Archives for July 2009

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Mutual Fund Fees & Expense Waivers

I’ve written before about the importance of reading a mutual fund prospectus. Just the other day as I was researching my article on low-cost, socially responsible investment options, I experienced a perfect example of why it’s so important.

According to the fund list I found, Pax World Investments’ Pax World International Fund was the lowest cost “socially responsible” international equity fund, with an expense ratio of 1.40%. But before suggesting it on the blog, I thought it would be wise to download and read the prospectus.

If you flip to page 40 (Fees & Expenses), you’ll see the real costs of running the fund. The total? 11.82% of assets! (Seriously. Go look.)

So how was it that a 1.40% expense ratio was listed elsewhere? As happens frequently in the mutual fund industry, the management company waived a portion of the expenses (in this case, almost 90% of the expenses).

The catch is that this waiver of fees isn’t permanent. In this case, it’s through 12/31/2012, but in many cases, the management company can discontinue it at any time.

Loss Leaders

Some fund companies run certain funds at a loss on an ongoing basis. For example, Schwab’s S&P 500 Index Fund only charges shareholders an expense ratio of 0.09% per year, when its gross expense ratio is 0.21%.

My understanding is that their purpose for this fund is much the same as that of milk at the grocery store: sell it at a small loss in order to bring in customers, to whom they can sell more profitable products (like higher cost, actively managed funds).

The existence of a fee waiver wouldn’t bother me much if I were pondering investing in one of Schwab’s index funds. In those cases, even if the waiver disappeared, it wouldn’t be that big of a deal as long as you noticed it within a couple years and switched to a lower cost fund. (Note: This would mean continuing to read prospectuses from time to time, even after investing in the funds.)

But that’s one big waiver!

But in the case of the Pax World International Fund, we’re not talking about a 0.12% jump in expenses if/when the waiver disappears. We’re talking about an increase in expenses equal to more than 10% of fund assets. I don’t know about you, but that would make me extremely hesitant to invest in the fund.

The Lesson: Read the prospectus

Assuming you plan to own a fund for several years, you need to know not only what its expenses are now, but what they’re likely to change to in the future. That’s the kind of information that you’ll only find in a prospectus.

Low-Cost, Socially Responsible Mutual Funds

From time to time I get emails or comments from people who have moral qualms with index funds–the issue being that the investor doesn’t want to own shares of companies that do things to which he/she is ethically opposed.

First of all, let’s be clear on one thing: Buying shares in a company does not really help the company itself. In almost every case, you’re buying shares from another investor. The company isn’t even involved in the transaction.

(One could argue that buying shares drives up the price, which helps the company, but that’s quite a stretch. For most of us, even if we invested our entire net worth in one company, the share price would hardly budge. Investing in index funds will have no impact upon the price of a given company’s shares.)

That said, if the issue isn’t so much that you don’t want to help the company by buying shares, but simply that you can’t justify owning shares of companies that do things you find morally reprehensible, then fine. That, at least, makes sense.

So if that’s your viewpoint, how should you go about investing?

Socially Responsible Mutual Funds

There’s an entire industry built around offering mutual funds that only invest in companies that fit certain criteria (some are religious-based, some are environmental, some screen out certain industries, etc.). It’s a neat idea.

But there’s one big problem.

The expense ratios are nothing short of appalling. Take a look. 2% annual expenses with a 5% sales load? Yuck!

Constructing a Low-Cost, Socially Responsible Portfolio

There are, at least, some low-cost, socially responsible investment options. Unfortunately, they’re few and far between, and constructing a properly diversified portfolio is rather difficult. That said, I think the main building blocks would be as follows:

In the domestic stock category: Vanguard’s FTSE Social Index Fund carries a relatively modest 0.31% ER.

Fixed income: This part is easy–simply avoid corporate bond funds completely and invest exclusively in low-cost Treasury-bond funds.  (Many experts recommend doing this anyway, for purposes entirely separate from moral considerations.)

International stocks: This part of the portfolio is trickiest, as I can’t find a single option that I’d really be happy investing in. My pick at this point would be Domini European PacAsia Social Equity Fund. (Portfolio turnover 31%, expense ratio 1.60%–far too high for my tastes, but modest among socially responsible funds.)

Additional Concerns

The Vanguard index fund is a large-cap growth fund. So an investor may want to include a domestic large-cap value fund and/or a domestic small/mid-cap fund as well.

Essentially, you have to perform a balancing act. On the one hand, you can lower your costs by over-weighting the Vanguard fund (the domestic, large-cap growth portion of your portfolio). Or, you can benefit from additional diversification (at the cost of higher expenses) by increasing the allocation to other equity classes–whether international stocks, small/mid-cap domestic stocks, or domestic value stocks.

Also, the above portfolio necessitates having accounts with at least 2 brokerage firms (Vanguard and Domini Social Investments). Vanguard has no account fees, and as far as I can tell, neither does Domini, but having multiple accounts is still a bit of a pain.

Finally, the published expense ratio on the Domini fund takes into account a waiver of fees–something that always concerns me. (More on this topic tomorrow. 🙂 )

What do you think? If you were going to construct a “socially responsible” portfolio, would it look similar to the one above?

Don’t Trust Financial Statements

The most basic skill in picking stocks is the ability to read financial statements. From an income statement, balance sheet, and cash flow statement, a skilled reader can supposedly glean all sorts of valuable/actionable information.

As someone whose career and educational background is in accounting, I’ve spent my share of time creating and reading financial statements. What many non-accountants seem to miss is that most of the information included in them is extremely imprecise.

The reason behind this lack of precision is that, as I once heard the Controller of a Fortune 500 company say, “accounting figures are estimates, based upon estimates, based upon questionable assumptions.” (Depreciation and amortization expense are two prime examples.)

To give you an idea of where financial statements stand, I prepared this handy Guide to Accuracy & Precision:

DataAccuracySpectrumThe general rule of thumb is that line items on financial statements cannot be trusted beyond their first significant digit. (And I’ve seen more cases than I care to count in which I’d argue that even that was a stretch.)

Now, does all this mean that financial statements are completely worthless? No, not completely. But before you go betting your life savings on a stock, at least be aware of the quality of information you’re dealing with.

Individual Investors vs. The Market

I frequently make the case that individual investors have little hope of reliably outperforming the market by trying to pick investments on their own. A recent comment on a post from a couple months ago argued that individual investors do have some advantages that might help them reliably outperform the market.

The commenter pointed out that:

  1. Mutual funds are required to stay within a given asset allocation range. Individual investors, on the other hand, can move entirely to cash or entirely to stocks whenever they see it as beneficial.
  2. While each individual trade is a zero sum game in terms of who will come out ahead, some investors aren’t necessarily seeking to come out ahead. That is, “Zero sum games can be beat if everyone is playing for different reasons.” For example, elderly investors might buy dividend stocks simply because that’s what they’re comfortable owning.

Individual Investors vs. Mutual Funds

Regarding the first point, that’s true. Fund managers are not allowed to move entirely into cash whenever they see fit. (Thank goodness!) People have been bringing this up for years. (They usually also point out that fund managers can’t invest more than 5% of the fund’s assets in a given stock, whereas individual investors have the ability to do so.)

Admittedly, these are at least potential advantages to individual investors. The problem is that to be able to exploit these advantages, investors have to be able to:

  • Predict short-term market movements (such that moving into or out of cash would be beneficial), and/or
  • Pick stocks that are likely to outperform the market (such that putting a large portion of one’s portfolio into a given stock would be beneficial).

Every piece of data I’ve seen on the topic indicates that individual investors have little hope of being able to perform either of these feats reliably. And that makes sense; most of us just don’t have the resources.

Individual Investors vs….Other Individual Investors

As to the second point above–the one about zero sum games–again, this one makes sense on a (wonderfully fascinating) theoretical level, but it seems difficult to exploit to one’s advantage.

Even if we assume that there are investors who buy stocks without the intention/hope of beating the market, what percentage of stocks do these investors own? I suspect it’s rather small.

And, more to the point, I’d be willing to bet that these older investors have far lower portfolio turnover than most other market players, meaning that the likelihood of one of these investors being on the other side of any given trade is exceptionally low.

Am I missing something?

What do you think? Is there something I’m leaving out that gives individual investors a meaningful advantage over other market players?

Rent a Home vs. Buy a Home

Not an investment?

Not an investment?

Recently, many personal finance authors/bloggers have taken to declaring that a home is not an investment. It’s a purchase.

I know they mean well, but that claim seems like nonsense to me.

What is an investment?

Webster’s defines investment as, “the outlay of money usually for income or profit.”

Using that definition (or any reasonable definition that I can think of) the purchase of a home most definitely is an investment, regardless of whether you ever plan on selling it and regardless of whether or not it ever increases in value.

If purchasing a home was not an investment–that is, if it didn’t have a monetary payoff in the end–it would be the most appallingly awful purchase imaginable. (If it were simply a giant storage bin that cost several hundred thousand dollars, what is the likelihood that it would be the single greatest happiness-inducing purchase you could make with that money?)

Luckily, buying/owning a home does have a financial payoff–even if you never plan on selling your home, and even if it never increases in value.

What am I talking about?

The payoff from buying a home lies in the fact that:

  • At some point, market rent prices will grow to exceed your total home-ownership-related cash outflows (mortgage payment + property taxes + maintenance costs), and
  • Eventually, the mortgage payment will disappear entirely, thereby making your cash outflows significantly less than what you’d be paying in rent at that point.

So should everybody buy a home?

No, that’s absolutely not what I’m saying. My point is simply that–even in light of the apparently astonishing fact that home values don’t have to double every five years–a home is still an investment. It has an expected financial payoff down the line, and it’s silly to ignore that fact.

Individual TIPS vs. TIPS Funds

TIPS (Treasury Inflation-Protected Securities) are U.S. government bonds that provide a specific after-inflation return (as compared to “nominal” bonds which provide a specific before-inflation return). Here’s the description of how they work, right from the source:

“The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.”

With municipal bonds and corporate bonds, the single greatest benefit of bond funds over individual bonds is that they diversify your money across several borrowers to reduce the overall risk of default.

With U.S. Treasury securities, however, that becomes a moot point, as they’re generally considered to have zero credit risk in the first place. (And even if the risk is greater than zero, investing in a fund made up exclusively of securities from the U.S. Treasury wouldn’t reduce that risk.)

So with the primary benefit of a bond fund no longer being relevant, is there still any reason to use a TIPS fund rather than buying individual TIPS?

Why buy a TIPS fund?

For the most part, the primary advantage of a TIPS fund is convenience.

Buying: TIPS funds can be bought at any time. Individual TIPS must be bought at auctions which only occur at specific intervals throughout the year.

Selling: You can sell a TIPS fund at any time (with no commission assuming it’s a no-load fund), whereas selling individual TIPS generally involves paying a commission ($45 if your account is with Treasury Direct).

Reinvesting: If you own individual TIPS, you’ll have to wait until the next auction date rolls around before you can reinvest the interest you’ve received. With a TIPS fund, you can have the interest reinvested automatically in the fund.

Why buy individual TIPS?

Lower expenses: Any TIPS fund will have to charge expenses. Yes, for good funds the expense ratio is quite low, but if you buy TIPS directly there will be no expenses eating into your returns.

Known return: With individual TIPS, you know precisely what real rate of return you’ll get over the duration of the bond. With a TIPS fund, you can’t be as sure because the fund is made up of an always-changing collection of TIPS with varying maturities.

Knowing your precise after-inflation return can be quite convenient when saving for situations where you’ll be making a cash outlay at one specific point in the future (that is, expenditures such as college, as opposed to retirement for which people spend cash on an ongoing basis over an extended period).

Which do you use?

For those of you who invest in TIPS, which do you use? A TIPS fund or individual TIPS? And was your decision based on one of the above factors, or are there some considerations that I’ve left out?

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