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| | Mutual Funds
Why buy and hold is baloney
The mutual fund industry has long preached a passive strategy that leads investors to sit on lousy funds. Here's a new approach that lets you dump losers.
By Timothy Middleton
If Willie Sutton were alive today, he wouldnt be robbing banks. Hed be robbing mutual funds. Thats where the real money is -- $7 trillion of it.
So much money, it seems, that there are those who have been unable to resist adopting his ways. But we mutual-fund shareholders have been unwitting accomplices, leaving our trillions lying around for the taking. If one clear lesson has so far emerged from the market-timing debacle, it's that buy and hold is baloney.
Buy and hold is the industrys religion, and Im becoming an agnostic. To take but one example, investors in Janus Mercury (JAMRX), should've sold it long before hedge fund Canary Partners allegedly market-timed it in 2002 and 2003. (Market-timing involves fast trading in a fund's shares, which hurts long-term shareholders.) Mercury was already on the way to joining its sister ship, the Titanic, at the ocean's bottom.
Just as professional investors admonish themselves not to fall in love with their stocks, you and I shouldn't fall in love with our funds. When one of them stops paying its way, it should be sold quick as a sneeze.
Why bother with funds?
But selling a fund is clumsy and possibly getting clumsier. One of the proposed cures for the scandal is to impose redemption fees on nearly all funds, putting even more pressure on shareholders to stay put. The proposal would make owning funds one notch less appealing than it has been, and a lot of notches are cutting into this belt, from rising fees to rising corruption.
The scandal has focused my attention on why I even bother to own mutual funds. In recent years, some serious competition to them has arisen in the form of exchange-traded funds. As I re-examine my own investments, this competition is looking increasingly attractive.
Im not alone. Lets begin to look outside the box, says Ken Winans, a money manager in Novato, Calif., who has been transitioning his investors into alternative portfolios. The fund structure, and the way the funds have conducted themselves, has failed.
No less a titan of buy-and-hold investing than Vanguard Group is launching a series of exchange-traded versions of its funds. They feature nearly all of the advantages of mutual funds plus those of common stocks: They can be margined, stop-loss protected, sold short and traded throughout the day.
While the fund industry belatedly turns to cleaning out its Augean stables, lets you and I turn to rethinking what investments we want to own, and in what form, be it fund or something else.
Fund alternatives
The woeful story of Janus Mercury aptly illustrates our alternatives as individual investors. Janus presents the fund as a buy-and-hold growth fund -- seeking the long-term growth of capital, as it says in its prospectus -- and, as of the end of September, it still clung to more than $5 billion of assets.
In fact, the fund is a barely disguised technology-sector portfolio. It badly trailed the market in six of the last eight full years, half the time by double digits. The two winning years were 1998 and 1999, coinciding with the Internet bubble. In those two years its assets increased almost sevenfold, to more than $13 billion.
Capitalizing on the Internet frenzy was hardly an investing sin: Mercury leaped 96.2% in 1999. But the Nasdaq 100 Index Tracking Stock (QQQ, news, msgs) behaved almost identically after it was introduced in March of that year, spurting 82.5% in slightly under 10 months.
When the bubble burst, the Cubes, as they're called, collapsed just as spectacularly as Mercury, but with this difference: You could have stop-loss protected yourself with the exchange-traded fund, but not the mutual fund. If you had kept a stop in place 20% below the Cubes price, which peaked at more than $117 in the middle of March 2000, you would've been stopped out less than one month later at a price around $94.
The bubble would have made you rich, and the stop-loss order would've kept you rich. The buy-and-hold fund investor, on the other hand, lost almost 23% in Mercury in 2000, nearly 30% in 2001 and 29% more in 2002. This brings us to the following lessons on investing in mutual funds:- Lesson No. 1: Sector funds aren't good long-term investments. Owning them in the fund format is a good idea only when it cant be avoided, such as inside a 401(k) plan with limited options. Everybody else should look for an exchange-traded version, such as Cubes for tech and iShares or the so-called Spiders for everything else.
- Lesson No. 2: Theres a big difference between long-term core investments and short-term trading opportunities such as tech stocks or funds. But heres the trick: There's core, and then there's core.
Building a personal portfolio
Let me explain. Leuthold Core Investment Fund (LCORX) always owns stocks and bonds, but the relative weighting of these two categories can swing dramatically, from a high in each instance of 70% of the portfolio to a low of 30%.
This is a so-called asset-allocation fund, and building a personal portfolio is an exercise in asset allocation. That's assuming you consider yourself a moderate investor, as opposed to a conservative or bold investor. If so, you'll always want to own stocks and bonds.
But there are times, like now, when you dont want a lot of bond exposure, because of the threat of rising interest rates. You didnt want to own a lot of stocks in the bear market. So the core of this type of investors portfolio -- the portion that's virtually never traded -- is pretty small. Id say about 40% of total assets, three-quarters of them in stocks and one-quarter in bonds.
Seen the other way, this means the portfolio will never have equity exposure of less than 30% of total assets, and bond exposure less than 10%. Everything else can be adjusted, including, obviously, adding more stocks and bonds.
Core and flexible investments
You can easily invest this core portion in mutual funds: Vanguard Total Stock Market Index (VTSMX) and Vanguard Total Bond Market Index (VBMFX) are ideal candidates. You could also employ Vanguard Balanced Index (VBINX), except that its weighting is 60/40 stocks and bonds, and you want 75/25.
Mutual funds enjoy one advantage over their rivals, which is automatic dividend reinvestment, and capturing that in the core isn't unduly expensive, in terms of surrendering your option to trade; you dont plan to exercise it, anyway.
In your flexible portfolio -- which is three-fifths of your investment assets -- the trade option is crucial. Tech stocks are notoriously volatile, and if you can avoid their valleys, youll have more capital to exploit their peaks. Cubes were designed to allow you to do that.
If you had bought them in September 2002, as the market was bottoming, youd be up about 75% today, a tidy sum. You could put a 20% stop under them at todays price and guarantee yourself a 40% gain on your original investment, risk-free. Mutual funds dont come with guarantees.
There are more than 100 exchange-traded funds, investing in domestic and foreign stocks (including sectors) and in domestic bonds. In coming columns, I'll delve into them in detail. There also are many hundreds more closed-end funds, another variety of professionally managed portfolio you dont have to marry.
End of the fund industry?
Ive been asked if the current funds scandal spells the industry's doom. I doesn't. Some 95 million Americans own them: Individual inertia and an army of brokers with incentives to flog them conspire in funds favor.
But thoughtful investors are already asking how they can protect themselves from future fund scandals. The answer is to own as few funds as possible, each selected with an eye on its competition, which includes other investment options.
The one fund category most likely to find itself forever outside my portfolio is the hot one. Something similar to it exists as an index exchange-traded fund, which has lower expenses, no redemption fees, no superstar manager poised to quit and run a hedge fund -- and no network of salespeople to support, and to possibly engineer the next scandal.
At the time of publication, Timothy Middleton owned or controlled shares in the following securities mentioned in this article: Vanguard Total Stock Market Index Fund.
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