Analytic Investment Management LLC

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funds

Fund Ownership of Mutual Fund Managers

Have you wondered why the mutual funds you owned in your 401k account continued to hold on to Lehman Brothers stock all the way from $65 on Jan 1, 2008 to $0 on September 15, 2008, even though there were plenty of time to get out at $50, $40, $30, or even $20, etc prior to it filed bankruptcy?

Morningstar recently published a great article on fund managers’ ownership of their own funds (https://news.morningstar.com/articlenet/article.aspx?id=372678), which may explain why most fund managers do not feel the pains fund shareholders are feeling:

“Fully 4,347 funds out of about 6,557 have at least one manager who isn’t investing in the fund. And of the 1,126 funds where there is just one manager, there is no manager ownership. On the plus side, 564 funds have at least one manager with more than $1 million at stake in the fund they run.”

4,347 funds out of about 6,557 is a shocking 66.29%! On the other hand, Warren E. Buffett, the most successful investor and money manager in the world, has invested almost all his money along with share holders of Berkshire Hathaway Inc.

ETFs or Mutual Funds?

Which is the better investment vehicle, ETFs or mutual funds? Many news media focus on minor details between the two, and compare the fee structures, asset values, turnover, trading cost, etc between them, but never mention two most important factors making them so different: liquidity and performance.

Liquidity is the top priority in any investment decision. Illiquid investments can create significant loss if timely stop loss can’t be applied immediately. Mutual funds only allow share holders to trade once a day. Many mutual funds in 401k, 403b, variable annuities, variable universal life, and 529 plans place more strict restriction, sometimes allowing trade only once a month.

Let’s look at what happened on Monday, September 15, 2008, one day after Lehman Brothers went bankrupt on Sunday.

VIX shot up significantly at market open, and it was obvious that it was not the time for long term investment.

S&P 500 was down significantly at opening. ETF investors had plenty of time to cut the loss to get out of the market. Mutual fund investors had to decide whether to cut the larger loss at the market close or continue to hold on to it, hoping it rebound the next day, which later created even larger loss.

On Oct. 19, 1987, S&P500 dropped 20% from open to close in one day. No one knows if it will happen again in the future, but using ETFs keeps the option open to cut the loss at 5% or even 10%.

Performance is another top concern for equity investors. There are more than 20,000 mutual funds in US alone. Yahoo! provides mutual funds performance data at: https://biz.yahoo.com/p/tops/all.html. According to the site, as of July 31, 2008, the top-performing mutual funds are:

Yahoo! also provides free ETF data at: https://finance.yahoo.com/etf/browser/mkt. The 3-month and 1-year performance data as of July 31, 2008 speak the different quality of managers between ETFs and mutual funds, despite there are only 807 ETFs as of today according to this site.

What is the Difference Between Stocks and Funds?

The main difference between a portfolio consisting of funds and stocks is performance potential. Let’s use 2007 as an example.

  • Only 10 stocks had over 100% gain in S&P 500 index in 2007.
  • None of stocks in Dow Jones 30 index had over 100% gain in 2007.
  • There were 4628 stocks with market cap over $100M as of 12/31/2007. 209 of them had over 100% return in 2007. A portfolio of 50 stocks selected carefully could easily contain some of 209 winners.
  • For mid sized funds buying stocks with minimum $1 billion market cap limitation, there were only 2136 stocks to select from in 2007. 91 of them had over 100% return in 2007. A portfolio of 50 stocks had less chance to contain some of 91 winners.
  • For large funds buying stocks with minimum $10 billion market cap limitation, there were only 572 stocks to select from in 2007. 30 of them had over 100% return in 2007. Most of the stocks in a portfolio of 50 stocks were guaranteed not to be in the 30 winners.

To make up the difference in performance potential, many trading techniques have been devised to capture the up trend of funds while avoiding the down trend of funds.

Following summarizes other differences between funds and stocks.

Pros of Funds:

  • Require very low amount of capital to start with some diversification.
  • Low cost way to buy and sell a basket of investment vehicles, such as a basket of home builders.
  • Can purchase investment vehicles other than stocks, such as real estates, bonds, gold, silver, oil, foreign currencies, international stocks, etc.
  • Able to short without unlimited loss or margin issue through inverse funds.

Cons of Funds:

  • Too many to choose from. Over 20000 mutual funds and over 800 ETFs are available in US.
  • Holdings of mutual funds are not transparent. Prone to end-of-quarter/year window dressing.
  • Cannot customize by excluding certain stocks in the holding of funds.
  • May not be aware many funds include same popular stocks, increasing risk of over concentration.
  • Over-diversification – due to funds size limitation, many mutual funds either simply buy and hold stocks of mega cap or buy hundreds of stocks like an index, offering little upside potential.
  • High management effort to properly time buy and sell a portfolio of different funds.

Pros of Stocks:

  • Complete transparency of portfolio holding. Stop loss can be applied on any individual stocks as bad news happen.
  • Offer better performance potential by picking the best individual companies regardless their size.
  • Able to liquidate completely on any dramatic event when market is open.

Cons of Stocks:

  • Very high management effort to establish and maintain a well diversified portfolio with 50 stocks or more. There are more than 8000 stocks in US exchanges to select from.
  • Even trading commissions has come down a lot, it is still cost prohibitive to build a diversified portfolio with 50 stocks or more for account size less than $100,000.
  • More items to report on schedule D for taxable accounts.
  • Unable to take advantage of tax-deferred variable annuity or life insurance.
  • Difficult to buy certain asset classes, such as real estates and international.