Hot Off the Web– September 6, 2010

Personal Finance and Investments

In the WSJ’s “A hedge fund lurking in your 401(k)” Kim and Tergesen look inside very popular target-date funds used in many 401(k) plans, and observe that in an effort to manage risk for those near or in retirement “Some firms are taking wider latitude in jumping from stocks to bonds to reach for higher returns or sidestep losses. Others are even increasing their use of derivatives to hedge positions or change the funds’ asset allocations. The moves bring a new level of complexity—and potentially higher costs—to what are supposed to be simple, transparent vehicles for millions of investment novices. The article indicates a growing use commodities, hedge funds, leverage, derivatives and tactical asset allocation; the result can be complex, expensive, unpredictable and performing poorly in a bull market.

Rob Carrick in the Globe and Mail’s “It’s a big world out there, and you should own a piece of it”reports that “A selection of online portfolio-building tools were tested for this column and each suggested a weighting in global stocks that was close to or greater than the weighting in Canadian stocks. Anything out of line here? Money managers and academics say no.”

Jonathan Chevreau in the Financial Post’s “Investors must stare down the two-headed monster” suggests that we’ll have to live with a few more years of uncertainty, inflation or deflation. As to which is a greater threat, he highly recommends Anthony Boeckh’s recent book “The Great Reflation”. In it the author suggests that “the great reflation is an unprecedented experiment with an uncertain outcome, he calls Greece which hit the financial wall the canary in coalmine, and while in the near-term (which he defines as 2-3 years) deflation is the greater threat “the trick is to discern when (the threat of) inflation will supersede deflation”.

In Daily Finance’s “10 signs your 401(k) plan is a clunker” Daniel Solin warns investors to watch out for: high costs, no investment advice, “revenue-sharing and hidden mark-ups”, non-fiduciary plan advisor, funds underperforming benchmarks, and too many investment options.(Thanks to Ken Kivenko of CanadianFundWatchfor recommending article.)

In the Financial Post’s “Wealth comes with problems for couple with complex investments”Andrew Allentuck discusses the situation where an “affluent couple risks loss of assets and income from a complex portfolio”. The article illustrates the effect of haphazard asset allocation and lack of a clear plan resulting in low returns, well below the 3% above inflation expected from a properly constructed portfolio. There are also interesting hints in the article about timing of CPP, tax planning (value of a testamentary trust), timing of generational asset transfer (including the after tax cost of LTC of transferor) and implication of U.S. succession duties.

Eleanor Laise in WSJ’s “Bruised quant funds seek human touch”reports that quantitative funds (computer-driven mutual funds) have “lagged behind 72% of their category rivals”. Now “the funds’ managers are seeking to make their models a little more like people, by making them more responsive to changing circumstances. That can mean revisiting computer models more often, tweaking their components, or incorporating measures of macroeconomic risk rather than just stock-specific information. Quant managers need to understand “that financial markets are better understood through the lenses of a biologist rather than a physicist,” says Andrew Lo”. The lack of transparency associated with the “black box” approach (you don’t know what’s in it) doesn’t help the funds’ credibility either.

In WSJ’s “Locking in income for life” Lavonne Kuykendall looks at potential encouragement by the U.S. government toward purchase of annuities (if low cost annuities were in fact available their attractiveness and usefulness would no doubt increase). The article also mention combining a systematic decumulation strategy with a pure longevity insurance (an approach that I have been advocating for a while to those whose risk tolerance permits it, but while such insurance products are available in the U.S. for almost five years, they are still not available in Canada; for an analysis of the value of such products you can see my Longevity Insurance- What does it buy you? blog).

Jonathan Burton in the WSJ’s “A simple recipe for investors: Less can be more” writes that “a strong case can be made for investors following a design principle known as KISS, which in this case stands for: keep it simple, saver”. The approach proposed is a balanced 50/50 stock/bond portfolio constructed from low cost index funds and infrequent trading. (Great idea! You might also be interested in reading my old Simple and Cheap ETF Implementation of a Balanced Portfolio blog on this subject.)

In the Globe and Mail’s “You don’t have to be a millionaire to bank on this advice”Rob Carrick interviews the co-founder of TIGER 21 an “exclusive investment club for the wealthy”. The focus/approach of the members of this club is: capital preservation, asset allocation (typically about 30% stock, 25% real estate including personal use property, 10-12% private equity, 5-10% or more in gold, 10-15% bond, and rest in hedge funds), increasing attention to cost, but are worried about a double-dip and the deficit.

Jeff Ostrowski writes in Palm Beach Post’s “Dilemma torments older jobseekers”  that older workers who lost their jobs and are unable to get another one due to weak job markets face a tough decision: spend down their savings or take early Social Security. People who are forced into early retirement by taking Social Security at 62, instead of 66, take a 25% reduction in benefits. “A record 2.74 million Americans filed for Social Security in 2009 and nearly 72 percent of men who filed for Social Security last year took their benefits before age 66.”

Real Estate

The U.S. June data released last week for “S&P Case-Shiller home price indices”indicates a 4.4% higher index in Q2 compared to 2.8% drop in the first quarter and 3.6% higher than 2009. “Housing prices have rebounded from crisis lows, but other recent housing indicators point to more ominous signals as tax incentives have ended and foreclosures continue.” “The worry starts when you remember that the Homebuyers’ Tax Credit has expired, foreclosures are still at high levels, and July data on home sales and starts were very, very weak. The inventory of unsold homes and months’ supply data were particularly troubling. If this relative weakness in demand continues, it will likely filter through to home prices in coming months.”

In the Herald Tribune’s “Housing prices up, yet doubt persists”Tom Bayles looks at the Florida picture, which he describes as having “ominous signals even in the cheery tally of rising prices: Tampa and Miami had among the lowest percentage rebound from the bottom. Neither the Sarasota-Bradenton nor Charlotte County-North Port markets are part of Case-Shiller, but the two economists behind the measure said those markets are likely experiencing the same pressure.” “Long term, Florida’s urban enclaves remain very attractive to retirees and families because of beaches, resorts and theme parks, which have historically drawn new residents. But none of that matters now because so many retirees are stuck in their homes in depressed northern markets.”

In an interesting twist, David Streitfeld in the NYT’s “Housing woes bring new cry: Let the market fall”reports that after “the administration has rolled out just about every program it could think of to prop up the ailing housing market…. there is a growing sense of exhaustion with government intervention. Some economists and analysts are now urging a dose of shock therapy that would greatly shift the benefits to future homeowners: Let the housing market crash. When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve.” (Referred to by CFA Financial NewsBriefs)

The June “Teranet-National Bank House price index” released last week indicates a 13.6% rise in Canada’s home prices compared to 2009. Increases were respectively 16.3% in Vancouver, 16.2% in Toronto, 7.1% in Halifax, 12% in Ottawa, 8.3% in Calgary and 8.7% in Montreal.  “Since the resale market has been slackening across Canada- from April to July of this year, more existing homes came on the market than were sold- it is too early to conclude that the relatively vigorous price rises of April, May and June launched a trend.”

And the debate continues as to whether Canada has a housing bubble, and whether a price bust is coming. The Globe and Mail in “Why Canada’s housing market may be heading for a correction” discusses the arguments between those who are forecasting a marginal drop and those who see a sharp correction in Canada’s home prices. The dramatic drop in month-on-month sales does not bode well even though house prices were still increasing. “Seniors are in the worst spot, the report suggests, because they can’t sit tight and wait for prices to recover. “And even if they can afford to wait, the sheer number of people who will be counting on selling their homes to make their retirement plans viable will mean a buyers’ market.”” But then in another Globe and Mail article Steve Ladurantaye reports that “No housing bust here: CD Howe”. The report is quoted saying that “A comparison of housing market policies in Canada versus the U.S., however, suggests that there is little likelihood of a U.S.-style surge in foreclosures or a collapse of house prices in Canada… “During the U.S. housing boom, both private insurers and government-sponsored enterprises facilitated looser underwriting standards by increasing their exposure to high-risk mortgage products such as low-documentation, interest-only and adjustable rate mortgages” “To the extent that current policies impose on taxpayers a significant exposure to mortgage insurance guarantees and, therefore, some of the aggregate risk of a decline in housing prices, it will be in the interest of all Canadians if policy makers recall the lessons of the 2008-2009 experience should pressures to relax underwriting standards reoccur in the future.”

In last week’s Hot Off the Web I mentioned the Ladybird Deed, as a potentially painless mechanism of transferring (Florida) real estate to the next generation. I asked Robert Keats, author of Border Guidehis thoughts on the subject, and he indicated that consideration should be given to some downsides to Ladybird Deeds, as compared to trusts.  Examples deserving consideration are related to: (1) no protection of a desired alternate outcome if one of the beneficiary children is deceased or is going through a divorce, just as the second parent dies, or (2) if the parent is incapacitated for many years and the property needs to be sold to raise cash, no one has the authority to do that without other provisions in the estate plan. In 95% of these types of circumstances, Keats indicated that he would recommend a living trust as it covers all of the benefits with none of the disadvantages of a transfer at death deed; the living trust can also be used for other assets to avoid probate, not just of the property itself. Where this type of deed might be useful is where you’ve got one single child, a relatively low value piece of property and not a lot of other assets, and the extra thousand dollars it might cost to draft a trust would not be cost effective for that individual.

Pensions

Note that there is an important upcoming event “NRPC and the Canadian Auto Workers union (which represents many former Nortel employees) are demanding that the Government keep the (pension) plans alive and consider investment alternatives more beneficial to the pensioners.  To drive home our demands, NRPC and the CAW will hold a peaceful rally at Queen’s Park (Toronto) on September 15th, beginning at 12 Noon and lasting about 1 hour.” Please attend if you can to help pressure the government to prevent compulsory/automatic annuitization currently the only permissible option for the Nortel pension plan windup.

In the Financial Times’ “Why proceeding with Nest is crucial” Pauline Skypala bemoans the high cost of many compulsory-participation retirement savings schemes like those in Hong Kong, Chile, New Zealand, and Australia. However this does not mean that other countries now considering similar compulsory auto-enrolment plans, should be deterred; instead government just must make sure that the private sector is not allowed a free rein. To be effective government must insure that the low cost benefits of scale are delivered to the citizens rather than the financial institutions.

Things to Ponder

The search for explanations as to what was the root cause leading to the May “flash crash” still continues as some are increasingly wondering if we reached “a point where there has been a dangerous breakdown in investor trust in the way markets work”. This is discussed in the Financial Times’ “High frequency trading: Up against a bandsaw” where Jeremy Grant points to HFT (high frequency trading) and quotes an investment manager indicating that “The mystery and mystique of HFT, the lack of clarity and therefore opacity has meant that retail investors – who have obviously been terribly burned over the last few years – look at this and say: ‘this whole Wall Street thing is just rigged against me’.” In the U.S. and Europe, 56% and 38% of all trading by value can be attributed to HFT, yet HFTs may not really be contributing to liquidity. The author also discusses how “HFT, coupled with the fragmentation of trading across venues, makes it harder to rely on one of the most basic functions of the markets: orderly and fair price formation.” “Because of the predatory nature of some participants we have no incentive to post liquidity”.” Knowing that a certain exchange’s system is about to run more slowly gives a trader an opportunity to set up a buy or sell order in advance. The process is called “quote stuffing” and is used in a strategy known as “latency arbitrage” – latency referring to the speed at which message traffic moves through a system.” There is increasing concerns that HFT operations can lead to systemic risk. Quote stuffing is also discussed in the WSJ’s “SEC probes cancelled trades” where Lauricella and Strasburg write that “Some in the market suspect the flood of orders is the result of high-frequency traders attempting to profit from tiny discrepancies in stock prices. They say waves of orders slow down electronic stock-trading networks or otherwise distort stock prices, creating profit opportunity to buy or sell at artificially high or low prices.” Regulators are investigating the combination of sub-penny pricing and quote-stuffing as potential means of market manipulation.

Vellacott and Valente in Reuters’ “Warnings mount as retail ETF surge gathers pace” discuss “worries over opacity and liquidity” of some new ETFs which were intended for institutional use but get significant retail investor uptake. The original intent of ETFs was to be low cost, passive, and highly liquid investment vehicles, but more and more new ETFs are esoteric investment with unpredictable behaviour. “While most ETFs hold straightforward baskets of assets, some also hold derivatives of the underlying securities, including swaps, futures and options, and seek to outperform the index they track.” “…in volatile markets, liquidity in the underlying securities could stall potentially opening up a large gap between the value of shares in the fund and the assets it tracks.” (From CFA Financial NewsBriefs)

Legg Mason’s Bill Miller writes in the Financial Times’ “US large-cap stocks are bargains of a lifetime” that “The summer of 2010, though, when most global markets are down, pessimism about the future is high, and macro concerns predominate, is one of those rare periods where one can reliably adopt a long-term strategy that promises (but of course cannot guarantee) returns superior to what just about everybody else is now doing…It’s a truism in capital markets that the best investments are those that have previously done worst, where expectations are low, demand is down, and prospects appear at best highly uncertain…US large capitalisation stocks represent a once-in-a- lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices.”

In the Financial Times’ “Beware the ending of a bond epic”Jonathan Davis writes that “Despite an unprecedented amount of monetary stimulus, record inflows have driven yields all along the curve to their lowest levels for not just one, but in some cases two, generations.” And referring to the current low interest rates, he suggests that “By the standards of the 20th century these are extraordinary figures which, if taken at face value, imply that inflation is not only dead but more or less permanently buried. In the short term they seem to point not just to a double dip recession, but to outright deflation continuing for several years. To purchase and hold to maturity a long-dated US Treasury or UK gilt at today’s yields is a remarkable act of faith in an unproven thesis.”

However, in the Globe and Mail’s “However you slice it, this has been no garden variety recession” David Rosenberg writes that “After all the monetary, fiscal and bailout stimulus, the economy should be roaring ahead, as would be the case if the economy were coming out of a normal garden-variety recession. The fact that there has been no sustained response is testament to the view that this is not actually a traditional recession at all, but something closely resembling a depression.” And, unlike Bill Miller above, he concludes with a very pessimistic “We may wake up to find out a year from now that whoever was buying the market today under an illusion of a forward multiple of 12-times earnings was actually buying the market with a 17-times multiple.”