Hot Off the Web– June 6, 2011

Personal Finance and Investments

In the WSJ’s “Pension plans for the rest of us” Anne Tergesen looks at some recommendations on how to convert savings into a retirement income stream. The scenario chosen is “married couple, both 65 years old and about to retire, with $1.7 million in various accounts ($950,000 of which in a 401(k)), a house valued at $600,000 and expenses of $7,500 a month. In addition to Social Security, they receive a monthly pension of $2,500.” Advice includes spending $336,000 on two Variable Annuities to secure a regular income stream (Fidelity), 80% on bond funds and 20% equities resulting in $38,000 pre-tax income (Financial Engines for 401(k) portion only; unfortunately it says nothing about what to do with the $750,000 taxable account, presumably to be more heavily invested into equities), 35% stocks and 65% bonds for $108,000-$130,000 spend rate after taxes (Guided Choice), and unspecified asset allocation $112,000 spend rate after taxes (Schwab). (If that leaves you somewhat confused, you are probably not alone.)

In another WSJ article “Plan finances for surviving spouse” Anne Tergesen reports that “nearly 40% of married women rely on a spouse or partner to plan their retirement finances”. She then makes a number of recommendations to prevent/reduce likelihood that the longer longevity spouse (typically the wife, end up with dramatic drop reduction in standard of living. Her list includes: (1) having a plan and insuring that both can manage it on an ongoing basis, (2) delay taking the higher earning spouse’s Social Security payment until 70 (if higher earner husband dies first, then widow gets to collect the higher payments), (3) if buying an annuity or have DB pension , make sure to select survivor option, (4) life insurance might also be used to pay off debts or replace the loss of some benefits, and (5) long-term care insurance. (Mostly a good list, and mostly applicable in Canada as well.)

In the pathetic but true category Margaret Collins in Bloomberg’s “Promise of lifetime income fuels 24% surge in U.S. variable annuity sales” reports that sales of such products (similar to GMWBs and GLiBs) typically come with fees of about 3.5%/year, limitations on the amount you can allocate to equities, at times the insurance company has right to raise fees, guarantees referring to annual income not assets and are too complex bordering on the incomprehensible to the buyers (and likely the salesmen of these products, as well).. “The high fees mean that “the upside potential” in these contracts is “fairly limited (or almost non-existent)” (The first time I read about one of these products, they sounded too good to be true; and they were. See GMWB I , GMWB II)

In IndexUniverse’s “Swedroe: Passive investing is the way” you can read the last chapter of Larry Swedroe’s book, which I reviewed a few weeks ago at “The quest for ALPHA”. If you haven’t read the book as yet, you should at least read this short last chapter.

In the Financial Post’s “Lies, damned lies and returns” Michael Nairne writes that you must pay attention when you hear the word ‘return’, as not all returns are created equal. The industry standard measure is TWR (time weighted return) which gives an accurate measure of the portfolio manager’s (performance) return independent of cash flows into and out of the portfolio; is not the investors’ return in the fund (investors typically get a lower return because they tend to buy high and sell low), a better measure of this is  the average investors’ return in the fund as measured by dollar weighted return or internal rate of return (IRR) e.g. see Morningstar Investor Return). Mutual funds typically quote returns after fees, whereas private investment managers quote returns before fees. Similarly, reported returns are pre-tax returns and “taxes in many instances can even exceed fees”. Nairne adds that investors must also understand how much risk the manager took to generate the returns, and finally past returns are not predictive of future returns.

And speaking of returns and what this might mean, Matt Hougan in FPA Trends in Investing’s “Understanding flaws in ETF data”explains some areas where in ETF data that you must make sure you understand what you are actually looking at and the importance of digging deeper at times. A powerful demonstration of what he is taking about the difference between plotting an ETF’s ‘Price’ history vs. the ‘Total return’ (the latter including not just price but also dividends and interest distributed over the period under consideration) history.

In IndexUniverse’s “McCall’s call: Wide world of commodity ETPs”Matt McCall reviews the wide variety of available commodity ETPs and how one might go about choosing the one(s) most suitable for your portfolio. (Canadians should take particular care given their likely already heavy exposure to energy and materials sectors in their allocation to the Canadian market, 47% of which being those sectors.)

Real Estate

The March data for the U.S.  S&P/Case-Shiller National Home Price Index is bad news and indicates that “Index declined by 4.2% in the first quarter of 2011, after having fallen 3.6% in the fourth quarter of 2010. The National Index hit a new recession low with the first quarter’s data and posted an annual decline of 5.1% versus the first quarter of 2010. Nationally, home prices are back to their mid-2002 levels…“The rebound in prices seen in 2009 and 2010 was largely due to the first-time home buyers’ tax credit. Excluding the results of that policy, there has been no recovery or even stabilization in home prices during or after the recent recession. Further, while last year saw signs of an economic recovery, the most recent data do not point to renewed gains…Atlanta, Cleveland, Detroit and Las Vegas are the markets where average home prices are now below their January 2000 levels. With a March index level of 100.27, Phoenix is not far off”. In WSJ’s “Home prices hit post-bubble low” Timiraos and Kalita write that the housing double dip is due to a combination of continued high unemployment, tumbling consumer confidence (in May), high foreclosed inventories, and “shortage of “trade up’ buyers…leaving many markets dependent on first-time buyers and investors who land discounts on foreclosures by making all-cash bids”.

In the Globe and Mail’s “Why the U.S. housing market will continue falling” Ian McGugan quotes “The Man Who Called the Last Two Bubbles” that “History suggests that while a housing bubble can temporarily push prices above the inflation rate, home prices inevitably fall back and remain remarkably constant in real terms. Based on that reasoning, Mr. Baker calculates that U.S. home prices still have 10 per cent further to drop. “That is what would be needed to return us to the real prices of 1996…Given that nearly a quarter of Americans owe more on their mortgages than their homes are worth, the weak real estate market poses a nearly impassable barrier to a strong recovery.” As to the Canadian housing market he says: ““My theory is that home prices in places like Canada are acting like bonds,” he says. Just as bond prices shoot up when interest rates head down, so Canadian home prices have rocketed on the back of low mortgage rates, because our shorter-term mortgages make us that more interest-rate sensitive than Americans. The corollary, of course, is that there will be big losses when mortgage rates inevitably head upward. “I would be wary in markets like Canada. In fact, I would be very, very wary.””

In the Globe and Mail’s “Renting v. buying your home: an affordability check” Rob Carrick discusses the rent vs. buy option especially given the run-up of house prices and no correction in Canada. Financial Times’ Lex article “Housing market: Renting on the rise” looks at the same topic in the U.S. market where after a massive drop in prices one might expect people to buy rather than rent, yet in fact more people are starting to rent. “For the first time since at least 1981, the median monthly rent in the US is now higher than the median mortgage payment….Homebuyers have been scared away by a combination of high unemployment, economic uncertainty and lack of finance…the winners are buy-to-let investors. The rental yield on a US house is creeping towards 5.5%, the highest level in a generation….but the profits are reserved for those with plenty of cash reserves.”

In the Financial Post’s “Southeast Florida draws global buyers” and “Praising Arizona”there are reports of ‘bargains’ and many foreign buyers including Canadians as reported by real estate agents. (If you are thinking of buying, I suggest you look carefully before you leap. Thanks to EF for recommending articles.)

Pensions

In CarpAction’s “Australian pension study finds that fees and costs of private sector pension plans seriously limit investment returns for pensioners” Susan Eng summarizes and comments on Wilson Sy’s Rotman International of Pension Management’s “Redesigning choice and competition in Australian superannuation”article. Eng indicates that “high fees and costs of private sector pension plans in Australia seriously limit investment returns for pensioners. All the more reason for a public option and real competition.” In Australia’s purely private sector implementation (similar to the PRPP now proposed by Canada’s Finance Minister) “the report argues that competition does not produce lower costs when individual investors face complex choices, as they do retirement planning and investing. Simply, complex choices are not functionally choices at all”. She concludes that “In Canada, a practical solution is clear – allow people to buy into a separate fund run by the existing not-for-profit pension funds like the CPP, OMERS, provincial Teachers Funds and the like. With their size and experience, they can offer low-cost, reliable defined benefit pensions. They have the advantage of scale and operate on a not-for-profit model.” (In fact it might not even have to be public sector; it might even work very well if implemented as a ‘mutual’ company like Vanguard in the US.)

Things to Ponder

So can ETFs collapse? – (cont’d): In last week’s Hot Off the Web I discussed this question including the answer I received from Vanguard on the subject. iShares’ answer came this week. The essence of iShares’ answer is that “under no circumstances will iShares funds deliver out cash or securities to redeeming unitholders unless all of the units being redeemed have been returned to the fund (i.e. then can’t be sold twice). For example, someone who has lent out their units cannot redeem them unless they are recalled and returned by the borrower. A unitholder must be in physical possession of the shares in order to redeem them.” Of course this still leaves the possibility for people to attempt to trade/sell (though not redeem) units and “it takes T+3 before trades settle. This allows your brokerage firm to recall the shares that were lent out to allow your trades to settle”. (In circumstance when there is an excess of units sold over and above those that have been created (a possibility especially in ETFs which have very low liquidity), there could be a lot of price volatility and heartache in those 3-days. The situation mentioned is not just associated with ETFs but in shorting of stocks in general, though one could argue that ETFs might (or might not) be more vulnerable because of the manner in which institutions use them in large scale for short term hedging purposes.) You might also want to read the related  Noel Archard’s iShares Blog at  “Kauffman strikes back (and out) again” which discusses in detail ETF the primary market creation/redemption process and what happens if an Authorized Participant (AP) is unable to deliver the securities with the required 3-days. The blog indicates that the trade did not fail but the AP is required to post collateral to allow the delayed delivery, so investors are still protected. In the secondary markets Market Makers are permitted to settle at T+6. “So if the SEC wants to create stricter guidelines and punishments for ETF settlement failures, they can, and I might even agree that they should.” In “Infighting does not help ETF case” (to be discussed below) Pauline Skypala reports that “ETF providers say (that) only short sellers suffer in a short squeeze. There is no risk to ETF investors, or to fund performance, by a failure to settle by a short seller. On the contrary: according to Ted Hood, chief executive of Source, the volume of trading in ETFs by short sellers is good for investors as it reduces the spread between buying and selling prices. Dan Dolan, director of wealth management strategies for State Street’s Sector SPDR ETFs in the US, seconds this, saying the active two-way market in the ETFs is reflected in their tight spreads. He adds that there is no evidence of short-selling of sector SPDRs contributing to any form of market disruption.” (While I don’t consider myself an expert in shorting or trade settlement issues associated with this debate, I wouldn’t bet against regulatory restrictions of some sort to prevent the possibility of such scenarios from actually occurring (there may already be rules in place which limit short selling e.g. “SEC moves to put limits on short-selling”, but in the meantime I would continue to use plain vanilla ETFs as originally intended and without using market or stop-loss orders.)

In the Financial Times’ “Infighting does not help ETF case”Pauline Skypala reports on the European infighting between ”synthetic ETF providers and iShares, the main provider of traditional (‘plain vanilla’) ETFs that hold index constituents” has essentially prevented creation of an ETF trade group. Pot-shots against ETFs are coming from regulators and (self-interested) mutual fund managers. “Some of the points they make are valid: growing complexity has muddied the concept to some extent, and made it important for investors to understand the nature of any product they buy. They cannot rely on an ETF actually being an exchange traded fund: it may be a credit note that only promises to provide the expected return, rather than a fund that holds ring-fenced securities. The ETF label is frequently used as a blanket term, which can be misleading”. Concerns have been raised about short (inverse) and leverage ETFs, as well as synthetic ones regarding counterparty risks as in the case of collateral held for swaps and “conflicts of interest when banks own an asset manager”. “This is an arcane debate. The complexities of the issues make the arguments hard to follow. It is detrimental to the ETF cause that providers have taken to fighting among themselves, rather than presenting a united front.” (Not sure if I agree; synthetic ETFs which use swaps and other derivatives have different risk characteristics that ‘plain vanilla’ classic ETFs which are built from the components underlying the index intended to be reproduced by the ETF. Perhaps they should be put in different buckets/categories so the retail investors who would like to (and may be better served by) ‘plain vanilla’/traditional ETFs know what they are consuming. And speaking of knowing what one is consuming Vikash  Jain recommends two TSX 60 ETFs as if they were equivalent representation of the index, iShares XIU (a plain vanilla ETF) and Horizons HXT (a swap based implementation), which they are not.)

In the Financial Post’s “Ignoring the core can keep inflation at bay” Lorenzo Bini Smaghi challenges the continued use of core (excluding food and energy) rather than headline inflation numbers to monitor and act upon the threat of inflation. He writes that “for core inflation to be a good basis for forecasting headline inflation, the variations in the prices of agricultural and energy products have to be temporary, and should on average not differ from other prices. If that is not the case, core inflation is neither a good estimate of underlying inflation, nor a good forecast of future inflation…apart from the 2008-09 recession and a few months of 2002, headline inflation is always higher than that of core inflation, both in Europe and the US, with a cumulative difference over the past decade of about 6 per cent in the euro area and the US, and 9 per cent in the UK. The reason is simple. Since 1999, the global index of energy and raw materials prices has more than doubled, as has that of food prices. These increases have not been short-lived at all, but have had a lasting effect…For central banks around the world, this means that core inflation is no longer a very useful indicator for monetary policy, and should probably be abandoned.” And the Financial Times’ Lex column further comments in “Central Banks: Counting up inflation”that “In the past few years, all the usual inflation measures have missed the worst economic distortions caused by bad monetary policy. Negative real policy interest rates have helped inflate asset price bubbles, which artificially stimulate spending – for a while. But normal inflation measures exclude financial assets such as shares and houses.”

In Bloomberg’s “Arnott index derided by Bogle as Witchcraft beats Vanguard fund”Bhaktavatsalam and Lubov discuss Robert Arnott’s fundamental indexing approach and the superior performance in the past 5-6 years over capitalization weighted index funds. They also indicate that Arnott says that “Fundamental indexing in bonds may very well be bigger than in stocks” and that “We’re looking now at how a debt burden affects gross domestic product and capital markets, and it paints a pretty scary picture.” (I would tend to agree with Arnott on the lesser applicability of capitalization approach to bond indexes than stock indexes.) Eugene Fama, who has previously indicated that Arnott’s approach is really a value tilt, suggests that “Arnott’s indexes represent a triumph of marketing rather than an innovation in investing”.

In the Financial Post’s “Mobius: ‘Another financial crisis around the corner’”Mark Mobius is reported to be predicting “another financial crisis is inevitable because the causes of the previous one haven’t been resolved”.  He says “Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.” and “The largest U.S. banks have grown larger since the financial crisis, and the number of “too-big-to-fail” banks will increase by 40 percent over the next 15 years”.

And finally, in the NYT’s “Fears, and opportunities, on the road to retirement” Alina Tugend discusses the “conflicting messages about aging”. Here are some of the messages: “On one hand, I’ve been hearing that life’s “second act” or “encore phase” is supposed to be a time of giving back to the community, of pursuing one’s passion…On the flip side, there are endless stories about those 55 and older who are worried less about hang-gliding than about just hanging on.” “The doctor tells you to exercise and eat well, while the editorial pages tell of a long gray wave of greedy geezers who won’t move aside to let younger workers in.” “There is a current climate that you can’t win for losing: if you work, it’s bad for young people and if you don’t work, it’s bad for young people.” The author says that “the concept of leisurely retirement years is a relatively new one, beginning around the 1950s and 1960s…(and) those post-work years of playing golf and touring the country in a recreational vehicle weren’t supposed to last for 30 years .“ “A lot of smart people are hitting this stage in life and are starting to think and write about it…The big challenge will be establishing an infrastructure so each person isn’t facing this issue on their own”. (There certainly must be lots of low hanging fruit in this domain. Thanks to MB for recommending article.)