April 2007 Archives

On Sunday, I cleaned my office and I came upon an interview with Robert Wilson by Brett Fromson of the Street.com. (It's several years old.) Robert Wilson is one of the great investors of the past half century. A hedge fund pioneer, he took $15,000 of his own money in 1949 and parlayed it into a $226 million fortune when he retired in 1986. He did by investing, not raking in fees. He was a billionaire at the time of the interview.

But here's the fascinating part. When he "retired" he divided his money among roughly 20 aggressive top-flight money managers. He ended up firing 14 over the years, but kept roughly the same number overall. But here's a calculation by Wilson:

Up until the beginning of 1999, I would say that if I'd put half of my money, in fact, I actually did a rough calculation of this, if I'd put half of my money in an index fund -- the S&P, the Vanguard fund -- and half of my money in two-year Treasury bills, I would have done almost as well as these managers did. The problem is, Brett, in any year, some manager was sort of losing touch and had to be replaced, another manager, who was doing fabulously, had a bad year, and things average out. I found it very frustrating, I was in fact, running a fund of funds and when I say very frustrating, that's overstating it. I didn't do anything about it and ...

He could have done almost as well with equity index funds and T-bills, with a lot less work and frustration.

What is his advice for you and me? Here goes:

I'd say as a general rule put it in index funds, there are even growth stock index funds now. I don't see why small investors should horse around with money managers.

They cost. They're more expensive than index funds, and there's no evidence that they do as well over a period of time.

Indexing is terrific for the individual investor.

While working my way through various stories this morning, I came on this piece written by Steve Hamm of Business Week. It's on his blog.

Steve has also written a book I highly recommend, Bangalore Tiger (McGraw-Hill, 2006). Anyway, I couldn't agree with Steve more on Lou Dobbs and his ilk. Here's what he wrote:

It's true. I admit it. I harbor ill will towards Lou Dobbs, the bloviating CNN anchor. Every time I see him promoting himself as the hero of the American middle class, I practically choke. While he may have some sincere concern for Americans who suffer the negative effects of globalization, he operates by exploiting hate and fear. In my book, that makes him dangerous--not just to the Latin Americans and Indians and other foreigners that he demonizes, but to the middle class Americans whom he claims to care about.

Besides, it seems to me the American middle class is pretty well off. It's the working class and poor who have plenty to complain about. We'd all be better off if the Congress would forget about the phony crisis of immigration and concentrate on doing things that improve the health, education, and job opportunities for America's less fortunate masses. That would be a worthy cause for Dobbs to get behind, too.

Amen to that.

Some more thoughts on long term care insurance.

The Center for Retirement Research at Boston College has a piece on Medicaid and long term care. It's by Howard Gleckman, a visiting fellow at the Center. I've known Howard for years as a senior correspondent at Business Week's Washington D.C. Bureau. It's well worth reading.

I want to highlight one section of his report, on long-term care insurance:

One way to reduce the taxpayer burden of long-term care is to shift costs to individuals by encouraging them to purchase private long-term care insurance. In 2006, Congress expanded the Partnership Act, which allows seniors who purchase long-term care insurance to increase the amount of the assets they may protect while still becoming eligible for Medicaid. For example, if an individual purchases a $300,000 long-term care policy, he could retain assets up to $300,000. Under the new provisions, 22 states plan to begin such programs in 2007. However, in the four states that have operated a Partnership program for many years, results have been disappointing. In part, the low demand for long-term care policies is a result of their cost. A high-end policy for a 62-year-old couple can cost between $7,600 and $11,500 per year.

That's a lot of money, and cost matters.

A few years ago, the Kaiser Family Foundation tried to calculate whether long term care insurance was a practical financial product for middle class families. Here's the study

The study's first pass on the data suggested that three out of four married couples (with the head of household between ages 35 and 59) could theoretically afford LTCI. Premiums are much more affordable when younger. Yet on a closer look, only one in five is well covered in other key areas, like saving for retirement, life insurance, health insurance, and disability insurance. Those other investments should take precedence.

As for older people, premiums are so steep that it's much harder to afford comprehensive coverage. The more affordable pared down products don't offer meaningful estate protection, according to the report. The Foundation calls for a greater emphasis on lower cost policies geared toward keeping people in their home as long as possible.

In the 1980s and 1990s, the world economy was dominated by the G-7 (the major industrial nations), and large capitalization stocks flourished. Think the Standard & Poor's 500.

However, small capitalization stocks have won the performance sweepstakes this decade. Think the Russell 2000.

James W. Paulson, chief investment officer at Wells Capital Management, wonders if this change in stock market leadership reflects more than simply a cyclical swing in investor sentiment. In his latest newsletter Paulson notes that large capitalization, brandname multinational corporations dominate the G-7 markets. But in the G-25, a much bigger list of dynamic countries that includes among others China, India, Malaysia Mexico, and Indonesia smaller companies in cyclical, industrial, or natural resources businesses are more commonplace and critical.

Perhaps the shift to small caps is a structural change reflecting a remarkable transformation in emerging market economies in recent years.

From the Alliance for Investor Education. There's a new website that offers investors easy-to-use information on where to check out financial professionals, how to report investment fraud, and help for dealing with other major problems, such as broker bankruptcies and 401(k) claims. It's at www.helpforinvestors.org. Check it out.

The Sunday Express, a British tabloid, reported the other day that a group of Middle east investors and U.S. private equity firms had combined forces to take Dow Chemical private. The price tag for the LBO? $50 billion.

Dow says it isn't interested. And it appears there isn't an offer on the table.

But here's the thing: No one really blinked at a $50 billion deal. That's double the $25 billion RJR/Nabisco LBO engineered by Kohlberg, Kravis, & Roberts in 1988. It tops the proposed $29 billion takeover credit card processor First Data--also by KKR.

Private equity firms like KKR have so much money that a $100 billion LBO isn't out of the question.

But are guargantuan LBOs economically and financially viable. I don't know. Wall Street always swings to excess, and there's a whiff of mania in the air: Too much money and not enough sense.

Index funds are boring, right? Not quite. The index fund world is in turmoil.

The reason is a new generation of customized indexes. They're based on dividends, earnings, book value, and other so-called "fundamental factors." The new indexes are mostly sold as Exchange Traded Funds or ETFs.

These so-called "fundamental" indexes are challenging the primacy of traditional benchmarks like the Standard & Poor's 500-stock index and the Russell 2000. Here's an article I wrote for Business Week on the subject.

Briefly, the details in this fight are over index construction. Traditional indexes like the S&P are "capitalization-weighted." That means the heft of each stock in the index is relative to the market value of its shares. In practice, the most highly valued companies--such as IBM--wield a disproportionate influence on the market performance of traditional indexes. The criticism is that traditional indexes can can become lopsided. For instance, during the height of the dot-com era, technology stocks accounted for more than 30% of the index, about double its historic average. That turned out to be a serious drag on returns when the bubble burst.

The capitalization-indifferent fundamentalist approach is less susceptible to such market mood swings and comes closer to ranking companies on their importance in today's economy. But there are drawbacks. The most important is that fees tend to be higher, and fees matter a lot when it comes to long-term performance. The new indexes are also hybrid funds, tinged with an element of active management or perhaps, more accurately, active strategists. And it is true that the good performance of some fundamental index funds reflects that they were in the right market sectors over the past several years. But market enthusisam waxes and wanes.

Now, if you think I am kidding that this is a fight, Wall Street style, here's John Bogle, the octogenarian founder of Vanguard. Bogle is a pioneer in bringing traditional indexing to individual investors. As you'll see, he's no fan of the new indexes. This excerpt comes from his new book, "The Little Book of Common Sense Investing":

The new members of this breed are not shy about their prescience. They claim variously, if a tad grandiosely, that they represent a "new wave" in indexing, a "revolution" that will offer investors better returns and lower voaltuility, and a "new paradigm." Indeed, they describe themselves as the new Copernicans, aftre the man who concluded that the center of the solar system was not the earth, but the sun. They compare the traditional market-cap weighted indexers with ancient astronomers who attempted to perpetuate the Ptolemaic virew of an earth-centered universe..... I recommend skepticism.

Here's my takeaway: I still tend to lean toward the traditional indexes. I don't think the "revolutionaries" have made their case yet. Still, I'm largely I'm agnostic on the debate. The reason: No matter what the individual investor comes out ahead.

Look, most investors own a mix of traditional index funds and actively managed mutual funds. Yet expenses on the fundamental indexes are less than half that of the average actively managed mutual fund. So, if fundamental indexes catch on, it could be at the expense of managed mutual funds, not traditional indexers.

I don't think the U.S. Court of Appeals decision striking down on March 30th the "Merrill Lynch rule" has gotten enough attention. It looks like the individual investor is the winner here.

The key term is "fiduciary duty." Briefly, the Investment Advisors Act of 1940, passed in the wake of the market scandals of the 1930s, said that an advisor had a fiduciary duty to disclose any conflicts of interest, must act in the exclusive interest of the client, and if a client believes they have been wronged, the client can sue. But the SEC had given certain broker-dealers exemption from the fiduciary requirement.

The Financial Planning Association and a number of other groups sued, arguing that the exemption gave brokers the ability to offer advisory services without adhering to fiduciary standards.

Here's Judge Rogers from the three panel ruling:

"A fundamental purpose, common to these statutes, was to substitute a
philosophy of full disclosure for the philosophy of caveat emptor, and
thus achieve a high standard of business ethics in the securities
industry... The IAA arose from a consensus between the industry and the
SEC that investment advisers could not completely perform their basic
function--furnishing to clients on a personal basis competent, unbiased
and continuous advice regarding the sound management of their
investments--unless all conflicts of interest between the investment
counsel and the client were removed."

Bottom line: The consumer should be better informed, get better information--and should have the ability to sue if an advisor doesn't live up to fiduciary standards. Not bad.

We all know money in politics is disturbing. And about the safest forecast I can make is this: The candidates for the White House will raise record sums for the 2008 election.

But I was going through some research papers I had put aside yars ago, and came on one by political scientist Stephen Ansolabehre of MIT, management professor of John de Figueirdo of MIT, and James M. Synder, Jr. of MIT They ask: "Why Is There So Little Money in U.S. Politics?"

It's intriguing. Yes, candidates, parties, and organizations spent a record $2 billion in the 2000 Presidential contest. (I'm taking the numbers from the paper.) Yet total government spending in 2000 was $2 trillion. And the Presidency is the most powerful job in the world. Breaking down the numbers, the value of affecting government policy is high. For instance, in agriculture, dairy producers gave $1.3 million and got price supports worth almost $1 billion in the 2002 Farm Bill. That is an incredible return on investment. You can come up with comparable figures in many industries.

Yet individuals and firms give far more to charity than politics. For instance, 15 large corporations in 1998 gave $1.6 billion to charity and only $16 million to political campaigns.

So, to put a different twist on the normal question: What accounts for the lack of money in politics? The scholars run through a number of theories, but they favor a "consumption" model. "Campaign contributing is a form of consumption, or, in the language of politics, participation," say the authors. It's like giving to charity, or public radio. And the single strongest predictor of contributing is income growth--and we are a much wealthier nation.

Or maybe it's easier to buy a vote than we think?

There still seems to be an expectation that apartment rent prices will rise this year, but I don't buy it. The supply of housing is simply too big, and there are too many speculative investors out out there with precarious finances. Many homeowners that stretched to buy another home hoping to flip it are now going to have to put it out for rent to limit their losses. This time around, I expect severe price weakness in the housing and condo markets will drive apartment rents lower.

In the 1980s, companies started retreating from offering their workers traditional "defined benefit" pension plans in favor of "defined contribution" plans, such as 401(k)s and 403(b)s. In essence, with the traditional defined benefit pension plan the employer bears all the investment risk and commits to a fixed payout of money, typically based on a salary and years-of-service formula. In sharp contrast, with the 401(k) and similar tax-deferred retirement savings schemes, workers take greater responsibility for their retirement plans and funding arrangements. Employee's decide how much money to invest and where to invest it, depending on the limits established by law and the choices offered by the employer. Employees bear all the investment risk. The trend away from traditional pensions in the prviate sector gathered momemtum in recent years.

For workers, there are a lot of advantages to traditional pensions. They don't have to make investment decisions today that will impact their standard of living in three decades. After all, most of us aren't steeped in modern portfolio theory. And they can better plan for their Golden Years knowing that they'll have a fixed pension payout. But from the company's point of view there were a lot of drawbacks to traditional pensions--especially their cost. Just ask the chief executive officer of General Motors

This article from the Center for Retirement Research suggests a different path toward restructuring pensions:

In response to the perfect storm of falling stock returns and interest rates that hit pension funds in 2000, many companies in the United States and the United Kingdom have shifted from defined benefit (DB) to defined contribution (DC) schemes. In contrast, Dutch pension plans have mainly preserved their defined benefit character in recent years, although they have switched from "final-pay" to "average-wage" schemes. The average-wage plans may be better viewed as hybrid DB-DC schemes. They are like DB plans in that accrued pension rights are based on an employee's wages and years of service, and contribution rates can be raised in response to a funding shortfall. They are like DC plans in that the annual indexation factor, which is applied to both the accrued rights of active workers and the benefits of retired workers, is tied to the fund's financial status and, therefore, investment returns. As a result, these hybrid plans have two mechanisms - contribution rates and indexation - to control solvency risk, effectively minimizing the risk of under-funding.

John Bogle is the legendary founder of Vanguard, the giant mutual fund company. He's an industry pioneer, and within the mutual fund business considered a certified curmudgeon. He's also one of the best friends the individual investor has had in recent decades. The reason is that Bogle opened up index investing to the individual investor with the Standard & Poor's 500 equity index fund in 1976.

He's out with a new book, The Little Book of Common Sense Investing. I've been reading it, and it's good. The first sentence is a gem: "Successful investing is all about common sense." He convincingly explains what he means by financial commonsense over the next 214 pages. Buy it. Read it. Bogle is good for your financial health.

We've been getting more and more questions about reverse mortgages.

A quick reveiw: With a reverse mortgage you get a loan against the value of your home. The maximum amount you can get comes from a combination of your age, the Treasury bond rate, and the value of the home.

The lender can pay you in a lump sum, a regular monthly check, or line of credit (or some combination of these choices). You're spending down the equity in your home to boost your income. The loan gets paid back when you sell the home, permanently move out, or die. To get a reverse mortgage, you need to own your home, and be at least 62 years of age. The AARP offers basic information on reverse mortgages, as well as a reverse mortgage calculator.

Reverse mortgages are a smart idea for an aging population with high rates of homeownership. But it's a complicated product and fees are high. Here's an example: Take a $200,000 home between 1975 and 2005. Assume that the same reverse mortgage product was available throughout that period of time. The amounts a 65 year old could have borrowed on a $200,000 home during that period ranged from 4.8% of the home's value in 1981 to 51.3% in 2002. One trade-off seems to bother a lot of parents: In most cases, a reverse mortgage means the kids won't inherit the home.

The good news is that the business is getting more competitive, it's growing, and fees are coming down. It's still a tough product to grasp, but I'm seeing much more focus on education and standardization.

The Federal Reserve Bank of Boston has an analysis of how to think about including a reverse mortgage into an overall portfolio.(I took the $200,000 home example between 1975 and 2005 from their paper). It isn't an easy paper to get through.

Still, the authors note that the most popular option when it comes to taking the money in a reverse mortgage is the line of credit. But they argue that under most assumptions the optimal strategy is to take a reverse mortgage in the form of a lifetime income at age 65. In essence, a reverse mortgage acts like a very safe annuity for the homeowner.

Christian Baha is hawking a fund of hedge-like funds for the people called Superfund. The Austrian-based Superfund offers 20 funds, two of them sold in the U.S. These are the kind of hedge-fund imitating investments that can be toxic to your wealth.

At least that the definite impression I got after reading a well-reported story about Baha and Superfund on Bloomberg. Baha "invites people with as little as $5,000 to put their money into investments that take hedge fund-like risks," writes Bloomberg reporter Kambiz Foroohar. Save your money.

The fees are outrageous. Superfund charges a 1.85% annual management fee; 1% each year for the cost of creating and distributing the fund; and 0.15% for operating expenses; 4% annual sales commission on an investment for the first 2 1/2 years; $25 brokerage fee per trade; and Superfund can take 25% of profit after expenses in any month when the fund reaches a new high. According to the prospectus filed with the SEC, the Series A fund has to earn a 6.75% annual return befiore investors see any gain; for the Series B fund the comparable figure is a whoping 8.63%.

The reporter compares the performance of the Series A fund to Vanguard's S&P 500 equity index since October 2002 (when the first Superfund started trading in the U.S.).The Vanguard fund's total fees add up to 0.34% of assets. The S&P fund returned 73% versus 23% for Series A fund.

I expect a lot more marketing of hedge-fund like investments to individual investors. Hold on to your wallet.

I was in New York on business last Friday. I ended up eating dinner at the Modern, the new restaurant at the Musem of Modern Art. I'm always in search of good restaurants to eat at when I'm by myself, and I'd recommend dinner at the bar if you're traveling alone to New York. The restaurant is lively, the service friendly, and the food terrific. Plus, you're given enough room at the bar to sit and eat comfortably. Now, the tab is steep, but at least the food and wine is worth the price.

Remember when the 9% drop in China's stock market toward the end of February rippled throughout the global economy? Well, it turns out that was nothing but a blip. China's stock market has reached a new record close. The Shanghai stock exchange is up 280% since bottoming out an an eight year low in mid-2005. It's up 45% year-to-date.

To cool off the speculative fever, China's central bank tightened monetary policy for the seventh time this year. But so far, the central bank hasn't been able to dampen "irrational exuberance" among investors. "However, the Chinese market is certainly crusing for a bruising," writes economist Ed Yardeni in his latest newsletter.

The Chinese stock market is a bubble. To be sure, bubbles aren't all bad and investor enthusiasm has helped fund the country's remarkable economic rise. Still, China's stock market maniacs seem increasingly out of touch. This bubble is primed to burst. Markets don't go up forever, certainly not when the central bank has decided enough is enough

Of course, I don't know the timing. But I bet China is the epicenter of the next global financial market crisis.