The Float

Brett Arends' 12 Rules

Back on May 1^st, the WSJ's Brett Arends spun out "12 Rules for Investing in the Next Bull Market," most of which are insightful and helpful. We generally like Arends' work and this piece is no exception. Though we're quibblers by nature, this is pretty strong stuff and it deserves your consideration. Here are a few of Arends' rules followed by our comments:

2. Avoid big moves.
If you buy or sell heavily in one shot you're taking a needless risk. And waiting for the right moment to make your move is futile. You probably won't catch the bottom or the peak anyway. If a market trend has much further to run, then what's the rush? And if it doesn't...what's the rush?

No quibbles here. This is exactly right. 

6. Be truly diversified.
That means investing across a spread of different asset classes and strategies. As investors discovered last year, "large cap value" and "mid cap blend" funds don't offer diversification. They're just marketing gimmicks.

Though it's true that correlations rose sharply among risky asset classes during the last 20 months, we aren't willing to concede this point. There are ways to slice the market too narrowly, but historically there have been--and, we think, will be again--material differences in the risk/return profiles of various classes of equities. Tilting strategic portfolios in one direction or another by weighting assets classes isn't just a marketing gimmick. Or, to be more precise, it isn't necessarily, or always a marketing gimmick.

10. Be patient.
Investment opportunities are like buses. If you missed one, you don't have to chase it. Relax. If history is any guide, others will be along shortly.

Yes.

11. Don't sit on the sidelines completely until it's too late.
You'll probably end up splurging at the last moment. If you are afraid to invest, do it early, little, and often.

Yes.

12. And above all: Price matters.
After all, an investment is just a claim check on future cash flows, whether it be a company's profits, a bond's coupons or an annuity's income stream. By definition, shares in a solvent company are twice as good at half the price...and vice versa. It's amazing how many people get suckered into thinking it's the other way around.

And yes.

But then there's this morning's Arends column, in which he taps some recent research suggesting that near-term economic prospects have almost nothing to do with stocks' long-term returns, which in turn makes the notion of "price" a little less concrete that most investors--and certainly less concrete than most fundamental analysts--would like to believe. Here's an excerpt:

The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

(The second reason is that short-term deviations from long-term trends in economic growth are typically resolved back toward those long-term trends within a few years.)

"This sort of analysis is a useful antidote to stock market moods," writes Arends. Maybe. But the other way of looking at Inker's research is that all we really have in the short run is "stock market moods." Which means you either trade on the technicals (with some attention to short-term expectations of the fundamentals, as in a Keynesian beauty contest) or, like Joshua in War Games, refuse to play the short-term trading game in the first place.*

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* It's one of the great lines in movie history: The rogue computer program "Joshua," having realized that "global thermonuclear war" produces no winners, declares that "the only winning move is not to play."

Sources

Brett Arends, "12 Rules for Investing in the Next Bull Market," Wall Street Journal, May 1, 2009

Brett Arends, "How to Value Stocks? Ignore Economic News," Wall Street Journal, May 11, 2009

Ben Inker, "Valuing Equities in an Economic Crisis," Grantham Mayo Van Otterloo & Co., April 6, 2009 (registration required)

The Cynicism of the ICI

In the investment biz, it's a tale of two meetings this week.

In Scottsdale, they're attending the annual Fiduciary360 confab, where fiduciary principles and practices form the programmatic core of the three-day event. Across the country, in Washington, D.C., we have the general meeting of the Investment Company Institute, the mutual fund industry's trade association.

Though the fi360 event is unlikely to make much news, the ICI meeting has made a few headlines already. Here's one that jumped off the screen at us: "401k fee critics overstate problem, ICI chairman says." From InvestmentNews (emphasis added in bold):

While supporting improved retirement plan fee disclosure, the head of the Investment Company Institute said yesterday that congressional criticism of 401(k) plan fees has been inflated by critics.

"What they don't mention is the long list of services that 401(k) plans provide," including investment management and record keeping as well as legal services, audits, websites, call centers and participant education, John Murphy, chairman of the Investment Company Institute, said in a speech to about 800 mutual fund executives at the group's general meeting in Washington.

Legislation introduced by House Education and Labor Committee Chairman George Miller, D-Calif., would require more disclosures of 401(k) fees.

In response to charges that plan fees are too high, Mr. Murphy cited a recent ICI-sponsored survey which showed that total fees for the plans were 0.72% of assets, "quite a bargain compared to the 3% that some critics cite."

He also said that "disclosure is not just about fees," adding that reports should include information on risks, performance and investment objectives. Disclosures, however, must be useful, and they should not overwhelm sponsors and participants "with data that they don't need," Mr. Murphy said.

Where to begin?

First, it's the very height of cynicism to list all the services "401(k) plans provide" in one breath, then cite a number (0.72%, which is the dubious number ICI claims is the average explicit expense--the expense ratio itself--of funds held in 401(k) plans) that not only excludes many of those services, but doesn't even reflect the true cost of mutual fund ownership.

As we've noted time and time again (here and here, for instance), mutual funds' implicit costs are difficult to pin down with absolute precision, and they don't show up in any prospectus (though trading commissions are reported in the Statement of Additional Information, always well-read by rank-and-file investors and their advisors, of course!), but they come out of investors' returns all the same.

We've heard that ICI personnel, when confronted by Capitol Hill over the incompleteness of "0.72%" (a number so thoroughly dubious as to deserve quotation marks every time it's cited, and we're happy to start that practice right here), respond by saying that they can't account for the services delivered and fees charged by professionals outside their own realm. True enough! But that means ICI can't cite a "long list of services 401(k) plans provide" that includes many services mutual fund companies don't provide. That seems pretty straightforward to us.

Second, that "average" cost of "0.72%" is misleading insofar as it's pulled lower by plans with truly rock-bottom investment expenses, and those plans are out there. Unfortunately, tens of millions of participants--and, by extension, their beneficiaries--are saddled with substantially higher explicit expenses, to say nothing of the fact that implicit costs tend to scale up in rough proportion to explicit costs.* So while the relative few might enjoy investment expenses of 20 or 30 basis points, the vast majority face true costs well in excess of "0.72%."

Third, "0.72%" doesn't include any annuity-related charges, which, alas, affect a shockingly large number of participants, many of whom are blissfully unaware of this particular problem.

Finally, while it's certainly possible to bury participants and sponsors under excessive information, the simple, obvious fact is that it's beyond easy to summarize and convey information on expenses and other plan characteristics to participants. The only question that matters is: Do you want to?

401(k) and other defined-contribution plans imply certain costs. But there's a blindingly clear divide between those meeting in Scottsdale this week, who want to reduce and disclose the true and total expenses investors incur, and those meeting in Washington, who commission unserious surveys, then spin the heck out of the place, in an effort to conceal the unpleasant realities of a defined-contribution system that's salvageable, and worth salvaging, but in need of bright light and serious reform.

The system is a lot like Steve Austin in the opening sequence of The Six Million Dollar Man. It's in pretty bad shape, but we have the technology. We can rebuild it. And rebuild it we must, with or without the ICI.**

UPDATE: Readers visiting from 401khelpcenter.com, please see this follow-up item, which draws on BrightScope's analysis of the ICI's claims.

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* This is true to the extent that the factors associated with high explicit costs, high-turnover funds in relatively illiquid asset classes, tend to correlate with high implicit costs, precisely because of turnover and relative illiquidity.

** A couple caveats: (1) Our problem here is with the ICI, not with all mutual fund companies, let alone everyone who works in the mutual fund business and (2) we use mutual funds in our 401(k) practice--inexpensive, index-based funds in every available asset class, but open-end funds nonetheless--so, again, our objections apply to ICI's political tactics, not all mutual funds.

Source

Sara Hansard, "401k fee critics overstate problem, ICI chairman says," Investment News, May 7, 2009

Fiduciary Delegation

Yesterday, we railed against the vacuous marketing concept of "co-fiduciary" services in the retirement plan world. Today, we ran across Scott Simon's latest "Fiduciary Focus" column from Morningstar. As usual, Scott has it exactly right. Here are three key paragraphs (emphasis added in bold):

Plan sponsors that choose to delegate their responsibilities and liabilities to a professional named fiduciary can, in effect, get out of the retirement plan business and be free to concentrate fully on their business so they can stay in business during these troubled times instead of worrying about fiduciary risks they are neither prepared nor trained to manage.

...

I have discussed in a number of these columns over the years how plan sponsors can, in accordance with the provisions of ERISA section 3(38), delegate their duties to select, monitor and (if necessary) replace a plan's investment options to a bank, registered investment advisor or insurance company. The off-loading of such fiduciary duties from the shoulders of plan sponsor executives and their transfer onto the shoulders of such entities is significant and provides immense value to such executives.

Yet this kind of delegation is rarely undertaken because the non-fiduciary business model followed by so much of America's retirement plan industry doesn't provide for plan sponsors to become informed about it. If plan sponsors were informed fully about the option of making such a valuable delegation, then the vast number of those participating in the industry--not fiduciaries in any way, shape, or form--might have to change their business model and actually become fiduciaries.

We won't be holding our breath.(By the way, here's a direct link to the first entry in this series on fiduciary delegation.)

Scott gives us plenty to look forward to in his next entry in this series, with this closing tease:

In next month's column, I'll lay out in certain detail how it's possible--based on allowances in ERISA--to insulate plan executives from virtually all day-to-day fiduciary investment and operational/administrative risk to which they would otherwise be subject for running a qualified retirement plan. I'll also answer the question raised by a plan sponsor at a conference that I attended last week--a question tinged with doubt that such insulation is achievable--"Why haven't I ever heard of this before?"

Good question. With a blindingly obvious answer.

Source

W. Scott Simon, "Delegation for Plan Sponsors (Part 2)," Morningstar Advisor, May 7, 2009

The Relative Meaninglessness of "Co-Fiduciary" Status

A while back, deep enough in the history of this blog to keep us from looking for the actual post(s), we suggested that product-pushing players who offered some sort of "co-fiduciary" services to retirement plans were trafficking in marketing slogans, not sound legal (i.e., ERISA) concepts.

So we were pleased to see this treatment of the "co-fiduciary" concept from attorneys James Baker and David Abbey (via the always-excellent 401khelpcenter.com). Here's a highlight (emphasis added in bold):

Well aware of the increasing but healthy paranoia felt by plan fiduciaries about their potential exposure to fiduciary breach lawsuits, an increasingly popular practice by consultants and other service providers to retirement plans is marketing their services as "co-fiduciary" in nature. They do so because co-fiduciary liability is much more limited than fiduciary liability. Some plan fiduciaries are under the impression that by assuming co-fiduciary status under ERISA, the service provider is actually assuming, or at the very least sharing, fiduciary responsibility for the particular activities being performed. These plan sponsors believe that by hiring a provider to assist it in selecting, monitoring, advising, or otherwise providing expertise on plan investments, they will either be relieved of those fiduciary obligations or that their responsibility for complying with such obligations will be reduced by the provider's purported acceptance of shared responsibility. Given the sophistication of such marketing programs, it is understandable why plan sponsors are led to such a conclusion. They are likely to be disappointed, however, if they engage a provider thinking that the provider's acknowledgment of "co-fiduciary" status has somehow reduced the plan sponsor's fiduciary obligations to the plan.

This takes us back to the great divide in the financial services industry between those who embrace their implicit and explicit fiduciary duties and those who resist them, then proceed to market their way around their own evasions.

This problem affects not only what gets sold to whom, but sponsors' assumptions about their ongoing fiduciary responsibilities. Here's another area in which more transparency, more bright light, would be very helpful indeed.

If you're into this sort of thing, we recommend the entire (relatively short) article.

Source

James P. Baker and David M. Abbey, "A Fiduciary By Any Other Name...Thoughts on Properly Delegating Fiduciary Duties," Benefits Law Journal 22(1), Spring, 2009

A Tom Toles Stress Test

More great stuff from Mr. Toles...

Extrapolating Atlanta

A couple weeks ago, the Journal ran a story on commercial real estate development in Atlanta. The first two paragraphs tell the story:

A one-mile stretch of Atlanta's upscale Buckhead neighborhood shows why commercial real estate is emerging as an obstacle to pulling the U.S. economy out of recession.

Separate developers in Buckhead are building four speculative office buildings at the same time with virtually no leasing activity. The 35 recent condominium projects will help give Atlanta a 40-year supply at the current sales pace.

40 years! Of course the hope (and reasonable expectation) is that the "current sales pace" isn't the future/permanent sales pace. At market bottoms (or depths, anyway, since the bottom might not be in in some of these markets), linear extrapolation might not make much sense. But it sure can create some eye-popping numbers.

Source

Alex Frangos, "In Atlanta, Irrational Building Exuberance," Wall Street Journal, April 22, 2009