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Looking for the Best Mutual Funds: Follow the Costs

One of the best determinants in looking for the better performing mutual funds in a specific category is its expense ratio. In a recent article in MorningstarAdvisor.com, Morningstar’s director of mutual fund research Russel Kinnel took a look to see the correlation between fund performance over time and its underlying expense ratio.

Kinnel separated mutual funds into quintiles based on underlying costs to see what percentage of funds from each cost quintile was able to beat the category average. Of domestic stock funds, 47% in the cheapest quintile succeeded in beating the category average over a ten year period, 33% in the next quintile, 30% in the following quintile, 27% in the next and just 19% in the costliest quintile. Or in other words, you are over twice more likely to beat the category average if you are in a low cost fund than in an expensive fund. The success disparity was also similar for other fund categories. For foreign stocks the probability of category out-performance between the low cost funds versus high cost funds was 40% to 18%, for taxable bond funds this was 48% and 7%; 49% and 9% in municipal bonds.

Kinnel then compared the cost quintiles against the cheapest index fund in each particular category. The results clearly favored the low costs funds succeeding as compared to the high cost funds. But what is revealing is how low the odds were for even a cheap fund to beat the most efficient comparable index fund. Of the cheapest quintile in each category, only 29% of domestic stocks, 32% of foreign stock and 19% of the taxable bond funds were able to beat the cheapest index fund.

This just goes to show that it is extremely hard to beat a cost effective fund over time, but it really is another example of why low priced index funds are hard to beat. Think about it. If you were playing five card poker and the dealer allowed you the option to receive an ace in every deal that you received, wouldn’t you take that ace each and every time? With the high probability of out-performing even the most cost effective actively managed funds, the odds of investing success are well in your favor and essentially your ace in the hole when it comes to investing.

Over 10% of Your Nest Egg in Company Stock? Bad Idea

Periodically I interact with individuals who choose to bet the farm and place a majority of their retirement funds in their employer’s stock. The individual usually has a very high conviction towards their company, but the problem is that there are not enough good reasons to justify doing this. Here are my top ten reasons why you should NOT have over 10% of your nest egg wrapped up in employer stock:

10) Increased Life Insurance Need: What if you bought life insurance and didn’t consider that the stock could tank and you suddenly pass away. Isn’t your family at financial risk if this is the case? And if you did consider it, there is the additional cost of paying for a higher amount or for the longer term so you can take this risk.

9) “Even the best companies will drop 50% every 20-30 years” – Warren Buffett. What if this drop happens right in your initial retirement years, selling at lows to cover cash flow needs? This is devastating to a retirement portfolio, increasing the probability of running out of money during your lifetime.

8) Being an Insider may not protect you. I often get responses such as, “I know better since I’m an insider.” There is absolutely no competitive advantage to being an insider. Just ask the former employees at Enron that one.

7) Ever drive without your seat belt on? This and placing a high amount of your retirement funds in the company stock are both great examples of uncompensated risk. It doesn’t take that much time or effort to diversify or put your seat belt on and the consequences of not doing this can be fatal. In the end, dedicating high amounts to your company stock is not investing, it’s speculation; and there is a big difference between the two. And if you come up on top, it was more luck than it was skill.

6.) The 80% Rule: Eighty percent of those who become rich due to a concentrated holding lose it because they fail to diversify.

5.) You can still do awfully well with a small stake: What if you are employed at the next Microsoft? You can still do extremely well with it a small portion of the stock in your overall portfolio.

4.) You not only have investment risk, but employment risk: People fail to take into account that they have financial risk with being employed by the firm as well. If the company does great, not only will the stock benefit, but won’t you benefit in the form of higher compensation, bonuses and commissions? What if the stock tanks? You probably have severely altered your retirement plans, but you may also be out of a job.

3.) Adephia, Enron, Worldcom & Delphi; How sure are you that your company will be different? Bethlehem Steel was once a component of the Dow Jones Industrial Average; it doesn’t exist anymore. Often people will have employer stock of a company that isn’t publicly traded and cite this as a reason that they won’t fall in the same trap. Former partners at the accounting firm Arthur Andersen can tell you that this does not protect you.

2.) What if the stock tanks during your pre-retirement years? If this is the case, it can have a domino effect. You would have to stash more away for retirement or worse, alter your retirement plans altogether. This may affect your college funding plans or force you to sell the vacation home you had. And as mentioned above, it may even cause you to lose your job. Is it worth it?

1.) If you lose it all, your spouse is never going to let you hear the end of this: A little more lighthearted here, but true. And although there is no financial cost here, the emotional grief over time isn’t worth it.

Do you have over 10% of your nest egg in company stock? If you do and if you are not restricted in any way or form to sell it, you better have 10 compelling reasons why you are doing this. I challenge you to try to come up with 10 good reasons to hold; I bet it going to take some time or a stretch to accomplish this.

How All Financial Advice is Not Regulated the Same Q&A

Earlier this week, I discussed a court ruling that affects the way you receive financial advice. It is important to understand the details surrounding this issue and make prudent choices for your financial well being. The following are some basic details on the issue in Q&A format:

--What is the difference between how brokers and fiduciary registered investment advisors are regulated?

The public is protected in two very different ways from any malfeasance by these professionals. Brokers must submit to what is called "compliance," which basically means they have to "comply" with the rules governing their sales activities. Meaning? For instance, that means if they recommend a mutual fund that is owned and operated by their firm, and which pays them an extra commission, they have to make sure that this is disclosed somewhere in the fine print of the many documents they give to the customer. Registered investment advisors are held to a fiduciary standard, which basically means that they have to put the customers' interests ahead of their own or the of the company they work for.

Brokers will tell you that they have to comply with so many rules that their protections are better, but this argument is seriously weakened by all the scandals that brokers have been involved in over the years. Anybody who reads the papers the last few years knows that this "compliance" standard somehow didn't stop the brokerage firms from having their research departments recommend initial public offerings even though they knew they weren't sound, or the brokers from recommending them to customers. It hasn't stopped brokerage firms and insurance companies from misleadingly selling variable annuities and life insurance contracts as retirement plans.

In fact, under this compliance regimen, there have been so many problems with customers that 36,379 different arbitration claims have been filed against brokers and their firms over the five years ending December 31, 2006.

--Why are brokerage firms fighting so hard against having to act as fiduciaries?

The brokerage business model is founded on what we in the profession call "conflicts of interest." The company manages its own in-house mutual funds, which charge above-average fees--AND the company's brokers recommend mutual funds to their customers. (Guess which ones often come highly-recommended?)

The company sells initial public offering shares to the public AND the company's brokers recommend that their customers buy IPO shares. (How many tell their customers that these are often poor investments right out of the gate?)

The company has its own life insurance subsidiary AND the company's brokers recommend that their customers buy life insurance coverage.

The company owns stocks, just like other investors, in its own investment account AND the brokers recommend stocks to their customers. (Is it possible that the brokers are told to recommend stocks that the company wants or needs to dump because the analysts have discovered a problem with the company's earnings?)

If brokerage firms were held to a fiduciary standard, instead of a lot of paperwork requirements, all of these recommendations would be examined in light of whether they really were best for the customer. Every expensive in-house fund recommendation, every IPO recommendation, every piece of advice regarding insurance or stocks would have to primarily benefit the customer, not the broker or the brokerage company's bottom line. Brokers would be forced to recommend the better (often no-load) investments, and the company's in-house products would languish.

AND these companies would be required, by law and by the SEC, to fully-disclose their conflicts of interest in plain language to their customers--who would, of course, have a strong hint that they're being sold something that is less than ideal for their situation. That's why the brokerage firms see this fight as a life or death struggle.

--Is there a solution that would allow the brokerage firms to survive, but still offer adequate protection to the public?

The brokerage firms, in their advertisements and in their sales pitches, are slyly positioning themselves as financial advisory firms, making it seem as if they're giving independent advice. The traditional brokerage role has been to sell investments and insurance to customers who were fully aware that they were involved in a sales process, or get people to buy or sell a stock or bond in return for a commission.

One uncomplicated solution would be to have the brokerage firms publicly acknowledge that their brokers serve in a sales capacity, just like the people who work at car dealerships--and you should no more expect them to sell you a low-cost mutual fund than you would expect a person working at a Ford dealership to tell you that the Toyotas down the street are better cars for the price.

The solution is to make them stop pretending to be something they're not. It really is that simple.

--Is there an easy way for a consumer to know whether a "financial advisor" is held to a fiduciary standard or not?

The easiest thing to do is ask the person if he or she is a registered investment advisor or is registered with the SEC. If this person says that "a division of the company is registered," that means that he or she is probably not held to that standard, and can recommend awful investment products, so long as they fill out the right paperwork.

You could also ask if this person is willing to be held to a fiduciary standard in his or her recommendations, and whether he or she would be willing to put that in writing.

In addition, you could look at the name on the door. If the "financial advisor" works for a large brokerage firm, the way things stand now, that person is not a registered investment advisor.

--One last question: why did the SEC allow brokers to be exempt from the fiduciary rules in the first place?

There's a very long answer to this, but the short answer is that brokerage firms have an exemption from registering as registered investment advisors, in the Investment Advisers Act of 1940, but only if their advice is solely incidental to their brokerage activities (which was selling investments and clearing stock and bond transactions) and only if they were not receiving special compensation for their advice (meaning advisory fees).

With the rise of the discount brokerage companies, the business of handling stock and bond transactions has become much less profitable--essentially a break-even business. It looks like the SEC was trying to give the brokerage firms a little time to evolve their businesses toward more of an advisory model, to make their money on fees rather than on transactions or selling in-house products.

Unfortunately, the brokerage firms decided, instead, to charge fees AND sell in-house products--to try to have the trust of a fiduciary, but still be free to make profitable or conflicted recommendations.

As the Appeals Court said in its ruling, the brokerage firms were never intended to have it both ways:

"A fundamental purpose, common to these statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus achieve a high standard of business ethics in the securities industry…"

Why should investors voluntarily settle for anything less than full disclosure and advice that is designed to benefit them?

A Victory for the Consumer and Fiduciary Advice

For those seeking financial advice that is in your best interest, some good news.

On March 30th, a three-judge panel for the U.S. Court of Appeals for the DC circuit ruled in favor of the Financial Planning Association (FPA) in its lawsuit with the SEC over the so-called "Merrill Lynch Rule." Essentially the rule allowed an exception to brokerage firms allowing them to provide financial planning advice as long as it was “incidental in nature.” Normally if you provide this advice, you would have to be a Registered Investment Advisor. Along with this, you have a fiduciary obligation to act in the best interest of the clients first and you are required to disclose all conflicts of interest. The gaping loophole with this that created the whole problem is that the SEC failed to define what “incidental” meant, enabling the brokerage industry to liberally use this to their advantage. In 2005, the SEC amended some aspects of this rule to provide more clarity and disclosure requirements, but was still porous in many aspects.

What’s going to happen now? The SEC can certainly take this to the Supreme Court, which will remain to be seen. One thing for certain, the lobbying group for the brokerage industry, the Securities Industry Association is going to go to their friends in Congress to try to change the rules in their favor. Unfortunately, it may also create a return to the commission based model, one that created conflicts of interest that the SEC was trying to veer the industry away from. It also entices the brokerage industry to find new loopholes to replace the old ones. But ultimately, this decision heads us in the right direction – acting in the best interest of the client first. Being a registered investment advisor, I don’t think it is such a difficult thing. Maybe someday the brokerage industry will figure it out as well. In a recent survey, most of their representatives would prefer to have a fiduciary obligation.

For those who are skeptical and don’t really think the difference in regulation means very much, I recommend checking out the March issue of SmartMoney. Writer Dyan Machan wrote an expose Many Brokers Offer Financial Advice They Shouldn't Give where she went into several brokerage firms posing herself as a regular consumer to see how close they were following the letter of the law. This expose is significant as it is one of the first articles written by a major personal financial publication on the subject. The more you know how your financial professional is regulated, the better money decisions you can make. The results weren’t that surprising for me, but may be very eye-opening to you.

For more information on this subject, feel free to check out past entries on the subject and other links:

The National Association of Personal Financial Advisors Focus on Fiduciary

Caveat Emptor: Not All Financial Professionals are Regulated the Same

Consumers Still Unaware that All Advice is Not Regulated the Same