Thursday, May 29, 2008

Investing IV

I ran into a person recently who was relentless with their "index investing" mantra. And let me repeat, index investing makes a lot of sense for those who do not consider themselves very sophisticated or those who do not want to bother with management. Your essential claim is "the general market's expectations are more accurate than my own would be." And that makes sense for some people.

Now I want to turn to portfolio strategy for a moment, then I'll turn to vehicles and useful tools. The strategy I laid out in the last post (mixing actively managed funds and passively managed funds) is called the Core/Satellite strategy. In this strategy you gain broad exposure by investing in index mutual funds for the majority, or core, of your portfolio. The core is usually made up of a Large-Cap U.S. index fund, a Mid-Cap U.S. index fund, an International Index fund, a Real Estate index fund, and a Bond Index fund. This should comprise about 70-85% of your portfolio. The rest is meant to be deployed a little more strategically in opportunistic or alternative investments. So what are some of those?

Emerging Economies: Tons of variety here. If you want Indian nano-tech, you can find a fund in that space. This could be a country or industry specific investment. Other up-and-coming countries to evaluate would be Vietnam, Ukraine, Scandinavia, Poland, Brazil, Mexico, and South Africa. You are looking for political stability, strong GDP growth (above 4%), currency stability (if the currency is pegged to the dollar, that is generally not a good sign. The country should have a market determined exchange rate), and a favorable business environment that enforces rules.

Infrastructure: Infrastructure is another interesting space. Infrastructure includes roads, bridges, utilities, airports, etc. The asset class will not give you as much up-side potential as investing in equity mutual funds because they are more conservative. But, they could dependably offer a return in the high single or low double-digits. Also, most infrastructure is tied to inflation (i.e. tolls, utilities, etc) so you can protect against potential rampant inflation. Inflation may not be your concern in the U.S. but it might be in Latin America. Infrastructure could give you meaningful exposure without the risk of losing big in the event of a massive peso devaluation.

Commodities: These include precious metals, timber, crops, and oil. Obviously these have been attractive areas over the last few years. And they are the only asset class that is negatively correlated with the S & P 500, meaning they do well with the stock market performs poorly (the opposite is also true). Commodity prices are tied to inflation, when inflation increases, so do commodity prices. There is also a strong demand component. Global demand is what really fuels commodity prices. As you might guess, developing countries like Brazil, India, Russia, and China are consuming more and pushing the global demand for commodities through the roof.

Clean Tech: Here's an area that has received substantial attention over the last couple years. You can reasonably assume that major dollars will continue to flow to cleantech. This is a very broad area that covers solar power, wind power, alternative fuels, green infrastructure, etc. However, the asset class is very dependent on political mandates.

You can make investments into any of these arenas through mutual funds. You could also use ETF's. ETF stands for Electronically Traded Fund. Their composition is similar to a mutual fund (pool of money spread across various holdings), but they trade like a stock. To this point, I haven't mentioned trading. Whenever you trade a Mutual Fund you have to wait until the close of business to get your price. So, if I decide at 9:00am to sell my mutual fund, I can enter (assuming you use an online account) the trade but will not know what the underlying price of my fund will be until the close of business. Many people don't like that. With an ETF, you can trade immediately and know exactly what the price is. They are also cheaper than Mutual Funds, with lower expense ratios. The downside? Everytime you buy or sell, you pay a commission (which is minimal). If you are one to actively trade, they probably don't make sense. But if you are the type to buy and hold, then they are a great option.

Some websites are very helpful in building a portfolio. I've mentioned Morningstar, but there are others that are equally as helpful. Here's a list.

Yahoo Finance ( Portfolio tracking and market news
Motley Fool ( Advice
Bogle Heads ( People will critique your portfolio (beware, not are all qualified)
AAII ( American Association of Individual Investors. Great site, excellent resource. You can become a member for a very small fee (I think around 20 dollars) and they will introduce you to various portfolio strategies with performance. They also put out a nice publication and list top finance websites.

There are thousands of others, but the ones above are a little off the beaten path. In my next post, I'll tie up personal portfolio construction.

Friday, May 23, 2008

Investing III, Picking apart a Mutual Fund

Finally I'll get to some of the finer points of personal portfolio optimization. One quick word about Stock picking first. I used the example of purchasing one share of stock in my previous post; well, you can't really do that. Stocks usually sell in lots of 100. If Citigroup is trading at $60/share, you need to fork out at least $6k. Again, that's why MF's make more sense (for most people).

What the Heck do all these numbers mean?!

Let's pick apart a mutual fund. Here's one from Morningstar's website; Fidelity Large Cap Stock. The name tells me that this is a mutual that invests in Large Cap (see previous post) companies. The "ticker" (used for referencing, is FLCSX). You can look it up yourself at by typing in the "ticker" in the upper left hand corner. Now, let me explain some of the salient terms you should definately know!

Front Load: None. What is a "load"? It's a commission. There are front, back, and no-load mutual funds. A so-called front loaded mutual fund is one that has a commission right off the top, usually 4-6%. So approximately 95% of your money starts working for you. A back-load is where you don't pay anything up front, but you do when you sell it (usually the same commission). No load means no commission, and no help. Meaning, most mutual funds that brokers offer will carry a commission, or, you are paying them for their advice. No load mutual funds mean you don't have an individual to talk to. Fidelity, T. Rowe Price, and others are all no load mutual funds. There is no dedicated advisor that you speak with.

Expense Ratio: .81%. This is your annual cost for the fund. This money pays the guy managing the money and his staff. Again, large cap mutual funds are generally cheaper. Expense Ratios range from .05% to 2.5% a year.

Minimum Investment: $2,500.

Standard Deviation: 10.9. This is a statistical term that measures volatility. Nevermind how you calculate it, it's the interpretation that matters. One "standard deviation" means that if you looked at the historical performance over a certain time period (in this case five years per the website), the returns of the fund would have fallen within plus or minus 10.9% of the five year average (which is 11.35%) 70% of the time. There's a good possibility (70%) that the value of your fund will be somewhere inbetween 22.25% and .45%. Obviously, for two funds with the same standard deviation, you want the one with the higher average, and given the same average, you want the one with the lower standard deviation.

Alpha: 1.71. Alpha measures out-performance, the higher the better. In other words, given the amount of risk the manager is taking, they are adding 1.71% of value through their skill.

Beta: 1.17. Beta measures the amount of risk they are taking. A Beta of 1, means they are taking the same risk as their index. The higher the Beta, the more returns will swing. So, if the market goes up 1%, this will go up 1.17%. If it goes down 1%, it will go down 1.17%. Again, these are all historical numbers that may not explain the future.

R-squared. 92. Another statistical term that essentially tells you whether or not you can use Alpha and Beta in analysis. If the R-squared is below 80, you should throw out Alpha and Beta as a means for explaining how your mutual fund will behave.

Number of Stock Positions. 185. You would own an interest in 185 publicly traded companies. Not bad for $2,500.

All this will help you understand a mutual fund, but how can you tell if your mutual fund is beating it's "benchmark?" A "benchmark" is an index.

Why You Need to Look at Indexes

Indexes are really important. What is an index? It's essentially a basket of stocks tracked by wall street that are supposed to represent a particular constituency. Here is a list of indexes that are most widely followed.

Dow Jones Industrial- Measures the stock performance of 30 U.S. Blue Chip companies.
S&P 500- Measures the stock performance of the 500 largest U.S. Corporations
Russell 1000- Measures the 1000 largest companies on the U.S. stock exchange (92% of all traded securities).
Wilshire 5000- Broadest index measures all U.S. equity securities.

The above are all U.S. indexes only. Chances are, your portfolio will track the indexes pretty closely. Which one should you follow? That depends. Obviously the Dow Jones, on its own, is not sufficient since it only follows 30 companies. If you're holding a portfolio of Mutual Funds, spread across various asset classes, you are holding thousands of securities. The answer is that your large cap mutual funds will follow the Dow Jones and S & P 500 fairly closely. Your medium and small caps will more closely track the Russell and Wilshire indexes. What about international?

MSCI EAFE- This stands for Morgan Stanley Capital International. The "EAFE," stands for Europe, Australia, and Far East. Your international mutual funds will track this one more closely, assuming you're in developed economies.

The key with looking at indexes is knowing what their constituents are. If you are properly diversified, no single index will explain your portfolio.

My Original Questions Was..

Why should you follow them? If I owned the mutual fund above, then my index would probably be the S & P 500. I want to know if the Fidelity Large Cap Stock mutual fund outperformed the S & P 500. Why? Because I'm paying for it (.81% a year). If the manager can't outperform, then I would rather just invest passively in the index and not pay anyone for it. Wait, you can do that? Oh yes....

Index Mutual Funds

One way to cut down on costs in your portfolio is to "index" your portfolio using "index" mutual funds. The premise for indexing comes from the aforementioned post on "efficient market theory." Which states that the market correctly prices every security, at any point in time, due to the transparency and availability of information. Adding to this is substantial research showing that most mutual fund managers will underperform their index, net of fees. There are mutual funds that are "passively" managed. This means they look at a certain index, i.e. the S & P 500 and do absolutely nothing but hold the exact same 500 companies in their fund. And for this, you pay a measly .05%. Much better.

There are many huge proponents of index investing. These people will quote tons of studies that illustrate what a rip-off advisors and money managers are since they can't beat the index and charge unnecessary fees. But I'm not entirely on board with index investing. In financial services, everything has a place and time. And there is definitely a time for active money managers. Indexing only makes sense for those asset classes that are very efficient, like Large, publicly traded, companies. But other asset classes have major inefficiencies (By inefficiencies I mean that it is possible for you or a money manager to know something that the general public does not). Inefficiencies increase as you move down in size (from medium to small and even micro-caps) and down in economic development (developing or emerging economies). Few analysts cover these areas and you can find some money managers doing very well in these spaces. With this in mind, a more efficient portfolio might look like this:

Large Cap: Index Fund
Mid Cap: Index Fund
Small Cap: Actively managed fund
Micro Cap: Actively managed fund
International, Large Cap: Index
Emerging Markets: Actively managed fund

Next up, "Beyond the Core (interesting opportunities and vehicles and the problem with Mutual Funds)."

Sunday, May 18, 2008

What to do with your money, Part II

Once you've taken care of the short term, how do you go about building a portfolio, and what instruments should you use?

First things first. You should take a survey that allows you to asses the amount of risk you are willing to bear. There are numerous surveys available for free to help you do this. Here's one from T. Rowe Price,,0,htmlid=904,00.html?rfpgid=8283

They mostly ask about your time horizon and your appetite for volatility. In other words, if you come home from work and find out that the Dow was down 5%, are you going to freak out?

Let's walk through the basics to portfolio construction. In the next post, I'll talk about how to understand and interpret the market.

I'm going to assume the long term here. In other words, I'm assuming you have adequate savings, and have paid off high-interest bearing debt.

Let's say after taking a survey, you (via the survey) determine that your asset allocation should look something like this: 50%Large-Cap U.S. equity, 15% Mid-Cap U.S. equity, 10% Small-Cap U.S. equity, 20% International Equity, 5% bonds. Now, let's stop there. What does all of this mean? 'Cap' stands for capitalization. This is calculated by taking the price of the stock and multiplying by the shares outstanding.

Large-Cap Companies: These are the largest companies in the world, i.e. Wal-Mart, Exxon, etc.
Mid-Cap Companies: Smaller than the large-cap and generally lesser known. But they are still huge. Examples include Starbucks and Abercrombie and Fitch.
Small-Cap Companies: Smaller than the mid-caps and fairly obscure. Still, they are very large with several hundred million in annual revenues. One semi well-known company is Ann Taylor (if you're not married, you probably haven't heard of it)
International Companies: Don't let these scare you. Most of these are very well-known in the U.S. Some large international companies include Toyota, Nikon, Rolls-royce, Bayer, Daimler, and Nestle.

Wait a minute, can't international companies be broken down further into large, medium, and small? Yes, but for simplicity, I will not do that here.

How do these categories react? Well, what you should be more concerned with is how they react to one another. In other words, if large-caps get slaughtered, will small caps as well? And if it's a bad year in the U.S., will my international portfolio also get slammed? That's the whole point to diversification, it isn't necessarily adding a ton of different holdings, but adding ones that do not correlate with eachother. How many times has the U.S. been the number one performing economy? Never! That's the argument for having exposure to international companies.

Tools to use

Mutual funds (I'll suggest some hybrids in my next post so don't run out and buy anything yet) make the most sense in trying to build out your portfolio. Why? Going back to my previous post, you can purchase one mutual fund that will hold 100 large-cap companies (or mid-cap, or small-cap, or whatever). If you want nano-tech in India, there is a mutual fund for that. If resources are tight, you could buy one mutual fund for each type of asset class and be done. Now, for this, the average mutual fund will charge anywhere from .5% to 2% a year, with small-caps and international stocks on the higher end (reason being more research goes into those asset classes). I'm being very general here, I will explain more in the next post, but this will do for know. I like morningstar's website the best (, you can register for free and get great information and search available funds.

Why I'm not a stock picker

Again, greater detail will be forth coming, but, in general, I'm not a stock picker and I don't think others should be. To be able to properly assess whether or not you are buying a company that is fundamentally worth more than the market is pricing it at (for this is the premise to picking stock of an individual company) you would have to know how to properly conduct a company valuation (which most people can't do) and have a very good grasp on intermediate to advanced accounting issues to locate potential trouble spots. And even if you could do that, the chances of you knowing something that hords of Wall Street analysts don't already know (when they travel in their Jet to meet with the CEO), are slim. Most likely, they've already priced the stock accordingly. This is called the "efficient market theory." Which says, the greater the transparency (the U.S. market is highly transparent, almost to a fault), the higher the efficiency which means the less likely it is that you will uncover something the "market" did not six months ahead of you. Does that mean the opposite is true (i.e. emerging markets)? Yes, now you are beginning to understand. I'll save advanced portfolio construction for the next post.

So what do we know now? We know that, taking a longer time horizon, we should have our money spread across multiple asset styles in order to hold assets that do not correlate with eachother or have a very low correlation. And, the quickest way to obtain excellent diversification is through mutual funds. And that I've deferred the 'meat' of the discussion until next time. Take a look around at some of the websites, it might make the next post more meaningful.

Now we have a basic introduction to portfolio construction.

Monday, May 12, 2008

Basic Investing

So I'm thinking I should actually write a post on investment strategy, since that's what I set out to do in the first place. But, I'm not sure where to start. If you're an "experienced" (defined as your mastery of knowledge and practice, not time) investor, then you could probably skip this post. I'm a little anxious because there are actually some very attractive opportunities out there that people should be taking advantage of (and it doesn't involve recruiting others and making $8million dollars a month without getting out of bed). I'll start with some vocab, and then, in a few days (I promise), I will follow up with some of those interesting opportunities. Then I'll conclude the 3-part series with some basic behavioral finance.

Basic terms.

  1. Stock- Stock represents ownership in a company. If the company does well, you do well. Likewise, if it performs poorly, the value of your stock decreases.
  2. Bond- A Bond represents a loan that YOU make to the company. In other words, a company may need $10million dollars for a new venture and they want to raise money for that venture. They issue bonds which means they will pay you for lending them money every year, and, at the end of whatever time frame (1,3,5,10 years), you get all your money back. So you get your money back and you get all the interest payments in the meantime. Whereas a stock is OWNERSHIP in a company, a bond represents LONERSHIP. What's the downside? Bonds are backed by the full faith and credit of the issuing institution. The more risky the institution, the more interest they pay you in the meantime (thus government bonds are considered to be the safest and pay the least amount of interest).
  3. Mutual Funds- Sometimes the cost of one share of stock or the purchase of one bond is prohibitive. For example, a share of Google may cost you a few hundred dollars. Or one bond might have a minimum face value of $1,000 dollars. Additionally, you may not like the fact that all your wealth is tied up in a few companies be it as a stock or bond. Mutual Funds are the answer. Nevermind the name, here is what they are. They basically pool everyone's money and buy in bulk. So, you may only have $1,000 dollars to invest. Well, you could own a few shares of Google, or, maybe, one share of Google, and maybe a few shares of something else. You could also buy one bond (maybe). Or, you could buy a Mutual Fund. Here, they combine your $1,000 dollars with everyone else and come up millions of dollars. Then they go out and buy shares, or bonds (usually one or the other, but not both), in several different companies (typically 100 or so) and you participate proportionately. Now, instead of only being diversified over a few companies, your spread across one hundred. Much more diversification. Which is an important term.
Where do you put money? How do you start? Here are my basic rules.

  1. Take the free money
  2. Short term savings. First things first, if you don't have 3 months worth of living expenses in a savings account you should do that first.
  3. Employee Retirment Plans. Some of you may have a 401(k) where you contribute 6% and your employer will match it (remember, you should do this. See rule number one). If you can't contribute the max, then start with whatever you can, because your employer matches.
  4. Roth IRA. This is a personal retirement plan. The IRS allows you to put a certain amount of money away each year that grows (without taxes) until you take it out (can't touch it until you're 60 without penalty). When you get to distributions, you don't have to pay taxes on them. This is a nice compliment to your 401(k), which you do have to pay taxes on when you take distributions.
  5. Brokerage account. This is where you open up that Fidelity, E-Trade, Scottrade, Schwab, T Rowe Price, account. You can buy and sell stocks or bonds whenever you like (but beware of extra costs).
As a note, 401(k)'s, IRA, and brokerage accounts are only shells--you still have to choose what to invest in (stocks, bonds, U.S., International, etc.)

Anyway, I'll get more detailed but I wanted someone with no experience to be able to read this and get a general idea.

Thursday, May 1, 2008

Private Equity, friend or foe?

Hectic week, easy post.

In order to understand the old, heavy-set, gentlemen (except on Fox, where, they've determined through scientific study, that when talking about money, people prefer to see women) that debate financial and market news, one should understand the world of private equity. And it's not too difficult to grasp but is so vital to our economy that I thought I would give everyone some insight into this very private world. You've probably heard buzz words in the news, or on the radio, maybe some terms like, "leveraged buyout," "Blackstone," "IPO," etc. First I'll explain the vocabulary, then move to economic factors that influence success of private equity firms, and conclude with advantages and disadvantages.

Private Equity is an investment in a privately held business. I know, no surprise, but many don't really understand what the alternatives are. Let me take a step back. Anyone can buy a share of stock. For example, if I fancy Microsoft, I can purchase one share of their company at any time and there is plenty of information available to help me analyze Microsoft. That's because Microsoft is "publicly" traded. What does that mean? It means the general public can buy shares and participate in the growth, or demise, of a company. In order to do this, Microsoft must follow very strict reporting and accounting guidelines so that the general public can make an educated decision since most people are not financial experts. O.K., good. How is private equity different again?

Who are they and what do they do?

Private Equity is an investment into privately held companies, so they don't have to comply with the excessive reporting standards of the SEC, and because of that, the general public can't participate. So who can? The SEC has determined that, because of the lack of transparency, only financially sophisticated and wealthy individuals/organizations can participate (in other words, you better know what you're doing). And they have a checklist to establish who may or may not be potential investors. Some privately held companies include AMC Theatres, Countrywide, Chrysler, IKEA, and Earnst and Young, to name a few. Rather than ownership being split up among millions of shareholders, private companies may only have four or five larger shareholders.

Some of the largest private equity firms are Blackstone, KKR, Caryle, Apollo, and Bain and Company. You'll hear about all of them in the news on a weekly basis. Now, here is where it gets a little tricky. These firms don't use their own money to invest in these private companies, rather, they mostly use debt and other people's money. And they will invest in multiple companies, here's how. Take Blackstone for example. Blackstone will say, "We think there are some pretty good deals out there, let's go raise some money to invest in these attractive deals." Blackstone decides they need approximately $10 billion to invest. Then they say, "We'll put in $1 billion and let's see if we can go find the other $9 billion from pension plans, college endowments, and large foundations." Once they come up with $10 billion in commitments they're ready to find deals.

Here's an example of how a transaction might work: Blackstone finds company A and offers $300 million (for example, $150 million could come from Blackstone's investors, and the other $150 million they might borrow from the bank) to purchase 51% of the company. This is called a Leveraged Buyout ("leverage," because that's what it's called when you use debt, and "buyout" because they are taking a majority). Once they take control, Blackstone works to improve the operations of the business with the intent to either sell it to someone else (for more than they paid), or take the company public (IPO, for Initial Public Offering) where they list on an exchange and offer shares to the public and comply with all the reporting guidelines.

What determines if they are successful?

  • Buying cheap. Isn't that how it works for everyone. Essentially, you want to make sure you bought the company at a very attractive price.
  • Access to Debt. Since they use debt to purchase these companies, the restriction of debt causes serious problems. That's why the credit crisis is affecting the large Private Equity firms. They can't get lending to purchase these companies.
  • An exit market. They have to be able to get rid of the company. A down market can really affect their two most promising exits; an IPO (again, offering shares to the public), or the sale to another firm. IPO's are hard because public investors do not want to invest in the new kid on the block when everyone is worried about the economy. A sale to another firm is hard because the prospective buyer may not be able to get lending from the bank to make the purchase in a tight market like our current one.
Are Private Equity firms good or bad?

There are two sides to the story. When private equity firms take over, they usually discontinue unprofitable or non-core business lines. This means job loss, which is never good. Conversely, some posit that private equity firms create better businesses in the long term. The argument here is that private companies don't have to be worried about quarterly earnings (as publicly traded companies do) so they can focus on building strong organizations rather than gaming accounting rules.

Anyway, hopefully this allows you to understand just a little more on the nightly news, or NPR.