Invest Wisdom

Yesterday, I wrote a bit about choosing mutual funds. Today, I’m writing about deciding between mutual funds and ETFs and about funds of funds, including balanced funds and lifecycle funds.

The ETF vs. mutual fund debate

The Toronto Stock Exchange invented the first exchange-traded fund in the 1990s. But in the last few years, their popularity has grown rapidly.

In a mutual fund, a money manager collects a big pool of money from investors, which he then uses to go out and buy stocks or bonds. Every time a new investor enters the fund, the manager has new money to invest. Conversely, the manager might have to sell stocks when someone leaves.

On the other hand, an ETF starts with the securities, which are mixed together, split up, and sold to investors. Think of ETFs as a chicken pot pie. The money managers throw in stocks and bonds as its ingredients, bake it together, and slice it up into portions, each with a little bit of each ingredient mixed in. After they’re created, the ETFs are traded on an open exchange, just like a stock.

It might sound like they accomplish the same thing. For the most part, that’s true. But the structure of ETFs allows them to carry lower expense ratios than those of comparable mutual funds and operate with greater tax efficiency. For example, the Vanguard Total Stock Market ETF and Vanguard Total Stock Market Index fund are each designed to give broad exposure to U.S. stocks. The ETF has an expense ratio of 0.07%. But the mutual fund has an expense ratio of 0.16%.

As far as disadvantages go, since ETFs trade like a stock, brokerages charge investors the same commissions that they would if the investor had bought a share of, say, Intel. Over the last few years, commissions have come way down. So, that drawback has become less and less relevant.

Most ETFs have been created to passively track indexes (like the S&P 500) or sectors (like green energy). Managers found it hard to create actively-managed ETFs because regulations would require them to disclose their holdings much more regularly than they would in a mutual fund. Managers with big funds sometimes have to accumulate stocks over several days or weeks. Disclosing their holdings frequently would allow other investors to see what they were buying and front-run them.

Despite that setback, the first actively-managed ETF was released in 2007—ironically, by Bear Stearns just before it went under. Even more ironically, the fund’s ticker symbol is YYY (say it outloud). Since then, several other money managers have started or said they intend to start active ETFs.

In deciding whether to use ETFs or mutual funds for your own portfolio, your main concern is how your brokerage fees compare to your mutual fund’s expense ratio.

Because of ETFs’ brokerage fees, in general, mutual funds are better if you buy them regularly as part of a savings plan (such as if you’re dollar-cost averaging). ETFs are better if you’re investing a large lump sum at once.

Let’s look at a real-world example using the Vanguard Total Stock Market ETF and the Vanguard Total Stock Market Index fund.

In the first case, let’s say you have $10,000 to invest all at once. If you chose the mutual fund, you’d have no trading costs. Pick the ETF, and you’d pay your normal brokerage fee (let’s say $10). The mutual fund’s expense ratio is 0.09% higher than that of the ETF. So if you chose the mutual fund, you’d pay an extra $9 in fees (0.09% * $10,000) every year, which would move up and down with your account value.

The total cost of the ETF for the first year is slightly higher than the mutual fund, but in the second year, the mutual fund’s extra $9 or so quickly eclipses the ETF’s initial trading cost.

For the second case, let’s say you’re investing $10,000 over a period of 10 months. The expense ratio difference is the same, but the trading costs of the ETF ($10 * 10 trades = $100) is much higher. So it takes much longer for the ETF to catch up to the mutual fund’s fees.

That example had some flaws. Some brokerage fees are lower than $10; the $9 in fees could shift dramatically if the account value skyrocketed or plummeted; etc. But the general point is the same. The more times a year you invest, the less buying an ETF benefits you.

As a rule of thumb, if you’re investing more than $5,000 at once, an ETF beats an equivalent mutual fund, according to the editor of the Journal of Indexes. Of course, your particular case will depend on your brokerage fees and the expense ratio difference between the funds.

What about funds of funds, like balanced funds or lifecycle funds?

Balanced funds are funds that invest partly in bonds, stocks, and cash. They can achieve this through either investing in the securities directly or by creating an overarching fund that invests in some of the mutual fund company’s bond and stock funds. Balanced funds start with an allocation (say, 50% in bonds and 50% in stocks) and regularly rebalance to keep themselves at their target.

On the other hand, lifecycle funds or target-date retirement funds, which I’ve criticized in the past, set the allocation based on your intended retirement age, and change the allocation from risky assets to less volatile assets as you grow older.

While target retirement funds have their weaknesses, they’re better than not rebalancing at all or than investing completely in stocks or bonds. Vanguard’s target retirement fund for those retiring in 2010 fell 21% last year—a terrible hit for someone nearing retirement. But if that person had just invested 100% in stock funds, he would have lost more than 40%.

If you use balanced funds, make sure you understand how they impact your overall allocation. Target retirement funds, for example, are intended to be the only mutual fund you hold. If you invest in stock or bond funds on top of the target fund, you’ll throw off the allocation that the money manager thinks is appropriate for someone your age. You may decide on your own that you want to be more conservative or aggressive than that manager. But at least pay attention to the underlying allocations of each of your funds.

When choosing a fund of funds, make sure you pay attention to the fund’s overall expense ratio. Fund of funds’ expenses are based on the expenses of each underlying mutual fund with a small overall fee thrown on top. Some websites only report the overall fee. So make sure you look at a fund’s prospectus to determine its total fee.

If you’re picking a fund whose allocation changes based on your age, you should also look at the prospectus or at a website such as Morningstar.com to see how the fund is split between stocks and bonds. Different mutual fund companies sometimes have drastically different ideas about what allocation is appropriate for people the same age. So you should figure out who you agree with. If you like a fund company but they seem too aggressive for your tastes, you could pick, say, the target retirement 2015 fund even though you’re retiring in 2025.

Again, these funds have their drawbacks, but if you truly want to “set it and forget it”, they’re an inexpensive choice.

— Joe Light

I write a lot in this blog about analyzing companies and company stocks. But the fact of the matter is that most investors, especially those who have better things to do than troll through a balance sheet, should devote most or all of their investments to mutual funds. If you have only a little time to devote to investing or if you have little money to invest, mutual funds can provide you plenty of diversification at a good price.

But unfortunately, picking a mutual fund isn’t as easy as you might think. According to the Investment Company Institute, there were 8,029 mutual funds in the U.S. in 2007, and 66,350 worldwide, not including most funds of funds (such as lifecycle and target-date retirement funds). To put that in perspective, the Fidelity Spartan Total Market Index fund, which is supposed to track the performance of the broad U.S. stock market, only holds 3,193 stocks.

For most investors, the great majority of mutual funds and ETFs are unnecessarily complicated or expensive. Despite that, building a portfolio of mutual funds isn’t hard.

Over the next two days, I’m going to go through the process of choosing mutual funds, whether it be for an IRA, Roth IRA, 401(k), or taxable account. This is going to assume that you’ve already determined what your asset allocation should be. If you haven’t, check out the calculator here for a quick rundown. It’s pretty simplistic, but it’ll give you a place to start.

Today, I’ll discuss the reasons passive, index funds are better choices than actively-managed funds most of the time, and what you should pay attention to with mutual fund fees.

Tomorrow, I’ll address the mutual fund vs. ETF debate and the benefits and drawbacks of funds of funds (including balanced funds).

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If I had to break down my requirements for a mutual fund into as few words as possible, it’d go like this:

Index funds, low fees, no loads.

Simply follow that, and it will be hard to go wrong.

But if you want to see some of the reasoning behind that advice or get into more detail, read on.

* Pick funds with low expenses.

Though there are thousands of funds out there, you’ll dramatically cut down on your choices simply by picking funds with below average fees. As you scan the list of available funds in your 401(k) or use a screener like the one at Morningstar, eliminate any that have expense ratios above 1.5% and red flag any others with expenses above 1%.

According to ICI, the average stock mutual fund in 2008 had an expense ratio of 0.99%. The average bond fund came in lower at 0.75%. Paying above (or even at) those averages just doesn’t make sense in nearly any circumstance when there are so many that can beat those fees.

The great majority of investors should also never pay a front-end or back-end load on a mutual fund. These are common in funds sold by commission-based financial advisers. With a load fund, you have to pay a commission (sometimes up to 5% of your total investment) upfront when you invest, or alternately you have to pay the percentage when you withdraw. Even funds with a share class that charges a load most often have share classes with no load. There are few reasons to pick a load fund. So, don’t.

You should also focus on funds with as little turnover as possible. Turnover is a percentage that measures how many of the holdings inside the mutual fund are changed within the year. Mutual funds that trade often spend a lot on brokerage fees and taxes. Very large mutual funds, which have to buy millions of dollars worth of stock at once, also pay a hidden cost, as their large purchases drive up the price of the stock they’re trying to accumulate.

* Think twice before choosing an actively-managed fund over an index fund.

It’s been well documented that active fund managers—that is, managers who try to pick stocks to outperform the market—underperform the index over time. Last year, the S&P 500 outperformed 72% of large-cap mutual funds.

While mutual funds’ records have been better in past years, picking a winning active fund manager is still a crap shoot. Even those who perform well one year, often underperform in subsequent years, erasing any advantage you had. In addition, active mutual fund managers charge you more than index funds for their expertise. So even if an active fund manager mirrored the index, the passive fund would make you more money, because it charged lower fees.

It’s not clear why actively-managed funds aren’t able to do better than average. Some people point out that since so much of the stock market is controlled by money managers, when you combine their returns, you’d just about have to get an average. When you have a stock market as closely monitored as that of the U.S., it’s also harder to find bargains that others haven’t already found (or so the argument goes). But in the end, the reason doesn’t really matter. The proof’s in the pudding. (Side note: For an explanation as to why I’m not using “proof in the pudding” correctly, see here.)

If you have choices between funds that track the same index, simply pick the no-load fund with the lowest fees. Those run by Vanguard and Fidelity are good, low-fee options. Some of Charles Schwab’s index funds also recently became the low-fee index fund leaders.

So, after all that, you still want to take a look at actively-managed funds? If you insist, take a look at Morningstar.com, enter the potential fund’s ticker symbol, and take a look at the fund’s track record over the last five years. Pay particular attention to the second row, where Morningstar compares the fund’s returns to that of the comparable index. You want a manager who has consistently beaten the index by a substantial margin.

If you’re using the active fund to fill out part of your overall asset allocation, scroll down the “Snapshot” page to see the “Asset Allocation %” of the fund. There you can see how true to the fund’s name the manager stays. The FPA Capital fund, for example, is a stock fund, but right now, its managers have 31% of the fund’s money in cash. That doesn’t mean the manager’s messing up. But it does mean that if you used only that fund to make up the “stock” portion of your allocation, you’d really have nearly a third of your stock money in cash.

It’s a bit of homework, but it’ll pay off if you want to choose an active manager. Even after doing all that work, I’d still devote only a portion of your portfolio (10% or less) to active funds and put the rest in low-cost index funds. You won’t regret it.

Come back tomorrow to read a little bit about the mutual fund vs. ETF debate and funds of funds.

— Joe Light

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There’s a saying on Wall Street that the only thing that goes up in a market crash is correlation. In lay terms, it means that “non-correlated” assets—that is, assets that are supposed to move in opposite directions to reduce a portfolio’s volatility—might suddenly move down together in extreme circumstances.

Not many asset classes were left standing last year.

That was certainly the case during this market crash. Nearly every asset class, whether it was bonds, stocks, real estate, or commodities, lost value. Many people have interpreted those results to mean that diversification doesn’t work.

One or two asset classes (I debated whether or not I should have put “asset class” in quotes) did make money. And you better believe those who manage them are letting people know about it. Managed futures are one example. Managed futures are run by commodity trading advisers who buy and short futures contracts for all sorts of asset classes, like commodities, stock indexes, and currencies.

Their returns for the last several years have been ridiculously good. On average, they beat the stock market by 51% last year, according to one index. I’m not too familiar with managed futures, but a columnist with the Wall Street Journal does a good job explaining why it might not be a good idea to jump into them based on their recent performance.

I would extend that warning to anyone looking for new asset classes to add to his portfolio and prevent drops like we saw last year. For one, it’s never a good idea to invest in something you’re not familiar with. Second, the factors that helped the new asset offset the losers might not be there next time, as the Journal columnist argues. But finally, ask yourself if diversification truly “didn’t work” last year.

Yes, corporate bonds lost money along with stocks, but they didn’t lose nearly as much. In fact, if you had simply invested in a total bond market fund (of which nearly a quarter would have been Treasury bonds) your fund would have made a few percentage points.

My feeling is that in times like last year, you’re likely to lose a substantial amount of money no matter how many asset classes you spread your investments in. If you want to earn a return above what cash equivalent investments give you, you’ll always have to take on risk. A new asset isn’t going to fix that.

— Joe Light

Lots of people who give out advice on investing and retirement (myself included) have been questioning their fundamental assumptions about risk and return over the last several months.

Recently, a company surveyed financial advisers about how the recession has affected their advice, and 77% said that they had altered their asset allocation strategy in reaction to the sell off. Thirty-six percent said that they felt less confident in their abilities to manage their clients’ assets. You can read more about the survey here.

I think it’s healthy to periodically check assumptions about something as important as asset allocation. It’s unfortunate that it has to happen after many soon-to-be retirees have lost more than 40% of their money. In the first story linked about the survey, a survey administrator said that the surveyed advisers have moved their clients’ money to more conservative investments like bonds and cash.

I don’t think such a shift is necessarily a bad move. Some of their clients might have discovered that they couldn’t handle the risk their previous portfolios entailed. But I hope advisers are accompanying that shift with a note to clients that they better save a higher percentage of their income to make up for the lower expected returns from their new portfolio. Moving to a conservative allocation simply because they don’t want to see their clients’ portfolios bounce around without compensating in some way could really hurt. Instead of having say, a 70% chance of retiring when they want in a traditional allocation (which I understand isn’t good), their clients might have a 0% chance of retiring when they want if they choose to go with the low guaranteed return of safe investments.

Again, I have no problem with going safe. There’s just some extra work involved if they do.

— Joe Light

To convert or not to convert?

That’s the question I’m facing now. Actually, I’m facing the question of whether to convert from a traditional IRA to a Roth for a second time. I converted the first time in February 2008. It was a rollover IRA from an old employer’s retirement plan, and I finally got around to turning it into a Roth. And then, along with the rest of the market, the account balance dropped by almost half. If I had kept it as a Roth, I would have had to pay income taxes on the high, February balance. So rather than take an unnecessary tax hit, I recharacterized it back into a traditional IRA.

Since then, and because of an extreme aversion to paperwork, I haven’t converted it back into a Roth. And now, of course, the market is up 30% from its low. I feel stupid for not converting it into a Roth again in March, when I would have paid the minimum in income taxes. But since that time has come and gone, should I wait? Or bite the bullet and convert now?

To answer this question, I turned to the fundamental source of my anxiety about re-converting. And that was: What if I’m wrong again and the market drops?

As I think the question through, holding out just in case the market retreats to new lows is a backhanded way of attempting to market time. If I really thought that the market was going to drop, I would move my IRA investments into a conservative bond fund or money market fund. I won’t do that, because I know that it’s just as likely, if not more likely, that the market will rise. So, the best time to convert from a traditional IRA to a Roth IRA is always going to be now, if I make the decision based solely on the direction of the market.

And what’s the worst that could happen? Well, I guess it’s that my account is worth less at the end of the year than it is now, in which case I simply recharacterize it all over again. I hate paperwork. But is a couple hours on the phone and in the post office worth several thousand dollars to me? Um, yes.

If you’re facing the same question I am, there are other things to consider. For example, your income tax bracket might change from year to year because you received a large bonus that didn’t come this year or vice versa. If you already have a lot of money in a Roth IRA but little in a traditional IRA or 401k, you might simply want to keep your tax-advantaged accounts diversified (that is, you might not want to commit fully to the idea that your taxes will be higher when you retire, which is what pre-paying taxes with a Roth does). But in my case, being unhappy in my market timing ability was no reason to delay.

A great source on IRA conversion and recharacterization rules is Fairmark.com. You can find their recharacterization literature here if you’re considering any of the same moves I am.

— Joe Light

I’ve written in the past about the price-to-earnings ratio and why it shouldn’t be your only measure of value. I’m about to not follow my own advice. Don’t kill me.

A few months ago, I wrote a story about how the market looked undervalued based on a very conservative use of the price-to-earnings ratio. Instead of dividing the market price by the current year estimated earnings or last year’s earnings, you divide it by the average of the market’s earnings for the last 10 years.

“Normalizing” the earnings in that way makes it so your P/E isn’t heavily influenced by earnings bubbles. Any “fake” growth or market cycles that might artificially inflate the earnings will be offset by earlier years of lower earnings. The P/E based on 10-year normalized earnings was made famous by Yale professor Robert Shiller in his book Irrational Exuberance, which accurately predicted the tech and real estate bubbles.

Back at the market low of 666, Shiller’s P/E stood at about 12, well below its historical average of 16. In other words, investors who bought at the low would earn about 8.3% per year (1 divided by 12) versus the 6.25% that they settled for in the past. Since then, the market has risen 30%. Would the same measurement say the market is a bargain now?

Right now, the S&P 500 stands at about 903. We don’t have the last few months of earnings data yet, but given that it’s a 10-year average, it shouldn’t make a huge difference. If we take 903 and divide it by our old earnings figure, we get a new P/E of 15.6. That is, investors by buying now would get a yield of 6.4% on their investment, right in line with the average. According to the chart we ran with my story a few months ago, investors who invested at P/Es in that range got 10-year annualized returns of about 5.7% on average.

In other words, based on Shiller’s P/E alone, it doesn’t look like the stock market is as much of a bargain as it was in March, though investors aren’t overpaying for stocks either. Shiller updates his P/E every month. You can find it in the Excel chart on this page.

I do these sorts of calculations frequently, but mostly as an academic exercise. Investors with a long time horizon would probably be better served by coming up with an appropriate asset allocation based on age, risk tolerance, savings and other factors and sticking to it, regardless of what the P/E says. This isn’t because Shiller’s P/E is wrong. It’s simply because tracking the P/E (and all the other measures of value) is hard and takes time. If you screw up even once, you could seriously harm your savings.

Back in the March story for Money, I wrote that someone wanting to take advantage of the low valuations might make a slight shift in their allocation—maybe you could put an extra 5% to 10% in the stock market while prices are low. I’d have to go back to my sources to see what they think, but it doesn’t look like the case for that kind of shift is as strong now.

— Joe Light

I purposely avoid TV news for business information. There’s too much there to provoke an emotional response and encourage frequent trading, which we all know is a bad idea. But one of the few general interest news programs I do watch is Meet The Press on Sunday mornings.

Has anyone else noticed that the press suffers from a bit of attention deficit disorder? For the fourth straight week, the economy wasn’t part of the newscast at all. This week, it made way for discussions about troubles in Afghanistan and Pakistan. Last week, it was the swine flu and Sen. Arlen Specter’s switch to the Democratic Party.

Those are all important topics, but it’s seeming more and more like the complete disintegration of our financial system has become yesterday’s news.

I suspect that’s because the stock market has risen more than 30% since the March low. But while the stock market is often the earliest barometer of which way the economy is headed, it’s worth pointing out that other economic indicators say we’re not out of the woods yet.

The June issue of Money Magazine (which isn’t online yet, unfortunately) explains three leading indicators that would point to an economic recovery.

1. Business sentiment goes up and stays up. The Institute for Supply Management’s non-manufacturing index (found here) measures how confident companies are about their growth prospects. The survey asks questions about business activity such as new orders, backlogs, and inventory changes to come up with an overall index.

For April, the index was at 43.7, a couple points above the March figure and much higher than the November low of 37.4. A score below 50 means that industries are contracting. A consistent rise in the index to a score above 50 would indicate that the recession is winding down.

2. Housing supply shrinks. According to the National Association of Realtors, the real estate market had nearly 10 months of supply in March (found here). A 10 month supply means that it would take about 10 months for home buyers to absorb all of the homes currently for sale. Since you generally don’t expect homes to be sold immediately, a “healthy” inventory isn’t 0 but closer to 6 months. Ten months is a bit below some of the highs last year, but not that much better.

3. The hiring of temp workers spikes. In the first stages of a recovery, companies tend to be cautious, preferring to hire temporary workers over full timers. But in the first few months of the year, temp staffing hasn’t risen or fallen (found here). You should see a consistent rise in temp hiring for a few months before being confident that the economy is growing again.

All in all, it doesn’t look like we’re quite on the precipice of an economic rebound—though that could be coming. This data doesn’t mean that you should avoid the stock market while waiting for the indicators to turn positive. On average, the stock market tends to bottom between four and five months before the end of a recession. These indicators, on the other hand, only turn positive 2 to 3 months beforehand.

By the time you see these “leading” indicators turn around. The best leading indicator out there — the stock market — might have already taken off.

– Joe Light

Just as a fun exercise, I took a look at some coincidences that signaled market rebounds in past recessions. They’re not tied to fundamentals (like unemployment or corporate earnings) in any way, but offer a window into the silly tendencies of book publishers, fund managers, and pretty much everyone else to mistime the market about as badly as possible.

The book How Harvard and Yale Beat the Market, for example, probably seemed like a surefire best seller back when the schools were posting double-digit returns. But unfortunately, the book came out just last month, soon after both schools’ endowments lost about a quarter of their value. I sympathize with publishers that have to try to guess what the economy will be like months beforehand.

A few books hitting my bookshelf, and another silly indicator, have given me reasons to feel pretty good. (Forgive me for not linking all these books. Some of them I’d rather not send the traffic.)

* The market is flooded with money “scare” books. This started in mid-to-late 2008 and continues now. In the past several months, I’ve received copies of Financial Shock, Game Over: How You can PROSPER in a Shattered Economy, and the Guide to the End of Wall Street as We Know It. More recently, it’s been The Ultimate Depression Survival Guide, Jim Cramer’s Real Money: Sane Investing in an Insane World, and The Great Depression Ahead.

By comparison, see the July 2006 classic How to Buy Real Estate Without a Down Payment in Any Market.

I’m not too familiar with the book industry, but the lead time on some of their books must be pretty long. In January, I bizarrly received a book titled Do-It-Yourself Hedge Funds, complete with a cigar-smoking cartoon character in a tophat on the front cover. As the lone Amazon reviewer of the book wrote, “I haven’t been this excited by a DIY book since ‘Do-It-Yourself Biohazardous Waste Disposal.’”

* A prominent value mutual fund manager is fired. We all know that we’re supposed to invest for the long run. But unfortunately for fund managers, their own industry doesn’t work that way. You see, it’s important for funds to post good returns every year. Otherwise, investors tend to leave the fund in droves. Although value managers are supposed to make money by being “contrarian”, that is, investing in companies that the market has shunned, in the shortterm that can lead to losses and put their jobs at risk before they have a chance to bounce back.

Last month, 72-year-old David Dreman was fired as the manager of the DWS High Return Equity Fund. Dreman had led the fund for two decades.

As this blog entry from Money notes, it was at the height of the tech bubble in 2000 when the last spate of value managers got canned. Their funds hadn’t kept up with peers loading up on tech stocks. You know what happened next.

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Unless I hear someone say something really interesting, this is about as far as I’m going to go in calling whether or not the March low was the bottom of this bear market. The real answer is “No one knows.” Yes, that’s a frustrating answer. But it’s the right one.

— Joe Light

The Federal Reserve released the results of the Supervisory Capital Assessment Program (a.k.a. the bank “stress tests”) this evening. The tests were designed to measure how well banks would hold up under two scenarios: 1. The “baseline” scenario, where the economy follows the trajectory currently forecast by economists and 2. The “more adverse” scenario, where the economy performs significantly worse than that.

The Fed had an inside look at banks’ assets and supposedly was able to determine whether banks had enough capital to survive should the economy worsen. It’s the same thing that banks are supposed to do on their own, but given the failure of many banks to do just that, the Fed thought it was in the best interest of the economy to do it for them and make it public.

The results weren’t all that surprising. The Fed wants the banks to raise about $75 billion in total. Banks that have to raise a lot include Bank of America and Wells Fargo. Banks that don’t have to raise anything include J.P. Morgan and Goldman Sachs.

But if you take a look at the actual report, there are a lot of interesting items that aren’t in most of the first blush news stories I’ve seen.

For example, take a look at this chart from the report. It shows which banks would lose the most if the Fed’s “more adverse” scenario took place.

As you can see (if you can squint and read the names), State Street’s assets are the most vulnerable to an economic downturn. Metlife is the least vulnerable. The chart doesn’t show who needs to raise more capital (GMAC would have low losses, for example, but it has no capital buffer), but it does show how stock investors should expect their companies will be affected if things get worse.

If you’re invested in any of the banks tested by the Fed, you owe it to yourself to flip to the end of the report where they detail possible losses in each asset class for each bank. I wouldn’t buy or sell a stock based on the information alone. After all, everybody has the report and much of it might be priced into the market already. But it will help you understand just what kinds of losses your companies are exposed to should the rosier forecasts that have driven the market upward don’t take place and the adverse scenario occurs. And it’s not every day that banks make that information public.

— Joe Light

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Zillow.com, which tracks home prices nationally, released a report today which concluded that 22% of all homes in America are “underwater”—that is, the homes’ owners owe more on their mortgages than they can sell their homes for.

I could go on and on about what trouble those homeowners are in. Even if they keep up with their mortgage payments, they basically can’t move without negotiating a short sale, putting up thousands of dollars at closing to make up the shortfall, or going into foreclosure.

A ways back, when I was a real estate reporter with the Florida Times-Union in Jacksonville, I remember talking to a homebuilder who made the case that a home was the best investment someone could make.

“In no other investment can people leverage their returns at such a low cost,” he said. (This was several years ago. I’m paraphrasing.)

“Just look at the math!”

Someone buys a $200,000 home with $20,000 down and a $180,000 loan. If the home price goes up 10% and the homeowner sells it for $220,000, he makes $40,000 on the deal. In other words, his return is 100%, even though the market’s return was only a tenth of that.

Sound familiar? It was nearly the same strategy Lehman Brothers used to generate its market beating returns for years.

According to a Bloomberg story written when Lehman went under, Lehman’s ratio of total assets to shareholder equity was 31. To put that in easier terms, it’s as if Lehman had bought a house and only put 3% down. (It’s just the inverse: 1 divided by 31)

Just a 3% drop in its investments completely wiped out Lehman’s equity.

According to Zillow, since last year, home prices have dropped 14%. That means, the average homeowner who put up to 14% down at this time last year has had more than a negative 100% return on his home “investment”. Even if the homebuyer was extremely frugal and put 30% down, his results would still be pretty terrible:

Let’s say he bought a $500,000 home and put $150,000 down. His home is now worth $430,000 after the 14% drop.

Unfortunately, the size of his mortgage didn’t change. But his equity dropped to $80,000. In other words, despite the 14% drop in home prices, his investment’s loss is 47%! (We’re not including monthly payments made between the purchase and the drop.)

That’s the kind of change we didn’t even bother to calculate in 2005, when a large drop in home prices wasn’t on the radar. Home buying is great as a forced savings vehicle. It also has tax benefits, and I’m sure it makes people happy to have a plot of land that can be called theirs. But an investment? To me, the leverage involved makes it one of the riskiest investments you can make.

And no—As a real estate reporter in 2006, I did not foresee that one day the American dream would put 22% of Americans in over their heads.

— Joe Light