Know When to Hold ’Em

Know When to Fold ’Em

January 18, 2010

“Don’t worry about your mutual funds going down, just wait and they’ll come back up,� is the standard line that preserves the status quo for the brokerage industry. However, in the decade just ended, people who bought and held mutual funds invested in the broad market lost 24%. I wonder what will happen to the brokers’ mantra that tells us, essentially, to quit thinking about our retirement accounts.

Becoming Numb
Until the financial crisis of 2008, I didn’t understand how thoroughly the average investor had accepted the buy-and-hold mantra. Last year I was surprised to hear intelligent people I know say they had simply stopped opening their brokerage and retirement statements. Since they didn’t really understand how the whole investment thing works, they decided just to do what their brokers said to do—nothing. They were simply leaving it to them—the financial people who understand financial instruments.

It’s a good situation—for the mutual fund managers and the brokers that sell them. Profits for all (except the investors) are assured by this collaboration. The public and the administrators of the retirement plans are the pawns of a system set up back in the 70s. It wasn’t supposed to be that way.

The mutual fund industry was created by the Investment Company Act of 1940. The idea was to give the average Joe—busy making a living—access to the stock market by buying shares of a pre-packaged product (called a mutual fund) made up of lots of different companies. The first mutual funds were based on the Standard & Poor’s 500 Index, comprised of the 500 largest U.S. companies.

Where financial instruments were concerned, the knowledge gap between financial professionals and laypeople was large. As today, financial professionals took advantage of that gap. They always made their money. If the stock market had a good year, the mutual fund investor made a little too.

Along Comes John
In 1974, John Bogle started the Vanguard Group of mutual funds. He observed that most mutual funds did not perform better than the S&P 500 Index. Trading fees, or “loads,� for funds were high—as much as 8% of the amount invested. Combined with the annual “maintenance� fees, the cost of the average mutual fund was well over 5% a year.

Bogle introduced the first “no-load funds� to the market. Having graduated magna cum laude in economics from Princeton University in 1947, he was a genius in his time. In 1974, he founded The Vanguard Group of mutual funds, marking a revolutionary approach to investing in the stock market. His intention was to advocate for the individual investor—the common person trying to get a toe up by investing for the future. The Vanguard Funds were based on the premise of low annual fees, investing in the broad stock market (S&P 500) and staying invested over time to avoid trading fees.

Bogle’s principle of buying and holding index funds was a breakthrough on behalf of the individual investor. When Congress passed the Employees’ Retirement Income Securities Act (ERISA) that same year (1974), mutual funds were the obvious investment choice for employer-sponsored retirement plans such as the 401(k) or 403(b).
What A Great Slogan!

“Buy-and-hold� sounded good to the marketing geniuses who borrowed Bogle’s premise for investing in low-cost index funds and applied the mantra to the entire mutual fund industry—omitting the low-cost aspect. Brokers were trained to repeat the buy-and-hold thesis as The Way to invest in the stock market through mutual funds. “We’re not traders, we’re investors for the long term,� became the refrain of the brokers (“Registered Representatives�) even before they began to call themselves “financial advisers.�

But This Is Now …
A lot has changed since 1974. Discount brokerage houses charge as little as $4 to buy or sell a stock. The average charge is $12. So, mutual funds—though often free to trade at a discount house—are not the escape they once were from the high fees charged by the big brokerage houses.

More importantly, we professional managers now have something much more efficient and less costly than mutual funds. There are big advantages besides the diversification they provide. Anything—any group of investments offered by a mutual fund—is offered by an exchange-traded fund (ETF).

Exchange traded funds allow us to set a price limit—what we’re willing to pay to buy something, or how low we’ll sell it. When our price target is reached, the order will execute. By contrast, mutual fund orders are submitted in dollars only—the 4 p.m. price per share is what you pay. Using ETFs, we managers can set “stop loss� orders to limit the amount of loss we’re willing to take—a huge advantage in controlling risk.

We can trade ETFs any minute of the day the market is open, whereas mutual funds trade once a day at the market close. Many of us licensed money managers are advocating for exchange traded funds to be offered in 401(k) and 403(b) plans. The SEC and the Senate Banking Committee are looking at it. But it’s an uphill battle, as the brokerage industry is not about to willingly give up its control of the retirement plan market using mutual funds.

Financial Crisis Strikes
Back to the past, on September 29, 2008, Federal Reserve Chairman Henry Paulson and Treasury Secretary Ben Bernanke met in special session to tell Congress the U.S. banking and credit systems were on the verge of collapse. Millions of individual investors reacted by selling their stocks and stock mutual funds over the following months. The fear peaked in March of 2009, which brought about the market bottom, or what is called “capitulation.�

Since then, I’ve observed there are two main camps of investors. Millions of savvy individuals and money managers took refuge in federally guaranteed Treasury bonds and bills, averaging 2% to 3.5 % and keeping their money safe. Many other individual investors pulled out of their stocks or stock mutual funds and have been sitting in money market funds now paying nothing.

Staying Numb
In the second camp are the individuals who have a broker whom they like and trust and who tells them not to worry, the market always comes back. Too often, these people are retired people who have been invested in stock mutual funds for years and don’t realize they need to cut back their investments in the stock market, boost their investments in the bond market and buy a fixed annuity that guarantees an income stream for life.

They think their broker (currently called a “financial adviser�) is going to look after them. While brokers are generally smart and personable people, the bulk of their customers don’t understand they are licensed as sales representatives. They sell investments: stocks, bonds and mutual funds based on either market. Mutual funds, by their nature, are buy-and-hold investments. To the broker, they are sell and walk away investments. As long as the investment was suitable back when he sold it, the broker has no further obligation to the buyer. The brokerage house he works for is always on his back for new sales, and his job is to make sales for the house.

The mutual fund industry spends billions of their trillions to buy ads promoting “buy-and-hold� investing. Ditto the brokerage industry that sells the funds. To say there are deep pockets involved is to say the least. It’s no accident that the average person, no matter how well-educated, believes the best thing to do is do nothing, just sit tight in your mutual funds.

Changes
The truth is, most people over the age of 65 should pare down their investments in the stock market and stock-based mutual funds. They need to have a good stash of individual bonds, Treasuries, corporate debt and high yield. But because of the structure of the brokerage/mutual fund collaboration, no one will be calling you to suggest a change. That is not their job.

This is not to suggest there’s something wrong with brokers. They are doing their job, with the rules in place now. However, a clear majority of us fiduciary money managers believe they are using outdated financial instruments—mutual funds—that benefit the brokers more than their clients.

Not To Worry
Last year, millions of scared people called their brokers to tell them to sell their stocks and stock funds as they heard about the plunge in the stock market. More affluent retired people already had a good portion of their money invested in individual bonds, and bought more. But brokers serving clients of average means had to take a different tack. If they couldn’t talk their customers into sitting tight and waiting it out, they talked them into bond funds.
What’s Wrong With Bond Funds?

Tens of millions of mutual fund holders are now sitting in bond funds. With interest rates near zero, it’s been a relatively safe investment. However, as the economy recovers and interest rates rise, the value of those bond funds will fall. So you’ll need to get out before interest rates rise. Even if you don’t believe the economy will recover, you should get out of bond funds. Buy individual bonds, preferably corporate, so you know what interest rate you’ll receive along the way and when you’ll get paid back in full, at the maturity date.

Jill Wasden heads a registered investment advisor firm and teaches in the business academy of UNM-Taos. Her email address is Wasden@taosnet.com.