Chapter 24. Comparing Mutual Funds With Folios

Folios are designed to combine the diversification advantages of a mutual fund with the advantages of owning a customized selection of individual stocks.

Folios can serve as some type of substitute for owning mutual fund shares, but investors need to understand that these two alternatives are completely different.

There is no minimum amount for a folio account or trade, as there is with a mutual fund. Keep in mind that minimum account requirements have been rising for many mutual funds.

Mutual funds, as investment companies, are registered with the SEC. The SEC does regulate folios to some degree because the companies that sell folios are registered as broker-dealers or investment advisors, but the regulations are not as strict as those for mutual funds. The latter come under the Investment Company Act of 1940, a well-established, successful piece of federal regulation. Mutual funds have operated successfully from a consumer standpoint for many years . There has been some talk of the SEC regulating folios in a manner comparable to the regulation of mutual funds. To date, the folio industry has strongly resisted this proposal.

Managers are hired to manage mutual funds. They have staffs to analyze and value securities, and they charge shareholders to cover these costs. In contrast, folios are managed by advisors or the organizations offering folios who decide on the stocks for the folios. Conversely, folios are at least partially managed by the folio owners themselves . Starting with a preselected folio, a folio owner can decide to change the folio, dropping a couple of stocks that are objectionable (e.g., tobacco companies) or stocks thought not to have good prospects.

Some investors appreciate the opportunity to fine-tune the particular set of stocks held. After selecting the appropriate folio, the investor can remove stocks that are not wanted. In fact, whole folios can be traded for others, even after investors have modified them with their own stocks. Of course, you can create a folio of stocks in almost any share size or dollar allocation that you choose.

Insights

Some investors ”indeed, perhaps many investors ”do not want to make investing decisions, deciding what to buy and when to buy and sell. They want to leave this task to someone else, in particular a mutual fund manager. Therefore, folio investing is not for lazy investors or those who simply do not feel comfortable choosing a portfolio of stocks to own. Decisions have to be made from time to time because changes in the portfolio need to be made periodically. Folios clearly offer more of a hands-on approach than do mutual funds, so if you don't want to take a more active role, you might not find folios appealing, or as appealing as some others will find them.

It is also important to note that flexibility and ease of transacting cuts both ways with regard to folio investing versus mutual funds. If you wish to invest your money in the S&P 500 Index, as many investors do, it is much easier to do so by buying an index fund like the Vanguard fund. It is very difficult, if not impossible , to replicate the S&P 500 exactly using the folio approach. It would be too cumbersome and too expensive. You could, however, buy FOLIOfn's Folio 50, the 50 largest stocks in the S&P 500 based on market capitalization. This list of stocks has had a very close correlation with the overall S&P 500.

As we have seen in previous chapters, mutual funds traditionally have paid little attention to the tax implications of their decisions. Shareholders have no control over how taxable transactions occur. Many mutual funds have portfolio turnover rates as high as 100 percent. With each transaction, a potential tax liability is being generated.

In contrast, folios are not mutual funds. They can be managed by advisors, who can manage them in a tax-efficient manner. Advisors can decide when to take a capital gain or loss. Or, the investor and owner can make all the buy and sell decisions, thereby avoiding any unexpected tax bills.

FOLIOfn offers some valuable services in the area of tax efficiency. It automatically identifies shares that will generate the largest savings in taxes when an investor is ready to sell, using multiple methods .

Folios can be priced and sold multiple times in a single day. Mutual funds, in contrast, are priced once a day and are bought and sold at calculated prices. This is of more interest to traders than long- term investors, but there are times when it could make a difference.

Folios offer real-time information concerning the investor's holdings. A folio investor knows each day exactly what the folio contains, the prices of the securities, the tax implications of the securities (e.g., is there a loss or a gain, and is the loss or gain short-term or long-term?), and so forth.

Mutual funds, in contrast, report their holdings with a lag of months. They are required to disclose their holdings only every six months, and few choose to do otherwise . Furthermore, there is a time delay for the semiannual report to reach shareholders. In the Spring of 2000, prices of technology stocks declined sharply, but mutual fund shareholders often did not learn of the damage until months later.

What about costs? It is somewhat difficult to compare folios with mutual funds regarding costs because several variables come into play, particularly the amount of money being invested and the type of mutual fund used. Let's consider some comparisons.

If an investor has $100,000 to invest, a $295 annual fee for folios is modest at $295/$100,000, or 0.295 percent of assets. However, if an investor has only $25,000 to invest, the fee becomes more significant at 1.18 percent of assets. Note, however, that the investor could have more than one account in the folio approach, because this fee allows for three folios.

For those investors who plan to hold only index mutual funds, we can make some estimates. If the expense ratio is only 0.20 percent, an investor would need $150,000 to be indifferent between the index fund and a folio where the annual fee is $295. Again, however, the ability to hold three folios can make a difference in favor of folios.

It is not cost-efficient to invest small sums of money using the folio approach. If you have $5,000, $10,000, or $25,000 to invest, it is probably better to stick with mutual funds. Also, with folio investing you must place market orders (at least to date), which are often not the cheapest way to transact . Mutual funds achieve much better execution in many cases with their buying power.