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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The investor does not need to be concerned with issues like capital gains or whether a money manager is adding valueAN ALTERNATIVE TO INDEX FUNDS An efficient way to achieve diversification in portfolios used to be to invest in index mutual funds. Index funds attempt to duplicate the exact holdings of an index that represents some part of the financial markets. Index funds theoretically provide a passive investment alternative. That is to say, the investor does not need to be concerned with issues like capital gains or whether a money manager is adding value. The index investor would hold the entire portfolio of stocks mirroring the index until they themselves decided to sell. Many index funds no longer provide the advantages for which they were intended. Frequently, it is their popularity that has created the problem. We will use the example of the most popular index funds, those claiming to duplicate that S&P 500, as an example: Lipper analytical services monitors 176 S&P 500 index funds. This does not include the hundreds more S&P 500 index funds held within universal life insurance or annuity products. It does not include smaller or newer funds. The Fidelity Spartan 500 Index fund alone holds $8.5 billion of assets. Investors are permitted to buy and sell fund shares daily. Typically, when markets are rising, there is a greater flow of money into the funds, and more shares of stock are immediately purchased. When the market is down, many people panic and sell their index funds, necessitating the sale of stocks within the index. Unfortunately this creates wide swings in the value of the indexes for the patient investors who were holding on for long-term growth. The constant flow of money in and out of the index mutual funds and the high level of buying and selling that this generates increases transaction costs of the fund. A mutual fund must pay transaction costs or commissions to buy and sell securities like everyone else. Although the cost per share is minimal, the volume of trades can make the overall transaction expenses enormous. You will not know what the transaction expenses are because there is no requirement that they be reported. It is a hidden cost impacting the performance of every retail mutual fund. In his book Bogle on Mutual Funds, John Bogle calculates this cost by doubling the annual turnover of a funds portfolio and multiplying it by 16% (a figure that comes from a 1993 study in Financial Analysts Journal). This means that some funds have additional unreported expenses as high as 3-4% per year. Trading expenses of 1.5-2% are common. Because of the issues just described, performance of S&P 500 index funds seldom duplicates performance of the index itself. Lipper Analytics ranks S&P 500 index funds just as it does any other fund type, affirming the variety of performance results between index funds For investors who require passive portfolios that represent a variety of market sectors, the solution is to use a tool called structured portfolios. Formerly known as unit trusts, these are predefined portfolios of securities that are designed to remain fixed during the predetermined life of the portfolio. Because these are unmanaged portfolios, only a nominal supervisory fee in the range of .15% to .30% is charged each year. There are no hidden transaction costs to eat into the performance. There is usually a nominal charge to purchase the entire portfolio that is less than it would cost to purchase the individual shares themselves at even a deeply discounted rate. The following lists are a sampling of the different types of structured portfolios available to investors. Stock Portfolios Energy Communications Financials Global telecommunications Health care Media Real estate investment trusts (REITs) S&P Industrial Technology Fixed Income Portfolios (these portfolios are usually structured to provide monthly income) Corporate bonds GNMAs Insured tax-free bonds Tax-free bonds State-specific tax-free bonds U.S. government bonds PROFESSIONALLY MANAGED PORTFOLIOS When and How to Use Them The original intent of mutual funds was to provide diversification to investors with smaller amounts of money. In the 1980s mutual funds were not as popular as they are today. It used to be difficult to convince people with smaller amounts of money that they should diversify by using a mutual fund rather than buying individual stocks. By the late twentieth century the pendulum had swung the other way. Now it is always surprising to see investors making mutual fund investments that go well into six figures and beyond. We can only conclude that most people do not understand that there is an alternative. The alternative is a professionally managed portfolio of individual stocks managed according to the objectives set out by the owner of the portfolio. If you do not want your money sent into a pool where the value of the portfolio can be subject to the whims of other investors, a professionally managed portfolio may be appropriate. Because your money and securities are not commingled with others, you realize several advantages: The prices of your holdings will not be subject to the high amount of volatility that occurs in mutual funds when investors bail out when the market is low and pour money in when the market is high. Tax advantages accrue to the investor because the portfolio manager can generate capital gains or capital losses according to the needs of the account owner. In most cases it can be significantly cheaper than using a mutual fund. The fee structure is completely different. No matter how much money you invest in a mutual fund, you will never get a discount. All investors, no matter how big, pay the same. Money managers charge on a sliding scale, and there are no hidden transaction costs. Here is how it works: 1. Cash or securities are deposited into an account at a financial institu tion. (In most cases, reputable money mangers do not take receipt of your money or existing securities.) 2. The manager you have selected executes transactions through your fi nancial institution on your behalf. 3. You receive monthly statements from your financial institution and performance reports from your money manager. SELECTING THE RIGHT MANAGER A manager should not be selected until the process outlined in Chapter 3 to determine your optimal portfolio is completed. Professional managers specialize in different styles and asset classes of securities. This makes the selection process easier. Obviously, only a manager with a long and successful record of managing small-cap value stocks should be selected to fill the small-cap value slot in your investment program. Most of our clients are always surprised to find that even within a certain style of investing (e.g., small-cap value), there is a wide range of methods that professionals use to manage portfolios. Many small-cap managers will buy up to 75 or even 100 different stocks in a portfolio to achieve the necessary diversity to decrease risk. Some managers visit each company whose stock they buy, keeping in regular contact with executives to stay updated on management philosophies and current projects. Other managers never want to talk to the company whose stock they are buying. They say it clouds their objectivity. They prefer to rely on results only and monitor factors like sales or increasing revenue. Understanding a portfolio manager s system for making money is important from two perspectives. First, the investor can decide whether the process makes sense to them and whether they are comfortable with it. Money management firms tell us that they will often lose an account that has had wonderful performance only because the client could not understand or appreciate the philosophy behind the investment decisions. Either their financial advisor had not taken the time to explain it, or the client had not taken time to listen. The second reason to understand a money manager s methodology is more intriguing. It takes us back to the issue of real diversification. Within a single equity style we will use small-cap value again as an example the different methodologies will perform differently at any given point in time. Here is why it is important to understand the rotational performance of different managers. Consider a 20-month period when small-cap value stocks are outperforming all other stock styles. A client has two small-cap value managers, Manager A and Manager B. For the first nine months Manager A significantly outperforms Manager B. Invariably, the client will decide that all of the small-cap value money should be allocated to Manager A. We discourage the client from changing managers because just as soon as all the money is moved to Manager A, Manager B begins to outperform by wide margins. We have not seen any studies on this phenomenon, but our empirical experience is extensive. Assuming that there has been no change in the management firms process or operation this is the job of your financial advisor to monitor a manager s performance will come in waves. The account should not be interrupted without very good reason. This knowledge helps the manager selection process. If possible, more than one manager should be selected for each style of stock. The investment methodologies of the managers should be very different. Risk will be decreased and the possibility of better returns increased. Incidentally, these same truths hold for mutual funds; it should shed more light on the foolishness of using past performance as the primary criteria in making investment decisions. We have observed another phenomenon once the money manager is selected and the account is set up: The level of performance tends to increase the longer the account is in place. The portfolios are less affected by declining markets and tend to do better in rising markets. Our industry could benefit by a thorough study of how frequently this occurs and why. We can only conclude that it takes time for the portfolio, the manager s technique, and the market to synchronize. WHEN TO USE A PROFESSIONALLY MANAGED PORTFOLIO The total amount you have to invest determines whether you employ a professional manager, use a mutual fund, or some combination of both. Professional managers can have minimums as low as $100,000-$250,000. If your investable assets are $250,000, you can employ only one or two managers. This is inconsistent with the optimization principles that will be so important to twenty-first century investing. Mutual funds will allow a $250,000 account to diversify across as many styles and asset classes as necessary because their minimums are usually as low as $1,000. A mutual fund can accommodate an investor with a $250,000 portfolio who needs to take a 5% position ($12,500) in emerging-markets stocks. An investor with $800,000 probably needs a combination of money managers and mutual funds. If the prescription calls for 30% large-cap value stocks ($240,000), two large-cap value managers could be hired. If a 5% position ($40,000) were required in high-yield bonds, a mutual fund would work. A 25% position ($200,000) in small-cap growth could accommodate two professional small-cap growth portfolios, and so on. Although there are always exceptions, at the $5,000,000 level and up, individually managed portfolios should be used almost exclusively. It is far more cost effective than mutual funds, and this efficiency alone can improve performance. THE IMPENDING PENSION PLAN CRISES The necessity of adapting the management of pension plan assets to the new dominant investment system is acute. To emphasize and expand on the critical nature of this problem, which we introduced in Chapter 5, we offer the complete text of a 2002 publication by Ryan Labs, the leading authority in the field of asset/liability management. The following is reprinted with permission. ESTIMATING THE LENGTH OF THE TWENTY-FIRST CENTURY FORMULATION AND ACCELERATION PHASES The NASDAQs discovery phase took 27% less time than the Dow Jones Industrial Averages discovery phase. Dow Jones discovery phase8/8/1896-9/7/1899= 37 monthsNASDAQ discovery phase1/9/1998-3/10/2000 = 27 months 27 months is 27% less than 37 months Dows formulation phase took 21 years, or 252 months. If NASDAQs formulation phase relates to the Dows like the discovery phase did, we could apply a 27% reduction to the Dows 21-year (252-month) formulation phase. 252 months less 27% = 184 months Insert these numbers into the equation A B Insert these numbers into the equation A + B 252 months 184 months = 46368 = 106.35 months 252 months + 184 months = 436 106 months = 8.8 years Therefore, the formulation phase that began in March 2000 could end between 2008 and 2009. The acceleration phase is measured thus: 252 months (Dows Formulation Phase) +96 months (Dows Acceleration Phase) 348 months total 348 months minus 27% = 254 total months for NASDAQ formulation and acceleration phases Insert 348 and 254 into the equation A B Insert 348 and 254 into the equation A + B 348 254 = 88392 = 146.83 months 348 + 254 = 602 146.83 months = 12.2 years 12.20 years NASDAQ formulation and acceleration phase -8.80 years NASDAQ formulation phase 3.40 years NASDAQ acceleration phase Therefore, if the acceleration phase begins between 2008 and 2009, it will end between 2011 and 2012. |
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