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Much of last week’s financial pages were filled with the doom and gloom of: recession (is it still coming or is already here), subprime mortgage crisis (well under way), the credit default swap crisis (just got under way, what is it and whether it will be worse the subprime crisis), the real estate crisis.
While you must be getting bored of reading about the subprime mortgage crisis, you may not have heard much about the just arriving CDS (credit default swap) crisis. The Financial Times’ Wolfgang Munchau writes that “This is not merely a subprime crisis” Credit default swaps are like an insurance policy against default of a bond. Two (unregulated) parties agree that for a fee (say 4%/year for 5 years) party A will buy the bond from party B at face value if there is a bond default. Of course as the market is unregulated, the “insurance” against default is only as good the seller’s ability to pay in case of default (counter-party risk). Pimco’s respected boss Bill Gross projects that losses from CDSs could be about the same as the expected $250B from subprime mortgage mess. Many of these CSD transactions attempt to protect the buyer of the “insurance” so that interim collateral payments may be required by the protection provider even if no default has occurred but bond values drop significantly. In “Default fears unnerve markets”  exactly such an occurrence is reported about ACA Capital which sold $69B of protection with just $425M of capital! As the firm’s credit rating came under scrutiny, there was an imminent downgrade which would have resulted in additional collateral payment that it could not meet. Many of the protection buyers ended up having to take significant write-downs on bonds that they were holding on which the “insurance” was no longer likely to pay the losses.
And Greg Ip of WSJ in “What a recession could mean to you”  reviews historical recession (defined as two consecutive quarters of GDP reductions) data. The 32 recessions in the U.S. since 1854 lasted an average of 17 months while those since 1945 lasted an average of 10 months. Most recessions start due to Fed raising interest rates to fight/prevent inflation and then 12 months after Fed starts easing rates S&P 500 is up an average of 17%; so 2008 could be a good year for stock if history repeats itself.
In “Protecting your nest-egg in volatile times” Eleanor Laise tackles the problem of retires who, unlike in the past, are told that they need to have a significant equity component in their portfolios because keeping their nest egg in fixed income securities only puts them at risk of running out of money. At the same time the same retirees are told that they must reduce the volatility of their portfolios, since portfolio drawdowns during market swoons (like the current one) can significantly reduce available assets for future growth. Strategies recommended to mitigate the damage include: well diversified portfolio, covered call writing (i.e. generating additional income on securities held in the portfolio by selling out of the money calls and thus forgoing some of the potential upside), large cash reserves (to minimize the need to sell after prices dropped), reducing spending by as little as 5-10% in poor performance years.
The popularity of Target Date Funds that you have read about here in Target Date Funds and Target Date Funds II is continuing to spread. Chevreau in “Mackenzie’s new target date funds emphasize equity, emerging markets”  reports the arrival of Mackenzie Financial’s new Destination+ target year 20015,2020 and 2025 funds and trumpets its equity and emerging markets components (but there is no mention of the management fees associated with the funds) built on a series of other Mackenzie funds with their own high management fees. Unlike other lifecycle funds, these come with additional daily lock-in feature (no doubt at additional cost). (Good to see more target date funds arriving to Canada, nut pay attention to costs, or even better build your own from ETFs)
Still on target date funds, WSJ’s Eleanor Laise write about the arrival of “New indexes keep tabs on target date funds” . Laise mentions indexes from Target Date Analytics, Dow Jones, Zack’s, and soon Lipper and Morningstar. These indexes are just beginning to help the growing numbers of lifecycle fund investors in assessing the performance of their funds. With these indexes, investors will have to find an index that is representative of the fund that they are invested in (not just the same target date as their fund). Asset allocations differ, often significantly: underlying asset classes making up the target date fund, their respective percentages that make up the fund as well as how these change over time as the target date approaches. While target date funds ease the management of an individual’s portfolio, they often carry “layers of fees” as they are often built on other funds. If this is a problem in the U.S., you can imagine what a problem this is potentially in Canada, where fees are often 5-10x higher).

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