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.

Thursday, December 29, 2005

Book Review: Megatrends 2010: The Rise of Conscious Capitalism

Check out William Baue's review of Patricia Aburdene's book. Excerpt:

"Ms. Aburdene may be crossing the line when she suggests a cause-and-effect relationship between spiritualism and capitalism. She cites a Global Environmental Management Initiative (GEMI) report entitled Clear Advantage: Building Shareholder Value, which presents "compelling evidence" that intangibles such as environmental, health, and safety (EHS) performance boosts financial performance.

"As GEMI puts it, intangibles become tangible," Ms Aburdene writes. "As I see it, consciousness becomes profit."

Many readers will accept this translation of terminology, while others will balk that she is pushing past linguistic limits. For the former set of readers, the book confirms and advances a helpful framework for thinking about "conscious capitalism"; the latter set of readers will find value in many of the book's tenets while remaining skeptical of the foundational underpinnings of the framework."

Tuesday, December 27, 2005

Sign Up to Save Gorillas, Rescue Endangered Girls, Liberate Child Soldiers, and More...

First Sustainable Teams Up With Alternative Gifts International in Membership Drive. Refer Your Friends, We Donate $1 To A Great Cause*

In an effort to increase our subscriber base, First Sustainable has created a promotion to donate $1 to Alternative Gifts International for each person that subscribes to our newsletter. For those that have not heard of AGI, they contract with various and screened non-profit agencies dedicated to specific relief or development goals. A whole catalog of worthy causes can be obtained from their web site.

My personal favorites among these causes include:

  • Saving Rwandan Gorillas. Twenty dollars (or referring 20 friends) can pay for one share of gorilla protection. Two hundred dollars pays for one day of poaching patrol.
  • Rescuing Endangered Girls in Southeast Asia. Fifty dollars (or referring 50 friends) provides the legal services to rescue one girl from forced prostitution. Twenty three dollars provides for one week of aftercare.
  • New Life for Child Soldiers in Columbia. Twelve dollars (or referring 12 friends) provides for counseling for one child at risk for forced recruitment. Sixty eight dollars is enough to enroll an at-risk child in one month of a workshop.
  • Medicine for Sudanese Refugees. Twenty dollars (or referring 20 friends) provides nutritional supplements for 75 children for one month. Ninety dollars supplies 45 men with antibiotics for one month.

If you find other causes that are more worthy of your support, then please select the appropriate option on the sign up form. Also, we can designate "where most needed" in the opinion of AGI.

The organization screens the recipients of the gifts. AGI received four stars from Charity Navigator for efficiency, and 90 percent of your gift goes directly to the cause you specify, with the rest going for AGI overhead and outreach. Renee and I gave many of these gifts to the people on our list that just don't need anything like a DVD or a fruitcake.

I hope that you can see that the real power of this promotion is not just in accepting the newsletter subscription and having $1 donated. You can really leverage the program by forwarding this message to your friends. We will send one email only, and a "double opt-in" is required. After that, they will never hear from us again.

All you have to do is sign up in the orange box to the right of your screen. Thanks.


*Now for the unpleasant disclaimers. First Sustainable will aggregate the donations and make one lump sum donation at the end of each calendar month with the percentage weighting for each cause according to those specified by the readers. Doing so limits overhead for Alternative Gifts International. Opting in is required to both ensure the legitimacy of the email addresses and to limit unwanted emails. The promotion will be capped at $10,000 in total donations. First Sustainable reserves the right to end the promotion at any time.

Thursday, December 22, 2005

Energy Efficient Mortgages a No-Brainer

Fannie Mae's EEM is the type of program that should be on the Socially Responsible Investor's radar. An EEM is a loan (usually a 2nd loan) to a homeowner with the proceeds going to purchasing energy efficiency upgrades. Lenders love this for the following reasons:

  • 100% of the project can be financed
  • It lowers the operating cost of the property
  • Much of the time, the decreased operating expense more than offsets the cost of the loan payment
  • If the loan is originated within their guidelines, Fannie Mae is standing by to purchase those loans. In other words, it's not an exotic instrument requiring lenders to keep the loan on their books

When Fannie Mae purchases these loans, they are then packaged and sold to investors just like the rest of Fannie's portfolio. Everybody wins: the homeowner gets lower operating expenses, the bank gets to originate a loan, Fannie gets to package and re-market it, the investor gets a FNMA-backed investment at market rates, the energy contractors get a sale, and the planet gets a less resource-intensive building.

Yet, lack of appropriate marketing has relegated these instruments to the fringes. EEM's need to be made sexy, like driving a Prius.

Tuesday, December 20, 2005

Alaska sues Exxon, BP over natural gas
Lawsuit alleges the two oil giants restrict supplies, keeping prices artificially high.

I am no defender of the oil companies, but Fortune did a terrible job reporting the complexities of this story. The oil companies are not the bad guys here.

Just about every state and municipal entity in Alaska wants to build a giant pipeline that traverses the state from the gas fields in the north down to the Canadian pipelines in the south. The federal government has already earmarked $20 billion for the project, thanks to the same congressman who chairs the energy committee and got approval for the now infamous "bridge to nowhere". It will surely provide lots of jobs and pad lots of pockets for our northern countrymen.

The problem is that the pipeline is not the best way to get the natural gas to the lower 48. Not even close. Private interests are proposing to build an undersea pipeline from the northern Alaskan ports to Canadian ports. The private Canadian proposal is much less expensive, much shorter, and most importantly, not nearly as destructive to the environment. Undersea pipelines rarely rupture, while overland pipelines rupture all the time. The great Alaskan oil pipeline is constantly springing leaks. Economically, shipping the gas will be cheaper for the energy companies, so it is no wonder that they would like to obstruct the Alaskan project in favor of the Canadians. Of course, the Canadian project will not get built if a massively subsidized competitor takes all the gas. The Canadian project is cleaner, cheaper, less destructive, and requires no federal money. Moreover, the end user's price will be higher using the Alaska scenario. How much more evidence do they need?

Fortune should recognize this lawsuit for what it is -- a cynical ploy by the Alaskans to embarrass the oil companies into complicity at a time when they are already universally reviled. Meanwhile, Alaskan governments deserve the "piggy" award in this case.

Monday, December 19, 2005

National Football League Proactive on... Climate Change?

Not normally seen as a beacon of progress on climate issues, the NFL and issued a press release touting how yesterday's Eagles-Rams matchup was the first climate neutral pro football game. When tens of thousands of people congregate in a heated and domed building like the Edward Jones Dome in the winter, you can imagine the size of the impact. In fact, estimted 58 tons of carbon dioxide were emitted.

The stadium's power source is fossil-fuel based, so they contracted with a Native American-owned Wind Farm and a Pennsylvania dairy farm methane plant to bring the equivalent amount of megawatts onto the grid. So, citizens who would otherwise be using fossil-fuel based energy will now be using these clean sources. The dirty power used during the game is offset by the clean fuel produced for others.

I applaud the Rams and Eagles organizations for taking this approach. They could also provide for Hybrid shuttle buses to the stadium, use energy efficient lighting, and make certain to recycle all of that aluminum and paper from concessions. Another idea would be to harness the methane emanating from FedEx Field yesterday, because the Cowboys STUNK IT UP.

Sunday, December 18, 2005

EPA Tries to Pull a Disappearing Act on the Toxics Release Inventory

Note: Thanks to William Baue at Socialfunds for this story.

In late September 2005, the Environmental Protection Agency (EPA) proposed "burden reduction" rule changes to the Toxics Release Inventory (TRI), which requires facilities that produce toxic chemicals to report their wastes and emissions. Established by the Emergency Planning and Community Right-to-Know Act of 1986 (EPCRA) in response to the Union Carbide gas leak in Bhopal, India in December 1984 that killed tens of thousands, TRI pioneered the use of disclosure (instead of regulation) as a powerful mitigator.

"EPA is launching a frontal assault on the Toxics Release Inventory program by proposing to convert the annual reporting requirement to alternate-year reporting," said Senator Jim Jeffords (I-VT) immediately after the announcement of the proposed change. "The Community Right-to-Know Act will become the Community Right-to-Know-Every-Other-Year Act."

Members of the socially responsible investing (SRI) community echoed this sentiment. Yesterday they launched the "" website to encourage those concerned about the changes to write to EPA during the public commentary period that was extended to January 13, 2006.

"What if we looked at corporate earnings every other year?" asks Julie Fox Gorte, vice president and chief social investment strategist for the Calvert Group, suggesting this analogy to highlight the absurdity of the proposal. "We might find corporations whose earnings didn't change between 2003 and 2005, but they sure changed a lot in the meantime!"

"Two years worth of no information in the investment world is forever--we react to what we see companies doing much more immediately than every other year," adds Dr. Gorte.

Other members of the SRI community, which relies heavily on TRI data to assess corporate environmental performance and potential financial risks, also express dismay at the proposal.

"The proposed changes would eviscerate the most cost-effective environmental rule the EPA has ever created in terms of increasing eco-efficiency and reducing risk," says Jon Naimon, founding president of Light Green Advisors (LGA), a Seattle-based SRI firm. "National emission reductions following the first TRI publication have been much faster than those generated by historical approaches to regulation embodied in the Clean Water Act, Clean Air Act, and the Resource Conservation and Recovery Act combined."

"TRI information is one of the few pieces of corporate accountability research that is rooted in physical quantities--and therefore it is empirical as opposed to normative information," Mr. Naimon told "Ironically, for a Republican administration that ostensibly favors information and market-based approaches, TRI is a program that works by spurring market forces rather than requiring command-and-control technology-forcing compliance."

The proposal would also increase ten-fold (from 500 to 5,000 pounds of toxic waste) the threshold for non-reporting using "Form A," which requires no details. The changes would also allow facilities emitting persistent bioaccumulative toxins (PBTs), such as lead and mercury that have been associated with human health risks even at low levels, to use Form A to report wastes less than 500 pounds without providing details.

These changes impact SRI research and beyond--including the Toxic 100, which lists top corporate polluters by aggregating TRI data by company.

"For the Toxic 100 and SRI research in general, this EPA proposal would be a giant disappearing act," said Jim Boyce, director of the environment program at the Political Economy Research Institute (PERI) at the University of Massachusetts, which created the Toxic 100. "The increase in the Form A threshold would make important information vanish, because even a small polluter can affect a large number of people if it's located in an urban area."

"Some companies might be able to change their activities so that more pollution happens in the unreported years, making them look better than they really are," Prof. Boyce told

Intentional or not, emissions change significantly year-to-year as business ebbs and flows with production lines closing temporarily and then reopening when market conditions improve, maintenance or accidents closing plants for extended times, and bad weather events intervening.

For example, in 2000 a BP chemical plant in Decatur, Alabama emitted 48,000 pounds of benzene, a known human carcinogen, and then rose to 62,000 pounds in 2001, according to data from the TRI Explorer program on the EPA website. In 2002, the releases dropped to 16,000 pounds, but the next year they increased six-fold to 104,000 pounds.

"Looking just at the even-numbered years at the BP Decatur plant, emissions declined 80 percent, but looking at the odd-numbered years, the data shows pollution increasing by 70 percent," said Eric Schaeffer, director of the Environmental Integrity Project (EIP). "When emissions are jumping back and forth five or even ten times higher or lower from one year to the next, it isn't hard to see why collecting data every other year just doesn't work."

Those concerned with the proposed changes can voice their opinion during the public commentary period through the EPA website or the website. A website for OMB Watch, which holds the White House Office of Management and Budget (OMB) accountable, links to seven different action alerts with templates for submitting comments on the proposed change, as well as to a report on the issue.

Friday, December 16, 2005

$10.1 Billion Verdict Against Altria Reversed

Something like 83 percent of socially responsible "negative screeners" have a screen for tobacco companies, so for those, this headline is relevant. The stock responded by moving to an all-time high.

As I've stated in previous posts, I think it is high time that the whole SRI business re-think the concept of negative screening (screening out bad actors like alcohol, tobacco, and gambling). Does a tobacco CEO really care that there is a discount on his stock because some investors refuse to buy it? If you consider that this has zero impact on his ability to deliver earnings, I doubt it. Tobacco companies are used to dealing with a "tort" discount, which I promise has a greater effect than SRI screening. Plus, there are always value (as opposed to values-based) investors that are there to scoop up a cheap stock with good cash flow.

The more productive use of SRI Screens is to identify those companies that integrate sustainable practices for profit. I live in Austin, home of Dell Computer. In fact, for a brief period at the beginning of this decade and after I had sold Daylight Online, I worked for that company, selling corporate systems.

The problem of electronic waste has always been a threat to the computer industry. The Wintel duopoly was successful in creating "planned obsolescence", which created the need for individuals and companies to replace aging computers every three years (on average). The innards of a typical computer has enough lead and mercury to cause concern for ground-water poisoning.

Dell was among the first PC-makers to recognize the value of recycling. Most IT-managers have a graveyard of old PC's, keyboards, and monitors that are too old to use and too expensive to dispose of properly. Dell stepped in and offered free recycling of old machines when a new one is purchased. It costs Dell about $25 per unit that it recycles, but the benefits are:

  • They solve a problem for the customer by getting rid of the graveyard, enhancing customer loyalty.
  • They get the machines from competitors out, and machines from Dell in.
  • They get a sale.
  • They get the satisfaction of helping the environment, and all the positive publicity that comes with it. And, boy, have they milked it.

Recycling has gone from a cost to a profit-center for the company with a little re-thinking of the standard model. This is type of practice that SRI practitioners need to pounce on, opening dialogues with the company, creating shareholder resolutions to get them to re-think their wasteful ways.

Thursday, December 15, 2005

What's Your SRI Style?

After several posts that focused on the financial aspect of SRI, now I would like to get back to the social aspect. This is pretty basic for those that are already on the SRI bandwagon.

Many people view Socially Responsible Investors as a bunch of fuddy duddies who want to screen out tobacco, alcohol, and gambling companies, but it is so much more. For one, there are more issues than those big three: weapons, animal testing, nuclear power, adult entertainment, corporate governance, board diversity, labor relations, etc. For two, SRI is not just about screening out the bad guys from your portfolio. I have come to the conclusion that the bad guys really don't care that some people are screening out their least, not yet. This is called a positive screen. You look for those companies making progress on emissions, waste, and other drains. This practice does not and should not have to be a money loser. Eliminating wasteful processes means that your operation is leaner, cheaper, or faster.

Even when positive and negative screening are considered, there is still much to flesh out. Consider these questions:

  • Do you believe in screening out companies with a history of bad behavior, even though they are currently making great strides? Case in point: General Electric. In the history of corporate polluters, GE ranks as one of the most prolific. However, today, GE is a company that is on the forefront of being clean energy technologies to market through their GE Wind and GE Osmotics (water usage) subsidiaries.
  • Can a company be a little bit pregnant? Would you screen out all cosmetics companies because of animal testing, or would you still invest in, say, Avon Products, which is the best of the sector in this regard?
  • Are you an activist? Do you care about your shareholder privilege of filing shareholder resolutions to affect a company's policies, or is your method of voting by selling a stock?
As a business, SRI needs to be about more than screening. I don't think the CEO's of large tobacco corporations care about the small fraction of potential shareowners who won't invest in their companies.

What do you think? I'm interested in those comments.

Tuesday, December 13, 2005

The Cost of Cashing in a 401(k)
The post below is an article for a First Sustainable Ad Campaign with CareerBuilder, the large job site. It is aimed at job changers.

You read our banner correctly. Hewitt Associates, the large human resources and outplacement firm, estimated in a 2005 study that nearly half of all job changers choose to cash in their
401(k) when they leave their jobs. One half of those who cashed in their 401(k) were unaware that they would incur substantial penalties if they did so. These penalties can easily wipe out fifty percent of the retirement nest egg you worked years to build up.

Cashing in your 401(k) rather than rolling it over to an IRA or another qualified plan is devastating to your future welfare in so many ways. First, let’s talk about present-day penalties. It may seem to be the easy thing to do to just cash in your 401(k), especially if you may be looking at a period of unemployment, but doing so incurs the following penalties:
  • 20% Withholding Tax. That’s right. If you withdraw $10,000 from your 401(k), you will only see $8,000 because your employer is obligated to withhold 20 percent.
  • Tax on Ordinary Income (less what is withheld). That $10,000 is taxed as ordinary income, regardless of your cost basis. The highest bracket is 39.6 percent
    (assuming the Bush tax cuts do not get renewed). Whack away another 19.6 percent, since the first 20% was withheld.
  • State Tax on Ordinary Income. If you are in an income tax state, they will ask for their cut, too. This adds up to as much as an extra six percent.
  • 10% Early Withdrawal Penalty. The IRS will not care how tough your circumstances. If you withdraw before age 59 ½, you will owe another 10 percent off the top.

If you have a large lump sum, just the distribution itself could put you in the highest tax bracket. The total haircut is as high as 56 percent, depending on your federal tax bracket, your state tax bracket, and your age.

It gets worse. Consider that the money you withdrew can no longer be used to compound
tax free. Though it seems far off, this is the most damaging aspect of your loss. Consider the table below. Assuming you achieve 7 – 11 percent average annual returns (these are very
achievable rates, based on historical averages), you can see that, by cashing out, you are foregoing many times the amount of your withdrawal. That $10,000 withdrawal could pay for several years of your retirement. Use the “Multiplier” column to determine how much you would forego based on the lump sum in your plan right now.

You should take control of your retirement funds, but leave them in a qualified plan. Any reputable 401(k) administrator will make it easy for ex-employees to roll their retirement funds into an IRA Rollover account or the next employer’s qualified plan. Both actions will not incur any penalties.

At First Sustainable, we enourage customers to roll it into an IRA Rollover account. This gives the investor the maximum control by enabling you to have the widest array of investment choices to match your age, goals, and risk tolerance. We can help guide you through this process, and we invite you to have a free consultation with a Registered Investment Adviser. Call (800) 774-3319.

Monday, December 12, 2005

Reason #1 to Fire Your Mutual Fund Company

Tenth in a Series

This is the last in my series 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 #1 – There are better, cheaper, less-risky alternatives

As I have said many times in this series, active management would be palatable and worth the outsized fees charged by mutual fund companies if they consistently delivered superior performance compared to a pre-defined benchmark, but they do not. Less than forty percent of actively managed funds beat their benchmarks in any one year. Over several years, that percentage becomes infinitesimal. If I have not convinced you yet of the superiority of passive strategies, then I recommend you re-read some of the previous posts. The point of this post is to outline the vehicles that enable you to get these results. While I admit that I am biased, I will attempt to be balanced in the discussion by explaining the drawbacks.

Separately Managed Accounts (SMA’s)

At First Sustainable, this is the vehicle we recommend for investors with $50,000 or more to invest. An SMA is an account that is set up by your investment advisor, which allows you to hold your own portfolio of well diversified instruments. The advisory makes its money by either charging a fee as a percentage of assets under management, a flat fee per year, or an hourly fee for the advisor’s time. Trading commissions are either nominal or free. Your adviser should take into account your needs and then arrive at a portfolio that is, for lack of a better term, the “YOU” Index.

Benefits. I love this vehicle, and here is why:

  • Your portfolio is completely tailored to your needs. You do not need to study every prospectus that comes to your door to see if a fund’s strategy has changed without your knowledge. Periodic rebalancing is all that is required when your financial situation changes.
  • You and your adviser can be patient. Because the adviser is getting paid from assets under management, there is no incentive to churn your account, which as I’ve demonstrated, destroys portfolios.
  • At least with First Sustainable, you can buy fractional shares of individual equities, enabling your portfolio to be spread among dozens, if not hundreds, of instruments. This factor accounts for why this vehicle is only now catching on. Until technology enabled this feature, an SMA only made sense for the very wealthy.
  • The above factor means that you can still invest periodically without messing up your asset allocation. Before, indexing in an SMA was only good for investing a lump sum. Now, you can set up a disciplined savings program.
  • Because your turnover should be lessened, your annual tax bill should be decreased.

Drawbacks. Your adviser will likely not have a published track record. Even if one was available, it would not necessarily be an adequate measure of your adviser’s competence. This account should be tailored to your specific needs, and thus, not comparable to anybody else’s portfolio, thereby making a comparison useless. At First Sustainable, we overcome this aspect by making available indexes that we subscribe to. These indexes do have track records and professional oversight.

What to Watch Out For. Do not let your adviser place you in this account if he is going to, in turn, recommend vehicles that also have high expenses. For instance, paying the SMA fee for the privilege of getting placed in other actively managed funds is not a good deal, as you are paying twice. Advisory firms get paid twice this way, and it should be outlawed. Yet, this is a common practice among our less dutiful competitors. The ONLY time this would be an acceptable practice is if your portfolio is small enough that the adviser recommends VERY LOW COST index funds or ETF’s. Even then, you should insist on a reduced SMA fee.

Index Funds

As investors have awakened to all the drawbacks of active management, these funds have exploded in popularity. They are essentially mutual funds that attempt to mirror the performance of an index. The most common indexes are the S&P 500, Russell 3000, Dow Jones Industrials, and a Total Market Index comprising all of these indexes. However, there are dozens of indexes for which funds are created. It is important that you and your adviser are capable of assessing the suitability of this index for your situation.


These funds have the lowest expense ratios around. The largest funds have expense ratios in the .05 percent range (that is .0005). A typical actively managed fund charges 3500 percent more.
They offer instant diversification
They require less research up front and less ongoing research.
They are ideal for investors who are just starting out with a small, disciplined savings plan.
Because indexes do not have high turnover, they are usually more tax efficient than actively managed funds.

Drawbacks. Not all index funds are created equally. First, some funds still claim to be low cost, but still charge well more than the stingiest funds. Many S&P 500 funds still get away with charging .5 percent, or ten times what the largest funds charge. Second, most indexes are created on a market capitalization basis. This means that their weighting is based on the company’s total market value. This could lead to an overweighting of the high PE stocks that are most likely to retreat in a correction.

Exchange Traded Funds (ETF)

An ETF is a closed-end fund that is comprised of an index and trades like a stock on an exchange. Like their open-ended counterparts, there are dozens of alternative indexes than the most popular Spiders (S&P 500), Diamonds (Dow Jones Industrials), and QQQ (Nasdaq 100).

Benefits. Because they trade on an exchange, they are continuously priced. Most open ended funds are priced once a day. This allows an investor to take advantage of short term moves. Some (including me) would say this is a drawback.

Drawbacks. Closed end funds still carry an expense ratio. Theoretically, this should be less since the management company does not have to deal with inflows and outflows. The largest ETF’s are less expensive for the most part. The less famous ETF’s still carry a high expense ratio, which is not as well disclosed.

I hope this series has been helpful. I would be interested in your feedback.

Thursday, December 08, 2005

Reason #2 to Fire Your Mutual Fund

Ninth 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 #2 – Technology Eclipses Their Reason For Being

Mutual funds gained popularity for the reasons down below. I maintain that both of them are now made obsolete by technology.

Economies of Scale Mean Lower Costs For Shareowners. On paper, the explanations sound great, but let us look at the evidence. What expenses are involved in running a fund?

  1. Trading Commissions. As I have pointed out in previous posts, this should be the primary benefit, but the evidence shows that mutual funds are not getting better prices than any ordinary investor can get. In fact, in many cases where soft dollar arrangements are concerned (See Reason #10), they are getting far worse. Before commissions were de-regulated in the 1970’s, this factor was reasonable. Getting cheaper commissions meant having a
    technology and trading infrastructure that was too prohibitive for the small
    investor. Today, this technology is available to everybody. Discount brokers use ECN’s to execute their customers’ trades, just like the mutual funds do.
  2. Shareowner Communication such as statements, proxies, confirmations, etc. There are expenses for printing and mailing these confirmations to be certain. However, proxies are only necessary because of the mutual fund structure. Statements and confirmations are required by regulations.
    Your broker sends these for free as part of the commission you paid.
  3. Management Salaries. Certainly, these cost money, but the evidence shows that shareowners are paying way more for these than they
    A multi-billion dollar fund manager is likely to have a salary in the high six figures if not in the seven figures. Who sets these salaries? The fund board. Although they are supposed to have a fiduciary duty to protect investors, their salaries are probably determined by two factors: their achievement versus the benchmark and their ability to attract assets.
    As we have seen, the latter factor has been more bane to existing shareowners than benefit. So, why is he worth millions, especially when most of them fail to reach their benchmarks?
  4. Administrative Expenses such as office space, office technology, travel,
    lodging, meals for staff, etc.
    Often, these expenses get paid by third party vendors in exchange for trading flow (See Reason #10), and investors end up paying far more for these items than they should. Furthermore, there is no rational reason for the fund manager to be parsimonious with his shareowner’s money. These expenses should come out of the management fee, but instead they are passed on to investors. So, ask your fund operators if they are flying coach instead of first class.
  5. Stock Research. This would be a worthwhile expense if the research enabled the fund to outperform, but as we have seen, it has too seldom been a difference maker. In the last few years, the public has seen
    how little value professionals place on this research. In fairness, it’s difficult for any buy-side investor to know if what is coming out of analysts’ work is worthwhile or fluff.

The second reason for a fund’s existence, as touted by the industry, isnstant diversification. I am absolutely on board with diversification being necessary and worthwhile. But, is getting diversification within the structure of a mutual fund worth the two percent or so that most investors are paying in management fees and expenses? The answer here is less clear, so one must look at the
alternatives. Index funds provide the ultimate diversification at a much lower cost. Exchange Traded Funds (ETF’s) provide diversification, although many of
these charge a management fee as high as 1.5 percent as well. Most of them charge well below one percent, and the biggest ETF’s are in line with the least costly index funds. On this point, the question hinges on whether
active management is worth getting dinged several times what one would be
charged otherwise with passive management. As we’ve seen, very few active managers are able to outperform their benchmarks over the long term.

To see if the mutual fund industry is drinking its own Kool Aid, one need not look any further the long term trend in expenses and management fees. In the last twenty five years, assets under management have skyrocketed from the low billions to approximately $4 trillion today (down from about $7 trillion at the peak of the market). Using their rationale, fund expenses should have decreased dramatically. Instead, they have gradually increased, before you take into account off-balance-sheet expenses such as soft dollar arrangements.

I am an advocate of Folio Investing. This style means that an individual investor, after consulting an adviser, buys into a diversified, asset-allocated portfolio that is appropriate for the individual’s stage in life, risk tolerance, and spending goals. Technology enables us to buy fractional shares of individual stocks, making it possible to create your own little mutual fund without the exorbitant fees and self-dealing. First Sustainable practices this method. I invite you to get a consultation by calling 800-774-3319.

Tuesday, December 06, 2005

Reason #3 to Fire Your Mutual Fund Company

Seventh 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 #3 - Chasing Performance

Just as fund companies tend to overstate the expertise level of their youthful, call-center "investment advisers" (see Reason #5), management also tends to attribute what the evidence shows to be more-or-less luck to extraordinary investment acumen. As I've said before, the exorbitant fees charged for active management would be well worth it, if superior returns were consistently delivered. But, the returns are not being delivered, and the fees are mostly not worth it (especially the overpriced, advisor-pushed funds). What's worse, while I concede that in any given year, two thirds of fund managers will beat the market, that percentage decreases dramatically as the time horizon lengthens. In fact, using a manager's good track record has been shown to be one of the worst things you can do when picking a fund. The maxim of past performance as no guarantee of future results is right.
In fact, superior past performance is almost a guarantee of sub-par results in the future. If you read the advertisements for mutual funds in the business pages, they are likely accompanied by smiling, happy, healthy people and in big numbers, the 1, 5, and 10 year returns on the fund. If they are really gutsy, and have happened to beat the S&P 500, they'll compare those numbers with the index as well. However, this only tells part of the story. First, every well managed fund that delivers consistently faces a huge upsurge in dollars to invest, making it harder to deliver those outperforming returns. Do they make this clear in the advertisement that the superior returns delivered many years ago are harder to come by now that they have 10x or more to manage? No. Second, one of the true benefits of operating a huge fund complex with dozens or hundreds of funds means that, at any given time, one of them will be outperforming. This means that the funds are touting what is hot at the moment, keeping silent about their underperformers, and exacerbating the first problem. I am reminded of the book maker who makes ten picks a week, so that he can be sure to have some correct calls to tout the next week.
The “Hot Hand” theory, as espoused by University of Illinois Finance Professor Josef Lakonishok, tells us that any fund manager who outperforms one year can expect to continue to outperform for a maximum of 10 subsequent quarters. Lakonishok attributes this to market momentum more than any investment acumen. As money pours into that manager’s fund and funds like it, asset prices are bid ever higher. After the period of overperformance, if there is indeed one at all, the manager is more than likely to underperform, and sometimes drastically underperform. The key takeaway is that you should not be enamored with advertisements of hot funds.

On top of this phenomenon, you should be aware that herd mentality makes it difficult for any fund manager. On a macro level, history bears this out. For example, in the early stages of the 1990’s bull market, fund inflows were about one tenth of the level in 1999-2000, when the market was at its peak. Conversely, fund outflows were at their peak in 2002-2003 when the market was at its bottom. The result was a $4 trillion dollar hickey to the small investor in the form of paper wealth vanished. To the extent that the fund industry continued with their deceptive advertising, they deserve some blame.

Tomorrow: Reason #2 – Technology Eclipses Their Reason For Being

Monday, December 05, 2005

Reason #4 to Fire Your Mutual Fund Company

Seventh 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 #4 - Short Term Speculation

For most of the history of the Mutual Fund Industry average annual turnover hovered around 15 to 20 percent. This means that 15-20 percent of the funds portfolio changed each year. Put another way, the average holding period for a stock in a mutual fund portfolio was 8 years. Starting in the late 1970's and accelerating in the mid-1990's, average annual turnover is now 100 percent. Put another way, the average holding period is now less than one year. So, while preaching that a steady, long term approach was appropriate for their customers, the industry has itself moved from a stock-ownership mentality to stock-rental mentality.

I am going to save for another day the discussion about how this makes it more difficult to achieve results commensurate with the enormous fees levied. Be aware that this is aspect is the biggest problem with a short-term mentality. However, there are quantifiable reasons to avoid high turnover.

How High Turnover Hurts You

I keep returning to this point. High fees and expenses are the primary reason that mutual fund performance lags their benchmarks. Some are more transparent than others:

1) Trading Commissions. This is not disclosed in the fund's expense ratio, making it harder to compare the true costs among funds. As I've mentioned in previous posts, you would think that a sizable mutual fund would be able to get competitive commissions, but in actuality, many of them pay far more than any individual can get, thanks to soft dollar arrangements (See Reason #10).

2) Taxes. If a fund manager sells a position for more than was paid, the fund is obligated to pass that through to investors (see Reason #8). If the holding period was less than one year, the gain goes into the "short term capital gains" basket. This is taxed as ordinary income. If the holding period was more than one year, the gain goes into the "long term capital gains" basket, which has a lower rate. So, if your fund has an abundance of short term capital gains, you are paying up to 250 percent more in taxes for short term gains than long term gains.

3) Spreads. Almost all stocks have a spread. When you see a price quoted with a bid (the price at which you can sell), and the ask (the price at which you can buy). The difference is the spread. On the most liquid stock, this amounts to pennies per share. On the lower-volume and international stocks, the spreads are wider. This can amount to a serious drag.

4) Slippage. This refers to the difference between the price that was received for a buy or sell order, and the price at the time the order was given. For funds with sizable positions, you can bet that heavy buying will raise the price, and heavy selling will lower the price. Even relatively small lots of 1,000 shares will move the market in the less liquid stocks, so imagine how this affects a multi-billion dollar fund.

None of these factors are figured into the expense ratio that was quoted in the prospectus or other marketing material.

How We Got Here

Many factors contributed to the rise of speculation among the stewards of your nest egg, some understandable, some nefarious.

1) The deregulation of commissions. The 1974 rule-change dropped the bottom out of the cost of executing a trade. This made short term trading more feasible, but it also created a need for Wall Street to substitute the lost revenue. They found it. In 1970, the average daily volume was 15 million shares. In 1990, it was 300 million. In 2000, it was 3 billion.

2) The rise of IT. Computer technology enables quants (the wall street term for a manager who makes trading decisions based on computer algorithm) to plug in a vast array of data points into their systems. The result is a whole lot more buy and sell signals.

3) Captive mutual funds trading through parent-company brokerage operations. This allows fund companies to pass some vigorish on to their corporate parent without disclosing it.

4) Soft dollar arrangements. Managers are showered with perks in order to direct more volume the way of brokerage houses.

What To Do

The body of academic studies makes one thing painfully clear. There is an inverse relationship between average annual turnover and fund performance. You would have to think that otherwise bright fund companies would know this, and adjust their fund management styles accordingly. Unfortunately, I think the evidence tell us that they do know about it, but that changing their style means less in their pocket.

Tomorrow: Reasons #3 - Chasing Performance

Saturday, December 03, 2005

Reason #5 to Fire Your Mutual Fund Company

Sixth 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 #5 - Fresh out of High School "Investment Advisers"

The fudging of expertise is appalling in our business. Believe me, I know. I am 35 years old now, and have been in the financial services business 13 years now. When I was 22, fresh out of the University of Texas with a History degree, my first job was with Fidelity Investments as a mutual fund adviser. I passed the Series 6 exam in a matter of days. After a few weeks of training, most of which was listening to one of the more tenured reps (by "tenured", I mean someone with six months experience), I was on the phone taking calls from all over the country, advising people on how to take care of their financial future. If you had called an 800 number on a prospectus or an advertisement, you would have been speaking with someone like me. Dozens of reps like me fielded calls, and not one of them had more than three years experience. I, myself, only lasted a year and a half in that job. Call center work has a way of burning you out.

In the 1990's, Fidelity was undergoing rapid growth, and they could not keep the place staffed. They had planned on staffing to a level where no more than five customers were holding at any given time. Shortly after I arrived, we were constantly on "red alert", which meant that 30 people or more were holding all the time. So, they relaxed their hiring requirements. They had previously insisted on a college degree for their newly hired reps. Soon, I was sitting next to pimply-faced 18-year-olds who had been in a high school classroom only a few months prior. Looking back on it, who was I to feel so superior? It's not like I learned how to plan someone's financial future in my "Western Culture, 1865-present" seminar at UT.

Think about that, though. Customers were entrusting their retirement plans to kids. If you go to Fidelity, Schwab, E*Trade, TD Waterhouse, Ameritrade, T Rowe Price, Ameriprise, or any of the other purveyor of mutual funds, and click on their links to "talk to an adviser", it is usually accompanied by a smiling, healthy, slightly graying middle-aged man with great teeth and his own corner office. In fact, you are more likely talking to a very young, underqualified, underpaid call center worker who barely has a cubicle and is definitely NOT smiling.

Of course, it is true that it does not take grand expertise to do what they do. Back in my day, we were given a script to inquire of a customer's marital situation, age, risk tolerance, spending goals, and that is it. With that information, there was (wait for it) a Fidelity fund that met their needs. This is how it works at most firms. You need what they are selling. Financial planning requires more than that.

All investment products should be discussed in the larger context of a person's life -- not just financial life, either. If you take no other advice from me, take this one tidbit. If a "financial adviser" is selling you a product from which he is getting paid a commission, he will not have your best interests at heart. Period.

Tomorrow: Reason #4 - Short Term Speculation

Friday, December 02, 2005

Reason #6 to Fire Your Mutual Fund Company

Fifth 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 #5 - Enablers of Poor Corporate Governance

An entire book could be written about the happy conspiracy between corporate managers and the investment community that pads both pockets at the expense of the everyday shareholder. In fact, one has been written. You should check out "The Battle for the Soul of American Capitalism" by John Bogle, the founder of the Vanguard Group. Bogle has been one of the few mutual fund industry luminaries that publicly decry the abuse taking place. It is an easy read. Check it out. Many of the top ten reasons are touched on in this book.

Over fifty percent of corporate America is owned by the top 100 financial fiduciaries. One would think that this alone would make them the most vigilant voices in the boardroom. In fact, few mutual funds demand accountability from management, and in many of the most egregious cases, they are guilty of downright aiding and abetting the fudging of numbers and the looting of otherwise good corporations. Why? Two glaring conflicts of interest prevent the industry from becoming the activists that they should become.

First, every company is a potential client for 401k and pension administration. Over half of invest-able assets are in defined contribution plans (401k, 403b, etc) or defined benefit plans (pensions). Company management gets to decide who handles these assets on behalf of their employees. Corporate managers who take a dim view of shareholder activism (and who does, except those that are abusing shareholders?) are unlikely to award this business to institutions who meddle too much. Management wants shareholders to blindly follow the recommendations of management. Shareholders who file corporate resolutions and offer up competing board slates are not likely to get a piece of the company's investment assets.

The second conflict is similar to the first. So many of the mutual fund industry's parent companies also have operations in investment banking. They are reluctant to raise hay because offending their management clients may result in their firms being left out in the cold when it comes to investment banking deals.

This is really a shame. Mutual funds have the expertise, the resources, and the position to demand accountability from management. Instead, management has used the diffusion of corporate ownership to increase their pay, fudge the numbers, cut sweetheart deals, etc. Bogle calls this a transition from "owners' capitalism" to "managers' capitalism".

Tomorrow: Reason #5 - Fresh Out of High School "Investment Advisers"

Thursday, December 01, 2005

Reason #7 to Fire Your Mutual Fund Company

Fourth 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 #7 - Alphabet Soup of Sales Charges

If most people can not easily explain how they are getting charged for services, you can almost always bank on a rip-off in your midst. Such is the case with many mutual funds and their "fund classes". Just like when a corporation offers up shenanigans like "super-voting" shares, grab your wallet.

Get this. The same organization with the same portfolio and same manager can have "A" class, "B" class, and "C" class shares. In some extreme cases they can also have "D", "E", "Z", and more, but these are rare and we will not go into them here.

"A" shares generally refer to the shares that have a front end "load" or sales charge. This is normally in the 3-5 percent range. This means that 3-5 percent of your investment comes off the top before it is even invested. Your $100k investment just became $97k with a 3% sales load. This sales charge is often split with the financial adviser, mutual fund supermarket, or other intermediary who placed you in this fund. Oft maligned, load funds are not always the worst possible solution. In many cases, the ongoing management fee that is charged every year is often lower for the "A" shares. If you intend to hold the fund for a long period of time, then this might actually be the cheapest way to go. More on this later.

"B" shares waive the front end load, but instead employ a contingent deferred sales charge (CDSC), or a back end load. In plain English, this means that you are not charged up front, but if you redeem your shares from the fund, you may face a sales charge. The most prevalent CDSC's are those that are reduced or phased-out over time, say seven years. If you hold the fund for seven years or longer in this example, you pay no front end or back end load. Why the complexity? The aforementioned intermediaries are likely to want their vigorish up front, so the fund obliges them, but wants to make sure they will get their money back from you. Placing these onerous restrictions enables the fund to at least cover their out-of-pocket expense for recruiting you. Again, "B" shares can be the cheapest alternative for a specific fund if you have a long-term horizon.

"C" shares have neither a front end nor back end load. However, it is likely that if a fund has this alphabet soup in the first place, the ongoing management fee is going to be higher than the "A" or "B" shares. Therefore, while every penny of your investment is put to work right away, over a long investment horizon, you may be paying more.

Which Class is Right For You?

With very few exceptions and for several reasons, the answer to this question is none of these classes are right for you. In fact, if you are presented with these fund options, you are likely getting hosed by your investment adviser. The reasons these classes exist is so that fund companies and advisers, two fiduciaries who are obligated to have your best interests foremost, can arrange how to split up your money. I am a firm believer that, in that circumstance, your interests will not be put first. By and large, the funds that employ these practices have a higher than average total expense ratio. I will always come back to the principle that the most reliable way of tweaking your mutual fund performance is to pick funds with low expenses and low turnover.

Most of the fund companies employing this method also have in-house advisory or brokerage services. Surprise, surprise. The real reason they love this method is that sales charges lead to immediate money for them. In theory, they are correct is saying that long-term horizons will make the loaded funds cheaper. However, let me be clear on this point, because I came from this culture myself. In a few months, or years, they are going to call you up again to advise you to switch funds, and ding you again. It sickens me. Really.

There Is A Better Way

To me, there are three superior approaches than buying class-laden funds, and only one of them involves a shameless self-promotion. :-) First, there are dozens of well managed, low cost, actively managed funds. Your adviser will not mention these, because he does not get paid for selling them to you. Second, I keep coming back to indexing and index funds. They are mostly low-cost, low turnover, and class-free. The principle mentioned above explains why I prefer this method over the former. Third, folio investing offers the benefit of zero cost, long holding period, tax advantage, and social screening. First Sustainable's program enables investors to, in effect, create their own mutual fund, based on their long term needs and social criteria. I invite you to get a free consultation.

Tomorrow: Reason #6 - Enablers of Poor Corporate Governance