Fund Bad, ETF Good?
Fund Bad, ETF Good?
While exchange traded funds, or ETFs, are a useful invention, we fear investors will get into more trouble with them than they do with ordinary mutual funds. The primarily benefit - low costs and tax efficiency - seem to be falling to the wayside as the other benefits, intraday trading, leveraging, shorting, and ultra-targeting of sub-sectors and investment strategies, take the spotlight.
We've often heard experts opine on how bad mutual funds are compared to ETFs. This is a bit silly as the same mutual fund companies running "evil" mutual funds are usually the same companies behind ETFs. Moreover, to most investors, there is little difference between a Vanguard open end fund and its ETF cousin. In fact, to those buying in relatively small allocations directly through the fund company, ordinary index funds remain the cost effective choice, especially when an investor is adding money regularly.
In response to a reader question about a book called The Lies About Money by Ric Edelman, Eric Tyson, author of Investing for Dummies notes:
"A number of financial advisers are cheerleading for ETFs. In my observation, this advocacy is self-serving, because such advisers have investment-management businesses built around using ETFs. And, in a competitive marketplace, they want to be different and appear current to appeal to novice customers.
In Edelman's case, he has written a purposely provocative and hyped book telling his readers the following:
'The retail mutual fund industry is ripping you off. ... You need to sell all your retail mutual funds. ... The fact is that the retail mutual fund industry is now flush with liars, crooks and charlatans. Daily business activities include deceit, hidden costs, undisclosed risks, deceptive trade practices, conflicts of interest, and fundamental violations of trust — all at your expense. Since September 2003, the retail mutual fund industry has paid out more than $5 billion in fines.'
That does indeed sound pretty awful, doesn't it?
...What's ironic and hypocritical of Edelman's comments is that he said in a prior book, 'I hate index funds.' Well, ETFs are index funds that you trade on a stock exchange!
ETFs are similar to mutual funds, with the most significant difference being that in order to invest, you must buy into an ETF through a stock exchange where ETFs trade, just as individual stocks do.
Thus, you need a brokerage account to be able to invest in ETFs.
ETFs are most like index mutual funds in that each ETF generally tracks a major market index. (Beware that more and more ETFs are being issued that track more narrowly focused indexes, such as an industry group and small country).
The best ETFs might also have slightly lower operating expenses than the lowest-cost index funds.
However, you must pay a brokerage fee to buy and sell an ETF, and the current market value of the ETF may deviate slightly from the underlying market value of the securities in its portfolio."
Bill Gross On Today’s Muni Bond Crash
Municipal bonds – which had been a model of stability and safety in investing - started sliding on February 12th. This was the day Money Magazine posted “Munis: The new power portfolio” and just days after Investor’s Business Daily penned, “Munis A Safe Haven While Bear Rampages”.
Yesterday, this slide turned into an avalanche. Many conservative municipal bonds funds fell between 1% and 2% and some leveraged closed-end municipal bond funds fell over 3%. Today promises to be worse than yesterday - troubling news because investors have been encouraged to buy municipal bonds recently to earn about 1% more after tax than safe treasuries. These investors have lost about 5% in the last couple of weeks in ordinary long term muni bond funds, and could be down in the double digits within a few days – to say nothing of the sixty billion or so in leveraged closed-end muni bond funds.
Bond kingpin Bill Gross or PIMCO fame appeared on the FOX Business Network’s “Cavuto” yesterday evening (in the segment after the one in which I appeared). He discussed yesterday’s wipeout in the municipal bond market and forecast that the real bloodbath would be today and perhaps Monday. Gross also predicted major buying opportunities in the next few days in munis:
Gross: There’s significant unwinds in terms of leveraged structures and the municipal market is in shambles. But it doesn’t mean that the credits themselves are not credit-worthy. And so if you can buy California at 5.5% to 6%, what an attractive value. Non taxable to the California holder. State of New York the same way.
These are values that probably won’t come around for another generation but they’re here at the moment. Yes, they’re risky because their prices are moving at the moment down. But they’re not uncreditworthy….
Cavuto: When do you start investing?
Gross: I think you start tomorrow. There’s 100s of municipal closed-end funds. Nuveen’s got some. Blackrock’s got some. PIMCO’s got some. They’re all out there. Tomorrow my forecast: They’re going to be hit hard.
Cavuto: Hit hard, responding to what?
Gross:Responding to these liquidations that are happening as we speak. Tomorrow will be a nasty day for the municipal market. For somebody who is willing to step in into a credit-worthy double A single A type of quality instrument that’s not going to default – cross your fingers – with no guarantees.
These values tomorrow and Monday and Tuesday of next week are going to be enormous."
What Bill Gross is talking about is highly leveraged hedge funds that have been buying up muni bonds and probably shorting treasury bonds.
The logic behind the trade is based on what many financial experts have been telling investors for the past few months: that municipal bond yields are historically high relative to treasury bonds – which is a good deal when compared to taxable treasuries for higher tax bracket investors.
For speculators it was a rationale to gamble. This yield gap between treasuries and munis should eventually converge, or so they thought, so shorting treasury bonds (which would make money if yields went up) and buying municipal bonds (which would make money if municipal bond yields went down) could make money with minimal risk because there is virtually no default rate on municipal bonds and no default rate on government bonds. General interest rate swings would not matter because both treasury bonds and muni bonds would move up or down together (assuming similar duration or interest rate sensitivity). The absolute ONLY risk was if municipal bonds yields went up while treasury yields went down…but why would that happen from already historically wide yield spreads between the two?
Well guess what happened yesterday? Municipal bond fund Vanguard Long-Term Tax-Exempt (VWLTX) was DOWN 1.21% (the fourth worst one-day drop in over a decade) while taxable government bond fund Vanguard Long-Term U.S. Treasury (VUSTX) was UP 1.49%! Now imagine being long munis and short treasuries with say, five times leverage. Doh!
We could have sworn we saw Bill Gross smirk at the trouble now facing the brilliant hedge fund managers. Watch the video closely. For those looking to follow Bill Gross’s lead and buy after the drop, consider unleveraged muni bond funds, like open end Vanguard funds, or closed-end funds that do not leverage, like Nuveen Municipal Value Fund (NUV).
Do As Suze Says, Not As Suze Does
Personal Finance Guru Suze Orman has done a decent enough job teaching textbook personal finance tips and tricks. When she dives into investing advice though, we often find her a little lacking. Take for example her Yahoo Finance "Money Matters" column today to sooth skittish investors:
Declines of more than 10 percent in the major stock market indexes over the past few months, along with the growing expectation of a recession, have set off a massive investor call to action.
By action I mean the urge to flee stocks for the apparent safety of bonds or cash. For the vast majority of investors, that move can be a costly mistake....
...Fear is natural, but there's a right way and a wrong way to handle fear when it comes to finances. Knowing when to act and when not to act is one of the keys to financial security.
Right now, we're all being put to the test.
....For these long-term investors, the best advice is to do nothing. Yes, nothing. If you have a well-diversified portfolio that's focused on building value over the next few decades, it doesn't make sense to overreact to a few months of volatility and bail out on stocks. It's no fun watching your portfolio fall, but you need to focus on a bigger problem: If you put all your money into super-low-risk investments such as money markets or stable value funds, you increase your risk, too -- the risk that your portfolio won't grow enough over time to build a hefty retirement account...
...If your investment time horizon is 10, 20, or 30 years, stay invested in your stock funds and ETFs. Over time (meaning decades, not weeks), stocks have consistently outperformed other types of investments. That includes periods when the stock markets fall. Doing nothing is going to net you better long-term results than doing something."
Buy and hold stocks through think and thin. Don't panic sell after a drop. If you have a long time horizon, stocks are the place to be. Timeless advice that now has that Suze Orman stamp of approval. Too bad she doesn't seem to follow it with her own money.
In a New York Times interview last year, we learned this about Suze's portfolio:
How much are you worth these days? One journalist estimated my liquid net worth at $25 million. That’s pretty close. My houses are worth another $7 million...
What do you do with the rest of your money? Save it and build it in municipal bonds. I buy zero-coupon municipal bonds, and all the bonds I buy are triple-A-rated and insured so that even if the city goes under, I get my money. I take a little lower interest rate to make sure my bonds are 100 percent safe and sound.
Do you play the stock market at all? I have a million dollars in the stock market, because if I lose a million dollars, I don’t personally care."
So there you have it. Suze Orman has about 3% of her net worth in stocks, 21% in real estate, and 76% in ultra-safe muni bonds. As any professional can tell you, in the long run stocks beat bonds and real estate. Apparently Suze makes here money giving advice, not following it.
And just to poke more fun at the tanned personal finance guru, we'll leave you with this quote from last year's interview:
Do you enjoy spending money? Oh, yes. My greatest pleasure is still flying private. I spend between $300,000 to $500,000, depending on my year, on flying private."
Remember that gem next time a personal finance guru tells you to scrimp on "expensive" lattes to save for retirement.
More MAXattacks on Suze:
OMG! Vanguard Shows GMO The Door
Vanguard U.S. Value (VUVLX) and Vanguard Explorer (VEXPX) may be among the cheapest actively managed value and growth funds (respectively) around, but Vanguard apparently has had it with their lagging performance:
Vanguard's Quantitative Equity Group (QEG) has begun managing the portions of Vanguard U.S. Value Fund and VVIF–Small Company Growth Portfolio previously managed by Grantham, Mayo, Van Otterloo & Co., LLC (GMO). QEG has also assumed primary responsibility for the assets previously managed by GMO for the Vanguard Explorer Fund.
QEG joins AXA Rosenberg Investment Management LLC as a co-advisor for Vanguard U.S. Value Fund. QEG now oversees approximately one-third of the fund, employing a quantitative investment approach to select stocks from the Russell 3000 Value Index that it deems attractive.
QEG will share advisory responsibilities with Granahan Investment Management for managing VVIF-Small Company Growth Portfolio. The firm will also expand its portfolio management role for Vanguard Explorer Fund, assuming responsibility for most of GMO's former portfolio, with the remainder allocated to the other advisors of the fund.
"Vanguard brings a vast amount of experience and expertise to its quantitative mandates and the funds' boards of trustees are highly confident in the group's ability to complement the strategies of the existing advisors and produce competitive long-term returns," said Mr. Brennan. "GMO has provided advisory services to Vanguard funds since 2000 and, on behalf of our shareholders, we thank them for their efforts."
Vanguard U.S. Value has been a fund favorite around here since 2002, largely because of low fees, and GMO's detailed and often doomsday-grade outlooks on the U.S. markets. While a MAXfunds favorite it has beat the S&P 500, but more recently the fund's managers have made some missteps. We have downgraded our outlook for large cap value funds in general due to years of outperformance and asset growth at many value funds - but this fund has underwhelmed in a weak category recently. In 2007 the fund underperformed the Russell 1000 Value Index (an index of larger cap value stocks) by about a half percent. In 2006 the fund missed the mark by around eight percent.
GMO (Grantham, Mayo, Van Otterloo) uses a quantitative take on value investing: like many other value managers, they screen for low value stocks (preferably ones that are unpopular with other investors) by looking at their interpretation of intrinsic value and price-to-normalized earnings. In addition, they look for stocks with some positive momentum. Unfortunately, this screen put GMO into too many retailers like Home Depot (HD), Dollar Tree Stores (DLTR), and Kohl's (KSS), financial services companies like Citigroup (C), Bank of America (BAC) and First American (FAF), and healthcare stocks like Pfizer (PFE), Merck (MRK), Unitedhealth (UNH).
GMO manages some $150 billion (and falling after this news...) largely in foreign stocks. GMO's own foreign funds (institutional funds) have done well next to competitors, however, their own U.S. stock funds have performed near the bottom of the heap.
The funny thing is we expect GMO's foreign funds to have more problems going forward than their domestic funds. By dumping GMO, Vanguard is in effect playing the same game they tell us not to play: performance chasing. (Or perhaps Vanguard just wants to manage more of their portfolios themselves. Better for profit margins...)
We are currently reviewing U.S. Value for possible expulsion from Our Favorite Funds lists, large cap value category.
Your Fund Company As Influence Peddler
Fund investors may not realize it, but some of the management fees they pay each year may be going to Washington lobbyists.
Mutual funds, which are technically called investment companies, have a trade association, the Investment Company Institute, that looks out for their best interest. Sometimes these interests are not the best interests of actual fund shareholders. Apparently the ICI was active in 2007 nuzzling up to politicians:
The mutual fund industry's trade association, the Investment Company Institute, paid Covington & Burling $240,000 in 2007 to lobby on tax issues.
The firm lobbied Congress and the Treasury Department on the taxation of mutual funds and mutual fund investors, according to a form posted online Feb. 13 by the Senate's public records office."
Lobbists may be ranked just above lawyers on many people's least popular list, but in this case the ICI's lobbying could be completely benign. Fund companies would like to get favorable tax treatment for fund shareholders. This would be good for shareholders and fund companies would have a more marketable product. However, sometimes fund companies want to rub out competing products (exchange traded notes perhaps...) that may offer tax and fee savings to investors who would ordinarily choose mutual funds.
Love Thy Neighbor, Pay Their Fund Taxes
2007 was a fair year for stocks, but as Marketwatch reports it was a great year for the IRS:
Many mutual-fund investors will get an unpleasant surprise from their tax preparer this year: A bill for the distributions they got from their funds, even though those funds may have had a disappointing year.
Year-end numbers for 2007 are not available yet, but it's clear that distributions will amount to a record of more than $500 billion. You read that right: a half-trillion dollars, nearly $100 billion more than in 2006, and that was the previous record.
That means $1 of every $23 invested in funds today was recycled, passed back to the shareholder and, in most cases, back to the fund again, creating a tax liability along the way. By the time final numbers are in, investors with taxable fund accounts will have paid Uncle Sam more than $25 billion for the privilege of playing buy-and-hold in 2007."
If you've owned a fund for a few years, don't be too concerned if you get a year-end taxable distribution. Heck, if you traded the stocks yourself directly you'd have some tax liability each year. What can be a problem is when a fund has to sell shares to meet redemptions of exiting investors. Those sales can lead to realized taxable distribution to some poor saps who bought the fund just recently, and have so far made nothing on their investment.
Until mutual funds can start tracking gains to each shareholder, getting somebody else's taxable gains will be a problem for fund investors, and one reason exchange traded funds are bringing in gobs of new money.
Depression Era Funds A Good Bet?
An article on TheStreet.com notes that many funds launched right before the Great Depression have stood the test of time:
Wouldn't it be nice to own a fund that had survived all the way since before the Great Depression? Wouldn't you think it might do pretty well during this time of volatility?
Things are different this time, of course -- or so they say.
In investing, things are almost always different, which keeps us on our toes and prevents the trend followers from inheriting the universe.
But at the same time, seldom are things overwhelmingly and permanently different from anything that has happened before...
...It might be comforting to know that some investment funds have survived and prospered through many 'different' environments over the years. Sponsors, managers and even their names have changed. Some have experienced mergers and investment objective redirections. But the funds have endured "different" environments as extreme as the Great Depression of the 1930s, the World War that followed and the subsequent Cold War, not to mention the Internet boom and bust and myriad other cyclical events."
Don't be impressed. Fund companies buy and sell funds and flip managers throughout the years. It's irrelevant how a fund did decades ago when it was run by a different fund company with different managers, often with a different strategies. What we don't see on this list is all the funds launched in the late 1920s that went bust. The real takeaway is funds tend to launch tons of new funds shortly before markets tank. Someday we'll look back at funds launched in 1999 and 2000 that stood the test of time.
Castro Quits, Fund Rises
News of the end of Castro's long tenure as president of Cuba boosted the one lone fund investing in Cuba - or rather in companies that benefit from economic activity in the Caribbean. The tiny closed-end fund offers only a fixed number of shares, which can lead to big swings in share price with minimal underlying change in the actual investments in the portfolio - as was the case yesterday:
The closed-end Herzfeld Caribbean Basin fund (NASDAQ:CUBA) CUBA, the only Cuba fund, shot up 17% to 8.70 on Tuesday. A record 1.44 million shares traded after the ailing 81-year-old dictator announced he will resign as president. Castro has held power since overthrowing Gen. Fulgencio Batista in 1959.
The fund seeks long-term capital appreciation and invests in companies from 20 countries in and around the Caribbean.
As a closed-end mutual fund, the Herzfeld fund trades at prices that might differ from the per-share value of their assets. The fund was trading at a 9.61% discount to its net-asset value prior to Tuesday.
Its surge signals hope that Cuba's future will be far different than the past 49 years under Castro. U.S. trade embargoes, enacted to protest Castro's Communist regime, have made life tough on the island nation."
Open-end funds would just issue more shares and would not jump so much in price on one-day on investor enthusiasm alone. We don't recommend buying closed-end funds trading a big premiums to NAV (net asset value).
New Global Dodge & Cox Fund On Horizon
Last Friday Dodge & Cox filed with the SEC to launch a new global stock fund - their first new fund since 2001 when they launched Dodge & Cox International Stock (DODFX).
When investors are able to buy Dodge & Cox Global Stock in about three months, the fund will be more expensive than other Dodge & Cox funds, with a 0.60% management fee and total expenses capped at 0.90%. Currently the other Dodge & Cox funds are in the 0.44% - 0.65% total expense ratio range. We expect the total expense ratio of this new fund to reach around 0.80% in the next couple of years, and ultimately settle at roughly 0.65% once assets take off (which might take a little longer now that the market is weak and other Dodge & Cox funds have reopened). These extra fees in the near term will more than likely be offset by increased performance (relative to other Dodge & Cox funds) due to the benefits of a much smaller asset level (you will notice a low fat fund index on this fund's data page during its formative years). But should you buy?
Back when D&C launched International Stock, we didn't wait around to add it to our favorite funds list, we did it in 2002. We'll probably add this new fund to our favorites list for the global stock category, but we're not particularly enthusiastic about giant value funds right now, especially ones investing abroad.
Dodge & Cox funds currently suffer from two problems: 1) too much money under management 2) the value style is slipping out of favor after years of outperformance.
Of course, most other funds suffer from far more problems: mediocre management, high fees, style never in favor, to name a few.
Value should continue having problems beating the S&P 500 because too much money has flooded the doors of top value funds like Dodge & Cox. Currently investors in many value oriented funds are learning that just because a stock has a low P/E ratio and pays a market beating dividend doesn't mean it can't be overvalued. Financial stocks are currently teaching this lesson. Energy stocks will be soon. With so many "fundamental" ETFs offered up in recent years, could it be any other way?
Today Dodge & Cox manages around a quarter trillion dollars in funds (much of it in Dodge & Cox Stock [DODGX]) and private accounts. In some ways Dodge & Cox (and T. Rowe Price) are following a similar path to Janus in the 1990s. These fund families are the low fee performance leaders in what happened to be the way the market pendulum was swinging. The press, fund analysts, ratings, and rankings all helped direct performance chasing fund investors into growth and tech funds in the late 1990s. In recent years the flood has been to value and international funds. While I don't predict the same deep troubles I did for Janus back in 2000, overly popular fund families deliver underwhelming performance.
Given the ultra-low fees and quality management, most long term investors will do fine in Dodge & Cox funds in general or this new one in particular - if you have a ten year time horizon this will be one of the best global stock funds over that time period. But then, going way out, most would do fine in Janus funds. Trouble is investors tend to buy near the top and sell near the bottom of the cycle. Those looking to get in on the cheap will do better buying Dodge & Cox funds when asset levels are lower, and other fund investors are less enthusiastic about value and international funds.
The First Rule Is...There Are No Rules
Choosing winning mutual funds is tough business.The experts regularly fail because past winners often become future losers. If we had to leave our readers with one sentence of fund picking advice, it would be this: choose low-fee funds that are not perennial losers in out-of-favor fund categories, and stick with them for a few years.
An article in yesterday's Financial Times offers a humble review of fund data to consider (much of which you can find right here on MAXfunds.com) when choosing your mutual fund investment:
Although many investors are swayed by evidence of excellent recent performance, statistically, it is unlikely that fund managers will manage to do well consistently over a period of years.
'There is some evidence that last year’s winners tend to repeat next year. But it is very slight. Mostly the effect comes from the fact that really bad funds stay bad. Their expenses are high, and their choices stay haphazard,' said Paul Samuelson, an academic, in his article 'The Long-Term Case for Equities', which appeared in the Journal of Portfolio Management in 1994.
However, this does imply that it is worth considering performance, if only to avoid the poor performers.
...When choosing an investment fund, performance is important. But it is also important to bear in mind that even excellent performance can be eaten up by investment management fees. A cheap index fund might do better for the investor than a well-managed active fund, so performance should not be the only consideration."
Using statistical measures of risk-adjusted return are useful but far from an end-all-be-all. Often funds that delivered have delivered good risk-adjusted returns in the past go on to deliver poor risk-adjusted returns in the future.
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