Posts tagged ‘Mutual Funds’

Changing of the Guard

Over previous decades, there has been a continual battle between the merits of active versus passive management. Passive management being what I like to call the “do nothing” strategy, in which a basket of securities is purchased, and the underlying positions remain largely static. For all intents and purposes, the passive management strategy is controlled by a computer. Rather than solely using a computer, active management pays professionals six or seven figures to fly around to conferences, interview executive management teams, and apply their secret sauce tactics. Unlike passive managers, active managers do their best to determine which winning securities to buy and which losing ones to sell in their mutual funds and hedge funds.

Caught in the middle of this multi-decade war between passive and active management are Vanguard Group (founded in Valley Forge, Pennsylvania in 1975 by John Bogle) and Fidelity Investments (founded in 1946 in Boston, Massachusetts by Edward C. Johnson II).  Currently John Bogle and Vanguard’s passive philosophy is winning the war. A changing of the guard, similar to the daily ceremony witnessed in front of Buckingham Palace is happening today in the mutual fund industry. Specifically, Vanguard, the company spearheading passive investing, has passed Fidelity Investments as the largest mutual fund company according to assets under management. Before 2010, Fidelity topped the list of largest firms every year since 1988, when it passed the then previous leader, Merrill Lynch & Co (BAC).

As of July 2010, Vanguard stands at the top of the mutual fund hill, managing $1.31 trillion versus Fidelity’s $1.24 trillion. Vanguard is sufficiently diversified if one considers its largest fund, the Vanguard Total stock Market Index Fund (VITSX), sits at around $127 billion in assets. The picture looks worse for Fidelity, if you also account for the $113 billion in additional ETF assets (Exchange Traded Funds) Vanguard manages – Fidelity is relatively absent in the ETF segment (State Street). Once famous active funds, such as Fidelity Magellan (now managed by Harry Lange – FMAGX) have underperformed the market over the last ten years causing peak assets of $110 billion in 2000 to decline to around $22 billion today. The $68 billion Fidelity Contrafund (FCNTX), managed by Will Danhoff, has not grown sufficiently to offset Magellan’s (and other funds) declines.

The Proof is in the Pudding

Some in the industry defend the merits of active management, and through some clever cherry-picking and data mining come to the conclusion that passive investing is overrated. If you believe that money goes where it is treated best, then the proof in the pudding suggests active management is the discipline actually suffering the beating (see Darts, Monkeys & Pros). The differences among the active-passive war of ideals have become even more apparent during the heart of the financial crisis. Since the beginning of 2008 through August 2010, Morningstar shows $301 billion in assets hemorrhaging from actively managed U.S. equity funds, while passive equity-index funds have soaked up $113 billion of inflows.

On a firm-specific basis, InvestmentNews substantiated Vanguard’s gains with the following figures:

In the 10 years ended Dec. 31, Vanguard’s stock and bond funds attracted $440 billion, compared with $101 billion for Fidelity, Morningstar estimates. This year through August, Vanguard pulled in $49 billion while Fidelity had withdrawals of $2.8 billion, according to the research firm.

Vanguard is gaining share on the bond side of the house too:

Vanguard also benefited from the popularity of bond funds. From Jan. 1, 2008, through Aug. 31, 2010, the company’s fixed- income portfolios pulled in $134 billion while Fidelity’s attracted $33 billion (InvestmentNews).

Vanguard is not the only one taking share away from Fidelity. Fido is also getting pinched by my neighbor PIMCO (Pacific Investment Management Company), the $1.1 trillion assets under management fixed income powerhouse based in Newport Beach, California. Bond guru Bill Gross leads the $248 billion Pimco Total Return Fund (PTTAX), which has helped the firm bring in $54 billion in assets thus far in 2010.

Passive Investing Winning but Game Not Over

Even with the market share gains of Vanguard and passive investing, active management assets still dwarf the assets controlled by “do-nothing” products. According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (2009). The analysis gets a little more muddied once you add ETFs to the mix.

Passive investing may be winning the game of share gains, but is it winning the performance game? The academic research has been very one-sided in favor of passive investing ever since Burton Malkiel came out with his book, A Random Walk Down Wall Street. More recently, a study came out in June 2010 by Standard & Poor’s Indices Versus Active Funds (SPIVA) division showing more than 75% of active fixed income managers underperforming their index on a five-year basis. From an equity standpoint, SPIVA confirmed that more than 60% domestic equity funds and more than 84% international equity funds underperformed their benchmark on a five-year basis. InvestmentNews provides some challenging data to active-management superiority, however it is unclear whether survivorship bias, asset-weighting, style drift, and other factors result in apples being compared to oranges. SPIVA notes the complexity over the last three years has increased due to 20% of domestic equity funds, 13% of international equity funds, and 12% of fixed income funds liquidating or merging.

Regardless of the data, investors are voting with their dollars and happily accepting the superior performance, while at the same time paying less in fees. The positive aspects associated with passive investment products, such as index funds and ETFs, are not only offering superior performance like a Ferrari, but that enhanced quality also comes at the low price equivalent of a Hyundai. On a dollar-adjusted basis, stock-index funds charge an average of 29 cents per $100, compared with 95 cents for active funds (almost a 70% discount), according to research firm Lipper. For example, Vanguard’s passive VITSX fund charges clients as little as 6 cents for every $100 invested (Morningstar).

There has indeed been a changing of the market share guard and Fidelity may also be losing the debate over active versus passive management, but you do not need to shed a tear for them. Fidelity is not going to the poorhouse and will not be filing for Chapter 11 anytime soon. Last year Fidelity reported $11.5 billion in revenue and $2.5 billion in operating income. Those Fidelity profits should be more than enough to cover the demoted guard’s job retraining program and retirement plan benefits.

Read the Complete InvestmentNews Article

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VITSX, PTTAX, BAC, FCNTX, FMAGX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 3, 2010 at 11:18 pm 3 comments

Paper Cut to Death with 12b-1 Fees

Paying all these 12b-1 fees and other expenses found in the small-print can be a lot like getting paper-cut to death.  The Securities and Exchange Commission (SEC) is looking to put a Band-Aid on the problem by capping these nonsensical fees and proposing more disclosure, albeit three decades after these fees initially got introduced. According to InvestmentNews, the SEC has proposed a .25 percent cap on 12b-1 fees, which may save investors upwards of $857 million per year if the proposal is enacted. That’s all good and great, but aren’t investors already getting pillaged and plundered with load expenses and other investment management fees?

The Original Rationale

The original thought process behind the 12b-1 fee movement was designed to allow the little guys (small fund management companies) to compete on an even playing field against the big guys (think of Fidelity, Vanguard, and the American Funds) when it came to product distribution. The SEC says about 2/3 of the 8,000 mutual funds in the industry charge 12b-1 fees, which reached over $13 billion in 2008. These 12b-1 fees generally account for 18% of the total annual fund expenses (ICI – Investment Company Institute).

Source: ICI. The general trend in 12b-1 fees was upwards until the financial crisis hit.

 So are small fund management companies truly benefitting from the customer kickbacks after 12b1-fees were unveiled in 1980? It appears the small fry fund companies have indeed scraped up some extra fees as ammo to market products against the big guys, but the big guys are receiving the same 12b-1 fees. It’s like giving both me and Alex Rodriguez (New York Yankees) an aluminum bat in the game of baseball. There’s  a good chance I may be able to clear the infield now, but A-Rod will instantly have the power to hit one out of the stadium – I have effectively gained no advantage with my new metal bat.

The Investor Perspective

If I’m an investor, what do I care if my mutual fund company has one investor or one million investors? I just want the best products at the lowest price. Yeah, there are these special items used in other industries that help pay for marketing and distribution expenses…they’re called sales and profits. What a novel idea. 

Deciphering all the mutual fund class flavors is tough enough. Like trading in a used car when buying a new car, the juggling of prices, fees, and taxes can become a head-spinning exercise in discovering the true component costs. The cards become even more stacked against investors, if you consider alternative products like the shady world of annuities (see Annuity Trap article).  If translating 12b-1 and load fees is not challenging enough for you, try digesting a slice of legalese heaven by examining this 259 page annuity prospectus gem.

The Flawed Structure

Unfortunately, the financial industry is rife with conflicts and opacity, with the investor getting the short end of the stick. The industry’s main incentive is all about generating commissions for the broker (salesman) and financial institution – not about generating the best return for the client. Here is how I see a typical conversation playing out between a broker and prospect:

Broker A:  “This is a slam dunk investment with guaranteed returns.”

Prospect XYZ:  “Wow, that sounds great – guaranteed returns in a world that everyone is talking double-dip. How do I learn more?”

Broker A:  “You can sign here on the dotted line, or borrow this forklift and take two months to review this gargantuan 259 page prospectus that I don’t even understand.”

Prospect XYZ: “If I have questions about 12b-1 fees, administrative fees, up-front commissions, management fees, mortality charges, trail expenses, or other costs, can I give you call?”

Broker A: “Oh sure, but I’ll probably be in the Bahamas drinking umbrella-coconut drinks with all the commission dollars I’ve earned, so if I don’t answer, just leave a message.” 

Why do 12b-1 Fees Exist at All?

OK, now that I’ve returned from my annuity rant, let’s get back to the pointless value of 12b-1 fees. I mean honestly, what privileged status does the financial industry have in charging customers for a business’s operating expenses? Why stop at charging customers for marketing and distribution costs…maybe customers can start paying for new fund development expenses or for employee health benefits? What’s more, if the financial industry is going to nickel and dime clients with all kinds of fees, then why not have customers subsidize the marketing and advertising campaigns in other industries, like in the pharmaceutical, tobacco, beer, and junk food industries?

Not all 12b-1 fees are created equally. Many funds do not even carry 12b-1 fees, or many that do carry a much more modest punch. While I respect Mary Shapiro’s courage in addressing the useless 30-year 12b-1 fee structure institutionalized by industry lobbyists, putting a Band-Aid on this paper-cut is only hiding the wound, not healing it.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and mutual funds, including Vanguard and Fidelity, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

September 3, 2010 at 1:21 am Leave a comment

Passive vs. Active Investing: Darts, Monkeys & Pros

Bob Turner is founder of Turner Investments and a manager of several funds at the investment company. In a recent article he reintroduces the all-important, longstanding debate of active management (“hands-on”) versus passive management (“hands off”) approaches to investing.

Mr. Turner makes some good arguments for the active management camp, however some feel differently – take for example Burton Malkiel. The Princeton professor theorizes in his book A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s stock page could select a portfolio that would do just as well as one carefully selected by experts.” In fact, The Wall Street Journal manages an Investment Dartboard contest that stacks up amateur investors’ picks against the pros’ and random stock picks selected by randomly thrown darts. In many instances, the dartboard picks outperform the professionals.

Given the controversy, who’s right…the darts, monkeys, or pros? Distinguishing between the different categorizations can be difficult, but we will take a stab nevertheless.

Arguments for Active Management

Turner contends, active management outperforms in periods of high volatility and he believes the industry will be entering such a phase:

“Active managers historically have tended to perform best in a market in which the performance of individual stocks varies widely.”

He also acknowledges that not all active managers outperform and admits there are periods where passive management will do better:

“The reason why most active investors fail to outperform is because they in fact constitute most of the market. Even in the best of times, not all active managers can hope to outperform…The business of picking stocks is to some degree a zero-sum game; the results achieved by the best managers will be offset at least somewhat by the subpar performance of other managers.”

Buttressing his argument for active management, Turner references data from Advisor Perspectives showing an inconclusive percentage (40.5%-67.8%) of the actively managed funds trailing the passively managed indexes from 2000 to 2008.

The Case for Passive Management

Turner cites one specific study to support his active management cause. However, my experience gleaned from the vast amounts of academic and industry data point to approximately 75% of active managers underperforming their passively managed indexes, over longer periods of time. Notably, a recent study conducted by Standard & Poor’s SPIVA division (S&P Indices Versus Active Funds) discovered the following conclusions over the five year market cycle from 2004 to 2008:

  • S&P 500 outperformed 71.9% of actively managed large cap funds;
  • S&P MidCap 400 outperformed 79.1% of mid cap funds;
  • S&P SmallCap 600 outperformed 85.5% of small cap funds.

Read more about  the dirty secrets shrinking your portfolio.

According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (passive strategies).  If you doubt the popularity of passive investment strategies, then look no further than the growth of Exchange Traded Funds (ETFs – see chart), index funds, or Vanguard Groups more than $1 trillion dollars in assets under management.

Although I am a firm believer in passive investing, one of its shortcomings is mean reversion. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. Active investing can take advantage of mean reversion, conversely passive investing cannot. Indexes can get very top-heavy in weightings of outperforming sectors or industries, meaning theoretically you could be buying larger and larger shares of an index in overpriced glamour stocks on the verge of collapse.  We experienced these lopsided index weightings through the technology bubbles in the late 1990s and financials in 2008. Some strategies may be better than other over the long run, but every strategy, even passive investing, has its own unique set of deficiencies and risks.

Professional Sports and Investing

As I discuss in my book, there are similarities that can be drawn between professional sports and investing with respect to active vs. passive management. Like the scarce number of .300 hitters in baseball, I believe there are a select few investment managers who can consistently outperform the market. In 2007, AssociatedContent.com did a study that showed there were only 22 active career .300 hitters in Major League Baseball. I recognize in the investing world there can be a larger role for “luck,” which is difficult, if not impossible, to measure (luck won’t help me much in hitting a 100 mile per hour fastball thrown by Nolan Ryan). Nonetheless, in the professional sports arena, there are some Hall of Famers (prospects) that have proved they could (can) consistently outperform their peers for extended durations of time.

Experience is another distinction I would highlight in comparing sports and investing. Unlike sports, in the investment world I believe there is a positive correlation between age and ability. The more experience an investor gains, generally the better long-term return achieved. Like many professions, the more experience you gain, the more valuable you become. Unfortunately, in many sports, ability deteriorates and muscles atrophy over time.

Size Matters

Experience alone will not make you a better investor. Some investors are born with an innate gift or intellect that propels them ahead of the pack. However, most great investors eventually get cursed by their own success thanks to accumulating assets. Warren Buffet knows the consequences of managing large amounts of dollars, “gravity always wins.”  Having managed a $20 billion fund, I fully appreciate the challenges of investing larger sums of money. Managing a smaller fund is similar to navigating a speed boat – not too difficult to maneuver and fairly easy to dodge obstacles. Managing heftier pools of money can be like captaining a supertanker, but unfortunately the same rapid u-turn expectations of the speedboat remain. Managing large amounts of capital can be crippling, and that’s why captaining a supertanker requires the proper foresight and experience.

Room for All

As I’ve stated before, I believe the market is efficient in the long run, but can be terribly inefficient in the short-run, especially when the behavioral aspects of emotion (fear and greed) take over. The “wait for me, I want to play too” greed from the late 1990s technology craze and the credit-based economic collapse of 2008-2009 are further examples of inefficient situations that can be exploited by active managers. However, due to multiple fees, transaction costs, taxes, not to mention the short-term performance/compensation pressures to perform, I believe the odds are stacked against the active managers. For those experienced managers that have played the game for a long period and have a track record of success, I feel active management can play a role.

At Sidoxia Capital Management, I choose to create investment portfolios that blend a mixture of passive and active investment strategies. Although my hedge fund has outperformed the S&P 500 in 2009, that fact does not necessarily mean it’s the appropriate sole approach for all clients. As Warren Buffet states, investors should stick to their “circle of competence” so they can confidently invest in what they know.  That’s why I generally stick to the areas of my expertise when I’m actively investing in stocks, and fill in the remainder of client portfolios with transparent, low-cost, tax-efficient equity and fixed income products (i.e., Exchange Traded Funds).

Even though the actively managed Turner Funds appear to have a mixed-bag of performance numbers relative to passively managed strategies, I appreciate Bob Turner’s article for addressing this important issue.  I’m sure the debate will never fully be resolved. In the meantime, my client portfolios will aim to mix the best of both worlds within active and passive management strategies in the eternal quest of outwitting the darts, monkeys, and other pros.

Read the full Bob Turner article on Morningstar.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but had no direct position in stocks mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 8, 2009 at 1:45 am 5 comments

Style Drift: Hail Mary Investing

Hail Mary

The mutual fund investing game is extraordinarily competitive. According to The Financial Times, there were 69,032 global mutual funds at the end of 2008. With the extreme competitiveness comes lucrative compensation structures if you can win (outperform) – I should know since I was a fund manager for many years. However, the compensation incentive structures can create style drift and conflicts of interest. You can think of style drift as the risky “Hail Mary” pass in football – you are a hero if the play (style drift) works, but a goat if it fails. When managers typically drift from the investment fund objective and investment strategy, typically they do not get fired if they outperform, but the manager is in hot water if drifting results in underperformance. Occasionally a fund can be a victim of its own success. A successful small-cap fund can have positions that appreciate so much the fund eventually becomes defined as a mid-cap fund – nice problem to have.

Drifting Issues

Why would a fund drift? Take for example the outperformance of the growth strategy in 2009 versus the value strategy. The Russell 1000 Growth index rose about +28% through October 23rd (excluding dividends) relative to the Russell 1000 Value index which increased +14%. The same goes with the emerging markets with some markets like Brazil and Russia having climbed over +100% this year. Because of the wide divergence in performance, value managers and domestic equity managers could be incented to drift into these outperforming areas. In some instances, managers can possibly earn multiples of their salary as bonuses, if they outperform their peers and benchmarks.

The non-compliance aspect to stated strategies is most damaging for institutional clients (you can think of pensions, endowments, 401ks, etc.). Investment industry consultants specifically hire fund managers to stay within the boundaries of a style box. This way, not only can consultants judge the performance of multitudes of managers on an apples-to-apples basis, but this structure also allows the client or plan participant to make confident asset allocation decisions without fears of combining overlapping strategies.

For most individual investors however, a properly diversified asset allocation across various styles, geographies, sizes, and asset classes is not a top priority (even though it should be). Rather, absolute performance is the number one focus and Morningstar ratings drive a lot of the decision making process.

What is Growth and Value?

Unfortunately the style drift game is very subjective. Growth and value can be viewed as two sides of the same coin, whereby value investing can simply be viewed as purchasing growth for a discount. Or as Warren Buffet says, “Growth and value investing are joined at the hip.” The distinction becomes even tougher because stocks will often cycle in and out of style labels (value and growth). During periods of outperformance a stock may get categorized as growth, whereas in periods of underperformance the stock may change its stripes to value. Unfortunately, there are multiple third party data source providers that define these factors differently. The subjective nature of these style categorizations also can provide cover to managers, depending on how specific the investment strategy is laid out in the prospectus.

What Investors Can Do?

1)      Read Prospectus: Read the fund objective and investment strategy in the prospectus obtained via mailed hardcopy or digital version on the website.

2)      Review Fund Holdings: Compare the objective and strategy with the fund holdings. Not only look at the style profile, but also evaluate size, geography, asset classes and industry concentrations. Morningstar.com can be a great tool for you to conduct your fund research.

3)      Determine Benchmark: Find the appropriate benchmark for the fund and compare fund performance to the index. If the fund is consistently underperforming (outperforming) on days the benchmark is outperforming (underperforming), then this dynamic could be indicating a performance yellow flag.

4)      Rebalance: By periodically reviewing your fund exposures and potential style drift, rebalancing can bring your asset allocation back into equilibrium.

5)      Seek Advice: If you are still confused, call the fund company or contact a financial advisor to clarify whether style drift is occurring in your fund(s) (read article on finding advisor).

Style drift can potentially create big problems in your portfolio. Misaligned incentives and conflicts of interest may lead to unwanted and hidden risk factors in your portfolio. Do yourself a favor and make sure the quarterback of your funds is not throwing “Hail Mary” passes – you deserve a higher probability of success in your investments.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Wade W. Slome, CFA, CFP is a contributing writer for Morningstar.com. Please read disclosure language on IC “Contact” page.

November 3, 2009 at 2:00 am 2 comments

Building Your Financial Future – Mistakes Made in Investment Planning

Building Your Dream Future Requires a Plan

Building Your Dream Future Requires a Plan

Building your retirement and financial future can be likened with the challenge of designing and building your dream home.  The tools and strategies selected will determine the ultimate cost and outcome of the project.

I constantly get asked by investors, “Wade, is this the bottom – is now the right time to get in the markets?” First of all, if I precisely knew the answer, I would buy my own island and drink coconut-umbrella drinks all day. And secondarily, despite the desire for a simple, get-rich quick answer, the true solution often is more complex (surprise!). If building your financial future is like designing your dream home, then serious questions need to be explored before your wealth building journey begins:

1)     Do I have enough money, and if not, how much money do I need to develop my financial future?

2)     Can I build it myself, or do I need the help of professionals?

3)     Do I have contingency plans in place, should my circumstances change?

4)     What tools and supplies do I need to effectively bring my plans to life?

Most investors I run into have no investment plan in place, do not know the costs (fees) of the tools and strategies they are using, and if they are using an advisor (broker) they typically are in the dark with respect to the strategy implemented.

For the “Do-It-Yourselfers”, the largest problem I am witnessing right now is excessive conservatism. Certainly, for those who have already built their financial future, it does not make sense to take on unnecessary risk. However, for most, this is a losing strategy in a world laden with inflation and ever-growing entitlements like Medicare and Social Security. There’s clearly a difference between stuffing money under the mattress (short-term Treasuries, CDs, Money Market, etc.) and prudent conservatism. This is a credo I preach to my clients.

In many cases this conservative stance merely compounds a previous misstep. Many investors undertook excessive risk prior to the current financial crisis – for example piling 100% of investment portfolios into five emerging market commodity stocks.

What these examples prove is that the average investor is too emotional (buys too much near peaks, and capitulates near bottoms), while paying too much in fees. If you don’t believe me, then my conclusions are perfectly encapsulated in John Bogle’s (Vanguard) 1984-2002 study. The analysis shows the average investor dramatically underperforming both the professionally managed mutual fund (approximately by 7% annually) and the passive (“Do Nothing”) strategy by a whopping 10% per year.

Building your financial future, like building your dream home, requires objective and intensive planning. With the proper tools, strategies and advice, you can succeed in building your dream future, which may even include a coconut-umbrella drink.

June 3, 2009 at 3:27 pm Leave a comment


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