The Float

From the Contrarian Files

We still can't feel as sanguine about our near- and medium-term economic prospects as traders (and the few remaining investors) appear to these days, but there's a powerful logic to "don't fight the tape"--let alone the Fed. Whatever the market's near-term prospects, when one takes a longer, multi-year view, this strikes us as a probabilistically attractive time to acquire equities.*

Two items caught our attention along these lines: Rob Arnott's much-discussed Index Universe piece on the relative performance of stocks and bonds in recent years. (We mentioned Arnott's research earlier this month.) As we argued in March, true bottoms tend to be marked by mass indifference, even revulsion toward stocks. In turn, one would expect that indifference to manifest itself in grinding, low-volume trading. But intelligent, sensible efforts like Arnott's can flash revulsion as well, not of the rash, emotional sort, but a kind of mean-reverting phenomenon in which the data Arnott cites, backward-looking by definition, are unlikely to repeat themselves. Take a look at Brett Arends' excellent coverage of this issue in Tuesday's Wall Street Journal:

"Starting any time we choose from 1979 through 2008," Mr Arnott writes, "the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." He argues the figures are even true going back to the late 1960s.

Mr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head.

But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute.

Should you follow suit? Not so fast.

Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.

The second item that leaped off the screen at us was yesterday's Journal story on financial advisers forsaking traditional buy-and-hold strategies rooted in asset allocation and Modern Portfolio Theory. We manage money in two styles, one traditional and strategic, the other (mildly) alternative and tactical. But we've been doing that since before the crisis, and when we see media coverage of rank-and-file advisors (and, implicitly, their clients) throwing up their hands in disgust at the supposed failure of traditional methods of portfolio construction, we can't help but think that this is a great time to have (or acquire) an inexpensive, diversified portfolio of global asset classes. To return, in other words, to the methods many people (professionals included!) can no longer abide. That's our kind of revulsion.

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* Which, as always, implies no particular guesses about the short-term direction of the market.

Sources

Rob Arnott, "Bonds: Why Bother?" Index Universe, April 27, 2009

Brett Arends, "Bonds' 30-year Hot Streak Begins to Cool," Wall Street Journal, April 28, 2009

Anne Tergesen and Jane J. Kim, "Advisers Ditch 'Buy and Hold' for New Tactics," Wall Street Journal, April 29, 2009

Fiduciary Loyalty

From time to time we refer to "fiduciary service providers," implicitly contrasting such providers with their non-fiduciary counterparts and competitors. As we see it, fiduciary status isn't just a legal distinction; it's a set of core principles, a worldview that guides individuals and firms in the marketing and delivery of financial services.

In a recent issue of InvestmentNews, Fiduciary360 CEO Blaine Aikin noted that "Fiduciaries owe a duty of loyalty to the beneficiaries they serve. But frequently, they find their commitment to the principle of self-sacrifice tested by conflicts of interest." To advance his argument, Aikin cited recent GAO research on conflicts of interest in traditional pensions and 401(k)-style retirement plans. Here's a summary of GAO's findings:

[O]ur econometric analysis using ongoing defined benefit (DB) plans and Securities and Exchange Commission (SEC) study data on pension consultants registered as investment advisers, who adequately disclosed their conflicts of interest and those who did not, detected lower annual rates of return for those ongoing plans associated with consultants that had failed to disclose significant conflicts of interest. These lower rates generally ranged from a statistically significant 1.2 to 1.3 percentage points over the 2000 to 2004 period.

Though GAO's analysts crunched numbers on defined-benefit plans, their findings apply to the defined-contribution (DC) world as well:

[B]ecause the risk of investment is largely borne by the individual participant in DC plans, participants are vulnerable to any decision, including those involving conflicts of interest, that could result in higher fees or other outcomes that can lower investment returns for participants. Given the multiplicity of parties involved in today's 401(k) plan arena, many opportunities exist for business arrangements to go undisclosed. Problems may occur when pension consultants or other companies providing services to a plan also receive compensation from other service providers. Without disclosing these arrangements, service providers may be steering plan sponsors toward investment products or services that may not be in the best interest of participants.

As Aikin notes, the best option by far is for service providers to avoid conflicts of interest in the first place. If such conflicts exist, he concludes, "anything less than full disclosure is unacceptable." Indeed.

Sources

Blaine F. Aikin, "For Fiduciaries, Loyalty is Everything," InvestmentNews, April 12, 2009

Charles A Jeszeck, "Conflicts of Interest Can Affect Defined Benefit and Defined Contribution Plans," Government Accountability Office, March 24, 2009

Still More on Target-Date Funds

Because we're in the business of providing asset management services to defined-contribution retirement plans, and because we care about the retirement security of our fellow citizens, we take a special interest in discussions of "target-date" mutual funds (see this, for example).

So we were delighted to see Tom Lauricella's semi-recent (and delightfully-titled) riff on target-date funds in The Wall Street Journal. Here's the bulk of Lauricella's short piece, with each excerpt (in blue) followed by our observations (in black):

With many target-date mutual funds inflicting big losses on investors nearing retirement, they've gone from hero to goat.

If history is any guide, these funds are still a better option in the long run than less-volatile alternatives like money-market funds -- a plus for Congress's decision to make it easier for employers to automatically direct employees' retirement money into target-date funds. But their poor performance is leading to scrutiny of how fund companies construct and market these portfolios.

Indeed. In the time-honored tradition of "follow the money," it's all about the construction and marketing of these things. More on these two factors below.

[M]any of the funds aimed at those in or near retirement suffered declines of 25% or more over the past year. Fund companies say the portfolios are designed for life spans that can last 30 years beyond retirement. That's cold comfort for those who need to start spending the money immediately upon retirement and will have less in play later on when, and if, the markets rebound.

As we've noted here before, the true finish line is one's life expectancy, not the day one retires. But the intervening moment of truth is the point at which an investor annuitizes a corpus of assets, turning that accumulated wealth into a stream of income (through an insurance product or a systematic withdrawal program).

Of course, the warnings that these funds may not be appropriate for every investor are spelled out in their prospectuses. But a 401(k) investor automatically placed into a fund by an employer is probably less likely to read a document that even engaged fund buyers rarely read.

Again, quite true. The clear imperative is to give participants (and other investors in these vehicles) plain-English versions of the relevant information, not thick prospectuses and statements of additional information.

Congress, somewhat belatedly, is looking more closely at target-date funds as default investments in retirement plans. One question is whether it should dictate investment-mix parameters -- or at least make it clearer that a 2010 "retirement" fund is actually a 2035 "death" fund.

This is why we favor a "target-risk" approach rather than a target-date model. We think the notion of risk-calibrated portfolios goes to the core of the problem, focusing on what really matters (expected risk and return parameters) rather than the wholly subjective premise of a future year when the difference between the "retirement fund" concept and the "death fund" concept can be very consequential...and totally opaque to most plan participants. If we're going to put rank-and-file participants in charge of their own investments, we simply must give them relevant information as straightforwardly as we can.*  

Some say there are more-fundamental issues to examine. Laws covering retirement plans were intended to ensure they are run in the sole interest of participants. There are prohibitions against "self dealing" by the fiduciaries. Mutual funds, however, are given a pass on these conflict-of-interest rules. That allows fund firms to build target-date portfolios with a tilt toward higher-fee stock funds, rather than low-fee bond funds. Even if that weren't a motive for asset allocation, in a bull market like the one through late 2007, the more stocks, the easier it is to attract clients.

This is really the central problem with proprietary target-date funds. Here, the construction and the marketing of these vehicles can produce some decidedly unhelpful cross-mojonation, contaminating the (legally/presumably) fiduciary function of portfolio assembly with the non-fiduciary imperatives of profit-making. Which is why Lauricella's last paragraph is his most important.

Another possibility is requiring 401(k) target-date funds to use asset-allocation models developed by a company not affiliated with the fund manager, in order to avoid conflicts of interest.

This is clearly the way to go, ensuring, when combined with rules governing advisors' compensation, a high degree of independence on the part of the professionals who assemble these portfolios.

One key, then, is to separate fund companies' profit-making imperatives from the process of portfolio construction. The easiest way to do that is precisely as Lauricella describes, using independent advisory firms to construct portfolios (preferably of the target-risk variety) using the best-available products from all fund companies, not just one.**

The second key is to communicate expected risk and return parameters to participants in simple, accessible terms, enabling them to make easy, informed decisions before returning to what they do best: working, deferring assets into the plan, and enjoying their lives without feeling the need to constantly monitor and tweak their 401(k) portfolios.

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* By "we," we mean plan sponsors and fiduciary service providers.

** For what it's worth, we use 15 funds in our 401(k) portfolios. Ten of those are Vanguard funds. Currently, the other five are Fidelity, T. Rowe Price (2), Alpine, and Pimco products. This list is always subject to change, but we'll only change it if we're convinced that some alternative vehicle would be better for plan participants and their beneficiaries.

Sources

Tom Lauricella, "Let's Set a Target, And Date, for Fixing Target-Date Funds," Wall Street Journal, April 6, 2009

Fred Reish, Bruce Ashton, and Jason Roberts, "Investment Advice for Participants: Prohibited Transactions and Level Fee Advice," Reish Luftman Reicher & Cohen, March, 2009

Buiter on Those Green Shoots

Nearly (truly?) alone at CNBC, David Faber appears willing to entertain the possibility that the recent/ongoing rally in equities is something other than the bright light at the end of the tunnel. A few minutes ago, he interviewed Willem Buiter, whose maverecon blog at FT.com is a must-read.

Here's a Buiter line from the Faber interview that rang true to our probability-minded shop: "While everything is possible, not everything is likely." Indeed.

And here's the item Faber referenced, whose title ("The green shoots are weeds growing through the rubble in the ruins of the global economy") wins the award for Best of 2009 So Far.

Hussman on Blinkered Short-Termism

John Hussman (emphasis added in bold):

Understand that the money that the government is throwing around represents a transfer of wealth from an unwitting public to the bondholders of mismanaged financial corporations, even while foreclosures continue. Even if the Fed buys up the Treasuries being issued, and thereby "monetizes" the debt, that increase in government liabilities will mean a long-term erosion in the purchasing power of people on relatively fixed incomes.

To a large extent, the funds to defend these bondholders will come by allowing U.S. businesses and our future production to be controlled by foreigners. You'll watch the analysts on the financial news channels celebrate the acquisition of U.S. businesses by foreign buyers as if it represents something good. It's frustrating, but we are wasting trillions of dollars that could bring enormous relief of suffering, knowledge, productivity, and innovation in order to defend bondholders of mismanaged financials, and nobody cares because hey, at least the stock market is rallying. If one thing is clear from the last decade, it is that investors have no concern about the ultimate cost of the wreckage as long as they can get a rally going over the short run.

The Real Issues Underlying 401(k) Litigation

We attended a local law firm's annual employee benefits workshop this morning, where the first 90 minutes focused on retirement plans: Reductions in employer contributions, partial terminations, suspensions of RMDs for 2009, rollovers by non-spouse beneficiaries, DOL guidance on investment advice, and prototype 403(b) documents.

In addition to all that, there was one segment that had us listening very closely indeed: a discussion of Hecker v. Deere, the 7th Circuit's February disposition of which got some coverage from Stephen Rosenberg and our friends at BrightScope, among many others.

This morning, the discussion of Hecker got the crowd involved, producing several good questions and sensible observations (as well as a few curious ones), all of which led us to the following conclusions:

One of the fundamental shortcomings of the status quo in the 401(k) marketplace is the "bundled" approach itself, in which most plan expenses (i.e., the vast majority of costs borne by participants) are reflected in mutual fund expense ratios. We see two big problems with this practice.

First, the bundled approach is fundamentally non-transparent. Unfortuantely, wrapping everything up into one number (a number that's subject to change, and often at the most inopportune times) leaves sponsors and participants unable to know what they're paying for which services. Given ERISA's clear requirement that plan fiduciaries understand, monitor, and knowingly approve plan expenses, the bundled approach is a per se departure from ERISA's core principles. If you're a sponsor and the question is: What do your participants pay for recordkeeping services? The answer can't be "nothing" (because that isn't true, unless you're paying RK expenses with company funds, in which case you should know anyway) or "I don't know" (because the law requires you to know). The answer should be "20 basis points annually," or "$40 per person per year," or something concrete. (For most plans, we like the per capita approach, for reasons we'll explain in the next paragraph.) Bundled plans can be relatively expensive or relatively inexpensive. But because they aren't transparently priced, they're more likely to be more expensive for the simple reason that it's easier to roll a bunch of unnecessarily high fees into a number that doesn't itemize separate services and is paid entirely by (usually naive) participants. Transparency and low expenses aren't the same thing, but more of the former would be directly conducive to the latter.

Second, bundled plans don't share economies of scale with participants. If expenses scale up proportionately with assets (as they must when they're paid through the linear mechanism of mutual fund expenses), a $200 million plan will cost exactly 10 times as much as a $20 million plan, and 100 times as much as a $2 million plan. The simple truth, however, is that service providers' "cost of goods sold" doesn't come close to scaling up in such linear fashion. So a $20 million plan shouldn't cost exactly 10 times as much as that $2 million plan. There's no brightline formula for what that multiple should be, but it's perfectly clear--painfully obvious, even--that it should be less than 10.* The point here is that failing to share economies of scale with participants is inconsistent with ERISA's central concept, which states quite clearly that decisions made for the plan should serve the interests of participants and their beneficiaries.

To summarize: The absolute level of plan expenses (including, as always, the hidden costs of mutual fund ownership) should be reasonable, and the lower the better. But regardless of their level, expenses should be transparent, and should be structured in a way that shares economies of scale with the people who've earned them: rank-and-file participants.

No matter what happens with Hecker and its cousins, we need to get these things right: Less expensive, more transparent, easier access to high-quality investment disciplines. The destination is clear, but, alas, the path to get there is cluttered with entrenched interests. For conscientious sponsors, concerned participants, and fiduciary service providers, much work remains.

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* One complicating factor here is the number of participants, where plans with more participants (or, more precisely, lower average account sizes) imply a higher "cost of goods sold" for service providers. But the beauty of the per capita model is that it accommodates this in a perfectly straightforward, economically rational, and legally defensible way.

S&P Findings on Active Management

This isn't surprising, but it's important (emphasis added in bold):

Passively managed funds outperformed actively managed funds across all categories during the past five years according to [research from] Standard & Poor's Index Services, which was released today.

Between 2004 and 2008, the S&P 500 stock index outperformed 71.09% of actively managed large-cap funds, according to the year-end 2008 report from the New York-based research firm.

In addition, the S&P MidCap 400 Index outperformed 75.9% of mid-cap funds and the S&P SmallCap 600 Index outperformed 85.5% of small-cap funds.

"The belief that bear markets strongly favor active management is a myth," Srikant Dash, global head of research and design at Standard & Poor's, said in a statement. "The bear market of 2000 to 2002 showed similar outcomes."

Similar results were also reported for international-equity and fixed-income funds.

Among international-equity funds, the indexes outperformed a majority of actively managed non-U.S. equity funds.

For fixed income, the relative shortfall from the five-year benchmark ranged between 2% and 3% a year for municipal bond funds and 1% to 5% a year for investment grade bond funds, Standard & Poor's reported.

Here's a link to the S&P report itself. Especially impressive is the way S&P corrects for survivorship bias:

The Standard & Poor's Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds' performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry. SPIVA scorecards show both asset-weighted and equal-weighted averages, include survivorship bias correction to account for funds that may have merged or been liquidated during the period under study, and show style consistency for each style group across different time horizons.

As we've written over and over, some active funds do outperform the averages in given periods. (By definition!) The trick is to hire those funds before they win...and fire 'em before they lose. After all, hiring them after they've gone winning streaks raises the near-inevitable problem of mean reversion. And hiring them after they've gone on losing streaks isn't especially smart either, because the data show that under-performance is substantially more persistent than out-performance.

So what's the intelligent investor left to do? Favor passive over active vehicles, and ensure that any active vehicles are different enough from their passive counterparts to have a real shot at delivering positive alpha.

Source

Sue Asci, "S&P passive funds trumped active over past five years," Investment News, April 20, 200

Toles on Wall Street

The guy just keeps the good stuff coming. From last week...

Hussman on Bear-Market Rallies

Here's some good stuff from the always-worth-reading John Hussman:

Bear market rallies from oversold conditions are not predictable, in the sense that a market that has endured a steep selloff can easily continue lower another 10%-15% or more. Still, there has historically been some tendency –- on average –- for the market to rally off of deeply oversold conditions. The problem is that those generally positive averages mask an enormous amount of variation, so the actual return/risk ratio isn't nearly as attractive as one might imagine.

With the warning that the following figures do mask a very large amount of risk and variation, the charts below present the average percentage returns of the S&P 500 in the weeks following points when the index was at least 10%, 15%, 20%, 22%, and 25% below its 50-week smoothing. The 22% category is included because the sample size quickly becomes very small beyond that point. I've included two charts – one including data from 1940 through 2007, and the second including data from 2008. Note that the inclusion of 2008 makes an enormous difference, because the market simply failed to advance despite very deep compression -– a reminder about the risk and variation within these averages.

Oversold bounces: Average cumulative S&P 500 % returns 1940-2007 based on starting % below 50-week smoothing (time scale measured in weeks):

That's some serious mean-reversion.

Read the whole thing. And while you're in Hussman's 'hood, read this from Bill Hester on the significance of trading volume in bull markets and bear rallies.

60 Minutes on Retirement Plans

Last night's episode of 60 Minutes led with a report on problems in the 401(k) world, most notably the fact that many millions of plan participants have seen their account values fall substantially over the last year and a half.

Reporter Steve Kroft and 60 Minutes had a chance to educate viewers on the realities of the 401(k) marketplace. Unfortunately, they settled for the too-easy television trick of (over-)dramatizing on a personal level rather than educating on a systemic level.

Kroft and his guests made a few good points. Among them:

• The vast majority of participants are novice investors. Expecting them to serve as prudent investment managers is entirely nuts.
• Participants who can't roll with short-term risk (financially or emotionally) shouldn't be exposed to it in the first place.
• Many of the setbacks of the last several months aren't 401(k) problems per se. They reflect problems with the financial system and the financial markets. The 401(k) marketplace needs work, but we can't/shouldn't blame it for everything that ails us.

All that said, however, California Congressman George Miller is exactly right when he says that the financial services industry has skimmed untold wealth from rank-and-file participants in defined-contribution plans. We're service providers ourselves, so we're not opposed to reasonable profit-making. But we are opposed to excessive profits derived from services that don't add value...and to super-cynical sales tactics that mislead sponsors and participants about where value can be added...and to anyone who concocts lame objections to maximum transparency on fees and expenses.

David Wray's halting non-answer to Kroft's repeated questions about mutual fund (and other service) providers' opposition to greater transparency was revealing in the extreme. Sometimes a guy just doesn't have any answers. This was one of those times.

We have one more objection, which goes back to our original point about 60 Minutes' failure to educate. That on-screen graphic listing various types of hidden expenses was extremely weak. What they included didn't strike us as particularly accurate, and what they excluded was hugely important. The segment should have spent two minutes or more helping people understand the hidden costs of most plans, and the factors that drive plans' hidden costs higher. Getting this right wouldn't be difficult, but it would require a greater commitment to education, and less time spent on the personal drama television seems to need. Alas.

UPDATE: One other sequence that was entirely on point, featuring Brooks Hamilton:

"The fact is that the typical 401(k) investor is a financial novice. They don't know a stock from a bond. And we give 'em a list of 20 or 30 mutual funds with really, really powerful names, you know, they sound like, 'Gee, that's where I want to have my money,'" Hamilton said.

"What are the, generally, the quality of the mutual funds in 401(k) plans?" Kroft asked.

"Mediocre," Hamilton replied. "I'm being real honest with you, with half the funds on the list really dogs, what people would characterize as dogs shouldn't be on the list to start with."