Heard about Herds?

It has been decades since behavioral economics took hold as a science of investor actions. Designed to study the irrational decisions that we all are apparently hard-wired to make, the field grew into a respectable and well-quoted discipline. Which is fine. We know we have incredibly limited potential to redesign ourselves, despite the pushing and prodding in one direction, the look-in-the-mirror study of our own foibles and the instructions on how to improve this very human lot in life. But we muster on. And this is why, even despite the improved access to our 401(k) plans does our retirement still suffer.

Studies done quite recently suggested that most folks will simply accept the status quo if given a confusing situation. Investing is just such a case-study in chaos, less so for the experienced investor, but even for that group, a churning pool of information keeps them struggling to keep up. But the behavioralists  insisted that auto-enrollment in a retirement plan would create great strides for the plan and even greater rewards for those who may have - and still do have the option of - opting out.

Auto-enrollment we have found out is a trip through the wardrobe. We may all have taken the first step. But what awaits us on the other side, in almost every instance, is our irrational mind. And in almost every instance as well, a less-than-wonderful 401(k) plan. But more on the plan later. Let's just focus on what we have done recently as we embrace our biases, follow our illusions and believe in the fallacies.

There have been several alarms ringing on Wall Street and those who invest in mutual funds have turned a deaf ear. Herd mentality, the primitive instinct to follow the herd because doubt in the face of danger can present death was considered a valuable possession. Somewhere along the line though, things changed.

In our wonderful modern brains, this instinct has evolved into a trait, or so say the behavioralists, the makes us run towards the danger because everyone else is. What once once a survival instinct is now a suicidal tendency, at least in the world of investing. (Look at it this way: It would be similar to seeing a crash on the highway and deciding that driving your car into the pile would be in everyone's best interest, including your own.) Evidence of this is beginning to crop up and our big "modern" brains are at fault.

There are three types of mutual funds or mutual fund investment strategies that have shown a tendency to attract these kinds of investors: emerging markets, commodities and a category I'd be willing to wager you didn't realized existed, floating rate funds. (Amy Or of Marketwatch.com describes them as "Unlike fixed-rate loans, floating-rate loans can capture rising interest rates and are deemed a good inflation hedge" and with some uncertainty about when if sooner-not-later, interest rates begin to rise, these funds will be able to capture the change in market conditions.

Recent herd-like inflows of over $14B suggest that the usually high load fees and the underperformance of late matter little. It is where, these investors believe they should be. But because, as so often is the case with herds like this, so many have heard the siren's call, the opportunity to make any more moves to the upside have been hampered. That means a lot of people will eventually follow the herd off the cliff, ost of whom bought at the top.

When they aren't betting on debt, they are looking at commodities. These funds, focused on such tangibles as oil, silver and gold will to most of us, seem to be destined to go higher. And if you bought into this sector recently, you have  high hopes that it wasn't at the top. But silver suggested it was, as did oil, and the drop in prices found those same people scrambling to get out. Most bought in with expanded exposure in their supposedly well-balanced portfolios and are now paying the price for having believed that diversity was just another word for profit.

And emerging market investors are beginning to realize that perhaps they too have been failing to listen to the global heartbeat. Europe is not finished with its economic woes. Commodity prices may have fallen but they still remain uncomfortably high for countries looking to emerge and now, predictions of slowing growth at expanding powerhouses like China have begun to worry the savvy investor. You newbies are deeply embedded in the herd still.

You may have been auto-enrolled, but the walk through the wardrobe left you in the middle of the Serengeti. And you probably won't get the memo that you are in danger until it is too late. This thinking about getting you in, attempting to educate you, guide you, slip you into an ill-suited target date fund came by way of Thaler and Sunstein's book called Nudge: Improving Decisions About Health, Wealth and Happiness. In is not the same as knowing what to do or how to act when you arrive. The information tsunami hasn't lessened and may have even gained strength over the last several years and investors, particularly the neophytes, will still drown before they learn to swim.

How running with the herd once saved you only to become the complete opposite will remain a mystery. And getting people into these plans by using science to study our unpredictable-ness is still a good idea, even if it seems suspect. But once there, the status quo is good. But who says what the status quo is? You may never get a clear bead on the answer,  Until you realize the herd is leaving the room.

An Attempt to Tally Mutual Fund Fees

No one ever said it was going to be easy being an investor. Mutual Funds are no different than any other investment. They offer numerous layers, a multitude of nuances and of course, risk. And despite all of the information floating out in the public domain, the ability to tell one fund from the other is still difficult.

So the question is: Can you do the mathematical calculations required to find out how much your mutual fund is going to cost you? Chances are you might say yes, if you consider yourself a very savvy investor, able to filter all of the costs in the prospectus into a final number, understand the tax implications known and as yet unknown, and then be certain that you are right – or as close to right as humanly possible.

But chances are you can’t. Instead you fall squarely into the camp of investors who either have no clue or look at one guiding number and the vast majority of you are 401(k) or IRA investors as well. That number, widely advertised by the one group that lobbies in favor of mutual funds, Investment Company Institute or ICI comes in at an average of about 1.17% for all actively managed funds.

Most financial professionals, understanding that this is the average, suggest it as the top any client or interested investor should pay for the privilege of a little more risk than a simple index provides. Some also understand that this is more a moving target and unless they raise the cap to 1.5% as the max, they may exclude some of the better performing funds in the investment world, even at a slightly higher price.

Read the full article from Target2025.com on mutual fund math.

Mutual Funds in the Next Year

The difference between 2009 and 2010 will be dramatic. Investors, always looking for the next big move will unwind their positions in conservative funds - albeit late - and move into equity income funds that provide some stability (from large companies that are well-established) and income (through dividends).

The real winners for 2010 will be in dividends and the funds that invest in them. Often referred to as equity income investments, these funds will begin to shine as businesses begin to increase their profit sharing (which is what dividends are) even if they have not begun hiring.

More here.

Let's Talk Target Date Funds: Investing While Hiding the Risk

On this weeks MomsMakingaMillion radio broadcast, the topic of target date funds is front and center.

The hosts Gina Robison-Billups of MIBN.org and Kat Belucchi of PensionsInc. asked the following question: Almost every 401(k) now has these funds. Many are used as default investments for new employees. But you have a long-standing problems with them Paul. Care to our audience why?

I have been on the record, with some decidedly trash talk centered thoughts about target dated funds in the past. Why do I think these are quite possibly the worst investment idea ever?

Let me explain what these funds are suggesting they can do and why, under the guise of protecting your assets as you grow older, they might not do as promised.

Shooting for a Distant Promise
A target dated mutual fund picks a date in the future that coincides with the year you would like to retire. So far so good. We all want to retire and we all have some idea when that time will be. For most, it it the arbitrary time picked for you by Social Security. For others it might be the moment, at age 59 1/2 when you can first tap those tax-deferred 401(k)s and IRAs.

Suppose you are 40 years old, your target date might be somewhere around 2030 or 2040, depending on what you do and whether you think you can do it for that long. You direct your money to a fund in your 401(k) that offers this date. These are in almost every tax-deferred account due to the Pension Protection Act of 2006 (perhaps one of the worst named pieces of legislation ever).

The fund prospectus suggests (you do read the prospectus, don't you?) that the fund will gradually shift from stocks to bonds over the course of that time frame, growing less aggressive as your account grows. This seems to fall into lockstep with what you have always heard about asset allocation and diversification. And it will be done automatically. No hassle investing for those who feel as though the whole process is too difficult to understand.

But what you fail to realize is that this is uncharted territory that has never really been navigated. Balanced funds offer something of a similar type of investing but usually hold steady at a 60/40 split between stocks and mutual funds. These investments however offer an actively managed approach to the process, a continuing shift in how the fund is invested.

The Success is Hard to Determine
This has not been done with any success in the past and may prove more costly - and more risky - than some investors realize. Some of these newly created funds hold orphan funds that, although they have not closed completely, would have had the fund family not stepped in to save it. This is out-sized risk that other investors have left for good reasons.

Many of these fund managers are entering into fixed income investing world with the idea that this might provide less risk. They may be incorrect in this assumption as bonds may see more problems down the road with inflation and deficit spending by the government, here and abroad.

There is also the question of performance as judged by the benchmarks. Many compare how well they have done against the S&P 500. But the need for new benchmarks still won't mean that these funds will be comparable. Ron Surz, president of Target Date Analytics suggested "The current practices [meaning investment styles] are all over the map. You could have 2010 funds with 90% equity to 20% equity. Any investor looking at the whole landscape is going to be challenged to what they like and what they don’t." And what they understand and don't.

Provider Accountability and Investor Assumptions
In a paper published by Vanguard Group that explored this problem, they describe benchmarks as holding "the provider accountable for the appropriateness of the return assumptions used in constructing the funds." They also suggest that historic returns are a reasonable guide for future results. If that is the case, many of us are in for a disappointment.

Currently, these types of funds employ a glide-path style of investing. But a paper published by Wilshire Funds Management believes this method needs to be rethought. In fact, they believe that a fund - and this might sound even more confusing - need multiple glide-path plans in order to make the fund work. If that happens, the "one-stop shopping" approach that these funds were advertised as doing, no longer works.

So what is an investor to do? While the industry struggles with the idea - and the SEC questions their methods and exposure to stocks - it is best to stay with a broad range of indexed funds across several market sectors or use the actively managed funds that do the same thing. Stocks still rule for the vast majority of us in large part because we simply haven't been investing that long to get any real benefit.

If you have to use target date funds, pick a date that is ten or twenty years beyond when you want to retire so you can get more exposure to stocks longer.

Closing the Doors on Return Chasers: Mutual Fund Inflows Create Problems

Like a torrential downpour can overwhelm gutters, flood streets and generally create the kind of havoc only water can, too much money flowing into mutual funds can also leave a mark on both new investors and those of record.

Now that the markets seem to be hellbent on leading the recovery (although there is still a popular consensus that this is not the real thing without jobs and earnings that are built on growth rather than cost-cutting), you have to wonder what is going on? Why is being asked quite frequently these days and many of the answers point to too much money on the sidelines suddenly feeling better about the opportunities and the fear of missing the recovery.

Investors who may have sold their stakes in funds that had done well for them in the past and then hurt them dramatically over the last part of 2008 are eyeballing this return to glory, ignoring the recent past at little more suddenly that I would have anticipated they would. Rushing back into the market is not what mutual funds need right now.

The Upside is the Downside
When investors flee, the remaining shareholders pay the price of staying. There are transaction costs and taxes to be paid (if the fund is forced to sell winning stocks to pay for redemptions) that are left for the fund to pay, passing on those costs. But those shareholders might benefit in the long run if their fund has positioned itself for the recovery. In fact, many investors are finding that staying put has them very close to the even point of where they closed the 2007 investment year.

But the problem with this rush is that it too causes an increase in costs for transactions and creates the possibility that too much money chasing too few stocks begins to artificially inflate those shares and we are off to the bubble races again. Some funds are so narrowly focused that the securities they need are being overbought.

This leaves investor money on the sideline, the exact place that it was before but no longer is. So fund managers are beginning to, at least temporarily close some of the hottest funds with the best year-to-date or quarterly returns. While this doesn't have any effect on shareholders currently in the fund, the problem of a deluge of new investors does not go away; it simply goes somewhere else.

This is especially problematic in the case of bond funds. Chasing performance while eluding risk is what bond investors have always sought. That and a return of their investment. Unless you own individual bonds, and plan on holding them to maturity, you may be unwittingly facing the same problem that mutual fund bondholders might be facing. Credit markets are still tight, the dollar is still weak and the economy has not yet fully embraced the enthusiasm of the stock markets. This makes bonds risky and increases the chances of default (which you will see in the increased yields).

When Fools Rush In
Overexposure and increased investments push bond prices higher and make profitable yields harder to find. This in itself, creates risk that many conservative and asset protection minded investors may not be willing to (or knowingly) assume.

At the same time, an opposite problem is looming for fixed income investors. Bonds are poised for difficulties in the coming years as inflation begins to rear its ugly head and deficit spending, necessary to facilitate the recovery begins to whittle away the current returns. For these investors, what would seem like a win-win situation might turn out to be something entirely the opposite.

Balanced funds and lifecycle funds may also be facing similar dangers as they try to increase bond exposure over time but are finding the endeavor more expensive than they would like. With fewer desirable bonds to purchase, these managers may be left with taking on more risk than the stocks in their portfolio have.

This imbalance could lead to more problems in the near term as investors seek out underinvested corners of the marketplace. The return chaser will simply head (or better, herd) for whatever is available. And a new cycle begins. Despite whatever notion of moving to a lower risk portfolio might provide, long-term investing still points to stocks as a safer haven. Which stocks is open for debate and future market gyrations. Yet, as fixed income portfolio managers try and warn their shareholders that this recovery is unlike any other, those looking for the safest of havens might not find what they are looking for in bond funds.

Paul Petillo is the Managing Editor of BlueCollarDollar.com

DiWorsifying: The Art of Looking at the Downside

Most of us now realize that our mutual fund investments, particularly those in our retirement accounts, can go down, often dramatically. Until recently, we paid little attention to how bad a fund can perform, focusing instead on how well it can do.

We make random estimates of how much money will be in the account when we choose to begin drawing it down. And as we now know, this can be less than we anticipated (just ask anyone who has postponed their retirement because of a lower than expected balances). So how do you determine the performance of a fund, or better, the risk that the fund will do what you intended it to do?

Some hedge fund managers think they have the answer. It is complicated? Yes. Is it impossible for the average investor to determine? Not if you consider the manager as the sole blame for the fund's performance.

Mutual fund managers are part of the equation you use to pick a fund. Tucked in amongst the performance of the fund, the underlying holdings and the fees, we look at the fund manager's tenure. The assumption being that the fund manager will do much better the longer s/he has been at the helm. tenure also assumes that the fund will have stabilized over the period that the manager is in control.

Fund managers as we (should) know must follow the charter of the fund, avoiding style drift (a notoriously common occurrence whereby the fund manager tries to imitate whatever index works, in the hope of mimicking the return of the benchmark it will compare itself to at the quarter's end). This is managing for the upside, often shifting holdings at or near the quarter's end to give the appearance of better-than-average performance.

Some fund watchers suggest that this is not only the wrong thing to look at when choosing where to invest you fund but can cause you to assume that good times are part of the continuing experience of investing. But markets go down. How the fund manager did during this peak to valley performance is, some are beginning to realize, might be a better indication of how well the fund has done and the manager has performed.

Richard Gates, portfolio manager for TFS Capital thinks "the best way to estimate risk is to try to quantify a portfolio's downside volatility. In other words, how much money can I lose in a given period of time?"

Volatility is an excellent measure of the fund's performance during certain periods. But few of us look at the way the fund manager managed the portfolio (during her/his current tenure and better, their performance in the past) as the indication that your fund will do as expected in the future.

Fund managers are awash in information and you rely on their ability to parse this information, apply it to where you would like the fund to go in the future, and limit the downside risk. Your fund may have lost money; but did it lose as much as comparable funds (benchmarks excluded)?

Some analysts suggest that instead of looking at the best day and make withdrawal assumptions, you should look at the worst day, the moment when your portfolio looks its weakest. If is better than most, you have hooked your fortune to the right manager. But don't limit your assumptions with the current fund under management. Look at all of the performance results from every fund they have managed.

No easy task, and we will talk more about in future posts. But is another piece of the puzzle we should consider. Past results, it seems, matter more than you might expect.

Mutual Funds Explained: Options in Your Retirement Plan

No doubt about it, your options in your retirement plan are about to change. There could be some questions about whether they need to or not. But rest assured, the effort is under way and many of these changes will not be seen as beneficial for the majority of us.

Cost cutting is one of the ways businesses had hoped to survive the economic downturn that is now a year old. Payroll has been chopped (including paychecks), inventories have been reduced (to accommodate the skeptical and mostly unwilling buyer at the retail level) and in many instances, the matching contribution that so many companies offered as an incentive has been greatly reduced or eliminated (and there is no expectation that this will change before 2011 0 if ever).

All of these moves have resulted in a stock market that has risen since the turn of the calendar year (the Dow is up 3,000 points since January). This vote of confidence by investors has encouraged companies to continue to trim any portion of their balance sheet that might be too costly. Keep in mind that these moves do not grow a business; they merely sustain it. Keeping it propped up in this way is a topic for another discussion. But the trend is alarming.

This cost-cutting mentality has found its way into your 401(k). In the coming months, expect the recent trend to continue. One way of doing this is to add funds with lower costs. According to survey conducted with 85 senior level executives (downloadable pdf), whose jobs require them to find every nickel and dime on the balance sheet, the change is just beginning.

Over half of those surveyed have or plan to make changes to their 401(k) offering by the end of 2009. Those changes will result in less equity funds available than there were just two years ago. What they plan no adding is more funds with longer durations, such as bond funds with long maturities.

This change has resulted in the firing (and in some cases the hiring) of different fund managers. This change has seen a net decrease in the equity side of their offerings in favor of fixed income. Domestic equity funds were reduced as a result of such moves by almost 20%.

These changes have also impacted the default investment side of the equation. Ninety-three percent of those surveyed now offer a default plan for those who have not signed up with 71% of those plans directing their employees to target-dated funds.

These execs also plan on implementing a stress test to these plans in an attempt to insure that certain predetermined funding requirements are met. This move does not necessarily offer additional disclosures for plan participants, ebven as Congress is looking into requiring such actions.

While taking fiduciary responsibility has been lax in the past, numerous companies are looking at adding some sort of monitoring system to protect their risk of liability for not doing so. According to Carl Hess, global director of investment consulting at Watson Wyatt “The uptick in activity could be a sign that many funds were caught off guard by the crisis and are now trying to mitigate their risk exposure."

The High Cost of Regulation

By now, the Madoff name, synonymous with theft and deceit on a scale so grand that Ponzi would be envious, is known worldwide. Although his actions (and those of his cohorts) did not trickle down to the vast majority of Americans, watching well-to-do people trust vast amounts of money to one person’s assurance and phony returns did not go unnoticed.

And although that wealth is gone for the most part, one thing remains certain, how it happened will force regulators such as the SEC to reexamine the rules that were bent into origami by Madoff’s scheme. What is deeply problematic, and is at the heart of the SEC’s desire to change certain rules could be based almost solely on one statement.

Stephen Harbeck, President and CEO, SIPC, testified before the Senate Banking Committee on the subject of this fraud on January 27th of this year. He suggested: “The prospect of stealing $10 million from a brokerage firm has only happened 10 times in 39 years. The regulators do a good job, generally speaking, of finding these kinds of actions."

Do they? Or is the tangled web of who holds what where, who is accountable, and just how much accounting for their client’s funds can be taken at the word of investment advisers and broker-dealers in need of repair? Securities Industry and Financial Markets Association doesn’t think so and in a letter to the SEC, gives the average investor a peek into why they object to any actions.

SIFMA, the lobby group for the securities industry seems to debunk what has happened to investors like those who believed in Madoff as incidental.

At the heart of SIFMA’s objection is the cost of what the SEC is proposing. The SEC wants to subject registered advisers, broker-dealers, custodians and everyone tangled in the massive web that investing has become (and to a lesser degree, what is your 401(k)) to a surprise audit. The SEC suggests that this type of auditing would cost these entities about $8100. SIFMA believes that it could rise to over a million dollars, calling the SEC’s estimation unrealistic.

Similar objections were raised when Sarbanes-Oxley was introduced following scandals at Enron and Worldcom. But the world of accounting managed to drive those initial costs down significantly as it developed methods to do this monumental task that streamlined the process. Members of SIFMA were surveyed about this proposal for surprise examinations and it was these members who offered their own cost of untangling the mess.

At the heart of the matter is who pays for what and are the protections that SIFMA believes are currently have in place, enough to satisfy the Commission and the investors who worry that they have no idea who or what has their hands in their accounts? The SEC would like the chief compliance officer to step up and certify compliance with the SEC’s request. SIFMA believes that the role of the CCO should be “to confirm that the adviser's compliance procedures regarding custody are reasonably designed and function appropriately. A CCO could, for example, review the adviser's reconciliation procedures, and compare the adviser's and custodian's records to client account statements” and they should not act as an accountant.

What the SEC wants can best be described as transparency. The Commission has suggested that the purpose of the surprise examinations is an effort to “confirm with the custodian all cash and securities held by the custodian, including physical examination of securities if applicable" and to "reconcile all such [assets] to the books and records of client accounts maintained by the adviser, and (ii) verify the books and records of client accounts maintained by the adviser by examining the security records and transactions since the last examination and by confirming with clients [emphasis added] all funds and securities in client accounts."

SIFMA points out the 100% examination may not be possible. Rule or no rule, the organization points out that “an accountant seeking to verify these assets must contact each issuer; if a single issuer is uncooperative or dilatory, the surprise examination may be delayed or even left incomplete.” Does this suggest stronger wording to force compliance, fines or both for those proving uncooperative?

The confirmation of all assets should not be that difficult. Except that in many instances, numerous parties handle these assets. This dilution of blame and accountability is what the SEC wants to improve. SIFMA seems to want business as usual and let the markets and the investors take of itself.

In a comment letter to the Commission, SIFMA asks what would happen if the adviser had no access to custodial rights? Does advice obligate them to have the same descriptive powers as the custodian does, simply for their role as a client’s adviser? There are affiliations to consider between the adviser, the custodian and sometimes the broker-dealer. It is this web of interactive handling of a client’s assets that presents the biggest challenge for SIFMA to rebut.

The SEC would like to untangle this by forcing advisers to independent custodians. To unwrap these wrap clients would incur costs but in the end offer an additional layer of assurance for those interested in retaining as much control with as few hands collecting fees for the service.

In light of the billions of dollars lost by investors over the last several years and the role the financial industry played in keeping that money safe, the SEC is on the right track to improve the standards of accounting, the accountability of the numerous parties involved and by giving them notice that business as usual will not be the best way to conduct business moving forward, it is doing the job they were supposed to do.

As I said, the cost of a surprise examination and a fully completed one will have costs. But those will go down as these wrapped accounts find a way to streamline their management efforts. One of the possible results of these types of rules will be less hidden fees, with less hands in the client’s assets.

Mutual Funds Explained: What Do Mutual Fund Directors Do?

If you listen to John Bogle, founder of the Vanguard group and index fund advocate extraordinaire the answer is not enough and not enough for the money they are being paid. While index funds need little in the way of director input and the manager need only track the index they are assigned, actively managed mutual funds are a different story.

Mutual fund directors are supposed to be independent of the fund family they work for and the managers they oversee. They have enormous fiduciary responsibilities and some take this very seriously. Some, not so much.

There is the possibilities that those who do a job that is not in the shareholders best interest may be compromised by the not only the amount of money they earn from each fund board they sit on but the sheer number of funds they are charged with overseeing.

Bogle raised some eyebrows when he compared the average salary of a board director in the corporate sector ($48,000 per year per board - many who qualify sit on numerous boards) and those in the mutual fund industry ($386,000 per year per board - nearly eight times the corporate average). He more or less called this kind of pay disparity bribery suggesting that the director could not possibly do his job effectively with those kinds of compensation packages being doled out by the fund family.

In essence, Bogle suggested that the director, rather than working for the shareholder is merely a fund manager's stamp of approval. Can a mutual fund director do his job effectively without jeopardizing his lucrative compensation?

Possibly. But could someone like Lee A. Ault, 73, whose name turned up in 371 SEC required filings in the past year? Possibly not. The answer is left to the SEC. Currently, the level of responsibility that these fund directors must assume is really quite low. New regulations would allow the directors to better monitor decisions and performance, set fees that do not unduly impact the returns of the shareholders and keep track of how soft money is spent.