It's a mailbag week on Industry Focus: Financials, which means our analysts and contributors are dipping into the mailbag to answer a few questions from listeners.
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Listen in to find out the difference between an equally weighted fund and a standard capital-weighted fund, and what this means for investors of both funds over the short and long terms; what a 13F is and how much the information inside of one should impact an investor's decision to buy in or pass on a company or fund; why it's not the best idea to carry a debt on your credit card with the intention of improving your credit score; and more.
A full transcript follows the video.
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This podcast was recorded on March 20, 2017.
Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You'relistening to the Financials edition,taped today on Monday, March 20,2017. My name is Gaby Lapera,and joining me on Skype is Jordan Wathen, ourfinancials specialist at The Motley Fool. Hey, Jordan! How's it going?
Jordan Wathen:Going all right! How about you, Gaby?
Lapera: Pretty good,any crazy St. Patrick's Day stories?
Wathen: No,I saved those for last week. We had a pub crawl. Thelargest in the United States is actually in Charlotte,and I went last week. This week, I stayed in and took it easy.
Lapera: Fair enough.I know that our producer Austin says thathe had a tiny headache on Saturday.[laughs] So, today is mailbag day. We'reanswering four listener questions that have been sent to the show. If you'd like to have your question answered on a future show, please email us at firstname.lastname@example.org. Ourfirst question comes from Rob. He writes, "Recently,I have been reading aboutequal-weight index fundsas compared to the standard capital-weighted funds. Example: RSP(NYSEMKT: RSP) vs SPY(NYSEMKT: SPY). Can youexplore these equal-weight funds in depth, please?" So,why don't we start with explaining what the difference is between those two types of funds.
Wathen: I think the big difference is that --there's really two differences, butone of the big ones is the standard is market cap-weighted, as he alluded to, which means that thelargest companies make up the largest part of the index. So,for something like the S&P 500, the largest holdings, in order, areApple,Microsoft,andJohnson & Johnson. Three out of 500 companies, those three, make about 8% of the S&P 500.
Lapera: That's incredible.
Wathen: If you look at anequally weighted index,it means that all of those are treated equally. So, those three,instead of making up 8% of the index, would make up 0.006% of the index.
Lapera: That makes sense. That would mean that in equal weighted funds, smaller cap companies make up a largerpercentage of the companies represented.
Wathen: Right. Ifyou look at it, you would saythe big difference between them is that the market cap-weighted funds, the standard funds, arebiased toward the largest stocks,whereas equally weighted funds are more biased toward the smaller stocks. In atraditional S&P 500 funds, the standard fund, itinvests about 45% of its assets in giant companies, or, super-large-cap companies. An equally weighted fund would only have about 12% of its assets in those companies. So, you can see, an equally weighted fund is way less reliant on the big 10 or 20 companies that make up the index.
Lapera: Yeah, and I'm sure there's pros and cons to each.
Wathen: Astandard S&P fund,the second big difference between these two isthe industry difference. As I said before, the twolargest components of the S&P 500 are Apple and Microsoft, two huge tech giants. Ifyou look at an equally weighted index, techonly makes up about 12% ofassets. But in a standard S&P 500, itmakes up about 18% of assets. So,there's a size difference, and there's also the industry difference between the two funds.
Lapera: Yeah. So,maybe if you're looking to be really heavily invested in tech and big companies, thestandard market cap weighted one might be for you. Butif you're looking to be a little bit more diverse in your interests,maybe the equally weighted one is for you.
Wathen: Right.I think what gets people interested in this is that over long spans of periods of time, the equally weighted one willprobably outperform because it has exposure to small and mid-cap companies, which typically outperform larger caps. But,obviously, that out performance comes with more volatility. You're going to have to deal with greater losses in a year where the S&P 500 is down.
Lapera: Yeah. Andthe reason that the small and mid-caps tend to outperform the large caps over the long term is because the small and mid-caps have room to grow, whereas the super-large, megagiant caps that make up a lot of the market cap-weighted ones don't haveas much space to grow, so it's getting harder and harder for them to outperform their performance from last year.
Wathen: Justlook at Apple, for example. If you look at Apple, by assets, alot of it is just cash. Andobviously, cashisn't going to beat stocks in the long haul. So,intuitively, it makes sense that a lot of these largest companies that derive a lot of their value from earnings years ago aren't going to outperform the companies that will outperform on the basis of earnings going forward.
Lapera: Definitely. This is a quick follow-upquestion that I'm actually asking,and it's more just things I think you should know when you'relooking at index funds. What are the most important things to look at when you're reviewing a fund? And my top answer is fees.I don't know about you, Jordan, butdefinitely check out the fees. If you're paying more than 0.6%, you're paying way too much.
Wathen: Eventhat sounds really high.
Lapera: That'sreally high, too. But I know some people in the 401(k)sor whatever, they can't do less than that,because some companies are really bad at picking out index funds for them. But,try really hard to make it as low as possible. You can get anS&P 500 fromVanguard. And I know that we all sound like we'rewriting a love letter to Vanguard here at The Motley Fool, butyou can get an S&P 500 from Vanguard for 0.05%. That is way better than 0.6%.
Wathen: I'm going to say this and I'm not going to give the company name,because I would actually be kind of embarrassed. But, there is an S&P 500Index fund tracker out there that has loads of, like, 3%,and an ongoing fee of 1.2%,and it's just disgusting, honestly. I would really hope they don't end it up with that. ButI would agree with you, if you're going to invest in an index fund, truthfully,all that matters at the end of the day is the expense ratio.
Lapera: Yeah,definitely. So,I feel good about that, so we're going to move on to our next question, which comes from Luke B. inCambridge, Massachusetts. He writes, "Ilistened to the recent show about credit cards," -- not so recent any more, heh -- "andcredit ratings earlier, andI'm interested to hear your thoughts on whether it'sworth it to carry some debt on your credit cardfrom month to month as a means of building your credit rating.I've always paid off each statement's worth of balance by the due date each month which,as someone who doesn't anticipate any large loan-worthypurchases in at least the next year, hasseemed like the most money-saving route to take. However, someone mentioned thatcredit card companies may prefer to see consumers actually 'managing' their debt rather thanpaying it off. I'd like your opinion on this matter. Theonly other type of debt I've had up until this pointin my life are my student loans, whichI have been paying them consistently for years, bothon my own and with some help from my parents. We'llhave them all paid off ahead of schedule." So,this is a great question, and this is actuallyone of the most common misconceptions that I see, and I have no idea where it started,but I've heard it from literally dozens of people, maybe even tens of dozens -- no, that's an exaggeration. But,you do not need to carry a balance on your credit cardin order to build your credit. You just don't. In fact,it's probably best that you pay off your account in full every month,because it's going to drive down your credit utilization ratio, which is a big part of how the bureauscalculate your credit score. It'salso going to make it easier for you to budget,because your card is always paid off, so you know how much you owe at any given time, and youdon't have to make interest payments on anything, which is also huge. I think a lot of people don't add in the idea of interest when they have carryover from month to month on their credit cards.
I think the origin of this idea that you don't want to pay off your credit card in full every month,I think people might have that confused with,you don't want to pay off your credit card as soon as a charge hits it every time. AndI do know some people who have done that in the past. They go toStarbucksand spend $5,and they go to the supermarket and spend $50, andat the end of the day they eat a cruller, and it's $2. Then,at the end of the day, they pay off that $57, instead of letting it sit on their credit card. Butyou don't really want to do that because what happens is,at the end of the month, the bankor the credit card company or whoever ownsyour credit card sends your statement over to the credit bureaus, and if it's $0 for long enough because you've beenpaying it off before,sometimes the credit bureaus will thinkyour credit card is no longer active and shut down your credit line. Or,it'll say that you don't have an active credit line anymore, andthat will drive down your credit utilization ratio. But,that's very rare, that doesn't happen very often. But,ideally, what you should do ispay it off once a month in full every month. If you're really worried about yourcredit utilization ratio being high, pay off half of it,if you're worried about, for whatever reason,the credit bureaus thinking your credit line is no longer there. Pay it off a little bit, and that will helpkeep your credit utilization ratio low. It'lllet the credit bureaus know that your card is still active. And it'll just be great.
Wathen: Right. Thisactually drives me nuts,because honestly, there's probably a one-pointbenefit to carrying a balance. But in the grand scheme of,does your credit score matter, the one point is not relevant. It'scompletely irrelevant. It doesn't matter to anything. But they can say that's true, so it's like, "Hey, pay us more interest," right? So,it's one of those cases where you can over-optimize, and end up paying $5 for one point on your credit score that makes no difference whatsoever.
Lapera: Yeah,that's true. The credit card companies care more about whether or not you're going to pay on time, and that you're not usingso much of your credit utilization ratio thatit's out of control. They care more about those things in terms oftrustworthiness rather than you having interest. And honestly, long-term, if you have a lot of interest, that is bad.
Wathen: Right,that's terrible. You never want to pay interest on a credit card. You can honestly have an 800 credit scorejust by paying on time andmaking sure your credit utilization ratio is never over 15%. Then,you're probably solid, right? It'sreally not that complicated. I feel like they make it almost too hard, or,we try to explain it to such a depth that doesn't matter. But really, just, pay your stuff on time, and ideally,try to never cross 15%.I know that's under the 30% threshold that everyone quotes, but thatmakes it a little bit easier,and you'll never cross that barrier. It's super simple.
Lapera: Yeah. It's reallynot a huge deal. I think, for me,one of the reasons this makes me kind of panickywhen I hear it from people is that I know that a lot ofpeople aren't very good at budgeting to begin with, and then they'retrying to carry a balance every month, and they'repaying interest on it, and I can see that situationrapidly spiraling out of control.
Wathen: Right,and there's another thing, a credit score only matters at the point in time whenyou need it. For example, my friend,he called me up one day and said, "Man,my credit score is really low butI paid everything on time." Andthe reason was, he had a card with a super low limit, maybe it was $500 to $1,000,and he would use it for everything that month and thenpay it off in full. It wasn't a big deal,he would never go over his credit limit or anything. But,when they took that snapshot in time, it would say he was 60-70%utilization. So, he asked me about it, and I said, "Juststop using it for a month or two when you know you'regoing to need a good credit score." Andhe did, and his credit score jumped 70 or 80 points. Which isthe difference between prime and subprime, in some cases. It's a big deal.
Lapera: Definitely. Theother thing that you could do is open another credit card, and that'llincrease your total credit limit, and use it rarely. There'sdefinitely multiple ways to play the system. Andtechnically, yes, opening a credit card will make yourcredit score dip, but it's only by a couple points for a few months, and then it'll goright back up, because your credit utilization, thetotal amount of credit you have, is much higher.
Wathen: Right,that's what I'm saying, that's what I feel like is whypeople don't understand this. There arethings that are true for three or four points. But in the grand scheme of things, three or four or five points on a 700 or 800 score does not matter. Yourlender is not going to deny you over three or four points. Youknow what I mean? Just get the big things right,and forget about everything else. I think I have a really goodcredit score, I could get really good low interest rates, andall I do is pay stuff on time.
Lapera: Me too. I will say, we have fool.com/creditcards,that's a great resource if you have questions about credit cards. Feelfree to email us, too. But,talk to a financial planner, as well,because as you guys know,since I'm so paranoid about legal things,[laughs]we do not offer personal advice, so do not take this as personal advice. Anyway, I had anonymous write in and ask, they have a name but, you know, "Should I base my investments on 13Fs?" Thisquestion needs to be broken down a little bit,starting with, what is a 13F. Jordan Wathen,a softball question for you.
Wathen: All right,one of my favorite regulatory filings. A13F is a filing that large investors or fundshave to file, and they have to disclose theirholdings at a point in time at the end of the quarter four times a year. That'sas simple as I can say it. But they only disclose theirlong positions, so,they only disclose what they own, not necessarily what they're short-selling. So, with hedge funds,you have to be a little bit careful.
Lapera: Yeah,and the type of people who have 13Fs are, like,George Soros or Warren Buffett or,like you said, hedge funds. So,I think that's why the person asked this question,because it is, in theory, these people who havesome sort of deepinsight into the market. You know what I mean?
Wathen: Right,that's why anybody looks at them. I would be lying if I said I didn't,because I really want to reverse engineer a greatinvestor's process. I look at it andtry to figure out how they're shaping their portfolio,and if I can learn something, why not,it takes 10 minutes to look at a 13F,so I, of course, do.
Lapera: But,the short story on this question --which is, to remind you, "Should I base my investments on 13Fs?" -- is no,you shouldn't.
Wathen: No.I actually want everyone who's listening to this to Google this. It's called The Medallion Fund,and it's managed byRenaissance Technologies. It's the greatest hedge fund of all time, period,end of discussion, ungodly returns. I'mtalking like 30% a year. Theyonly have one losing year since 1988, and it wasn't 2008, it was 1999. But, they'veblown it out of the water. But if you look at their 13F,you will learn nothing,because The Medallion Fund tradesin and out of stocks more often than you change your socks on your feet. They trade constantly. So the point in time snapshotwhich you get from a 13F hasactually no value whatsoever.
Lapera: Yeah,and that's exactly why you shouldn't be making these long-terminvesting decisions on what's going on with the 13F.I think one of the most popular people to look at is Warren Buffett. Recently --you told me this when we were talking about it before the show -- he boughtExxonMobil,and he said he bought it because it was better than having thatmoney in cash.
Wathen: Yeah,at the Daily Journalannual meeting,Charlie Munger basically said, "Doyou know why we bought ExxonMobil? We thought it was better than cash." Andthey literally held it for less than two years. If you think about what Buffett does and whatBerkshire Hathaway(NYSE: BRK-A) (NYSE: BRK-B) does, they'retrying to beat the market over long periods of time. Butif you don't understand that nuance, youmight look at it and say, "Oh,ExxonMobil, they bought it,it must be great, they're trying to beat the market," whenin actuality, all they wanted to do was beat asavings account. There are so many investments to do that. So, I think you really just have to understand who's filing the 13F, first of all, andsecond of all, what is the goal with the stocks that they buy? WithBerkshire, it's changed so much. They used to want to smash the market, and now, apparently, they're reallyjust trying to be the savings account,which is a really low threshold.
Lapera: Yeah. It'salso hard because Berkshire Hathaway,like we talked about earlier with thosereally big companies that have trouble outperforming how they didhistorically, Berkshire Hathaway has the exact same problem.
Wathen: Right.I'm not trying to give Berkshire a hard time. I can see, they're probably thinking, dividend income, tax at a lower rate, those kinds of things. I'm not trying to rag on Buffett. He'sthe most successful investor of all time.I don't know if anyone will ever top him. But if you follow him now,he's investing much differently than he did in the 1980s and 1990s, what he's really known for.
Lapera: Yeah. Again, short story to, "Should I base my investments on 13Fs?" is no. Andif you want, I'm more than happy to send you an article on this. We writeapproximately a million every year. That might be a mild exaggeration. But it feels like that,because I edit it all of them.
Wathen: You just have to look at them as shopping lists. Youstill need to do your own analysis, butI don't think it's ever bad to look at what a greatinvestor is buying and try to understand why. Iactually think that's a really productive use of your time.
Lapera: Yeah,definitely. And it's definitely also really interesting to get a stack of 13Fs together, historical 13Fs, and see what's going on over time. But yeah, youshould not base your entire portfolio around what one person, or even a set of really good investors, is doing,because you have no idea what's going on in their mind. They'rejust saying what they own, not why they own it.
Wathen: Andthat's the thing, too. Because they don't report short sales,it's really important that you are really careful abouthow much weight you put on to it,because someone could be longWal-Martand shortTarget, to haveneutral to retail,but they don't really love Wal-Mart that much. They just love it more than Target. It's a pair straight, but you would never know the opposite side of it with a 13F.
Lapera: Theother thing to keep in mind is that it's kind of a snapshot of an investor's portfolio. They couldexit the position the day after 13Fs are out,and you wouldn't know until the next 13F comes out. And,those come out about once a quarter, in case you're curious. But you don't really 100% know exactly what's in there based on the 13Fs.
Ourfinal question of the day comes from David. He writes, "I have a question about trading on margin. I just opened a brokerage account and I'm building a portfolio of high-quality stocks thatI intend to hold for the long term. I'm wondering if there's a way to invest Foolishly using margin. Forexample,I'm making monthly contributions to my account and adding to my positions, keeping my transaction costs under 2%, but I don't always have cash on hand to make my purchases, so I end up using margin. Does itmake sense to maintain a marginposition as my portfolio grows? The interest rate is only 1%, and I'm hoping my returns will continue to exceed that hurdle. If Iplan on holding my investments for the long term,the interest will be constantly adding to my margin position, and I will grow and grow at anaccelerating rate over time."
First off, I did send this listener a set of articles about trading on margin, and I'm happy to send those to you if you write to email@example.com and ask for them. Jordan, I know that you and I have very similar risk-averse personalities. I'm going to say what I said to this guy, which is that I cannot give you personal advice -- I know I'm harping on this, but as always, I need you guys to know that. But, this is how I personally feel. I am a very risk-averse person, and trading on margin makes me very, very, very nervous. So, I would never personally trade on margin, but you have to decide what's best for you. What would you say, Jordan?
Wathen: I'm going to be a bit of a hypocrite, because I've short sold things before, and that's inherently on margin before, and exposes you to unlimited risk. But, truthfully, if you're going to manage a constantly long portfolio and you're going to use margin, it sounds like, to me, "Is it OK to use heroin one day a week, or every day of the week?" It's like, I'm never going to advise it, it's so dangerous. It looks so lucrative,especially when stocks are going up. If I just doubled my portfolio value by leveraging it,it would be fantastic, but --
Lapera: Wait,actually, that reminds me. Can you explain what trading on margin is, real quick?
Wathen: Trading on margin isbasically using the broker's borrowed money, you'reborrowing money from a broker to buy stocks, andyou pay interest on the margin. So, if you borrow $10,000 to buy stocks at a retail broker, they might charge you 4% interest on that every year, or $400 a year.
Lapera: Yeah. And that's great, as long as the stocks are going up, if you're not shorting. But the problem is,if you're shorting a stock in particular --and that's when most people trade on margin, as opposed to our friend David -- there'spotential for unlimited amounts of loss.I don't know if you remember this, Jordan,do you remember the guy who shortedKaloBioson margin?
Wathen: I did. It's a good lesson on why you should never short a biotech company.
Lapera: Yeah. This guy,what was it, a year ago?
Wathen: It wasabout a year ago.
Lapera: Heshorted this company called KaloBios, and it was something like $3,and then it went up to $17 when he wasn't looking, and he lost an absurd amount of money. I think it was like $100,000. That'scrazy. What he did was start a GoFundMe to helppay off a debt to his brokerage. Which is funnyin and of itself. He's like, "Idon't understand why the brokerage didn't tell methis could happen." They do, it's just in the fine print.
Wathen: Right. Andthat's a problem. They give you a 27-page contract. Everyone goes through it and signs theirdigital signature and then moves on with life. I can reallycategorize this into two basic ideas that sayin a general rule, it's not good to use margin. Thebig one is that margin is not like a mortgage. If yougo buy a house with a mortgage and the house drops 50%, the bankcan't just show up, knock on the door, and say, "Hey,you owe us a ton of money." That'sexactly how margin loans work,because it's market to market every single day. If the stock you buy with margin goes down,you have to come up with money or you have to close it out. Youmight have to sell at a price you would never dream of selling a stock at, which is the No. 1 oops,don't want to be part of that. The second one is, you'repaying so much in general to borrow money from a broker that you'regiving up a lot of the upside, butthe downside is still 100% yours. If the stock moves against you, that's all your loss. Ifit moves up and that's gravy, you're still paying interest. You have ascenario where you get less than 100% of the upside, and 100% of the downside. It'snot a great deal, conceptually.
Lapera: Yeah,definitely. There's a difference between shorting, whichyou do on margin, andinvesting on margin. I want to make that clear for listeners. But, when a stock loses out,the most you can lose is 100%if you're trading normally. Like I said, if you're shorting,you can lose way more than that. But if you're trading on margin,you're still on the hook for the amount of money that you borrowed, pluswhatever you've lost in the stock itself. AndI wanted to follow up on how that turned out for the listener who emailed me. And I know when we first talked about this, you were like, "Man, 1%, that's really cheap for trading on margin." But he wrote back after I responded and told me he had misread the fine print on the margininterest rate. He thought it was 1%,but it was actually 1% abovethe base rate of 8% percent. He says, "Needless to say thatI won't be using margin going forward because I'm not confident in exceeding a 9% hurdle rate with my returns."
Wathen: Yeah,that's just massive. And truthfully,if you go to any retail broker,I don't think there's a single one even at $3 million of account equity that'llgive you money at 1%. They just won't. Benchmark interest rates are 0.5%, why lend to Joe Blow on margin? You just don't. That's the thing. It'sreally hard to beat the benchmark at most retail brokers. Andeither way, it doesn't matter. Even if you didn't have to,I would just say, it's OK, just leave a little moneyoff the table to not expose yourself to such massive losses.
Lapera: Yeah,definitely. I'm not surprised that we havefairly similar feelings on this concept. Do you have anything else youwant to say about any of the questions that listeners asked, orgeneral life advice?
Wathen: I would truthfully say that,honestly, just keep it simple. With everything we talked about today with margin, with credit scores, really,if you just follow the most basic golden rule, you'll be OK. Withcredit scores, pay it on time. With margin,just don't do it. You'll be OK. 8% a year over the long run is anincredible return. You'll get that whether you're levered or you're unlevered. There's no reason to takesuper risk just to have a little bit more money at the end of the day. Thedownside is so tremendously bad thatI don't think you want to.
Lapera: Definitely. Mylife advice is actually not related to financials. It's: Don't mix bleach and ammonia when you'recleaning stuff. I had a friend almost kill themselves this weekend by doing that when they weretrying to clean their bathroom. It's a terrible idea. I just wanted to put out that PSA, because,please don't do that, people. Austin,do you have any life advice for listeners?
Austin Morgan: Nothingoff the top of my head.
Lapera: Nothing on how to hit a baseball better?
Morgan: Swinghard and hope for the best.
Lapera: Just,so you guys know, Austin is also a baseball coach.
Morgan: The first two strikes are for you.
Lapera: [laughs] I think that's it. Enough shenanigans. Let us know if you have any questions by emailing us at firstname.lastname@example.org. As usual,people on this program may have interestsin the stocks that they talk about,and The Motley Fool may have recommendations for or against, so don't buy or sell stocks basedsolely on what you hear. Contact us at email@example.com, or by tweeting us @MFIndustryFocus. We loveanswering your questions,but we can only answer themif you ask them. So, email us. Thank you to Austin Morgan, baseball coachextraordinaire and today'stotally awesome producer. Andthank you to you all for joining us. Everyone, have a great week!
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple, Berkshire Hathaway (B shares), Johnson and Johnson, and Starbucks. The Motley Fool owns shares of ExxonMobil and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.