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Seven Habits of Highly Defective Funds

October 10, 2007

Yesterday we noted a high yield bond fund that has seen its fund price (NAV) fall about 40% since early June. Higher risk bond funds follow a pattern of feast and famine – the key to investing in such funds is to identify the types of bond funds that can tank 40%, and either avoid them completely or consider a speculative investment near the bottom of a famine cycle.

The trouble is that these bond funds tend to look the best at exactly the wrong time. They have the best reviews and ratings, and the performance figures smash the competition.

But remember, for most types of bond funds, performance comes largely from just two things: the fund’s expense ratio and the quality of bonds the funds hold. A much smaller part of the performance can be attributed clever bond selecting.

Here then, dear reader, is the MAXfunds “Seven Habits of Highly Defective Bond Funds”, our step by step instructions for lousy managers to destroy their perfectly good bond fund:

1. Beat the competition by a country mile by loading up on thinly traded, low or no grade debt.

2. Watch gobs of money flood your aggressive bond fund, because the “impressive long term record” is assumed to be the result of your brilliant bond picking.

3. Join other deluded bond investors and bid up the junky debt to near safe debt yields.

4. Express shock as a scary event happen “out of nowhere” that makes investors reconsider the safety of their higher risk debt positions. Note how “these are truly unprecedented times”. Yes, who would have thunk it might be hard to sell no-money-down, no-doc, interest-only, subprime debt when foreclosures climb?

5. Pull a “Heartland” (in October 2000, Heartland High-Yield Municipal Bond Fund plummeted 69% in one day) and pretend or guess that the no-market-price bonds are worth a little bit more than they probably are to preserve the fund price and try to trick investors to staying put till the mayhem passes.

6. Watch in horror as your fund’s shareholders could care less that your bond fund is down only 10% and not 20%, and sell anyway.

7. Panic sell thinly traded bonds with the rest of the herd and send your fund price down even more as the bids for your bonds quickly evaporates when you try to move your big stakes.

Funds Keep Singin’ The Subprime Blues

October 9, 2007

Every few years there is a mini bond crisis. Each time the same thing happens: bond funds that looked great by beating their peers, fall precipitously. Same goes for 2007.

The [Regions Morgan Keegan Select High Income Fund (MKHIX)] is down about 35% this year, and is at the bottom of the junk-bond fund category for the one-, three- and five-year annual performance periods, illustrating how recent events are starting to tarnish even manager Jim Kelsoe's impressive long-term record."

Lord knows how much investors would have lost in these high flying RMK bond funds if the giant financial firm behind the funds didn’t step in (RMK funds are owned by Regions Financial RF):

The annual report that covers these funds also outlines some important steps taken by the funds' adviser and affiliates to help cope with recent losses. These include stepping in to buy about $55.2 million in shares of the High Income Fund and $30 million in the Intermediate Bond Fund [MKIBX] from the beginning of July to the end of August to help provide liquidity."

The takeaway is that you shouldn't mix mutual funds with thinly-traded higher-risk investments, or you could end up singing the subprime blues:

I went to the bond market, fell down on my knees
I went to the bond market, fell down on my knees
Asked the Lord above, have mercy now, save my poor bonds if you please

Standin' at the bond market, tried to flag a buy
Whee-hee, I tried to flag a buy
Didn't nobody seem to know me, everybody pass me by

Standin' at the bond market, risin' sun goin' down
Standin' at the bond market baby, the risin' sun goin' down
I believe to my soul now, my po' bonds is sinkin' down

You can run, you can run, tell my friend Bennie B
You can run, you can run, tell my friend Bennie B
That I got the bond market blues this mornin', Lord, baby my bonds are sinkin' down

(To the music of Crossroads Blues / Robert Johnson 1936)

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Ask MAX: A Fund with an 18% Yield?

October 6, 2007

MAX,

I recently received an email solicitation for the 'High Yield Investing Newsletter,' featuring a mysterious diversified fund called The Korea Fund (KF) which sports a whopping 18.4% dividend with a 34 .4% projected yield! Is this even possible

Mike
Los Angeles

Dear Mike,

It is, in fact, possible for a diversified fund to yield 18.4%. But of course, there is a catch. This kind of yield is best avoided. The income newsletter's marketing department has clearly opted to transform lemons into lemonade. So let’s get to the bottom of this allegedly attractive investment opportunity.

There really is no such thing as a free lunch when it comes to investing. When stocks pay dividends that beat the S&P 500 (which is currently yielding under 2%) by such a large margin, there is always a reason:

• The stock might have lower growth prospects than most companies (regulated utility stocks are a good example.)
• The business has mandatory high payouts, much like a mutual fund (we often see this with real estate investment trusts)
• The company is simply issuing a sizable one-time dividend (as Microsoft did in 2004).
• The stock has fallen on hard times, or faces an uncertain future (as Merck did in 2006).
• The dividend payouts might be unsustainable or likely to be cut (like General Motors and Ford in recent years).

Sometimes, über-high dividend prospecting works out. Just ask the investors who bought Merck last year. More often than not, though, investors wind up with a cut dividend and a sinking stock.

Mutual funds yields can be confusing. Since a diversified stock mutual fund owns dozens of individual stocks, it's very unusual for one to garner a steady, legitimate yield several times greater than the S&P 500 . Such oversized yields are hard to come by, especially since funds deduct their fees from collected dividends.

The problem is that yields can be inflated to appear more impressive than they really are. Strong yields make it appear as though a mutual fund is collecting steady dividends from all the portfolio’s stocks, but such buy and hold dividend collecting today nets only about 2-3% for the typical common stock investor. Vanguard High Dividend Yield Index Fund (VHDYX), for example, is currently yielding a paltry 2.68%. Funds boasting much higher yields have to be doing something else, like buying bonds or REITs, in order to juice their yields. Sometimes, that attractive yield is nothing but smoke and mirrors.

In the case of the Korea Fund, its 18% "dividend " is merely an old-fashioned capital gains distribution.

When mutual fund managers sell stock at a gain, they realize either a short or long-term capital gain. If they have no losses to offset that gain, they have to distribute the gains to the fund's investors. This distribution generally takes place near the end of the year.

If you consider such a payout a yield, then we have in fact seen "yields" of over 50%. You won’t make a dime buying one of these funds before the distribution is made, but you will get slapped with a big tax liability if you own the fund outside of a tax deferred account when it happens. This payout is a mere accounting gesture: a fund valued at $10 per share might pay a $5 dividend . Shareholders wind up with twice as many shares at $5 each, but now they owe tax on that $5 phantom gain. The real gain was made by owning the fund as its value rose to $10 a share. Most shareholders want to avoid large capital gain distributions. In fact, fund companies often hide them in order to avoid a massive run for the exits.

Because emerging markets have performed so well in recent years, many of the stocks in the Korea Fund’s portfolio are way up - with average increases of 100% or more. Believe it or not, this is normal. What is abnormal for a hot emerging markets fund this year is the fund's recent fund management change. The new management has a different group of stocks it finds attractive, so it sold most of the old holdings. Since these old holdings had gone way up in recent years, the fund is now realizing significant taxable gains that must be distributed to its shareholders.

Buying this fund today is buying somebody else’s tax liability. You're also getting a new manager, so the past performance touted in the income newsletter pitch is not that relevant.

The Korea Fund (KF) is a decent, low-fee, single-country, closed-end fund whose managers almost certainly knew nothing about their fund being featured in an ad for an investment newsletter with an aggressive marketing campaign. Ironically, the fund recently sent a letter to its investors, in which it acknowledged its shareholders' displeasure at receiving such a large one-time dividend (you can research the historical dividends here). The fund's management indicated it would take steps to prevent such big distributions from occurring in the future. In fact, the true dividend yield you’d get from owning a fund like this is about 1% per year – nothing to live off of in retirement, that’s for sure. Such low yields and high risk make this fund more suitable for an aggressive growth portfolio, not an income portfolio anyway.

Thanks for the question.

MAX

Want to ask MAX a question of your own? Send him an email by clicking here. Please include your name and where you live.

Vanguard’s 7% Forever Funds

October 3, 2007

Vanguard recently announced plans to launch three new managed payout funds. Managed payout, managed distribution, or level-rate dividend policies mean the mutual fund company decides how much the fund’s distributions will be, or manage the portfolio specifically to create a certain distribution payment stream. With most mutual funds irregular capital gains and dividend distributions are the result of income and realized capital gains building up in the fund portfolio. According to Vanguard, their highest payout fund is:

…geared toward investors who seek a higher payout level to satisfy current spending needs while preserving their capital over the long term. This fund is expected to sustain a managed distribution policy with a 7% annual distribution rate…"

This move by Vanguard brings a little legitimacy to a sometimes questionable strategy used primarily by closed end funds to give investors the illusion of steady yield.

As investors retire, they want regular returns so they can live off their portfolio. Stocks offer growth to beat inflation, but little in the way of regular income – even a fund made up of the highest yielding common stocks in the market delivers under 4% today. Bonds offer slightly more yield, but no principal growth to offset 30 retirement years of inflation.

Vanguard’s new funds will attempt to address this problem. They will be formulated with the right asset mix to allow monthly liquidation at a rate as high as 7% a year with minimal principal downside.

The proposed Vanguard Managed Payout Funds will be structured as funds-of-funds, investing predominantly in Vanguard domestic and international stock index funds, bond and REIT index funds, and inflation-protected securities and money market instruments. The funds may also allocate a portion of their assets to commodity-linked investments, as well as pursue market-neutral and other absolute-return strategies."

The problem is that this is easier said than done. Historically the proposed asset mix has performed very well with each investment option uncorrelated enough to allow a 7% withdrawal with minimal portfolio volatility (stocks down, REITs and commodities up, etc). Whether this formula will work going forward (now that REITs, bonds, small caps, emerging markets, and commodities have gained significantly) remains to be seen. As for market neutral portfolios – no fund company has ever delivered a market neutral portfolio that could withstand a 7% withdrawal rate long term without principal erosion.

Too avoid simply giving investors their money back – called return of capital – Vanguard may be forced into tricks to produce dividends and capital gains (at the expense of net asset value) to maintain a high payout during rough market periods. Today there are dozens of closed end funds that have high payouts but steadily eroding NAVs – the result of creating yield where it does not naturally exist.

Even the mighty Vanguard 500 Index fund (VFINX) – a fund that any lower risk diversified fund of funds will have a tough time beating over the long term – wouldn’t have been able to deliver a steady 7% managed payout. If you had invested $10,000 in VFINX at the end of 1996 and had drawn down 7% each year (including dividends), you would have a little less than your initial $10,000 investment at the end of 2006. You’d be much worse off if you started a level payout strategy with VFINX in 2000. Today your principal would be far below your starting amount and current payouts would be around 4% of your $10,000 original investment..

Investors want stock market returns with bond market yields and downside risk. This doesn’t really exist in the long run. It’s unlikely Vanguard can create a fund delivering big 7% payouts with principal preservation and stability.

Our Favorite Funds

October 2, 2007

Which stock funds are best? Which fund categories are most attractive? The MAXfunds Our Favorite Funds Report answers these and other key questions facing fund investors. Fortunately for you, dear fund investor, Our Favorite Funds is now available for FREE. And unlike most things, you get more than you pay for.

With thousands of mutual funds and dozens of fund categories to choose from, selecting the right funds is tough enough, but building a well balanced portfolio is becoming more difficult by the day. Our Favorite Funds is our handpicked list of the best mutual funds in each fund category, along with our analysis of each fund category as a whole.

Discover the complete list of MAX's Favorite Funds by clicking here.

Motley Fool’s Orwellian Moment

September 28, 2007

In Animal Farm, George Orwell describes a Utopian society that slowly morphs into the evil farm that its founders initially rose up against. The Motley Fool’s latest advertisement, touting “255% Gains in Six Months,” is perhaps their "four legs good, two legs better" moment.

Motley Fool is a success story that has spawned books, radio, websites, and most recently, investment newsletters. The brothers Gardner (Motley Fool founders David & Tom) built a strong following upon a distinctly anti-establishment investment mantra: you don’t need Wall Street’s expensive yet mediocre advice. Theirs was a message of individual investor empowerment.

Much of the message centered around the belief that actively managed mutual funds were inferior to index funds, and investors could easily beat the lords of Wall Street with simple strategies like the Foolish Four – a sort of Dogs of the Dow system for success.

The Fools summed it up best in one of their many successful investment books, saying, “In our brief Foolish history, we’ve enabled thousands of average people who didn’t previously know a dividend from a divining rod to invest their own money without the help of Armani suits, and crush Wall Street at its own game.”

Somewhere along the way, however, things changed. The Fool's anti-Wall Street rhetoric was toned down. Some Foolish portfolios, including the early Foolish Four, were quietly closed for underperforming the market. The court jester hats came off on CNBC. The Motley Fool even launched a paid newsletter recommending – gasp! – actively managed mutual funds.

The Foolish Four was exterminated near the peak of the tech bubble after it underperformed the S&P 500. This was right around the time that value strategies began beating the market again. As it swept the Foolish Four under the rug, the Motley Fool switched its focus to more exciting portfolios, like the Rule Maker, which it launched in February 1998. Unlike the dividend-oriented Foolish Four, this portfolio contained exciting growth stocks, like Yahoo (YHOO), JDS Uniphase (JDSU), Intel (INTC), and Cisco (CSCO).

By early 2003, the Motley Fool had closed the Rule Maker Portfolio, since buying growth leaders was starting to appear as dumb as buying value stocks had been in 2000.

According to the Motley Fool, “The Rule Maker Portfolio has had a cumulative investment of $44,000. As of December 10, 2002, its current value of all cash and equities is $31,172.74. This equals an internal rate of return of -11.0% since the launch of the portfolio in February 1998.” Too bad they didn’t hang onto the Foolish Four…

This pattern of closing mutual funds that fall on hard times in order to focus on the good stuff looks strangely familiar. That's because it's the same strategy used by the very mutual funds that the Motley Fool used to ridicule. With mutual funds, this cleansing process is called survivorship bias. This trick-of-the-trade is why many fund companies appear to hold only decent funds in their roster. The Merrill Lynch Internet Strategies Funds of the world are effectively deleted from history.

One thing the Motley Fool does today that mutual funds are not allowed to do is cherry pick performance information in order to market their wares. Of course, the Motley Fool is not alone here. Virtually all investment newsletters tout their spectacular returns through methodologies that would make a mutual fund marketer blush. But because everybody is doing it, selling an investment newsletter without such circus barker-grade promotion is nearly impossible.

The status quo only excuses so much, however. In its latest advertisement, the Motley Fool notes, "David’s #1 stock nabbed 255% gains in six months and is still going strong. Tom’s top stock returned 589%. 26 of their picks have doubled or more."

If mutual funds were allowed to advertise in this way, the Vanguard 500 Index fund (VFINX) could brag, "151% in 2006, 127% in 2005, 208% in 2004, 428% in 2003! This is how our top performers have performed in recent years. Find out how we beat other experts' picks by a country mile in our new prospectus - yours FREE if you act now. We’ll even throw in our new semi-annual report so you can see our current top picks!"

This ad would be accurate (but misleading), as these returns are merely the best performers from the S&P 500 over the last four calendar years, respectively: Allegheny Technologies (ATI), Valero Energy (VLO), Autodesk (ADSK), and Avaya (AV).

We’re not claiming that investors following this particular Motley Fool newsletter didn’t beat the S&P 500 in recent years. In fact, the Motley Fool prints some of the better investment newsletters out there. Just keep in mind that most stock funds beat the S&P 500 in recent years because the large cap growth stocks that dominated the S&P 500 in the late 90's have been out of favor for much of the new decade (as followers of the Rule Maker’s portfolio learned the hard way…) Also keep in mind that performance comes and goes, and newsletter performance records have been no more predictive of future returns than mutual fund records have.

For example, over the last five years, the Jacob Internet Fund (JAMFX) has beaten both the S&P 500 and the hot annual returns quoted by the Motley Fool for the newsletter in question – and this was a ridiculed mutual fund five years ago, that is, right before it got hot again.

What we are saying is this: the Motley Fool has nearly morphed into what it most hated about Wall Street – the message to pay up for and respect our investment genius, look at our expensive suits, pay no attention to the man behind the curtain…

On that last point, it’s interesting to note that the Motley Fool home page now displays a variety of Motley Fool experts including the brothers Gardner wearing pinstriped suits (but no jester hats) and selling their expert advice. Contrast that to the Goldman Sachs (GS) website, on which the firm profiles some of their people. No suits. A few sweaters. Even one red tank top. This, from the #1 investment bank at the top of the Wall Street game. How the tables have turned. In Animal Farm, the pigs maintained leadership with exaggerated stories of how bad the other choice for leadership – humans – were.

We’ve got nothing against changing your strategies as time passes, or even selling what used to be free – Lord knows, we’ve done it. There's nothing wrong with trying to make money running the farm – Goldman Sachs sure does. But when you come across investment pitches, make like the original Motley Fool followers (as was one of our cofounders), and be wary of too-good-to-be-true pitches for help from men in fancy suits.

Sneaky Mutual Fund Tricks

September 24, 2007

If we didn't think mutual funds were the best investment option for the vast majority of people, we wouldn't have started MAXfunds.com way back in 1999. But that doesn't mean we love everything about them. Author Ric Edelmen exposes three sneaky mutual fund industry tricks fund companies use to confuse and confound fund investors (all of which MAXfunds has written about at one time or another) in this article for the Maryland Gazette.

Confusing share classes

Retail mutual funds are now available with a dizzying array of pricing models. In many cases, a single fund might offer a half dozen share classes, and the only difference among them is the cost. If you select the wrong share class, you could pay more than necessary.

Talk about opening Pandora's box. Today, fund investors must choose among Class A, B, C, D, F, I, J, K, M, N, R, S, T, X, Y and Z shares. Depending on the share class you purchase, you might incur a load when you buy, when you sell or annually. The load might disappear after a time, or it might remain forever. In some cases, you might enjoy a lower load, but incur higher annual expenses, or vice versa. And in some instances, you might buy one share class only to have your shares automatically converted to another share class in the future!"

Incubation strategy

This is one of the retail mutual-fund industry's most devious ploys. Here's how it works: Create a whole bunch of mutual funds. Wait three years. Then evaluate the results of each fund.

The results of each fund will either be good or bad. If a fund's performance was bad, close it before anybody hears about it. But if a fund posts good results, send the data to Morningstar, which will award a five-star rating (Morningstar won't rate funds that are less than 3 years old.)"

Fund seeding

When a company issues stock, it offers a limited number of shares. A given retail mutual fund company buys as many shares as it can, and when it does, it doesn't say which of its individual funds is doing the buying.

Later, if the initial public offering (IPO) proves to be successful, the fund company disproportionately allocates the shares to its newer, smaller funds. Result: the IPO artificially boosts the return of these funds, supporting the Incubation Strategy (see above). The investors who buy seeded funds are in for a rude surprise when the fund proves to be incapable of repeating its earlier 'success.'"

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Pentagon Sets Sights On Brokers

September 20, 2007

Normally when you hear the Department of Defense is presenting Congress with a report on their progress, a highly politicized debate over Iraq comes to mind. This time the report deals with protecting soldiers not from IUDs but RIAs (registered investment advisors), brokers, and insurance salesmen.

Working in the military can be a tough job with not much in the way of financial reward. This is why unscrupulous insurance and investment salesmen deserve the new military surge against dangerous investment advice targeting enlisted men and women:

Whenever the U.S. military gears up for a war, (Georgia state insurance commissioner John Oxendine), its personnel become prey for unscrupulous financial advisers because they’re young, naïve and don’t have a lot of experience with finance.

'To me, this is nothing more than being a war profiteer,' he said.

The Department of Defense’s inspector general is scheduled to present Congress with a draft of a report about progress in this effort at the beginning of next month.

The law also states that the military must track advisers and insurance agents who have been kicked off military bases for dishonest sales of investment products.

The law, titled the Military Personnel Financial Services Protection Act, mandates that the secretary of defense, currently Robert Gates, keeps a list of names and addresses of advisers that have been barred, banned or restricted from military bases."

The crackdown stops certain questionable sales practices:

And certain product features, such as automatic premium payment provisions, are prohibited completely. The new regulation also adopts Defense Department solicitation rules. For example, it is now a 'deceptive trade practice' for an adviser to solicit in barracks, day rooms and other restricted areas."

We like the Personal Commercial Solicitation Report, which "lists insurance and financial product companies and agents currently barred from soliciting on specific DoD installations as reported by the military services."

The report contains such gems as, "Agent barred for loitering near enlisted quarters; falsely inferring command endorsement; and attempting to discourage a military member from reporting him for soliciting on-duty personnel and soliciting personnel in a mass audience."

Apparently some war profiteers hock financial peace of mind…

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How Some Mortgages Are Like Load Funds

September 14, 2007

Many borrowers are now finding that getting out of their mortgage can be financially painful, according an article in the New York Times:

Homeowners whose loan rates are soaring may want to head for the exits. Many of them, though, will find no way out. If they sell their home or
refinance, they will face a penalty of thousands of dollars for paying off their loans early."

While we feel sorry for the borrowers who were not aware of penalties, millions of mutual fund investors have faced a similar unexpected punishment when trying to move out of one fund and into another.

Back end load funds were invented by the mutual fund industrial complex as a way create the illusion of selling a no load fund (a fund where the investor pays no sales commissions to buy) while still collecting the load. The sales fee, or load, in only charged when the investors sells. To this day, most back end load class fund investors have no idea there is a large commission involved - as high as 5.75% - when they sell shares.

In fact, we'd say supposedly predatory home lenders are less predatory than some mutual fund companies (and the brokers who sell such wares). At least the home buyers received a lower teaser rate for the first few years.

Buyers of back end load funds pay the same yearly expenses as no load fund buyers - the back end load is extra fees. Most banks are just making back their teaser rates with their version of back end loads.

The government will probably take steps against such mortgage lending practices because home ownership is a sacred cow. The government will continue to allow sneaky hidden loads to take billions from fund investors while they try to save for retirement.

Too Much Fund Focus – A Bad Thing?

September 12, 2007

An article in the Chicago Tribune warns of the risks of mutual funds with too few holdings:

No equity-fund manager has made a clearer confession than William Nygren, co-manager of the Chicago-based Oakmark Select Fund, a so-called focus fund holding stocks in just 24 companies at the end of June. Fourteen percent of the fund was in mortgage lender Washington Mutual.

The fund's performance has been 'dreadful,' Nygren wrote to shareholders last month. So far in the quarter, the fund is down nearly 9 percent….Ed Maracinni, co-manager of the JohnsonFamily Large Cap Fund in Racine, Wis., said the pessimism in stocks has been overdone, apart from financial and real-estate-related stocks. The fund is down nearly 5 percent in the current quarter….This summer's concentrated disasters prove the risk of narrow bets on a few stocks or a few sectors..."

We’d counter with "Too much diversification spells mediocrity for most stock funds".

While it is true that diversification lowers risk, it also reduces upside. At MAXfunds we tend to prefer more focused funds with fewer than 100 holdings (in fact it has been a component of our ratings and is highlighted on each funds data page). While these funds can fall the hardest in down markets, they tend to outperform in up markets. Why is this a good thing?

First of all, over the longer haul, markets tend to go up more than they go down. Second, funds with too many holdings tend to act like index funds – only with the performance drag of higher fees. If you want broad diversification, stick with ultra cheap total market index funds. Third, too many holdings can be the result of too much money in a portfolio, leaving the portfolio manager little choice but to add more and more picks (or bigger and bigger stocks).

You choose actively managed funds because you believe a fund manager has skill in picking stocks. If so, wouldn’t you prefer owning his top 10-50 ideas? Why would you want his next 500 best ideas? If you want more diversification, own a few concentrated funds in different fund categories rather than trying to have one fund solve all your diversification issues.

Be aware that even thirty stocks can be a fairly low risk diversified portfolio if the stocks are evenly distributed in the portfolio and from different industries and are a mix of value and growth, small and larger cap. Even the Dow with its thirty stocks is safer than a single sector fund that may own one hundred stocks - or even the Nasdaq as a whole, with thousands of stocks.

Funds mentioned in this article:

Oakmark Select I (OAKLX)
JohnsonFamily Large Cap Value (JFLCX)

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