Chapter 6
Building Your Portfolioio - A Look at Fund Options

While individual stocks may be an option for some highly skilled investors, they are not the best choice for most investors. Here's why: When you invest by purchasing individual stocks, you are competing head to head with professional money managers. Individual stock picking demands a lot more knowledge and attention than most average investors are willing to put into it, and even then the odds are high against you beating half of the professionals.

An investor needs at least 50 stocks spread into different asset classes to be diversified, and no one stock should be more than 4-5% of equity holdings or the investor will add "specific stock risk" to his portfolio. So, for most investors, and especially those who don't want to spend a lot of time on their portfolio, using mutual funds is a far better choice.

Mutual Fund Basics
A mutual fund is a pool of stocks or bonds purchased by the fund’s manager. An investor can buy the mutual fund and thus own all the stocks or all the bonds in that fund. There are also funds that contain both stocks and bonds. I’ve mentioned that there are around 7000 stocks available for purchase, and there are even more mutual funds! You can find a fund that covers any area of the stock, bond or international markets you wish to invest in.

There are two basic kinds of mutual funds—closed-end funds⁹ and open end funds. Open ended funds are far more popular and are the ones you hear about and see advertised. All references in this guide are for open-ended funds.

Mutual funds can buy and sell stocks at the manager’s discretion; therefore, the stock selection can change. If you wish to purchase a fund you would call the fund company or brokerage that has the fund you are interested in and place an order during a market trading day, but actual purchase will not occur until the close of the market that day. The price of a fund is called the net asset value (NAV) and it always reflects the average price per share of all the stocks held in the fund.

Mutual funds can further be classified into load funds, no-load funds, actively managed funds, index funds and exchange traded funds (ETFs). Index funds and index ETFs are also known as passive funds because they are designed to track a particular asset class or segment of the market without any managerial attempt to increase returns or moderate risk.

Mutual Fund Expenses - How they earn money
All mutual funds and ETFs have management fees. These fees are expressed as a percentage of assets removed from the fund before the total return is reported. Other fees, usually advertising expenses or commissions, can be attached as well under what is known as a 12b-1 fee. 12b-1 fees and management fees are combined and expressed as a fund's expense ratio. Expense ratios can range from a very low 0.10% for some index funds to over 2.0%. On a $10,000 investment, that’s $10 per year compared to $200 per year.

Load Funds
Load is another word for commission. Funds that carry loads are sold by commissioned agents, advisors and brokers. Loads are applied most frequently in three ways:; front end (A shares), back end (B shares), ongoing (C shares). There are several other letter designations for other asset classes as well.

A shares of a fund usually have a commission of around 5.75% of the money you invest, and it is taken even before the fund is purchased. If you hand the agent or advisor $10,000, $575.00 will go into the advisor’s pocket and only $9425 will actually be invested.

The commission is sometimes not obvious because the real value of the fund—the net asset value (NAV)—is not reported to you when it appears in your account statement. Instead, you might see a buy price, market price or something similar so it will appear that all the money was invested. Commissioned advisors do not like to show you what you paid, which ought to put you on the alert about their methods. A shares do offer discounts on the commission based on the purchase amount, but you probably won’t get a discount unless you request it.

Mutual fund B shares designate a back-end load. This is a commission taken when you sell the fund. Back end loads usually get reduced each year you own the fund. An example would be a 5% charge the first year, 4% the second, 3% the third and so on. But it may take 6 years or more to get out from under a redemption commission. And all the while you will pay a higher expense ratio for B shares than A shares because there is normally a 12b-1 fee (commission) attached. Most B share funds convert to A shares once the redemption fee is phased out.

C shares have the commissions built into the expense ratio and they show up in a 12b-1 fee, which is part of the overall expense ratio. These are called level loads, and they are applied as long as you own the fund. This commission can raise the total expense ratio to over 2%.

Additional information on share classes
http://www.saveandinvest.org/Military/manageMoney/investorAlerts/P005975

In recent years more classes using different letter designations have been developed which further complicate the costs of these funds. These loads have nothing to do with operating the fund—the money goes strictly to sales profit.

The idea behind these commissions is that they are supposed to get you investment advice. But, advisors who make money this way often recommend investment choices that make them the most money. There is a lot of conflict of interest here that can bias an agent's recommendations.

No-Load Funds
No load funds are just that—they have no commissions at all. You buy them direct from the mutual fund company, a discount brokerage or through a fee-only advisor.

Index Funds
An index is a group of stocks chosen to represent the whole market or certain parts of the market. The performance of an index represents the average returns of the market segment being followed. The Morgan Stanley Capital International (MSCI) broad market index is one of several indexes that track the total U.S. stock market. You cannot buy the actual indexes, but you can buy mutual funds that track them.

There are index funds for all of the asset classes and the nine market segments shown previously plus some others as well. The most famous index fund is the Standard and Poors 500 (S&P 500). The S&P 500 is used as the standard for the total market because it tracks the whole market very closely and it was created before there was a total market index.

The hallmarks of true index funds are they are capitalization-weighted and track their asset class closely. Most, but not all, are very low cost because they don’t have an active manager, they don’t need to spend money on stock research, and they have very low turnover.

Exchange Traded Funds-Index
ETFs are put together and sold as a single unit like a stock, which means you can buy or sell them at any time during a trading day. But like a stock, you have to purchase through a broker and you will pay a commission for the trade. Buy/sell commissions can run from zero dollars at a discount broker to over $100 at a full-service broker.

When ETFs first arrived on the scene, they were all copies of true index funds. But now there are many more that index something other than a pure asset class. Like index funds, most ETFs have very low expenses. Avoid those that don’t. ETFs can be a good choice if you refrain from frequent buying and selling.

Actively Managed Funds
As the name implies, these types of funds hire a manger to put together and maintain a fund. The objectives of active funds as a group are far more varied than index funds which just have the job of tracking an index. In general terms, fund managers are trying to beat their benchmark index, although some actually try to limit downside risk as well. The ways in which mangers try to achieve their goals is where the creative variations come in.

More on actively managed funds
http://en.wikipedia.org/wiki/Active_management

Choosing Passive or Active Funds
The better an investor is educated in the area of finance, the more likely he or she is to choose index funds. But most investors are not interested in doing a lot of academic research. Average investors respond to only what is right before their eyes—lists of current top performing funds and big returns. But, what you see is not likely to be what you are going to get.

The benefits of indexing are not obvious nor intuitive. Index funds do not crowd the top of the hot fund lists, but they definitely do produce higher returns over longer periods of time. There are two simple reasons for this: 1) Index funds have lower costs. 2) Index funds are not subject to several problems that active funds encounter.

It’s difficult to connect these two simple advantages to higher long-term returns. What happens is index funds continue to produce benchmark returns minus low costs, whereas the great majority of active funds simply cannot continue to overcome their higher costs and avoid problems.

The following data shows the percent of funds beaten by their index for all nine market segments over a ten year period ending 2/31/2004.¹² Over longer periods the numbers are even higher.

LV=66%
LB=82%
LG=84%
MV=89%
MB=79%
MG=95%
SV=68%
SB=93%
SG=63%

This following link provides a list of index fund advantages and a series of quotes from professionals compiled by author and investor advocate, Taylor Larimore.
http://www.bogleheads.org/forum/viewtopic.php?t=881

Beating the Market
One critical mistake uneducated investors make is to believe they can and must select managers that can beat the market. Successful investors, however, understand that trying to beat the market long-term is a losing proposition. It is not a competitive game. Those who treat is as a contest usually do not make good investors.

The purpose of investing is to achieve financial goals with an efficient, systematic plan. Investing is always a balancing of risk against reward—not a contest to see who can get the highest returns.

Investor Returns
Investors do not actually capture the returns funds produce because of:
behavioral mistakes

1. behavioral mistakes
   
2. costs
3. problems active funds incur that hurt performance

So, the smart play becomes eliminating things that can reduce returns. To put it simplified terms, don’t shoot yourself in the foot. Maximum long-term gains are the result of capturing the highest percentage of market returns—Increase the odds of long term success with low costs and avoidance of potential problems.

To use a car trip analogy—, the way to win is not to get from point A to point B first; it is to achieve the best gas mileage.

Active Funds Additional Risk
As mentioned, managed funds start off with the handicap of higher costs and an array of potential problems that can suddenly sink a fund. Investors need to understand that this handicap equates to higher risk of success because it’s not possible to identify those funds which will outperform in the future, and that is where the additional risk lies.

If an investor holds 10 active mutual funds, the odds are extremely high that several will fail to do the job for which they were purchased. Managing a portfolio of all actively managed funds requires more time evaluating performance and searching for replacement funds. Because some will fail, they are not good choices for taxable accounts where big tax penalties will add to the problem.

Potential Problems
Asset bloat - Popular funds draw a lot of new money. And ironically, too much success is one of the biggest causes of eventual failure. As the fund's assets grow it becomes harder and harder for the manager to find good stocks to buy. A fund company with true fiduciary responsibility to its investors will close the fund, but most will just keep taking in the money until performance sinks to the bottom of the list.

Manager changes - Managers who have put up good numbers and received lots of media attention tend to move on to other, more lucrative positions. It’s worth noting, though, that some very good active funds have multi-managers, which suggests that the company’s underlying philosophy is more important than the manager.

Fund Purchase- it’s not uncommon for successful smaller fund companies to be bought-up by big firms with mediocre records and high fees. The funds with the good records are heavily advertised, but once the higher fees and new company management interference is in place the outstanding funds from the smaller company lose their luster.

Style drift - A managed fund that you purchased to cover the small value asset class can change to small blend, mid value or something else. When this happens, your target allocation gets shifted.

Objective changes - Managed funds can decide to change what they are investing in or how they invest, which dismisses the carefully chosen reasons you bought the fund in the first place.

Choosing Good Funds.
Why concern ourselves with choosing actively managed funds if it is an inferior strategy? For one reason, lots of investors use actively managed funds, and some who are informed and experienced are successful. Using active funds does demand more time and vigilance, and success absolutely depends on using proper fundamentals.

Another reason to know how to select active funds is sometimes investors have no choice. Tax-deferred plans like 401ks, 403bs and 457s usually do not offer index funds or even top rated managed funds. Participants in these plans are forced to work with what is available.

Selecting Active Funds
1. The most important thing to look for when choosing an actively managed fund—and the hardest to recognize—is a fund’s commitment to shareholder fiduciary responsibility. Investors need to evaluate the company’s philosophy and how they interact with shareholders.

2. Select funds with low expense ratios and never buy load funds. High expense ratios and 12b-1 fees are a drain on higher returns. The best funds also seem to hold advertising costs to a minimum.

3. Look for funds that have low turnover. Hidden transaction costs and capital gains taxes add to fund costs. Also, the best funds seem to be those that buy carefully and then hold their chosen stocks.

4. Look at five and 10 years past performance records. There is no way you can make a judgment based solely on past performance, but the farther back you can trace performance the better. Be very leery of funds with spectacular gains. Look for consistency and discipline.

5. Pay special attention to how much money the fund is managing (asset size). When a good fund is recognized by the crowd, it can receive a lot of new money that can cause problems. The best fund pickers will have identified a good fund like this several years earlier. The best funds will close rather than continue to accept money that will harm the investors. This is a sign of fiduciary responsibility.

6. Pay particular attention to balanced funds. They seem to be the most consistently reliable over time, perhaps because they aren't competing against, and not trying to beat, some stock fund benchmark. Unfortunately, these types of funds are not very good choices for taxable accounts.

Additional considerations -
http://www.mymoneyblog.com/archives/2007/09/flip-side-finding-the-best-active-mutual-fund-managers.html

Moderating Downside Risk
One other reason an investor might consider actively managed funds is to reduce downside risk. Some actively managed large value funds and equity income funds have lower downside risk.¹¹ Note that while past performance of returns is not an indicator of future performance, historical risk characteristics are somewhat useful in getting some sense of what to expect from a mutual fund as long as the objective has not changed.

It may be a good idea to offset your large blend fund or large growth fund with a large value fund or an equity index fund having a lower beta number if you wish to moderate your risk profile. This is common practice for investors in or near retirement. These types of funds usually throw off dividends too. And since the total market and the S&P 500 are naturally weighted toward growth, a large value fund is a good compliment.

Three measures of risk to look at are a fund's volatility (standard deviation), its bear market ranking¹¹, and it's beta number.¹¹ Beta is a number that indicates a fund’s swings in returns relative to movements of an index. For stock funds, the index used is usually the S&P 500, which as a beta of 1.00.

A fund with a beta of 0.85 means the fund might go up or down only 85% as much as the index. In up markets it will underperform by about 15%, but in down markets it will lose roughly 15% less than the index. Part of the reason for some of the lower risk is probably due to these funds holding some cash. Index funds do not hold cash. And be aware that there is no guarantee that the calculated performance will match the actual performance.

Building Your Portfolio - An Example
"The greatest enemy of a good plan is the dream of a perfect plan."
A favorite quote of John Bogle originally attributed to Prussian general Karl von Clausewitz.

There is no perfect investment plan. No one fund, no one allocation, or one strategy will be correct for every investor in all market conditions. And as you will discover, the investment options at your disposal will not always be exactly what you want.

When first starting out, things are usually quite simple. Your first investment venture might be an IRA or Roth IRA. Using these types of accounts allows you invest in almost any fund you want, but you will not have enough accumulated money to add to every asset class. One of the best ways to begin then is to use an asset allocation fund. These can be simple balanced funds or they can be fund-of-funds such as life strategy funds, or retirement funds.

These types of funds create an instant diversified portfolio for you. Be careful where you buy these funds though. Some companies tack on a management fee on top of the expense ratios of the underlying funds, which makes them too expensive.

Balanced funds and most asset allocation funds hold both stocks and bonds and you can find them in different allocations to match your needs. These are the simplest worry-free funds you can get. You can buy them and forget them because even the rebalancing is done automatically within the fund. You can get fund-of-funds and balanced funds in both managed and index varieties.

At work you hopefully will have access to 401k, 403b or other retirement accounts. These can be great investment vehicles because of their tax deferral, but it’s the rare plan that doesn’t come with some compromises or problems, including high costs and limited choices.

You will probably find you cannot build a well balanced, fully diversified portfolio with the options you have in one plan. Most investors use their traditional IRA accounts, Roth IRAs and taxable accounts to round out their portfolios.

To keep track, break things down like this example:

Overall Asset Allocation = 60% stock, 40% bonds and cash (define your own chosen allocation here)

Equities (equaling 60%)

401k
large value fund - 18%
international fund - 15%

Roth IRA
large blend - 9%
sm cap fund - 6%
REIT - 6%

Taxable
Total stock market - 6% (tax efficient)

Bonds (equaling 40%)

401k
intermediate bond - 28%

Roth IRA
TIPs- 12%
_________________
Total = 100%

Notes:

9. For information on closed-end funds, see www.closed-endfunds.com
11. Add a fund name or ticker symbol to Morningstar's Mutual Fund "Quotes" box, and then click on "Risk Measures” Measures." www.Morningstar.com
12. Gus Sauter, "Vanguard Chief Investment Officer Discusses State of Indexing,'" 1/25/2005, www.Vanguard.com

On to Chapter 7