Wednesday, April 20, 2011

Investing PART 13: Mutual funds

Now that’s a broad subject

There are so many different types of mutual funds that covering just the categories could fill an encyclopedia, or Wikipedia if that’s your preference. So, it seems PART 13 is an appropriate time to address them. For a musical reference use Lucky Man and the reader can pick the version and artist to fit the type of fund being discussed. With so many types of mutual funds, one shouldn’t be surprised that The Hedged Economists’ comment about not liking mutual funds comes with caveats. So, the natural question is, “How can an investor best use mutual funds?”

They’re a decent place to park investment funds while waiting for an opportunity. They are an excellent way to get initial or additional exposure to certain asset classes. They provide a convenient benchmark that is easy to interpret. But, they are an extremely inefficient, hard to analyze, and risky way to invest in certain asset classes that should be the major focus of individual investors.

Nothing that follows negates the statement, “The only thing that is more dangerous than advice is letting someone else manage your money.” Managing other peoples’ money is what a mutual fund manager does. Don’t get me wrong. Most mutual fund managers are bright, honest, hardworking, and knowledgeable. They are frequently evaluated against goals that I’d respectfully decline. But, “therein lies the problem.” Their goals aren’t mine, and probably aren’t yours. To illustrate, many people complained about their stock mutual funds declining during the recent market turmoil without bothering to check whether the fund was achieving its stated objective. The investor’s objective was different from the funds’ and thus the fund managers’.

Thus, one of the reasons to not like mutual funds is that people assume that someone who knows what they’re doing is managing their money and acting in their interest; not possible, since the fund manager doesn’t even know what their interest is. If one wants a set-it-and-forget-it investment, don’t expect it from a mutual fund. Mutual funds need to be watched more closely that a stock portfolio; they’re dangerous. Things change at mutual funds more quickly than at most companies. Furthermore, there tends to be better information on what’s going on at companies than at mutual funds, and the information is more accessible. It follows that with rare exceptions a mutual fund shouldn’t be a long-run holding.

Those following this blog will immediately note the consistency of this attitude with the previous posting on 401(k)s (PART 11 ). Since the best use of a 401(k) is accumulation, not investment, temporarily being in mutual funds is OK. That is a natural lead into the second good use of mutual funds: they’re often a convenient place to temporarily park money within a target asset class while waiting for, or looking for, an opportunity to invest in the asset class. But, keep in mind, one pays for that parking space (in the form of fund fees).

The fee-based parking space analogy extends to a potentially non-401(k) use, although it’s preferable to do it in a 401(k). A temporary parking spot is appropriate if one wants to diversify into an asset class in which they don’t feel comfortable analyzing the individual assets. There is no preset limit on how long the parking spot is used.

For example, foreign stocks (other than truly global companies) include a large number of companies that most investors probably never heard of, and it may be difficult to get good information about even global companies that are foreign based, especially information one can interpret and trust. That’s especially true of emerging markets where the problem may be complicated by differences in how markets function and data is defined. Thus, for foreign investments mutual funds may come to resemble permanent features. Eventually, however, many investors will be able to take a few positions replacing some of the mutual fund positions in order to increase performance and reduce the fees they’re paying the funds.

Differences in accounting practices and tax treatment among different asset classes can be a problem even with domestically-based companies. For example, most publically traded corporations in the US are what are called “C corps” or C Corporations. In fact, C corp is what most people mean when they say “corporation.” Real Estate Investment Trusts (REITS), technically trusts, and Master Limited Partnerships (MLPS) are just two examples of other forms of securities that are fairly widely traded. They each have their own reporting and tax wrinkles. Mutual funds may be a way to ease into these asset classes.

Mutual funds don’t eliminate the need to understand the accounting and tax treatment in general. However, mutual funds eliminate the need to understand the relative impact of the unique features within the asset class. In other words, you can initially concentrate on the impact of holdings in the class on YOU. Later you can start analyzing the impact of those features of the asset class on the different offerings within the asset class.

Once the general implication of each asset class’s unique features are understood, mutual funds may represent a way to gain initial exposure while becoming more familiar with the asset class. Fortunately, these asset classes have a lot in common with stocks of C corps. It won’t be long before it will be the tax implications of holding the individual assets that are driving the choice between direct investment and mutual fund investment. At that point, individual holdings may offer tax and cost benefits, as well as potential return benefits.

Another use of mutual funds is to benchmark one’s management of a portfolio. To illustrate, stock mutual funds are an excellent way to benchmark one’s stock portfolio. One can benchmark it against an index or a specific manager. Some friends who are mutual fund managers think it is foolish for an individual to manage a stock portfolio. They’re quick to point out the advantages fund managers have. There are many. However, mutual fund managers use those advantages to accomplish their objective which generally involves beating a specific benchmark over a specific time frame. That benchmark may be totally irrelevant to you.

Bogle argues that it’s folly for anyone, professional or individual investor, to try to manage a stock portfolio. When boiled down, his argument is based on that the assumption the performance of a capitalization-weighted index should be ones objective. That’s ridiculous. Why not seek a lower volatility or some other objective? Others have argued for other weights, but the entire logic hinges on some weighting scheme matching one’s objective. That’s equally silly. Ultimately, no weighting scheme can match your timing requirements, tolerance of volatility, etc.

By using a mutual fund to benchmark one’s portfolio, one can see whether the fund, with its own objectives, or your portfolio, constructed to accomplish your objective, actually comes closer to achieving your objective.

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