Hot Off the Web- April 15, 2013

Contents: Active vs. passive funds, adviser fees: watch out for dually registered ones, paying off the mortgage, hedge funds cooking the return rates? Canada’s housing downturn? does the shadow inventory negate Canadians’ perceived real estate opportunity in Florida? large scale purchases of single-homes for rental income an opportunity in the US? pension return rates to come back to haunt, sucking the life-blood out of the US economy: 2% of US GDP goes to legal costs, Coggan’s “Paper promises”, Siegel: unwinding QE and stocks are still it, money/gold/Bitcoin: are we on the way to losing trust?

Personal Finance and Investments

In the Financial Times’ “Beware the costs of actively managed funds” John Authers asks “Why defend the indefensible? Traditional actively managed mutual funds are obsolete.” The arguments that: active managers can exit market before it dives (but do they?), index funds are guaranteed to underperform the index by costs (but outperform active managed funds on the average after costs) and choosing the index funds is ignoring the active managers who consistently outperform (but how can you tell which ones will do so in the future?), are all made to look ridiculous in the face of the real facts. Authers only concedes one point which is the service that active managers perform for the entire market by “seeking out inefficiencies”.  He furthermore argues that the only way to beat the index might be to abandoning diversification completely and invest only in  5-10 stocks or in a couple of sectors, with the adverse consequences should you bet wrong! You might also be interested to read the Globe and Mail’s   “How to respond when your adviser tries to dissuade you from index funds” in which Andrew Hallam lists ways to counter your advisor’s attempt to push you away from index funds. By the way in the Financial Times’ “Why passive investing is buy high, sell low” Somerset Webb makes some (mostly weak) counter arguments against passive investing: passive will always underperform index, buying high selling low on price (cap-weighted) indexes like during the dotcom bubble, the benefits of non-traditional indexes (e.g. fundamental indexes). And speaking of passive investing, for those who still have not fully converted to passive investing spend the 53 minutes required to view the video “Passive investing: The evidence that fund management industry would prefer you not to see” it is compelling. (Thanks to VP for recommending video.)

In WSJ’s “Questions to ask your adviser about fees” Chana Schoenberger suggests some questions to ask to better understand how your adviser gets compensated and how that might affect the advice that you get: “How are you registered? (‘registered representatives” or RIAs registered investment advisers” or sometime both or dual or hybrid registered so you may get dinged for sales/transaction/trailer commissions/fees and well as fees for advice, e.g. see “Hybrid advisers may have skewed report on commission business” ), “What am I paying you and your firm directly?”, “What payments are built into the products I may buy from you?” (e.g. trailer costs on funds, bid-ask spreads on bonds).

In WSJ’s “Pay off that mortgage now” Brett Arends argues that “Repaying a mortgage early offers…a risk-free return in the form of the interest saved. Nowadays anyone with a mortgage of 4% or 5% can earn more by repaying the loan than by investing in bonds, which have been rallying for most of the past three decades.” He suggests using money already allocated to bonds in one’s portfolio.

The Economist’s “Trimmed hedges” discusses the necessity to take with a very large grain of salt even the only thing that hedge funds supposedly do disclose, since they “routinely revise their performance data, often in ways that seem designed to fool outsiders…Counter-intuitively, most fixes aim to make performance look worse than originally stated…(because the use of performance fees based on high watermark valuations) managers have an incentive to belittle past returns. Indeed they are the most avid revisers, knocking an average 0.62% off the numbers. In contrast, funds with no need to beat past high-water marks typically inflated their first submissions by 0.4%, making them look more successful to prospective backers”. (Surprised? Perhaps you shouldn’t be.)

Real Estate

In the Financial Post’s “Signs of a Canadian housing downturn are everywhere” Theresa Tedesco reports that Canadian home sales were off 15.8% over the year ago volume and off 2.1% during February of this year. “Almost 80% of local markets posted year-over-year declines in house sales while new listings dropped 60%; worst in Toronto, Vancouver, Montreal and Saskatoon.” We heard much about the correction under way in Toronto and Vancouver but “But signs of another bust in the making point directly to the Greater Montreal area, which has as many individual homes for sale right now as Toronto and Vancouver combined — just under 32,000 — while at the same time, it has twice as many condominiums on the market than Toronto… while Ottawa has not only seen its MLS inventory spike, its condo market has seen active listings jump by a whopping 40% year over year as prices fell 4% during the same period.” The economic consequences to a correction in house prices and demand can be significant in Canada not only because of the wealth effect felt when prices are rising, and the opposite when falling, but also because 27% of the Canadian economy is housing related, which is even higher that the 24% number at the peak of the US housing bubble!

In the Palm Beach Post’s “Growing shadow inventory of foreclosed homes driving up prices in Palm Beach County” Kimberly Miller reports that shadow inventory “the number of foreclosed homes that are not listed…including continued borrower default” is up by 82% in Florida (from 175,707 in Q1’2012 to 319,147 at end of Q1’2013). These “…properties are a boon and bane to real estate. They offer the tease of more inventory in a property-starved market, but can also can deteriorate, hurting neighborhoods and threatening to cut sale prices if too many rundown homes go up for sale at once… But the pileup in the shadow inventory is also a case of banks not wanting to take a hit on distressed properties…Lenders don’t want to reduce a home’s value by 40 percent on their books and pay thousands of dollars to rehab it for sale”.  “If we don’t see more inventory, and buyers outpace sellers, it may increase prices too much in too short of a time period,” Brink said. “We are going from one extreme of too much inventory to too little.”

And in the spirit of the last sentence of the previous paragraph, in the Globe and Mail’s   “Hey aspiring snowbirds: The Florida housing market could be rebounding” Andrea Cornish writes that following the 40-50% drop in home/condo prices “Rock bottom prices and a high exchange rate made purchasing U.S. property an attractive proposition for northern neighbours. According to the National Association of Realtors, nearly a quarter of home sales in the 12 months ending in March 2012 were by Canadians.” (While there is one sentence about Florida’s high foreclosure rate of 13.7%, much of the article refers to quotes from various real estate people who, some might suspect of trying to pump up the market….no mention of the discriminatory property taxes against non-residents if prices really were to increase (I am not counting on this)…and the fact that it may cost as little as 50-70% as much to rent as the carrying costs of condo ownership even excluding cost of capital, when you factor in taxes, maintenance costs, insurance, special assessments, etc…and in any case, the key word in the title of this article is ‘could’, given the shadow inventory mentioned earlier which I have seen quoted at the equivalent of 29 months of sales compared to the normal level of 6 months!)

In the WSJ’s “Cheaper by the dozen” Telis Demos reports about firms having bought up foreclosed single-family homes which they are now starting to offload to hedge funds and private REITs. These investors are trying to capitalize on the rental boom since the 2008 financial crisis “But the business model still is in the early innings, and it isn’t clear how efficient it is. Much will depend, analysts say, on the expertise of individual managers in such nuts-and-bolts items as leases and building maintenance. Investors are nibbling, in part because they are hungry for returns at a time when interest rates are hovering near zero and in part because there are strong signs of a housing-market recovery… (but) The potential headaches of being a landlord include prolonged vacancies, unexpected maintenance and repair costs, deadbeat tenants and difficulty refinancing… repair costs are greater for single-family-home rentals than they are for comparable apartments in a single complex.” “There are two big questions for investors: Will the REITs produce the income they expect, and will they be a good vehicle for profiting from rising home prices?”

Pensions and Retirement Income

In the WSJ’s “The pension rate-of-return fantasy” Andy Kessler discusses the consequences of municipal bankruptcies like the recent one in Stockton, CA and the ‘fine work’ done by actuaries ( who by the way he suggests are people “who really wanted to be accountants but didn’t have the personality for it”) assuming 7.5% returns on pension plan assets when ten year  Treasury bonds are paying 1.74%. Realistic returns today might be 3% rather than the 7.5-8.5% assumptions floating around. As reality starts to sink in municipalities (read taxpayers) will dramatically have to increase pension contributions, but likely so will employees. And of course, like in the private sector, DC plans will likely be replacing DB plans in municipalities and states and in the case of bankruptcy “the only thing left is to cut retiree payouts, something Judge Klein (in Stockton’s case) has left open… When Wisconsin public employees protested the state government’s move to rein in pensions in 2011, the demonstrations got ugly—but that was just a hint of the torches and pitchforks likely to come.” (Unlike the case of US private sector employees whose DB pension plans are generously insured by the PBGC, public sector pensions have no such insurance on the expectation that they can always resort to raising taxes to cover shortfalls.)

Things to Ponder

And speaking of bankruptcy related litigation, my mind jumps to the almost $1B that was charged so far to the Nortel estate resulting primarily from legal costs, there is a Financial Times’ article entitled “Prosperity requires more than the rule of law” in which John Kay notes that “…spiralling costs of litigation establish an environment in which the rule of law operates in favour of bullies and the rich and privileged – a process whose outcomes closely resemble those of dispute resolution in very primitive societies… even with legal costs absorbing almost 2 per cent of gross domestic product, the US is an affluent country…but impediments to growth…(include)  sclerosis arising from the conflicting demands of too many established vested interests.” (Wow…2% of US GDP goes to legal costs…now here is an opportunity to take an axe to…this sounds as corrosive to society as Canada’s mutual fund fees of 2-3%.)

See my review in my earlier blog this week of “Paper Promises- Debt, Money, and the new world order” by Philip Coggan. It is a timely book given the discussion generated by the Bitcoin bubble (see at the end of this blog) as well as the growing pressure among some states in the US who are losing confidence in the Fed money printing and would like some mechanisms to re-establish a gold-backed US dollar or gold as legal tender. As a teaser to get you to read this book, you can read one of the subjects discussed in it being retold in the Economist’s “Where did all the money go?”  where Buttonwood (Philip Coggan) discusses how bubbles develop and what happens to the trillions which evaporate when bubbles collapse. “…those equity and property prices. In a free market, like an auction, prices are set by the marginal buyer and seller. If there is an imbalance between willing buyers and sellers (as there was in American, Spanish and Irish housing in the middle of the last decade), then prices will rise sharply. The average homeowner feels wealthier as a result. But only a small proportion of the housing stock (or of equities) trades on any given day. The price set by marginal buyers and sellers is not the price that could be realised if all owners of the asset in question tried to sell their holdings at the same time. In such a moment, there will be more willing sellers than buyers, and prices will plunge. High house or share prices, relative to personal incomes or profits, represent a bet that the good times will continue, and that incomes and profits (and cash flows in the form of dividends or rents) will rise significantly in future. When that bet proves wrong, the wealth disappears. ”

In IndexUniverse’s “Fed should up reserve requirements” Jeremy Siegel discusses some ideas about how the Fed might unwind the current quantitative easing (e.g. by sharply raising bank reserve requirements), about the reasons for the historically low interest rates being not just a consequence of QE but also a demographic phenomenon especially in the developed world where aging population which has been badly bitten by two stock market crashes in the last dozen years is increasing its risk aversion at the same time as pension funds are also pulling back on equities to reduce market risk; and yet Siegel believes that stocks are quite cheap by absolute measures and relative to other assets, and that people will overcome their fear of the equity markets and some of the $11T sitting in money market funds will find its way into the market.

And finally, the Bloomberg Businessweek’s “Bitcoin may be the global economy’s last safe haven” if nothing else it’s an educational article on how money can be created out of thin air…you don’t even need central bankers or precious metal or other backing, just a bunch of people who will believe/trust that someone else will accept it in exchange of some goods/services…and it’s good to go…well at least until it’s not (“Ugly day for Bitcoin as virtual currency price plunges” 41% from its intraday high and “Et tu, Bitcoin” demonstrating human that gullibility or the triumph of hope over reality or other similar sentiment has no limit?…but according to the Economist’s “Mining digital gold”  even if Bitcoin crashes, it might change the financial world the way Napster changed how music is bought.)… and by the way in a sign that people are losing confidence in the Fed (even though credited with having saved the US from a depression starting in 2008) and its monetary policy with moves to promote gold as legal tender in some US states as discussed in  “Trust in gold not Bernanke as U.S. states promote bullion” and “Midas moment: States rush to make gold legal tender” (Not sure what any of this actually means, or how one can reconcile this with the recent drop in gold prices and forecasts of its further softening in the near future. Still all this talk might be further undermining trust in money (and money is all about trust) and our financial system, or is perhaps just a teachable moment for those controlling our currencies and/or all of us collectively about the meaning/creation of money.)


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