ETF Prime Archive

If CEO’s Don’t Know, How Can We?

None of us has ever seen a time when so many companies are going out of business, needing to be consolidated, or teetering on the brink of bankruptcy.   The management of these companies never seem to see it coming.  It’s like some fantastic surprise that the economic or business outlook changed and they didn’t think about preparing for it. 

So you are wondering how this affects us as investors. Trust me, it affects everyone. For the investors who are stock pickers, it’s like walking through a land mine. Straight from the CEO’s mouth, Bear Stearns is fine and you believe them. For the mutual fund manager it’s a huge challenge because they have hundreds of companies to track and can’t get intimate enough with the management to get a feel for who they can trust and who is competent.  

That might be another reason why almost all mutual funds underperform their benchmarks over the long haul and why indexing with low cost ETF’s make makes more sense.   

Let’s go back in time and I will show you a few examples of some very supposedly competent CEOs who have said things that make you wonder.  

Robert Toll, CEO of Toll Brothers, was named one of Barron’s Top 30 CEOs worldwide in 2005.  On December 6, 2006, Toll announced he’s seen the bottom of the housing slump. 

As we know, over two years later and we still haven’t found bottom yet.

Hank Greenberg, former AIG Chairman and head for four decades. On September 18, 2008, Greenberg said AIG didn’t need a bailout.

In September 2008 AIG took in $85 billion from the federal government.  In October 2008 an additional $38 billion.  In November 2008 another $27 billion.  Today AIG now needs more – lots more.

Rick Wagoner, CEO of General Motors.  July 15, 2008 Wagoner said GM was a taking a series of actions that would add $15 billion of liquidity to GM’s already strong cash position.

November 2008, three months later, General Motors asked the government for aid and this February GM sought a total of up to $30 billion in U.S. government aid, more than double its original request in November.  GM is certain to need billions more in order to survive.

I could go on, but you ge the point….often times CEO’s – even the best ones – can’t effectively project where their companies are headed.  If they can’t, how can an individual investor?  And how can an actively managed mutual fund manager who is supposed to be following hundreds, or even thousands, of companies?

Industry at a ‘Tipping Point’

I mentioned last week that the entry of Schwab into the ETF business marked a pretty important day for the industry.  Today Marketwatch.com posted a story on their site about the same topic, but made a bold statement.  According to Marketwatch, Schwab’s entry, along with Pimco’s announcement last year that it was getting into the business, could mark a ‘Tipping Point’ that forces all the other major mutual fund houses to follow suit. 

Most of the important indexes already have good ETF alternatives.  It will be interesting to see if Schwab and Pimco simply copy ETFs that are already available, or use their formidable resources to drive additional innovation in the industry.  Let’s hope it is the later.

Wall Street Journal: Diversify with ETFs

In Monday’s Wall Street Journal, there is a great article about how investors can use ETFs outside of their 401k plans to improve their portfolio.  Most 401k plans are full of mutual funds that give exposure to stocks and bonds, but few give you access to alternative assets.  These assets, such as gold and other commodities, real estate, and foreign currencies, can lower the risk and potentially increase the returns of a portfolio compared to one made up strictly of stocks and bonds.

 ETFs can get you direct exposure to alternative assets.  Since most 401ks don’t give you this access, every investor should use some of their non-401k investments (and IRA , for example) to invest in this asset class with ETFs.  Longer-term, the demand for ETFs will ensure they make their way into everyone’s 401k plan (regardless of whether the mutual fund industry embraces the idea), but for now at least average investors have the tools available through ETFs to compensate for existing 401k plan limitations.

Schwab Gets In The Game

As we’ve mentioned before on this blog, many mutual fund industry analysts have been predicting gloom and doom for mutual fund companies over the next few years.  The market drops have been killing their asset levels, and the move of market share into ETFs is only exacerbating the problem.  The industry has been laying off employees by the thousands.

Some companies have started to hedge their bets, and have gotten into the ETF industry either through acquisitions or by internally developing their own ETFs.  But none of the big boys had gotten into the game until now.  As Investment News Reports, Charles Schwab has now thrown its hat into the ring by filing with the SEC to issue its first ETF.  The ETF will track a total market index (not really an ETF anyone needs), but that’s not really important.  What is important, however, is the simple fact that they filed.

Schwab makes a ton of money distributing mutual funds through its popular OneSource platform.  So do the mutual fund partners that participate with Schwab.  Getting into the ETF game won’t make those fund companies very happy, and Schwab is surely going to take a profitability hit if assets begin to flow from their mutual fund platform into their ETFs. 

Schwab is figuring out what many in the financial services industry already have – the fat profit margins of the past are over, and the dollars that used to pay executive bonuses are now moving into the back pockets of investors.  Schwab will survive by driving its own profit margins lower.  The other big players in the industry will follow.

Buy The One-Star Funds?!

The New York Times recently ran an article interestingly titled “A Quarter When Mutual Fund Rankings Didn’t Matter” referring to the fact that highly rated mutual funds failed to weather the stock market’s dramatic decline in the 4^th quarter of 2008 any better than a portfolio simply representing the market as a whole.  A portfolio of Morningstar five-star rated domestic equity mutual funds lost 22.3% in the fourth quarter compared to 21.9% for the S&P 500 index and 22.9% for the Dow Jones Wilshire 5000 index.  A portfolio of the top-ranked Value Line, Inc. funds lost 22.2%.  This might come as a surprise to some investors, particularly when considering the hefty fees these actively managed funds charge for their purported “outperformance”, or alpha.

Proponents of highly-rated actively managed funds are sounding the popular refrain, “one bad quarter does not make a year”.  Their explanation is simply that funds were caught in a violent downdraft that couldn’t be avoided or as the New York Times article quoted, “It’s very difficult in a down market for a fund’s alpha to overcome its beta”.  However, the data would suggest that this lack of performance in the 4^th quarter of 2008 is anything but an aberration.

As mentioned in a previous post, fund managers have a hard time beating their generic index benchmarks in any type of market with ishares finding that 75% of active fund managers underperform on an annual basis.  Furthermore, consider the following analysis referenced in “The Nick Murray Reader” by Nick Murray:  “According to Morningstar, one-star funds have outperformed five-star funds by 45% since 1995. If you invested $1000 across the universe in one-star funds in January 1995 and then moved the proceeds each year to the then current crop of one-star funds, your investment would have been worth $2948.54 at the end of 2001. If you pursued the equivalent five start strategy you’d have $2030.48”.

So be wary when considering purchasing the next highly-rated mutual fund.  You might be paying five-star fees (according to ICI data, the average actively managed mutual fund has an expense ratio of 1.47%) for performance that can be obtained at a fraction of the price through low-cost indexed investments such as exchange-traded funds.