The Float

Wring Out the Excess

As the world turns to the FOMC--perhaps expecting too much--let's think about the big financial-economic picture for a moment.

The Fed has a very tough job, made tougher still by its own prior actions (and inaction, for that matter) as well as the overwrought mythology of the central-bank-in-control.

The essence of the Fed's mission is to pursue three objectives: low inflation, steady economic growth, and functioning financial markets. But here's the thing: Sometimes functioning financial markets--markets operating on the basis of fundamental economic conditions--produce credit contraction and falling asset prices.

After all, if the collateral behind big chunks of the asset-backed commercial paper market is weak and weakening, shouldn't demand for ABCP decline?

If lending standards have gone completely around the bend, shouldn't those standards tighten up?

If home prices are simply unaffordable for marginal buyers borrowing under economically defensible terms, shouldn't those prices fall? Don't they need to?

Taking anything other than the shortest possible view, these developments are actually very positive for economic growth. The last few years saw (1) a gross mis-allocation of resources to economically unproductive assets (that is, the housing stock--the creation, remodeling, buying, and selling of which creates economic activity, but the existence and use of which do not) and (2) a toxic mix of underpriced risk and excessive leverage.

The point here is not that the Fed--or anyone else--should be unconcerned about difficulties in the financial markets. When good credits can't borrow for economically useful purposes, market failure requires a policy response. But it's important to remember that inflated asset prices--when fully detached from underlying production or productive capacity--can themselves be evidence of a kind of market failure.

At such times, letting asset prices--for debt, equities, real estate, commodities, derivatives, &c.--return to something approaching rational equilibrium levels is itself conducive to the efficient allocation of economic resources. And that allocation of resources is what markets should do best.

Sources

John P. Hussman, "Waiting for the Witch Doctor," Hussman Funds Weekly Market Comment, September 10, 2007

Mark Pittman, "Commerical Paper Slump Eases; Asset-Backed Drop Slows," Bloomberg, September 13, 2007

Scott Lanman and John Fraher, "Fed, Blamed for Asset-Price Inaction, Is Told 'Tide Is Turning,'" Bloomberg, September 4, 2007

Daniel Taub, "U.S. Housing Recovery Is Unlikely in 2008, S&P Says," Bloomberg, September 13, 2007

Brian Louis, "U.S. Housing Slump May Last Until 2009, Moody's Says," Bloomberg, September 10, 2007

Friday Reading

As Tuesday's FOMC meeting approaches, it's time to cast a broad net...

• From Portfolio's John Cassidy, Greenspan revisionism in its purest form.
• And from Greenspan himself, some not-quite-convincing book-tour pushback. Remember the concern isn't just that the Greenspan Fed kept overnight rates too low for too long. We think those rates were too low for too long, but reasonable people can disagree about that. What's beyond debate--in our view, anyway--is that the Fed's lack of regulatory oversight in lending practices gone haywire was very unhelpful.
• Minyanvile's Kevin DePew isn't thrilled with the idea of a Fed rate cut, suggesting that it would/will be tantamount to feeding the economy "more of the same virus that caused the sickness in the first place."
• August retails sales weren't thrilling and preliminary September consumer sentiment printed a relatively anemic number this morning.
• Calculated Risk is on fire. Go read it.
• Northern Rock: Ouch.
• Let's not forget about the commercial paper market.
• And here's Felix Salmon on the monetary policy confidence game.

ETFs and 401(k) Plans: Part II

As we noted yesterday, Monday's Wall Street Journal featured the paper's monthly "Investing in Funds" section. Taken together, the three stories on the front page of that section lead us to a simple conclusion: Status quo 401(k) plans need some serious work.

Yesterday, working off a Diya Gullapalli story on ETF providers' efforts to win retirement plan business, we took a broad view of the 401(k) marketplace: dominated by (often mediocre, expensive) mutual funds and primed for change by the Pension Protection Act of 2006. Today, we'll cover a few highlights from the other two stories from Monday's page R1: "Tough Market Favors Those With Time To Tough It Out," by Ian McDonald, and "Workers Gripe About High Fees, Limited Choice at Some 401(k)s," by Jennifer Levitz.

The moral of the McDonald story is simple: Investors with long time horizons shouldn't sweat short-term volatility. That's certainly true as far as it goes. But we'd add an important corollary: Investors with long time horizons and solid asset allocation programs already in place shouldn't sweat short-term volatility.

Which leads us directly to today's discussion, because 401(k) assets are almost always* long-term investments, but plan participants often struggle to assemble an appropriate asset allocation program. Target-date funds of funds are often serviceable solutions to the latter problem, but as we noted yesterday, some of those vehicles are a lot less appealing than others.

In the Levitz piece, we see the shortcomings of too many defined contribution plans: Excessive fees, weak investment vehicles, even too many choices. Too many? No doubt. Academic research has found that people forced to choose from an excessive number or options not only struggle to choose wisely; they often struggle to choose at all. In the 401(k) world, the only thing worse than choosing unwisely is not choosing at all.

As it happens, Terri Cullen writes in this morning's Journal about her uncle Bill's difficulty in making heads or tails out of his new employer's 401(k) plan. So Bill asked Cullen for help. "It's an appeal I've heard many times over the years from family members flummoxed by their retirement plans' myriad choices," she writes. And back to Monday's Levitz piece, where we learn that IBM considers its 401(k) plan a recruiting tool. One reason? It offers employees access to more than 200 mutual funds. Now, the IBM plan may have several strengths--we're sure it does--but a menu of 200 mutual funds is definitely not one of them.

After all, how should we expect rank-and-file employees to choose from that menu? What independent knowledge do they bring to bear on that important task? How likely is it that participants in that plan will end up with a truly sound asset allocation program? Yep, those questions are rhetorical, and the point is that participant-directed 401(k) plans saddle participants with unjustified and unfair burdens. For every stock jockey who benefits from the freedom of choosing among dozens of options, several participants will end up with sub-optimal investments, sub-optimal long-term outcomes, and, ultimately, some combination of sub-optimal living standards in retirement or undesirable delays in retiring in the first place.

All of which leads us, finally, back to our central claim. We think plan participants need--and deserve!--a very different kind of retirement plan defined by fewer choices of higher quality at lower expense. To the extent that plans offering managed accounts of ETFs, facilitated by technological advances in trading and accounting platforms, can fill that urgent need, we think such plans meet the needs of sponsors, fit comfortably in the regulatory framework of the Pension Protection Act, and, most importantly, serve the long-term interests of plan participants.

The 401(k) marketplace, primed for change by new legal, technological, and economic realities, screams out for creative thinking from sponsors and service providers who see ERISA's fiduciary imperatives as true first principles.

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*Yes, almost always. Even those on the verge of retirement should consider their 401(k) assets long-term investments, because the finish line isn't retirement itself; it's the indeterminate (and with rising life expectancies, increasingly long) time spent in retirement. There are exceptions, cases where 401(k) participants should consider potential short-term needs (say, for a loan against plan assets), but those exceptions are rare and shouldn't obscure the logic of treating 401(k) assets as long-term investments.

Sources

Diya Gullapalli, "ETFs Seek Room in Your 401(k)," Wall Street Journal, September 10, 2007

Ian McDonald,  "Tough Market Favors Those With Time To Tough It Out," Wall Street Journal, September 10, 2007 (subscription required)

Jennifer Levitz, "Workers Gripe About High Fees, Limited Choice at Some 401(k)s," Wall Street Journal, September 10, 2007 (subscription required)

Terri Cullen, "Making Sense of Retirement Plans," Wall Street Journal, September 13, 2007 (subscription required)

ETFs and 401(k) Plans: Part I

Page R1 of Monday's Wall Street Journal (the front of the latest "Investing in Funds" section) featured three important and interconnected stories on its front page. The unifying theme: Status quo 401(k) plans need some serious work.

Because this is such a big topic, we've split it down the middle. Today we'll discuss the broad contours of the defined contribution marketplace. Tomorrow we'll wrestle (again) with the shortcomings of the typical 401(k) plan and offer our thoughts on the advantages of a specific kind of ETF-based solution.

In "ETFs Seek Room in Your 401(k)," Diya Gullapalli describes the following big picture:

• Mutual funds dominate 401(k) plans.
• A small but growing number of plan administrators and ETF providers have built trading and accounting platforms that overcome the obvious drawback of ETFs relative to mutual funds--per-trade commissions that make dollar-cost averaging prohibitively expensive if each plan participant has to pay them individually, but become negligible if orders can be aggregated across many participants and trading expenses broadly distributed.
• Adoption of ETF-based plans has been slow but may accelerate as ETFs' low and transparent expenses satisfy the spirit and letter of last year’s Pension Protection Act.

Now let's take a deeper look at a few key passages from Gullapalli's story. Beginning near the beginning:

The 401(k) market helped boost the profile and earnings of mutual-fund companies, and some say it could provide the same ride for ETFs -- if only someone would hand them a ticket.

What is holding them back? ETF providers blame mutual-fund companies, some of which run some of the biggest 401(k) plans, saying their resistance stems from fear of competition. ETFs in general charge lower fees than average mutual funds.

Mutual-fund purveyors see it differently. They say that they already offer plenty of low-cost mutual funds that track stock- and bond-market indexes as most ETFs do, and that some of the most heavily touted features of ETFs, such as tax efficiency and flexible intraday trading, offer few advantages in 401(k) plans, which already are tax-advantaged and geared toward long-term investing.

Before we start digging into all this, let's remember one thing: There's a lot of money at stake here, so one should interpret all the big players' claims in that context. But an underlying profit motive doesn't make all competing claims equal. Some, you might say, are more equal than others.

First, of course mutual fund providers fear competition from ETFs (and other alternatives). And who can blame them? The appropriate response here isn't to demonize fund companies; it's to ensure that plan sponsors, participants, service providers, legislators, and regulators evaluate their claims on their merits.

For example: mutual fund companies' insistence that "they already offer plenty of low-cost mutual funds that track stock- and bond-market indexes" in 401(k) plans doesn't pass the laugh test. Investment options in 401(k) plans are overwhelmingly dominated by actively managed mutual funds, both as stand-alone vehicles and wrapped up (horrifyingly) in variable annuity products.

Second, it's true that ETFs' tax efficiency and trading flexibility are essentially irrelevant in 401(k) plans. (Similarly, mutual funds' tax inefficiency is a big problem in taxable accounts but not in tax-advantaged retirement accounts).

The question of whether ETFs make sense in defined-contribution plans has to turn on other considerations:

Some ETF advantages relative to mutual funds line up nicely with a push by the U.S. Labor Department and other federal agencies to improve fund and fee disclosure for individual investors, ETF providers say. The Labor Department's Employee Benefits Security Administration was recently taking comments on the best ways to improve 401(k)-plan administrative and investment-related fee information. Because ETFs track indexes, data on their holdings are available at all times, while many mutual funds run by managers who pick stocks are required to disclose their holdings only periodically throughout the year. U.S. diversified stock ETFs, on average, charge 0.40% of assets as an annual expense, while comparable mutual funds charge 1.37%.

While we think concerns about transparent holdings are often overdone,* transparent expenses are more than important; they're legally mandated by the spirit and letter of ERISA itself. But there's more to recent legislative and regulatory changes than transparency. There's also latitude and encouragement for sponsors to take a more paternalistic approach to their plans and participants. Here's Gullapalli again:

One way ETFs may wind up in more 401(k) programs is through the booming category of target-date funds. These funds automatically shift to more-conservative holdings from more-aggressive ones as the investor nears retirement, the "target date" of the fund. The Pension Protection Act of 2006 is helping expand 401(k) default investment options to include such funds. In general, these investments are "funds of funds," meaning they invest in a range of mutual funds -- or ETFs -- rather than individual securities.

Two points here. First, in many 401(k) plans, target-date funds are relatively good options--relative, that is, to the expensive mediocrity available in their other options. But as we've done some industry reconnaissance over the last few months, we've noticed three primary problems with many target-date funds:

• Strange asset weightings, often (in our view) over-allocated to large-cap domestic equities and domestic fixed income
• Too-frequent, calendar-driven rebalancing
• The inclusion of badly under-performing funds with a few better performers, which is almost enough to make one think the fund company couldn't sell its weak funds without packaging them alongside its stronger ones.**

Second, Gullapalli is right to point to the Pension Protection Act as a force for change in the retirement plan business. By elevating "managed accounts" to a privileged legal position, the PPA opened the way for ETF-based solutions that simplify participants' choices, reduce expenses, ensure pension-caliber investment discipline and performance, and satisfy legal and practical requirements for expense transparency and disclosure.

We'll reboot this topic tomorrow morning--and try to tie the entire discussion together--by taking a close look at the other two articles from page R1 of Monday's Journal.

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*There's nothing wrong with transparency of fund holdings, of course, but we think its value pales in comparison to the value of transparent expenses.

**This is a prime example of product-driven sales imperatives running directly counter to ERISA's fiduciary principles.

Source

Diya Gullapalli, "ETFs Seek Room in Your 401(k)," Wall Street Journal, September 10, 2007

Wednesday Reading

A little mid-week food for thought...

• Bloomberg's Wes Goodman and Daniel Kruger ask some tough questions about foreign investors, the dollar, and U.S. Treasuries.
• Reuters columnist Jim Saft puts the risk recession in the scale alongside concern about "moral hazard"...and sees wisdom and prudence pushing the Fed to initiate a rate-cutting cycle.
• At MarketWatch, Mark Hulbert extracts a couple important lessons from the financial-market aftermath of 9/11.
• Reuters' Al Yoon passes along some (unsurprisingly) poor news about the still-cresting wave of mortgage rate resets.
• Calculated Risk collects a few months of sales forecasts from "the comedians" at the National Association of Realtors.
• This won't be the last story we see on revolving credit rising to replace mortgage equity withdrawal as a primary source of household consumption (i.e., debt accumulation).
• More Mark Hulbert, this time with a classic two-by-two table on the market effects of employment news.
• Michael Lewis strikes again.

More on Monetary Policy Implications

After we posted yesterday's think piece on the potential implications of a Fed rate cut, we ran across three related items that help fill out this picture.

First, Herbert Lash of Reuters riffs on the possibility that the FOMC could reprise its August move by taking the discount rate lower and leaving the fed funds rate unchanged. We doubt that, but investors should note that the Fed can see multiple paths branching off from this point of departure.

Second, John Hussman of Hussman Funds makes a (much) stronger version of our Monday argument. Here's a key excerpt:

Ultimately, what's really going on is that we in free market economies are very uncomfortable with the idea that there's nobody in control. As Voltaire said, "If there were no God, it would be necessary to create him." And since we can be pretty sure that God's first priority isn't bailing out the mortgage market, we look to the Fed. When things are going smoothly, we understand that the economy is complex, and diffuse, and driven by millions of individual decisions. But when trouble strikes, we want to believe that there's somebody up at headquarters with their hands firmly on the controls of the entire operation.

Still, just as Pavlov's dog salivated when he rang the bell, investors have been conditioned to believe that the Fed matters. And so it does. But it's important to recognize that this effect is primarily psychological. Unfortunately, the belief that the Fed somehow has our back creates a "moral hazard" by encouraging speculative risk. One might recall that the Fed did not prevent the U.S. stock market from losing more than half its value several years ago, despite fourteen consecutive rate cuts.

What the Fed does next week will certainly have an effect on short-term market psychology. The Fed can also have an impact by maintaining liquidity in the banking system in response to short-term demands for withdrawals. But managing the day-to-day demand fluctuations in a $41 billion pool of funds will not cure the much deeper solvency issues in the trillion dollar mortgage and commercial paper markets. To believe otherwise is plain and dangerous superstition.

Readers may also be interested in Hussman's inversion of the classic Friedmanite claim about inflation as a monetary phenomenon. Here's Hussman:

Monetary policy, at bottom, is not independent of fiscal policy. While reckless fiscal policy invariably ends in attempts to "monetize" the government's debt by printing money instead of issuing bonds, inflation is ultimately always and everywhere a fiscal phenomenon. Money and bonds are essentially portfolio substitutes, and interest rates fluctuate in order to ensure that the existing quantities of both assets are held in equilibrium.

Third, PIMCO's Paul McCulley wrestles with the aftermath of the Kansas City Fed's Jackson Hole symposium, in particular the question of what the Fed should do now. The entire piece is a must-read, a concise one-stop analysis of the last several weeks in the credit markets, with emphasis on the linkages between and among the Fed, the banks, "the shadow banking system" (i.e., "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures"), and the Main Street economy. Here's one passage that struck us as especially insightful (emphasis added):

And right now, particularly under new Fed Chairman Bernanke, policy makers want to disabuse the markets of any notion of a free Fed Put for the foolish levered risk taker. As both a theoretical and practical matter, it is hard to argue with that proposition. In capitalist financial markets, discipline and prudence require that investors fear--yes, fear--that they can lose; and lose big time. Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation. The question is not whether the Fed Put exists, but where is its strike price?

Where indeed.

Sources

Herbert Lash, "Fed may cut discount rate, not fed funds rate," Reuters, September 10, 2007

John P. Hussman, "Waiting for the Witch Doctor," Hussman Funds Weekly Market Comment, September 10, 2007

Paul McCulley, "Teton Reflections," PIMCO Global Central Bank Focus, August/September, 2007

If the Fed Acts, Will it Matter?

With Fed policy makers meeting next Tuesday, market participants have been preoccupied with two obvious questions: Will the FOMC cut the fed funds rate? If so, by how much? We can certainly imagine other outcomes, but we think the probabilities tilt toward yes and 25 basis points.

But there's another question lurking out there that deserves a little more attention: If the Fed moves, what difference will it make?

At a key point of departure like this, it pays to be as systematic as possible about the implications of a potential policy change. To that end, let's think about how the Fed might affect a few key ingredients in our current stew.

• Financial market psychology. It's tempting to expect market sentiment and risk appetites to improve in response to a rate cut. Here, we think the probabilities favor some sort of short-term (potentially very short-term) bounce in the aftermath of a policy change. But with expectations of a rate cut more or less fully formed at this point, one has to wonder how much warm and fuzzy feeling is already baked into asset prices. We wouldn't push this line too hard, though. After all, asset prices held up well over several months when fed funds futures projected relatively high probabilities of rate cuts--only to be confounded by a status quo FOMC. Statement-parsing has been a popular sport during the Fed's steady-state phase; it'll surely be important this time, too, but now the policy move itself takes center stage. Another sentiment-related factor to consider: If the Fed were to move by 50 basis points, would investors interpret that as a sign of a panicky, "behind-the-curve" Fed? Or would the presumed effects of the monetary easing itself trump those more abstract concerns? Our best guess is that the answer would come in two stages: Immediate euphoria followed by a creeping sense of macroeconomic and financial-market weakness.

• The U.S. dollar. The greenback is on a serious losing streak (see 10-year chart at right) and, to put it mildly, a Fed rate cut is unlikely to reverse that trend. Apart from the implications for Treasury rates (potentially heading higher if global investors dump Uncle Sam's debt), a weakening dollar will not help on the inflation front. If crude oil, which is priced in U.S. dollars, heads significantly higher--or even bounces around in the 70s--the Fed's inflation-fighting job will only get tougher.

• Residential real estate. This, of course, is a very big deal. Together with all its economic and financial  accompaniments, housing has led us to this difficult juncture, so the effects of Fed policy on residential real estate will be broadly consequential.* Here we don't see much benefit from a rate cut. The problem in housing isn't high interest rates. It's the combination of tighter lending standards (i.e., the availability of credit more than its cost) and falling asset values. Some marginal buyers (weak credits) have been removed from the market by the former, and the latter creates incentives for other marginal buyers (stronger credits) to wait out the slow-and-sure markdown of the housing stock. In addition, many adjustable-rate mortgages are pegged to LIBOR, which has remained stubbornly higher than the U.S. fed funds rate. With elevated inventories and fewer buyers in the housing market, a Fed policy change will have little near-term effect in this important sector.

• Corporate investment. Beyond broad measures of business confidence, the concrete realities of the commercial paper market could well impair corporate spending and investment in the coming weeks and months. To the extent that the die has already been cast for trouble in this important corner of the financial markets (cast, that is, by the poisonous combination of weak collateral and excessive leverage), it's difficult to see Fed policy making much of a short-term dent here. But a rate cut might boost business confidence enough to overcome some of the trouble in short-term financing. And of course short-term financing needs vary widely from sector to sector and firm to firm. Those with relatively small borrowing needs will continue to weather the storm more successfully.

• Consumer spending. Here's another big one. Calling for U.S. consumer retrenchment has long been a losing bet. But we think we're at a turning point here, with the present mix of flat-to-falling property values, unease in the financial markets, and employment-related anxiety pushing households into balance-sheet repair mode. Whether this amounts to outright declines or just anemic growth is impossible to say, but we think the trend in consumer spending is not likely to be higher.

Economists have long noted a disconnect between incoming data, Fed decision-making, and monetary policy. The typical sequence is: (1) Incoming (and, by definition, almost entirely "backward-looking") data prompt reconsideration of the status quo; (2) Fed officials consider making a policy change; (3) after seeing "confirming" data of some sort, officials do make a change; and (4) that new policy takes meaningful effect several months later. Thus the widespread sense that the Fed responds too late to bubbles and busts alike.

But whatever the lag may turn out to be in this case, our sense is that a rate cut will have very limited effects on our macroeconomic and financial market problems. Of course an extended series of cuts would be more consequential, but that would/will take several more months to take full effect. The picture here isn't all bleak, but there's a characteristic of paying the piper that even the wisest, most timely FOMC can't eliminate from the business cycle.

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*One might also say that with its expansionist monetary policy and lax oversight of lending practices, the Fed itself got housing to this difficult juncture. And one would be right to do so.

Monday Reading

We live in interesting times, no? Here's some reading to kick off the new week...

• Three weeks ago we posted on accounting standards and earnings quality. Fortune's Peter Eavis revives that important subject in this excellent piece. 
• An important juncture: Banks and companies will be looking to refinance $140 billion in commercial paper by the end of next week.
• Caroline Baum makes in important point: Given the very low signal-to-noise ratio in monthly nonfarm payroll numbers, the impact of Friday's -4,000 print is all about market (and "real economy") psychology.
• For many weeks (even months), risk-seeking investors took the market higher on good news (e.g., quarterly earnings surprises) and bad news (e.g., obvious and deepening weakness in residential real estate) alike. Now, with risk appetites diminished, Intel makes a clearly bullish announcement and...the NASDAQ is off almost 15 points mid-morning. The point: Sentiment-driven risk appetites move markets.
• Interesting timing: With the Fed meeting on September 18th, Goldman, Morgan, Lehman, and Bear report Q3 earnings from the 18th to the 20th.
• Herb Greenberg notes Paul Kasriel's concern about households spending more than they earn. Here's a direct link to a July report from Kasriel on the extent and effect of household borrowing and asset sales in propping up consumption.