Good news/Bad news

While we have all been, on occasion, asked to choose between the good news and the bad news, when it comes to your 401(k), both sides of the question mean something. Today, I'd like to look at some of the good news, bad news that has been coming out of the world of the 401(k).


Investments
Good news: People continue to contribute to their 401(k). A recent Investment Company Institute report found that only 2.4% of investors using this sort of plan did not contribute in 2010. This is considered a generally good statistic for two reasons: the resurgence of the company match may have prompted more people to begin to contribute more in 2010 than they did in 2009 (3.4% ceased contributing) and two, the stock market rewarded these folks for doing so. This means that account balances also increased.

Bad news: Those who did continue to invest actually pulled money from the equity side of the investment equation. The ICI was confused by the pattern, which typically dictates that when the stock market does well, investors tend to increase their holdings rather than withdraw. The shift they suggest may point to a lower risk tolerance which doesn't necessarily explain why there was an increase in international exposure.


Risk
Good news: There is a much clearer understanding of the risks involved in the investment world. Although there are still a sizable number of senior investors (those at least 65-years-old) who are willing to take above average risks with their portfolios, most recognize the danger in doing so.

Bad news: too many younger folks are unwilling to assume risk via equity investments. While 10% of the 65-year-olds reported they take on above average risk, their counterparts in the  35-to-49 age group admitted that they do as well. Defining above average risk is often difficult to do. Related to a balance of investments, with popular sentiment suggesting a gradual decrease in more volatile investments (equities) to more conservative ones (bonds, fixed income), this group may be making these adjustments too soon in their investment lives. If, as popular sentiment suggests that we will work longer, a 35-to-49 age group could possibly be leaving a certain amount of aggressiveness untapped. If you are thinking that you will work until 70[years-old and beyond, a 35-year old should invest in much the same way as 25 year-old would have just ten-years ago.


Better 401(k) choices
Good news: There has been over the last several years, an acknowledgement of sorts from the plan sponsor world that better choices for their participants is directly correlated to the types funds offered. Fees dominated the conversations held by plan sponsors and administrators as those that used their plans turned their focus on how much each investment was costing them. Plan costs eat away at potential returns. So many plans reduced the number of funds offered and with those reductions, the types of funds offered. The shift to a larger selection of index funds and target date funds may have helped create a better investment environment for those using the plans.

Bad news: As fees were lowered amongst the plan's offering, the plan itself became more expensive. This change in how the fees are levied make both the newly low-cost funds offered simply appear as if this were a bait and switch. Fee disclosure will only increase in the coming years as the Department of Labor looks to better reporting of these costs. The trouble is you may not where to look and may be able to little about these costs. You can sue over poor investment choices. But unless you actually leave the company you work for, the 401(k) you have is what you are stuck with.

Turnover

Good news: The turnover rate in the mutual funds offered by your company's 401(k) has dropped somewhat over the years. This is reflective in the choices. Index funds have near zero turnover, rebalancing only when the index shifts. Target date funds tend to shift in a similar way but don't offer the investor anyway of knowing how much is being turned over in the funds within the funds.

Bad news: While turnover is often equated with higher fees, a certain amount of this activity is generally considered acceptable if the rate of return is increased as a result. Most investors will shift their money into a fund based on the size. And the larger the fund, the more cumbersome investing becomes and because of that, the lower the turnover.


Target Date Funds
Good news: Target date funds have increased in plan usage from a scant $57 billion in 2000 to almost a trillion dollars invested in 2010. The good news here is limited to the success of the fund families marketing strategies and the required auto-enrollment of new hires. Add to that the financial debacle of 2007-2008 and numerous investors in 401(k)s simply saw the risk in these self-directed plans as too confusing. Turning to target date funds seemed on the surface to be the most logical conclusion for most.

Bad news: Target date funds still have some hurdles to jump through before they gain my seal of approval - no that they are necessarily currying my favor. They remain murky at best. Most target date funds, with the exclusion of those that comprise of index funds only, are a fund of funds. This suggests that a fund family, rather than close a poorly performing mutual fund, simply roll the fund into a target date fund. Because of this, there are still transparency issues. Add to that the suggested target date may not be your target, that no two target date funds are at the same point in investment holdings (risk) as a similarly dated cohort, that there is no fund manager who can offer conclusive evidence that this is the best method of rebalancing and lastly, that most users tend to set-it-and-forget-it.


Fees
Good news: As I mentioned, they have dropped over the last several years. But most investors still make assumptions that fall squarely into the "if it is an index fund, then it must cost less". This lower cost is mostly true and is  normally attributed to index funds, even though some smaller index funds that track the S&P 500 charge considerably more than their larger counterparts for the same investment. Even with that in mind, an investor can build not only a well-balanced portfolio using index funds alone, they will do so at a much lower cost than any other investment portfolio in their plan.

Bad news: Most target date funds act as if they can do what they do for less, they don't. Some target date funds have expenses and fees that are well north of 0.80%.


Participation
Good news: more folks are using their options across more age groups and accessibilities. Most mutual funds are held inside 401(k)s by twice compared to those held outside. Add to that the growing number of average to lower income households entering this market for the first time using this sort of investment.

Bad news: Education still has a long way to go. Trusting, finding or using an advisor is still the purview of the more affluent investor. The average balances in these plans increased but it suggests that was a result of an increase in the stock market value rather than an increase in participation or contributions.

Mutual Funds and You: Not Always an Easy Relationship

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

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

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

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

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

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

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

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

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

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

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

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

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

Do You Know How to Invest?

There is no easy answer to this question. But in the following three part series, we will take a look at one of the more successful investors to come along in the past century. A humble man prone to self-examination and reflection. Most investors never take the time to do what is necessary to achieve this sort of inner investor peacefulness. 


In part one of this review on one of the greatest investors, Bernard Baruch, titled "Notes on Investing: Baruch and Lessons Learned", we looked at what he has learned from his own mistakes, errors that we all make and of which numerous books have been written in anattempt to correct our own investor and totally human fallibilities on the subject. 


In part two, we looked at, among other things, the art of investing and getting a good night's sleep.


In part three of this series, we take a look at Baruch, the behavioralist, predating the science and doing so by examining how people react to markets, how he responded to his own inner biases and why stepping back for a spell gives one new and better perspective. 

The Plight of the Savvy Investor and the Goldilocks Mutual Fund

We are a fickle bunch. We think of ourselves as savvy investors, although there is a great deal of room for improvement among all investors to which degree of savviness. Yet we are in almost every instance our own worst enemy. Victoria Holt is quoted as saying: "Never regret. If it's good, it's wonderful. If it's bad, it's experience". Yet still, after several decades of behaviorists studying our actions in the marketplace like so many mice in a lab, we still do the same predictable things time and again.

And perhaps the first emotion we feel once we begin to second guess each of our "investment" decisions is regret. And if the recent selling of actively managed mutual funds by investors over the last year or so is any indication, regret for past decisions is in full swing.

Adding to the chatter that actively managed mutual funds and by default the managers who stand at the helm, is John Bogle, chanting the mantra he has carried since the late seventies. Why, he has asked, would anyone choose to look for more than what an index fund can provide? And as we begin to acknowledge the pull and tug, feel the most susceptible to such cost savings as a lower fees, which is always good, index funds begin to come to the front of our thinking about which investment is best.

But once you begin to believe that getting mediocre returns in the equity markets is the "new" goal, the attempt at saving some money in terms of the fees charged by actively managed funds in exchange for the smaller returns that index funds offer becomes the overall focus. And if that is the sight path you choose, index funds are definitely the right fund to use.

In a recent report in the NYTimes on the subject of this exodus from highly regarded performers over decades to index funds in search of lower fees, one thing stands out in the numbers. This is simply a beast feeding upon itself.

Consider this: You own X amount of shares in an actively managed mutual fund and you sell. But rarely do investors act alone. They are signalled by some change in the wind, some report drilled over and over or perhaps, it is from the suggestion of a colleague. Suddenly, fear sets in and you begin to think that you have the wrong investments. The fees are too high, you think and then anything that resembles a stick snapping alarms you and your fellow investors and you run.  And then you regret.

The selling prompts the redemption of shares, which when enough investors sell simultaneously, and enough shareholders accounts need to be made whole as they leave, markets move. And if the movement is great enough, the equities drop. And so do the indexes. So you sell at a loss only to buy shares in a fund you just, via the herd, lowered.

In many instances, the outflows are no reason to believe that the actively managed mutual fund world will implode. In fact, according to Brian Reid, the Investment Company Institute’s chief economist, 93% of the investment assets stayed right where they were as the remainder moved to other investments. Among those investments - more than just index funds reaped the benefit of this change in loyalty to actively managed funds - overseas funds gained as well as funds focused on commodities. Bond fund outflows also helped boost the index fund profile.

And what did this sell-off net the exiting investors? What were they looking for? Believe it or not, index funds that are actively managed. This surprising move has some folks, including myself, scratching our collective heads.

True, the fee structure of index funds is far cheaper that that of the actively managed fund (index funds average about .16% while actively managed funds average about .97% - with many load and closed end funds added into that average and increasing it as a result). But once you let a broker enter the mix, the fee structure changes, coming closer to the cost of the actively managed fund and at a lesser overall return.

Index funds because of the tax efficient structure belong in taxable accounts - as long as the capital gains tax remains historically low. Inside a tax deferred account such as a 401(k) or an IRA, the effect is lost. This is and should be the domain of the actively managed mutual fund. And while you should never lose sight of the role fees play in the long-term performance of your investments, believing that fees are the only driver in achieving steady returns is misplaced.

And while I have nothing against index funds, the growing number of funds  that slice and dice the markets do not always lead to lower fees for investors. But talk about index funds enough, and investors won't notice nor take the time to compare one index to another.

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.