Rekenthaler Report

Avoiding Avoidable Mistakes

M*_JohnR — Tue, 17 Nov 2009 21:40:00 GMT

I quite enjoyed James Kwak's recent exercise in retirement planning. Plugging in various possible savings rates and investment returns, Kwak explores what retirement might look like for a hypothetical youngster who expects to retire as a 65-year-old in 2051.

One of the major lessons of Kwak's piece is the impossibility of investing out of the hole created by a low savings rate. Even with rates of return, and starting to invest at the tender age of 22, investing at the national savings rate of 2.4%-3.6% (the estimate varies according to the time period selected) won't lead to anything more than a supplemental portfolio. Forget about a nest egg that can replace Social Security for meeting basic needs, or combine with Social Security to make for a dream retirement. It ain't happening.

Another critical lesson is the importance of avoiding avoidable mistakes (to use the words of Morningstar's Don Phillips) when implementing the savings. Kwak estimates that investors may squander 400 basis points (i.e., 4 percentage points) of performance per year versus an unmanaged index by selecting higher-cost active managers who are moderately unsuccessful at picking stocks, and by chasing hot funds.

I find Kwak's estimate of slippage to be too high, but on the other hand, he has assumed a stock-only portfolio for his analysis, with its accompanying higher rate of return. Which is very generous. So I agree with his final resting point that investors who make the common mistakes of overpaying for second-tier active management, and of buying high and selling low, figure to make 200-250 basis points per year of real, after-inflation return.

All of which tells me, thank goodness for target-date funds. They take arrows from their critics and stern pokes from their friends, but they do an excellent job of avoiding avoidable mistakes.

High fees? Yes, given their economies of scale, target-date funds should do better, but nonetheless the asset-weighted average annual expense ratio for the category is a moderate 0.69%, well below the industry average.

Poor active management? Of the three largest target-date families, which have most of the industry assets, one indexes (Vanguard), one has had successful active management (T. Rowe Price), and one is in an intermediate-term slump but has had good active management over the longer term (Fidelity).

Buying high and selling low? Target-date investors are the stablest investors in existence. They hardly ever make trades.

I recommend Kwak's piece--or something in a similar vein--to policymakers. It makes quite clear how critical it is to devise a system the reduces the avoidable mistakes.

On a side note, what should pop up in my e-mail today but a prompt to an article entitled Target-Date Funds' Future Questioned. The thesis is that investors have soured on target-date funds after last year's losses, and that target-date funds won't be able to survive another market downturn like 2008's in their present form.

To which I respond, huh? This will be the biggest year yet for new cash flows into target-date funds, surpassing 2008, which in turn supplanted 2007. As for the possibility of suffering through a similar down market, well 2008 was the second-worst loss for common stocks over the past 138 years. Sure, target-date funds will disappoint mightily if they lose 25%-35% again anytime soon. It's pretty unlikely that they will, however.

Why It's Hard to Save Enough

M*_JohnR — Wed, 05 Aug 2009 03:41:00 GMT

A few days back, The Wall Street Journal ran an article on getting your 401(k) back on track. Included in the piece were several calculations run from popular online investment planning services (one of which was from Morningstar).

This item struck my attention: "Let's assume you're 50 years old with a $500,000 portfolio, contributing $1,000 a month to your 401(k) and planning to retire at 65 ... If you were 70% invested in stocks, the [name withheld to protect the innocent] model predicts that at 65 you could have annual income from about $89,000 if the market performs poorly to $476,000 if the market performs very well." The article goes onto say that the median income under the projection is about $190,000.

I stopped right there. Say what?

Let's get out the back of the envelope. Take a $500,000 portfolio, over 15 years, assume a generous return of 5% annually (generous because I happen to know that the model in question makes its projections in real, after-inflation terms, and 5% real after expenses is pretty darned good), that's about $1,000,000. The $1,000 per month donation is less significant, that might account to another $250,000 by age 65. So $1.25 million total. Plus some Social Security.

And that's going to give a median income of $190,000? Even if Social Security is assumed to be a healthy $40,000, that's $150k per year coming out of a $1.25 million portfolio--12%. No, that ain't happening, not unless our 65 year old doesn't mind perhaps running out of money as early as his or her late 70s. (More realistically, a fixed annuity rate for a 65 year old single male is about 6.5%.) As for the market heroics required to arrive at an annual income of $476,000, well my envelope is now starting to emit black smoke. The returns would have to be at least 20% real over the 15-year period. At least.

So, I don't know what was going on, except that the actual model is certainly not so wacky. Rather, the reporter must have misentered or misunderstood some of the data. Perhaps the model is reading the inital asset as being much larger than it is, or that the user has entered a termination date of age 80, or something. But the point is, it's a big error, yet neither the reporter nor her editor caught it. And this is The WSJ. If the Journal can't grasp the numbers, who will?

My point being, investment planning is nonintuitive. There's no way to get the numbers to make sense--to all but the most experienced user, it's gibberish in, gibberish out. And people can't internalize gibberish. They can't take it to heart, and truly believe it. So when they receive the projections of what they must save, and how much, and how much they will have, well it just doesn't catch hold of them. It's just numbers.

Finally, it sure would be nice if those figures were true, eh? With a half-million nest egg at age 50, just work another 15 years with 401(k) contributions, but no additional savings, and expect about $200k annually at the time of retirement. Sign me up for that deal. Please.

The 80% Myth

M*_JohnR — Thu, 06 Aug 2009 17:54:00 GMT

My previous column, Why It's Hard to Save Enough, sparked many splendid responses. Among them was a gem from one "DrH," who managed the very difficult feat of being spot-on about everything. (I am envious.)

This bit in particular grabbed my attention: Another absurd statement is that you "need" 80 or 90% of pre-retirement income to live on. We're living comfortably on less than half of what we used to earn--the biggest budget category decreases, in order, are taxes, retirement savings and charity.

Bingo! The financial services industry misleads the everyday investor by selling the notion that an 80% replacement rate of pre-retirement income is required for a successful retirement. DrH does fine on 50% of pre-retirement income. My mother and stepfather have no complaints, either. They are now in their 28th year of retirement. During this retirement period, they have traveled the world over--Japan, India, South and Central America multiple times, Switzerland on at least five occasions, London, Southern France, Romania, Italy, and many more. They also hike frequently in the U.S. national parks, indeed they spent last week in the Sierra Nevadas. This was achieved with my stepfather generating a healthy but nonetheless middle-class income, and my mother bringing almost no assets or income into the mix. With each party retiring at age 50. If they had targeted 80% of pre-retirement income as the prerequisite for retiring, they might be working still. (Well, not quite, but very likely until age 70.)

They don't buy new clothes at department stores (unless it's a big sale). They don't often eat at restaurants. If they drink Starbucks, it's because they brewed it at home rather than paying $4 for a latte. They drive a used Kia, not a new BMW, and so forth.

But you know, forgoing those items causes them very little unhappiness. I suspect that they are not alone. I suspect that the large majority of Americans would prefer to cut back on the luxury items that make up so much of their pre-retirement spending--and yes, eating out at a restaurant when one has the time to shop and cook, is a luxury item--if that permitted them to retire on the timeline that they desired.

But who tells people that? Instead, the conventional planning advice is that you want 80% of pre-retirement income, you can reluctantly settle for 70%, and if you only get 50%, you're eating cat food. (Which is partially true, as cats would no doubt adore my mother's grilled salmon, although not her fresh roasted vegetables.)

This mind-set has sunk in so deeply, that it's almost impossible to combat. A few years back, I was in charge of an investment-planning software program that Morningstar sold to financial services companies, to make available to their 401(k) employees. I knew that the biggest problem with such programs is that they are so gloomy--the employee puts in his or her age, assets, targeted retirement, savings rate, etc., and then is told to save twice as much, and work until age 78. At which point the horrified employee exits the program, and gives up on the notion of investment planning.

So I built the program to target an initial rate of 50% of pre-retirement income, as a "floor." Rather than focus on an 80% rate that few people would achieve, and then show them that their current plan was far short of that objective, the program steered people toward a more realistic plan. (In fact, it forced them to create a floor plan; if the user did not do that, they would not receive the specific fund recommendations.) The program contained various prompts to encourage users to see if they might be able to hit higher targets, so it wasn't as if it "settled" for 50%. Rather, it used that as a starting point.

And it never got off the ground. I could not sell that version of the program to the financial services companies. It wasn't so much that they wanted a higher target so that employees would raise their savings rate, put more into mutual funds, and thereby increase the fund company's assets under management. The companies recognized the truth in my argument that setting a lower target would get more employee participation, so they figured that what they lost by using Morningstar's program on the one hand, they would gain on the other hand.

No, the problem was that they had been brainwashed by the consultant studies on the subject, the ones that insisted that 70% was a bare minimum for subsistence, 80% to 90% desireable, and 50% meant cat food. They just would not accept the notion that employees should be permitted to create a 50% plan.

So, I gave up. After all, the program wouldn't be changing anybody's future, if it were never installed. So I upped the floor to 70%--the minimum acceptable figure--and had the program altered in various ways, so as to be more cheerful, and also to encourage the user to think through retirement needs, and to move the income slider down if he or she so desired.

Which is what you should consider doing. There's nothing wrong with an 80% target. That's my current goal; it works for me. But it may not always work for me, in which case I will be happy and completely unafraid to downsize. So should you.

A Supreme Case Over Fund Fees: Inside the Courtroom

M*_JohnR — Mon, 02 Nov 2009 21:42:00 GMT

It's 8:45, back in line. The law students behind me are discussing how the swine flu has swept through their campus. I take two steps away from them. The line has lengthened, there are maybe 150 people now. The law students wave toward the back and say sagely, "They don't have a chance." The courtroom can seat more than 200, but most spots are reserved for the VIPs who needn't wait in line with the riff-raff. Just like Super Bowl tickets.

The suits start to appear. They have that sleek, groomed look of people who have been well off for so long that they can't quite remember the alternative. Several have brought not only the significant other, but also children. We glare at the little monsters. Those could be our seats! One of the law students says, "There oughta be a rule that nobody under 16 is allowed." Hear, hear.

The suits keep coming and coming. We begin to fear for our slots. At 9:30, a guard steps up and yells: "Who is #50?" Upon receiving the answer, she says that numbers #1 to #50 will be admitted for this hearing.

We shuffle in, through two sets of X-rays. Save for a pen and a pad of paper, we must put all belongings in a locker. That costs me a quarter. A co-worker can't fit her umbrella into her locker. I must reopen mine to stash the negligent article. Now I'm out 50 cents. I carry my pad of paper within a leather portfolio--my bad, as only the paper and not the portfolio is permitted into the courtroom. 75 cents. My boss will mock me if I submit this in an expense report.

Finally, we are admitted into the courtroom itself. The seating is in the form of wooden pews, as in a church. The pews are entirely full. Behind the pews are wooden chairs, which look to be temporary. That is where we 50 will be seated. We're on the very edge of the courtroom; in fact, a few of the chairs spill outside the courtroom itself, being on the other side of the door. But hey, we can see and hear. Close enough.

The courtroom itself is as I would have expected. Not that I ever thought about what the inside of the Supreme Court would look like, but if I ever had entertained such thoughts, this would have been the room. Square, very high ceilings, four marble Greek-style pillars along each wall, with what appear to be red velvet curtains laced with gold trim draped behind them. Oh so neo-classical. The giant clock above where the justices sit reads, "6:20." This is not comforting as the actual time in Washington D.C. is 9:57.

Clang! 10:00 a.m. arrives, the justices march in, we all stand up, we all sit down. The hearing will take one hour. Chief Justice Roberts begins with a joke, admonishing the attorneys that while it's always a mistake to look at the clock during proceedings, it would be a particularly big mistake today. I wonder briefly how he knows about the clock, since he can't see it from where he sits. Perhaps when he entered the building …

The hearing begins. The counsel for the plaintiffs, who has been allotted 20 minutes, begins to talk. He is permitted about 20 seconds before being interrupted with the first question. Justice Kennedy wishes to know if a fund director has a different level of fiduciary duty than does a corporate director, or a bank trustee, or so many other parties that bear fiduciary responsibility. This doesn't seem to be a particularly promising line of inquiry--the plaintiff's counsel doesn't have a real answer, and if he did, it's not clear how that would affect the case. Justice Kennedy likes the question, though, and keeps pressing. He'll come back to it later, as well.

The plaintiff's counsel's case rests upon the notion that Congress created legislation in 1970 expressly to ensure that fund companies and fund directors negotiated "fair fees" that represented what price a third party would pay for investment-management services in an "arm's-length transaction."

Justice Ginsburg asks a question that will reverberate throughout the hearing: When the plaintiff maintains that the retail mutual fund charged a management fee that was twice as high as that levied to institutional accounts (0.88% vs 0.45%), is that not because the services are greater for the retail fund? No, replies the plaintiff's counsel, the services were actually greater for the institutional investors. The issue of whether the services were comparable is often and hotly disputed throughout the session--interesting stuff, but the Supreme Court shouldn't be conducting a fact-finding mission, no?

Chief Justice Roberts asks what appears to be a disingenuous question. "How does performance fit into pricing? If a fund has outperformed other funds by, say, 5 percentage points per year over the past five years, how does that affect its price? Does it charge twice as much as other funds? Three times as much?" Surely the Justice must understand that mutual funds are not priced in such a fashion. The plaintiff's counsel indicates why in his answer: Funds are paid regardless of their performances. If they underperformed they wouldn't be asked to give the money back.

Justice Roberts persists: "Surely you don't suggest that the fee should be the same for a fund if the level of performance is different?" Now he really must be joking--he certainly must realize that asset-management fees are charged by percentage of assets, not by the returns generated by the mutual fund. Mustn't he?

Justice Roberts continues. Technology has changed since the Congress of 1970. Nobody needs to be clueless about how much a fund charges, the context for such a fee, or for that matter for the relative quality of the fund. "In 30 seconds, you can look it up on Morningstar," he says. Immortality! I note, however, that the Morningstar reference was used in support of the fund industry's position. The Justice continues. "If you don't like a fund, you can always move." This is essentially Judge Easterbrook's argument from the Circuit Court, that market forces take care of fund fees, not fund directors. I don't think that Justice Roberts fully believes this position. But he is advocating the devil quite forcefully.

Plaintiff's counsel is uncomfortable. He starts to get creative in his answers, about how "one quarter to one third" of fund investors are 401(k) owners who are stuck with whatever fund their company puts in their plan. That's not an argument that he wishes to make for many reasons, one of which being that to my recollection, 401(k) assets are only about 15% of industry assets (though later Russ Kinnel e-mails me that the actual number is 11%). At any rate, he gets slapped down by Justice Roberts.

The discussion reverts to Congressional intent, and Justice Sotomayor intervenes. Forcefully. She certainly doesn't act as if she's a newbie. She's leaning forward into the microphone, pausing for effect--it's the most dramatic moment of the hearing so far. What does the term "fair fee" really mean, she asks? How do we measure whether a fee is fair or not? What are the standards for determining this? Without clear answers to such questions, she states, it's "meaningless" to talk about whether a fund's fees are fair or unfair.

Justice Scalia and plaintiff's counsel now bewilder me. The Justice asks about the recourse that a fund board has for advisers who wish to overcharge their client. He and plaintiff's counsel both agree that the board cannot fire the adviser and hire a new adviser. It can't? This is news to me. Either I need to revise my notion of the rights of a fund board, or all parties at a Supreme Court hearing agree to a description of fund boards that isn't true. My head itches; I must scratch. Meanwhile, Justice Scalia says that even if a fund board can't hire and fire an adviser, it can determine the costs. He says, "The board can cut the fee in half if it likes."

Plaintiff's counsel retires, saving his remaining 3 minutes for his final argument. He hands the baton to an attorney representing the U.S. government, which has also decided to join the plaintiff's case. The government attorney has 10 minutes. I notice that the clock no longer reads 6:20, and is instead at 8:00. It's 10:20 now, so not yet accurate, but it seems to be heading in the right direction.

Justice Roberts points out that the SEC has not attempted to prosecute a case for overly high mutual fund fees since 1980. As the SEC has the right to take up such cases, the Justice assumes this means that the marketplace has successfully overseen fund fees. The government attorney carefully replies that well that's not quite the case; rather, it's that the SEC has chosen to focus its limited resources on other areas and has left it to fund boards to ensure that fees are appropriate.

Justice Sotomayor returns to the notion of what a fair fee might be. Could double the going price be OK? How would we know or not know? I note that the clock now reads 9, and the minute hand is moving as if it's the second hand. That means that in 90 seconds, we'll be at the correct time. It's 10:30 now, time to switch from the plaintiff to the defendant.

Justice Sotomayor immediately jumps on the defendant's counsel. Under what circumstances can directors be sued, she wonders? Can they be held liable for bad process alone? Or for a high fee alone, even if the process seems acceptable?

Surprisingly, the defendant's attorney is willing to play this game and offer specifics. There are two potential problems that can be addressed by Section 36(b) of the Investment Company Act, he says. One is if a fee is extremely high. Even if the process by which the fee was established was acceptable, the directors might be liable. The second is a high (if not super-high) fee, and a flaw in the process.

This concession is notable in that it conflicts with Judge Easterbrook's Circuit Court decision. So we have the curious situation in which both the plaintiffs and the defendants appear not to accept the ruling that is being appealed before the Supreme Court. It's fair to say that despite Justice Roberts' occasional feints, the Court will not be wholeheartedly embracing the market-solution approach that was advocated by Judge Easterbrook.

The defendant's lawyer draws comfort from a portion of Section 36(b) that protects fund directors by stating that the board's actions "shall be given such consideration by the court as is deemed appropriate under all the circumstances." This draws a derisive "Wow" from Justice Scalia, who mockingly repeats the section, then says, "That is utterly meaningless." The defendant's counsel has no answer to that--best to let Scalia have his way.

More discussion about what a fair fee might be, and pushing for the definition of what level of fee is "outside the bounds" of normal, finally results in counsel stating that the standard comparison should be "other mutual funds of a similar type." After 45 minutes, we have clarity! Although this information we already knew coming in … the plaintiffs state that it's fair game to compare mutual fund fees to the fees charged by the company's institutional accounts, and the defendants do not. But now they have each stated that officially.

Scalia and Sotomayor now pounce upon the defendant's counsel for points in which he does not appear to be supporting the Easterbrook decision. From Scalia: If the defendant does not agree with Easterbrook, should we not remand? From Sotomayor: "Are you discarding the 7th Circuit's market-based approach?" Sotomayor continues to be the most direct and hardest-hitting of the justices. Under Sotomayor's questioning, the defendant's attorney concedes that he does not accept the Easterbrook standards, and instead believes that the previous so-called "Gartenberg" standards were correct.

The clock now says 10:05 and the minute hand is no longer moving like a second hand. I wonder if somebody thinks that the clock is fully fixed. The defendant's counsel, meanwhile, is reluctantly conceding that in certain cases, it may be appropriate for fund boards to examine the prices of institutional accounts. Now Justice Breyer speaks up, for the first time. When? Under what conditions? Justice Breyer suggests that perhaps the standard should be to always compare the mutual fund fees to institutional fees, because what harm could be caused by looking, and surely this is likely to be relevant information. This is the strongest statement thus far on behalf of the plaintiff from any of the Supreme Court justices--it is, in fact, pretty much repeating the plaintiff's argument.

Justice Breyer persists. Should the court follow the Gartenberg standards that prevailed from 1982-2008, or should it modify the Gartenberg standards to come up with something that might more directly address whether process and/or fees are reasonable?

The defendant's counsel closes strongly. In managing its fund, Harris Associates L.P. charged an average fee for a fund that had strongly above-average performance. The court can see that was quite reasonable. The alternative to accepting that a reasonable-looking fee was arrived at by a reasonable-seeming process, is to "consign 8,000 funds to fee by trial." The judges listen attentively and make no comment.

Plaintiff's counsel steps out for his final word. He is asked if it's true that Harris Associates' fund was such a strong performer … Judge Roberts and Scalia seem rather taken with the notion that high-performing funds have the right to charge pretty much what they like. Plaintiff's counsel responds that the performance of the fund was very good for one part of the time period under question, but then below-average for another time. The judges appear to regard this point as being relevant. They truly are receptive to performance-based arguments!

Plaintiff closes by concluding that he agrees with defendants that Easterbrook should be overturned, and the Gartenberg standards reinstated. But he would like to see them reinstated with more bite, in particular by permitting and encouraging the comparisons of retail fund fees to institutional fees.

The session closes, and just about everybody leaves. The crowd was here for Jones vs. Harris Associates L.P., not for the technical case on the permissibility of class-action lawsuits that follows. I see Paul Stevens leaving the courtroom. He is the head of the Investment Company Institute, the fund-company trade organization. Ten minutes later, he will also be name-dropping Morningstar, and also in defense of the fund industry's position. We do appear to make strange friends!

So that is my fly-on-the-wall take on the Jones vs. Harris Associates L.P. Supreme Court hearing. I'll be following up with a couple of interpretative articles that will develop further some of the themes that emerged from the session.

We're No. 8! In Line for the Supreme Court Hearing, That Is.

M*_JohnR — Mon, 02 Nov 2009 14:46:53 GMT

We arrived at 5:25 a.m. to secure our spot for the Jones vs. Harris Associates L.P. oral argument. It didn't take me long to realize that my cavalier Chicago attitude of "who needs a coat in D.C.?" might have been slightly misplaced. OK, largely misplaced.

We kill time by small-talking the law students who are standing behind us. "It's like waiting in line for concert tickets," I say. They look at me. "Like Billy Joel," one of them responds. Billy Joel?! Well I suppose he could have said Neil Diamond, but that still smarts. I want to say, "Nah the Arctic Monkeys," but naturally I do not think of this witty rejoinder until it's far too late.

By 7:30 there are about 70 people in line. The guard hands out the admission cards and tells us we are permitted to leave now. Just be back by 8:45. Off to Union Station's Au Bon Pain to recover feeling in the toes and purchase the coffee that I should have bought two hours ago.

We're No. 8! In line for the Supreme Court Hearing, That Is

M*_JasonS — Mon, 02 Nov 2009 13:45:20 GMT

In Praise of Buy-and-Hold

M*_JohnR — Fri, 04 Sep 2009 21:39:00 GMT

If there was one abiding lesson to come from 2008, it was that buy-and-hold strategies based on long-term strategic allocations had failed. They were the product of a bull-market mindset. Rather than a static policy, investors need a flexible investment approach that recognizes current market and economic conditions, and which responds accordingly.

Or so I have been told, at conferences, and on television, and in Internet articles, and pretty much everywhere, as far as I can tell. Morningstar's own Investment Conference this past May had not one but two panels that poked at the existing conventional wisdom.

How does this work in practice, though? It doesn't, I would submit. Morningstar's Dan Culloton noted the following figures this morning: Vanguard REIT Index Fund, up 82% since March 9; Vanguard Small Cap Value Index, up 75%; and Vanguard Small Cap Index, up 70%.

Wonderful stuff. The sudden surge that occurs only once every several years, at very best--the rare payoff that accrues to those who have the courage to own risky assets.

But let's say you had followed a flexible investment policy, and cleared your house at some time in 2008 of these illiquid, value-oriented securities, which you correctly surmised would be dragged far, far down during the recession.

I'm saying right here, right now, had you sold those securities in the name of flexibility, you never would have gotten back in them to enjoy their gains.

I remember early March 2009. I was at an institutional investment conference, with stocks dropping daily, the knowledge that bottom-fishing over the previous 18 months had meant nothing but disaster, relentlessly bad economic news, and a series of depressing presentations from Wall Street's top economists showing absolutely no turnaround in sight. Who was buying?

Well, somebody was of course, as those stocks stopped falling as of March 9 and started to rise. However, I strongly suspect that the actual buying power was quite modest, that the rally kicked off simply because the sellers were exhausted, and there was a bit of fresh money among those who had never left the market in the first place, to reverse direction. I highly doubt that the truly flexible investment managers decided right then and there, to get back into the market. In fact, I know they didn't, because as a group the hedge-fund industry missed the March rally entirely.

This is how it always goes. In 1988, in 1991, in 2003, and now in 2009. It seems sound looking back to the previous year to acknowledge the failure of blind, dumb strategic policy, and to embrace common sense. But somehow common sense isn't all that common when it comes to getting back into the stock market after the decline has occurred. It wasn't in 1988 and 1989, when the heroes of the 1987 crash lagged dramatically; it wasn't in the early 1990s; it wasn't in the middle 2000s, and it won't be over the next couple of years, either.

There is a time for flexibility. There is a time when we should listen to those who talk about the virtues of not being fully invested. Unfortunately, that time is not now. Not after the losses have been sustained. That time is when the DJIA is at record highs, when people are buzzing about what they saw on CNBC, when Morningstar.com's boards are buzzing with speculative stock selections.

But who listens then?

To echo Mr. Churchill, buy-and-hold is undoubtedly the worst form of investing -- except for the alternatives.*

*Dr. Paul Kaplan of Morningstar wishes to inform the audience that Rekenthaler's term of "buy-and-hold" is a shorthand term for "strategic policy with rebalancing." As Paul points out, buy-and-hold benefits greatly from rebalancing. And of course while the rebalancing would have been no fun at all during 2008, it would have maintained a healthy allocation in the REITs, small value stocks, and other such fare that have rebounded so strongly over the past six months.

Duly noted.

In Praise of Bric-a-Brac

M*_JohnR — Fri, 11 Sep 2009 00:38:00 GMT

In college, everybody knew that Stevie was the smartest guy around. He wowed them in the honors Shakespeare seminar, beat the math majors at their own game (eventually picking up a math degree of his own, just for the fun of it), and was outright brilliant in his chosen field, economics. By the time he was a senior he had outstripped the undergraduate curriculum and was taking graduate courses under the tutelage of the previous year's Nobel Laureate.

And then, he quit. Abandoned all plans of becoming an economist, deciding instead between law school (Harvard, naturally) or an advanced degree in computer science (MIT, naturally). I asked him, why? He had been so excited about economics, since the first day as a callow, pimpled freshman.

It was because he no longer believed. He said the theories were beautiful, the math was precise, but as he advanced further in the subject he had come to the conclusion that the foundation was unsound. He no longer regarded economics as an accurate description of human behavior; rather, he regarded it as a lovely, elaborate, and fictional construction. He was thoroughly crushed, as only the young and idealistic can be. He had lost his faith.

I thought about Stevie when reading Paul Krugman's article in The New York Times Magazine, How Did Economists Get It All Wrong? Forget Krugman's politics, or even his positions within various economic debates. The point is, the article makes amply clear just how prescient Stevie was. Across the board in economics, the traditional models have been shaken by the appearance of this anomaly and that exception. These oddities exist because of this model's simplifying assumption or that model's useful postulate--neither of which turned out to be, ahem, true. To correct those assumptions or postulates means mucking up the model with complexities to the extent where it no longer can be manipulated, even with the techiques of higher mathematics, or if it can, then the output cannot readily be interpreted.

Which is why in his (mostly successful) 20 years at the Fed (we'll pass over his misunderstanding of the housing bubble), Alan Greenspan bypassed relying on a big model, and instead cobbled together a plan by picking one insight here, a different viewpoint there, a third perspective in another place, eventually assembling these items without an official instruction manual. Bric-a-brac economics.

In Greenspan's view, the task of determining the appropriate Federal funds rate could not be handed over to a unified theory. Instead, it needed several theories--signals, really, "theories" being too grand a word--then human judgment to assemble that information.

The same holds true for that specialized sub-branch of economics, investing. For the most part, the investment managers who make the real money do so on a case-by-case basis. Traditional stock-picking managers, such as Peter Lynch or Warren Buffett, operate on general principles and a whole lot of gut (Buffett in particular on his read of the opposing party's principles). Most hedge fund managers are also generally situational rather than mathematically driven--for example, Julian Robertson or George Soros. Successful commodity traders typically build systems that seek to take advantage of observed datapoints, as opposed to being based on defensible theory. So too for arbitrageurs.

The message for us, as mutual-fund investors, is analogous. I say, let's not bother building models--or ratings systems--that attempt find the perfect fund. Instead, let's use general principles, judgment, and a dash of personal opinion to form portfolios that are built on a sound basis, and which suit our own tastes. General principles being: the fund carries low costs; the sponsoring fund company has a good record of stewardship; the fund company has demonstrated expertise in the fund's particular investment arena; and the asset class is not obviously "hot" (i.e., gold today). This construction won't be pretty. It will be bric-a-brac, not an investment castle. But when the sands shift, the bric-a-brac has the better chance of remaining upright.

Green Skies

M*_JohnR — Wed, 09 Sep 2009 19:30:00 GMT

In recent months, I've received several e-mails that read like this:

Dear Morningstar,

I called Prominent Fund Company because your data did not match what it is publishing about its really big fund. The Person on the Telephone for Prominent Fund Company told me that 'Morningstar always gets our funds wrong.' Why does Morningstar continue to make these type of mistakes?

Signed - A concerned Morningstar subscriber

The reality, of course, is that the 2,400 people at Morningstar haven't gone AWOL, permitting basic data about a really big and really important fund to be incorrect month after month after month. The issue lies instead with the very reason that Morningstar exists: Different fund companies use the same words in different ways.

Not everybody shares a single definition of growth stock, or calculates option-adjusted duration identically, or even assigns credit ratings in a consistent fashion. There is no SEC mandate that instructs how to do these things, nothing from the CFA Society. It is up to each individual fund company to adopt its own definitions.

Which is indeed what they do. Then Morningstar comes in, does its best to sort through the babble, and establishes a single standard that it uses for its own products. This standard won't necessarily match what many and sometimes even most fund companies use, but it will at least be consistent throughout Morningstar's products, such that accurate comparisons can be made between different funds. And the standard will be as close as possible to the middle ground, such that some fund companies fall on one side of the standard, and a roughly equal number fall on the other side.

Which all makes sense, right? I mean, if two large and reputable companies report different figures for the same statistic, the odds are pretty high that they define that statistic differently, and pretty low that one of them just can't add numbers very accurately. So why is it that an anonymous Person on the Telephone at the fund company was able to convince the caller almost instantly that the unlikely was indeed what occurred?

You know why: The fund has enjoyed excellent performance. And when a fund has had excellent performance, the credibility of all who are associated with that fund skyrockets. If the fund has had excellent performance, and has had it for a very long time, the Person on the Telephone could state that the sky is green, and I would soon be receiving a letter inquiring as to when Morningstar would fix the problem it has with the color blue.

Whereas if the fund were in the 73rd percentile of its category over the past five years, the caller would mutter, "Hmmm, they're not only bad at running funds, but they don't even have good answers when I call about a data question."

My point is not to bash the unnamed fund company (that's why I kept it unnamed), or to console myself by whining (OK, not much), but rather to point out the logical fallacy. We tend to trust fund companies according to their numbers. And we should not. The worst mistakes I have seen in 21 years of following the fund industry have been with investors who took winning fund companies at their word. That's how really bad investments happen.

This tendency for sterling reputations to overwhelm analysis is scarcely confined to the mutual fund industry, nor to retail investors. A decade ago, Long-Term Capital Management raised billions by waving Nobel Prize references in front of institutions, and Enron management beguiled Wall Street analysts with Enron's ability to "make the numbers." In each case, the buyers made purchases based on faith in investments that they did not understand, and later paid dearly.

This argument can be turned in the other direction as well--toward Morningstar. Over the years, I've had my share of discussions with animated portfolio managers who were angry about Morningstar's treatment of their funds, and heard them say in frustration, "Oh what do the facts matter? Nobody will believe me even if I'm right." Which is true--when Morningstar criticizes a manager whose funds have performed poorly, our analysis tends to be taken as the word of (a lesser) god. Although sometimes, yes, we too are in the wrong.

My message? It's fine to lean on trusted sources for information, indeed I certainly hope that you lean on Morningstar that way. But ultimately, it's your money. And your responsibility. In the words of President Reagan, "Trust ... but verify."

The Power of Inertia

M*_JohnR — Wed, 12 Aug 2009 19:13:00 GMT

Far be it for me, a longtime Morningstar employee, to argue against investment education.

At the same time, it must be acknowledged that sometimes a bit of education can be a dangerous thing. Consider my stepmother. She is a fairly active investor and certainly knows quite a bit more about stocks, bonds, and the financial market than does the typical 401(k) investor. In addition, she has a financial advisor. Yet she came out of 2008 worse than did those clueless 401(k) owners. By year end, she (along with the reluctant permission of her advisor) had succumbed to the notion that the normal rules of investment no longer applied, and she therefore shifted a chunk of her portfolio from stocks to Treasuries. The typical 401(k) investor, in contrast, did absolutely nothing. No trades.

You know how those moves played out: Year to date, the intermediate government-bond index is down 4%, while the average stock mutual fund is up about 15%.

And no, this isn't a token victory for an army that has already lost the war. I don't know where so many people get off claiming that 2008 destroyed portfolios. For those few who sold at the bottom, sure. But not for the majority who just kept plugging away. Over the past five years, almost all mutual fund categories have turned a profit, with several domestic stock categories and every international stock type save for Japan, outpacing both short government bonds and inflation. The 401(k) investor who closed his or her eyes and just kept marching forward with a diversified portfolio, socking away a bit more with each paycheck, is almost certainly wealthier today than in mid-2004.

Vanguard released a study earlier this year, "Inertia and retirement savings: Participant behavior in 2008," that demonstrates the extreme inactivity of the typical 401(k) participant. Throughout 2008's extraordinary market, with the second-worst stock-market returns in a century and widespread comparisons to the onset of the Great Depression, 84% of Vanguard's 401(k) participants made not a single trade. Even the trades that were made, were by no means consistent in swapping stocks for safety. On a net basis, Vanguard's participants swapped 4% of their equity exposure for fixed-income. A regrettable 4% if it occurred late in the year, but nonetheless only 4%.

The same pattern occurred at the start of this decade. Amid widespread predictions that the untested, unwashed masses of the 401(k) programs would trigger a technology bear market by panicking and blowing out their portfolios, 401(k) investors were just about the only market segment that did not rush to the doors when the technology sell-off finally did begin. And those few exceptions tended not to be the normal 401(k) investor, anyway. They were instead wealthier, more active, and more educated participants, such as the pilots' association that informed me in 1999 that it had added a technology fund to its 401(k) plan, and a brokerage window so that its members could trade stocks.

I'm not proposing that investment education be curtailed. Quite the opposite. But it's clear from the evidence that the structure of 401(k) plans--the passive nature of the enrollment and investment processes, the tax penalties for withdrawals, the long, long time horizon--goes very far in promoting successful investor behavior. Financial advisors would be wise to consider that lesson. In addition to educating the client, what can be done to get the client to let go of the investment, and permit time to do its work? I suspect that over the next few years, we'll see behavioral researchers offering suggestions. Ultimately, promoting successful client behavior is as much about framing as it is about teaching.

Wacky Days at the SEC

M*_JohnR — Fri, 17 Jul 2009 15:36:00 GMT

I met with the representatives of a new fund-of-funds last week. The company's funds are only 1 month old, but the SEC permits them to quote a three-year track record. They would like Morningstar to do so, too.

I said, quite wittily, "Huh?"

It works like this. None of the underlying funds held by the fund-of-funds have a three-year track record--but the SEC permits the new funds to use the record of the existing funds from which they were cloned. OK, we've seen that before. But how to create the performance for the wrapper, for the fund-of-funds itself? Easy. The fund of funds is based on an index, so just say that the fund-of-funds would have held the underlying funds in the same proportion as specified for the index.

Now, that might sound sane, if you don't think on the subject for very long. But consider this: The index isn't three years old, either. Yes, it has a longer track record, but that record was calculated as if the index had existed; it wasn't a live calculation. So the whole foundation rests on sand. It's entirely backfill, every single grain.

And even if the index had existed during the entire time period, who is to say that fund of funds would have found exactly those particular underlying funds to map against the index three years ago, and that the mapping would have been done in that particular fashion? (After all, there are many ways to map a fund to an asset class, or series of asset classes.)

This follows on the heels of daily phone calls from a hedge fund that has converted to a mutual fund. The SEC, you guessed it, is happy to let that fund show its previous record in its mutual fund marketing materials. Hedge funds, unlike mutual funds, are not required to calculate daily net asset values, maintain a board of directors, or use an outside pricing agent. But whatever. It's all the same. Let 'em quote.

Before the year is over, I expect to receive a visit from a fund that has been backtested on the theory of Super Bowl winners and the colors worn by the winning Kentucky Derby horses, and hear that the SEC is permitting it to show a 27-year track record. And Morningstar wouldn't wish to be left behind with its data, would it?

A Target on Their Backs

M*_JohnR — Fri, 19 Jun 2009 18:01:00 GMT

Target Date mutual funds took quite a hit at yesterday's Washington hearing, co-sponsored by the SEC and DOL. They misled investors. They sowed confusion. They are mislabeled. They don't do what they say.

Which is all quite amusing. Because there are mutual funds that do mislead their investors. Big, popular mutual funds. For example, funds that called themselves "income plus" because they sold options and distributed their premia--which are not income. See, when you call something "income" and it's not actually "income," that's misleading.

Or, "American government" funds that, it turns out, invested in the Americas. Meaning, Argentina. Or Mexico. Because they are in the continent named after Amerigo Vespucci, right? Now, when you call yourself an American government fund, and in some cases even toss in a sketch of the red, white, and blue on the fund marketing materials, you clearly are doing so in the hopes that the audience doesn't look too closely at the portfolio. Because if it does, it might wonder why these American governments all seem to be using pesos.

Or, funds that call themselves "double alpha." Now technically, alpha can cut both ways, but in practice the term "alpha" is used to mean some type of positive outcome created by a portfolio manager. For example, an institutional investor might say, "I buy index funds for beta, and hedge funds for alpha." So double alpha is an implicit promise that the fund will select long securities that outperform the market (alpha #1), and that the fund will short securities that underperform the market (alpha #2). That is a promise that cannot be reliably delivered.

Or, today's hot new category, "Absolute Return" funds. Do they actually deliver absolute return? That is, do they make money each and every day? Every week? Every month? Every year? Every 3 years? No, no, no, no, no, and probably no. See, I might be simpleminded, but when a fund cannot reasonably claim to do what its label states, I call that at least potentially confusing.

Whereas with Target Date funds, where is the problem? The instructions are, to select the fund according to when the investor thinks he or she might retire. The fund is then managed with that date in mind. Is there any question at all that the fund is not doing what the label states, that it is being managed for somebody who is scheduled to retire at the target date? Rhetorical question: The answer is no.

Now, somebody might argue about the investment strategy of these funds--and indeed, that is what most of the hubbub is about. In the wake of the 2008 downturn, many people have now decided that investments should be managed more conservatively than they thought was appropriate in 2006, when indeed the industry trend was to add more equity exposure. I recall few complaints about that trend when the market was heading north. The concerns are emerging instead now, after the 2008 losses. Funny how that works.

Look, I am not critical of these hearings. They have surfaced quite a bit of investor confusion about how target date funds operate. They have uncovered the need for better disclosure and communications. They have continued the healthy debate about just how the funds should be managed as they approach the targeted date of retirement. Indeed, I would suggest that one item to come out of this discussion is the need to approach investors as they near retirement and to force them to make a decision--do they wish for a fund that they will continue to hold throughout retirement (which might be as long as several decades), or do they wish for a fund that they will liquidate upon the date of retirement? Such an approach would solve many of the concerns that were voiced at the hearing.

But the fund industry on bad behavior? No. I've seen that before, I'll see it again. But not here.

How to Save the Mutual Fund?

M*_JohnR — Fri, 05 Jun 2009 20:18:00 GMT

A fellow named Dave Swanson who is a fund marketer/consultant, has circulated a paper called "How to Save the Mutual Fund [Before It's Too Late]." www.swandogmarketing.com The intended audience is mutual-fund executives, facing the challenge of ETFs and other investments that are threatening to take market share from mutual funds.

Swanson's prescriptions -

1) Build the case for active fund management by giving them greater investment freedom. They're underperforming because they're hemmed by in narrow investment mandates that force them to invest in stocks of a certain investment size and style. If the managers only had the freedom to do what they wished, the numbers would be different.

Hmmm, yes, the old "style box made me do it" argument. The trouble with that idea is, it never actually works. Take 2008. If I screen for diversified U.S. stock fund managers who clearly don't care about Morningstar's style-box constraints, because they have at least 20% of their equity assets each in small, mid, and large-cap stocks, I find that in 2008 they lost an average of 40.8%, putting them 200 basis points behind the other U.S. diversified equity funds. Nope, I don't think we found the secret to investment success.

2) Lower base management fees and add a performance fee.

Hmmm, again. The last time I checked, mutual fund performance fees were required to be symmetrical. That is, if a fund receives a bonus for outperforming an index, then it must also face conceding a like amount of revenue if it underperforms the index.

Which pretty much kills this idea, as very few investment managers, hedge fund scions included, are brave enough to take on that type of bet. They're happy enough with the asymmetric payoff of the traditional hedge-fund performance fees, but they will not take on the considerable business risk that occurs with the symmetrical structure.

3) Improve the shareholder report by making it clearer and more candid. Send it out much faster, don't wait anything like the 60 days that is permitted by regulation.

I can't argue with any of that.

As for me, I'd say that Swanson's opening suggestion about unleashing the investment manager isn't entirely off base, it just needs a realignment. The problem isn't that the system waters down the selections of 1000s of managers who have convictions. The problem is, most of those 1000s of managers don't actually have convictions. After you conduct a few hundred interviews, you learn when you're receiving the Wall Street consensus on a company, as opposed to original thought. And you realize, there is a whole lot more consensus than original thought in this business.

So I would say instead, the mutual fund industry needs to attract more managers who are different. Who build portfolios that truly don't look like somebody else's. One example would be the FPA organization. No FPA fund ever looks like another fund in the industry.

Meaning, with all due respect to Mr. Swanson, I am sure can offer a useful service to his clients, that the fund industry should recognize that it won't market its way out of this hole. Instead, it will need to invest its way out. No ETF can duplicate the work of those managers with convictions who presented at Morningstar's 2009 Investment Conference last month. They give the industry its backbone. They just need company, that's all. There must be more such managers for the industry to resume its historic position of leadership.

Rating the Idea of R Bonds

M*_JohnR — Mon, 15 Jun 2009 23:57:00 GMT

The Treasury department has been exploring issuing so-called "R bonds" as a core investment for proposed mandatory, automatically enrolled versions of IRA accounts. These R bonds would be new securities created to be either default options for the automatic enrollment program or at the least as a readily available conservative option for investors who were actively choosing their investments.

Initially, I loathed this idea. Deciding at a time of very low bond yields, unusually high historic real returns on bonds, and relatively modest bond valuations that a sound idea is to build a portfolio consisting of 100% bonds, no stocks, feels a whole lot like fighting the last war. With stone axes. Then there's the little matter of pushing a security that the adminstration needs to pump out by the trillions through a mandatory, automatically enrolled program. So that the least educated investors, who are the target of the R bond plan, end up with portfolios of long-term debt at a time of rapidly expanding money supply and, very probably, higher levels of future inflation. That seems like force-feeding the unsuspecting goose--before removing his liver.

Now, I merely dislike the idea. For one, details on the R bonds have not been released, so it is possible they might be inflation-adjusted securities, or structured in some other way that would ease their sensitivity to rising interest rates. Second, the administration does suggest that their primary use might be as starting points for portfolios, so that nervous investors who have put their very first dollars into an investment might be reassured by the R bonds' relatively steady performances. The notion also is that once the accounts became large enough, the investors might somehow be switched into more-diversified portfolios.

So that is a bit better. But overall, this has a bad feel to it. We wouldn't want a brokerage firm creating a new investor purchase program expressly for the one security that is clogging its inventory. So why would we wish for the government to do the same?

Jeremy Siegel Was Right

M*_JohnR — Thu, 16 Apr 2009 21:47:00 GMT

OK, that his upbeat WSJ column of February 25, 2009, came only two weeks before the market's bottom, when stocks were languishing about 15% lower than today's prices--yes, that was lucky. But regardless of the market's immediate signal, the message was spot on.

And the message was, people who are reporting the S&P 500's official earnings are understating the value of the index. I have made versions of this argument for 10 years, thereby gathering nothing but derision (in fairness, Siegel's argument was much more clearly stated that what I have done). My argument is, has been, and always will be that the process of dumping the earnings of all 500 stocks into one bucket, then using this as the "earnings" of the S&P 500, is useless from an investor's view. It's fine for an economist, but not for an investor.

Because the two have different needs. If the U.S. consists of two companies, one of which destroys wealth and lost $1 trillion in 2009 and the other of which creates wealth and gained $1 trillion in 2009, the economist would correctly state that the national earnings of the U.S. economy is zero, therefore if the U.S. stock market as a whole is valued at $10 trillion, because the wealth creator sells for $9.99 trillion and the wealth destroyer for $0.01 trillion, then the P/E ratio is 10 trillion/0, which is a particularly large version of infinity.

But as an investor, what do I care about the market P/E? If I put $1,000,000 in an index of this market, I have wasted $10,000 on a junk company that will go to zero, and I have spent $990,000 on a great company that will give me $100,000 worth of earnings--a P/E ratio of 9.9.

And that, as Mr. Siegel pointed out, was pretty much where the U.S. market lay in late February--a market P/E of 9.4 for the good companies, disguised in the standard P/E calculation process by losses from banks, autos, and other horrors.

Anybody who analyzes financial statements knows that what an accountant views as truth may not be helpful to the economist. But not so many understand that a similar process holds true for market measurements. What satisfies the economist may mislead the investor.