What Impact will GM’s Bankruptcy Have on Your Mutual Funds?
By Ron DeLegge, Editor
June 1, 2009

SAN DIEGO (ETFguide.com) – How will the crippling fall of General Motors (NYSE: GM) into bankruptcy affect your mutual fund investments?

Exactly one year ago General Motors (NYSE: GM) traded at $17.44. In January it fell to $3.65 per share. And today, it trades around 0.88 cents and has a $580 million market value. Clearly, the carmaker’s financial woes are fully reflected in its miserable stock performance.

Funds with the Largest GM Stake
The top mutual fund holders of GM’s stock are all index mutual funds and index ETFs. The Dow DIAMONDS (NYSEArca: DIA) carries almost 7 million shares, the Vanguard 500 Index Fund (Nasdaq: VFINX) has 5.8 million shares and the SPDRs S&P 500 ETF (NYSEArca: SPY) owns 5.26 million shares. Because GM is a component of key stock benchmarks like the Standard & Poor’s 500 and Dow Jones Industrial Average, index funds following these benchmarks have been forced to own the stock. What type of performance has that meant for investors?

Even with the dead weight of GM, the S&P 500 index still outperformed almost 72% of actively managed mutual funds over the past 5 years. Some fund managers may proudly declare they avoided GM, but their collective performance still hasn’t produced profitable results for the typical mutual fund investor. According to fund researcher Dalbar, stock fund investors lost 41.6% last year compared to a 37.7% decline for the S&P 500 Index. Today, roughly 85% of the $9.6 trillion invested in mutual funds is invested in active funds attempting to beat the market. “The belief that bear markets favor active management is a myth,” states a recent S&P report of active managers versus indexes.

Loading up on Trouble
As one of the 500 companies within the S&P 500 index, GM’s influence upon the index has been declining. Why is that? Because as a market capitalization based index, the S&P’s movement and performance is most impacted by stocks with the largest market size. Since GM no longer commands the huge market cap it once had (today it’s around $580 million), its affect on the S&P 500’s performance has substantially declined.  Also, one thing an index fund and index ETF will never do is to double or triple down on a dead beat stock. The same cannot be said of mutual fund managers. Let’s analyze a real life example.

Despite nuclear bombing $18 billion and needing more than $50 billion from the U.S. government to stay afloat, Citigroup (NYSE: C) was still a good investment according to certain mutual fund managers. Fidelity Investments, the world’s largest mutual fund company, more than doubled its stake in Citigroup during the fourth quarter of 2008. For that same time period, Citi traded in a wide range from a high of $23 all the way to a low of $4.70. Today, the stock trades around $3.75 per share. Fidelity’s gutsy bet on Citi has had about the same nauseating effect as eating pizza with a glass of orange juice.

Toxic Advice on Toxic Stocks
What about Wall Street’s stock analysts? Since they spend their days analyzing reams of financial data, surely they’ve been able to help investors to avoid toxic stocks like General Motors, right?

I’m displeased to report Wall Street’s stock analysts haven’t been much help. During the fourth quarter of last year Barclays Capital and Credit Suisse each downgraded GM not to an outright sell but to “underperform” and “underweight.” Assuming you followed this advice, you would’ve have held GM in your portfolio but in smaller increments. What kind of help is that? The worst advice was given by UBS, whom issued a buy recommendation on GM in October 2007 that looked like it was forgotten until it was abruptly changed to a “sell” in March 2009. If you followed the advice of UBS, you would’ve bought GM at around $37 in 2007 and then sold it around $2.50 per share in March 2009. For the mathematicians reading this article that works out to be a 93% loss.

Lessons Learned
We should not overlook the financial damage that GM has caused to its employees and retired workers that invested their retirement money in both its stock and bonds. Some of these people will lose their entire nest egg because they didn’t heed the advice to diversify their portfolios. Could they have avoided financial calamity with just a little bit of planning?

After witnessing and experiencing trillions of dollars in financial damage, what are the lessons learned? For those that suffer from financial puberty, they’ll argue that people need to select their stocks more carefully. Others will tell you that you need to pick your mutual funds more carefully. The real lesson, however, is that people should only be investing in individual stocks and with active funds after they’ve built their portfolio with a diversified mix of low cost index funds. After you’ve taken care of this priority and there’s additional money you don’t mind risking, do whatever you’d like.

In the February issue of the ETF Profit Strategy Newsletter, we assembled a short list of 50 Blue Chip Stocks and their ETF Replacements. What “Blue Chip” stocks today will become tomorrow’s General Motors? The basic idea is to help you identify which ETFs best match up with popular stocks and to avoid financial calamity. Check it out.