Tag Archives: mutual funds

Closed-end funds in the simplest possible terms

Side benefits of having a blog: when you get tired of trying to explain a concept, you can use the platform to explain it in the simplest possible terms.

Let me also begin with a promise. As this essay gets more involved, I will let you know at those points, so you can say “nah, we done now” rather than go further. It looks long. It need not be.

Because we live in dumbth nation, I must include the disclaimer that nothing herein should be construed as investment advice; that all investments should be evaluated through one’s own research; and that the aim of this article is to promote the understanding of how investments work, not to encourage investment in any specific security or security type. And that, therefore, the author assumes no liability or responsibility for nincompoopery in anyone’s investing.

God, how I hate that. One day tire irons will come with warnings saying “DO NOT EAT.”

A substantial part of my investing energies goes into closed-end funds, which many people seem not to know exist. I try to explain them, and how they differ from conventional open-end mutual funds, and eyes go vacant.

All right. This is too simple to be eye-glazing.

Cora, Eve, and Clark offer to invest your money. Each will give you his or her own branded poker chips representing shares. How much each share (white chip) costs depends on the day. Hear out their plans.

If you go with Cora, she accepts your money, manufactures the proper amount of chips, and issues them to you through your broker. Some may be fractional; in fact it’s rare for anyone to hit a perfectly round number. Cora will invest your money, along with that of others, according to guidelines she publishes. Cora’s value lies in her perceived market savvy and expertise. She has a prestigious degree, lots of whizbang charts, and other marketing hoo-hah to convince you to buy and hold onto her chips.

The price of a Cora chip is based on the total value of her investments divided by the number of her chips that exist, so that changes every day and is determined about two hours after the markets close. Sometimes the government makes Cora pay you dividends or capital gains, so they can get tax from you sooner. To fire Cora, before the trading day is over you tell your brokerage to sell however much $ worth of her chips. This occurs at the price that is determined after market close. Cora gets your chips back and melts them down, then pays you based on that day’s price. If you don’t place your order with the brokerage before market close, your order happens tomorrow. Note that you lack firm control over the price you pay. Market went nuts in last five minutes? Could be good for you. Could be bad.

 

Eve has a different plan. She is like Cora in that she invests other people’s money, and she does publish a base chip price determined in the same way Cora does, but you don’t do business directly with Eve nor at that base price. You pay a brokerage to find someone to sell you his or her Eve chips. The amount of Eve chips stays the same, unless Eve makes one of her rare new chip productions.

Eve’s guidelines say that she has to mimic a given stock or bond index to the best of her ability. Therefore, the market price never gets far from the base price Eve calculates (referred to as an NAV). Eve pays regular dividends, and you have to pay tax on them. Unlike Cora, though, who coughs up the tax bomb as a Christmas present, Eve pays them regularly throughout the year with little suspense. Because Eve gets a small fee for her work, she never quite beats the index she tries to mimic. But she comes damn close without fail and, about 60-70% of the time, Eve’s results pummel Cora’s.

Cora gets very good at filling up her regular chipowner reports with great excuses for why she again underperformed her target index. Oh, and Cora’s annual fees are ten times Eve’s. She hopes chipholders won’t stop to think about that. She also hopes the people holding her chips won’t stop to ask why, during a year in which she actually lost them money, they still had to pay a bunch of tax on gains. If bugged about it, she blames the government and the law.

 

Clark’s program resembles Eve’s. When he started up, like Eve did, he made a bunch of chips and sold them into the market through an investment banker; thereafter he doesn’t create or destroy or transact them. Like Eve’s, you buy Clark’s chips from someone who wants to unload theirs. Because Clark is not trying to mimic an index, his chips’ market price can swing well above or below the base price he calculates. His job is as hard as Cora’s. He can screw up.

Clark only invests in bonds with moby payouts, and he buys hundreds of them. High-risk bond issuers have to offer high interest to attract buyers. Because some are at risk of not being repaid, Clark spreads the money out very thinly. He pays chip owners high yields, often 10-12% per year in monthly installments. Sometimes the money comes out of interest on the bonds, sometimes out of profits from selling bonds, and at times out of uninvested cash. Clark’s chip owners will have a shit fit if he cuts the payout, so he does his best to avoid that. However, Clark is human, and if he screws the pooch, the payout could go down. If he does that, his base value might go down, and his chips will probably trade for a lot lower price than his base value.

 

Cora manages a conventional open-end stock mutual fund. Eve manages an exchange-traded stock index mutual fund. Clark manages a closed-end bond mutual fund.

If you want to, keep reading for more details. If you just wanted the simplest possible explanation that I promised you, I hope I succeeded, and thanks for giving me a chance to explain it.

 

It’s important to know what the terms mean. Without definitions, one wanders blindfolded through an explanation.

A security is a (nowadays mostly virtual) piece of paper that says you own something. In conventional investing, one buys shares of securities in pursuit of growth (one hopes to sell them later at a profit) and/or income (one wants to be paid just for owning them). Sometimes both goals are in play, and obviously anyone seeking income at least wants his or her original money back in the end.

There are other rational goals, but those are the two big ones. It’s foolish to buy securities without knowing what you want from them.

What are securities? Many types: common stocks (you own a little piece of a corporation), bonds (you own a little piece of a loan), preferred stocks (you own a weird hybrid of stock and bond), publicly traded partnerships (like stocks, but instead you own a little piece of a limited liability company), mutual funds (you own a little piece of a whole bunch of securities someone else picks out), and some more.

If you are following the main thrust of this post, it has registered with you that this makes a mutual fund a security of securities. True.

Most individuals and many professionals lose money buying individual stocks. Buying individual bonds is sometimes risky and usually cumbersome for individual investors. Thus, someone proclaims him or herself an expert, files an ocean of paperwork, and says: “I will invest other people’s money according to some preset guidelines. I know what I am doing.” This results in what we call a pooled investment–as in ‘your money is pooled with others’– commonly called a mutual fund.

The three major sorts of mutual funds all work differently. That’s why I began this article with that poker chip explanation. I believe it is the least understood, most-needed-to-be-understood aspect of modern personal finance. I believe that understanding liberates you from bad decisions. Here’s the less simplified version, which I hope the first example made easier to follow.

First, you need to know what is meant by ‘ticker symbol.’ Stocks, mutual funds, and stock-like securities all go by shorthand labels called ‘ticker symbols,’ consisting of letters. Microsoft is MSFT. Alaska Airlines is ALK. Long ago, Continental Illinois Bank was CIL. RCS is the Pimco Strategic Income Fund, a closed-end bond fund.

Conventional mutual funds (CMFs; Cora’s fund) work like this. All shares are bought and sold through the fund manager or its agent. All CMFs are distinguished by five-letter ticker symbols ending in X. Thus, FCNTX happens to be Fidelity Contrafund. VFINX is Vanguard S&P 500 Index Fund, and so on. Thousands exist. They usually trade by dollar amounts rather than numbers of shares, which are recorded to three decimal places. (Going back to our starting example, imagine Cora, Eve, and Clark’s chips stamped with their ticker symbols.)

When you buy CMF shares, the company accepts your money and issues (creates) the shares to you. When you sell them, the company redeems (destroys) the shares and pays you their market value, which is based on that percentage of every security the fund owns. A CMF’s share price is referred to as its net asset value (NAV). That distinction matters because they are not stocks and must not be viewed as stocks. The number of shares of a CMF in existence thus changes daily.

If CMF shareholders sell (redeem) enough shares at once, the company may not be able to pay the sellers from free cash. Those following along very well have registered that the company might have to sell some of its security holdings to fund very large redemptions, thus demonstrating one of CMFs’ biggest problems: their mechanics can force them to trade when its managers might not prefer to do so, which means your highly paid professionals aren’t allowed to use their full best judgment, which in turn is what you (yes, you) pay them for. It’s like a computer managing a baseball game that calls for a bunt even when a slugger–and a lousy bunter–is at the plate. The slugger can only shrug and attempt the bunt, knowing it’s a bad idea.

I used to work for a company that managed CMFs. The big money situation works in both directions. What if a huge pile of money comes into the fund at a time when it’s a lousy time to buy? And yet the fund guideline says that it will be no more than 5% in cash? There is no choice. Disobey their own guidelines and they will be in big trouble. They must pick the least unpromising choices available in compliance with their guidelines. It’s like hiring a contractor when there’s too much work for contractors (or at any time in Portland): all the best options are booked six months out. Only the inferior builders will even come out to look at your job, and they will charge too much for crappy work.

Ever hired a house-sitter? If that person was an adult, you probably set out some guidelines, but ultimately you realized that the reason for having a house-sitter was to have a responsible adult keeping an eye on your place. If the adult could not contact you, or detected an emergency, you would have to trust that adult to do intelligent and prudent things to protect your property. Owning a non-index CMF is like hiring a house-and-pet-sitter but with such extensive rules as to paralyze the sitter’s best judgment. Who hires a house-sitter without trusting that judgment? This is stupid.

Index CMFs, a variation on the above, take the judgment out of the equation by attempting to imitate a stock or bond index (fictional investment portfolio meant to represent some portion of the market for benchmarking purposes). A Standard & Poor’s 500 index fund buys, in proper proportion, all the stocks in the S&P500. If S&P ditches a stock, so does the fund. (This may sound to you like Eve’s method. It is. Think Cora’s chip issuance mechanics combined with Eve’s investing plan.)

In workplace 401ks, an index CMF is often the least doggy of the ten or twelve dogs on offer. And if it’s a conventional 401k, there won’t be an annual tax hit. Most 401k CMF offering lists I have seen were full of mediocre funds. I believe that most are selected by the 401k custodian through kickbacks. I am also convinced that the 401k custodian often pays off the employer’s representatives in order to be selected. It’s the most logical reason for such laggard choices.

Index ETFs represent the same basic idea as index CMFs, but with different mechanics since one buys or sells them on the open market at a price negotiated with another investor by brokers. Either way, the NAV (and thus your price) goes up and down in lockstep with the index. Both charge low fees because this doesn’t take that much brainpower. If Slave Labor & Prostitution, Inc. (ticker: SLAP) gets big enough for Standard & Poor’s to include it in the S&P 500, the index fund managers of S&P 500 index funds will obediently buy the correct proportion of SLAP shares to mimic the new composition of the index. Since Rust Belt Decay Corporation (RBDC) got thrown out of the index to make room, the managers dump its shares. All of them. Eve’s ETF does it this way.

Index ETFs can attempt to imitate bond indices, or in fact any imaginable security index. So can index CMFs, of course, and they do. In the case of bonds, pooled investments represent the primary way individual investors park their money in fixed income (the sophisticate term for bonds, but which includes some other investments that also pay a, wait for it, fixed income).

CEFs, like Clark’s, are the main subject of this article; however, to understand them, one needs to understand how they differ from their lookalikes. Most invest in bonds, but there are stock CEFs and perhaps other kinds. Maybe there are some that invest in partnerships, or preferred stocks, or gold coins. My focus here is on high-yield fixed income CEFs, because I’m impatient and greedy and don’t have much faith in long-term promises or institutions. I have faith in what can no longer readily be taken away from me.

CEFs interest me because if I buy them intelligently, I get distributions amounting 10-12% per year, paid in monthly installments. I may even get a capital gain if I ever sell them–but the goal is not growth. It is income, paid now and not later, which means two things I like:

  1. It’s too late for them to screw my money up or take it back. I got it. Not theirs anymore.
  2. Because I get it now, not later, I can use it now. I can buy more shares now and increase the amount of money that’s paying me that 10-12%.

At this point, I consider CEFs well explained. Everything after this para expounds my experiences and observations, and may herewith wander from the topic. If all you cared about was the topic, school’s out. Thank you!

 

Most people investing in the stock market would figure 12% a reasonable goal, year over year on average. They would accept major declines, and might stay invested for years without having actually locked in most of their gains (i.e. sold the shares). And 12% is in fact a very rational goal based on long-term historic performance. But I want my money now, not later, so that I have it to reinvest.

That’s what I do with CEFs. I buy them, at a discount to NAV where possible. I hold them unless/until they decrease the distribution, or I find better options. If they cut the distribution far enough to make them unattractive, I find better options with ease. I may take a capital loss doing so, but remember that all along–for years, even decades–I got my 10-12%. And all along, therefore, I had that money to use for something else–such as more CEF shares.

Yeah, I paid tax on those distributions…except when I did not owe any. Those CEFs in my traditional IRA were not subject to tax. I got that money every month. When enough of it piled up, I looked over my CEF universe (current holdings plus potential holdings of interest), decided which would pay me the most money without being too overweighted in a given CEF, and bought shares. Those shares then started to pay me money.

Now and then, I’d see a major share price dump in a CEF. I’d go to find out why. Usually it was that they’d cut their distribution, absorbed another CEF, experienced shareholder drama, or otherwise done something excitingly harmful to my pleasantly dull regular payments. Most commonly, I’d just dump the CEF shares regardless of capital gain or loss. I would redeploy that amount into the best available option at the time.

A surprising percentage of the time, thanks to cheapskate buying practices, I’d realize a capital gain from selling the shares. Now that was fun. Pay me monthly for eight years, then a parting bonus for firing you? Yes, please.

This took me minimal work. Every month or two, I’d go to my spreadsheet comprising my CEF watch list. I would update current market values, current NAVs (so I could see whether it was trading at a premium or discount, and what magnitude), monthly payouts, and my own original cost for the shares. The latter numbers were essential to me knowing what I was currently being paid. The rest of the numbers related to what I would be paid if I bought shares now. I would also seek to add a CEF to my universe, searching my brokerage for the best paying bond CEF, then reading up to filter out the ones that seemed unsustainable or outlandish. If it looked too good, probably was. The biggest dog in my universe, after all the updating? I’d cease tracking it. If I actually still owned it, I’d place a sell order. If I knew I could get 11%, why would I even follow something offering 7%? No need.

Some years, the stock market would eat flaming death. Many people would freak out. Many would panic-sell their stock shares, mutual fund shares, everything, eek, the sky is falling, sellsellsell. I would go shopping. When my CEFs looked to be down about 25%, I’d update my spreadsheet and blow every dollar of cash in my account on dirt-cheap shares. I knew what I was seeing was panic, irrationality–and opportunity. I didn’t buy on margin, but I bought with every real dollar that had been piling up. Since I paid less for the shares, I got much higher yields, some almost embarrassing.

I would be paid those grotesque yields for years and years, until they either cut the distribution or I sold the shares.

Eventually I no longer bought separate issue securities at all. With money I couldn’t afford to have bounce up and down to any degree, I bought conservative bond index ETFs. With money I wanted to grow, I put part of it into CEFs, and part into a rough 80/20 mix of small-cap stock and conservative bond ETFs called the 3% Signal. I no longer even cared what high-flying tech stock the pundits touted. I stopped reading financial pundits, none of whom ever paid a penalty for being wrong. I decided that I was never again going to take advice from a Jim Cramer unless he was putting in writing to reimburse me any potential losses. If the market were to crash, I would make a lot of money and it would recover within a couple of years. History supported me.

Only a total collapse of the national economy, including the dollar’s value, would wreck me. If I ever came to believe that was likely, I would have invested in some other way that was immune to such a cataclysm. All those ways are very big bets on very unlikely outcomes. I realized that everyone who bought any form of securities, no matter how preppy he or she talked, didn’t really believe in this impending disaster. I have pure contempt for the concept of professing a philosophy one does not in fact believe, be it religious, economical, what have you. If you believe it, your actions will prove it.

How you invest money you can’t afford to have vanish is what you really think about the economic future. What one says means nothing. If you buy gold, but you leave it on deposit at Edward Jones, evidently you think there is a greater risk of home burglary or theft than of a cataclysm causing Edward Jones to close its offices. If you put money into your 401k, but talk big about how everything is going to be destroyed, you are lying. If you were that sure of your outcome, you wouldn’t put one dime into a 401k even if your employer matched it. Double nothing is still nothing.

There could still be a total collapse that renders everything irrelevant. If there is, it’ll also nullify most of my potential protective measures and screw me (and nearly everyone else) up real bad. It doesn’t make sense for me to prepare for something that has been predicted annually going way back, without happening or punishment for the wrong predictors. It is more logical for me to prepare for recurrences of what has been demonstrated to occur.

I’ll keep collecting my 10-12%.

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Shareholder revolts

I love closed-end fund shareholder revolts, when you get two different ballots, and one of them is all about how management sucks. Such a refreshing change from ballots issued by management, which typically say that management is wonderful and that we should therefore vote as management desires.

(If you do not know, a closed-end fund is a form of mutual fund. Most trade in bonds. The biggest difference between CEFs and conventional funds, the kind most people think of when they hear the term ‘mutual fund,’ is that conventional funds are open-ended. All their trading is between the investor and the fund. Thus, when you buy shares, they are created; when you sell (redeem) them, they are annihilated. In a closed-end fund, shares are not created or annihilated. They are traded between buyer and seller, neither of which is the fund. I have given lengthy criticisms of conventional funds in the past, and probably will do so again, just because they need frequent slappage.)

What I love even more is when the rebels’ complaint is that the fund is going to be kept around two years before liquidation, and should be instead liquidated immediately. I guess I should have bothered to read their semi-annual reports, or perhaps this liquidation is a more recent development. In any case, it’s good to see something other than the standard blind endorsement of management. Usually the most revolutionary thing on the ballot is some proposal put forth by an environmental group or something, demanding greater accountability or constraints on executive pay. Management always votes against all such proposals, claiming that they are already doing more than what the proposal would require. You can believe them if you like; I don’t.

So. What to do?

In my case, first I go vote for the revolt. If I were keeping the shares, I might stick around to care who wins. However, if the fund is going to be liquidated, I don’t wait to be paid out. I slap trailing stop sell orders on my shares. Whatever drama they’re going to have, they can have it without my money. I can surely find a better job for my money than a fund that is being managed toward a liquidation date.

This one (KMM) was fun. It was one of my lowest yielding CEFs, and I had a capital gain to boot. Yes, please.

Simple true statements about investing to cut through the mountain of baloney

When I talk to people about investing, I see how easily they get overwhelmed. Can’t blame ’em. So let’s reduce it to a series of statements that are simple and true (in my opinion and experience), independent of one another, and see if that helps.

My suggestion is to read and absorb just one a day. That ought to last a while.

  • All stocks, bonds, and mutual funds are securities. When one says ‘securities,’ one means all those, but excludes raw precious metals, commodities, real estate, Cabbage Patch Dolls, and stuff like that.
  • An index, like the Dow or S&P 500 or NASDAQ, just watches a pool of securities and reduces it to a total number. It’s only as indicative as the chosen securities and the weight each receives.
  • In all investing, percentage is key. Don’t look at the raw number change of the index, or the security. Look at percentage change. If you can’t divide using Windows Calculator, you can’t understand investing. Of course, if you can divide using Windows Calculator, you can understand investing.
  • Stock splits mainly change looks and convenience. If a $500 stock splits ten for one, the fundamental valuation didn’t change. Everyone just got ten shares of $50 stock in return for one share of $500 stock. It’s about as significant as breaking a $20 bill into tens, fives, ones, whatever.
  • A common stock represents a share of ownership of a company. On the fundamental level, it is buying a piece of a business.
  • A bond represents borrowed money, with bondholders as debtholders. Your car loan or mortgage would be in effect a bond issued by you to your bank, if you only had to pay the monthly interest as you went and then had to fork over the principal at the end of the term. Since you have to cough up principal as you go, it’s not quite the same.
  • A preferred stock is a hybrid of bond and stock (oversimplification for ease of understanding), but in my opinion is more like the bond part than the stock part.
  • When we say ‘fixed income,’ we generally mean bonds, but preferred stocks fit the category as well.
  • There are two main ways to make money: growth and income.
  • In growth, you want to sell it later for more than you paid for it. In income, you want to get paid as you go along. Some go for one, some the other, some for a combination. I like getting paid as I go along, myself. Then it’s too late for them to back out on paying me.
  • Conventional open-end mutual funds (most of the ones you hear about) apply 1975 logic and constraints to 2015 investing. Which was fine in 1975, less so today.
  • Roth vs. traditional IRA: you are deciding whether you want to get the tax benefit now (traditional) or trust the government to give it to you later (Roth). Your call, and there are good arguments for both sides.
  • Your employer’s 401k often limits your choices to crappy open-end conventional mutual funds. Not much you can do about it. It’s a great racket for fund administrators and fund companies, which is not to say it’s all bad for you. Rather, it’s not as good as if you were free to invest it as you chose.
  • Most conventional open-end mutual funds don’t beat their target market indices, so it raises the question of why keep paying them 1-2% per year when you can, in effect and with ease, buy the performance of the index and pay the index fund manager about 0.2%.
  • Buying a precious metal fund or mining company stock is not the same as buying the metal, and the two shouldn’t be confused.
  • Looking at interest/dividend yields, here’s the simple math: divide the total annual money they pay you per share by the price you paid for the share. Payout$ / price$ = yield%. If they pay you $5 per year for a share that cost you $100, you are getting 5%. If the share went up to $150, you are still getting 5%, provided the dollars paid you per year do not change.
  • A full-commission broker is only as good as his or her thinking, and has to outperform by the commission amount just to break even for you. Worse: the broker generally has a vested interest in trading. Buy-and-hold makes him/her no money, unless it’s an unlimited free trades setup, in which case you’ll pay about what you’d pay a conventional mutual fund manager.
  • The Dow Jones Industrial Average is worse than worthless. Why? Because if you take two stocks of companies of the same overall value, one priced at $10 and one priced at $100, and each change by $1 in a given day, for the first it’s 10% (a huge day) and for the second it’s 1% (a typical day). Yet both have equal impact on the Dow. You would be better off if you strove never to even learn what the Dow does.
  • You don’t know how good your investing nerves are until you watch the whole market go to hell one day. What you do, or do not, when that happens for weeks, is your answer.
  • Bond funds are not the same as bonds, any more than gold stocks are the same as gold.
  • Bonds don’t have a market like the NYSE or NASDAQ. They’re bought and sold from inventories. As such, bond indexes can’t perfectly imitate their markets; they can only try very hard for representative samples.
  • Bonds die. Stocks don’t. In ten years, a ten-year bond goes away, with its principal paid out in redemption, and it no longer exists to buy or sell. IBM stock, in some form, has existed for nearly a century.
  • The bond your school wants you to approve involves them getting a loan from investors, with you agreeing to pay the investors the interest, and in time, reimburse the investors for the principal. So investing is part of your world if you pay rent, because your rent covers the property taxes, and that’s where school bond taxes are paid.
  • It’s unrealistic to expect gains every year. The realistic comparison is to the relevant indices: did your total return % (growth plus income) exceed them? Match them? Underperform them? If the indices took a 20% dump, and you only took 15%, good job, well done. If the indices climbed 30%, and you only got 20%, you took a bath. Terrible year.
  • The market is full of euphemisms. One is ‘correction.’ A correction means that the market took a big dump. It sounds so much better in print than ‘big dump,’ more dignified, but money is money.
  • Feel free to engage in ethical investing, long as you accept that you have reduced the focus on making money. And remember this: the total amount of stock doesn’t change because you refuse to own Monsatan (poisons), Wal-Mart (first world exploitation), Nike (third world exploitation), Reynolds (tobacco), or Exxon (fossil fuels), or Diageo (alcohol). To sell it, someone has to buy it. If you really want to annoy the company, buy their stock, donate the dividends to causes that hassle the company, and vote against management’s recommendations in shareholder elections.
  • Read too much investment media, and it’s like politics or football: you can find articles to confirm any perception. Want to believe next year is crash year? There’s a guy at Marketwatch who predicts crashes every year. About once a decade, he’s right. No one calls him out on the other nine years.
  • If you get your market information from Jim Cramer, that’s like getting your history information from the History Channel, or your understanding of basketball from the Globetrotters, or your science information from a religious scripture. As in all media, do not confuse financial news with financial news entertainment.
  • If you hand your money to a financial planner, find out how s/he gets paid. With every investment: find out who gets paid, and what. No one’s doing any of this free. Two things are true: 1) everyone is getting paid, and 2) you are paying them, somehow, somewhere. It’s okay to pay, but stupid not to know what/who/when you pay.
  • I keep using the long phrase ‘conventional open-end mutual funds’ not to be cumbersome, but because there are a number of mutual funds that are neither conventional nor open-ended, which I want to exclude from the statement.
  • For equities (securities representing ownership rather than debt), we identify them by a ‘ticker’ of one to five letters (AT&T is T, Microsoft is MSFT, Fidelity Magellan Fund is FMAGX). Five letters ending in X is a conventional open-end mutual fund. Five ending in Q is usually a company in bankruptcy, delisted from the major exchanges. Five ending in Y is a foreign stock’s American shares, without getting too complicated. Five ending in F is a foreign stock.
  • Note that there is no way to tell exchange-traded mutual funds, real estate investment trusts, closed-end mutual funds, and many other pooled investment shares from common stocks by looking at the ticker symbol. Note also that not all foreign stocks have an F or Y at the end, or five letters. Toyota is TM.
  • Any dividend that looks too enormous is soon to be cut or eliminated. Simple.
  • When you see lots of people around you doing a stupid thing financially, brace for impact. Security guards bragging in the elevator of your skyscraper about big returns? Venture capitalists throwing money at anyone with a domain name and a tattoo? Banks lending money to people who can’t pay it? Brace for impact.
  • 95% of Americans should just buy index ETFs and sit on them, rebalancing every year or two. That works unless you forecast an apocalypse that destroys the value of the US dollar and economy.
  • If you forecast an apocalypse, not even your mattress is safe. If you really believe it, you should emigrate to someplace you do not forecast will face an apocalypse, because even if your doomsday doesn’t kill you, it will make your life suck.
  • Investing is a great way to find out what people really believe, as distinguished from what they like to say and think they believe. Show me someone who thinks it’s all going to hell, and who’s putting money in a 401k, and I’ll show you someone who doesn’t believe his or her own words.
  • Rebalancing is good. It means when you divide your investments among several things, and adhere to a percentage allocation by selling what you now have an excess of, and using it to buy what you have a shortage of.
  • Yes, Wall Street is ripping us all off. Imagine if you were allowed to go to Vegas (or the local Native American casino), but if you lost big, got bailed out. You will not get to play by Wall Street rules, which are for very rich people. That, however, doesn’t mean you can’t make gains; they just will never match the gains guaranteed to those who own the system and operate it mostly for their own profit. That’s no reason not to get some gains of your own.
  • If you think the investing public is smarter than you are, think on this. Money market mutual funds are basically savings accounts in most people’s eyes, but in reality they aren’t guaranteed. They maintain a share value of $1 a share, and that’s what you actually own in them: shares. In 2008 or so, a few MMFs ‘broke the buck’–had their share value slip below the $1 which everyone takes for gospel. It was cause for panic, and in panic times, people run for safe havens. Where did they rush to? The safe haven of…money market mutual funds! To get out of the burning building, they ran outside, then back into the building. That’s your competition. Still think they’re smarter?

Our system is greed-based, and the extent and style of your participation in it is a personal decision.

Why I don’t believe in ethical investing

Considering how I feel about many major corporations, it might be shocking to hear that I have zero compunction about profiting from their stock. None. Monsanto, Wal-Mart, AT&T, Toyota, whoever–I don’t care about their sins in this context.

Why? Because my reason for investing is to make money.

I believe that investing to bring about social change is just fine, if you think it through; however, then acknowledge to yourself that this abandons moneymaking as the primary purpose, and don’t complain when you take a bath because your eco-friendly investment rolled over and threw up again. Personally, I think you could do more to bring about social change by sending charitable contributions to well-investigated causes, but hey, it’s your money.

Mine will be invested for profit, and for no other purpose. That is the game as defined by the market, and the laudable goal as defined by our broad social consensus.  I did not design this game. Were it up to me, a whole lot of corporations would be running very scared, but it isn’t.

The individual investor in the marketplace, which is heavily rigged by the big guys, is like the new and friendless inmate in a major maximum security prison. He did not design the prison, with its gangs, variably-ethical guards, drugs and hazards, but it’s where he is. He can either spend a lot of time trying to effect ‘change’ against a tide like they get in the Bay of Fundy–and get nowhere–or he can figure out how to find some comfort, learn to do time. He may have to do things he’d never have considered on the outside, associate with the worst scum in society. He may have no choice. As with combat veterans, it’s not sensible to lecture him on morals if one hasn’t been there, felt what he felt, seen what he saw.

But how can you stand to own stock in Unislime (NASDAQ:UNSL), which treats its workers like Michael Vick treated dogs, pays them almost enough to buy one Taco Bell meal a day if they don’t pay rent, and last year gave the CEO a $4 trillion bonus while laying off the entire populations of five impoverished Appalachian cities? I won’t say that I feel moral joy owning UNSL shares, though it makes me economically joyous if it’s up 14% this year and coughed up a 3.5% dividend. (Once I sell it, it’s welcome to jump off a bridge, so I can buy it again real cheap.) Remember: there is no such thing as shares which are sold but not bought. I could dump UNSL, and someone else would own it. My selling would have the infinitesimal impact of driving the current share price down a tiny notch for a brief half-second, it is true, but the share price overall is based on market perceptions, the greatest percentage of which come from mutual and hedge fund managers. If a $12B mutual fund owns 5% of UNSL, and decides the stock has reached its target price, it will start selling and the stock will go down. Whether I own fifty shares of UNSL, or someone else does, will have no measurable effect on anything.

Haven’t you ever heard of shareholder activism? I have not only heard of it, I have engaged in it with some malicious glee. It works like this: every year, corporations hold shareholder meetings. Inevitably, some shareholder proposals make it onto the ballot for voting. Management invariably recommends a vote against all shareholder proposals and in favor of all its nominees, policy changes and so on. You can bet that if I get my UNSL shareholder ballot, and I see that a coalition of nuns has proposed something deeply idealistic and completely loopy, they have my vote just because that’s fun for me. I myself do not take shareholder activism seriously, because the only reason I own the stock is because I think it will make me money. Others feel differently, and consider it a powerful weapon. Good for them, but that is investing for social change. I’m investing for profit, and profit alone. Any satisfaction I get from doing something management won’t like is a minor bonus.

But you’re supporting Unislime by owning its stock! Your money is blood money! Eeeeeeeeeeeek! Icky! In order: not true, just sounds like it should be; yes, as is most of the money made in the market; stop screaming; no money is icky.

As mentioned before, someone’s going to own UNSL. Might be Unislime itself, using its cash reserves for a big stock buyback. My ownership or non-ownership is not itself support; that assertion is mindless and disintegrates under scrutiny. My ownership just means I own some phantom pieces of paper representing a little chunk of UNSL. Voting for Unislime’s paid Congresspeople–that is support. Did you stop to check on that before you marked your November ballot? Also, do you own a 401K? Does it own mutual fund shares? Do you check rigorously to see if any of your funds own UNSL? Do you even know how to find that out? If you have an employer-sponsored retirement account, you probably own UNSL shares indirectly, or stocks of even more odious corporations. Most of the large ones are so unscrupulous that ‘ethical investing’ would be problematic anyway, especially considering how much we do not know. Most of them would be out of bounds. CEOs are paid to increase shareholder value, not be ethical.

It’s much easier for a corporation to be ethical when it’s not publicly traded. A very good friend of mine works for such a firm in Portland. He tells me, and I believe him, that his company has very high ethics toward the communities in which it does business. Fantastic! I’d want to work for an outfit like that, and I’d love to own stock if it would make me money. But I can’t buy their stock, and unless I need teeth for my earthmoving equipment, I’m not in a position to steer them any business. I respect them and their business practices, and I hope they prosper handily, but they are not germane to my own investing.

So, it’s pretty hard to do any investing at all without profiting from the profit of a company who earned it by working to someone’s disadvantage. It is to the company’s advantage to sell goods and services at the highest possible profit, which usually means paying employees less, offering fewer benefits, and gouging consumers to the highest possible degree. Publicly traded companies answer to shareholders, and shareholders demand value. That’s just how the game works. And as before, if you buy mutual funds, unless you do a pretty thorough walkthrough of their portfolios, odds are you are building your Sun City sunset years nest egg on ‘icky’ blood money. You can face that with eyes open, or pretend it’s not so, or choose to invest for social change rather than financial gain. We all have to be comfortable with our financial plans. Mine are to make money, and devil take the hindmost.

This all sounds like a big rationalization to liberate you from ethical considerations. For starters, I don’t believe I’m obligated to ethical considerations in what is essentially a free-for-all where the biggest players just laugh at the concept of ‘ethical considerations.’ I’ve never seen evidence that my owning or not owning a stock affected the business outcome. My stance is that the vast majority of people invest for the same reasons I do, deep down, but that some are not self-honest about it. If you do not believe in owning certain types of shares, and you fail to review the portfolios of all the mutual funds you profit from, you aren’t self-honest about it. I prefer to apply my ethical considerations in areas where I feel I make a true difference: recycling, shopping local, supporting deserving causes. I have never had a charity interrogate me to ask whether my contribution was ‘blood money.’

I’m a Muslim. I invest only in funds that are consistent with Islamic principles. Some years, that’s turned out very well for you financially. I’m not a Muslim, and I considered buying a couple of the Amana funds myself–because I don’t care what the fund stands for, just whether or not it makes me money. There are plenty of funds whose charters are based around ethical notions, be they Islamic, Christian, environmental, fair trade, no sin stocks, no defense/guns, what have you. Sometimes you’ll do pretty well. But tell yourself the truth: You are investing with a social (religious) agenda that trumps the profit motive. If that’s how you must invest in order to feel okay about your money, as before, best of luck. I don’t think less of you for it, unless you get self-righteous with me without being self-honest.

This sounds so Randroid. Haven’t I heard you say more than once that you find her ridiculous? And you’ll hear it again. Here’s a logic trap I believe in avoiding: eschewing an idea because some jackass also happens to share or advocate it. I can’t say whether Ayn Rand would approve of my investing notions, but I’m not investing to annoy or please a dead priestess of avarice. I’m investing to make money. No matter what your idea or view is, on any topic, you can find a complete scoundrel who advocates the same. Stalin had a draft; if you support conscription, does that associate you with Stalin? Jefferson owned slaves; if you admire his Constitutional concepts, does that mean you advocate slavery? It’s silliness to think so.

This whole greedy attitude is what’s wrong with America. Be the change you want to see. Nobly motivated, but you’re spending too much time addressing the wrong person. I didn’t design this prison; the gangs and the hacks have all the power here, and I have to live in reality. How about instead asking your legislators to be said change, since they’re the prison guards turning a blind eye to real wrongdoing? As demonstrated before, what I do with my investment capital will effect no social change, because what shares I do not own, someone else will. I can make my way within reality, or let it crush me without even noticing or caring. If I do, of course, I have less ability to effect other change. Take a look at Bill Gates, who made most of his money providing uncreative bloatware while assimilating or destroying most of what was better (and nearly everything else was). Now he’s giving most of the icky money away. You can argue that all of his money is filthy, if you believe there is such a thing. You cannot successfully argue that he is misusing his gains. He’s using them so honorably that Warren Buffett is just going to send all his money (a great buttload) to Bill.

Furthermore, this greedy attitude is America. Has been since the first Europeans showed up. The modern nation’s vast wealth was created through grants and exploitation of free real estate by pushing aside, confining or killing its original owners, whose descendants still aren’t getting a fair shake. Much of the initial labor was provided by slaves or indentured servants, many of whom shared in none of the rewards during their lifetimes, and whose descendants likewise still aren’t getting a fair shake. You may like this truth or loathe it, but it is reality. Unless you own nothing in the United States, or are prepared to surrender all that you own here because its economic base was gained through injustice, you’re a participant at some remove. Greed, and taking from others, made it all possible. Either none of the money is icky, or it’s all been icked out for centuries.

I don’t believe in small feelgood gestures that do no good. If you want to do some good, get out there and do some. You don’t need money to do that, but if you invest purely for profit–even in UNSL and its ilk–you may obtain greater means to do that.

Plus, look on the bright side. How good will it feel to make a bunch of money off UNSL, then dump it, and wait and watch smugly as it tanks later on? Even the ethical investing crowd has to like that.

Screw this. The conventional mutual fund model is broken.

It pains me to say that.  I used to work for Rainier Investment Management, a good company with smart managers that ran (and still run) several relatively successful mutual funds.  They treated me well; I still have friends there, and I hope they prosper as a firm and as individuals.  I learned so much there–and ironically, learned why conventional mutual funds are a broken model.  At the time (mid-1990s), they were not.  Now they are as outdated as the idea of scanning a newspaper for stock prices, phoning a broker to get a current quote, and paying him 7% to buy a stock.

But at this point, I can’t recommend anyone invest money in conventional mutual funds unless there is no adequate alternative (as in most 401ks).  They have three big problems:  the creation/destruction of shares, the way they are transacted, and the fee locusts that eat away the money.  And that’s the no-load funds.  If there is a load (a massive commission paid to the manager for the privilege of becoming his or her customer), add a fourth big problem.  If your broker charges a transaction fee of any size, add a fifth.

Before we get into that, for benefit of anyone who’s not sure, let’s detail how a conventional mutual fund works.  I was present for the founding of four of them, so I understand how this happens.  A money management firm files all the necessary paperwork to open a mutual fund, gets assigned a 5-letter ticker ending in X, invests some seed capital, hires an agenting bank to custody the money/shares, and writes up a prospectus.  Included in this are the investment guidelines, which are what keep the manager from just buying whatever the hell s/he wants.  Typical guidelines sound like:  the Fund will invest no less than 80% of its assets in U.S. equities (that would be stocks)  with capitalization levels below $1 billion (that would be small cap stocks, i.e., little companies).  The fund may hold up to 10% of its assets in cash equivalents (that would be money market mutual funds, essentially the savings accounts of the investing world) at the manager’s discretion. Okay, fine.

All well and good…so you go to buy it.  You place an order (in dollars, not shares) during the market day.  A couple hours after market close, the fund reports its Net Asset Value (that’s the price per share) for that day, and your purchase executes, with amount of shares calculated to three decimal places.  Those shares were created on the fly, just for you.  Had you redeemed (sold), shares would have been destroyed.  Tomorrow morning at 6:30 AM PT (9:30 AM ET), your manager will start thinking about how to invest the new money you sent him (so to speak).  You’ll share in the fund’s gains, losses and fees.  What’s wrong with fees? Everyone’s got to make a little money, right?

Let us say that everyone’s got to earn a little money.  It is stupid to pay someone a fee to underperform (do worse than) the overall market, the performance of which can be purchased using an index fund.  The idea of hiring a pro, right, is that s/he knows stuff you do not, does major research, digs deep, knows the right questions to ask, has a finger on the market pulse? Then how come a majority of them do worse than the market indices they compare to, a majority of the time? With all respect to the pro’s hard work, what the hell benefit is the investor getting?

It makes sense here to explain the alternative, the index fund.  It may be conventional (which suffers from all the flaws of all conventional mutual funds, but suffers them with lower fees) or exchange-traded (hereafter called an ETF, mechanics different from conventional funds, explained later).  Its basic idea is that the manager just buys the securities in a given index.  Doesn’t take much brains, as the manager has zero discretion.  S/he must maintain the fund in as perfect a mirror of the given index as possible.  If you own the fund, your performance will be the performance of that index less relatively small, more reasonable fees than actively managed funds.

The only reason to pick conventional funds over index funds is the belief that the manager will beat the market on a consistent basis.  Most do not.  Most get beat by the market, accentuated by the fees.  This adds value…how?

In fact, it subtracts value–and you pay for that service.  Well, if I want to do worse than the market, I don’t need professional help for that.  If I want my investments screwed up, I’m capable of that all by myself.  Now that I’ve explained the model and how it functions, let’s detail why it is broken.

1) Creation/destruction of shares.  Sounds simple enough, right? Not so much.  Suppose the market is going great guns.  Everything the manager bought is fairly expensive right now.  Because the market is going great guns, investors’ money pours in.  The manager’s guidelines require him or her to buy–but there’s nothing out there that’s a good deal.  S/he must buy at the inflated prices.  Okay, now the market is eating flaming death, or the fund had a bad quarter.  Investors head for the exits.  They must be paid, meaning the manager must raise cash for redemptions.  But there’s nothing s/he really wants to sell right now! There is no choice.  The manager must sell a security s/he did not want to unload, probably because this is a terrible time to sell, locking in a large loss.  Both of those dynamics damage performance.  It’s bad enough with stocks; it’s worse with bonds, which is why conventional bond funds are such a dumb investment.  Bonds are mostly not traded on markets, but are sold from broker inventories.  One can’t just buy a bond index, as the bonds in it are not always available.  This is why bond funds can go up and down in price:  after their issue, bonds will trade at premiums or discounts to their original par.  So for a bond fund, you get the potential for losing money of a stock fund, but you don’t get the high upside of stocks.  Seriously? Who wants this?

2) The way they are transacted.  If you buy a stock or bond, you buy at a market price.  You can issue trading instructions.  If your trade conditions are met, bang, you bought it–same is true for selling.  If you buy a conventional mutual fund, you issue the order when the market is open, and after it closes, you find out the price you paid.  In what world is this even remotely acceptable? I have some books for sale.  If you place an order during the business day, I’ll fill it this evening, but I don’t yet know the price you’ll pay.  I’ll know that later.  Would you buy books that way? Then why will you buy thousands of dollars worth of mutual funds this way? Do you hate your money and want rid of it? If so, send it to me.  I won’t charge you any fees and I will pay your postage and/or wire fees with a friendly smile.

3) The fee locusts that eat your money.  The fees are not inconsequential.  How it works:  the fund pays out money, including (most significantly) to the manager for his or her professional expertise.  Okay, fine.  Typical management fees for actively managed stock funds amount to about 1-3% of the total money in the fund.  You pay that, though you do not see it occur.  Worse:  you pay that even when the manager underperforms the market.  Dead serious.  You often pay them to lose you money.  Is there a one of us who cannot lose his own money without help, for free? If you want a free money-losing service, the offer above stands.  I’ll take it off your hands and I swear not only never to charge you a fee, but to cover all costs.  Hang on; there are also 12b-1 fees, ranging from 0.25% to 1%, that go to pay people for marketing the fund.  I’m pretty sure, for example, that’s how Fidelity gets paid for its no-transaction-fee funds.  These, too, you pay whether the fund wins or loses.  How does it add value to you? It doesn’t.  It’s just a way to get you to pay the freight for marketing and distribution of someone else’s goods.  You are the customer, not the manufacturer.  Why are you paying your vendor to market his product to you? Isn’t that rightly his expense?

4) Sales loads.  Typically 5.75%, a one-time fee assessed when one buys (front-end load) or sells (back-end load).  Often called a ‘sales charge.’  The very term is insulting to one’s intellect and commercial sense.  You have to pay them a massive fee for the privilege of having them charge you further hefty fees to underperform the market? In order to make up for the crater this fee will put in your returns, the manager must outperform for years at a time.  Odds are heavily against that.  So, let me get this straight.  You’re willing to buy something this disadvantageous? I have a better idea.  Buy an index fund, and send me any portion of the 5.75% you feel fair and right.  I will cover all fees and expenses for this process, and I’ll never charge you any further fees for it.  Why do load funds even exist? That’s so that full-commission brokers, who sell the illusion that they are acting in their clients’ best interests and who get paid every time they trade securities, can get paid to put the client in mutual funds (which will not generate ongoing commissions for the broker, being typically buy-and-hold investments).  Full-commission brokers are as obsolete as sales loads, conventional mutual funds and learning the stock results from a newspaper.

5) Broker transaction fees.  These vary from discount brokerage to discount brokerage, so let’s talk about how Fidelity does it.  At Fidelity, I pay $7.95 to trade stocks up to some large amount of shares.  Some conventional mutual funds have no transaction fees (I assume because the fund managers agreed to slip Fidelity some 12b-1 fees).  Here is an excellent article about this.  Others have a $75 transaction fee.  If I buy $7500 worth of stock, I pay about 0.1% in commission.  If I buy $7500 worth of mutual fund shares, I pay 1% in commission (let’s call this what it is, shall we?). Every nickel of commission that you pay is a loss to you.  One always pays something, but in the gods’ names, why pay more for no benefit? Ah, but say you really want into that fund.  Do you want it badly enough to lose this much money immediately, so that a professional manager can then pay him or herself a handsome annual fee to do a worse job than an index fund? Because on balance, that is what is going to occur.

Think of your finances as a human body.  The conventional mutual fund model is a series of leeches, slowly but surely drinking the body’s nutrients.  In return for what? On balance, on average, in return for lowering the body’s health. What is the benefit? A sexy name? An illusion of security? Sorry, but to me it just looks like being covered with leeches.

If a single person asks, I will author a follow-up article about why ETFs and CEFs (closed-end funds) are so far superior.