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How to Pick the Best Mutual Fund for Your IRA or 401(K)

Monday, August 11th, 2014

How to Pick the Best Mutual Fund for Your IRA or 401(K)

If you are a participant in a typical 401(k) plan, you face a list of 18 mutual funds to choose from.   If you set up your own IRA plan, the list grows to over 4000 funds in the universe.  Most people don’t have the foggiest notion of which fund choice is the best for them.  The answer is actually quite simple, if you understand a few essential truths.

Before you get to the mutual fund choice, you may have an even more important decision to make. It involves the kind of IRA you pick.  The Roth IRA is an infinitely better choice than the traditional IRA.  You forego a tax deduction in year one but you avoid paying ordinary income taxes every year you withdraw money during your retirement years when the amounts you withdraw are greater and the tax rate you pay is likely to be higher than during that first year (the government ultimately will be forced to raise rates to pay for social security and the interest on the federal debt).

The Roth IRA is such a good deal for you and such a bad deal for the government that they severely limit how much you can contribute ($5500 a year or $6500 if you are over 50), and if you make over $127,000 as a single or $188,000 as a couple, you can’t contribute at all.  If you qualify, choosing a Roth IRA over a traditional IRA is a no-brainer.  After five years and you reach 59 ½, there are no restrictions when (and if) you withdraw money while your nest egg continues to grow tax-free, including the dividends.

Astonishingly, in spite of the considerable advantages of Roth IRA’s, only 2% of all IRA investments are in Roth IRAs.  That is an unbelievable number to me. I just don’t understand how so many millions of Americans have made the absolutely wrong choice for themselves.  Of course, they also drop millions of dollars every day at the casinos, knowing full well that the house will win every time over the long run.  So I guess we should not expect them to be very smart about their IRA choice, either.  But it is a sad fact for me.

If your company’s 401(k) plan does not offer a Roth IRA alternative, speak to HR and ask them to get it in there.  Your fellow employees, and you, deserve it.

Once you have selected the Roth IRA alternative (if it indeed is a choice for you), you face the mutual fund choice challenge.  Why do you suppose that the average 401(k) plan has 18 choices?  That seems to be a fairly large number to choose from.  Surely, your company could figure out the three or four best choices out there and restrict your choices to those.  That would be offering a real service to anyone who lacks the financial education or experience to make that kind of important choice for their future livelihood.

Sadly, apparently the biggest reason that many companies offer a large number of mutual fund choices in their 401(k) plan is to avoid a lawsuit.  Class action suits have (successfully) been brought by employees of many companies against their employees because mutual fund choices were more beneficial to the mutual fund companies and just awful for the employees.  The courts have sided with the companies when a large number of mutual fund choices were offered (“it was the employees who decided to pick those bad ones – they had a better choice but did not take it” was the reasoning).

In a perfectly just world, the companies would also be required to provide more information to employees as to which the best choices would be for their employees. But as we all know, our world is far from perfect.

Fortunately, there is a best choice, and it is definitely not the most popular one.  The most popular choice is the target-date funds.  They make intuitively good sense.  You know the approximate year when you expect to retire, and you just select that date fund.  More than 40% of 401(k) participants make that choice (and that number is projected to grow to 50% by 2020). 

The sad fact is that there is not a single 5-year period ever when target-date funds have outperformed a low-cost broad-based index fund.  The only time when they have come close is when the stock market has crashed (since some of the target-date money is in fixed-income instruments, they do not fall quite as much as the overall market in market-crash years).  Over the last 5 years, target-date funds have lagged behind the market by 22% – 47% depending on the target date – truly monumental losses for all target-date fund owners.

Target-date funds underperform for two important reasons.  First, expense ratios (management fees) are higher, usually about three times as much as most index funds.  It doesn’t take a smart Wall Street MBA to pick the stocks in an index fund (rather, a fixed selection of stocks is blindly followed).  Consequently, the management fee can be much less for the index fund.

 Second, trading costs are usually two or three times as great in equity funds (especially target-date funds) compared to passive index funds.  The turnover rate can be 50% to 100% for many equity funds, running up considerable commission and trading costs that are passed on to participants (and generally not revealed to them). 

Even worse, this excessive turnover is subject to the completely hidden costs of high frequency trading which skims off millions of dollars for Wall Street every single trading day.  The big losers from high frequency trading are the owners of non-index equity mutual funds.

I have written a Kindle book that explores this entire issue in far more detail and tells you specifically exactly which fund you should choose for your 401(k) plan.  It is designed to be read in an hour (although two hours is probably a better time to allot).  I have immodestly called the book The Best Little Book on investing in an IRA or 401(k), Period! It is yours for only $5.99.  It could change everything you ever knew or were told about retirement investing.  If you have a single target-date or other non-index mutual fund in your investment portfolio, this small investment of your time and money could save you thousands of dollars over your lifetime.  Get it now, here.

The book includes one suggestion that is highly unlikely to have been disclosed to you by HR and is almost guaranteed to save you thousands in tax savings when you retire.  Why would any rational 401(k) participant not plunk down $5.99 to discover it?  Maybe because they are at the casino where they think they are more likely to come home with more money than they started out with.

All About Back Spreads

Sunday, December 9th, 2012

Back spreads and ratio spreads are usually discussed together because they are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread.
Since ratio spreads involve selling “naked” (i.e., uncovered by another long option) they can’t be used in an IRA.  For that reason, and because we like to sleep better at night knowing that we are not naked short and could possibly lose more than our original investment, we do not trade ratio spreads at Terry’s Tips.

Back spreads involve selling one option and buying a greater quantity of an option with a more out-of-the-money strike. The options are either both calls or both puts.
A typical back spread using calls might consist of buying 10 at-the-money calls and selling 5 in-the-money calls at a strike low enough to buy the entire back spread at a credit. 
Ideally, you collect a credit when you set up a back spread.  Since the option you are buying is less expensive than the one you are buying, it is always possible to set up the back spread at a credit.  You would like as many extra long positions as possible to maximize your gains if the underlying makes a big move in the direction you are betting. 
If you are wrong and the underlying moves in the opposite direction that you originally hoped, if you had set up the back spread at a net credit at the beginning, all of your options will expire worthless and you will be able to keep the original credit as pure profit (after paying commissions on the original trades, of course).
Call back spreads work best when the stock price makes a large move up; put back spreads work best when the stock price makes a large move down.
One of the easiest ways to think about a back spread is as a vertical with some extra long options. A call back spread is a bear vertical (typically a short call vertical) plus extra long call options at the higher of the two strikes. A put back spread is a bull vertical (typically a short put vertical) plus extra long put options at the lower of the two strikes.
The purpose of a back spread is to profit on a quick extended move toward, through and beyond the long strike. The purchase of a quantity of more long options is financed by the sale of fewer short options. The danger is that because the short options are usually in the money, they might grow faster than the long out-of-the-money options if the stock price moves more slowly or with less magnitude than expected. This happens even faster as expiration approaches. The long out-of-the-money options may lose value despite a favorable move in the stock price, and that same move in the stock price may increase the value of the short options. This is when the back spread loses value most quickly. This is depicted in the “valley” of the risk profile graphs. The greatest loss in the graph occurs at exactly the strike price of the long options.

There are two reasons that I personally don’t like back spreads.  First, they are negative theta.  That means you lose money on your positions every day that nothing much happens to the underlying strike price. 

Second, and more importantly, the gains you make in the good time periods are inconsequential compared to the large losses you could incur in the other time periods.  If the stock moves in the opposite way you are hoping, you end up making a very small gain (the initial credit you collected when the positions were originally placed).  If the underlying doesn’t move much, your losses could be huge.  On the other hand, in order for you to make large gains when the market moves in the direction you hope it will, the move must be very large before significant gains come about.

Here is the risk profile graph for a back spread on SPY (buying 10 Dec-12 142 calls for $1.55 and selling 6 Dec-12 140 calls for $2.78 when SPY was trading at $142.20 and there were two weeks until expiration):

You have about $1100 at risk (the $1200 maintenance requirement less the $115 credit (after commissions) you collected at the outset.  If the stock falls by more than $2.20 so that all the calls expire worthless, you would gain the $115 credit.  If the stock moves higher by $2, you would lose just about that same amount.  It would have to move $2.20 higher before a gain could be expected on the upside, and every dollar the stock moved higher from there would result in a $400 gain (the number of extra calls you own).

The big problem is that if the stock doesn’t do much of anything, you stand to lose about $1000, a far greater loss than most of the scenarios when a gain could be expected.  In order for you to make $1000 with these positions, the stock would have to go up by $5 in the two-week period.  Of course, that happens once in a great while, but probably less than 10% of the time.  There there is a much greater likelihood of its moving less than $2 in either direction (and a loss would occur at any point within that range).

Bottom line, back spreads might be considered if you have a strong feeling that the underlying stock might move strongly in one direction or another, but I believe that there are other more promising directional strategies such as vertical spreads, calendar or diagonal spreads, or even straddles or strangles that make more sense to me.

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I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins