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  1. 1. December 2007 Mutual Fund Selection 1 By William Parmenter, editor Dimensional Fund Advisors (DFA) created one of the first index funds in 1981. DFA created Timothy Bock, founder of Summit Portfolio Management, spoke on the topic of passively managed mutual funds designed to capture the added returns from small and value mutual fund selection on Nov. 3 at the Santa stocks. DFA funds aim to keep expense ratios Monica branch library, 2101 Ocean Park Blvd. and transactions costs low. The funds are sold Summit Portfolio Management, founded only through investment advisors. in 1984 by Bock, has six offices and is a fee- The active management approach takes only financial consulting firm that offers the position that stock prices are often incorrect comprehensive personal financial services. and can be exploited via market timing or stock Portfolio structure determines returns, is picking. In contrast, the passive management Bock’s thesis. Only four percent of returns are attributable to stock picking and market timing, factors that can actually reduce return. Table of Contents Bock reviewed active versus passive Timothy Bock …Mutual Fund Selection ….p.1 investing, coming down on the side of passive Erick Glicksman…Structured Products…………...p. 2 investing, due to the efficient market hypothesis. Sharat Shroff .Investment in India p.3 Investors should use index funds, approach takes the position that market because capital markets are efficient. mechanisms price securities correctly, guided by Concentrated portfolios have higher risks and the efficient market hypothesis. costs. Superior returns are attributable to asset Evidence on these strategies comes from structure. Picking a manager or funds based on examining the results of the average stock fund track record does not help. Less than 10 percent investor. During the same period that the of the managers of mutual funds actually add Standard and Poors 500 returned an average of value. 13.2 percent a year, the average stock fund Between 1926 and 2006: stocks investor earned 3.7 percent a year. Bad timing produced a 6.8 percent higher return than based on emotional reactions was largely Treasury bills; value stocks produced a 3.1 responsibly for the poor results. percent higher return than growth stocks; and Star fund manager performance may be small company stocks produced a 4.7 percent suspect. For example, Bill Miller of Legg higher return than large company stocks. Mason outperformed the S&P 500 for fifteen To get a superior return one’s portfolio consecutive years. But he is a value manager, so should be more heavily weighted with small cap should have been evaluated against a value and value stocks. index. Against that index he was average. Most of Miller’s success was due to an early pick of AOL. 1
  2. 2. Relying on fund ratings is another way exchange and such financial instruments as: to lose money. A study of five rating services options, swaps and forwards. showed a fund receiving wildly different ratings Structured products meet the objectives by different services. No consistency has been of enhanced return, risk management, market found in fund manager performance. Regarding access, tax and regulatory efficiency, and cost Morningstars’ ratings, it has been found that 80 and time efficiency. percent of money goes into five star funds. But, The promise of enhanced return with that is a formula for losing money, as three star structured products makes them attractive as funds were found to outperform five star funds you doe not have to time the market and they by a four percent compounded rate. reduce risk. Bock had a number of conclusions: Structured products bridge the gap invest. Don’t speculate. Passive investing is between the individual and the institutional better, due to lower costs, less risk and above investor. With structured products you can average returns. Control risks through defer taxes and convert short-term capital gains diversification of securities, and countries. into long-term capital gains. Control your emotional influences—a huge source of underperformance and loss. Measure results against appropriate benchmarks. Get Los Angeles County Meeting Schedule expert guidance if you are not an expert. Bock distributed an information packet, Westside Computer Group – Don Gimpel, 310/276-9875 Sat. Dec. 1, at 10:30 a.m.. Veterans of containing eight articles on financial topics, Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, such as how emotions influence investing Culver City, Topic The Retirement Withdrawal Issue (featuring six spread sheets). outcomes, equilibrium-based investing, active versus passive management, and strategies to Pasadena Group – Pasadena Library 285 E. Walnut Street, Topic and date TBA reduce taxes. These articles and many more are available at Bock’s website, at: Mutual Fund Group – Gunter Hagen 310/457-7404, 10:30 a.m. Sat, March 1, 2008. Topic: Smart Investing Strategies and Global Investing Trends. In the community room of the Fairview Branch of the Santa Monica Public Library, 2101 Ocean Park Blvd., Santa Monica. The Improving Portfolio Efficiency Using meeting is free to the public Structured Product Investments Stock Selection Group—Norm Langhout, 310/391-6430, By William Parmenter, editor Fourth Wednesday of the month at 7 p.m. Fairview Branch of Santa Monica Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA Erick Glicksman spoke on structured financial products at the Skirball meeting of the San Fernando Valley Group – Mid Valley Library Community Room, 16244 Nordhoff St. North Hills, Topic, TBA AAII Los Angeles Chapter on Saturday, November 17. Glicksman is Managing Director IBD Meet-Up/AAII CANSLIM Group – Santa Monica Library, Fairview Branch, 2101 Ocean Park Blvd., Santa Monica and head of product development for structured products at UBS. Los Angeles Chapter Mtg.—No meeting in Dec. 2007. Up-coming meeting dates through July for 2008: Jan. 12, Feb. 23, March 22, Structured products are defined as an April 19, May 17,, June 28, and July 19. emerging investment class; they are a means to get access to liquid asset classes. Currently structured products are more common in Europe. Growth of structured products started in Traditional investments include stocks, Europe in the early 1980s, but has lagged in bonds and cash. Nontraditional investments development in the U.S.A. Structured product include: hedge funds, commodities, foreign growth in the U.S.A. hit $1.8 B(illion) in 1998, grew to$9.6 B in 2003; rose to $40.4 B in 2007, 2
  3. 3. and is projected to hit $100 B in the U.S.A. and most competitive level. Structured products is a $200 B in Europe by the end of the year very robust area that is “growing like crazy.” The majority of money invested in structured products comes from individual Growing in a Slowing World, investors. Investment Opportunities in India Structured products can access: indexes, By William Parmenter, editor individual equities, hedge funds, commodities, interest rates, foreign exchange rates, baskets of India’s equity market and business credits and baskets of equities. climate offer challenges to overseas investors, The components of structured products but progress is being made, and the country has fall into four risk categories, as follows: an enticing growth rate. Sharat Shroff, CFA, 1) Protection: in which 100 percent of portfolio manager for Matthews International the investment is guaranteed at the end of Capital Management, LLC, spoke on investing investment term. Example: an absolute return in India and the country context at a November barrier note with a term of 18 months, and 100 17 talk to the Los Angeles Chapter of AAII at percent principal protection, with the underlying the Skirball Center. index being the S & P 500. Among the challenges to foreign 2) Optimization: in which the return on investors are ownership restrictions (a premium the investment is range bound at the end of the is charged to foreign investors for such stocks as investment term. Example: a yield optimization telecom, banks and defense), tax laws are 10 percent per annum note with contingent ambiguous, the rupee is not fully convertible, protection with a range bound return and a one- and shorting of stocks is prohibited to year term, issued by UBS. institutional investors. 3) Performance: uses a tactical strategy The difficulty in direct overseas for flat or bullish markets, with the S &P investment in India led to the rise of a parallel financial index as the underlying index. market, where participatory notes (offshore Example: an autocallable optimization security, derivative instruments) were sold. They rose in with contingent protection, with a one-year value from about $7 billion in 2004 to about $90 term, callable quarterly, issued by Lehman billion by late 2007, accounting for 8 percent of Brothers. India’s total market capitalization. 4) .Leverage: the most risky as the In mid-October, the Securities and investment would be in call or put options. Exchange Board of India announced measures Example: performance securities with to substantially curtail the issuance of contingent protection, with S&P 500 being the participatory notes, in hopes creating a more underlying index, and the issuer being HSBC equitable market between domestic investors USA Inc., with a term of five years. It trades and participatory note investors. daily, giving a higher risk-adjusted return. India’s growth rate has picked up Glicksman envisions structured products significantly. Between 1950 and 1980 it was3-4 as a component of your portfolio, along with percent; between 1980 and 2000, it was 5-6 equities, bonds, real estate and alternative asset percent; and between 2000 and 2005 it was 6-8 classes. percent. Growth has been stable within a band In the question and answer session, of 4 to 8 percent for the last 10 years. Glicksman pointed out that UBS is developing The government’s micromanagement of financial products with a longer holding time to the economy and a stifling bureaucracy have avoid tax hits. The three percent fee, an been sources of complaint, but the situation is opportunity cost, is being squeezed down to the improving. Entrepreneurial activity is increasing despite existing constraints: 11 3
  4. 4. procedures to start a new business; 35 days to This quarter, heavy industry and infrastructure start a new business; 1,420 days to enforce a companies reported strong results, while contract; and 10 years to close a business. companies in consumer goods and automotives Transformation of the economic had compressed operating margins due to rising landscape, particularly in big cities, reeling from costs. population inflows, is under way. Average age The Bombay Sensitive Index (Sensex) of in India is about 25 years. Capital markets need 30 stocks had a twelve month forward P/E of to be deepened and broadened. Deregulation about 16 in 2007, and a growth rate of around and privatization are opening up new markets in 20 percent. The growth band has been between a country that is aiming at achieving a greater 15-21 percent since 2002. The index cannot be balance between manufacturing and services. purchased. Unequal wealth distribution (making for Foreign capital continues to flow into political volatility), a dearth of public health India at a rapid pace, so far $17 billion this year, resources, inadequate educational opportunities, double the amount in all 2006. Capital inflows lack of infrastructure and a populations base of have led to a rapid appreciation of the rupee, hundreds of millions of peasants subsisting on although the currency was stronger in 1980 than less than $1 per day are all simultaneously today. significant economic challenges and Shroff distributed informational packets opportunities for growth. containing two in-house magazines from India needs to broaden its base of Matthews International Capital Management, growth, as the informal economy amounts to 60 and a quarterly report and prospectuses on the percent of GDP, and employment growth has Matthews Asian funds. Matthews has nine been stagnant over the last decade. Also, there Asian mutual funds, including four aggregate has been a stall in the reform agenda with an funds, a technology fund, and four country uncomfortable alliance between Congress and funds, including the India Fund. center-left parties, with high decibel anti- The India fund (symbol MINDX) started capitalist rhetoric coming from the communists. in Oct. 31, 2005, is an open-ended fund with The social dilemma is how to create jobs for $1.1 billion in assets, and operating expenses of those hundreds of millions surviving in grinding 1.41 percent. The fund is spread across various poverty. sectors, the heaviest weighting being financials, On the bright side, the much publicized industrials, consumer discretionary, information software sector generates $45 billion a year, and technology and health care. is growing at 30 percent a year. Yet it amounts The India fund’s benchmark is the to less than one percent of employment and five Bombay Stock Exchange 100 index, which it percent of GDP. India is a large regional has significantly underperformed. As of Oct. supplier of pharmaceuticals, which amounts to 5 31, the fund had a one-year return of 50 percent, percent of GDP, and is growing at 25 percent a compared to 69 percent for the benchmark. year. Since the fund’s inception it returned 52 India is self-sufficient in agriculture, percent, compared to 71 percent for the coal, cement and other commodities. But, 55 benchmark. percent of oil is imported, and paying for More information on Matthews Asian imported oil presents a formidable problem. funds can be obtained on the web at: Bombay’s stock market was the first . stock exchange founded in Asia, but capital markets are still largely undeveloped. The Bombay Stock Exchange 100 Index finished the month of October at record high. 4
  5. 5. Pro Forma Pro Forma Editor William Parmenter Pro Forma Editor, Emeritus Orvis Adams SIG GROUP CHAIRMEN Asia Pacific Group Robert Hsu IBD Meet-up/ AAII CANSLIM Norman Langhout Mutual Fund Group Gunter Hagen Pasadena Group Ivan Wong Palm Springs Group Patti Gammino San Fernando Valley Group Evan Press Westside Computer Group Don Gimpel Pro Forma is offered free of charge exclusively via email from the Los Angeles Chapter web site at: The American Association of Individual Investors is an independent nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research. Pro Forma is published for advising members of the groups' activities and for sharing information. All material compiled without verification of accuracy to a specific task or computer system. All material provided in the Newsletter is for educational and illustrative purposes only. Comments are the views of their author and no other person or organization. Investing is an inherently risky business. Investors may loose their entire investment or more. Past performance is not necessarily indicative of future returns. The American Association of Individual Investors, the Pro Forma and the Los Angeles Special Interest Groups of the AAII do not endorse the purchase or sale of any given security, service or product. All trademarks are the property of their holder. Pro Forma is Copyrighted by the Los Angles Special Interest Groups of the AAII. All Rights Reserved. No part may be reproduced without (freely granted) permission. AAII Los Angeles Chapter Web Site Note to Pro Forma Contributors: Please have your copy emailed to me by the fifth of the month in which we publish. Letters and comments are welcome. If you want to email a polemic about global warming, the price of oil, or some other looming economic catastrophe, you will have a chance to alarm, or amuse, our readers. Book reviews are welcome. Mail disks to: 319 Walnut Ave., Apt. 2, Long Beach, CA 90802, or use email: My home phone is (562) 437-2412. 5
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