Investment: Mutual Funds vs ETF's By Gareth Milliams

It is the question that I get asked the most: “What is the better investment, the ETF or the mutual fund?” There is no easy answer, so lets look at the differences.

Mutual funds begin with buckets of cash and a (hopefully) top-notch investment team. The fund is then marketed by salesmen to the public. The fund manager is more often than not, a stock picker with a particular brief. The quality of the fund manager determines the success or otherwise of the mutual fund.

ETFs work almost in reverse. They begin with an idea -- tracking an index -- and are born of stocks instead of money.

What does that mean? Major investing institutions like Barclays or the Deutsche Bank control billions of shares. To create an ETF, they simply transfer a few million of them, putting together a basket of stocks to represent the appropriate index, say, the Nasdaq composite or the Shanghai Stock Exchange.

They deposit the shares with a holder and receive a number of creation units in return. Creation units are the building blocks of an ETF. One creative share represents each individual stock within that ETF. Dependent upon the ETF and the weighting of the index, there could be 50,000 shares within a creative unit. The creation units are then split into individual shares for public consumption.

So, then what are the differences?

There are many, but rather than being fundamental, they tend to be nuanced.

For example, a mutual fund often has a minimum subscription of $50,000 or more. This is not the case with ETF’s, which have no minimum whatsoever.

As a mutual fund becomes more successful, more shares are purchased. In an open-ended mutual fund, additional shares do not dilute the net asset value (NAV) nor should they radically affect the value of the underlying assets.

A disadvantage of an ETF in an illiquid index (such as some soft commodity markets) is that the ETF can fundamentally change the price of the asset rather than reflect it. This has led to price fluctuations in markets such as corn and even oil. Many hedge fund managers favour the ETF because of its inherent flexibility.

But no investment is perfectly structured. Imagine, that you own a lump sum portfolio and it’s 10am in New York and the markets are tanking. The S&P 500 is 3% down and looking as if it has further to fall. You call me and ask me to sell immediately. I then immediately fax a sell instruction to the portfolio bond provider and the ETF is sold within the next few minutes. I can also take advantage of the declining market by buying short ETF’s.

Another client with another Tokyo brokerage owns mutual funds. He too, is spooked by a market down 3% and calls his broker who accordingly, faxes the provider who places the sell order. If the client is lucky (very lucky), the mutual fund will be sold at the end of the working day. Far more likely, it’ll be the end of the week or month or quarter with potentially horrendous damage to repair.

The ETF has also been bought and sold at a very low cost (less than 0.15%) whereas some mutual funds from boutique managers (usually fund of funds) can have redemption penalties of 5% or even more.

However, the story is not completely one sided. Whilst there are benefits to ETF’s with lump sums, there are also benefits to mutual funds with savings plans, particularly with regard to dollar cost averaging.

Dollar cost averaging demands that comparatively small amounts of money are invested on a regular basis into an investment. Here the mutual fund has an advantage. Because we are averaging, we are not going to sell should the NAV of the fund drop. In fact we initially encourage losses in order to build up additional units bought at discount. Additionally, because the mutual fund also holds cash, its position is slightly more defensive.

The ETF however, has a zero cash position and much higher expenses (brokerage fees etc) particularly if you buy very small amounts on a regular basis. Conversely, the costs of investing in a managed mutual fund based within a monthly contribution offshore savings plan with a major institution are comparatively low. Offshore mutual funds within a formal savings plan often have no bid/offer spread and they have unlimited switching.

So the answer to the question of “what is the better investment, ETF’s or managed funds?” is not simple. I generally prefer ETF’s for lump sum portfolios unless I come across something very special from a fund manager. However, within a monthly savings plan the managed mutual fund concept works very well indeed.

In my opinion, both of these popular investment vehicles have a viable future. The ETF industry will continue to grow at leaps and bounds, but there will always be a place for investments managed by people.

The Crisis: Is it over....or is it astroturf? By Gareth Milliams

I heard a nice phrase the other day.

There are no green shoots, the recovery is artificial. It' s only astroturf...

Apocalypse When? Or What Will Happen To Your Money When The Correction Comes? By Gareth Milliams

The chart above which takes into account inflation in order to plot 'real' returns is quite shocking. It seems that this financial crisis has been retracing the 1929-1949 bear market very closely indeed.

The run up from March 9th until now is almost unprecedented & the gains have been astronomic. Unfortunately, the rally has been built upon low expectations and cheap prices. But those expectations are now higher and the stocks are no longer cheap. These markets now have to justify their values and thats proving harder to do.

The rally is becoming unsustainable and is fast running out of breath. Volumes have been dropping gradually since March and rallies need to be fed.

The correction is coming and for my portfolio clients it will be an opportunity. They are cash rich and equity poor.

We expect all bond prices and commodity ETF's to drop in lockstep with equities and these will be our focus.

All savings plans less than a year old will dollar cost average, those with a considerable capital sum attached will be moved to a dominant cash position with possibly a small percentage switched to the CAAM Volatility World Equity Fund .

The question is this:

For those of you who are not my clients, I ask what are you doing to protect yourself from the gathering storm? More importantly, what is your financial adviser doing to preserve your wealth?

The next few weeks could be key. For many advisers who missed last years crash to your cost, it is a second chance. Should they miss the opportunity again, then you must surely reconsider your options.

The Markets: Plus ça change, plus c'est la même chose

The more things change, the more they stay the same. Below is a daily summary of the Wall Street Journal from 1930. They talk of a bull market and a summer rally as well as credit expansion by the Fed. It is shocking to read in light of what is happening now. The past truly is prologue.

Thanks to newsfrom1930 for the content and James In Japan for the tip off.

Market commentary:

Bulls encouraged by resistance to repeated bear efforts Saturday and Monday following explosive rise Friday; buying movement spread broadly across the market early. Major industrials strong including US Steel, GE, Westinghouse, as were major utilities and rails (Consol. Gas, New York Central). Steel news caused some irregularity, but good buying appeared on setbacks. Bond market firm; corp. and preferreds up; govts. steady; Dow 40 bond average at new yearly high of 96.61.

E. Johnson, former Pres. Victor Co. (merged with RCA), returns from trip to survey conditions in Europe; feels general US business recovery under way, will be comparatively rapid up to a certain point; thinks stock prices somewhere near bottom.

Conservative observers even more cautious than usual; believe recent rally due to oversold condition, and decline will resume when short-covering ends.

Some market students encouraged by repeated support above June lows, advise buying leading stocks if they again approach these levels.

J.H. Oliphant & Co. finds Dow action this summer technically interesting; 6 times since June, market has found strong support after declining to 215-218 level.

Bears reportedly less confident after last week's action, though short interest remains large. Public participation still seen small.

Increase in credit outstanding in first half was interpreted bullishly, but has stopped since mid-June. “This may mean that stimulus to business in the form of credit expansion induced by Federal Reserve policy has reached its effective limits ... ”

Economic news and individual company reports:

US rail freight loadings for week ended Aug. 9 were 904,157 cars, down 14,178 from previous week and 187,966 from 1929; worst decline yet vs. 1929.

Steel production industry-wide was at 54.5% last week vs. 56% previous week and 58% two weeks ago; US Steel at 62% vs. about 62.75% previous week and 64% two weeks ago. Decline was unexpected; some improvement had been rumored.

Oil curtailment still working: Gasoline in storage at refineries Aug. 16 was 41.252M barrels, down 1.477M in past week; refineries operated at 72.6%, up from 69.1%; crude oil production was 2.464M barrels/day, down 16,800 from previous week and 478,000 from 1929.

Public utility earnings generally higher year over year in each month, though declining month by month this year. June net earnings of 95 utilities were $83M vs. $79M in 1929, but lowest of year so far and down from high of $92M in Jan.

NY City budget for 1931 expected over $600M vs. $569.8M this year.

Investment:Volatility Is Your Friend By Gareth Milliams

The stock and equity fund investor is always going to be vulnerable to losses during recessions. There are so many factors that can make a single stock or an entire market fall; whether it be disappointing earnings, declining profits, increasing losses or more general financial unhealthiness such as a fall in national GDP or even a perception of weakness.

Investing into a single stock or equity fund is a declaration of faith. It is an affirmation of a belief that the share or unit will be worth more when sold than when bought. To achieve that aim, all the positive financial ducks need to be in a row. Perception has to be ready to strengthen and that sentiment has to be translated into the physical purchase of goods and services. Moreover, those goods and services need to be sold at a healthy margin.

Only then can our equity funds show profit.

Unfortunately we are having to constantly battle a 7 year cycle of boom bust. For example:

2008: Global Financial Crisis

2001: Global Recession

1994: Mexican Peso Crisis

1987: Black Monday

1980: Global Recession

1973: Oil Crisis

1966: Global Recession

Investment can be hazardous (to say the least) for the average punter. However, those of you who invested with me were out of the equity markets in August 2008. We preserved capital and kept our powder dry.

The issue that we face now, is what to do with that saved money? We have bought some high yield bonds and will look (when appropriate) to buy more (probably tier 2+) in the future. We will buy these assets because they offer real value at discounted prices.

Last week I met with two senior executives of Friends Provident International. They told me of a new fund that they are launching with Credit Agricole which invests in the volatility created within the S&P 500, DJ Eurostoxx 50 and the Nikkei. Weightings are 50%, 30% and 20% respectively.

The basic principle is simple:

When volatility is high, they are short and when volatility is low, they go long. The results have been stunning. In 2008, the CAAM Volatility World Equities fund returned 26.84%. 2009 has also been positive YTD.

It is daily traded and marked to market with daily pricing and redemption and has an institutional class. It is available via the Reserve portfolio bond and as a mirror fund in Premier and Premier Ultra.

This fund is not designed to be a core profit driver but as a satellite holding with a 10% position.

Below is its chart since actual inception (please click to enlarge to full size):

I think that we can all agree that the recovery will be volatile. Happy days are not quite here again and it will be a bumpy road until we get there. This fund is designed to smooth those bumps and ensure that you get there wealthier and in comfort.

Investment: The End Of A Year Of Living Less Dangerously By Gareth Milliams

For a year I held back, not believing the propaganda and kept it simple, just gold and yen/dollar. However, in the last week, after consultation with clients and much research, we bought back in.

Bought back in, but not into the equity market, nor into commodities. Instead, we bought high yield corporate bonds from banks. The bond that we bought had an interest rate in excess of 7% but a price less than half of its original minimum. The yield is based upon the original minimum, therefore because the price has dropped below half we will receive a return in excess of 16%pa. No matter how far down the price drops, the yield always assumes that the bond price is at EUR1.00.

With the bond price below EUR0.50, we can look forward to further growth with a price of at least EUR1.00 on maturity. That is way beyond double.

Obviously there is risk with the bond price. It has already fallen more than 50%. With that in mind we bought the minimum subscription. This reduces risk but more importantly will allow us to buy further tranches if the market falls.

This blog post is in no way a solicitation to buy and we assume all investments have risk attached.

The Markets: When Sticking To Your Guns Feels Like A Futile Gesture By Gareth Milliams

Apologies Father for I have sinned, it has been nearly a month since my last post.

It has been a while. I feel a bit like the man who built a nuclear shelter. And waited. And waited. Only for the Berlin Wall to collapse along with the Soviet empire.

A year ago, I sold my clients equity assets and held just physical gold and currencies. Until last week, this was still my strategy. Maybe I'm a bitter-ender, the last man standing, but I cannot believe that all is well, when the worlds financial architecture crumbled less than a year ago.

There has been no reform, unless massive quantitative easing constitutes reformation. But chucking money at a bankrupt financial system is like putting out an oil fire with water. There will be an explosion and people shall be burned.

So, I'll stick to my guns until I know I'm wrong and I will not risk my clients money buying equities in a market as brittle as this.