fiduciary investor

Overcoming Fiduciary Fear

2010-02-24T10:55:00.002-05:00

There are two kinds of fears that 401(k) plan fiduciaries must overcome in order to effectively manage a prudent investment process .… the fear of doing something and the fear of doing nothing.

Specifically with regard to investment maintenance, fiduciaries often demonstrate a strong reluctance to swap out underperforming investments in an investment lineup. This behavior suggests they feel the risk implicit in changing a plan investment is far higher than maintaining an underperforming investment. Inertia makes maintaining the status quo seems like the risk-less option. Some fiduciaries are simply uncomfortable making decisions on behalf of others.

A countervailing fear, the fear of inaction, is characterized by a compulsion to act immediately when an investment falls below some established performance benchmarks. A mechanistic approach to policy adherence seems procedurally correct to plan fiduciaries, yet taking action too promptly can sometimes generate unnecessary portfolio turnover and detrimentally impact participant portfolios similar to a “buy high, sell low” strategy.

To manage the first fear, plan fiduciaries need to embrace the idea that a good investment portfolio is not static. Changes are inevitable and are required. Fiduciaries need to establish a pattern of investment turnover in order to fulfill their fiduciary responsibilities. The degree and extent of change will vary based on the level and sophistication of plan benchmarking as well as the bias employed in the investment selection process. The closer a plan gets to adopting timeless, consistently executed, and well diversified investment strategies with compatible benchmarks, the less frequently changes will be necessary. The more performance oriented the selection process, the more emphasis put on heroic investment alpha rather than the value of compound investment returns, the more frequently changes will be required. One of the most important skills that differentiate a good portfolio manager and a good fiduciary is the knowledge and ability to “pull the trigger” on meaningful and justified investment changes.

As we saw recently, an excessively mechanistic and pedantic approach to performance based investment changes can backfire on plan fiduciaries who execute their investment policies to the letter. Many good investments underperformed so substantially in 2008 that their longer term performance fell below peers and benchmarks. Strict adherence to standard 3 and 5 year oriented investment policy performance guidelines might have required these investment managers be cut loose…..only to see them outperform by a similarly wide margin in 2009 as the market rebounded. While following investment policy performance standards is a primary rule of prudence, even the best standards won’t always apply to every investment or situation. Prudent judgment is also required. Good investing requires patience, a bit of contrarian sentiment and an acknowledgement that specific facts and circumstances might invalidate general policy rules. Acting in the best interests of participants means making guality decisions not merely following guidelines.

Fiduciaries are required to make investment decisions in the face uncertainty. Avoiding decisions can harm participants and create liability. So can acting without the appropriate deference to current facts and circumstances. Fiduciaries should approach investment decision making with some reluctance…a reluctance borne of patience and careful judgment not one born of fear and lack of information.

Leverage Can Reduce Risk ???

2010-02-09T15:58:00.001-05:00

That’s the conclusion of the State of Wisconsin Investment Board after it authorized a strategy to lever up its pension plan assets from 4% this year to as much as 20% over the next 3 years. This strategy, generally referred to as “risk parity”, has been used for several years by a number of well known hedge funds, including several which advised the Investment Board.

The essence of a risk parity strategy, which is showing up in public pension board room presentations across the country, is that an expected return rate similar to a traditional 60% equity portfolio could be supported with less volatility by using leverage to boost exposure to lower risk asset classes in a plans asset allocation. Leverage provides a way to ratchet up the returns of the lower risk assets while altering the portfolios risk profile by reducing the proportion of equity risk, the risk that has traditionally dominated most pension portfolios.

While it is not surprising that portfolio risk has taken on a more visible role in asset allocation strategies, it perplexes many that leverage, the proximate cause of the 2008 and other past financial crises, is now the centerpiece of a risk reduction strategy.

The theoretical case for using leverage in a risk parity framework to reduce risk for any given expected return level is sound. It follows the well accepted mean variance, efficient frontier framework that most pension plan sponsors have already accepted as a foundation for their asset allocation decisions. Risk parity simply factors in the ability to borrow at a rate less than or equal to the savings rate. When borrowing is considered, the efficient frontier (the set of portfolios that maximize risk adjusted returns) moves from the concave curve we are all familiar with to a tangent line to the curve originating at the risk free rate. Visually, the equivalent return portfolio on the borrowing frontier has less risk than on the concave frontier

While the risk of higher leverage is dependent on the predictability of the levered risk (in this case fixed income risk is regarded as a much lower risk than equity), the practical case for using leverage may not be as elegant as the theoretical case. Leverage tends to seduce investors because it amplifies investment results. While small amounts of leverage, like the 4% WIB starting position, can’t do irreparable harm, positive outcomes will inevitably lead to overconfidence and higher leverage. Higher leverage will eventually collide with unanticipated market conditions creating the potential for another species of leverage induced portfolio meltdowns.

Just like external leverage in the form of pension obligation bonds was once considered an attractive option for making up public pension under-funding, risk parity is the new way for plans to borrow their way to abundance. It may not turn out to be a bad strategy for all plans but is likely to damage a few as this theoretical free lunch is just too tasty to resist.

The Value of TIPS in Pension and 401(k) Plans

2010-01-03T12:01:00.004-05:00

There is a growing sense that the monetary and fiscal policies required to exit the great recession of 2008/2009 are laying the groundwork for future inflation. This sentiment alone can have an impact on asset returns and investor behavior, regardless of the future course of inflation. In light of that, we briefly examine the case for providing exposure to Treasury Inflation Protected Securities or “TIPS” in both pension plans and 401(k) plans.

TIPS provide investors protection against inflation while protecting against deflation. They are government issued bonds designed to provide a certain pre-tax real return when held to maturity. TIPS pay interest twice a year, at a fixed rate. The rate is applied to a principal value which is adjusted for accrued CPI inflation. Interest payments rise with inflation and fall with deflation. When a TIPS matures, investors are paid the greater of its adjusted principal or original principal, providing a hedge against both inflation and deflation.

The yield on a conventional Treasury bond that pays a fixed coupon must also include an expected inflation component to compensate the investor for future inflation. Its yield therefore includes a real rate of interest and an expected inflation component. With TIPS, the coupons and principal adjust relative to CPI so its yield is simply the real interest rate. The difference between the two yields reflects, among other things, expected inflation.

Pension Plans
While the primary role of fixed income in many non ALM pension investment programs is to serve as a volatility hedge for stocks, it can also be constructed to offer inflation protection. The value of TIPS in a fixed income allocation, specifically as an inflation hedge, will be dependent on the nature of the plan’s liabilities.

Since the typical defined benefit plan has a set of liabilities that acts like a mix of nominal (retirees, term vested or frozen actives) and inflation linked (benefit accruing actives or inflation indexed retiree benefits) bonds, inflation can have varying impacts. Inflation protection may be less critical for pension plans that are mature, are not duration matching their liabilities and don’t have benefits that are linked to cost of living. Mature plans with a lower proportion of active participants may not be as exposed to salary inflation and might even benefit from the impact that inflation can have on devaluing plan liabilities. If a plan’s liabilities are not indexed to inflation, it benefits by paying nominal liabilities in inflated assets. Deflation represents a more considerable risk for these plans, so inflation protection may not be a primary objective.

Pension plans with a "COLA" liability based on their benefit formula can be negatively impacted by inflation. They would be natural holders of TIPS, along with other investors who want to match assets and liabilities in real terms. Financial assets, like nominal bonds, typically do poorly badly during periods of inflation, so a mix of TIPS and other inflation hedging assets such as commodities might be a good fit for these plans.

TIPS can also be used in pension plan portfolios as a diversifier since they behave differently than traditional fixed income securities in various market environments. Recent changes in pension accounting rules and the funding calculations of the Pension Protection Act of 2006 add to the diversification value of TIPS as either a strategic or tactical asset class.

401(k) Plans
401(k) plan sponsors have traditionally emphasized long term growth investments such as equity funds for their retirement investors. Equity tends to grow faster than bonds and has outpaced inflation in the long run. Traditional retirement portfolio planning suggests that as plan participants approach retirement they should increase their allocation to bonds to avoid the volatility of equity and other inflation hedging assets such as real estate or commodities. However, as their bond exposure grows, inflation replaces volatility as a primary risk. At a modest 3% inflation rate, prices can double over the life expectancy of the average retiree.

Plan participants often have only a few bond fund alternatives. The majority of 401(k) plans offer either a stable value fund or a money market fund and maybe a market value intermediate bond fund or two. None of these alternatives may not fully hedge inflation. Nominal bonds can perform poorly in the immediate wake of an inflation spike as yields increase. As yields and prices stabilize, nominal bond returns can ultimately predominate price declines, but the timing of this catch-up depends on the nature of the bond fund. Money market returns are likely to increase after an inflation spike, but their response is based on monetary policy and may have limitations. Stable value funds can adjust to inflation, perhaps better than money market funds, though the extent of the lag and the degree of their participation depends on their portfolio structure, duration and cash flows.

TIPS fully hedge inflation as measured by CPI and therefore could be a valuable addition for some investors in a 401(k) plan. There are also certain tax advantages to holding TIPs in a tax deferred account. Investors receive full inflation protection if TIPS are held in a tax deferred 401(k). According to Hewitt research, specialty bond funds, including TIPS funds, increased by 10% in 2009. Vanguard’s 2009 retirement plan survey data indicated 19% of its defined contribution plans offer a TIPS funds.

While TIPS are well suited for a role as an inflation hedge or fixed income portfolio diversifier in a 401(k) plan, other aspects should be considered in determining their suitability for particular plan populations.

While TIPS are relatively risk-free in the long run, they can be quite volatile in the short run. Naïve investors might assume that the inflation adjustment is the primary source of total returns for TIPS. However, the change in real interest rates, positively correlated with investors’ inflation expectations, has historically had a more significant impact on TIPS returns. TIPS can generate losses, even with rising inflation expectations, should real rates be rising faster or should heavy demand for TIPS drive yields down.

If TIPS notes are not held to maturity, investors loose their fixed real rate of return. Fluctuations in the yield on newly issued TIPS result in changes in the prices of existing securities, exposing investors to capital gains or losses. This market price exposure means that holding TIPS for short periods of time negates their inflation hedging capabilities and exposes investors to almost a similar level of price risk as nominal Treasuries.

Most 401(k) plans that offer TIPS use a TIPS fund rather than individual TIPS. TIPS funds have some advantages but do not allow investors to hedge date certain future liabilities. TIPS funds can be thought of as a rolling ladder of individual TIPS which have a specific duration. This structure exposes investors to some level of realized gains and losses as they draw down their investment through retirement. The financial impact of these hedging mismatches will be determined by the dollar weighted inflation component of pre retirement accumulations vs. post retirement distributions. For long term regularly scheduled accumulations and distributions, these impacts would theoretically average out.

TIPS investments can provide a conservative way for 401(k) plan participants to diversify their fixed income portfolios and hedge a slower growth, inflationary environment. However, like many fixed income sectors, they are somewhat complex and less well understood by participants, raising the potential for inappropriate expectation and utilization. Plan sponsors should consider a number of factors when determining whether a TIPS investment would be a suitable alternative for their plans:
· Demographic distribution of plan participants
· Range and characteristics of existing total plan and fixed income alternatives
· Retention of retirement accounts by post retirees
· Associated defined benefit pension plan benefits
· Ability to educate/inform participants about TIPS
· Utilization of advice facilities

More International Equity?

2009-10-30T16:08:00.002-04:00

A question posed by fiduciary investors today is whether they should increase their allocation to International Equity. The answer depends on whether their intention is to chase international performance or to adjust their long term strategic exposure to international equity?

A neutral global market capitalization weighted investment benchmark would allocate about 50% of equity to international. Academic studies and industry practice suggest there is diminishing value from international allocations beyond 40% of equity. A 20% international allocation of total equity is often considered a minimum prudent allocation. Many plan fiduciaries discount back from a strategic 40% exposure for the following reasons:

1) global market return correlations have been going higher thereby reducing the diversifying value of int’l equity,
2) pension plan liabilities are often denominated in US $’s making foreign denominated assets more volatile relative to liabilities,
3) foreign investments costs more than domestic investments, and
4) comparability with similar pension plan allocations.

Many investors are tactically overweighting international equity due to the weakening dollar and perceived lower valuations. Long term institutional strategies presume currency effects tend to cancel out over time and that valuations tend to mean revert. Using currency or valuation to support changes in international equity is tactical and implies performance chasing rather than strategic alteration.

Senate Committee Review of Target Date Funds

2009-10-28T17:18:00.008-04:00

The Senate Special Committee on Aging held another fact finding session on Target Retirement Funds (TRF), concerned by their lack of transparency, high fees and and potential conflicts of interest. Testimony (available via webcast) provided by a range of regulators and private fund providers was similar to what has been presented in the past.

The Q&A portion was of particular interest in that it addressed arguments on both sides of proprietery fund management and whether conflicts of interest inherent in proprietary target date funds, but not addressed by ERISA due to an exemption, are adequately covered by securities regulations as intended by Congress when drafting ERISA. Other points of interest raised during the prepared comments:

SEC will be focusing on the use of dates in fund names, whether TRF sales material requirements provide sufficient information and balance and investor education.

EBSA is looking at QDIA regs to see if more specific guidelines are necessary to help plan fiduciaries better understand, select and monitor TRF's. In the Q&A it sounded like DOL will give additional consideration to the use of more conservative funds as QDIA.

Morningstar was concerned about the range of fee, the issue of proprietery fund management which would not be considered institutional investing best practice, and the low level of conviction managers have in these funds as indicated by their very low personal investments in them. 57% of TRF managers have no investment in them.

Fidelity made some important and often overlooked points about the intrinsic value of these products for uninvolved investors. They also indicated support for a number of recommended communication initiatives. A later point about investors desires to have a company and brand they are comfortable with manage the totality of their investments was well made. Having a good product is only half the battle, getting plan particpants to select the product is just as important and brand plays a big role in that decision. Plan fiduciaries must also consider that aspect when selecting a TRF for their plan.

A private TRF provider pointed out the inconsistency of DOL's rethink of the investment advice rules because of conflicts of interest while allowing proprietary funds to be used within a TRF product because they are not considered plan assets under ERISA. A point made here was that requirements & remedies are available under securities laws to address these issues.

The Committee members seemed to appreciate the difficulty in trying to legislate investment results in this area.

Mutual Fund Incubation

2009-04-10T11:27:00.002-04:00

Establishing a minimum required track record of at least 3 years along with setting a minimum asset requirement can help investment fiduciaries avoid the potentially misleading effects of mutual fund incubation.

Defined Benefit Plans - Modest Relief in 2009

2009-04-07T17:59:00.002-04:00

Market turmoil over the last year has severely impacted DB plan funding levels and future funding obligations. While plan sponsors can t directly control interest rates or capital market performance, they can influence funding requirements via plan actuarial assumptions. Recent legislation and regulatory guidance provides additional flexibility in this area.

Liability Discount Rates: new IRS guidance allows plans to change their yield curve election in 2009 without IRS approval. Plan sponsors that choose to use the corporate bond yield curve in lieu of segment rates may use the same look-back period ( 4 months preceding January 2009 for a calendar year plan) that is allowed for plans selecting segment rates. This would allow plan sponsors to use discount rates that could be up to 1% higher than those allowed without the look back provision and in lieu of the segment rates. The IRS has not indicated whether another election will be allowed in 2010 so the use of a current yield method could introduce higher future volatility in plan funding requirements.

Asset Smoothing : the IRS provided additional guidance (Notice 2009-22)on how asset smoothing, allowed under the Worker, Retiree, and Employer Recovery Act of 2008, could be implemented. This guidance is particularly valuable given large recent asset losses. The notice provides automatic approval for a change in asset valuation methods for plan years beginning in 2009.

Adopting actuarial assumptions which reduce long term funding volatility while providing a beneficial current impact seem to be a win-win for plan sponsors. Adopting an asset smoothing methodology seems to be an easy decision while the benefits of adopting a corporate bond yield are not as straightforward. Each case should be determined in consultation with your plan actuary.

Fiduciary Liability Insurance

2009-03-10T08:44:00.002-04:00

Given market conditions and investors need to make up for losses, plan fiduciaries should get to know the details of their fiduciary liability insurance. Steve Saxon provides guidance in his comments at Plansponsor.

Mutual Funds Fees are Too High

2009-02-11T17:37:00.003-05:00

This study on mutual funds, Identification And Performance of Equity Mutual Funds with High Management Fees and Expense Ratios by Haslem, Baker and Smith, finds that economies of scale are not generally shared with fund holders because the market lacks the competitive pressures to drive fund expense downward. This is due to product a variety of product differentiation strategies that probably have little correlation to a funds future sucess.

Active vs Passive

2009-02-11T09:45:00.003-05:00

Another perspective on the active vs passive debate. Typically, its a toss-up before fees and a loosers game after. Good managers do exist but they cant be uncovered simply by looking at past performance.

Active Manager Underperformance in 2008

2009-02-06T17:10:00.003-05:00

If your actively managed investment funds underperformed dramatically and collectively in 2008, Wurts & Associates developed a presentation which describes what happened. Their points may be useful in putting 2008 benchmark relative results in context for your investment committee.

Target Date Retirement Funds - Best Practices

2009-02-05T13:02:00.003-05:00

According to testimony before the Advisory Council on Employee Welfare and Pension Benefit Plans, evaluating Target Date Funds(TDF) is challenging, difficult, complex and one-size-does not fit -all. Best practices noted in the testimony

• the single most important decision is the design of the glide path of the TDF
• active/passive management, value customization and participant impacts are other important factors in considering the utility of TDFs
• TDF’s must be evaluated periodically (most often quarterly).
• fiduciaries should compare TDFs to their peers and relevant benchmarks,
• communications that effectively explain the TDF so participants clearly understand the underlying investments and how the glide path works is important also,
• a plan sponsor should consider what levels of defined benefit, Social Security benefit or other pension benefit that participants are likely to have,
• the design and structure should be compared to the plan’s unique demographics,
• consider individual participant risks - participants need to understand the limitations of these funds,
• customization will be big in the future,
• annuity type options or managed payout type funds are going to become more and more prevalent,
• benchmarking is a problem. Focus should be on trying to define a “process” for evaluating these things and not relying on one particular measure to monitor it,
• one firm’s TDFs would be appropriate if the plan sponsor is comfortable with the overall philosophy and that should not change based on the target date of the fund,
• looking at the underlying funds that may make a TDF could be illustrative since the underlying funds have likely been in existence long enough to build up a track record,
• liquidity of certain investments in a TDF may be a challenge,
• consider using different TDFs from different vendors,
• carefully evaluate costs,
• Plan sponsors should ask vendors for an investment policy statement,and
• sponsors should strive to maximize the number of participants who reach a minimum level of income replacement in retirement.

Mutual Fund Family Performance

2009-02-05T10:04:00.001-05:00

Many publications provide periodic data or rankings on composite mutual fund family performance. A question arises as to whether investment fiduciaries should derive comfort or concern from these lists.

For instance, in a recent WSJ article, the performance of the 10 largest mutual fund families was profiled. The fund family rankings were based on asset weighted excess returns over their morningstar style box from the market peak in October 2007. The article acknowleges that "this overall scoring may have little correlation to your personal investment results" though they point out that "the results give some indication of how each complex has served its investors overall since the market peak".

The Street.com provides its own ranking of fund families based on its rating system which they indicate should "provide a solid framework for making informed, timely investment decisions".

There is often dissonance between lists. For instance, The Street's top performing fund family with more than 100 rated funds rates a 2.6 under the Morningstar ranking system where "the scores range from 1.0 to 5.0. A score below 2.5 is an indication that the firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average".

All performance rankings have limitations, especially those based on short time periods. Family fund rankings have even less value since they dont reflect the characteristics of any specific investment strategy. They are simply an artifact of a set of asset class, investing process, research and outlook biases that may be correlated across funds in a family.

Investment fiduciaries whose investment programs, such as 401(k)'s, hold many investments from a single fund family may not be fully meeting their fiduciary responsibility to diversify plan assets. A study by Elton, Green and Gruber, "The Impact of Mutual Fund Family Membership on Investment Risk" finds:

"evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio."

Using fund family ranking information to assess the merits of an investment progam would be like selecting a job candidate by interviewing her family. Though some general traits may be "genetic", investment performance and therefore fiduciary attention should correlate to the unique characteristics of each investment fund.

401(k) Tweets

2009-02-02T13:45:00.014-05:00

A new 401(k) program ranking tool, Brightscope, is now available on line. According to the firms press release;

"The new BrightScope Rating is a quantitative 401k plan rating developed by BrightScope, Inc. in partnership with some of the country's top independent fiduciaries, finance professors, and 401k experts. BrightScope Ratings take into account over 200 unique data inputs per plan and calculate a single numerical score to define 401k plan quality at the company level. The ratings algorithm runs thousands of simulations for each 401k plan in order to determine how quickly each plan will propel the average 401k participant to retirement. Using this rigorous approach, BrightScope ensures that every factor that affects retirement outcomes - such as company generosity, fees, investment menu quality, vesting schedules, and more - is accurately reflected in a company's rating. The site provides open access to 401k ratings, allowing anyone to compare any 401k plan with another."

Proclaiming the value of true transparency and disciplined benchmarking, the firm indicates that;

"Plan sponsors who use BrightScope can demonstrate to their employees, their board, their retirement committee, and to regulators that they are taking the necessary steps to improve the quality of their 401k plan."

Unfortunately, transparency isnt very transparent when a proprietery and presumably undisclosed process generates rank results. Fiduciaries would not be wise to rely on a quantitative "black box", especially one designed by industry experts....because we have seen where that will lead. The quality and timeliness of plan data inputs have been a persistent problem in past plan comparability efforts. A database that relies on voluntary data of unknow quality or stale but offical public domain data shouldn't necessarily be relied upon for fiduciary decision making either.

Perhaps, when a comprehensive suite of federally mandated investment and plan disclosures becomes available on a close-to-real-time basis and its ranking criteria and standards are revealed, a tool like this will have real value. Until then it will be an interesting curiosity.

While their intentions may be good and the output is interesting, Brightscope seems to sacrifice meaningful detailed information and a transparent ranking process for mindless usability. That may be a wise tradeoff to capture the eyeballs of the twitter generation but probably won't support its goal of being a fundamental fiduciary support tool that plan sponsors could really use.

FAS FSP 132R-1

2009-01-28T13:17:00.002-05:00

Plan sponsors will be required to provide more transparency about the assets in their defined benefit pension plans based on FASB’s recently issued FSP FAS 132R-1, "Employers’ Disclosures about Postretirement Benefit Plan Assets."

This new disclosure guidance addresses perceived inadequacies about the types of assets and associated risks in retirement plans. Plan sponsors generally provide info on only four asset categories: equity, debt, real estate, and other investments. The growing popularity of alternative assets and their lack of homogeneity and unique risks make the "other investment" category particularly challenging for financial statement users to evaluate.

The new disclosures are designed to provide additional insight into:

• The major categories of plan assets
• The inputs and valuation techniques used to measure the fair value of plan assets
• The effect of fair value measurements using significant unobservable inputs (Level 3 measurements in FASB Statement 157, Fair Value Measurements) on changes in plan assets for the period
• Significant concentrations of risk within plan assets
• How investment decisions are made, including factors necessary to understanding investment policies and strategies

Required for financial statements with fiscal years ending after December 15, 2009.

Pension Expected Return Assumptions - Hitting Back

2009-01-18T17:57:00.007-05:00

Current pension accounting allows pension plans to use an estimate of expected future returns instead of actual returns to compute periodic pension costs. The logic behind this accounting is that, in the long run, a combination of company resources and investment earnings must equal plan obligations. Pension plan liabilities are long lived and therefore some stable long run estimate of corresponding asset returns should be used to determine the periodic cost to the business of meeting plan obligations. Accounting further recognizes that annual differences between actual and expected returns are inevitable. These are accumulated and amortized into periodic cost over time.

There is a natural asymmetry to how this accounting regime is viewed depending on market performance. In bull markets, most seem satisfied in the conservatism reflected by periodic pension costs being higher than current earnings might suggest. Yet in bear markets, critics become vocal about the potential manipulation and overstatement of income as a result of using positive expected returns when market returns are negative. The wider the gap the more vocal the critics and the more concerned the actuaries and auditors who have a professional tendency towards asymmetrical conservatism. A recent article reflects this view.

“That 8 percent annual return on investment you and your pension fund manager were banking on is now looking almost as optimistic as Madoff’s magic 12 percent, as deleveraging and deflation bite. With extremely low or negative interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.”

It is a well accepted fiduciary notion that short term investment results are very noisy and carry little useful information to guide long term investment strategies. Yet, after market drops like 2008, misguided critics insist that plan sponsors should be lowering their expected return assumptions to accommodate what ever change in strategic assumption they would argue has been revealed by the market drop. In this case, presumably, overleveraging was explicitly factored into past return forecasts rather than being a source of an unexpected positive variance from past forecasts.

In fact, long term expected return assumptions as defined by FASB, properly based on long horizon strategic factors, should not be subject to frequent marginal shifts given; the likely estimation error in any such forecast, the infrequency of major structural market changes and the provisions of accounting to amortize actual to forecast return differences overt time. Further, unless the market principle of mean reversion has been suspended, it is fallacious to assume that forward expected return forecasts should be lower after a market collapse. Historically, periods of heavy losses have been followed by periods with above average returns. Diamond Hill calculated that if the S&P 500 only returned to its April 2000 level in the year 2016, that appreciation, coupled with the dividend yield, would result in an annualized total return of over 12%.

While we are not expressing a view as to whether the average pension plan’s expected returns accurately reflect future returns, it is illogical to presume that the passage of the last year has provided plan sponsors with significant additional insight on strategic factors that were embedded in their long term forecast assumptions. Though it is understandable from a risk aversion perspective, it is also illogical that pension actuaries and auditors should bias plan sponsors to lower long term expected returns after the market has seen its worst decline in 50 years. Given their biases, pension plan fiduciaries should not unduly allow their advisors to tactically influence their strategic pension accounting assumptions.

The Perils of Cumulative Returns

2009-01-11T17:24:00.002-05:00

In addition to having to confront miserable absolute returns in their investment programs, investment fiduciaries will have to contend with more than the usual number of relative performance issues where investment funds are not meeting their performance benchmarks. This is because of the higher than average fund performance dispersion in 2008 and the surprisingly significant impact that a single high deviation performance year can have on 3 and 5 year cumulative returns.

Short term investment performance is generally regarded as having a high noise to signal ratio. This means short term performance patterns usually do not persist into the future and therefore provides little useful information for investment decision making. Yet, 1 year performance variances, positive or negative, can substantially infect longer term 3 and 5 year cumulative performance measures, which are routinely used by investment fiduciaries in investment decision making. The larger a fund’s annual performance variance, the higher that years impact on 3 and 5 year cumulative performance. We have estimated that equity mutual fund performance return dispersion is 31% higher in 2008 than the average annual return dispersion since 2003. This suggests that the 3 & 5 year cumulative return rankings for investment funds will be subject to more fluctuation, influenced by a broader range of positive and negative 1year variances.

To counteract the effects of these short term performance biases, it is particularly important that investment fiduciaries look at a mosaic of other quantitative measures such as long term (5 +) and life of fund performance as well as rolling period data when evaluating fund returns. Fiduciaries might be considered imprudent not to consider other factors besides returns in their analysis. A number of risk measures are routinely used in conjunction with returns. Some studies, such as that by Martin Eling, Does the Measure Matter , point out that the Sharpe ratio is a reasonable and adequate measure to rank funds for additional due diligence work, though these measures are time period dependent as well.

In truth, even multiple statistical tools may not capture the critical attributes and dynamics of an investment fund. Subjective analysis and investment judgment will always be required to transform investment data into prudent investment decisions. Evaluating the fallout of 2008 will put a particular premium on those skills.

Investment Fiduciary Mulligan

2009-01-04T13:30:00.024-05:00

Investors and investment fiduciaries may be wishing they could take a mulligan on their long term equity oriented investment strategies in the face of this decade’s second equity market implosion. Global equity (MSCI World) returns have been nil over the last decade ending November while global bond returns (MLGBM) were about 5.2% annualized.

Certainly, fiduciaries might surmise that, had they learned their lesson after the technology wreck in 2000, and either teed up a more conservative portfolio with less equity exposure or diversified their portfolios into alternative asset classes, they would be much better off today. Surprisingly this would not be the case. Since the market bottom in 2002 through November 2008, neither a more defensive asset allocation nor a more diversified allocation using alternative investments would have provided much relief.

Annualized returns for the period from the bear market bottom in October 2002 through November 2008 for various portfolios suggest that the positive equity returns enjoyed by investors over the intervening years was directly proportional to the losses they suffered in 2008. In other words, higher equity allocations lost a similar proportion of their past gains in 2008 as portfolios with lower equity allocations implying that the degree of equity allocation made only a modest difference in portfolio return over this period. The following benchmark portfolio returns illustrate this (Stocks=75% R3000, 25% MSCI EAFE, Bonds=Barclays US Aggr, rebalanced quarterly)

Portfolio 6Yr 1Mnth Return
Stock 80% Bonds 20%     4.16%
Stock 70% Bonds 30%     4.27%
Stock 60% Bonds 40%     4.36%
Stock 50% Bonds 50%     4.41%
Stock 40% Bonds 60%     4.43%
Stock 30% Bonds 70%     4.42%

Another investment strategy made popular by the large endowment funds was designed to diversify portfolios away from equity market risk. These strategies featured an asset allocation which included “alternative” investments. For all but the largest portfolios, this typically would have included allocations to real estate, commodities and hedge funds, through a fund of fund vehicle.

For comparison purposes we created a benchmark portfolio which included a 30% allocation to alternative assets (10% Wilshire global REITs, 10% HFRI Funds of Funds and 10% S&P GSCI) and an 80% allocation of remaining assets to stock and 20% to bonds. The 30% alternative portfolio returned 5.36% annualized for the 6 years through October 31, 2008 vs. 5.12% for the standard 80% stock 20% bond portfolio. The allocation to this set of alternative assets over this period added a modest .24% to portfolio returns (reduced porftolio volatility by a small amount) yet exposed investors to other non-statistical risk factors which are still playing out in the markets.

So, while all investors lost strokes over the last 6 years, mulligans were awarded for virtually every differential investment strategy. Investment fiduciaries have had the opportunity to learn a number of important lessons about the markets, about risk and about their own risk appetites and investment psychology. These should be carefully considered as part of their course management. Though no one knows what lies ahead in the markets, a big risk is that investment fiduciaries will rely too much on their “muscle memory” of 2008 in teeing up their investment strategies going forward.

401(K) Plan Cash Equivalent Options

2008-12-21T16:06:00.012-05:00

As the credit crisis grinds on, issues in the money markets and Fed policy are forcing 401(k) Plan fiduciaries to consider their responsibilities to participants with regard to providing a safe, cash equivalent type of investment option.

To meet 404(c) requirements (as well as their basic fiduciary responsibility), Plans are required to provide a broad range of investment alternatives. The broad range requirement will be satisfied if “participants are afforded a reasonable opportunity to materially affect the potential risk and return on amounts in their accounts; choose from at least three diversified investment categories; and diversify investments so as to minimize the risk of large losses”.

Further, “the three categories of investments in the aggregate (must) enable the participant, by choosing among them, to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant”. Traditionally the three core investment categories have been considered to be stocks, bonds and “cash equivalents” (i.e. money markets or stable value funds).

From a modern portfolio theory perspective, cash equivalents anchor the efficient frontier and are necessary both as a standalone option or to modify the risk profile of a portfolio of either bonds or stocks, in order to meet the normal range requirement. Therefore, it is often interpreted to be a required core asset in a 401(k) plan.

404(c) further defines the required attributes of the core cash equivalent option. If any investment alternative permits changes more frequently than once every three months ( most do), at least one core investment must permit the same frequency of change, and the investment into which participants can transfer must be income producing, low risk, and liquid.

If the statutes require that a low risk, income producing and liquid cash equivalent account be available to participants to qualify for 404(c) protection, which alternatives satisfy these conditions?

Treasury Funds - After the Reserve Money market fund broke the buck on September 19, 2008, the US Treasury agreed to provide limited insurance for money market fund balances for participating money funds. Many money market fund vendors took the maximum time allowable to determine whether paying the trivial fee for the government protection was in their best interests. Meanwhile, a large proportion of their prime money market shareholders sought refuge in Treasuries and Treasury money market fund products, driving Treasury yields down further and likely costing these funds and their shareholders many multiples of the cost of the federal guarantee.

Now, as the FOMC recently set its target range for fed funds to 0% to 0.25%, Treasury fund yields are approaching zero, are closing to new money and are forcing Plan fiduciaries to consider whether negative yields are palatable to their participants or prudent from a fiduciary perspective. Plan fiduciaries should inquire how their Treasury fund managers are handling this issue and whether there are any disclosed yield floors in their funds. While US Treasury obligations are still considered low risk and liquid, their ability to satisfy the income requirement is limited, making then the functional equivalent of a "plush pillowtop".

Prime Funds- Meanwhile, those prime money funds which have the benefit of federal money market insurance, seem prudent and protected, at least for balances held as September 19, 2008. New money in these funds leave participants exposed to falling Treasury yields and the credit and liquidity issues associated with continued turmoil in the structured credit, commercial paper and repo markets. CD’s, another common investment in these funds, generally don’t carry full FDIC protection. Government “insured” prime money market funds seem to meet the 404(c) requirements, though fiduciaries should carefully evaluate a fund’s holdings to determine the potential risk and liquidity issues that face new uninsured allocations.

Stable Value Funds - Stable value funds offer a seemingly ideal combination of guaranteed principal and substantial yield in this environment. However, their risks are not well understood. Their risks are structural rather than statistical. Their book value security relies on low variance book/market value relationships, constrained cash-flows, careful contractual compliance and well capitalized wrap providers. A single headline event such as a stable value fund lockup could conceivably create a run on stable value funds regardless of competing funds provisions and employer put options. To protect existing fund-holders and wrap providers, product sponsors might be forced to suspend redemptions. The recent industry trend to provide additional “safe” alternatives and access to non competing fund alternatives may increase the risk of such a stable value fund event. The structural risks of stable value funds and their potential illiquidity should be of concern to plan sponsors. Additional fiduciary due diligence to monitor these risks is essential.

CD’s- Bank or brokerage certificates of deposit have not been traditional choices in 401(K) Plans. Yet they are often available through a brokerage window option. Current yields are respectable and within appropriate FDIC insurance limits could be considered risk free. Liquidity might be a consideration as most CD’s access a penalty for early withdrawal.

As a technical matter, plan fiduciaries must provide an income producing, low risk, liquid fund as a core fund option in their 401(k) plans in order to meet the requirements of Section 404(c). Current conditions in the money markets have altered the characteristics of many cash equivalent products. This requires that investment fiduciaries go through the exercise of re-evaluating the kind of cash equivalent alternatives they offer and performing additional due diligence on their composition and potential risks. In the context of today’s markets, a prudent investor should consider potential risks and illiquidity in much broader terms than might have been necessary 6 months ago.

401(k) Trading Restrictions Old Fix..New Fault

2008-12-11T16:31:00.000-05:00

Following the mutual fund market timing scandals in 2003/2004, mutual fund companies and plan sponsors took action to prevent short-term in and out trading, other wise known as “market timing”. The goal of a market timer of that era was to capitalize on changing markets and in particular to take advantage of arbitrage opportunities in international markets due to stale pricing. While market timing was not per se illegal, it was argued that market timing disadvantaged fund shareholders and therefore required fiduciaries to employ methods to prevent it. Consequently, many mutual funds established a regimen of redemption fees and trading restrictions designed to reduce trading activities in their funds. Some plan sponsors also amended their plan documents to allow for trading restrictions. By definition, these trading restrictions limit the amount of control a plan participant has on their investments.

Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA) provides, among other things, that if a plan permits its participants to exercise control over their assets and that they exercise such control, then Plan fiduciaries would not be liable for any loss, or breach which results from that exercise of control. Section 404(c) further provides statutory criteria for determining whether participants would be deemed to have independent control. According to the statute a Plan would not fail to provide the opportunity for control because, among other things it:

"Imposes reasonable restrictions on frequency of investment instructions. A plan may impose reasonable restrictions on the frequency with which participants and beneficiaries may give investment instructions. In no event, however, is such a restriction reasonable unless, with respect to each investment alternative made available by the plan, it permits participants and beneficiaries to give investment instructions with a frequency which is appropriate in light of the market volatility to which the investment alternative may reasonably be expected to be subject".

Could excessive trading rules, which often limit a participant’s ability to execute roundtrip trades within a 90 day period even in the context of a normal, well disciplined rebalancing protocol, be unreasonable in today’s volatile investment environment? One might certainly argue so! Investment fiduciaries should be careful not to shoot themselves in the foot under 404(c) while fighting yesterday’s battle on market timing.

Investment Fiduciaries - Living in the Left Tail

2008-11-23T13:48:00.003-05:00

Investment fiduciaries have developed a set of historically biased, analytically oriented and rules based approaches to support their investment decision making. This governance process is largely predicated on assumptions about the past cyclicality of capital markets, their reversion to the mean and a relatively normal distribution of economic and market events. This process, slavishly executed, may be insufficient in the face of today’s unique market losses and the almost unprecedented level of uncertainty.

It is not clear to what extent these drastic times call for drastic fiduciary measures. It is certain however, that an enhanced level of fiduciary judgment and decision making is required to accommodate today’s markets. Simple rote execution of fiduciary processes established in normal times may not be considered fully sufficient. Investment fiduciaries should re-examine their investment policies and investment review process to ensure they address the unique characteristics, risks and uncertainties implicit in the current markets.

The majority of investment policies are largely descriptive and rules based. Rules based investment policies are easy to execute and provided a simple demonstration of fiduciary governance. However, the rules and assumptions that work in normal market environments (and are reflected in most investment policies), may not work in today’s markets. Many fiduciary committees are uncomfortable departing from strict compliance with investment policy rules since it is a fiduciary breach under ERSIA not to comply with Plan documents. However, rules based investment policies are rarely comprehensive enough to address every critical investment characteristic through every market. Therefore, a prudent fiduciary process requires the consideration of all relevant facts and circumstances, even those that may not be explicitly defined in an investment policy statement. Some of these alternative standards may produce alternative investment conclusions. These might include:

Active/Passive – There is a pronounced investment trend towards the separation of core low cost investment beta returns from higher cost active alpha. Investment fiduciaries should have substantial principles based support for not providing/utilizing a passively managed investment alternative for all core asset classes. To the extent passive managed alternatives are made available, the ability to select/offer higher potential, though more volatile, actively managed funds may be better justified than without index funds. This also substantially reduces plan sponsor liability. When using active funds, Plan fiduciaries should be careful to avoid, to the extent possible, over-concentration or overlap (see below).

Strict Reliance on 3-5 year Investment Performance Standards - Strict fiduciary reliance on historically normalized market performance standards could cause fiduciaries to overreact to today’s performance. Many best of breed investment manager have fallen out of compliance with a standard market cycle (3 and 5 year) view of comparative performance. Relying more on qualitative investment factors and “life of fund”, rolling period and longer term comparative performance measures can provide other important performance perspectives. However, fiduciaries should not freeze up over investment manager changes. A record of properly evaluated prior fund underperformance that continues through the current markets, still presents an fiduciary obligation and an opportunity for plan sponsors to offer a better alternative.

Investment Characteristics –The nature of performance oriented investment selection virtually guarantees that investments with the dubious qualities so well rewarded over the last 5 years are well represented in today’s plan investments. Plan fiduciaries should review investments and policy criteria with a specific eye toward principles such as; level of structuring, transparency and clarity of underlying investments, complexity, fees levels and disclosures and leverage.

Investment Diversification – Investment funds within a plan should be reviewed to ensure they contribute towards investment diversification and not mistakenly expose investors to over-concentrated exposures. Fiduciaries attempting to provide diversification by offering broad asset class funds and overlapping sectors funds can mistakenly expose the plan or its participants to unexpected levels of over-concentration or high risk sector exposure. For instance, offering an international equity fund with a broad mandate to invest in emerging markets along side an emerging markets fund has the potential to create an exposure to emerging markets beyond many investors risk appetites. The utilization of both hybrid high yield bond funds and core plus bond strategies has created similar unintended levels of credit risk in some Plans. Hybrid asset don't usually add much value in a balanced portfolio anyway. Similarly, within an investment style, care should be taken to offer different investing strategies. For instance, using 2 deep value manager’s may provided less diversification benefit than having a deep value total return strategy with a dividend oriented income strategy.

ERISA 404(c) Compliance - Broadly speaking ERISA 404(c) compliance requires that Plans offer at least 3 distinct investment alternatives, each of which is diversified, each of which has materially different risk and returns characteristics and each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant's or beneficiary's portfolio. In today’s world, a Plan with a money market account and all equity funds may not, arguably, meet the criteria since all equity funds have been highly correlated in this bear market. Such Plan sponsor’s might reasonably consider adding a market value bond account. 404c compliance further requires diversification so as to minimize the risk of large losses. Traditionally money market funds or stable value funds have provided a safe option for participants. Recent credit market events and liquidity conditions require that fiduciaries examine these products and re-evaluate how comfortable they are with their safety. Given the markets extraordinary volatility, fiduciaries might also consider whether 404 (c) trading requirements can be met given the emergence of redemption fees and trading restrictions in many funds.

Investment fiduciaries should consider a principles based overlay for their investment policies and additional topics for evaluation in their investment reviews. A simple shift in perspective from "what did" to "what if" should provide a broader context for investment decision making and greater depth of support for a plans investment positions in todays markets.

Stable Value Fund Due Diligence

2008-10-26T20:47:00.000-04:00

Stable value funds often invest in a portfolio of fixed income investments beyond the average term and allowable credit quality of a money market fund. The term premium and credit spread is intended to provide a return over money market products while insurance contracts provide book value accounting and loss protection for participant withdrawals prior to maturity.

Stable value funds seeks to provide a stable net asset value and crediting rate by managing portfolio cash flows, managing the duration, quality and diversification of the underlying fixed income investments, amortizing market value based portfolio gains and losses over the duration of the portfolio and by utilizing wrap providers who are contractually required to make up the difference between portfolio market value and book value under certain circumstances.

This has been a challenging environment for stable value products as the recent spike in credit spreads has driven market values below book value in many stable value funds. High quality stable value products are now seeing market values at 95% and less of book value. Issuer specific credit events may also be causing problems for funds with concentrated exposures. Structured credit products continue to present liquidity, pricing and credit risk for underlying portfolios. Lastly, financial issues in the insurance and banking sectors have impacted the credit quality and capacity for wrap providers. Given these issues it would be prudent for investors with fiduciary responsibility to review the condition and operation of their stable value funds and to identify any general or specific risks and issues.

Credit and duration position. - Longer duration and lower credit quality in the underlying portfolio presents more risk. Funds with MV/BV ratios under 1 may be shortening duration to amortize their negative book value differences more quickly. Underlying portfolios should be well diversified by sector and issuers and shouldn’t have material positions in investments subject to inappropriate liquidity or default risk. Any structured investments should be very short duration and fully covering P&I. Inquire about the market valuation methodology for any structured investments in the underlying portfolio.

Cash flows - Substantial issues can arise in a stable value fund if cash-flows are negative when the portfolio market value position is less than the book value position. At that point, participants are effectively getting a $1 worth of assets when they leave and the fund is getting less than $1 in asset sales proceeds to pay them out. This inequity drives stable value managers to try to avoid book to market differences beyond a 5%-6% spread. Book to market value differences can be managed by reducing portfolio duration, thereby speeding up amortization and increasing portfolio quality while reducing spread risk The more severe the market value discount, the more the underlying portfolio characteristics should resemble a money market fund. In these cases, principal protection should take precedence over the yield and crediting rates. Stable value contract restrictions are designed to impede negative cash-flows. Stable value products often have a put option on sponsor level withdrawals in situations where there is a negative impact to existing fund holders such as when MV is less than BV. Plan participants don’t usually have withdrawal restriction per se but competing fund rules and required “equity washes: can serve to minimize participant withdrawal activity.

Wrap – SV funds faces deteriorating credit quality and diminishing capacity in the wrap market. As a practical matter, SV funds might have to get to a crediting rate of zero or experience substantial net cash-outs before the wrap providers would suffer a claim. While the probability of this occurring simultaneous with a wrap provider’s insolvency may have been historically small, fiduciaries are faced with unprecedented market conditions. SV managers should be very aware of the issues they face in this environment and should be proactively managing them .

Monitoring a stable value funds MV/BV ratio, underlying portfolio attributes, cash-flows and wrap exposures are important due diligence steps for a plan fiduciary in this environment.

DOL Addresses SRI Funds

2008-10-17T16:56:00.001-04:00

Today the Department of Labor issued an interpretative bulletin addressing the use of ERISA plan assets for socially responsive investing purposes.

"ERISA's plain text thus establishes a clear rule that in the course of discharging their duties, fiduciaries may never subordinate the economic interests of the plan to unrelated objectives, and may not select investments on the basis of any factor outside the economic interest of the plan except in very limited circumstances..In light of the rigorous requirements established by ERISA, the Department believes that fiduciaries who rely on factors outside the economic interests of the plan in making investment choices and subsequently find their decision challenged will rarely be able to demonstrate compliance with ERISA absent a written record demonstrating that a contemporaneous economic analysis showed that the investment alternatives were of equal value.

In short, while some SRI investments may still be prudent under ERISA, no allowance can be made outside the economic interests of plan participants. While this bulletin doesnt raise the bar for including and monitoring SRI funds in a 401(k) plan, it certainly makes the height of the bar and the risks for missing it more visible.

Fiduciary Investment Selection - Horses to Courses

2008-09-11T17:26:00.005-04:00

This horse-racing expression means a horse should be judged by its suitability for the track on which it will run. Similarly an investment fund should be chosen by a fiduciary based on the context in which it will be used.

When selecting actively managed investment funds, plan fiduciaries should, among other factors, consider the management structure of the funds since academic research indicates that it has an effect on managerial behavior and fund performance. Structurally a fund can be managed by either an individual manager or a team of managers.

According to the study; When Should Firms Share Credit with Employees? Evidence from Anonymously Managed Mutual Funds, the choice of management structure is strategic for the investment fund family and has been steadily migrating through time from individual to team management. This migration can be explained by the migration of star manager to the hedge fund world.

“Between 1993 and 2004, the share of mutual funds disclosing manager names to their investors fell significantly… the choice between named and anonymous management reflects a tradeoff between the marketing benefits of naming managers
and the costs associated with their increased bargaining power. Consistent with this tradeoff, we find that funds with named managers receive more positive media mentions,have greater inflows, and suffer less return diversion due to within
family cross-subsidization, but that departures of named managers reduce inflows, especially for funds with better past performance. To the extent that the hedge fund boom differentially increased outside opportunities for successful named managers, we predict that it should have increased the costs associated with naming managers and led to more anonymous management. Indeed, we
find that the shift towards anonymous management is greater in those asset classes and geographical areas with more hedge fund activity.”

From an investor’s perspective, the decisions of a team managed portfolio are not simply the sum of the individual manager’s decisions. The study; Is a Team Different from the Sum of its Parts? Evidence from Mutual Fund Managers concludes that the behavior and thus the performance of team managed funds are systemically different that individually managed funds.:

“team opinion is the average opinion of the team members. Extreme opinions of members in a team are averaged out and teams eventually make less extreme decisions than individuals do…This holds true for risk taking decisions (total risk, systematic risk, unsystematic risk) as well as for decisions on investment style (value vs. growth, small cap vs. large cap, and momentum vs. contrarian style."

A related study; Team Management and Mutual Funds also concludes that the management behavior of teams and individual managers differ:

“Funds managed by teams exhibit significantly lower (unsystematic) risk than single manager funds and adjust their risk to a lesser extent as response to prior performance. In their investment style teams are less extreme and more consistent over time. Looking at fund performance, we find some, albeit only weak, evidence that team management has a negative impact on fund performance. However, team-managed funds are more persistent in their performance over time. Fund investors seem to care about fund management structure. Our findings show that team-managed funds experience significantly higher inflows.”

As to relative performance, the authors of Performance Characteristics of Individual vs. Team Managed Mutual Funds conclude that:

“funds managed by teams has grown by seven times the rate of funds managed by individuals, there is no significant difference in performance on a risk-adjusted basis. However, funds managed by teams are significantly less risky. In addition to differences in turnover in many fund categories, the total
cost of owning a team-managed mutual fund is nearly fifty basis points lower per year than a mutual fund managed by an individual, on average”

In Horses for Courses: Fund Managers and Organizational Structure, the authors conclude that the individually managed funds might be expected to outperform team managed funds except that the variance drag due to the performance extremes of their idiosynchratic portfolios more that equals the performance potential lost by team managed portfolios due to their more conventional holdings and strategies.

“We find that, consistent with the literature, after we control for investment style, team-managed funds underperform. However, we show that, conditioned on the endogenous selection of team management, team-managed funds outperform single-manager funds. The contrast between unconditional underperformance and selection-conditioned over-performance suggests that the best and brightest managers select into individual management. Consistent with this observation we document rather bland holdings and strategies for team-managed funds. These funds hold more conventional portfolios given their style and also tend to follow investment styles based on generic portfolio investment strategies, such as momentum, book-to-market, and large capitalization stock strategies. These results suggest that institutional design team management, per se, has a positive effect on fund performance. However, this design’s very virtue, restricting managerial discretion, discourages the most talented managers from subjecting themselves to it, leading to the coexistence of team-managed and single-manager funds and only muted differences in performance between them”.

Finally, fitting the horses to the courses:

Team managed funds could be a more prudent fiduciary choice for many participant directed retirement plans since individual investors tend to focus more on performance. Higher volatility investments can trigger counterproductive investor behavior, (ie buy high, sell low). More conventional strategies and lower tracking error can reduce investor and sponsor mistakes and fiduciary risk.
Team managed funds could be a more prudent choice for fiduciaries that do not want to dedicate additional time or skilled resource to the manager selection process. Individually managed funds may provide the potential for higher alpha but require both skill and patience to be identified and retained.
Team managed funds could be a more prudent choice for fiduciaries that do not have the appetite to use a potentially large and diverse collection of investment funds. The high variance associated with any individual managed funds can be mitigated through building a diversified portfolio of volatile funds. Fund diversification can provide an average compound return that is higher than the average return of the constituents because of the reduction in variance drag.

Structural differences in fund management and portfolio construction can have an impact on portfolio performance and should be explicitly considered, along with other factors, in a fiduciary investment selection process

DOL Investment Advisory Proposals

2008-08-28T14:27:00.001-04:00

On August 22, 2008 the DOL published proposals to implement the investment advice provisions of the pension protection Act of 2006. A good summary of the proposals is available here with additional commentary at Benefitsbizblog.

Overall, the intent of these proposals is to make “quality” and “affordable” investment advice more available and more broadly utilized by DC plan participants The proposals were designed to address what the DOL understands to be the primary reasons why plan sponsors have not adopted investment advisory offerings in any meaningful way. Namely, that they have fiduciary concerns about the conflicts of interest associated with many prospective advice providers and that the costs to both sponsor and participants in finding and monitoring purely independent advice could be prohibitive.

According to the DOL, the class exemption was specifically designed to embrace business models that occupy large parts of the defined contribution plan market which wouldn’t qualify under the broader level fee exemptive relief of the PPA. The proposed class exemption significantly expands the scope of the level fee relief by limiting the level fee requirement to the individual adviser, and not applying it to the fiduciary adviser employing the individual adviser. This is beneficial for many of the defined contribution businesses with proprietary fund platforms where the investment advice function and the investment product manufacturing functions are integrated in a single corporate entity.

From a cost perspective, DOL research indicates that a market price proxy for computer driven advice is 10 basis points while in person advice is 20 bpts. Similar IRA services are 15 bpts and 30 bpts respectively. They acknowledges that the class exemptions provide potentially conflicted advisors with access to a large and growing market segment however the tradeoff is that these advisors may be in a position to offer services at low or no direct cost since they may have other revenue and profit streams from a client relationship to subsidize advice provision.

It appears the DOL has tacitly acknowledged that, from an overall individual investor perspective, the gains to be had from customized asset allocation and a consistently applied investing strategy and discipline outweight any potential disadvantages from proprietary product or revenue bias that might slip through the controls and disclosures established in the proposed regulation. Their premise seems reasonable.

However, despite the overall benefit to the minority of advice utilizing plan participants, these arrangements may not gain as much traction as the DOL estimates. This is because plan fiduciaries face additional fiduciary responsibility and more importantly increase their fiduciary risk and exposure to potential litigation by adding advice components to their DC plans. As the majority of plan participants are forecast not to meet their retirement expectations regardless of how well their portfolio’s are managed, providing fiduciary underwriting for this kind of activity carries inestimable and largely uncompensated risk for many plan fiduciaries.

Wal-Mart 401(k) Suit - Benchmark Bias

2008-05-10T10:44:00.002-04:00

A Missouri employee has filed an ERISA fiduciary breach suit against Walmart (Braden vs. Wal-Mart Stores, Inc) for failing to help its retirement plan participants "Save Money Live Better".

The class action suit charges that retail share class mutual funds in the plan were imprudent and unnecessarily expensive since the plan could have qualified for institutional funds and that Merrill Lynch, the Plans Trustee, received undisclosed kickbacks in the form of 12b-1 revenue sharing payments. The issues of fee propriety and disclosure for servicing 401(k) Plans are being addressed by legislators and industry regulators. Whether general practice, as reflected in this case, has been imprudent in retrospect remains an issue for the courts to decide.

The suit also argues that most of the plans investment funds were actively managed funds which cost more and delivered less than either Vanguard index alternatives or a selected sample of low cost Vanguard actively managed funds. Both Vanguard's index funds(slected by fund category)and individually specified Vanguard actively managed funds were used in the suit as performance benchmarks by which to establish the range of participant losses.

Biased benchmarking is undoubtedly one of the largest sources of perceived or marketed "alpha" in the investment industry. We wondered if biased benchmarking might account for some of the alleged participant losses claimed in this case.

We created a composite portfolio using only the actively managed equity funds outlined in the suit(WMT Actual Funds). We weighted the funds based on their proportional assets at 12/31/2007 and assumed all portfolios were rebalanced annually. We were not interested in trying to replicate total portfolio returns using actual cashflows and other funds but simply wanted to compare the Plans actively managed equity fund returns to a similar weighted portfolio of independently selected benchmark indices (Index Benchmark)and to a similarly weighted portfolio using the specific Vanguard funds identified in the suit.

Historical returns for each of these portfolios are presented below:

Portfolio	1Yr	3 Yr	6 Yr	10Yr
WMT Actual Funds	-3.3%	8.3%	7.2%	6.2%
Vanguard Alternative Funds	-5.3%	8.3%	8.3%	10.9%
Index Benchmarks	-5.4%	7.7%	6.7%	4.8%
Vanguard Composites	-4.5%	8.2%	7.3%	6.9%

WMT Funds Outperform Index
While the suit did not specify which specific Vanguard index funds were used as investment benchmarks (there were some categorical discrepancies), a portfolio using independently selected benchmark indices(shown below)for each fund, underperfomed both WMT's actual funds and the alternative Vanguard funds for the periods noted.

Vanguard Funds Outperform WMT Funds
This exercise supports the contention that the specified Vanguard active fund portfolio outperformed WMT's actual funds. However, fund selection bias (having the advantage of perfect hindsight in selecting Vanguards best past performing funds)and some significant style bias (categorical value bias across ½ the Vanguard Funds in comparison to the WMT funds)could account for some of the Vanguard outperformance.

To quantify this we compared the WMT funds to Vanguard funds using strictly identical style categories, to the extent possible (Vanguard does not have a foreign large growth fund). We noted a distinct value bias in the Vanguard active funds. Over the last 6 year performance period in the suit, value has outperfromed growth by a wide margin. In addition, in categories where Vanguard offers multiple actively managed funds, we used an equally weighted composite return of all those funds.

Selection & Style Bias Account for Vanguard Outperformance
These adjustments, reflected in the Vanguard Composite retruns, were intended to correct for style and lookback bias. Based on the results it looks like these biases account for virtually all of the selected Vanguard portfolio's excess returns over WMT's actual fund portfolio.

While there are obvious factual and interpretational limitations to this brief analytic, the point is that the calculation of relative investment gains or losses is unique to the yardstick or benchmark by which they are measured. Benchmarking bias, either intentional or not, can create negative alpha just as easily as it can positive alpha. Plan fiduciaries should not be too dogmatic in their benchmarking. Broadly evaluating absolute and relative benchmarks will provide additional insight into performance perceptions and fidcuiary exposures.

WMT Funds	Vanguard Funds	Vanguard Composite Funds	Index Benchmarks
AIM Intl Grth FLG	Vngd Intl Grth FLB	Vngd Intl Grth FLB	MSCI EAFE Grth(net)
Amer Fnds EurpoPac FLB	Intl Val FLV	Intl Grth FLB	MSCI EAFE
Ariel MCB	Strategic Eq MCB	Strategic Eq MCB	R2500V
Davis NYV LCB	Windsor LCV	G&I & Div.Income	R1000
Frkln SMID MCG	Capital Opp	Cap Opp & MC Grth	R2500G
MFS Grth LCG	PrimeCap LCG	PrimeCap& GrthEq&MrgnGrth&USGrth	R100G

Commodities in Retirement Plans

2008-04-15T17:54:00.002-04:00

In reviewing capital market activity over the last few years it has been impossible for plan fiduciaries to miss the parabolic increase in commodity returns. Global investment in the sector has surged about tenfold in five years, reaching $178 billion in 2007, according to Barclays Capital. Strategic investors must determine if the run up in commodities is sustainable based on long term fundamentals or primarily driven by cyclical factors and speculation. The fundamental argument is that commodities have and will continue to benefit from supply shocks due to an aging and constrained infrastructure and growing global demand from emerging markets, particularly China. Of course, investor’s proclivity to chase returns in the face of a weakening outlook for traditional investments and the rapid development of easy to use products like ETF’s to meet this demand must also account for some of the unprecedented growth in commodities.

The merits of commodities as a strategic asset class are not universally accepted. In an often cited study, Gorton and Rouwenhorst conclude, based on a 25 year review, that commodities offer equity like returns and volatility with a low to negative correlation to bonds and stocks and inflation. These investment characteristics are well aligned with institutional investor’s interest in alternative asset categories, especially as pension and accounting regulations increasingly penalize portfolio volatility. Pension funds have begun to develop meaningful allocations to commodities. Several large public pension plans have adopted commodities mandates. Calpers, the California Public Employees' Retirement System, the largest U.S. pension fund, invested $500 million in commodities last year and expects to increase its allocation substantially.

Yet, historical commodity prices have generally declined over the long term. Long term spot commodity prices have fallen by about 1.5% over the last 100 years according to a paper by Ronald Layard-Liesching. Historically the “roll yield” has been the predominant provider of commodities returns as futures prices were consistently lower than spot prices. In today's world however, spot prices tend to be lower than futures prices for many commodities. Erb & Harvey in a 2006 study "The Tactical and Strategic Value of Commodities" concluded that holding a basket of commodities provides investors with no real (after inflation) return, though they acknowledged their countercyclical diversification benefit.

While there is general consensus about the positive portfolio diversification properties of commodities, the extent and source of their strategic expected returns is unclear. Commodities contracts are conceptually a zero-sum game where the long position can only earn a risk premium at the expense of the short position. There are other factors which should be considered in evaluating commodity returns & characteristics for suitability in a pension plan
• actual commodity index return streams are relatively short. This should be considered in developing a confidence level and reliance on past history as it influences the allocation,
• the risk reduction benefits of commodities are period-sensitive according to some studies,
• high fund fees and high trading costs must be overcome before commodities provide excess returns,
• normal "backwardation", a process which created returns in the last 25 years to protect against inflation may be lost as a broader range of investors bid up prices for inflation protection,
• after several years of double-digit returns, commodities have suddenly become a core asset class,....it must be different this time
• the commodities product market has deepened and become more liquid potentially reducing risk premiums and introducing a more speculative and volatile facet

While commodities appreciation might continue based on both fundamentals and momentum, it has been a very volatile asset class and promises to be even more in the future. Fiduciary investors should develop specific rationale aside from returns for adding commodity exposure to their self managed portfolios. Be it a dollar hedge, an inflation hedge, a hedge on financial assets, a play on global growth or a portfolio diversifier. Though the fundamental premise for allocating to commodities seems sound there is a speculative element in the market that would suggest a strategic allocation should be very carefully considered, implemented over time and modest in relative proportion to real return producing assets such as stocks and bonds.

Given commodities controversial asset class merits, it's recognized volatility and the speculative flavor of today's markets, fiduciaries should use the utmost care and prudence in determining the suitability of commodity investments for participant directed investment offerings.

Other Public Plans Seek to Expand Retirement Coverage

2008-04-11T09:17:00.003-04:00

The State of California is considering a proposal (Assembly Bill 2940) to allow employees at businesses without retirement plans to set up IRA type accounts that would be managed by the California Public Employees Retirement System (CALPERS). The retirement industry questions whether this and other similar proposals are effectively publicly funded subsidies which create an unfair competitive disadvantage for them. The unique details of each proposal may have to be further developed to ultimately decide that question.

What is absolutely clear is that many small business employees are competitively disadvantaged in their ability to save for retirement. They either don't have access to a retirement program or must contend with the debilitating effects of high fees and/or poor investment alternatives.

The small retirement plan market, which seems to be the primary focus for these proposals, is obviously not homogeneous. There are many reasons why employers don’t have plans. The diversity of needs and objectives in this market should accommodate many providers and solutions. The State plans could provide a very attractive solution for certain segments of this market and might simply increase overall retirment savings, not materially displace existing programs. These models could provide a very modest form of self-funded public intervention in very inefficient markets. This has the potential to provide substantially more benefit than downside.

CT Small Business 401(k)/Retirement Plans -SB652

2008-03-31T17:12:00.005-04:00

The reality of the small plan retirement marketplace is that many retirement plan alternatives (both plan structures and service providers) exist, but they can be far from optimal for many businesses. Their characteristics often impede a plan sponsor’s desire to establish them or a participant’s ability to maximize their retirement security through them. The proposed State of CT defined contribution plan could provide a meaningfully superior alternative in the small plan market. It would offer both a “real” competitive advantage to small businesses adopters in CT as well as benefit all small plan sponsors and participants by forcing existing plan providers to “up their game” against a highly visible retirement plan alternative with a strong investment structure.

Since the passage of ERISA legislation over 25 years ago there has been a monumental shift in the country’s retirement system away from defined benefit plans toward defined contribution plans. This shift in retirement responsibility to the individual has been accompanied by substantial technological changes in both retirement plan administration and asset management. Technology, product and process changes have created stunning efficiencies, to the point where the cost to manage and administer marginal increments of retirement assets is probably quite close to zero. Unfortunately, these cost and efficiency advances have been arbitraged primarily to the benefit of sponsors and participants in the larger plan market where the scale and resource has been available to expedite realization of these benefits.

Plan sponsors and their participants in the small plan market are facing their new and highly complex retirement planning and savings responsibilities using a complex patchwork of retirement plan vehicles and an inefficient market of retirement plan providers with legacy fee structures and investment products that can severely undermine their best efforts. The current proportion to which small plans are disadvantaged is hard to quantify because of service bundling, investment subsidization and obscure fee disclosures but a reasonable estimate could be in the range of from .5% to over 2.5%. This includes both the impacts of higher fees and the opportunity cost of investment limitations. Some, though not all, of this inherent difference is artificial, unnecessary and unfair. It continues to exist because of structural inefficiencies in the retirement plan market that small retirement plans can't easily overcome.

Market efficiency is implied by some groups simply based on the fact that there are a multitude of retirement providers trolling the small business community for clients. However, the notion that the mere presence of multiple competitors forces retirement market efficiency presumes that buyers are fully informed, have sufficient experience and resources and the pertinent information to make optimal retirement plan decisions. This assumption couldn’t be further from reality! Despite what ERISA demands of them, plan sponsors, particularly small businesses, often know very little about retirement plan administration and generally assign a higher priority to other business demands that require their time and capital.

Our experience suggests that it is nearly impossible for retirement plan sponsors without specific skills and background to meet the substantial fiduciary burden to acquire, understand and validate all the information that is necessary to prudently evaluate competing service packages as required of them by ERISA. Consequentially, small market plan sponsors, without the resources to hire unbiased experts, often either rely on other far simpler decision making heuristics or potentially conflicted, non fiduciary outside resources. In most cases, they simply avoid the decision to implement a retirement plan all together.

Structural inefficiency in the retirement plan market is propagated by information asymmetry and conflicts of interest.

Plan sponsors often don’t fully understand their fiduciary responsibilities given the highly technical and legal nature of the regulations that bind them. For instance, ERISA imposes obligations on plans and their fiduciaries to “act with the care, skill, prudence and due diligence under the circumstances then prevailing that a reasonably prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.” Trying to derive actionable practice from relativist language like this would be inconceivable for the inexperienced.

Plan fiduciaries must act prudently and solely in the interest of plan participants and their beneficiaries in establishing fees and appropriate services with retirement plan providers. The practices of product bundling, asset-based fees and the utilization of revenue sharing and internal investment subsidies to offset retirement plan provider’s costs of administration has made it very difficult for plan sponsors to fully understand fee structures. This lack of transparency makes an objective evaluation of competing products and services at best expensive and often impossible for unassisted retirement plan sponsors.

Perhaps the most impenetrable exercise for plan fiduciaries is determining which investments to make available to plan participants. The small business employer is responsible for prudently selecting and monitoring investment options made available in the plan. Plan sponsors generally do not possess the specialized skills and information required to appropriately evaluate the quality and potential of investment products offered to them.

Finally principal-agency conflicts infect many small market retirement products which are designed to maximize the vendor’s revenue rather than the best interests of the plan sponsor or participant.

In complex markets, like the retirement plan market, which require specialist knowledge, the arbitrage process, whereby information and efficiency gets broadly incorporated into products and prices, takes years and years. This has not fully occurred in the small retirement plan market. In an inefficient market, prices, products and services do not represent the best value.

In an inefficient market, the proposed State of CT defined contribution program could offer a number of valuable benefits to small retirement plans:

•deliver certain of the technological and structural benefits of administrative and asset management scale,
•deliver a productive, cost effective and well, diversified set of investment options including ongoing monitoring for effectively zero marginal cost
•provide the flexibility and greater benefit of a 401(k) plan in terms of its higher deferral opportunity, potential loan provisions, flexible vesting schedule, a Roth option and no required employer contributions in some cases as required by other simpler plan alternatives,
•provide a well known “brand” that would be attractive to sponsors who would avoid the decision to adopt a plan based on other issues.

The State of CT has a vested interest in helping it small business base become more competitive and its workers as well prepared for retirement as possible. The proposed State sponsored retirement plan could be a unique step in shifting industry dynamics to afford all future retirees, regardless of their employer size, the best opportunity that can make available under current laws, to maximize their retirement security.

Continuing to ignore or subsidize segments of the retirement plan industry operating in an inefficient market is unproductive. Plan sponsor inertia and diverse businesses needs for a range of retirement solutions will ensure that market opportunities will continue to support a wide range of retirement plan employers in the State. The State should move ahead with the proposal based on the fact that it could expand retirement plan coverage in the small employer market.

Selecting Investment Experts - I

2008-03-10T11:24:00.001-04:00

Marc Faber, a noted investor, once remarked “Investors want to believe in an "expert", in the same way the sick will often believe in a faith healer. They want a clear opinion about the future direction of the investment markets, without any recognition of the fact that, at least 50% of the time, deference to such views will lead to significant losses, as, no matter how diligent we "experts" are, we nevertheless remain largely ignorant of the future.”

When investment fiduciaries select investment managers/funds for their portfolios they must address two essential questions. Can expertise in active investment management add consistent value to their portfolio and, if so, what recognizable characteristics can be used to identify that expertise?

Scientific research addressing these questions may help fiduciaries answer these questions. Time magazine ran a recent article The Science of Experience on the value of experience and expertise related to the presidential race. The article distilled the findings of research by Anders Ericsson, a 58-year-old psychology professor at Florida State University, and fellow researchers who have studied the question of what makes people really good at a given pursuit. Their studies have been published in The Cambridge Handbook of Expertise and Expert Performance. This reference is a compendium of studies from over scientists who have studied exceptional performance using scientific methods across a wide variety of domains which included stock picking. In reviewing other references to this topic here and here,the following general conclusions are made:

“The trait commonly call talent is highly overrated”

"Consistently and overwhelmingly, the evidence showed that experts are always made, not born”

“10 years is a necessary minimum to achieve expertise in most fields though it doesn't guarantee success”

"The number of years of experience in a domain is a poor predictor of attained performance."

“practice makes perfect …the amount and quality of practice were key factors in the level of expertise people achieved”

“when it comes to choosing a life path, you should do what you love — because if you don't love it, you are unlikely to work hard enough to get very good”

When it comes to stock-picking the general results may not be that surprising. “Ericsson notes that some entire classes of experts — for instance, those who pick stocks for a living — are barely better than novices".

A specific study on this topic The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets identified in the NY Times Freakanomics blog was authored by Ericsson, Patic Andersson and Ed Cokely. This study provides both good news and bad new for those who want to believe in investment experts. While there is clear evidence that investment skill exists within a subset of investment managers, the aggregate costs of investing overwhelm the aggregate value of investment expertise.

“Our review demonstrates reliable and reproducible effects of consistently superior performance in investment and forecasting even for markets that are consistent with the efficient market hypothesis (Fama, 1970, 1991). With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction ( recently estimated at $100B across the market) are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance.

In identifying investment expertise, the study suggests that specialization in particular industries, strategies or companies are correlated to superior investment performance.

“the superiority demonstrated by expert investors and analysts can be traced to deeper and more accurate knowledge about companies, a finding consistent with evidence from other domains of expertise like accounting and medicine. In fact, virtually all experts are remarkably specialized, such as scientists working on very constrained research problems, elite musicians only playing a limited repertoire on a single instrument, and expert athletes only excelling in one type of sport.

Specialization in particular industries and in-depth (insider) knowledge about specific companies would be recognizable markers related to reproducibly superior investment performance according to this work.

We will provide additional thoughts on the markers of investment expertise in a related post.

The 8% Solution

2008-03-03T19:00:00.001-05:00

Let's say you are using an actuarial assumed return of about 8% for your pension plan... like many other plans in the US. Then, let's say your auditor asks you why?

Give them page 4 of this , not page 18 of this!

Public Pensions - What Crunch

2008-02-28T18:16:00.003-05:00

Municipal pension plans are under pressure as noted in a recent WSJ article Dear Crunch, Wish You Werent Here.

"With interest rates low, stock markets uncertain in the credit crunch and real-estate prices falling, government pension funds are facing a brutal investment climate. As a result, some state and local governments are feeling the heat."

While the dynamic and temporal nature of politics and the disciplines required for sucessful long term pension funding may not always integrate well, the current public pension plan funding situation may not be be as dire as portrayed by funding statistics. The National Association of State Retirement Administrators publishes an annual compendium of public pension plan data that covers 85% of the assets and participants in state and local goverment pensions in the US.

The most recent Survey Summary indicates that funding ratios have declined from over 100% in fy 2001 to 86% in fy 2006. Funding ratio's are usually stated as the ratio of an actuarial value of plan assets over plan liabilities. Actuaries commonly use 'smoothing' or 'averaging' methodologies for public pension plans to calculate an actuarial value of assets, which is intended to make this value less volatile than the market value of assets. Averaging or smoothing is generally designed solely to reduce contribution volatility and improve funding predictability.

The characteristic of a smoothed actuarial asset value for a plan with substantial equity is that it is higher than the comparable market value through bear markets and lower through bull markets. Looking at the pattern of capital market returns over the past 5 years, smoothed actuarial asset values may continue to rise as they phase out the substantial market losses of 2000-2002 and phase in the strong investment gains from 2003.

An exhibit, reproduced above from the study, compares the actuarial asset valuations to market valuations of plans included in the study. The significant number of public plans with excess market value over actuarial value indicates that, all other things being equal, public plans may already have some funding level improvements "in the bank".

Finding the balance between current fiscal needs and funding long term commitments across taxpayer generations remains a distinct challenge for public pension plans. The nature of politics, human behavior and the capital markets virtually guarantee that not all plans will meet the challenge. This should not imply that most wont.

Should Fiduciaries Invest Like Warren Buffet?

2008-02-27T13:54:00.001-05:00

The duty to act prudently is one of a fiduciary’s primary responsibilities under ERISA. With this fiduciary responsibility, there is also potential liability. Fiduciaries who don’t adhere to the basic standards of prudent fiduciary conduct may be organizationally and personally liable for Plan losses. Fulfilling these responsibilities requires expertise, particularly in an area such as investments. Lacking the expertise, fiduciaries should employ professional investment strategies.

In a February 15, 2008 interview with students from Emory's Goizueta Business School and McCombs School of Business at UT Austin, Warren Buffet remarked on investing and the value of diversification.

“If investing is your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your 1st choice. If you have a harem of 40 women, you never really get to know any of them well. Charlie (Munger)and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest.”

Unfortunately, ERISA fiduciary prudence requires diversification to minimize the risk of large investment losses to a retirement plan. Though adequate diversification is not specifically spelled out in ERISA, it would be determined on a facts and circumstances basis using recognized generally recognized investment standards. By example, the Investment Company Act of 1940 provides some guidance on legal diversification and industry concentration. Section 5 of the 1940 Act requires that mutual funds elect to be classified as either "diversified" or "non-diversified". As a diversified fund, the Fund is limited as to the amount it may invest in any single issuer. Specifically, it provides that “with respect to 75% of its total assets, a diversified fund may not invest in a security if, at the time of purchase and as a result of such investment, (1) more than 5% of the fund's total assets would be invested in securities of the issuer of such security, and (2) the fund would hold more than 10% of the outstanding voting securities of such issuer” exclusive of cash and Us government securities. In contrast, a "non-diversified" fund is defined by the 1940 Act to be any fund that is not a "diversified" fund.

This implies that a "diversified" fund would have a minimum holding of at least 20 investments. Other studies suggest that 90% of the benefit of diversifying against unsystematic or stock specific risk would be derived from portfolios holding 15 – 20 stocks.

“Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet”

Good investment governance relies on establishing investment performance benchmarks. However, fiduciary benchmarking processes can serve to “pull the rug out from under the feet of fiduciaries”, turning quotational or unrealized losses into realized losses. This happens on a fairly regular basis as fiduciaries exit investments for not meeting performance benchmarks. The reference benchmarks are often not reflective of the nature of correlated investment. Benchmarking is particularly ineffective for concentrated portfolios which contain substantial unsystematic risk such as WB's. In these cases, fiduciaries are forced to choose between either not employing a significant procedurally prudent process or ignoring its results. Neither option would be very defensible in the event of a poor investment outcome.

Despite his extraordinary success, fiduciaries would have to think long and hard about their exposure before singularly employing Warren Buffet's unique investing strategies.

“If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. The economy will do fine over time. Make sure you don’t buy at the wrong price or the wrong time. That’s what most people should do, buy a cheap index fund and slowly dollar cost average into it. If you try to be just a little bit smart, spending an hour a week investing, you’re liable to be really dumb.”

CT Small Business 401(k) Plan

2008-02-21T10:07:00.001-05:00

Pioneering legislation has been proposed in the State of Connecticut which would allow the State to provide 401(k) plans for; small companies with less than 100 employees, non profit organizations and the self employed. The proposal is designed to reduce plan administrative costs for small businesses by leveraging the existing employee base and purchasing power of the State of CT. The State of CT offers a very attractive defined contribution plan for state employees. This model might be extended to small employers to make their retirement benefits more competitive with larger organizations.

Retirement investing is not a statistical “fair game” for many small investors and retirement plans because of a fragmented market, information asymmetry and principal/agency conflicts. These biases virtually guarantee that investor’s interests are subordinated to the interests of a cornucopia of providers and intermediaries in that market. Large retirement plans have the investment and financial resources to manage these issues. Small market retirement plans typically aren’t aware of the issues and may not have the time or resources to effectively manage them.

Small market 401(k) plans have been underserved and subject to pricing and servicing inefficiencies. Efforts to deliver lower costs, more independent investment expertise, disciplined quantitative investment processes and fiduciary best practices to smaller retirement plans could substantially improve the level of retirement sufficiency for many.

Managing Investment Uncertainty - A Fiduciary Requirement

2008-02-17T09:14:00.001-05:00

Managing uncertainty is an investor’s primary occupation. In scientific models uncertainty is categorized as either aleatory or epistemic. Aleatory uncertainty refers to random errors or, for our purposes, the random variations inherent in capital markets. “Random walk” in the markets cannot be reduced by evaluating more data points or having better information. Its role can be managed, though not eliminated, by basic statistical concepts of variability, probability and expert judgment. On the other hand, epistemic uncertainty or systematic errors stem from a lack of knowledge, inaccurate or incomplete information or flawed models. Systematic bias, which we refer to as selection bias in the investing process, can be either informational or procedural in nature.

Selection bias can distort the conclusions drawn in investment evaluation based on the way investment data is calculated, presented, evaluated or processed by investors. Selection bias probably accounts for a significant amount of investment under-performance as well as fiduciary risk. The prudent expert standard of care required of investment fiduciaries accommodates uncontrollable randomness in markets. It does not tolerate preventable selection bias. A requisite level of knowledge, information and analytical process necessary to overcome selection bias is required of investment fiduciaries. A sample of selection biases include:

Branding Bias - investors often use brand as a heuristic in their investing decisions since the indicia of investment quality are not readily apparent. Marketing studies show that familiar brands have an advantage in competitive, commodity like markets. Branding reinforces recognition and can become a “proxy for quality” in complex products like investments. Icons for investment quality, such as fund ratings, conspire with product branding to bolster investor’s perception that investment quality & suitability can be evaluated at a glance. Minimal diversification of investment managers in products or investment programs can indicate branding or other selection bias.

Universe Bias – many investors are presented with investment fund universes that have been pre-screened to facilitate their investment selection. In general, the best attainable portfolios in terms of risk/return efficiency are diminished when investment universe constraints are imposed. Our experience suggests that constrained fund universes can reduce diversification benefits and potential alpha. Since optimal investment selection can be subverted by other interests in investment screening, fiduciary investors have an obligation to understand any economic or quantitative selection biases that have been applied to their investment selection universe. Open fund architectures provide a richer palette from which to build efficient portfolios.

Fee Bias - there is significant regulatory and legal activity around fee presentation & disclosure in the 401(k) domain. The prevailing bias has been to bundle investment, administration and intermediary fees into net returns and provide disclosures about the bundled fee components in collateral literature. The majority of investors don't/won't read collateral no matter how simple. What investors will react to are explicit detailed service charges on their quarterly statements. When it is clear to investors that they are purchasing services, they will be more motivated to ensure they and their plan sponsors are purchasing efficiently. In other sectors of the economy such as healthcare, where consumers have choice and can control cost, falling costs and increasing productivity follow.

Benchmarking Bias – benchmarks are an important investment policy tool used to determine relative performance of portfolios and investments. To provide relevant information, a benchmark should be a viable passive investment strategy and it should have similar asset class and styles proportions as the implemented fund/portfolio. Improperly constructed benchmarks lead investors to mistake beta for alpha and under-performance for out-performance. Our research suggests inappropriate benchmarking is a large source of phantom “alpha” and selection bias in investor portfolios. Use of customized style benchmarks, benchmark correlation testing and timing/selection performance attribution are indicative of processes designed to overcome this bias.

Performance Presentation Bias – What investors see depends on what they are shown. Cumulative returns (i.e.1, 3, 5 year) can suffer from return smoothing and “endpoint bias”. Cumulative compound annual growth calculations smooth out returns through the time period. Any significant excess performance creates the illusion that the fund has consistently outperformed and hides characteristics such as return consistency and volatility which should be important to investors in setting ex-ante return expectations. Similarly, the particular time periods and starting points for which investment performance data is shown can drastically alter investor’s perception of fund quality. The ubiquitous presentation of cumulative investment returns can disguise more than it can reveal. Use of rolling return periods, backward graphing, annual period return evaluations and a mosaic of other statistical performance information can help investors overcome data presentation biases.

Fiduciary investors can’t overcome random bias in the capital markets. However, a prudent expert standard of care compels them to overcome systematic uncertainty, such as selection bias, in their investment decision making. Selection bias is rooted in low levels of investor awareness and knowledge. It can be propagated through behavioral manipulation and statistical artifices which pander to investor’s desire for simplicity. Evidence of selection bias is obvious to a prudent expert and therefore represents a source of risk to investment fiduciaries. Mitigating this risk can be as simple as opting out of the selection process by utilizing a passive investment strategy or investing resources in improving the investment selection process.

Retirement Annuities - Investments or Insurance

2008-02-13T13:21:00.000-05:00

Several recent studies have pointed out the economic value and higher adoption rate potential for deferred retirement annuities (“DRA”). These are annuities which could be purchased prior to or at retirement and would commence paying income at a predetermined age later in retirement. Their cost would be a fraction of an immediate annuity and their product characteristics could help overcome some of the behavioral obstacles to annuitization.

Economic and quantitative based research indicate that immediate annuities provide the most “utility” for retirees by helping them smooth the consumption of resources over their lifetime, unconstrained by limited lifetime resources. However, historical annuitization rates have been very low. Unfair actuarial costs, a high liquidity premium and framing are thought to account for this economically irrational behavior.

Unfair actuarial cost - George Akerlof and other researchers propose that adverse selection in the annuity markets contributes to this puzzle. Adverse selection arises due to information asymmetry. Individuals know their level of risk but the insurer does not. This informational advantage motivates “bad risks” to annuitize, thereby driving up costs and prices which in turn repel “good risks”. A Deferred Retirement Annuity, while still subject to adverse selection, could broaden the insured pool using the intuition that the smaller the financial bet needed to annuitize, the more individuals with average mortality would voluntarily annuitize. Greater institutialization of products that include this component could reduce biased actuarial costs.

Liquidity premium - Individuals apparently assign a very high premium to the liquidity inherent in a lifetime savings portfolio. In approaching an annuitization decision, the cost of foregone liquidity is often perceived to be much higher then the risk of poverty should they outlive their retirement savings. One estimate of the cost to give up liquidity and earnings potential for longevity insurance was between .25% and 1.55% per year. Gong & Webb in their 2007 study calculate that: “a household planning to smooth consumption through its retirement would need to allocate only 15 percent of its age 60 wealth to an ALDA with payments commencing at age 85, holding the remainder of its wealth in unannuitized form to finance consumption from age 60 to 85”. A cost shift of this magnitude could make annuitization a relevant choice for many more individuals.

Framing - Brown, Kling, Mullainathan and Wroble focused on the behavioral aspects of this decision in their 2008 study. They suggest that the investment context in which annuitization is often presented could be a source of its rejection. “Survey evidence is consistent with our hypothesis that framing matters: the vast majority of individuals prefer an annuity over alternative products when presented in a consumption frame, whereas the majority of individuals prefer non-annuitized products when presented in an investment frame”.

Annuitization seems to be most often approached in the financial planning process as an alternative investment decision where payback periods and returns depend largely on how long an individual lives. Similar to Social Security in that it has a large insurance component, both are often evaluated based on their investment breakeven payback rather than for their insurance or consumption utility. It seems likely that a partial annuitization would more easily be framed and accepted by individuals as an insurance or consumption decision where the payment is akin to an insurance premium rather than a capital investmnent.

Deferred Retirement Annuities could mitigate a significant and individually unmanageable risk for retirees (longevity). They could also provide the psychological comfort of maintaining a liquid asset pool and reduce the potential risks of inappropriate consumption through a fixed term spending period. The choice to meld an insurance component with an investing component in retirement plans would be superior to 100% of either option for many individuals.

Retirement Planning - Playing Catch-Up

2008-02-10T11:42:00.000-05:00

“Economics is premised on the assumption that choices reveal true preferences—that the choice of A over B indicates that the individual will in fact be better off with A rather than with B. If consumers' choices are to a large extent arbitrary, then the claims of economists that free markets will lead to maximum well-being are substantially weakened. Market institutions that maximize consumer sovereignty need not maximize consumer well-being”. Dan Ariely – Behavioral Economist. MIT Advisor to BoulevardR

There is abundant academic and empirical evidence suggesting the shift to consumer driven retirement will not optimize consumer well being due to behavioral impediments and generally low investment interest and acumen. This issue is well recognized and has been partially addressed by regulators and the retirement industry via “fiduciary immunization” for automated contributions and prepackaged lifecycle driven investment products. 401(k) plan auto-enrollment and utilization of target retirement funds can overcome some level of investor inertia with regard to savings and investment decisions. However, these tools are limited in their ability to ensure retirement sufficiency across a wide range of investor circumstances and preferences.

Retirement planning is the process by which individuals specific circumstances and goals are used to bring retirement inputs (savings levels, investing strategies, retirement age) into equilibrium with their retirement outputs (retirement lifestyle and duration). Since this process is self initiated, inherently complex, costly to outsource and requires effort to collect collateral information, it is avoided by many individuals. To avoid triggering investor’s avoidance behaviors, many retirement planning tools available on the web seek relatively little input. Basic age, salary, savings, income goals & investment /inflation assumptions are required to provide an estimate of retirement savings needs. Beyond merely creating an awareness of potential retirement funding gaps, the realistic shortcomings of these tools may exceed their value.

A new generation of web based retirement planning tools is emerging that may better bridge the gap between ease of use and utility of results. For instance, Boulevard R has developed a “lifestyle driven” retirement planning tool. The tool begins with an intuitive retirement goal setting front end that can be easily customized by users. Developing appropriate saving & investing decisions through identifying specific “lifestyle” cash flow liabilities is consistent with institutional pension planning disciplines. Boulevard R then solicits other cash utilizing goals along with basic census and financial data before providing a picture of retirement sufficiency. The tool encourages and facilitates planning iteration, which is absolutely essential in providing individuals with a feel for the leverage and variable implicit in their assumptions.

Boulevard R’s underlying assumptions were mostly transparent and reasonable. With regard to investments, very few institutional investors use an average historical equity return assumption (10%-11%) as a go forward estimate. Additionally, lifestyle driven investing conventions suggest a post retirement investment earnings estimate of 8% is quite aggressive.

Nevertheless, BoulevardR seems to combine strong technology, a basic though robust retirement planning structure and principles of behavioral economics to create an engaging and useful retirement planning product for those who are neither detail analytics or financial advisor outsourcers. Continued progress in this direction and for this particular audience will be necessary for a successful transition to consumer driven retirement.
Note; Matt Iverson, BoulevardR co-founder, responds & expands via comment

LDI - Lifestyle Driven Investing

2008-02-08T11:57:00.000-05:00

January’s equity sell-off and interest rate declines sparked a resurgence in the topic of LDI or liability driven investing. LDI employs pension plan liabilities as a performance benchmark rather than the traditional total return measure using indexed assets. The fundamental argument for LDI is that real economic risk eminates from a mismatch between the correlation of a plans assets and liabilities. Correlation mismatches create volatility in Plan funding and sponsor balance sheets. Sponsors have a strong preference for stability and certainty in both these areas. The decision to seek stability has a trade-offs. The primary one is a reduction in long term returns by shifting from an equity based total return strategy to a fixed income based LDI strategy. Stability effectively costs returns. The fundamental concepts behind LDI and the stability vs. return tradeoff is equally applicable to individual retirement planning. There are at least several elements that individuals must employ to follow an LDI “lifestyle driven investing” strategy.

Identify the Liabilities – Since future liabilities are the benchmark, a good approximation must be available. Actuaries prepare these for pension plans. The plan liability analogue for an individual would be their required post retirement income need. These are the “liabilities” an individual must fund. Individuals often don’t solve the savings and investing equation for a specific required retirement income need. They simply let their retirement liabilities emerge, constrained as a byproduct of their earlier savings and investing decisions. This is backwards and inconsistent with LDI. To apply lifestyle driven investing, individuals must specify their lifestyle “liabilities” in terms of both required dollars and duration (longevity). Lifestyle Driven Investing requires starting with the end in mind.

Identify Acceptable Lifestyle Volatility - Pension plans can choose from a full spectrum of investment strategies to fund their liabilities. High equity strategies at one end of the spectrum provide the promise of lowest long term cost via the maximization of the equity return premium. The cost of this strategy can be significant funding and balance sheet volatility for the sponsor. On the other end of the spectrum, pension plans can match their liability cash-flows with corresponding fixed income assets or derivatives to effectively immunize plan surplus from changing interest rates to stabilize their funding and accounting. This reduces the volatility related to asset liability mismatches but leaves the sponsor with more out of pocket responsibility for funding the Plan.

Lifestyle Driven Investing presents similar tradeoffs in retirement distribution for individuals as pension plans face in their funding decisions. Individuals can choose a higher long term retirement lifestyle or a lower, but more certain periodic lifestyle. Equity investing will allow individuals to enjoy a higher long term post retirement lifestyle (i.e. higher average income or longer average duration) with perhaps more volatility with regard to the timing of periodic distributions. In good market years individuals can withdraw more while in poor market years individuals should withdraw less. Lower risk fixed income investing can provide more certainty around distribution patterns but at a cost of a lower average lifestyle (ie less income or shorter duration).

Lifestyle Driven Investing calculus simply suggests that certainty has cost. If individuals have more flexibility in their retirement decisions (when to retire, annual spending), they should be equity investors and can enjoy an elevated retirement lifestyle.

International Diversification

2008-02-07T06:47:00.000-05:00

Evidence continues to support the value of international equity investing, despite higher correlations due to globalization and the integration of the global financial products markets. However, January 08 returns (US -Russell 3000 -6.1%, MSCI World ex US -9%) tend to confirm that, in market downturns, when investors want the benefits of covariance the most, markets become highly correlated.

A Wharton School study on international diversification suggests" the average small-investor portfolio has 10% to 12% of its equity investments committed to foreign stocks". This might underestimate investors international exposure by the significant foreign equity allocations that many funds, categorized as US equity funds, have made on behalf of their shareholders. It also may not account for the surge of cashflows into international funds in 2007. Of an aggregate $950B in 2007 flows, a net $200b was in international vs. a net -$.60B in US equity. $600b went into money market funds.

Regardless of the statistics, the fundamental intuition behind the value of international investing is that investors gain by effectively doubling their investment opportunity set.

Longevity Securitization

2008-01-31T13:10:00.000-05:00

These days 401(k) investors are focused on what they perceive to be their largest risk ….the risk that that their investments will lose value. In fact, many are unaware that a much larger risk looms....longevity risk.

Longevity risk is the risk of either under-living or outliving their planned asset base/income stream. As the level of defined benefit plan, longevity- protected, distribution streams fade and the baby boomer cohort faces retirement, the demand for individual annuities, which address this risk, will probably increase. The adoption rate of retirement annuities will however, be influenced by; investor perception, pricing, insurance industry risk retention models and the state of the structured investment markets.

As demand for individual annuities increases, insurer’s capacity to handle this exposure is ultimately limited by a risk warehousing approach and by industry capital requirements. Just as the securitization phenomena allowed banks to increase their underwriting capacity and disintermediate mortage risk, so securitization of longevity risk could attract more capital and provide a lower priced more flexible annuity product than is available today.

Advancements in capital market solutions and tradeable indices for longevity risk could contribute substantially to defeasing one of the most significant risk transfers from the demise of the defined benefit retirement model.

Fiduciary Challenges II

2008-01-29T17:11:00.000-05:00

Market events in 2007 reinforced that simplicity can be a valuable attribute of an effective fiduciary investment strategy. In today’s capital markets virtually any income stream can be transformed into an asset class. Financial engineers have found it lucrative to reformulate and leverage common risks into complex alternative asset structures with supposedly superior investment characteristics. The complexity of these structures leads to information asymmetry which is an uneven distribution of information to the parties at risk. This enables risk premiums to be transmogrified into much more attractive “alpha”.

The current mortgage credit crisis is an obvious example of how complexity and information asymmetry worked against investors. The “excess” return in structured mortgage products was, in fact, compensation for the unlikely event that the mortgages would default. As it turns out , the cost of this uncompensated tail risk could be quite high. Investor’s faith that sophisticated global banks and money managers properly understood and were managing these risks was obviously misplaced. Moody’s Investor Services warned that “the complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined, probably forever”.

Fiduciary responsibility and prudence has long required a detailed evaluation of under-performance. In the future, fiduciaries may have to be just as vigilant about examining the true nature of out-performance. Despite all the financial innovations, the most significant risk and return generator for most portfolios remains common stock. Managing the extent and concentration of that exposure is still one of the most important and consequential fiduciary responsibilities. The single strategic decision about how much stock to have in a portfolio should occupy the majority of an investment fiduciary’s consideration since it alone can determine much of the outcome of the portfolio.

Investors who understand and implement a prudent investment process will be sucessful, in at least a relative sense, in part because the utilization of a disciplined process will help them take advantage of the benefits available to long termism and escape some of the pitfalls inherent in investment complexity. While this seems simple…it is not easy. It requires patience, self restraint and the discipline necessary to overcome strongly ingrained instinctive behaviors.

Target Retirement Funds - Home Squeezed or Heart Healthy

2008-01-27T15:07:00.000-05:00

The Target Retirement Fund is a recent investment product innovation that fulfills a basic need for a simple, professional lifecycle driven asset allocation for uninvolved investors. It promises to provide a healthier financial retirement. From a marketing and product development perspective, an analogy can be drawn to a basic consumer commodity…orange juice. The primary virtue of orange juice is its high vitamin C content which helps the body fight infections like colds and is essential for tissue repair as well as wound and bone healing. It promises to provide a healthier physical lifestyle.

For both products, innovation in product development and marketing is a key factor in driving sales and revenue for the seller. The differentiation of products (target retirement funds or orange juice) by key features and minor details is an important strategy by which sellers both promote their brand and defend their fees. Yet these innovations may have limited realizable marginal benefit for consumers while in aggregate substantially complicating their selection decision making.

In selecting and evaluating Target Retirement Fund’s, fiduciaries are effectively faced with a “walk down the orange juice aisle” where product selection has become impossibly complex due to the phenomenal growth of brand extensions. For instance, Tropicana alone offers these choices; Original with No Pulp, Homestyle with Some Pulp, and Grovestand with Lots of Pulp. Calcium + Vitamin D with No Pulp, Grovestand (Lots of Pulp) with Calcium, Organic Orange Juice, Orchard Medley, Fiber, Low Acid, Healthy Heart, Healthy Kids, Antioxidant Advantage, Light n Healthy with Calcium, Light n Healthy with Pulp and others.

Target Retirement Funds are offered under different brands by competing firms. They fulfill the same basic need but typically do not have identical features. The differential features of Target Retirement Funds include their; core asset allocation and asset class diversification, equity glide paths and the investment structure by which the funds are implemented (active vs. passive investments, proprietary vs. sub-advised managers).

Because of the substantial variation in how Target Retirement Funds can be developed and implemented, it has been difficult to establish general standards and benchmarks by which fiduciaries can objectively measure the value of each fund’s distinctions. The industry is focused on this question and at least several firms have addressed the Target Retirement Fund benchmarking. Capital Group and Vanguard both offer some alternative thinking on approaches. An obsession with developing the perfect Target Retirement Fund benchmark can be somewhat academic however.

Given the single age based risk parameter and average investor assumptions upon which these funds are based; intrinsic investment uncertainty and the relevance and dispersion of individual investor circumstances probably far out-weight any additional ex ante performance improvement that can be developed via a better benchmarking process. Target Retirement Funds can be a good investment solution for everybody but can never be a perfect ex post investment solution for anybody, regardless of how well they are constructed.

While random selection is perfectly acceptable in the orange juice aisle, it is not quite that simple for fiduciaries selecting Target Retirement Funds. However, by following some basic selection criteria, (such as reviewing funds from reputable firms, with low costs, good asset class diversification and a reasonable equity roll down), fiduciaries should be able to avoid the investment equivalent of a Sunny Delight.

No Fiduciary Mulligans

2008-01-23T12:14:00.000-05:00

Many unsuspecting investment fiduciaries will be forced to pick up some pieces of their portfolios resulting from the breakage of the housing bubble and the structured investment and credit market collapse. While most prefer to spend their resources looking ahead, all should look back over this episode and try to learn something about they can improve of modify their investment philosophy and/or investment allocation and selection practice.

The Federal Reserve Bank of New York recently hosted a Liquidity Conference to go through this process. Reflective fiduciaries can take advantage of some esteemed thinking in this area. I have provided 3 examples of work that can be found at their conference site.

Understanding the Subprime Mortgage Crisis

"We find that during the explosive growth of the subprime market in 2001-2006 the quality of loans monotonically deteriorated and underwriting criteria loosened. In this respect, the rise and fall of the subprime market resembles a classic
lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. We show that the
problems in the subprime market were imminent long before the crisis in 2007, securitizers were to some extent aware of it,
but a high house price appreciation in 2003{2005 masked the true riskiness of subprime mortgages."

Understanding the Securitization of SubPrime Credit

"In this paper we provide an overview of the subprime mortgage securitization process and the seven key informational frictions which arise. We discuss how market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how the rating agencies assign credit ratings to mortgagebacked securities, and outline how the agencies monitor the performance of mortgage pools over time."

What Happened to the Quants provides the following conclusions:

"A small random shock in the global financial system can propogate rapidly"
"certain hedge funds and investment strategies may be more correlated than assumed", and
"regulations and registration may not address the systemic risks that hedge funds pose to the global financial system"

Unfortunately, fiduciary responsibility doesn't provide for mulligans. Fiduciaries should take full advantage of the unique clarity that is only provided by direct experience and hindsight to understand what happened to their investments. This will yield dividends in their futre decision making process.

Mediocrity - A Superior Investment Strategy?

2008-01-19T12:08:00.000-05:00

Investment selection and monitoring is an important responsibility for investment fiduciaries. The investment vehicle of choice for most investment fiduciaries will be a diversified investment fund managed by either; a bank, an insurance company or an investment advisor registered under the Investment Advisors Act of 1940. Investment selection is subordinate in terms of impact to the asset allocation decision for fiduciary driven investment plans such as defined benefit plans but of central importance to fiduciaries of participant driven investment plans such as 401(k) plans.

The investment selection decision tree first branches at the choice between using actively managed funds or passively managed funds. Utilizing a complete array of market based index fund alternatives requires low fiduciary maintenance and provides minimal fiduciary exposure and a highly reliable opportunity for "average" investment outcomes. In practice, institutionally managed portfolios have long recognized the benefits of supplying at least a portion of their portfolio's "beta" or market exposure via these low cost funds. Most fiduciaries understand the basic value proposition for index funds.

In electing to utilize actively managed funds, fiduciaries are implicitly acknowledging a belief and a desire to accept additional risks in return for the potential to outperform a market index on a fee adjusted and risk adjusted basis. The historical returns based decision making criteria broadly used by fiduciaries to profile, differentiate and select actively managed funds is woefully inadequate. It does little to help them understand what risks may be present in the Fund or help them set reasonable performance expectations as they monitor the fund prospectively.

While there are many complicated statistical tools and fundamental characteristics that fiduciaries can use to guide their active fund selection process, one simple attribute to examine is portfolio concentration. Portfolio concentration refers to the number of individual holdings (stocks or bonds) in a fund. The general rule is that the more concentrated the fund (fewer holdings) the more volatile its returns will be, both on an absolute basis (measured as standard deviation) and relative to a benchmark (measured by tracking error or volatility in returns relative to the benchmark). Whitney Tilson, a concentrated value manager describes the arguments behind both highly concentrated and more diversified investment approaches in an FT article.

Simply put, the impact of having an investment decision turn out to be right or wrong in a concentrated portfolio is much higher than in a more diversified portfolio. The degree of appropriate fund concentation depends principally on the fiduciaries confidence in the manager as well as the context in which the fund is offered. Investment fiduciaries whose prime objective is to limit the potential for large losses, would need to have a much higher confidence level (or have a lower overall allocation) in choosing a manager of a concentrated fund over a manager of a more diversified fund given the magnified impact of any bad investment outcome.

In terms of context, a concentrated fund might be suitable (or, in fact, preferable) as part of a carefuly managed portfolio where unique manager specific risks due to concentration are diversified with other non-correlated concentrated funds (ie a concentrated portfolio
fund of funds). From a fiduciary perspective, concentrated funds may be least suitable as part of a participant selected offering such as a 401(k) plan. The performance volatility of many concentrated funds make them difficult to satisfactorily maintain under most general investment policy performance criteria. In addition, higher performance volatility invites irrational investor behavior (sell low buy high) which can be detrimental to long term wealth accumulation.

There is no free lunch in the sense that tracking error & volatility must precede excess returns. Investment fiduciaries however face assymetric risk & rewards. There is significant fiduciary exposure for exposing a portfolio or its investors to downside risk and "unsuitable" diversification. There is little reward for providing opportunities for upside return.

We agreed with Whitney that "the level of diversification exhibited by many mutal funds - holding 200-300 stocks" - can be a "form of closet indexation that invites mediocrity". Yet , diversification can be a post hoc fallacy with regard to mediocrity. Will Danoff is an example, amongst others, of managers who can rise above mediocrity with a very diversified portfolio.
In fact, mediocrity of this calibre, is often superior from a fiduciary standpoint. It reduces the chance of a major loss and with lower volatility than a concentrated portfolio reduces the opportunity for behavioral mistakes that can ruin a long term investment strategy.

Fiduciary Challenges I

2008-01-18T10:48:00.000-05:00

In 2007 we witnessed increased market volatility, greater dispersion in returns and fallout from innovations in financial engineering and quantitative finance. These conditions intensify the challenges that face investment fiduciaries, particularly with regard to maintaining a long term investment perspective and appropriately utilizing new products that seemingly offer risk-less portfolio enhancements.

While managing a long term investing strategy is not synonymous with doing nothing, it has many advantages over a process which is predominated by a series of short term oriented decisions. As Jack Gray, a strategist from Grantham, Mayo & Otterloo put it “long-termism is not a panacea for investment decision making, nor is it a paragon of investment virtue, but it does offer some advantages over short-termism, namely better predictability, lower risk and lower cost[i]. Jack noted that barriers to long term commitment are plentiful and can be rooted in psychology and organizational behavior.

Psychologically, investors can fall into many cognitive traps. Over-reliance on data such as historical returns and believing the future will look like the past are perhaps the most common. As Ray Dalio, founder of Bridgewater Associates noted recently, with the quantum leaps in technology it is very easy to see what would have worked in the past and then lever up and over optimize those relationships. Leveraged bets on the safety and consistency of mortgage spreads over Treasuries cost billions in financial losses, jobs and organizational reputations in 2007.

Organizationally, fiduciaries should understand that while doing nothing is not responsible performance, neither is feeling compelled to adjust their portfolios to compensate for current market conditions. We have been conditioned to expect that successful meetings result in specific outcomes (usually decisions and action items). However, fiduciary committees should feel most accomplished when they think more than they act. Generally…but not always, the option to do nothing should be their favorite option. While reacting to short-term market fluctuations can often be financially destructive, fiduciaries should not feel guilty about adjusting an investment strategy based on well reasoned short term signals that may have long term relevance. Those fiduciaries who reacted quickly to the substantial realignment in the credit markets this summer seemed to have fared the best.

[i] Avoiding Short Termism in Investment Decision Making -, Jack Gray, CFA Publications December 2006 Presnetation avaiable here

Capital Markets 4th Quarter 2007

2008-01-16T13:00:00.000-05:00

Concerns about the economic and financial risks associated with continued deterioration in the US housing market and a revitalization of the credit crisis during the fourth quarter drove losses in the equity and corporate debt markets while Treasury bonds rallied as investors fled from risk and uncertainty.

Asset prices recovered early in the quarter from midsummer’s credit panic as investors believed the Fed’s liquidity intervention in mid September and large write-off’s by bewildered bankers would substantially address the deteriorating credit and liquidity conditions. However, a substantial new batch of mortgage related downgrades along with escalating oil prices (57% increase in 2007) and an emerging picture of slowing corporate earning growth soured investor sentiment and depressed most market indices for the remainder of the year.

Global stock market results were heavily influenced by troubles in the credit markets for the quarter, though strength in international markets helped US investors and large US companies. Overall, US stocks lost -3.3% for the quarter per the Russell 3000. Full year stock returns were 5.14%, as growth outperformed value for both the quarter (-0.88% vs. -5.91%) and the full year (11.4% vs. -1.0%). Export exposed large capitalization stocks continued to outperform small cap stocks as the Russell 1000 outperformed the Russell 2000 for both the quarter ( -3.2% vs. -4.6%) and the full year ( 5.8% vs. -1.6%). Large capitalization companies derived about 44% of their revenue from overseas sources according to S&P. Financials, which is the largest capitalization weighted sector in the S&P 500 (17% weight at year end vs. 22% at the beginning of 2007), lost -15% for the quarter while energy, the best performing sector, gained only 4.1% for the quarter.

Sector performance generally followed the geographic exposure theme. Energy (32%), materials (20%) and technology (15.5%) were supported by strong international demand while financials (-20.8%), housing , real estate and consumer discretionary (-14.3) were stunted by domestic issues. Utilities (15.8%) traded as a higher yield alternative to bonds. Commercial real estate peaked early in the year and softened significantly through the rest in the face of tightening credit. The NAREIT index lost -12.0% during the fourth quarter, ending the year down -17.8%.

International stocks outperformed the US for the fifth straight year based on stronger growth prospects and a US dollar that reached new all time lows during the quarter. For the fourth quarter the MSCI EAFE lost -1.7% but ended the year with an 11.6% return, almost doubling those of the US. Amidst generally lackluster European returns, Germany stood out with a 22% annual return while Japan lost -4%. Emerging markets continued to benefit from the perception that their strong economic growth would be sustainable in the face of a global developed market slowdown. Emerging-markets stocks returned 3.7% and 39.8% for the forth quarter and full year respectively. Emerging markets overtook the US on a price/earning ratio basis this year. Net redemptions for U.S.-stock funds totaled nearly $31 billion, the highest outflows since 2002, while funds investing outside the U.S. enjoyed net inflows of $100 billion in 2007 per Bank of America.

High quality bonds for the most part had a strong fourth quarter, though spread products were challenged as the price of risk returned and spreads widened. The risks implicit in the “originate and distribute” model of mortgage banking became apparent this year. Structured investments became the markets “hot potato” as investors could not track how losses due to sub-prime mortgage related delinquencies, which rose to 16% in 2007, were distributed through these products. SIVs – a banker’s structured “sleigh of hand” to avoid regulatory capital requirements, came under further pressure as their funding source in the commercial paper market seized up. As a result, investors fled to the safety and security of US Treasuries driving their yields down for the quarter. Even safe havens such as enhanced cash funds and money market accounts became unsuspecting victims as the market for AAA short term collateralized issues sank.

Despite the fact that inflation appeared to be ascending, long duration Treasuries outperformed stocks and other domestic bond sectors for the year. Annual inflation growth was at a 17 year high of over 4%. The Lehman US Treasury Long Index returned 5.7% for the fourth quarter and 9.8% for 2007.

The lack of bond supply and strong demand no doubt offset an expected inflationary premium priced into bonds. Investment grade bonds had a good year, returning 3% for the quarter and 7% for the year per the Lehman Brothers Aggregate. The dispersion in returns across bond managers and bond index funds was high as individual credit positioning and mortgage exposure had a large impact on performance. The cost to buy credit protection also rose significantly through the fourth quarter. As spreads widened, high yield bonds lost ground, returning -1.1% and 2.2% for the fourth quarter and 1 year periods respectively.

Alternative 401(k) Plan Structures

2007-06-07T13:25:00.000-04:00

Zvi Bodie has made a number of concrete recommendations to improve the structure of Defined Contribution Plans:

"First, to enable participants in employer-sponsored 401k-type plans to hedge minimum levels of retirement income, employers should offer inflation-protected annuities in the plan.

Second, advisors should explicitly take account of the individual's willingness to postpone retirement in suggesting an optimal asset allocation. The greater one's willingness to continue working past the expected retirement date, the greater the proportion of one's assets should be invested in stocks.

Third, sponsors of self-directed investment plans can enhance the risk-reward opportunities available to investors by offering option like securities or contracts as an additional asset class. These assets can provide a means of leveraging participation in stock market gains while protecting one's minimum standard of living."

SRI in 401(k)

2007-06-06T12:53:00.000-04:00

The Social Investment Forum commissioned a study to benchmark socially responsive investing in Defined Contribution Plans in the US. The study provides; a current perspective on the popularity of SRI (19% of DC plan sponsor respondents currently offer 1 or more SRI options), It may be worth considering whether the studies conclusions are representative of the market given the respondent base was only 129 plans however, other useful information in the survey included an outline of fiduciary legislation and interpretation on the issue of SRI (SRI options are acceptable within ERISA plans though the same requirements for due diligence apply to SRI and non-SRI funds) and a process and resource guide to adding SRI investments to a Plan.

Investment Advisor's Top Mutual Funds

2007-06-05T13:01:00.000-04:00

Though investors may actually be disadvantaged by the popularity of their mutual funds, they can gain some comfort in knowing that their funds are also being utilized by professional investors. A new website, Advisor Perspectives purports to show the 25 most popular mutuals funds and ETF's by category which are used by a universe of investment advisors for their high and ultra high net worth investors. According to the Website, the data is gathered from 48K individual investor accounts covering $38 billion in marketable securities and funds with a $900k average account size. The top 15 most popular funds are reproduced below though the site provides additional lists by fund category and style:

1 ISHARES TRUST MSCI EAFE FUND
2 JP MORGAN INTERMEDIATE TAX FREE SELECT FUND
3 DODGE AND COX INTERNATIONAL STOCK FUND
4 S&P DEP RECEIPTS
5 AMERICAN EUROPACIFIC GROWTH FUND
6 ISHARES MSCI JAPAN IN
7 PIMCO TOTAL RETURN FUND
8 JULIUS BAER INTERNATIONAL EQUITY FUND
9 VANGUARD 500 INDEX FUND
10 GROWTH OF AMERICA FUND
11 MATTHEWS ASIAN GROWTH AND INCOME FUND
12 DODGE AND COX STOCK FUND
13 FIDELITY DIVERSIFIED INTERNATIONAL FUND
14 FIRST EAGLE SOGEN OVERSEAS FUND
15 PIMCO REAL RETURN FUND

Harvard's Investment Advice

2007-06-04T16:30:00.000-04:00

Dr. Mohamed A. El-Erian, President and CEO of Harvard Management Company, Deputy Treasurer of Harvard University, and member of the faculty of the Harvard Business School was interviewed by Fortune magazine and provides a 4 point strategy for investors:

1) Diversify and internationalize - growth rates are higher outside the US and commodity exposure provides diversification and a hedge against middle eastern "events."
2)Private equity's huge appetite for targets will propel large cap US stocks ahead of small caps.
3)Inflation protect your portfolio. US productivity gains and the impact of global labor outsourcing will diminish over time.
4) Be aware of the huge potential impacts of soverign wealth funds (SWF's). According to Morgan Stanleys estimates, the world’s SWFs could grow from US$2.5 trillion now to nearly US$12 trillion by 2015, and could exceed the total size of the world’s official reserves within five years, i.e., by end-2011.

Credit Complacency = Fiduciary Risk

2007-05-17T16:58:00.000-04:00

Much has been written about the potential impact of the sub-prime mortgage sector meltdown and the impact that tighter credit and falling home values might have on the economy. However, a weakening credit discipline due to the growing role and appetite of leveraged investors and an increase in the sophistication and complexity of credit instruments should also be of concern to investors.

The credit derivatives market has not captured investors’ attention because it has been dominated by private over the counter deals organized primarily by large investment banks. According to the International Swap Dealers Association the credit derivative market has doubled in each of the last 5 years and totaled $34 trillion in notional value at the end of 2006. Hedge funds also play a large role in this market. Lehman Brothers estimated they account for over 50% of the trading volume in this market.

Credit derivatives are simple in concept. They provided insurance against corporate bond defaults. Credit derivatives have become popular because they allow corporate lenders and bond investors to reduce and/or actively manage their credit risk by separating out the credit risk part of these investments and selling it to others. These sales contracts are called credit default swaps. The loans or bonds don’t change hands but derivatives dealers will make an agreement to insure them against a credit default for a fee. The dealers often pass along these risks by bundling these credit exposures into what are known as a synthetic collateralized debt obligation (CDO). Slices of the CDO are rated by rating agencies and then sold to hedge funds and institutional investors. CDO’s soaked up $150 billion of mortgage backed bonds last year, the majority of which included sub-prime mortgages according to Deutsche Bank.

As these risks are packaged, leveraged and structured in ever more complex ways, the nature of the resulting risks may not be transparent or fully disclosed and can be misunderstood, mis-modeled and inappropriately executed and priced. The typical borrower-lender relationship changes as the underwriters of the risk and the eventual risk bearers become disconnected. Risk sellers may be financially motivated to understate credit risk. Because of these issues, the market puts substantial reliance on credit rating agencies. However, the ratings agencies, whose role is to evaluate the risks of these structures, can suffer from both limited information and financial conflicts of interest[1].

Clearly the phenomenal growth of the structured credit markets has been due in part to easy credit and investors’ demand for yield. Many argue that the growth of the credit derivatives market should disperse credit risk amongst a broader and more diverse investor base thus making the credit markets more resilient to credit ”events”. However, the democratization of credit risk may also help disguise risk and transmit financial contagion much more efficiently. The real concern is that no-one really knows that these risks aren’t accumulating in an inappropriate way or aren’t being concentrated in areas which won’t be sustainable through an inevitable normalization or downward leg of the credit cycle.

Private equity, hedge funds, real estate and credit derivatives have all benefited from cheap capital and a strong economy. It is likely that the demand for these assets over the last few years has limited demand for traditional risky investments such as large cap stocks. Time will tell whether the ex ante risk reward expectations driving these investments is founded on sustainable fundamentals or just plain old leverage and perfunctory risk disciplines. For now, investment fiduciaries should be more cautious than usual about credit risk, leverage and lack of transparency in their portfolios.

[1] Frank Partnoy The Paradox of Credit Ratings / How & Why Credit Rating Agencies are not Like Other Gatekeepers.

SEC's Perspective on 12b-1 fees

2007-05-11T08:39:00.000-04:00

Comments from SEC Chairman Christopher Cox in an address to the Mutual Fund Directors Forum.

"What the SEC had in mind in 1980 is that requiring current investors to subsidize the sale of fund shares to new investors could be a good thing - even from the standpoint of the current investors - because increasing overall fund size could help better diversify their holdings, and also proportionally reduce
the burden of administrative costs that might now be spread over a wider pool of investors. After all, higher expense ratios reduce investors' returns percentage point for percentage point.
But whether, in fact, a fund's current investors are getting a break depends upon how the investment advisory contract is written. If increasing the size of the fund simply enlarges the fees earned by the investment adviser, the supposed benefits from economies of scale are undone. So one of the things that independent directors must concern themselves with in reviewing the propriety of any 12b-1 fees used for distribution is whether the fees paid to the management company and other vendors, as a percentage of total fund assets, has risen or fallen as the fund has grown. If the size of the fund is increasing, but the expense ratio isn't falling, then using a 12b-1 fee for marketing and distribution expenses is very likely harming, not helping, the current investors.There are other reasons to
question the continued vitality of Rule 12b-1. Today the mutual fund industry is no longer at risk of suffering crib death, as was the case years ago when rule 12b-1 was adopted. At more than $10 trillion and counting, the survival of the mutual fund industry is plainly no longer at issue. Indeed, we have learned by this point in the 21st century that it can be just as big a problem for investors when a fund grows too large as when it is too small. The assumption can't always be made that growth in total assets inevitably assists existing investors. When funds grow too big, they can lose flexibility, with the result that investors get lower returns.For all of these reasons, the original premises of Rule 12b-1 seem highly suspect in today's world. If ever it was justified to indulge an irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund shares, that time surely has passed. Collecting an annual fee from mutual fund investors that is supposed to be used
for marketing is no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers."

First Quarter Commentary

2007-05-08T10:59:00.000-04:00

Global Equity Markets “Shanghaied”
Along with a reminder that S---[1] happens, the capital markets provided diversified pension investors with a 1.6% return for the quarter, slightly under their pro-rated 8% annual target return. The quarter’s activity also left investors feeling, at least temporarily, more vulnerable due to the collapsing sub-prime mortgage market, declining corporate profitability and the increasingly obvious bipolarity of the Fed’s goals to both stimulate growth and throttle inflation.
The global equity markets, after being “shanghaied” on February 27, rebounded to finish the quarter in positive territory. The uniformity of the February drop indicated no particular geographical or style origin, though financials led the slump. Continued losses in the financial sector for the quarter (-3.4%) confirms that sub-prime fears more than anything triggered the event. The S&P 500 bottomed at -5.9% below its previous high for the year, though it regained over 6.7% as of tax day.

Within the US equity markets, large cap stocks returned +0.6% for the quarter per the S&P 500 index. Style distinctions were trivial, though the overall market returns masked a specific preference for smaller names (Russell Midcap +4.4%) and general distain for mega caps (Russell Top 200 -0.1%). Mid cap stocks lead the US equity market based on the energy sector as oil prices rose 11% during the quarter. The pricing support implied by private equity acquisitions also drove mid caps higher. Utilities and materials, also value sectors, performed well. Small caps returned +2.0% per the Russell 2000, though growth (+2.5%), lead by technology and healthcare, outperformed value (+1.5%).

The fact that investors continue to be indifferent to large caps is puzzling given they have long been considered to be the equity asset class of choice in uncertain times and also have a valuation advantage over smaller caps.

We think institutional investors’ fascination with alternative assets and retail investors’ propensity to chase performance account for some of this lack of interest. Alternative assets (i.e. real estate, private equity and hedge funds) now account for 10% of defined benefit plan assets. The growth in M&A and in particular private equity also appear to be a defining trend in this market. Private equity groups still have hordes of cash to put to work and can continue to shop the market as long as cash-flow yields exceed financing rates. However, their target size hasn’t yet reached the level of US blue chips, leaving large caps with little prospects beyond being proxies for global growth.

In international markets, US dollar investors enjoyed both strong local market returns and the positive foreign currency effect of a declining dollar. MSCI EAFE quarterly returns were +3.4% locally and +4.2% for un-hedged dollar investors. Small and mid caps ( MSCI EAFE Small Cap +7.2%) outperformed large caps internationally as well. The Pacific markets ex Japan generally outperformed Europe. The emerging markets, down -1.6% in February, snapped back in March returning +2.4% for the quarter per MSCI EM. The popular BRIC index didn’t recover from the quarter’s sell-off (-0.4%) as 3 of its 4 constituents ended the quarter down (Russia -3.0%, India -3.4%, China -2.3%, Brazil +6.2%).

Real estate was up just over 2% for the quarter ( NAREIT composite), though money flows were negative as investors feared further sub-prime damage. Hedge funds turned in a respectable quarter, adding 2.3% per the Hennessee Hedge Fund Index. Not surprisingly, merger arbitrage and distressed debt funds lead first quarter performance.

The quarter’s bond market returns don’t fully reflect yield volatility through the quarter. The Fed left short rates unchanged, though the yield curve oscillated with the unveiling of each new piece of economic data and Fed nuance throughout the quarter. Overall, rates fell across the curve, except for the long end, and the curve steepened by quarter end. The curve steepening presents a dilemma. If long rates continue to respond to higher expected inflation, this could act to further constrain economic growth forcing the Fed to cut rates more then might be necessary, sparking additional inflation fears. Returns dispersion across the fixed income sectors was tight Despite the quarter’s general shift in risk appetite, high yield provided the best quarterly returns among US fixed income at +2.7% per the Merrill Lynch High Yield index as defaults remained low. Credit spreads widened somewhat after the market dip in later February. The Lehman US TIPS index returned +2.5% for the quarter as inflation data surprised on the high side. The investment grade mortgage sector returned +1.5% for the quarter per the Merrill Lynch mortgage Master. It is predominantly AAA credits (i.e. Freddie Mac, Fannie Mae) and was minimally impacted by the sub-prime mortgage meltdown. Other domestic bond sectors bunched up in the +1.0% to +1.5% return range for the quarter. International bonds benefited from the quarter’s dollar decline returning +1.2% per the Merrill Lynch Global Broad Market ex US.

[1] Standard deviation ☺

Coming to a Pension Plan Near You

2007-04-16T17:55:00.000-04:00

Casey & Quirk summarize consultant search activity in 2006

2007 will see a significant increase in consultant search activity
Overall rising interest in alternative searches
More consultants will focus on Hedge Funds than on any other strategy
… but traditional Equity searches will still generate most search activity
Consultants will prefer Fund of Funds over direct Hedge Fund investing
Core and Core Plus Fixed Income managers face a barren search year
Private Equity and Real Estate searches abound in 2007
Expected increase in defined contribution-related searches
Demand for 130/30 products will be selective
Prospects are weak for Liability Driven Investments
Consultants are indifferent over style

Small Cap & Value Premium

2007-04-01T08:03:00.000-04:00

The rationale for "value" and "small cap" premia, following the research of Fama and French, continues to be debated. In their original study, using market data from 1964, they conclude that small-cap and value stocks outperformed large-cap and growth stocks. Fama and French concluded that since small and high book to market companies outperformed larger and growth companies, size and value must be proxies for risk. Despite arguments that their research suffered from sample selection bias, further research across different time periods and markets provided additional support for the existence of these premia.

In their new research paper, Migration , Fama and French provide additional insight into the source of the premiums. They conclude;

The size premium is due almost entirely to the extreme positive returns of a small number of small stocks that migrate to large stocks through substantial outperformance from one year to the next.
Three factors contribute to the value premium. (i) value stocks that improve because they are acquired by other firms or because they earn high returns and so migrate to a core or growth portfolio; (ii) growth stocks that earn low returns and as a result move to a core or value portfolio; and (iii) slightly higher average returns on value stocks that remain in the same portfolio compared to growth stocks that do not migrate.
The value premium is somewhat offset by small growth stocks that are more likely to become big than small value stocks from year to year. The average returns from these transitions are huge, and their greater weight in the small growth portfolio pushes up its average return and lowers the value premium.

This work parallels some of the statistical evidence and intution regarding equity investing strategies. Managing downside risk is important - value investing tends to limit downside risk while the primary risk in growth investing, according to this research, is downward migration.
It is difficult to ouperform large cap value benchmarks- picking the winners or avoiding the lossers in this category does not seem to have a large impact on excess returns. The larger dispersion of returns in small caps confirm the importance and value of having exposure to the winners each year. Active small cap managers have the opportunity to provide large excess returns but must be skilled or lucky since large performance penalties exist for being wrong.

source: Mark Hulbert NYT

Hedge Fund Due Diligence

2007-03-31T18:26:00.000-04:00

The operational risks implicit in hedge fund investing are often greater than the risks associated with the investment strategies. The International Organization of Securities Commissions has developed a set of principles for valuing hedge fund portfolios, especially those whose strategies include illiquid or complex financial instruments. The principles address the conflicts of interest that may arise between hedge fund managers and their investors. Hedge funds can use significant leverage which makes appropriate valuation even more critical. The principles, outlined below, provide a good due diligence checklist in this area.

1.Comprehensive, documented policies and procedures should be established for the valuation of financial instruments held or employed by a hedge fund.
2. The policies should identify the methodologies that will be used for valuing all of the financial instruments held or employed by the hedge fund.
3. The financial instruments held or employed by hedge funds should be consistently valued according to the policies and procedures.
4. The policies and procedures should be reviewed periodically to seek to ensure their continued appropriateness.
5. The Governing Body should seek to ensure that an appropriately high level of independence is brought to bear in the application of the policies and procedures and whenever they are reviewed
6. The policies should seek to ensure that an appropriate level of independent review is undertaken of the individual values that are generated by the policies and procedures and in particular of any valuation that is influenced by the Manager.
7. A hedge fund’s policies and procedures should describe the process for handling and documenting price overrides, including the review of price overrides by an Independent Party.
8. The Governing Body should conduct initial and periodic due diligence on third parties that are appointed to perform valuation services.
9. The arrangements in place for the valuation of the hedge fund’s investment should be transparent to investors.

Mutual Fund Ranker

2007-03-29T13:29:00.000-04:00

If you are interested in a more sophisticated and very quantitatively oriented mutual fund screening process check out Mutual Fund Ranker. The site provides free downloads for a limited universe of mutual fund categories; large cap growth, large cap blend and large cap value equity. Complete universe data for these categories is available by contacting the site.

The Fund Ranker tools allows users to apply weighting to a number of statistical attributes of fund performance such as; downside risk, excess returns, information ratio and correlation. In addition several statistcis are ranked based on a style benchmark instead of a traditional market benchmark. The tool is a beta version.

International Large & Mid/Small Funds Outperformed MSCI EAFE 1, 3 and 5 years

2007-02-23T17:58:00.000-05:00

Returns through January 2007 1 year 3 years 5 years 10 years
Accessor International Equity Adv 24.70% 21.85% 17.38% 8.64%
AIM International Small Company A 26.28% 33.93% 33.75% N/A
AllianceBernstein Intl Val A 24.55% 24.36% 22.67% N/A
Allianz NACM International Instl 22.23% 26.57% 22.14% N/A
Amer Century Intl Disc Inv 22.99% 24.34% 21.78% 16.09%
BlackRock International Opp A 23.25% 28.54% 24.97% N/A
Columbia Acorn International Se Z 28.72% 25.00% 20.40% N/A
Columbia Acorn International Z 25.58% 27.96% 22.35% 13.07%
Delaware Pooled Int’l Equity 24.52% 21.07% 18.47% 11.09%
Delaware Pooled Lab Select Intl Eq 24.31% 20.69% 18.51% 11.61%
DFA Intl Small Cap Value 22.82% 27.32% 31.25% 13.48%
DFA Intl Value 27.92% 25.54% 23.26% 12.16%
DFA Intl Value II 28.19% 25.75% 23.44% 12.22%
DFA Intl Value III 28.20% 25.75% 23.47% 12.37%
DFA Intl Value IV 28.18% 25.76% 23.44% N/A
DFA Tax-Managed Intl Value 27.19% 25.11% 22.18% N/A
Dodge & Cox International Stock 22.24% 25.02% 21.85% N/A
Dreyfus Founders Passport F 21.45% 22.11% 21.88% 10.71%
Forward Inter Equity 24.92% 21.53% 17.82% N/A
Forward Inter Small Co Instl 22.37% 25.71% 25.42% 15.72%
Gartmore International Growth A 23.73% 25.27% 18.64% N/A
Glenmede International 21.08% 20.77% 17.25% 10.40%
GMO Foreign III 20.88% 20.45% 19.30% 12.16%
GMO Foreign Small Companies III 28.81% 27.41% 27.03% 16.39%
Goldman Sachs Structured Intl Equity A 21.89% 21.01% 17.07% N/A
Harbor International Instl 23.59% 23.48% 21.02% 12.52%
Hartford Intl Small Company HLS IA 22.25% 21.24% 22.05% N/A
Hartford Intl Small Company Y 21.50% 20.77% 22.29% N/A
ING International SmallCap A 20.84% 24.34% 19.56% 16.90%
Janus Adviser International Growth S 30.20% 30.92% 19.49% N/A
Janus Aspen International Grth Instl 30.92% 31.04% 19.76% 13.97%
Janus Overseas 31.86% 31.34% 20.72% 14.12%
JPMorgan International Equity Index Sel 20.92% 20.94% 17.64% 9.00%
JPMorgan International Val I 26.13% 25.56% 19.82% 8.82%
Julius Baer International Equity A 23.37% 23.84% 20.90% 16.91%
Laudus Rosenberg Intl Small Cap Instl 21.16% 26.02% 28.23% 12.98%
LWAS/DFA Intl High Book To Market 27.93% 25.50% 23.23% 12.17%
Manning & Napier World Opportunities A 25.26% 21.83% 17.54% 12.46%
MFS International Value A 22.58% 22.47% 19.05% 11.14%
Nicholas-Applegate Intl Growth Opp I 20.65% 25.40% 21.33% 19.09%
Oakmark International Small Cap I 29.77% 26.97% 25.76% 15.61%
Oppenheimer International Small Co A 21.62% 32.00% 31.12% N/A
Phoenix Foreign Opportunities A 25.03% 24.08% 19.94% 9.62%
Putnam International Capital Opp A 24.05% 26.18% 20.34% 16.26%
Putnam International Growth & Inc A 21.76% 20.72% 17.00% 10.91%
Quant Foreign Value Ord 22.57% 23.19% 23.37% N/A
RiverSource Intl Select Value A 20.80% 23.53% 19.93% N/A
Rochdale Atlas 21.04% 25.13% 20.23% N/A
SA International HBtM 24.98% 23.45% 20.20% N/A
SSgA International Stock Selection 22.53% 22.46% 19.20% 7.69%
T. Rowe Price Intl Gr & Inc 23.72% 22.69% 18.94% N/A
Templeton Instl Foreign Equity 23.26% 20.96% 17.58% 10.74%
The Boston Co Intl Core Equity 23.15% 23.17% 21.54% 12.13%
The Boston Company Intl Small Cap 22.25% 29.86% 29.35% N/A
Thomas White International 20.93% 24.87% 20.10% 10.86%
TIAA-CREF Instl International Eq Instl 22.89% 21.10% 17.85% N/A
TIAA-CREF International Equity 22.91% 20.71% 17.36% N/A
Vanguard International Explorer 24.97% 26.92% 24.01% 16.65%
MSCI EAFE Index 20.33% 20.12% 16.85% 8.52%

Large & Mid Cap Mutual Funds that Outperformed S&P 500 over 1,3,5 & 10 Years

2007-02-23T11:10:00.000-05:00

Manager Returns through January 2007. Funds in Bold also outperformed their style benchmarks for the same periods. 1 year3 years5 years10 years returns
AIM Leisure Inv 25.60% 12.54% 9.93% 15.00%
Alger Capital Appr Instl I 16.15% 13.55% 6.95% 11.41%
Allegiant Large Cap Value I 17.29% 14.96% 10.58% 9.24%
Allianz OCC Value Instl 19.25% 12.09% 9.68% 13.08%
Amana Trust Income 15.88% 19.04% 12.99% 9.66%
Am Beacon Lg Cp Vle Inst 17.46% 15.87% 12.89% 9.82%
Ameri Century Equ Inc Inv 17.60% 11.38% 10.50% 12.22%
Am Century Inc & Grth Inv 15.90% 11.39% 8.39% 8.78%
Am Century Value Inv 17.57% 12.24% 10.49% 10.87%
Am Funds Am Mutual A 15.34% 10.84% 8.29% 9.27%
Am Funds Wash Mutual A 16.51% 10.43% 7.93% 9.52%
Aston/Optimum Mid Cap N 14.82% 12.26% 11.78% 11.96%
Baron Asset 17.46% 18.11% 12.39% 9.30%
Baron Partners 24.07% 25.72% 19.04% 14.73%
Barrett Opportunity 17.89% 14.68% 9.72% 9.54%
BB&T Large Cap I 18.36% 13.43% 8.32% 8.61%
BlackRock Basic Value I 20.71% 11.91% 9.98% 9.51%
BlackRock Focus Value I 18.93% 12.35% 9.36% 11.83%
BlackR Mid-Cap Value A 17.48% 17.24% 12.33% 12.84%
Columbia Disci Value T 19.28% 15.11% 7.33% 8.61%
Columbia L Cap Value Z 14.91% 13.10% 9.80% 8.01%
Concorde Value 16.21% 11.25% 6.98% 8.00%
Consult Grp L Cap Value E 17.53% 12.76% 8.78% 8.49%
Credit Suisse L Cap Value A 18.90% 12.94% 9.23% 9.87%
Davis NY Venture A 14.70% 12.43% 10.56% 10.18%
Delafield 15.96% 16.28% 15.63% 13.25%
Delaware P L-Cap Value Eq 21.87% 12.39% 9.58% 8.94%
DFA U.S. Large Cap Value 18.07% 16.60% 12.78% 11.84%
DFA U.S. Large Cap Value II18.25% 16.73% 12.89% 11.87%
DFA U.S. Large Cap Value III18.23% 16.74% 12.93% 11.99%
Diversif Value & Income Inv 17.36% 12.20% 9.08% 9.32%
Dodge & Cox Stock 16.28% 14.88% 13.33% 14.05%
Dreyfus Prem Core Value A 19.80% 11.93% 7.49% 8.46%
Dreyfus Prem Strat Value A 18.42% 14.36% 10.41% 10.25%
DWS Equity Partners A 17.03% 11.29% 10.26% 9.94%
Eaton Vance L-Cap Value A 17.53% 15.61% 10.32% 11.50%
Evergreen Discip Value I 17.77% 14.29% 9.74% 9.60%
Federated Stock 16.24% 10.68% 7.72% 8.94%
Fidelity Adv Equity Income I 14.91% 11.84% 9.37% 9.58%
Fidelity Equity-Income 17.55% 12.23% 9.27% 9.12%
Fidelity Exchange 17.31% 11.56% 8.56% 8.18%
Fidelity Select Air Transpor 24.29% 21.73% 11.25% 15.39%
Fidelity Select Chemicals 16.81% 18.77% 15.84% 10.25%
Fidelity Select Consumer St 21.73% 14.73% 9.76% 9.14%
Fidelity Select Defense & A 20.96% 20.50% 16.40% 14.89%
Fidelity Select Leisure 17.64% 12.51% 11.32% 12.21%
Fidelity Select Retailing 16.25% 14.08% 9.76% 11.60%
Fidelity Value Strategies 14.54% 10.54% 11.48% 12.21%
Fifth Third Mu Cap Va Adv 15.35% 12.92% 12.12% 11.40%
First American Equity Inc A 17.28% 10.82% 7.63% 8.53%
First Eagle Fund of Amer Y 16.81% 13.06% 10.76% 11.88%
Gabelli Asset AAA 20.45% 14.49% 11.80% 12.75%
Gabelli Equity Income AAA 16.74% 12.51% 11.63% 11.22%
Gabelli Value A 20.55% 11.64% 10.05% 13.50%
Goldm Sachs MCap Val Inl 15.37% 18.85% 15.74% 14.16%
Harbor Large Cap Value Instl 15.67% 11.13% 7.72% 8.88%
Hartford Div & Grth HLS IA 17.45% 13.05% 9.48% 9.94%
Hartford Value Opportu N 15.23% 13.19% 9.79% 9.29%
HighMark Value MomentFid 17.31% 13.60% 9.50% 8.57%
Homestead Value 14.74% 15.02% 11.67% 9.84%
ING Corporate Leaders Tr B 15.99% 15.95% 12.05% 9.01%
ING T. Rowe Price Equ Inc S 17.72% 12.34% 9.40% 8.35%
JPMorgan Div Mi Cap Val Sl 15.97% 14.29% 12.11% 12.70%
JPMorgan Equity Income Sel 21.25% 12.63% 8.10% 7.95%
Legg Mason Part Inve Val A 15.85% 10.48% 7.82% 9.43%
Longleaf Partners 19.83% 11.15% 11.28% 12.81%
Loomis Sayles Value Instl 21.97% 17.64% 11.85% 8.93%
Lord Abbett Affiliated A 14.52% 11.08% 8.02% 9.62%
Madison Mosaic Mid-Cap 15.55% 11.29% 9.80% 11.17%
MainStay ICAP Equity I 16.02% 13.98% 8.43% 9.46%
Managers Value 16.18% 11.55% 7.21% 8.44%
Manning Napier Pro Blmaxt 15.22% 13.33% 10.27% 11.42%
Manning Napier Tax ManaA 18.20% 14.36% 9.99% 10.74%
MassMutual Premier Value L 15.54% 11.76% 8.69% 8.01%
Meridian Value 15.62% 11.98% 11.24% 17.86%
MFS Value A 18.97% 13.98% 10.27% 12.01%
Mor Stanley L Cap Re Val A 15.11% 13.50% 8.52% 10.11%
Mor Stanley I Md Cp Value I 21.58% 17.07% 11.32% 12.64%
Morgan Stanley Inst Value 17.97% 12.94% 9.35% 8.53%
Munder Large Cap Value Y 15.90% 13.15% 9.65% 8.17%
Mutual Beacon Z 21.13% 15.61% 12.39% 11.91%
Mutual Qualified Z 19.62% 16.33% 12.70% 11.95%
Mutual Shares Z 18.04% 14.70% 11.62% 11.39%
Neub Berman Socia Resp Inv 14.66% 11.93% 11.14% 9.07%
Old Mut Anal U.S. Lg/Sht Z 21.90% 13.12% 7.30% 9.32%
Pioneer A 16.01% 11.94% 7.16% 9.34%
Pioneer Equity-Income A 22.64% 15.46% 10.03% 10.04%
Princ Inv Equity Income I A 16.26% 15.17% 12.13% 11.05%
Putnam Equity Income A 17.40% 12.38% 9.62% 9.32%
Putnam New Value A 16.29% 12.39% 10.23% 9.39%
RSI Reti Trust Value Equity 16.19% 12.01% 8.10% 10.10%
SEI I Mgd La Cap Value A 18.12% 14.07% 10.16% 9.60%
Selected American Shares S 14.76% 12.02% 10.14% 10.52%
Sound Shore 16.18% 12.23% 10.71% 10.11%
State Farm Growth 14.89% 10.45% 7.57% 8.11%
STI Class L Cap Rel Value I 16.72% 13.48% 8.95% 9.18%
STI Class L Cap Value Equi 19.43% 13.19% 9.44% 8.56%
T. Rowe Price Equity Income 17.88% 12.55% 9.67% 9.99%
T. Rowe Price Value 17.93% 13.52% 10.22% 10.95%
Target L Cap Value 17.30% 14.85% 12.62% 10.02%
TCW Dividend Focused N 17.73% 13.21% 12.05% 11.76%
T Boston Co L Cap Core 14.93% 10.74% 8.09% 8.22%
Thornburg Value A 21.40% 13.15% 9.08% 11.98%
UBS PACE L Co Val Eq P 15.32% 14.02% 9.94% 7.95%
Van Kampen AmerValue A 17.43% 15.40% 12.02% 10.87%
Van Kampen Comstock A 16.74% 12.17% 8.76% 11.87%
Vanguard Equity-Income 18.77% 12.78% 9.11% 9.61%
Vanguard Value Index 19.44% 14.43% 10.36% 9.07%
Vanguard Windsor 17.70% 12.04% 9.48% 9.29%
Vanguard Windsor II 17.19% 13.97% 10.90% 9.89%
Weitz Hickory 21.15% 13.98% 11.27% 11.97%
Weitz Partners Value 22.60% 10.94% 8.16% 14.14%
Weitz Value 21.78% 10.73% 8.64% 14.13%
Wells Far Ad CB Lg Cap Val 20.31% 11.11% 10.64% 11.19%
Wells Far Adv Div Income In 15.60% 13.24% 8.11% 9.62%
Wells Far Adv U.S. Val Z 16.06% 10.86% 8.61% 8.72%
Westwood Equity AAA 15.48% 15.14% 9.26% 9.45%
Wilshire Lar Co Value Invmt 15.56% 13.00% 9.85% 8.96%
S&P 500 14.51% 10.32% 6.82% 7.93%

Rock the House.. Big Time

2007-02-07T17:15:00.000-05:00

An FT article reveals a few jaw dropping statistics from Merill Lynch research:

28% of fund management industry revenues are accounted for by hedge funds which manage an estimated 3% of the industry's assets.
Private equity accounts for 8% of industry revenue with about 1% of assets

Barrons also details some hedge fund statistics from recent Dresdner Kleinwort research:

hedge Funds may account for 1% of global AUM but triple to 3% with leverage
hedge funds account for 2/3 of margin debt
hedge funds account for 25%-60% of trading in major global markets
transaction costs and manager & performance fees consume about 8-9% of assets managed annually meaning funds must generate returns of 20%/yr

Mutual Funds Outperform..without your money

2007-02-02T21:43:00.000-05:00

A study mentioned in the FT suggests mutual fund managers can add value by picking stocks but fall behind as they are forced to manage investor cash-flows. In the study, Does Motivation Matter When Assessing Trade Performance? An Analysis of Mutual Funds authors Gordon J. Alexander, Gjergji Cici, and Scott Gibson conclude that:

“fund managers possess the ability to value stocks and that motivation matters when assessing trade performance. Conditioning on the size of trades and net investor flows, we find that valuation motivated buys outperformed their benchmarks by a statistically significant 2.79% in the following year. In contrast, liquidity-motivated buys underperformed by a statistically insignificant 0.41%, suggesting that fund managers were unable to beat the market when forced to invest excess cash from investor inflows. The evidence from stocks sold by fund tells a similar story. Valuation-motivated sells underperformed their benchmarks by an insignificant 0.66%. In contrast, liquidity-motivated sells outperformed by 1.55%, suggesting that fund managers were compelled to sell stocks they would have (correctly) preferred to hold longer based on valuation beliefs. These results are found to be robust to alternative methods of portfolio creation and benchmarking.”

These findings support the contention that actively managed ETF’s should have a performance advantage over mutual funds and that SEC’s proposed rule 22c-2 should have a positive impact on investors.

Taken a step futher these results might imply that closed end funds should yield superior pre-tax performance to open end funds. In addition, funds with limited investor cashflows due to size, obscurity, availability, smaller distribution channels etc might exhibit a higher propensity to outperform. Funds with tightly focused and disciplined valuation driven buy /sell rules will often have more concentrated portfolios and may accumulate inflows or sales proceeds as cash while they wait for the market to offer those higher potential valuation driven buying opportunities. These are the Funds that can add value to a portfolio, though by virtue of their valuation discipline, can look unappealing and out of step with benchmark performance in the short run.

Pension Conference

2007-02-01T11:57:00.000-05:00

Plansponor has made available audio recordings of presentations from the Plansponsor Defined Benefit Summit conference held in early December. Registration is required. While certain sessions may be of particular topical interest to you, we found these sessions worth a listen.

Opening remarks- Ron Gebhardtsbauer provides an optimistic alternative perspective on the future of DB plans. Factually illuminating in terms of the basic rationality of the PPA legislation but not persuasive that this will stem the tide of Plan terminations.

Session B – as part of a panel discussion, Michael Peskin of Morgan Stanley provides interesting opinions on FASB regulations, imbalances in Public DB plans, future of DB plans and liability driven investing in the US and the mismatch of the current legislative and regulatory structure to what is needed to secure a future for DB plans.

Opening Dinner – Keith Ambachtsheer, a noted academic authority on pension plan governance, outlines his idea for a revolution in pension coverage that would provide 100% coverage using a lifecycle based approach, an annuity backend and delivery by a large pension co-ops.

Session H – Roger Fenningdorf from Rocaton Advisors provides a very good overview of hedge fund options in today markets, highlighting the pros and cons of single manager, multi-strategy and fund of funds. He reviews hedge fund risk and provides a summary of principles to observe when investing in hedge funds

P&I Top 1000

2007-01-30T06:41:00.000-05:00

The annual Pension & Investments 1000 provides a good profile of the portfolio implementations of the top US pension plans. The Top 1000 corporate DB average asset allocation at 9/30/2006 was; US fixed income 26%, domestic equity 41%, international equity 16.5%, real estate 3.3% and 14.2% all other. A small year over year rise in corporate plan bond allocations was suggested as evidence that sponsors are starting to employ liability driven strategies. The relative level of indexing remained static, though an shift to more exotic “betas” has been observed. Enhanced indexing strategies grew as sponsors continued to look for opportunities to increase returns.

Of the top 200 Plans, 153 offer defined contribution plans. The aggregate aset mixes remained stable though diversified fund assets grew. 50 plans offered age based lifecycle or risk based lifestyle funds while 14 offered REITS and 13 offered TIPS. Index and enhanced index options grew as well.

Empty Voting

2007-01-29T07:23:00.000-05:00

The lead story in Friday's WSJ, "How Borowed Shares Swing Company Votes" adressed the topic of "empty voting". In empty voting, equity shares are lent/borrowed prior to their record date and returned afterwards. This has traditionally entitled the borrower to the voting rights. Through this practice, borrowers can establish control over a large block of votes without mantaining any continued economic interest. Empty voting can be used to promote interests other than those of the fiduciary shareholders.

It has grown along with the securities lending business. Estimates of the size of the equity securities lending markets are in excess of US$700 billion, with significant participation from mutual funds, pension plans, endowments and insurance companies. The history and issues involved in Empty Voting are outlined in both the referenced study by University of Texas professors Hu and Black and by Charles Nathan in his article “Empty Voting” and Other Fault Lines Undermining Shareholder Democracy: The New Hunting Ground for Hedge Funds.

Securities lending and the separation of voting rights from the economics of stock ownership may be of concern for plan fiducaries. Legally, a transfer of title normally occurs when a security is loaned. Therefore, fiduciaries may have no explict responsibility to follow ERISA proxy voting rules as established in the DOL Interpretative Bulletin on Proxy Voting.

However, language in the Bulletin might broadly suggest that fiduciaries have an explicit responsibility to weight the benefits associated with securities lending activity against the "value" of voting rights and the potential that those rights could be voted in a manner that is contrary to participants best interests.

" the responsible fiduciary consider those factors that may affect the value of the plan's investment and not subordinate the interests of the participants and beneficiaries in their retirement income to unrelated objectives.....The named fiduciary must carry out this responsibility solely in the interest of the participants and beneficiaries and without regard to its relationship to the plan."

Though the extent of empty voting is unknown, the potential costs and conflicts of interest of securities lending may be growing larger than prudent fiduciaries can ignore. Fiduciaries should be aware of any securities lending activities that involve their plan assets. They should also inquire about how their agents prevent or detect abusive activity.

Bo Knows Investments

2007-01-25T06:00:00.000-05:00

Professional investors select investments such as mutual funds based on their expected “investment value”. Investment value is determined by carefully reviewing and comparing a variety of quantitative and qualitative characteristics to benchmarks and other alternatives. Non-professional investors, including many retirement plan fiduciaries, on the other hand, tend to select investment providers and investments based on little more than their “franchise value”. Franchise value is the popularity of a brand name with consumers. Starbuck's, and McDonald's are industry leaders because consumers recognize and value their corporate identities as much as their products. The same is true for the Fidelity’s and Goldman Sachs’ of the financial world. Their brands have been carefully designed and managed to serve as proxies for quality.

Investors often use short cuts in their investment decision making. We know this through our own observations and through numerous research studies such as one performed by the Consumer Federation of America. This study concludes that most mutual fund investors do not follow the practices recommended by experts. When selecting mutual funds, investors give little weight to elements considered important by experts such as; cost and information provided in the fund’s prospectus. The wide use of franchise value as a short cut for sorting and selecting amongst a large universe of investment alternatives is well recognized by regulators and marketers.

Brand based purchasing behavior is a particular risk in markets characterized by information asymmetry. Information asymmetry exists in markets where sellers are better informed about product characteristics than buyers. In the financial services and asset management markets, buyers are not always capable of assessing the long run risk return nature of the products they are encouraged to consume. Extensive regulation and disclosure requirements in these markets recognize this disparity and seek to limit the seller’s advantage. ERISA fiduciary responsibilities and the “prudent expert” standard of fiduciary care were no doubt designed to protect investors from the inadequacy of naïve investment decision making using factors such as franchise value.

Financial services companies fully understand the economic value in establishing or terminating ie PBHG or Strong a high level of brand recognition and franchise value for their business. High franchise value is becoming a major competitive asset for financial service firms as it; creates demand, allows for premium pricing and stifles competition. Not coincidentally, they are spending huge amounts on branding and celebrity endorsement. Anecdotal examples in the most recent issue of Investment News include:

London-based Barclays agreed to pay nearly $400 million over 20 years for the right to have its name on an arena in Brooklyn.

Prudential Financial Inc. agreed to pay $105 million over 20 years for the name PrudentialCenter on a new arena.

Citigroup Inc. agreed to pay the New York Mets $400 million over 20 years to call the team’s new baseball stadium in Queens, N.Y., Citi Field.

Principal Financial Group Inc. is hoping that Hall of Fame pitcher Nolan Ryan will help the company win customers as the new national spokesman.

Bo Jackson now is teaming up with the Guardian Life Insurance Company of America in New York.

The lesson, particularly for investment fiduciaries, is that a favorable inclination towards certain investment providers or funds is probably an insufficient and unsupportable basis for a fiduciary decision. As Fred Reish notes:

"fiduciaries must engage in a prudent process. That is, they must: determine what information is needed to make an informed decision; gather, examine, and understand that information; and then make a reasoned decision based on that information. While this process is straightforward, it may seem daunting to many fiduciaries because it requires an understanding of sophisticated investment concepts and an analysis of detailed information about investments. For example, US Department of Labor guidance and court cases make it clear that fiduciaries are expected to understand and apply generally accepted investment theories such as modern portfolio theory and prevailing investment industry practices such as the quantitative and qualitative analysis of the mangers of mutual funds."

The Rock, leather bound presentations, Paul McCartney, You & Us, gold leafed educational packets, lava lamps, Higher Standards, Lance Armstrong, erudite investment commentary and the Red umbrella don’t guarantee results and won't keep you out of court!

Mutual Funds UnderPerform - Agency Issues?

2007-01-21T11:53:00.000-05:00

A study entitled Economies of Scale, Lack of Skill or Misalignment of Interest? A Study on Pension and Mutual Fund Performance by R. Bauer, R. Frehenc, H. Lumb and R. Ottenc implies that agency conflicts of interest may account for the fact that mutual funds were found to significantly underperform retirement plan investments. This study concludes that:

DB and DC pension fund investment net returns were nominally less, though substantively similar to the performance of their benchmarks,
mutual funds underperformed their benchmarks by at least 150 to 200 basis points per year,
index mutual funds posted the smallest under-performance, around 50 basis points,
mutual fund returns exhibited modest persistency in returns while pension funds exhibited none,
mutual fund underperformance relative to pension funds was larger than could be attributed to their differences in cost, risk or style leading to the study's conclusion that a misalignment of interests between mutual fund companies and their investors was responsible .

It was unclear why DC equity returns were comparable with DB equity returns when about 50% of DC assets, at least in the US are in mutual funds. Several possible reasons:

DC average equity in the study was $617 million, indicating a higher probability that the DC equity was managed via unitized separate accounts
Research indicates DC plans have better access to and generally utilize "better" mutual funds than the mutal fund average,
Index fund representation may be higher proportionally in DC plan universes than in mutual fund averages due to fiduciary standards,
statistically, any active selection process, even naive performance chasing avoids mutual fund "perma-dogs" which are contained in mutual fund averages.

Rewarding, Very, Very, Very Rewarding

2007-01-21T08:40:00.000-05:00

The 401(k) business has been very rewarding for investment product and service providers. Financial institutions and asset managers around the world have achieved record profits and profitability over the last four years in a row, in part due to the growth in 401k plans, increasing plan contributions levels and steady capital market appreciation. They have a highly leverageable business and economic model. Their consumers generally; accept the value added premise and fees associated with active management as they equate positive short-term performance with skill rather than random chance, prefer the ease of bundled services and fees and rely on brand name as a proxy for quality.

The demise of DB plans and the provisions of the Pension Protection Act, passed in August 2006, promise to generate even greater growth in the 401K market in the years ahead. Morgan Stanley predicts that DC plan inflows will increase to $30 billion in 2008, peaking at $37 billion in 2010. In addition, providers that can establish corporate 401(k) relationships receive an extremely valuable free dividend, hundreds or thousands of plan participant relationships, which they can leverage outside the 401k domain. Recognizing the growth opportunity and the free call option on participant relationships, merger and acquisition and hiring activity in the 401(k) industry is on the rise.

Unfortunately, a portion of the financial success of the 401(k) business has been directly and unknowingly subsidized by Plan sponsors and participants. The recent 401(k) litigation highlights areas where asset managers and service providers have arguably generated excess revenue at the expense of 401k plans. Asset based revenue matched with fixed cost administrative services, the failure to recognize asset management economies of scale by using fixed price retail mutual funds and closet indexing are examples .

The courts will determine the fiduciary prudence of past practices given the “facts and circumstances then prevailing”. The implications however, could be substantial given the prevalence of these practices. Plan fiduciaries have been put on notice and must now be more proactive in dealing with expense and investment value issues or they invite tremendous liability. In light of this, plan fiduciaries should critically re-evaluate their plan structures and provider programs and embrace new options under the Pension Protection Act to reduce their fiduciary liability.

Index- 401K plan fiduciaries retain the responsibility for prudently selecting and monitoring the investments they make available to plan participants. Excluding actively managed investment opportunities represents a substantial opportunity to rationalize plan structure, minimize expenses and hidden costs and reduce sponsor risk and liability. According to William Sharpe “properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”. This logic is irrefutable and provides a sound fiduciary basis for indexing. Decades of equity mutal fund research also indicate an inability of fund managers to beat market indices. As the separation of “beta” or market returns from “alpha” or active manager relative returns becomes a more commonly accepted way of looking at both investment returns and costs, the potential excessive cost of alpha in many actively managed products could very easily become the next cause of action against plan fiduciaries. 40 sof research indicate equity mutual funds

Unbundle- Unbundling is where plan sponsors select the best provider for each service element of their 401K plan such as; administration, investments or education. Unbundling tends to reduce the embedded conflicts of interest and cross subsidized services that create fiduciary risk and require fiduciary effort to understand. Research indicates that services can be acquired less expensively if separately negotiated. Though larger plans may benefit most from unbundling, the growth in DC plans as well as the number of new competitors in the market means the opportunity and benefits from unbundling apply to a larger population of plans. The introduction of single fund solutions (target retirement funds) and ETF’s make unbundled solutions more competitive in the smaller plan market as the need for investment education, materials and technical support diminishes. Providers who can provide competent recordkeeping and compliance at much lower prices can compete more effectively in a world where 401(k) investors make a single lifetime investment decision.

Plan fiduciaries should consider the economic present value of their 401(k)relationships, including their growing fiduciary liability, when selecting and negotiating product and service agreements with vendors. On the whole, the more rewarding the 401(k) business is for asset managers and service providers, the more exposure plan fiduciaries will have.

2006 Capital Market & Fiduciary Review

2007-01-16T11:53:00.000-05:00

Investors enjoyed strong returns across a broad spectrum of assets classes in 2006 as ample liquidity and low market volatility encouraged and rewarded risk taking. Pension plans generally improved their funding status. Asset increases, averaging 12% for moderate risk diversified portfolios, outpaced a 1.2 % increase in average liabilities according to Mellon Financial. Despite improving pension plan economics, the regulatory and accounting changes enacted this year increase the defined benefit plan burden for many plan sponsors. As defined contribution plans shift from being a supplemental to a primary retirement resource, political, regulatory and legal scrutiny is on the rise.

Capital Markets Trade Higher in 2006
Global capital markets traded higher in near unison as a combination of cash, generated by strong corporate profits, petrodollars and Asian central banks, and financial leverage, provided by cheap debt, sought investment opportunity. Though market activity seemed generally rational, there were signs of momentum buying in certain areas.

Domestic equity –Almost half of the S&P 500’s 15.7% return for 2006 was delivered during the strong 4th quarter rally. Though market capitalization and style performance return differentials narrowed through the year, value investing maintained its global market leadership, marking a 7 year trend. The Russell 3000 growth index retuned 6.2% during the 4th quarter (9.5% ytd) vs. 8.1% for Russell 3000 Value (22.3% ytd). Investor’s reluctance to adopt growth investing - a residual of the tech boom, continued as elevated oil prices and a huge level of private equity transactions supported value style investing.

Despite expectations to the contrary, US small cap stocks dominated larger capitalization stocks again in 2006. The Russell 2000 small cap index returned 8.9% (18.4% ytd) for the 4th quarter vs. 6.7% (15.5% ytd) for the Russell Top 200 large cap index. Small cap strength can be attributed to the market’s low risk aversion as well as by private equity and hedge fund interest and the increasing use of ETF’s which may proportionately favor small caps.

In the US, indexing outperformed active management. Only 19% of all funds in the diversified stock fund category were able to beat the S&P 500 vs. 61% last year according to the WSJ. The “mega cap” discount and value and international active management biases provided less of an advantage to active managers in 2006. In addition, fewer than ½ the companies in the S&P beat the index according to Merrill Lynch, making stock selection more critical.

International Equity - Returns were equally strong based on strong global earnings growth, moderate equity valuations and a foreign currency kick for US investors. The MSCI EAFE Index returned 10.4% (26.9% ytd) for the quarter. Mutual fund investors piled into the non domestic markets in 2006 as an estimated $5 flowed into non domestic equity funds for every $1 that went into a domestic equity fund. Strong trends in flows like this can be self perpetuating as momentum investors tend to follow and reinforce the trend. Trend reversals however, can be equally powerful. Emerging markets recovered from a sharp sell off in the spring and retuned 17.6% (32.6% ytd) for the quarter according to the MSCI Emerging Markets Index%. Value and growth enjoyed similar gains in emerging markets, perhaps indicating less discriminating buying.

Private Equity - Fund raising set a new record in 2006, collecting over $320 billion as pension plans and institutions added or increased allocations to make their “8%”. With this kind of money to invest (over $1 trillion levered by with 3-4 times debt), private equity funds did bigger deals and started looking beyond the safe, high cash-flow companies they normally prefer. Questions abound as to whether traditional private equity approaches will continue to work in an era of mega buyout deals and how these investments will fare in a more difficult economic environment.

Commercial Real Estate- The rally continued in 2006, providing returns of 34.4% per NAREIT. The top performing REITs targeted international real estate, REIT privatization (Equity Office Properties Trust) as well as apartment REITS, which benefited from the reduced affordability of single family homes. US REIT share prices are rising faster than earnings, driving dividend yields below Treasuries, indicating a speculative element in this market.

Hedge Funds - Overall, hedge funds returned 12.1% in 2006 according to the Greenwich Global Hedge Fund Index. While research indicates that portfolio diversification rather than returns is the primary reason why hedge fund allocations are increasing, the correlation of hedge fund strategies to the equities markets have increased significantly over the last few years. It will be interesting to see if a new breed of low cost hedge fund “indexes” can successfully mirror the “beta” or market component of these strategies and absorb some of the growing demand for absolute returns.

Fixed Income – The anticipated turn in the credit cycle didn’t materialize in 2006 and credit spreads remained tight, perhaps not fully reflecting market risks or the growing but unknown impact that the dramatic increase in credit derivatives might have in less serene times. US bond yields reached a peak at mid year and drifted lower as the market anticipated Fed easing in response to slower economic growth. Credit risk was generally rewarded while duration was not.

Three month T–Bills returned 1.3% (4.8%YTD) for the quarter vs. Long Term Governments .48% (1.8% YTD). The yield curve remained inverted at year end, with yields on short term bonds (5.02% - 3 month T Bill) exceeding those of long term Treasuries ( 4.71% - 10 year Note). This has traditionally been a recessionary signal and continues to puzzle the markets as it contradicts the consensus forecast for a “soft landing” in 2007. Event risk challenged investment grade corporate bonds as leveraged acquisitions and new debt issuance put downward pressure on credit ratings.

Investor appetite for higher yield debt drove the boom in leveraged buyouts and boosted returns, yet compressed yield spreads, in the high yield bond market. High yield bonds returned 4.1% (11.6% ytd) for the quarter vs. the Lehman Brothers Investment Grade Bond Index 1.2% (4.3% ytd). Defaults, another driver of high yield bond prices, remained low at 1.3% in 2006 vs. a 20 year average of 4.5%.

Emerging market debt provided substantial returns for the quarter 4.6% (11.6%) according to Merrill Lynch.

Housing and Rates- Key to 2007
US economic growth slowed throughout 2006, particularly in the second half, largely due to a sharp falloff in housing activity and weakness in the motor vehicle sector.
At the same time, corporate profits and consumer demand remained strong and decreases in energy prices have substantially reduced overall consumer price inflation and core inflation showed signs of slowing. New job formation and low unemployment also suggest continued strength. The markets seem priced for an economic “soft landing” in 2007. According to John Neff, “the Goldilocks school has a very large class.” The future direction of housing and Fed action on interest rates will probably have a primary impact on US economic and market direction in 2007, not withstanding other wildcards like oil prices, geopolitical strife, etc…

For now there is much uncertainty about where we are in the housing cycle and its future impacts. Though there have been early signs of stabilization, significant evidence suggests more trouble ahead. Housing prices have decreased but remain historically high vs. rents and rates and while sales seem to have stabilized, cancellations which are not accounted for in government sales and inventory figures, have risen significantly.
The Fed has been encouraged by expected downward tilt in inflation but seems satisfied with its current monetary policy and will probably be satisfied to hold rates to ensure the positive trend is structural and not simply related to recent oil price and inventory adjustments.

Capital Market and Fiduciary Challenges Ahead

In 2006 ERISA fiduciaries had to confront substantial regulatory and accounting changes. With regard to defined benefit plans, sponsors are beginning to consider liabilities as their asset benchmark and broadening their asset allocations to include alternative non-correlated assets to diversify risks and improve returns.

Liability Driven Investing (LDI) – Recent regulatory and accounting reforms penalize under-funding and plan surplus volatility. As a result, plan sponsors are becoming more aware of their risk versus plan liabilities. LDI focuses on managing assets versus a liability benchmark rather than an asset benchmark. LDI strategies can be implemented in a variety of ways, but typically involve a combination of fixed income and derivative instruments, and can also include alpha transport components. The practice of LDI will be driven by large firms with the resources to develop products. Broader acceptance of LDI will likely be limited to plans that are fully funded and wont go down market until cost effective products are developed to allow plans to match liabilities but not altogether forego equity risk premia.

Increasing Portfolio Diversification - Equity losses during the late 90’s and a low expected return environment is altering pension plan and institutional investing behavior.
Pension plans are systematically diversifying portfolio into riskier asset classes, justifying their inclusion by the statistical risk reducing property of non-correlated returns. This diversification is conceptually warranted based on the idea that portfolios can simply expend a different risk in each of these uncorrelated asset classes. For instance illiquidity risk (private equity, private placements, commercial real estate), credit risk (high yield, emerging markets bond), skill risk (actively managed funds, hedge funds).

This has worked splendidly in hindsight. However, there is substantial estimation error implicit in the risk, return and correlation inputs used to model these new “asset classes”. We suspect that “crowded trades” and the reality that all correlations go to 1 when investors most need diversification will moderate this trend at some point in the future.

As Defined Contribution plans transition from being supplemental to primary sources of retirement security, fiduciaries will face increasing scrutiny and risk but, thanks to the Pension Protection Act, have additional ways to limit their liability,

Additional Disclosures - Defined Contribution Plan sponsors have been systematically disadvantaged by “asymmetric information”. Nobel Prize winner George Akerlof pointed out the implications of a market in which sellers are better informed about product quality and characteristics than buyers. The prevalence of negative alpha, poor investment benchmarking and obtuse fee structures in the 401k industry are all reflective of the information disparity in this market. In these kinds of markets, vendors focus on marketing and brand name development as proxies for the quality and attributes of the investments, which buyers often can't discern.

At least a dozen large lawsuits have been filed against large industrial company plan sponsors as well as retirement plan providers including Fidelity and some of the major insurance companies such as Nationwide, Principal, ING and Hartford Financial Services group. The common claim is that fiduciaries did not have and did not disclose sufficient information on plan expenses to enable prudent fiduciary decisions. While regulators will likely attempt to level the informational playing field via broadened disclosure requirements, fiduciaries will need to allocate more time and resource to stay current with the growing domain of disclosures.

Better Liability Protection - As fiduciary risks are better recognized, sponsors will increasingly take advantage of the new safe harbors in the PPA legislation. Life Cycle funds will capture an even bigger portion of plan allocations in 2007 as sponsors take advantage of the likely fiduciary safe harbor associated with their utilization. Unfortunately, Lifecycle fund choices will proliferate beyond what is necessary, making prudent selection more difficult. At the extreme, some sponsors may choose to reduce their liability further by eliminating all actively managed single asset class options from their plans and offering strictly index funds or life cycle retirement funds.

We think structural risks in both the capital markets and fiduciary domain have risen over the past year. Liquidity and the search for yield has likely driven interest rates and risk premiums to unsustainably low levels making a broad swath of assets vulnerable to risk reappraisal. Maintaining broad diversification to core assets and limiting substantial new mandates to risky assets seems a prudent approach for 2007. Proactively understanding and managing emerging fiduciary risks remains a high priority in 2007 as well.

401(k) Excessive Fee Litigation - It's Not About Total Fees

2006-12-18T20:29:00.000-05:00

I am not sure that Plan sponsors understand the nature of the 401(k) excessive fee litigation. They continue to take solace in the fact that their overall mutual fund expenses may be competitive. Even if their overall fund expenses are competitive, the "revenue sharing" allocations made from the "investment" manager or affiliate to the "recordkeeping" company or affiliate can be quite different on a per person basis depending on factors such as average participant balances. It is this plan to plan difference in per person administrative fees when compared to a relatively homogenous set of services that seems to be the basis for the excessive fee charges detailed in these recent suits.

Here is a ficticious example. Assume two $100 Million 401(K) plans, both using the same mutual funds, which we'll say have an average fee of 1%, and the same recordkeeper. Of that 1%, the investment management company gets .6% while the remaining .4% in "revenue sharing" goes to the "recordkeeping" company.

Further, assume that Plan A has 1000 employees and Plan B has 5000 employees. In 1 year for both Plan A and Plan B the "investment" company would receive $600K in revenue while the "recordkeeping" company would receive $400K.

Participants in both plans pay investment management expenses of .6% for every dollar of their invested assets. Investors with higher asset balances would pay a higher dollar value of investment management fees, though that would be expected. Using asset base as a basis for investment management fee generation seems fair and reasonable.

The issue arises in using the same asset base as a basis for determining what each participant pays for services, which we presume are roughly the same for both plans (recordkeeping, internet and phone access, research, materials etc). Plan A with 1000 employees pays $400($400k/1000) per participant for services while Plan B pays $80($400k/5000)per participant for their services.

This differential in per participant fees between the plans, as I understand it, is at the heart of the "excessive fee" complaint. In this case, Plan A is paying $320 more per participant in "excess fees" for plan services than Plan B. The fiduciaries of Plan A, according to the perspective taken in these complaints, were responsible for making sure these fees were reasonable in light of services provided. If services provided are roughly similar in both plans then to what do they attribute the cost differences?

While the courts will decide if there is merit to the charge that service providers fees can be "unreasonable" even within the context of reasonable overall fees, plan sponsors with either; very large plan asset balances, very large participant balances or plans with very strong asset growth might be most exposed to this kind of litigation.

Excessive Fee Suit Finds Fidelity

2006-12-14T16:29:00.000-05:00

The WSJ reported today that Schlicter Bogard and Denton has filed suit #11 against Fidelity and 401(k)Plan sponsor Deere & Co for improper, undisclosed and excessive fees. According to the article, the suit alleges that 1/3 of the fees collected by Fidelity go to revenue sharing and that the nature of a flat revenue sharing fee structure disproportionately benefits service providers as individual asset balances grow. Another allegation is that the Plan had a long standing agreement to select only Fidelity products.

It will be interesting to review the details of this complaint since this is the first major excessive fee suit filed against a servive provider.

Private Equity - Less of an "Alternative"

2006-12-03T17:17:00.000-05:00

Retirement plan fiduciaries have been confronted by a host of new fiduciary issues over the last few quarters. PPA, SFAS No.158 & excessive fee litigation have been widely addressed. Less recognized are some significant capital market trends that promise to have a growing impact on investment fiduciaries. Among others, substantial innovation in the derivatives market is adding complexity, uncertainty and risk to the fiduciary oversight process. The rapid development of private equity markets will also influence the investment opportunity set that retirement plan fiduciaries must consider providing and monitoring for their plans and participants.

The Committee on Capital Markets Regulation, an independent, bipartisan committee composed of leaders from business, finance, law, accounting and academia just released a study concluding that the US capital markets are becoming less competitive due to excessive regulation, enforcement and class action litigation. The dramatic increase in the use of private U.S. markets is indicated by these study statistics.

5% of the value of worldwide initial public offerings was raised in the U.S. last year,versus 50% in 2000.
the U.S. share of total equity capital raised in the world’s 10 top countries has declined to 27.9% so far this year from 41% in 1995.
private equity firms, almost non-existent in 1980, sponsored more than $200 billion of capital commitments last year
since 2003, private equity fundraising in the U.S. has even exceeded net cash flows into mutual funds and going private transactions have accounted for more than a quarter of publicly announced takeovers.

The benefits of private equity investing are addressed in an Update by the Center for International Securities and Derivatives Markets.

"Private Equity is generally regarded as an investment which offers investors the opportunity to achieve superior long term returns compared to traditional stock and bond investment vehicles. The long-term high returns of private equity represent a premium to the performance of public equities. Private equity provides higher return opportunities relative to traditional asset classes primarily through their ability to participate in a vast and growing marketplace of privately held companies not available in traditional investor products as well as their ability to create value by proactively influencing invested companies’ management and operations, thereby providing the opportunity to gain excess return over conventional stock and bond investments."

A substantive competitive decline in the US public capital markets would certainly have financial and economic implications that should be considered in future fiduciary decisions on market and asset class opportunities. Moreover, an increasing share of global capitalization allocated to private equity may particularly disadvantage defined contribution plan investors which generally can't access this asset class. As private equity becomes an accepted component of modern portfolio building practice by pension plans, endowments and other “qualified” investors, DC plan fiduciaries may in the future find it imprudent not to provide access to some level of private equity investment.

GAO Concludes 401(K) Fee Disclosures Inadequate

2006-12-01T06:47:00.000-05:00

The Government Accountability Office (GAO) completed an examination of fee levels and disclosures for 401(k) plans and concluded that current disclosure practices are inadequate for investors, plan sponsors and regulators. The GAO recommends that ERISA be amended to require that; service providers disclose all revenue sharing compensation, participants receive information on all fees related to each investment in the plan and that plan sponsors provide summaries of all fees paid by either the Plan or its participants. According to the study:

"fees that 401(k) plan sponsors are required by law to disclose is limited and does not provide for an easy comparison among investment options. The Employee Retirement Income Security Act of 1974 (ERISA) requires that plan sponsors provide participants with certain disclosure documents, but these documents are not required to contain information on fees borne by individual participants. Additional fee disclosures are required for certain—but not all—plans in which participants direct their investments. These disclosures are provided to participants in a piecemeal fashion and do not provide a simple way for participants to compare plan investment options and their fees. Labor has authority under ERISA to oversee 401(k) plan fees and certain types of business arrangements that could affect fees, but lacks the information it needs to provide effective oversight. Labor collects information on fees from plan sponsors, investigates participants’ complaints or referrals from other agencies on questionable 401(k) plan practices, and conducts outreach to educate plan sponsors about their responsibilities. However, the information reported to Labor does not include all fees charged to 401(k) plans and therefore has limited use for effective oversight and for identifying undisclosed business arrangements among service providers. Without disclosing these arrangements, service providers may steer plan sponsors toward investment products or services that may not be in the best interest of participants and may cause them to pay higher fees."

3rd Quarter Pension Peer Benchmarks

2006-11-22T05:56:00.000-05:00

In measuring your portfolio performance it is informative to look at institutional trust universe medians as well as market benchmarks. Care should be taken in drawing comparative performance conclusions however because the size, fees, asset allocations and objectives of the median in these universes may be substantially different than yours.

For the third quarter 2006:
the ICC median Master Trust returned 3.4%. This universe includes 21,000 portfolios with an aggregate market value of approximately $1.7 trillion.

the Mercer(Mellon) US corporate Plan Sponsor Median Universe return was 3.9% for the third quarter. Asset allocations are not provided.

The Northern Trust Corporate Median Plan return for third quarter was 3.9%. This universe covers 300 large institutional plans with over $550 Billion in assets.

REITS as an Investment Option

2006-11-21T12:44:00.000-05:00

The $200 Billion government Thrift Savings Plan (TSP)recently concluded they would not add a separate Real Estate Investment Trust or REIT fund as a program option. The following criteria were used to make this determination:

Is it a major asset class not currently offered as an investment option?
What financial benefits could participants expect from participating in the new fund?
Is the fund tied to indexes that could be used for the investment?
Are peer plans adding such funds?

The program further declined separate investments in non-U.S. bonds, value and growth stock funds, emerging markets stocks, TIPS and commodities for not meeting all the criteria.
The TSP is unique in scale and composition so these criteria may not fit all Plans. It does however, provide a nice illustration of the kind of prudent decision making process fiduciaries should adopt in developing their investment line-ups.

Fiduciary WMD

2006-11-20T07:00:00.000-05:00

"derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" Warren Buffet

The global financial system has become more competitive and efficient as a result of extraordinary innovation in risk transfer products. The investment derivatives market has grown in size and complexity, driven by the demand for more sophisticated risk hedging as well as higher returns. Retirement plans and hedge funds have been the primary drivers. Retirement plans are taking a larger role in these markets to meet return objectives and fund managers/hedge funds are taking a larger role to post attractive returns and remain competitive and profitable.

The Bank for International Settlements reports that the notional amount of all outstanding OTC derivative contracts was $370 trillion at June 30, 2006, 24% higher than at the end of 2005 and 4 times larger than in 2000. Credit default swaps increased by 46%, interest rate derivatives grew by 24%, foreign currency contracts grew by 22%, while equity and commodity contracts grew by 17% and 18% respectively. The “net” market risk of these contracts, after accounting for offsetting exposures, increased 3%. This was a less astounding $10 trillion.

Being reasonably informed is a much harder task in derivatives than in other parts of the capital markets, especially in the OTC markets which are largely unregulated. Derivatives can be used for speculation or risk reduction. Speculation can be extremely risky because derivatives employ high risk leverage. Using derivatives to hedge portfolio exposures is less risky, though instability in correlations can create unintended risks. The DOL provided guidance on a fiduciary’s responsibilities for direct investments in derivatives.

“Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries. In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses”.

Indirect derivative investments require fiduciaries to;

“obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances”

Investment fiduciaries need to understand the unique risks (market, credit, operational, liquidity and legal) and opportunities posed by investment derivatives since they have the ultimate responsibility for determining if they are being suitability utilized for their plan and participants. What might have been a prudent due diligence process for derivatives a few years ago would certainly not be sufficient today. Fiduciaries should be especially aware that the current low yield environment motivates fund managers to amplify risk to improve returns.

The mind numbing complexity of the current generation of derivatives can easily disguise speculative activity and the endemic risks of derivatives for which plan fiduciaries can be held responsible.

Fiduciary Decisions

2006-11-16T10:30:00.000-05:00

Investment fiduciaries under ERISA will be judged based on their decision making processes. It is their conduct not the outcome of their decisions that matter most. Decision making is central to human activity yet there are many impediments to a good fiduciary decision making process. Human behavior in the face of uncertainty, group decision dynamics, time and resorce constraints and information asymmetry can can hinder good decisions.

The first decision fiduciaries must make tackle is...are they appropriately skilled and positioned from a time and resources perspective to make investment decisions? ERISA requires them to be or to seek counsel from those who are. Not critically addressing this most fundamental decision may stand out as a primary reason why plans and participants are underperforming, why poor investment products proliferate and why conflicts of interest still pervade the retirement investing industry. Oversimplifying investment decisions or avoiding them altogether generates fiduciary liability.

Robert Rubin made some thoughtful comments on decision making that are relevant to fiduciaries:

"recognizing that all decisions are about probabilities rather than certainties should lead us to uncover and engage with the full array of complexities around making the best decisions"

"each alternative possible outcome is not a simple, single effect, but the net effect of tradeoffs between competing considerations"

"often, decision-makers faced with a situation where all choices are bad, react by not deciding. That, however, is a decision in itself, and often the wrong decision"

"reality is complex, and recognizing complexity and engaging with complexity was the path to best decision-making"

Over-engineering Target Retirement Funds

2006-11-15T20:21:00.000-05:00

Single asset class investment funds are the investment equivalent of blunt objects. They provide basic though limited value when utilized on a standalone basis. Their potential value is unlocked when combined with other asset class investments. The leading target retirement funds do a reasonable job of combining asset classes in an efficient way and also provide a simple method for matching investments to investors. These products fit many investors generally though few specifically. Competent individual investment advice provides the greatest potential for optimizing asset mixes in a way that best suits the unique appetites and circumstances of each investor.

Though building customized target retirement funds may make sense in certain cases, the cost, effort and added fiduciary liability incurred in over-engineering these products might be better spent in the delivery of consistent and comprehensive personalized investment advice to retirement plan participants. In providing participant tools for retirement, it may be more effective for plan sponsors with a good pile of “rocks” to provide “nail guns” instead of “hammers”.

Risk

2006-10-27T08:34:00.000-04:00

San Diego parts company with their consultants, providing another lesson from Amaranth.
Sophisticated due diligence may not fully identify the risks implicit in many hedge fund strategies and new investment products. Hedge fund returns are not normally distributed. They can exhibit extreme levels of skewness and kurtosis. Because of this, standard measures of volatility are insufficient to measure hedge fund risk. Mean variance analysis, which is commonly used to develop portfolio asset allocation strategies, isnt an adequate tool for these strategies.

If your pension plan has hedge fund exposure and the rationale for that investment shows up on a standard "efficient frontier", you don't have all the information you need to evaluate its risks.

Risks Increase in Global Financial Markets

2006-10-26T09:10:00.000-04:00

A recent CFA publication addresses the risks and rewards implicit in the growth and breadth of global capital markets.

The depth and flexibility of global financial markets has grown significantly by integrating new geographic regions, creating innovation in financial products and attracting new investors. However, these changes in market structure have also increased the potential risk and magnitude of a global financial crisis. As new investment products proliferate, untested market dynamics, market liqudity & the operational infrastructure pose additional risks.

For instance, the leveraged loan market has grown substantially through the use of new instruments such as credit default swaps and collateralized debt obligations and the use of leverage to provide attractive yields. The demand for these products is high, driven by hedge funds and other institutional investors. According to S&P, the demand (liquidity)is driving "loose" underwriting and increasing the risk when the credit cycle turns.

Peer Benchmarks

2006-10-24T09:00:00.000-04:00

Northern Trust reported that the median return for their universe of 300 investment plans ($1.8 Billion avg. assets) was 7.4% YTD. For the quarter the median return was; corporate Plans 3.8%, public plans 3.7% and foundations/endowments 3.2%. Over 5 years, median return was corporate 9.4%, public 9.8%, endowment/foundation 9.4%

Investment fiduciaries own Best Execution

2006-10-23T11:13:00.000-04:00

The DOL asserts that Plan fiduciaries have a duty to ensure “best execution” in the acquisition/disposition of plan assets. They retain the duty of oversight with this standard even if they delegate trading responsibility to their investment managers. Therfore, investment fiduciaries should be aware of regulatory guidance and practice in this area. “Soft dollar” regulation, in particular, has been somewhat nebulous and even contradictory over the years.

When the SEC abolished the fixed commission structure in 1975 , guidance was required to establish the definition of best execution. Section 28(e) of the 1934 Act provided a limited fiduciary safe harbor for brokerage commissions in excess of the amount of commission another broker-dealer would have charged, if a good faith determination indicated that the excess was reasonable in relation to the value of brokerage and research services provided. These excess commission costs for research are referred to as "soft dollars". The DOL has indicated that plan fiduciaries are not covered by this safe harbor if they do not "exercise investment discretion". In addition, the use of "soft dollars" to pay for non-research related services may be a violation of securities laws and or ERISA .

Since the adoption of Section 28(e) in 1975, the SEC has issued three interpretive releases on the subject. The first did not protect ordinary commercial products while the second, issued in 1986 changed positions and invited broad interpretation of the safe harbor coverage. The third release in 2006 provided greater clarity on allowable research & brokerage expenses. Investment fiduciaries should get familiar with this material and implement a formal process to periodically review their plans and investment manager's use of soft dollars and best execution procedures and results.

How Employers Can Improve Defined Contibution Plans

2006-10-19T08:20:00.000-04:00

The Financial Economists Roundtable meets annually to address an economic priority. The result of this years meeting is a set paper entitled, Best Practices for the Design of Defined Contribution Plans. . A summary of the panel's recommendations is available at Knowledge @ Wharton. It concludes that employers should:

implement autoenrollment
minimize use of employer stock
expand use of annuities
provide financial education

Target Retirement Funds - Prefab vs. Home Brew; Ford Motor Co Study

2006-10-18T12:01:00.000-04:00

The Pension Protection Act of 2006 will create a new paradigm in the investment profile of participant directed plans. Target Retirement Funds(TRF’s) are beginning an inevitable and rational (simply selected, diversified portfolios which are constantly monitored and consistently rebalanced while providing a fiduciary safe harbor) march to dominate 401(k) plan investment allocations. Several recent articles stimulated our thinking on alternative TRF implementations.
An article in Investment News indicated some advisers are urging employers to create their own customized TRF’s by using the population of funds available in the plan. Alleged benefits of the "home brew" from the advisors perspective were better information and control over the asset allocation and individual funds in the mix. This leads to a carefully unstated but strongly implied promise of better performance than the pre-fabricated TRF”S offered by proprietary providers which could be populated with the “mid level funds..put there by managers who are eager to generate assets in a fund that might be struggling” according to the article

While we don’t necessarily take exception to the notion that the pre-fab TRF’s are designed to meet both their sponsors economic objectives as well as their clients investment goals, we suspect there are probably not that many plans where the customized TRF solutions based on their existing fund lineup would both; have an inherent expected performance advantage and the “expected” excess returns would out-weight the added expense and liability that the sponsors would bear in creating it. We think this is so because; most plan investment menus are limited and fund selection is often driven by standards other than portfolio optimization, active management of individual fund choices is counterproductive and has a long tail in 401k plans and plan fee structures are often similar between prefabs and across investment menus.

Limited Investments (Asset Class) Options - The average 401(k) plan investment choices do not generally span the efficient frontier and are predominated by large cap equity funds which have the lowest statistical probability of outperforming their benchmarks. In addition, the ERISA suitability standard, as generally interpreted in practice, limits many investment line-ups to “core” investments. Institutionally driven TRF asset allocations should, under the principles of modern portfolio theory, include a broad array of asset classes, some of which might be deemed unsuitable and present fiduciary exposure on a stand-alone basis. Real estate is a good example of an asset class that is broadly used in institutional strategic asset allocation practices but is fairly limited in 401(k) plan line-ups.

Advisor Added Value by Active "Control"
The promise that advisors can optimize TRF return performance by actively managing the individual fund holdings within a TRF mix is largely illusory. Other than for the short term persistence inherent in some momentum strategies, fund performance is largely related to asset class exposure and accident. In addition, the process required to remove or add funds within a 401(k) plan has a fairly long horizon due to the various layers of authorization and communication which must happen before fund changes are implemented.

Investment Fees are not proportional to Plan size
The 401(k) fee industry fee structure is asymmetric in favor of providers. Fees can go up to ensure provider profitability for smaller plans but fees often don’t go below the level of fees (profitability/revenue sharing) implicit in mutual fund structures. Larger plans should enjoy economies of scale in investment fees. However, the predominant use of registered mutual funds, which often only have several price classes, limits the scale economics that many plans could take advantage of. Plans that use lower priced trusts or that have broad index fund coverage in their plans may be able to take advantage of the this via a customized TRF vs. certain prefab TRF’s.

We noticed that the Ford Motor Co 401(k) plan recently announced some 401(K) fund changes. To provide an anecdotal ex post example of the performance differential between a prefab TRF and a similarly constructed customized fund, we used the Ford Motor Co. 401(k) Plan as an example. We obtained a list of the investments in Ford’s 401(K) Plan at FundAdvice.com. We did limited due diligence on the holding list and concluded it was reasonably current, though it did not reflect the recently announced fund changes.

We took the asset allocation of the Fidelity 2040 Freedom Fund as of 9/30/2006 (selected for its predominant equity allocation) as implied by the Morningstar category of each of the funds held within the Freedom Fund, and built 3 portfolio composites (rebalanced quarterly) with this static asset allocation. Historical return results are posted below.

FREEDOM 2040 STATIC – a composite using the Fidelity funds held within this fund of funds as of 9/30/2006. To create a 5 year history, we used an appropriate index return series to fill the gap for those funds with less than a 5 year track record.

FORD 401k – a composite using the actively managed funds within the Ford 401k plan in the same allocation as the Freedom 2040 static using Morningstar categories. Since Ford had no mid-cap funds, the mid cap allocation was split on a market weighted basis between Fords small & large cap equity funds. Real estate was excluded since this asset class wasn’t represented in the Freedom 2040.

FORD 401K BM a composite representing the asset allocation implicit in the Freedom 2040 Static using appropriate benchmark indicies for each asset class and style

Though purists can quibble about the details, the results of this example align with our intuition that a composite of carefully and specifically selected actively managed individual funds available in a 401(k) plan would not seem to have a distinct performance advantage over an exclusively actively managed and similarly carefully selected prefab TRF or for that matter an index based TRF. There may be some justification to the argument that having funds from the same provider in both TRF’s leads to this result. One could argue more broadly however, that systematic excess return in any diversified portfolio of actively managed funds should be similar over time since alpha by nature should be uncorrelated. We'll leave the conclusion about the sign of the expected excess return for another time.

Annualized Return through September 2006

Portfolio	1 Qtr	1 Yr	2 Yr	3 Yr	4 Yr	5 Yr
Ford 401K	2.8%	10.2%	12.3%	12.2%	15.6%	9.1%
Freedom 2040 Static	3.2%	10.1%	13.4%	13.3%	16.4%	9.8%
Ford 401k Benchmark	4.3%	10.6%	13.2%	13.6%	16.7%	9.6%

Calendar Year Returns September 2006

Portfolio	YTD	2005	2004	2003	2002	2001
Ford 401K	6.0%	8.6%	10.3%	31.9%	-16.8	-7.1%
Freedom 2040 Static	6.2%	9.8%	12.1%	31.1%	-17.1%	-10.3
Ford 401k Benchmark	8.0%	7.7%	12.8%	31.5%	-17.8	-10.9

DOL Advisory Opinion 2006-08a Posted

2006-10-16T12:26:00.000-04:00

DOl Advisory Opinion 2006-08a, which addresses fiduciaries consideration of plan liabilities in portfolio asset structure, was posted today and is available here.

DOL Advisory Opinion 2006-08a

2006-10-16T05:48:00.000-04:00

The United States Department of Labor has released Advisory Opinion (2006-08A) requested by JPMorgan's Investment Bank. This Advisory Opinion provides defined benefit pension plan fiduciaries with greater clarity on the consideration of liabilities and associated risks as part of prudent investment decision making.

US pension plans have generally managed assets with an eye towards maximizing long term investment returns rather than managing pension surplus volatility. The expressed preference has been to sacrifice funding stability with long term funding minimization. Large equity allocations have been characteristic of US Plans, with an equity allocation averaging around 60%. Changes in the pension environment will stimulate interest in asset liability (surplus) management, as indicated by the JPM opinion (which has not yet been posted to the DOL website).

As Plan's mature and increasingly freeze benefits, the proportion of active participants to retirees and terminated vested employees will decline. As this happens, overall plan liabilities become more predictable and facilitate offset by similar duration fixed income strategies. Equity has also been important as an inflation hedge for future wage increases for plans with large active populations. The need for this protection will diminish as active plan populations decline.

Surplus immunization strategies will never be prominent when Plans are underfunded since sponors would prefer to fund from their assets rather than their pocketbooks. As the PPA 2006 regulations effectively force improved funding, the risks and volatility associated with a large equity exposure designed to improve funded status may begin to outweight the theoretical higher expected returns.

Finally, the convergance of US accounting rules with international accounting standards will limit sponsors appetites for the traditional equity oriented pension portfolio exposure. Financial Reporting Standard 17 issued in November 2000 and implemented in 2003 requires market value accounting and income statement recognition of both assets and liabilities. This had consequences internationally. UK pension funds had historically allocated a high proportion of their assets to equities, relative to the US, Japan and other European countries, with a 71% equity allocation in 2000. However, this allocation fell to 56% as UK pension funds switched assets into fixed income securities according to the FSA.

As the imlicit "costs" of higher expected returning equity- centric pension portfolios grows due to the changing pension climate, asset liability management will likely gain prominence. Asset liability optimization and strategies such as duration matching and portable alpha may over time replace asset only optimization as industry best practice. We suspect 2006-08a is one step in defining practice in this new direction for pension plans.

Interestingly, a large segment of the asset management industry now serving plans has little competency in liability analysis or asset liability management. Because of the entrenched asset only optimization practice and with minimal growth opportunity in the defined benefit plan space, industry wide transition to these new strategies will be slow and primarily deployed by the largest plans.

401(k) Fees - Documented or Defendant

2006-10-12T17:36:00.000-04:00

There couldn't be a better time to ask your service provider to help you document how your employer/employees 401(k) dollars are being spent. Take a minute to familiarize yourself with Plan fees using these resources;DOL Plan fees , 401khelpcenter Collected Wisdom on Plan Fees,or CIEBA Plan Fees , then send a request like this to your 401(k) service provider.

Dear Service Provider,

Pension plan fiduciaries are responsible for selecting and monitoring both their plan service providers and the investment options that are made available to their plan participants. Responsible plan fiduciaries must ensure that the compensation paid directly or indirectly to their service provider is reasonable, taking into account the services being provided to the plan as well as other fees or compensation received by the provider in connection with the investment of plan assets.

The Department of Labor has consistently taken the position that plan fiduciaries must obtain sufficient information regarding fees or other compensation that service providers receive related to the plan's investments and then must make an informed judgement as to whether the service provider's compensation is reasonable.

Recent litigation has placed renewed emphasis on these fiduciary responsibilities and the attendant demand for full disclosure and transparency of all Plan fees, expenses and revenues received by any Plan service provider. Therefore, we request you complete the attached fee disclosure worksheets for the XYZ 401(k)Plan as of September 30, 2006.

The intent of the attached DOL Fee Disclosure Worksheets , or ASPPA Fee Disclosure Worksheet or 401khelpcenter Annual Service Provider Disclosure Worksheet is to confirm the hard dollar fees paid directly by either Plan participants or the Plan sponsor and to identify any additional soft dollar or intermediary fees which your organization may receive related to your service or investment relationship with the Plan. The completed worksheets should reflect the total actual or estimated fees for the Plan and any revenues which your organization receives related to your servicing relationship with the Plan.

Respectfully,

Landmark Agreement - No Investor Left Behind!

2006-10-10T17:51:00.000-04:00

Per today's new release "Attorney General Elliot Spitzer announced a landmark agreement that will set new national standards for transparency in the marketing of retirement products and provide compensation to each of more than 50,000 teachers in upstate New York".

"Under today’s settlement, ING has agreed to set a new industry standard for retirement product disclosure by providing a simple cover-page summary of all the costs of each plan it offers. This disclosure will include a chart demonstrating the impact that these costs have on long-term investments. On this disclosure page, ING will also explain that mutual fund managers often pay ING to have their funds appear on the menu of options offered to investors." The "landmark" 1 page disclosure appears below.

Important Facts About [Name of Product]
This retirement product is not free. ING and the funds offered in the product charge various fees and expenses. Many fund companies pay ING in return for being offered as investment options, as well as for the recordkeeping and related services ING provides. Funds are selected based on the revenue they pay to ING and on ING’s ssessment of their quality and cost. Both ING and the mutual fund companies seek to make a profit from the product. Any fees that you pay as part of your retirement plan will have an impact on your savings over time. An investor in this product pays ING and the fund companies an average of __% of his or her account balance every year. The table below shows the impact of the average fee on the account of an investor who saves $__ at the beginning of each year over a twenty-year period, assuming that the investment portfolio (before fees) increases by 7% per year

.
Year EOY Bal. Without Fees EOY Bal. With Average Fees
1
5
10
15
20

Total impact of average fees = $

Putting the Conflict Back into Advice

2006-10-10T12:16:00.000-04:00

Beginning in 2007 the Pension Protection Act (PPA) provides a prohibited transaction exemption for fiduciaries to provide investment advice to plan participants. Historically, sponsors have not wanted to take on the fiduciary exposure related to advice provision. Money managers have preferred to maintain their investment arrangements with plan sponsors rather than focus on plan investment advice, since the potential conflicts inherent in providing both of these services created a prohibited transaction under ERISA.

The PPA advice provisions, presumably cognizant of the self dealing potential associated with money management firms providing advice covering their own products, allows only 2 kinds of investment advice arrangements; those incorporating a level fee structure or those generated by an objective computer model. Both these exemptions have been recognized in a case specific way by the DOL prior to the PPA. The SunAmerica letter dealt with computer generated advice models while the Country Trust Letter dealt with fee leveling.

The flat or level fee model requires that the fees received by the fiduciary advisor are not dependent on the investment selections made. What is not specified in the PPA is whether the fee leveling relates specifically to the individual providing advice or also to the advisor's employer or a member of a controlled business group. Consistent with the old ERISA advice exemptions, the PPA legislation may have been drafted to prohibit any advisor from qualifying under this exemption should either they or any member of their employer or controlled group benefit from differential fees. On the other hand, there is opinion that this was not the intent of the legislation. From our perspective, the most critical piece of the PPA advice provision remains subject to interpretation or subsequent technical correction.

The large insurance and investment firms are lobbying for a technical correction to the langauge which would clearly contain the fee leveling requirement to the individual or registered rep level. Should they prevail, this would be a major directional change in ERISA. It would also represent a monumental business opportunity for the large money manager/retirement plan providers to capture individual account relationships, profit from them while in a qualified plan and retain them as they rollover post retirement.

Six Early Lessons from Amaranth

2006-10-10T12:03:00.000-04:00

Noted commodities expert Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, finds in a paper titled EDHEC Comments on the Amaranth Case, Early Lessons from the Debacle

"that the fund employed a Natural Gas spread strategy that would have benefited under a number of different weather-shock scenarios. These were economically defensible, although the scale of their position-sizing relative to the capital base clearly was not. Using a returns-based analysis to infer the sizing of positions, it is found that the Amaranth’s energy portfolio likely suffered an adverse 9-standard-deviation event on the Friday (September 15th) before the fund’s distress became widely known."

2006 Public Pension Fund Survey

2006-10-03T20:10:00.000-04:00

The 2006 Public Pension Fund Survey is an online compendium of key characteristics of most of the nation’s largest public retirement systems. A key objective of the Survey is to increase the transparency of the public pension community and pension funding levels, providing a factual and objective basis on which to discuss many issues related to retirement benefits for public employees.

The Survey presents 2005 FY data on public retirement systems that provide pension and other benefits for a combined 12.8million active (working) members and six million annuitants (retired members, disabilitants and beneficiaries). Combined, systems in the Survey hold in trust $2.26 trillion, invested in diversified portfolios of public and private equities, corporate and government bonds, real estate, cash, and other assets. The membership and assets of systems included in the Survey represent approximately 88 percent of the entire state and local government retirement system community. According to the U.S. Census Bureau, employees of state and local government comprise more than ten percent of the nation’s workforce.

Amaranth - Another Meteor Strikes Earth

2006-10-03T08:16:00.000-04:00

An EDHEC study by research associate Hilary Till ,as reported in the FT, concludes that the natural gas market moves that decimated the Amaranth hedge fund were statistically less probable than those that ruined Long Term Capital, (similar to the probability of a meteor striking earth). However, the fund's "massive" position in natural gas derivatives virtually guaranteed disaster as the fund, without adequate capital, was forced to liquidate its holdings.

While the historical diversification and risk/reward opportunities in hedge funds can look attractive on a mean variance basis, as Jeremy Siegal points out, the risk in certain strategies can't be quantified regardless of the length of the historical analysis.

Schlichter, Bogard & Denton 401(K) ERISA Suit vs International Paper

2006-10-02T08:37:00.000-04:00

Plaintiff law firm Schlichter,Bogard & Denton has filed ERSIA breach of fiduciary duty suits against at least 7 Fortune 500 employers; Lockheed Martin, General Dynamics, United Technologies Corp, Bechtel Group, Caterpillar Inc, Exelon and International Paper. These plans collectively have more than 400,000 employees in their 401(k) plans.

We took a closer look at the International Paper (IP) complaint to understand the specific claims and to highlight possible exposures for other Plans. The IP plans had about $4.3 billion in assets and $666 million in IP stock ending 2005 according to their 10-K filing.

Overall, the complaint charges breach of fiduciary duty for allowing excessive fees and incomplete disclosures to Plan participants. The relevance of these suits to the rest of us is that the alleged breaches pertain to fairly common industry practices such as; master trust account structures, revenue sharing and generalized fee and performance benchmarking.

Master Trust Structure Understates Disclosed Fees
Master trust structures are widely used in the 401(k) industry to provide multiple employers or related groups with a common trust to facilitate uniform administration of the assets of multiple plans and multiple investment managers. According to the complaint, this structure understates Plan expenses reflected in information available to participants. For instance, certain master trust specific expenses, while being taken out of fund net asset values are not explicitly detailed in Plan regulatory filings. These expenses are included in Master Trust filings, though these are presumably not readily available to plan participants.

Unapplied and Undisclosed Revenue Sharing Arrangements
Revenue sharing arrangements (compensation transfers usually from asset managers to service providers) are commonly employed in the industry and can fund a substantial percentage of a plan's expenses. These arrangements are lightly disclosed and relatively unregulated by the DOL or SEC and were not addressed since they werent common practice when ERISA was drafted. The complaint charges that established revenue sharing arrangements were not utilized to offset hard-dollar plan costs – effectively making plan participants pay an unnecessary premium for services. In addition, the revenue sharing arrangements were not disclosed to Plan participants.

Revenue sharing arrangements are common in the industry and, like any tool, can be properly used or abused. These arrangements have been getting better disclosure at the sponsor level, though participant level disclosure probably lags. In the small 401(k) market, plans are largely “price-takers”. These Plans have less recourse in accepting revenue sharing arrangements and may be less informed and/or limit disclosure. A $4 billion Plan, on the other hand, can avoid undesirable revenue sharing arrangements and many generally practice better disclosure. According to the 2005/2006 Deloitte & Touche 401(k) Benchmarking Study, Plans with assets >$1Billion (mega plans) are more likely to fully disclose plan administration costs without any revenue-sharing or investment revenue offsets as well as disclose revenue-sharing arrangements and investment offsets (75 percent and 79 percent, respectively) compared to the national sample (63 percent and 67 percent, respectively). Revenue sharing arrangements in this segment that exceed costs of service are more likely to result in a fee credit (19%) than in the average. Avoiding the capture of available revenue sharing on behalf of plan partcipants could be a big fiduciary issue for IP. This case also point out the need for additional regulatory or legal clarity around common revenue sharing practices that impact many plans.

Misleading Fee Benchmarks
IP Plan fiduciaries allegedly compared their Plan investment expenses ratios to a Morningstar average including retail share classes (which include the impact of sales commissions/deferred charges etc). Use of the Morningstar Overall Fee Average is a favorite “head fake” used regularly in the asset management business to put distance between their fees and a peer mean.

Though this comparison may not be an example of discerning fiduciary benchmarking, the level of fund expenses, which were not disclosed in the complaint, should be substantially below this average, even after considering that they support some level of non-sponsor paid service provision in 401(k) plans. According to the Deloitte and Touche study, average fund expense ratios for mega plans should be 38% to 50% percent lower than in other segments.

Misleading Performance Benchmarks
The complaint states that “the performance and quality of the Plans investment options is, and has been quite poor”. Though no performance details were provided, the complaint argues that several fund benchmark changes, an incorrectly benchmarked S&P500 fund and an improperly scaled risk return exhibit provide evidence of Plan self-promotion and misleading performance.

Though actual performance data is critical to judging the merit of these charges, they don’t appear especially flagrant given practical imprecision in comparative performance analysis. The complaint seems very literal and naive in its assertions about what constitutes maket indicies and the absolute correlation of performance indicies to actual holdings. For instance, the complaint alleges the combination of an 80% MSCI EAFE and 20% S&P EMI EPAC (extended market index in the Euro Pacific region) is not a valid “market benchmark”. Only the facts can determine whether this composite matches the implemented investment strategy but composite benchmarks generally signal more sophisticated not less relevant benchmarking. The complaint alleges that benchmarking a large cap fund which held undisclosed securities “with risk levels incompatible with large cap investing” to the S&P 500 was misleading. Though this may be "literally" inappropriate, it is normative practice. Look at Growth Fund of America, a US large cap fund that includes 12% cash and 19% international equity. The complaints benchmarking example would probably require an extreme set of facts to be considered "misleading" beyond currently accepted fund categorizations.

Excessive Fees for the Employee Stock fund
This portion of the complaint reads like a “stock drop” suit where underperformance and participant risks are enumerated. However, in the end, the fiduciary violation charged is excessive management fees for what they regard as a “low cost” ( ie no-one manages the investments) option. Though the expenses weren’t detailed, unitized employer stock funds are expensive to manage because; the asset pool size is limited, daily pool liquidity must be managed, they often require one-off record keeping systems and processes and also represent legal exposure for the trustee/administrator. For this, firms levy higher investment management fees than comparable generic investment pools.

The IP complaint addresses several areas of industry practice which have developed beyond specifc regulatory or legal standards. The DOL has strenghtened fee disclosure requirements effective in 2008. Under the new Schedule C requirements Plans will have to provide more information about third-party financial relationships. Plans will have to identify all service providers that receive $5,000 or more from plan assets. At this point, Plan sponsors should focus on understanding and memorializing any revenue sharing arrangements. Request all service providers document their fee and revenue arrangements. Reviewing and documenting external fee comparables would be prudenta s well. Sponsors might also review participant disclosures and plan/trust documents to ensure comprehensive disclosure of all relevant fees and arrangements. To the extent employer stock is held in the Plan, review your goveranance and fiduciary monitoring protocol with ERISA counsel.

401(k) Default Regulations - Capital Market Assumptions

2006-09-30T07:24:00.000-04:00

The Employee Benefit Security Administration of the Department of Labor used a simulation model to estimate the impact of the proposed 401(K) default investment regulations on retirement savings in the US. This work provides several capital market return asumption data points that plan sponsors could use as collateral support for their capital market assumptions or plan participants could use in forecasting retirement needs.

The model inputs were:
9.48% nominal average return on diversified equity (6.5% real returns)
5.8% nominal average bond return (3% real)
2.8% inflation rate
Equity standard deviation estimate was 18.44%

A 60% equity portfolio using these parameters would expect about an 8% return. This is around the mean actuarial assumed return for US defined benefit plans. One peer reviewer noted the equity return assumptions may be overstated over a 20 year horizon due to the current historically high P/E multiple and the absence of an explicit fee assumption. Individuals using these projections might to apply a 100-150 basis point haircut.

FASB No. 158 - New Defined Benefit Plan Accounting Standards

2006-09-29T13:59:00.000-04:00

Today, the Financial Accounting Standards Board (FASB) issued the final Statement No. 158 Accounting for Defined Benefit Pension and Other Post Retirement Plans. Per FASB, the funded status and costs associated with employer’s postretirement benefit plans were not readily available to investors in a complete or understandable way under the old accounting rules. The new accounting standard:

recognizes a balance sheet asset for a plan’s overfunded status or a liability for a plan’s underfunded status,

measures its funded status as of the end of the employer’s fiscal year, and

recognizes changes in the funded status in the year in which the changes occur through comprehensive income or changes in net assets for non-profits.

The industries primary objection to this standard was FASB's use of a Plan's Projected Benefit Obligation (PBO) rather than the Accumulated Benefit Obligation (ABO) to measure pension liabilities. One consulting actuary estimated that this change could reduce shareholder equity across large public companies with active Defined Benefit plans by almost 10%. Plan curtailments are certainly a rational response given this estimate.
The PBO creates a higher liability than the ABO because it includes an estimate of future increases in compensation which are not current obligations. The industry belives the future compensation increase estimates would not qualify as a current liability under other FASB rules and shouldnt be included here. The FASB believes that the PBO fairly represents a Plan's contractual and economic obligation.

The issuance of Statement No. 158 completes the first phase of the Board’s comprehensive project to improve the accounting and reporting for defined benefit pension and other postretirement plans. A second, broader phase of this project with potentially more damaging income statement accounting impacts on defined benefit plans remains.

401(k) Safe Harbor Default Rules

2006-09-27T17:29:00.000-04:00

The DOL provides the following overview of their Investment Default Safe Harbor proposal. The full Proposal is available here.

ERISA provides relief from liability for investment outcomes to fiduciaries of individual account plans that allow participants to exercise control over the investment of assets in their plan accounts.The proposed regulation deems a participant to have exercised control over assets in his or her account if, in the absence of investment direction from the participant, the plan fiduciary invests the assets in a qualified default investment alternative (QDIA).Assets must be invested in a “qualified default investment alternative” as defined in the proposal.

Participants and beneficiaries must have been given an opportunity to provide investment direction, but failed to do so.
A notice must be furnished to participants and beneficiaries 30 days in advance of the first investment, and at least 30 days in advance of each subsequent plan year, and must include: a description of the circumstances under which assets will be invested in a QDIA; a description of the investment objectives of the QDIA; and an explanation of the right of participants and beneficiaries to direct investment of the assets out of the QDIA.
Any material, such as investment prospectuses and other notices, provided to the plan by the QDIA must be furnished to participants and beneficiaries.
Participants and beneficiaries must have the opportunity to direct investments out of a QDIA with the same frequency available for other plan investments but no less frequently than quarterly, without financial penalty.
The plan must offer a “broad range of investment alternatives” as defined in the Department’s regulation under section 404(c) of ERISA.
Plan fiduciaries would not be relieved of liability for the prudent selection and monitoring of a QDIA.

Qualified Default Investment Alternatives
Under the proposed regulation, a QDIA must satisfy the following requirements:

A QDIA may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer the investment from the qualified default investment alternative to any other investment alternative available under the plan.
A QDIA must be either managed by an investment manager, or an investment company registered under the Investment Company Act of 1940.
A QDIA must be diversified so as to minimize the risk of large losses.
A QDIA may not invest participant contributions directly in employer securities.
A QDIA may be a Life-cycle or targeted-retirement-date fund;Balanced fund; or Professionally managed account.

Fiduciary Investment Issues in 401(k) Plans

2006-09-21T19:58:00.000-04:00

This article from IFEBP reviews a fiduciary's resonsibilities relating to defined contribution (DC) plan investments, mitigating fiduciary liability for investment performance, and investment fees.

"DC plan trustees can limit their potential liability by prudently investigating and evaluating potential plan investments, and by documenting the facts and reasoning that led to the decisions. Finally, DC plan trustees should investigate potential undisclosed fees and expenses that may be charged by their investment advisors. Trustees can further reduce their potential fiduciary liability by relying on the advice of an investment consultant and by structuring the plan to allow participant-directed investments in compliance with DOL regulations. After an investment decision is made, the trustees have a continuing fiduciary duty to monitor vendors and investments."

Amaranth - A Deeper Level of Understanding

2006-09-19T21:53:00.000-04:00

An April 2006 article in ALPHA magazine spotlights SDCERA's CIO David Deutsch and his allocation of roughly $1.3 billion, or one fifth the Plans total assets, to an alpha engine portfolio. He decided to dispense with the fund of funds convention and save some "real money" self-diversifying by;

"adding some big-name multi-strategy funds to the mix. It allocated $175 million each to D.E. Shaw & Co. and Amaranth Advisors in addition to giving $125 million to Silver Point Capital. In so doing, the fund demonstrated that it has deepened its level of understanding, vis-à-vis individual hedge fund strategies, choosing Amaranth for its arbitrage approach and D.E. Shaw for its quantitative models that include statistical arbitrage. Silver Point further diversifies the portfolio through its active investing and loan origination activities."

The point - even sophisticated investors despite a "deepened level of understanding" still face uncertainty and the risk of large losses when allocating to levered funds. Amaranth was, in theory, a "multi-strategy" hedge fund. However, it's collapse suggests it's risks were not detected by an expert fiduciary's due diligence process. Smaller pension investors without sophisticated due diligence resources are at even greater risk that allocations to complex investment strategies could generate losses and subsequent fiduciary trouble.

401(k) Fee Lawsuits -II

2006-09-19T19:38:00.000-04:00

Groom Law group has published a follow-up on 401(k) Fee lawsuits.Their analysis concludes;

"These cases represent the next development in the evolution of the law regarding fees and relationships between plans and their service providers. The potential impact of the cases on the structure and operation of plans is significant. Each of the complaints alleges that plan recordkeepers, consultants and TPAs are fiduciaries and imply that revenue sharing payments are plan assets. The retirement service industry as a whole would be greatly affected if a court were to agree."

401(k)helpcenter has reviewed and summarized one of these complaints filed against Northrop Grumman Corporation, The Northrop Grumman Corporation Savings Plan Administrative Committee and Investment Committee, numerous corporate offers and their Board of Directors. They reval that similar suits have been filed against at least five other major Fortune 1000 companies with over a dozen more soon to follow.

401(k) Fee Lawsuits

2006-09-18T08:35:00.000-04:00

The Seyfarth Shaw Law firm reported that Schlichter, Bogard & Denton, a plaintiffs’ law firm, filed a wave of complaints involving 401(k) plan fees.

"These lawsuits target large 401(k) plans sponsored by large employers( in the Illinois & Missouri area) name the employer as defendant, and in some cases, plan fiduciary committees and their various individual members. In the "cookie-cutter" complaints, the plaintiffs allege a variety of breaches of fiduciary duties and prohibited transactions relating to fees paid by 401(k) plans"

Seyfarth produced a Presentation on 401(k)Plan Fees for their clients. Plaintiff's attorney Keller Rohrback may be on the fee case as well. It is currently investigating companies that serve as "Investment Providers" for 401(k) plans and the company fiduciaries that retain them in order to determine whether they have breached their fiduciary duties under ERISA by, among other things, causing 401(k) plans to incur excessive management and administration fees or entering into improper fee sharing arrangements with mutual fund companies that are selected by them. (source: Plansponsor)

The Plaintiff firm's must see their window to litigate fiduciary breaches on non-disclosed fees closing because of the new Form 5500 Schedule C disclosure rules to be implemented in 2008.When ERISA was legislated, its intent was to make all plan fees and expenses explicit and transparent. It did not anticipate the emergence of mutual funds and the practice of netting fees, including intermediary revenue sharing arrangements, against assets as is common practice today. This practice makes fiduciary oversight of fees very difficult both in terms of a sponsors ability to understand their own plan's fee details and in having access to comparable public fee data from their peers.

Under the new Schedule C requirements Plans will have to provide more information about third-party financial relationships. Plans will have to identify all service providers that receive $5,000 or more from plan assets. Plans currently must report only the 40 highest-paid service providers. Also, if a plan fiduciary or “listed service provider” received more than $1,000 from a source other than the plan or the plan sponsor, the Plan would have to provide information about the payer, the services and the compensation. Listed service providers include contract administrators; securities brokerages; insurance brokerages or agents; and those providing custodial, consulting, investment advisory (plan or participants), investment or money management, recordkeeping, trustee, appraisal or investment evaluation services. Reportable compensation would include all brokerage fees and commissions, and any “float” or similar earnings on plan assets or deposits retained by the service provider as compensation.

CALSTRS Loads up on Real Estate

2006-09-12T17:12:00.000-04:00

The California State Teachers' Retirement System, the nation’s second largest public pension fund ($144 billion assets) will be significantly changing its asset mix. The new long-term asset allocation targets are: 40% US equity, 20% Non US equity, 9% Private Equity, 11% Real estate and 20% Fixed Income. The portfolio change shifts 6 percent of the portfolio from fixed income and 1 percent each from U.S. equity and cash. The real estate portfolio will see the largest increase at 5 percentage points; alternative investments will receive a 3 percentage point increase.

This is a relatively large adjustment in the portfolio’s overall risk return profile which recognizes the increased returns the asset base must produce to fund liabilities. It seems to be an even larger long term bet that public markets returns will under-perform private markets.The Plan’s capital market estimates are nominally higher than what we would consider to be mainstream estimates these days, especially when using a 2.25% inflation rate. US and Non US Stocks 9%, US Bonds 4.75%, Cash 3.5%, TIPS, 4.5%, Real Estate 7.5% and Alternative Investments 12.5%. By way of comparison the 2006 Wilshire Report of State Retirement Systems used US and Non US Stocks 8.25%, US Bonds 5%,Real Estate 6.25% and Private Equity 11.75%

Heroic asset allocations and capital market assumptions look like they can save the day but often just move the day of reckoning into the future.