The Questions to Ask

The person with a wrench in his or her hand who has worked as a car mechanic for 20 years knows the questions to ask when they hear that whirring sound coming from the right back when the car gets up over 60 miles per hour.  Most car owners won't - they just know it is a sound they haven't heard and that something is wrong.

I'm in the same boat many times with new clients.  Just recently I was presented with a 401(k) managed by a leading 401(k) fund provider.  The administrator of the fund had that uneasy feeling that the fund wasn't doing that well.  He knew something was wrong but like the car owner didn't know the questions to ask.

I gave him a brief rundown of my recommended approach to managing assets using low-cost well-diversified index funds, concentrating on asset allocation and carefully monitoring performance relative to a well-defined benchmark.  This set the backdrop for questions.

We then looked at the 40(k). It was comprised of load funds that charged a front load of 5.75%.  Annual expenses were on the order of .66%.  He said he was sure he didn't pay the load but would ask his broker.

Here's a question to ask:

Has there ever been a load on any fund invested in this account?

As it turns out, sometimes loads are dropped once funds exceed $1 million.  Thus, this fund may not be paying a load on investments today - to which the broker would answer that it doesn't pay any load - but it has in the past!

Follow-up question:

Can you specify for me all payments received by you and costs charged to this account over the past 12 months?

The sad fact of the matter is that the industry is totally opaque when it comes to costs and expenses and how people are compensated.  Sadly, it is rife with conflicts of interest.

In discussing performance, the client said he can get performance anytime he wants by calling up his broker.  That's a bit different, of course, from being able to go online and retrieve performance through the close of the previous business day anytime you want  for any combination of account portfolios. But that's OK if the client wants to go through that hassle.  The real question to ask is:

Can I have up-to-date performance for year-to-date, 12 months, 3 years, and since inception compared to a relevant benchmark?

It is natural that, unless you are an investment professional or have taken the time to educate yourself, you wouldn't think to ask about a benchmark.  You wouldn't appreciate the importance of setting up a benchmark beforehand.  Think about this:  when you buy a car, it is likely that you study average miles-per-gallon, average annual maintenance costs, and even likely trade-in value.  All of these are benchmarks, i.e., reference points that aid in your decision.  Sadly, similar benchmarks are purposely avoided in the investment management arena.

Even the fact that these questions have to be asked tells you something!

Bernanke Lectures

Interested in how central bankers think?  Here are the 4 lectures given by Federal Reserve Chairman Bernanke to GW students. Although they do take a bit of a time commitment, they are well worth watching IMHO.  The Chairman covers history, the crisis of 2008, the Fed's response, and the aftermath.

If you're like me, they don't provide a lot of confidence in the people flying the plane--if you get my drift.

Bernanke reminds me of a ghost buster who sees a ghost every time the bushes move.  He saw deflation in 2003 and, along with Greenspan, led the Federal Open Market Committee to push the fed funds rate to 1% in the face of a housing market that was already picking up. Why?  Because, as a student of the Great Depression, he arrived at the conclusion that the big mistake in the 1930s was the failure of the Fed to act aggressively in the face of an economic downturn.

He casually deals with criticisms of the Fed for lowering rates but cites weak data that 1% fed funds wasn't a serious cause of the housing bubble.  In this, he fails to mention evidence produced by John Taylor that suggested following the Taylor rule and keeping the rate at 3% and above would have dampened and possibly prevented the 2008 debacle.  The GW students, who on the whole asked some pretty good questions, failed to bring this up.

He also seems genuinely puzzled by the fact that the economy acted so differently to the housing bust compared to the 1987 stock market crash.  It is fact, supported by embarrassing quotes, that Fed officials, primarily Bernanke and Greenspan, were totally befuddled by the whole housing market downturn.  This extended to the Fed's confusing response of providing a liquidity response to what was (and still is!) a solvency problem.

Another puzzling piece to me is how Fed examiners didn't come up with a funny smell in doing their job of examining bank financials, because surely they came across their off-balance sheet holdings. Bernanke admits that the Fed was focused on controlling interest rates rather than ensuring a stable financial system (which is an important part of what Congress gave them a mandate to do!) during this period, but this simply isn't good enough IMHO.

In fairness, Bernanke, et al. deserve kudos for acting swiftly once they confronted the modern-day version of a panic when money market funds faced massive withdrawals.  I'm still not clear where they got the authority to guarantee everything they did, but they probably did prevent another Great Depression.

It is clear from watching the lectures that Bernanke is an excellent teacher.  I, for one, would like to see him go back to Princeton and resume his teaching career.



I'm sitting in the back of the plane until that happens--I hear that's the safest place.

How Are Your Investments Doing?

I have to admit that I am constantly surprised to learn that investors many times have no idea of their investment performance.  If they have an advisor, they are typically at the whim of the advisor in receiving investment performance.  More times than not, I find returns are reported absent any meaningful benchmark. This is like telling an alien that your automobile gets 30 miles to the gallon.  Is that good?  It would have no way of making an assessment.

I point out the fact that up-to-date investment performance, relative to an appropriate benchmark, is at the fingertips of Schwab clients.  Performance is available for individual accounts as well as for combined accounts.  For example, if you have a brokerage account, an IRA, and a Roth IRA, you can get performance for each account as well as all three accounts combined.

When I point this out to potential clients, they sometimes respond that they don't follow their performance by frequently checking on it.  I agree - it isn't a good idea to check on it constantly.  But isn't it good to know it is there when you need it?

Here is performance for Schwab's "Moderate" portfolio.  Note the well-specified benchmark.  The returns are for the last three months, year-to-date, one year, etc.  They are through the close of the previous day!  The return on the right-hand-side, 2.40% annualized,  is since inception of the account, 4/15/2011.

Source: Schwab

CLICK TO ENLARGE

Source: Schwab

CLICK TO ENLARGE  Here is the model to which the returns are tracked.  This is where an investor begins to get information on whether it is an appropriate model.

The index approach that I and many others follow seeks to attain returns close to the returns of the model.

But the model is also useful for those who see themselves as a market-beating investor.  It provides a well-defined benchmark against which to compare stock picking, market timing prowess.  Sort of like telling an alien that similar cars only get 28 miles to the gallon.  Then it has a benchmark.

Do You Know What's in That Fund?

Here is a really excellent piece--Hey, What Do You Think Of My Investment?--I recently came across that describes where an advisor was asked what he thought about a particular fund.  I empathized because I run into this all the time.  Asking an advisor what he thinks about a particular fund puts him or her in a difficult spot without knowing the overall goals and structure of an individual's investment program.  It's like asking about a team's draft choice if you don't know the structure of the overall team.

Still, he analyzed the fund's performance and structure.  Performance was a bit erratic - having performed well several years ago but under by quite a bit over the past 3 years.  But this is seen a lot:  advisors and individuals pick the best-performing funds but then the funds don't live up to their past performance.

What I found interesting about the piece, and what should give pause to those who invest in funds via their 401(k)s, 403 (b)s, and even brokerage accounts, is that the fund only had 15% of the Fund's assets invested in small cap growth stocks.  But it is a small cap growth stock fund!  The fund isn't investing in what its title claims it invests in.  In fact, the writer points out:

Let’s say you decided you wanted to dedicate 5% of your portfolio to small growth, so you put 5% of your portfolio into this fund.  In reality, you’ve only put 0.75% of your portfolio into small growth, not 5%.

Please spend 5 minutes and read the article.  I believe it will be eye-opening for most readers and could save a good chunk of a lot of nest eggs over the longer term.

Client Makes First Trade

Source: Capital Pixel

Experts continually point out that market timing and stock picking over long periods of time underperform the major market indices after taking into account fees, hidden and explicit, charged by active managers.

The impact on retirement assets can be substantive.  This has, understandably, attracted considerable attention to indexed investing.

The icing on the cake that investors are coming to understand is that the process is easy, doesn't require a lot of time, and can readily be monitored to see if you are on track to produce the required nest egg in retirement.

This week I introduced the trading part of the process to a novice investor.

We first reviewed 3 basic steps:  asset allocation, figuring out how to invest, and monitoring the process.  We chose an asset allocation model that is basically 40% stocks/60% fixed income/cash.  She is 42 years old and this is her entry into the world of investing, so she is starting a bit conservatively.  She set up her brokerage account with Schwab.

The model is: 

Source: Schwab

CLICK GRAPHIC TO ENLARGE  As you can see, the targeted percentage for each asset class is specified.  From here she just needs to know what funds to invest in, do a little arithmetic, and where to go on the Schwab site .

Broker sites will have a prominent link on their main page to execute a  trade.  Click on the Schwab trade link and it takes you to:

Source: Schwab

CLICK TO ENLARGE This, of course, is where you enter the trade.

She opened her account with $10,000 and, by her model (above), she wants 25% in "Large Cap Equity."  Thus, she needs to invest approximately $2500 in a "Large Cap Equity" index ETF.

There are several ways to find the ticker symbol for various choices.  One way is to Google "large cap indexed ETFs."  Another way is to find someone who is knowledgeable about markets.  I suggested the commission-free Schwab ETF with ticker symbol SCHX.

At the bottom of each Schwab page is a quote box, which she used to find the price of SCHX.

Source: Schwab

She divided $2500 (amount she wanted to invested as determined above) by the price-per-share of $32.21, and she found that she needed to buy approximately 75 shares.

From here it is straightforward.  In the box above, she entered the symbol (SCHX), selected "buy" from the "Action" drop-down menu, entered 75 in the "Quantity" box, and chose "Market Order" from the "Order Type" drop-down list.  Then she clicked "Review Order."

CLICK TO ENLARGE  Note the estimated dollar amount of the trade.  On the same page, the amount available to trade is also given.  It is good practice to get in the habit of eyeballing this amount.

All she had to do next was to scroll down and hit the green "PLACE ORDER" button.

She had made her first trade!

Disclosure:  This post is for educational purposes.  Individuals should do their own research or consult a professional before investing.

Where Are Investors Putting Their Money?

Tracking investment flows is a popular pastime on Wall Street.  It is a way to get a sense of market thinking.  Exchange traded fund (ETFs) flows for June, as reported by the ETF Industry Association, showed the biggest inflows, as follows:

ETF	INFLOW	MARKET SECTOR	RETURN (%)
SPY	$3.6 bln.	S&P 500	7.66
QQQ	$1.4 bln.	NASDAQ	7.65
LQD	$1.3 bln.	INV. GRADE CORP. BONDS	1.3

 Biggest outflows:

ETF	OUTFLOW	MARKET SECTOR	RETURN (%)
VB	$.965 bln.	SMALL CAP STOCKS	10.42
SHY	$.65 bln.	1-3 YR. TREAS.  NOTES	-0.08
FXI	$.568 bln.	CHINA	4.27

*Returns are from Morningstar and are based on fund net asset asset value for the 30-day period ended 7/3/2012.

During the month, the Federal Open Market Committee announced a continuation of "operation twist" whereby they focus on investing in the longer maturity portion of the yield curve in lieu of shorter maturities.  It appears that this was impetus for investors to seek higher-yielding corporate bonds in this part of the curve.

For additional detail, see the Bond ETFs Remain Top Draw in June by Tom Lydon.

Year-To-Date Performance

Source: Capital Pixel

Although markets followed patterns of recent years and were a bit shaky during the 2nd calendar quarter of 2012, they held their gains for the year and rewarded investors who were well-diversified and who stayed with their asset allocations.  This performance builds on the 20-year performance ended 2011 of the diversified portfolio as reported by BlackRock.  The report covers several asset classes as well as a diversified portfolio comprised of 35% fixed income and 65% stocks.  Over the 20-year period ended 2011, the portfolio achieved an average annualized return of 7.7%. At that rate, money doubles in approximately 9 years.  Thus, over the period, a sum of money invested in line with the diversified portfolio would have quadrupled.

The performance of the asset classes comprising the diversified portfolio over the 1st 6 months of 2012 along with component weights and expense ratios are shown in the following table constructed with data from Morningstar :

CLICK TO ENLARGE  The overall portfolio has achieved a return of 6.1% year-to-date. 

A few observations are worth making here.  First off, there has been significant scary news throughout the course of the year that would scare even the bravest investors from the capital markets.  The talk of Europe imploding, the weak U.S. economy, and the fast approaching "fiscal cliff " has been incessant.  Secondly, the alternatives are pathetic.  Treasury bills and money market funds yield marginally above zero and, after taking into account inflation and taxes, are guaranteed to lose ground.  Finally, there is a group of so-called tactical asset allocators who argue that buy-and-hold is dead and that assets need to shifted around in response to valuation metrics. They argue, as well, that they don't really have an appropriate benchmark because they don't have a set allocation but can instead invest in any asset class.

I believe the numbers reported here bury the "buy-and-hold is dead" argument.  I would further argue that the performance here is an excellent benchmark for the tactical asset crowd.  It is a choice investors could easily choose over the tactical approach.  If the tactical approach isn't beating the well-diversified, low-cost diversified portfolio, then I would think at some point questions would arise.