Archives for May 2007

Now that Vanguard allows us to waive all their $10 low-balance fees, I need to reconsider my choice in bond funds. But which one? Here’s a my brief and very generalized understanding of bonds, based on my own readings. Please use this only as a starting point for your own research.

Quick Bonds Primer
Bonds are essentially loans, either from government or private companies. In portfolios, they are usually used to reduce the overall volatility because of their low correlation with stocks. When stocks go one way, bonds tend more to go the other (thought not always). This can allow you to lower risk without significantly lowering returns. See this Vanguard illustration.

While there are many different types of bonds – corporate, mortgage-backed, U.S. Government Treasuries, municipal, to name a few – you can break them down into two ways:

Maturity Risk
The longer the loan length, or time until maturity, the more sensitive bond prices are to interest rate fluctuations. Bonds are often grouped into short-term, intermediate-term, and long-term categories. The lender (us) is usually compensated for this extra volatility with higher returns. Another way to measure sensitivity of a bond fund is by looking at the duration. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond’s price would rise by about 2% when interest rates fell by one percentage point.

Credit Risk
Just like with consumer loans, the worry is about defaults. The riskier the borrower is, the higher interest they must pay. Given the same maturity length, a junk bond with a low credit rating will pay a higher return than a government-backed Treasury bond. Foreign bonds aren’t very popular, due to the added currency risk and also higher expenses.

Where’s the best risk/reward combination?
Just because as risk goes up, return goes up, doesn’t mean that there is a linear relationship between the two. You want to find the best combination for your portfolio needs.
[Read more…]

Here’s a nice Reuturs article interviewing Warren Buffett and Charlie Munger shortly after the recent Berkshire Hathaway shareholder meeting.

On index funds and beating the market:

Warren Buffett said on Sunday most investors are better off putting their money in low-cost index funds, though he believes he can still outperform major market indexes.

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,” Buffett said at a press conference, a day after the annual shareholder meeting for his Berkshire Hathaway Inc.

As for Berkshire, which ended March with nearly $90 billion of stock and fixed-income investments, Buffett said “we think we can do better than the S&P. I would be disappointed if our portfolio didn’t do a couple of percentage points better. I would be amazed if it did (much) better.”

I’m not sure if this is Buffett being humble, or he is admitting that beating the S&P by a large margin is getting harder and harder.

On performance chasing:

Charlie Munger, Berkshire’s vice chairman, said at the press conference that many investors actually fare worse in actively managed funds. He said many funds perform well when they’re small, but struggle to keep up when investors chase that early performance, and pour in cash.

“Successful funds attract a massive amount of money, and the later performance typically gets mediocre,” he said. “Then they keep publishing returns for the whole period for someone who started 20 years ago…. The reporting has falsehood and folly in it.”

If I believed in the “Buffett way”, which on some days I do, I would simply buy BRK directly rather than try to replicate or beat his results by trading on my own as a mere mortal.

I recently received an e-mail that went like this:

“It’s not expenses that matter, it’s total return after expenses. You could charge 1% but if I make you 30% who cares? Why don’t people understand this? I offer my clients superior performance for my fees.”

This irked me. I thought about sending him a few articles about why there’s no proof that any consistent market-beating performance by money managers exists. But instead, I said okay, fine. Here’s an open invitation. I give you my money to manage. You can choose whatever investments you like – mutual funds, individual stocks, whatever.

Instead of a flat fee, you choose the investments, and you get to keep 80% of how much you beat a benchmark portfolio where I try to match your level of risk using index funds. If you fail to beat my portfolio, you must pay me back the difference. So let’s say an advisor would charge 1% of assets. All they would have to do is beat the market consistently by 1.25%, and they’ve got that made already. If they kick butt and beat the market by 5%, they get 4% of assets!

Yes, all the risk here is held by the manager. So what? If you’re so confident you can do better than my portfolio of index funds, put your money where your mouth is. It’s like working for straight commission. You make me more money than my no-brainer portfolio, I make you money. I feel this is much more fair than the current setup, where we pay a relatively fat fee regardless of ensuing performance.

You might be thinking: “But no manager would have enough money to guarantee against that kind of potential loss”

Again, very true. I’d need some collateral to make sure he wouldn’t cut and run. The risk could be mitigated if you could buy some sort of insurance policy to hedge against catastrophic losses. Now, it would probably be expensive, as going back to my original point, as historical statistics show that market-beating performance is unlikely to happen. Maybe Lloyd’s of London is balking, and that’s why I haven’t heard back from him yet…

A more reasonable option?
Although I still wouldn’t buy such a mutual fund, here’s a more reasonable option for actively managed mutual funds. If you fail to beat the relevant index, your expense ratio should be 0%. No need to make people “whole”, but you have to refund all fees taken from the last year. Otherwise, you can earn a pro-rated amount of any market-beating gains with a cap of say, 2%. I know some mutual funds vary their expense ratios slightly based on performance, but none as harshly as this.

Ever wonder why this isn’t how mutual funds are set up?