Hot Off the Web– March 7, 2011

Personal Finance and Investments

We’ll start with a well worth reading of a Richard Stolz interview with Robert Arnott who is the architect of and stakes claim on the superiority of fundamental indexes (which some don’t believe to be an indexes but really a value oriented selection of stocks) over the more common capitalization weighted ones in “Robert Arnott on the limitations of traditional market indexes and future equity returns”. In the interview Arnott addresses various topics: cap-weighted indexes are really ‘popularity’ weighted indexes and a more sensible approach is to weight them according to the size of the businesses, fundamental index adds value by the “rebalancing…against wherever the market is making its most extreme bets” and just because stocks might have produced double digit returns over the past 80 years with dividends now in the 2% rather than 5% range lower returns should be expected going forward. For his inflation protection toolkit, Arnott lists not just TIPS and REITs, but also emerging market stocks and bonds, high yield bonds, gold and oil (but he suggests that you should select those that are currently relatively cheaply priced).

In the Globe and Mail’s “Ignoring the fine print on disability insurance could cost you”Preet Banerjee warns readers that “It is very important to understand that the exact definitions and clauses vary between insurance companies. Some policies state that you must be unable to perform all functions of your job, whereas some may state you must be unable to perform only the major duties of your job. It is very important to sit down with a knowledgeable insurance agent to go over all the details of your disability coverage.” He specifically mentions the difference between “regular occupation” and “any occupation” clauses, and whether there is an automatic shift from the “regular” to the “any” category after two as is the case in many policies.

In Bloomberg’s “Vanguard topping Fidelity shows shift to independent advisers” Christopher Condon writes about the inroads that RIAs (U.S. Registered Investment Advisors) are making inroads over brokers by offering  fee-only (mostly a fixed percent of assets), independent advice, built on an open architecture (i.e. can chose the best products on the market rather than being restricted to products offered by their employers), using low-cost liquid index vehicles (ETFs), and having a “legal duty to put clients’ interests first”.

William Baldwin in Forbes’s “Six ways to get income during retirement”list two bad ways to generate income (expensive funds and ‘covered call’ schemes) and good ways  to generate not necessarily income but cash flow (which is what one really needs); these include: invest for total return and use an automatic withdrawal plan, high yield stocks, junk bonds, annuities)

In the Financial Post’s “We need better financial advice”Jonathan Chevreau  quotes Saul Schwartz in his “controversial “fox in the chicken coop” criticism of the financial industry’s dominance of the Financial Literacy Task Force…who says the report “reads like the soothing words of the foxes, spoken upon taking command of the chicken coop.” he suggests instead “New Zealand’s Citizens Advice, whereby governments provide free objective advice to citizens on topics as varied as what refrigerator to buy to how to buy stocks. This model has also been used in Europe. “My main point is we need impartial advice.””

In the Globe and Mail’s “Maxed out RRSP? Try a life insurance strategy” Ted Rechtshaffen  suggests that if you are 40 years old and you maxed out your RRSP a good way to ‘most likely’ get 8% tax free return by insuring the life of your essentially healthy 70 year old mother (U.S. female life expectancy is about 16 years, i.e. half will live longer, and healthy female 70 year olds even longer) by paying  $12,000/year for $180,000 life insurance which grows annually by the premium paid; so after 15 years you’ll have $360,000 of insurance for the $180,000 premiums you paid. (I may be unique but I find the thought of taking steps for profiting from one’s mother’s death in this manner somewhat distasteful, and the thought of benefiting from her earliest death even more so.  Instead, investing in a diversified stock portfolio will get you pretty close to the $360,000 on an after capital gains tax basis at the end of 15 years, but of course you are now exposed to market risk instead of your mother’s longevity risk; this is because if she lives longer than age 85 the amount of insurance is capped at $360,000, whereas your stock portfolio will continue to grow. Additionally, with the stock investment, if your financial circumstances change you can stop paying the $12,000/year and have access to the stock portfolio any time for emergencies. And by the time your mother hits age 90 the expected value of the stock portfolio (at 10% total return) might be an after tax $477,000 vs. only the ‘guaranteed’ $360,000 for insurance policy whenever she dies.)

And speaking of insurance in Bloomberg’s  “Accidental death becomes suicide when insurers dodge payout” David Evans writes on the ways insurance companies try to avoid or at least delay paying claims. ““It’s their job to protect the insurance pool by blocking undeserved payouts,” Langbein says. That doesn’t give them the right to wrongly deny claims, he adds. “There’s a profound structural conflict of interest,” he says. “The insurer benefits if it rejects the claim. Insurers like to take in premiums. They don’t like to pay out claims.” .…The money life insurers refuse to pay to people like Jane Pierce is emblematic of how the industry is increasingly making efforts to delay paying out benefits. In the past two decades, insurers have made a common practice of keeping money owed to survivors in their own investment accounts, even after claims are approved. (Thanks to CFA Institute Newsbriefs)

In the Financial Times’ Lex column “Annual reports v SEC 10-K fillings” it advises that “Shareholders tend to ignore these horrendously presented filings in favour of annual reports with glossy photos of management gifting wind farms to poor communities. That is a mistake. The 10-K is one of the best sources of information investors can get.”  They suggest that you start with item 7 (the management report) then risk factors in item 1A, differences between GAAP and non-GAAP measures and then footnotes.

In the NYT’s “A planning aid, but not a road map” John Wasik compares online retirement calculators to GPSs, in that “they will  give a general idea of how to reach your destination, they won’t necessarily show you the best route or steer you away from the worse roads.” He then points to an extensive list of retirement calculators that you may wish to explore.

Real Estate

Scotiabank’s Global Real Estate Trends indicates that “Taking into account the long-term rising trend in house prices relative to income, the current overvaluation in average Canadian home prices is probably around 10%….We expect the adjustment to restore long-run affordability will be relatively orderly given a low share of high-risk mortgages, only gradually rising interest rates, and continued population and income growth. Assuming flat nominal home prices (i.e. modest real price declines) and annual income growth of 2% per worker, the average price-to-income ratio would return to its long-term trend by mid-decade.” (Though it’s not obvious to me why one should take it for given that we’ll have a continued increase in the Canadian House Price to Income Ratio trendline; a graph of the trendline in the report shows it to have increased from 3 to 5 between 1980 and 2010. In fact, if a primary cause of the increasing ratio was due to decreasing interest rates over that period, a reversal of the interest rate trend will probably lead to a lowering of this ratio.) On the same topic, in the Globe and Mail’s “Home prices nearing bubble territory but cool-off expected” Julian Beltrame reports that  according to the Bank of Montreal “unless there is some moderation in sales and prices, the market could be setting the stage for a major correction…“While we do not expect a significant correction nationwide, the risk of such would increase, especially in some regions, if prices were to continue to outrun incomes or if interest rates were to increase rapidly”… The bank says there should be no major correction if incomes increase faster than home prices in the future, as expected. It says sales are expected to cool and prices to stabilize this year in response to higher interest rates and tighter mortgage rules that go into effect later this month.”


CLC president Ken Georgetti argues forcefully on the superiority of an expanded CPP over PRPP in the Toronto Star’s “CPP a better bet than private plans”. He says “Left completely on their own, people have saved too little for retirement and far too much of what they do manage to save is swallowed up by the outrageous management fees charged by investment advisers and financial institutions…. if we don’t do something the cost of providing GIS to beneficiaries will rise from $9.2 billion in 2011 to $22.2 billion in 2030.” His argument in support of an expanded CPP includes the matching employer contributions and the lower cost of the CPP as compared to private investment options available in Canada. (An expanded CPP might be a necessary but not sufficient solution to the systemic failure of Canada’s pensions, even without a matching employer contribution for incremental savings. Furthermore recent articles have suggested that CPP, while much cheaper than private sector options, is not as low cost as thought by many, with investment management and administrative costs as high as 1%; some large scale U.S. based 401(k) plans have ‘all in’ costs as low as 0.2%.)

Tara Perkins in the Globe and Mail’s “OMERS wants in on private pension plans” reports that “Pension funds want Ottawa to let them in on the new private-sector retirement savings pools, allowing the funds to compete head-to-head against banks and insurers.” The CEO of OMERS argues that insurance companies should not be the only ones which can participate in offering investment vehicles with the proposed PRPPs. (The field should be opened up even further, including non-profit mutual investment companies like Vanguard in the U.S. and costs must benchmarked against the lowest available in the U.S.)

In the Huffington Post’s “Blame Wall Street, not hard working Americans, for the pension fund fiasco”William Lerach writes that responsibility for public pension fund deficits should not be laid to the feet of so called “greedy unions (which) extorted extravagant and now unaffordable benefits which justify pension cutbacks and union-busting. This is a false. The real cause of the pension fund debacle is the greed of Wall Street and its corporate allies. It’s a result of their dismantling of our nation’s regulatory safeguards and Wall Street’s capture and abuse of America’s public pension funds — charging them huge management fees, while losing trillions of dollars of pension fund assets in risky investments.” (You can argue that Wall Street had a significant hand in the sorry state of the public sector pension plans, but the analysis as to the root causes are much more complex than that alone, and the solutions proposed by Lerach, the creation of 7-8% TIPS exclusively for public sector pension plans, are nothing more than a Federal government bailout (paid for by tax-payers) for the state and municipal pension plan shortfalls. It’s unlikely to happen.)

Things to Ponder

In the Globe and Mail’s “Forget boring: It’s time to be wary”Tom Bradley indicates that his approach to investments is similar to Seth Klarman’s “Worry top down. Invest bottom up”.  Bradley advises being “approximately right” means not trying to time the market, still aiming for the strategic asset allocation but allowing some slight deviations, perhaps lighten up on bonds a little in favour of cash and watch for equity overvaluations.

Mark Trumbull in the Christian Science Monitor’s  “Don’t blame Federal Reserve for record-high food prices” writes that with world food prices are at a 21 year high, gasoline prices up 49% in six months and U.S. CPI up at an annual rate of 3.2% in the past six months, some are starting to worry about 70s style ‘stagflation’ (rising prices and high unemployment). “Even if Bernanke is correct that the Fed’s easy monetary policy isn’t behind the oil and food price trends, the global patterns could have implications for the US economy. A sustained rise in commodity prices, he acknowledged, “would represent a threat both to economic growth and to overall price stability, particularly if [it] were to cause inflation expectations to become less well anchored.”…. Like in the 1970s, many nations – including China – effectively peg their currencies to the US dollar, and one result is close parallels in monetary policy. An easy policy may make sense for the US, given America’s current high unemployment rate. But that doesn’t mean Asia benefits from similar policies right now, or that the Fed should make its policies simply by looking at US conditions in isolation from the rest of the world. One other risk factor: High levels of government debt in many advanced nations may tempt officials to view moderate inflation as a backdoor way of reducing the debt burden.” (Thanks to CFA Institute’s Financial Newsbriefs for recommending.)

The Bloomberg’s Roger Lowenstein writes that you should “Beware of market gurus with new strategies” in reference to a new book by James Glassman, author of 1999 book “Dow 36,000”. “As for Glassman’s second “change,” back in the days when he was writing “Dow 36,000” he considered “only one kind of risk” — price volatility. Volatility is what you can learn from a price chart. If markets were dice, charts would be sufficient. Roll enough dice and you will discover that snake eyes occur once in every 36 rolls. And those would be dependable odds in the future. But markets, Glassman learned, are also subject to “a second kind of risk” — better known as uncertainty. This refers to risks that can’t be captured in price data, such as the chance of a terrorist incident or a depression. You can’t quantify the odds of a depression simply by knowing that we had one in the 1930s and haven’t had one since.”

John Kay writes in the Financial Times’ “Don’t blame luck when your models misfire”that “The source of most extreme outcomes is not the fulfilment of possible but improbable predictions within models, but events that are outside the scope of these models… There are no 99 per cent probabilities in the real world. Very high and very low probabilities are artifices of models, and the probability that any model perfectly describes the world is much less than one. Once you compound the probabilities delivered by the model with the unknown but large probability of model failure, the reassurance you crave disappears… Insurance companies do fail, but not for the reasons described in such models. They fail because of events that were unanticipated or ignored…the search for objective means of controlling risks that can reliably be monitored externally is as fruitless as the quest to turn base metal into gold. Like the alchemists and the quacks, the risk modellers have created an industry whose intense technical debates with each other lead gullible outsiders to believe that this is a profession with genuine expertise.  We will succeed in managing financial risk better only when we come to recognise the limitations of formal modelling. Control of risk is almost entirely a matter of management competence, well-crafted incentives, robust structures and systems, and simplicity and transparency of design.”

In the Globe and Mail’s “Ben Bernanke warns of U.S. deficit’s ‘near and present danger’” Kevin Carmichael reports on Mr. Bernanke’s recommendations to Congress: “Draw up a rigorous deficit-reduction program, but delay its implementation until the economy is comfortably on track…The idea is to keep the bond vigilantes at bay. If investors are reasonably confident that U.S. politicians are serious about the country’s fiscal problems, they will continue to lend the government money at reasonable rates. But if investors lose faith, the cost of financing a public debt that is projected to climb to $17-trillion by 2020 will become more expensive, making the current fiscal challenge even harder. The reason for urgency is that it is impossible to know when market sentiment will turn.”

And to prove the seriousness of the situation in the U.S. Henry Bloget in Business Insider’s “Here’s the only chart you need to see to understand why the U.S. is screwed” provides two charts covering F2010 of U.S. government finances, a breakdown of the $2.2T revenue and the breakdown of the $3.5T expenses; the so called entitlement portion of expenses represents 58% of the pie, defence and interest are 20% and 6% respectively, leaving only 16% of what might be considered discretionary spending. Even zeroing out the 600B discretionary spending would only reduce expenses to $2.9T still leaving a significant de $700B deficit. Bloget says that “as horrifying as these charts are, they don’t even show the trends of these two pies: The “expense” pie is growing like gangbusters, driven by the explosive growth of the entitlement programs that no one in government even has the balls to talk about. “Revenue” is barely growing at all. (Thanks to Ken Kivenko for recommending the article)

Barry Eichengreen in the WSJ’s “Why the dollar’s reign is near an end” reports that “Fully 85% of foreign-exchange transactions world-wide are trades of other currencies for dollars…The Organization of Petroleum Exporting Countries sets the price of oil in dollars. The dollar is the currency of denomination of half of all international debt securities. More than 60% of the foreign reserves of central banks and governments are in dollars…” However he believes that all this will change in the next 10 years.  He argues that the dollar became so dominant because of: the depth of dollar denominated markets, the dollar is a safe haven, and there are not many credible alternatives today. However all this will change in the next decade. The author sees two viable alternatives: the Euro and the Yuan.

And finally, Jeff Rubin in the Financial Post’s “Only a recession stands in the way of $200 oil” predicts that with supply and demand moving in opposite directions, plus the growing instability in the Middle East and speculators pilling into oil, $200 oil is unstoppable; however he appears to be betting on a oil price induced recession well before $200 reached.


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