A Special Intern Mailbag Episode

It's intern's week on the Motley Fool's Industry Focus: Financials podcast, a special week when this summer's most-Foolish interns have the chance to pepper host Gaby Lapera and analyst Jay Jenkins with all the financial industry-related questions they've been thinking about, but have never had the chance to ask.

With intern Emily Flippen as a special in-studio guest, this episode touches on "too big to fail," when to start saving for retirement, Warren Buffett's million-dollar bet against hedge funds, and a lot more of the most-pressing issues in the financial sector today. Whether you're an intern yourself or a seasoned investor, this episode has something for you.

So what are you waiting for? Click play now!

A full transcript follows the video.

This podcast was recorded on Jun. 20, 2016. 

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the financials edition filmed today, on June 20, 2016. My name is Gaby Lapera. Joining me on Skype to answer some questions that our interns are asking is Jay Jenkins, one of our top analysts in the financials bureau. Thanks for joining me. How's it going, Jay?

Jay Jenkins: Hey, Gaby! Thanks for having me. Everything's great.

Lapera: Fantastic. For our listeners out there, it is officially that time of the year in D.C. where there are lots of young people in very uncomfortable suits sweating profusely on Metro platforms because the interns have arrived in Washington, D.C. We, at the Fool, have been graced with a crop of top-notch interns who have a ton of questions, and we figured, what better way to include the interns in the podcast and answer their questions than to have an interns ask week? Get excited, because all week is going to be questions from interns, for all the episodes. If you're not excited about that, I guess, don't listen. But I hope you are, because I am. So you might have noticed that I am joined by an intern in the studio. This is Emily Flippen. Everyone, say "hi" to Emily. Tell us a little bit about yourself, Emily: Where you go to school, what's your major, what year are you, what are you doing at the Fool?

Emily Flippen: Sure! I'm Emily Flippen, I'm a rising senior at NYU Shanghai, majoring in business and finance. I'm with the investing team here at the Fool.

Lapera: That's super cool, I didn't know any of this. I hadn't really talked to Emily beforehand, which is my bad. But Emily seems really cool, and I'm totally going to have lunch with her after this. Just to make you feel comfortable, what's your favorite Girl Scout cookie flavor?

Flippen: Tagalongs, without a doubt. Chocolate and peanut butter -- you can't do better.

Lapera: Okay, I'm not going to judge you too harshly for that answer, but the clear winner is the Samoa, followed by the often-overlooked Savannah Smile. I don't even know if they have Savannah Smiles anywhere else than D.C., but they're a lemon-flavored cookie, and they're my favorite. Do you have a favorite, Jay?

Jenkins: Tried-and-true Thin Mint. I'm not going to go too far off the rails on that one.

Lapera: Fair enough. Emily is going to help us out today by reading the questions that she and her fellow interns asked, and potentially asking follow-up questions if any occur to her. So, why don't you go ahead and start with the first question?

Flippen: Sure, this comes from Michael Schramm. He's an intern here at editorial, and he asks, what type of businesses are included in financials?

Jenkins: There's actually a surprising array of companies that are classified as financials. Most obviously, you'll see banks like JPMorgan or Bank of America (NYSE: BAC) or Wells Fargo, or any of the regional or community banks around the country or around the world. But drilling down into banks, there's investment banks -- maybe Goldman Sachs is the industry leader, and the most well known. But there's also a whole wide variety of investment banks other than these headline-catching national brands, whether it's in private equity, or management, or mergers and acquisitions. There's a whole subset there. 

On the other side of financials, we also have specialized companies, like business development companies, or real estate investment trusts, or even mortgage real estate investment trusts.

Lapera: And these are all fun because they all have acronyms. Most of the time, we refer to business-development companies as BDCs, and real-estate investment trusts as REITs, and mortgage real-estate investment trusts as mREITs.

Jenkins: That's right. And these companies are all really cool because they have, typically, very large dividends. There are tax incentives for them to pay huge dividend yields. It's a small niche in the market, but it's really interesting, and really appealing to a lot of people, because it's not often that you can find a company with a 12% dividend yield, and the dividend is actually pretty legitimate and safe.

Lapera: Definitely. Then, on top of that, we also have insurance companies.

Jenkins: Insurance companies, from the very largest, like AIG, and some of these pure-plays, all the way over to Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%), which is more of a conglomerate these days; but really, at its core, it's an insurance company, and has been for 50 or 60 years now.

Lapera: We also have payment processors like Visa and MasterCard. And then we have some new players in the space like PayPal, and who knows what they're going to do with Venmo. I think everyone is holding their breath on that one.

Jenkins: The payment processors are an interesting niche, too. At a certain point, these companies all start to look the same. American Express is a good example. They're a payment processor, and everyone has seen their commercials and his heard of their brand; but they're also kind of like a bank. They make loans, and those loans have to be repaid. So they have parts of their business that function very much like a traditional bank. And the on the flip side, the other half of the company functions a lot like Visa or MasterCard, where it's all transaction based.

Lapera: Yeah, I think that pretty much covers all of it. Can you think of any other financial companies, Emily? 

Flippen: I think the better question is, what company isn't a financial company? There are a lot of businesses in there.

Lapera: Definitely.

Jenkins: And later on in the week, I think the real question is going to be, what company is not a technology company in this day and age?

Lapera: That's so true. Do you want to go to the second question?

Flippen: Definitely. This question comes from me. During my internship, I've heard about a bet that Warren Buffett apparently made with a hedge-fund manager. Supposedly, he bet the manager that a low-cost index fund would outperform any five hedge funds he picked out over a 10-year period. My fellow intern told me that Buffett is currently winning this bet. If this is true, why does anyone choose to invest their money in other areas? Should all of my money be in index funds?

Jenkins: Let's give some background first, because that final question is the million-dollar question.

Lapera: Or the hundred-dollar question, if that's all you have.

Jenkins: Yeah, at this point. A million dollars soon enough. The hedge-fund guy is named Ted Seides. The bet was, Buffett puts a bond that, at the time was worth something like $350,000, but at maturity, would be worth $1 million, and Buffett put the value of that into an S&P 500 Index Fund. Mr. Seides would take the equivalent bond, and put it into five hedge funds of his choosing. And then it would play out over a 10-year period. Whoever wins, the million dollars of that bond goes to charity of their choosing.

Inherently, I think, in the bet, Buffett had an advantage going into it. The advantage is, because Ted Seides put the money in five different hedge funds, he kind of diversified. What that's going to do is lower the risk of putting the money into that niche of the market, into that hedge-fund area, but it also eliminates his ability to put a lot of his money into one winning bet. If there's one all-star hedge-fund manager who consistently puts out top returns over and over, year after year, in interest of the bet, he'd probably be better off putting it in that guy's fund. But he didn't; he diversified. With five funds, it regresses to the mean, and most likely -- and the bet has shown -- he's gotten average hedge-fund performance, which is really not all that impressive over the last five-10 years since the financial crisis. So he diversified, but he also limited his ability to truly outperform. 

When hedge funds make the news, it's because they have these ridiculous returns. John Paulson makes $1 billion in a year, or George Soros breaks the Bank of England like he did back in the '90s. So, you have the averaging effect, and that's made worse because hedge funds charge such large fees. Two-and-20 is the common fee structure. That means you put $1 million into a hedge fund, they're going to take 2% of your money every year just for having access to the fund, just for coming out, and then 20% of any profits -- the hedge fund keeps that, as well. So because of that fee-heavy structure, even if the hedge-fund manager does outperform the S&P, the S&P has an advantage because it doesn't have to do all that great. It can just almost keep up. Then, after fees, the S&P 500 may end up having a better year overall.

So that combination of the fee-heavy structure with, essentially, the five hedge funds, that makes him an average performer through that diversification. I think Buffett had an advantage straightaway.

Lapera: Not just that, but -- I'm sure this guy picked some very reliable hedge funds -- but there's always a chance that a hedge fund will just go out of business, and an index fund is never going to go out of business unless there's complete economic collapse.

Jenkins: That's true. They can do anything they want, at the end of the day. They can invest in virtually anything, any amount, at any concentration. There's really no control if these guys are free to do whatever they want. So there is that risk.

Now, should everyone just invest in low-cost exchange-traded funds, whether it be a bond fund, or an S&P 500 fund? A lot of people say that, for retirement planning, that's a smart strategy -- diversify yourself through time. As you get older, you're going to want more bonds that are going to be safer to the rising and falling of the economic cycle, and when you're younger, put it in, maybe, a smaller-cap Russell 2000-type ETF and go that way.

The biggest advantage of that, to me, is twofold. One, you have the tax advantage of a retirement account, so you're not paying taxes on your gains until you're 60 or 70 years old. Two, these ETFs are so cheap. A Vanguard fund might charge 15 or 20 basis points to manage your money for you, while a mutual fund, or certainly a hedge fund, or private equity, or one of these more-esoteric ways of investing, they're going to charge 2%, maybe 4%. They're going to take 20% of profits, if not more.

Lapera: Someone actually asked me this the other day, and I hadn't realized that everyone didn't know -- when Jay says 15 basis points, that's going to be 0.15%.

Jenkins: That's right, one basis point is 1/100. So it's virtually free. When you take into account the gains, 15 basis points is nothing. It's less than pennies. S, from a value perspective, it's a great advantage. And over a 30-50 year period of time investing, from your time now as an intern to your ultimate retirement, saving all that money on fees adds up tremendously. It can work out to millions of dollars in certain scenarios. That's the biggest advantage. 

Other people who say that an actively managed fund can outperform over time -- and there's certainly examples of very smart investors who have consistently done that. Warren Buffett is an example. There are others. It is possible; it's just very, very difficult.

Lapera: And kind of unlikely. Some facts to put out there, the Vanguard S&P 500 ETF, which goes by the ticker symbol VOO, their expense ratio as of April 27th, 2016, is 0.05%, which is nothing in comparison to... on average, I think, a mutual fund charges 1.33%. So there are some really low-cost alternatives out there. Also, as of February, 2016, the Vanguard 500 Index Fund Admiral shares, which is what Warren Buffett put his money into for the bet, is up 65.7%, and the hedge-fund manager's are at 21.9% average gain. So... booyah, I guess.

Jenkins: And they have two-more years to go before the bet's over?

Lapera: Two more... we're eight years in.

Flippen: Looking good for Buffett.

Jenkins: That's right.

Flippen: That actually led right into my next question, because I, as an intern, I have a Roth IRA -- but I'm not sure what I should be buying with it. On one hand, I mean, I'm not really risk adverse; but on the other hand, I know it's a retirement account. Should I be more conservative with those investments?

Jenkins: First of all, I think you're very far ahead of the game among your peers -- and a lot of people who are much older than you -- in that you already have one, and you're already thinking about it. Awesome job; that's amazing.

Lapera: And I'm going to hedge in here that we are not allowed to offer any personal advice, so keep that in mind with your answer, Jay.

Jenkins: Sure. Speaking very generally, I think the most-important thing is to start young, and consistently squirrel money away. Your own personal risk tolerances or savings goals are going to vary from person to person across the world. But the key is, if you continuously put money in every month, just keep squirreling it away; 5%, 10%, 15% -- whatever you're comfortable with and can afford. That's the most-important thing. If you do that, you're probably going to be fine over the course of your career. Beyond that, my advice would be to try to stay away from fees, and make sure you're doing everything in a very tax-advantaged way, legally. Make sure you're taking advantage of Roth, when you're in college. When you're in a job, they'll most likely offer a 401(K). Take advantage of that. The more money you can get into that account that can start growing tax free and low fee, the returns will just compound and compound and compound. Over 30 years, you'll be able to retire very comfortably.

Lapera: Yeah. If you have any questions about Roth IRAs or traditional IRAs, or IRAs, in general, I encourage both Emily and our listeners to refer back to an episode that Dan Caplinger and I did on IRAs a couple weeks ago. If you can't find it, I'll email you a link if you email me. The other thing is, I think it's pretty-common advice that you start out fairly risky, and then become more conservative as you age. Once you start aging, you're going to be more reliant on that income, and the chances of recuperating anything that you've lost when you're young are bigger because you have a greater timeline. So I think that's very standard advice that I happen to agree with.

Jenkins: Sure. A lot of people who were nearing the retirement age in 2006 and 2007 had to delay their retirement -- some of them still to this day -- because of the hit that they took in the markets. When your whole nest egg is on the line, and the market drops 20%, that's such an emotional thing, and it's hard to think and act rationally; so too-many people panic, and sell at the worst time possible. You can really do yourself a lot of harm like that. To Gaby's point, if they had been in bonds at that point, maybe that 20% drop would have been a 5% drop, and that emotional aspect is not as strong, and they're able to weather that storm a little bit better.

Lapera: Yeah. So, the long answer short is, there's no perfect combination; but maybe become less risky as you age. It's not something that you can set and forget, unless you happen to be completely invested in index funds. And even then, if the market drops 20%, you're still going to lose a huge chunk of your portfolio. So just actively think about what your goals are, and where you are in life, and manage your portfolio accordingly.

Jenkins: Think long term.

Lapera: Yeah. I wanted to take a quick break to give a brief shout-out to Levi Waddell. Levi is a loyal listener from South Dakota who frequently tweets and emails us. Most recently, he sent me a picture of what he does while listening to the podcast, which happens to be driving a tractor. I am a holy terror when driving tractors; I have almost run over a couple fences and people. Small animals seem to get out of my way fairly quickly, so I haven't run over any dogs or anything yet. I'm really glad that Levi is driving the tractors instead. Thank you for tweeting us, Levi! Everyone else, feel free to do the same thing.

Back to the show?

Flippen: Sounds great. Our next question is from Lindsey, our intern in Colorado. She asks, if a bank is labeled as too big to fail, does that mean it's generally a safer investment?

Jenkins: The short answer is no. I think anyone who had invested in Citigroup (C 1.41%) or Bank of America back around 2007 or 2008 would wholeheartedly agree with that. So, what does too big to fail actually mean? It means that the financial institution -- it could be a bank, it doesn't have to be; a lot of insurance companies are also too big to fail. It just means they're so interconnected with the global financial system that if they were to go bankrupt or cease operating, the entire globe would come to a halt in a financial sense. Payments wouldn't go through, companies would go to write checks and it wouldn't work -- wouldn't make payroll. It could send a huge shock through the whole world. 

The consequence of that is that governments are willing to step in and prevent these banks from, not necessarily failing, but from ceasing to operate. Citigroup is a great example. Citigroup is gigantic. It was a massive global bank, super interconnected all around the world. The financial crisis hit, and Citigroup started taking big losses, the capital ran out, they ran out of liquidity, and ultimately, what happened is, the government had stepped in, and forced Citigroup to raise new capital, diluting existing shareholders to an extreme degree. I don't have the number in front of me, but their stock today remains something like 90% below what it was back in 2006-2007 at its peak.

So it's safer in the sense that, if you have your deposits at one of these really-large banks, those deposits are going to be pretty doggone safe, because the government is not going to let this bank fail. As an investor, it does not mean anything. Any bank can fail. If that happens, the brand Citigroup may survive, but existing shareholders are likely going to be wiped out, or nearly wiped out as the company is forced to raise new capital, be it via the government or via private new money. 

Lapera: The other thing to keep in mind is that this is a super-hot-button political issue right now. Bernie Sanders has definitely mentioned this quite a few times, if you're following anything on the debates, or if you have a Facebook account. So we don't really know what's going to happen. Maybe the government will provide regulation that causes the big banks to have to become smaller. There's potential for that. But really, the only way to safely invest in anything is to do your research. There's no 100% safe with anything, not even too-big-to-fail banks.

Flippen: Definitely.

Lapera: Our next question also has something to do with banks.

Flippen: It does! Our next question is actually coming from a fellow investing intern, Ben. Ben's wondering, as the rate of auto lending, particularly subprime auto lending, has increased to record highs, are there any financial companies that are overly exposed to this subprime auto-loan market that could adversely impact this company's performance?

Jenkins: I'm going to skip around the answer directly to make a bigger point. Subprime is kind of a dirty word. The mortgage crisis burned in everyone's brain that subprime is bad. But we need to remember that, subprime back in 2008, the mortgage market was extremely widespread. Something to the tune of 30% of the mortgages originated at the very peak of the bubble were subprime. And that bubble, when it burst, was so massive. It had led to problems literally everywhere; it trickled to the commercial market, and the residential market. And it had broad, sweeping impacts on the labor market, the whole economy all over the world.

Subprime auto lending is much smaller than subprime mortgage ever was. In terms of the banking industry, if there is a subprime auto bubble and it bursts, there'll be impacts, there'll be losses from it, but it'll be nothing like what was experienced in 2007, 2008, and 2009. However, some banks will have more exposure than others. But in general, auto lending is a pretty-small component of a bank's larger book of business. Generally, mortgage lending is most, then some commercial real estate lending; then other times it'll be commercial and industrial lending, lines of credit for working capital needs, and so forth. And only then do you get into these consumer loans like auto loans or personal loans.

I wouldn't worry too much about the subprime auto-loan market specifically. It's good practice, if you're going to invest in a bank or lender, to look at their loan portfolio and see if they have any concentrations, in general, and make sure you're comfortable with that concentration before you dive into the investment.

Lapera: Definitely. Just an FYI for listeners -- when you say subprime, they're referring to your credit score. Credit scores range from, I think the lowest I've ever seen is 300, but they range from potentially lower than that to 850. Subprime is considered anything below 600. I have an Automotive Financial Lending report pulled up right now, and it looks like the states with the greatest default levels are energy states, which isn't that surprising right now, because if a bank has a lot of customers that are reliant on the energy sector (and the energy sector was down for a while, because this is from Q1 -- so who knows what it looks like exactly right now) but it's not surprising if a lot of people are defaulting because they don't have a job anymore.

Jenkins: That's right.

Lapera: But you're right that it's totally up. It's just something to keep an eye on.

Flippen: I think one thing we're talking about, and we've gotten the gist of throughout this, is that financials are particularly sensitive to the overall economy, which is why Amanda, an intern here at The Motley Fool is wondering that, if even minor changes in unemployment and consumer confidence can have a great impact on consumers' willingness to borrow, or the repayment rates, when economic growth slows, it's likely that the sector will slow, as well. As an investor, do you expect that the economy is going to expand in the future?

Jenkins: Yeah, the overall point here is totally true. Banks are very-much reliant on the broader economy. If business is booming, generally, banks will be booming, too. You think, who are the customers that banks serve? They're individuals who need jobs to not only take out loans or buy houses with mortgages, but also have savings, deposits -- all these other financial services that banks serve. And on the other side, businesses. Banks are giving loans to businesses to expand their facilities, to buy inventory, to make payroll, to do all these different things. If business is doing really well, then naturally, the bank also would be doing really well. And vice versa is also true.

In conclusion, do I expect the economy to continue to expand in the future? Long term, absolutely. Short term, your guess is as good as mine, and as good as anyone else's. It's impossible to predict what the economy will do in the next month or quarter, likely in the next year. But in 10 years, am I confident the economy will continue growing and doing fine? Absolutely. Twenty years, I'm even more confident. The system has proven itself for hundreds of years, if not thousands of years, for the general financial system that the world uses.

Long term, I'm very confident. Short term, I have no idea. You think, later this week, Great Britain is going to vote to potentially exit the eurozone. How that plays out is going to have a tremendous impact on not only the markets, but the global economy. There's all sorts of worries about Chinese growth slowing down, and potentially a bubble in our economy. How that plays out will have huge implications, and no one knows how that's going to work out. It's impossible to predict.

Lapera: That's totally true. But to get back to your historical point, this is part of the reason that investing in index funds make so much sense, is because historically, the economy always expands, and companies make more money over time. In theory. So that's part of the reason it's such a good investment. But I also agree that, while there are a lot of worries about what's going on globally in the financial markets, there's also a lot of opportunity in a lot of countries. People are just starting to hook up to the greater financial market. It's hard to see, because we're in the United States, I think. It's hard to realize that there's other countries that aren't nearly as enveloped or as enmeshed in the global economy as we are. And as those countries join, that provides a lot of opportunity for a lot of people.

Jenkins: I think domestically, as well. You buy a good company in America today, because America is the leading economy in the world. There's a lot of advantage to that company, a lot less risk. If you can find a company that's valued attractively, that's in a business that's likely to stay in business for some time to come, and you can really understand their operations and make a good case for it, that company is probably going to do well over a 10-20 year period. The U.S. economy has proven it, and I have complete faith that it will continue to.

Lapera: Yeah. But you're right; short term we have no idea. We wish we knew; then, we would make a lot of money. Emily, do you have any other questions?

Flippen: I think that about sums it up for us interns.

Lapera: Awesome. Jay, do you have any other pearls of wisdom?

Jenkins: I'm just so impressed that Emily already has a Roth IRA. That's so awesome. 

Flippen: You can thank my mom for that.

Jenkins: You're way ahead of where I was, for sure.

Flippen: That's the first thing she told me to do when I got a job, is put as much as you can into a Roth IRA. It's the best advice she's ever given.

Lapera: As long as it's within the legal limits, which I believe is around $5,500 this year.

Flippen: I don't have that much.

Lapera: That's OK; I don't think most of us do. But maybe one day. So everyone, thank you very much for joining us, Emily and Jay. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at [email protected], or by tweeting us @MFIndustryFocus if you have any questions, or if you're an intern, or if you're bored. We would just like some interaction. We like you guys; we hope you like us, too. Thank you very much to Austin Morgan, our awesome mix master behind the glass, and thank you to all the listeners for joining us. Hope everyone has a great week!