January 18, 2009

Reasons to Avoid Mutual Funds

Posted in finance tagged , , , , , at 5:48 pm by mj

I’m finishing up David Swensen’s Unconventional Success: A Fundamental Approach to Personal Investment. This is part of my self-study aimed at becoming a better investor. (You may notice more finance/investing articles here and on my link blog. I’m finding it incredibly interesting.)

Swensen manages Yale University’s endowment, and is generally known as one of the top fund managers in the business.

Swensen advocates systematic portfolio rebalancing, which increases returns and decreases variance year-to-year. Unfortunately, the rebalancing activities required often run against our instincts, so few have the discipline for it. Even most mutual fund managers.

A large part of his book is devoted to explaining, in excruciating detail, and with more statistics than you could possibly process in a single read, why mutual funds are a bad investment.

Consider this small excerpt, comparing the offering of mutual funds to a standard, passively managed index fund (all emphasis is mine):

Fifteen-year results show a scant 5 percent probability of picking a winner. […] In a cruel twist of fate, for those skilled (or lucky) enough to identify a mutual-fund winner, the gain proves far more mediocre than the race track’s long-shot payoff, as the average winnings amount to a scant 1.5 percent per year. Fully 95 percent of active investors lose to the passive alternative, dropping 3.8 percent per annum to the Vaguard 500 Index Fund results.

And a bit later, discussing tax implications in non-tax-deferred accounts:

A miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum. Arnott notes that “starting with an equal amount of money in 1984, fifteen years later an investor in the average losing fund would have roughly half the wealth that would have been amassed had the money been invested in the Vaguard 500 Index Fund.”

He goes on in his book to outline all the reasons: high sales (load) fees, commissions, marketing fees, hidden fees, poor/average managers, conflicts of interest, trend following, using skewed statistics as marketing pitches, etc. And those are just the obvious, legal reasons. The mutual fund industry is steeped in misdirection and outright fraud.

It strikes me as unfortunate that the most prominent form of investing for the average person–401(k) accounts–is driven by the mutual fund industry. What’s worse, the typical 401(k) account does not even have access to all mutual funds: it’s usually a pay-for-play affair.

So even if you identified the best mutual fund managers (1 in 20 probability), you’re completely at the mercy of whatever financial deal your employer has struck, and likely you have no choice but to invest in (at best) average funds. And all of this is endorsed at multiple levels of the government, not least of which the IRS.

Anyhow, I highly recommend this book. There are only two shortcomings that stick with me.

First, as a numbers guy, I wanted more numbers, more charts, and to see the data behind summaries. But he provides an excellent bibliography section, so I can always go look it up. (Might cost a bit, though.)

Second, he could have included 20 more pages worth of explanations. Sometimes he assumes you know more than you probably do (or maybe I’m just more ignorant than the average reader), requiring a re-read and visit to wikipedia. An extra paragraph here and there (no more than 2-3 pages per chapter) would have gone a long way.

But those are minor. Go buy it.

I will also read his previous work (which has a new edition now), Pioneering Portfolio Management, which, I suspect, will be even meatier.

He’s given me a lot to think about, and a lot to study. I will also perform simulations with what I’ve learned to better understand how things play out and what the downsides are, which I’ll try to incorporate into future posts.

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January 13, 2009

Self-Deception and the Financial Meltdown

Posted in finance tagged , , , , , , at 6:18 pm by mj

This NYTimes article on Value-at-Risk (VaR) and the systematic masking of investment risk (use bugmenot for registration) provides the most coherent explanation I’ve yet read.

Essentially, it tells the story of the rise of Value-at-Risk (VaR), a metric that purports to ascertain how much money you’re likely to lose in the short-term.

Don’t miss how all the financial institutions exploited its known, even deliberate shortcomings to their advantage–by essentially structuring their investments so that any risk could be shoved off into the “1% probability” that VaR was specifically designed to ignore.

Or how VaR didn’t gain widespread acceptance until 1997, when the SEC gave VaR its “seal of approval.” Not just by saying “it’s OK,” but by forcing financial institutions to disclose a quantitative measure (and since there were no such competing measures around, VaR was the path of least resistance). And then, told those same financial institutions that it’s perfectly acceptable to rely on their own internal calculations, and not disclose the input.

Score one for good ol’ Uncle Sam and his Golden Regulators.

It’s a most excellent read, both for the explanation of how financial risk has been widely (mis-)measured in the past decade, and for the stunning example of how self-deception is such an integral part of the human condition.

September 24, 2008

FDIC Insurance Myths & Sound Personal Banking Practices

Posted in finance tagged , , at 3:08 pm by mj

The economy is in the crapper. Banks are failing. The “full faith and credit of the United States government” is all people believe in. Which is scary, if you think about it.

Anyway.

Everybody’s concerned about FDIC insurance coverage, and graphs like this (via the WSJ via Paul Kedrosky) are sending people into fits:

From Paul:

The U.S. has a $6.881-trillion on deposit with banks, but only $4.241-trillion is insured. In the case of IndyMac something like $1-billion deposits was uninsured.

It seems this is one of those cases where subtleties are nearly impossible to communicate, because summaries of FDIC regulations are incomplete.

Hence why I’m writing this, hoping to do my part to help spread accurate information and reduce fear in my tiny part of the world.

First, let’s get this out of the way:

NEVER put all your money in a single bank.

The examples below are extreme cases. In addition to the possibility of bank failures or robberies, you also have to deal with compromised account numbers, being held at gun point, and so on.

A rule we like is a minimum three banks, and a minimum of two accounts that require going to the physical bank to access (e.g., CDs).

OK. So the rule everybody hears is “The FDIC insures you up to $100,000.” What they leave out is the multiple “ownership categories.”

The best source of information is the FDIC’s own introduction to FDIC insurance.

To quote:

Deposits maintained in different categories of legal ownership at the same bank can be separately insured. Therefore, it is possible to have deposits of more than $100,000 at one insured bank and still be fully insured.

Read that carefully. Then read the following pages that describe the eight ownership categories.

For example, use the FDIC Deposit Insurance Estimator to calculate your coverage under the following scenario at a single banking institution:

  • Bob & Alice have a joint savings account with $200,000 balance;
  • Bob has a single savings account with $100,000 balance; and
  • Alice has a single savings account with $100,000 balance

The result? Bob and Alice have $400,000 covered under the FDIC program.

How does that work?

Under FDIC rules, a combined savings account is split equally among all owners of the account, each of whom can be covered up to $100,000 in the “joint ownership” category.

And the “join ownership” category is independent from any coverage in the “single ownership” category.

This has other advantages, as well. If Alice were to get held at gun point, she could not, alone, wipe out their savings, because she does not have access to her husband’s money.

Similarly, if Bob were to get hit by a bus, Alice would immediately have access to 1/4 of their savings–even if there were some hold placed on the joint account (say, if Alice were being investigated because her best friend was driving the bus).

Also, if Bob and Alice were to get a divorce, they’d both be able to get by for a while–and amicably–even if there were a dispute about their shared property. And if they love each other now, it only makes sense they’d want to protect their partner in the event that things turn sour.

This is actually less than what’s possible. Add in a couple of IRAs ($250,000 each) and requited “payable-on-death” accounts, and it balloons to $1,100,000. Beyond that, and I believe you’re past typical personal banking needs. (Unfortunately, the EDIE tool doesn’t allow deep linking to the final reports.)

Given this, how is it that so much of the nation’s deposits are not insured? Too many single people? Too many rich idiots? Or are those graphs wrong and simply based on assuming any amount over $100,000 is uninsured?

My take-away is that the FDIC’s rules–which may seem a little troubling (why only $100,000?)–reinforce sound personal banking practices.

But more troubling for me is the possibility that the FDIC may not actually be financially prepared for what’s coming. From this article:

The total amount of losses to be covered is estimated to be as high as $8 billion. According to the FDIC 2007 Annual Report, the FDIC has only $53 billion to cover losses of this nature. If all the banks on the FDIC watch list were to fail, how much would it cost the FDIC? Does the FDIC have estimates calculated for this?

Of course the FDIC has calculated the estimates.

And, as with almost all institutions, they don’t have enough money.

So of course if all the banks on the list failed, they’d be in trouble, and so would we all.

But Bob and Alice have each other.

And they have their gold bullion investments.

And that secret stash of diamonds buried in their basement.

And that’s all that matters when all the world economies fail. Love. And diamonds.

What’s that you say? They should have buried gasoline instead? Dang. I guess they’ll just suffer, then. Poor Bob and Alice.