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401(k) Not Ok?

July 4, 2007

No time to read a half-dozen articles about retirement plans before the fireworks tonight? Well today is your lucky day. MAXfunds co-founder Jonas Ferris tells you all you need to know about your 401(k) in this handy dandy video from the Fox News Channel. If you have old-fashioned dial-up internet access you'll may want to wait until you're back at work to watch.


ETFs Aplenty

July 2, 2007

The Boston Globe reports on the ridiculous number of new exchange traded funds being launched this year:

Exchange traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May.

Investment management companies have responded to that kind of demand by burying investors in new products. A total of 150 new ETFs were created in the first five months of this year, according to research by the industry's two largest competitors. That's almost exactly the number of all the new ETFs created during the entire year in 2006, and three times the number formed in 2005. About half of all ETFs on the market today have arrived in the past 12 months."

This plague of ETFs brings to mind an important point about fund companies: they don't launch investment vehicles because they think those vehicles are particularly likely to perform well. In fact, we'd wager that most of the funds started by fund companies are not expected by their managers to be top performers. That's because fund companies are interested less in their funds posting big returns as they are with getting investors to buy them.

Fund investors usually make investment decisions based on recent past performance. Most of the time the new mutual funds and ETFs that are the most saleable are not the ones that are set to post big gains in the near future but those that are in the hottest categories. So what if study after study shows that funds that are top performers rarely remain so? As long a performance chasing investors are buying, the fund companies will be selling.


Why World’s 3rd Richest Person Is In A Lower Tax Bracket Than You

June 28, 2007

Warren Buffett in the Washington Post confirms what I’ve suspected for quite some time: he is in a lower tax bracket than me.

Warren E. Buffett was his usual folksy self Tuesday night at a fundraiser for Sen. Hillary Rodham Clinton (D-N.Y.) as he slammed a system that allows the very rich to pay taxes at a lower rate than the middle class.

Buffett cited himself, the third-richest person in the world, as an example. Last year, Buffett said, he was taxed at 17.7 percent on his taxable income of more than $46 million. His receptionist was taxed at about 30 percent."

But how could he be? My income was significantly less than Buffet’s last year (and every other year for that matter).

The answer is because while all men may be created equal, all income is not. Relatively recent changes to the tax code have created even more favorable classes of income.

A dollar earned is taxed as income – at the local, state, and federal level. Income tax rates go up with higher level of incomes because we have progressive taxes – meaning you pay a higher rate the more you earn. Worse, social security and other payroll taxes are a huge percentage of your total taxable income if you earn a normal wage, but because they are largely capped these taxes become a very small percentage of your taxes if you earn $9 million.

But that only explains why many people are in such a high tax bracket. Why is Buffett in such a low bracket? A dollar passively earned is rarely taxed as income. Start a company and sell it for a billion dollars, and that billion dollars is long term capital gains, not income. Stock dividends are now taxed at lower rates than a clock watcher’s salary. And of course, social security and other payroll taxes don’t apply to passive income. Income from your checking account (0.50% interest rate…) is still taxed as income. As is CD, savings account, and bond income.

Unfortunately the money in our 401ks and IRAs will be taxed as income someday, not long-term capital gains or dividends. Hopefully our country’s financial situation won’t be so screwy that Congress will have to raise income taxes right when we need our retirement income.

While low taxes on passive investment income is good, most non-billionaires and those not partners in private equity outfits and venture capital firms would probably prefer a lower tax rate on income and a higher tax rate on investments – a simpler tax where income is income and there are no favorable ways to earn it.

Perhaps no tax on the first $25,000 and a 25% tax bracket on all income over $25,000 – no matter how it comes in. That way Buffett wouldn’t be in a lower tax bracket than his Secretary.


Insurance Industry Screws Up Important 401(k) Legislation

June 26, 2007

Participation in company sponsored retirement plans like 401(k)'s increases significantly when workers are automatically enrolled by employers versus having to sign up themselves. The U.S. Government, hoping to encourage savings rates among citizens, wants employers to do just that.

The problem is that companies are worried that if they enroll employees automatically they will get sued by said employees if the market hits the skids. Congress responds by writing the Pension Protection Act of 2006, which protects auto-enrolling employers from 401(k) related lawsuits if those employers offer certain lower-volatility "default" investment options in their 401(k) plans. A list of funds suitable for long term investment was drawn up. And that, says Chuck Jaffe at Marketwatch, is when things get complicated.

...the insurance industry was unhappy with the exclusion of stable-value funds. Stable-value offerings are popular in retirement plans; they are built to provide a set return, guaranteed by the insurer.

While they have a role in some portfolios, stable-value funds are too conservative to be the sole investment option of a worker who is not otherwise saving for retirement. The return may indeed be stable, but it doesn't provide sufficient growth over time. They might be a choice for employers fearing lawsuits about losing money, but the idea of including them as a default choice is anachronistic given the Pension Protection Act's goal of helping more workers to save successfully.

Alas, the insurance industry doesn't seem to care. Seeing its primary retirement-plan issue being cut out of the default-choice pool made the big players green with envy (several firms seem to forget that they have mutual fund arms that operate funds suitable for being the no-pick option).

And so, they started lobbying. They hit the legislators hard, getting them to write the Department of Labor. And the insurers wrote in themselves."

And now the whole thing is stuck in legislative limbo. Sure was a good idea, till greed got in the way.


The Big, Fat, Retire Early Lie

June 25, 2007

Maybe I just watch too much TV, or maybe my eyes open wide whenever I hear questionable financial promises (Ponzi-dar?). Whatever the reason, I can't seem to escape the latest multi-million dollar ad campaign by one of America's largest financial services companies.

The ad starts with a dismal scenario visited upon a baby boomer: relocate or lose your job. Fortunately for the boomer, a brief consultation with a financial expert using sophisticated modeling software showed how early retirement was entirely doable. Goodbye cubicle, I'm going fly fishing, or whatever other boomer financial fantasy (retirement porn) is being used to hustle investment advice.

Not only did the brilliant financial services professional solve this person's dilemma, but, as the advertisement goes on to say, the early retiring boomer's boss called the same professional, wondering if he could retire early too.

The likely problem with the early retirement scenario? It's based on modeling using optimistic investment returns.

In a recent Wall Street Journal article about early retirement, an eerily similar scenario to the one teased in the advertisement is highlighted. Only the real world example uses real world market returns.:

Between 1994 and 2002, brokers from the Charlotte, N.C., branch of Citigroup Global Markets held more than 40 seminars and hundreds of individual meetings with BellSouth workers to show them how they could take early retirement. Central to the brokers' pitch was that the employees could expect to earn 12% a year from their investments and could withdraw about 9% a year from their accounts, according to the NASD complaint.

"You should be able to expect 12%," one broker told a couple, according to the NASD. "That is not guaranteed....We may do 15, may do 18 or 20. But good times, bad times, I think that we would do 12%."

What the workers were not told about was the risk they were taking by cashing out of their pensions, which provided guaranteed payouts, and putting the money in the stock market, where returns would fluctuate. The brokers' materials didn't mention that 12% returns were above the stock market's average returns over the long term -- 10.7% a year over the last 50 years, according to Standard & Poor's.

In addition, NASD said brokers didn't adequately disclose that customers would pay annual fees of 2% to 3% -- and as a result, workers would actually have to earn 14% to 15% on their investments to hit the promises made by the brokers.

When the stock market turned south, the brokers held a series of conference calls to try to hold onto accounts opened by BellSouth early retirees, the NASD said. During these calls, the brokers made various predictions that the markets would soon rebound. One prediction: the Dow Jones Industrial Average would rise to 20000 or 21000 by 2006. (The Dow is now around 13400.) In the end, more than 200 BellSouth employees saw their original investments decline by about $12.2 million, according to the NASD."

These early retirement clients may be fly fishing - but it may be because they can't afford to buy food.

We tend to take the opposite approach as those selling financial services - expect a below historical market return on your investments to make sure you're not broke at 75. If the market in fact delivers double digit returns, great, buy a boat. In the meantime, plan on working and saving more.

Of course, that doesn't make for much of an ad campaign: "I talked to my financial advisor. He said scrap the beach house idea and take a part-time job."


2006 Was A Cheaper Year

June 20, 2007

Here's some good mutual fund news: a new study finds that fund fees in 2006 were the lowest in more than a quarter century.

A study going back to 1980 found that mutual fund fees and expenses haven't been lower than they were last year.

Fees declined again in 2006, continuing a multiyear trend, as ever-larger investor portfolios triggered reduced load fees and as funds continued to tamp down expenses to boost their competitiveness. Many growing portfolios had smaller fees taken out because their size enabled them to receive discounts on large purchases as well as fee waivers. Overall, it seems investors had much to cheer about in 2006.

The Investment Company Institute, the mutual fund trade group, found that investors in stock funds paid fees, including both loads and expense ratios, that averaged about 1.1 percent, a decline of .04 percent from 2005."

Fund fees are going down for two big reasons: 1) More money is being invested in funds. Fund operating costs do not go up proportionally with more assets under management, so rising assets should lower fees. 2) Investors are paying more attention to fund fees, and investing in lower cost funds.

The study is quiet about 12b-1 fees, which have been rising as a percentage of the total rake over the last two decades, as well as commissions to buy mutual funds at brokers, which have been jumping across the board in recent years. But it seems that more and more mutual fund investors are picking funds based on cost - and mutual fund companies, ever looking for ways to attract investor assets, are trying to give investors what they want. Let's give ourselves a round of applause.


Interesting ETF Facts

June 18, 2007

Five of MSN Money's 10 surprising Exchange Traded Fund facts are interesting, the other five, not so much. Here are the good ones:

  • 163 versus 134. The raw number of ETFs launched in the past six months versus the number of ETFs launched in first 10 years (1993 to 2003) of the ETF business' existence.
  • 23 of 93. Of the 93 international ETFs on the market, only 23 are diversified funds that invest across a range of countries, regions and sectors. The rest are country- or region-specific or international-sector funds.
  • 0.67%. The average expense ratio of ETFs launched in the past six months, many of which were leveraged index funds; sector, industry or niche funds (ophthalmology, for instance); or offerings tracking specialized or custom-made benchmarks.
  • 0.45%. The average expense ratio of all the ETFs launched before December 2006.
  • $284 billion versus $196 billion. Barclays' share of the ETF industry versus everybody else's.


New 'Our Favorite Funds' Report

June 14, 2007

Note to MAXadvisor Powerfund Portfolios subscribers: the Second Quarter, 2007 'Our Favorite Funds' report has been posted. MAXadvisor Powerfund Portfolios subscribers can access it by clicking here. Each 'Our Favorite Funds' report reveals what our analysts consider to be the very best no-load mutual funds in each fund category.

The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here.

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?

Motley Fool's 'Best Funds' List Is Really Dumb

June 8, 2007

When you spot an article titled 'The Market's 10 Best Funds', you might be tempted to think that if you'd read it you'd get a list of ten great mutual funds that are set to produce market beating returns in the years ahead. Not so for readers of a recent posting on The Motley Fool. Readers who clicked on that snappy headline were treated not to a list of inexpensive, high-quality funds in undervalued categories, but merely a list of the top performing funds of the last ten years:

As we are sure the decidedly un-foolish readers of MAXfunds.com know, one way to all but guarantee poor returns going forward is to buy funds based on past performance. Of the funds that topped the ten-year performance charts back in 2000 (Invesco Technology II [FTCHX], T. Rowe Price Science & Tech [PRSCX], Spectra [SPECX], RS Emerging Growth [RSEGX], Janus Twenty [JAVLX], Managers Captl Appreciation [MGCAX], Dreyfus Founders Discovery F [FDISX], Janus Venture [JAVTX], American Cent Ultra Inv [TWCUX], Fidelity Growth Company [FDGRX]) none have since performed better than the S&P 500.

The Motley Fool's list of 'Best Funds' is actually more likely to under-perform the market going forward than funds chosen at random. That's not just foolish, it's stupid.