The Triple Net Return

As we close out 2010 and begin a new year, many of us will be considering resolutions and goals. I would encourage all investors to commit to determining how much they are spending for investment management. How much are you paying your advisor? How much are the internal costs of the funds inside your portfolio? What is your tax rate for capital gains, dividends and interest?

Jason Zweig, a journalist for The Wall Street Journal, calls this the “net, net, net” return. Every investor should know this. I would suggest that investors who are paying more than 1%-1.5% in advisory fees and portfolio expenses are overpaying. My firm’s clients pay less than 1.00%.

Some investors might argue there is nothing we can do about taxes. So why pay much attention to them? Well, investors can actually do something about portfolio-related taxes. “Asset location” is the process of placing investments in the most tax efficient accounts within a clients’ portfolio. Investments that are inherently tax-inefficient, because they generate current income, should be placed inside tax-qualified accounts like IRAs, Roth IRAs and 401(k)s. Investments that are tax-efficient, because they create little current income can be placed in taxable accounts.

Many investment analysts suggest the next several decades will bring market returns that are significantly lower than they have been. If this occurs, managing fees, expenses and taxes will play a very important part in intelligent investing.

Happy New Year!

The Market Recovery

The Dow Jones Industrial Average closed at 11,573 today. The Dow is up 13.86% year to date.

How far we have come from March of 2009 when the Dow fell as low as 6,469. In less than two years, the Dow is now within a reasonable distance of the all-time high, 14,164, reached in October of 2007.

What would it take for the Dow to once again reach this high point? A 22% increase.

The lesson: Markets are cyclical. Intelligent Investors understand this and they have the courage to remain committed to their investment plan even during the darkest of markets.

Merry Christmas!

Market Beating Fund Managers

The debate about active vs. passive investment management will never end. This weekend‘s Wall Street Journal offers support for the active argument. In the article “The Return of the Market Beating Fund Manager” we learn that active stock fund managers may be able to beat the market with greater success than they have in the past.

The article suggests that active fund managers will benefit from a recent trend in which stocks are not as closely correlated as they have been recently. This should allow skilled managers to identify stocks which will outperform others.

In addition, there are some new tools which allow investors to find stock funds that will outperform their peers. “Active share” measures the percentage of fund assets that are invested differently from the fund’s benchmark. This could be helpful, because many large stock funds have become “closet index” funds which merely track their benchmark rather than attempt to beat it. A study by Antti Petajisto, a visiting assistant professor of finance at New York University’s Stern School of Business, found that one-third of U.S. stock funds essentially mimic their market benchmark. In contrast, the article argues, those funds with a high “active share” are more likely to beat the market. Professor Petajisto found that most active stock pickers beat their benchmark by 1.26 percent annually after fees.

I would very much like to review Professor Petajisto’s research. It is certainly not consistent with the data I have seen over the years on the success of active fund managers. Most fund managers underperform the market. There will always be some manager that beat the market. The problem is that we cannot know in advance who these managers will be. Furthermore, there is no way to know how long this market-beating performance will last.

Wouldn’t it be nice if we could identify the star fund managers in advance, stay in their funds until they lose their Midas touch and then jump out of their funds and into the next hot funds? Unfortunately, this is simply not possible.

The article also notes that actively managed U.S. stock funds have average expenses of 1.39% according to Morningstar, compared to 0.1% for inexpensive index funds. This is a big difference and active managers must beat it in order to outperform their benchmark. The reality is that very few of them do.

Sharpe Ratio

We know that investors “purchase” investment returns by parting ways with their money and accepting risk. The risk, of course, is that the money will not earn the return that was expected or, worse yet, that not of all of the money is even returned.

Investors are often concerned about returns. They want to know what the investment has returned in the past. They also want to know what the return is likely to return in the future. Unfortunately, while we usually know the former, the latter is unknown. Past performance is no guarantee of future results and future performance may be lower than past performance. We need to look no further than the market crash of 2007-2009 to see that markets can deliver terrible performance.

While investors should be concerned about performance, they should be even more concerned about risk-adjusted performance. The question is how much risk must an investor assume in order to receive the anticipated return. Given two similar investments that have identical returns, investors should select the investment with the lower risk. Alternatively, given two investments with identical risk, investors should select the investment with the highest return.

Nobel Laureate William F. Sharpe developed a formula to measure risk-adjusted returns. The Sharpe Ratio is calculated by subtracting the risk free rate from the rate of return for the investment (or a portfolio) and then dividing that result by the standard deviation of returns. The proxy for the risk free rate is Treasury Bills. We learned in an earlier post on my blog that standard deviation is a measure of risk.

We can compare investments using the Sharpe Ratio. The investment with the higher Sharpe Ratio is the preferred investment. We can also use the Sharpe ratio to simply evaluate performance in isolation. The higher the Sharpe Ratio, the better. A negative Sharpe Ratio suggests that a risk free investment would have performed better.

Intelligent Investors are very concerned about risk-adjusted returns.

Risk-Adjusted Returns

Over the past several weeks I reviewed several measures of return, risk and correlation. These tools allow the intelligent investor to evaluate securities and determine how they will perform relative to each other inside a portfolio.

Many retail investors do not appreciate the relationship between the return of an investment and the risk of that investment. If we were to ask investors rather generally about their investments, many would be able to tell us how they have performed in terms of rate of return. However, if we were to ask how much risk they accepted to achieve those returns, few investors would know.

Investing involves balancing the risk and return of investments. You might think of the process this way. When you invest you enter the marketplace with a bucket of risk. The marketplace consists of all kinds of investments offering various amounts of return and requiring the acceptance of proportional amounts of risk. If you are willing to accept no risk, your only option is securities issued and guaranteed by the United States government. You will not lose your money. However, the return you receive will be very low.

If you are willing to accept a very large amount of risk, you might invest in highly speculative hedge funds or private equity. These investments can return 20%, 40%, 50% or more. However, you could also lose some or all of your money.

The point is that investors should be aware of how much risk they are accepting when they deposit their money in an investment. The most attractive investments are those that have relatively high risk-adjusted returns.

Given the choice between two investments with the same expected, which are otherwise similar, the rational investor will place money in the security with a lower level of risk. Alternatively, if two investments have similar levels of risk, the rational investor will select the investment with the higher expected return.

Of course the amount of money you receive from your investments will also be a function of how much money you are willing to part with. The more you are willing to invest, the more you are likely to receive.

Correlation

Over the past few weeks we have discussed some of the key building blocks for the construction of a portfolio.

We identified standard deviation as a measure of risk or volatility. The higher the standard deviation of a security (or a portfolio of securities), the greater the risk.

We came up with several methods to measure risk. We can use the simple mean (or average), the time-weighted return (also known as geometric return), and the money-weighted return. When evaluating investment or fund managers, we use the time-weighted return, because it allows us to most appropriately evaluate performance in light of flows into and out of a portfolio or fund over an extended period of time during which performance may vary.

Last week I introduced Beta which is the measure of the risk of a security (or a portfolio of securities) in comparison to the market overall. We learned a common proxy for the market is the Standard & Poor’s 500 index. The convention in portfolio theory is that the market has a beta of 1. A security with a beta greater than 1 will have price movements that are greater than the market. A security with a beta less than the market will have price movements that are less than the market.

We’re still missing a critical piece of information. That is the way in which securities (or asset classes) perform in relation to each other. This is called “correlation.” We’re looking for securities that will provide diversification. If some of the securities in the portfolio are “zigging,” we want others to be “zagging.”

We can calculate this relationship between securities with correlation coefficient. The formula is a bit involved. So, I won’t post it here.

Correlation is measured from -1 to +1. Securities that have a correlation of -1 are perfectly negatively correlated. If one moves up by 10%, the other will move down by exactly 10%. Securities that have a correlation of +1 are perfectly positively correlated. If one moves up by 10%, the other moves up by exactly 10%. Securities that have a correlation of 0 have no relationship with each other.

In reality most securities are positively correlated with each other. Intelligent Investors are interested in building a portfolio that will be well-allocated across asset classes. The less correlated the asset classes in the portfolio the lower the risk. You can Google “asset class correlation” and find all kinds of data on asset class correlation.

I’ll have more to say about correlation in future posts.

Beta

Back to the classroom. In the past two weeks I have written about how to measure risk and return. We learned that we use standard deviation to measure the risk of a security. There are several methods to measure return, including the simple mean, the time-weighted return (also known as geometric return), and the money-weighted return.

So, now the question is, how do we combine securities in a portfolio? Can we simply add securities until we reach some reasonable number? Maybe 30 or 40?

Actually, what we really need to know is how securities act in the marketplace. How do they perform relative the market itself? We might consider the Standard & Poor’s 500 index as a proxy for the market.

We can readily find data for the return of the S&P 500 index. What about the risk of the market? The Capital Asset Pricing Model describes risk with the term Beta. Beta is a measure of volatility of a security. The market itself is assigned a beta of 1. The beta for any security can be calculated through regression analysis. Beta tells us how much the price of a given security will move relative to the market.

If a security has a beta of 1.0, its price movements will mirror the market. A security with a beta greater than 1.0 will be more volatile or risky than the market. A security with a beta less than 1.0 will be less risky than the market. If a security has a beta of 1.5, it will be 50% more risky than the market. A security with a bet of 0.75 will be 25% less risky than the market. What about a beta of zero? This means that there is no statistical relationship between the security and the market. A negative beta indicates that the security acts in opposition to the market. If the market return were up 10%, a security with a beta of -1.0 would theoretically be down by 10%.

So, does that give us enough information to start building our portfolio? No. Come back next week for another critical piece of this puzzle.

Measuring Return

Let’s continue our discussion of Modern Portfolio Theory. Last week I suggested that portfolio construction involves carefully selecting securities based on their risk and return characteristics.

I probably should have mentioned that return can be calculated in various ways. The simplest is the mean or average. To calculate this return we simply add up all the returns and divide by the total numbers of return in the data set. If we had annual returns from 2000-2004 of -9.1%, -11.9%, -22.1%, 28.7% and 10.9%, the average return would be -0.70%. This was the actual return of the Standard & Poor’s 500 index.

When evaluating investment advisors, fund managers or portfolio managers, there is a different measure that gives us better insight into performance. Time-weighted return eliminates the distortions caused by the inflows and outflows of money over time. This is also called the geometric mean. It is calculated using holding period returns (HPR) for each investment period (e.g. a year) and linking them together.

The formula for holding period return is (ending value - beginning value + dividends/interest +/- other cash flow) divided by the beginning value.

To calculate time-weighted returns we add 1 to each of these HPRs, multiply these values against each other then subtract 1 from that result.

Here’s the formula

= [(1 + HPR1)*(1 + HPR2)*(1 + HPR3) ... *(1 + HPRN)] - 1.

If the investment period is greater than 1 year, then we need to annualize the return for the HPRs we calculated. The formula for this is (1 + compounded rate)1/Y – 1 where Y is the total time of years.

Yet another way to measure performance is money-weighted return. This involves calculating the internal rate of return. We calculate the return that will cause the inflows and outflows to be equal. For investment outflows include the purchase price, reinvested dividends or interest and contributions. Inflows include the proceeds from the sale of the investment, dividends or interest received and withdrawals. Calculating money-weighted return requires using Microsoft Excel or a financial calculator. We use the money weighted return instead of holding period return for investment periods that are greater than 1 year.

Source for formulas: Investopedia

Standard Deviation

I will be teaching the Investment course in the CFP certificate program at the University of Portland over the next several weeks. The course provides an overview of investing fundamentals. I encourage students to think of the class as a fast paced review of many concepts. We run through them quickly and rarely go very deep into any subject.

One area that merits a bit more attention is Modern Portfolio Theory. Most investment advisors rely on MPT to build and manage portfolios. The theory involves attempting to manage the relationship between risk and return in a basket of securities. Using various research sources (e.g. Morningstar) we can identify the risk and return characteristics of a given security. MPT tells us we should combine securities in a way that maximizes the risk adjusted return of the portfolio.

How do we measure risk? First, we need to define risk. This is the chance that the return from the security will not be what we expected. We are, of course, concerned with returns that fall below our expectation. We’re happy if returns exceed our expectations.

We can measure risk using Standard Deviation. This measures the dispersion of historical returns from its mean (i.e. average). We take the square root of the variance to calculate standard deviation.

If a security earned 8% year after year, there would be no dispersion and, therefore, no risk. The mean would be 8% and the standard deviation would be 0.

But if the security earned -12% one year, +16% the next and +20% the following year, the mean would still be 8%. But the dispersion (and the risk) would be much greater. In fact, the standard deviation for that security is 17. Which would you rather own?

Intelligent Investors understand MPT and they use it wisely to build and manage their portfolios. I will be discussing other concepts that underlie MPT in future posts.

What are Emerging Markets?

You have probably heard of emerging markets. But do you know what they are?

These are economies in nations that are rapidly growing and maturing. They are characterized by stable governments, established mechanisms for trading goods and services, a stable currency, controlled levels of inflation, and liquid securities markets. They are typically in a state of growth. Many will eventually become “developed” countries.

As of May 2010, Dow Jones classified the following 35 countries as emerging markets:

Argentina
Bahrain
Brazil
Bulgaria
Chile
China
Colombia
Czech Republic
Egypt
Estonia
Hungary
India
Indonesia
Jordan
Kuwait
Latvia
Lithuania
Malaysia
Mauritius
Mexico
Morocco
Oman
Pakistan
Peru
Philippines
Poland
Qatar
Romania
Russia
Slovakia
South Africa
Sri Lanka
Thailand
Turkey
United Arab Emirates

Why should investors care about these countries? Because investing in these countries offers the potential for relatively rapid capital appreciation. The companies in these countries are likely to grow at a faster rate than companies in developed markets like the US, Canada, Japan, and Western Europe.

In addition, investments in these countries are likely to have a relatively lower correlation with developed markets. This means that the values of investments in these countries will not move in lock-step with investments in developed markets.

Emerging markets belong in a low-cost, passively managed portfolio.

What are Emerging Markets?

You have probably heard of emerging markets. But do you know what they are?

These are economies in nations that are rapidly growing and maturing. They are characterized by stable governments, established mechanisms for trading goods and services, a stable currency, controlled levels of inflation, and liquid securities markets. They are typically in a state of growth. Many will eventually become “developed” countries.

As of May 2010, Dow Jones classified 35 countries as emerging markets.



Why should investors care about these countries? Because investing in these countries offers the potential for relatively rapid capital appreciation. The companies in these countries are likely to grow at a faster rate than companies in developed markets like the US, Canada, Japan, and Western Europe.

In addition, investments in these countries are likely to have a relatively lower correlation than with those in developed markets. This means that the values of these investments in these countries will not move in lock-step with investments in developed markets.

Emerging Market Bonds?

There has been a significant flow of capital into emerging market equities over the past several months. Some of this is “hot money” chasing what speculators consider as the next asset class to provide outsized short term profits. But some of this investment flow is coming from long term investors looking for diversification, income and long term capital gains.

So, what about emerging market bonds? Do they belong in a well-diversified, low cost, passive portfolio? Perhaps. These debt instruments may offer income that is less correlated to the bond markets in the developed markets. However, according to Morningstar, this asset class carries with it risk from currency fluctuations, foreign taxation, economic risk, political risk and differences in accounting and financial standards.

Right now there few ways to invest passively in emerging market debt. However, this will undoubtedly change. One option is the iShares JPMorgan Emerging Market Bond Fund (EMB). http://us.ishares.com/product_info/fund/overview/EMB.htm

I’ll have more to offer on this asset class when research companies (e.g. Morningstar) provide information about the investment characteristics of the funds in this asset class. What is correlation? What are fund expenses? What is the risk? What are the returns?

The Fiduciary Standard

The Financial Planning Association (FPA) ran a two full page advertisement in The Wall Street Journal on Tuesday (October 12, 2010). It promoted the value of working with a financial planner who is a member of the FPA. One of the reasons cited is that members are required to adhere to a Fiduciary Standard of Care.

The section included several questions and answers. One of the questions addressed the fiduciary issue. It states, “A financial planner who upholds a fiduciary standard of care makes five promises to clients. They are required by law to (1) put your best interests above all, (2) act with due care and utmost good faith, (3) be transparent an disclose all facts, including the cost of services and recommended investment and insurance products, (4) avoid conflicts of interest, and (5) not mislead you.”

Smart consumers only work with financial planners who adhere to this standard. Unfortunately, it is not readily apparent to the consumer who does and who does not. So, I recommend simply asking.

Yale Endowment Falters

Yet another large university endowment has indicated that it suffered significant losses during the recent economic storm. An article in The Wall Street Journal (September 25/26, 2010) indicates Yale’s endowment fell from $22.9 billion in June 2008 to $16.3 billion in June 2009. It has since recovered to $16.7 billion as of June of 2010.

The endowment earned 8.9% for the 12 months ending June 30, 2010. According to Wilshire Associates, this lagged the 13.33% median return for large endowments, pension funds, and foundations. The Dow Jones Industrial Average returned 18.9% for the same period.

The results at Yale are particularly interesting. I am a big fan of David Swensen who is the Chief Investment Officer at Yale. I’ve read Swensen’s book, Unconventional Success which advocates a passive investment strategy for individual investors. Swensen believes only large institutions with significant resources for in depth analysis and research should invest in areas such as private equity, real estate and hedge funds. As it turns out, these are the areas where Yale incurred its big losses.

The lesson for the individual investor is that a low cost, passive approach to investing will result in optimum long term results.

Is Gold an Inflation Hedge?

Gold reached yet another record high yesterday, closing at $1,290.20 an ounce on the Comex division of the New York Mercantile Exchange.

The Federal Reserve recently indicated that it stands prepared to provide greater support to the U.S. economy. The financial markets translated this into additional purchases of US government securities, greater liquidity, a weaker U.S. dollar and the specter of inflation.

Let’s continue to explore gold. Is gold an inflation hedge?

If we consider the 35 year period, 1975-2010, inflation averaged 4.03% according to the Bureau of Labor and Statistics. But this really does not tell the story. If we look above at the price of gold, we see that it was flat or declining for about 20 years. Inflation was hardly non-existent during this period. Do you remember interest rates in the late 70s and early 80s?

The following chart shows the relationship between inflation and the price of gold over the past decade.


We have been in a period of very low inflation. However, gold has experienced a rather noticeable run up. So, at least over the past decade, the notion that gold is a hedge against inflation does not seem to be supported by the data. Particularly in the past decade and currently, gold seems to be acting largely independent of inflation.

Today the concern is rather equally balanced between inflation and deflation. There is little evidence that gold serves as a hedge for either.

Harvard doesn’t Beat the Market

The Wall Street Journal recently (September 10, 2010) reported that Harvard University’s endowment fund posted a return of 11% for the 12 month period ending June 30, 2010. Harvard’s endowment, at $27.4 billion, is the largest college endowment.

Harvard manages the endowment internally through the Harvard Management company. The team managing the endowment is prominent in the endowment community for its positions in real estate, private equity and venture capital.

The median return for large endowments for the period was 12.3% according to Wilshire Associates. The Dow Jones Industrial Average returned 18.9% in this period. A portfolio of 60% stocks and 40% bonds would have outperformed Harvard’s endowment with a return of 12.6%.

I would add that the 60-40 portfolio would have undoubtedly taken on much less risk.

This is yet another piece of evidence that suggests that attempts to beat the market are fraught with risk. In addition they are burdened with significant expenses. The Harvard Management Company provides compensation that is comparable to that of the leading Wall Street money management firms.

The most intelligent way for individual investors to manage their portfolios is through low-cost, passive investments.

Gold Hits New High

Concerns about the stability of European banks drove gold to a new all-time high on Tuesday, September 7, 2010. The Wall Street Journal ran an article on Tuesday suggesting that the stress tests for European banks may have understated their exposure to government debt. The fear is that some European nations may yet default on some of their obligations. Gold closed at $1,257.30 an ounce.

So, is it time invest in gold?

Investors are rewarded for investing in gold only if they can find someone else who is willing to pay more for it than they did. This is not a problem as long as the price of gold is going up as it has been for the past several years. But when the price of gold is going down or moving sideways, investors who hold gold may not be able to sell it without incurring a loss.

This naturally leads to the history of the price of gold. Has the price of gold risen in a manner that has made gold an attractive investment?

The world went off the gold standard in the early 1970s. Previously the price of gold was controlled by the world’s largest central banks under the terms of the Bretton Woods system which was negotiated after World War II. So, we’ll focus our attention on the period that followed.

In 1975, 35 years ago, gold was priced at an average of $161 an ounce. Today gold is trading at roughly $1,250 an ounce. This is a growth rate of 6.0%.


Source: http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx

However, notice the price of gold actually drifted lower for the better part of this 35 year period. How would you have felt had you purchased gold in the late 70s or early 80s?

To put this in some perspective, the Standard and Poor’s 500 Index returned 11.7% from 1975 to 2009. (Source: Standard & Poor’s Index Services Group)

Based on this data alone, gold does not appear to be a particularly attractive investment.

Ibbotson on Investing

The current issue of Money (September 2010) includes an interview with Roger Ibbotson (pp. 105-108). Ibbotson Associates publishes the Ibbotson SBBI Classic Yearbook which analyzes historical data for stocks, bonds, Treasury bills, and inflation. It is commonly the reference for the historical returns quoted in the financial press.

Ibbotson is a professor of finance at the Yale School of Management. He is the founder and former Chairman of Ibbotson Associates, a financial research and information firm that was acquired by Morningstar in 2006. He is also the founder, Chairman, and Chief Investment Officer for Zebra Capital, a hedge fund.

In the article, Ibbotson was asked about investing in index funds vs. actively managed funds. Here’s his response:

“To the extent you’re in index funds, you’re going to have less risk because you’re eliminating the impact of active management. You’ll also have lower fees. In actively managed funds, your risk level goes up, as will hat you pay in fees. The question is, do you think the funds you pick can compensate for the extra risk and higher fees? On average, the answer is no, but there can be a subset of investors who outperform.”

I would add there will always be some investors who choose actively managed funds and outperform the market. The issue is how long they are able to do this. Few will be able to do it consistently year after year. The question you have to ask yourself is whether you can be among them.

If you are not confident about beating the market, after expenses, then you are better off in a low-cost, passively managed portfolio. You will not beat the market. You will earn the returns of a broadly diversified portfolio. Your investing expenses will be a fraction of the typical actively managed fund.

If you review Dalbar’s research on investor performance results, you’ll find that if you achieve “average” results, you’ll be doing much better than the vast majority of investors, including large institutional managers.

Gold as an Investment

I just finished writing an article on gold. You can find it on the CWM web site. I have been thinking about gold for several years. None of the CWM portfolios contain gold. Frankly, I have never considered it a serious asset class.

But, in light of ongoing market turmoil, I decided I needed to take a good hard look at gold. Is it truly an attractive investment? What are the benefits of investing in gold? What are the detriments? What are the returns relative to the risks? Does it belong in a low-cost, passive portfolio?
Here’s an excerpt from the article:

People have invested in gold for literally thousands of years. From what does gold derive its value?

Gold is valued because of its physical properties (an attractive yellow metal with a relatively high density) and its scarcity compared to many other physical objects. People have long considered gold precious and it is this quality that gives gold its value.

It is interesting to note that unlike many other conventional investments, gold produces no income for those who hold it. Many investments are valued based on the income they create. Examples include stock dividends, bond coupons, rental property income, etc. We can readily value these investments by determining how much income they are likely to produce and when it will be received.

Investments that do not generate income are more difficult to value, because the valuation process is far more subjective. These investments are worth whatever someone will pay for them. Think of art, antiques, stamps, baseball cards and other collectibles. These items are perceived by their collectors as valuable because of their uniqueness. A non-collector may well find no value in these items.

Gold is worth whatever the market determines. But understanding the basis for the value of gold is alchemy by itself.

Selecting Passive Investments

Some of the largest hedge funds on the planet have been pouring investor funds into gold-related assets over the past year or so. The managers running these funds, including John Paulson, Eric Mindich, George Soros and David Einhorn, are among the shrewdest actors in the global marketplace.

If you are an astute investor, you might naturally consider whether you should place some portion of your portfolio in gold. Unfortunately, the hype surrounding gold is so overwhelming it is very difficult to separate fact from fiction. Nonetheless, it is worthwhile to wade into the sea of information about investing in gold to determine whether it belongs in a portfolio.

I sit on a small investment policy committee with two other advisors who also run their own firms. We get together quarterly to review our existing model portfolios, evaluate the individual asset classes currently held in these portfolios and consider new investments for inclusion in these portfolios.

We do not often make changes to the composition of our portfolios. While there are new investments entering the market daily (literally), we consider most of these to be introduced by the marketing and sales departments of large financial institutions. We’re pretty well convinced that Wall Street has the game set up to entice individual investors through glossy marketing brochures, fancy power point presentations and seductive conference calls to buy expensive products that are destined to underperform the market.

We are interested in those investment opportunities that satisfy criteria we believe are consistent with the fundamentals of low-cost, passive investment management. Many bright, highly-educated professionals are constantly researching and studying the elements that drive investment performance. So, we are certainly not alone in this process. But we do take a rather narrow approach to this process, because of our belief that markets are generally efficient and it is not possible to earn excess returns over long periods of time.

Here are 10 questions we ask about every investment we consider:

1. Does the investment represent an opportunity to invest in a new asset class? An asset class is a group of investments that share basic characteristics, perform similarly in the market and are subject to the same laws and regulations. The application of this definition can be somewhat subjective. Is frontier investing a new asset class? Yes, we think it is. Is “clean tech” a new asset class? So far, I am not convinced. We currently track some 15+ asset classes.
2. What does this investment bring to our portfolios? Does it provide income? Does it provide growth? Is it an inflation hedge?
3. How do we invest in this investment? If we cannot access the investment through a no load mutual fund or an exchange traded fund, we’re probably not interested. These vehicles provide diversification, professional management, and low cost of entry.
4. What is the return history of this investment? Naturally, we’re interested in investments that provide a healthy return for our clients.
5. How much risk must investors accept to receive the returns this investment provides? Investors accept risk in order to earn returns. We’re keenly interested in the risk-adjusted returns an investment offers.
6. What is the correlation of this investment with other investments in our model portfolios? Correlation refers to the relationship between assets. We like investments that do not act the same way. We can achieve diversification and reduce the risk of portfolio declines. Investments that are closely correlated with each other are less attractive, because they all tend to move in the same direction. When the stock market crashed in 2009-2009, we saw that most asset classes went down in tandem.
7. What does it cost to invest in this investment? What are the trading costs (commissions bid-ask spreads)? What are the internal costs inside the vehicle? We like investments that have very low trading costs. We prefer investments that have internal costs that are less than 0.25%.
8. How liquid is this investment? If we are to use a fund to invest in this investment, are there a large number of shares actively traded at all times? If we need to sell, can we get out quickly?
9. What are the tax characteristics of this investment? Does it generate income (i.e. dividends) that receives favorable tax treatment? Does the asset instead grow over time and avoid taxation until it is sold? Would we put this investment in a taxable portfolio or in a tax-qualified portfolio?
10. Finally, can we invest in this investment in a passive manner? Is there an index that tracks this investment? Are there passively managed funds that offer access to this investment? If only active funds invest in this idea, we’ll pass.

Selecting Passive Investments

Some of the largest hedge funds on the planet have been pouring investor funds into gold-related assets over the past year or so. The managers running these funds, including John Paulson, Eric Mindich, George Soros and David Einhorn, are among the shrewdest actors in the global marketplace.

If you are an astute investor, you might naturally consider whether you should place some portion of your portfolio in gold. Unfortunately, the hype surrounding gold is so overwhelming it is very difficult to separate fact from fiction. Nonetheless, it is worthwhile to wade into the sea of information about investing in gold to determine whether it belongs in a portfolio.

I sit on a small investment policy committee with two other advisors who also run their own firms. We get together quarterly to review our existing model portfolios, evaluate the individual asset classes currently held in these portfolios and consider new investments for inclusion in these portfolios.

We do not often make changes to the composition of our portfolios. While there are new investments entering the market daily (literally), we consider most of these to be introduced by the marketing and sales departments of large financial institutions. We’re pretty well convinced that Wall Street has the game set up to entice individual investors through glossy marketing brochures, fancy power point presentations and seductive conference calls to buy expensive products that are destined to underperform the market.

We are interested in those investment opportunities that satisfy criteria we believe are consistent with the fundamentals of low-cost, passive investment management. Many bright, highly-educated professionals are constantly researching and studying the elements that drive investment performance. So, we are certainly not alone in this process. But we do take a rather narrow approach to this process, because of our belief that markets are generally efficient and it is not possible to earn excess returns over long periods of time.

Here are 10 questions we ask about every investment we consider :

Morningstar: Fees Best Predictor of Fund Success

In case there was any doubt, Morningstar has settled the debate about the best predictor of a mutual fund’s future success. Perhaps you thought the funds with the most stars from Morningstar would shine brightest. Alas, this is not the case.

Morningstar’s research indicates the lower a fund’s fees, the better its performance. The findings were outlined in an article in The Wall Street Journal on August 9, 2010, “Low Fees Outshine Fund Star System.” This information should further motivate investors who are looking for ways to pick up the pieces from the recent stock market swoon.

Why do funds with lower fees perform better over time? Because funds that charge less leave more for their shareholders.

We know that actively managed funds charge more than passively managed funds. We also know that most of them underperform the market.

So, intelligent investors buy low cost, passively managed funds. As a result, they end up with more in their coffers

Comment on the SEC Study on Fiduciary Issue

I have mentioned that the financial reform bill that was signed into law last month includes language authorizing the U.S. Securities and Exchange Commission to conduct a study of the current standards of care that exist in the financial services industry for the delivery of financial and investment advice. Further, once the study has been concluded, the SEC has been authorized to impose a new standard.

If you wish to comment on this very important matter, you may visit the SEC at this location:

The National Association of Personal Financial Advisors, of which I am a member, has offered the following guidance:

(1) The bona fide fiduciary standard of conduct should apply to all those who provide investment advice to retail investors, without exception;

(2) No "hat switching" should be permitted - i.e., once a person is in a relationship of trust and confidence with his or her client, the fiduciary obligations of the advisor extend to the entire relationship. A client's trust would be subsumed by any attempt of the advisor to switch to a non-fiduciary (arms-length) product sales relationship.

(3) No denigration of the fiduciary standard of conduct currently existing under the Investment Advisers Act of 1940 should occur through the adoption of "particular exceptions" - the SEC should maintain the fiduciary standard of conduct as the "highest standard under the law."

(4) Restoring the trust of individual Americans in our financial system begins with individual Americans trusting in the individual advisor across the table from them. All the other reforms seen recently will fail to protect Americans if, at the final point of advice provided to individual Americans, the advisor fails to adopt the client's interest as his or her own.

(5) Americans need and desire truly objective, expert advice. The provision of such advice, in today's complex financial world, is essential for the future retirement security of hundreds of millions of Americans. Moreover, should Americans fail to receive objective advice, this will result in less capital formation, less private savings, and increased strain on federal and state government resources - precisely when governments are strained with their own fiscal difficulties.

I encourage you to make your voice heard on this issue.

The New Normal

Bill Gross manages more money than anyone on the planet, with the exception of a few (but not many) central banks. He is the co-chief investment officer of PIMCO which is located in Newport Beach, CA. Gross and his team manage over $1 trillion. PIMCO is known for its bond funds. But it has recently begun to develop equity funds.

Gross is one of the most respected voices in the investment community. He is frequently interviewed by major newspapers, network television and cable news programs. If you search for him on the web, you will receive thousands of pages.

CNN Money recently asked Gross about the “New Normal.” While I have heard and seen this term frequently since the recession began, Bill Gross was may have coined the term. He uses it to describe a prolonged period of deleveraging, reregulation and de-globalization. The New Normal will result in slower economic growth and lower inflation in developing countries.

The implications of Gross’ New Normal for investors are rather sobering. He anticipates equity returns will be around 5% instead of the historical 10%. For bonds returns will be around 4%.

Think about this. If Gross is right and if you have a portfolio that is comprised of 50% equities and 50% bonds, your weighted expected return will be 4.5%. If you pay taxes at the rate of 30% on this return, your after-tax return will be 3.15%. If inflation runs at say 3% (below the historical rate of 4%), then your inflation adjusted, after tax return will be just about zero! (Actually, it’s 0.15%)

Now, what can investors do to improve their returns? They can practice low-cost passive investment strategies. Investors who have actively managed portfolios can cut 0.50%-1.00% of expenses out of their portfolios by shifting to funds (mutual funds and exchange traded funds) that have lower internal expenses than actively managed mutual funds. They can save more by working with an investment advisor who charges less than the going rate of 1%.

Cascade Wealth charges 0.75%. Our portfolios have internal expenses of around 0.25%. So, all in, most of our clients pay about 1%. Investors with firms that actively manage their portfolios routinely pay 1.00% in advisory fees and another 0.75%-1.00% in internal fund expenses. In total these investor are often paying 1.75%-2.00%.

Do the math. If you have a $1 million portfolio, you can save $7,500-$10,000 by working with an advisor who practices low-cost passive investment management. You take no additional risk. You simply pick up another 0.75%-1.00% in net return by being an intelligent investor.

DIY Investing – 4 Questions

I am often asked by prospective clients why they should work with an investment advisor. This question usually comes up after I have explained the differences between active and passive investing and why Cascade Wealth uses only passive investment strategies. At this point, most people are convinced that they should have a passive portfolio. It seems pretty simple. The goal is to capture the returns of the market and minimize expenses. There is no active management. No effort to beat the market. No trying to pick the next hot mutual fund. Just build a portfolio using low cost index and passive funds and keep an eye on it. … So, why would anyone want to pay an advisor for this?

I respond to this question by asking four questions. I tell these people that if they can answer “yes” to each question, then they probably don’t need an investment advisor.

1. Are you capable of learning how to passively manage your own investments? This requires understanding basic investing principles. It also involves learning a bit about Modern Portfolio Theory. The concepts are not extremely difficult to grasp. But becoming knowledgeable and competent takes some capacity for math.

2. Do you have the time to learn how to build your own portfolio? Do you have the time to monitor it and adjust it when necessary? The initial construction of the portfolio is important to the ultimate success of the portfolio over time. You really need to get that right. But you also need to monitor the portfolio over time. Passive investing is not neglectful investing. Also, will you systematically rebalance the portfolio when appropriate?

3. Will you enjoy managing your investments? We tend to avoid the things we do not enjoy. So, if you are not interested in managing our investments, you will probably not put in the effort that it requires. On the other hand, I do get concerned about those who are a bit too enthusiastic about managing their investments. They are prone to tinkering with things when it is not necessary.

4. Can you manage your emotions and make rational decisions about your investment regardless of what is happening in your personal life and in the world around you? This is the most important question. I meet many people who are able to answer the first three questions in the affirmative. But when they ponder their past experiences with investing, they realize they have not been able to keep their emotions out of the process. I believe a good investment advisor adds the value to client relationships by helping them manage the emotions we all feel towards investing.

Those who can check all four boxes probably can manage their own accounts and experience satisfying long term results.

A Convicted Criminal Speaks of Ethics

I just attended the local chapter meeting for the Financial Planning Association. I do not often attend these meetings. But this luncheon offered 3 hours of Ethics credits which I need to maintain my professional credentials.

Over the years I have found most of these ethics-related sessions rather tedious. It has long amazed me that financial services representatives do such stupid things and cause such harm to their clients. While I acknowledge my own professional failings, I have never engaged in fraud, cheating, embezzlement, etc.

The speaker today was Patrick Kuhse. You have probably never heard of him. I had not until today. I won’t forget him.

Here’s what Patrick says about himself on his web site, www.speakingofethics.com, “I'd like to take you on my own personal journey, from successful stockbroker with a loving family and home in the suburbs of San Diego, to the jungles of Costa Rica as an international fugitive, to incarceration in two countries and back again. After spending four years in prison, I now devote myself to speaking to audiences worldwide about the importance of ethical behavior.”

This presentation was riveting. It had a message that was far more than how to be “ethical” in the financial services industry. It was about how any of us can lose perspective, commit critical thinking errors and slide into an ethical morass. I found it humbling.

Patrick opened his presentation with a reference to Socrates. The famous Greek philosopher would evaluate an issue, an opportunity or a situation by asking three simple questions:

1. Is this truthful?
2. Is this good?
3. Is this useful?

If Socrates could not answer each of these questions positively, he would simply move on.

How simple. We should ask ourselves these questions whenever we are uncertain about how to react to a set of circumstances.

Successful DIY Investors

I recently read William Bernstein’s The Investor’s Manifesto. He wrote this in the aftermath of the recent stock market crash. Bernstein seeks to help investors regroup and reminds them of the strategies that lead to long term investing success.

In the foreword to the book, Bernstein identifies the characteristics of successful investors:

1. They possess an interest in the process of investing.
2. They have a basic knowledge of probability and statistics.
3. They have a firm grasp of financial history.
4. They have the emotional discipline to execute successful investing strategies.

How many self-directed investors truly possess these qualities? Indeed, how many investment advisors can make this claim?

The Responsibility of the Media

An article from The New York Times News service ran in yesterday’s (July 6, 2010) Oregonian. The article was titled, “Get out now, stock theorist warns.” The article described how one stock market forecaster, Robert Prechter, is predicting that the Dow “is likely to fall below 1,000 over perhaps five or six years …”

Apparently, Mr. Prechter is a forecaster and social theorist who basis his work on something called the Elliott Wave Theory. I will admit that despite having been an avid student of investing for a decade and I have never heard of this theory. So, I went on the web and did some research.

As I suspected, Elliot Wave Theory is a form of technical analysis (source: Wikipedia.org). It is used to forecast trends in financial markets by identifying extremes in investor psychology, highs and lows in prices and other collective activities. The concept was developed by Ralph Nelson Elliott (1871-1948) who was a professional accountant.

I have studied technical analysis. It uses price and volume data in an effort to predict the direction of a security or the market in general. It has been widely discredited in the academic community. Burton Malkiel’s book, A Random Walk Down Wall Street, is probably the most well known work that refutes the notion that security prices follow any pattern. The Efficient Market Hypothesis, even in its weakest form, dismisses the usefulness of pricing data in market forecasts.

I find it disturbing that the media would pick up the shocking predictions of one prognosticator and suggest the investors should “get out” of the market. This to me is completely irresponsible journalism. I could easily find several equally credible market forecasters who predict that the market will reach some glorious new level in the next five years.

The truth is that no one knows where the market is going. A read of the most credible work on investing consistently warns readers to be wary of anyone who claims to know where the stock market is headed. There are two kinds of people. Those who know they do not know and those who don’t know they don’t know.

Shame on The Oregonian for printing an article that was clearly intended to incite the reader. Just what we need. Millions of investors panic and sell their investments. Then Mr. Prechter’s predictions just might come true.

SEC to “Study” Fiduciary Issue

As I suspected all along, the House and Senate punted on the imposition of a fiduciary standard for all financial advisors. The financial reform bill has been renamed the Frank-Dodd Wall Street Reform and Consumer Protection Act of 2010 after House Financial Services Committee Chair Barney Frank (D-Mass.) and Senate Banking Committee Chair Christopher Dodd (D-Conn.). It calls on the Securities and Exchange Commission (SEC) to conduct a six month study of the issues surrounding the standards of care under which various financial advisors operate. Currently, stock brokers, insurance agents and other advisors operate under a “suitability” standard. Registered investment advisors must adhere to a “fiduciary” standard. [See my previous blog posts for an explanation of the differences in these two standards.]

The SEC must develop regulations that reflect the findings from this study. The bill’s provisions empower the SEC to impose the same “fiduciary” standard on broker-dealers that applies to registered investment advisers. Indeed, Representative Frank has indicated that he expects the SEC to do so. “We gave the SEC the power to do it,” said Mr. Frank from the House floor, “and they’re going to do it.”

We shall see. The bill must still pass in the Senate. With the recent passing of Senator Robert Byrd (D-West VA), that won’t happy until after the July 4th recess. There continues to be significant opposition to the bill in the Senate and it is not clear that the bill will pass as written.

Fiduciary Issue Still Unresolved

The House and Senate continue to wrangle over the fiduciary issue as they reconcile their respective versions of the financial regulatory reform bill.

In case you have not been following this story, here’s the problem. Currently, investment advisors must provide advice and service that is in the client’s best interest. In addition, investment advisors must disclose conflicts of interest. Broker-dealers and insurance agents are required to offer products and services that are “suitable” for the client.

As you might imagine, the brokerage industry, the banking industry and the insurance industry all opposed to a fiduciary standard. They believe a study of the matter is necessary. They also claim a fiduciary standard would change their “business model.” … Yes, and this would clearly be in the best interest of their clients.

Under consideration is a watered down proposal that would empower the SEC to conduct a study of the standards of care currently in place in the financial marketplace and then establish a single fiduciary standard, if this would eliminate gaps in oversight of various types of financial advisors.

I am not optimistic about this. The forces acting against the fiduciary standard are incredibly powerful. The stakes are high for them. I predict Congress will fail to implement the fiduciary standard. … We should know the outcome soon, as the negotiators would like to complete the bill tomorrow.

The Risks Associated with Investing in Bonds

Investors have been pouring money into bonds since the stock market swoon that began the end of 2008. In fact, according to the Investment Company Institute, there has not been a single month over the past 17 months in which the net flow into bonds has been negative. This is hardly true for domestic and foreign equities.

So, what can we make of this? Investors have clearly become less willing to risk their funds in the stock market. They would rather invest in bonds even if yields are at historically low levels. The yield on the 10 year Treasury is around 3.5%.

But are bonds as safe as most investors seem to think? What are the risks associated with investing in bonds? Here’s a quick overview:

Interest rate risk: When interest rates rise, the value of bonds goes down. The reason for this is that bonds have fixed payments in the form of coupons and a final maturity value. When interest rates rise, these fixed payments become comparatively less valuable. The only way an investor would be willing to be a bond with a lower coupon payment would be if the price of the bond itself were less. This adjustment maintains the marketability of the bond.

Call risk: Some bonds are callable by the issuer. This means that they can be bought back from the bond holders prior to maturity. Issuers tend to call bonds when interest rates drop, because they can re-issue new debt at lower rates and thereby reduce their financing costs.

Prepayment risk: Some bonds allow the issuer to repay portion of the outstanding principal prior to maturity. If rates have dropped, the bond holder will likely be unable to reinvest these proceeds at the coupon rate of the bond.

Yield curve risk: The yield curve represents the relationship between market interest rates and the time to maturity of bonds. Changes in the yields of bonds with different maturities can change the shape of the yield curve. When yields change, prices change.

Reinvestment risk: Bond holders receive payments for providing (i.e. loaning) the bond issuer a principal sum. Investors are concerned with their ability to invest these payments at attractive rates. If market rates drop, reinvestment risk rises.

Default risk: This is the risk that the issuer of the debt will be unable to make the required payments. Default is the failure to maintain the terms of the debt obligation. Issuers perceived to have greater default risk are required to compensate lenders with higher coupon rates.

Credit spread risk: The spread is the difference between yields on Treasury securities and any non-Treasury securities that are otherwise identical. Treasury securities are risk free. All other securities carry some form of risk. The spread represents the risk that the investor takes on for investing in securities that are risky.

Downgrade risk: This is the risk that a credit rating agency will lower its rating on a particular issue. When this happens, the bond is considered riskier. In order to compensate investors for this additional risk, the price of the bond will fall.

Liquidity risk: Liquidity refers to the ability to quickly sell a security. Bonds that can be readily bought and sold with relatively low transaction costs are considered liquid. Investors tend to prefer bonds that are liquid. Bonds that are relatively illiquid are not as attractive and, as a consequence, will sell at lower prices.

Exchange rate risk: This risk is associated with bonds denominated in currency other than the U.S. dollar. Investors who exchange US$ into other currencies and the purchase bonds in those currencies are faced with additional risk of converting the foreign currency back to US$. If the US$ has gained value during the foreign bond holding period, the investor will lose money converting back to US$.

Volatility risk: Bonds with options (call options, prepayment options, and put options) are subject to volatility risk. Change in the volatility of interest rates affects the value of bonds depending on the type of option that are embedded. Imagine a put option on a bond. If volatility increases, the value of the put increases. . This increases the value of the bond.

Inflation risk: Inflation erodes purchasing power. Bond investors are faced with using fixed coupon payments to purchase goods and services that increase in cost over time. If inflation jumps unexpectedly, bond values will drop.

Event risk: Bonds can drop in value if an adverse event occurs. A natural disaster, a corporate change or a regulatory change could cause credit analysts to downgrade a bond. This will lead to a loss in bond value.

So, while investors seem to be rushing into bonds, one wonders how well they understand the risks of investing in these securities.

Sources: Investment Company Institute, CFA Institute

Deflation Threat Remains

The very tepid economic recovery has economists in developed countries pondering the prospects for deflation. Deflation is a general decline in the price of goods and services. Everything becomes less expensive. So, why the worry?

Deflation is typically caused by a decrease in consumer, government and investment spending. There has not been a period of sustained falling prices in this country since the Depression in the 1930s. In fact it is so rare that economists have not had many opportunities to study it in real time.

In Europe and the US, consumers are paying down debt, cutting their spending and saving more. Many countries in the European Union, afflicted with large national debts and budget deficits, are also being forced to cut back on spending. The result of this belt-tightening is a slow down in price increases. The Wall Street Journal reported this week that “excluding volatile food and energy sectors, consumer prices [in the US] were up just 0.9% in May, the smallest increase since 1966.”

Government policy makers find combating deflation very difficult. Traditional policy tools are designed to fight inflation, not deflation. Central banks can’t lower interest rates, because they are already almost zero. Government spending will only exacerbate budget imbalances and increase sovereign debt levels. Consumers will put off purchases, if they expect prices to be lower in the future. This further compounds the problem, as prices have to drop even further to entice consumption.

Lower prices lead to economic contraction. Wages fall, incomes drop, spending falls further, and on it goes. It is a downward spiral that can result in a reduction in overall economic welfare.

Let’s hope we don’t face a serious prospect of deflation, because the Federal Reserve has a very limited ability to do anything about it.

Congress Still Considering the Fiduciary Standard

Last week the Senate passed a financial reform bill that, while the most sweeping since the Depression, failed to include amendments that would have held all financial advisors to a fiduciary standard. Apparently, Senators Menendez and Akaka, who support the fiduciary standard, could not garner enough support for their amendment. So, they pulled it, rather than allow it to be defeated.

All is not lost. The Senate and the House are currently assembling a team of lawmakers who will gather to reconcile differences in the Senate and House versions of financial reform legislation. Conference members may still include language modeled after the House bill which includes a fiduciary standard.

The Senate bill still includes a provision that requires the Securities and Exchange Commission to study the differences between the fiduciary standard and the suitability standard and make appropriate recommendations to Congress.

We do not need a federally funded study of this issue. Consumers deserve to be served by those who act in their best interests. It’s really that simple.

The banking, securities, and insurance industries are opposed to the implementation of a fiduciary standard. They are concerned that such a standard could impair their ability to conduct business, including selling proprietary products and charging commissions. They will lobby for the study and hope nothing comes of it.

Let’s hope our legislators defend consumers and pass a financial reform bill that includes the fiduciary standard.

Americans Confront the Reality of Retirement

There were several reports this past week about American’s lack of preparation of preparation.

According to a study by Hewitt Associates, a global human resources consulting and outsourcing services company, employees will need 15.7 times their final pay when factoring in inflation and postretirement medical costs. Of the 15.7 times final pay, Hewitt estimates that Social Security will provide 4.7 of it, leaving employees responsible for making up the remaining 11 times final pay. This will likely have to come from company-provided plans and personal savings. But of the more than 2 million employees at 84 large U.S. companies it examined, Hewitt’s study found that only 18% of these people who are expected to work a full career will meet this goal.

TD Ameritrade released a survey indicates that 57% of Americans feel they are either a “little behind” or “far behind” in their planning for retirement. The majority (56%) indicated that they started saving for retirement later in life. The survey found that Americans are concerned about health care expenses, working longer than anticipated, outliving savings and managing their retirement savings.

There is an interesting parallel between what is currently happening in many European countries and the plight of many Americans. Greece, Spain, Portugal, and Italy (among other Euro countries) are dealing with the reality of excessive debt levels and government budget deficits. These countries can no longer finance their debts at sustainable levels. Further, they are no longer able to spend more than they take in. These countries are being forced to take austere measures to reduce debt, cut spending and balance their budgets.

Sounds remarkably similar to what many Americans are experiencing …

Funding Retirement

The greatest threat to those who are retired is not death. It is running out of money. While no one looks forward to dying, without sounding insensitive, it is relatively inexpensive to die. There are final expenses which may include hospitalization, hospice care, a funeral or memorial, and burial or cremation. But these expenses are typically less than $10,000 for most people.

The much greater costs are those of living over a long period of time. Consider a person just now entering retirement who needs $4,000 a month to live comfortably.
Let’s imagine that Social Security provides $1,500 a month. That leaves $2,500 which must come from a pension or withdrawals from retirement savings.

How much money must a person have in savings to be able to draw $2,500 a month for the rest of her life? The rule of thumb in the financial planning community is that a sustainable rate of withdrawal is 3-6%. This will allow the retiree to maintain her purchasing power against the erosion of inflation and never run out of money.

So, if we assume a 4% withdrawal rate and a $2,500 monthly income need, our retiree will need $750,000 in retirement savings. This is significantly more than most Boomers have set aside currently for retirement. In fact, over half of that generation has less than $50,000 in savings.

Clearly, people need to save more. The question is, will they?

Wants vs. Needs

Recent economic data from the Commerce Department indicates that consumers are beginning to spend again as we emerge from the longest recession since the Depression. Consumer spending accounts for 70% of the demand in our economy. So, the 0.6% increase in consumer spending in March might be cause for celebration.

Wages, as measured by the Labor Department’s employment cost index, rose 0.2% from February’s level. But personal income rose by just 0.3% in March.

What does this mean? Consumers are likely reaching into their wallets for their credit cards in order to pay for purchases. In fact, the personal savings rate fell from 3% to 2.7%, the lowest level since September 2008.

So, once again consumers appear to be spending beyond their means. We know this is not sustainable and we know how this story ends.
Perhaps we need to remind ourselves of the difference between a “need” and a “want.” A need is something that we need to exist. Food, water, clothing, and shelter all come to mind. A want is something that … well, we want. We want new cars, a Hawaiian vacation, a new HD TV … Do we need these things? Clearly we do not.

There is nothing wrong with buying things we want, unless this impairs our ability to save for the future. If we don’t save for the future, we will be hard pressed to pay for our needs, much less our wants.

The Fiduciary Standard – Hope Remains

There may yet be hope for consumers of financial products and services. Senators Daniel Akaka (Democrat from Hawaii) and Robert Menendez (Democrat from New Jersey) have offered an amendment to the Financial Reform bill (Restoring America’s Financial Stability Act) that would remove a provision (Section 913) that would provide for a study of the whether the fiduciary standard should be imposed upon broker-dealers. The new language would mirror the House reform bill and authorize the Securities and Exchange Commission to adopt rules requiring broker-dealers who provide advice to comply with the fiduciary standard.

To review, under the current legal structure, most financial advisors, including stock brokers, insurance agents, and financial representatives in banks and credit unions are not required to put their client’s best interest first. Instead, they are required to offer products and services that are “suitable.” This is a lower standard than the fiduciary standard and leaves consumers vulnerable.

According to the web site fi360, there are five core principles to the fiduciary standard:

•Put the client’s best interests first;

•Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;

•Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;

•Avoid conflicts of interest; and

•Fully disclose and fairly manage, in the client’s favor, any unavoidable conflicts

I strongly support the inclusion of a fiduciary standard in the Financial Reform legislation. I see no point in “studying” this issue. It is rather obvious that financial advisors should be required to act in their client’s best interest.

The banking, securities, and insurance industries are lobbying Congress in an effort to prevent the imposition of the fiduciary standard. Make your voice heard and tell your representatives in the House and Senate that the fiduciary standard is imperative to meaningful financial reform in this country.

The Moral Abyss on Wall Street

The Securities and Exchange Commission has recently filed charges against one of the most highly regarded firms on Wall Street, Goldman Sachs. The lawsuit claims Goldman defrauded investors by misstating and omitting information about a complex financial product tied to subprime mortgages.

The SEC alleges that Goldman Sachs created the synthetic collateralized debt obligation (CDO) called ABACUS after it was approached by a leading hedge fund, Paulson & Company. John Paulson, the funds manager, asked Goldman Sachs to create a financial product that would allow his firm to essentially bet against it. Paulson’s firm was actively involved in structuring the transaction and paid Goldman Sachs $15 million to put it together.

According to the SEC, Goldman Sachs represented that the residential mortgage backed securities were selected for ABACUS by an independent firm, ACA Management. The debt inside ABACUS soon became non-performing and investors in allegedly lost more than $1 billion. Paulson & Company made billions betting against ABACUS and other similar financial products.

Goldman Sachs has denied the charges and indicated that it will defend itself. The firm claims that it was not required to disclose who provided input into the mortgage-selection process for the transaction or what their intentions were.

When I was a senior at Stanford University, I interviewed for an analyst position at Goldman Sachs. This was in the late 1980s when investment banking was one of the more attractive fields for students graduating in economics from leading universities. I remember studying Goldman Sachs and preparing for my interviews in Palo Alto and in New York. I also remember thinking that Goldman Sachs was clearly the premier firm on Wall Street. Ultimately, I was not hired by Goldman Sachs and I pursued other opportunities.

I am not particularly interested in the nuances of the law and whether Goldman Sachs committed fraud. Based on what I’ve read, Goldman Sachs may be able to defend itself against these accusations. What I find disturbing is Goldman’s failure to adhere to basic standards of fairness, honesty, and integrity. I am left wondering if Wall Street has reached a tipping point and fallen hopelessly into a moral abyss.

Fee Only Advisors Frown Upon Annuities

So, why do most fee only financial planners and investment advisors view annuities with disfavor?

Annuities are expensive products. The internal expenses inside a variable annuity routinely exceed 3% per year. Annuities contain administrative expenses (0.10-0.30%), mortality expenses (0.50-1.5%), investment expenses (0.35-2.00%), and, in many cases, riders (0.25-1.0%). Let’s assume the annuity earns an average of 9% (this would suggest a rather aggressive allocation within the annuities subaccounts). The owner will lose 1/3 of the annuities growth to expenses. It is easy to see why an advisor serving in a client’s best interest, and therefore concerned about fees paid by the client, may discourage the purchase of an annuity.

Annuities are generally not very liquid. The owner cannot readily surrender the annuity and move the money inside the contract without incurring substantial charges. Charges are typically applied for surrenders that occur for 3-15 years from contract inception. These charges typically decline over time, but can start as high as 10%.

Annuities are insurance products sold by licensed insurance agents. These agents earn a commission for selling annuities. Commissions are usually 3-10% of the amount placed in the annuity. So, assuming a 5% commission and a $100,000 deposit, the commission will be $5,000. This strikes most non-commissioned advisors as excessive.

Many advisors also feel that insurance agents sell annuities to people in situations where they are really not appropriate. Annuities with heavy surrender charges over lengthy periods have been sold to retirees in their 80s. Annuities are routinely placed in IRA accounts, which makes little sense from a tax perspective. Insurance agents too often move the vast majority of a person’s investable assets into an annuity instead of spreading the assets across different investment vehicles.

While annuities certainly have many attractive features, they are generally expensive and illiquid. It is no wonder that fee only advisors view them with suspicion.

Annuities Can Play Role in Retirement Portfolio

I grew up in the insurance industry. My father was a life insurance agent. I learned about insurance products at the dinner table as a kid. After I graduated from college, I entered the financial services industry as an advisor for a major life insurance company. I earned my Chartered Life Underwriter designation in my early 20s. So, I have pretty solid understanding of annuity products.

Over the years I have watched the insurance industry develop a vast array of annuity products. These products have become very sophisticated and, one might argue, too complex. In addition, most of them are very expensive. It is not unusual for an annuity to be loaded with expenses that total 2-3%.

So, while I like some of the features of annuities, I have not been particularly inclined to advise clients to purchase them. [Our firm is fee only. We do not sell any financial products.] Most clients do not understand the newer annuity products and few realize how expensive they are.

However, based on several recent articles and white papers, I am beginning to think there may well be a place for a low cost annuity inside a well structured retirement portfolio. Why? Because a guaranteed, fixed income stream from a highly-rated insurance company can serve to greatly improve the odds that the client will not outlive their resources in retirement.

Our firm has a responsibility to help our clients maintain their lifestyle after they stop working. Given that our clients are routinely living into their 80s and 90s, we need to be diligent about building a portfolio that can withstand the erosion caused by 30-40 years of inflation. We also need to attempt to insulate the portfolio from the impact of cataclysmic market drops as occurred twice in the most recent decade.

So, annuities may serve a valuable role in a retirement portfolio.

Supreme Court Weighs in on Mutual Fund Fees

The nation’s highest court issued its views on Jones V. Harris Associates, in which investors in Oakmark mutual funds sued the fund manager for allegedly excessive fees. The case reached the Supreme Court after a lower court overturned the “Gartenberg standard.” Under this standard, which was established by a court ruling in 1982, the only way for an investor to prove that a fund’s fees were excessive was to establish that the fees were not properly negotiated with the fund board.

The high court re-established Gartenberg and went further. The ruling accepted the argument that judging whether a fee is excessive requires comparing the charges applied to different types of clients. This brings to light the large discrepancy in fees between individual/retail investors and institutional investors. This new interpretation may require fund managers to inform their boards how much they charge and explain the differences. This may prove very difficult.

Investors should realize that almost all fund companies are profit seeking. It’s pretty obvious that the more they charge you, the more profit they generate. Wise investors look for funds with low fees and high marks for stewardship from Morningstar.

Source: The Wall Street Journal

Congress May Fail to Create Fiduciary Standard

For months I have watching the Senate Banking Committee and the House Financial Services Committee grapple with whether or not to impose a fiduciary duty of care on anyone offering advice on investments.

In case you are not aware, the fiduciary standard requires advisors to act in the best interest of another party. You may be thinking, “But aren’t all investment advisors required to do this?” No, they are not.

Currently, advisors inside banks, credit unions, insurance companies, and brokerage firms are only required to do that which “suitable” for the client. Under this standard, the advisor must recommend only those products that are suitable based on the client’s situation. This is a lower level of care and it has resulted in consumers being sold products and services that, while perhaps suitable, are not in their best interest.

As you might image, the companies that manufacture and distribute financial products are resistant to the idea of holding their advisors to a level of care that would likely result in a reduction in the sale of their financial products. The advisor inside a national bank, the agent for a major life insurance company, the broker for a major wire house would all be required to make only those recommendations and sell only those products that were in the client’s best interest.

The only advisors who are currently held to a fiduciary level of care are those who act under the Investment Advisers Act of 1940, those who carry the CERTIFIED FINANCIAL PLANNER (CFP) designation and those who operate in the retirement plan arena under the Employee Retirement Income Security Act of 1974 (ERISA). I am a CFP and Cascade Wealth Management is a Registered Investment Advisor acting under the 1940 Act.

The Certified Financial Planner Board of Standards, the National Association of Personal Financial Advisors (NAPFA) and the Financial Planning Association (FPA) formed the Financial Planning Coalition (www.financialplanningcoalition.com). The coalition’s mission is to ensure that financial planning services are delivered to the public with fiduciary accountability and transparency. I am a member of the NAPFA and the FPA.

It does not appear that Congress is going to find the courage to implement the fiduciary standard in the investment industry. The true losers are Americans who should be served only by those acting in a fiduciary capacity.

The CFA Institute on Indexing

I am currently laboring through the coursework to sit for the Level 1 CFA Exam in June. The CFA Institute offers the Charted Financial Analyst charter. The CFA designation is held by, among others, portfolio managers, investment research analysts, and investment bankers. I decided to pursue the charter, because I believe it will help me better serve our clients.

I was also interested in obtaining the base knowledge that portfolio managers use to actively manage portfolios. We do not practice active management. I have never been persuaded by Wall Street’s message to consumers that investors can beat the market. The academic research indicates that very few active managers actually deliver above-average risk-adjusted returns. But since there so many firms attempting to do this, I want to know how they attempt to go about it.

While I am still in Level 1 of the CFA program - there are three levels to the CFA curriculum – it has been very interesting to see the position that the CFA institute takes on the issue of active portfolio management.

Here are a few quotes from CFA Program Curriculum, Volume 5, “Equity and Fixed Income.”

“The majority of professional money managers cannot beat a buy-and-hold policy on a risk-adjusted basis.” P. 93

“Without access to superior analysts or the time and ability to be a superior investor, you should manage passively and assume that all securities are properly priced based on their level of risk.” PP. 93-94

I am using a review program produced by Kaplan Schweser to prepare for the exam. In Book 4, “Corporate Finance, Portfolio Management, and Equity Investments,” the author states, “money managers as a group have not outperformed the buy-and-hold policy. P. 184

Further, “since you cannot, in general, expect to beat the market, you should attempt to match the market while minimizing your costs. One way to match the market’s performance is to put your money into an index fund.” P. 184

I find this very interesting. Why are so many advisors putting their clients in funds that are actively managed? Do they actually believe they can identify the few portfolio managers who do beat the market? Do they realize that this small group of managers is not consistent over time? Just because a mutual fund earned a 5 star rating from Morningstar last year does not mean it will do so again this year.

Hopefully, I will pass the Level 1 exam and move on to Level 2 and Level 3. I am very curious about the additional insights I will have into the issue of active vs. passive investment management.

Hunting for Yield

There has been a lot of dialogue about how conservative investors can boost their yields with minimal risk. There really are no easy answers. Yet investors and their advisors continue to look for them.

I would suggest that this issue should be placed in a broader perspective. Inflation is largely non-existent right now, as measured by the government’s CPI numbers. In fact, in January prices actually decreased.

The issue for those requiring income is their ability to stay ahead of inflation and maintain their purchasing power. If inflation is running at 4% and I earn 6% in my income-oriented portfolio, my inflation adjusted return is 1.92%. If inflation is 0.5% and I earn 2.5% in my portfolio, my inflation adjusted return is 1.99%.

We did not hear much about the need for yield when inflation was running at 3-4%, because investors were able to earn enough yield in CDs, money markets, treasuries, high grade corporate bonds, and dividend-paying stocks to maintain a healthy margin over inflation.

I am, of course, ignoring taxes. But the point is that investors need to focus on their inflation-adjusted returns. The situation is not as dire as many believe.

Declining Projected Returns

I read in The Wall Street Journal on Monday (March 1, 2010) (http://online.wsj.com/article/SB10001424052748703316904575092362999067810.html?KEYWORDS=calpers++rate) that CalPERS (the California Public Employees’ Retirement System) is considering reducing the projected rate of return used to make investment decisions. This is further validation of a growing sense in the investment community that investment returns are likely to be lower than they have been historically. (Note: The Pew Center on the States reports the most common projected rate of return among public pensions in the U.S. is 8%.)

Since 2003, CalPERS has assumed that the value of its stock, bonds and other holdings would increase by 7.75% per year. However, the board has been advised by its investment consultants that this is not likely to occur. BlackRock, a leading investment company, suggested that the huge pension would be “lucky to get 6% on your portfolios, maybe 5%.”

The lower projections will result in increased contributions needed from employees and local governments to meet future payouts promised to retirees and their beneficiaries. This is not good news in a state that is already facing dire financial conditions.

But what does it mean to you? Well, the same returns that affect massive institutional investors like CalPERS (and Oregon PERS by the way), affect individual investors like you.

The CalPERS portfolio is allocated broadly across multiple asset classes. You can see this on their web site. (http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml) As of December 31, 2009, the CalPERS portfolio included 66% in global equities (stocks), 23.5% in global fixed income (bonds), 6.8% in real estate, 2.4% in inflation linked securities and 1.3% in cash.

Most economists expect income tax rates to rise from their current levels as the government seeks additional revenue to reduce the federal budget deficit and pay for social programs. Tax rates on dividends, interest and capital gains (the sources of investment income) are likely to increase by many percentage points.

This means that investors will give up more of their returns to the government. If we assume the CalPERS recent projected return of 7.75% and a blended tax rate of 30%, then the after tax return is 5.43%.

Now let’s imagine that the rate of inflation over the next 25 years runs at 4%. I realize that this is considerably higher than the current rate. But it is consistent with historical rates and it very likely understates the rate we will actually experience.

Now the 5.43% return, after subtracting inflation, is 1.43%. (This is an approximation. The actual inflation-adjusted return is actually slightly lower.)

We have, thus far, ignored expenses and fees. These costs include advisory fees, management expenses, commissions, etc. For investors in actively managed portfolios, these expenses can easily top 2.25%. (Note: Cascade Wealth Management builds passive portfolios which typically have total expenses and fees of less than 1%.) This would wipe out what’s left of the returns that have been adjusted for taxes and inflation.

So, investors need to consider carefully how lower future returns will affect them. If you are retired and rely on your investments for income, review the rate at which you are drawing from your portfolio. You want to make sure your investments support you for the rest of your life. If you are still working, make sure you are saving enough to meet your income needs in retirement.