Yesterday, I posted about why I chose against investing in most actively-managed funds. I actually do hold one actively-managed fund right now, the Bridgeway Ultra-Small Company Market Fund (BRSIX). Why did I choose this fund? It turns out that many of the warnings against buying an actively-managed fund can be flipped to find the best mutual fund managers. Here are several things to look for, as well as some of the companies that many of these characteristics.

Do They Have A Clear, Consistent Investment Strategy?
In order to beat the market, by definition they have to have substantially different holdings from the market and stick to their guns. Also, is it clear enough that you really believe in their strategy? If not, you might bail out yourself during a rough patch and miss out on the fund’s long term returns.

Do They Charge Reasonable Fees
To start, one would hope to see no front-end or back-end loads. If they are “to discourage excess trading”, then any fees should be directed back into the fund shares, not into the manager’s pockets. Otherwise, look for below-average fees, and for those fees to decrease as the amount of money under management increases. For example, the Vanguard Windsor II fund is one of the largest mutual funds available with $52 billion in assets, and has an expense ratio of only 0.33%. That’s more than many sub-par Large-Cap index funds.

Do They Limit Asset Bloat?
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Alan Greenspan was a guest on The Daily Show with Jon Stewart recently, mainly to promote his new book The Age of Turbulence but conveniently after the recent rate cut. It was amusing seeing Greenspan in the hot seat. Via the Bogleheads.

Update: Having some problems with the embedded video, so here is the direct link to the clip.

As anyone can see, I like to invest my investment portfolio in passively-managed mutual funds. There are numerous reasons for this. For one, the average actively-managed fund underperforms the average passive fund. In addition, even if a fund does well up to a certain point in time, it does not necessarily to do well later. In other words, you can’t pick out the superstars ahead of time by looking at performance.

But still, from time to time, I may take a second look at certain managed funds. One example is the sometimes-persuasive writings behind the Hussman Strategic Growth Fund (HSGFX). Or perhaps something not a mutual fund but similar like Berkshire Hathaway (BRKB). But I never buy them! Here’s why:

Higher Fees
The most obvious hurdle remains one of the largest. Actively managed funds have higher fees. The more the mutual fund makes, the less you make. They have so many ways of making money – fees when buying (front-end loads), fees while selling (back-end loads), fees while holding (management fees)… they even make you pay for their advertising costs (12b-1 marketing fees). Can the fund keep covering this and more?

What’s Their Secret?
In the beginning, most funds start off with their own unique plan to take advantage of some specific market inefficiency. If the fund manages to maintain a streak of good performance, word will soon spread. Others will start to scrutinize the manager and their trades in order to see what their methodology is. If they figure it out, whatever that market inefficiency was will soon disappear.

Asset Bloat
[Read more…]

Whenever you hear a stock market update on TV or even online, it’s usually related to the Dow Jones Industrial Average (DJIA)… “The Dow went up 100 points today.” “We are pushing back towards Dow 14,000!” I never really thought about this until reading in my current nightstand-book All About Index Funds that the Dow, started in 1896, has quite a number of flaws as compared to other newer indexes. These flaws are well described in this academic paper The Dow Jones Industrial Average: The Impact of Fixing Its Flaws. Here’s a quick summary:

#1 – The Dow only includes 30 somewhat-arbitrary stocks
In 1896, the DJIA had 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. That’s it. It’s still just 30 stocks almost 80 years later. Not only that, but it’s not even clearly defined as the largest 30 companies or something like that. It’s simply 30 companies chosen by a committee to best represent the market out of the ~5,800 readily-priced publicly traded companies out there. Certain major sectors like transportation and utilities aren’t even covered.

#2 – The Dow is a price-weighted index
The DJIA is not weighted according to the relative value of the companies like the S&P 500 is. Instead, it’s weighted by price. So if GE’s share price of $41 goes up by $1 (market value change of ~$10 billion) , it can be negated by a $1 decrease in 3M share price of $92 (a market value change of ~$700 million). This skews the average towards the activity of higher-priced stocks.

#3 – The Dow doesn’t include dividends
This flaw is common to all of the other major stock indexes ? S&P 500, Nasdaq, Wilshire 5000. But given the relatively large amount of dividends that the companies in the Dow has historically paid out, this is important. The paper found that a total return index of the Dow companies including reinvested dividends would make the value of the index to be over 250,000 points today. Other indexes, like the Nasdaq, pay out a very small percentage in dividends in comparison.

Most surprisingly, the paper also concludes that #1 and #2 haven’t actually made that that much difference when comparing long-term returns with the other major indexes. Add in all that tradition, and I guess we’ll be seeing the Dow stick around for a long time to come.

Lot’s of people have been asking me how to open up a bank account denominated in a foreign currency. The main reason appears to be a desire to hedge against future declines of the dollar. For example, right now the US dollar is trading at all-time lows versus the Euro, and at 30-year lows versus the Canadian dollar.

I must admit that I have no clue how to do this if one is not a citizen or permanent resident of another country. If you know how, please do enlighten us in the comments.

Now, I’m no currency expert, but doesn’t this sort of behavior seem like performance chasing? It’s the new “sure thing”. I figure if you own a good chunk of international stocks, you are already enjoying some foreign currency exposure. In addition, a weak dollar makes our exports cheaper across the border, which increases sales for domestic goods. As I expect to keep earning and spending US dollars for the foreseeable future, I don’t see any need for any additional hedging. If anything, I might hold more international stocks, but I’m still open to contrary opinions.

Let’s say you do have a desire or need for some currency hedging. Instead of opening up a bank account in Euros, here are two alternatives:

Foreign Currency CDs at EverBank
EverBanks offers what it calls WorldCurrency Certificates of Deposit, which invest in a variety of foreign currencies. For example, with the Euro CD your $10,000 will be converted to Euros, earn an interest rate between 2.50-3.0% APR depending on term length, and then be converted back to US dollars upon maturity. The British pound CD is currently earning between 4.25 and 4.50% APR. So you’ll have the chance to make (or lose) money from differences in exchange rates in addition to earning interest. Here are more pros and cons:

– Guaranteed interest rate
– $10,000 minimum purchase
– Available in 3, 6, 9, and 12-month terms. No account fees
– FDIC-Insured against bank failure, but not currency losses
– EverBank likely makes money off the yields in addition to the conversions: ?The currency conversion rate will be within 1% of the wholesale spot price EverBank pays for the currency.?

Foreign Currency ETFs from Rydex
Rydex has a group of foreign currency ETFs that come close to pure plays on that currency. For example, Euro:USD exchange rate is approximately 1.39:1, so the share price of the CurrencyShares Euro ETF (FXE) is $139. If the exchange rate goes to 1.50:1, then the share price would be about $150. Along the same lines, the British Pound Sterling ETF (FXB) has a share price of $201.

In addition, the ETF do effectively earn interest like bank accounts, as they give off monthly dividends. The Euro ETF is currently yielding 3.39%, and the British pound ETF is yielding 5.46%. This seems pretty good, considering Capital One 360 UK is yielding 5.25%. More pros and cons:

– Can buy as little as one share, from existing broker
– You are subject to possible stock commissions, and bid/ask spread
– Possible premium/discount to NAV
– Expense ratio is about 0.40%
– Trade in and out at anytime during market hours

Comparing the EverBank CDs and the CurrencyShares ETFs, it would seem that the ETF would win out if you had a broker that offered free trades like Zecco or WellsTrade.

Finally, you may be able to purchase or exchange into foreign currencies directly via a FOREX-specific broker or a standard stock brokerage that offers such capabilities. I’m not sure how much interest these sites pay though – I wonder if it is is standardized or if it varies like money market fund rates here.