- Jun 6, 2007
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This posting is ultimately directed toward Federal Regulators, members of Congress (who have a charge to try to create and protect wealth for all Americans) and executives of the Financial Industry who have a civic duty likewise to try to create and protect prosperity throughout America's society. Specifically, my topic has to do with mutual funds and by association Exchange Traded Funds (ETFs).
It helps to understand the lesson that I learned the hard way over the last week when I looked at my retirement accounts and saw they dropped dramatically in value, largely I lost all my earnings from last year which was an outstanding year for the financial markets. Basically the point is that I did not realize and I don't think many people realize what a "growth" mutual fund involves and means especially in comparison to a "value" mutual fund; one can plug the investment product of ETF into this discussion instead of mutual fund the same concerns apply. Before this week I always thought a "growth" mutual fund was a fund in which the investment manager of the fund looks at the "entire" stock market and invests in a broad array of companies, companies he or she thinks are most poised to have their stock grow in price to the optimal degree. My error and I think probably is a commonly held wrong view is that in "growth" mutual funds the investment manager doesn't select stocks from the "entire" stock market he or she only selects from "growth" stocks he or she discards "value" stocks in the market from consideration. This is a critically important characteristic of this investment product because it makes this investment a high risk one. A little explaining is in order here; see "growth" stock are ones where investors see a likelihood of significant increase in sales revenue and thus earnings from the underlying corporation. This earnings potential "ordinarily" results in "growth" stocks having a significantly to enormously higher price to earnings ratio compared to that of "value" stocks. I say ordinarily referring to good overall economic conditions when economic conditions become bad or strained this higher price to earnings ratio of "growth" stocks drops and often drops dramatically; explaining why one should classify them as high risk investment products. This high risk quality of these funds reared its head over the past two months considering that this past December inflation was recorded at 7% compared to the previous December and the prevailing wisdom is that the Federal Reserve Board will raise interest rates three to five times this year depending on the ongoing inflation rate throwing the economy into a lower gear, equity investors understandably viewed and view these developments as the economy heading into a strained state and accordingly treated growth stocks as warranted under these conditions and so "growth" stocks dramatically dropped in value. The point being that there is a lack of education in the system for ordinary equity investors about "growth" funds and "value" funds (actively managed funds) and this is an important shortfall because many many Americans have 401K funds which are largely their retirement income source and as a society we shouldn't want these Americans' retirement funds prevalently dramatically hurt for this lack of education, this education shortfall should be eliminated!
I checked the Prospectuses for the Growth Funds that I invested in and the Funds put in the requisite disclaimer but it was the bare minimum it is not written so that an ordinary person would appreciate what is going on here. The Securities and Exchange Commission (SEC) and the Consumer Financial Protection Bureau (CFPB) need to do a better job in carrying out their mission to have investors/consumers informed about the investment product they are being sold. The following or something like it should be boilerplate provisions in prospectuses for all actively managed mutual funds and ETFs. Stocks fall into one of two categories "value" stocks or "growth" stocks. A "value" stock fund only invests in "value" stocks; a "growth" stock fund only invests in "growth" stocks. A "Blended" stock fund invests in both "value" stocks and "growth" stocks. Generally, stocks are priced according to multiples of the earnings of the respective underlying corporation. Ordinarily for a "value" stock the underlying corporation has a low earnings growth trajectory, however the earnings generally is expected to be relatively stable over time; on the other hand, for a "growth" stock ordinarily the underlying corporation has a moderate to high earnings growth trajectory. Under ordinary and basically good overall economic conditions "growth" stocks are priced at a significant to enormous higher "price to earnings" ratio compared to the "price to earnings" ratio for "value" stocks. Under bad or strained overall economic conditions it is common to see this higher price to earnings ratio of "growth" stocks fall and sometimes fall dramatically. These pricing dynamics can tend to cause "value" stock funds to appear as underperforming during ordinary and good overall economic conditions. Conversely, when the overall economy moves into a state of being in a bad or strained overall economic condition this often results in "growth" stock funds dropping dramatically in value.
If anyone really looks at the issues one should conclude that Congress, the Federal regulators and Executives of the Financial Industry should be doing more to grow and protect American's 401K and IRA accounts for Americans need these accounts for retirement income and the analysis is that these accounts aren't sufficient for many Americans to maintain the quality of life they had during their working life. Plus, America has a real problem with wealth disparity, actually this problem threatens the stability of our nation, and the way most people get their wealth is they inherit it and so if the government can improve the system to grow peoples' wealth, namely their retirement wealth, they will have more to pass on to future generations of their family which will lessen this wealth disparity problem we have in our country!
What I think that the system needs is a hybrid between an index fund and an actively managed fund. The problem with an index fund is that the fund is stuck buying individual stocks or a sector of stocks in the index which any prudent investor knows are going down in value. There is an abundance of examples seen over the years in 2020 the oil sector stocks (for one day the price of a barrel of oil went below zero), during the Obama administration regulators tightened regulations so that one knew clearly there would not be any new coal powered electricity generation plants built in American and the shuttering of existing ones would be accelerated which made it practically a certainty that coal company stocks would drop in value, and periodically one sees either an over supply of pork or chicken or there is a breakout of disease amongst hogs or chickens where its practically guaranteed that the stock price will fall of producers of the respective meat. The system should have eighty percent index funds or seventy percent index funds where the fund manager is permitted to drop off twenty or thirty percent respectively of stocks in the index (obvious bad stocks would be dropped), the same rules would apply for the fund manager for buying stocks in the remaining list of stocks in the modified index, he or she buys based on the individual stock's market capitalization compared to the total market capitalization of all the stocks in the modified index.
A critique to this idea would say well if you do this you are taking out a price floor or the damper on the price drop of these bad stocks because fund managers now have a green light to sell these stocks when they obviously turn bad and when you have a dramatic price drop in a stock price the underlying corporation has a more difficult time raising capital and is under more pressure to cut expenses which often means eliminating jobs. The practical effect on the corporation of a bad stock this critique identifies is at least somewhat true but the important question here is why are index fund investors stuck paying for helping corporations of bad stocks it needs to be considered that wealthy Americans who mostly have great investment managers managing their money because they can afford to compensate them and don't have to get stuck in the mutual/ETF fund track aren't holding on to these bad stocks they are selling them as fast as they can. This reason for blocking this hybrid index fund product isn't persuasive. One benefit of this hybrid index fund product is that it would tamp down on this casino capitalism mentality that permeates the U.S. financial industry this mentality that was seen in spades over the last eighteen months that drove up stock prices way above the level of a responsible system; a common story referenced these days is how the NASDAQ index (Technology stocks) is down twelve percent this month and it is because the Wall Street system drove up many Tech stock prices way above their fair value. This modified index fund product would allow these fund managers to drop bad stocks from the index and they could label bad stocks as way overpriced stocks; it would allow these fund managers to speak out about the irresponsibility in the system. Look at the abuse of the system for the Tesla stock on November 5th of last year the Wall Street machine drove up the price of that stock to $1222 giving Tesla a market capitalization of $1.2 trillion dollars General Motors and Ford at their highest market capitalization point over the last year was $97 billion dollars and $98 billion dollars respectively; there is no way Tesla is worth ten times these great American car companies for crying out loud Tesla made more money selling these environment protection credits they get from making EV vehicles than they actually made from selling their product EV vehicles last year, it was like $1.2 billion compared to like $900 million earnings; and our very flawed system revealed itself considering the closing price of Tesla stock today, it closed at $846.
On these modified index funds regulations could be set-up to give the investor great transparency on what is going in the fund to be fair to the investor. For the top twenty percent of stocks in the index by market capitalization the fund manager would have to at the latest publicly publish on a monthly basis all the stocks in this top twenty percent bracket that are not currently in the index. To strike a balance between allowing fund managers to keep their secret sauce but to let investors know what they are investing Fund managers would be required to at the latest on a monthly basis publicly report a portion of the list of the stocks they dropped from the index; the portion they would have to report is the Fund Manager could keep confidential the identity of stocks on the list numbering ten percent of the total quantity of stocks on the index, the balance on the list would have to be reported. Of course modified index funds would have a higher expense than regular index funds because they would have to hire investment professionals to weed out bad stocks and this fund expense would be incurred by the funds' investors; the fund expense would likely be modest at most like one half to a full percentage point based on the industry's going charges; the goal here is not to be running an actively managed fund per se, the goal would be to identify bad stocks that a reasonably prudent investment manager would classify as bad stocks and get them out of the fund, bad stocks because the underlying business of the corporation which underlies the stock is bad or that is bad because the stock is grossly overvalued and a good and normal operating market would price the stock at a significantly lower level. The suggestion here is not looking for Warren Buffets to run these modified index funds but qualified fund managers that have the education and experience to do the job and at least perform competently, stop the foolish behavior in the operation of these mutual funds from an investing standpoint.
Two quick points that regulators should implement on actively managed mutual funds. People invest in these funds because they want to minimize downward risk they want to minimize the loss of value to the fund so their intentions are that fund managers diversify and spread downward risk amongst a lot of stocks. To that end one sees on the publications of these funds that the top five to eight stocks held by these funds often hold rather significant portions of the fund like 4, 5 and 6 percent of the funds assets. Often their FANG stocks or like Microsoft stock and as we see over the past two months these stocks sometime experience a significant downturn. The federal regulation should be that these broad based mutual funds cannot invest greater than three percent of their fund in an individual stock; obviously good stocks go up in price so that three percent could readily grow to five or six percent so the second part of that Federal regulation is that once the individual stock surpasses three percent in value the fund manager has forty-five days from that day to recalibrate the holdings in the fund to bring back that individual stocks ownership amount in the fund to three percent or below the total value of the fund. The second point again relates to insuring that downward risk is spread amongst a lot of individual stocks in an actively managed mutual fund that is part of the essence of the agreement between the fund investor and the fund. The federal regulation should be that if the fund invests all the monies in the fund the investment manager should be investing in at least sixty individual stocks and if the fund is holding cash reduce the number by one for each 1.666% of the funds total value held in cash.
It helps to understand the lesson that I learned the hard way over the last week when I looked at my retirement accounts and saw they dropped dramatically in value, largely I lost all my earnings from last year which was an outstanding year for the financial markets. Basically the point is that I did not realize and I don't think many people realize what a "growth" mutual fund involves and means especially in comparison to a "value" mutual fund; one can plug the investment product of ETF into this discussion instead of mutual fund the same concerns apply. Before this week I always thought a "growth" mutual fund was a fund in which the investment manager of the fund looks at the "entire" stock market and invests in a broad array of companies, companies he or she thinks are most poised to have their stock grow in price to the optimal degree. My error and I think probably is a commonly held wrong view is that in "growth" mutual funds the investment manager doesn't select stocks from the "entire" stock market he or she only selects from "growth" stocks he or she discards "value" stocks in the market from consideration. This is a critically important characteristic of this investment product because it makes this investment a high risk one. A little explaining is in order here; see "growth" stock are ones where investors see a likelihood of significant increase in sales revenue and thus earnings from the underlying corporation. This earnings potential "ordinarily" results in "growth" stocks having a significantly to enormously higher price to earnings ratio compared to that of "value" stocks. I say ordinarily referring to good overall economic conditions when economic conditions become bad or strained this higher price to earnings ratio of "growth" stocks drops and often drops dramatically; explaining why one should classify them as high risk investment products. This high risk quality of these funds reared its head over the past two months considering that this past December inflation was recorded at 7% compared to the previous December and the prevailing wisdom is that the Federal Reserve Board will raise interest rates three to five times this year depending on the ongoing inflation rate throwing the economy into a lower gear, equity investors understandably viewed and view these developments as the economy heading into a strained state and accordingly treated growth stocks as warranted under these conditions and so "growth" stocks dramatically dropped in value. The point being that there is a lack of education in the system for ordinary equity investors about "growth" funds and "value" funds (actively managed funds) and this is an important shortfall because many many Americans have 401K funds which are largely their retirement income source and as a society we shouldn't want these Americans' retirement funds prevalently dramatically hurt for this lack of education, this education shortfall should be eliminated!
I checked the Prospectuses for the Growth Funds that I invested in and the Funds put in the requisite disclaimer but it was the bare minimum it is not written so that an ordinary person would appreciate what is going on here. The Securities and Exchange Commission (SEC) and the Consumer Financial Protection Bureau (CFPB) need to do a better job in carrying out their mission to have investors/consumers informed about the investment product they are being sold. The following or something like it should be boilerplate provisions in prospectuses for all actively managed mutual funds and ETFs. Stocks fall into one of two categories "value" stocks or "growth" stocks. A "value" stock fund only invests in "value" stocks; a "growth" stock fund only invests in "growth" stocks. A "Blended" stock fund invests in both "value" stocks and "growth" stocks. Generally, stocks are priced according to multiples of the earnings of the respective underlying corporation. Ordinarily for a "value" stock the underlying corporation has a low earnings growth trajectory, however the earnings generally is expected to be relatively stable over time; on the other hand, for a "growth" stock ordinarily the underlying corporation has a moderate to high earnings growth trajectory. Under ordinary and basically good overall economic conditions "growth" stocks are priced at a significant to enormous higher "price to earnings" ratio compared to the "price to earnings" ratio for "value" stocks. Under bad or strained overall economic conditions it is common to see this higher price to earnings ratio of "growth" stocks fall and sometimes fall dramatically. These pricing dynamics can tend to cause "value" stock funds to appear as underperforming during ordinary and good overall economic conditions. Conversely, when the overall economy moves into a state of being in a bad or strained overall economic condition this often results in "growth" stock funds dropping dramatically in value.
If anyone really looks at the issues one should conclude that Congress, the Federal regulators and Executives of the Financial Industry should be doing more to grow and protect American's 401K and IRA accounts for Americans need these accounts for retirement income and the analysis is that these accounts aren't sufficient for many Americans to maintain the quality of life they had during their working life. Plus, America has a real problem with wealth disparity, actually this problem threatens the stability of our nation, and the way most people get their wealth is they inherit it and so if the government can improve the system to grow peoples' wealth, namely their retirement wealth, they will have more to pass on to future generations of their family which will lessen this wealth disparity problem we have in our country!
What I think that the system needs is a hybrid between an index fund and an actively managed fund. The problem with an index fund is that the fund is stuck buying individual stocks or a sector of stocks in the index which any prudent investor knows are going down in value. There is an abundance of examples seen over the years in 2020 the oil sector stocks (for one day the price of a barrel of oil went below zero), during the Obama administration regulators tightened regulations so that one knew clearly there would not be any new coal powered electricity generation plants built in American and the shuttering of existing ones would be accelerated which made it practically a certainty that coal company stocks would drop in value, and periodically one sees either an over supply of pork or chicken or there is a breakout of disease amongst hogs or chickens where its practically guaranteed that the stock price will fall of producers of the respective meat. The system should have eighty percent index funds or seventy percent index funds where the fund manager is permitted to drop off twenty or thirty percent respectively of stocks in the index (obvious bad stocks would be dropped), the same rules would apply for the fund manager for buying stocks in the remaining list of stocks in the modified index, he or she buys based on the individual stock's market capitalization compared to the total market capitalization of all the stocks in the modified index.
A critique to this idea would say well if you do this you are taking out a price floor or the damper on the price drop of these bad stocks because fund managers now have a green light to sell these stocks when they obviously turn bad and when you have a dramatic price drop in a stock price the underlying corporation has a more difficult time raising capital and is under more pressure to cut expenses which often means eliminating jobs. The practical effect on the corporation of a bad stock this critique identifies is at least somewhat true but the important question here is why are index fund investors stuck paying for helping corporations of bad stocks it needs to be considered that wealthy Americans who mostly have great investment managers managing their money because they can afford to compensate them and don't have to get stuck in the mutual/ETF fund track aren't holding on to these bad stocks they are selling them as fast as they can. This reason for blocking this hybrid index fund product isn't persuasive. One benefit of this hybrid index fund product is that it would tamp down on this casino capitalism mentality that permeates the U.S. financial industry this mentality that was seen in spades over the last eighteen months that drove up stock prices way above the level of a responsible system; a common story referenced these days is how the NASDAQ index (Technology stocks) is down twelve percent this month and it is because the Wall Street system drove up many Tech stock prices way above their fair value. This modified index fund product would allow these fund managers to drop bad stocks from the index and they could label bad stocks as way overpriced stocks; it would allow these fund managers to speak out about the irresponsibility in the system. Look at the abuse of the system for the Tesla stock on November 5th of last year the Wall Street machine drove up the price of that stock to $1222 giving Tesla a market capitalization of $1.2 trillion dollars General Motors and Ford at their highest market capitalization point over the last year was $97 billion dollars and $98 billion dollars respectively; there is no way Tesla is worth ten times these great American car companies for crying out loud Tesla made more money selling these environment protection credits they get from making EV vehicles than they actually made from selling their product EV vehicles last year, it was like $1.2 billion compared to like $900 million earnings; and our very flawed system revealed itself considering the closing price of Tesla stock today, it closed at $846.
On these modified index funds regulations could be set-up to give the investor great transparency on what is going in the fund to be fair to the investor. For the top twenty percent of stocks in the index by market capitalization the fund manager would have to at the latest publicly publish on a monthly basis all the stocks in this top twenty percent bracket that are not currently in the index. To strike a balance between allowing fund managers to keep their secret sauce but to let investors know what they are investing Fund managers would be required to at the latest on a monthly basis publicly report a portion of the list of the stocks they dropped from the index; the portion they would have to report is the Fund Manager could keep confidential the identity of stocks on the list numbering ten percent of the total quantity of stocks on the index, the balance on the list would have to be reported. Of course modified index funds would have a higher expense than regular index funds because they would have to hire investment professionals to weed out bad stocks and this fund expense would be incurred by the funds' investors; the fund expense would likely be modest at most like one half to a full percentage point based on the industry's going charges; the goal here is not to be running an actively managed fund per se, the goal would be to identify bad stocks that a reasonably prudent investment manager would classify as bad stocks and get them out of the fund, bad stocks because the underlying business of the corporation which underlies the stock is bad or that is bad because the stock is grossly overvalued and a good and normal operating market would price the stock at a significantly lower level. The suggestion here is not looking for Warren Buffets to run these modified index funds but qualified fund managers that have the education and experience to do the job and at least perform competently, stop the foolish behavior in the operation of these mutual funds from an investing standpoint.
Two quick points that regulators should implement on actively managed mutual funds. People invest in these funds because they want to minimize downward risk they want to minimize the loss of value to the fund so their intentions are that fund managers diversify and spread downward risk amongst a lot of stocks. To that end one sees on the publications of these funds that the top five to eight stocks held by these funds often hold rather significant portions of the fund like 4, 5 and 6 percent of the funds assets. Often their FANG stocks or like Microsoft stock and as we see over the past two months these stocks sometime experience a significant downturn. The federal regulation should be that these broad based mutual funds cannot invest greater than three percent of their fund in an individual stock; obviously good stocks go up in price so that three percent could readily grow to five or six percent so the second part of that Federal regulation is that once the individual stock surpasses three percent in value the fund manager has forty-five days from that day to recalibrate the holdings in the fund to bring back that individual stocks ownership amount in the fund to three percent or below the total value of the fund. The second point again relates to insuring that downward risk is spread amongst a lot of individual stocks in an actively managed mutual fund that is part of the essence of the agreement between the fund investor and the fund. The federal regulation should be that if the fund invests all the monies in the fund the investment manager should be investing in at least sixty individual stocks and if the fund is holding cash reduce the number by one for each 1.666% of the funds total value held in cash.
