Mutual Funders' Opus

Why Your Mutual Fund Doesn't Return as Much as You Think

As tax time nears, many mutual fund investors are starting to wince. While most mutual funds' returns were down last year, their tax bill remains high.

After years under-performing the S&P 500, the average US stock mutual fund finally beat the index last year. But while the average fund was down just 0.37% v. the S&P 500's 9.1% drop, investors in the average fund actually lost around 3% when you add in the fees and capital gains taxes they must pay, says James O'Shaughnessy, CEO of Netfolio.com and author of the bestseller What Works on Wall Street.

"Mutual fund performance figures often leave out the taxes and some fees you are required to pay as an investor," says O'Shaughnessy, a former mutual fund manager and architect of a new investment service that eliminates the big drawbacks of mutual funds. "The little guy is left thinking he didn't do too badly when in fact he didn't do nearly as well as he thought."

Even the Securities and Exchange Commission is fed up. Just weeks ago, the SEC set new rules requiring mutual funds to disclose what they haven't disclosed for years -- the impact of income taxes on a fund's performance.

In the 1990s, investors all but overlooked their tax hit and the hidden costs in mutual fund investing. Strong and steady bull market fund returns made taxes a non-issue. But now, as investors gear up to pay taxes in April, many are discovering the inequity of paying high taxes on funds that declined in value.

How do taxes eat into fund returns? Let's say you invested $1,000 in the average mutual fund in January 2000. You would think that because the fund declined 0.37%, it left you with about $996 in December. Not too bad, you say, it could have been worse.

But not so fast. Throughout the year, the manager of the average mutual fund commonly sells 92% of his fund's stocks in an attempt to boost returns. Who pays the capital gains taxes on his giddy trading activity? You do. In fact, you'll have to pay a higher, short-term tax rate on the gains from assets the manger held for less than a year.

That means you'll have to use your income tax bracket to calculate your bill rather than the lower 20% rate charged on long-term gains. Your tax rate on these gains could be as high as 50% after you add up the your federal, state and local tax rates.

But taxes are only half the story. The typical mutual fund also charges annual fees, an expense ratio it uses to pay the fund manager, and transaction costs it uses to pay the fund's brokerage expenses.

Now let's revisit that $1,000 you invested in the average mutual fund last January. By December, you would have paid about $18 in fees and about $12 in capital gains taxes. So you lost about $30 on your $1,000 investment, not $3.70. That's about a 3% decline rather than the 0.37% drop reported recently by fund-tracking firm Lipper Inc. The 0.37% decline is the gross return of the average US stock fund and does not include taxes or fees.

"Mutual fund investors should be offended by the amount of taxes and fees they have to pay," says O'Shaughnessy. "Mutual funds may seem like no-brainer investments but they can compromise your long-term savings potential. All the money you spend on fees and short-term capital gains taxes could have remained invested and compounding."

O'Shaughnessy has identified five big mutual fund drawbacks:

1. High expense ratios. Investors pay a fee for the privilege of owning shares. That fee goes to the fund's manager. But instead of a flat amount, the fee is based on your assets in the fund. The more money you have invested, the higher your fee.

2. Undisclosed transaction costs. This is the fee that a mutual fund pays to its broker to buy and sell stocks. The fee is not found in a fund's prospectus and is deducted from the fund's returns. The higher the fund's portfolio turnover rate, the higher its transaction costs.

3. No control. You have no say over what stocks the fund owns. Some stocks may be ideal for you while others are not.

4. Little knowledge. Because you don't know what specific assets a mutual fund owns on a daily basis, you could wind up owning the same stocks in several different funds. Or the types of stocks the fund buys now may differ from the ones it set out to buy when you originally invested.

5. Significant tax hits. In addition to the capital gains taxes you pay when your fund manager actively trades stocks, you also face "embedded capital gains." These can occur when a fund you recently bought sells a stock it has held for many years. Your tax hit on that trade will be equal to someone who has the same amount invested but owned the fund for many years and profited from that stock's long run-up in price.

What's the average mutual fund investor to do? Alternatives are emerging that provide individuals with more control over their investments and taxes. The Web-based services in this new "personal fund" sector offer stock portfolios that are tailored to an individual investor's personal financial goals.

Instead of buying mutual fund shares, investors in personal funds buy an entire portfolio of stocks for a relatively low minimum investment. By owning the stocks in a personal fund, you control your capital gains taxes by choosing when to buy and sell stocks. You also know at all times the stocks you own.

The low cost of ownership and individual control of tax responsibilities offer individuals significant advantages over mutual funds and other popular investment vehicles. As such, Forrester Research, an e-commerce research firm in Cambridge, Mass., predicted that more than $1 trillion will be invested in personalized funds rather than mutual funds over the next 10 years.

"The days when mutual fund investors have to eat what they are served are over," says O'Shaughnessy of Netfolio.com. "Personal funds make it possible for every individual investor to own a professionally selected stock portfolio that is reasonably priced and designed for their needs and goals."

Netfolio.com is one of several new services offering individual investors personalized fund portfolios and -- surprise -- the first headed by a former mutual fund manager.

To begin investing at Netfolio, you pay $200 a year or $20 a month to subscribe to its service. Then you open a Bear Stearns account online at the Netfolio site at no additional cost.

To invest, you ask Netfolio to recommend personal funds that suit your investment objectives. Or you can pick them on your own from Netfolio's list. Each personal fund comes with a recommended stock portfolio that you can customize prior to investment.

You can buy an entire portfolio of stocks in a personal fund with a minimum investment of just $5,000. And there are no commissions when you invest in Netfolio's personal funds online through Bear Stearns.

"This type of personalized investment advice used to be available only to the superwealthy," O'Shaughnessy says. "Now, thanks to the Internet, individual investors everywhere can access the same type of service through their computer."

Courtesy ARA Content, http://www.aracontent.com.

Investing Course Ode

A Remedial Course in Investing

Was it really just a year ago that we were all running around trying to prevent computers from coming to a grinding halt on the first of January, and speculating about civil unrest and traffic jams around the globe?

Time flies, even if the ensuing year hasn't been much fun for investors. In hindsight, I'd say the real Year 2000 Bug was the gut-wrenching flu that struck the stock market, bringing a big dose of reality back into the picture.

For those of us who have participated in the investment arena for more than just the past couple of years, 2000 will likely go down as "not unprecedented and long overdue." For the investors who have come to the party more recently, it was a brutal, eye-opening, and sobering experience. Buying every dip didn't work. Dot-com IPOs didn't work. This year was truly a coming-of-age experience for millions of "adolescent" investors.

Those willing to stay the course benefited from a number of important lessons. In the style of that famous late-night talk-show host, here are the "Top 10 Things We Learned about Investing during the Year 2000."

Lesson Number 10: Yes, Virginia, There is a Wealth Effect.

I get frustrated when strategists point out that there's little correlation between what the stock market does and how optimistic consumers feel. Virtually everyone is involved in the market -- at least tangentially. And it's only natural to think twice about every purchase you make when the value of your investment portfolio is declining by double-digit amounts. Just ask the folks whose loans are tied to severely under-water stock options: Negative debt positions have a funny way of curbing spending.

Lesson Number 9: Rapidly Rising Markets Make Questionable Stocks Look Like Good Investments.

This is similar to the fact that floodwaters make a lot of things float that aren't actually boats. In a heady environment, the quest for the quick buck rapidly overtakes common sense, and companies with questionable business plans get funding (from venture capitalists) and attention (from analysts hoping for investment-banking business). Just because someone is willing to fund it or follow it doesn't make it a legitimate business plan or a viable long-term investment.

Lesson Number 8: Dot-Coms as an Asset Class Crashed; Dot-Coms as Businesses Didn't.

By some estimates, 95 percent of the pure Internet companies that went public in the past couple of years eventually will fail. Many already have done so -- with a lot less fanfare than when they were offered. Nonetheless, their very existence scared the daylights out of many "old-line" businesses, which quickly responded with their wherewithal, existing infrastructure, and newly energized management. These "new Old Economy" players are now wiser, stronger, and more nimble thanks to the brief threat from on-line competitors. I'm sure it's sweet justice for them to have the employees who jumped shop for greener pastures come running back -- even as the stocks of dot-com competitors fade faster than Fourth of July fireworks.

Lesson Number 7: Investing isn't for Wimps.

Gambling (read "day trading, IPO flipping, buying on hot tips, et cetera") is best done in casinos. Even though the economy, technology, and the world political scene all change, certain basic rules don't. To be a lasting entity, a company has to make a profit at some point. Another way to look at it is that in an economy growing at 3 percent or even 7 percent, most companies can't grow at 30 percent or more for an extended period of time. Investing requires thought, not hot tips. It requires thorough research, not direct-from-the-management PR.

Lesson Number 6: Leverage and Volatility are a lot More Fun on the Upside.

For five years prior to 2000, both the stock and bond markets basically went up, as the best of investment environments -- improving productivity, declining interest rates, stable political environment -- kept getting better. "Volatility" was great, because it really only went up. While a lot of folks suspected things were going too far in one direction, it was too exhilarating a ride to disembark. The flip side of volatility became painfully obvious as 2000 dragged on, however, and many high fliers plummeted from triple digits to double digits. . . and then on into single digits.

Lesson Number 5: "Asset Allocation" isn't such a Nasty Phrase After All.

Our reacquaintance with the dark side of volatility and leverage introduced many all-equity cowboys and cowgirls to the concept that owning a few bonds, some real estate, or (shock of all shocks) a higher cash position might not be such a bad idea after all. A little stability in one's portfolio might, in fact, allow a day or two of rest for the Tums bottle.

Lesson Number 4: Even if Your Statement Shows a Gain, the Money isn't Yours to Keep.

This was perhaps one of the toughest lessons to learn, as we all became mesmerized by our steadily rising brokerage account balances. Yet the reality of investing is that until you convert some of the asset to cash, the gain is not truly yours to keep. (And even the process of conversion means giving up some of your gain to the IRS and inflation.) The bottom line is that whether you convert assets or let them ride, the stock market doesn't "owe" you the 20 percent or 30 percent annual gains to which many of us became accustomed. The long-term average is still closer to 8 percent or 10 percent.

Lesson Number 3: Time and Rest are the Best Cures for the Flu.

As painful as it was, we hope last year will prove to have been a beneficial rest period in an overall upwardly biased market. It has been useful for wringing out some of the speculative excesses spawned by hedge funds, venture capitalists, day traders, newcomers, and leveraged participants. Last year forced all players to re-examine their strategies and focus on thorough analysis.

In the meantime, the economy has been healthy. Corporate America has become even stronger and more competitive. And valuations have retreated to more comfortable levels -- all of which leaves stocks well-positioned for the coming years.

Lesson Number 2: When the Going Gets Tough, the Tough Stay Put.

Despite the frustrating nature of 2000, it still wasn't worthwhile to jump in and out of the market. Many studies (and even more war stories from market vets) will attest to the fact that no one can successfully pick tops and bottoms. If you want to fully participate when the market starts to move, you have to be in place already. If your analysis has been patient and thorough, you will be positioned in the companies that are likely to lift off first.

Lesson Number 1: Fear and Greed Still Rule the Roost.

Since the earliest days of American trading under the old buttonwood tree, these two emotions have ruled investors' actions. That's true despite the attempts of business-school professors to prove that some scientific system guide investors' choices. It's been a long time since we've seen widespread fear, but it's somewhat reassuring to know that the more things change, the more the basics of investing stay the same.

Carol Clark is a principal with Lowry Hill, a comprehensive, private-wealth management firm with $6.9 billion in assets and offices in Minneapolis, Naples, Fla. and Scottsdale, Ariz. She can be reached at cclark@lowryhill.com.

Courtesy ARA Content, http://www.aracontent.com.


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Investment Strategy Ode

Why Buffett’S Investment Strategy Won’t Work For Buffett Anymore – But For You It Will Still Work!

You probably already know that Warren Buffett is the world’s greatest investor of all time. Starting with only $ 100, Buffett made an unprecedented journey in creating a personal fortune of $ 48 billon. A truly unprecedented accomplishment, especially when you consider he never started a company of his own and never invested a single penny in technology stocks. His complete fortune comes from investing in the stock market!

And, as a matter of fact, Buffett’s investment strategy isn’t that complicated: buy shares of quality companies when they are ‘on sale’. That’s all there is! With this straightforward strategy Buffett earned his billions of dollars. But, as we take a deeper look at Buffett’s returns over time something stands out...

The outperformance of Buffett compared with the S&P 500 diminishes over time. Between 1957 and 1966 Buffett outperformed the S&P 500 by a massive 14.5 times. In the most recent decade his outperformance has been diminished to ‘only’ 2.2 times the S&P 500. Of course, Buffett still shows that he is able to beat the indexes. But, now only at a fraction of the outperformance he achieved in earlier decades.

So, what’s the reason for this? Has Buffett’s system of buying quality companies on sale stopped working? Or has Buffett lost his ‘Magic Touch’? Twice the answer is negative.

The explanation behind the diminishing returns

The real explanation for the diminishing (relative) returns is actually quite simple. Nowadays, Buffett has to invest large amounts of money. Even investments of a few hundred million dollars aren’t worth the trouble anymore. Just, calculate along with me...

Buffett’s total investments currently have a value of approximately 110 billion dollar. So, should an investment still have some effect on the performance of the total investment portfolio this investment has to be at least 2 billion dollar. And that’s the problem.

As Buffett’s doesn’t want to influence a stock price too much (buying in large quantities drives the price of a stock up…) and wants to remain somewhat flexible, normally it isn’t possible to buy (or sell) more than 10% of the shares in a certain public company.

And, as the 2 billion equals 10% of the market capitalisation, we are speaking of companies with market capitalisations of at least 20 billion dollar. And, simply put, there aren’t that many companies with market capitalisations of over 20 billion!

And, besides the fact that there simply aren’t that many companies with market capitalisations that big, these companies are much more followed and researched by investment analysts and all kinds of investment professionals.

Because of this these companies are priced less inefficient. And voilà, here we have the second reason for the diminishing outperformance of Buffett.

Maybe you didn’t realize it, but as a consequence of this you have actually a considerably advantage over Buffett (unless you are Bill Gates…). After all, you aren’t limited to invest only in these giant, more efficiently priced companies. You can choose from a much, much greater supply of more inefficiently priced companies!

Buffett agrees with this reasoning:
"I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
–Warren Buffett, Businessweek, 25 th of June, 1999.

Also the returns of a couple of hedge fund managers show that it is an enormous advantage NOT to have too much money to invest. We will look at two of them: Joel Greenblatt and Mohnish Pabrai. Both of these top investors can be considered as Buffett copycats.

Joel Greenblatt

A few years ago, Greenblatt became known to a wider public as author of ‘The Little Book That Beats The Market’. In this book Greenblatt outlines a strategy in line with Buffett’s investment strategy. Greenblatt’s desire for stocks with high returns on invested capital accompanied by high earnings yields is essentially the same as Buffett’s desire for ‘quality companies on sale’.

Greenblatt’s hedge fund earned annual returns of over 40% for over twenty years. In his first ten years he even achieved annual returns of over 50%. And, like Buffett, Greenblatt got the same problem as Buffett: too much money to invest. And that’s why Greenblatt choose to buy out all the external investors in his hedge fund and to continue investing only with his own, private money!

An example of a recent investment of Joel Greenblatt is his purchase of shares of Aeropostale, a highly profitable clothing retailer. Within only a few months shares of Aeropostale had appreciated over 40%. Greenblatt sold his shares already. With a market cap of around 1 billion dollar at the time of Greenblatt’s purchase, such a transaction would be unthinkable for Buffett.

Mohnish Pabrai

Pabrai, like Greenblatt, can be considered as a Buffett follower:
‘M r. Buffett deserves all the credit. I am just a shameless cloner .’ – Mohnish Pabrai

In 1999, Pabrai started his investment fund with only 1 million dollar to invest. Now, only eight years later, Pabrai manages over 500 million dollar. Of course, Pabrai’s performance justifies this enormous growth: an annualized return of over 28% (after all fees and expenses).

An example of a recent transaction of Pabrai is his purchase of shares of Cryptologic, a software supplier for casinos on the internet. Total market capitalisation of Cryptologic at the time of Pabrai’s first investment: less then 250 million dollar. Pabrai, meanwhile, has seen this investment increase in value over 50% in less than 6 months. Again, this would be totally unthinkable for Warren Buffett.

But, like Buffett, both Greenblatt and Pabrai will be confronted with the laws of financial gravity. Also their relative returns will diminish over time. For sure, some will claim that Greenblatt and Pabrai just had some good fortune and claim that Buffett’s investments strategy doesn’t work anymore.

But also in the future new Buffett’s will arise. And they will demonstrate the sceptic, once again, that it’s still possible to outperform the market. Simply by buying shares of quality companies when they are on sale!

Hendrik Oude Nijhuis is the cofounder of http://www.magicformulastocks.com and is an expert on value investing and a long-time value investor himself. He extensively studied the investment methods of Warren Buffett. More recently, he started studying other exceptional value investors like Joel Greenblatt as well. Hendrik holds an MSc in Public Administration from the University of Twente.

The website http://www.magicformulastocks.com is dedicated to explain private investors (free of charge) why to select stocks on combinations of Return on Capital and Earning Yield. You will learn exactly how to select the most promising and most profitable stocks.


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