Successfully picking stocks that consistently make money is not easy. The odds are heavily stacked against the average investor. One major difficulty is determining exactly what stocks to buy, but more important is when to buy and when to sell them. Moreover, if your stock portfolio is not diversified because you decided to load up stocks from one industry, then you are exposing yourself to more risk than perhaps you intended to take.
Bad news about your stock, its industry group, or even a competitor’s stock can result in large down moves that can decimate the stock’s price by 25 to 50 percent almost overnight. To avoid potential losses that can occur at any time for any reason, the astute investor will steer clear of individual securities entirely. Simply put, the risks are too high with respect to the rewards. If the majority of professional money managers with impeccable financial credentials and vast experience cannot consistently select a stock portfolio that does better than a comparable benchmark index, then how do you expect to do it? Consider the fact that only 31 percent of actively managed large-cap mutual funds beat their benchmark over the 15-year period ending June 2009.
Instead of investing in individual stocks, consider investing in a few no-load mutual funds such as index, sector, and leveraged funds. These represent a wide range of investment choices. Make sure that you understand the components, details, and costs of each of these investment vehicles before deciding to invest. And make sure that you take into account your risk tolerance.
An index fund is a unique type of mutual fund that holds stocks that exactly mirror the makeup of an existing stock market index. The index fund’s performance will replicate the performance of the index it is mimicking minus the fund’s internal operating expenses. In 1971, Wells Fargo Investment Advisors marketed the first index fund to institutional investors. In 1976, John C. Bogle, founder of the Vanguard Group, marketed the Vanguard Index 500 Trust to retail investors. This index replicates the Standard & Poor’s (S&P) 500 Index. Almost 40 percent of mutual-fund assets, as of year end 2009, were invested in S&P 500 Index funds. The total assets in index funds at year end 2009 were $837 billion in 359 index funds. Also, 27 percent of households own at least one index fund.2 A sampling of the least expensive S&P 500 Index funds, as measured by the annual expense ratio, is provided in Table 5-1.
Equity index funds represent 13.7 percent of all mutual-fund assets. In 2009, of all equity fund inflows, almost 60 percent of new
investor money, went into index funds. Index funds slightly underperform the index they are replicating because, unlike the index itself, the funds incur operating and administration costs that slightly reduce their performance.
Fidelity Spartan 500 Index (FUSEX) holds stock in the same proportion as the S&P 500 Index. If the S&P 500 moves up or down 15 percent, this Fidelity fund will move in lockstep with it and go up or down close to 15 percent. For example, for the year 2009, FUSEX increased by 23.61 percent com pared with the S&P 500’s rise of 23.45 percent, the 0.15 percentage point difference being the result of internal operating expenses (0.10 percent) and administrative fees.
Index funds are available from many mutual-fund families. They cover major indexes such as the Wilshire 5000, Russell 2000, Morgan Stanley Capital International (MSCI), Europe, Australasia, Far East (EAFE), and 10-year bonds. Index funds are managed passively, and portfolio changes are rare. As a result, administrative and internal costs are minimal.
Compare this situation with that of standard equity mutual funds that are actively managed. They have annual operating expenses ranging between 1.19 and 1.97 percent and an average annual portfolio turnover of between 60 percent (e.g., conservative allocation funds) and over 100 percent (e.g., aggressive funds) depending on the fund type. The average balanced domestic mutual fund has portfolio turnover averaging 62 percent per year, with a 1.25 percent annual expense ratio (AER), according to Morningstar.3 All this trading eats into the performance of such funds because trading fees mount up. Interestingly, trading costs are not included in the annual expense ratio numbers. Investors would like to see these trading costs embedded in the AER to show the full cost, but such a change will need approval by the mutual funds themselves and initiative from regulators.
Key Factors in Selecting an Index Fund
When investing in an index fund, make sure you obtain the following information:
- Minimum initial investment amount. Some funds have minimums of $1,000, whereas others may require $5,000, $10,000, or even higher amounts.
- Annual expense ratio. A ratio below 0.20 percent is desirable. A number of funds have a ratio below 0.10 percent. Sector funds have an average expense ratio of about 1.60 percent. This means that 1.60 percent of your investment is going toward paying the fund’s overhead each year, in addition to any load or commissions you pay on purchasing or exiting the fund. The lower the ratio, the better.
- Trading deadline. Each fund family has a specific deadline for making an exchange or a trade the same day. Typically, the time ranges between 3:30 and 3:59 p.m. to get today’s closing price. Calling and placing your order after 4 p.m. will result in getting the next day’s closing price.
The later in the day the trade deadline, the better, because you have more time to make the decision. Trades can be made online through the fund’s Web site if you bought the fund directly, through your brokerage account if bought through that venue, or via a phone call. Keep in mind that mutual funds do not trade during the day like ETFs, so the price you receive is the closing price, even if you want to sell the fund at 1 p.m. that day. This is one of the negatives of owning mutual funds compared with ETFs, which trade throughout the day.
Maximum number of trades permitted over a 12-month period. Most funds are very stringent about the number of trades permitted, and almost all fund families do not cater to market-timers. Make sure that you can make at least four transactions a year at a minimum. The optimal situation is being permitted to have unlimited trades with no restriction during a 30-day period. The more trades allowable, the better.
Redemption fees. Some funds levy charges of approximately 0.5 to 1 percent if a fund is redeemed within 30 to 180 days of purchase. Each fund has its own policy. Try to select a fund that does not have these fees.
If you subscribe to Morningstar online (www.morning star.com) or its Morningstar Mutual Funds publication (available in most libraries), you can check out and compare all index funds at once instead of going to each Web site or receiving the material in the mail. Another comprehensive resource is www.indexfunds.com.
Market Timing with Index Funds
You can invest in any index fund when using market timing to make buy and sell decisions. For example, if you are interested in investing in large-cap stocks or the market as a whole, you can select an index fund that tracks the S&P 500 or the Wilshire 5000 (total stock market).
Of course, if you prefer to invest in other market indexes, such as a small-cap or value fund index, that’s easy to do too. To spread your risk, you may want to select a few different index-style funds (e.g., large-, mid-, or small-cap growth; large-, mid-, or small-cap value; or international funds) with different weightings (e.g., 60 percent in small-cap growth fund, 20 percent in international, and 20 percent in large-cap value). This approach is similar to building a diversified stock portfolio, except that in the case of index funds there could be thousands of stocks represented in the index.
Morningstar offers a tool called Instant X-Ray to provide the total portfolio composition of an investor’s mutual fund holdings. The objective is to minimize overlapping positions of multiple funds and to provide the necessary diversification. All you have to do is key enter the ticker symbols of your funds, and the program provides the analysis.
There are two mutual fund families that cater directly to traders and market-timers: Rydex SGI funds and ProFunds. Their annual expense ratios and minimum investments are typically higher than those of other mutual-fund families for index funds, but they provide a wide selection of sector, index, and leveraged funds without restrictions or penalties for frequent trading. More detailed information about these funds is provided in the upcoming sections, and their respective Web sites contain comprehensive fund information.
Only a few mutual-fund families offer sector funds. As the name implies, sector funds purchase stocks in a particular industry sector. Typical sectors include technology, biotech, consumer cyclicals, financial services, precious metals, real estate, natural resources, and medical equipment. Sector funds replace the need to purchase a group of individual stocks in a particular industry, which thereby avoids multiple brokerage com missions. Having a large number of stocks in a sector fund portfolio offers some degree of diversification. However, if the entire sector is having financial difficulties or is out of favor, then its performance will suffer. Investing in a sector fund is much riskier than investing in a broad index fund; therefore, you need to have specific defensive rules in place to exit the fund if it declines.
Typically, sector funds have higher volatility and portfolio turnover and usually higher returns and losses than a diversified stock fund because of their highly focused stock selection. Only more experienced and venturesome investors with a higher risk tolerance should use these funds. Make sure to have mental stoploss orders to protect your principal because placing automatic stops on mutual funds is not possible. Keep in mind that some industry sector funds usually excel in bear markets, such as natural resources, and precious metals. Thus, depending on the market’s trend, the right sectors need to be cho sen; otherwise, large losses may result. Interestingly, in 2002 and 2008, not one of the 10 S&P sector categories had positive returns. This is a rare occurrence, but it can and has happened.
Fidelity is the pioneer in sector fund offerings, and it has named its funds Fidelity Select Portfolios. The company’s first few sector funds came out in July 1981, with additional funds being launched in the mid-1980s and a few more added in the last few years. Currently, there are 41 sector funds, including one sector money-market fund. This large selection makes Fidelity the largest sector fund player in the mutual-fund industry.
Fidelity Select Portfolios have no load and a minimum $2,500 investment for regular accounts and $500 for SEP-IRAs or Keoghs. There is also a 0.75 percent redemp tion fee when a fund is sold within 30 days of purchase. Fidelity does not encourage market timing, and it will restrict your trading if you exceed a certain number of trades in a given time period.
According to the Fidelity Prospectus:
Shareholders with two or more roundtrip transactions in a single fund within a rolling 90-day period will be blocked from making additional purchases or exchange purchases of each fund for 85 days. Shareholders with four or more roundtrip transactions across all Fidelity funds within any rolling 12-month period will be blocked for at least 85 days from additional purchases or exchange purchases across all Fidelity funds. Any roundtrip within 12 months of the expiration of a multifund block will initiate another multifund block. Repeat offenders may be subject to long-term or permanent blocks on purchase or exchange purchase transactions in any account under the shareholder’s control at any time.
Complete information about the Select Portfolios is available at www.fidelity.com or by calling Fidelity at 800-343-3548. Other mutual-funds families that offer sector funds include Vanguard (www.vanguard.com), Rydex-SGI (www.Rydex-sgi.com; 17 sectors), and ProFunds (www.profunds.com; 23 leveraged and inverse sector funds). Check their Web sites for the latest statistics and fund information.
Market Timing with Sector Funds
Sector funds offer the experienced and aggressive investor a way to capture significant profits, but only when these funds are purchased and sold at the right time. Timing is extremely critical with these funds; otherwise, you could suffer losses from which you might take years to recover. Bad earnings or a killer bear market can decimate any sector fund, even if it contains so-called highquality stocks. In bear markets, most sectors get hit hard, except for the precious metals sector, which usu ally excels, but not always. Thus sector funds should be used only with specific buy-and-sell rules and market timing strategies to protect your principal.
Leveraged mutual funds amplify the performance of the indexes they track. Prior to the inception of the Rydex Funds in 1993, an investor had no way of obtaining leverage on mutual-fund investments without resorting to margin (if offered on mutual funds by the brokerage firm). And margin interest would be accruing every day, eating into any gains. Retail investors, traders, and markettimers therefore were delighted when Rydex offered leveraged funds without margin. Rydex currently offers 81 funds in different categories, as well as many leveraged and unleveraged funds. Table 5-2 provides a snapshot of just Rydex’s leveraged/inverse broad market equity funds. Rydex also offers four leveraged/ inverse fixed-income funds and leveraged inverse international funds.
Rydex Funds: First Inverse and Leveraged Funds
Leveraged funds provide magnified returns that are between 25 and 200 per cent greater than those of nonleveraged funds. These funds have betas between 1.25 and 2.00. This means that the risk rises as well. For bull ish investors who want leverage, the Rydex Nova fund tracks the S&P 500 Index with a beta of 1.5. Thus every 1 percentage point move in the S&P is equivalent to a 1.5 percentage point move in Nova. If the S&P 500 rises 10 percent, then Nova theoretically would rise 15 per cent. I use the word theoretically because the percentage may not be exactly 15 percent, although it should be very close to it. That is so because there could be a tracking error, which is the difference between the price behavior of the leveraged fund and the price behavior of the index.
If the S&P falls instead of rises, this fund will lose money 1.5 times as fast. Thus timing the purchase and sale of these funds is critical to capital preservation. Nova’s annual expense ratio is 1.28 percent, and the minimum investment to open an account for a self-directed investor or for a retirement account is $25,000.
For bears, the Rydex Inverse S&P 2 Strategy fund tracks the inverse of the S&P 500 with a beta of 2.0. Thus every 1 percentage point drop in the S&P means a 2 percentage point rise in the fund. If the S&P 500 Index falls 10 percent, then the fund should rise about 20 percent. This fund’s annual expense ratio is 1.43 percent. If the Inverse 2 Strategy fund is held by a financial intermediary, the minimum investment is $15,000, and if it is opened with a brokerage firm, the minimum is $2,500 for regular accounts and $1,500 for retirement accounts.
For additional information on Rydex Funds, call 800-820-0888 or access the company Web site at www.Rydex-SGI.com. Some investment firms offering access to the Rydex family include Fidelity, TD Ameritrade, Charles Schwab, Vanguard Brokerage Services, T. Rowe Price, and Scottrade, among others.
ProFunds opened its doors in 1997, in direct competition with Rydex Funds. ProFunds offers 64 index-based funds, more than any other mutual-fund firm. The funds offered include:
- 11 Classic ProFunds
- 10 Ultra ProFunds
- 13 Inverse ProFunds
- 22 Sector ProFunds
- 5 Non-Equity ProFunds
- 1 Money Market ProFund
- 2 Access High Yield–Flex Funds
ProFunds’ minimum initial investment for all types of accounts is $15,000 for self-directed individual investors or $5,000 for investors working through an affiliated financial professional. To provide leverage, ProFunds not only invests in securities but also may invest in futures contracts, options on futures contracts, swap agreements, options on securities and indices, U.S. government securities, repurchase agreements, or combinations of these instruments.
The performance statistics of each of the ProFunds is provided on its Web site at www.profunds.com. ProFunds can be purchased directly from the firm or through the following firms: Accutrade, TD Ameritrade, Charles Schwab, Fidelity Investments, and Scottrade. Table 5-3 provides information on ProFunds Ultra sector funds. Other data in this format can be found on the company Web site.
Market Timing with Leveraged Funds: Be Very Careful
Initially, investors just starting out with market timing strategies should not jump into leveraged funds. Once an investor feels comfortable with his or her market timing strategy, his or her rules for cutting loses (including the use of stop-limit orders), and his or her performance against a suitable benchmark, that investor can consider leveraged funds—but only after he or she first acquires a complete understanding of leveraged funds, how they work, and their inherent risks. A novice market-timer using leverage can get destroyed in a week if the market declines, assuming mental stops are not used to get out with a small loss. Losses of 50 percent and higher can occur easily with the doubleleveraged (2.0-beta) funds.
After investors have used market timing profitably for a few years, they may want to invest in leveraged funds, but they should begin with a minimal dollar amount to get real-world experience before putting more money at risk. After six months of experience, additional positions can be taken. Slow and steady wins the race with these enhanced funds. Your main concern is minimizing your losses and protecting your capital, not maximizing your profits. The profits will come if you have the proper timing model in place and if you follow your game plan.
Leveraged funds offer market-timers who get on the right side of the market a powerful vehicle for participating in both bull and bear markets. For aggressive investors who are able to control their risk, leveraged funds can lead to significant returns in short time frames. However, leveraged funds can be deadly in the wrong hands. So make sure that you are aware of all the nuances before getting involved in these rocket-propelled funds.
Since both Rydex and ProFunds offer leveraged ETFs, most investors will use them instead of their mutual-fund counterparts
because there are no restrictions on minimum account size, they have lower annual expense ratios and they can be traded throughout the day like a stock.