Archives for May 2007

A mere two days after I ranted about Zecco’s slow opening procedure in the second part of my Zecco Free Trades Brokerage Review, reader Richard alerts me that they have removed the mail-in paperwork requirement for many new applicants. After applying, you now see this:

If you applied for an Individual or Joint account on or after Thursday, May 10th, and you have a US Social Security Number, you?re all set.

However, if you either:
– applied prior to Thursday, May 10th for any account
– applied on or after May 10th, but you were asked to mail your documents
– applied for an IRA account
– do not have a US Social Security number:

please provide your required paperwork.

Hmm… This is either coincidence, or maybe I have some influence after all. 😀 Somebody also said that Zecco was swamped with IRA applications near the April 15th deadline, which further slowed things down. Either way, I hope this indicates better things to come!

Continuing on the line of thinking started by my post on What if my bank fails?, the next question might be what if my mutual fund company went bankrupt? I mean, I have a lot of money in Vanguard and Fidelity right now. What happens if one of them “pulls an Enron” or simply runs out of money?

One source of information is this 2004 Money magazine article written shortly after previous mutual fund scandals:

What happens if my fund company fails?
Your money is safe. Under the Investment Company Act of 1940, which governs the industry, each fund is set up as an individual corporate entity, with its own board of directors. Essentially, your fund hires the fund company to manage its assets. If the company were to file for bankruptcy, its creditors would not be able to touch the funds’s assets. And the fund’s directors could immediately hire a new manager, pending shareholder approval.

The way I read this, mutual fund managers are interchangeable. If the fund company goes bankrupt, the assets would remains the same, one would just have to hire a new company to manage it. In addition, one of the features specific to Vanguard is that it is set up as client-owned. How this works is that each of us might own a share of a mutual fund like VFINX. In turn, that mutual fund is a separate entity that contributes money to fund Vanguard’s operations, instead of the other way around. Here is an excerpt from Mel Lindauer of the Diehards forum, which explains this setup well:

First, The Vanguard Group Inc. (VGI) is actually a subsidiary of the various mutual funds, each of which is a separate legal entity. The best way to describe Vanguard’s unique structure would be to think of General Motors turned upside down, with Chevrolet, Cadillac, Oldsmobile, Pontiac, etc. as the corporate parents, and General Motors as a subsidiary. If you think of Chevrolet, Cadillac, Oldsmobile, Pontiac, and the other GM divisions as mutual funds, and General Motors (the subsidiary, in this situation) as Vanguard Group Inc., you’ll get the picture.

Since VGI is actually owned and funded by the various mutual funds, it technically couldn’t go bankrupt unless all of the various mutual funds that support it went bankrupt. The only way that could happen would be for the value of all of the stocks and/or bonds held by each and every individual Vanguard mutual fund to go to zero. So, forget about Vanguard going bankrupt — it just isn’t going to happen.

Some have expressed concerns about putting “all their eggs in one basket” by consolidating their investments at Vanguard. There’s simply no need to worry about that. Each fund is a separate investment company (and part owner of the Vanguard Group, rather than the other way around). Thus, having all of your investments in several Vanguard funds is tantamount to having your investments spread among a variety of baskets, each independent of the other. So, put your fears to rest; your investments are safe at Vanguard.

The Real Question – Ethics and Management
In the end, the real fear that one should have is that their mutual fund management will simply make poor or reckless investment decisions and lose your money perfectly legally. Also, in previous ethics scandals, managers also performed illegal trading or other activities specifically forbidden in their prospectuses. This is why ethics and consistency of management should be a component of why you choose to invest in a mutual fund, and why I feel very comfortable with the majority of my assets in Vanguard index funds.

I have never heard of a mutual fund company going out of business. But I’ve read about a lot of bad mutual funds with horrible performance. And this drop usually happens after a period of great performance and the heavy advertising and money inflows that ensues. Something to think about.

A reader e-mailed me an interesting article about index funds from today’s Wall Street Journal entitled A Close Race, a Surprising Finish. It’s only available for 7 days, after that a subscription is required.

The basic idea was to try and compare after-tax returns of index mutual funds and index ETFs, due to the often-touted tax-advantages of ETFs. The article summarized these theoretical benefits well:

The tax-related advantages of ETFs stem from their unique structure. ETFs are created when securities brokerages or specialists assemble baskets of stocks that match an ETF’s underlying index and exchange them with the fund for ETF shares that the brokerages can either hold or sell to small investors. These ETF shares can be bought and sold any number of times without the underlying stocks they represent being touched. When the brokerages opt to take ETF shares off the market, the fund hands over stock, rather than cash. This allows the ETFs to avoid selling their underlying stocks to accommodate investor traffic.

(This explains why many mutual funds have purchase or redemption fees to discourage active trading, while ETFs can be bought and sold all day long.)

For this study, commission costs for both were assumed to be zero. So who won?

Big, low-cost index funds from Boston-based Fidelity Investments and Vanguard Group Inc., Malvern, Pa., outperformed the ETFs in most of the comparisons we set up. For the 40 time periods studied, the mutual funds prevailed in 34 — including a sweep of the one-, three-, and 10-year after-tax categories.

Why is this?

The lesson for small investors: Whatever structural differences ETFs may have in the way of tax advantages, other factors — such as a fund’s expense ratio and management philosophy — can be equally important in determining performance in the competitive index-tracking business.

ETF tax advantages pertain, by and large, to capital gains, not dividend distributions. And, as noted, ETFs almost never sell their funds’ underlying securities, so capital-gains taxes are rare… But S&P-500 index mutual funds are pretty efficient, too. They don’t trade holdings as often as mutual funds run by stock pickers, so they rarely distribute capital gains either.

The lack of significant tax advantages for index ETFs is especially true in the case of Vanguard ETFs and mutual fund equivalents, as they are just different share classes of the same investment holding. I believe Vanguard does this so they can use the ETF “side” to keep their taxable events to a minimum, benefiting the mutual fund costumers as well. Here, the only difference in raw performance should be due to the different expense ratios.

Added
Management philosophy? Why does this matter in an index fund? Well, this is another area that may surprise some – it takes skill to manage an index fund!! A good index fund manager can eek out a few more basis points of return. From the article:

In addition, tactical moves by index-fund managers can boost results. While an index fund should, in theory, trail its benchmark by at least the amount of its expense ratio, fund managers can reduce at least some of the cost through techniques such as lending out the fund’s underlying stocks for payments, and buying stocks ahead of anticipated additions to their index.

From Vanguard:

Not all index fund managers have equal skill in tracking target benchmarks. Skilled managers may, for example, be able to minimize the transaction costs associated with managing the portfolio.

Vanguard and Fidelity both seem to be adept managing index funds well. Here is an article from Efficient Frontier (see, I told you it has some good stuff.) that discusses this further, calling it transactional skill, as opposed to stock selection skill.

Summary
This article is intended for people who have already decided that index funds are best for them, and they are just wondering how to best implement it. As the title says, it was a close race and there was no runaway winner. This is important! It’s unlikely you’ll end up in the poor house due to picking over the other.

Now, if you do want to optimize, the article indicates that while low expense ratios, structural tax advantages, and good management are all important, any one by itself won’t guarantee the absolute best performance. You have to find the best combination of all three, as well as consider things like fees, commissions, and minimum balance requirements.

Want more to read about investing? Here are two sites that have supplied me with a lot of good food for thought. I find these intriguing because while both are written by men well known for their financial acumen, they often sway far from those topics and can touch on politics, family life, and the pursuit of happiness in general.

Warren Buffett – Berkshire Hathaway Shareholder Letters
Every year, Mr. Buffett writes a letter to shareholders that discusses his company’s successes, mistakes, future moves, and a bit of everything else. Although I don’t view him as a deity like many others do, and have no plans to buy any BRK stock, I do find his writing to be easy to follow and often offers fascinating insights to a successful investor’s thought process.

However, I think one thing that people overlook is that Warren Buffett gets very intimate with many of the companies that he invests in, either with close relationships with the management or even by becoming the management for a while. He knows these companies inside and out, and can affect change within them. That’s something the common investor can’t easily emulate.

William Bernstein – EfficientFrontier.com Articles
In addition to being a practicing neurologist, starting a portfolio management company, and writing one of my favorite books on investing – The Four Pillars of Investing, Mr. Bernstein also writes a quarterly article on his website EfficientFrontier.com. It mainly discusses asset allocation, such as his thoughts on commodities, but has also wandered into areas like the housing market and estate taxes.

Here’s an excerpt from this most recent article:

If you want to pick your own stocks and bonds, be my guest. Just don?t imagine that making your decisions on the basis of publicly available information and analysis will lead you anywhere but to the poor house. You?re going to have to look at the primary data and analyze it entirely by yourself. And you?d better be good at it.