Fiduciaries, Expenses, ETFs and Timespans

Introduction

Apparently the favorite interview press query at the Academy Awards is “what are you wearing?” The answer, according to script is the designer’s name. However, this is an incomplete description of the garment. The question and answer works in a sound bite commercial world for some but does not tell us anything as to the talent of the actress (or actor), the role portrayed, and most importantly how the performance worked. This is an example as to how we use labels to convey a familiarity of topic knowledge and “being in the know” exclusivity. The media, government agencies, and some investors also use labels in the same way and these could be traps in terms of making sound long-term investment decisions.

Fiduciary

This week the US Department of Labor produced a 208 page document which I actually read. The full title is “Fiduciary”; Conflict of Interest Rule - Retirement Investment Advice. In brief summary the document mostly discusses the appropriate disclosure of compensation arrangements by various investment intermediaries. As both a registered investment advisor and an employer of other fiduciaries, I read this as a cynical document. One of the definitions of a cynic is that he or she knows the price of everything and the value of nothing.

The investment process at the professional level is long and often difficult in terms of coming to present conclusions from past performance and the surrounding analysis. (It is worthwhile that the Securities and Exchange Commission requires a cautionary statement to be appended to investment performance claims that past performance does not guaranty future performance.) I am sympathetic to the government’s desire to help investors, in particular ones investing for retirement. They believe that disclosing various ways that the investment system has found to receive compensation is useful. This is like the true statement that at some future point we all will meet our maker.

The real problem is that the professional community has been unable to fully identify the system-wide cost of investing, from securing a relationship, lifetime training and servicing, all of the administrative expenses including legal and tax professionals, as well some recognition of the standby costs to have these services available for when they are needed. In aggregate, I don’t know  what the real costs are. 

For many individuals the biggest single investment in their lifetime is the purchase of a home. Before the pressure of competitive pricing, the “going in” costs are quoted at 6% + closing costs. (I have often said “protect me from a ready to move-in house.” Within the first couple years of ownership perhaps another 10% or more may be spent converting the home to what we really want.) Thus realistically I view the true cost of a new home as the transaction price plus 10-20% a few years out. I suggest that the true cost of the time and efforts of all professionals dealing with your retirement capital is probably in the same order of magnitude on a much larger amount.

With the exception of performance fees, no one attempts to recapture these kinds of costs on the surface when investing retirement money. This does not mean that these service provider costs are not there or that they are a great deal lower than residential real estate transaction costs. Traditionally the investment community has recognized that there was a customer barrier to charging up front the lifetime expenses of a transaction. Thus, the favored way to earn compensation is first to receive annual payments which if the accounts stay with them long enough; e.g., 10-20 years, payments may reach equivalent to residential real estate expenses. The second way is to have many more transactions than the average real estate broker, which in turn probably means a significant increase in marketing costs.

The hope of the financial community is that investing for an individual’s retirement is a long-term effort and can receive periodic payments to make the effort worthwhile. Getting back to the cynic (who similar to the Department of Labor, is focusing on price disclosure) like many in the investment community wants to be paid on the basis of value received. Financial professionals have not been very good at demonstrating the value received beyond relatively few performance fee contracts which often are counterproductive by emphasizing shorter term performance. Without this ability, all too often the investment community charges relatively nominal amounts on the surface and has found methods to get additional compensation other ways. The DoL wants these to be fully disclosed. Good luck. The hope is that analyzing fully identified expenses will become the model of retirement investing behavior.

As a continuing student of investing and the investment communities, I think there is a substantial chance that when one restricts the price of a service the value provided in that service declines. What may happen is that instead of the title of fiduciary being something of an honorific, it will identify those that can’t make enough money by being good investors. If there is any chance that I am correct, those with small amounts, albeit growing, of retirement capital will find it difficult to get a high level of service. (Under these conditions some employer-sponsored savings plans; e.g., 401(k), 403b, and 457 plans may be modified to accept additional investments from existing and retired employees who will be able to keep their retirement capital relatively safe within their plans for their lifetimes. We would be interested in working with them on that prospect.) 

Exchange Traded Funds (ETFs)

Many people throw around this term, but don’t understand the differences between these vehicles. Most of the money in ETFs is in beta-matching products attempting to replicate various published indices. These indices were never designed to be prudent portfolios or to  meet specific investment needs. A smaller group (in terms of assets) but much larger in terms of numbers of funds are indexed to various sectors or in some cases to various investment factors. These presuppose that the creators of these profits selected correctly those stocks (or in some cases bonds) that will now and in the future capture the essence of the sector or factor. I question whether anyone can predict the future well enough to lock into future investments. Finally there are ETFs and ETNs (Exchange Traded Notes) that are “super-securities” used as a way to capture the general movement of items that don’t trade frequently or have enough liquidity; for example bonds of various qualities and duration, very small companies, emerging market securities, and commodities. As one can easily see, each different type of ETF or ETN is sufficiently different that labeling the same thing can be misleading. At some future date I will discuss the practice of managing accounts exclusively with these products.

TIMESPAN L Portfolios

          Regular readers of this blog are aware of my TIMESPAN L Portfolios^®.  A unique benefit of this construct is its ability to enable the management of capital through single-purpose beneficiary portfolios that allocate investments over specific timeframes and risk tolerances.  TIMESPAN L Portfolios can be a suitable strategy for defined contribution retirement plans, non-profit organizations and family wealth. 

          A visual example and description of TIMESPAN L Portfolios is available in hard-copy.  Qualified institutional investors: Please send me your mailing address and a brief description of your interest to aml@lipperadvising.com .

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Labor Activity Needs Protection

Introduction

The nature of humans is to labor to make better and safer lives for themselves and their families. The unfortunate image coming out of today’s school systems and many of its union-dominated teachers is that manual labor and skilled labor by employees is to be celebrated only on Labor Day in the US and similar holidays elsewhere.

I see labor all around. Certainly the homemaker producing meals, keeping house, and often serving as the household purchasing agent is laboring. Laboring also are the portfolio managers who are acting, along with others, as stewards for the retirement funding of employees. Many of these put in more hours than some that are punching a time clock or equivalent.

On Labor Day 2014, I think we should be thinking about how to make all that labor a better value. At the first level we should see how to improve unemployment and under-employment. At the next level we should be paying attention to retirement funding. Finally, almost all laborers desire to take care of beneficiaries after they are gone. This post will share some of my own thoughts on each of these topics.

Mismatched openings and job seekers

As someone who speaks with various employers and particularly entrepreneurs about their future progress, I often learn about the need to fill particular positions within their organizations. Often they cannot fill existing (or more importantly new positions) not because applicants don’t have the required skills. If the employment decision was left to a computer match procedure, it is estimated that all or almost all the roughly four million job openings would be filled very quickly. But that is not the case when are faced with hiring fellow humans.

I don’t know where so many of these applicants get their work-related attitudes; whether from their families, friends, or their teachers. The first hurdle is that the world or others owe them a job. The second is that they have pre-conceived notions as to the conditions of employment which they think they should dictate. In many cases they do not grasp how a commercial organization functions to provide what the clients expect and need. Too often they anticipate that their co-workers will make room for them and coach them on the first day as to how the work and social elements really work.

I believe that everyone within an organization is a salesperson meant to convince every contact that his or her firm is absolutely the best organization to meet people’s needs. We are all involved with sales and service. People who want to join a firm need to feel loyalty to the firm, its customers, managers, and fellow employees. The sad truth is that there is not enough of these people, thus a number of the openings will not be filled.

The cost of vacant jobs

The economic and financial impacts of not filling the vacancies are significant. As long as people are unemployed the cost to the society will be high in terms of taxes paid and more significantly a shortfall in consumer purchases. There are also, at this time, important investment implications to the unfilled openings. Organizations will not be operating at optimum productivity levels. Profit margins will be less than what they could have been. Today there is concern that profit margins, not profits, have reached record levels. If these slip, even with higher sales generated profits, the valuation afforded these stocks will decline, as they will be viewed as more cyclical and thus could lose their place in some portfolios.

Profit margins are under pressure in numerous employers and particularly in health and financially oriented concerns today. Due to increases in compliance and supervisory responsibilities, companies are being forced to hire good but unproductive people in terms of bringing in more sales. This is hurting existing margins. When we combine these pressures with much more restrictive activities mandated for the financial community the results are significant layoffs at numerous banks and other financial firms. Major clients are already seeing a decline in the levels of service and supervision. I suspect that this trend will continue unless there are major changes in regulation.

Retirement funding awareness

One of the potentially major upticks for labor in the US is the ability to influence its own retirement funding. The switch to Defined Contribution plans from Defined Benefit plans can produce a retirement account that more closely represents what the specific employee wants from the available alternative options rather than being bundled with all other employees. The various 401(K), 403b and 457 plans leave the responsibility of choice to the individual. These plans need to be carefully constructed in terms of levels of contributions, matches, vesting, fees and expenses.

I am pleased that according to BrightScope, the Number One plan based on these characteristics in 2013 was the Second Career Savings Plan for the National Football League and the NFL Players Association that I have advised as to the construction of nine specific fund accounts.

The reason for the nine accounts was to allow the Players to decide how they wanted their money to be invested, in a collection of mutual funds or separately managed accounts that generally clone their advisor’s funds. Other retirement accounts that we manage are customized to the needs of the employee base. However, all investors including retirement plans are exposed to both stock and bond markets. With that thought in mind, we all should ask whether there are parallels between Labor Day 2014 and Labor Day 1929.

As was noted in The Wall Street Journal, both days had just past the 2000^th day of a bull market. In the case of the earlier market it continued to rise in September and started its cataclysmic decline in October 1929 to recover in December but the damage had been done to the confidence in the market and eventually the economy.

Should employees and other investors totally jump out of the market with the belief that they will jump back in at materially lower prices?

The great portfolio manager, Peter Lynch, who built such a great record at Fidelity, is quoted as saying that more has been lost by investors trying to execute such a maneuver than the size of the losses at the bottom. In addition, I would be particularly careful investing substantially in high quality bonds now. Instead of celebrating that the purchasing power of bonds is now stable to perhaps rising which will help the long punished retirees, the central banks such as the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan are very much interested in raising the rate of inflation to spur more risky investment as a way to create jobs. If they are successful, the purchasing power of bond principal and interest will decline. Based on their past record they may not be successful.

Helping beneficiaries

All of us who are looking to the future for the benefit of families and others such as universities, hospitals, and other non-profit groups need to invest over multiple time spans. In prior posts I have discussed our Lipper Time Span Fund Portfolios which are designed to meet the different needs of beneficiaries. With the measurable possibility of a significant market decline sometime in the next five years we have created a Replenishment Fund Portfolio concept (REPPORT) to replenish the capital that will be spent over the next two years to meet operating needs by the Operations Fund (OPPORT).

The Replenishment Portfolio probably has a mixture of equities and fixed income funds or securities with a maturity of five or fewer years. With the recognized risk of a significant decline and Peter Lynch’s warning, a conservative approach is warranted. At this point I would select funds that invest in companies that have relatively little debt but compared to others have high returns on assets, equity, and invested capital.

At the other extreme in terms of time spans, the Legacy Fund Portfolio should be looking into funds that invest in companies that are spending wisely in research and development plus intelligent brand building. If these companies do spend wisely they will be creating the kind of unassailable position often called the protective moat. At that point they should be producing substantial excess capital, fulfilling Warren Buffett’s favorite structure of a company that has both a moat and a fortress. On the way their financial ratios are unlikely to match those found in the Replenishment Portfolio.

Question of the Week:

 

Where and how are you finding new good people to hire?
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Copyright © 2008 - 2014

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Are We Entering The Most Risky Phase?

Apparently this quarter’s surge in net flows into equity funds has been identified as sourced from idle cash, not from in my opinion the most risky asset class, bonds.  I would suggest that two other factors need to be considered to get a fuller picture. The first factor was the January surge, led by stock investments from defined contribution plans; i.e., 401(k), 403(b), and 457 plans in addition to bonuses. In some of these cases the employer’s contributions and the bonus money are once a year events. Further, I suspect the level of gross redemptions in 2013 are down somewhat relative to 2012, which would magnify the impact of one of the highest January inflows on record.  

                             

There is no denying that many investors both institutional and individuals have turned more positive to equities, almost on the basis of ‘what doesn’t kill you, makes you stronger.’  With a few exceptions, major stock markets gained in 2012, rather than going down in early 2012 as many had thought. This result is in contrast to 13 years of equities generally going nowhere. Total reinvested return calculations for the last ten years of equity mutual funds does show a 10% compound growth rate mainly through reinvesting distributions into more shares at lower prices. Those that spent their distributions did not get this benefit.

Whatever the reason, we are being asked to become more aggressive with client portfolios. We manage each account for its own needs. In almost all cases we produced double digit returns for 2012 and in some cases were ahead of the equity averages (even though the accounts had somewhat of a balanced nature). In one case our gross performance was above the 20% level. Nevertheless some accounts are asking for even better returns which we would also like to deliver, but the increase in the potential level of risk is uncomfortable.     

The nature of risk

Risk is not what is taught in various schools by academics which should be more accurately described as the variability of returns. Risk is not the volatility of prices from short-term period to period, which may describe the comfortableness of a ride along a trend line compared with some other price series.  Essentially risk is the penalty for being wrong to the extent that it causes the investor or his/her beneficiary to change permanently one of life’s essential goals. For you or I, risk is a potential loss of serious magnitude. For you as an institutional investor, a million dollar decline in your portfolio is a bit distressing but your beneficiaries are not really hurt until the loss may be in eight or nine figures. For others personally, a loss equal the cost of a new car or one or two annual college tuition bills would be painful.        

When to expect large losses?

In typical capital preservation-oriented accounts that are well diversified in uncorrelated assets, large risk of large capital losses come from two sources.

The first is that there is greater correlation of price movements than expected, which is what happened in 2008 where practically everything except Treasuries and a handful of other assets fell, with many funds dropping  20-40% or more.  The other way is to become unbalanced through the exceptional success of a single investment, think of Apple^* or Berkshire Hathaway^* for early investors. Instead of representing say 5% of a portfolio and because of relative appreciation, one position now represents over half of the value of the portfolio. Assume that Apple at the top represented 60% of the portfolio and with the current slide of approximately 40% from the top, the portfolio could be down 24% ($60x.40%= 24%). How could this happen?  Allow me to quote from the esteemed Howard Marks, president of Oaktree Capital: “Things get riskier as they become more highly respected (and thus appreciate). There can be more risk in thinking you know something than in accepting that you don’t.” He further states: “the better returns have been, the less likely they are-all other things being equal to be good in the future.” 

* Owned positions in personal or managed accounts

Nevertheless, we have often heard the advice to sell your losers and let your gains run. To do the opposite has been the curse that has fallen on US and UK managers of funds sold into the Japanese retail market where many Japanese measure risk only by seeing how much the price or net asset value has gone up and then they redeem relatively quickly. This view may be aided by their brokers who are interesting in recycling their money into newer investments. In my opinion, both extremes of holding forever (for which I can be accused), or quickly selling after a sharp rise, can be wrong. The key is that every day one should evaluate both the upside potential and the downside risk of permanent loss. 

What are the increased risks today?

If we choose we can buy into the belief that while this year may be economically challenging, like the IMF we can choose to believe that 2014 will be better than 2013 not only for the US but importantly for Europe. This “happy talk” is increasingly being accepted despite the strong odds that France will join the deteriorating countries who won’t come to grips politically with their problems. The potentially sizeable problems of France could well be too much for the German taxpayers’ willingness to carry. Further, I suspect that any significant solutions to the US deficit problems unless solved in the next six months won’t be meaningfully addressed until after the 2014 congressional elections, when the fundamental composition of both houses could change and the White House will completely focus on its legacy.     

The current Federal Reserve Board believes that they are largely in control of the both the level of interest rates and the relative value of the dollar. I believe that the Fed can be surprised by non-monetary events. For example a pandemic of SARS or similar life-threatening waves that can affect the US directly or indirectly. This weekend’s issues around Cyprus could produce symptoms of much bigger problems. For example, if the Cypriot banks can tax depositors on their euro accounts, won’t other governments under pressure to raise tax revenues at least consider doing the same thing? Possibly the regulated banks will be considered less secure than they were a few weeks ago. The skeptic in me always looks for something below the surface to actions of governments. In this case perhaps one should look beneath the surface literally. Off Cyprus to the north there is believed to be a large undersea gas field that Turkey wants to develop. To the south there are possibly two potential offshore oil/gas fields which people from Cyprus and Israel want to develop, and the Russians would like an Eastern Mediterranean port for five of their ships. (Remember this would not be the first time that these types of issues have driven geopolitics both within and beyond the Middle East. The British government sponsored what was, in effect, British Petroleum’s takeover of the Suez Canal from a failing French firm.) Other potential offshore gas and oil deposits could also produce conflicts and disabling price movements in terms of the disputed Chinese/Japanese islands and possibly a significant discovery off Vietnam. One only needs to look at the deep-water find off Brazil and the opening up of Mexican oil exploration as examples of how ‘surprises’ can cause disruption to the Fed’s neat playbook. 

A small but potentially new player is on the scene: Irrevocable Trusts.

In the aftermath of the year-end changes on US estate taxes, I believe a significant number of new irrevocable trusts were created out of former estate plans to lower the size of the estate taxes. Many of these trusts used the maximum allowed of $5 million per grantor. In many cases these trusts are designed for children/grandchildren, personal foundations or other charities. Since these are non-returnable gifts, quite probably their investment character should change. As long as the money was in the planned estate corpus it may have been invested for capital preservation to make sure that the grantor and spouse will have enough capital and income to meet their expressed needs. As the money is permanently set aside and could have a materially longer if not eternal (dynasty) horizon, some or all of this portfolio will be more aggressively invested in a capital generation mode as distinct from the same dollars in the past invested for capital preservations. 

The buyers who could drive the stock market

The following is pure speculation, perhaps informed speculation. As indicated, investment advisors are being asked to produce higher returns particularly at present low interest rates. Money from the sidelines appears to be coming in. The continuing flow from salary reduction savings plans is augmented by employer contributions, particularly as more defined benefit plans are being tapped in favor of new defined contribution plans. Foreign investors who are becoming increasingly nervous about unfriendly home governments may also, at least temporarily, want to shift money into US traded equities, And finally some of the money comes from new irrevocable trusts.         

My dilemma is that I believe we have entered a phase of heightened risk. When these flows do come in, by definition they will have the effect of increasing risk to our markets. Jumping out of the stock market too soon may cause professional managers to lose their jobs. Waiting too long to reduce positions could lead to substantial loss of capital or real risk. Exit timing is the most difficult part of the investment art.   

How are you going to time some of your exits?

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