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PostPosted: Mon Jun 08, 2009 3:39 pm    Post subject: GM Reply with quote

BOSTON -- The stock market and the economy are prompting plenty of questions from readers. Among other things, investors want to know how General Motors' bankruptcy will affect their index funds, why GM wasn't booted from those funds a long time ago, and what's behind the changes at a Vanguard money-market fund.

Question: I saw that General Motors is out of the Dow Jones [Industrial Average] and [Standard & Poor's] 500. Does that create a problem for my index funds? What happens when a big stock just drops off like this? -- John in Seattle.

Answer: Bankruptcy is a deal-breaker for virtually every index there is, so GM (GMGMQ: undefined, undefined, undefined%) didn't just fall out of the Dow and S&P, it's out of just about every index you can think of. And it also must be out of funds based on those indexes.

While investors typically think of index funds as passive investments that simply mirror the benchmark, often index-fund managers get busy swapping out stocks that have fallen off for newcomers.

Some indexes, like those run by Russell, go through a regular reconstitution, where the keepers of the benchmark make changes to the holdings so that their index better reflects the current market. Stocks also can just fall off an index due to a merger, bankruptcy, growth (too big for a small-cap index) or shrinkage (too small for a large-cap index). Some indexes -- such as the Dow and S&P -- make immediate replacements when bankruptcy knocks a stock like GM off their list; others (like the Russell indexes) wait until they make semi-annual changes.

Aside from the loss suffered during the stock's decline, for the most part it's a non-issue for index-fund shareholders. The fund manager basically has "a reasonable amount of time" to unload shares. Some may have made the move once bankruptcy for GM appeared to be imminent and inevitable; some will try to eke out a few extra pennies if the stock bounces back on the Pink Sheets based on company news.

How smoothly managers unload their shares will help determine how closely the index fund tracks its benchmark. Indexes have no trading costs, but index funds do; those expenses come off the top and are part of the friction that typically causes the fund to lag the return of its index.

(GM's de-listing pushed it off indexes, but the process has been going on for awhile. A decade ago, the stock was on the Russell Top 50, Top 200 and 1000 indexes; it dropped off the Top 50 in 2000 and off the Top 200 in 2008 before falling out completely with its bankruptcy filing.)

Once GM emerges from the bankruptcy process, it may rejoin some indexes, but fund managers will not hold onto their current shares hoping to avoid transaction costs if there's a quick turnaround.

"There are too many uncertainties for the manager of an index fund to hold on," said Jason Hsu, chief investment officer of Research Affiliates, which develops fundamental indexes. "It most likely will come through bankruptcy as a new stock, with new shares, and the old shares will have no value, so while GM could come back to the indexes when it is out of bankruptcy, managers can't assume it will be the same GM."

Why the delay?

Question: GM has been sick for a long time, so why couldn't an index-fund manager have just gotten rid of it a long time ago? Their fund would have done better without it. -- Mike in Memphis:

Answer: There's no question a manager could enhance an index by getting rid of the dogs. Had you cut the Standard & Poor's 500 down to the S&P 499 by eliminating General Motors in 2007 or 2008, performance would have improved.

But that would be active management. You'd be adding a layer of active decision-making, which raises costs. And once you step onto that road, you're not just talking about one ill stock -- you start wanting to weed out any investment that creates concern, and then judgment starts coming into play.

Active managers have a long record of struggling to beat their benchmarks, so even an "enhanced index fund" -- which is mostly index with an active component thrown in -- should be considered carefully. If you want active management, get a strategy you can believe in; if you want exposure to an index over time, buckle up on appropriate index funds and go along for the ride.

Investors get better deal

Question: I have some money in Vanguard Treasury Money Market fund, and my son says they are kicking out small investors. Is that true? -- Ann in Tucson.

Answer: The short answer is absolutely not. In fact, you will actually benefit from what Vanguard is doing, because your expense ratio is going to shrink and your returns will grow. Here's the back story:

Vanguard announced this week that it's merging its Treasury Money Market fund into its Admiral Treasury Money Market fund. Both funds are closed to new investors, but when they were taking new accounts you needed just $3,000 to get into the ordinary fund, compared to $50,000 to get started in the Admiral shares. Killing off the fund with the low minimum to keep the fund with the high entry price is probably what's behind the misimpression that Vanguard is somehow dumping small investors.

On most Vanguard funds, Admiral shares represent a different share type (with a higher minimum and lower costs) on the same underlying fund. The two Treasury funds, however, are actually separate stand-alone funds. That duplication -- on funds that are virtually identical -- is the reason for the merger, which will be completed by mid-August.

Shareholders in the Treasury fund will not have to increase their stake to Admiral level to stay in the fund. Meanwhile, their expense ratio will fall by 0.13%, and their current yield -- now at 0.05% -- will jump to the level of the Admiral fund -- now 0.19%. Vanguard spokeswoman Rebecca Cohen said the fund's board will review the minimum if and when it decides to re-open to new investors; it could re-set the bar at any level when the time comes.
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