Objective information about financial planning, investments, and retirement plans

What Do ETFs and Youth Soccer Have in Common?

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Another sign of spring here in the Chicago area is the appearance of lines on the local youth soccer fields.  All three of our kids played soccer and we still miss watching them play.

So what do ETFs and youth soccer have in common?  From our experience as the parents of three travel soccer players, including one who was a ref for several years, very few parents understand the rules of the game which sadly too often leads to some really bad behavior on their part.  From many of the questions that I get and from what I read many investors don’t understand ETFs all that well either.  This post will attempt to highlight some of the basics of ETF investing for those readers who may be unclear or have a few questions.

(One example of some over the top soccer parents occurred when our now 23 year daughter was playing in a 9 year old game.  Some parents from the other team came over to our side of the field and started a fight.  My wife ended up as a witness in soccer court and two dads ended up being banned from any Illinois youth soccer game or practice for two years.) 

 

 

What is an ETF? 

According to the NASDAQ site:

“In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market, they try to be the market. 

ETFs have been around since the early 1980s, but they’ve come into their own within the past 10 years.”

In simple terms ETFs are essentially mutual funds that trade on the stock exchanges much like shares of common stock such as Apple or IBM.  They are bought and sold during the trading day just like stocks.

While it is true that the first ETFs were index tracking products, actively managed ETFs are coming into play with perhaps the most successful active ETF so far being the ETF version of PIMco’s Total Return bond fund (ticker BOND).

Advantages of ETFs 

ETFs have several features that are advantageous to investors:

  • Most ETFs are transparent as to their holdings.
  • ETFs can be bought and sold during the trading day.
  • Stop orders can be used to limit the downside movement of your ETFs.
  • ETFs can also be sold short just like stocks.
  • Many of the index ETFs carry low expense ratios and can be quite cheap to own.
  • Due to their structure, many ETFs are quite tax-efficient.
  • ETFs provide a low cost, straightforward way to invest in core market indexes. 

Disadvantages of ETFs 

  • ETFs can be bought and sold just like stocks.  In some cases this could cause investors to trade in and out of ETFs when perhaps they shouldn’t.
  • The popularity of ETFs has caused ETF providers to introduce a proliferation of new ETFs, some are excellent, some not so much.  Many new ETFs are based on untested indexes that have only been back-tested.  Additionally there are a number of leveraged ETFs that multiply the movement of the underlying index by 2 or 3 times up or down.  While there is nothing inherently wrong with these products they can easily be misused by investors who don’t fully understand them.
  • Trading ETFs generally entails paying a transaction fee, though a number of providers have introduced commission-free ETFs in order to gain market share. 

All ETFs are not created equal 

Much of the growth in ETFs was fueled by basic index products such as the SPDR 500 (ticker SPY) which tracks the S&P 500 index.  Vanguard, ishares, and the SPDRs all started with products that tracked core domestic and international stock and bond indexes.  The popularity of ETFs grew in the wake of the financial crisis and ETF providers have been falling all over themselves to bring new ETFs to market.

Some of these new vehicles are good, but others track questionable indexes or benchmarks.  These products are essentially made up in a lab, reminiscent of Gene Wilder, Terri Garr, and Marty Feldman in Young Frankenstein.

There is a site with an ETF Deathwatch section listing various ETFs and other exchange traded products that are on life support.  This Bloomberg article comments on some ill-fated ETFs as well.

Free trades are good or are they? 

Fidelity and Schwab most notably have offered platforms that allow commission-free ETF trades for their own branded ETFs and a select menu of other ETFs.  This is fine as long as these are the ETFs that you want to own.  Note I’ve found that several of the Schwab ETFs are very low cost and track core indexes so they can be good choices.

Additionally you can trade Vanguard’s ETFs commission-free if you trade in an account at Vanguard.

At the end of the day you should buy the ETFs that are best for your situation.  This assessment should include the underlying ETF benchmark, the expense ratio, and the liquidity.  If you can trade it commission-free so much the better.

Overall ETFs can be a great investment vehicle for both traders and long-term investors.  As with any investment vehicle it is incumbent upon you to understand what you are buying and how it fits into your investment strategy.

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.

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I use Morningstar extensively for investment research and portfolio analysis in my practice.  While I have subscribed to several of their services geared to financial advisors over the years, I have maintained my premium subscription to morningstar.com.  Click on the banner (also an affiliate link, no extra cost to you) below to get a free trial for their wide array of premium services which includes extensive research and information about ETFs.


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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.

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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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1% a Small Number with Big Implications

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Percent Symbols - Best Percentage Growth or In...

The inspiration for this post comes from fellow finance blogger and financial advisor Jim Blankenship and his November is “Add 1% to Your Savings Month” movement.

It’s amazing how a small number like 1% can have such a big impact on your investments and the amount you’ll be able to accumulate for goals like retirement.  Here is a look at the impact of saving 1% on your investment expenses.

Mutual fund expenses matter

Using two share classes of the American Funds EuroPacific Growth fund as an example, the chart below illustrates the impact of 1% in expenses on the growth of your investment.  I was able to find two share classes of this fund whose expense ratios were exactly 1% different.  The B shares (ticker AEGBX) carry an expense ratio of 1.59% and the F-2 shares (ticker AEPFX) which carry and expense ratio of 0.59%.  Using Morningstar’s Advisor Workstation I compared the growth of a hypothetical $10,000 investment in each fund held over three time periods.

5 years ending 10/31/13 

Value of $10,000 investment
B Shares $17,710
F-2 Shares $18,606

 

As you can see varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $896 a 5.1% increase over an investment in the B share class.

10 years ending 10/31/13

Value of $10,000 investment
B Shares $22,677
F-2 Shares $24,734

 

Again varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $2,057 a 9.1% increase over an investment in the B share class.

From 4/30/84 through 10/31/13 

Value of $10,000 investment
B Shares $205,652
F-2 Shares $260,042

 

Once again varying nothing more than the expense ratio in these otherwise identical mutual funds, investing in the fund with a 1% lower expense ratio resulted in the accumulation of an additional $54,390 a 26.4% increase over an investment in the B share class.

A couple of things about the above comparison:  The assumption is that an investor put $10,000 into each of the funds and held them for the full time period, including the reinvestment of all fund distributions.  Any potential taxes or the expenses of engaging an investment advisor were not considered.  Further B shares are no longer available to new investors and even when they were they would generally convert to the less expensive A shares after a period of time.  None the less this comparison illustrates the impact saving 1% on your investment expenses can have on your returns and the amount you can potentially accumulate over time. 

How to reduce investing expenses 

While you may not always be able to save a full 1%, reducing your investment expenses by even a fraction of 1% can have a significant positive impact.  Here are some ideas that may help:

  • Utilize low cost index mutual funds and ETFs where possible and where they fit your investment strategy.  In many asset classes index funds outperform the majority of actively managed products.  Combine this with low expenses and index funds have a major leg up on most of their competitors.
  • In all cases make sure that you invest in the lowest cost share class of a given mutual fund that is available to you.
  • Avoid sales loads whenever possible.
  • Understand the expenses associated with the investment choices in your company’s 401(k) plan and the plan’s overall expenses.  If they are excessive consider asking your company’s plan administrator to look at some lower cost alternatives.  You might also  consider limiting your contributions to the amount needed to receive the maximum company match (if one is offered) and invest the remainder of your retirement savings elsewhere.
  • If you work with a financial advisor you must fully understand all of the ways in which your advisor makes money from your relationship.  This might include fees (hourly, flat-fee, or a percentage of assets).  In some cases the advisor makes money from the investment and insurance products they sell to you.  This can include up-front sales commissions (loads), deferred loads (B shares which are mostly obsolete), and level loads (C shares).  Additionally the advisor may make money from trialing commissions (12b-1 fees) or surrender charges incurred if your sell out of some mutual funds or annuity products too early.  If you are a regular reader of this blog you know that I am horribly biased in favor of using fee-only advisors (of which and I am one), avoiding the inherent conflict of interest that can arise when an advisor earns money from the sale of financial products. 

Saving 1% might seem like a trivial endeavor, but as you can see it can have big ramifications for investors.

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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ETF Price Wars: A Good Thing or Just More Hype?

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Fidelity has fired another salvo in the ongoing ETF price wars with the introduction of a number low cost sector ETFs.   Schwab, TD, Blackrock, Vanguard, and others have also participated in this price war in one form or another over the past couple of years.  Low ETF expenses and low or no transaction fees are a good thing, but should they be the deciding factor in your decision where to invest?

Walmart on Black Friday 2009

Understand what you are buying 

As we’ve learned from the PBS Frontline special The Retirement Gamble among other sources, low investment costs are a key determinant accumulating a sufficient retirement nest egg.  The first and most important factor in choosing an ETF to include in your portfolio is to understand what the ETF invests in.

An ETF that tracks an index such as the S&P 500 is pretty simple.  However ETF providers are introducing new products seemingly every day.  According to Chuck Jaffe in a MarketWatch article, a Vanguard report found that “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.”

Beyond commissions and expense ratios 

Fidelity recently published an excellent piece on its site, Beyond Commissions: An ETF’s Price Matters.  According to the article:

“Commissions aren’t the only cost to consider when buying an ETF. Most investors compare expense ratios, but a less appreciated—yet important factor—is the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for an asset (bid) and the lowest price at which a seller is willing to sell (ask). While investors should consider the Net Asset Value (NAV) of an ETF, the price you pay is a seller’s ask price, which can be at a discount or premium to the NAV.

“It’s important to remember that not all ETFs are created equal,” says Ram Subramanium, president of Fidelity brokerage services. “So, investors may want to look for ETFs with established track records and low bid-ask spreads relative to their peers.”

As an interesting aside here, one of the low cost sector ETFs that Fidelity recently introduced was its materials ETF Fidelity MSCI Materials ETF (FMAT).  This ETF competes directly with the Vanguard Materials ETF (VAW) and has an expense ratio of 0.12% vs. 0.14% for the Vanguard ETF.  However the recent bid/ask spread for the Fidelity ETF was 11.68% vs. 1.57% for the Vanguard ETF (according to Morningstar).  The passage above from the Fidelity article might indicate that the older, more established Vanguard ETF is a better choice here.

Other factors to consider

  • Unless you are a frequent trader or you are purchasing ETFs in small dollar amounts trading commissions really shouldn’t be a major factor in your ETF investing decisions.
  • Consider the full breadth of the investment products available to you as well as your investing objectives when choosing an investment custodian.  ETF price wars are much like loss leaders in retailing.  Major custodians such as Fidelity are using low cost ETFs to get you in the door and to hopefully entice you to use their services to invest in mutual funds, stocks, and other investment products via Fidelity.
  • Are the commission-free ETFs the right ones for your portfolio?  For example a number of the ETFs offered on Schwab’s commission-free platform are not ones that I would generally choose for my client’s portfolios.
  • How cheap is cheap?  I doubt that selling one ETF and buying another to save say 0.02% on the expense ratio makes sense, especially if there are transaction costs or capital gains to consider when selling.
  • How well does the ETF track it’s benchmark index?  I’m often surprised by the variations when comparing two ETFs that I would assume to be identical other than the name of the ETF provider.

Are ETF price wars a good thing for investors?  Yes.  Are ETF price wars being used by major custodians and ETF providers to create hype in the financial press in order to lure investors?  Again yes.  The bottom line here is that your financial plan and investment strategy should guide your choice of ETFs, mutual funds, or any investment vehicle, not a slightly lower cost or the lure of free trades.

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.   

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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.


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5 Things You Should Know About ETFs

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English: Wall Street sign on Wall Street

ETFs continue to gain ground as an investment of choice among many individual and institutional investors.  ETFs are similar to mutual funds in that they are pooled investment vehicles and to closed-end funds in that they are traded on a stock exchange like individual stocks.  ETFs, though popular, are often misunderstood by investors.  Here are 5 things you should know about ETFs.

Not all ETFs use conventional underlying benchmarks

The first ETFs were largely index products such as the SPDR S&P 500 (ticker SPY) which tracks the S&P 500 index.  SPY remains one of the most traded ETFs day and day out in terms of volume.

An ETF like SPY is pretty easy to understand.  The underlying holdings mirror the S&P 500 index and performance generally tracks the index less the ETF’s expenses (0.09% according to Morningstar).

With the popularity of ETFs, the growth and proliferation of new vehicles is quite high.  Many of these new ETFs track some “funky” benchmarks.   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.”   

I suspect this issue will become more prevalent as ETF providers continue to introduce new ETFs in a bid to capture market share and assets.

Some ETFs are based on fads or gimmicks 

The Winklevoss twins (of Facebook fame) recently announced the proposed launch of a new ETF tracking Bitcoin.  Bitcoin is virtual currency that exists outside of governmental regulation.  The ETF faces many hurdles and may never get off of the ground.

Should the ETF ever become available for trading this would be the ultimate in gimmicky ETFs.  I find Bitcoin itself a bit hard to understand.  An ETF tracking this at best undeveloped market would in my mind be a stretch.  As an investor this is the type of ETF that I would seriously question.

There are any number of ETFs and other Exchange Traded Products (ETPs) that just don’t work out.  You can find many of these on the monthly ETF Deathwatch listing.

ETF Liquidity is complicated.

With stocks liquidity and the trading volume of the equity are closely correlated.  While a thinly traded ETF might result in a little less liquidity the real determinant of liquidity with an ETF is the liquidity of the underlying investments that make up the ETF.

For example the SPDR S&P 500 is made up of the 500 largest domestic stocks.  These stocks are highly liquid and generally all have substantial daily trading volume.

By contrast we’ve seen some fairly wide spreads between the underlying net asset value and the market prices of some emerging market ETFs of late.  This is in large part a function of a lack of liquidity of the underlying holdings of these ETFs.

Not all ETF structures are identical

Vanguard’s ETFs are structured as another share class of their mutual funds in most cases.  Many popular ETFs are structured as open-end funds, others are structured as Unit Investment Trusts (UIT).  Many single commodity ETFs are structured as Grantor Trusts.  Exchange Traded Notes (ETN) are actually debt instruments linked to the performance of a currency, a commodity, or an index.

Each of these structures have different characteristics and these characteristics may have an impact on the tax treatment of gains or distributions.  For example some commodity based ETFs have a different ongoing tax treatment than say an equity-based index ETF.

It is important that you understand any such factors of your ETF or ETN to avoid nasty surprises at tax time or undo risks that may be associated with the product’s structure. 

Free commission ETFs may not be the best deal for you 

Schwab, Fidelity and others are offering a number of ETFs that trade commission free.  That’s a good thing, but before jumping on one these offers make sure the ETFs offered for free are the best deal for you.

The benefit of free commissions can quickly be negated by high ongoing expenses.  Trading costs are relatively low at most online and discount brokers so unless you are a frequent trader this really shouldn’t be a factor in the decision as to which ETFs belong in your portfolio.

Additionally buying an ETF that doesn’t fit your investment objectives just to save a few dollars in trading costs is absurd.

ETFs can offer a low cost vehicle to build a portfolio.  I use index ETFs extensively for their low costs and adherence to an investment style as a key building block in my client asset allocation strategies.

Like anything else, however, it is vital that you understand what you are buying and that you invest in ETFs that are appropriate for your investment plan.

I want to thank local ETF expert Christian Magoon for his contributions to this post. 

Please contact me at 847-506-9827 for a free 30-minute portfolio review consultation 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.   

For you do-it-yourselfers, check out Morningstar.com to analyze your ETF and all of your investments 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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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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Forget Retirement Seek Financial Independence

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This is a guest post by author and financial journalist Jonathan Chevreau.  Jon is editor of MoneySense Magazine and the author of the book Findependence Day.  

While the media and the financial services industry seem equally obsessed with the concept of retirement, there is in myFindependence Day Book from Jonathan Cheverau view a better more practical goal: one that is far less intimidating for newer investors just starting on their life and financial journeys.

Financial Independence vs. Retirement

This goal is Financial Independence or the short-form I’ve coined that means the same thing: Findependence. Note that Findependence is NOT synonymous with retirement.

Financial independence can and probably should precede traditional retirement by a decade or two. In these days of clean and healthy living and good prospects for longevity, it makes little sense to take “early” retirement in one’s 50s, if you define what follows as 30 or 40 years of doing little more than watching daytime television, playing golf and sailing.

By contrast, no age is too soon to establish findependence: if you can do so in one’s mid 20s, that’s a good thing, and many technology entrepreneurs have done just that: from Steve Jobs to Mark Zuckerberg to Tumblr founder David Karp, who just sold out to Yahoo at the tender age of 26. The first two did not stop working once their early payday arrived and I’m sure that will also be the case with America’s newest multi-millionaire, Mr. Karp.

What is Findependence?

As I note in my book Findependence Day, Findependence just means that total income from multiple sources – pensions, investments, rental income, employed or part-time work, etc. – exceeds earned income from the traditional sole employer.  I define Findependence Day as the day in the future when this magical moment arrives: henceforth you may continue to do exactly the same thing as before, except that deep down you know that you are choosing to continue to work, rather than feeling that one has no choice but to do so because of financial pressure.

To me, early findependence is a good thing, while early retirement may or may not be. Findependence means having the freedom and flexibility to pursue one’s heartfelt goals and dreams, without having to make financial compromises merely to make ends meet. Ideally, you want to achieve financial independence “while you’re still young enough to enjoy it,” which happens to be the sub-title of the new U.S. edition and e-book version of the book, which came out in April. (See www.findependenceday.com ).

For financial planners and investment advisers, such a paradigm shift would I think benefit their clients: average consumers and investors who use their services. And financial planning is a big component – fully a third – of what I’ve dubbed the Findependence Day model.

The other two aspects are online discount brokerages and index investing: either through index mutual funds or exchange-traded funds. And when I say financial planning, I mean primarily fee-only planning, although it can also encompass fee-based planning at least while clients are in transition from the traditional model to this mode of planning and investing.

In these days of ultra-low interest rates and volatile stock returns, I believe costs matter more than ever. Online or discount brokerages are one way investors can reduce transaction costs, while ETFs and index funds facilitate prudent diversification while minimizing investment management costs. But the third aspect of the model is also important, despite the perception by many that so-called do-it-yourself investors buying their own ETFs at online brokerages are in no need of third-party advice.

It’s true that in these days of online investing and so many online tools, financial blogs and social media, that do-it-yourself investors are more empowered than ever to make more of their own investment decisions. But there’s no reason why they can’t add a layer of financial advice, albeit on their own terms, and I believe the best of all worlds for such investors is through fee-only financial planners, the kind that can be found through NAPFA (the National Association of Personal Financial Advisors.)

In other professions, it’s perfectly natural for consumers to engage lawyers, accountants or physicians on a la carte basis, paying only for services as they are contracted for and provided. It shouldn’t be such a big leap for consumers to view the acquisition of financial advice in the same way, negotiating with the planner for a comprehensive financial plan at such and such a set price, or agreeing to tax and estate planning services on an hourly basis, or perhaps through monthly or quarterly retainers to monitor ETF portfolios and rebalance them yearly.

That to me is what financial independence is all about: a partnership with a financial life coach whose vision of your future findependence is perfectly aligned with their own values and skill-sets. You’re reading this guest article on the blog of just such a professional and I thank Roger for the opportunity. And by the way, the book – which some have described as a financial love story – is set in part in Chicago, which is where the action begins.

Jonathan Chevreau is editor of MoneySense Magazine and can be reached at jonathan@findependenceday.com.  His book Findependence Day  is available at Amazon.com, Barnes & Noble.com and Trafford.com.  Jon is a must follow on Twitter. 

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.  

Ignore These 5 Investing Lessons at Your Own Risk

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Little Book of Common Sense Investing

The stock market is in the midst of a 4+ year rally that has led to all-time highs for major market benchmarks.  It’s a bit of a strange rally in that the percentage of U.S. households owning stocks is at historically low levels.  Couple this with the raging market bulls we see on shows such as CNBC and it’s easy to see why many investors are confused as to how to precede.  Here are 5 investing lessons to keep in mind as you move forward.

Risk matters 

The potential downside risk should be a key consideration on how you allocate your portfolio.  This is especially directed at those of you readers over the age of say 45 who are within sight of retirement and certainly those of you who are retired.   Even in a well-diversified balanced portfolio if you haven’t rebalanced in awhile you allocation to equities might be higher than your plan exposing you to more risk than you might be comfortable with.

On the bond side it’s likely that the bond market’s best days are behind us.  While not advocating that you necessarily decrease your allocation to fixed income, this might be a good time to look at reducing the duration in your bond holdings.  Duration is a measure of the impact that a 1% increase (or decrease) in interest rates could have on a bond or a bond fund.  For funds you can find this on the morningstar.com website and elsewhere.

As for you 20 and 30 something’s I’m not advocating that you ignore risk, but I am saying that at your stage of life growth from the amount saved and from how your investments are allocated should be foremost in your mind, especially in your retirement savings strategy.

It isn’t different this time 

Prior to the 2000 market drop investors where touting tech stocks, including many companies with no real business plan or balance sheet.  They said it was different this time, it wasn’t.

Prior to the most recent recession housing was the magic bullet.  Real estate was the great hedge.  It wasn’t.

I’m not sure what is being touted as different this time, perhaps its all of the talking suits on TV telling us that it’s OK to increase our equity exposure even in face of these market highs.

The point is to let your own good common sense and an up-to-date financial plan be your guide to a reasonable investment strategy for your situation.  Ignore the hype.

Costs matter 

The deleterious impact of investment fees and expenses has been well-documented in the press of late, and were highlighted on the PBS Frontline show The Retirement Gamble.  The financial press is right.

  • Index funds and ETFs can be a great choice for your portfolio, but make sure that you are buying the lowest cost index product that covers the area of the market that you are seeking to invest in.
  • If you use actively managed mutual funds, make sure the added expense is justified by value added by the manager.
  • As many funds offer multiple share classes try to buy the lowest cost share class available to you.
  • If you work with a financial advisor understand how he or she is compensated and the true cost of your relationship with this advisor.  Besides high fees you want to understand if the compensation structure subjects you to potential conflicts of interest in terms of the financial products that the advisor might suggest for you.

Inflation is your enemy 

Inflation has been pretty benign in recent years but it won’t always be this way.  Even a relatively tame level can erode your purchasing power pretty quickly in retirement.  For example at 3% inflation your purchasing power will be cut in half within 24 years, a very likely life expectancy for a retiree today.  As I often say to those at or near retirement, your biggest investing risk comes from inflation versus the risk of actually losing money from your investments.

You have to play to win 

As I mentioned above the percentage of U.S. households holding stocks is at historically low levels.  What this means is that many families have not participated in this stock market rally.  While I am clearly not advocating that investors jump in to ensure they don’t miss any further gains, I am advocating that if you don’t have a financial plan in place get one done.  You can then gauge how to allocate your investment dollars as an outgrowth of your financial plan.  Jumping out of stocks when the market is at a low point as too many investors did in late 2008 and early 2009 and then jumping back in at a time like the present when it “feels good” is a recipe for fiscal disaster.  This is the value of having a plan.

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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