Boomers Take Note

The week’s economic numbers continued their trend toward improvement with manufacturing store sales, consumer confidence, and jobs growth all moving ahead. Even Greece looks to end the week on a strong note as arm-twisting forced enough bondholders to swallow losses of more than 100 billion euros ($132 billion) and allow the beleaguered country to move forward with its next phase of debt re-structuring.

Jobs growth continued at a reasonably healthy pace in February, according to the government. The gain of 227,000 jobs followed gains of 284,000 in January and 223,000 in December. Jobs were produced primarily in the services industries of the private sector. By industry, job gains were strongest in professional and business services, health care and social assistance, and leisure and hospitality, according to Econoday. Average hourly earnings rose a modest 0.1% in February, following a 0.1% gain the month before. The average workweek for all workers in February was unchanged at 34.5 hours. According to the household survey, the unemployment rate remained steady at 8.3% as the pool of available workers rose as fast as new jobs were created.

Consumer confidence is on the rise as more Americans said the economy was improving, according to the Bloomberg Consumer Comfort Index. The index rose to a minus 36.7 in the period ended March 4^th, the highest since April 2008 and up from minus 38.8 in the prior period. The gauge on the state of the economy reached a one-year high while the buying-climate measure climbed to a level last exceeded in December 2009. Joe Brusuelas, a senior economist at Bloomberg said consumers are much more comfortable about their own personal financial situations, which is largely negating the recent rise in gasoline prices.” But he also noted index remains at the low end of its historical range.

Consumers took their improved moods shopping last week according to Goldman Sachs and Redbook. Goldman’s weekly same-store sales index rose 1.3% in the week ended March 3^rd, while Redbook’s index saw a 3.0% rise of year-on-year same store sales ended March 2^nd. This rate compared to a 3.4% gain the prior week. Redbook sees stronger sales ahead for the month ahead.

The ISM reported that its non-manufacturing index rose 0.5% to 57.3. Econoday says the composite may understate underlying strength in the bulk of the nation's economy where order levels are building with new orders up nearly two points to a very strong 61.2 vs. January's already very strong 59.4. The index is comprised of agriculture, mining, construction, transportation, communications, wholesale trade and retail trade companies.

The manufacturing sector cooled modestly as factory orders fell back 1.0% following very strong gains in the prior months of 1.4% and of 2.2%. Weakness was centered in durable goods orders which fell 3.7%. Orders for non-durable goods, which always reflect price swings in commodities especially oil, rose 1.3%.

Boomers Take Note

An article this week caught my attention as an example of how terrible financial advice can be taken as sound by it's association with the presenter; in this case the Wall Street Journal. The article was titled Testing the 4%-a-Year Retirement Rule and features Bill Bengen, a financial planner in Southern California who developed the 4% rule.

The following description of his rule is excerpted from the article: “In a study published in 1994, he said that if retirees withdrew 4% of their nest egg in the first year, and then increased the dollar amount by the inflation rate every year, their savings would easily last 30 years. He assumed that the portfolio was held in a tax-deferred account and was evenly split between large-company stocks and U.S. Treasury bonds. In a subsequent study, Mr. Bengen added U.S. small-company stocks to the mix, which increased the portfolio's volatility and potential return. To adjust for this, he revised the withdrawal rule to 4.5%.”

The first problem is with the article itself. There was no testing to be found. The author merely points out that as stocks have become more volatile, many wonder whether Mr. Bengen's rule still holds. The answer?: Well, Mr. Bengen says he thinks it does. However, he says the next five years could be crucial, particularly for individuals who retired in 2000 and have experienced two major stock-market downturns since then. He expects stock returns to be low for a while; if that is coupled with high inflation rates, "then retirees have a big problem," he says.

In my view Mr. Bengen’s ‘rule’ has several problems. While it seemingly addresses inflation, it ignores capital market uncertainty. Uncertain returns (portfolio values) mean that spendable income (4.5% of portfolio plus inflation) will swing wildly from one year to the next. My experience is that people really don’t like their income to swing.

Take for example a couple with a million dollars to spend over their remaining 30-year retirement. Mr. Bergen’s examples use a deferred account invested in a balanced portfolio (60% equities and 40% fixed) so we will too. Using our Monte Carlo system to live our couple’s lives virtually 1,000 times through randomly generated capital market returns (against an allocation of 60% equities and 40% fixed) we find that their income would range significantly depending upon the kinds of market returns they would experience.

	Lowest	Highest
	Income	Income
25th Percentile - Good Markets	$34,376	$65,038
50th Percentile - Average	$36,335	$66,382
75th Percentile - Poor Markets	$30,396	$49,012
In today's dollars

Here’s how the cash flows look under these three lifetime scenarios.

The picture above illustrates why so many throw their hands up and buy annuities, which are basically contracts which pay the insurance company to give them back their own money.

There’s another huge problem with Mr. Bengen’s rule of 4.5%. Look below at all the money our couple would have left over at their deaths; money that they may have wanted to use during their lives. Even at the 75^th percentile, the most pessimistic of our examples above, the couple left $783,832 in the bank, unspent. OK, they may have heirs to whom the money might have gone. But shouldn’t the donors get the chance say how much?

Here’s a better way.

Take our same couple, assuming the same portfolio and risk allocation of 60% stocks and 40% bonds. But this time, let’s suggest that instead of accepting a lifestyle dictated by their returns let’s give them the opportunity to do some dictating themselves. We would ask them what level of spending might be ideal as well as what would minimally suffice if other more important goals required it. In this case our only other goal is to leave something for the kids.

Our couple tells usthat it would be ideal for them to spend $45,000 (after-tax) annually (adj. for inflation) for the rest of their retired lives. If necessary their spending could be reduced to $40,000. They would ideally like to leave their children $100,000, but not less than $50,000.

We inform our couple that they could accomplish both goals at their ideals and have an 81% confidence of exceeding both goals. Our objective is to maintain, to the extent possible, our clients’ income and estate goals through actual market turbulence and the uncertainty of future markets. By continually measuring uncertainty in our clients’ plan we can make adjustments to their spending, estate, and portfolio risk (allocation) according to their priorities to maintain a comfortable level of confidence.

The table above illustrates the broad range of potential outcomes for a $1 million portfolio delivering an annual after-tax income level of $45,000 (adj for inflation) and ending with $100,000. There is a 75% chance the portfolio will be worth more than $300,000 at death and a 25% chance that it will exceed $2.1 million. It is a picture of why our couple needs professional assistance in managing the uncertainty ahead of them and why a simple 4.5% rule of thumb simply won’t do.

Have a nice weekend.

Tick . . . Tock . . . Tick . . . Tock

It is now two and a half years since the Great Recession officially ended. The 18-month downturn was the longest and most severe since World War II according to the National Bureau of Economic Research, a private, nonprofit research group which officially calls the beginning and ends of recessions. But things are getting better you say. Why bring up the ugly past?

Some economic data have indeed shown improvements, particularly of late. Manufacturing has been a steady stalwart of the recovery. Exports have persisted strongly for months, while the much touted automobile industry has made a ‘remarkable’ turnaround domestically. GM regained the lead over Toyota for goodness sake.

Yesterday the Commerce Department announced that it revised fourth quarter GDP growth up to 3.0% (GDP is a measure of the nation’s economic output) from an initial estimate of 2.8%. This figure compares to .4% 1.3% and 1.8% for the prior three quarters of 2011. So the near-term trend looks pretty good, but look a little deeper.

Unemployment is getting better, but at rates not even approaching previous recoveries. And the rates of growth in consumer spending are slowing. Remember, rising employment doesn’t bring more spending, it’s the other way around. Businesses don’t hire until they begin selling more stuff that they will have to replace. And they are not. The rise in employment could well roll over just like that red line below in GDP. 

Since the Great Recession started, the US government has invested/spent/squandered (depending upon your viewpoint) an unprecidented $4.5 trillion more than it has realized in taxes and TARP paybacks. That’s just on the fiscal side. On the monetary side, the Fed is giving it away for free (when inflation is considered) and promises to do so for another two years.

With free money guaranteed well into the future and literally trillions already washing around in the economy, shouldn’t we expect to be doing far better than the chart above indicates we are? The gray bars on the right are shorter than they should be relative to the years ‘03-‘06 and the red line demonstrates a big rollover after peaking at growth of 3.5%. With all these great incentives, why arent we partying like’s it’s 1999?

Since the Great Recession was officially declared ended in June of 2009 the S&P has rallied almost 50% (not including dividends), but there’s not much celebrating there either. The average still remains 7% below the level it occupied when the recession officially began. Adding to the conumdrum is the fact that Treasuries (as measured by the Barclay’s 7-10 year index), which should have been clobbered as stocks rose 50%, are 16% higher (not including interest) since the recession ended.

Bond buyers typically look much further into the future than do stock buyers. This is because they are making a relativly long-term commitment to a steady stream of income payments that will not change as prices rise or fall. Inflation is their biggest concern, and strong economies are much more apt to gnerate rising prices than weak ones.

Stock investors, on the other hand, invest with the hopes that companies will increase their earnings at the expense of their competitors or more often when the broad economy grows. It could well be that stock investors are beginning to question whether prices may already reflect the potential ahead. This week State Street announced that confidence among institutional investors may be breaking down. Their monthly index fell to a weak 86.5 in February which reflects an easing in demand for equities. State Street said that the North American sample shows the greatest weakness, at 80.5, representing its lowest reading in more than three years. Europe is at 95.2 and Asia is at 96.3. A reading below 100 indicates demand for safety (bonds – Treasuries in essence).

Now, back to the question of why this recovery seems to be so anemic given the gigantic stimulus measures thrown at it. The usual suspects like Europe, high energy and food costs, high unemployment, and falling home prices seem daunting, but our economy has tossed aside hurdles more challenging than these with impressive growth in previous recoveries. Could it possibly be that a significant majority of our collective economy have become like bond buyers? Are more of us coming to the conclusion that the stimulus is no longer nourishing, but poisionous, that the deficits and mounting debt will eventually swamp our productive capacity or will?

Since December of 2009 our government has spent $4.5 trillion that’s $4,500,000,000,000 more than it brought in. This number represents a full third of the US economy and that’s on top of the $9.1 trillion government collected and spent during the same period. US Government debt now stands at $15.4 trillion which is very close to 100% of the nation's total economic output. Projections take it to 108% in 2014. The last time debt was this high relative to our output we were at war on two fronts with Nazi Germany and Imperial Japan. As a country we were perhaps more united than any time in our history, including our fight for independence. Today its hard to imagine we were ever more divided and still at peace within our borders.

Some like to to blame the nation’s financial problems on presidents. After all, they are the guys who submit the spending budgets. But if you like to speak from a political point of view, the numbers below don’t provide much moral high ground for either party. They do however suggest a trend.

Obama Deficits
		% Spending
FY 2012	1,327	35%
FY 2011	1,300	36%
FY 2010	1,293	37%
Bush Deficits
		% Spending
FY 2009	1,413	40%
FY 2008	459	15%
FY 2007	161	6%

In trillions of dollars

Others realize that it is the Congress and the “Washington Machine” that are to blame. That’s where the money is appropriated and spent, and overspent. In fact the Congress has increased the US debt limit 74 times since 2001. Do they even know what 'budget' means?

And there are a very few who remember that we are a democracy and that “WE THE PEOPLE” are ultimately to blame for the mess in which we find ourselves trapped. Out of abject neglect we have stood by for decades and allowed an elected few to squander the greatest natural and material blessings ever bestowed on a single nation. As a result our very future is now nearly 'underwater,’ buried in a rising sea of debt. 

In the language of an investor, the US's next quarter ends this November with few signs of improvement. Analysts estimate that profits and growth are expected to be sub-optimal for years, possibly decades to come due to an inexperienced, self-serving management, a lousy balance sheet (near-bankrupt in many industries), an aging physical plant, an outdated, inefficient corporate bureaucracy and culture, inept training, little innovation, and union incalcitrance. If and only if the shareholders can somehow replace the bad management at all levels with more competent, visionary leaders, then there is a chance this giant enterprise may once again become that "shining city on a hill" as once proudly proclaimed by a former CEO. If not, maybe the bonds will prove a better way to go. Their meager 2% returns may prove safe from inflation or deflation as there will be little chance that the US economy will grow fast enough to erode spending power.  

Warning: Active Management Is Dangerous to Your Wealth

Last week in Measuring Uncertainty I focused on the pitfalls of using performance alone to measure progress toward reaching your financial goals. It’s only natural to use returns because they are the universal language of the financial services industry. And if the language of the industry is returns, then the methodology for producing them is active management; where managers make specific investments with the primary goal of outperforming an investment benchmark index. But with return alone as your guide, you are left to wonder just how effectively your managers are improving your situation relative to your goals, how are they managing your wealth?

While some managers may beat their benchmarks, occasionally with stellar returns, there is no guarantee they improve your wealth. Active managers are expensive, generate significant taxes, and will eventually under-perform their benchmarks. They concentrate investments in less than fully diversified positions in order to better their benchmark, thereby exposing your wealth to greater risk than you may know about or need. The concentrated positions can make your investments considerably more volatile than the indexes against which they are measured, encouraging irrational decisions driven by fear or greed.

As a rule, actively managed portfolios are significantly more expensive than passive funds (those that match an index). Large salaries and bonuses are required for the smart people who direct the management investment decisions. Lots of transactions are required to position the portfolio among companies, industries, and sectors as directed by their managers. These transactions incur commission charges from the brokers executing the trades and they suffer another meaningful but rarely mentioned expense known as the spread (the difference between what is paid for a stock and what it is sold for). The spread, which ranges from a few pennies to a half percent or more, goes to the market maker of a stock, and it dissapears from your wealth every  time a stock is bought or sold. A study done by the Wharton School of Business in 1999 found that mutual fund trading costs, which are not reported in prospectuses, averaged .78%. That’s more than three quarters of a percent the managers have to clear just to beat their benchmark.

Typically, when you buy a mutual fund you pay a sales charge of as much as 5.75%. Add that to the internal expenses of the fund which can range between .25% and 2% and you begin to see the challenge of simply catching up to where you could start with an index fund. If you bought a typical growth fund and paid the 5.75% up front commission, and incurred an ongoing .7% internal fund expense ratio, your fund would have to clear 1.83% a year for five years, just to break even with the benchmark index. But wait, there’s more . . . don’t forget the .78% that Wharton says is hidden among mutual funds’ expenses. Are you beginning to sense the magnitude of the challenge? If a mutual fund is going to offer any value at all to you in improving your wealth, the manager must scale a hurdle of more than 2.6% annually just to match the return you can get by duplicating his benchmark with index funds. 

What we’ve been talking about so far concerns the margin or amount funds' returns exceed or fall short of their benchmarks. Fund managers can employ all kinds of shenanigans between quarterly reports to improve their returns, and these actions usually subject the fund, and your wealth to more risk than is inherent in the performance benchmarks. One way to check is to compare the fund’s beta to that of its benchmark index. Beta provides a measure of the volatility of a security or a portfolio relative to a benchmark. If, for example, the manager of a domestic growth fund allocates say 15% of his holdings to international stocks, he has added greater risk in the form of volatility to his portfolio than is contained in the benchmark (i.e. currency, credit, and small cap volatility to name a few). His fund will likely carry a beta over 1.

Alpha on the other hand measures the fund’s ability to produce returns beyond those that can be captured through a combination of low-cost index funds matching the makeup of the fund. This measure provides a better gauge of whether the manager provides value beyond simply owning the indexes.

Vanguard, a champion of low cost index funds, recently did a study to determine the probability of selecting funds that offer superior alpha. In their introduction they note that “talented managers can deliver better than-benchmark returns, and it’s easy enough to identify managers who have produced alpha in the past. Unfortunately, these historical feats shed little light on a fund’s future."

The study used the Morningstar database of the returns of actively managed mutual funds from 1990 through 2010. They calculated alphas relative to the stock market’s four common risk factors, as outlined by Fama and French (1993) and Carhart (1997):

• Market risk factor (the difference between the returns of the broad stock market and risk-free U.S. Treasury bills);
• SMB risk factor (a measure of the historical difference between the returns of small- and large-cap stocks; SMB refers to “small [market cap] minus big”);
• HML risk factor (a measure of the historical difference between the returns of stocks with high book-to-market and low book-to-market values; HML refers to “high [book-to-market ratio] minus low”); and
• Momentum risk factor (the historical difference between the returns of stocks with the highest returns over the past 3 to 12 months and those with the lowest).

For each of the rolling 36-month periods in the database, they grouped the funds in quartiles from lowest alpha to highest alpha. They then calculated the probability that a top-quartile fund would remain a top-quartile performer over the following 1-, 3-, 5-, and 10-year periods, as shown below:

“The figure presents two sets of probabilities, one calculated from a database free of survivorship bias (which includes records both of existing funds and those no longer in existence) and a database that is survivor-biased (eliminates the funds which have ceased to exist). The results based on the two datasets were different, but both led to the same conclusion: The probability that the highest-alpha funds will remain the highest-alpha funds in subsequent periods was no better—and was sometimes worse—than chance. (In a random distribution, we would expect to see 25% of the top-quartile performers in that same quartile in future periods.)”

The study's authors noted “the survivor-bias-free dataset is more reflective of an investor’s real-world experience. An investor’s long-term challenge is to identify a fund that can both outperform and stay in business long enough to deliver that outperformance to shareholders.

If you are curious about why the beige bias-free probabilities are lower, the reason is simple math, notes the authors. While the numerators (top number) were similar in both datasets, the denominators differed. The denominator of the beige bias-free dataset included both surviving and non-surviving funds and was hence larger than the denominator of the blue survivor-biased funds.

The study concluded by saying “unfortunately, the quantitative evidence of this skill—alpha and other measures of historical performance—is of little help in identifying tomorrow’s superior performers. The elements that distinguish talented investment managers are difficult, if not impossible, to quantify in a simple metric. Active management is both art and science. Talent exists, it produces alpha, but its basis can’t be captured in a mechanical formula.

If your objective is to improve wealth, then it is fair to say that the odds are stacked pretty highly against you if you choose to go the way of actively managed mutual funds. They are expensive and are apt to underperform. But there’s another problem. The trading that goes on in their daily management and to accommodate buyers and sellers of the fund both generate significant taxable income. If you own mutual funds in taxable accounts, you will mostly likely be hit with short and long-term capital gains at year’s end even if you didn’t sell a share. That’s because mutual funds are required to pass their capital gains and losses to shareholders each year. These taxable gains can be material. Returns on average can be reduced by 2% or more. Taxes of this kind are a steady and unnecessary leak of your wealth.

A study by Blackrock reveals just how extensive the damage to your wealth the tax costs of active management can be. The table below represents the impact of various tax cost assumptions on a portfolio of $1 million growing at 8% for 10 years. You should not be surprised to find that the tax cost of some of the most popular mutual funds easily clears 2%. In the figure below note that the impact of a 2% tax cost annually can reduce your wealth by as much as $400,000 over a ten year period. These are losses or leaks that CAN BE REDUCED, AND POSSIBLY ELIMINATED.

In my 30 years advising clients, I have found that the most persistent wealth destroyer is emotions. Investors who make decisions based on fear or greed are highly apt to sacrifice big chunks of their wealth needlessly. Active management plays a significant role in contributing to these behavioral mistakes. As a performance manager for 25 of my 30 years I am all too familiar with the warning signs. “What do you think about the market ahead? “What do you think about gold?” “Should we buy some Apple shares – they’ve doubled in the last three years?” “My barber says he’s got a year’s worth of canned goods in his basement.” “Should we park some money on the sidelines until things settle down a little?”

The actively managed marketplace known as the financial services industry provides a cornucopia of choices from 'zero' risk to Katie-bar-the-door. They are sold by appealing primarily to clients' natural fear or greed, and all too rarely what is best for their unique wealth needs. And when investors make decisions on emotion they are apt to seriously impact their wealth.

The figure below represents another study done by Blackrock. It represents the lost opportunity of sitting on the sidelines while the stock market (S&P 500) delivers its best months of performance. If I had a dollar for every time I heard “I wish I had gotten back into the market last. . . .”  

The S&P 500 appreciated 124% from the period 1/97 to 12/06, yet those who missed the best 10 months of that 10-year period did not even beat the returns of 3-month T-Bills - a huge sacrifice of wealth lost while they hunkered down.

When a managed portfolio experiences volatility beyond that of a widely reported benchmark, like say the S&P 500, then shareholders tend to panic and get out more often. Conversely, if a portfolio is constructed with market-efficient fixed and equity index funds or ETFs that provides more consistent returns, with lower volatility than say the S&P 500, then investors might be expected to stay invested, accumulating wealth for future needs – true?

The objective in building a market-efficient portfolio is to maximize the portfolio’s expected return for a given amount of portfolio risk, or alternatively to minimize risk for a given level of expected return, by carefully choosing the proportions of various assets, essentially fixed (bonds) and equities (stocks).

We use six standard model portfolios that are efficient relative to the capital market assumptions developed by Wealthcare Capital Management. People often ask how we did during the Great Recession, particularly over the 2008 market period. Because we are wealth managers and not performance managers my answers generally focus on the experiences of our clients. The short answer is that our clients were relatively content by comparison to other investors riding out the storm. Our phones did not ring any more than usual and we did not have to talk a single client out of bailing.

The graph below provides a visual explanation of why our more risk-sensitive clients remained confident. The blue line represents our most conservative portfolio (Risk Averse). The red line is the S&P 500 and the green line represents the 7-10 year US Treasury index.

Wealthcare’s studies have found that 7-10 year Treasuries provide the best offset to equity risk. When stocks are declining, Treasuries, historically rise in value, offsetting the potential wealth-erosion in their absence.  As you can see below, the Treasuries (which represent 60% of the Risk Averse Portfolio) did exactly what they were supposed to do. They pulled the blue line - our client's wealth - up as the red line was pulling it in the opposit direction.

When using the capital markets to accumulate and grow wealth, active management has numerous pitfalls. As wealth advisors we believe that by using market-efficient portfolios to control what is controllable; costs, taxes, and under-market performance, and by continually measuring uncertainty, we can confidently help our clients exceed their important goals and aspirations.

Have a great weekend.