Now that Vanguard allows us to waive all their $10 low-balance fees, I need to reconsider my choice in bond funds. But which one? Here’s a my brief and very generalized understanding of bonds, based on my own readings. Please use this only as a starting point for your own research.

Quick Bonds Primer
Bonds are essentially loans, either from government or private companies. In portfolios, they are usually used to reduce the overall volatility because of their low correlation with stocks. When stocks go one way, bonds tend more to go the other (thought not always). This can allow you to lower risk without significantly lowering returns. See this Vanguard illustration.

While there are many different types of bonds – corporate, mortgage-backed, U.S. Government Treasuries, municipal, to name a few – you can break them down into two ways:

Maturity Risk
The longer the loan length, or time until maturity, the more sensitive bond prices are to interest rate fluctuations. Bonds are often grouped into short-term, intermediate-term, and long-term categories. The lender (us) is usually compensated for this extra volatility with higher returns. Another way to measure sensitivity of a bond fund is by looking at the duration. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond’s price would rise by about 2% when interest rates fell by one percentage point.

Credit Risk
Just like with consumer loans, the worry is about defaults. The riskier the borrower is, the higher interest they must pay. Given the same maturity length, a junk bond with a low credit rating will pay a higher return than a government-backed Treasury bond. Foreign bonds aren’t very popular, due to the added currency risk and also higher expenses.

Where’s the best risk/reward combination?
Just because as risk goes up, return goes up, doesn’t mean that there is a linear relationship between the two. You want to find the best combination for your portfolio needs.
[Read more…]

Here’s a nice Reuturs article interviewing Warren Buffett and Charlie Munger shortly after the recent Berkshire Hathaway shareholder meeting.

On index funds and beating the market:

Warren Buffett said on Sunday most investors are better off putting their money in low-cost index funds, though he believes he can still outperform major market indexes.

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,” Buffett said at a press conference, a day after the annual shareholder meeting for his Berkshire Hathaway Inc.

As for Berkshire, which ended March with nearly $90 billion of stock and fixed-income investments, Buffett said “we think we can do better than the S&P. I would be disappointed if our portfolio didn’t do a couple of percentage points better. I would be amazed if it did (much) better.”

I’m not sure if this is Buffett being humble, or he is admitting that beating the S&P by a large margin is getting harder and harder.

On performance chasing:

Charlie Munger, Berkshire’s vice chairman, said at the press conference that many investors actually fare worse in actively managed funds. He said many funds perform well when they’re small, but struggle to keep up when investors chase that early performance, and pour in cash.

“Successful funds attract a massive amount of money, and the later performance typically gets mediocre,” he said. “Then they keep publishing returns for the whole period for someone who started 20 years ago…. The reporting has falsehood and folly in it.”

If I believed in the “Buffett way”, which on some days I do, I would simply buy BRK directly rather than try to replicate or beat his results by trading on my own as a mere mortal.

I recently received an e-mail that went like this:

“It’s not expenses that matter, it’s total return after expenses. You could charge 1% but if I make you 30% who cares? Why don’t people understand this? I offer my clients superior performance for my fees.”

This irked me. I thought about sending him a few articles about why there’s no proof that any consistent market-beating performance by money managers exists. But instead, I said okay, fine. Here’s an open invitation. I give you my money to manage. You can choose whatever investments you like – mutual funds, individual stocks, whatever.

Instead of a flat fee, you choose the investments, and you get to keep 80% of how much you beat a benchmark portfolio where I try to match your level of risk using index funds. If you fail to beat my portfolio, you must pay me back the difference. So let’s say an advisor would charge 1% of assets. All they would have to do is beat the market consistently by 1.25%, and they’ve got that made already. If they kick butt and beat the market by 5%, they get 4% of assets!

Yes, all the risk here is held by the manager. So what? If you’re so confident you can do better than my portfolio of index funds, put your money where your mouth is. It’s like working for straight commission. You make me more money than my no-brainer portfolio, I make you money. I feel this is much more fair than the current setup, where we pay a relatively fat fee regardless of ensuing performance.

You might be thinking: “But no manager would have enough money to guarantee against that kind of potential loss”

Again, very true. I’d need some collateral to make sure he wouldn’t cut and run. The risk could be mitigated if you could buy some sort of insurance policy to hedge against catastrophic losses. Now, it would probably be expensive, as going back to my original point, as historical statistics show that market-beating performance is unlikely to happen. Maybe Lloyd’s of London is balking, and that’s why I haven’t heard back from him yet…

A more reasonable option?
Although I still wouldn’t buy such a mutual fund, here’s a more reasonable option for actively managed mutual funds. If you fail to beat the relevant index, your expense ratio should be 0%. No need to make people “whole”, but you have to refund all fees taken from the last year. Otherwise, you can earn a pro-rated amount of any market-beating gains with a cap of say, 2%. I know some mutual funds vary their expense ratios slightly based on performance, but none as harshly as this.

Ever wonder why this isn’t how mutual funds are set up?

A mere two days after I ranted about Zecco’s slow opening procedure in the second part of my Zecco Free Trades Brokerage Review, reader Richard alerts me that they have removed the mail-in paperwork requirement for many new applicants. After applying, you now see this:

If you applied for an Individual or Joint account on or after Thursday, May 10th, and you have a US Social Security Number, you?re all set.

However, if you either:
– applied prior to Thursday, May 10th for any account
– applied on or after May 10th, but you were asked to mail your documents
– applied for an IRA account
– do not have a US Social Security number:

please provide your required paperwork.

Hmm… This is either coincidence, or maybe I have some influence after all. 😀 Somebody also said that Zecco was swamped with IRA applications near the April 15th deadline, which further slowed things down. Either way, I hope this indicates better things to come!

Continuing on the line of thinking started by my post on What if my bank fails?, the next question might be what if my mutual fund company went bankrupt? I mean, I have a lot of money in Vanguard and Fidelity right now. What happens if one of them “pulls an Enron” or simply runs out of money?

One source of information is this 2004 Money magazine article written shortly after previous mutual fund scandals:

What happens if my fund company fails?
Your money is safe. Under the Investment Company Act of 1940, which governs the industry, each fund is set up as an individual corporate entity, with its own board of directors. Essentially, your fund hires the fund company to manage its assets. If the company were to file for bankruptcy, its creditors would not be able to touch the funds’s assets. And the fund’s directors could immediately hire a new manager, pending shareholder approval.

The way I read this, mutual fund managers are interchangeable. If the fund company goes bankrupt, the assets would remains the same, one would just have to hire a new company to manage it. In addition, one of the features specific to Vanguard is that it is set up as client-owned. How this works is that each of us might own a share of a mutual fund like VFINX. In turn, that mutual fund is a separate entity that contributes money to fund Vanguard’s operations, instead of the other way around. Here is an excerpt from Mel Lindauer of the Diehards forum, which explains this setup well:

First, The Vanguard Group Inc. (VGI) is actually a subsidiary of the various mutual funds, each of which is a separate legal entity. The best way to describe Vanguard’s unique structure would be to think of General Motors turned upside down, with Chevrolet, Cadillac, Oldsmobile, Pontiac, etc. as the corporate parents, and General Motors as a subsidiary. If you think of Chevrolet, Cadillac, Oldsmobile, Pontiac, and the other GM divisions as mutual funds, and General Motors (the subsidiary, in this situation) as Vanguard Group Inc., you’ll get the picture.

Since VGI is actually owned and funded by the various mutual funds, it technically couldn’t go bankrupt unless all of the various mutual funds that support it went bankrupt. The only way that could happen would be for the value of all of the stocks and/or bonds held by each and every individual Vanguard mutual fund to go to zero. So, forget about Vanguard going bankrupt — it just isn’t going to happen.

Some have expressed concerns about putting “all their eggs in one basket” by consolidating their investments at Vanguard. There’s simply no need to worry about that. Each fund is a separate investment company (and part owner of the Vanguard Group, rather than the other way around). Thus, having all of your investments in several Vanguard funds is tantamount to having your investments spread among a variety of baskets, each independent of the other. So, put your fears to rest; your investments are safe at Vanguard.

The Real Question – Ethics and Management
In the end, the real fear that one should have is that their mutual fund management will simply make poor or reckless investment decisions and lose your money perfectly legally. Also, in previous ethics scandals, managers also performed illegal trading or other activities specifically forbidden in their prospectuses. This is why ethics and consistency of management should be a component of why you choose to invest in a mutual fund, and why I feel very comfortable with the majority of my assets in Vanguard index funds.

I have never heard of a mutual fund company going out of business. But I’ve read about a lot of bad mutual funds with horrible performance. And this drop usually happens after a period of great performance and the heavy advertising and money inflows that ensues. Something to think about.

A reader e-mailed me an interesting article about index funds from today’s Wall Street Journal entitled A Close Race, a Surprising Finish. It’s only available for 7 days, after that a subscription is required.

The basic idea was to try and compare after-tax returns of index mutual funds and index ETFs, due to the often-touted tax-advantages of ETFs. The article summarized these theoretical benefits well:

The tax-related advantages of ETFs stem from their unique structure. ETFs are created when securities brokerages or specialists assemble baskets of stocks that match an ETF’s underlying index and exchange them with the fund for ETF shares that the brokerages can either hold or sell to small investors. These ETF shares can be bought and sold any number of times without the underlying stocks they represent being touched. When the brokerages opt to take ETF shares off the market, the fund hands over stock, rather than cash. This allows the ETFs to avoid selling their underlying stocks to accommodate investor traffic.

(This explains why many mutual funds have purchase or redemption fees to discourage active trading, while ETFs can be bought and sold all day long.)

For this study, commission costs for both were assumed to be zero. So who won?

Big, low-cost index funds from Boston-based Fidelity Investments and Vanguard Group Inc., Malvern, Pa., outperformed the ETFs in most of the comparisons we set up. For the 40 time periods studied, the mutual funds prevailed in 34 — including a sweep of the one-, three-, and 10-year after-tax categories.

Why is this?

The lesson for small investors: Whatever structural differences ETFs may have in the way of tax advantages, other factors — such as a fund’s expense ratio and management philosophy — can be equally important in determining performance in the competitive index-tracking business.

ETF tax advantages pertain, by and large, to capital gains, not dividend distributions. And, as noted, ETFs almost never sell their funds’ underlying securities, so capital-gains taxes are rare… But S&P-500 index mutual funds are pretty efficient, too. They don’t trade holdings as often as mutual funds run by stock pickers, so they rarely distribute capital gains either.

The lack of significant tax advantages for index ETFs is especially true in the case of Vanguard ETFs and mutual fund equivalents, as they are just different share classes of the same investment holding. I believe Vanguard does this so they can use the ETF “side” to keep their taxable events to a minimum, benefiting the mutual fund costumers as well. Here, the only difference in raw performance should be due to the different expense ratios.

Added
Management philosophy? Why does this matter in an index fund? Well, this is another area that may surprise some – it takes skill to manage an index fund!! A good index fund manager can eek out a few more basis points of return. From the article:

In addition, tactical moves by index-fund managers can boost results. While an index fund should, in theory, trail its benchmark by at least the amount of its expense ratio, fund managers can reduce at least some of the cost through techniques such as lending out the fund’s underlying stocks for payments, and buying stocks ahead of anticipated additions to their index.

From Vanguard:

Not all index fund managers have equal skill in tracking target benchmarks. Skilled managers may, for example, be able to minimize the transaction costs associated with managing the portfolio.

Vanguard and Fidelity both seem to be adept managing index funds well. Here is an article from Efficient Frontier (see, I told you it has some good stuff.) that discusses this further, calling it transactional skill, as opposed to stock selection skill.

Summary
This article is intended for people who have already decided that index funds are best for them, and they are just wondering how to best implement it. As the title says, it was a close race and there was no runaway winner. This is important! It’s unlikely you’ll end up in the poor house due to picking over the other.

Now, if you do want to optimize, the article indicates that while low expense ratios, structural tax advantages, and good management are all important, any one by itself won’t guarantee the absolute best performance. You have to find the best combination of all three, as well as consider things like fees, commissions, and minimum balance requirements.

Want more to read about investing? Here are two sites that have supplied me with a lot of good food for thought. I find these intriguing because while both are written by men well known for their financial acumen, they often sway far from those topics and can touch on politics, family life, and the pursuit of happiness in general.

Warren Buffett – Berkshire Hathaway Shareholder Letters
Every year, Mr. Buffett writes a letter to shareholders that discusses his company’s successes, mistakes, future moves, and a bit of everything else. Although I don’t view him as a deity like many others do, and have no plans to buy any BRK stock, I do find his writing to be easy to follow and often offers fascinating insights to a successful investor’s thought process.

However, I think one thing that people overlook is that Warren Buffett gets very intimate with many of the companies that he invests in, either with close relationships with the management or even by becoming the management for a while. He knows these companies inside and out, and can affect change within them. That’s something the common investor can’t easily emulate.

William Bernstein – EfficientFrontier.com Articles
In addition to being a practicing neurologist, starting a portfolio management company, and writing one of my favorite books on investing – The Four Pillars of Investing, Mr. Bernstein also writes a quarterly article on his website EfficientFrontier.com. It mainly discusses asset allocation, such as his thoughts on commodities, but has also wandered into areas like the housing market and estate taxes.

Here’s an excerpt from this most recent article:

If you want to pick your own stocks and bonds, be my guest. Just don?t imagine that making your decisions on the basis of publicly available information and analysis will lead you anywhere but to the poor house. You?re going to have to look at the primary data and analyze it entirely by yourself. And you?d better be good at it.

Traditionally, when you look at the historical return of mutual funds, you are getting what is called a time-weighted return. For example, the 5-year return is what you would have gotten if you bought the fund five years ago and held it continuously until today, all the while reinvesting dividends.

Last year, Morningstar rolled out what it terms the Morningstar Investor Return, otherwise known as a dollar-weighted return. This measures the returns that investors actually achieved in that fund, based on dollar inflows and outflows. It’s actually pretty interesting: If investors as a whole timed their purchases correctly and bought more shares when the fund was low, then their returns would actually be higher than the time-weighted returns. If, instead, investors waited until the fund performed well before buying in, and then sold their shares when the price was lagging, then their dollar-weighted returns would be lower than the time-weighted return. Guess which one happens almost all the time?

To find these numbers, go to Morningstar and type in any symbol in the quote box. Let’s take my very first mutual fund purchase, Janus Mercury (now Janus Research), symbol JAMRX. Then click on Total Returns, and then finally on the Investor Returns tab on the top. You should find this:

Yikes. If you take the 10-year historical return, which includes both the big Tech bubble and crash, instead of the happy 10% annual return number most people see, the average investor actually lost 2% annually during this period. They tried to time it, and lost tons of money in the process. (I was one of them.)

Now, don’t think this performance chasing doesn’t apply to index funds. It does. Check out the Investor Returns for the classic Vanguard S&P 500 Index Fund, VFINX:

Not quite as bad, but the average owner still lagged the fund’s performance by over 1% a year. What do we learn from seeing these Investor Returns?

Making a decision on which mutual fund to buy based on past performance is simply not a good idea. What happens when the performance starts to lag? Since you’re making decisions based on past performance, then you’re probably going to find another fund that’s been doing well recently, and then jump on that ship instead. It’s just a never-ending cycle of losing money.

This is why when I am looking at mutual funds to purchase, I completely ignore recent performance. I couldn’t tell you the recent returns of any of my fund holdings. The things I do look at are – the asset class and what index it follows, the expense ratio, and the tax efficiency. Maybe the fund minimums too, but that’s it.

(I also ignore the Morningstar Star rating system as I think it’s pretty useless as well, but that’s another post.)

2. Volatility matters. Buy-and-hold works… if you hold! You keep hearing that people shouldn’t own too much in stocks if they can’t tolerate the risk. You can see why by viewing the Investor Returns on the more volatile funds. They stink! According to this CBS MarketWatch article, the funds with the greatest relative volatilities had dollar weighted returns of just 62% of time-weighted returns.

When people see ups and downs on the Great Stock Market Ride, as a whole they are horrible at timing when to get on and when to get off. When (not if, when!) the market crashes again, people who aren’t prepared will panic and get off the ride. But when will they get back on? The result is lost money.

Here, the lesson is that even if you do plan on sticking with index funds, you must remind yourself during the rough patches that staying the course will be most profitable in the end.

I decided to open a brokerage account with Zecco.com. This is not going to be my main brokerage account just yet, but I do plan on using it. (I’m going to revive my Play Money account, for those that have been reading for a while. More on this later.) For now, since I think a lot of people are curious about this account, here are my experiences with the account itself.

Introduction: Why open a Zecco account?
Two words: Free Trades. As of 10/1, they offer 10 free market/limit trades per month, if you have $2,500 in total account equity (stocks + cash). There is no minimum balance to open, but if you have under $2,500 trades will cost $4.50. Finally, with no inactivity fees it seems like a great account even for someone who doesn’t trade frequently. Some other brokers offer free trades, but none with such a low balance requirement. There is a $30 annual fee for IRAs.

Why wouldn’t you open a Zecco account?
This is also simple – free trades aren’t everything. Zecco has been around almost a year now, and I don’t see Chuck Schwab declaring bankruptcy. Trust and customer service are big. Can Zecco execute the trades in a timely manner, and can the online interface and customer support match the other brokerages? (Or at least come close enough.) Hopefully, this review will help answer some of these questions.

Also, can they make enough money off of ads and margin interest to stay in business? If not, you’ll be faced with a $50 transfer-out fee and possible commissions elsewhere if you need to sell.

Opening Process Overview

1. Sign up for your MyZecco account. It is important to note that there are two parts to the Zecco website. First is the myZecco layer, which a more informal area that allows you to post on blogs and forums without an actual trading account. They will actually e-mail you this username and password, which I think is fine because no financial information is included in this layer. You don’t even need to enter your name or address.

2. Apply for a trading account. This seemed like a pretty standard brokerage application. One thing to note is that you may want to apply for a margin account, even if you don’t plan on trading on margin (borrowed money). Here’s why:

In a cash account the proceeds of a sell order will not affect your buying power until settlement, which is T+3 (trade date plus three business days). To avoid this situation you may want to consider establishing margin on your account. With a margin account the proceeds of a sell order will update your buying power immediately. To establish a margin account you can request it at the time you open your account or if your account is already established you can complete the Combined Customer Agreement Form…

3. Wait for application approval. You’ll get an e-mail saying that your application is approved, mine arrived the next morning. You will get information on how to set your Trading Key. This separate password gives you access to the second part of the Zecco website, the Trading area. This layer is a secure encrypted area and does contain sensitive information. I wouldn’t make your Trading Key the same as your myZecco password!

4. Send in your new account paperwork and copy of government ID. You should mail this in as soon as possible, as without it they will assume that you are subject to backup withholding. (Update: Now, it appears they have implemented system that allows most people to get their paperwork processed electronically.)

Still, you need to make sure it is processed before you can start trading. To check, log into your trading account at myInfo tab > Customer Info > Outstanding Paperwork. You want it to say “No” as shown below:

5. Fund your account. If you want to fund online (which is what I did), you need to first link up your bank account first if that’s how you will be making your deposit. The popular 2-small-deposit verification system is used, and takes a couple of days to show up. Other ways to fund include via check or bank wire.

6. Request money market sweep. By default, free cash in your account only earns 1% APR. But you have the option of setting up a money market sweep account by sending in this form. There are three options by Scudder Investments, and I think the symbol for the taxable money market is CSAXX, currently with a 4.38% yield. Why they don’t make this higher yield the default in the first place is beyond me. 😕 The Treasury Money Market option might be a good bet for those with state income tax rates.

7. Next Steps. After you fund and your paperwork is processed, you should be ready to trade. I’m currently waiting on my opening deposit to arrive, and will report back once I’ve done more with the website and maybe made a few trades. Here are some things I’ve noticed so far:

– The administrative back end of Zecco is clearly provided by Penson Financial Services, as it looks identical to the back end of MB Trading, another broker that I have used which is popular amongst active traders. This actually provides me with some familiarity, although the contrast between the “Web 2.0-style” Zecco website and the bare-bones Penson interface is very stark and makes the site overall feel a bit unpolished.

– Zecco does not receive payment for order flow. All orders are routed and executed by Penson Financial Services. Hopefully this will lead to good fills.

– Zecco is insured by the SIPC, like most other brokers.

– You can set up dividend reinvestment if you wish, although you can’t buy partial shares:

Dividend reinvestment is a feature that is available to our clients and can be setup during the account opening process. If you would like to add this feature after the account opening process is complete, you must submit the request in writing to our customer service department.

For the rest of my experiences, see the second part of my Zecco Review.

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Zecco Review, Part 1
Zecco Review, Part 2