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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Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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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.

Financial Illiteracy: Too Many Are Not Ready For Retirement

This week my thoughts have turned to retirement for others, including my children and grandchildren as well as many others that I know. The concept of a voluntary cessation of producing an economic income and relaxing comfortably at leisure is shaping up to be one of the great myths. They simply won’t have the money to be only mild spenders and not earners at hard work. If we think the current debt structures and deficits are troublesome, we only need to look at the future. Unless we dramatically change the savings, investing, and living practices, the size of the population that will need help to retire with any sort of comfort will be huge. In my view the only long-term answer to the crushing problem is practical education. Of the three parts to the solution: saving, investing and life style, my only expertise is in investing. Nevertheless, I recognize the other learned skills of budgeting (controlled spending) and leading a healthy life are equally important.

Investment is an art that begins with reading

While almost all could benefit from reading Wealth of Nations by Adam Smith, Securities Analysis by Benjamin Graham and David Dodd or even to a much smaller degree my book MoneyWise, these are not what I am talking about. The kind of reading that I am alluding to is reading the situations around the world by observing every single day. Particularly now in these stressed times we watch conspicuous consumption with some awe. We do not pay enough attention to those who are not currently spending because they can’t and those who choose to spend less. Both groups are important to observe. Those with little resources and living moment to moment didn’t follow (or found it too difficult to follow) their few successful classmates, teammates, fellow workers, neighbors, etc. There are always some that took advantage of the opportunities to move up and out. Luck was not the source of their ascendency, but rather they recognized opportunity and the willingness to do the difficult. The second group of curtailed spenders may well be future-oriented as distinct from living moment to moment. The second group has internalized the fact that limiting current spending is transferring resources (no matter how small) to a future period. This transfer can earn additional awards through investing. Other places to read the economy are the gas stations (gas prices and level of maintenance and repair work), supermarkets (changing prices, excess inventories, the shifting to store brands from nationally advertised brands, quality of produce, etc), and shopping malls with high turnover stores (promotional and everyday prices, inventory of your size, stock liquidations, imports vs. locally produced merchandise).

There are too many financial illiterates

At the last board meeting for the Museum of American Finance where I sit as a Trustee, there was mention of a study by Annamaria Lusardi (George Washington School of Business) and Olivia S. Mitchell (Wharton School, University of Pennsylvania) entitled “Financial Literacy and Retirement Planning in the United States.” In a survey of 1200 responding Americans, the study asked three very simple questions; (1) understanding that interest rates can add to the value of savings, (2) understanding that inflation can reduce spending power in the future, and (3) whether some form of diversification lowers the risk of loss. Only 35% of the respondents got all three answers correct. What is even more discouraging is when the respondents were divided between those that are planning for retirement and those who were not, 47% of the planners got all three correct and the non-planners 23.9% got all three correct.

Salary savings plans: 401(k), 457, 403b come to the rescue

These savings plans increasingly require all the new, and in many cases present, employees to participate in defined contribution plans which are replacing defined benefit plans where and when possible. These plans are usually funded by employer and employee contributions. These contributions are invested at the discretion of the employee into various options including default options if they fail to make a choice. Open end mutual funds are the single most popular choice for managing this money according to the funds' trade association, the Investment Company Institute (ICI). Last week I contributed a brief column to Reuters on how I select the various options to be offered within a plan. In addition to the nine alternatives, I suggested that a managed account offered through the 401(k) could adjust the investments to changing market conditions and outlooks.

There are two dangers lurking in these plans

Both of the dangers lurking in these plans stem from some of the participants (beneficiaries) of the plan and an occasional sponsor of the plan not grasping that these are fiduciary accounts whose sole purpose is to build retirement capital. Another survey by Transamerica Center for Retirement Studies found that 63% of those who had participated in a 401(k) plan drew cash out when they became unemployed, and 34% of the underemployed did as well. Not only is there a tax penalty for a premature withdrawal, they are in effect robbing their own retirement money and/or benefits that could go to their family or heirs. I suspect that many who withdrew would have been part of the 65% who did not correctly answer the three basic questions in the other survey. Also they did not read (or see) the poor and struggling retirees around them. In the long run they and the rest of society who will give them some support will have suffered from their financial illiteracy and their inability to observe others around them. The contribution to our future deficits will be caused by this failure to educate our people.

The second risk, which is much smaller, but still a risk in some relatively small plans of privately held employers, is an attempt to replicate the senior executive's personal investment account. Even in the smallest of plans with just one owner and one employee, the sponsor has a fiduciary responsibility to the sole non-owner employee that the money is being invested in a prudent fashion. Also the executive who presumably has a significant personal account would be better off investing in potential capital gain earners in their personal account where, under current US tax regulations, they will pay fewer taxes when they liquidate.

What has me worried is when I see sector-oriented indexed exchange traded funds (ETFs) in retirement plans. These are narrowly focused portfolios designed to replicate a fixed list of stocks in one sector or industry. My concern is that these are good trading vehicles particularly when combined with short sales of some stocks within the industry. But the flows in and out of these ETFs are much more volatile than the underlying stocks. According to the ICI, the gross redemptions for all sector/industry funds through August, 2012 was $146 billion and the total assets in these funds was $246 billion. To be fair, the gross redemptions were somewhat offset by some inflows. Nevertheless, the gross redemption total indicates to me the speculation that is going on within these kinds of vehicles. This is just one of the types of investments that may be wonderfully appropriate in a personal account, but should not be found in a fiduciary account for all employees in a plan. Luckily, instances of these hyper-aggressive strategies in retirement plans are rare.

Opportunities

I speak with bias, in that I manage a small, private financial services fund that has positions in a number of investment management stocks. Despite the problem with financial literacy, I believe that defined contribution plans will continue to grow at rates faster than employment and the economy in general. Investment management company stocks should benefit from this perceived trend.

Are you reviewing your retirement planning?

My next blog will come from London.

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