Topics: Fiduciary cost, commissioned fiduciary? retirement ‘black holes’ and ‘quicksand’, diversification vs. hot sectors, currency hedging? valuation based asset allocation, shadow inventory release to affect US housing, tax treatment property, Justice Winkler on Nortel bankruptcy and the legal ‘profession’, pension plans reduce equity, stocks: time to buy or not, assault on indexes, wealth destruction in progress, financial repression.

Personal Finance and Investments

InvestmentNews reports the results of a new study indicating that “brokerage industry’s claims of more expensive products fail to take “agency rents” into account” in “Fiduciary standard doesn’t raise costs”. Blain Aikin (CEO of fi360 and sponsor of the research) writes that “the formidable brokerage industry lobbying machine has been working overtime to delay, dilute or defeat imposition of the fiduciary standard”. The academic study entitled “The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice” authored Finke and Langdon based the study in looking at the differences between U.S. states which already impose fiduciary standards on brokers, those that don’t and those that fall in-between. The Texas Tech University professors found that the “fiduciary standard is not more expensive for investors; it is more efficient. They can acquire advice that is subject to higher accountability without higher costs or reduced choices”. The reason that there is no cost differential is because “In the absence of fiduciary obligation, broker-dealers and their representatives are able to exploit the information imbalance by extracting extra “agency rents” from clients… The results of the study suggest that when obligated to place investors’ best interests first, broker-dealer firms should accept lower profits rather than raise prices or cut services.” Still on the subject of fiduciary responsibility Michael Kitces writes in InvestmentNews’s “Fiduciary standard can cover brokers too” that in a new twist, the latest recommendation to the SEC suggests that “the fiduciary duty is fully consistent with sales-related business practices, including receipt of transaction-based compensation, sale of proprietary products, and sale from a limited menu of products.” Kitces supports this approach as he believes that “the real conflict has never been about suitability vs. fiduciary, per se, but about advice vs. sales. If you want to give personalized advice, you subject yourself to a fiduciary duty, which can be accomplished regardless of compensation model; if you want to avoid the fiduciary duty, just don’t give personalized advice, or hold yourself out as being an advisor”. Kitces asks: “Can fiduciary rules and/or principles be established that can reasonably apply regardless of compensation model?”

In the Financial Post’s “A tough time to retire” Michael Nairne discusses the challenge of navigating between the ‘black hole’ resulting when  overly aggressive investors must draw from such heavily depleted principal (as a result of bear market coupled with withdrawals) that one’s portfolio will never be able to benefit from market’s recovery,  and the slower but equally devastating ‘quicksand’ which plagues over-conservative investors who choose to invest in “safe government bonds” and end up being ground down by inflation….(Regretfully the (non-specific) suggestion that “fortunately there are new investment and insurance vehicles” which might help deal with these risks, immediately made me think of GMWBs and “products” with principal guarantees, and promptly made me cringe.)

Preet Banerjee in the Globe and Mail’s “Tempted by a hot sector, restrain yourself” warns readers against trying chase hot sectors, and instead he advocates staying with the asset allocation defined in the Investment Policy Statement (IPS). He reminds us that “Diversification is essentially a tradeoff that guarantees you will never make a killing in exchange for never getting killed.” For those enjoy getting your information graphically, he points to a very interesting “chart (which) visualizes various asset classes’ annual returns and the growth of $1 invested continuously over a span of 42 years.* It also allows you to compare it to a diversified portfolio. What you’ll notice is that the diversified portfolio is never the absolute winner or loser in any given year, but the value of $1 is the largest when invested continuously in that portfolio.”

Steve Johnson in the Financial Times’ “The long and short of a hedging dilemma” explores the need for currency hedging of foreign assets in one’s portfolio. Referring to a Dimson, Marsh and Staunton study, he writes that currency hedging may reduce volatility for short and medium investment but for long-term investor it actually increases risk. Furthermore they argue that unhedged foreign equity exposure is superior historically, but for a fixed income portfolio hedging is preferred otherwise “currency effects can dwarf the fixed income exposure”.  Of course, avoiding fully hedged long-term investment also reduces/eliminates hedging costs. (With very few exceptions, I have not been hedging my equity exposure; you can think about the multi-currency exposure as another form of diversification.)

In journal of Financial Planning’s “Withdrawal rates, savings rates, and valuation-based asset allocation” Wade Pfau uses historical evidence that supports lower savings rates and higher withdrawal rates using a valuation based asset allocation. He uses Shiller’s cyclically adjusted P/E ratios (PE10) in combination Graham and Dodd inspired valuation based asset allocation strategy; a 50:50 stock/bond allocation is default and is changed to 75/25 or 25/75 stock/bond when PE10 drops below 2/3 or moves above 4/3 of historical average. Improvements in withdrawal and savings rates were observed in most years. Pfau concludes with the observation that “this research does propose a potential asset allocation approach for advisers and clients wishing to incorporate valuations into their asset allocation choices, but also wishing to maintain a formal commitment to an asset allocation decision framework that will hopefully help prevent hasty emotion-based decisions.”

In WSJ’s “Brokers raise fees, but not to investors” Ian Salisbury reports that mutual fund “revenue sharing” fees paid to brokers are increasing. “Industry veterans liken the payments to “shelf-space” arrangements, in which cereal companies pay grocery stores to get brand names stocked at eye level… Wall Street firms say that since the payments go to brokerages rather than to individual financial advisers—who receive separate payment streams—they don’t affect advisers’ judgment in picking funds.” (If you believe that, then I have a bridge for you…) “The legal framework that governs the industry may be inching in the direction critics prefer. One proposal, favored by Securities and Exchange Commission Chairman Mary Schapiro, would make all financial advisers so-called fiduciaries. (That would be good; see my recent blog Fiduciary duty is necessary, but not sufficient)

Real Estate

Kathleen Howley reports in the Financial Post’s Bloomberg originated “Tidal wave of foreclosed homes about to flood U.S. market” that “As many as 1.25 million of America’s least cared for homes are headed for auction after a year-long probe into foreclosure practices kept them off the market…Prices for the homes could drop as much as 10% because they deteriorated as they were held in reserve during investigations by state officials resolved in February…A surge of cheap foreclosures may erode prices in the broader real estate market, even as the economy expands and residential building increases”.

Tim Cestnick in the Globe and Mail’s “I bought a second condo. How will that affect my taxes?” explains the intricacies of converting a personal use property to an income producing one: what expenses are deductible (condo fees, utilities, insurance, property taxes, etc) but not mortgage interest unless you can demonstrate to the CRA that you “had borrowed to buy the old condo, also the “change of use rules”  “will deem you to have sold your old condo at its fair market value on the day you changed its use to an income property, and will deem you to have re-acquired that property at that same value”; if original property was a principal residence then the immediate effect is just one of resetting the adjusted cost base to current market value. Cestnick suggests that you see a tax-pro to minimize chance incorrectly executing the procedures necessary to maximize tax benefits.

Pensions

In another insightful article, on the “progress” toward resolution of the Nortel bankruptcy case, Bert Hill discusses the value destruction resulting from the machinations of the legal system and “profession” now entering the fourth year of bankruptcy procedures, in the Ottawa Citizen’s “Chief Justice Winkler vs. the Nortel quagmire”. He writes that Ontario Chief Justice Warren Winkler’s “biggest challenge of his illustrious career — and a glaring example of everything that is wrong with the justice system — is finding a solution to the Nortel Networks bankruptcy quagmire…Winkler has already lost nine months on the mediation assignment because of legal wrangles involving huge European claims that, at least for now, have been blocked. Hopefully, he can find solutions before he reaches the mandatory retirement age of 75 next year…The 10,000 Canadian Nortel pensioners had pensions cut by up to 40 per cent and were stripped of life insurance, dental and drug benefits a year ago. Several hundred long-term disability recipients are living on public disability benefits that are a shadow of their former income…The bills sailed past the $300-million mark last year as senior lawyers charge more than $1,000 an hour and a bevy of junior counsel, accountants and consultants run up monthly itemized bills, called dockets, that record every email, phone calls or dinner meeting in increments of as little of six minutes.” (While this is not news, Nortel’s pensioners and disabled are being savaged, yet the federal government refuses to amend Canada’s bankruptcy act to provide priority in case of employer bankruptcy to DB pension plan shortfalls and prevent corporations and their creditors from enriching themselves on the backs of pension plan beneficiaries.) (But what I found particularly revealing are comments of Justice Winkler on the legal “profession”: what it used to be, what it should be and how it might have lost its way. See Fiduciary duty is necessary, but not sufficient blog)

Pension plans are finally getting religion on ALM (Asset Liability Management) also called LDI (Liability Driven Investing). The WSJ’s “Low trading volumes potentially a pension problem” attributes lower trading volumes to reduction in equity positions in pension plan assets in an effort to reduce portfolio volatility and better match behaviour of asset and liability positions of the funds. Pension funds have increased the bond and alternatives (private equity, hedge funds, etc) positions at the expense of public equities. Also the International Financing Review’s “US corporate pension gap hits wider ever level, study says” reports that the 100 largest corporate pension funds’ deficit increased by $95B to $327B during 2011. This was due to reduced recent contributions in anticipation of lower permissible contribution starting 2012, and the “financial repression” of artificially low interest rates. The article also discusses the increasing shift away from stocks, and that it is driven by desire to apply LDI principles, also encouraged by credit rating agencies. (It is a strange time to get religion on bonds when many believe that bond valuations are at historically high levels, though nobody knows for sure when they’ll return to ‘normalcy’.)

The timing of pension plans’ move into bonds may turn out, in retrospect, not to be the only recent bad move by the funds. In NYT’s “Public worker pensions find riskier funds fail to pay off” reports that “Searching for higher returns to bridge looming shortfalls, public workers’ pension funds across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds. But while their fees have soared, their returns have not. In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.” (So while ALM/LDI might be the right long-term strategy for pensions, the recent knee-jerk shifts of allocations to bonds and alternatives at relatively high valuations might get reversed again.)

Things to Ponder

In the category of “forecasting is difficult, especially about the future” you might recall in my last week’s blog a reference to The Economist’s Buttonwood questioning the bullish forecast on stocks by Goldman Sachs. Well this week in the WSJ’s “Goldman Sachs: We like stocks, just not this year” Steven Russolillo writes that another Goldman equity strategist predicts a 12% U.S. market drop this year. When asked to explain the few days earlier forecast of a “once in a lifetime opportunity for long-term investor” by another Goldman strategist, the answer was that “both views can coexist in the context of different investment horizons”. (As long as the “Muppets” pay the fees/commissions, market up or down…who cares…not the investment banks.)

In IndexUniverse’ “Emerging Global questions MSCI dominance” Alex Ulam writes that the MSCI emerging market index is under attack by firms offering products in emerging markets space. The issues raised range from concerns about the appropriateness of continuing to include South Korea and Taiwan in the emerging market index and the extent to which this inappropriately reduces the exposure to BRIC countries, all the way to alternative strategies which might or might not be more suitable ways to get exposure to emerging market-type drivers of investment returns. (With the growing threat of indexing to active managers’ business, we will see more challenges questioning the validity of indexes or proposals for new “smart indexes” as means to justify higher investment management fees than the benchmarks being set by plain vanilla index based ETFs.)

In CNBC.com’s “’Massive wealth destruction’ is about to hit investors: Faber” Marc Faber (also known as Dr. Doom) forecasts  that “Runaway government debts have triggered uncontrolled money printing that in turn will lead to inflation that will decimate portfolios” He says that “Somewhere down the line we will have a massive wealth destruction that usually happens either through very high inflation or through social unrest or through war or credit market collapse”. “He reiterated both his commitment to stocks and gold, but said investors also can find value in other hard assets, particularly in distressed properties in the U.S. South.” (I have heard Marc Faber speak a number of times very persuasively on this subject over the last decade, but just because, so far his predictions have not come true, his concerns cannot be dismissed.)

And finally Edward Chancellor in the Financial Times’ “Post-war financial repression is back” explains that though specific mechanisms are different this time, the effect is the same. “Western governments have learnt the lessons of history. Interest rates – both long and short – are being maintained below the level of inflation. Moderate levels of inflation are boosting nominal GDP and in time will reduce the real value of outstanding debts, both public and private. Savers are once again paying the price. If the post-war experience is any guide, they could face many more years of suffering.”