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Small Stake, Big Break

February 12, 2007

Steve Butler at the Contra Costa Times describes the value of adding a small stake in a high-risk emerging market fund to his conservative portfolio.

Beginning with a quick lesson in calculating a "weighted average return," I will assume that I have a $100 portfolio and that $5 will be invested in an aggressive fund or combination of funds.

If the $5 doubles in value in a two-year period, I will have $5 of earnings.

If the remaining $95 invested conservatively averages 10 percent per year for two years, that portion will earn $9.50 per year for a total of $19. On the entire portfolio, I have earned $24 in two years.

This works out to be $12 per year, or a 12 percent average annual return. (I have ignored compounding because the time is so short.)

Some would argue that investing only 5 percent of a portfolio aggressively is not enough to "move the needle," but this simple example shows that it can be worth it when the high-risk investment is successful.

On the flip side, what happens if the high risk investment on 5 percent of our money drops by 50 percent in two years?

On $5, we just lost $2.50, or $1.25 per year. On the remaining $95 we still made $19, or $9.50 per year. Our total annual earnings on the entire $100 works out to be $8.25 -- or 8.25 percent. We haven't lost everything. We just had two years where our return was about 2 percent less than it otherwise would have been. Overseas funds of all types are being swamped with new money.”

He ended up investing in T. Rowe Price Emerging Markets Stock (PRMSX), to which our newly overhauled Fund-O-Matic gives a MAXrating of 80. The fund with the highest MAXrating in the category is currently the DFA Emerging Markets Value (DFEVX), but with a $1 million minimum that choice might be a little rich for most people's blood. Our top MAXadvisor Favorite Fund in the category is SSgA Emerging Markets I (SSEMX)


Invest in Mutual Funds Like a Hedge Funder

February 11, 2007

No, not the part where you hand over millions of dollars to (largely unregulated) hedge fund managers who can do pretty much whatever they want with your money. And not the part where you pay them both management AND performance fees. The part where you aren’t allowed to sell for two or three years.

Following complex strategies requires some stability in assets, so hedge funds -- which have a limited number of investors -- don't allow willy-nilly trading. Instead, most operate with a "lock-up," a time period when the investor agrees to stay put. Most often, the lock-up period is 12 months, although some funds are now going out for two and three years. When the lock opens, a hedge fund investor either agrees to another year, or pulls out.

It's the lock-up that ordinary fund investors should lock down and make part of their investment criteria. The lock-up requires the investor to answer one basic question: "Do I like this fund enough to be locked into it for another year or two?"

More than 5 percent of all hedge funds have been liquidated each year for several years, with the attrition owing to investors deciding that they don't want to lock their cash up with the same fund again. A hedge fund manager who sees a bunch of shareholders making a no-confidence vote when it's time to re-up for another year may simply pull the plug before most of the cash heads for the exits.

Mutual funds not only have no lock-up, they practically encourage inertia and mediocrity. With no pressure to make a hold or sell decision -- and with management free from worry that investors will rush the exits -- shareholders often settle for mediocrity.”


Fund Supermarket Gets a Little Less Super

February 10, 2007

We new it was coming. Discount broker Firstrade recently notified us that they are changing their mutual fund policy.

Starting February 15th (or March 15th if you have an account), Firstrade moves to a more traditional commission structure for buying and selling mutual funds in brokerage accounts – a.k.a. mutual fund supermarkets.

Customers will now have to pay to buy and sell no-load funds unless those funds kick back 12b-1 fees to the broker to be on the brokers “no transaction fee” (NTF) list.

In an effort to land new accounts, Firstrade had allowed buying and selling of ANY fund on their list of thousands for no fee - even cheapo funds like Vanguard 500 (VFINX), so long as investors didn’t sell for 180 days.

Low fee funds don’t skim enough fees from shareholders to pay a kickback and are usually not on NTF lists. This loss leader was a boon to fund investors who want the convenience of owning all of their funds in one place, yet the costs of buying funds directly from fund companies.

We’ve been recommending Firstrade as the best choice for fund investors because of this deal –though we knew it had to end someday. The last broker we recommended for the same deal (Scottrade) eventually stopped offering free fund trading as well.

Like Scottrade, those who loaded up on Vanguard and other low fee funds (like say, me) for no transaction fee, will soon have to pay a transaction fee to sell. (Why the FTC isn’t cracking down on this is a mystery – what if they started charging $5,000 to sell after you got in on “free trades”?)

That said, Firstrade’s new fee structure - $9.95 to buy or sell a non-NTF fund is still lower than anybody else – Scottrade charges $17, E*Trade $20, Schwab – you don’t even want to know… Plus Firstrade shortened the short-term redemption fee period to 90 days and now has over 10,000 funds available.

Better Than a Dartboard… But Worse Than An Index

December 22, 2006

Picking mutual funds is tricky business. That’s why most individual fund investors underperform the S&P 500 index. But in theory it should be easier than choosing stocks. The expert fund managers are doing the difficult work of picking the stocks to buy and sell. Investors just have to pick the right pickers.

There are dozens of reasons a mutual fund that had been a top performer can suddenly stop performing well. Professional fund analysts exist to look beyond the mere data and do actual fund manager interviews and additional research. Morningstar, the world’s premier mutual fund research company, has a sea of analysts keeping tabs on the growing (and growing….) list of funds. The job of these analysts is to choose the cream of the fund crop.

Morningstar recently updated the performance of their fund analyst picks. At first blush, the results look quite good.

As their director of mutual fund research concluded, “I'm pleased to see that our picks delivered superior returns.” The test was relatively simple: “Basically, we compare each fund with its peer group and ask whether it outperformed its peer group during the time when it was a pick.” In other words, if a fund analyst picks Super Duper Large Cap Value Fund as a large-cap value fund pick, does it beat the returns of most of the large-cap value funds going forward?

“For the trailing five years, it's 65%.” Not bad. That is, until you compare Morningstar analysts’ performance to some alternatives.

First of all, if an ordinary investor throws darts at a list of funds in any category (say, large-cap value), and sits back for five years, statistically they have a 50% shot of outperforming the “peer group”. But it would be pretty easy to improve these odds.

In any fund category, up to 10% of the funds have almost no chance of beating the category average. Sort of like the horses at the race with no chance of winning – the 50:1 long shots.

Some funds continue to exist for no apparent reason. They have expense ratios double the category average, often because of diminished asset levels, and have usually underperformed their benchmark index 95% of the time going back for over a decade.

While there is little probability a fund that has performed well will continue to perform well, there is a large probability that a true perma-stinker fund will continue stinking until the fund company puts it out of its misery. That’s why Morningstar’s most accurately predictive rating is one star. Those funds tend to stay in the bottom half of the class.

So remove the easy-to-screen-out 10% of the population of real losers and your dartboard pick should beat the entire category 55% of the time.

Why stop there? If you just throw darts at the 10% of funds that are the lowest-fee funds in the category, you will probably have at least a 65% chance of beating the category over the next five years. Fees aren’t an end all be all, but they are a good starting point to identify future fund winners.

But is there an easier way to improve your odds?

Yes, it’s called an index fund. No, not any old S&P 500 or total market index fund (which will beat the entire population of all domestic fund categories about 70% of the time over five year stretches), but a category-specific index fund.

While there are more and more ways to index-invest as new ETFs are rolled out seemingly every day, investors generally don’t need to get any more creative than Vanguard.

Let’s look at relevant Vanguard index funds in the major “style box” classifications and see what percentage of funds in their peer group these index funds beat over the ensuing five years:

Large-cap value – Vanguard Value Index (VIVAX) beat 71%
Large-cap growth – Vanguard Growth Index (VIGRX) beat 61%
Large-cap blend – Vanguard 500 Index (VFINX) beat 62%
Small-cap value – Vanguard Small Cap Value Index (VISVX) beat 48%
Small-cap growth – Vanguard Small Cap Growth Index (VISGX) beat 89%
Small-cap blend – Vanguard Small Cap Index (NAESX) beat 50%
Mid-cap value – no Vanguard index fund five years ago
Mid-cap growth – no Vanguard index fund five years ago
Mid-cap blend – Vanguard Mid Cap Index (NAESX) beat 83%

And what about other fund categories?

Short-term bond – Vanguard Short Term Bond Index (VBISX) beat 61%
Long-term bond – Vanguard Long Term Bond Index (VBLTX) beat 39%
Intermediate-term bond – Vanguard Total Bond Index (VBMFX) beat 54%
Japan – Vanguard Pacific Stock Index (VPACX) beat 88%
Balanced (moderate allocation) – Vanguard Balanced Index (VBINX) beat 65%
ForeignLarge Blend – Vanguard Developed Markets Index (VDMIX) beat 78%
Europe Stock – Vanguard European Stock Index (VEURX) beat 41%
Diversified Emerging Markets – Vanguard Emerging Market Index (VEIEX) beat 49%

Total funds: 15
Total that beat peers: 11

In other words, if you simply picked the relevant Vanguard index fund in any category you were looking to pick a winner, you had a 73% chance of beating the fund’s peer group – a better result than the experts.

The few Vanguard funds that were not in the top half of the class only did so by a very slim margin. Note that many of the winners beat far more than 50% of the competition.

These index funds are also more tax-efficient than competitors. If you look at after-tax returns of all funds in the category, your odds of winding up in the top half of the class improves significantly.

There are also commissions to consider. Buying and selling index funds at Vanguard is free, unlike trading ETFs and ordinary funds at your broker.

And index fund investors can expect to do even better than Vanguard’s 73% peer-group-beating success rate. Why? The last five years have been particularly hard times for index funds that are market-cap-weighted – as all Vanguard and most other index funds are. We told you this was going to happen six years ago. This is because larger-cap stocks have underperformed smaller-cap stocks. Most actively managed mutual funds are not market-cap-weighted (except for the closet indexers) so they had an advantage over index funds in every category in recent years – and they still royally screwed up. The small-cap-kills-large-cap jig is up. It would not surprise us to see your chance of success using index funds climb to 80% - 90%. In our own handpicked fund portfolios and favorites lists we are using more index funds than we did a few years ago.

The implications are troubling, to say the least. If experts can’t succeed, where does that leave everybody else? Fund analysts get to interview fund managers. They can also pick from any fund they want to juice their returns – including load funds – and magically ignore the performance drag of the sales loads. And yet these pros still can’t pick actively managed funds that beat relevant index funds.

What hope is there for typical fund investors – especially the millions who use 401(k)s with their limited selections of generally higher-fee funds? Print this article and give a copy to the people in charge of picking funds for your 401(k) plan.

There are more sophisticated ways to build mutual fund portfolios, but if you want an easy way to almost guarantee the funds you pick will beat the majority of the funds in their category, just buy a category index fund. If none is available go with the cheapest alternative. Don’t feel guilty for cheating. We do it ourselves all the time.

NOTE: fund category names are from Morningstar and do not match ones used on MAXfunds.com. Category ratings are from Morningstar as of 10/31/06

Focus On: Emerging Markets

December 1, 2006

(Published 12/01/06) There are two ways to invest in emerging market funds. One is to choose a small allocation and stick with it through booms and busts. As these fluctuations will sometimes occur opposite the other investments, investors may experience a lower overall risk. With a buy and hold strategy, investors should rebalance after big market moves to maintain their small – say, 5% to 10% – emerging market allocation.

The other way is to invest a bit more than this permanent allocation, but only after significant weakness in emerging markets and widespread fear of crisis by investors occurs (i.e., when prices are dirt cheap). Such an active strategy would require lightening up after a big run-up in emerging markets (such as we did in our portfolios in recent years). This means a 20% allocation after an emerging market slide, lowered to perhaps 5% after significant gains.

We’re following the second plan – invest when down, and lighten (even to 0%) when up. However, there is nothing wrong with the first method for investors who don't have the time or the expertise to be active investors.

Sadly, too many investors follow plan 9 (from outer space) – they load up on emerging markets funds after a big 3-5 year run, only to get slammed by the eventual hit these markets will take. Then they sell low. We know this happens because funds in this category often have tax loss carry forwards on the books – ghosts of bad investments by investors.

We can tell we're probably near a market peak when all the past losses on the books of old emerging market funds are gone. Today, the Vanguard Emerging Market Index fund (VEIEX) – one of the largest (started in 1994) and a favorite here – has almost no capital gains on the books, even after a 5-year average ANNUALIZED return of 23%. That's one of the best performing funds in recent years, and as a group, shareholders haven’t made a dime. That should give you an idea of how badly fund investors time their buying and selling of emerging market funds. (Not to brag, but our other fund favorites in this category have beaten even this top–performing, low-fee emerging market index fund, and the bulk of all emerging market funds since we added them as favorites).

Investor activity is a good way to gauge optimism – tracking what they’re buying and what they’re selling. This is our primary gauge of investment opportunity. Another is fund company launch dates. Check the inception date of most emerging market funds and you’ll see they were launched in the early 1990s – around the time of big run-ups in emerging markets, and right before a big slide.

Another useful indicator is relative valuations across investment categories.

If junk bonds (high yield bonds) are in favor with investors, prices generally run high relative to other bonds. This means a low quality corporate bond might pay just 2% more than an ultra safe U.S. government bond. In times of investor fear of default, junk bonds can pay 4% or more than U.S. government bonds. We had larger allocations to junk bond funds in our model portfolios in the “Enron” days a few years back when these fear premiums were more pronounced.

Emerging market stocks currently trade at a discount of roughly10-15% to the valuations of “emerged” stocks like you find in the U.S. In other words, a beverage company in Brazil may trade at 15 times earnings, while Coca-Cola (KO) trades at 17 times earnings.

Clearly, Coke is a safer investment. The company is based in the U.S. and has global operations. As far as any single stock goes, Coke is relatively low-risk. The chances of currency fluctuations, accounting shenanigans, or political risks destroying your investment in Coke are small.

The Governor of Georgia isn’t going to nationalize Coke. Their core product is safer than most products from the risk of competitors guzzling their market share, and most people that drink Coke can afford to – regardless of where the economy goes. Investors can relax…and enjoy Coke. They’ll even collect dividends along the way. Unlike bank CDs, the dividends will even likely go up over time.

By comparison, a company located in an emerging market is chock full of extra risks. How much cheaper investors expect to get emerging market stocks as a whole is a good indication of how enthusiastic they are about investing in emerging markets in general. Scared investors would expect a big discount. You want to invest where investors are scared to go without major incentives in the form of cheaper stocks.

Just a few years ago, before most emerging market stocks went up 2x, 3x, even 4x or more, emerging market stocks were trading at big discounts to U.S. stocks – 50% or more typically, or 10x earnings compared to 20x earnings in the U.S. Not anymore. Returns have been exceptional because there has been valuation expansion (now stocks trade at higher multiples of earnings) AND earnings have grown faster than safer stocks. This is the double whammy that leads to huge investor returns – it’s exactly what drove tech stocks in the late 1990s.

Rather than considering the risks in emerging markets, investors today are more focused on great opportunities. Unlike in the U.S., economic growth in many emerging markets seems boundless. The worldwide commodity boom has been particularly lucrative for many emerging markets that rely heavily on commodity exports.

But there is always a good reason why an investment can continue to go up. The investment went up largely due to these reasons in the first place. In fact, those reasons seem more sound the better the past performance – the ultimate legitimizer of investor theories (…these numbers don’t lie…).

This current optimism is why future returns will be sub-par going forward. Current optimism is not quite as wild as it was in the last emerging market craze – the early 1990s. Back then, emerging market stocks were actually trading at HIGHER valuations than U.S. stocks. From those levels investors in U.S. stocks did very well, and investors in emerging markets fared poorly. Some emerging market funds are only now getting back to those boom 1993 levels. The difference was about as extreme as it has been in the last five years, as the Dow struggled to get back to year 2000 levels and emerging markets posted double digit gains year after year.

It’s possible that the action in emerging markets will continue a little longer. We’ve already shortchanged the emerging market move and bailed out a little too early. Maybe we’ll return to early 1990s valuations and U.S. stocks will be cheaper than emerging markets. However, we don’t play the hope-for-valuation-expansion-to-save-us game.

Category Rating: (Least Attractive) - should underperform the market and 80% of stock fund categories over the next 1 to 3 years

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: -8% (lowered from -7% in our last favorite fund report)

1. SSgA Emerging Markets (SSEMX) 9/02 209.90% 145.86% -2.93% 45.08%
2. Excelsior Emerg Mkts (UMEMX) 9/02 217.43% 153.39% -5.09% 37.90%
3. Vanguard Emerging Markt Indx (VEIEX) 9/01 224.45% 194.02% -3.20% 37.89%
4. Bernstein Emerging Markets (SNEMX) 9/02 270.69% 206.65% -3.26% 36.36%

Sixth Annual Mutual Fund Turkey Awards

November 23, 2006

Gobble gobble. It’s that time of year again: Time for MAXfunds to nominate funds for our sixth annual fund turkey awards. With this series we’ve developed a nice track record identifying lousy funds before they get wiped off the map by forced extinctions or mergers – or just sued into oblivion by limousine-chasing lawyers – and we aim to keep up the good work. (Our methodology helps identify great funds, too - which is why our MAXadvisor Powerfund Portfolios continue to post market-beating numbers)

This year is full of fund turkeys that are plump, juicy, and full of trans fats.

The MAXfunds Turkey Awards: Suitable for framing or “Exhibit A” in shareholder class-action lawsuits.

The “Losing Real Money” Award
Winner: Oppenheimer Real Asset A (QRAAX)

Money always piles into a fund right before the music stops. You can’t really blame the fund company. Oppenheimer Real Asset launched in 1997 – and immediately tanked about 50%.

Investors shied away from commodity investments for a few years. After a big run in commodities in recent years, they piled back in -- just in time to lose money. Oppenheimer Real Asset is up pretty big in recent years, but investors have lost a few hundred million dollars in the fund nonetheless.

In the 2005 movie A History of Violence, mob kingpin Richie Cusack (after his henchmen fail to kill someone after a perfect setup) says, “How do you f*** that up?”

Fund shareholders looking over their account statement this year are probably saying the same thing. What with the commodity boom? The financial media is still ga-ga for gold, gas, oil and other metals?

Yet low and behold, Oppenheimer Real Asset (much like the benchmark Goldman Sachs Commodity Index) is down over 10% in 2006, while the S&P 500 is up over 10%. Even thought the fund is up big over the last few years, it has still managed to destroy a few hundred million of fund investor money. That’s because so many people piled into commodities and this fund at the very peak, after the run-up. Too late.

Fund investors would have done better in fake assets this year: Stocks and bonds.

For those who are still hot for commodities, consider less expensive alternatives to Oppenheimer Real Asset (a load fund), like iPath Dow Jones-AIG Commodity Index TR ETN (DJP), iPath GSCI Total Return Index ETN (GSP), the PowerShares DB Commodity Index Tracking Fund (DBC) or the iShares GSCI Commodity-Indexed Trust GSG.

Over long periods of time commodities should roughly match inflation -- a lousy return. But fund investors tend to buy after big runs (and exciting new fund launches), all but ensuring poor returns.

The “Losing Money In Up AND Down Market” Award
Winner: Black Pearl Long/Short (no ticker)

The Curse of the Black Pearl. As we’ve noted before, fund companies generally need the wind of a rising stock market at their back to cover high expenses, trading commissions and generally mediocre stock picking. Still, fund companies occasionally break out a long/short fund (or a somewhat similar market neutral fund). The goal is to prove manager prowess by making money on longs (owning stocks) and shorts (essentially betting a stock will go down).

In theory it’s a great idea. Investors would have a lower risk fund that wouldn’t swing wildly with the market – just deliver pure picking returns as the fund manager’s shorts fall and their longs rise.

Long/short funds separate wild market gyrations from the true value of active fund management. Unfortunately, the true value of active fund management is a lot less than the near double fees charged by most long/short funds. (Why not? It’s twice the work, right? Wrong.)

Black Pearl Long/Short was launched about a year ago and has promptly underperformed the S&P 500 by about 30%. That performance proves our pearl of wisdom about long/short funds: “If the bad stock picks don’t get ya, the high fees will.”

Guess who is behind this gem? Firsthand Funds. Quite frankly we wouldn’t expect any less from the fund company behind billions in shareholder losses because their tech bubble-era funds crashed and burned. At least this one won’t bring in performance-chasing fund shareholder money right before it crashes; It crashed before it brought in any money. According to the most recent report, less than a $1 million is in the fund.

THIS JUST IN! Something we can all be thankful for. Firsthand Funds filed with the SEC the day before Thanksgiving to put this fund turkey out of its misery. Usually our fund turkey articles are published BEFORE fund companies liquidate stinkers.

The “We Can Shrink Your Portfolio” Award
Winner: CAN SLIM Select Growth (CSSGX)

Remember Duncan-Hurst, the momentum fund managers from the 1990s? Well, Duncan-Hurst is back…and losing money again on momentum bets.

Duncan-Hurst managed a few funds in the go-go years, like Duncan-Hurst Aggressive Growth, Technology, International Growth and Large Cap Growth 20.

When we interviewed Beau Duncan at the very peak of the growth and tech bubble in March 2000, he let New Economy zingers fly like: “Well first of all, valuation is not part of our process,” and “I would say in general we are in a positive environment for growth stocks as opposed to value stocks.”

Not long after that, the relatively small Duncan-Hurst funds were down big time, falling far more than the S&P 500. Apparently the $7 billion under management in institutional and private accounts at Duncan-Hurst in early 2000 didn’t fare much better; Duncan-Hurst now manages $633 million.

The Duncan-Hurst mutual funds were closed, liquidated, merged, or sold to the highest bidder. While the times have changed, Duncan-Hurst is still a momentum shop and has been following this strategy for around 20 years.

About a year ago the company launched CAN SLIM Select Growth (CSSGX) – a momentum fund licensing the CAN SLIM strategy popularized by Investor’s Business Daily.

Unfortunately, momentum investing stopped beating the S&P 500 on May 9th, 2006. Mark your calendars. Since the peak in Mo-Mo investing, investors in this fund are down about 25%, while the S&P 500 is up. (Over the last 12 months ending 10/31/06, the S&P is up almost 20%, while shareholders in CAN SLIM Select Growth are down slightly.)

The fund’s 1.7% expense ratio is only going to drag on already dragging performance. Frankly, this fund should have been a much cheaper ETF.

Let this be a warning to all readers of Investor’s Business Daily: If this seasoned professional money manager missed the S&P 500 by a country mile in just a year following the CAN SLIM strategy, how do you think you’re going to do?

TURKEY ALERT FOR NEXT YEAR? Since momentum investing came to a screeching half this year, other funds will likely trail the S&P 500 for the next three to five years: Rydex Sector Rotation A (RYAMX), FundX Upgrader (FUNDX), First Trust Value Line 100 Fund (FVL) and PowerShares Value Line Timeliness Select Portfolio (PIV).

The “A Day Late And A Dollar Short” Award
Winner: WisdomTree

The mutual fund business has a long history of launching funds that would have been great ideas five years earlier but are duds the day they debut.

Firms launch funds when there’s public thirst for a strategy that’s already done very well. Usually similar funds have brought in billions and CNBC is going on and on about some hot area. By then, fund investors associate the very name of a sector or strategy with near guaranteed wealth creation: Tech, Internet, Growth, Emerging Market, Biotech, China, Telecom, and Energy. These were all must-have funds at one time or another.

Back in 1999, you couldn’t give away a yield-oriented fund. Go back and look at the low asset levels of almost any value fund, any REIT or any dividend or income-oriented product.

But what was out is now very in. Dividend, yield and income are three words cropping up in fund names far and wide. In the last few years we’ve seen dozens of new open-end funds, closed-end funds and ETFs offering the gift that keeps on giving: Dividends.

WisdomTree is a new ETF advisor that has cranked out over 30 new dividend-oriented ETFs this year, all promising market-beating performance from the ever-so-simple strategy of selecting high-dividend stocks. As their perpetual commercials on CNBC announce, WisdomTree’s research is “very impressive.” Unfortunately, WisdomTree couldn’t supply us with any of this “impressive research” despite repeated attempts to see this magic money formula. We even asked the president, who put his best people right on it. We’re still waiting.

Looking backward high-dividend stocks have outperformed the S&P 500. Looking backward REITs have outperformed the S&P 500. But this does NOT make them a better or even good investment now. Need proof?

Looking backward from the vantage point of 2000 growth was a better bet than value. Looking backward in 1990 Japanese stocks were a much better bet than U.S. stocks. Looking backward in 1929 buying stocks on margin was a great way to get rich.

The flagship WisdomTree product, the WisdomTree Total Dividend (DTD), has underperformed the S&P 500 since its launch in June 2006. We expect this trend to continue for the next few years. At some point in the future we’re going to recommend an over allocation to high dividend stocks. Unfortunately this fund family might have already closed its doors by then. Of course that’s when a dividend fund will be a great idea again.

Honorable Mentions
Ridiculously Expensive Index Fund: Rydex S&P 500 H class (RYSPX)

You really need an S&P 500 index fund with a 1.45% expense ratio. Here’s a possible tagline for the fund: “Passive investing with active investing fees!”

As the prospectus notes, “H-Class Shares of the Funds are sold principally to
clients of professional money managers.
” That’s scary.

Things Look Great From Here: Northern Emerging Markets Equity (NOEMX)
Somebody has to launch a fund at the top. It debuted on 4/25/06, about two weeks before a big fall in emerging markets. Emerging markets have climbed back, but it’s possible this fund will never show a positive return since inception.

An ETF A Day Keeps Retirement Away: Various ETF Fund Companies
Thanks for launching over 100 exchange traded funds in 2006 because fund investors need more ill-timed and ultra-focused ideas to day trade. While in theory we like lower-fee funds and more sophisticated strategies, in practice fund investors do worse with more targeted their investment options. It’s like giving an Indy car to a teenage driver.

This ETF craze will not end well for investors.

Large Cap Is Back But Just Not Here: American Century Select (TWCIX)
Finally large cap growth funds are having a good year but not this one. This fund has somehow managed to lose money and wind up in the bottom 3% of its category. That’s an embarrassing return outdone only by another family product, American Century Ultra (TWCUX).

At least it’s not a closet index fund. Clearly.

Fund Managers Of The Year. Just Not This Year
Bill Miller, Tom Marsico, Bill Gross, John Calamos. They’re all underforming the market in 2006.

Share The Wealth…And The Losses: Janus Olympus (JAOLX)
Olympus merged with Janus Orion (JORNX), bringing with it billions in tax-loss carry-forwards from the tech crash. Now slightly less unfortunate Orion shareholders get to benefit from these Olympus losses. (The portfolio manager can realize gains and wipe them out with losses to minimize year end taxable distributions to shareholders). Both fund shareholders are now in a bigger fund that’s slightly more difficult to manage. What about fees? They remain the same. Chalk up one more tech-wreck track record swept under the rug. It’s win-win…for Janus.

Shameless Self Promoter: Elliot Spitzer (Repeat Offender)
New York State Attorney General and governor-elect continued to let many fund companies get off with lame-o “neither admit nor deny” cash settlements to bolster his own brand equity. Some of these firms blatantly stole money from their own shareholders. Rather than go after the real offenders in a multi-year smack down, a no-holds-barred fund trial of the century, Spitzer goes for the easy shakedown. Now it’s business as usual in fund land. For shame, Governor, for shame!

“Screw the shareholders. What’s in it for me?” AmSouth Bancorp
This acknowledgement is for not choosing a fund administrator based on low costs (or other benefits to fund shareholders) but based on who would kick back the most money to the advisor directly. That’s even if it meant overcharging shareholders for administrative services. This award will be shared with BISYS and a couple dozen more fund companies, once those turkeys are named publicly.

Free Fund Trading?

October 19, 2006

It was bound to happen sooner or later. With Google buying startup YouTube from a couple of twenty-somethings for almost two billion smackers, other dot-com era ideas had to be in the pipeline.

On Wednesday Bank of America announced free trading for their Banc of America brokerage customers. The stocks of competitors like E*Trade (ET), TD Ameritrade (AMTD), and Charles Schwab (SCHW) fell sharply on the news. Is a price war brewing?

This bold, dot-com era move (it’s been tried before) is noteworthy to mutual fund investors because today there are so many other ETF (exchange traded fund) choices. ETFs trade on exchanges like stocks, and therefore, the same zero-commission offer would apply.

The main downside of ETFs over ordinary index mutual funds is having to pay commissions to buy and sell them. This can easily wipe out the benefits of low fund operating fees, particularly for smaller trades or with those making regular investments.

If you buy $5,000 worth of an ETF, hold it for one year and sell, a 0.25% ETF expense ratio quickly becomes 0.85% in total expenses (2 trades at $14.95 works out to 0.60% of $5,000).

Then you have to factor in the “spread” between the bid and the ask price. Ignoring commissions completely, you’d still lose money buying an ETF and selling it a few seconds later – not because the market moves but because you buy at the ask (higher) price and sell at the bid (lower) price.

Another factor rarely considered is that the market price can be slightly higher than the actual underlying NAV or net asset value of the ETF. If you wind up selling when the market price is at a slight discount, you lose even more on the trade.

The typical ETF investor is paying closer to 1% a year to trade and own ETFs when you factor in commissions, spreads, and premium/discounts – far more than a plain-vanilla index fund investor would have to swallow.

And most new ETFs today have expense ratios higher than 0.25%. Worse, most ETF investors have holding periods measurable in days, not years.

For these reasons we’re excited about Bank of America’s new deal for ETF investors. For ordinary mutual fund investors (those who buy Vanguard, Janus, American Century, and T. Rowe Price funds), the offering is less compelling – commissions for buying and selling ordinary mutual funds at Bank of America are among the highest in the business.

Like most brokers, you can buy about 1,200 funds (some parts of their website claim 1,500, others 1,200) with no transaction fee or commission (as long as you hold for at least 90 days). As BofA’s website says, “Because of our relationships with the fund companies, you can purchase No Transaction Fee Funds, or NTF Funds, without paying any sales charges or additional transaction fees”. This “relationship” is the one where higher-fee funds kick back some of the fees paid by fund shareholders (whether they own the fund through a broker or not) back to the broker.

The trouble is with the non-NTF funds – generally the cheap ones that don’t play the kickback game. If you buy a Vanguard or Dodge & Cox fund in your Banc of America brokerage account, you’ll pay somewhere between $45 and several hundred dollars per trade (you get a 10% break for online trades – big whoop). Putting $5,000 into a Vanguard or Bridgeway fund will cost you $45. It’s worth noting that many cheap funds like T. Rowe Price and Janus now have special higher-fee classes and are available for NTF at brokers like BofA.

There are a few other catches:

Clients need $25,000 in combined assets at Bank of America (one of the top 5 banks in the world) in order to use the new system. This DOES NOT INCLUDE money in the brokerage division – you must have this balance in CDs, checking, savings or money market accounts with Bank of America, not Banc of America Investment Services (the brokerage arm).

This can be tricky because checking, savings, and money market accounts at Bank of America (like most big banks) pay paltry rates of interest.

Park $40,000 in a BofA money market and you’ll earn an unimpressive 2.37% a year (I earn 5.05% on my online savings account at HSBC – with no minimum to boot). You’re giving up $500 a year on a $25,000 balance – enough to pay the trading commissions at your regular discount broker. Don’t lose $500 to save $14.95 a few times a year.

The best way to qualify for the free trades is to park $25,000 in a Bank of America CD. While they currently tease you with a 5%, 7-month high-yield CD, you can expect to consistently earn a full 1% less than competitive CD players. In other words, you’re tossing away about $250 a year parking CDs at BofA compared to say, NetBank or E*Trade bank (or many others).

On the flip side, if you already park $25,000 in low-yield checking, savings, and CD accounts at other big banks (Citigroup, Chase), there is no lost income if you switch – which is what they really want you to do at Bank of America anyway. This move is really more of a threat to Citigroup than to TD Ameritrade.

You can’t trade more than 30 times a month and get free trades. Bank of America isn’t interested in stealing active traders from online brokers (or losing money on the accounts, which is what would happen if a day trader had a zero-commission account – it would be like giving free, all-park passes to kids at Disneyland).

The brokerage industry claims you’ll get better execution (speed and price) than you’ll get at Bank of America, though this claim is hard to prove. Whether your ETF trade goes through in 2 seconds or 2 minutes is irrelevant to a non-active trader accustomed to ordinary mutual funds, which only allow trading at the end of the day.

Bottom line: If you primarily invest in ETFs, stocks, and mutual funds that trade without transaction fees (check the list below), and you trade fairly often (say, more than 30 times a year), you can do well taking advantage of Bank of America’s free trade offer. Others will do much better at a low-fee broker like Firstrade where you can buy any ordinary mutual fund for free (including Vanguard), and trade ETFs, closed-end funds, and stocks for just $6.95.

The offer is currently available in the Northeast, but Bank of America will be rolling out the service across the country in the next few months.

The 'F' Word: Foreclosure

September 29, 2006

After years of steady double-digit gains in prices, real estate seems like a can't-lose way to get rich. Unlike tech stocks (which seemed like a can't-lose way to get rich six years ago), home prices seem like they don't go down. Better still, you can buy in with somebody else's money, and keep all the gains for yourself.

Besides the history of positive returns, another reassuring factor some home buyers consider is that, worst-case scenario, they'll just give the keys to the bank and walk away. Heads, I win (home prices go up); tails, you lose (home prices go down).

I've heard this “logic” from home buyers entering the market at prices they know are a little stretched, I've read it in the paper, and I've heard it from economists and other experts. Even the doomsayers — warning of rising interest rates leading to banks taking over properties from adjustable-rate-mortgage-fueled home buyers — seem to think the worst-case scenario is handing over the keys to the bank. If only that were so.

While hedge fund managers can earn a 20% cut of profits on other people's money, yet suffer no loss of their own if things go sour, home buyers have no such protection.

Foreclosures — the process where banks and lenders repossess and liquidate the property securing a loan that the borrower defaults on in an effort to pay off the debt — have been at very low levels in recent years.

Even now, with so much data pointing to a slowing housing market, only about 1% of mortgages were somewhere along in the process of foreclosure, according to the Mortgage Bankers Association. This figure is even lower than seen during the hot economy of the late 1990s. While foreclosures are on the up-tick this year, most of the trouble is in lower-quality loans and in regions facing economic hardship, like around Detroit, or along Hurricane Katrina's path.

Foreclosure laws vary state by state, but broadly speaking, if you miss a few payments on your mortgage loan, the bank (begrudgingly, believe it or not — they would much rather see you make payments) will try to sell the property and pay off your debt. Normally, the house will sell for more than the outstanding debt.

House prices tend to climb over time, building up equity for the owner. Traditionally, homeowners have had to put down some percentage of the cost to buy a house. With 20% down, it would take a big crash in real estate for a bank to actually lose money on a home loan, which is the main reason most home buyers wind up paying such a low interest rate — barely above the rate the government borrows at, and lower than many U.S. corporations. The typical bank would rather loan you money at 6% than General Motors.

But what happens if the bank can't auction your house for what you owe? What if you buy a house for $200,000 with only $10,000 down (just 5% down, with a mortgage of $190,000) and you lose your job a few weeks after closing? What if the housing market turns south and your house can only be sold for $170,000? Are you out the $10,000 down payment, while the bank eats $20,000 ($190,000 loan less the $170,000 proceeds from sale)? Only in fantasy land.

The bank is going to try to squeeze you for the $20,000 you still owe them. The outstanding debt becomes a general unsecured liability to you, like a $20,000 balance on a credit card. At the very least, your credit report will get slammed — a big punishment in an era where everybody uses your credit report as a gauge of your credibility (even employers).

Worse, you may have to file for bankruptcy and liquidate any non-protected assets (like your 401k) to settle the debts and get the bank off your back. Trouble is, with last year's bankruptcy law changes, it is difficult for many to file for bankruptcy and just walk away from debts. While these changes did not bring back debtor's prison, those with median incomes or higher will have to seek credit counseling and likely get on a debt payment plan with the bank.

Until the last few years, foreclosure rates have been climbing steadily for decades. While many factors play a role in the foreclosure rate (unemployment rates, incomes, interest rates, divorce, health care costs — even availability of casinos) the government has found the top cause is loan to value ratios (LTV). In other words, as more of the percentage of a home purchase is paid for with borrowed money, the higher the incidence of foreclosure. In the 1950s, when lenders played it safe and required substantial down payments, foreclosures were even lower than today.

The second most important factor — and closely related — is rising home prices. With homes, a rising tide lifts all boats. Even the most overextended buyer with questionable credit and minimal job security is insulated from disaster when home prices climb 20% a year, creating instant paper equity where little traditional (down payment) equity existed.

Now that home price appreciation is leveling off, the ugly side from the growth of no-and low-money-down lending should rear its head.

In the 1990s, companies relied on double-digit stock market returns to hide problems with their pensions which resulted from a lack of real funding — problems that wouldn't have materialized if stocks kept going up year after year. Today, mortgage lenders and borrowers are playing an equally fiscally irresponsible game, relying on home price appreciation to hide the dangers of low-equity home loans.

In recent weeks, home builders have announced unforeseen declines in home buying activity. The inventory of homes for sale is at 10-year highs. Even the always-be-bullish National Association of Realtors has lowered their expectation for home price appreciation.

Just wait until banks start foreclosing on homes at 1990s (or worse) levels. Unlike today's picky sellers, banks will lower prices to get the sale. Those priced out of today's real estate market may get a chance soon. Just have some cash ready. Next time around, banks will want to see some more green.

While rising foreclosures have implications for home owners, buyers, and sellers, there is also something for fund investors to consider.

Today much of the outstanding debt is mortgage backed. When you borrow money to buy a home, that mortgage is often packaged with other people's mortgage and sold as a mortgage backed security. Some of these bonds are issued by quasi-government agencies like Fannie Mae and Freddie Mac, others by Wall Street firms.

These mortgage-backed bonds often find their way into bond fund portfolios. In fact, most bond funds own some of these bonds, notably bond index funds, as these mortgage bonds represent such a huge portion of total bonds outstanding. If the pace of foreclosures ticked up significantly – and the prices of homes fell enough that those who own these mortgage backed bonds would be inheriting property worth less than the outstanding debt (and mortgage bond insurers failed) these bonds could fall in price.

While its unlikely an investment in, say, Vanguard Total Bond Market Index (VBMFX) or Fidelity U.S. Bond Index (FBIDX) would fall precipitously, they could underperform lower fee bond funds that do not own as many of these types of bonds by a small margin, during a crisis. Vanguard Total Bond Market Index has 40% in mortgage-backed securities – 35% government mortgage-backed, 5% commercial mortgage-backed. These bonds are currently investment grade, meaning default risk is deemed extremely low by bond rating agencies.

Vanguard Intermediate-Term Investment-Grade (VFICX) or Vanguard Short-Term Investment-Grade (VFSTX) (MAXadvisor Powerfund holdings) have much smaller allocation to these types of bonds, relying mostly on corporate bonds. Funds with “treasury” in the name tend to avoid mortgage-backed bonds and corporate bonds.

Corporate America is likely going to prove to be a better credit risk than the average recent home buyer if we get a big fall in home prices.

Ask MAX: Should I Listen to my Neighbor?

September 22, 2006

Dear MAX,

My neighbor's son is going into his second year of college. She told me that the best way they saved up for tuition [was] by concentrating on a single stock or sector. Do you think that's the right way to go? Or should I build a diverse portfolio with a stock/bond mix?


Dear Robin,

Your neighbor is dispensing some pretty lousy advice. If you had a neighbor who didn't save for their son's college tuition, but had a very lucky weekend in Las Vegas (where they parlayed $1,000 into room and board for a four-year private college), would you listen to them if they said the best way to save up for college was to get lucky at gambling?

While you have a shot at bigger winnings the more concentrated your investment — one stock being at the far extreme of concentrated portfolios — you have an equally good shot of having no money at all for school.

While Warren Buffet, the great investor, pokes fun at diversification, the drag of diversification also leads to more predictable returns.

Imagine having to tell your son (when all his friends are applying to college), “Unfortunately our hot Ethanol stock crashed when gas plummeted back below $2.00 a gallon. But look on the bright side — people are driving more and there are many jobs at gas stations!”

Build a more diverse portfolio and plan on saving aggressively to reach your goals — don't gamble with a smaller account.

A good way to go is a low-fee, diversified “fund of funds” that ages with your son. Such a mutual fund is made up of other stock and bond funds and is a complete diversified portfolio in one stop. Some of these funds are know as “lifestyle” or “target” funds because they get more conservative as time goes by (more cash and bonds, less stocks) as opposed to an ordinary balanced fund (which owns bonds and stocks) in about the same ratio.

Normally such funds are used to save for retirement, but from a financial planning point of view, your son is “retiring” when he goes off to college in the sense that you need to access the portfolio to pay for school. You can't handle a 50% hit right before the tuition is due, so a portfolio that gets conservative at that point is a good move.

Vanguard has a series of funds called “Target Retirement,” each one with a year associated with when you expect to retire. If your son is going to college in about 10 years, go with the Vanguard Target Retirement 2015 (VTXVX). There are Target 2010, 2015, 2020 an on all the way up to 2050 (stepping up by 5 years between funds). These funds are dirt cheap, you can invest with $3,000, and make small contributions along the way — even set up an automatic investing plan. Check out vanguard.com or call 800-997-2798. Other companies like T. Rowe Price (T. Rowe Price Retirement 2015) and Fidelity (Fidelity Freedom 2015) have similar fund lineups, but the low fees at Vanguard help with asset allocation type funds.

Thank for the question.


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Ask MAX: A dollar saved?

September 10, 2006

Dear MAX,

They say a dollar saved today is much more valuable than a dollar saved 10 years from now. So if that's true, if I manage to save only a small amount between now and the time my child is ready for college, will she have to borrow that much less for tuition?

Indianapolis, IN

Dear Lana,

The short answer is yes — saving now makes paying for anything later easier because time works to your advantage when saving. Save $1 today, and in ten years you'll have about $2.

The above math is a bit simplistic, because in ten years a dollar will only be worth about $0.78 because of inflation. It will be about as easy to come up with $1.28 in ten years as it will be to put aside $1 today — inflation means you'll be earning about 28% more in ten years without getting promoted. So why not wait to save? Problem is, college tuition will also be 28% more expensive in ten years — if not more than 28% given recent trends.

When you save, it's fairly easy to beat inflation in the long run. As the first example shows, you'll have $2 for every $1 you put aside at about a 7% annualized rate of return. Putting aside $2 in ten years will be harder than putting aside $1 today (unless you win the lottery in a few years…) because you probably won't be earning twice as much money.

I get worried when I hear “small amount” in your question. Don't think the magic of compounding will solve all future woes. Earning 7% a year will be difficult going forward. 7% may be the high end of the likely range of your future returns. You'll still need to save aggressively each year. Expect to have to save an entire year's tuition along the way. Growth of your savings account plus your daughter's student loans should carry your daughter through and help leave her with a manageable debt load at graduation.

One pitfall: don't save the money in your daughter's name — it could make qualifying for student aid (not just loans which almost anyone can get, but actual grants) difficult. This is the one case where saving now will mean your daughter will have to borrow more in the future!

Thanks for the question.


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