Mutual Funds for the Utterly Confused

The health of the economy is not always gauged by the strength of the stock market indices, the ups or downs the unemployment numbers or even the consumer sentiment number.  In fact, of all of the indicators available to investors and prognosticators, none signal potential problems like municipal bonds.

A recent report in the New York Times is now indicating that munis, as they are commonly referred to, are beginning to look like a troubled investment, even as the rest of the economy begins its slow grind to recovery.  Munis are used by states, cities and local communities to fund all sorts of projects that generally offer, at least in principle, to do some public good.  These projects, that could range anywhere from an urban development to a stadium to the repair of local roads, is done through borrowing.  Borrowing has become more difficult in every sector of the economy and munis were not expected to escape unscathed.

One of the most basic problems facing states and municipalities is similar to the same issues facing home owners: the ability to use financial products to help with their short-term and long-term financing.  The report, issued by Moody’s, a bond rating company, suggests that decisions made when  borrowing was much less expensive have come back to put unnecessary pressure on the municipalities books.

It was hoped that President Obama’s stimulus project, designed to rejuvenate the local infrastructure, would have made its way done to some of these troubled local economies.  And troubled is putting the situation mildly.  As foreclosures mount, tax bases slip away at an alarming rate.  Budgets, perhaps overly optimistic are being scrapped as the expected revenues fall.  Some states have under-financed their pension plans and are now using bonds like these to push that obligation further into the future at a time when the cost of borrowing has risen. This has forced many municipalities to go to the general public in order to find funding for essential services.

But the question the bond rating agencies are asking is how will they pay it back.  Once the bond is downgraded, the risk of owning it increases.  And once the risk increases, investors, fearing default will demand high interest rates.  This further increases the difficulties as some of these bonds are used to pay investors in maturing securities.  This borrowing to pay off debts, a patently bad idea when interest rates are high (and a common practice when rates are low) can lower the overall grade a municipality receives.

Now no one expects cities or states or counties to go out of business. But because these local governments do as all governments do, redistribute wealth and provide services to the least fortunate, cut backs are inevitable.  For those who are able to pay, the thought of higher taxes at a time when paychecks are feeling setbacks is just not what a locale wants to do.

Should you, as an investor see this as an opportunity?  The answer is really straightforward: only from inside the safety of a mutual fund.  The temptation to take the tax-free status that many of these bonds offer to residents individually seem, at least on the surface to be too good of a deal to pass up.  Avoid it. 

Mutual fund managers offer the average investor the best place to buy this kind of risk.  The information about each bond may be overwhelming to all but the most savvy among us and the risk, while seemingly impossible to determine on your own, may be better judged by the experience of a good fund manager.

Even though municipal bond fund managers have seen some tough times, it is much easier to judge their potential moving forward than it would be to find a good equity manager (based on past results). Ben Bernanke, The Federal Reserve Chairman understands this risk and my offer some sort of federal reinsurance.  This would go a long way in making these bonds more appealing and somewhat less risky.  But that has happened yet.

If you were to try and calculate where we will be as investors in twenty years, you might find a wholly different place. If you were to try and base this future view of the world on what the past has told us, you might even be somewhat optimistic. You may have realized that what happened in 2008 and into 2009 was an event unlike any other that preceded it and the lessons learned were indeed good ones. You might even say sometime in the near future that what happened then lasted longer than any recession has since.

The investment landscape for many individual investors has changed and for all intents and purpose, will continue to evolve. But what will the average investor look like twenty years from now? Will they have realized that buy and hold, the mantra of the investing past completely betrayed them over the last ten years? Will they redefine their own personal wealth as the sum of not what you might be worth but instead what you have amassed in cash? Will the future unveil a land of savers?

We have gone from an abysmal savings rate of zero - and often less than zero - to a quest for at least three percent. While this is healthy and important, the savings is not coming from the squirreling away of cash from spending, but from a shift in risk in numerous retirement accounts. Will this leave a whole generation of investors on the sidelines? Will we take what is long overdue and in the process take it too far?

Your professional money manager is now offering his/her clients a mirror of those feelings. Allowing you to put valuable dollars away in fixed income and cash focused investments - as of February, this has become so prevalent that almost half of all retirement accounts have gone super-conservative - is simply not responsible. I have been crusading for years on the platform that you can do whatever it is you pay your financial adviser to do. You can make bad decisions with similar outcomes. You can become conservative without paying someone to tell you what you already feel. You can miss the mark again and again without the aid of a third party aiding and abetting that decision.

There are three things you need to know to avoid this type of advice. We are in a bear market because folks have lost faith in equities, capitalism and the power of American and global growth. That will pass. Secondly, the market is in a bear type situation because, in short, credit became suspect and the lenders who offer credit to companies big and small became self-conscious of their poor investment decisions, under-capitalization and liberal leverage rules. Changes are in the pipeline to dissuade similar behavior in the future. And lastly, bear markets demand our attention.

Instead, we have turned away at the very instance that we need to refocus that attention. Your financial adviser should have known better than to allow you to continue to invest in stocks when the prudent move would have been to move to a balanced position of bonds and stocks. But that kind of move would have found him/her on the perimeter during the run up and not exactly someone whose services you considered invaluable. To do this, advisers would have had to be less mirror-like (telling you what you wanted to hear) and more devil’s advocate.

And now, just a few long months later, what have they learned? To keep your business, they are continuing to mirror your attitudes as you shift into somewhat more dangerous waters en masse. Because many 401(k) plans do not offer money market accounts, the next best thing has been chosen as the conservative tool for this skittish, once-bitten-twice-shy group: guaranteed investment contracts or stable-value funds. So what exactly are these super conservative investments?

According to StableValue.org, this $300 billion market can be summed up as follows: Guaranteed Investment Contracts or GICs come in three basic forms. The traditional, separate account and synthetic all rely on crediting rates and are supported by a variety of different investments. These contracts can be held in a constant state with the rate “set at the beginning of the contract or reset periodically to reflect the performance of an underling security, portfolio or investment manager”.

I am positive that you are aware of all of this. But for those of you who have yet to be thoroughly confused by this insurance product (that’s right, the credit risk you will find in traditional and separate account GICs is controlled by insurance companies), there is more. GICs contain an amortization feature that looks at the payout in the future and adjusts itself accordingly. Hence, the involvement of the insurance company.

Traditional GICs offer a specific rate of return for a predetermined period of time. Separate accounts shake things up a bit by offering varying strategies to achieve their fixed income objectives. The later GIC is primarily offered to plan administrators of pension funds.

Synthetic GICs offer a more direct ownership and control of plan assets. Synthetic GICs are divided into two additional categories: maturing (offering a portfolio containing a single security or one that holds securities that are similar and because of that strategy, which tends to resemble the traditional GIC, this often the most sought after type for average investors under the advice of their advisers) and evergreen (which have no set date of maturity, can be actively managed and may contain those securities of infamous renown, mortgage backed securities, CMOs and other non-Treasury securities). Synthetic GICs along with traditional and separate account GICs can be pooled into another GIC that taps some of each of the aspects of the other.

These are not toys for the uninitiated investor and while offering safety they do not guarantee much of anything. The “guarantees” in these contracts come from insurance companies, which you would assume would be conservative by nature (AIG?). Add to that, they are not guaranteed by the FDIC (as many bank sold CDs and money market accounts tend to be), are not backed by the full faith and credit of the government (in the way Treasuries are), they barely beat inflation if at all (resembling short-term bonds in overall return), and unlike all of the aforementioned investments, come with substantially higher fees (essentially wiping any realized gains before you have a chance).Not to mention the fee your adviser will skim as they reflect what you are feeling at the moment. Your need for sleep, your inability to accept and embrace any risk at all, and your eventual change of heart somewhere down the road when equities begin to rebound (probably in the fourth quarter) should be at the center of their concerns for your portfolio’s health. While some have switched to high-yield bonds for safety, those that choose GICs will be sadly disappointed in their decisions by the year’s end. And most of that disappoint will not come from loss of cash but from money lost in protecting it.

By that time, it will be too late.

As much as I despise the narrative that television, newspapers and many internet sites offer the public, I find myself rubber-necking at the spectacle they offer.  Someone like me can only hope that everyone will be able to see through the veneer of sensationalism and draw something worthwhile from watching small percentages of the world, thin slices of reality displayed for conversation and commentary.

Because I am a fan of mutual funds, and this blog discusses not only their overall benefit but their shortcomings as well, the attacks on these unique investment tools has me concerned.  Stock pickers would have you believe that owning mutual funds is mediocre at best, offering paltry returns as compared to their “actively” traded counterpart the Exchange Traded Fund and the much more actively traded individual stock.

The naysayers suggest that your returns will not be what you expected.  And they say this because they understand what you expected? Hardly.  Nassim Nicholas Taleb, author of the Black Swan was on CNBC the other day.  He explained that key to his wealth was the preservation of it in cash.  As a trader, he suggested that his clients also stay in cash, committing two-thirds of their wealth to this investment.  He remains a wealthy man because of it but does not shove the notion down anyone’s throat.  Unlike the active stock traders, he rests on his record, mediocrity and all.  It should be noted, that he keeps the other third of his portfolio invested more actively, the part he is willing to sacrifice to the risk of the unforeseen.

Many traders would have you avoid mutual funds for the same reasons, offering you a very interesting road to travel.  Many would have you bail on funds, which in terms of expenses is still far less than a broker, and buy ETFs (essentially index funds that you can buy and sell - incurring transaction costs at both ends) and while you are it, buy some stocks.

But this is much easier said than done.  Individual traders must first learn to control their impulsive natures, which has most investors buying on the way up and selling on the way down, the way they look at returns in terms of taxes-owed, trading costs and whether you beat an index or not, and even more importantly fully understanding and come to grips with the fact that what you are doing as you build your model portfolio, is, in essence, a very expensive and time consuming personal mutual fund with only one investor (no one to be accountable to but yourself).

Throwing stones at mutual funds as an investment is easy.  Mutual funds have had a rough go of it, as have all investment tools.  But as a cornerstone of most retirement portfolios, it is far less expensive and provides greater stability than attempting to beat the markets.  After last year, the future of any comparison by anyone, individual investor or fund manager to any index will be suspect.

Most will point out your returns as the try and persuade you to get out from under the diversification umbrella that funds offer.  Yes, you would have done better in cash - the most mediocre of all investments, but you would have beat the market handily had you done that - and had you used 35% of what you had left to invest to “play the markets for more control and the opportunity to make money”, you would still have more or less broken even.

Is mediocre the new wealth?  Probably.  Will it generate great wealth? Probably not.  But it would certainly be almost fee-free, risk-free and worry-free.  And that surely has a calculable cost.