those feelings into investment actions. Seasoned investors have a better grip on this inner investor; new investors bring most if not all of the problems investors want to avoid to every action they make.

Mutual funds offer a comfort zone of sorts. Even as we seek to embrace the simplest fallacy: that mutual fund managers know what they are doing because they are in charge of hundreds of millions of dollars. Mutual funds offer us a set-it-and-forget opportunity to participate in the activity of investing without bringing vast storehouses of knowledge about the markets or even ourselves to the experience.

But do they produce as promised? Not always and not always enough of what we expect. Our anticipation of future growth – often based on what has happened – tends to be the first mistake we make. We look at the past performance, the stars a rating agency such as Morningstar might give a fund, the tenure of the fund manager, the turnover (how many times in a given year the fund trades its portfolio; the higher the turnover the higher the costs) and the fees against those returns and make decisions. And then we hope.

Should hope even enter into the equation? It does because of who we are. We have no idea what inflation will offer in the years ahead. Taxes will increase as Social Security benefits may decrease. Which leaves us with two options: invest more and hope for the best. This means that we are using a current self-sacrifice as the template for future returns. I have suggested this on numerous occassions: if you want the “current” lifestyle you lead to be the lifestyle you have in retirement you can either increase your contributions significantly (which impacts how much you have to live on now) or expect to live on less.

So how do we invest using mutual funds? The quick and easy answer is use index funds, spread these investments out across as many varied sectors as your 401(k) offers and increase you contributions.

But you will still look at actively managed mutual funds with a wanton eye. You can buy these as well but do so with great care not to cross-invest. In other words, owning an S&P 500 fund and a large-cap growth fund would give you the same category of investments and the same underlying investments. You might look to making your small cap and mid-cap investments in actively managed funds, where managers tend to be more nimble in volatile markets.

Yet, as in many things in life, there is a bottom line. In mutual funds, it involves education. You should learn what your plan offers and why. You should understand how long you have to invest and for what goals (even if they are far-off in the future and can’t be quantified let alone verbalized). And lastly, that lackluster contributions will most certainly provide you with lackluster retirement benefits. Mutual funds may be what you believe they are but not knowing can cost you.

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.

The Old Mutual Fund vs ETF Argument or An Investment Stranger than Truth

Mark Twain once submitted an essay to a contest about the art of falsehood.  In it, he suggested that only children and fools tell the truth, citing what he thought of as an old proverb.  What really dismayed him wasn't the actual lie, he described that as: "as a Virtue, A Principle, is eternal; the Lie, as a recreation, a solace, a refuge in time of need, the fourth Grace, the tenth Muse, man's best and surest friend, is immortal, and cannot perish from the earth while this club remains" , it was instead the ability to deliver in a successful way. A noble art he called it. Which makes theETF lie all the more true.


What do we know about ETFs? We know they are low cost. But perhaps not as low cost as they might seem.  For the investor moving millions of shares, or even thousands, the costs are just as low for them as it is for the investor owning a single share.  They are basically index funds.  But they are also stocks.  And the lie that owning a single share is just as costly as owning a million or so is told so often, individual investors often become dismayed, even disillusioned by the security when they purchase or sell it.


ETFs are not meant to be a buy-and-hold investment. This is actually a truth designed to look like a lie. Folks who buy ETFs intend on selling them, sometimes at the close of the trading day only to buy them again at the beginning. You can do this when the quantities are huge.  But when they are small, you are left with some tough decisions.  Wait it out and hope that the big investors jump back in or sell on the movement?  Either way, you have bought and are left holding.


ETFs have made the market more democratic and safer. On the other hand, ETFs are responsible for the flash crash where the Dow dropped a 1000 points and regained 650 points. Perhaps not directly, but indirect selling in those ETFs and of those ETFs created more volatility than was needed. According to Chuck Jaffe at Marketwatch: "Many ETF investors set stop-loss orders — pre-scheduling a sale to protect profits if the share price drops to some pre-determined level — but that didn’t minimize their pain in the flash crash, as the market busted many of those orders, flying past the limits because there were no buyers at those prices." The truth was that just because you have something to sell, there will be buyers.  The lie: someone always wants what you have unless everyone is selling the same thing.


ETFs are not mutual funds. Except when they are. If it looks like a basket of stocks or bonds or whatever is popular and you can't afford to buy each and every company in the sector, you look to make a purchase as a group. That is a fund with a mutual benefit.  The fund goes down and everyone loses except when the smart ones get out first. And that is the peril with a fund acting like a stock and trading openly throughout the day.
Some folks just know more than you do and benefit from that. No, they are necessarily seers or prognosticators or even forecasters.  They are just intuitive and quick and you are at work and busy and about to lose more than you thought you could.


Markets are not scary, therefore ETFs aren't scary - its investors who are scary.  Investors often don't have time to be scared before they are scarred by their own inaction. ETFs create volatility because that is how they are designed. Suppose you knew that something big was about to happen in technology or pharmaceuticals. You being a smart investor wouldn't look for an individual stock; you would buy a basket. And soon as the news panned out, or didn't, out you would go.


ETFs in your 401(k) are a good idea. Perhaps one of the single biggest lies being told by retirement planners.  They tout the low-cost, the employee demand and anything else they think the poor guy or gal in HR or in the CFO's chair wants to hear.  But ETFs in a 401(k) drips commissions and fees to the plan sponsor and gives the employee the illusion of doing something they really aren't doing.


The ETF lie is true. Odysseus told numerous fictions to a wide variety of people, each crafted to the circumstance of the one receiving the falsehood. The Greeks may have given the liar his due, even their admiration of a lie well-told. But when it comes to your portfolio, when it comes to your circumstance and your willingness to hear what you need to hear, the ETF is crafty fiction indeed. Good for some who understand it. But for those who think they do, it is simply a deception.

This article originally appeared at Target2025.com and was written by Paul Petillo

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

Mutual Funds and Performance

On Friday mornings at 8am PST, I appear on MomsMakingaMillion radio with Gina Robison-Billups and Kat Bellucci.  We discuss topics that focus on how to make their listeners independently wealthy.  The discussion has been focused on retirement investments and lately, on the mainstay of our 401(k) plans, the mutual fund.

Kat Bellucci: Last week we talked about taxes and the mutual funds inside our 401(k) plans.  Now you want to peel another layer back on the mutual funds with a talk about performance.

Paul Petillo, Managing Editor of Target2025.com: 

I don’t know about you, but I have been watching the Olympics with great interest and one thing you have to notice about the sports being played in Canada is how they are portrayed.  Three winners emerge from amongst the competitors and we give them medals.  But those that lost were the best in some other country – just not the best on this world stage.

And if you think about it, they all have plenty of reasons why they didn’t win.  Perhaps the winners had better coaching, better training facilities, better financing, you name it, they came to compete as the best among the rest of their countrymen and women but there was always someone better.  Someone who went faster, farther, didn’t fall.  It is the same with mutual funds.

Kat: How so?

Paul: Mutual funds as we have discussed are nothing more than big teams of investors who hire a money manager to lead them to victory.  He or she is the focal point.  The one we give credit to when things do go right, the one we blame when things go wrong , the one who never seems to be on that end-of-the-quarter podium.  Often, not even close.

We want to win.  The problem is, we want what someone else has, that moment when we can say we did better than anyone.  The spirit of competition, the grass is greener on the other side sort of thinking that gets us into trouble. So the first problem we have is with comparison.

Kat: Good point.  What do up suggest we compare them to?

Paul: There are numerous ways to compare mutual funds and none of them good.  The rule of thumb seems relatively straightforward and you will hear this from just about everyone: look for long-term performance, the cost of the fund, and the tenure of the manager in charge.

Kat: And I’d be willing to bet that it is not that easy, is it?

Paul:  No Kat, it’s not.  There are basically two kinds of funds out there.  Passive funds (index funds, mutual funds that follow a published index or some other list) or actively managed funds (the fund manager buys and sells what she or he wants within the confines of the fund’s charter).  Two different types of funds employing two different techniques.

Which makes the subject of performance much more confusing when actively managed funds are compared to indexes. Passive measures are poor indicators of what an active manager holds.  This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they also increase returns by limiting exposure to unnecessary risk.  Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic.  And actively managed funds hold even less.

Kat:  So passively managed funds like indexes cost less but on the other hand, they limit risk.  And less risk means less reward.  So how do we judge actively managed funds if comparing them to an index is not such a great idea?

Paul: For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future.  They call this disclosure.  And investors use it as one of the default guides when making the choice of which fund to buy.

Over the last decade we have had two huge bubbles and two market reactions to those events.  Had you purchased a mutual fund, any fund actively managed or indexed as a bubble reached its peak, the previous five years performance would not have included how bad it did the last time the bubble burst. If the bad year happened six years ago, a five-year performance chart would not have included it. Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. 

Those five years offer the investor an average return. And averages suggest some odd things.  If you line-up of one hundred people, ninety-eight of whom are six feet tall, it would not change the average even if the person on one end was ten feet tall and the one on the other end was three feet in height.

Kat: So the past really isn’t an indication of future results?

Paul: These days, to get to the top of a bull market usually takes five years.  The bottom is usually hit in six months. This is a lot different than markets just a couple of decades ago. Bottoms were reached quickly while the top of the market was often a slow slog.

Kat: So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws.  And past performance leaving us with no real picture of the future based on the past, how does one judge performance? 

Paul: Without considering fees, look at the worst day the fund ever had and wonder, what if this was the day I began withdrawing money from it?

Kat: Can we talk more about this worst day performance measure next week?

If a picture or in this instance, a graph could speak volumes, this one would. In 2009, actively managed funds, despite lower inflows, outperformed their respective benchmarks handily.

In any given year, a handful of active mutual funds will do better than the benchmark index fund. And investors are usually warned, and I obligated to as well, that what is hot today or last quarter, even over the past year in all likelihood will not be so after you invest. This is why it is always recommended to look much further afield, at least five years, ten is even better see how well a fund has performed.

Should you switch your investment style in your retirement portfolio as a result? Read more here.

Paul Petillo is the managing editor of Target2025.com.

Resolution Time: Fixing a Few Bad Investment Habits

Most of us look at the turn of a calendar year with the hope that the investment mistakes we made in the previous year will not be made in the new one. This is noble and in many cases futile. These attempts are usually too difficult to handle, which is why, in many cases you haven't done anything before this point.

But with little effort, you can change how you invest. For the vast majority of us, investing requires far too much time. It requires continued education (which I fully recommend), frequent monitoring (which can involve little more than opening your statement just to make sure your investments are going where you intended) and a clear-cut understanding of where you are on the timeline (beginning to invest or at it for awhile).

Altering bad investment habits is not that difficult. Five Tips for 2010...

Paul Petillo is the Managing Editor of Target2025.com

A Performance Discussion on Mutual Funds

The last lines of Matthew P. Fink's book, "The Rise of the Mutual Fund" suggest that although he is a "worrier; nonetheless, I am optimistic". This speaks volumes to the "extraordinary success of mutual funds". Mr. Fink believes that despite the speculation about the maturity of the industry, it is far from falling from its exalted position. This elevated status is due, he writes "to adherence to high standards of fiduciary behavior".

Yet the mutual fund industry continues to be attacked for any number of reasons. The largest component of your 401(k) plan, your IRAs and the driving force behind numerous college savings plans, these investments are often questioned on their transparency, why they charge what they charge and even more commonly, why, if you win one quarter, can you not win the game.

Comparing Mutual Funds
There are numerous ways to compare mutual funds and none of them good. The rule of thumb for a fund is relatively straightforward: look for long-term performance (I have suggested that you also look to how well the fund manager did in poor markets rather than how they did during the good times), the cost of the fund (fees and expenses do not often tell the whole story but offer a telling sign of how much the fund manager trades and why), and the tenure of the manager in charge (an ever shifting picture as fund managers come and go and new managers look to put their investment stamp on the portfolio).

The subject of performance is often more confusing when actively managed funds are compared to indexes. These passive measures are poor indicators of what an active manager holds. This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they increase returns by limiting exposure to unnecessary risk. Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic. And actively managed funds hold even less.

Looking at Past Performance
Performance also comes to the forefront when we look backwards. For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future. While this has been disclaimed as a method of disclosure, it is still one of the default guides for new and even seasoned investors when making the choice for which fund to buy.

Over the last decade we have had two bubbles and two market reactions to those events. Had you purchased a mutual fund, any fund as a bubble reached its peak, the previous five years would not have reflected the previous bull market's demise. I clearly remember the sigh of relief as the year 2001 was dropped from the 5 year returns in 2007. No longer would the bad bets made during the internet bubble show up as a stain on the investor information sheets. Ironically, even as some funds dove into the depths, they took the whole market down with them. (As did happen recently in 2008.)

Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. Averages suggest some odd things. A line-up of one hundred persons, ninety-eight of whom are six feet tall would not change the average if the person on one end was ten feet tall and the one on the other end was three feet in height.

But stock markets rarely have a peak that moves quickly from the bottom to the top whereas the bottom is often reached in less than six months. The top of a bull market takes five years, at least as witnessed over the last decade, to attain. This is not the case for any period prior to this. Bottoms were reached quickly while the top of the market was often a slow slog.

So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws. And past performance leaving us with no real picture of the future based on the past, how does one judge performance? Without considering fees, the worst day of a fund. Based on the simple idea that, if mutual funds are the primary holding in a retirement account and at one point in time, you will be begin to drawdown that account, picking the worst day to do so gives you a valuable peek at a worst case scenario. That is probably a truer indication of performance that averaging it our over a period in time. You can read more about low-mark performance here.

Next, a discussion about fees.

Paul Petillo is the Managing Editor of Target2025.com

Mutual Funds are Different than ETFs

The argument is never clear. When we compare mutual funds to ETFs, we often miss the differences between the two in large part because we are discussing two different types of investments, how they should be used and what they are. Folks on the ETF side of the disagreement point out a variety of plus while conveniently leaving the minuses out of the conversation. People who argue for mutual funds are looking for something other than a simple index fund.

The Pluses of ETFs (with the minuses)
The tax benefits that are often touted by the ETF camp rely on the buy-and-hold strategy that index funds offer. It should be noted that when comparing these two investments, one should drop the vast majority of mutual funds from the argument and concentrate only on the index mutual fund.

With any investment, capital gains are a consideration. The only way these two can be compared on a tax basis is when there is a sale. While funds held outside of a 401(k) or other retirement account distribute capital gains on a regular basis, ETFs do so only when sold. An actively managed mutual fund (which is what numerous ETF supporters believe is a fair comparison) can generate a capital gains even if the fund losses money. Actively managed mutual funds shift the holdings in the fund during the course of the year and this does present the possibility that you will need to pay taxes on those transactions. But like index funds, ETFs only shift holdings when the index fund it tracks shifts holdings.

So in this argument, ETFs and index funds are similar in tax efficiency. But when ETFs are compared to actively managed funds, ETFs seem the better choice.

Are ETFs a more simple investment?
While you buy an ETF at a set price (which can also be done with index funds, the main difference is the when the price is fixed - in mutual funds it is at the four o'clock close; ETFs reprice throughout the day depending on how well the underlying portfolio has done) that price can gyrate wildly throughout the day. In fact, much of the last minute swings in the overall market are due to ETF positioning and may offer you a false picture of the underlying worth of the ETF.

Those for ETFs suggest that this one price, one trade principle makes these investments better. But the cost of that one trade can be much higher than the purchase of a mutual fund (actively managed or indexed) and that trade, which is whatever your brokerage account charges, is also a factor in the sale. If you add those two transaction to the cost and the fact that many mutual funds do not charge for the purchase of their shares, the argument about simplicity falls flat.

So in this argument, on the surface, ETFS seem less expensive but only as long as you buy and hold which is not what professionals do with this investment.

Perhaps ETFs are more cost-effective
Once again, ETFs cost you dollars to trade. While this is a fixed cost that can be calculated, mutual funds charge expenses against portfolio balances. This makes any mutual fund purchase, even index fund investments, subject to fee considerations. The lower the fee, the greater the cost-effectiveness. With ETFs, you do pay an underlying fee which when compared to index funds is often higher and you pay commissions on the purchase and sale.

One percent is one percent no matter who charges it but if you can buy one for nothing compared to the cost of a brokerage fee both in and out, the ETF argument runs into problems.

The ETF option
While there are numerous types of ETFs available there are also numerous types of mutual funds tracking essentially the same markets. Mutual funds offer sector investments just as ETFs do. Here ETFs are probably better. The simple reason is the ability to allow you to get in and out of a hot sector without any pain other than the cost of the trade. But for the vast majority of investors, their style is passive. They really want to do the research, make the decision and then let the money and the investment ride.

ETF investors crave action even if they do it under the guise of flexibility. They are essentially chasing the next hot corner of the market while mutual fund investors leave the pursuit up to the professional manager they hired.

So in this argument, ETFs play nicely to the investor who wants to move quickly in and out of a hot sector.

Are ETFs easier to transfer
Of course they are easier to transfer. Held in your brokerage account, the shares are yours to take wherever you want. Transferring assets in a mutual fund (index or actively managed) does require a bit of work and there may be a slight charge for the effort but this argument also falls flat. When moving a fund, those shares must be sold and there is a cost in doing so. But most mutual fund investors spend a great deal of time researching their investments (manager tenure, fees, performance and underlying holdings/investment style) and if they desire to move, it is because something has gone wrong with the fund. In this instance, moving a fund is worth the cost incurred. ETF investors move based on price value alone. And they move to another ETF.

So in this argument, the better research you do the more likely you are to buy an index fund and hold it or buy an actively managed fund and monitor it. Owning an ETF is always a temporary investment and the investor is always looking for another ETF to suit their needs.

When to Buy a Mutual Fund: Tax Advantaged Mutual Fund Investing

Most of us who write about retirement planning and investing all focus on getting in as soon as possible and staying invested as long as you can.

And to do this, we use mutual funds. Now we all know that mutual funds have their faults. Some drift in style exposing us to the possibility that we will hold too much of the same underlying investment. Some simply charge too much compared to their peer group. And others simply cannot find the right investments to boost their performance and keep the investors they already have, interested in staying for the long-term.

Attracting new investors and keeping legacy shareholders happy is the real key to the success of the mutual fund. You do not have to be represented by a large mutual fund company to be a very good mutual fund. Not only does the availability of invest-able funds grow, making growth opportunities increase, but the potential for the worst possible problem for a fund, redemptions, stay at a minimum.

Redemptions cause two things to happen. First, the fund manager is forced to sell some of the fund's underlying holdings to satisfy your fellow shareholder's exit. A lot of these types of transactions makes the fund vulnerable and adds to the grief experienced by fund shareholder who believe that the fund is a good one, even if the markets as a whole are suffering.

The second thing it does is force a taxable event. Whether you defer the taxes in your 401(k) or hold the mutual fund outside in a taxable account, this is perhaps one of the worst things that can happen to a future or current shareholder.

Mutual Funds and Taxes
Taxable events are unavoidable in any investment. In fact, it acts as a confirmation that you have made money - in most instances. But in a mutual fund, the tax event might come as a surprise even if the fund will or has posted a loss.

Read the full article here.

What's a Mutual Fund Manager To Do?

This debate will never end. Actively managed mutual funds are not the easiest of animals to tame. Performance relies on a series of variables that few of us could deal with on a day-to-day basis. And in their defense, I want to offer some alternative thoughts to what you might be forming as an opinion.

Not all Index Funds or their counterparts, the ETF, are created equal.

I cringe every time I hear the description of who you are as 'the average investor'. To achieve average, you must have some comparative tool by which to determine better or best, and on the flip side, worse and worst. And of course, index funds have risen to the challenge. They pose a poor comparative tool at best. In Ruth Chang's "Making Comparisons Count" she begins with the philosophical difference between incomparability and incommensurability.

They are in fact, one in the same. These terms are often used when describing different values. In truth though, it is not the value but items that bear value. The problem is, how do you compare alternatives when you need to make a choice only to find out that the comparison of these alternatives, say Fund A, B, and C are not really comparable at all. This would leave you with no tool to make the decision.

When comparing two funds, which is more often the case - more than that and the differences become diluted - investors unwittingly employ the Trichotomy Thesis. Ms. Chang offers the following when making a comparison, "the first must be better than the second, worse than it, or the items must be equally good".

She also suggests that all comparisons may have an element of bidirectionality, a feature that allows some [of the mutual fund] to be better and some of it to be worse.

Comparing Likes

Index funds and the numerous ETFs or Exchange Traded Funds that plumb every corner of the invest-able marketplace with their version of indexing are not worthy comparisons for actively managed mutual funds.

Index funds essentially are trade-less platforms in theory and adjustable ones when the index creator decides to alter the make-up of the index. This keeps the costs down and fund in a passive state. When the whole of the market goes down, the index follows in lock-step. Sometimes. And this is where you compare likes. If the index falls and your index mutual funds falls more, you do not have the index you thought you did. If it costs more than next to zero, you do not have an index fund. If it costs more than $100 to gain access, it is not worth buying. (Note on this last item: Vanguard Group will charge you a fee if your fund falls below $3,000 in value and will continue to do so until the balance has regained that threshold.)

This is how you compare likes - similar products with near-identical traits and in the case of funds, underlying investments.

Since indexes are, for lack of a better term, alike, comparing actively managed funds to them is not only foolhardy, but a waste of time. No actively managed fund is identical to any other fund. Each is a species unto itself with the only similarities that they possess to other mutual funds is where they exist. Both humans and geckos share the same planet, but the comparisons more or less end right there.

The problems facing actively managed funds come from numerous directions. And most, if not all of these problems are a result of shareholder involvement.

Consider this problem specific to actively managed funds: The market goes up and the value of the companies in your portfolio does likewise, and because you have positioned your shareholder's money well, it does better than the whole of the market or any index. Now what? Chances are, the amount of money invested in your fund will increase, coming from current investors looking to make more than they already have and from new money. And the question might seem simple enough to answer: buy more stocks. But where?

Buying more of your winners will only propel the winner's higher. Buying an undervalued stock will also have the same effect and may, in the short-term distract your new investors when the cost of buying-in seems to be higher than they anticipated. These investors will squawk when they do not get the same returns from the previous quarter, received by the investors who were there at the beginning.

The fund has a charter and that should be followed. It is an outline of the fund's strategy and if it is a growth fund, they must find undervalued growth stocks in order to continue to... grow. What happens when they have no real good prospects? They often drift and purchase a value play or simply begin to become an index. Both are lazy moves on the manager's part but it is the investor who is forcing him in those directions.

The SEC does limit the amount of cash a fund can hold. So, it must be invested. This also generates costs in trading and research. Is it bad? Not if the fund has beat its peers. It is against similar type funds that we should compare actively managed funds.

Until that is done, the comparison between actively managed funds and index funds in simply incomparable.

Mutual Funds Explained: Why Portfolio Turnover Matters

I discuss in my book, Mutual Funds for the Utterly Confused (McGraw-Hill 2008), the differences between the various expenses that impact an investors interest and return in a mutual fund. Among the sneakiest of these fees, is the turnover ratio. Why do investors still use funds that consistently report high turnover of the stocks in the fund's portfolio can be answered two ways. But first, what is a turnover ratio and how is it determined?

The Turnover Ratio is the result of the fund manager repositioning the portfolio. This is done much more often in a growth fund, where the manager may be looking for fund appreciation and to take advantage of this, they must sell some of what they hold in order to buy stocks that they feel will benefit their shareholders.

To determine the ratio on your own, investors will need to divide the value of both the purchase and sale transactions for the period by two and then, divide that figure by the total holdings of the fund. The higher the trading activity, which usually takes place in a growth fund more than in a value fund, the higher the turnover ratio.

If the turnover ratio is 100%, the fund has changed the underlying portfolio completely over the given the period. Less than 100% turnover, the fund's expenses for trading are lower than a fund that has exceed that number. Questions is: why would a fund manager trade so much if they knew that the cost of this activity creates a tax implication (in a retirement account, this tax consequence is deferred until you actually begin to draw on the funds)?

There are several reasons. New managers, of which there are many new faces in the mutual fund world after 2008, like to find better opportunities than their predecessors. Older managers may be attempting to restructure their portfolio to take advantage of newer opportunities that would redeem their fund's less than stellar performance during the height of the downturn. neither of these reasons though are very good.

You pay for research and subscribe to a charter (what your fund's investment focus is) and expect your fund manager to use these costs wisely. A high turnover ratio basically puts the spotlight on poor decisions followed by poorer, more costly revisions of those decisions. The higher the turnover, the more these managers have ignored research offered by their fund family or found that what you already paid for was somehow flawed. The higher the turnover ratio, the greater the resemblance a fund manager has to a day trader.

Even in a growth fund, these costs can be kept down and thoughtful and prudent trading can help a great deal. Believe it or not, there is a limited number of stocks available at any one time. To buy, you need a seller. As all investors know, the seller must know something that the buyer does not. In the small-cap arena, the number of stocks is much smaller because of liquidity (the number of shares available at any one time). Too few shares means that nay activity will drive the price up on the share price, create unnecessary costs, and in many instances, void any potential the stock might have in the near future.

This doesn't mean you should run for an index fund or even a value fund just because of fees. It does pay to consider them though and whether the fund's performance will be great enough to overcome the higher costs.

In a fund held outside of a retirement account, turnover ratios are essentially a taxable event (selling something profitable always creates taxes) and this is often taxed at the short-term rate. If you are using growth fund in your retirement portfolio (and I highly recommend that this is where they should be held) this tax is deferred. But that is not a reason to hold a fund that turns over its portfolio too much in any given period. For a growth fund, the portfolio turnover should not exceed 50-75%. If it exceeds this, something might be wrong.

Be sure to check out our all important examination of why investors do what they do.

Mutual Funds Explained: Prepping for the Third Quarter and Beyond

No market appreciates the beginning of a new quarter when it coincides with a holiday. No market enjoys bad economic news either. So, as earning season begins on Wall Street, a time of speculation, expectations and often dashed hopes and dreams, I want to take a moment and cover some of the behaviors that investors need to come to grips with.

Our sister blog has been reviewing some of the investor habits that are worth noting. You have just watched the recovery of many of your mutual funds, especially of you were not in index funds but allocated in growth both domestically and abroad.

Before You Buy: Why Investors Do What They Do

Loss Aversion begins the discussion with "Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made."

Investors are also guilty of narrow framing. "Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk."

Many of our beliefs about investing revolve around another bad habit: anchoring. Investors "may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring."

Mental accounting affects how we invest as well. "Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past."

Diversification is not what you think it is. "These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In the first part of 2008, billions of dollars were being invested in a market near it top. In the second half of 2008, billions were withdrawn. This is herding at its best and worst. "It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder."

And then there is regret. "One of the basic assumption in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret."

Nothing has impacted your investment style and direction and is in fact least suited to do so, than the media. "Has the hype in the media over the last several months had an effect on how your invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television."

And lastly, there is optimism, that feel good, I want to invest emotion that often gives us reason to engage in all of the previously mentioned investor behaviors. "In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior."

So before you get back into a market (that I hope you never left), take the time to examine the investor in the mirror.