INSTITUTE OF BUSINESS & FINANCE
QUARTERLY UPDATES Q4 2007
Copyright © 2008 by Institute of Business & Finance. All rights reserved.
v2.0
Quarterly Updates Table of Contents MUTUAL FUNDS MUTUAL FUND DIRECTORS MORNINGSTAR RATING SYSTEM TARGET-DATE FUNDS AND FOREIGN EXPOSURE VALUE VS. GROWTH STEWARDSHIP RANKINGS AFTER-TAX PERFORMERS MULTIPLE ASSET CLASS INVESTING MUNICIPAL BOND DEFAULT RATE INTERNATIONAL EQUITIES MAKING A CASE FOR UTILITIES STRUCTURED NOTES 30 YEARS OF WITHDRAWALS
1.1 1.1 1.2 1.2 1.2 1.3 1.4 1.6 1.7 1.7 1.8 1.10
RETIREMENT MORNINGSTAR’S 401(K) PLAN FUND FAMILY MANAGER RETENTION RATES 529 PLANS VS. ROTH IRAS
2.1 2.1 2.2
ANNUITIES INCOME ANNUITIZATION ONLINE ANNUITY RESOURCES IMPROPER ANNUITY CONTRACT STRUCTURE
3.1 3.1 3.2
REAL ESTATE GNMA ISSUES REVERSE MORTGAGE BONDS REVERSE MORTGAGE CHOICES REIT WEBSITES REAL ESTATE LOSSES REAL ESTATE GAINS
4.1 4.1 4.2 4.3 4.3
CLOSED-END FUNDS CLOSED-END FUND FACTS COVERED CALL CEFS
5.1 5.1
ETFS MUNICIPAL BOND ETFS ETN RUSH FREE ETF AND MUTUAL FUND TOOLS FOREIGN BOND ETFS
6.1 6.1 6.2 6.3
MISC. NO OIL SHORTAGE HEDGE FUND TRADING FUND CURRENCY HEDGING CORPORATE PROFITS PRESCRIPTION DRUG COVERAGE RATING HOSPITAL CARE LONGER LIFE EXPECTANCY
7.1 7.1 7.2 7.2 7.2 7.3 7.4
QUARTERLY UPDATES MUTUAL FUNDS
1.1
1.MUTUAL
MUTUAL FUNDS
FUND DIRECTORS
Mutual fund directors can negotiate lower fees for shareholders, fire fund managers, and merge a fund into another. Directors also oversee the valuation of hard-to-price securities and 12b-1 fees. Fund directors must also assess their own performance, explain their reasons for approving advisory contracts, and have policies designed to prevent securities law violations. Fund boards typically meet 4-5 times a year; the median director compensation for the largest fund families was $172,000, according to a Management Practice survey. A third of the directors surveyed said they spend more than 50 hours per quarter on board work. A study by Binghamton University and Cornell University found that funds that received good Morningstar governance grades outperformed those with bad grades by 1.2 to 1.9 percentage points a year between late 2004 and the end of 2006. Another study indicated that more independent boards have less patience with poorly performing funds and are more likely to merge them with other funds.
MORNINGSTAR RATING SYSTEM The Morningstar star rating system is a way advisors and investors can easily see a mutual fund’s long-term risk-adjusted performance over the past three-, five-, and 10years. Each fund is compared to its category (vs. a broader asset-class that was used until 2002). Thus, a small cap value fund is now compared to other small cap value funds. The system is based on the assumption that at any given risk level, investors are happy to reduce their risk level in return for less return potential (vs. the old rating system which looked only at a single point on the risk/reward curve). Funds that charge a commission are penalized under the star rating system. At the end of June each year, Morningstar does a comparison to see how accurate their ratings have been. Generally, 5-star funds have slightly outperformed 4-star funds, 4-star funds have slightly outperformed 3-star offerings, and so on. When you compare 5-star with 1-star funds, the differences become noticeable. For example, for the 5-year period ending 6/30/2007, 5-star domestic stock funds beat their 1-star peers by 1.5% annualized; in the case of foreign stock funds, the difference was 0.90% per year difference. The ratings for the past five years have worked best for balanced funds, where a 5-star rating resulted in an average performance advance of 3.1% annualized over 1-star balanced funds. Taxable bond funds rating 5-star outperformed 1-star funds by 0.7% per year; 1.1% in the case of municipal bond funds. Morningstar also looked at expense ratios, “Funds that are both 5-star and low cost have a significantly lower standard deviation than those that are just five stars.� QUARTERLY UPDATES
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MUTUAL FUNDS
1.2
TARGET-DATE FUNDS AND FOREIGN EXPOSURE Even though about half the value of the world’s total stock market value is outside the U.S., few advisors would feel comfortable with such a high exposure for their clients. Two areas that target-date funds have been criticized are too little exposure to equities (given the multi-decade time horizon of their typical investor) and not having enough foreign exposure. Ibbotson Associates recommends a 30% international weighting for long-term investors; Vanguard suggests 20% of the portfolio should be overseas, while Fidelity is closer to 25%, Putnam is around 30%, and AllianceBernstein is above 35%.
VALUE VS. GROWTH According to the book, “What Works on Wall Street,” from 1963 to 2005, high p/e stocks returned 6.9% a year, compared with 15.0% for low p/e stocks. The book’s author, James O’Shaughnessy, points out that low price-to-sales stocks returned 5.6% versus 2.6% for their high price-to-sales peers. From 1927 to 2006, large cap value stocks returned 12.0% a year, compared to 9.1% for large cap growth, while small cap value returned 14.8% a year versus 9.6% for small cap growth. For the period 1927 to 2004, value stocks returned 12.5% a year versus 9.0% for growth stocks, based on price to book value, according to Morningstar.
STEWARDSHIP RANKINGS Morningstar ranks mutual fund families in five areas (corporate culture, fund manager incentives, board of directors oversight, fees, and regulatory history) to arrive at Stewardship Grade. Of the five criteria, “corporate culture” counts for up to four of the 10 possible points a fund family can receive. Regulatory compliance receives zero points, but can count for up to two negative points if a family ignores its regulatory obligations. The October 2007 table below shows the fund families that have the highest stewardship ratings; the number of funds in the family are shown in parentheses.
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MUTUAL FUNDS
2007 Stewardship Grades Fund Family Clipper (1)
Grade A
Fund Family FPA (5)
Grade B
Davis/Selected (7)
A
Vanguard (96)
B
Dodge & Cox (4)
A
Primecap (3)
B
Diamond Hill (3)
A
American Funds (24)
B
T. Rowe Price (69)
B
Royce (11)
B
AFTER-TAX PERFORMERS When deciding whether or not to use an index fund or ETF, one of the considerations is its performance compared to a benchmark, on a before and after tax basis. The table below shows the percent of active domestic stock fund managers who have outperformed their respective index on a before tax and after tax basis. The results were based on 10year annualized figures (1987-2006). The figures shown in parentheses represent the percentage of actively-managed U.S. stock funds that have outperformed their benchmark on an after tax basis.
Active Management vs. Index [1997-2006] Value
Blend
Growth
Large Cap
15% (4%)
31% (14%)
63% (44%)
Mid Cap
13% (0%)
46% (16%)
54% (30%)
Small Cap
35% (7%)
81% (53%)
82% (69%)
As you can see, the chances of a fund manager outperforming its value benchmark on an after-tax basis ranges from 0-7%, while the odds of a small cap growth or blend active manager having better after-tax returns ranges from 53% to 69%. This means that over the past 10 years, the vast majority of advisors interested in value stocks would have been better off using an index fund or ETF.
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MUTUAL FUNDS
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MULTIPLE ASSET CLASS INVESTING A study by Roger Gibson covering the 25-year period from 1986 to the end of 2005 shows the benefits of structuring client portfolios using multiple asset categories, particularly real estate and commodities. A quote from Talmud (circa 1200 B.C.-500 A.D.) supports this view: “Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.” As of the end of 2005, the world’s total investable capital market was valued at $93.4 trillion, according to UBS Global Asset Management. As you can see, the U.S. represents close to half the world’s investable capital (25.5% + 16.9% + 6.2% + a portion of “cash equivalents”).
$93.4 Trillion Capital Market Breakdown [12-31-2005] U.S. Bonds 25.5% Non-U.S. Bonds 21.5% Non-U.S. Stocks 20.7% U.S. Stocks 16.9% U.S. Real Estate 6.2%
Cash Equivalents 4.1% Emerging Market Bonds 2.9% Emerging Market Stocks 1.8% Private Markets 0.3%
The Gibson study which looks at every 25-year rolling period ending 1997 through 2005, includes a number of exhibits that can be summarized as follows: [A] For every 25-year period, a pure long-term bond portfolio has the least amount of risk when its composition is 70% in U.S. corporate bonds and 30% in foreign bonds, almost always resulting in slightly lower returns. However, in all cases, when the foreign bond exposure was increased from 0% to 10%, 20% or 30%, the small loss in returns was more than offset by a correspondingly higher percentage drop in risk. [B] Stock diversification into foreign equities usually resulted in a lower standard deviation; an increase from 20% to 30% in foreign stocks made virtually no difference. Thus, historically the advisor did not increase or decrease risk or reward by altering the international equity weighting from 20% to 30% or from 30% to 20%. However, adding foreign stocks to a pure U.S. stock portfolio did decrease risk by 1-7%, usually adding nothing or little to annualized returns. Specifically, over every 25-year period, portfolio volatility was lower with a foreign equity allocation of 10% or 20%; in almost every 25year period, volatility was also lower with a 30% allocation to international stocks.
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MUTUAL FUNDS
[C] Looking at every possible 1-4 asset class portfolio (U.S. stocks, foreign stocks, real estate securities, and commodities) and reviewing every 25-year rolling period from 1972 to the end of 2005: (1) two-asset portfolios generally had less risk and better returns than single asset portfolios; (2) three-asset portfolios had better risk/return characteristics than two asset class portfolios; and (3) the four-asset-class portfolio (25% in U.S. stocks, 25% in foreign stocks, 25% in real estate securities, and 25% in commodities) had less risk than any combination of 1-3 asset classes (except an equal weighting in U.S. stocks, real estate securities, and commodities) and a higher annualized return (over 13%) than most combinations. As an example, a portfolio with an equal weighting in all four asset classes had a return very similar to a 100% investment in real estate securities (which was the number one performer over the 25-year rolling periods) but with 1/3rd less risk. This is quite a surprise since the other three asset classes (U.S. stocks, foreign stocks, and commodities) had lower returns and more volatility than real estate securities. The table below shows the returns of the 15 equity portfolios described in “[C]” above for all 25-year rolling periods from 1972 through 2005 (note: U = U.S. stocks, F = foreign stocks, R = real estate securities, and C = commodities). All of the annualized return figures have been rounded off to the nearest ½%, with the exception of the Sharpe Ratio, which was rounded off to the nearest 1/10th).
Returns and Risk for 15 Different Equity Portfolios [1972-2005] Portfolio
Return
Portfolio
Std. Dev.
Portfolio
Sharpe
RC
14.0%
URC
11.0%
URC
0.7
FRC
13.5%
UFRC
11.5%
FRC
0.7
URC
13.5%
FRC
12.0%
UFRC
0.7
R
13.5%
UFC
13.0%
RC
0.6
UFRC
13.5%
UC
13.0%
UR
0.6
FC
13.0%
RC
13.5%
UFC
0.6
FR
13.0%
UR
14.5%
UR
0.5
UR
13.0%
UFR
15.0%
FC
0.5
UFR
13.0%
FC
15.5%
R
0.5
UR
12.5%
FR
15.5%
FR
0.5
UFR
12.5%
R
16.5%
UFR
0.5
C
12.0%
U
17.5%
UF
0.4
UF
11.5%
UF
17.5%
U
0.4
F
11.5%
F
22.0%
C
0.3
U
11.0%
C
24.5%
F
0.3
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Returns and Risk for 1-4 Asset Portfolios [1972-2005] Portfolio
Return
Portfolio
Std. Dev.
Portfolio
Sharpe
4 assets
13.5%
4 assets
11.5%
4 assets
0.7
3 assets
13.0%
3 assets
12.5%
3 assets
0.6
2 assets
13.0%
2 assets
15.0%
2 assets
0.5
1 asset
12.0%
1 asset
20.0%
1 asset
0.4
As you can see from the summary table above, the four-asset-class portfolio had the highest returns, the least risk, and the best Sharpe Ratio. This table clearly shows the advantages of asset class diversification. The final table below shows the five worst calendar years during the 1972-2005 period for each of the four asset classes as well as a portfolio with an equal weighting in each (U.S. stocks, foreign stocks, real estate securities, and commodities). As you can see, there is a huge difference between a single asset category portfolio and one with all four asset classes.
Five Worst Years [1972-2005] U.S. Stocks
Foreign Stocks
R.E. Securities
Commodities
Equal Allocation
-26% (1974)
-23% (1990)
-21% (1974)
-36% (1998)
-13% (2001)
-22% (2002)
-22% (1974)
-18% (1998)
-32% (2001)
-8% (1974)
-15% (1973)
-21% (2001)
-16% (1973)
-23% (1981)
-6% (1981)
-12% (2001)
-16% (2002)
-15% (1990)
-17% (1975)
-3% (1990)
-9% (2000)
-14% (1973)
-5% (1999)
-14% (1997)
-1% (1998)
MUNICIPAL BOND DEFAULT RATE Between 1970 and 2006, only 41 municipal bonds defaulted. The default rate for the 10year period 1997-2006 was just 0.1%, versus a 0.5% default rate for AAA-rated corporate bonds and 2.1% for investment-grade bonds, according to Moody’s. According to a PIMCO report, high-yield municipal bonds had a 16% correlation to stocks and a 41% correlation to high-yield corporate bonds over the 10 years ending September 2006.
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MUTUAL FUNDS
INTERNATIONAL EQUITIES Since 1975, adding foreign stocks (MSCI EAFE Index) has almost always produced a diversification benefit, lowering volatility over three-year holding periods. Historical data indicates that the average returns and volatility for the EAFE Index and S&P 500 have been very similar when looking at the period 1971 through 2005. For example, during this time period, the S&P 500 averaged 12.1% per year and had a standard deviation of 16%, while the EAFE averaged 12.6% with a standard deviation of 17%.
MAKING A CASE FOR UTILITIES Utility funds are often ignored by advisors and brokers, yet, this conservative sector asset category can add needed portfolio diversification, a proven stream of comparatively high dividends, and total return figures that rival the S&P 500, with similar risk. For example, the table below compares annualized returns for large cap blend with utility funds.
Large Cap Blend Funds vs. Utility Funds [periods ending December 31st, 2007] 3 year
5 year
10 year
15 year
Utility Funds
21.5%
11.5%
10.2%
9.7%
Large Cap Blend Funds
10.1%
6.0%
7.7%
9.9%
A desired effect of adding any asset category is the hope of reduced portfolio volatility, a result of either a lower correlation coefficient or the risk characteristics of the investment itself. Surprisingly, the standard deviation for utility funds is slightly greater than that of large cap blend or value funds (8 vs. 7), but lower than large cap growth funds (10 vs. 8), even though utilities have a much lower beta (0.6 vs. 1.0 for large cap blend and 1.3 for large cap growth funds).
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MUTUAL FUNDS
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With an R-squared of just 25 (vs. 85 for large cap blend funds and 100 for the S&P 500), it is easy to see the possible diversification benefits. Moreover, such diversification is needed now that it appears the correlation coefficient between blend, growth, and value domestic funds is quite high, as shown in the table below.
Correlation to the S&P 500 [3 years ending 6/30/07] Value
Blend
Growth
Large
0.97
0.99
0.94
Mid
0.90
0.90
0.87
Small
0.84
0.84
0.83
For the 15-year period ending 6/30/2007, utility funds had a 0.34 correlation to the S&P 500 (vs. 0.15 for gold, 0.51 for energy, and 0.28 for REITs). Over these same 15 years, the S&P 500 experienced 60 months of negative returns; utility funds outperformed the S&P 500 60% of time when the S&P 500 had a negative month.
STRUCTURED NOTES Structured products usually combine some type of downside protection along with some degree of upside potential. Typically, a structured note uses derivatives to either add or remove risk from a specific asset such as a stock, market index, commodity, or currency. During the 2006 calendar year, U.S. investors bought over $64 billion of these products (vs. over $190 billion in Europe), a 32% increase from the previous year. There are three basic types of structured notes: principal protection notes, enhanced yield products, and reverse convertibles; the AMEX website defines 54 different subsets of the structured products it trades in.
Principal Protection Notes PPNs offer investors equity exposure without risk to principal. These notes usually have a five year maturity and 100% market participation along with 100% principal protection. For example, a Merrill Lynch note that tracks the S&P 500, the Nikkei 225, and the Euro 50 indexes guaranteed a minimum return of at least 5% along with FDIC insurance.
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MUTUAL FUNDS
The correlation between U.S. stocks and other developed stock markets has generally been higher during U.S. bear markets. Yet, even when the correlation is high, international investing may provide the short-benefit of higher returns, as during most U.S. bear markets, or lower volatility, as during the technology bubble. As you can see from the table below, even excluding the 1987 Crash, the returns of the S&P 500 and EAFE Index has generally been high during bear markets.
S&P 500 and EAFE Correlation 1971-2005
1971-1986
1988-2005
Bear
Bull
Bear
Bull
Bear
Bull
65%
47%
52%
39%
75%
54%
During six of the eight U.S. bear markets since 1971, a 20% allocation to EAFE stocks provided an average 2.2% greater return and just 0.7% less volatility than 100% invested in the S&P 500. During bull markets during this same period, a 20% EAFE weighting resulted in 0.8% less return and 1% lower volatility.
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MUTUAL FUNDS
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30 YEARS OF WITHDRAWALS Suppose you have clients who believe their remaining life expectancy is 30 years and have little or no donative intent. With a goal of structuring a portfolio that will least 30+ years, given a consistent annual withdrawal amount (meaning no adjustment for inflation), the table below shows the odds of obtaining that goal. The table below shows the odds of someone not outliving their nest egg using different withdrawal rates. All of the percentage figures, which range from 72% to 100% are based on Monte Carlo probability analysis using stock, bond, and cash equivalent indexes over the past 25-80 years (20 years in the case of EAFE stocks and 80 years in the case of all other asset categories). The 5,000 simulations done to obtain these percentages (odds of success) did not factor in any expense ratios or other costs associated with a brokerage or mutual fund account. — Annual Withdrawal Rate — 3%
4%
5%
6%
S&P 500….100% Long-term corporate bonds….0%
99%
98%
95%
89%
S&P 500….50% Long-term corporate bonds….50%
100%
99%
98%
93%
S&P 500….50% Long-term corporate bonds….50%
100%
99%
92%
72%
S&P 500….28% EAFE Index….12% Long-term corporate bonds….40% Cash (90-day T-bills)….20%
100%
100%
99%
94%
Asset Mix
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2.1
2.MORNINGSTAR’S
RETIREMENT
401(K) PLAN
The table below shows the mutual funds that Morningstar uses for their own 401(k) plan, as of the third quarter of 2007. Funds that include “**” indicate a portfolio weighting of 15-20%, a “*” means a weighting of 3-8% (note: it appears that no fund has a weighting of 9-14%). American Beacon Small Value (AVPAX) * American Funds New World (NEWFX) Brandywine (BRWIX) Harbor Capital Appreciation (HACAX) ** Oakmark Select (OAKLX) ** PIMCO Real Return Insl (PRRIX) * PIMCO Total Return (PTTRX) Primecap Odyssey Agg. Growth (POAGX) * Selected American D (SLADX)
T. Rowe Price High-Yield (PRHYX) T. Rowe Price Small-Cap Stock (OTCFX) * Tweedy, Browne Global Value (TBGVX) * Vanguard Institutional Index (VINIX) Vanguard FTSE Social Index (VFTSX) * Vanguard International Growth (VWIGX) ** Vanguard LifeStrategy Growth (VASGX) Vanguard Selected Value (VASVX) *
FUND FAMILY MANAGER RETENTION RATES Mutual fund advisory firms generally agree that performance and manager retention are closely related. Fund companies that have a high retention rate are usually near the top when it comes to peer group performance. Similarly, funds near the bottom when it comes to retention are often poor performers. The table below shows the five-year average manager retention rate of 24 of the largest mutual fund families, for the period 2002-2006). The retention rate was determined by looking at who was listed as a fund manager of a fund within a family at the beginning of the year and then seeing if that person was still listed as a manager of the fund at the end of the year (note: if a manager stayed with the parent company but was no longer listed as the fund’s manager, it was still considered a departure).
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RETIREMENT
2.2
2007 Fund Manager 5-Year Retention Rate 95-100% retention
85-89% retention
Dodge & Cox
PIMCO
American Funds
Van Kampen
T. Rowe Price
90-94% retention
Columbia Fidelity
Janus
ING
Vanguard
AIM
Oppenheimer
John Hancock
Franklin Temnpleton
Principal Investors
Hartford
BlackRock
American Century
79-84% retention
GMO
MFS
AllianceBernstein
JP Morgan DWS-Scudder Putnam
529 PLANS VS. ROTH IRAS A Roth IRA may be a better alternative to a 529 Plan when it comes to funding a child’s education. Withdrawals from a Roth IRA are tax-free and penalty-free whenever it is used to fund higher education, versus restrictions for 529 Plan withdrawals. The biggest advantage of a 529 Plan is that it is funded with pre-tax dollars, while a Roth IRA uses after-tax dollars; the biggest advantage the Roth has is that its flexibility is much greater.
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3.1
3.INCOME
ANNUITIES
ANNUITIZATION
A 2007 study by Wharton and New York Life Insurance shows that an income annuity can provide an income stream for life at a cost of as much as 40% less than a traditional stock, bond, and cash mix. Phrased another way, the study shows that someone who needs a $1 million next egg can maintain the same lifestyle by purchasing a $600,000 lifetime annuity. A 65-year-old male will receive about $86,000 a year, while $1 million invested in a traditional securities portfolio would generate $40,000-$50,000 annually, depending on the withdrawal rate. Even though a 65-year-old man is expected to live to age 85, about half of these men will live well past age 85, some may even reach 100. Retirement income planning tends to “break down” for those that live longer than expected, according to Wharton School Professor David Babbel and Brigham Young Professor Craig Merrill, the two authors of the study. According to Babbel, “The best strategy is to invest enough in an annuity early in retirement to cover basic fixed costs. That allows you to invest the remainder of your portfolio more aggressively.” The Wharton study is available at investmentnews. com/retirementcenter/annuities.
ONLINE ANNUITY RESOURCES The following online sources can help you determine if a client should invest in annuities and, if so, how much: immediateannuities.com Instant quotes for monthly payouts from immediate fixed-rate annuities longevityalliance.com Describes different types of annuities and sends quotes, via email or telephone, for immediate annuities. incomesolutions.com/annuityfaq.asp Answers basic questions about immediate fixed-rate annuities.
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ANNUITIES
3.2
sec.gov/investor/pubs/varannty.htm The SEC publication, “Variable Annuities: What You Should Know.” naic.org/documents/consumer_alert_annuities_senior_citizens.htm The National Association of Insurance Commissioners description of the different types of annuities, whether annuities are the right choice, and warnings about deceptive sales practices.
IMPROPER ANNUITY CONTRACT STRUCTURE According to Advanced Sales Corp. (ASC), from 2002 to 2006, 38% of variable annuity contracts were improperly structured (who should be the owner, annuitant and beneficiary). The most common shortcoming has been not naming any beneficiary. The second most common mistake was naming someone as beneficiary other than the person who was intended to inherit the contract, usually the client’s spouse. There are over 600 different variable annuity contracts. Four simple rules to keep in mind are: [1] every annuity pays out when any contract owner dies, unless spousal continuation is allowed; [2] with an owner-driven contract, the death of annuitant means nothing—there is no death benefit payout; [3] with an annuitant-driven contract and the sole annuitant dies, the contract must pay out; and [4] every rule can have an exception.
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4.1
4.GNMA
REAL ESTATE
ISSUES REVERSE MORTGAGE BONDS
The U.S. Government insures about 90% of all reverse mortgages, according to the Federal Housing Administration. Since 2003, the number of reverse mortgages that are backed by the federal government has increased from 20,000 to 108,000 (as of 9-302007). GNMA announced in early November 2007 that it will soon offer the “first standardized” bond issue backed by reverse mortgages. The first offering is expected to be about $120 million and will consist of more than 1,000 government insured reverse mortgages.
REVERSE MORTGAGE CHOICES Close to 120,000 reverse mortgages were originated in 2007, up from less than 80,000 in 2006; 90% of all such loans are insured by FHA. As the marketplace for reverse mortgages becomes more popular, the number of lenders and product structure has also opened up. For example, one lender has reduced the minimum age requirement from 62 to 60; another lender is going after “jumbo” reverse mortgages for homes valued as much as $10 million (borrowers can receive up to 65% of this amount). Most reverse mortgages are variable rate, but some institutions also offer a fixed-rate option. Upfront fees from well-known reverse mortgage lenders such as Wells Fargo and Bank of America can be as high as 5% or more of the home’s value. Practitioners advising clients about reverse mortgages should ask the prospective lender what index is used for the reverse mortgage (some use Libor and others use the CMT index, which is based on U.S. Treasury bonds). The advisor should also find out the total amount of fees that are to be paid.
For example, toward the end of 2007, someone in Georgia with a $500,000 house could receive a reverse mortgage for up to $148,300 with a 7.8% loan (rough 1-1.5% higher than a conventional first mortgage loan backed by GNMA or FNMA); the fees paid would equal about $7,000 (or 1.4% of the home’s value). The same borrowers could get up to $140,600 through a FHA-backed reverse mortgage, pay $13,260 in fees and receive a 4.9% loan.
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REAL ESTATE
4.2
REIT WEBSITES www.nareit.com The national REIT trade group (NAREIT) provides daily market information, index data, historical returns, updates, and real estate news. www.investinreits.com Operated by NAREIT, this site includes information on 200 REIT stocks, real estate mutual funds and ETFs, as well as closed-end REITs. www.nareit.com/portfoliomag/ NAREIT’s print publication, Real Estate Portfolio, includes stories and news about specific REITs and information on foreign REITs. http://biz.yahoo.com/industry/ This Yahoo Industry Center provides links to REIT company news, earnings releases, and other information. www.wilshire.com/Indexes/RealEstate The latest news on stock indexes such as the Dow Jones Wilshire Real Estate Securities Index, provided by Wilshire Associates. www.inman.com Headline news on the real estate industry, provided by an independent source. www.cushwake.com The Cushman & Wakefield website includes annually updated research reports, headline news, industry analysis and rental/vacancy rates from around the world. www.rer.org The trade group, Real Estate Roundtable, represents owners of $700 billion in properties. The site highlights the latest political and economic topics affecting the real estate industry; website links to other industry groups are also included.
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4.3
REAL ESTATE
REAL ESTATE LOSSES A December 2007 report from the Organization for Economic Cooperation and Development estimated that investors lost $300 billion related to real estate mortgages. According to Stanford professor Michael Boskin, “Even if two million households facing subprime resets reduced their consumption 25%, overall national consumption would decrease just 0.3%. Consumer spending accounts for 70% of the GDP for the U.S. In a December 12th, 2007 letter addressed to The Wall Street Journal, former chairperson of the Federal Reserve, Alan Greenspan noted: “The value of equities traded on the world’s major stock exchanges has risen to more than $50 trillion, double what it was in 2002….The market value of global long-term securities is approaching $100 trillion….Although central banks appear to have lost control of longer term interest rates, they continue to dominate in the market for assets with shorter maturities…The current credit crisis will come to an end when the overhand of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities.”
REAL ESTATE GAINS According to the National Association of Realtors, from 2002 through the end of 2005, the national existing median home price rose 33%. The gains for 2006 were estimated to be in the 5% range, but the number is questionable since it now appears prices peaked during the second or third quarter of 2006. However, even including a 2006 estimated gain of 5%, the cumulative gain for 2002 through the end of 2006 was just under 40%. Even strong real estate advocates and real brokers would agree that these 3-4 years have been some of the very best for home appreciation. However, as shown by the table below, one could make the argument that stocks were an even better option during this same period. Starting with 1995 year-end values, appreciation for the median existing U.S. home was a cumulative 100% for the 11-year period, 1996 through 2006. During this same period, the S&P 500 had a cumulative appreciation of 178%; small stocks had a total return of 321%.
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U.S. Median Home Price Appreciation vs. Stocks [1996-2006] homes S&P 500 Small stocks
1996 1997 1998 1999 2000 2001
2002 2003 2004
2005 2006
5% 23% 18%
6% -22% -13%
12% 5% 6%
5% 33% 23%
5% 29% -7%
5% 21% 30%
5% -9% -4%
6% -12% 23%
9% 29% 61%
9% 11% 18%
5% 16% 16%
The case for stocks becomes even stronger for this time frame when you factor in the costs of homeownership (e.g., debt service, fire insurance, property taxes, maintenance, remodeling, etc.). For example, subtracting 2% annually for homeowner expenses (a conservative estimate since annual property taxes alone are 1-2%+ of the home’s value), the cumulative return for median home appreciation drops from 100% down to 63%.
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5.1
5.CLOSED-END
CLOSED-END FUNDS
FUND FACTS
According to the Closed-End Fund Association, a trade association located in Kansas City, the first closed-end fund (CEF) was introduced in the U.S. in 1893, more than 30 years before the first open-end fund. As of the third quarter of 2007, over $350 billion was invested in closed-end funds (CEFs), versus more than $11 trillion in traditional mutual funds. The average expense ratio for a mutual fund is 1.29% versus 1.26% for the average CEF. The average U.S. household has $60,000 invested in financial assets; the average household that owns mutual funds has a typical balance of $125,000—the average household owning CEFs has $370,000 invested in closed-end funds. Municipal bond funds are the largest category of CEFs ($95 billion), followed by stock CEFs ($87 billion) and U.S. taxable bond CEFs ($68 billion). As of the middle of 2007, the average discount for a CEF was 5.6%. The IPO volume for CEFs for 2007 may reach an all-time high, surpassing the 2003 record of $31 billion.
COVERED CALL CEFS Since 2004, over 40 stock funds have launched a covered call, or “buy-write,” strategy; most of the offerings have been closed-end funds (CEFs). Many of these funds that focus on covered call writing promote their double-digit yields instead of total return. The selling of covered calls is what generates the vast majority of the funds’ current yield. Over half of the buy-write funds have NAVs that are below their initial offering price, meaning capital gains have suffered. One argument against covered call writing is that the best performing stocks get called away; a number of funds counter this argument by selling covered calls against a market index such as the S&P 500. Advisors who are attracted to a covered call strategy using CEFs should never buy the IPO, since the majority of all CEFs end up trading at a discount that reflects a commission premium (typically 4.8%) and liquidity. For example, a buy-write fund could show a 12% annual return for the past 2-3 years but only a 7% return for initial investors who paid a premium for the IPO. Two of the bigger participants that utilize a covered call strategy are Eaton Vance and Nuveen.
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6.1
6.MUNICIPAL
ETFS
BOND ETFS
The first municipal bond ETF was introduced in September 2007 (iShares S&P National Municipal Bond Fund). Barclay’s bases this ETF on the S&P National Municipal Bond Index of 3,069 issues with a rating of BBB- or better from at least one of the major rating services. The Barclay’s ETF contains about 36 (7 year duration) of the 3,069 issues. State Street’s SPDR Lehman Municipal Bond ETF is benchmarked against the Lehman Brothers Municipal Managed Money Index; the index is comprised of over 22,000 muni bonds rated AA3/AA- or higher. State Street’s ETF will use about 37 (8 year duration) of the 22,000 index securities. PowerShares uses a customized Merrill Lynch muni index. Illiquid securities can behave quite differently than liquid bonds in the same index. State Street expects a tracking error of 0.50% to 0.75%; any “error” could either benefit or hurt investors. The 1,929 municipal bond funds tracked by Morningstar have an average expense ratio of 1.1%, versus 0.25% for the Barclay’s ETF and 0.2% for the State Street ETF.
ETN RUSH Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) both track an index and trade throughout the day. The ETN is a way for a financial institution to repackage and sell “structured notes,” which previously were only available to wealthy investors or institutions. ETNs do not have to adhere to some of the regulations that apply to ETFs and traditional mutual funds. ETNs: [1] are traded throughout the day, [2] can be bought on margin, [3] can be shorted, and [4] are registered under the Securities Act of 1933. ETNs do not have a net asset value; their daily value is based on indexes published by the issuer. Perhaps the biggest appeal of an ETN is that they allow investors to participate in asset classes and geographical areas that they cannot directly invest, due to lack of accessibility or restrictions. Unlike ETFs, ETNs are not backed by a specific pool of assets; an ETN represents a promise by its issuer to match the returns of a particular index or commodity. Because ETNs are backed by the issuer’s promise, investors need to keep abreast of the issuer’s credit rating. IF the ETN issuer had financial difficulty, investors might have to get in line with other creditors. ETNs are considered to be “senior, unsubordinated, unsecured debt securities.” ETNs are registered with the SEC, but do not have to comply with Investment Company Act regulations (e.g., no board of directors is required). The tax status of ETNs is still uncertain. The current belief is that investors should only realize a capital gain or loss upon the sale, redemption, or maturity of their ETN. A number of ETNs have a 30-year maturity date. QUARTERLY UPDATES
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ETFS
6.2
Because an ETN owns no securities or commodities, all trading costs can be avoided. And, since no stocks or bonds are owned, there are no taxable distributions (the status of this was still uncertain as of November 2007). ETNs are not actually “notes;” they are prepaid forward futures contracts. Institutions can sell an ETN back to the issuer at anytime; the issuer pledges to pay an amount exactly equal to the benchmark minus expenses. Individual investors must go through a broker and pay a commission. The typical bid-ask spread of an ETN is 5-10 basis points. The total value of outstanding ETNs was $3 billion by the fourth quarter of 2007. The table below shows some of the ETNs currently trading.
Name
Investment
Expense Ratio
iPath CBOE S&P 500 Buywrite (BWV)
Covered calls
0.75%
iPath Dow Jones-AIG Commodity (DJP)
commodities
0.75%
iPath EUR/USE Exchange Rate (ERO)
currency
0.40%
iPath MSCI India Index (INP)
emerging markets
0.89%
iPath S&P GSCI (GSP)
commodities
0.75%
A number of banks are launching exchange-traded notes (ETNs): Barclays (commodities, currency, and other investments), Goldman Sachs (enhanced commodity index), Bear Sterns (index of master limited partnerships), Deutsche Bank (Morningstar Wide Moat Focus Total Return Index), and J.P. Morgan Chase (commodity and other products).
FREE ETF AND MUTUAL FUND TOOLS Fundgrades.com grades ETFs and funds ranging from A+ to F on expenses, return, and risk. The ratings are based on a comparison between the fund selected and its peer group. The free service also compares the ETF or fund against the broad universe of U.S. stocks. For example, SPY (iShares S&P 500) is described as, “Almost no risk of substantially underperforming the large-blend asset class, but a significant risk of lagging behind the broader pool of U.S. stocks.” Another web site, etfguide.com/beta helps investors understand the foundation of any ETF strategy. Indexuniverse.com has a “fundamental ETF screener” that lists ETFs that weight holdings based on fundamental factors. For advisors who cannot decide between a mutual and ETF, the web site rydexinvestments.com (look for “investor resources”) does a cost comparison based on how often trades are expected and commissions paid.
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ETFS
FOREIGN BOND ETFS For advisors who wish to diversify their clients’ fixed-income or simply profit from a falling U.S. dollar, there are ETFs that are based on foreign government bonds. The SPDR Lehman International Treasury Bond ETF (BWX) is based on a Lehman Brothers index of government bonds of 18 countries denominated in 11 currencies.
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QUARTERLY UPDATES MISC.
MISC.
7.NO
7.1
OIL SHORTAGE
As of November 2007, the amount of oil in storage tanks around the world was 4.2 billion barrels. According to British Petroleum, the world’s proven reserves are now 1.4 trillion barrels, up 12% in the past 10 years. Additionally, there is an estimated 1.7 trillion barrels of oil that can be extracted from Venezuela’s Orinoco tar sands. Combined (1.4 + 1.7 trillion), this represents 100 years of production at current rates. There are now 45% more oil rigs in service today than there were three years ago. It is estimated that it costs Saudi Arabia $4-$5 a barrel to produce a barrel of oil. The full cost of new production, even in a “challenging” area such as Canada’s oil sands is about $30 a barrel. Iran is not likely to end exports, which account for 50% of their GDP and 90% of its hard currency earnings.
HEDGE FUND TRADING As the list below shows, hedge funds are responsible for quite a bit of the trading activity for a number of securities and derivatives. Sometimes, these unregulated pools of capital are responsible for more trading than banks, mutual funds, or insurance companies. The figures below come from a 2007 study by Greenwich Associates, who polled 1,333 U.S. institutions, questioning them about their debt instrument trading.
Hedge Fund Debt Trading Asset emerging markets debt Investment-grade derivatives Junk rated derivatives Distressed debt All fixed-income
% of total trading volume 55% 55% 80% 85% 30%
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MISC.
FUND CURRENCY HEDGING Most mutual fund prospectuses give funds quite a bit of leeway when it comes to currency hedging. The majority of international funds, including Fidelity, American Funds, and Vanguard index funds, do no hedging. Some fund families, such as Janus, Oakmark, and First Eagle, have flexible hedging policies. For example, management at First Eagle have no view on currencies so they split the difference between the two extremes and hedge about 50% of their overseas portfolios. Still other fund families, such as Tweedy Browne, Longleaf Partners, and Mutual Series are either mostly or fully hedged all the time.
CORPORATE PROFITS Over the past 25 years (1982-2006), the economy’s average annual growth rate has been 5.9%, versus a 10.3% annual appreciation rate for S&P 500 stocks; if you add dividends, the annualized return for the S&P 500 has been 13.4%. In 2006, corporate profits represented 13% of national income, versus 9% in 1990 and 7% in 1982. The last time such profits represented 13%+ of the economy was in 1965. S&P 500 companies receive 40% of their earnings from abroad. However, the surge in earnings has also come at the expense of employees. The percentage of corporate profits going to employee wages and salaries has dropped from 56% in 1980 to 52% in 2006. All of this suggests corporate profits will likely slow in the future, meaning advisors may want to consider increasing their clients’ exposure to bonds, cash equivalents, and foreign equities.
PRESCRIPTION DRUG COVERAGE Roughly 24 million seniors and others eligible for Medicare benefits have signed up for the Medicare drug benefit. The average monthly premiums for the top three Medicare drug benefit plans are expected to rise to $29 in 2008, representing an increase of over 25% from 2007. The average 2008 premium among the top 10 carriers are expected to range from $20.70 to $40.35 per month. Many plans will require those covered to shoulder a larger share of the cost of drugs covered. However, a few insurers are lowering their fees for 2008. United-Health Group and Humana control about 44% of the drug-benefit market.
MISC.
7.3
When advising your clients about this benefit, compare monthly premium costs, the list of drugs covered by the insurer as well as the cost-sharing requirement. The class of drugs most severely affected in 2008 is “nonpreferred” brand-name drugs (e.g., Zocor and Celebrex). Medicare offers online tools (www.mymedicare.gov or www.medicare. gov) that include report cards that rate plans based on a number of factors, including customer service, drug pricing, ease of getting a prescription filled, out-of-pocket cost comparisons, and pharmacy networks in the area. Information can also be obtained by calling 1-800-medicare.
RATING HOSPITAL CARE One of the best sources for hospital data is www.hospitalcompare.hhs.gov. Hospital Care is a web site set up by the federal Centers for Medicare and Medicaid Services, hospitals, and other groups. Your clients can search by city, state, or other criteria and compare more than 5,000 hospitals against one another. Much of the “best practices” data provided by Hospital Care comes from Medicare data and focuses on three of the most common areas of hospital care: heart attack, pneumonia, and surgery. The table below provides a list of resources to help the advisor find quality hospitals.
Hospital Care Online Sources Source
Description
Hospital Compare www.hospitalcompare.hhs.gov
Hospital adherence to practices that improve patient care—no rating on how well patients do after treatment.
Leapfrog Group www.leapfroggroup.org
Consistency of how 1,300 hospitals follow 30 practices—only covers a fraction of the country’s 6,000 hospitals.
Nat’l Assoc. of Health Data www.nahdo.org/qualityreports.aspx
Which states provide consumer-friendly hospital data— no link to a state agency’s web site.
Agency for Healthcare Research www.talkingquality.gov/compendium/
Links to state agencies offering reports, databases, and other information on hospitals and health care organizations—some information is dated.
Health Grades www.healthgrades.com
Compare 5,000+ hospitals on 32 conditions and procedures, including complications and death rates— much information is free, but extensive reports are $18
Dartmouth Atlas www.dartmouthatlas.com
How hospitals care for patients shortly before they die, including hospice transfers and time spent in ICU— very detailed data makes searches complex.
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7.4
MISC.
LONGER LIFE EXPECTANCY A big mistake retirees make is underestimating their life expectancy. According to 2000 Census and American Society of Actuary data, there is a 25% chance that a 65-year-old couple will see one spouse live to age 97. According to the Department of Biological Sciences at Stanford University, it is estimated that life expectancies will increase by 20 additional years between 2010 and 2030, assuming anti-aging therapies become widespread.