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.
Friday, March 26, 2010
Friday, March 19, 2010
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.
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.
Thursday, March 11, 2010
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.
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.
Thursday, March 4, 2010
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.
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.
Wednesday, March 3, 2010
Mutual Fund Families and the Destruction of Wealth
Morningstar released a study of the extent to which mutual funds companies have created or destroyed their investors’ wealth over the past decade. The survey included the 50 largest mutual funds (measured by total net mutual fund assets).
TOP WEALTH CREATORS
FUND FIRM, WEALTH CREATED ($ MILLIONS)
American Funds, $190,953
Vanguard, $188,959
Fidelity, $153,082
Franklin Templeton, $78,442
PIMCO, $71,381
BIGGEST WEALTH DESTOYERS
FUND FIRM, WEALTH DESTROYED ($ MILLIONS)
Janus, -$58,397
Putnam, -$46,407
Alliance Bernstein, -$11,376
Invesco AIM, -$10,081
MFS, -$7,651
It is probably not fair to draw any profound conclusions from this study. However, those who follow the mutual fund industry will surely note that companies that destroyed the most wealth have not been considered strong stewards for their investors.
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