Portfolio Management

Mutual Funds

Why Mutual Fund Fees Matter

     When the stock market rises mutual fund investors’ sensitivity to costs goes down. In an up market investors rationalize that the fees paid to a fund’s manager are justified. And, if you ask the fund manager, he/she will agree. This is a textbook example of “myside bias,” the tendency to evaluate evidence in ways that mirror one’s own views and put one-self in the best possible position.

     In the economic downturn of 2009 mutual fund bond funds saw inflows of about $200 billion as of October 2009. At that time the average cost of owning a taxable bond fund was 1.03% of invested assets with a maximum of 2.98%.  When Treasury yields were 3% to 4%, with the risk of losses if rates rose, those fees were large. Today, wealth preservationists argue that mutual fund fees always matter, regardless of the market’s direction.

     If the market is up 1%, a fund that charges a 0.5% annual fee will leave the fund investor with a 0.5% net profit, while another fund with expenses of 1.5% would leave the investor with a 0.5% net loss. That makes the three fold gap between their fees important when choosing a mutual fund.

     Fee blindness is correctable. To determine the cost of a mutual fund, look up its annual expense ratio on the fund’s Web site. Then multiply that ratio by the total amount of dollars you anticipate investing in that fund. The resulting dollar amount is the annual cost for owning that fund. That sum will be deducted, without notice to you, from your account over the course of a year. By comparing expense ratios of various mutual funds, you can shop for the lowest cost fund.

     To counter the argument that “you get what you pay for,” compare the expense ratio of a low-cost index mutual fund to a comparable actively managed fund. Then check the results of both for the last calendar year. Most likely the returns over the past year were about the same, except that the low-cost fund’s fees were less thus resulting in you having a higher account balance.

Exchange Traded Funds

 Understanding the Difference Between Passive and Active ETFs


        As of March 2008, the U.S. Securities and Exchange Commission was moving closer to giving approval to active ETFs that would not be required to track a set index.  Of concern for investors is that active ETFs have no real-world track record and no known investment managers.


            Passively managed, index-linked ETFs have appealed to different types of investors.  Professional traders, speculators and hedge funds like the ability to trade in and out of ETFs during the trading day, since the ETFs trade like individual stocks.  By comparison, mutual funds are priced once daily at the market close.  The pros also favor ETFs with options and futures and can be shorted or bought on margin.


            Long-term investors favor ETFs because of low fees, diversification, tax efficiency and transparency.


            Active ETFs are much different than their passive index-linked siblings.  As active ETFs do not track an index, investors are betting on an unknown managers’ skill.  It appears that active ETFs are merely another investment product of Wall Street to sell to Main Street investors.


            In bringing active ETFs to market, the biggest concern for Wall Street marketers is portfolio disclosure.  For active ETFs to trade fluidly, market makers must know the securities that make up the active ETFs portfolio.  This ensures that the complicated arbitrage process functions, which prevents premiums and discounts to the portfolio’s net asset value.


            Active ETFs must balance portfolio disclosure and concerns of front-running.  In essence, an active ETF manager fears that revealing his holdings will invite other traders to step I front of his trades or allow imitators to profit from his research.



Exchange Traded Funds


Leveraged ETFs Are for Investment Pro Day Traders


            ETFs are funds that trade during the day like stocks.  A leveraged ETF seeks to use futures and other derivatives to multiply the daily return of a market index.  Some, called “ultra,” “2x” or “3x bull,” attempt to double or triple the market’s return each day.  Others try to double or triple the opposite of an indexes return; on a day when the market goes down, these “ultra-short,” “inverse 2x” or “3x bear” funds should go up two or three times as much. 


            Leveraged ETFs are suited for day traders who can adjust their holdings to maintain a specific exposure level.  They are not suitable for ordinary investors who usually buy-and-hold their investments.  The returns of leveraged ETFs are predictable relative to the index only if you own them for a day or less.  Over longer periods, such as a week or more, leveraged ETFs may not correlate with the underlying index.  Thus, leveraged ETFs are for day traders and are not designed as hedging investments.

Natural Resource Investments

Timberland As An Investment

           Since 1987 an investment in timberland has outperformed equities as an investment.  Per the National Council of Real Estate Investment Fiduciaries’ Timberland Index, a dollar invested in 1987 was worth $21 at the end of 2009, a compounded annual return of more than 14%.  That same dollar invested in the Standard & Poor’s 500 stock index was, with dividends included, worth $7.83, a return of 9.4% a year.

           Historically, timberland has also tracked the consumer price index, thus serving as an inflation hedge.  Over the long haul timberland generates income from timber sales, hunting leases, watershed rights, subsurface resource easements, utility easements (i.e., pipe and electricity lines), and recreational uses.

           As an asset class, timberland makes sense only for high net worth individuals who have a long investment horizon.  Timberland is not the commodity that trades as a short-term futures contract but a decades long investment where lumber comes from.  Timberland investing is an investment of scale.  Small plots do not generate enough income as only a small percentage of the trees are harvested in any year.  So, large acreage is necessary for an adequate return on investment.  For example, 400 acres in the Southeast, the wood basket of the U.S., at $2,000 an acre costs $800,000 as an initial investment.  So, Tom, Dick and Harry are unlikely to be investing.

          Investors often place their money with timberland investment management organization (“TIMOs”) to manage their investment.  Minimum investments range from $1 million to $5 million.  Individuals with lesser amounts are sometimes permitted to pool their monies into a single account to reach the investment minimum.  The minimum period for a TIMO is about a decade, which means timberland is an illiquid investment.

          As to risks, besides being illiquid, timberland is high maintenance, and susceptible to natural disasters (i.e., forest fires, storms, insects, and tree diseases).  Trees that are damaged before they mature are harvested for pulp rather than higher paying saw mill timber resulting in less financial return.  Further, Timberland prices are subject to market dynamics, particularly those of the timber industry.  When the 2008 housing bubble burst, timberland and timber prices fell.

          For less affluent investors, timber real estate investment trusts are available.  On the New York Stock Exchange the Potlatch, Plum Creek Timber and Rayonier REITS are available.  When evaluating a timber REIT an investor should ascertain that it is diversified by being invested in multiple regions in the U.S. and multiple tree species.  Timber REITs are susceptible to company mismanagement in addition to the risks described in the preceding paragraph.  And, market forces may require the REIT’s management to see assets to payout exiting investors thus diminishing the future returns of current investors.  Side agreements should also be inquired about.

          For further information, contact Mr. Yules.