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.

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.

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.

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.

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.

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.

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.

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.

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

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.