Monday, July 29, 2013

Mutual Funds: Behind The Curtain (1)


Investing in a mutual fund requires little more than money and some key strokes on your computer or a phone call to a broker.  Notwithstanding the simplicity of interaction, there is a lot going on behind the curtain; much like the Wizard of Oz.  Establishing and operating a typical mutual fund consists of a number of different functions.  The sponsor of the fund organizes the fund  and provides the initial "seed money" to get it started.  The sponsor, as the first shareholder, establishes an initial board of directors to manage the fund.  Once people invest in the fund, they become the fund's shareholders and thereafter elect the directors.  Typically, the sponsor is also the investment adviser, directing the fund's investments and managing the portfolio.  This key function could, however, be handled by a different company.  Administrators perform the "back office" operations.  They provide the various things needed to run a fund such as office space, clerical staff, internal accounting, and the filing of reports with the SEC and the Internal Revenue Service.  Mutual fund investors buy and redeem their shares in the fund through an underwriter.  The underwriter agrees with the mutual fund to buy and sell shares of the fund to the public.  Transfer agents keep track of the accounts and calculate each investor's share of dividends and capital gains distributions.  They also provide account statements, notices and income tax information to the shareholders.  The fund's portfolio of stocks, bonds or other investment assets are usually held in the name of a custodian.  An outside accounting firm audits the books and records of the fund and provides the required opinions concerning its financial status.  In short, a fund has a lot of moving parts, and each party playing a role must be paid.  Hence, the fees and expenses charged the shareholders.

Mutual funds fall into two general categories: active and passive management.  The portfolio of an actively managed fund is overseen by an investment adviser with the goal of beating a recognized market average, such as the S&P 500 index.  This is a difficult job, and a majority of funds fail to reach this goal in any given year.  This gives rise to a good deal of debate as to the true benefits of mutual funds.  On a world wide basis, mutual funds of all kinds invest trillions (yes, that's with a T) of dollars.  In recent years, the number of funds in the US, approximately 7,000 or so, exceeds the number of individual stocks listed on the NYSE and the NASDAQ, roughly 4,500.  If you add stocks listed on other exchanges, the number of stocks climbs to almost 6,500; a number still smaller than the number of funds investing in them.  In effect, mutual funds, collectively, are the market.  Their combined trading of stocks creates a large percentage of the annual market volume and movement, in effect, the market average.  If that is true and you deduct the fees and expenses of mutual funds from that average, it is simple mathematics.  When you deduct the expenses and fees, most mutual funds stand no chance of beating their market average.  Notwithstanding this, mutual funds remain the investment of choice for most people.

John C. Bogle, the founder of The Vanguard Group, explained this phenomenon in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor, as follows:

While the wide selection of mutual fund offerings has provided much of the impetus for the industry's growth during the past two decades, (he is speaking of the1970s & 1980s) four time-honored principles of mutual fund investing are the core of the industry's success.  These principles are (1) broad diversification, (2) professional management, (3) liquidity, and (4) convenience.  They remain as valid today as they were when the first U.S. mutual fund was introduced. 

We will learn more about this type of investment in the next blog.

Comments are always welcome.

Monday, July 22, 2013

Pooled Investment Basics


There are four types of pooled investments, technically referred to as investment companies.  They are open-end investment companies, closed-end investment companies, exchange traded funds and unit investment trusts.

The most familiar type, the open-end, is what is commonly known as a mutual fund.  The shares of the fund do not trade in the market; however investors can quickly and easily purchase and redeem their shares in a mutual fund through the fund sponsor.  The net asset value (NAV) of a fund and, hence, the value of its shares is based on the value of the investments in the fund.  The NAV is calculated and announced at the end of each day of trading.  NAV is the sum of any cash reserves and the closing prices of all of the securities held in the fund less liabilities, if any.  That number is then divided by the number of shares held by investors.  This price then holds for share purchases and redemptions for the next trading day at the end of which, a new NAV is determined. 

A closed-end fund is organized and traded basically as a stock.  The fund is offered to investors in a form of initial public offering.  Their money is used to purchase stocks, bonds or any other investment assets which the fund is intended to hold.  Unlike an open-ended fund, money is not thereafter added or subtracted from the fund.  In other words, the fund is closed to new money.  The shares of a closed-end fund trade in the market just like a stock.  The price of closed end shares may be higher (a premium) or lower (a discount) than the actual NAV of the fund for any number of reasons, such as the basic rule of supply and demand, perceived prospects for future growth or decline of the fund's assets and all the other reasons prices rise and fall in an active market.

Exchange Traded Funds (ETF) are hybrid securities.  Essentially, an ETF is a mutual fund; however, it trades in the market just like a closed end fund or a stock.  ETFs do not have a mutual fund's NAV set daily.  Rather, the value of an ETF fluctuates during the day like a stock.  Many ETFs contain a pool of stocks that mirror a market index, like the S&P 500.  In fact, the first ETF was an S&P 500 index fund, commonly referred to as a spider since its ticker symbol is SPDR.  Some ETFs invest in only certain sectors of the market, such as car manufacturers, health care, emerging markets and virtually any other area of the market you can name.  Like stocks, an investor can short ETFs and buy them on margin.  The management fees and transaction costs of operating an ETF index fund are generally lower than those of an index mutual fund.

A unit investment trust (UIT) combines several features of the other three types of investment company.  Like a closed-end fund, the sponsor offers a fixed number of units in the trust to investors in a public offering.  No additional shares in the trust are ever offered again.  The offering proceeds are invested in securities which remain the same for the life of the UIT.  There is little, if any, change in the portfolio over its life time.  Unlike the other investment companies, the UIT has a termination date, at which point the securities in the trust portfolio are sold and the cash is distributed to the investors.  Like a mutual fund, units may be purchased or sold.  However, the units are traded on a secondary market maintained by the sponsor.  The sponsor itself does not buy and sell units.

There are advantages and disadvantages for each of these forms of investment, but a detailed discussion of them is beyond the scope of this post.  Here is a link to more information about these investments at Investopedia

We will examine the most familiar type of investment company, the mutual fund, in the next post.

Comments are always welcome.

Monday, July 15, 2013

Shotguns and Money


Hunters have the option to use either a rifle or a shotgun, depending on what is being hunted.  Similarly, investors have the option to purchase either a specific investment or a mutual fund.  In order to diversify a portfolio, the individual stock purchaser must spread his or her money over a number of companies in different industries.  You may recall that the collective advice of the value investors we have studied in earlier posts is to purchase between ten and thirty different companies, each in a different industry.  For an investor just starting out, the successful assembly of such a portfolio will take both time and effort.  Not everyone has the time or the inclination to do this.  Once a person starts a career and has the funds to invest, there never seems to be enough time for much more than work, family and friends.  Most retirement plans offered by employers offer only mutual funds as investment options.  Many individual investors take the shotgun approach and put their money into mutual funds.  It would seem that a majority of people in the market do so via pooled investments.

Pooled investing has been around for centuries.  Many financial historians point to a Dutch investment trust (called a negotiatie) as the first such investment established in 1774.  Its stated purpose was to provide diversification to individual investors at a small cost.  Numerous negotiaties were organized in the latter part of the 18th century to invest in the credit of a new country, the United States of America.  The organizer of the original trust, Adriaan van Ketwich, organized a second one in 1779 which remained in existence for 114 years.  It was dissolved in 1893, the same year that The Boston Personal Property Trust, one of the first American investment trusts, was formed.

The fore bearer of the modern American mutual fund, the Massachusetts Investors' Trust, was established as an open-end fund in Boston in 1924.    The Wellington Fund, launched in 1928, was the first mutual fund to specifically invest in both stocks and bonds, a balanced fund.  The value investor, Phillip Carret, was one of the organizers of the Pioneer Fund in 1928.  Pioneer is still in business today.  The number of funds increased over time, but many were wiped out during the 1929 Wall Street Crash.  Investigations into these failures revealed a fair amount of chicanery and self dealing on the part of the operators of the  failed mutual funds.  This led to the passage of The Investment Company Act of 1940 which placed numerous restrictions on the operations of US mutual funds and required certain disclosures to investors.  The Act also attempted to reduce the conflicts of interest revealed in the investigations.

Over the years, the popularity of mutual funds has waxed and waned.  Mutual funds grew rapidly during the 1960s, but the number dropped precipitously after the bear market of 1969, with only 360 funds remaining in 1970.  Later, two tax law changes gave the industry a big boost.  The Individual Retirement Account (IRA) and a form of retirement plan known by the tax section which authorized it, 401 (k), provided large platforms for the sale of mutual funds to millions of Americans saving for their golden years.  Interest in mutual funds dropped again in 2003 with the revelation of wide spread scandals in which a number of funds were alleged to have  allowed their large hedge fund customers to engage in abusive trade timing practices at the expense of their smaller customers.

Memories are short on Wall Street, and the mutual fund industry has recovered since 2003.  It is reported that there were approximately 14,000 mutual funds, including money market funds, in existence in 2011.  The funds offer every sort of investment strategy in stocks, corporate bonds, government debt, gold, oil and any other investment asset you can think of.  The irony is that, year in and year out, a large percentage of the funds (some say as high as 80%) fail to meet or beat the annual performance of their respective markets as a whole.

We will look at mutual fund investing in the next post.

Comments are always welcome.

Monday, July 8, 2013

Are We There Yet?


Every parent has heard this complaining question from the back seat of the car at one time or another.  Usually, it is a daily chorus as the family's summer road trip plays out.  Many times, the question is followed with another old standard, "Why is Daddy so crabby?"  Children just do not comprehend the distance and time involved in reaching vacation destinations.

Some investors approach their investments in a similar manner.  They fail to identify their destination and formulate a realistic time frame in which to reach it.  They forget to tailor specific methods of investing to specific goals.  For some, the goal is just making money.  There is nothing wrong with that.  Making money is a good goal; but then what?  Long term goals, such as meeting college tuition for the children or investing for a comfortable retirement, are best reached with long term investments.  Years of short term trading with its ups and downs is probably not an appropriate way to achieve retirement security.  The risk of suffering a crippling loss shortly before reaching retirement age is just too great.

In Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow discussed the interplay between goals, strategy and time as follows:

A prime ingredient in any investment strategy must be a considered time frame, which will be directly related to major, intermediate, or minor price objectives.  How long is one willing to wait in anticipation of an x percent move?  What happens to one's calculations if the stock moves the wrong way?  Should one sell automatically, regardless of time, if a goal is reached? or protect the position with puts?*

Once a person sets a goal and establishes the amount of time needed to achieve it,  the next step is to consider and adopt the appropriate investment strategy or philosophy.  The investor or trader needs to develop basic ideas on which their way of investing is based.  Aswath Damodaran, a Professor of Finance in the Stern School of Business at New York University summed this up in his book, Investment Philosophies, as follows:

An investment philosophy represents a set of core beliefs about how investors behave and how markets work.  To be a successful investor, you not only have to consider the evidence from the markets, but you also have to examine your own strengths and weaknesses to come up with an investment philosophy that best suits you.  Investors without core beliefs tend to wander from strategy to strategy, drawn by anecdotal evidence or recent success, creating transaction costs and incurring losses as a consequence.  Investors with clearly defined investment philosophies tend to be more consistent and disciplined in their investment choices.**

Although most of the advice given above would seem to apply to long term investors, traders also need a goal, a strategy and a time frame.  The most famous trader, Jesse Lauriston Livermore, followed the basic tenet of quickly selling losers and letting profits ride.  He had a strategy for identifying and selling stocks which were not performing to his standards:

Hope is the villain here and it has ruined millions of speculators over the course of time -- take your losses right away they are real whether you sell the stocks or not.

To put this in another way I have two stops in mind when I enter a trade I have a "PRICE STOP" and I have a "TIME STOP."  I will not stay with any trade more than a few points if it moves against me and I will not stay with a stock position for more than a few days if the stock does not perform as I expect it to perform.***

It would seem that he did not always follow his own advice.  Livermore is reputed to have made and lost four multimillion dollar fortunes over his forty year trading career.

Aimlessly wandering from place to place without a plan and a map is a recipe for a bad family vacation.  Likewise, aimlessly bouncing from one investment to another without a goal and a strategy is a recipe for financial disaster.

*  Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder

**  Excerpt from Investment Philosophies, Aswath Damodaran, ©2003, published by John Wiley & Sons, Inc., page 13

*** Excerpt from How to Trade in Stocks, Jesse Livermore, ©1940, updated edition in 2001 with comments from Richard Smitten, published by McGraw-Hill, page 108

Comments are always welcome.

Monday, July 1, 2013

Trading Platforms & Slot Machines


One sure sign of the market's getting "frothy" is the number and silliness of TV commercials for on line trading from  brokerage firms.  My all time favorite is an ad aired in the late 1990s during the dot com bubble which featured a plumber driving his truck to a job and  talking about the island he had just purchased with the money he had made trading on line with a brokerage firm.  It seems that as the market rockets upwards, TV ads increase proportionately, promising easy, quick profits.  As with most advertising, this message must be taken with a grain (or tablespoon) of salt.

On line brokers tout their trading platforms and low trading costs.  The platforms offer computerized technical analysis with moving averages, volume and price charts, breaking news services and whatever other indicators a trader might want to see on the screen.  Some people make small trades and use leverage (margin loans) to increase profits.  Given the costs, many traders give most of their profits, and more, to the broker in interest expense and trading costs.

Traders have different trading periods.  Position or trend traders can hold their positions for several months to several years.  The goal is to find a stock which is trending upwards and hold onto it for the duration of the run.  A second type of trading is called swing trading (the new name for the old strategy of momentum trading) with near term time frames of several days to several weeks and intermediate terms of up to six months.  The shortest time frame is the day trade in which the trader holds a position for anywhere from several minutes up to a day.  The day trader will close out all of his or her positions at the end of the day.  They avoid losses they might  otherwise incur if their positions remained exposed to the action of after hours markets.  Markets now follow the sun and are open for trading twenty-four hours a day around the world.

The look and feel of trading screens is similar to that of slot machines with flashing lights and beeping alerts.  In my opinion, the similarity is not coincidental.  The gaming industry has spent a considerable amount of time and money determining what sort of display will keep a person feeding coins into a machine.  I believe that on line trading on your home computer and playing the slots in a casino share many characteristics, the fundamental one being that both activities are just gambling.

The Securities and  Exchange Commission has posted comments about day trading.  Their advice included several statements, two of which I will share with you:  Be prepared to suffer severe financial losses and Day trading is an extremely stressful and expensive full time job.  Granted, these are from a regulatory agency, but they should give pause to anyone interested in those supposed easy and quick profits touted by the brokerage firms.

If it were that easy and profitable, why would they share their secrets with you for just $7.95 a trade?  One advantage of slot machines - you need not pay a fee to pull the lever or hit the button.  You just drop in your coin and play.

Comments are always welcome.