Wednesday, February 27, 2013

If You Can't Beat 'Em, Join 'Em

The Journal of Indexes had an interesting article in its March/April 2013 magazine titled "Are Active Mutual Funds Becoming Less Active?"

The conclusion is that yes, active mutual funds ARE becoming less active. One theory behind this movement is that the managers are moving to an indexing management style. Since there has been mounting evidence of increased correlation in the stock market, a manager's "ability" to to choose a security which would outperform the average of the index has become increasingly difficult. Some would argue that there has never been a manager that has been able to outperform his or her index except for pure luck, but we'll save that for another story.

If indeed the active mutual fund managers are moving to an indexing style of management, it is even more important for the investor to look at the cost of doing business with that mutual fund. Many equity mutual funds have internal fees ranging from 1 1/2% to 1 3/4% or more. When these fees are put up against index ETF fees which may range as low as 0.05%, underperformance of the more expensive mutual fund is almost a guarantee.

While consumers may roll their eyes at 1 1/2%, remember, it adds up to real money. For a portfolio of $1mm, that 1 1/2% represents $15,000 per year on wasted mutual fund fees. That is money that could be going to the investor rather than the mutual fund company.

As individuals with larger portfolios enter retirement and search for ways to fund retirement and create retirement income, they should carefully investigate mutual fund fees. $15,000 a year is a lot of money to waste. 

Tuesday, February 5, 2013

Stay in Money Market or Go Out Slightly on Curve?

The most common question we are getting from the media right now has to do with "bonds getting slaughtered" and "do you think we are in a bond bubble?"

The answer to the first question is "which bonds?"

The answer to the second question is "yes."

Let's take a look at staying in money market (currently earning about 2/10ths of 1%) versus buying a 10 year bond. If we were to buy a 10 year bond (say GE 5% due 7/15/23) at 3.50%, what would happen if we have a yield curve rise (interest rate rise) of 1% over the next 24 months? How do we look 24 months from now if we have a parallel shift in the yield curve 100 basis points higher?

Well, rolldown is currently worth 22 basis points a year, meaning in 2015, we'd be looking at 3.50% rolling down to 3.06%. However, add in a 100 basis point rise in rates and voila, we are at 4.06%. In this scenario, our bond has fallen 3.78% in amortized principal value while the client has picked up 7% (3 1/2% x 2 years to make it simple) in yield.

The net gain or loss to the client is a gain of 3.22%. The person sitting in money funds has gotten 4/10ths of 1%...perhaps as much as 1.40% if they captured the move in the funds rate.

At some point, it makes sense to hide out in money funds, but in a steep yield curve environment, it more often than not makes sense to buy the 7-12 year part of the curve.

The difference of a 1% or 2% return may not sound like much, but when you are looking at a portfolio of $2mm, you are talking about anywhere from $20,000 to $40,000 difference in value.

We urge everyone to quantify their bond exposure and not fall prey to the media's hype.