Mutual Fund Investing: So what are mutual funds and how can they improve your life in 2011?

You have mutual funds if you have a 401(k). Individual Retirement Accounts (IRAs)hold mutual funds as the primary investment and despite their use throughout the world of investment and retirement planning, too few people have a positive attitude about what this tool can do for them. Most of the negative propaganda comes in spite of the ease of use, often lower expenses than any other investment tool, accessibility, better transparency (or well on the way to providing better insight) and often, tax efficiency. Some do this with great effort; others revamp their portfolio only when an index is restructured.

So what are mutual funds and how can they improve your life in 2011? There are only two types: actively managed or those indexed to a specific grouping of investments. From there, it gets complicated but getting from there is where the whole traffic jam of ideas begins. It makes no matter, which school of thought you ascribe to if you do at all: everyone needs and actively managed group of mutual funds and a passive group if you expect to do anything worthwhile in 2011.

In the coming year, one which is predicted to be quite good despite my doubts, which I will put forth in couple of days with my year-end look at 2011, diversity will deliver more than simply chasing one ideology of the other. The "indexers believe that these sorts of funds are all you need to succeed in any year. Offset by relatively low costs, these funds make up for hoping that that through diversity they can achieve better than average returns for those who invest in them.


As a group, index investors are a fervent bunch. They espouse this investment as the be-all-to-end-all tool and in doing so, give those who chose the other camp - the actively invested mutual fund - to wonder if they may be right. There are reams of research that indexers point to as the reason why they believe this approach. But passively sitting back and letting the market determine your investment outcome is not for everyone.


Actively managed mutual funds are structured in the same way as index funds: a portfolio of investments (stocks, bonds or both), a manager (be it one, more than one or a computer), disclosure and regulatory rules that they must abide by, and performing as billed, if not better. The difference in who picks what is in the fund. Index funds are determined by an index published by such notables as Standard and Poors or Russell or Wilshire. Actively managed funds contain investments picked by management.

Both bring like-minded investors together to pool their money and in doing so, offset the risk and cost of having to build a similar portfolio on your own. Actively managed funds try and outperform their index counterparts in large part because it is these indexes, right or wrong, in which their performance is gauged and graded. If they do better than an index, investors notice, add their money and create increased opportunities for the fund manager to increase those returns with additional acquisitions.

It doesn't always work and some comparisons are unjust (how can you compare a fund with fewer than 100 holdings to one where 500 are held?) and do not paint a true picture of performance. But in tandem, they might work for different reasons for everyone interested in a more profitable 2011.


In times of turmoil, everyone feels pain. When the whole of the marketplace dropped precipitously in 2008, no investor escaped. Some were damaged more than others but as a group, we all felt pain in some form almost at the same time. Investors who simply plowed money into a 401(k) or loaded up on their own company's stock and thought that investing was a world of do-no-wrong, were given a rude awakening. Those that traded actively on their own and were beginning to feel some invincibility creep into their results were caught unaware as well.

And in the past year, investors in US stock funds did what they had done in the previous three, withdrew more than they invested, Called outflows, they impact mutual funds harder than the selling of shares from your own portfolio. These outflowing funds are produced with the sales of a portion of the portfolio. And every such move impacts the remaining shareholders in the mutual fund.

Inflows, or your money pouring into a mutual fund comes automatically in a 401(k), through deductions into an IRA and self-deposited by individual investors. Yet only a handful of people I speak with everyday likes the idea of a mutual fund as an investment and if last year was any indication, think fund focused on the US stock market alone is not the path to financial success.


Why? We want simple things to work extraordinarily well. Nothing does but we expect it of mutual funds. We want low fees, we want moderate risk and we want to know that our money is safe from market interruptions and taxes. And at the same time, we want growth, to retire early and to have our investments perform without hiccup for decades. Only mutual funds can do this - even if we dislike the idea.

Low fees, moderate risk, safety and tax efficiency is a tall order with three of the four fitting the index fund bill. Safety is subjective and safer, even more so. But no equity index fund alone can do this. No bond index fund alone can do it either. Target date funds, hybrids of other equity and bond funds (and often a basket of such funds from the fund family) promise all of the above but have yet to prove they can deliver.


Yet three out of four isn't bad. Put this type of fund in a Roth IRA and put as much as you can in it, consistently over 2011 and you will do as well as this year has done (which looks to be two back-to-back years of double digit gains for the S&P500 index). Even if you do half as well as the 20% plus gain in 2009, you'll be way ahead of where you'd be otherwise.

In the other group, looking for growth, outsized returns and freedom from hiccups, look to your 401(k) where your employer may be retuning to offering a match in 2011. If they do, this is not so much free money as hedged money. A 6% match added to your 6% contribution gives you a lot more room to assume risk that you probably are. Retiring early is a dream even as we acquiesce to work longer. But it can be closer to a reality if two things happen: you invest more and use actively managed funds in your 401(k) to get there and the market corrects a little in the first half of the year. This means buying more for less and positioning yourself for a good 2011. Not 2010, but close.


Whatever your outlook for 2011, a tandem approach to investing - using index funds and actively managed mutual funds might be the best approach in the next year. Be cautious of only two things: this isn't advise and be careful you don't over-expose yourself in any one sector.

Are you asking the right questions about your portfolio?

Most questions you should ask yourself about your retirement you do not ask. It isn't because you don't have the question in hand. In many instances you do but you simply fail to seek the answer. For example: when would like to retire is much different that when will you retire. Both queries speak to the same time in your life when your current working career shifts into another realm. But the answers, like the questions, are different.



Target date funds, the darlings of the skittish post-2008 investor, the new-hire and the plan sponsor who believes they are doing the right thing by their employees, the funds that pick a date in the far-off distant future, a point in time when your retirement is supposed to happen don't answer the question the way we all assume. In fact, they may not answer it at all.

Target date funds are designed with, among the obvious pick-a-date moniker, an asset allocation shift over time. If you buy into a fund, such as one that picks 2040 or 2050 as a retirement date, you will have, at least according to the sales pitch, an aggressive to conservative journey spanning the next 30 to 40 years. The idea is that your fund will find the right investments to gradually ease you from being exposed to equities and the potential growth they offer to fixed income and the protection they offer over that time period.


So which fund do you pick if you can't or won't answer the either question? Imagine a 25-year old entering the workforce. They have the opportunity to pick a fund that reflects an investment arc spanning 40 years. Even if they don't understand how to invest or what to invest in, there is little likelihood that this employee will stick with this plan and this fund over that period. Few people buy any mutual fund and devote that sort of loyalty to a fund that almost predicts diminishing returns (all in the name of capital preservation).

As the worker ages, things change. Life happens and in the process, you become more educated, perhaps more risk tolerant (or averse), and you understand the markets better. This changes your investor approach to these funds. You begin to question their strategies, how they allocate the money you dutifully send each paycheck, and whether the fund is doing as advertised. And after all of that, you would have to aks yourself, when will I retire? And if I do, will I keep this fund?


Target date funds come with risks. Many of which are well-known even if they are not well understood. The Labor Department is looking to clear up this confusion for target date investors even if the information is already available - if under used.

Among those risks are disclosure of the fund's asset allocation. Depending on your time horizon, the fund you pick and how that mix of assets changes over time, every target date fund differs in their approach. Now keep in mind, most of us will encounter these funds in a 401(k) plan and have little ability to shop around for a target date fund that does better. Also keep in mind that "better" is a tough call. Any comparisons made between two similarly named funds ends right there.

The Labor Department would also like the the significance of the target date explained. Even the most novice of investors can grasp the target. What they can't wrap themselves around is the fund's investment policy. Few can and because of this, even fewer read this already published information. And what troubles the Labor Department the most about these funds, often given set-it-and-forget-it status in the minds of many of these investors is the inclusion of a including a statement that the fund could lose money - and it might happen close to retirement.


How could something so simple become so complicated? You pick a retirement year (simple) and the fund matures with you (simple) and because there are no guarantees (complicated) and no way of telling whether this is the right fund on the day you put your first dollar in it (even more complicated), how do you know?
Charles Jaffe of Marketwatch believes it is a "to or through" question. Will you have the fund at retirement invested as conservatively as possible or will you be keeping a couple of decades after you retire? Something this simple should be this complicated. The question is really to or through but "why bother"?

I have no problem with auto-enrollment of new hires. I have no problem with educating and offering these new employees some insight on how their 401(k) operates and what it offers. I do however have a problem with the perceived safety of the target date fund in the plan and the seemingly risk-free idea that this is a fund you keep  even if the employee will not stay with the company - or that particular fund - forever or at least until that retirement date.


Making target date fund reporting more transparent as the Labor Department proposes is not going to make the task of choosing easier for those considering this type of fund or who have been auto-enrolled in one. Most mutual fund investors know that there is risk - some can even describe it. Most know that there are no guarantees. Yet target date funds seem to offer a false assurance that time is on your side in a way that is not so for other retirement investors. And that is a problem.

Your 401(k) should have been your retirement savior

Despite the metaphors surrounding what retirement planning is supposed to be: a three legged stool, a three pronged approach, whatever visual cue you need to make sense of the process, your retirement is or at least should be, a lopsided financial affair. It should be something that works as a part of whole but not in any sort of equal sense. Social Security and the state of your financial affairs at the time you decide to quit working is really only supposed to be a small part of the retirement plan. In truth, the most prudent people who plan their retirement do so without any consideration of income from any outside source.

Not so in the years following the Great Recession. The vulnerabilities are now something we have seen first hand and many of us have recoiled in horror. Instead of relearning where we went wrong, we looked for the safest rock to hide under. Perhaps that is why, when the latest report from the Investment Company Institute was released this past November, your defined contribution plan or for most of you, your 401(k) was given equal stature amongst the other two "legs" of the retirement stool.

Social Security was designed to help keep those without from becoming destitute in retirement. Not surprisingly, the report points out this use of the program by those who are the least fortunate, the lower paid worker, as more reliant on those benefits than the higher paid worker. As they look at a post-ERISA world (the 401(k) actually came nto being in 1981), they conclude that this has always been the case and if it has, then so be it.

But the study wasn't designed to be much more than a good-old-boy pat-on-the-back. The ICI sees the distance between the demise of the pension as the sole means for retirement among workers in 1974 as a trip worth traveling. Coming out on the other end of that journey finds the lobby arm of the mutual fund industry rather satisfied. they point out that the median income from a defined contribution plan per person in 2009 was $6,000; in those same 2009 dollars, the same median was $4,500 in 1974.

It is not surprise that many of the remaining firms in the private sector still maintain them. But these plans are not considered a reason to work at these companies when it comes to the younger workforce. Pension breed company loyalty while 401(k)s allow workers to shift jobs when a better offer is available. On the other hand, pensions often leave this same group of workers with no retirement benefits, essentially, at least according to the ICI report, when vesting rules and the timing of benefit accural are used as a rodbloack to getting those benefits for time worked.

But during the time frame they used to conduct the comparisons (1975 to 2009), Social Security now makes up a larger share of retirement income even among those who had assets and other income sources. Based on per capita income at either end of the spectrum, with the lowest income group using just 2% of what the study calls asset income with an 85% reliance on Social Security compared with what the higher income group employs (20% assets and 33% of income from Social Security).

While the ICI celebrates the success of the defined contribution plan that replaced the private sector pension and they point out that those with DC plans are doing better than DB plan recipients in the past, one simple fact remains: we aren't doing enough.

While the answers seem clear: you need to invest more - probably much more than you would be comfortable in making, live smaller now while you are working, and hope that your health, inflation or taxes doesn't take a toll on those accumulated finances. In the face of such daunting news, you could expect a pull back. Instead of increased focus, we would get more ennui. Instead of an emphasis on better educated investment and financial decisions, we should expect more use of what we assume of are set-it-and-forget-it investments such as target date funds.

To answer the question in the title: was your 401(k) intended to be complimentary for retirement? I believe the answer was no. It should have been the investment savior, a Wall Street miracle. Trouble is, now many people. financial professionals included are looking for a way to provide the same guaranteed income that those long-shunned pensions provided. And when they do, we will wish it was 1975 all over again because it will come at a much higher cost than we imagined.

To Index or Not: Mutual Fund Investors still ask

It isn't like this would be a fair fight. But get two investors who believe in one or the other in the same room, and the index fund investor would declare their style the winner, based on low cost alone. While fees play an important role in the long-term objectives of any investor, particularly those using mutual funds for retirement, the idea of long-term has seen its day come and go. As Tom Lydon of ETFTrends suggested recently: "The notion of buy-and-hold investing shows signs of falling out of favor. Ten years ago, 80% of advisors’ portfolios were buy-and-hold. Today, that’s 30%."

Which leaves the actively managed mutual fund investor, often described as a resident of Lake Wobegon (where everyone is above average) as the beneficiary of this shift ininvestment style. The question that every index fund investor will ask every opportunity they get: how do you pick an actively managed mutual fund if so many underperform?

And it is a good question. But the problem is, how do you make that call if you are essentially comparing these sorts of funds to those that buy across a broad market? An index fund, for the sake of argument we'll use the S&P500 index as an example, buys the top 500 companies. These companies are in the top 500 due to market capitalization. But index funds don't buy all 500 equally, weighting their funds based on numerous criteria.

Among those are as I mentioned, market cap. To be eligible for this index, a company must have $5 billion of market worth (issued stock) with 50% of that stock available for the public to buy. They must be based in the US - it doesn't matter where they do business as long as the headquarters are on US soil, follow GAAP reporting practices and offer sector representation.

The weighting of an index like this, which many investors assume is done much more evenly, actually gives the top ten companies based on market cap, over 20% of the index, leaving the 490 remaining companies to fill out the rest of the index. How would this sort of style compare to a actively managed mutual fund that owns less than one hundred stocks in their fund? Talk to an indexer or as they often refer to their group as Bogleheads, after the man who brought the index fund into existence (there were attempts made earlier than Mr. Bogle's but the ability to do it correctly was dependent on the advent of the computer) and they would quip, there is no comparison.

Yet, this is the very comparison they make, time and again. Their argument does hold some merit. Index funds have lower fees because they trade only when the index changes. (This is an irony lost on many indexers as the these funds must divest any interest they might have in a stock taken from the index and purchase any security the index has added - a sort of counterintuitive move of selling losers and buying winners.) Many still charge 12b-1 fees even if they are in company sponsored plans and act as the default investment. Over five years, performance of the S&P500 index has been north of 15% and that was due to the large amount of value given those top stocks in the index and the dividends paid by many of these large businesses.

Actively managed funds do have more to contend with in terms of trading (more frequently but the best funds do so prudently without changing their whole portfolio in a given year) research (they aren't given a group of stocks to buy as the index publishers do) and their are management fees (the cost of hiring a professional to wade into the marketplace for you). Yes these do impact the overall returns of a fund and as investors focus more on these items, they have dropped significantly in recent years.

So what do you get with an actively managed fund that isn't there for indexers. Obviously, a bit more nimbleness, less buy-and-hold and if your fund manager is good, acceptable returns. Most investors do still look to the performance - and too often in the short-term, as in a year or even a quarter just past - as the tool most likely in their portfolio picks. Doing this at the exclusion of tenure - how long the manager has been at the helm - the fees - they should be low, under 1% with a portfolio turnover in any given year of less than 60% - and should be able to best their peers in both categories, if not the index they are often compared to, over five years or longer.

Indexed funds have pluses that seem outsized compared to actively managed funds. But too often, a one size fits all approach to investing is not suited for everyone and this is where actively managed funds fill the void left by that sort of approach.

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.