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.

Do You Know Where Your Value Fund Is?

Last week the topic of emerging markets came up on a radio show I host every Friday. Although we only skirt the issue on many occasions, this week the term "emerging markets" kept popping up during the course of conversation with Lauren Templeton and her husband Scott Phillips, both of Templeton Capital Management. These two are value investors and if you have never met one (or two), they offer an unique perspective on the world of investing that is counter to what many of us think it is.

Now I often mention that emerging markets are often mature well before they lose the emergent title. In fact, the grey area between when they cease to emerge and the point when they are considered developed is often prolonged, with noticeably slowing growth and maturing markets. But even then, the unrest that signals investors that there is still significant (and sometimes worthwhile) risk makes the investment worthwhile well past its prime.

For most investors these days, emerging markets are usually considered as the economies of Brazil, Russia, India and China, or what has become known as amongst investors, the BRIC countries. Many of the four nations have growing GDPs, some doubling every six to ten years. Compared to countries like the US, where GDP doubles about once a generation, it is easy to see why this fast past growth adds to the risk factors.

Growing pains aside, many of these nations still have governments that are either over-involved or not involved enough. Depending on who you speak with, this can be both a good thing and a bad thing. As David Brooks of the NYTimes recently suggested: "emergent systems are bottoms-up and top-down simultaneously". As long as we can't predict with any accuracy which will prevail or better which should prevail given our predisposition to the investment, emerging will always signify opportunity somewhere for the nimble footed investor.

The BRIC countries all run the risk of slowing down with the brakes of banking and government concern with growth and its stepchild inflation pushing hard on the pedal. Some see this as the initial signs that regulation will swoop in eventually, followed by over-regulation and that, value investors feel is the death knell for emergence. What makes a country emerge in the first place?

Chuan Li writing for the University of Iowa Center for International Finance and Development breaks it down into four simple, and easy enough for the average investor to understand. He writes: "Emerging markets stand out due to four major characteristics. First, they are regional economic powerhouses with large populations, large resource bases, and large markets. Second, they are transitional societies that are undertaking domestic economic and political reforms. Third, they are the world's fastest growing economies, contributing to a great deal of the world's explosive growth of trade. Fourth, they are critical participants in the world's major political, economic, and social affairs."

In other words, they have all been bitten by the capitalist bug. In the past, countries emerged with assistance. Now they emerge with investment. Companies swoop in and entice governments with their investment approach, the benefits that their involvement in the country will have on its people and that the system works best where the regulation hasn't yet developed to the point of constraint.

But that bug bite doesn't necessarily mean that the country will ever fully emerge. Political systems are delicate beasts that needs to be groomed and sold to the growing economic classes in many of these countries and even after decades of what appears to be peaceful expansion, the simple cost of producing enough to eat can bring the whole of this effort down. By this time, the emerging market investors have left the building. Confidence is a risky business in and of itself and needs to be sold to the growing middle class who for the first time, may have the feeling that they deserve even more.

As Investopedia describes the risks: "The possibility for some economies to fall back into a not-completely-resolved civil war or a revolution sparking a change in government could result in a return to nationalization, expropriation and the collapse of the capital market." Now you may ask, why bring up value investors?

For two reasons: First I always saw them as the patient investor, willing to research and parse every bit of information available, make a decision and quite possibly never see the need to rethink their position. Once made, value investors held their decision sacrosanct, quite possibly putting more money into the investment if the cost fell farther. And two, they always invoked the names of those who pioneers (Ben Graham, David Dodd, Sir John Templeton and most recently and possibly even more famous, Warren Buffet) as their only mentors; all other discussions were off the table.

The lines were blurred when the stocks they picked rose, turning their investments into profits and prompting their exit from the investment. And even though they considered what they did fundamentally sound, they chuckled albeit under their breath as they sold to new buyers. To find value, you must find someone who is willing to sell what you know is worthwhile. To sell that investment, you need to find a buyer who sees only the increased worth of the stock and makes the assumption that it is indeed a good buy if it is now worth more than it previously was.

It makes a growth investor think twice, an index investor think less, a technical investor to wonder what's next for the stock and to the portfolio investor an opportunity to add risk or as they prefer, diversify. But value investors seem to snub the rest of us a merely fools.

Here's a little quiz to help you decide where you fall on the investment curve. Consider Japan. The markets that track Japan have seen net outflows steadily increase over the last several weeks since the earthquake, tsunami and nuclear reactor problems swept its way into the world's focus. If the markets are as Jeff Sommers of the NYTimes recently described it: "It’s as if the world’s markets have been responding to the baton of a mercurial but authoritarian maestro, who changes direction often, but insists that all orchestra members play together as one" and Warren Buffet is spending time touting the investment opportunities in Japan, does investing there suggest value or virtuousness?

Japan is hardly considered emerging, even as they consider nationalizing their utilities, a hallmark of what is considered risk in emerging markets. Can rushing in at the point of this orchestrated exit be virtuous as some value investors suggest, infusing capital as a sign of their belief that the sell-off has gone too far? At what point can this sort of risk be explained away as "doing the right thing"?

Opportunity has often be the domain of the growth investor. Risk is why growth investors do what they do: selling when they perceive the risk to be too great and buying at the point where the risk subsides. Yet value investors claim to do the same sort of maneuvering. Acting less like the lion in pursuit of the wounded zebra and more like the vulture preparing to clean the carcass left behind, value investors create the illusion of running counter to the herd. Or in the orchestration of the markets, playing an instrument that doesn't jive with the whole.

While every investors plays a role in the orchestrated market, value investors seem to want no part of this group. Even as they write the next score for the investor musicians, they refuse to consider themselves for what they are. Backing their decisions with the fundamentals of research is not an excuse nor is it virtuous. It is simply embracing risk differently. Yes, Japan offers opportunities. But to suggest these opportunists are focused on the virtue rather than the profits masks the underlying bug bite: we are all in for the profit and with value investors, that profit is once again, based on your mistakes.

Hope for the Best: Picking Mutual Fund Winners

Picking winners is an exercise in hope. Picking winners amongst the thousands of mutual funds available in the actively traded world requires more than just hope. Mutual funds, for those of you who may not be well-versed in the subject, offer investors an opportunity to ride with a fund manager to investment success. To determine this success, the fund manager must beat the benchmark that the fund is best judged. These benchmarks are index funds.

Now I have mentioned here before, this is a less than perfect way to determine success. But it is all we have. No actively managed mutual fund owns, in the same proportion, the underlying portfolio of the index fund. Index fund advocates suggest that index funds offer the wide diversification needed to get investors from point A to point B and do so in a passive manner.

Actively managed mutual funds do something quite different. And investors who use them know this. Investors looking for just a little more from their investment dollar believe that there is always the chance that the fund they pick will outperform the index fund benchmark. Few do. But the effort is worth the gamble. So why is it that we look backwards in order to move forward? Is what happened important to what might happen?

When an investor buys an actively managed fund, they have two choices to help enable their decision. The first is what the focus of the fund is. Understanding the underlying investments, how the manager approaches the fund's individual charter, how often the fund needs to readjust to complete that task and whether the fund manager can accomplish this in a cost-effective manner all play into the decision of whether or not to buy in. These are forward looking mechanisms designed to give us some level of expectation.

The second tool we use in the decision making process uses the exact opposite methodology: where has the fund been. By no means is this a necessary tool. Yet it is often employed by index fund advocates to point out the error of the actively managed mutual funds. Based on where these funds have been, indexers point out that had these same investors used an index fund, they would have been better off.

But this is not why people invest in actively managed funds. They do so to fulfill some inner need to do better than average. So why if that is this case, do these same investors, who see themselves as better than average and more savvy than the rest, look in their rearview mirror to get some indication of what the road ahead holds for them?

What was will never be again. None of the fund screeners offered around the web, from CNBC's to Forbes to the brokerages to the Persistence Scorecard offered by the Standard and Poors give you any idea whether the fund you are considering will do good in the next quarter, the next year or even the next ten-years. In fact, all of these screeners suggesting who won in the previous time periods would be useless in picking the next benchmark beating fund.

There are several things to consider when looking to invest in an actively managed fund. At the moment right before purchase, every one is on equal footing. This is referred to as the initial opportunity set. Every fund manager is equally skilled and/or prone to the same luck. The differences lie in the cost of the fund in terms of administrative costs. This is somewhat similar to suggesting that every horse in the race has four legs.

Yet unlike a horse race, where lineage, training and numerous other factors come into play, at the beginning of the race, all mutual funds are essentially equal. Once the new quarter begins, the race is on to beat not only what the benchmark might achieve but what other funds might do as well. At the end of the race, unlike horse racing, the gamblers place their bets. Sounds odd when considered like that, but it is essentially what happens. When the quarter is complete, new investors look for the winners, something that has already occurred and buy in.

The S&P Persistence Scorecard suggests that you will be right about 25% of the time employing a method of picking past winners over the previous five years (a period that seems to be quite a long time). You would have done slightly worse trying to pick a long-term winner amongst the mid-cap sector; slightly better with a small-cap fund. What the Scorecard does not suggest is the shifts among the stocks in the small cap to mid cap to large cap arenas during that period depending on capitalization (a shift that can change with each bull or bear market, mergers and acquisitions or simply with bankruptcies).

In fact, the Persistence Scorecard suggest that the middle of the pack might be a better indicator of what might come. If the top quartile is predicted to not repeat and the bottom quartile should be not considered as potential winners in the future (most at the bottom of the scorecard will probably merge or be liquidated in the future because of this underperformance), that leaves the second and third tier funds as the next winners.

If past indicators tell us anything, it might be to look the other way. Or, they might suggest that last quarter's average will be the next quarter's winner. Whatever it is, some skill and a lot of luck keep the current winners at the top of the rankings. Which is why few do with any success. If you are picking your next opportunity based on what happened, you would be better off with an index fund. I say this because average in the actively managed mutual fund world is a bit more expensive than simply buying the index.

But if you think you know the future, your ability to pick the next winner will make the envy of your fellow investors. And considering the odds, you have about a one-in-four chance of doing so.