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Seven Habits of Highly Defective Funds

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

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

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

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

Funds Keep Singin’ The Subprime Blues

10/09/07 - Junk Bonds, Subprime Woes

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

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

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

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

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

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

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

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

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

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

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Ask MAX: A Fund with an 18% Yield?

10/06/07 - Ask MAX, Ask MAX, Investing Newsletters, Korea Fund

Mike asks:

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

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

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

Vanguard’s 7% Forever Funds

10/03/07 - New Fund Launches, Vanguard

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

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

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

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

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

Our Favorite Funds

10/02/07 - 'Best Funds' lists, Our Favorite Funds

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

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

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

Buddy, Can You Spare a 10 Cent Euro Coin?

10/01/07 - Powerfund Portfolios Feature Article

Since late 2002, investments have gone up, up and away. Stocks, oil, metals, real estate, art, collectibles, classic cars – you name it. Every investment carries a higher price tag than it did then. In the last five years, it's been difficult to lose money. Everything has gone up. Or has it?

Motley Fool’s Orwellian Moment

09/28/07 - Motely Fool, Professional Advice, Watch Out

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

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

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

Sneaky Mutual Fund Tricks

09/24/07 - Investing Tips, Load Funds, New Funds, Watch Out

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

Confusing share classes

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

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

Incubation strategy

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

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

Fund seeding

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

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

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Pentagon Sets Sights On Brokers

09/20/07 - Professional Advice