Recently, I’ve seen it reported that Harvard’s endowment portfolio performed well during 2008 because of alternative investments.  As it turns out, the reporter meant their fiscal year 2008, which ends in June. It was a perfect time to end the year, right before all asset classes lost significant value…great reporting.

So, as a follow-up to that original article, let’s look at fiscal year 2009. 

The Wall Street Journal reported today that one of Harvard Endowment’s top bond managers made $6,300,000 last year, managing the fixed income portion of the now $37 billion fund. It has been announced that this manager is leaving the endowment. Why?

The endowment is forecasting one of its worst years, down almost 30% at the end of June and is positioning itself to become more liquid. 

This move to become more liquid is the result of being very illiquid in the past.  So much so that during the credit crisis, the school had to make cuts, lay-off employees, and borrow money due to the endowment being tied up in illiquid investments like hedge funds and private equity. 

The school and endowment like other schools’ endowments have more problems than I have quickly mentioned.  It seems that the endowment, created to provide for the schools needs (the school gets 34% of its revenue from the endowment), is now in a way holding the school hostage. 

Before the credit crisis, the endowment’s illiquid investments helped the portfolio to average 14% annually. This over allocation (greed) ended up hurting the school.

This shows that there is a deeper problem in the financial services industry and should bring up the question; who’s serving whom?

Index Universe asked the following questions to Mr. Bogle following his on-line presentation:

Wiandt: Every year we hear from active managers that “this is the year of active management.” Do you believe that there are environments that are more favorable to active management than passive management and index investing? And if so, what do those times look like?

Bogle: There is no way that active managers can possibly have an advantage no matter what the circumstances are. Just think about this: Almost 75% almost of all stocks are owned by institutional investors now, and they are basically, by and large, professional investors. They are pension fund investors. They are pension money managers, they are pension trustees I should say, pension money managers, mutual fund managers, which also manage pension funds and endowment funds. And that’s 75% of all stocks, and only 75% of all stocks. It is just not possible that they can be taking the individual investor on the other side— the remaining part of the market—to the cleaners with every trade. There is no evidence of that.

So what we find is that institutional investors and individual investors basically each capture the market return and they each capture the market—and together they each capture the total market return. That is inevitable. And that’s before cost. So when you take out costs, which are high, you end up explaining almost all the reasons that active managers cannot and do not beat the funds, beat the market itself. It is just statistically, mathematically, tautologically impossible.

Wiandt: An asset allocation question: One of the main reasons we use asset allocation and diversification in our portfolio is to balance the risk. So if one thing is going up, another thing is coming down. If one thing is coming down, you’ve got something else coming up. The problem is—and if you look to October you can see this—when things go bad, it seems like everything goes down. And so what can you say to that? Is there anything that people should do in that environment or do you just ride it out?

Bogle:To me, first, in general, the question is correct insofar as it applies to equities. And it’s been long said—many, many years ago, and it’s proved so true in every crisis since then—international diversification lets us down just when we need it the most. And truer words than that were never spoken. On the other hand, the fact is that bonds produce a very good countercyclical return.

I don’t know exactly what they did in September. But I mentioned at the beginning of my remarks that the bond index fund went up 5% last year. That really was counter in direction, if not in amount, to the 35%, 37% decline in the U.S. stock market. Now I look at bonds as being the ultimate diversifier. I don’t look at diversification in equities [in terms of] being in different equity styles as being particularly helpful in the long run.

Look, we all know there are times when growth is doing better than value and vice versa, that large-cap is doing better than small-cap and vice versa. But they seem to come back. They seem to revert to the mean over long, long periods of time. And it’s very hard. Individual stocks, individual styles, have a very similar correlation with a stock market as a whole, a very similar correlation with one another and with the stock market as a whole—even down to the individual stock level and the style level and the manager level. So I think if you are looking for safety, the best instrument for safety is a high-grade bond portfolio, including Treasuries and high-grade corporates.

Wiandt: It looks like we have got an active investor here with a question. I think you may enjoy this one. He says, “Jack, you continue to encourage individual investors to buy and hold. However, I challenge you to name one goal-oriented endeavor besides investing where an intelligent individual would select a passive approach over an active one. Can you name even one?” he says.

Bogle: I’m sorry. You are just going to have to explain the question. Name even one investor?

Wiandt: Some activity that you would want to do in life where you would choose to be passive instead of active as a way of succeeding.

Bogle: Oh, that is such a great question! And, you know, there is an answer to it. And this is why we get so messed up in the financial business. Would you go to an average doctor? No. Why would anyone go to an active doctor, to a passive doctor or not the best doctor around? The problem is, in the financial markets, they are different from any other endeavor in American life. And that is, there is a market out there and it has a certain value. And all of us together own that market. So literally the only way to capture the market return is to own the market without cost. That cannot be done. But you can do it with a cost of as little as 0.1%, and you will, by definition, beat all these other investors who do it at a cost of maybe 2%–2.5%. There is really not any mystery about this. It is all what I’ve been willing to call or have been able to call the “relentless rules of humble arithmetic.” Get the croupiers’ take out and you capture the market return; you as a group of investors. Lave the croupiers’ take in—pay the croupier … pay Wall Street … pay the money managers … pay the brokers … pay the investment bankers … pay the investment advisers … and you get what’s left.

You know, you are sitting—you individual investor who has asked the question—you, pal, are sitting at the bottom of the food chain of investing. You know, everybody gets paid before you do. Where else is that true in American business? I don’t know if it is true anywhere else at all. So, yes, unequivocally, it is different and it has to be different. And our failure to acknowledge that difference is what gets us into so much behavioral problem.

This is where the philosophy of “keep investing cost low” comes from. Every penny you pay in fees, those you see and those you don’t, is one less penny you have to compound into the future.

Thank you Index Universe for this great interview.

Casey T Smith – Wiser Wealth Management, Inc

After reading this article, I did a search for the FDIC’s failed bank list to see which GA banks were on the brink of failure. I quickly became aware that the FDIC does not publish its failure watch list. This makes some sense as this could cause a “run on the bank” that would cause the institution in question to surely collapse. They do publish the banks that have been taken over by the government.

This list for GA is quite lengthy, but after going through the list I could not help but notice one glaring similarity, but first, let me explain how I came to this discovery.

At Wiser Wealth, we manage CDs for many of our more senior clients. For a small fee, we can access CDs across the country and place them all in one brokerage account. This keeps our clients from driving across town and by using various banks, we can keep the entire account FDIC insured. Inevitably, a client would call me up and say that he was driving and saw a sign that said “Bob’s Bank”  had a 5%, 1 year CD.  I would explain that we could not do business with just any bank but only those that established a relationship with TD Ameritrade, our custodian. I also saw the CD advertisements in our local Marietta Daily Journal.

 And so, as I looked over the failed bank list, I saw Alpha Bank, Integrity Bank and American Southern Bank. I realized that these banks were just a few I remembered offering these very generous 5% CDs.

A bank is on the FDIC watch list for several reasons, but one is certainly not having the funds to keep operations running. If a bank needs to raise deposits, CDs are one way to do this. And certainly if the funds are needed quickly, a 5% CD in this environment is certainly going to get the attention of the conservative investing public. I am not saying that every bank that offers a exceptionally high CD rate is on the brink of extention, but it should be noted that this pattern at least applies to our failed banks in Georgia.

Currently the FDIC insurance limit per person is $250,000 (until 2014). One should never exceed this at a bank, especially in this environment. A brokerage account filled with various bank CDs is  much more secure than all your savings at one bank, no matter what the institution size.

Certainly these banks did not get on the failed list because of 5% CDs. In Georgia, most of these banks failed because of unpaid loans from real estate. Regardless, the old saying that “there is no free lunch” applies here!

Casey T Smith – Wiser Wealth Management, Inc

 When investing in mutual funds, the investor is handing his money over to a mutual fund manager, giving him or her full discretion in trading the asset as he or she sees fit.   This is a simplified scenario, as behind the scenes there are usually a lot of internal and external controls put on the managers, but from the small investor’s standpoint, he has no say in how the fund is run.

 Exchange Traded Funds (ETFs) bring much more transparency to the table.  Instead of having no control and limited knowledge about what your investment assets are up to, ETFs allow you to know throughout the day what they hold and the value of those holdings.  ETFs are also rule based, meaning that you will know exactly how an ETF will function, as its only objective is to track an index.

 This gives the investor, who needs diversification, a way to have zero manager risk.  This means that the investor now has control of a diversified basket of stocks in an inexpensive wrapper.  With now hundreds of ETFs available, basically, any investment view can be expressed using ETFs.

 With this power, comes more responsibility for the investor.  ETFs are extremely efficient and effective tools and those who understand their basic principles can utilize them in almost every situation.  On the flip side of that, a misunderstanding of the unique features and risks of ETFs can lead to problems. 

This is why, as with any investment decision, it is best to at least get some advice or research report concerning the investment strategy and investment vehicle.

Supply and Demand

Sometimes when people ask me about ETFs and I can tell they don’t want a long answer, I say “ETFs are like mutual funds that trade like stocks and track an index at a low cost.”  This statement is true and not true at the same time.  It’s like a mutual fund in that it is a way to be diversified and like a stock in the way you can trade it throughout the day.

 It’s this “throughout the day” that is important to distinguish here.  Stock prices are set by the demand for that particular stock.  An increase in buying demand will cause the price to increase just like selling demand will drive prices down.

ETFs Are Followers Not Leaders

ETFs, unlike stocks are price followers, as their price is not determined by supply and demand.  To be clear, just like a stock, the price will change with demand but this is artificial since ETFs are simply tracking its holdings’ market prices.  With traditional ETF structures, the ETF’s objective is to track an index.  The ETF company will put together a basket of stocks, bonds, or futures and options (when tracking asset classes like commodities).  The price of this basket is called the ETF’s NAV or net asset value.  The ability of this NAV to track the index is measured by its tracking error. 

The ETF will then trade on the market at a price which should, in theory, reflect the NAV.  When the market price is above the NAV price, the ETF is trading at a premium.  When the price is below NAV, the ETF is trading at a discount.

 This is why, when buying and selling positions of ETFs, it is best to use a limit order.  A limit order will buy or sell an ETF at a determined price or better.  A limit order guarantees a price but not execution.  In this way, you are trying to buy the ETF that reflects its characteristic as a price follower not a price determined by demand.

 Using a limit order to buy and sell ETFs is a smart way to reflect an understanding that ETFs sometimes trade at a premium or a discount to NAV and that when you buy a large amount of ETFs that have low trading volume, you may not get the price you wanted or thought.  A smarter way to buy would be to set a limit order at NAV, since ETFs are followers of that NAV price. The NAV price for an ETF can be obtained from your broker’s trading desk. At a recent Power Shares event, it was mentioned that a good rule of thumb is to place a limit order between the bid and ask price for an ETF. This spread can be pennies and in some cases dollars.

 If an investor placed a market order to buy an ETF, a scenario could be the following:

NAV for XYZ ETF is 90. The Bid is 89.9 and the Ask is 90.1. There are Sell Limit orders from the market as follows:

Limit 92          1000 shares

Limit 91.5       1000 shares

Ask    90.1       1000 shares

 Your market order for 1000 shares is placed the same time as another investor’s 1000 share market order. Your order’s que is milliseconds behind the other which allows the first purchase to get the NAV price at 90, then your order got routed to the next available price at 91.50. You just paid a $1.5 premium per share!!! If you had used a Limit order at NAV, your order would have waited in que for the next seller at NAV.

Why ETF Trading Volume Does Not Matter 

For an ETF purchaser or seller, ETF trading volume does not matter. ETF trading volume is the number of shares of the ETF that have traded over a time period. This is usually reported daily.

If a new ETF came out tracking the S&P 500, it may have low trading volume, especially if it charged more than the ETF’s tracking that index already on the market.  Even if the volume of the ETF was very low, that does not mean that the ETF is illiquid or will fail to execute its objective. If properly handled, the investor would place a limit order at the ETF’s NAV. Should there not be enough demand to execute the order, the market maker will go onto the market and purchase the stock within the index then convert the shares into shares of the ETF, which will allow for the order to be executed. The reverse would happen in a sell situation. In reality, if you place a NAV limit order and it is not executed quickly and you are in a low volume situation, call your trading desk. The trading desk will contact the market maker.

 Large orders will not “move the market” but will actually get poor pricing if limit orders are not placed.

Final Thought

The issue of liquidity and ETFs brings me to my last point, which is exceptions.  What we have covered above are some principles of ETF investing that investors should be aware of in general.  The point of view I took was from an investor, not a trader (who may be very concerned with bid/ask spreads). With limit orders and knowing the NAV, we aren’t too worried about that spread.  There are always exceptions to these ETF principles.

For instance, ETFs that track indexes trading overseas have a unique attribute.  Where most ETFs are price followers, these ETFs can have an element of price discovery.  This happens when new information comes into the market when overseas markets are closed and investors have only the ETF through which to express the information.  There are other instances of this in the bond markets where market-to-market pricing is used and ETFs can add liquidity to a bond market that is not liquid.

All and all, ETFs make the market more efficient.  They are a powerful tool for any investor at any size.  It is because they are powerful tools that they need to be understood. I recommended that advice be sought before investing on your own.

This article was written for www.etfmarketpro.com.

Casey Smith – Wiser Wealth Management, Inc

Borrowing from Mr. Zweig’s example, this securities lending is much like subletting your house except the fund will keep upwards of 50% of the funds earned from this lending practice. In some cases 100% of the money is kept by the fund manager, who is usually the lending agent for the transaction. Once these shares are lent out, the shareholders of the fund are at risk, not the fund advisor. An example of this risk of lending is the mutual fund Calamos Growth CNWGX. This fund took 475 million that it receives from lending securities and invested it in a money market that then purchased Lehman Brothers. The fund lost 8.6 million in the transaction, of which 100% is passed on to the fund’s shareholders. 

I agree with Mr. Zweig in that securities lending should take place and that nearly 100% of the proceeds should go to the investors, not the fund managers.  I will note that here at Wiser Wealth, our iShares and Vanguard index funds do pass on the proceeds at the near 100% mark. This process is fairly transparent in indexing, but in the Mutual Fund world, it is less obvious as the current process of lending is not regulated by the government.

In my opinion, this is another case where the transparency of indexing is better for the individual investor.

Casey Smith – Wiser Wealth Management, Inc

Each quarter, Standard and Poors comes out with a report detailing how mutual funds performed compared to passive investments or indexes.  Remember, ETFs are investment products that track indexes and are comparable with them.  This report, the Standard and Poor’s Passive Verses Active Scorecard or SPIVA Scorecard, takes a unique view of how mutual funds performed verses indexes.  The scorecard weights its category averages of mutual funds by average investor experience, or simply, how much money investors as a whole have in the funds, with more money invested giving the fund a higher weighting in the category average.  This is unique in that it details how the average person is invested in America.  From this we can show if the average investor would be better served elsewhere.

Below is a 5 year comparison of the active manager’s annual return verses a comparable index.  The active management’s numbers are averaged by S&P using the asset weighted approach to analyze where the average investor’s assets where located.

In all three broad US categories, passive benchmarks outperform active benchmarks.  In a further breakdown of style (Growth and Value), international, and real estate category averages verses benchmarks we can see that in 2008 and the 5 years prior to the end of 2008, passive benchmarks outperformed the highly paid, professional money managers, who, for the most part, spent their careers specializing in investing.  The table below shows the fund category, comparable benchmark, and the percentage of funds that did not beat their benchmarks over the time periods.  The fund averages are equally weighted and all information has been gathered from the latest SPIVA Scorecard. 

Mutual funds have difficulties outperforming benchmarks.  This happens for several reasons and goes against general conceptions of the industry.  These facts uncover a common myth in the investment industry, that mutual funds, with professional oversight, can sidestep obvious market downturns.  This is apparently not true for the majority of mutual funds

 By their nature, mutual funds hold some amount of cash for withdrawals, which in market downturns, would slightly soften the funds’ performance on the downside; however on the whole, the majority of mutual funds in most categories did not demonstrate any softening effect during the most recent downturn.

 The sad part about this picture is that investors do not receive the quality investment advice they need.

 A Winning Strategy: Making the Switch

 As explained, the majority of mutual funds will not allow an investor to win even with a great diversification and asset allocation strategy.  Exchange Traded Funds, ETFs, can update your old investment toolbox and allow for a winning strategy to be effective.

 For example, the S&P 500 which outperformed 71.9% of large cap mutual funds from 2004-2008, can be cheaply and effectively utilized through either of two ETFs.  Below is a chart of the iShares S&P 500 Index (IVV) and the first and largest ETF, the SPDR S&P 500 ETF (SPY) graphed against the S&P 500 Index.

Notice that the two ETFs track the index very closely.  This is just one example showing the importance of  having an effective investing tool.  A mutual fund that underperforms and is very costly to own will drag performance down over time and as the economy recovers, there is no guarantee that the mutual fund will recover with it.

With ETFs, where an investor held a large cap value index, switching over to a similar ETF like iShares S&P 500 Value Index Fund (IVE) can be a way to keep the same investor strategy or asset allocation but update the tool.  This is a common misconception of what really drives returns.  It is typically not a manager that drives a fund’s return but the strategy of the fund like large cap value or large cap core, that drives the return and the investment tool or which fund you choose allows you to capture that return characteristic. 

 ETFs are a cheap and highly efficient way to build a highly diversified portfolio based on your long term investment strategy.  For nearly every asset class and mutual fund category there is a comparable ETF that would allow the investor to access an asset class’ complete return characteristics.

Casey Smith – Wiser Wealth Management, Inc

A blog posted on CNNMoney.com’s Money and Main Street, Click Here, discusses a vague disclosure report from the White House concerning President Obama’s household assets and investments. 

 Page two of the original report, which the blogger links to, lists the President’s assets, where and what they are held in, and an estimated value.

What is most interesting is that the President has somewhere between $1-5 million in US Treasury Bonds and the second largest holding of somewhere between $115-250 thousand in the Vanguard FTSE Social Index.

The Obama Portfolio 

When President Obama was first elected, there were many people who advertised “Obama Portfolios.”  As it turns out, the original Obama Portfolio favors US Treasury issued debt and socially responsible companies in a simple index fund package.

The interesting part is that the President of the United States, who would have the best investment advisors at his disposal, chose a low cost, diversified portfolio of US stocks.

In light of recent market turmoil, many ETF industry commentators are saying the ETF market place is too crowded and grew faster than it was able to attract assets.

Bruce Bond, president and CEO of Invesco PowerShares, said this about the closings in the press release, “After carefully evaluating numerous factors including shareholder considerations, length of time on the market, asset levels, and the potential for future growth, we proposed closing certain portfolios that have not gained sufficient acceptance with investors.”

PowerShares closes some of the category of funds it is best known for, the FTSE RAFI Index tracking ETFs and 4 ETFs tracking Dynamic Intellidex Indexes.

12 of the closing ETFs are ETFs following the RAFI Indexes created by Robert Arnott, RAFI standing for Research Affiliates Fundamental Index, which weight index components by five fundamental factors.  Fundamental indexing proponents propose that market capitalization weighted indexes tend to overload themselves with overvalued stocks, the opposite of what an investor would want to do. These weigh an index based on fundamental factors and not by market cap which is a function of price. The 12 ETFs are all sector funds and the PowerShares FTSE RAFI Asia Pacific ex-Japan Small-Mid Portfolio.

The other seven ETFs closing represent either small slices of the market or niche concepts like the PowerShares High Growth Rate Dividend Achievers Portfolio, PHJ, which seeks to track an index that includes 100 companies with the highest dividend growths rates who have increased their annual dividends for the last ten consecutive years.

The closing Process

ETFs have closed in the past and since ETF assets are held outside of the company’s balance sheet, in trust, ETF assets are returned to an ETF investor upon the issuing company closing for bankruptcy or the ETF closing. 

As PowerShares has announced, it will begin the process of closing the funds in the first part of May.  During this time, the funds will no longer be required to meet their investor objective of tracking the index but will be seeking to get best price and execution of the underlying securities.  This will cause tracking error to increase.

As of May 19, 2009, the 19 closing ETFs will no longer allow new investors in the funds.  Investors who hold the ETFs at the close of trading on May 18, 2009 will receive the NAV of the ETFs as of May 22, 2009 as a cash deposit in their brokerage accounts.

Up to the closing of the funds to new investors, on May 19, creation and redemption of the funds can still take place to ensure that the ETFs represent the basket of underlying securities, which will keep this period of ETF closing orderly.  Investors will be able to trade the ETFs up to the closing of new investments and should seek receive prices close to NAV, which may include the using limit orders.