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How your money is managed: the Mutual Fund industry up close (podcast)

Mutual funds have introduced millions of Americans to investing in the stock market.  While their popularity and usage may have changed throughout the last 30 years,mutual funds still play a critical role in many portfolios.  Yet, many investors — smart, educated people — still don’t quite understand how they work.

Summary

In this episode of Tradestreaming Radio (if you don’t see it below, click here), we talk to Theresa Hamacher, a true mutual fund industry veteran.  Along with Bob Pozen, Hamacher is the co-author of the new book, The Fund Industry: How Your Money is Managed (Wiley Finance).  It’s a good read and an important book to have in your investment library because it’s scope is so broad.  The book discusses the history of mutual funds, their legal structure, career paths in the industry, how different funds are managed (stocks vs. bonds), and how fund analysts decide which securities to invest in.

Our discussion meanders through different facets of the industry, investing, and Hamacher’s book.

We discuss:

  • how to use mutual funds
  • the asset management industry
  • the financial crisis and how funds were involved/affected
  • how mutual funds shape up against exchange traded funds (ETFs).
  • why the mutual fund industry views the upstart ETF industry as competitive.

Listen below

 

 

Resources:

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401(k) “re-enrollments”: Nudging employees to make bad decisions

Far be it from me to argue with behavioral economist, Richard Thaler (Nudge was awesome, bro) but 401(k) re-enrollment is only good for the sponsors of such plans like T. Rowe Price ($TROW).

The WSJ is reporting this morning on a growing trend for employers to choose something called “re-enrollment” for their employees’ retirement plans.  It goes like this:

Employees have the options of sticking with their current investment selection, if it’s still offered, or choosing another mix. But in a re-enrollment, unless the participant specifically opts out, his or her 401(k) will be re-allocated to the company’s chosen default investment.

Thaler was concerned that employees don’t have enough time/brainspace to make better decisions so it sounds like he likes this approach

“Many [participants] never change their asset allocation or contributions over their working lifetime, meaning that their asset allocation as they get older can be quite different than the one they intended,” says Richard Thaler, professor of economics at the University of Chicago Booth School of Business

Listen, I’m all for nudging children towards better eating habits by the strategic placement and display of such foods in school cafeterias but forcing employees to a made-up allocation for exposure to the stock market…well, not only is that paternalistic, that’s just bad investing.

Digging deeper into target date funds

I understand where the companies are coming from.  The data show that rarely — if ever — do employees change their asset allocations.  Fine — but what target date funds do is determine exactly how much allocation investors in such funds should have to the market.  The hope is that returns will be X over a certain time period (the target date).

But guess what?  These things always had too much exposure for most investors to the broad stock market and remain badly markets, explained and disclosed (and that’s the dig by industry rag, Morningstar).  Another market plummet and wham, a lot of employees who didn’t even realize they had been re-enrolled will wake up with a lot less $$ in their retirement accounts.

The truth is that target date funds are a flawed product for a genuine problem: helping guide retirement investors to make better decisions.  The answer isn’t ensuring they max out on equity allocations.

Only thing this is good for is the stocks of the mutual fund companies who run 401 (k) plans.  This smacks of being “the industry solution” for the vast build-up of cash in most retirement accounts.

Well, O retirement investor, consider yourself (re)warned.

As for actionable investment ideas? I’d love to see exactly how much cash there is on the sidelines and expectations for re-enrollment.  This could be a good catalyst for Franklin ($BEN) and T. Rowe Price ($TROW) as this cash gets crammed into mutual funds.

Read more

  • Your employer knows best. Perhaps. (WSJ)
  • New Problems with 401(k) Target Date Funds (Institutional Investor)
  • A new 401(k) default? Moving money into target funds (Nudge Blog)
  • Morningstar 2010 Target Date Fund Survey (Morningstar)
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Looking at Magic Formula returns, Morningstar gets all apologetic over industry performance

Screening 2.0 and beyond

Readers of this site have learned a bit about Screening 2.0 — the ability to use Internet tools (many of them, free) to recreate portfolios that conform to the investment criteria of history’s best investors.

Validea’s John Reese has done much of the research legwork on the subject and has produced a premium product to help investors create Peter Lynch, Ken Fisher, and Ben Graham portfolios (among others).

The magic of  Greenblatt’s Magic Formulamagictrick

One source I mention frequently is Joel Greenblatt’s Magic Formula.  Greenblatt wrote about his investing magic in The Little Book that Beats the Market.  He also provides investors with a free website to screen for the top ranking stocks that fit his criteria at magicformulainvesting.com.

Morningstar takes a look at Magic Formula returns in a recent piece.  Here’s what they come up with:

We see that the formula posted approximately a 19.9% annualized return from the beginning of 1988 through Sept. 30, 2009. Over that time, the S&P 500 Index returned 9.4% annualized.

Not too shabby.

But as a frequent shill for the mutual fund industry, Morningstar feels the need to compare this market-trumping return to top performing mutual funds.  And that’s when things take an interesting turn:  The article’s author, John Coumarianos, sounds surprisingly introspective in his (near) critique of active fund management.

The market isn’t efficient, as the indexers say, but its inefficiencies are apparently not easily exploitable for some of the finest pros either–at least given how many of them currently go about investing, trying earnestly to predict future profits and discounting them back to the present. Perhaps managers outthink themselves or have too much confidence in their predictive abilities instead of relying on past results.

Why funds may perform so badly as a class

The author also cites the mutual fund structure, size, and the legacy nature of a fund portfolio — making it so easy for investors to buy and sell an already outdated model — as an impediment.  Does this mean that portfolio mirroring a la kaChing and Covestor (where investors sync their brokerage accounts up to a professional investor’s portfolio model) has another leg up on the industry?  The separately managed account model (SMA) which institutionalizes this mirroring process does have its benefits, including better tax efficiency (all stocks are held in investor’s name and cost basis is individualized) and transparency (stocks in the portfolio are held in brokerage account).

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ETFs, overindexing and the power of financial brands

Just doing some thinking about the growth and future of the ETF industry:

In my eyes, ETFs began as a second-generation of mutual funds with the following characteristics:

  • Passively managed: ETFs were passively managed (though that’s changing), building upon Jack Bogle’s success at Vanguard.  Most research at the time clung to the Efficient Market Hypothesis and academics declared that trying to beat the markets was a fool’s game.  ETFs were this vehicle.
  • Cheap: They were cheap.  If theory shows that you can’t pick stocks and win the game that way, better to index and reduce fees for better long term success.  ETFs’ passive structure enabled fund sponsors to get big and compete on price, driving prices further downward.
  • New access: Beyond their philosophical underpinnings and reduction in asset management fees, ETFs also opened doors to new asset classes (commodities), markets (Peru), and strategies (leveraged short funds) that weren’t easily accessible or understandable for retail investors previously.

Things are a’changin

Things are changing.  With Blackrock’s purchase of Barclays Global Investors iShares (BGI), ETFs are no longer seen as a pure threat to the much larger mutual fund industry.  Diversified asset managers like Blackrock and PIMCO, mutual fund firms like Vanguard and Fidelity, and online brokers like Schwab are building and buying ETFs as part of a larger smorgasboard of choices for their clients.  ETFs fit in like precious metal and international funds into a firm’s offerings.

In a sense, ETFs have now become purely productized, competing against similar strategies in different structures.  Contributing to this trend is the fact that numerous ETF offerings targeting the same strategy/geography have all hit the market. With multiple offerings for almost every market and strategy in ETF land, overindexing has blurred any and all distinctions in investors’ minds about which securities to select.  Instead of doing the work to pick the most appropriate security, brand will ultimately trump other things.

While there may be 3 general, broad ETFs for investors to get Chinese market exposure, most retail investors have no idea that they’ve been structured differently, that the compositions of the indices these ETFs track are wildly different and have led and may very well lead to different performance outcomes.

Brands, brands, brands

What this means, then, is (like most things in life), competition in the ETF space gets muddled.  ETFs compete against mutual funds every bit as much as they do against each other and with this backdrop, the emergence of the firm’s brand will trump performance and index structure.  Index composition or the race to build a better mousetrap becomes less important.  Branding will sway investor decisions and assets away from the smaller, more innovative players, towards the larger, stronger brands.

Like everything commercial, brands wield power.  So true in the financial sector as well.