Volume III: Frank Armstrong answers
questions from readers of Investment Strategies for the 21st Century. To submit a
question to Frank, write to us.
Questions and Responses:
How do "wrap fee" and
"fee-only" systems work?
from Dave
Q: I understand commission based systems but how do
"wrap fee" and "fee-only" systems work? Any explanation, source of
info, or example will be appreciated.
A: I am not sure that there is a
"dictionary" meaning for the terms. I think there is a common understanding in
the industry for each.
Fee-only to me means that the only payment of any kind provided for
doing a service is the stated fee, paid by the client and fully disclosed. This
arrangement is most often used by independent Registered Investment Advisors. We have no
proprietary product, and receive no other compensation for our services. There is a clear
separation between our advice function, and the brokerage/custodian function which is
carried out by an independent third party provider. Many advisors offer their clients a
choice of custodians. For instance, we utilize Charles Schwab, and will shortly offer Jack
White.
Wrap-fee is generally employed by the brokerage houses, or broker
dealers. They devised the term to help overcome the common perception that excessive
churning was common and the practice driven by their commission crazed representatives.
So, they agreed to cap the commissions to the buyer, and bundle their services for a
single fee. In practice, it is simply a great public relations term, because the wrap-fee
structure does not address the numerous conflicts of interest which still remain. For
instance, pay for order flow, incentive pay to the "producers", trips, bonuses,
perks, and the use of proprietary products. The Wall Street Journal once ran an analysis
of several wire house "wrap-fee" programs and concluded that the actual benefit
accruing to the wire house from these undisclosed sources was a multiple of the stated
fee.
As a rule of thumb, whenever there is less than full disclosure in
an atmosphere of blatant conflicts of interest, some people are sure to get abused.
Do you have any suggestions for riskier
funds?
from Kurt
Q: I have just graduated from college and I am
looking to invest in some mutual funds. Since I am only 23 I want to invest in some of the
riskier funds. Do you have any suggestions?
A: Most of us prefer to follow a policy of
maximizing our rate of return per unit of risk. However, if you are serious about high
risk, high reward strategies you can accomplish your objective using mutual funds. But,
you will need a very high level of discipline. If you lose heart during the downturns and
abandon your strategy, you will most certainly shoot yourself in the foot.
Certain asset classes have higher expected rates of return than
others. Invariably these asset classes have high levels of risk. But, you can build a
diversified portfolio of reasonably risky assets that doesn't have insane levels of risk
when measured at the portfolio level.
Asset classes which are highest in expected return include emerging
market funds, small company funds, value funds, foreign small company funds, foreign value
funds, and foreign small company value funds. If you have lots of time, and the stomach
for the risk, load up on these funds.
Does a U.S. Bond Fund make sense for me?
from Sheldon
Q: My 401K plan offers several fixed income options
including a MM (Money Market Fund), a GIF (Guaranteed Income Fund), and a short-term U.S.
Bond Fund. All three funds have very low expense ratios. Since short-term U.S. bond funds
seem to have a historical return of 1 to 2% above inflation, does it make sense to keep
any of my 401K assets in the bond fund when the GIF and even the MM funds are returning
between 2 to 3% above inflation?
A: I don't have a very high opinion of longer term
bonds as an investment for individuals. Perhaps they are appropriate for insurance
companies, banks or other institutions with regulatory or investment policy restrictions.
But, for most of us they carry a high level of risk and a low return.
If your objectives require a bond type asset class then I think you
are correct to consider the MM Funds or the GIF. You may also want to check out bond funds
with an duration under 2 years for a little more yield without picking up too much
additional risk.
However, none of these alternatives have a high enough return to
make them very attractive to long term investors. You just can't "save" your way
to wealth. Equity returns swamp debt returns and are generally "worth" the
additional risk unless you have a short term time horizon or need to schedule regular cash
withdrawals.
Should I go for growth and aggressive
income for the next 20 years?
from Martha
Q: I am a 38 years old and have just recently
realized that I need to start making my money grow in order to enjoy a comfortable
retirement. I will most likely begin an IRA soon and I am thinking about a mutual fund IRA
(maybe that's the only kind). My employer does not offer a 401k so I am starting one on my
own. I have been doing some reading about investing and understand some of >the basic
concepts.
My question is: should I go for growth and aggressive growth for the
next 20 years? I understand that I need to beat inflation and who knows what sort of
Social Security check I will receive. It is scary to think about losing my money, but I
realize that I need to do something.
A: Most of us hate risk. But, we have to realize
that risk is directly linked to return in the investment markets. The good news is that
diversification, asset allocation, Modern Portfolio Theory, and international investing
all give us ways to manage risk and keep in within tolerable levels.
It's also very good news that investment risk falls over time. The
longer you hold a risky asset the lower the risk. So, that at your age most projections
will show that the worst probable outcome for a diversified investment in equities is
better than the best probable outcome in a "safer" investment like CDs or
T-Bills.
Given that the returns in those "safer" investment classes
will be so small that you will be unable to realize any reasonable economic objectives,
the choice becomes a little clearer.
Of course, there will be discouraging days. We know a great deal
about risk, and returns, but nothing about the timing. Risk Happens! So, you will just
have to keep the faith during the bad days in order to make your objectives for a
comfortable retirement a reality.
You are right to be starting now. The longer you put off a
retirement plan for yourself, the harder it will be to make it work.
Please help me understand bond
funds vis-a-vis bonds
from Clay
Q: Please help me understand Bond Funds vis a vis
Bonds. Though I am not a doom theorist, I did cut my investment teeth in the high
inflation, high interest rates of the late 1970's. I've seen what they can do.
I have long thought that bond funds were a losing idea. It seems
they have all of the disadvantages of a bond, and all of the disadvantages of
"mutual" ownership, and all of the disadvantages of the vagaries and arcana of
the bond market. In short, it seems that a bond fund exposes me to just about every risk
there is, with very little potential for a commensurate return. Put aside for the moment
that there may be big capital appreciation in a falling interest rate environment. The
purposes for investing in bonds are to get income, and preserve capital. A bond fund
assures neither of these.
If interest rates go up, my net asset value will fall. This is a
triple punch because inflation will cut the value of my money further, and my fellow
investors will throw in the towel pounding down the NAV further, leaving me to mop up the
blood.
However, if interest rates go down, I get to watch my income dry up.
My NAV may increase (maybe even a lot). But interest rate speculation is sort of the
antithesis of owning bonds. Added to the widely held notion that when rates move they will
almost certainly go up and you have a really bad bet.
So it seems like the things to do if you want to own bonds are: 1)
Buy high quality issues from several different sources. 2) Hold them in certificate (no
point in getting screwed by some pismire speculator the way Lloyd's was). 3) Occasionally
put your ear to the rails to make sure the issuer is chugging along O.K.
I know there are untold billions in bond funds and I assume I am
missing something pretty big. What is it?
A: I don't like long term bonds--or bond funds that
hold them--very much for all the reasons you mentioned. They are not an efficient asset,
being almost as volatile as the S&P 500 with a very small return.
However, some folks need a short term store of value, a fund for
scheduled withdrawals, or just can't stand a full measure of equity risk. A bond fund with
a very short duration will perform very well to meet those needs. There isn't a great deal
of capital risk in a bond fund with a duration of under 2 years, but they will have a
reasonable yield and will perform well as inflation and/or interest rates rise. The
shorter the duration, the quicker we expect them to catch up to rising interest rates and
recover their principal.
If you were an insurance company or a bank you probably would be
required by law to hold a high proportion of bonds in your portfolio. Other institutions
such as pension plans like to hold them to match the plan liabilities to their assets. It
can be handy to have some bonds mature about the same time as a group of workers retire.
But for most of us who want to maximize our returns at a particular risk level, bonds
don't look nearly as good.
Fund Group "Hype" vs. Peformance
History "Type"
from Stuart
Q: Some fund families tout the fact that their fund
managers have been in place or at least in the business for an extensive length of time.
It has been my less than "expert" observation that some of the best performers,
both long and short term, seem to have changed managers somewhat regularly. Should I
concern myself with this theory before investing in say, Fidelity Select Regional Banks,
Home Finance, Electronics, or Computers in favor of historicaly mediocre performing funds
like those of the Smith Barney group, relying on all those years of "experience"
of thier managers to turn around and pay off long term?
A: I don't believe that any fund manager can
reliably add value over an index fund buy and hold strategy. I don't care how long they
have been at it. A few get lucky, but that luck can't be predicted, and past performance
is of no value in predicting future performance.
It's not terribly useful to compare Smith Barney's funds to
Fidelity's sector funds. They are not the same animal. I wouldn't want either one of them,
but for different reasons.
Smith Barney's funds are all load funds of one type or another. As
you pointed out, the performance across the board has been dismal. But, even if it had
been acceptable, for every load fund you find, I can find you lots of better no-load
funds. I wouldn't pay a commission to a broker in a system fraught with conflicts of
interest and without any type of reasonable disclosure. That's a formula for getting
victimized.
Fidelity's sector funds also carny a load, and heavy expenses. But
there is another basic problem: Sector fund selection is really just a top down market
timing decision. There is no evidence that anyone can reliably select sectors. Some may
get lucky, but they are taking a big bet against the market, and the odds are that they
will not profit. After loads, taxes and trading expenses the deck is pretty heavily
stacked against the players.
So, neither approach is likely to end up with close to an optimal
solution. Every investor should first go through the process of defining their objectives,
and then build an appropriate asset allocation plan.
Ideally I would select index funds to carry out my asset allocation
plan. But, if you just have to have an actively managed fund I would suggest one with a
broad diversification, stable management "style" (no style drift), no loads and
LOW EXPENSES.
What is a "world class" brokerage
house?
from GS
Q: Thank you for your recent E-mail about choosing
a discount brokerage house insured by SIPC. You mentioned not to bother with brokerage
firms unless they are "world class". By that, do you mean a large firm - one
that does business internationally on a grand scale? For example, does Waterhouse or
Charles Schwab come under the term "world class." Could you please clarify this?
A: What I meant was, when considering custodians,
use only large national firms with impregnable balance sheets. Don't entrust your
investments to some dinky little custodian firm nobody has ever heard of. I have seen
small state regulated trust companies fail, and it isn't fun for the investors. Life is
too short to add that risk to all the others that we must endure.
Schwab, Waterhouse, Fidelity, Jack White, Vanguard etc. are all what
I would call World class. Most of us can sleep well, assured that they will be there
tomorrow.
What are the negatives of
"duplication"?
from John
Q: I am a small investor who takes the
notion of "diversification" to what most professional believe to be its
illogical extreme - that of "duplication". (I won't put more than the minimum in
one fund.) What are the negatives of duplication? Although arguably it works against
maximum returns, is not it also arguably safer?
A: Diversification is a great risk control
tool. But it is possible to carry it too far. I would have some concerns with your
approach:
First, simply buying one of everything isn't an investment
strategy. It wouldn't seem to just naturally lead to an appropriate asset allocation plan.
Unless it did, you have no control over either expected risk or rate of return.
More likely your strategy will end up with a great deal of
overlap in fund holdings. One manager's strategy would be cancelled out by another's. Two
funds could literally end up exchanging the same stocks - after expenses and taxes of
course. Net result: no strategy, and a very expensive portfolio.
You can't diversify away market risk, so buying one of each
fund will not end up in a lower risk position. Costs will be higher and rate of return
will be decreased without reducing risk.
A better way to reduce risk is to allocate your assets into
markets with low correlation to one another, and if necessary blend in some bonds to
further reduce it to a tolerable level for you.
copyright (c) 1995-97, Frank Armstrong.
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