Investment Management Fees Are (Much) Higher Than You Think

I saw this is piece in a recent edition of Financial Analysts Journal, occasionally they publish a guest editorial, this one, by Charles D. Ellis, CFA is a must read if you are paying a firm to actively manage your investments. The editorial in its entirety is below.

Although some critics grouse about them, most investors have long thought that investment management fees can best be described in one word: low. Indeed, fees are seen as so low that they are almost inconsequential when choosing an investment manager. This view, however, is a delusion. Seen for what they really are, fees for active management are high—much higher than even the critics have recognized.

When stated as a percentage of assets, average fees do look low—a little over 1% of assets for individuals and a little less than one-half of 1% for institutional investors. But the investors already own those assets, so investment management fees should really be based on what investors are getting in the returns that managers produce. Calculated correctly, as a percentage of returns, fees no longer look low. Do the math. If returns average, say, 8% a year, then those same fees are not 1% or one-half of 1%. They are much higher—typically over 12% for individuals and 6% for institutions.

But even this recalculation substantially understates the real cost of active “beat the market” investment management. Here’s why: Index funds reliably produce a “commodity product” that ensures the market rate of return with no more than market risk. Index funds are now available at fees that are very small: 5 bps (0.05%) or less for institutions and 20 bps or less for individuals. Therefore, investors should consider fees charged by active managers not as a percentage of total returns but as incremental fees versus risk-adjusted incremental returns above the market index.

Thus (correctly) stated, management fees for active management are remarkably high. Incremental fees are somewhere between 50% of incremental returns and, because a majority of active managers fall short of their chosen benchmarks, infinity. And when market returns are low, as in recent years, management fees eat up even more of an investor’s return. Are any other services of any kind priced at such a high proportion of client-delivered value? Can active investment managers continue to thrive on the assumption that clients won’t figure out the reality that, compared with the readily available passive alternative, fees for active management are astonishingly high?

Fees for active management have a long and interesting history. Once upon a time, investment management was considered a “loss leader.” When pension funds first mushroomed as “fringe benefits” during the post–World War II wage-and-price freeze, most major banks agreed to manage pension fund assets as a “customer accommodation” for little or no money—that is, no explicit fee. With fixed-rate brokerage commissions, the banks exchanged commissions for cash balances in agreed proportions. The brokers got “reciprocal” commission business, and the banks got “free” balances they could lend out at prevailing interest rates. In the 1960s, a few institutional brokerage firms, including DLJ, Mitchell Hutchins, and Baker Weeks, had investment management units that charged full fees (usually 1%) but then offset those nominal fees entirely with brokerage commissions.

When the Morgan Bank took the lead in charging fees by announcing institutional fees of one quarter of 1% in the late 1960s, conventional Wall Street wisdom held that the move would cost the bank a ton of business. Actually, it lost only one account. Thus began nearly a half century of persistent fee increases, facilitated by client perceptions that fees were comfortably exceeded by incremental returns—if the right manager was chosen. Even today, despite extensive evidence to the contrary, both individual and institutional investors typically expect their chosen managers to produce significantly higher-than-market returns. That’s why fees have seemed “low.”

A relatively minor anomaly is getting more attention: While asset-based fees have increased substantially over the past 50 years—more than fourfold for both institutional and individual investors—investment results have not improved for many reasons. Changes in the equity market have been substantial, particularly in aggregate. Over the past 50 years, trading volume has increased 2,000 times—from 2 million shares a day to 4 billion—while derivatives, in value traded, have gone from zero to far more than the “cash” market. Institutional activity on the stock exchanges has gone from under 10% of trading to over 90%. And a wide array of game changers — Bloomberg, CFA charterholders, computer models, globalization, hedge funds, high-frequency trading, the internet, and so on—have become major factors in the market.

Most important, the worldwide increase in the number of highly trained professionals, all working intensely to achieve any competitive advantage, has been phenomenal. Consequently, today’s stock market is an aggregation of all the expert estimates of price-to-value coming every day from extraordinary numbers of hardworking, independent, experienced, well-informed, professional decision makers. The result is the world’s largest ever “prediction market.” Against this consensus of experts, managers of diversified portfolios of publicly traded securities who strive to beat the market are sorely challenged.

If the upward trend of fees and the downward trend of prospects for beat-the-market performance wave a warning flag for investors—as they certainly should—objective reality should cause all investors who believe investment management fees are low to reconsider.ⁱ  Seen from the right perspective, active management fees are not low— they are high, very high.

Extensive, undeniable data show that identifying in advance any one particular investment manager who will—after costs, taxes, and fees—achieve the holy grail of beating the market is highly improbable. Yes, Virginia, some managers will always beat the market, but we have no reliable way of determining in advance which managers will be the lucky ones.

Price is surely not everything, but just as surely, when analyzed as incremental fees for incremental returns, investment management fees are not “almost nothing.” No wonder increasing numbers of individual and institutional investors are turning to exchange-traded funds and index funds—and those experienced with either or both are steadily increasing their use of them.

Meanwhile, those hardworking and happy souls immersed in the fascinating complexities of active investment management might well wonder, Are we and our industry-wide compensation in a global bubble of our own creation? Does a specter of declining fees haunt our industry’s future? I believe it does, particularly for those who serve individual and institutional investors and continue to define their mission as beat-the-market performance.

Notes

ⁱ. The announcement in February by the U.S. Labor Department that it will require more disclosure of fees to 401(k) sponsors and participants may help some investors do so.

CBlakely, CFP®         05/2013

Wee Three Things

As we are in the middle of the Holiday Season I thought now a fine time to take respite from fun and family and talk about taxes and estate planning, which, in the end is good for your family.

First, with the buzz around the fiscal cliff and the Bush tax cuts that are set to expire in 2013, what is getting overlooked is a tax that will definitely take effect in the 2013: the 3.8% tax on investment income.

Congress passed the 3.8% tax in 2010 to help fund President Obama’s Affordable Care Act and Medicare overhaul, and the new tax is scheduled to go into effect on Jan. 1, 2013.

As a result, you should meet with your advisor before year-end to decide whether to sell any assets before the end of the year. One simple idea is to rebalance your portfolio this December, instead of January, that way any gains would not be subject to the new tax. A good news note, about half of all accounts that hold dividend paying stocks are in tax-advantaged vehicles, so they remain indifferent to this new tax policy.

According to the congressional Health Care Caucus’ information site, the new tax will be imposed on unearned net investment income, including capital gains from stock sales, dividend income, bonds, mutual funds, annuities, loans and home sales. People subject to the tax are individual filers who earn adjustable gross income of more than $200,000 and married couples filing jointly with AGI of more than $250,000.

Next, if you're planning to make a charitable donation, do it before December 31 and you may be able to write it off on your 2012 taxes. A donor-advised fund can give you even more benefits. Remember you can receive an immediate tax deduction for contributions to offset taxable income, also, you can avoid capital gains taxes on the contribution of appreciated assets held for more than one year and it removes contributed assets from your taxable estate.

Finally, I found an interesting exhibit in one of my estate planning books. It compares Chief Justice Warren Burger and Elvis Presley’s wills. Elvis Presley’s will contains many important clauses that are necessary in a well constructed will. Warren Burger’s will is literally three sentences long. Elvis passed on 27 percent of his estate to heirs, while Warren Burger passed on 75 percent of his assets. The length and number of clauses mean very little to estate planning if proper planning is not completed.

Meet with your CFP® advisor or estate planning attorney, if you don’t have one start interviewing candidates.

CBlakely CFP®, CTFA      12/2012

Sources: http://health.burgess.house.gov/ Bloomberg LP, Estate Planning, by Michael Dalton

Revisiting the 4 Percent Spending Rule

A well-known approach to addressing prudent retirement spending is known as the “4% spending rule.” This guideline states that retirees with a diversified portfolio balanced between stocks and bonds can safely withdraw 4 percent of their initial balance at retirement, then adjusting the dollar amount for inflation each year thereafter.An inflation-adjusted withdrawal rate is intended to provide a predictable stream of withdrawals that keep up with inflation.

 

Conversely, using a percentage-of-portfolio withdrawal method, the retiree withdraws the same percentage annually from the prior year-end portfolio balance. The dollar amount will fluctuate with market performance, and while the portfolio balance and withdrawals may shrink, the portfolio is unlikely to ever be fully depleted.

In practice, retirees are likely to incorporate a hybrid spending method—spending moderately in years when the market is up and spending less when the market experiences prolonged downturns.

The factor that has the biggest impact on withdrawal rates is the retirement planning time horizon. For most people, an estimate of how long the retirement portfolio will be needed can be based on the investor’s current health and anticipated longevity, as determined by statistics, and history. An estimate of age 90 is a reasonable default given today’s longer life expectancies. For a 65-year-old married couple today, for example, there is a 72 percent chance that at least one spouse will live to age 85, a 45 percent chance that one will live to age 90, and an 18 percent chance that one will reach age 95!

With today's yields near historic lows retirees, whose dividends and interest combined are less than 4 percent are often reluctant to spend from principal to make up for the deficiency. And many are wondering whether 4 percent is still a reasonable spending goal.I feel it is a reasonable starting point for investors who follow a total-return spending approach. A total-return approach is one in which investors remain appropriately balanced between stocks and bonds, and diversified across varied asset classes so that portfolios may potentially benefit from both dividends and interest and appreciation of capital (i.e. stocks moving up in price).

Instead of changing the portfolio to chase income, by reducing equity exposure and adding bonds it may be wise to consider the total-return approach to allow for spending both from portfolio cash flow and from the potential increase in the portfolio value.This empirically decreases the odds of  outliving your portfolio.

CBlakely CFP®, CTFA                   October 2012 

 

Source: Society of Actuaries Retired Participants 2000 Mortality Table., Fiancial Planning Journal

Stocks are Dead; Long live Stocks!

The S&P 500 is setting multiyear highs right now. It’s the economy right? Not really, the U.S. economy grew 1.7 percent in the second quarter, creating about 140,000 jobs a month on average this year. That is less than half of the monthly hires needed to bring the unemployment rate back to pre-crisis levels by 2015. Well then, it’s due to our government averting the so-called fiscal cliff—the spending cuts and tax hikes that could stall the economy next year. Not so fasr, our government has not addressed that issue yet – hey, they still have 100 days. Europe’s financial crisis is resolved! That’s not it, Europe’s problems, while getting better, remain unresolved.

So how is it that the Standard & Poor’s 500-stock index is up 25 percent over the past 12 months? Stocks have reached levels not seen since Lehman Brothers and Bear Stearns existed.

Over the long term, through all the noise, stock prices actually move relative to corporate earnings. S&P 500 profits estimates (Bloomberg) suggest earnings growth of 11 percent next year, and 12 percent in 2014; this may send the S&P 500 to record levels if earnings come in at or near expected.
Corporate America is lean and mean - think of great comapnies like Apple and Wells Fargo. We are also counting on help from the Federal Reserve, which is widely expected to start a third round of bond purchases to boost the economy.

With that said, the threats to the market remain (actually they never quite go away). Chief among them is the fiscal cliff. Under a law passed last year the failure of lawmakers to agree on some combination of spending cuts and tax increases would result in $1.2 trillion of automatic cuts and accompanying tax hikes in January 2013. That combination could shave 2.9 percent off economic activity in the first half of 2013, according to the Congressional Budget Office. While many economists believe the impact to be good for the economy long-term, in the short-term the market would likely hiccup, frankly creating a chance to buy on the dips.

Europe also remains a potent threat, Greece has yet to ratify the spending cuts necessary to receive life saving bailout funds and there is no guarantee that Spain, which is suffering through an economic depression, will agree to more austerity in exchange for the European Central Bank’s financial aid.

Individual investors could also decide to get with the program. While prudent managers have been suggesting to add equities to portfolios where appropriate, do it yourself investors have pulled money from U.S. equity mutual funds for a fifth straight year in 2011, moving $75 billion out of stocks this year alone. If these dollars come back to stocks it could raise stock prices even further – as individual investors usually buy high.

As always, talk things over with an accreditied investment manager or financial planner to see what proportion of high-quality equities make sense for you.

CBlakely CFP®, CTFA     Sept. 2012

Sources: Bloomberg LP.

401(k) Reform?

Defined contribution [DC] plans - 401(k)s, 403(b)s, 457s, much as they have grown to be dominant, have for many, been a failure. Recent statistics indicate 97 percent of Baby Boomers have not saved enough for retirement. Many, though not all people like the illusion of control, and seeing their balances — it makes the DC plan tangible, even if you don’t get what is really needed at retirement. Our cultural obsession with consumerism may keep us well dressed and living in nicely furnished homes, but it is quietly killing our financial future.



Retirement plan reform has to face three realities. First, people don’t know how much to put away for retirement. The general answer is, for almost all people, put away 15 percent of your gross pay. Next, most people don’t know how to invest, so should be handed off to advisors who will do it for you, being very mindful of costs. Finally, given that many people are poor investors or not interested in investing, offering a low cost annuity option at retirement makes sense as an option. Managing a lump sum on your own as you retire is not advisable for many. Annuitization currently is an option only for defined benefit [DB] plans.


Given the above changes and assuming heavy doses of mandatory participant education yield increased savings rates, this likely leads to much better results for plan participants. This is the sort of plan that would yield better results for most, given that DB plans are out of favor, and participant-directed DC plans lead to high expense/poor results. It may be time to consider a hybrid plan: A trustee-directed DC plan for accumulation and a DB plan for distribution.


In the meantime do yourself a favor and pay off credit cards every month. Put away 15 percent of every paycheck and take advantage of employer 401(k) matching plans. If you can, retain and use the services of an accredited financial planner to help you navigate the retirement investment landscape.


Christopher P. Blakely, CFP®, CTFA, CMFC 03/2012

Viewer Discretion is Advised!

2012 seems like it could be the year prognosticators of doom and end of days theorists will be in the spotlight. Full disclosure: – I have a 2012 Mayan calendar and the kitten pictures are just too cute. But seriously, there is one prognosticator in particular that actually does scare me. Not because I think it is true, nope, that’s not even a consideration. It’s that it is loaded with exaggeration using scaremonger tactics to frighten investors into actually buying into this baloney.

Dis-infomercial

I was watching TV and saw an ad for an online video with the following warning label: “The following presentation is controversial and may be offensive to some audiences. Viewer discretion is advised.” “OK,” I said “you got my attention.” The production values are pretty high and I thought it made sense to at least skim the thing before passing judgment. So I watched this video proclaim the end of America and the dollar as we know it. Interestingly, it carried the requisite language ‘may’ and ‘likely’ added to avoid absolutes. This keeps the investment regulators at bay but makes for strange narration with phrases like – “there is absolutely no doubt that this may happen.”

What the video contains is about 45 minutes of hyperbole followed by thirty minutes of a really cheesy sales pitch for investor newsletters authored by the team at Stansberry Investment Research. Really?

Back in 2007 this group was substantially fined by the SEC for securities fraud. Now they make an end of the America as we know it pitch using scare tactics and specious charts and graphs (why are they not properly sourced or labeled?) to goad people into buying their newsletter.

While we are all entitled to our opinion a person who acts in a fiduciary capacity is held to a higher standard. Fiduciary law, putting others interests in front of your own, may be the highest law in the land. And to treat it lightly is to breach that duty. While I have read forecasts that are indeed dire, none of the pieces close by trying to sell you a way to actually make money, while the economy and the dollar and our standard of living collapse around us.

To give one example, at one point during the video Mr. Stansberry talks about something called the 100% Strategy. He claims you can make money without ever having to own a stock. OK, sure, that’s true. Then he makes the statement that you might be forced to buy a stock at less than its current value if something goes wrong with the 100% Strategy. These two positions are so obviously at odds with one another. This is one of myriad examples of how crafty yet misleading this report is.

Fool me once…….

Successful investing is difficult enough with an advisor that is working with you in your best interests, it is nearly impossible otherwise. My advice is to avoid this wolf in wolf’s clothing.

Chris Blakely, CFP® 01/2012

The 14 Percent Solution

Bond Mavens United

Stock analyst Meredith Whitney grabbed headlines recently with her perilous prognostications for the U.S. Municipal bond market. Hundreds of billions in municipal defaults will plague the country over the near term is essentially what she has been saying to the media.

While I disagree with her headline grabbing prediction (as do most reasonable analysts), many purveyors of municipal debt have said the effect of this will be to move municipal rates up thereby creating a buying opportunity for tax-free income investors. It is true municipal rates have jumped over the last few months, but is this a buying opportunity? I don’t think so.

Currently, the major risk with municipal debt (corporate and government included) is not credit risk but interest rate risk. Yields have recently increased but are still deep in the pygmy range. That is what will eventually hurt you (your net worth specifically).

James Grant, a leading authority on interest rates and bond markets, along with Bill Gross from PIMCO and others have essentially been saying the same thing. Stargazers beware; a bear market in bonds is in the offing - a secular move from decreasing interest rates to an environment of sustained interest rate increases.

Central bankers have lowered the cost of money for 30 years now, following global disinflationary forces downward, but also allowing for increased leverage due to lower real interest rates. Today however, yields have less to do with disinflation and more to do with providing fuel for an asset-based economy. 10-year real interest rates fell from over 5 percent in the early 1980s to just less than 1 percent recently.

But the tide is at the turn. U.S. Government debt has experienced recent price declines (yield increases) as the European Central Bank said monetary policy has to be monitored, and if needed, corrected. China’s central bank raised reserve requirements for lenders for the second time this year to counter inflation and curb property-price gains. German producer prices are increasing at the fastest pace in more than two years.

Inflation will be a dominant theme as we look ahead, global inflationary forces will generally push rates higher around the world. A Morgan Stanley gauge of stocks such as Archer Daniels Midland Co. and Deere & Co. meant to rally when inflation expectations match Federal Reserve targets added 46 percent since August 2010, almost double the Standard & Poor’s 500 Index.  While emerging-market equities beat developed countries every year in the past decade, except in 2008, you should not count on that now as Brazil, Russia, India and China battle higher food and commodity inflation.So what is one to do? Confront the risk and reward tradeoff, look hard at alternative strategies. Shorten the average maturity (duration) of your fixed income investments. Look at alternatives, such as a high quality mortgage REIT like Annaly Mortgage (NLY). This company greatly weathered the great recession, ROE looks good and using measured leverage has kept the stock in a fairly tight range, all while paying a 15 percent dividend. Buy blue chip stocks that pay higher dividends. There are options to explore that can mitigate the deleterious effects of higher interest rates and inflation.

C Blakely CFP®, CTFA 02/2011

Sources: Grant’s Interest Rate Observer, PIMCO, Bloomberg LP

Where to Invest Now for the Next 30 Years (Give or Take)

The largest economies 2011:

U.S., China, Japan, Germany, France, UK

The largest economies 2041: (30 years from now)

China, U.S., India, Japan, Brazil, Russia

If you have a long-term investment perspective and think globally about asset allocation, it may be time to review where you are invested internationally. If you are considering international investing you may want to consider a deeper analysis of these up and comers. Growth generated by the large developing countries, particularly India, China, Brazil and Russia could become a much larger force in the world economy than it is now – much larger than many investors currently expect.

Goldman Sachs issued an optimistic research report on global economies in 2003 which illustrated how China’s economy would overtake Japan’s economy as early as 2016. Well, they were right, kind of, it did happen, it happened in 2010. Maybe Goldman wasn’t optimistic enough.

A lot can happen over 30 years and there is a good chance that the right conditions in one or another countries economy will not fall into place and any projection will not be realized. However, if the BRICs (Brazil, Russia, India, and China) pursue sound policies (I’m talking mostly to you Russia) these projections may indeed become a reality. Remember, fifty years ago Japan and Germany were struggling to emerge from reconstruction. Thirty years ago South Korea looked a lot like North Korea looks today.

The progress of the BRICs will be critical to how the world economy evolves; they could become a dominant force in generating spending growth over the next few decades.

As developing economies grow, they have the potential to post higher growth rates as they catch up with the developed world. China's economy during the past 30 years has changed from a centrally planned system that was largely closed to international trade to a more market-oriented economy that has a rapidly growing private sector and is a major player in the global economy, not to mention the green economy.

There is a well-known existing econometric model from Levine and Renelt (http://www.fordham.edu/economics/mcleod/LevineandRenelt1992.pdf) based on cross-country econometric research that explains average GDP growth over the next the next thirty years as a function of income per capita, investment rates, population growth and secondary school enrollments. This closely matches the Goldman projections (in parenthesis) which employ a very different technique. The results are as follows:

Brazil – 3.3 (3.7) Russia – 3.5 (3.9) India –5.3 (5.8) China -5.8 (5.6)

These numbers predict robust average growth for these countries over the next several decades. Higher growth may lead to higher returns and increased demand for capital in these markets.

What are the implications? Well, the weight of BRICs in investment portfolios could rise sharply. The movement of capital might move further in their favor and significant currency realignments would take place.

As we become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for many global companies like Coke and Caterpillar. Being involved in emerging markets is likely becoming an important strategic choice for many firms large and small.

Therefore, being invested in and involved in the right markets –particularly the right emerging markets may become an increasingly important strategic choice. While international investing does not reduce portfolio risk by a significant amount, it is measureable. And it does increase a portfolios expected return slightly and in the long run that’s what equity investors are looking for – whether stocks are 20 or 80 percent of the portfolio.

CP Blakely - CFP®, CTFA, CMFC 12/2010

Sources: CIA The World FactBook, Global Economics Paper Number 99 - Goldman Sachs, American Economic Review Vol.82 pp. 942-963

PIGS Headed Off to Slaughter

The largest financial crisis in history has spread from private to sovereign entities to paraphrase Nouriel Roubini, founder of Roubini Global Economics..Europe’s recovery will suffer and the falling euro will subtract from growth in its key trading partners. At its worst it conceivably precipitates a double-dip recession.

Now, governments everywhere are releveraging to socialize private losses and jump-start private demand. But public debt is ultimately a taxpayer’s burden. Governments subsist by taxing private income and wealth, eventually governments must deleverage too, or else public debt will explode, precipitating further, deeper public and private-sector crises.

This is already happening. Greece is first over the edge; Ireland, Portugal and Spain (yes, the acronym for these countries is pigs) trail close behind. Italy, while not yet illiquid, faces serious risks. Even France and Germany have rising deficits. UK budget cuts are starting. Eventually Japan and the US will have to cut too.

At home, recent data on employment, GDP and personal income highlight the complexity of information, which is sometimes contradictory and adds to the difficulty in making appropriate decisions. What the numbers suggest is that underlying demand in the economy remains subpar relative to the typical recovery. Therefore the rub is: there is a recovery (granted it’s a recovery only a statistician could love) but it remains disappointing relative to expectations and therefore disappointing relative to the financial markets - the Dow 30 recently fell from 11,200 in April to under 10,000 in early June.

This recovery is going to take more time to coalesce than those in the past. Job growth will remain disappointing compared to prior recoveries and therefore personal income and eventually consumption will be disappointing. Moreover, persistently high unemployment suggests the labor market is seeing lots more structural unemployment, which is a mismatch between the needs of employers and the skills and training of the labor force) compared to earlier recoveries. Slower growth is also associated with continued low inflation and steady interest rates. Yet, despite very low mortgage rates I don’t see a jump in housing starts any time soon. But given the current state of the Euro community and the headwinds facing us domestically, I continue to see a subpar recovery.

I’ve said it before and I’ll say it again. A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways. A portfolio defined today must play out in the uncertainty that is our future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Since the stock market is not going anywhere anytime soon why not take a look at the debt side of your balance sheet. With 15-year mortgage rates at about four percent it may be wise to compare the cash flows of your 30-year loan to with those of a 15-year mortgage at the current market average of four percent (don't forget to factor in points). Running my own mortgage comparison, I found it was a cash flow push, meaning I would pay the same monthly mortgage payment on the 15-year note as I am on my 30-year mortgage, with one huge exception: my mortgage would be paid off 84 months sooner. That means huge interest cost savings (sorry Mr. Banker).

Christopher Blakely 07/02/2010

Sources: Roubini Global Economics, Bloomberg LP.

Tim Geithner Should Resign......Unless

Financial reform seems to be going nowhere fast. Legislation has been proposed, but it is complicated and diffuse. Most of the proposed fixes are incremental changes that don’t seem likely to prevent future meltdowns or bubbles.

The House and Senate are squabbling over which federal agency should take the lead in supervising banks. The Secretary of the Treasury, as well as Congress, have fallen into the trap of trying to fix everything. Instead, they should agree on the most important remedies.

The banking crisis exposed several serious problems:

• Mortgage regulation was too lax and in some cases nonexistent.
• Capital requirements for banks were too low.
• Trading in derivatives such as credit default swaps posed giant, unseen risks.
• Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed.
• Bankers were moved to take on risk by excessive pay packages.
• The government’s response to the crash also created a big hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again. It’s time to end too big to fail by making it less palatable for banks to remain big.

The first of these problems, mortgages, has already been addressed by the Federal Reserve and other regulators. It is much harder today to get a "ninja" loan or a mortgage with no money down. Banking regulators should ensure that the reforms stick by adding a policy principle: mortgages should be approved only on the basis of a borrower’s ability to service the loan, not on the expectation that the loan will be refinanced.

There has also been a hint of progress on the second problem - capital requirements. The Group of 20 nations have agreed to raise standards for banks when the world economy recovers. The U.S. does not need to wait we should insist on higher standards now. Leverage is already down from pre-crash levels, so regulation would ensure that banks won’t return to their old, highly leveraged ways.

The Securities and Exchange Commission and bank regulators should update model-based approaches that set leverage ratios according to Monte Carlo-type formulas. These formulas focus on too narrow a range of probabilities wherein we know that the tails, while statistically small, are significant.

The proposed legislation attacks the third issue by requiring that some derivatives be traded on an exchange where, presumably, they would receive adult supervision. Critics are unhappy because many derivatives still could be traded in customized, private arrangements.

But the issue of where derivatives are traded is secondary. AIG got into trouble because it had to post tens of billions of dollars in extra collateral as its positions went way against them. Thus, the relevant question is the amount of collateral supporting each trade.

A regulatory expert from Harvard Business School, has suggested an ingenious solution. Exchanges should require traders to post significant collateral, and the SEC should mandate that, for derivatives traded off exchanges in private transactions or elsewhere, traders adhere to the highest collateral minimums set on the exchange.

Moody’s, Standard & Poor’s and Fitch Ratings fed the mortgage bubble with crazily permissive ratings on mortgage-backed securities. The ratings companies were paid by the Wall Street firms who put the deals together and needed the ratings to market their products.

Yes this is a conflict-ridden arrangement but I believe the ratings agencies did not understand what they were rating. Chuck Prince the previous CEO of Citibank had no idea or understanding of what his derivatives desk was doing - he just let them do it (it was good for his bonus!). Also, a money management firm asked me to review a retail CDO (collateralized debt obligation) in 2008 and at first blush it looked fine, a triple A rated, 7 percent government agency bond (in a 3 percent market, hmmm). After a deeper analysis I realized this was a Wizard of Oz offering - lots of smoke and mirrors. The ratings agencies need to continuously educate their analysts to stay abreast of the new new securities coming out of Wall Street.

Inflated compensation, is endemic to all industries, not just financial firms. But it encouraged excessive risk-taking, and thus high leverage, on Wall Street (and in Charlotte). The government is trying to restrain compensation in various ways, such as rulings from the pay czar and Fed guidelines for banks. They aren’t working -- witness the return of big bonuses on Wall Street. Moreover, the new fixes suffer from micro- management. I really don’t want bureaucrats sifting through paychecks.

A better fix would be to require shareholder approval for large pay packages, say $3 million and up. Many banks would pay just under the threshold to avoid a vote. Investment bankers might discover that life can be acceptable on $2,999,999 a year. And for those who get shareholders to approve greater swag, that’s capitalism at work.

Finally, when regulators bailed out Bear Stearns, Fannie Mae and Freddie Mac, they insisted they weren’t setting a precedent for future rescues. Fed Chairman Ben Bernanke said addressing the problem of too big to fail should be a "top priority." In a perfect world, all banks would be allowed to fail.

We know from recent experience they aren’t. Endowing them with a privileged position promotes reckless behavior. The government, instead, should make it undesirable for banks to be within the circle of protection. It could do this by charging big financial institutions larger insurance premiums and by further raising their capital standard. This would encourage them to shrink to a size where failure didn’t pose a threat to the U.S. economy.

As bad as the financial crisis was, we don’t need the government running Wall Street nor do we need new federal agencies. We need a few carefully chosen rules to reassert proper incentives and proper limits. So get on it Tim, your time is running out

C Blakely 11/2009 VGKDWNUGWKGK

Sources: Bloomberg LP, WSJ, Harvard Business Review

Important New IRA Rules

Starting January 1, 2010 the qualifying income limits that have prevented many individuals from converting a traditional IRA or employer-sponsored retirement plan to a Roth will be eliminated. The change is one of the most important on the IRA landscape in years. The question most frequently asked is, “should I convert my traditional IRA to a Roth IRA?”

There is no simple answer but there are several important considerations.
First there is the fact that there is little to no advantage to doing a Roth IRA conversion if you have to withdraw money to pay the resulting income tax from other retirement plan assets.

Moreover, conversion to a Roth IRA should be account balance neutral (see the table below for a sample illustration).

And yet there may be several reasons to consider conversion. At RKM we have the capacity to run the numbers to assist you in making the right choice.

+ When rates are going down the conversion likely makes no sense.
+ When interest rates are going up the conversion is more likely to make sense.
+ Conversions are likely better for the person who doesn’t need to live off the funds. There are no required distributions associated with a Roth IRA. With traditional IRAs, you must begin tapping your account after reaching age 70½. In doing so, you increase your taxable income starting in your 70’s.
+ Conversions are generally better for a person that has other funds to pay the taxes. Paying taxes with IRA assets defeats the purpose.
+ Conversions for a couple may make sense.
+ Conversions for a person with an estate tax issues will make more sense than for a person without. Your estate ends up with a higher percentage in tax-favorable retirement plans.
+ Conversions to leave a Roth IRA to grandchildren often have merit. Because Roth IRA owners are not subject to required minimum distribution rules the assets in the account continue to grow tax-free. And over a period of years this growth can be exponential. Although Roth beneficiaries are required to take distributions each year the withdrawals are tax-free. Making the Roth a great retirement asset for which to transfer the greatest amount of wealth.
+ Conversions for a person with net operating losses or other loss carry-forwards can make sense. In order to realize this favorable tax attribute there is the option of using a Roth IRA conversion to “offset” the loss or carry-forward.
+ Triggering large capital gains to pay the income tax on the Roth IRA conversion, one essentially loses tax deferral that might otherwise normally occur in a portfolio – this may make a conversion to costly.
+ A person who will need the money in retirement will need to withdraw less from a Roth IRA, because they won't need to cover the tax liability. This leaves more money in the account and leaving more in the account can be a great comfort during retirement and adding a tax-free account gives you the most flexibility to keep taxes low in retirement.

Who Qualifies?

Individuals whose modified adjusted gross income for 2009 is $120,000 or more can’t contribute. For couples who file joint tax returns, the cutoff is $176,000.You can’t convert traditional IRA assets to a Roth if your household’s modified adjusted gross income exceeds $100,000. A married person who files a separate tax return is prohibited from converting—no matter how what their income level. While the income limits for funding a Roth will remain, the rules for conversions are about to change.

As part of the Tax Increase Prevention and Reconciliation Act, the federal government is eliminating permanently, the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns. The changes also should allow more retirees—who rolled over their holdings from 401(k)’s and other workplace savings plans into IRAs—to convert to Roth IRA’s.

When you convert assets from a traditional IRA or workplace plan to a Roth, you have to pay income tax on all pretax contributions and earnings included in the amount you convert. However, you may either report the amount you convert in 2010 on your tax return for that year or spread the amount converted equally across your 2011 and 2012 tax returns, paying any resulting tax in those years. The two-year option is a one-time offer for 2010 conversions.

If you are age 70½ or older and taking required minimum distributions from a traditional IRA or workplace plan, you can convert remaining traditional IRA assets to a Roth.

If you hold traditional IRAs made up largely of pretax contributions, such as a 401(k) rollover, your tax bill could be steep. One way to mitigate the tax-bill pain is to get your tax advisor to help you figure out how much you could convert within your current tax bracket each year without bumping yourself into a higher one. Interestingly, the new rules come at a time when many IRAs have significantly declined in value, meaning the taxes on such conversions will likely be lower, as well. And with taxes expected to rise in coming years, the idea of an account that’s safe from tax increases may appeal to you.

If you expect your income to be lower in retirement—and tax rates to stay about where they are—then a Roth conversion might not make sense. Whether you convert or not basically depends on what you expect to happen with your income in retirement, compared with your income while working, and whether you’re more comfortable paying taxes sooner at current rates or betting on lower taxes later.

First Things First

First look at past tax returns you have in file boxes. You’re supposed to keep a running record of nondeductible IRA contributions on IRS Form 8606 and file it with your tax return. If you haven’t done so, you can either buy back your old tax returns from the IRS, using Form 4506, or you can order a free transcript of everything that’s reported about you to the IRS, using Form 4506-T. Included in your transcript is information from IRS Form 5498, which reports contributions you made to an IRA. Other resources are year-end statements from your IRA custodian.

Some owners of IRAs that hold variable annuities with depressed account values are planning to convert those investments to Roth IRAs as well. The current value of the underlying investments in their variable annuities has fallen below their income benefit or death benefit. In that situation, if you convert to a Roth, you’d pay tax on the lower account value—and potentially get a higher benefit in the future, tax-free.

Still, if you have a variable annuity and you’re considering a Roth conversion, make sure you value the account according to the latest IRS rules. The IRS ruled that you have to get the actual fair-market value of your account from the insurance company and use that number.

The Next Steps

Organize paperwork for any nondeductible IRA contributions you’ve made in the past. By taking that step, you should be able to come up with an estimate of how much of your potential conversion would be taxable. If you expect your 2010 income to be similar to 2009 you can look up the tax brackets at http://www.irs.gov/ to get an idea of the taxes to be paid.
It may help to consult a financial planner or tax advisor who has experience working with retirees relying on IRAs. The tax rules governing IRAs are convoluted and obtuse. A mistake may leave you with significant unintended consequences.

Chris Blakely, CTFA 08-09


Sources: The Wall Street Journal, IRS.gov, rothconversion.com

Out of the Frying Pan into the Other Frying Pan?

Recession Ending?

The pace of U.S. job losses slowed more than forecast last month and the unemployment rate dropped for the first time since April 2008, the clearest signs yet that the worst recession since the Great Depression is easing.
Payrolls fell by 247,000, after a 443,000 loss in June, the Labor Department said today in Washington. The jobless rate dropped to 9.4 percent from 9.5 percent.
The report stoked optimism for a recovery in the second half of 2009. While the Obama administration’s fiscal stimulus efforts are projected to have a significant impact on the economy, any rebound in hiring may be delayed as this recovery like the last may be labeled a jobless recovery. Unemployment is a lagging indicator.
We – as consumers - are by no means out of the woods, but we are moving in the right direction, many economists have revised forecasts to reflect moderate growth in the second half of 2009 and more of a pickup in 2010.
Even so, economists predict consumer spending, which accounts for 70 percent of the economy, will be slow to gain speed. Wages and salaries fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department data issued this week.

Tax Increases?

The current administration recently raised its estimate for this year’s federal deficit by 5 percent to a record $1.84 trillion as the recession reduces tax receipts and increases the costs of propping up the economy. U.S. consumer prices may rise from 2 to 4 percent in 2010, according to economists in a Bloomberg News survey, and may head higher from there.
On August 2, 2009, on ABC's This Week, Treasury Secretary Timothy Geithner refused to rule out middle class tax hikes in an interview with George Stephanopoulos. Following is some of the exchange from the show:
George: "I know you believe that passing health care is central for getting the deficit under control. But independent analysts say even with that you are going to need to find new government revenues. The former deputy Treasury Secretary Roger Altman said it is no longer a matter of whether tax revenues should increase but how. Is he right?"
Tim Geithner: "George, it is absolutely right and very important for everyone to understand we will not get this economy back on track, recovery will not be strong enough to sustain unless we can convince the American people that we're going to have the will to bring these deficits down once recovery is firmly established."
The U.S. Treasury expects the U.S. national debt to bump up against the debt ceiling of $12.1 trillion (yes that’s trillion with 15 zeros) in the final quarter of 2009. One way to bring down deficits is to raise taxes.

Monetary Policy as the Economy Recovers

From the Board of Governors of the Federal Reserve System Monetary Report to Congress (July 21, 2009):
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.

While the Fed has done a yeoman’s job averting depression it looks as if they have given short shrift to recovery plans. Specifically on dealing with the expected inflation that heavy economic stimulus brings.
We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation. Therefore, inflation-hedge securities should be in most investor’s portfolios when the economy begins to gain some traction. (Refer back to the beginning of this piece.)
A well diversified portfolio includes asset sub-classes such as agribusiness, managed timber, Treasury Inflation-Protected Securities, known as TIPS, commodities, energy and others. These mostly real assets have historically done well in inflationary environments.

CPB, August 2009

Sources: Bloomberg LP, the Board of Governors of the Federal Reserve

The New Normal

The New Normal

In a recent speech Bill Gross of PIMCO outlined what his firm has termed the "New Normal." In a world of more regulation, private-sector deleveraging and less consumption, "it's hard for PIMCO to imagine" the Dow Jones Industrial Average/quotes/comstock/10w!i:dji/delayed climbing back to 14,000 or home prices returning to 2006 levels, growth will be stunted," he said. "It will be a different type of world and we have to get used to that."

“The U.S. economy will grow at between 1 and 2 percent a year rather than 2 to 3 percent a year for the next three to five years at least, that will make a significant difference for corporate profit growth," he said. Moreover, unemployment will hover around 7 to 8 percent rather than the recently typical 4 to 5 percent, he added, and the higher rate would be around "for a long time to come." Gross added that inflation would also start to accelerate in the near future.

This “New Normal” economic climate prompts investment advisors to question many previously held assumptions -- especially about whether stocks will outperform bonds, and what this means for their portfolios. Data shows that over certain time cycles, bonds have outperformed stocks.
Many experts have been pointing out how great U.S. government bonds have done the past 30 years – which they have - but in our view at RKM it's nearly mathematically impossible for bonds to do that again, based on current yields. The future can't be like the past; in fact it might be a mirror image – that is a reversed image.

We are convinced that equities now are priced more attractively. Government bond yields coupled with the looming threat of inflation - the curse of fixed-income investors - as the government prints money to combat the financial crisis provides more ammunition for this case.

What about the Banks? Financial engineering had supplanted real engineering in cities like London and New York and whole economies (Iceland) became dominated by the fast growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10 percent in the early 1980’s to 40 percent in 2007! The stock market value of financial services firms increased from 6 percent in the early 1980’s to 23 percent in 2007! Why didn’t they see this crisis coming?

Relying on financial innovation has proved disastrous - think 80’s S&L crisis, 90’s international banking and LTCM crisis and the debacle we are still living. In “A Short History of Financial Euphoria,” economist John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." At this point we recommend avoiding bank stocks and bank sector mutual funds until the smoke clears.

What to do
Maintaining your wealth in the future will require strategies that reflect this changed vision of global economic growth. Bond investors should confine purchases to shorter maturities where price protection is more probable and as inflation increases, cash from maturing notes can be reinvested at higher rates. Investors may experience lower rates of return than what they grew accustomed to until 2008. Returns are the result of an economic environment.
In light of this “new normal” reality, investors should look for stable income from a portion of their investments, rather than reaching for returns. Short-term bond ladders and income paying stocks are two good examples.

Also, there is a chance that the dollar will lose its reserve status. The U.S. simply has too much debt. To be ready for that day, investors should invest outside the U.S., in faster growth economies. In particular, the BRIC countries - Brazil, Russia, India and China, for instance, consumption in China is 35 percent of GDP compared to nearly 70 percent in the U.S.- that shows huge growth potential.

PIMCO’s co-CIO’s Gross and El-Erian sum things up succinctly with the following half dozen sentences. “For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 [U.S., Japan and Europe] and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector.”

“The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.”

“In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth.”

If the above holds true and you are paying your advisor 2 or 3 percent in total fees your portfolio may suffer needlessly, therefore think about lowering your costs. As John Bogle was recently quoted saying, “A financial system that takes too much out of investor returns doesn't create additional value. We want to beat the market but will inevitably fail because of [transaction] costs, so I question our values and what is really enough.”


Chris Blakely, June 2009

Sources: PIMCO, Bloomberg LP, JK Galbraith, John Bogle, Morningstar, Marketwatch.com, NBER

Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”

Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.

Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”

Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)

Phantom Wealth v. Real Wealth

I recently heard a radio interview with David Korten, an author and engaged citizen, who spoke about two forms of wealth creation – phantom and real wealth. It really got me thinking.

Phantom wealth is basically money that is created out of nothing. And Wall Street was masterful at phantom wealth creation. Like pumping up financial bubbles, it was tech 8 years ago and of course, the whole mortgage debacle, which was based on the assumption that housing prices would only rise - like the stock market. And housing prices did rise, year over year, even though there was no change in the size of the home, its livability, its location or anything else. It was pure inflation. But it was treated as though inflating housing prices was actually creating real wealth. And it did create wealth right up until it did not anymore.

Real wealth is anything of real value or utility. It can be land, labor, education and ideas. And at the most basic level its healthy children and a strong family, it's a healthy environment, its capitalism when working.

Adam Smith praised in “Wealth of Nations” – a market that looks very much like a local farmers market: a place where small producers and consumers come together in a community to exchange goods and services. My firm advises clients more efficiently and competitively than the largest providers, yet it’s common to hear that bigger is better. Now what his writing has been used to justify is the consolidation and monopolization of economic power and, in fact, those who study Adam Smith's work in depth conclude that he actually wrote “Wealth of Nations” as a tirade against the concentration of corporate power.

What we need to face up to is that we are exceedingly consuming beyond what the planet can sustain. Now, we're often told that any change in our consumption level will require sacrifice – not exactly true. There are enormous opportunities to at once reduce our consumption and increase our quality of life. But it requires a reallocation of resources from those uses that are harmful, to a focus on meeting real needs and meeting the real needs of people. This requires our economy doing a 180 degree turn to focus on life needs rather than on increasing the financial assets of the already wealthy. Banks collapse our economy about every ten years (S&L crisis late 80’s, global banking crisis late 90’s and the current situation) which puts the whole economy into a condition of instability. We need banks terribly but let’s not abuse debt such that we all end up working for the banks in the end.

We need to redesign around a primary value on life, on the health of our families, the health of our communities and the health of our environment. But it requires local economic control, it requires local ownership, it requires the broadest possible participation in ownership (investing), and it means managing the economy for the long term. Now that means, using locally owned banks and local businesses when appropriate.

CBlakely 04-2009

Source: NPR interview with David Korten