Paul Winkler: Welcome to “The Investor Coaching Show.” I am Paul Winkler, talking money and investing, as I am wont to do.
Understanding Financial Basics
I’m an avid collector of financial planning degrees, so you might as well use the information. Let’s see, I’m a chart and financial consultant, life underwriter, training council fellow, credit asset management specialist, wealth management certified professional, chart advisor for senior living, retirement income certified professional, and just a lot of stuff.
So I like talking about this stuff and I like studying it obviously, and sometimes I answer questions right here on the show. And if you can get to my website, you can ask questions. It’s paulwinkler.com, and I assume all of you know how to get to a website. Paulwinkler.com, and you can go there and you’ll find where you can ask questions for the show, and shoot us some stuff.
And the other thing that I’ve got going on, I’m going to tell you about real quick. I’m going to be doing Channel 5+ again Wednesday night. So if you ever watch OpenLine, that’s something we’re going to be doing on a regular basis. I like that. It’s a lot of fun because you get the visuals and I bring a little board and just have an absolute blast on there answering questions.
The last time I went on it, it was so fun because it was a whole different audience than who normally hears me, and they were like, “This is really interesting.” So I got into some basics. And if you’ve never heard me get into the basics, that’s really fun.
Because I think, people, if you understand this stuff, you don’t fear it anymore, and we tend to fear that which we don’t understand.
But I try to make everything just understandable from the get-go. Check it out Wednesday, OpenLine, Channel 5+, and just bug me, call me, when I’m on there. But anyway, so the way to ask questions is to go to paulwinkler.com.
Changes to 401(k) Plan
Now, so I had a situation where somebody asked me a question. A big company, I’m not going to mention the company that they work for, but I’m okay with mentioning the mutual fund company involved. It was about 401(k)s.
Because a lot of people have 401(k)s through this company, I want you to know what to look out for. I want you to know what you need to be looking out for yourself.
I don’t care how big the company you work for or how big the company is managing your 401(k) plan is, you have to watch out for yourself.
Because they are certainly not necessarily watching out for you, from my experience. In this particular case, Fidelity is managing this 401(k). They’re a huge fund company, huge. And you all have heard commercials, seen them, know who they are.
Now in this situation, an employee for the company sends me something and says, “Hey Paul, is this something that I need to be looking at? It seems kind of sales pitchy.” And it is somebody that I have worked with and educated, and brought through some education processes, and he knows a sales pitch when he sees it. Hats off.
But he sends me this thing and in there, and they’re saying, “We’re always looking for ways to enhance our benefits,” is what they’re saying. And it says, “We’re excited to announce improvements to our 401(k) plan.”
It gets into, it says, “We’ve made some upgrades to our fund lineup, and there’s no action required on your part. We can make some changes. You’re going to be automatically moved to the new investment options unless you tell us differently,” is the deal here.
Small Cap Growth Stocks
So, “What’s changing?” was asked in there and they said, “Well, we have this mutual fund. We’ve got the XYZ small cap growth fund change.”
And they’re saying, “We’re always on the lookout for new ways to help employees plan for retirement. We love you, we’re going to take care of you.” You’re going, “Oh, gosh.”
“We’ve decided to change our small cap growth fund.” Now number one, small cap growth funds. And in this particular case, this person, when I helped them allocate their 401(k), I did not choose this fund to begin with.
So this particular message doesn’t apply to them, but this message may be something that applies to you. You may own a small cap growth fund in your 401(k) and need to be really conscious of this.
Now, small cap growth stocks, these are small companies. These might be companies that are between 1-2 billion dollars; you can buy the whole company for that. That would be a small cap — small capitalization is what it stands for. And they would be looking for growth companies. In other words, companies that have grown rapidly.
They’re well thought of, they’re well-managed companies. And you think, That’s exactly what I want. I want a small company with lots of potential. And because they’re small, and they’ve got lots of room to grow, and maybe they’re companies that are well thought of, that would be great. That would make a lot of sense for investing, right?
Well, not so fast. If we go back to the 1920s till now, and we look at small companies that are growth companies, the historic return is not that great in that particular asset category, and you go, “Well, why? It seems like it would be the sky’s the limit.”
Well, the research has been that typically, a lot of times people running these companies tend to blow money on just bad projects.
That’s one of the theories as to why they haven’t done that well. They’re companies that are small, they’ve got lots of potential, and sometimes they’re just a little bit loose with the money, and they don’t necessarily spend the money on the best of things.
Now in that particular case, you look at that and go, “Well, okay, so why do they do that?” Well, it’s just they’ll throw caution in the wind. And with the belief that we can really grow rapidly, sometimes people’s egos get carried away with them, and that’s what the research shows — that their egos tend to get carried away, and they tend to do that.
But anyway, so in this particular case, I avoided this fund, but I avoided it for a second reason as well because there are times when I’ve had to choose and I go, “Oh gosh, I don’t have any other small cap choices at all,” so I’ll use it if I have to.
Companies With Multiple Funds in a Category
But in this case, there was also a manner of choosing investments that was based on the idea that we, the fund managers, are really smart. And that’s what gets me about these huge mutual fund companies. You might have a company that’ll have 1,400 mutual funds, and that’s Fidelity. They’ve got well over a thousand, they’ve got hundreds and hundreds of mutual funds.
And you go, “Well, if they really knew what was going to happen in the future, how many funds would they really need?” Well, they wouldn’t need more than a couple, right? I mean, one.
How many stocks would they need to have in there? One because they really know the future, they know which stock would do better than anything else, but that’s ridiculous.
But you look at it, you go, “Well, do we need 1,400?” I mean, that’s kind of ridiculous too, if you think about it.
So in this particular case, you say, “Well, I just need one small cap fund. I don’t need a dozen mutual funds that invest in that particular area.”
But that’s what fund companies will do. They’ll have lots of different funds in a category, and the reason is if they can get one of those, let’s say it’s 14 funds, and one of those 14 funds does better than the other 13, then they go, “Hey, look how skilled we are. We’re really, really good at this investment management thing. So what we’re going to do is we’re going to market the fund that did really, really well and just say, ‘Hey, look, we’re great.’”
And then of course what ends up happening is that fund underperforms, and then they go push it off to the side and they say, “Well, this other fund did really well,” and that’s the fund they market over the next year. That was my experience in the investing industry.
They would do that all the time. That doesn’t happen anymore, does it? I mean, I’m telling a story that’s 25 years old. Oh, wait a minute.
So this guy sends me this thing, and it has the list of funds and they say, “What’s changing?” Now number one, the XYZ small cap growth fund change.
Now they said, “We’re always on the lookout for new ways to help employees plan for retirement because we’ve got your best deal. We want to take care of you, right? We’ve decided to change our small cap growth fund because we want to make sure that you have the best fund, right?”
Well, what were the criteria that they used to make this decision to choose a new fund? That’s the next sentence. “This fund change brings with it improved historical fund performance.” In other words, we’re going to get rid of that stinky fund that we had that we had you in and since it was lousy and it stunk, we’re going to put you in a new fund that did well over the past five years or 10 years or whatever criteria they’re looking at.
And I’m looking at it going, “Well, wait a minute. That’d be really great if I could jump in a time machine and go back five years and invest in the fund that you are now adding to the 401(k) plan.” But guess what? I can’t jump in a time machine because one doesn’t exist, to our knowledge.
Relative Losses
So in effect, what they’re doing is the investors that had the fund previously got hosed, they ended up with this poor performance. And I actually charted the fund that was in there. I got a chart of the fund that was in there, and you know what it looks like? It had this huge outperformance in 2019 and 2020.
Then they add the fund to the lineup and go, “This fund is a great fund. We’ve got to have this in our 401(k) for our employees. Look how great the performance was.”
And then it goes on to stink up the place from 2021, 2022, 2023, and so far in 2024. In fact, if you look at the 2022 return, it lost 28%. I mean, that bad.
And you go, “Ooh, that was terrible.” Well then in 2023, what does it do? Oh, it made 9%. Oh, wait a minute.
The area of the market it was investing in went up 22.61%, according to Morningstar. It went up nine, and the market area went up 22. That’s a 13% underperformance. So it didn’t lose money, it had a relative loss.
And this is the thing that if I could get people to get this, oh my goodness, this would be a huge victory.
You may not necessarily be losing money in whatever you’re doing. Are you suffering relative losses?
That’s the issue I’m constantly trying to get people to understand. Did the market go up X amount — in this case, 22% — and you only went up nine? Well, that’s an underperformance. That’s a relative loss.
When the market went down, did you go down more than the market did? In this particular case, the fund did go down more than the market did in this particular asset category, in year-to-date return.
How did it do this year so far? Up 1.95%, and to the end of September. Well, what did the market segment do? 10.98%. So you’re basically looking at about a 9% additional underperformance over that period of time.
So, “We’re going to help you. We’re going to help employees plan for retirement.” You’re helping employees plan for retirement like Bonnie and Clyde helped banks. It just doesn’t seem like a good idea.
Historical Fund Performance
The next fund in here, JP Morgan, has an emerging markets equity fund change. Okay, we’re looking at this fund line and we’re going to add that fund in here because, “what we’re doing is we’re evaluating underperforming stocks,” is literally what it says here, no joke. “We’re evaluating underperforming stocks.”
Well, it would’ve been way better if you had evaluated these underperforming stocks before they underperformed. That would’ve been way more helpful than evaluating it after the investors in this fund took it on the chin, and they got that underperformance.
So what we’re going to do, we’re able to lower the expense ratio, which is good, that’s good. Lower the expense ratio, no sense in having unnecessary expenses, and improve performance. I love this line, “We’re going to improve performance.”
That’s an implied guarantee, in my humble opinion. If a compliance officer heard me saying that, they’d hit me over the head with a two-by-four. You can’t say that and be a fiduciary.
Anyway, so they’re saying, “We’re going to improve performance on an already strong performing fund. Okay, so what we’re going to do is we’re going to do that.”
Now, this is good. You can lower the expense ratio. This is a valid one right here. This is valid, if they’re lowering expenses.
But they’re saying that we’re doing this on an already strong-performing fund. Well, what’s that based on? Past performance. Now, I didn’t look at the fund to see if it just got lucky and outperformed or what was going on there, but this is a valid reason here.
Now, the third one is this one, and they said here, “The fund change brings with it reduced administration fee,” which is good, “As well as improved historical fund performance.” Again, what are we looking at here?
We reduced the expense, which is perfect, but they’re choosing the fund based on historic performance, what it did in the past. If you read the prospectus, it says, “Past performance is no indication of future performance,” and yet that was the criteria that they used to choose this investment for the 401(k).
Now, what do we want to choose? What do we want to use? And this is where, when you’re judging an investment, I am looking at how the fund did versus the benchmark in the past. I’m not looking at heroic outperformance versus a benchmark, which seems like it would be a good idea.
Don’t we want that? Don’t we want great performance versus … if a fund is investing in small company stocks that it did really, really well versus small company stocks? No.
Because what we know is that historically, with fund outperformance versus a benchmark, heroic fund outperformance is usually due to luck.
And we do not want to invest based on luck.
Stock Picking
Now, with an asset category like small U.S. stocks, historically, if we look at that, the historic return of the asset category without somebody figuring out when to get in it, when to get out of it, which stocks to choose, has been pretty admirable, let me put it that way, in the long run. Small U.S. stocks going back to the 1920s, historically, that asset category is about 12% going back, 11.9% to be exact, from 1926 through the end of 2023.
So with that asset category, you didn’t have to figure out which stocks were better than others to actually capture that asset class return. But what happens is fund companies, in order to get a leg up on their competitors and get business and capture market share, will often try to outperform the benchmark because that gets them attention.
And the reason it gets them attention is because people believe that there’s this skill of determining which companies are better than others, when to get in the market, and when to use tactical asset allocation. And this is something I’ve talked about a lot in recent weeks where I’ve been going through the local investment firms, just literally all the ones that I’ve gone through, have basically said that they believe that their job is fundamental analysis of portfolios.
In other words, they’re trying to figure out which stocks are better than others, making sure that they have the better stocks in their portfolios, and they avoid the bad ones. Well, that is stock picking. By definition, it is something that, as I’ve talked about, is a form of market timing because you’re trying to time with individual stocks, but it is the belief that the companies I can find will outperform the benchmarks.
What we know is that funds that do outperform benchmarks don’t repeat. Very rarely do they ever repeat in the future.
But it is very valuable from a marketing standpoint, and that’s why fund companies engage in this type of activity. With your 401(k), watch it. Don’t necessarily believe just because you work for a huge company or that there is a huge company managing your 401(k), that they’re necessarily doing things that are prudent and make a lot of sense.
But I’m just glad that clients bring this stuff to my attention because I said, “Whoa, whoa, whoa, whoa, whoa. Before they make any changes, let’s go back in there and make sure that we don’t have them mess up anything that we’ve done,” because they have a tendency to do that.
And I believe that they really think that they’re finding new ways to help employees plan for retirement, as they said in this email to the client. I think that they really believe that they’re helping. Evidence is not so great that they are.
Anyway, what we want to look for is making sure that we’re matching benchmark returns, asset class returns, no heroics, avoid stock picking. Market timing is everywhere.
And if you don’t know how to do that, and that’s something that you’re going, “I’m not going to even look at this stuff,” look at turnover ratios. But read prospectuses, they will tell you in prospectuses whether they’re engaging in it.
And if that’s not something you’re likely to do, that’s what we’re here for. You can always call us, paulwinkler.com. This is “The Investor Coaching Show.”
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
