IBF - Updates - 2009 (Q4 v1.0)
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Transcript of IBF - Updates - 2009 (Q4 v1.0)
Copyright © 2010 by Institute of Business & Finance. All rights reserved. v1.0
QUARTERLY UPDATES
Q4 2009
Quarterly Updates
Table of Contents
FINANCIAL PLANNING
HEALTH CARE 1.1
DJIA: OCTOBER 2008 TO OCTOBER 2009 1.1
MARKET LINKED CD EXAMPLE 1.2
COMMODITY LINKED CD EXAMPLE 1.5
THE DOW JONES - UBS COMMODITY INDEX 1.5
DOW JONES - COMMODITY INDEX QUARTERLY FIGURES 1.6
WORLD EQUITY MARKET CAPITALIZATION 1.7
CORRELATION COEFFICIENTS 1.7
STATE DEATH TAXES 1.7
529 PLANS 1.9
REASONS TO OWN FOREIGN SECURITIES 1.9
REDUCING SYSTEMATIC RISK 1.10
MUTUAL FUNDS
ACTIVE MANAGEMENT 2.1
INDEXING VS ACTIVE MANAGEMENT 2.1
WORLD’S LARGEST MUTUAL FUND 2.2
MEASURING AND COMPARING FUND PERFORMANCE 2.2
RETIREMENT PLANNING
ROTH IRA CONVERSIONS 3.1
FIXED RATE ANNUITY RETIREMENT RESEARCH 3.2
A SECURE RETIREMENT USING STANDARD DEVIATION 3.6
ADVANTAGE OF ANNUITIZATION DURING RETIREMENT 3.9
REPLACEMENT RATIO 3.10
THE VALUE OF HUMAN CAPITAL 3.12
BONDS
WHAT HAPPENS WHEN RATES INCREASE 4.1
EMERGING MARKETS DEBT 4.1
TREASURIES VS. INFLATION 4.2
MUNICIPAL BOND SAFETY 4.3
BONDS 4.4
STOCK/BOND CORRELATION AND INDEXES 4.7
BOND SECTOR RETURNS 4.8
EFTS
KEEPING ETF PRICES CLOSE TO NAVS 5.1
THE STRANGE STATE OF EFT EVALUATIONS & RATINGS 5.1
QUARTERLY UPDATES
FINANCIAL PLANNING
FINANCIAL PLANNING 1.1
QUARTERLY UPDATES
IBF | GRADUATE SERIES
1.HEALTH CARE
Health care costs have risen at more than twice the pace of overall inflation since 1990 ,
more than doubling their share of the economy during that period. Even adjusting for the
size of its economy and population, the U.S. spends far more money on health care each
year than any other country in the world. As of 2009, health care spending made up
15.3% of the U.S. economy compared to an average of 8.8% for developed countries.
Under current policies, government spending on health care is projected by the
Congressional Budget Office to rise to more than 18% of GDP per year over the next 75
years; since WWII, the U.S. government has collected tax revenue to finance its entire
budget that has equaled an average of 18% of GDP each year .
DJIA: OCTOBER 2008 TO OCTOBER 2009
The table below shows DJIA numbers from October 1st, 2008 through September 2009.
Over this period, the Dow dropped from its peak of over 14,000 down to 10,000 (October
2008) to its March 2009 low and then back up to 10,000 for the first time (October 14,
2009) since dropping to 10,000 at the beginning of October 2008. The “Losers” figures
show the percentage of DJIA stocks with a negative monthly return; “P/E” reflects the
DJIA price/earnings (source: WSJ Market Data Group). The DJIA hit a closing-day low
point (6,547) on March 9th
, 2009.
Dow: From 10,000 to 6,547 back to 10,000
[October 2008 through September 2009]
Date 10-08 11-08 12-08 1-09 2-09 3-09 4-09 5-09 6-09 7-09 8-09 9-09
Return -14% -5% -1% -9% -12% +8% +7% +4% -1% +9% +3% +2%
Losers ~26% ~31% ~13% ~72% ~68% ~24% ~45% ~26% ~55% ~30% ~74% ~65%
P/E N/A 18.5 18.3 19.3 23.4 25.2 33.4 42.7 12.3 14.8 15.3 15.7
FINANCIAL PLANNING 1.2
QUARTERLY UPDATES
IBF | GRADUATE SERIES
MARKET LINKED CD EXAMPLE
During the last part of October 2009, Union Bank offered a market-linked certificate of
deposit (MLCD) with the following features:
4-year term (Oct. 28th, 2009 to Oct. 28th, 2013)
4% minimum cumulative return (e.g., worst case, $100k grows to $104k)
80-112%* of S&P 500 growth (dividends not included)
5-7%* quarterly cap rate on gains (but no quarterly cap on downside)
FDIC insured up to $250,000 (includes principal and growth)
note: * means actual rate was determined on Oct. 28th, 2009
The advantage of this investment is your client is guaranteed to earn at least 1% simple
interest each year. There is also the possibility of a return that ranges from 80-112% (a
best-case annualized yield of 15.8% to 20.6%). The disadvantages of this type of CD are:
[1] little, if any liquidity during the four-year hold; [2] any quarterly loss, no matter how great, “stays on the books” until it is fully offset by future quarterly gains; [3] return
potential does not include S&P 500 dividends; [4] annual tax liability (whether gains or
not)—IRS imputes (assumes) a 3.9% growth rate each year and taxpayer must pay taxes
on that 3.9%—if the cumulative return works out to be less, investor is entitled to a
refund; [5] any form of averaging (in this case, quarterly) is usually a negative for
investors; [6] there is little likelihood of capital appreciation of 80-112% for the S&P 500
over any four-year period and [7] this is a note, any eventual gains are taxed as ordinary
income. Each of these points is expanded upon below.
[1] Little Liquidity
The issuer does not intend to make a secondary market and there is no assurance any kind
of secondary market will be developed by anyone. This means if money is needed before
the four-year maturity date, investor will either not be able to tap this source or (if a
secondary market does develop) incur a moderate to severe discount of actual value.
[2] Quarterly Losses
Since there is no downside to a quarterly loss, it could take the investor several quarters
to offset any such loss. For example, during the extremely negative year of 2008 S&P
500 quarterly losses were (dividends excluded): Q1—2008 (-5%), Q2—2008 (-7%),
Q3—2008 (-8%) and Q4—2008 (-23%). None of any quarterly losses for 2007, 2006,
2005 or 2004 even come close to the negatives of 2008; in fact, almost all quarterly
results from 2004 through 2007 were positive . Still, the gains enjoyed during those years
were completely offset by the losses of 2008.
FINANCIAL PLANNING 1.3
QUARTERLY UPDATES
IBF | GRADUATE SERIES
[3] Dividends Not Counted
Often times, investors are shown a “mountain” chart of total returns (appreciation and
dividend reinvestment) over an extended period of time, such as from 1926 to the present.
This is misleading when used in conjunction with equity-indexed annuities and market-
linked CDs since neither includes dividends. The difference can be profound. For
example, from the beginning of 1926 to the end of 2008, $1 invested in the S&P 500
grew to $2,050 (total return) but only $70.80 (capital appreciation) if dividends were
excluded. This extreme percentage difference should be viewed only as an interesting historical figure since loss of dividends over a 4-8 year period would not be nearly as
dramatic. Still, over time, dividends have averaged about 3.5% per year over the past 80+
years and, therefore, have had a significant impact on overall returns.
[4] Annual Tax Liability
The Union Bank disclosure statement points out that there is a tax schedule for this
investment each year, regardless of performance. The “imputed” rate is 3.9% each year.
Thus, a $100,000 investment in a taxable account would incur a $1,000 federal income
tax liability each year, assuming a 25% tax rate. The investor would also be liable for any
state income taxes (based on the same imputed rate). When the note comes due in four
years, there will be additional tax liability if the investment’s return exceeds its 3.9%
annual imputed growth rate; if growth is below 3.9%, the investor will be entitled to a
refund.
[5] Averaging
There are situations wherein averaging can be beneficial. However, this is usually not the
case. For example, if one compares an equity-indexed annuity (EIA) that includes
averaging with one that does not, upside potential for the EIA without averaging is
typically a third to a half higher than the one with averaging.
[6] Likelihood of 80-112% Cumulative Gain
Since 1970, the best four years in a row for the S&P 500 (appreciation only) were 1995
through 1998 when annual appreciation gains were: +34.1% (1995), +20.3% (1996),
+31.0% (1997) and +26.7% (1998). Adding up just these annual returns results in a
cumulative gain of 112%. Once a bad year is factored in, the results are quite different .
For example, from 1997 through 2000, annual appreciation for the S&P 500 was: +31.0%
(1997), +26.7% (1998), +19.5% (1999) and -10.1% (2000), a cumulative gain of 67.1%.
Few would argue that being in the market from 1997 through 2000 would not have been a blessing. However, 67.1% is a little more than half the 112% cumulative gain of 1995
through 1998 (112%). Still, 67.1% works out to an annualized return of just under 14%.
Thus, there are circumstances wherein return potential for this investment could be quite
attractive.
FINANCIAL PLANNING 1.4
QUARTERLY UPDATES
IBF | GRADUATE SERIES
[7] Ordinary Income Taxes
The investor needs to be reminded that she is really lending money to Union Bank (via an
FDIC-insured CD). Gains on notes are always taxed as ordinary income, regardless of
holding period or underlying equity link (such as the S&P 500).
Observations
Evaluation of a MLCD is difficult because there is a tendency to forget there is no chance
of a loss if the investment is held to maturity. This means a proper comparison would be with a traditional CD or other high-quality asset with a four-year maturity (e.g., short-
term bond or fixed-rate annuity).
The table below shows cumulative returns for the appreciation (no dividends) of the S&P
500 for the 20 years ending 2008. Even though such figures do not reflect any kind of
quarterly averaging, they should still provide a fairly good idea of the historical return
potential for a market-linked certificate of deposit (MLCD).
S&P 500 Cumulative Appreciation—no dividends [1989-2008]
Year Index Year Index Year Index
1989 27.7 1996 58.1 2003 87.1
1990 25.9 1997 76.1 2004 95.0
1991 32.7 1998 96.3 2005 97.8
1992 34.1 1999 115.1 2006 111.2
1993 36.6 2000 103.5 2007 115.1
1994 36.0 2001 90.0 2008 70.8
1995 48.3 2002 69.0
Using numbers above as a rough guide, the investor would have made more than 1% a
year (the minimum guarantee) if the investment started at the beginning of any year from
1989 through 1997 plus 2001 through 2003 (75% of the time).
Compared to an equity-indexed annuity (EIA) with a 3-5 year holding period and
an annual cap rate of 6-7% (annual reset design), this equity-linked CD investment
looks quite appealing. The EIA has zero downside risk (vs. 4% simple interest for
the MLCD) and an upside potential 7% annualized (vs. 20.6% for the MLCD).
FINANCIAL PLANNING 1.5
QUARTERLY UPDATES
IBF | GRADUATE SERIES
COMMODITY LINKED CD EXAMPLE
Commodity-Linked CD Example
During the last part of October 2009, Union Bank offered a commodity-linked certificate of deposit (MLCD) with the following features:
4-year term (Oct. 28th, 2009 to Oct. 28th, 2013)
5% cumulative minimum return (e.g., worst case, $100k grows to $105k)
45-60%* rate on gains
FDIC insured up to $250,000 (includes principal and growth)
note: * means actual rate was determined on Oct. 28th, 2009
This MLCD is structured in a fashion similar to the preceding S&P-linked CD example
with the following differences: [1] underlying index is Dow Jones UBS Commodity
Index (DJ-UBSCI), [2] cap on gains is calculated differently and does not use any kind of
averaging (it is a “point-to-point” design), [3] maximum cumulative gain is lower, 45-
60% and [4] IRS imputed interest increases from 3.9% to 4.6%. This commodity-linked
CD could deliver annualized returns ranging from 7.7% up to 9.9%.
THE DOW JONES - UBS COMMODITY INDEX
The index is comprised of 19 physical commodities in five groups (agriculture, energy,
metals, industrial metals and livestock). No one commodity can comprise less than 2% or
more than 15% of the index and no group can represent more than 33% of the index.
Index weightings for each commodity as of early 2009 were:
DJ-UBS Commodity Index Weightings [2009]
Crude Oil (14%) Heating Oil (4%)
Natural Gas (12%) Zinc (3%)
Gold (8%) Sugar (3%)
Soybeans (8%) Coffee (3%)
Copper (7%) Soybean Oil (3%)
Aluminum (7%) Nickel (3%)
Corn (6%) Silver (3%)
Wheat (5%) Lean Hogs (2%)
Live Cattle (4%) Cotton (2%)
Gasoline (4%)
FINANCIAL PLANNING 1.6
QUARTERLY UPDATES
IBF | GRADUATE SERIES
DOW JONES - COMMODITY INDEX QUARTERLY FIGURES
Qtr. Ending Index Close Qtr. Ending Index Close Qtr. Ending Index Close
Mar—98 106.5 Mar—02 99.6 Mar—06 165.2
June—98 96.6 June—02 99.5 June—06 173.2
Sep—98 90.4 Sep—02 106.3 Sep—06 160.0
Dec—98 77.8 Dec—02 110.3 Dec—06 166.5
Mar—99 81.0 Mar—03 113.2 Mar—07 172.0
June—99 82.6 June—03 115.8 June—07 169.7
Sep—99 92.4 Sep—03 120.9 Sep—07 178.2
Dec—99 92.3 Dec—03 135.3 Dec—07 185.0
Mar—00 98.5 Mar—04 150.8 Mar—08 201.6
June—00 104.8 June—04 144.0 June—08 233.0
Sep—00 107.0 Sep—04 153.2 Sep—08 167.8
Dec—00 114.6 Dec—04 145.6 Dec—08 117.2
Mar—01 105.4 Mar—05 162.1 Mar—09 109.8
June—01 101.6 June—05 152.9 June—09 122.5
Sep—01 95.1 Sep—05 178.2
Dec—01 89.0 Dec—05 171.1
Since this commodity-linked CD has a five-year holding period, consider how often gains
were positive, looking at every five-year rolling period (e.g., March 1998 through March
2002, June 1998 through June 2002, etc.). Out of the 30 possible five-year rolling
periods, commodity gains were positive 26 out of 30 times. The best five-year period was
September 2001 through September 2005 (an 83.1 point gain); this translates into an 87%
cumulative gain (83.1/95.1). However, the CD-linked investor would have had a
maximum cumulative return of 45%-60% (cap rate set by the issuer).
Observations
Often, advisors and clients alike have difficulty in imaging commodity prices going
down over any extended period, but the reality is quite different. For example, the
difference between the table’s starting point (106.5) and the ending point (122.5)
represents a gain of just 15%. The time period is just over 12 years; this translates into an
annualized return of just over 1%. Extreme movements downward have also been
experienced: from June 2008 through March 2009, this commodity index dropped 53%.
FINANCIAL PLANNING 1.7
QUARTERLY UPDATES
IBF | GRADUATE SERIES
WORLD EQUITY MARKET CAPITALIZATION
Country/Region 2004 mkt. cap. 2009 mkt. cap.
U.S. 51% 42%
Europe 29% 29%
Asia/Pacific 15% 21%
Americas (w/o U.S.) 4% 7%
Africa/Middle East 1% 1%
CORRELATION COEFFICIENTS
Over the long term, different asset categories tend to have predictable relationships
(correlations). For example, U.S. Treasury prices usually move in the opposite direction
of stocks because people buy Treasuries and sell stocks when they are worried about the
economy and do the reverse as they get more optimistic. Over short periods of time,
correlation coefficients can vary wildly.
For example, from the end of July 2009 to November 2009, the U.S. dollar index and
S&P 500 were 60% inversely correlated (71% inverse correlation in October). However,
between January 2007 and the end of July 2009, the correlation was just 2% (an almost perfect “random correlation”).
Over a recent 15-year period (1994-2008), the correlation between oil prices and the S&P
500 ranged from +20% to -20% (random correlation). At extremes, the correlation was
+40% to -40%; in mid-June 2009, the correlation briefly hit +75%.
STATE DEATH TAXES
For 2009, individuals avoided estate taxes if their taxable estate was valued at $3,500,000
or less. At this level, it is estimated just 5,500 estates a year were subject to federal estate
taxation. At the previous $2,000,000 limit, 17,500 estates annually were subject to the tax
(source: Urban-Brookings Tax Policy Center). The figures for state estate and inheritance
taxes vary widely.
FINANCIAL PLANNING 1.8
QUARTERLY UPDATES
IBF | GRADUATE SERIES
State Estate and Inheritance Taxes
State
Tax
Type Exemption
Max
Rate % State
Tax
Type Exemption
Max
Rate %
Connecticut E $2,000,000 16 New Jersey E/I $675,000/$0 16/16
Delaware E $3,500,000 16 New York E $1,000,000 16
Illinois E $2,000,000 16 N. Carolina E $3,500,000 16
Indiana I $100 20 Ohio E $338,333 7
Iowa I $0 15 Oklahoma E $2,000,000 10
Kansas E $1,000,000 3 Oregon E $1,000,000 16
Kentucky I $500 16 Pennsylvania I $0 15
Maine E $1,000,000 16 Rhode Island E $675,000 16
Maryland E/I $1,000,000/$150 16/10 Tennessee I $1,000,000 9.5
Massachusetts E $1,000,000 16 Vermont E $2,000,000 16
Minnesota E $1,000,000 16 Wash., D.C. E $1,000,000 16
Nebraska I $10,000 18 Washington E $2,000,000 19
Keeping track of constantly changing state death taxes can be difficult. Delaware added
an estate tax in 2009, while Kansas and Illinois were expected to eliminate such a tax in
2009. Eight states have inheritance taxes that are levied on heirs, not estates. In many
states, rates are tied to how closely the heir is related to the now deceased donor. For
example, Pennsylvania taxes children and grandchildren at an almost-flat rate of 4.5%
while more distant relatives pay up to 15%.
Taxpayers who live in states without estate taxes, such as California and Florida, may
face estate taxation if they own property in a state that has an estate or inheritance tax. Such possible taxation is based on “domicile,” a much broader definition than
“residency.” It is possible for someone to have multiple domiciles since domicile may be
determined by where the person votes, has a church or club membership, registers a car
or owns a burial plot. For example, when Campbell Soup magnate John Dorrance died in
1930, both New Jersey and Pennsylvania each collected about $15 million in death taxes.
Advisors may wish to consider a bypass trust for married couples living in a state that
imposes any kind of death tax that has an exemption lower than the federal level. With a
bypass trust, when the first spouse dies, assets go into a trust the surviving spouse can
draw. When the second spouse dies, any remaining assets in the bypass trust pass tax-free
to heirs, thereby preserving the value of both individual exemptions.
FINANCIAL PLANNING 1.9
QUARTERLY UPDATES
IBF | GRADUATE SERIES
529 PLANS
About 32% of parents’ savings for children’s college expenses put money into 529 plans
during 2009, up from 30% for 2008. Every state except Wyoming offers at least one plan; many states offer more than one plan. Investors are not required to invest in their home
state’s plan. However, by sticking to a plan offered by one’s state of residency, the
investor may be entitled to an upfront state tax deduction.
The most common investments for 529 plans are those tailored to a child’s expected date
of matriculation or the family’s appetite for risk. Under IRS rules, 59 plan investors could
only make one change per year; in December of 2008, the IRS stated plan holders could
now make two changes per year. As of November 2009, four plans (Arkansas, Indiana,
Iowa and Missouri) offered ETFs. Besides generally having lower expense ratios, ETFs
inside a 529 plan are not subject to commissions every time there is a buy or sell.
REASONS TO OWN FOREIGN SECURITIES
The U.S. share of exchange-based global market capitalization has been falling, from
52% at the end of 2001 to 35.2% as of September 2007. As of January 2009, roughly
40,000 stocks traded in foreign exchanges—compared with about 6,000 on the NYSE
and NASDAQ.
At one time, sticking to the domestic market ensured the world's greatest quality of
management, accounting standards, and transparency. But much of the world has caught
up: Today more than 1,500 of the world's largest 2,000 companies are domiciled outside
America's borders, including industry leaders such as Nestlé, Toyota, HSBC, Royal
Dutch Shell, and Samsung.
Investing directly on a foreign exchange is not the only way to gain exposure to international shares, of course. Take American depositary receipts (ADRs), which are
certificates corresponding to a certain number of shares of a foreign company. ADRs
trade on U.S. exchanges providing investors with timely dividend payments and
widespread information, but sticking to ADRs limits your universe to the large,
multinational firms that tend to issue the securities (about 3,200 foreign firms currently
list in the U.S.). ADRs are priced in U.S. dollars, so they mute the effects of exchange-
rate fluctuations—one of the arguments for investing in international stocks.
FINANCIAL PLANNING 1.10
QUARTERLY UPDATES
IBF | GRADUATE SERIES
While foreign markets have some unique investing risks—some regions are more volatile
and can have the potential for faster gains or losses—they have also been home to some
of the largest returns over specific periods of time.
International markets historically have been much more likely to produce outsized returns
than U.S. stocks—or other assets, for that matter. Fidelity tracked the performance of 17
asset classes—including cash, high-yield bonds, real estate, gold, and stocks of different
sizes and styles—during the 27 calendar years since 1983 (including the first half of 2009). Foreign stocks of one kind or another were the top-performing asset 15 times,
while domestic stock categories generated the best returns only five times. Foreign stocks
were also the worst-performing asset class eight times during that time period.
Of the 50 top-performing stocks in the MSCI All Country World Index through March
31, 2009, 40 were foreign. Foreign countries have a much more favorable
macroeconomic outlook than the U.S.—which could provide the backdrop for greater
stock returns. U.S. GDP is expected to grow 1.5% during 2010, compared with 3.1% for
the overall world economy.
REDUCING SYSTEMATIC RISK
According to The Handbook of Financial Investments (2002) by Frank J. Fabozzi: “For
common stocks, several studies suggest that a portfolio size of about 20 randomly
selected companies will completely eliminate unsystematic risk leaving only systematic
risk (note: the first empirical study of this type was by Wayne Wagner and Sheila Lau,
“The Effect of Diversification on Risks,” Financial Analysts Journal, November-
December 1971). In the case of corporate bonds, generally less than 40 corporate issues
are needed to eliminate unsystematic risk.”
A chart in Fabozzi’s book shows roughly 60% of total risk is 95% eliminated through
the (near 100%) elimination of unsystematic risk. This means that an advisor can
eliminate close to 60% of a client’s stock market risk by avoiding unsystematic risk.
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QUARTERLY UPDATES
MUTUAL FUNDS
MUTUAL FUNDS 2.1
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2.ACTIVE MANAGEMENT
A 2009 study by Morningstar concludes: “while about half of actively managed funds
outperformed their respective Morningstar indexes, only 37% did on a risk-, size- and
style-adjusted basis. The numbers are similar for five and 10-year returns.” Funds that
performed in the top 25% over the past three years had much lower risk and volatility
than their peers.
INDEXING VS ACTIVE MANAGEMENT
According to financial advisor William Thatcher, indexing tends to beat active
management in top-performing asst classes and loses to active management in the worst-
performing asset classes. Thatcher believes “in the best-performing asset classes, index
funds are rewarded for purity and active managers are punished for their impurity (many
do not stay true to a particular investment style).” Results of Thatcher’s study (1998 -
2007) show that the benefit of indexing was not consistent over one-year periods. The
results of the Thatcher study were consistent with research done in 1999 by advisors
Steve Dunn and William Bernstein.
Active vs. Index Investing [1998-2007]
Asset Annualized Active Managers
S&P MidCap 400 11.2% 78% underperformed
S&P MidCap 400 Growth 11.1% 72% underperformed
S&P MidCap 400 Value 11.1% 70% underperformed
S&P MidCap 600 Value 9.0% 53% underperformed
S&P SmallCap 600 9.0% 61% underperformed
S&P SmallCap 600 Growth 8.2% 50% underperformed
S&P 500/Citigroup Value 6.6% 46% underperformed
S&P 500 5.9% 60% underperformed
S&P 500/Citigroup Growth 4.8% 35% underperformed
MUTUAL FUNDS 2.2
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WORLD’S LARGEST MUTUAL FUND
As of November 2009, PIMCO’s $186 billion Total Return fund is easily the biggest
mutual fund in the world; it would be the seventh largest fund group (family) in the U.S.
The second largest U.S. bond fund is Vanguard’s Total Bond Market Index at $64 billion.
For a fund that focuses on U.S. Treasuries, a market that exceeds $7 trillion, size is not an
issue for either fund. According to Barclays, the total size of the investment-grade
corporate bond market is about $5 trillion. The Barclays Capital U.S. Aggregate Bond
Index, the fund’s benchmark, has a market value of about $13 trillion (note: PIMCO Total Return’s size represents roughly 1.5% of the benchmark’s market value). The total
amount of global debt is roughly $53 trillion.
MEASURING AND COMPARING FUND PERFORMANCE
Fund advisory services know that past performance is not necessarily indicative of future
returns. The regulatory structure that requires this acknowledgment of future performance
uncertainty is appropriate because: [1] most fund ratings are based primarily on past
performance and [2] the evidence of predictive value in fund ratings is uneven.
Amenc and Le Sourd (2007) found little merit in the fund rating methodologies of
Lipper, Morningstar and Standard & Poor’s. Yet, there is somewhat conflicting evidence.
For example, Morey and Gottesman (2006), arguably the most laudatory evaluation of a fund rating service published in recent years, concluded that the Morningstar rating system, as revised in 2002, predicted relative mutual fund performance within nine
domestic equity fund categories pretty well over the following three years . The
principal change in the Morningstar rating system in 2002 was to switch from a single
domestic equity category to nine categories analogous to the Morningstar style boxes.
A number of studies have found that funds that have performed well in the past tend to
continue to perform relatively well, with some reservations. Past performance may be
useful in selecting the better performers among, say, large-cap growth funds. Of course,
the ratings primarily reflect the recent relative performance of the funds, so it is difficult
to see any need to transform recent fund performance into a rating system. The
transformation may create a salable proprietary product, but it does not necessarily
improve the usefulness of the information delivered to investors. The Morey and
Gottesman results suggest that investors would be as well served with simple past
performance comparisons as with formal ratings.
MUTUAL FUNDS 2.3
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The fact that most fund ratings emphasize performance relative to a peer group of funds
is the most significant weakness of most fund evaluation models. Every investor would
not necessarily have (or want) access to the peer group funds that a fund evaluation
service selects for its comparisons. Furthermore, it is usually possible to invest in an asset
class or category without using any of the funds in a mutual fund peer group. ETFs and
structured notes are alternative vehicles, for example. Even if comprehensive fund peer
group ratings are sometimes useful to investors, the appropriate way to evaluate a fund
varies as costs, fund holdings, fund structures and investors’ objectives change.
To illustrate how an adviser might develop and use detailed fund information effectively,
consider how to enhance an investor’s or an adviser’s understanding of the elements of
fund performance. Even if a fund-rating calculation considers a fund’s ability to do better
than its peers during the most recent bear market, the performance measurement that
dominates most ratings is a single performance number for each fund for each year or
quarter. A breakdown of how and why the performance of the fund was achieved in that
period is a better guide to what the future might hold for that fund than a simple historic
return calculation or a longer-term comparison of returns among a group of funds.
For example, good performance achieved by consistent implementation of a stock
valuation strategy with patient trading is likely to be more sustainable than performance
achieved by a single major allocation shift or by moving from equities to cash and back
again in an attempt to predict market direction. It is essential to look beyond ratings and rankings and into the manager’s actions for better ways to identify funds with superior
investment processes and prospects and to develop comprehensive information that will
improve fund choices. A number of academic studies have shown the following:
Active fund manager “value-add” is obscured by combining good results for true active managers with poor results from closet indexers who are charging active management fees to their investors but not delivering value.
The ability of fund managers to value securities and make performance-enhancing portfolio transactions can be obscured and overwhelmed by flows of investor funds into
and out of mutual funds.
Portfolio transaction costs for funds exceed the fund’s expense ratio on average, but
funds add value with some of their discretionary transactions. Transactions made to accommodate investor flow into and out of a fund and transactions larger than the
average trade size in comparable competitive funds will hurt performance.
Managers with superior stock selection skills can be identified and their skills persist over
time. Past performance may not be a reliable indicator of future results, but it is not meaningless.
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RETIREMENT PLANNING
RETIREMENT PLANNING 3.1
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3.ROTH IRA CONVERSIONS
Starting January 1st, 2010, an income limit that previously prevented many Americans
from converting their traditional IRAs into Roth IRAs disappeared. If your client’s
household income is more than $100,000 (the previous limit), converting to a Roth will
be an option for the first time. Married couples filing separate tax returns also will now
be able to convert. Listed below are strategies for the advisor’s consideration.
Pay taxes on converted amount
You have to pay income taxes when you convert. For example, a client in the 28% tax
bracket will owe $28,000 (plus state income taxes) on a $100,000 conversion.
Converting may benefit the client in the long run—if a higher tax rate is expected during
retirement. If, like most people, the client is not sure about his future tax rate, consider
converting just part of his traditional IRA to a Roth. Doing so gives "tax diversification"
because some money would be in a Roth and some still in a traditional IRA.
Consider source used for taxes
Stick with the traditional IRA if the client does not have money available outside of the
IRA to pay conversion taxes. Pulling money out of an IRA to cover taxes can defeat the
purpose of making the switch in the first place. By reducing retirement savings, clients
reduce the ability to generate future tax-free earnings on money invested in the Roth. If
under age 59½, amounts pulled out of a traditional IRA to cover taxes may be subject to a 10% IRS penalty.
Two conversion strategies
If the client does not have enough money to pay taxes on all converted assets, or if doing
so would push her into a higher tax bracket, consider converting just part of the
traditional IRA assets. A special option applies only to 2010 conversions; the taxpayer
can elect to evenly divide the tax liability over 2011 and 2012. If tax rates go up in 2011,
this split-year strategy may not be a good idea.
Longer time horizons are better
A conversion may not be wise for clients who expect to withdraw money wit hin five
years. Generally speaking, the client will only be able to withdraw earnings from the
account without taxes and penalties if age 59½ or older and a Roth IRA has been held for
at least five years. Withdrawals of the original conversion amount are always tax-free;
however a 10% early penalty may still apply. The client must be either at least age 59½ or wait at five years after the conversion to make the withdrawal in order to avoid the
10% penalty.
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Heirs can benefit
During lifetime, the Roth IRA client is not subject to RMDs, meaning the entire amount
can be left to someone else. A beneficiary who inherits a Roth IRA may be subject to
RMDs, but withdraw the original conversion tax-free. Earnings are also tax-free,
provided the Roth IRA meets the five-year holding requirement.
FIXED RATE ANNUITY RETIREMENT RESEARCH
Following are summaries of major research studies that demonstrates the important role
of fixed annuities in securing retirement income.
Wharton Financial Institutions
Investing your Lump Sum at Retirement, August 2007
by David F. Babbel
Summary: This essay describes the conclusions from an earlier study as well as findings
by other prominent economists. It concludes that income annuities can provide secure
income for one's entire lifetime for 25-40% less money than it would otherwise cost
an individual, thanks to an insurer's ability to spread risk across large numbers of
people.
The authors note that "...economists have come to agreement from Germany to New
Zealand, and from Israel to Canada, that annuitization of a substantial portion of
retirement wealth is the best way to go. The list of economists who have discovered this
includes some of the most prominent in the world, including Nobel Prize winners.
Studies supporting this conclusion have been conducted at such universities and business
schools as MIT, The Wharton School, Berkeley, Chicago, Yale, Harvard, London
Business School, Illinois, Hebrew University, and Carnegie Mellon. The value of
annuities in retirement seems to be a rare area of consensus among economists."
In the press release accompanying the essay release, Prof. Babbel said: "Our research
shows that only lifetime income annuities can protect individuals in an efficient way
from the risk of outliving their assets and that this simply cannot be duplicated by
mutual funds, certificates of deposit, or any number of homegrown solutions. We
believe we have shown that income annuities clearly should be more widely used, given
that highly rated insurance companies are reliable and inexpensive sources of guaranteed
income streams in retirement."
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Employee Benefit Research Institute (EBRI)
Measuring Retirement Income Adequacy, September 2006
by Jack Van Derhei
Summary: The author notes that for decades "replacement rates" have been the primary
rule of thumb measure used to estimate an adequate level of income during retirement.
Replacement rate is annual retirement income divided by annual income just before
retirement. For example, someone who retires from a job with $100,000 in salary and has $75,000 in retirement income has a replacement rate of 75% (which many financial
planners consider adequate).
A weakness of replacement rate models is that some important retirement risks are not
taken into account, including investment risk, longevity and the risk of potentially
catastrophic health care costs. Taking these risks and inflation into account and using a
Monte Carlo model, the study demonstrates that for most retiree groups, converting
some retirement assets to an income annuity at retirement can lower the
replacement rate needed to achieve a 90% probability of income adequacy. For
example, the study illustrates one example where a 124% replacement ratio, half of
which is provided by an annuity, can have a probability of adequacy, equal to replacement ratios of 148% to 180%, with no annuity purchase and various earnings
assumptions.
Journal of Financial Planning
Meeting the Needs of Retirees: A Different Twist on Allocation, January 2000
by John Rekenthaler, CFA
Summary: The author educates the financial planning community about pitfalls of
developing retirement income plans based on "average" investment returns. He uses
historical charts to show that, for the retiree making withdrawals from assets, the sequence of the annual returns on those assets can be of greater importance than the
average of those annual returns.
The author makes the case that traditional asset allocation models, used to optimize
accumulations while saving for retirement, do not work for allocating assets during
retirement. In retirement, the asset allocation mix should recognize that a long time
horizon, which is a friend of the young investor, is an enemy of the retiree who needs
income from the portfolio for every year of retirement. Asset allocation models also
need to consider that volatility in portfolio returns, which may average out for
investors accumulating assets, will damage the level of withdrawals that a
retirement portfolio can sustain.
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The author (correctly) predicts that new asset allocation models will be developed for the
asset "draw down" phase to account for the risks that are not present during the asset
accumulation phase.
Journal of Financial Planning
Making Retirement Income Last a Lifetime, December 2001
by John Ameriks, Ph.D., Robert Veres and Mark Warshawsky, Ph.D.
Summary: The authors explore the sustainability of alternative asset withdrawal plans
using different asset allocation mixes during retirement. The probability of failure of
various plans is examined for various model portfolios ranging from asset allocations
labeled from conservative to aggressive.
An historical chart illustrates that, regardless of the asset allocation strategy, the
withdrawal rates that were sustainable for a full 30 years were between 3 .50% and 5.00%
per year adjusted for inflation. The aggressive portfolio sustained the higher withdrawal
rates for the 30-year period. Looking specifically at a 4.50% inflation-adjusted
withdrawal rate, historical analysis shows that, relative to the conservative portfolios, the
more aggressive portfolios had a higher likelihood of sustaining income for a long
withdrawal period. But even the aggressive portfolio showed a tendency to fail too
frequently to be considered a stable withdrawal plan for a long retirement.
Finally the authors examine whether the purchase of an immediate fixed annuity helps or
hurts the sustainability of the withdrawal plans considered. Using both an historical
analysis and a Monte Carlo analysis, their charts illustrate that for all time periods
and for all investment portfolios in the study, the addition of the fixed annuity leads
to better results. Also provided is a "discussion" of the pros and cons of an immediate
annuity purchase and the factors that should be considered.
Journal of Financial Planning
Determining Withdrawal Rates Using Historical Data, March 2004
by William P. Bengen, CFP
Summary: The author shows how to use historical performance data to determine "safe"
withdrawal rates and asset allocations during retirement so that retirees do not outlive
their savings. This paper is a reprint of the author's 1994 landmark research on this
subject.
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From the historical data, Bengen concludes the maximum "safe" withdrawal rate is about
4% for the typical retiree of age 60-65 relying on a conventional portfolio of stocks and
bonds. The 4% withdrawal rate is used to calculate the actual withdrawal dollar amount
in the first year of retirement. This withdrawal amount (in dollars, not percentages) is
then increased in each future year for actual inflation. Looking at the historical
evidence, he characterizes 5% withdrawal rates (adjusted for actual inflation) as
"risky" and 6% rates as "gambling."
Journal of Financial Planning
Merging Asset Allocation and Longevity Insurance, June 2003
by Peng Chen, Ph.D. and Moshe A. Milevsky, PhD.
Summary: MPT is widely accepted in the academic and finance industries as the
primary tool for developing asset allocations. Its effectiveness is questionable,
however, when dealing with asset allocations for individual investors in retire-ment,
because it does not consider longevity risk and the portfolio's random time horizon.
This article reviews the need for longevity insurance (i.e., income annuities) during
retirement and establishes a framework to study the total asset and product allocation
decision in retirement, which includes both conventional asset classes and immediate
payout annuity products. Retirees must make their own decisions on what products
should be used to generate income in retirement. However, there are two important risks
that must be considered when making these decisions:
[1] Financial market risk — the volatility in the capital markets that causes portfolio
values to fluctuate. If the market drops or negative corrections occur early during retirement, the portfolio may not be able to cushion the added stress of systematic
withdrawals. This may make the portfolio unable to provide the necessary income for the
desired lifestyle or it may simply run out of money too soon.
[2] Longevity risk — the odds of outliving one’s portfolio. Life expectancies have been
increasing and retirees should be aware of the substantial chances for a long retirement
and plan accordingly. This risk is further magnified for individuals taking advantage of
early retirement offers or who have a family history of longevity.
The authors claim an optimal asset/product allocation mix in a well-balanced retirement
portfolio is derived from a two-step process. First, a conventional asset allocation process
is used to derive an optimal asset mix (without regard to longevity risk). The product
(i.e., income annuity) purchase decision is then developed after considering the retiree's
bequest motives and health assessments.
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A SECURE RETIREMENT USING STANDARD DEVIATION
Using a 70-90% equity weighting, studies over the past few years recommend an
inflation-adjusted (real) retirement withdrawal rate of 4-6% per year. Pension actuarial
tables show that a 65-year-old client has a 94% chance of living for an additional five
years, 56% chance of making it to age 85 and a 16% chance of living to age 95. All this
translates into a median remaining life expectancy (for someone age 65 and in good
health) of 23 years. The next four tables show the probability of “retirement ruin”
(running out of money before death) based on two remaining life expectancies (23
and 35 years) and two different annual withdrawal (spending) rates (4% and 8%).
All of the four tables below share the following characteristics: [1] a mortality rate is
assumed (note: by using real world mortality rates, the probability of outliving one’s
income decreases), [2] a median life expectancy (withdrawal period) is assumed, [3] rates
of return adjusted for inflation are listed (1-10%), [4] failure rates (probability of
outliving one’s nest egg) are defined as having a zero account balance before death and
[5] standard deviation ranges (5-25%) are provided so the advisor can select higher
equity exposure and/or greater weighting to small cap and emerging markets (in return
for accepting more volatility).
The first table makes the following assumptions: 8% withdrawal rate, 23-year life
expectancy and 3% annual mortality rate. Assuming a balanced portfolio of stocks and
bonds that returns 5% annually (inflation-adjusted), there is a 46% chance that the client will completely delete their nest egg, assuming a portfolio standard deviation of 10%; if
the volatility changes from 10% to 20%, the chance of running out of money increases to
63%. Thus, all other inputs being equal, the greater the standard deviation, the more
likely the investor will use up 100% of principal. On a somewhat similar note, the higher
the portfolio’s expected return, the lower the failure rate (since 8% is being withdrawn
each year).
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Probability of Outliving One’s Nest Egg [8% withdrawal rate & 23-year life expectancy]
Mortality: 3% a year Median Life Expectancy: 23 years
Annual Withdrawal Rate: 8%
---------------------- Portfolio’s Standard Deviation ----------------------
5% 10% 15% 20% 25%
Return
1% 83% 84% 87% 90% 93%
3% 63% 67% 72% 78% 84%
5% 41% 46% 54% 63% 71%
7% 23% 29% 37% 47% 57%
10% 7% 11% 18% 27% 38%
The next table is based on the same assumptions as above, except life expectancy is
increased from 23 to 35 years (and annual mortality drops from 3% to 2% per year). As
you can see, the failure rate increases, regardless of standard deviation, due to the
lengthened period of time (and lesser chance of death). If the portfolio returns 7% a year
(adjusted for inflation) and has a standard deviation of 15%, the probability of outliving
one’s nest egg is 49% if a balanced portfolio is used.
Probability of Outliving One’s Nest Egg [8% withdrawal rate & 35-year life expectancy]
Mortality: 2% a year Median Life Expectancy: 35 years
Annual Withdrawal Rate: 8%
---------------------- Portfolio’s Standard Deviation ----------------------
5% 10% 15% 20% 25%
Return
1% 96% 95% 96% 97% 99%
3% 82% 83% 85% 88% 92%
5% 57% 62% 68% 75% 81%
7% 32% 39% 49% 58% 68%
10% 8% 14% 23% 35% 46%
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The next table also assumes a 35-year withdrawal period, but a withdrawal rate that has
been cut in half—from 8% to 4% per year (inflation adjusted). As you can see, the
probability that the portfolio will run out of money over these 35 years is lessened.
Probability of Outliving One’s Nest Egg [4% withdrawal rate & 35-year life expectancy]
Mortality: 2% a year Median Life Expectancy: 35 years
Annual Withdrawal Rate: 4%
---------------------- Portfolio’s Standard Deviation ----------------------
5% 10% 15% 20% 25%
Return
1% 60% 67% 76% 85% 94%
3% 25% 35% 48% 62% 76%
5% 7% 13% 24% 39% 55%
7% 1% 4% 10% 21% 36%
10% 0% 0% 2% 7% 16%
The final table has the same assumptions as above, but life expectancy has been reduced
from 35 to 23 years. Again, because of the shorter expected period, the chance of failure
(outliving one’s nest egg) drops (source: Moshe A. Milevsky, 2007). Keep in mind that
the withdrawal rates used in all four of these tables are adjusted for inflation. Thus, if the
projected return is 7% and inflation is expected to be 3%, the assumption is the gross
return is 10% (but the 7% “Return”) row is being used (since “Return” numbers in all
four tables have already been adjusted for a 3% inflation rate).
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Probability of Outliving One’s Nest Egg [4% withdrawal rate & 23-year life expectancy]
Mortality: 2% a year Median Life Expectancy: 23 years
Annual Withdrawal Rate: 4%
---------------------- Portfolio’s Standard Deviation ----------------------
5% 10% 15% 20% 25%
Return
1% 37% 45% 66% 68% 80%
3% 15% 22% 32% 46% 60%
5% 5% 9% 16% 27% 42%
7% 1% 3% 7% 15% 27%
10% 0% 1% 2% 5% 12%
ADVANTAGE OF ANNUITIZATION DURING RETIREMENT
If a 65-year-old investor annuitizes 100% of a portfolio, the chances of outliving the nest
egg drop from 41% down to 21%, a reduction of just under 50%. The reason
annuitization helps is that it takes part of one’s portfolio and creates a “mortality
subsidy,” thereby increasing investment return (source: Milevsky, The Implied Longevity
Yield, 2005). The mortality subsidy works as follows: A large group of retirees, all the
same age and each subject to the same risk of death, pool their nest egg into one large
portfolio. Each member of the pool takes out exactly the same amount each year. As
members in the pool die off, survivors receive a higher payout (fewer members making withdrawal). The amount distributed to each living member is the sum of expected
investment return plus the mortality rate.
There is also the option of using a fixed-rate annuity that includes a cost-of-living provision. However, there are few insurers that a competitively priced annuity that
includes an annual inflation adjustment. For example, one company offered $685 a
month for a man age 65 with a single premium payment of $100,000. The same company
lowered the amount from $685 down to $502 with a CPI adjustment ($183 a month
difference). If inflation were to average 3%, it would take more than 10 years for the
$502 payment to get to $685 per month. Moreover, this calculation does not take into
account what the monthly difference could grow to (note: an annually declining
difference due to increased payments from the CPI-adjusted annuity).
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Another way to protect downside risk is to purchase put options on all or part of the
equity portion of the portfolio. Still another method is to use a variable annuity with a
living benefit feature.
8% Annual Withdrawal, Portfolio Grows 7% (inflation adjusted) [20% standard deviation]
Age at Retirement
Median Age at Death
Annual Mortality Rate
Ruin Probability with
Life Annuity
Ruin Probability w/o Life Annuity
50 78 2.5% 34% 53%
55 83 2.5% 34% 53%
60 83 3.0% 28% 48%
65 84 3.7% 21% 41%
70 85 4.7% 13% 33%
75 86 6.5% 6% 24%
80 87 9.4% 2% 14%
REPLACEMENT RATIO
One way advisors view a client’s retirement income needs is to use the expense-method
approach (projected expenditures during first year of retirement). What is not often considered is the fact that expenses generally decline as the client ages. The table below
is based on data from the Consumer Expenditure Survey. As you can see from the table,
expenses in all categories except health care decline once the client reaches age 75 and
older.
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Expenditures Based on Age and $40,000+ Annual Income
Expense Age 65-74 Age 75+ Change
Food $5,779 $3,970 -$1,809
Housing $12,027 $9,678 -$2,349
Apparel $2,160 $1,256 -$904
Transportation $8,185 $5,428 -$2,757
Health Care $2,385 $3,189 $804
Entertainment $2,108 $1,027 -$1,081
Insurance/Pensions $4,540 $2,678 -1,862
Total $43,967 $36,825 -$7,142
A shortcoming of several retirement income models is that they do not factor in
long-term care insurance. This type of coverage can greatly reduce the cost of nursing
home care (thereby bringing down projected expenditures for health care).
The financial planning community estimates a retiree’s expenses will drop by about 20%
upon retirement; the client who used to spend $80,000 annually will spend approximately
$64,000 during the initial years of retirement. Because one’s expenses generally decline by about 20% (from age 65 to 75+), the replacement ratio can also be adjusted
downward.
For example, with an initial replacement ratio of 80%, the rate used by the advisor
should be 70%, assuming the client has a remaining life expectancy of 25 years. The
reduction is due to a “blending”—the initial rate combined with the lower rate as one
ages. If the advisor assumes a replacement rate of 75%, then the blended rate for
remaining life expectancy (of 15 years) can be reduced to 70%; if the client has a
remaining life expectancy at age 65 of 30 years, the blended rate drops to 65%. By using
a blended replacement ratio (vs. traditional replacement ratio), a smaller nest is needed
for the 65-year-old retiree.
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Blended Replacement Ratios
Life
Expectancy
80%
Rate
75%
Rate
70%
Rate
65%
Rate
10 years 80% 75% 70% 65%
15 years 75% 70% 65% 61%
20 years 72% 68% 63% 59%
25 years 70% 66% 62% 57%
30 years 69% 65% 61% 57%
THE VALUE OF HUMAN CAPITAL
What is almost always left out of portfolio diversification discussions is the value of
human capital. As an investor begins his working career, there is a present value
that can be assigned to lifetime paychecks. That present value figure increases as the
client becomes more valuable in the workplace, receiving raises along the way.
Several years before retirement, the present value figure can begin to decline (e.g., forced
retirement, health problems, layoffs, etc.).
Including “human capital” as part of an investment portfolio means two things: [1] diversification has relatively little importance during the early years and [2] savings from
human capital can make up for portfolio losses in the early years. The table below is an
example of how human capital might be incorporated into the portfolio.
Human Capital and the Financial Portfolio
Age Human Capital Financial Assets Total
22 $705,000 $0 $705,000
32 $871,000 $62,000 $933,000
42 $1,003,000 $206,000 $1,209,000
52 $988,000 $518,000 $1,506,000
62 $551,000 $1,171,000 $1,722,000
67 $0 $1,722,000 $1,722,000
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BONDS
BONDS 4.1
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4.WHAT HAPPENS WHEN RATES INCREASE
For every one point rise in interest rates, the price of a 10-year Treasury decreases by
8.5%; a rise of two percentage points would chop a 10-year Treasury bond’s current
value by 17% (source: Barclays Capital). In the case of a high quality taxable bond fund
with a 22-year average maturity, a two-percentage point increase would decrease the
fund’s NAV by 22%; just 3.9% if the fund’s average maturity was 2.6 years (source:
Morningstar).
According to a study by David Babbel of Wharton, stable-value funds averaged 6.3%
annual returns over the 20 years through 2008, versus 4.1% for money market funds and
5.7% for the Barclay’s index for intermediate-term corporate and government bonds.
EMERGING MARKETS DEBT
According to Morningstar, there were 31 mutual funds and ETFs emerging market bond
funds. In contrast, there were 141 funds and ETFs within the emerging market stock
category, as of October 2009.
Emerging market bond mutual funds are generally less volatile than emerging market
stock funds because interest payments help smooth out overall returns. Over the past 15
years ending March 31st, 2009, diversified emerging market bond funds suffered double-
digit losses in 12 rolling three-month periods (12 out of 58 such periods). This compares favorably to emerging market stock funds, which suffered double-digit declines in 33
rolling-three month periods (33/58). In some cases, there were distinct differences in
decline severity. For example, emerging market bonds dropped 11% in 2008 while
emerging market stocks tumbled 53%. For the 10-year period ending September
2009, emerging market bonds had average annual returns of a little more than 11%,
compared with 3% for emerging market stocks.
Another notable difference between emerging market bond and stock funds is regional
exposure. While both types of funds typically provide significant exposure to Brazil,
Mexico and Russia, emerging market bond funds generally provide less exposure to
Asian countries such as China, South Korea and India. Conversely, emerging market
bond funds may provide exposure to "frontier" countries (e.g., Venezuela), places where
emerging equity funds may not invest.
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The table below shows bond and stock returns for 2008 and the first three quarters of
2009, ranked from lowest (U.S. investment-grade bonds) to highest volatility (foreign
stocks). In the case of fixed income, emerging markets bond funds are second only to
domestic high-yield bonds when it comes to volatility.
Total Return Figures for 2008 and first three quarters of 2009
Security
2009 YTD
(9/30/09) 2008
Short-Term Bonds 0.2% 2.2%
U.S. Investment-Grade Bonds
Intermediate Government 0.1% 10.4%
Municipal 14.0% -2.5%
Corporate 14.9% -3.1%
Foreign Bonds
Developed Markets 9.5% 1.7%
Emerging Markets 26.3% -10.9%
U.S. High-Yield Bonds 49.1% -26.1%
S&P 500 19.3% -37.0%
MSCI EAFE Index 29.1% -43.3%
TREASURIES VS. INFLATION
The table below shows the cumulative effects of inflation on 30-day Treasury Bills
(“cash equivalents”) and 20-year Treasury Bonds over the 20-year period ending
December 31st, 2008. The base year is 1989; yields for each subsequent year (for the T-
bill and T-bond columns) reflect the actual annual yield and what the yield would have
been, adjusted for inflation.
For example, in 1989, T-bills had an average yield of 8.4% for the year; for 1990, a CPI-
adjusted yield would have resulted in a yield of (8.4% x 1.061). For 1991, the CPI adjustment would have resulted in an annual yield of (8.4% x 1.061 x 1.031), reflecting
the cumulative effects of inflation since 1989. This process is repeated for each
subsequent year, up through the end of 2008. The table considers only yield, not total
return (note: total return and yield would be the same each year for T-bills). As you can
see, in order to maintain 1989 purchasing power for 2008, a T-bill would have had
to be yielding 14.0% by the end of 2008 (vs. its actual yield of 1.6%).
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Cumulative Effects of Inflation on Treasury Yields [1989-2008]
Year Inflation
(CPI)
T-bill yield
(CPI adjusted) T-bond yield
(CPI adjusted)
1989 4.7 8.4 (base yr.) 8.2 (base yr.)
1990 6.1 7.8 (8.9) 8.4 (8.7)
1991 3.1 5.6 (9.2) 7.3 (9.0)
1992 2.9 3.5 (9.5) 7.3 (9.2)
1993 2.8 2.9 (9.7) 6.5 (9.5)
1994 2.7 3.9 (10.0) 8.0 (9.7)
1995 2.5 5.6 (10.2) 6.0 (10.0)
1996 3.3 5.2 (10.6) 6.7 (10.3)
1997 1.7 5.3 (10.7) 6.0 (10.5)
1998 1.6 4.9 (10.9) 5.4 (10.7)
1999 2.7 4.7 (11.2) 6.8 (10.9)
2000 3.4 5.9 (11.6) 5.6 (11.3)
2001 1.6 3.8 (11.6) 5.7 (11.5)
2002 2.4 1.6 (12.1) 4.8 (11.8)
2003 1.9 1.0 (12.3) 5.1 (12.0)
2004 3.3 1.2 (12.7) 4.8 (12.4)
2005 3.4 3.8 (13.1) 4.6 (12.8)
2006 2.5 4.8 (13.5) 4.9 (13.1)
2007 4.1 4.7 (14.0) 4.5 (13.7)
2008 0.1 1.6 (14.0) 3.0 (13.7)
MUNICIPAL BOND SAFETY
Despite severe economic troubles, there have been no investment-grade defaults during
the past year (2008), and there were none in the previous 30 years. Defaults can occur,
but they almost never do, for investment-grade bonds (i.e., rated BBB/Baa or above).
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BONDS
Advisors and clients expect stocks to outperform bonds over any reasonably long period
of time. Sometimes this is not the case, particularly if very specific dates are selected. For
example, from the beginning of 1968 to the beginning of March 2009, $1 invested in the
S&P 500 grew almost 26-fold, versus an over 29-fold increase for 20-year U.S.
Government bonds (dividends and interest payments reinvested). In addition to this 41 -
year span, bonds also did better than stocks for the 20-year span from 1929 through 1949
and for the 68-year period from 1803 through 1981. When the periods are not “cherry picked,” total return figures are much different.
From 1802 to February 2009, stocks returned about four million times one’s initial
investment, versus 27,000 times one’s initial investment for the long -term
government bond investor. This difference works out to a difference of 150 to one;
surprisingly, this 150-fold relative wealth translates into just a 2.5% per year advantage
for the stock investor. Even though 2.5% compounded over well over 200 years results is
quite a difference, the performance line has been quite jagged:
From 1803 through 1856, stock investors ended up with 1/3rd the wealth of a bond-holder (it
was not until 1871 that the stock investor caught up);
From 1857 until 1929 (72 years) stock investors beat out bond investors;
The 1929 to 1932 crash resulted in stock investors trailing bond investors on a cumulative basis until the early 1950s (20 years);
From 1932 until 2000, stocks outperformed bonds by quite a large margin and
From the peak in 2000 to the end of 2008, the equity investor lost nearly 3/4th of his wealth, relative the to bond investor.
It can take tremendous patience to be invested in stocks: from 1926 through February 2009, stocks spent 173 out of 207 years (84% of the time) either dropping from old highs or recovering past losses—and that only includes periods of 15+ years for stocks to reach a new
high and
When looking at real returns (adjusted for inflation but not income taxes), the 1965 peak for the S&P 500 was not surpassed until 1993 (28 years).
The 1802 stock market peak was first surpassed in 1834, a 32-year period that included a
12-year bear market period when stocks suffered a cumulative loss of over 50%. The
peak of 1802 was not convincingly surpassed until 1877; by the 1929 peak, the 1802 peak
had been surpassed by a five-fold increase.
BONDS 4.5
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The 1929-32 market crash resulted in a cumulative drop in stock appreciation that,
adjusted for inflation, briefly fell below 1802 levels. It is hard to imagine that there was a
130-year period when U.S. stocks experienced a return of zero (note: none of these
figures include the impact of dividends). Still, stock investors were able to use their
dividends. The bear market of 1982 saw S&P 500 share prices fall below their inflation-
adjusted levels first reached in 1905—a 77-year period with no price appreciation.
There are a number of conclusions that can be reached from all of this historical stock analysis (again, the slant of the study is negative for stocks):
[1] Looking forward, a 2.5% excess annual return for stocks over bonds appears to be more appropriate than the 5.0% figure used in the past.
[2] The only thing that goes up in a market crash is correlation; equity diversification has often been overrated—especially when it is needed the most.
[3] Quality debt asset categories should probably comprise more of an overall portfolio than what was used by advisors in the past.
BONDS 4.6
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During September and October 2008, 16 different asset categories suffered losses ranging
from less than 1% to over 41% (source: Research Affiliates), as shown in the following
table:
September and October 2008 Asset Class Returns
Asset October Monthly
Rank Since 1988
2-Month
Return
MSCI Emerging Equity Index 2nd worst -41%
MSCI Equity Index worst -32%
FTSE NAREIT All REITs Index worst -30%
DJ-AIG Commodities Index worst -30%
Russell 2000 Equity Index worst -30%
S&P/TSX 60 Index worst -28%
ML Convertible Bond Index worst -27%
S&P 500 Index worst -25%
Barclays U.S. High Yield Index worst -23%
JP Morgan Emerging Market Bond Index 2nd worst -21%
Barclays Long Credit Index worst -19%
Credit Suisse Leveraged Loans Index worst -17%
JP Morgan Emerging Local Markets Index worst -12%
Barclays U.S. TIPS Index worst -12%
Barclays Aggregate Bond Index 4th worst -4%
ML 1-3 Year Government/Credit Index 29th worst -0.6%
Based on available historical data, losses from all 16 of these asset categories for the
same month never occurred—until September 2008. October 2008 was the worst single
month in 20 years for 3/4th
of the 16 asset categories shown. For most of these assets,
October 2008 was the single worst month ever recorded. The next table shows how selected market indexes fared (source: Research Affiliates).
BONDS 4.7
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For the 20-year period 1989-2008, the MSCI Emerging Markets Index had a monthly loss
of 10% or more 18 times, compared with four times for the S&P 500.
2008 Selected Market Returns
Asset 2008
20-30 Year Treasury STRIPS +56%
Barclays Capital U.S. Aggregate (bonds) +5%
1-Year Treasury Bill +3%
HFRI Composite Fund of Funds Index -21%
HFRX Global Hedge Fund Index -23%
S&P 500 -37%
MSCI EAFE -43%
S&P GSCI -47%
MSCI Asia Pacific ex Japan -50%
MSCI Emerging Markets -55%
HFRX Convertible Fixed Arbitrage Index* -58%
* An “absolute return strategy” that was supposed to protect investors during market turbulence, taking short positions in stocks and long positions in bonds.
STOCK/BOND CORRELATION AND INDEXES
From 1969 to 2009, the classic 60/40 (stock/bond) balanced portfolio had a 98%
performance correlation to stocks, with 38% less risk. A 40% allocation to T-bills instead
of bonds would have also resulted in significant risk reduction (but with returns
averaging 1.4% less per year).
Bond indexes can have shortcomings, just like stock indexes. For example, there was a
time when Cisco represented 4% of the S&P 500, even though it had just 20,000
employees worldwide. During the same period, Nortel stock represented more than 30%
of the Canadian market. In the case of bond indexes, GM and Ford bonds together
comprised 12% of the U.S. High-Yield Bond Index in 2006.
BONDS 4.8
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BOND SECTOR RETURNS
The table below shows returns for different bond categories for 2008 and the first nine
months of 2009 (source: Barclays Capital).
Bond Sector Performance
Category 2008 2009
Treasury Securities 13.7% -2.3%
TIPS -2.4% 9.5%
GNMA Securities 7.9% 5%
Corporate Bonds—investment grade -3.1% 14.9%
Corporate Bonds—high yield -26.2% 49.0%
Municipal Bond -2.5% 14.0%
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EFTS
ETFS 5.1
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5.KEEPING ETF PRICES CLOSE TO NAVS
ETFs usually trade at market prices that are close to the underlying NAVs of their
portfolios because large institutional investors [called Authorized Participants (APs)] can
use arbitrage to profit from any difference between the fund's price and its NAV.
Let's say an ETF has a NAV of $20 per share but is trading at a market price of $19.80—
a 1% discount to NAV. The AP can buy 50,000 ETF shares, deliver them to the ETF sponsor, receive shares of the underlying stocks or bonds equivalent to 50,000 ETF
shares and sell those securities on the open market. This nets a profit of 1% for the AP
and also pushes up the market price of the ETF. The AP will keep doing this until the
price equals the NAV.
If the ETF is trading at a premium to its NAV, the AP will buy shares of the underlying
stocks or bonds, give them to the ETF sponsor in exchange for new ETF shares and sell
those ETF shares on the market, pushing the price back down toward its NAV. Howe ver,
if the stocks or bonds become difficult to trade on the market because other buyers and
sellers are nervous, it may be difficult for the AP to engage in this arbitrage trading,
meaning prices and NAVs can diverge.
THE STRANGE STATE OF EFT EVALUATIONS & RATINGS
ETF comparisons tend to focus much more heavily on fund expense ratios than most mutual fund evaluations do. This is puzzling because index ETF expense ratios vary less
from fund-to-fund than mutual fund expense ratios. The emphasis on ETF expense ratios
is partly the result of the ready availability of this measure. The expense ratio is one of
the first things an investor sees when she examines the ETF’s Fact Sheet. Another reason
for focusing on the ETF expense ratio is probably that, while mutual funds often have a
number of share classes and fee structures, ETFs charge every investor the same fee.
Because ETF expense ratios tend to be lower than mutual fund expense ratios, expense
ratios have been emphasized by ETF proponents in making the case for ETFs. However,
the reality is that expense ratios are often lower than trading costs due to index
composition changes.
ETFS 5.2
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As ETF trading volume has expanded, there has been increased emphasis on comparing
EFT bid/ask spreads. The message investors receive from the focus on the bid/ask spread
is the obvious one: a narrow spread is better than a wide spread when trading. This point
is indisputable; but the numbers cited for an ETF’s average spread usually understate the
spread an investor will encounter when she checks a live quote. Furthermore, for a long-
term investor, the spread is paid only twice—once when she buys the shares and once
when she sells them. The cost to trade ETF shares is important for a number of reasons,
but trading cost will rarely be a make-or-break item for a long-term investor.
Another characteristic of ETF evaluation that differs strangely from mutual fund
evaluation is that a great deal of attention is paid to ETF tracking error—a measure of the
relative performance of the fund and its benchmark index. It gets a lot of attention
because it is relatively easy to measure, but most fund raters are not sure what to do with
it.
The approach most fund analysts take in evaluating ETFs and their managers is
qualitatively as well as quantitatively different from the approach they take to mutual
funds. Most ETFs are index funds ; index fund managers have yet to capture the
imagination of fund analysts and investors in the way that some active managers have
done. Trading transparency around index composition changes is usually a more costly
drag on fund performance than most of the features ETF analysts stress in their
comparisons. Furthermore, an index fund manager who trades away from the official index change date can improve the fund’s return.