Archive for the ‘mutual funds’ Category

Dear index buyer, you too are an active investor

The “consensus” view of personal finance right now is that we should all be index investors. It’s been well documented that active mutual fund managers have a poor track record of getting above-average returns. According to Standard & Poor’s, the S&P 500 beat 72% of active funds that invest in large companies. So, the theory goes, stick with a mutual fund that simply invests in everything and charges an extremely low fee.

But even if you’re an index investor, you do ultimately have to make choices about your asset allocation. You need to decide how much you’re going to put in a U.S. stock index fund, how much you’ll put in a U.S. bond index fund, an international index fund and on and on.

At first, financial planners and magazines like mine started making recommendations about that allocation based on readers’ ages and risk tolerance. Then “balanced” funds came along. They would let you decide on what mix of stocks and bonds you wanted based on your age or risk tolerance, and the fund manager would maintain that 50-50 (or 60-40, 70-30 etc) mix between a stock index fund and a bond index fund.

I previously wrote about my interview with Chuck de Lardemelle and Charles de Vaulx of IVA Funds. As part of my end-of-the-magazine-cycle clearing up of my desk, I listened through the interview again. De Lardemelle and de Vaulx run active funds that cross all asset classes. They can move money to cash, high yield bonds, U.S. stocks, international stocks, gold…you name it.

For a passive investor trying to build out his asset allocation, such a fund is a nightmare. If you invest in a set of mutual funds and an IVA Fund is one of your picks, you might think you have 50% of your money in stocks and 50% in bonds. But if de Lardemelle and de Vaulx decide to, they could swing the balance in one of their funds from stocks to…gold. Or, recently, to high-yield bonds.

So here’s the question: Should you decide your asset allocation or should an “expert” do it?

You can’t answer, “But I’m a passive investor! I invest based on my age and risk tolerance.” To me, allocating based on age is also an active choice. You’ve decided that in the long-term, certain historical trends will continue, making an age-based portfolio the most likely solution to get you to your goals. 50% of my savings will go into stocks today just as 50% went into stocks at the height of the tech boom and the trough of the tech bust.

I’ve seen enough evidence to convince me that most active managers are poor stock pickers. But I haven’t seen a lot of research telling me one way or the other if active managers are poor asset pickers.

Here’s what de Lardemelle said when I asked, “Since they don’t have much time to devote to thinking about investments, shouldn’t our readers just allocate a certain amount of their portfolio to each asset class and be done with it?” When reading his answer, keep in mind that he’s trying to sell his fund.

You’re right that it’s hard to pick companies to invest in internationally if you don’t spend time doing it. But if you try to do it yourself through index funds, what you’re basically doing is trying to figure out an asset allocation. And that’s not that easy either. You need a lot of data. You need a lot of experience. Usually the stuff you want to be in is the stuff that’s been forgotten by anybody and everybody.

There are few funds that have taken on that challenge of being a fund for all weather and that can shift gears from one asset class to another. Usually you have a mutual fund that does Southeast Asia, another fund that does small-cap value in the U.S. or whatever. That is I think how we differ from so many others. We can do high yield, cash, gold. There are few funds like that. I think it is a small piece of the market that’s going to grow. Basically, financial advisors themselves are looking for funds that take the burden of asset allocation off their shoulders.

Is that the right path? I’m waiting for someone to come out with an actively managed fund that only invests in index funds. “That’ll be the day,” you scoff. But is that much different than hiring a financial advisor to determine your allocation?

Update: After thinking about it for a bit longer, I guess actively managed funds of index funds do exist. Many target retirement funds or balanced funds have investment committees that tweak allocations based on what they see in the marketplace. I never thought of target-based retirement or lifestyle funds as being “active” funds before but I guess that’s not far off base.

– Joe Light

The scariest thing a fund manager’s ever told me

I was just organizing some old notes from last year and ran across this gem of a quote from a mutual fund manager. My notes were hasty, and this is an old interview. So you should definitely take this as paraphrasing, but here goes:

Sometimes you have to know when to ride stocks on the way up even when you know they’re overvalued. I mean, if I didn’t do that, I’d miss out on some serious profits. You ride on the way up and then get out before the bottom falls out.

I’m not going to say who this was, because I don’t even remember the context of the interview. But good lord, does that kind of sentiment send shivers down my spine. Normally, when we think of mutual fund managers, we make a distinction between “growth” and “value”. Value fund managers invest in companies based on its low share price relative to its earnings. Growth fund managers are willing to pay a higher share price because they’re in the business of predicting what those earnings will be several years from now.

Dancing with a bull market

Dancing with a bull market

I feel like “momentum” fund managers deserve their own category — the quoted fund manager was definitely one of them (at least a component of his strategy was, anyway). Momentum investors are quintessential market timers or stock timers. They invest in a stock, not based on any valuation metric or growth estimate, but simply on how the stock price has moved in the past. I can’t say that their strategy is bunk. In fact “positive feedback” has become a pretty well established fact as the driving force behind bubbles like the real estate and tech stock booms. (For an early take on the subject, see a paper by the director of the National Economic Council and former Treasury Secretary Larry Summers.)

What bothers me is that those irrational swings in market sentiment that drive price are far from predictable. The fund of the manager I quoted trailed the market each year between 2005 and 2007 (he underperformed the market by more than 25% in 2007) before outperforming in 2008 and so far in 2009 (he outperformed the market by more than 25% last year.)

When you add those periods of under and overperformance up, you get a mutual fund that’s performed a little bit under the average for the market, a little bit over the average for its category, and I imagine has given quite a few investors heart attacks in the process. I wonder how many even stayed in the fund after those underperforming years.

There’s no question that the market has irrational tendencies. But personally, I prefer strategies that count on the market’s return to reason rather than count on its continued deviation from reason. Why? Well for one, ultimately, a company (or the companies a fund holds) is only as good as the profits it gives you. If a share of Company X had an earnings yield of 10%, that means your money is earning a 10% return no matter where the stock price goes. Alternately, and more accurately, you might look at the dividend yield.

Investing with the expectation that the share price will go up is kind of like buying into a Ponzi scheme. The stock will only give good returns as long as other suckers step in and drive it up even further. If you’re the last one holding the bag, and the company doesn’t make enough money to justify the share price, the price comes tumbling down.

As mentioned in a previous post, investors might already be starting to put a renewed interest in dividends. Some studies have shown that dividends, not rising stock prices, have been the source of market returns for some time.

I think of it this way: Pretend the market shut down, and you were stuck holding all the companies you own in your portfolio right now. Wouldn’t you want companies that are paying you money? Shouldn’t a fund manager want the same?

– Joe Light

Why your mutual fund company thinks it can rip you off

For the first time ever, a federal court has sided with investors who accuse their mutual fund company of charging excessive fees. Shareholders of Ameriprise funds sued the company for charging higher fees to the fund investors than what they charge for similar institutional accounts. gavel-by-jason-morrison

This quote, from an e-mail between Ameriprise officials, is priceless:

Even before the Board’s request, there is some indication that Ameriprise knew that a fee discrepancy between institutional accounts and mutual funds might concern the Board. In response to a Wall Street Journal article that discussed the industry-wide disparity in fees, an internal email noted that “this could come up in a Board meeting” and suggested that “we should have a reply, though it may or may not be convincing.”

No kidding.

You can read the entire court opinion here.

Some of the more damning evidence is how Ameriprise apparently set its mutual fund fees. According to testimony from Ameriprise’s own board, they charged fees not based on what their actual costs were, but on what they could get away with.

Ameriprise entered the negotiation with a pricing philosophy wherein it attempted to establish fees that were “in the middle of the pack of funds with a similar size, objective and distribution model.”

Don’t you just love it when a fund company strives for mediocrity?

The funds in question are Ameriprise’s RiverSource funds. Just take a quick look at Morningstar’s fund family page, and you’ll see why investors should have known these were a bad deal going in.

78% of RiverSource’s funds charge a 3% to 6% upfront load for the privilege of investing with them. In other words, to even get into an Ameriprise fund, someone who invested $500,000 over a number of years would have paid an initiation fee of $15,000 to $30,000. Even after that sacrifice, RiverSource funds still charge annual expense ratios of between 1% and 2%. In other words, after paying $30,000 up front, that investor then paid RiverSource about $5,000 a year to keep managing his money.

And, as mentioned in a previous post, that doesn’t even include the mutual fund’s brokerage fees.

But lets take one fund as an example and see just how much Ameriprise was potentially overcharging the little guys in comparison to its top customers. According to recent returns on the RiverSource Disciplined Value fund, institutional clients were charged somewhere between 0.38% and 0.74% in expenses per year. That’s very low.

The equivalent mutual fund? 1.28%, or more than four times as much, depending on the year.

Loyola University professor Charles Murdock testified on behalf of the investors that “the advisory service provided to the mutual funds was similar, if not identical, to the service Ameriprise provided to its institutional clients.”

So riddle me this: Why does a mutual fund company charge small investors twice as much as big investors for the same service?

I have a sinking suspicion that it’s because they thought they could get away with it.

Let’s hope this changes.

– Joe Light

I’m a stock. You’re a bond. Target-date retirement funds are a pain.

When it comes to retirement planning, sometimes simple, no-brainer concepts take a hell of a long time to catch on. Take “human capital,” for instance. The basic idea is this: Your wealth is not only made up of the cash, stocks and bonds in your portfolio but by your future earnings potential. worker-in-suit-by-steve-woods

So, a 24-year old might be concerned that he only has $10,000 saved for retirement, but can rest easy that he has another $3 million in potential earnings over the course of his career. A 66-year old with only $10,000 in savings would be a little more worried.

“No duh,” you might say.

But let’s take a slightly different scenario. In the first case, take a 35-year old advertising salesman, making $70,000 a year (Note: this is improbably high, but possible). He has $50,000 saved for retirement. His pay is good but unpredictable. Depending on factors outside of his control, like the economy, he might have a particularly good year followed by a string of dismal years.

Next, take a 35-year old tenured professor, making $70,000 a year. He also has $50,000 saved for retirement. As long as his college merely survives, he’ll always have a job and depending on the school’s policies, will always get a moderate pay increase until he retires. He’ll get to work as long as he’d like and can pretty accurately project his income for years and years out.

The ad guy’s earnings are “stock-like” – erratic with possible good and bad years. The professor’s earnings are more like a bond – steady and easily forecast.

Now which of these guys do you think can take more risk in his portfolio? To me, it seems pretty obvious that the ad salesman should save more now and keep more of that money in bonds just in case his earnings take a dive.

But surprisingly, that concept hasn’t really caught on in retirement planning until recently, with the writing of York University professor Moshe Milevsky’s Are You a Stock or a Bond?. To see an interview Money magazine recently conducted with Milevsky, click here.

In my mind, it’s yet another blow to the idea behind target-date retirement funds. The 35-year-old ad salesman might be better advised to get into the target-date retirement 2015 fund (as if he were retiring in his 40s) than to pick the 2040 fund.

And to all you mutual fund companies, I pose this question: Why not just call them what they are? Why not call it a 90% stock/10% bond fund (or 90/10 Fund, 70/30 Fund, etc.) and let the consumer know that he’s going to have to figure out for himself what his proper allocation is or get help?

That certainly beats oversimplifying the most important investment decisions a wannabe retiree will make.

For another post on target-date retirement funds, click here.

– Joe Light

Why your fund’s expense ratio is only half the story

I just got out of an interview with Ric Edelman, a financial advisor and asset manager. The conversation was wide ranging, but he pointed out a weakness in reported mutual fund expense ratios that I hadn’t thought about until now.

When we tell people to find funds with low fees, most often, we’re talking about a fund’s expense ratio. It’s that seemingly small percentage of assets that a mutual fund company takes out of your fund to pay for things like fund manager salaries, rent for their offices, and so on. Of course, over time, just one percentage point of difference in your return can make a huge difference. (See chart, and sorry about the color issue. Needless to say, the fund with the lower expense ratio is the higher line.)

Growth of $10,000. Assuming an 8% annual return.

Growth of $10,000. Assuming an 8% annual return.

Unfortunately, that expense ratio, found so easily in the prospectus and categorized at Morningstar, only represents a fund’s ongoing costs. It doesn’t include the transaction costs that can bring down a fund’s actual return. In something like an index fund which has low turnover, that cost will be negligible. But in an actively managed fund, in which a manager is buying and selling stocks all the time, Edelman says that the fund’s total expenses can sometimes be significantly higher.

Let’s take the Dryden International Value Fund, by way of example. I’m not trying to pick on them. I just noticed that their portfolio turnover rate last year was 27%. In other words, it switched out about one in every four stocks that it owned last year. In the past, the fund’s turnover has been much higher, hitting a pinnacle of 121% in 2005.

According to the fund’s prospectus (page 53), the no-load shares’ expense ratio is 1.31%.

But let’s see how much that 27% turnover cost them last year. In the fund’s “Statement of Additional Information” on page 86. You’ll see that the fund spent $156,431 in brokerage fees last year. According to Morningstar, the fund’s Net Asset Value right now is about $136 million. That means that investors paid an additional 0.11% for those transaction costs without knowing it.

I’m not saying that 0.11% is a lot, but it seems like that kind of off-the-top fee is exactly what investors think they’re getting in an expense ratio. And according to a study by a few researchers from Boston College and Virginia Tech, the trading costs of a fund can sometimes exceed that of the expense ratio.

It took me about 30 minutes to find that Statement of Additional Information and calculate the added cost. If it’s unreasonable to do that yourself, a reasonable proxy is to just look at the turnover rate, which is pretty easy to find in the prospectus. The higher the turnover, the more you’re likely paying in hidden broker fees. But besides that, you probably want a mutual fund manager who picks stocks for the long run anyway and doesn’t have to switch around a quarter of his portfolio every year.

– Joe Light

Why do mutual funds get prizes for losing money?

The 2009 Lipper Awards for the best mutual funds of last year were given out last week. Here’s the list of winners. While one of my colleagues at Money Magazine finds it pretty ironic that awards were given to funds that actually lost money in 2009, it doesn’t really bother me. money-prize-by-taroslav-b

The Intrepid Small Cap fund, for example, lost 7.1% last year. That’s pretty bad, but it’s more than 25 percentage points better than the small cap category as a whole. The bottom line is that small caps were a bad class of stocks to be in last year. The best decision you could have made (though no one could have seen this at the time) was to avoid small caps altogether. But unless you’re in an actively managed balanced fund, that seems like the kind of decision you should have made, not the fund manager. If the small cap category returns a positive 20% this year, you’d better believe that investors would be mad as hell if their small cap fund manager had moved a lot of the fund’s money to cash because he thought there were dangers in the sector. (Ironic disclosure: Intrepid has 7.5% of its money in cash, which is actually quite a lot. I wonder if that cushioned their losses last year.)

To easily see how your mutual funds are allocating their money, check out Morningstar. Most features on the site are free but might require registration.

Another useful tool whose founders I recently spoke to is Mutual Decision. Take a gander at the “Active Share” tool which will show you how active your “active” mutual fund manager really is by comparing his investments to those of his benchmark. After all, there’s no reason to pay a manager 2% a year if he’s mostly just following an index. The site (which costs money but has a free trial) was founded by a few college professors at Georgetown and Rutgers. They basically take academic studies on mutual funds and develop tools that allow investors to apply those studies to their investments. Interesting stuff, but I’d stick to the free trial until its proven that using the tools can actually save you money.

– Joe Light