Archive for January, 2014

Should you keep your Mutual Funds?

If you own a lot of mutual funds this next bit of news isn’t going to exactly make your day. The fact is, the vast majority of them underperform the average return of the stock market. The simple fact is that it’s probably a good chance that you own one of these underperforming mutual funds. In fact, most Americans do because most 401(k) plans will only let you invest in mutual funds.

What this means is that it’s up to you to decide whether or not you’re going to just accept the substandard returns that your mutual funds are giving you or whether you’re going to  become enlightened about the rights that you have to get returns that match the market.

The question now that you have to ask yourself is whether you should stay invested in mutual funds or look for greener pastures. If you recall the binder that you were given when you signed up for the 401(k) plan at your company or the quarterly mailings that have been coming to you since you opened your IRA, the first thing you’re going to want to do is grab those and start going through them for critical information that they hold.

Be prepared for some of the most confusing, boring and dry language you’ve ever encountered. Somewhere in that confusing mess you’ll find wording that describes not only your fund’s investment policy’s but also their  objectives, their risks and, most importantly, their costs. You’ll also find historical performance data and all sorts of legal mumbo-jumbo.

You can also go online to find all of the information that you need about your various mutual funds, along with all sorts of data and analysis on the thousands of them that happen to be out there. Once you do there are 5 specific things that you need to start looking for in those reports.

  1. Management changes. One of the most important things about a mutual fund is that it has a long-term and stable manager. In some cases you’ll find changes but, no matter who’s in charge, it’s always important to know exactly who’s handling your money.
  2. Fee changes. Another key factor, you should be aware that mutual funds are NOT required to keep their fees at the same level that they originally started at. One of your jobs as a fund shareholder is to make sure that the fees for your mutual funds don’t keep increasing and, if they do, consider dumping them.
  3. Style changes. If the mutual fund that you have in your portfolio is known for purchasing slow growth, high dividend blue-chip stocks and they suddenly start buying stocks from a nameless startup that just entered the market, you definitely will want to know about it and keep an eye on your fund’s holdings.  If you purchased it because it was assigned one label and it suddenly starts changing style to another, you need to know about it  and make changes when necessary.
  4. Turnover changes. A mutual fund with lower than average turnover rates is much more preferable to one that turns over on a regular basis. Rates of 50% or lower are best. Index fund turnover can be as low as 5% for example.
  5. Performance changes. While this one is a little bit more difficult the fact is that underperformance, even on a relatively frequent basis, is not unusual or particularly unexpected even with a good fund. The reason we mention this is that just because your funds might have had a bad quarter or even a bad stretch of a year or two, you might not particularly want to dump them. Track performance of course and, if you see poor returns over a five-year period, it might be time to start looking in another direction.

Noteworthy changes in any of these areas may mean it is time to reassess the mutual funds that you hold in your portfolio. It doesn’t necessarily mean that you have to automatically sell them because, in some cases, these changes might be for the better. In other cases they might not be positive but they’ll be better than the ill effects that selling will cause.

If you’re truly keen on keeping track of your mutual funds and increasing your returns, the 5 areas above are definitely what you should be looking at regularly. Reviewing them quarterly is a great idea so that it becomes as automatic as changing the oil in your car or giving the house a thorough cleaning.

While many investors are quick to praise the cost efficiency of ETF’s as well as seeking out the cheapest options, what many focus on is simply the expense ratio. The problem with this is that the expense ratio is only 1 of number of vital elements that should be taken into account when investing in ETF’s.

If a person is going to compute a complete and accurate cost of investing in ETF’s, they are going to need to consider not only additional explicit costs and fees that could be incurred from trading but also commissions, effective interest rates and bid-ask spreads. If that’s you, you’re in luck as this blog is going to look at these additional costs and fees so that you know exactly what you’re getting into. Enjoy.

It’s important to note that the effective percentage that  commissions represent can vary significantly from one ETF to another. The fact is, trading fees are measured in absolute dollar terms (generally).  For an investor who’s putting significant dollar amounts into ETF’s and has very  little turnover, commissions will probably impact their bottom line minimally. Investors using a more active approach however will find that commission costs can add up quite quickly. For example, an investor with a $200,000 portfolio who pays $10 to execute every trade and makes 2 trades a month (2 buy and 2 sell orders) the annual commission cost can exceed $400, something that adds approximately 25 basis points to their total expenses.

One of the best ways to lower commission expenses is to take advantage of free commissions. The best  news for ETF investors is that they have several options for avoiding commissions altogether. For example, Schwab and Vanguard allow you to trade ETF’s for free if you’re a brokerage client. IShares  has recently partnered with Fidelity and they are now offering free ETF trading on 25 of their most popular iShare  ETF’s.

Some ETF’s have effective interest rates that are more advanced and thus need to be taken into account when figuring out overall costs. Leveraged ETF’s and futures-based commodity products, those that utilize derivatives to establish exposure, in general maintain cash balances that can earn interest. What that means is that  if you have invested cash that’s being held by leveraged and commodity ETF’s, it’s going to have a higher yield, something that will offset the expense ratio charged by the fund and lower the ETF’s overall cost.  This of course can have a material impact on the bottom line return of an ETF, something that companies that issue leveraged ETF’s pride themselves on.

One element that isn’t as explicit as expense ratios and commission fees but needs to be taken into the total cost picture of an ETF because it can add up so quickly is the bid-ask spread. Without going into mind numbing detail, the bid-ask spread component of the ETF expense equation, depending on the period of time that a person holds on to their investment, could actually dwarf their expense ratio component. Thus the bid-ask spread is definitely something that should be taken into account when investing in ETF’s.

If you have questions about investing in ETF’s or any other type of acid class, or you just have questions about personal finances in general, drop us a note or send us an email and we’ll get back to you with advice and answers.

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