The Float

"Your Mileage May Vary"

Yesterday we noted the perils of performance-chasing, especially in an illiquid asset class like residential real estate. But behavioral errors matter in liquid asset classes too. Consider the well-known evidence compiled by Boston-based Dalbar, Inc.

From 1986 to 2005, the average annual return of the S&P 500 was roughly 11.9%. Not bad! Unfortunately, the average equity mutual fund investor earned only 3.9%, outpacing inflation by a scant 0.9%. Why? Investors tend to chase performance in uptrending markets and bail out in downtrending markets. Here's the accompanying commentary from Dalbar's 2006 report:

Improving investors' actual returns depends more on correcting behaviors than on the performance of the fund.

While published statistics of mutual fund performance are within a few percentage points of the index, investor behavior erodes the returns on even the best performing fund.

Investors in fixed-income funds also underperformed: 1.8% annually, against 9.7% for the long-term government bond index (and, again, 3% inflation). What about investors who chose asset allocation funds? Not a pretty picture here either: 3.3% annual returns. In risk-adjusted terms (in other words, because asset allocation funds had cash and fixed-income components that underperformed equities in this period), the picture here is a little brighter, but truly just a little.

We were reminded of the Dalbar results by the inaugural issue of Morningstar Advisor, a new magazine published for investment advisors. Unfortunately, the story is not available online, but "Your Mileage May Vary" provides additional evidence of the effects of behavioral errors on bottom-line returns. (The methodology behind Morningstar's "Investor Return" calculations is described here.) Morningstar's key points are that more volatile funds and asset classes tend to exacerbate the effects of investors' buy high/sell low tendencies.

In our White Paper on the value of good professional help, we describe the five key factors in investment outcomes:

1. Asset allocation
2. Investment discipline
3. The performance of one's chosen investment vehicles
4. Taxes
5. Expenses

The first two are overwhelmingly the most important and while the order of the last three can vary, together these five factors are the ingredients of success (when investors get 'em right) and failure (when investors get 'em wrong).

Because asset allocation and discipline are as much behavioral as technical, investors need to understand the enormous impact of emotion on their investment outcomes.

Markets tend to be pretty darn efficient over the long-term, but scholars working in the field of behavioral finance have established that investors, who tend to operate on shorter time horizons, are not always the rational calculators of traditional economic theory. Research findings from Dalbar and Morningstar leave little doubt: getting the behavioral stuff right is the foundation for investment success.

The Risks of Performance-Chasing

Here's a tough-to-read story from Money about Steve and Carol Daimler. It's an object lesson in the perils of counting on a single hot asset class to carry you through.

To supplement their retirement savings of $260,000, they figured they'd buy fixer-upper homes to renovate, then sell at a profit in the state's hot housing market. "We thought we'd make $100,000 without batting an eye," says Carol.

But when the housing bubble burst, so did their dreams of a real-estate funded retirement. The properties have been on the market for nine months without a serious offer, and the carrying costs are killer: The Daimlers pay more than $65,000 a year on their mortgages (including loans for their primary residence and a vacation house in North Carolina), plus tens of thousands more for property taxes, insurance and maintenance.

The couple are pulling out $15,000 a month from savings to cover their expenses, and they've already run through more than half of their nest egg. The irony: On paper they seem to be in great shape, with a net worth of $1.6 million. But since most of that money is tied up in real estate - assets they can't easily sell - it doesn't ease their current cash crunch.

Then today: More news of weakness in residential real estate, with new home prices falling precipitously (but sales picking up in response to lower prices).

New homes sold at an annual pace of 981,000 in April, up 16.2 percent from the revised 844,000 pace in March. Economists surveyed by Briefing.com had forecast an 860,000 rate in April.

The gain in sales compared to March is the biggest jump in 14 years. But even with the April spike factored in, April sales came in 10.6 percent below year-earlier levels.

The median price of a new home sold in April plunged 10.9 percent from a year earlier to $229,100. The new price reading was also down 11.1 percent from the March reading.

It was the sharpest year-over-year drop in median new home prices since December 1970 and the biggest month-to-month drop on record.

Paul Kasriel, chief economist with Northern Trust in Chicago, equated the strong sales to the strategy of the Detroit automakers, who cut prices and offer other sales incentives to counteract weak demand for their cars and trucks, sometimes taking a loss on the sales.

"The builders are clearing out the merchandise," he said. "They're doing a Detroit here. When you have excess supply, the quickest way to move supply back into balance with demand is to cut the price, and finally they're doing that. I would not say this is the bottom of the housing recession."

It's an interesting dynamic here. Slack demand created excess supply in the housing stock, excess supply forced builders to slash prices, and lower prices finally pulled buyers back into the market. Where does housing head from here? What does that imply for Fed policy? Given today's action, it's obvious that, after earnings season and in the absence of significant M&A news, expectations of Fed policy are going to move the markets.

Sources

Donna Rosato, "Retirement Interrupted," Money, May 22, 2007

Chris Isidore, "New homes prices plunge, sales soar," CNNMoney.com, May 24, 2007

"Wall Street Closes Sharply Lower on Rate Worries," Reuters, May 24, 2007

More M&A Enthusiasm

Last Friday, we asked a couple important questions:

When will the torrid pace of M&A, buybacks, and private equity buyouts begin to slow? What will trigger the slowdown? With credit readily and cheaply available and corporate balance sheets flush with cash, we don't pretend to know.

When will the dealmaking slow? The answer is clearly not just yet as we get news that Alcan is inviting a bidding war, potentially pitting BHP Billiton against Alcoa after Alcan rejected Alcoa's unsolicited offer on Tuesday.

As we've noted before (here and here), the market's heading higher not only on the abstract force of enthusiasm, but on the concrete effects of a shrinking equity supply. So we think this is just about right:

"Interest rates are still low compared to the earnings yield of the stock market, so that indicates an attractive valuation of the market and also implies we'll continue to have more M&A activity going forward," said Bucky Hellwig, senior vice president at Morgan Asset Management, in Birmingham, Alabama. "As companies go private or merge, there are fewer shares for the investment community to buy. It's a classic supply-and-demand situation."

Source

Jennifer Coogan, "Stocks rise in takeover-driven rally," Reuters, May 23, 2007

Chinese Bubble Watch, Part II

At the start of the week we wrote about the vertigo-inducing climb of the Shanghai Stock Exchange Composite (up another 1.5 percent today!). Excerpting a recent AP piece, we quoted a few new-to-the-game investors who seemed to come straight outta central casting. Today we find more of the same, this time from Reuters.

Here's a telling passage:

"I only need to pay 9,000 yuan interest for the loan I got, but I think I can make at least 70,000 yuan a year by investing that money in stocks," Hua, an office worker, said.

"So why not? I see almost no risk."

And another:

Laid-off workers have become day traders, glued to big screens at smoke-filled city-centre brokerages. Foreign students, trading through their Chinese friends, are dabbling.

State media reported that some companies in Shanghai are even setting aside an hour every day for employees to trade shares....

As befits a feverish market, retail investors like smaller, speculative stocks. Blue-chips, by contrast, have been relative laggards.

And again with the "Olympics put":

"I'm pretty sure that the boom will last at least until the Olympic Games are over next year," Hua, the office worker, said.

"That's been the experience of other countries. So I can't be so stupid as to waste this chance. It won't come again."

Let's be clear: We aren't in the business of calling tops in any market, let alone the Chinese one. But we do think we used the right adjective on Monday: unhinged.

Source

Eadie Chen, "Ignoring warnings, Chinese rush into stocks," Reuters, May 23, 2007

One More Thought (For Now) on the Rollover/401(k) Question...

We've done a little more thinking about the rollover/401(k) question. Here's the fundamental issue as we see it...

Legally, ERISA plans are firmly rooted in fiduciary principles. Unfortunately, non-fiduciary practices such as excessive fees, poor disclosure, closet index funds, and product-driven selling continue to afflict thousands of 401(k) plans. Until all of that changes--and it could be a while--an intelligent, cost-conscious rollover should be the first choice for most investors.

Leave It? Or Roll It Over?

In the May issue of CFO Magazine, Russ Banham takes up the issue of whether people should roll their 401(k) balance to an IRA when they change jobs or retire. It's an important question, but we think Banham misses a few key points in recommending that participants may be better served by leaving their assets in their former employers' retirement plans.

First, Banham seems to underestimate the costs of the typical 401(k) plan (a topic we've written about here) relative to the IRA alternative. Naturally, some methods of managing rollover accounts are more expensive than others. In general, however, an appropriately priced rollover program should be significantly less expensive than the vast majority of 401(k) plans. 

Another cost-related advantage of the rollover option, at least in our world: Larger accounts enjoy meaningful economy-of-scale savings, as graduated fee structures bill marginal dollars at lower rates (e.g., 1% on the first $250k, 0.75% on the next $250k, and 0.5% on each additional dollar). Due to appropriate non-discrimination rules in ERISA plans, your 401(k) can't offer those marginal savings for larger account balances. In fact, in plans that pay administrative expenses on a percentage basis (often through elevated mutual fund expense ratios, which facilitate kickbacks known as "Sub-TA revenue-sharing"), larger accounts actually pay significantly more for basic fund administration.

Second, Banham cites the fiduciary duty of the plan sponsor as an advantage of the 401(k) over an IRA rollover. Unfortunately, given current practices, sponsors' fiduciary duties only go so far, and in light of the recent wave of class action litigation against major corporate retirement plans, it seems they don't go quite far enough. Fiduciary duty to investors is hugely important, but every registered investment advisor (RIA) in the country operates under that legal obligation, so investors can enjoy fiduciary guidance by working with a responsible, cost-conscious RIA.

Third, Banham seems to applaud the introduction of a truly superfluous feature in one particular retirement plan. Says the CFO in question (emphasis added): "We publish newsletters and regularly communicate [with employees] about their retirement investments. We've also introduced an online system [that enables] people to check their balances hourly." This is truly backward.

As Banham points out, academic research indicates that an excess of investment choices in retirement plans can impair participant decision-making. A similar logic applies to an excess of information. Research also suggests that infrequent monitoring of account balances correlates with better performance. The premise is: "Don't just do something, stand there!" When it comes to shuffling assets around in retirement plans (and elsewhere), less is truly more.

Hourly updates? Neither necessary nor helpful. We don't know the details, of course, but we suspect that somewhere, somehow that particular feature may cost a little something. And stories like this one suggest service providers are peddling bells and whistles that don't help improve participant outcomes. And ultimately, those outcomes are what all of this is all about.

Bottom line: We think Banham overstates the drawbacks of a high-quality rollover arrangement and understates the costs of a typical 401(k) plan.

As always, there's more on this topic to come...

Sources

Russ Banham, "To Rollover, or Not? Why retirees should think twice before shifting 401(k) assets into an IRA," CFO Magazine, May 1, 2007

Gregory L. Ash, "401(k) Plans in the Cross-Hairs," Spencer Fane Britt & Browne, March, 2007

Fun With Headlines

Today in the Wall Street Journal...

Page C1: "U.S. Investors' Overseas Bets Dent Greenback: Quest for Stronger Gains Leads to Weaker Dollar; A Self-Fulfilling Cycle"

Page C6: "Dollar Looks Set to Move Up: Outlook for Japan, Europe Lend Hope for More Gains"

But seriously: The U.S. Dollar index does seem to have bottomed, at least short term. And maybe (emphasis on maybe) more: In late April, USD bounced off what could be long-term support (at the level it carved out in late December, 2004.)

"Absolutely Obsessed"

Just ran across this item from the Sunday New York Times on the massive financial fraud perpetrated against older Americans. Playing a central role in this infuriating story: Wachovia, which these days leads with the (somewhat creepy) claim that "we are absolutely obsessed with satisfying our customers." Sure. Tell that to 92 year-old Richard Guthrie, whose life savings were drained while Wachovia allegedly looked the other way.

Here's the basic scam: A "friendly" caller engages an elderly citizen in conversation, solicits personal information, including account numbers, in order to "update files" at an insurance company or government agency. How'd the caller get the recipients' contact information in the first place? From lists of those who've signed up for sweepstakes, among other sources. "These people are gullible," one list said. "They want to believe that their luck can change."

And how's this for heartbreaking: "'I loved getting those calls,' Mr. Guthrie said in an interview. 'Since my wife passed away, I don't have many people to talk with. I didn't even know they were stealing from me until everything was gone.'"

This civil suit is apparently the first to target Wachovia for conspiracy to commit financial fraud. We don't think it'll be the last. And we suspect Wachovia, for all its apparent complicity, won't be the only target of such litigation. At this juncture, Payment Processing Center ("PPC") and infoUSA appear to be leading players in this awful story. In filing criminal charges against PPC in 2006, the U.S. Attorney in Philadelphia noted that "Wachovia received thousands of warnings that it was processing fraudulent checks, but ignored them." That's ugly stuff. 

With more American living longer lives, it becomes more important than ever for their children and other caregivers to help them avoid these infernal rackets. And it becomes the moral responsibility of the business community to detect, disrupt, and report any and all fraudulent abuses of our senior citizens (and the rest of us, for that matter).

UPDATE: While we're at it, here's another fabulous new "service" from the banking industry: Gift cards with fine-print terms ridiculous enough to un-sell the product...if would-be buyers can bring themselves to read 'em.

LATER UPDATE: Last year, we received a $25 "gift card" from the bank that did our mortgage. Not sure if there were any fees embedded in the thing, but there was another problem: It didn't work anywhere but Starbucks! And sometimes not even there...

Source

Charles Duhigg, "Bilking the Elderly, With a Corporate Assist," New York Times, May 20, 2007

"Civil Suit Alleges Wachovia Conspired With Payment Processor in Scheme to Defraud Elderly," PR Newswire, April 12, 2007

David Colker, "The incredible shrinking present: Bank gift cards may be convenient, but obscure fees can quickly deplete their face value," Los Angeles Times, May 20, 2007

From Parabola to Asymptote

It's true, we haven't used the terms "parabola" and "asymptote" in the same sentence since graduate school...or was it high school? Either way, the Shanghai Stock Exchange Composite has come utterly unhinged. See the 5-year at right and don't adjust your monitor if you get a sense of vertigo; it's a common consequence of looking straight up at something this vertical!

Clicking through Saturday's Barry Ritholtz Linkfest, we were reminded of an AP blurb from the previous weekend. This is a bubblicious classic, with a few characters straight outta central casting. Ultimately, it's not the chart per se that screams bubble.* It's the participation of millions of new investors--and what those investors are saying about the market.

Here are the AP's opening paragraphs:

After watching Chinese stock prices gallop upward for months, Ding Xiurui wanted a piece of the action. The 45-year-old office worker stood in line at a bustling brokerage Friday to open her first trading account. She brought her sister, who opened an account too. They joined millions of other novice investors who are jumping into a market that has soared to dizzying heights, with prices up nearly 50% this year.

"We still can make money," Ding said as she stood at the counter at Tiantong Securities with the paperwork for her new account. Asked what stocks she would buy, Ding said, "I don't know. I'm still learning."

From the time-honored script:

"I have a stable income but in China now a stable income doesn't mean a good life," said a 26-year-old government employee who was opening an account at Tiantong Securities and would identify himself only by the English name Leon. "Seeing other people earning a lot of money, all you can think is, you're earning so little and how can you make more?"

Again:

A 60-year-old cleaning woman in the southwestern city of Chongqing is being feted in the media as a market wizard after doubling her 20,000 yuan ($2,600) investment in two months.

"At a time like this, who can lose money?" the newspaper Chongqing Morning Post quoted her as saying.

But then, this market might not be--or behave--like other markets:

"We hear that before 2008, the government won't let prices fall," said Ding's sister, Ding Jingxian. "We're not afraid."

You have to wonder what the VIX and Put/Call might look like in Shanghai these days.

UPDATE: The Chinese government buying a stake in Blackstone Group? What Gaffen (and others) said.

~~~~~~~~~~~~~~~~

* Yes, we're aware of China's rapid growth and that even at these elevated levels valuations aren't as nutty as many U.S. tech-sector multiples were in the late 1990s. But we're not sure that's the most reassuring comparison! From where we sit, Shanghai just doesn't seem to have much (or enough) risk premium these days. To paraphrase Charles Barkley, we may be wrong, but we doubt it.

Source

"First-Time Investors Snap Up Chinese Stocks," Associated Press, May 13, 2007

Tamora Vidaillet, "Blackstone hopes China will bet on its funds," Reuters, May 21, 2007

More on Private Equity and M&A

On Friday, we wrote about the effect of the current private equity/M&A boom on the supply of equities in the U.S. market--and suggested that the dealmaking was beginning to feel a little frothy.

Saturday morning, we found the following headline on the WSJ's breakingviews.com column by John Paul Rathbone and Edward Chancellor: "Mergers Take It Up a Notch: Lengthening Premiums Point to Value Destruction; The Risk of a Buyout Bubble." Rathbone and Chancellor note, as we did on Friday, that conditions are more favorable for constructive buyout activity today than they were in the late 1990s. But they're concerned about the premiums seen in the latest deals: 85% for aQuantive and 46% for Reuters, for example, relative to an average of 39% in 2000.

Here's the key passage from Rathbone and Chancellor:

"A breakingviews.com analysis of these deals suggests that they are value-destructive: the premiums paid can't be justified by the synergies promised by the acquirers. That means shareholders in target companies have more to celebrate than those of the buyers."

Then this morning we learn that Alltel will be taken private in the largest leveraged buyout ever in the telecommunications industry ($27.5 billion, $23 billion of which is debt). This morning's relatively modest jump in AT reflects only part of the underlying premium, as takeout rumors sent the stock sharply higher in late December.

Then we hear CNBC's David Faber suggest that the AT premium could have been higher still if another private equity consortium had prevailed. At least one such group had offered a higher bid, and apparently the deal includes no "go shop" provision that would accommodate additional bids. That's intriguing and, as Faber notes, not necessarily shareholder-friendly.

Let's be clear: We don't know nearly enough about this deal to draw any firm conclusions. But if it generates excess economic "rents" for management and their investment bankers at the direct expense of shareholders...we would interpret that as evidence that things are getting a little carried away and that we're in the late stages, if not the final stage, of the private equity/M&A boom. And somehow we don't think this is the kind of thing Clayton Christensen and Scott Anthony had in mind when they wrote this.

Finally: Is this funny or frightening (or both)? Here's Faber, discussing this morning's ~$4 spike in ValueClick on speculation that it must be next: "I'm channeling 1999 here!"

Sources

John Paul Rathbone and Edward Chancellor, "Mergers Take It Up a Notch: Lengthening Premiums Point to Value Destruction; The Risk of a Buyout Bubble," Wall Street Journal, May 19-20, 2007

Ritsuko Ando and Jessica Hall, "Alltel stock jumps on $25 billion buyout," Reuters, May 21, 2007

"Private equity sees Alltel as possible target: report," Reuters, December 29, 2006

Clayton M. Christensen and Scott D. Anthony, "Put Investors In Their Place: Why pander to people who now hold shares, on average, less than 10 months?" BusinessWeek, May 28, 2007