Hot Off the Web- January 16, 2012

Personal Finance and Investments

In WSJ’s “Does total freedom boost returns?” Karen Damato discusses tactical asset allocation (TAA) funds where managers have leeway to move money between asset classes (e.g. stock funds, bond funds, cash, real estate and commodities) in the hope of avoiding or minimizing the impact of market swoons (e.g. going to cash) or improving returns (e.g. reducing/increasing allocation to perceived expensive/cheap asset classes). A recent article reported that 75% of advisors believed that TAA over time can outperform. (Another article on the subject “Not going tactical could pose real business risk, advisors fear”suggested that TAA was a key element in the value proposition of advisors, even as it questioned the ability of advisors to time the market.) The Vanguard group, after five years of disappointing results with their TAA fund are terminating the fund and argue that “when fund managers have very wide discretion on how to invest…all you are doing there is increasing the distribution” of results—from big gains at the funds whose managers make astute shifts to big losses at those who blow it. That potential for wide variations relative to a benchmark is, to us, much more risk for the average investor…” Damato includes a list of questions to ask the managers by those contemplating investing in a TAA fund including: “Is there a baseline asset allocation? What is it?”, asset classes used, basis upon which change allocation decisions are made, min/max limits for each asset class, manager’s objective, are hedging and shorting used? (My personal approach is anchored around a risk tolerance based strategic asset allocation, with ‘some’ minimal TAA at the fringes.)

In the NYT’s “Everyone should use the overnight test” Carl Richards suggests you consider the “overnight test”. If somebody sold all your investment one night and you woke up with 100% cash, “Here’s the test: you can repurchase the same investments at no cost. Would you build the same portfolio? If not, what changes would you make? Why aren’t you making them now?”

Burton Malkiel in the WSJ’s “Where to put your money in 2012” writes that Treasury bonds are likely to be sure losers after inflation and corporate bonds won’t be much better. Over the long term “…with no change in valuation, U.S. stocks should produce returns of about 7%, five points higher than the yield on safe bonds. Moreover, price-earnings multiples in the low double digits, based on my estimate of the earning power of U.S. corporations, are unusually attractive today”. “Emerging markets offer the best prospects for both equity and bond returns over the next 10 years.” Emerging economies are favoured by: fundamental factors (favourable fiscal balances, low debt ratios) and demographics.

In the Globe and Mail’s “Seven millionaire myths”Claire Bradley “Maybe you see a pattern here: today’s millionaires are people who live within their means, budget and spend wisely, and focus on financial independence first. These are habits that take discipline, but ones we can all adopt to begin growing wealth. If these facts prove anything, it’s that every one of us can strive to become a millionaire – you can start by driving your old car with pride.”

In the Financial Times’ “Do hedge funds offer value for their fees? No” Jonathan Davis discusses the value added, or not, by hedge funds and mentions (an industry insider) Simon Lack’s new book “The hedge fund mirage”in which he raises the issue of “the disproportionate way in which the rewards of success are distributed between hedge fund managers and clients…(between 1998 and 2010, hedge fund managers) took 84 per cent of the investment profits their funds made, leaving just 16 per cent for the investors…(adjusting) for survivorship bias, fund of funds fees and so on, it is probable…that hedge fund managers have kept all the money made, and investors have in aggregate received nothing.” (According to another article mentioned toward the end of this week’s blog in context of a Financial Times series of articles on capitalism, hedge funds do add value to society in general by providing liquidity, so long as they don’t reside un a “too-big-to-fail” institution”.)

The Lethbridge Herald’s “Canadian investors need protection”reports comments by Larry Elford, “a longtime member of the (Canadian) investment and securities industry” to the effect that regulators should be there to protect investors rather than industry and that there is a “crying need for an enforceable code of ethics for people selling investments” including: “do no harm”, fiduciary responsibility to investors, and being qualified professionals rather than just commissioned salespeople. He also argues that it is long overdue in Canada for the federal government to start focusing on white-collar crime. “If the federal government is determined to build more prisons and order longer sentences for major crime, perhaps it should get serious about white-collar crime. If the American investment industry resembles the Canadian situation in any way, those expensive new prisons might be needed.”

Real Estate

In the Globe and Mail’s “Reverse mortgages hit record high” Roma Luciw reports that according to Canada’s sole provider of reverse mortgages, in the fourth quarter of 2011, they “closed a record number of reverse mortgages worth $67.2 million. That’s up 42% from fourth quarter of 2010”. (Much of the rest of the article sounds like an advertisement by the reverse mortgage company.) There are no specifics as to why these reverse mortgages are so wonderful (they are not) other than “home owners can borrow up to 50 per cent of the appraised value of their home. They repay the principal – and interest that has been accumulating – when they sell it.” (That might sound good but there is no mention of little details like costs and interest rates which can result in the rapid and ultimate loss of the owners’ equity built up in the home.) The only moment of sober second thought about the value of reverse mortgages is in the final paragraph of the article in a quote from David Trahair that “They may make some sense for house-rich, cash-poor seniors who are having trouble buying groceries but for everyone else, simply applying for a home equity line of credit before retiring is a much cheaper way of securing access to emergency funds.” (Perhaps this article would have been more appropriate for the “business” (great company profitability) rather than the “personal finance” section (it’s good for you).)

Grant Robertson reports in the Globe and Mail’s “RBC, BMO warn on housing” about warnings from executives of some of Canada’s major banks (CIBC, RBC and BMO) that “Canada’s housing market is showing signs of peaking”, “The market should inevitably cool in 2012 as housing supply begins to outstrip demand, and consumer debt hovers at historic high levels”, they “expressed concern over cooling housing prices, particularly in the condo markets in Toronto and Vancouver, where capacity is significantly overbuilt”, “RBC has conducted stress tests on its books for a decline in housing prices of as much as 25 per cent. Though the bank doesn’t figure the situation will become that dire”.


In Investment Review’s “PRPPs: The unintended consequences”Gerry Wahl tables further potential issues associated with the proposed PRPPs. (Not that we don’t already have a long enough list of issues on the table.) Among those mentioned are: (1) unintended consequences like given that “financial institution becomes the administrator and a trustee of the plan hence the sponsors’ current administrative and fiduciary role responsibilities will be transferred to a financial institution” driving all pension plans and sponsors to have to transfer plans to the PRPP because otherwise “an employer would be remiss if it did not transfer its DC or RRSP pension programs to a PRPP to relieve owners and shareholders of the potential legal and financial risk associated with defined benefit or CAPs”, (2) low investment cost, but many large sponsors already have negotiated low investment management cost but there are also administrative and trustee costs so the how is “low cost” to be achieved, and (3) conflict of interest in fund offering that can only be overcome by requiring financial institutions providing PRPPs to include passive investment vehicles (passive implementation of both asset classes and asset allocation).

In the Financial Post’s “Europe’s pension bomb about to explode” Christie and Woodifield report that “State-funded pension obligations in 19 of the European Union nations were about five times higher than their combined gross debt, according to a study commissioned by the European Central Bank.”  The combination of increasing longevity (without corresponding increase in pension eligibility age) and low interest rates drive up pension liabilities. This is in addition unfavourable demographic trends (e.g. today France 4.2 working for each pensioner and will go to 1.9 by 2050, while in Germany from 4.1 to 1.6; and often the European plans are unfunded or only partially pre-funded.)

Closer to home, in the Financial Post’s “No decision on changes to public sector pensions, Harper says” Jason Fekete reports that Prime Minister Harper  said that it’s purely speculation that the federal government is considering reform of the federal civil service pensions, given estimates of $200 billion shortfall. He indicated that whatever changes that may be contemplated “will be fair to both federal employees and taxpayers”. “Federal civil servants currently contribute 35 per cent of pension service costs, but that rate will increase to 40 per cent next year, with the government (as the employer) contributing 60 per cent. But, many public-sector pension plans in the provinces have a contribution split of approximately 50-50.” However in Benefits Canada’s “The war on public pensions” Greg Hurst writes that while public sector DB plans have inherent risks associated with them like all DB plans, there are also some “big lies” intertwined in the current “propaganda war”. Specifically he questions: the use of current market bond yields to calculate liabilities given future uncertainties, that benefits are excessive and will lead to tax increases given that some public sector plans have already taken steps curtail benefits and share risk with employee, that pension featherbedding is rampant in public sector when in reality it is more prevalent in private sector. Hurst opines that “the biggest pension issue in Canada is the lack of pension coverage for private sector workers” and implicitly suggest that the propaganda war against public sector workers’ pension is essentially a diversionary tactic by Canada’s business leaders (and government) to draw attention away from the pension crisis in the private sector. (This is an interesting perspective that I haven’t considered before.)  

On the Nortel pension front, the  US Court of Appeals has rejected the Nortel UK pension plan trustee’s and the UK board of pension protection fund’s appeal to allow their multi-billion dollar claims (on some bizarre grounds) to be entered against US Nortel estate. (See the ruling US Court of Appeals decision; not sure if this automatically applies to the Canadian estate as well.) The judges in their concluding remarks added: “In summary, the situation before the various courts and tribunals is that there are insufficient funds to satisfy the claims of all the creditors. We have seen no estimate as to the total of the claims filed in the United States and Canadian bankruptcies. The issues of the competing claims will be determined in the allocation stage. We are concerned that the attorneys representing the respective sparring parties may be focusing on some of the technical differences governing bankruptcy in the various jurisdictions without considering that there are real live individuals who will ultimately be affected by the decisions being made in the courtrooms… Mediation, or continuation of whatever mediation is ongoing, by the parties in good faith is needed to resolve the differences. No party will benefit if the parties continue to clash over every statement and over every step in the process. This will result in wasteful depletion of the available assets from which each seeks a portion. There appears to be one constructive solution – the protocol agreed upon by appointing Justice Winkler to resolve the allocation issues. He apparently has the respect of all parties and we hope (although it is not in our power to order) that the parties promptly devise a process by which all conflicting claims are put in his hands for resolution.”

Things to Ponder

In the Financial Times’ “A Swiss army knife no longer so Sharpe” John Keele discusses concerns about the effectiveness of the Sharpe ratio as a measure of risk adjusted return (defined as the difference between the asset return and the risk-free rate, divided by the standard deviation of the asset return) in a very low “risk-free” rate environment. Other issues with it mentioned are: that correlations are disregarded, the time interval considered (e.g. is a five year history sufficient or you need ten or more years to allow meaningful comparison), the impact of the (e.g. normal or fat tail) distribution of assets being compared. (It’s not perfect and is not the only metric; it is just one of the tools in the tool box.)

Pauline Skypala in the Financial Times’ “We need more insiders to speak out” writes in reference to the savings and investment industry that “The basic problem is a blatant disregard for customers’ or society’s interests.” She argues for greater need for insiders to step forward and tell the real story, and mentions David Norman who “claims the total cost of owning an actively managed fund is about 3 per cent a year, taking account of trading costs, platform fees, etc”. Norman further states that the industry forgot that the funds managed actually belong to “real people” whereas the industry is devoted “to coming up with cleverer and more intricate ways to make profits”.

In the WSJ’s “Investing in a ‘Fat Tail’ world” Pimco’s Mohamed El-Erian writes that “Navigating such unpredictability requires investors to rely less on historical short cuts and, instead, spend more time decomposing asset classes into their constituent risk factors. Moreover, they need to internalize a much broader set of correlations, pursue a more global opportunity set, and mitigate risk not only by diversifying but also by using active tail hedging aimed at protecting against the bad extremes of possible outcomes. Investors must also stay ahead of a whole range of “unconventional” policy interventions that alter the very functioning and liquidity of markets, including the large-scale use of public printing presses by central banks in Europe and the U.S. By driving interest rates to very low levels, central banks are pushing investors out on the risk spectrum… In such a world, prudence is the name of the game, and patience will likely be rewarded. To paraphrase Will Rogers, investors are well-advised to worry first about the return of their capital and second about the return on their capital.” (No doubt this contains an element of truth but also sounds like a strong pitch for the potential value added of active management by Pimco experts.)

In the Globe and Mail’s “Recent cheery numbers mask U.S. economic woes” Brian Milner quotes  Rob Arnott who “points to the embattled housing market, worsening job outlook and deepening fiscal woes to back his contention that investors should be getting out their umbrellas to deal with what he calls the eventual “3D hurricane” of soaring debt and deficits and aging demographics…. He thought the ideal time to build that third pillar (of sound investing, the other two being stocks and bonds) would come more than two years ago, when he recommended that investors build a hedge against home-grown inflation and reduce risk by diversifying into other markets and assets, including commodities, high-yield corporate bonds and emerging market debt.” (He admits that he was early two years ago, but much less early today.)

And finally for those of you interested to ponder “Capitalism in Crisis” the Financial Times has whole series of articles trying to answer questions such as:  have we lost our way, where to now, what is capitalism, etc. Some of the articles I found of interest include: the editorial “Capitalism is dead; long live capitalism” (“At a time of ongoing financial shocks, this need for adaptation has not ended. On the contrary, it is as important as ever… the achievement of extraordinary wealth may not reflect exceptional merit. In societies that rely on consent, this is politically corrosive.”), John Plender’s  “The code that forms a bar to harmony” (“The enrichment of bankers, corporate chiefs, flash traders and their cronies is testing tolerance of inequality”), Lawrence Summers’ “Current woes call for smart reinvention not destruction” (What we need is application of capitalist/market principles to health, education and social protection), “You may not want  to…but it is time to hug a hedgie” (We need traders to provide liquidity. “…the market is distorted: much trading goes on inside too-big-to-fail behemoths that have an implicit government backstop. If you subsidize the risk in trading, naturally it will be copious and, worse, dangerous”. Hedge funds offer part of the answers.), Samuel Brittan’s “The market still has no rivals” (The market does not reward personal merit. “Redistribution is best carried out by a (preferably unified) tax and social security system“, the “central case for competitive capitalism is that it promotes personal and political freedom”.), and all the way to one by John Kay’s “Let’s talk about the market economy”(We don’t really have capitalism today. In Marx’s time it was about individuals with capital controlling the means of production, then we moved to a separation of ownership from control and now critical success factors are “its systems of organization, its reputation with suppliers and customers, its capacity for innovation”. Continuing to use the old term ‘capitalism’ “we are liable to misunderstand the sources of strength of the market economy and the role capital plays within it”.).


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