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5 Mutual Fund Investing Lessons from the Bill Gross Saga

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The soap opera at PIMco that began with the departure of Co-CEO Mohamed El-Erian in January came to a head with the recent departure of PIMco flounder Bill Gross.   More than just being the founder of PIMco Gross managed the firm’s flagship mutual fund PIMco Total Return (PTTRX).  His high profile exit once again brings one of the pitfalls of investing in actively managed mutual funds to the forefront.  Here are 5 mutual fund investing lessons from the Bill Gross saga.

Know who is in charge of your fund 

Bill Gross was the very public face of PIMco and was known as the “Bond King.”  To his credit he built PIMco Total Return into the world’s largest bond fund and the fund did very well for investors over the years.  The question investors, financial advisors, and institutions are now asking themselves is what is the future of the fund without Gross?

While PIMco promoted two very able managers to take over at Total Return, the redemptions that have plagued the fund over the past several years as a result of its downturn in performance have continued and seem to be accelerating in the short-term.  Much of this I’m sure stems from the uncertainty over the direction of the fund under these new managers.

Succession planning is vital

While most fund manager changes don’t take place in this fashion if you invest in a mutual fund run by a superstar manager what happens if he or she leaves?  For example does Fidelity have a plan to replace Will Danoff when he decides to leave Fidelity Contra (FCNTX)?

One of the long-time co-managers of Oakmark Equity-Income (OAKBX) retired a couple of years ago.  This was planned and announced ahead of time.  Shortly after that the fund brought on four younger co-managers to help the remaining long-tenured manager manage the fund and more importantly to provide succession and continuity for the fund’s shareholders.

The investment process matters 

What makes an actively managed mutual fund unique is its investment process.  If the fund were to merely mimic its underlying index why not just invest in a low cost, passively managed index fund?  There have been a number of articles in the financial press in recent years discussing “closet index” funds.  These are actively managed funds that for all intents and purposes look much like their underlying benchmark.  This is fairly prevalent in the large cap arena with many funds mimicking the S&P 500.  Why invest in an actively managed fund that is really nothing more than an overpriced index fund?

An institutionalized investment process is key when a manager leaves a fund.  I can think of three small cap funds I’ve used over the years that transitioned to new managers seamlessly via the use of a solid investment process.  While it is expected that the new managers may make some changes over time, I’ve also seen well-known funds replace a superstar manager and essentially have the new manager start over.  The results are too often not what shareholders have come to expect.  To a point this is what has happened to Fidelity’s one-time flagship fund Magellan since the legendary Peter Lynch left a number of years ago.  Subsequent managers have never been able to come close to replicating the fund’s former lofty position.

Even the best managers have down periods 

Bill Gross has made a lot of money for shareholders in PIMco Total Return and other funds he managed over time.  However Total Return has lagged its peers over the past several years which has led to a lot of money flowing out of the fund and the firm in recent years.  It is not uncommon for a top manager to go through a few down years over the course of a solid long-term run.  The trick is to be able to determine if this is a temporary thing, or if this manager’s best days are in the past.  For example if the fund has grown to be too large the manager may have more money to manage than he or she can effectively invest.

Is an index fund a better alternative? 

To be clear I am not in the camp that indexing is the only way to go when investing.  There are a number of very good active managers out there, the trick is to be able to identify them and to understand what makes their strategy and investment process successful.

However before ever investing in an actively managed mutual fund, ask yourself what will I be gaining over investing in an index mutual fund or ETF?

It was sad for me to see Gross’ tenure at PIMco end as it did.  It is not always easy to go out on top.  Michael Jordan should have quit after sinking the winning shot to secure the Chicago Bulls’ last championship.  Perhaps the role model here is the late Al McGuire whose last game as the men’s basketball coach at Marquette ended with the Warriors winning the 1977 NCAA championship.

For more on Bill Gross and PIMco please check out my two most recent articles for Investopedia:   What To Expect From Pimco After Bill Gross and Pimco Investor? Consider This Before Bailing.  

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Is Your Mutual Fund Bloated and Should You Care?

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Asset bloat in a mutual fund is akin to the situation we’ve all found ourselves in while dining out.  Our meal is fantastic and we can’t stop eating it even though we know we’ll feel lousy and bloated if we don’t stop.  Mutual fund asset bloat can also be a big problem for investors.

What is asset bloat? 

Asset bloat is simply a large increase in the assets managed by a given mutual fund.  Asset bloat is typically not an issue for index funds or money market funds, but it certainly can be for actively managed stock and bond mutual funds.

Asset bloat can be caused by an influx of new money into a mutual fund, often the result of a period of superior performance by the fund.  It has been my experience over the years that investor money chases good performance.  Asset bloat can also be organic in nature via the fund’s investment gains.

Morningstar’s Russ Kinnel wrote an excellent piece on mutual fund bloat that you should check out.

Why is asset bloat a problem? 

At some point an actively managed mutual fund can become too large for the manager(s) to effectively manage.  As an example, Peter Lynch was the legendary manager of the Fidelity Magellan Fund (FMAGX).  Lynch managed the fund from 1977 until 1990 during which time the fund’s assets grew from about $18 million to about $13 billion.  During this time period the fund’s average annual return was 29%.

At the end of the decade of the 1990s the fund’s assets had hit $100 billion, ultimately dropping to today’s level of about $16 billion.  Subsequent to Lunch’s departure the fund’s performance never hit the levels seen during Lynch’s tenure.  I have to believe that this was in part due to the massive growth in the fund’s assets.

This phenomenon is especially problematic in mutual funds that invest in small and mid-cap stocks.  Due to the smaller market capitalization of the underlying holdings in these funds at some point it becomes difficult for the manager to find enough good stock ideas within the fund’s mandate to continue to deliver the top performance that was responsible for the asset growth in the first place.

There have been many instances of small and mid-cap funds that have grown to be so large they have started to invest in larger stocks and ultimately have migrated to another investment style, for example from mid to large cap.

How can funds curb asset bloat? 

Close the fund to new money.  I always respect mutual funds that shut off purchases by new investors in the interest of benefiting existing shareholders.  More assets under management means more money for the fund company.  A shining example of a fund that does this is Sequoia (SEQUX) which has been closed for most of the past 25 years.  The fund’s long-term track record is exemplary.

Start losing money or underperforming.  I say this only partially tongue and cheek.  Nothing will reduce mutual fund assets like a period of underperformance.  Just ask the folks at Fidelity Magellan.  Just as investor money often chases superior mutual fund performance it also has a tendency to flee poor performance.

As Russ Kinnel points out in the Morningstar piece referenced earlier, asset bloat is a symptom of the solid stock market performance we have seen over the past five years.  This is not to say that a large fund cannot be effectively managed.  Case in point is Fidelity Contra (FCNTX).  Manager Will Danoff has done a credible job given the sheer volume of money under his management.  On the other hand American Funds Growth Fund of America (AGTHX) has been called a “closet index fund” meaning that its investments are extremely closely correlated to its benchmark Russell 1000 Growth Index.

For investors in actively managed mutual funds it is important to monitor the fund’s size as one of the indicators that you look at in your periodic review of your mutual fund holdings.  No single indicator is a reason onto itself in determining whether to hold onto a fund or consider selling it, but several key indicators viewed together can help you understand what is happening with your fund holdings.

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

The Chicago Financial Planner is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com. If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small fee, yet you don’t pay any extra. Click on the Amazon banner below to go directly to the main site or check out the financial planning related selections in our Book Store.

 

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4 Considerations When Evaluating Active Mutual Funds

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It’s spring here in Chicago (fingers crossed), the baseball season opened yesterday, and the first quarter of the year is in the books.  This means that you will be receiving statements from your 401(k) and your various investment accounts.  For many investors mutual funds comprise a significant percentage of their portfolio.  Here are 4 things to consider when evaluating actively managed mutual fund holdings.

Who’s running the show? 

Even with index mutual funds the manager(s) of the fund are a consideration.  However the management of the fund is a vital consideration when evaluating an actively managed fund.

Davis New York Venture (DNVYX) is an actively managed large cap blend fund with a long track record of success under two long-tenured co-managers.  When one of these co-managers unexpectedly left at the end of 2013 this was a cause of concern in evaluating the fund.  The fact that Davis moved quickly to replace this manager with an experienced member of the team at Davis was reassuring.  The fund continued its solid relative performance in the first quarter of 2014 after a solid 2013, which was preceded by three very sub-par years.  It is too early to tell what impact the management change with have on the long-term performance of the fund and this will bear close scrutiny.

Another example is the veritable soap-opera unfolding at PIMco over the departure of former Co-CEO Mohamed El-Erian.  While El-Erian didn’t manage many of PIMco’s funds, I’m guessing the whole situation was a distraction to CEO and founder Bill Gross who is also the manager of the firm’s flagship fund PIMco Total Return (PTTRX).  While this situation may not have been the cause, the fund finished in the bottom 15% of its peers in the first quarter.  This is on the heels of sub-par performances in calendar 2011 and 2013, though the fund ranks the top 5% of its peers over the trailing ten years all under Bill Gross’ leadership.

It is not uncommon for a fund that has achieved a solid track record over time to see the manager who was responsible for achieving that track record move on.  It is important when looking a mutual fund with a stellar track record to understand if the manager(s) responsible for this track record are still on board.

Size matters 

One of the truisms that I’ve noticed over the years is that good performance attracts new money.  Even if a top fund is responsible enough to its shareholders to close the doors to new investors before asset bloat sets in, the assets inside the fund might still balloon due to investment gains.  Two closed funds that I applaud for putting their shareholders first are Artisan Mid Cap Value (ARTQX) and Sequoia (SEQUX).

I’ve seen several formerly excellent actively managed mutual funds continue to take on new money to detriment of their shareholders.  Asset bloat can be a huge issue especially for equity mutual funds that invest in small and mid cap stocks.  At some point the managers have trouble putting all of this extra money to work and can be faced with investing in stock with larger market capitalizations.  At this point the fund might have the same name, but it is likely a far different fund than it was at its inception.

Closet index funds

According to a 2011 article in Reuters: 

Since the height of the U.S. financial crisis, more funds are playing it safe, hugging their benchmarks and sometimes earning the unwanted reputation as “closet indexers.” 

About one-third of U.S. mutual fund assets, amounting to several trillion dollars, are with closet indexers, according to research published last year by Antti Petajisto, a former Yale University professor who now works for BlackRock Inc. 

In general, Petajisto defines a closet indexer as a fund with less than 60 percent of its investments differing from its benchmark.” 

I was quoted in this 2012 piece in Investment News discussing closet indexers.  As the article mentions a fund is considered a closet indexer when its R2 ratio (a measure of correlation) reaches 95 in comparison to its benchmark.  In the example of American Funds Growth Fund of America this benchmark index would be the Russell 1000 Growth Index.

The point here is that if you are going to pay up in terms of an actively managed fund’s higher expense ratio, you should receive something in the way of better performance and/or perhaps better downside risk management over and above that which would be delivered by an index mutual fund or ETF.

An example of a an actively managed fund that you might consider being worth its expense ratio is the above-mentioned Sequoia Fund.  A hypothetical $10,000 investment in the fund at its inception on 7/15/1970 held through 12/31/13 would be worth $3,891,872.  The $10,000 invested in the S&P 500 Index (if this was possible) would have grown to $901,620 over the same period.  This fund suffered a much milder loss than did the S&P 500 in 2008 (-27.03% vs. 37.00%) and outgained the index considerably in challenging 2011 (13.19% vs. 2.11%).  Sequoia’s R2 ratio is 80.

R2 can be found on a fund’s Morningstar page under the Ratings and Risk section of the page.

Performance is relative 

Superior performance is an obvious motivation, but you should always make sure to compare the performance of a given mutual fund to other funds in the same peer group.  A good comparison would be to compare a Small Cap Value mutual fund to other funds in this peer group.  A comparison to Foreign Large Value fund would be far less useful and in my opinion irrelevant.

Unfortunately superior active mutual funds are often the exception rather than the rule, one reason I make extensive use of index mutual funds and ETFs.  However solid, well-run actively managed funds can add to a portfolio.  Finding them and monitoring their performance does take work.

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss  all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

The Chicago Financial Planner is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com. If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small fee, yet you don’t pay any extra. Click on the Amazon banner below to go directly to the main site or check out the selections on financial planning and related topics in our Book Store.

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Shake-Up at PIMco – Should Investors Care?

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The big news in the mutual fund world this past week was the announcement that PIMco Co-Chairman Mohamed El-Erian will be resigning from the firm effective in March.  El-Erian is a frequent guest on CNBC and a really smart guy.  This has been a huge story in the financial press.  As an investor should you care?

Mohamed el Erian - World Economic Forum Summit...

Some background 

PIMco was founded by the soon to be sole Chairman and Chief Investment Officer Bill Gross.  PIMco is perhaps the preeminent bond mutual fund shop.  Many financial advisors, including yours truly, have client assets invested with them.  Their flagship bond fund PIMco Total Return (PTTRX) has had middling results the past couple of years and experienced significant fund outflows in 2013.

El-Erian is the second key executive to leave the firm recently preceded by the retirement of Paul McCulley in 2010.  Some say El-Erian’s departure is an outgrowth of PIMco’s rough year in 2013.

What others are saying 

Jeff Benjamin of Investment News wrote:

“Even as speculation ranges from whether the highly regarded and high-profile economic strategist was forced out or simply burned out, the general consensus is that Mr. El-Erian’s departure will not hurt Pimco‘s reputation or asset management prowess. 

“The news was an incredible surprise, and we have a number of clients with investments in Pimco funds,” said Richard Konrad, managing partner at Value Architects Asset Management. 

 “But at the same time, the issue of talent within the Pimco organization is unquestionable,” he added. “Even without [Mr. El-Erian], the essence of the firm remains, along with a track record that has been established over many years.”” 

The New York Times Dealbook said:

“The move was surprising because Mr. El-Erian, 55, has been the public face of Pimco since he rejoined the company in 2007, taking some of the spotlight from the company’s famous founder and co-chief investment officer, William H. Gross. 

In 2012, Mr. Gross said, “Mohamed is my heir apparent.” On Tuesday, by contrast, Mr. Gross took to Twitter to announce: “I’m ready to go for another 40 years.” That would take Mr. Gross to his 109th birthday. 

Mr. El-Erian’s resignation underscores the upheaval in the investment world as rising interest rates put an end to a bond bull market that lasted for decades and helped build industry giants like Pimco and BlackRock.” 

My take on the PIMco announcement 

PIMco is a very solid fund company with a deep bench of talented managers and researchers that offers a number of very solid mutual funds, closed-end funds, and ETFs.  They are best known as fixed income managers, which going forward will be a tough place to be for any firm.

On the other hand company literature has often mentioned the use of a consensus model called their Secular Outlook developed as the result of an annual meeting of PIMco personnel.  One has to wonder with El-Erian and McCully gone will Bill Gross dominate the discussion here or will others within the organization be able to step up and balance Mr. Goss’ views?  More importantly does PIMco have or are they in the process of developing a succession plan? As youthful as Mr. Gross looks at 69 I’m not counting on him being around PIMco for another 40 years as he indicated he is “… ready to go…”

This situation brings to mind Janus Funds, one of the preeminent go-go growth mutual fund houses of the 1980s and 1990s.  Beginning with the departure of star manager Jim Craig in 1999 and followed by the market drop of 2000-2002, several corporate restructurings, involvement in the mutual fund scandal of the early 2000s, and an awful lot of fund manager and executive turnover this company has never been the same.  I’m not saying PIMco will follow suit, but the potential parallels are there.

My strategy is simple.  I plan to watch the overall situation with the firm and to continue to evaluate my client’s PIMco holdings in the same fashion as before this announcement.  In my opinion this management shake-up is not a cause for any immediate or drastic action, but time will tell.

Personnel issues with a mutual fund and or its parent company are a valid reason to place a fund or a family of funds on your watch list.  This is generally a component of an Investment Policy Statement.  Do you have an orderly due diligence process in place to react to changes in your mutual funds and those in charge of managing them?

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your financial planning and investing questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services. 

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7 Reasons to Consider Selling a Mutual Fund

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Investing in mutual funds takes work, even index funds. Whether you own actively managed funds or index funds you still need to monitor your holdings. Here are 7 reasons you might consider selling a mutual fund holding.

Sale

A significant outflow of dollars

In my view, mutual fund managers should try to stay fully invested within their investment mandate. If I am investing in mutual fund in the large growth style, I want those dollars invested in large cap growth stocks.  I don’t want an equity fund manager deciding to be in cash, if I want to be in cash I’ll put that portion of the portfolio in a money market fund.   When a mutual fund experiences a high level of redemptions the managers may need to keep more cash on hand to meet these redemptions. This cash is not being invested in the stocks, bonds or other vehicles that the fund should be focused on.  In an up market like this one excess cash can be a drag on returns.

A significant inflow of dollars

Money follows success. Last year’s hot fund will attract more investors hoping to latch on to the fund’s success. Too much new cash in a short time frame can pose a real problem for a fund manager in terms of finding good investment ideas within the fund’s investment style.

This is not as significant for an index fund or a fund that invests in larger cap stocks.  However, for a fund investing in small- or mid-cap stocks this can be a death knell in terms of future success. I really admire mutual fund companies who close popular funds when they become too large.  Two that come to mind are Sequoia Fund (SEQUX) which was closed for over 20 years at one point and recently closed again after reopening for a couple of years (purchases can only be made directly from the fund company last time I checked).  Another is Artisan Funds and their Artisan Mid Cap Value Fund (ARTQX).  The mention of these funds should not be construed as investment advice in any way, shape, form. 

The flip-side is funds that simply allow new money to come in droves.  All too often these once stellar performers become tomorrow’s laggards.  I don’t know if this behavior is born out of stupidity, greed, hubris, or all three.  At the very least a fund taking in a vast amounts of new money should be raise a red flag as you monitor your portfolio. 

 A change in personnel

For an actively managed fund, a manager change is a significant event. Who will be in charge going forward? Will the fund’s investment style stay the same? This can also be an issue for an index product in terms of a change in its indexing methodology.

Personnel issues in the management of the fund company can also be an issue. As an example once high-flying Janus Funds has experienced heavy turnover in the executive suite over the past decade.  There has also been a fair amount of management turnover in many of the company’s mutual funds.  I find it hard to believe that this doesn’t have an impact on day to day operations and the management of the funds.

A change in the fund’s investment style  

I alluded to shifting investment styles above, but it’s worth repeating.  For example I recently suggested to the Committee of 401(k) plan for whom I serve as investment advisor that we remove a mutual fund whose investment style had shifted along with their investment methodology and some of the fund’s personnel.  While there’s nothing wrong with a go-anywhere fund that is style agnostic, if your intent is to invest in a mutual fund that invests in small cap growth stocks you should consider replacing that fund if its investment style changes to say small cap blend or value.

Fund mergers

Mutual fund companies sometimes merge laggard funds into other mutual funds within their families.  There are rules about restating past results for the surviving fund, but nonetheless if this happens to a fund you own, or recently took place in one you are thinking of buying, be sure to dig into the details, holdings and performance of the surviving fund to be sure it still makes sense for you as a part of your portfolio.

The reasons listed above generally warrant selling out of mutual fund entirely.  Here are two additional reasons to consider a total or partial sale that have nothing to do with negative developments with the fund. 

Donating appreciated fund shares 

As year-end approaches many of us look to make contributions to our favorite charities.  If you own shares of a mutual fund that has appreciated in value donating some or all of the shares to the charity is an excellent and tax-efficient way to make this contribution.  By donating appreciated shares owned in a taxable account (as opposed to a tax-deferred account like an IRA) you avoid paying capital gains taxes that would be due if the shares were simply sold.  You also receive a charitable deduction for the full market value of the shares donated.  Many charities have the capacity to receive donations in this fashion. 

Rebalancing your portfolio 

I generally suggest that most people look to rebalance their portfolio back to its intended asset allocation at least once or twice annually.  For example with the solid gains in most equity asset classes this year and the relatively flat to down performance of many fixed income asset classes, it is likely that your portfolio is over allocated to equities.  This potentially exposes you to more risk than your financial plan and your asset allocation calls for.  It is very appropriate in this case to sell off some of your mutual fund (or other investments) holdings where you are over allocated and adding to fund positions in areas of the portfolio that have become under allocated. 

I am not an advocate of the frequent buying and selling of mutual funds or any other investment vehicle for that matter.   However, mutual fund investing is not about sending in your money and forgetting about it. Successful mutual fund investors monitor their holdings and make changes when and if needed based upon a number of factors.  

Please contact me at 847-506-9827 for a complimentary 30-minute consultation to discuss all of your financial planning and investing questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.

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Mutual Funds and The Rolling Stones: Time is on Their Side

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The Rolling Stones' "Tongue and Lip Desig...

One of the Rolling Stones’ greatest hits is called Time is on My Side.  Given the potential impact that the passage of time will have on the trailing five year returns of many mutual funds  by the end of 2013, the fund companies should be singing this song as well.

In a recent article on Market Watch Chuck Jaffe highlighted this quirk as cited by Morningstar.  According to Jaffe and Morningstar:

“For example, the average large-cap growth fund entered September with a five-year annualized return of 6.38%, according to Morningstar Inc. If the market simply stays flat and the average fund stands still to the end of the year, that five-year average will be 9.2% once September is wiped off the books, and will reach 15.16% by the end of the year.” 

As a case in point, the Vanguard Growth Index (VIGSX) fund’s five year annualized return as of June 30, 2013 was 7.15%.  At the end of the most recent quarter ending September 30, 2013, the fund’s five year annualized return stood at 11.73%.  This is a combination of fund’s 11.99% loss for the third quarter of 2008 dropping off of the five year record and the addition of the fund’s very solid gains of 8.48% for the most recent quarter.

If we carry this forward, at the end of the 2013 the loss of 23.81% for the fourth quarter of 2008 will fall off of the fund’s five year track record.  As Jaffe and Morningstar indicated even a flat return in the fourth quarter of 2013 will result in a significant jump in the fund’s trailing five year track record at the end of 2013, erasing a large portion of the financial crisis from the track record of this and many funds.

A marketing boon for mutual fund companies 

Just like the folks who market breakfast sausage, cars, or life insurance, mutual fund marketers are paid to accentuate the positive aspects of investing in their funds.  The mere passage of time will result in a marketing boon for these folks.

Be leery of the facts

If a mutual fund company touts the fund’s sheer numerical return, this is pretty meaningless.  Mutual fund returns should be viewed in the context of the fund’s peer group.  For example an average annual five year return of 10% might sound great, but not if 90% of the other funds in this same investment category (peer group) did better than that.

Further look at the fund’s risk-adjusted returns.  Did the fund take inordinate risks to achieve their returns, or did they do this with less risk than the average fund?

The past may not be a good indicator of the future

Past returns are not an indication of future results is a standard disclaimer in our industry.  The past is the past.  Many things can change.  Perhaps the fund manager who racked up this stellar track record has moved on.  In the case of small and mid cap funds, gathering too much money to effectively manage can be an issue and is often the result of outstanding performance.  Money has a habit of chasing returns.

Don’t be fooled by the hype that will surely surround these returns on steroids.  Always analyze any mutual fund’s results in terms of the potential implications of this performance and structure on future relative performance.

Please contact me at 847-506-9827 for a free 30-minute consultation to review your mutual fund holdings and to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services. 

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Are Best Mutual Fund Lists a Good Investing Tool?

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Money (magazine)

We all like to read lists that rank things.  Top colleges, top new cars, best and worst dressed and the like are just a few lists we see periodically.  Mutual rankings have been around for awhile.  Many top personal finance publications such as Money Magazine, Kiplinger’s, and U.S. News (for whom I am a contributing blogger) publish such lists that rank mutual funds based upon performance.  Are these Best Mutual Fund lists useful to you as an investor?

Best compared to what? 

In order for any mutual fund ranking tool to be useful the comparison needs to be apples-to-apples.  Comparing a large cap domestic stock fund to a fund that invests in gold mining companies is a pretty useless exercise.  Make sure that you understand what is being compared and the basis for the rankings.

Past performance is not an indication of future performance 

This is a pretty common disclaimer in the investment industry and it is one that should be heeded.  Last year’s top mutual fund might finish on top again this year or it might end up at the bottom of the pack.  This is especially true for actively managed mutual funds where results can often depend upon the manager’s investment style.

Who’s in charge? 

It is not uncommon for a top mutual fund manager to be wooed by a rival fund company or for them to go off and start their own mutual fund.  This is not such a big deal with index funds, but when looking at any actively managed fund be sure to understand whether or not the manager(s) who compiled the enviable track record are still in place.

What period of time is being used? 

Make sure that you understand the time period used in the rankings.  Returns over a single year can vary much more than returns compiled over a three, five, or ten year time period.  Additionally understand that one or two outstanding years can skew longer-term rankings.  Longer periods of time tend to smooth out these blips in performance.

Why didn’t you tell me about this fund a year ago? 

I recall looking at many of these lists over the years and wondering why the publication didn’t write about how wonderful the fund was a year ago before it chalked up this large gain.  Well the answer is that this isn’t the job of the publication and they and most of us can’t really predict this.

Is looking at performance worthless? 

No it isn’t but you need to look at performance in context.  As a financial advisor I look at performance over varying time periods and always in relation to the fund’s peers.  Among the things we look at:

  • Risk adjusted performance
  • Performance in up and down markets
  • Performance over rolling periods of time
  • Adherence to the fund’s stated style
  • Costs and expenses
  • Consistency of relative performance
  • Changes in the level of assets in the fund

In short selecting and monitoring mutual funds is about more than looking for the top performers of the past.  Like any other investment vehicle mutual funds need to be viewed in terms of potential future performance and in terms of how they fit into your overall investment strategy and your financial plan.

Please contact me at 847-506-9827 for a free 30-minute consultation to review your mutual fund holdings and to discuss all of your investing and financial planning questions. Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.    

Check out Morningstar to evaluate your current mutual funds or any that you may be considering.  I use both their basic website and one of their advisor workstation programs every day.


Morningstar Stock Fund Investment Research

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Understanding Your Bond Fund’s Duration

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Interest Rates

For most of the past 30 years bonds and bond mutual funds have had the proverbial wind in their sails.  However with interest rates at historic lows it is unlikely that bonds will perform as well over the next few years.  Perhaps we are beginning to see some of this based upon the losses sustained by many bond funds over the past few weeks.  Many investors are wondering if it is time to get out of bond funds.  A key number that all holders of bond mutual funds and ETFs must know and understand is the fund’s duration.

What is duration? 

According to Morningstar, “Duration is a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.”  A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond.  A bond’s duration is expressed in years and is generally shorter than its maturity.

What does duration tell us? 

The popular bond fund PIMco Total Return (ticker PTTRX) has an effective duration of 4.73 years according to Morningstar.  This tells us that if interest rates rise by 1% the value of the underlying bonds held by the fund would likely decline by around 4.73%.  Note this number is an approximation and bond prices can be impacted by factors other than changes in interest rates.

By comparison the T. Rowe Price Short-Term Bond fund (ticker PWRBX) has shorter duration of 1.69 years and would see less of an impact from rising interest rates.

The Vanguard Long Term Bond Index fund (ticker VBLTX) has a duration of 14.71 years and would see a serious decline in value should interest rates rise.

What should I do now?

As I mentioned above duration is a good indicator of the impact of a change in interest rates upon the value of your bond fund, but other factors also come into play.  As an example in 2008 many bond funds saw outsized losses and investors moved their money into Treasuries as a safe haven during the financial meltdown.  Many high quality bond funds suffered major losses that year based only upon this flight to quality by investors.  A case in point was Loomis Sayles Bond (Ticker LSBDX) which lost almost 22% that year.

Bonds are traded on the secondary market and prices are a function of supply and demand much like with stocks.  Additionally part of a bond’s total return is also the interest paid.

Bond mutual funds and ETFs offer the advantage of a managed portfolio.  On the flip side unlike an individual bond, mutual funds and ETFs never mature.  I’ve recently read arguments for both types of fixed income investment approaches in the face of this new world for bonds.

Is it time to get out of bond funds?  The point of this article is not to advocate that you necessarily do anything differently, but rather that you understand and evaluate the potential duration risk in any bond mutual funds or ETFs that you currently hold or may be considering for purchase.  Bonds still have a place in many diversified portfolios, but for many investors the characteristics of the fixed income portion of their portfolios may need an adjustment.  This might mean shortening up on bond durations and looking at other, non-core types of bond funds.

The landscape of the financial markets is continually evolving and the potential for rising interest rates is another phase in this evolution.  As investors we need to understand the potential implications on our portfolios and adjust as needed.

Please feel free to contact me with your investing and financial planning questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.  

For you do-it-yourselfers, check out Morningstar.com to analyze your bond mutual fund and ETF holdings and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

Photo credit:  Flickr

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Pens, Trinkets, and Mutual Funds

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McCormick Place

With the annual Morningstar Investment Conference coming up here in Chicago next week, my thoughts naturally gravitate to replenishing my office supply of high quality pens in the exhibit hall at McCormick Place.  Truth be known, my thoughts are more focused on preparing for my participation on a panel on Friday morning called Practical Solutions for a Challenging Retirement Landscape.  Morningstar’s superstar financial author and columnist Christine Benz was kind enough to invite me to participate in this discussion along with representatives from T. Rowe Price and Vanguard.

Pens and Trinkets

Ever since the first financial conference I attended in the mid 1990s I’ve never ceased to be amazed by the number of items that mutual fund providers and other financial services vendors can find to stick their names and logos on.  When my kids were younger they were the only ones in their school with backpacks from places like the Philadelphia Commodity Exchange and the London Stock Exchange.

At one point I had a whole section of T-shirts from defunct mutual fund companies like Strong and Berger.  Add an infinite number of logoed tote bags and baseball hats and you get the picture.  Our kids always liked the stress balls I found at many of the booths (we were obviously tough parents).

In recent years I’ve tried to be more practical at Morningstar and other conferences and focus on gathering a supply of pens for the office.  I always grab as many as I can because my wife and kids always seem to be on the prowl for these as well.

While strolling around the exhibit hall at last year’s conference I was really making a great haul on pens when it suddenly hit me:  There are a lot of companies that offer mutual funds and I’ve never heard of many of them.  And I’m a financial advisor.

How many mutual funds are there? 

According to the Investment Company Institute there were 7,596 mutual funds at the end of 2012.  This is down from the high of 8,305 at the end of 2001.  Add in 602 closed-end funds and 1,194 ETFs and there are lots of choices for investors.

How do you choose the right funds? 

Any selection of mutual funds, ETFs, or any other investment vehicle should start with an investment plan, which is ideally an outgrowth of your financial plan.  Once you have an asset allocation strategy you will want to fill these allocation buckets with funds and ETFs that are appropriate for your situation.

Here are six mutual fund selection mistakes to avoid:

  • Assuming that a “brand name” fund from a well-known fund family is automatically a good investment choice.
  • Relying on lists of top mutual funds from popular magazines or websites.
  • Ignoring a fund’s history.
  • Avoid mutual funds from fund issuers that you’ve never heard of.
  • Assume that all index funds are created equally.
  • Assume that mutual fund companies automatically have your best interests at heart.

Some additional considerations in selecting mutual funds and ETFs:

  • Expenses matter.
  • When using an index product make sure that you understand what index the fund is tracking and that it tracks that index closely.
  • Avoid actively managed funds that are nothing more than closet indexers.
  • When building a portfolio understand the concepts of diversification and correlation.
  • Understand why you are choosing a given fund or ETF, where it fits in your portfolio, and what would cause you to eliminate this holding.

The Morningstar Investment Conference is a great place to catch some excellent educational sessions and to talk to fund and ETFs issuers to learn about their products.  I would be remiss in not mentioning the great work done by Leslie Marshall and her team from Morningstar in staging this conference.  The fact that it always runs smoothly is a tribute to Leslie’s organizational and management skills.

Please feel free to contact me with your investing and financial planning questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.   

For you do-it-yourselfers, check out Morningstar.com to analyze your mutual funds and ETFs and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

Photo credit:  Flickr

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Investing: Even Indexing Takes Work

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INDEX IIM Lucknow Logo

The benefits of low-cost index mutual funds and ETFs are all over the news.  They were front and center in the recent PBS Frontline Special The Retirement Gamble.  Index funds are a great tool for investors of all ages; in many cases these passively managed funds beat the majority of their actively managed peers within the same investment style.  However, investing in index funds takes work, especially with the proliferation of new index products that continue to hit the marketplace.

Expenses matter 

Costs matter when investing.  One of the biggest lures of index fund investing is that many of these products provide a low cost way to investment in a given segment of the market.  If you are looking for an index fund that mimics the S&P 500 there are many great low cost alternatives such as the Vanguard 500 Index Fund (Ticker VFINX) with an expense ratio of 0.17% or the SPDR S&P 500 Index ETF (Ticker SPY) with an expense ratio of 0.09%.  On the other hand, there is also the Rydex S&P 500 A (Ticker RYSOX) with its expense ratio of 1.51%.  How big of a deal is this difference?

A $10,000 investment in the Vanguard 500 fund made on May 31, 2006 and held until May 15, 2013 would now be worth $15,064.  That same investment in the Rydex S&P 500 fund would be worth $13,798 or 9.2% less for an investment in a mutual fund tracking the same index as the Vanguard fund. 

Understand the underlying index 

In the wake of the 2008-2009 market downturn new index products, especially in the ETF space, have proliferated.  ETF providers are falling all over themselves to bring new index products to the market hoping to attract assets.  Like any investment, investing in an index fund or ETF requires that you understand what it is that you are buying.

When I think of indexing I think of the traditional, basic index products that track benchmarks such as the S&P 500, the total U.S. stock market, the total non-U.S. market, the domestic bond market, etc.  Additionally I typically use index funds to benchmark the U.S. small and mid cap equity spaces, real estate, and emerging markets equity among others.

Several months ago Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”  

As an investor this should be a huge red flag.  What this study says is that many of these new index products were developed much like the monster in the Mel Brook’s classic Young Frankenstein.  Look back-testing is not inherently bad and many of these new index products are appropriate for professional traders.  However if you are looking to index in the fashion that Vanguard founder John Bogle and others espouse then you should consider sticking with index products that track known, battle-tested market benchmarks.

Asset allocation is still vital 

Whether you use index products as a portion of your overall portfolio in conjunction with other investment vehicles such as actively managed mutual funds or individual stocks, or if you invest in index funds exclusively you still need to develop and asset allocation for your portfolio.  As I say frequently on this blog, this should be done as an outgrowth of your financial plan.

Even a seemingly simple strategy of investing in a total U.S. stock market fund, a total international stock market fund, and a total bond market fund still requires that you determine how much to invest in each fund, that you monitor your allocation and rebalance when needed, and that you review and adjust your target allocation as you age or if your situation changes.

Index funds and ETFs are a great investment tool.  Like any tool it is important that you select the right index product and that you manage your portfolio properly.

Please feel free to contact me with your investing and financial planning questions.  Check out our Financial Planning and Investment Advice for Individuals page to learn more about our services.  

For you do-it-yourselfers, check out Morningstar.com to analyze your index mutual fund and ETF options and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.  

Photo credit:  Wikipedia

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