Friday, November 30, 2007

Life insurance on Children

Another example of a bad deal is life insurance on children. In rare cases where a child actually has a substantial income that others depend on, it can make sense to take out life insurance on the child. But, in most cases, insuring a child’s life makes no sense; remember that the insurance offers no protection from death!

I have had insurance agents try to talk me into insuring my children by arguing that I would need to cover funeral expenses, and that buying the insurance would guarantee future insurability. This was all nonsense. I can afford a funeral without the help of insurance, and if I couldn’t, I would choose something less costly than the standard funeral.

The future insurability argument requires more explanation. When you buy term life insurance for, say, 10 years, it comes with or without the guaranteed right to renew the insurance at a particular price after the 10 years are up. If your insurance is renewable, then even if you develop a terminal illness in the tenth year, the insurance company has to let you renew.

When it came to renewal in my case, the guaranteed price was about double what I was able to get after they checked out my health again. So, the renewal price would only have applied if I was at high risk of dying.

To get guaranteed insurability in case your child gets terminally ill later in life, you have to pay for life insurance for decades before it is really needed. This is a high price to pay the questionable benefit of continued insurability.

The final pitch that one insurance agent tried on me was “don’t you love your son?” This one caught me off guard, and I mumbled some sort of reply, but I wish I had said “get out of my house.” Prove you love your children by feeding them well, playing games with them and reading to them, not by buying pointless life insurance.

For more detail on the arguments for and against life insurance for children, see this CNNMoney article and this post on My Dollar Plan.

Overall it pays to figure out whether the insurance you buy is actually eliminating any serious risk to your finances.

Thursday, November 29, 2007

When Can Insurance be a Bad Deal?

Have you ever been to see a doctor who is obviously upset about something that has nothing to do with you? This has happened to me a couple of times where a doctor was complaining about something and I had little choice but to sympathize even though I was much more concerned about my own problems. Otherwise, why would I be seeing a doctor?

One of these times the doctor was having a problem with her extended health coverage for topping up the basic Ontario government medical coverage. Her partners wanted her to go in with them on a plan that cost $400 per month for each doctor, but she saw in the fine print that the plan had a lifetime cap on all benefits of $25,000. She correctly figured out that she would pay $25,000 in premiums in just a little over 5 years.

I asked her if she could afford to pay $25,000 right now if she had some sort of medical problem, and she said yes, which isn’t too surprising for someone with the income of a successful doctor. So, this means that the insurance company wouldn’t be reducing her financial risk very much.

From the discussion of utility of money in my last post, both the doctor and the insurance company qualify as rich for the amounts of money at stake here. It must be that one of the two parties was getting a bad deal, and in this case, it was the doctor.

The doctor would have been better off with a plan that only paid for treatment costs above some amount, like $5000 per year. She could easily afford the first $5000 each year, and the premiums for this type of insurance would be much less than $400 per month. Such a plan would actually protect her against real financial risk instead of only covering an amount she could easily afford anyway.

The various medical insurance plans I have had through employers had similar problems. There were yearly caps on all types of coverage: $500 for physiotherapy, $200 for glasses, etc. These plans were nice to have, but they weren’t really insurance because they didn’t reduce my risk of financial ruin. I just thought of them as a little extra income. If any expensive medical problem came up, I was on my own.

In the next post, we continue with bad insurance deals.

Wednesday, November 28, 2007

The Utility of Money

Some financial decisions, particularly about insurance, must take into account what is called the utility of money to get the right answer. Normally the concept of utility is explained in very mathematical terms, but it doesn’t have to be. Let’s take a fun example straight from a game show.

You’re standing beside Howie Mandel playing a super-sized version of Deal or No Deal. You’re down to just two amounts left, 1 cent and $3,000,000! You get the following offer: take $1,000,000 now, or take a 50/50 chance at the $3,000,000. What should you do?

If you got to do this many times, then on average, taking the chance you would win half the time and get an average return of $1,500,000. This is more than the million dollars you were offered, and so you should take the chance, right? Not so fast.

Most people would correctly figure out that they should just take the million dollars. The reason is that the first million would make a huge difference in their lives, and an additional two million doesn’t have the same impact. This is exactly what we mean by the utility of money: how useful the money is to you. The more you have, the less useful the next dollar is to you.

So, if you are already rich, the first million isn’t as big a deal, and you should probably take a chance on getting the full three million. But, if you aren’t rich, and that first million would completely change your life for the better, then you should just take the million that was offered.

One simple model for the utility of money is to view things in percentage terms. Suppose that everything you have in the world, including future earnings above the amount you need to live, adds up to $250,000. Then a million dollars increases your net worth by 400% to $1.25 million. Adding another two million dollars to this is a 160% increase, which is less than the first 400%. So, the extra benefit of taking a chance in the game isn’t worth the risk. For a rich person who starts with a net worth of $4 million, the first million adds 25% to make $5 million, and the next two million adds 40% more. For this person, the risk is worth it.

All this explains why a car insurance company with deep pockets is willing to take on risk, but individual drivers are better off paying a little extra to reduce risk. In the next post, I’ll show how the utility of money can be used to make decisions about other types of insurance.

Tuesday, November 27, 2007

How Can Insurance be Good for Both Sides?

In my last post, I discussed how insurance is a financial matter and doesn’t do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance?

When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit.

To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver minus administrative costs. But, doesn’t this mean that each driver is making a bad deal and is wasting $400? Not exactly.

If we knew that each driver would claim exactly $600 for accidents during the year, then it would be a bad deal for the drivers. But, the majority of drivers will make no claims, and a small number will make large claims. If two cars are totalled, the claim could be $50,000 or more, and if people are injured, the claim could be $1,000,000 or more. Losses like this for the average person can be devastating financially. It is worth paying a little extra to avoid a small chance of losing everything you have.

This type of reasoning takes the “utility of money” into account, which we’ll discuss further in the next post.

Monday, November 26, 2007

Insurance is not the Same as Protection

A while ago during a temporary gap in my house insurance, some of my friends joked about coming over to my place and “having an accident” to make some big money. Of course they weren’t serious, and we all had a good laugh.

Later on I thought about what had made the joke funny. If you think about it, a fraudster would have better luck getting a big settlement from an insurance company than from me. So, for a short while my house was probably the worst place to target for faking an accident. But my friends and I all got the joke instantly, even though it doesn’t seem to make much sense after some thought. What is going on?

To answer this you need to look at how house insurance is marketed and sold. The best example is one insurance company that shows the image of a giant protective blanket enveloping your house. As long as you don’t think about it too much, you have the feeling that house insurance actually helps prevent accidents. The marketing promotes this subconscious idea. Of course, if you think about it, it’s clear that all the insurance does is give you money if something bad happens (that is covered). This is valuable enough, but accidents are just as likely to happen whether you have insurance or not. So, my friends’ jokes depended on our false sense that insurance somehow prevents bad things from happening.

When making decisions about what insurance to buy, it is important to keep in mind that insurance is essentially a financial matter. You are not buying protection from calamity so much as you are buying financial compensation when accidents happen.

Friday, November 23, 2007

More on Why Stock Prices Rise

In my last post, I discussed how stock price increases over the long term are possible. A reader, Steve, asks “If the value of stocks keeps on rising at a greater rate than inflation, wouldn't that mean that less and less people could buy stocks in the future due to lack of necessary funds?” This is a good question that points to the seeming paradox of the stock market creating value out of nothing.

Let’s start with understanding inflation. Inflation is a measure of the increase in prices of the things we buy, like food, gas, and clothes. At the beginning of the year, a particular basket of items is selected as the typical things that people need, and the price of this basket of items is added up over the course of the year to measure the cost of living. If inflation is 3% one year, then the cost of this basket of items has risen 3%. Another way to view this is that the things we buy have constant value, and the value of money has dropped.

Now, just because inflation is 3% doesn’t mean that we all have 3% more income to spend. Some of us will have more than 3% more income over the course of the year, and some less. The fact that over the long term the stock market rises faster than inflation means that our overall buying power rises faster than inflation. So the question becomes, how is it that we can afford to buy more and better stuff today than we could 50 or 100 years ago?

The answer is that we can produce most items like food and clothing with much less human effort than was possible in the past. Better processes make it possible to produce goods with less effort, which frees people up to do other things and make other goods. This ability to do more with less means that the sum total of all the things we can produce rises over the years, and this is reflected in stock market prices.

So, stock market prices cannot indefinitely run away from the amount of money people have to spend. In fact, over the long term, stock market prices exactly reflect the total value of all the goods and services we produce. Over the short term, the stock market can fluctuate wildly, but over the long term, it can’t get away from the sum total of the value of our efforts.

Thursday, November 22, 2007

What Makes the Stock Market Go Up?

Over the last 100 years, the Dow Jones Industrial Average has gone from about 65 to 13,000, a factor of 200. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last 100 years, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up.

Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win.

What makes stock prices rise over the long term? The short answer is innovation and hard work. The increasing number of people is a factor too, but the main driver of stock market prices is the continuous improvements in our lives due to better ways of doing things, better tools, and better toys. When a company hits the market with a better product at a lower price, the average person’s life improves a little, and this ultimately translates into more overall value in the stock market.

If you still believe in continued innovation in our society, then you should be comfortable with the long-term prospects of stocks as a whole.

See more on this in the next post.

Wednesday, November 21, 2007

More Fund Manager Arguments Against Indexing

This is the third post examining the arguments given by fund managers against leaving their funds and investing in an index.

Argument #4: Over such and such a time period active funds beat index funds.

It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win is in periods where the stock market performs poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks.

However, stocks have been much better long-term performers than cash. The cash component of actively managed funds is actually a factor in their long-term underperformance compared to index funds. For the investor who prefers to buffer bad times in the stock market by holding cash, a solution with lower fees than owning actively managed mutual funds is to own index funds along with some cash.

Argument #5: Some index funds do not have low costs.

This is certainly true. There are fund companies who have tried to jump on the indexing bandwagon and offer index funds, but with high costs to trap the unwary. This is a nice job if you can get it – charging high management fees without having to do much management.

This argument is like saying that medicine is bad because some people sell bad medicine. Investors in index funds just need to pay attention to management expense ratios (MERs) and avoid funds with high expenses.

In summary, I’m not against active stock picking. What I am wary of is paying a high price in the form of management expenses and other fees for the services of an active fund manager.

Tuesday, November 20, 2007

Fund Managers Argue Against Indexing

In the previous post, I started to examine some of the reasons fund managers give against leaving their funds and investing in an index. Here are a couple more.

Argument #2: Our gains are more intelligent.

Some of the arguments given by active stock pickers amount to saying that their returns are somehow better than the returns on an index fund because of some vague attribute like intelligence, precision, or global-mindedness. This raises an important question: would you rather make a 10% return intelligently or 12% mindlessly? I’m not advocating investing without thinking, but what matters ultimately to your financial future are results, not the process.

Argument #3: Some people need their hands held.

The argument here is that some people need advice, and if they try to manage their own money they might get nervous and sell at a bad time. There is a lot of truth to this. Many people do panic and sell near a market bottom when they would have been better off just holding on. However, there are two problems with this argument.

How much should people pay for this “steady hand”? If you have $200,000 invested in mutual funds with an average management expense ratio (MER) of 1.5%, then you are paying $3000 every year to have your hand held. You might consider finding some cheaper way to avoid getting panicky and making poor decisions.

Just because you are invested in actively managed mutual funds does not mean that you automatically have someone there to stop you from making rash decisions. Many people own mutual funds in a self-directed account and are able to trade in an out of funds without the benefit of a friendly expert to calm their nerves. Fund managers may try to hold on to stocks that have dropped in price, but some of the fund’s investors will sell out of the fund forcing the manager to raise cash by selling stocks.

I will continue with more of these arguments used against indexing in the next post.

Monday, November 19, 2007

Fund Managers Running Scared

The investing strategy of indexing is a major threat to the mutual fund industry. (See some of my previous posts for an explanation of indexing, examples, and how to get into an index.) When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in a mutual fund with a Management Expense Ratio (MER) of 1% pays $1000 per year in fees. Up that to the $500,000 you’re hoping to have one day and a 2% MER, and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing.

Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing. After all, nothing is completely good or completely bad. In the rest of this post and some following posts, I will go through the main points in the case against indexing and give my thoughts.

Argument #1: Some index funds aren’t very diversified.

This is true to a point. For example the Vanguard Energy ETF is an exchange-traded fund that tracks an index of energy stocks. This fund is for investors who like energy stocks, not for those looking for diversification. The implication of this criticism is that all index funds lack diversification, and that you need an active portfolio manager to be safe from having all your eggs in one basket. This is simply not true.

S&P 500 index funds invest in 500 of the biggest U.S. companies. If you are concerned owning only large companies, then there is the Vanguard Total Market ETF that holds 1200 of the largest U.S. companies plus a representative sample of the remaining stocks. If you are concerned with owning only U.S. companies, then there are international index funds. Some of your money could go into low cost bond funds as well, or you could buy a bond directly. There is no reason to pay high management fees to get diversification.

In the coming posts, I’ll look at some of the other arguments against indexing.

Friday, November 16, 2007

A Third Investing Pitfall: Overconfidence

So you’ve been investing for a while, know some buzz-words, and now you’re a financial whiz. It’s time to start trading in and out of speculative stocks and stock options to make big money.

Hold it right there! This could be a disaster. You could lose most of your money very quickly. There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own. Following a stock price is not the same as following the company. If you own an individual stock you should have read its financial reports and have an informed opinion about the company’s prospects and whether the current stock price is high or low relative to those prospects. This is not true of the average investor. There is plenty of evidence that even most professional investors can't beat the market. Be wary of overconfidence. You may be better off sticking with the unexciting and low-action index fund strategy.

Overconfidence can creep in slowly. It might begin with thinking that you can predict a period of dropping stock market prices, and so you sell some of your index fund and put it in a bond with the plan to switch back later. It is true that there are some people who do this successfully. Some of these people might actually be skilled rather than just lucky. However, there is strong evidence that most investors do not make good market-timing choices, and the result is higher trading costs and poorer investment performance than if they had just left things alone.

If you can avoid the potential pitfalls of taking control of your investments and buying index funds, you will get better returns than most people who invest in high cost mutual funds with financial advisors.

Thursday, November 15, 2007

Another Investing Pitfall: Losing Your Nerve

Pundits, friends, and acquaintances confidently drone on about interest rates, the balance of trade, commodity prices, and the impending doom in the stock market. History tells us that when stock prices have been falling, the negative predictions increase. There is no reason to believe that these people know any better than anyone else whether stocks will go up or down in the short term. Anyone who could actually predict where the stock market was going in the short term could easily make a fortune fast.

Some successful investors say that one of the best times to buy is when the masses agree that stocks are doomed. This barrage of negative news about the stock market leads to a common problem for nervous investors: selling when prices are low. If the stock market then rallies, these investors lose out. I’m not advocating waiting with your cash until the world seems to be crashing down and then buying in either. This kind of market timing works for few people.

If your investments are keeping you up at night, it could mean that you are listening to too many predictors of doom, or that you have too much of your money in stocks rather than bonds. As long as you don’t need the money for a few years, there is no reason to be nervous about short-term market fluctuations.

For another investing pitfall, see the next post on overconfidence.

Wednesday, November 14, 2007

Investing Pitfall: Quick Decisions

The idea of indexing is to put money that you won’t need soon into one or more low cost index funds for a long time. There are pitfalls with handling your own investments that might cause you to deviate from your strategy. One such pitfall is making quick decisions about your investments.

It is very easy to place stock market trades with a web browser. While connected to your broker’s web site to look at your investments, the trade button is sitting right there on the screen. In a moment of weakness, you might make some trades you later regret. Fortunately, North American markets are only open from 9:30 am to 4:00 pm eastern time, and not too many people are making trades after a beer or two.

When you pay the fees to work with a financial advisor, the advisor usually has to be contacted to make investment changes. One of the good things that most financial advisors do is to talk people out of doing anything rash.

In the coming posts, I will discuss other potential pitfalls of striking out on your own to invest.

Bonus: A Question About Index Funds and ETFs

In a comment a reader asked “I have some index funds, but now I'm wondering about ETFs; when would they be preferable to index funds?”

An Exchange-Traded Fund (ETF) is a fund whose units trade like stocks on the stock market. You can place an order to buy them the same way that you would buy shares of Microsoft. The fact that a fund is exchange-traded does not tell you anything about the type of investments held by the fund. There are index ETFs, actively-managed stock fund ETFs, bond ETFs, and so on.

An index fund is a fund that invests in the stocks that make up a particular index, such as the S&P 500 in the U.S. or the S&P TSX in Canada. Index funds require little management because they just hold the stocks in the index rather than actively buying and selling stocks. Some index funds are ETFs and some are not.

How well an index fund matches its index is more important than whether it is an ETF or not. The main cause of index funds underperforming the index they are trying to match is the Management Expense Ratio (MER). If two funds both mirror the S&P 500, the one with the lower MER is preferable (all else being equal), regardless of whether they are ETFs or not.

Tuesday, November 13, 2007

How Can an Investor Get Into Index Funds?

To those who have opened a self-directed brokerage account and have bought and sold stocks, this might seem like a trivial question. However, this whole business can be quite bewildering to the uninitiated. To start with, you need to choose a broker. I won’t recommend any particular broker, but the following surveys may help.

U.S. Brokers. In a survey by SmartMoney, the top brokers in the premium category were E*Trade, Fidelity, and Charles Schwab. The top brokers in the discount category were TradeKing, Scottrade, and Firstrade.

Canadian Brokers. In a survey by the Globe and Mail, the top Canadian online brokers were Qtrade Investor, E*Trade Canada, TD Waterhouse, and BMO Investorline.

Opening an account. After choosing a broker, follow the instructions on the broker’s web site for opening an account. This process is similar to opening a regular bank account except that the brokerage account can hold stocks, bonds, and mutual funds in addition to cash. There are several types of brokerage accounts, and the main choice is whether or not the account is tax-sheltered for retirement (IRA in the U.S. and RRSP in Canada). For non-retirement accounts, you can choose a cash account or a margin account. The difference here is that margin accounts permit the risky practice of borrowing money to invest.

Buying the index fund units. Once the account is open and full of cash, you need to decide what fraction of your portfolio that you want in index funds, bonds, and possibly other investments. For the index fund portion, choose one or more of the many available index funds. Two that I discussed in my last post were Vanguard Total Stock Market (U.S., ticker VTI) and iShares Canadian Large Cap 60 Index (Canada, ticker XIU). When placing buy or sell orders, the ticker symbol is used to identify what you are trading. I chose these two funds as examples because they are large, popular, and have low fees; I have no financial interest in these fund companies.

For the average person, an advantage of indexing is that there is no need to follow individual stocks. You are betting on the continued success of the companies making up the index, which is an entire country in the case of the two example index funds discussed above.

In the next post, I will discuss some of the potential pitfalls of going it alone that must be avoided to be a successful investor.

Monday, November 12, 2007

Index Fund Examples

Low-cost index funds are a great way to own a very broad range of stocks without paying high fees. Of the many index funds to choose from, two are described in the table below. If some of the table entries don’t mean much to you, don’t worry because I’ll explain them.

Fund NameVanguard Total Stock MarketiShares Canadian Large Cap 60
Stock TickerVTIXIU
Description1200 large U.S. companies60 large Canadian companies

These two funds are called Exchange-Traded Funds (ETFs) meaning that they can be bought and sold like stocks in the stock market. Other mutual funds are bought directly from the mutual fund company or through an intermediary like a financial advisor who deals with the fund company. The stock ticker listed in the table above is the symbol that is used to identify the stock (or ETF) when making a buy or sell order.


An important attribute of these funds is that they have very low Management Expense Ratios (MERs). Calculating the expense ratio over 25 years, which I abbreviate MER25 in the table, gives a better idea of how low the fees are with these funds. A typical mutual fund in the U.S. might have an MER of 1%. After 25 years, this eats up 22% of your money, but the Vanguard Total Stock Market Fund only takes 1.7% of your money after 25 years. A typical Canadian fund is closer to a 2% MER, which corresponds to a 40% MER25, compared to only 4.2% after 25 years with the iShares Canadian Large Cap 60 Index Fund.

If you haven’t heard of these funds before, it might be because your financial advisor makes his money from commissions, and these funds don’t pay any commissions. Beware of funds that are called index funds, but charge high commissions anyway. By definition, index funds don’t require a manager who makes decisions about which stocks to buy, and charging high management expenses cannot be justified.

Low Taxes

There are experts who decide which companies belong in a given index, and these experts make infrequent changes as necessary. A low rate of change means that the fund does not often buy or sell stocks. This is important for investments that are not tax-sheltered in an IRA (U.S.) or an RRSP (Canada). Less change means lower capital gains taxes that investors have to pay each year that they own the fund. However, these index funds are fine for tax-sheltered accounts as well.

In the next post, I will discuss how to go about investing in index funds for those who have not worked without a financial advisor.

Friday, November 9, 2007

Alternative to High Fees: Indexing

I have been talking about the dangers and high costs of investing in typical mutual funds, which is useful to a point, but you may ask “well then, what should I do with my savings?” Of course, this is a question that everyone has to answer for themselves, but one possibility to consider is a strategy called indexing.

An index is a measure of prices among a particular set of stocks. For example, the Dow Jones Industrial Average (DJIA) measures stock prices of 30 of the largest public companies in the U.S. When you hear that “the Dow is up 100 points today,” the commentator is referring to the index of these 30 stocks. Other familiar indexes in the U.S. are the Nasdaq and the S&P 500. In Canada, the main index is the S&P TSX, often abbreviated as the TSX. Each of these indexes is reported as a number that gives us a sense of whether stock prices have gone up or down. If an index goes from 10,000 to 10,100 one day, then stock prices have risen by an average of 1%.

The investment strategy of indexing means owning all the stocks in a particular index. In the case of the S&P 500, this would mean owning shares in each of the 500 large U.S. companies that make up this index. Without some help, the average small investor could not do this. Starting with $50,000, it would be crazy to try to buy an average of $100 worth of 500 different stocks. Fortunately, there are mutual funds available to help with indexing.

The main advantage of indexing is that there are index funds with extremely low Management Expense Ratios (MERs). In the coming posts, I’ll have more to say about indexing including some examples of index funds and how we can go about investing in them.

Thursday, November 8, 2007

Mutual Fund Scandal

This will be the last discussion of the ugly side of mutual funds for a while. After this post I will be talking about an alternative to the standard mutual fund.

I have always liked Will Rogers’ advice about investing:
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
There is a slight temporal problem with this strategy, but it is clear that if you could look into the future, investing would be easy. Another way to look at this quote is that you should wait until a stock goes up and then buy it at the old price. But who would be foolish enough to let you do this?

Late Trading

Back in 2003 there was a big scandal where some mutual funds allowed their preferred clients to do what is called late trading. Generally, mutual funds set the day’s price of their units when the stock market closes (4:00 pm eastern) and any trades (buying or selling of mutual fund units) during the day are executed at this price. If a trade order comes in after 4:00 pm, it is supposed to be delayed until the next day’s price. However, some funds were permitting preferred clients to make trades after 4:00 pm and still get that day’s price.

Now this may not seem like a big deal, but let’s dig a little further. Many companies wait until the stock market closes to make big announcements about events that will affect their stock to give everyone a chance to digest the news before any trading begins again. Each trade of stock has a buyer and a seller, and if the company made a positive announcement during the day, someone who heard the news first could buy some stock at a low price from someone who hadn’t heard the news. Overall, the markets run more smoothly and fairly if everyone has a chance to hear the news before trading begins.

Suppose that a mutual fund holds a lot of stock in a company that makes an announcement of unexpected good news. This will cause the mutual fund’s units to rise in value. A late-trading investor places an order at 4:20 to buy mutual fund units at the 4:00 price, and then sells these units the next day. So, the late trader puts a sum of money into the fund one day and takes out more money the next day with very little risk. The profit he makes comes directly out of the assets held by the mutual fund. All of the other investors share a loss exactly corresponding to the late trader’s profit.

Eliot Spitzer summed things up nicely: “Allowing late trading is like allowing betting on a horse race after the horses have crossed the finish line.”

To the best of my knowledge, this particular problem has been eliminated. But the fact that it happened at all illustrates that at least some mutual funds are clearly not being run for the benefit of the investors, as is required by law.

Wednesday, November 7, 2007

A Mutual Fund Too Successful to Succeed?

Suppose that you have found a mutual fund called XYZ with a good track record of strong returns and an honest manager who has not closed and renamed losing funds and has not incubated funds as discussed in my last post. Hurray!

XYZ fund manages $50 million making it small by mutual fund standards. The fund manager is very skilled at investing in small companies that are about to grow big. So, you switch out of your current mutual fund and switch into XYZ. This is going to be good!

The herd is with you.

It turns out that you weren’t the only person with this idea. Literally thousands of other people pile into XYZ chasing those high returns. Assets under management at XYZ swell to $2 billion, a 40-fold increase.

This is great for the fund’s managers; they will collect 40 times the management fees. But, what are they going to do with all that investor money? XYZ fund was successful at finding a handful of small companies that give big returns. These companies aren’t big enough to buy 40 times as much stock in each one. The fund managers worked hard to find 20 good investments, and suddenly they need at least 100 more investments, fast!

Something has to give.

XYZ’s managers quickly find several more small companies along with some larger ones and invest the whole $2 billion. However, these hasty investments turn out to be nowhere near the quality of their picks back when XYZ was small, and a year later, the returns are very disappointing. XYZ has turned into just another mediocre fund. You got into this fund too late to make any money.

This illustrates the danger of chasing high-returning funds – you get mediocre returns and keep paying fees and possibly loads for switching in and out of funds frequently.

Tuesday, November 6, 2007

Mutual Fund Mantra: Focus on Long-Term Returns

My last post discussed how mutual fund managers close, rename, and merge mutual funds with a history of low returns to hide their poor record. To counter this, investors are advised to choose funds with a long history of good returns. Typical advice is to focus on 10-year returns.

Investors do tend to choose funds with a history of high returns. However, they often focus on just the past 1 or 3 years of returns, rather than looking at longer periods. Not surprisingly, mutual fund managers are aware of this.

Because mutual fund managers are paid a percentage of their fund’s assets each year, they are motivated to attract as many investors as possible to the fund to drive up its total assets under management. This has led to an interesting practice among some mutual fund companies to drive up reported returns.


Some companies start up several mutual funds with small amounts of private money and run them aggressively. After a while, the poor performers are closed and the strong performers are ready to be advertised to the public. This process is called incubation.

The returns on these incubated funds look great initially, and they attract a lot of investor money. Of course, once the managers have to invest a big pot of new money without the benefit of quietly closing losing investments, the returns tend to be just mediocre.

Incubating funds to get high reported returns is a bit like holding a lit match under a thermometer to warm a room. The thermometer will report a nice high temperature, but the room will be just as cold.

If the management company keeps an incubated fund open to the public after the first year or so, the returns during the incubation period can be dramatic enough to unrealistically influence even the fund’s 5 and 10-year returns.

I have no idea how to find out if a particular fund has inflated its reported returns with incubation. This makes it hard to put much faith in any mutual fund tables full of investment returns.

Monday, November 5, 2007

Why did My Mutual Fund Change its Name?

I used to hold mutual funds in an employee savings plan. The first time that one of the funds I held changed its name, I was puzzled. Was I switched to a different fund? Why was this done?

I asked the representative of the firm that managed our savings plan about this. He said I shouldn’t worry because the name change was inconsequential, and this seemed to be true. The number of units I held and their approximate value didn’t change. What was the point of all this?

After comparing my last two statements, I did find one seemingly small difference. The part of my most recent statement with the 1-year and 5-year performance of my fund was blank. The previous statement listed these returns for the old fund name, and the returns weren’t very good compared to other mutual funds.

Erasing History

The purpose of the name change was to erase an unpleasant history and start over. Because of this little trick, mutual fund lists are purged of their poorest performers. There are definitely funds that do badly, but their records go away after a while.

This leads to what is called survivorship bias. If you calculate the average 5-year return of all mutual funds, you will get a percentage that is higher than the real returns seen by investors, because the bad returns are missing from the average. I guess my investing performance would look a lot better too if I could eliminate all my bad investments.

So, if your mutual fund changes its name, odds are that you’ve lost some money. Erasing the history of this loss will help you forget about it, but the money will still be gone.

Friday, November 2, 2007

Common Investment Traps: Borrowing to Invest

The second financial advisor I actually invested money with was a pleasant woman who used to work at my bank branch handling my mortgage and had moved out on her own. I won’t use her real name; let’s call her Gina.

Initially, my wife and I each invested a small sum with Gina in some mutual funds. We were contemplating moving the rest of our investments over from our first financial advisor, but Gina had an idea for something even bigger.

The Pitch

Based on our income and lack of debt, Gina said that we should be borrowing a large sum of money and investing it. Interest rates were low, and when it came to taxes the interest could be deducted from the big gains we were sure to make on our investments. At the end of 5 years, we would have big profits with “no money down”.

Gina worked on us for quite a while with this pitch. Fortunately, the borrowing made us nervous, and we decided not to go for it. This all took place just before the high-tech bubble burst. We would have lost a lot of money and would have been left paying off a large debt for some time.

Although Gina was surely aware that she was recommending something that would make her a lot of money, I think she believed she was helping us. The training Gina received as a financial advisor with her firm told her that borrowing was the right thing for a couple in our situation. I don’t think she knew any better.

Common Tactic

My wife and I are not alone in getting this pitch. Members of my extended family as well as friends have been hit with higher pressure versions of this “borrow big to invest” strategy from financial advisors. This appears to be a common tactic that financial advisors (or the firms who train them) use to increase mutual fund sales.

Borrowing large amounts of money to invest is called using leverage and is an advanced and risky investing strategy. This does not mean that it is always the wrong thing to do, but if you need a financial advisor to show you how to invest, then it is likely that borrowing to invest is not for you.

This is part 3 of 3 parts. Back to part 1.

Thursday, November 1, 2007

Common Investment Traps: Wrap Accounts

A few years after I began investing with a full service brokerage firm, my advisor Mike seemed excited to be offering me the chance to get in on a new type of account. For 1% of my assets each year, a professional money manager would handle my account making investments specifically suited to my needs.

I misunderstood how this would work at first. I thought that this money manager would be picking individual stocks for me and running my account like its own little mutual fund. It turned out that my account would actually hold several mutual funds with the mix of funds shifted around once in a while as I got older.

At the time I was just starting to understand mutual fund management expenses and financial advisor fees, and the rest of the conversation with Mike went something like this:

Me: “So, each year I would be paying the MER on the mutual funds plus another 1% to you guys?”

Mike: “Uh, yeah, but ...” followed by a bunch of confusing reasons why this was a good idea anyway.

Me: “No, thanks.”

What I was offered was more like a fund wrap than what is usually called a wrap account.  Depending on your needs, a wrap account with just one layer of fees can make sense.  But if the package you're offered just adds another layer of fees, beware.

This is part 2 of 3 parts. Next part. Back to part 1.