Mutual Funds for the Utterly Confused

Why do we always want to lead new investors, those who have not begun participating in their retirement plans at work or their self-directed plans using IRAs,  down the path of the least resistance? A recent thought I bumped across online suggested that buying that first fund was similar to a first date.  And that might be true.

Yes, buying your first fund is like a first date. But no second date ever occurred until there was at least some familiarity with who (or in the case of investing, what) you were dating. You will spend that first meeting getting impressions and feedback, reactions and input and in the end, you will rely on your feelings. These are complex emotions, some genetic, some conditioned through experience.  For the first time investor, these are noticeable absent. 

Finding the right mutual fund is no easy task.  Why then, do we suggest a point and click variety of investing for newbies?  How often have you heard folks who consider themselves sage investors offering an index fund or worse, a target-dated fund, as the best road to travel those first steps as if there were nothing to it!

But as every investor in America now knows, there is more to it. Every investor in America is questioning those first impressions, their initial reactions to investing and those wonderful feelings that an ever-rising stock market gives. All questions that they should have asked on the “first date”.

Index funds are too tax efficient to be used by 401(k) investors, especially newer, younger ones. Target-dated funds are still unproven (yet well-touted and grossly oversold) investments that offer fund of funds opportunities.  The arguments many make: the S&P 500 allows you access to 500 of the largest companies in America; target-dated funds rebalance as you get closer to retirement so you don’t have to think about allocation. 

Let’s take a moment to clarify.  Often, investors fail to consider tax efficiency.  If a fund sells very little over the course of the year - and index funds only change holdings when Standard & Poors company shifts the members of their index.  The buy and hold strategy does not create profits (or losses) until the underlying stocks (companies) in the index are sold.  Inside a 401(k), you defer these taxes until you retire.  When you retire, you are assuming that your tax bracket will change to a lwer level and this is why something that generates low tax consequences should be kept outside your retirement plan.  Currently, the capital gains tax is 15%.  My argument is: why not pay for it now when it is low rather than wait until retirement.  Actively managed funds are less tax efficient and because of this are better for a portfolio that hopes to pay less in the future.

As for target-dated funds, the type of investment Wall Street would love to see you have and one they lobbied exptensively to get included in the Pension Protection Act of 2006.  This Act makes target-dated funds the default investment for those who are just beginnig their investment lives and know little about what to do pr how to do it.  often referred to as lifestyle funds, these investment pick a year when you plan on retiring and shifts the underlying investments from growth oriented to conservative based holdings as you age.  The problem with these types of funds is what they are.  Often, target-dated funds include a basket of funds that may or may not be doing well enough to stand on their own.  These funds are included under the guise that they provide diversity when, in many instances, they simply keep underperforming funds alive well past their expiration date.

Should you be in a position to speak to a new investor, you would be doing a greater service to them by doing two things: spending some time with them explaining nuances, your experiences and your thoughts concerning investment education and then, secondly, finding a basket of funds in their plan that offers a little of everything.

For the younger investor, some aggressiveness is an absolute necessity. Some growth and some value as well as something like a bond fund would make up a decent beginning investor portfolio. For the older investor, less aggressiveness but still a large part of the portfolio involved in stocks.

Then the conversation can turn to the perils that may lay ahead and how these are often overlooked when markets recover - and they will - and the value of dollar cost averaging even when they are not doing well.

Some employer continue to offer a 100% match up to a certain percentage.  Some have scaled back on this perk choosing instead to focus on the business rather than the employees who work for them. Even if that occurs, would you tell those new investor that they should still be putting at least 5% away? And why.

When we find ourselves in the role of mentor for new investors, we should take the task seriously.  Just getting them in is not enough.  Simply saying, invest in an index or a target-dated fund passes off our fiduciary responsibility, one we assumed when they came to us for input and advice.

Keep in mind that the first date is not like their first investments.  Spurned investors aren’t as resilient as a spurned dater. Loneliness and the need for company and companionship pull daters back into the date. But investors who have had a bad experience, tend to never go back or worse, go back conservatively.

If you are ever in a position to help someone who has asked “what should they do”, do not simply pass off the responsibility.  Helping them might also shed some light on your own thinking, how you approach your investments and whether the philosophy you brought has worked.  Introspection is hard.  Lack of it is simply irresponsible.

Fees have dropped - and as you might suspect in a post-downturn world. What investors need to concern themselves with now is the term “average”. Average will be touted as a way to attract investors and many actively managed funds will try to stay as close to what the markets consider average as possible.

Over the years, fees have dropped. This is due in large part to the proliferation of index funds that have cropped up in just the last five years. These funds have driven the average fee charged by a fund down almost a half of a percentage point - which can mean thousands of dollars that will be invested (or re-invested) rather than paid to fund managers.

The problem is that many of these funds that consider their portfolios as actively managed have charged relatively the same fees with little or no price breaks. There is good reason for this. Research and trading costs have become less expensive but the cost of satisfying shareholders - not the fund investors but the public companies that own the fund itself, have begun to demand better performance. The only way to do this is through increased fee structures.

What investors should be most wary of is actively managed funds trying to mimic index funds and garnering higher fees for the efforts. I think we will see much more of this as the markets try to recover and fund managers attempt to keep pace - and attract new investors.

But higher fees - at least in the arena called “fee expense ratios” - are on the way. Even for index funds. A recent Wall Street Journal article reported “The decision by low-cost stalwart Vanguard Group to raise expense ratios for many of its mutual funds is a clear sign to investors of a tough year ahead.” Expect fees to go from 0.2% to 0.5% - not earth shattering by any means but an increase that battered portfolios are not welcoming. Higher fees and lower overall performance point to less in the investor’s portfolio - indexed or not.

With “the industry’s total assets under management fall to $9.5 trillion from $12 trillion”, the increase in fees, used to cover operations is seen as the only way to recover some of the lost costs for maintaining the current investment structure. Keep in mind that in 2008, the industry average mutual-fund expense ratio was 1.19%. Some of you are paying much higher. And as a rule of thumb, much higher that 1.5% is too much to fork over no matter what the fund promises to return.

But help may be on the way. In the fall, the supreme court begins to hear oral arguments concerning the accusation that institutional investors received lower fees - substantially in some case - than individual investors. The case charges collusion was present as the board and fund manager made conscious decisions to do so. This may take the market out of this type of pricing.

For more info on which fund charges what, checkout this Zack’s Mutual Fund Screener.

It is easy to second guess. In fact, the ability to guess at all is something only humans can do. We can weigh the possibilities of one move over another, project outcomes and chose which path we are better suited to travel. It may be something unique to our species, but it is incredibly frustrating when it comes to investing.

With so many choices and numerous potential outcomes for every decision we make, mutual funds are open to criticisms that other investments are not usually subject to. Stocks are straightforward (although beneath the veneer we have found is often some nefarious dealings that seem undisclosed upon cursory inspection) and bonds are what they are (except when they default and simply leave investors in line for pennies on their dollar). Mutual funds rely on performance.

So it is easy to say thing like: they make money for their managers when they lose money for their investors. It s the AIG paradox, anger over profits that aren’t fully shared with those who believe their slice of the pie is far too small.

But mutual funds are different. To answer the question of whether they ever make money, something numerous folks have emailed me asking: yes they do but it is over the long-term. See this related post for more info: http://mutualfundsinvesting.blog.com/4748146/

Secondly, when most of us invest via employer sponsored programs such as 401(k) plans, your employer does so and encourages this kind of investing in mutual funds because nowhere, in any other investment can you find a broad based portfolio. And it is their obligation and fiduciary responsibility to see that you are doing something for your future. Even if you do it incorrectly and even if the market doesn’t satisfy your expectations.

Third, all mutual funds have done poorly over the past year - but then again, so have almost every stock and bond, save for Treasuries and they, according to Roger Lowenstein in this past weekend’s New York Times Magazine, are also poised for trouble.

Fourth, paying a fund manager more than 2% is too high when similar services can be had for much less. Finding low-cost alternatives is always the best option although most people look for the best performance before they consider the cost of what the fund will charge. Use 1.25% as the high end of your baseline when choosing a fund for purchase. Yes fund managers get their money no matter whether they win or lose, but consistent and unexplained losses don’t reward them with tenure in most cases or new shareholders.

So don’t give up on something you only have passing knowledge of or second guess a tough environment for any investor. Instead, gain more info and make decisions that you have not made. Such as how much risk can you tolerate, how much money are you investing and, more importantly, why.

When I wrote about mutual funds in my book “Mutual Funds for the Utterly Confused - McGraw-Hill 2008“I mentioned the very first mutual fund. Opening its doors to investors in 1924, Massachusetts Investor Trust became the first mutual fund. Until that moment, a stock could only be purchased by certificate - yes they issued paper - and this made access to markets for the average investor expensive and difficult.

Mutual funds have used this fund as a template for how they give investors access to stocks and bonds across a broad range of companies and for a reasonable price (expenses for this fund run around 0.85%). Keep in mind, although innovators tried to open an index fund but the need for vast calculations made these types of funds inaccessible for another fifty or so years.

For those of you interested in this fund, it has taken a beating along with the rest of the market - which is the point Chuck Jaffe is trying to make. It isn’t the fund - it is the markets that go down, dragging the fund with it.

We sometimes place too much emphasis on the skills of the fund manager. This is often not fair. They must, under many circumstances, try and bail water while keep the ship headed in the right direction and do this, while investors stage a mutiny. Not to mention, he or she must attract new investors at the same time. In many instances, it would be like selling a house that is on fire.

For brief moment, revel in the birthday celebration of this historic fund and its achievement over the last 85 years. And even if things are not appearing to be the same, they sometimes can be if we are patient enough to wait.

Not many of us like the term average. It implies that you could have done better while suggesting on the other hand that most have done worse. Average looks are not how any of us want to be described. Average income also comes with the stigma that someone is also doing much better. And if you have an average income, you probably got average grades in school, came from average parents in an average town. Mathematically, average is good.

For those wanting to know what is generally expected, average sets the baseline with some factors doing well and some doing worse. Both are called anomalies and are not treated the same way we would treat a below (or for that matter, an above) average cohort. One we disdain, the other we attempt to emulate.

And this is where the problem begins for most of us. Average just doesn’t seem to be good enough. But as it happens, when it comes to investing, this slow-as-a-turtle approach, the steady feeding of your accounts in a rhythmic, no thought way is proving to be the best way to keep invested in a downturn and not be over invested when the markets begin their run for the top.

First rule of investing is wrapping yourself around the notion that you cannot pick a bottom nor can you find the peak. Panic causes one while euphoria pushes the other. Both are emotions that suggest nothing average. Instead, they are firmly rooted in extremes. Yet we still run from one while rushing toward the other. We are genetically wired to do so. If our early ancestors heard the cry “stampede” the last thing they would want to do is run towards it. But if those same ancestoral leaders found something that would make your survival easier, you would not run away.

Mention dollar cost averaging to your friends and it will no doubt be met with disdain. Even if they had employed just such a strategy in their own 401(k) plans on the way up, many have stopped the practice on the way down. Defined contribution plans like 401(k) plans offer the employee the chance to contribute a measured amount of pretax income from every paycheck. This had the effect of giving the participant a good feeling when the markets where on the rise.

Some allowed for only the company match. Some were forward thinking (or at least they thought of themselves as such), going beyond the match and putting as much money as they could possibly afford into their plans. The markets rewarded those efforts by rising, almost steadily for years.

And then, the bottom dropped out - as we all know. Folks lost faith in Wall Street and rightly so. The narrative turned negative triggering those base emotions to run for the exits. When someone yells “fire”, few will attempt to find the source and make our own judgments. We are genetically conditioned to trust those who control the crowd.

But when it comes to the stock market, a place where risk is as important as the blood coursing through your veins, you would do well to look for the reasons why, reassess your positions and make determinations on your own. Dollar cost averaging does that for you.

If you have stayed put, not sold your positions or reworked them into other types of more conservative investments, you will come out the clear winner. When is harder to say. Dollar cost averaging ignores the news, disdains the panic and refuses to get caught up in the euphoria. All of these elements move the markets in one direction or another. DCA keeps your invested dollar right in the middle.

In times of lower prices, DCA allows your dollar to purchase more shares. in times of higher prices, DCA keeps you from chasing overpriced investments. It understands that average is much better for the long-range investor. It understands highs and lows and takes much of the wagering out of your investment decisions.

For those of you that have kept your investment allocation on a steady stream may have thought you were throwing good money after bad. Some of you have continued to do so even as your employer has cut or eliminated their matching contribution. Some of you have wondered whether what you did was the right thing to do.

In only a few instances will you be able to look back at what history has taught us - many of the charts and analysis from the past seem to no longer have relevance as we move forward - and seek comfort in our decision. Those who seek the average, tend to do better than those who do not. I could tell you that had you invested $100 each month for thirty years from 1929 to 1959, your $36,000 would be worth $411,000.

Would some investors have done better? Without a doubt. Would some have faired worse? I am sure of it. But average would have netted you something neither group had and that can be warm comfort when the markets turn chilly.

Some things to note about DCA. This method works best when you are buying mutual fund shares. Buying individual stocks is much more treacherous to try and do even if they are your own company’s shares. Mutual funds spread the risk again by allowing you to purchase a basket of securities rather than one or two. And spreading risk allows you to embrace it without hugging too tight.

Mutual fund investors should consider risk when using this type of investment. Here is a recap of some of those risks.

Active Trading Risks

Counter Party Risk

Derivative Risks

Foreign Investment Risk

Growth Investment Risks

Issuer and Leverage Risks

Management Risks

Market Risks

Regulatory Risks

More on Leverage Risk

Sector Risks

Before you buy, consider screening those funds with this helpful tool from Zacks

There has been a lot of talk about fund managers of late. And with good reason. The blame needs to fall somewhere and on their respective desks, it has landed with a thud.

And there is no shortage of critics. MarketSci believes in what is known as the quantative approach. Subscribers call themselves quants. He believes that by locking those of his ilk in a room would help them think outside the box. Step in the box to think outside of it. Curious.

(Before we move on, a quant or quantitative analyst, as described by Wikipedia is a “person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not called quantitative analysis. In the investment industry, people who perform quantitative analysis are frequently called quants. Although the original quants were concerned with risk management and derivatives pricing, the meaning of the term has expanded over time to include those individuals involved in almost any application of mathematics in finance.” For those of you who are still confused. most mathematicians as these quants tend to be, can’t figure out simple math - the kind we live with everyday.)

Cam Hui at the DailyMarkets thinks a little differently but not by much. He poses the question: “would you buy sushi from a pizza joint?”, a suggestion that you, the fund investor are perhaps looking for something you thought might exist in a place where it clearly doesn’t.

Although Mr. Hui, your defense of mutual fund managers brings up a lot of arguably good points, the failure of fund managers lies with the next level of manager in the chain, the fund family.  Not the fund investor as you would suggest.

Mutual fund managers now are even with the rest of us. Quants or not, subscribers to modern portfolio theory or not, stockpickers or not, they are forced to do two things that open their profession up to the foibles of behavioral investing.

First, they must perform. Performance is key to attracting shareholders and keeping the folks that are still on board invested. This is tricky business with or without a successful investment model.

Second they must perform for shareholders of the public company that many mutual funds are. These shareholders are concerned with profits, not the underlying models that attain those profits or the people that run the individual funds.

This puts all investors in a precarious situation. Who is the master? The mutual fund shareholder? The shareholder in the company that manages the mutual fund?

This problem, in almost every situation forces the mutual fund manager to adopt a “style drift”, an action that undermines the chartered focus of the fund and leaves investors underdiversified as fund managers try to mimic the gains (or recently, the losses) of a similar index fund. A drift can result in more narrow losses - if you have failed to use funds as a building block as you suggest. You, on the other hand suggest drift as a result of under-capitalization when many funds are forced to keep an inordinate amount of cash on hand for redemptions.

But in the current environment, when ten-year performance numbers are at or below zero, when many large-caps are now mid-caps, mid-caps are small, this is difficult to avoid. Investors, those that have avoided the temptation to slip into a target-dated funds (something I have little regard for) are left with a manager who is struggling to comprehend the market just like the rest of us. Oh the humanity!

Simple observations such as 60% stocks, 40% bonds are no longer applicable. What is applicable and has yet to be offered is increased transparency, an admittance that these “traders” were not as superhuman as we all believed and a promise to re-examine how they approach the market place.

Unfortunately, as long as the pressure comes from the top down, fund managers will continue to do everything they can to satisfy the wrong master. We may not go to a pizza shop to order sushi, but we expect an incredible pizza when we do. And fund managers have not been able to deliver this with any consistency. True skill is present when things are bad and this is sadly missing.

They control the markets. What worries me is who controls them.

Our sister blog, Retirement with a Plan has taken the subject of target-dated funds, or as they are sometimes referred to as lifestyle funds, and exposed them for what they really are.

Consider this…

Steve Selengut Professional Investment Manager since 1979 and author of “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read”, and “A Millionaire’s Secret Investment Strategy”published a four part report in October 2008 in collaboration with
Claus Silfverberg, Managing Director, World Federation of Investors Corporations that outlined suggested rights that investors should possess. Steve believes in investors and the contribution they make towards economic growth.

This is a take on those rights designed with mutual fund investors in mind.

1. Mutual Funds will be transparent. Many investments, stocks and other securities are the sum of underlying investments. We know this is true in mutual funds. But how much do we know about what is in those holdings? Before we buy, we can often get a list of the top ten holdings, some information about the risk involved (basically a projection into the future based on the results of the past - a very poor method of prediction), and what the fund is attempting to do.

Mutual funds have balked at the idea of transparency suggesting that to unveil their holdings would reveal their style. Baloney. If you are successful, then you should open source your methodology and see if others can imitate what you have done. This is a way to prove principles and projections and this will make your fund a star among stars or, if you are off-base, and many of these funds are, you will be exposed for what you are.

Transparency is not the same as football coach stealing plays or a baseball player relaying signs to the dugout. Transparency does more than level the playing field, it elevates those who play better.

2. Regulation is not only necessary, it needs to be enforceable. Self enforcement is not the key to making the markets better. Mutual funds are front-loaded with numerous investor protections. IT is the sticks that make up the lion’s share of their investments that need additional accountability. These rules would make speculators more obvious, hedge fund activity more clear and the ability to determine risk somewhat easier.

(I use the word risk with some trepidation. It is not a clearly defined concept other than knowing that some is needed to achieve growth and that there are only a handful of people that know how to manipulate it to be profitable and more importantly, remain profitable.)

3. Retirement Plans should be free of outsized risks (a determination that is easy to amake in the wake of what is happening) and in order to do this, offerings inside of a defined contribution plans should force the fiduciary to guarantee a bottom. Many of these plans would do well to set up sell triggers for their participants who, in spite of themselves, do not bring enough know-how to the process. We know quite a bit about investors, how they think and more importantly, how they react. This knowledge is generally ignored by fiduciaries even as they claim to want to educate investors.

Steve has suggested something different writing: “Dr. [Teresa] Ghilarducci, professor of economic policy analysis at the New School for Social Research, drew the most attention and criticism. She proposed that the government eliminate tax breaks for 401(k) and similar retirement accounts, such as IRAs, and confiscate workers’ retirement plan accounts and convert them to universal Guaranteed Retirement Accounts (GRAs) managed by the Social Security Administration.”

Could the solution simply be to switch all pre-existing accounts to pensions?