Recently in Mutual Funds Category

For being the most popular investments in the country, many people have a "black box" picture of mutual funds. Money goes in one end and more money (usually) comes out the other.



Mutual companies in general are a very old concept. The Egyptians had them in ancient times, mostly for insurance purposes. For one time investments, they go back at least to europe in the middle ages. But it wasn't until 1924 in the United States that somebody had the bright idea of making it a continuing thing, an actual business planned around the continual making of communal investments. (The very first mutual fund is still going, by the way, as a member of one of the bigger advisory fund families.) Regulation of mutual funds and similar entities dates to the Investment Company Act of 1940.



The basic concept is this: A group of people get together and pool their investment money, and invest it as a group. They all own a portion of the entire pool of investments.



This buys a lot. It buys economies of scale, as the costs to trade 10,000 shares are significantly less than 100 times the cost of trading 100 shares, and way less than 10,0000 times the cost of trading a single share. It buys instant diversification, as the group has plenty of money to split among enough investments so that the failure of any one will not unduly hurt them. It buys (theoretically) top tier money management, because there's enough money in the group such that the cost to pay such a person isn't prohibitive, as it is to average investors on their own. Furthermore, there is no need to purchase an even number, or even an integer number of shares, so you can invest any amount that is at least whatever minimum the group agrees upon. You can typically buy mutual fund shares in increments as small as one one thousandth of a share, so if you want to invest $507.63 exactly, that's not a problem as long as it's above the minimum investment, or minimum additional investment, whichever is applicable.



Because there are costs to the group associated with adding a new investor or making a new investment, they do have rules about minimum initial investment and minimum additional investment. For some "no-load" funds, the minimum investment can be several thousand dollars. For advisors funds, where there is a sales charge, the minimums are typically smaller, something along the lines of $250 or $500, as the sales charges discourage short term trading. Indeed, some of the advisors funds will accept initial investments as small as $25, as long as you agree to monthly investments.



The math of mutual fund share price is mostly important to the accountants, not the investors. Initially, it's quite arbitrary. There is a given pool of investment dollars, and the group, or investment company, decides that share price is going to be $10.00 or $25.00 or whatever. Note that, with mutual funds, there is no practical difference between $1000 buying one hundred $10 shares or forty $25 shares. It's just a matter of record-keeping. There is a minor record keeping argument for setting initial share price low, but it's mostly important for record keeping.



During each trading day, the number of shares is kept constant. Whether or not there is any trading activity, any new investment, or any redemption, the number of shares stays constant until the end of the trading day. At the end of the day, the fund computes the value of the underlying investment, divides by the number of shares for that trading day, and that becomes the share price. At this point, the end of the trading day, any redemptions or new investments take effect If someone wants to redeem a given number of shares, the company sends them share price times number of shares. If someone wants to redeem a given amount of money, the fund divides that by the share price and redeems that number of shares. If someone invested money in the fund that day, the purchase takes effect at the end of day price. You can buy a given number of shares (providing you sent them at least enough money) or, more commonly, you can invest a certain number of dollars, which will be divided by the share price to calculate the number of shares you bought. For these reasons, among others, short-term trading mutual funds of any sort is a pointless way to waste money, and Exchange Traded Funds are a method for extorting money from the gullible (If you must day trade, S&P and similar option based alternatives are superior). Mutual funds are for investors who intend to hold for a while.



As time goes on, there are several sorts of events that influence share price. First off, that the underlying pool of investments fluctuates in value, going up and going down with supply and demand. This happens whether that investment is bonds, stocks, or both. Bond prices and stock prices change every day, with supply and demand and market conditions. Always, within a given day, the number of shares in the fund is constant. At the end of the day, the effects of the market and any trading the fund did are taken into account, and the end of day share price is computed, and all of the day's transactions in shares take place at the end of the market day. In order to be processed by the fund on that day, any orders to buy or redeem shares must be received by the fund prior to market close, or they get the next day's share price. There have been people criminally convicted and sent to jail on this point, for gaming the share price.



The second thing that happens to influence share price is income. Every so often, one of the fund's underlying investments will pay a dividend (stocks) or make an interest payment (bonds). Each one of the fund's shares (not shareholders!) is entitled to an equal share of this money. Say that the fund gets a million dollars over the course of a certain period, and there are ten million shares outstanding. Each of the shares will get a payout of approximately ten cents. I say approximately, because there are other concerns involved. Now, because this money has been received over a period of time, and until the payout was included in the overall value of the fund, the price per share will be reduced by whatever the payout is (and all funds hold at least a small amount of cash). So if the price per share was $15.00 before a $.10 per share payout, it will be $14.90 afterwards. Some shareholders will have elected to receive income in cash, and some will have elected to have it automatically reinvested (each share's payout purchasing 1/149th of a share in this example), but in either case, this has tax consequences for the investors unless they made their investment from within a tax deferred account such as an IRA (among many others), and the money remains within that account.



The third thing that has an impact upon share price is capital gains (and losses!). If the fund invested $1 million by buying 50,000 shares of ABC company at $20 per share, and ABC company goes to $30 per share, the value of those shares has increased to $1.5 million. So long as the fund management holds onto those 50,000 shares of ABC, it's just a paper increase, and if there are ten million shares of the fund outstanding, that means that each share of the fund effectively owns fifteen cents of ABC, and five cents of that is an unrealized gain.



But let's say that the share price of ABC goes to $50 per share, and the fund management decides that it's time to sell those 50,000 shares. Now they sold for $2.5 million, and of that, they cost $1 million to buy (This is usually stated by saying that those 50,000 shares had a basis of one million dollars) But the remaining 1.5 million dollars is profit for the fund. If there are still ten million shares outstanding, that's a 15 cent per share capital gain. Assuming there are no other capital gains or losses for the period, the fund declares a fifteen cent capital gain. Just like income received, if the share price was $15.15 before, it will be $15.00 after. Some investors will have chosen a payout, and some will have chosen to reinvest. The ones who have chosen a payout will get a check of fifteen cents multiplied by however many shares of the fund they own, while the ones who have chosen to reinvest will each get one one hundredth of a share per share they already own. Whichever they have chosen, unless the investment comes from and remains within a tax deferred account such as an IRA, there will be tax consequences for the individual investors.



Most mutual funds are not "stand-alone" investment companies. They are members of a family of funds, theoretically investing only in a particular investment niche. This allows the entire fund family to amalgamate their marketing efforts and administration. Particularly with advisory funds, most investors should find a single fund family that meets their needs to stay within, in order to minimize sales charges. The family may or may not have input as to a given fund's management team. Nonetheless, each fund has its own board of directors, and there is not usually anything legally binding a particular fund ("investment company") to a particular fund family if the investors and fund management really want to leave.



Now there are some potential weaknesses of mutual funds. The fact that there are tax consequences for investors is not an issue while still holding most other sorts of investments, at least not to the same degree. So most mutual funds find themselves with incentives to do something, or not do something they would otherwise have done, due to tax consequences to their investors. Furthermore, most mutual funds are way too dilute. The optimum number of investments, according to mathematical models, is between twenty and thirty, and given that the overwhelming majority of investors who invest in mutual funds have invested in several different ones, a smaller number of investments per fund is more appropriate than a larger number. It being that time of year right now, I just got a statement from one of my funds listing over 400 holdings. There are reasons I continue to invest in that fund and that family, but I'm certainly not happy about that aspect.



Nonetheless, even with these weaknesses, a mutual fund's ability to deliver immediate diversification, economies of scale, and professional management with only a modest investment, well within the capabilities of beginning investors, are excellent reasons why most investors should strongly consider them as an investment vehicle, especially starting out. That they are also very liquid, and not subject to large purchases and redemptions significantly influencing share prices, can give even a large investor with "high risk" predilections reason to park money there for a time.



Caveat Emptor

Reading the papers, I see all kinds of garbage about mutual funds. Probably the biggest single piece of garbage is that only the so-called "no load" funds are any good. They focus only on the cost of the "loaded" fund, as if there is no benefit to be had from the fact that the "load" pays a professional advisor to help you out. Indeed, it has been well established by DALBAR that net returns of investors with paid advisors, in aggregate, tend to significantly outperform those of investors without.



It's not just investment knowledge, no matter how much people protest that they know every bit as much as the professionals. If you aren't, you don't. It's investor psychology and not being so emotionally involved in the problems and knowing what to do in the first place so as not to spend so much of your money on basic mistakes. This isn't play money you're working with, and if it was, the experience wouldn't help when it came to making real investments. When you don't get do-overs, and the time you've lost and wasted is the worst thing about the situation, and when the average investor makes three avoidable mistakes costing twenty percent or more of their portfolio value, five percent plus a quarter of a percent per year doesn't look like such a bad investment. On the same theory that a lawyer who represents himself has a fool for a client, show me a financial advisor who handles his own "big money" without paying for advice and I'll show you an advisor to stay away from.



With that said, some people are bound and determined to do it all themselves. That's fine, so long as you admit to yourself that it's likely to cost you money, and that the ego thing is more important to you than the money.



What I look for, what most professionals look for, in a mutual fund family, is three things. Good Asset Class coverage. Sticking to a fund's stated modes. Willingness to change a fund management if the performance lags the class over time.



Good Asset Class coverage has to do with the standard categories of funds. Small versus large versus mid cap. Value versus Income versus growth. Bonds versus stocks. I want to see funds within the family that "hit the corners". Large Cap Growth, Small Cap Growth, Large Cap Value, Small Cap Value, Investment bond, Government bond, "High Yield" bond (aka "junk"), Income, and preferably multiple international choices as well. I may not put money in every category, but I want it available to me. I insist that Value be Value, not "growth and income." Real Value funds are harder to "sell" laypersons on, but long term, they tend to outperform growth.



The second thing I want is that the management sticks with the fund's asset class, and doesn't play funny games with the definition. I don't like funds that break type to chase today's returns. A full explanation as to why is beyond the scope of this essay, but For a quick illustration: A few years ago, there was a very hot no-load fund family. Literally top of the demand curve. Everyone wanted their funds. They advertised like hell to attract business, and it worked. They got almost fifty percent of the money coming into mutual funds for a while - and every single fund of theirs put their money into basically the same companies. I did a comparison on them and could not find two of their funds with less than a forty percent investment overlap. This was basically using increased demand to drive price, and hence, temporary paper returns. But this couldn't last, and they went from being the darlings of the market to absolute bottom in one year.



The third of the most important things that I look for is willingness to replace a bad fund manager on behalf of the family management. I'm not looking for immediate replacement if they lag the class for one quarter. I'm looking for family management that is willing to replace someone that consistently lags the class over time. This is harder to get than you might think. Typically by the time that someone has risen to fund manager, they've been with the family for a while and know where most of the bodies are buried. "Charlie" who heads the family goes golfing every week with "George" who's doing a rotten job and deserves to be replaced, but you don't fire your golfing partner. It's all among friends, right? Well, no. It's my money this clown is wasting.



There are a couple other things that are highly beneficial. Limited number of investments, preferably a maximum number set in the prospectus. Twenty to thirty investments is the optimal tradeoff between diversification and dilution, and most funds are too dilute. Availability of Sector funds is also a big plus. But none of them is as important as the big three.



Caveat Emptor.

It seems I can't hardly turn around in the investment world without a paean to Jack Bogle, who preaches the advantage of the index fund.



Mr. Bogle's reasoning goes something like this: Looking at the world of mutual funds, relatively few funds beat the S&P 500 Index, so why not just buy the whole S&P Index?



This is nothing short of the most successful sales pitch based upon a straw man argument in history.



Index funds are huge. Mr. Bogle's own original fund is the largest mutual fund, and both of the two largest mutual fund families base their pitches (in large part) upon their large number of Index Funds based upon various indices. That's how successful the pitch has been.



What Mr. Bogle doesn't tell you is that Index funds aren't the Index either.



There's a bit of Red Herring in the argument also. Index Funds aren't some ideal investment package that doesn't have expenses. They may be low (21 basis points per share for the biggest the last time I looked), but they are there. So in an ideal universe, they lose to the index by this amount. Plus they do have the same need managed funds have to hold some cash. Since the market goes up about 72 percent of the time (over the course of historical years), and they lose an amount of gain or loss proportional to their cash holdings, over time they lose more than they gain on this. By comparison, the measurement made of managed funds is after all such inefficiencies.



In other words, the Index Fund sales pitch reduces to "Most of these other finds don't beat this measurement. Come to us where you're guaranteed to fall short!" The thrust of their sales pitch is holding themselves out to a a perfect idealization, which in fact they are not.



There are other reasons to avoid Index Funds. The most famous, best known and largest are all built upon the S&P 500 Index. This is a market capitalization based Index. The Fund buys into these companies based upon market capitalization. It should be no surprise to anyone that this means that whatever the largest company in S&P is, it will be several times the size of number 500, so the funds investment in them will be correspondingly weighted, while having zero investment in number 501. This means (because Index funds are such a large portion of the overall market) that Index Funds cause demand for those companies which are a member of this universe to have larger demand than they otherwise would, therefore artificially inflating the share price of those companies somewhat.



Now, one of the reasons people gravitate towards mutual funds is instant diversification of investment. You put in your $1000, and because it's is in turn invested as a part of a much larger investment pool, you have much more diversification than you would otherwise be able to purchase with that same investment were you to purchase stocks directly. One of the reasons I worked almost exclusively with mutual funds (and mutual fund-like) when I was in the business is that if you want to build a diversified direct stock portfolio in an efficient manner (buying whole, as opposed to odd share lots), it takes about $100,000. This is more than most folks are willing or able to invest in a single shot.



But one of the open secrets of the mutual fund industry is that many, if not most, funds are over-diversified. Their holdings are so diluted that when they pick a winner, their shareholders see comparatively little benefit because they've made too many bets. When you bet 100% of your money and the stock doubles, you get 100%. When you bet 1/500th of your money and the stock doubles, you get 0.2%. This dilution effect is directly proportionate to the number of investments (bets) they have made, while the benefits of diversification are only proportionate to the square root of the number of investment holdings they have. In other words, the fund with 400 holdings is sixteen times more dilute than the fund with 25, but only four times as protected by diversification. One of my favorite fund families, in which I myself continue to invest for other reasons which outweigh this, had 432 holdings in its growth fund the last time I got a report. That is way too many. Mathematical models have determined that the optimal number of holdings for a fund is in the range of twenty to thirty, getting good protection of diversification while not suffering from over-dilution of good investments. I am becoming, more and more, a fan of "focus" model funds, where the investment managers are forced to be choosy by limiting the overall number of investments to a certain number of securities.



Index funds typically have way too many funds to qualify for this. Of all the major indices, only the Dow Jones ones have a small enough base to be considered as having a near optimal number of components. I just don't hear about people wanting to invest in those. 20 Transportation? 15 Utilities? They're derided as sector investments, and not good ones. 30 Industrials still seems to have some cachet, but by comparison with S&P 500 or even the Russell Indices (1000, 2000, and 3000), the amount invested in Dow Industrials is microscopic. Perhaps because it's not a "true" index, but is selected by the publishers of the Wall Street Journal, theoretically for the components representation of the entire market.



Index funds are not without their benefits, of which their mindless vanilla nature is probably the greatest. If you want an investment you can just make and not watch and not worry about unless the entire asset class tanks, Index funds are fine (S&P is large cap blend). For market-timers, index funds are unmatched, particularly since their cost of putting the investment in and taking it out tends to be low. But I am not a mindless vanilla investor, and for one step up the mental chain, index funds can be beaten by periodic investment class reallocation. Furthermore, I am an investor, not a market-timer. So any time somebody's recommendations for investing include index funds, I'll pass those recommendations by.



Caveat Emptor.

For being the most popular investments in the country, many people have a "black box" picture of mutual funds. Money goes in one end and more money (usually) comes out the other.



Mutual companies in general are a very old concept. The Egyptians had them in ancient times, mostly for insurance purposes. For one time investments, they go back at least to europe in the middle ages. But it wasn't until 1924 in the United States that somebody had the bright idea of making it a continuing thing, an actual business planned around the continual making of communal investments. (The very first mutual fund is still going, by the way, as a member of one of the bigger advisory fund families.) Regulation of mutual funds and similar entities dates to the Investment Company Act of 1940.



The basic concept is this: A group of people get together and pool their investment money, and invest it as a group. They all own a portion of the entire pool of investments.



This buys a lot. It buys economies of scale, as the costs to trade 10,000 shares are significantly less than 100 times the cost of trading 100 shares, and way less than 10,0000 times the cost of trading a single share. It buys instant diversification, as the group has plenty of money to split among enough investments so that the failure of any one will not unduly hurt them. It buys (theoretically) top tier money management, because there's enough money in the group such that the cost to pay such a person isn't prohibitive, as it is to average investors on their own. Furthermore, there is no need to purchase an even number, or even an integer number of shares, so you can invest any amount that is at least whatever minimum the group agrees upon. You can typically buy mutual fund shares in increments as small as one one thousandth of a share, so if you want to invest $507.63 exactly, that's not a problem as long as it's above the minimum investment, or minimum additional investment, whichever is applicable.



Because there are costs to the group associated with adding a new investor or making a new investment, they do have rules about minimum initial investment and minimum additional investment. For some "no-load" funds, the minimum investment can be several thousand dollars. For advisers funds, where there is a sales charge, the minimums are typically smaller, something along the lines of $250 or $500, as the sales charges discourage short term trading. Indeed, some of the advisers funds will accept initial investments as small as $25, as long as you agree to monthly investments.



The math of mutual fund share price is mostly important to the accountants, not the investors. Initially, it's quite arbitrary. There is a given pool of investment dollars, and the group, or investment company, decides that share price is going to be $10.00 or $25.00 or whatever. Note that, with mutual funds, there is no practical difference between $1000 buying one hundred $10 shares or forty $25 shares. It's just a matter of record-keeping. There is a minor record keeping argument for setting initial share price low, but it's mostly important for record keeping.



During each trading day, the number of shares is kept constant. Whether or not there is any trading activity, any new investment, or any redemption, the number of shares stays constant until the end of the trading day. At the end of the day, the fund computes the value of the underlying investment, divides by the number of shares for that trading day, and that becomes the share price. At this point, the end of the trading day, any redemptions or new investments take effect If someone wants to redeem a given number of shares, the company sends them share price times number of shares. If someone wants to redeem a given amount of money, the fund divides that by the share price and redeems that number of shares. If someone invested money in the fund that day, the purchase takes effect at the end of day price. You can buy a given number of shares (providing you sent them at least enough money) or, more commonly, you can invest a certain number of dollars, which will be divided by the share price to calculate the number of shares you bought. For these reasons, among others, short-term trading mutual funds of any sort is a pointless way to waste money, and Exchange Traded Funds are a method for extorting money from the gullible (If you must day trade, S&P and similar option based alternatives are superior). Mutual funds are for investors who intend to hold for a while.



As time goes on, there are several sorts of events that influence share price. First off, that the underlying pool of investments fluctuates in value, going up and going down with supply and demand. This happens whether that investment is bonds, stocks, or both. Bond prices and stock prices change every day, with supply and demand and market conditions. Always, within a given day, the number of shares in the fund is constant. At the end of the day, the effects of the market and any trading the fund did are taken into account, and the end of day share price is computed, and all of the day's transactions in shares take place at the end of the market day. In order to be processed by the fund on that day, any orders to buy or redeem shares must be received by the fund prior to market close, or they get the next day's share price. There have been people criminally convicted and sent to jail on this point, for gaming the share price.



The second thing that happens to influence share price is income. Every so often, one of the fund's underlying investments will pay a dividend (stocks) or make an interest payment (bonds). Each one of the fund's shares (not shareholders!) is entitled to an equal share of this money. Say that the fund gets a million dollars over the course of a certain period, and there are ten million shares outstanding. Each of the shares will get a payout of approximately ten cents. I say approximately, because there are other concerns involved. Now, because this money has been received over a period of time, and until the payout was included in the overall value of the fund, the price per share will be reduced by whatever the payout is (and all funds hold at least a small amount of cash). So if the price per share was $15.00 before a $.10 per share payout, it will be $14.90 afterwards. Some shareholders will have elected to receive income in cash, and some will have elected to have it automatically reinvested (each share's payout purchasing 1/149th of a share in this example), but in either case, this has tax consequences for the investors unless they made their investment from within a tax deferred account such as an IRA (among many others), and the money remains within that account.



The third thing that has an impact upon share price is capital gains (and losses!). If the fund invested $1 million by buying 50,000 shares of ABC company at $20 per share, and ABC company goes to $30 per share, the value of those shares has increased to $1.5 million. So long as the fund management holds onto those 50,000 shares of ABC, it's just a paper increase, and if there are ten million shares of the fund outstanding, that means that each share of the fund effectively owns fifteen cents of ABC, and five cents of that is an unrealized gain.



But let's say that the share price of ABC goes to $50 per share, and the fund management decides that it's time to sell those 50,000 shares. Now they sold for $2.5 million, and of that, they cost $1 million to buy (This is usually stated by saying that those 50,000 shares had a basis of one million dollars) But the remaining 1.5 million dollars is profit for the fund. If there are still ten million shares outstanding, that's a 15 cent per share capital gain. Assuming there are no other capital gains or losses for the period, the fund declares a fifteen cent capital gain. Just like income received, if the share price was $15.15 before, it will be $15.00 after. Some investors will have chosen a payout, and some will have chosen to reinvest. The ones who have chosen a payout will get a check of fifteen cents multiplied by however many shares of the fund they own, while the ones who have chosen to reinvest will each get one one hundredth of a share per share they already own. Whichever they have chosen, unless the investment comes from and remains within a tax deferred account such as an IRA, there will be tax consequences for the individual investors.



Most mutual funds are not "stand-alone" investment companies. They are members of a family of funds, theoretically investing only in a particular investment niche. This allows the entire fund family to amalgamate their marketing efforts and administration. Particularly with advisory funds, most investors should find a single fund family that meets their needs to stay within, in order to minimize sales charges. The family may or may not have input as to a given fund's management team. Nonetheless, each fund has its own board of directors, and there is not usually anything legally binding a particular fund ("investment company") to a particular fund family if the investors and fund management really want to leave.



Now there are some potential weaknesses of mutual funds. The fact that there are tax consequences for investors is not an issue while still holding most other sorts of investments, at least not to the same degree. So most mutual funds find themselves with incentives to do something, or not do something they would otherwise have done, due to tax consequences to their investors. Furthermore, most mutual funds are way too dilute. The optimum number of investments, according to mathematical models, is between twenty and thirty, and given that the overwhelming majority of investors who invest in mutual funds have invested in several different ones, a smaller number of investments per fund is more appropriate than a larger number. It being that time of year right now, I just got a statement from one of my funds listing over 400 holdings. There are reasons I continue to invest in that fund and that family, but I'm certainly not happy about that aspect.



Nonetheless, even with these weaknesses, a mutual fund's ability to deliver immediate diversification, economies of scale, and professional management with only a modest investment, well within the capabilities of beginning investors, are excellent reasons why most investors should strongly consider them as an investment vehicle, especially starting out. That they are also very liquid, and not subject to large purchases and redemptions significantly influencing share prices, can give even a large investor with "high risk" predilections reason to park money there for a time.



Caveat Emptor

Updated here

Reading the papers, I see all kinds of garbage about mutual funds. Probably the biggest single piece of garbage is that only the so-called "no load" funds are any good. They focus only on the cost of the "loaded" fund, as if there is no benefit to be had from the fact that the "load" pays a professional advisor to help you out. Indeed, it has been well established by DALBAR that net returns of investors with paid advisors, in aggregate, tend to significantly outperform those of investors without.



It's not just investment knowledge, no matter how much people protest that they know every bit as much as the professionals. If you aren't, you don't. It's investor psychology and not being so emotionally involved in the problems and knowing what to do in the first place so as not to spend so much of your money on basic mistakes. This isn't play money you're working with, and if it was, the experience wouldn't help when it came to making real investments. When you don't get do-overs, and the time you've lost and wasted is the worst thing about the situation, and when the average investor makes three avoidable mistakes costing twenty percent or more of their portfolio value, five percent plus a quarter of a percent per year doesn't look like such a bad investment. On the same theory that a lawyer who represents himself has a fool for a client, show me a financial adviser who handles his own "big money" without paying for advice and I'll show you an adviser to stay away from.



With that said, some people are bound and determined to do it all themselves. That's fine, so long as you admit to yourself that it's likely to cost you money, and that the ego thing is more important to you than the money.



What I look for, what most professionals look for, in a mutual fund family, is three things. Good Asset Class coverage. Sticking to a fund's stated modes. Willingness to change a fund management if the performance lags the class over time.



Good Asset Class coverage has to do with the standard categories of funds. Small versus large versus mid cap. Value versus Income versus growth. Bonds versus stocks. I want to see funds within the family that "hit the corners". Large Cap Growth, Small Cap Growth, Large Cap Value, Small Cap Value, Investment bond, Government bond, "High Yield" bond (aka "junk"), Income, and preferably multiple international choices as well. I may not put money in every category, but I want it available to me. I insist that Value be Value, not "growth and income." Real Value funds are harder to "sell" laypersons on, but long term, they tend to outperform growth.



The second thing I want is that the management sticks with the fund's asset class, and doesn't play funny games with the definition. I don't like funds that break type to chase today's returns. A full explanation as to why is beyond the scope of this essay, but For a quick illustration: A few years ago, there was a very hot no-load fund family. Literally top of the demand curve. Everyone wanted their funds. They advertised like hell to attract business, and it worked. They got almost fifty percent of the money coming into mutual funds for a while - and every single fund of theirs put their money into basically the same companies. I did a comparison on them and could not find two of their funds with less than a forty percent investment overlap. This was basically using increased demand to drive price, and hence, temporary paper returns. But this couldn't last, and they went from being the darlings of the market to absolute bottom in one year.



The third of the most important things that I look for is willingness to replace a bad fund manager on behalf of the family management. I'm not looking for immediate replacement if they lag the class for one quarter. I'm looking for family management that is willing to replace someone that consistently lags the class over time. This is harder to get than you might think. Typically by the time that someone has risen to fund manager, they've been with the family for a while and know where most of the bodies are buried. "Charlie" who heads the family goes golfing every week with "George" who's doing a rotten job and deserves to be replaced, but you don't fire your golfing partner. It's all among friends, right? Well, no. It's my money this clown is wasting.



There are a couple other things that are highly beneficial. Limited number of investments, preferably a maximum number set in the prospectus. Twenty to thirty investments is the optimal tradeoff between diversification and dilution, and most funds are too dilute. Availability of Sector funds is also a big plus. But none of them is as important as the big three.



Caveat Emptor.

It seems I can't hardly turn around in the investment world without a paean to Jack Bogle, who preaches the advantage of the index fund.



Mr. Bogle's reasoning goes something like this: Looking at the world of mutual funds, relatively few funds beat the S&P 500 Index, so why not just buy the whole S&P Index?



This is nothing short of the most successful sales pitch based upon a straw man argument in history.



Index funds are huge. Mr. Bogle's own original fund is the largest mutual fund, and both of the two largest mutual fund families base their pitches (in large part) upon their large number of Index Funds based upon various indices. That's how successful the pitch has been.



What Mr. Bogle doesn't tell you is that Index funds aren't the Index either.



There's a bit of Red Herring in the argument also. Index Funds aren't some ideal investment package that doesn't have expenses. They may be low (21 basis points per share for the biggest the last time I looked), but they are there. So in an ideal universe, they lose to the index by this amount. Plus they do have the same need managed funds have to hold some cash. Since the market goes up about 72 percent of the time (over the course of historical years), and they lose an amount of gain or loss proportional to their cash holdings, over time they lose more than they gain on this. By comparison, the measurement made of managed funds is after all such ineffieciencies.



In other words, the Index Fund sales pitch reduces to "Most of these other finds don't beat this measurement. Come to us where you're guaranteed to fall short!" The thrust of their sales pitch is holding themselves out to a a perfect idealization, which in fact they are not.



There are other reasons to avoid Index Funds. The most famous, best known and largest are all built upon the S&P 500 Index. This is a market capitalization based Index. The Fund buys into these companies based upon market capitalization. It should be no surprise to anyone that this means that whatever the largest company in S&P is, it will be several times the size of number 500, so the funds investment in them will be correspondingly weighted, while having zero investment in number 501. This means (because Index funds are such a large portion of the overall market) that Index Funds cause demand for those companies which are a member of this universe to have larger demand than they otherwise would, therefore artificially inflating the share price of those companies somewhat.



Now, one of the reasons people gravitate towards mutual funds is instant diversification of investment. You put in your $1000, and because it's is in turn invested as a part of a much larger investment pool, you have much more diversification than you would otherwise be able to purchase with that same investment were you to purchase stocks directly. One of the reasons I worked almost exclusively with mutual funds (and mutual fund-like) when I was in the business is that if you want to build a diversified direct stock portfolio in an efficient manner (buying whole, as opposed to odd share lots), it takes about $100,000. This is more than most folks are willing or able to invest in a single shot.



But one of the open secrets of the mutual fund industry is that many, if not most, funds are over-diversified. Their holdings are so diluted that when they pick a winner, their shareholders see comparatively little benefit because they've made too many bets. When you bet 100% of your money and the stock doubles, you get 100%. When you bet 1/500th of your money and the stock doubles, you get 0.2%. This dilution effect is directly proportionate to the number of investments (bets) they have made, while the benefits of diversification are only proportionate to the square root of the number of investment holdings they have. In other words, the fund with 400 holdings is sixteen times more dilute than the fund with 25, but only four times as protected by diversification. One of my favorite fund families, in which I myself continue to invest for other reasons which outweigh this, had 432 holdings in its growth fund the last time I got a report. That is way too many. Mathematical models have determined that the optimal number of holdings for a fund is in the range of twenty to thirty, getting good protection of diversification while not suffering from over-dilution of good investments. I am becoming, more and more, a fan of "focus" model funds, where the investment managers are forced to be choosy by limiting the overall number of investments to a certain number of securities.



Index funds typically have way too many funds to qualify for this. Of all the major indices, only the Dow Jones ones have a small enough base to be considered as having a near optimal number of components. I just don't hear about people wanting to invest in those. 20 Transportation? 15 Utilities? They're derided as sector investments, and not good ones. 30 Industrials still seems to have some cachet, but by comparison with S&P 500 or even the Russell Indices (1000, 2000, and 3000), the amount invested in Dow Industrials is microscopic. Perhaps because it's not a "true" index, but is selected by the publishers of the Wall Street Journal, theoretically for the components representation of the entire market.



Index funds are not without their benefits, of which their mindless vanilla nature is probably the greatest. If you want an investment you can just make and not watch and not worry about unless the entire asset class tanks, Index funds are fine (S&P is large cap blend). For market-timers, index funds are unmatched, particularly since their cost of putting the investment in and taking it out tends to be low. But I am not a mindless vanilla investor, and for one step up the mental chain, index funds can be beaten by periodic investment class reallocation. Furthermore, I am an investor, not a market-timer. So any time somebody's recommendations for investing include index funds, I'll pass them by.



Caveat Emptor.