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 www.morningstar.com 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)."