Knowing What You Own
It is very easy to get caught up in the moment. When reading that statement, it’s likely that the notion of a romantic encounter came to your mind. Picture a movie scene in which the characters shouldn’t do something, but they do it anyway because it just feels right. In most movies, the situation usually works out in the end, so that the “moment” turns into a lifetime of bliss. Movies like Fatal Attraction, however, may be closer to reality.
I say this because romance is probably not where you get caught up in the moment. It’s probably something to do with finance. It can take the form of buying something you don’t need while on a visit to K-Mart (a subsidiary of Sears Holdings (SHLD)) because it’s a “Blue Light Special,” to bidding too much for an item on eBay (EBAY) because some unknown person tried to outbid you in the last moments of an auction. It can also have an impact on decisions about what investments you own.
With stocks, many investors get caught up in the moment of a good story. The story is “as old as song,” to steal a snippet from Disney’s (DIS) Beauty and the Beast. Some sector has wonderful prospects for any number of reasons, so investors start to put money into it. As money flows into the sector, the shares there advance. Once other investors see this, they pile in, using the original story as the logical reason for their investment—even though hot performance was the more likely motive. At some point, investors start to realize that the story doesn’t justify the prices that the stocks in the sector have been bid up to and investors start to head for the exit. After enough people start leaving, everyone else gets the idea that things aren’t so rosy and there is a stampede for the exit. The last ones leaving the dance get mauled.
This was the case in the Internet bubble where companies like eBay, Amazon.com (AMZN), and Pets.com (which didn’t survive the fallout) came into being. There were similar bubbles in bio-tech stocks and, more recently, housing-related stocks, like Beazer Homes (BZH) and PulteGroup (PHM). The same mentality can flow into other securities, too, including debt instruments (such as the ones tied to mortgages that were too inviting to avoid for large banks such as Citigroup (C) and several companies that were ultimately swallowed by Bank of America (BAC)), commodities, and derivatives.
Avoiding the lure of these siren songs can be very difficult, which is why many investors prefer to “outsource” their investment management needs to mutual funds. At first blush, this sounds like the perfect solution. If you put a professional between your money and your emotions, it should help to reduce your chances of getting involved in an emotionally charged investment decision. Moreover, by purchasing a mutual fund you are, inherently, diversifying your investments—helping to reduce the stock specific risk of your overall portfolio.
All of this is, to some extent, true. The only problem is that you have to buy the right funds to achieve these goals. In fact, many mutual fund companies routinely use the human tendency of getting caught up in the moment to market mutual funds that focus on hot sectors. This happened prominently in the tech boom, when the introduction of new Internet-focused funds was a blatant display of “me-too-ism” by fund companies. Many of the funds launched no longer exist today.
One of the most recent examples of the risk of getting caught up in the investing moment is a type of mutual fund called a floating rate fund (the terms bank loan fund and leveraged loan fund are also used, at times). The basis of the funds is pretty simple. They purchase debt from companies that have lesser credit ratings. This form of debt normally has an interest rate that resets at fairly short intervals. Thus, as rates rise, the debt payments received by the funds increase.
With interest rates at historically low levels, many investors are concerned about the future—when rates inevitably head higher. The story surrounding floating rate loans, and the funds that invest in the loans, is, thus, a good one since they will provide some protection against rising rates. Looking back at the performance of these funds shows that they had stellar returns in 2009. To an investor caught up in the rate story, they might look past the market dislocation that likely led to the strong 2009 showing for these types of funds.
There are some leveraged loan funds with relatively long histories, such as no-load Fidelity Floating Rate High Income Fund (FFRHX) and load fund Eaton Vance Floating-Rate Fund A (EVBLX). But, according to some reports, these funds are being joined by similar, soon-to-released offerings from Goldman Sachs (GS), BlackRock (BLK), and others. This flood of new products has a distinct similarity to the Internet funds that came and went in the 1990s.
This isn’t to suggest that owning a floating rate fund is a bad idea. The story is, to be sure, a good one. But it is to point out that investors need to do their homework, even for mutual funds, to ensure that you know exactly what they own and why. Otherwise, there might be a symbolic rabbit boiling on your investment statements in the form of red ink when you would much prefer a prince (or princess) to magically appear.