WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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 19, 2013
Monday, August 12, 2013
Mutual Funds: Behind The Curtain (3)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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.
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 dot.com 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 gains. The 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.
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 dot.com 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 gains. The 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.
Monday, July 29, 2013
Mutual Funds: Behind The Curtain (1)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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.
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
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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.
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
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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.
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?
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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.
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.
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