The Float

Hussman on Cicularity

John Hussman's most recent weekly comment contains the following insights, with which we happen to agree wholeheartedly:

In recent weeks, the dominant view of investors and analysts has shifted clearly to the expectation that the U.S. economy is in recovery. Appearing to seal the deal for some analysts was the third consecutive increase in the index of leading economic indicators. For that index, interest rate spreads and the S&P 500 Index have been the strongest contributors in recent months, as 10-year yields have shot higher from near 2% at the beginning of the year to about 4% before retreating a bit, and stocks have similarly rebounded from deeply oversold levels. Unfortunately, as I've noted before, there is little information content in mean reversion following extreme moves, and that's what the LEI is picking up here–-to a much greater extent than has typically been the case at the end of recessions. Put another way, the case for an economic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in jobless claims or other measures to a level that is on par with prior recoveries).

...

Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking the presumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning.

Assets, Liabilities, and Retirement Plan Management

In a recent issue of InvestmentNews, Fiduciary360 president Blaine Aiken opens his "Fiduciary Corner" column with this:

An investment fiduciary's duty of loyalty demands that the investor's best interests guide the decision-making process.

Moreover, close attention must be paid to the consequences of decisions, and corrective action must be taken if those decisions are not serving the investor's interests. Sometimes limited fine-tuning is all that is needed; at other times, no amount of tinkering seems to achieve the desired results, and a complete reassessment of the approach is required.

It appears to me that participant direction of retirement plan assets fits in the latter category.

Aiken goes on to note that even the (overrated, virtually unattainable) rules of section 404(c) "did relatively little to prevent participants from making poor investment selections." As longtime readers know, we too see problems with the conventional model of participant direction (see this and this, for example).

"Because a participant holds a separate account, rather than an interest in a commingled aggregate portfolio," Aiken writes, "the costs of participant-directed plans can be higher than they are for sponsor-directed portfolios." No doubt. But as we'll explain in a moment, the big picture turns on the fact that participants hold separate accounts at the individual level.

Aiken suggests that it might be "time to ask whether the whole concept of participant direction is a losing proposition for investors." That's a timely, important question. Here's Aiken's exploratory answer:

Centrally administered portfolios, like those of foundations, endowments and defined benefit plans, are less complicated. Investment fiduciaries have direct control of the process and are accountable from design to execution. The investment committee or chief investment officer, usually with the support of professional advisers and money managers, makes asset allocation decisions, directs the investments, and can change the portfolio composition as needed.

Plan sponsors and their advisers should consider whether a fundamental change in their approach for 401(k) and other defined contribution plans from participant direction to investment committee or trustee direction of the assets would better serve the best interests of the investors they work for.

Again, all of that sounds perfectly reasonable to us, but for one fact: Centrally administered portfolios would create a disconnect between plan assets (which would be managed at the system level) and participant liabilities (which would remain at the individual level).

Generally, the economic needs (i.e., risk and return objectives) of defined-benefit pension funds are relatively easy to specify, such that central decision-makers can manage assets at the system level (and participants and their beneficiaries can plan the liability side of the ledger with relative certainty as to the future payments they'll receive). The economic needs of individual account-holders, on the other hand, vary widely and unpredictably, such that central control of plan investments could/would create a disconnect between group-level assets and individual-level liabilities.

Put differently, as long as accounts balances remain individually-specified (which, after all, is pretty much the definition of defined-contribution plans), most 401(k) participants will need help with their investment decisions, but they also need the opportunity to tailor their investment programs to their idiosyncratic circumstances.

In our view, the appropriate middle ground looks like this: Participants confront a dramatically simplified choice of five or six globally diversified, risk-adjusted, pension-style portfolios (rather than a long menu of mutual funds written in Wall Street language that might as well be Sanskrit). To work outside those boundaries, they must secure the consent of their primary beneficiary (or beneficiaries), as ERISA requires fiduciaries to protect the interests of beneficiaries as well as participants.

The objectives here are (a) to make the process easy and (b) to reduce the likelihood of big mistakes. Done prudently, it can also produce meaningful reductions in plan expenses. We think this type of program solves most of the problems associated with the traditional model of participant direction while leaving room for participants, beneficiaries, and their advisors to connect assets and liabilities.

There's more individual-level risk in this type of program than in traditional pensions, but the defined-contribution regime is here to stay. The question now is how to make such plans work as well as they can.

Source

Blaine F. Aiken, "It's Time to Rethink Retirement Plans," InvestmentNews, July 12, 2009

WSJ on Index Funds in 401(k) Plans

Over the weekend, Eleanor Laise published an enormously important Wall Street Journal story on the (slowly but noticeably growing) presence of index funds in 401(k) plans. As longtime readers know, this subject resonates in a big way here at Interlake. Here's the crux of the story:

Employers are making it easier for workers in 401(k)s to own low-cost index funds and exchange-traded funds, a move that has implications for the mutual-fund industry.

As it stands, roughly 90% of the $1.5 trillion in 401(k) and other defined-contribution assets in mutual funds are in actively managed offerings. This is the case despite clear evidence from studies that index funds tend to outperform their actively managed rivals.

The stodgy 401(k) world won't change strategies overnight. Fund companies won't easily relinquish their active-management fees, which tend to be higher than those charged on index-tracking products, especially at a time when rocky markets are pinching profits. And actively managed funds tend to do more "revenue sharing," which involves fund companies making payments to plan administrators.

While total index mutual-fund assets jumped 84% over the past six years, the funds grew at a substantially slower pace inside defined-contribution plans.

Our view is that 401(k) services are more sold than bought, and that the sellers have long had self-interested reasons to obscure plans' true costs, stuff investment menus full of sub-optimal (often but not always proprietary) funds, and engage in various forms of "move along...nothing to see here."

It is long past time for service providers, sponsors, and participants to insist on fiduciary principles and practices. In most conventional asset classes, excellent index-based mutual funds (and/or ETFs and collective funds) are readily available. Because such funds don't engage in "revenue-sharing" (a euphemism for concealing and often inflating the costs of administrative services), their use will require greater transparency. But then that's exactly the point, isn't it?

And speaking of transparency, it's great to see our friends at BrightScope get some excellent press in the Laise piece. These guys aren't at the leading edge of the transparency movement. They are the leading edge.

Full disclosure: Interlake is proud to be the investment advisor to two of the plans mentioned in this article.

Source

Eleanor Laise, "More Index Funds Sought for 401(k)s," Wall Street Journal, July 18, 2009

ERISA Litigation

We ran across an interesting report in InvestmentNews on a lawsuit against the service providers--investment advisor, recordkeeper, and custodian--to a $2 million 401(k) plan in Kansas. To this point, of course, most 401(k) litigation has focused on the biggest plans. Here's IN's Mark Bruno:

A group of fewer than 30 employees at a small company in Kansas has filed a lawsuit against the investment adviser, record keeper and custodian for its $2 million 401(k) plan, alleging that the trio of plan providers caused participants to pay "secret" and "excessive" fees.

The claim itself is a familiar one, of course, as more than a dozen Fortune 500 companies that boast billions in their 401(k) plans have been hit with similar suits in the past four years.

However, experts said, this latest suit represents the first time that participants have taken aim at such a small plan--and an investment adviser.

They also suggested that this could just be the beginning of a potential wave of litigation in the small-plan market, one that could put a bull's-eye on investment advisers and service providers that typically supply most of these plans.

In the age of LaRue v. DeWolff, sponsors and service providers need to get serious about their fiduciary duties to plans of all sizes and shapes.

Source

Mark Bruno, "Employees name investment adviser in 401(k) suit," InvestmentNews, July 19, 2009

"Failure of a Fail-Safe Strategy"

Given the meltdown in so many asset classes over the last two years (remember: it was in the Summer of 2007 that the music first stopped without enough chairs), it has become somewhat fashionable to question the benefits of diversification across asset classes.

We've weighed in on this issue here and here, arguing that diversifying across relatively risky asset classes shouldn't be--and never should have been--seen as a means of reducing risk amid crisis conditions.

On Friday, Tom Lauricella filed another entry in the not-so-sure-about-this-asset-allocation-thing genre. As he so often does, Lauricella handles the material well, noting that correlations among risky asset classes had been rising before the recent meltdown. But the most important point about the last 24 months is that cash-equivalents and treasuries held up remarkably well, providing capital preservation and even some appreciation for investors who held them while risky assets cratered.

Lauricella's story opens with a Raymond James broker saying, AA-style, that he's "a recovering asset-allocationist." Near the end of his piece, Lauricella tells us about this broker's new style: more cash, and more flexible mandates for the active managers he hires for clients. We think this makes pretty good sense. As we've argued repeatedly in this space, asset allocation should be inexpensive and index-based; active management should be nimble and relatively unconstrained. In other words, they should be different, and purchased/pursued under different frameworks (not in the big, expensive mash-up of market- and manager-driven returns offered by most mutual funds).

Lauricella closes with this telling sequence about his example broker:

He says he is convinced there is a way to make diversification work. In fact, after the strains of last year, he says, many investments are behaving more like they did before 2008.

Asset allocation, he says, "might well have been injured....But I don't think it's gone forever."

No doubt. Properly understood and executed, asset allocation remains a perfectly intelligent strategy. To paraphrase Churchill's quip about democracy, asset allocation might be the worst thing out there...except all the others that have been tried.

One more note: Be sure to look at the WSJ's interactive graphic on asset-class correlations over the last 15 years. Good stuff.

Source

Tom Lauricella, "Failure of a Fail-Safe Strategy Sends Investors Scrambling," Wall Street Journal, July 10, 2009

More on Delegation for Plan Sponsors

Exactly a month ago, we posted our third item on Scott Simon's remarkably important (and almost certainly under-appreciated) series on the process of delegating decision-making authority for ERISA plans to independent fiduciaries.

Last Thursday, Scott posted his fourth column on that topic. As usual, it's must-read material for anyone who cares about these things, a list of readers that should include plan sponsors, participants, service providers, and policy-makers. Here's a highlight:

If many of the fiduciary sponsors of qualified retirement plans that have the responsibility to provide participants with prudent 401(k) plans have little motivation or knowledge to do so, then the non-fiduciary plan providers that dominate the retirement plan industry have none. Why should such providers want to educate sponsors about anything that will cost them profits and expose them to the added risks of assuming real fiduciary responsibility?

The law of ERISA is clear that professional fiduciaries fully conversant with the ins and outs of ERISA laws and procedures ideally should run qualified retirement plans including 401(k) plans. And yet many, many (non-fiduciary) service providers in the retirement plan industry force (fiduciary) plan sponsors into an imprudent business model featuring 401(k) plans with investment options bearing high (and hidden) costs and woefully inadequate diversification of risk. No wonder very few plan sponsors have ever heard of the kind of significant risk mitigation discussed in this series that's always been open to them under ERISA.

We couldn't put it more clearly ourselves. Now go read the whole thing.

Source

W. Scott Simon, "Delegation for Plan Sponsors (Part 4)," Morningstar.com, July 2, 2009

From the Contrarian Files

From time to time a headline strikes us as an especially fraught suggestion that the investing herd is buying or selling en masse, often quite late in whatever the latest game might be. In Monday's Wall Street Journal, Shefali Anand came up with a classic of the genre: "A Taste for Risk--Again." Here's how the story opens:

It's amazing the difference a rally can make in investors' appetite for risk.

A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They're back to buying relatively safe investments like high-quality corporate bonds. But they're also pouring money into the riskiest investments. They're lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds--making these among the 10 best-selling mutual-fund categories this year.

Unfortunately, the story doesn't deliver enough compelling data to get our contrarian hackles all the way up, but it's one of those things that gives us pause.

And here's another ingredient in our current caution. In the chart below, you'll see how the 20-day moving average of the S&P 500 (the red line) provided support on two key occasions during the rally off the market's March lows (especially on April 20^th/21^st and throughout mid-May). Then on June 15^th the S&P closed right on the 20-day, broke below it on the 16^th, and bumped its head on it at the start of July. In addition, the 20-day has rolled over.

In the relatively short term, we don't make much of moving average crossovers, but we've certainly noticed that the 20-day is now moving lower for the first time since the middle of March.

None of this is to say that the rally can't or won't re-ignite. But the Summer's burden of proof may have shifted from the bears back to the bulls.

Source

Shefali Anand, "A Taste for Risk--Again," Wall Street Journal, July 6, 2009

David Rosenberg Delivers

Yesterday we took the risky step of turning our dial to CNBC. To our immediate delight, we were greeted by the visage of one David Rosenberg, formerly the Chief North American Economist at Merrill Lynch, now the Big Thinker at Gluskin Sheff in his native Canada.

We'd transcribe some of Rosenberg's discussion with the Squawk Box crew, but as Barry Ritholtz noted yesterday, his entire appearance was such a command performance that there's simply no substitute for watching it from beginning to end. Our only quibble is that it ended so soon.

For a super smart, perfectly balanced, historically aware, clearly articulated take on where we've been, where we are, and where we're headed, behold these clips:

Opening Segment (10:32)

Middle Segment (9:51)

Closing Segment (1:00)

The Slipperiness of "Macroprudential Regulation"

Back on April 1st, we produced an excerpt from Simon Johnson's excellent Atlantic essay "The Quiet Coup." We called our post "Line of the Year," with reference to Johnson's statement that "anything too big to fail is too big to exist."

Yesterday, at The Baseline Scenario, Johnson extended that line of thinking by wondering out loud whether the Fed--or any other "macroprudential regulator"--can "sniff" bubbles before they threaten the financial system.

"Asset bubbles may not be that hard to identify," [New York Fed President William C.] Dudley argues. Fine, but it would help to know exactly the Fed would do this ex ante-–not using the rear view mirror.

Of course, if the Fed can't get better at spotting bubbles, the implication is that no one can. Which means that "macroprudential regulator" is just a slogan-–a nice piece of what Lenin liked to call "agitprop."

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are-–or are perceived to be–-too big to fail"?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

We think Johnson's exactly right, not just in sensible-capitalist principle, but in practical terms as well. Government has a fighting chance to get antitrust-style stuff right. But identifying bubbles? And doing something about them at the right moments...neither too soon nor too late? We just don't see it.

More Good Stuff from BrightScope

Way back at the start of this wild year, we celebrated the launch of BrightScope, a leading light in the movement for greater (indeed, the greatest possible) transparency in the retirement plan market. We titled that first item "A Great Leap Forward." Today, we're pleased to note another step in the right direction: BrightScope's consolidation and presentation of data from Form 5500 for a huge number of plans--somewhere, we think, in the neighborhood of 500,000.

Here's an example: 5500 data from Boeing.

Now, those 5500s have their shortcomings. They're dated by the time they go public, their categories are funky, and they're only as complete as sponsors make them...so their completeness varies widely.

But for what they're worth, these data are now more clearly presented and more easily available to participants, sponsors, and service providers than they've ever been. Well done, BrightScope.