Tag: Funds

Judging Performance

Never forget these two axioms:

Money frees us, but its pursuit enslaves us.

It’s not how much you have at the end; it’s how much you could have made.

 

JUDGING PERFORMANCE

 

Unfortunately (at least for some), there is a lot of math and statistics entailed in investing. Lots of metrics, numbers, stats, and the like are thrown around on the news, by financial advisors, in the papers and websites, etc, etc,

It’s rare that I speak in absolutes (which often drives my family and friends, but extremely rarely patients and their families), but in this one case, I will speak in definitive absolutes.

THE SINGLE MOST IMPORTANT NUMBER IN ALL OF INVESTING IS UNDERSTANDING HOW WELL YOUR INVESTMENT IS DOING—IE, ITS PERFORMANCE.

Nothing will impact what you do as much as this one number. It will guide you in what to do, when to do it, and whether to change course or not.

A few basic rules of the road when judging performance:

  1. Always calculate your returns net of fees (I warned you that you’d hear this phrase again) and your total amount after taxes are paid out of that amount
  2. Always use your benchmarks for comparisons rather than just looking at your percent return in a vacuum and think “Hey, I’m pretty awesome at this investing thing. Move over, Warren Buffett!” when in reality you’re worse off than the average investor. You need to know your guideposts for understanding where you stand each quarter or year especially if paying fees for what should be a higher return. (You’re paying for something, so shouldn’t you be getting what you pay for? Shouldn’t you know if you’re truly getting a higher return and not just being reassured or reassuring yourself with what you want to be true rather than what is true?)
  3. You need to look at your monthly, quarterly, or, at a minimum, annual statements. No matter how “remote control” or “passive portfolio” you’re in (or, much worse, think you’re in), you need to see what is going on there. Falling asleep at the wheel of your portfolio for a decade is just a terrible idea. You literally cannot afford to do that. Literally, And, I mean that. It’s literally not like all the people who use “literally” as a crutch word and actually mean figuratively.

{RLE #8: An extremely hard working and dedicated doctor I know only opens his statements and sees what they were in value last month and now this month with nothing else even remotely looked at. It was only after I spoke with him that he even realized that he may actually be losing money many months, but it looked like he was making money since the loss for that particular month may be less than he was contributing to his investment account. You have $100,000 in your investment account and are putting in $5,000 a month. Then, the next month, when you have $103,000, you’ve not actually gained $3,000. I don’t want alarm you. But I do have bad news for you. You’ve lost $2,0000. I couldn’t believe a guy as smart as him didn’t understand that basic truth of investing and how to even read your statements. In his entire professional career, he wouldn’t even think of being this careless or superficial in understanding a test, imaging, lab, or pathology report when it came to his patients. Yet, here he was, without even a basic grasp of his entire investment account…twenty years after he began investing for his retirement. If he was like this, how many others are there? And they don’t even know it? That is the really alarming part of this whole RLE.}

BENCHMARKS

OK, let’s get started.

First thing is to know what you should be comparing your investment to.

Stocks=S&P 500. It’s that simple…for once.

Mutual Funds and ETF’s are more complicated. They each have their own benchmark which is shown on each statement. If you search online for the performance of the fund in question, you will also see the accompanying benchmark fund to compare against. There is something known as the Lipper awards where a financial analytical company (Thomson Reuters Lipper) scours tens of thousands of funds over dozens of countries to grade each one (1 to 5 with the higher the number being better), They even award the best funds in each sector or category (eg, utilities, foreign, financials, etc.) at the end of each year based on expense and returns among other things, The Lipper grade for funds’ performance over 3, 5, and 10 years is assigned by the following metrics: Total Return, Consistent Return, Capital Preservation, Tax Efficiency (For US Funds Only), and Expense . You can use these Lipper grades to give you an idea how your fund compares to its peers.

But recall, the comparison is apples to oranges until you subtract your fees (ie, the fund’s expense ratio—remember that?) out of your fund’s performance numbers. Just simply take the percent return your fund did over the year and subtract out the expense ratio from it.

Bonds  are either the simplest investment to track for performance or the most complex.

Dr. Unwise: Huh?

Dr. Scared: This is it! This is it!! This is how they screw you!!!

PWT: No. Exactly no. It’s precisely how no one screws anyone else.

A bond has a coupon (remember?) which tells you how much you’ll get in interest payments each year until it “matures” (ie, it expires and your original value or par value is returned to). There is no true benchmark to compare against for bonds, but you can compare one bond’s performance to that of another (YTM or yield to maturity, remember?). The thing to keep in mind is that inflation (3.22% on average, right?) is eating away at your returns, especially on bond returns since they are generally speaking such low returns.

[My opinion here only: Regardless of how conservative of an investor you are, low yield (ie, low interest) bonds are not a good way to invest until you near retirement and just want to maintain what you’ve already earned. You won’t build wealth with low yield bonds and could actually lose money in a relative sense even as you gain in numerical value if your yield is less than what inflation is during the entire term of your bond. Not a great investment. Not swell. Not. At. All.]  

Let’s go through some examples.

STOCKS

You have  $10,000 of stock in Company X and check on it every so often when you hear about it on the news. It does well over the year and like a dutiful investor armed with the learned knowledge from PWT, you check on how it did versus the S&P 500.

2017 returns for Company X= 15.8% (Great job, major player!)

2017 returns for S&P 500=21.83% (Uh..oh…well, not so great job, little player…)

If you have used a financial advisor to purchase this stock for you, then that fee will need to be paid out as well. Let’s say that your financial advisor is nice and very affordable and charges you 0.5% (AKA 50 basis points in their jargon) which means that you are being charged 0.5% of the total assets with your advisor (regardless if it’s stocks, funds, or bonds).

SR: Hey, guy, I warned you about all these statistics…  

PWT: Yeah, yeah, I know.

For that $10,000 you have with your advisor, you’ll be paying your advisor $50 every year as long as you hold that money or investment with him or her. (Or, in other words, for every $10,000 you have with your advisor, you’ll pay $50 yearly. So $500 each year for $100,000. $5,000 for $1 million. And so on and so forth.) As your investment increases, so does the payout to your advisor. Therefore, your interests are aligned since the advisor makes more money as you do.

In this example then, your 2017 return for holding Company X was 15.3% (15.8-0.5), not 15,8%.

Let’s do the same example with a new twist.

$10,000 in Company X with a 4% dividend (paid out quarterly into a cash account) with a 2017 return=15.8%

2017 returns for S&P 500=21.83%

Your total investment return (pre-tax) is then at 19.8% without any advisor or 19.3% with an advisor.

However, if the dividends are automatically reinvested into Company X each quarter, then the return will be different and possibly significantly so. The total return in this case will be determined by the following:

  1. how much stock was purchased by each dividend payout (ie, what  the stock price was at the time of each purchase) which will in turn determine how much the next dividend payout will be with each dividend reinvestment leading to a higher one the next payout
  2. what the stock itself is doing in terms of its price
  3. what the dividend yield is doing (stable, up, or down) as the year progresses
  4. the taxes on your dividends
  5. the taxes on your sale of the stock if it happens (ie, capital gains taxes if you are selling higher than you bought for)

The easiest way to calculate total return in stock you held all year and didn’t sell is to just look at your 2016 year end statement and then see the value of the same stock in your 2017 year end statement, then do the easy math with a calculator. After that, you need to subtract out the taxes you owe for the dividends (whether the dividends are generating cash or being reinvested into the stock generating the dividend in the first place AKA a DRIP [Dividend Re-Investment Plan] or any other investment) no matter what. (As of 2013, the dividend tax has been 15% (or 20% for you all rich fat cats that light your fancy cigars with $100 bills and are in the top income tax bracket of 39.6%) with a 3.8% surcharge for married couples with incomes over $250,000 or single taxpayers with an income of $200,000 which was enacted in 2010 to help pay for the Affordable Care Act. [Thanks a lot, Obama!])

If you were in the top income tax bracket of 39.6% from 2010-2017, your entire dividend tax was 23.8% (20% dividend tax + 3.8% NIIT [Net Investment Income Tax AKA the Obamacare surtax among many other things].  It was fairly easy to calculate an approximate figure of your post-tax dividend gains—just divide your dividend gains by four and hold three parts for you and give one part over to the federal government or multiply the dividend gains by 0.75 if you prefer (since 23.8% is approximately 25%).

Therefore, in the above tax bracket, it will be calculated as the following.

$10,000 in Company X with a 4% dividend (paid out quarterly into a cash account) with a 2017 return=15.8%

2017 returns for S&P 500=21.83%

Pre-tax dividend gains + Company X return= 19.8% return

Post-tax dividend gains + Company X return~18.8% return (or, precisely, 18.848%).

You can see the attraction to dividend paying stocks or funds now. They can really juice the returns.

Now, the new tax reform passed in December 2017(officially titled as The Tax Cuts and Jobs Act of 2017 [TCJA]) changed all of this. (One thing that didn’t change is the following: Dividends are considered “qualified” once you own the stock or fund producing the dividend for over sixty days (ninety days for preferred stock). Selling before that would make your dividends taxed as ordinary income which would mean that they are taxed far higher than what the taxes would be for qualified dividends given the income levels for the average physician.   

Dividends are now taxed at the following rates:

  1. 0% below $77,200 of taxable income for married joint filers or below $38,600 if single (or, the rarer category, married filing separately)
  2. 15% between $77,200-$479,000 for married joint filers or $425,800 if single (or, in the rarer category of being married filing separately, $38,600-$239,500)
  3. 20% if above any of the upper thresholds listed above in the 15% bracket
  4. The 3.8% NIIT is still applied to all dividends based on your modified adjusted gross income (more on taxes in a later post) of $250,000 for married joint filers or $200,000 for single (or all other) filers.

 

If you’re selling stocks and/or funds for a gain, you will be taxed at a capital gains tax rate. Short term capital gains are defined as anything held less than a year. Anything held over a year and then sold for a profit is considered a long term capital gain. Short term capital gains are taxed at whatever level your income level determines as short term capital gains are taxed as ordinary income. Long term capital gains are taxed far below what the taxes would be for short term capital gains given the income levels for the average physician.   

Long term capital gains would be taxed as the following:

  1. 0% below $77,200 of taxable income for married joint filers or below $38,600 if single (or, the rarer category, married filing separately)
  2. 15% between $77,200-$479,000 for married joint filers or $425,800 if single (or, in the rarer category of being married filing separately, $38,600-$239,500)
  3. 20% if above any of the upper thresholds listed above in the 15% bracket
  4. No NIIT!!

 

SR: Hey, wait a second…those long term capital gains tax rates…aren’t they…?

PWT: Yep. Both the qualified dividend and long term capital gains tax rates are identical.

Mutual Funds

Thankfully, mutual funds are treated exactly the same as stocks in terms of taxing the dividends and capital gains. So re-read the above (or reference the above passage) when dealing with mutual funds and their tax implications.

SR: About time something broke our way…

There is one exception however when it comes to ETFs.

SR: God Damn it! Well, that didn’t last very long…

Dr. Scared: This it! This is it!! This is how they screw you!!!

PWT: It’s actually a good thing.

The dividends of ETF’s are taxed precisely the same way as those of mutual funds. The one difference is that ETFs create less taxable events leading to what should be less taxes for you on average over an extended period of time (years, not months).

Just don’t forget to subtract out the expense ratio from your earnings from any fund, then your taxes out of that figure. It’s an extra expense (and step) you don’t have to deal with when it come to stocks.

Bonds

Bonds can be a little tricky when it come to taxes depending on the type you get.

Dr. Scared: This is it! This is it!! This is how they screw you!!!

Dr. Unwise:…so annoying….

Let’s go over the generalities first.

Only the earnings from the bonds (either the payout or the difference between the original purchase price and what you sell it for are what is taxed, not the original principal investment) are taxed. By whom for each bond is explained below.

The earnings from corporate bonds are taxed by all levels of government (federal, state, and local) as ordinary income. Keep that in mind as you calculate your earnings from a corporate bond.

The earnings from municipal bonds are free from local taxes. State issued bonds are free from state taxes. Most state bonds have their earnings taxed at the federal level as ordinary income whereas municipal bonds are usually exempt from federal taxes.

However, there is a potentially juicy bonus here. There are municipal bonds that are known as “triple tax free” where all three levels of government have decided that a certain construction project is so important that no local, state, or federal taxes will be levied against the earnings from these particular municipal bonds. Often, these “triple tax free” bonds have a lower yield rate since they already have such a great  tax advantage to them. Therefore, a little math will be needed to figure out if these bonds are the best earning for you vs other bonds that are taxed by one, two, or even all three levels of government, but have a significantly higher yield to compensate for these taxes. That’s also where you handy dandy friendly neighborhood financial advisor comes in. They do all those math, so you don’t have to. Honestly, they should. You’re paying them after all. This is exactly how they earn it.

Lastly, the earnings from federal AKA US Treasury bills/notes/bonds (remember the difference?) are not taxed at the federal level, but are at the local and state level.

I always judge performance only after all fees and taxes owed are paid out. After all, that’s what you will live off of eventually, not the debt to your mutual fund, financial advisor, or taxes still owed. I look at how much total I put into any investment and then take out all the fees and taxes owed and then see what I have left thus telling me exactly what I made each year or over the years.  Anything else is a complete overestimation of how much you have/have made which will blind you to how well you or your financial advisor is really doing and how tax efficient your investing is which would in turn help you decide if you should stay the course and keep adding to said investment or change it for better returns by making either at least this investment or even your entire portfolio more tax efficient (at a minimum) OR just changing your investments totally in a different direction/asset class,etc.

One last point before we depart…

When figuring out how well your investment has done over multiple years (say, 3, 5, 10, 15, or even 20 years), you need to understand how to calculate how well your investment did on average yearly over that time, not just as one lump sum at the end of the time period you decided to study/look at your investment.

If you put $10,000 into an investment—anything as it doesn’t matter what for the sake of this example, but to make it simple, let say it’s an index mutual fund—and five years later, it has grown to $15,000 (Hells yeah!), then you’ve had a fifty percent gain over the past five years. The temptation is to say that you have earned an average of 10%/year over the past five years to give you a total return of 50% over the past half decade. Then, you march out the (in this example) fund’s expense ratio (let’s say…hmm, I don’t know, 0.14%, for no particular reason) and you get a very healthy 9.86% per year average over the past five years.

Right?

Right??

Wrong.

Dr. Scared: Oh God, just kill me now!   

When you calculate your average growth rate over five years properly, the actual compound average growth rate (CAGR) is 8.45%/year over the past five years, not 10%/year which is just the arithmetic mean (total return/years needed to gain this return).  After your theoretical expense ratio is subtracted out, then your CAGR is actually 8.31% over the past five years, not 9.86%. If it had been 9.86%, then your $10,000 would be $16,000 five years later, not $15,000—a sizable difference when dealing with tens or especially hundreds of thousands of dollars, no?

The reason for the difference here is simply that you have to account for the yearly gains since the money is gained throughout each year and not just all at once at the end of the five years in this example.

Ten percent of $10,000 the first year would be $1,000 making $11,000. Then, 10% of $11,000 would be $1,100 making the total $12,100 thus already showing you how off the calculation is by year two alone. (Even these calculated assumptions can be quite off depending on when the gains are made [ie, how early or late in the year] versus when the interest is applied [beginning of the year, end of the year, or throughout the year evenly or irregularly throughout the year as more money is put into a stock or fund which is usually the case when investing money at regular time intervals without paying attention to the cost of the equity which is known as dollar cost averaging as sometimes you will buy at a lower price and other times at a higher price, but overall will get it at a hopefully great company at a good price on average.])

Well, I think we have done enough (and then some) for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word to your family, friends, and colleagues. It would be greatly appreciated.

Until next time…

Risk: A Game of Not Global Domination, But Financial Planning

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.

It’s not how much you have at the end; it’s how much you could have made.

Risk: A Game of Not Global Domination, But Financial Planning

Before determining what you’re buying at what price in what quantity and keeping said security for whatever length of time, you need to decide for yourself (and your family if applicable) what you want as an end result of your investing and what risk you’re willing to take to hold them as an investment.

Realize that all investments contain risk.

ALL.

OF.

THEM.

By risk, we mean that you will lose money on said investment, possibly even all that hard earned money you put in originally.

We all do this every day as doctors. As we take care of patients, we weight the risks and benefits of each treatment or testing option and move forward with the most beneficial course with risks ranging from none to tolerable to even high.

That’s essentially all investing is when talking about what is known as risk tolerance.

Virtually all securities that return a greater amount of money carry a higher risk than those that return a lesser amount.

Unfortunately, risk and return are directly related.

In my mind (and perhaps mine alone), it’s like why all the best tasting stuff is bad for you and the healthiest stuff tastes…meh.

ANYWAY…

In reverse order of risk:

Bonds carry low risk.

Federal or AKA Treasury bonds (bills and notes too, but I’ll just say bonds moving forward for the sake of convenience) are considered risk free because of the almost metaphysical certitude by which they are paid. The US government would have to completely fold and not pay anything ever before bond payments stop . If you recall, you as the bondholder are the creditor that is owed money before the debtor (in this case, the US government)  goes bankrupt. Given the fact that the US government can literally print as much as money as needed for any reason under the sun (reading this again as I proofread this post…this explains a lot of what is perhaps wrong with our current polticoeconomic situation), it’s virtually impossible to have US Treasury bonds default. Thus, risk free…

Municipal (AKA US city or county) bonds are slightly higher risk than federal bonds, but lower risk than any other widely available security. CIties (or counties or states) would have to go bankrupt before bonds issued by them became worthless. It can happen (hello again, Detroit! Also, hello Stockton, California!), but it’s extremely rare, may not affect these bonds while the city or county or state government “reorganizes” its finances, and is easily avoidable in the first place by knowing which areas are fiscally distressed. The latter is easily found out by a five minute Internet search into the area that is issuing the bonds or just simply (here’s a novel idea!) reading/listening to the news and being aware of the world around you. Remember that there may be extra tax benefits to certain municipal bonds which may make the juice worth the squeeze.

Corporate bonds are still safer than either stocks or funds by quite a bit (provided that they are not the often talked about and greatly derided/feared junk bonds), but less safe than other aforementioned (What a great word! You literally cannot sound stupid saying it) types of bonds. As expected, the riskier these bonds the higher the yield, And the lower the yield, the lower your risk you have to endure to get your money.

Mutual funds and ETF’s carry a risk in between bonds (lowest) and stocks (highest risk). The collection of stocks and/or bonds will offer downside protection because even as some stocks fall, other will rise or at least stay even.

Stocks offer the highest return of the Big Three widely commercially available securities with the highest possibility of downside. Just ask anyone who suffered through the 2008-2009 Great Recession.

In 2008, the S&P 500 finished the year 37% lower than it opened.

This is what the risk averse and haters of the stock market in general or stocks specifically bring up as soon as the topic of investing comes up. Even if you had suffered through the brutality of the 2008 market (which didn’t hit its bottom until March 2009 actually), the market went on a tear that hasn’t slowed down since. In fact, it’s been on a rocket since 2017 began.

The annualized return from January 1, 2009 to December 31, 2017 (thus even including the terrible months of Jan-March 2009) is 15.29%.

SR: Uh, yeah, stats guy. That’s great and all…IF YOU’RE A NERD!!! What does that mean in real dollars?

 

PWT: Sure Great question. After all, that’s why we’re all here.

 

SR: Nah. I’m mostly here to crack wise. I’m like a digital Statler…or Waldorf…or both.

 

PWT: Not one millenial here has any idea what you’re talking about right now.

 

SR: Ah, shut up, money man.

 

PWT: Anyway…

For every $100 you had in the stock market (not bonds, cash, etc.) at the start of 2008, you would have $63 at the end of that same year.

SR: Ouch

Dr. Scared: This is it!! This is how they screw you!

For every $63 (the amount left from the original $100 once reduced by the annus horribilis of 2008)  in stocks starting at the beginning of 2009, you’d have $226.80 on January 1, 2018.

So, 226% increase since 2009.

Not bad.

Even if you include 2008, the worst performing year of the last three decades in the stock market, you had a 8.49% per year annualized return in a S&P 500 only portfolio from Jan 1, 2008 to Dec. 31, 2017.

SR: Hey there, guy, I just need…

PWT: We know, We know.

For every $1 you put into the market at the start of 2008,  you would have wound up with $2.26 by the end of 2017…and that’s with surviving the worst year in recent memory.

For those who would argue that they would have retired in 2009 if the stock market hadn’t crashed, then you likely weren’t positioned for retirement in the first place. (Much more about this in a later post.)

Also, this assumes you were only in stocks, not any outperforming fund, bonds, any alternative investments, or just cash (always in style, always fits, and never gets old). Even if you had 100% of your portfolio in only stocks, and then decided to not see the 2008-2009 crash as a buying opportunity (but hopefully not as a selling point either), then you would have been forced to work until 2012 ended. (If you worked through the end of 2011, your stocks only portfolio would be 94% of its January 1, 2008 value.)

The above is predicated on two basic assumptions:

  1. ) Your stocks only portfolio is completely identical to the gyrations of the         S&P 500.
  2. ) All dividends were included and calculated in these returns.

This shouldn’t scare you off from the stock market, but rather convince you that you need to always be cognizant of your age, your net worth, your closeness to retirement, and what your Magic Number is.   

Therefore, the closer you are to your Magic Number, the more you need to be oriented towards maintaining your net worth (what is known as capital preservation) rather than growing it further.

ANYWAY…

Think of risk tolerance as an individual exercise. Don’t worry that yours may be dramatically different than your best friend’s, colleagues at work, etc.It should be different. In fact, I’d be worried if your risk tolerance is the same as everyone else you know.

Think of it like this.

How do you drive? How aggressive are you? How fast above the speed limit are you willing to push it on a highway? How willing are you to hit bumpers when you have to parallel park?

There’s plenty of online quizzes that test your risk tolerance as an investor that you can search for, but none of them are much better than thinking about what kind of driver you are.

It all boils down to the following:

Aggressive investors are willing to lose money in the short term in order to make outsized gains in the future/long term.They’re exchanging security for better returns.

Conservative investors are willing to have lower returns as long as their original investment is preserved and gradually increases in value over time. They’re exchanging returns for security. Or, as some might say, they’re exchanging returns for peace of mind.

And there are moderately aggressive investors that have a blended approach between the two which is likely where the vast majority of us are.

Just reading this probably tells you where you lie based on how you felt as you read that last passage.

It’s easy to be critical of others that aren’t like you, but being more aggressive than you’re comfortable and working on an ulcer rather than sleeping each night is nothing to brag about. But, people do it all the time. I know some that do. I’m sure you do as well.

Grousing about how well the market is doing and bitching about it all the time when you’re investing too conservatively for you and your family is nothing to celebrate and is certainly is not any way to live.

Personally, I’ve always been an aggressive investor and it has been great for me. But, realize what that means. You don’t have to be invested in companies you don’t understand like high technology (ie, AI, cloud computing, cybersecurity, etc) companies, but rather blue chip Dividend Aristocrats along with index funds which will get you great returns, but still categorize you as an aggressive investor. I always wanted to ensure my investments after any fees and taxes were subtracted out was significantly above inflation (3.3% on average, remember?). At the end of the day, though, you need to invest to your style and comfort and no one else’s.  

What is your risk tolerance?

Think about it.

If you’re married or in a seriously committed relationship, talk to your spouse or partner about it. Hopefully, if you’re not on the same page, you can find a very terrifically happy medium.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Please spread the word about this blog to your friends (real and virtual), family, and colleagues.

Talk to you soon.

Until next time…

Asset Classes, Part IIC: Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.

Asset Classes, Part IIC

Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds

You’ll hear actively managed funds or index funds in relation to usually only mutual funds, but in reality, it can be true for ETFs as well.

An actively managed fund is one in which a “fund manager” or an entire management team makes decisions about how to invest the fund’s money—stocks, bonds, how much, which ones, and when to buy/when to sell.

An index fund, by contrast, is passively managed and follows a market index. It does not have a manager or management team making any investment decisions. Whatever index it follows (e.g., Dow Jones, S&P 500, NASDAQ, etc.), it will mimic those exact same stocks in the exact same proportions exactly (I know, I know; redundant and repetitive) and precisely nothing else. (If you want to know about stock indexes/exchanges, slow your roll, as the kids say,…creepers…that’s the very next post…no peeking!).

Actively managed funds carry far more expense with it than index funds because the manager needs to be paid (a murky number, but the average when last checked out is just over $436,000/year with some over $20 million/year based on performance bonuses, but, hey, you know all about the Krebs cycle, so you’ve got that going for you), research staff/analysts, data analytic software which require updates, etc., etc.

For that reason, how much index funds charge you (the expense ratio, remember? Come on people. This is only going to get harder as we go and impossible if you can’t remember the simple stuff. You can do this. You went to med school and forced yourself way less important stuff than this. Other than the really important things in your life and your professional career, this is the most important thing you need to know and understand) is usually way less than an actively managed fund.
Actively managed funds often carry an expense ratio of 1% or greater whereas index funds are often less than 0.5%, even below 0.1%. When dealing with such small percentages, it may seem like there’s not much difference, but when dealing with many thousands of dollars over many years as you undoubtedly will in the future eventually, it makes a massive difference which will only be overcome by your actively managed fund doing much better than an index fund every year year after year. (Much more on this in a later post.)

Actively managed funds make it possible to beat the market especially in down years. As soon as the conversation on actively managed funds vs. index funds comes up, the actively managed fund groupies always invoke the name: Peter Lynch.

Ah, yes.

Peter.

Lynch.

The sainted Peter Lynch, the fund manager of all managers, ran Fidelity’s Magellan Fund, the world’s most famous actively managed fund (mostly because of Lynch), from 1977-1990. Under his management, the Magellan Fund outperformed the S&P 500 in 11 out of 13 years and had the best performance record of any mutual fund in the world over that time.

Not bad, huh?

At a time where the S&P 500 was at an absolutely sizzling 14.43% per year, the Magellan Fund from 1977-1990 averaged just over 29%/year.

In other words, if you do the math using the Rule of 72 and the Rule of 144, in those heady days of the 1980’s, you doubled your money in just five years by broadly investing in the S&P 500.

Pretty awesome!

But, if you had your money parked with Peter Lynch and the Fidelity Magellan Fund, you quadrupled your money just under five years.

Even more awesomer!!

Fidelity couldn’t have been more thrilled because when Lynch took over the Magellan Fund in 1977, the mutual fund had $18 million in total assets under management and by 1990, assets in the fund had increased 1,286 times to over $14 Billion!

(To be fair, Lynch didn’t post the best returns ever or not in the history of the Magellan Fund even. The best return for the Magellan Fund for one year was 116.08% (!) in 1965, and the best three year record was 68.32% annualized between 1965 and 1967.)

Lynch retired at the top of the financial world in 1990 at age 46 and never re-entered with a net worth reportedly hovering around $350 million in this past decade.

Also, not bad.

SR: “OK, Lynch did great for himself. Fidelity crushed it. What about the average guy like me who invested in the Magellan Fund?”
Physician, Wealth Thyself AKA PWT: If you invested only $10,000 in the Magellan Fund the day Peter Lynch took over and then sold the day he retired and not even more dime the whole time, you made $280,000 before taxes.
SR: Oh. Well, yeah, but who’s that lucky to go in and out with only Lynch?
PWT: 1.) It’s not Lynch’s fault what you do or don’t do. You asked about him; I gave you what you asked for. ***Never ask a question unless you want the answer.*** 2.) When you notice your exceptional fund manager that has beaten the market for over a decade is exiting the place, you should walk out too. It’s like defying gravity. Sooner or later, you have to start dropping. Get out while you can.
If you don’t know who your fund manager is and when they leave, then you’re
doing actively managed fund investing wrong.
WHETHER YOU REALIZE IT OR NOT, ONCE YOU INVEST IN AN
ACTIVELY MANAGED FUND, YOU HAVE DECIDED TO BECOME
AN ACTIVE, INVOLVED INVESTOR. SO DEAL WITH IT.
3.) Even if you fell completely asleep and were under a rock for the decade after
Lynch retired, you did well if you stayed in the Magellan Fund.

Year*   MFR**   S&P 500 Return
1990    (4.51%)          (3.10%)
1991     41.03%            30.47%
1992     7.01%               7.62%
1993   24.66%          10.08%
1994   (1.81%)             1.32%
1995   36.82%          37.58%
1996   11.69%          22.96%
1997   26.59%          33.36%
1998   33.63%          28.58%
1999   24.05%          21.04%

*Duh
**Magellan Fund Return
Any returns in parentheses are negative. (Don’t ask me why. It’s an accounting thing.)
(Keep that in mind when you peruse your statements.)

As far as Lynch retiring in his 40’s with many millions and being celebrated worldwide… not bad work if you can perform for that level for that long…which no one else ever has thus why Lynch is a legend and bringing us to the problem of actively managed funds.

Statistically speaking, the vast majority of actively managed funds tend to “underperform,” or in other words, do worse than the market index.
The Magellan Fund (the example cited above) is bandied about so often because it’s the exception to the rule, not the rule…not even close actually.

Plus precisely no one guessed that the Magellan Fund would have done so well when Peter Lynch began as its manager. (Quite frankly, the Magellan Fund was an obscure fund that only became main stream a few years after it took off year after year.) We only know how well it did looking back.
Realize that every single time an actively managed fund sells a stock, the fund is hit with taxes and fees, which diminish the fund’s performance. Therefore, the more buying and selling (i.e., turnover) in an actively managed fund, the worse it will do unless the performance of the stocks it remains in outdoes the taxes and fees it has accumulated in the process…a chancy proposition.

Remember this also: You’ll pay a flat fee every year regardless of whether your fund does well or does poorly. (That’s true for index funds too though.) If the index offers a 7.25 percent return, and your index fund charges you 0.25%, then you’re at a 7% gain for the year. If your actively managed fund gives you an 8 percent return (Yay!) instead, but charges a 1.5 percent fee, then your gain that year is 6.5% (Booo).

Owning an actively managed fund means you’re dreaming of beating the market consistently or, at least, often enough and high enough that, net of fees (i.e., once you’ve subtracted out how much you’re paying each year as a privilege of owning the fund—you’ll see this phrase used a lot in articles, books, etc., so memorize what this means), you’re coming out ahead of an index fund.

Realize one more thing: If you own an index fund, you can just check in on your index (e.g., S&P 500, NSADAQ, Dow Jones) for the day, week, month, or even year and know exactly how well you did in that fund (minus a small expense ratio).
If you own an actively managed fund, how the market or a certain index or a certain stock or even a group of stocks performs tells you absolutely nothing about how your actively managed fund has done. In fact, believe it or not, the market or index could be up and your actively managed fund could actually be down because your genius fund manager (who only got the job because he’s the fund family’s CEO’s idiot nephew—bitter much, PWT?) is heavy into the only stocks that are actually down in an up market.
The only way to check on how your actively managed fund is doing is to check on the actual fund itself.

I think we’ve all had enough for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

Asset Classes, Part IIB: Mutual Funds vs. ETF’s: The Final Showdown*

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.

Asset Classes, Part IIB

Mutual Funds vs. ETF’s: The Final Showdown*

Think of your investment portfolio as a wardrobe.
It’s many different pieces (shirts, pants, socks, shoes, etc.) that cover all of you. Stocks, mutual funds, ETF’s, bonds, commodities, and many other items (all known as financial instruments) comprise your “financial wardrobe” so to speak.
Funds can be like that great piece of wardrobe that has many functions/pieces just as a fund may have many stocks or bonds or both in any combination.
But they can be structured very differently.

Open End Funds vs. Closed End Funds

Open End Funds=Mutual Funds

There. That’s it.

You’re welcome.

*Crickets*

*Puzzled faces*

OK. Fine. Let’s talk some more (eye roll so severely hard that you can hear it through the Interwebs).

Open end funds (which are typical/normal mutual funds) have no limit or end to the number of shares that it can issue. When someone buys shares of an open end fund (which you are buying from the fund itself), more shares are created (really out of thin air). When someone sells their shares of an open end fund, these shares are “retired” or taken out of circulation.
When a massive load of shares are sold within a short period of time (often within a day), the fund may actually sell/have to sell some part of its investments to pay for the amount of money owed to the seller(s). This is known as a redemption.
Though they’re usually composed of stocks, open end funds don’t trade/fluctuate like them. Open end funds reprice at the end of each weekday based on how many shares are bought or sold. (Simplistically thinking, massive buying of shares ups the price of an open end fund whereas massive selling of shares deflates the price.)
The price of the shares of an open end fund at the end of the day is determined by the total value of the fund based on the buying/selling of the shares throughout the day. This total value of the fund is known as the net asset value (NAV).

NAV=Total assets-Total liabilities/Outstanding shares

Total assets (i.e., all the stocks, bonds, etc. the fund owns)

Total liabilities (i.e., all the debt, borrowed money, etc. it owes)

Outstanding shares (remember this? What do you mean, no? Jerks! It’s all the shares of the [in this case] fund floating out there in the world for anyone to buy)

Realize that not only some stocks will produce dividends quarterly (or much more rarely monthly) which will be taxed, but mutual funds as well. (More on all of this in a later post.)

Closed end funds

Closed end funds, in contrast, have a fixed number of shares that do not increase or decrease depending on sales and are bought and sold among investors, not the fund itself, on an exchange
(i.e., marketplace). Like stocks, their share prices are determined according to supply and demand. They also are often at a steep discount (Yay!) or at a high premium (Whoa!) to their net asset value. (In all seriousness, realize that there is usually a reason something is really cheap [“it’s a porker”] or expensive [“you want quality, you have to pay”]. You just have to ensure that you’re getting value for the money you spend as you buy anything…anything at all.)
Just over 2/3 of closed end funds use borrowed money (known as “leverage”) to invest to bring about a bigger return to make the fund and, in turn, you money. So, anything that makes it more expensive for the fund to borrow money (e.g., higher interest rates, a fund being downgraded—more on this in a later post) will cost the fund more which will then be passed on to you one way or another thus lowering returns back to you as the investor.
Therefore, you have to watch quite a few things pretty frequently to ensure you’re in the right closed end fund and don’t need to avoid them or bail out of the one you’re already in.

Generally speaking, open end funds are safer and more predictable than closed end funds though their upside can be significantly higher than that of open end funds. Either can have dividends (though they’re more common in closed end funds), but those of the closed end funds are usually higher, but also far more likely to get cut depending on underlying conditions with that fund or the economy in general.

We will discuss investing in funds in a later post, but closed end funds are neither for the novice or faint of the heart.

Exchange-traded funds

Exchange-traded funds (ETFs) are similar to mutual funds because both group together securities (usually stocks or bonds) to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can be grouped together to comprise an ETF.

SR: Uh, pal…That’s no different than a mutual fund. So what gives?

PWT: So here are the differences between mutual funds and ETFs.

SR: Finally!

ETFs are just like stocks in that they fluctuate throughout the day while, if you remember, mutual funds trade only at the end of the day at the net asset value (NAV) price.
Most (but certainly not all) ETFs track to a particular index and therefore have lower operating expenses than actively invested mutual funds. ETFs have no investment minimums (which mutual funds often do—i.e., you can’t buy any shares of a particular mutual fund unless you fork over what they demand such as $5,000 or $10,000).
Also, some mutual funds charge for the privilege of owning some shares of the fund (sales “loads” as you purchase the shares [front loaded] or as you sell the mutual fund shares [back loaded] vs. ones that don’t charge at all [no load]) whereas ETFs do not. Lastly, once you sell a stock or mutual fund, you are charged capital gains tax on it (much more on this in a later post), but that’s not the case with ETFs necessarily.
As you sell the shares in your ETF, the ETF doesn’t actually sell any shares (stay with me here), but rather creates and then offers to sellers what is known as “in-kind transactions or in-kind redemptions” which are often not taxable. Therefore, ETFs allow you to either significantly reduce or altogether avoid taxes on your way out of the ETF.

Here are the differences summed up in table fashion for all you bottom line chart/table/graphics learners out there. (Yeah, you know who you are. I went to med school too, people.)

ETFs                                                           Mutual Funds

Trade during trading day           Trade at closing NAV
Low operating expenses             Operating expenses vary
No investment minimums        Most have investment minimums
Tax-efficient                                   Less tax-efficient
No sales loads                                 May have sales load

Both open end and closed end funds have been around for decades, even a century. Closed end funds are the oldest type of fund debuting in the late 19th century.
Exchange traded funds, or ETFs, are the Johnny Come Latelys (Latelies? Who really knows how to spell these made up colloquialisms?) of the fund world being introduced just over twenty years ago.

Mutual funds are MASSIVELY popular. And why not? They allow you to invest broadly in the economy (US or global) or any part of it as you desire (e.g., technology, energy, utilities, etc.).
Currently, 7,467 open end funds exist with total net assets of $12.1 trillion (Yes, Trillion with a capital T—that’s $1,000 billion for those of you keeping track at home) as per Morningstar, the most well-known investment firm in the business.
In a relative sense (and only in a relative sense), the ETF market is small: roughly $1.7 trillion placed in 1,550 ETFs.
But closed end funds by far have the smallest amount in terms of both the number of funds and total assets: 568 funds worth about $252.6 billion (not even a measly trillion dollars; wealth just ain’t what it used to be.)

I think we’ve all had enough for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

*My favorite Europe song of all time.** What a hair band!! Too bad they broke up in 1992…and then got back together!! And are now still touring around somewhere…somehow…

**It was actually The Final Countdown, but whatever. Still good fun. Though it was always unclear what they were counting down to as they had already launched off Earth early in the song as per the lyrics. The countdown to their oxygen running out? Maybe. But that’s probably just the Pulmonary/Critical Care guy in me coming out unnecessarily again.

 

Asset Classes, Part IIA: Putting the Fun in Funds

Never forget these two axioms:

 

Money frees us, but its pursuit may enslave us.

It’s not about how much you have at the end; it’s how much you could have made.

 

 

Asset Classes, Part IIA

 

Mutual Funds/ETF’s

 

 

Mutual funds and ETFs (exchange traded funds) are simple to understand in principle, but complicated to follow in practice. Simply put, they are just a collection (or “basket”) of stocks or bonds or a combination of both that collectively will determine if the mutual fund or ETF will increase or decrease in value. Inevitably, some of these stocks will go down as others will go up.

 

Whichever direction the majority goes is the direction the mutual fund/ETF goes…possibly. The “possibly” part comes in that no fund (for the sake of convenience, I’ll just say fund from now on in reference to both mutual funds and ETF’s) is obligated to buy each stock in the exact same proportion as each other stock already held.

 

For example, Fund X (sounds cool and futuristic—who wouldn’t want to get a piece of this???) may hold/own/have (all meaning the same thing, but used by different people thus adding to people’s confusion potentially) 200 stocks in it, but ten of those stocks may comprise 50% of the fund [and not even 5% each necessarily, but in any combination adding up  to 50%] whereas the other 190 remaining stocks make up the other 50% of the fund.

 

If 200 stocks in one fund sounds excessive, it’s not.

 

Sapp and Yan in their splendid paper in Financial Review in 2008   showed that the average mutual fund owned a portfolio of 91 stocks and that the top 20% of most diversified mutual funds hold (on average) 229 stocks. Not much has changed since then.

 

The choices are dizzying.

 

The number of mutual funds in the US alone as of 2016 was 9,511.

The number of ETFs in the US as of 2016 was 1,707.

(To be fair, the two largest stock exchanges—NYSE and NASDAQ—have 3,812 companies listed for anyone to buy their stock. There are over 15,000 more companies offering their stock for sale in lesser exchanges. Thus, the US alone has nearly 20,000 companies you can be a shareholder in. Much more on stock exchanges in a later post.)

 

The expenses associated with stocks are the following three:

1.) when you buy them (obviously)

2.) taxes on any dividends

3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)

 

Funds however have four potential associated expenses as detailed below.

1.) when you buy them (obviously)

2.) taxes on any dividends

3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)

4.) expense ratio

 

Dr. Unwise: Uh…wait…what’s this expense ratio you speak of? What’s that all about?

Dr. Know It All: Pffft. You don’t know that?!? God, how stupid are you? Everybody knows that. 

Dr. Unwise: So…you know?

Dr. Know It All: Of course I do! 

Dr. Unwise: So tell me.

Dr. Know It All: It’s very complicated. I doubt you would understand. 

Dr. Unwise: Well, tell me. I’m pretty smart. I am a doctor after all.

Dr. Know It All: Let this blogger guy tell you. He seems weirdly passionate about all this investing stuff. 

PWT: Sure, super duper smart guy, I’ll let you hide behind your bluster…again. 

 

The expense ratio (or ER) is the annual fee that all funds charge their shareholders. This does not include any charges related to the purchase of the fund itself. Stocks do not have such an expense.

So, unlike stocks, you are charged a fee every year no matter what as long as you hold the fund just for the privilege of owning this fund. How much you’re charged, why that much, etc. is variable between funds.

This fee is what pays all the people at that fund to help run it, manage it, sell stocks (hopefully) that they believe will perform poorly, and (hopefully) buy stocks that they believe will perform well.  (Much much more on expenses, taxes, and their breakdown with all basic investments in a later post.)

So why not then just buy stocks instead of funds?

It’s that dreaded two word phrase no doctor ever wants to even hear about, let alone deal with: risk management.

A fund has many stocks which will protect against the downside in any one company or even sector of the economy (such as oil/gas/energy) undergoing a downturn whereas owning one stock which may get crushed by some new technology destroying its way of business (e.g., music stores were wiped out by MP3 players, downloads, and streaming music services) or your company is destroyed by a civil war in a country you’ve never even heard of where the critical supply of a mineral you’ve never heard of is from and without said mineral the process needed to make their final product which you also never heard of is impossible.(If the latter happens to one of the companies where your money is, you didn’t do your homework. Sorry. This blog holds hard truths. If you want someone to make you feel better, call your mom. Seriously. Call her. She’s probably awesome and loves you unconditionally. So call her and tell her the same. And don’t text her. Call her. And Dad too. You are where you are because of them. Don’t be a jerk.)

Funds can be (let me emphasize the words “can be” here and further emphasize the word “are” was not used) a simple way of still getting upside in your investment as/if the economy hums along with decreasing the potential downside as mentioned above.

Perfect investment, right?

Dr. Know It All: Obviously. Everyone knows that. 

PWT: Eh…not necessarily.

Mutual funds over a five year period of time generally do not beat the S&P 500 and never beat the S&P 500 over a longer time period (10-20 years) and that’s before accounting for the expense ratio (ER) costing you money.

If you’re invested in only funds and nothing else, you’re banking on the gains minus the ER being close to how the S&P 500 performs while ensuring a few under performing stocks don’t sink you.

Whew!

A lot of assumptions are baked into that line of thinking.

As an advocate of the “funds only” approach, you’re assuming that as a stock only holder, you’d have the worst performing stocks thus making your funds only approach look brilliant.

But what if you just held only four stocks in equal 25% proportion each, the so called FANG stocks (Facebook, Amazon, Netflix, and Google [now Alphabet])?

Your returns would be 27.1% as opposed to 7.21% for the S&P 500 by late 2017.

Yes, it’s only one year, but look at those FANG stocks again. You’d have to think the next five years will be very kind to them.

No way, your mutual fund is going up 27.1% (unless the entire market is) even if the FANG stocks are a core holding of your mutual fund because the fund will have dozens (or hundreds) more stocks crowding out the FANG stocks thus dragging down the overall return of the fund. Then subtract out the ER. Then if you have any dividends from your mutual fund, those will be taxed.

So…

Not so easy, this investing thing huh?

I think we have done enough for one day.

Coming up next…the difference between different types of mutual funds and ETFs

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.