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Tuesday, May 22, 2007

Why You Can Rely On Financial Advice from Warren Buffett….But Not From CNBC

Many people I encounter challenge my assertion that indexing is the only rational approach for investing by pointing to “investing geniuses” like Warren Buffett. Ironically Buffett and his mentor Benjamin Graham have recommended index investing as the best strategy for most investors.

Buffett did so once again at the annual meeting of Berkshire Hathaway as reported by cbs marketwatch:

Chairman Warren Buffett reiterated his view that for most small investors who don't have time to research individual companies, cheap index funds are the best way to invest in the stock market.

"The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry," Buffett told CNBC anchor Liz Claman.

"If you buy it over time, you won't buy at the bottom, but you won't buy it all at the top either," the billionaire investor said.

…"If you have 2% a year of your funds being eaten up by fees you're going to have a hard time matching an index fund in my view," Buffett said. "People ought to sit back and relax and keep accumulating over time."

Then there is the supposed controversy over exchange traded funds vs index mutual funds. In fact the debate is not over etfs vs index funds but over investor behavior. It has two main elements.

1. The first part of the “controversy” is over the active trading of mutual funds. Yes one can trade etfs throughout the trading day, but no one requires that an investor do so. The problem is that too many people go ahead and trade the etfs on a short term basis. But that has nothing to do with the etf structure. Individuals trade in and out of individual stocks and actively traded mutual funds as well. The other difference is that you can’t trade mutual funds intraday.

Buffet himself realizes this:

"I have nothing against ETFs, but I really think an index fund that just charges a few basis points for management is pretty hard to beat," Buffett said. "You put it away, you have nobody encouraging you to trade it next week or next month ... your broker isn't going to be on you."

The CBS marketwatch report correctly points out that

Numerous academic studies have shown that individual investors have a bad track record at timing stock-market moves, often because they chase recent performance to their detriment, essentially buying high and selling low.

The father of index mutual funds John Bogle has also criticized etfs as encouraging trading:

"If long-term investing was the paradigm for the classic index fund, trading ETFs can only be described as short-term speculation," he wrote. He also criticized ETFs' movement to narrower market segments and warned that brokerage commissions and taxes can ratchet up investors' overall fees when they trade ETFs a lot.

But most of the press misinterpreted Bogle’s message as well. The fault lies in the investors’ behavior not in the financial instrument:

Bogle said( in a recent wsj piece) that if they are not traded, they can often match regular index funds. "In this format, used in that way, ETFs are solid competitors to their classic forebears,".

2. The second part of the controversy is related to the mass proliferation of etfs targeted at extremely small sectors of the market. For instance there are 3 “water” etfs others devoted to medical equipment, nanotechnology, individual countries, apartment reits etc etc. Imo no one can totally fault the etf companies for trying to make a buck and marketing new financial products.

The real problem is again investor behavior. Etfs are a a great instrument for creating a portfolio diversified among major asset classes (US and International Stocks, fixed income, reits and commodities), But when investors jump in and out of small sectors of the market using etfs they are taking the loaded gun handed to them by the etf industry with its etfs targeted towards speculative sectors of the market and shooting themselves. It is no more likely that individual investors will be successful trading in and out of sectors of the market than they were trading in and out of individual stocks.

But don’t leave it to CNBC reporters to point that out to you. The other day CNBCs Erin Burnett

interviewed a very intelligent advisor who uses etfs in constructing client portfolios, holding long term positions in the etfs that represent the major asset classes. When asked about the “etf controversy” he replied that several years ago enough etfs had been created to cover the major asset classes. To which crack cnbc reporter Burnet replied

“Do you only invest in etfs of asset classes like the S+P 500 or healthcare, do you have to be that broad to make it work “

No, Ms. Burnett, as any book on investing and asset allocation will tell you, healthcare stocks are not an asset class.

Monday, May 21, 2007

About Those Actively Managed Bond Funds

In an earlier post I wrote that using an actively managed bond fund is particularly poor choice for the income allocation in a portfolio since it does not fulfill the function of a bond allocation in a portfolio. This is particularly true of “go anywhere” bond funds which have not limitations on the maturity or type of bond that they own.

The fixed income portion of a portfolio is supposed to reduce the overall risk of a portfolio by adding to the asset mix a bond position that provides fixed interest payments and return of principal, as close to a riskless asset as possible. As many others have pointed out the way to do this is to limit the risk due to interest rate fluctuations by keeping the maturity short and to minimize the risk of default by purchasing only government or very high quality corporate bonds. For most individuals this means a very low cost bond fund or etf indexed to a high quality short term bond index. Two good choices would be the ishares Lehman Brothers 1 -3 treasury bond index etf or the ishares Lehman 1 -3 Government – Credt bond index etf. Vanguard offers mutual funds that target the same indices and an etf that targets the govt credit bond index.

On the other hand the actively managed fund particularly a “go anywhere” fund is simply giving your money to a manager who takes bets on the future course of interest rates and the relative performance of various sectors of the market. In fact he the managers of these funds do the exact opposite of the strategy described in the above paragraph. It wanders all across the fixed income markets. Based on its forecast for the direction of domestic and international interest rates, credit spreads, currencies and other factors they compose a portfolio. There is no guarantee the returns will be stable and no transparency as to the content of the portfolio, it will change based on the judgements of the manager about the bond market.

Do you really want a portfolio including Brazilian government bonds denominated in foreign currency and not currency hedged as part of the portion of your portfolio allocation that is supposed to be stable and very low risk ? I think not.

So when I read this article in the WSJd I wasn’t particularly surprised

Pimco's Gross:
Living Down
A 'Big Mistake'

Wrong Bet on Rates
Lands Big Bond Fund
Near Bottom of Pack

The article is abut PIMCO’s Bill Gross, considered one of the best bond managers in the world and his Pimco Total Return fund one of the largest bond funds in the world and yes a “go anywhere “ fund

The “news” in the article is that even a bond guru like Gross can make bad market calls and when he invests the funds money according to those market expectations the fund returns and the shareholders suf fortunately, Mr. Gross is having to accompany both occasions with a mea culpa.

Last year, Mr. Gross, chief investment officer at Pacific Investment Management Co., became convinced that the U.S. housing market was in dire shape, and that the Federal Reserve would have to cut interest rates as a result. So he stocked up on securities that would gain from a rate cut. And he avoided high-yielding corporate bonds, on the assumption that a slowing economy would hurt riskier debt.

That call, Mr. Gross acknowledges, was a "big mistake."

While he was right about the housing market, he was wrong where it counts -- on interest rates. The Fed hasn't cut rates, and high-yield bonds have been on a hot streak.

As a result, the $104 billion Total Return Fund is trailing far behind the competition for the past year. In the past 12 months, the fund is up 6.22%, compared with an average 6.96% for similar funds. That may not seem like a lot, but in the world of bonds, a few hundredths of a percent make a big difference. Today, the Total Return is trailing roughly three-quarters of its peers.

This is a rare extended spell of bad performance for Mr. Gross. In the past 10 years, Total Return Fund has provided investors with better returns than 97% of the competition. Until last year, it had never once landed in the bottom half of its category for a calendar year, according to fund-tracking firm Morningstar Inc.

Since Mr. Gross took the helm of the fund in May 1987, Total Return has posted an average annual return of 8.29%, compared with 7.25% for the average fund in Morningstar's intermediate-term bond-fund category. During this period, the average bond fund gained 6.55%, and the average stock fund gained 9.98%. Pimco is a unit of Germany's Allianz AG.

Despite the current woes, observers and clients say it would be a mistake to count Mr. Gross out. "Certainly, styles go in and out of favor...but Bill Gross is an example of a portfolio manager who's demonstrated through different market conditions that he's a great investor," says Michael Travaglini, executive director at the $48 billion Massachusetts state pension fund, which has $1.3 billion in the Total Return Fund.

As of last week it got even more interesting Pimco has hired ex Fed Governor Allan Greenspan as a consultant. The WSJ writes:

PIMCO's famed fixed-income manager Bill Gross will be getting a bit of help from former Federal Reserve Chairman Alan Greenspan. PIMCO just announced that it has retained Greenspan as a special consultant. He'll participate in the firm's quarterly cyclical Economic Forums, as well as its annual Secular Forum.

Far from being an academic exercise, these meetings help Gross and the entire investment management staff at PIMCO set interest-rate, sector, credit-quality, and country and currency positioning across their lineup of bond funds, including PIMCO Total Return PTTDX , the nation's largest bond offering. Greenspan's knowledge of the internal workings of the Federal Reserve.

Having Mr. Greenspan on board as an economic consultant fits into Mr. Gross's investment strategy. "A lot of mental energy is expended at Pimco trying to figure out what's going to happen with interest rates," says Paul Herbert, a fund analyst at Morningstar. That differs from some other bond managers, who place more emphasis on picking individual bonds or sectors of the bond market, and try to minimize the importance of getting the precise interest-rate calls correct, Mr. Herbert says.

Will the outome of the Greenspan input be significantly than Gross’ bad call described below ?:

Early last year, Mr. Gross's outlook for the U.S. bond market hinged on housing. "We did our homework," he says. "We sent out scouts into middle America, down to Florida." They did make some correct calls, such as predicting a drop in long-term interest rates last summer.

What Pimco didn't foresee was the impact on the U.S. of the strength in the global economy, led by China and the rest of the Asia. Mr. Gross says they recognized there was inherent strength abroad. But they counted on issues such as the U.S. trade deficit and increasing leverage around the world to have "snapback potential like a rubber band" that would restrain growth and allow the Fed to lower rates. That didn't happen.

Two interesting things emerge from the above paragraphs

  1. The performance of the Pimco fund is particularly dependent on subjective forecasts of the economy and interest rates; something that is inherently fallible. In one description of Pimco’s economic research the WSJ reports that Pimco sent “scouts” that looked at the housing market in Florida and other locations . But their scouts they missed the obvious downturn. Pimco didn’t really need much in the way of” scouts” to learn about the state of the Florida real estate market. A phone call to my sister and her neighbors in south florida would have told them that the air was coming out of the Fla real estate bubble.
  2. Alan Greenspan is a very bright man. But unless he is getting illegal inside information from his former colleagues at the Fed and sneak peaks at government economic data, it is unlikely that his input in Pimco’s decision making will have any impact on their investment returns.

I also wasn’t surprised to find an article entitled

Four of Our Favorite Core Bond Funds

Published on morningstar’s website on virtually the same day as the WSJ article on Pimco’s missteps. All four of the funds we were the type of “go anywhere funds” that are precisedly the wrong kind to hold as a core holding in the bond allocation of a portfolio. And which fund was one of the four: Pimco Total Return In their description of the fund Morningstar writes:

…. PIMCO is more convinced than the others that the Fed will have to lower rates, and relatively soon, to prevent a calamity in the property market. To capitalize from this eventual easing, they're taking on more interest-rate risk than peers are.

In other words, they are taking a big bet on the direction of interest rates.

But is it worth tying the returns on your fixed income allocations to bets based on the analysis of bond guru Gross and his adviser Uncle Alan. Wouldn’t you be better of with a simple short term bond index instrument, either the vanguard fund or ishares etf that index the short term govt/corporate index. Here are the numbers:

1 yr



Vanguard Short term bond index




Pimco Total Return




The returns are basically identical and perhaps more importantly Morningstar’s own data find that the standard deviation of the funds , an often used measure of risk shows the pimco fund 75% riskier than the vanguard fund with a standard deviation of 2.84 vs 1.64.

And I wouldn’t think the odds for the pimco fund outperforming the index fund over the long term are particularly high; and even if it does it will do so by taking significantly more risk. The vanguard index fund has a management fee of .17%. By comparison the pimco fund has a management fee of .90% (some classes of the fund even have front or back end loads)

A .70% management fee differential is huge even though at first glance it may not look like much. Assume the long term return on a bond fund will be in the area of 5 -6% per annum .That means the extra fees on the pimco fund chops off over 10% of the funds returns. Put another way Bond Guru Gross has to do 10% better than the fund on autopilot (index fund) just to stay even. Even with the help of Uncle Alan it won’t be easy at all.

Here are some numbers (from the pimco website) showing the risk the fund is taking to get the higher returns: mortgage back securities make up 42% of the portfolio, government/agency 29%, high yield (junk) corporate 3%, investment grade bonds 2% foreign developed bonds 12% and emerging market bonds 4% . By contrast the Vanguard fund is 95.5% domestic, 93% A rated or better(no junk bonds) and 70%govt /agency.

As is the case in stock investing, bond investors are far better off indexing than tying their fortunes to an actively managed fund. Even one run by the top “bond guru” and the man who was formerly the most powerful man in the world economy.

Monday, May 14, 2007

Old Myths Die Hard

It seems that even when an article on investing in the press gets it partially right, they get some things very wrong. And old myths die hard. An example is a May 12 article in the NYT entitled: In Investing Passive Beats Active.

The article reviews the most recent data which to any reader of this blog is not at all surprising:

THEY say you get what you pay for, but mutual fund investors often get less. Actively managed stock portfolios find it hard to achieve the returns of low-cost index-tracking funds, and that was especially true last year.

In 2003, when the bull market began, 61 percent of actively managed funds specializing in American stocks beat the return of the Standard & Poor’s 500-stock index, according to the research firm Morningstar. The following two years produced similar results, but in 2006 the figure plunged to 32 percent.

Greater volatility and a leveling off in the relative performance of shares of smaller companies, which many managers favor and which showed far more strength early in the bull market, accounts for some of the sharp falloff. But there are enough other factors for some analysts and financial planners to conclude that last year was the rule, not the exception.

They warn that underperformance by active managers may continue in the next market cycle and may be even more pronounced. The inherent disadvantages of active management — mainly higher costs — as well as changes occurring in the financial-services industry almost guarantee it, they say.

Unfortunately, the article goes on to perpetuate one of the major myths pushed by the actively managed mutual fund industry and their apologists (like,for example, those folks at Morningstar). That myth is the one that in certain “corners” of the market there is a better chance for actively managed funds to outperform index funds:

For an actively managed fund to beat an index tracker over the long run, the manager’s decisions have to add more to returns than is eaten away by the extra expense. It is possible, but long-term returns suggest that it is not probable. “In any one-year stretch anything can happen, but generally index funds have fared fairly well,” said Sonya Morris, a fund analyst at Morningstar. “Over the long haul, they’re pretty hard for active managers to beat.”

The ones who are thought to have the best shot focus on comparatively obscure niches like smaller companies and emerging markets, but those areas are less under-researched than they used to be. That makes it harder for managers to find potential big winners that have escaped the notice of their peers.

“It’s possible for markets to become more efficient over time,” Ms. Morris said. She added that “it’s also possible to find talented managers in any corner of the market who are not overburdened by high expense ratios and have a proven ability to beat benchmarks over time.”

Examples she offered include two small-cap funds, Master Select Smaller Companies and Champlain Small Company, and three focusing on emerging economies: American Funds New World, Oppenheimer Developing Markets and T. Rowe Price Emerging Market Stock."

Not surprisingly a quick check of the active funds mentioned in the article by the Morningstar analyst shows emphatically that her assertion is nonsense. In fact the long term indexing strategy employed by DFA funds in which it establishes indexed portfolios based on value and market capitalization works even better in these “corners” of the market than it does in the large cap US or total US market equity sectors.



5 yr

small cap active recommended funds

masters' select small cos




champlain small company


DFA Index Fund

DFA Small Cap




DFA Small Value




emerging markets active recommended funds

t rowe emerging




oppenheimer emerg




amer funds new world




dfa index funds:

dfa emerging mkts index




dfa emerging mkts small index




dfa emerging mkts value index




The article closed with this sage advice from a very well known and oft quoted financial advisor

“We’re big believers in indexing,” he said. “Even really good managers, whom you would think could beat an index, can’t beat it because of factors out of their control. And even when you have a manager that has beaten the index, is he going to continue to beat it?”

But as compelling as the argument for indexing may be, Mr. Evensky accepts that many investors will fail to heed it.

“People are going to continue to look for something that’s going to do a lot better,” he said. “But if it ain’t out there, it ain’t out there.”

Excellent advice, but we do find it a little surprising coming from financial adviser Harold Evensky who we cited a few days ago as using actively managed bond funds for the fixed income portion of his clients portfolios.

Wednesday, May 9, 2007

How Not to React to Market Volatility

No doubt that emerging markets are a volatile asset class. In our opinion it belongs in most portfolios’ equity allocation, but in a percentage appropriate to the investors’ risk tolerance. Unfortunately, it seems most investors check short term performance. Thus the following investment flows into emerging market mutual funds:

2005 $20 bln in inflows (13.5% of all mutual fund inflows)

January 2007 $2.6 bln inflows

February 2007 $ .8 Bln in inflows

March 2007 $2.3 bln in outflows

A glance at the chart at the top of the page of the emerging market index exchange traded fund (etf) for the past 2 years shows clearly that investors were more performance chasers than asset allocators, bailing out after the 20% drop in February and missing out as the market fully recovered and turned positive in the following 3 months. Year to date emerging markets are outperforming the US market. Note the extremely high volume (lower scale) coinciding with each major selloff in the emerging market etf (no doubt sparked by panic selling)

Tuesday, May 8, 2007

A “Top” Adviser Gets It Wrong Big Time On Bond Funds

The WSJ’s monthly section on investing in funds ran a generally informative piece on the new bond exchange trading funds. It pointed out that the new bond etfs aren’t necessarily better than existing bond index funds like those of Vanguard in terms of fees or ability to match an index. All of this is correct.

But then the article closes with this whopper from a well known financial planner

Investors also should weigh bond ETFs against actively managed mutual funds. Some financial advisers believe that actively managed funds are a better way to access the bond market, where many securities are thinly traded and pricing can be murky. While all of the bond ETFs now on the market track indexes, both Vanguard and Bear Stearns are hoping to launch actively managed fixed-income ETFs, according to regulatory filings.

Harold Evensky, a financial planner at Evensky & Katz in Coral Gables, Fla., uses active managers for the bond portion of client portfolios, partly because of the market's inefficiency and partly because bond ETFs don't cover municipal bonds, a key investment for many tax-sensitive investors.

Interestingly the WSJ and its sister publication, Smart Money Magazine have pointed out two reasons why the above is not at all the case:

1. The purpose in owning a bonds in a portfolio is to get a portfolio with a clearly defined maturity and risk level, otherwise one is really not getting exposure to the asset class characteristics of bonds. Furthermore just as no one can predict the future course of the stock market, no one can predict the future course for the bond market

An actively managed bond fund fails because you are depending on an active manager to “beat “ the bond market either by trading among maturities (predicting the course of interest rates) or among issuers (predicting the credit prospects for the issuer). For instance one of the most acclaimed bond fund managers Bill Gross of Pimco can move between foreign bonds currency hedged and unhedged,and domestic bonds across maturities and issuers in the Pimco Total Return Bond Fund. The investor in this fund is not gaining exposure to the bond asset class in any real sense, he is giving money to Bill Gross to trade as he sees fit in anything in the category of fixed income investments

As the WSJ’s sister publication Smart Money notes on its website:

Bond funds can be even trickier than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key fixed characteristics of individual bonds.

In addition, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager. In this way a bond fund is closer in character to equities than it is to individual bonds.

2. The other big reason to hold a bond index fund rather than an actively managed fund is that with the expected returns from the bond portion of a portfolio lower than the equity portion, actively managed fees in bond funds cut into an even higher portion of returns. As the WSJ’s excellent columnist wrote:

Why have bond-index funds fared so well? Partly, it's the expense advantage. While high-quality taxable-bond funds typically charge around 1% of assets each year, Vanguard's four bond-index funds have annual expenses of 0.2% or less, equal to 20 cents for every $100 invested.

"It's a durable advantage," says Ken Volpert, head of Vanguard's bond-indexing team. "It's there year after year after year."

That means the typical manager trying to outperform a bond-index fund is starting each year at a 0.8 percentage-point performance disadvantage. It's tough to make up that deficit, especially with bond yields so low.

"Bonds are where indexing really works," says William Bernstein, an investment adviser in North Bend, Ore. "Just as location, location and location are the most important things with real estate, so expense, expense and expense are the most important things with a bond fund."

A possible exception to the above might be rock bottom fee bond funds that are strictly limited as to issuer and maturity. One example would be the Vanguard Short Term Investment Grade Bond Fund which has strict parameters in maturity and credit quality and has a management fee of .21%. There are several others, but generally bond index funds or index etfs are the best choice for a portfolio, just as is the case for equities.