The Float

The March Jobs Report

Today's employment report shows 180,000 jobs added in March and upward revisions to the initial numbers reported for January and February. By the standards of the last couple decades, this isn't an especially big number. By the standards of the last couple years, it's a decent one, and it complicates a data picture that has been relatively weak lately.

It's unusual to get a jobs report on a day when the equity markets are closed, but even a half-day of trading in the bond markets--where bond prices fell and yields rose--tells us how the Street interprets these data: Less likelihood of a rate cut from the Fed in the next several months.

The Problem with "Style Convergence"

Today at Reuters (yes, it's our favorite news source), Muralikumar Anantharaman notes a recent rise in "style convergence" among large mutual funds. When value managers pick growth stocks and growth managers pick value stocks, investors might wonder how they can know what they're getting when they buy funds advertised as style-specific. Here's Anantharaman:

An increasing number of fund managers are blending growth and value tactics to pick stocks, but this trend is not popular with some investors, who want to diversify by using two distinctive styles.

Morningstar has moved 41 equity mutual funds from the value category to classify them as blends in the past 14 months. Over the same period, 13 funds have moved from the growth category to blend, and four funds have moved from growth to value styles, the fund research firm said.

This classic problem, often described as "style drift," is one reason we think investors should avoid style-constrained active management. There's good reason to diversify between (and within) the growth and value styles, but the best way to do so is to own index funds and/or ETFs that provide precise, reliable, inexpensive exposure to each "style box" (large growth, large value, small growth, small value, &c.).

Then, to pursue excess return and manage risk actively, investors should hire unconstrained managers who can identify and exploit opportunities wherever they appear in the capital markets. The point here is that asset class exposure and active management are fundamentally different objectives. They should be understood as such and they should be undertaken through different means.

The formula here is simple. For style and asset class exposure: Inexpensive, tax-efficient, index-based vehicles intelligently rebalanced when necessary. For excess return and active risk management: Agile, unconstrained, eclectic portfolios in which style per se is irrelevant.

We don't think this is the right way to invest because it's what we do at Interlake. We do it at Interlake because we think it's the right way to invest.

Source

Muralikumar Anantharaman, "Growth and value stock-picking styles converge," Reuters, April 5, 2007

Housing Derivatives

Jonathan Keehner of Reuters has an interesting (and cleverly titled) item on the rise of housing-related derivatives. Here's the premise:

While investors in nearly all other major asset classes enjoy the utility of a derivatives market, often to hedge their risk, those in fragmented and opaque U.S. real estate markets largely have not.

But access to real estate indexes is adding U.S. commercial and residential property ownership to the list of items, from companies' debtworthiness to the weather, that investors can speculate on through listed and over-the-counter markets.

Given the incredibly rapid expansion of derivatives markets over the last several years, this is hardly surprising.

Source

Jonathan Keehner, "The Futures of Real Estate," Reuters, April 4, 2007

Morning Reading

A few interesting items this morning...

• "U.S. services index falls to four-year low" (Reuters)
• "Feb factory orders up less-than-expected 1 pct" (Reuters)
• "Merrill's Bernstein Raises S&P 500 12-Month Forecast to 1590" (Bloomberg)
• "Crude falls as Iran says it'll release U.K. sailors" (Marketwatch)
• "Golf only goes so far: No matter how rich you are, work beckons in retirement" (Marketwatch)

Add it all up: Continued signs of a slowing but still growing economy; new bullishness from one of Wall Street's smartest (and temperamentally least bullish) strategists; welcome, if temporary, relief in the Middle East; and the continuing redefinition of retirement in the U.S.

The High (and Hidden) Costs of Many 401(k) Plans

Back on March 14th, the WSJ published an important piece (subscription required) by Eleanor Laise on the high costs of retirement plans in general and 401(k) plans in particular. Here are a couple key passages:

401(k) plans aren't required to make clear how much participants are being charged in fees. And there can be a lot of them, including charges to cover independent audits; tracking and maintaining accounts; advisory services; as well as help lines, and of course the basic expense of managing funds in a plan. In fact, investing in a fund through a 401(k) often can be more expensive than buying it through a retail brokerage account.

...

Employers often help pay the bill. But a survey by consulting firm Hewitt Associates showed workers have been shouldering a growing share of many plan fees in recent years. Participants can find fund expense ratios in a prospectus. But there's typically no clear breakdown of how much each participant is paying for various plan services like accounting or custody of plan assets.

First, it's important to note that 401(k) and other ERISA plans--with their daily trading flexibility, extensive reporting obligations, stringent compliance standards, and constant administrative and accounting needs--inevitably impose operational costs on plan sponsors (employers) and participants (employees) not encountered in ordinary brokerage accounts. In addition, participant-directed plans will always be more expensive than traditional pension funds, which negotiated rock-bottom asset management fees, did not pay a sales force to "distribute" investment vehicles like mutual funds, and faced much lower administrative costs due to their economies of scale.

In light of all that, our concerns about 401(k) plans, which seem to be more widely shared all the time, turn on two problems: Reasonableness and transparency.

Laise cites an example that illustrates both issues.

Funds in a 401(k) can come with many layers of fees. For instance, a retail investor can buy Class A shares in the American Balanced fund, which invests in both stocks and bonds, for a 5.75% sales charge, and pay annual expenses of 0.59%. But the same fund's R2 share class, which is designed for retirement plans, carries an annual expense of 1.45%. This breaks down to 0.46% for services like plan administration and record-keeping, 0.24% for management expenses, and 0.75% in so-called 12b-1 fees, which are intended to compensate the 401(k) plan's financial adviser.

Again, we freely acknowledge that 401(k) plans incur significant administrative costs, in part because plan participants, with two decades of self-interested encouragement from the mutual fund industry, have come to expect daily valuation, more or less constant trading opportunities, and a wide variety of investment options (all of which is unfortunate, because the relevant research indicates very clearly that the vast majority of plan participants would be better off with less-frequent valuation, fewer trading opportunities, and an adequate but smaller--and thus more manageable--number of inexpensive investment choices).

But why should plan participants pay 75 basis points (0.75%) in 12b-1 fees simply to compensate a sales force? We don't think they should, and the reduction or elimination of that superfluous layer alone would reduce expenses in Laise's example by half or more.

Now...high-quality, institutional-caliber portfolio management services would absolutely be worth paying for. Unfortunately, brokers' sales efforts simply don't meet the same value-added test.

With the old regime of defined benefit plans on its way out, 401(k) plans are here to stay. For what it's worth, we think defined contribution plans can and should move back in the direction of traditional pension plans. In fact, we see some indications that that shift is already underway; we'll write more about this trend in future posts.

For now, here are a few key elements of our vision for 21st-century retirement plans: Get eligible employees participating through automatic enrollment provisions, ensure that participants assume an appropriate degree of risk in their portfolios (often the problem is employees taking too little, not too much), and reduce the costs borne by participants to the minimum level consistent with effective administration of the plan and implementation of its investment choices.

If self-reliance is the new name of the game in retirement savings, and it sure seems to be, policymakers, plan sponsors, and the financial services industry should take every possible step to help plan participants succeed.

Clarifying and reducing 401(k) expenses is an important shift in the right direction and we're pleased to see things moving that way. But there's still plenty of room for improvement.

UPDATE: We encourage you read more on retirement plans in general by scrolling through our collected work on this immesely important topic.

Sources

Eleanor Laise, "What is Your 401(k) Costing You? As Congress, Regulators Scrutinize Hidden Charges, Employers Begin to Ditch High-Cost Plans, Negotiate Lower Fees" Wall Street Journal, March 14, 2007 (subscription required)

Ross Kerber, "Fidelity to end employee pension plan: Change reflects push for 401(k) plans," Boston Globe, March 29, 2007

Andrea Coombes, "A brave new retirement world: These changes coming soon to a 401(k) near you," Marketwatch, March 22, 2007

Mercer Bullard Is Right

At Marketwatch, Jonathan Burton interviews shareholder advocate Mercer Bullard, the founder of Fund Democracy and now an Assistant Professor at the University of Mississippi School of Law.

After a discussion of independent boards at mutual funds, Burton turns to what Bullard has called the "broker penalty." That's where we join this important conversation.

MarketWatch: You've also focused on brokers who put clients into costly mutual funds when cheaper options were available. How serious is this "broker penalty," as you call it, that some investors apparently wind up paying?

Bullard: At the margins you will have brokers who are not providing the most efficient advice to their clients because they have an economic incentive not to do so. We did a study intended to isolate this conflict of interest. We chose index funds, which are essentially a commodity; matching the Standard & Poor's 500 is the same no matter what fund you invest in.

We didn't look at compensation paid to the broker. Maybe you're paying too much, but once you've paid the broker for the advice, what is the cost of this generic product he sells you? If this were a logical system, if you've paid more to get advice, the broker should be selling you or directing you to the low-cost S&P 500 Index fund.

What happened instead was people got exactly the opposite advice. First, you pay the broker for the advice, and then you get bad advice that leads you to invest in the higher cost fund. In a sense you pay for advice and then get penalized for the advice.

MarketWatch: How can fund investors cut a better deal with brokers and financial advisers?

Bullard: Find a broker who is going to put you in an asset-based fee program. Although I still think you are probably going to pay too much, at least you will get a benefit in that the broker has incentive to put you in the lowest-cost S&P 500 fund, or if it's an actively managed fund, to find you one that is going to perform the best.

Why is that? Because the greater the growth in the fund the broker recommends, the bigger the broker's fee. It aligns your interest with the broker's. You both want to see the account grow, and the broker isn't getting any side payments in any form.

The problem is you need that disclosure to be made explicitly, and you actually have to ask for it because brokers who are providing you personalized investment advice don't have to be treated as if they're a fiduciary who must disclose to you all their conflicts of interest. These brokers, no matter how personalized the investment advice, can be treated as salespeople who have no obligation to disclose those kinds of conflicts. [Emphasis added]

Bullard is right, and his distinction between brokers (who are salespeople) and Registered Investment Advisors (who are legal fiduciaries) is both hugely important and badly underappreciated. Investors who understand the far-reaching implications of Bullard's argument will be better-prepared to look out for their own interests.

We'll be writing more on the matter of paying for financial help in upcoming posts.

Source

Jonathan Burton, "Holding Mutual Funds to the Fire: Investor Advocate Mercer Bullard on Independent Boards and Greedy Brokers," Marketwatch, March 26, 2007