Porterian

This is my personal blog. Travel, financial and political observations. Notes to myself and my friends. Content development for my monthly newsletter, Porter Stansberry's Investment Advisory (www.stansberryresearch.com).

Friday, March 03, 2006

MUTUAL FUNDS I'D BUY

Morningstar Inc. calculates … so-called hard-asset funds now have combined assets of almost $104 billion,” up from less than $19 billion five years ago.”
-- Jonathan Clements, WSJ March 1, 2006



Oh boy…the lemmings are piling into commodity mutual funds. This is probably the beginning of a very ugly ending…

Here’s what happened last time one sector of the market got this popular.


The chart is Firsthand Fund’s Technology Innovator’s mutual fund. It closed its doors to new investors in November 1999 because it was flooded with new money – getting $80 million in only 11 days. We all know what happened next: like everything else associated with tech, it crashed.


You could look at almost any tech-centric mutual fund and you’d see the same thing.

There are a lot of reasons why I despise mutual funds – I hate the way lousy mutual fund managers can still earn millions of dollars. I hate the way people who own mutual funds smugly assume they’re being smart about their finances. I hate the way mutual funds spread their commission dollars around Wall Street, corrupting analysts and bankers, creating myriad conflicts of interest. But…at the very core of my violent distaste for 95% of all mutual funds is the fraudulent promise at the heart of the industry: the lie that you can get rich by doing nothing and knowing nothing about investing.

It’s simply not true.

Nor is it reasonable to believe that you can trust someone at an institution to handle your finances alongside thousands of other investors with any genuine fiduciary care. It’s a myth – one of the most valuable myths of the modern financial era. The lie they tell is very compelling: just send us all your money and we’ll take care of it. Investors go for it because it relieves them of their second biggest worry – that they’ll lose their wealth. (The first worry is losing your health…)

When you buy a mutual fund, you’re buying the fund, as it’s comprised today, at current prices. But no mutual fund only owns securities that it considers to be attractive at today’s prices. No, in fact most of the assets of the fund should be long-held investments that should have increased in price significantly since they were added to the fund. But, as a new investor, you’re buying all the assets and the current prices – including all of those stocks whose prices aren’t current attractive to the managers. Or, in other words, you’re buying all of their gems that have faded, but you’re paying full retail.

That’s no good. And from there, it gets worse.

If you’re buying an “index fund,” which typically tracks the performance of the S&P 500 or the Dow Jones Industrial Average, you’re buying a group of the biggest and supposedly best stocks around. This means they’re also the most expensive and the least likely to appreciate much. Even worse, most indexes (like the S&P 500) are “marketcap weighted” which means the bigger the marketcap of a stock is, the more weight it carries in the index. Or, said another way, the more expensive a company is, the more weight it carries in the index. That means when you buy an index fund, most of your money is going into the most expensive stocks. That doesn’t make any sense, does it?

There is undisputable evidence that proves small cap value stocks will outperform any other type of similar financial asset. However, these stocks are typically too small for any large institutional investor to buy. Thus, small cap value is out of bonds for index funds and even for most mutual fund families. When you buy a mutual fund, you’re automatically condemning yourself to subpar investment performance, a truth that’s proven in mutual fund performance studies. Dalbar, a Boston consultancy, did a study which showed the average mutual fund investor made less than 6% a year, on average, during the great bull market ever in stocks, from 1981 through 2000.

The incredibly poor showing is due, in part to the contrary motivations of the fund companies. They get paid based on total assets under management, not investment performance. As a result, the fund companies advertise the hottest sectors heavily as they go higher. They know investors will chase performance. Thus, in all the mutual fund ads you see now in the financial magazines, you’ll find the 1, 3 and 5 year performance figures for the fund companies’ hard asset mutual funds. These are the same funds they were trying to hide from you six years ago at the top of the tech boom. Back then all the ads touted the tech funds.

So today you see investors piling into real asset funds just like they piled into tech funds in 1999. And you know what’s going to happen next. It’s sad and pathetic.

However, there are some notable exceptions. There is a relatively small group of top notch managers who because of their tremendous skill are no longer concerned with garnering assets and have the freedom to do the right thing for the current and prospective customers. I’m talking about the guys like Marty Whitman of Third Avenue Value and Mason Hawkins at Southeastern Asset Management. Unfortunately these mutual fund managers aren’t accepting any new clients right now because they’re honest about the dearth of attractive investment opportunities.

Seems like we’re out of luck…

However, I did find a new group of mutual funds that seem like a really good idea. They focus on a broad range of top dividend paying stocks, which I know is a sound long term strategy. They’re ETFs -- low cost, closed-end funds that trade like a single stock and are really holding companies. These ETFs buy high dividend paying stocks and weight their investments according to dividend yield, not marketcap. John Spence wrote about them in last Tuesday’s Wall Street Journal.



The best performing dividend centric ETF is called the PowerShares High Yield Equity Dividend Achievers fund. It trades on the American Stock Exchange, under the symbol PEY. There are a few similar sister funds too, such as an international version, which trades under the symbol PID.



I know a little about the PowerShares family of index funds because my friend and colleague Steve Sjuggerud has recommended their biotech fund. What he noticed about their funds is how smartly they’re put together – they’re not brainless index funds. For example, the biotech fund limits the size of any single stock, preventing all your money going into Genentech and Amgen, which dwarf all the other biotech companies in the index. As a result you’re buying a broader array of biotech companies.

What I like about the idea of a dividend tracking index fund is that such a fund solves the management problem for you – eliminating one of the biggest problems with mutual funds. You don’t have to worry about having some 25-year old MBA managing your money and killing you by trading heavily and generating a big tax bill. You don’t have to worry about some 55-year old manager who is too bored to work anymore putting your assets into the most boring; least risky firms that he knows won’t get him fired.

PowerShares High Yield Equity Dividend Achievers (PEY) is on “autopilot.” Each year it buys the top 50 yielding stocks that have raised their dividends for at least 10 straight years. The index it tracks has garnered a 12.6% total return annually for the past five years. That number – 12% -- rings a bell with me because I publish the 12% Letter, an advisory that seeks to earn 12% a year by investing in dividend paying companies, with most of the returns coming from dividends. I know that’s the most amount of money you should expect to make via dividend investing. That this fund produces that kind of return is significant: they’ve found a formula that works.

Just as importantly, the way these funds are structured insures your money can’t get caught up in a fad. By buying the highest yielding, most stable firms, the fund is automatically buying high quality and relatively cheap equity. The formula makes sure you stay invested in relatively out-of-favor stocks – which, of course, are how these funds generate such nice returns.

Finally, because these funds are “closed” they operated as stand alone businesses – holding companies. You’re not buying into some pile of money; you’re buying a share of a stand alone business, which eliminates a lot of the fiduciary issues of mutual funds.

Owning these funds is very inexpensive: the fees are half of one percent, per year.

Another similar index is the S&P High Yield Dividend Aristocrats Index. Its corresponding ETF (SPDR Dividend: SDY) is managed by State Street Global Advisors, which is a multi-billion investment company. This ETF tracks the performance of the 50 highest yielding U.S. stocks that have consistently raised dividends for at least 25 years. The index has a five year annualized return of 11% -- but its investments are spread out across a wider variety of industries: 13% in healthcare, 20% in consumer goods, 13% in industrial materials, 27% in financial services and 18% in utilities. Owning this fund is even cheaper: it charges only one-third of one percent.



These ETFs are among the few mutual funds I’d ever consider buying.

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