Home Sales Still Weak

As quoted in the Wall Street Journal, then S&P/Case-Shiller home-price index declined 3.1% between January 2010 and January 2011.  That's not so bad considering that home prices were being buoyed by a home buyer tax credit last spring.  the decline in home prices has put a damper on any hopes for a robust economic recovery in the first or second quarters.

A good part of the responsibility for the lingering weakness in home prices is the fallout from the mortgage market meltdown.  The market can not find clearing prices because there is a shadow inventory of homes that will be coming on the market as soon as banks foreclose on them.  Foreclosures are being delayed to a) address irregular procedures that servicers had followed in executing foreclosures, and b) come to agreement on how to provide relief to borrowers whose homes are worth less than their mortgage balance.  Banks have submitted a settlement offer addressing both issues.

In the meantime, cash buyers are able to buy portfolios of homes out of bank portfolios for cash.  These institutional buyers use the all-cash and quick close offer to negotiate a low price on several homes, relying on diversification to protect the profit margin.  These deals exist because the entire owner-occupied home market is in disarray: the price discovery mechanism is broken, the financing mechanism has been all but removed, and the biggest private participants in the market have been demonized.  Furthermore, the outlook for resolving these issues is not favorable.  Prepare for another year (at least) of stagnant home prices, which will continue to be a drag on macroeconomic performance.

Pension-Like Income From a Defined Contribution Plan

Financial Engines was first to market with a discretionary management strategy incorporating an income target.  Now, Dimensional Fund Advisors and Putnam are getting into the act.  Investment News reports on these new offerings in quite glowing terms.  Financial Engines and DFA accomplish the goal by establishing a core bond portfolio which is to provide the monthly income requested by the client and managing the remainder to provide some inflation protection.  No annuities are employed so as to avoid " single-carrier risk or insurance fees."  For their services, IN reports, Financial Engines charges 50 basis points and DFA charges 45 basis points.

Neither company will guarantee that the income will endure, and neither publishes its investment models supporting their programs.  Therefore we can't analyze the efficacy of the strategy for meeting the targets.  I would expect, though, that the income goals will be under estimated (or conversely capital will be over-committed).  Therefore, total return is likely to be less than optimal.  And still the income target is not guaranteed.

An advisor may be able to provide an overall superior solution with a few helpful tools.  The Otar Retirement Calculator will help and advisors determine whether a client's assets are sufficient to support the required retirement income, and assist in determining an optimal asset allocation.  The Income for Life Model (R) is a robust platform for planning, communicating, and executing a retirement income strategy that can provide a minimum monthly income guarantee, while maintaining full client flexibility over his portfolio.

Most Researched ETFs

Investment News published a list of the ten most researched ETFs, as compiled by Morningstar.  They were4 able to compile the list by tracking the number of times a fund's profile was accessed through Morningstar Advisor Workstation.  The top ten are:

1. iShares Barclays TIPS Bondsw (TIP)
2. iShares MSCI Emerging Markets (EEM)
3. SPDR Gold (GLD)
4. iShares MSCI EAFE (EFA)
5. Vanguard Emerging Market Stock (VWO)
6. iShares Barclays Aggregate Bond (AGG)
7. SPDR S&P 500 (SPX)
8. PowerShares DB Commodity Index Tracking (DBC)
9. iShares iBoxx $ Investment Grade Corp Bond (LQD)
10. iShares S&P U.S. Preferred Stock Index (PFF)

Only a couple of surprises here.   PFF is a pleasant surprise.  Preferred shares provide an attractive yield and are eligible for the 15% qualified dividend tax rate.  And its 7.40% yield dominates the 4.79% of LQD.  That there are three funds representing an inflation hedge theme (TIP, GLD, and DBC), with significantly different strategies and sponsored by three different management companies, is a testament to the sophistication of advisors today.

What this list indicates to me is that advisors are looking to ETFs to fulfill two roles in client portfolios:

1. Instant diversified exposure to a broad market or asst class; and
2. Easy liquid exposure to for highly specific portfolio enhancement (e.g. yield enhancement, inflation hedge).

These were the original objectives driving the development of ETFs at the turn of the century. As with open-end mutual funds, product extensions representing more narrow or arcane investment strategies are interesting, but will not be the main focus of the advisor community.

What To Do When

Over the past couple weeks, indeed over the past two years, several independent broker dealers have closed their doors.  This has left hundreds of advisors, and their tens of thousands of clients, without brokerage support.  This article from Investment News provides four steps for being prepared for the unthinkable:

1. Don't ignore signs of trouble. 
2. Look into your firm's potential regulatory and/or arbitration problems in relation to its financial strength
3. Look into your B-D's errors-and-omissions-insurance coverage. 
4. Start formulating a backup plan.

The biggest point is that a backup plan needs to be in place before any signs of trouble emerge.  And that backup plan should consider some radical changes: resigning FINRA licenses and opening an independent RIA; assigning clients to a trusted colleague at another firm for a while; executing your succession plan.

I do some work with a group of advisors.  They came together as a result of a life insurance company getting out of the independent BD business.  They were able to affiliate with another BD and get all of the other infrastructure in place to serve their clients within four weeks.  As long as I have been working with them, they have had a contingency plan.  The consortium is constantly entertaining ideas for new affiliations, and has twice organized a formal investigation into organizational options.  Now, the group estimates that they able to serve their clients after a weekend, and will have a full transition in place within five business days.  This is not only good business planning, it gives a client a sense of confidence to know that the contingency plan is in place.

ETF Fees and Expenses

The Mad Hedge Fund Trader has posted a short commentary on hedgetracker.com.  His premise is that new entrants into the ETF space will break the monopoly of BlackRock, State Street and Vanguard.  He cites new offerings by PIMCO, Van Eck, and ProShares as competition that will drive costs down and improve profit margins for traders.

In general, competition will tend to put downward pressure on pricing of similar products.  That said, Vanguard and State Street are two of the lowest cost producers in the industry, and Barclays was one as well.  Since BlackRock picked up the indexing business of Barclays (including the iShares franchise), it seems that BlackRock will continue that business model.  On the other hand, PIMCO, Van Eck, and ProShares are not considered among the pricing innovators.  Don't expect them to lead a revolution in ETF pricing any time soon.

Social Impact Bonds

Following up on my earlier post on Impact Investing, I was following some threads on impact measurement when I came across a New York Times article about Social Impact Bonds.  This led to the website for The Young Foundation in the UK, which has been developing the concept.

What is clear is that these are not bonds that we would recognize.  Instead, it is a a funding mechanism that links the capital markets (which provide the funding for social programs) with the government appropriation that is conditioned on outcomes.  According to the Young Foundation, this structure addresses some of the problems created by misaligned incentives in social policy.

The problem is that the "bonds" just replace one amorphous source of funding with another.  The only consequence to the service agency is that it does not raise the next round of funding.  In reality, one could expect to see gaming of the outcome requirements to assure success and continued funding, just as we have now.

What would really align incentives is for the agency to get paid a part of the value created by the services provided.  For instance, an agency contracted to provide job training could be paid out of the first year wages earned by its students.  Let's say a training program can train 60 workers a month, and 75% of them get jobs that pay $15,000 per year on average.  If the agency were to charge the employer 5% of wages paid, the agency would receive $33,750 for each monthly class.  The value created is more than just the wages being earned by the students.  It includes a thriving business community that is employing the students, renting local real estate, and paying business and payroll taxes.  It includes allowing the human capital of a community to become productive.  And it reduces the demand for services from the governmental entities, from subsidized housing to law enforcement.

Of course, if the above scenario were possible, there would be no need for specialized funding vehicles like Social Impact Bonds.  The trick is to find a way to fund operations that create societal value which is not easily monetized.  And the hardest part of that is measurement.  Shifting the risk to the capital markets is not the answer.

GAO Study of Target Date Funds

The Target Date Funds (TDFs) were adopted as default investments in 40101(k) plans when the Department of Labor determined that money market funds might not be suitable in that role.  Plan sponsors adopted these funds just in time for them to be in place as markets melted down in 2008.  In general, the TDFs showed declines in value, as would be expected of funds invested in risky assets such as stocks and bonds.  However, the performance of TDFs was surprising and disappointing in that:

• certain of the TDFs that were designed for employees retiring in 2010 experienced significant losses in 2008;
• TDFs with the same target retirement date but from different fund families had widely divergent performance;
• In general, losses incurred by the TDFs were larger than participants or plan sponsors expected.

The General Accounting Office studied the marketplace and issued a report on  it findings on February 23.  Not surprisingly they found that differing fund performance can be traced to differing investment objectives and policies.  The GAO found no consistency in the construction and management of TDFs from one fund family to another.  Thus there was one TDF that had a 65% equity allocation in its 2010 TDF as late as June of 2008.  Some companies retained discretion over the asset allocation decision within a policy band.  In some cases, rebalancing was not pursued ant time over the 2008 - 2010 period.  Essentially, the only thing that these funds shared was a category name.

The GAO has recommended that plan sponsor explicitly consider and document characteristics of their employees and plan participants in selecting TDFs as investment options in 401(k) plans, and creating additional educational material from plan sponsors.  That's fine and dandy, but an advisor will truly add value for his client by:

1. Identifying TDF families that have strict investment policies governing the allocation among asset classes, and validating that the fund companies adhere to their policies;
2. Use TDFs that have an equity allocation that methodically declines toward a small (less than 25%) allocation at maturity;
3. Use TDFs that use passive funds for their asset class allocations to ensure participation in the relevant market (in the jargon, reduce "tracking error");
4. Keep costs low by avoiding a fee more than 10 basis points for administering these mechanical, passive portfolios.

These four guidelines will give a plan sponsor comfort that the TDFs' performance is entirely dependent on the market, and will not underperform because of a poor decision made by someone else.  This framework will ensure that a participant investment risk assumed closely reflects his investment time horizon.  And with proper documentation, the sponsor has demonstrated effective discharge of his fiduciary duties.

Investing for Higher Inflation

With the Federal Reserve Bank pouring some $600 billion of liquidity into the economy with QE2, after a decade of easy money, it seems a foregone conclusion that we can expect a bout of increased inflation, and sooner rather than later.  What can an investor do to protect his purchasing power?  Gold and silver have been the traditional answers, but these metals have their drawbacks, not least of which has been a meteoric rise over the past three years.  A more generalized commodities exposure is intellectually attractive, but vehicles for gaining that exposure are expensive and have structural problems.

Smart Money mentions three mutual fund categories that tout their inflation hedging properties.  Real return funds have proliferated recently.  Smart Money recommends avoiding funds heavily weighted in TIPS as the yields on these  bonds have been bid down to next to nothing.  I concur.

The second option is global bond funds.  The argument is that foreign countries, especially ones that export natural resources, are going to be somewhat sheltered from the effects of inflation, if not actually benefit from it.  As the commodity exporting countries tend to be emerging markets, and thus pay a premium yield, this can be true.  However, these are fixed income investments, and so values will decline as interest rates rise, as they will if inflation ticks up.  Also, emerging market economies tend to peg their currencies to the dollar, either formally or informally.  This peg could undermine the hedging benefit of foreign bonds.

The final suggestion is bank loan funds.  I have commented on these funds here.  Suffice it to say that, though these funds are being touted for their inflation hedging properties, there is a high probability that investors will be disappointed.

I heard a presentation on a unit investment trust (UIT) structured to be interest rate hedge.  The portfolio is constructed with a 20% weight in each of dividend paying stocks, closed end funds investing in convertible securities, closed-end funds investing in TIPS, closed-end funds investing in master limited partnerships, and closed-end funds investing in limited duration bonds.  This sounds to me like a more rigorous inflation hedge portfolio.  The dividend paying stocks and convertible securities reflect the research done at the end of the 70s and into the 80s showing common stocks to be highly effective inflation hedges, though I would probably leave them in the equity portion of the client's portfolio.  The TIPS are a natural portfolio inclusion and the MLPs are income producing hard assets  with a revenue stream tied somewhat to commodity prices.  I would probably forgo the short bonds, as they should already be represented in the traditional portfolio, and add some income producing real estate in the form of some REITs or a REIT fund.

There you have it.  An inflation hedge portfolio consisting of TIPS, real estate and MLPs.  There are low cost mutual funds and ETFs that will give you simple exposure very inexpensively.  Worth considering.

New 401(k) Regulation

I don't usually comment on laws and regulations, nor on retirement account issues, but I saw an article today that touches on a subject that keeps coming up like Whack-A-Mole.

Bloomberg has the article about proposed Department of Labor regulation that would "apply a fiduciary standard to those firms who advise plan sponsors about which investments to offer."  The rationale:

Improved regulation of retirement plans is needed because employers and participants may not understand that the person educating them about their 401(k) investments may have a financial stake in the choices they make, the U.S. Government Accountability Office said in a report released yesterday.

“If left unchecked, conflicts of interest could lead plan sponsors or participants to select investment options with higher fees or mediocre performance, which, while beneficial to the service provider, could amount to a significant reduction in retirement savings over a worker’s career,” the GAO said.

 I other words, an advisor to the plan would be responsible for ensuring that the plan is administered solely in the interest of participants.  The article states that the regulation is designed to prevent conflicts of interest.

There are so many things wrong with the proposal.  First, ERISA already assigns fiduciary responsibility to the plan sponsor, and the participant is presumably looking out for his own interest.  If advisors to the plan  are to be held to a fiduciary standard, can other vendors be far behind?  And when everyone has responsibility, no one does.

Second, fiduciary responsibility is a very vague standard.  What is in the best interest of participants is the subject of judgment.  What bis a good investment?  What is a reasonable cost?  How many funds are to be offered?

Finally, advisors will  not be willing to take on these liabilities without additional compensation.  If the concern is that the plan is incurring excessive costs, the solution is not to add another cost factor onto the plan.

The answer to conflicts of interest is disclosure.  The DoL went a long way some years ago when it introduced a worksheet that allowed a plan sponsor to calculate the total cost of administering a plan and managing its investments.  While that tool was somewhat unwieldy, it got the conversation moving in the right direction.  Such a tool could be adapted to show the specific compensation information so that the plan sponsor can make informed decisions.

On the other hand, there are a n umber of firms that are voluntarily offering to accept a fiduciary role as a partner with plan sponsors.  By contract, the advisor accepts fiduciary liability with regard to the plan on behalf of the plan sponsor.  Now there is no questions as to who is the fiduciary, and the authorities are aligned with the responsibilities.  These firms are receiving a premium fee for these services, and these fees are fully disclosed.