Keep Job, Take 401(k) Elsewhere
Hate the investment options in your 401(k) plan? Old enough to remember watching the Beatles on Ed Sullivan? Forbes reports on 401(k) "in-service" distributions, an obscure provision that allows 401(k) investors who are 59 1/2 and older to roll over some or all of their 401(k) assets into an individual retirement account without paying taxes or penalties:
Employers and 401(k) plan administrators don't advertise this fact, but most workers 59 1/2 and older, and even some younger ones, can roll over 401(k) funds while they're still working and contributing to the plan. This option isn't right for everyone. But in some cases it can provide more attractive investment choices, a better way to leave money to your kids or even a chance (new in 2008) to move 401(k) dollars directly into a Roth IRA.
The law allows workers to empty their 401(k) accounts once they hit 59 1/2. They can roll all the money into an IRA without paying tax now. Or they can take cash out, pay any ordinary income taxes due and spend what's left. The same goes for participants in government and not-for-profit savings plans similar to 401(k)s."
As the article mentions, employers can refuse to allow these early 401(k) exits, but "in-service" distributions are currently available at 70% of U.S. companies. As we well know by reviewing billions of 401(k)s for the MAXadvisor 401(k) Planner service, there are a lot of lousy company-sponsored retirement programs out there. "In-service" distributions are a great way to escape a plan that offers a mixed bag of low-quality or expensive 401(k) investment options.
Bottom Fishing Financials - Not A Novel Idea
MAXfunds is all about avoiding overheated fund categories and sniffing around for out of favor fund categories. Our category rating system looks at fund flows and past performance across all funds in a category to find attractive areas. Funds that invest in financial stocks appear to be attractive as the mortgage meltdown has led to tens of billions in losses and big stock price declines for banks and other financial companies and the funds investing heavily in these stocks. Unfortunately for true contrarians, everybody else is looking to make the same bet:
Investors put $2.8 billion last month [January] into U.S. mutual funds that concentrate investments in financial-services companies, the most since Emerging Portfolio Fund Research started compiling the data in 2004....The net new deposits pushed up assets in financial-services mutual and exchange-traded funds by 20 percent to $17 billion in January...The collapse of the sub-prime mortgage market has led to more than $145 billion of investment losses and write downs for the world's biggest financial institutions since June. The S&P Financials Index fell 21 percent in 2007. Investors pulled $260 million from financial funds during the last four months of last year."
This means more money has been going into financial sector funds trying to catch the supposedly big buying opportunity than left during the financials crash last year.
We've seen this phenomenon with the Select Sector SPDRs Exchange Traded Funds. You'd think the Financial Select Sector SPDR ETF (XLF) would be hemorrhaging cash with its stakes in many troubled financial stocks. However, today this sector ETF has more money in it ($5.5 billion) than any of the other nine sector SPDRs - even the popular and hot-performing Energy Select Sector SPDR ETF (XLE). At the end of January (during peak bottom fishing optimism in financials) the ETF had $6.7 billion in assets - way up from the roughly $5 billion at the end of December.
We're going to need to see some of this money leave the sector before we see a true buying opportunity. It's not a true buying opportunity until only a few people want to buy.
Ritchie (a little less) Rich
With all the news of the real estate bubble trouble dominating financial headlines, mutual fund investors may have forgotten perhaps the greatest systematic fraud perpetrated on fund shareholders - namely, the great mutual fund skimming scandal (known aliases: fund late trading, fund timing).
Fear not, dear fund investor, the money police (SEC or Securities And Exchange Commission) is still hot on the trail of fund cattle rustlers. Today's Chicago Sun Times reports on the latest and greatest:
Ritchie Capital Management, founder Thane Ritchie, an employee and the Ritchie Multi-Strategy Global Trading Ltd. hedge fund are paying a total of $40 million to settle charges of illegal late trading.
The settlement is one of the largest the SEC has secured since it started an industrywide crackdown in 2003 against alleged mutual-fund trading abuses.
The SEC said that from January 2001 through September 2003, Ritchie Capital placed thousands of late trades in mutual fund shares and used news and information breaking after the market closed to make its trading decisions while receiving the same day’s value for the funds traded.
Late trading involves favored customers receiving the market-closing price for mutual fund shares for orders placed after the stock market closes for the day at 4 p.m. EST."
E*Trade Ads Spell Trouble For Emerging Markets
We all remember the infamous "Let's light this candle!" ad for an online broker in 1999. The day-trader-era focused ads made riches seem available to all who clicked buy. We all know what happened: pain and suffering as the Nasdaq declined about 80% top to bottom.
To those watching the Superbowl yesterday, you may have noticed a sort of retro dot com era ad flashback. Not only were many of the multi-million dollar ads run by dot-coms (just like the old days), but ads for online brokers were making the rounds again.
Check out E*Trades current slew of ads. Our favorite is the one that touts E*Trade's new feature where customers can buy shares directly in foreign markets. In the ad, one customer is particularly enamored by his ability to load up on Chinese stocks. This of course doesn't bode well for the future of Chinese stocks. This is the E*Trade (ETFC) that moved heavy into mortgage lending right before well... just check out their stock price.
Dodge & Cox Reopens Funds
Apparently fund investors are sick and tired of all the scary recession talk and stock market volatility. In recent weeks many closed funds have reopened to new investors amidst a flight of old investors. The latest and perhaps greatest to announce the lock is off the door is Dodge & Cox funds. The value oriented firm will be reopening Dodge & Cox Stock (DODGX) and Balanced (DODBX) funds on Monday:
Dodge & Cox Funds, one of the most popular U.S. mutual fund families, said it will reopen to new investors its flagship Stock fund and its Balanced fund, which invests in stocks and bonds, after performance lagged its peers for the first time in more than a decade.
The $63 billion asset Stock fund and $27.1 billion balanced fund will reopen on Monday. Dodge & Cox had in 2004 stopped accepting money from new investors after assets in the funds had grown too rapidly for it to invest easily. It continued to accept money from existing investors."
Dodge & Cox is losing investors for an unusual reason for this top-performing family, underperformance:
In a statement on Friday, Dodge & Cox said investors have recently been redeeming money from the funds because of weak returns and volatile markets....the Stock fund last year returned 0.1 percent, trailing 61 percent of its 'large-value' peers, while the Balanced fund returned 1.7 percent, lagging 89 percent of its 'moderate allocation' peers. Both funds had outperformed a majority of their peers in every year over the previous decade..."
Investors still love Dodge & Cox International Stock (DODFX) - a good sign this fund and international funds in general will underperform U.S. stock markets going forward.
Let Bygones Be Bygones
As banks are now learning the hard way, relying on past performance to predict future returns can be a recipe for disaster. If mortgage default rates remained at the levels of the past, all the no-money-down lending made in recent years wouldn't be causing a financial calamity today. The same is true for investing in mutual funds. What has worked in the past often doesn't work in the present. As a fund investor, you have to be very careful you are not loading up on yesterday's good ideas. Unfortunately, fund rating and ranking systems tend to have the opposite affect: they direct you into yesterday's winners.
A current article on TheStreet.com titled "Five Perpetually Winning Mutual Funds" shines a spotlight on five funds that TheStreet's rating system has given highest marks to for the last two years.
In the first table below are the "Perpetual A+ Winners" -- the five funds with two years of continuous A+ ratings. Especially with the recent market turmoil, it is not easy to outperform 96% of the open-end fund universe for 24 month in a row."
The "A+" funds in question are:
AIM European Growth A (AEDAX)
JPMorgan International Value A (JFEAX)
Franklin Mutual European A (TEMIX)
DFA International Value IV (DFVFX)
Dodge & Cox International Stock (DODFX)
Everybody loves a winner. Unfortunately these five fund will all very likely underperform the S&P 500 over the next few years.
The main problem is that this list of winners is really just the best performing funds in a fund category that has happened to beat most other funds over the last eight years - foreign funds that are more value than growth. If TheStreet had created this list in 2000, they would have wound up with five large cap U.S. stock funds with a heavy growth bend. Janus, PBHG, and Firsthand funds would probably have dominated the list.
Rating funds based on how they do against all funds in general is very dangerous. Morningstar learned this the hard way when they dolled out five star ratings to just about every U.S. large cap growth and tech fund manager with a pulse in 2000 while slamming foreign and small cap value funds. Morningstar eventually started doing things a little more like MAXfunds has since 1999 - comparing each mutual fund to similar funds (though they do not consider fees, fund size, category valuations among other things we consider). Clearly TheStreet.com is still using this old fashioned fund rating methodology.
If you think the next few years will be more of the same - a sharply falling U.S. dollar and European stocks clobbering U.S. stocks, these funds are for you. You certainly won't be alone in your decision - this is how most fund investors are allocating their money to funds these days. Our guess is it is many of the people who overloaded on tech and growth funds in 2000.
What To Look For In Your Fund's Annual Report
Mutual funds are required by the SEC to deliver an annual report report to shareholders each year, usually right around now. Think of these - the semi-annual and annual reports - as your fund's twice-a-year report card - it's very important (albeit tedious) to read through the annual report carefully to find out what your fund manager has been up to in the past year. In it you'll find crucial information including detailed performance data, asset level changes, changes in holdings and strategies, and pent-up tax liabilities. Chuck Jaffe tells you exactly what to look for when your mutual fund's annual report lands in your mailbox. Here are the highlights:
Performance - Find out why the fund has beaten or lagged its benchmarks.
Statements from Management - Funds should provide candid, clear explanations of what happened, what to expect and why.
The Fund's Portfolio - Look for a portfolio that is consistent with your expectations in terms of diversification, international exposure and size of companies.
Expenses and Portfolio Turnover - A fund with high or rising expense ratios is not maximizing your returns. High turnover can lead to big capital gains tax liabilities, which you end up paying.
Asset Growth - That's one investment trend that, eventually, you may want to follow.
The Auditor's Report - Don't bother reading it, just count the paragraphs. If there are more than three, there could be trouble.
Changes in Structure - while many issues are boilerplate and legalese, some proxies seek your approval for dramatic changes in style and strategy.
Taxable Gains - A fund that is tax inefficient - where the bulk of its returns come from trading profits and dividends rather than long-term buy-and-hold investing - forces an investor to pay taxes for big chunks of their gains annually.
Some managers write generic boilerplate but some write interesting commentary that really gives you some insight into the past, current, and future goings on in the portfolios. Much of the fund data in annual reports finds its way onto the MAXfunds.com fund data pages (be sure to check the 'details' links), often with our custom interpretative statistics.
No Hiding From This Bear
Following the recent steep drop in foreign markets, today the U.S. stock market opened way down - in early trading we saw a 4% fall. Since the market peak in October 2007, stocks have been weak around the world. While the market has come back in the afternoon, we just about saw the most indexed and benchmarked of U.S. stock indexes down 20% from the highs hit just over three months ago.
A 20% drop is a measure often used to denote a bear market. We haven't had a 20% fall since the great bubble pop of 2000-2002. Unlike the last bear market, this one is proving hard to dodge.
In the late 1990s we didn't have across-the-board asset price booms. Real estate was relatively cheap, as was natural resources and commodities, small cap stocks, and value stocks in general.
Back in 1999 the entire Russian stock market had a combined market cap less than any individual major stock in the Nasdaq or S&P 500. Even safe U.S. Government bonds had a decent yield. The bubble was in tech, telecom, U.S. large cap and growth stocks. Anyone who was "properly" diversified across multiple asset classes at least partially avoided the market meltdown that eventually took the S&P 500 down almost 50% and the Nasdaq almost 80%.
Over much of the last few years investors have been piling into foreign stock funds. Today the iShares MSCI EAFE Index (EFA) exchange traded fund or ETF tips the scales at around $50 billion - second only to the oldest ETF, the SPDR S&P 500 ETF (SPY) exchange traded fund with $85 billion. Heck iShares MSCI Emerging Markets Index (EEM) has $24 billion - more than the $19 billion in the Nasdaq 100 ETF or QQQ (the ticker is now QQQQ).
Unfortunately in this down market all this diversification is hurting, not helping. The Dow and S&P 500 are among the relatively best performing areas to invest - many foreign markets have fallen over 10% in the last two days alone. Most of the big foreign stock markets are already down more than the U.S. market during this downturn. Real Estate Investment Trusts or REITs - a favorite to the diversification crowd - are now down near 40% from the peak in February 2007.
Bottom line, diversification helps when investors are adding cheap out-of-favor asset classes. Adding expensive asset classes - even ones that have been historically less correlated to U.S. stocks - can increase portfolio downside in a bear market. Going forward, we expect U.S. stocks to continue to outperform essentially all the hot categories of recent years. Our fund category rating system rewards categories that have underperformed and seen a lack of interest by investors in recent years.
Why are ETFs More Tax Efficient Anyway?
You hear it all the time: exchange-traded funds are more tax-efficient than traditional mutual funds - what you don't hear is the reason why. Smartmoney gives a good answer:
When investors decide to exit an ETF they can sell their shares in the open market. In some cases, the authorized participant will redeem large chunks of ETF shares directly with an ETF sponsor like WisdomTree, performing what's called an "in-kind" redemption. In essence, they reverse the initial purchase transaction. So WisdomTree would return that sampling of individual shares in its portfolio to the AP in exchange for the ETF shares. The twist: WisdomTree will generally return the shares with the lowest cost basis — the ones it paid the least for and, hence, the ones with the highest potential capital gains — in order to hold down its potential tax hit. The AP doesn't care because its tax basis will be based on the current share price. The IRS perceives the whole deal as two companies exchanging one type of share for another, so it's not considered a taxable event.
That transaction method helps insulate existing ETF shareholders from unexpected capital gains — a luxury mutual fund holders don't enjoy. Indeed, an investor who leaves a mutual fund can potentially trigger capitals gains in their wake, since a manager has to sell shares to pay them off. Meanwhile, an investor who leaves an ETF pays taxes on his own profits; the existing shareholders don't get whacked with any unexpected capital gains."
Of course, non of this matters if you own your funds in a tax deferred account like an IRA.
Vanguard Tries To Ruin Your Investing Tax Break
You can count on mutual fund companies to try to squash any product they think is a competitive threat to their multi-trillion-dollar-in-assets cash machine.
The latest attack on mutual fund dominance is from the relatively unknown exchange traded notes (ETN). These ETF-esque securities are essentially exchange traded derivative contracts. The main force behind ETNs is Barclays iPath® Currency Exchange Traded Notes. With their popular iShares lineup, Barclays is already a big player in ordinary exchange traded funds (ETFs). So far the offerings are mostly focused on commodities and currencies. Still, according to an article on Bloomberg.com today, Vanguard is already trying to nip notes in the bud:
Barclays Plc introduced a new product that put a scare into Vanguard Group Inc. and the rest of the $13 trillion U.S. mutual-fund industry. Now Congress and the Treasury Department are coming to the funds' aid.
The security, called an exchange-traded note, allows individual investors to buy a type of forward contract linked to commodities and assets ranging from oil to currencies to foreign stock indexes. It has lower fees than mutual funds, is less regulated and, for now, lets holders defer taxable income indefinitely.
While less than $10 billion of the notes have been issued so far, mutual-fund companies see the potential for the new instruments to catch on in a big way with investors. The notes are 'derivatives for the masses,' said Alex Gelinas, a tax lawyer at Sidley Austin LLP in New York. For the mutual funds, reining them in is 'the issue of the year.'
The funds argue that the way the notes are handled for tax purposes puts their products at a disadvantage. The industry's trade group wants the government to either scrap the notes' favorable tax treatment or extend it to them too....In response, the Investment Company Institute [ICI], the trade association representing Vanguard and other funds, sent letters to Congress and Treasury calling the tax advantages of exchange- traded notes 'unwarranted, unintended and unfair.'
It got results. The Treasury Department in December said the interest income generated by currency-related notes can't be deferred because they are debt instruments. It may rule on other types of notes this year."
This is not the the first time funds acted to protect their best interests. In recent years fund companies were concerned people would buy professionally managed stock baskets without the inefficiencies, regulations, and costs of the old fashioned mutual fund structure, so they sicked their trade group, the Investment Company Institute, on small upstarts offering these services. Fortunately for fund companies, the idea never gelled with consumers as similar exchange traded funds became popular.
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