Conversations - Winter 2002

Content:
News
Investment Philosophy
Index Funds Are Not Created Equal

LWA NEWS

We have some new office space!  We have taken over the building connected to our Building #1, previously occupied by Burgdorff Realtors.  This building was the original courthouse.  We’re actively working on moving into this space and hope to be settled in by the end of January. 

We’re pleased to let you know that Roxanna Pletchan and Pat Daquila have returned from their leaves of absence just in time for the beginning of tax season!  It’s great to have them back in the office.

Diahann has been elected Treasurer of the Board of Directors for Center for Women’s Business Research (formerly National Foundation for Women Business Owners).  The Center is the premier source of knowledge about women business owners and their enterprises worldwide.

Clare was quoted recently in Time Magazine.  The article entitled “Don’t Bet it All on Your Employer” concerned the risk to employees of having a large proportion of their 401K investments in their company’s stock.

Diahann appears in a commercial for the New Jersey Society of CPAs that begins airing on New Jersey Network (NJN) in mid-January during the BBC News segment.  Diahann says this is definitely not the start of a new career.J

Diahann will appear next on CNBC’s “Make Your Money Work” segment of Power Lunch on January 15th, February 14th  and  March 13th.

INVESTMENT PHILOSOPHY

By Diahann W. Lassus, CFP®, CPA

In a discussion with a client, it was brought to my attention that sometimes we need to review our overall philosophy and why we do not believe in having “just” a portfolio of individual stocks.  He suggested I should share what I wrote to him with the rest of you.  After some thought, I decided that he had a great idea.  Here’s an edited version.

If you believe in only one type of investment philosophy, like growth or value, you invest and hope that you do OK when the market turns against you.  Sometimes it works and sometimes it doesn’t.  That is basically what a money manager or fund manager does when they invest in individual stocks.  They invest in one area according to their philosophy and hope they make it through other types of markets.  I don’t believe that any “one” manager can be right all the time.  That means that the risk is extremely high.  Take for example Janus Fund.  If you had believed in that philosophy and hired the Janus folks to manage an individual portfolio of stocks for you and all of your equity investment was in that manager’s hands, your losses could have been significantly higher than they were with funds.  The flip side is yes – if they guess right, you have the “possibility” of doing better than a portfolio of funds, but again the risk is the issue.  Just look at what happened to Lucent, Enron, AT&T and many other individual stocks in the last year.

Currently, I have truly begun to lose faith in the ability of any group to outperform the market on a consistent basis, especially in the current type of environment.  That is why we are moving more and more toward the ETFs or Exchange Traded Funds that are basically index based.  With these we can control tax liability as effectively as you can with individual stocks, the expenses are very low and we know we will never under-perform the market.

Next, the reason we rebalance is to take profits when something is doing well so that it does not take over the portfolio and increase the risk level.  At the same time, we want to buy low or cheap when some investments are down.  Just because an investment has gone down in value does not mean it is a bad investment.  If a fund has lost 20% but the average fund of its type has lost 30%, it may still be a good investment ..and you want to buy it when it is out of favor.  The discipline of rebalancing based on targets is to make sure that you continue to buy at low prices and sell at high prices.  It really does work, but I know it sometimes feels very wrong.  It is hard to buy something that has fallen in value and even harder to sell something that has done very well.

When we review each of your accounts to determine whether we need to rebalance specific holdings, we go through several levels of review.  The first is that the account is reviewed and preliminary recommendations are made by one of our Investment Analysts or Planning Associates.  I then review them based on performance, tax consequences and the cost of making the changes.  If our “Model” (the target established for each investment) says to sell some of an investment and I decide to hold it, that typically means either the tax consequences are too high or it is not cost effective to sell at that point in time. 

Please let us know what you would like to learn about in our newsletter.  We want to provide a useful source of news and to answer questions you may have. 

Have a great Quarter!!!!!!

 INDEX FUNDS ARE NOT CREATED EQUAL

By Gigi Collins, CFA

An index fund is an index fund is an index fund.  Well, sort of.  Almost everyone agrees that index funds are an important part of your portfolio because they are “cheaper” than active funds and their performance “matches” the performance of the market.  But not all index funds are created equal and here is why.

The Index

Because index funds are so popular, there are lots and lots of index mutual funds out there to analyze.  The most important aspect of an index fund is:  what index does the fund track?  The most popular index is the S&P 500 Index which tracks the top 500 companies in the U.S.  There are small company indexes like the Russell 2000, foreign stock indexes such as the MSCI EAFE, indexes that track bonds such as the LB Aggregate and even a “total market” index called the Wilshire 5000.  Each index is composed of different company stocks or bonds and is calculated based on market capitalization weighted, price-based weighted or equal-weighted.  For example, the S&P 500 is composed of 500 US large capitalization stocks and is calculated based on market cap. 

Each index has its own performance that matches the performance of the underlying stocks or bonds that it holds.  So, before you invest in an index fund….you have to know what index you want to invest in and pick a fund that is focused on that specific index. 

The Expenses

The single most important factor that affects a mutual fund (index or not) is the expense ratio.  This is what it costs to run the fund.  The expense ratio is what the fund charges the fund shareholders on an annual basis.  The expense ratio represents the expenses of managing the fund as a percentage.  It is taken out of the performance of the underlying investments, so it reduces the performance of the mutual fund.   

Expense ratios for index funds are generally less than expense ratios for actively managed funds.  However, even among index funds you will find a range of expense ratios.  For example:  Index fund expenses for funds that track the S&P 500 index range from .19% up to 1.5% and for funds that track small cap stocks expenses range from .27% up to 1.8%.

Because funds have expense ratios and indexes do not, the performance of the funds will be less than the index that they track by the amount of the expenses.  So you can see that expenses are a very important factor when choosing your index fund (or any fund for that matter).

Tracking the Index

In some cases, index funds can’t physically buy all the stocks that are in an index (like in the case of the Wilshire 5000).  In that case, the index manager has to decide what they will buy and what they won’t buy.  The bottom line is that whatever they do buy, it must perform to match the index.  So index managers use techniques like sampling or modeling to decide what to buy.  You can see that once again, this will have a direct impact on the performance of the fund versus the index.  If the manager picks incorrectly, they may have a lower (or a better!) performance than the index that they are trying to track.  And each manager is different, so index funds that track the same index may have different performance.

There is even a mutual fund that is based on the S&P 500 but hedges risk through puts and calls. The result is modest losses -- and modest gains -- when the market is making much wider swings.

Conclusion

These are some of the factors that go into our analysis when we look at index funds.  It is important to understand the index that you are investing in and then pick a fund that has reasonable expenses.  Index funds have an important role in your portfolio and they must be monitored just like all the rest of your investments. 

Thank You!

Everyone in business today recognizes how difficult it is to move forward in a slowing economy and an uncertain world.  We wanted to take a minute to say Thank You.  Thank you to all of you who have supported us in so many ways.  A special thank you to those who have referred friends and helped us to grow in such a difficult time.  In a period of such turmoil in the world, we are very grateful for the tremendous relationships we have with each of you. 

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