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Some Good Reasons to Dump Your Mutual Funds
By Mary Rowland

11/7/01 1:43 PM ET

A couple of years ago I predicted the demise of mutual funds. I thought savvy investors would recognize the pitfalls in traditional funds and move to individual stocks and hybrid funds.

Then the market plummeted. Individual stocks became treacherous, and many experts argued that mutual funds proved their mettle during the market doldrums.

Fine. But financial planners think differently. They are moving rapidly away from mutual funds and into the exchange-traded funds on the Amex, where there are now close to 100 choices, ranging from broad market indices to an index of Real Estate Investment Trusts (REITs) to a Goldman Sachs natural resources index. There are a half-dozen different value and growth indexes, and the only health-care index fund available anywhere, so far as I know.

The exchange-traded funds are all index funds. Each one follows an index such as the Standard & Poor's 500 SPDR Trust (SPY:AMEX) or the Dow Jones 30 Industrials Diamonds Trust (DIA:AMEX) or the "total stock market" as measured by the Wilshire 5000 Vanguard Vipers (VTI:AMEX) . None of the funds is actively managed, although experts say active funds will be available as exchange-traded funds, perhaps next year or the year after.

Cheap, Pure and Efficient
So what's the appeal? Three things: Low expenses, tax efficiency and purity of asset class, an important characteristic for a financial planner who is trying to set up an asset allocation strategy for clients.

The difference between investors who prefer active management and those like Harold Evensky who move clients' assets to exchange-traded funds is that the active group still has faith that at least some managers can beat the market.

Where you come down on the active vs. passive argument will determine whether you like exchange-traded funds. If you like passive management, you have a choice between the low-cost Vanguard or TIAA-CREF mutual funds and the exchange-traded funds.

So let me give you a quick background on ETFs, which are hybrids: a cross between the open-end mutual funds and the closed-end funds that have traded on exchanges for decades.

Four Strikes Against Old Funds
The big disadvantages to traditional open-ended funds such as those at Janus, Fidelity and Invesco are these:

They cost too much. The average expense ratio of a domestic stock fund is more than 1.5%, money skimmed off your investment dollar every year. We don't know what's in the portfolio. Funds are required to post holdings only twice a year, and by the time we get them, they're outdated. Funds post prices once a day, after the market close. Funds can be a tax nightmare because the portfolio manager trades securities throughout the year, handing shareholders the capital gains. Funds can be taxable even in a year when they lose money. Last year mutual funds distributed $325 billion in gains, a record, even though most lost money. According to one study, taxes shaved about 3 percentage points off the five-year returns of most fund categories. For instance, mid-cap growth funds returned an average of 9.7% for the past five years, but only 6.3% after taxes.

Exchange-traded funds offer a pot of securities, just like open-end funds. But ETFs are much cheaper. The Vanguard Vipers cost 15 basis points a year. Many ETFs carry expenses in the range of 20 to 30 basis points, with the special sector indexes in the 60-basis-point range and foreign funds a bit higher. None costs as much as 1%.

And investors know exactly what is in each portfolio. You can go to the iShares Web site or the Amex Web site and see a list of stocks in each portfolio. The shares trade throughout the day and can be shorted or bought on margin.

Taxes might be the clincher. Index funds trade less and are more tax-efficient than active funds. And ETFs have a clever device to reduce taxes further.

Shares are redeemed and created only "in kind," which means big institutions can create new shares by bringing in the actual stocks in the index or redeem shares by taking back stock. ETFs were designed with this safety valve to keep the price honest. One of the problems with the old closed-end funds was that the price responded to supply and demand; sometimes a fund traded on the exchange sold for far more or less than the underlying assets were worth. This arbitrage feature of ETFs keeps the share price at actual value.
The Capital Gains Game
Some of our community regulars have pointed out that shares of an ETF such as the Nasdaq 100 Trust trade off the actual close of the index at the end of the day. I asked Lee Kranefuss, head of individual investor services at Barclays Global Investors, sponsor of iShares, about that. He said that because the shares trade until 4:15, they reflect changes in prices of the underlying stocks between market close of the index and close of trading on the ETF.

This "in-kind" creation and redemption has another advantage. When a typical mutual fund sells shares, it sells those with the highest cost-basis first. Suppose a fund has shares of General Electric (GE:NYSE) that it bought at $10 and shares it bought at $55. If the manager sells GE at $60, he will sell the shares that cost $55 to reduce capital gains tax. But what he is really doing is embedding the gains of those $10 shares in the fund because they must be paid by shareholders at some future date. So when you buy a mutual fund, you're set up to pay somebody else's gains.

Here's what an ETF does: When an institution redeems shares and takes back the stock, the fund gives the institution the low-basis stock, or the GE that it paid $10 for, keeping the higher-basis stock in the fund and maximizing tax efficiency.

These are some of the reasons Evensky says he's moving to ETFs. Like many investors, Evensky believes that equity risk premiums will decline. That makes the impact of expenses and taxes bigger "so the hurdle that managers have to overcome is so much higher," he says.

Evensky says he has also been giving some thought to his traditional approach to investing, which is to allocate money on the basis of market capitalization, distributing client assets to large-cap, medium-cap and small-cap stocks.

Though the approach is intellectually sound, he says, it is flawed for investors who must pay taxes, because the small-cap managers sell stocks that get too big to the mid-cap managers, and then the mid-cap managers sell to the large-cap managers. The same stock moves up the capitalization ladder, and the investor pays tax on it every time it is sold.

So I've made my case for exchange-traded funds. But there are so many of them. How to choose? I'll write about that next week for those who prefer a more passive approach, and the following week for more aggressive investors.

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At the time of publication, Mary Rowland owned the following equities mentioned in this column: SPDR Trust and the Nasdaq 100 Trust.
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© 2001 TheStreet.com, Inc. All Rights Reserved

-- posted by way2go

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» Rande - The Latest -- 11/9/01

Quite a week for the markets with a little help from the Fed. Interesting to note that the "50/50" portfolio is now showing positive since 12/31/99, albeit just by a hair. Quite a move now from the 9/21 lows too. Again, hope all those historical examples of how the markets tend to bounce back from tragic shocks were helpful in ignoring the typical end-of-the-world messages. Have a grrrrrrrreat weekend. Here's....

The Latest (as of 11/09 close):

YTD 2001:

DJIA -10.9%
S&P -15.2%
SPY -13.6%
VTSMX (W5000 Index Fund) -14.6%
Nas -26.0%
QQQ -35.4%
R2000 -9.4%
MDY (S&P 400 Midcap) -8.3%
VEURX (European Index Fund) -21.0%

Since 12/31/99:

DJIA -16.4%
S&P -23.8%
SPY -21.6%
VTSMX -23.4%
Nas -55.0%
QQQ -58.7%
R2000 -13.2%
MDY +7.7%
VEURX -27.2%
50/50 Total Stock/Total Bond +0.02%
(includes Total Bond through yesterday)

Since Previous Closing Lows:

DJIA (9/21/01) +16.7%
S&P (9/21/01) +16.0%
SPY (9/21/01) +16.3%
W5000 Fund (9/21/01) +16.1%
Nas (9/21/01) +28.5%
QQQ (9/21/01) +33.8%
R2000 (9/21/01) +15.6%
MDY (9/21/00) +15.8%
VEURX (9/21/01) +21.7%

Since Previous Closing Highs:

DJIA (1/14/00) -18.0%
S&P (3/24/00) -26.7%
SPY (3/24/00) -25.0%
VTSMX (3/24/00) -28.4%
Nas (3/10/00; ) -63.8%
QQQ (3/24/00) -68.0%
R2000 (3/9/00) -27.7%
MDY (9/7/00) -13.9%
VEURX (3/24/00) -29.7%
___________________________

Previous Closing Highs

DJIA 11722.98 (1/14/00)
S&P 1527.46 (3/24/00) [back to 1530.09 intraday on 9/1/00]
SPY 153.56 (3/24/00) [back to 153.5938 intraday on 9/1/00]
VTSMX 35.58 (3/24/00)
Nas 5048.62 (3/10/00)
QQQ 117.75 (3/24/00)
R2000 606.05 (3/09/00)
MDY 101.4525 (9/7/00)
VEURX 29.85 (3/24/00)

Benchmark Closing Lows (lows since previous all-time highs):

DJIA 8235.81 (9/21/01)
S&P 965.80 (9/21/01)
SPY 97.28 (9/21/01)
VTSMX 21.40 (9/21/01)
Nas 1423.19 (9/21/01) (intra low -- 1387.06 on 9/21/01)
QQQ 28.19 (9/21/01) (intra low -- 27.20 on 9/21/01)
R2000 378.89 (9/21/01)
MDY 74.45 (9/21/01)
VEURX 16.85 (9/21/01)

Market Cycle Peak to Trough:

DJIA (1/14/00 - 9/21/01) -29.8%
S&P (3/24/00 - 9/21/01) -36.8%
SPY (3/24/00 - 9/21/01) -35.3%
VTSMX (3/24/00 - 9/21/01) -38.2
Nas (3/10/00 - 9/21/01) -71.8%
QQQ (3/24/00 - 9/21/01) -76.1%
___________________________

Index returns are price change only, ETFs and mutual funds including divs/distributions. Returns not guaranteed as to accuracy -- relying on unaudited third-party sources (may have missed a dividend or two, which would understate returns).

-- posted by Rande

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» JenL_2 - Re: The Latest -- 11/9/01

In response to message posted by Rande:

To illustrate:

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
VTSMX, VFINX, VEXMX Comparison 5 YR Chart

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
3 YR Chart

<img src="http://chart.neural.com/servlet/GIFChart..." width=500 height=350>
1 YR Chart

<img src="http://pvcharts.quicken.com/bin/icenter...." width=470 height=250>
YTD Chart

…..Jen

-- posted by JenL_2

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» smile_1 - purging fools... stronger US... better humanity (hopefully)

Foolish cut back of personnel has led to loss of good workers but may pave the way to survival for remaining fools...

Sorry to see ya go Carl. Good luck to you.

Lean and mean is how many companies will come out of this downturn.

Translates to stronger economy in the end. We need more help on the long end guys, unfortunately I don't think anyone is home on the subject in Congress. Lower long rates (not short rates) will do more for this downturn than any stimulus package on the Congressional table. Common sense.

Macro view, our country will be a better place in a global sense for a number of reasons as a result of the 911 cowardly attack of this great nation.

No, those who lost their lives in the despicable acts which took place on 911 and after, did not die in vain.

I can not even imagine the courage it must have taken to jump from 100+ stories given the choice of burning up or die quickly, or the courage it took for those who downed the 4th plane to save others from the same fate...

With Bush/Cheney (where is he BTW) leadership, we have entered a new era of vigilance. Recognizing that if others in this humanity are suffering, suffering will visit us if we are not proactive or if we chose to ignore and do nothing.

We all have an obligation going forward, search your heart and you will see it too. We will not lose our resolve, all one has to do is call upon the emotions of 911.

Unfortunately, I missed Bush's speech the other night, but my other half told me the joy and pride felt when Bush said "... this great country of ours will not be intimidated..."

Amen to that.

-- posted by smile_1

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» JenL_2 - Re: Bush Speech

In response to message posted by smile_1:

Unfortunately, I missed Bush's speech the other night, but my other half told me the joy and pride felt when Bush said "... this great country of ours will not be intimidated..."

Amen to that.

Smile - did ya see this post of the Bush Speech on the "America at War" thread:

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

My favorite part of the speech was at the end - the tribute to the heroes of Flight 93 - with the last line....

My fellow Americans, let’s roll.

.....Jen

-- posted by JenL_2

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» Kirk - walkerman market bet

Author: walkerman
Date: November 13, 2001 7:32 AM
Subject: Re: Re: Re: Re: Re: Re: Re: Re: Re: walkerSPIN

In response to message posted by Fred2000:
Freddywithateddy.....I would have to go with the line of thought that says the stocks that got hit the hardest on the way down are the ones that will recover the fastest and the most on the way up. I'm betting on a recovery, which means growth will outperform value. Moreover since, in the beginning of a recovery, small outperforms big, I've been averaging into IWM and MDY for months now.

---

This sounds wise and seems to agree with my observations.

Many of my small/micro cap stocks that were hard hit have seen very large recoveries off their bottoms. For example, SFAM is up something like 224% from $1.00 to $3.24!

My favorite mid cap (or is it small cap?) LRCX is well up (over 50%) from its very recent low.
http://stockcharts.com/def/servlet/SC.we...
Seems to have a very clear trading channel also... but the good swing traders say "Count on 3 and expect 4" swings and it seems LRCX has done that and could now be starting another breakout to the upside.

HWP is up over 50% from its bottom, but it had other issues to drive it down so it might not count.

WCOM is still low and near its bottom, up only about 20%
http://stockcharts.com/def/servlet/SC.we...

Lucent (I don't own it) seems to be in a trading range between $5 and $8 but is well off its recent bottom of $5.00 that was a test of its June bottom of $5.04
http://stockcharts.com/def/servlet/SC.we...

I wonder if the small caps will lead for some years as the large caps sure seem expensive on most valuation metrics?

I think Rande has some good data somewhere showing how small and mid caps lead out of a recession.

-- posted by Kirk

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» Rande - Re: walkerman market bet

In response to message posted by Kirk:

Small caps do have a tendency to lead out of a bear market. Of course, this could be misleading since many a solid large cap leading up to the bear market might have found themselves a bit smaller coming out.

Something to keep in mind in the current context, however, is how mid and small caps have behaved throughout the current market cycle. The observation was made that perhaps those stocks which have been beaten down the most will have the most bang for the buck coming out. Maybe, maybe not (could be many of them deserved to be beaten down and to stay there). BUT, since 12/31/99 MDY has been one of the best performing asset classes, up 9.7%, NOT what you would expect in a bear market and certainly not consistent with the notion of buying the most beaten down areas at this point.

-- posted by Rande

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» Kirk - Hays says 10.9% UNDERVALUED!

Exerpts:

. The Valuation model as we show on our website is still in undervalued territory, being 10.9% undervalued.

this chart of the division of the 10-year T-notes yield by the t-bill yield, is the best way in my opinion to look at this critical leading economic indicator—the yield curve. In the past when this drops under 1.0, you can almost guarantee that a recession is in the cards. That was the case almost a year ago. For many milder economic scenarios, when this does move back above 1.2 that is sufficient to resuscitate most economies unless the consumer and corporate environment has unusual problems. When it goes above 1.4 it will be sufficient to cure almost all economic problems that are inhibiting the renewed growth of a more severe recession. Occasionally, however some extreme fear or problem is so overwhelming that the banks become so afraid to loan, and the consumers and corporations are afraid to borrow that it takes more.

I mentioned the “real” fed funds rate several times in the last few weeks, showing my belief that King Alan would bring out the chart at his meeting last week, of the “real” fed funds level—the nominal fed funds rate that subtracts his favorite inflation gauge, the consumption price deflator. The consumption price deflator is now only 1.5%. So when the banks do not want to lend money to anybody that “needs” money but only those who don’t need money (in other words extremely well-collateralized borrowers), the Fed has to drive interest rates down so low that these “fat-cats” will start to borrow money even though they don’t need to. Traditionally this key level is under the inflation rate. That would mean, of course, that the fed funds level will eventually fall under the 1.5% level. Can you imagine that??

Full Hays Text: http://www.suite101.com/discussion.cfm/i...

I think we are seeing some of that low rate effects in the auto industry where GM and Ford borrow at low rates to finance the incentives. I've also noticed that some companies like LRCX and KMAC have used this period to get a pot of money at low rates.... perhaps to buy other companies that are cheap when they see a sign of the orders increasing?

-- posted by Kirk

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» JIMMY62 - Re: walkerman market bet

In response to message posted by Kirk:

I would have to go with the line of thought that says the stocks that got hit the hardest on the way down are the ones that will recover the fastest and the most on the way up.

We have just seen in the past two years that the stock that went up the fastest also went down the fastest, so there is some logic to your thought. Once volatile, volatile for a while more.
But, since the big run up in some stocks in 1999 made those stocks highly over valued by fundamental measures, is not their big fall a market correction, a return to more rational values? If so, there is no reason to think those same stock will return to irrational values again.

-- posted by JIMMY62

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» Kirk - Re: Re: walkerman market bet

In response to message posted by JIMMY62:

Walkerman said it, not I.

Remember, some stocks like Ariba, ICGE and CMGI (or even my own BOWG) went to the moon and returned to a crater.

I doubt you can put BOWG, ICGE and CMGI in the same class as Cisco or CACS, large and micro cap companies in the telecom equipment industry that did make a profit in good times.

As always, you need to be selective. Some stocks got hit very hard for a VERY GOOD reason.

-- posted by Kirk

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