Hot Off the Web– October 11, 2010

Personal Finance and Investments

The WSJ’s Alex Tarquino writes in “The perils and pitfalls of ETF investing”that “while ETFs have helped keep many investors in the market, the more arcane, niche-oriented products being introduced of late — and there are now more than 1,000 funds from which to pick — have created potential booby traps that even many pros didn’t anticipate….(also) studies suggest that many ETFs are having trouble keeping up with their main promise to investors: to stay as close as possible to, or “track,” the index they’re supposed to follow, whether it’s oil, gold or a breed of companies. Critics say that in a few worst-case scenarios, ETFs’ performance has been exactly the opposite of what their marketing would suggest.”  The recommendation is to stay with broad index (original intent of ETFs) and high capitalization ETFs (>$50M to reduce the risk of fund closures), avoid leverage (“all 52 leveraged ETFs operating since January 1, 2008 lost money”), very narrowly focused niches (“speculation in disguise”) and futures based (unless it’s the only way to get exposure to asset class) ETFs.

According to Tom Lauricella in WSJ’s “Annuity shopping made easier”Vanguard has introduced a simple and highly transparent service to purchase immediate fixed annuities. The Vanguard service, unfortunately only available to Vanguard clients, provides annuity quotes from 8-10 insurance companies with high financial-strength ratings and a low (2%) commission and selectable options.

In the WSJ’s “Gold mania? Not quite”Brett Arends writes that “Through the end of July, according to FRC, investors poured $22 billion into emerging markets mutual funds. And a remarkable $155 billion into bond funds. Compared to these figures, the amount invested into gold is chickenfeed…. If you want to play this bubble and you think it has a long way to run, but you want to minimize your risks, one smart way is to buy “out of the money” call options. They’re like a long-odds bet on a price jump. That gives you plenty of upside in a boom with small risk. Building positions in stages, instead of jumping all-in at once, remains the way to go.”

Jonathan Chevreau in the Financial Post’s “Defending the indefensible”describes the Canadian mutual funds industry’s attempt to argue that the media’s “misinformation” that management fees are high is false and there isn’t sufficient ‘value’ placed on the advice that comes with the fees. (I can’t figure out why this is still an issue for investors, when they can just go out and buy index based ETFs with 0.1-0.3% MERs; those who still buy the 2.5% ETFs perhaps deserve little sympathy.)

In the Globe and Mail’s “Don’t play with risk inside your RRSP”Avner Mandelman suggests “A big mistake even seasoned investors make in their private finances is to take too much risk in their RRSP…just as gains in your RRSP are not taxable, losses in it aren’t tax-deductible either, so there is nothing to cushion the pain of losses.” “I look for shorter-term investment-grade corporate bonds, maturing in three to five years, where the cash flow coverage is sufficient, but not ample, to cover interest payments. I prefer cash flow to be twice or more debt payments. As for the principal, I also insist that there must be ample assets to pay off the bonds.”

Karen Blumenthal in the WSJ’s “Five common 401(k) mistakes”lists the common mistakes such as: thinking that the most important decision is asset allocation rather than how much you actually save, limiting amount invested to just get the company match, considering your own 401(k) in isolation rather than looking at all the family’s investments holistically, overinvesting (>10%) in your own employer’s stock, and picking funds only on the basis past performance without consideration of fees.

Real Estate

In WSJ’s “Why are distressed homeowners still paying their mortgage?”Brett Arends explores the question of why underwater homeowners still pay their mortgages. “I’ll confess this issue makes me uneasy. But my feelings are almost certainly awry. We live, alas, in a world, and an economy, which rewards ruthless self-interest and penalizes “morality.” Just look at the big banks. A mortgage isn’t a blood oath, it’s a business contract—a collateralized loan. It isn’t simply a promise to repay the lender. It’s a promise to repay the lender or to forfeit the home. Isn’t someone simply fulfilling their contract by handing over the keys when asked? The banks knew full well what the fine print said when they made the loan. And so they should: They wrote the fine print. The economy will suffer if more homeowners default. But it will suffer if they don’t. Those bad debts are doomed and need to be written off. Why should the homeowners eat them rather than the banks? Why is the reckless lender more at fault than the reckless borrower? Japan struggled for 20 years with “zombie banks”—so called because their debts, if properly recognized, made them insolvent. Here in America, we have millions of zombie homeowners. Why is this any better? Businesses make secured loans against property or collateral all the time. If the loan goes bad, the lender takes the collateral. Nobody expects executives to dip into their own pockets …”

In the Financial Post’s “’Demographic shock’ challenges security of real estate” Jonathan Ratner quotes “The strategist and economist said the drastic decline in this age group in many advanced countries is a relatively unknown phenomenon. He highlighted the “demographic shock” that awaits the euro zone and Japan over the next five years as being particularly pronounced. “With demographic forces about to get into full swing, the popular belief that real estate constitutes a preserver of wealth will be challenged,” Mr. Marion said in a note. He warned that the resulting decline in home prices will lead to an erosion of household wealth, and will likely impact consumer behaviour.”

The WSJ’s opinion piece “The Politics of foreclosure” argues that the halt in foreclosures is all politics by writing that “Talk about a financial scandal. A consumer borrows money to buy a house, doesn’t make the mortgage payments, and then loses the house in foreclosure—only to learn that the wrong guy at the bank signed the foreclosure paperwork. Can you imagine? The affidavit was supposed to be signed by the nameless, faceless employee in the back office who reviewed the file, not the other nameless, faceless employee who sits in the front. The result is the same, but politicians understand the pain that results when the anonymous paper pusher who kicks you out of your home is not the anonymous paper pusher who is supposed to kick you out of your home…If evidence emerges of policies or actions that wrongly threw people out of their homes, by all means investigate and prosecute violations of law. But allowing people to live in homes without paying for them is not cost-free.” There are costs which are borne by MBS holders, servicers, and taxpayers who guarantee the mortgages. But “The bigger damage here is to the housing market, which desperately needs to find a bottom by clearing excess inventory and working through foreclosures as rapidly as possible. The moratoriums further politicize the housing market and further delay a housing recovery”. For masochists here are other articles tackling different perspectives of the same subject are “Foreclosure freeze adds to US woes” “Foreclosure sales freeze leaves buyers in the cold”, “Foreclosures: It’s getting harder to retake homes the banks don’t even want”, “In foreclosure controversy, problems run deeper than flawed paperwork”

In the Herald Tribune’s “U.S. real estate on sale, foreigners discovering”Michelle Conlin writes that in Miami “Individual investors from as far as Argentina, Canada, Colombia, France, Israel, Italy, Norway and Venezuela are swarming the city’s sales offices to get in on what they see as one of the greatest real estate fire sales in the history of the United States…Miami is hardly the only hot spot for buyers from outside the United States. Real estate brokers say they have seen a surge in Washington, New York, Las Vegas, Los Angeles and San Francisco….This year in Phoenix, for the first time, there have been more buyers from Canada than from California, according to real estate data outfit Information Market.” But “In many places, prices continue to fall. What happens if currency values reverse and a foreign owner needs a quick sale? Or a renter bolts in the middle of the night, leaving an empty unit and no cash flow? It’s not as if foreign buying can be counted on for a housing market turnaround. Overseas buyers represent a mere 7 percent or so of today’s total. Yet in some cities, such as Miami and Washington, the foreign sales are helping to stabilize the markets.”

Edward Chancellor in the Financial Times’ “Why housing bubbles remain”looks at the differences in the housing markets: the US crash versus the UK, Spanish and Australian not (yet) fully deflated markets. “The ratio of Spanish house prices to disposable income climbed from 3.8 times in the late 1990s to 7.7 times by 2007.” Yet it has only come down 15% from the peak. There are differences in supply and financing methods but the “unburst bubbles remain a potential source of vulnerability to the global financial system”.


Pauline Skypala in the Financial Times’  “Help needed as pension burden shifts”looks at the excitement in the financial advice industry about the population’s “movement back to financial responsibility”; the realization that the reliance on high future investment returns and rapid housing appreciation will have to be replaced by increased need to save. However Skypala is wondering if the designers of savings products are up to the implications of this. Target date funds were first products aimed at this space and the variety of risk levels taken in these funds showed that not all were ready for the financial crisis.” Running funds for DC pensions as if they were just a means to getting exposure to assets with growth potential is unhelpful. To use industry jargon, the saving journey should be about outcomes not products. The question is how to get to the required outcome, in terms of annual income. Just saving with no idea of what you might get at the end is not financial planning.”

In last week’s Hot Off the Web I mentioned Patrik Marier’s report in which he reviews Canada’s retirement income system and what we could learn from abroad or even Saskatchewan. I’ve tried to summarize Marier’s extensive report “Improving Canada’s retirement saving- Lessons from abroad, ideas from home”in which he lauds Canada’s retirement income system for reducing seniors’ poverty, but having failed at maintaining workers’ standard of living in retirement.

Things to Ponder

After last week’s SEC report suggesting, somewhat unbelievably, that a single fund’s hedging trade initiated the ‘flash-crash’, the Barron’s Jim McTague in “The real flash crash culprits”points to different culprits based on the data in the same report. “The official explanation of the May 6 tumult, which saw the Dow plunge by nearly 1,000 points before largely recovering, does not hold up beyond a reasonable doubt….the jargon-encrusted back pages of the report suggest that far greater damage was inflicted on investors that day by their brokerage firms. The brokers abandoned them to the wildfire…The fact is, high-frequency traders and brokerage houses acting as market makers did more to drive down prices. They stopped buying and started selling…some of these players reduced executions of sell orders but continued to execute buy orders. In other words, they’d sell stock to a retail customer but wouldn’t buy stock from a retail customer. They wanted to get rid of their own inventories, not accumulate more shares. So they sent the customer sell orders onto the swamped stock exchanges.” (Now that’s a little more credible story.)

Wagstyl and Oakley in the Financial Times’ “Bubble fears as emerging markets soar”discuss the pros and cons of the debate on whether emerging markets are overheated or not. Arguments supporting the overheated position include: destabilizing effect of “heavy capital inflows” driving up currencies, some emerging markets at all time highs, a 275 bp bond spread to US government debt and some analysts say that ““These are generally still poor countries with weak institutional structures, huge levels of income inequality, political fissures, difficult business environments and high levels of corruption” and it is unclear which of these is already priced in. The ‘not overheated’ arguments include: P/E of about 13 on 2010 earnings, currency appreciation, they account for 30% of global GDP they are only 2-7% of developed country financial institutions’ assets,

While some analysts are still predicting decade long deflation, others are concerned about the fed’s new quantitative easing pronouncements (QE2). The WSJ’s opinion piece “The ‘Limited Inflationists’” discusses arguments suggesting that ‘some’ inflation is good (<2% is bad) but they are “downplaying the costs and risks”. The article quotes the father of the modern Fed, Chairman Martin warned (and was then proven right during the 70s) that “There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions”. Another indicator of investors’ inflation fears is provided in Michael Mackenzie’s Financial Times article “Investors price in US inflation fears”reporting  that “breakeven inflation rates, which are the bond market’s expectations of future inflation levels (represented by the “difference between yields on cash Treasury bonds and those of Treasury inflation-protected securities”), have leapt on the growing belief that the Fed will initiate a fresh round of quantitative easing. Breakeven rates for the 10 and 30 year Treasury bonds increased to 1.98% and 1.31%, respectively.

In the Financial Times’ “Barbarians at the gate of complexity” John Kay recommends Joseph Tainter’s book “The collapse of complex societies”which tries to “explain why the sophisticated society of ancient Rome, with its advanced weaponry and powerful armies, fell victim to a less developed people” and how this applies to modern societies like the  US. “The defining characteristic of civilization is the complexity of its organization. But complexity breeds complexity, and is subject to diminishing returns. Eventually the costs of increased complexity exceed the benefits. The greatest achievement of the Romans was territorial conquest. The peoples of the empire initially benefited from law and order and technology. But as the empire grew, the costs of central organization rose and the benefits of further expansion became ever more marginal…. The nature of bureaucracy is to generate work for other bureaucrats to do.… (And today,) Trading in securities naturally invites trading in derivatives…The volume of activity, and the number of people employed in financial services, increases more rapidly than the number of people employed in the underlying trade in goods and services.”

In the Financial Times’ “The rise and rise of correlation”Sakoui and Kaminska write that “Like fish swimming in shoals, shares in the world’s largest companies have see-sawn in lockstep as investors have bought heavily only to head for the exits later. This indiscriminate buying and selling, also called “risk-on, risk-off” trading, has characterized the sharp swings in equity markets during the summer sell-off and later rally… Most active fund managers add so-called “alpha”, or risk-adjusted returns, by focusing on earnings fundamentals and relative valuations. But rising correlation means that their work has gone unrewarded – stock moves have tended to be driven by sentiment about the direction of the global economy and little else.” According to one study, the reason for the rising correlation is a combination of growth in index investing (using ETFs) and high frequency trading. But not everybody agrees; some argue that the rise in correlation is a combination of increased globalization and the historical increase in correlation during crises.

Michael Milken in the WSJ’s “Toward a new American century”lists six areas of required changes to re-launch America’s pre-eminence: housing (stop government incentive driven misallocation of investment into housing), entitlements (“unrealistic promises of overly generous health and retirement benefits” by private companies, as well as state and local governments), education (teacher quality is the driver), health (advances from massive increase of government investment in medical research “would lessen pain and grief while yielding enormous productivity benefits” and individual responsibility in prevention by lifestyle changes), immigration (the debate should be refocused from the undocumented and low skilled to the encouragement of highly educated and investor class immigrants), and energy (recognition that “energy security is at least as important as cotton and tobacco whose prices we support. Oil needs similar support…”)

In the Financial Times’ “Big Mac index gives more than a taste of true worth” Steve Johnson looks at what Purchasing Power Parity (PPP) based currency valuation, as defined by the cost of a Big Mac (Big Mac index calculated by The Economist) in various parts of the world, tells us in these time of high currency volatility and threat of competitive devaluations. Based on the Big Mac index  “the currencies of China, Malaysia, Thailand, Indonesia, Taiwan, Egypt and South Africa are all at least 30 per cent undervalued against the US dollar…emerging markets account for more than 50 per cent of world gross domestic product on a PPP basis, but under a third on a dollar basis.”

In Knowledge@Wharton’s “In a withering market, where will your investments grow?”,the limited landscape of investment opportunities is looked at and the perceptive conclusion is that “Because of the decline of the stock market, many investors are reducing if not eliminating their stock market positions. This is a more serious problem,” says Marston. “Investors who have given up on volatility are going to have to settle in and live on bond returns … [Government] bond returns, in the long run, have an average return adjusted for inflation of 2% to 2.5%. If investors have saved so much money that they can settle into bonds, that’s great news for them. But most Americans haven’t.” (Thanks to VP for recommending the article)

Frightening statistics are presented by Scott Hamilton in Bloomberg’s “Global government debt level are on ‘explosive path’, S&P says” . “Based on current fiscal policies, median net debt as a percentage of gross domestic product in 49 economies accounting for more than two-thirds of the world’s population will rise to 245 percent by 2050… As aging populations drive up costs for pensions and other social services, increases in debt will likely lead to sovereign-rating downgrades unless governments change their fiscal policies… Spending pressure will push up government debt to about 750 percent of economic output in Japan by 2050, around 590 percent in the Netherlands and 510 percent in Greece, S&P said. The average government deficit may climb from a current level of 4.5 percent of GDP to more than 6 percent by the mid-2020s based on current fiscal policies”.

And finally, there is long but fascinating story about the cause of the Greek financial crisis, community/individual psychology, the life of Greek monks and their business strategy in Vanity Fair’s article “Beware of Greeks bearing bonds” by Michael Lewis.


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