Mark Brandon is the Managing Partner of First Sustainable (, a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Wednesday, November 30, 2005

Reason #8 To Fire Your Mutual Fund Company

Third in A Series

The next several posts are going to be dedicated to the proposition that small investors are getting ripped off with mutual funds thanks to a complex scheme of self-dealing and back scratching.

Reason #8 - Tax Inefficiency

Mutual fund investors who hold their funds in a retirement account are not affected by this aspect, since income is tax-deferred in most cases. However, if you hold mutual funds in a taxable account, which includes a substantial portion of retirees, you will be doubly surprised this year. First, you will be hit with a tax bill whether or not you sold your fund during the year. To add insult to injury, you may be responsible for a large capital gains bill despite your fund being an overall loser for the year. Second -- and few people know about this one yet -- the expiration of three year tax loss carryforwards, means that your bill be larger this year than it's been in the last five. Why? The losses sustained during the bear market of 2000-2002 enabled funds to offset gains in subsequent years. That expires this year. Lipper estimates that the average capital gains distribution is going to increase 50 percent this year (see Boston Globe).

How Did We Get Here?

Whether you are an individual or an organization, the IRS wants its cut of any income from capital gains and dividends. Mutual funds are not excluded. So, when your mutual fund manager sells positions for what you hope is a gain, that gain is taxable, regardless of whether there are offsetting losses. The same is true when a stockholding pays a dividend. For organizations that pass through these gains to the shareholders, the gains are taxable at the individual's tax rate instead of the corporate tax rate. It is prudent to pass through these gains, since a large percentage of shareholdings are in non-taxable accounts, and few individuals that are in taxable accounts are in a higher bracket than the corporate rate.

You can't fault the funds for choosing to pass through the gains. However, you can fault them for high turnover in their portfolios. In 25 years, funds have gone from an average turnover of 8 years (meaning that fifteen percent of their holdings are bought and sold in a year) to today's average turnover of 100 percent. This means that in every year, all stocks are bought and sold. Some of the most egregious offenders turn over their portfolio five times in a year. The mutual fund industry has transitioned from buy-and-hold stewards of corporate America to being short-term, rent-a-stock traders in that time. Although evidence is conflicted about why this has happened, the pessimist in me believes that it is because of the aforementioned soft dollar arrangements resulting in an incentive to trade frequently.

Why Should I Care?

The average mutual fund already trails it's benchmark indexes because of the high fees mentioned in previous posts. Now, if you take into account that you will have to pay a larger bill to the tax man, that just means your performance suffers even more. If you lose one percent per year to taxes, that amounts to serious money over time. Over a 30 year saving period, this difference amounts to more than 25 percent of your ending net worth. Considering that this could make the difference between you running out of money before you die, it is not to be ignored.

What You Can Do About It

Index funds do not have high turnover. The only turnover they have is periodic rebalancing when their benchmark indexes change. This makes them more tax efficient.

An even better option is to engage First Sustainable to create a so-called Folio. This combines the technology available to a mutual fund to enable you to create your own diversified, asset-allocated mutual fund. You can buy fractional shares of individual stocks. This way, your only tax bill comes when you also do periodic rebalancing to suit your financial situation. To me, this is way more acceptable than swallowing a bill that was based on some conflicted manager's financial situation.

Tomorrow: Reason #7 - Alphabet Soup of Sales Charges

Tuesday, November 29, 2005

Reason #9 To Fire Your Mutual Fund Company
Second in A Series

The next several posts are going to be dedicated to the proposition that small investors are getting ripped off with mutual funds thanks to a complex scheme of self-dealing and back scratching.

Reason #9 - 12b-1 Fees

The 12b-1 fee is the obscurely-named outrage that dings investors in mutual funds so that management can market the fund. In 1980, the mutual fund industry successfully lobbied the SEC to allow this fee with the justification that a larger fund lowers the expenses for everybody. In theory, the logic is right when you take into account the same expenses being spread over a larger pool of assets. However, there are several problems with this thinking:

1) A larger fund does not necessarily become easier to manage. Over the last 25 years, multi-billion dollar mutual funds have become the norm. When I worked for Fidelity in the early 1990's, the largest fund in the world at the time, the famous Fidelity Magellan, was around $25 billion. Even then, concerns had set in that it had become too large to outperform the market. Since then, Magellan's size has been a deterrent. Like a large barge, meaningful changes in its trajectory take too long to implement. Of the funds with in excess of $5 billion, most of them track the S&P 500 minus their outsize fees because that is all they can do. Yet, even these large funds continue to charge the 12b-1 fee.

2) Certainly, if a fund is closed to new investors (which makes the fund easier to manage), the existing shareholders should be relieved of the 12b-1 fee. But, as of November 2003, when the House introduced HR 2420, 139 closed funds still levied the fee. Huh? Like crack cocaine, fund management firms just became addicted to the stream of poorly disclosed fund fees.

3) A fund is able to call itself "no load" as long as the 12b-1 fee is 25 basis points (.25%) or lower, although many funds charge the max-allowable 100 basis points.

In practice, the 12b-1 fee is partially shared with advisers who tout the funds, and the rest is gravy to the fund firm. They do not disclose this fee as part of their management fee, and even obscure the fee in their overall expense ratio.

Two thirds of mutual funds charge this fee, and I would bet that few investors know about it. HR 2420, introduced by congressman Mike Castle of Delaware, sought to ban this fee for closed funds only, and even that was stalled in the Senate, despite broad bi-partisan support and backing from the white house.

Sunday, November 27, 2005

Reason #10 To Fire Your Mutual Fund Company

First in A Series of Articles from Sustainable Log

#10 - Soft Dollar Expenses

The reason a mutual fund exists is so small investors can pool their money, hire professional management, and attain diversity that would be nearly impossible for the small investor by himself or herself. It would stand to reason then that funds with hundreds of millions, or even billions, would have economies of scale to demand from the street the most competitive rates for trading their shares. Yet, as you will see, not only are fund firms NOT getting the most competitive rates, they are paying well more than any individual can get through their discount broker.

What are Soft Dollar Expenses?

Hard dollars are expenses that come out of a fund manager's management fee. These expenses include salaries for the fund managers, analysts, and customer service people (yep, you get dinged when you call that 800 line), the costs of printing all those statements and other required literature, and all other office expenses associated with running a fund. Oddly, very real expenses such as spreads and trading commissions are not included in the hard dollar tally, and show up only as a slightly decreased, barely perceptible decrease in annual performance. High friction in these areas can amount to substantial costs over the course of a year when you consider that a multi-billion dollar mutual fund trades billions and billions of shares.

Recognizing that decreasing a dollar of hard expenses for a fund manager increases profit to their bottom line by a dollar, sell side firms make arrangents with the fund managers to provide everyday items in exchange for order flow at above-market costs. For example, a sell side brokerage firm provides investment research (the value of which is itself in doubt), Bloomberg terminals, office space, even a junior analyst or two, in exchange for the fund's order flow at, say, 5 cents a share versus the normal 2 cents a share. The sell-side brokers get fat commissions, the fund manager gets "stuff" that would otherwise be paid out of his management fee. Everybody is happy...except for the shareholders who are footing the bill, and for the most part, have no idea, that this is going on unless they read deep into the prospectus' fine print.

Why You Should Care

The Wall Street Journal investigated this practice and determined that, in 2002, $12 billion dollars were spent in soft dollar arrangements, where $6.7 billion of this was an unnecessary mark-up from the sell side. Further, WSJ spotlighted several firms that were paying 5 cents per share traded. That's $50 per 1,000 shares. Now, consider that any individual can open an account with a discount broker and pay less than $10 for a comparable execution. The wholesale rate for clearing these trades is probably $1 for diligently-shopped execution services performed on an agency basis for a multi-billion dollar fund.

The Investment Company Institute (the apologist association of Mutual Fund Management Firms) brushes off this practice by stating that all of the items received have value that the shareholders would have to pay anyway. Maybe. But, these expenses should be coming out of the management fee. This practice masks hidden expenses that can be used by individuals and their advisers when comparing one fund versus another. The only reason to mask the true expenses is to hide the fact that the managers are siphoning off more money from investors than their fiduciary duty allows. In less savory professions, this arrangement is called a kickback.

Tomorrow: Reason #9 - 12b-1 Fees

Friday, November 25, 2005

Longhorns 40, Aggies 29

Got to hand it to the Aggies. They played valiantly against a superior opponent. Alas, Vincent Young's chances at the Heisman were probably dashed today. No shame in losing to Reggie Bush, though.

Thursday, November 24, 2005

A New Year's Resolution on Thanksgiving Day

Tomorrow is the biggest shopping day of the year. If you're interested in sustainable living, make this resolution to ask yourself when shopping:

1) Does the recipient really need it? Looking through the phone-book sized Thursday morning paper with all of its circulars, you notice that there are too many one-purpose appliances. This year, I've seen a tabletop s'more maker, a whip cream maker (as if stirring was too hard), and an inside-the-egg scrambler. These are gifts that will be used once or twice and then shelved indefinitely. Yet, the packaging alone requires a substantial resource commitment.

2) Can it be gotten second-hand, and can it be re-used after the recipient has finished with it? Close the loop. If you're getting a computer for your youngster, this person may only need it for low-resource activities like web-surfing and email. Most three-year-old computers can handle this, and it will be much, much cheaper.

3) Can it be obtained from a closer source? Global supply chains require a tremendous expenditure in transportation costs, especially if you're talking about agro-products.

Happy Thanksgiving. For so much, we should be thankful.


Wednesday, November 23, 2005

Leverage This Year's Charitable Contribution 5,000 Percent
The One Percent in Community Initiative will help your charitable dollars go much farther

Whether by design or fortune, I am glad that the deadline for tax deductible charitable contributions is at the tale end of the holiday season, when people are in a charitable mood. This year, some of our charity has been spent with disasters in Southeast Asia with the tsunami, Pakistan with the Earthquake, South America with Hurricane Stan, the food crisis in Niger, and of course, Hurricane's Katrina and Rita closer to home. We have had unprecedented calls for -- and needs for -- our charitable dollars this year. With the great need for help, we need to explore how to make those dollars go farther. The One Percent in Community Initiative can help your dollars go farther to the tune of 5,000 percent. Let me show you how.

Community Investing Explained

Much of this article is borrowed from Timothy Freundlich of the Calvert Foundation. Community Investing can be directed to four areas:
  • Affordable Housing helps enable low income families to afford a home mortgage.
  • Microenterprise Development enables low income individuals to start their own businesses with loans ranging from $50 - $10,000, levels that for-profit commercial banks will not touch.
  • Small Business Development picks up where Microenterprise Development leaves off with loans of more than $10,000 in a more structured vehicle
  • Community Development lending supports non-profits that help the disadvantaged.
How Your Charity is Leveraged 5,000 Percent

Suppose you were considering donating $20 to your favorite charity this year. You write your check and that $20 goes to help someone in need. A worthy cause to be sure.

Now suppose you had a $100,000 portfolio with a typical allocation of 60% equities, 35% fixed income, and 5 percent cash. If you directed one percent of your assets to community investing, you could take $1,000 (one percent) of your portfolio or 20% of your cash position, and direct it to a FDIC-insured CD at a Community Development Financial Institution (CDFI) like Shorebank. Compared to non-CDFI alternatives, you may sacrifice that same $20 per year in interest. But, the entire $1,000 is going to help people in need. One thousand dollars is 5,000 percent of $20. There you go.

How to Invest

As with any financial decision, you should first consult your financial adviser and determine the amount you feel comfortable investing, how long you can stand to have it tied up, where you want your investments to be directed (locally, nationally, internationally), and your risk tolerance.

Several vehicles are set up to receive community investments. They include:
  • Community Development Banks (CDB). These are for-profit entities that are regulated and backed by the FDIC.
  • Community Development Credit Unions (CDCU). These are just like any other credit union, only they have a directive on their lending activities.
  • Community Development Loan Funds (CDLF). These are unregulated and uninsured, but possibly yield more. Your returns will be below-market compared to conventional loan funds.
  • Community Development Corporations (CDC). Also unregulated and uninsured, this involves direct investment in a corporation that engages in these activities.
  • Microfinance Institutions (MFI). Unregulated and uninsured. Usually non-profit. They serve the poorest of the poor using a peer-lending model. Grameen Bank is the shining star in this field, though thousands are cropping up every year.
Links to CDFI Membership Organizations

Association for Enterprise Opportunity - the national membership organization for microcredit programs
CDFI Coalition - the national coalition and advocacy group for the CDFI industry with over 350 members
National Community Capital Association - umbrella organization for over 40 CDFIs
National Congress for Community Economic Development - a membership organization for 800 CDCs
National Federation of Community Development Credit Unions - membership group of 200 CDCUs

Tuesday, November 22, 2005

Ok, folks. This is my first attempt at blogging. Thanks to Donovan for suggesting the service.

The first thing I am going to do is start with a blatant commercial. I wrote the article below for First Sustainable.

10 Reasons to Fire Your Financial Advisor (And Hire First Sustainable)

As the managing member of First Sustainable, LLC, God knows I am not against financial advisers or the advisory firms. Web discount brokers have done the investing public a disservice trying to convince us that we should be do-it-yourselfers when it comes to our financial lives. This reminds me of the time I tried to be a do-it-yourself plumber. Was I able to get the water to go through the pipes under my bathroom sink? Sure. Should I have farmed out the job to a professional? Considering that my do-it-yourself hack job hastened corrosion in other parts of the water line, causing greater damage than otherwise would have been caused, I should have called Roto Rooter. This is similar to the current state of financial services. Just because you can press the buttons that send the orders to be executed does not mean it's the right thing for your financial life. So, let it be known that financial advisers and their firms have a place.

But, for decades -- centuries even -- the financial services business has operated with inherent conflicts of interest. Those conflicts are so widespread and so well accepted that investors have forgotten that they are being taken to the cleaners. The fact is that the financial services business is built around selling products and not servicing clients' financial needs, especially when it comes to socially responsible investing. Of course, commissions have come down over the past decade, but like the proverbial balloon that gets squeezed in the middle, the conflicts have just been moved elsewhere, refined to be ever more invisible. The only time you notice them is after several years of sub-par returns. Below are the ten reasons you should consider firing your financial advisor. If you suspect that you are a victim of one of these practices, do not accept that this is the way of the world. Better yet, call a First Sustainable adviser at (800) SRI-3319 or contact us by chat or email. We will tell you if, in fact, you have been run through the ringer, and recommend to you how to fix it. Please remember our pledge to you: We will never accept financial considerations from financial product sponsors. We have the model that mostly closely eliminates these conflicts (see Our Services), and we invite you to discover how it can be applied to your portfolio.

10. Double Dipping. Many financial advisers charge a fee based on assets under management. We don’t condemn this practice. We do it as well, as it is a fair way to compensate advisers for hours of work on your behalf. But, when the adviser gets additional compensation for placing you in proprietary products, buyer beware. Many of the vehicles he is likely to recommend such as in-house mutual funds or annuity products come with their own management fees and sales charges, making you pay twice. At First Sustainable, we pledge to not accept any money or other considerations from sponsors of financial products. Our fee for assets under management of 1.25 percent is enough.

9. Proprietary Products. For the largest names in the financial advisory business, in house products have badly underperformed their benchmarks. I will refrain from naming names here, but you know who they are. There is little wonder why they are laggards. Their expense ratios are much higher than industry average, sometimes double the 1.38 percent average for all mutual funds.

8. Social Screening. Go ahead. Call your Amex or Raymond James adviser and ask them if your portfolio has a stake in unethical corporations. While you are at it, be sure to ask him if the overpriced, in-house mutual funds he sold you have unethical stakes, as well. Then, see if he even knows what you consider to be unethical. Prepare to be amused.

7. Mutual Fund Underperformance. Multiple academic studies have shown time and again that actively managed funds fail to beat their benchmarks over the long term. What’s worse, the leading funds today are likely to be the laggards tomorrow when the hordes of amateurs chasing performance force the managers to do the same. So, why do financial advisers keep recommending actively managed funds? Because they offer the fattest commissions. See reason #10. At First Sustainable, we are not blinded by the ease of selling the mutual fund story. We actually prefer to put our clients in baskets (or folios) of equities, based on your diversification needs and social criteria.

6. Over-reliance on Mutual Funds. For this, we refer you to Top 10 Reasons to Fire Your Mutual Fund Company. We have to admit. Mutual funds have a great story. Professional management, clearly understood mission, instant diversification, low costs. The fact is that the mutual fund industry gets away with more than you know, and it all comes straight out of your pocket. First Sustainable’s folio method of investing offers lower cost, tax advantages, and conformity with your social values.

5. Ongoing Selling Pressure. At a minimum, you should be talking to your adviser once a quarter, and then the conversations should be about you. If your financial adviser’s idea of a quarterly follow-up is to tell you about what’s new at his firm, it’s time to fire him. This tactic is a ploy to get you to trade out of what he sold you last time and buy something new, all to get another commission.

4. Sales Contests. If your financial adviser calls you out of the blue to tell you about a “special situation” or a “new item that just came across my desk”, he is likely trying to win a sales contest. In our opinion, the quickest way to success is to NOT deviate from your plan with every new “special situation”, which are usually nothing more than an exhortation from his upper management to sell you more of their overpriced, underperforming in-house products. Once a plan is in place, your adviser should contact you once a quarter to make certain nothing has changed with your goals and needs. Everything else is probably a sales ploy. At First Sustainable, you will already be aware of the special situations that warrant a change to your financial plan. These include changes in income, changes in employment, family events such as births and deaths, medical needs, business needs, etc.

3. Condescension. Another favorite sales ploy of the typical financial adviser is to talk down to you, “wow” you with credentials, and speak in indecipherable gobbledy-gook that means nothing anyway. He does this to take control of the relationship so that you’ll follow his lead any time he has one of those aforementioned “special situations”. At First Sustainable, we want educated customers. If you need help with a topic, we want to explain it to you, so that you continue to be happy with our services. We want you to feel free to ask questions, and we want you to take control of your own finances. Most of all, we want our customers to think about and then invest with their values, so that a better world can be created for all.

2. Commission Scales Determine Financial Advice. The firm that bills itself as having the most financial planners on staff (really, glorified salesmen) recently threatened their sales force with reduced commissions if they sold any funds other than in-house funds. Why would they need to do this? The in-house funds had been such universally awful performers for years that the funds were hemorrhaging money. Customers started to question why they were stuck holding such dogs in their portfolios. Before the change to their commission scale, the sales force had an extra incentive to flog the in-house funds, but at least they were not penalized for steering their clients to better performing options. The table below will tell you how poorly in-house products perform versus independent options. They lag because brokerage firms use their funds to vacuum more money from their customers, via fund expenses, trading expenses, and sales loads.

1. First Sustainable is Just Plain Better. Now for the shameless self-promotion. Seriously, we are better because:
a. Indexing provides superior performance.
b. Folio indexing is more tax advantageous than mutual funds
c. Folio indexing allows you to create your own mutual fund
d. First Sustainable will help you reward the good players and weed out the bad players from your portfolio, based not on someone else’s definition of socially responsible, but on yours.

First Sustainable invites you to take advantage of our free consultation, wherein a qualified adviser will talk to you about the concepts of folio indexing and financial planning. If you like what you hear, you can engage our services on a no obligation, hourly basis, or have us implement your financial plan for you.