“The Retirement Gamble” FRONTLINE


At the suggestion of a client, I watched this documentary. My post about Price vs Value demonstrates that if active fund management delivers added value that is GREATER than the difference between the managed fund and a non-managed index fund fees then the investor is ahead. After all, if your managed fund is delivering a 20% higher net rate of return than the index fund; 10% vs 8%  for example, do you really care how much they are charging for management? Keep in mind that when you compare rates of return for mutual funds, the figures you read are standardly NET rate of return. That is NET of management fees; AFTER the fees have been deducted.

In my humble opinion, in this story the effect of management fees are grossly exaggerated as a factor in the shortcomings of the 401(k) as a retirement vehicle for working Americans. The discussion about why company pensions went away did not focus on the real culprit: the drive for maximum profit. This factor was carefully couched in the mention of “global competition”. I believe that without a doubt company pensions are the second best way to insure a comfortable and well earned retirement for an American worker. The best way would be Social Security. We know, however, that the grand bargain struck between Roosevelt and the “captains of industry” in the 30’s; that is union recognition and company benefits such as pensions and healthcare has been smashed by the Reagan era and years subsequent. Social Security now claims to be a “supplemental retirement benefit” which should be supplemented by personal savings and investment. Social Security could become the primary and sufficient retirement plan for American workers. It would only take the political will to raise the contribution rate for employees and employers.

Corporations now only need to offer the 401(k)’s to claim they have a “retirement plan”. The old fashioned pension plan was funded (frequently invisibly) by the employee and the company together. The employee was given a statement that showed what their income would be until they died if they worked X number of years for the company. The management of risk fell on the company’s advisor. Some pension managers did better than others and they were expected to have a fiduciary obligation to the company. The employee had no need to learn the intricacies of investing.

Automation through computerization and robotics has caused skyrocketing productivity. This means that it takes fewer employees to produce the same number of products. Therefore, fewer and fewer workers are employed by the company resulting in less money flowing into the pension fund. However, companies howl at their unfunded pension obligations while  banking the excess profits they have reaped through automation.  I believe this is the primary cause of the insolvency of so many pension funds since the mid-1980s.

Jack Bogel, CEO of Vanguard has soap to sell. He sets his mutual funds apart from the pack by claiming the superiority of index funds over managed funds with their “exorbitantly” higher fees. In my previous post I took that claim apart with the first comparison I made. The real culprit of the dismal success of the 401(k) as a retirement plan is its complexity, corresponding lack of access to competent advisors with a fiduciary obligation to the participants, insufficient plan contribution by the employer (the “company match”), and most of all, downward wage pressure that leaves workers with insufficient disposable income to invest in their retirement.


Index Funds: Price vs Value

I had a meeting with a client last week and we had a debate over the use of “managed” vs “index” mutual funds. Managed funds are those that have a team of stock analysts led by a manager or team of managers. Index funds are passively “managed” mutual funds that seek to mirror an index or “benchmark”.  There are many, many indexes in the investment universe. Perhaps the best known two are the S&P 500 and the Dow Jones Industrial Average (“DOW”, “DJIA”, “DOW 30″). The S&P 500 (Standard and Poor’s 500) index is 500 US publicly traded stocks that strives to represent the entire U.S. stock market. The DOW is 30 stocks that seeks to represent the best examples of corporations of 30 diverse industries in the U.S. The DOW “average” is the average of the sum of a single share of each of those companies. I have been following the DOW since I was licensed to sell securities in 1993 and that is the index I use to watch the “Market”.

My client has heard a great deal about how index funds are so much cheaper than managed funds. She was led to conclude that since they are cheaper they must have higher rates of return. After all, common sense dictates that if something costs less to operate then it can deliver more value than something that costs more to operate. I did not have the facts at my fingertips so I had to assert my philosophy instead. The advisors’ “rule of thumb” on the topic is that about 20% of mutual funds beat their index. That does not mean that the same funds or same fund management teams are consistently in this quintile. I also hold that active fund management presents the possibility that short term events, whether  natural, political, industry-wide, sector-wide, or even news about a particular stock can be taken advantage of or “leveraged”.

This morning I set out to test my theory using a real mutual fund in my portfolio. I found a corresponding index fund and learned that the index fund had a total expense ratio (“expense”) of just .20% while the fund in my portfolios was 1.06%; more than 5 TIMES HIGHER! You would think then that the index fund was delivering a higher “net” (after fees are deducted) rate of return because it didn’t have “all those fees”. I was pleasantly surprised, however to see that my fund had more than 47% higher net rate of return (NROR) for one year; about 800% higher NROR for the 5 year average and more than 35% higher NROR for the 10 year average. Morningstar reports that in the past year there were 773 mutual funds in this category. My fund, rated “5 Stars” was #1 while the index fund was #17 (3 Stars), still very good.

How can this happen? There are several factors. First I noted that the index fund had 906 stocks in it while the managed fund had only 56. The index fund might hold all the stocks the index holds in an effort to “mirror” the index. Since the managed fund has no such obligation, it can hold a much smaller number of stocks making it easier to not only track their performance but to actually track their governance, inventory, research and development, product liability risk, labor stability and a host of other issues. This information can be used to accurately predict the profitability of a company and possibly, a corresponding future demand for its stock.

The managed fund can take advantage of the fluctuations in events to buy and sell not just 56 stocks but any in the universe of that category. The managed fund had a turnover of 38% compared to just 8% for the index fund. Turnover is the proportion of stocks traded in the fund over a given period of time. This leads one to believe that the managers are trading the stocks in the portfolio and generating capital gains. Capital gains are part of a fund’s “total return”; a performance factor missing from the not actively managed index fund.

Indeed, the Morningstar report shows a potential capital gains exposure of 15.96% for the managed fund while the index fund has just a 1.25% potential for capital gains. This is a tax liability issue for the investor and many shy away from this. The maximum capital gains tax rate is 15% and I will argue that 85% of something is a whole lot better than 100% of nothing. I think that the additional expense of .86% for the managed fund is money well spent because it delivers a whole lot of value for that expense.

I could buy a pair of lace up oxford dress shoes at Payless Shoe Source for $25 and they might even be leather. However, I choose to buy a pair of $120 Bostonian lace up oxford dress shoes instead. Why? They don’t pinch, take a shine and fit from day one. I don’t have any Payless shoes I bought in 1980 in my closet but I have several pairs of Bostonians from 1980. This is the difference between “price” and “value”. The same holds true for mutual funds. Maybe not always but a whole lot of the time.