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.

The One Fee You don't need in your Mutual Fund

Mutual funds, as we all know, are a group effort. The thinking goes something like this: the more investors in the fund, the higher pool of available cash for investments. To attract this pool of investors, mutual funds advertise. A 12b-1 fee is essentially the cost of this advertisement. If you are buying a fund from a broker, chances are they were compensated by this fee. On the surface, this costs seems to be one of those cost-of-doing-business fees that for the greater good of the investor pool is levied on all the owners of the fund.

But what if the fund is charging you this fee inside your 401(k)? Should you pay for something that has already been marketed to your employer? This sort of fee was first introduced in the late seventies when investor distrust of the stock market was at an all-time high. Mutual fund companies argued that in order to keep their product viable, they needed to increase the number of investors and the only way to do this was to advertise their product.

Fast forward thirty some odd years later, past the greatest bull market, past the introduction of the 401(k), past the two big bubbles of the first decade of the 21st century, past the default investment in our retirement plans, and the fees still exist. According to SEC Chairman Mary L. Schapiro, the reasoning for these fees, which are paid by the investors in these funds has passed. In a press release detailing the SEC's examination of this fee, Ms. Schapiro writes: “Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating.” That lack of transparency at a time when we want to see what our fund dollars are doing when they are not generating returns is troubling.

So the SEC believes that the need for 12b-1 fees has passed. “Our [SEC] proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.” Yet, like all decisions of this nature, there are bound to be casualties. 12b-1 fees are still used by smaller fund families for the very reasons they were initially adopted: to grow the pool of investors. Larger funds families, who have household names and a firm foothold among investors still levy this cost on its shareholders.

Inside a 401(k), where you are essentially a captive audience, these fees offer no benefit. According to BIll Barker, writing for the Motley Fool "They are not used to improve the research of stocks bought for the fund, nor in any way to improve the performance of the money already invested in the fund." And because of that, he opposes them. So do I.

Without any identifiable benefit to existing and often long-term shareholder, the cost of this fee, often $2 on every $1,000 invested should go away. Inside a 401(k), this fee is something bordering on criminal. In a closed fund, one where the fund is no longer accepting new shareholder but still allows current shareholders to contribute to the fund, 12b-1 fees are an abomination, costing their fund participants millions of dollars. (A mutual fund can close for a variety of reasons, the most popular being that they simply have too many shareholders which makes investing according to the charter difficult.)

If you have funds in your 401(k), tell your plan sponsor to do something about it. This is fiduciary responsibility they may not have been aware they had. If your mutual funds still charge these fees and you agree with the investment community - the folks who put their hard-earned dollars in, not the people who sell these products, let the SEC know. You have until November 5th to voice your opinion. You can do so here.

The Overvalued Emerging Market

It is easy to be attracted to emerging market mutual funds in your portfolio. If you are investing through a 401(k), you have noticed in your last statement how well they have been doing. Your US equity funds have done well over the same quarter or even perhaps YTD. But the contrast with the mutual funds that might be available to you that invest in other countries might have caught your eye.

Return envy is still one of the primary weakness that investors have. They see a fund that has done well, in this case, almost the entire sector, and we jump, feet first without knowing whether there is a shallow bottom or not. In the world of emerging market mutual funds, that bottom might be closer than you realize.
Emerging market mutual funds have a great deal of headwind to navigate as they get those returns. And just like the days of yore - only two years ago or so - risk is the reason why. Those risks are numerous.



First is the money issue. No country can be considered a viable investment unless they have a good banking system. That statement could be the reason why many stateside investors have looked to other countries for their investment needs. But in truth, the US does have a better banking system than most countries abroad. In its defense, it is able to survive a serious economic blow, put together a plan to recover from it and, although it can be criticized for many of its moves of late, it will still survive even if it is has already shown much of its financial hand. The simplest way to do this si compare a developed and mostly mature system such as that of the US and those in that outperforming emerging market fund.


The second issue is politics. We might have what seems to be a chaotic and disagreeable political system. But because of that robustness, we can be assured that even though we don't know what taxes will be, the discourse on how much we pay will be discussed at length and resolved with compromise. In addition to how the government operates, it is still a business-centric governing body that even when it falters in doing what it considers right, it does what it considers best for the creation of jobs. And even if the US seems to be burdened with regulations, many of which are direct and legislative reactions to abuses, countries overseas have placed these sorts of restrictions before the fact. This keeps investments and innovation under the control and purview of whomever is in charge at the time.


The third issue is economic freedom. While we take capitalism for granted, it si not the case in the largest emerging markets. It is often difficult to comprehend that a country the size of China or India could be considered emerging. But the definition of emerging suggests that while growth seems to be on pace and often well-beyond that of the US and Europe, it is done without the transparency that we enjoy. If China has the ability to drop a trillion dollars in cash into its economy - something a developed country would need to borrow to do - this offers a glimpse of instability.


The fourth issue is risk. By risk I mean your ability to predict and project how much you might make and how much you might lose. Most of us don't do this sort of metric exercise prior to shifting our money from one place to another. We look at all of the basics: return, tenure, return, cost, return, risk, return. And then we buy.

Understanding the risk in an emerging market mutual fund is much harder because of the reasons I have already discussed. But risk comes in numerous forms and the one most likely to derail you is diversity. You may, through your target date funds, your index funds, and even your bond funds, all of which may bill themselves as domestic, may have placed some of your money in markets your are currently looking at with envious eyes. Diversity in a portfolio simply suggests that of there is trouble in one place, not all of the investments you own will be impacted the same. Some will fair better than others.


The fifth issue is investor impatience. Most emerging markets are not near maturity and therefore have a period of time to traverse before they become more reliable. Political unrest needs to be quelled, businesses need to feel as though their investments are safe from political unrest, money needs to be available to be borrowed and infrastructures are solid enough to make it all possible. This is difficult feat in developed and relatively stable economies. Imagine a country on less solid footing, unable to embrace different political outcomes and survive them more or less intact. Which means, the investor who is willing to pay the higher-than-normal fees for such funds, need to wait a much longer time to get back what they have invested in portfolio risk and cost.

This is not to say you shouldn't have emerging market funds. Ten to even twenty percent of a portfolio would be acceptable in most instances. Just be prepared for cloudy days and they will come and you will want to sell. But the developed world needs emerging countries to buy their goods. In that sense, the investment becomes symbiotic and over the long term, you will probably be pleased. But be warned.

(One final note: the exchange traded fund - ETF - market for emerging market investments has grown substantially. In this author's opinion, the risk of selling too frequently and chasing minute returns, as ETF investors are more likely to do,  poses just as much a risk as you would face if you simple held this investment for a longer period of time.)