Monday, September 14, 2009

The Myth of Diversity from Mutual Funds

It had never happened before. All asset classes dropped in the fall of 2008. It wasn't supposed to happen like that. 80 years of history says that when bonds go up in value, equities decrease and vice-versa.

I had avoided the storm--barely--by moving out of equities quite a bit before the calamity of August 2008 hit.

So after an absence of attention to markets coinciding with the birth of my son in April, I am looking to get more of a return and increase my risk.

I come across the Edward Jones Advisory Solutions (TM) program from my trusted and likeable Edward Jones agent. I do like him, and I trust him. However, I am having a hard time seeing the value.

Lets talk about being diversified. You can have diversity across an asset: ie. owning shares in lots of different types of companies. This protects you when one company goes bad. And then you can have diversity amongst asset classes: ie. owning equities and bonds--because historically, they move in opposite directions.

What happens when they all move in the same direction? Well that was the question no one asked until the Fall of the fall of 2008. Now that the stock markets have gain 50%, have bonds sold off like they should have according to the last 80 years of history? Nope they are even higher. Some of them at their 52 week highs. So asset classes are moving together again but no one cares because they are moving in the right direction: up.

There are two reasons to own stocks: 1) because you think you will be paid a dividend on the stock, and 2) you think someone else will come along and pay more than you did for the stock.

For bonds it is much the same: 1) the interest paid on the bond, and 2) Someone else will pay more for that interest than you did.

But lets get back to the myth of diversity.

In the Advisory Solutions (TM) program, there are dozens and dozens of different funds to choose from for both equities and bonds, and then a couple of 'niche' market real estate and commodity funds plus a couple of money market funds.

The program is marketed as one that provides diversity. And maybe in another time, it would have.

But it doesn't now.

It looks like it is diversified: the color coded brochure helps my eyes to understand which funds have which size caps, and which ones focus on value as opposed to the completely different growth. Then there are US, international, and emerging market funds.

Wow feeling pretty good about diversity--as there are all the big names in each of the colored sections--and we haven't even gotten to the bonds yet. Then there are bonds: government, corporate, domestic, tax exempt, etc. And then a couple of commodity ETFs (I count ETF's as the poor-mans mutual fund). Now to own these, you have to pay fees the companies that run these funds (fees are smaller for the ETFs) and of course there is the fee to Edward Jones.

So then I start looking at how some of these funds have performed.

Google finance is the great equalizer, and I click on charts for the various equity funds in the various colors. I click on 'max' for time view.

And here is where the illusion of diversity disappears.

Every equity fund's chart has the exact same shape. Prices may be very different. But they all went up up up through 2007 then crashed fall of 2008 to March of 2009, and then rebounded 50% higher to today.

I am pretty sure in a year or so if I were to make toys in the shape of all these different mutal funds and then ask my 2 year old which one of these is not like the others, he would tell me they are all the same.

Now 80 years of history tell my Edward Jones guy that Mid caps are the first ones to rebound, followed by Small Caps, and the Large Caps--or something like that.

But a two year old would be able to tell me that they all look the same.

So why should I pay several points for someone when they all move together?

Well at least there are bonds. Except that all the bond funds are mostly at their 52 week highs. Plus debt markets are a bit unpredictable as the US government is incurring massive debt to stimulate the economy. And debt is what got us into the trouble in the first place.

The bottom line here for me on equites is that meeting either of the two conditions is suspect: Dividends aren't being paid enough to justify the risk of equities. And if I am skeptical of buying at these prices, how can I expect someone else to come along and pay more for something I already think is overvalued?

Then again, this kind of thinking went a long way in driving real esate and equity markets higher in the past, so we could see a lot more upside.

The consumer makes up 2/3rds of the economy. 1 in 10 consumers are out of work. Their houses are worth less. The banks won't lend to them. The credit card companies have decreased their lines of credit.

How exactly is the consumer going to spend enough to increase earnings?

It is kind of annoying.

"Professionals" tell you never to try to 'time' the market. Except that now is always the best 'time' to buy into the market. Buy and hold.

The old adage that 'this time its different' is usually said at the tops of frothy markets. From Tulips to NASDAQ, this time there won't be a crash. Buy real estate now, because you may never get in at these prices.

I have a suspicion that this time it truly is different.

And the professional investing class has not adjusted to the undpredictable future where the old rules of investing don't work.

2 comments:

phattman said...

Thanks for turning on the fog lights. I have also been a fairly happy client of Ed Jones for many years and I have to say they have made me some money. But I have also paid a lot of money.
But I have to wonder why the Advisory Solutions and now?
My thoughts......greater diversification makes it truly difficult to assess true performance. I have always felt handcuffed when the time came to make substantial changes because of market shifts. This may be good or bad. Keeps one from making knee jerk reactions but makes it real dificult to see what the true performance is.
Why not just buy the S&P, Dow, Russell or better yet, Berkshire Hatheway .

jwholland said...

Why the shift in strategy? Haven't they alwasy promoted diversity? What makes Advisory Solutions any different from my well diversified portfolio I have today? On a comparison, my 401K with various Vanguard Index Funds has out performed my Portfolio of American funds. That 1.365% annual fee also catches my eye. So, how many thousands of dollars will I be paying out for the various funds and fee's Edward Jones will be tacking on cost me?
I am in agreement with phattman's comments. I have paid out a lot and I am not too anxious to pay out more.

Thanks, Jim