130/30 exchange traded note

I was going through some old starred items in Google Reader and stumbled across an old post from Random Roger about a 130/30 exchange traded note from First Trust. (Roger notes he's skeptical about 130/30 strategies in the post.)

There is a charts of the price history on the First Trust product page for the 130/30 ETN, and it looks like it's fallen from the high 40s in June to the mid 20s in November. The performance of this style of fund/note hasn't turned around since my last post on 130/30 funds.

Frontier funds coverage heating up

Frontier funds are in the news again, this time being covered by Money magazine (see my previous posts on the topic here and here.

Enter the newest fad: frontier funds. They go to places that may have barely functioning stock markets and shaky governments but often have astounding growth rates. Côte d'Ivoire's market spiked 122% in 2007. Namibia's rose 63%.

Within the past year, three funds specializing in frontier stocks have launched: T. Rowe Price Africa & Middle East, Fidelity Emerging Europe, Middle East, Africa and Claymore/BNY Mellon Frontier Markets, an ETF. And more are on the drawing board.

The T. Rowe Price fund and the Claymore/BNY fund were in some previous articles I cited in my old posts. The Money story goes on to point out some rather big risks in investing in frontier markets, and questions whether the individual investor has the stomach for the 50% swings that can happen in these markets.

The emerging markets are still tiny, with only a $191 billion market cap according to the story, so they have a lot of room to grow. But now that the mainstream media is covering these markets more and more, is it really the right time to invest, or is it a sucker's bet now?

Collective funds instead of mutual funds

Collective funds are like mutual funds, but generally only available in retirement plans (like 401(k) plans), and are increasing in popularity as investment vehicles in 401(k) plans (free WSJ Digg link). The reason that they're replacing traditional mutual funds? They're cheaper.

Just like mutual funds, collective funds pool investors' assets and invest in stocks, bonds and other securities. The chief difference: Collective funds are typically available only in retirement plans. Because they aren't sold directly to the general public, they generally aren't regulated by the Securities and Exchange Commission.

Collective funds tend to be substantially cheaper than mutual funds, largely because they don't have to comply with SEC regulations or market to retail customers. That's driving 401(k) plans to embrace these products, which are offered by big fund providers like Fidelity Investments, Vanguard Group and Charles Schwab Corp. as well as by banks and trust companies.

Only 58% of large defined-contribution plans such as 401(k)s used retail mutual funds in 2007, down from 65% in 2003, according to research and consulting firm Greenwich Associates. By contrast, 39% of such plans used collective funds last year, up from 33% two years earlier. Other common 401(k) investment options include institutional-class mutual funds sold to retirement plans and other large investors, and "separate accounts," which are custom-designed for a single retirement plan.

I checked my 401(k) and sure enough, the funds I'm invested in are collective funds, not mutual funds. In fact, my 401(k) plan offers more collective funds than mutual funds.

Collective fund drawbacks

The Journal story talks about one drawback of collective funds being that they don't have to update their performance frequently, and that their daily prices aren't reported in newspapers. My 401(k) plan publishes daily price changes of the funds on its Web site, so this hasn't been a problem.

Another drawback cited is that collective funds "can't be rolled over to an individual retirement account when the participant leaves the 401(k), so participants have to transfer their funds into other investment options if they take these assets from the plan." However, I don't see this as a big deal since I've never done a direct in-kind rollover from a 401(k) to a rollover IRA when I've left an employer. I've always liquidated the 401(k) holdings and then rolled over.

Are high mutual fund minimums good?

High mutual fund minimums can be a good thing. The mass affluent segment should investigate funds with higher minimums. Here's a story that gives reasons why (free WSJ Digg link).

But there are reasons for considering paying up. Of course, by raising minimums some funds are being picky about who they let in the front door. But in some cases, they also are trying to control costs and protect shareholders. The fewer shareholders a fund has to deal with, the less it has to spend on annual reports or account maintenance. That can translate into lower annual fees. High minimums can also cool off asset inflows into a hot fund.

Once I'm invested in a good fund, I want the fund to restrict who else can invest. Basically, I want the manager to only have enough money that he or she can invest well. If the fund gets hot, and new money pours in, the manager has to start investing in worse and worse ideas that are going to lower overall returns.

Let me give a simple, canned example. Let's say I have $10,000 in a fund that owns a single stock that returns 20% a year. Therefore, leaving out fund fees for simplification, the fund returns 20% to me a year. Now the fund let's in another investor who invests $10,000. The fund manager invests the new money in a stock that returns 10% a year. Now since I own 1/2 the fund, and the new investor owns the other 1/2, I essentially have $5,000 invested in a stock that returns 20% a year, and $5,000 invested in a stock that returns 10% a year. This has put me in a worst position than when I was the sole investor in the fund.

Discouraging frequent redemptions is another feature I look for in my mutual funds. Frequent redemptions by other shareholders causes either the fund manager to keep cash on hand instead of investing it, or to sell investments to raise cash, potentially selling investments that still have room to run.

Active vs. passive fund management

The current issue of Fortune is its investor's/retirement issue, and has several good stories. The obligatory Buffett story is particularly good this time, as it covers a bet between Buffett and a hedge fund as to whether the hedge fund can beat the S&P 500 over 10 years. The basics are:

Protégé has placed its bet on five funds of hedge funds - specifically, the averaged returns that those vehicles deliver net of all fees, costs, and expenses.

On the other side, Buffett, who has long argued that the fees that such "helpers" as hedge funds and funds of funds command are onerous and to be avoided has bet that the returns from a low-cost S&P 500 index fund sold by Vanguard will beat the results delivered by the five funds that Protégé has selected.

Will 2 and 20 doom Protégé to lose?

The hedge fund selections have a big obstacle to overcome, fees:

A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones "bought" by Buffett in the bet.

On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the "helpers" that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P.

Personally, I think that individuals can beat the market over an extended period of time (I hear the Bogleheads screaming at me already). However, I don't think that typical hedge fund performance justifies anywhere near their typical fees. In losing years, the hedge funds are still taking their standard 2% management fee, to which I say, thanks for nothing.

Long Bets

Don't miss the part of the story that describes the long bet mechanism that made this bet possible in the first place. It's a cool innovation.

130/30 mutual funds sucking wind

I still haven't pulled the trigger on a 130/30 fund yet, and maybe that's a good thing (free WSJ Digg link). Most 130/30 funds are trailing their benchmarks, and the article blames managers who aren't good at going both long and short.

Some are run by managers with relatively little short-selling experience. Take Fidelity 130/30 Large Cap Fund, introduced in April and ahead of the broader market since then. Skipper Keith Quinton is a stock-picking pro; his Fidelity Tax-Managed Stock fund is in the top 10% of Morningstar Inc.'s U.S. "large blend" category for the past three years. But his shorting experience? Thirteen years ago, he ran a trust fund that made bearish bets. Fidelity says its trading desk has long experience with short sales.

Other funds are run by skippers who may have experience shorting stocks but lackluster stock-picking records. The managers of RiverSource 130/30 U.S. Equity Fund, which so far this year trails the broader market, have been in the bottom half in recent years at stock funds they've run. RiverSource declined to comment on its managers' performance.

My search for good hedge fund-like investments for the mass affluent continues.

Fidelity and Delta offer (still valid)

I received a letter this week about a Delta SkyMiles offer from Fidelity. If you open a new nonretirement brokerage account with Fidelity and deposit $50,000 you can earn 25,000 Delta SkyMiles. $10,000 will get you 15,000 miles, and $2,500 will get you 5,000 miles. It says the offer expires July 15, 2008. fidelity.com/delta has details.

Updated June 2: I received a postcard that says the offer expires August 15, 2008. The Web page makes no mention of any expiration date.

Updated January 4, 2009: I found another postcard while going through old mail that says the offer expires November 18, 2008, but when I checked the link again today, the page still makes no mention of any expiration date.

130/30 mutual fund performance lagging

There was a blurb in this week's BusinessWeek on 130/30 fund performance:

While these funds have yet to amass the multiyear track records that disciplined investors rely on, they have gotten off to a lackluster start. "We haven't found them to be that compelling," says Marta Norton, an analyst at Morningstar (MORN). According to Norton's data, the two dozen 130/30 mutual funds on the market lost 8.82% so far this year, vs. a decline of 9.05% for the Standard & Poor's (MHP) 500-stock index. Over the past year the average 130/30 fund dropped 8.44%, surpassing the S&P's 3.60% decline.

I'm still interested in these funds, and continue to research them to perhaps invest in one sometime.

While searching for the electronic version of the article (since I couldn't find it through the BW table of contents page for the issue), I found an older article by the same author that gives more of an explanation of 130/30 funds (or 120/20 funds).

IRA changes in 2008

Vanguard sent me a letter that nicely lays out the legislative changes to IRAs for 2008. Some of these are the result of the Pension Protection Act of 2006.

Direct non-Roth 401(k) to Roth IRA rollovers

Previously, you could roll over a non-Roth 401(k) to a traditional rollover IRA, and then convert the traditional rollover IRA into a Roth IRA. Now you can skip the step of having to roll over into the traditional rollover IRA, and roll over and convert at the same time. There are still tax consequences from converting the pre-tax non-Roth 401(k) into the post-tax Roth IRA. There are income limits of $100,000 as well. More details can be found in the IRS publication, Notice 2008-30.

Q-1. Can distributions from a qualified plan described in § 401(a) be rolled over
to a Roth IRA?

A-1. Yes. The rollover can be made through a direct rollover from the plan to the
Roth IRA or an amount can be distributed from the plan and contributed (rolled over) to
the Roth IRA within 60 days. In either case, the amount rolled over must be an eligible
rollover distribution (as defined in § 402(c)(4)) and, pursuant to § 408A(d)(3)(A), there is
included in gross income any amount that would be includible if the distribution were not
rolled over. In addition, for taxable years beginning before January 1, 2010, an
individual can not make a qualified rollover contribution from an eligible retirement plan
other than a Roth IRA if, for the year the eligible rollover distribution is made, he or she
has modified adjusted gross income (“MAGI”) exceeding $100,000 or is married and
files a separate return.

I won't be doing this anytime in the future, for tax diversification purposes.

Starting in 2010, anyone can convert a traditional IRA (or 401(k)) into a Roth IRA

This year and in 2009, your MAGI, as described above, has to be $100,000 or less to do a traditional to Roth conversion. That limit goes away in 2010. I do plan on doing this in 2010. I feel my traditional, non-Roth 401(k) assets are enough to keep me tax diversified. I'll eventually write a post on how I'll be doing this, as I've been planning it since the laws changed in 2006.

Traditional and Roth IRA income limits increase

The income limits for full deductibility of a traditional IRA increases to $53,000 for single filers and $85,000 for joint filers. The income limits for full contributions to a Roth IRA increases to $101,000 for single filers and $159,000 for joint filers.

130/30 performance update

Long-short funds are down, but not as much as the S&P, says a story in the Journal (free WSJ Digg link).

Long-short funds are down, on average, about 4.2% over the past three months through Monday, compared with the Standard & Poor's 500-stock index's 11.4% decline, according to Morningstar Inc. The period roughly corresponds to the stock market's plunge from its Oct. 9 high.

In fact, long-short funds have performed better than every other category of stock funds that Morningstar follows during that period, except "bear market" funds, designed specifically to profit when the market falls.

Still, being down is being down.

Update: Random Roger had a post on the article.

Investing beyond emerging markets - the frontier markets

For those with the risk tolerance to handle them, frontier markets offer potential big returns (free WSJ Digg Link).

Long overlooked by all but the most intrepid investors, frontier markets are attracting increasing attention in spite of their small size and often patchy infrastructure. In terms of geography, they are a diverse bunch, ranging from quasideveloped markets in Eastern Europe, to oil exporters in the Persian Gulf, to countries in sub-Saharan Africa and beyond.

Bigger and better-known developing markets such as India and China are famous for their rapid economic growth, but a similar process is also unfolding in many out-of-the-way markets. The countries of sub-Saharan Africa, for instance, are projected to grow 6.8% in 2008, according to the International Monetary Fund, while Kazakhstan is set to expand by nearly 8%. Booming commodity prices, growing investment, and efforts to rein in debt have contributed to the rosier picture.

How an individual can get in

The article gives ways for individuals to get into these markets:

For individual investors, getting dedicated exposure to these markets is tough. T. Rowe Price Group Inc.'s three-month-old Africa & Middle East fund is open to small investors, as is a listed London-based frontier fund run by Progressive Developing Markets Ltd.

Mutual funds growing a pair

I prefer my headline, but the Journal's works too, in a story about mutual funds working for their shareholders' interests (free WSJ Digg link). The short of it is a T. Rowe Price mutual fund owned shares in a company that was being taken private. The Price fund manager thought the buyout price being offered for the company was too low, and then he waged a battle against the buyout offer. In the end he lost, but it's significant that he tried.

Early this year, mutual-fund manager Brian Berghuis learned that a company in his portfolio was targeted for takeover. Normally this would be good news. But when the T. Rowe Price manager examined the offer, he came to a different conclusion: The price for Laureate Education Inc. was so low it was "laughable," he says.

[...]

Better known for retirement accounts than rabble-rousing, T. Rowe Price is among a handful of mutual-fund firms that have loudly complained that some of the many recent management buyouts -- in which a public company's managers team up with private investors to buy out shareholders -- haven't been fair. In a traditional takeover by an outside buyer, they say, management's goal is usually to win the highest price for their company. But when managers buy their own operation, there can be an incentive to pay as little as possible.

[...]

Early this year, Fidelity Investments took a stand against a private-equity buyout of radio-broadcaster Clear Channel Communications Inc., and helped win improved terms that shareholders approved last week. After Lord Abbett Inc. and other shareholders opposed a proposed private-equity buyout of OSI Restaurant Partners Inc., which operates the Outback Steakhouse chain, the offer was sweetened; the enhanced pact won shareholder approval in June. In July, New York fund manager Pzena Investment Management helped thwart financier Carl Icahn's takeover of auto-parts supplier Lear Corp., rejecting the argument of Mr. Icahn and Lear's management that the price was fair in light of the challenges facing the big U.S. auto makers and their suppliers.

"Eventually, you just say you're not going to take it anymore," says Richard Pzena, the firm's founder.

Why don't mutual funds fight more often?

Critics say mutual-fund companies have dodged these fights in part to avoid offending companies that could be potential customers for investment services. Mutual funds deny that charge.

Fund companies say they've skirted confrontation for other reasons. There are regulatory hurdles. To monitor possible collusion, the SEC requires investors who own more than 5% of a company to register as either "passive" or "active." A passive investor isn't permitted to lobby other investors on matters that affect how a company operates or on votes in corporate elections. An active investor can seek to influence other investors, but those registering as activists are restricted from trading a company's stock for 10 days after filing.

Mutual funds are there for the benefit of their shareholders. Funds should always be fighting for better takeover terms. Stories lie these should be the rule and not the exception.

A money manager becomes an activist

What was behind Berghuis's decision to fight?

For 48-year-old Mr. Berghuis, who joined T. Rowe Price in 1985, the path to activism began in January 2006. That is when one of his holdings, Fairmont Hotels & Resorts Inc., announced a buyout involving a private equity group. The group offered to buy back shares at $45 apiece, a level that valued the company at $3.9 billion.

Mr. Berghuis felt Fairmont's valuable real-estate holdings, which included the 651-room Scottsdale Princess resort in Arizona, would make it worth $65 or more per share. T. Rowe Price went by its traditional playbook: It complained privately to the company, then voted its shares against the deal. The buyout was approved a few months later.

In July 2006, Fairmont's new owners sold the Scottsdale property for $345 million, while continuing to operate the resort. A few months later it sold seven other properties, roughly one-quarter of its portfolio, for $1.5 billion. Mr. Berghuis took the sales to mean his $65-a-share estimate had actually been low. "This was a heist!" he says.

I'm a realist. I don't expect all fund manager's to get religion and oppose sweetheart takeover deals. But it's heartening to see that there are principled ones out there fighting for their funds and the little guy.

ETFs try to elbow into 401(k)s

ETFs are attempting to make their way into 401(k) plans (free WSJ Digg link), a move that the mutual fund industry is pushing back on. According to the story, 14% of total mutual-fund money is 401(k) accounts, while only 1% of ETF money is in 401(k) accounts. Total mutual-fund assets are $1.49 trillion, while total ETF assets are $500 billion. The arguments the two sides are making are:

ETF providers blame mutual-fund companies, some which run some of the biggest 401(k) plans, saying their resistance stems from fear of competition. ETFs in general charge lower fees than average mutual funds.

Mutual-fund purveyors see it differently. They say that they already offer plenty of low-cost mutual funds that track stock- and bond-market indexes as most ETFs do, and that some of the most heavily touted features of ETFs, such as tax efficiency and flexible intraday trading, offer few advantages in 401(k) plans, which already are tax-advantaged and geared toward long-term investing.

The other challenge is the need to develop trading platforms to trade the ETFs in 401(k) accounts.

The logistics of offering ETFs also complicate things: ETFs can be bought and sold on exchanges like stocks, but most 401(k) programs aren't set up to process the trades. And because they trade like stocks, ETFs charge commissions -- costs that can diminish the returns of workers who make small, regular contributions to their retirement accounts.

[...]

To gain a foothold, many ETF providers are either building computerized "platforms" to support trading of ETFs within 401(k) plans or forming partnerships with companies that are. Some firms are devising solutions to minimize ETF trading commissions -- aggregating trades across investor portfolios, for example, to limit the role of stockbrokers and other middlemen.

[...]

Firms like BenefitStreet are trying to narrow that gap. The San Ramon, Calif., company, which runs about $8 billion in retirement money for more than 7,100 plans, started offering ETFs from Barclays Global Investors and others in June on a 401(k) platform it sells to client companies. Its approach involves aggregating ETF trades among, say, hundreds or thousands of employees, to diffuse commission costs. It eventually aims to send trades directly to stock exchanges, bypassing floor brokers.

Another small firm, Invest n Retire LLC in Portland, Ore., already trades directly with exchanges and has a patent pending on the method. Rather than bundle the trades, Invest n Retire processes them throughout the day with an automated system that executes them for a few cents a share. RPG Consultants of New York offers a system that places orders to brokers in bulk daily to help keep costs low.

Admittedly, I don't know all the details of how these systems work, but the aggregation and bundling of trades concerns me. One of the great advantages of ETFs is the ability to trade them like stocks, with near real-time execution of the trades. Another is the ability to put limit orders on ETF trades. Anything which would diminish these capabilities, which is what this aggregation and bundling sounds like it would do. I would suggest enhancing the individual stock trading capabilites already in some 401(k) plans to add ETF trading.

The story has some good nuggets of information about the retirement plan industry:

The plans held an estimated $2.7 trillion at the end of 2006, representing about 17% of the overall U.S. retirement market, according to the Investment Company Institute, a mutual-fund industry trade group. (About half of retirement money is held in defined-contribution plans, which include 401(k)s, and in individual retirement accounts, according to the ICI. The other half is in government pension and private-sector defined-benefit plans, as well as annuities.)

Just over half of the money in 401(k) plans was invested in mutual funds as of the end of last year, ICI statistics show, followed by investments in products offered by insurance companies, banks and other institutions.

The $1.49 trillion of mutual-fund money in 401(k) accounts represented about 14% of total mutual-fund assets in the U.S. at the end of last year. While assets in ETFs have more than quintupled to about $500 billion since 2002, less than 1% of 401(k) money is estimated to be in the products.

Rich get richer - this is not a capital gains tax rant

This week's Getting Going column in the WSJ discusses how 'wealth begets wealth' (free WSJ Digg link). Mass affluent consumers should be taking advantage of everything mentioned. Looking at the points made:

Financial-account fees. For instance, once you've built up some savings, you are less likely to get hit with bank charges, you will avoid the account-maintenance fees often levied on smaller brokerage accounts, and your mutual-fund company might waive its annual individual retirement account fee.

Keep over the minimum balance in order to avoid these fees. The minimum balances I've seen range up to about five thousand dollars. Also, I make absolutely sure that each individual account kept with a financial institution meets these minimums. Some financial institutions do a total balance across all accounts for fee determination, but some make the fee determination per individual account, and many mutual fund companies set up a separate account for each fund of theirs in which you invest. You could have hundreds of thousands of dollars with a mutual fund company, but if the company has a $5,000 per account minimum and just one of your accounts falls below that $5,000 threshold, you'll get hit with a fee. (Of course, you should call and complain to them and point out how much money you have with them if this happens.)

Even bigger savings could lie ahead. Fund investors with $25,000 or $50,000 invested may pay reduced commissions on broker-sold "A" shares. Favor no-load funds? If you have $100,000 in a Vanguard Group fund -- or $50,000 and you've been invested 10 years -- you can qualify for the firm's lower-expense share class. Similarly, Fidelity Investments offers lower-cost shares to index-fund investors with a $100,000 fund balance.

I'm not even going to get into how anti broker-sold mutual funds I am, so I'll skip that sentence. I didn't know the fact about the Vanguard no-load funds, but sure enough, when I looked at some of my funds' prospectuses, it says that you will get a break on annual expenses the more you have invested.

I'm skipping the part about credit cards because I don't carry a balance, and I wish it was within everyone's means not to have to carry a balance. Borrowing costs, ok,;buy car instead of lease; avoid PMI, yep. Next up, insurance, all right:

Insurance premiums. With your wealth ballooning, your tolerance for financial risk will rise. Before long, you may be comfortable raising the deductibles on your homeowner's and auto insurance, because forking over $1,000 or $2,000 toward fixing storm damage or repairing your crashed car will no longer seem like a financial catastrophe.

Automobile deductibles. My personal feeling on cars is that I don't need a big fancy nice car, and I have the highest possible car insurance deductible. I have some scratches and a cracked plastic panel on my car that I just don't care enough about to get fixed. I'd rather use the money on something else. Now, that will change, of course, when I can get a classic mint condition gas guzzling American muscle car, but I'd still take the highest possible deductible on that. (It's only coming out for Sunday drives. The enviro-liberal-commie in me won't let my childhood fantasies take over that much. Besides, I'll be washing and waxing it the other 6 days of the week.)

130/30 mutual funds

I ran across this article on 130/30 mutual funds in the Wall Street Journal (free WSJ Digg link). Its basic explanation of these long/short funds is:

A 130/30 fund may invest $100 in a basket of stocks, such as those in the Standard & Poor's 500-stock index, then short an additional $30 in stocks believed to be overvalued. That means the fund borrows $30 worth of those overvalued stocks, hen sells them in hopes that they can be replaced with cheaper shares later.

The article gives an indication that investing in these funds may be worthwhile for someone seeking alternative investments, but who doesn't have the money needed to invest in a hedge fund (such as the mass affluent segment).

It's too early to judge most of the 130/30 mutual funds. But Mr. Deutsch said initial results from separately managed accounts -- often run by traditional long-only money managers -- suggest the managers are beating their benchmarks and producing "alpha," or returns above those that a typical investor is expected to make based on market averages.