QUARTERLY UPDATES Q3 2012
Š 2012 by Institute of Business & Finance. All rights reserved.
v1.1
Quarterly Updates Table of Contents INVESTMENTS MUNICIPAL BOND STRATEGY VENTURE CAPITAL HEDGE FUNDS ROYALTY TRUSTS THE VIX AND FUTURES
1.1 1.1 1.1 1.2 1.3
MUTUAL FUNDS MUTUAL FUND RETURNS MUTUAL FUND MANAGER CHANGES MORNINGSTAR TRACKING ERROR SHORT-TERM HIGH-YIELD BOND FUNDS WSJ FUND ANALYSIS ADOPTED MUTUAL FUNDS
2.1 2.1 2.1 2.2 2.2 2.3
ANNUITIES 2011 ANNUITY SALES VARIABLE ANNUITY SHARE CLASSES ANNUITY PRODUCT TRENDS FOR 2012 FIXED-RATE ANNUITIES
3.1 3.1 3.3 3.3
STOCKS DIVIDEND-PAYING STOCKS RISK LEVEL OF DIVIDEND-PAYING STOCKS PREFERRED STOCKS SEPTEMBER, OCTOBER, AND NOVEMBER
4.1 4.1 4.1 4.2
FINANCIAL PLANNING U.S. ENERGY GIFTS AND 529 PLANS
5.1 5.1
FINANCIAL PLANNING (CONT.) STATE ESTATE TAXES MEDICARE STRATEGY HOMEOWNERSHIP RATES HEALTH INSURANCE COSTS HOUSING PRICE UPDATE [SEPTEMBER 26, 2012] HOUSEHOLD NET WORTH MISCELLANEOUS STATISTICS CLIENT PRIMER: INVESTMENT THEORY CLIENT PRIMER: WHY DIVERSIFY
5.2 5.2 5.2 5.3 5.3 5.4 5.4 5.4 5.6
THE LAST BEAR MARKET HIGH PRICE OF BAD TIMING BUILDING A DIVERSIFIED PORTFOLIO REBALANCING MAY HELP AGE-BASED 529 PLANS LIFE EXPECTANCY HEALTH CARE COSTS
5.8 5.8 5.9 5.10
5.10 5.10 5.11
QUARTERLY UPDATES INVESTMENTS
Investments
1.MUNICIPAL
1.1
BOND STRATEGY
Starting with the 2013 tax year, high earners will start paying an extra 3.8 percentage points on investment income (to help pay for health care overhaul); this tax does not apply to municipal bond interest.
VENTURE CAPITAL According to a September 2012 article in The Wall Street Journal, the “common rule of thumb is that of 10 start-ups, only 3–4 fail completely.” The National Venture Capital Association believes 25–30% of venture-backed businesses fail. There are different definitions of “failure.” If “failure” is defined as an investor losing 100% of his investment in venture capital, it is likely 30–40% of high-potential start-ups fail. However, if “failure” is described as investors not getting the kind of projected return (e.g., a certain growth rate or return of principal by a specified date), then > 95% of start-ups fail. According to a Harvard professor, venture-backed companies tend to fail after their fourth year—when investors have stopped adding money to the business. Looking at all U.S. start-ups, ~60% survive for years and last approximately 10 years (source: U.S. Bureau of Labor Statistics). Of those that do not “survive,” some are acquired, and others simply languish. According to Dow Jones, of the over 6,600 U.S.-based companies initially funded by venture capital from 2006 and 2011, 84% are currently independently operated, 11% were acquired or had an IPO, and 4% went out of business.
HEDGE FUNDS As of September 2012, there were ~10,000 hedge funds, which collectively held $2.5 trillion in assets (source: eVentment/HFN). From 1980 through 2008, hedge funds averaged 12.6% a year (source: Ilia Dichev, Emory University, and Gwen Yu, Harvard). However, hedge fund investors only experienced a net return of 6.0% per year (largely due to chasing top performers after they experienced a large return). Over the same period, mutual fund investors underperformed mutual fund benchmarks by 1.5% per year by chasing hot performers (e.g., 9.4% vs. 10.9% for the S&P 500).
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Investments
1.2
One way to view hedge funds is that they generally fall into one of two categories: risk reducers or return enhancers. Morningstar lists over 250 mutual funds as “alternatives”—funds that use a hedge fund–type approach. Investors also have the option of using “replicator” mutual funds and ETFs (e.g., Goldman Sachs Absolute Return Tracker, Natixis ASG Global Alternatives, IQ Alpha Hedge Strategy, Marketfield Fund, and Merger Fund). Recent research shows hedge funds receive much of their return by owning assets that lack liquidity during market panics. This “liquidity-risk premium” translated into 10.6% annual returns from 1996 through 2009 versus 4.1% per year for hedge funds that had much more liquidity (source: Ronnie Sadka, Boston College). Red flags all hedge fund investors and advisors should be concerned with often center around “operational risks” (e.g., fund uses a little-known accounting firm, relies on its own model to value assets, and makes trades using its own brokerage arm).
ROYALTY TRUSTS A royalty trust collects and distributes income from oil and gas or mining operations. There are ~30 royalty trusts in the U.S. with a combined market value of ~$12 billion. Most are designed to self-liquidate in 20 years or less; these trusts have no employees or physical assets. A royalty trust holds the right to receive income from a fixed number of properties. Once established, the trust is frozen and cannot acquire any new assets. Since oil and gas as well as mines are depleting assets, yields from royalty trusts almost always decline as years pass by. When no money is left, these trusts disappear; unlike bonds, there is no remaining underlying principal. A number of investors do not realize that royalty trusts are not really a fixed-income alternative. Royalty trusts describe the likely income an investor will receive over the life of the trust. For example, one trust shows future available cash for distribution to be an estimated $1.4 billion, yet total market value was $2.3 billion. Another trust projects future payouts of $109 million and a market value of $123 million. Both sets of numbers show that investors will not even receive their principal back over the life of the trust, based on current market valuations.
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Investments
1.3
If total payouts are expected to be $1.4 billion and market value is $2.3 billion, investors appear to be willing to pay 61% more up front than what they will be cumulatively receiving over the trust’s life (remember, there is no return of principal at the end). This example would be a great opportunity for short sellers to arbitrage the difference, but royalty trusts are very thinly traded.
THE VIX AND FUTURES Investors often worry about market volatility. One hedging strategy is to look for investments that increase in value when markets decline in order to get some downside protection. VIX is an abbreviation for “volatility index.” Its actual calculation is complicated, but the basic goal is to measure how much volatility investors expect to see in the S&P 500 over the next 30 days, based on prices of S&P 500 Index options. When options traders think the stock market is likely to be calm, the VIX is low; when they expect big swings in the market, the VIX goes up.
VIX Index [Select Dates during Select Years] 1995
13
2007
10
1998
36
2008
61
2000
20
2010
19
2002
20
2011
16
2004
15
2012
19
During times of high market turmoil, the VIX has tended to rise. The VIX index moved steadily higher as the market approached the peak of the late 1990s technology bubble, calmed down during the steady growth period of 2003–2007, then spiked during the 2008 credit crisis and also in the latter half of 2011. Because of this pattern of behavior, the VIX is sometimes referred to as the fear index; when market participants are worried about the market, the VIX tends to rise. Investors who see the VIX having increased sharply while the market went down might be tempted to seek an investment in the VIX as a source of potential protection during market turbulence. QUARTERLY UPDATES
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Investments
1.4
Like all indexes, you cannot directly buy. Moreover, unlike a stock index such as the S&P 500, you cannot buy a basket of underlying components to mimic the VIX. Instead, the only way investors can access the VIX is through futures contracts. Index futures, such as those tied to the value of an index like the S&P or VIX, do not involve the actual delivery of anything when the futures contract matures. Instead, they use a cash delivery tied to the value of the index on the delivery date.
Contango The potential problem, as with any futures contract, is contango—when the futures price for something is > its current price. For example, if VIX is at 15 today and a one-month VIX futures contract is trading at 16, the VIX futures market is in contango. Imagine your goal is to always have a certain part of your portfolio invested in VIX futures. If the futures contracts are always more expensive than the current VIX level, then you pay a premium every time you buy futures. You are essentially buying high and selling low, which erodes the value of your investment over time. Contango is not purely academic. VIX futures contracts have often been more expensive than the VIX index. According to Bloomberg, in 50 of the past 73 months, the threemonth VIX futures contract was above the VIX level—68% of the time over a period just over six years. In the table below, you can see what $10,000 would be worth if it had been invested in the VIX itself versus a portfolio of short-term VIX futures contracts. These portfolios are based on actual ETFs that buy VIX futures contracts.
Value of $10,000 Investment [Short-Term VIX Futures vs. VIX Index] S.T. VIX
VIX Index
S.T. VIX
VIX Index
Apr. 2011
$10k
$10k
Jan. 2012
$12k
$14k
July 2011
$10k
$11k
Apr. 2012
$7k
$11k
Oct. 2011
$24k
$28k
July 2012
$5k
$13k
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Investments
1.5
Since April 2011, the futures contracts have lagged significantly behind the value of the VIX index. By the end of the time period, the value of $10,000 hypothetically invested in the VIX itself would have risen to almost $13,000 while the portfolios of futures contracts were worth $5,500. Had an investor actually been able to buy the VIX, the investment would have paid off during this time period; the actual investable instruments lost significant amounts of money. Just because an investment has VIX in its name does not mean that it will move in line with the VIX index. The VIX itself can be extremely volatile—the index lost 64% of its value between September 2011 and March 2012.
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QUARTERLY UPDATES MUTUAL FUNDS
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Mutual Funds
2.MUTUAL
2.1
FUND RETURNS
Over the past decade, 57% of active mutual fund managers failed to beat their benchmark indexes. For 2011, 84% underperformed (source: S&P).
MUTUAL FUND MANAGER CHANGES Advisors often wonder what to do when a favored mutual fund manager leaves a fund or simply retires. According to studies, when a new manager steps in, subsequent returns are somewhat mixed. For example, an August 2012 study from the University of Rochester shows there is, overall, no difference in returns. However, funds that trailed their benchmarks tended to perform better after the management change—an enhanced performance may likely be due to any fund’s returns that revert to the mean after periods of ups and downs. This also coincides with what happens when a manager of an aboveaverage performing fund leaves—returns tend to decline (reversion to the mean). Advisors who wish to take a different approach to a manager departing should consider the following: [1] Is the departing manager a core driver for fund performance? [2] How closely did the new manager work with the departing manager? [3] How much do sector weightings change with the new manager? [4] How many of the 10 largest holdings change with the new manager? [5] Has the fund’s overall turnover rate changed much?
MORNINGSTAR TRACKING ERROR According to Morningstar, “tracking error” is the amount a fund’s returns veer from its benchmark. For the 12-month period ending August 31, 2012, tracking error for bond funds was 2.2% (vs. 2% for the same period ending in 2011). For the five-year period before the 2008 meltdown, the deviation averaged 1.4% for a 12-month period.
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Mutual Funds
2.2
SHORT-TERM HIGH-YIELD BOND FUNDS Although rarely discussed, a diversified short-term high-yield bond fund may be the answer for advisors seeking to maximize return while staying somewhat conservative. For example, the Wells Fargo Advantage Short-Term High-Yield Bond Fund lost < 6% while the average high-yield fund was down > 26% in 2008. Although the Wells Fargo fund has been around for > 15 years, almost all short-term high-yield funds have been in existence for < a couple of years, including: SPDR Barclays Capital Short Term, PIMCO 0â&#x20AC;&#x201C;5 Year High-Yield Corporate Bond Index ETF, and the RiverPark Short Term High Yield. According to Lipper, over the past 20 years, the worst 12-month period for equityincome funds was March 2008 to February 2009 (-41%). The average real estate mutual fund lost 48% in just three months between September and November 2008. The worst 12 months for real estate funds was April 2009 to March 2009 (-59%). From March 2008 to February 2009, the typical emerging markets stock fund returned -58%. For high-yield bond funds, the worst 12 months over the past 20 years (1992â&#x20AC;&#x201C;2011) was December 2007 to November 2008 (-29%).
WSJ FUND ANALYSIS An October 2012 article in The Wall Street Journal (WSJ) recommends the following approach for overseeing a mutual fund: [1] Set realistic return expectations. [2] Top managers often have mediocre returns in ~3 out of every 10 years. [3] If a fund falters, give it at least two years to recover. [4] Large fund inflows may result in poorer returns in the future. [5] Look for funds that just had one to two years of bad returns. [6] If a client tends to panic during downturns, consider a balanced fund.
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Mutual Funds
2.3
The WSJ article also included a survey of WSJ readers who listed the mistakes they most often made with their mutual fund positions: Biggest Mistake
% of Respondents
Being Too Cautious
44%
Buying Too Late, Post Run-Up
18%
Picking a Volatile, Niche Fund
14%
Not Firing a Fund Soon Enough
14%
Not Diversifying Enough
7%
Firing a Manager Too Soon
3%
ADOPTED MUTUAL FUNDS In the typical adoption, a large mutual fund company takes over the management of one or more funds from a smaller firm, retaining the fund’s investment managers as subadvisors. There is usually a cash payment to the smaller firm based on the size of the fund, its track record, and the length of the track record. These “adoptions” are considered a prudent way for a fund family to expand its lineup. The average fund being adopted has $500 million to $2 billion in assets; some adopted funds have just $25 million. For the small funds, their managers may have more of a passion for the management of money and not for the management of the business. Adopted funds tend to have high ratings when it comes to returns. Fund adoptions usually require shareholder approval. Advisors should look for fee changes and possible changes in the fund’s investment objective.
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ANNUITIES
3.2011
3.1
ANNUITY SALES
Total annuity sales for 2011 were $231 billion ($155 in variable annuities [VAs] and the balance in fixed-rate annuities). Of this $231 billion total for 2011, $223 billion was invested in deferred annuities and less than $9 billion to immediate annuities. The vast majority of variable annuity sales are from 1035 exchanges (not new money). The ratio of net flow to total sales for 2011 was under 18%. Variable annuity net flows (new money) were < $28 billion of the $155 billion in total sales (new money + exchanges). In 2002, total net assets of annuities (fixed and variable) totaled $1.2 trillion, $2 trillion in 2007, and $2.2 trillion ($1.5 in VAs and $0.7 in fixed) by 2011. The table below shows the top 10 VA sellers for 2011 (source: Morningstar).
2011 Variable Annuity Sales [In Billions] Top 10 Sellers Company
Total Sales
% of 2011 Sales
MetLife
$29.5
19%
Prudential Financial
$20.2
13%
Jackson National
$17.5
11%
TIAA-CREF
$13.5
9%
Lincoln Financial Group
$9.4
6%
SunAmerica/VALIC
$8.0
5%
Nationwide
$7.7
5%
AXA Equitable
$7.0
5%
Ameriprise Financial
$6.4
4%
AEGON/Transamerica
$5.4
3%
Source: Morningstar
VARIABLE ANNUITY SHARE CLASSES A-Share Variable Annuities A-share annuities are similar to A-share mutual funds: an up-front sales charge, but no surrender charges. The commission charge is a percentage of each premium payment. A shares offer breakpoint pricing. Additionally, some companies include an investorâ&#x20AC;&#x2122;s purchase of other products offered by the company when computing breakpoints. Generally, A-share contracts have lower annual M&E fees than annuities with surrender charges. A shares are not nearly as popular as B shares. QUARTERLY UPDATES
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ANNUITIES
3.2
C-Share Variable Annuities Similar to C-share mutual funds, C-share VAs have no up-front or back-end fee. The investor can liquidate any or all shares at any time without cost or fee.
L-Share Variable Annuities There is no up-front sales charge with L shares, but there is usually a 3- to 4-year surrender period with fees. L shares often have M&E and admin fees higher than other share classes.
O Shares O shares combine features of A and B shares. O shares are designed for long-term investors. This share class is only offered by a very small number of insurers. An O share has no up-front charges (unlike A shares) but does have a deferred sales charge (just like B shares). During the surrender period, M&E expenses decline until they reach a level similar to M&E expenses for A shares (which is typically lower than M&E costs for B shares). The issue for brokers and advisors is likely to be a reduction in any commission trails.
X-Share Variable Annuities X-share VAs credit the contract with an additional amount (bonus), calculated as a percentage (1–6%) of the initial premium. For example, an investor’s initial investment of $100,000 might become $103,000 when the contract is first issued. X-share contracts typically have a longer surrender period and higher ongoing costs than contracts that do not offer a bonus. From a purely math perspective, the bonus (and any resulting compounding) makes sense only if the investor assumes an overall annual net return of 6–8% per year. Some of these products allow the insurer to recapture part or all of any bonus if the contract is surrendered within the first few years. There are also VA contracts that credit additional amounts to the contract if the investor adds money to the contract within the first several years. These are classified as persistency bonuses.
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ANNUITIES
3.3
Variable Annuity Sales Year
# Unique Products
# Companies Selling Variable Annuities
Average Funds Per Contract Type
2005
1,008
45
44
2008
1,491
40
51
2009
1,591
40
49
2010
1,694
40
50
2011
1,951
41
62
Source: Morningstar
VA sales for 2011: B shares = 60% / L shares = 24% / X shares = 7% / A shares = 3% / C shares = < 3% / I shares = < 3%
ANNUITY PRODUCT TRENDS FOR 2012 EIA sales have greatly benefited from three innovations: bonuses (percentage of initial premium purchase), GLWBs, and GMDBs. These three factors provide a strong incentive for 1035 exchanges. Less-used innovations include: income account/benefit base bonuses (money added to the amount from which future guaranteed lifetime income withdrawals are made), a bonus vesting schedule (lowers insurerâ&#x20AC;&#x2122;s cost and provides an incentive for investor to hold the contract), persistency bonuses (reward contract owners for keeping their contract), and annuitization bonuses (reward owners annuitizing their contracts). Here are some additional examples of product innovations and trends with annuities in general: [1] dual-sleeve guaranteed withdrawal structures (AXA, Allianz), [2] percentage and step-ups tied to U.S. Treasury rates (AXA, Allianz), [3] step-ups during the withdrawal phase (SunLife), [4] guarantee tied to account value and increasing withdrawal percentage (Protective), [5] long-term care rider (Lincoln), [6] VIX-based fee structure on a withdrawal benefit (SunAmerica), [7] O shares (Pru, SunLife, SunAmerica), and [8] fee-based I shares (various insurers).
FIXED-RATE ANNUITIES No insurer has ever missed an annuity payment. In 2011, the GAO endorsed fixedrate annuities as a source of income for middle-income retirees. QUARTERLY UPDATES
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ANNUITIES
3.4
Fixed-Rate Annuity Sales Year
Billions Sold
2007
$57
2008
$107
2009
$104
2010
$76
2011
$76
Source: Beacon Research
Long-Term Care/Confinement Benefits Linked-benefit annuities cover costs of long-term care insurance by providing a benefit that is a multiple or percentage of the annuity contractâ&#x20AC;&#x2122;s value. The insurer (annuity issuer) pays for this benefit by taking a fee from the contract. This type of long-term care protection usually costs quite a bit less than an individual long-term care policy; if the long-term care benefit annuity rider is never used, the contract owner still has something of value (the annuity). A potential advantage of a linked-benefit annuity is gaining protection without having to complete a medical questionnaire or pass a medical exam. During 2011, a modest number of fixed-rate annuities included GLWBs that doubled or tripled in value if long-term care was needed. Long-term care insurance (LTCI) is purchased by individuals or through a companyâ&#x20AC;&#x2122;s group benefit plan. Individually sold policies accounted for > 75% of LTCI premiums collected in 2011. Only a modest number (7.2 million) of Americans have LTCI.
Retirement Middle-income baby boomers have a number of concerns about future retirement: 21% have little or no confidence, 48% question their knowledge about investing, and 57% have not used an advisor or broker to coordinate their long-term finances. People retiring today face two problems: retirement has become more expensive (longevity and health care costs) while traditional retirement income sources have diminished as the age to receive maximum Social Security benefits has increased and fewer Americans are covered by traditional pension plans and retiree health insurance.
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QUARTERLY UPDATES STOCKS
Stocks
4.DIVIDEND-PAYING
4.1
STOCKS
Of the 500 stocks in the S&P 500, 402 now pay a quarterly dividend, the highest level since 1999. S&P 500 dividends represent an average of 33% of earnings for these companies; historically, S&P dividends have been 50% of earnings (source: S&P).
RISK LEVEL OF DIVIDEND-PAYING STOCKS There is a perception that dividend-paying stocks are safer than the market as a whole; if stocks suffer a large loss, dividend payers will drop less. However, the 100 highest dividend-paying stocks in the Russell 1000 Index have a beta of 0.96, making their market-related risk almost the same as the S&P 500 (which always has a beta of 1.0). With this presumption of increased safety by going into dividend-paying stocks comes a trade-off often not considered: swapping one risk for another. For example, seeking higher dividends may mean a much higher concentration in just a few sectors. Telecom (21 P/E), utilities (17 P/E), and consumer staples (15 P/E) are considered “defensive sectors.” But these three sectors have P/E ratios higher than the S&P 500’s (source: 12month trailing P/Es, as reported by FactSet in September 2012). Consider another sector: food, beverage, and tobacco companies. This group has a trailing P/E of 18.7 as of mid-September 2012 (vs. 14.5 for S&P 500). Yet some of the companies in this group have a P/E as high as 32.
PREFERRED STOCKS As of September 2012, the preferred stock market was valued at $500 billion. The yield of the S&P U.S. Preferred Stock Index was 6% versus ~2% for the S&P 500. These hybrid securities often have a call feature. Some preferreds can be converted to common stock. But just like common stocks, the dividend can be cut or cancelled without notice by the company’s board of directors. During the financial crisis, the preferred stock index fell 63% from July 2008 to the market low in March 2009. Over the same period, the S&P 500 dropped 46%. This greater loss was largely due to the fact that many preferreds have a junk rating. Banks and other financial firms issue most preferreds. Financing for these companies is no problem during decent economic times, but money can dry up when credit is tight.
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Stocks
4.2
As a generality, just 5–10% (or less) of a client’s fixed-income portion of a portfolio should be considered for preferreds. Examples of preferred funds include: PowerShares Preferred ETF, Market Vectors Preferred Securities ex-Financials, Global X “Super Income” Preferred ETF, and iShares S&P Preferred Stock Index.
SEPTEMBER, OCTOBER, AND NOVEMBER Since 1926, large company stocks (S&P 500) have gone up an average of 0.9% per month. In September, these same stocks have lost an average of 0.8%. Large cap stocks have risen in just 50% of every September since 1926, far below the average of 62% for all months. The table below shows how three broad categories of U.S. stocks have fared since 1926 (source: Bank of America Merrill Lynch).
Average Monthly Returns for U.S. Stocks [1926–2011] Sept.
Oct.
Nov.
Large Cap
-0.8%
0.5%
1.4%
Mid Cap
0.8%
0.0%
1.8%
Small Cap
-0.5%
-0.5%
1.6%
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QUARTERLY UPDATES FINANCIAL PLANNING
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Financial Planning
5.U.S.
5.1
ENERGY
During September 2012, natural gas was selling for $2.50 to $3.00 per thousand cubic feet. Production costs for natural gas have fallen dramatically over the past few years, largely due to advances in directional drilling and hydraulic fracturing. Fracturing is the process of injecting enormous amounts of fluid (90% water, < 10% sand, and < 1% chemical additives) into the ground below the water table. It is likely that natural gas will provide the cheapest source of energy—projected to be six cents a kilowatt-hour: > 20% cheaper than new coal and nuclear or most renewable alternatives. Exporting natural gas has its own set of economics (per thousand cubic feet): [1] add 15% to the cost due to gas loss during the liquidation process, [2] liquidation costs are between $2.50 and $3.00, [3] shipping ranges from $0.85 to $2.80, depending on whether the liquefied gas is going to Europe or Asia, and [4] converting the liquefied gas back to natural gas costs an additional $0.40. Historically, the ratio between the cost of natural gas and oil on an energy-equivalent basis has been one to six. Today, that ratio is far higher due to the greatly decreased price for natural gas. The North Dakota Bakken/Three Rivers field produces 600,000 barrels of oil a day, up from 250,000 barrels in 2008. It is now estimated that the U.S. can economically (selling at $70 a barrel) and technically recover 45 billion barrels of oil, representing 10% of total North America oil in place.
GIFTS AND 529 PLANS There are 18 states (plus D.C.) that have an estate tax lower than the federal amount; only Connecticut has a gift tax (for annual gifts > $13,000), according to CCH. Surprisingly, a gift made to a 529 plan for someone other than your spouse is excluded from the donor’s estate even though the donor can access account principal for his own personal use without penalty or taxation. The donor can also access 529 plan earnings but will incur income taxes and a possible 10% penalty on such growth. What makes this “surprising” is that the donor, who is the custodian of the 529 account, still has a constructive receipt, yet the account value is not considered part of the donor’s estate.
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Financial Planning
5.2
STATE ESTATE TAXES In 2001, all 50 states had a death tax. By the summer of 2012, only 19 states still had such a tax.
MEDICARE STRATEGY Medigap insurance covers the 20% of costs not covered by Medicare Part B. These optional supplemental plans cover nine types of standardized policies offered by companies such as AARP and Blue Cross/Blue Shield. Medicare Part D (prescription drugs) is not standardized; the drugs covered and their costs vary by policy. Medicare Part C, sometimes called an Advantage Plan, allows your clients to opt out of traditional Medicare and sign up for a private version. Part C is intended to provide equivalent services of Medicare Parts A, B, and D and Medigap. Part C is promoted as a less-expensive alternative because the patient is limited as to what providers can be used. If a Part C participant uses a doctor or hospital outside the network, costs can be considerably more. Financial advisors may wish to use the services of outside consultants when helping clients with Medicare questions. The U.S. government funds a nationwide network of free State Health Insurance Assistance Programs (SHIPs). These companies provide information about Medicare enrollment, plan selection, claims, disputes, and appeals. For $80 to $150 an hour, patients with a more complex situation may consider using forprofit organizations.
HOMEOWNERSHIP RATES According to the Census Bureau, homeownership in the U.S. was 65.4% in March 2012, the same level it was in early 1997. The rate peaked at 69.2% at the end of 2004. The rate has steadily fallen since housing prices started to decline in 2006. Median rent for Q1 2012 was $721, its highest level since early 2009.
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Financial Planning
5.3
HEALTH INSURANCE COSTS For 2012, the average cost for health care insurance for a family was $15,745 (source: Health Research & Educational Trust). Workers contributed an average $4,316 toward the cost of a family plan (28% of total premium). Employer premiums for a single person were $5,615 for 2012.
HOUSING PRICE UPDATE [SEPTEMBER 26, 2012] For the first six months of 2012, home prices increased 5.9%, according to the S&P/Case-Shiller 20-City Index. The index tracks 20 metropolitan areas and reports on a two-month delay. The index was among the first to use repeat sales as its methodology— measuring prices of the same homes that have two or more recorded sales. Home sale pairs are accumulated in rolling three-month periods to keep sample sizes large enough. Before Case-Shiller, the most widely watched home-price measure was from the National Association of Realtors (NAR). NAR uses a median sales price for thousands of different types of homes in hundreds of locations that sell in a given period. Median prices can be skewed when there is a shift in the “mix” of what is selling: the number can turn higher in months where more expensive homes are sold, revealing little about the direction of prices. CoreLogic Inc. and the Federal Housing Finance Agency (FHFA) also use repeat-sales measures. CoreLogic covers transactions in ~80% of the country, a wider scope than Case-Shiller’s. The FHFA index is based on the sales of homes which Fannie Mae and Freddie Mac guarantee or purchase the loan. As a result, it does not track more expensive homes. The FHFA index is unit-weighted, meaning all sales count equally. CaseShiller is value-weighted, giving greater emphasis to more expensive properties; high-cost markets such as New York and Los Angeles have an outsize effect. The FHFA index shows prices rose 34% from 2003 to 2007; prices are now ~16% below their peak. Case-Shiller shows a 52% gain from 2003 until peaking in mid-2006; prices are still ~30% of their peak (as of September 2012).
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HOUSEHOLD NET WORTH As of the end of June 2012, the market value of U.S. household real estate was $19.1 trillion, still below its all-time high of $25 trillion in the mid-2000s. Owners’ equity as a percentage of the market value of household real estate was 43.1% as of the end of the second quarter of 2012. Stocks and real estate each represented 25% of householdsector assets; the remaining 50% of household assets were in pension funds, life insurance cash values, bonds, cash, and savings accounts.
MISCELLANEOUS STATISTICS Since 1946, there have been 11 bear markets for the S&P 500; these market drops of at least 20% occur at an average of one out of every six years. Total foreign spending by the U.S. ($37 billion) represents < 1% of its $3.8 trillion budget (source: Office of Management and Budget). The country’s largest public pension fund (California Public Employees’ Retirement System) reduced its target rate return from 7.75% to 7.50% in March 2012. The average licensed driver logs in 12,700 miles per year. This translates into 18 hours and 31 minutes spent during the week behind the wheel of a car. For the 12 months ending March 31, 2011, 73,000 reverse mortgages were completed in the U.S. From 2005 to 2009, the use of federally insured reverse mortgages increased 170% (source: SmartMoney magazine, November 2010).
CLIENT PRIMER: INVESTMENT THEORY An early description of theory and markets came from the 1900 dissertation of French mathematician Louis Bachelier: “Past, present, and event discounted future events are reflected in market price … the determination of these fluctuations depends on an infinite number of factors; it is therefore impossible to aspire to mathematical prediction of it …”
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A few decades later, the Cowles Commission for Research in Economics (home to academics such as Nobel laureates James Tobin and Harry Markowitz) published its research on market forecasting by summarizing that the markets outperformed forecasters. A 1934 landmark publication, Security Analysis by Graham and Dodd, heralded the age of fundamental analysis. Graham and Dodd stressed balance sheet analysis (the “fundamentals”). The authors strongly recommended that a stock should only be purchased when its fundamentals met or exceeded a number of criteria. Their focus was on individual stocks, not the portfolio. The most famous and successful disciple of Graham and Dodd has been Warren Buffett: “Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value…. While they differ greatly in style, these investors are mentally always buying the business, not buying the stock.” Using a far different approach, Harry Markowitz—beginning with his 14-page March 1952 article in the Journal of Finance, “Portfolio Analysis with Factors and Scenarios”— wrote, “You should be interested in risk as well as return.” Markowitz’s premise was simply genius: risk is central to investing; and the portfolio, not a particular position, is fundamental for investment management. Harry’s original article evolved into his 1955 thesis; the full description was published in 1959 as Portfolio Selection: Efficient Diversification of Investments. This work is now referred to as modern portfolio theory. Suppose you have two stocks or even two asset categories; each position has an expected return of 10% a year and a standard deviation of 10%. Prior to Markowitz, the standard deviation of a 50/50 portfolio of these two assets was believed to be 10%. In fact, the standard deviation of such a portfolio would only be 10% if the two positions had a perfect correlation coefficient (1.0). Suppose the correlation were 0.5 (considered random). The standard deviation for the portfolio would then drop to 8.7% (a 13% decrease). Now consider an equally weighted two-asset class portfolio constructed from two of the following three investments: Return
Std. Dev.
Correlation with A
Investment A
8%
15%
Investment B
6%
10%
0.3
Investment C
6%
8%
0.9
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Here, the focus should be on correlation coefficients, particularly since B + C are expected to have the same return. And even though C has a standard deviation higher than B, the advisor should choose A + B because the overall portfolio’s risk level is lower than it is with A + C. Return
Std. Dev.
Investment A + B
7%
10.2%
Investment A + C
7%
11.2%
When looking at systematic risk (which cannot be diversified away) and unsystematic risk (which can be completely eliminated), it has been shown that a portfolio of 10–12 poorly correlated stocks eliminates the vast majority of unsystematic risk. This is quite desirable since there is no net benefit to having unsystematic risk. Markowitz’s efficient frontier, which shows the most efficient (highest) return for each level of risk, presents numerous important concepts: There is no perfect portfolio. There are an infinite number of efficient portfolios. Efficient portfolios fall along the efficient frontier. Current portfolios may be improved by repositioning assets resulting in o greater return with the same risk level as the current portfolio, o same return but less risk than the current portfolio, or o greater return and sometimes less risk.
CLIENT PRIMER: WHY DIVERSIFY The goal of diversification is not to boost performance—it will not ensure gains or guarantee against losses—but it can help set the appropriate level of risk for an investor’s time horizon, financial goals, and tolerance for portfolio volatility. At the heart of diversification lies the concept of correlation. Simply put, correlation is a measure of how returns of two assets move together (i.e., whether their returns move in the same or in opposite directions and how often).
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Correlation is a number from -100% to 100% that is computed using historical returns. A correlation of 50% between two stocks, for example, means that in the past when the return on one stock was going up, then about 50% of the time, the return on the other stock was going up too. A correlation of -70% tells you that historically 70% of the time, they were moving in opposite directionsâ&#x20AC;&#x201D;one stock was going up, and the other was going down. When you put assets together in a portfolio that have low correlations, you may be able to get more returns while taking on the same level of risk or the same returns with less risk. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return. To build a diversified portfolio, an investor should look for assets whose returns have not historically moved in the same direction and, ideally, assets whose returns move in the opposite direction. That way, even if a portion of a portfolio is declining, the rest of the portfolio may be growing. Thus, you can potentially dampen the impact of poor market performance on your overall portfolio. Another important aspect of building a well-diversified portfolio is to stay diversified within each type of investment. Within individual equity holdings, beware of overconcentration in a single stock. For instance, you may not want one stock to make up more than 5% of your stock portfolio. It is also smart to diversify across stocks by capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions prosper at the same time; so you can help reduce portfolio risk by spreading your assets. If you are investing in funds, you may want to consider a mix of styles, such as growth at a reasonable price, quality growth, and aggressive growth. Similarly, if you need to increase your bond allocation, consider bonds with varying maturities, styles, and sensitivities to inflation and interest rate changes. If you are investing in funds, you will want to consider whether they have been strong, consistent performers relative to their stated objectives and styles. Just because your investments have not been historically correlated when you choose them, that does not mean they will stay that way. Correlation can change dramatically and rapidly in volatile markets. Assets can become highly correlated, meaning their returns move in the same direction. This reduces the short-term benefit of diversification, which is what happened during the bear market downturn of 2008â&#x20AC;&#x201C;2009, but it does not reduce the long-term appeal of diversification.
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The Last Bear Market During the 2008–2009 bear market, the correlations of U.S. stocks (Dow Jones Wilshire 5000) to virtually every type of asset except Treasury bonds (not shown below) increased sharply. As the chart below shows, correlations of U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from being negatively correlated to U.S. stocks to being positively correlated. All of this reduced the effectiveness of diversification during this period.
Correlation to U.S. Stocks September 2008
February 2009
Foreign Stocks
81%
91%
Emerging Markets Stocks
76%
83%
U.S. High-Quality Bonds
-14%
29%
U.S. High-Yield Bonds
54%
89%
Cash
-4%
24%
High Price of Bad Timing Unfortunately, many investors struggle to realize the benefits of their investment strategy because they sell out of stocks when they are falling or change their investment mix to chase the returns of a rising stock market—a practice known as market timing. Trying to time the market is notoriously difficult. A study by Dalbar has shown that investors trail the market significantly. This means the decisions investors make about diversification and when to get into or out of the market, as well as fees, cause them to generate far lower returns than the overall market. The table below (source: QAIB and Dalbar) shows returns for a 20-year period (1991–2010). Although the S&P 500 outperformed a 60/40 mix (9.1% vs. 8.8%), it did so with far greater volatility. The table also shows how mutual fund investors have fared poorly compared with their respective index (3.8% vs. 9.1%, 2.6% vs. 6.8%, and 1.0% vs. 6.9%).
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January 1, 1991 to December 31, 2010 Investment
Annualized Return
S&P 500
9.1%
Average Equity Fund Investor
3.8%
60% S&P 500 + 40% Barclays Bond Index
8.8%
Average Asset Allocation Fund Investor
2.6%
Barclays Aggregate Bond Index
6.9%
Average Fixed-Income Fund Investor
1.0%
Building a Diversified Portfolio The investment mix (e.g., stocks, bonds, and short-term investments) should be aligned to your investment time frame, financial needs, and comfort with volatility. The sample target asset mixes below show some asset allocation strategies that blend stock, bond, and short-term investments to achieve different levels of risk and return potential.
Portfolio Returns: 1926â&#x20AC;&#x201C;2010 Best 1 Year
Worst 1 Year
Best 5 Years
Worst 5 Years
Average (1926-2010)
Short-Term
15%
0%
11%
0%
4%
Conservative
31%
-18%
17%
0%
6%
Balanced
77%
-41%
23%
-6%
8%
Growth
110%
-53%
27%
-10%
9%
Aggressive Growth
137%
-61%
32%
-14%
9%
Very Aggressive
163%
-68%
36%
-17%
10%
Note: Short-Term = U.S. T-Bills / Conservative = 50% bonds, 30% T-Bills, 14% S&P 500, and 6% foreign stocks / Balanced = 40% bonds, 35% S&P 500, 15% foreign stocks, and 10% T-Bills / Growth = 49% S&P 500, 25% bonds, 21% foreign stocks, and 5% T-Bills / Aggressive Growth = 60% S&P 500, 25% foreign stocks, and 15% bonds / Very Aggressive = 70% S&P 500 and 30% foreign stocks.
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Rebalancing May Help Just diversifying is not enough. Once you have a target mix, keep it on track with periodic checkups and rebalancing. If you do not rebalance, a good run in stocks could leave your portfolio with a risk level inconsistent with your goal and strategy. Consider a hypothetical growth portfolio with 70% in stocks (49% U.S. and 21% foreign), 25% bonds, and 5% short-term investments in March 1992. A decade later, at the end of March 2002, the bull market of the late 1990s would have changed the investment mix dramatically to nearly 80% in stocks (64% U.S. and 14% foreign), 19% in bonds, and 3% in short-term investments. The portfolioâ&#x20AC;&#x2122;s risk level as of March 2002 was 12% greater than that of the target mix due to changes in the asset allocation associated with the relative returns of stocks, bonds, and cash. By the end of March 2012, changes in the stock market would have reduced the allocation slightly for stocks to 77%, closer to the target but still significantly above it. The stock mix also shifted significantly to 61% in the U.S. and 16% in other parts of the world. The bond and short-term allocations were also off. This added to a portfolio risk level 10% higher than the target due to changes in investment mix.
AGE-BASED 529 PLANS As of September 2012, there were 170 age-based investment tracks within 529 plans (source: WSJ). The difference between fund offerings can be wide. For example, one aggressive age-based option leaves 28% of the portfolio in equity funds when a child is in college; the least aggressive offering has 0% in stocks at the time. For individual investors and advisors, there are a few sources that can help them decide which age-based track to select. Morningstar and Savingforcollege.com both rate 529 plans and include online comparison tools.
LIFE EXPECTANCY Life expectancy has increased dramatically; a person born in 2010 can expect to live to age 79, 32 years longer than a person born in 1900. More importantly, there has been an increase in the life expectancy of a 65-year-old. In 1980, the average life expectancy for a 65-year-old male was 79.1 years. In 2010, this number increased to age 82.7. These extra three years has a great impact on retirement security.
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Say a person has annual expenses of $50,000 in retirement; expenses for 14 years total $700,000. If this 65-year-old lives 17 years (instead of 14), the three additional years adds another $150,000 (a 21% increase). Now factor in inflation. For someone living 14 years (65 to age 79), a 3% annual inflation rate means $854,000 will be needed; adding another three years (to age 82) increases the total needed expenses to $1,088,000 (27% higher).
HEALTH CARE COSTS In 2010, health care costs accounted for 17% of the GDP; it is projected to reach ~20% by 2017. The typical person covered by Medicare will have out-of-pocket medical expenses of more than $4,300 per year ($8,600 for a couple). These figures include health care premiums, copays, and expenditures not covered by Medicare. It is estimated a healthy 65-year-old couple will need $260,000 to pay for health care and LTC costs for the remainder of their lives. The cost of nursing home care is expensive: national average rates for a private room are $1,250 daily or $90,000 annually in 2010; the national average rate in 2010 for a semiprivate room was $78,000 a year. Premiums for Medicare Part B are taking a growing bite out of Social Security checks. For 2012, Medicare Part B premiums will account for 8.2% of the average Social Security benefit, up from 5.1% in 2000. While the average Social Security check is 31% higher than it was in 2001, premiums for Medicare Part B have doubled.
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