No Hiding From This Bear
Following the recent steep drop in foreign markets, today the U.S. stock market opened way down - in early trading we saw a 4% fall. Since the market peak in October 2007, stocks have been weak around the world. While the market has come back in the afternoon, we just about saw the most indexed and benchmarked of U.S. stock indexes down 20% from the highs hit just over three months ago.
A 20% drop is a measure often used to denote a bear market. We haven't had a 20% fall since the great bubble pop of 2000-2002. Unlike the last bear market, this one is proving hard to dodge.
In the late 1990s we didn't have across-the-board asset price booms. Real estate was relatively cheap, as was natural resources and commodities, small cap stocks, and value stocks in general.
Back in 1999 the entire Russian stock market had a combined market cap less than any individual major stock in the Nasdaq or S&P 500. Even safe U.S. Government bonds had a decent yield. The bubble was in tech, telecom, U.S. large cap and growth stocks. Anyone who was "properly" diversified across multiple asset classes at least partially avoided the market meltdown that eventually took the S&P 500 down almost 50% and the Nasdaq almost 80%.
Over much of the last few years investors have been piling into foreign stock funds. Today the iShares MSCI EAFE Index (EFA) exchange traded fund or ETF tips the scales at around $50 billion - second only to the oldest ETF, the SPDR S&P 500 ETF (SPY) exchange traded fund with $85 billion. Heck iShares MSCI Emerging Markets Index (EEM) has $24 billion - more than the $19 billion in the Nasdaq 100 ETF or QQQ (the ticker is now QQQQ).
Unfortunately in this down market all this diversification is hurting, not helping. The Dow and S&P 500 are among the relatively best performing areas to invest - many foreign markets have fallen over 10% in the last two days alone. Most of the big foreign stock markets are already down more than the U.S. market during this downturn. Real Estate Investment Trusts or REITs - a favorite to the diversification crowd - are now down near 40% from the peak in February 2007.
Bottom line, diversification helps when investors are adding cheap out-of-favor asset classes. Adding expensive asset classes - even ones that have been historically less correlated to U.S. stocks - can increase portfolio downside in a bear market. Going forward, we expect U.S. stocks to continue to outperform essentially all the hot categories of recent years. Our fund category rating system rewards categories that have underperformed and seen a lack of interest by investors in recent years.
Why are ETFs More Tax Efficient Anyway?
You hear it all the time: exchange-traded funds are more tax-efficient than traditional mutual funds - what you don't hear is the reason why. Smartmoney gives a good answer:
When investors decide to exit an ETF they can sell their shares in the open market. In some cases, the authorized participant will redeem large chunks of ETF shares directly with an ETF sponsor like WisdomTree, performing what's called an "in-kind" redemption. In essence, they reverse the initial purchase transaction. So WisdomTree would return that sampling of individual shares in its portfolio to the AP in exchange for the ETF shares. The twist: WisdomTree will generally return the shares with the lowest cost basis — the ones it paid the least for and, hence, the ones with the highest potential capital gains — in order to hold down its potential tax hit. The AP doesn't care because its tax basis will be based on the current share price. The IRS perceives the whole deal as two companies exchanging one type of share for another, so it's not considered a taxable event.
That transaction method helps insulate existing ETF shareholders from unexpected capital gains — a luxury mutual fund holders don't enjoy. Indeed, an investor who leaves a mutual fund can potentially trigger capitals gains in their wake, since a manager has to sell shares to pay them off. Meanwhile, an investor who leaves an ETF pays taxes on his own profits; the existing shareholders don't get whacked with any unexpected capital gains."
Of course, non of this matters if you own your funds in a tax deferred account like an IRA.
Merrill Lynch: Suckers For A Bubble
There seems to be quite a bit of surprise among Wall Street today at how much money Merrill Lynch (MER) lost in the great housing bubble:
Merrill Lynch & Co., the world's largest brokerage, lost nearly $10 billion in the last three months of 2007, its biggest quarterly loss since it was founded 94 years ago, after writing down $14.6 billion of investments slammed by the ongoing credit crisis….Merrill Lynch posted a net loss after preferred dividends of $9.91 billion, or $12.01 per share, compared to a profit of $2.3 billion, or $2.41 per share, a year earlier….Wall Street analysts had been forecasting a loss of $4.93 per share…"
This shouldn’t surprise mutual fund investors: Merrill Lynch is a sucker for bubbles.
Sure most investment banks are guilty of letting irrational exuberance get in the way of rational analysis, but Merrill Lynch has earned a special place among big money managers as the firm that thinks rising tides that lift all boats never recede.
One gem is this New York Times editorial by Bruce Steinberg (then chief economist for Merrill Lynch) penned in October 1999, countering the growing belief among skeptics that the stock market had become a dangerous bubble:
But the doomsayers are looking for signs of disaster where none exist. The American economy has performed better in the 1990's than at any time in history, and there is no end of that success in sight….The bubble theory rests on arguments that the stock market is overvalued…Assets are said to have become overvalued, leading to overconsumption and an overheating of the economy that will inevitably end in a violent correction -- a stock market crash. But this argument will not stand up to a careful analysis…
The pessimists' misinterpretations begin with stock prices, which have indeed grown rapidly... However, values are highest in the sector where growth prospects are highest and demand is accelerating: technology. With the technology stocks excluded, the price-earnings ratio for the rest of the companies in the index is around 19. Adjusted for interest rates, that's comfortably in line with the experience of the past few decades."
This was less than five months before the S&P 500 peaked and then promptly fell around 50%. The S&P 500 today is almost exactly at the level it was over eight years ago when this cry for more insanity was penned (Merrill Lynch stock is currently lower than it was then, but that hasn’t stopped hundreds of millions in bonuses from being paid). Steinberg was fired in 2002 at the very bottom of the market.
Mutual fund investors know Merrill’s past bubble follies. Merrill Lynch launched the infamous (at MAXfunds anyway) Merrill Lynch Internet Strategies fund on March 22, 2000, within days of the market peak. The launch arrived just in time to bring in over a billion dollars (with a sales load…) before diving nearly 80% in the first year alone.
Merrill quietly swept this fund under the rug, just in time to miss the second wave of internet investing which has carried Jacob Internet (JAMFX) up 240% over the last five years. Apparently Merrill moved on to home loans. Talk about buy high, sell low.
As a nervous fed chairman noted today in congressional testimony, one out of every five dollars of the $1 trillion in subprime mortgages outstanding are now delinquent – and expectations are for this number to rise.
Investment banks are supposed to be run by the best of the best when it comes to allocating capital – that’s why they get paid the multimillion dollar bonuses right? Who decided owning billions worth of loans made to people with bad credit who stretched to buy a home that doubled in price before they bought was a good way to make 6-8% on your money? Probably people who got some very big bonuses in recent years.
Fidelity Magellan Fund Re-Opens
Fidelity investments announced yesterday morning that it was re-opening its flagship Magellan fund (FMAGX) to new investors for the first time in nearly a decade.
Steven Syre at the Boston Globe thinks its a perfect time for investors to dive in:
The fund that has been closed to new investors for a decade is in the right place at the right time, favoring large growth stocks at a time when the market pendulum has swung into that category after years of preference for value-oriented equities. It moves easily around the world, investing 26 cents of every dollar under management outside the United States, at a time when a global perspective is necessary for superior performance (Finnish cellphone maker Nokia Corp. is Magellan's single largest holding).
There's more: Lange has managed Magellan for just two years, but he has a long record as a superior stock picker. Fidelity has stayed off Lange's back and let him pull together an eclectic portfolio, about 260 stocks of all sizes from all over the world. His big picture view of the global economy emphasizes information technology stocks (nearly 29 percent of the portfolio) and underweights financial investments (11.6 percent)."
Syre's logic is wrong on several counts.
First, while Magellan is about half the size it was in 2000 it is by no means svelt. The fund still has around $50 billion in investor assets.
Second, we've been harping on the comeback of large cap growth for awhile now (and upgraded large cap growth funds to our highest category rating in 2006). We've recommended funds like Vanguard Growth Index (VIGRX) and the ETF version Vanguard Large Cap Growth (VUG). In 2007 these funds were up around 12.5% while iShares Russell 2000 Value Index (IWN) was DOWN 10.3% and Vanguard Small Cap Value Index (VISVX) was DOWN 7.1%. That's a pretty big performance gap, which means you're getting in a little late to the resurgence of large cap growth party.
Lastly, and worst of all, is the statement "at a time when a global perspective is necessary for superior performance". What little solid performance this giant fund has delivered in 2007 has largely been because of a large foreign stock position - a relatively recent increase. This foreign stock allocation is going to drag on returns over the next 1 - 3 years and will be the main reason Magellan will continue to underperform the S&P 500. As long time readers of MAXfunds know, we're contrarian investors. This means we don't think foreign stocks are necessary for superior performance, even though about every domestic fund manager and fund analyst thinks so.
Bottom line, the best thing Magellan has going for it is low fees and a size and diversification that will prevent a major collapse relative to the market. Your chance of matching much less beating the S&P 500 over longer periods of time in this fund remains slim, which is what we've been saying since 2000.
A Reformed Broker Exposes Wall Street
Michael Lewis tells a wonderful story in the new Portfolio magazine – a coming of age piece if you will – of a successful stock broker who slowly realizes the (ahem…) shortcomings of his business.
‘Seven months in at Lehman, I was one of the top rookie producers,’ Blaine says, ‘but every stock I bought went down.’ His ability to be wrong about the direction of an individual stock was uncanny, even to him. At first, he didn’t understand why his customers didn’t fire him, but soon he came to take their inertia for granted. ‘It was amazing, the gullibility of the investor,’ he says. ‘When you got a new customer, all you needed to do was get three trades out of him. Because one of them is going to work. But you have to get the second one done before the first one goes bad.'
It wasn't exactly the career he’d hoped for. Once, he confessed to his boss his misgivings about the performance of his customers' portfolios. His boss told him point-blank, ‘Blaine, you're confused about your job.’ A fellow broker added, ‘Your job is to turn your clients' net worth into your own.’ Blaine wrote that down in his journal."
The story first attacks the notion of beating the market with stock picks then moves on to picking wining mutual funds:
SmartMoney’s cover story ‘Seven Best Mutual Funds for 1996,’ whose selections later underperformed the market by 6.7 percent. In 1997, SmartMoney found seven new best mutual fund managers. They finished 3.4 percent below the market. In 1998, the magazine’s newest best funds came in 2.2 percent below the market. Soon after, Wellington says, ‘SmartMoney stopped its annual survey of the best mutual fund managers.’
Eventually our hero moves his clients and his conscience to Dimensional, proprietors of the successful DFA (which stands for Dimensional Fund Advisors) funds.
DFA, an early pioneer of low fee index funds, has $152 billion under management. Unlike Vanguard, DFA does not have actively managed funds or ETFs. DFA indexes are not just market cap weighted or based on well known indexes like the S&P 500, Nasdaq, or Russell 2000, but involve custom screens that remove some individual holdings that would ordinarily show up in a straight market cap screen.
DFA funds are institutional funds sold though advisors, who tag their own fees on top of the underlying fund fees.
In addition to learning some great sales techniques used to con prospective brokerage clients into paying full service commissions for stock bad stock picks, the article focuses on the benefits of low fee indexing over more expensive and inconsistent active management. What the article doesn’t do is question the logic of dozens of different asset classes – too much of a good thing perhaps.
If a broker’s stock picks tend to underperform broad indexes, why won’t an advisor’s sector or style picks using DFA funds do the same?
In The Red
If you had to sum up the current financial problems of the U.S. economy and stock market in one line, it could be this: consumers are just maxed out. Day after day we are hearing more stories of consumers not able to make payments on their obligations - this week's tales of woe ranged from homes to cell phones to credit cards.
In Thursday's Wall Street Journal "Fiscally Fit" column, Terri Cullen walks us through the steps she went through refinancing her six figure home equity line of credit:
A home-equity line of credit works a lot like a credit card -- we have a set credit limit and can borrow as much or as little as we need. Our current credit line charges a variable rate of interest, much like a credit card, so how much or how little we pay in finance charges depends on the direction of the prime rate. But unlike revolving credit-card debt, which is unsecured, our line of credit is secured by our home equity -- if a financial crisis hits and we can't pay back the loan, we could lose our house.
We chose a home-equity line of credit for convenience. We knew we'd be financing a number of large projects over several years, but weren't sure how much we'd need to borrow in total. The flexibility of the credit line allowed us to borrow only what we needed, when we needed it, which would keep our monthly payments low. We spent $45,000 on a mid-level kitchen remodel; another $10,000 to update our leaky family room; $25,000 to install a deck, patio, and landscape our backyard; and most recently another $3,000 for maintenance costs to replace an aging furnace and central-air conditioning unit."
The lengthy article is informative. Every single thing the author does makes sense. Certainly lower rate debt that is tax deductible is smarter than higher rate non-deductible debt. But when I step back and think about the scope of her thought process, I come to the conclusion that there is something wrong even when everything seems right.
The notion that a home is a perpetual equity producing machine that magically turns $1 in renovations into $2, that home equity is an asset that can be tapped, that using home borrowing for consumption is smart, that things you want are worth financing, and that any low interest credit available should be claimed and not questioned as too much credit may be what is now unraveling in the economy.
We're not being critical of the author's path or sound advice and logic - rather questioning when these kinds of moves became normal and "fiscally fit". Don't hate the player, hate the game.
We're Printer Friendly!
MAXfunds reader Bill asks:
I am wondering if it is intentional or just accidental that your web pages are nearly impossible to print?
I, for one, sometimes work off-line and it's helpful to be able to spread the paper around in order to be able to see and compare different funds. So, unless it's intentional, please provide a decent print capability. Otherwise, I'll get by with screen shots and just stay annoyed. Thanks for considering the idea."
It was intentional, but we just fired our mean-spirited web designer and are now happy to announce that our mutual fund data pages have been optimized for printing.
You won't see a 'print this page' link, but if you now print any of our data pages, backgrounds colors, ads, sidebars and headers will automatically be removed - and all that will print is the important info itself.
Give it a try.
Safety First
As investors get optimistic, riskier assets tend to outperform. As they get more pessimistic, safer assets tend to win. While there were some big ups and downs in the stock market in 2007, the real fear was in the bond market - the place where real estate bubble borrowing goes to find a buyer.
In 2007 investors started to question the likelihood that all these trillions in borrowing would get repaid. What started in real-estate-related debt moved to all consumer debt and even lower grade corporate borrowing. Where did all this newly conservative money flock? Good ole' Uncle Sam debt. That's right - capitalists favorite whipping boy, the government, is the investment of choice when the going gets rough.
Look no further than Vanguard for an indication how the bond market was in 2007. Vanguard Long-Term U.S. Treasury (VUSTX) was up 9.2%, while Vanguard High Yield Corporate (VWEHX) was up a paltry 2%.
But the real winner in 2007 was bond king Bill Gross, who's negative outlook on the economy and general suspicion of the fancy financial footwork in the housing market led his bond funds to a strong return in 2007, after a ho-hum 2006:
The Pimco Total Return fund that Gross runs scored a gain of 8.6% last year, a higher return than 90% of its peer bond funds -- and better than the 6.4% gain of the average stock fund -- after Gross' gamble that the housing crisis would force the Federal Reserve to cut interest rates paid off late in the last third of the year.
For the fourth quarter, Gross' fund returned 3.8%."
We've had a long-time Powerfund Portfolio holding in Bill Gross-managed Harbor Bond Institutional (HABDX), which was up 8.7% in 2007.
2007 - The Year Of The Tax
The Wall Street Journal notes 2007 may turn out to be the year of the biggest taxable fund distributions in history - eclipsing even 2000. In addition to explaining why this year may be the worst ever, the article notes some perennial tips to minimize the tax bite:
- Consider index funds or exchange-traded funds. Broad-based index funds, which track benchmarks like the Standard & Poor's 500-stock index, rarely pass out capital gains because they don't trade much. For the most part, they vary the securities they own only when companies are added to or subtracted from their benchmarks.
- Broad-based ETFs can do index funds one better. They have a special way of creating and eliminating fund shares that makes distributions even rarer.
- Check out after-tax returns. The Securities and Exchange Commission requires funds to publish after-tax returns, which assume investors pay the highest applicable tax rate on dividend and capital gains. You may not actually have to pay the highest tax rate, but the figures are a good tool for comparing funds' track records.
- Put active funds in your retirement account. If you are building a broad portfolio with several types of funds, consider keeping tax-friendly index funds in your taxable investment account and actively managed funds that trade more frequently in a 401(k) or individual retirement account.
- Do some tax-loss selling. Remember how fund managers can use losses to offset capital gains? You can do the same thing. If you have fund shares or other investments that are worth less than you paid, you might "harvest" the losses by selling them."
We'd add our own MAXfunds tax tip that never seems to make the mainstream fund press: stop buying funds after they have posted big gains and focus on some out of favor categories that are sitting on tax losses from other investors' bad timing.
When investors buy the previous year's top performing funds, chances are that fund is going to pay a big taxable gain. Worse, this tax bomb often hits after the performance slips and investors leave, forcing the manager to make some sales to raise cash.
When investors buy a down-and-out-fund, the manager is already sitting on stocks that were bought at higher prices, and probably has realized a good deal of losses. The manager can use these losses to offset future gains. This is why your typical value fund has paid out higher distributions in recent years than many growth funds.
Of course the way this year is starting, investors might not have to worry about taxes at the end 2008 at all.
B Class Funds - Designed To Deceive
The trouble with fund share classes is even the experts don't understand them. God help the rest of us. Gretchen Morgenson at The New York Times wrote an article about fund share classes that tells us fund investors are wise about avoiding sales loads and that the poor B class fund is much maligned, but often the best choice:
While the bulk of mutual fund investors wisely choose no-load funds — 73 percent in 2006, according to the Investment Company Institute — $37 billion went into funds with loads.... One message comes through loud and clear from a trip through the analyzer: There is no such thing as the right share class for all investors. Indeed, one of the most intriguing findings is that Class A shares, the most commonly sold class today and the one usually characterized as the best value for individual investors, are often more expensive than B and C shares.... Class A shares are typically viewed as cheaper because their lower operating expenses are thought to offset their upfront sales loads, which can run to 5.75 percent. In 2006, such shares accounted for 51 percent of all load fund sales, versus 13 percent in 2002. Finra’s fee analyzer shows how wrong this conventional wisdom can be."
The article then proves this point by running a few load funds through an online fund fee calculator available by the newly re-branded Finra, aka NASD, available here. Unfortunately, in this case conventional wisdom was true: B class funds are for clients of questionable brokers and often the worst class to chose. This should come as no surprise because brokers looking to dupe clients is exactly who B class funds were designed for in the first place. The B class load was created to hide the obvious 5.75% front end sales commission that is whisked away from your account when you buy a load fund. People tend to notice when $575 of their $10,000 investment goes poof by their first statement. With the threat of no-load funds growing, the mutual fund industrial complex invented a load fund that looked like a no load fund. Of course, the fund companies where not going to build a cheaper fund class that paid brokers less in commissions, so they hid the 5.75% commission in a high yearly "distribution" charge of 1% on top of the ordinary annual fund costs. But how, pray tell, do fund companies prevent a shareholder from selling in a few years and avoiding the full 5.75% commission? With a contingent deferred sales load, or CDSC. This fee often starts at 5% and falls as the years roll by. At no time are you going to get out and save that much over an A class fund. Then how come some funds are cheaper to own as B class funds than A class funds as the article claims? Simple: the example funds are not typical load funds. Every load fund family has a slightly different way of levying the loads. Whether a B class is better than an A class for a particular fund often breaks down to the spread between the 12b-1 fees. Normally A class load funds have 0.25% 12b-1 fees and B class funds have 1.00% fees. In such a case the A class is almost always the better class when your time horizon is more than a couple of years. When the 12b-1 fee is 0.35% on the A class it is possible for a few years the B class will be the better class - and often not by much. If you review the largest load funds out there, it is clear the typical spread makes the A class the better choice. The prospectus fee table confirms this. American, PIMCO, Legg Mason, Davis, Van Kampen, and Franklin funds typically have the 0.25/1.00 12b-1 split. When you factor in that larger investments - either in a single fund or across the same fund family - can qualify for reductions in A class sales loads, the A class becomes the far superior choice. Crooked brokers use B class funds to avoid giving wealthier clients A class discounts in addition to hiding the loads from sight. We have no hard numbers on this, but from our own discussions and emails with hundreds of fund investors, most have no idea they are in a load fund when they are in a B class fund - which was the original purpose of the invention. Success! If you must go load, most of the time C class funds are best for very short term investments of under three years, and A class shares are better for longer term investments over three years. Occasionally (rarely) a B class is better for around 3-6 years if the CDSC is low (under 5% to start) and/or the 12b-1 is higher than 0.25 on the A class or lower than 1% on the B class. LINK