Personal Finance: a Gospel Perspective

1. Personal Finance: a Gospel Perspective Investments 8: Picking Financial Assets

2. Objectives • A. Understand why you shouldn’t be picking stocks until Phase IV when your assets have grown • B. Understand where to find important information on mutual funds and stocks • C. Understand what makes a good mutual fund • D. Understand index funds

3. Applications #1 • Bill and Suzie, both 30, are married with one child. They can answer affirmatively to all the questions from the top of the investment hourglass. They have determined they need $15,000 in an emergency fund, will save 10% of their gross salary, and their asset allocations are 75% equities and 25% bonds and cash with targets: • 25% bonds/cash (Lehman Aggregate) 25% T 0% R • 55% U.S. (S&P 500 Index) 35% T, 20% R • 10% small cap (Russell 5000 Index) 4% T 6% R • 10% international (MSCI EAFE Index) 4% T 6% R • How do they select the mutual funds to obtain exposure to their chosen asset classes?

4. A. Understand why you shouldn’t be picking stocks until later • While we have talked about many things thus far, we have not talked about picking stocks. Why? • There are five major reasons why we have not talked about picking stocks. Picking stocks violates the following principles: • 1. Principle 3: Stay Diversified • Picking single stocks violates the principle of diversification, especially when you are just beginning to build your portfolio • With a small portfolio, it is difficult to achieve acceptable diversification with limited numbers of stocks

5. Stock Selection Strategies (continued) • 2. Principle 4: Invest Low Cost • Investing in stocks when you have a small portfolio is very expensive. • Transactions costs for purchasing stocks are the highest of any major asset class • 3. Principle 6: Know What You Invest In • Picking stocks when you have not developed the knowledge base necessary to evaluate stocks is risky • Most have not as yet put in the time to learn to evaluate stocks nor have developed the tools to make good stock selection decisions

6. Stock Selection Strategies (continued) • 4. Principle 8: Don’t spend too much time trying to “Beat the Market” • Picking stocks is very difficult and challenging • There is so much more to be learned about valuation that can’t be taught in a single class. • We have given the basics only in this course • 5. Stock selection is not required to have a successful investment portfolio • While it is intellectually challenging to select stocks, you can generally improve returns and reduce risk more by properly selecting asset classes. • You may never need to buy an individual stock

7. Stock Selection Strategies (continued) • Remember, since analyzing companies is not likely going to be many of your jobs, it will be in your best interest to develop a “Sleep Well Portfolio”. This is done by: • Writing and following your Investment Plan • Write it well and follow it • Maintaining a generally passive strategy • Indexing is a viable long-term strategy • Enjoying your family and friends • Make memories, not investment reports • Doing well in your day jobs • Make a difference where you work

8. Questions • Any questions on why you shouldn't be picking stocks until later?

9. B. Understand where to find information on Mutual Funds • Where do you find mutual fund and stock information? • Stockbrokers • Mutual Fund Supermarkets • Schwab, Fidelity, TD Waterhouse • Mutual Fund Monitoring companies • Morningstar, Lipper • Financial Websites and the Financial Press • Yahoo, MSN Money • Kiplinger’s, Smart Money • BYU Libraries • HBLL has great information – See TT10

10. Mutual Fund Information (continued) • What is the best format for the information? • In a database of consistent, pertinent information that is updated on a regular basis • The database must be directly searchable with a consistent framework and structure • Our example: • Morningstar • Note that this is just one of the many available databases. By choosing this database, I am neither implying or endorsing Morningstar (although I think they are pretty good). It is just that it is available free in the library

11. Mutual Fund Information (continued) • What is the process to pick mutual funds? • 1. Determine the asset class needed for your Plan • 2. Determine the appropriate benchmark • 3. Determine the key parameters for that asset class, i.e., principles, such as costs, fees, diversification, etc. to identify potential funds • 4. Using a database program, set those parameters, and evaluate each of the potential candidates • 5. Evaluate each candidate and select the best funds • 6. Purchase the funds (but not in December before distributions are made) and monitor performance carefully

12. C. Understand What Makes A Good Mutual Fund What makes a good mutual fund? Good diversification Low costs Low turnover Low un-invested Cash No manager style drift Small tracking error

13. Diversification • Diversification is your key defense against market risk • Stay diversified at all times. Pick a fund with many companies in their portfolios within your asset class • Diversification your primary defense against things that might go wrong in investing • Remember where you are in the hourglass. • Avoid sector (industry) funds, individual stocks or concentrated portfolios of any kind until you have sufficient education, experience, and assets • And even then, keep that percentage of these assets small in relation to your overall assets.

14. Where do you find Diversification? • Diversification by: • Numbers (Portfolio: Top 25 Holdings) • Total Number of Holdings (Portfolio: Top 25 Holdings) • Concentration of Holdings (Portfolio or Snapshot: % in top 10 holdings) • Type (Portfolio: Asset Allocation) • Type of holdings (stocks, bonds, cash) • Location (Portfolio: International Exposure) • Location of companies invested in (geographic area)

15. Diversification Pages

16. Low Cost • Invest low cost • In a world where investment returns are limited, investment costs of all kinds reduce your return • Invest in no-load mutual funds • You should rarely (if ever) pay a sales load of any kind (front end, level load, 12-b1, etc.). • Rear-end loads, since you are long-term investor, may be OK as long as they are less than 180 days. • Keep management fees to the lowest possible within the sector. • Remember: A dollar saved is a dollar you can earn more money with

17. Where do you find costs? • Costs (Fees & Mgmt: Fees and Expenses) • Administrative costs • Management fees • 12b-1 Fees • Other Fees • Most important ratio: Total Expense Ratio • Compare that to your category average • Taxes • Tax Cost Ratio (Tax Analysis)

18. Fees Pages

19. Low Turnover • Keep turnover low, as it’s a proxy for fund expenses and taxes • The costs associated with turnover are hard to quantify and may not be disclosed in the prospectus. These costs include commissions, bid-ask spreads, and market impact. • Each transaction generates a taxable event for you, and these cumulative costs can be very expensive. • Stick to funds with the low turnover (and low management fees), as they generally have lower costs and are more tax efficient as well

20. Where do you find Turnover? • Turnover • Annual Turnover (Snapshot: Portfolio Analysis - Turnover) • Potential Capital Gains Exposure (Returns: Tax Analysis)

21. Turnover Pages

22. Low Un-invested Cash • High cash levels are drags on performance. Keep cash low • Many funds hold cash to fund potential redemptions, or as part of their investment policy, which are drags on performance. • Choose funds that are fully invested (95%-99% depending on the asset class and fund size) in the market segment that you are targeting • Do not pay them to manage cash • Some frictional cash is OK though for open-end mutual funds

23. Where do you find Un-invested Cash? • Un-invested Cash • Percent of cash in the fund (Snapshot: Portfolio Analysis – Asset Allocation)

24. Cash Pages

25. No Manager Style Drift • Make sure the managers investment style remains constant • Investment fund managers have no authority to change the asset class • If you purchase a small cap fund, you don't want the manager to purchase international shares. • The fund's prospectus should clearly define the market, size company, and growth or value tilt for the portfolio. • If you are looking for a domestic small value fund, screen for funds with the all of their assets invested in the U.S., the smallest average company size, and the highest book-to-market (or lowest price-book) ratios.

26. Where do you find Manager Style drift? • Managers Style • Managers Style Box (Portfolio: Style Box Details) • The style box should not change over time

27. Style Drift Pages

28. Small Tracking Error • Tracking error should be small • Tracking error is the historical difference between the return of a fund (i.e. a mutual fund) and its specific market/sector benchmark or index. • The smaller the tracking error, the better the performance of the Index fund. • However, you won’t complain if the tracking error is positive (i.e., your fund had higher returns than the index)

29. Where do you find Tracking Error? • Tracking Error (Returns: Performance History) • Tracking Error versus the Index (+/- Index) • Tracking Error versus the Category (+/- Category) • % Rank in Category (Number is in top %--the lower the number the better)

30. Tracking Error Pages

31. Mutual Fund Information (continued) • Lets look up some information • www.byu.edu • See Teaching Tools: 7A Using Morningstar to Select Mutual Funds using the HBL Library 7B Using Morningstar to Select Mutual Funds using the Internet

32. Questions: • Any questions on what makes a good mutual fund? • Websites to review: • www.morningstar.com • www.Indexfunds.com • www.cnnmoney.com • http://finance.yahoo.com • www.fool.com

33. D. Understand Index Funds • What are index funds? • Mutual Funds or Exchange Traded Funds which hold specific shares in proportion to those held by an index • Their goal is to match the benchmark performance • Why have they come about? • Investors have become concerned that most actively managed funds have not been able to beat their benchmarks after all fees, taxes and costs. • So instead of trying to beat an index, investors accept the index return and risk. • Interestingly, in the process, index funds have tended to outperform most actively managed funds

34. Index Funds (continued) • Why the big deal about index funds? • Index funds have become the standard against which other mutual funds are judged • If a mutual fund cannot perform better (after taxes and fees) than an index fund (index funds are very tax efficient), then investors should lean toward index funds • There are nearly 1,000 different index and exchange traded funds which follow different geographical, maturity, capitalization, and style indices

35. Index Funds (continued)

36. Index Funds (continued) • Why have index funds and ETFs grown so quickly? • There is no correlation between last years winners and this year’s winners for actively managed funds • Actively managed funds tend to hurt performance through excessive trading, which also generates taxes • Actively managed funds generally have higher management fees which must be overcome through higher returns (18 basis points for an index fund versus 80-250 basis points for an actively managed fund) • It is very difficult to beat these funds on a consistent basis after fees and taxes

37. Do Winners Rotate?

38. Do World Regions Rotate?

39. Do Sectors Rotate?

40. Does Style Rotate?

41. Ten-Year Annualized Return on the 30 Largest Mutual Funds Investor return for calendar years 1993 to 2002; largest funds as of year-end 1992 Average mutual fund return: 8.14% Vanguard 500 Index fund return: 9.27% Funds outperforming the index: 12 out of 30 (40%) Correlation to prior decade return: -.181

44. Benjamin Graham

45. Indexing and Mutual Funds? • Reasons to not index • Passive investing is boring • Picking stocks can be intellectually challenging • Investment war stories are fun to share with friends • Doing nothing about your investments is unnerving • Reasons to index • Immediate diversification • Superior long-run performance • Tax efficient • Takes very little time

46. 1. Most actively managed funds and brokerage accounts will generally under-perform index funds in the long run after all taxes, costs and fees 2. The competition in stock-market research is intense and will get more competitive going forward, making markets more efficient and indexing even more attractive 3. Market indexing or “passive investing” is a free-ride on the competition and it takes very little time Suggestion: For broader diversification, choose an index fund that has more members or a “total market” index fund Insights on Indexing?

47. Index Funds on a $50 a Month • Transamerica Premier Index Fund (tpiix) • Type: S&P 500 Index, Expense ratio: .25% • Min. Investment: $50 month, $1,000 initial AIP • TIAA-CREF Equity Index (tceix) • Type: Russell 3000 Index, Expense ratio: .26% • Min. Investment: $50 month, $50 initial AIP • MassMutual Select Index Equity Z (miezx) • Type: S&P 500 Index, Expense ratio: .21% • Min. Investment: $0 month, $0 initial AIP • There are many others which fall under this same Automatic Investment Program criteria and that are even cheaper!

48. Questions? Any questions on indexing and why it is important?

49. Review of Objectives • A. Do you understand where to find important information on mutual funds? • B. Do you understand what makes a good mutual fund? • C. Do you understand index funds and why they are attractive investment assets? • D. Do you understand why you shouldn’t be picking stocks until the Deepen phase when your assets and experience have grown?

50. Review of Teaching Investments • Teaching Investments • 1. Know the Principles of Successful Investing • 2. Understand Asset Classes and Asset Class Performance • 3. Know the Priority of Money • 4. Write a Quality Investment Plan • 5. Understand Portfolio Construction • 6. Know the Process of Investing • 7. Understand Portfolio Reporting and Rebalancing