Monday, March 3, 2014

A Word of Explanation.

Pick a mutual fund for your purpose.

Last month's postings on mutual funds all referenced open-end funds (“The Three Fund Portfolios, A Core of Mutual Funds: Part 1 and Part 2, Funds for Asset Class Diversification”).  The use of open-end funds was consistent with the focus of the postings. 

Often, much is made of the distinction between closed-end versus open-end funds, open-end funds versus Exchange Traded Funds(ETFs), and index funds versus managed funds.  Each type of fund is appropriate for a particular investment objective. 

Most people have no problem understanding that when the decision is between a bond fund versus a stock fund.  By contrast, when they focus within the stock fund universe, both investors and financial commentators lose sight of the fact that each type of mutual fund has a purpose.  They often get absorbed by recent relative returns or short-run projected returns.  

The investor ultimately has to select a type of fund that is consistent with his or her objective for the fund investment.  For example, last month’s postings make quite clear that the selection between index funds and managed funds had nothing to do with short-run projected returns or historical relative returns.  The selection criteria were based on the portfolio objective.

However, just stating what the portfolio objective is and pointing out funds that meet that objective does not automatically rule out alternatives.  Consequently, why other alternative types of funds were not appropriate for last month’s portfolio discussion is worth addressing.  One of the advantages of such a discussion is that it provides an opportunity to identify when those alternatives would be appropriate.

In last month’s discussion of mutual funds, the importance of low fees was pointed out.  Thus, a legitimate question is: Why were ETFs, which often have lower fees than open-end funds, not used instead of index funds?  The March 1, 2014 WALL STREET JOURNAL ran an article entitled “Do ETFs Turn Investors Into Market Timers?”  For those who did not already know, it documents how ETFs’ primary advantage, that they can be traded easily, is far from a blessing. 

The research cited in the article includes a Vanguard study that summarizes why ETFs were not mentioned in last month's postings: “The individuals owning ETFs were more than twice as likely to fall outside the "buy and hold" category than those who owned open-end share classes….”  Since the postings were about a buy-and-hold strategy, open-end funds seemed more appropriate. 

The fact that Vanguard’s ETF investors were not pursuing a buy-and-hold strategy does not mean an ETF could not be used in a buy-and-hold strategy.  Theoretically one could purchase an ETF and use it in exactly the same way as the postings recommended using open-end funds.  However, that does not seem to be what happens in practice.   The theoretical possibility is interesting, but what really matters is actual investor experience.  By applying a statistical model that relates frequency of trading to various investor characteristics, the Vanguard study hints at something more fundamental being at work.  People with the same investor characteristics seem to behave differently when they own ETFs instead of open-ended funds.

That impression is supported by data from the largest brokerages in Germany. The researchers found that performance deteriorated for the average investor after he or she began investing in "easy-to-trade index-linked securities" such as ETFs.  Further, the deterioration in performance was related to trading.  "Bad market timing" that the typical investor engaged in after investing in ETFs was identified as the source of lower returns.  While the Vanguard study used statistical techniques to isolate the impact of ETFs versus open-end funds, the study by the German brokerage firm looked at behavior over time.

Yet additional support for the impression comes from the experience of investment advisers.  A Hulbert Financial Digest study monitored 23 advisers who maintain both a model portfolio of ETFs as well as one focusing on open-end funds. The ETF portfolios over the past five years trailed their non-ETF fund portfolios by an average of 2.5 percentage points on an annualized basis.

The research is inconclusive, but in truth, one hardly needs the research results.  All one has to do is listen to the marketing pitch for ETFs: it is quite clear that trading convenience is their primary selling point.  Clearly, if one’s objective is to trade a particular asset class, an ETF may be appropriate vehicle.  By contrast, if one just wants to participate in the long-run performance of a particular asset class, an open-end mutual fund may be the more appropriate vehicle despite slightly higher expenses.

Similarly, closed-end mutual funds can be very useful investment vehicles.  However, the biggest return in closed-end mutual fund investing results from trading activity rather than a buy-and-hold strategy.  How successful one is at investing in closed-end mutual funds depends upon timing the trades. 

Successful closed-end fund traders are navigating two sets of timing variables as well as the basic issue of portfolio composition characteristic of any mutual fund.  First, those timing variables included cycles in the relationship between each fund’s price and its net asset value.  The second time variable involves cycles in the asset prices of the particular sector or country in which the closed-end fund invests.  Needless to say, those two timing variables interact.

There is a further complication with closed-end mutual funds: one cannot assume that selecting a good fund manager is the most important decision.  A truly good fund manager of a closed-end mutual fund will have an impact upon the relationship between the price of the mutual fund and its net asset value.  As a consequence, the fund manager’s ability to select the right investments may be totally offset by the fact that the fund has to be purchased at a premium; the premium being a price above the net asset value of the fund’s holdings.  Thus, the fund may hold the right assets, but the investor is overpaying for them.

One further consideration with closed-end funds is whether their charter allows them to take on leverage.  When it does, the leverage can be a major consideration.  Analyzing the leverage (how much, what duration, what rates, etc.) is not a trivial task.

As a consequence, closed-end mutual fund investing is a discipline in-and-of-itself.  People who are good at it can make a substantial trading profit.  It is a discipline quite different from portfolio management and long-term investing.  The Hedged Economist has generally found it easier to select individual stocks for a portfolio than to time purchases of closed-end funds.  Any diversification needed to supplement the stock portfolio can easily be purchased using open-end funds.  Achieving that additional diversification was the focus of last month's postings.

Both ETFs and closed-end funds are useful trading vehicles.  However, as such, they were inappropriate for last month's postings about buy-and-hold strategies.  Theoretically one could argue that the lower expenses of an ETF justify using it in a buy-and-hold strategy instead in an index fund.  The theory is nice,  but it is not what happens.  Similarly, one could argue that the closed-end fund if purchased when it trades significantly below its net asset value is a reasonable substitute for a managed open-end fund.  However, with a closed-end fund one cannot avoid the timing issue involved in determining an adequate discount to the net asset value.  One of the advantages of the strategies discussed last month is that for the long-term investor timing is irrelevant.

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