With so much market volatility, it can be difficult to determine the best investments to use in a 401(k) account or IRA.  With such a limited selection, what should we do when they are all going down?

     Our immediate emotional response would be to move to the sidelines – a cash or money market account.  We can rationalize that it is better to not make anything than to see a loss.  However, that is a form of market timing, and it does not work for long term investing.  Most investors miss the biggest opportunities while sitting in a money market account.

     Some people even consider withdrawing the money from their IRA, especially if they are able to withdraw from an IRA without penalty.

     Today, we will look at five of the most common criteria advisors use to evaluate mutual funds.  Using these criteria individually can be helpful in maintaining a quality investment portfolio.

Performance against the benchmark

     Performance alone is not something to consider.  Too often, investors look at the investment return tables and choose the funds that have the largest numbers.  That’s not quite the right method to use.  While we do want funds that are performing well, if we only choose all of the top performers on the list, we are very likely to pick most of the higher-risk options and none of the more conservative choices.

     We need to compare apples to apples.  We want to evaluate a fund against its own peer group.  Large cap value funds should be compared to other large cap value funds.  Intermediate term bond funds should be compared to other intermediate term bond funds.

     Funds should be compared against their own peers and their respective benchmarks.

Five-year performance

     While any fund in any category can have a good year, we want to make sure that a great return is not simply a fluke – a bet that paid off well.

     Looking a five-year performance can give us a better idea of whether the manager is able to sustain good performance.  There will usually be one or two bad years in a five-year cycle, so this will help us evaluate a manager in both good and bad years.

     This performance should also be considered against peers and the respective benchmark.

Manager tenure

     Performance doesn’t mean much if a manager is new.  We cannot give much consideration to a fund’s 10-year performance record if the manager has only been working with the fund for two or three years.  That would mean that the majority of the fund’s history is attributable to another manager.

     Funds with new managers should be monitored carefully.  Sometimes they are brought in to replace a manager with a bad record.  Other times, managers retire or move on to other opportunities.  Nevertheless, it will take awhile to get a good idea of whether or not the new manager will be a valuable addition to the fund.

Style drift

     Funds have investment objectives.  They are designed to invest in a specific way.  For example, large cap growth mutual funds are supposed to buy stock in large companies that still have growth potential.  If they start buying value stocks or mid and small cap stocks, then they are not remaining true to their objective.  This is called style drift.

     Some managers drift in an attempt to improve performance.  However, it is not appropriate because it ultimately misleads the owners of the mutual fund shares.  How can we create a balanced portfolio if the mutual funds we select are able to buy in whatever category they want?

Fees

     While some investment products are less forthcoming with their fee structure, it is still important for an investor to understand the costs involved in owning the funds.  Fees should be comparable to other peers and not excessive.

     While this list is far from complete, it does describe the most common criteria that are used to evaluate retirement plan mutual funds.  It can be used as a starting point to help determine whether we should consider making changes to our current retirement account portfolio.

     With the major shift we’ve seen in the economy over the past few years, everyone has been a bit nervous about the state of their finances.  The housing industry has definitely made America nervous.  Foreclosures are still happening.  Companies are still letting employees go.  Many people are finding themselves unprepared for an unexpected retirement.

     Other companies are going out of business or filing for bankruptcy protection.  Lending guidelines have tightened so much that even people with good credit are having a hard time refinancing.

     With all of the chaos, that nervousness has spread to Wall Street.  The market has recently seen some of its worst days in years.  Investors are worried about the economy, so they are pulling their money out of stocks and moving to conservative money markets.  The influx of capital into the money market has been astronomical.

     So, what do we make of all this?  Should we follow suit and move our funds too?  Should we sit back and wait?

     Pulling your money out at the first sign of trouble is not the best response.  We need to invest intelligently and not let emotions get in the way.

     The best advice that I can give you without knowing your personal situation is to review your current portfolio.  Double checking your investments never hurts.

What am I looking for?

     The best way to determine whether you are prepared to weather this storm is to make sure that you are properly diversified.  Remember that old saying, “Don’t put all of your eggs in one basket?”  That really applies when it comes to your investments.

     True diversification means that your money is spread across different sectors, different types of companies, and different countries.  If you have a little bit spread out over many different places, the impact of any potential catastrophe will be minimal.

     In diversifying among sectors, you want to make sure that you aren’t over-invested in any one category.  In the early part of the century, many investors put most of their money in the internet or technology sector.  We all heard about people who lost everything in the “Dot Bomb.”  Real Estate had a good run, too – until recently.  Those who didn’t see things changing lost a large amount of money.  So, spread your money across many sectors, and don’t focus on what’s hot right now.

     We also want to spread our money across different types of companies.  Funds should be allocated to large, mid-sized, and small companies.  Each style has its turn to shine, so stay invested across the board, and you will do fine.

     Lastly, we want to make sure that we have international exposure.  While we do live in a great country, we don’t want to miss out on opportunities that may come from an emerging country.  This will give us even more balance to weather the storms.

     I want to give you two last things to remember.  First, keep in mind that everything cannot be down at the same time.  Every category has its cycle.  If you stay invested everywhere, you will be ready for the increase when it comes around.

     Second, having money in multiple mutual funds may look good on the surface, but that doesn’t ensure that you are properly diversified.  Review your prospectus to see exactly how funds are allocated within the mutual funds to make sure that your overall portfolio is properly diversified.

     While poor recordkeeping may lead us into trouble, poor disclosure habits may mean that we see some changes in the investment world.  Regulators are taking a closer look at the fees that investors pay.  The fee that is getting a lot of attention now is known as a 12b-1 fee.

What is a 12b-1 fee?

     The Securities and Exchange Commission (SEC) began allowing mutual funds to charge 12b-1 fees back in 1980.  The name comes from the SEC rule that authorizes the fee.

     The fee was originally designed to cover expenses related to distributing mutual funds.  This can include the costs of marketing, advertising, and promoting the mutual fund.  The fee also covers the printing and mailing of fund prospectuses and sales literature.  In addition, brokers are often paid a portion of their commission from the fund’s 12b-1 fee.  The limit on this portion of the fee is 0.75%.

     The fee may be collected for other shareholder services, such as making representatives available to respond to investor questions or requests.  There is a 0.25% limit on this portion of the fee.

Where can I find out if I am being charged a 12b-1 fee?

     According to Lipper, about two-thirds of mutual funds assess a 12b-1 fee.  Mutual fund companies are required to list the 12b-1 fee in the fund’s prospectus.  While it is listed separately, the 12b-1 fee is also included in the fund’s gross expense ratio.

Protecting consumers

     Since so many consumers are unaware of the fees they pay for their mutual funds, the SEC is thinking about requiring better disclosure of the fee.

     The organization has also considered the possibility of eliminating the fee.  While the fee was originally intended to help with advertising and promoting the funds, very little of the fee is actually used for that now.  The majority of the 12b-1 fee is passed on to brokers who sell the funds.

    There is a concern that if brokers are provided with extra compensation for selling certain investment products, there is a stronger likelihood of a conflict of interest arising out of the broker’s recommendation.

Not an immediate red flag, but…

     The fact that a fund has a 12b-1 fee is not an automatic deal-breaker.  Some funds carry these fees and still have low costs overall.  However, in a time where high returns are not the norm, larger fund expenses can severely impact the overall gain in an investor’s account.

     For example, a $10,000 investment earning an average of 8% interest per year over 20 years would grow to $46,609.57.  If the fund carried a 1% 12b-1 fee that lowered the average interest rate to 7% per year, the gain would only grow to $38,696.84.  The long term effect of the 12b-1 fee is significant.

     While investors should seek out advisors who are trustworthy, it is still important for investors to research the investments they carry to ensure that the decisions made on their behalf truly are in their best interest.

     With all of the financial troubles and retirement account mistakes that have plagued investors in this country lately, the investment industry has been debating the regulations and standards expected of financial professionals.

     One major area of disagreement comes with respect to whether the standards expected of financial professionals should be identical.  As it stands now, there are different expectations for brokers and advisors.

History of the standards

     In the 1940s, laws were established for the brokerage industry.  Brokers are, in essence, the middlemen between investors and registered investments.  They initiate transactions, buying and selling investments for profit.  While some transactions are done on behalf of a client, brokers will also buy and sell securities for themselves.

     The standard established for brokers was an obligation to ensure that the investment is “suitable” for the client.  There is no requirement to take care of the client, such as recommending a product that is truly in the best interest of the client.  In fact, a broker is not required to gather adequate background on a client in order to ensure that the products provided really meet the needs of the client.

     During the same time period, the Investment Advisors Act of 1940 was passed to establish a standard for those who provide investment advice.  Contrary to the standard required of a broker, an advisor must gather details about the client and provide recommendations that are in the best interest of the client.  There is a fiduciary obligation taken on by an investment advisor, and there is a heavier amount of responsibility expected of the advisor.

     Sadly, the differences between the two roles have been glossed over, and most investor clients are unaware of the differences.

Registered representatives

     Registered representatives are employees of broker-dealer firms.  For example, wirehouse firms are broker-dealers.  As employees of broker-dealers, registered representatives are expected to honor the suitability standard when assisting their clients in choosing investment options.

     Registered representatives, as employees, have a duty to their employer to help the company make a profit.  While most registered representatives will make an effort to present sound options, the client is not the first priority.

     Another fact often unknown by investor clients is that registered representatives are not able to provide investment advice.  With liability concerns, the broker dealer employer will often not support this activity by their registered representative employees.  This is really interesting when we consider that so many of them call themselves financial advisors.

     Some broker-dealers will also register as investment advisors.  Some registered representatives are then able to be investment advisor representatives.  However, many financial professionals who call themselves advisors have not taken this extra step.

Investment advisors

     The fiduciary standard expected of an investment advisor requires an advisor to put the client’s interest above his or her own interest.  It requires a truly unbiased recommendation.

     As such, investment advisors provide fee-based advice.  Since they are compensated the same regardless of the advice given, a client can be more confident that the recommendations are really in their best interest.

     Investment advisors must get to know their clients as completely as possible to make sure that the advice provided best meets the client’s needs.

     While broker-dealers are less open with respect to their compensation arrangements, investment advisors must disclose this, along with any potential conflicts of interest.  This enables clients the opportunity to determine their level of comfort with following through with the advice given.

     Investor clients are welcome to choose to work with either registered representatives or investment advisors.  There is nothing inherently wrong with either choice.  However, it is most important to understand the role that the financial professional has agreed to take in working with you so that you can feel comfortable with the actions you take as a result.

     With the economy looking questionable, everyone is searching for the best place to save and invest their money.  With Social Security benefits becoming less reliable, investors are really weighing their aslternatives.  When the market gets volatile, people want to research other options.  While I am opposed to jumping ship too soon, I still encourage educated decisions.

     Clients have been asking for more information on exchange-traded funds.  Exchange-traded funds (or ETFs) are still relatively new investment products.  They were first introduced in 1993, but have been gaining in popularity ever since.

What is an ETF?

     The best way to describe an ETF is a mutual fund that trades on the stock market.  An ETF owns many different stocks and tries to reflect an index, such as the S&P 500.  There are many different companies and indexes available, so owning ETFs will not impact your ability to properly diversify.  There are even ETFs available for fixed income classes, or bonds.

     There are several pros to owning ETFs in your portfolio.  Many investors like the greater flexibility, management transparency, and added diversification that can be achieved with ETFs.

Flexibility

     Since ETFs trade on the exchanges like stocks, you can buy and sell them at the fund’s current trading price.  In contrast, mutual fund prices are only determined once per day, at the end of the trading day.  You cannot know your purchase or sales price prior to the close of business.

Transparency

     These funds are also more transparent than traditional mutual funds.  When you buy a specific asset class, you get what you expect.  Many mutual funds tend to stray over time as managers scramble to produce better returns for the investors.  When managers stray, it puts investors at risk and takes them away from their original goals.

Diversification

     In choosing to further diversify your portfolio, you may decide to increase your exposure to a particular industry or sector.  Rather than trying to pick the one stock that may prove profitable, purchasing an ETF that focuses on that industry can give you that exposure while reducing the risk.  Owning multiple stocks with one purchase is a cost-effective way to accomplish this goal.

Cost savings

     From a financial standpoint, investing in ETFs can also result in reduced taxes and lower costs.

     ETFs offer reduced tax liabilities when it comes to taxable gains.  When mutual funds sell stocks for a profit, the shareholders are financially liable for their portion, regardless of whether they sold any shares.  ETFs don’t buy or sell stocks.  The low turnover means that there are no gains to pass along to investors.

     The best advantage of ETFs over mutual funds is the low annual operating cost.  Most mutual funds have many different fees that are deducted annually.  These fees can bring annual expenses into the 3-4% range and severely impact your ability to see the growth in your investment.  In contrast, many ETFs have annual operating expenses of less than 0.5%.

     ETFs are not for everyone.  The biggest hurdle has to do with commissions.  Since ETFs trade like stocks, there is a commission involved in the purchase.  This is not a problem when investing a large sum of money, but it can be a challenge if you are looking to set up a monthly purchase plan to take advantage of dollar cost averaging.

     Before choosing to purchase an ETF, please review the pros and cons to determine if this investment vehicle works for your goal.  Consult your advisor and compare ETFs to your current holdings so that you are able to make a truly informed decision.