Archives for July 2009

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Options Strategies for the Passive Investor

As regular readers will know, I’m a proponent of a very simple buy & hold, passive investing strategy. However, I do believe that there’s a value to discussing and understanding alternative strategies so that you can decide whether they’re appropriate for you. That’s why I recently invited Mark Wolfinger, author of Options for Rookies to write a guest post. He was kind enough to oblige.

Option strategies, specifically the collar strategy, can provide additional safety for your portfolio. That means a guarantee against incurring significant losses (you decide how much loss you are willing to accept–much like the deductible on an insurance policy). No asset allocation program comes with guarantees. They may come with high probability of fulfilling your needs, but that’s not as good as a guarantee.

Many of you have a negative feeling towards options and that’s understandable considering how much bad press options (or any derivative product) have received. The truth is that options were created as hedging (risk reducing) tools, and if more investors used them for that purpose, options would have a better reputation.

My specific objective today is to share why I believe passive investors can benefit by using options. General option education is available elsewhere.

There’s more to investing than choosing between passive and active management. For example, the Prudent Man Rule tells us that asset allocation and diversification are vital to reducing risk. But, the recent (technology bubble and 2008) market meltdowns have convinced many that these methods only work in bull markets.

A recent WSJ article discusses how a bunch of financial advisors have been shaken by a failure of ‘prudent’ measures. Another article tells how some advisors abandoned their traditional ideas and are now making (in my opinion) extraordinary investment decisions–in a desperate attempt to succeed. These advisors have abandoned passive investing. I’d never suggest that you do the same, but there are steps you can take to make your portfolio bulletproof. Of course, that excellent protection comes at a cost, and that cost is accepting limited profit potential and giving up the possibility of earning a substantial sum in a hurry. You still have room for growth, but it is limited.

The difficult part of investing is to find methods that provide relatively good results when markets are falling. That does not mean losing 30% when everyone else is losing 40%. It means not incurring any large losses. Ever. For the majority of investors, preventing occasional large losses is impossible and the question is: Are you confident that owning a properly diversified portfolio with assets appropriately allocated is good enough? Do you believe you are protected and can survive during bear markets, or would you prefer to own the necessary protection, knowing that your portfolio will underperform when markets are marching steadily higher?

If you are uncertain and concerned that years similar to 2008 will occur with more frequency going forward, option strategies can alleviate that concern. My host, Mike, says that good asset allocation worked last year, minimizing losses. I have no idea how well diversified portfolios performed, but the WSJ articles quoted above suggest that asset allocation did not do the job. How well did you do?

Here’s what I suggest: Continue asset allocation and diversification. But take out insurance when possible. As I explained in a recent post, owning collars underperforms significantly in bull markets and outperforms just as significantly during declining markets. (For reference, Mike’s counter-argument can be found here.)

Using collars protects your investments from serious losses. It also limits profits.  Collars provide a smoother ride because the portfolio value is less volatile. Again, options are not for everyone, but insuring the value of your equity and commodity holdings by adopting a collar strategy guarantees long-term survival.  Failure to use options shows a willingness to be satisfied with the (current) advice given to the Prudent Investor. Which is right for you?

Closet Index Funds: What They Are and Why to Avoid Them

Hiding something?

Hiding something?

Closet index funds are actively managed funds that claim to attempt to beat the market, but in reality they simply mimic an index fund (at a higher cost).

The problem, of course, is that if a fund manager is investing in the same stocks that make up the index (and in similar proportions), while at the same time charging you higher costs, then there’s roughly zero likelihood that the manager will actually succeed at his job. (His job being to outperform the relevant index/benchmark.)

How to Spot a Closet Index Fund

One way to determine whether an actively managed fund is a closet index fund is to calculate the correlation between the fund’s performance and the performance of its relevant index/benchmark. The higher the correlation, the more likely it is that the fund manager is a closet indexer.

As a random example, I went to Fidelity’s fund overview page, and chose the first domestic stock fund in the “Large Blend” category that has been in existence for 10 years or more: Fidelity Disciplined Equity Fund. (I used a Large Blend fund simply for convenience, as that’s the category for which the S&P 500 is the relevant benchmark.) Then I dropped the fund’s performance figures into a spreadsheet along with those of Vanguard’s S&P 500 index fund:

Picture 3

Next, I used Excel’s “correl” function to calculate the correlation between the two. The answer? 98.7% correlation. Hmm…think we caught one?

Check your own funds.

If you invest in any actively managed funds (or are considering doing so), you might want to try the above exercise on them. It could be an eye opener. Be sure, however, to use the appropriate index. (For example, don’t compare an international stock fund to the S&P 500.)

Of course, I’d still argue in favor of avoiding actively managed funds entirely, if that’s an option.

Introductory Guide to Asset Location

Asset location is the process of determining which investments to keep in which accounts. That is, after you’ve determined your appropriate asset allocation, how should you divvy that up between your tax-sheltered accounts and your taxable accounts?

Example: Let’s say that you decide that your appropriate asset allocation is a simple 70/30 stock/bond split. You currently have $100,000 in your 401(k), $50,000 in a Roth IRA, and another $100,000 invested in taxable accounts.

So your grand total is $250,000, and you would like $175,000 (70%) invested in stocks and $75,000 (30%) invested in bonds. A few potential asset location options would be as follows:

  • Split each account up so that it’s allocated 70/30,
  • Invest $75,000 of your taxable account in bonds and invest everything else in stocks,
  • Invest $75,000 of your 401(k) in bonds and invest everything else in stocks, or
  • Invest all $50,000 of your Roth in bonds, $25,000 of one of your other accounts in bonds, and everything else in stocks.

Option 1: Shelter those bonds!

From a tax standpoint, it typically makes sense to put all of your bonds in tax sheltered accounts. Why? Because they pay the most taxable income.

In contrast, stock income comes in the form of either dividends (which, for the moment, are taxed at a lower rate than interest income) or capital gains (which, if the holding period for the stock was greater than one year, are also taxed at a lower rate than interest income). As a result, you stand to benefit more from tax sheltering your bonds than you do from tax sheltering your stocks.

Option 2: Split everything equally.

Rick Ferri in his All About Index Funds argues that, from a psychological point of view, each account should be split up so that it has the same asset allocation as your whole portfolio.

Ferri makes the case that, if one account were to be entirely bonds and another entirely stocks, many investors would have a hard time considering them as part of a broader portfolio, rather than separately. (And, therefore, rather than deriving the psychological comforts that usually come with having a diversified portfolio, the investor would be watching whichever account is comprised entirely of stocks and panicking whenever it goes down.)

Ferri’s viewpoint makes sense to me. I certainly see a potential psychological benefit to having a mix of asset classes in each account. However, I suspect that the value of that benefit depends largely on the individual.

Which approach is best?

Anytime there’s a math vs. psychology debate, I’m reluctant to declare one option as “best.” As for my own portfolio, however, the entire bond portion is located in my Roth IRA.

When to Sell an Actively Managed Mutual Fund

A friend recently sent me an email asking for my advice regarding a one of his mutual fund holdings.

The fund underperformed the market pretty seriously over the last year. As a result, it now has 3-year and 5-year performance records that are below those of either an S&P 500 index fund or a Wilshire 5000 index fund–despite the fact that the fund was a big outperformer in prior years.

His question was how to know whether the fund manager had “lost his touch.”

My answer, of course, was that there’s no way to know. And in fact, it’s impossible to say for sure whether the fund manager ever had a “touch” to begin with.

His question highlights what I see as one of the biggest issues with holding actively managed funds:

  • If the fund has outperformed the market over the period that you’ve owned it, how do you know whether the fund manager has genuine skill or just good luck?
  • If the fund has underperformed, is it because the fund manager “lost his touch?”* Or is he still a skillful manager–one who has simply had a bad year? Or, was the fund manager never skillful to begin with?

In either case, you’re stuck asking yourself, “should I continue holding this fund?”

Index Funds & Peace of Mind

By way of comparison, with an index fund, you never have to rely on the existence of a brilliant fund manager. All you’re betting on is the likelihood that the businesses of the world, over time, earn a net profit.

(Side note: That’s just one of the reasons why I sleep better at night knowing that I’m invested in index funds.)

What about you?

For those of you who invest in actively-managed funds, how do you decide when to throw in the towel and find a new fund?

*In terms of the possibility of a fund manager “losing his touch,” I doubt that any truly skilled professional would spontaneously lose his skill. However, if his above-average performance was the result of exploiting a particular market inefficiency, it’s possible that that inefficiency could eventually be eliminated, causing the fund’s above-average performance to end.

How to Be a Successful Investor

It’s no wonder that people find the topic of investing to be confusing. Everyday we receive conflicting messages about how to be a successful investor.

The mutual fund industry and the stock-tip-newsletter industry tell us that:

  • Picking stocks successfully is difficult for the average investor, but
  • A professional has a good chance of picking stocks that will outperform.
  • A mutual fund (or stock newsletter) that has outperformed the market in the past is likely to outperform the market in the future.

The discount brokerage firms tell us that:

  • Picking stocks on your own is easy!
  • Rapid buying and selling of stocks (or other investments) is the best route to profits.
  • With up-to-the-minute information, you can time the market successfully.

The mainstream financial media tells us that:

  • Knowing what happened in the market yesterday (or last month) is essential for your success as an investor. If you watch the news enough, and listen to enough economists/market analysts, you have a good chance of predicting the next market move.
  • You can improve your performance by picking hot funds (particularly, those mentioned by a magazine).

The academics tell us that:

Who do you believe?

Given that three of the four parties involved are trying to sell us something while they give us advice, I’m personally inclined to believe the fourth. (It probably doesn’t hurt that the academics appear to be the ones with the best evidence to backup their claims.)

What about you? Who do you believe?

Why We Invest in Actively Managed Mutual Funds


The diagram admittedly leaves out the whole “everybody thinks that they’re above average” psychological aspect. But I think that it still conveys one important part of the issue.

If you like the diagram, feel free to use it on your own blog.

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