Monday, May 2, 2011

Investing PART 13: Mutual funds (contd.)

Stock funds: It is amazing they get away with this stuff (i.e., their sales pitches)

This series on investing started with a reference to an article that talked about asset mix. It used mutual funds in the illustration. Note that the definition used throughout the series has included all types of funds including Exchange Traded Funds (ETF)s.

The previous posting discussed some potentially positive uses of mutual funds. This posting starts a discussion of some misconceptions and downright destructive aspects of mutual funds. Since there is a lot to cover, it’s going to be broken down based on broad categories of funds. The first category and the subject of this posting is stock funds.

It is very important to note that in the first part of this posting diversification was NOT among the reasons for owning a mutual fund. A mutual fund can provide diversification, but usually only within an asset class and, in most cases, far beyond any reasonable level. Using large cap stocks as an example one could chose 10 to 20 stocks with an eye toward avoiding industry overlap and companies with similar reactions to the economy. The resulting portfolio would provide more of the benefits of diversification than most mutual funds.

Mutual funds make it more complicated, not less. There are more mutual funds trading stocks than there are stocks on the New York Stock Exchange. So, the belief that it’s easier to pick a mutual fund than a stock rings hollow. Further, with mutual funds there’s less performance data. For historical data, with a mutual fund one basically gets price data, unless it’s a new fund, in which case, one may not even get that. For most funds digging to get historical cost data beyond a few years or historical holdings is far from easy. Tenures of fund managers aren’t easier to forecast than management tenure at a corporation. It would seem that who is going to run the place is worth knowing. Getting historical data on dividends and capital gains distributions for a mutual fund seems a lot harder than getting data on the history of a corporation’s dividend. Dividends and capital gains are basic information on the cash flow generated for investors.

Basically, if you’re willing to make the long shot bet that the fund manager is going to pick winners, managed mutual funds make sense. But, it’s a long shot. Most fund managers don’t beat the market even before fees. One should be careful how one interprets such statistics. Keep in mind that not all mutual funds try to beat the overall market. But, the fact remains.

Some people advocate index funds as a response to the underperformance risk. Index funds, a specific type of mutual fund, are specifically designed to reflect the value of a specific type of asset. Generally they do. That’s almost always true of traditional index mutual funds and generally true of index ETFs.

Bogle, the founder of Vanguard, 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 the assumption that the performance of a capitalization-weighted index should be one’s 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.

Joel Greenblatt, founder of New York hedge fund Gotham Capital and author of 2005's "The Little Book That Beats the Market," launched a family of mutual funds. He obviously has skin in the game since he’s launched his own index fund based on his weights. Nevertheless, his critique of cap-weighted funds is worth noting. Weight uses market capitalization to decide how much importance to put on individual stocks, after adjusting for the amount of shares available for the public to trade. Cap-weighted funds, he argues, are forced to overpay for wildly popular stocks.

About all index funds have going for themselves is low expense ratios, But that’s no guarantee the expenses will be lower than a self-managed portfolio. For example, it isn’t that hard to pick a portfolio of a dozen stocks that would pretty much track the S&P 500 over a decade or two with no costs other than the initial commissions. The important point though isn’t just cost. The important thing is what the index represents. If it’s a stock index, it will be just as volatile as stocks. If it is held long run, expect big down years. If it’s a bond index fund, it is just an interest rate play and one you don’t control.

With index funds, it gets especially important to know what makes up the index and how the fund imitates the index if the index is for a specialized sector. Sector ETFs are a case in point. They often are proxies for a few company stocks, including stocks one might not buy if presented separately along with their financial data.

Thus, while there are ways to use stock mutual funds, an awful lot of what’s said about their benefits is non-sense. Sales pitches have content. Generally, the more content the better the pitch. But, they’re a pitch, not financial advice. Don’t confuse one for the other.

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