Mutual Fund Returns - Skill or Luck?

Now that we must rely on our investment prowess to provide sustainable retirement income, it is more important than ever to understand investing in mutual funds does not create wealth - quite the opposite.

Two of the most pre-eminent economists alive today, Eugene Fama and Kenneth French, have recently published a paper that revisits, yet again, the question of whether anyone can accurately pick stocks. Their paper is titled, "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates."

Here is the long and short of it, from the abstract:

"Bootstrap simulations produce no evidence that any managers have enough skill to cover the costs they impose on investors. If we add back costs, there is some evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates. The evidence for performance is, however, weak, especially for successful funds, and we cannot reject the hypothesis that no fund managers have skill that enhances expected returns." (emphasis mine)

So why do Americans continue to buy actively managed mutual funds when it almost guarantees sub-par performance? Largely because they don't know any better.

One of the most dangerous principles is social proof, which says in the absence of certainty, humans look around to see what others are doing and do the same thing. The more uncertainty, the more likely we are to stick close to the herd. This  behavior was very helpful, for the species, in getting to the top of the food chain. However, not so helpful in getting to the top of the investor food chain.

If you understand that markets don't reward all participants equally, you will also understand that doing what everyone else is not going to get you to the top of the investment heap.

If you are interested in what you might do as an alternative, I would encourage you to sit down with any number of our free special reports available to Snider Insiders (free registration required) and read them carefully. Specifically, I would recommend "How to Not Just Survive, But Thrive, in Turbulent Financial Markets."

Tip of the hat to Jim Mahar, of FinanceProfessor.com for the heads up on this paper.

No statement in this post should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such. All investments involve risk including possible loss of principal. Complete information can be found on our website or by calling 1-888-6SNIDER.

The role of luck in a financially secure retirement

A new type of mutual fund was introduced in late 2007 by the fund industry called managed-payout funds. The goal of these funds is to give retirees a steady stream of income. At the time, they were touted as being an easy way for investors to get regular income payouts, professional money management and relatively low fees. Early players in the managed-payout fund arena were Fidelity, Vanguard, John Hancock, and Charles Schwab.
 
These funds demonstrate something known as the “sequencing of return problem” for retirees. If a retiree experiences losses early in their retirement, principal is quickly depleted and the amount of time until the retirement portfolio runs out of money is reduced.
 
Like the new retiree, these funds are being decimated by the stock market plunge. Right out of the gate, these funds are unable to meet their obligations to retirees and are basically returning principal.
 
"The plight of managed payout funds dramatizes boldly, what can happen to investors if they experience a serious market downturn early on, when they are starting to draw down their payments in retirement," said Dan Culloton, a fund analyst at Morningstar.
 
The Sequencing of Return Problem
 
When you are in growth mode, sequence of returns doesn't matter. Regardless of whether a portfolio experiences weak or strong returns early on, the ending market value will be the same.
 
Let's look at an example:
 
Assume we have two portfolios, X and Y. Each starts with $500,000. Neither is taking withdrawals. Portfolio X experiences early losses. Portfolio Y experiences early gains. As you can see from the chart below, there is no difference in the ending value.

This is not the case once you begin taking distributions. As you can see from the chart below, Portfolio X experiences losses early on and runs out of money in less than 20 years. Portfolio Y has strong early returns and is still going strong at age 100.

Even though both averaged 6.5% return, the difference in the two outcomes is massive!

This demonstrates the tragic flaw in a traditional capital appreciation portfolio when your investment objective is income replacement. There is just too much dependence on luck. You are basically betting on a random sequence of numbers over 30 years and the consequences if your bet doesn’t pay off, are catastrophic.
 
How cash flow solves the sequencing of return problem
 
Capital appreciation is when you buy something in hopes it will go up in price. When it does, you sell it for more than you paid for it, and the profit is called capital appreciation.
 
Cash flow is money that comes to you while you still own the asset. Examples of cash flow would be rent, royalties, interest, dividends, and option premiums. The key characteristic of cash flow is that you do not have to sell the asset in order to make money.
 
Another important characteristic of cash flow investments is cash flow is typically tied to the amount invested rather than the market value. Take a bond, for example. The yield is a percentage of the face value. A $1000 bond paying 6% will pay $60 in cash flow whether the bond is worth $900 or $1100.
 
Cash flow is the blindingly obvious solution to the sequencing of returns problem, among others. Imagine your monthly expenses are $9000 a month and your portfolio generates $12,000 a month in cash flow. So long as the $12,000 is not connected to the market value of the portfolio, the sequencing of return problem goes away. Your portfolio withdrawals would be unaffected by the sequence of return.
 
Why does Wall Street continue to try to shove the same old square pegs in increasingly round holes, as evidenced by the dismal failure of the managed payout funds? As Robert Frey, an adviser in Bozeman Montana, says, "These funds are dogs." It's time for the capital appreciation model to be put out of its misery.
 
SOURCE:
 
    1. Funds Featuring Managed Payouts Off To Rocky Start. (2009, February 11). InvestmentNews. Retrieved from http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090201/REG/302019983/1030/MUTUALFUNDS.

No statement in this article should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such.  All investments involve risk including possible loss of principal.  Complete information can be found on our website or by calling 1-888-6SNIDER. Some information for this article has been gathered from external sources.  We believe they are reliable, but Kim Snider and Snider Advisors assume no responsibility for the accuracy of this information.

Mutual Fund Performance

"Out of almost 2,100 diversified retail U.S. stock mutual funds that are open to new investors, just 17 have positive returns for both the past 12 months and year-to-date, according to investment researcher Morningstar Inc."

Tip of the hat to Barry L. Ritholtz.

Source:

Burton, J. (2008, August 27). Up and Away: Eaton Vance's Tooke is That Rare Stock-Fund Manager Still in the Plus Column. Market Watch. Retrieved September 5, 2008, from http://www.marketwatch.com/news/story/only-17-equity-funds-black/story.aspx?guid={8C79C669-46A7-4F15-87DD-5B80248A50D6}.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

No Skin in the Game

I saw this quote on the wall at the grocery store the other day:

"'Tis an ill cook that cannot lick his own fingers."
– William Shakespeare, Romeo and Juliet

I always thought the quote was about cooking. But maybe the Bard was also trying to warn us about mutual fund managers.

According to a report from Morningstar, almost half (46%) of the U.S. stock mutual fund managers studied haven’t invested a dime in the funds they manage. And it gets worse from there, says Morningstar’s Russel Kinnel:

Fully 59% of foreign-stock funds have no ownership, 65% of taxable-bond funds have no ownership, 70% of balanced funds put up goose eggs, and 78% of muni funds lack ownership.

The data Morningstar used cover 6,000 funds. In 2004, the SEC began requiring fund managers to disclose their personal holdings, partly as a response to several scandals in the mutual fund industry. (There were so many scandals around 2003, I can’t even begin to list them all. Wikipedia has a good account, though.)

The SEC only requires managers to disclose the range of their holdings, and they’re pretty broad ranges:

• $1 - $10,000
• $10,001 - $50,000
• $50,001 - $100,000
• $100,001 - $500,000
• $500,000 - $1 million
• < $1 million

No matter how broad the ranges, though, these disclosures can give us an idea of how much skin the manager has in the game. Too often, the manager has nothing at stake. Kinnel continues:

There are really only two excuses for not owning a fund you run. First, if you run a single-state municipal-bond fund for a state other than the one you live in, it doesn't make sense to own that fund as you won't benefit from the tax breaks. Second, managers who are citizens of foreign countries have a good excuse if their country bars investment in U.S.-domiciled funds.

A number of foreign-stock funds are run by foreign citizens and that may account for the ownership difference between U.S.-stock funds and international-stock funds.

For managers who run niche funds or run a lot of funds, there's good reason for them to be at the lower end of the ranges, but not at zero. The number of managers showing no faith in their process is staggering. With the two exceptions I spelled out, I can't think of why anyone should invest in a fund that its own manager doesn't invest in. True, higher investment levels aren't a guarantee of success or an ethical manager but at least they show that managers believe in the funds and they pay some of the costs and taxes that the rest of shareholders do.

Amen! This is yet another example of how Wall Street doesn’t have your best interests at heart. If their interests aren’t aligned with yours, how can you trust them? If they don’t trust themselves with their own dollars, what makes you think you should trust them with yours?

As for my husband and me, the bulk of our total investable assets (excluding our equity in real estate and our business) is in the Snider Investment Method®. The remainder includes our emergency fund, of course; some money in qualified retirement plans; money needed for something specific within the next two years; or accounts that are too small to be invested using the Snider Investment Method®. All of that money sits in a savings account, money market funds, T-bills, or laddered CDs. We would own U.S. Treasury bonds and TIPS as well, but at the moment we don’t.

Everyone has a different situation, so your investment objectives and needs may differ from mine. Still, you should know that when it comes to investment methodology, I eat my own cooking. Can your advisor say the same?

SOURCES:
1. Kinnel, Russel. “Managers’ Investment Secrets Revealed.” http://news.morningstar.com/articlenet/article.aspx?id=241183&page=/OwnershipArticle (accessed 08 July 2008)
2. “2003 Mutual-Fund Scandal.” http://en.wikipedia.org/wiki/2003_Mutual-fund_scandal (accessed 08 July 2008)

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Kim Snider is the President and Founder of Snider Advisors, an investment adviser registered with the SEC, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Financial Advisor Double Whammy

Academics are slowly peeling back the curtains on the financial services industry to expose some serious shortcomings. One groundbreaking study, which I've referenced before, found that commissioned financial advisors don't bring any appreciable value to investors. It found that the mutual funds recommended by traditional advisors severely underperform the market as a whole.

No real surprise there, since the vast majority of the funds are expensive, actively-managed funds that typically pay the advisor fat commissions.

Now there's a study that shows that clients of commissioned financial advisors severely underperform within those same investments. In other words, not only does the mutual fund underperform the market, the investor underperforms the fund!

The reason, according to the authors, is that clients of traditional (commissioned) financial advisors are more likely than self-directed investors to try to time the market:

Our results sound a warning to fund investors who are considering whether to attempt market timing, either on their own initiative or through their broker's advice. On average, active investing leads to underperformance relative to a passive dollar invested in the fund. In addition, the use of an investment professional to trade shares is correlated with even worse investment timing performance.

The study, "Investor Timing and Fund Distribution Channels," is written by Mercer Bullard of the University of Mississippi, Geoff Friesen of the University of Nebraska-Lincoln, and Travis Sapp of Iowa State University. The authors studied 6,164 funds between 1991 and 2004.

Investors in load funds lagged the performance of the funds by 1.82% on average annually. Those invested in legal no-load funds (funds with no commission and a low 12b-1 fee) lagged their funds' performance by 1.91%. And those involved in Class B fund shares underperformed by 2.28%. The only investors who didn't underperform were those in pure no-load index funds.

This study shows that traditional financial advisors are no better than anybody else when it comes to timing the market. And they don't seem to do anything to curb the behavior of their clients who think market-timing is possible:

One potential explanation is that brokers seek to justify their compensation not only by helping their clients pick funds, but also by demonstrating their active monitoring through market timing advice. If this is the case, the evidence suggests that this advice, on average, is less than helpful. Another possible explanation is the well-documented psychological tendency of investors to overweight recent performance. Although investment professionals presumably are more aware of, and less, susceptible to, a short-term performance bias, their clients might be more susceptible to this bias than self-directed investors. … A third explanation is that some brokers may be able to appeal to their unsophisticated clients' short-term performance bias in order to increase sales compensation. Thus, brokered shares may show evidence of (bad) timing because of client pressure, the broker's financial incentives, or both. [emphasis added]

The authors were especially critical of advisors who put their clients in Class B shares.

Why do Class B shareholders fare so much worse? One reason might relate to questionable conduct by brokers. Class B shares often are an inferior choice for investors and have been the subject of a number of enforcement actions alleging misleading sales practices. Sales of Class B shares can provide higher compensation to a broker than other shares and therefore present an economic incentive to steer clients toward these shares.
…
It is possible that a broker who recommends Class B shares in order to maximize compensation may also tend to emphasize recent returns in order to allure investors. More prudent advice would instead tend to emphasize long-term performance, but on this count Class B shares fare poorly.

I think the biggest takeaway from this study is this: Ask yourself if your advisor is providing any value. Did you hire them because of their expertise? Their access to better investments? Their potential to keep you from making dumb mistakes? If they aren't providing any value, why are you still paying them?

SOURCES:
1. Bergstresser, Daniel, John Chalmers, and Peter Tufano, 2006, Assissing the costs and benefits of brokers in the mutual fund industry, Working paper.
2. Bullard, Mercer, Friesen, Geoffrey C. and Sapp, Travis, "Investor Timing and Fund Distribution Channels" (December 2007). Available at SSRN: http://ssrn.com/abstract=1070545

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Mutual Funds Don't Keep You Diversified

I'm traveling with a group of wonderful Snider Method alumni in Alaska this week, but I wanted to break for a moment to discuss one of my favorite topics: Mutual Funds.

I've written a lot about Mutual Funds on my blog, but I haven't addressed one of the biggest misconceptions about them for a while. Many investors get sucked into mutual funds, thinking that they provide instant diversification. This may have been true in the past, but for the most part, it isn't true anymore.

Actively-managed mutual funds have largely outlived their original purpose. The reason they came into existence was to allow investors to pool their assets and get diversification with a fairly small amount of money.

Everyone still believes that by buying mutual funds, they are diversified. Most actively managed funds really aren't diversified, though, for two reasons.

The first reason is known as "style slip," and here's how it works. Let's say you buy into Kim's Small-Cap Value Fund. The prospectus tells you that the fund will invest in small-cap stocks that the manager (in this case, me) believes are undervalued. So you assume that you'll be investing in just that -- undervalued small-cap stocks.

As we know, the market doesn't all go up and down at the same time. Certain sectors will outperform or underperform others. For example, in 1997 small-cap value didn't do so well while large-cap growth stocks were going up like gangbusters. So let's say Kim's Small-Cap Value Fund was only returning 6 or 7 percent around that time while the market as a whole, driven by large-cap stocks, was up 23 or 24 percent.

If you were an investor in my fund, what would you do? You'd most likely sell, wouldn't you? Even though my objective as a fund manager was to buy small-cap value, I know that if I don't perform close to the market in general, I'm likely to lose customers. So that makes me a closet indexer. I aim to get close to the indexes, regardless of my stated objective, because badly underperforming the benchmark index is death to a fund manager.

So even though I say my objective is small-cap value, I'm only going to invest that way when that sector is doing well. The rest of the time, I'm going to invest in whatever else is doing well. Because all the other fund managers are doing the same thing I am, we all wind up buying the same stuff.

What this means to you, the investor is this: You own several different funds, but they all own the same stocks! You may have a percentage in a small-cap value fund, some in a large-cap growth fund, some in mid-cap, some in international, etc., but it doesn't really matter. All the managers put you in the same things. You really aren't diversified.

The second reason mutual funds don't offer the diversification you expect is more systemic. Globalization has changed the way we should diversify to create uncorrelated asset classes. For example, we used to think that stocks and bonds always moved in opposite directions -- as stocks go down, bonds go up -- but that doesn't hold true anymore. We used to buy international stocks because they tended to move in opposite directions of U.S. stocks. Now they're a lot more intertwined.  So although an investor may go out and buy different funds in the hopes of getting several uncorrelated asset classes, they wind up all moving in much the same direction at the same time.

So if one of the main jobs of actively managed mutual funds was to provide diversification, and they can't do that job anymore, why are we still investing in them? Combine the lack of diversification with the track record of lousy performance compared to the indexes, and you should realize that you can do a lot better.

SOURCE
1. Jackson, David. "ETF Investing Guide: So You Thought Mutual Funds Help You Diversify?" Seeking Alpha, 1 July 2006. http://seekingalpha.com/article/15159-etf-investing-guide-so-you-thought-mutual-funds-help-you-diversify (accessed 4 June 2008)

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Financial Advisor Red Flags

I've been talking with a number of our prospects the last couple of weeks, and the stories they tell of being ripped off by various financial advisors and investment schemes are amazing. The chutzpah of some of these advisors is incredible - I don't see how they can sleep at night when they sell so many investments that are clearly designed to benefit the advisor more than the client.

I thought it would be useful to jot down some of the things to look out for when dealing with a financial advisor or broker. We'll call these Financial Advisor Red Flags. Here they are, in no particular order:

1. Invoking a dead relative in an effort to keep your account.

I met with someone the other day - I'll call her Ann - who gave this egregious example. Her husband was a rapidly climbing young executive before he died unexpectedly. Fortunately, he had life insurance.

Ann said she didn't know anything about investing, so she contacted the salesman who sold her husband the policy. The insurance guy sold her all sorts of insurance products like variable annuities. He convinced her that all these products were in her best interest. But after a couple of years, Ann looked at her investments and realized that they didn't meet all her objectives, so she called up the insurance guy and told him she wanted to pull money out.

Instead of defending the investments he sold her on their merits, he tried to shame her in to staying put. "Your husband trusted me," he said, "and he would be so disappointed in you."

I wish I could say that surprised me, but I've heard stories like this from lots of people. Some of them inherited their parents' financial advisor when they inherited money, and were guilt-tripped when they tried to move the investments somewhere else. Others said their advisor invoked the "but we're friends!" card: "But we've been in Rotary together for 20 years! I thought you trusted me!"

Any time a financial advisor uses a guilt-trip or an emotional plea to try to keep your account, that should be a big red flag.

2. Recommending variable annuities when they're not appropriate - such as in an IRA.

I've written a lot about the problems with variable annuities. They cost too much, they rely on terrible mutual funds that underperform the market, the list goes on. (You can read up on the problems with variable annuities here.) But my primary objection is that they're appropriate for only a small portion of investors. Most of us would be better off in something else.

I get particularly mad when I hear about an advisor selling someone a variable annuity inside their IRA. An IRA is already a tax-advantaged vehicle. A variable annuity is tax-advantaged, too - it makes absolutely no sense to have one tax-advantaged investment inside of another.

3. Recommending you move money out of your 401(k) or stop contributing.

This is financial malpractice at its worst. Sure, 401(k) and similar plans have their faults, but for most of us they form the cornerstone of our retirement plan.  Until you leave your employer and are eligible to roll over the money into an IRA, you probably should stick with your 401(k) plan. And if your employer matches part of your contributions, that's free money you'd be leaving on the table by shifting your savings elsewhere.

It's also a red flag when an advisor recommends you borrow from your 401(k). Treat your retirement funds as sacred. If you need cash to deal with an emergency, pretend that 401(k) money doesn't exist. If you borrow from your 401(k), you're robbing yourself of the power of compounding and exposing yourself to penalties if you leave your job before the loan is paid off.  Read more about 401(k)s here.

4. Constructing a portfolio for you with an expected annual return of less than 10%.

Many advisors still ascribe to the old way of thinking, that the best way to ensure your money lasts as long as you do is with a typical 60/40 portfolio (60% stocks, 40% bonds). But this construction is too conservative, and its expected annual return is only 8%. That 8% may give you a high probability you won't run out of money, but it almost assures you won't be able to buy anything with the money you have left.  In other words, the 60/40 portfolio doesn't take into account inflation and taxes.

To pay yourself 4% of your portfolio each year in retirement (the generally accepted "safe" withdrawal percentage), keep up with the historical rate of inflation and pay Uncle Sam at a marginal tax rate of 25%, you have to earn a 10% return. The formula is your withdrawal rate plus inflation divided by one minus your marginal tax rate, or (4 + 3.5)/(1-0.25). If you want to withdraw more or if your tax rate is higher, you'll have to earn an even higher return.

So a double-digit annual return is your goal. If your advisor builds a portfolio for you that is designed to return less than that, you should look for another advisor.

5. Recommending only mutual funds, especially those that are only available through his/her company.

I don't like mutual funds as a rule. I really don't like actively managed mutual funds because their high fees virtually guarantee over time that you will underperform the market itself. So mutual funds are bad enough - but conflict-of-interest from your broker or financial advisor makes it even worse.

A groundbreaking study by Daniel Bergstresser and Peter Tufano of the Harvard Business School and John Chalmers of the University of Oregon found that mutual funds sold by financial advisors badly underperformed the funds selected by investors on their own. The study is titled "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry," and you can read more about it here. You can also listen to my interview with one of the authors here.

A lot of financial advisors will try to steer you toward proprietary funds that are only available through their company. For example, an Ameriprise advisor may try to steer you toward RiverSource mutual funds, which are only available through Ameriprise. It's not because these funds are the best performing. It's because the financial advisor's employer pays him or her to sell the firm's product. It's another example of conflict-of-interest and is a reason to avoid commission-based advisors. For that matter, let's make accepting commissions its own flag:

6. Accepting a commission from products they sell

Any advisor who takes a commission off the products they sell you has a conflict of interest. You can't tell whether the product he recommends is really in your best interest or if he is recommending the product because it pays him well.

If you do use a financial advisor, your best bet is to go with a "fee-only" advisor, one who doesn't get paid commission on the products they recommend. That's the only way you can be sure to avoid the conflict-of-interest.

This post is getting pretty long, so let's stop there for now. I have lots of other red flags to watch out for, and I'll post those later on. If you have a suggestion for a red flag, send me an email. I will compile your suggestions for a future post.

March Mutual Fund Madness - Part One

I spent several days this week in New York and Chicago meeting with reporters from the Wall Street Journal, Dow Jones News Wire, Smart Money, The Street.com and others.  (This is a picture I took, with my cell phone camera, of the New York Stock Exchange. Look to the right at the guy with the helmet, flak jacket and rifle. The military-like security was kind of unsettling.) Anyway, as I made the rounds, talking with reporters about Snider Advisors and the Snider Investment Method, I had the opportunity to give them my take on the problems with traditional investments.

We talked about traditional cash flow investments like bonds, preferreds and dividend paying stocks - none of which pay enough. We talked about the reverse compounding problem with a capital appreciation portfolio. I gave Janet Paskin, from SmartMoney, an unscheduled earful on variable annuities.

But looking back, it occurs to me, I never even talked about one of my favorite whipping posts - actively managed mutual funds. In fact, I can't think of the last time I wrote about the systematic fleecing of unsuspecting mutual fund owners.

What has gotten in to me? I must be getting soft! You know what? I have two hours to kill on this flight. How about we haul them out - just for old times sake?

First of all, mutual funds cover a pretty broad spectrum. There are funds that invest in stocks, bonds, money market funds, REIT's - all kinds of stuff. For now, let's limit the discussion to funds that invest in stocks.

There are closed end funds which trade on the exchanges, similar to a stock, and then there is what we think of as the more traditional fund, where you purchase your shares from the mutual fund company, either directly, or through a broker. Within that category, there are actively managed funds and passive funds or index funds.

An actively managed fund is one where the fund manager is picking stocks, based on whatever criteria he or she uses, in an attempt to outperform the market. An index fund just holds the stocks in the index it is trying to mimic and only changes those stocks when the stocks in the index are changed. Other than that, they rebalance on a constant basis to make sure the fund reflects the weightings of each stock in the index, and that is all that is done.

My beef is with actively managed, equity mutual funds. I will tell you right off the bat that I am not a fan of actively managed mutual funds. In fact, people kid me. You know how companies have tag lines that go with their company name, like “Built Ford Tough” or “Like A Rock”? People tease that my company tag line should be “We'd Rather Stick Pins in Our Eyes than Put Money in a Mutual Fund!”

The problems with actively managed funds fall into three broad categories: 1) Lack of control; 2) Lack of transparency; and 3) Lousy performance. I will outline each of these three areas briefly and then expand on each over the next few weeks.

Too often I see people who are like leaves - just floating along in the current. Wherever it takes them is where they will end up. This is no way to manage your investments. If you care about reaching your financial destination, I believe you have to grab hold of the rudder and steer. With mutual funds, you completely give over control to someone else.

You do not control what stocks the fund invests in or whether the fund even sticks to its stated investment objective. This is known as style slip. You don't control who is managing your money or what they are investing it in.

You also don't control when the fund makes taxable distributions. This makes planning difficult and in certain situations, this can cause you to pay unnecessary taxes or penalties.

Transparency is the second problem. In fact, it is Wall Street's biggest problem. But I won't go down that rabbit hole for now.

You don't really know what your mutual fund owns. It generally only reports the top holdings and often well after the fact. Many mutual funds actually invest in exchange traded funds but few include that information when they report their holdings.

The combination of style slip, also known as closet indexing, globalization, and lack of transparency in fund holdings, makes it difficult - if not impossible - to create a truly diversified portfolio. You would be amazed at how correlated, if not actually duplicative, the holdings of your various funds really are.

And speaking of those exchange traded funds inside a mutual fund - why don't we hear more about that? The fund buys an exchange traded fund that mimics the index. That does two things. It adds an undisclosed layer of costs - the management fee of the ETF. But what should really burn investors is the fund manager continues to charge you active management fees.  The fund is basically charging you for work it did not do! What the heck is that about?

Also, did you know that the way mutual funds are required to report their returns, doesn't tell you how much an investor in that fund would have made or lost? Their return numbers tell you how much the stocks in a funds portfolio went up or down - but they don't tell you how the fund's investor's fared. Often, that is a very different story depending on the timing of the investment.

More disconcerting, you don't really know what you are paying for management. There is no line item showing the debit for fees. They are hidden. And don't count on the prospectus to clue you in.

There are three layers of costs that do not have to be disclosed in the prospectus: transaction, market impact and spread costs.  Academic studies indicate these costs can add an additional 2% to the stated management fee.

I probably wouldn't get my hackles up over these fees if the performance of these portfolio managers offset the costs, but they don't. According to Morningstar, the average domestic equity fund with a track record of at least 15 years, trails the S&P 500 by 2%. So what are we paying them for?

Does 2% matter? Oh my gosh does it matter! Do the math.

Let's take an average actively managed mutual fund with an expense ratio of one and a half percent, which is cheap compared to many mutual funds. Let's compare that with a low expense strategy that has a hypothetical expense ratio of .2 percent. If we apply that to a $250,000 investment and assume that both can earn 10% compounded over the next 20 years, the difference is almost $378,000.

Now consider your required rate of return. To pay yourself 4% of your portfolio each year in retirement, keep up with the historical rate of inflation and pay Uncle Sam at a marginal tax rate of 25%, you have to earn a 10% return. The formula is the withdrawal rate plus the rate of inflation divided by one minus your marginal tax rate, or (.04 + .035) / (1 - .25) = 10%.

If your required rate of return is 10% and your mutual funds return 2% less than their benchmark indexes because of the drag from fees, can you afford to invest in mutual funds? 

Bottom line - you can do better.

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Kim Snider is the President and Founder of Snider Advisors, a SEC Registered Investment Advisor, focused on solving the problem of retirement income for long-time planners, savers and investors who still find themselves wondering if they will have enough. For more information on Snider Advisors or the Snider Investment Method and how we may be able to help you make your retirement savings go farther than you thought, please visit snideradvisors.com.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Am I on target with target date funds?

Lately, I have been getting a lot of questions about target date funds. No wonder. Target date funds are being touted as the answer to our retirement investing conundrum. They are being proposed as the default choice in a 401(k) plan. And they are sprouting up like weeds. So should you put your money in a target date fund?

 

The short answer is ... only as a last resort. But first things first.

 

A target date fund is a mutual fund with an asset allocation tied to your target retirement date. If you think you will retire in 20 years, you would pick a 2030 target date fund, with 2030 being roughly the year you plan to retire.

 

These funds are really funds of funds. The fund manager chooses other funds, from the same fund family, in percentages that make up a reasonable asset allocation given your time until retirement. It is the fund managers job to adjust those percentages for you automatically as your retirement date approaches, becoming progressively more conservative. These funds typically hold a mix of stocks, bonds and cash and will often include an allocation to foreign equities as well.

 

It's no wonder I have been getting so many questions about target date funds lately. In 2000, there were only 23 target date funds in existence, with just about $8 billion in assets. Today, there are over 250 target date funds, with $160 billion in assets, and more being brought to market every day. But should you plunk your retirement savings in a target date fund and forget it?

 

I don't think so and here is why …

 

1. One size doesn't fit all, with any investment.

2. Target date funds are too conservative.

3. There are better ways.

 

Target date funds are being touted as one stop shopping. Just pick a retirement date, pick the fund with your retirement year in the name, and let the fund manager do the rest. But does it really make sense that the CEO of a company should have the same asset allocation as a clerk in his Accounting Department? Not likely!

 

An investor has to put together an asset allocation based on his or her long-term objectives, risk tolerance, time horizon and temperament. You choose the combination of investments that has the highest probability of satisfying each of those criteria over your anticipated time horizon. It is possible that is a single investment but often it is not.

 

My biggest gripe with target date funds is they are too conservative. Let's make some assumptions about your retirement. The first is your retirement will last thirty years. That is the joint life expectancy of a 65 year old, non-smoking couple.

 

Second is that inflation will average 3.5% over that 30 years. Forget for a moment that seniors experience inflation at a greater rate than the nation as a whole, largely because of the cost of healthcare. We'll just use the historical average.

 

Third is that you will begin withdrawing funds from your portfolio at the rate of 4% a year. And fourth, let's assume your marginal tax bracket will be 25%. Now, what is the return required over your 30 years in retirement to pay Uncle Sam, pay you, and still get enough growth in your portfolio to keep up with inflation?

 

The answer is 10%. That is (4 + 3.5) / (1-.25) or your withdrawal rate plus inflation divided by one minus your marginal tax rate. Which means we have a gap. Our current way of thinking about investments is too conservative.

 

If you model the traditional 60%/40% retirement portfolio, the expected rate of return over 30 years is only 8%. A 4% withdrawal rate may give me a high probability I won't run out of money but it almost assures that I won't be able to buy anything with the money I have left. In order to protect against conversion risk, target date funds, because they are based on asset allocation models designed for our parents and grandparents, get too conservative too fast.

 

What worked for previous generations will not work for ours. We are the first generation solely responsible for funding our own retirement. Unfortunately, no one told us that until, for many of us, it was too late. On top of that, we are living longer. Life expectancy has increased by ten years. That is both good news and bad news. That's ten more years to travel, play golf and spend quality time with our family. But it is also ten more years without a paycheck.

 

Like it or not, we have to come to grips with the idea that our investment time horizon isn't our retirement date. Our time horizon extends over our entire lifetime. Moreover, it seems plainly obvious to me our lifestyle in retirement is going to be a function the amount of our portfolio we leave in stocks. Unless you are one of the few with more than enough money, that is the only way our portfolio can keep up with inflation, taxes, and still support a reasonable lifestyle over 30 years.

 

Target date funds don't do that. They are by nature too conservative.

 

My regular readers and radio show listeners know I don't like mutual funds, as a rule. I especially don't like actively managed mutual funds because their high fees guarantee over time you will under-perform the market itself. The only time I would ever use a mutual fund is in an employer-sponsored retirement account, like a 401(k) or 403(b) and that is just because I don't have a choice.

 

Most plans are adding target date funds as an investment option. Should you choose it?

 

Only as a last resort. I believe a well-thought out asset allocation of low-cost index funds, like the one in our 401(k) course, is the much better plan. But if your plan doesn't offer low-cost index funds, or you aren't willing to spend the time and money required to learn how to maximize your 401(k), (which is minimal BTW), then target date funds are far better than just picking the funds with the best historical performance and/or allocating between stocks and bonds based on what you think the market is going to do. That is a sure fire way to waste your retirement funds.

 

Bottom line on target date funds … they aren't the panacea the fund industry would like us to think they are. Do the work. You can do better.

 

Kim Snider Financial Communications makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk, including possible loss of principal. Individual results may vary. Individual performance depends on individual savings, investment time frame and market conditions. Diversification does not ensure a profit or protect against loss in a declining market.

 

 

Nearly Perfect Wrongheadedness

There are five core beliefs that underlie the way I invest my money and teach others to invest theirs. One of them is that our emotions - namely fear and greed - are our worst enemies. Nature has played a cruel trick on us. Our brains are wired backwards - at least when it comes to investing. The survival instincts that got us to the top of the food chain make us terrible investors.

 

Our herd instinct is the classic example. After millions of years of natural selection we are, at our basest core, herd animals. That is pretty useful when you are out hunting and gathering with your cave men buddies. It is far more likely that you are going to bring down a wooly mammoth if you band together to track and kill your quarry. If you are successful, the meat is divided and more families live through the winter than if each had gone out on their own hunting rabbit.

 

As investors, this instinct has the opposite result. In 2006, large cap international funds rose 24% while domestic large cap funds only rose 12%. In an instinctive rush to herd with our buddies, mutual fund buyers pored $150 billion, or 80% of mutual fund inflows in 2006, into international funds. What we should be doing here is selling international and buying domestic.

 

Herding causes us to buy high and sell low. Let's say you need a new set of sheets for your guest bedroom. Linens and Things is having a white sale. Do you think to yourself, "I don't want to buy now. What if they lower the price more?" Of course not. Do you wait until the sales ends and then rush in to buy? No.

 

But think about stocks, or real estate. We do the exact opposite. Where does the trickery come from? It comes from the profit motive. You don’t intend to sell the sheets – but someday you do intend to sell the stocks you buy.

 

When you buy something to hold it forever, we buy it as cheaply as we can. But when we buy something we plan to turn around and sell to someone else, suddenly we get that all twisted around the axle and do the opposite. We buy as the price is going up – often when it is making new highs, and sell when prices are going down – often when markets are making scary lows!

 

Investing may be the only place in our lives where we insist on doing this. Nick Murray calls it "nearly perfect wrongheadedness." Ask yourself whether this really makes sense? The obvious answer is no, which is why I say our brains have been wired backward. Our instinctive behavior makes us terrible investors.

 

Not only do we have emotions, but over millions of years our brains have created logical shortcuts, called heuristics, to help us process the vast amount of input our brain receives. without these heuristics, we would simply be overwhelmed – paralyzed by having to process the trillions of pieces of information we come into contact with each day. In many ways, these shortcuts serve us well. But as investors, they are decidedly counter-productive.

 

These heuristic shortcuts create what behavioral finance calls emotional biases. One of the most common of the emotional biases is known as familiarity bias. Familiarity bias causes us to place more value on things we are familiar with than things we are unfamiliar with, even when that flies in the face of all logic.

 

Sports fans give their teams higher probabilities of winning than those that are not fans, for example, even when they really stink. German’s think their stock market will perform better than the US stock market this year. Americans, on the other hand, believe the U.S. stock market will out-perform the DAX.

 

Familiarity bias is responsible for many interesting phenomena including the tendency for investors to be overly concentrated in the stock of the company they work for and to be overly concentrated in home equity. But what caused me to start thinking about familiarity bias is how it causes us to overestimate the prospects and life span of a company we are familiar with.

 

There are certain companies that we have all grown up with, that to our emotional brains, just seem inconceivable that they might cease to exist. But think about this - in just the last few years, the inconceivable happened.

 

In recent years Sears, AT&T and Gillette vanished – ceased to exist as entities – swallowed up by K-Mart, SBC and Proctor and Gamble! SBC's changing its name to the new AT&T notwithstanding, that is pretty amazing when you think about it.

 

It is hard for investors to remember that companies are just like people. They do not "live" forever. Companies are born, they grow up, they mature, they get old, and slow, and then they die. Some never make it out of childhood or adolescence. A few live abnormally long lives. But in the end, they all die. That is what has happened to Sears, Gillette and AT&T. They got old and slow and were gobbled up by a younger, faster competitor.

 

This is exactly why I invest by assimilating data, probabilities, and statistics, processing it and acting on it in exactly the same way each and every time without ever deviating from that system.

 

Familiarity bias makes the idea of a world with no Gilette unthinkable. But a world with no Sears also means there will some day be a world with no Cisco or GE or Wal-mart! It’s something to ponder. How much does familiarity play a role in your investment decisions and what good investments do you avoid for the same reason?

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.