ETFs and Other Mutual Funds

Million Dollar Journey today asks Can You Invest Solely in ETFs? The answer given is, basically, yes. And that is true. You could also live for a week eating only pickles. At least I’m pretty sure.

This is probably as good a time as any to give a quick rundown of the differences between open-end mutual funds and ETFs.

What is usually meant when somebody says “mutual fund” is an open-end mutual fund. Like with all funds, what you own when you own shares in an open-end fund is a proportionate share of a large portfolio of assets run by a management company.

With an open-end fund, you can buy or sell shares only once a day, at a price calculated based on the closing prices of everything in the portfolio. When you buy/sell shares, you are trading with the fund itself. If you buy, your money goes in the fund and new shares are issued to you. If you sell, your shares are cancelled and cash comes out of the fund.

Most open-end funds are “active” meaning that the management company is actively deciding on a day to day basis what to have in the portfolio. A sizable minority are “passive” or “index” funds that simply hold the members of a published index, such as the S&P 500.

ETFs, or Exchange Traded Funds, are similar in that you own shares of a portfolio, but these trade all day long on the stock exchange like a stock. When you buy or sell shares of ETFs, you are trading with another investor who is selling or buying.

For reasons I will spare you, ETFs are always passively managed portfolios.

In both types of fund the management company that runs it gets paid in the form of annual fees, sometimes referred to as “expenses.” (I’m not sure if an “expense” sounds smaller than a “fee”, but it sure does sound more unavoidable.) How much the management company charges varies a lot from fund to fund, but as a general rule, active open-end funds charge the most, followed by ETFs, followed by passive open-ended funds. Additionally, to buy or sell an ETF you would pay a commission to a stock broker.

So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn’t. The long one is that there are a few situations in which it makes sense. Since ETFs trade like stocks you can short them, buy them on margin, and trade them at a moment’s notice. There are also some rather exotic types of assets available as ETFs but not as open-ended funds. But if you are a typical investor looking to hold a vanilla index for more than a week or two, ETFs will only cost you more money.

Bonus Outrage Resolved

If you read my post two days ago on the Wall Street Bonus Outrage you can imagine my relief at the President’s press conference yesterday.

You see, from all this hysteria about excessive Wall Street compensation, partially whipped up by Mr. Obama himself, I was really worried that the President might do something rash, such as, for example, restrict Wall Street compensation.

The new rules will not apply to firms that already have received government aid, will only apply in the future to the recipients of some kinds of help, will only restrict the compensation of a very small number of top executives (who collectively didn’t make much of a dent in the $18.4B that got everybody bent out of shape) and only requires that these few be paid in stock instead of cash, which is fairly typical anyway.

Whew. That was close. Turns out the President isn’t ignorant of how Wall Street works and isn’t a closet bomb-throwing socialist. He’s just a cynical politician willing to kick people when they are down to score political points. Thank god for that.

Phil Town’s Rule #1, Part #2

[This is the second installment of a review of Rule #1, by Phil Town. If you haven't already, you might want to read part 1 first.]

Rule#1 starts with a bang. From page 1:

This book is a simple guide to returns of 15 percent or more in the stock market, with almost no risk. In fact, Rule #1 investing is practically immune to the ups and downs of the stock market – and by the end of the book I’ll have proved it to you.

The First Amendment is a wondrous thing. You can say anything you want in a book (or a blog) and the worst thing that will happen to you is that people will think you are a jerk or an idiot. On the other hand, if Phil Town had started a mutual fund and put this paragraph at the start of his sales brochure, government regulators would have shut him down right away. (Although as a hedge fund he might have gotten away with it for a while. This is almost exactly what Bernie Madoff claimed to be delivering to his clients.)

As I wrote in part #1, there are lots of books that promise a formula for getting rich picking stocks. What makes Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! attractive as a victim of my scrutiny is that most of Town’s “simple strategy” is very specific. So specific, in fact, that I can program a computer to carry it out. I can go back in time and work out what stocks his system would have picked and track their performance. This is what is known in the investment biz as a backtest. It’s the first thing that would pop into the head of a pro being pitched on a system for picking stocks. It is pretty clear that Town’s mind is uncluttered by such concepts.

Town summarizes the core of his system, not all that gracefully, as four Ms: Meaning, Management, Moat, and Margin of Safety. Meaning and Management are squishy subjective things. And squishy subjective things annoy me. By Meaning, Town signifies both that you should understand the business of the company involved and that it should resonate with you in a vaguely moral way. And by Management he means that you should make sure that it has good management. I can’t teach my computer to simulate these two, so they get a free pass.

Moat turns out to be a set of ratios Town calls the Big Five. Four are growth rates: growth in sales, earnings, free cash flow, and book value. And the fifth, ROIC, is strongly associated with growth. (ROIC, according to Town, stands for Return On Investment Capital. Actual investment professionals believe it stands for Return On Invested Capital.)

Town says you should calculate each of the numbers three times, for one, five, and ten year time periods. Then, if a stock has a score of at least 10% on each of these fifteen numbers it is attractive enough to be further considered for purchase. I can only assume that his intent is that his reader should do this by hand, one stock at a time, which would eat up the weekly 15 minute time allotment pretty fast. But with access to the right tools, I can do 1000 stocks relatively easily.

Which is exactly what I did. I took the 1000 largest stocks in the US as of December 31, 2007 and found those that pass the Rule #1 Moat test. There are exactly 20 of them. Which means that only 1 in 50 stocks pass this screen, and there are more screens to come. Imagine what it would be like to use this system without automation, testing one stock at a time. And 12/31/07 is pretty typical. I tested the eight previous years and found, on average, 16 stocks that cleared the screen out of possible 1000.

Of course, the point is to find stocks that will go up, and on this score the screen is marginally better than throwing darts. The 20 stocks that cleared the hurdle at the end of 2007 lost an average of 34.67% in 2008. That’s actually not that bad, as the other 980 stocks gave up 37.53% on average. Including the other eight years of this decade the stocks that met the criteria to pass the Moat test returned an average of 4.29%, against 2.82% for the others. That ain’t terrible, but consider:

1) So few stocks clear the screen that one or two lucky picks can make the whole thing look good. In 2000 the screen only picked 5 names, but two of them, Paychex, up 83% for the year, and Concord EFS, up 71%, did very well. Kick out those two and the average return for the screened stocks for the whole nine years drops to 0.14%.

2) 4.29% is nothing like the 15% returns promised.

3) So few stocks clear this screen, and remember this is only part of the Simple Strategy, that a person has to wonder if this is really a practical methodology for an ordinary investor.

Next up, I will continue with Rule #1′s value screen, the Margin of Safety.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]

Wall Street Bonus Outrage!

There’s been rather a lot of self-righteous indignation lately about the bonuses paid out for 2008 by Wall Street. The hullabaloo started off with the New York State Comptroller announcing that bonuses were down 44% year-on-year. This was meant as a dire warning that the economy of New York City was going to hell in a hand basket. Somehow, what got picked up was that bonuses still weighed in at $18.4 billion, which some people still consider to be a lot of money.

Very surprisingly to me, some of those people turn out to be the folks in Washington who are planning to spend $887 Billion with a straight face. (How much money is that? See this brilliant post.) Last Thursday our President called the bonuses “shameful” and that unleashed an avalanche of outrage. The ever-level-headed Maureen Dowd called for a “a special prosecutor or three” in her New York Times column. Even personal finance blog The Digerati Life joined in on the fun.

If you have no idea how Wall Street works, don’t understand how many people work there, and are just generally the jealous type, it is easy to be sucked into this. Heck, it’s kinda fun. But the mundane truth is that the term “bonus” is confusing you. Wall Street bonuses are not extra money passed out at year end on top of regular compensation. They are the primary way people get paid for their labor.

Wall Street firms are very decentralized affairs, really more like vast collections of tiny independent operations that share office space and brand names. Strange as it may seem, the great majority of Wall Street workers made money for their firms last year and rightfully expect something like their usual cut. True, a very small number of employees managed to lose spectacularly large sums of money, enough to outweigh all that the profitable ones brought in. And it is also true that in most cases the firms were not contractually obligated to pay all that they did.

But you can only stiff your employees once, and only then in the process of bankruptcy. Nobody would ever work for you again. Vaporizing the big Wall Street firms is certainly a conceivable option, but I think there is general consensus that we should keep them alive.

And then there is the fact that bonuses are down 44% from 2007, which was down some from 2006. Are the car makers cutting pay 44%? Is anybody ready to suggest that to the UAW and then hint that even at that level it is “shameful”? (I know I’m not. Seriously, fellas, it’s just a blog.)

The financial crisis seems to be clouding all thinking as regards money and Wall Street. For example, my hero John Thain has been getting a lot of grief lately. David Brooks’ column in the Times today jokes that Thain got in trouble because “it is no longer acceptable to spend $35,000 on a commode for a Merrill Lynch washroom.” Which is really funny as long as you think that “commode” means a toilet and not the antique sideboard that he actually bought. (Geez, David, don’t you watch The Daily Show? Jon Stewart showed a picture of the thing last week.)

John Thain took over a brain-dead company in 2007 that, we know now, was circling the drain. He kept a good poker face, even spending lavishly to outfit his new office. He then hoodwinked one of the largest banks in the world into paying $50 billion for the company, which was at least $50 billion more than it was worth. That has got to be one of the greatest feats of salesmanship of all time. I’m not sure I would want to work for Thain, but he can work for me anytime.

A lot of the anger and frustration about Wall Street bonuses and office furnishings stems from the fact that these Wall Street types, who are at least partially responsible for getting us into this mess, are now the beneficiaries of government largess. That’s understandable. Why should these irresponsible pinheads get any of our money? It would be like enacting a subsidy for low-end home buyers or creating another wave of cheap mortgages or even passing a law to stop all foreclosures. All of those things would be just a transfer of wealth from the taxpayers to reward the fools that started this fiasco. Can you imagine the outrage something like that would cause?

I know I can’t.

Phil Town’s Rule #1, Part #1

As cynical as I am, there are still forms of human gullibility that surprise me. For example, I am forced to conclude that those Nigerian emails promising tens of millions of dollars must somehow snare a few people, otherwise they wouldn’t get sent. And don’t get me started on Bernie Madoff. I guess it is my dim view of my fellow man that has me scratching my head. I just can’t believe anybody is really that optimistic.

So you will understand how stupefied I am at the sales of the many books that claim to contain a sure-fire way to get rich in the stock market. Individual titles come and go, but there always seems to be a few members of this sub-genre haunting the bestseller lists. (Although at the moment they are relatively less popular. Go figure.)

Hundreds of thousands of people spend hard earned money on these books. Difficult as it is for me to contemplate, it seems inevitable that some of those people read this blog. So with uncharacteristic patience, I am going to review one of the more popular of these tomes, Phil Town’s Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week. I will do this in several installments, and, just to make it clear now, I will not have anything nice to say.

Hard sales figures for books are hard to come by, but it is clear that Mr. Town has done very well by this, his first book. He can safely be put into the growing club of those who have become rich by selling advice to others on how to become rich. Somebody should tell the Nigerian scammers about this. If only they charged money for their emails.

You do not need to open Rule #1 to know that it most certainly does not contain a recipe for wealth. None of these books do. They can’t. If this is not immediately obvious to you, consider the following.

Suppose you stumbled on a “simple strategy for successful investing” that allowed you to consistently make money in the stock market. Of course, you wish to profit from your discovery, and two possible ways to do that occur to you. You could a) make millions by writing a book that explains your method or b) make billions keeping your mouth shut and running a hedge fund. Which would you choose? Hint: a billion is a thousand millions.

Put another way, suppose you developed a way to play golf especially well. Would you teach it to others at the local country club or join the PGA Tour?

The bottom line is that everybody who can really beat the market does that for a living. They do not write books. And they rarely give interviews. In fact, people with effective schemes for making money in the stock market are generally very secretive about how they do what they do. If everybody knew and used the trick(s) they wouldn’t work so well. Indeed, Madoff could get away with what he did because it is common for hedge funds to disclose very little about what they do, even to their own investors.

Investing may be the ultimate “those that can, do, those that can’t, teach” subject. Because doing just pays so darn well. I know I am being a wet blanket. I just can’t help myself.

Still, I am sure that there is an optimistic fool or two reading this that hopes that maybe Rule #1 will be the exception. Town’s picture on the cover just looks so trustworthy. So in the rest of this series of posts I will methodically examine his simple strategy and I will show how Phil Town is the only person who will ever make a dime from it.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]