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.
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.
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're listening to the Financials edition, taped today on Monday, March 20, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, our financials 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. The largest 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 that he had a tiny headache on Saturday. [laughs] So, today is mailbag day. We're answering 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 email@example.com. Our first question comes from Rob. He writes, "Recently, I have been reading about equal-weight index funds as compared to the standard capital-weighted funds. Example: RSP (NYSEMKT:RSP) vs SPY (NYSEMKT:SPY). Can you explore 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, but one of the big ones is the standard is market cap-weighted, as he alluded to, which means that the largest companies make up the largest part of the index. So, for something like the S&P 500, the largest holdings, in order, are Apple, Microsoft, and Johnson & 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 an equally 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 larger percentage of the companies represented.
Wathen: Right. If you look at it, you would say the big difference between them is that the market cap-weighted funds, the standard funds, are biased toward the largest stocks, whereas equally weighted funds are more biased toward the smaller stocks. In a traditional S&P 500 funds, the standard fund, it invests 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: A standard S&P fund, the second big difference between these two is the industry difference. As I said before, the two largest components of the S&P 500 are Apple and Microsoft, two huge tech giants. If you look at an equally weighted index, tech only makes up about 12% of assets. But in a standard S&P 500, it makes 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, the standard market cap weighted one might be for you. But if 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 will probably 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. And the 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 have as much space to grow, so it's getting harder and harder for them to outperform their performance from last year.
Wathen: Just look at Apple, for example. If you look at Apple, by assets, a lot of it is just cash. And obviously, cash isn'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-up question that I'm actually asking, and it's more just things I think you should know when you're looking 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, but definitely check out the fees. If you're paying more than 0.6%, you're paying way too much.
Wathen: Even that sounds really high.
Lapera: That's really high, too. But I know some people in the 401(k)s or 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 an S&P 500 from Vanguard. And I know that we all sound like we're writing a love letter to Vanguard here at The Motley Fool, but you 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 500 Index 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. But I 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. in Cambridge, Massachusetts. He writes, "I listened to the recent show about credit cards," -- not so recent any more, heh -- "and credit ratings earlier, and I'm interested to hear your thoughts on whether it's worth it to carry some debt on your credit card from 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-worthy purchases in at least the next year, has seemed like the most money-saving route to take. However, someone mentioned that credit card companies may prefer to see consumers actually 'managing' their debt rather than paying it off. I'd like your opinion on this matter. The only other type of debt I've had up until this point in my life are my student loans, which I have been paying them consistently for years, both on my own and with some help from my parents. We'll have them all paid off ahead of schedule." So, this is a great question, and this is actually one 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 card in 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 bureaus calculate your credit score. It's also 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 you don'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. And I do know some people who have done that in the past. They go to Starbucks and spend $5, and they go to the supermarket and spend $50, and at 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. But you don't really want to do that because what happens is, at the end of the month, the bank or the credit card company or whoever owns your credit card sends your statement over to the credit bureaus, and if it's $0 for long enough because you've been paying it off before, sometimes the credit bureaus will think your 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, and that will drive down your credit utilization ratio. But, that's very rare, that doesn't happen very often. But, ideally, what you should do is pay it off once a month in full every month. If you're really worried about your credit 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 help keep your credit utilization ratio low. It'll let the credit bureaus know that your card is still active. And it'll just be great.
Wathen: Right. This actually drives me nuts, because honestly, there's probably a one-point benefit to carrying a balance. But in the grand scheme of, does your credit score matter, the one point is not relevant. It's completely 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 using so much of your credit utilization ratio that it's out of control. They care more about those things in terms of trustworthiness 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 score just by paying on time and making sure your credit utilization ratio is never over 15%. Then, you're probably solid, right? It's really 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 that makes it a little bit easier, and you'll never cross that barrier. It's super simple.
Lapera: Yeah. It's really not a huge deal. I think, for me, one of the reasons this makes me kind of panicky when I hear it from people is that I know that a lot of people aren't very good at budgeting to begin with, and then they're trying to carry a balance every month, and they're paying interest on it, and I can see that situation rapidly spiraling out of control.
Wathen: Right, and there's another thing, a credit score only matters at the point in time when you need it. For example, my friend, he called me up one day and said, "Man, my credit score is really low but I paid everything on time." And the 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 then pay 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, "Just stop using it for a month or two when you know you're going to need a good credit score." And he did, and his credit score jumped 70 or 80 points. Which is the difference between prime and subprime, in some cases. It's a big deal.
Lapera: Definitely. The other thing that you could do is open another credit card, and that'll increase your total credit limit, and use it rarely. There's definitely multiple ways to play the system. And technically, yes, opening a credit card will make your credit score dip, but it's only by a couple points for a few months, and then it'll go right back up, because your credit utilization, the total amount of credit you have, is much higher.
Wathen: Right, that's what I'm saying, that's what I feel like is why people don't understand this. There are things 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. Your lender is not going to deny you over three or four points. You know what I mean? Just get the big things right, and forget about everything else. I think I have a really good credit score, I could get really good low interest rates, and all 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. Feel free 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?" This question 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. A 13F is a filing that large investors or funds have to file, and they have to disclose their holdings at a point in time at the end of the quarter four times a year. That's as simple as I can say it. But they only disclose their long 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 have some sort of deep insight 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 great investor's process. I look at it and try 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 by Renaissance Technologies. It's the greatest hedge fund of all time, period, end of discussion, ungodly returns. I'm talking like 30% a year. They only have one losing year since 1988, and it wasn't 2008, it was 1999. But, they've blown it out of the water. But if you look at their 13F, you will learn nothing, because The Medallion Fund trades in and out of stocks more often than you change your socks on your feet. They trade constantly. So the point in time snapshot which you get from a 13F has actually no value whatsoever.
Lapera: Yeah, and that's exactly why you shouldn't be making these long-term investing 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 bought ExxonMobil, and he said he bought it because it was better than having that money in cash.
Wathen: Yeah, at the Daily Journal annual meeting, Charlie Munger basically said, "Do you know why we bought ExxonMobil? We thought it was better than cash." And they literally held it for less than two years. If you think about what Buffett does and what Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) does, they're trying to beat the market over long periods of time. But if you don't understand that nuance, you might look at it and say, "Oh, ExxonMobil, they bought it, it must be great, they're trying to beat the market," when in actuality, all they wanted to do was beat a savings 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, and second of all, what is the goal with the stocks that they buy? With Berkshire, it's changed so much. They used to want to smash the market, and now, apparently, they're really just trying to be the savings account, which is a really low threshold.
Lapera: Yeah. It's also hard because Berkshire Hathaway, like we talked about earlier with those really big companies that have trouble outperforming how they did historically, 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's the 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. And if you want, I'm more than happy to send you an article on this. We write approximately 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. You still need to do your own analysis, but I don't think it's ever bad to look at what a great investor is buying and try to understand why. I actually 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, you should 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're just saying what they own, not why they own it.
Wathen: And that's the thing, too. Because they don't report short sales, it's really important that you are really careful about how much weight you put on to it, because someone could be long Wal-Mart and short Target, to have neutral 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: The other thing to keep in mind is that it's kind of a snapshot of an investor's portfolio. They could exit 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.
Our final 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 that I intend to hold for the long term. I'm wondering if there's a way to invest Foolishly using margin. For example, 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 it make sense to maintain a margin position as my portfolio grows? The interest rate is only 1%, and I'm hoping my returns will continue to exceed that hurdle. If I plan 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 an accelerating 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 firstname.lastname@example.org 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 is basically using the broker's borrowed money, you're borrowing money from a broker to buy stocks, and you 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's potential for unlimited amounts of loss. I don't know if you remember this, Jordan, do you remember the guy who shorted KaloBios on 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 was about a year ago.
Lapera: He shorted 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's crazy. What he did was start a GoFundMe to help pay off a debt to his brokerage. Which is funny in and of itself. He's like, "I don't understand why the brokerage didn't tell me this could happen." They do, it's just in the fine print.
Wathen: Right. And that's a problem. They give you a 27-page contract. Everyone goes through it and signs their digital signature and then moves on with life. I can really categorize this into two basic ideas that say in a general rule, it's not good to use margin. The big one is that margin is not like a mortgage. If you go buy a house with a mortgage and the house drops 50%, the bank can't just show up, knock on the door, and say, "Hey, you owe us a ton of money." That's exactly 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. You might 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're paying so much in general to borrow money from a broker that you're giving up a lot of the upside, but the downside is still 100% yours. If the stock moves against you, that's all your loss. If it moves up and that's gravy, you're still paying interest. You have a scenario where you get less than 100% of the upside, and 100% of the downside. It's not a great deal, conceptually.
Lapera: Yeah, definitely. There's a difference between shorting, which you do on margin, and investing 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, plus whatever you've lost in the stock itself. And I 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 margin interest rate. He thought it was 1%, but it was actually 1% above the base rate of 8% percent. He says, "Needless to say that I 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'll give 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's really hard to beat the benchmark at most retail brokers. And either way, it doesn't matter. Even if you didn't have to, I would just say, it's OK, just leave a little money off the table to not expose yourself to such massive losses.
Lapera: Yeah, definitely. I'm not surprised that we have fairly similar feelings on this concept. Do you have anything else you want to say about any of the questions that listeners asked, or general 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. With credit scores, pay it on time. With margin, just don't do it. You'll be OK. 8% a year over the long run is an incredible return. You'll get that whether you're levered or you're unlevered. There's no reason to take super risk just to have a little bit more money at the end of the day. The downside is so tremendously bad that I don't think you want to.
Lapera: Definitely. My life advice is actually not related to financials. It's: Don't mix bleach and ammonia when you're cleaning stuff. I had a friend almost kill themselves this weekend by doing that when they were trying 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: Nothing off the top of my head.
Lapera: Nothing on how to hit a baseball better?
Morgan: Swing hard 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 email@example.com. As usual, people on this program may have interests in the stocks that 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 firstname.lastname@example.org, or by tweeting us @MFIndustryFocus. We love answering your questions, but we can only answer them if you ask them. So, email us. Thank you to Austin Morgan, baseball coach extraordinaire and today's totally awesome producer. And thank you to you all for joining us. Everyone, have a great week!