Portfolio Strategy

Go Big Or Go Index?

October 23, 2007

The largest funds (in terms of investor assets) are often the ones with the best track records – they don’t get big by accident. These monster funds deliver huge profits to the companies that run them, so they can afford to hire the best managers. Giant funds also tend to have lower fees because they have so many shareholders to cover fund operating costs. Sounds like a recipe for continued success.

So what is the better investment – a big successful actively managed fund or an index fund?

Morningstar takes a look back at how the ten biggest funds of 1997 in the large cap blend category did in the ensuing ten years.

Of the 10 biggest large-blend funds back in 1997, six have outperformed the majority of their rivals since October 1997. We recommended five of those funds for purchase at that time….The other four funds in that group of 10 have underperformed their typical large-blend rival since 1997. True, we did recommend all four funds at the time…"

The takeaway from this article appears to be that big funds do well (and that Morningstar seems likes recommending big funds…). But a 60% success rate is not particularly impressive.

Throwing darts at large blend funds in 1997 and falling asleep at the wheel for ten years should lead to a 50% success rate – odds are half of the dartboard funds would be in the top half of the performance curve... ...read the rest of this article»

Bring in the Love, Push out the Jive

August 22, 2007

Lately the market has had more ups and downs than Lindsey Lohan's personal life. CNNMoney.com looks at five no-load mutual funds that have succeeded in capturing market gains while limiting losses during downturns.

1. Fairholme Fund (FAIRX)

2. Third Avenue Value Fund (TAVFX)

3. Jensen Fund (JENSX)

4. Neuberger Berman Fasciano Fund (NBFSX)

5. Royce Special Equity Fund (RYSEX)

Of the five, two (Fairholme and Neuberger Berman Fasciano) are currently included in the MAXadvisor Our Favorite Funds list – our hand-picked list of the best funds in each fund category. Jensen is no longer a fund favorite, but was in the past. We recently sold or stake in Fairholme in our MAXadvisor Powerfund Portfolios because the fund has become too popular with investors (thanks to lists like the above…).

We don’t think value in general and small cap value in particular are going to save a portfolio from the next major market downdraft. What worked in 2000-2002 won’t necessarily work today.


In Praise of Index Funds

June 12, 2007

Walter Updegrave at CNNMoney wades into the old index-versus-actively-managed-fund debate, and comes down squarely on the side of the indexers. Here's why:

  • Many (index funds) charge 0.2 percent a year or so, and some have expenses that are even lower, sometimes as low as 0.07 percent. That's a pittance compared with the 1 percent to 1.5 percent or more than most actively managed funds collect from investors.
  • Index funds slavishly follow an index or benchmark, so you always know what you're getting. You don't have to worry about your large-company fund manager poaching in small caps to juice his returns, or a value manager picking up a few growth stocks to boost performance when value stocks are on the outs.
  • Index funds tend to be tax-efficient, which is a fancy way of saying they generally give up less of their gains to taxes.

We think most index funds are fabulous for the very same reasons that Updegrave does, and for disengaged or inexperienced investors a well-diversified all-index portfolio is what we recommend. But when we're building portfolios for our private management clients and for the MAXadvisor Powerfund Portfolios, we use a mix of index and high-quality low-cost actively managed funds. Why? Because carefully chosen actively managed funds in out of favor areas can beat the indexes, and make up for their higher costs.

Index funds, for example, can seriously underperform actively managed funds when the largest stocks by market cap are not leading the market. Since the stock market peak in 2000, most actively managed funds have beaten the market cap weighted S&P 500. For more on this issue, read this seven-year-old article by MAXfunds co-founder Jonas Ferris which predicts that actively managed funds should start beating the indexes (which they did).


See also: Ask MAX: What's better: an index fund or an actively managed fund?

Bob Barker is Your Financial Advisor

June 5, 2007

Chuck Jaffe at Marketwatch compares fund investing to games features on the 'Price is Right'. While the analogy is a touch strained, the concepts are sound:

1. The Bargain Game: Investors looking to buy a fund ultimately should boil their picks down to a select few, and then go bargain hunting. In this case, that means examining a side-by-side description of the funds to see how they intend to accomplish their investment objective. If two funds take the same strategy, the better bargain is clearly the fund with the lowest expense ratio; if they take different strategies in the same asset class, picking the better bargain will mean balancing any additional costs against an expectation of higher returns. If a fund can't convince you that it can deliver more for your money, it's no bargain compared to a lower-cost competitor.

2. Triple Play: The idea is to hit the big prize -- a fund you can count on, that can deliver to your expectations -- in several different asset classes. The first fund tends to be easy -- because it's a broad, safe choice with the fewest chances to go wrong -- but expanding your holdings into sectors, international stocks and more makes subsequent choices more difficult. To win, an investor must own several high-quality funds that move independently, so that a market nose-dive doesn't do permanent damage and scare the investor to dump the whole thing.

3. That's Too Much: In mutual funds, this is a contest investors should play when looking at a fund's expense ratio, and they can win if they remember one simple playing hint. For a stock fund, the ''too much'' number is 1.25 percent; for a bond fund, it's 0.75 percent.

Those numbers keep a fund slightly below average for their broad category; upon seeing costs above those levels, say ''That's Too Much!'' and consider whether it's worth the excess costs. Moreover, solid funds with numbers well below those averages are showing you a key reason for their success.

4. Take Two: In fund investing, the dollar target is the amount needed to be ''set for life,'' to achieve the ultimate goal of lifetime financial security. The key is picking mutual funds -- a few from the thousands of available choices -- that the investor believes can turn current and future savings into that jackpot.

To play successfully, investors should determine their target number, the amount needed to actually reach their goals; this makes the rest of the savings and investment process easier, as it makes it possible to determine the returns needed from funds in order to reach the goal. If your funds can't deliver those necessary returns, investment and/or savings habits most likely need to be changed or the game may be lost."


Smaller Fund Outperformance – It’s Not Just Mutual Funds

May 30, 2007

The bigger a mutual fund gets, the harder it is to outperform. This relationship is why we created our “Fat Fund Index” back in 1999. As it turns out, managing too much money hurts other types of investment portfolios as well.

According to a segment on CNBC this morning, Thomson Financial did a study showing that private equity returns over the last 15 years have run an average of 15.9% a year for smaller funds (less than $1 billion under management) compared to just 11.6% a year for larger funds (over $1 billion). For private equity funds that specialize in startups – venture capital funds – the outperformance is even greater: 23.1% vs. 15.5%. Private equity funds are funds with fewer restrictions on their investments and catering to institutional and high net worth investors – those that the SEC thinks can look out for themselves.

Mutual funds invest almost exclusively in the stocks of publicly traded companies, which tend to move as a group. Private equity funds often take stakes in private business – ones that do not sell shares to the public. The private equity funds that invest in startups see the biggest performance boost from being small because they can invest in smaller startups that have the biggest upside potential. Apparently giant funds have had to pass on too many good small deals.

For mutual funds the benefit of being small also increases as fund managers look to smaller companies to buy. Having $2 billion under management may not hurt a fund that invests in U.S. large cap stocks, but it can be a big drag for small cap or emerging market oriented funds.

Our Fat Fund Index (available on most fund data pages here on MAXfunds.com) adjust for this moving target issue. Check a few of your favorite ticker symbols in our fund-o-matic and see for yourself.

Magic Dividends Impress the Experts, MAXfunds Not So Much

April 8, 2007

We live in a world of single-digit yields. No mutual fund is earning a legitimate 10%+ yield today, but that doesn’t stop some fund companies from pretending that they do.

In such a underwhelming investment environment, you can imagine investors’ surprise last week when Forbes.com launched a video entitled “BlackRock's Dividend Machine,” in which BlackRock Enhanced Equity Yield & Premium Fund (ECV), a closed-end fund, reported a double-digit yield. The video is a follow-up to a previous article entitled “Eye-Opening Yield In A Closed-End Fund." Not surprisingly, the fund shot up 1.7% after the video was posted.

The fund is now trading at an approximate 11% premium over net asset value (NAV). In other words, investors are willing to pay $1.11 for $1.00 worth of the fund. And why not? As the article notes, "the fund’s current payout is $2.05 per share, for a yield of 10.06%."

So how is such an eye-opening yield generated? Certainly not from stock dividends. The S&P 500 is currently yielding less than 2%. The fund’s top five holdings, Microsoft (MSFT), ExxonMobil (XOM), General Electric (GE), Qualcomm (QCOM), and Intel (INTC), are the stuff of 2% dreams, not 10%. Besides, the fund’s 1.11% expense ratio would eat up at least half of the dividends collected from the fund's stock holdings.

In fact, the extra yield is actually the result of option writing. Selling, or "writing" call options is a way to earn income by selling off the upside of a stock. The safest way to use options is to sell calls on stock already owned - that way, if it goes up 100%, the option seller can just hand over the appreciated stock.

In contrast, ECV writes naked (uncovered) S&P 500 and S&P 100 Index options that the fund can then settle in cash instead of delivering the underlying stock. The fund owns a similar basket of stocks with a high correlation to these indexes, so their risk is minimal. In most scenarios, this fund would be safer than a regular index fund (about a 10-15% lower risk in a big market drop).

There is a cost for this income and reduced downside, however. The fund will probably never have the upside of a stock fund. In general, option writing strategies allow investors to earn non-bond income. They're particularly effective when stocks go sideways for long periods of time but still demonstrate enough volatility to keep option premiums rich.

Unfortunately, the story is out on option writing. There are now dozens of closed-end funds grinding out yields by selling options. That makes it hard to get a juicy yield going. In fact, in a moderately strong market, investors are likely to see option “premiums” turn into option losses that will have to be settled when those options expire.

In an up market like last year's, investors could expect to earn about 10%, which is quite a bit less than the 15%+ that the S&P 500 delivered. So is that what the fund paid out last year? The 10% return from writing options and collecting dividends? Nope.

Imagine that you bought Microsoft stock at $20 per share and simultaneously sold a call option on the S&P 500 for $2 in proceeds on each unit. If Microsoft rose to $24 and the S&P 500 gained, your $2 index option premium would then turn into a $4 liability, and you'd have to settle up with the option buyer in cash, representing a $2 loss. However, you’d still be up $4 on MSFT, so you would’ve really made $2, or 10% (not the 20% that you would have earned had you bought MSFT outright). If you didn’t sell all of your Microsoft shares to pay the option buyer, you wouldn’t have much of a realized gain.

By law, mutual funds have to pay out all of their realized taxable gains and income - that's why they're not taxed like other companies (shareholders are taxed on distributions instead). But there's no law that says the fund can’t pay out MORE than their taxable gains and income. Doing so is really just handing investors their money back – a non-taxable event. This creates the illusion of a regular, artificially large dividend.

Apparently this magical high-yield fund executed a lot of trades like our Microsoft example, because most of ECV’s 2006 distributions just paid shareholders their money back. Of the bold $2.05 per share paid out last year, a whopping $1.21, or 60%, was a “non-taxable return of capital.”

Is this just nitpicky tax stuff? The fund’s NAV was up 11% in 2006 - they just paid it all out as income, right? Wrong. Lots of funds were up 11% (or more) in 2006. Many paid dividends of a few percent. Unless the funds realized gains of over 10%, they didn’t pay out cash to match their returns. Bottom line - this fund does not yield 10%. It actually lost money on the option writing and just made more on the stock positions.

A similar open-end fund that we’ve recommended in the past (and that we own, both personally and in our model portfolios) is Gateway (GATEX). This lower-risk fund was up 10.15% in 2006. Unlike the more expensive ECV, Gateway didn’t pay distributions in 2006 of 10%. Instead, the dividend was about 1%. Of course, investors could have sold some of their GATEX shares if they'd wanted 10% in “income."

Those who want the income opportunities that come from option writing are better off with GATEX, which, like all open-end funds, trades at NAV, not at a premium to NAV like BlackRock Enhanced Equity Yield & Premium Fund. Someday, ECV will fall back to a 10% discount to NAV when the spotlight is off of option writing. Investors could conceivably lose as much buying ECV at a 10% premium and selling at a 10% discount as they could in any other S&P 500 Index fund.

For the record, in our 2006 HotSheet (free to subscribers of the MAXadvisor Powerfund Portfolios) we recommended NFJ Dividend Interest & Premium Strategy (NFJ), a similar option writing closed-end fund that was better, had lower fees, and had been trading at a deep discount to NAV. NFJ is no longer as much of a bargain, but it's still a much better deal than the BlackRock fund in fees, performance, and premium to NAV.

Funds That Invest Like Buffett

March 29, 2007

Tim Paradis at the Aspen Daily News takes a brief look at mutual funds that try to invest like Warren Buffett, one of the worlds best-known and successful value investors. Some of these funds actually mimic the stock portfolio of Buffett, while others have merely adopted his buy-and-hold philosophy.

The funds, which characteristically invest in a smaller number of stocks than other mutual funds and often hold those investments far longer, can be a good match for investors looking years down the road who won't dwell on every bump."

Funds mentioned in the article:


22 Funds Morningstar Thinks You Should Sell

March 26, 2007

Morningstar's Fund Spy lists 22 funds their analysts think have "strong competitive disadvantages". The list includes SunAmerica Focused Large Cap Growth (SSFAX) because of poor long-term performance versus similar funds, Payson Value Fund (PVFDX) and BlackRock Basic Value II (MAVAX) because of relatively high expense ratios, and ten Principal Protection funds from ING because of concerns about the principle protection strategy in general and these funds in particular.


You'll also note serious problems with all these fund's MAXratings on our MAXdata pages. Click the links above to view our takes on them.

Make More Cash On Your Cash

March 22, 2007

Sometimes even the safest mutual fund is too risky. There really is no stock or bond fund that is immune from at least some degree of volatility, and the last thing you want before putting the down payment on your new house into escrow is for you to all of a sudden have 5% less money than you though you did. That's where high yield savings accounts really come in handy. They are great places to stash cash that you don't need right away, and the best ones offer rates that can be many times higher than what you'll get in your bank's savings account. Get Rich Slowly runs down some popular options:

I did some research. I googled for “high yield savings account” and “ING direct” and “HSBC Direct“. I followed promising links (and ads) from the search results. As of March 19th, here are the offers that I was able to find with minimal digging. All of these accounts are FDIC insured.

  • Countrywide Bank offers a variable rate, from 4.00% to 5.40% APY, can link to other bank accounts. $1,000 minimum to open.
  • AmTrust Direct offers 5.36% APY, “no monthly service fee or minimum balance fees”, can link to other bank accounts. $1000 minimum. This is a money market account.
  • WT Direct offers 5.26% APY, no fees, can link to other bank accounts. No minimum to open, but your interest rate drops if you don’t have a $10,000 balance after 60 days.
  • E-Loan offers 5.25% APY, no fees, “industry’s strictest privacy policy”. $5,000 minimum.
  • Presidential Online Bank offers 5.25% APY, no fees, ATM access, web interface. $5,000 minimum to open.
  • Emigrant Direct offers 5.05% APY, no fees, can link to other bank accounts, web interface. No minimum.
  • E*Trade offers 5.05% APY, no fees, an automatic savings plan, can link to other bank accounts. $1 minimum to open.
  • HSBC Direct offers 5.05% APY (with a temporary 6.00% APY promotion), no fees, can link to other bank accounts, web interface. $1 minimum to open. The HSBC web site is a busy mess.
  • Capitol One offers 5.00% APY, no fees, free checks and ATM card, an automatic savings plan, can link to other bank accounts. $1 minimum to open. This is a money market account.
  • Citibank Direct offers 4.65% APY, no fees, $25 sign-up bonus. No minimum.
  • ING Direct offers 4.50% APY, no fees, an automatic savings plan, web interface. No minimum.


See also:

Ask MAX: A Good Place for Some Short-Time Money?
Ask MAX: Should I Settle for 3%?

Active Versus Passive Investing

March 20, 2007

An interesting take on the active versus passive debate from Chuck Jaffe. It's not so much whether you invest in an index or an actively managed fund that matters. They best kind of fund for you is the one that will make it less likely for you to get stuck in the devastating buy high, sell low cycle:

McGuigan was concerned when he read a Morningstar Inc. report this year, showing that the average investor in index funds actually captured just 79 percent of the return that they should have gained (so if the index was up 10 percent, the typical investor gained 7.9 percent).

Indexing is designed to be a buy-and-hold strategy. Yet numerous studies show that investors in all funds tend to earn less than the fund does, because they buy in after a fund has shown big gains and sell out when a fund hits rock bottom. McGuigan was surprised to see that indexers lagged their benchmarks by so much. He figured that a rapid indexer would know better than to jump around.

His conclusion is a simple equation, one that explains the real reason why many investors are better suited to actively managed funds regardless of the cost/turnover benefits of indexing:

Real investor returns = actual investment returns +/- investor behavior.

'The second part of the equation is so important, because investors constantly hurt themselves,' says McGuigan. 'So the important thing is that investors believe in what they are doing. If they believe in passive investing, they need to believe it enough to stick with it; if they believe they can pick better managers, they need to give those managers a chance.'

So the issue is not so much active versus passive - or a mix of the two - as it is: 'Which can you stick with when the going gets rough?'

No matter which type of fund you buy, declines are inevitable. But if you can pick a good performer, active or passive, and stick with it to get the same results that the fund actually delivers on paper, that's when you'll have a portfolio that has a real chance of helping you reach your financial goals.


MAXadvisor Private Management, the fund-based financial advisory company we founded in 2002, buys both index and low-cost actively managed funds for our client portfolios - and we never, ever buy whatever fund happens to be at the top of the performance heap for the very reasons that McGuigan describes.

See also:

Ask MAX: What's better: an index fund or an actively managed fund?

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