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Financial Literacy

What You Can Learn From This Billionaire’s $500 Million Mistake

Hedge fund billionaire George Soros conceded this week that he made a $500 million error in judgment.

You can learn a crucial lesson from his realization – even if you have a few dollars less of your own to invest.

Let’s start at the beginning…

Last September, famed money manager Bill Gross left Pacific Investment Management – and its Pimco Total Return Fund – to set up shop at Janus Capital.

This was big news.

After all, with over $260 billion in assets, Pimco Total Return was the world’s largest actively managed fund. And Gross – famously known as “The Babe Ruth of Bonds” – was the man largely responsible for its outperformance.

Decades ago, Gross pioneered a new approach to bond investing. Until then, a lender handed their money over to the borrower and then collected interest until the borrower repaid the loan. The notion that anyone might routinely trade these instruments by selling them to others prior to maturity didn’t exist.

However, Gross saw that opportunities existed to trade in and out of various sectors of the bond market – as well as individual issues – and moved to capitalize on them.

Thanks to inefficiencies in the bond market – and a general lack of competition – he spent many years outperforming both the JPMorgan Global Government Bond Index and the Barclays Capital Aggregate Bond Index.

But in the last few years, he stumbled at Pimco with a couple of ill-timed sector bets. Money cascaded out of his fund. Management turned up the heat. And fed up with the pressure, Gross left the firm to start afresh at Janus.

It was a major endorsement when Soros plunked $500 million into a special institutional account modeled on Gross’s new Janus Global Unconstrained Bond Fund. (The fund allows him to buy – or bet against – any type of bond, of any maturity and any credit rating, in virtually any market around the world.)

But it has not been a pretty start.

The fund plunged 2.7% in a single day in August, an unusual whacking for a fixed-income fund. It also took a big hit in May as investors sold off both government and corporate bonds. Not only is the fund down for the year, it has underperformed three-quarters of similar funds.

As a longtime hedge fund manager, Soros is no stranger to volatility. But he’s had enough, pulling his entire stake from Gross.

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Here’s the lesson Soros is late in learning: actively managed bond funds are for losers.

Industry insiders know that over the long haul the best-performing fixed-income funds are not the ones with the hotshot managers but the ones with the lowest expenses.

As a sophisticated income investor, you should own either a) a diversified and laddered portfolio of individual bonds, b) low-cost exchange traded funds (ETFs) or c) Vanguard bond index funds.

In particular, the Vanguard Group has a unique not-for-profit structure among mutual fund companies.

The company’s funds – and therefore the funds’ shareholders – own all the common shares of Vanguard itself. And as the nation’s largest mutual fund group, Vanguard enjoys economies of scale that make the company’s costs the lowest in the industry.

Vanguard bond index funds have annual expenses of as little as two-tenths of 1%. The average managed bond fund has expenses that are four times higher. And some are as much as seven or eight times as expensive.

Bottom line: Ninety-four percent of Vanguard’s bond funds have outperformed their peer-group averages over the last decade.

Do you really want to take that 6% chance that you can do better with an active manager?

Over the last several years, the bond market has become more efficient. There are relatively few differences in bond characteristics, so it is increasingly difficult for managers to shine through portfolio selection, even for someone as knowledgeable as Gross.

And the high annual fees – even on no-load funds – are a huge headwind.

Plus, yields remain near historic lows. That means a bond fund with a 1% expense ratio can eat up as much as a third or even half of your annual return.

So here’s the takeaway.

As an investor, there are a lot of thing you cannot know for certain: Future levels of inflation… The direction of interest rates… The Fed’s decision at its next Open Market Committee Meeting…

But here’s something you can take to the bank: All else being equal, the lower your annual costs, the higher your net returns.

Once you recognize this, you should do what George Soros did – and move your money.

Good investing,

Alex


About

An expert on momentum investing, value investing and investing based on insider activity, Alex worked as an investment advisor, research analyst and portfolio manager on Wall Street for 16 years. He now runs the wildly successful Oxford Communiqué, ranked as one of the top investment newsletters by Hulbert Digest for more than a decade. He is also the author of four national best-sellers: The Gone Fishin’ Portfolio, The Secret of Shelter Island, Beyond Wealth and An Embarrassment of Riches. He shares his wisdom in his free daily e-letter, Liberty Through Wealth.

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