Thursday, June 29, 2006

Siegel vs Bogle

Jeremy Siegel and John Bogle debate market weighted vs fundamentally weighted index investing in this Wharton piece. Its hard to argue that value and small cap market leadership over the last few years would favor fundamental investing but will it outperform in the future.

Thursday, June 22, 2006

Hedge Fund Side Letters

Another aspect of hedge funds that must be of concern to fiduciary investors is the utilization of “side letters”. Side letters can provide certain beneficial options to select investors which may be to the detriment of other investors. Under securities law, these preferential deals are not illegal provided they are disclosed. It may be more difficult for a fiduciary to substantiate how an investment like this, with materially different terms for a certain class of investors, could be construed to operate solely in the best interests of their participants and beneficiaries.

Wednesday, June 21, 2006

Assessing Investment Manager Skill

BestInvest concludes that "the success of only 11% of 1562 UK asset managers can be attributed to skill". They measure managers outperformance vs. an appropriate risk adjusted index. They then subtract the probability of this result being achieved by chance. Financial Times

The probability of a managers excess return being due to chance or skill can be indicated by its T-statistic. The t statistic is a measure of how extreme a statistical estimate is. You compute this statistic by subtracting the benchmark return from the calculated risk adjusted return and then dividing by the estimated standard error.

There is an indication that the managers results may be the result of luck or random chnace when the t-statistic is close to zero. Alternately, manager skill may be indicated when the t-statistic is large positive. Finally, there may be an indication that the manager has consistently lost value when the t-statistic is large negative.

Monday, June 19, 2006

Fiduciaries own "Soft Dollars"

Benn Steil comments on the pending interpretative release by the SEC on brokerage soft dollar practices in todays WSJ. Of significance to pension plan fiduciaries is the fact that “if the fund manager buys items directly from the suppliers, he pays with his firm's cash. If he buys them through brokers when executing trades, however, the law, or the SEC, lets him use his clients' cash.”

From an ERISA perspective, payments for commissions are Plan assets and must be used to directly benefit plan participants. Steil, in previous testimony to the US Senate estimated that the average institutional broker kicks back $1 for each $1.60 it receives in commissions. This $1 kickback is legal under the Section 28e “safe harbor” of the 34 Act. Section 28e allows an investment adviser to pay “more” than the lowest available commission rate to a broker, and still fulfill his fiduciary duty. The SEC merely requires that advisors subjectively determine if the paying of a higher commission provides better value to its customers. Better value doesn’t always correlate to participant benefit. Steil notes that “client-financed commission payments have become so generous that a broker for one of the nation's largest fund management companies made the headlines in 2003 by thanking the funds' traders with a lavish dwarf-chucking bachelor party”.

Despite the fact that plan fiduciaries may delegate discretionary authority and thus fiduciary status to their money managers, they retain the responsibility to monitor the manager’s use of plan assets. Plan fiduciaries should document and review their providers soft dollar policies and practices.

Saturday, June 17, 2006

Well Said

Referring to Fed Chairman Ben Bernanke; "people are confusing his clarity with their uncertainty". Art Samberg, Barrons
Referring to inflation;" it is not the disease but the cure that investors fear".
Tim Harford, FT
Judge Owen referring to the charges he dismissed against Merrill Lynch for undisclosed revenue sharing for preferred shelf space; "the investors failed to identify misleading statements". Jack Willoughby, Barrons

Friday, June 16, 2006

"We know lawsuits"

Denver, Colo.-based law firm Holland & Hart will consider adding advice to its $180 million 401(k) plan. An official said the firm is waiting for regulators to provide a safe harbor for plans that give its participants advice programs before it starts looking. "It's all about being held liable... Come on, we're a bunch of lawyers, we know about lawsuits," she said.

401(k) Microplans

There are and should be lots of dissatisfied 401(k) plan sponsors and participants in the microplan market. (<$1M assets) Why? Because the economics don’t work without excessive fee generation through either investment revenue sharing arrangements, the margins imbedded in proprietary investment products or high contract cover charges as explained in this article from Institutional Investor. If large Banks and Insurance Companies can get comfortable with the margins …plan investors have little opportunity for investment success.
This is an inefficient market from a buyers perspective, and the sellers have informational advantages that most plans sponsors don’t. The mutual fund companies will increasingly put pressure on the insurance companies Relatively new competitors in this space, virtual or on line providers, are also beginning to have an impact as well. Unfortunately as they succeed, they are taken out by guessed it …Banks and Insurance companies.

Thursday, June 15, 2006

Protect Investors From Themselves

Dalbar confirms that investors do more to harm their portfolios than the best investments could overcome. Investors loose over 3/4 of their potential gains primarily by attempting to avoid losses. The average equity investor earned 3.9% vs 11.9% annually for the S&P500 over the last 20 years according to Dalbar.

Plan fiduciaries have a legal obligation to act in the "best interests" of their participants. In the future, this might be construed as a responsibility to protect participants from themselves. Providing investment alternatives such as diversifed lifstyle funds, either risk or maturity based, could meet this standard.

Fed favors Autoenrollment

Fed Chairman Bernanke identifies non participation in employer retirement plans and over investment in employer stock as symptons of a lack of financial literacy and education. Behavioral based approaches such as autoenrollment and default investment choices are positive though not comprehensive solutions.

Wednesday, June 14, 2006

Auto-Pilot 401(k)

AARP provides a summary of the features and benefits of an Auto-Pilot 401(k) Plan. General concerns employers have with these plans are:

  • Fiduciary risk without legislated safe harbors for multi asset class investments
  • Costs of increased enrollment
  • State anti-garnishment laws

Senate and House Pension reform bills currently include a nondiscrimination safe harbor provision for employers that implement specific automatic enrollment features in their 401(k) plans and would remove the antigarnishment to auto-enrollment by amending ERISA to preempt any state law if it would impede an employer’s ability to offer an automatic enrollment feature.

Tuesday, June 13, 2006

Forecast Investment Returns

It is always valuable to document and evaluate the investment return assumptions used to create the actuarial assumed returns for a defined benefit plan or the investment eranings asumptions used to generate participant financial plans in a 401(K). Mellon has published their 5 year return forecast. Mellon's 5 year forecast expectations are inflation 2.25%, Large cap US equity 8.5%, Small Cap Equity 9%, International Equity 9% & Intermediate bonds 5.45%.

Using these assumptions a 60% equity portfolio with 20% of equity in International and 20% of domestic equity in small cap and 40% Intermediate Bonds would have a forecast return of about 7.4%. The industry mean actuarial assumed return is about 8%....leaving us with .6% gap. Typically actuaries will use a longer term inflation rate of 3%-3.25%, more consistent with the intermediate assumption used in something like Social Security forecasts. This difference in expected inflation is often the primary reason why your actuarial returns may be higher than a calculated returns using 3-5 year forecast numbers like these. Differences in portfolio asset allocation can also impact forecast returns..higher equity/higher returns.

Monday, June 12, 2006

Love Paris in the Springtime?

I am sorry I couldnt get to Paris for the 28th International Congress of the Actuaries. -. On second thought…………

2005 Mutual Fund Expenses

The ICI reports that overall average mutual fund fees decreased in 2005 to 1.13% (.91% net of sales loads) for Equity, .90% (.7% net of sales loads) on Bonds and .41% on Money Market Funds.

Retirement Plan providers frequently mislead retirement plan sponsors and their participants by comparing their fund expenses to Morningstar total fund expense ratios. The Morningstar total fee ratio's include the fee impact of sales loads which are not at all relevant to institutional investors such as retirement plans. This practice grossly distorts the comparison in favor of the providers yet it is common practice. At a minimum, Plan fiduciaries should insist their providers compare Plan fund expenses to Morningstar No Load averages.

401(k) Improvements

John Wasik points out some interesting statistics and ideas to improve retirement savings through universal 401(k)'s. Among these, better education, personal advice and auto-enrollment are getting attention cuurently. Separating 401(k) plans from employers is a more obscure idea that will become prominent if (when) 401(k) litigation grows.

401(k) plan fiduciaries have an affirmative responsibility under ERISA to act in the best interests of their participants and as “prudent experts”. Yet, empirical evidence strongly suggests that individual investors do not have the knowledge and may not all be provided with adequate investment opportunities to achieve their goals. Class action attorneys are taking notice of this misalignment. Inevitably, fiduciary conduct will become a focal point as a proximate cause for why employees may ultimately fail to meet their goals.

Friday, June 09, 2006

2005 Foundation Returns

U.S. foundations reported an average annual return of 8.1% in Fiscal Year 2005 according to the Commonfund Benchmarks Study® - Foundations and Operating Charities 2006.. Average returns ranged from 7.4% to 8.4% for all size groups. Average 3-year and 5-year returns for all institutions were 13.9% and 5.2% respectively.

Average asset allocations for total institutions reported for FY 2005 showed some significant changes from the previous year. Domestic equities declined to 37% vs. 45% percent the previous year. Within domestic equities, large cap allocations dropped to 50% vs. 59%; Index equities rose to 24% vs. 17%; mid cap were 10% vs. 9%; small cap remained unchanged at 15%.

Risk Aversion, Alpha and Credit Derivatives

Raghuram G. Rajan, Economic Counselor and Director of Research, International Monetary Fund describes what he sees driving risk aversion in today’s market. He highlights four types of behaviors—risk shifting, illiquidity seeking, tail risk seeking, and herding which are amplified and appear to be risk tolerance when interest rates are low. Reversals in these behaviors, as monetary policy tightens, now appear to be risk aversion.
Also, some thought provoking comments on alpha, poor man's alpha, and accidents waiting to happen in credit derivatives.

ERISA 404(C) Context for Diversification

W Scott Simon explains how the "broad range" diversification requirements of ERISA 404(c) are tied to Modern Portolio Theory. Key points; evaluate investment risk relative to the entire portfolio rather than on a standalone fund basis & minimize risk at the portfolio level by diversifying both across asset classes (horizontal) and within each asset class (vertical).

Thursday, June 08, 2006

Target Retirement Fund Changes

Based on the increasing popularity and utilization of Target Retirement Funds, Vanguard has introduced an additional to their fund lineup. Despite their attractions, these products can be difficult for investors and fiduciaries to benchmark appropriately. The Dow Jones Retirement index was issued last year and recently was adjusted to make it a bit more aggressive in its equity position beyond the target retirement date. This is consistent with a general trend towards more growth orientation in these products. Fiduciaries should pay particular attention to the asset allocation and rolldown methodology and the quality and consistency of the underlying funds when evaluating Target Retirement Funds.

Hedge Fund of Funds

Most investors can achieve similar performance in a properly diversified portfolio of stocks and bonds as they can in the average Hedge Fund of Funds (HFOFs), according to a historical analysis of hedge fund investment performance by Presidio Financial Partners LLC.

The fiduciary logic behind holding a HFOF can be challenging for many ERISA pension plan sponsors. Now, the investment premise may be suspect as well. Ultra high cost, ultra low transparency and fiduciaries that arent well positioned to conduct appropriate due diligence or fully understand each funds investment strategies and risks are not charcteristics of prudent management.

Wednesday, June 07, 2006

Pension Underfunding Improves in 2005

According to a recent Standard & Poor’s report, S&P 500 defined-benefit plans as a group were $140.4 billion under funded for 2005, a slight improvement from the $164.3 billion under funded position of 2004, but still in stark contrast to the $280 billion of over funding posted in 1999 at the height of the bull market. Funding improved to 90.4% in 2005 from 88.5% in 2004, but remains well below the 128.2% level of 1999. Fully funded plans decreased to 47 in 2005, from 55 in 2004.

Tuesday, June 06, 2006

National Retirement Risk Index

Alicia Munnell and colleagues conclude that retirement risk has been growing steadily over time due to; changes in Social Security replacement rates, the shift from DB plans to 401(k)'s where participants generally mismanage their saving and investment responsibilities, increasing life expectancy and lower interest rates.

They estimate that 43% of future retirees will be at risk of being more than 10% below a calculated target replacement ratio at retirement. Single women, low income households and those with no pensions or 401(k)'s only are most at risk. And if that is not bad enough, retiree risk increases to 66% if the assumption that retirees annuitize their assets and acquire reverse mortgages is relaxed.

Monday, June 05, 2006

Treasuries Turn to Junk

Standard & Poors reports that unless there are drastic changes made to public and fidcal policy, the aging global population could raise the Debt levels of the US, France, Germany, Italy, Japan and others to those normally associated with "junk" bonds.

S&P ran the simulations to highlight the overpowering impact pension and health care costs will have without further adjustment. Japan could turn into junk in 14 years whiel the Us would be expected to turn junk in 2040.

S&P assumes this data suggests most governments will be forced to reduce pensions and other benefits to avoid these scenarios.

Retirement Plan Investment Fees

The Invesmart retirement portfolio cost barometer suggests .58% is a "reasonable standard" for retirement plans to pay for an all equity portfolio while .51% is reasonable for a 60% equity/40% bond portfolio. Their updated study showed the large cap equity fee was .44%, small & mid cap equity .84%, International equity .73%, domestic fixed income .4% and cash alternatives .29%.

If these fees seem much lower than your retirement plan fees you shouldnt be surprised. Invesmark removed finders fees, 12b-1 fees, dealer concessions, shareholder servicing reimbursements and subtransfer agency fees from the fees of the "best of breed' funds they used in the study.

Since many Plan sponsors arent provided with these underlying fees, you might pursue getting this information from your plan provider. An alternative approach would be to calculate your plan's total fees and reduce it by $100-$150 per active participant in your plan. This amount approximates the average cost to adminster a 401(k) plan per participant. This should leave you with the net investment cost, which should roughly correspond to Investmarts estimates. If you are still a long way off from these estimates need to start asking questions and doing some additional due diligence.