The Float

BrightScope Responds to the ICI

BrightScope's Ryan Alfred has posted the latest entry in the ongoing debate between leaders of the transparency movement (where BrightScope is at the head of the class) and the mutual fund industry's Investment Company Institute. For what it's worth, we've contributed our thoughts here, here, and here.

You should read Ryan's post in its entirety, but we think this is the most important thing he wrote:

The more we listen to both sides on this issue the more we realize that any single number used to describe 401k fees, be it asset-weighted, plan-weighted or participant-weighted is not all that useful in trying to help participants and plan sponsors understand what fees they are paying within their plan.

Exactly right. Though we'll always have a little uncertainty about plans' hidden expenses, it's perfectly straightforward to develop a general sense of which investment vehicles are likely to have higher and lower implicit costs. And it's even more straightforward to understand and disclose the full list of explicit costs facing a plan and its participants.

If we can get individual plans right, in the sense of both transparency and modest expenses, the average/aggregate numbers will take care of themselves. Those aggregate numbers are important, but only to the extent that they reflect the actual experiences of actual participants. And there's still so much variance across plans and participants that there's no substitute for calculating, disclosing, and, where necessary, reducing expenses at the level of individual plans.

Fun With Headlines

A telling pair, from this week's issue of Investment News:

• "Absolute-return trend inspires both optimism and caution"
• "Investors abandon 130/30 strategies"

Given the track record of the fund industry's faddish product roll-outs, we'd counsel more caution than optimism on those absolute-return funds (as we did a while back in this space).

Real Returns on Residential Real Estate

As we've noted in this space (here and here, for example), with a few local/short-term exceptions, residential real estate has been a pretty lousy investment.

So we were pleased to see Brett Arends weigh in on this question in this morning's Wall Street Journal. An excerpt:

Conventional wisdom long held that home ownership was a route to wealth, and the imputed rent -- in other words, the right to live in your home -- was just part of the value you got from it. Under that widespread view, the recent housing bust was simply a temporary, though deep, pothole.

Yet for very many people, even over the past 15 or 20 years, the imputed rent may have been all, or nearly all, the real value they actually got from their home.

Indeed. And as Arends notes, the bust ain't over. Consider the key elements of this morning's report on sales of existing homes:

• Sales rose 2.9% from March, but declined 3.5% from April, 2008. 
• Median prices fell 15% from a year ago, but readers should handle these numbers with care. See this item from Calculated Risk for more on the math of medians and means. 
• Fully 45% of sales were distressed properties.
• Foreclosure filings rose to a new record, 32% higher than a year ago.
• Supply picked up, with inventories rising to 10.2 months from 9.6 in March.
• Inventories of homes priced at or above $750,000 have reached a 40-month supply.

So...no. Across a full market cycle and in most places, residential real estate hasn't been a very good investment. When prices are rising, the magic of leverage makes it seem like the best investment around. But as millions of "homeowners" and "investors" have learned, the flip side of leverage is pretty ugly, especially in a relatively illiquid asset class like real estate.

None of this means buying residential real estate is unwise. It just means that the benefits--a place to live, forced saving through an amortizing mortgage, the potential for at least some real appreciation--should be kept in proper perspective.

Sources

Brett Arends, "Is Your Home a Good Investment?" Wall Street Journal, May 27, 2009

Bob Willis, "Home Resales Rise on Drop in Prices," Bloomberg, May 27, 2009

Our Response to ICI's Response to BrightScope's Response to ICI's 401(k) Survey

Over the last two weeks, we've participated (marginally) in a discussion of the Investment Company Institute's recent survey of costs borne by 401(k) plans and participants. Elements of that discussion--including our initial post on the topic--have focused not just on the findings of the survey, but on ICI's descriptions thereof.

Writing at BrightScope's blog, Ryan Alfred advanced the debate by examining the ICI survey's sample. That sample leaned heavily on large plans, which tend to be less expensive than small plans, though there's enormous variance even among the biggest ones.

Yesterday, the ICI posted a comment on Ryan's response at BrightScope's blog and a longer response at its own website. We're pleased to see this discussion continue. It's important. And judging by the progress we've already made, it should help sponsors, participants, service providers, policy-makers, and reporters better understand the 401(k) marketplace.

Here are a few thoughts on the ICI's response to BrightScope...

Sampling. Here's ICI on this key factor:

The survey used a sampling technique known as nonproportional quotas. Knowing that the universe of 401(k) plans includes more than 450,000 plans, and that smaller plans are harder to find, the survey was specifically targeted across the spectrum of asset sizes and stayed in the field until specific quotas for plans of different sizes were filled. This survey design ensures that all segments of the population are included and resulted in the extensive, comprehensive data presented.

This is a perfectly reasonable approach. As we noted in our initial item on this topic, the biggest problem isn't with the sample per se; it's with the ICI's description of the report's findings. About those adjectives: We'll grant ICI "extensive," but we won't quite go for "comprehensive," and we certainly wouldn't grant them the most important descriptor (which they don't use)...representative.

What ICI Has Said About the Survey. ICI notes that in his description of the report's findings, ICI Chairman John Murphy said this (emphasis added in bold by ICI):

"The median all-in fee for these plans was 72 basis points. Less than three-quarters of 1 percent--quite a bargain compared to the 3 percent that some critics cite."

In fact, however, ICI's estimate isn't an "all-in" fee, at least if you consider "fee" and "expense" practical synonyms in this context. By excluding trading costs (more on that in a moment), ICI compares its incomplete picture of what participants pay with others' claims about plans' and participants' true and total costs. In addition, for all the reasons we cited back on May 8^th, ICI's "0.72%" excludes more than just implicit fund expenses. Bottom line: We need to get everyone on the same page, talking about the same elements of plan expenses in the same terms.

What Do 401(k) Participants Pay? The most important point made in ICI's response is that while most plans are small, most people participate in large plans. Weighting aggregate, system-wide estimates of expenses by assets or participants is fine. But it can't obscure the fact that, as an anonymous ICI employee posted at BrightScope's blog, "small and tiny plans" need help. And it shouldn't obscure the fact that a lot of non-small, non-tiny plans need help too.

Trading Costs. In a short summary of its response to BrightScope, posted at BrightScope's blog, ICI calls trading costs "a complicated issue." Indeed. But it's not so complicated that we can't get serious about understanding it and--just as important--including it in all discussions of plans' and participants' true and total costs. Here's what we know:

• Trading costs are, as ICI rightly points out, unavoidable.They can also be very substantial indeed.
  
• All else equal, they tend to be higher for funds in relatively illiquid asset classes (due to larger bid-ask spreads).
• All else equal, they tend to be higher for funds with more assets under management (due to larger market impact).
• All else equal, they tend to be higher for high-turnover funds (due to trading commissions and the fact that high turnover raises spread and impact costs).

To the extent that plan participants and fiduciaries care about implicit costs, as they should, they can compare investment options on the basis of asset class liquidity, fund size, and turnover. The point here isn't that big, high-turnover funds in less-liquid asset classes are always and everywhere bad choices. It's that sponsors and participants, guided by fiduciary service providers, should understand the nature and impact of these costs, and, armed with that knowledge, make prudent decisions about their investment options.

Big Ideas. The ongoing debate about expenses is important. The sooner we can establish a shared framework for comparing plans' and participants' true and total costs, the sooner we can agree on a new regulatory framework and industry standards to match. But we shouldn't let this talk about expenses and transparency distract us from the fundamental objective: to give participants and their beneficiaries a better shot at a decent retirement. Simply put, it's all about outcomes.

We care about expenses because, all else equal, lower expenses will produce better outcomes. We care about transparency because we think more and better information will help sponsors and participants correct the informational asymmetry that continues to plague the 401(k) marketplace. And we care about the 401(k) marketplace because it has profound implications for participants' economic outcomes.

So let's get disclosure right. Let's eliminate unnecessary expenses and shrink the rest. Let's replace the industry's selling machine with a thoroughly fiduciary model. Let's do all those things. But let's also remember that for the vast majority of participants, long-term outcomes are more a function of their investment programs--their original formulation, their ongoing maintenance, their periodic changes--than of the costs they pay to participate in these plans.

As we've noted in this space, a true fiduciary plan features low expenses and good decision-making. Unfortunately, the current model--in which participants (even those in the least expensive plans) are presented with a menu (which is often incomplete) of mutual funds (which are often mediocre) and left to fend for themselves--tends to produce all sorts of dysfunctional behavior and sub-optimal outcomes.*

So above all, let's organize the entire defined-contribution model around the inherently fiduciary concept of improving participants' long-term outcomes. That means modest expenses, full transparency, and easy access to superb, portfolio-centered (as opposed to fund-driven) investment programs.

~~~~~~~~~~~~~~~~
* See this post from late 2007, "Real Participants, Real Problems," for our take on The Uncertain 1/n Hedger, The Shameless Performance-Chaser, and other categories of participants behaving badly.

Economic Stress

For a tour of the current economic landscape, we recommend this interactive map from the Associated Press (via Barry Ritholtz). Click on the map to go to the interactive version...

Fun With Headlines

From the hope springs eternal file, a few headlines in today's "Before the Bell" missive from Reuters:

• "Oil firms above $60 on U.S. refinery fires, Nigeria"
• "Japan GDP sinks at record pace"
• "Deere quarterly net falls 38 percent"
• "Toll Brothers' homebuilding revenue dives 51 percent"
• "Hewlett-Packard outlook disappoints"

and...

• "Stock futures point to higher open on economic optimism"

Toles on the Second Derivative

Catching up with the irrepressible, irreplaceable Tom Toles...

May 7^th

May 11^th

Dueling Realities

We're disinclined to attribute single-day trends in the capital markets to anything in particular, but it does appear that today's reports out of India and Lowe's have boosted traders' enthusiasm.

Here's a bit from the Lowe's announcement, quoting CEO Robert Niblock (emphasis added in bold):

"The economic pressures on consumers remain intense, and bigger ticket projects continue to be postponed as wary home improvement consumers watch the economic climate and housing market dynamics very closely," Niblock added. "But, as spring arrived, we saw relative strength in smaller, outdoor projects."

Niblock clearly understands the "intense" pressures on consumers, but traders might want to contrast middling concepts like "relative strength in smaller, outdoor projects" with this CNBC report on rising credit card defaults: "Credit Card Defaults Reach Record Highs in April." Here's a summary via Calculated Risk:

	April	March
Citigroup	10.21%	9.66%
Wells Fargo	10.03%	9.68%
JPMorgan Chase	8.07%	7.13%
Discover Financial Services	8.26%	7.39%

Hard to muster a lot of "second-derivative" enthusiasm off of numbers like these.

BrightScope Gets It

Last Friday, we posted an item on the Investment Company Institute's latest efforts to obscure the true costs of qualified retirement plans. We think we touched on a few important points, and that post generated quite a lot of traffic around here for a few days. But the more important contribution to this discussion--more important by far--is Ryan Alfred's latest post at BrightScope's blog. This is required reading, and it's required this very second.

If you're still reading this--and if you are we have to ask why, because you should be reading Ryan's explanation of what's wrong with the research on which ICI has hung its organizational hat--we'd like to note that when we called the ICI's survey "unserious" last week, we didn't expect that term to be among the more charitable adjectives applicable to this particular research product. (Or, more precisely, to ICI's presentation of the research, as they describe it as something it clearly isn't.)

Here's Ryan:

Due to the inadequacy of the sample in the two areas deemed most critical in driving fees by ICI/Deloitte--asset size and participant size--it is safe to say that the survey systematically underestimates median fees for the DC marketplace.

As it turns out, the ICI study oversamples the biggest plans (and thus wildly undersamples small ones) several times over. Because small plans tend to incur higher costs, this grossly unrepresentative sample can't help but understate mean and median plan costs (while excluding implicit costs entirely, which is another big problem).

Here are the key data from Ryan's post:

That pretty much says it all, doesn't it? Taken together, micro and small plans, which comprise fully 96% of the plan universe, are only 20% of the ICI survey. Mega plans, meanwhile, one of every thousand plans in the population, are one of every five in the ICI sample.

Memo to plan sponsors, reporters, and policy-makers: Don't believe the hype. Dig a little deeper. And, as always, follow the money.

Ben Inker: "When Diversification Failed"

After citing his work on Monday, we spent some time reading Ben Inker's recent white paper on diversification, portfolio design, and asset class valuation. This is very good stuff, a timely reminder that valuation determines medium- and long-term investment returns--and that diversification across risky asset classes won't do much to limit losses when most or all of those risky asset classes had become similarly overvalued. (We riffed on this topic back in January.)

There's much more in this paper than we can cite here, so please register at GMO.com and read the whole thing. But here's a very telling paragraph (emphasis added in bold):

Before getting into the lessons to be learned from the recent past, we should recognize that once the world was in the situation it was in by the summer of 2007, there was no way that portfolio construction techniques could have reduced the size of the overall losses. In 2007, the world saw the most profound bubble in risk assets ever seen, and it is the bursting of this bubble that has led to the enormous loss of wealth we have experienced to date. While we can try to second guess the government policy decisions that have brought us to where we are today, the truth is that most of the money lost in the last 18 months has simply come from overvalued asset classes reverting to the mean. A single institution could have avoided the fall by selling out of all of their risk assets, but if every institution had tried, they would have simply succeeded in hastening the collapse. The world in general is long risk assets. An individual investor selling out or even going short risk only serves to redistribute the losses; he does not reduce them. The only way to have avoided the aggregate pain would have been to have avoided the bubble in the first place, which would have involved changing the way portfolios were invested in the period between 2000 and 2006.

Here and elsewhere, the key variable is the price one pays to acquire a financial asset. In 2007, risky assets were all expensive. And the rest is recent history.

There's more, in particular the ways in which diversification across (and, implicitly, within) asset classes plays out over varying time horizons.

If you crave sentences such as "The period from 2003-07 was probably the Golden Age of the covariance view of risk for institutional investors," this is the paper for you. Speaking for ourselves, we do, and it is.

Source

Ben Inker, "When Diversification Failed," Grantham Mayo Van Otterloo & Co., December, 2008 (registration required)