Mutual Funds for the Utterly Confused

This is it folks. We begin the book at page one. Chapter one: The Great Investor Equalizer relishes the opportunity to begin our discussion in the throes of an economic downturn. We are not thrilled by it but the chance to talk about a bear market while one is in existences is a rare chance indeed.

Mutual funds are, hands down, the best place to be during - as well as before and after - such events. Because the book, Mutual Funds for the Utterly Confused offers so many analogies, this blog will offer some deeper insight beyond what will be published in December, 2008.

We often hear the word bubble when the world of finance is discussed.

There are good reasons for this and for the numerous terms that relate to the physics of surface tension, liquids and tension. Much of this knowledge that is lifted without reference is due to the work of Italian physicist Carlo Marangoni.

Bubbles are the result of liquid with a certain surface tension, creating elasticity. But their life is fleetingly short. But pure liquid bubbles are short-lived. Add soap to the mix and surface actually stabilizes, albeit for a short time. Prior to Marangoni’s discovery, the belief was that soap added to water strengthened the liquid. What the soap did was dilute the surface concentration and by doing so, it increased the tension of the surface.

The surface of a bubble, caused by this increase in surface tension, forms a sphere, which actually has the smallest possible surface area. Two bubbles can merge, forming an object, also spherical, with the smallest possible surface area.

As we open the book, I begin the discussion with bubbles. Ironically timed, the stock market bubble in the early part of this decade – which was not well named; it more like a balloon filled with air whose contents were gradually, okay, quickly, allowed to escape – which led to the housing bubble. Which is not much of a bubble either but a slow moving train wreck. But the moniker of bubble stuck.

In the world of mutual funds, bubbles have even less meaning. The Dow Jones Industrial Averages mean nothing to mutual fund investors. I mention this because mutual fund investors need to pay attention to the much longer-range reasons for buying a fund. Even as the markets have reeled from one bad batch of news after another – and as I write this, banks are failing, Wall Street is transforming itself and begging for government intervention – read: taxpayer bailout – and the chances of a recession are all but a given with only its length and breadth as unknowns, we are simply setting ourselves up for another bubble in the future.

The surface tension of the markets is not very strong at the moment. Mutual fund investors should not care. Bold words, I realize. But if the fund manager you have chosen is going to earn her/his/their/its money, the longer the term the better the chances of profits falling squarely back where they belong. In your fund and in your pocket.

Next up: Mexican bubbles past.

And the conclusion of the rejected introduction to the book.  After this post we will begin to look at some of the colorful analogies I use to help with the topic of mutual funds.  I will be receiving the page proof next week, so I am told, and after that, the book goes to publication.

Mutual funds, when they are working at their best, employ, often unwittingly, a control theory of their own.  Invested in a variety of equities (stocks), fixed income (bonds) or currency (money markets), mutual funds seek to take some of the chaos out of the markets that are used by individual investors and control the process.  This is no easy process but then, neither is going it alone in the stock or bond market.
When I wrote the book Investing for the Utterly Confused, I was concerned that my discussion about stocks would reveal my belief that investing on your own was, even for the semi-experienced investor, too risky.  Would I leave a telltale trail that would lead the reader back to the mutual fund and away from “going it on their own”?

In the book prior to this one, Retirement Planning for the Utterly Confused, I took no such precautions.  Unabashedly, I suggested that mutual funds are the best way to get from whatever point

A you start from to the point B we all seem to be heading for.  Mutual funds in a retirement plan are the default investment in many cases.  Because that book focused on so many additional aspects of the plan we were developing for your retirement, the discussion about mutual funds was left to where, when and how to use them to their best advantage.

Now we really get to take them apart, examine the inner workings, and wonder, as only the skeptic can, why do they come in so many different flavors? The wide assortment of funds available is, at first glance, overwhelming and in many instances, redundant.  True, the high number of funds in any one fund family are designed for a wide market appeal, many still are created to test the vulnerability of the investor, much like economics games - only with real money.

We will look at you, the mutual fund investor (or soon to be) and how you think.  Only rarely can an investor successfully walk between the two worlds. Most of us know very little about mutual funds. 

Some of us know what they are, what they do, and how to zero in on some number and use that as your guidepost for investing.
 
This book is not for the individual stock investor however. Once bitten by the individual investment bug, it is hard to go back to mutual funds.  Once you shun mutual funds for individual shareholder status, you begin to eye the funds you still own in your retirement plan with increased suspicion. 

You ask yourself. “Are they moving quickly enough” realizing that nothing is as nimble as the online investor, a population of do-it-yourselfers expected to grow to over 12 million strong by 2011?  “Are they performing as expected,” you might ask, fully aware of your own personal charts and your daily balances, proof that your skills would allow you to do as well as any fund manager – if you had at your disposal the vast banks of information that they had, in real time! 

An individual stock portfolio can be energizing (or on the flip side, crippling) experience.  And yet, as a captain of your investment world, you would think you would know better.

Mutual fund investing requires all of the skill that an individual stock investor has, just without the chaos that often grips that type of investing.  Instead, mutual fund investing can be done with great success if the investor uses the control theory to her/his advantage.  In mutual funds, control exists much the way it does in a plane.  Onboard navigation and stabilization systems adjust with each little nuance in wind speed and weather, keeping the plane aloft.  Because mutual funds spread their investments over a wide range of companies, many avoid sudden gyrations that plague individual investors.  They are not immune to them, just less likely to be devastated by them.

Because most mutual funds spread the risk of day-to-day market fluctuations across many stocks, investors can employ old-fashioned, plain vanilla techniques like dollar cost averaging with great success.  The longer-termed the investment, the greater those successes can be.  More narrowly focused funds, not so much but still better than holding one or two losing stocks in a highly downgraded sector.  

Index funds, as we will learn, buy stocks numbering in the hundreds or even thousands, making all but total market crashes seem insignificant even in the short-term picture.

We will begin the book with a review on some of the basics of investing.  These are disciplinary necessities for every investor and even if you think you have the fortitude to invest without looking these important tenets, you should take the time. 

Once we have laid the groundwork, we will move on to the nitty gritty of mutual funds.  We will examine why Mr. Farrell thinks so little of them and why Mr. Barry thinks that tiger poo is a better investment.  Mutual funds have a history that was revived with the creation of the 401(k) plan, so much so, you would have thought they had had a hand in the unexpected find in the tax code.  And if they missed that opportunity, it would be the last.

Working our way through the vastness of the mutual fund landscape is no easy task.  We should have enough space to touch on virtually every kind of fund known to man or woman and offer some comments about their merit – or not. And each fund will contain a brief interview with a fund manager in that space.  We will discuss how they think, whether the fund reflects who they are, if economic news phases them, how they picked the index that their fund compares to, and possibly, even getting them to admit why they remain a mutual fund manager. 

In the process, we will discuss the fees associated with each of these kinds of funds, keeping a running tally of their worthwhile-ness.  Some funds, based on the risk and cost of research may be worth the slightly higher fee rates they charge.  But most, based on calculating performance and taxes, do not merit the fees they charge investors.

Did I mention taxes?  At the beginning of every investment, the taxman is there to cheer you on.  No one wants to see you succeed more than the US Treasury and its collection arm, the IRS.  The better you do, they better they do.  It is why the capital gains and dividend tax is always something worth consideration.  If the tax is low, investors will be inclined to divest themselves of long-term holdings in an effort to avoid paying a high tax in the future.  That means more money available to be taxed, even if it is at a lower rate.  We’ll take a look at how to position the IRS a little further down the priority list and how we structure your mutual fund investments might surprise you.

While mutual funds as a discipline all operate in a similar fashion, what they invest in and how makes all the difference to your success.  We will look at many of the rules and regulations that guide this industry and focus on some of the problems they have yet to overcome.

Many of those problems are in part due to the Wild West approach to investing that hedge funds have employed.  Mutual funds, limited by many of those rules and regulations cannot hope to compete with hedge funds in terms of trading abilities or disciplines - yet.  But many investors think they do and I’ll tell you why you should not covet thy neighbor’s hedge fund investment.

The newest invention on the market to attract otherwise smart investors from mutual funds is the daily traded Exchange Traded Fund or ETFs.  Mutual funds, you will come to find out, are priced at the end of the trading day, usually by four o’clock eastern time. ETFs on the other hand, are traded on the American Stock Exchange or AMEX all day and priced throughout, giving this once minor player in the world of stock exchanges a new life.  The AMEX handles about 10% of the trades in the US, the rest falling to the New York Stock Exchange (NYSE) or the NASDAQ.  ETFs surge in popularity came along just in time to keep the AMEX viable.

ETFs are mutual funds by nature and disposition.  The people behind them have the same focus and the people who invest in them, enjoy the thrill of having it both ways.  The differences, while subtle and on the surface almost negligible, can have an effect on how well you would do if used them as an investment and how you might benefit if you avoided them altogether. 

And no discussion about mutual funds would be complete without mentioning annuities.  Disguised as an investment but hanging out in insurance circles, annuities have a place in certain portfolios – not yours and especially not if you have a choice.  In some retirement plans, they are an unavoidable fact of life.  Because of that the conversation we will have about them is very important.  One day, you will be faced with what seems like a perfect deal with your specific needs in mind.  Some slick individual will offer you a monthly income for life, perhaps with a little life insurance policy for the survivors of the dearly departed thrown in for good measure, and the best marketing technique ever: an opportunity that seems too good to be true. 

And as often as we hear those words of warning, faced with the possibility of an annuity, we forget them.  A little talk about them will help if you are already in them and what to do if you cannot avoid them.

And the funds themselves will be put under the microscope.  They may all seem as though they are treading in deep mud most of the time, some actually do have a method to their madness. We will look at how they rank among their peers and how to pick an index to compare them to.  Unless of course, you are picking an index fund.  In that case, we will examine why they are not all created the same even though they may do essentially the same thing.

Because mutual funds are, well, socially mutual, I want to suggest we do this book as exploration how we create expectations, compete and eventually gain control.  If there is one corner of the investment world where you can successfully gain some modicum of control and a healthy dose of profit, it is with mutual funds.