Why Mutual Funds?

By on September 22, 2006

Originally published in August 1998:

INDEXES ON 7/31/98

DJIA 8,883.29

S&P 500 1,120.67

NASDAQ 1,872.39

The stock market continues to weather the approaching storms fairly well. This is to be expected when everywhere you turn the press exudes confidence in the market and most of the elves on Wall Street Week are confidently bullish (much like lemmings heading for the cliff).

Alan Greenspan, ever watchful for the prospect of irrational exuberance, let some air out stocks (400 Dow points) by mentioning the possibility of inflation. The greater threat, however, is deflation. The world is awash in excess productive capacity…especially Asia. Full shiploads of goods are arriving on U.S. shores from Asia and returning nearly empty. Having lived through the inflation of the 70’s and 80’s, investor’s minds are embedded with the notion that inflation of the prices for goods is a normal state. In fact, deflation has been more the norm than inflation during the last 200 years. Consumers are overextended with mortgage and credit card debt, filling their garages with so much stuff that they can’t get both cars in. So an inflation in prices fueled by over consumption is not in the cards. The economy is nearing full employment and consumer and commodity prices continue to retreat.

An uncontrollable deflation has a very depressing effect on demand as consumers hold back spending waiting for ever lower prices. This does not bode well for profit margins or corporate profit growth. Already the negative effect of the profit squeeze has manifested itself in the stock prices of smaller companies. Approximately 70 percent of NASDAQ stocks are down a whopping 30 percent or more from their highs. Thirty-five percent of the small NYSE stocks are in the same boat. This indicates that something is very wrong with the bullish case. A handful of large cap stocks continue to buoy the major indexes. A company like Coca Cola can have down earnings, sport a PE of 50+, and continue to hold its ground. We are witnessing the height of a nifty 50 mania, last seen prior to the 1974 bear market. People buy stocks based on name, size, and market position without much regard for earnings growth. This is a recipe for disaster. A mini-bear market in the order of 15 to 25 percent reducing the Dow to the 7,000 to 8,000 range is probable before the end of the year. Protectionism will likely rear its ugly head during such a decline bringing back the specter of the 1930’s. Fortunately, the chance for a crash of that magnitude is nearly nil.

Why Mutual Funds?

When constructing a portfolio it is important to keep an eye out for any and all possibilities for enhancing return while keeping risk at a tolerable level. I have chosen to include mutual funds within this realm of possibility. Generally, I’m not in favor of investing in actively managed funds, due to a several factors: 1) the costs (expense ratios) involved, 2) possibility of manager turnover, and 3) embedded capital gains. However, in the “real world” portfolios I’ve allowed the inclusion of funds since they can enhance diversification and stability if chosen carefully. If the fund is actively managed, you also want the fund manager to be someone extraordinary . In the conservative portfolio, Janus Worldwide Fund has been included as a “core” holding. By “core”, I mean that this holding will probably never be sold, unless there is a change in managers or the cost of owning the fund increases to the point where it is no longer attractive. Janus Worldwide, run by the talented Helen Young Hayes, holds a significant proportion of its assets in international stocks which normally increases diversification and has had a tendency in the past to lower risk. The fund also has a below average annual expense ratio of just above one percent. Janus Worldwide has one of the best records in the business and Morningstar rates it as a 5 star fund.

In the aggressive portfolio, two funds have been included: Vanguard European Portfolio and Mutual Discovery Fund. The Vanguard fund is an international index fund with very low expenses. The Discovery fund is run by Michael Price and his associates. They have a excellent reputation for achieving high risk adjusted returns. The Discovery fund also holds many international stocks in its portfolio. The aggressive portfolio recently became top heavy internationally so portions of both of these funds were sold during the most recent sell signal.

Brokers Ranked

A composite ranking of on-line brokers has been recently put together by InvestorGuide. It’s located at http://www.investorguide.com/BestBrokers.htm. If you’re not using an on-line broker, you should be, since it can lower commission costs considerably.

Fools

One of the best investment sites on the internet is “The Motley Fools” at http://www.fool.com. Their “fool portfolio” is up an astounding 47 percent so far this year. Some skeptism is in order though. The fool portfolio has 14 stocks in it, but about 65 percent of the assets are held in two issues: America Online (NYSE: AOL; 117 1/8) and Amazon.com (NASDAQ: AMZN; 110 7/8). Definitely not for the faint of heart. Also, they have been known to fold portfolios that did not produce good results (something the mutual fund industry is known for).

Portfolio Updates

Observations on the stocks held in the portfolios can be found at http://members.aol.com/stocksystm/holdings.htm

Recommended Allocations

Aggressive portfolios: 75% equities, 25% cash.

Conservative portfolios: 55% equities, 45% cash.

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