Tag Archives: mutual funds

Types of mutual funds: passive vs. active

A passive mutual fund invests in a portfolio that mirrors the component of a market index. For example, an S&P 500 index fund is invested in the 500 stocks of Standard & Poor’s 500 Index. There is no attempt made to try to determine which stocks are expected to do well and which are not.

Actively managed funds are managed by an individual manager, co-managers, or a team of managers. The mangers try to buy stocks that they think will outperform the market.

The costs associated with passive investing are lower than the costs of active management. Active managers attempt to justify their higher costs by doing better in either up or down markets.

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What are mutual funds?

A mutual fund is an investment vehicle that is made up of money contributed by many people for the purpose of investing in stocks, bonds, real estate or other kinds of investment vehicles including money market instruments.

Mutual funds are operated by money managers who make the actual investment decisions and who attempt to provide capital gains and income to the investors.

One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital.

When a mutual fund sells a security like a stock or bond, or collects income such as a dividend or interest payment these are passed along to the shareholders of the fund.

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How does your financial advisor get paid?

No one expects their professional service provider to give their services away for free. Doctors don’t, lawyers don’t, CPAs don’t nor do financial advisors. However, in the financial services industry often what you actually pay is not clear.

Cerulli Associates surveyed investors and found that most investors wanted to understand how their advisors were getting paid. They wanted “transparency.”

“Helping investors understand the full extent of an advisor’s potential revenue streams has been a persistent challenge for both advice providers and advisors, and has become even more complicated with the ongoing evolution of integrated wealth management conglomerates,” Smith explains.
“The financial industry was built around the premise that investors understand the fees they pay and sign documents affirming their awareness,” Smith continues. “Cerulli’s research indicates that investors who truly comprehend the entirety of their costs are more the exception than the rule. The overall expenses of pooled investment vehicles, including management fees and other embedded fees such as 12b-1s, are essentially nonexistent to many investors-if they do not see a line item deduction from their accounts, they do not recognize a transfer of wealth from themselves to their advisor or provider.”

Even that last sentence can add to the confusion if you aren’t very familiar with the terminology of the investment industry, with terms like “pooled investment vehicles,” “embedded fees,” and “12b-1s.” To better understand how (and from where) financial advisors are paid, here’s a brief list:

“Commissions:” when you buy of sell a stock, bond, or fund, you pay the broker a commission. This also applies to insurance products such as life insurance and annuities. Broker commission formulas for stocks are often based upon the stock’s price and trading volume. Commissions for insurance products and annuities are generally a fixed percentage of the size of the policy being sold, but they can be as high as 10%-15% for some products. Commissions for bonds are discussed below.

“Mark-up” or “mark-down:” this typically applies to the purchase or sale of bonds, and is the difference between the market price of a bond and what an investment firm offers an investor. In other words, it is the difference between what the bond is actually worth and what you can buy or sell it for. The mark-up or mark-down formula is based upon the number of bonds being bought or sold, their price and their bond rating.

“Load:” a sales charge that is assessed when purchasing a mutual fund. Some load fees are charged up front (referred to as a “front end load,” often seen with A share class mutual funds bought or sold via a broker), when sold (referred to as a “back-end load,” often seen with B share class mutual funds bought or sold via a broker), or as long as the fund is held (referred to as a “level load,” often seen with C share class mutual funds bought or sold via a broker). The load you pay is passed along to the broker. Front end loads are usually between 3% – 8%, with 5% being fairly typical. Back end loads are the most confusing, and (thankfully) are being eliminated by many fund companies. In very general terms (for the sake of this article), they don’t charge you a front end load, but if you want to sell the fund within 5 or 6 years of purchasing the fund, they will hit you with a fee (called a “deferred sales charge”) of between 1% – 5%, depending on how soon you sell it (with the higher fee coming the earlier you sell it). Oh, and on top of that, they typically also charge you a 12b-1 fee (discussed next) of 1%. Level loads typically don’t charge a front end load or a back end load, but they do maintain a 1% 12b-1 fee for as long as you own the fund.

“12b-1 fee:” an annual fee, usually 0.25%, paid by the mutual fund to the broker to help the fund market its products. It’s often referred to a “trailer.” As mentioned above, for B and C share class mutual funds, this fee is typically a much higher 1%.

“Management fee:” this is the fee that an investment manager charges for creating and managing a portfolio of securities.

A “Fee Only” investment advisor’s only compensation is the management fee. This eliminates the conflict of interest inherent in the other types of compensation such as commissions, loads and trailers. It provides an incentive for the Fee Only advisor to shop for the lowest cost investment products for his clients.

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Why roll your 401(k) over when you retire?

According to an article in 401(k) Specialist Magazine, 401(k) providers favor proprietary products. What does this mean to the typical worker? Here’s the bottom line:

“Mutual fund companies that are trustees of 401(k) plans must serve plan participants’ needs, but they also have an incentive to promote their own funds.
The analysis suggests that these trustees tend to favor their own funds, especially the poor-quality funds.”

The article goes on to say that these fund companies often make decisions that appear to have an adverse affect on employees’ retirement security.

The investment industry is, unfortunately, rife with conflicts of interest and bad apples. That is why a prudent investor should work with a trusted investment professional who is a fiduciary. A fiduciary has an obligation to place the client’s interests ahead of his own. As a rule of thumb, a fee-only, independent, Registered Investment Advisor, who does not work for one of the large investment firms that have to answer to public shareholders, and who has access to virtually all investment vehicles, has fewer conflicts.

As we mentioned in a recent article:

A fee-only RIA works for you. Stockbrokers, insurance agents, even mutual fund managers, work for the companies that pay them. They are legally required to work in the best interest of their employers, not their clients. Some of them do try to work in their clients’ best interests, but there can be large financial incentives to do otherwise. A fee-only RIA works only for you. We act in your best interest and use our expertise to allow you to take advantage of opportunities in good markets and weather the bad ones.

This gets back to the original question. Rolling your 401(k) into an IRA with someone who isn’t trying to get you to invest in “poor quality funds,” does not have a conflict of interest, and is legally obligated to put your interests ahead of his own is a good reason to roll your 401(k) into an IRA.

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The Trend: Fewer “Self-Directed” and More “Advisor-Reliant” Investors

According to Cerulli Associates more households rely on advisors than ever before.

Since 2010, the households classified as “self-directed” investors had shrunk from 45% to 33%, while households termed by Cerulli as “advisor-reliant” investors — regularly consulting with an advisor — had grown from 34% to 43%.  What drives this trend?

I can think of several reasons.  Two that come readily to mind are:

  • the increasing complexity of financial markets and
  • the number of dramatic financial shocks that people have experienced in the last 15 years.

I can remember a time, back in the 20th Century, when “investing” meant calling a well-know investment firm and buying a stock, like General Motors.  Well, good old GM went bankrupt a few years ago and since then about 25,000 mutual funds have appeared.  In addition there are options, derivatives, structured products, and – of course – ETFs (exchange traded funds).  And that’s just here in the good old USA.  But there’s a whole world out there that people can invest in: foreign stocks, foreign funds, world stock funds, emerging markets, commodities, to say nothing of foreign bonds and currencies.

Few people have the time to study all of these, so the rational thing to do is to find a financial advisor to help you make sense of it.

And then there are the financial disasters that decimated many self-direct portfolios.  In the year 2000 the dot-com bubble collapsed, devastating the portfolios of those riding the tech boom.  And who can forget the housing bubble that led to the financial crash of 2008, wiping out some of the major banks and investment firms and ending the dreams of a comfortable retirement for many people?  Professional advice should be concerned with risk control as their first objective, followed by getting a fair rate of return on your invested assets.

During all this time, financial advisors who were once employees of the major investment firms decided that they could best serve their clients by declaring their independence.  They set up their own firms, becoming Registered Investment Advisors (RIAs) offering fiduciary services.  That is another development that has helped to make financial advice more accessible to individuals and families, the mom and pops of the investment world.

If you’re one of the shrinking do-it-yourself crowd, check us out and see why you may be much more comfortable with us as your advisor.  And if you are one of those with an advisor but wonder if you could do better, feel free to get a second opinion.  We’re a family firm.  We deal with several generations of families that look to us for guidance.  We look forward to hearing from you.

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Successful and investing and emotional control

One of the big benefits of professional money management is “emotional control.”

Emotional control is the ability to control one’s emotions in times of stress. Napoleon once said that “The greatest general is he who makes the fewest mistakes.” There is a similarity between war and successful investing. Both require the ability to keep a cool head at times of high stress.

There is another old saying in the investment world: “Don’t confuse brains with a Bull Market.” When the market is going up, it’s easy to assume that you are making smart investment decisions. But your decisions may have nothing to do with your success; you may simply by riding the crest of a wave.

That’s when people become overconfident.

When the market stops going up, or the next Bear Market begins, the amateur investor allows fear to dominate his thinking. The typical investor tend to sell as the stock market reached its bottom. In fact, following the market bottom in early 2009, even as the stock market began to recover, investors continued to sell stock funds.  Since then the market has doubled.

Professional investors are not immune to emotion, but the good ones have developed investment models that allow them to ride through Bear Markets with moderate losses and ride the rebound up as the market recovers. It is that discipline that allows them to make fewer mistakes and, like Napoleon’s general, come out ahead.

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Paying a million dollars in taxes?

It’s time to pay our taxes and for many people it’s a painful chore. Whether you’re getting a refund or sending the US Treasury a check, the amount of money the government takes from our hard-earned income is never pleasant.

But I have told people that one year I would like to actually have to pay the government $1 million in taxes. Why? Because it means that I probably earned in the neighborhood of $2 million and that’s a nice neighborhood.

I have had a number of conversations this year with clients who have to write big checks to the government. The question always comes up “is there a way to pay less?” The answer is “yes” but the trade-off is not always to their advantage.

Tax free bonds (“munis”) have been a traditional way of avoiding taxes. Unfortunately the Federal Reserve’s zero interest rate policy has reduced the yield on munis to the very low single digit range. A triple A rated Virginia muni maturing in 10 years yields a touch over 1.5%. Unless you are very taxaphobic the idea of tying your money up for a decade at a rate below inflation is not very attractive.

Exchange Traded Funds (ETFs) have been touted for their tax efficiency. That’s true, but unless you buy and hold them forever, at some point you will have to sell them to get money for living expenses.  That’s when the tax comes due. And the tax rate could actually be higher.

The same argument goes for buying individual growth stocks. At some point, you will want to turn them into cash that you can spend for, say, a new car, travel, or all the other things you need money for and that’s when the tax man wants his share. Keep in mind that today’s growth stock can be tomorrow’s bankruptcy. Trees don’t grow to the sky and at some point even Apple may find that there’s a worm in the core. Individual stocks are fine, but lack of diversification is one of the biggest risks to wealth.

The US tax rate reached 94% during WW II in 1944. In the years that followed the rate never dropped below 70% until 1981. Investments were offered whose primary goal was to shelter income from taxes. These were often extremely poor investments. One shelter I recall was an investment in an aircraft leasing company that owned used aircraft. When the price of fuel rose, these planes were sidelined for more efficient models.  Some of the used planes were sold for parts.  Most investors eventually broke even … after a decade or so. The lesson here is that you should not let tax avoidance drive your investment decisions.

Top federal tax rates
These “tax shelters” mostly dried up during the Reagan era when top tax rates dropped to 28% in 1988.

They have been rising gradually since then.

Regular garden variety mutual funds have been getting a bad press because their capital gains distributions are not predictable. However, they have two advantages: (1) they focus on the primary objective of growth of capital rather than secondary issues, and (2) they allow you to pay your taxes as you go. The benefit of that is that when you want to turn your mutual funds into cash to pay for groceries – or whatever is you need money for – most of your tax may already have been paid and the tax man will take a smaller bite.

The desire to avoid taxes is natural, but the best way to manage money is to focus on avoiding major losses and getting a fair return. If taxes bother you, vote for the candidate who you think will lower the tax rate. That’s the smart way to manage your taxes.

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Would you invest with a billionaire hedge fund manager who made a fortune during the housing crisis?

Watch out.

Many people would jump at the chance and many wealthy people have given John Paulson lots of money to invest for them.

But there’s a downside to trying to get rich via the stock market. The people who “swing for the fences” often strike out.

We found this article in Private Wealth an excellent illustration of this point.

Billionaire John Paulson posted the second-worst trading year of his career in 2014 as a wrong-way energy bet added to declines tied to a failed merger and investments in Fannie Mae and Freddie Mac.

The worst performance was in the Advantage Plus fund, which plummeted 36 percent last year, two people with knowledge of the returns said. …

Paulson & Co.’s performance placed it near the bottom of the hedge fund pack last year as the industry returned a meager 1.4 percent. The manager, who shot to fame after making $15 billion on the housing crisis in 2007, has struggled to regain its footing since 2011 when bets on the U.S. recovery went awry, losing money in all of its main strategies — including a 51 percent tumble in the Advantage Plus fund. Paulson also lost money in investments tied to gold and Europe’s economy, causing assets to dwindle to $19 billion, half the peak in 2011 ….…

Investors in the Advantage fund have lost 48 percent since the end of 2010, while clients in Advantage Plus are down more than 66 percent. ….

At Korving & Company, we are fiduciaries, Paulson is not.  He’s a hedge fund manager who makes big bets.  We don’t bet, we invest.

We manage retirement money. People nearing retirement don’t want to see the money they are saving cut in half. That could force them to work years longer than they planned. People in retirement who saw their savings plummet would have no choice but to reduce their lifestyle.

With that in mind, we do the opposite of Paulson. Our primary directive is keeping what we have and making a fair rate of return on that money by a carefully thought out process of diversification.

Realizing that even the smartest or luckiest investors – like Paulson – can be wrong, we focus on picking good funds but making sure that if any of our fund managers has a bad year, our clients will not have their plans interrupted or their lifestyles affected.

To go back to our baseball analogy, we just want to get on base and do so consistently.

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Markets rise as year-end approaches

We are approaching the end of 2014 with the markets at/near a record high. The market’s recovery since March of 2009 has now lasted nearly 5 years with only a few pullbacks. There has been some concern about the market’s rise as headlines bring reasons for concern. The American middle class does not seem to be benefitting from the less-than-robust economic recovery. The labor force participation rate has hit a 35 year low. Add to that a record national debt now over $18 trillion, unrest both here and abroad; there are a lot of things to worry about.

That is all true, but stocks are driven by corporate profits and profits are rising.

spprofits

It’s too easy to get distracted by “noise.” While the issues that get the headlines are important, they may have little or no impact on the price of any one stock or the direction of the market. And in the investment business, that’s what counts.

There is one issue that can create a problem for many investors. It’s the issue of “indexing” and relative performance. The S&P 500 index is the primary benchmark for many investors and portfolio managers. However, it can create a self-fulfilling prophesy because it is market weighted. That means that all 500 stocks are not treated equally. The larger the company, the more impact it has on the index. Consider that the 20 largest stocks in the S&P 500 are just 4% of the stocks in the index but about 30% of the weight of the index. That means that just a few stocks have an outsized influence on the index.

That’s fine when the price of these large companies go up. But when they begin to go down, people have the impression that all stocks are going down. This is not true. But since indexing has become so popular, the passive investors in the index funds will experience a great deal of financial pain if and when these over-valued stocks come back down to earth.

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Companies Offering “Financial Wellness” Benefits.

Companies offer benefits to their employees to attract better employees. It’s also a way to encourage good employees to stay. The range of benefits has expanded to include financial wellness.

Financial wellness is becoming an important priority for many companies. Money troubles can distract employees from their jobs. Merideth, Inc., publisher of such magazines as Better Homes and Gardens and Ladies Home Journal, does more than offer employees a 401(k). It reimburses eligible employees for the services of a financial counselor.

A number of companies help their top executives as well as their over-50 employees with their financial planning. They realize that they don’t want these experienced, highly paid employees to spend their time studying investment guides or wondering how to invest their retirement plan. Employees who suffer from money worries get sick more often, do not perform as well, and are apt to be absent. By offering to pay the fees of a financial advisor, these companies – for a relatively modest investment – reward their employees and boost productivity.

The typical company offers workshops for their employees, being careful that these meetings do not turn into a sales pitch.  If an employee decides that they wish to work with a particular financial advisor, they sign a separate form stating that they are entering an agreement separately, not as part of a company sponsored solicitation.

The advisor is almost always fee-only and often an independent RIA (Registered Investment Advisor).

If your company wants to offer financial wellness benefits, contact us.

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