ETF Prime Archive

American Funds Raising Fees

I referenced an article last month from the Motley Fool [link to post] that discussed the possibility that mutual fund fees would go up in 2009.  Despite the market meltdown of 2008 and the exodus of assets out of equity funds, American Funds has made the somewhat predictable decision that they need to raise their fees so they can, in their words, “maintain our ability to serve fund shareholders in the best way possible”.  Hmmmm.  In case you’re wondering, here are the 2008 returns for some of the largest mutual funds in the American Funds family – these are all ‘A’ shares:

Fundamental Investor:  -39.7%
Growth Fund of America:   -39.1%
Income Fund of America:  -28.9%
Investment Company of America:  -34.7%
New World:  -46.3%
Smallcap World:  -49.4%

See more information here.

Control Your Emotions…Or Get Help!

The quote I referenced recently from John Galbraith is a reminder of how much emotions play into investing.  You can have a perfectly designed asset allocation strategy and the best low cost investment vehicles available, but if you don’t stick to a plan, your returns will be abysmal.  Unfortunately, that happens more often than not with most investors.

The market research firm Dalbar recently did a study on the returns of retail investors and found that most investors end up jumping into ‘hot’ funds at the end of bull markets and then get burned when the market drops.   Their results were actually pretty amazing.  They found that over the 20-year period ending December 31, 2007, the average equity investor earned 4.48% annually, compared to the 11.81% return of the S&P 500 index.  The annual return of the average equity investor was actually barely above the annual inflation rate during the same period.  Fear and greed are tough habits to shake.

My own investing experiences, including a jump into internet stocks in the bubble of the 1990’s and my subsequent ride down to zero in some cases (I have a great story about selling Qualcomm and putting the proceeds into Globalstar) taught me that I was my portfolio’s own worst enemy.  That realization lead me initially to look for a financial advisor and, ultimately, to start The ETF Store.

If you can stay objective and unemotional with your investments, congratulations; you are the exception.  If you think you’ve sabotaged your performance or you can relate to my own experience, you might want to think about calling an advisor.

Fidelity Customers – Are You Diversified?

One of the beautiful things about ETFs is you can access an asset class or a broad market index and know exactly what you own – – without any overlap in holdings.  You can easily construct a portfolio that gives you precise and systematic coverage of all desired asset classes.  Not so with mutual funds.  Because funds are only required to report holdings quarterly or semi-annually to the SEC, it is nearly impossible at any point in time to known what you own, or know whether your desired allocations are in place.

It’s common for people to hold a number of mutual funds from the same fund family.  It’s also common for each of the mutual fund managers within that fund family to use the same group of analysts to determine what stocks to buy.  As a result, managers of different funds will end up owning the same stocks, even though the investment objectives laid out in their prospectuses may be quite different.

While fund overlap is an issue at many fund companies, my sense is that it might be a bigger issue at the larger ones.  So I asked the software Company Overlap [www.overlap.com] to calculate the amount of overlap for a group of Fidelity Funds.  The output is below.

Pretty interesting stuff.  If you own a few of the funds in the graph, you might wonder why you have a basket of funds that own a lot of the same stocks.  One major caveat to the graph though – this is based on the most recent holdings information provided to the SEC.  Since the funds don’t report their holdings very often (and those are on a delayed basis) I have no idea what the overlaps would be today!

Understanding Modern Portfolio Theory

It is not at all uncommon to encounter an advertising banner relating to a mutual fund manager or financial advisor that proudly proclaims adherence to the tenets of Modern Portfolio Theory (MPT), or to extensions of the pioneering work achieved by Nobel Prize winning Harry Markowitz.  But what lies beneath the hyperbolic, marketing-driven, vague references to “scientific method” and the technical jargon in which the theory is often wrapped or, rather, shrouded?  Just what is MPT and, just as importantly, what is it not?

What it is:

A body of theoretical work, and extensions to that work that suggest a systematic and quantitative approach to evaluating risk and diversification in investment portfolio construction.  Application of the theory suggests that, at the portfolio level, risk (a.k.a. volatility of returns) can be reduced by combining assets having similar expected returns but less than perfect correlation in returns.

What it is not:

A portfolio construction “How to …Manual”, a recipe book, or a silver bullet lying on the shelf, just waiting for the elite, financial engineering literate to put to work.
In his landmark 1952 paper, Portfolio Selection, published in the Journal of Finance Markowitz embarked on a mission to quantitatively define risk as security-specific and portfolio-level volatility of investment returns.  He further sought to quantify the impact of combining dissimilar assets on portfolio-level volatility of investment returns.

The practical outcome of this work was an improved level of clarity regarding the benefits of asset diversification and the reduction of volatility in portfolio returns gained through combining assets having less than fully correlated returns.  Markowitz showed, conceptually and within a mathematical framework, that combining such uncorrelated assets could give rise to a portfolio having a lower level of risk (i.e., volatility) for a given level of expected return.  He further demonstrated that specific combinations of less-than-perfectly-correlated assets could enable the minimization of portfolio risk across a range of expected returns … generating an “efficient frontier,” or  risk vs. returns curve representing optimal asset combinations that would maximize expected returns for each incremental unit of risk (volatility).

Markowitz’ work provided a useful theoretical and mathematical foundation and framework leading to more than fifty years of academic and applied research related to finance and investment practices.  Extensions of MPT include the Capital Asset Pricing Model and the Black-Scholes option pricing model – products of other Nobel Prize winners.
Where investors, at both the Main Street and institutional levels, have gotten into trouble is in the application of MPT and its extensions as a literal recipe book for investing and risk management.  Key assumptions underlying models associated with the theory must be relaxed when describing the real and dynamic world.  Among these are assumptions regarding perfect information flows in markets, consistently rational investor behavior, normal (bell-shaped) distribution of returns, independence and random nature of price moves relative to prior price moves, and, quite importantly, stability in volatilities and cross-security correlations over time.

Modern Portfolio Theory provides a simple, clear and common sense framework for understanding the benefits of portfolio diversification.  However, a proper understanding of MPT’s underlying assumptions and an appreciation of their limitations is critical to any and all practical applications of MPT in the investment world.  The streets, now and historically, are littered with the financial corpses of those failing to take good measure of the limitations associated with MPT’s underlying assumptions and related, real-world applications.

How Did Madoff Happen?

A lot of people are wondering how, in this age of Sarbanes Oxley, someone catering to sophisticated investors could pull off a $50 billion Ponzi scheme.  Didn’t the internet bubble, Enron and WorldCom teach investors and regulators anything?

The answer is complex, and has a lot to do with the lack of transparency and regulation in the hedge fund world (both to change soon).  More broadly, it has a lot to do with human psychology.  This isn’t the first major financial scandal to come undone during a financial crisis and it certainly won’t be the last. This is conveyed perfectly in this passage from John Galbraith’s book “The Great Crash of 1929” – – I found the quote at Andy McSmith’s blog.

“To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the Bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.”