Active Or Passive Muni Bond ETFs?

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Tom Lydon at ETF Trends posted an interesting question in “Muni Bond ETF Debate: Active or Passive?”

Should an exchange traded fund (ETF) be created to beat the benchmark index or outperform it? Municipal bond ETF providers are butting heads over the polemical issue of whether ETFs should offer an investor pure exposure or provide investment know how.

As it stands, the majority of providers such as BlackRock, State Street Global Advisors, Van Eck Global and Invesco Powershares believe passive is the way to go. Those landing on the active side of things include providers such as PIMCO, Grail Advisors and most recently Eaton Vance.

By the end of January, there were 27 muni ETFs available with $6.19 billion in assets. Prior to 2009, all muni ETFs were passively managed – the ETFs bought bonds in a target index and tried to provide a 95% correlation with the index.

Bond holdings in passive muni ETFs only represent a small portion of the overall bond index. Passive muni ETF portfolio managers aim to reflect the benchmark index through “representative sampling.” The portfolio managers would break down the index into categories like credit risk, duration and maturity, and weight the fund with bonds that recreates the aggregate risk characteristics of the benchmark.

PIMCO, like other actively managed ETF providers, believes that a portfolio manager should devote his or her time to research and beat the market. PIMCO launched its first actively managed ETF last year, the PIMCO Intermediate Municipal Bond Strategy Fund (MUNI). The fund has a published benchmark index but only uses it as a comparison. Grail Advisors shortly followed with its own intermediate fund, the Grail McDonnell Intermediate Municipal Bond ETF (GMMB). Most recently, Eaton Vance has registered to launch a series of actively managed funds.

Actively managed muni ETFs provide investment expertise of an established manager at a lower cost than mutual funds and greater transparency. For instance, Grail’s muni ETF has an expense ratio of 0.35% while the average mutual fund fee is 0.9%.

More important than the active vs. passive argument at this point is whether these issues are even worthy of investment consideration. The 2 funds mentioned above (MUNI and GMMB) are tiny in size ($20 million and $5 million) as well as extremely weak in volume.

I did not even bother to look at the bid/ask spread, because most of these new offerings need some time to establish themselves in the market place. My rule of thumb is that I want to see at least 9 months of price data to be able to look at their trends and make comparisons. That’s the time where you can revisit the idea as to whether active beats passive or not.

Right now, I simply acknowledge that these ETFs have come on the market, but would not consider them investment quality. It goes without saying that I have no holdings in any of the ETFs mentioned above.

Mutual Fund Fee Makeover

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The NYT featured an article titled “Mutual Fund 12-b1 fees Could Get a Makeover.” Here are some highlights:

Many investors might skip over the line on their mutual fund disclosure statements that says, ”12b-1 fee.”

They might want to start wondering what’s behind that label. These fees are the money that many funds collect to offset a variety of expenses, from advertising to broker’s commissions. They can cut into investors’ returns.

The fees, whose name is a legacy of the Securities and Exchange Commission rule that created them three decades ago, brought in $9.5 billion for fund companies last year. That amount is equal to 18 percent of all fund expenses, not counting sales charges, according to the fund industry’s Investment Company Institute. The 12b-1 fees typically amount to around $2 a year for every $1,000 invested.

The SEC is questioning whether investors should be paying them. Chairwoman Mary Schapiro has asked her staff to present a recommendation on 12b-1s for the commission to consider this year. Schapiro’s predecessors have studied possible 12b-1 changes, but there haven’t been any overhauls.

Schapiro sounds serious. ”Investors may have no idea these fees are being deducted, what services they are paying for, or who they are ultimately compensating,” she said in a speech last month.

Broadly, the SEC says 12b-1s are supposed to cover fund distribution, and in some cases, shareholder services. These expenses frequently aren’t covered by the sales charges that many funds assess, or the management fees all funds charge for overseeing an investment portfolio.
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And a fund that doesn’t compensate advisers through a 12b-1 is probably collecting that money elsewhere. Increasingly, 12b-1s have become revenue substitutes for the growing number of funds that don’t charge ”loads,” or sales fees. A fund touting itself as ”no-load” may be hitting you up in the form of a 12b-1 or another expense after you buy in.

”It doesn’t make sense to use 12b-1s alone as a tool to screen out funds,” says Mercer Bullard, president of Fund Democracy, a fund shareholder advocacy group. Bullard is a former assistant chief counsel at the SEC.
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Besides compensating brokers, 12b-1s were created to help a then-struggling fund industry recover from tough times in the 1970s. The thinking went like this: 12b-1s could help funds cover marketing and advertising costs to lure back investors. The more assets the funds have, the more efficiently they’ll be run, leading to expense cuts that can benefit all. Eventually, many funds could become big enough that their governing boards would decide to stop charging 12b-1s.

But it often hasn’t worked out that way, because of the varied arrangements that fund companies use to compensate brokers selling their funds. Take American Funds, which assesses 12b-1s at its biggest funds. That includes the nation’s largest stock fund, Growth Fund of America, whose biggest share class (AGTHX) charges a 12b-1 fee of 0.24 percent. That’s about one-third of overall expenses at the 36-year-old fund, whose assets now total $156 billion.
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American Funds spokeswoman Maura Griffin said the company views 12b-1s ”in part as a method of compensation for transaction-based financial advisers for their ongoing advice and service to their clients.”
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ICI, the industry group, says scrapping 12b-1s would eliminate incentives for advisers to continue serving clients, for example, by giving them investment advice. A 2005 study by ICI found that only 2 percent of 12b-1 fees supported advertising and other promotions. About 40 percent went to advisers for initial sales, with 52 percent for ongoing support.

”The vast majority of 12b-1 fees are for compensating advisers for services they provide, and investors want,” ICI chief economist Brian Reid says.

But the National Association of Personal Financial Advisors — whose members are compensated on a fee-only basis without commissions — applauds Schapiro’s 12b-1 review.

”When you peel back the layers, you see that some mutual fund companies are making a profit on 12b-1 fees,” says NAPFA Chairman William Baldwin.

Schapiro says the fees may have made sense when they were introduced in 1980. But now, she says, ”it is past the time to reassess their need and their effectiveness.”

I agree that the original idea of 12b-1 funds may have had merit, but an overhaul of this old law is in order especially if these fees are no longer used for their intended purpose.

To increase profits for mutual fund companies in a roundabout way, that is not transparent to the investor, is simply not acceptable. Additionally, if you purchase such a fund directly, and some of these fees are at times (at the fund’s discretion) used to pay a commissioned broker, then you should not be paying for “services” you don’t receive.

According to the above article, 12b-1 expenses seem to have turned into a kind of a slush fund for mutual fund companies to be used as they see fit. In today’s environment of transparency and disclosure, this is an area that definitely needs to be improved.

One Reader’s 401k Issues

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Reader Scott experienced some changes to his 401k set up and is considering a couple of choices. Here’s what he had to say:

My question concerns my 401k account through work. We have been fully invested with Vanguard funds; however, we have recently been forced to transfer all our funds to T D Ameritrade brokerage since Vanguard is no longer supporting small company 401k accounts at its brokerage.

This all fine except that after the first year at Ameritrade all the Vanguard funds will incur a transaction fee to trade in or out of. This will be unacceptable in my opinion so I need to change something.

I have researched correlated NTF funds to replace the Vanguard offerings with, but they carry higher expense ratios, usually .50 to 1.00 higher than the Vanguard fund.

Do you think I would be better off to switch to an all ETF portfolio and incur the commission for each trade up front, or go with the NTF funds with the higher expenses?

You are actually very fortunate to have that choice. Many 401ks do not offer ETFs at all leaving the participants stuck with mutual funds and their (at times) severe trading restrictions.

Personally, I would go with the ETF set up; no questions about it. Trading costs are negligible these days, especially if your investment horizon is long term and you don’t engage in day trading.

It’ll also make it easier to follow my trend tracking approach, if you’re so inclined, along with the use of trailing sell stops. My weekly StatSheet will provide you with the backup information to hopefully assist you in making more successful investment selections.

Hedge Funds Anyone?

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“Hedge Funds for the masses” features an update on how Long-Short (L/S) mutual funds have performed during the past couple of years. Are they really an alternative for the average investor? Here are some thoughts on this topic:

Hedge funds enjoy a certain glamour that the humble mutual fund lacks, including wealthy investors, the promise of outsized returns and billionaire money managers. Now this rarefied club is open to individual investors, and many are eagerly signing up.

The number of mutual funds attempting to replicate hedge fund strategies has risen dramatically, with 80% of today’s long-short funds launched in just the past few years. The funds have come from both mutual fund firms branching into a new area and hedge fund managers making their strategies available in mutual fund formats.

Investors have responded: in 2009 long-short mutual funds and saw more than $10 billion in net inflows, double their previous annual high, in 2006, according to investment researcher Morningstar Inc.

A move of hedge fund-style strategies into mutual funds could be a win for all concerned: investors could see steadier returns while traditional hedge fund firms open their doors to more clients. For mutual fund firms, these funds can be a way to attract new money in choppy markets and also keep investors from fleeing during times of panic.

But is this type of fund right for you? A hedge fund-style strategy should in theory deliver returns independent of the stock market — a fact that appeals to many investors still smarting from the market’s meltdown in 2008 and early 2009.

Indeed, hedge funds seem to have weathered that storm much better than mutual funds. Data from Hedge Fund Research Inc. show that the HFRI Fund Weighted Composite Index fell 19% in 2008, versus a loss of more than 40% for the average stock mutual fund.

Still, investors need to be careful if they decide to include a hedge-like mutual fund in their portfolio. Some of these offerings limited losses in 2008, to be sure, but many failed. Morningstar’s long-short fund category, where managers bet against, or “short” some stocks while staying bullish on others, saw 2008 returns ranging between a 40% loss for the worst-performers and a 12% decline for the best. The average long-short fund lost 15.4%.

The independent nature of these funds also means they’re likely to lag during rallies. The benchmark Standard & Poor’s 500-stock index rose 26.5% in 2009, but long-short funds added only 10.5% on average, according to Morningstar. On the downside, the worst performers lost 18%; the best of the group soared 82%.

“The average long-short fund was bad for investors” in 2009, said Nadia Papagiannis, alternative investments strategist at Morningstar.

Among so-called market neutral funds, which Morningstar places in the broader long-short category, there were also large differences. Vanguard Market Neutral Fund (VMNIX) lost 8% in 2008 and was down 11% in 2009, but JPMorgan Market Neutral Fund (JMNAX) lost 1.1% in 2008 and gained 9.7% last year.

Morningstar has one “analyst pick” in the long-short category, Gateway Fund (GATEX 25.53), which has seen annualized returns of 2.8% over both the past five and 10 years. Over three years, the fund is down 0.2% on an annualized basis.

Manager J. Patrick Rogers uses call options to generate income from stocks representing the S&P; 500 while buying puts as a hedge.

In recommending the fund, Morningstar noted Rogers’ lengthy tenure and the fund’s “sophisticated, yet easy-to-follow strategy.”

“The fund managed to avoid much of 2008’s market losses and keeps expenses low, making it a good fit in many investors’ portfolios,” wrote Papagiannis in a late February research note.

Gateway Fund charges annual expenses of 0.94%. Its Class A shares lost 13.9% in 2008 while the S&P; 500 fell 38.5%.

There is much more to this story, so be sure to read the entire link if this subject is of interest to you.

You may have a hard time justifying the use these types of funds, because of the lag in performance. Any investment approach, which attempts to minimize losses during market downturns, including trend tracking, will lag the subsequent upturn.

That is the problem for some investors in that they want to see bear market avoidance and expect to be in at the bottom of the next bullish rebound. It simply won’t happen. There will always be a lag. That’s why it’s important to combine bearish and bullish periods to arrive at a return that reflects both.

This is the main reason why you hear me regularly harp on the fact that the S&P; 500 still needs to gain some 14% from current levels just to reach the point we sold at on 6/23/08. When considering L/S funds, or any other bear market avoidance approach, you need to also look at the longer term picture and not just at the rebound of 2009.

In my data base, I am tracking 10 L/S funds as shown in the table above. While this represents a short term picture with the longest performance period being our current Buy cycle (since 6/3/09), it shows that some funds, especially SWHEX, have done very well by lagging SPY by only a few percentage points.

Others did not fare as well and have adjusted only slowly to the changing market conditions in 2009. L/S funds may not be the answer for everyone, but they may offer an opportunity to deploy some of your portfolio’s assets with better safety than simply buying and holding blindly.

Disclosure: I have no holdigns in any of the funds mentioned above.

Domestic Or International Investing: Where Are The Opportunities?

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Jim Jubak took the view in “For now, the money’s made in the USA” that over the next few months the U.S markets should lead the globe. Here is some of his reasoning:

I can think of a dozen reasons why, in the long term, U.S. stocks will do worse than stocks in China, Brazil, India and Canada — and maybe even in Norway, South Africa, Germany and Turkey.

Huge government debt, highly leveraged consumers, underinvestment in infrastructure, a lagging education system, rising interest rates, a small and, in industries such as autos, uncompetitive manufacturing sector, out-of-control health care costs . . . do I need to go on?

But in the next three to six months, I can’t think of a better stock market in the world for my money. China? Beijing is raising interest rates and shrinking the money supply. Brazil? It’s looking at rate increases, too, and all the uncertainty that comes with a close presidential election. India? Interest rates and inflation are both due to climb.

In contrast, the U.S. looks like it’s in for stable interest rates, inflation just high enough to take worries about deflation off the table, and easy year-to-year corporate-earnings comparisons with the first half of 2009.

Hey, I still think there’s plenty of bad news coming our way in the fourth quarter of 2010 or early in 2011, but in the short run, the U.S. stock market looks, comparatively, like the best bet in the world for equities. I’m not saying the U.S. market and economy are perfect or wonderful — just that for this period they look better than the other guys’.

Conditions aren’t so fabulous that I want to go out and bet the farm on U.S. stocks, but they are good enough that I might want to add a dash of U.S. stock to my portfolio for the next quarter or two. I’m not going to tear up my long-term plan to overweight developing market equities, though.

Over five to 10 years, I think stocks from China, Brazil and the rest of the developing world will leave U.S. stocks — and stocks from other developed economies even more so — in their dust. But U.S. stocks are attractive enough in the short run that putting some cash to work there makes sense.
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Think long, act short

One of the lessons that the bear markets of 2000 and 2007 should have taught us is that investors need to think both long and short term. It’s not enough to put your money behind a great long-term stock and then forget about it, lulled into complacency by a belief that in the long run your investments will do fine.

In the short run, we’ve learned, even the best long-run stocks can take beatings so horrible that most investors can’t hold on for the turnaround.

There is much more to this story as Jim goes on to share his views dissected in 5 paragraphs as to why he favors the U.S. markets for the short-term. While all of his reasons have merit, they’re based on an assessment of the fundamentals as they are right now.

From my point of view, we are living in a fast paced world where fundamentals can change at a moment’s notice, which renders them useless when it comes to making investment decisions. A sudden debt default in Europe, or anywhere else for that matter, can change the game in a hurry and derail the domestic market just as easily as it would affect global markets.

While there is nothing wrong with looking at fundamentals, just don’t get stuck on the idea it has to play out a certain way. World markets are intertwined and will affect each other. With too much debt represented in all global economies, a black swan event is bound to happen sooner or later.

My point is that your thinking has to be flexible when it comes to your investments. Do not become married to any of your holdings and make your decisions based on what the market tells you.

In other words, focus on trend direction and get out when your sell stops indicate you should. Don’t rely on fundamentals; the only reality you have is the price of your holdings at the end of the day. Everything else is just useless market noise.

Investors Aren’t Buying It

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MarketWatch featured a story titled “Easy does it,” supporting the view that many U.S. mutual fund investors have not participated in this market rally:

Bull market be damned: U.S. mutual fund investors continue to sidestep this stock market.

According to a report released by New York-based Strategic Insight on Thursday morning, investors put $30 billion into stock and bond mutual funds in February. Read the Strategic Insight report.

For the first quarter of 2010, net inflows to stock and bond funds could top $100 billion, a big reversal from the less than $10 billion garnered in the year-ago period.

But where are investors putting money to work, specifically?

It’s all about fixed income products.

Loren Fox, Strategic Insight’s senior research analyst, says that, with money-market funds and deposit accounts continuing to offer near-zero yields, investors are hungry for income alternatives.

In total, they put $24 billion into bond funds in February. Leading the inflows, says Fox, were short- and intermediate-maturity corporate bond funds, with $10 billion in combined net inflows.

Global bond funds captured more than $4 billion in the latest month, he says, while inflation jitters encouraged inflows of $2.5 billion to TIPS funds.

Enthusiasm for bond funds mirrors trends that unfolded last year. Full-year 2009 inflows to bond funds — including traditional mutual funds and ETFs — reached an all-time record of $396 billion.

The massive inflows into bond funds will continue into 2010, says Fox.

“Interest rates will not rise significantly this year,” he says. “So money market funds and bank deposit accounts will continue to be not all that attractive from a yield point of view.”
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“There are two trends at work here,” says Fox. “Investors for many years now have been increasing the global diversification of their portfolios. Also, international markets have done better than the U.S. equity markets. So that has emboldened investors to put more money into international funds.”

However, in contrast to bond funds and international equity funds, investors showed little love for the home team.

Flows into diversified U.S. equity funds were negative in February, says Fox, despite the average domestic equity fund delivering a 3.4% total return in the month and nearly 60% return for the prior 12 months.
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But, despite this hard rally, a lot of investors seem to think U.S. stocks are a bad bet, given the uncertain path ahead for a fragile economy plagued by ongoing problems in housing, commercial real estate, and the labor market.

“We are not sure when investors will begin putting more money into equity funds,” Fox says. “They haven’t embraced stock funds because they do have lingering concerns about how this recovery will take shape.”
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How do financial advisers, who guide most investment decisions, feel about where to put money to work in the investment world?

According to a survey conducted by Charles Schwab in January, financial advisers intend to pull away from fixed income: 16% plan on investing more in bonds versus 25% in July.

But there wasn’t much cheerleading for U.S. stocks, either: 26% say they’ll invest more in large — cap U.S. stocks versus 30% in July.

Separately, and sort of interestingly, ETFs experienced $5 billion of aggregate net inflows during February, a reversal from the net redemptions seen in January. The biggest draws were U.S. equity ETFs like the SPY.

Why would investors withdraw money from U.S.-focused mutual funds, but commit capital to U.S. equity exchange-traded funds?

One reason, says Fox: Investors might be more comfortable slowly tip-toeing back into the market with relatively cheap, passive vehicles.

“They are a bit less risky because they are lower cost than actively managed funds,” he says.

[Emphasis added]

It’s interesting to note that investors withdrew assets from equity mutual funds and deployed them in equity ETFs. I don’t think that the fact that costs are lower has anything to do with it or the claim that they are allegedly less risky.

I think it underscores the general trend that ETFs are the investment of choice much to the chagrin of mutual funds. No trading restrictions, tremendous choices, intra-day trading and high volume with many issues make ETFs a superior tool.

Last not least, let’s not forget the most important reason for using ETFs: They allow us to easily follow the trends in the market place and let us implement an effective sell stop discipline, in case the markets reverse and head south again.

Protection of our investment capital during bear markets still remains a top priority, a view that has served us well during the severe down drafts of 2000 and 2008.