Another Nail In The Coffin

FINRA posted a loss for 2011.  So what's its response?  Fee increases, pretty much across the board.  At least that is what seems to be the answer according to a story in Investment News.  The plan:

For this year, Finra will be proposing a hike fees for advertising reviews, corporate financing and new-member applications, Mr. Ketchum told members

In addition, a 25% increase in the trading activity fee will be proposed. For next year, Finra will propose an unspecified "regressive tiered rate" for branch office assessments, and hikes in various registration and disclosure fees.

Overall, the proposed hikes range from around 5% to 50%.

This on top of a $36 million budget cut for 2012.  I suspect that its actually a reduction in the budget growth.

These increased costs are being imposed on broker-dealers, who can ill afford to absorb them.  However, if the B/Ds try to pass them on to advisors, another wave will exit the B/d channel and become independent RIAs.  And the downward spiral continues.

Right now, all of the environmental factors favor advisors becoming independent.  What will it take to reverse the trend?

REITs in Target-Date Portfolios

NAREIT has been promoting a study from Wilshire Associates touting the benefits of including REITs as a specific allocation in target-date funds.  I read about it in a story from Pensions & Investments website, pionline.com.  The white paper is available on reit.com, the NAREIT website.

The conclusion that a portfolio with a REIT component will be more efficient (higher return with the same volatility, or lower volatility in delivering the same return) is intuitive: The introduction of a distinct investment opportunity set with its own risk and return characteristics should add value on a portfolio level.  Thus, Wilshire was able to find that the addition of global REITs could add about 30 basis point of return to a portfolio with a given expected risk, and that domestic REITs could add up to 60 basis points of return.

The study stands only as a suggestion of efficacy though. The statistical analysis is thorough, but neglects to account for the changes in the structure and operation of the capital markets over the past 35 years.  For example, the correlation of REITs to the domestic stock market was relatively low during the 70s and 80s, approximately 0.35 to 0.40.  By the mid 90s, that correlation had risen to about 0.60.  And while I have not seen any statistics on recent performance, I would expect that the correlations have become stronger, given the general convergence of the equity markets.

Another point to recognize is that REITs are added to portfolios at the expense of high yield and non-US bonds and TIPS.  Recognizing that much of a REIT's return comes from dividends, REITs are still equities, often carrying significant leverage.  The mean-variance analysis does not necessarily pick up the equity risks of investing in REITs that are not expressly demonstrated in its volatility of returns.

The last item of note is that by adding a distinct REIT allocation, an overweight to REITs is being deliberately adopted, if not explicitly.  REITs are a part of the equity market, whether domestic or global.  They typically are included in the small-cap sector, where they might represent 10% of capitalization.  Thus, any REIT allocation will duplicate or amplify the market allocation, if no adjustment to the equity allocation is made.  Even if the equity allocation is adjusted, any allocation in excess of 2% or so is an overweight relative to the global capital market.

The paper cites a number of asset managers and retirement plan sponsors that have indicated that the inclusion of REITs in these target-date portfolios.  These changes may make the portfolios more diversified, but investors may not experience additional efficiency.

I recently ran across this blog post by Jason Zweig on WSJ.com.  His premise is that claims of investing in inefficient markets as a course to superior performance are not justified.  As he points out, Standard & Poor's research indicates that fund managers are no more successful in outperforming an appropriate benchmark in inefficient markets than are those in efficient markets.

While it may seem that inefficient markets should offer more and greater opportunities for excess return, those same factors creating the inefficiencies will militate against consistent outperformance.  Fewer and less sophisticated market participants will reduce the probability that a mispriced asset recognize its true value within a time frame that justifies its purchase.  Ultimately, any perceived excess return is most likely the result of an unrecognized risk factor, such as illiquidity.

Recognize that this a critique of the assumption that an inefficient market will benefit an active manager.  Many of these markets add value to the portfolio just through exposure, either through return enhancement or risk reduction.  To add value through active management in these capital market sectors, a manager must exhibit the ability to recognize many opportunities and to convert a high percentage of them into profitable transactions.

If It Walks Like A Duck And Quacks Like A Duck...

Commodity related mutual funds (including exchange-traded funds) have become very popular.  These funds provide a easy way to gain exposure to specific commodities (e.g. gold) or broad baskets (e.g. the energy complex) with a small capital commitment, liquidity, and professional administration and management.  The funds are touted as priding diversification through non-correlated performance and/or inflation protection.

Many of these fund gain exposure to the commodities through futures contracts.  The market is active and deep, providing an efficient means to participate in the price movement of the selected commodity.

Now the Commodities Futures Exchange Commission (CFTC) is asserting its regulatory authority over these funds, according to a story in Investment News.  The funds have relied on a rule exclusion that had allowed the funds to avoid registering with the CFTC. Effective January 1, those funds that invest primarily through the futures markets will be required to register as commodities pools and the fund managers to register as commodities pool operators.

Naturally, the funds are opposed, citing the regulatory oversight by the Securities and Exchange Commission (SEC).  Other negative affects of the move by the CFTC would be the potential application of conflicting regulations, and increased costs.  All of these costs would be to the ultimate detriment of the investor.

Nevertheless, the move is appropriate.  Futures contracts and the exchanges on which they are traded are fundamentally different from stocks and bonds and their respective markets.  In their composition and operation, these funds are clearly more like commodity pools than your typical mutual fund.  So, the additional regulation is relevant, along with SEC oversight of the mutual fund vehicle.

Of course, this will bring up another regulatory question: Who is qualified to recommend the purchase of one of these funds?  Will broker/dealers require advisors to acquire a FINRA Series 3 or 31 registration?  If the B/D is going to be held responsible for CFTC compliance with regard to these products, I would expect it to adopt the requirement.  Of course, since there is no such requirement for an unaffiliated Registered Investment Advisor, it would another nudge down the path of diminishing independent B/D competitiveness.

Into Each Life A Little Levity Must Fall

I know it's a little late, but this Wall Street Journal blog has some very clever April Fool's Day pranks.  A little distraction on Tax Day.  My favorite?  WestJet KargoKids.  Enjoy

Accurate ...But Wrong

Investment News carried a story about the state of municipal finance.  the premise of the article is that Meredith Whitney's analysis of state and local creditworthiness was correct, just her prediction of mass defaults was off a bit.  The story goes on to examine the status of three municipal bankruptcies -- Jefferson County, AL; Harrisburg, PA; and Stockton CA -- and come to the conclusion that bondholders are going to come out all right.Yes, revenue streams for local governments have been negatively affected, and yes all of the easy budget catting has been done.  Of course, there are municipal projects that are struggling to meet debt service.  Still, generally speaking, bondholders appear to in good shape in terms of issuers' willingness and ability to meet their bond requirements.  So, Meredith Whitney got everything right,except the part about the actual investment advice.

In the meantime, Bloomberg's yield tables indicate that AAA rated tax exempts continue to trade at higher yields than Treasuries.  Enjoy them while you can.

In Defense Of Gold

David Merkel writes in Seeking Alpha:

Gold does nothing, and that's good. We need some things in this hectic world that do nothing. What is the value of doing nothing?

Quietness. Pause. Repose. Reflection. Measurement Standard.

As he points out in the article, Merkel is no gold bug.  He doesn't even own any, other than a bit of jewelry.  He defends it against Warren Buffet's straw man of 400 million acres of farmland and 16 ExxonMobils (plus $1 trillion).  Merkel points out that the 68 feet cubed of gold in existence today will still be 68 feet cubed of gold tomorrow, next week, 100 years.  The value of gold is in its constancy.

But constancy does not create a store of value.  In a market economy, value is a relative concept. And value will change over time reflecting changing demand preferences, depletion of scarce resources, introduction of new technologies, and shifting demographics.

This does not mean that gold has no value in our economy.  As commenter notes, gold is a hedge against bad economic policies.  In economic terms, bad policies debase the currency, which is reflected in increased prices for unchanging commodities, such as gold.

However, gold is not an investment in the same sense that a holding of a diversified basket of stocks and interests in income producing real estate is.  This second portfolio is exposed to, and thus respondent to, the changing preferences, resources, technologies, and demographics that affect our economy on a daily basis.

It's Going To Happen

Mary Shapiro, Chair of the SEC, finds herself in an awkward position. As Investment News reports, she is trying to pass regulation that has the potential to keep money market funds from attracting the "systematically significant" label from the Financial Stability Oversight Board.  But she has run into opposition from both the industry and some of her fellow commissioners for proposing a regulatory burden: either provide capital subordinate to the stable NAV shares to absorb fluctuations in asset values, or let the NAV float.  The funny thing is that if the SEC fails in its regulatory efforts, the "systematically significant" designation will carry a consequence at least as burdensome.

I understand the marketing appeal of the stable NAV for a money market fund.  However, I have to wonder about the judiciousness of an investment proposition that relies on an arcane accounting trick to fulfill its objectives.  There are alternatives that have comparable yields, such as bank money market accounts.  It seems that the hadnwriting is on the wall for money market funds.

Right On Cue

As if responding to the protests against speculators (see Tuesday's post), the International Energy Agency has announced that "Oil markets are better supplied for the first time since 2009," according to a Bloomberg article.  OPEC is also signaling that supply is meeting user demand.  Both organizations blame the 12% increase in the price of crude oil on speculation related to geopolitical unrest and the related Iranian embargo.  Supplies are increasing slightly faster than demand, resulting in a decrease in the number of days of demand in inventory to 59.6.

So, even though production has not caught up to demand, that gap is narrowing,  largely due to weakening demand factors.  However, the market is subject to additional risk, partly identified with one participant and partly more amorphous.  This risk is not well defined right now, so speculators have stepped in to help the market find its price.

Note that the speculators are responding to market conditions, not to the availability of an investment vehicle.  Any speculator using ETFs today, would find another vehicle with which to take his positions if ETFs did not exist.  Banning ETFs would have little effect on the price of oil, or any other commodity.

Ready Fire Aim

An article in Financial Advisor magazine describes an attempt by consumer advocates and public interest groups to ban Exchange Traded Funds that invest in commodity related vehicles.  Their rationale is that the speculation represented by the ETFs is pushing the cost of these commodities up and thereby fueling inflation in food and, especially, energy costs.

The complaints are a lot of hot air.  If commodity prices were "too high" sellers, yes speculators, would be providing inventory until the price found its "correct" level.  Current commodity prices reflect supply and demand pressures on both the domestic and global markets, as well expectations for future market stocks based on economic, demographic, and policy trends.

Yes, demand for gasoline is rather inelastic, and $4 per gallon seems high.  But the culprit is not Exchange Traded Funds.  More responsible are the regulations that are mothballing oil refineries, and limiting the exploration for and production of oil within the U.S.