Focus On: Technology Funds
(Published 09/01/06) The last time we upgraded technology-oriented mutual funds was in August 2002, when we raised the category from a 
(Weak) to a 
(Neutral). At the time, the Nasdaq was in the 1,300 to 1,400 range – close to the crash low and near the index levels of 1996.
Why didn’t we upgrade to a 
(Interesting) or even a 
(Most attractive) given the opportunity in tech at the lows of 2002? The main reason was, at the time, there were better opportunities in other fund categories and our rating system is relative to the market.
Recent subscribers may think of us as negative on most fund categories, but at the time of our 2002 tech upgrade we had top ratings on several fund categories: small-cap growth, telecom, natural resources, utilities, convertibles, balanced, international diversified, global, global balanced, Japan, Asia, Europe, and Latin America. Most funds in these categories have beaten tech stocks over the three years following August 2002. Today, with valuations and investor optimism where it is, we’d be more excited about tech only if the Nasdaq was at 1,300.
In 2002 our rationale for the tech upgrade was–-
“…largely because the valuations of many tech stocks today are not that far out of whack with the rest of the market, adjusting for potential future growth. We don’t see tech stocks as a class dramatically underperforming the market as we have the last couple of years. We’d be perfectly happy if it takes five years for the NASDAQ to reach 2000 because from these levels that would be a 10% return per year. “
As it turned out, the turnaround in tech came on pretty strong after it finally bottomed in late 2002. The Nasdaq broke 2,000 – almost a double from the crash low – at the beginning of 2004 but has been holding at that level ever since. We downgraded the category back to a (Weak) in June 2004 (at Nasdaq 2,000).
Such is the nature of the stock market – often it takes an advance on the future prosperity of corporate America, and then has to sit and wait for fundamentals to catch up.
The Nasdaq took a quick dip to below 1,800 in 2004 after our summer downgrade and we upgraded back to a (Neutral) in September 2004. Along the way we’ve picked up some tech funds (usually ETFs like iShares Semiconductor – IGW) in our higher-risk portfolios during moments of weakness. Some we’ve sold after the Nasdaq ran up a few hundred points to the outer reaches of reasonable valuations.
We don’t see technology stocks as a particularly great value now, just reasonable compared to everything else, hence the upgrade to a positive rating – our first for tech. We expect a 6 to 8% return annually in the coming years, with some swings that may make it possible to see 10% or more with the right entry point.
Fundamentally, technology stocks are risky and sensitive to an economic slowdown (computer budgets get slashed during hard times – at home and at work). More important to us, investors are not that interested in technology anymore – they see better upside abroad or in commodities. Mega-cap tech, the old 1990s growth favorites, like Dell (DELL), Intel (INTC), and Microsoft (MSFT), are particularly out of favor compared with just about any time in the last decade or so (the market crash bottom of 2002 being the only possible exception). Some of this is warranted as growth going forward is going to be slow and margins compressed. Without a major recession it’s unlikely these sorts of companies will fall on much harder times – or at least do no worse than most other companies. We’d have to see actual panic selling in tech and even better valuations – maybe Nasdaq 1700 or so – to upgrade to our highest rating, but funds investing in tech stocks should perform better than most going forward.
Tech ETFs are among the least favorite of the more mainstream ETFs around. Total assets in all no-load tech funds and ETFs are just under $20 billion today. For comparison, near the bubble peak just two tech funds collectively had over $20 billion in assets (T.Rowe Price Science and Technology - PRSCX and Janus Global Technology - JAGTX).
More stunning is the fact that fund investors have lost more money in tech funds in the 2000-2002 crash than currently is in tech funds. They even lost more money collectively than was made in all those hot, triple-digit return years of the late 1990s. Buy high, sell low.
It’s almost impossible to find a tech fund that isn’t sitting on tens of millions – sometimes billions – in loss carryforwards from the crash. Paper gains quickly became very real losses for millions of investors. Don’t expect any taxable dividend distributions anytime soon in this category.
It’s a good idea to invest in fund categories that other fund investors have lost gobs of money in. It’s proof you are doing the opposite of other fund investors – and doing what the other investor isn\'t is the cornerstone of the Powerfund strategy.
Category Rating: (Interesting - should outperform the market and 60% of stock fund categories over the next 1 to 3 years)
Previous Rating: (Neutral - should match the market\'s return and perform in the middle of other stock fund categories).
Expected 12-month return: 8% (raised from 6% in our last favorite fund report)
| RANK/FUND NAME/TICKER | ADDED | SINCE ADD | vs. S&P | 3 MONTH | 1 YR. |
| 1. SSgA Emerging Markets (SSEMX) | 9/02 | 209.90% | 145.86% | -2.93% | 45.08% |
| 2. Excelsior Emerg Mkts (UMEMX) | 9/02 | 217.43% | 153.39% | -5.09% | 37.90% |
| 3. Vanguard Emerging Markt Indx (VEIEX) | 9/01 | 224.45% | 194.02% | -3.20% | 37.89% |
| 4. Bernstein Emerging Markets (SNEMX) | 9/02 | 270.69% | 206.65% | -3.26% | 36.36% |
The Fed - Dr. Feelgood
Much of the volatility in the stock market in recent months relates to investors’ fears about the Federal Reserve’s decisions on short-term interest rates. Until very recently, the big questions were, ”When will The Fed stop raising rates? Will they overdo it and cause a recession? Will they fail in trying to stop the climbing inflation rate?”
On August 8th The Fed didn't raise rates, ending a campaign that started back in June 2004, yet some fear they are not done yet – while others worry that the damage was already done.
The Federal Reserve gets a lot of play in the financial press, but the reasons behind the fed raising and lowering interest rates are not clear to most people. We thought it was high time for a short primer on why the Fed does what it does.
Fear not – we’re not going to get into the complex mechanisms of central banking. Suffice it to say that the Federal Reserve has the ability to cause money to be easy or hard to come by. Easy means low interest rates and plenty of it around for borrowers to get their hands on to build or grow businesses – or just to buy stuff. Hard monetary policy means higher interest rates that can make borrowing money more difficult.
While maximizing employment and creating general financial soundness remain important, nowadays the primary goal of the Fed is to stabilize prices – not necessarily to work toward low inflation, but rather to steady inflation. If the Fed had to choose between a steady 4% a year inflation rate (prices of goods and services on average climb each year by 4%) or a rate that goes from 1% one year, to 5% the next, to 2% the next, they would choose the steady 4%. People make business decisions based on future price levels – namely what interest rate to pay on borrowed money – and stability makes it easier to predict the future cost of money. Lenders will require less of a safety buffer if the future looks stable, making money easier to come by for borrowers.
Officially, the Federal Reserve does not try to buy us out of recessions (that’s the job of the White House…) or to change policy to prick asset bubbles (irrational exuberance in the Nasdaq circa 1999). In reality the Federal Reserve is obsessed with recessions and asset bubbles because general economic activity and wealth are big drivers of how much borrowing goes on in an economy, and how much spending takes place. If we all woke up tomorrow and the stock market (or housing prices) had doubled, we would probably save less and spend more because our wealth, on paper at least, had increased. All that spending would cause the prices of goods and services to climb with the increased demand.
So what if things overheat? Why not just let the economy and asset prices move along with the free market? Why should the Fed try to cool down the economy (as they did toward the very end of the late 1990s boom) or stimulate borrowing and economic expansion during recessions (like they did shortly after the stock market and eventually the economy both took a dive a few years ago)? There are famous economists who advocate a hands-off approach to central banking.
Simply put, the Fed doesn't trust people to always do the right thing with their money. The government thinks if the economy takes a dive, business people and investors will eventually panic and cut back on spending and investing, creating a snowball effect that will eventually lead to another Great Depression. Nobody will want to lend or borrow, confidence in the economy will hit rock bottom, as one company lays off staff, other companies will have to follow as their customers are now unemployed with no disposable income.
The Fed makes borrowing essentially free, and discourages playing it too safe with your investments. How can you leave your money in a money market fund paying just 1% when a corporate bond pays 5%? The Fed is prodding you to use your money to keep the economy humming. The Fed is punishing you if you panic and play it too safe.
On the flipside the Fed thinks we become as crazed and irrational as children left in a candy store with no adults when the good times get a little too good. We live high on the hog and shift our investment strategy from sensible, moderate-risk diversification to outright speculation – looking to get in on all the action. Without the watchful eye of the Fed, we’d create an economic and asset house of cards that would collapse without warning.
The Japan asset bubble and resulting multi-year deflation and economic stagnation – even with near 0% interest rates – is the likely precedent for much current Fed thinking here, just like our own Great Depression is a big reason Fed policy has been overly careful about buying us out of a recession before it gets too bad.
The Fed thinks consumers, business leaders, and investors are all manic depressive and need Fed-dosed lithium to moderate the mood swings – or we’ll destroy ourselves in the unbridled euphoria and depression. The millions of people driving the economy and stock market need the detached brilliance of a handful of experts – who often can’t agree with each other on what policy mix is needed, or even where the economy or prices are going.
In truth, somewhere between the two extremes of a managed economy and a let-it-all-hang-out economy is what is called for. People are irrational, but a small number of economists don't necessarily make correct decisions either.
Worse, it’s possible the big dips and gains we don’t see in the economy because of the Fed would teach us restraint. Anyone who lived through the depression is wary of risk and speculation. Today’s generation is quick to speculate on homes with high-risk mortgage products or emerging market stocks or commodities – just a few years after one stock bubble nearly caused a major problem in the economy. Maybe the Fed stopped a big wipeout with their 1% interest rates prescription, but maybe that wipeout would have stopped future speculation better than the Fed ever could.
The 'Rent vs. Buy' Lie
After a multi-year plateau, rents are finally rising again. Rising rents can make buying a smart move, but with inflated home prices, renting and investing in mutual funds could be a better move.
Renters are watching closely, and asking themselves if now is a good time to buy a home. Rents are currently going up faster than home prices, reversing a multi-year trend of homes price increases far outpacing rents.
Unfortunately, many so-called “rent vs. buy” calculators on the Internet can lead you down the wrong path. For one thing, they should be called “rent & invest vs. buy”.
For the last few years, home prices have climbed, but falling interest rates (and creative mortgage products) have made homes almost as affordable (in terms of monthly payments) as they were before the big run-up. Recent increases in interest rates — notably shorter-term rates that are used to set many adjustable rate mortgages — have made the current home price levels unaffordable for many new buyers. This increases demand to rent, which, coupled with decreases in the supply of rental units from condo conversions, can raise rents. But do rising rents make buying a smart decision now?
Buying instead of renting is almost always a good idea in the long run (over 10 years) because you are essentially renting the property to yourself for phantom income, and are generally putting away more (toward a mortgage) than you would if you rented (forced savings). Surprisingly though, the actual return of the underlying investment, adjusting for maintenance, is pitifully low and on par with inflation (recent memory of wild home price gains aside).
With renting, costs are predictable. The main thing to worry about is rent increases. While a hot rental market with limited units and an inflow of workers can cause double-digit percentage increases when the lease is up, in reality, the inflation rate (or slightly above the inflation rate) is a good starting point for your guess on future increases. Three to five percent per year is a good estimate.
With buying, monthly payments on the mortgage are the main cost — but these can be fixed and made more predictable than future rent changes. Less predictable are maintenance and taxes. It is not out of line to use the same estimates for future growth here as with rents, namely three to five percent.
If the rent was the same as your mortgage, tax, and maintenance cost, owning is a smarter move, as not only will your rent go up and ultimately be more than your fixed mortgage, but you'll also own an asset in 30 years as opposed to owning nothing. However, buying the same home you rent is almost always more expensive. How much more is where the nuances of renting vs. buying come into play.
Most rent vs. buy calculators do a fine job of letting you plug in variables for the above items (including important considerations like tax rates). The trouble starts with two key figures: how much your home appreciates in value, and how much you can earn on money if you didn't put it toward buying (and maintaining) a home.
Many calculators, notably the one run by the Government National Mortgage Association (Ginnie Mae), miss on these points. Ginnie Mae is the government entity that insures mortgages against default; it was created to increase home ownership in America. What better way than to make home buying always seem like a brilliant idea? You can't enter a negative number for “Yearly Home Value Increase Rate” into Ginnie Mae's online calculator.
If the total cost of home ownership is $5,000 a month and you can rent the same place for $3,000 a month, buying is always going to make good financial sense if you assume (like many “rent or buy” calculators) that home prices do not decline (it’s just a matter of how much they go up!) AND that you would spend the extra $2,000 a month you are “saving” by not buying a home on non-investment consumer purchases (like eating out, vacations, and flat panel TVs).
While many renters who can afford the extra money to buy may dispose of that disposable income, they could save the $2,000 difference in a stock index fund like Vanguard Total Market (VTSMX), which over long periods of time outperforms real estate.
Additionally, home prices can fall, particularly over shorter time periods of 1 to 5 years. There is virtually no scenario where buying beats renting if home prices fall, especially factoring in the leverage used in a home investment. Even the Wall Street Journal calculator — perhaps the most advanced of the lot — doesn't handle negative estimates well.
Is it so absurd to want to see the financial damage done buying a beach house that has doubled in value in the last few years if it returns to its 2003 price?
Some calculators have improved in recent months. Bankrate.com's may have become more ridiculous. Now the site just asks some touchy-feely questions about your lifestyle and personal observations on local home price, then it tells you if you should rent or buy. Bankrate.com gets an “A” for ease of use by the average homebuyer, but a “D” for its inaccurate financial analysis of which is a better move.
No calculator that I found lets you enter a “job security” value, like how likely are you to be able to make payments on a house one year from now. No calculator has warning pop-ups when you enter a preposterous value for home appreciation, like 15% to 35% a year (as some markets have seen in recent years).
Rents are going up. Like stocks and underlying earnings, this can legitimize higher prices. Buying a home instead of renting is almost always a good idea in the long run. However, you should be comfortable with the risk of losing your ability to make payments for a few months, the chance of home prices declining 10% to 30% in the next few years, and the reality that you can buy a stock index fund with the extra money you would earmark for buying a home — and earn more than the home appreciation rate of return.
Don’t Get Swept Away
The good news about the Fed bringing interest rates back up is that investors no longer have to make due with pitifully low yields on the cash they have lying around.
Trouble is, many poor souls with accounts at the nation’s premier brokers are STILL earning rock bottom rates of around 1% (and lower) a year. In today’s 5% world, this just shouldn't be. The culprit is the innocuous sounding “sweep” account. At the big four “discount” brokers – E*TRADE, TD Ameritrade, Schwab, and Fidelity – investors parking cash often get carjacked.
How are the brokers sticking it to customers, and what can customers do about it?
When you are not in stocks, bonds, or mutual funds, your cash is swept into the broker’s “interest bearing” account.
Many investors keep a good chunk of their account in cash at any given time – not just between trades but often for years at a time. Recently E*TRADE customers had total cash deposits of $10 billion in sweep deposit accounts – the largest single place customers park cash, more than money market, savings accounts, and CDs combined. E*TRADE paid out an average rate of 0.74% on this $10 billion last quarter.
Today, buying an ordinary Vanguard money market fund yields near 5%. For E*TRADE and other discount brokers, borrowing money from customers at less than 1% is very profitable, especially when they can loan the money back to other customers in the form of margin loans at near 10%.
E*TRADE now makes more from net interest income than they do from stock trading commissions. According to E*TRADE, customer cash “…[is] a low cost source of funding.” Other big brokers also make big dollars from lending their customers money.
But shrewd investors know that these brokers often have higher-yielding options for sweep balances – they just go out of their way to hide them from you.
When setting up a new account online, E*TRADE offers new customers a couple of sweep account options. The default choice is the E*TRADE Extended Insurance Sweep Deposit Account. Here, an investor with $4,000 lying around earns a whopping 0.25% APY, or $10 per year. Larger investors do slightly bit better. Bring your cash balance up to $45,000 and they will reward you with 0.50%. A $90,000 balance earns a paltry 1% - a fraction of what somebody with $3,000 can earn at Vanguard in a plain vanilla money market fund.
What E*TRADE doesn't want new customers to do is choose a money market fund as their sweep balance, but if you select “view tax-free alternates” when asked to choose a sweep option, other higher-yield options appear.
The tax-free money market funds pay far more than the normal sweep options – and the interest is tax-free federally, and could be tax-free in states with the appropriate fund.
Already have an E*TRADE account and want to switch? You can’t do it online, but if you send an email to service@etrade.com with the subject line, “Change My Sweep Option selection” (include your account number and desired fund choice – like JPMorgan Municipal Money Market Fund, E*TRADE Class Shares – in the email itself), within days you’ll be earning about 2.3% tax-free.
TD Ameritrade offers a similar raw deal on sweeps. A $4,000 balance gets you 0.25%, $20,000 earns 0.50%. $40,000 offers a slightly less-ridiculous 1.45%. TD talks a good game about better options, but it’s unclear how you get them. On a new online account application at TD, you are not given a choice for money market funds. On the website you can find a page that shows the tantalizing 4% + yield, but you have to call to buy the fund.
When I called TD Ameritrade a representative told me there are no higher-yield options available to me unless I had $100,000 in cash in the account. Such a standard, which the vast majority of TD Ameritrade accounts never reach, earns you a money market fund sweep option with a yield of roughly 4% or so.
I was informed I could gain access to this privileged club by simply trading more frequently – though how much they could not say. According to the representative, TD didn’t make any commissions off my account, which is in mutual funds.
Schwab offers a slightly better deal than E*TRADE and TD Ameritrade do for ordinary customers who do not hunt for a better sweep account option. While Schwab reserves the high-yielding money market funds as a sweep option for those with $500,000 in total Schwab account value (does not have to be in cash, and includes linked accounts), those with over $100,000 in total Schwab assets earn between 2% and 3% on idle cash (the rate goes up with total Schwab account size). Those with under $100,000 earn about 1%. Schwab has much higher average account sizes than either E*TRADE or TD Ameritrade, so many are getting better yields.
As a Schwab spokesperson is quick to point out, they offer a variety of options including CDs to buy with idle cash – though such options require trades, as apposed to an automatic sweep.
Good choices for Schwab investors include Schwab YieldPlus (SWYPX), a $2,500 minimum ultra short-term bond fund yielding over 4%. The fund is available for no transaction fee for Schwab customers and can be sold with no onerous short-term redemption fees like Schwab charges for sales in non-Schwab mutual funds. Those who can meet the $50,000 minimum will do slightly (like 0.15%) better in the lower-fee Schwab YieldPlus Select (SWYSX) class.
Fidelity offers the squarest deal of the big four on sweep balances in their brokerage accounts. The default sweep option yields almost 3% – even on cash balances under $10,000. The rate goes up slightly on larger balances. Like E*TRADE, Fidelity customers can choose a municipal money market fund as a sweep option and earn tax-free income. Like Schwab, clients can buy and sell Fidelity Cash Reserves (FDRXX), a money market fund with a $2,500 minimum and low fees, currently yielding about 4.6%. Better yet, Cash Reserves is available as an automatic sweep option for retirement accounts.
Fidelity is in line with the better deals generally available at smaller discount brokers. Scottrade offers 1.5% on even a $50 sweep balance. On $5,000 you’ll earn 2%, and 2.75% on over $10,000. Firstrade offers 2% on less than $10,000 in cash, with rates going up with larger balances. Keep in mind that the big four are far more expensive places than Scottrade or Firstrade to buy and sell most mutual funds.
If your broker doesn’t have better options, there are a number of mutual funds that are essentially higher-yield money market funds (though technically they have slightly more risk). SSgA Yield Plus (SSYPX), Payden Limited Maturity (PYLMX) and PIMCO Low Duration Class D (PLDDX) are three funds most any brokerage client can buy for no transaction fee (NTF) and earn a normal yield (currently around 4.5%).
Unfortunately, if you have to sell these funds in a few months time, the brokers will likely charge you a short-term redemption fee for the privilege (often defeating the purpose of the purchase in the first place). Your best bet is the broker's own house brand ultra short-term bond funds or money market funds, if any, as these funds can be traded with no penalties. Those with lousy sweep options but low trading commissions could consider iShares Lehman 1-3 Year Treasury Bond (SHY), an exchange-traded fund that owns short-term government bonds – not quite a money market fund but a very low-risk choice. Just don’t let the commissions eat up the extra yield.
Sell High
The top of the great emerging markets run will likely be very close to the levels hit on May 16, 2006. That’s the day Dreyfus filed with the Securities and Exchange Commission to launch another emerging market stock fund – to be named Dreyfus Emerging Markets Opportunity Fund.
With billions of new money flooding into emerging markets funds (after a massive three-year rally that has seen most funds in the category triple in value), Dreyfus is getting tired of sitting on the sidelines while competitors bring in all the loot.
Can you blame ‘em? Emerging market funds are about the last area where a fund company can make an honest buck. Management fees for your typical emerging market stock fund are double domestic stock funds – even the ETFs in this area have high expenses. iShares MSCI Emerging Markets Index (EEM) charges 0.75% a year. As this ETF recently peaked at around $14 billion in assets, Barclays Global Investors (the company behind the popular ETFs) rakes in more money from this fund than any other they run.
They funny thing is, Dreyfus already has an emerging markets fund – the solid Dreyfus Emerging Markets Fund (DRFMX for class A), which has been in a couple of our higher-risk model portfolios back when it was a no-load fund (converted to load 11/02 – we switched to SSgA Emerging Markets SSEMX but sold that a couple of months ago as the whole category is overblown at this point).
Trouble is, the old Dreyfus fund is closed to new investors (as it should be at around $1.5 billion in assets) and is a bit too conservative to attract hot fund seekers, who gravitate to the top performers in up markets more than down.
The even funnier thing is that Dreyfus closed a “redundant’ emerging market fund by merging it into Dreyfus Emerging Markets Fund. Who needs two emerging market funds in the fund lineup in early 2003 when few were buying? As it often turns out with fund closings, this marked (almost to a T) the end of the fall for emerging market stocks and the start of the big move up.
This whole escapade smacks of Vanguard’s decisions to effectively close by changing their excellent Vanguard Utility Income fund (which we owned) right before the great utility stock rally of recent years. Vanguard then launched a new utility ETF (Vanguard Utilities VIPER – VPU) in early 2004, when utilities became a little more saleable to the average consumer.
Want more proof? Dreyfus has been known to launch and close funds right around the top and bottom of market cycles. Remember Dreyfus Premier NexTech Fund (DPNTX)?
Dreyfus filed with the SEC to launch this fund in March 2000 – the very top of the Nasdaq bubble, when the tech and telecom-fueled index was around 5,000. Everybody was launching tech funds – that’s were billions of new shareholder money was flowing and unlimited profit potential abounds.
In what would be funny if it didn’t cost shareholders dearly, the company noted,
“Specific high-tech sectors that will be evaluated for the [NexTech Fund] include
Internet products and services or e-commerce companies; optical communications components; wired and wireless communications services, equipment and component suppliers; storage devices and networks; computer hardware and software; and semiconductors. The Fund will also seek to participate in the initial public offerings of companies in these sectors.”
The Dreyfus president went on to say,
"Innovative new technologies can continue to fuel the growth and success
of this sector ....We will strive to provide our shareholders with the types of investments that are of most interest and benefit to them."
Unfortunately, the types of investments that are “of the most interest to shareholders” one year are often the same ones that perform the worst the next. This particular fund promptly fell 85% in the bear market. The only thing that kept the fund from falling even more was that the market already turned south between when the fund was filed with the SEC and when it was actually cleared for takeoff with the SEC – in May, 2000.
Dreyfus merged the fund into their Premier Technology Growth Fund on December 17, 2003 and buried this embarrassment and case study in bad investment timing from the public eye forever. Apparently this time around Dreyfus should be trusted to know opportunity when it strikes.
When a certain type of fund is saleable, you should pass. When I launched an emerging market stock fund back in 1998 – right after the Asian financial crisis – we literally couldn’t give away fund shares. At the recent peak in emering markets, the fund was up over 1,000%. I can assure you, investors are more likely to lose 30 to 60% on this new Dreyfus fund than make even 1/10 as much as emerging market investors made in what seemed like a very stupid investment in late 1998.
Ask MAX: Payoff Debt or Takeoff in Funds?
Dear MAX,
We are a 26-year-old couple getting married and want to invest our wedding money in the best way possible. (We estimate receiving 25k.) My fiancé is still in grad school, and I am paying off student loans. Should we put the money toward paying off our educations? Or should we invest it in a mutual fund?
Ray and Margaret
Salem, PA
Dear Ray and Margaret,
As an investment advisor, I should tell you to pay off all debts before investing because it's unlikely you'll earn more investing than the rate on your debts — especially after taxes, commissions, and the like. Plus, it's a lower risk strategy — imagine your investments go sour, you lose your job (the two can be correlated with the economy) AND you still have your debts.
That said, I'd only pay off high interest rate debt like credit cards (and then only if you WON'T rack the debt right back up). Student loan interest is acceptable debt to carry. For one, unless you earn a lot of money ($65,000 per year single filers or $130,000 for joint filers) the interest is deductible on your taxes (thank you Bill Clinton). Credit card interest is not deductible (thank you Ronald Reagan).
Thanks to government backing, student loan interest rates are ultra low given they are secured by nothing but your social security number. The key is to consolidate the loans at as low a rate as possible, which you can do by calling the government (1-800-848-0979) who probably has your current loan. Also set up automatic deduction of payment from your checking account because the government will give you a discount on the rate if you do. Unfortunately, student loan interest rates reset at a higher level on July 1st, 2006.
Home mortgage interest is largely deductible (Reagan kept that one alive). While it’s a good idea to pay off your mortgage at an advanced rate, you will want to invest along the way as you pay off the house debt.
Its important to start investing early and get in the habit of adding to your portfolio (as well as making timely debt payments). If you don't plan on using this newfound wealth to buy a home in the next few years (which would require playing it safer, with more savings, bonds, and less stocks, so you don’t lose big right before you need the dough), buy a stock mutual fund, as you are young enough to take on some risk. Consider Bridgeway Blue Chip 35 (BRLIX) with about $20,000 (don't panic if your account drops by $5,000 in a rough market) and put $5,000 in a high yield savings account for a rainy day (so you can keep paying your debt if you lose you job…).
For no risk savings, go with a low fee money market fund like Vanguard.
Thanks for the question.
MAX
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Ask MAX: Should I Settle for 3%?
Dear MAX,
I am retired and widowed. Since the stock market has been so up and down, should I just put my savings (less than $100,000) in a savings account paying 3%? I feel that I am too old to always be keeping an eye on the stock market.
Robin
Florida
Robin,
The stock market is always up and down. The key is to only invest an amount of money that you can stand to see go up and down. The single biggest mistake investors make is investing too much of their portfolio and panic selling after an ordinary 10% - 20% drop in the market — often right before the market turns around.
Consider putting some of your money in a low fee stock index fund like Vanguard 500 Index (VFINX) — perhaps just 25% if you are nervous about losing money. A larger chunk, say 50%, should be in lower risk investments. A low fee bond index fund like Vanguard Total Bond Index (VBMFX) is a decent choice with limited downside (perhaps 10% in a down market for bonds) and a roughly 5.25% yield. The rest (25%) could be in a virtually no risk investment like a Vanguard money market fund — the Vanguard Prime Money Market Fund, currently yielding just under 5%. Fidelity has an equally good and cheap lineup of similar funds.
Buy these funds through Vanguard to save on commissions that an ordinary broker may charge.
As for earning 3% in savings - shoot higher. I've linked my checking account to HSBC Direct and ING's Orange Savings account (both are “online” savings accounts — FDIC insured with no risk). You can sweep money in anytime and earn over 4% (these are not teaser rates but current rates will change with swings in shorter term interest rates). HSBC Direct currently yields a whooping 5.05%. Your bank branch can't come close to matching these rates on liquid FDIC insured money with no minimum or transfer fees.
Thanks for the question.
MAX
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A Fund Fee We Love
Nobody hates mutual funds fees more than we do. At MAXfunds.com, we absolutely hate loads, deplore high expense ratios, and barely tolerate 12b-1 fees. So you'd think when the Securities and Exchange Commission ruled last year to continue to allow mutual fund companies to charge shareholders for selling shares of a fund (up to 2% in redemption fees) that we'd be hopping mad. But we're not. In fact, we're actually tickled pink. Redemption fees, you see, are the ones we absolutely love.
Redemption fees are charged by some funds if an investor sells a position held for less than a certain period of time. The amount of the fee and the redemption fee period varies from fund to fund, but a common redemption fee is 1% of sales made within 90 days after purchase.
Redemption fees do bear a strong resemblance to back-end loads (or contingent deferred sales commissions or CDSCs), which we hate. So why are we in favor of a fee that seems to do just about the same thing? Because redemption fees discourage short-term investing - the practice of hopping in and out of a fund to benefit from quick rises in NAV prices.
Besides the fact that we think short-term mutual fund investing is, in the long run, a losing game for you as an investor, people switching in and out of a fund hurts the shareholders who remain in a fund. Such "hot money" raises a fund's expenses because of increased transaction costs and, more importantly, presents a fund manager with the problem of a fluctuating asset base that makes it tougher to stick to his chosen investment strategy. Redemption fees make short-term investing (in funds that charge them) prohibitively expensive.
Another important difference between back-end loads and redemption fees is that the money generated by the load goes into the pocket of the broker or fund manager, while redemption fee money goes go back into the pot held by other shareholders. This redemption fee money offsets the trading costs that are run up by short-term shareholders but paid for by long-termers.
Redemption fees can, of course, hurt investors who might have a legitimate need to sell shares of a fund before the redemption period has expired. A loss of employment or a natural disaster like hurricane Katrina could necessitate an unforeseen fund sale, but there are currently no exemptions offered by redemption fee-charging fund companies for such emergency sales.
Despite the loss of flexibility caused by redemption fees, we think fund investors should look at redemption fees as positives when evaluating a mutual fund for purchase. The managers behind MAXadvisor Private Management and the MAXadvisor Powerfund Portfolios certainly do when assessing funds for their fund portfolios. You can find out if a fund you are considering buying (or selling) charges a redemption fee by checking the fee table of the fund's prospectus
As an investor you must be sure you hold a fund long enough to avoid the fee. Nobody tells you when you are about to make a sale that will incur a redemption fee - it's up to you to keep track of your fund's purchase date and redemption period.
Callable CDs
Imagine getting an FDIC-insured 6.5% return with zero risk! Too good to be true? With Callable CDs you can get mouthwatering returns without the ups and downs of stocks. Trouble is, you can’t have your cake and eat it too.
CDs (certificate of deposit) are appealing to risk-averse investors. They are FDIC-insured against loss (unlike mutual funds) and readily available with just a few thousand dollars at your local bank – seemingly without sales charges or commissions.
With interest rates on the rise, CDs are becoming more attractive, particularly to those worried about stock market gyrations and low dividend yields from stocks.
Because of the safety, CDs typically don’t yield much – the best CDs yield slightly more than government bonds for similar maturities. As interest rates have climbed in recent weeks, investors can typically get around 4% - 5.5% on better CDs, depending on the term.
Some CDs have higher yields than others – even for the same time period. As all bank CDs are FDIC-insured and there is no expense ratio (or manager or other considerations), gravitating toward the highest-yielding CDs is appropriate. Websites like bankrate.com make researching CD yields easy, and most investors will find they can do better shopping around online than at their local bank branch – in fact, they will likely do better in their discount brokerage account or online bank.
Right now I can buy a three-year CD at E*Trade yielding 5.3% APY (Annual Percentage Yield includes compounding), 5.32% at Scottrade, or 5.21% in my Netbank online account.
My local Chase branch? 4% APY for a three-year CD – and that’s only because I have a checking account at Chase. 1.3% a year is a big difference – you’d earn around $420 more over three years on a $10,000 CD at E*Trade than with Chase.
Some CDs appear to offer better returns than the yields you see at the best CD outfits, which tend to be the same places.
In all likelihood, these are known as “Callable CDs”. Unlike ordinary CDs – which make up 99%+ of all CDs – callable CDs can be 'called in' by the bank, much like a callable bond. Most callable CDs are available through brokers, as are ordinary CDs. Some are available direct from a bank.
Callable CDs offer tantalizing yields that are generally about 0.5% – 1.5% more than regular CDs for the same term – almost what you’d get in a high-yield corporate bond fund (like Vanguard High Yield Corporate VWEHX fund, which currently yields 7.06%) only with no risk (unlike the Vanguard fund).
Here is how these callable investments work:
A traditional, or “bullet” CD has a term of, say, five years. While this is a risk-free investment, it can be a bad investment. Risk is defined as the chance of losing money, not giving up extra returns. Imagine walking into a bank and buying a five-year, 5% CD. Two days later interest rates take off on inflation fears and the same bank now offers a five-year, 6% CD. While you didn’t lose any money, you are locked in at 5% for five years when you could have gotten in at 6% for five years.
On the flipside, if interest rates fall sharply two days after you step out of the bank, you are sitting pretty – you have a five-year, 5% CD while new customers are getting five-year, 3% CDs. This is why CDs are very similar to owning government bonds of the same maturity: you get the rate you signed up for, but you benefit if rates fall after you buy, and are hurt if rates climb after you buy. With bonds, you can see the changes in value daily: if you pay $1,000 for a five–year, 5% bond today and rates drop sharply tomorrow you can probably sell it for $1,050 or so as your bond has a better yield than other bonds. In theory you could sell your CD at a premium, but CDs are hard to trade, which is why government bonds can be a better investment.
Back to the magic extra yield. If interest rates fell to 3% you would not want a bank executive to call you and say, “Remember that CD you bought that pays 5% for five years? We want to give you your money back and not pay you 5% for five years. We’ll give you 5% for one year and call it a night, okay? There is no need to raise your voice. You can buy another CD for four years with a 3% yield. Now you’re just being greedy. Good day, sir!”
A callable CD is a CD the bank can cash in when they want to (once it becomes callable). Clearly this is worth less than a traditional, non-callable CD, as you can’t even bank on a 5% yield for the full five years. This is why banks pay you more for a callable CD – they are rewarding you for the risk that you may not earn the juicy return for a full 5 years. In fact, unless interest rates climb, they will likely call the bond.
Such an investment leaves you suffering when interest rates go up (you could have bought a higher-yielding CD) and suffering when rates go down (you are given your money back to reinvest at lower yields). A money market fund has a better risk-to-reward ratio because your yield may go down if rates fall, but your yield will go up if rates increase. For reference, Vanguard Prime Money Market Fund currently yields 4.7% – and you can write checks or simply liquidate the account whenever you want!
There are scenarios when a callable CD is a good deal. If interest rates stay flat or drift up slowly over the life of the CD, the bank probably won’t call it in and you would have done better in the Callable CD than in a regular CD or with a money market account.
However, the extra yield is probably not worth the risk – we’d like to see a 1% premium per year to consider callable over traditional. Right now a five-and-a-half-year callable CD available through Scottrade yields 5.83% APY, while a similar five-year CD yields 5.54%. Don’t sell off your upside for a lousy 0.29% a year!
A big word of caution: Callable CDs can be very long-term, like 10 to 20 years. The call provision is only one year. These are pitched as “6.5%, one-year callable CDs – FDIC-insured!”. YOU CAN’T CALL THE BOND in a year, only the bank can. You are stuck for 20 years.
A comparable investment is a callable bond. Callable bonds also pay higher yields than traditional bonds because the issuer can give you your money back when you don’t necessarily want it (when interest rates are lower). And unlike CDs, you can sell callable bonds.
Bottom line: Callable CDs are not a terrible idea but are illiquid, don’t have enough spread over regular CDs, and can leave you with a lump of money when interest rates are low. These CDs might be better for those who don’t need to live off investment yield and can gamble with the risk of getting their money back in a low-rate environment.
Ask MAX: What should I do with my old 401(k)
Dear MAX,
A while back you helped me with my 401(k). Although it's only been a short time I was very satisfied with your services. I have since moved on to another company and I hope once again you can assist me with my new 401(k) options.
Do you have any advice on what I should do with my old 401(k)?
Kind regards,
CW
CW,
Would you leave your personal belongings in your old desk? Take your retirement money, along with the pictures of the kids, when you move on to bigger and better things.
The best choice for your old 401(k) is to roll it over into a low-fee broker like Firstrade where you can buy any number of funds, or to a fund family like Vanguard with a wide selection of low-fee funds.
Moving your old 401(k) plan – or 403(b) – is better than leaving your 401(k) at your old employer with their limited selection of often high-fee funds or even moving the old plan to your new employer’s plan, as the new plan will likely have the same shortcomings.
While you can't combine this old 401(k) with a ROTH, you can combine it with other traditional IRAs and maintain the account’s tax-deferred status. The downside of combining it with other accounts is that you can’t move it back to a 401(k) at a later date – it’s been sullied by the other money, so to speak.
The likelihood of your new 401(k) being better or cheaper than having the money in an IRA at a low-fee, multi-choice locale is near zilch, so who cares? You can keep the money in a separate IRA (conduit or separate rollover IRA) if you are dying to move the money back to a 401(k) some day.
There used to be one upside of keeping the money in a 401(k) – protection from lawsuits. Your IRA was fair game in bankruptcy court, unlike employee-sponsored retirement accounts operating under the Employee Retirement Income Security Act (ERISA) rules. The new Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 shields your retirement account from creditors whether it is an IRA or a 401(k). Now you can owe millions and still live high off the hog because your IRA is safe from creditors!
Be sure to watch out for IRA maintenance fees. Though most low annual fees will still likely be cheaper than the hidden costs of the mediocre, expensive funds in your old 401(k), you can easily figure out ways to keep these IRA fees at zero, either by meeting a certain combined account size at a broker or fund company, or just choosing an IRA fee-free zone in the first place (like Firstrade or Scottrrade).
If you don’t need a plethora of fund choices or you simply don’t want to manage your account yourself (if for some strange reason that defies all earthly logic, you do not want to use our Powerfund Portfolios to make this job easy and fruitful!) there are simple options that are still better than leaving the money at the ole’ salt mine.
Move the account to Vanguard and go with a one-fund portfolio like their Vanguard STAR (VGSTX) fund, a very low–fee, moderate-risk total portfolio fund with a $1,000 minimum. Alternatively, assuming you plan on retiring in about 30 years, go with Vanguard Target Retirement 2035 (VTTHX), which you can buy and forget for decades (the fund ages with you and gradually gets more conservative as you do – not politically, just in terms of risk aversion). If you don't plan to retire for forty years, consider the Vanguard Target Retirement 2045 fund (VTIVX). You can do it all online at Vanguard.com or call 800-997-2798.
This one-fund simple solution is still better than leaving your money at the old employer, where you will still have to make fund choices yourself or choose from the often more expensive all-in-one investment options in your old or current 401(k).
Best,
MAX
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