Tuesday
Dec292009

Clueless Janet Napolitano has to go

[after taking her driver's test]
Cher: So, how did I do?
DMV Tester: How'd you do? Well, let's just see shall we? You can't park, you can't change lanes, you can't make right hand turns, you damaged private property and you almost killed someone. Off hand, I'd say you failed.

memorable lines from Clueless (1995)

Wednesday
Dec092009

How the stimulus plan really works

The Hill today reports on exactly how the federal stimulus plan works:

Nearly $6 million in stimulus money was paid to two firms run by Mark Penn, Hillary Clinton’s pollster in 2008.

Federal records show that $5.97 million from the $787 billion stimulus helped preserve three jobs at Burson-Marsteller, the global public-relations and communications firm headed by [Mark] Penn.

Whatever happened to the old fashioned notion that looters should be shot on sight?

Sunday
Dec062009

Too good not to read

Robert Arnott & John West have just published an article, '3D' Hurricane Force Headwind, that is probably the best I've read for those concerned about the longer term forces acting on our economy, the impact of inflation, and what it may mean for traditional investing. It's too good not to read.

Thursday
Dec032009

If you're keeping the good stuff inside as a compensation scheme, what are you selling the public?

The abstract of The Good, the Bad or the Expensive? Which Mutual Fund Managers Join Hedge Funds? by Dueskar, Pollet, Wang & Zheng is below:

Abstract:     
Does the mutual fund industry lose its best managers to hedge funds? We find that a mutual fund manager with superior past performance is more likely to start managing an in-house hedge fund while continuing to manage mutual funds. However, a mutual fund manager with poor past performance is more likely to leave the mutual fund industry to manage a hedge fund. Thus, mutual funds appear to use in-house hedge funds to retain the best-performing managers in the face of competition from hedge funds. In addition, the managers of mutual funds with greater expenses are more likely to enter the hedge fund industry. The magnitude of such expenses is negatively related to subsequent performance in the hedge fund industry. Hence, hedge funds do not acquire superior performance for their investors by hiring these expensive managers.

We'll let the academics and the hedgies chew on this a bit more, but it does raise some interesting questions. First, the mechanic of hedge funds as a repository for over priced, under performing mutual fund managers may be good news for investors in actively managed mutual funds.

On the other hand, the issue raised in the title of this posting is worth considering.  Consider the implications: they offer internal emolument to managers of mutual funds in the form of hedge funds (platform, assets, manager compensation via carry, leverage, optionality, tax 'structuring' etc.) and perhaps subsidize them via operational cost absorption. Is that form of investment available to the preponderance of mutual fund investors? Well, the short answer is no.

Hmmm ... good for me, but not for thee.  We all know what that means for retail and smaller institutional clients. And all fully compliant, too.

Tuesday
Nov172009

Unable to obtain any concessions, but evidently willing & able to provide them  

The Federal Reserve letter of Nov. 15 offers some interesting reading for those skeptical of the settlement of counterparty risk granted in favor of counterparties to the detriment of US taxpayers, the duration of which detriment will last perhaps a half a century or so. You may read that more broadly as all US citizens, all participants in the current and future US economy.

 

Well, in the spirit of glasnost, do tell! Can we see the book, the list of all the AIG related counterparties and amounts of date, so we may determine whose interests were served and how specifically "systemic" was defined and administered?  

No doubt the list contained "a wide range of creditors." In addition to the usual suspects cited above one may very well surmise the list also includes mind numbingly large amounts paid to soverign entities; foreign central banks; agencies of soverign entities or foreign central banks; foreign banks & US and foreign branches of foreign banks; NGO's; US banks; US investment banks; and bunches of other counterparties all of whom should have joined in the "concessions".

It was a colossal failure of nerve, confidence, and equity. We need to follow the money, and US citizens are due an open accounting of how much was given to whom and why.

Monday
Nov022009

Nouriel Roubini on the US$ carry trade

Nouriel Roubini has an article in today’s Financial Times that is a must read: Mother of all carry trades faces an inevitable bust , excerpted below. 

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

He's got the broad structural issues right, although perhaps stated with a flair for the dramatic. Timing & rates of reaction are critical for these kinds of things: will we have a moderate point of inflection or a herd stampeding over a cliff?

A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

I'm not sure any analyst, including the Roubini or the Fed, has a clue, or at least a valid one.  My experience in the global markets has led me to believe that >80% of any liquidity (sovereign or otherwise) is determined by no more than 15 players, 3 of whom are seated next to the door, proximity to which is in order of cognitive ability. The other 12 investors are watching them. This is the stuff of which catalytic events are made.  The rates of reaction can be a little slower here given the scale involved and limited options for alternative reserve currencies. But an observer of grizzly bears knows that big things may look slow but can actually move quickly, particularly when faced with threats or a prospective meal.  Big things can also can grind quite finely.

Some have argued that Fed policy distorts a variety of macroeconomic factors including inflation measures, that nominal Treasury bonds less TIPS spreads are artificially low (I'm less sure on that one but am unwilling to rule it out). Roubini below argues Fed policy has induced an artificially low global volatility (although equities recently seem to contraindicate) with a tsunami of liquidity and artificially low interest rates.

The structural aspects do seem to follow a certain logic of unintended consequences that derive from the Fed's strategy of trying to manage excessively large and stupid concentrations of risk (i.e. "too-big-to-fail") by further aggregating and centralizing even greater concentrations of stupid risk.

Now, the question is, if you're the Fed,

"You're thinking...now to tell you the truth I forgot myself in all this excitement. But being this is a .44 Magnum, the most powerful handgun in the world and will blow your head clean off, you've gotta ask yourself a question: "Do I feel lucky?" - Dirty Harry

Well, do we?

The unwind could get a bit bumpy, but the point here is not to scare people but to help.

From from a practical perspective, what does this mean for investors? Our framework of bounded asset allocations, efficient diversification, and prudent risk management in many ways accomodates many of the concerns implicit here. Appropriate asset allocation is the touchstone. It is not only a measure of expected returns, but a matter of risk management. And if you find yourself inclined to changing it or second guessing things in response to market activity or headlines, stop right there. It doesn't fit or you're mis-using it. 

Rebalancing is critical. In broad concept if you've had a run up of some 80-92% in equities over the last 12 months (for example China, Turkey, or Brazil) rebalancing as a mechanic would lead you naturally to sell some of the rockets and perhaps lead you to consider some that have fared less well (US regional banks were off some 27% over the same period). Similarly, foreign small caps are up nearly 50% over the same time period while US large cap value stocks weigh in at 2-4%. The same goes for fixed income: emerging markets debt and domestic high yield bonds have racked up 12 month returns in the low 40%'s, while US short bonds have gone sideways. A rebalancing in front of the US$ unwind may not be a bad thing. Rebalancing will naturally remove the excesses from the portfolio, a systematic sell high/buy low (for many of us a novel experience).  Generally, this takes the portfolio in the direction you are intuitively inclined to go, but in a bounded and disciplined way.

It is very clear that now is not the time to stretch prudence in reaching for yield. Take the market rates and live within prudent risk budgets. Now is also not the time to run short on liquidity.

Stay the course with diversification. The corelations are in the words of a trader 'all kinds of screwed up' by virtue of the artifice of the Fed. It is not clear to us that anyone has an elegant solution to model and correlation risk (just ask the rating agencies), but common sense can go a long way.

Lastly, as an enterprise and portfolio matter, take a look at counterparty credit risk profiles and potentially embedded performance risks. Like it or not you've got 'em. For example, make sure you understand the operational risks of your book... like hypothecation risk in your custody agreements. On credit/counterparty performance risk I remain suspicious of whatever is highly regulated, complex, and opaque...insurance comes to mind....and for that matter Congress as well.

 

Saturday
Oct312009

You know it's got to be bad when ABC gets in the game

We noted today's blog by Jake Tapper in Political Punch $160,000 Per Stimulus Job? White House Calls That 'Calculator Abuse'  October 30, 2009 7:12 PM

“Posting its results late this afternoon at Recovery.gov, the White House claimed 640,329 jobs have been created or saved because of the $159 billion in stimulus funds allocated as of Sept. 30.

Officials acknowledged the numbers were not exact, saying that states and localities that reported the numbers have made mistakes….

The White House argues that the actual job number is actually larger than 640,000 -- closer to 1 million jobs when one factors in stimulus jobs added in October and, more importantly, jobs created indirectly, such as "the waitress who's still on the job," Vice President Biden said today.

So let's see. Assuming their number is right -- 160 billion divided by 1 million. Does that mean the stimulus costs taxpayers $160,000 per job?

Jared Bernstein, chief economist and senior economic advisor to the vice president, called that "calculator abuse."

He said the cost per job was actually $92,000 -- but acknowledged that estimate is for the whole stimulus package as of the end of 2010.”

In addition to plain old common sense there is a credible body of competent macroeconomic evidence to suggest these kinds of PT Barnum scams have negative multipliers. It’s the same template as Cash for Clunkers with the same practical results. The government taxes working people to “create or save”[i] a job at cost of $160,000/job. Of course, there is not enough current tax revenue to pay the costs, so the government issues bonds which current and future generations (your children) will have to pay off.

In the spirit of constructive suggestions, how about this bold cost saving idea for next time? 

  • give away $80,000 (instead of $160,000) to a million randomly selected people (random, because you wouldn’t want to risk value laden linking of outcomes to behavior)
  • take $60,000 per person ( ~$60,000,000,000) out back and burn it in the same fire pit you burned the Cash for Clunkers money;
  • you thereby save the taxpayers $20,000 per job ‘created or saved’ or about $20,000,000,000 
  • you save the taxpayer interest on the interest on the $20,000,000,000 debt that wasn't issued

Better get used to it.  Now where is the US $ trading again?

Just wait for healthcare.


[i] c.f. p.176, Generally Accepted Enron Accounting Principles ("GAEAP") as cited by Madoff in Heads I Win Tails, You Lose, 2008, Wide Stripe Press, NY, NY

 

Thursday
Oct292009

The car guys weigh in on Cash for Clunkers

Cnn reports here that the car people at Edmunds have weighed in on the Cash for Clunkers program. It's not pretty. Excerpts from CNN follow:

"A total of 690,000 new vehicles were sold under the Cash for Clunkers program last summer, but only 125,000 of those were vehicles that would not have been sold anyway, according to an analysis released Wednesday by the automotive Web site Edmunds.com ...

The Cash for Clunkers program gave car buyers rebates of up to $4,500 if they traded in less fuel-efficient vehicles for new vehicles that met certain fuel economy requirements. A total of $3 billion was allotted for those rebates.

The average rebate was $4,000. But the overwhelming majority of sales would have taken place anyway at some time in the last half of 2009, according to Edmunds.com. That means the government ended up spending about $24,000 each for those 125,000 additional vehicle sales.

"It is unfortunate that Edmunds.com has had nothing but negative things to say about a wildly successful program that sold nearly 250,000 cars in its first four days alone," said Bill Adams, spokesman for the Department of Transportation... "

No doubt Mr. Adams characterizes the plan to give away money as "wildly successful" but the people who funded this program might have found higher and better uses for their monies, such as saving for their children's college educations, saving for their retirements, or perhaps helping with their parents' eldercare expenses... or buying their kids or themselves a computer or a washing machine.  But the freedom to make those choices, to exercize their judgement in the best interests of their families was taken from them by this arbitrary government policy.

Those who are disappointed can still find your money...it's just that someone else is driving it.

As to the practical outcome of $24,000 per incremental car sold, how about this cost saving idea for next time?

  • buy 125,000 cars for $18,000 instead of $24,000;
  • give away the cars;
  • take $5,000 per car out back and burn it;
  • thereby selling the same number of cars but saving $1,000 per car!

Better get used to it.  Now where is the US $ trading again?

Just wait for healthcare.

 

 

Thursday
Oct082009

Active management loses in risk study

"The study by Morningstar Inc. found that, [sic] over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes [sic] ... only 37% did so on a risk, size, and style adjusted basis. The numbers are similar for five and ten year returns."

source: Fund Track by Sam Mamundi , Wall Street Journal, October 8, 2008

----------------------------------------

The empirical evidence just keeps stacking up. Active management is simply ineffective in most sectors of the equity market.

Wednesday
Oct072009

To Roth or not to Roth?

"From a mathematical standpoint, the decision of which type of IRA is more beneficial for a particular investor is primarily dependent on the investor’s expectation of their [sic] future tax rate relative to their [sic] current tax rate.... 

Since the future of tax rates is unknown, investors may want to hedge their bets by investing in both traditional and Roth IRAs. This approach, often referred to as “tax diversification”, allows the investor to lock in taxes at current rates on a portion of their portfolio balance, thus alleviating some of the uncertainty about future tax rate changes."

Source: The rules for Roth conversions are changing in 2010, Vanguard, Sept. 2009

--------------------------

The analysis is, of course, correct, and it is based on a reasonable assumption of significant uncertainty regarding future tax schemes (translation: no one has clue what these crazy SOB's might do). 

An irrational, unpredicable tax policy might be helpful to those seeking to monetize the ability to dispense economic favor by way of law or regulation, but it is not a helpful policy for the creation of wealth, either individual or national.  

Tuesday
Oct062009

Something is fundamentally wrong with this process

"The Senate is expected to vote on a health bill in the weeks to come, representing months of work and stretching to hundreds of pages. And as of now, there is no assurance that members of the public, or even the senators themselves, will be given the chance to read the legislation before a vote."

source: Congressional leaders fight against posting bills online Washington Examiner of October 6, 2009

Friday
Oct022009

Views on the economic stimulus package: is it effective?

Excerpts from Stimulus Spending Doesn't Work

Wall Street Journal of Oct. 1, 2009, 12:54 P.M. ET by Robert J. Barro and Charles Redlick

"The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure "multipliers" are greater than one—so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production, and investment (by lowering rates)….

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin. In ongoing research, we use long-term U.S. macroeconomic data to contribute to the evidence. The results mostly favor tax rate reductions over increases in government spending as a means to increase GDP…

The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller…"

___________________

I would very much like to hear Mr. Barro address the very important question,"So what, what does this mean?"

Many citizens will need help to connect explicitly the dots.  What are the consequences of the massive stimulus package if the multiplier is significantly less than 1? 

The answer is, we fear, a declining standard of living for our children.

Wednesday
Sep232009

Not acting the way we should ... or the way you want? Keep your hands off my kids and the schools.

The administration believes that the American public does not understand energy costs and behaves wrongly. It is now targeting children via the educational system.

Off to the eco re-education camps...?

excerpt from the Wall Street Journal

 Dr. Chu said he didn’t think average folks had the know-how or will to to change their behavior enough to reduce greenhouse-gas emissions.

“The American public…just like your teenage kids, aren’t acting in a way that they should act,” Dr. Chu said. “The American public has to really understand in their core how important this issue is.” (In that case, the Energy Department has a few renegade teens of its own.)

The administration aims to teach them—literally. The Environmental Protection Agency is focusing on real children. Partnering with the Parent Teacher Organization, the agency earlier this month launched a cross-country tour of 6,000 schools to teach students about climate change and energy efficiency.

“We’re showing people across the country how energy efficiency can be part of what they do every day,” said EPA Administrator Lisa Jackson. “Confronting climate change, saving money on our utility bills, and reducing our use of heavily-polluting energy can be as easy as making a few small changes.”

Still, Secretary Chu said he didn’t think that the public would throw the same political temper tantrum over climate legislation has has happened with the healthcare debate.

 

By what authority do they consume valuable educational resources of classroom and instructional time, not to mention the direct costs?  This has nothing to do with fundamental educational missions of literacy or numeracy.

 

Saturday
Sep122009

This is not good...

U.S. to Impose Tariff on Tires From China - "In one of his first major decisions on trade policy, President Obama opted Friday to impose a tariff on tires from China..."

  • Raising trade barriers
  • Raising US marginal tax rates on capital
  • Raising US marginal tax rates on labor
  • Raising US energy costs (via cap & trade)
  • Raising US health care costs (I don't buy the cost neutral scenario for a minute)
  • Increasing ineffective and costly regulatory burdens on large & small US companies
  • Reducing global competitiveness of American industry
  • Record deficits with no end in sight
  • Raising inflation expectations (eg rising gold and falling dollar)
  • Increasing % of GDP controlled by government (with consequence of decreasing marginal productivity of those $)

How much more can you push this?

 

Tuesday
Aug252009

Except that the size of the future liability is not known

"More than banks, life insurers, or predatory loan originators, government sponsored enterprises led the mortgage market into the abyss.  In the second act, we are likely to see the federal government guarantee auto warranties, public and private pensions, municipal bonds, and even home loans.  Federal guarantees encourage risk-taking by the insured at the expense of the taxpayer. Crisis is practically inevitable (italics added).

Guarantees are structurally very similar to debt, except that the size of the future liability is not known...

The systematic risks being created by the Federal Reserve and the Treasury eclipse those created by the private sector by gargantuan proportions."

Steve Francis in letter to WSJ 8/25/09

 

Wednesday
Aug122009

Sensible health care approaches

John Makey in today's WSJ, The Whole Foods Alternative to ObamaCare ,  has some utterly sensible suggestions for health care reform.

  • "Remove the legal obstacles that slow the creation of high-deductible health insurance plans and health savings accounts (HSAs). The combination of high-deductible health insurance and HSAs is one solution that could solve many of our health-care problems. For example, Whole Foods Market pays 100% of the premiums for all our team members who work 30 hours or more per week (about 89% of all team members)....Money not spent in one year rolls over to the next and grows over time. Our team members therefore spend their own health-care dollars until the annual deductible is covered (about $2,500) and the insurance plan kicks in. This creates incentives to spend the first $2,500 more carefully. Our plan's costs are much lower than typical health insurance, while providing a very high degree of worker satisfaction for our high-deductible health-insurance plan. We also provide up to $1,800 per year in additional health-care dollars through deposits into employees' Personal Wellness Accounts to spend as they choose on their own health and wellness. .
  • Equalize the tax laws so that employer-provided health insurance and individually owned health insurance have the same tax benefits. Now employer health insurance benefits are fully tax deductible, but individual health insurance is not. This is unfair.
  • Repeal all state laws which prevent insurance companies from competing across state lines. We should all have the legal right to purchase health insurance from any insurance company in any state and we should be able use that insurance wherever we live. Health insurance should be portable.
  • Repeal government mandates regarding what insurance companies must cover. These mandates have increased the cost of health insurance by billions of dollars. What is insured and what is not insured should be determined by individual customer preferences and not through special-interest lobbying.
  • Enact tort reform to end the ruinous lawsuits that force doctors to pay insurance costs of hundreds of thousands of dollars per year. These costs are passed back to us through much higher prices for health care.
  • Make costs transparent so that consumers understand what health-care treatments cost. How many people know the total cost of their last doctor's visit and how that total breaks down? What other goods or services do we buy without knowing how much they will cost us?
  • Enact Medicare reform. We need to face up to the actuarial fact that Medicare is heading towards bankruptcy and enact reforms that create greater patient empowerment, choice and responsibility. "

Many of these basic issues impair the proper functioning & delivery of health care to individuals, families & businesses across the nation, and voters should hold Congress accountable. Why are citizens held hostage to intra state coverage lines? Why is there asymmetrical tax treatment? This is not brain surgery: it smells of market manipulation, the selling of economic dispensation via regulation to the collective disadvantage of our citizens.

Monday
Aug102009

Lowering standards to accommodate broker practices?

The vested interest of the brokerage industry is to avoid real fiduciary standards. They can thereby retain the ability to harvest fees for overpriced, under performing product and sell those products to clients under the safe harbor of the "suitability" standard.

This is the same old story: industry participants collude with legislators to tilt the regulatory table for economic advantage.  We've seen this act before... remember the Savings & Loan Crisis? Fannie & Freddie & the Sub Prime mess? 

We don't know the folks at Fund Democracy, but we think they have it exactly right:

“Our concern has always been that if the SEC were to decide what the fiduciary duty is, it would lower the standard in order to accommodate broker business practices,” said Mercer Bullard, founder and chief executive officer of Fund Democracy LLC, an advocacy group based in Oxford, Mississippi.

source: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDRJvkh6IQGk

Wednesday
Jul292009

The specific language on "Advance Care Planning" from the current bill

Do you really want Congress to mandate a Post Office like functionary in the ICU meeting room with you and your family?

You can get the full monty here. See SECTION 1233. ADVANCE CARE PLANNING CONSULTATION p424 ff.

‘(5)(A) For purposes of this section, the term ‘order regarding life sustaining treatment’ means, with respect to an individual, an actionable medical order relating to the treatment of that individual that— ‘‘(i) is signed and dated by a physician (as defined in subsection (r)(1)) or another health care  professional (as specified by the Secretary and who is acting within the scope of the professional’s authority under State law in signing such an order, including a nurse practitioner or physician assistant) and is in a form that permits it to stay with the individual and be followed by health care professionals and providers across the continuum of care;‘‘(ii) effectively communicates the individual’s preferences regarding life sustaining treatment, including an indication of the treatment and care desired by the individual; ‘‘(iii) is uniquely identifiable and standardized within a given locality, region, or State (as identified by the Secretary); and (iv) may incorporate any advance directive (as defined in section 1866(f)(3)) if executed by the individual.‘‘(B) The level of treatment indicated under subparagraph (A)(ii) may range from an indication for full treatment to an indication to limit some or all or specified interventions. Such indicated levels of treatment may include indications respecting, among other items— ‘‘(i) the intensity of medical intervention if the patient is pulse less, apneic, or has serious cardiac or pulmonary problems;‘(ii) the individual’s desire regarding transfer to a hospital or remaining at the current care setting;‘‘(iii) the use of antibiotics; and‘(iv) the use of artificially administered nutrition and hydration.’’ 

Monday
Jul202009

Auction rate securities: two noteworthy stories 

TD Ameritrade Settles Securities Case

"TD Ameritrade Inc. agreed to buy back $456 million of auction-rate securities from its clients as part of a settlement with New York Attorney General Andrew Cuomo, the Securities and Exchange Commission and Pennsylvania securities regulators.

The online brokerage intends to return the money to customers across the country -- including individuals, charities, nonprofit entities and businesses by March 2010 but could need until June 30 to complete the buybacks.

Auction-rate securities, short-term debt instruments whose prices reset in periodic auctions, caused billions in losses for investors after the $330 billion market collapsed in early 2008.

Over the past year, regulators have reached settlement agreements with several Wall Street firms and brokerage houses, which have agreed to buy back over $60 billion of the securities from investors..."

source: 7/20/09 Wall Street Journal

 

Cuomo Says Schwab Faces Fraud Suit

" In an official notice sent to Charles Schwab & Co. Friday, Attorney General Andrew Cuomo warned that his office plans to sue the largest online brokerage firm for civil fraud over its marketing and sales of auction-rate securities to clients. Emails and testimony cited in the letter show Schwab's brokers had little idea of what they were selling and later failed to tell clients that the market was collapsing...Charles Schwab executives received daily reports showing in the fall of 2007 that demand for the instruments was declining rapidly, but it didn't make that information available to clients, said the letter."

source: 7/20/09 Wall Street Journal

Tuesday
Jul142009

Free alpha or expensive beta? Either way costs matter.

 

This is a picture about a wealth transfer from an investor to a broker dealer done under color of 'incidental' advisory service.

It's a real story, unfortunately, and in many ways has come to represent the state of the financial services industry where the interests of the client are subordinate to the revenue preferences of a firm operating on a 'suitability' standard.  An unsophisticated investor will get harvested.

By the way, the difference in the picture is just fees. It is the 'wealth transfer' of your money to the financial services industry. Ever wonder who's paying for the mahogany offices?

It's old fashioned, but costs matter and compound over time. More often they're hidden to some extent, certainly not transparent.  In this case the investor was paying a private banking group (of a broker dealer affiliated with a major US global bank) 3% p.a. for separately managed accounts.  The result was about 1,000 trade confirmations a year and unfathomable account statements some 60+ pages long. What to do?

Analysis revealed it would be possible to 'clone' the performance characteristics of the managed portfolio with a diversified portfolio low cost indexed product comprising some nine distinct asset classes. The comparative analysis above assumes an alternative total cost structure of .80% pa, and the results over 15 years increase the wealth of the portfolio by more than 30%

For another perspective, think of it this way: if you expect

  • an 7% equity return (on the S&P 500 or the Wiltshire 5000) and
  • the 10 year Treasury is paying 3% and
  • you have a 50/50 debt/equity portfolio, then
  • you have an expected return of 5% before fees on the portfolio

Let's pretend this is your Roth, so there are no taxes (taxes, of course, make everything worse). 3% pa fees consume 60% of your expected pre-tax return.

Some friends came to us, and this is their story. Unfortunately, it is true.  The private banking group was charging excessive fees for under performing product. As you can see it has significant adverse long term implications for wealth creation. 

It is your money. Make your story end well.  It's too important.