Index v/s Managed funds

Mutual funds for the most part are managed by a professional (mutual fund manager). They have costs (expense ratio, loads) associated with them because after all the manager has to be paid for doing his/her job. The goal of most mutual funds is to beat a certain benchmark. For pure equity based funds, the benchmark can be any of the equity index (S&P 500). Sadly, many managed funds do not beat the index. Index funds track the index itself and so their performance is basically capped to that of the index being tracked. Index funds require little to no management and hence are cheaper than traditional funds.

"You get what you pay for" is what we have been told all these years. You would expect a fund managed by a paid professional to be able to beat a fund that is not managed at all. Research conducted in the Edinburgh, Scotland, by market research firm The WM Company found that almost 75% of "active funds" deviate only marginally from their benchmark index. The study covered data from 1980 to 2000, and found that 40% of supposedly active funds deviate by between 0-3%, and a further 34% by 3-6% per cent. The study also found that roughly three-quarters (127 out of 168) of funds simply do not beat the index.

The market indices are a good indicator of all the macroeconomic factors that affect the individual stocks. Most of these macro factors (jobs report, unemployment, inflation) have a bigger toll on the individual stock than the story surrounding the stock itself. The current recession is a classic example of how a company with good news dosen't get the same treatment it would in a bull market. Managed funds cherry pick stocks based on the stock story. They do not factor in the external, uncontrolled macro factors that affect the stock price. Index funds factor in those parameters implicitly. This is probably why money managers have a tough time barely beating the index or sometimes just meeting the index.

Asset allocation of the 2010 target date funds.

Target date funds are under scrutiny by Washington because apparently the 2010 funds from different fund families (Fidelity, T Rowe, Oppenheimer) took a 40% dive in 2008. Most of the target date funds were heavily invested in stocks instead of bonds and cash despite being so close to the target date (2010). The fact of the matter is that 2008 has been an ugly year for all funds out there. Even pure income/bond funds have been hit hard. Bonds are safer than stocks but they are not risk free. Even money market funds carry some risk. The 2008 meltdown has effected stocks and bonds equally. The only safe place is "cash". Below are some of the year to date asset allocation numbers for 2010 funds from different fund families.

TRRAX (T.Rowe 2010)

Cash 43.83%
Stocks 34.47%
Bonds 21.12%
Preferred 0.16%
Convertible 0.08%
Other 0.34%

JSWSX (JPMorgan 2010)

Cash 9.51%
Stocks 40.88%
Bonds 48.71%
Preferred 0.11%
Convertible 0.01%
Other 0.77%

FFFCX (Fidelity 2010)

Cash 11.37%
Stocks 50.17%
Bonds 35.64%
Preferred 0.22%
Convertible 0.12%
Other 2.49%

VTNEX (Vanguard 2010)

Cash 2.57%
Stocks 52.23%
Bonds 44.42%
Preferred 0.05%
Other 0.73%

OTTAX (Oppenheimer 2010)

Cash 8.15%
Stocks 61.48%
Bonds 29.12%
Preferred 0.05%
Convertible 0.01%
Other 1.19%


JP Morgan 2010 is the only fund with more bonds than stocks in 2009. Even though T.Rowe 2010 is more invested in stocks, it has the highest cash position (which I like), the 44% cash position offsets any risk the 35% exposure to stocks entails. The folks at T.Rowe have it right. When you are closest to your target date, most of your money is allocated to the safest medium "cash".

I did hate to be the owner of OTTAX, VTNEX right now. Unless, you are a raging nursing home equity trader, you are SOL with that kind of asset allocation so close to the target date. I guess the fund managers are trying to make up for the 2008 losses in HOPES of a 2009 recovery and have therefore invested in stocks so late in the game (close to 2010). The ethical question they are facing is whether they should stick to the asset allocation ratio they were supposed (as dictated by the fund prospectus) or should they deviate from it so as to make up for the unprecedented 2008 losses. In the end, its all about making money for the investors, however HOPE was not the sentiment I was looking for in professional money managers.

Good v/s Bad - The stock market way

If you are Generation X, you have probably heard your parents lament about how the "state of the union" (where the union = world) is bad and how we are all going through a giant wave of ethical, moral and religious degradation. Life back then was a lot more innocent and folks back then were less crime prone. Is our generation more crime prone or are we just victims of a media on steroids which has its spotlight on the tiniest of infractions. I mean seriously, when did a drunk driving incident in Hong Kong warrant CNN coverage in the US?

Nevertheless, it seemed like an interesting exercise to see if there was a single metric that would sum up our moral,ethical and religious priorities and I figured the stock market is one hell of an indicator. Take three mutual funds VICEX, AVEMX and IMANX.

VICEX: The "Vice" fund is a mutual fund that invests in companies that deal with human vice i.e. alcohol, tobacco, firearms, wars. Companies include: Philip Morris (Marlboro), Carslberg (Beer), Lockheed Martin (planes, missiles...wars?).

AVEMX: The Ave Maria Catholic Values. Invest in companies that support catholic values and meet their religious criteria. Companies include: Western Union, Sherwin-Williams, General Cable etc.

IMANX: Iman K. This fund invests in companies that adhere to Islamic values. Companies include: Google, Coca-Cola, Eli Lilly, China Mobile (I'm still researching the connection between Islam and these companies).

Over the past 10 yrs, which are a slice of the "supposed evil times" we live in, the VICEX grew 33%, AVEMX grew 10% and IMANX grew 12%.

Here's the 10yr Google chart

Of course, the same chart over 1yr, 5 yr periods shows that the good and the bad got hammered by the UGLY (the sub-prime mortage mess)

1 yr chart

5 yr chart

However, the YTD chart for 2009 are looking good for the "faith based/religious" funds. Looks like all that praying during the downfall of 2008 paid off!!.

Year to date chart

Insuring your retirement

Popular retirement vehicles such as 401K and IRA just expose the average investor to raw equities/bonds with no guarantees. Even though these vehicles are for parking your money for the long term and they are tax deferred, there is no security net. Your retirement can go to $0 in theory.

When you buy a big ticket item like a house, car you get insurance. The money that you sock away for retirement is sacred and it makes sense that it should be insured too. Annuities offer exactly that. They provide insurance for the money you sock away for retirement. They are tax deferred. There are fixed income and variable annuities (backed by the equity market) depending on what sort of income you want upon maturity of your annuity. A fixed income annuity will give you fixed income which may not keep up with inflation. A variable annuity (backed by mutual funds) can give you more income but can also go down, but because these are packaged with insurance, you do get some money if things were to go sour when you were about to retire.

Annuities because of their inherent tax deferred nature are best handled outside a 401K and IRA

Here's an excellent article on Annuities from the SEC

California's $24 billion budget deficit & YOU!

California is facing a $24 billion budget gap with no obvious way to close it. You may not live in CA, but the budget cuts in CA and its Govt's inability to pay its own employees is a warning bell for all those California "bond" holders like you.

A "bond" is something Govt's issue to raise money for infrastructure projects. So its essentially an IOU from the Govt where the U is literally you the investor in mutual funds. If the CA Govt does not feel the need to pay its employees because of the budget cuts, it certainly will default on the IOUs it has doled out to the average Joe investor. California defaulting on its $59 billion in outstanding general obligation bonds is unavoidable.

To the average Joe investor this means check your mutual fund portfolio and make sure you are not heavily invested in CA govt bonds through local municipal bond funds or national funds that invest heavily in CA. Unfortunately, CA is the highest issuer of tax exempt bonds, so its popularity is high and it is probably sitting right there in your portfolio about to go bust.

Target date mutual funds

Target date mutual funds (aka Life cycle, retirement funds) are growing in popularity in company 401Ks and IRAs. They are mutual funds where you pick a date when you want to retire (say 2030) and then you pick a fund with that date. Target date funds model the classic investment mantra of picking more risky stocks over bonds when you are still young and decades away from retirement and then as you approach retirement you limit your risk and have some income generating bonds in your portfolio. The appeal of these funds is that all the rebalancing and asset allocation is done for you automatically and is adjusted as you approach your retirement age. These funds are ideal for passive investors who do not have the time to research funds on a continuous basis nor do they have a professionally managed portfolio. Since a target date fund models diversification, asset allocation and all that good stuff for you, it makes sense to allocate 100% of your money to a target date fund in your portfolio. If you have other funds in your portfolio, your "overall" portfolio mix will be skewed I.e. you might be over/under invested in stocks/bonds.


Most fund families (Fidelity, T.Rowe Price, Vanguard and Oppenheimer) with their respective 2030 funds (FFFEX, TRRCX,VTHRX) offer no-load funds. Look out for expense ratios, fees, Morningstar rating, read about the fund manager and have an idea on the fund's objective.

CD Ladders

Simply put, a CD ladder is a collection of CDs bought at regular intervals so that they’ll mature at regular intervals as well. Let’s say I wanted to create a simple CD ladder out of six month CDs. I buy one on the first of each month for six months. Then, on the first day of the seventh month, that first CD I bought matures and I collect a nice return. I can then either buy a new CD for the original amount and pocket the return, just keep all of the return and the original amount for some purchase, or I can buy a new CD for the total return. After that, each month, a CD matures and I can either buy a new one or use it for something else.

Advantages

• Usually higher rates than a savings account
  
• Recurring income
• Easy liquidity
  

Disadvantages

• Taxes.
• Money is locked in.
  

Hedge fund like mutual funds

Do you have a million dollars in your back pocket, or $200,000 a year in income? If not, you can't qualify as an accredited investor according to the SEC, and it means you are completely shut out of investing in hedge funds.

Hedging is a strategy of investing in a manner to limit risks. If you are long on a stock, you are totally at the mercy of the stock going to zero. If however, you also went short on the same stock you would limit your risk since the investment would go up in a downturn.

Hedge funds have been notoriously famous as the rich people's investment vehicles. Hedge fund managers are famous for their over the top salaries partly because they bust their behinds trying to maximize returns for their investors. Unlike traditional mutual funds which have a SEC limitation of not holding more equities short than long, hedge funds are kinda under-regulated allowing hedge fund managers to adopt aggressive strategies to make money.

New mutual funds have popped up recently that adopt hedge fund like strategies (long/short, market neutral, arbitrage). The following chart shows the different hedge-fundish mutual funds compared to JDVBX (a somewhat conservative mutual fund)

Compare

Index linked CDs

The classic "Certificate of Deposit" CD is the the fixed interest rate CD. There is also an index linked CD where the interest rate on the CD varies with the underlying equity index. It can go down or up and there is no guarantee that you will get a fixed return after maturity, although there is a high probability for the return to be higher than a traditional fixed rate CD should the market behave well.

There is one interesting catch with an index linked CD though that sets it apart from mutual funds and raw stocks. Your principal is FDIC insured. So at the end of 6 months, you may not make any money on the principal but the volatility of the equity market does not eat up your principal, something that would happen in a mutual fund or a raw stock.

Index linked CDs are an attractive option for nervous wannabe stock market investors who don't want to lose what they have but don't mind making more!. Index linked CDs are ideal for an IRA account. You get tax deferred capital preservation with a possibility of making money!

Scrambled nest eggs

The average 401K plan savings has gone down by 30% thanks to the economic downturn. That is a significant hit for a person who is about to retire today. You are left high and dry smack dab in the middle of your retirement plans because of the wanton greediness exercised by the higher echelons of the finance industry. You put your good faith in the US equity markets and at the end of the day you are shoved the tiny footprint in your face "FDIC Not Insured".

Why are some aspects of the 401k plan not FDIC insured?. The first $250,000 of a bank account are insured by the FDIC, why then is the principal that I deposit through my paycheck every payday not insured?. The capital gains on the principal need not be insured. I don't even care if the company match is insured. Hell, I'm even willing to pay higher capital gain taxes if I'm guaranteed to have my principal when I'm about to cash out my 401K.

We tout this plan as a retirement plan, a supposed "nest egg" and it has a zero safety net!.

No thanks, If I want my eggs scrambled, I will go to IHOP. Please leave my 401k nest egg alone!

Copycat investing.

Picking stocks/funds for investing is neither an art nor a science. It is voodoo. For those of us with non-finance and non-investment related full-time jobs, it is time consuming to research stocks and get the story straight on any one particular stock. It is easier instead to peek into the portfolio of a seasoned investor and see what they are up to and try to mimic or learn from that.

While trying to know what Warren Buffet's portfolio looks like, I stumbled upon StockPickr. It lists the portfolios of many famous investors and Wall St. veterans. It also lists what stocks some mutual funds hold.

Copycat investing should be prudent and make common sense. A few things to remember are

• It is important to note "when" the investors got in on the stock. Timing is everything. If Buffet got in on a stock X when it was $60 and today the stock is $100, you are kinda late to the party. Move on to the next stock.


• You also want to know if the investor is "long" or "short" on the stock. Don't go long on a stock that Carl ICahn is shorting. That is like swimming against the tide!.


• Also you should still get to know the underlying reason why the investor got in on the stock, because when that reason ceases to exist, you should bail out of the stock before the seasoned investor does (which is very difficult). Usually, when a a big player sells his position in a stock, there is a sell off and you don't want to be riding that downward slope.

Taming inflation with TIPS

Benjamin Franklin (1706-90) wrote in a letter to Jean-Baptiste Leroy, 1789, which was re-printed in The Works of Benjamin Franklin, 1817: "'In this world nothing can be said to be certain, except death and taxes."

Let me also add one more thing that is certain .. "inflation". Things just keep getting expensive!!. Inflation is a hidden monster that eats away at your savings and investments. If you are conservative with your money its not going to grow fast enough to keep up with inflation. Savings and checking accounts offer low interest rates and although your money is safe it just doesn't grow fast enough.

Investing in stocks and mutual funds through 401K and IRA may make your money grow, but those are long term investment plans for your retirement and your money is kinda locked in and cannot be withdrawn without penalties, also your money can go down in value as these are after all stocks & bonds controlled by the free market and general economic conditions.

What you need is an investment vehicle where your money does not go down in value and its not locked in and grows at a rate that factors in inflation. Enter TIPS.

TIPS stands for Treasury Inflation Protected Securities. These are securities sponsored by the US Dept. of Treasury (aka Government). You can buy and sell them in the open market and the value of these securities is indexed against the inflation index so that when there is inflation, the principal goes up and when there is deflation (very rare), it goes down and the best part is that if your principal goes down in value, the US govt will give you back your original principal. You can never lose money this way. Your money is not locked in unlike traditional savings bonds, 401Ks and IRAs (which have a maturity date). You get paid interest twice a year with TIPS and you get paid interest on the inflation adjusted principal.

Some might say that TIPS are like CDs, high interest savings but they are not. CDs lock you in. High interest saving accounts expect you to have a minimum balance maintained, plus none of these are adjusted for inflation.

TIPS