Monday, August 26, 2013

Thank You, Mr. Dow


We have looked at equity mutual funds and their constant struggle to beat the stock market.  What, exactly, is that market?  The short answer would be that the market can be whatever you want it to be.  Stock markets are composed of thousands of publicly traded companies and can be measured in various ways.  The goal of a stock market index is to compile a group of stocks that reflect the general movement of all of the stocks traded in a particular market.  Today, the three most recognizable stock market indices are the S&P 500, the NASDAQ and the grandaddy of them all, the Dow Jones Industrial Average (DJIA).  When people ask, "How did the market do?", they generally expect to hear what happened to the DJIA that day.

Charles Dow, Edward Jones and Charles Bergstresser formed Dow Jones & Company in 1882.  Their original publication was the Customer's Afternoon Letter, which later became the Wall Street Journal.  In 1884, Dow published his first stock average, which highlighted growth stocks of the time.  His first benchmark average included nine railroads (probably seen as high tech then), a steamship company and Western Union.  In May, 1896 Dow converted these original stocks into his Transportation Average and created his first Industrial Average, based on twelve companies.  One of the original industrial companies still remains as part of the average to this day, General Electric, which was organized by Thomas Edison in 1890.  Although the companies changed over the years, the DJIA included only twelve stocks until 1916 when it was increased to twenty companies.  The number increased to thirty in January, 1929, where it has stayed ever since.  The 1929 average included some companies still recognized today, but no longer in the average, such as General Motors, Goodrich, Sears Roebuck, Westinghouse and US Steel.

Originally, the average was calculated each day by adding up the stock prices of the Dow components and then dividing that by the number of stocks in the average.  This provided an accurate average only so long as none of the companies announced a stock split or issued a stock dividend to it shareholders.  As that occurred over the years, the divisor had to be recalculated.  The Dow divisor today is 0.14452124.  The DJIA is a price-weighted method of calculation.  Most of the other stock indexes today are based on the weighted market capitalization of the component companies.

In January, 1900 the  smaller average (12 stocks) was 68.13.  It took until 1920 for the DJIA to first break 100.  It peaked at 307.01 in January,1929 (then thirty stocks) before plunging after the stock market crash and subsequent depression to a low of 41.22 in 1932.  The average remained in the 100s from 1934 until December, 1949 when it closed over 200.  It did not break 1,000 until 1972, but seesawed thereafter until the beginning of the roughly eighteen year bull market in 1982.  The Dow went on to surpass 2,000 in 1987 and 3,000 in 1991.  The bull market continued with the DJIA breaking 4,000 in February, 1995 and 5,000 nine months later.  It went above 6,000 in 1996 and crossed the 11,000 mark in 1999.  The subsequent market drop, starting in 2001, lowered the average and it did not recover to its previous high until 2006.  Subsequent market increases and falls continued until May, 2013 when the DJIA crossed 15,000.

The Dow's reaching each benchmark of 1,000 points piques the interest of the public and garners media attention.  However, most experienced investors recognize that it is just that, interesting but not really significant from a financial standpoint.

Comments are always welcome.

Monday, August 19, 2013

Index Funds: If You Can't Beat The Market, Buy It


Professor Burton G. Malkiel, the famous proponent of the Random Walk theory, wrote an article in the May 29, 2013 Wall Street Journal titled, "You're Paying Too Much For Investment Help."  In the article he analyzed the costs and expenses charged by actively managed mutual funds and concluded that investors looking for a better return should focus on index funds instead.  He advised investors that while they can not control the market, they can control their cost to invest in it.

An index fund is essentially a portfolio of stocks which make up an index such as the S&P 500 or the thirty stocks in the Dow Jones Average or some other index of market assets, such as the Wilshire 5,000 Total Stock Market Index.  Index funds were first offered only to institutional investors in the early 1970s.  John Bogle's company, Vanguard, was the first to offer this form of fund to individual investors, the Vanguard S&P 500 Index Fund.  Once the index of stocks has been duplicated, trading is minimal since the fund advisers only need to rebalance the fund depending on what happens to the stocks comprising the index.  This provides the individual investor with the opportunity to buy a particular market with a low expense ratio.

Given this background, an individual could rightfully ask whether it matters which particular index fund he or she purchases if they track the same index.  Won't two S&P 500 Index funds produce the same results?  Sadly, the answer is "not necessarily."

Although the costs and expenses of an index fund are lower than actively managed funds, they still exist.  The operation of an index fund involves the same functions as an active fund (see my earlier post).  A larger fund can spread those costs over more investors.  Another drag on returns is the efficiency with which a fund can buy and sell stocks, the execution/trading costs it incurs.  Some smaller funds do not actually buy all of the stocks in an index.  It is just too expensive.  They try to duplicate the index by the process of sampling.  Sampling means that the fund creates a portfolio of stocks with the same characteristics as the total index.  Keep in mind that a sample will not provide the exact same return as the total index.  Hopefully, the costs and expenses saved by sampling are passed along to the fund's shareholders to make up for the lower return they will receive.

To see how close the return of an index fund tracks the return of the actual index, the investor must look at the R-squared rating of the fund.  R-squared is a mathematical measure of the difference in returns.  If the fund's return is identical to that of the index, the R-squared is 100%.  Virtually all funds fall short due to their costs of operation and execution.  Aswath Damodaran, in his book, Investment Philosophies, suggests that investors check Morningstar rankings of index funds to find out what their R-squared percentage is.   He advised investors, "As an investor looking at index funds on a specific index, you want to pick the fund with the lowest expenses and the highest R squared."

Investment Management is a collection of chapters written by investment professionals and edited by Peter L. Bernstein and Aswath Damodaran.  The advantages of index funds are described in the book as follows:

First, no information costs or analyst expenses are associated with running these funds, and transaction costs associated with trading are low.  Most index funds have turnover ratios of less than 5 percent, indicating that the total dollar volume of trading was less than 5 percent of the market values of the funds.  Transaction costs for these funds are 0.20 percent to 0.50 percent, or less than one-third the costs of most actively managed funds.  Second, the index funds' reticence to trade reduces the tax liabilities that they create for investors.  In an typical actively managed fund, the high turnover ratios create capital gains and tax liabilities even for those investors who buy and hold these funds.*

*Excerpt from Investment Management, edited by Peter L. Bernstein and Aswath Damodaran, copyright 1998, published by John Wiley & Sons, Inc., page 228.

Comments are always welcome.

Monday, August 12, 2013

Mutual Funds: Behind The Curtain (3)


John C. Bogle, the founder of The Vanguard Group, decried some investors' habit of only focusing on past performance when looking for a mutual fund.  He labeled it, "a flawed and counterproductive way to select a mutual fund."  He recommended looking at a fund's structural characteristics as well as performance in his 1994 book, Bogle on Mutual Funds New Perspectives for the Intelligent Investor.  He suggests every investor check the following when looking for a suitable mutual fund.

Three of the most obvious characteristics are the size of a fund, its age and the tenure of the managers.  Bogle suggests investing in funds in existence for at least five years which have more than $50 million and less than $1 billion in assets.  you should also look to see how long the portfolio manager or the team of managers have been running the fund.  Assume that the past performance of a fund is due for a change if the managers who generated those returns are no longer in charge.  Another characteristic to consider is the cost of owning shares in a fund.  Are there sales charges when you buy and redemption charges when you sell?  Search for "no load" funds.  Funds are required to publish their expense ratios, so an investor should compare them when deciding between a number of funds.  The lower the ratio, the more money remains for the investor.

Of primary importance is the fund's portfolio of stocks.  The investor must learn a fund's cash position, since all funds have to keep some cash reserves.  As Bogle points out, it makes no sense to pay advisory fees to someone just to hold cash.  Avoid funds with cash positions of more than 5% of total assets.  Portfolio concentration is another area to investigate.  The investor should look at the top ten stock holdings of a fund and determine what percentage of the total portfolio these ten holdings represent.  If the top ten stocks comprise more than 50% of the total holdings, Bogle feels that there is a good possibility of the fund providing extraordinary performance.  Unfortunately, that performance can be either positive or negative.  Also check to see if the fund is really a disguised "sector" fund, with a concentration in only one or two industries.  Another important characteristic is the market capitalization of the stocks in the portfolio.  Bogle points out that an average market cap of $5 billion to $8 billion is what you will find in a typical stock fund.

Since taxes and expenses must be considered, the investor should also confirm a fund's turnover rate.  How often are the securities in a fund purchased and sold?  A fund devoted to a long term strategy will have a lower turn over rate than a fund devoted to quick trading profits.  The more trading, the higher the costs and the larger the tax bill for capital gains.

In short, investing in a mutual fund requires as much research and study by an investor as when he or she is purchasing an individual stock.  If an individual must work just as hard for either type of investment, is there an easier way?

The answer is yes.  Look to index mutual funds.  We will consider these in the next post.

Comments are always welcome.


Monday, August 5, 2013

Mutual Funds: Behind The Curtain (2)

In addition to the drag on annual returns from fees and expenses, mutual fund returns must also be reduced by the income taxes generated during the fund's tax year.  Under the federal tax code, mutual funds are "pass through" entities which do not pay income taxes.  They annually distribute all dividends received and capital gains generated in the portfolio to their shareholders, who elect to receive that money either in the form of a check or by reinvestment in the fund (more shares).  Most distributions are made in December of each year.

If an investor buys shares in the mutual fund just before a distribution, that individual incurs a tax liability on the entire year's worth of income even though he or she may have only held the shares for a month or so.  By way of example, assume you invested $500 in a fund and received 10 shares at a per share price of $50.  Two days later, the fund makes its annual distribution, $5 per share.  Assuming you elected to reinvest distributions, you now have 11.11 shares at approximately $45 per share.  You still have the same $500 invested in the fund, but you owe taxes on the $5 per share distribution.  Before investing in a mutual fund, an investor should check to see when the fund makes its annual distribution and time purchases accordingly.

To make matters worse, there have been loss years in which the mutual fund shareholders watched the value of their investment decline, but still had to pay capital gains tax.  When the bubble burst, many mutual funds which had invested in high tech stocks ended the year with a loss.  Despite the losses, the funds had sold quite a bit of the stock they had earlier purchased at much lower prices to meet redemptions, thus generating capital gainsThe shareholders had to not only watch their investments lose money, but also send a check to the IRS for gains that were of no economic benefit to them.

None of these tax issues matter if you hold your mutual fund investment in a tax deferred retirement account, such as an IRA or a 401 (k).

Much has been written about the apparent inability of a majority of actively managed funds to beat general market averages.  As stated in the last post, due to the imbalance between the number of funds investing in the stock market and the smaller number of stocks available for such investment, it could be that the mutual fund industry actually comprises the market.  Subtracting the fees and expenses of the funds must therefore result in a return lower than that of the market.  In his 2003 book, Investment Philosophies, Professor Aswath Damodaran cites three behavioral factors which might be seen to also contribute to this shortfall in return: lack of investment consistency, herd behavior and  the practice of window dressing.

A mutual fund's prospectus states its goals and the investment philosophy it will use to reach them.  Unfortunately, studies have revealed that investment advisers will pay only lip service to these stated objectives in times of market turmoil.  Fund managers have been seen to repeatedly switch their investment styles in response to the latest market moves, up or down.  The second factor, herding, is simply a human trait.  Human beings tend to act collectively, much like other species.  With so many market professionals engaged in the same activity, it should be no surprise that institutional investors tend to buy and sell the same stocks at the roughly same time.  This magnified action will tend to drive stocks up or down to a greater degree than might otherwise be expected.  The third behavioral factor, window dressing, also reflects human nature.  It is well documented that fund portfolios are subject to a noticeable amount of change just prior to the dates on which the funds must report their results and reveal their share holdings.  The losers are sold, and the most recent market winners are purchased just prior to reporting results.  The  basis for this might be, in part, the cynical belief that the investing public will pay more attention to the reported portfolio holdings than the actual returns made during the period.  Such activity is self defeating since it results in increased trading costs and a concomitant decline in returns.

Looking only at portfolio holdings or returns is not the recommended way to invest in mutual funds.  We will look at how to invest in funds in the next post.

Comments are always welcome.