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: The Index Fund Argument

This argument is getting tedious. I goes something like this: Index funds have outperformed actively managed funds about 75% of the time. Those that cite that tedious fact, suggest that the next logical step an investor can make is to invest in index funds. Not so fast.

I have heard this index fund argument so often that I am concerned some folks may think that this is how to build wealth - at least enough for retirement. It's not.

Retirement accounts need actively managed funds to succeed. These types of accounts are tax-deferred (meaning that the taxes you would have paid on any growth are not paid until you begin drawing on the account and to continue the theory just a little further, you pay them when your tax bracket is lower). This is my primary argument for why retirement accounts should not have index funds in them. Index funds are simply too tax efficient.

Actively managed funds, provided you invest in the least expensive, the funds that beat their peer group - not some index - and offer a broad market style belong where risk is spread out over a long period of time. The problem with indexers, those who believe that the low fees are worth the low risk, is a need to embrace the set-it-and-forget-it style of investing. Could they just be lazy?

This belief - that index funds are better - can be blamed on the actively managed funds themselves. They have used indexes, often the wrong ones, to compare their performance. Side by side, this just doesn't work. No actively managed fund can offer 500 companies in its portfolio at any one time. Their goal is to pick the best from a group and run with it. They become investors, just like us only with far more market savvy than the guy sitting at his laptop in the coffee shop.

Actively managed mutual funds need monitoring in part because it is investing - not saving. With a good basket of actively managed funds, you can better diversify your risk and still avoid investment overlap (which, if one of your funds is an index fund, you are doing).

Keep actively managed mutual funds in a tax-deferred account. Keep index funds on the outside of these accounts and pay the taxes on any gains you have made (the tax on long-term capital gains is still low enough to make this an attractive strategy).

Investing is risk management. Remove the risk and you will pay with far less long-term reward.

Mutual Funds vs. Stocks: Better, Cheaper, Easier?

Fellow blogger Jenny Decki at BeyondMom asks the following questions:

Why would I invest in a mutual fund?

If I choose five stocks (or 10 or 15) isn’t that (basically) the same thing as being in a mutual fund but without the fees?

I understand that a mutual fund has a manager that watches the stocks within the fund and makes changes as appropriate, but how is that different than day trading? (Other than the fact it’s someone else doing the day trading.)

Jen,

You raise some interesting questions: can you do what a mutual fund does and can you do it cheaply enough to make it worthwhile?

Mutual funds are still both cost effective, tax efficient, and in many cases, a far better investment than wading into the world of stock picking. Yes, mutual funds offer a fund manager(s), a level of research and discipline often not found in the individual investor, and the ability to diversify into a wide variety of stocks. Whereas the individual investor has far more flexibility to sell at moment's notice, some basic problems arise from the effort.

1. Which stocks to buy? While it depends on whom you listen to, the stock market has yet to retain any long-term stability. News, even reports that seem wholly irrelevant to the shares you might own, is still driving the investor to do things they would not normally do during a more stable and predictable market. True, no market offers itself to forecasts, and no stock is immune to industry trends, they can be and should offer some sort of confidence, a belief that the decision they have made is the right one long-term.

2. Which stocks offer long-term stability? Legendary investors always look for value. The average investor looks for gains. The two can be compatible but patience and time are what turns value into profits. Those looking for gains generally do not bring that sort of approach to the effort. Build a sample portfolio at any one of the financial portals and you can test this discipline before you commit real dollars. Keep in mind that these sample portfolios do not usually simulate trading charges or taxes.

3. Are stocks cheaper in the long run? Only in the long run. If you spend a fair amount of time looking at the tickers crawling across the bottom of broadcasts on CNBC for example, the wildly traded moves, the end of session strategies employed by many ETFs (exchange traded funds), and the instant reaction that many of these floor traders have to news (the ability to disseminate what is important right that minute to whatever position they may have taken) is very difficult for the average investor to control. Buying and selling all have costs (to you they are more expensive; to the institutional investor these costs are much lower) and depending on how much you have in your brokerage account, the advertised price many broker offer will be much higher.

4. Are stocks cheaper than mutual funds? Those same legendary investors offer the same legendary advice: fund your retirement, keep your financial house in order and only invest in individual stocks with money you do not need. Benjamin Graham, one of the most legendary of investors coined the term "Mad Money" to describe these accounts. He suggested that you should only put in money you do not need and never replenish those funds (if you win great; if you lose, lesson learned). Investing in stocks, for lack of a better analogy, is gambling. Ask yourself this: if you were at a casino and you had spent all of the cash in your pocket, would ask for a line of credit to continue?

That said, mutual funds still offer you the best way to keep your money working in the markets without taking outsized risks. Keep actively traded funds in your retirement account (the tax deferred opportunity is wasted on index funds in these types of accounts - keep them outside of your retirement account and pay the taxes on the gains and get the tax break on the losses). Be sure to take the time to build an adequate emergency account so you will never touch those retirement investments (these accounts are often referred to as savings - they are not), and if you still have money left over, wade into the ocean of stocks.

As Warren Buffet once said (as legendary an investor as you could quote):"price is what you pay; value is what you get."

Sidestepping Risk: Bond Funds Offer More of Less

It is an act of faith to invest. Michel Eyquem de Montaigne (1533–1592), credited with the invention of the essay once suggested "How many things which served us yesterday as articles of faith, are fables for us today" would not be surprised by how investors are looking at their options. No more do investors believe that they can beat the market. No longer do they see risk as something will always play in their favor, rewarding them year over year with riches and gain simply by believing in forces many have no idea about. It seems that they no longer have faith.

We don't need to rehash old news about how far the market has fallen and even as it picks itself up, there are doubts that the once glorious years are well past us. Mutual fund outflows compared to the years prior see a steady rise, enable by the number of people who, for one reason or another think that selling at the bottom (or near bottom) is still far better than taking a long-term approach.

Wall Street and those that report on the happenings there see investor sentiment shift from stocks to bonds and like all good industries, they are moving with the crowd. This is the same crowd who shifted $25.7 billion in assets out of mutual funds in march even as the S&P 500 posted hefty gains. The were undeterred by the fact that there will eventually be a recovery, perhaps, as I mentioned in another post, in as little as four to five years. The folks making the shift have time to wait. But choose instead, to head for the doors.

On the flip side, bond funds gained. The Investment Company Institute, a mutual fund trade group that tracks these sorts of trends noted that the current bond market investment now totals almost $4 trillion, almost a 50% increase over the year earlier (a time when investors still had faith).

Some of that money is headed into target-dated funds, an unproven investment vehicle that promises to gradually shift an investor's money from stocks and bonds to bonds and stocks as they age and become closer to what the fund calls the target. That target, suggested by the fund's name and more importantly, the estimated tolerance of risk as they head toward retirement, has seen net inflows of over $10 billion in the first three months of the year.

This is in part due to the default option in 401(K) plans, where the employer, as directed by the Pension Protection Act of 2006, may invest on the employees behalf in such a fund. And once that happens, studies on investor habits have shown, the employee is not likely to change where their money is headed.

(It has been well-noted here that target-dated funds are an even bigger leap of faith than actively managed stock funds may be, an argument that suggests that these funds are often a mix of bedraggled and failing funds the fund family is keeping alive, albeit in a resuscitative form. Also problematic is the idea that these funds will perform as promised any better than if you had done it yourself, for lesser fees and only an annual revisiting and adjustment of holdings. And one last thing: will the fund manager at the helm be the same one five, ten, or twenty years down the road, perhaps the single biggest factor in the long-term success of the fund?)

There has been an interest in index funds as well. The argument against these in a retirement account is simple: taxes. These funds trade little and because of that lack of activity, their tax implications are very low. If you want to hold an index fund, do so outside of your retirement account where you can still take advantage of the low capital gains taxes. Adding to their attractiveness and your profits in the long=term is the low cost of owning an index fund, which, for the investor means more money in their pocket at the end of the line.

Driven by the need to protect what is invested, even the investment grows at a much slower pace, bind funds have become resurgent. For the younger investor, this type of investment is closer to stashing money under the mattress. For the older investor, it should part of, not the whole of their portfolio. But right now, lack of faith, a downturn in optimism, and the long range outlook focused on short-term results, will drive an increasing number of investors to give up potential gains in favor of not losing.

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We have moved to this blog from our previous location on April 10th. You can find numerous additional articles along with notes from the book "Mutual Funds for the Utterly Confused" (McGraw-Hill, 2008) by clicking here.