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Brokers to be Held Accountable for Bad Advice

April 11, 2007

A new ruling by the U.S. Court of Appeals in D.C. means that brokers will now be subject to the same regulatory standards as investment advisors. Previously brokers could sell you whatever crappy investment that made them the biggest commission and only pretend to have your best interests at heart, and then not get sued when those investments lost you a bundle:

The U.S. Court of Appeals for the District of Columbia ruled March 30 that the Securities and Exchange Commission doesn't have the authority to allow some brokers to sidestep regulation as investment advisers. The court's ruling makes all brokers fiduciaries, and increases their responsibility and liability to clients.

Investment advisers adhere to a different set of standards than the transaction-oriented broker, or registered representatives, as they are known in the financial-services industry. Investment advisers are mandated to provide advice that is in the best interest of a client. They can't recommend an investment product strictly for the purposes of a sale.

Rather, investment advisers have to take into account an investor's entire financial planning scenario and give appropriate advice. Registered representative brokers, however, could until now sell investment products that were in their best interest (say a higher-paying commission product) instead of in their client's best interest.

This is probably why more wealthy people have chosen investment advisers to manage their money. Can you trust that a broker employed by a large Wall Street brokerage firm is selling you the right type of investment product for your portfolio or is merely trying to make a buck?"

No, you can't. That's why the founders of MAXfunds.com manage money as commission-free investment advisors, not as brokers.


Six Mutual Fund Tax Tips

April 10, 2007

Morningstar lists six ways you can make your mutual fund portfolio more tax efficient by minimizing your taxable fund distributions. Tax-efficient funds are those that make very few or relatively small taxable payments to shareholders; some funds try to keep trading activity low (minimizing realized gains which have to be distributed), some watch the way they buy and sell securities in an effort to minimize the tax burden to their shareholders.

  1. Invest in Tax-Managed Funds - The managers of tax managed funds take special care to keep taxable distributions to a minimum. They generally don't do much trading, and attempt to "sell losing stocks to offset winners elsewhere in the portfolio." Tax managed funds mentioned in the article: Vanguard Tax-Managed Growth & Income (VTGIX), Vanguard Tax-Managed Balanced (VTMFX), and Eaton Vance Tax-Mgd Value A (EATVX).
  2. Look for Closet Tax-Managed Funds - Many funds, such as Oakmark Fund (OAKMX) and Third Avenue Value Fund (TAVFX) don't officially call themselves tax efficient, but have managers that try to keep taxes low.
  3. Don't Forget about Index Funds - Index funds track indexes such as the S&P 500, and the people that decide which stocks are included in such indexes don't add or remove stocks from them very often. Because these funds tend to have low turnover, they are generally very tax efficient.
  4. Think about ETFs - Most ETFs track indexes, just like index funds do, and hence have low turnover. Low turnover usually equals high tax efficiency. In addition, ETFs unique structure minimizes taxable gains that have to be distributed to shareholders.
  5. Make Other Investors' Losses Your Gain - Mutual funds that have had particularly bad performance periods (think tech funds in 2002), can 'carry forward' those losses and offset gains for years to come. This is one we particularly like because it also means you are probably making a contrarian investment – investing where others have just lost money.
  6. Houseclean Your Own Portfolio - If you're planning on dumping a fund that has posted a loss, selling before December 31st will allow you to use the loss as a tax deduction on that year's taxes.


Of course, the most tax-efficient funds are the ones that stink when you own them, because they never distribute profits (there are none!) and often generate nice tax losses when you sell them.

See also:

Ask MAX: Capital Gains Quickies

How Mutual Funds Work - Capital Gains

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.

S&P 500 Index Secrets Revealed

April 6, 2007

Despite challenges from new-fangled upstarts, the good old Standard & Poor's 500 Index still reigns as the king of the stock indexes. It's the basis for such mutual fund giants as Vanguard 500 Index Fund (VFINX) and Fidelity's Spartan 500 Index Fund (FSMKX). In all more than $4 trillion in investor dollars is tracking it (some of which is probably yours). Marketwatch reveals some fascinating facts about the S&P 500 index that you might not know:

  • Some people see indexing as a static, sanitized investment strategy. To be sure, the S&P 500 represents about 75% of U.S. stocks by market value, but it's hardly monolithic. Just 86 of the original 500 companies are in the index today. The others were acquired, failed or dropped from the ranks.
  • The S&P 500's strength -- ranking stocks by market value -- can be a weakness. In runaway bull markets especially, the index can become a poster child for speculative excesses. When investors ignore valuation and bid shares of the biggest companies to stratospheric heights, the index can become dangerously unbalanced.
  • Today, about 18.5% of the S&P 500 is tied to technology and telecom stocks. That's second to financials, at 22% of the index's total value. Add the health-care sector, at 12%, and more than half of the index is represented.
  • In the bear market that persisted through most of 2002, index-fund investors found no shelter as the S&P 500 lost half its value.
  • To most investors, the S&P 500 is the stock market's apple pie, a uniquely American product. In fact, though the benchmark companies are U.S.-based, their customers are increasingly global. The S&P 500 has so much total international-sales exposure, your stock portfolio might not even need a separate international component for diversification.


Individual Investor Revolution Goes Too Far?

April 5, 2007

Mutual funds are loading up on derivatives and WSJ reporter Elenor Laise is scared swapless:

Derivatives can be used to boost returns, increase yield, get access to more-exotic asset classes like commodities or simply reduce risk. Indeed, many types of derivative-heavy funds thrived in recent years amid relatively placid markets. But in recent weeks, as markets have gyrated more wildly, the vulnerability of some of these funds has become more apparent.”

Nowadays fund investors have easy access to all sorts of esoteric investments. Alternative investments have become about as alternative as…well alternative music (read: not very alternative at all).

Of course derivatives are like bullets. Derivatives don’t kill portfolios, fund managers kill portfolios.

On the one hand, a relatively cheap ETF that tracks a single commodity is probably a “better” way to speculate on say, silver, then ordinary silver futures. On the other hand, by making commodity speculation easier, the fund industry attracts people who normally would stay far away. Before, when some commodity was up 100% in a year, hardly anybody knew it. Now anybody armed with a mutual fund screener will happen across all these exciting alternative investments. CNBC has almost morphed into a commodity price reporting service.

Fund managers are just trying to deliver exactly what investors want: more than traditional investments today can deliver. Investors are not happy with the low yields available today in both stocks and bonds. It’s almost impossible for a fund company to hide their 1%-1.5% fees and sales loads when the underlying investments – be it REITs, utility stocks, or whatever, yield a paltry 4%.


SEC Looks to Expose Hidden Fund Costs

April 4, 2007

You'd think when a mutual fund publishes its total expense ratio, you could be confident that number represented all the costs you'll pay to invest in the fund. Well, it doesn't. There are all sorts of hidden trading costs associated with mutual funds that don't show up in the total expense ratio, but do weight on the fund's returns. Two funds could have the exact same expense ratio, but one that trades frequently could be more expensive to own than one that trades very little because every time a fund buy or sells a stock they pay a commission, just like you do in your E*TRADE account.

LAtimes.com reports that the Securities and Exchange Commission hopes to require funds to more accurately account for true cost of fund ownership:

In an interview, Cox said companies that manage funds and retirement plans should be required to report 'one simple number that captures fees and expenses.' As traditional pensions disappear, more workers are relying on 401(k)s and individual retirement accounts. But excessive fees can jeopardize the financial security of retirees.

These costs are often hidden now — either buried in the fine print of a fund prospectus, or simply deducted from accounts without ever showing up as a line-item expense.

'It's our top regulatory priority,' said Cox, who wants to make it easier to compare funds. 'There are always technical concerns raised by someone, but the truth is that apples-to-apples comparisons are quite useful for consumers. The same should be possible for our retirement savings.'


Sounds like a good idea, but it won't be easy. The problem is that some trading costs are easy to hide, and others hard to measure. If a fund thinks investors are paying attention it is not difficult for them to obfuscate the amount they pay to brokers to buy and sell stocks. A fund could, for example, make a wink-wink nudge-nudge deal with a broker to pay very little in commissions per trade in exchange for paying a slightly higher price per share of a stock.

While the SEC will be grappling with this difficult issue for quite a while, MAXfunds is ahead of the curve. If you're looking for one simple number that captures fees and expenses (including an estimate of trading costs), we've got some good news for you. Our MAXrating: Expenses, found on each funds data page here on MAXfunds.com, does just that.

Three New Fundamental Index Funds from Schwab

April 3, 2007

A traditional stock index, like the S&P 500, is market value (or capitalization) weighted, meaning the bigger the market cap of a stock in an index the bigger the chunk of the index that is occupied by that stock. When you put money into the Vanguard 500 Index (VFINX), which benchmarks the S&P 500, more of your money goes into big cap names like Microsoft (MSFT) and ExxonMobil (XOM) then say, Tyson Foods (TSN).

Until recently, the only notable non-market cap weighted index was the Dow Jones Industrial Average, commonly known as the Dow. The Dow is price weighted – stocks with higher prices like IBM (IBM) are “more important” than lower price stocks like Microsoft (MSFT), even though Microsoft is a bigger company by market capitalization.

The so-called fundamental index does things a little differently. It weighs the stocks in its index not by sheer market value, but by factors such as book value, dividends, profits, and other data.

The creators of a controversial new fundamental indexing strategy say the fundamental method is a more accurate way to index than traditional market cap weighted indexes.

Because of market inefficiencies some companies have market caps that are either higher or lower than they should be, and these inaccurate valuations create a drag on the performance of the market-weighted index. The fundamentalists say that an index weighted toward a real measure of a company’s value will produce greater returns over the long-haul.

"The Fundamental Index reflects a more rational view of a company's success by looking at factors that are reliable signs of a company's strength, such as sales and profits, rather than a narrow view focused simply on how much the market thinks a company is worth," says Bob Arnott, who developed the fundamental indexing concept. "Historical analysis shows that the traditional cap-weighting approach tends to overweight overvalued stocks and underweight undervalued stocks. While conventional indexes mirror the composition of the broad stock market, and so are drawn in by the fads, bubbles and crashes of the market, the Fundamental Index mirrors the composition of the broad economy."

Schwab apparently agrees, announcing the launch of three fundamental index mutual funds. The Schwab Fundamental US Large Company Index (SFLVX), the Schwab Fundamental US Small-Mid Company Index (SFSVX), and the Schwab Fundamental International Large Company Index (SFNVX) are based on the fundamentally weighted FTSE RAFI Index. (They are not the first. WisdomTree is an entire fund company with dozens of new ETFs that was recently created to offer fundamentally weighted indexes to the investing public.)

Charles Schwab calls fundamental indexing the "the most important innovation in passive investing since indexing was popularized in the 1970s", but others aren't so enthusiastic. John Bogle hates the idea, and others call fundamental indexing merely an "investment strategy masquerading as an index.

What's our take?

There are big problems with these newfangled solutions to the market cap weighting issue. The trouble with bubbles and mis-valuations (and resulting poor performance) from market cap weighted indexes won’t magically go away if everybody starts buying stocks based on "real" measures of success, like dividends or earnings - you can have bubbles in fundamentals as well. Bidding up a slow-growth, high-dividend paying stock until the dividend is just a small percentage payout doesn’t make any more sense than paying a triple-digit PE for Cisco (CSCO).

The market tends to favor growth or value for years on end, until that type of company gets overvalued and the other type is positioned to do better going forward. All of these backward looking, anti-growth and mega-cap stock looking investment products will likely underperform the S&P 500 over the next 5-10 years.

Petite Prospectus?

April 2, 2007

Chuck Jaffe reports on the mutual fund industry's efforts to reduce the size of the distributed fund prospectus:

If you buy a computer, the "quick-start guide" helps you get the equipment up and running without forcing you to learn many of the fine points that may or may not be useful information some day.

The powers behind the mutual fund business want you to get the same kind of jump start when it comes to their products.

Paul Schott Stevens, president of the Investment Company Institute, the trade association for fund companies, called for big changes in fund disclosure this week, specifically suggesting that investors would be better served by ditching the traditional prospectus in favor of a jump-start user's manual, along with instructions on how to access the true prospectus on the Internet.

It's hardly a new idea, but there's one significant difference this time, namely that the Securities and Exchange Commission is receptive to the idea, and the fund industry powers are more anxious than ever to ease their paperwork burden."


We are, generally, in favor of the idea, assuming these slimmer documents contain the information investors need to make buy decisions. The data in a prospectus that is important to the vast majority of investors could fit on about a page and a half, and a standardized sheet that contains just these key points will make identifying quality funds easier. Could save a tree or two to boot.

MAXadvisor Powerfund Portfolios Update

April 1, 2007

Note to subscribers of the MAXadvisor Powerfund Portfolios: April's feature article has been posted. Subscribers can log in by clicking here.

This month we look at how far the current sub-prime loan fallout will spread into the economy. Our opinion? Pretty darn far.

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.

Start Small

March 30, 2007

You want to start building a mutual fund portfolio, but you don't have the $3,000 or so you need to meet most funds' minimum initial investment requirements. John Waggoner in USA today finds two no-load funds with minimum investments of just $500, one of which, Homestead Value, is a MAXadvisor Favorite:

Excelsior Mid-Cap Value and Restructuring (UMVEX) ($500 min/$250 IRA)

Homestead Value (HOVLX) ($500 min/$250 IRA)

He also reminds us that T.Rowe Price offers entrée to many of their funds for as little as $50 if investors agree to participate in an automatic investment plan, wherein a certain amount is deducted each month from contributor's bank account and invested in the fund.

Buffalo, Artisan, and Weitz (among others) also accept reduced initial investments from automatic investment plan participants.


Note: We're frankly not sure why Waggoner included Hennessy Cornerstone Growth (HFCGX) ($2500 min/$1000 IRA) and USAA Capital Growth (USCGX) ($3000 min/$1000 IRA) in an article about low minimum funds as these fund's minimums are certainly no lower than average. If you can figure it out, let us know by posting a comment.

See also:

Where to Start
Ask MAX: Can I build a fund portfolio with just $17,000?
Ask MAX: Investing $20 a month?
Ask MAX: Where do I start?