Hey, groovy gals and guys, let’s take the investing Wayback Machine to 1973. What’s this? No 401(k)s? No IRAs? No exchange-traded funds? No index funds at all!

In other words, investors were screwed. Into this wasteland came A Random Walk Down Wall Street, by an economist, Burton Malkiel, who compared stock market analysts to dart-throwing monkeys and argued that we’d all be better off if we could just invest directly in the S&P 500. Two years later, John Bogle established the first index fund (the Vanguard 500, VFINX). If you own an indexed stock or bond fund–and you should–you owe a debt to Burt Malkiel.

Random Walk came out in its tenth edition this year. It now covers behavioral finance (that is, stupid investor tricks), the ongoing economic crisis, financial innovations good and bad, and why indexing still wins. Malkiel, 78, is professor of economics at Princeton University and spent nearly three decades as a director at Vanguard. He spoke with MintLife’s Matthew Amster-Burton.

This is part one of two.

The bad old days

MintLife: Take me back to 1973, when the first edition of Random Walk came out. What does the investing landscape look like? There are no index funds, no IRAs. What are my options?

Malkiel: What you typically had at that time were full-service brokers, and the biggest one was Merrill Lynch. If you made a modest, say, $1,000 or $2,000 investment, you would have a registered representative, usually suggesting a stock to you, and you would pay a commission that might be as much as $100. So that was the investing landscape.

Alternatively, the registered representative would say, “Hey, you need diversification. You ought to buy this mutual fund.” And the typical mutual fund at the time had a 7% load fee. So a $2000 investment might mean $140 in essentially a commission, of which the registered representative would get a certain proportion of it, usually 30, 35%, depending on the broker. So I would say that that was the investing landscape then, in that most of the mutual funds were load funds. There were no index funds.

And the view was, when my book first came out, “What a stupid thing to say. We know that investment professionals can do much better than the market.” And there was certainly a view that people couldn’t do things on their own. They needed these professional brokers, professional investment managers, and it was ridiculous to think that anybody could do it on their own. The idea of buying a dumb index fund was absolutely stupid.

MintLife: It’s amazing to me that you hear this criticism these days that the system is rigged against the individual because of high-frequency trading and institutional dominance of the market. It seems like it was much more rigged against the individual then.

Malkiel: I think that’s absolutely right. In fact, on high-frequency trading, look, there are some bad things you can do, like these kind of flash orders that are trying to manipulate the market that really aren’t real orders. So I’m not saying everything that’s done there is right. But one of the things that I like about it is, since I believe in index funds and ETFs, which now are the biggest growth investment product that there is, with way over a trillion dollars in it–the reason I like high-frequency trading is that it means that those things are going to be efficiently priced.

I want the guy on the street who buys a SPDR, or who buys VTI, which is the Vanguard Total Stock Market ETF–these things with less than ten basis points (0.1%) of expense–I want to make sure that they are priced appropriately relatively to the underlying stocks. Take the example of the SPDR. If the SPDR, which is an S&P 500 ETF, if it gets a little bit out of line with the underlying stocks, what the high-frequency trader does is–say the ETF is too high–short the ETF, buy the individual stocks, trade them in for ETF shares to cover the short. And this is a good thing, because what it means is, the guy on the street’s getting the right price.

So I think if anything, these things make the market more efficient and make it more likely that the individual will do, in my view, not only as well as the experts but better. And if there are a couple of loose pennies for the high-frequency traders to pick up, that’s terrific, because that makes the market more efficient.

The LinkedIn IPO and efficient markets

MintLife: Let’s talk about market efficiency. You hear lots of objections to the efficient market hypothesis, and I think a lot of them have to do with the name. People have this idea that saying that the market is efficient is equivalent to saying that the market should never go down.

Malkiel: That’s a very good point, because I think people misrepresent what the efficient market hypothesis means.

MintLife: So what does it really mean?

Malkiel: Okay, here’s what it really means. First of all, let me say what it doesn’t mean. What it doesn’t mean is that the price is always right. How could prices be right? The price of a stock, what I teach my students is, that any stock is worth the discounted present value of all of the future cash flows. So what does that mean? That means that somebody’s got to estimate a bunch of future cash flows, and nobody knows what they’re going to be. Is LinkedIn (LNKD) a bubble or not? Well, who the hell knows what the future cash flows are going to be for LinkedIn?

Nobody knows! And some people are going to think it’s a bubble because the market is discounting tremendous growth, and other people will think, hey, you don’t understand, this is really something new, and this is something that is just in its infancy, and the amount of earnings that you’re going to get from it is going to be absolutely enormous. When Google came out, people thought, oh my God, it’s a bubble, it’s a terrible thing, and in fact, Google turned out to be cheap. On the other hand, Pets.com turned out to be, if you’ll pardon the expression, a dog.

So nobody knows. The efficient market hypothesis doesn’t mean the market’s always right. The market’s always wrong. But nobody knows whether any price at any time is too high or too low. So what does it mean? What is does mean is that there are no arbitrage opportunities, by which I mean: the market, it may not be right, and in fact it’s always wrong, but nobody can beat the market.

Now, if a hedge fund is long stocks and the stock market goes up and they’re leveraged up to the eyeballs, they will beat the market, but they’ve taken on much more risk. Sometimes 25% of hedge funds go out of business in a year.

MintLife: What do you think of the argument that, okay, indexing, that’s just one philosophy among many. You can be an indexing kind of person, you can be a “watch the 200-day moving average” kind of person, and it’s just a matter of taste and there isn’t a preponderance of evidence one way or the other.

Malkiel: Well, there is a preponderance of evidence, I believe. To take your example, is the technician who follows the 200-day moving average going to do any better than the index guy? What I’ve done in every edition of the book is to say, okay, this was a thesis, that the index fund is going to do better than the vast majority of professional managers, so did it work? And every time I do the book, including the 2011 edition, I look at the data and ask whether it worked, and I would argue that the data are very clear that it works and it continues to work.

I’m not that sort of super extreme and dogmatic, but what I do say–and this is in the 10th edition–there’s at least enough evidence that indexing isn’t average, it’s above average. There’s enough evidence that it works that at least the core of one’s portfolio ought to be in index funds. Then, you know, investing’s fun. You want to go out and buy some individual stocks? You really think LinkedIn is the way to go? Go do it! You can then do it with much less risk if the core of your investment fund is indexed. So what’s in the book is kind of a core-satellite approach, and it’s really based on evidence. The evidence is that it works.

MintLife: I had someone ask me how he could use his 401(k) to buy into the LinkedIn IPO, and I said, “Maybe consider using some fun money for that instead.”

Malkiel: Well, exactly. In other words, your important money, your 401(k) money ought to be in index funds. You want to have a little fun? And it is fun. Investing is fun. I buy some individual stocks. But I can do it with much less risk because my core IRA money, and at universities we have something called a 403(b), which is the same as a 401(k), that’s basically invested in index funds.

This interview has been condensed and edited.

Tax season is over. It’s time for some portfolio spring cleaning. Let’s Roomba this sucker.

We’ve told you before why it’s important to roll over your old 401(k)s and other workplace retirement plans into an individual retirement account (IRA). It usually saves you a bundle on fees and expenses. It gives you access to better investment options. It makes your portfolio more comprehensible and easier to manage. And Mint can get you started. If you’ve worked a bunch of jobs (who hasn’t?) and left a mess of 401(k)s, 403(b)s, and SIMPLE IRAs in your wake, now’s the time to consolidate them. Get it over with.

Even if you’ve been diligent about rolling over old plans, however, you’re probably holding too many mutual funds. Walk into the office of a financial advisor—especially one who works on commission, and you’ll probably be talked into splitting your money among six, ten, twelve funds (I’ve also seen fee-only advisors do the same).

Why do they do this? One reason is that it reinforces the idea that investing is too complicated for you to handle yourself, and you should leave it to the experts who understand the difference between growth stocks and midcap stocks and international REITs and junk bonds. So when it comes time for annual rebalancing, you need to go back to the advisor. Bring your wallet.

Well, this is (to use a technical term) horse poop. We’re going to wean you down to the only funds you really need to get the job done.

Cut the clutter

Assuming you and your spouse work for The Man (i.e., you’re not self-employed), here’s what you should have in your bag of tricks when you’re done rolling over:

• Two workplace retirement plans (one for each spouse)
• Two IRAs (one for each spouse)

If you’re single, your investing life is that much simpler. But don’t you long for someone to practice asset allocation with in your twilight years? Don’t answer that.

Now it’s time to decide what mutual funds to put in those accounts. For recommendations, I turned to certified financial planner Allan Roth, author of How a Second-Grader Beats Wall Street and writer of the Irrational Investor blog. You only need three funds, says Roth:

• A US stock index fund
• An international stock index fund
• A total bond market fund

“Those are the three core funds that I get clients as much into them as possible,” says Roth. “These three funds are far more diversified than your 43 funds you have now.”

(If you’re not sure how much to put in stocks and how much in bonds, let me direct you to MintLife’s ever-useful column, The Lazy Portfolio.)

The office

Start with the workplace plans. You’re at the mercy of your pointy-haired plan administrator for fund selection here. A typical 401(k) has a terrifying list of funds with names that make German wine labels look comprehensible. All you care about, however, is what’s cheap. Every fund has an expense ratio which tells you the percentage of your money paid to the fund administrator every year. Look for the word “index” and find the stock and bond index funds with the lowest expenses.

Why? As Morningstar put it, “In every single time period and data point tested, low-cost funds beat high-cost funds.” Morningstar is the company that gives star ratings to mutual funds. In its own study, Morningstar found low expense ratios were a better indicator of success than a high star rating in 58 percent of the test cases. In a workplace plan, an expense ratio under 1% is acceptable, under 0.5% is good, and under 0.2% is awesome.

You don’t have to hold all three kinds of funds in your 401(k). My wife’s retirement plan, for example, has excellent stock index funds and a lousy bond fund. So we hold almost entirely stocks in that plan and bonds in our Roth IRAs. The key is to diversify overall, not within each account. “It’s the total portfolio that matters,” says Roth. This also makes it easier to hit the minimum opening balance for the best funds, which is often $3000 or more.

Inviting IRA to the party

For the IRAs, you have your choice of any funds offered by your mutual fund provider. Roth recommends the following Vanguard funds, but all major mutual fund companies have competing index funds:

What about ETFs? What about adding real estate, small-cap value, or commodities? “If you want to, you can specifically tailor your portfolio in various ways beyond those three funds. But you don’t have to,” says Mike Piper, author of many books on investing and writer of the Oblivious Investor blog. “Those three funds are really all you need.”

Now you can get back to the important things in life, like thinking of more “asset allocation” puns.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster. Mad props to his two favorite investing books, The Elements of Investing and The Bogleheads’ Guide to Investing, for inspiring this column.

(iStockphoto)

It’s the holy grail of investing: stock market returns without stock market volatility.

Sure, the stock market has returned an inflation-adjusted 7% annually since 1950. Unfortunately for those of us (i.e., everyone) who would like to watch our money grow steadily year after year like rising pizza dough, some years are like 1998 (up 28.6%!), and some are like 2008 (down 38.5%). That’s not rising dough. That’s a busted seismograph, spewing ink.

In an effort to court investors who are sick of watching their money disappear in a bear market, investment companies offer products that seem to promise less stomach-churning returns. Maybe you won’t get the full return of the S&P 500, the pitch goes, but you’ll reach your destination with much less volatility.

The industry calls them “absolute return” funds, and these hedge fund-like mutual funds appeared in droves after the dot-com implosion of the early 2000s. They go by catchy names like Rydex Multi-Hedge Strategies (RYMSX) and Hatteras Alpha Hedged Strategies (ALPHX).

Now, in the aftermath of the 2008-09 crash, absolute return is back. Morningstar classifies most of these funds in the “long-short” and “market neutral” categories, and money has been pouring in: nearly $16 billion flowed into these types of funds in 2010, up steadily from only $2.7 billion in 2007. Steady returns in any market? Investors seem to be saying, Sign us up.

One of the companies that launched absolute return funds at what in hindsight seems an auspicious time is Putnam Investments. Its Absolute Return family features four funds whose goals are to return 1%, 3%, 5%, and 7%, respectively, above the return on treasury bills, on a rolling three-year basis.

The funds launched in December 2008, and so far they’ve brought in $3 billion in assets and are on track to meet their goals. (Two of these funds, confusingly, are classified as bond funds by Morningstar and the other two, as balanced funds, so their assets aren’t included in the statistics above.)

Putnam says everybody needs a healthy dollop of absolute return in their portfolio. “These products have been in the marketplace for almost two years, and they are ahead of their goals, and we’ve been through some of the most volatile markets that I ever want to experience during that period,” says Jeff Carney, Putnam’s head of global marketing and products.

The company has added the absolute return funds to its target-date funds, its 529 plans, and its retirement income series. “They’re a great product for 529 [plans], because you have a shorter time frame for saving, so you actually want less volatility in your portfolio than you do for retirement,” says Carney.

The big test

So how are absolute return funds doing? The one good thing about the 2008 – 09 Recession was it effectively acted as these funds big test. How did they do on an annualized basis over the last five years?

• Rydex Multi-Hedge Strategies fund (RYMSX): -1.85%
• Hatteras Alpha Hedged Strategies (ALPHX): -0.49%
• JPMorgan Multi-Cap Market Neutral C (OGNCX): -1.17%

• S&P 500 Total Return: +2.4%
• Vanguard Balanced Index Fund (VBIAX, 60% stocks/40% bonds): +4.62%

According to Morningstar, the long-short and market-neutral categories as a whole did somewhat better than these cherry-picked examples. Long-short returned 1.18% and market-neutral 0.9%. In other words, they didn’t even keep up with inflation, and they plummeted in 2008 along with everyone else.

Why should the new generation of absolute return funds be any different? “I think it’s the skill set of the portfolio managers,” says Carney. “I think we’re very fortunate to have a team that’s been doing this for a long time in the institutional space. You don’t want a startup portfolio manager undertaking these things. I can’t speak to the other players in the marketplace and what went wrong and what didn’t.”

Absolute return has, indeed, been a fixture of institutional investing for over a decade. David Swensen, the phenomenally successful endowment manager at Yale, considers absolute return a vital part of Yale’s portfolio. As he explains as politely as possible in his book Pioneering Portfolio Management, however, there are a limited number of David Swensens who are talented enough to make money off this strategy, and most people who attempt to add absolute return to the mix end up receiving a return more like a money market account.

Similarly, Vanguard, not a company known for chasing investment fads, has an absolute return product, the Vanguard Market Neutral Fund (VMNFX). Minimum investment: $250,000. Don’t try this at home, says spokesperson Joshua Grandy. “A large part of our business is comprised of institutional clients, including pensions and endowments,” he says. “This fund is geared to these types of investors who are looking specifically for assets that are uncorrelated to the broad markets to diversify their institution’s portfolios.”

Check the label

Putnam’s funds are unique among absolute return products in that the names of the funds suggest a specific performance target. The prospectus is packed with disclaimers. “The fund may not achieve its goal, and it is not intended to be a complete investment program. The fund’s efforts to achieve lower volatility returns may not be successful.”

If the label says it’s a beef taco, customers expect to find 100% beef in the taco. What about a mutual fund called Absolute Return 700? “That was a big concern of ours and still is, that investors can misunderstand what that number’s actually implying,” says Morningstar fund analyst Rob Wherry. “They’ve put a lot of energy into explaining these things to the advisor community. But certainly, they’re the only funds in the mutual fund world that use that notation.”

“The reality is, it’s just the name of the product,” counters Putnam’s Carney. “And I think by having 1, 3, 5, and 7, we’re making it more clear, really, what the risk and return is of these products in a way that’s very transparent.” He’s not concerned about misunderstandings. “I do not worry about the promissory part, because it’s the fiduciary responsibility of every advisor to make sure clients understand what they bought.”

The problem is, the SEC doesn’t regulate the term “absolute return” the way it regulates, say, a fund with “small cap” in the name, so an absolute return fund can have almost anything in it, and many contain an alphabet soup of derivatives: interest-only swaps, collateralized mortgage obligations, and so on.

“People worry that the word ‘derivative’ means risk. It’s actually hedging the risk,” says Carney. “So it’s used in a defensive way, not an offensive way.”

Individual investors looking to dampen market volatility already have a venerable tool available to them: asset allocation. A defensive mixture of bonds and stocks, such as the Vanguard Retirement Income Fund (VTINX), made it through 2008-09 with less of a plunge than the typical absolute return fund and recovered quickly.

As for the Putnam funds, “We’ve been very vocal in the fact that until they turn three, investors take a wait-and-see attitude,” says Morningstar’s Wherry. “They’re innovative but unproven. And I stress unproven.”

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.

(photo: iStockphoto)

One of the primary advantages in mutual fund investing is its simplicity compared to owning stocks — or so some investors believe.

It’s true that professional management, diversification, and the ease of reinvesting earnings, are all great advantages. But when you pick one mutual fund over another, are you sure you are getting the fund that offers the lowest fees?

All professionally managed funds charge a management fee, and that is typically about 1.5% of annual net asset value. But beyond this fee charged by all managed funds, a range of other fees — some obvious and others less so — can also be charged. The best-known of these fees is the load, which is a commission taken from funds invested to pay a salesperson.

The comparison between load and no-load funds is not as straightforward as it seems at first glance. A “load fund” charges a load, or sales commission. This is applied either up front (taken out of investment dollars) or as a back-load, assessed upon sale of shares. A back load may also be called a “redemption fee.” A no-load fund does not charge a sales commission of any kind.

Simple enough; but there is more. Some funds, including many so-called no-load funds, charge fees of different types and names. To make a truly valid comparison between different funds, you need to understand what those fees are and how expensive it is to own shares of a no-load fund.

One of the most audacious of these fees is the so-called 12b-1 fee. This is a fee charged to investors to pay for the marketing and promotion of the fund. It may range between 0.25% and 0.75% of asset value every year, and is included in the fund’s expense ratio.

That 12b-1 fee may seem like a small percentage, but over time, it adds up to a significant difference in investment outcome.

Consider this example: A 100% no-load earning 9% annual net return per year yields $295 per $1,000 after three years.

$1,000 (1.09)³ = $1,295, yield $295

With a 5% front-end load, the same investment yields only $230 per $1,000. 

$1,000 – 5% = $950.

  year 1: $950 x 1.09 = $1,035.50

  year 2: $1,035.50 x 1.09 = $1,128.95

  year 3: $1,128.95 x 1.09 = $1,230.28, yield $230.28

Take out 12b-1 fees every year in addition to the front-end loand, and your real return can be drastically reduced, even with compounding. In other words, 9% is not always 9%, because fees and the timing of their assessment change what you really earn.

Not all no-load funds charge a 12b-1 fee. Those that do not are called “true no-load” funds. 

There are still other types of fees you may encounter when researching your investments. Funds, load and no-load, may assess “custodial” or “managerial,” or “administrative” fees. So a fund advertising itself as a no-load may end up paying salespeople through assessment of a fee with a different name. If those fees are collected every year and based on your net asset value, they will add up to much more than an up-front load charged for the same commission.

With the many names given to fees, making accurate comparisons is complex. But there is help. The Financial Industry Regulatory Authority offers a free mutual fund fee analyzer that compares the overall cost structure of different funds. Check it out for yourself here – and remember, a sales load by any other name is still a sales load.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Hidden Fees in No-Load Funds was provided by Minyanville.com.  

Diversify, diversify, diversify: This is the message individual investors hear more than any other. Thanks to an explosion in the number of mutual funds and exchange-traded funds (ETFs), diversifying your portfolio has never been easier.

Because they pool investors’ money to invest in baskets of stocks, bonds or other securities, ETFs and mutual funds are sort of a shortcut to diversifying your portfolio across a variety of assets and asset classes. You can now choose among 7,677 different mutual funds and 832 individual ETFs, according to the Investment Company Institute (ICI).

So where should you put your money? Mutual funds or ETFs? Well, that depends. The masses are sticking with mutual funds. In February alone, investors put $87 billion into mutual funds, compared to only $19 million into ETFs, according to ICI.

If you want more flexibility along with your diversification, however, you should take a closer look at ETFs, which have a few distinct advantages over mutual funds.  Keep in mind, some of the investing strategies described below are fairly sophisticated and may not be for everyone. If you subscribe to the “buy and hold” investment philosophy and don’t plan to engage in daily trading or market-timing, focus on the first two points in order to make a decision whether ETFs make sense for you.

(Should you decide to build an ETF portfolio, on the other hand, this series of videos should help you get started.)

ETFs Are More Tax Efficient

Because of the way most ETFs are managed, they are very tax efficient. Typically, when you own an ETF, your capital gains tax liability will occur when you sell the fund rather than while you own it. That puts you in control over when and how taxes will be paid. The less you pay the tax man, the more you get to keep for yourself: a clear advantage for those who manage their ETFs portfolios in a way to keep their tax liability at a minimum.

By contrast, most mutual funds buy and sell stocks often, accumulating a tax liability that they pass on to their shareholders (i.e. you). That tax liability, also known as a capital gains distribution, could become quite large if one or more major holdings were all sold at the same time. And this doesn’t only affect investors who owned shares of the fund at the time those trades were made: investors who bought shares afterwards also share in that liability. Actively managed mutual funds can be even worse from a tax perspective because they trade much more often.

ETFs Have Lower Costs

The average mutual fund charges a combination of several fees that can total 1.3-1.5% of total assets under management. (Often twice as much for actively managed funds.) To put that in easier terms, if you had $10,000 invested in a typical mutual fund that charged 1.3% of assets you would be paying $130 a year in fees. These fees are charged whether the fund goes up or down in value. Over time, these fees can eat up a significant portion of your total portfolio.

ETF fees, on the other hand, can be as low as 0.18% to 0.20% of assets. The costs are low because most ETFs are pegged to an index (as opposed to actively managed), so there are no fund managers and other administrative staff to be paid.

ETFs Allow Stop Losses

ETFs trade in the open market just like stocks–which means you can buy or sell them anytime during market hours. If you want to buy or sell a mutual fund, on the other hand, you have to wait until the market closes for the day before you can enter or exit your trade.

Because you can trade ETFs anytime during market hours, you can place stop-loss orders on your trades. A stop-loss order is conditional trade you place ahead of time that gives your broker instructions to automatically sell your position if the price of your ETF drops below a specified price in the future. Think of it as insurance against sudden price drops. Even if you are not watching your portfolio at the time the market tanks, your broker will automatically take you out of your trade–saving you from further losses.

ETFs Are Shortable

Mutual funds give you a great way to diversify across asset classes you are bullish on, but they don’t do much for you if you are bearish. ETFs, on the other hand, work well for both bullish and bearish investors.

Since ETFs trade just like stocks, you are able to short an ETF just like you would a stock. When you short a stock or an ETF, you make money if the price of the stock or ETF goes down, and you lose money if the price goes up.

How it works: you borrow shares of an ETF from your broker with a promise to return them on a specified date in the future. Once they’re in your account, you immediately sell those shares in the open market. At some point, you will have to go back into the open market and buy back the same number of ETF shares that you sold, but the hope is you will be able to buy those shares back at a lower price and pocket the difference.

For example, if you sold shares of the SPDR S&P 500 ETF (SPY) short at $115 per share and then bought them back again after the price had dropped to $100 per share, you would make $15 per share ($115 – $100 = $15).

ETFs Have Options

Perhaps the biggest difference between ETFs and mutual funds is that many ETFs are “optionable.” That means you can buy and sell call options and put options that are based on the underlying stock or ETF–which opens up a world of trading strategies you simply can’t use with mutual funds.

One option strategy ETF traders are particularly fond of is covered calls (sometimes called call writing). When you own a mutual fund and it starts trending sideways, there isn’t much you can do to make money with that mutual fund. You just have to sit and wait and hope it starts to increase in value.

When you own an ETF and it starts trending sideways, on the other hand, you can sell a call option on that ETF and bring in some extra cash while you wait for the ETF to start moving higher again.

Confused? Here’s an example:

Imagine you own 100 shares of the SPDR Dow Jones Industrial Average ETF (DIA). If you sell a DIA call option, you are giving someone the right to buy your 100 shares at a specified price before a predetermined date in the future. In exchange for this right, the person who buys the call option from you pays you a premium that you get to keep, no matter what.

Keep in mind that you get to choose the specified price (strike price) at which you will sell your 100 shares when you sell the call option. In a situation like this, you would typically choose a price that is higher than the current trading price of your ETF. And if the price of the ETF never reaches that price, you get to keep your 100 shares plus the premium you received from the call-option buyer.

If the price of the ETF does rise above the strike price before the predetermined date (expiration date), you may have to sell your 100 shares, but you still get to keep the premium.

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Most investors are painfully aware that the past 10 years have been pretty dismal for the average Joe and Jane. The “Lost Decade” is aptly named, seeing as the S&P 500 wound up basically flat over that time, even as it endured several roller-coaster rides. As you might expect, some money managers destroyed an inordinate amount of wealth over the past decade.

Goodbye, money

According to a recently released report from Morningstar, one mutual fund complex was responsible for the largest fund-related destruction of wealth over the past 10 years. Janus Capital Group’s collective offerings experienced a 10-year asset weighted return of (negative) -1% a year from 2000-2009, which amounted to a loss of $58.4 billion. Much of this loss came in the 2000 and 2001 bear market when Janus’ growth-oriented funds were hit hard by the deflating of the tech bubble.

Of course, it may not be completely fair to single out Janus as a wealth destroyer. Fundholders at Putnam Investments didn’t fare much better, losing a collective $46.4 billion during the same time period. Alliance Bernstein lost $11.4 billion, while Invesco AIM lost $10.1 billion. And many Janus funds have since rebounded, performing rather well in the latter half of the decade under study. And while there’s no changing the amount of wealth that was destroyed by some fund families in the opening decade of the new millennium, there are a few important lessons investors can take away from these events.

Learning from the past

The biggest reason why Janus landed at the top of the money-losing charts was simple: During the late 1990s the shop was pretty heavily growth-oriented. Most Janus funds were heavily invested in technology stocks like Microsoft and Cisco Systems, which had a great run-up in the late 1990s but were slammed in the ensuing bear market.

That’s the danger in following trends too closely: eventually you’re going to be on the wrong side of the market. Janus got into trouble by betting too aggressively on high-priced tech names with little regard for valuation. Investors should exercise caution not to blindly chase performance or run after the hottest-performing investment just because it’s done well in the past. That’s a surefire recipe for disappointment, since investors typically arrive late to the party and miss most of the early gains. (Gold bugs, take note!)

Secondly, this is another lesson on the importance of diversification — not only between stocks and bonds or among market capitalizations and countries, but among fund families as well. Unless you’re tied into a single-fund-family retirement plan, make sure that your fund choices span across several fund shops.

Some firms tend to be more value-oriented and may invest in dividend-producing names like ExxonMobil and Procter & Gamble, while others pursue more richly valued, fast-growing stocks like Apple and Google. You want exposure to both types of stocks and multiple investment approaches, and the easiest way to accomplish this is to invest in a handful of different top-rate managers.

Lastly, when it comes to mutual fund investing, it’s not enough just to sock money away in a random fund and hope that it does well. History has shown that most actively managed funds don’t beat the market consistently over long periods of time. You need the best funds in the bunch — the ones that have the best odds of making you money over the long run.

This article was originally published as The Biggest Wealth Destroyer of the Past Decade on Fool.com.

photo: Pink Sherbet Photography

Last year, legendary investor Warren Buffet bought a water treatment provider, Nalco Holding Company, adding to other water-related investments in his wildly successful portfolio.  (As of March 30, 2010, a single share of his company, Berkshire Hathaway, could be bought for $122,459.)

The move sent ripples through the investing community: a clear signal that investing in water is an untapped opportunity. Water, like oil, is finite. There is only so much ocean saltwater, glacier freshwater and water in the air, while global consumption is growing twice as fast as the world’s population.

Climate change affects how and where this resource is delivered around the world, with more intense rainfalls and dry spells impacting everything from the food cycle to manufacturing to drinking supplies. Climate change is expected to account for about 20% of the global increase in water scarcity in coming years. The World Bank estimates water availability will change dramatically by the middle of this century, leading to what some have called “water wars.”

New water management technologies are the key to managing water scarcity. Buffet’s investment in Nalco, which had $3.7 billion in sales in 2009, is one example. The company helps its industrial customers reduce water and energy use. For example, it claims it 3D TRASAR® cooling water technology has saved more than 200 billion gallons of water. Nalco is also teaming up with organizations like the World Wildlife Fund to help develop ways to conserve water. The company’s stock price has doubled over the past year.

Also doing well is Buffet’s investment in General Electric: the company’s stock price is over 70% over the past year. About a quarter of the company’s total revenue is in energy infrastructure, which includes wind and oil as well as water, up from 17.8% of revenue just two years ago.

In a recent interview with the nonprofit news site Circle of Blue, General Electric Water’s director of marketing Jeff Fulgham identified two drivers for GE’s water business: helping manage water demand by creating new supplies through desalination, and water re-use technologies (the company itself has committed to reducing its consumption of water by 25% by 2015), as well as helping improve water quality.

The World’s Water Crisis

Water quality is a concern in the U.S. and around the world. The New York Times recently ran a series called “Toxic Waters” that exposed the worsening pollution in U.S. water systems and lax regulatory responses – despite the Clean Water Act, which helps regulate 100 pollutants. The fact remains that most of the pipes in the U.S. are over 100 years old; the American Water Works Association (AWWA) estimates that domestic water utilities will need to invest $330 billion over the next 20 years to replace aging pipes and treatment plants.

The rest of the world faces even direr water problems. China has 21% of the world’s population but only 7% of the renewable water resources. The country’s spending on water infrastructure reached $250 billion in 2008. By some accounts, the lack of clean water and sanitation slows the world’s economic growth by $556 billion each year.

Industry Players With a Future

Companies that can fix broken water systems are set to benefit from President Obama’s stimulus dollars, which are expected to flow in 2010. “The plan divides $21.4 billion to water and environmental infrastructure and $30 billion to building infrastructure, which should be allocated within the next four years,” says Michael Gaugler, an equity analyst who covers water for Brean Murray, Carrett & Co. He recommends Tetra Tech for the expected revenue uptick it will get for its consulting, engineering and technical services focused on water. (Buffet, meanwhile, also owns privately-held pump-maker Wayne Water Systems.)  

The best opportunity at the moment may be publicly traded water utilities, says John Dickerson who runs Summit Global, a water focused investment fund based in San Diego. “Water utilities are the subject of benign neglect,” he says. “[They] are basically trading at a discount to the regulated asset base.”

Case in point: Aqua America, one of the country’s largest publicly traded utilities operating in 13 states which has been trading below last year’s stock price. Meanwhile, American Water Works, with an even larger reach in 19 states and across Canada, is trading around the same price as last year.

“Utilities are cheaper than they have ever been,” Dickerson says.

Invest Like Buffet – On a Budget

To be sure, unless you have a sizeable portfolio and feel comfortable investing in individual stocks, you may simply consider a fund like Dickerson’s, which has been around since 1999. Several new water-focused funds have launched over the past five years as well. Brennan Investment Partners’ Kinetics Water Infrastructure Fund invests in companies that provide solutions to water industry problems; Credit Agricole Funds Aqua Global and FourWinds Capital’s Aqua Resources Fund are also on the water scene. 

As always, diversification should remain a key part of your investment strategy. Gaugler suggests that 10% to 20% of one’s portfolio may be invested in water, but depending on your risk tolerance and investment horizon, that may not be the case for you.  Many individual investors may be better off dedicating a smaller share to that – or any other — industry. Be sure to consult with your financial planner or adviser (if you have one) before making any radical portfolio moves.

Tatiana Serafin, a former staff writer at Forbes, now heads Global Markets and Ideas.

We recently covered the why and how of purchasing a mutual fund, but you were probably left wondering what exactly you should be looking for when choosing which funds to buy. It’s a great question and can often be a daunting one for a beginning investor. In reality, it’s relatively easy to research and find good mutual funds. Once you’ve done it a few times, you may actually begin to enjoy the thrill of the hunt!

The Longstanding Mutual Fund Debate

There are two camps when it comes to choosing mutual funds. The first consists of those who believe you should invest in actively managed mutual funds that outperform their peers and their indexes over time. The second camp consists of those who believe that the only type of mutual fund you should invest in are index funds. Index funds differ from actively managed funds in that they are typically managed passively by mathematical computation and computers.

Index fund fanatics, or Bogleheads (named after Vanguard and index fund founder John Bogle) as they are affectionately referred to, often cite the fact that the majority of actively managed funds are outperformed over time by their index fund counterparts, which cost less to own.

Regardless of which camp you favor, we will provide some general guidelines to follow when you are hunting for actively managed funds and how to compare them to their index fund counterparts.

How to Comparatively Measure a Mutual Funds Performance

1. Expense Ratio: Expenses are never good. They will eat into your returns over time. Be wary of a mutual fund with a high overall expense ratio, especially if its performance lags its index and peers over time. As a benchmark, there is no real reason to purchase a fund with more than a 1.2% overall annual expense ratio, and there are many good ones that can be found for less than a 1% expense ratio. Many index funds will have much lower fees than this, but fees should not be your only determining factor.

2. Fund Manager History: Here’s a dirty little secret of the mutual fund industry – the fund itself doesn’t really matter. It’s all about who is selecting the investments, not the ‘brand’ of the fund. When you buy an actively managed mutual fund, you are purchasing the skills of that fund’s particular manager. So, what should you look for in a fund manager?
Most important is sustained long-term performance success (at least 5 years) vs. the fund’s peers and index. Look also for loyalty to the fund that you are investing in. If they move, they take their skills with them. Lastly, you’ll want to find a fund manager with an investing philosophy that jives with your personal financial goals.

3. Load or No-Load: Funds with loads should not be purchased. Period. Loads are an additional management fee that claims a percentage of your overall investment when you move in or out of a fund (often-times around a whopping 4-6%). When there are numerous equally or better performing funds available that don’t carry a load, there is no reason compelling enough to pay the extra fee. Comparatively, index funds rarely have a load fee.

4. Net Assets: In the mutual fund world, it is possible to get too big. Some of the star mutual funds end up attracting performance chasing investors. This creates a problem in that the more money a fund has to invest, the less nimble it becomes. As a benchmark, stay away from actively managed funds that exceed $10 billion in net assets. When a fund exceeds this level, there is no real advantage to choosing it over its index fund counterpart. Many fund companies realize that this is an issue and they end up creating ’sister’ funds that mirror the strategy of the original fund, but with much less in the form of assets to slow them down.

5. Performance: If a managed fund is under-performing its peers and its comparable index fund, you’re probably better off going with their index fund and saving on the expenses. Look for long-term sustained success of at least 5 years, but preferably 10 or more.

Where do you Find all of this Information?

Most major investment aggregators will contain all five of the previously mentioned metrics and more. A few favorites to whittle down your possible fund selections are:
Morningstar’s mutual fund screener
Yahoo Finance fund screener

Once you have narrowed it down to a few funds, you’ll want to use tools such as those found at Morningstar and Google Finance to research each fund. You may also want to read the prospectus of the funds you are thinking of before making your final purchase.

For more of GE Miller’s writing, visit personal finance blog 20somethingfinance.com.

Valerie Everett

The simple answer to the question ‘why should I buy a mutual fund?’ recalls the proverbial joke about the chicken crossing the road. The answer, ‘to get a good return on my investment’, or even more simply ‘to make money’ seems so obvious as to be almost an insult to one’s intelligence. But mutual funds are just one of a variety of potential investment vehicles. Stocks, bonds, and other investments that are available for purchase also offer the potential to make money. So what makes mutual funds the investment of choice for many? When you boil it down, mutual funds provide three major benefits for those who decide to invest in them:

1. Diversification, 2. Expertise, .. and 3. Time

What do each of these mean?

Diversification: In times of high volatility and risk, owning one, two, or even five different stocks, bonds, or whatever security you’d like to invest in can be risky in that there is simply no guarantee that your picks are going to be winners. Mutual funds, on the other hand, offer risk diversification. This means that funds purchase more than a few different investments and the risk of losing significantly in any one investment is minimized by being distributed over a number of investments.

Expertise: You can be fairly certain that professional mutual fund managers have more research, knowledge, connections, and experiences at their disposal than you do. However, expertise and resources don’t always produce stellar results. In fact, only 31% of actively managed stock-based mutual funds outperformed the S&P 500 over the five years ending Dec. 31, 2008. That’s why many investors choose index mutual funds as an alternative to actively managed funds. Index funds simply aim to match the performance of the index that they are following. Since index funds don’t have professionals choosing the investments, their fees tend to be lower than actively managed funds. Whether you choose index or actively managed funds, you are paying for the expertise and convenience offered by those funds.

Time: Without professional resources at your disposal, successful investing can take an extreme amount of time and energy. There is a very high learning curve involved in investing that few have enough time to pick up. If you opt to buy more investments in order to diversify, your time commitment only increases. Opting to put your money into mutual funds frees the time that it takes to research and keep up with each of your individual investments.

How to Purchase a Mutual Fund

If you’ve determined that you want to purchase a mutual fund, here’s how you can do it, step-by-step.

1. Choose a discount brokerage (i.e. Zecco, Scottrade, Etrade, Fidelity, Schwaab, etc.) to purchase your fund through. You could opt to invest in mutual funds through a full service advisor, but there is a wealth of comparative resources available to help you choose your fund for free so that you can purchase through a low fee discount broker instead.

2. Start an investment account through your broker. This could be a a general trading account or a retirement account such as a Roth IRA or Traditional IRA.

3. Research. In an upcoming post, we’ll highlight what you should look for in a mutual fund. For starters, you may want to focus on choosing a fund that consistently has at least met and preferably beat the performance of its peers at a fee that is lower than its peers.

4. Fund your Account: You must send in money via check, wire, or other deposit to your discount broker. Once your account has funds available, you can make your mutual fund purchase.

5. Make your Purchase. Enter a dollar amount that you’d like to apply towards the fund. This differs from entering a price you want to pay as you do when you purchase a stock. The price you will pay for each share will be the closing price on the day that you purchase the fund. The amount you enter will be divided by that share price to determine how many shares of the fund you will receive. When you first purchase a fund, you need to indicate whether you would like your dividends, capital gains, or both reinvested into additional shares. You can change this election at a later time. There is little reason not to choose ‘both’.

Some funds offer no transaction fees when you make a purchase. For those that do charge a fee (typically $25-50) you do not have to pay this fee when you purchase additional shares of the same fund. It’s also worth noting that many funds require a minimum initial purchase that depends on what type of investment account you are using.

6. Add to your Shares Over Time at your Discretion

For more of GE Miller’s writing, visit personal finance blog 20somethingfinance.com.