Active management Archives - The Chicago Financial Planner

How Much Apple Stock Do You Really Own?

January 5, 2020 by Roger Wohlner 4 Comments

Apple (AAPL) stock has been a great investment over the years. Based upon its stock price and the number of shares outstanding it is the largest U.S stock based upon market capitalization. This means it is the largest holding in many popular index mutual funds and ETFs. This can lead to significant stock overlap in your portfolio if you aren’t aware of the underlying holdings in the funds and ETFs you own.

Chuck Jaffe wrote an excellent piece for Market Watch several years ago discussing the impact that a significant drop in Apple stock had on a number of mutual funds that hold large amounts of Apple. He cited a list of funds that had at least 10% of their assets in Apple. On a day when Apple stock fell over 4% these funds had single day losses ranging from 0.22% to 2.66%.

The point is not to criticize mutual fund managers for holding large amounts of Apple, but rather as a reminder to investors to understand what they actually own when reviewing their mutual funds and ETFs.

Major price gains

Apple stock gained over 88% in 2019 and has an average annual gain in excess of 32% for the 15-years ending December 31, 2019. For index funds and ETFs whose holdings are market-cap weighted, these types of gains mean that the percentage of the fund in Apple stock has increased as well.

Percentage of Apple stock in major funds and ETFs

A number of index ETFs and mutual funds counted Apple as a significant holding as of December 31, 2019. The following percentage of assets for each fund are from Morningstar.

ishares Russell 1000 Growth ETF 8.53%
Vanguard Growth Index Investor 8.17%
Fidelity Growth Company 5.98%
SPDR® S&P 500 ETF Trust 4.57%
iShares Core S&P 500 ETF 4.57%
Fidelity 500 Index 4.34%
Vanguard 500 Index Investor 4.32%

In addition, it is also a dominant holding in several tech-related index funds, including:

Technology Select Sector SPDR® ETF 19.72%
Vanguard Information Technology ETF 17.53%
Invesco QQQ Trust 11.51%

Stock overlap

In the late 1990s a client had me do a review of their portfolio as part of some work I was doing for the executives of the company. He held 19 different mutual funds and was certain that he was well-diversified.

The reality was that all 19 funds had similar investment styles and all 19 held some of the popular tech stocks of the day including Cisco, Intel and Microsoft. As this was right before the DOT COM bubble burst in early 2000 his portfolio would have taken quite a hit during the market decline of 2000-2002.

This type of situation could easily be the case today with stocks in companies like Apple, Microsoft, Alphabet (Google’s parent), Facebook and others. Tools like Morningstar can help investors look under the hood of various ETFs and mutul funds to gauge the amount of stock overlap across their portfolio. (The prior link is an affiliate link. I may receive compensation if you purchase their service at no extra cost to you)

Understand what you own

If you invest in individual stocks you do this by choice. You know what you own. If you have a concentrated position in one or more stocks this is transparent to you.

Those who invest in mutual funds, ETFs and other professionally managed investment vehicles need to look at the underlying holdings of their funds. Excessive stock overlap among holdings can occur if your portfolio is concentrated in one or two asset classes. This is another reason why your portfolio should be diversified among several asset classes based upon your time horizon and risk tolerance.

As an extreme example, someone who works for a major corporation might own shares of their own company stock in some of the mutual funds and ETFs they own both inside their 401(k) plan and outside. In addition, they might directly own shares of company stock within their 401(k) and they might have stock options and own additional shares elsewhere. This can place the investor in a risky position should their company hit a downturn that causes the stock price to drop. Even worse if they are let go by the company not only has their portfolio suffered but they are without a paycheck from their employer as well.

The Bottom Line

Mutual fund and ETF investors may hold more of large market capitalization stocks like Apple and Microsoft than they realize due to their prominence not only in large cap index funds but also in many actively managed funds. It is a good idea for investors to periodically review what their funds and ETFs actually own to ensure that they are not too heavily concentrated in a few stocks, increasing their portfolio risk beyond what they might have expected.

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Filed Under: Investing Tagged With: Active management, Asset allocation, Exchange-traded fund, Index fund, Investing, Mutual fund

Reverse Churning Are You a Victim?

June 4, 2017 by Roger Wohlner 7 Comments

One of the best things about being a freelance financial writer and blogger is that I often learn new things in the course of my writing. A reader left a comment on a post here on the blog and mentioned reverse churning. Until that time, I had never heard this term, but after a bit of research I found that its’s one more thing that clients of stock brokers and registered reps need to be aware of.

The issue of reverse churning is one that will come to the forefront as the initial implementation of the DOL fiduciary rules commences next week. Here’s what you need to know about reverse churning to protect yourself and to make a good decision if your broker proposes a fee-based account.

What is churning?

Investopedia defines churning as “Excessive trading by a broker in a client’s account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws.”

Churning conjures images such as the boiler room in the movie Glengarry Glen Ross (actually they sold real estate) or the iconic 2002 ad by Charles Schwab (SCHW) in which a brokerage house manager is depicted as telling the brokers, “Let’s put some lipstick on this pig” in reference to a sub-par stock he wants them to pitch to clients.

What is reverse churning?

A 2014 piece by Daisy Maxey in The Wall Street Journal describes reverse churning as follows:

“The Securities and Exchange Commission says the practice of so-called “reverse churning”–putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee–is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client’s brokerage account, then move that client into an advisory account and collect additional fees.”

This occurs in brokerage accounts that at one point generated significant commissions for the broker from the purchase and sale of individual stocks or other commission generating transactions. If the activity in the account tails off the broker makes little or nothing from this client.

As a way to generate ongoing fees from this type of client, the broker may suggest moving to a fee-based advisory account, often called a wrap account.

Under this arrangement there is an ongoing fee based upon the assets in the account plus often trailing commissions in the form of 12b-1 fees from the mutual funds usually offered in this type of account. These generally include proprietary mutual funds offered by the brokerage firm, or at the very least costly actively managed funds from other fund families in share classes geared to offering broker compensation.

Fee-based is not fee-only

Fee-based is often confused with fee-only. I suspect the brokerage industry likes it this way.

Fee-only compensation means that the financial advisor earns no compensation from the sale of financial products including trailing fees and commissions. Their fees come from their clients. These can be hourly, a flat-fee or as a percentage of the assets under management.

Fee-based compensation, also called fee and commission, is a mix of the two forms of advisor compensation. A common form of the fee-based model entails the client paying the advisor to do a financial plan and then if the client chooses to have the financial advisor implement their recommendations this will often be via the sale of commission-based products.

The version with fee-based advisory accounts associated with reverse churning by brokers and registered reps arose out of a 2007 rule that prohibits the charging of fees in brokerage accounts. Many broker-dealers have a registered investment advisor (RIA) arm which runs these accounts.

The fiduciary rule

The new fiduciary rules make fee-based accounts more desirable for brokers and other fee-based advisors. These types of accounts will become even more prevalent with the disclosures required for retirement accounts under the new rules.

There has been a movement towards fee-based accounts in the brokerage world for several years now, likely in anticipation of the eventual issuance of these rules. This movement should accelerate in IRAs. In some cases, this will be a good thing as clients will fully know what they are paying in terms of fees.

In other cases, clients will find themselves paying 100 basis points or more in wrap fees for accounts where they were formerly trading infrequently on a commissioned basis. Whether the fee-based account will be a better deal will vary.

If all they are getting is an expensive managed account filled with bad to mediocre mutual funds that charge high fees on top of the wrap fee, this is not a good deal. If the advisor does little more than collect a fee, this sounds like the definition of reverse churning based on my understanding of the term. Much will depend upon the level and types of advice clients receive for the fees they will now be paying.

Buyer beware

If you are working with a stock broker or registered rep and they propose moving to a fee-based or wrap account, you should take a hard look at what you are being offered. What is the wrap fee? What types of investments are used in the account? Are they expensive actively managed mutual funds that throw off 12b-1 fees in addition to wrap fees? What is the track record of the manager of the account that the advisor is proposing? What types of advice and service will you receive for the fees you will paying?

If your broker proposes a wrap account make sure this arrangement is in your best interest.

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The Bottom Line

I can’t recall hearing about a case of churning in recent years. Reverse churning is a new term to me, but from the perspective of a broker or registered rep, fee-based advisory accounts make a ton of sense. They provide ongoing fee income and frankly require little attention from them. If your broker proposes a wrap account, make sure you understand how this arrangement benefits you the client.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

NEW SERVICE – Financial Coaching. Check out this new service to see if it’s right for you. Financial coaching focuses on providing education and mentoring on the financial transition to retirement.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Filed Under: Investing Tagged With: Active management, fee-only, Financial Advisor, Investing, Mutual fund, Mutual fund fees and expenses

Smart Beta ETFs the Next Big Thing?

October 20, 2015 by Roger Wohlner Leave a Comment

For those of us involved in financial services it is hard to check your Twitter stream or visit an industry website without seeing the term smart beta. ETF providers have really taken to this trend and have introduced many new ETFs based on some aspect of smart beta.

Nobody follows a trend quite like the folks who market mutual funds or ETFs and smart beta is the hip thing that all of the “cool kids” are doing. At a recent ETF industry conference sponsored by Morningstar (MORN) this was virtually all anyone was talking about in the sessions I attended.

What is smart beta and is it really smart? Are smart beta ETFs the next big thing in ETF investing?

Smart Beta Defined

According to Investopedia (for whom I am a frequent contributor):

“Investment managers that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That’s because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation.”

We will attempt to expand on that definition a bit below.

Factor investing

Most smart beta ETFs take an aspect or a factor from a traditional index. Traditional index ETFs passively track a market value weighted index like the S&P 500. Some popular factors include low volatility, momentum; equal-weighted indexes, dividends and quality are common factors. An equal-weighted index would give equal weighting to a huge stock like Apple (APPL) and to the smallest stock in terms of market capitalization in the S&P 500 Index.

An example of a smart beta ETF based on a factor is the Powershares S&P 500 Low Volatility ETF (SPLV).

This ETF invests in the 100 stocks in the index that have exhibited the lowest volatility over the past 12 months. A sound idea in theory and perhaps ultimately in practice.

Like many smart beta ETFs the inception date of SPLV was May 5, 2011 over two years after the low point of the markets during the financial crises. The index the ETF follows was essentially created in the lab via back-testing, much like the Peter Boyle character in the movie Young Frankenstein. This means that most of the “history” of this ETF is via back-testing and not real performance data. As a presenter at the Morningstar conference said, he’s never seen a back-test that did not yield a positive result.

Looking at SPLV’s results, the ETF trails the S&P 500 index in terms of trailing three year returns 12.95% to 14.77% on an average annual basis for the period ending 10/19/2015. However for the year-to-date period through the same date SPLV has gained 1.27% versus 0.41% for the index.

Looking at another measure, standard deviation of return which measures the variability of the ETF’s returns (up and down) over the three year period ending 9/30/2015, the standard deviation for SPLV is +/- 9.63% versus +/- 9.74% for the index. My guess is that a selling point of this ETF would be lower volatility but over the past three years the smart beta ETF is only fractionally less volatile than the index and an investor would have considerably less money if they had held SPLV over a more traditional ETF like the SPDR S&P 500 ETF (SPY).

Is an investment in SPLV a bad idea? I don’t know because I have no idea how this ETF will hold up in a pronounced bear market. Yes it has performed better than the full index so far in 2015 including the volatility in August and September. How will it do if we hit a rough patch like 2000-2002 or 2008-2009? Good question.

A growth area

According to data from Morningstar as of 6/30/2015:

There were 444 smart beta products listed in the U.S.
These products accounted for $540 billion in assets under management which was 21% of all U.S ETF assets.
Of the new cash flows into ETFs over the past 12 months, 31% went into smart beta products.
The assets in these products grew 27% over the same period.
A quarter of new ETF launches over the past five years were smart beta products.

Who uses smart beta ETFs?

From what I have heard and read smart beta ETFs are being used largely by financial advisors and institutional investors versus individuals. You might say so what? These folks are likely investing your money either via your relationship with a financial advisor who may use them in a portfolio or use a TAMP (turnkey asset management program) program offered by a third-party to manage your money.

Reasons to use Smart Beta

Morningstar cites several reasons investors and advisors might consider smart beta ETFs:

To manage portfolio risk
To enhance portfolio returns
For tactical asset allocation, meaning an allocation that is based in part on the advisor’s assessment of market conditions
Reducing fees versus actively managed mutual funds
To use an active strategy grounded by an index core

Many, including me, view strategic beta as a form of active management. A presenter at the Morningstar conference suggested that any smart beta ETF with an expense ratio of 50 basis points or higher should not be considered as this is the lower end of the fee range for the better actively managed mutual funds offering an institutional share class.

What does this mean for individual investors?

Again I suspect that most of the money invested here will be institutional or via financial advisors. As an individual investor working with a financial advisor who suggests using smart beta ETFs in your portfolio, you should ask them to explain their rational. Why are these ETFs a better choice than an asset allocation strategy using more traditional index products?

If you will using smart beta ETFs on your own, be sure that you fully understand the underlying index which was likely created post-financial crises via back testing. Understand that smart beta strategies may look good on paper but in reality they can take a number of years to prove themselves. Lastly understand that strategies that look good in testing may not work as well when millions of dollars are actually invested there real-time.

For financial advisors

Most financial advisors that I know are very deliberate in testing new products and investing ideas before using them with clients. With the rise of third-party advisors such as TAMPs and ETF strategists, financial advisors still need to understand the underlying products and strategies being used to invest their client’s hard-earned money.

The Bottom Line

Smart beta is the next evolution of ETF investing or so say the firms trying to gather assets into these products. I’m not saying that smart beta isn’t an enhancement or that I am against new investing inovations. I am leery of any investment vehicle designed to solve a problem or fill a role in portfolios that have not gone through a full stock market cycle. With any investment vehicle that you are considering, be sure to fully understand the benefits, the risks and the costs. How smart is smart beta? We really won’t know until the market goes through a full cycle that includes a significant correction.

Filed Under: Investing Tagged With: Active management, ETF, Exchange-traded fund, Investing, Investment

Are Brokerage Wrap Accounts a Good Idea?

January 4, 2015 by Roger Wohlner 4 Comments

A reader recently emailed a question regarding a brokerage wrap account he had inherited from a relative. He mentioned that he was being charged a one percent management or wrap fee and also suspected that he was incurring a front-end load on the A share mutual funds used in the account.

Upon further review we determined that the mutual funds were not charging him a front-end load. Almost all of the funds being used, however, had expense ratios in excess of one percent plus most assessed 12b-1 fees paid to the brokerage firm as part of their expense ratios.

Are brokerage wrap accounts a good idea for you? Let’s take a look at some questions you should be asking.

What are you getting for the wrap fee?

This is the ultimate question that any investor should ask not only about wrap accounts but any financial advice you are paying for.

In the case of this reader’s account it sounds like the registered rep is little more than a sales person who put the reader’s uncle into this managed option. From what the reader indicated to me there is little or no financial advice provided. For this he is paying the brokerage firm the one percent wrap fee plus they are collecting the 12b-1 fees in the 0.25 percent to 0.35 percent on most of the funds used in the account.

Before engaging the services of a financial advisor you would be wise to understand what services you should expect to receive and how the adviser and their firm will be compensated. Demand to know ALL aspects of how the financial advisor will be compensated. This not only lets you know how much the relationship is costing you but will also shed light on any potential conflicts of interest the advisor may have in providing you with advice.

What’s special about the wrap account?

While the reader did not provide me with any performance data on the account, from looking at the underlying mutual funds it would be hard to believe that the overall performance is any better than average and likely is worse than that.

Whether a brokerage wrap account or an advisory firm’s model portfolio you should ask the financial advisor why this portfolio is appropriate for you. Has the performance of the portfolio matched or exceeded a blended benchmark of market indexes based on the portfolio’s target asset allocation? Does the portfolio reduce risk? Are the fees reasonable?

What are the underlying investments?

In looking at the mutual funds used in the reader’s wrap account there were a few with excellent returns but most tended to be around the mid-point of their asset class. Their expenses also tended to fall at or above the mid-point of their respective asset classes as well.

Looking at one example, the Prudential Global Real Estate Fund Class A (PURAX) was one of the mutual funds used. A comparison of this actively managed fund to the Vanguard REIT Index Fund Investor shares (VGSIX) reveals the following:

Expense ratios:

	PURAX	VGSIX
Expense Ratio	1.26%	0.24%
12b-1 fee	0.30%	0.00%

Trailing returns as of 12/31/14:

	1 year	3 years	5 years	10 years
PURAX	14.03%	14.47%	11.12%	6.66%
VGSIX	30.13%	16.09%	16.84%	8.41%

While the portfolio manager of the wrap account could argue the comparison is invalid because the Prudential fund is a Global Real Estate fund versus the domestic focus of the Vanguard fund I would argue what benefit has global aspect added over time in the real estate asset class? Perhaps the attraction with this fund is the 30 basis points the brokerage firm receives in the form of a 12b-1 fee?

Looking at another example the portfolio includes a couple of Large Value funds Active Portfolios Multi-Manager A (CDEIX) and CornerCap Large/Mid Cap Value (CMCRX). Comparing these two funds to an active Large Value Fund American Beacon Large Value Institutional (AADEX) and the Vanguard Value Index (VIVAX) reveals the following:

Expense ratios:

	CDEIX	CMCRX	AADEX	VIVAX
Expense Ratio	1.26%	1.20%	0.58%	0.24%
12b-1 fee	0.25%	0.00%	0.00%	0.00%

Trailing returns as of 12/31/14:

	1 year	3 years	5 years	10 years
CDEIX	10.01%	NA	NA	NA
CMCRX	13.11%	19.30%	12.98%	5.78%
AADEX	10.56%	21.11%	14.73%	7.57%
VIVAX	13.05%	19.98%	14.80%	7.17%

Again one has to ask why the brokerage firm chose these two Large Value funds versus the less expensive institutionally managed active option from American Beacon or the Vanguard Index option. I’m guessing compensation to the brokerage firm was a factor.

Certainly the returns of the overall wrap account portfolio are what matters here, but you have to wonder if a wrap account uses funds like this how well the account does overall for investors.

The lesson for investors is to look under the hood of any brokerage wrap account you are pitched to be sure you understand how your money will be managed. I’m not so sure that my reader is being well served and after our email exchange on the topic I hope he has some tools to make an educated evaluation for himself.

The Bottom Line

Brokerage wrap accounts are an attempt by these firms to offer a fee-based investing option to clients. As with anything investors really need to take a hard look at these accounts. Far too many charge substantial management fees and utilize expensive mutual fund options as their underlying investments. It is incumbent upon you to understand what you are getting in exchange for the fees paid. Is this investment management style unique and better? Will you be getting any actual financial advice?

The same cautions hold for advisory firm model portfolios, the offerings of ETF strategists and managed portfolios offered in 401(k) plans. You need to determine if any of these options are right for you.

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Filed Under: Investing Tagged With: AADEX, Active management, Asset allocation, CDEIX, CNCRX, EMGAX, Index fund, Investing, Mutual fund, Mutual fund fees and expenses, Personal finance, VGSIX, VIVAX

4 Considerations When Evaluating Active Mutual Funds

April 1, 2014 by Roger Wohlner 4 Comments

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 with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner.

Filed Under: Mutual Funds Tagged With: Active management, Index fund, Investing, Mutual fund, PIMco

My Thoughts on PBS Frontline The Retirement Gamble

April 29, 2013 by Roger Wohlner

The PBS show Frontline recently aired The Retirement Gamble, an investigative documentary on the state of retirement savings and the problems with 401(k) and similar retirement plans. The show did a great job of highlighting a number of issues and was pretty scathing in its treatment of the financial services industry and workplace retirement savings plans.

As a professional who serves as a financial advisor to a number of 401(k) plan sponsors as well as to individual clients (most of whom are either close to retirement or in retirement) I watched this broadcast with great interest. Here are my reactions to what I saw.

Key issues highlighted by The Retirement Gamble

The high fees imbedded in some retirement plans, often these fees are next to impossible for the average participant to uncover.
Poor investment choices offered in some plans.
There are a lot of lousy 401(k) plans out there.
The confusion and frustration that many retirement savers in 401(k) and other defined contribution plans feel due to the fact that they are responsible for accumulating enough for retirement. This is in contrast to the era when many folks were covered by a defined benefit pension plan where the investment risks and responsibilities for funding the plan were on the employer’s shoulders.
While the issues highlighted were not new to me nor to many of us in the industry, I think this documentary was a bit of an eye-opener to many in the general public. I say this as there have been several surveys taken over the years where a shocking number of investors responded that they had no idea that there were fees charged by their 401(k) plan.

Where the documentary fell a bit short in my opinion

As regular readers of this blog and those who follow me on Twitter and other social media outlets know, I am highly in favor of lower retirement plan fees and anything that increases transparency for investors. That said I thought The Retirement Gamble had a very decided bias against the financial services industry and almost felt as though they had come to their conclusions before they started on the project.

The show did not highlight a single good 401(k) plan and there are many out there.
The show did not highlight a single person who had used the 401(k) to accumulate a significant nest egg. I have the privilege to serve as advisor to a number of folks who have done just that.
While I am an admirer of Vanguard founder John Bogle and use index funds extensively in the 401(k) plans that I advise and in the portfolios of all clients, I disagree that there are no actively managed funds worthy of investor’s dollars. That’s not to say that these are the majority of active funds, but they do exist. Finding them and determining if they are an appropriate investment choice for a plan sponsor to offer is what plan investment consultants are paid to do.
While the program did mention advisors who act as Fiduciaries in passing, the focus was on those advisors, reps, and brokers who sell plans and/or suggest investment options that serve to line their pockets sometimes at the expense of the plan’s participants. Why not interview some advisors who do the right thing for their plan sponsor clients and the participants of those plans?
The worst part of The Retirement Gamble was that while many problems and issues were brought to light, there was little in the way of advice or suggestions for plan participants on what to do to improve their situation.

I do have to say that the most amazing part of the show was the interview with the head of Prudential Retirement Christine Marcks. She insisted that she was unaware of any of the research showing the advantages of low cost index investing over high cost active management. While she may or may agree with the findings, the fact that she insisted that she was unaware of this research was jaw-dropping in my opinion. I think Ms. Marcks should have been coached prior to her appearance by someone at Prudential.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Photo credit: Flickr

Filed Under: Retirement Tagged With: 401(k), Active management, Fiduciary, Financial Advisor, Frontline, Index fund, John Bogle, retirement

ETFs or Mutual Funds? – Why Not Both?

April 8, 2013 by Roger Wohlner 8 Comments

Over the past several months I’ve read a number of articles along the lines of “ETFs vs. Mutual Funds.” In most cases these articles take an either or position which is generally in favor of ETFs. While I am a fan of ETFs and use them extensively in client portfolios, my question is why do we need to choose between ETFs and mutual funds? Why not use both?

Looking over the portfolios of my individual clients I could not find one that did not include both ETFs and mutual funds. In addition some include closed-end mutual funds as well as individual stocks.

Advantages of ETFs

Originally ETFs were introduced as a way to trade various stock market indexes. The S&P 500 SPDR (ticker SPY) just turned 20 and is generally at or near the top of the list in terms of ETF trading volume. The availability of low cost ETFs across a variety of equity and fixed income indexes has mushroomed over the years. As a financial advisor I use them extensively for their style consistency, low cost, and in many cases their consistently above average performance within their style peer groups.

Especially after the 2008-09 financial crisis the number of ETFs offered has mushroomed and so has the variety of offerings. Actively managed ETFs are growing and the success of PIMco’s ETF version (ticker BOND) of its popular PIMco Total Return (ticker PTTRX) mutual fund will undoubtedly spur further growth here.

Why bother with Mutual Funds?

In looking at mutual funds you have to divide them into actively managed funds and passive (index) funds.

If you are indexing all or part of your portfolio you want to look at various factors in making your decision as to whether to go with a mutual fund or an ETF. These include:

The size of your account/portfolio. Even in the world of index mutual funds there are some lower cost versions available to investors who can meet higher minimum investment thresholds. Vanguard is a good example here.
Cost to own. The expense ratio should be the main factor, but transaction costs can come into play. While the availability of no-transaction fee ETFs is growing, the ETF you want to buy may not be on this menu at a given custodian. Likewise some mutual fund families might incur a transaction fee at certain custodians.
How will you invest? If you are dollar cost averaging into a fund/ETF at say $250 per month you’ll want to look for options with no transaction costs.

While actively managed mutual funds get a bad rap in the press, there are still a number of well-managed reasonably priced funds across equity and fixed income styles. A Schwab study a number of years ago touted a “core and explore” approach to investing. This meant that the core of the portfolio would be index funds, with the use of actively managed funds in certain asset classes where good index products were not available.

Given the expansion of indexing to a wide range of assets classes in both the ETF and mutual fund format this approach in its original form may be passé. However I still use a number of actively managed funds across both individual and institutional portfolios.

In choosing an active fund I’m looking for some or all of the following:

Long-term outperformance.
Superior risk-adjusted performance.
Consistency of management.
Something that I can’t find in an index product that adds to the overall quality of the portfolio.

Certainly there are a lot of mutual funds that don’t belong in your portfolio. Loaded funds, proprietary funds from various brokerage houses and other high fee alternatives put a lot of money into your broker/registered rep’s pockets. Go with no load funds and always shop for the most competitive share class available to you in terms of expense ratio.

Why exclude either ETFs or Mutual Funds?

My point here is not to argue the merits of either mutual funds or ETFs, or for that matter active management vs. passive. Certainly I’ve seen some excellent examples of portfolios that are all ETF and/or all index products.

However why limit yourself and feel that you need to avoid funds or ETFs? There are so many choices out there, I feel that I owe to my clients to look at the whole universe of ETFS, mutual funds, and other products that might enhance their portfolio and help them to achieve their investment goals. In building a portfolio I suggest that you take the approach of picking the best investing vehicles for the various allocation “buckets” in your portfolio whether they be ETFs, mutual funds, actively managed, or passive index products.

Please feel free to contact me with your questions.

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Filed Under: Investing Tagged With: Active management, Asset allocation, ETF, Index fund, Investing, Mutual fund

Do Index Funds Reduce Investment Risk?

February 27, 2013 by Roger Wohlner 10 Comments

Index mutual funds and ETFs (we will refer to them as index funds unless otherwise indicated going forward in this article) have received a lot of favorable press of late. This is justifiable as index funds offer a low cost way to invest and are generally quite specific to a given investment style. Over the years I have been asked if index funds reduce investment risk. Let’s examine this question.

What is investment risk?

One definition of investment risk as the variability of the investment’s returns also known as standard deviation. Note variability means returns that are both higher and lower than the fund’s average returns over a given period, say the trailing three or five years.

I contend that most investors would define investment risk as the risk of losing money on an investment. This is especially true in the wake of the recent financial crises.

An index fund takes on the risk of the underlying index it tries to replicate. For instance, in 2008 the S&P 500 Index lost 37 percent. There are many funds and ETFs that track that index. They all lost around 37 percent plus the fund’s expenses. For example, the Vanguard 500 Index Fund (symbol VFINX) posted a loss of 37.02 percent for the year.

Active management vs. index funds

Let’s take a look at several of Morningstar’s analyst favorites in the Large Growth style compared with an index fund in this style and with the S&P 500 index.

	10 yr. Standard Deviation	10 yr. mean return
Vanguard Growth Index (VIGRX)	+/-15.14%	8.10%
Jensen Quality Growth (JENSX)	+/-13.19%	6.62%
Vanguard Primecap (VPMCX)	+/-15.50%	10.83%
Harbor Capital Apprec. (HACAX)	+/-15.57%	8.65%
S&P 500 Index	+/-14.80%	7.93%

Data from Morningstar.com

In plain English, the Vanguard Primecap fund posted an average annual return of 10.83% over the trailing ten years depicted. Based on fund’s standard deviation of +/- 15.50% one would expect the fund’s returns to range between -4.67% and +26.33% about 68% of the time.

The bigger take away from this chart is that the Vanguard Index fund’s volatility was lower than a couple of the funds and higher than Jensen. As with any index fund the Vanguard fund experienced approximately the level of risk and return of its underlying index, other actively managed funds in this category experienced more or less risk and return based upon the stock selections of the managers.

Manager Risk

Index funds can eliminate manager risk, or the risk of investing in an actively managed fund only to see the manager underperform the benchmark index. As an example for the trailing periods ending January 31, 2013 the Vanguard Growth Index outperformed 83% of the other Large Growth funds for the trailing three years; 84% of the other fund for the trailing five years; and 61% of the other fund for the trailing ten years.

This is not to say this will be the case with all index funds over all periods of time. However, a well-run index fund should track its underlying index closely and deliver index-like performance.

Several years ago an instructor at a continuing education session indicated that many of the actively managed mutual funds atop the 10-year rankings in their respective categories most likely spent three of those calendar years in the bottom quartile of their category rankings. For an investor who held one of these funds over that entire 10-year period this isn’t a problem. But investors who bought into such a fund at a different time or over various periods of time may have had quite a different experience. As we know, money tends to chase performance, hot funds attract investor dollars, funds that are struggling tend to see more client redemptions. This is so prevalent that Morningstar measures investor performance along with the actual performance of the mutual fund. Investor performance provides a measure of how actual investors fared by investing in this fund, including the timing of investments and redemptions. In many cases investor performance varies significantly from the actual fund returns.

A few other points to consider:

Expenses matter

You should generally buy the cheapest index fund that tracks the index you are interested in. There is a huge disparity in the fees for funds that track the S&P 500 for example.

Understand the underlying index.

There has been a proliferation of new index ETFs tracking a variety of indexes. In many cases I have never heard of many of these indexes. Make sure the index tracked by the fund or ETF you are considering makes sense for your overall portfolio and that the index has a real history not just some back-tested data behind it.

Using index funds is no guarantee of investment success

Just like with any mutual fund or ETF, how you use these products is the key to your success. Index funds are nothing more than a building block to construct your portfolio.

Don’t dismiss active managers

Evaluate actively managed funds and understand why they have been successful in the past and in what types of environments they might lag their peers. Moreover, carefully think through the role the fund might play in your portfolio, and be aware of who is managing the fund. Is the same person or team that actually compiled the impressive track record still in charge? Or has this manager moved on, placing the fund in the hands of some new, unproven manager?

Index funds do not necessarily reduce investment risk or guarantee a higher return

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Index funds do not necessarily reduce investment risk or guarantee a higher investment return than using actively managed funds. Like anything in the investment world, investing with a strategy (ideally tied to your financial plan), monitoring your results, rebalancing your allocation, and making adjustments to your portfolio when warranted are still key elements in successful investing. Index funds are simply a tool you can use in this process.

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Filed Under: Investing Tagged With: Active management, Exchange-traded fund, Index fund, Investing, Mutual fund

Mutual Funds and Alabama Football – Does Past Performance Matter?

January 16, 2013 by Roger Wohlner 2 Comments

As most of you know, The University of Alabama is once again the king of the college football world. They recently vanquished Notre Dame to win their second consecutive BSC Championship and their third in the past four years. Including a BCS title while coaching LSU, Alabama coach Nick Saban has won four BCS titles in the last eight years.

Can we infer anything about the future from this performance? I would argue yes based upon a couple of recent articles that I have read about Saban’s approach to coaching and managing the football program. According to the articles, there is a process in place for just about every aspect of the program from recruiting to practices and so on. While Alabama still has to go out and play the games (in arguably the toughest conference around) they generally seem to find a way to win under Saban as evidenced by his worst record of 10-3 in 2010.

A repeatable process is what sets Saban apart and in my opinion is the key factor in his coaching success. A repeatable process is also a key element in investment success.

Clearly in the investment world a disclaimer on the order of “…past performance is no guarantee of future performance…” is often used. And with good reason. If we apply this to the world of mutual funds any number of factors can come into play. I and many other advisor colleagues and self-directed investors have migrated in large part to passive, low cost index funds and ETFs simply because so few active managers deliver top returns year in and year out.

Two active mutual funds managers who consistently deliver superior performance

Sequoia SEQUX is a large cap blend fund that started as disciples of Warren Buffet’s investing style and still has a very definite process in place for finding stocks that meet the management team’s criteria. Over the 15 years ended 12/31/12 the fund ranked in the top 5% of its category and has beaten the return of the S&P 500 by an average of 308 basis points annually. The fund ranks in the top 2% for the trailing 3 and 5 year periods and the top 22% for the trailing 10 years. Moreover this fund is closed to new investors more than it isn’t the fund was closed for 25 years until 2008. At that point I added this fund to the portfolios of a number of clients. The fund closed again at the beginning of 2012. This is a sign of a superior fund company in that they didn’t feel they can invest all of the new money that was flowing into the fund so they closed it.

PIMco Total Return PTTRX is an Intermediate Bond Fund run by famed bond fund manager Bill Gross. This is the largest and one of the most successful bond funds around. Gross is very visible in large part due to his regular appearances on CNBC. Many thought he had lost his touch in 2011 when the fund ranked in the bottom 13% of its category; however the fund turned around and finished in the top 12% for 2012. The fund ranks in the top 25% for the trailing 3 years ended 12/31/12; the 7% for both the trailing 5 and 10 year periods and the top 3% of its category for the trailing 15 years. In all cases the fund has outperformed its benchmark the Barclay’s Aggregate Bond Index significantly. Gross and the PIMco team clearly have a process in place that has been successful and this was reinforced by the success of the recently introduced ETF version of the fund. I have client money in this fund.

Two active managers who used to deliver consistently superior performance

American Funds Growth AGTHX was at one time a preeminent large growth fund. While fund had a very strong year in 2012, returning 20.54% and outpacing the S&P 500 by 454 basis points, the fund ranked in the bottom half of its category in 3 of the 5 calendar years from 2007 -2011. This was after a five year run during which the fund had ranked in the top 18% or better of its category in each of those five years. I suspect the fund’s bloated size followed by significant reduction in fund assets via withdrawals contributed to this recent mediocre run.

Legg Mason Capital Management Value Trust LMVTX was formerly managed by the legendary Bill Miller who had rattled off a string of 15 consecutive years of beating the fund’s benchmark the S&P 500 Index. In recent years the fund has fallen off to the point where the fund ranked in the 99^th percentile for the 5 years ended 12/31/12 and the absolute bottom of it category for the trailing 10 years.

The point is that there are actively managed mutual funds who deliver consistently excellent performance. Even here, the performance can be uneven as evidenced by the fact that Sequoia has ranked near the bottom of its category in several individual years over the course of its solid run.

I tend to use index funds and ETFs pretty extensively, but I still use a fair number of actively managed funds as well. Finding funds that fit the needs of my clients takes work and ongoing monitoring, but I have found this to be worth the time spent. Even with the best managers there are no guarantees about the future, but analyzing and understanding the details of their past performance can provide insight.

As for the Crimson Tide, they may not win a third straight national title, they might not even win their division of the SEC (LSU and Texas A&M are formidable obstacles) but I have no doubt that they will be in the mix in 2013 and as long as Saban is coaching due to his process and preparation.

Please feel free to contact me with questions about your mutual funds or to address your investment and financial planning advice needs.

Do-it-yourselfers check out morningstar.com to analyze your investments and to get a free trial for their premium services. Check out our Resources page for links to a variety of tools and services that might be beneficial to you.

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Filed Under: Mutual Funds Tagged With: Active management, Bill Gross, Exchange-traded fund, Investment management, Mutual fund, Nick Saban, University of Alabama

Are Mutual Fund Closures a Bad Thing?

December 19, 2012 by Roger Wohlner 2 Comments

You’ve been following a mutual fund for awhile and you’ve decided that this fund is a good fit for your portfolio. You go online to make an initial purchase and you learn the fund has closed to new investments. While you might be frustrated, overall I tend to view fund closures as a positive move in most cases.

Factors that might lead to a fund closing

Typically the main reason that mutual funds close to new investments is that more money is coming in than the managers feel they can effectively invest. Closely related to this is the rule that funds are only allowed to buy into the stock of a single company if that holding is 5% or less of the total value of the fund. (Note a holding may constitute more than 5% of a fund’s value due to price appreciation). Generally fund closures occur in actively managed mutual funds versus passively managed index products.

Fund closures benefit existing shareholders

In my opinion, a fund closure is generally a sign of a fund company that values its shareholders. A case in point is Artisan, a fund company based in Milwaukee. Over the years I have used Artisan Mid Cap Value (ARTQX) extensively in several of the retirement plans for whom I serve as advisor as well in the portfolios of many of my individual clients. The management team of this fund was named Domestic Manager of the Year for 2011 by Morningstar.

Artisan runs 12 funds, of which 5 are currently closed to new investors, including Mid Cap Value. Even with the closure, fund assets have topped $8 billion a high for the fund. The fund’s performance has lagged in 2011, though I don’t think that it is related to the increased size. The fund ranks in the top 1% of all Mid Cap Value funds over the past 10 years.

The fact that Artisan is willing to close a popular fund like Mid Cap Value speaks volumes about the firm. Shutting off the spigot of new money means that the firm will lose the fees it would collect on these assets. Artisan is also in the process of going public.

Examples of large funds that didn’t close

This can work both ways. An example of a fund that in my opinion should have closed to new investment is Ariel (ARGFX). This was an outstanding Small Cap Value fund run by John Rogers, a well-known Chicago-based value investor. Fund assets ballooned from about $600 million in 2001 to over $4.7 billion in 2005. The fund never closed its doors to new money and was forced to increase the market cap of the stocks held in the fund.

As a Mid Cap Blend fund, performance has largely been below average, the fund ranks in the middle of the pack for the trailing 5 years and in the bottom 25% of its category for the tailing 10 years. Performance has picked up in recent years with the fund ranking in the top quarter of its category in 2009, 2010, and year to date in 2012. In-between the fund ranked in the bottom 7% of its category in 2011. This improved performance follows a significant decline in fund assets in recent years.

I haven’t followed this fund for several years and have no client money invested here. Would shareholders have been better served had the fund closed its doors a number of years ago and stuck to the type of investing it was known for? In my opinion yes, but I’ll leave that to others to decide.

On the flip side of this is Fidelity Contra (FCNTX). Will Danoff manages about $85 billion in this fund and over $100 billion in this style (Large Growth) when you add in some other portfolios under his management. The fund has placed in the category’s top 39% or better in every annual period since 2002 with the exception of 2009 (when the fund earned over 29%). For the trailing 10 years the fund ranks in the category’s top 7%. To be able to manage this much money as well as Danoff has year in and year out is a commendable and rare feat.

Asset bloat

While asset bloat can be a problem in any fund, it is generally a more serious issue in a fund that invests in small or mid cap stocks. At some point there are only so many good places to invest new cash coming in.

While fund companies are in the business to make money, my experience has been that the fund companies that tend to close funds when they get too big also tend to run funds that are better performers over time. At some point if a fund gets too big it might also become a “closet indexer.” In those situations, why pay the fees associated with an actively managed fund? Why not just buy an index fund or ETF?

What if my fund closes?

Typically if you already own a fund and it closes, you be able to buy more shares if you wish. This is not always the case, however.

If a fund that you were considering closes before you own it, look for an alternative fund. This might be a good opportunity to consider a low cost index fund or ETF in the same asset class.

Feel free to contact me with questions about your investments.

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Filed Under: Mutual Funds Tagged With: Active management, Exchange-traded fund, Index fund, Investment, Mutual fund

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Understand the underlying index.

Using index funds is no guarantee of investment success

Don’t dismiss active managers

Two active mutual funds managers who consistently deliver superior performance

Two active managers who used to deliver consistently superior performance

Factors that might lead to a fund closing

Fund closures benefit existing shareholders

Examples of large funds that didn’t close

Asset bloat

What if my fund closes?

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