You probably know about certificates of deposit, or CDs, which banks issue. CDs are not bonds, but they are very similar from the perspective of a regular investor. It’s really easy to get one from your bank, but they’re typically not as good as Treasury bonds, and they can have heavy penalties if you take your money out early. That penalty is not worth the slightly higher yield over Treasurys. There are also money market funds, which are an agglomeration of short-term paper that allow you to get a cash like return on your money. These are extremely popular because they are priced at a dollar and can be redeemed instantly. They are what we call “cash” when we speak of their asset class, something that has mystified many of my viewers when I use the term.
Finally, you’ve probably heard of municipal bonds, which are issued by state and local governments. The earnings from these bonds are tax-free, so their yields are also pretty low. Keep municipal bonds out of your 401(k) and IRA, because they are already tax-advantaged. In an IRA, municipal bonds are simply low-yielding bonds with nothing special going for them. Municipal bonds are great if you’re already rich, because the rich are taxed at higher rates and thus get a better break on tax-free income. short-term municipal bonds, or munis, are practically like cash, and the longer term ones can be structured by brokers. Because I’m rich—okay, I said it—and because I am not allowed to own individual stocks because of the obvious conflicts of owning stocks and hosting a stock show that moves stocks, I’m in the New Jersey Vanguard Admiral Fund (Vanguard’s funds are the best) for short-term municipal bonds. I can actually write checks against that account, and your ultimate goal should be to join me in that no-brain-required, little-risk fund, where the returns are solid and you can access your money at your leisure. I like this fund in particular because it has extremely low fees, something that, again, matters all the time but particularly when you are dealing with bonds, because they don’t make you much money and fees depress their limited returns.
That’s really what it all comes down to with bonds. All this stuff is incredibly eye-glazing, and if you’re still awake, I congratulate you because there’s nothing more boring and tedious than bonds. You can buy them yourself; just set up an online brokerage account. Or if you want to save money, you can set up an online account with Treasury Direct to buy Treasurys directly from the government for a much lower brokerage fee. You can call or mail Treasury Direct too. It’s not solely online, but that’s become the best way to buy them: www.treasurydirect.gov.
But why, after reading all of this, would you ever want to buy bonds directly? The best way to get your bond exposure is to buy into a bond fund rather than investing in individual bonds, provided, again, that the fees are extremely low, meaning a small fraction of a single percentage point. Since you’re buying bonds in order to buy stability as you get older, I recommend you go for a fund that buys Treasurys, because it’s simply not worth the extra hassle and worry trying to pick up most of these higher-yielding but less secure bonds. Investing in stocks can and should be engaging, interesting, and fun. Investing in bonds is something that will always be necessary and boring. Outsource your bond-buying to a bond index fund and stop worrying about it.
Mutual Funds
For those of you who don’t have the time or the desire to invest in individual stocks and don’t want a bond fund, you’ve got a lot of options, but few are good. There are thousands of mutual funds out there. In fact, there are more mutual funds in the United States than there are stocks listed on the New York Stock Exchange and the NASDAQ put together. If this fact seems ridiculous to you, that’s because it is. We have a voracious appetite for people who claim they can make us money, or at the very least claim that they’ll worry about the money for us. For every person who desperately wants to be a day trader, there are easily another dozen people who want to know the best mutual fund they can invest in. And that makes the mutual fund business a really terrific one. Throw in the fact that money we invest in our 401(k) plans has to flow into mutual funds almost by default, and the companies that run and sell mutual funds are making fortunes. (What are your options in a 401(k) plan? Remember, it’s usually company stock or mutual funds, and you know you should never own company stock.)
I’ll put all of my cards on the table. You know I’m a stock junkie, and you know that investing in individual stocks is the best way to go. But you’ve also been told repeatedly that if you can’t or won’t do every last piece of your stock homework, you’ll end up making a big dent in your capital. This is a situation where the best is the enemy of the good, and I wouldn’t be quoting Voltaire unless the phrase really summed up the situation. You want to invest in stocks to earn great returns, but since few people really want to listen to conference calls and read quarterly reports, what usually happens is that you end up owning a stock, not doing all of your homework, and then sooner or later you start getting confused and begin hemorrhaging money. And then after you lose a bundle investing in stocks without the right kind of education, without the right kind of homework, and without a clue as to what’s going on, you decide that it’s impossible to make money in the stock market. Instead of going through this excruciating process, why not honestly figure out whether or not you actually have the time and inclination to manage your own portfolio. For most people the answer is no, and that’s fine. You won’t take the best path to wealth, you’ll take the good one.
Before I tell you what I’d do, let me tell you what’s out there, because a lot of it is trash, and you need to know how to avoid it. When I said there were more mutual funds in this country than there are stocks on the NYSE and the NASDAQ put together, that was slightly misleading because the term “mutual fund” includes more than just the funds that invest in stocks. Typically a mutual fund will invest in stocks, bonds, and even cash if it’s a money market fund. There are mutual funds that invest only in equities (stocks); there are funds that invest only in bonds. But since you know how many different types of bonds there are, you also know that’s meaningless information. These days there are even mutual funds that invest only in other mutual funds, called “asset allocation funds,” and I consider that highway robbery, pure and simple. One big downside to all mutual funds, and this is as true of actively managed funds as it is of ETFs (exchange-traded funds) or index funds, is that they all charge fees. The fees vary from fund to fund, and in fact there’s an enormous amount of creativity in how they come up with ways to gouge you, but the one constant is that there are always fees. Fees don’t just eat into your profits—that would be one thing—they eat into your assets. That’s how mutual funds do it. When you invest in a mutual fund, you’ll pay out some percentage, called the “expense ratio,” of your assets, no matter what. It doesn’t matter if the fund loses you money. You’re still paying those fees.
I have absolutely no right whatsoever to complain about high mutual fund fees, but it’s the one thing every fund has in common. Hedge funds, by contrast, are meant to make you money in good and bad times; they short common stocks in bad times to profit from the declines. Because of their ability to go both ways and the promise of a steady return no matter what the market does, the fee structure is much different and higher. At my hedge fund our fee structure was simple: we took 2 percent of your assets every year and claimed 20 percent of the profits. Those are much higher fees than you’ll find from most mutual funds, but I was running a hedge fund and, not to brag, it was a great hedge fund. My clients compounded their investments at 24 percent annually after fees. Not many mutual funds can sustain that kind of performance for over a decade, as I did. But this is practically a moot point: there are regulations governing who is allowed to invest in hedge funds, so all you need to know now is that unless you’re an accredited investor, you’re legally prohibited, with some exceptions, from investing in a hedge fund. To become an accredited investor you need either a net worth of over $5 million or you need to have earned $200,000 or more last year, and $200,000 or more the year before, along with having a reasonable e
xpectation of earning $200,000 again this year. If you’ve got the money, you want to find a hedge fund with a great manager. What defines a great manager and what defines a hedge fund worth investing in? (1) The manager has to have a great long-term record of beating the market and making money even if the market goes down. (2) The fund should make you money after all fees are taken out of the equation. (3) The manager should invest most of his or her money alongside you. (4) The manager will tell you what you are invested in and whether prices of the merchandise are all readily available online. (5) The manager respects that it is your money, not his or hers. Some people like to invest in hedge funds through what is known as “funds of funds,” where people select the funds for you. My feeling is that hedge fund managers are like stocks: you have to pay attention to them and you should not trust anyone else to do so. Plus, the funds of funds I have seen can take up to 2 percent to do this placing and following of your monies. You can save money and do much better watching these funds yourself. I would like to focus more on hedge funds in this book, given my extensive knowledge of the industry, but since most people don’t have the money—and hey, if you’ve got 5 million smackers already, you can afford to wait—I’d rather tell you about funds that most regular people can actually invest in.
You can invest in mutual funds, but again I have to stress that you need to be very picky when choosing a fund. And you have to understand that being a good mutual fund investor does not mean investing in a fund and letting your money sit there for decades. You have to find a good manager and keep track of him or her. Actively managed funds make or break themselves based on the quality of their managers. If you get into a fund because it has a good manager and the manager leaves, it’s time for you to get out too. Despite the labeling, there is no such thing as a “team-managed” fund. There is always a captain, and if the captain leaves you should leave too.
I could have started with all the different ways mutual funds classify themselves based on the assets they invest in and how they invest, but I want to hit the one thing all funds have in common before I break them down into their categories. In terms of fees, a lot of mutual funds get you not just coming and going; they get you coming, staying, and then going. When you invest in a mutual fund, you’re giving up a lot of control over your assets. That’s fine, because you’ve recognized that you don’t have the time or the inclination to manage your own money. But because you’re giving up so much control, you need to exercise the best judgment possible with the elements of mutual fund investing that are within your control, and picking out funds with lower fees is totally within your control.
There are several different fees a fund might charge you, and you can see some of them when you look at the fund’s expense ratio. That’s the percentage of your assets that you owe the fund for keeping your assets with them for one year. These can vary from minuscule fees in ETFs and more traditional index funds, to enormous fees for actively managed mutual funds. A fund has administrative costs; it has management costs, especially if it’s an actively managed fund; but it also has distribution and marketing costs, and you pay for these through 12b-1 fees. Nothing offends my sense of fair play more than these 12b-1 fees. Remember, as funds are given more assets to invest, their performance generally declines. Funds can use money from these fees to market themselves, and even more ridiculously, they can use the money to compensate brokers for directing their clients to the fund. How corrupt and awful is that? This is why I’m always saying you cannot trust your broker. The worst thing is that you could be paying up to 1 percent of what you put into the fund every year, and the fund can spend three-quarters of that money on marketing and distributing. You are paying your mutual fund to make itself larger and thus hurt its own performance: you’re paying them, with these 12b-1 fees, to make you less money.
It’s preposterous, I know, but size-wise those fees are far from the worst. Many mutual funds also have what are called “front-end loads” and “back-end loads.” These are fees that can be enormous and are paid either when you invest in the fund (front loads) or pull your money out (back loads). This is money that goes to your broker or, less frequently, the mutual fund, and it could be as much as 5 percent of your investment, which is a mighty big bite. Not every fund has loads—in fact, most don’t these days—which is why you want to steer clear of any “loaded funds,” as they’re called, unless they have some incredible genius fund manager with a record of consistent outperformance that’s impressive enough to negate the big hit you’re taking by paying a load. Also, most mutual funds are divided into three different classes: A, C, and institutional. The actual investments for each class are the same, because they’re part of the same fund, but the fee structures are different. One might have no loads but a higher expense ratio; one might have a huge back-end load but a lower expense ratio. Institutional investors typically pay much lower fees, but they’re forced to deposit much larger sums of money to get their special, low fee status. Remember, never select a fund without analyzing its after-fee returns, because the before-fee returns might look huge, but after fees, the return could be below the market’s performance. If you own this mutual fund through your company’s 401(k) plan, maybe enough of your coworkers participate, or enough of the planner’s other participant plans want to buy into this fund, so they can pool their resources and then pay much, much lower fees—this happens all the time with anything even vaguely pension-related. Most funds with high fees aren’t worth it, but that’s probably simply because most funds aren’t worth it. You get the idea. You can afford to shop around, especially with the list of great mutual funds I’m giving you in a later chapter. All of these fees and the different tiers of funds should be wiped out or regulated much more aggressively by the federal government, but the mutual fund industry is very powerful and has stopped repeated attempts to do anything but force fine-print disclosures of these fees. You have to work hard to find the true numbers, because most of the fees are high to get brokers to steer you into the funds regardless of the performance. This is why the industry has such a bad name, but nobody’s doing much about it to protect you, so you have to protect yourself.
Enough about fees. On the most important level, there are just two different types of mutual funds. They have been categorized in so many different ways by so many people and institutions that it’s sometimes hard to keep track of them. What is a large value fund or a medium blend—isn’t that something you get at Starbucks? I’d like a medium blend with a front load and some international flavor, please. Anyway, the distinction I’m talking about is between actively managed funds and passively managed, or index funds. In an index fund there’s some set benchmark, maybe the S&P 500 or the Wilshire 5000 Total Market Index, but it could be any index, and the job of the fund is simply to match the index by owning all of the stocks in the index and weighting each stock the way the index does. The job of an index fund manager is simply to make sure the fund matches the index. These funds are universally cheaper than actively managed funds, and any index fund will consistently beat the vast majority of mutual funds, if only because the fees are so much lower. With very few exceptions, I’m a strong advocate of owning index funds. I think John Bogle, the man who created the first modern index fund and opened up indexing to nonprofessionals, is both a genius and, from what I saw when I brought him on my old TV show Kudlow & Cramer, a really good guy. Even if Bogle were a jerk, he’d still be right about index funds. If you really cannot or will not spare the time and energy to research your own stocks, index funds are a great way for you to get exposure to pretty much everything you need. As long as you own a solid, diversified index, like the S&P 500, you’ll do almost as well as you would have done on your own. Perhaps you’ll do even better in an index fund than you expected to do while managing your own money. Bogle is adamant that most actively managed funds can’t beat index funds over the long term, because in the end they will look and act too much like index funds but charge higher fees. I remember being upset
with him about this and confronting him directly: didn’t I disprove his whole thesis by consistently outperforming the averages? Bogle stopped me cold by asking me one simple question: “Did you restrict the number of investors in your fund and the amount they could invest?” I said, “Certainly.” He said, “There’s your answer. If you opened up your fund to everyone who wanted in, you too would underperform.” He was dead right.
Jim Cramer's Stay Mad for Life Page 14
