The Float

Target-Date Funds Under the Microscope

Not enough time this afternoon to give this the full treatment (in part because Typepad just ate the first version of this post, which, yes, is a problem that's easily overcome with a preemptive copy-and-paste...but still...very annoying). But we ran across two items interesting pieces on target-date funds, which have been frequent topics of discussion in this space for three primary reasons:

1. They're increasingly prominent features of defined-contribution plans, and thus increasingly important ingredients in the future retirement security of millions of Americans.
2. Like 401(k) plans themselves, target-date funds are loaded with potential...and plagued by a few non-trivial (and easily avoidable) shortcomings, most of which can be traced back to non-fiduciary practices in the financial services industry and lack of awareness among sponsors and participants.
3. Whenever fund companies get excited about selling a particular type of product, it's time to add an extra layer of vigilance.

We'll have some analysis of these two pieces as soon as time permits (tomorrow morning's looking good from here). Until then, both are worth a few minutes of your time if you're interested in such things: "Twelve observations on target date funds" and "New Study Finds Target Date Industry Has Serious Shortcomings."

Caution: Reporters Trying to Help

In Sunday's Washington Post, Nancy Trejos assembled a true classic of the "what-should-investors-do-now" journalistic genre. Fortunately, Trejos quotes a couple sane observers, most notably Vanguard's Gus Sauter. But there's enough unhelpfulness in this piece to merit a few observations.

First, even the subtitle--"How to Play Your Stocks When They Keep Falling"--implies a wrong-headed approach to the financial markets. The number of Post readers who should be "playing their stocks" in any environment is vanishingly small. But let's move on to the more substantive elements here. We'll pull a few passages out and add some commentary after each item.

So if your money's tied up in the stock market, what are you to do?

First of all, if you've properly diversified your investments among various sectors and stocks, bonds and mutual funds, strategists suggest you just hold tight.

This isn't a huge deal, but as we've noted on several previous occasions (here, for example), some journalists tend to conflate investment vehicles (in this case, mutual funds) with asset classes. They're different, of course, and reporters should know--and help their readers understand--the difference.

If you decide selling is the right move, make sure you do it a little at a time. "Selling today will lock in that loss. Our recommendation would be to continue to trim but don't do a wholesale fire sale," said William Keller, senior vice president and director of investments for the Washington region at PNC.

This notion of "locking in" losses bothers us a little. A loss is a loss, whether it's realized or not, and though tax considerations might affect one's timing preferences on the margin (in some cases making selling more attractive in order to offset realized gains), selling (or reducing) a position is either a good idea or it isn't. If it is, then lock that loss right in there!* Doing so "a little at a time" is only a good idea if one is scaling out of a position as part of a serious, systematic plan.

Yared, on the other hand, thinks that if it's a real loser, you should not be afraid to dump it. "From an investors' point of view, you have to be somewhat coldhearted," he said.

Do a lot of research beforehand, a rule that applies to both buying and selling, he said. Look at balance sheets, stock prices, growth rates, the history of the company. Read its quarterly and annual reports. All that information and more is available on the Internet, he said.

Yared's plea for coldheartedness is spot-on. But that second paragraph, the Cramer-esque bit about digging into balance sheets, growth rates, and company reports strikes us as decidedly bad advice for the vast majority of the Post's readers, advice that encourages rank-and-file investors to overestimate both their own abilities and the utility of such information in the first place.

Late in her piece, Trejos names four companies: Johnson & Johnson, Wal-Mart (or is it now *Walmart?), General Electric, and Goldman Sachs. Cue the crickets! All that stock-jockeying advice and what do we get? A semi-plausible four-stock proxy for the S&P 500. Go figure.

But let's conclude on a high note:

Of course, each individual investor has to decide how much risk he or she can tolerate and go from there, the strategists said. If all this is too much for you and you just want to hold on to your cash, that might be the right move for you, but consider this: Inflation might be on the way, and if it gets here, it'll take a big bite out of your reserves.

"Cash has its own risks, and the erosion of purchasing power is one of them," Horan said.

That's not to say you shouldn't keep cash. "You need to have a fallback of immediate liquidity whether it's a line of credit or cash at hand," Keller said. "You have to have that because these are rocky times now."

Yes, yes, and yes, with one important amendment: inflation isn't "on the way." It's already here.

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* Of course, one can "lock in" losses if one sells a position (at a relatively low price) and doesn't replace that position until asset prices have risen. But selling X and buying Y more or less at the same time doesn't "lock in a loss" so much as it changes one's exposure from X to Y.

Source

Nancy Trejos, "When You're Tied Up in a Down Market," Washington Post, June 29, 2008

Random Thoughts on Market Conditions

Amid this morning's sideways action, traders and investors* would be well-served to take a deep breath and evaluate market conditions. Not so much to guess what'll happen in the very short run, but to gain some perspective on the broader lay of the land.

Over the last few days, it has become almost cliché to note that sentiment-based measures of market anxiety have not spiked as they did at the last few intermediate bottoms in the equity markets (see the followning two charts of the CBOE's equity put-call ratio and the VIX, both through yesterday's close).

Note that current measures of the put-call ratio, both the single-day numbers and the 21-day exponential moving average, remain well off their March peaks. Though the 21-day EMA is in the neighborhood of its August, November, and January tops, the daily readings themselves have seen only one spike up to 0.9, and none to 1.0 or higher. So the picture here is a bit muddled. Or, to be precise, more muddled than it is even in its least-muddled configurations.

There's a similar story in the VIX chart, with daily readings moving back into the 20s, but the 21-day EMA lingering well below the levels associated with market bottoms over the last year. And we haven't had any single-day readings above 24 since March. Here, too, we have a relatively muddled picture, one that does not scream market bottom. But we live in a (Bayesian) probabilistic world--not a deterministic one--so we'll keep updating our "priors" along with all of you.

Here's another miscellaneous thought prompted by yesterday's action. In Thursday's "Four at Four," MarketBeat editor David Gaffen quoted a money manager saying this: "We're very much in a declining market...People have to realize that the returns in the market, or expected returns, are going to be lower." The point here isn't to indict the guy who said this, but we think the opposite is closer to the truth. As asset prices decline, expected returns actually improve.

Now, it's certainly true that this is walking and talking like a declining market, and near-term returns could well be negative. We aren't making any particular claim about near-term market action. But, again in good Bayesian fashion, we now have new data in the model: lower prices for long-term assets. And lower current prices imply higher future returns. That doesn't do much to salve investors' short-term pain, but it's true nonetheless.Those of us who speak to the investing public should work to clarify these counter-intuitive subtleties, popular understanding of which would help rank-and-file investors make fewer big mistakes.

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* Now that we mention it, this distinction could make a good addition to "Things We Don't Like About CNBC." Too frequently to count, CNBC's talking heads talk about what "investors" might want to do in the next few hours. At the risk of being a little picky, investors aren't especially concerned about what happens in the next few hours. In fact, they'll be better off if they totally ignore what happens in the next few hours.

Participants (and Others) Behaving Badly

Tuesday afternoon we posted an item on Bloomberg television's recent feature on hidden costs in defined-contribution retirement plans. In that short assessment, we noted that plan costs come in three flavors: explicit (mutual fund expense ratios, insurance charges, recordkeeping, administration, sales loads, advisory fees), implicit (mutual fund trading costs, impaired dividend reinvestment), and behavioral (participants managing their plan assets suboptimally in one way or another).

This is necessarily imprecise, but we think the amount of attention each category of costs receives is inversely related to the extent of its effects. High explicit costs are (relatively) easy to identify and, where fiduciaries want to do the right thing, easy to correct. High implicit costs are tougher to identify, but still reducible when there's sufficient interest in doing so. Behavioral costs are exceptionally difficult to quantify, in part because the current regime of individual accounts privileges rank-and-file participants' autonomy over plan-level management (and, therefore, effectiveness).

But again, it's the behavioral costs--the toughest to quantify and the least-understood--that often wreak the most destruction on participants' long-term outcomes. As we noted back in November, the best plans feature low expenses and high-quality decision-making (see adjacent table).

Which is why we were so pleased to see Financial Engines release the results of its study of participant behavior (available here after you enter some basic identifying information). The findings, as you might imagine, were not particularly encouraging. But as we've long argued, there's nothing wrong with the defined-contribution system that can't be fixed with a few good (i.e., painfully obvious) ideas and a healthy dose of fiduciary responsibility.

Writing at WebCPA.com, Stuart Kahan has a good, short summary of the Financial Engines report. We're going to dig into the report itself and post a more substantive evaluation (probably early next week), but we did want to make special note of one general conclusion Kahan mentions in his piece. Here are the key passages:

Participants earning the lowest salaries are the most likely to make investing mistakes. More than half (53 percent) of participants with annual salaries below $25,000 have portfolios with very inappropriate risk and/or diversification, compared to 33 percent of those earning more than $100,000 per year.

...

In terms of salary, 63 percent of those earning less than $25,000 per year fail to save enough to receive the full employer match, compared to 24 percent of those with salaries between $50,000 and $75,000, and 12 percent of those with salaries greater than $100,000 per year.

None of this is especially surprising. Lower-income workers may be less financially sophisticated, but they certainly have less access to sophisticated help.* The real problem here is that a system driven primarily by participants' elective reductions of their own present income will necessarily put lower-income workers at a significant disadvantage. So not only have plan sponsors and the financial services industry (by resorting to the false security of 404(c), among other mistakes) pushed responsibility for account management down to rank-and-file participants; the system has doubled down on the problem by placing low-income participants--those who need the most help and have the worst retirement security prospects--in an especially difficult position.

This is not a satisfactory state of affairs, but we (policymakers, sponsors, service providers, participants themselves) have the means to improve upon the decidedly imperfect status quo. And time is of the essence...

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* Let's not make too much of this sophistication argument; plenty of affluent, highly-educated participants make big mistakes too, in many cases as a result of overconfidence.

Sources

"Who Benefits from Today's 401(k)?" Financial Engines, June, 2008

Stuart Kahan, "How Well Are We Handling Our 401(k)s?" WebCPA, June 20, 2008

DB v. DC in WV

With our blogging vacation behind us, we have some catching up to do around here. One particularly interesting item that appeared over the last week is Janice Revell's story on the choice faced by public school teachers in West Virginia: Stay with the 401(k)-style defined contribution plan that replaced the schools' traditional pension system, or abandon the DC plan in favor of returning to a defined-benefit pension system.

We'd excerpt the story, but we'd end up passing along just about the entire thing, so instead we'll insist that you spend two minutes reading this very revealing piece. Just about every element of the bigger story in the U.S. retirement system is here: underfunded pensions, employers' cost-conscious transition from DB to DC plans, expensive/underperforming insurance-focused products, poor decision-making by participants, and, as a consequence of all of that and more, grossly inadequate outcomes for rank-and-file participants.

Revell is right to wonder about taxpayers' potential costs in all this. But the teachers' interests represent the other side of this troublesome coin: American workers who need--but generally aren't getting--the best possible retirement savings programs.

Source

Janice Revell, "Take this 401(k) and shove it," Money, May 20, 2008

Confidence Springs Eternal

In this morning's Wall Street Journal, Jenny Strasburg has a short piece on the "cash on the sidelines" currently held by hedge fund investors (as distinct from hedge fund managers). We're not particularly impressed with "cash on the sidelines" per se as a contrary indicator, as only increased risk appetites, which leave buyers more enthusiastic than sellers, can translate cash into higher asset prices.

But for our purposes the most interesting nugget, a truly classic behavioral finding, is buried in Strasburg's last two paragraphs:

The moneymaking outlook is so-so. Investors surveyed by Deutsche Bank said they expected hedge funds to earn a median 7.5% return this year.

The same investors apparently believe they possess superior skills in choosing managers: For their own portfolios, they are projecting a 10% return.

This disconnect between one's projected average for the masses and expectations for oneself--also known as overconfidence--is a cornerstone of the behaviorist understanding of market participants.

One minor statistical quibble while we're at it. Investopedia's short description of investor overconfidence opens with this (emphasis added in bold):

In a 2006 study entitled "Behaving Badly", researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.

When making arguments like this one, we think it's smart to be as precise as possible. And as it turns out, more than 50% of the sample can be above average--as long as the median outcome is higher than the mean outcome. Think of it this way: Just a few terrible outcomes can drag the average (i.e., the mean outcome) lower, but because they're already below the median (i.e., they're already in the bottom 50% of performers), their truly awful underperformance can produce a population in which more than 50% enjoyed above-average outcomes.

Using the numbers in Strasburg's story, think of an average outcome of 7.5% per year, where the bottom 10% of participants produced returns of -10% per year (in a kind of "fat tail" phenomenon). One can easily imagine a world in which more than half the participants did better than 7.5% per year. A general assumption here would be that, as a group, any outcomes in the above-average "fat tail" outperformed by less than the worst laggards underperformed.

Now, our point about overconfidence remains. It's plenty real (and may even be a necessary condition for risk-taking). But it is mathematically possible for more than 50% of participants to do better than average.

Source

Jenny Strasburg, "Hedge-Fund Portfolios Stockpile Cash," Wall Street Journal, May 6, 2008

Equity Exodus

We've spilled a lot of pixels on the topic of rank-and-file investors' decision-making in defined-contribution retirement plans. And we're pretty sure this, from PlanSponsor.com (free registration required), speaks for itself...

Participants moved assets from equities to fixed-income investments during 80% of the trading days in March, according to the Hewitt 401(k) Index.

In fact, during the first quarter of 2008, participants transferred $2.8 billion from equities to fixed-income investments on a net basis, which is the largest quarterly equity outflow during the history of the Hewitt 401(k) Index.

In March, the overall transfer activity level was slightly above the 12 month trailing average--0.05% of balances were transferred on a daily basis. Additionally, five days of the month experienced above normal transfer activity, and two of those were "high" volume days--March 10, where transfer activity was more than twice "normal" levels, and March 18, where activity was three times normal.

Note that March 18 saw an enormous move higher in the broad equity market. Alas, this sell-low capitulation came straight outta central casting.

Source

"Participant Equities Exodus Continues in March," PlanSponsor.com, April 21, 2008

"Prediction" Breakdowns

On Tuesday, the prolific team at CXO Advisory Group posted an interesting item on the predictive capacity of S&P 500 futures traders. The key distinctions were across type of market (1995-2000, 2000-2003, 2003-2008) and type of trader (commercial hedgers, large speculators, retail speculators).

We recommend the post in its entirety, in part for the excellent graphical presentation. But the key takeaways here are (1)retail speculators are generally wrong in all periods and (2) all types of traders have become less predictive over time. Interesting stuff.

Vaguely related: Developments in the correlation between the CBOE equity put-call ratio and the broad equity market. As we've noted in this space on several occasions (most recently here), peaks in this indicator's 21-day exponential moving average have coincided very neatly with intermediate bottoms in the stock market.*

In the chart below, you can see quite clearly that the market lows of August, November, January, and March matched up with highs in the equity put-call. What we've found interesting is that since the March lows, the 21-day EMA has moved only slightly lower as the S&P 500 has moved non-trivially higher. Our suspicion is that the residual fear reflected in CPCE could provide a firm foundation of sentiment (i.e., skepticism) for further moves higher.

Notwithstanding today's relatively impressive corporate reports--and, more importantly, investors' bullish reactions to very mediocre ones--we remain concerned about the medium-term earnings outlook. But medium-term markets are a bunch of short-term markets stacked end-to-end. And the current short-term environment, driven by a mix of re-awakened risk appetites, stubborn anxiety, and non-apocalyptic news, looks relatively buoyant from here.

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* Here's more from CXO on whether put-call ratios are leading or lagging indicators.

Disconfirmation in the Total Put-Call?

Friday morning we posted an item on the CBOE's equity put-call ratio, asking whether the current (very high) reading would be as useful a contrary indicator as similar readings had been throughout the preceding year.

With data from Friday and Monday now in the books, our favorite smoothing device for this time series (the 21-day exponential moving average) moved higher as equities moved lower. In other words: Several days of relatively extreme put-call readings, but no bottom in the broad averages. See the following chart, with the S&P 500 in red and major tops in $CPCE's 21-day EMA in dashed blue lines (data through yesterday's close).

Given this morning's central bank announcements, today's trading isn't an ideal reflection of the market's underlying sentiment. On the other hand, however, one might read today's furious morning rally as a product (in part) of just how tight the sentiment rubber band had been stretched.

In any case, when one looks at the CBOE's total put-call ratio (i.e., the number that includes index as well as equity options), it's clear that bearish sentiment has not quite reached levels associated with major tradable bottoms in 2007 (which, in the following chart, are marked by dashed blue lines--the March '07 version of which is barely visible near the left edge). 2007's March and August bottoms saw $CPC's 21-day EMA top out above 1.2. But yesterday's reading, the highest since late August, was at 1.16.

In a purely qualitative sense, this fits with our perception that equities' year-to-date declines have been less panicky than those of 2007. It's almost as if traders are more resigned to the reality of a weak market. Bottom line: There's a whiff of fatalism in the air these days.

Source

Scott Lanman, "Fed to Lend $200 Billion, Take on Mortgage Securities," Bloomberg, March 11, 2008

The Put-Call Ratio Screams Higher...But What Is It Saying?

We last took up the question of the CBOE's equity put-call ratio in mid-February, we noted that the indicator's 21-day exponential moving average had climbed back to levels associated with four significant bottoms in the preceding 12 months. We noted the absence of the kind of fearful capitulation we'd seen in previous episodes, most clearly in August, 2007.

As you can see in the chart below, the 21-day EMA of the put-call ratio (the blue line) has now surpassed its 2007 highs, reaching 0.81 at yesterday's close. With a weak open coming this morning, we'll be watching to see whether and where traders draw the line.

The level of risk-aversion out there is unusually high. But then again, so is the level of risk.