We propose three financial reforms to benefit individual investors, explain index vs. active funds, and pick our favorite fantasy reunion tours.

Q. We always hear about the need to reform Wall Street, but what we don't hear are specific, realistic ideas that could lead to that reform. So ... if we granted you temporary omnipotence and freedom from political and corporate backlash, what would you do to change the system for the betterment of individual investors?

A. I have three suggestions, none of which will be instituted, ever.

1. Require investment banks to be partnerships. From the same principle as "no one ever washes a rental car," I believe that Wall Street's bankers should have as much exposure to the risks they take as possible. In the past, investment banks had been partnerships, so that if a bank took on too much risk and it went badly, its partners bore the full brunt of the consequences.

Once the banks converted to publicly traded, limited liability structures, employees had way more incentive to attempt to shoot the lights out, as the structure allowed them to keep the majority of the gains and pass losses on to outside shareholders.

2. Ditto the stock exchanges. One of the roles of a stock exchange is to serve as a quality control for companies that get listed. This standard setting should be an incorruptible function of the exchanges. Once the stock exchanges became publicly traded entities, they suddenly became beholden to another constituency with an entirely different set of interests. Suddenly the exchanges started to worry about things like market share and quarterly earnings.

Well, if you're an exchange trying to meet some quarterly revenue target, what's the single easiest way to do it? Yep: Lower your standards to be more compelling for companies seeking to list. In other words, having high shareholder protection standards is, in some ways, a competitive disadvantage.

A few years ago, hundreds of Chinese small-cap companies came public in the U.S. by a process called a "reverse merger," which is a way of gaining status as a publicly traded company without holding an IPO. The New York Stock Exchange and the Nasdaq competed vigorously for these companies, even though many of them had financial statements that were impossible to verify.

When the inevitable happened and American investors lost billions of dollars at the hands of these same dubious companies, an NYSE spokesman claimed that the exchange had also been blindsided by the scope of the fraud.

Blind is more like it. Do I believe that the exchanges would have behaved differently if they weren't publicly traded entities and were instead owned by their member institutions? Yes, absolutely.

3. The SEC should hire some bad guys to run investigations and pay 'em a ton.

One of the biggest problems in regulating and prosecuting Wall Street is that the regulators are captured by the massive amounts of money that Wall Street can throw at them. I'm not talking about corruption, necessarily, but it is remarkable how many former SEC and Treasury officials take jobs with investment banks and other investment firms with pay packages that include multiple commas. There is a great disincentive among regulators and enforcement officials to give the banks too hard of a time, lest they jeopardize their own shot at substantial wealth.

You want to see some convictions on Wall Street? Here's how you do it. Hire people who know how the game works, exempt them from federal employment standards, pay them $5 million per year apiece, and give them an incentive structure that rewards them for rooting out scams and frauds.

It's not high-minded, but I guarantee you we'd not be sitting here five-plus years after the financial crisis wondering where all the convictions were.

 

Q. Using magical powers, what group would you reunite for a farewell tour?

A: I invited members of the team to nominate their choice.

My pick is The Band.

For a musical group that's in the Hall of Fame, I still think that the sheer musical genius of The Band is totally overlooked. Resurrect Levon Helm, Richard Manuel, and Rick Danko, and let them get to work with Robbie Robertson and Garth Hudson. Sheer magic. The ultimate concert band. I would love to have seen them play.

(Other bands I considered: The Clash, The Yardbirds, Led Zeppelin, Mother Love Bone.)

Bill Barker: "For me it would be Dire Straits, though if I were trying to please the crowd it would be the Grateful Dead or the Beatles."

Greg Haygood, our fund accountant: "I don't think magic would be required as much as money, but I'd say A Tribe Called Quest represents the best of hip-hop."

Tony Arsta: "I'd vote for a three-way tie between The Tommy Dorsey Orchestra (fronted by Frank Sinatra), N.W.A., and Nirvana."

Tim Hanson: "I'm cheating a little, but I want Bob Marley with all of the Wailers, even if they never played together."

Tim Hanson's 3-year-old, Ben: "Bring back the original Wiggles."

Which band would you choose? Send your answer to askbill@foolfunds.com.

 

Q. I know you love college basketball and that you love the name Nimrod. Did you know there's a kid who plays for Lamar University named Nimrod Hilliard?

A. You actually hit a trifecta for me. College basketball, awesome names, and an utter fascination with how the name "Nimrod" became synonymous with "idiot." If only you could have worked North Korea into the mix, it's quite possible my head would have exploded.

This is the second time I've been asked about the name Nimrod (see "Starbucks, Cash Flows, and Nimrods," October 2012). I think it's an awesome name, and not in an ironic hipster "I wear scarves and drink Pabst Blue Ribbon" kind of way. In fact, TMFNimrod was one of the screen names I considered when I joined The Motley Fool (many years before taking my current role with Motley Fool Funds), since it is a name that is equal parts literary and historic and – let's face it – self-deprecating. I went with TMFOtter, which offers awesomeness and a bit of personal history – but I'm totally down with Nimrod.

For most of history, the name Nimrod was associated with, according to the Bible, the world's first stupendous badass. (Genesis 10:8: "Cush fathered Nimrod; he was the first on Earth to be a mighty man.") Nimrod was particularly renowned as a great hunter. A killing machine. He could track a falcon on a cloudy day. Or was that Westley from The Princess Bride?

The blame for discrediting Nimrod lies with Bugs Bunny. He continually referred to Elmer Fudd as a "nimrod," essentially because as a hunter Elmer Fudd was rather hapless. It was an ironic usage, in the same way that you might call your friend who is particularly poor at basketball "LeBron." Only since most people didn't get the reference, they assumed that the word "nimrod" was some sort of direct insult.

I'd read a bit about Nimrod Hilliard, and he seems like an awesome kid. He's actually Nimrod Hilliard IV, which means that his dad, granddad, and great-granddad have also experienced life with this unusual name, baggage and all. And he told reporters in Beaumont, Texas, that he likes his name so much that he intends to pass it on to his son someday. Good for him. Nimrod deserves a comeback.

So ultimately, here's my take: People who make fun of the name Nimrod are essentially admitting that they aren't learned enough to understand the historical nature of the name. Put another way – those who use "nimrod" as a term of insult are actually betraying the fact that they don't understand the reference, and therefore it is they who are the nimrods.

(Or should I say doofuses?)

 

Q. What is your recommendation for a person in his 80s? I have a modest nest egg and am a little concerned about a coming downturn. At the time I am fully invested in stocks and have done well, but know I should be in more conservative investments. – Wendell in Richland, Wash.

A. You've answered your own question. If you are worried about your nest egg, you should downshift some to more fixed-income stuff. Enjoy your time – you've won! What good does it do you to be nervous?

 

Q. Is it true that mutual funds and index funds perform about the same, but the fees for mutual funds are higher? If that is true, why would an investor invest in mutual funds? Are there advantages to index vs. mutual? Thanks, Bill! – Gerry in Talent, Ore.

A. Generally speaking, this is true. The average index fund outperforms the average actively managed mutual fund. (Point of information – they're all mutual funds. Some are actively managed, while index funds are passive.)

We are enormous fans of index funds. If you truly don't want to think about your investments anymore, I would absolutely recommend them. The Fool Funds family does not include a domestic large-cap option for the very reason that we believe that this is an area where investors are extremely well served by low-cost index funds. (It's possible we might offer one in the future, though.)

The active-vs.-passive fund management discussion is a huge reason we make no attempt to have our fund composition mirror that of our underlying benchmarks. As a result, our portfolios are vastly different from most of those with which we are compared. Over the long term, we believe that our rigorous security selection process, our business-centric approach, and our long-term temperament will give us the opportunity to create outsized returns for investors which is, in essence, the case we make for investing in mutual funds.

 

Q. About 20% of your 2009 holdings are still in the Independence Fund. Is this trend to be expected going forward as well? What has been the portfolio impact of selling quality stocks early after the impact of rolling the capital into other stocks is taken into account? – Anurag in San Jose, Calif.

A. Our turnover rate in the Independence Fund is quite low, well below the average of our peers, which on average hold a company in their portfolios for less than one year.

I understand the thrust of this question, but it contains a few misconceptions about mutual fund management, including the basic premise that what happened on Day 1 of the fund has much relevance today.

In 2009, the Independence Fund started with $1 million, which we invested nearly immediately into approximately 60 companies. Let's just take one of the companies we bought that day as an example: Melco Crown. On that day, Melco Crown closed at $4.45. As I write, Melco Crown trades at a hair under $43. The return for the shares that we bought that first day would have been more than 900%.

The actual return to Independence Fund shareholders would be nowhere near that amount, though, even if we'd held on to the shares (we sold at about $11). The reason has to do with fund flows – the amount of money that comes in or leaves a fund because of customer investment or redemption decisions. That first day we bought about $20,000 worth of Melco Crown, about 2% of the fund's paid-in-capital. At present, paid-in-capital for the Independence Fund is about $221 million, which means that 99.55% of all net money invested in the fund has come after Day 1.

If we owned Melco Crown today, it would be under one of two conditions. First, we could still have a cost basis of $4.45, but the total size of the position would be about $193,000. As the Independence Fund has a total asset base of $338 million, a sub-$200,000 position barely moves the needle in terms of performance. We'd have been spectacularly right to hold on to the stock, and it wouldn't have mattered a lick.

The second condition is how things really work in the fund business. When we come in to work each day, we receive a schedule that shows how much new money we have available to invest. Some days we've had redemptions, but over the past four-plus years, we've had to deploy an additional net $220 million of paid-in-capital. Each day we have to make the decision on what to buy. And we don't get to buy at the prices at which we first purchased the shares – we buy at whatever price is quoted that day. What we could not have is a $6 million position (approximately 2% of the Independence Fund) at a $4.45 cost basis. So even for companies we've held since we first opened each fund, our return on investment is vastly different from (and usually lower than) our return on thesis.

To manage our portfolios we keep a master list of companies and our buy-below prices, which we update periodically to reflect our thoughts on the intrinsic value of the underlying asset. This list also contains our "awesomeness rating," which we use to determine how likely we are to sell a security at certain values. Companies that have the highest quality rating we are much more unlikely to sell, since they tend to be excellent at multiplying capital over the long term.

I've said in the past that for a fund that has a growing asset base, not buying a security is essentially the same as selling it. When we look at our security master sheets, a company – even a high-quality one – creates a dilemma for us. We aren't that interested in adding capital at high prices, but we don't necessarily have much interest in adding money at prices that we don't consider to be that attractive. Nor, as the Melco Crown example demonstrates, does it do our shareholders any good to hold on to a company that becomes such a small percentage of the fund that its results are functionally meaningless.

One other thing about your question – I can think of only one occasion when we sold a security to specifically roll it into another stock. Generally we have sold to go into cash. Occasionally we've had to sell (especially in 2012) to meet redemption requests by shareholders.

In a market that has risen so magnificently, it has tended to be a net negative for our shareholders when we have converted our stock holdings into cash by selling. In cases where we came to determine that selling was a mistake (most notably Chipotle), we bought back in once we believed the shares once again represented a bargain.

In the case of Melco Crown, several analysts and I have spent substantial time in Macau and studying that market, and we became nervous about the company's competitive positioning (its properties have the potential to be squeezed at the top and bottom ends) as well as its level of leverage. These are risks that we would accept at certain valuations, but not at others. We are delighted for people who have generated huge gains by holding on for the long term, but we do not consider the shares anywhere near attractive at current prices.

I hope this drawn-out response provides some clarity to your question, even if it is impossible for me to provide a direct answer. I appreciated the chance to speak to this factor in some detail in our investing program.

 

Q. I am 57 years old with about five to seven years to retire, thanks to health-care costs. I am considering putting all of my bond holdings into a Vanguard small-cap fund in my IRA. Do you think I should?

A. Well, you're ticking the right boxes. Vanguard has some low-cost funds, so they're great options. And you're young! You've got many years of life expectancy left, so there's no reason for you to walk away from investing in stocks.

All this said, I can't really give you an answer, because I don't know what your needs are, or if you're describing 2% of your total net worth, or 95% of it. I wouldn't monkey around with money that you will absolutely need to survive after you retire.

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