Individual Investor Revolution Goes Too Far?
Mutual funds are loading up on derivatives and WSJ reporter Elenor Laise is scared swapless:
Derivatives can be used to boost returns, increase yield, get access to more-exotic asset classes like commodities or simply reduce risk. Indeed, many types of derivative-heavy funds thrived in recent years amid relatively placid markets. But in recent weeks, as markets have gyrated more wildly, the vulnerability of some of these funds has become more apparent.”
Nowadays fund investors have easy access to all sorts of esoteric investments. Alternative investments have become about as alternative as…well alternative music (read: not very alternative at all).
Of course derivatives are like bullets. Derivatives don’t kill portfolios, fund managers kill portfolios.
On the one hand, a relatively cheap ETF that tracks a single commodity is probably a “better” way to speculate on say, silver, then ordinary silver futures. On the other hand, by making commodity speculation easier, the fund industry attracts people who normally would stay far away. Before, when some commodity was up 100% in a year, hardly anybody knew it. Now anybody armed with a mutual fund screener will happen across all these exciting alternative investments. CNBC has almost morphed into a commodity price reporting service.
Fund managers are just trying to deliver exactly what investors want: more than traditional investments today can deliver. Investors are not happy with the low yields available today in both stocks and bonds. It’s almost impossible for a fund company to hide their 1%-1.5% fees and sales loads when the underlying investments – be it REITs, utility stocks, or whatever, yield a paltry 4%.
SEC Looks to Expose Hidden Fund Costs
You'd think when a mutual fund publishes its total expense ratio, you could be confident that number represented all the costs you'll pay to invest in the fund. Well, it doesn't. There are all sorts of hidden trading costs associated with mutual funds that don't show up in the total expense ratio, but do weight on the fund's returns. Two funds could have the exact same expense ratio, but one that trades frequently could be more expensive to own than one that trades very little because every time a fund buy or sells a stock they pay a commission, just like you do in your E*TRADE account.
LAtimes.com reports that the Securities and Exchange Commission hopes to require funds to more accurately account for true cost of fund ownership:
In an interview, Cox said companies that manage funds and retirement plans should be required to report 'one simple number that captures fees and expenses.' As traditional pensions disappear, more workers are relying on 401(k)s and individual retirement accounts. But excessive fees can jeopardize the financial security of retirees.
These costs are often hidden now — either buried in the fine print of a fund prospectus, or simply deducted from accounts without ever showing up as a line-item expense.
'It's our top regulatory priority,' said Cox, who wants to make it easier to compare funds. 'There are always technical concerns raised by someone, but the truth is that apples-to-apples comparisons are quite useful for consumers. The same should be possible for our retirement savings.'
Sounds like a good idea, but it won't be easy. The problem is that some trading costs are easy to hide, and others hard to measure. If a fund thinks investors are paying attention it is not difficult for them to obfuscate the amount they pay to brokers to buy and sell stocks. A fund could, for example, make a wink-wink nudge-nudge deal with a broker to pay very little in commissions per trade in exchange for paying a slightly higher price per share of a stock.
While the SEC will be grappling with this difficult issue for quite a while, MAXfunds is ahead of the curve. If you're looking for one simple number that captures fees and expenses (including an estimate of trading costs), we've got some good news for you. Our MAXrating: Expenses, found on each funds data page here on MAXfunds.com, does just that.
Three New Fundamental Index Funds from Schwab
A traditional stock index, like the S&P 500, is market value (or capitalization) weighted, meaning the bigger the market cap of a stock in an index the bigger the chunk of the index that is occupied by that stock. When you put money into the Vanguard 500 Index (VFINX), which benchmarks the S&P 500, more of your money goes into big cap names like Microsoft (MSFT) and ExxonMobil (XOM) then say, Tyson Foods (TSN).
Until recently, the only notable non-market cap weighted index was the Dow Jones Industrial Average, commonly known as the Dow. The Dow is price weighted – stocks with higher prices like IBM (IBM) are “more important” than lower price stocks like Microsoft (MSFT), even though Microsoft is a bigger company by market capitalization.
The so-called fundamental index does things a little differently. It weighs the stocks in its index not by sheer market value, but by factors such as book value, dividends, profits, and other data.
The creators of a controversial new fundamental indexing strategy say the fundamental method is a more accurate way to index than traditional market cap weighted indexes.
Because of market inefficiencies some companies have market caps that are either higher or lower than they should be, and these inaccurate valuations create a drag on the performance of the market-weighted index. The fundamentalists say that an index weighted toward a real measure of a company’s value will produce greater returns over the long-haul.
"The Fundamental Index reflects a more rational view of a company's success by looking at factors that are reliable signs of a company's strength, such as sales and profits, rather than a narrow view focused simply on how much the market thinks a company is worth," says Bob Arnott, who developed the fundamental indexing concept. "Historical analysis shows that the traditional cap-weighting approach tends to overweight overvalued stocks and underweight undervalued stocks. While conventional indexes mirror the composition of the broad stock market, and so are drawn in by the fads, bubbles and crashes of the market, the Fundamental Index mirrors the composition of the broad economy."
Schwab apparently agrees, announcing the launch of three fundamental index mutual funds. The Schwab Fundamental US Large Company Index (SFLVX), the Schwab Fundamental US Small-Mid Company Index (SFSVX), and the Schwab Fundamental International Large Company Index (SFNVX) are based on the fundamentally weighted FTSE RAFI Index. (They are not the first. WisdomTree is an entire fund company with dozens of new ETFs that was recently created to offer fundamentally weighted indexes to the investing public.)
Charles Schwab calls fundamental indexing the "the most important innovation in passive investing since indexing was popularized in the 1970s", but others aren't so enthusiastic. John Bogle hates the idea, and others call fundamental indexing merely an "investment strategy masquerading as an index.
What's our take?
There are big problems with these newfangled solutions to the market cap weighting issue. The trouble with bubbles and mis-valuations (and resulting poor performance) from market cap weighted indexes won’t magically go away if everybody starts buying stocks based on "real" measures of success, like dividends or earnings - you can have bubbles in fundamentals as well. Bidding up a slow-growth, high-dividend paying stock until the dividend is just a small percentage payout doesn’t make any more sense than paying a triple-digit PE for Cisco (CSCO).
The market tends to favor growth or value for years on end, until that type of company gets overvalued and the other type is positioned to do better going forward. All of these backward looking, anti-growth and mega-cap stock looking investment products will likely underperform the S&P 500 over the next 5-10 years.
Petite Prospectus?
Chuck Jaffe reports on the mutual fund industry's efforts to reduce the size of the distributed fund prospectus:
If you buy a computer, the "quick-start guide" helps you get the equipment up and running without forcing you to learn many of the fine points that may or may not be useful information some day.
The powers behind the mutual fund business want you to get the same kind of jump start when it comes to their products.
Paul Schott Stevens, president of the Investment Company Institute, the trade association for fund companies, called for big changes in fund disclosure this week, specifically suggesting that investors would be better served by ditching the traditional prospectus in favor of a jump-start user's manual, along with instructions on how to access the true prospectus on the Internet.
It's hardly a new idea, but there's one significant difference this time, namely that the Securities and Exchange Commission is receptive to the idea, and the fund industry powers are more anxious than ever to ease their paperwork burden."
We are, generally, in favor of the idea, assuming these slimmer documents contain the information investors need to make buy decisions. The data in a prospectus that is important to the vast majority of investors could fit on about a page and a half, and a standardized sheet that contains just these key points will make identifying quality funds easier. Could save a tree or two to boot. ...read the rest of this article»
MAXadvisor Powerfund Portfolios Update
Note to subscribers of the MAXadvisor Powerfund Portfolios: April's feature article has been posted. Subscribers can log in by clicking here.
This month we look at how far the current sub-prime loan fallout will spread into the economy. Our opinion? Pretty darn far.
The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here.
Start Small
You want to start building a mutual fund portfolio, but you don't have the $3,000 or so you need to meet most funds' minimum initial investment requirements. John Waggoner in USA today finds two no-load funds with minimum investments of just $500, one of which, Homestead Value, is a MAXadvisor Favorite:
Excelsior Mid-Cap Value and Restructuring (UMVEX) ($500 min/$250 IRA)
Homestead Value (HOVLX) ($500 min/$250 IRA)
He also reminds us that T.Rowe Price offers entrée to many of their funds for as little as $50 if investors agree to participate in an automatic investment plan, wherein a certain amount is deducted each month from contributor's bank account and invested in the fund.
Buffalo, Artisan, and Weitz (among others) also accept reduced initial investments from automatic investment plan participants.
Note: We're frankly not sure why Waggoner included Hennessy Cornerstone Growth (HFCGX) ($2500 min/$1000 IRA) and USAA Capital Growth (USCGX) ($3000 min/$1000 IRA) in an article about low minimum funds as these fund's minimums are certainly no lower than average. If you can figure it out, let us know by posting a comment.
See also:
Where to Start
Ask MAX: Can I build a fund portfolio with just $17,000?
Ask MAX: Investing $20 a month?
Ask MAX: Where do I start?
Funds That Invest Like Buffett
Tim Paradis at the Aspen Daily News takes a brief look at mutual funds that try to invest like Warren Buffett, one of the worlds best-known and successful value investors. Some of these funds actually mimic the stock portfolio of Buffett, while others have merely adopted his buy-and-hold philosophy.
The funds, which characteristically invest in a smaller number of stocks than other mutual funds and often hold those investments far longer, can be a good match for investors looking years down the road who won't dwell on every bump."
Funds mentioned in the article:
Independent Fund Board Rule Kaput
Chuck Jaffe at MarketWatch writes:
Alas, when it comes to the debate over whether mutual fund boards should have chairmen and a supermajority of directors who are independent of the management company, it appears that fund interests are going to win out.
In 2004, the Securities and Exchange Commission passed a rule requiring all funds to appoint an independent chairman and to make three-quarters of the board of directors independent. The rule came in the aftermath of the rapid-trading scandals of 2003 and was universally applauded by consumer groups. But the Investment Company Institute and several big-name fund firms -- most notably Fidelity Investments -- railed against it, saying it was unnecessary and costly.
The rule was rejected twice in federal appeals court, which cited the SEC's administrative process as a big part of the problem. So the agency reopened the discussion.
In December the SEC released two reports from the Office of Economic Analysis examining the costs and benefits of having a chairman and 75% of the fund's board independent from the investment adviser. Both sides of the debate had until March 2 to file comments.
And while there is no official word from the SEC yet, it is pretty clear talking to agency insider's that the issue is dead."
While these independent fund boards are a great idea in theory, in practice we don't think the loss of this rule will be much of a negative for fund investors. These so-called independent directors would still have been appointed by the fund companies, so the true extent of their independence would have been debatable. Furthermore, the rapid-trading scandals of 2003 that this rule was a result of are probably not the kind of thing a once-a-quarter board of directors would have had uncovered. This rule would also have added significant costs to running a mutual fund, which would have unfairly hurt small and new fund companies.
22 Funds Morningstar Thinks You Should Sell
Morningstar's Fund Spy lists 22 funds their analysts think have "strong competitive disadvantages". The list includes SunAmerica Focused Large Cap Growth (SSFAX) because of poor long-term performance versus similar funds, Payson Value Fund (PVFDX) and BlackRock Basic Value II (MAVAX) because of relatively high expense ratios, and ten Principal Protection funds from ING because of concerns about the principle protection strategy in general and these funds in particular.
You'll also note serious problems with all these fund's MAXratings on our MAXdata pages. Click the links above to view our takes on them.
S&P 500 Index Secrets Revealed
Despite challenges from new-fangled upstarts, the good old Standard & Poor's 500 Index still reigns as the king of the stock indexes. It's the basis for such mutual fund giants as Vanguard 500 Index Fund (VFINX) and Fidelity's Spartan 500 Index Fund (FSMKX), and in all more than $4 trillion in investors dollars is tracking it (some of which is probably yours). Marketwatch reveals some fascinating facts about the S&P 500 index that you might not know:
LINK ...read the rest of this article»