Mutual Funds - General Discussion

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Top 604. Jun 22, 2004 1:07 PM

» bob90245 - Wrong eggs in the wrong baskets

Coffeehouse Investor: Wrong eggs in the wrong baskets again
2001-06-03
by Bill Schultheis
Journal Columnist

Time for the Coffeehouse Quiz: What is the first rule of investing?

By now, at least in this column, the answer is an overstatement of the obvious you already know to be true: Don't put all your eggs in one basket -- diversify!

Unfortunately, talking about diversification is one thing. Integrating it within a portfolio amid our pursuit of top returns is quite another story.

Not surprisingly, Wall Street gets in the way of our efforts to diversify by combining lots of different eggs in all the wrong baskets, and you, the investor end up with a jumbled portfolio lacking any logical game plan for the long haul. That's not the way it should be.

To take a closer look at this perplexing issue of having the wrong eggs in the wrong baskets, I put in a call to Larry Swedroe, Director of Research for BAM Advisor Services of St. Louis, and author of "What Wall Street Doesn't Want You To Know: How You Can Build Real Wealth Investing in Index Funds" (St. Martin's Press).

This is what he had to say:

There are several reasons for the growing popularity of passive (index) investing.

First, studies continue to indicate that an active management approach has failed to deliver on its promises to persistently outperform benchmarks and protect investors during bear markets.

Further, capital gains taxes created by active management places a tremendous burden on taxable investments in such funds.

Another significant reason that passive investing is winning approval over active management is a growing recognition of active funds' tendencies to "style drift." Style drift occurs when a fund's actual investments begin to drift away from its intended investment style.

As a result, investors begin to lose control of their portfolio, not knowing whether they are capturing the asset allocations they have established as their objective.

A study published in the Summer 2000 Journal of Economics and Business sought to determine whether mutual funds actually adhered to their stated objectives or whether they succumbed to style drift by analyzing Morningstar data for the period 1993-1996.

It is important to recognize that Morningstar classifies funds by their stated objectives. Morningstar reviews a fund's prospectus and marketing literature, but it does not try to second-guess the sponsor; if the fund sponsor calls its fund a growth fund, Morningstar classifies it as such.

This can be misleading if a fund style drifts or if it tries to outperform its benchmark by deviating from its stated objectives. For example, a fund might state its objective as low risk, but actually pursue a high-risk strategy.

Or, it might state its objective as small-cap but purchase large-cap stocks when the manager believes that they are "hot." By doing so, he or she hopes to beat the fund's benchmark.

To test for style drift, the authors evaluated funds based on many well-established investment criteria, including price-to-earnings (P/E) and price-to-book (P/B) ratios, market capitalization and dividend yield. They then compared funds' actual styles to their Morningstar classifications.

Here is what they found:

* Only 46 percent of the funds had investment attributes that were consistent with their stated objectives. Thus more than half of the funds were misclassified.

* Over a third of the funds were severely misrepresented. Keep in mind that the Investment Company Act of 1940 states that an investment company will not deviate from its investment policy (asset allocation) unless authorized by a majority of shareholders.

* During the short period covered by the study, 54 percent of the funds that survived changed their investment style at some point.

* Only 27 percent of funds held constant investment attributes throughout the period.

Yet another study, "Chasing Performance Through Style Drift," conducted by George R. Arrington and published in the Summer 2000 Journal of Investing, found that mutual funds attempt to improve performance by drifting toward the style with the highest recent return. The author found that, within most 12-month periods, about a quarter of fund managers shifted style, drifting to the hot asset classes. Given that there is no evidence that mutual funds actually outperform based on such shifts, it is likely that these actions only served to increase turnover and trading costs and reduce tax efficiency.

Several studies, including the 1986 landmark report published by Brinson, Hood and Beebower, demonstrated that approximately 94 percent of the variability of a portfolio's investment return is a result of asset allocation rather than either market timing or stock selection decisions.

Therefore, it seems logical that investors should take control over this decision. Yet, the evidence is clear that by choosing active managers, investors can lose control over this critical issue and never know it has happened. To the extent the funds are misclassified, investors are making decisions based on faulty, if not outright misleading, information. The consequences of misclassification are that investors can be misled on the following important issues:

* The asset allocation decision

* How well their portfolio is diversified by asset class

* Expected return of the portfolio

* The level of risk being taken within the portfolio

Given the preponderance of evidence that indicates investors cannot rely on actively managed funds to remain true to their stated objectives, we would conclude that the best way to take control over the most important determinant of expected returns -- asset allocation and associated risks -- is to use passively managed funds, index funds or exchange-traded funds (ETFs) as the building blocks of a portfolio.

Bill Schultheis is author of "The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street and Get On With Your Life" (Longstreet) and an investment adviser with Pacific Asset Management. His column runs Sundays. He lives in Seattle. Reach him at 1-800-676-1215 or wjs5@aol.com or visit his Web site at http://www.coffeehouseinvestor.com.

-- posted by bob90245

http://story.news.yahoo.com/news?tmpl=st...

Top 605. Jun 25, 2004 11:40 AM

» SteveT - AT LAST!

Hope over the next few years all fund investors will see some benefits

SEC Orders Independent Mutual Fund Chairs

Wed Jun 23, 4:39 PM ET

By Kevin Drawbaugh

WASHINGTON (Reuters) - Mutual fund boards must have chairmen who are "independent" of fund portfolio managers, a deeply divided U.S. Securities and Exchange Commission (news - web sites) ruled on Wednesday, shaking the $7.4-trillion fund business.

In a 3-2 decision, the SEC adopted a rule likely to force thousands of mutual funds to reorganize after nine months of scandals that have tested public trust in an industry that handles the investments of half of all U.S. households.

The independence rule won't take effect until late 2005.

"This is the capstone decision of the rules and regulations we have put forward" to reform mutual funds, said SEC Chairman William Donaldson after an SEC open meeting where commissioners on the normally congenial panel argued forcefully.

The SEC's vote also required that 75 percent of fund directors must be independent, up from a 50-percent minimum, and that directors must be free to hire staff if they wish.

Fund industry leaders, including Fidelity Investments Chief Executive Edward Johnson, had lobbied fiercely to block these governance reforms, especially the independent chairman rule.

Opponents called the rule -- which prohibits ties between a chairman and a fund's managers with the aim of reducing conflicts of interest -- both unnecessary and impractical.

But Chairman Donaldson -- a Bush administration appointee and former Wall Street banker -- voted for it, siding with SEC Commissioners Harvey Goldschmid and Roel Campos. Donaldson is a Republican, the other two are Democrats.

"Today's rule-making makes clear to fund boards that they are watchdogs whose masters are the investors," said Campos.

Two Republicans on the commission -- Paul Atkins and Cynthia Glassman -- voted against the rule and said they intend to publish dissenting opinions on the vote.

Saying there was a lack of empirical data to support it and predicting that it will impose new costs on investors, Glassman, an economist, opposed the rule.

"I am unwilling to risk requiring 80 percent of the mutual fund industry to change its governance structure" without harder evidence to back the reform, she said.

CONFLICTS SEEN AT TOP

About 80 percent of fund boards today have chairmen who are also employed by the fund management company. Critics have said this poses conflicts by placing too much responsibility for investors' welfare in the hands of people who profit by charging investors fees and otherwise managing their assets.

But Commissioner Atkins, a lawyer, blasted the independence rule as supported only by "a hope and a prayer" and said it "mandates excessive rigidity and costs."

"Gut feelings, even if dressed up as common sense and logic, are not sufficient grounds" for rule-making, he said.

The additional costs that investors might bear to hire staff for independent directors and pay an independent chairman would be "peanuts" for large mutual fund groups, replied SEC Investment Management Division Director Paul Roye.

As for a perceived lack of data to support the SEC's decision, Donaldson said: "There are no empirical studies that are worth much.... It's very difficult to find any studies that aren't biased in one way or another."

Some Republican lawmakers on Capitol Hill applauded the SEC's action, including Ohio Rep. Michael Oxley and Louisiana Rep. Richard Baker. Both had backed legislation recently to require independent fund board chairmen, but it was torpedoed by other lawmakers amid heavy industry lobbying.

"Finally, mutual fund investors will have someone leading the board who is focused on earning returns for shareholders, rather than earning fees from shareholders," Oxley said.

Ever since New York Attorney General Eliot Spitzer launched investigations last fall into improper trading in fund shares, the SEC has scrambled for a response. Critics have said it should have detected and stopped the problems Spitzer exposed.

Since then, the SEC has extracted $1.3 billion in penalties and disgorgements from fund companies in eight major legal settlements and undertaken a multifaceted reform push.

The SEC also voted 5-0 on Wednesday to require that mutual funds tell shareholders why a fund's board decided to hire, or recommend hiring, an investment adviser.

-- posted by SteveT

http://www.marketwatch.com/news/yhoo/sto...

Top 606. Jul 7, 2004 3:14 PM

» SteveT - Fundamental blind spots

Fundamental blind spots
Top 12 mistakes investors make
By Andrea Coombes, CBS.MarketWatch.com
Last Update: 4:12 PM ET June 18, 2004

SAN FRANCISCO (CBS.MW) -- Investors who've been buying and selling stocks for a few years like to think they know what they're doing. But we all make mistakes.

And some knock us flat more often than others: A false sense of being diversified and focusing too much on tax-avoidance are just two of the most common and costly investor errors, according to chartered financial analysts surveyed by the CFA Institute, which administers coursework and exams leading to the designation

Given the turbulent stock market of late, more investors are wondering which way's up, and that confusion can lead to even more problems.

"If someone is confused or concerned, they don't understand why they're not achieving investment success ... they don't recognize what the problem is," said Bob Bilkie, a chartered financial analyst and president of Sigma Investment Counselors in Southfield, Mich.

"You often don't even know that you're doing something until someone points it out," he said.

Here are the 12 mistakes represent our most common blind spots.

No. 1: Plan-less

Are you buying great companies, maintaining a diversified portfolio, being tax efficient? It's not enough.

Without a road map -- a.k.a. investment strategy -- you could be enjoying a meandering trip through the pasture lands, but never realize you're miserably lost.

"If you don't know where you're going, you're never going to get there," Bilkie said. First, figure out your objectives: Retirement, kids' college tuition, you name it.

Then determine your strategy. Say your objective is to retire in 10 years, and you need your portfolio to produce $20,000 in cash flow for living expenses.

"Most professionals use a rule of 5 percent spending. If you need $20,000 in cash flow, you need $400,000 in assets to produce that cash flow. You need to save and invest to get to $400,000 within the next 10 years," Bilkie said.

"The way you get there is your strategy. You might say 'I'm going to put my money in a coffee can in the backyard.' Then you have to get four $100,000 bills in that can in those 10 years, and that's your strategy."

No. 2: False sense of diversification

Most investors know the problem of focusing too heavily in any one industry, but few realize that the heady feeling of diversification gleaned from mutual funds is often false.

"If you own fund A, fund B and fund C, and effectively they're the same funds because their top 10 holdings are more or less the same, then you're not diversified," said Brian Breidenbach, a chartered financial analyst and managing principal of Breidenbach Capital Consulting, in Louisville, Ky.

"You can think 'I've got this great diversification when really you don't have diversification at all," he said.

Many 401(k) plans compound the problem by offering "several large-cap mutual funds, and they might have only one small-cap option," Breidenbach said. "It doesn't help the participants much to have three identical asset-class-type funds."

But owning a broad array of funds may come with its own problems, Bilkie said.

"If they want to buy several different funds -- a small-cap value fund and a small-cap growth fund, and a midcap and a large cap -- eventually they're going to be replicating the structure of the Wilshire 5000," Bilkie said, referring to the index measuring equity performance of nearly all U.S. companies.

"Rather than buying all those funds, just buy the Wilshire 5000. You'll save 80 points in management fees. Vanguard Total Market fund (VTSMX: news, chart, profile) is basically the Wilshire 5000 -- you're going to have the same diversification at a fraction of the cost."

Over-diversification is another potential mistake. "There is an optimal point of diversification with regard to the number of stocks you own," Bilkie said.

Above that number, "the transaction costs and the costs of following those (stocks) outweigh the diversification benefits."

What's the ideal number of stocks? That varies by expert. For his part, Bilkie said about 200 stocks represents optimal diversification.

"Within that 200 you'll want to cover the smaller stocks, the middle-size companies (and) the large-cap stocks, as well as the growth and value-oriented companies."

No. 3: Investing in stocks, not companies

For some investors, that feeling of "I love this product" inspires cash outlays in a company's stock, while others abide by technical charts.

"I've seen people that just look at charts. They don't know and they don't care what the companies do," Bilkie said.

"That's fraught with peril (because) you don't then have an opportunity to think independently and critically about whether the pattern you've observed on the chart can reasonably be sustained."

For instance, an egg-packaging company has surged recently because of the low-carb craze, Bilkie said. "It would be folly to expect that rate of increase in the consumption of eggs to continue into the future, but if you were just investing based on the chart, you might buy that stock."

To assess a company, do the work. Professional investors look at price/earnings ratios, sales growth, earnings growth and profit margins. They study balance sheets and assess industry competition.

Don't forget to look at the company's corporate-governance profile. "Make sure there's a sense of responsibility to shareholders on the part of the board," Bilkie said.

No. 4: Buying high

Investors know they shouldn't, but they do it nonetheless. "Every investor is predisposed to buy high and sell low," Bilkie said. "We tend to convince ourselves that the recent past represents the future."

Breidenbach agreed. People are "unfortunately probably psychologically wired to fail in this area. They gravitate to safe things," he said. But then "you've missed all the opportunity in that price appreciation."

Focus on a company's prospects for future performance, and leave the past to the historians.

No. 5: Selling low

Some investors bail at the first sign of bad news, when the company may well recover from its downward blip, while other low-sellers ride a company down its final death spiral, refusing to give up hope it will bounce back.

This is where your company research comes into play. "If you know the company, (you can) take the emotion out of everything," Breidenbach said.

But don't feel bad if you've made this mistake. Even the professionals have a hard time. "Knowing when to sell is the hardest aspect of investment management," Bilkie said.

That said, make sure you have an exit strategy for every stock you own. Some impose a "20-percent-drop-means-I-get-out" rule, but Bilkie said he assesses each stock individually. "You have to know what's in the band of normal outcomes on a daily trading basis."

No. 6: The churn factor

Many investors confuse trading activity with better performance, but that can be a costly mistake.

"The more you turn your investments over ... the more (transaction) cost is going to weigh on your performance return," Breidenbach said.

Instead, think of investments like a garden: Keep a close watch, but don't constantly dig. "If you go out every day and uncover the acorn to see how it's doing, you'll never get an oak tree," Bilkie said.

No. 7: Acting on tips and sound bites

Whether the source is your cab driver, your best friend or the newscast, remember the hot tip requires further investigation.

"Just because someone thinks it's a great company doesn't mean anything. They're not looking at the price inefficiencies or seeing what's in the drug pipeline," Breidenbach said.

No. 8: Paying too much in fees, commissions

Even institutional investors often fall prey to this mistake, Breidenbach said.

"Most people are not able to do a good comparison because the data is not presented in an apples-to-apples way," he said. "What may appear to be cheap on an operating-expense ratio isn't so cheap because maybe the actual commission is marked up in the security."

Remember, too, that "too much" will vary by investor, Bilkie said. "I may require much more handholding and much more assistance ... so I should expect to pay more."

Some say 1.2 percent for financial advice is appropriate, Bilkie said, but "if you were doing all of the work, that's paying way too much. If, on the other hand, someone was giving you full advice and managing the portfolio for you, 1.2 percent is a fair rate."

No. 9: Tax-avoidance at any cost

Being tax efficient is one thing, but too many investors lose sight of the bigger picture: Their return. Here's an example to scare the most tax-savvy among us:

One of Breidenbach's clients held over $3 million in shares received after his company was bought. The client was afraid of steep capital-gains and alternative minimum tax costs, and refused to sell even after Breidenbach noted potential problems with the company going forward.

In a matter of months, the stock fell by half. "The $3 million holding became a $1.2 million," he said.

"Don't let tax be the only thing that drives you," he said. Put taxes in perspective: "It's a darn shame that you actually had to pay taxes because you were successful."

No. 10: Unrealistic expectations

A few years ago, investors were too optimistic and these days, pessimism reigns. Instead of see-sawing, investors should temper their enthusiasm as well as their black-cloud outlook, Bilkie said.

"Recognize that the market is cyclical and when it's going down it's not going down forever and when it's going up it's not going up forever."

To avoid unrealistic expectations, investors should learn how investments and securities markets work. Like any sport, if you don't know the rules, you're going to lose, Breidenbach said.

No. 11: Neglect

You may feel good that you're putting money into your IRA every month, but that's not enough.

Investors say "if I just buy it and put it away, I'll be all right," Breidenbach said. "You hear that a lot ... it's scary. You're just not going to get anywhere."

Instead, investors should conduct regular portfolio check-ups, at least every three or six months.

No. 12: Not knowing how much risk you can really bear

Investors usually think losing money will be easier than it really is. "If you have a $1 million portfolio and it goes down by 10 percent, most people say 'I can handle 10 percent,'" Breidenbach said, "but they don't realize they have $1 million dollars that went down to $900,000. People get upset when they lose money."

One dubious upside to the recent bear market? More investors have a clearer idea of their risk tolerance.

-- posted by SteveT

http://www.suite101.com/discussion.cfm/i...

Top 607. Jul 7, 2004 4:03 PM

» bob90245 - Re: Fundamental blind spots

In response to message posted by SteveT:

As Merriman, Bernstein and Swedroe explain in their books and articles, a properly diversified fund portfolio can often achieve better diversification than a Total Stock Market fund. This is especially critical for retirees as I explain at the 'slice and dice' message board.

-- posted by bob90245

Top 608. Jul 7, 2004 8:14 PM

» Normxxx - Re: Re: Fundamental blind spots

In response to message posted by bob90245:

During different phases of the market, different sectors do well-- e.g., small cap value does best at the beginning of a bull phase and worst at its end. If you want to adjust for the market phase, you'll still want the separate funds so you can adjust your weighting. If you plan on holding through a bear phase, do so with large cap value stocks. Also, avoid small cap growth entirely-- they can be very exciting, but historically, they generally wind up badly overall.

-- posted by Normxxx

http://callan.com/resource/periodic_tabl...

Top 609. Jul 7, 2004 8:37 PM

» bob90245 - Re: Re: Re: Fundamental blind spots

In response to message posted by Normxxx:

Something like this...

Now all we need is the boxes for the next 5 years filled in and we'll be all set! <img src=http://www.suite101.com/images/emoteicon...>

-- posted by bob90245

Top 610. Jul 8, 2004 8:25 AM

» Normxxx - Re: Re: Re: Re: Fundamental blind spots

In response to message posted by bob90245:

Beautiful representation! It shows that, except for a (very few) years, small cap growth should be avoided. EAFE is very extreme-- either outperforming by much or underperforming by much, primarily because of the FE Emerging Markets. My strategy with FE-EM is to get in shortly after it crashes and get out when it begins to look extremely frothy. I got out earlier this year, luckily before the first crash (right now about 5 FE markets are experiencing various degrees of crash). Not for the faint of heart or the casual investor.

-- posted by Normxxx

Top 611. Jul 8, 2004 9:06 AM

» bob90245 - Re: Re: Re: Re: Re: Fundamental blind spots

In response to message posted by Normxxx:

One interesting factoid is that EAFE index was heavily influenced by Japan (recall the bubble and burst surrounding 1989). That could explain the extreme returns you see there.

Although I haven't read him say specifically, I suspect this is the reason Bill Bernstein setup his "No-Brainer" portfolio this way in regards to slicing international funds:

(15%) Total Stock Market (VTSMX)
(10%) S&P 500 Value Index (VIVAX)
(10%) Small-Cap Value (VISVX)
( 5%) Small-Cap Index (NAESX)
( 5%) REIT Stock Index (VGSIX)
( 5%) European Stock Index (VEURX)
( 5%) Pacific Stock Index (VPACX)
( 5%) Emerging Markets Index (VEIEX)
(40%) Short-Term Corporate Bond Index (VFSTX)

-- posted by bob90245

http://story.news.yahoo.com/news?tmpl=st...

Top 612. Jul 9, 2004 4:38 AM

» SteveT - Study Questions Mutual Funds Fees

Study Questions Mutual Funds Fees

Wed Jul 7, 1:43 PM ET

By MEG RICHARDS, AP Business Writer

NEW YORK - In a review of fees charged by stock mutual funds, Standard & Poor's found that those with lower-than-average expense ratios consistently outperformed their more expensive peers over time.

S&P, a provider of independent investment research, ratings and indexes, maintains a database of more than 3,000 different mutual fund portfolios. In its second annual study of performance and fees, it found that funds with lower expenses outperformed their pricier counterparts in eight of nine investment styles.

For the second year in a row, the only place investors got an edge by paying more was in the mid-cap blend category, where funds with higher expenses did better over five- and 10-year periods than those with lower expenses. S&P researchers attributed this to the recent success of small-cap stocks, which were available to many mid-cap blend managers.

"The mid-cap blend is the ultimate non-style," said Phil Edwards, managing director of S&P's investment services department. "They can reach up or reach down, and the ones that reached up into large caps suffered, and the ones that reached down into the small caps did well. In that one sector, the higher expenses won."

Despite this anomaly, the study underscores something professional investors have known for a long time: Paying more doesn't necessarily get you a better deal on Wall Street.

"The philosophy that you get what you pay for should not be applied to mutual fund selection," said Eric Tyson, author of the guidebook, "Investing for Dummies."

If you think about what it takes to be a successful mutual fund company, Tyson said, you have to consider the economy of scale: As a fund manages more money, it spreads its fixed expenses over a larger set of assets.

"That means you should be able to buy better fund management at a lower cost," Tyson said.

Regardless of how many assets they hold, large-cap funds generally charge the lowest expenses, as larger stocks are easier to trade and the issues that affect them are usually well-known. Small-cap stocks are less liquid and often require more research on the part of the fund manager, so paying more for active management in that category has traditionally made sense.

The average expense ratio for large-cap funds tracked by S&P is about 1.16 percent. For mid-cap funds it's about 1.13 percent, and for small-cap funds it's about 1.35. The average expense ratio for bond funds is about 1 percent. If you own a passively managed index fund, the expenses are even lower — perhaps 0.25 to 0.30 percent.

If you're not sure what you're paying, you can go to the fund sponsor's Web site and look for the prospectus, which typically includes a table with the expenses, and whatever loads — sales commission paid to brokers — that apply.

For math-phobic investors who don't take the time to calculate the costs, high expenses can take a serious bite out of mutual fund returns over time. Part of the problem, Edwards said, is that fees are expressed in percentage rather than dollars and cents. The fact that they are costs that will be incurred in the future may also make them seem less ominous.

"A lot of people are more worried about paying their $50 cable bill than a percent and a quarter on their investment every year," Edwards said. "But let's say you have a retirement account with $50,000 in it; that's $625 a year, every year. Not just one year, but every year. ... It adds up."

That means as your investment grows, so do your costs. The year your account reaches $100,000, you'd be paying $1,250 in fees.

There also are other costs that might be tricky for a novice to dissect. For example, your expense ratio may be 1.25 percent, but you may also be paying a 0.25 12b-1 fee, which is supposed to cover the cost of advertising and selling the fund.

What's confusing is that some funds charge these marketing fees even after they've closed to new investors. There also may be other charges, such as trading costs, that are not clearly disclosed. This has caused many industry watchers to call for reforms in mutual fund fees.

Edwards and other experts say fees are one of the first things you should consider when you're deciding whether to buy or sell a fund. Other fundamental criteria include consistency of performance, quality and consistency of management, the style of the fund and whether it is appropriate for you, and the quality of the fund sponsor.

Some firms, such as Vanguard, T. Rowe Price, Dodge & Cox and American Funds, are known for producing better-than-average returns while charging lower-than-average expenses. Vanguard has made a practice of avoiding 12b-1 fees altogether.

The only time high expenses might be called for is if you're buying into a brand new fund with lower asset levels, said Tyson. Even then, you should think carefully about whether you want to buy into a fund without a performance history. An exception could be made for a manager who has an outstanding track record with other funds, or if you feel reasonably sure that assets will rise and expenses will fall.

The best strategy, however, is to simply "limit your investments to funds that have low fees and a history of good performance," Tyson said. "You can have your cake and eat it too."

-- posted by SteveT