Blocked From Buying and Selling Mutual Funds
Thursday, May 15, 2014

T. Rowe Price blocked approximately 1,300 American Airlines employees from trading into their retirement plan mutual funds over the past three years due to excessive activity, according to Money Magazine. Some of the airline’s employees received lifetime bans. Southwest Airlines employees have also been warned by Vanguard to end their trading, according to Money.

Those of you who subscribe to Money may have seen the article. It’s not the first one on the subject and likely won’t be last. Though most mutual funds reserve the right to ban an investor from buying and selling its funds, it is rarely used. Investors who do get banned have frequently traded in and out of mutual funds, commonly on the guidance of a newsletter or an adviser.

It is my understanding that in order to get banned, or even to get a warning letter, a large amount of short-term trading has to occur. What prompts the warnings and the bans can often be a group of investors acting in unison, often on the recommendation of a central party (e.g., an advisory service). If enough shareholders move to buy or sell at the same time, the mutual fund could end up with more cash inflows or outflows then it is prepared to handle.

Understanding the structure of mutual funds is key to understanding why investors who trade too frequently can be banned. A mutual fund pools shareholder dollars together to buy and sell securities. It may be helpful to visualize a mutual fund as a group bucket of shareholder dollars. The fund manager, in turn, uses the cash in the bucket to buy various securities on behalf of the shareholders—while taking a small amount out of the bucket for the fund’s fees. When shares of the mutual fund are bought by an investor, new dollars are put into the bucket. When shares of the mutual fund are sold by an investor, money comes out of the bucket.

Mutual fund managers always keep a small amount of cash in the bucket to facilitate typical deposits and withdrawals by shareholders. Problems occur when the flow of cash into or out of the bucket is greater than usual. Such occurrences can give the fund manager more excess cash to work with than he planned on, or, in the case of withdrawals, can cause the fund manager to sell more securities than he would like to at a particular point in time. This is why mutual fund companies take steps to discourage too-frequent trading and ban those who ignore warnings to stop.

Short-term trading is also why exchange-traded funds were created. ETFs are designed specifically to be bought and sold throughout the trading day. When an ETF is bought or sold on the open market, the exchange occurs solely between the transacting parties (e.g., two investors). The assets of the ETF are not impacted. Rather than accepting money from shareholders, ETFs exchange creation units (blocks of 50,000 shares) with institutional investors and market makers. This different structure makes ETFs the more suitable vehicle for trading.

There is also another reason why you should look to ETFs if you want to trade: transparency. ETFs update their portfolio holdings frequently, while mutual funds update the list of their holdings with a lag. When you trade a mutual fund, particularly one that is actively managed, you are doing so without full knowledge about what the fund’s current holdings are. As a result, you are making a decision based solely on recent price performance without knowing what underlying holdings are affecting the returns or what recent changes the manager has made.

None of this is to say you should engage in active trading. Trading too frequently can hurt your performance. But, if you want to trade in and out of funds, don’t do it with mutual funds, use ETFs instead. Mutual funds are designed to be long-term investments and should be treated as such.

AAII Model Portfolios Updated

No changes were made to the AAII model portfolios this month.

The Model Shadow Stock Portfolio lost 3.9%, underperforming the Vanguard Small Cap Index fund (NAESX), which declined 2.3% and the DFA US Micro Cap Index fund (DFSCX), which was lost 3.4%. For the year, the Model Shadow Stock Portfolio is now down 7.1%, trailing NAESX, which is up 0.2%, and DFSCX, which is down 2.9%. The Model Shadow Stock Portfolio has a compound annual return of 17.6% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period.

The Model Fund Portfolio performed better, but still declined by 0.4% in April, and the Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF) was down 0.3%. In comparison, the Vanguard Total Stock Market Index fund (VTSMX) gained 0.1%. For the year, the Model Fund Portfolio is now up 3.0%, ahead of VTSMX, which has gained 2.1%. The Model Fund Portfolio has a compound annual return of 9.6% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 9.1% annually over the same time period.
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The Week Ahead

Nearly 25 members of the S&P 500 will report their quarterly results. The only Dow component on the calendar is The Home Depot (HD), which will report on Tuesday. Many other retailers will report earnings, including Lowe’s Companies (LOW) and Target Corp. (TGT) on Wednesday.

The minutes from the latest Federal Open Market Committee (FOMC) meeting will be released on Wednesday afternoon. Otherwise, there isn’t much on the economic calendar. April existing home sales will be announced on Thursday and April new home sales will be announced on Friday.

Several Federal Reserve officials will make public appearances. Dallas president Richard Fisher and San Francisco president John Williams will speak on Monday. Philadelphia president Charles Plosser will speak on Tuesday. Chair Janet Yellen, Kansas City president Esther George and Minneapolis president Narayana Kocherlakota will speak on Wednesday.

The Treasury Department will auction $13 billion of 10-year inflation-adjusted securities (TIPS) on Wednesday.

Local Chapter Meetings

AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!
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What’s Trending on AAII

  1. A More Dynamic Approach to Retirement Spending
  2. From Saver to Spender: Managing Your Money in Retirement
  3. The Three Pockets Approach to Investing
AAII Sentiment Survey

Investor optimism bounced back this week and neutral sentiment continues to climb, while pessimism fell.

Bullish sentiment, expectations that stock prices will rise over the next six months, bounced back to 33.1%, up 4.8 percentage points from last week. Optimism has not shown a clear direction over the past few weeks, but it still remains substantially below its long-term average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose another 1.3 percentage points to 44.3%. Neutral sentiment has been increasing for five straight weeks. This is also the 19th consecutive week that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 6.1 percentage points to 22.6%. This puts pessimism below its historical average of 30.5% for the fourth straight week.

The current streak of below-average bullish sentiment readings is the longest since a 13-week stretch between August 30, 2012, and November 22, 2012. Neutral sentiment is above its historical average for the longest consecutive period since a 24-week stretch between January 28, 1999, and July 8, 1999. Bearish sentiment has not been above average for four consecutive weeks since April 11, 2013, through May 2, 2013.

Neutral sentiment continues to stay very high. This is a characteristic of investors that we have noticed since the beginning of 2014. Once again, investors seem to be looking for a catalyst to drive the market up or down. The environment remains friendly for equities, but there are international concerns. In addition, valuation is higher than average.

This week’s special question asked AAII members when they expect the Federal Reserve to increase interest rates, given our current unemployment rate and historically low labor participation rate. Responses were mixed, ranging from “pretty soon” to 2016, but the vast majority believe it will be sometime in 2015.

Here is a sampling of the responses:

  • “I think the consensus is the second quarter of 2015. I’ll go with that.”
  • “Not until inflation picks up.”
  • “Mid-2015 if the labor participation rate improves.”
  • “The Federal Reserve has communicated their intentions well, with appropriate options to change as conditions change. For now, they expect to start raising rates in the second half of 2015.”
  • “I see a slow gradual increase over three years so that the market can adjust to normal interest rate levels.”

This week’s Sentiment Survey results:

Bullish: 33.1%, up 4.8 points
Neutral: 44.3%, up 1.3 points
Bearish: 22.6%, down 6.1 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Take the Sentiment Survey.