Mutual Funds for the Utterly Confused

There are couple of things you should know about small-caps. One, they have harder access to money to capitalize their businesses (borrowing is more expensive).

Two, they rely on private investors and issue stocks, usually in large blocks to these groups making the pool of available stocks small (generally not available but sometimes counted as if it were).

Three, many of the shares available are not really for sale but are listed as such, held by company executives (yet another block of stocks).

Four, no index can buy all of the small-caps listed on the popular indexes such as the Russell 2000 (some are just too small).

That creates risk.

Each time a fund looks to buy small company stocks, it runs the risk of increasing the share value simply because they purchased it. No real growth speculation has taken place in the markets and that makes the share price for very small and largely inactive companies to get a share price increase they do not deserve. Generally, only about 850 companies in the Russell 2000 index are considered invest-able.

But when we have market downturns, the border between what is small-cap and what is mid-cap blurs. Defining capitalization is relatively standard although not without some leeway. To determine a companies capitalization, multiply the outstanding number of shares by the price of the share. Generally, they fall into one category in a stable market.

• Mega Cap: $200+ billion
• Big/Large Cap: $10 - 200 billion
• Mid Cap: $2 - $10 billion
• Small Cap: $300 million - $2 billion
• Micro Cap: $50 - $300 million
• Nano Cap: <$50 million

But these are not stable markets and some formally well-capitalized companies have slipped making what see as a unique opportunity to own businesses that will regain their footing eventually and break-out of their fall from a previous cap-group.

That’s not to say that there will not be less risk. Many of these smaller companies have unique and often difficult financial arrangements, higher than average debt levels, and in many cases, do have the financing to change course on a particular product or service to meet with changing competitive environments. Lack of liquidity and increased volatility make the risk very real and tangible and because of that, they require special care and placement in a portfolio.

For instance, the younger you are, the greater portion of your portfolio can be allocated with these types of funds. Even at a youthful level, no more than 30% of what you put away for retirement should be in these types of funds.

The recent losses in the markets hit small-caps harder than large-caps. But the recovery will swing just as far in the other direction when the recovery takes hold. Lack of liquidity can often mean a more nimble approach.

Funds who buy these types of stocks tend to have higher expenses and increased turnover ratios making the need for higher overall returns more important. Once you embrace this risk for what it si, you can find yourself on the winning side of returns.

At the beginning of the book I suggest that a bear market is the best time to talk about the fundamentals of investing. When these types of markets take hold, investors begin to rethink strategies, realign holdings and become more cautious and skeptical. When a bear market persist, we review the extreme elements of risk, the reason we are where we are right now.

Sector risk is a discussion about weight, sort of an investors food pyramid. We all know how the FDA looks at what we eat, creating a pyramid of foods that we need the most of making up the base and as you gradually climb move to the top of the pyramid, you have the foods we may have but should have in such moderation as to almost not bother.

I have two problems with the pyramid as an illustration: Our eyes always go to the top of the pyramid caring little about foundations and cornerstones, what gives the top its height and strength.

And because of that, we crave whatever resides up there more than we should. Where fats and oily foods take the top billing on the food pyramid, sector funds would be there for the investor pyramid.

Sector risk is real only if you have failed to rebalance or obtain any balance in your portfolio. Risk is needed to grow your money, but it should be measured. The savviest of investors have always built a foundation of conservative investments in their portfolios. This doesn’t mean no risk, instead, it means risk that are so widely spread (the keyword is diverse) around the broader market as to not feel too much pain at once should the market falter.

According to paper published by Qing Li, Marisa Vassalou and Yuhang Xing in 2003, “The underlying idea is that various sectors of the economy may receive different productivity shocks that will result into different returns on capital for the firms of those sectors. The return on capital is directly related to equity returns, and in the context of business cycle models, the two notions are identical. But the return on capitalalso determines investments and as result, the investment growth of the sector.”

The more specific a fund’s offering becomes, the higher the risk for your investment dollar. Drilling down into a specific industry such as financials, commodities or real estate, to mention a few of the scorching hot sectors that have turned icy cold over the last fifteen months would have seen enormous returns (which attract numerous investors, lured in by the possibility fof out-sized gains).

Once again, risk is necessary but in measured doses. Although sector funds do offer some great opportunities if that sector takes off, they are best kept to less than ten-percent of your retirement portfolio. Outside of that, in a taxable portfolio, you may take a plunge of up to 25% if you spread the risk among numerous sectors.

Your eyes my look to the fatty foods at the top of the food pyramid for comfort but the overindulgence of them can lead to serious problems. Same applies to sector funds (much easier for many of us to access when they are sold as exchange-traded funds, priced throughout the day just like stocks). Moderation is always the wisest choice when it comes to risk. Too much never leads to long-term benefits.

Earlier in our discussions about risk, we looked at what leverage risk could do to your mutual funds.  The idea of borrowing to buy stocks is nothing new.  Federal laws are in place to prevent funds from borrowing more than 30% of their total assets.  When they leverage, mutual fund managers attempt to buy additional shares with borrowed money for the fund to increase returns and if the stocks do well, sell for a profit.

But when stocks do poorly, the results can hurt a fund worse than if they hadn’t borrowed a dime.  The reason is fairly straightforward: you also have to pay back what you borrowed and as the value of the stocks go down these funds often sell well below the purchase price.  For individual investors, this is referred to as a margin call.  For mutual fund managers, this is referred to as a disaster, a perfect storm.  To the overall markets, the effect can be amplified, forcing the sale of stocks that might have been held onto until the markets recover.

That said, could this be a return to simplicity, a time when things were more clear and transparent?  Possibly but it will be only until investors begin to forget the lessons we should have learned. 

Many of the recently created 130/30 funds took some of the hardest hits in the recent downturn.  Investors might take another look at the strategy, which works like this:  When a fund has $100 invested, the manager borrows $30 worth of stock (called shorting, where possession never really takes place and the manager buys at a price hoping the stock goes down so the difference between the sale price and the purchase price create a profit) which essentially creates a $130 worth of stick where only a $100 was actually used.

If you happen to be in a closed-end fund, you are most likely holding a fund that has engaged in this kind of leveraging but has had to deleverage once the credit markets froze and as they thaw, become more expensive.  To continue to borrow, these funds are now forced to pay a higher rate for the action.  Closed-end funds are also subject to the federal law and unlike other types of funds, trade like stock.

What do you do if your closed-end fund takes (or has already taken) a much harder hit than comparable open-end or no-load funds?  If the fund family is large, you can look for mergers with funds within the family that have little or no leverage exposure.  The merger in essence, satisfies the law and gives the fund a renewed asset base to begin the process all over again.  Another idea, rethink your fund choices an opt of the no-load, lowest fee fund possible.  The switch could can you several percentage points in returns.

This is a very real and tangible concern for mutual fund managers. The recent (and continuing slide) of the markets have placed the need for regulation of some sort to the forefront of the conversation. Once the question of prevention (how can we stop this from happening again?) enters the discussion, people who manage businesses and those that invest in them begin to worry. Should you as well?

First, regulatory risk at the business level can range from environmental issues to the operation to financial reporting. Increasing regulation often translates into increased operational costs and this cuts into the potential for growth and profits. Sarbanes-Oxley was a form of regulation that forced CEOs to sign-off on their financial statements. It met with a great deal of resistance and was fought vigorously by the Bush administration. It remains in place because the accounting industry, in the short span of a couple of years, developed stream-lined and cost-effective methods of conforming to the regulation.

But those initial costs can cause a stock to under-perform and under-performance leads to lower overall earnings. Investment managers are worried that their bad decisions will prompt further regulation to prevent this type of economic catastrophe from occurring again. The end result of tighter regulatory measures is lower profits for investors.

From a record-keeping standpoint, it will be tough for new investors in a mutual fund to determine why a fund did so well for so long and then suddenly, the growth dropped off. Increased regulation will provide transparency and that should make-up for this potential problem but the days of year-over-year growth in the aftermath of increased regulation tends to be much more muted.

Increased regulation, for all of its faults, does create a more level playing field. The risk is mitigated and you will find less volatility in your investments. For many, this is good. For others, the market movers, day-traders and those moving vast amounts of money around in an effort to eke out every potential penny they can, this is often met with cries of outrage. In the long-term, any regulation designed to benefit the investor is good. In the short-term, it seems like bad medicine.

Back in January of 2006, Barbara S. Poole (Roger Williams University), Candy A. Bianco (Bentley College) and Craig Giroux (Investors Bank and Trust) attempted to answer the question that has plagued investors since the beginning of the mutual fund industry: “how do we determine the performance of the fund manager?”

They wrote: “Investors believe that the mutual fund market is far from efficient and that they need to pay a great deal of attention to who is managing their money. While mutual fund investing provides the benefit pf professional management, the effectiveness of the professional management is not consistent across all funds.” It is this the authors suggest, keep mutual fund buyers looking for “clues that suggest that a mutual fund manager will exhibit superior talent or ability”.

And as we continue our discussion about risk, we look at the management.

Some folks have studied the level of education and come up with no discernible differences in how one manager performed compared to another with a greater degree of education. Tenure was ruled out as a deciding factor and eventually the size of the fund under management. What did stamd out was the relationship between tenure and risk. A manager with greater degree of time spent at the helm was likely to take greater but more calculated risks.

What you should know is that investment loss is just that, a loss. You are unable to lay claim against the fund for losses the management may have incurred. But the same rule for picking a fund manager seem to apply.

1)The longer a fund manager is at the helm, the greater the chances the fund will perform as promised.

2) Risk cannot be eliminated and the manager of the fund will be held accountable with the published performance reports. In many cases, try to look back about ten-years but if the fund still doesn’t compare to its peers, drop last year from your decision.

3) The reason short-term managers do less well is the readjustment of old portfolios. That doesn’t mean you should avoid a fund with a new manager but look judiciously at how well the fund does in terms of turnover. Not everything needs to be sold to create a winning year.

As we continue to look at the risks that face mutual fund shareholders, issuer risk and leverage risk can play an important role in how we assess what we want in an investment. But first, let’s take a look at what these types of risks are and how you may not be able to avoid them altogether.

Issuer risk deals primarily with fixed income securities.
An issuer, who pays the coupon or the interest payment on the bond holding is rated by a rating agency. That rating helps investors determine the ability of the issuer to pay back the loan. If they are highly regarded, the bond will offer little in the way of interest on the investment because the risk is low. On the flip side, if the credit rating the issuer has received is low, the interest rate will be higher because the risk the issuer might not be able pay in full are greater. The reward for risk is interest rates. Low risk equals low return rates; high risk cost the issuer more to attract investors.

There was a great deal of discussion among the quantitative guys on how to assess risk in these types of situations. If the portfolio was plain vanilla with determinable maturities and easily assessable risk factors, an issuer risk number would be relatively straightforward. But these financial instruments have gotten so complicated that who owes what and when is often not known unitl is is too late for the investor. The mortgage meltdown is grounded in issuer risk.

Leverage risk is not altogether different than issuer risk except it is you, the investor who is the risky party.
Okay, you the investor as a mutual fund manager. Leverage is best described as the ability to secure a loan with the underlying asset as collateral. Much like your house. If you were to miss a payment, the home would be taken away despite the amount of payments you may have already made.

Stocks work the same way. There are times when a mutual fund charter may allow the manager to buy stocks with margin. This is essentially borrowing the stock with the promise to pay an agreed upon price. If it goes down, you are liable for the cost. If it goes up, you pay off the broker and sock away your profit on the transaction.

It is only leverage risk when things go bad in the markets and you (or in this instance, your fund manager) have to cover your losses with the sale of stock or worse, cash. It is only issuer risk when the borrower fails to make payments to you. Both of these types of risk can pose out-sized risk but in some cases, it might be unavoidable.

Next up: management risk

Growth used to be the buzz word. Now it represents other more nefarious terms such as risk, chance, and possible loss of capital investment. To a company with an idea, a product or a whole host of services, growth represents the golden ring, the ability to make itself more attractive to investors, lenders, and potential buyers looking to integrate their businesses with another next new thing.

But growth depends on three elements: desire, trust and belief. In the mutual fund world, where growth represents potential or the fulfillment of projected expectations, you need more than the desire to build or offer something that consumers want now or will need in the future. It represents more than trust that the business plan laid out for investors and shareholders will be worthwhile and worth the risk. It also represents more than the belief that future markets will receive your notion warmly or knick-knack with open arms.

You might say that growth boils down to the ability to borrow. And you would not be incorrect in this assessment. Credit and the extension of current credit depends on the lenders embrace of a company’s desire, belief and trust. What else do they have to go on? New companies will rely on private capital to get up and running. But established companies, those that have gone public, need investors to shore up the desire of the management, trust that their directions are the right ones and the belief that if they hang on long enough, the rewards will be worth the investment.

Growth is risk and risk offers the potential for reward, and loss. So as we continue our discussion about investment risk, it is important to grasp the need for this. You cannot hide from this risk even if you tried to moderate the growth. As last year showed many novices and experts alike, growth can bite back.

But that is no reason to ignore the potential because you were once bitten. Shyness will result in two things. First, if you are in it for your retirement fund, shunning growth in favor of value (older, more established companies with dividends), bonds (the government issue type not the corporate or municipal kind), or worse, savings in traditional certificates or accounts, you will work longer. Growth is not just for the younger investor either. Older investors still need a portion of their portfolio in a growth focused fund (with the rest of the portfolio diversified in less risky investments).

And secondly, if you are in it for the investment, growth will provide the largest gains over the long-term. Long-term, for the sake of this discussion is a period of time lasting ten years or more and relies on the simple principle of dollar cost averaging (putting a fixed amount in each month during that period) to be truly successful.

Growth investment risk is not only necessary but will power the economy back to profitability - and yes, it will recover - help you achieve the rewards that accompany the risk. The problem with growth is the temptation to put everything into what is doing well and when the market corrects such speculation, it is the growth investors who feel it first. But when it recovers, it will be the growth investors who win first.

The lesson is diversification - always has been. But growth risk is a much needed ingredient - similar to flour in bread.

In our continuing look at the risks facing mutual fund investors, we now look to investments your mutual fund manager may be making outside of the US and, if you have a mutual fund that is focused on a global approach to investing (I suggest that these types of funds might a good place to put some of your portfolio in 2009 - I also suggest it in the book as well) you will face what is known as foreign investment risk.

This is a worthy risk
We wanted a global economy and we got one. For better or worse, and we all know how worse it can be, the world doesn’t hinge on the US economy, it swings with us. No longer does the world catch a cold when the US sneezes, it is part of the whole illness. Keep in mind that most of the money that fueled the economy over the last several years was funneled into our wallets courtesy of over seas investors.

Foreign investment risk can catch some of us by surprise and as much as I hate to keep saying it, the book really does a much better job of explaining all of the possible problems that can arise from a foreign investment. It could come from any number of different angels, from a crisis in a currencies to mismanaged governments to poor banking to environmental considerations to tax issues.

And because of that, the cost of the fund might be higher. The volatility of the fund will be greater. And the chance that something unforeseen in some other part of the globe might have devastating effects on the fund’s holding are not be taken lightly.

Nor should they be avoided. Foreign investment risk, in other words is a worthy risk, albeit in small portions, say 10% or less of a retirement portfolio. If you are younger, the bet is an extremely good one. There is little chance that a long-term investment in a fund with foreign exposure will not pay-off handsomely. The global audience will not be slowed by the recent recession. There are just too many people around the planet who want the kind of lifestyle that we have to allow for this to last too long.

Next up: growth risk

As we continue to break down, in detail, what drives mutual fund investing and the risk investors may encounter, the next topic is by no means an easy one and is not something that would be considered new. Recent turn of the calendar articles have speculated as to why we behave in such a way that we, as investors, tend to have incredibly short memories, even after the sting that 2008 was, and are, for the most part, likely to participate in the next bubble - often with complete abandon and disregard for the risk that might be there.

This belief is well founded when it comes to derivative risk. Here is list of some of the events the financial world has experienced, largely at the hands of derivative traders.

12th Century In European trade fairs sellers sign contracts promising future delivery of the items they sold. In essence, this seems like a good idea. The money goes to finance the trade before the trade happens and allows the trading mission for goods in far off lands to happen. In the 12th century though, the risk that what you had invested would actually make it back to the marketplace was high. The New Cambridge Medieval History offers some insight into the financial transaction. Some investors demanded repayment only if the ship returned safely.

13th Century There are many examples contracts entered into by English Cistercian Monestaries who frequently sold their wool up to 20 years in advance to foreign merchants. During this century, derivatives, although that term was not coined for some time, and the risk the investor undertook was now accompanied by information about past trades, current trading conditions and the worth of not only the currencies being exchanged but the creditworthiness of the traders. Think silk road.

Early 17th Century 1634-1637 Tulip Mania in Holland Fortunes are lost in after a speculative boom in tulip futures burst. Every financial writer mentions this at one time or another. I have - many times and never do i seem to understand why such foolish can happen. But this is where it began. Credit along with envy and greed pushed this exotic market and the world for that matter, to near collaspe.

Late 17th Century Dojima Rice Futures In Japan at Dojima, near Osaka a futures market in rice is developed to protect sellers from bad weather or warfare. To understand this, you have to consider rice as the coin of that ancient realm. Rice was paid to feudal lords and they, in turn needed to sell it. There was only so much rice a ruler could eat. Problem was, and it took almost a half-century after the Dojima was first licensed, to understand that the rich were controlling the prices, acting as a central bank for those that were paid in rice. It was until 1773 that the government realized, according to the SamuariWiki, that “the need for governmental control of such policies; exchange rates, monetary standards and the like had to be set by the government, and not left in the hands of an increasingly wealthy and powerful merchant class which was intended to be at the bottom of the neo-Confucian mibunsei class system.”

19th Century 1868 Chicago Board of Trade On April 3, 1848, the Chicago Board of Trade (CBOT) was officially founded by 83 merchants at 101 South Water Street. Thomas Dyer is elected the first president of the CBOT. The first trades were offered on “arrive” contracts.

20th Century Late 1960s - Black and Scholes begin collaboration Fischer Black and Myron Scholes tackle the problem of determining how much an option is worth. Robert Merton joins them in 1970. The problem is, it doesn’t really work outside of a campus setting. For it to work with any success, remembering of course that an option is priced according to what it might be worth under certain market conditions when it arrives to that market, there must be no-restriction short selling, free borrowing, continuous trading, along with a whole host of other, often non-existent factors in the open market.

April 1973 The Chicago Board Options Exchange opens. The CBOE offers investors an opportunity at buying equities but as an option to buy. Consider this: equity options offer the investor protection of stock holdings from a decline in market price, increased income against current stock holding, help the investor prepare to buy a stock at a lower price, and last but not least, benefit from a stock price rise, without having to buy the stock outright. The CBOE explains that “If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity.”

May/June 1973 The Black-Scholes Model is Published. It appears in the Journal of Political Economy, one of the journals that had previously rejected it. it still didn’t work in the real world but its publication gave many economist pause - which is what dismal scientists do when they are thinking about abstract stuff with no real world grounding. At about this time, it all begins to unravel.

1994 Metallgesellshaft loses $1.5 billion on oil futures.

1995 Barings Bank goes bust.

1998 Long Term Credit Management Bailout The hedge fund is rescued at a cost of $3.5 billion because of worries that its collapse would have severe repercussions for the world financial system.

1999 The Flaming Ferraris Some traders at CSFB are sacked following allegations of illegal trades in an attempt to manipulate the Swedish stock market index.

21st Century 2001 Enron goes Bankrupt The 7th largest company in the US and the world’s largest energy trader made extensive use of energy and credit derivatives but becomes the biggest firm to go bankrupt in American history after systematically attempting to conceal huge losses.

2002 AIB loses $750 million John Rusnak uses fictitious options contracts to cover loses on spot and forward foreign exchange contracts.

2003 Terrorism Futures Plan Dropped The US Defense Department had thought that such a market would improve the prediction and prevention of terrorist outrages.

January 2004 NAB admits losing A$180 million Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.

August 2004 Citigroup bear raid Citigroup traders led by Spiros Skordos made €15 million by suddenly selling €11 billion worth of European bonds and bond derivatives, and buying many of them back at a lower price.

November 2004 China Aviation loses $550m in speculative trade This loss is the largest amount a company in Singapore has lost by betting on derivatives since the case of Nick Leeson and Barings.

October 2005 Refco suspends trading One of the world’s largest derivatives brokers is forced to freeze trades.

September 2006 Amaranth Advisors loses $6 billion the US-based hedge fund suffered enormous loses trading in natural gas futures.

January 2008 Société Générale loses €4.9 billion in unauthorised futures trading A rogue trader is blamed for the world’s largest banking fraud up to that date.

In short, derivatives “are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds. There are two main types: futures, or contracts for future delivery at a specified price, and options that give one party the opportunity to buy from or sell to the other side at a prearranged price.”

In a mutual fund, this kind of activity can greatly increase your risk.

Next up: foreign investment risk

How Counter Party Risk affects your mutual fund investment.

This can be summed up in one word, albeit dramatically: Lehman. The demise of this financial institution was a shock to the economy in 2008 that still reverberates. What Lehman did is at the heart of counter party risk. As we continue our look at risk in mutual funds, this type of risk may not be thing of the past. Why? Some feel that the markets would lock-up without it.

So what is counter party risk?

In a mutual fund, the manager may buy a security that is a repurchase agreement whereby a seller agrees to a price for security and the commitment that they will repurchase that security at set price and time. The risk here is you are never quite sure what kind of commitment the other party has with other investors. This creates the illusion that, should the other party default, the investors standing in line will be you alone.

But sometimes, the other party resells the same agreement to many investors, making the line longer should problems occur and leaving your position in line in question.

Jeff Miller of Seeking Alpha describes the activity in terms of a gamble on a sporting event. He wrote this about Lehman in September of 2008.

“Let us start with an example that everyone can understand.” He begins. And because the correlation between this kind of investing and the world of sport’s betting, he asks you to, “Suppose that you occasionally make a football bet (completely illegal) with an online sports betting service or a local provider of such services. Since you are a recreational player, your normal unit is $100, an amount less than tickets to a local sports event. If you lose, you have to sacrifice some fun. If you win, you can have more fun. Either way it is not a life-changing event.

“Let us further suppose that you have a friend who is a rabid fan of some team with uncertain potential.” This team with uncertain potential represents the other party’s belief in the investment they are offering your fund manager. “Your friend,” Mr. Miller continues, “wants to bet on the game. He does not have a place to bet, and he wants to bet with you. Let us suppose that he offers a bet of $1000 and is willing to lay 3 1/2 points.”

For those of you who might not know what laying off means, the bet that was placed with the bookmaker was bet again with other bookmakers as a way to hedge against losses.

Mr. Miller writes, “Since you can “lay off” this action with your dependable source while giving only 2 points, you take the bet.” Your friend in other words was willing to offer you a greater percentage of the win should you place the bet with him, more than your bookmaker offered when you place “the bet” with him. “If you lose to your friend, you collect from the other party. If you win from your friend, you collect from your source. If the result if the game is your friend’s team winning by 3, you collect on both bets, making $2000. If you win from the friend and lose to your illegal source, you pay the “juice” and lose $100, your normal risk amount. You decide to bet with your friend and lay off the action, locking in a low-risk position with considerable upside.” You can see that this appears to be win-win proposition and why, when there is a an opportunity to make easy money, this type of transaction can very tempting for fund managers looking to boost returns. And we all know returns are what bait future investors and keep current shareholders happy.

But there are flipside risks to consider. Mr. Mill adds that, “The risk in this totally illegal maneuver relates to the counter parties. Let us suppose that your friend’s team loses big. You need to collect from him to pay off the other side. Finally, let us suppose that you later learn that your friend has made ten such bets, and you are standing in line to collect. Meanwhile, your obligations are instantly collectible.”

Some funds paid big for this type of gamble and if I know Wall Street, this type of activity will not cease entirely. Remember, the markets need assurances and above all, risks in order to generate money for investors. This is not saying you should ignore the opportunities that risks offer but instead, measure them carefully into your goals.

Next up: derivative risks
Previously: active trading risks