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Mutal Funds, ETFs too faulty to be reliable

Tuesday, April 28th, 2015

I received a request from Lillian, who wants me to look at an REIT ETF that she holds and is asking if now is the time to sell because of the upward pressure on interest rates.

REIT is short for real estate investment trust. ETF is an exchange-traded fund.

The difference between an ETF and a mutual fund is that an ETF trades like a common stock on a stock exchange. An ETF can be sold or bought on the market during market hours and a mutual fund can be bought or sold only once a day at the close of the market, after the fund has calculated its net asset value.

A mutual fund is generally actively managed by a fund manager, which will cause the fees to be higher. A mutual fund also could be sold by a broker with a front-end or a deferred sales charge.

An ETF works like an index fund and an investor is just buying a basket of whatever that ETF specializes in.

Brokers will generally not recommend an ETF unless they are charging a management fee for the portfolio. Individuals can buy these through such online brokerage firms as Charles Schwab or Fidelity and pay only a fee for the transaction — the same as they would a stock.

I am not a fan of mutual funds or ETFs. Only in very rare circumstances will I use them.

The best case I can think of is when I want to short the market, which means I expect the market will go down and I will profit from the decline and use that as a hedge, or an insurance, if you will, against positions that I hold in my portfolio.

Other than that, I prefer to research the best stock, or, in this case, the best real estate investment trust.

The reason Lillian is concerned about interest rates rising is that many real estate investment trusts are highly leveraged with debt to equity that average nearly 150 percent.

This is why I am not excited about an ETF or a mutual fund that would hold many real estate investment trusts: Unless you want to spend a lot of time looking at each holding, you will not really know what you have.

For example, the real estate investment trust that we hold in our portfolio has about 40 percent less debt to equity then the average.

The reason I am so concerned about rising interest rates is that the more debt a real estate investment trust has, the higher the increase in expenses will be because of higher interest rates it will have to pay.

When I looked at this Vanguard REIT ETF, I was disappointed to see its performance. I discovered the three-year total return is only 14.1 percent. Total return includes both the appreciation of the stock — or in this case the REIT — and dividends paid. The current yield on this REIT is 3.5 percent.

The reason I'm disappointed in that total return of 14.1 percent is that I know what stocks have done over that same time frame and I also know what other REITs have done. This Vanguard ETF is well below my expectations.

I need to point out that Vanguard is a very good company and it does have some great funds, both mutual and exchange traded.

I don't like to hear two things from investors.

First, they like Vanguard because of its low management fees. While that is important, investors should never make a decision based on how much they are paying.

The second thing I always hear — and keep in mind I've been doing this for more than 30 years — is that when the markets do well, people tend to move into index funds because they don't feel it is worthwhile to pay an adviser.

I can tell you that when the markets suddenly go down, those who bought index funds tend to sell them because they're losing money. They don't understand what they own and are focused only on the returns, and when those returns come up negative, many investors head for the exit.

The same holds true for this ETF, which is an index real estate investment trust. I'm fairly confident that when these real estate investment trusts begin to decline, investors will head for the doors and complain about how much money they lost in real estate investment trusts.

So what investors must do is understand more about their investments or find a fee-based adviser who knows how to make money for their clients.

So to summarize, Lillian, I would recommend that you sell your real estate investment trust ETF for two reasons.

First, I can't tell you enough detail on all the real estate investment trusts that they hold.

Second is that when interest rates rise, real estate investment trusts generally decline, and only when the earnings come out will investors find out that the lower-leveraged real estate investment trusts still have good earnings and, therefore, separate themselves from the highly leveraged real estate investment trust.


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