Investing PART 13: Mutual funds (contd.)

Other fund categories: A fund for each season, but not for all seasons.

So far, funds have been discussed in terms of assets held in the funds. It’s a logical starting point: after all, the assets one owns are important. However, a mutual fund makes ownership an indirect affair. So, this posting address some categories of mutual funds based on characteristics of the fund one is letting own one’s assets. That is also important.

Let’s quickly dispense with load verses no-load funds by reviewing a little history. Load funds charge a fee / commission to buy the shares. Originally funds with a load tried to sell directly to the public. Competition from no-load funds killed that fast. Mutual fund salesmen where able to keep load funds alive for a while, but then the “mutual fund salesman” went the way of the dinosaur. The fund companies shifted to stock brokers and insurance salesmen as sales agents. Why anyone would buy based on a broker’s recommendation for a mutual fund escapes me. The history of the industry on stock recommendations should at least provide a caution. It’s equally curious that anyone would think representing a good insurance company qualifies a person to pick mutual funds.

The most recent incarnation of the mutual fund salesman is the financial planner. This is a true disgrace. It’s one thing for a person to say they’re a salesman (as are brokers and insurance salesmen) to then sell you something. It’s disgraceful to represent oneself as providing a planning service when in fact you’re a commissioned salesman. Fortunately, fee-based planners and wrap fees (an annual fee based on assets being managed) are creating pressure on commissions.

Alas, however, there are planners who “double dip” (i.e., charging a fee and taking commissions). One suspects that the days of double dipping are numbered. What this little tour down memory lane should make clear is that the existence of mutual funds with loads involves an unnecessary sales cost. People who plan to invest should just avoid them as a general rule.

Another way the mutual fund offering can be segmented is based on whether they are closed-end or open-end. Closed-end funds have a fixed number of shares trading on the stock exchanges. The shares trade at prices that can substantially differ from their Net Asset Value (NAV). There can be many reasons why the fund may trade at a price that differs from the value of its assets. People who trade closed-end funds tend to become specialists on the topic of NAV-to-price gaps. More power to ‘em, but the phrase “trade closed-end funds” sums up the issue. Closed-end fund trading is different from long-run holding.

There is another important point. Some closed-end funds in both the stock and the bond fund space use leverage. They borrow in order to expand their asset base. Letting someone manage the leverage in one’s portfolio doesn’t seem like a good long-run strategy. At times, using short-run loans to purchase longer-run assets makes sense, and closed-end funds may be able to access markets that most investors can’t access such as the repo market. However, the use of leverage as a tactic or even as a strategy is very different from just turning it over to a fund manager.

Just to round out this list of things not to like, let’s look at Exchange Traded Funds (ETFs). Most people don’t get past the lower fees when they consider ETFs. Then many people trade in and out so quickly they never benefit from the lower management fees. Those lower fees CAN be a big benefit if the ETF is liquid, but one has to hold the ETF long enough for the lower fees to offset trading costs. Remember there are bid-ask spreads and potential brokerage fees (currently waived on the ETF trade by some brokers for some or all customers).

Stop for a moment and consider why a money manager would create an ETF. The first thing you’ll notice is that many of the initial ETFs weren’t created by pure money managers. They involved organizations with an interest in making a market (i.e., organizations that make money based on the volume of transactions). Consider this perfectly reasonable spawn-of-the-devil explanation for their origin:

A bunch of market makers get together to commiserate about how hard it is to earn a decent 7 figure bonus when investors just buy an S&P 500 index (or any mutual fund) and don’t trade. When that happens, the only time the market maker earns any money is when the stocks trade in order to accommodate a fund being liquidated by an investor. Since index funds buy the entire index, they don’t even impact relative performance which would at least produce some trades as the composition of the index changed.

Finally Stanley turns to Morgan and says, “If only we could get investors to trade the index.” Morgan being trained as a market maker says, “Yes, and in a way we can get more than one transaction out of it. We could really leverage our high frequency trading platform then. We could take some when they trade the index AND when the stocks in the index get traded.” Just then Stanley jumps up and shouts “I’ve got it! The problem is they need a way to do it.” Thus, a first was born: an investment vehicle perfectly tailored for investors who don’t want to commit to their investment for a full day.

Suddenly Morgan’s mouth starts to water. “To heck with just tapping the S&P index, we’ll spawn a whole family of indexes, use any old index we have laying around and create new ones if we have to.” Stanley senses irrational exuberance and realizes he had better interject some reality into Morgan’s get-rich-quick scheme. “Remember the index fund industry is competitive. We’ll get some boost from the trading, but we’ll be stuck managing a bunch of low fee funds.”

Now, Morgan’s true brilliance shows through. “Stanley you’re not thinking outside the box. We can double the benchmarks; one trade of the ETF will result in multiple trades of the underlying assets. The leverage possibilities are boundless and won’t even involve margin restriction. People may not even recognize how leveraged they are.” Morgan’s on a roll now: “Better yet, we’ll create perishables: we’ll offer ETFs with options as the underlying asset. Even offer ETFs that only track a benchmark for as little as a day. We’ll invent day trading in mutual funds. We’ll be famous. No, come to think of it, let’s stay anonymous. This is going to blow up for some traders. We’ll just take the money.”

Stanley, now infected with the sprit, but trained as a broker rather than a market maker, interjects a flash of brilliance. “With stocks, it’s really hard to churn-and-burn anymore. But, with asset classes, it’s a brave new world. I’ll bet with a little ‘education’ we can get the account holders to do the churning. We’ve got historical data on returns for different asset classes. All we have to do is show historically how moving assets between classes improved returns. It won’t be hard; it IS history after all.”

Morgan, ever the optimist where his ideas are concerned, suggests they might get a book out of it if they can think of a sexy name for it. “We’ll wait to publish. After all, having all those added assets moving between asset classes, especially with the added trading leverage, will make all the assets more volatile. If it works and produces more volatility, a little more history will make it look even better.”

Did this conversation take place? No, but it’s probably a decent reflection of someone’s thinking. Yet, spawn of the devil or not, some investors have learned how to make ETFs work for the investor. In so doing, here are a few things to keep in mind.

Having the commission on an ETF trade waived doesn’t make the trade costless. There can be an explicit bid-ask spread. High frequency traders with access to order flow (i.e., the buy and sell orders) can front-run the trade in the ETF. The same process can be repeated on the underlying assets if they need to be traded in order to manage the ETF’s NAV to price relationship. Further, there can be commissions on the trades of the underlying assets. Those commissions are a cost that the investors will bear. For the ETF purchaser, trading cost may be hard to identify and manage. Thus, the entire churn-and-burn damage could go undetected.

Even without churn-and-burn, ETFs aren’t cheaper than a decent stock portfolio. I recently saw this example, “The all-ETF portfolio might reduce hassle, but it is going to be FAR MORE EXPENSIVE for most! (It may be cheaper for some "just getting started" investors.)

DLN is listed at 0.28% and DGS at 0.63% expense ratio. [DLN and DGS are two stock ETFs.] By the time you have $30,000 invested equally between those two ETFs, you will be paying $273 per year (and climbing as your portfolio grows, we hope). $273/year is more than I pay in trading costs, and my portfolio is significantly more than $30,000 and I am spread between 6 accounts! (I used $30,000 because in the article $20-$30K is the range where no holding will be over 10% of the portfolio.)

[Stock] investing is not about trading, so trading costs are already minimal which means investment expenses of even a cheap fund look high.”

There is tail risk with EFTs. No one can predict how they will perform under stress conditions. ETFs are somewhere between a closed-end fund and an open-end fund. If trading in the ETF is too brisk, the ETF may not be able to keep the price equal to the benchmark (i.e., NAV and price may drift apart). There already are examples of these disparities continuing for months in some specialized ETFs. Even if the NAV and price don’t drift apart, the cost of keeping them aligned could skyrocket if bid-ask spreads on the underlying assets open up.

While most ETFs are like other mutual funds, some commodity-based ETFs are treated differently from other mutual funds for tax purposes. However, that is only an indication of a deeper problem an ETF investor has to consider. It seems market makers will generate an ETF for anything they think people will trade. They have no incentive to restrict their attention to investment vehicles. Thus, knowing what an ETF holds is even more important than with other mutual funds.

The very proliferation of types of ETFs is often advanced as a blessing ETFs make available. Investors can use ETFs to take positions in all sorts of exotica. But, it seems, those investors holding stocks and some bonds of companies that make things people want often get better portfolio returns. But, as always, it depends on the time frame picked and the length of the holding period. Yet, those who tout ETFs because of the range of assets they offer don’t realize that “more options” is NOT the same as “better options.”