Hot Off the Web– April 20, 2010

Personal Finance and Investments

Jonathan Chevreau in the Financial Post’s “Ten timeless investing wisdoms” lists Vancouver advisor’s timeless wisdoms to successful long-term investing. Among them are: (1) the unthinkable does happen, (2) prepare and stick to your long-term plan, (3) diversify, (4) understand all the fees and (5) bull markets start in midst of crises.

In the Globe and Mail’s “Looking for a better deal on home insurance? Good luck”Rob Carrick rightly complains about the rising cost of home insurance, in his case averaging an annual increase of over 10% during the past five years. He adds that “The problem isn’t just that my insurer is raising its rates. It’s that all companies are doing it to one extent or another, and it’s near impossible to find a better deal.” (Not surprised; the property portion of my home policy premium increased last year by 100%, while the coverage only increased by 6%! This is in spite of having been claim free for over 30 years with the same company! As the old saying is, you might not want to buy their product, but you should consider buying their stock.)

Jason Zweig in WSJ’s “Watch out for hidden tax traps inside ETFs” reminds readers that “an investment’s taxation can by itself make the difference between a winner and a loser.” He specifically discusses the importance of understanding of what’s inside some “alternative asset” class ETFs, like commodities and currencies, which “often aren’t “funds” at all, but trusts or limited partnerships that pass income and gains through to their investors. The income or gains may come from foreign currencies or physical commodities—but also from money-market instruments, forward contracts, swap agreements, futures contracts or other derivatives.” The tax treatment is much different from stocks. Examples given are: how futures contracts must be marked to market at year end and tax paid on unrealized gains, or that the IRS considers investment in gold as in a collectible with a higher tax rate, or exchange traded notes (ETNs) are structured and treated for tax purposes as a bond and tax is payable on imputed interest rate calculated annually even though no income might be due until maturity of the ETN. (The article represents the U.S. IRS handling; I don’t know what Canada’s CRA position might be for similar investment vehicles.)

In the WSJ’s “Reverse mortgages now look cheaper” Green and Tergesen  report enthusiastically about recent reductions in reverse-mortgage closing costs, but Tara Siegel Bernard in the NYT appropriately puts it slightly more realistically “Reverse mortgages still costly, but less so” . (My advice to anyone contemplating reverse-mortgages is unchanged: explore other options to generate income requirements before committing to a reverse-mortgage, and get advice from a fee-only advisor who gets no benefit from the outcome of your decision.)

Ken Kivenko looks at some actively managed ETFs in “The rise of actively managed ETFs” and concludes that while they may be cheaper than Canadian mutual funds, when you look at their total expense ratio (TER), higher taxes due to higher trading, the occasional performance fee payable to the manager and the questionable ability of active managers to consistently outperform the appropriate passive index, they offer little benefits. In a related Globe and Mail article “ETF providers have cluttered a pristine landscape”Tom Bradley argues that despite the lower fees, “ETFs no longer take a back seat to closed-end funds or mutual funds when it comes to complexity, opaqueness and fine print. Investors need to ask the same questions they would of any packaged investment product. Will I own stocks, commodities or derivatives? Is there any leverage? What index is the fund replicating? Is it currency hedged? How well does it trade? Are there other fees or costs? In the rush to catch the wave, the ETF providers have cluttered what was a pristine landscape just a few years ago.” “The marketing of ETFs has gone from being all about cheap, broad-based and passive to being focused on specialization and active trading. Most new products are designed to allow investors who “have a view” to implement their strategy with surgical precision.” (Treat with care all ETFs except the lowest cost, highest liquidity, and broad index ones; the only exception that I would suggest, is if you want to access some otherwise inaccessible asset class.)

In the LA Times’ “Fees can take a big bite out of retirement contributions” (Thanks to Ken Kivenko for bringing this article to my attention) Kathy Kristof reports on the conclusion of some recent studies that 50% of the average saver’s IRA contribution “is eaten up by fees each year” and “about half of the average investor’s “real” return…is gone”. “People need to understand that fees are lethal,” said Mitch Tuchman, chief executive of a self-help portfolio management website called MarketRiders, which conducted the study of fees. “They are a hidden tax that people have no idea they’re paying.” (And of course Canadian mutual fund fees are typically 50-100% higher than American ones.)

In the Financial Post’s “Do the math: Diversity is critical” Jonathan Chevreau writes that “diversification, with the promise of solid but safe returns, seems the closest thing to a free lunch investors can get.” In this article, he discusses money manager Choueifaty’s theoretical and formal definition of diversification. The manager argues that the various capitalization, fundamentally and equally weighted index funds all have flaws, whereas in his “maximum diversification” strategy, based on volatility and correlations, “He puts his emphasis not on the quantity of stocks held, but on finding stocks not correlated with each other. Thus, his U.S. portfolio holds maybe 60 stocks — versus 600 for the MSCI US benchmark –but he insists those 60 stocks are more diversified than the 600.” (Of course, as the disclaimers usually indicate, past performance (or past correlation, or volatility) is not predictive of future results. I’ll stick for now with my primarily low cost indexed approach to my portfolio.)

Pensions

In the Financial Post’s “Time to finally act over Canada’s pension reform” Jonathan Chevreau quotes Keith Ambachtsheer that “It’s “high noon for pension reform” and time to move from debates to decisions”. Chevreau looks at some of the most popular reform proposals for pensions (or retirement income, since few Canadians, other than public servants, will be getting pensions (other than CPP/OAS) in the traditional sense given the completely unravelling Canadian pension system). Even with the overwhelming evidence indicating Canada’s serious pension crisis, there some like Hamilton at Mercer (Nortel’s pension plan actuary- the ones who calculated the required Nortel contributions to the plan to prevent underfunding) and of course Finance Minister Flaherty who indicated that there is “No need to rush pension reform”since ”Canada’s retirement plan is the “envy” of the world. (It doesn’t sound like we should be expecting any reform from the current government.)

William Robson may have the answer why Mr. Flaherty has such a difficult time recognizing that Canada has a pension crisis.  In the Globe and Mail’s “MP pensions: plans Canadians can do without” Robson points out a couple of “small” details pertaining to MPs’ pension plans: the effective cost “exceeds 50% of pay” (“nearly three times more than the 18 per cent most Canadians can set aside in RRSPs or defined-contribution pension plans”) and there are no assets backing the promised pensions (i.e. money will have to be borrowed or taxes raised to pay for them). (Is this why MPs don’t understand that there IS a pension crisis?)

And for a completely new twist on dealing with pension deficits consider the Financial Times article “Uniq delivers different deficit idea”in which Adam Jones reports on a proposal by Uniq, whose defined benefit pension shortfall is 17 times larger than its market capitalization. The proposal is that the company will contribute, starting in 2013, 10M pounds or a third of its EBITDA. “The agreement Uniq has reached with its pension trustee would also allow it to raise “ring-fenced” money from shareholders for new acquisitions – capital that would not be swallowed by the pension scheme if the business was wound up.” (The good news is that the pensioners in the U.K., unlike Canada, are well protected by a government run pension insurance fund. Therefore, the government/regulators just have to decide if they take the insurance loss now or defer it to a future date.)

Real Estate

The Sun Sentinel’s “South Florida’s condo crisis: how the market went from boom to bust—and what’s ahead” does a pretty good job at summarizing how Florida’s condo crisis developed with speculation and overbuilding, ending up with about 50% drop in prices, and many developments having 50% of the units abandoned by their investors , leaving the remaining owners to carry the maintenance load. An example of the scale of what happened in Florida, consider that “in downtown Miami alone, construction began on 22,000 condos between 2003 and the end of 2009 — more than double the number built over the previous 40 years.” “Moody’s Economy.com estimates it could be 20 years before housing prices reclaim their recent peaks.”A lot of people, if they think they are going to stay long enough to get what they paid for the condo or more, they’re going to end up carrying them out feet first”” (For those who bought at the peak and took a 50% loss so far, would have to see ‘real’ values double to get back to their original cost, and that would require about 4% real annual increase in price, which is about twice the historical average; bottom line, very low probability outcome.)

The Globe and Mail’s Steve Ladurantaye in “Home listings reach all-time high”reports that Canada’s real estate market continues to fire on all cylinders with “The national average price also spiked in March, hitting $340,920 – just $300 short of the all-time high reached last October. Compared to a year ago, the average price has gained 17.6 per cent. CREA said 49,256 homes were sold, the second highest for any March and 40.8 per cent higher than March 2008.” The first quarter of this year also had record number of new homes listed. ““Higher mortgage interest rates and the rise in new listings may also soon reduce some of the urgency to purchase in Toronto”.

Quite a different story in the U.S. as described in “Foreclosures in U.S. surge to record high”which Barrie McKenna explains as due to high unemployment coupled with large “shadow inventory” (made up of mortgages where borrowers have fallen behind on payments, but the bank has not yet moved to seize the property). “Foreclosures reached a new high of 367,056 in March, up 8 per cent from the same month last year. Banks also took possession of a record 260,000 properties in the first quarter, up 35 per cent from a year earlier, according to RealtyTrac, which began issuing its reports in 2005.”

Sky-high Florida property insurance rates have been a problem for years. Paige St. John in the Herald Tribune’s “Regulators take a gamble on discount insurance”takes a look at a new approach to insurance in Florida, with the blessing of the state’s insurance regulators. “Sell policies over the phone instead of through agents, and stop handing out checks when homeowners filed claims, sending repairmen to fix the problems instead. The approach was unorthodox, so much so that even the man Gold hired to run his company thought it was headed for disaster. “I just knew it wouldn’t work,” Richard Widdicombe told state investigators after leaving the company in early 2009. “There’s no way you can replace a thousand people’s roofs with your own people.”” (No doubt this will work well after a hurricane?!?)

Things to Ponder

John Dizard in the Financial Times’ “Strategies for the coming correction” suggests that it’s time to prepare for the coming correction. “The signals I’m paying attention to are not persistent unemployment, or the still-high piles of distressed real estate, but the numbers and anecdotes that say the recovery’s strength is underestimated. We are getting closer to inflation and capacity constraints than the public thinks, which means both short and long-term borrowing are going to be more expensive, sooner than is expected.” Similarly in the WSJ’s “Evidence mounts of strong recovery” Mark Whitehouse reports that despite expected sluggish recovery (due to high unemployment and high personal debt) “those headwinds aren’t holding back U.S. consumers. Economists now expect inflation-adjusted consumer spending to grow at an annualized rate of more than 3% in the first quarter, up from earlier estimates of less than 2%. As consumers shed an increasing amount of debt through defaults, and as the government implements new incentives for banks to forgive mortgage principal, the added relief could help keep the spending going.” Also, Kelly Evans in WSJ’s “Shelter skews the deflation view” argues that the Fed is still focused on deflation because “core prices” (which exclude food and energy) are showing small increases (1.3%) whereas overall U.S. consumer price index is expected to be up 2.4% from last year.

Dominic Elliott in the Financial News’ “Fear drives value-at-risk models” discusses the loss of (unfounded) faith in value-at-risk (VaR) as a good measure “for determining the probability of losses in trading books (e.g. bank portfolios). It assesses the size of losses over the next 10 days under “normal conditions”, which are defined as conditions that occur 99% of the time.”  VaR used for regulatory reporting has failed to deliver during the recent financial crisis. Reasons listed in the article result from: being “a backward looking measure”, “excluding non-market risks” (e.g. counterparty and bond default risks). One analyst quoted argues that “In periods of lower volatility, it was common for banks to take bigger and bigger positions to use up all of their VaR limits, but when volatility increased they then breached their limits and had to sell these positions, triggering negative feedback in pricing: the more they sold, the more prices fell, the more they had to sell.” The more sophisticated banks use “stress testing” (including fat-tail returns and “worst-of-worst” correlations) to generate multiple risk metrics to better assess their exposures than demanded by regulatory processes.

Ewing and Saltmarsh warn that the “E.C.B. sees risk of new financial crisis” because “a resurgence of enormous trade imbalances, and growing government debt, were creating a volatile mix that could ignite fresh economic turmoil”.

Scism and Maremont in WSJ’s “Life, death and insurance: Indiana’s $15 Million Mystery” describe the accidental (?) death of a fully clothed woman in a bathtub after returning home inebriated; only a few months later it surfaces ”that the last person to see the woman alive had a $15M insurance policy on her life”. “The dispute over the $15 million policy is a dramatic example of a larger controversy roiling the life-insurance industry over “stranger-originated” policies. In recent years, insurance agents, hedge funds and other investors have induced thousands of elderly people to take out giant policies. Investors then buy these policies, pay the premiums, and collect when the insured dies. Insurers argue the practice violates “insurable interest” laws that require a buyer to be a relative, employer or someone else more interested in having the insured person alive than dead.”

And finally, capping off last week was the Goldman story, where “the SEC alleges that this mutual fund of bonds, this CDO, was sold to a big German bank and that ABN AMRO Bank N.V., the big Dutch bank that eventually had to be sold, bet on it. And in that betting they never understood that it had been built to fail by Paulson and Co. and Goldman together” reported in “Boyd Erman explains the SEC charges against Goldman Sachs”; also “Goldman Sachs wasn’t just smart or prescient, in the SEC’s account; it committed fraud. “This appears to be a straightforward case of a privileged client asking Goldman to help the client make a ton of money, and Goldman agreeing while simultaneously failing to make the appropriate disclosure,” says Boston University law professor Elizabeth Nowicki, a former SEC attorney. “Paulson was not devious. Paulson was smart,” she said.” In WSJ’s “A narrative for the crisis emerges in Goldman allegations” , David Wessel suggests that “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in the investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.” In the Financial Post’s “A true battle of the titans”, Theresa Tedesco also hints at  the politically motivated timing (if not action)  in “the same day the SEC swooped down on Wall Street, U.S. President Barack Obama was entreating supporters to back his controversial financial reforms.” . More details are available in WSJ’s “Paulson, looking to go short on mortgages, found a willing partner”. For another perspective of what’s wrong with Wall Street (or Bay Street) “financial engineering” so called “products” see Michael Hiltzik’s LATimes article “Pointless deals line Wall Street pockets, Goldman Sachs suit shows” . (Time will tell if the court will find Goldman at fault, given that the other side of the trade, the buyers, were big banks who many will argue should have known better!?!)