The Old Perfessor's Investment Blog

Target Date Funds and Your 401(k) Part 2

2012-01-22T17:25:00.000-08:00

A few weeks ago I commented on some of the issues we had with Target Date Funds (TDFs) http://oldperfessorsinvestmentblog.blogspot.com/2012/01/target-date-funds-and-your-401k-part-1.html . This week I’ll share the protocol that I use to evaluate whether or not to recommend that clients use the target date funds available in their 401(k) plans.

1. Determine the clients risk tolerance

2. Develop an asset allocation based on risk tolerance

3. Develop a portfolio using the non-target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.

4. If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance … not the one whose target retirement date most closely matches the client’s.

5. Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.

6. If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is, however, along with common sense, all we have to base decisions on.

7. If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One issue with TDF’s is that some fund families have used them to gather assets for in-house funds that have performed poorly and have difficulty attracting assets on their own. This however will show up in poor performance relative to properly designed competing portfolio.

This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.

One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:

1. Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.

2. If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners http://www.paladinregistry.com/ .

Merrill Lynch Spurns Small Investors

2012-01-14T19:49:00.000-08:00

Merrill Lynch announced this week that it will eliminate or severely reduce compensation for its advisors on accounts under $250,000. The message to investors with accounts in this asset size range is pretty blunt, “Your account doesn’t interest us”. Other large brokerage firms are expected to follow suit shortly. Keep in mind that this is from the same folks (Big Brokerage, Inc.) who late last year spent hundreds of millions of dollars lobbing congress to successfully bury the effort to apply the same fiduciary standard that applies to investment advisors to brokerage firms. Their reasoning was that, if held to a fiduciary standard (putting their client’s interests ahead of their own), they could no longer afford to provide service to smaller investors. It appears that now their business model will not allow them to provide service to smaller investors even if they are allowed to ignore what’s best for the client.

Our firm is a small, fee-only financial planning and investment management practice. We do not sell financial products nor do we accept commissions on financial products. We readily acknowledge the fiduciary responsibility that the Investment Advisors Act of 1940 holds us to. We have found accounts of the size that the major brokerage firms are spurning to not only be profitable, but well supported by or fee- only business model. The question is, if we can do it why can’t they? We find the treatment of smaller investors by the major brokerage firms reprehensible and wonder why people continue to do business with companies so opposed to their best interest.

Target Date Funds And Your 401(k) - Part 1

2012-01-02T13:04:00.000-08:00

Target Date Funds (TDF’s) have become a popular option in 401(k) and other defined contribution plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, (usually from the fund family sponsoring the TDF) as the underlying fund investment holdings. For example, Vanguard target date funds are managed using other Vanguard funds as the underlying investment vehicles. TDF’s are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.

Despite a great deal of regulatory scrutiny during the 2008 financial crisis, TDF’s have been adopted by many 401(k) plans as a default investment for plan participants who are auto enrolled (placed in the plan automatically when they become eligible). A practice endorsed by the U.S. Department of Labor. A recent article in the Huffington Post http://www.huffingtonpost.com/2011/12/30/no-lost-generation-for-ge_n_1176557.html indicated that despite opinion poll data that shows investors are less willing to take on risk by investing in stocks than in the past and that many are distrustful of the financial markets, more Americans than ever have some of their money in stocks. In fact, the number of retirement plan participants in their twenties who had 80 percent or more of their 401(k) funds in stocks grew to an all-time high of just over 60 percent. Since this is the age group most likely to have been auto enrolled, it makes sense that the increase is primarily due to the use of target date funds as the default investment option. The diversified nature of TDF’s would require stock content and the long time horizon of the funds used by younger participants would indicate a high stock allocation.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues. The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investor’s risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence, there is an incredible amount of variation in the amount of equity (stock) exposure between funds with the same target retirement date in portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

If you are a 401(k) participant and you are using a Target Date Fund for some or all of your retirement investing, make a News Years resolution to find out exactly what you are investing in and if you are comfortable with the risk involved. Start with the information provided by the plan vendor. If you need help, determine if your plan offers the help of an investment advisor. If the plan fails to provide adequate advisory services (a not uncommon occurrence) find a fee-only investment advisor to guide you. Information on qualified fee-only investment professionals near you can be obtained at http://www.paladinregistry.com/. In our next post we’ll share the protocol that we use at Pilot Capital http://www.pilotcapitalmanagement.com/ to evaluate whether the target date funds available in your 401(k) plan offer a superior opportunity.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investors should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

The Failure of the Congressional "Super Committee" and Your Portfolio

2011-11-28T21:29:00.001-08:00

Last week the failure of the congressional “super committee” to find ways to reduce the U.S. budget deficit by at least $1.2 trillion resulted in a sharp correction in the stock market. In short, we were not surprised by either the committee’s failure or the resulting market reaction. Congress basically set the committee up to fail by including automatic spending cuts of $1.2 Trillion beginning in 2012 in the same budget agreement reached in August of this year that created the “super committee”. This was the perfect out for congress as all areas of government will be affected and congress can respond to angry constituents by saying that they never really agreed to any specific cuts. This is Washington politics at it very best (gutless and cynical). We are assuming that congress does not repeal the automatic cuts or alter the sequestration process that implements the cuts.

Our investment outlook for 2012 remains unchanged. Most economic analysis we have seen of the automatic spending cuts show that the cuts, while effective in reducing the deficit, would have little impact on economic growth. The cuts are simply not big enough to make more than about a 0.5% dent in real GDP growth. We still see a prolonged recovery marked by painfully slow growth and high unemployment accompanied by higher than usual volatility in the financial markets.

We are more concerned with 2013 when the Bush era tax cuts will expire. The higher rates for higher income taxpayers coupled with higher taxes on investment income and capital gains and higher payroll taxes could have a serious negative effect on consumer spending in 2013.

In conclusion, we do not believe that the” super committee’s” failure in itself was a significant blow to the economy because the automatic spending cuts already in place will likely do much the same thing the committee was supposed to do. A much more serious threat in the form of higher taxes may be on the horizon for 2013. The situation in Europe is also likely to deteriorate further and could impact economic growth in this country if timely and constructive steps are not taken by European political leaders and central banks. We are monitoring this situation carefully and at this point are still optimistic that the European debt crisis will result in a moderate recession and not deteriorate into a prolonged and severe period of economic struggle.

We also remain concerned as to investor’s fortitude while working through this difficult time. We have often said in this blog that it takes both courage and patience to be good investor. The coming few years will test both. As always, if you are concerned about market volatility call an independent, fee-only financial advisor and schedule an appointment to review your portfolio and make sure it is appropriate for your risk tolerance.

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.

Bad News for 401(k) Participants

2011-09-22T14:17:00.000-07:00

On Monday the U.S. Department of Labor released a very disappointing ruling for 401(k) investors that withdrew a proposal to subject financial professionals who give investment advice to 401(k) plan participants to a fiduciary standard of conduct. This means that brokers and insurance agents who service investors in what has become our nation’s most important retirement savings vehicle would have had to put the investor’s interests ahead of their own. This would have meant no more selling outrageously priced investment products to plan participants, no more selling whatever fund pays them the highest commissions and no more placing poor performing funds in 401(k) plans whose only attraction was their willingness to pay the plan vendor to be in the plan. Needless to say the brokerage and insurance industries mounted an intense and heavily funded effort to defeat or delay this regulation.

Predictably, the political attack on DOL was lead by members of Congress hailing from states in the Northeast where the insurance and securities industry is concentrated. The main argument from these companies is that, if they have to place the plan participant’s interest above their own, then the small investor would actually suffer because they could no longer afford to give them advice. You can restate this more accurately as “if we are fiduciaries we can no longer get away with charging outrageous fees for selling products that mostly benefit our respective companies”. I find their (the brokerage and insurance industries) argument baseless as, my own firm, Pilot Capital Management, and many other fee-only, independent Registered Investment Advisors (RIA’s) have been successfully counseling small investors while being held to a fiduciary standard for a very long time. The stance taken by brokerage firms and insurers reflects their need to build and maintain large companies (and impressive buildings) that, in general, have not succeeded in producing better advice for investors. Fee-only RIA’s have found it very difficult to compete in the 401(k) arena because of the ease with which brokerage firms, insurance companies and banks have been able to hide the very high fees charged to plan participants, particularly in small to mid-sized plans. This regulation would have helped level the playing field. DOL did say that it plans to reissue the proposed regulation in early 2012.

Thankfully there is some good news for 401(k) plan participants. Beginning in 2012, 401(k) plan vendors will have to show every plan participant exactly how much they are paying in fees (in dollars) on each statement. Our guess is that this will be a very eye-opening experience for many plan participants. Examine your first statement in 2012 carefully for the fee disclosure. If your total fees are greater than 1% of your plan balance (for small company plans) or greater than 0.5% (for larger company plans), then you have a right to be concerned. Go to your employer and ask if the plan fees have been compared to similar plans to determine if the fees are reasonable and ask to see the data. Your employer is a fiduciary and is legally bound to place the interests of the plan participants above all others involved with the plan. Also, you are being charged these fees for “investment advice”. If you’ve never actually received any advice (this occurs more often than the industry cares to admit) then you have a right to question exactly what it is you are paying for.

Finally if you’re in the habit of writing to your elected representatives, write and tell them that you are outraged at Congress’s surrender to the lobbying efforts of the brokerage and insurance industries on this matter.

S&P Fires Warning Shot at Congress

2011-08-08T16:21:00.000-07:00

Late Friday evening, well after the market close, Standard & Poor’s announced that it was lowering its credit rating on U.S. Government debt obligations to AA+ from AAA. This, not totally unexpected, move is the first such downgrade in the history of The U.S. It occurred after the other two leading credit rating agencies, Moody’s and Fitch reaffirmed their AAA rating but with a negative future outlook. S&P made it clear in their statement that the downgrade was based, not on a question of the ability of the U.S. to pay, but rather the amount of fiscal brinksmanship displayed during the disgraceful performance of our Congress. For an excellent commentary on this I urge you to read a timely post in The Economist http://econ.st/rr2d5X. I agree that this downgrade appears to be aimed squarely at the U.S. Congress and hence indirectly at ourselves. We must limit our long term obligations via entitlement programs (Medicare, Medicaid and Social Security) and we must address these issues now.

The downgrade tells us very little that we didn’t already know. S&P held true to its reputation for gleefully bayoneting the wounded after the battle. The downgrade may have negative credit implications for any entity public or private that depends heavily on U.S. Government spending. I will be writing more about this later as this works itself out. In the regular course of life this downgrade means very little as all credit ratings are relative. If you downgrade the cream of the crop, then everything below moves down a notch also. In fact, more than few respected analysts have noted that AA+ is becoming the new default rating for risk free. Despite S&P’s ongoing hissy -fit with Congress, the United States still enjoys a high credit rating (still AAA from two of the three agencies) and is not expected to have any trouble meeting its obligations in the short run and unlike the PIG countries in Europe controls its own currency.

The S&P downgrade of U.S. debt doesn’t change our investment thinking, mainly because our analysis and portfolio positioning already takes into account the serious domestic and global debt problems that influenced the downgrade. The significance of the global debt problem is that it will likely take many years to reduce this debt, and as it is being worked down it will hamper economic growth. The markets appear to be resetting to lower levels in broader reflection of this view that growth is likely to be slower than some were expecting.

Which brings us to the ultimate question, why, after the down grade did the prices for U.S. Treasury bonds actually go up? And why are foreign investors fleeing to the dollar and U.S Treasures as a safe haven? When you think about it, selling stock and buying Treasuries is very un-rational, not that markets are renowned for rationality. A more compelling consequence is that the downgrade scares U.S. consumers back into the recession hiding place from which they only recently exited. This has indeed stepped up my consideration of such a possibility which as late as early last Friday I considered as not very likely http://bit.ly/qjrJ99.

In the meantime, we expect a lot of turmoil in the markets and would be inclined to sit tight and watch for opportunities if stocks cheapen even more from where we are currently. I would reiterate that this is not 2008. The difficulties we face here in the U.S. are nowhere close to those we met at that awful time. I cannot say the same for our friends in Europe however, where it does look a lot like 2008. There are some very good U.S. companies that are not in any financial difficulty with generous yields that are looking very buyable. Morningstar published an excellent piece on what to do in a turbulent market. In Brief:

Step 1: Check adequacy of cash reserves.
Step 2: Check your long-term positioning.
Step 3: Initiate defensive hedges with care.
Step 4: Make sure you're taking advantage of "gimmes."
Step 5: Develop a strategy for deploying cash.

To read the full article click here: http://bit.ly/nHLpEd

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.

Is the U.S. Headed Back Into Recession?

2011-08-05T14:35:00.000-07:00

Many U.S. investors are questioning whether the U.S. is sliding back into another recession. In short, the answer is probably not. Most of my clients and readers know that I try not to rehash topics that other, more talented writers have already covered. James Swanson, CFA, the market strategist at MFS, has written a very good, brief analysis of the current situation and concludes that while a return to recession is more of a concern than in the past, it is still more likely that we are in a prolonged period of painfully slow growth. I urge you to read his article: https://www.mfs.com/wps/portal/!ut/p/c5/04_SB8K8xLLM9MSSzPy8xBz9CP0os3j_QKNAf3MPIwN342BnAyMXE39j01BjQxcXU6B8JLK8j4UjUN7fLczbLMDA3dKQgG4_j_zcVP2C3IhyAK-qVGo!/dl3/d3/L2dJQSEvUUt3QS9ZQnZ3LzZfT1EyUU83SDIwRzNTQzAyRDRPMzVVMzFEMzc!/?clearPortletSession=true .

I agree with Mr. Swanson’s view on the economic picture here in the U.S. and we now see a much better value proposition, particularly in larger cap U.S. Equities, following the recent correction. We are redeploying some of the funds that we withdrew from stocks in the second half of 2010. Now is an excellent time to take a look at your portfolio(s) and sit down with your advisor and rebalance so you are sure that you have an exposure to stocks appropriate for your risk tolerance.

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.

Borrowing From Your 401(k) May Not Be Your Best Option

2011-07-22T06:53:00.001-07:00

With the tough economy and tight credit, you may be tempted to tap your 401(k). But before you decide to take a plan loan, be sure you understand the financial impact. It's not as simple as you think.

The basics of borrowing

A 401(k) plan will usually let you borrow as much as 50% of your vested account balance, up to $50,000. (Plans aren't required to let you borrow, and may impose various restrictions, so check with your plan administrator.) You pay the loan back, with interest, from your paycheck. Most plan loans carry a favorable interest rate, usually prime plus one or two percentage points. Generally, you have up to five years to repay your loan, or longer if you use the loan to purchase your principal residence.

The opportunity cost

When you take a loan from your 401(k) plan, the funds you borrow are removed from your plan account until you repay the loan. While removed from your account, the money isn't continuing to grow tax deferred within the plan. So the economics of a plan loan depend in part on how much those borrowed funds would have earned if they were still inside the plan, compared to the amount of interest you're paying yourself. This is known as the opportunity cost of a plan loan, because you may miss out on the opportunity for more tax-deferred investment earnings.

Can you continue to contribute to the plan?

If you take a loan, will you be able to afford to pay it back and continue to contribute to the plan at the same time? If not, borrowing may be a very bad idea in the long run, especially if you'll wind up losing any employer matching contributions.

What if your employment terminates?

If you terminate employment, your plan will typically provide that your loan is immediately payable. If you can't repay the loan, the outstanding balance will be treated as a taxable distribution to you (reduced by any after-tax contributions you've made). And, if you're not yet 59½, a 10% an early distribution penalty may also apply to the taxable portion of your distribution.
However, if you borrow from a Roth 401(k) account and you don't repay the loan, there will be no income tax consequences if your distribution is "qualified" (that is, your account satisfies a five-year holding period requirement, and you're either 59½ or disabled). Even if your distribution isn't qualified, only the earnings you've borrowed from your account, not your own contributions, will be subject to tax and potential penalty.

When should you consider a loan?

Plan loans may make sense in certain cases (for example, to pay off high-interest credit card debt, or to purchase a home). But make sure you compare the cost of borrowing from your plan with other financing options, including loans from banks, credit unions, friends, and family. To do an adequate comparison, you should consider:
Interest rates with each alternative

Whether the interest will be tax deductible (for example, interest paid on home equity loans is usually deductible, but interest on plan loans usually isn't)

The amount of investment earnings you may miss out on by removing funds from your 401(k) plan

A fee - only, independent, Registered Investment Advisor can help you work through this decision.

Although prepared from sources believed to be reliable, Pilot Capital Management makes no claim as the accuracy of the contents of this report. You should never enter into any financial transaction or strategy intended to alter your federal or state tax liability without consulting a CPA or other qualified tax advisor.

The U.S. Economy and Debt Ceiling Debate

2011-07-12T14:49:00.000-07:00

The U.S. Treasury estimates that without further borrowing, the government will run out of money around August 2, 2011, and has given this date as a deadline for Congress to raise the debt ceiling. This is a newer source of short-term uncertainty for the markets. As with the Greek situation, I think the most likely outcome is a political agreement that avoids a near-term market upheaval. This could provide some very modest upside to the stock market and other “risk” assets and have little effect on bonds. But the longer-term structural problem with our debt and deficit will likely remain unresolved, and possibly won’t be seriously addressed until after the 2012 presidential election. (I hope I am not being optimistic in thinking that it will at least be addressed at that point.) There is also a chance the two sides don’t reach an agreement and the debt ceiling is not raised by August 2. If this happens, I’d expect a sharp negative market reaction until an agreement is reached (which we expect would be quickly forthcoming) followed by some recovery.

I view this as a nasty, but short term, investment risk. As stated above, I feel that an agreement will be reached, if not before August 2nd then very shortly thereafter when congress realizes the damage they will have done by not reaching an agreement in a timely matter. Either way, post agreement, we end up in the same position, and all else not falling to pieces (Euro Zone Debt, China etc.) so should the markets.

Investors should review their portfolios with their advisors and gauge the impact of a short term severe correction in stocks on their portfolio. If the prospect causes concern, then perhaps a more conservative asset allocation is warranted.

The above commentary is the opinion of the author and should not be construed as investment or tax advice. Always consult a qualified investment and/or tax advisor before investing or changing investments.

A Long, Hot Summer

2011-06-03T11:21:00.000-07:00

As I write this, U.S. and foreign equity markets are in a long expected correction. Currently, this amounts to about 5% from the 52 week high of 1370 for the S&P 500 Index achieved in late April. We have been anticipating this for some time and have previously made reductions in the equity exposure in all but our most aggressive accounts. We do expect this correction to get somewhat worse over the near term and we hope to see an opportunity to redeploy at least some of those funds back into stocks as the risk- reward proposition for this asset class improves (stocks get cheaper).

There is ample evidence that the U.S. recovery is stalling. This is undoubtedly due to a combination of higher energy prices and the end of the Federal Reserve’s quantitative monetary easing (QE2). Oil prices have already began to correct and we believe they will decline further as the self-correcting mechanism (high prices lead to lower demand leads to lower prices) will act much faster following the financial crises (traders are unwilling and, because of lack of access to credit to leverage positions, unable to push the price of any asset class, including energy, to levels achieved before the financial crisis). We do believe that the market will stabilize and move higher in the fourth quarter of the year. In other words we continue a slow, painful recovery from our debt hangover and muddle through. During this time it’s important that we stay focused on the relative risk/return relationships between broad asset classes and be alert for any tactical opportunities that the market offers.

As the title implies it’s gonna be a long, hot summer. I have said many times before that good investors have both patience and courage. The markets this summer will ask us to exercise both, although not to near the extent that was required during the financial crisis.

What S&P’s Opinion on the Credit Rating of the U.S. Government Means to You.

2011-04-19T14:38:00.000-07:00

Yesterday, credit rating agency Standard and Poor’s fired a warning shot across the bow of the United States Government by changing its credit rating outlook to negative from stable. This means that there is a one in three chance that they would be forced to lower the U.S. Governments credit rating from the current AAA. S&P stated that the action was taken to reflect concern that congressional budget negotiations to reduce U.S. spending had bogged down and that an agreement could be difficult to reach or take too long to be effective. Oddly, the other major credit rating agency, Moody’s announced on the same day that it was reaffirming the U.S. Government’s AAA rating with a stable outlook, stating that they believed that the proposals now circulating around congress can succeed in bringing the budget deficit under control.

As an investor you should be concerned, because a downgrade of the credit quality of U.S. Treasury bonds, notes, bills and other obligations would extend to everything the government now backs, which includes the vast majority of the mortgages now outstanding in the U.S. and the FDIC. A downgrade would tighten credit and raise borrowing rates throughout the economy, not just for the government. This could slow the economy and nip our nascent recovery in the bud. In addition, if you own existing bonds of any kind, the value of those bonds would decrease as market interest rates rise. Note that this is not a problem if bonds are held to maturity but can be somewhat disconcerting when looking at your statement. It is also a problem in bond mutual funds where the manager may be forced to sell at lower prices due to redemptions.

While I’m concerned at the possibility of a downgrade, I take everything that comes out of the major credit rating agencies with a grain of salt these days. It’s worthwhile to keep in mind that these are the same folks who once rated virtually all mortgage backed securities AAA. Ever since the financial crisis (when we all found out that many were anything but) S&P and Moody’s have been falling all over one another trying to prove that they can actually get out in front of something. In this case I believe that S&P is overcompensating. The U.S. has a long history of doing what needs to be done… eventually. Our country also possesses an invaluable mature infrastructure and the world’s largest hoard of gold. ($387 Billion at last count). Hopefully S&P’s warning shot will wake up some folks in Washington and we can get our fiscal house in order sooner rather than later.

While I view a downgrade of U.S. sovereign debt improbable, it may be prudent to take steps to protect your portfolio from rising rates. Note that the specter of rising inflation would produce the same result and is more likely. We have been taking these precautions in our managed accounts at Pilot Capital. They include shortening maturities, reviewing the positioning of bond fund managers and considering some alternative (to bonds) income producing asset classes.

Your Investment Portfolio and Middle East Unrest

2011-02-27T18:45:00.000-08:00

Like all of you I have been watching recent events in the Middle East with apprehension and horror and, like all of you, I am concerned about the effect this unrest will have on the budding economic recovery here in in the U.S. I will not comment on the social/political conditions that have brought the current situation in the Middle East to the unfortunate position that now exists. As the say in the military, that would be well above my pay grade. Nor do I know to how many other countries the unrest will spread. The socio-political conditions that are the underlying cause (extreme concentration of wealth in the hands of a few and a lack of economic opportunity for most) exist in a great many OPEC countries. I do, however, have to think about how to counsel our clients on what they should be doing from an investment perspective in response to the resulting turmoil in the financial markets.

At this point I do not expect that the temporary loss of Libyan oil production will seriously impact world oil reserves. Saudi Arabia has already indicated that they will increase production to make up for the relatively small drop. I do, however, expect continued upward pressure on oil prices. World oil demand has now recovered to pre-recession levels. Prior to the “great recession” oil was selling for over $100 a barrel and spiked as high as $140. This was primarily due to supply-demand factors. If demand has returned to pre-recession levels, then shouldn’t the price also return to pre-recession levels?

Most of the economists whose opinions I’ve read over the past month or so do not believe that oil at $100 will cause a spike in inflation, primarily because food and energy constitute a relatively small portion of household spending in the U.S. (about 14%). Housing and wages have much more of an impact on inflation. Frankly it’s difficult to envision upward pressure on either of these inputs. Housing prices are still declining and most probably will continue to do so for some time. In addition it’s difficult for labor to demand higher wages with the unemployment rate at 9.5%. As far as the recovery is concerned, the consensus in the economic community seems to indicate that oil could rise as high as $125 a barrel before the modest GDP growth predicted for the next few years is jeopardized.

For these reasons, the turmoil in the Middle East, while a humanitarian, political, and moral crisis, is not yet an economic one, despite the financial news media’s attempt to depict it as one. However, should the unrest spread to a major oil producer such as Saudi Arabia, I would be forced to reconsider. Our advice to investors is to review your investment strategy and your asset allocation and be sure that it is appropriate for your risk tolerance and financial situation. Next review your portfolios and be sure that you are adequately diversified. Stick to your plan and have courage and patience, both hallmarks of great investors. Oh, and if you’ve been sitting on cash remember that crisis brings opportunity.

Why We Procrastinate With Financial Issues

2010-09-15T04:46:00.000-07:00

I have been a financial advisor for close to 25 years. If I had to cite the one problem that stops most people from being fully financially functional it would have to be procrastination. It’s very difficult to be a successful investor if you simply just can’t get started. As evidence for the seriousness of this problem I offer the astounding success of auto enrollment in 401(k) plans. Auto enrollment plans do not wait for employees to sign up to participate in the plan. When the employee becomes eligible they are simply enrolled without their consent and some percentage of their pay is deducted and placed in a default investment option (usually a money market or target date fund). It is then up to the employee to opt-out if they do not wish to participate. Employers report 20 to 40% increases in long-term participation rates when auto enrollment features are put in place. Keep in mind that, other than the auto enrollment feature, these plans were unchanged. Therefore, one can conclude that the only reason these employees were not participating before was that they just couldn’t get started.

Procrastination is such a universal human pastime because its roots lie deep in our evolutionary biology. During much of our history as a species, goodies had to be seized and consumed immediately because; a. it was problematic that you would find more goodies any time soon, and b. it was difficult or impossible to store goodies for future use. Humans adapted by heavily discounting future benefits in favor of current benefits. The expression “a bird in the hand is worth two in the bush” perfectly describes this problem of “intertemporal choice”, as psychologists put it. This is why we put off going to the gym, saving money, losing weight, quitting smoking, and reading the great classics in favor of watching TV, eating Twinkies, the comfort of tobacco, and reading mindless trash. All of these choices involve foregoing current benefits for future benefits. Let’s face it, for most of us, dealing with our finances effectively means just that, foregoing current consumption in return for future benefits. Procrastination, in addition, is a surprisingly complex behavior (no, it’s not simply laziness) other factors also have an impact on our decisions to not take action on a specific issue. Fear (of failure, of making bad decisions, of being “sold” something by aggressive sales people), and being overwhelmed by the sheer size of the problem (this factor has gotten far worse with the explosion of information available on the internet) both contribute significantly to financial procrastination.

There are very few aspects of our lives, however where procrastinating hurts us worse than our finances. Typically people wait until their late 50’s to seek help with retirement planning. This is far too late. I have been asked to “fix” 401(K) portfolios that had been ignored for over a decade. These included portfolios where vendors had been replaced and all the funds simply allowed to “map” over to what the new vendor said was a similar asset mix several times. In many cases these investors were leaving return on the table and at worst they exposed themselves needlessly to additional risk by not rebalancing to their original target asset allocation. Some never really had a target allocation.

How can we overcome our natural tendency to procrastinate?

1. Redo the mental math that causes us to discount future benefits in favor of current ones. One of the best ways I’ve found to do this is to picture what you want your financial life to look like. If you are like most of us, it is a far cry from your present situation. Draw this diagram on a piece of paper. Where you want to be versus where you are. Congratulations, you’ve just taken the first step in figuring out how to get from where you are to where you want to be financially.

2. Set realistic financial goals and prioritize them, then attack the ones that, by ignoring them, damage you the most. The first thing we do with new planning clients in our practice is to help them through this process. Most people cannot address all of their financial issues simultaneously, most of us have neither the money nor the time, but we can deal with the one or two we identify as the most critical.

3. Keep track of your spending! This doesn’t make me very popular with clients but most people have no idea where their money is going, just that it’s gone. A few years back I decided to take weight loss seriously. The best advice I came across was to track how many calories I was eating for a few weeks, not diet, just count the calories. I was shocked at how many calories I was mindlessly consuming. I was then able to set a daily calorie target. In case you didn’t recognize it, this is a form of budgeting. Try it for a few weeks with your spending.

4. Set aside a few hours each week to deal with financial matters. This is in addition to the time you spend paying bills. Use that time to read up on financial matters, especially in areas that you have identified as a priority.

5. Get a financial coach. Make an appointment with a fee-only financial advisor. Initial consultations with these professionals are usually free of charge. During this meeting the advisor will want to get to know both you and your financial situation. He or she will help you list and prioritize your financial goals and give you a general idea of how the advisor can help you achieve them and how much it will cost. The advisor should be willing to serve as your financial “coach” to help motivate you to stop procrastinating and get your financial house in order. Stick with fee only advisors; this avoids the fear we all have of being sold something.

Note: this post is almost two weeks late… I just couldn’t seem to get it started.

Merger Arbitrage Funds May Have a Place In Your Portfolio

2010-07-13T07:57:00.000-07:00

Note: Matt Staub, an economics graduate student at Temple University co-authored the following post.

Like many investors who pay attention to valuations, we are concerned about the relatively low returns we expect from both stocks and bonds over the next few years. Coupled with concerns about the condition of the global economy and its myriad problems, these expectations have led us to start searching for alternatives to traditional stocks and bonds and their mutual fund equivalents.

One such alternative is mutual funds whose mangers practice merger arbitrage strategies. Arbitrage is defined as the simultaneous purchase and sale of an asset in order to profit from a difference in price. It is a trade that creates a profit by exploiting short-term price differences of identical or similar financial instruments. Simply stated, arbitrage opportunities exist as a result of market inefficiencies, and arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. Such strategies have long been the bread and butter of hedge fund managers.

Merger arbitrage is one specific type of arbitrage. It is important to distinguish merger arbitrage from typical long/short strategies based on market timing. Merger arbitrage is an event-driven strategy. When a merger is announced, the stock price of the target company generally trades at a discount to that offered by the acquirer until the deal closes. This discount reflects the tension between the likelihood that the deal will close at the stated terms and the willingness of holders of the target company’s stock to sell at a discount to lock in gains and avoid the risks if the deal fails. Merger arbitrageurs provide liquidity to holders of target stocks who often sell after a merger or other corporate event is announced. Basic implementation of merger arbitrage involves taking a long position in the target company and a short position in the acquirer (in a stock only deal). The art of this trade is to structure the positions such that when the merger closes a return is produced that exceeds a preset hurdle rate. The hurdle rate is usually based on a risk free rate like the prevailing 30 day T-Bill rate or LIBOR. Typical of this strategy is The Arbitrage Fund ( ARBFX) which has a target return of the T-Bill plus 400 basis points.

Most mainstream forecasters are indicating that returns for stocks and bonds will be mediocre in the near future. The economic outlook is uncertain and could get considerably worse. However, many corporations are currently flush with cash reserves from their efforts to prepare for financial Armageddon sixteen months ago. With excess cash reserves and the expectation that interest rates will remain low, at least in the near term, corporations are in a position to finance economically justified mergers and acquisitions. This should provide merger arbitrageurs with plenty of trade fodder.

As with any investment opportunity, it is important to consider the positive and negative aspects of merger arbitrage. As a result of hedging with short positions, merger arbitrage funds hold up well in bear markets because the short positions do well in a falling market. In bull markets, however, merger arbitrage can severely under-perform, again due to the short positions. Therefore this strategy is not for aggressive investors that are sensitive to equity under-performance. Additionally, funds concentrating on merger arbitrage are not cheap to own. This investment strategy is highly specialized work done by mathematically gifted traders, and there is a great deal of discipline and expertise required. Management fees typically run one half to three quarters of a percent higher than equity mutual funds. However if you are a moderate risk investor who is not concerned about missing a major upward market move, merger arbitrage funds can provide some return in a moribund market. There are a number of funds available whose managers are excellent practitioners of the arbitrageur’s art. Consult your independent, fee-only investment advisor for more information and guidance.

Overcoming Your Wealth Destroying Instincts and Becoming a Better Investor II - Anchoring Bias

2010-06-28T05:03:00.000-07:00

Have you ever purchased a product or service based on an outsized focus (obsession) on one particular aspect of the product that really had no relevance to its usefulness? Like the very used Chevy Camaro you bought in high school with the hard earned $500 you’d saved from five summers of mowing lawns because you couldn’t resist the candy apple red paint job. The fact that the car was a mechanical disaster just seemed to pass you by. Don’t feel bad, we’ve all done that. In fact, we do it all the time but usually in far subtler ways. Psychologists call it “Anchoring Bias”, or the tendency of humans, when making a decision, to anchor our thoughts to a reference point even though, disturbingly often, it has no real relevance to the decision.

In 1974, the founders of behavioral economics, Kahneman and Tversky used a clever experiment to demonstrate the power that anchoring has in human decision making. They had participants spin a wheel with numbers from 1 to 100. Participants were then asked a question requiring then to make an estimate such as “What is the percentage of UN membership accounted for by African countries”. When the wheel came up on a higher number the estimate was on average much higher than when the wheel came up on a lower number. Obviously the spin of the wheel, a completely random number unrelated to the question, had a great influence on the participant’s response. They were anchoring on a recently experienced number to evaluate a problem.

Although the evolutionary basis of anchoring is the subject of much debate, it seems obvious that it was important to our not–so- distant hunter-gatherer ancestors to be able to make decisions such as what to eat, when to run, what critters not to mess with, etc. very quickly. The process that developed seems to base much decision making on reference points, or anchors. So our brains are constantly searching for these anchors. This is an almost totally unconscious process.

In our financial lives anchoring on the wrong information can get us in a lot of trouble. The way our brains process information worked extremely well when the anchors were unambiguous. Not so much today when so much information has little or no bearing on the true nature of the problem of the moment. Take for instance a sudden drop in the price of a stock. Many investors will buy it immediately without evaluating the reason for the drop. They anchor on the previous high price and the company looks like a bargain at the current price. Likewise, investors who own the stock already tend to hold on regardless of the news assuming that “it’ll come back”. In fact, an event or events may have transpired that makes the lower price a truer reflection of the value of the company. Perhaps the company’s product is becoming obsolete or a competitor has developed a less expensive manufacturing process and can now significantly under price the company’s product. In any case, basing your decision on the higher price alone will cause you much grief even though our natural tendency may be to do so. Successful investors like Warren Buffet are able to anchor on data that are relevant to the problem and effective in determining the true value of the company given its current situation and its future.

Perhaps nowhere is anchoring more apparent, or more damaging, than in the case of a great many small investors who use the current market value of their portfolios as a mental anchor. Thus during booms when their portfolios reach x number of dollars, they equate this to the true value of their investment holdings. This may or may not be the case as the value may have been artificially inflated by a temporary euphoria for risky assets. Then when the value drops because market participants are willing to take less risk they feel cheated out of their wealth and get angry or fearful and sell when in fact the value of their holdings may now be more reasonably priced to their true worth.

So, when making investment decisions how do we overcome our innate anchoring bias? The first step is realizing that it exists, and make a conscious effort to be sure that our value judgments are made on rational and relevant data points and not arbitrary ones. For instance when considering a stock purchase we should be looking for clues to what the true value of the company is, for example as determined by discounted cash flow or dividend discount calculations. The 52- week high or any other price the stock has obtained is irrelevant. The relevant question is “Is the price we are paying reasonable given the value we are getting?”

If you are a mutual fund investor what is important is not that we own the hottest performing funds of the past year. The decision to buy a mutual fund should be based on the role the fund plays in your portfolio allocation, the investment technique and philosophy of the manager, and the fund’s long term track record compared to its peer group. These are the data points that you should be “anchoring” on.

Overcoming Your Wealth Destroying Instincts and Becoming a Better Investor 1 - Following the Herd

2010-05-10T15:24:00.000-07:00

I thought that in the aftermath of the “Great Recession” that it would be beneficial to use the blog to discuss the numerous errors that investors tend to make that are not unique to who we are but rather to what we are. I have been an investment advisor and financial planner for almost 25 years. When you have spent that length of time on the other side of the desk from thousands of individual investors you realize that some errors in financial management are so common that their basis seems to be rooted in human nature rather than anything unique to any individual. Because of my background as a biologist, I tend to look for physical explanations for human behaviors and I feel very strongly that a lot of what we do, particularly how we react to stressful situations is rooted in our evolutionary biology. The fact is that we have been something that can be identified as human for about 2 million years or so and we have only been investors for about 2000. So 99.9% of our evolutionary development has been devoted to developing the survival skills of a hunter/gatherer rather than investing skills.

It has long been noted that we tend to exhibit a herd mentality when it comes to investing. The most glaring example is the stock market where investors habitually crowd in when stocks are doing well and flee in droves whenever the market corrects. One of my greatest frustrations as a financial advisor is that, while investors are more educated that ever and have access to more and better information than ever, the “herding” problem appears to be getting ever worse as evidenced by the increasing frequency of financial bubbles.

An interesting proof of this is the data that mutual fund research firm Morningstar gathers to produce a calculation of the “effective return” that the average investor actually received in any given mutual fund due to money moving in and out of the fund rather than the actual returns earned by the fund manager. Keep in mind that this has nothing whatsoever to do with fees, as all results were net of fees. This discrepancy in the return the average investor received is due solely to investor behavior.

An interesting and illustrative example is the CGM Focus Fund run by famed manager Ken Heebner. A recent article in the Wall Street Journal notes that CGM Fund was the top performing mutual fund for the prior ten year time period, posting an annualized return of 11% per year. However the Morningstar data revealed that the average investor in the fund actually lost an average of 10% per year during that same time period! No, you didn’t misread that, a loss of 10% annualized. What happened? Is Mr. Heebner guilty of a misrepresentation or worse yet a fraud? Absolutely not, Mr. Heebner and his staff are very good at what they do and did, in fact, posted those excellent returns. Rather, the problem lies with the behavior of the investors themselves.

Mr. Heebner is, as most investment professionals know, a growth manager and is extremely aggressive with this particular fund. Investing with him in CGM Focus can be very rewarding but requires a cast iron stomach and a great deal of patience as this fund has very good long term performance relevant to its peers but is prone to wide swings in value. Investors who invested in the fund at the beginning of that ten year period and stayed invested did indeed see their money grow at an 11% annualized rate. But during this period the fund fluctuated so much in value that many of its investors were alternately so overly optimistic that they ignored its well publicized risks or were panicked into selling during the downswings. One example, in 2007 CGM Focus produced an astounding 80% return and investors crowded in flooding the fund with $2.6 Billion in late 2007 and early 2008 just in time to catch its breathtaking 48% drop in 2008 when they withdrew $1.2 Billion. It seems to me that investors have misused this fund. It should be considered for the aggressive growth allocation in a broadly diversified portfolio not as a market timing vehicle.

All of the academic literature that I have seen indicates that small individual investors underperform the market rather dramatically. This is a perfect example of why. Our instincts tell us to follow our fellow humans. Why? Simply because for 99.9% of our existence as a species if one hung with the herd he/she didn’t get eaten by the saber toothed tiger or stepped on by a wooly mammoth. If one went off on one’s own, he/she did get eaten or stomped on. Evolution, in this case, has produced a very powerful instinct. Unfortunately, as evidenced by the prior example it’s an instinct that can cause us a great deal of harm in today’s investment environment. In the words of Walt Kelly’s Pogo, “We have met the enemy and he is us”.

So how can you avoid this costly tendency? First of all do not chase returns. Realize that by the time you hear your barber, your co-worker or your great Uncle Joe talking about how great any investment opportunity is, it’s too late. What you should do is design a diversified portfolio that suits your risk tolerance and time horizon (an experienced, fee-only investment advisor can help with this) and develop a funding plan. Then, and this is the hard part, stick with your plan no matter what the market throws at you. Sound investment practice requires both patience and courage. It is vital that you rebalance your portfolio(s) at least once a year to maintain your target asset allocations. Also recognize that all of the variables involved in any investment plan (risk tolerance, return requirement, funding requirement) change over time, so sit down with your investment professional and revisit your plan at least once a year.

On Short Sellers, Goldman Sachs, and the Small Investor

2010-05-03T05:50:00.000-07:00

Short selling is a trading strategy where one sells stock on which you don’t intend to make immediate delivery to the buyer. Either because you don’t actually own the stock (uncovered short) or because you own the stock and wish to protect yourself against a drop in the price (covered short). Either way, a broker allows you to borrow the shares to make delivery to the buyer and charges you a finance charge until you cover the short by replacing the stock by buying the shares on the open market or surrendering yours. Profits are made on a short sell if the stock declines (you replace the borrowed shares for less than the sale proceeds) and losses are booked if the stock increases in value from the time of the short sale. There is tremendous risk in short selling because, while the value of a stock can only drop to zero, there is potentially no end to how much it can increase and therefore no bottom to the potential loss on a short position. Short positions can be constructed with just about any security not just stocks. The key issue is finding a counterparty (someone willing to take the “long” side of the trade).

There is a great deal of controversy ( and indeed public outrage) recently surrounding large trading organizations such as investment banks and hedge funds that use short selling as a trading strategy. A short strategy is at the heart of the Goldman Sachs transaction that has landed the firm in hot water. Basically the firm created and sold a pool of subprime mortgages called a Collateralized Debt Obligation (CDO)(the long position) at the request of a client. In fact, the client helped select the loans to be included in the pool. The client then in turn created at short position by buying a Credit Default Swap (CDS) on the same security. The CDS was an insurance agreement with a third party that in the event of the mortgages in the pool defaulting the third party (in this case AIG Insurance) would pay the holder of the CDS the value of the covered security. In other word Goldman’s client was betting that the securities it helped created would default. This is, in fact, a short position. It is important to understand that nothing that any of the firms did was illegal. The SEC’s complaint is that the short interest of Goldman’s client and their involvement with the construction of the mortgage pool was not disclosed to potential buyers of the subprime mortgage pool.

There is something about short selling that causes revulsion in most of us. Most investors will never utilize short selling because they do not have the risk tolerance and in reality no need for the hedge that a short sell offers. A short sell is a bet against something and usually something that we view in a positive light, a company, a country’s ability to repay its sovereign debt, or in the Goldman case, something that Americans hold very dear, home ownership. As much as we dislike shorts, they are a necessary part of efficient markets. At the most basic level every trade requires two parties, a buyer who thinks the security will go up and a seller who thinks it will go down or needs the money for something else. The shorts supply a big enough percentage of the sell side that, if missing, would cause a significant liquidity problem. Also, the ability to sell something borrowed is very difficult to limit without a severe impingement on all of us to dispose of property we own or control. Also many entities including investment banks, farmers, commodities intermediaries, and companies dependent on natural resources for raw materials are forced to take long positions in a great many markets. The only way for these entities to protect themselves against market disasters is to be able to take an offsetting short position. Without this ability these entities would be more likely to fail and indeed, many may cease to exist because no one would be willing to take the associated risks and the economy would suffer greatly.

We must allow short selling but it also must be regulated. From 1938 until 2007 there was a rule that prohibited short sells on stocks unless there was uptick in the price. The purpose of this rule was to discourage outside entities from executing “bear raids” on stocks (a trader's attempt to force down the price of a particular security by heavy selling or short selling). Together with a prohibition against naked short selling (conducting a short sale while neither owning nor borrowing the stock for delivery) these rules created enough risk that short sellers had to be careful about when, what, and how they shorted. The SEC under the Bush Administration abolished the uptick rule and flat out failed to enforce the prohibition against naked shorting. Both rules need to be reestablished and enforced. Another issue is the fact that the most active short sellers are hedge funds, which are exempt from either registering or reporting to the SEC (or anyone else for that matter). As a consequence regulatory authorities have no clue what these people are doing with billions of dollars (and leveraged at 30 to 50 : 1 to boot) and no way to gauge the effect of this trading on markets. This puts you, the individual investor at a tremendous disadvantage. A disadvantage that can be partially rectified by having hedge funds register with and report their activities to a regulatory authority. In the meantime, you as an individual investor need to be aware that these activities occur, we may not like them, but they are required for efficiently functioning markets. It is very difficult for individual investors to muster the resources required to judge the effect that short sellers have, or could have, on the securities they own. That is precisely why I recommend that the large majority of individual investors use mutual funds for their portfolio construction. Professional investors, such as mutual fund managers, have both access to data and the expertise and experience to gauge the effect of shorting on their portfolio positions and perhaps even use it to the advantage of their shareholders.

Emerging Markets Bonds May Protect Purchasing Power of U.S. Investors

2009-10-04T16:06:00.000-07:00

At Pilot Capital one of our concerns going forward is the value of the U.S. Dollar relative to its peers (Yen, Euro, and Pound) and to the currencies of developing markets. We believe that, over the next several years, the dollar will continue to be weak because of the still-large (although shrinking) U.S. trade deficit, our very large (and growing) national debt, and the anemic U.S. economic growth that we foresee. This has profound implications for the financial well being of our clients, whose wealth is denominated in U.S. dollars. Remember that we all operate in a global economy (we buy lots of stuff from folks in other countries and we depend on them to buy things from us). Any decline in the dollar versus the currencies of our trading partners lowers your purchasing power relative to the folks we are buying from and selling to, an uncomfortable situation. This makes it important that we look for a hedge against a chronically declining dollar. It would also be helpful if we were being paid to hold this hedge.

When looking for what currencies would represent a good hedge against a declining dollar, we rejected the other developed market currencies as many are in the same situation as the dollar. In fact, there is the strong possibility that developed market currencies will “lock” over the next few years and essentially move together eliminating any diversification advantage.
Many emerging markets countries, on the other hand, run trade surpluses, are less indebted to the rest of the world, and are likely to grow faster than the U.S. and the rest of the developed world in the foreseeable future. The most visible examples of this are Brazil, India and China. In addition, emerging-markets currencies offer higher yields, which attract the capital flows that support their currencies. Longer term, as the balance of the global economy shifts, it may become increasingly in emerging-market countries’ self-interest to allow their currencies to appreciate versus the dollar (currently many peg their currencies to the dollar) in order to improve the purchasing power of their consumers. Taking into account all these factors, we believe that a basket of emerging-markets currencies is the best way to protect our balanced portfolios from a decline in the U.S. dollar. The best way to achieve this goal is to own a diversified portfolio of good quality bonds denominated in (interest payments are made in) a variety of these currencies. If global economic recovery continues and the dollar continues to weaken we would profit in three ways.

· First, we are being paid our interest in the local currencies. For this income to be returned to us it must be converted to dollars. If the dollar cheapens versus the local currencies we can buy more dollars (hence preserving our spending power).

· Second, rates are much higher in developing countries than in the U.S. and the yield curve much steeper (a bigger difference between short and long term rates) this gives a good, active manager an opportunity to use interest rate risk strategies to add value.

· Third, we believe that the perception of risk in these markets will decline over the next few years and there may be more demand for debt from these countries allowing for capital gains.

When looking for an investment vehicle to position this hedge we favor active managers and not indexed funds (note that this effectively eliminates ETF’s). An active manager is able to take full advantage of the steeper yield curves available in emerging bond markets as well assess currency weightings in the portfolio to maximize currency translations versus the dollar.

Jobs Data a Rally Killer?

2009-07-03T07:34:00.000-07:00

The stock market reacted violently to yesterday’s jobs data. As usual I would be very cautious about making any moves based on a single data point. In this forum I like to help my readers find information that’s important. Also I try not to reinvent the wheel (who has time for that anyway) and, where appropriate, to defer to better writers. In just that spirit I direct you to Bob Johnson, the Associate Director of Economic Analysis at Morningstar who yesterday put up an excellent post on why you should not read too much into yesterday’s jobs data. http://advisor.morningstar.com/articles/blogentry.asp?id=16776 Enjoy and have a safe and pleasant holiday weekend.

2009-06-17T06:25:00.000-07:00

This week I’m delegating my blogging chores to a “guest blogger”. This link will take you to EconBlog, which is written by a promising young financial writer who is interning in our office this summer. For a look at emerging markets and the risks and return potential there, click on http://econblogsoc.blogspot.com/2009/06/emerging-markets-worth-look.html.

Keep Watching Libor

2009-06-05T14:13:00.000-07:00

Of all the economic news posted lately the most encouraging was that the three-month U.S. Dollar Libor, seen as a key gauge of the effectiveness of the Federal Reserve's monetary policy, fell to 0.63688% yesterday, the lowest rate since the British Bankers Association began publishing Libor data in 1986. Click this link for the Wall Street Journal Article http://online.wsj.com/article/BT-CO-20090603-704345.html?mod=dist_smartbrief . Very early in the financial crisis the three month Dollar Libor rate peaked at 4.81875% on Oct. 10, 2008, indicating a near shutdown of interbank lending. LIBOR is important for a host of reasons. The most important is that it is the rate that banks around the world charge each other to borrow U.S. Dollars. It is generally regarded as a measure of the level of confidence that bankers have in each other’s institutions. It is also vital to the health of the balance sheets of individual families as it is a key standard for setting interest rates on all kinds of variable rate loans such as floating rate mortgages and home equity loans. Many commercial and municipal loans with variable rates are also based on Libor. Obviously lower rates on these loans help individuals and businesses meet their debt obligations and are a key piece of working our way out of a very nasty economic situation. We said very early on that Libor was going to be a key indicator of our progress. Myriad problems remain in the global economy, but real progress is very visible. We are encouraged, and so are the financial markets.

On the downside, we are concerned that the recent rise in oil prices could nip our nascent recovery in the bud. Keep in mind that the drop in gasoline prices from over $4 a gallon to less that $2 was a de facto tax cut for the U.S. consumer. The recent rise to $2.50 is not a killer but bears watching. In general, gasoline in the U.S. over $3 a gallon is a problem for consumers. This is a two edged sword for Pilot Capital though, as our managed portfolios at PCM tend to have an overweight to energy. We continue to like the sector. Our long term secular outlook for a great many people looking to use fewer resources remains intact.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Change in Name and Focus

2009-06-05T13:09:00.000-07:00

Please note that I am changing the name of my blog from” Mutual Fund Watch” to “The Old Perfessor’s Investment Blog”. I am finding the number of investment topics that I want to share with you going far beyond just mutual funds. I’ll still write about mutual funds, but the wider scope allows me to comment on so much more at a time when I feel it’s sorely needed.

Thanks for Reading!

Greg Staub, Ph.D., CFA

Old Perfessor’s Investment Blog

I have been a professional investor for over 20 years. To say that a great deal has changed in that time is a spectacular understatement. When I first started helping others to invest, there were about 1,500 publicly traded mutual funds. Today, the Morningstar data base lists 26,842 mutual funds and ETF’s. We live in an age of virtually unlimited, inexpensive access to massive amounts of information about just about anything. Perhaps my greatest disappointment has been that despite the profusion of data that investors now have available, it seems that individual investor’s decision making is worse than ever.

From an investor’s point of view, the world has become a much more complex and dangerous place. The basic problem, as I see it is that the vast majority of individual investors no longer see investing as the ownership of assets that can build wealth or deliver steady income. Rather, investing has become more like a giant gambling casino complete with get rich quick schemes and “systems” delivered to us 24/7 on cable TV. Very few people seem capable of looking at the information available to them, taking a step back and asking, does this make any sense in light of what’ s possible and what’s probable.

My goal with the “Old Perfessor’s” blog is to find information that will allow you to invest the right way and filter out the massive amounts of financial pornography that’s flooding the media in all its myriad formats. I’m going tell you what’s important and what it means to you. Also it’s my opportunity, from time to time, to have a little intellectual fun with the purveyors of the aforementioned material.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Target Date Funds Create Controversy

2009-04-19T16:38:00.000-07:00

In a March 26th letter to the Senate Special Committee on Aging, the Department of Labor announced that it was beginning an immediate review of Target Date Funds (TDF). TDF’s have become a popular option in 401(k) and other defined contributions plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, usually from the fund family sponsoring the TDF. For example, Vanguard target date funds are managed using Vanguard funds as the underlying investment vehicles. They are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues. The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investors risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence there is an incredible amount of variation in the amount of equity (stock) risk between funds with the same target retirement portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

Given the above issues, it’s not surprising that when an extremely trying market cycle occurs that a significant number of investors in target date funds are going to be disappointed in their results. I thought it would be helpful to share the protocol that I use to evaluate whether to recommend that clients use the target date funds available in their 401(k) plans.

1. Determine the clients risk tolerance
2. Develop an asset allocation based on risk tolerance
3. Develop a portfolio using the non target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.
4. If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance not the one whose target retirement date most closely matches the clients.
5. Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.
6. If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is however along with common sense, all we have to base decisions on.
7. If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One other issue with TDF’s is that some fund families have used them to gather assets for in house funds that have performed poorly and have difficulty attracting assets on their own.

This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.

One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:

1. Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.
2. If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners www.paladinregistry.com .

For what it’s worth, here are some suggestions for the Department of Labor and The Senate Special Committee on Aging as they look into participant complaints regarding target date funds:

1. Require a disclaimer on information of all forms accompanying target date funds that warns participants that the risk inherent in investing in a TDF may have no relation whatsoever with their own tolerance for risk.
2. Set standards for information that should be made available to plan participants so that they can make informed decisions. This information should be readily accessible and streamlined so that plan participants do not need advanced degrees in economics, law or finance to use or understand the material.
3. Recognize, finally that not all plan participants want to, or are able to, make their own investment decisions and allow plan sponsors (employers) to be able to offer the services of independent, unbiased fee-only investment advisors without the fear of lawsuits provided that those giving advice have the proper credentials and training.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

Time To Consider Some Inflation Insurance?

2009-01-19T19:23:00.000-08:00

As I have written before, I firmly the believe that the actions being taken by the U.S. Federal Reserve and most other major central banks around the world, while costly and politically unpopular in many circles, are both necessary and correct. We are in the midst of a major global recession caused by an intense deleveraging movement by businesses and consumers. Financial markets have experienced a massive flight to quality. There are very few historical parallels to this situation, but history clearly indicates that to keep the current situation from deteriorating into a prolonged and deeper recession and potentially a deflationary spiral, central banks need to act as a counterweight to the deterioration in both credit and liquidity by re-inflating the financial system. Here in the U.S. the Fed is literally throwing everything, including the proverbial “kitchen sink”, into the effort to repair the system and restore economic stability.

My biggest concern is not that the Fed’s action will not work; they will eventually produce the desired results, but rather the consequences and future cost of the “fix”. One of my bigger concerns is future inflation. You may ask how I can be concerned with inflation when the global economy appears to be walking a very thin line between disinflation and deflation. Providing liquidity basically means printing money. This action has the potential to be extremely inflationary. In the short run it is not, because it counterbalances a decrease in the money supply due to the aforementioned deleveraging and flight to quality. Eventually, however, the effect of all that liquidity will produce the desired result (people start spending again) and then the Fed must withdrawal liquidity to avoid inflation (too much money chasing too few goods and services). There are two problems with this. First, central banks tend to err on the side of caution, meaning rather than nip off a developing recovery the Fed will keep then excess liquidity out there longer. The second is that politically, it is more difficult to withdraw liquidity and rain on the recovery party.

My working hypothesis is that liquidity actions by global central banks begin to take hold late in 2009 and the recession bottoms during that time. Inflation then, may rear its ugly head by mid to late 2010. I believe it is prudent to begin to seek opportunities to reposition some assets as “inflation insurance”. Assets that I am considering include real estate, commodities, infrastructure investments and Treasury Inflation Protected Securities (TIPS).

Right now TIPS appear to offer a decent entry point. For a discussion of what TIPS are and how they work to protect your spending power, please see my article on TIPS recently posted on Pilot Capital’s website http://www.pilotcapitalmanagement.com/files/TIPS%20Article%201-9-09.pdf. As of this writing, The Vanguard Inflation Protected Securities Fund (VIPSX) offers a yield of 3.02% without any inflation adjustments. The comparable treasury fund, Vanguard’s Intermediate Term Treasury Fund (VFITX) yields 2.02%. TIPS are commonly valued in terms of the Break Even Inflation Rate (BIR). Normally the BIR would be on the order of 3%, in other words inflation would have to be at least 3% to have the TIPS perform equal to the comparable treasury. Right now the BIR is -1%. This means that the market is expecting consumer prices to drop 1% a year for the next 7-10 years. I view this as possible, but not probable as, since 1933, there have been only three years when the CPI growth rate was negative. The way I look at it, we can buy a U.S. Treasury bond with absolute inflation protection for 1% more yield than one with no inflation protection. In other words the U.S Treasury is buying our inflation insurance. Sounds like a deal!

A couple of caveats however, are in order. Note that TIPS work much better in tax advantaged portfolios such as IRA’s as the inflation adjustments to TIPs represent a taxable event and lower the after tax return in taxable accounts. Interestingly, this is an asset where the ETF alternative is not cheaper. Both the IShares Barclays TIPS Fund (TIP) and VIPSX charge an identical 0.25%. In addition, there is currently a disconnect between the net asset value (NAV) of the ETF, and its actual price. The ask premium over the NAV at the date of this writing is about 3.5%. Paying this premium would more than negate the advantage over the comparable treasury. Even with the trading advantages of the ETF, I prefer the mutual fund in this case.

Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investor’s should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.

What I do Worry About

2008-11-18T14:22:00.000-08:00

As I write this entry at the close of the market on Tuesday, November 18th, the market finally was able to sustain a gain without the afternoon selloff and continues bumping along in a volatile fashion. Unfortunately, I expect the volatility to continue at least into early next year. Stocks are faced with low confidence, poor visibility on earnings and a significant amount of tax selling (which will continue into December). This is balanced by pretty attractive valuations in a lot of areas, large institutions rebalancing their portfolios (from fixed income to stocks, in general) and (we hope) a winding down of forced selling by hedge funds and other leveraged entities.

As I have written before, I always liked client meetings because they often force you to look at problems in a different light and question your thinking. I had a client ask recently if there was anything that would change my mind about staying the course on a well thought out and diversified asset allocation for the long haul. I came up with six conditions that, in the current environment (or any environment for that matter) would concern me to the point that I would have to reconsider our involvement with some or all of the assets classes that we invest in. These would be:

1. If the Fed withdrew liquidity from the system by shrinking the money supply. Note that thus far the Fed and all other G7 central banks have been exceptionally accommodative in this respect. The Central banks must act as a counterweight to what is going on in the economy. Deflation must be countered with an increase in the money supply and vice versa in an excessively inflationary environment.

2. Attempts to restrict foreign trade. The imposition of tariffs or any barriers to trade globally would be a very bad sign. Note also that currently trade between most of the free world remains relatively unrestricted.

3. A refusal to provide fiscal stimulus on the part of G7 governments. In the present situation it is vitally important that government spend money to counteract the slowdown in the private sector.

4. Any attempts at wage or price fixing. One of the things that prolonged both the Great Depression and the stagflation of the 1970’s were the government’s ill-fated attempts at establishing legislated price and wage levels.

5. A large increase in taxes. This includes imposing excise taxes on the sale of goods and services. I accept that taxes will probably go back up to where they were during the Clinton Administration. I would prefer no tax increases until we are clear of the current mess. But moderate increases are not an economy killer. One of the New Deal’s errors was tripling taxes during the mid 1930’s.

6. Increases in the cost of employing people. Whether its increased payroll taxes or increased regulation, compulsory unionism or whatever. We must not discourage employers from hiring.

Asset Allocation and Bill Gross Weigh’s In

2008-10-23T07:35:00.000-07:00

I’m in my office after the market close on Wednesday (a 500 pint drop) listening to yet more technical experts on CNBC. What strikes most about this particular panel discussion is that all of these people are traders; hence their time horizon is very short. One gentleman noted that he is really only interested in what happens this week. He admitted that there may be longer term value in the market but he really never gives that any thought. The other big discussion is that hedge funds continue to be forced sellers of all kinds of assets, including stocks. Keep in mind that these people have no choice; they are forced to sell because they borrowed money to buy the assets and/or (usually both) the investors in the fund are demanding their money back. The discussion did eventually turn to what the individual investor should be doing. After looking at each other for a painful few seconds they all pretty much agreed, nothing. Because if you do, you have in fact become a trader not an investor and this is a very dangerous market in which to trade.

I’ll reiterate again that, provided you are comfortable with your assets allocation, you should not go to all cash. There are two reasons for this 1. Cash is a lousy long term asset, particularly in an inflationary environment. Make no mistake, the actions taken by the Fed and Treasury are exactly what should be done but in the long run they will be inflationary. Right now we are in a deflationary environment and the Fed’s job should be to act as a counterweight (i.e. feed the system money). 2. The people whose opinions I trust now agree that financial Armageddon or a second Great Depression is off the table. This means that this is a good old fashioned correction caused by recession fears and exacerbated by the forced selling and deleveraging of hedge funds and consumers. What this means is that when the stock market turns back up it will do so quickly and unexpectedly. If you miss even one or two of the best days it will be too late, you will have destroyed your future return and further damaged your retirement funding.
I will also add that I do not know when this will occur. I also don’t know if we go lower first. It’s not my business to try to predict short term moves in the financial markets. Here’s what I do know. The S&P 500 is now off somewhere around 40% from its high in 2007, and only 8% higher than its low in the last recession in 2002 (only 6 years ago). I pretty much own the same things I did then. I was comfortable owning them then and when their value increased to the market high last year. Do I have every confidence that in the next five years those same assets can repeat that, - yes. Do I need the money in the next five years, - no.

Given the risk in trying to trade or even rebalance in this environment, I’m going to sit tight and advising my clients to do anything else would be a disservice to them and their future wealth. That said, if you are having trouble sleeping over all this or your short term financial picture has changed, you need to sit down with your financial advisor and reassess your risk tolerance and asset allocation. No advisor can read your mind and we really do try not to take actions that make our clients uncomfortable.

One last item below is a link to PIMCO’s Monthly Market Outlook. Bill Gross is probably the smartest bond guy on the planet. PIMCO’s take on the current situation is recession not depression then recovery then inflation. Enjoy the read and bookmark the site.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Gross+October+2008+Fear.htm
Greg Staub, CFA

On Credit Default Swaps and OPEC’s $300 Billion Dollar U.S. Stimulus Package

2008-10-20T14:02:00.000-07:00

I came across an interesting idea this morning from none other than Ben Stein (see the link below). Mr. Stein suggests that a resolution to the Credit Default Swap (CDS) mess may be too just declare these contracts null & void because they were illegal insurance contracts as most of the parties involved had no insurable interest. This would negate all but those contracts held by people who actually held debt securities of the defaulted company, which is a tiny fraction of the amount of CDS’s outstanding on any entity. All the others simply return any premium collected plus interest and everybody’s happy. I really do look for the government to attempt something along these lines depending on how the unwinding of the Lehman Bros. CDS settlement goes. The thing I find most amazing in this process is how few people actually realized how large this market was. In reality, the only people who knew were those in large investment banks who worked in that area of finance. The Treasury and SEC apparently didn’t have a clue. I’ve talked with some fairly large and sophisticated mutual fund managers and they didn’t know either, primarily because they are equity investors who never tread in the arcane world of fixed income investing. This market is going to be an area of intense regulatory focus for the foreseeable future and I, for one, feel it is much needed.

http://finance.yahoo.com/expert/article/yourlife/115733

There was an interesting article in Barron’s today that picked up on my thoughts on the benefit of lower energy prices. The gist of the article was that the recession may not be as long or as deep as many of the gloomier forecasts. Forbes’s economics staff, which is very good, based this on: 1) Lower energy prices (a price of $90 on Crude oil would produce an estimated savings of $300 Billion dollars over the course of 12 months. If the price holds at the current level of about $80, it would be about $340 Billion. Forbes estimates that this would translate into a 3.5% per quarter boost in consumer spending). 2. Inventories were very lean going into the crisis (unlike most recessions). 3. Capital spending was also subdued during the last expansion (which is why many corporate balance sheets are so strong) and finally, 4) Net exports are likely to continue to boost growth. I’m sorry that I could not produce a link, but Forbes is religious about their distribution rights.

Have a great day today!

Greg Staub, CFA

The Oracle of Omaha Weighs In

2008-10-17T06:44:00.000-07:00

I can’t really think of any better way to end this week than with today’s Op-Ed piece in the New York Times by Warren Buffett. I think I’ll just let Mr. Buffett take it from here. Follow the link and enjoy.

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=1&ref=opinion&oref=slogin

My best wishes for a good and safe weekend.

A Mixed Bag of News and Some Thoughts on Recessions

2008-10-16T06:39:00.000-07:00

Byron Wien, of Pequot Capital Management, a long time and successful market strategist made a rather astounding call on CNBC yesterday. I have watched Mr. Wien for almost my entire career, particularly when he was chief market strategist at Morgan Stanley. I have never known Mr. Wien to be what I would call overly optimistic. In fact, there have been many times when I thought he was the biggest bear around. Anyway, he is now positive but cautious on U.S. stocks. Below is the link to his spiel on CNCB yesterday morning.

http://www.cnbc.com/id/27193509

I watched an interesting panel on CNBC this morning. The panel included Vanguard’s John Bogel, Abbey Cohen of Goldman Sachs, PIMCO’s Paul McCulley and Black Rock’s Bob Doll. Wow, that’s a lot of brain power. On the whole, the panel was positive but cautious. Most notable for individual investors, John Bogel urged that if they had reasonably diversified portfolios and didn’t need the money for five years to not be panicked into making long term strategic decisions. Also, Goldman’s Cohen reiterated that they expect that the U.S. is in a moderate recession which would end in mid 2009.

Goods earnings news (better than expected) was had Wednesday from Wells Fargo, Coca Cola, Intel, and JP Morgan and this morning from United Technologies, Citigroup and several others. This was largely ignored however as the futures market focused Wednesday on a significant 1.2% drop in retail sales and the market dropped sharply. As I write this the market appears to be opening higher on Thursday. Of concern are higher average mortgage rates 6.46% vs. 5.99% last month. By the way these numbers are pretty much right on the historical long term average of 6%. Mortgage apps were up 5.1% last week. There was pretty good evidence that the commercial paper market was back to levels (volume) of a year ago. I am trying to get some numbers on this. Now if we can get some money to move out of t-bills, the markets will feel a lot better.

More good news that I think is being overlooked is that that crude oil is down almost 50% from its high last summer. I don’t know about you, but my gasoline tab is down by 25% from just a few months ago. I don’t remember where I read this but someone calculated that this pumps about 100 Billion dollars a year back into the pockets of Americans. It also helps businesses where fuel is a significant part of costs. Also local governments and school districts will benefit.

Another thought I had this morning as I was doing my morning reading is that yes, recessions hurt investors, but they are a necessary part of a capitalist economy. Excesses build up and must be worked out. Sometimes there is a lot of short term pain but always … I repeat always, the economy recovers and grows. You are welcome to stop by my office and take a look at my historic chart of the Dow. Look ahead a little with me for a minute. Two things that were hurting the economy and making life miserable for all of us were the high cost of energy and the high cost of buying a home. Going forward we will have, at least for a time, cheaper energy and for a great while cheaper housing. This is important because the echo baby boomers are poised for household formation and this would be a great leg up for an entire (and large) generation and an important foundation for our economy.

Greg Staub, CFA

Long Term Bear Turns Positive

2008-10-14T13:41:00.000-07:00

In my morning look through Morningstar’s daily 20-30 emails to advisors I came across one item that absolutely blew me away. Jeremy Grantham (his firm GMO is a major institutional investor), a long time bear, has turned positive on stocks. Mr. Grantham has had a low opinion of equities for virtually my entire lifetime. For him to be buying equities gives me a very warm feeling indeed. I have provided an excerpt of Morningstar’s article below.

Have a great day!

Greg Staub, CFA

A couple weeks ago I had a scary thought: Things are worse than Jeremy Grantham predicted. It's kind of frightening when one of the most bearish market seers has understated the risks and intriguing at the same time because he was really on the money. So, I checked in with him on Monday, Oct. 13 to see what he makes of the current situation. The markets were up about 5% when we spoke, and Grantham thought it had come close to returning to fair value.
Today Grantham says we're in for slowing global economic growth. In particular, he believes China will slow down more than expected as most economists have taken in their forecasts for Chinese growth only a touch. He argues that China is very dependent upon exports and that the countries on the other end of the trade are too weak.
Grantham expects that slowing growth will also keep commodity prices falling. "I would keep out of commodities for the near term," he said.
In addition, he sees the deleveraging--an unpleasant unwinding of debt-- leading to a reverse wealth effect for companies and consumers alike. Both had been living beyond their means and now will have to adjust to below-average earnings and income, and that means they'll be tight with spending.
Nonetheless he's now more constructive about equities because he believes they are trading at severely depressed prices. He said that at the end of Friday, global equities were trading as cheaply as they had been since the 1980s. In fact, the U.S. had traded below GMO's fair value estimate--though as we spoke Monday morning a rally had brought it back to around fair value. Specifically, he prefers blue chips to small caps or highly leveraged companies.
By Russel Kinnel 10-14-08 Morningstar, Inc.

A Change in Focus for Mutual Fund Watch

2008-10-13T12:42:00.000-07:00

As of today I am switching gears with my Mutual Fund Watch blog. For the duration of the credit crisis I will make a daily (I hope) comment on the markets and how they affect you. I am especially looking to provide you with articles that give you information that you can use without the hype and hysteria so often served up by the financial press these days.
Obviously not much in the stock market over the past few weeks has seemed very rational. One of the things that struck me as most ridiculous was the endless parade of market mavens supplied by CNBC. The majority of these people (Jim Cramer & the like) are short term traders whose time horizon is a few weeks at most. I would strongly recommend that you tune these people out and stick with your investment plan which, if it is well thought out and matched to your risk tolerance, will continue to serve you well. I’ve attached two articles that I thought especially insightful.
The first is by Knight Kiplinger, editor of the Kiplinger Letter. I have long provided a link to Kiplinger.com from PCM’s website because they provide consistently solid, useful advice. Pay special attention to Mr. Kiplinger’s thoughts on the importance of continuing to fund and maintaining the asset allocation in your 401(k).
http://www.kiplinger.com/features/archives/2008/10/knight-kiplinger-on-buying-stocks-now.html
The second article is from The New York Times and contains some thoughts on the current investing situation from Ken Heebner and Marty Whitman, mutual fund managers whose track record must command respect. They point out the unwarranted amount of damage being done to the stocks of some very good companies.
http://www.cnbc.com/id/27137494
Enjoy and hang in there.

Greg Staub, CFA

When Evaluating Active Managers - Look At The Value Proposition

2008-09-14T07:27:00.000-07:00

Every once in awhile, it can be useful to reexamine some ideas that you’ve pretty much accepted as gospel. Many times when you invest other people’s money, these reexaminations are prompted by a client(s) asking “why are you doing this? It’s not working”.

At PCM we have long used The Jensen Portfolio (JENSX) as a large cap growth manager in our managed portfolios. Our initial selection of Jensen came shortly after the collapse of the tech bubble in 2002-03. We were very frustrated with the tendency of large cap growth managers to buy “bubble” stocks. At that time it was Tech but every bubble seems to lead to the same behavior with the growth crowd. I view this inability to say no, no matter how outlandish valuations become, as a serious disease, A disease that eventually leads to gut wrenching portfolio damage. That said, we do need to fill the large cap growth allocation in our portfolios, these stocks do provide a key growth component in a diversified portfolio. Our search was for a manager who could successfully invest the large cap growth universe but who did not suffer from the disease.

Jensen seemed well suited to perform this function in our portfolios. In short, their strict investment discipline has kept them from buying into severe overvaluations. However, there are times when the fund exhibits significant underperformance to its benchmark, the S&P 500. One of these was the late 1990’s when the S&P, powered by S&P’s addition of newly minted large cap tech stocks and its removal of some solid foreign companies to make room for them, surged to dizzying heights. From 1994 to 2000 the S&P 500 grew 25% annualized while Jensen managed a trailing but respectable 21%. Subsequently, from August of 2000 to September of 2002 the S&P fell a breathtaking -22% while Jensen only -4.3%. In general the clients we serve do not mind the upside of bubbles but they very much dislike the downside. Most recently, Jensen has underperformed the S&P primarily due to the fund’s lack of exposure to the energy sector (yet another bubble). Again, Jensen’s investment discipline does not favor stocks, like energy companies whose profits are driven by volatile commodities.

During a recent client review, the client pointed out that over the last 15 years (as far back as our charts go) Jensen has only just matched the performance of the S&P 500. “Why not just buy the S&P 500 via an ETF at a fraction of the cost?” he asked. “Yes”, I pointed out, “but it has given us a much smoother ride and this is worth the extra cost.” After this meeting I was pondering this statement. I’d always assumed that less volatility in fund performance was a good thing even if we just broke even with the benchmark over time. The clients would be happier and I’d have more pleasant client review meetings.

To evaluate this assumption I thought it would be a good idea to quantify the risk reduction by comparing the standard deviation of Jensen versus its benchmark. The latest published Standard Deviation for Jensen is 6.5 (all data from Morningstar) vs. 7.89 for the S&P 500. This represents a 20% reduction in risk! So essentially over the past 15 years, after expenses, Jensen would have equaled its benchmark with 20% less risk. Same return at substantially less risk at no additional expense? I’ll take that proposition every time.

There are two points here that I hope you will incorporate into your own investment thinking. The first is that it is possible to focus too much on fees and expenses to the detriment of your portfolio. I’m willing to pay the extra freight for active management if the value proposition looks promising. In the case of Jensen it does. The second is that when you look for managers for your mutual fund portfolio, look for people with a viable and tested investment strategy that meets your investment goals and whom you trust to stick to that strategy no matter what happens in the market. These are the people that will, over a reasonable time horizon, make you money and allow you to sleep well at night

Using Morniningstar's Star Ranking System As A Fund Screening Tool

2007-11-14T23:37:00.000-08:00

It’s not often that you get to back-test a key part of your fund selection methodology and have someone else do all the work! Such was the case recently when I came across a paper by Matthew Morey and Aron Gottesman of Pace University . Morey and Gottesman have produced the first study of the predictive value of Morningstar’s revised star rating system for Mutual Funds. As background material for the two or three investors out there who may not be familiar with the system, Morningstar rates mutual funds on a scale of 1 star to 5 stars with one being the worst in category and five being the best. This system was revised to its present form in 2002. The Pace University study looked at subsequent three year returns following the change to the new system.

Our interest in this at PCM is that the Morningstar ranking system is the first line in our screening process for funds used in our managed accounts. Our first step is to eliminate all funds ranked 1 or 2 stars. My thinking here is that we eliminate the riff – raff by making this initial cut. The key question is: Is this effective in eliminating funds we’re really not interested in and likewise are we eliminating some funds that we should be looking at?

Morey and Gottesman expressed the effectiveness of the star rankings by measuring the probability that any funds in a particular asset class would be outperformed by the average fund in another higher or lower rank in the same class. In other words, what percentage of Large Cap Value Funds ranked 3 stars would be beaten by the average large cap value fund ranked 5 stars, etc. This was very useful information from my point of view because a quick calculation showed that on average a fund ranked 1 or 2 stars by Morningstar was 20% more likely to be out-performed by an average fund ranked 3, 4 or 5 stars. Thus we’re eminently justified in eliminating funds ranked in the lowest two categories immediately.

I have been critical of using Morningstar’s rating system exclusively for fund selection for a number or reasons, the most notable being that they will rate funds after only three years of existence. It is possible in the investment management business to be more lucky than skilled over a relatively short time period like three years. Of course one could ignore the three year ranking and just concentrate on the 5-year or better yet the 10-year rankings. However, given the emphasis placed on these rankings by the financial press, financial product sales people and by the funds themselves, it’s not surprising that the investing public could misinterpret the significance of the three year ranking.

We strongly urge our readers not to use the Morningstar Star ranking system as an exclusive means to pick funds but rather an initial screening tool to eliminate grossly unacceptable funds. Final selection should be made using a methodology such as ours that selects for consistent long term superior performance (top 25%) within peer group. Final fund selection should also encompass fees, investment philosophy and methodology, and stewardship of shareholder funds.

Is Morningstar's New Investor Return Stat Useful?

2007-10-22T20:34:00.000-07:00

I read an interesting article in Morningstar Advisor Magazine this week about Morningstar’s new Investor Return (IR) statistic. This performance figure is an asset weighted return, in other words it adjusts return for the movement of assets in and out of a fund. Morningstar is touting IR as indicative of the return that an average investor in a given mutual fund received rather than that actually posted year to year by the fund.

The fund industry hates this measurement because in most cases, over the last ten years, IR trails the actual return of the fund. The fund industry’s point is that this is not their problem because they cannot control investor behavior. I agree; one of the most frustrating problems with managing OPM (other people’s money) is that you cannot control when people bring you money. Investors do tend to want to invest money when the market is doing well and not invest or sell when the market is not doing well. This is human nature and very difficult for most of us to overcome. The financial press is touting the IR statistic as some new revelation in its ongoing and long running “how Wall Street screws the little guy” expose. Although this one’s a little hard to swallow, their point seems to be that the fund industry somehow actively encourages poor market timing behavior by investors.

The Morningstar Advisor article by Christine Benz, Morningstar’s Director of Fund Research, looked at IR from a variety of perspectives and found that there were two key factors in the difference between IR and actual return. The first was volatility. The more volatile a fund’s return the more investors jumped in and out and the lower was the return for the average investor. The fund sectors showing the largest differences between IR and posted returns were, not surprisingly, technology and growth funds (both large and small cap). The second factor was stewardship of fund assets. Morningstar assigns a grade for stewardship ranging from A (best) to F (worst). Among the things that will cause Prof. Morningstar to trash your stewardship GPA is not actively discouraging frequent trading. Frequent trading in a fund is a key factor in lower IR for a number of reasons, the most notable being the greater possibility of poor investor timing and higher expenses for all shareholders. The number crunchers at Morningstar calculated a success ratio for fund families by looking at the percentage of the posted return actually earned by the average investors in that family of funds. Fund families with higher stewardship grades tended to have investors with higher success ratios.

I was pleased to see Funds families that populated our managed portfolios earn high success ratios. Vanguard and Dodge & Cox were in the top 5 of the fund families tested. I consider mutual fund analysis to be one of Pilot Capital’s core competencies (stuff we’re really good at) so whenever some one comes up with a new performance parameter we carefully consider whether it’s of any use in our process for choosing managers for our managed portfolios and/or evaluating the effectiveness of client-managed portfolios that we are asked to evaluate as a consultant. In this case I found the IR performance statistic to be of little use other that to verify that the research parameters that we are already using are leading to good decisions regarding manager selection.

Pilot Capital’s mutual fund research effort is designed to provide our portfolios with mangers for each asset class that supply the best and most consistent performance available in that asset class. Consistency of return is most critical. It is a constant source of wonder to us how few people in the fund business fail to see that their job is to compound money for shareholders. Among the parameters we use to evaluate fund mangers are the ability to consistently finish in the top 25% of peer group, Sharp Ratio (a measure of management efficiency), cost and quality and consistency of investment philosophy (we like people who stick to their knitting and knit in ways we understand and feel comfortable with) and… stewardship of shareholder assets. So it was very satisfying that the fund families we use tended to have high IR’s. All the folks at Morningstar managed to do with IR was provide some means of verification for what an intelligent, fundamental, commonsense approach to fund selection should do anyway and to reprove once again that the very large majority of human beings make lousy investment decisions because they’re, well… human.