Bond Fund Breakdown

Many investors who have stayed away from bond funds in the past are now pouring money into them.  A bond fund may be riskier than you think, let’s take a look at how to break down a bond fund.  

Let me first describe want a bond is.  Simple put it is a loan.  You can loan a company, government, or government agency money (principle).  They promise to pay you back with interest (coupon) over a certain period of time.  If you hold the bond until its maturity date you will get all your interest and principle. 

Bonds carrier a risk of default and therefore have a credit rating associated with them.  U.S. Treasury bonds, bills and notes have the highest rating of AAA. The scale goes down from there and it depends on how the rating agency assigns letter ratings to determine risk.  A bond fund will breakdown how much of the fund in is each rating or give you the average rating.  

The longer the term or maturity of a bond generally the greater the risk of price fluctuations.  Bonds are traded on the open market.  If you needed to sell your bond before maturity you may sell it for a gain or a loss.  Generally speaking if current interest rates are less than your bond you can sell it for a gain, but if current rates are higher you have to discount your bond and sell at a loss.  Bond funds have a measurement called duration expressed in years.  If the duration of a bond fund is 8 years, that means a 1% rise/decline in interest rates equates to an 8 percent loss/gain all other things being equal.   

For investors currently looking to add bond funds to their portfolio consider the environment.  Current interest rates are very low and have little room to go down and we are in a recession.  When analyzing a fund look for a fund with most of its money in A rated bonds and an duration of 5 years or less.  If you want to take less risk go with a fund whose duration is under 3 years.  

Since bond funds are interest bearing instruments the expense ratio is extremely important.  There are plenty of bond funds with expense ratios under .70%.  Any higher than that and I do not know how a company can justify the cost.  

Bond funds are a great addition to a portfolio but do carry risk.  With the current economic environment do some research before jumping in. 

Performance Guaranteed Variable Annuities

After the market collapse I was getting grief from some individuals that I talked out of purchasing variable annuities with a minimum guaranteed rate of return.  The annuities go by many names and are different in their benefits and features across companies.  The bottom line is that they all guarantee a minimum rate of return no matter what the performance of the underling funds you select.  This made many individuals pick some of the riskiest investments offered in the product.  The philosophy was that by going into the riskiest funds you had unlimited upside potential but the downside risk is a guaranteed minimum return by the company of 6-7 percent. 

So why would I not recommend this product to investors?  Number one is you have to read the fine print in all of these annuities and there is a lot of it.  None that I know of would actually let you take the entire balance out of the fund.  Most allow you to collect income off the accumulation.  Two, with most of them you have to hold them for a ten to fifteen year period.  If you held a well diversified portfolio of stocks, bonds and other assets for the same period of time there a few periods in history that the annuity guarantee would be needed.  So you paid for the guarantee in the form of higher fees for no reason most of the time.  Lastly, the guarantee is backed by the insurance company who may not be able to keep its promise. 

It turns out that my last reason should be the biggest concern for those who own these annuities.  A recent Wall Street Journal article, “Investing in Funds: A Quarterly Analysis-Brokers Fear Many Insurers Ignorant of Annuity Risk” points out that the rating agencies are downgrading the ratings of many of the insurance companies who sold these annuities. 

I do not want to spread fear and panic like Jim Cramer or Suze Orman last October, but you should be concerned.  There is little chance you will lose all of your money in one of these annuities.  The more likely scenario is that you do not get the guaranteed rate of return, but will get the balance in your account with the market losses.  This would mean that you paid higher fees for investing than you would of in just mutual funds without the annuity rapper.

Hopefully everyone is learning from this downturn.  There is no guy (Madoff and others) out there that can defy the laws of investing with above average returns without volatility. There will be no product out there (performance guaranteed variable annuities) that can give you the upside potential of riskier investment without the downside risk. 

In hindsight I stand by my recommendation to those individuals who I told to stay away from those annuities. 

Finding the bottom with Behavioral Finance

I was having a debate of sorts with an individual on an online forum about actively managing your portfolio verses passively managing your portfolio. During the discussion I explained that I use Behavioral Finance to decide when to change my allocation.

Below is an explanation of behavioral finance from Wikipedia.com

"Behavioral economics and behavioral finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.

The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral Finance has become the theoretical basis for technical analysis. [1]

Behavioral analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest."

I use behavioral finance along with other information to help me find the top and bottom of the market. I can do this because I talk to many individuals a week about there investments. I start to see patterns in the questions and behaviors of investors and get an idea if we are near the top, bottom or still have further to go in either direction.

Let me give you some examples. In late 2004 and early 2005 many of the people I talked to who sold there stocks back in the bear market of 2000-02 were telling me that they did not want to get back into stocks until the market started doing better. The S&P returned 28.7% in 2003 and 10.87% in 2004. The market recover was well on its way, yet I was meeting people who did not realize it. At the time I was thinking about reducing my equity position but from talking to individuals and realizing that the turnaround did not hit the average American I held on to my stocks.

In 2006 everyone I talked to wanted to buy and sell real estate. That is one signal we could be near the top. Think of gold right now. Then I started to hear people talk irrational, which is when I start to think about taking action. Several people I talked to made the same statement, “you can never lose money in real estate”. So in 2006 I put one of my investment properties up for sale and realized that the slow down had all ready begun.

So the question is, using behavioral finance are we at the bottom. It is harder for me to tell this time around because no strategy will work if the financial system is broken. I do have some signs that make me optimistic that we are nearing a turnaround. One sign is the local news cashing in on the crisis with stories like, “Recession Sex” brought to you by Fox news of course. I have not met with an investor in weeks who wanted to sell their stocks. All I need now is some people making irrational statements. Then there is a more fundamental sign, a record amount of money going into treasury securities. Some people are calling it a treasury bubble and I have to agree.

It is important to point out that I only make slight changes to my allocation like going from 80% equities to 60%. I just take some off the table. This way if I am wrong I do not get hurt that bad. I also want to point out that I  moved all my retirement money into equities when the Dow dipped below 8000 the first time. I did not use behavioral finance but I got anxious.  If I was using behavioral finance I would not of bought.  

As somebody who advises people on investing I still think the vast majority of individuals are best served with a buy and hold strategy with the occasional rebalancing of their portfolio.  Your average worker in a 401K plan just does not want to sell when they see their investments making money and do not want to buy the investments losing money.  

Are you a buy and hold investor or do you actively management your portfolio?

Mutual Fund Share Classes

Many investors have no idea what mutual fund share class they are in or why. If you are about to do business with a broker or advisor a little education will go a long way.
There are three main share Classes; A, B, and C. Class Y will represent other share Classes explained later.

	Class A	Class B	Class C	Class Y
Managemant Fee	.50	.50	.50	.50
12b-1 Fee	.25	1.00	1.00	0
Other	.10	.15	.20	.15
Total annual Expense Ratio	.85	1.65	1.70	.65

Excluding class Y, you can see from the table above that Class A has the lowest annual expense ratio. The annual expense ratio is the fee taken from the fund each year. It is somewhat of a hidden expense because you never see it come out of your personal account. Instead it is taken from the fund's assets. The net effect to you is a total return minus the expense ratio. So if you own Class A shares and the fund returned 10% the fund company takes .85% and you get 9.15% versus Class B where you would get 8.3%. So why would anybody by Class B or C? Class A carries a 5% or more front end sales load. A front end sales load is taken from the amount you put into the fund. If you contribute $10,000, only $9,500 is invested.

Class B has a back end or contingent deferred sales load. The load is on a declining scale. For example if you sell your shares in the year one or two you pay 5%, year three you pay 4% until the load goes to zero in year 6 or more.

Class C you will only pay the load if you sell the shares within the first year. After the first year the load usually is zero.

Now you are thinking why buy Class A or B. The answer is because of the expense ratio. Class A has the lowest expense ratio and Class C the highest. Over long periods of time Class C becomes the most expensive. The class with the lowest expense ratio will have the highest rate of return. You pay less year after year so you keep more of the return. Eventually the compounding of the higher return makes up for the front end load in Class A. With most companies Class B shares will convert to Class A shares after a number of years and to the lower expense ratio. The Class C shares never get a reduction in expense ratio.

If you are going to hold your shares for 10 or more years more often you are better off with Class A. If you think you are going to hold your shares for 5 years or less, Class C may be your best bet and between 6 and 10 years Class B.

I also put Class Y in the table above. I picked any letter to describe the next set of share classes. Some companies may have one or two more share Classes and other will have several. Most of the other share classes have to do with shares offered in pension plans, 401(k) plans or sold through fee only advisors. They are generally the lowest priced share Class.

The information above is very general including the table. There are many variations to the share Classes by company. For example the spread in the over all expense ratio between the Classes, how long the contingent deferred sales charge is and when and if Class B converts to Class A. The aim here was to give you a general understanding of how share Classes work. I also wanted to point out that what seems like the obvious choice when looking at the sales loads, may not be your best bet when you consider the entire expenses of the fund.

The details about overall expenses can be found in the mutual fund’s prospectus. I encourage everyone at a minimum look at the expense section of the prospectus before you invest.

Recessions, Painful but Healthy

There has been a lot of news lately about a change in America’s attitude toward saving and becoming more fugal.  Americas have gone from a negative savings rate to a positive one.  It is now common place to hear people talk about how they are trying to save money on purchases.  This change in the savings rate and attitude was brought about by the recession.  Going back years you could read about how disturbing it was to financial professionals that we were at a negative savings rate.  People did not change their behavior until they had to. 

Recessions happen because we stray to far from the basics or fundamentals.  This time both individuals and companies over extended by borrowing or leveraging to much.   We ignored the fact that allowing individuals to borrow 100% or more with closing cost to purchase a home is a fundamentally flawed practice. At some point something has to give.

Take a look at the auto industry.   The companies that have been more efficient like Toyota, Honda, and Ford are doing much better than General Motors or Chrysler.  Without government intervention both GM and Chrysler would have failed and other auto makers would have become more profitable.  All the companies, even with the bailout are currently being forced to become more efficient. I am not trying to start a debate about the auto industry’s bailout, but most economists believe that a bailout only prolongs the economic cycle. In the end the recession will bring about long needed change in the auto industry.       

So what has changed for investors this time, nothing!  It really never does.  If you stick with the fundamentals and have time to wait out the corrections you will do well.  The hard part is turning off the noise coming from the talking heads.  Here is a question to ask if you are paying for managed money.  Did your advisor, trust company, broker etc. do any better for you than the market itself?  It will be hard to get a straight yes or no, but the answer will be no the majority of times. 

The fundamentals of investing are simple but hard to follow. 

Keep expenses low. 

Stay diversified.

Do not chase returns, like technology in the nineties, real estate this last go around and gold/commoditiess now.

Pay attention to taxes.

Buy good companies with good management and hold on to them.

Tune out the noise.

I do not know when the recession will be over, but it will end.  Those who follow the fundamentals will soon see profits again.

Investing, Who can you trust

With the news about Bernard Madoff and another “investment manager” Joseph S. Forte who took investors for about 50 million in the Philadelphia area, many investors are asking who you can trust for financial advice. The good news is there are basic things you can do to protect yourself.

Joseph S. Forte was not licensed or registered with the state or federal government. You will find that the majority of individuals committing securities fraud are not licensed or properly registered. This is your first line of defense. Go to the Financial Industry Regulator Authority’s website FINRA.org and use their BrokerCheck tool. This tool will let you know if the individual is registered with FINRA and if they have any violations. It also allows you to look up a registered investment advisor firm who may not be required to be licensed but should be registered. If the RIA has fewer than 25 million dollars under management you will need to check their record with the state government. If the individual is not on record with FINRA or the state you do not want to give them your money.

You want to avoid individuals who make claims that they can provide specific rates of return. An advisor may be able to put you into an investment that will guarantee 4% over 5 years with some strings attached, but if they are claiming market beating returns and above average fixed rates be careful. That leads us to the next line of defense.

Know what your money is invested in. You should receive a report of what investments you are in. The advisor should be able to tell you were your money is and you should receive detailed statements with the holdings. Avoid advisors who claim they can not disclose how or where they invest your money. This is a major red flag.

If the advisor is providing returns to good to be true or if your balance never fluctuates while earning above average returns, fraud is most likely involved. This was the biggest tip off in the Madoff scandal. It is simply impossible to provide above average returns without volatility in your account.

You can also protect yourself by understanding what type of financial service you need. A life insurance agent may be able to provide advice for protecting your family in case of death, but you should not seek tax advice from them. Do not be afraid to ask questions like; how long have you been working in this area of finance, what companies have you worked for in the past, and how are you compensated.

FINRA has a very good section on their website under the tab “Protect Yourself” with many more tips to avoid being scammed. I encourage everyone to read it before working with a financial professional.

As someone who works in the industry I can tell you that the majority of professionals are just that, professionals. They do what they do because they love helping people with their finances and want to build a business doing it. In any business you have a few bad apples that ruin it for the rest. As a consumer you need to protect yourself. Taking the few simple steps mentioned above will help you avoid most of the bad apples.

Keep saving in your 401K

Many of the individuals that I have meet over the last month stopped saving into their employer sponsored plan.  The reason that they all gave, is that when they look at their account balance they have been losing their contributions.  That is not exactly the case but certainly looks that way.  What they are actually losing is past principal and earning.  If you have $10,000 in your account and make a $100 contribution and the losses in your stock funds are $350 for the contribution period, it looks like you lost your last contribution. What really is happening is you are now buying more shares for the same contribution.  If a $100 contribution bought you 10 shares of a stock fund, it now buys you about 20 shares. So when your stock fund goes back up $1, you make $20 on your last contribution.  This helps your account value come back much faster, but that is not the only reason why stopping contributions is a bad idea.

Let’s say you have two individuals, Sally Saver and Fred Freeloader (I was going to use Joe the Plumber).  Both 35 years old and saving $250 a month for retirement.  They both plan on retiring at the age of 65.  For simplicity sake we will assume they are both just starting to save. Because of the market they want safe investments earning 3.5% (not advisable but I want to make a point).  If Fred Freeloader waits 5 years to start making contributions he will have at age 65 $119,053 and Sally Saver would have $157,789, a difference of $38,736 more for Sally.   That is still not the whole story.  Sally would be paying less in federal income tax for five years all things being equal. This may be about another $3,500 in tax savings. The above example does not even take into account an employer match, which could have Sally's account balance much higher. 

Stopping contributions to your retirement plan is one of the worst things you can do.  If the losses in the stock market have you that upset, then ask the company that manages your plan if they have a guaranteed investment.  Be sure to ask if there are any strings attached with the guaranteed investment as there usually is.  This is the time to save more to make up for the losses, not give up on your retirement goals.  

The Difference Between Saving, Investing, and Gambling

Let’s take a look at the definition of each of the above words from dictionary.com.

Saving-
A Reduction or lessening of expenditure or outlay: a saving of 10 percent

Investing-
To commit (money or capital) in order to gain a financial return: investing their savings in stocks and bonds.

Gambling-
To stake or risk money, or anything of value, on the outcome of something involving chance: to gamble on a toss of the dice.

The above definitions shed some light on the differences of each word, but let me elaborate on them a little further.

In finance, saving would refer to setting aside money for the future. Forgoing consumption today to have more in the future. It does not mean buying shoes on sale. The major difference between saving and investing in my opinion, is that saving involves little or no chance of loss to the principle. Things like Money Markets, bank CDs and U.S. saving bonds. 

Investing on the other hand has both the potential for gain or loss. Because of the potential for gain or loss many people think of investing as gambling. They say things like, I lost money in the stock market before, and I rather take my chances at the casino. This is simply not true and I will explain why.

There are major differences between the two. Gambling involves either total gain or total loss. Also you can put up a small sum for a large payout, like the state lottery. Investing is more of a process in which you put up relatively a large sum of money compared with gambling, and it can take a long time for your investment to grow. Your money is placed into something, whether it is companies, real estate or a promissory note. You rarely lose all of your money when investing. With gambling one party wins and one party loses. With investing and saving many parties benefit from the transaction. For example, I put money into a saving account at the bank, the bank pays me interest and I make money. The bank loans the money to you for a new car, you get a car. The bank and the dealership make money. If the dealership deposits that money back into the banking system the process starts all over again.

My deposit- $20,000

Bank lends you my-$20,000

You give dealer $20,000 for a car

Dealer deposits same-$20,000

the bank lends the same $20,000 again and the process goes on and on. So my $20,000 deposit has provided $40,000 in loans or money into the financial system so far. This is an over simplified example of the multiplier effect to make a point. The bank has reserve requirements for safety and to meet withdrawals. A different process happens with stocks and bonds but has somewhat of the same effect. When investing, you are a contributor to the capital markets. Gambling may be fun but it is not the same as investing. As far as I can tell in the long run investors come out way ahead.

So which are you a saver, investor, or gambler, two of the three or all three?

Is actively managed funds dead?

In today’s Wall Street Journal there is an article on Bill Miller legendary stock picker for Legg Mason’s Value Trust Fund (Article:Stock Picker's Defeat). According to the article the fund outperformed the Standard & Poor’s 500 Index from 1991 to 2005. Now due to recent losses and big bets on financial stocks the fund has underperformed the S&P 500 for nearly all time periods. So does this mean investors should abandon stock pickers and just invest in index funds?

There are plenty of people who would say yes, but I say not so fast. Index funds are great and should be part of your overall stock portfolio, but that does not mean you should not even consider actively managed funds. It is true that over long periods of time index fund outperform most actively managed funds. I attribute part of that to the fact that there are so many bad actively managed funds. Let me explain what I mean by bad without naming any funds. A bad actively managed fund would be one with high expense ratios and 12b one fees. The higher the fees the less likely the fund manager will be able to outperform the market. You also need to consider were the fund is spending its fees. If it is going to wholesalers and brokers to push the fund, then investors are getting no return on investment for the fee. If the fees are going to pay for research and analyst than that should provide value for fund investors in the form of higher returns. Another thing you want to be careful of is so called actively managed funds that are really index funds. This is where a fund claims to be actively managed and charges a higher fee than an index fund but invests like an index fund.

Proponents of index funds would say why bother with all that and just relax and invest in a low cost index fund. I say if you are willing to do a little research and find some low cost actively managed fund with a fund manager that has a solid track record; it can pay off big time. Just a 1% higher return can be thousands of dollars over a 10 to 15 period. Of course I realize that it works the other way to.

The bottom line is you should not just dismiss a fund because it is actively managed.

What do you think? Are you an index only investor, actively managed or both?