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Mutual Funds – B Shares are a Dumb Ox

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I’m guessing that our family is no different from most in that we have some unique ways of communicating.  For example, beef tenderloin was a dish that my wife would make on a number of special occasions as the kids were growing up.  She cooked it in a black roasting pan with white specs, hence beef tenderloin is forever know as “polka dot pot meat” in the Wohlner house (the black roasting pan is long gone).

 English: Oxen in Marine Drive, Mumbai, India.

In this same vein, the word oxymoron has been changed to “Dumb Ox” in Wohlner speak.

Several years ago I was having lunch with a CPA who was also licensed as Broker Dealer and sold securities including loaded mutual funds to some of the firm’s clients.  I’ve never understood how a trusted advisor like a CPA could turn around and sell financial products for a commission, but that is for another post.  Over lunch the CPA said “… I know that you will disagree, but I often think there is nothing better for many clients than a good B Share…”   He’s right I do disagree, to me a “Good B Share” is the ultimate “Dumb Ox” (no offense to any Oxen intended).

Share Class Comparisons

In the world of commission and fee-based financial product sellers, one way for these brokers and registered reps to be compensated is via commissions from selling mutual funds.  The main share classes where this occurs are A, B, and C Shares.  Using the American Funds Growth Fund as an example let’s take a look at the differences in these three share classes:

Share Class Ticker Front Load Deferred Load Expense Ratio 12b-1 fee
A AGTHX 5.75% 0% 0.71% 0.24%
B AGRBX 0% 5.00% 1.46% 1.00%
C GFACX 0% 1.00% 1.49% 1.00%

Source:  Morningstar.com

The American Funds, like an increasing number of fund companies no longer sells B share mutual funds.  However, even if there are no new B shares being sold; many investors are still trapped in the overpriced funds by the surrender charges.

With the A shares, a $10,000 investment would incur an upfront sales charge of $575, meaning that $9,425 would be invested in your account.

The No Front Load Option – B Shares

As an alternative for investors who didn’t want to pay the upfront sales charge B shares were created.  While there is no upfront sales charge and the entire $10,000 is invested, the ongoing expenses of the fund are considerably higher.  Additionally you are literally trapped in the fund by the deferred sales charge which starts at 5% and declines by 1% each year until it goes away altogether in year 6.  While you can generally exchange your fund for another B share fund in the same fund family, you will get hit with the surrender charge should you sell any or all of the shares.  At the end of the surrender period the B shares are supposed to revert to the less expensive A shares.  I’ve heard of instances where B shares were not automatically moved to the A shares, it is always a good idea to read your brokerage statements.

What if I still own B shares?

If you hold B shares of any fund family I suggest the following:

  • If your fund has moved out of the surrender period and has not moved to the less expensive A shares call your financial advisor and ask why.
  • If your fund is still in the surrender period do a cost/benefit analysis to determine if moving out of the fund and buying into a less expensive (and presumably better performing) alternative would be cost effective.  Basically you want to look at the difference in the annual expenses of the B share fund vs. the alternative and determine how long it would take you to breakeven after incurring the surrender charges based on the cost savings.
  • Consider firing the financial advisor and the firm that put you into the B share in the first place.  I’ve been in this business a long time and I can’t see any reason to have put a client into a B share except greed (though I’m open to listening to other explanations).  The ongoing payments to the brokerage firm (the 12b-1 portion of the expense ratio) and the “handcuffs” placed on shareholders by the surrender charges are quite lucrative for the broker, and serve to reduce your returns.  At the very least confront the advisor and ask them why you were sold a B share in the first place.
  • I’m biased on this subject and in the interest of full disclosure I am a fee-only financial advisor and I do not accept commissions or sales loads of any kind.

As always, be sure that you understand ALL expenses and fees that you will be paying when working with a financial advisor.  What you don’t know can really reduce your investment returns.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

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American Funds Growth – A Fallen Star?

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falling star

My last post asked Mutual Funds – Should You Pay Extra for Active Management?  As a follow-up I am taking a look at an actively managed Large Growth fund that was once a top-flight performer, but has really slipped in recent years.

Readers of this blog may note that two of the most popular posts have dealt with the American Funds in the context of their use in 401(k) plans.  American Funds Growth remains a major holding across the 401(k) universe.

The asset base of American Funds Growth (across all share classes) is huge at just over $116 billion, but it is down considerably from its 2007 high of about $202 billion.  Still the fund remains the largest in the Large Growth category.

Let’s compare Growth’s A Share class with the Investor Share Class (the most expensive) of the Vanguard Growth Index Fund.

The A shares have a low expense ratio of 0.68%, but the Vanguard fund’s expense ratio is 0.24%.  The average fund/ETF in this category had an expense ratio of 1.22% as of June 30.  Note the A shares carry a front-end sales charge; the returns below do not reflect this.

YTD

12 months

3 years

5 years

10 years

Amer. Funds Growth

17.86%

27.94%

10.03%

0.06%

8.72%

VG Growth Index

18.20%

31.08%

14.90%

3.39%

8.22%

As of September 30, 2012 – courtesy of Morningstar.

A Former Star Performer

The superior performance of American Funds Growth over the ten-year period is consistent with the fund’s annual performance.  From 2002-2006 the fund outperformed the Growth Index fund during each of these years.  Further the fund ranked no worse than the top 18% of all of the funds in the Large Growth Category.

A Fall From Grace

Since 2006, the story is a different one.  American Funds Growth  has lagged the Growth Index fund in each of these years.  Further the fund has ranked in the lower half of the Large Growth category in 3 of those 5 years.  For the three years ended September 30 the fund ranks in the 74th percentile (bottom 24%) of the Large Growth category.  The fund ranks in the 68th percentile for the trailing five years and the 24th percentile for the trailing ten years.

A Closet Index Fund?

While American Funds Growth’s expenses are generally reasonable (though not for some of the share classes that are sold via the broker channel) what are you getting by paying the extra cost?  Further, the fund’s R-Squared (a measure of correlation) with the Russell 1000 Growth Index over the past three years is over 97%.

Essentially the fund has become a closet indexer with lagging performance and higher expenses.  I’m not saying American Funds Growth will never be a consistent long-term performer again, nobody can predict the future.   I respect the American Funds as an organization.  But why invest in a closest index fund when you can invest in the real thing?  If your broker or registered rep tries to convince you otherwise ask them the same question.

Please feel free to contact me with your investing and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze your investments and to get a free trial for their premium services.


Morningstar Stock Fund Investment Research

 

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Mutual Funds-Should You Pay Extra for Active Management?

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I was recently quoted in the industry publication Investment News in an article discussing how many Large CapCommon Sense on Mutual Funds: New Imperatives ... domestic equity mutual funds have become very highly correlated with their benchmark index.

The article’s author cited the American Funds Growth Fund of America as an example with its three year R-squared to the Russell 1000 Index having increased to 98% from 77% just five years ago.  R-squared measures the strength of the statistical relationship, in this case between the fund and its benchmark.

Here are my two quotes from the article:

“If I buy an active fund in the large-cap space, I want somebody who’s going to do something over the long term to outperform,” said Roger Wohlner, a financial planner at Asset Strategy Consultants. “Why pay 70 or 80 basis points for active management that doesn’t give you much differentiation from the index?” 

“Downside protection is one of the reasons that led Mr. Wohlner to rush some of his clients into the $5.5 billion Sequoia Fund (SEQUX) when it briefly opened to new investors in 2008. As the S&P 500 fell 37% in 2008, the Sequoia Fund fell 27%.” 

Both quotes reflect my belief that an active mutual fund manager needs to add value beyond what you can find in an index mutual fund or ETF.

Index Funds Often Outperform Their Actively Managed Peers

Especially with Large Cap funds, quite often index funds out perform a large percentage of their actively managed peers.  Let’s look at an example:

Vanguard Growth Index Signal (VIGSX) – Large Growth Category

YTD

1 year

3 years

5 years

10 years

Fund Return

10.77%

6.49%

17.66%

3.06%

5.97%

Category percentile

24

8

14

17

28

# Funds in category

1,543

1,499

1,328

1,137

736

As of June 30, 2012 via Fi360.com

By way of explanation:

  • Category percentile represents its ranking among all of the mutual funds and ETFs in this Morningstar Category.  For example for the three years ended June 30 the fund ranked in the top 14% of the 1,328 funds in the category with a three year track record.
  • The fund delivered these results quite cheaply.  The fund’s expense ratio is 0.10%.  This compares to the average mutual fund/ETF in this category of 1.22% as reported by Morningstar.
  • While this share class may not be available to all individual investors, the Admiral Share class ($10,000 minimum investment) and the ETF version (which can be traded commission-free at Vanguard) of this fund also carry a 0.10% expense ratio.  Even the basic Investor share class is very cheap to own with a $3,000 minimum investment and a 0.24% expense ratio.  In addition there are many other excellent index ETFs in this category that are solid low cost choices.

Why Pick an Actively Managed Fund? 

A bit over half of the money that I have invested on behalf of my clients is in some sort of index product, across both mutual funds and ETFs.

That said I still use a number of actively managed mutual funds as well.  What am I looking for in an active fund?

  • A long-term track record of excellence.  There are still a number of active fund managers who in my opinion add value.
  • A manager who excels at controlling their fund’s downside risk when the markets drop.
  • Superior management in an investment style that is not well-represented by index products.

As we have seen especially over the market cycle of the past decade, it is increasingly difficult for actively managed mutual funds to add value to investors over and above what inexpensive index funds deliver.   This is especially true with equity funds.  If your financial advisor suggests a portfolio of pricey actively managed mutual funds ask why (especially if these funds are proprietary products of their employer).  What added value do these funds provide over less expensive index alternatives?  If you advisor is paid all or in part via commissions I’ll bet his/her compensation is part of the answer.

Please feel free to contact me with your investing and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze 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.

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Mutual Funds – Know Your ABCs

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The mutual fund companies in many cases do nothing to make selecting or understanding their funds easy.  One area of potential confusion for investors is (in some cases) the myriad of share classes available among the same fund.

An assortment of United States coins, includin...

Under the broker-sold model, the basic share classes are A, B, and C.  Using the American Funds Washington Mutual Fund, a Large Cap Value fund, as an example here is a comparison of the returns and expenses by share class:

A – AWSHX B – WSHBX C – WSHCX
3 yr return 15.66% 14.79% 14.72%
5 yr return 1.21% 0.44% 0.40%
10 yr return 6.11% 5.31% 5.25%
Expense ratio 0.62% 1.38% 1.42%
Front Load 5.75% NA NA
Max Def Load NA 5.00% (6 yrs) 1.00% (1 yr)
12b-1 fee NA 1.00% 1.00%

Source:  Morningstar

All three share classes are sold by commissioned based and fee-based advisors.

  • The A shares are the cheapest to own over time; however investors pay an upfront charge of 5.75%.  For every $10,000 invested, $9,425 actually goes to work for you with the rest going to the broker.  Typically there is no load for purchases above a certain dollar level and subject to some restrictions exchanges between other funds in the same family will not incur a sales load.
  • The B shares are no longer sold by the American Funds and many other fund companies.  While there is no front-end load, the deferred sales charge starts at 5% in the first year, drops to 1% by year 6, and disappears in year 7.  This means that there is a back-end sales load if you sell in the first 6 years.  In addition, the 12b-1 charge which is part of the expense ratio makes the fund more expensive to own each year.  This fee goes to compensate the broker in lieu of the front-end load.
  • The C shares have a level load in the form of a 1% 12b-1 fee that never goes away.  In addition there is a back-end load in the form of a 1% deferred sales charge for the first year.  With both the B and C shares, there is typically no additional charge for transferring to another fund in the same family and share class, though this could trigger a taxable situation if there is a gain and the fund is held in a taxable account.

Beyond the load world, there are still a number of share class options to consider:

  • A number of fund companies offer separate retirement share classes for use in 401(k) plans.  The most robust menu of retirement plan share classes belongs to the American Funds.  Continuing with the American Funds Washington Mutual example, there are 6 retirement plan share classes with the following expense ratios:
    • R1 – 1.40%
    • R2 – 1.39%
    • R3 – 0.96%
    • R4 – 0.65%
    • R5 – 0.35%
    • R6 – 0.31%

These lower expenses fall right to your “bottom line” in the form of higher returns to shareholders.  If your plan contains funds in what appear to be a higher cost retirement share class (whether via the American Funds or other fund families) this might be a reason to question those who are responsible for running your company’s plan.  The fund expense disclosures that you have likely received by now for your company retirement plan are a great starting point to review the expenses of all investment options offered by the plan.

  • Even low cost provider Vanguard has different share classes for some of their funds; generally the more advantageous share classes have a higher minimum investment than their base Investor share class.  Using the Index 500 Fund as an example, the Investor share class has a low expense ratio of 0.17%.  However, if you have $10,000 invested in this fund you will have access to the Admiral share class with an ultra-low expense ratio of 0.05%.  In some situations the next level fund for investors might be the Signal share class with an identical expense ratio.  If you hold the Investor share class check with your custodian to see which share class you are eligible for.  Typically if you invest directly with Vanguard they will notify you automatically if you are eligible for the Admiral shares.
  • One of the advantages that I am able to offer my clients is access to more advantageous share classes than they could generally get on their own.  One example is the PIMco Total Return bond fund.  The D share class is no-load with a $1,000 minimum investment.  This share class carries an expense ratio of 0.75%.  I have access via Schwab to the Institutional share class of the fund, which usually carries a $1 million minimum investment and a much lower expense ratio of 0.46%.  This difference is significant especially in a bond fund.  This is a benefit that many advisors can bring to their clients across various investment platforms.

These just a few examples of differences in share class among the same mutual fund.  Whether you invest on your own, via a financial advisor, or within your company retirement plan; it behooves you to understand and question the various share classes available to you.  While the differences in expense ratios may seem small, the impact of a lower expense ratio can be huge in terms of the amount you accumulate over time.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Also please check out our Resources page for more tools and services that you might find useful.

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Vanguard and the Power of Twitter

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Image representing Twitter as depicted in Crun...

Two upfront disclaimers:

1.      Nothing in this post or on this blog should be construed as financial advice or a recommendation to take any action of any kind.  Financial decisions should be made only after a careful review of your personal situation and in consultation with your tax and financial advisor.
2.      I have a great deal of respect and admiration for the Vanguard organization.  Across my base of individual and institutional clients I use a number of Vanguard mutual funds and ETFs.
That said Vanguard recently made a decision to lower the investment minimums on its Admiral Share class of funds for investors in these funds who hold their shares at Vanguard.  The Admiral shares offer an even lower expense ratio than Vanguard’s Investor Share class which already has very low expenses.  This is a great gesture on Vanguard’s part because they are essentially earning less by doing this.  Other than the expense ratios, the fund portfolios are the same across all Vanguard share classes.
However, Vanguard did not initially extend this opportunity to Vanguard fund shareholders at other custodians such as Schwab or Fidelity.  Though this did not impact a large number of my clients, I viewed this as unfair to clients of many financial advisors.  Like many advisors, I use Schwab as my primary custodian for most of my individual clients and one of my larger retirement plan clients.  There we hold mutual funds and ETFs from a variety of fund companies, including Vanguard. 
The idea of Vanguard treating the clients of financial advisors holding their funds elsewhere differently (and worse) than shareholders who dealt directly with Vanguard really bothered me.  This seemed very “un-Vanguard-like.”  Most of my institutional clients are already in lower cost share classes; additionally I have tended to use Vanguard’s ETFs for most of my individual clients which carry a very low expense ratio that is generally comparable to Vanguard’s lowest expense mutual fund share class.
None-the-less I sent several Twitter messages to Vanguard saying in effect that it was wrong to treat our clients as second class shareholders and also asking them why they were anti-advisor.  Evidently so did a number of my fellow advisors and consultants because a short time later I received an email saying that a similar opportunity would be made available to advisor clients at other custodians.  The social media activity was mentioned to me in a conversation with a Vanguard rep.
The point is that Twitter and social media can be a powerful communications tool for financial advisors.  In this case it proved to be an excellent vehicle for us to pressure Vanguard to do the right thing for our clients.  Many mutual fund companies are using social media as a vehicle to engage advisors and shareholders.  That’s great, the more we know the better able we are to make intelligent investment choices for our clients.  The flip side is that the fund companies should expect to be called out when they do something as short-sighted as what Vanguard did recently. 
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American Funds-The Secret Sauce for 401(k) Plans?

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Many registered reps selling 401(k) plans in the small to mid-sized market would have you believe this.

To be clear, I have enormous respect and admiration for American Funds as a fund family. They offer a number of excellent funds. They have a deep management/research group. I use several of their funds in 401(k) plan line-ups and in the accounts of some of my individual clients (no-load share classes).

Contrary to what these registered reps may tell you, an all American Funds lineup is not, in my opinion, a complete 401(k) solution.

  • There are no domestic small or mid cap funds in the American Funds line-up. These are typically core asset classes in a well-balanced plan lineup.
  • For 401(k) plans, the R class of shares is typically used. For smaller plans this might entail the R1 or R2 share classes, larger plans can use the much more reasonable R4 or R5 share classes.
  • For example looking at the Large Value Washington Mutual Fund
    • R1 expense ratio is 1.43% which includes a 12b-1 fee of 0.99%
    • R2 expense ratio is 1.50% which includes a 12b-1 fee of 0.75%
    • R3 expense ratio is 0.97% which includes a 12b-1 fee of 0.50%
    • R4 expense ratio is 0.69% which includes a 12b-1 fee of 0.25%
    • R5 expense ratio is 0.39% with no 12b-1 fee
  • In the case of most registered reps and commissioned brokers, the 12b-1 will go to compensate them for their involvement with the plan.
  • These expenses take their toll on the quality of the fund. Washington Mutual’s R1, R2, and R3 shares earned a score of 42 in the Fi360 ranking system as of 3/31/2010. This score is just in the top half of the peer group. By contrast the R4 shares earned a score of 23, which places this share class in the top quartile of its peer group. The R5 shares earned a score of 17.
  • Looking at this another way, the five year average annual return for the R1 shares is 0.47%; for the R5 shares it is 1.55%.

As a plan sponsor, if your advisor suggests going with an all American Funds line-up for your company’s 401(k) plan, you should ask many questions.

In the commissioned world, the American Funds represent one of the best fund families many of these reps can sell. As with other top-notch fund families such as T. Rowe Price and Vanguard, using a line-up consisting exclusively of any fund family is usually not a good idea and generally does not provide the best 401(k) line-up. This approach may be in your broker’s best interests, but as a 401(k) plan sponsor you need to do what is in the best interests of the participants in your company’s retirement plan.

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.

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Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

 

 

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Characteristics of a Good 401(k) Plan

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My last post discussed some really sub-par 401(k) plans. I’ve also been fairly vocal in discussion groups on LinkedIn about some of the issues and problems I see in many plans.

So what does a good 401(k) plan look like? Here are some of my thoughts based upon my experience as a consultant to a number of small to mid-sized plans (typically in the $3 million to $75 million range). Some of the characteristics of good, well managed plans are:

An active and engaged Investment Committee is essential. Several committees I deal with are comprised of the company chairman, president and the top financial executive. One committee is made up of the president, the senior finance and human resources executives, as well as three members of the union from the company’s manufacturing operations. What these committees have in common is an interest in the plan and a desire to offer a top-notch plan for their fellow plan participants.

An investment process governing the management of the plan. The major piece of this process is a written Investment Policy Statement (IPS). Think of the IPS as the “business plan” for the 401(k) plan. Included in a good IPS are things such as a definition of the types of investment vehicles permitted; asset classes to be considered; criteria for the selection of the investments offered; criteria for monitoring those investments; a process for the review and possible replacement of any investments that fall outside of acceptable criteria. Additionally the IPS should specify that the Investment Committee will review expenses associated with administration, custody, and related services, as well as the quality of those services.

A well-documented investment process does two things. First it is a vehicle for the plan sponsor to document that they are running the plan in a fashion consistent with their fiduciary obligations. Second, this type of process, if followed, will ensure that there are solid investments being offered and that expenses are being reviewed.

A menu of solid, well diversified investment options is offered. A provider can offer the greatest website and all of the bells and whistles available, but at the end of the day what really matters is that the participants have a diversified menu of very solid investment choices that are selected and monitored in accordance with the IPS. The investments should cover most or all of the nine Morningstar domestic style boxes as well as at least one fixed income, money market or stable value, and at least one international equity choice. Balanced options, lifestyle, or target funds that allow the participants to delegate the allocation of their assets should also be included. These choices should be scrutinized, monitored, and reviewed in the same manner as the other plan investment options. Depending upon the preferences of the Investment Committee, the company’s census demographics, and other factors, options in other assets classes might be included as well.

Overall plan expenses are monitored and controlled by the investment committee. Investment expenses are an obvious aspect of this, but the plan sponsor is responsible for all plan expenses. This also includes all expenses associated with record keeping, administration, and custody. The sponsor should know what is being charged for all services and how these total expenses compare with plans of a similar size. If there is revenue sharing involved, the plan sponsor should receive a full accounting at least annually of all revenue sharing paid to the plan provider and how that revenue sharing was spent. This is after all the participant’s money, accounting for these dollars is a fiduciary obligation of the plan sponsor.

In the future hopefully plans will offer their participants the option of having an unbiased, unconflicted Fiduciary Advisor manage their individual 401(k) accounts. This goes far beyond the education currently offered by some plans and, in my opinion, gets to the real heart of what participants need.

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