Mutual Funds for the Utterly Confused

Before we move on to taking a look at which mutual fund is which, beginning with the riskiest and heading to the least risky, I end the discussion on fine print (which included an expansive discussion on what risk was, which risk was which, and how to keep risk working for you) with a look at the tapestry.

Mutual funds have always struck me a s such, something art critic Matthew Gurewitsch suggested was neither focused or blurred but rather, almost pixelated, a “granular sparkle that plays across the entire surface.”

But what is a tapestry? Woven on a loom, these artworks were portable, could be hung on special occasions and in many instances, were decorative insulation. They date back to the 3rd century BCE and were often depictions of sporting or hunting scenes, religious in nature, and possibly mythical and sometimes all three.

Aside from their artistic value, their worth was increased with the weaving of gold thread throughout the cloth. This is also why so few great pieces remain. During several upheaval periods such as the French revolution, the tapestries were burnt to recover the gold.

And yes, I believe every mutual fund is a tapestry, an art form not always appreciated by everyone who sees it, not possessing the clarity of paint on canvas perhaps or the three dimensional feel of a sculpture, but art. Investors gather and weave their hopes and dreams on an idea, spread across numerous marketplaces in the hope of a return on investment.

I have always been opposed to fine print. I have seen it as the most destructive part of anything involving money. Much of what is wrong in the world would solved with the elimination of font sizes smaller than the body text. Would it increase the chances you would not make a bad financial decision ever again? Not likely. But rest assured, you would never claim the information was hard to find, that you did not have access to it, and lastly, you didn’t understand it.

And then, as if that wasn’t enough, right at the beginning of chapter ten I ask: Can you, even with all of the information you have at hand and are likely to gain in the following chapters, improve your return to be better than average?

Yes you can.

There has been a push to provide the all-important prospectus as something available online. I know online. And you won’t read it all. You won’t thumb through tens, often hundreds of pages that contain every regulation required tidbit of information the all-important investment. You will use search tools to hunt down key words or phrases. But you won’t read it.

And even if you had it delivered on the back of your mailman, you might not. But the chances that you will, especially if you allot a certain hour or so each month to your finances, are much greater than risking you will find the report more entertaining than a wasted half-hour on YouTube.

This is an important chapter for equity investors.

I write at the beginning of chapter nine, “The Bandwagon Effect” that mutual funds offer you a psychological comfort zone. Opening the section of mutual fund investing in equities is a study done by Albert Mehrabian in 1998.

In a paper titled “Effects of Poll Reports on Voter Preferences” focused on voters prior to a primary, in this cause, the Republican primary in 1996. Potential voters were given bogus information about where a candidate might have been in terms of voter popularity based on polls. Ironically, polls have never so dominated the presidential election just past. Reportedly, the increase of polling information tripled in the short span of eight years, from the 2000 election to the election of Barack Obama.

This is why invest in mutual funds. We are not perfect filters for all information. We have psychological roadblocks that we encounter when we try to make even the most informed (and often important) decisions of our lives. When it comes to mutual funds, we tend to drill down to some basics, especially when it comes to equity mutual funds.

Are they winners, short-term, long-term, whatever?

Is the fund inexpensive compared to its peers?

How much does it cost to get in?

But there is so much more and chapter nine begins with a look at the fund manager, be it a woman, man, group of aforementioned, or a computer spewing out algorithms. At the heart and soul of your fund is a manager (or team) with a charter in hand and a singular goal in mind.

And of course, with that comes the sales pitch.

Not to stray to far from what we are doing here (giving you a little more insight into some of the topics I brought up in the book, Mutual Funds for the Utterly Confused) but many of you have a dim view of what funds have done of late. And you would be only half right in blaming many of the funds and managers behind their investment strategy. The rest of the blame lands with you.

You made choices when you bought those funds, believing, if only part of the quote on page 97: “If you are not making mistakes, you’re not taking risks.” Only most of us never questioned the possibility that we might be making a mistake. Pinching our collective selves as we wondered if this might be too good to be true was not even a consideration as we loaded up our portfolio with riskier and riskier bets, narrowing our diversity down, sometimes so narrow as to chase commodity or sector funds that were focused on balancing on the head of pin.

As I said, this is something you can correct in the future. I often tell folks that I am unable to fix something mechanical because I have no idea what right looks like. In the chapters ahead, I give you the template for what right looks like and you can fix what you have based on that template.

Great countries inspire, what Americans call patriotism. But on much smaller scales, patriotism gets lost, replaced with rivalry. It might play itself out on a Friday night football game or even when two intrastate colleges play. In Italy, it s called campanilismo.

The reference is to the large bell towers that towns have erected over their rural outposts. These campaniles seem to rise directly to the sky, dominating the cityscape.

These massive, often beautiful works of art, inspire fierce loyalties. But as we leave the corporate bonds, we want to move to a more international offering. The path is much different as anyone who has ventured outside our borders understands: no matter how much you care about your country, the most importance thing you can remember is that you are not at home.

New laws and customers will determine your successes in this new land. BUt with care - and with the tools the book provides, you will do just fine investing overseas, where opportunities might be much more profitable for the wisest investors.

Here are some more pictures of campaniles, the last being the Giotto’s Tower, which dominates the surrounding city of Florence Italy.

Why do I mention Robert Glen Johnson Jr. as the opening story on corporate bonds?

First, corporate bonds, a mechanism that allows companies to raise needed money for capital expenditures such as new plants and buildings, research and development and even to fund mergers and acquisitions. Corporate bondholders receive the “first-in-line” stature that allows them to receive something, perhaps not much if you consider some of the enormous failures of financial institutions recently, but some recompense for their investment.

Preferred shareholders are next, followed by the common shareholder who benefits when things are good and can lose everything when they are not. And after discussing par and discount, premium, short, intermediate and long, taxes, yields and economic influences on these fixed income investments, chapter seven focused on these type of bonds and the funds that hold them.

But Mr. Johnson, or Junior as he was professionally known provides us with a unique way of looking at the investment.

He took advantage of what should have been obvious to every other driver and exploited it to his benefit. This former bootlegger, who developed that action-movie turn we are all so familiar with, the complete reversal, a one-eighty, at almost full-speed, took his understanding of not only how cars work but how they interact with one another as they race for the finish line, invented something much more prosperous: the draft.

He knew that of he followed closely enough to the car in front of hi, the aerodynamics of the maneuver would make his car almost free of wind resistance, something that the car in front must conquer with horsepower. Corporate bond funds offer great things for those who can take advantage of what they have to offer. But a very clear understanding of that potential is needed.

In a side note: Johnson, who was convicted of bootlegging was eventually convicted and then, quite interestingly, pardoned by Ronald Reagan. This allowed him to once again obtain a passport and to vote. Johnson sells food now after retiring from racing in 1966.

The name Oliver Goldsmith probably doesn’t ring a bell. And oddly enough, it should. His poetry was one of warning and foreboding even as the rich got richer and poor wanted to be rich.

He was an Irish poet, perhaps best known for his work “The Deserted Village”. Written in 1770, he worried that the folks who were shedding the country way of life in the hopes of riches in the cities would not come to good.

He wrote:

The quest for luxury items were leaving the poor in rural parts of the community to become even more destitute and he was concerned that his fellow poets were not comprehending the severity of the situation.

Ironically, another Oliver Goldsmith, this time his grand-nephew wrote a poem called the Rising Village, suggesting that even as the poor grew poorer, their futures could be vastly improved by visiting the New World, where villages were young and prosperous and everything seemed the complete opposite.

I mention Mr. Goldsmith because of the quote from him that appears in the book. When dealing with bonds, you are essentially loaning money to a total stranger in the hopes of profiting from the use of that money. Mr. Goldsmith offers the bond investor this advice: “Subtlety may deceive you; integrity never will”. Keep that in mind.

Municipal Bonds and the funds that invest in them are finding a rare opportunity among the economic downturn that is effecting our nation and the globe as I write this post. Chapter six, deals with this type of investment and as we have come to find out, what could be quite a lucrative one at that.

Now, between you and me, a municipal bond fund, for all of its tax advantages, especially if you live in a state where the fund provides you tax-exemptions, is only as good as the city, county or local government’s ability to repay the bondholders.

I open the chapter with a look at two scientists - yes, I refer to them often and use them throughout all of my writings - who are looking for what could be the exact moment the crust of the earth, the ground beneath our feet became solid. One of the easiest ways to do this is to find fossilized bacteria.

Ancient plate tectonics, as pictured above were found in Greenland at the Isua Supracrustal Belt, offering geophysicists a look back at some of the earliest solid ground, aged at 3.8 billion years ago. Identifying these “pillow lavas and associated dikes” and “the finding of ophiolites in the oldest known rock structures leads the scientists to believe that such rocks have formed throughout Earth’s nearly 4.5 billion year history”.

Municipal bonds and the funds that buy them are basically investors in the local infrastructure. Roads, schools and stadiums are all constructed with the use of public money that is paid back with interest. One thing to beware of though: if the bond issuer - your municipality cannot make the bond payment, your local taxes may rise to do the job, offsetting any gain you may have thought you received.

Do you exhibit miserly behavior when it comes to decision making? Psychologists thinks so and refer to the someone who has such a condition - and there may be quite a few of us out there - as cognitive miser.

Described as: “A mental characteristic in which the least amount of attention and mental effort needed to process information is used. This concept assumes that humans are limited in their capacity to process information and, therefore, make use of automatic processes (mental shortcuts, formally referred to as cognitive heuristics) that simplify complex problems. In other words, all other things being equal, we are motivated to use relatively effortless and simple mental shortcuts that provide rapid but often inaccurate solutions rather than effortful and complex mental processing that provides delayed but often more accurate solutions.”

I worry about this. This categorization of knowledge to its least common trait - often seen in folks who group people together based on race, may filter over into the world of investing on a grand scale. We may, even after having all of this fundamental and necessary information about mutual funds, investing in them, and using them as part of our retirement plans, see them as something of the same thing.

Each nuance is lost when we do that. Track records of actively managed funds - those that are not linked to an index - are simply a blur of facts and figures and this kind of thinking, this “throwing your hands up approach” or “just toss a dart approach” to investing can lead to a great deal of anxiety down the road when we realize, that not all funds are created - or managed - equally.

Absorb the details. Use your big brain. And realize, as I mentioned at the beginning of chapter eleven, investing is a fluid endeavor, like water, shifts and changes and follows its own path. Only with the right thinking can we follow that path - and without sounding too Zen-like - achieve the investment goals we have set.

It is much harder making the tough choices, the ones based on information than it is to make a blanket choice because your are a cognitive miser.

I mention the African Cichlid for good reason.

The fish pictured above actually does more than what we normally perceive fish as doing. Sure we know that they swim in schools. We know that they may even cooperate in hunting of smaller fish.

Because these fish usually gather in small groups, assigning tasks to support a breeding pair, the analogy of this species as a sort of homespun way of explaining municipal bond funds was too good to pass up.

Many of you who have aquariums with these types of fish know also that it is not all that simple. According to one team at Stanford, “In their natural habitat, male cichlids are constantly trying to ascend socially by beating each other up,” said study co-author Russell D. Fernald, professor of biological sciences at Stanford. “It would be really valuable for them to know in advance who to pick a fight with.”

This cooperation, much like the coordinated effort of a mutual fund - which by the way, depends on the participation of all of the shareholders for the fund’s success, meaning, as exiting shareholders head for the door, it is the remaining shareholders who must pay for that skittishness - allows the whole group to benefit.  Once the group disbands, each individual fish is left more vulnerable.

Mutual funds shareholders reap benefits when the fund does well and when it hits a rough patch, it is inevitable that some shareholders will sell their shares.  But when huge numbers do so - as in a panic situation - the remaining shareholders lose in numerous ways.  The fund must sell shares to pay the exiting investors and if that involves selling winning stocks, the remaining shareholders will be left with the tax bill.

Oh to have panics as simple as the one that occurred in 1907! Banks were a much simpler entity, lending what they had from depositors. Now we all know that this is not the best way to run a business, literally acting like a gate keeper.

In the early part of our economic history, bank panics were somewhat commonplace. At one point, you could count on one about every twenty years or so. 1819 saw a panic erupt after the War of 1812. This occurred shortly after the establishment of the first central bank, something that Alexander Hamilton saw as incredibly important to the economic welfare of the country but Thomas Jefferson, another famous founding father objected to creating. Jefferson saw it as “a giveaway to the rich”.

Much of that panic in 1819 came at the hands of President Andrew Jackson, who did not like the idea of central banking (a Jeffersonian) and not only would not approve the creation of another central bank, he dismantled the first, leaving a void for such an important institution that lasted over seventy years.
Panics began to crop up with increased regularity. In 1836. President Jackson’s view of central banking as the “root of all evil” did little to help the rising economic prospects of the young nation. Foreign investors stepped in and extended credit where a central bank once have, and with so many currencies, goods being bought and sold, land being purchased and products being grown or developed at a pace unlike any previously seen, left the whole economy in a state of confusion. There was also a currency confusion brought on by overseas borrowing which created “redundancy of credit and of the spirit of reckless speculation engendered by it were a foreign debt contracted by our citizens”. We had a depression.

By 1857, the panic that occurred was due largely to improved telecommunications at the time. A business could run into financial difficulties hundreds of miles away, news that would have taken weeks or months to reach the financial capitals, was now available almost instantaneously. The telegraph caused yet another panic. When a branch of the Ohio Life Insurance and Trust Company failed, the stock market plunged, jobs were lost and food in the inner cities became scarce. Add to that, the over-speculation in railroads and real estate and you have yet another depressive reaction to a lack of central banking authority.

Jay Cooke and Company was a large and respected banking house, who had “helped the U.S. Government finance the Civil War and also underwrote the construction of the Northern Pacific Railroad. On September 18, 1873 it announced that it had failed.

This failure, reported in the morning New York Times panicked some investors who sold in the morning on the news. Other investors, having seen panics come and go in recent decades, held on as long as they could until they were no longer able to because of a margin call. This is the single most feared term in investments: a call to return the money the investor had used to borrow stocks. Once a stock reaches a certain level, the lender can demand refund and sell shares to obtain it. Remember, investors actually held paper stocks that needed brokers to transact the sale.

Railroads had been seen much the same way as the internet was less than a decade ago. Full of hope and promise and the way the future would unfold. Commodity prices were high and investors were pouring money into speculative bets that these prices would stay up forever. “August Belmont, J.P. Morgan and Henry Villard“, warned president elect Grover Cleveland that a panic was nearing, and used the opportunity to add pressure to get him to repeal of the Sherman Silver Purchase Act of 1890. Then, just before the inauguration, which was held in march not January as it is now, the Philadelphia and Reading railroad failed. Commodity prices on grain and steel fell through the floor.

J.P. Morgan is mentioned in the book for his spearheading of the notion of central bank and his ability and strength of will at bringing a coalition of bankers together to offer secured lines of credit to corporations that were being persecuted by the trust-busting efforts of President Roosevelt. Mr. Morgan also convinced the government to make deposits in these banks allow credit to unfreeze - at least temporarily. Even though there were now twelve banks spread across the country, lending money to each other, nothing central had been created nor was it very well coordinated. And then, “On February 26, The U.S. Congress passes a General Appropriations Act, including a provision increasing to $12,000 the annual salaries of Cabinet members, the Speaker of the U.S. House of Representatives, and the Vice President; and to $7,500 the salaries of members of Congress. On March 13, A financial panic begins with a sharp drop of the stock markets.”

Recent history (Panics in 1929, 1987 and most recently, 2008) has taught us that panics happen, although for different reasons and under vastly different circumstances. But generally, at the heart of all panics is over-speculation, poor understanding of credit and the belief that nothing could ever go wrong.