MONEY IRAs

This Simple Move Can Boost Your Savings by Thousands of Dollars

Stack of Money
iStock

Last-minute IRA savers and those who keep their money in cash are paying a procrastination penalty.

Individual Retirement Account contributions are getting larger—an encouraging sign of a recovering economy and improved habits among retirement savers.

But there is an “I” in IRA for a reason: investors are in charge of managing their accounts. And recent research by Vanguard finds that many of us are leaving returns on the table due to an all-too-human fault: procrastination in the timing of our contributions.

IRA savers can make contributions anytime from Jan. 1 of a tax year up until the tax-filing deadline the following April. But Vanguard’s analysis found that more than double the amount of contributions is made at the deadline than at the first opportunity—and that last-minute contributions dwarf the amounts contributed throughout the year. Fidelity Investments reports similar data—for the 2013 tax year, 70% of total IRA contributions came in during tax season.

Some IRA investors no doubt wait until the tax deadline in order to determine the most tax-efficient level of contribution; others may have cash-flow reasons, says Colleen Jaconetti, a senior investment analyst in the Vanguard Investment Strategy Group. “Some people don’t have the cash available during the year to make contributions, or they wait until they get their year-end bonus to fund their accounts.”

Nonetheless, procrastination has its costs. Vanguard calculates that investors who wait until the last minute lose out on a full year’s worth of tax-advantaged compounded growth—and that gets expensive over a lifetime of saving. Assuming an investor contributes the maximum $5,500 annually for 30 years ($6,500 for those over age 50), and earns 4% after inflation, procrastinators will wind up with account balances $15,500 lower than someone who contributes as early as possible in a tax year.

But for many last-minute savers, even more money is left on the table. Among savers who made last-minute contributions for the 2013 tax year just ahead of the tax-filing deadline, 21% of the contributions went into money market funds, likely because they were not prepared to make investing decisions. When Vanguard looked at those hasty money market contributions for the 2012 tax year, two-thirds of those funds were still sitting in money market funds four months later.

“They’re doing a great thing by contributing, and some people do go back to get those dollars invested,” Jaconetti says. “But with money market funds yielding little to nothing, these temporary decisions are turning into ill-advised longer-term investment choices.”

The Vanguard research comes against a backdrop of general improvement in IRA contributions. Fidelity reported on Wednesday that average contributions for tax year 2013 reached $4,150, a 5.7% increase from tax year 2012 and an all-time high. The average balance at Fidelity was up nearly 10% year-over-year to $89,100, a gain that was fueled mainly by strong market returns.

Fidelity says older IRA savers racked up the largest percentage increases in savings last year: investors aged 50 to 59 increased their contributions by 9.8%, for example—numbers that likely reflect savers trying to catch up on nest egg contributions as retirement approaches. But young savers showed strong increases in savings rates, too: 7.7% for savers aged 30-39, and 7.3% for those aged 40-49.

Users of Roth IRAs made larger contributions than owners of traditional IRAs, Fidelity found. Average Roth contributions were higher than for traditional IRAs across most age groups, with the exception of those made by investors older than 60.

But IRA investors of all stripes apparently could stand a bit of tuning up on their contribution habits. Jaconetti suggests that some of the automation that increasingly drives 401(k) plans also can help IRA investors. She suggests that IRA savers set up regular automatic monthly contributions, and establish a default investment that gets at least some level of equity exposure from the start, such as a balanced fund or target date fund.

“It’s understandable that people are deadline-oriented,” Jaconetti says. “But with these behaviors, they could be leaving returns on the table.”

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MONEY ETFs

Hot Money Flows into Energy and Bonds

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Sometimes it pays to follow the crowd. At other times, you'll get burned.

All too often, I see investors heading in the wrong direction en masse. They buy stocks at the top of the market or bonds when interest rates are heading up.

Occasionally, though, active investors may be heading in the right direction. A case in point has been the flow of money into certain exchange-traded funds in the first half of this year.

Reflecting most hot money trends, billions of dollars moved because of headlines. The Energy Select SPDR exchange-traded fund, which I discussed three weeks ago, gathered more than $3 billion in assets in the first half, when crude oil prices climbed and demand for hydrocarbons remained high.

The Energy SPDR, which charges 0.16% for annual management expenses and holds Exxon Mobil , Chevron , and Schlumberger , has climbed 22% in the past 12 months, with nearly one-third of that gain coming in the three months through July 18. Long-term, this may be a solid holding as developing countries such as China and India demand more oil.

“We think the Energy Select SPDR is a play of oil prices remaining high and supporting growth for integrated oil & gas and exploration and production companies,” analysts from S&P Capital IQ said in a recent MarketScope Advisor newsletter.

Headlines also favored European stocks as represented by the Vanguard FTSE Developed Markets ETF , which holds leading eurozone stocks such as Nestle, Novartis , and Roche. The fund has been the top asset gatherer thus far this year, with $4 billion in new money, according to S&P Capital IQ.

As Europe continues to recover over the next few years and the European Central Bank keeps rates low, global investors will continue to benefit from this growing optimism.

The Vanguard fund has gained nearly 16% for the 12 months through July 18. It charges 0.09% in annual expenses and is a solid holding if you have little or no European exposure in your stock portfolio.

Rate Hikes

Not all hot money trends make sense, however. As the economy accelerates and interest-rate hikes look increasingly likely, investors are still piling money into bond funds, which lose money under those circumstances.

The iShares 7-10 Year Treasury Bond ETF , which holds middle-maturity U.S. Treasury bonds, continued to rank in the top 10 funds in terms of new money in the first half. The fund, which holds nearly $5 billion, is up nearly 4% for the 12 months through July 18, compared with 4.2% for the Barclays U.S. Aggregate Total return index, a benchmark for U.S. Treasuries. The fund charges 0.15% in annual expenses.

While investors were able to squeeze a bit more out of bond returns in the first half of this year, they may be living on borrowed time.

The U.S. Federal Reserve confirmed recently that it would be ending purchases of U.S. Treasury bonds and mortgage-backed securities in October. This stimulus program, known as “QE2,” has kept interest rates artificially low as the economy has had a chance to recover.

The phasing out of QE2 could be bearish for bond funds.

Will interest rates climb to reflect growing demand for credit and possibly higher inflation down the road? How will the ending of the Fed’s cheap money program affect U.S. and emerging markets shares?

Many pundits believe public corporations may pull back from their enthusiastic stock buybacks and trigger a correction. Yet low inflation and modest employment gains may mute bond market fears.

“The Fed is on track to complete tapering in the fourth quarter, and we think there is essentially no chance that it will move the fed funds rate higher this year,” Bob Doll, chief equity strategist with Nuveen Investments in Chicago, said in a recent newsletter.

“With the 10-year Treasury ending the quarter at 2.5%, the yield portion of this forecast is more uncertain,” Doll added, “although we expect yields will end the year higher than where they began.”

While there could be any number of wild cards spoiling the party for stocks, it is wise to ignore short-term trends and prepare for the eventual climb in interest rates.

That means staying away from bond funds with long average maturities along with vehicles like preferred stocks and high-yield bonds that are highly sensitive to interest rates.

Longer-term, shares of companies in consumer discretionary, materials and information technology businesses likely to benefit from a global economic resurgence will probably be a good bet.

Just keep in mind that the hot money can be wrong, so build a long-haul diversified portfolio that protects against the downside of a torrid trend going from hot to cold.

MONEY Ask the Expert

Can I Diversify My Portfolio With One ETF Rather than Four?

Q: Does investing in a “total stock market index fund” give you diversified exposure to large-, medium-, and small-sized companies? Or do I need to invest in separate mutual funds for my large- and small-company stocks? — Toby, Davis Junction, IL

A: No, you don’t need separate funds. The Vanguard Total Stock Market ETF is designed to give you exposure to a broad cross-section of different types of domestic equities in a single exchange-traded fund.

Its portfolio breaks down like this: around 72% is invested in large companies, a little less than 20% is in medium-sized businesses, about 6% is in small-company shares, and 3% is in so-called micro-cap stocks.

Now, you can achieve similar diversification by allocating your dollars into a collection of more narrowly constructed funds that focus on industry-leading large companies or quick-growing but volatile small companies.

For instance, you could pick up Money 50 funds Schwab S&P 500 Index , with iShares Core S&P Mid-Cap and iShares Core S&P Small Cap . (Although, if you’re not careful, you might end up with more exposure to smaller companies than you want. About 30% of IJR’s portfolio is in micro-cap stocks.)

All things being equal, says BKD Wealth Advisors’ portfolio manager Nick Withrow, you’re better off going with the one fund than three or four.

For one thing, each fund comes with its own expenses. If VTI dovetails with your risk tolerance, then you’ve taken care of your domestic stock portfolio at a measly cost of 0.05% of assets annually. That’s marginally cheaper, by about 0.06 percentage points, than buying a host of exchange-traded funds that collectively approximate VTI’s portfolio, says Withrow.

But there’s another reason — you.

Basically, you don’t want to get into the business of buying and selling ETFs to try and time the market. And you’re much less likely to get into that expensive habit if you buy-and-hold one fund, rather than picking three or four.

“The more choices an investor has, the more apt he or she is to feel that they have to do something,” says Withrow. “The idea of simplicity, especially with a buy-and-hold attitude, goes a long way.”

Of course, one total market exchange-traded fund doesn’t mean your portfolio is complete. Don’t forget about foreign equities or, you know, bonds. But when it comes to U.S. stocks, one cheap total market ETF (like VTI) is particularly useful.

MONEY ETFs

As BlackRock Goes to War With Vanguard, Mom-and-Pop ETF Investors Win

Even with $1 trillion in exchange-traded fund assets, BlackRock is being forced to slash costs on ETFs to compete with low-cost leader Vanguard.

Even as BlackRock is set to amass $1 trillion in exchange-traded fund assets in its iShares business, U.S. retail investors increasingly prefer to send their money to low-cost leader Vanguard.

With $998 billion in ETF money, BlackRock has more than the next contenders, Vanguard and State Street, combined.

But the company has struggled to compete with Vanguard, known for its investor-friendly low-cost investing, for mom and pop’s nest eggs. Retail investors now account for more than half of the $1.8 trillion in ETF assets under management in the U.S, according to consulting firm PwC.

So far this year, Vanguard has pulled in about $30.3 billion in net new ETF money in the U.S., or about 43% of the market, while iShares is second with $24.7 billion, or about 35%.

That reflects a trend that’s been going on for years: At the end of 2009, BlackRock had 47.7% of total U.S. ETF assets under management, compared with 11.7% for Vanguard. By the end of May, BlackRock’s market share was down to 38.9%, compared with 20.6% for Vanguard, according to Lipper.

“Our aspiration is to be number one in flows, and we can’t get there without being higher in the retail market place,” said Mark Wiedman, the BlackRock executive who heads the iShares business globally, speaking at the company’s annual meeting in New York in June. “We are starting to change our voice for that audience and I would say historically we frankly haven’t done that good a job.”

The market share loss comes in spite of BlackRock’s two-year effort to win retail investors.

BlackRock introduced a line of low-cost “buy and hold” investor-aimed ETFs in 2012, and since then has been cutting the fees on its ETFs, revamping its sales team, and pushing a new branding campaign. The firm has cut expenses on 12 funds since 2012, ranging from its S&P Total U.S. Stock Market ETF then to its high-dividend ETF in June 2014.

BlackRock says its flows have improved since it started its new retail effort.

One of the most significant price reductions was in its iShares High Dividend ETF. The cost to investors for that fund dropped to 0.12% of assets a year from 0.40%, a move that would cost BlackRock $11.2 million annually, based on the $4 billion in the fund. Last quarter, iShares ETFs generated some $765 million in base fees revenue.

“Every basis point that you cut a fee impacts revenues, but we don’t really look at that — we look at the profitability of our ETF business over the long term,” BlackRock executive Frank Porcelli, head of U.S. Wealth Advisory Business, said at Reuters’ Global Wealth Management Summit in June.

Asked about how fee cuts would affect BlackRock’s profits, he said it was “not relevant.”

With $4.4 trillion in total assets among its various product lines, BlackRock remains the world’s largest asset manager and is unlikely to be eclipsed by Vanguard anytime soon.

BlackRock has nearly tripled the size of the iShares business since it bought it from Barclays five years ago, largely by selling to big institutions, such as the Arizona State Retirement System, which plunked down $300 million to seed three iShares funds last year. It has also won institutional and retail investors abroad; BlackRock has a strong presence in Europe, Asia, Canada and Latin America. Total BlackRock ETF assets outside of the U.S. are about $280.5 billion, about 36 percent of the $700 billion total market.

Analysts say that iShares’ size and scale makes the effect of fee cuts in the near-term fairly minimal on the overall business, but that a prolonged price war could hurt the firm.

“It’s a tough spot to be in,” said Edward Jones analyst Jim Shanahan. “There is some growth potential there, but it is slow to materialize and it has to be powerful enough to offset the addition of a lot of these products with fees less than the current weighted average fee rate.”

Vanguard, which unlike BlackRock isn’t publicly traded, offers significantly cheaper funds. The average expense ratio of a Vanguard ETF is 0.14%, or $14 for every $10,000 invested, compared with the industry average of 0.58%. BlackRock’s average expense ratio is 0.32%.

“When talking about large, commoditized ETFs, low cost makes a big difference, and Vanguard is a little bit more competitive,” said Gabelli & Co analyst Macrae Sykes.

“Investors recognize Vanguard as the low-cost leader — whether for index funds, for active funds, for bond funds, for money market funds, or for ETFs,” said Vanguard spokesman David Hoffman. “We like to say that we’ve been lowering the cost and complexity of investing for 38 years. We are also increasingly being recognized for our commitment to providing high-quality products that can play an enduring role in a portfolio.”

MONEY mutual funds

Can Indexing Actually Grow Too Big and Fail?

As index funds are sopping up the world's investment dollars, an argument is emerging that this will eventually tip the scales back in favor of active managers. Don't worry just yet.

Indexing has always been a bit of a conundrum.

When this strategy — which calls for simply owning all the stocks in a market, rather than picking and choosing “the best” securities — hit Wall Street in the 1970s, it was regarded as downright “un-American.”

After all, why would any investor settle for the market’s average returns through indexing, when they could hitch their wagon to a stock picker whose goal is always to be above-average?

Well it turns out that over the long run, the vast majority of stock pickers aren’t consistently able to generate above-average returns. Part of that is because of the higher fees that stock pickers charge, which serve as a drag on performance. But another key element is the notion that markets are by and large efficient. And it’s very difficult for a lone stock picker to consistently outsmart an efficiently priced market.

Today, as indexing has transformed from a niche strategy to a widely embraced one — more than a third of the money invested in stock funds is currently pegged to a benchmark, thanks in part to the rise of exchange-traded funds — new questions about indexing are emerging.

Namely, if a plurality of investors switch from being inquisitive analysts digging for the truth about the long-term prospects of companies and instead throw up their hands and index, won’t the market become less efficient over time? Who would be left to sort the good stocks from the bad ones, so index investors don’t need to worry about it? And if that’s the case, won’t active managers start to gain an upper hand again?

Index investors often disparage active stock pickers for failing to “beat the market.” But this criticism gives active managers short shrift. The so-called market that portfolio managers can’t beat is made up of other active managers. It’s not necessarily that stock pickers aren’t good at what they do. It may be that the competition is so fierce that no particular active manager can consistently beat the consensus of his or her peers.

But as more and more of the world’s investors turn their back on stock picking and become indexers, that competition becomes less fierce.

This isn’t just an academic debate. This topic has grown sufficiently urgent that Vanguard, creator of the first retail index fund and one of the largest mutual fund companies in the world, saw fit to publish a response.

As far as theory goes, the notion that indexing’s popularity could one day alter the long-standing dynamics of the stock market isn’t totally crazy, notes Vanguard senior investment analyst Chris Philips. “It’s been an interesting intellectual debate,” Philips says. But he’s quick to add: “I don’t know if you can quantify if there is or will be a tipping point.”

One thing Vanguard is adamant about is that we haven’t reached such a point yet. While more than a third of mutual fund and ETF assets today are indexed, Vanguard asserts that a far smaller fraction of the overall stock market is in benchmark-tracking strategies.

While some institutions like pension funds use indexing strategies outside of mutual funds, even accounting for these holdings, Vanguard estimates only about 14% of money invested in the stock market is invested in index funds.

What’s more, if index funds were really driving a critical mass of portfolio managers from the market, the lessened competition would mean the remaining portfolio managers should do better. That hasn’t happened. Last year about 46% of active managers beat the market, according to Vanguard’s tally. (If you flipped a coin half would beat it in any given year.) That was up from about 30% in 2012, but about equal with the number that be beat the market in 1999.

This doesn’t mean the phenomenon couldn’t take place at some point in the future. But even if it did, presumably more would-be stock jockeys would try their hand at attempting to beat the market at that point, which would make the trick difficult again.

Vanguard’s Philips is skeptical that index investing will become popular enough to make that happen, at least not for a long time. “I’d be surprised if passive gets about 50% market share,” he says. That’s because Wall Street needs to make money and index funds are too tough a way to accomplish that.

“There is always going to be the search for an edge,” he says. “There just is not a lot of money in offering an index fund.”

MONEY Ask the Expert

Should I Be More Hands On With My 401(k)?

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Robert A. Di Ieso, Jr.

Q: I am in my mid-30s and I am hands off with my 401(k). Should I be more active with the funds my 401(k) is plugged into? – William E. Collier

A: When it comes to 401(k) plans, inertia tends to rule—many people never revisit their initial investment choices after enrolling. It’s important to keep tabs on your plan and to make a few tweaks occasionally. But whether you should be a lot more active depends on how comfortable you are managing your own investments.

Most 401(k)s offer low-cost core stock and bond funds, including index options. If you are familiar with the basic rules of asset allocation, you can easily build a diversified, inexpensive portfolio on your own. But recent research makes a good case that getting some professional help with your portfolio can boost returns.

Pros may not outsmart the market, but they can often save your from your own worst instincts—taking too much or too little risk, or changing your investments too frequently. As a recent study by consultants AonHewitt and advice provider Financial Engines found, investors who followed their plan’s financial guidance earned median annual returns that were 3.3 percentage points higher than do-it-yourselfers, net of fees. The study analyzed the returns between 2006 and 2012 for 723,000 plan participants, including investors in target-date funds and managed accounts, those using the plan’s online tools, as well as do-it-yourselfers.

A three percentage point gap is substantial. A do-it-yourselfer who invested $10,000 at age 45 would have $32,800 by age 65; by contrast, the average 401(k) saver using professional advice would have $58,700 at age 65, or 79% more, the study found.

Another analysis by investment firm Vanguard found a smaller difference in returns for those who got help vs. those who didn’t. Target-date investors earned median annual returns of 15.3% vs. 14% for those managing on their own. The do-it-youselfers also had a wide range of outcomes, with the 25% earning median annual returns of less than 9%.

These days more plans are providing guidance in the form of online tools and target date funds: 72% of 401(k) plans offer target-date funds, up from 57% in 2006, according to the Investment Company Institute. The Plan Sponsor Council of America found that 41.4% offered some kind of investment advice in 2013, up from 35.2% the previous year.

Taking advantage of this help can be a smart move. But if you opt for a target-date fund, be sure that you use it correctly—as your only investment. Adding other funds will throw off what’s designed to be an ideal, all-in-one asset mix. Unfortunately, nearly two-thirds of target-date fund users put only some of their money in one, while spreading the rest among other investments. That move may lower your median annual returns by 2.62 percentage points, the study found, compared with investors who put all their money in a single target-date fund.

If you decide to go it alone, make sure to build your own ideal portfolio mix—try Bankrate’s asset allocation tool. To minimize risk, rebalance once a year to prevent any one allocation from getting too far out of whack. As you near retirement, remember to ratchet down the risk level in your portfolio by shifting to more conservative investments, such as bonds and cash.

Make these few moves, and you won’t get left behind by being hands on.

MONEY financial advisers

Facing Robots and Price Wars, Wealth Managers Push Advice

2001: A SPACE ODYSSEY, Keir Dullea, 1968
Courtesy Everett Collection

As fees for investing portfolios fall, big Wall Street firms are emphasizing advice. But new services threaten their dominance of that business, especially when it comes to younger investors.

Jack Bogle, the founder of Vanguard Group and the pioneer of low-cost index investing, has won.

Data shows investors have steadily paid lower mutual fund fees every year since 2003. Some 35% of all money in mutual funds is managed passively by computer models instead of humans. The average upfront sales fee paid to brokers by mutual-fund investors has fallen 74% since 1990, according to the Investment Company Institute trade group.

At the recent Reuters Global Wealth Summit, “transparency” and “fees” were among the most popular words spoken by top wealth and asset management executives.

“All of the sudden, everybody understands that high cost is your enemy and low cost is your friend,” said Bogle, 85.

Yet he is not ready to rest on his laurels. And that is bad news for the rest of the industry.

The win for budget-minded investors presents a dilemma for investment management firms ranging from Charles Schwab and Morgan Stanley to Blackrock. How do they remain profitable when their bread and butter, transactions, are being commoditized?

Furthermore, coming down the pike behind the low-cost indexers is the next generation of robo-advisers: Algorithm-driven, web-based advisory startups such as Wealthfront, Hedgeable, and SigFig, which promise to manage portfolios for just a few cents on the dollar.

Some speakers at the summit hypothesised that average advisory fees ultimately could collapse to 0.5% of assets under management under those competitive pressures.

Executives from mainstream firms are taking a few different tacks. Most, such as Schwab and Morgan Stanley, are de-emphasizing investment products, and focusing instead on offering advice to consumers, a trend that has reached critical mass.

In 2013, Morgan Stanley’s wealth management unit made $7.6 billion, or 54% of its revenues, from asset management fees, instead of commissions, which made up only 15.5% of net revenues. The remainder was in investment banking, investment income and some other categories.

The firm currently has 37% of its assets in so-called fee-based advisory accounts and is aiming at 40%, wealth and investment management head Greg Fleming said at the summit.

At Schwab, originally conceived as the firm for do-it-yourself investors looking for low-cost trading, all the talk is about connecting on a human basis.

There is a “relentless move to, ‘I would like a person to talk to about my goals and markets and my portfolio,’” said John Clendening, executive vice president and co-head of the firm’s retail business.

“We launched our first advisory solution in 2002. Fast forward to today and we have $163 billion in client assets in advisory solutions,” the main Schwab fee-based approach.

Bank of America’s Merrill Lynch is recruiting new advisers who will take up its emphasis on a “goals-based” approach, said John Thiel, the head of US Wealth Management and Private Banking at Merrill.

“We knew we could do a better job where we talk about life priorities versus just numbers,” he added.

Even Blackrock, with almost $1 trillion in assets in its low cost, indexed iShares exchange-traded funds, is intent on marketing its higher-fee products, such as hedge-fund-like ETFs, to advisers.

Frank Porcelli, managing director and head of Blackrock’s U.S. retail business, said his firm sends experts out to talk to advisers about how alternative funds can fit into advisory plans.

“Advisers are moving from the traditional business model to platforms where they charge one holistic wrap fee and then they can put anything in that portfolio they want. They are positioning themselves as portfolio managers,” he said.

THE 0.5% SOLUTION

But beyond all the lip service given to human advice in the post-2008-crisis marketplace is the fact that advice might be the next big area of commoditization.

Virtually all of the large and small brokerage firms that sent speakers to the summit talked about wanting to win assets from the under-40-year-old demographic. But they will be marketing themselves to generation Xers and millennials against (currently minuscule) data-driven upstarts such as SigFig, which aggregate portfolios of any size for free and offer fee-cutting investment advice for $10 a month.

Mike Kane, chief executive officer of Hedgeable, another automated advisory firm, told summit attendees he expects the industry average fee to coalesce to around 0.5%, which would be 50% lower than the current 1% industry standard. That was the same figure Bogle said he saw in the future for financial advice.

Although global wealth and the number of wealthy individuals continue to grow and the competition is fierce, even the upstarts do not expect to replace the old line multi-trillion dollar brokerage/asset management firms any time soon.

There will be room for multiple models; for clients who want algorithms and clients who want to talk to humans and clients who want to buy specialized products that will cost more than the Bogle bottom line, said Kane.

“My dad is a financial planner,” he added. “I don’t want to put my dad out of business.”

MONEY funds

3 Bad Reasons We Pay So Much For Mutual Funds

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Why do investors let active managers reel in their assets? Getty Images

The numbers say that cheap index funds are your best bet. So why are people still willing to pay fund managers so much?

Every time the market makes a big turn, this happens: A bunch of money managers previously hailed as brilliant get caught betting the wrong way. This time it’s hedge fund managers making “macro” bets. For example, the $13 billion fund run by Paul Tudor Jones is down 4.4%, according to the Wall Street Journal, while the general stock market is up 5.4% and bonds are up 3.4%.

Meanwhile, in the prosaic world of mutual funds available to you and me, the evidence is overwhelming that most managers can’t beat the market. Over the past five years, according to S&P Dow Jones Indices, about 73% of blue chip stock funds trailed the S&P 500 index. You can buy a passive S&P 500-tracking index fund for almost nothing—as little as 0.05% of asset per year—and get roughly all of the market’s return. Funds that instead use human being to pick stocks often charge 1% to 1.4%, for worse results.

In a post on his Pragmatic Capitalist blog, Cullen Roche wonders why people keep buying these funds that cost more and deliver less. His explanations sound right—you should read them—and boil down to people being poorly informed and too emotional about investing. Not everyone knows how hard it is to beat the market, and the ones who do are overconfident about their ability to do better.

But I’d like to propose a few more reasons people like active funds, which go beyond overoptimism. I’m not advocating for these active approaches. In each case, if this why you use active funds, I’ll suggest an alternative way of coming at the problem.

1) Using an active fund as a de facto financial adviser.

Many if not most fund managers these days are “closet indexers,” meaning they stick pretty close to a stock benchmark like the S&P 500, with just a few deviations they hope will goose performance enough to justify their fees. But there is a subset of managers with a broader mandate. They mix up U.S. stocks, foreign stocks, bonds and other assets. Some, like the popular T. Rowe Price and Fidelity “target-date” funds, shift among these assets according to a pre-set formula based on their investors planned age of retirement. Others move around based on their views about whether, say, U.S. stocks look expensive or cheap. But in either case, their investors may not really be coming to them for market-beating stock picks. They are using those funds to help find the right split among stocks and bonds.

In other words, these funds are stand-ins for the financial advisers who help people set up their portfolios. The advice isn’t personal, but really good personal advice is hard to get if you don’t already have a big portfolio.

The better alternative: Buy a target date fund that uses cheap index funds instead. Or an index-based “balanced fund” with about 60% in stocks and 40% in bonds. Even if that’s not quite the optimal mix, the advantage of low fees is often more important. Or you can build your own cheap three fund portfolio using the index funds on the Money 50 recommended list.

If what you really want is a fund manager who knows when to get you out of stocks before they drop, well, the truth is neither fund managers nor advisers are likely to time these turns consistently well. Investors who want to preserve capital in bear markets are better off just dialing back their stock exposure as a matter of policy.

2) Going active to get a tilt.

Not everyone wants exactly the level of risk the stock market delivers. Investors willing to live with more volatility to get a higher return might, for example, want to add more small companies to their portfolio. Likewise, there is some evidence that a bias toward value stocks can deliver better returns over the long run. For a long time, buying an active mutual fund was really the simplest way for most people to get a slightly different mix of risk and return characteristics than the market offered.

Those days are over. You can buy an index-based exchange-traded fund to capture almost any slice of the market or stylistic tilt. I’m skeptical of whether most of these funds are worth the bother, but many are cheaper and more reliable than pure active funds.

3) That enterprising feeling.

I’ve been a convinced indexer for so long that sometimes I forget how cynical the approach can sound to the uninitiated. You’re just tossing your money into the market and betting that on average it works out. Mutual fund managers, on the other hand, say they are scouring companies’ “fundamentals,”and “kicking the tires,” and “thinking of ourselves as owners of businesses.” (Never mind that for many fund managers holding a stock for a year is what counts as a long-run strategy.) At first blush, this doesn’t only sound like a smart way to make money… it sounds like the right thing to do. A way to be a good steward of wealth and to help build the American economy. I’m often struck by how people seem to admire Warren Buffett not only as a smart businessman with a rare stock picking ability, but as a kind of spirit guide. Not for nothing is his annual shareholder meeting called the Woodstock of Capitalism.

Roche has what I think is a deep insight that might make you think differently about this. The money you put into equities via your 401(k) or IRA isn’t really “investing,” just saving with more risk and an incrementally better expected return than bonds. That’s because you aren’t handing any funding to the company, but buying an old claim on it from someone else.

…the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO).

Whether you buy an active fund or an index fund, you’ll be at a pretty distant remove from the companies you indirectly own. On average, you won’t have much chance of a big return, and some tire kicking here and there won’t add a lot of value. There’s nothing wrong with that. Most of us don’t have the time or the interest to be even part-time entrepreneurs. There’s no shame—and a lot of gain to be had—in keeping it cheap and simple and moving on.

MONEY Social Security

Surprise! Even Wealthy Retirees Live On Social Security and Pensions

Older Americans with six-figure portfolios rely on old-fashioned programs for half their income.

Where do affluent retirees get their income? Portfolios invested in stocks and bonds, you might think—but you’d be wrong. Turns out many are living mainly on Social Security and good old pensions.

That’s the surprising finding of new research from a surprising source: Vanguard, a leading provider of retirement saving products like individual retirement accounts and 401(k)s. Vanguard studied the income sources and wealth holdings of more than 2,600 older households (ages 60-79) with at least $100,000 in retirement savings. The respondents’ median income was $69,500, with median financial assets of $395,000. (The value of housing was excluded.)

The researchers were looking for answers to a mysterious question about the behavior of wealthier retirement account owners: Why do few of them draw down their savings? They found that nearly half the aggregate wealth of these households comes from the two mothers of all guaranteed income programs, Social Security (28%) and traditional defined-benefit pensions (20%).

The median annual income for these households is $22,000 from Social Security, with an additional $20,000 from pensions. Tax-deferred retirement accounts came in third among those who have them, at $13,000 (11%).

“Only a small number of the people who have 401(k)s and IRAs are really relying on them as a regular source of income,” said Steve Utkus, director of the Vanguard Center for Retirement Research. “There’s a lot more income from pensions than we expected,” he adds.

That last finding may seem surprising, given all the publicity about shrinkage of defined-benefit pensions. Although most state and local government workers still have pensions, only a third of private-sector workers hold a traditional pension, down from 88% in 1975, according to the National Institute on Retirement Security. And NIRS data points to a continued slide in the years ahead.

“Will this look different 10 years from now—will we have less pension income and more from retirement savings accounts? I think so,” Utkus says.

Another interesting finding: 29% of affluent retirees get some income from work, with a median income of $24,600. And the rate of labor force participation was even higher—40%— among households more reliant on retirement accounts.

“That’s only going to jump dramatically over the next few years,” Utkus says. “All the surveys show there’s a real demand for work as a structure to life. People say they can use the money, or they want to work to get social interaction.”

The findings are all the more striking because the big buzz in the retirement industry these days is about how to generate income from nest eggs. That includes creation of income-oriented portfolios, systematic drawdown plans and annuity products that act as do-it-yourself pensions.

Yet few retirement account holders actually are tapping them for income. The Investment Company Institute reports that just 3.5% of all participants in 401(k) plans took withdrawals in 2013. That figure includes current workers as well as retirees; the numbers are higher when IRAs are included, since those accounts include many rollovers from workplace plans by retired workers. With that wider lens, 20% of younger retired households (ages 60-69) take withdrawals, according to a study for the National Bureau of Economic Research and the Social Security Administration’s Retirement Research Consortium.

The income annuity market has been especially slow to take off. One option is an immediate annuity, where you make a single payment at the point of retirement or later to an insurance company and start getting a monthly check; the other is a deferred annuity, which lets you pay premiums over time entitling them to future regular income in retirement.

Deferred annuity sales doubled in 2013, to about $2 billion, according to LIMRA, the insurance industry research and consulting group. But that’s still a drop in the bucket of the broader retirement products market. And the Vanguard survey found that just 5% of investors surveyed held annuity contracts.

“The theme of translating retirement balances into income streams is emerging very slowly,” Utkus says.

The Vanguard study also underscores the importance of smart Social Security claiming decisions, especially delayed filing. “There’s been a sea change over the past year,” Utkus says, with more people recognizing that delayed filing is one of the best ways to boost guaranteed income in retirement. Vanguard is “actively discussing” adding Social Security advice to the services it offers investors, he says.

 

 

MONEY 401(k)s

Working for a Small Business? Your 401(k) Is Probably Small, Too.

At Mom-and-Pop companies, workers may miss out on perks like employer matches. Here's what to do.

You might call it retirement inequality. Over the past couple of decades, 401(k)s have become our national retirement plan, but you are most likely to be offered one if you work for a large- and mid-sized company. Only 24% of small businesses offer a 401(k).

If you’re working at small business that provides a 401(k), congrats—you can make headway in retirement saving. Many small business 401(k)s are doing a decent job, a new Vanguard survey found. The survey covered 1,418 of the fund group’s small business 401(k)s, those with up to $20 million in assets. The average plan had 44 participants and held $2.4 million.

But your savings are likely to lag your counterparts at larger employers. Compared with overall 401(k) balances, small plan accounts are just half the size—an average $55,657 in 2013 vs. $101,650 for 401(k)s overall. Still, small balances rose 10% gain over $50,610 in 2012. Median balances, which better reflect the typical employee, averaged just $11,171, up just 2% from $10,950 in 2012.

One reason for the difference: Small businesses tend to offer lower salaries than large companies, and many have higher turnover, so workers have less time to save. Company matches may also be less generous. Three out of four small businesses offer an employer contribution, compared with 91% of 401(k)s overall, according to Vanguard. Some 44% provided a matching contribution, 10% offered both a match and non-matching contribution, and 21% gave out a non-matching contribution only.

In other ways, small business plans are keeping up with larger 401(k)s. Participation averaged 73%, similar to overall levels. The savings rates were lowest for employees younger than 25—only 46% contributed in 2013. And just 47% of those earning less than $30,000 saved in their plans. For those who did join, the typical savings rate was 7.1% of pay, nearly identical to the overall savings rate.

Mirroring larger plans, the most popular investment was a target-date fund, which gives you an all-in-one asset mix that shifts to become more conservative as you near retirement. Two-third of small business workers had all or part of their portfolio in a target date fund, while 46% held one as their only investment. Another 6% opted for a balanced fund or other model portfolio.

The one 401(k) feature not explored in Vanguard’s small business survey: costs. Of course, Vanguard is famous for its inexpensive fund and ETF offerings. But outside of Vanguard’s orbit, many 401(k)s are saddled with with high fees—and that’s especially true for small plans, which lack economies of scale.

If you’re investing in a small business 401(k) plan, save at least enough to get a full match, if one is offered. And choose low-cost, broad index funds, if they’re available. If your plan charges a lot—more than 1.25%—put any additional money in a Traditional or Roth IRA. Aim to save as much as 15% of pay, both inside and outside your plan. That way, your nest egg will grow bigger, even if the business remains small.

 

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