One of the largest and first money market mutual funds ever has broken the buck yesterday. The Primary Fund, run by The Reserve, with $65 Billion in assets, saw it’s per-share price drop from the standard $1 to 97 cents, due to it’s holdings of Lehman Bros. debt. They are also restricting withdrawals for up to 7 days. According to the NY Times, this is only the second time in history this has ever happened.

In the aptly titled Pride Goeth Before a Fall, NY Times blogger Floyd Norris points out how The Reserve actually made fun of other money market funds for being careless. This is from a letter from The Reserve to shareholders from earlier this year:

When we created the world’s first money fund in 1970, we clearly stipulated the tenets that define a money fund: sanctity of principal, immediate liquidity, a reasonable rate of return — all while living under the overarching rubric of boring investors into a sound sleep. Unfortunately, a number of firms that sponsor money funds, and a number of investors that selected them, have lost sight of the purpose of a money fund and the simple rules that guide them in their foolhardy quest for a few extra basis points. […] Thank you for your confidence in our Reserve. We never forget you have entrusted us with your reserve(s).

Yeah, you’re welcome. Can I have my money back now? 😛 If you trade with TD Ameritrade and have a money market sweep set up with them, I believe they use The Reserve.

Where Should I Put My Cash?

Consider sticking with an FDIC-insured bank account. Money market funds are not insured. If you want that, you should stick with an FDIC-insured bank and mind the FDIC insurance limits carefully.

Besides, it’s more profitable right now. You can get a savings account today with no fees or minimums that earns up to 3.75% APY. The fund that failed above was only yielding 1.19%, and I don’t know of any money market fund that yields higher than 3%. (Even if it does, be suspicious!). Why settle for less interest and more risk?

Invest in a Treasury money market fund. But many of us have brokerage accounts with an automatic sweep or “core” option. We have to pick some sort of money market fund. In this case, to get the most safety you should choose the “Treasury” money market option, because these only invest in Treasury securities which are backed by the U.S. Government. You often end up with a lower yield, but some of it is recovered if you live in a state with income taxes. Treasury interest is exempt from state income taxes.

For example, with Zecco Trading their taxable money market (CSAXX) is yielding 1.81% while their Treasury MM (ITRXX) is only at 1.16%.

Invest in big fund companies with lots of assets. You might be surprised to know that many other money market funds would have broken the buck this year, except that the fund companies stepped in with their own money to prop things up. The Wall Street Journal reports that “20 money-fund advisers have moved to support their funds within the past 13 months”. One recent example is the influx of money by Wachovia Corp. into the money market funds from Evergreen Investments, which they own.

Why do they do this? Not out of the goodness of their hearts. It is to protect the trust of their brand and to prevent a huge onslaught of withdrawals. I would certainly never invest in a company that I can’t even trust with my cash. Therefore, if you are going to invest in a money market fund, buy one in a company which would spend every last penny to protect it’s name brand. From Marketwatch:

Phillips speculated that because The Reserve is solely a money market shop, it didn’t have the resources to bail out Primary Fund in the way a diversified mutual-fund giant such as Fidelity Investments, Vanguard Group or Evergreen Investments, which is owned by Wachovia Corp , would be able.

FYI for those who invest in Vanguard money market funds:

Vanguard Group’s money-market funds have no exposure to commercial paper from Lehman, Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group Inc., Washington Mutual or AIG, according to a spokesman for the Valley Forge, Pa., asset manager.

As for Fidelity:

Fidelity’s taxable, general purpose money market funds have no exposure to any Lehman Brothers entity, Crowley said. The taxable money market funds do have “modest” exposure to two issuers that are subsidiaries of troubled American International Group.

Although most of my cash is in FDIC banks right now for the higher yield, I would personally still sleep well with money kept in a money market fund from Fidelity or Vanguard.

Have you ever daydreamed about becoming a daytrader? Sitting at home in your pajamas, making some clicks here and there, and making money out of nothing. Much of daytrading is based on technical analysis, of which Wikipedia says:

Technical analysis is a financial markets technique that claims the ability to forecast the future direction of security prices through the study of past market data, primarily price and volume.

Basically, you try to find patterns in the stock chart, and time your buys and sells accordingly. Doesn’t sound that hard, right?

I just stumbled upon a really cool simulator called ChartGame that tests your ability to do so using old charts (via Bogleheads). Every day, you can either buy or sell your position. Your goal is to at least beat a buy-and-hold investor in the same stock. For those that are familiar, you can even plot things like RSI, Bollinger Bands, and MACD (moving averages). Try it!

Don’t get too excited though if you win a few times, though. Given the parameters, a blindfolded, drunk monkey should beat buy-and-hold half the time. Remember, this is even before taking into account transactional costs like commissions, bid-ask spread, or taxes! See if you can win, say… 8 out of 10 times or better.

Although you may not believe me, I actually used to want to program this exact type of simulator when I was first learning about investing. People often think they can see patterns, but this game gives you a taste of reality. I’ll be honest – I was horrible at it.

I believe in holding a diversified, low-cost, passive investment portfolio. However, at the same time there is so much financial hype out there that I understand the natural tendency of people (especially intelligent, hard-working, competitive people) to actively manage their investments. They may think they can pick the best growth stocks like AAPL or GOOG, they may be Buffett disciples and search for durable competitive advantages, or they may be stable dividend seekers. Or maybe they just want to pick the best fund managers instead.

But what if you suck at it? By investing in low-cost index funds, you are essentially guaranteeing yourself to be somewhat above average every year. Wander off-course, and you could do great, or more likely you could crash and burn.

Many people decide mitigate this risk by doing some form of Core and Explore investing, where you keep most of your money in passive funds and gamble a bit with the rest. Since I do this myself to a (very) small degree, I’ve been toying with an idea that takes this one step further.

1. Start Out Small
Let’s say you are young and aggressive, and want your portfolio 100% stocks. Let’s say you carve out 5% of that, throw it into a cheap discount broker, and start trying some ideas out.

2. Track Your Performance Honestly

Thinking you’re doing well at stock-picking without knowing your relative performance is like running around the track alone with no stopwatch and saying “Gee, I’m fast!”. To gauge your self properly, you need to:

1. Keep track of all investment inflows and outflows. This means keeping track of all your contributions, buys, sells, and fees/commissions paid.
2. Account for uninvested cash. If you would have put $1,000 into an index fund, but instead bought $500 of GE, that means you also have $500 of idle cash earning 0-4%.
3. Calculate your return properly, taking into account the information from the previous two steps. Here are two ways, one provides an estimate while the other gives more accurate numbers.
4. Pick the appropriate passive benchmark portfolio. For example, the S&P 500 only works if you are investing in large, US-based companies.

3. Adjust Based On Your Relative Performance
You should run a comparison with your benchmark regularly. Each year that you beat your benchmark, you can increase the percentage of your portfolio which you actively manage. If you lag behind the benchmark, you must decrease the percentage of your portfolio which you actively manage. A really crude rule might be simply to increase or decrease the active amount by 2% each year based on performance.

If you are truly horrible, you’ll be out of stock-picking completely in a few years. For most people, you’ll probably be out of it within a decade or so, having learned a valuable lesson. If you are the proper mix of skillful and lucky, then soon you’ll be controlling the entire portfolio.

Sound reasonable?

Well, the United Rentals tender offer that I participated in went through successfully. As expected, the offer was oversubscribed (press release), which means that more shares were offered than they were looking to buy. Only an estimated 34% of shares tendered will be bought, which left many would-be arbitrageurs holding shares of URI they didn’t really want. The stock price dropped to $16.83 as of the end of Friday.

Most Larger Investors Didn’t Do So Well
This means that even if you bought more than 100 shares at the lowest price available after the tender offer was announced ($18.95), sold whatever you could at $22 and sold the rest for the best price available afterwards ($17), you wouldn’t have made any profit. In fact, you would have lost about 4%. While you can always hold onto the stock and hope for a rebound, that leaves you as a stock investor, not an arbitrageur.

In practice, trying to game one of these tender offers on a large scale is very difficult. Even if you have confidence the offer will not be revoked, there are too many smart people playing. If the offer price is close to the current share price, the expected profit would be so low that the risk wouldn’t be worth it. If the offer price is significantly above the share price, then everyone will rush will tender their shares, ironically resulting in nobody being able to sell their shares.

Better Opportunity For Smaller Investors
However, if you bought an odd lot of 99 shares, which are given priority in many cases including this one, you would have gotten all your shares cashed out. Buying perfectly at $18.95 and selling at $22 would be a 16.1% gain in about a month’s time. Of course, your actual profit before commissions and fees would have only been $301.95. $300 is the cost of a schmoozing business lunch with a few martinis on Wall Street. Therefore, this is a great chance for small-time investors to have an edge.

My timing wasn’t quite perfect – I bought at $19.81 per share, resulting in a profit after fees of $191.91 (9.8%) in less than a month. Annualized return is likely to be north of 100%. Even after taxes, that will be buy me over 25 meals from the lunch carts. 😉

I’m pretty picky about which of these offers I decide to jump into, so we’ll have to see if any other interesting ones pop up.

Yesterday, I bought 99 shares of United Rentals (ticker URI) stock for $19.81 per share, in the hopes that the company will buy it back from me next week for $22. Huh?

Quick Background
Sometimes companies choose to buy back their own shares for a variety of reasons. Often this is done via a Dutch auction process where each shareholder will indicate at what price they wish to sell (“tender”) their shares. The company will then start buying back starting with the cheapest price and going up until they get enough shares. If you indicate a higher price, you balance getting more money with the risk of having them not be sold.

United Rentals Details
URI is the largest equipment rental company in the world. In early June, United Rentals told shareholders that they wanted to buy back 27 million shares using a Dutch auction with a range of $22 to $25 per share. The offer period ends on July 16th. At the time, the stock price was only $19.50. You can find more in their Letter to Shareholders, part of a larger SEC Filing.

Risks and Rewards
The price of URI stock has been wavering recently between $18 and $21. Given that the $22 minimum offer price is currently a ~10% premium over the current market price, one risk is that too many people will tender their shares for $22, which means URI will only buy a partial amount of your shares. Your remaining shares may then drop below the price at which you bought. This risk is alleviated if you buy an odd lot of 99 shares, because according to their stated buying process your shares will be bought first.

Another related risk is that this tender offer will be canceled or amended. The company might lower it’s offered price. So then it becomes a fuzzy skill to “read between the lines” and make an educated guess as to how the management will handle this.

I am not an expert at this process by any means and am not recommending that anyone else follow my example, but here is why I think it will still happen:

• The day before the tender offer came out, the share price was only $19.50. With less than a week to go, the stock price is around $20. The stock has not plummeted or anything, but has been moving up and down with the overall market a bit. The picture remains about the same, so there is no new reason for them to change their minds if they haven’t already.
• The company had the ability to back out on this offer on July 1st (and technically every other day so far) based on one out-clause, but declined to do so.
• The current P/E ratio of the stock is only 6. It is not an overpriced growth stock, although it does have some debt issues. Most examples of fundamental analysis that I found have reported this company to be at least somewhat fairly valued.
• The financing for this deal appears to be taken care of already. So they don’t need to find anyone to lend them the money for this.

Again, I am primarily a passive index fund investor; I am not an expert in this area (not even average) and I do not consider this stock part of my portfolio. This more of a calculated gamble with a short-term resolution (offer expires July 16th), with the added bonus of learning more about stock markets in the process. I am always interested in learning more, and have been waiting for a good opportunity to try another one of these. (Kaizen!) Besides, you tend pay more attention when you have some skin in the game. 😉

Personal Details
I bought my shares yesterday for $19.81 with a limit order set at $20 before market open. Upside: If all goes well, I will gain $216.91 (minus $25 in fees) with an initial investment of $1961.19. Basically I’m trying to make $200 while putting up $2,000. That is a return of 10% over what should take a few months. Annualized that’s still over 30%. Downside: The tender offer is canceled, and I am left with 99 shares of URI. I can either keep them and hope for positive return down the road, or I can sell them. If I really want to minimize potential losses, I can set a sell stop order.

Although I have an account with Zecco Trading (review) for my other fun money plays that has free trades, I decided to buy these with my Scottrade (review) account because I have used them for similar arbitrage transactions in the past and I have a few free trades left over from their referral program. I will need to contact Scottrade today and let them know that I wish to participate in this tender offer. I will be subject to an additional $25 fee for “non-mandatory reorganizations”. In cases like this, I like having a local branch to talk to so I can make sure things are done in a timely manner.

More References
» Fat Pitch Financials Contributor’s Corner – An excellent resource for such arbitrage deals, but requires a paid subscription of $125/year (or $15/month). I recently bought a year’s subscription when it was still $100/year.
» Stable Boy Selections – His 7/8 post reminded me about this offer, which I had actually forgotten about.
» New York Times DealBook Blog – More discussion on the probabilities of this offer going through.

A co-worker of mine disclosed today that she moved her entire 401k to cash and bonds last week. She is older than me and has what must be a sizable balance because her reasoning was “I couldn’t stand it anymore, all my contributions for the last year have disappeared! Why did I bother?”

I thought that it was an interesting – albeit dangerous – way of measuring returns. I can see how it can be depressing if you start with $100,000 at the beginning of the year, keep putting away $1,000 every month for a year, and then at the end of year… you still have only $100,000 due to market drops. It can be easy to view it as simply throwing money away. I miss the safety of cash!

But this is dangerous because comparing absolute changes in your entire account to your current contributions would seem to greatly magnify any gains or losses in your account. For example, if you start with $100,000 put in $1,000/month for a year in a bull market, you might end up with $124,000 at the end of the year. You put in $12,000, but your balance grew by $24,000! Feels great, maybe I need more stocks! But in reality this is basically the above scenario in reverse, and nowhere near a 100% return.

This way of framing losses reminded me of the popular behavioral finance book Your Money & Your Brain. Are our brains just wired poorly to deal with the swings of investing?

On the other hand, perhaps this should also serve as a reminder to properly assess your appetite for risk. Going back and forth between lots of stocks and zero stocks is highly unlikely to return in better overall returns. Numerous academic studies have shown that even professional money managers don’t do market timing well at all. Simply picking something in the middle and sticking with it actually turns out better. We can try to use these gloomy times to try and find that balance where we won’t be tempted to go either way in both good times and bad.