Tag Archives: VFINX

Funds Hold GM to the Bitter End

What does a company need to do to get kicked off of an index around here?

As of Friday, General Motors was still in the S&P 500 and the Dow Jones Industrial Average. If the indexes hold the stock until the company declares bankruptcy are the index funds and ETFs that track indexes with GM as a component obligated to hold it to the bitter end? Are they are allowed to sell it ahead of time or do they have to suck up the loss, even though everyone saw this coming from a mile away?

According to AOL Money & Finance, all of GM’s shares are now owned by large block holders. Institutions hold 36%, mutual funds, which includes ETFs, hold 62% and the rest with others like the executives. State Street Global Advisors hold the most GM shares of any institution, 26.9 million, or 4.37% of all the GM shares outstanding. Surprisingly, only 5.26 million of those shares reside in the SPDR Trust (SPY). Still that’s a big loss for one fund no matter how you slice it. Vanguard Group has the second most shares, 23.99 million, or 3.93% of the shares outstanding. However, four of its funds are in the top 10 holders, the Vanguard 500 Index (VFINX) has the most shares of any fund, 5.8 million. This is followed by Vanguard Mid-Cap Index Fund (VO), Vanguard Total Stock Market Index Fund (VTI) and Vanguard Institutional Index Fund. Barclays Global Investors, owner still of the iShares ETF family, comes in third with 17.8 million shares.

The shocking part is that according to Standard & Poor’s, a component of the S&P 500 needs to have a market cap of at least $3 billion. With 610 million shares outstanding, GM would have to trade at $5 to make that. But GM last saw $5 on its shares on Dec. 8, 2008, more than five months ago. It’s not like S&P doesn’t remove stocks from the index. It’s deleted nine companies already this year.

Peter Cohan knows how to evaluate a company. He’s amazing at looking under the hood and breaking apart a company’s financial statements to see the rotting husk of a business. At Daily Finance, he says the failure of GM matters because it shows of success can lead to failure and how now the U.S. can’t even fail right. Companies can’t shut down without government intervention. He adds that the U.S. system of economic growth, venture-backed innovation, has been nearly snuffed out and that is not good news.

Cohan also list the five big reasons why GM didn’t have to fail and squarely lays the blame at the feat of managers who were overly impressed with themselves for no good reason. The five reasons: 1) bad financial policies, 2) Uncompetitive vehicles, 3) ignoring competition, 4) failure to innovate, 5) managing the bubble. Ignoring the competition and failure to innovate are the worst crimes and that should justify Rick Wagoner’s firing pretty easily.

Making the Case for Index Funds

Investing is long term. Speculation is short term.

Can you watch the market every day? If not, you should invest, rather than speculate. Without a doubt indexing is the way to invest. The crash of 2008 has not only highlighted the risk of owning single stocks, but also exposed the dirty underbelly of actively managed mutual funds.

Going for the index avoids getting stuck with the stocks that might be left behind. If you believe in the concept of diversification, then single stock risk is just too huge of a risk to take. And while you might be able to buy 20 stocks and build out a nice portfolio, one bad stock can wipe out 5% of your portfolio and two bad stocks decimate the fund. (Get it? Decimate? Remove 10%. Ok, moving on. …)

If you want to own financials, 30 are better than two stocks. If the two financials you owned last year were Bear Stearns and Lehman Brothers, you, my friend, have completely lost your portfolio of financials, and maybe your entire portfolio. Buying an index fund tracking the financial sector of the S&P 500, such as the Financial Select Sector SPDR (XLF), gives you 80 stocks, about 11% of the S&P 500. You can get more exposure to one narrow niche of the market and diversification at the same time, hence less risky. Sure, the financials took a hit, but considering most of them are still in business, you still have some of your investment.

So, single stock risk is out if you’re not buying for dividends. But what about actively managed mutual funds? The whole point of the actively managed fund is to give you, the investor, alpha, those extra percentage points of return that comes from the fund manager’s skill and intellect. The financial crisis has shown how hard it is to find true alpha.

It’s pretty much common knowledge these days that only about 20% of active fund managers beat the major market benchmarks. Considering many active funds are essentially index fund copycats, you will never beat the market with their huge management fees. Fund managers counter that even if they don’t beat the market going up, they at least have the ability to post narrower losses on the way down, because they can sell off the worst performing sectors while the index can’t. I think a little bit of research will show they are also posting returns worse that the indexes on the loss side as well.

And even those that don’t post worse losses, is a 35% loss that much of an improvement over a 37% loss?

So, if you eliminate single stock purchases and actively managed funds, deductive reasoning says you must go with the index. Of course, this mostly applies to U.S. equities. In some markets, such as emerging markets, a smart manager might have some market knowledge that hasn’t disseminated widely, but in the U.S. that kind of information gets spread around pretty quickly.

Indexes can be volatile and risky. If the stock market falls, an index tracking the stock market will fall. However, with the index fund you can rest in the knowledge you matched the market and didn’t do worse than most of the market.

If you really want a lesson, John Bogle, the inventor of the index mutual fund, explains why indexing is better than stock picking in “The Little Book of Common Sense Investing.” Essentially, Bogle says you can maximize returns and lower risk by not buying single stocks but mutual funds. Followers of Bogle have written a book called “BogleHeads” which expands on this theme.

Now in a shameless plug for myself, my book ETFs for the Long Run takes Bogle’s argument one step further. I agree with Bogle that indexing is the way to invest. Bogle likes the mutual fund structure, but I think Exchange Traded Funds are the mutual fund for the 21st century. In the book, I explain indexing, the advantages of buying mutual funds instead of single stocks and then why ETFs are better than mutual funds. The key reasons being they are cheaper, more tax efficient, more transparent and more flexible. I also explain how to buy and sell ETFs and how to use them to build a portfolio.

Since you don’t know what sector of the market will rise, you should own a broad market index, such as the Vanguard 500 mutual fund, (VFINX), or buy an ETF such as the SPDR, (SPY), or the iShares S&P 500 Index (IVV). The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average and the PowerShares QQQ (QQQQ) follows the technology heavy Nasdaq 100 index. The Vanguard Total Bond Market (BND) is a broad bond index.

Then you break it down into sector specific indexes that you want to follow.

Finally, you need to watch fees. ETFs typically charge smaller expense ratios than mutual funds. However, if you are dollar cost averaging, which in this market is the only way to go, the ETF’s commission will significantly eat into your returns if you invest less than $1,000 a pop. If you are investing less than $1,000 a pop, then go with a no-load index fund. Buying an index fund with a load is like paying for your own security in a gated community. It’s a waste of money.