Mutual Funds for the Utterly Confused

There is a lot of talk about balancing a portfolio. But little is said about what to do if you have suffered serious losses to funds in those portfolios. Do nothing if you can find other funds to re-allocate your future retirement investments. In other words, if you have held a basket of stocks (other than the company stock) and mutual funds in your portfolio, chances are, if you are in it for the long haul - more than ten years, you need not do a thing.

Do nothing to the funds but rethink your position in the stock you may own in that portfolio. Often, the stock tends to be shares of the company you work for and because they often offer additional incentives to buy those shares, they alter any effort at balance you might think you have or want to achieve. This is a selling situation for that reason alone. Keep stock outside of your retirement portfolio where you can use the capital gains tax rate or, the capital loss write-off that you may sorely need.

In the current market environment, it is extremely difficult to pick out the cases of mismanagement that would be the easiest indicators to sell. Everyone is down and some who bet big - and you enjoyed the ride as much as the next investor, was hit harder. Were they that much worse at management or did the market defy their strategy?

If you fund suffered losses greater than similar funds - and the fund is in your retirement portfolio - do nothing. But do not add any additional funds to it. Instead, open another fund that suits your newly shaped outlook and savvy. There is no doubt that you are wary and mistrusting and want to go directly into the safest possible investment. Resist that urge if you, once again, are in it for the long haul.

Outside of a retirement portfolio, you might want to sell if along with your perception of mismanagement, the fees have increased and the tax implications of holding on to it do not work out. Many funds are expecting to tax their shareholders at year end for gains (when they sold profitable holdings to pay for panicked investors who were heading for the door) and that is not what any investor needs. Sell it and buy it back in thirty-one days to avoid the wash rule. (Or call your tax preparer and ask their advice.)

It is always time to sell if the fund you bought was not what you thought it was. If you have found out that the fund family or the fund does not align with your personal goals or lifestyle, you have reached an age when a more conservative investment is better or you simply are spooked by the whole financial mess, by all means sell.

But the bottom line is this is the best time to be in funds. They are diverse, generally cost less than stocks held individually, and often lose at a smaller percentage rate that stocks.

The best allocation is a portfolio of mid-cap funds, small-cap funds, and international and emerging market funds. How you divide these is best left to you and your risk tolerance. Just remember this: mid-cap funds are buying up very profitable, formally large-cap stocks, small-cap funds are doing the same to values found in mid-cap stocks that no longer fit into the category, and international funds as well as emerging market funds will rebound, perhaps faster than US stock funds.

By 2010, I will be spending all my time discussing the opportunities you should have taken and reminding you about what we are going through now.

Chapter 16 offers us a look at some of the more specific areas of investments in mutual funds. Sector funds, Target-dated funds and Special funds that offer something of a hedge fund experience all play a role in your investments. They may not be right for everyone and probably shouldn’t be used by a vast majority of us, but their convenience and availability make them tempting targets for those that may not know otherwise.

I do hope that you have enjoyed this extended insight into the book and hope that you leave it just a little more enlightened about the world around you.

In the coming days, we will begin the blog again. This time focusing on a much more specific topic: which funds are best, which should be avoided and just what the heck is going on with that retirement portfolio of yours.

I will leave you with two quotes that appear towards the end of the book. Both by investment and economic sages whose renown needs little introduction.

The first is by Benjamin Graham, the guy who taught the Buffet guy all he knows. He said:
“The individual investor should act consistently as an investor and not as a speculator. This mean that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase.”

And the last thought I will leave you with comes from John Kenneth Galbraith: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

I realize that using the “Ask the Experts” sidebar throughout the book finds you reading about a number of long-since-dead philosophers and scientists. i do this largely out of irony - if we had listened and remembered these great tidbits of information we might not be in need of reminding so often of what is mostly common sense and because they seem to be seers of sorts, offering thoughts about where we are, how we got here and what we need to do to change the course of our financial lives.

As I approach the topic of Exchange Traded Funds in Chapter 15, I am skeptical of this type of investment. I go out on a proverbial limb to suggest that only 75% of the investors who have access to this type of investment tool, avoid it.

To that, I bring Henri- Frederic Amiel into the discussion. Mr. Amiel was great thinker, a Swiss philosopher who found himself in Switzerland at his birth, the son of Huguenot parents who relocated there in the early nineteenth century. he had the unique opportunity to cavort with some of the greatest intellectual minds in Europe. What he wasn’t was a prolific writer.

His isolation, due to his studies of moral philosophy left him outside of the aristocratic circles that many sought to dwell within. But after his death, his private journal was published revealing some interesting quips and observations that make him an expert in the very axiom I seek as a writer to maintain.Namely: a common sense approach to whatever I endeavor to do.

I use the quote in the book to suggest your approach to ETFs: “Common sense is calculation applied to life” but there are many more I could have used.

He is credited with:
“The man who insists on seeing with perfect clearness before he decides, never decides.”

and
“Truth is not only violated by falsehood; it may be equally outraged by silence”

and of course the question that every thinking person asks themselves at one time or another
“Is all my scribbling collected together- my correspondence, these thousands of pages, my lectures, my articles, my verses, my various memodanda- anything but a collection of dry leaves? To whom and for what have I been of use? And will my name live for even a day after me, and will it have any meaning to anyone? An insignificant, empty life! Vie Nulle!” As an instructor of financial information, these words ring the truest: “The highest function of the teacher consists not so much in imparting knowledge as in stimulating the pupil in its love and pursuit. To know how to suggest is the art of teaching.”

John Ray, an English born naturalist is credited with some of the most quoted quotes: Snippets such as “misery loves company” and “beauty is power; a smile is its sword” to “hell is paved with good intentions” have entered into our lexicon often without the credit given to the man who coined them.

As we continue our discussion about index funds, we ask, what happens when an index mutual fund misses investor expectations? The unfortunate lesson of this is that all index funds are not created (or for that matter, act) the same.

Reviewing that index funds operate as an investment that mimics a published index and because most of the thinking that would otherwise be involved in an actively managed fund is not there, the costs should be far lower than their active counterparts. This frugality (which was the cause for the Ray quote to appear: “Industry is fortune’s right hand, and frugality its left”) comes with the territory. Index funds need only make a trade when the index it tracks changes.

But it is that tracking error that creates problems.

John Ray was born on November 29, 1627 to a father who was a blacksmith and his mother was known as a healer and herbalist. It has been assumed that it was her influence on the young man that fostered his love of nature. He eventually entered Cambridge University in 1644, where he became expert in languages, mathematics, and natural science. His love of plants specifically and nature in general led him to become a Fellow in 1649, a Lecturer in 1651, and a junior Dean in 1658.

It was his ability at observation that grew his philosophical arguments and nurtured his theological tendencies. At the time. most religions believed that nature was separate from worship. Ray felt otherwise. But it was his ability to write about what he saw, not only in nature but about the people he taught and dealt with that gave him his legacy.

Chapter Fourteen of Mutual Funds for the Utterly Confused finds the argument for indexing the result of a long and well-debated topic that took place well before John Bogle opened his now famous index shop at Vanguard.

Consider this: “The “Efficient Markets Hypothesis” was made famous by Eugene Fama (1970) and later connected to the rational expectations hypothesis of New Classical macroeconomics. It did not please many practioners. “Technical” traders or “chartists” who believed they could forecast asset prices by examining the patterns of price movements were confounded: the EMH told them that they could not “beat the market” because any available information would already be incorporated in the price. It also had the potential to annoy some fundamentalist practioners: the idea of efficient markets rests on “information” and “beliefs”, and thus does not, at least in principle, rule out the possibility of speculative bubbles based on rumor, wrong information and the “madness of crowds”.

Fama made his observation based upon the work of Holbrook Working (1934), whose field of expertise as an econoist focused on a variety of price series, Alfred Cowles (1933, 1937), who published “Can Stock Market Forecasters Forecast?”, 1933, Econometrica was a student off American stock prices and the investors who followed them and Maurice G. Kendall (1953) who followed much of the same path of studies but did so for British stock and commodity prices. To these men, whose findings did not sit well with investors or those who thought the could forecast market direction, it seemed as there was no correlation between successive price changes on asset markets.

Keep in mind, there were no real securities regulations protecting investors at the time these three men published their thoughts. These were the early days of financial theory. Investing was largely based on intuition which made the work of pioneers like Louis Bachelier (1900) easy to dismiss.

Remember also, this was before Keynes (specializing in theories about hedgers and speculators and futures contract pricing), before Graham (who focused famously on finding value), before Markowitz and Tobin (who, according to The New School did their work as they estimated “the benefits of diversification would require that practitioners calculated “the covariance of returns between every pair of assets”), before Modigliani-Miller (who focused on the underlying assets of a firm) and before Paul A. Samuelson (1965) and Benoit Mandelbrot (1966) (who proved that financial markets did not work according to the laws of economics).

Cowles believed that the stock market was simply too difficult of an environment for any one investor to fully grasp, let alone profit successfully from. He developed the Cowles Commission Index, the first index fund but, without the use of computers to help, the fund drew only a few adherents. But the fund still exists today as the Standard and Poors 500 Index.

How can you be sure of what you are seeing? Be it mutual funds or as I mention, in the photos of Olivo Barbieri, you can never be quite certain of what you are viewing is exactly what it is.

Mr. Barbieri shoots his famous photography from the air or a higher vantage point using a method called tilt-shift. This method is a Photoshop induced tweak of aerial shots that alters what you see making the resulting image appear as if it were a model. Blurring certain elements of the background and focusing on a small section of the photo, the eye is drawn to what appears to be a staged reproduction of what the eye would have seen under normal exposure, as a simple crisp shot.

Here is an example of some of Mr. Barbieri’s work and below, why this reference ended up in the book.

Las Vegas

Venice

Los Angeles

New York

Rome

This sort of sleight of sight is fascinating but less so when it comes to your mutual fund choices.  What happens, as I ask, when you are looking at fund that presents a conundrum of sorts and flies in the face of what we have been focusing on?  Suppose a fund has high turnover, above average expenses, and a huge tax bill.  Does this fund qualify as something we should invest in despite the odd against its success, even though it may have defied those odds and performed well over three or five or even ten years?

The short answer is no.  In the world of the average investor, each ding against our gains is important.  Overlooking one means less of a return on our investment.  Add two or three and the return we might expect is compromised.  While the fund might show out-sized gains, the true return will nothing more than an altered image of what could have been.

The bottom line: stay within your boundaries and invest where the gains are good as measured against the subtractions that might alter those gains published by the fund.

Imagine for a moment the task given to Denis Diderot. He was asked to translate a work of reference titled the “Universal Dictionary of Arts and Sciences”. His resume at the time included such works as the translation of the “History of Greece (1743)”, a translation of Robert James’ “Medical Dictionary (1746)” and what is commonly known to be a free rendering of a previously published book “Inquiry Concerning Virtue and Merit (1745)”. Not known for staying within the boundaries, Diderot took the challenge of translating the book but did so on his own terms.

He wanted to do more than simply translate the work. This philosopher turned lawyer turned writer wanted to elevate the Cyclopedia to include a collection of active contributions by writers of his day, the very people he believed that were providing the cultivated class with new ideas and knowledge. He was worried that many of these great thinkers were not getting the exposure they needed to change the course of civilization.

Diderot believed his work, which he called an encyclopedia “ought to make good the failure to execute such a project hitherto, and should encompass not only the fields already covered by the academies, but each and every branch of human knowledge.” From this collection of information, all in one place, the encyclopedia would have, “the power to change men’s common way of thinking.”

I mention Diderot at the beginning of Chapter 13 with good reason. Looking inside an equity fund that focuses on value forces you to approach the investment with a wary eye. I quote Diderot: “Skepticism is the first step on the road to philosophy” and it is an important element in the purchase of this type of an equity mutual fund.

Funds as we have found out, are affected by market inefficiencies and in the equity arena, these problems are amplified. Investors rely on analysis of companies as do managers of funds. But that analysis can often be left wanting, especially when it comes to value funds. Value funds you will learn, tap into a market that has slower growth, pays larger dividends than growth stocks and is otherwise, on the border of doing good or bad depending on how much market share they can hold on to.