The following aspects of each index are highly recommended to know. In fact, any savvy investor that got invests or going to invest using the index investing approach is well aware of the following facts. This is because stock indexes seldom represent the whole economy of the whole country and knowing them will assists in making a wise decision about index investing.

For every index that you are going to invest in using either index mutual funds and/or exchanged traded funds, know the following,

1. How many companies or other types of securities are included in the index at any one time?

For example, the S&P 500 consists of 500 listed companies. Some of the index like Dow Jones Industrial Average and Singapore Straits Times Index contain as little as only 30 companies, no doubt that they are blue chips in their respective countries but actually not really diversified as there are eventually only 30 companies.

Knowing the number of companies or other kinds of securities like bonds is essential if you want to be aware of the levels of risk that you are exposed to. All things equal, more companies means less risk and less companies means higher risk. That is only in the case of all things equal.

Since there are many indexes nowadays, with number of stocks ranging from 30 to hundreds to thousands of both stocks and bonds, further differentiated by market capitalizations and industry sectors, then depending on your risk tolerance and knowledge levels, there will be many low cost index mutual funds and exchange-traded funds to choose from.

2. What are the objective criteria for including a company under the index?

How well your index investments do depends on the index, it can never do better than the index, especially after deducting fund expenses, though much less than actively managed mutual funds but still got some expenses.

Knowing the criterion is important since the returns of index funds/exchange-traded funds does more or less depend on what companies are included under the index.

3. Majority of the companies generate their revenues in which country?

Since an index usually contain many companies and other securities like bonds operating under one country as in their revenues and hence ability to fulfill debt obligations of bonds as well as returns from net profits depends very much on the general economic and political conditions of that country.

For buy and hold investors, I will put up in a separate post how long the bear market in each country last for the past 100 years, so that you can take the average of the bear market period and enter the market like for example, 4 months after the stock market tanked in order to get the best price for stocks. It is impossible to know where the exact bottom lies for both stocks and real estate, but at least know when prices are lower.

In that whether an investment in stocks or real estate will do well 10 years or more depends on jobs, income and population in that country, i.e. the demographic profile. Who is going to buy the goods and services if there are much lesser people than now more than 10 years later? If they are no people or significantly less, then who is going to buy the stocks from you 40 years later? But if there are too many people now, prices of real estate will jack up too much and it will be worse 40 years later when majority of people become old and the country can no longer sustain an even more people since the high number of working adults imported now will have become old and need an equal high number of working adults 40 years later. Worse still, that is when people need to cash out from holding in stocks to pay for living expenses.

Index investing is different from owning individual stocks in that the financial statements of a company matter much less but other factors like that mentioned here matter much more, since you are literally investing in a lot of companies.

For example, though the stock market in general for Japan did not do well for more than a decade, prices of Toyota and Honda stocks are in opposite directions in the same period. You need to use different parameters when exposing to equities through direct stock ownerships or index investing. In addition, there are different yardsticks also for active managed mutual funds.

4. What is the turnover rate of the companies under the index?

Given the sheer volume and amount of dollars invested in index funds and exchange traded funds tracking S&P 500 and other indexes nowadays, a high turnover rate of companies in this index means that there will be higher trading costs involved that will eat into the fund expense and ultimately increases expense ratio.

5. What is the total investment dollars invested in that index?

A large amount of masses investment dollars in a particular index, for example, the S&P 500 got more dollars invested in it than all other indexes combined, simply means that once the marginal companies in that index changes, there will be large increases in the stock prices of the companies that are going to be included in that index and corresponding large decreases in stock prices of companies going to drop from the index. The simple reason begin that the fund managers need to sell previous holdings of companies that are dropped from the index and vice versa, need to buy shares of companies in that index.

Other than general market timing like enter the market some time after stock market tanked, buy and hold investors holding for 10 years or more, you may consider when the turnover occurs and the time lag between companies are changed in that index and the index funds/exchanged-traded funds sell the unlisted companies and buy the listed companies of the index.

One major downside in index investing is that when the dollars invested by the masses and general public is large, as it is already now and will be even more in future, especially for marginal companies that got include in S&P 500 this year and exclude from S&P 500 in the other year, fund managers of index funds and exchange-traded funds tracking S&P 500 will usually ended up buy high for company entering S&P 500 and sell low for company leaving S&P 500. However, do take note that the benefits of index investing far exceeds this downside and the fact that there are other indexes with lower turnover and dollars invested, hence this only downside will be kept even lower.

Speculators can intelligently speculate on this possible fact but check the historical data first to ascertain this and keep in mind that past results does not equal to future performance.

Related posts:

1. What is a good index for index investing?
2. How to choose from among so many Index funds and exchanged traded funds?
3. Danger of leveraged and inverse index funds and ETFs

However, by basing your decisions on which fund to invest simply only on a fund’s historical return is in my opinion, not a very wise action to take. Mutual fund companies know that know that past returns sell funds, precisely is the reason why advertisements in print media like newspapers and financial magazines specifically show past returns. Most may not find it easy to believe, it is actually the low expenses of a fund that is more predictive of its return, though a fund’s return is still to a certain extent reveal to you whether it is worth owning. To make an informed decision on whether a fund is good to invest for you, you need to take note of the following points,

1. What is return anyway?

We talk about returns in businesses and investments, and in many finance literature. And when we invest, we want returns, it is therefore important to know the definition of two types of returns commonly used in many places. These two are total returns and annualized returns.

Total return is simply that capital gains (or losses) in the market value of the stocks and/or bonds that the fund owns and the income that is received from those stocks and bonds. Stocks got pay dividends, though not every regular interval got, unlike bonds got a relatively stable income from coupon payments every six months.

In equation form, the total return is,

Total return = capital returns + income returns

There is another return terminology that is related to total return. An annualized return is return expressed in percentage form, over one or more years. It is sort of an average return over a period of time. The period of time can be 3, 5 or 10 years and annualized return takes into account compounding effect. A fund with a four years annualized return of 8% does not mean that it made exactly 8% every year of course since that is almost impossible in reality for a mutual fund managed by humans and given market conditions. It may made 12% in year 1, lost 29% in year 2 and then return another 40% in the last two years. The annualized return means that if you buy into the fund during year 1 and hold on to it until end of year 4; you would have like earned 8% every year on the initial capital.

2. Long term returns matter, not short term high returns.

In many mutual funds advertisements, one usually does not discover their advertised returns for more than 8 years as the figures may not look good. You need to look at the fund’s returns for at least the past 5 years and compare it with two types of benchmarks, namely its respective indexes and funds that invest in the “same area”, in order to have a better perspective on performance. For instance, almost every technology funds clocked impressive returns during the dot com bubble, lasting a few short years but their long term returns are dismay ever since the dot com bubble burst.

A fund that performs not that well in one year but do good in more than 5 years is not necessarily a bad buy since even Warren Buffett does not achieve a 20% return every year but its annualized return ever since the inception of Berkshire Hathaway is more than 20%. In the extreme end, it is not advisable to invest in a fund that performs poorly consistently over many time periods again since Warren Buffett also did not do worse than the market for most of the last 30 years.

In many cases, it is the fund manager behind the fund that matters or responsible for producing superior returns, If the feller dies or jump ship and work in other mutual fund companies, then the satisfactory return in the past 10 years will most probably not materialised in the future.

3. Indexes as benchmark to compare mutual fund returns

The most commonly used yardstick for comparing how well the mutual fund managers do their jobs is simply by comparing fund’s return to its related index. Almost every fund’s shareholder report compares its returns to one or more indexes, the misrepresentation comes when a wrong index is chosen for comparison, and it will be like comparing apples with oranges.

Stocks are classified based on many parameters, the most common of which is their market capitalisations. The S&P 500 is a good index to benchmark against when the active managed fund focus on large cap and Brand Name United States Company. Although it may not be that ideal also, since the S&P 500 index is built in such a way that companies with larger market cap make up a larger percentage of the index and hence, the performance of companies like Microsoft and Exxon Mobil and General Electric will be reflected in S&P 500 also.

Given that small cap and large cap usually go their separate ways in terms of performance given any time periods, one commonly misrepresentation used by some mutual funds companies is that comparing a large cap value fund performance with Russell 2000 – index made of small caps when it does not do well relative to the large caps index and/or its similar peers. As a result, you have to ensure that an appropriate index is used for comparing mutual funds performance.

4. Peer groups as benchmark to compare mutual fund returns

Peer groups in this case mean other mutual funds that invest a large part of in the “same area”. The same area in this case does not only refer to geographic area but also cap size, value or growth, sectors, and maybe other less commonly used parameters like dividend yields.

In some cases, using indexes only may not be effective or even non applicable, a fund that invest in technology stocks in the United States may perform worse than the S&P 500 but this index is diversified into many different sectors and the technology fund did not load up on financial stocks before the economic crisis of 2008, and hence may not do well relative to S&P 500 during years 2006 and 2007. As a result, comparing to other mutual funds that invest in technology stocks makes more sense in gaining into insight of its performance.

5. Beware of chasing after returns

I know that it does not feel good watching your large cap fund achieving negative returns or lag seriously behind other categories. This happens during the dot com bubble when technology funds do very well relative to old economy stocks. But by the time you jump inside the bubble is already waiting to be burst. In other words, there are really no clear signals on when to buy and sell this or that hot fund. When it comes to mutual fund investing, it is better to be a contrarian investor, when everyone is investing in a fund category, that means that category is about to cool off and when everyone is selling in another fund category, that means it is about to rebound to some higher prices. Note that contrarian investing does not always applies to individual stocks as some times, prices drop and remain low due to fundamental business reasons whereas a mutual fund usually holds quite a large number of stocks from many different companies. There is one investment company that blindly jumps into buying large stakes in Australia ABC Learning Centre because it is like what Warren Buffett is doing when American Express prices fall due to a scandal.

In view of the pitfalls of chasing after this or that hot fund, it is recommended that most investors construct a portfolio of funds in different categories so that in any market conditions, there are some portions of your portfolio that aren’t do too bad.

6. How much do taxes reduce returns?

There is a saying that there are only two certainties in life – one is death and the other is taxes. Returns are mentioned earlier but that does not account the “take home pay” after taxes. When capital gains are realised and income is received from either dividends or coupon payments, you have to pay taxes on them. Investing in what type of funds depends on whether you are investing through a taxable or non taxable account.

Related posts:

1. Risks inherent in mutual funds
2. Is investing in POSB’s MyHome Fund wise?
3. Essential 7 guidelines for actively managed mutual funds investing

The stated asset allocation model is based on a single assumption.

As will be expected from historical data and the causations behind, trends favouring either small or large caps will continue for at least a few years most of the time.

As a consequence of the above, there is only one simple rule to follow when doing asset allocation between small and large caps, which is to cash out from current holdings in small or large caps and invest in either one that returned more in the preceding year. The challenge now lies in choosing suitable benchmarks and ETFs that tracked them for use in this simple asset allocation exercise between small and large caps. The first step in implementing this asset allocation model is to choose a suitable benchmark to represent both the small and large caps respectively. There are two factors to consider for choosing the best benchmark for doing this asset allocation exercise. The first is that it is best or even essential that the indexes contain almost all the listed small and large caps stocks listed on the various stock exchanges as the fundamental reasons for the large differences in return between small and large caps is due to four reasons affecting their earnings in various economic climates. Indexes like the Dow Jones Industrial Average and S&P500 are definitely not a good representative of the whole large caps stocks due to their relatively small numbers of large caps include compared to how much large caps there are in the whole country. After which is choosing the index that has the longest history. Finally, still needs to choose a suitable ETF that track the index chosen from among many others.

When the above mentioned steps have been done, the next is to analyze historical results and see whether historical data conforms to this theory for the case of your country. For the sake of illustrations, we will choose the Russell 1000 for large caps and Russell 2000 for small caps. With these two indexes or benchmarks in mind, then take the following steps to decide which market caps stocks to invest in.

1. For simplicity, we will use the last day of the calendar year, as in last trading day of the calendar year to ascertain the total returns.

2. There are only two possibilities, either the small or large caps returned more, which to invest in for the coming year will depends on which one return more for the preceding year. For instance, if small caps returned more at the end of the year, then continue staying invested in small caps or switched to small caps for the coming next year if hold large caps currently.

We can analyze the results from past returns data, compare and contrast two investing strategies, having a fixed asset allocation and holds small and large caps all the way, that is buy and hold for a really very long term versus a slightly more active method but still not active to the extent of spending your life watching stock tickers of basing investment decisions on which market caps returned more during the year at the end of the year. That is if you observe, will give significantly higher returns than just simply buy and hold.

Translating into physical actions by implementing the above asset allocation plan with ETFs,

There are some slight differences between the returns of indexes and the ETFs that tracked them, returns from market indexes do not consider tax effects and distributions from capital gains when the ETF involved needs to sell a stock when the company is removed from its index, though it does includes dividends and that capital gains distributions are relatively minor. In addition, see that ETFs historical and current price information can be easily obtained from Yahoo Finance or other similar websites. Do take note that ETFs returns will match pretty close to but still less than their underlying indexes since there is this expense ratio, though still much smaller than actively managed mutual funds.

In conclusion, the reason behind this asset allocation is to increase returns significantly relative to just buy and hold a fixed percentage of asset allocation between small and large caps for decades, without corresponding increase in risk. Another crucial point to take note is that in any statistical game of chance, one still needs to stay in the game long enough to reap its rewards, even if the odds is in your flavor. In this case, as you can find out for yourself, by following the above two steps or strategy, you will be correct around 70% of the time, from historical data, a pretty high success rate. But to be correct 70% of the time, one needs to follow the strategy consistently through the decades. But since past performance is not guarantee of future results and if you are a high net worth individual, there is no need to do this asset allocation using 100% of funds intended to invest in equities. Like if worth more than $10 million and got $5 million invested in stocks, can use $1 million or less for this particular asset allocation model.

Related posts:

1. Why doing asset allocation between large and small caps is better than not doing so
2. Concepts in managing portfolio and asset allocation
3. Exchange Traded Funds 101 – a simple introduction

Professional wealth management is really a great business to be in, just look at the number of financial advisers on the streets, gathering contact numbers for financial consultations. Investors tend to be less aware of the relatively large figure spent in asking someone to manage your money. The reasons are not hard to understand, there is no bill or receipts showing how much you owe for managing money, fees are even out during the year and investors’ tendency to focus on returns since at any given year, there is a good chance that the returns are either significant larger or smaller than the costs of management. However, please know that these fees being not small in the first place, will add up to quite a lot decades later, given the compounding effect.

There are costs in managing a fund, be it active or passively managed, these costs are, including but not limited to, management fees, administrative expenses, marketing and distribution costs. A particular fund’s expense ratio basically tells you the percentage of a fund’s assets that is used to cover all the various costs as listed out above. A $10 million dollars mutual fund with 1% expense ratio means that it is charging all the shareholders of that fund $100 000 each year to manage their money.

1. Considering expense ratios

If all the fund’s expense ratios are the same, then there is no need to think much about this point. The fact is that not all the fund’s expense ratio are the same, or not all higher expense ratio translate into equally high quality management. Do take note that the highest expense ratio in the world does not have the best fund managers; neither do the lowest expense ratio has the lousiest fund manager.

Most investors tend to look at the charts showing all the wonderful past returns and assumed that since the fund can achieve great returns and more than enough cover its higher expense ratio, there is no reason or at least a good chance that it will be able to in the foreseeable future. This is a reasoning fallacy that you should overcome if you were to attain greater wealth, as the rationale behind is simple to understand. The statistics is that for every high cost fund, together with higher risk, that managed to make great returns, there are at least ten more others who fail. But those who fail get sweep under the carpet, television and other forms of mass media rarely give coverage to losers. This is like you always hear success stories of Bill Gates but there are many others who fail in businesses and never to succeed in making millions throughout their life and that only lottery winners receive press coverage, but not the millions who win nothing. Funds that kept losing most probably close down already, where got let you see the past returns and feels impressed by its track record.

In general, expense ratio seldom if ever changes with time passes, as a result, they are one sure indicator of future returns since with the effect of compound interest, a fund with much lower expense ratio generates much greater return for the same annualized return over more than 20 years period. The difference between a cheap and not so cheap fund does not add up to a few dollars for a cup of Starbucks coffee after more than 20 years, the difference can be a few thousands or more, depending on your investment capital. This is not a hypothetical situation; in fact, this is what happens in practice also. A study performed by Morningstar shows that for all categories of mutual funds, funds with lower expense ratios already outperformed those with high costs over a five years period already.

There is an implicit assumption that if you want higher quality, you have to pay more. A belief that most people, including myself holds for other things in life, but this is not the case in the universe of mutual funds. The probability that an outstanding individual runs a low cost fund is actually around the same as a fuck out manager running a much more expensive fund. Anyway, there are many examples in other aspects that paying more does not translate into higher quality, one does not have to look far from at Windows and Linux or even the government of a small city state.

Always check the expense ratio of the funds you intend to buy or already own, if there are some that are more expensive than what is the norms for their respective categories, see and check whether you can switch to a lower annual fees alternative.

2. Knowing the market rate for expense ratios

By right, economically and theoretically speaking, one should not pay more than is necessary for a given mutual fund type. In general, the lower the expected return of a particular asset class, the lower one should fork out in expense ratio or annual fees. This is not hard to see, fund managers know that it is not easy to beat other fund managers when it comes to bonds and the fact that it really does not take much time and effort to select triple A bonds with the required maturities. As trading of bonds is mostly done by institutional investors, and institutional investors are people with first class honors degree from Harvard or MIT (the institutions is staffed by people with that qualifications), it is easy to see that why there are relatively few opportunities to achieve returns by a big margin than other fellow fund managers. As a result, for a bond mutual fund, there is a very good chance that funds with much higher annual fees do worse than those with lower annual fees.

In general, you should not invest in a bond fund with expense ratio higher than 1%, as the total return is likely to be in the area of 5% return. If the fund cost more than 1%, you can see that the return can go very low, coupled with the fact that it is unlikely the fund manager can do much work to justify the higher than 1% fees, even for bond funds targeting emerging economies.

3 Keep a lid on sales charge

For those uninformed, sales charge is the upfront cost when buying a mutual fund, though there are other cost structures associated with mutual funds. Let us look at the following distinct cost structures of mutual funds and some advices on which are suitable in which circumstances.

a. No-load funds

No-load funds are simply those that carry zero sales charge, meaning to say that there are no fees levied when buying and selling. This is suitable for those who can build an outstanding portfolio in a one man show, all by yourself. But there are people who are not very familiar with asset allocation and the time to constantly monitor portfolio, especially if you are an A list celebrities like Tom Cruise, top surgeons or lawyers with obscene income. In this case, paying for a good financial adviser or broker and spending on sales charge will be better and wiser.

b. Front-end load funds

The name already tells us that for this type of funds, sales charge is simply the upfront cost. That means if you invest $1000 and the load is 5%, you will ended up paying $50 in sales charge and investing $950 into the fund only. This type of cost structure is suitable for long term investors who purchase through a financial adviser or broker, if and only of the annual expenses is low enough to justify the higher upfront commissions.

c. Deferred load funds

The name also tells you that there is no sales charge at the time when the fund is bought but of course the sales charges is still going to be charged on you, later when you sell the fund. In addition, the sales charge decrease each year that you holds on to the fund. But this is only one side of the equation, there is still another side which is its annual expense, deferred load funds usually include high annual fees commonly known as 12b-I fees which contribute to the fund’s expense ratio. The high priests of finance like brokers like to sell this type of mutual funds and kept emphasizing on its favorable sales charge structure because they receive income every year from this 12b-I fees but these high annual fees can drastically reduce returns even though the sales charges deal sounds like a good deal. In general, front-end load funds have lower 12b-I fees and hence lower annual fees.

d. Level load funds

They have either zero or relatively low sales charges and a level 1% annual fees which may be high for a particular fund. They are more suitable for a very short term investor and definitely not good for a long term investor. With totally no sales charges, a short term investor can buy and sell in short time period in a volatile market and make quick buck.

Last but not least, for every load fund, there will be a no-load alternative.

4. Be aware of hidden costs

Other than obvious and stated costs like sales charge and annual fees which is the expense ratio, there are two types of hidden costs that can be a large drag on bottom lines. These two types of hidden costs will of course eat into your return, though they are not included inside expense ratio in the first place.

a. Market Impacting Costs

There is a difference between fund managers selling large blocks of share and small files like you and I selling a few lots of shares from time to time. For a large block of shares that belong to a single company, selling it in a matter of few days’ means that there is a high chance that the selling price is less advantageous with each lot being sold, the reason being that of simple supply and demand. At any one time, only a finite number of people will want to buy the stocks of a company at a certain price. If there is an increased supply of shares, offer prices have to drop before other the same or other buyers will want to buy as they also have finite money for purchasing them. In other words, if only around 1 million shares of a stock changes hand on a day and the fund manager needs to sell 10 million shares as a result of some strategies that he is using, it will take him at least 10 days to complete the transaction. In addition, by flooding the market with oversupply of stocks means that the sales price becomes less and less.

Since market impacting costs are so called hidden costs or more hidden than stated sales charge and expense ratio, the only way to discover whether a particular fund is at a higher risk from higher market impacting costs is to based on three characteristics. First point to take note is that small caps have much lower trading volume and outstanding shares; hence funds that focus on them stand a good chance of impact market costs reducing returns. Second is that fund with larger asset base will of course have more of this problem than that with smaller asset base, the rationale behind is easy to understand. A fund with a large asset base will have a much greater number of outstanding shares to buy or sell for a given company’s stock or bond than one with a far smaller asset base. Thirdly and lastly, for high turnover funds that trade too much, it is not difficult to see that they stand an excellent chance of experiencing more of this market impacting costs.

c. Brokerage Commissions Costs

When we buy and sell stocks, we need to pay brokerage commissions. When fund managers buy and sell stocks, they also have to pay commissions. By right, since fund managers trade in far larger volume, they should be entitled to volume discounts, but there is a practice known as directed brokerage which regulators of financial industry banned a few years ago in the year 2004, whereby funds opt to pay more for the trading fees in exchange for placing their mutual funds on the brokerage’s preferred list. Some may still preferred to pay more for research data as of now, though the research data may at the end of the day be useful in achieving higher returns for the fund involved.

5. Strategic Tax Consideration

You can choose to buy mutual funds through yourself which is taxable or a tax shelter vehicle like 401(K). In the simplest sense, it is wise to buy mutual funds with high turnover rate through tax shelter vehicle like the 401(K) instead of through yourself. Vice versa, considering holding municipal bond funds, low turnover funds and mutual funds that are tax managed by yourself and need not through 401(K).

Related posts:

1. Deciding between actively managed mutual funds and passive index funds
2. Essential 7 guidelines for actively managed mutual funds investing
3. Are you aware of what your mutual funds own?

Why it is that market capitalization of companies affects their performance in various economic climates?

While it is a fact that both small and large caps represent a wide range of industries, with so called different performances in different economic and financial conditions. The following four factors do affect the relative performance of both small and large caps stocks, as can be seen historically. As a result, it follows that the same effect by the same causation will persist in future.

1. Rate of growth in corporate profits

Small caps have a much greater sensitivity to changes in main factors affecting profitability, one of which is labour costs, a slower rate of growth in labour cost translates into much greater profitability of small and medium sized businesses than is for the large ones.

2. Broad economic conditions and growth

During times of strong economic growth, small caps and their stocks are benefiting more than large caps. In other words, they are able to expand more rapidly than large companies. In the reverse sense, during recession, small businesses faced a higher chance of failure and/or their earnings shrink faster.

3. General credit conditions

Businesses seldom don’t need credit from banks and financial institutions to operate. Even large, cash rich companies like Microsoft still got make a bank loan, for reasons of leverage while small and medium businesses are no choices have to borrow money. When times are good, banks are more likely to lend to small companies without too high an interest rate or premium, relative to a large and well known company with strong balance sheet. This can be seem before the subprime mortgage crisis, whereby any Tom, Dick and Harry can loan 100% to finance the purchase of a house, which ultimately causes the subprime mortgage crisis. During periods of financial crisis, prolonged recession and great depression, banks and financial institutions are very reluctant to make loans to small companies, especially just after getting burned, like after the economic crisis during the year 2008. Large companies during hard times are relatively easier to get loans as they are generally perceived to be more stable.

4. Local, regional and international political stability

Theoretically speaking, at least according to this feller, Pradhuman, in his book called Small Caps Dynamics, large caps are good defensive stocks during periods of local, regional and international instability. Common sense will tell you that when the Earth is stable, the general public will feel safe investing in riskier assets such as small caps as they are also potentially able to generate higher returns. However, what is supposed to be true theoretically may not be true sometimes, due to unknown reasons. For instance, after the 911 incident, small caps unexpectedly perform better than large caps until end of the year 2006.

The four conditions result in differences in performances of small and large caps such that periods of time that flavours either of them can last a few years so that you can recognise the trend and profit from it. As you shall see from historical data, there is really a large disparity between returns from large and small caps for any given year. Fortunately, there is a simple asset allocation model that any person of average intelligence can used to increase overall returns from wise and timely shift between large and small caps stocks, no need to have first class honours.

Related posts:

1. A simple asset allocation model for deciding between small and large caps
2. Concepts in managing portfolio and asset allocation
3. A more comprehensive analytical framework for analysing asset classes

Warren Buffett’s million dollar charity bet

During the year 2008, Warren Buffett famously made a million-dollar bet with a fund that consisted of hedge funds, net of fees, an S&P500 index fund will beat the expensive hedge fund over the next 10 years. The winner can decide which charity the one million dollars will be donated to.

It is a well known fact that the sage of Omaha once rejected a $2 bet in a golf course when the odds are not in his flavor, what caused him to have such a high conviction that most actively managed mutual funds, not only hedge funds will do worse than the markets in the long run like 10 years?

Bill Sharpe, a Nobel laureate, wrote a very common sense paper in 1991 that the average dollar invested in the stock market from all the investors will equal the market’s return minus expenses. This is a simple mathematical fact, the conclusion that the market must equal itself. Think about it, if MacDonald is still there 10 years later, any exchanges of its shares among investors during these 10 years will not and does not affect the underlying economic profits of its businesses. The price of Macdonald’s stock 10 years later depends on what investors are willing to pay for it 10 years later regardless of how many exchanges done between investors themselves during these 10 years – the market must equal itself.

In almost every marketing message of actively managed mutual funds, there is always this message of “long term investing”, however, this is not always what the fund does in reality. The fact is that if the fund will to do better than the market, the fund managers cannot simply buy and hold, in doing this, the funds will most probably achieve market returns, and then you don’t really need their expensive services. You can buy and hold on your own. As a result, they need to constantly trade securities. However, this will increase transactions costs, though their costs of buy and selling stocks are less than what we paid through brokers. This results in turnover of more than 100% in any one year when they tell you about the benefits of “long term investing.”

But how can your fund manager beat the market when fellow fund managers are also as smart as your guy?

The conclusion is that the reality of the funds contradicts their marketing messages of “long term investing.” And when you trade too much, you are subjecting yourself to Newton’s fourth law of motion, which states that returns decreases as motion increases. (Be it an average person or a fund manger with state of the art software and Bloomberg terminals)

Next look at all the costs associated with an actively managed mutual fund, initial fees, management fees, expense ratios, A much higher return is required to be generated by fund managers given that after paying so much costs, I think one cannot expect just a positive return that is around the same as bank fixed deposits, nor even market returns (as you may as well invest in index funds).

The problem is that actively managed mutual funds need to generate a 50% more return than the market just to give a decent return, as need to deduct all the initial and ongoing costs. For example, if only got 10% return, net of costs, most probably the return is less than market, though still a positive return. Anything less than maybe 6% return of the fund means that you have made a lost investing in it.

Any return less than that means that one will be better of investing in passively managed index funds.

You can look at historical returns of some mutual funds/unit trusts in Singapore and United States to justify what I said.

Of course, this is inconclusive that every active managed and high cost mutual funds will do worse than the market but the odds are there given the causations and what history tells us.

Assume the following for a fair comparison,

1. Using a holding period of 5 years

2. The mutual fund/unit trust has an initial charge of 6% and annual fees of 1.5%.

As you can see, the professional fund manager needs to achieve average return for these 5 years of 7.5% to match market’s return or investor’s return of 5%, which is around 50% better.

What are the odds of that, coupled with all that I mentioned?

In the next post, I will further elaborate on market cycle investing using index funds rather than buy and hold until cash out 40 years later. This will significantly increase returns than just simply buy and hold index funds.

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1. Essential 7 guidelines for actively managed mutual funds investing
2. How to choose from among so many Index funds and exchanged traded funds?
3. Danger of leveraged and inverse index funds and ETFs

When considering investing in any of the major asset classes, it will be wise to see through the above mentioned perspectives so as to identify major trends, length of these trends and how these trends affect asset prices in terms of extend and magnitude. Savvy investors should consider all the following modes of analysis for better investment performance.

1. Social conditions analysis

There are many aspects of a country that affects the prices of assets in that country in both the long and short run, not only commonly used factors like interest rates, price-earnings ratios or present value of future cash flows of an asset. The overall economic health of a nation consists of political, social, financial and economic spaces that are not mutually exclusive to one another.

For the case of political space, conditions favorable to rising asset prices are including but not limited to credible legal and regulatory frameworks, privatizations of assets, checks and balances, and of course respect of human rights of the general populace. In contrast, nationalizing of assets and unstable political environments leads to declining asset prices. In the economic domain, more integration into the world’s and regional markets, with increases in living standards over time and rising GDP points to favorable asset prices. In reverse, reducing domestic consumption, savings and investment in businesses as a whole leads to drop in value of assets.

In addition, economic policy of trade barriers and declining standards of living for residents will be destructive to assets generating income from the place. For financial realm, efficient financial markets would promote the formation of capital for investment, coupled with free markets.

2. Market cycle analysis

Be it stocks or any other asset classes, you seldom see their prices remain stable throughout the time. Not only equities, but other assets like bonds, gold, silver and commodities go through market cycle characterized by five distinct phases. In general, at each stage of the market cycle, people valued assets differently. People don’t always value a piece if financial asset by their discounted cash flows or fundamentals like supply and demand of the products and services that the businesses are procuring. There are times when other factors like liquidity and psychological play a part.

There are three major factors that determine asset prices. They are psychological, fundamentals, technical and valuations. Psychological simply means investors’ emotions from greed, fear, panic to euphoria while valuations means things like present value of future cash flows and riskiness of future cash flows. Technical factor refers to the attractiveness of an asset comparing with other assets.

i) Bear market

At this stage, investors are more affected by psychological factors. That is why one can find various blue chips sell below their intrinsic values when there is a bear market.

ii) Bottoming

This basically means bottom of the market cycle. Note that there is no way for a normal person to determine when bottoming occurs exactly and accurately every time.

iii) Early stage recovery

At this point, the bottoming prices lead investors to buy at a bargain, hence lead to a small rally.

iv) Middle stage bull market

During this stage, fundamentals and valuation of intrinsic value of assets will be reflected in the prices. In other words, reversion to the mean will occur much more frequently during this stage of the market cycle.

v) Peak bull market

This is similar to the bear market in the sense that rational valuations are thrown out of the window and people’s greed elevates prices to high levels. Formation of asset bubbles and high price-earnings ratios are the norm.

3. Financial analysis

Financial analysis simply means to determine the value of a financial asset, be it exotic investments like art and wine, stocks, bonds or real estate. Be it investment research or ordinary investors, all have to answer one particular question at the end of the day.

Is the value of an asset < , > , or = to its given market price?

The inequality signs refers to greater than, less than or equal to.

There are many quantitative and qualitative concepts and tools to find out the answer to this question. But many people uses the following two, hence by using these two concepts to determine value of an asset relative to its market price, one can reasonably certain that the estimation is correct to a great extent, though no guarantee since what people will pay for in future for the same asset is based on what ideas they used to value the same asset in future. One other asset valuation is simply by comparing the market prices of similar assets and another is by using the many different discounted cash flows models available.

4. Financial market analysis

The climate for financial markets can decide to a great extent how major asset classes will perform for long holding periods of five years or more. As a result, when doing asset allocations, that are allocating investment capital among different asset classes, there is a need to analyze the financial market climate also since it will result in either positive or negative returns from asset classes with their respective distinct characteristics.

Prevailing signs in certain financial market conditions point to a reduced holding in equities and assets that behave like equities. These are when there is dramatically expanded use of financial leverage, increase in magnitude and complexity of derivatives and you started seeing highly leveraged institutions surfacing here, there and everywhere, like Lehman Brothers and Bear Sterns. In addition, traditional equity valuation measures like price-earnings ratio and price-to-book value show unrealistically high values and coupled with low dividend yields.

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We all know that mutual funds are in general are diversified, how diversified it is for active managed funds will depends on each specific fund and for the case of passively managed index funds, will have to depend on the specific index tracked, like both the United States Dow Jones Industrial Average and Singapore Strait Times Index only got 30 companies each. For current purpose, we assumed that mutual funds and ETFs in general are well diversified such that the probability of losing every capital is next to zero.

However, you can still lose everything if the company that issue that mutual funds and/or ETFs or brokerage house that stores your mutual funds and/or ETFs, went bankrupt due to the greed of the CEOs. There was a time when Bear Sterns and Lehman Brothers operated America’s most prestigious brokerage houses, now their names have become history.

Most of us know that our savings and fixed deposits will be safe if the banks are FDIC insured. The insurance by government on savings and fixed deposit is necessary so as to prevent banking panic in times of financial crisis. But given that the citizens and residents of the nation and most other developed countries also got billions in various countless mutual funds and exchange-traded funds, is there similar protection for it?

Similar to Federal Deposit Insurance Corporation to insure liquid cash and savings in banks, there is this Securities Investor Protection Corporation, short form SIPC, which insures your funds up to US$500 000. In other words, if the brokerage houses went bankrupt like Bear Sterns and Lehman Brothers, the mutual funds still remain yours for transfer to other financial institutions. But just like the FDIC for liquid assets, there is a limit, but in this case, higher at US$500 000 which will be more than enough for most people.

For cash and savings, if what you have exceeds the limits, simply place in different banks, for mutual funds, you can also simply do so should you exceed the US$500 000 limit by utilizing the services of different brokerage houses. Alternately, you can check whether the brokerage houses involved got carry supplemental insurance to protect portfolio beyond half a million. For example TD Ameritrade and Zecco got offer protection for up to US$150 million and US$35 million respectively.

More information on this risk that has got nothing to do with the stocks and bonds that the funds contain is available at official website of Securities Investor Protection Corporation, http://www.sipc.org/.

For other countries, you will need to check with relevant authorities whether your government got provides this protection for the average investor who can only well afford to participate in returns from equities through mutual funds, be it actively managed or index funds, in mutual fund form or exchange-traded funds.

After your portfolio exceeds or going to exceeds US$500 000, or have initial capital near to or more than US$500 000, it is wise to ask current or prospective brokerage houses about whether they got contain supplemental insurance to cover amounts more than half a million as it is simply stupid to lose whole or some capital due to no faults of the stocks and bonds that you invest in.

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The risks for mutual funds is different from the risks from investing in individual stocks, the former is more of market risk while the latter is more of individual company risk.

Knowing the following categories of risk is essential in the sense that we are all human beings and driven by two emotions then it comes to money, namely fear and greed. There will always be bear market from time to time, and bull market as well. As a result, it is not so easy to tell yourself that when a $10 000 investment reduces to $680; it is just paper losses as long as you don’t cash out. As usually, these paper losses translate into great fear and many sleepless nights until finally sell it out, afraid that things will get worse, paper losses are turned into actual losses.

Even institutional investors like Sovereign wealth funds got buy at the top and sell at the bottom, and got one happen all the time, which by right should not have happened as they are supposed to have the resources to hire top talents with first class honors degrees from renowned colleges around the world, though it is most probably because of them turning to an army of yes man like the case for Lehman Brothers.

In other words, it is hard to be rational when things don’t look good, especially when it comes to hard earned money. In general, a fund that generates larger returns in a short time can also at the same time incur larger losses. Again, the perfect example is funds that invest heavily in Internet companies during and after the dot com bubble.

1. Sector Risk

There are many sectors in our economy. To give a few examples, they are, including but not limited to, health care, consumer goods, financial, energy, utilities, technology, telecommunications and media etc. There mutual funds that focus on only one sector, like financial, and get burned heavily during the 2008 economic crisis, or those that invest mainly in technology stocks, also got burned when the dot com bubble burst, regardless of how skilful the fund managers is or how many As he or she get during colleges or how many percent you pay for their management fees.

For those funds that are not sector specific, they may also be vulnerable to sector risk as mentioned above if a significant percentage of fund’s weightings are in one sector. Knowing about sector risk does not mean you don’t invest in funds that skewed towards one sector or with large weightings in one sector but to be aware of not buying another fund that also only contain stocks in the same sector as this will increase risks when you can increase expected returns without the added risks by simply placing investment dollars in other sectors.

2. Past volatility is predictive of future volatility

There is a common saying in investment arena that past returns do not equal future results. There is a less well known fact in investing that past volatility is equal to future volatility. This is in addition to checking the fund’s weightings in which sectors and whether there are significant holdings in some individual stocks. In fact, the past volatility of a fund and even individual stocks can accurately indicate its future volatility also.

3. Knowing your threshold of losses

As a consequence of the above, the worse losses sustained by the fund in the past may most probably be its worst losses in the future also, touch your heart and ask yourself, if you can still hold on to the fund during its worst period. If can, then it is wise to buy into the fund, if not, there is a good chance that you are going to realise your paper losses in future since past volatility is almost equal to future volatility also.

To have a rough and accurate gauge of future losses, one can simply look at its worst historical period and imagine if you can hold on to that amount of losses.

4. Company specific risk

Other than sector risk, there is one other important risk that mutual funds have. There are now much more mutual funds in the market than the total number of stocks. Some is really diversified into hundreds of different of stocks while some hold only between 20 to 30 stocks. One thing to note is that almost every fund manager does not spread all the fund’s investment dollars equally across all the different companies, if there is a fund that does that and charges you 2% per year in management fee, there is most probably only high school graduates doing simple administrative work for the fund simply because you don’t need to pay some fellers 2% per year if they do nothing other than divide the dollars equally across all investments. I think any school kids know how to do average.

As such, it is essential to check a mutual fund top 10 companies and find out how much of a fund’s assets are invested in there. Please be aware that even if a fund got more than 100 different companies’ stocks, there could still be high volatility if near to 50% of fund’s assets are concentrated in 10 or less holdings. All else being equal, that funds will of course be more volatile than another one with same number of holdings but less concentration on a few holdings.

5. Standard deviation as a measure of risk

More than an academic interest, standard deviation has practical uses in a real life investing world. Intuitively, standard deviation is a qualitative measure of a fund’s returns fluctuation around the mean during a chosen time period and the mean is defined as the average annual return for that time period. To give an example, if a large cap growth fund had a mean of 8.80% and a standard deviation of 20.63% for a five years period, it tells you that for 60% of the time, the fund annualized return was plus and minus 20.63% of 8.80%.

As with returns, one doesn’t look at standard deviation in isolation. You need to compare it with a benchmark index or funds in the same category groups. A rational investor should not choose to invest in a large cap fund with a mixture of value and growth if its standard deviation is significantly higher than the S&P500 and if the returns are not any higher than the S&P500. The S&P500 index is a standard benchmark for large cap funds and a higher standard deviation than the index means that you are not equally compensated for the volatility it brings if the returns are around the same.

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The same goes for investing in mutual funds, though one can buy and sell at any time, it is not advisable due to sales charges and lost in capital if enter and exit at the wrong time and price. However, it is unlikely that one can lose 100% of the capital when investing in mutual funds due to legislations prohibiting any fund from holding more than 30% of a single company stock or bond.

The following words will address some elements of any mutual funds that any one investing must know. They will assists you in understanding why the prices behave in the past, make reasonable predictions on how it will do in future and most importantly, how that fund can complement your investments in other areas.

A mutual fund basically owns either one or a combination of three things – cash, stocks or bonds. I once saw an advertisement for an actively managed bond fund that claims to holds up to 40% cash during volatile times. The problem is you don’t need to pay someone more than 1% per year in management fees just to kept 40% of your cash in their bank accounts, accruing interest for them and earning 1.5% from you as well. Knowing what you own is important because how a fund manager invests and where he invests has a significant impact on performance.

In addition, most of the times, a fund name nowadays does not tell you what it actually owns because their names are too generic. In other words, you can’t even tell whether they invest in small cap or large cap, the first thing that one need to be aware of in deciding to invest. A fund prospectus also did not tells you anything much about the fund other than some basic parameters, they are written in broad terms so that the fund managers can have the flexibility to invest as they think fit.

For a stock mutual fund,

1. Geographic regions

Most funds have their respective specific geographic regions in which they invest in order to suit the risk appetite of various investors. One simple way in which to group stocks based on regional is developed and emerging economies. Other than this, mutual funds can also be grouped by countries and continent like, United States, Europe, China, Asia (including or excluding Japan) and last but not least, Australia and New Zealand.

2. Stock size – average market capitalization

Most of the funds either focus on micro cap, small cap, mid-cap or large cap in their portfolios. In investing vocabulary, stock size is measured by market capitalization which is basically price of one share multiplied by number of shares outstanding. Cap size alone can affect a particular portfolio of stocks risk level. How it affects and to what extend depends on a permutation and combination of other factors as mentioned in this blog post. Although there is a much greater number of small caps companies than large caps, they only make up around 10% of a given region total market capitalization of all companies.

Not every mutual fund focus entirely on either large caps or small caps, there are some funds that got contain a mixture from every cap size. In this case, their average cap sizes determine their risk levels from market capitalization.

3. Investment style – Value or growth

After the above two, the third of grouping stocks is growth or value. In the simplistic sense, growth stocks are those with higher price-earnings ratio while value stocks are those with lower price-earnings ratio. But fund managers do not necessarily use the simple measure of price-earnings ratio only to determine whether a stock is a growth or value. Other parameters like dividend yields and its past and expected future earnings growth are taken into consideration also.

If we define three categories for market capitalization and three categories for investment style such as value, growth and a blend of the two, meaning somewhere in between. We will have a total of nine permutations with different levels of risk. The large cap and value will be lowest risk while that of small caps and growth will be of higher risk.

4. Sectors – Energy, utilities, health care, financial services, electronics etc

Our economy is made up of many different sectors that provide different products and services. There are funds that diversified onto different sectors and funds that focused exclusively on one sector. There are 12 major sectors that stocks can be in and these 12 sectors can be under three major groupings like information, manufacturing and services. Knowing how much of your fund is exposed in each sector, i.e. percentage of exposure in each sector, is crucial since which industry the fund invests in determines its performance much more than the fund managers behind for most of the time. A perfect example is during the dot com boom and bust period.

In addition, if one fund is heavily concentrated in one sector like automobile industry, then it is better that any spare investment dollars are invested in funds that hold stocks that are not in the same industry as it.

5. How many companies are inside the fund?

There will be significant difference in the behavior of fund prices if it holds 25 stocks (or companies) compared with if it holds more than 500 different stocks. Obviously, a fund containing 25 different stocks is going to be more volatile, for better or for worse, than a fund with over 500 stocks, regardless of who is the fund manager.

6. Turnover rate

When we invest in actively managed mutual funds, we are paying a substantial management fees per year, of course the fund managers must do something like buy and sell at the right time, in order to achieve higher than overall market returns. However, if the turnover rate is too much, it most probably will reduce returns by virtue of its transactions costs involved.

Defining turnover rate,

A turnover rate of 50% means a holding period of two years.

A turnover rate of 100% means a holding period of one year.

The turnover rate for a mutual fund for a particular year is simply calculated by dividing the lower of that fund total purchases or sales by its mean monthly assets for that year.

High turnover fund not only reduces return through transactions costs but also shift the markets prices substantially. This is especially so for a large fund looking to either shore up or off loading large amount of shares in a particular company. At any one time, the market cannot absorb a large number of shares at a certain price. In general, funds with large assets base, like in billions, with a high turnover rate, are unlikely to achieve higher than overall market returns in the long run, though there will always be exceptions but they are few and far between.

As a result, you will greatly increase the odds of getting better long term performance if the bulk of investment dollars are placed in relatively low turnover funds.

For a bond mutual fund,

1. Interest rate sensitivity

A bond is more sensitivity to changes in interest rates than a stock. The reasons behind is easily explained, when a new bond is issued at a time when the interest rate is high, investors will rather buy them than older bonds with longer time to maturity that yield lesser in interest payments. This in turn depresses the price of existing bonds in the market as investors sell them to buy new bonds with high interest. The opposite happens when interest rate is low. One thing to note is that the number of years left to maturity for bonds greatly affects its sensitivity to interest rates.

2. Credit rating of bonds

Unlike stocks, credit ratings determine the prices of bonds much more than other parameters like cap size of companies issuing the bonds, high or low price earnings ratio, etc. Independent third parties like Standard and poor or Moody determines and then assigns credit ratings to bonds. Credit rating is a measure of how likely the bond’s issuer is likely to go default on payments, in both interests and principals.

Of course, in a bond mutual fund, where it invests in bonds from many different issuers, the bond fund credit rating is basically the weighted average of the credit ratings of all the bonds inside the fund. In general, bond funds with higher credit ratings and low interest rate sensitivity are deemed to be less risky than otherwise, less risky as in lesser changes in prices and lesser chance of default by bond issuers.

Knowing what your fund actually owns is the first step in investing in bond funds, knowing how to measure performance is the second step.

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