Investing in Mutual Funds

In this paper I introduce the four types of publicly available Mutual Funds, which are SEC Regulated Investment Companies (RICs), key points every investor should know about each type, and a little about the yields paid by each type. It is best to own mutual funds that will pay you to hold. Over the long term, dividends have been critical to Total Return. From the end of 1929 through March 2012, reinvested dividends provided almost half of the S&P 500's total return — a 9.4% annualized return versus just 5.2% for price appreciation alone. Generally speaking, Closed-End Funds (CEFs) tend to payout the highest yields, but can also lose values because of that high yield. Alternatives include Unit Investment Trusts, Open-End Funds, and Exchange Traded Funds. The most import thing to understand about mutual funds that are big and have been around for a long time (like the Wellington Fund that was start in 1929 and is how managed by Vanguard, a RIC that is owned by the investors and therefore has one of the lowest expense ratios) or that are designed to track a major index that has been around for a long time (like Vanguard's Total Stock Market ETF or Total Bond Market ETF) tend to be investments that are very likely to survive and to see higher prices in the future; and are therefore a wonderful investment for most individual who want to participate in the growth of our economic system without having to master too much investment skill. Let's take a quick look at each type to better understand the differences.

Unit Investment Trusts (UITs) are a type of investment company that offer a fixed, unmanaged portfolio, generally of stocks and bonds, as redeemable "units" to investors for a specific period of time. It is designed to provide capital appreciation and/or dividend income. Here are the main points to understand about CEFs:

  1. A UIT may be either a regulated investment corporation (RIC) or a grantor trust. The former is a corporation in which the investors are joint owners and this form can be listed and trades on an exchange, just like any other stock. The latter grants private investors proportional ownership in the fund's underlying investments; and is similar to a partnership with the exception of being a separate taxable entity, with some enhanced liability protection — losses are limited to the value of the trust.
  2. UITs are the oldest form of pooled investment company (mutual fund), first offered in 1774 by the Dutch merchant Adriaan Van Ketwich. The Boston Personal Property Trust was created in 1893 and the first one offered in the U.S; its structure was modeled on British funds popular in Europe at the time.
  3. Because UITs have a fixed end-date, they naturally come to an end; and for that reason they are the least common form of publically available mutual fund. The non-RIC (private grantor trust) type is a little more common; but they're not that easy to find, and they are very illiquid.

Open-End Funds (OEFs) are the most common form of mutual fund; and these are what most people think of when they hear the words "mutual fund" because just about everyone has some type of employer sponsored retirement account (e.g. 401k or 403b) and most of these accounts only offer this type of fund to invest for the future. There are three main differences to understand about these funds:

  1. Shares in the fund are created and issued to the investor by the fund managers whenever new money is invested in the fund; and shares are retired (canceled) whenever investors decide to "cash out" of the fund. You can only buy shares from (invest directly in) the fund and can only sell shares back to the fund at the next closing price; they do not trade on the popular exchanges like stocks.
  2. These funds only trade once per trading day at the Net Asset Value (NAV) price that is based on the closing price (normally at 4 pm EST) of all the underlying securities owned in the fund.
  3. Money tends to flow into these funds after the fund has made a big move up, and money tends to flow out after the fund has made a big move down; and that tends to force the fund managers to buy securities at high prices and to sell at low prices to meet redemptions. This is one of the two main reasons why individual investor returns from these funds underperform the broader market averages — too many investors are buying high and selling low. (By-the-way, the other reason is that the broader market averages have no real transaction costs or fees to bear; actual mutual funds have real trading costs and management fees to pay, which reduce the returns of the fund investors.)
  4. If you're like most of us who needs to save for retirement and does not have the time or desire to learn about investing, the best generic financial planning advice says that you should save (invest) at least 10% of your wages in a passively managed Total World Stock Market Index fund like VTWSX, which should provide in time the growth you need without taking on undue risk.

Exchange Traded Funds (ETFs) are the third and newest form of mutual fund. An ETF is a security that tracks a major market index (like the S&P 500 or MSCI EAFE Index), a market sector index (like Basic Materials or Consumer Staples), or a basket of similarly positioned securities or goods (like Short the S&P 500 or gold). Here are some things to understand about ETFs:

  1. Unlike Open-End Funds (OEFs), ETFs trade throughout the day just like all other stocks.
  2. Just like all other stocks, ETFs begin trading as a part an IPO process.
  3. Like OEFs, the actual number of shares outstanding (available to trade) is open and is a function of the Creation/Redemption Mechanism that is unique to ETF.
  4. An ETF can theoretically trade at a discount or premium to its NAV. But except for a few very new or very small (number of shares outstanding) and illiquid issues, most ETFs trade very close to par (the ratio value of the index or basket they track) thanks to arbitrage and the ETF creation/redemption mechanism.
  5. Prior to 2008, all ETFs were passively managed funds primarily focused on tracking a market index like the S&P 500 and as a result they tended to have very low expense ratios; and they could be more tax efficient than open-end funds because the individual investor selects when to realize their capital gain. Owning these issues is all about earning Beta; earning Alpha is a function of your (investor) strategy and timing. In 2008, the U.S. government allowed ETFs to evolve away from the passive index restriction. Today, you can buy an ETF that can invest in almost any basket of related issues like gold bullion and issues that are likely to grow their dividend.
  6. Most ETFs tend to pay lower yields and are therefore better shorting candidates. Note that if you are short the stock, you are also short the dividend (instead of earning dividend income, you'll have to pay a dividend expanse). Whoever owns the stock on the close of the trading day just before the Ex-Dividend date earns that dividend payment). Dividend.com is a good source of current dividend information.
  7. Beware of Ultra ETFs. These are ETFs that use leverage to magnify (double or triple) the moves made by their underlying index or basket. During the trading day, they do a very good job of tracking (magnifying) their underlying index or basket; but these issues tend to lose value over time because they use derivatives and other techniques to achieve the leverage, which also magnifies the transactions cost associated with the fund. It is best to leave these issues to the pros.

A Closed-End Fund (CEF) is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO). The CEF is listed and traded on an exchange, just like all other stocks. Here are the main points to understand about CEFs:

  1. CEFs are one of the oldest form of pooled investment company (mutual fund). The first were created in the later part of the 1800s. CEFs were very popular in the Roaring Twenties; but went out of favor after the Wall Street Crash of 1929 because so much investment capital was lost primarily due to the excessive leverage that was allowed in both these funds and in the broader stock and bond market. On the heels of the 1929 crash, the Securities Act of 1933, Securities Exchange Act of 1934, and the Investment Company Act of 1940 were passed to address the problems identified and to impose regulatory requirements on all RICs.
  2. CEFs are primarily actively managed investments with higher fees. Owning these issues is all about earning Alpha on Beta; these funds are a good way for retail investors to capture the benefits offered by some of the best investment managers and presumably know some of the best strategy and timing techniques.
  3. Based on current market condition, the strategy employed by the fund manager can be work or not. More on this latter...
  4. CEFs can and often trade at a premium or discount to their NAV.
  5. They can and often do pay out higher yields resulting from the value added by the active management.
  6. When an ETF, like any other stocks (including CEFs), pays a dividend, does a stock distribution or a stock split, most chart services will adjust the historical price data, which will cause the associated charts to look a little different from the prior day. For example, let's say ticker XYZ closes at $10.00 per share and then pays a 5¢ dividend. The next morning, assuming that there is no other reason for the stock to trade up or down, XYZ should open at $9.95 per share because it is now trading Ex-Dividend; and all the charts for XYZ should also have the values associated with each bar reduced by that 5¢ dividend. The reason for this adjust is based on the simple accounting fact that the 5¢ per share no longer belongs to the business — the value has move the Cash account (Asset side of the balance sheet) to the Accounts Payable account (Liability side) on the books of that business.
  7. Even though they are available to smaller retail investors, they are primarily marketed toward large and institutional investors who need a high and steady yield to meet their continuing commitments. For example, company pensions, insurance (annuity) companies, and endowments have to make regular and on-going monthly and quarterly payments to their clients; and these funds help to bring a real measure of predictably to uncertain market returns.
  8. When these fund managers are unable to meet their high payout commitments, the balance of the payout is considered a Return of Capital, which reduces the cost-basis (the amount of money put into the investment). Individual investors are only liable for taxes on the non-Return of Capital part of the dividend payout until the Return of Capital reduces the investment's cost-basis to zero — Yes, it is possible to earn a high-yield in perpetuity on an effective zero cost investment (this is a way to buy a free money cash stream). When/if the cost-basis becomes zero, all subsequent dividend income is taxable. Note that a reduction in the cost-basis also affects the capital-gain results. Furthermore, a transfer from the shorter-term dividend tax rate to a longer-term capital-gains rate may be a strategy worth considering when that dividend income is taxed at the higher rate as in the case of most REITs.
  9. Active management can results in higher capital-gains and/or more shorter-term taxes. There are some tax efficient actively managed funds. The less tax efficient funds should be held in qualified accounts like IRAs.
  10. Because many, but not all, CEFs have such high payout rates, these funds tend to have very limited upside price appreciate. Much of the value generated in these funds is paid out in dividend income.
  11. The high-yield investments, like all high-yielding securities, tend to be very interest rate sensitive, especially if the CEF uses leverage. All higher-yielding investments are considered fixed-income (bond) alternatives or competitors.
  12. Some CEF use leverage; but not all. Leverage magnifies the returns of the fund. Avoid investing in leveraged funds when the underlying economic conditions do not favor the fund's investment objectives.
  13. Never buy a CEF at its IPO. CEFs always IPO at a premium to cover its marketing cost. This premium always evaporated over the subsequent months of trading. Furthermore, you want to give the managers some time to see what kind of returns they are able to generate.
  14. Most CEFs trade at a discount to their NAV. The Closed-End Fund Discount" by Elroy Dimson and Carolina Minio-Paluello is a professional research paper that considered the reasons to explain the phenomena. Unfortunately, there's no one good reason, but there are a number of valid reasons that in my humble opinion amount to so much noise. Bottom line, except for a few popular funds, like from PIMCO, which seem to always command a premium, most CEFs tend to trade at some discount. What is important to understand is that CEF prices tend to vary around some average discount/premium value. It's best to buy when current prices are below the average and maybe sell when they're ridiculously above that average. MorningStar.com has a proprietary Z-Statistic that makes it easy to see the current status; a positive number indicates the current price is trading above the average, a negative number indicates prices below the average. It's not uncommon to see values at or a little above +/- 1; but number greater than +/- 2 occur less than 2.25% of the time.
  15. Return of Capital — When a fund makes regular payments consisting of "return of capital," it can be a signal of a dangerous dividend. Often, these payments are simply returns of an investors' own capital (fund shareholders' equity). Funds supplement their distributions (the amount paid out to the owners of the fund) with returns of capital when investment income or gains aren't enough to maintain the dividend. In effect, the fund dips into its capital pool (sells assets owned by the fund) to keep up the dividend, which lower the NAV of the fund — the manager have fewer resources to work with, which makes it even harder for them to maintain the same level (amount) of the cash payout — the fund may still pay the save yield, say 10%, but that yield will be on a lower NAV and stock price.
  16. Undistributed Net Investment Income (UNII) — Closed-end funds are required to distribute at least 90% of their taxable income each year to avoid paying corporate taxes on what's distributed. They also must pass along at least 98% of their income and net capital gains each year to avoid paying a 4% excise tax on what's distributed. However, some managers elect not to distribute all income earned during the year and instead pay the 4% excise tax on this income. What's lost to taxes is gained in asset value, and the UNII can be used to supplement future distributions as needed. So UNII secures the dividend and bodes well for dividend increases. In contrast, over-distributed net investment income — when a fund distributes more than it made in a year — may be a sign of dividend danger. The statement of assets and liabilities tells you whether the fund has undistributed or over-distributed income. A rising UNII balance implies the fund is out-earning its current distribution yield and increasing the fund's NAV; and a declining UNII balance indicates the alternative — bad news. A sustained trend in either direction indicates an adjustment in the fund's distribution rate is likely to help balance (maintain) the earnings (Beta + Alpha) and distribution ratio. Positive UNII tends to occur in CEFs that hold fixed income, which are about two-thirds of the total.
  17. Income Only Yield and Payout Ratio — Closed-end fund distributions typically can come from three sources: Capital Gains, Investment Income, and Return of Capital. Capital gains are earned whenever the fund managers are able to use fund resources to buy securities at one price and sell the same securities at higher prices. Investment Income comes for dividend and interest income earned on the holding of assets in the fund. See Return of Capital above for more information about that. Of these, investment income is generally the most predictable as payments are issued at regular intervals. The "income only yield" and payout ratio provides a handy measure of how much of the fund's distribution comes from investment income, net of expenses; this is dividend or interest income earned from the assets held in the fund (that is, if the fund manager do nothing but sit on the fund's assets, they'll earn this yield). This ratio (percentage) provides a quick gauge of how secured the distribution yield (the amount paid out to the owners of the fund). So if a fund earns $1.00 (10%) per share in net investment income and pays out $0.90 (9%), then you can quickly see the fund can cover its payments to the fund's investors. But if the fund earns only 10¢ (1%) per share and pays out $0.90 (9%), then the fund managers have to work harder (earn lots of Alpha) to cover the 9% payout ratio; and when they fail they'll have to dip into the fund's capital (do a Return of Capital) or depending on capital appreciation (stock gains). likely to do a return of capital, which lower the NAV of the fund.
  18. Here are two old but still very good books on the subject:

When a fund pays a high distribution yield, that yield has to come from somewhere; and the higher the yield, the more likely that yield is coming out of capital (price) appreciation — we're consuming the growth, which is why we need to focus on 1) survivable issues, like these funds, that will pay us to hold, and 2a) Total Return (Capital Appreciation + Income from ownership) and 2b) our Cost-Basis (the position's break-even price), which may require us to manage (average down) our cost-basis to realize a good (10% +/- a point or two) total return.

Note that the economy tends to normally grows at about 2 to 4% per year, inflation normally adds another 2 to 4 points, and profits from operations of businesses in the S&P 500 can yield another 2 to 4% (all on average, the actual percentage rate in any one year is a lot more variable). Adding these all up we get a long-term historical average growth rate of about 6 to 8%, which can be adjusted by a change in the market multiple (P/E ratios). All this is called Beta — the market rate of return. If you then add professional trading/investing strategies to this level of growth, which is called Alpha, you can get (theoretically) an even higher rate of return. But please note that in any individual year Alpha and Beta can be much higher or lower and even negative values because the economy is contracting or the professional strategy does not work in the current market environment.

If the fund manager is unable to use positive Alpha + Beta to meet the fund's targeted distribution yield, that yield will either have to come down or the fund will have to do a "bad" Return of Capital (RoC) to meet the high distribution yield. RoC can be either "good" or "bad". Basically, good does not lower the capital base of the fund (the fund's NAV) over longer periods of time (about a year or so), and bad does. The best way to spot the difference is to compare how an individual fund is doing relative to it's peers (i.e., the average for the class of funds). Click here to learn more about RoC.

Also note that the market, market sectors and groups cycle up and down over time, thanks to economic business cycles and natural issue rotations, which can cause any fund's price and NAV to cycle up and down over time. This cycling up and down of prices gives us a chance to buy at discount prices (or build a discounted cost-basis) and sell at premium prices (or at a price above our cost-basis). If the fund can survive and we can manage our cost basis (i.e., lower it when given the opportunity), then making an 8 to 10% average rate of return over time is just a function of time and portfolio management, assuming future market condition will be like prior market history.

Stan Benson