Contents: ETFs disconnect from underlying, capturing long-term equity risk premium (ERP) comes with inevitable occasional “horrifying short-term losses”, Fidelity IRAs provide Qualified Longevity Annuity Contract (QLAC) option (why not in Canada?), indexing perspectives: providers/bond and stock indexes/indexes for benchmarks vs. portfolio construction/, pre-mortem before the next inevitable 50% market drop.

Much ink spilled in the past 2-3 weeks was focused mainly, though not exclusively, on market volatility. Consider some articles which I found of insightful and interesting.

In The Financial Times’ “ETF providers question US trading limit rules” Rennison and Bullock report that following the recent market volatility when stocks hit trading limits and trading was halted, ETF providers (and investors) were perturbed about the disconnect between the prices of ETFs and the underlying stocks, blaming “underlying market structure issues”. The WSJ’s “Stock market tumult exposes flaws in modern markets” Hope, Vaishampayan and Driebusch point more specifically at the many ETFs trading at significant discount to their underlying net asset values because ETF market makers “were unable to accurately calculate the value of the underlying holdings or properly hedge their trades. That caused them to lowball their buy offers and overprice their sell orders to ensure they didn’t take on too much risk. This sent ETF market values tumbling, too, and caused disruptions in the trading of other assets.” Clearly BlackRock, Vanguard and other ETF providers are working with the exchanges at ways to insure that in the future dislocations are minimized. So while the disconnect in ETF pricing relative to its underlying assets is disconcerting, the simplest way for investors to protect themselves is to avoid trading on days when volatility is high and never place a market order but always specify a limit price to protect you on the downside when selling and on the upside when buying.

The real problem that investors have to deal with is the reality of market volatility. Jason Zweig in the WSJ’s “The cruel psychology of the 1,000-point drop” writes that “In order to capture the potentially higher returns that stocks can offer, you have to reconcile yourself to the certainty of horrifying short-term losses. If you can’t do that, you shouldn’t be in stocks—and shouldn’t feel any shame about it, either.” Let’s face it, what we need is a long-term plan which factors in our willingness, ability and even need to take risk. (This was discussed in my recent post on Stocks in retirement? Asset allocation considerations in retirement.)

In the WSJ’s “A new retirement income option for IRAs at Fidelity” Anne Tergesen reports that Fidelity 401(k)s started offering “deferred income annuities” inside 401(k)s; this type of annuity (longevity insurance) allows individuals/couples to purchase at age 65 a deferred income stream starting typically at age 85. For example an immediate annuity for a 65 year old man would buy $6,792/year with a t $100,000 premium, whereas deferring the payment start to age 85 the lifetime income stream will be $53,892. New U.S. tax rules solve the problem associated with 401(k)s and traditional IRAs which have required minimum distributions (RMD) starting at age 70; ” The new tax rules give certain qualifying deferred-income annuities relief from those rules, provided their owners begin collecting income by age 85 and put no more than 25% of their traditional-IRA money and no more than 25% of a 401(k) account into such an annuity, up to an overall maximum of $125,000.” If these 25% and $125,000 limits are observed for the purchase of the longevity insurance, then the RMD may be calculated by excluding the amount used to purchase it. (Why are these longevity insurance products still unavailable in Canada? With fewer and fewer baby-boomers employed in the private sector having traditional pension plans these longevity insurance type annuities are a relatively low cost way of securing lifetime income for those who live past age 85. There is no tax revenue lost, only small shift in the timing of the revenue. I sent a note to the Honourable Finance Minister Joe Oliver on the subject this week; you might also wish to contact the Finance Minister to encourage the introduction of this in Canada.)

In the Financial Times’ “Investing: The index factor” John Authers explores the power exercised by index providers (e.g. MSCI’s recent decision to defer inclusion of China’s domestic A-shares into the emerging market index), noting that some believe that “indices and the companies that calculate them have grown so powerful that they do not just track markets, but move them…” or even “help inflate investment bubbles”. But index providers disagree, arguing that while theoretically it may be a concern, none of the past bubbles were index related (a valid argument on the surface, but heavy use of indexing is only recent). Index providers use their power responsibly according to the article, usually following transparent rules that investors can even front run. Some of the biggest indexing concerns related to bonds where the biggest debtors end up with the heaviest representation in the index (also discussed in “Mechanics of bond indices raise concerns” which points out that “the US, Italy and Japan together constitute over half of the entire $42.5tn universe of the Barclays Global Aggregate, the dominant international bond gauge”; but investors choosing instead the new “total return” or “unconstrained” bond funds may find themselves in a minefield; similarly Authers notes that “If all money were managed passively, markets would cease to function”. Index providers have some discretion; e.g. “S&P fills vacancies in its S&P 500 index of big US companies whenever they arise… It attempts to maintain a balance between sectors and to avoid companies that have not yet built a history of trading profitably”. Even though years ago indexes were used a benchmarks for active managers, today they are used for constructing passively managed portfolios, but the reality is that most investors have little or no understanding of index construction and index providers.

And finally, Jason Zweig in his WSJ mid-August article “Reassess your investments before next panic” provided a reminder to readers that “If you think stocks can’t fall by at least 50% again, you are wrong. If you think you (or anybody else) can know exactly when that will happen, you are crazy. And if you think you won’t overreact when it does, you had better test that belief now—before it is too late to find out you were kidding yourself.” He suggests using a “pre-mortem” thought-experiment and “Imagine that markets have crashed, your portfolio’s value has fallen by 50% overall and some of your holdings have lost 90% or more. What outside forces caused it? What beliefs did you hold that turned out to be wrong? …and consider” what, if anything, you should do to minimize the damage”.