Personal Finance – Page 7

How To End Index Gaming

Posted on 11 July 201512 July 2015 by David Merkel

There was an article at Bloomberg on gaming additions to and deletions from indexes, and at least two comments on it (one, two). ?You can read them at your convenience; in this short post I would like to point out two ways to stop the gaming.

Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
Control your index so that additions and deletions are done at your leisure, and not in any predictable way.

The gaming problem occurs because index funds find that they have to buy or sell stocks when indexes change, and more flexible investors act more quickly, causing the index funds to transact at less favorable prices. ?You never want to be in the position of being forced to make a trade.

The first solution means using an index like the Wilshire 5000, which in principle covers almost all stocks that you would care about. ?Index additions would happen at things like IPOs and spinoffs, and deletions at things like takeovers — both of which are natural liquidity events.

Solution one would be relatively easy to manage, but not everyone wants to own a broad market fund. ?The second solution remedies the situation more generally, at a cost that index fund buyers would not exactly know what the index was in the short-run.

Solution two destroys comparability, but the funds would change the target percentages when they felt it was advantageous to do so whether it was:

Make the change immediately, like the flexible investors do, or
Phase it in over time.

And to do this, you might ask for reporting waivers from the SEC for up to x% of the total fund, whatever is currently in transition. ?The main idea is this: you aren’t forced to trade on anyone else’s schedule. ?The only thing leading you would be what is best for your investors, because if you don’t do well for them, they will leave you.

Now, that implies that if you were to say that your intent is to mimic the S&P 500 index, but with some flexibility, that would invite easy comparisons, such that you would?be less free to deviate too far. ? But if you said your intent was more akin to the Russell 1000 or 3000, there would be more room to maneuver. ?That said, choosing an index is a marketing decision, and more people want the S&P 500 than the Wilshire 5000, much less the US Largecap Index.

So, maybe with solution two the gaming problem isn’t so easy to escape, or better, you can choose which?problem you want. ?Perhaps the one bit of practical advice here then is to investors — choose a broad market index like the Wilshire 5000. ?At least your index fund won’t get so easily gamed, and given the small cap effect over time, you’ll probably do better than the S&P 500, even excluding the effects of gaming.

There, a simple bit of advice. ?Till next time.

Avoid Indexed Life Insurance Products

Posted on 8 July 2015 by David Merkel

Everyone reading should know that I am an actuary, as well as a quant and a financial analyst. ?Math is my friend.

Math is not the friend of many of my readers, so I usually don’t bother them with the math. ?Tonight’s post will be no different. ?It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.

What is the return that you get from an indexed annuity? ?It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option? ?You get the return on T-bills plus zero to a slight negative percentage. ?So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.

Why is that? ?Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller. ?There are some exceptions to this rule, but it favors at-the money option sellers, never buyers.?Buying options is what happens with?indexed annuity products.

Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average. ?That doesn’t affect my point. ?With games of chance, some get get good outcomes, and other get bad outcomes.

Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down. ?True enough. ? What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund. ?You may even earn more investing in their high yield fund, or even their bond market index fund.

In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company. ?In an insolvency, your policy will be affected. ?The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.

Add to that the illiquidity of the product. ?Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy. ?For most people, the surrender charge psychologically locks them in.

Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average. ?That’s all, aside from the postscript.

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Postscript

How does an insurance company make a profit on an indexed annuity? ?They take the proceeds of the sale, pay the agent, and use the rest to invest. ?About 90% of the money will be invested in a bond that will cover the minimum guarantee. ?The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and?a charge for profit. Not a lot is typically left in a low yield environment like this. ?The company tries to buy the most attractive options that they can on a limited budget. ?Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.

Stocks or Bonds?

Posted on 19 June 201521 June 2015 by David Merkel

I was writing to potential clients when I realized that I don’t have so much to write about my bond track record as I do my track record with stocks. ?I jotted down a note to formalize what I say about my bond portfolios.

One person I was writing to asked some detailed questions, and I told him that the stock market was likely to return about 4.5%/yr (not adjusted for inflation) over the next ten years. ?The model I use is the same one as this one used by pseudonymous Philosophical Economist. ?I don’t always agree with him, but he’s a bright guy, what can I say? ?That’s not a very high return — the historical average is around 9.5%. ?The market is in the 85th-90th percentiles of valuation, which is pretty high. ?That said, I am not taking any defensive action yet.

Yet.

But then it hit me. ?The yield on my bond portfolio is around 4.5% also. ?Now, it’s not a riskless bond portfolio, as you can tell by the yield. ?I’m no longer running the portfolio described in Fire and Ice. ?I sold the long Treasuries about 30 basis points ago. ?Right now, I am only running the Credit sensitive portion of the portfolio, with a bit of foreign bonds mixed in.

Why am I doing this? ?I think it has a good balance of risks. ?Remember that there is no such thing as generic risk. ?There are many risks. ?At this point this portfolio has a decent amount of credit risk, some foreign exchange risk, and is low in interest rate risk. ?The duration of the portfolio is less than?2, so I am not concerned about rising rates, should the FOMC ever do such a thing as raise rates. ?(Who knows? ?The economy might actually grow faster if they did that. ?Savers will eventually spend more.)

But 10 years is a long time for a bond portfolio with a duration of less than 2 years. ?I’m clipping coupons in the short run, running credit risk while I don’t see any major credit risks on the horizon aside from weak sovereigns (think the PIIGS), student loans, and weak junk (ratings starting with a “C”). ?The risks on bank loans are possibly overdone here, even with weakened covenants. ?Aside from that, if we really do see a lot of credit risk crop up, stocks will get hit a lot harder than this portfolio. ?Dollar weakness and US inflation (should we see any) would also not be a risk.

I’ve set a kind of a mental stop loss at losing 5% of portfolio value. ?Bad credit is the only significant factor that could harm the portfolio. ?If credit problems got that bad, it would be time to exit because credit problems come in bundles, not dribs and drabs.

I’m not doing it yet, but it is?tempting to reposition some of my IRA assets presently in stocks into the bond strategy. ?I’m not sure I would lose that much in terms of profit potential, and it would increase the overall safety of the portfolio.

I’ll keep you posted. ?That is, after I would tell my clients what I am doing, and give them a chance to act, should they want to.

Finally, do you have a different opinion? ?You can email me, or, you can share it with all of the readers in the comments. ?Please do.

At RT/America’s Boom/Bust

Posted on 16 June 2015 by David Merkel

I had the fun today of taping a segment with Ameera David on RT Boom/Bust. The above video covers the first half of the session, and lasts about seven minutes. We covered the following topics (with links to articles of mine, if any are applicable):

Bond Market Illiquidity
Stock Market Valuations
The Slowness of the FOMC
Why?many retail investors get skunked by the market
How to invest in this environment
Potential?Equity Market Sector Picks

The second half, should it make it onto the show, deals mostly with international issues. ?Enjoy the video, if you want to.

Yes, Build the Buffer

Posted on 5 June 2015 by David Merkel

Photo Credit: www.SeniorLiving.Org also Ken Teegardin

I was riding home with child number seven after a basketball practice about four months ago — this is the child that if any of mine has the capability of taking over for me someday, this is the one. She said to me, “Dad, I always knew we were better off than most, but it finally sank home to me how much better off we are than most of the people we know.”

Me: “What do you mean?”

7: “I’ve been talking with my friends after basketball practice, after church, and other times, and I hear about what happens when their parents?have a?$500 surprise bill for a repair, and things like that. ?They have to scrape for months to deal with the added expense, and they can’t do a lot of things that they do normally while they rebuild their finances.”

Me: “Okay, so what makes us different?”

7: “We just had three disasters hit us at the same time, and you just dealt with them for the long term without making?a lot of noise about it. ?Had that happened to any of my friends’ families, they would not know what to do, it would be impossible for them to do it without help.”

Me: “Actually there are a few of your friends whose families would likely survive what hit us easily, but yes, you’ve hit on something that I think is the most significant initial lesson on finance for the 75% of the population on the low end of incomes. ?People need to start saving early, and build a buffer against disasters, etc.? If I were going to give a talk at most churches on personal finance, I would talk only about that, and almost nothing more. ?Earn, budget, save, and be generous. ?After that, we can talk about investing, but it is only relevant to a minority of the population with enough discipline to save early and often, initially aiming for 3-6 months of expenses.”

7: “When did you and Mom finally have that much saved?”

Me: “Going into our marriage back in 1986. ?I had been a graduate student, and your mom a high school teacher in one of the poorest school districts in California, but we still both lived low on the hog, and saved money. ?That gave us enough money that we were able to buy a small house at an opportunistic time six months after we married. ?Within a year, we had rebuilt the buffer, and we haven’t been without it since.”

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In personal finance, you have to develop good habits early, and learn that life isn’t about how much you spend. ?I try to teach my kids that — Seven understands it, as does three or four of her siblings. ?The other three or four don’t understand, despite my best efforts — some of it seems to be personality-driven, but I have seen one or two of them change and get better at money management. ?We’ll see… they are still developing.

In finance, you have to focus on what you can control. ?You have reasonable control over ordinary spending. ?You have less control over what you earn, and almost no control over accidents and investment returns. ?Thus the first bit of advice is to live below your means and save. ?The second bit is to plan against catastrophes on a reasonable level. ?Insurance can be useful to protect against some of the worst outcomes. ?Just remember, insurance?is an expense and not an investment.

Along with the above article cited, note these four basic articles and one book review on personal finance:

The last one is useful for learning to live less expensively, while still having most reasonable comforts that others have.

Now, what I have written about above has been noted in the financial media lately regarding a study done by JP Morgan on how many people don’t keep a buffer around, no matter how much they earn. ?Here are two articles that talk about that study (one, two?– good articles both, read them if you can). ?Personally, I’m not surprised having worked with people who earned a lot and spent to the limit. ?They lived far more opulent lives than I do, but decided they would save later.

If you want to save, start now. ?Most good habits have to be started now, or they won’t get started. ?Most good intentions don’t die from a frontal assault, but from the idea that you have plenty of time to change. ?As a result — you don’t change. ?And that is not just you, it is me in my life also. ?Change must start now, or it does not start.

Two more articles worth a read:

Are You Overlooking Big Threats to Your Finances??(Jonathan Clements is always good), and
Five Things New Grads Should Do When?They Get Their First Paycheck

These largely follow my point of view on personal finances. ?Save, protect against bad risks, and take moderate risks to earn money both in work and in investing. ?You can do it too, but remember, it is not a question of knowledge, it is a question of whether you have the will to do it or not. ?I wish you the best in your efforts.

Now if you haven’t done it yet, go build the buffer.

Advice to a Friend on a Concentrated Private Stock Position from His Employer

Posted on 28 May 2015 by David Merkel

Photo Credit: Jugbo || A puzzle to solve…

From a friend of mine:

About a quarter of my assets are in my company stock. I have been counting this as a stock in my portfolio, but now I am wondering if that might be making my portfolio too conservative. The company is privately held, and they manage the “price”, so that it goes up consistently with the growth of the company. As long and the company does not go bust, this seem to be more stable than a stock fund.

What do you think?

I don’t think you are being too conservative. ?Count it as stock. ?Here’s why:

Don’t look at the price, on the first pass. ?Consider the underlying stability of the company. ?Here’s a way to think about it: if the company borrowed money over the intermediate-term from a bank, or floated a bond, what kind of rate would they pay? ?Would they be considered investment grade, and pay a low interest rate, or would they be more like a high-yield bond, where both the covenants on the debt and the yield paid are significant.

If it would be an investment grade lending risk, you might be able to think about it as partially stock and partially a bond. ?If not, then stock. ?Regardless of how you think about it, you have to realize that you are running a concentrated risk here, and play everything else a little safer as a result.

Now, the stock price that they quote to you does have a meaning, which varies based on what your employment plans are with your firm. ?If you are thinking of leaving, you would like a high price to get cashed out at, but if you are thinking of staying, you would probably like a lower price, as you may get more shares.

I don’t know everything here, so my advice is general. ?It would change if you could buy or sell with discretion, but that is not likely. ?If you have some idea of how upper management views the long-term prospects of the company, that could guide your reasoning. ?As an analogy, consider the investment banks on Wall Street prior to their becoming publicly traded. ?Management viewed their ownership in the bank as part of their pension, so they shot down ideas that were too risky. ?They were happy to see the value of the firm grow at a reasonable rate with near-certainty, rather than a rapid rate with a moderate probability of failure.

So, think about your management team and what they do. ?Make discreet inquiries to them if you think it is wise. ?Be careful with the rest of your assets. ?How careful depends on the soundness of the firm, your risk tolerance, and your time horizon for when you will need to convert the assets to another form for your own use.

Decline Free Food

Posted on 25 May 2015 by David Merkel

There is no getting something for nothing. ?There is always a cost involved, even if it is feeling vaguely obligated to listen to the person?giving you a gift. ?We are social creatures, and we want to favor people who are kind to us.

I get a lot a pitches in the mail because I profile?well to wealth managers and those?like them. ?The age, assets, income add up to a likely client, except that I am in a related business, and am not interested in making my assets?less flexible, at least right now.

My advice to you is that you do not respond to free gifts, whether it is good food, baubles, etc. ?It’s not worth it, and if you have a need, it would be far better to draw up your own story, and send it to five wealth managers, putting them in competition with one another, so that you can compare and contrast what they do and charge.

Even in my own limited experience, going to free conferences I find that I am the product being sold, and for months thereafter I have to tell marketers that I am not interested — and to the pesky ones point out some flaw in what they do.

Your time is valuable. ?So is your money. ?Thus remember what I always say:

“Don’t buy what someone else wants to sell you. ?Buy what you have researched that you want to buy.”

Thus, make them play your game. ?Don’t play their game. ?Send out your proposal for competitive bid, and choose the one that is best for you.

On Partnership Investing

Posted on 7 May 2015 by David Merkel

Tonight’s topic comes from a note sent to me by a friend. Here it is:

David, I have heard you say that you have entered into partnerships in the past.? What are your rules for partnerships, who will you enter with?? I have a neighbor who is interested in starting a business, the start up cash is small $5000.? I think there might be good opportunity, but I am concerned for good reason about my time availability, as well as Not being “unequally yoked”.? What business relations do Paul’s words govern.? do you have different rules for minority, majority, or controlling shares?

I appreciate your thoughts.

I have two “partnership” investments. ?One is very successful and is an S Corporation. ?The other is a limited partnership, and I wonder whether it will ever amount to anything. ?Both were done with friends.

There are a few?things that you have to think about with partnerships:

Is your liability limited to the amount of money you invested, or could you be on the hook for more if there are losses/lawsuits?
Are there likely to be future periods where capital might need to be raised? ?Under what conditions will that be done?
What non-capital obligations are you?taking on as a result of this? ?Labor, counsel, facilities, tools, etc?
How will profits and losses be allocated? ?Voting interests??How will it be managed??When will the partnership end? ?How can terms be modified? How can partnership interests be transferred, if at all? ?Etc.
Do you like the people that you will be partners with? ?You may be partners for a long time.
Be ready for the additional tax complexity of filling out schedule C, or a K-1, or some other tax form.

Go into a partnership with your eyes wide open, and check everything. ?If your partnership interests have limited liability, and the economics are structured similar to that of a corporation, then things are clearer, and you don’t have to worry as much.

Take note of any obligations that you might have that don’t fit into the “passive provider of limited capital with proportionate ownership” framework. ?Those obligations are the ones that need greater scrutiny. ?Include in that how those working on the partnership get compensated for their labor. ?Parties to the partnership may have multiple roles, and there can be conflicts of interest — imagine a partnership where one partner works in the business and receives a large salary, thus depressing profits for the non-working partners. ?How does that conflict of interest get settled? ?(Note that the same problems that exist in being an outside, passive, minority public stock investor reappear here.)

Also be aware of how ownership interests can change, and whether you may be forced to add more capital to maintain your proportionate interest in the business.

Try to have a good sense of the skill of the partner or employee managing the business. ?That makes all the difference in whether a business succeeds.

Most of what I say here assumes that you will not be a controlling majority partner, and that you will have limited influence over the business. ?If you do have control, the?problems of getting cheated by someone else go away, but get replaced with the problem of making sure the business is run adequately for the interests of all partners. ?Your ethical obligations also expand.

You mention the “unequally yoked” passage from Second Corinthians 6, verses 14 and following. ?In one sense, that doesn’t have much?more application here than it does in all investing if one is a Christian. ?Don’t involve yourself in businesses that of necessity involve you in things that you would not do yourself as a Christian. ?Don’t invest in enterprises where it is obvious that management does not care about ethics — you can see it in their behavior. ?This will be a little clearer and close to home in a partnership with a friend — you will know a lot more about what is going on.

With a non-limited partnership, there is an?additional way the “unequally yoked” passage applies. ?You expose your entire economic well-being to risk when you are a general partner. ?It is like a marriage — it is very difficult to negotiate your way out of the unlimited guarantee that you make there. ?It is like being a co-signer, which the Bible says to avoid.

Of itself, that doesn’t expose you to the unequal yoke, but when you are in an economic agreement that binding, if your partner takes the business in an ethical direction you find dubious, you will be in a weak position to do something about this. ?There is where the unequal yoke appears amid unlimited liability.

That’s all for now. ?There’s a lot more to consider here, but this is meant to be an introduction to the issues involved in partnerships. ?Hope it works well for you.

Index Investing is not Inherently Socialistic

Posted on 18 April 201519 April 2015 by David Merkel

How does capital get allocated to the public stock markets? ?Through the following means:

Initial Public Offerings [IPOs]
Follow-on offerings of stock (including PIPEs, etc.)
Employees who give up wage income?in exchange for stock, or contingent stock (options)
Through rights offerings
Company-issued warrants and convertible preferred stock, bonds, and bank debt (rare)
Receiving equity in exchange for other claims in bankruptcy
Issuing stock to pay for the purchase of a private company
And other less common ways, such as promoted stocks giving cheap shares to vendors to pay for goods or services rendered. ?(spit, spit)

How does capital get allocated away from?the public stock markets? ?Through the following means:

Companies getting acquired with payment fully or partially in?cash. ?(including going private)
Buybacks, including tender offers
Dividends
Buying for cash?company-issued warrants and convertible preferred stock, bonds, and bank debt
Going dark transactions are arguable — the company is still public, but no longer has to publish data publicly.

I’m sure there are more for each of the above categories, but I think I got the big ones. ?But note what largely does not matter:

The stock price going up or down, and
who owns the stock

Now, I have previously commented on how the stock price does have an effect on the actual business of the company, even if the effects are of the second order:

My initial main point is this: capital allocation to?public companies does not in any large way depend on what happens in secondary market stock trading, but on what happens in the primary market, where shares are traded for cash or something else in place of cash. ?When that happens, businessmen make decisions as to whether the cash is worth giving up in exchange for the new shares, or shares getting retired in exchange for cash.

In the secondary market, companies do not directly get any additional capital from?all the trading that goes on. ?Also, in the long run, stocks don’t care who owns them. ?The prices of the stocks will eventually reflect the value of the underlying claims on the business, with a lot of noise in the process.

My second main point is this: as a result, indexing, or any other secondary market investment management strategy does not affect capital allocation much at all. ?Companies going into an?index for the first time typically have been public for some time, and do not issue new shares as a direct consequence of going into the index. ?The price may jump, but that does not affect capital allocation unless the company does decide to issue new shares to take advantage of captive index buyers who can’t sell, which doesn’t happen often.

The same is true in reverse for companies that get kicked out of an index: they?do not buy back?and retire shares as a direct consequence of going into the index. ?They may buy back shares when the price falls, but not because there aren’t indexers in the stock anymore.

So why did I write about this this evening? ?I get an email each week from Evergreen Gavekal, and generally, I recommend it. ?Generally it is pretty erudite, so if you want to get it, email them and ask for it.

In their most recent email, Charles Gave (a genuinely bright guy that I usually agree with) argues that indexing is inherently socialist because you lose discipline in capital allocation, and allocate to companies in proportion to their market capitalization, which is inherently pro-momentum, and favors large companies that have few good opportunities to deploy capital.

I agree that indexing is slightly pro-momentum as a strategy, and maybe, that you can do better if you remove the biggest companies out of your portfolio. ?Where I don’t agree is that indexing changes capital allocation to companies all that much, because no cash gets allocated to or from companies as a result of being in an index. ?As a result, indexing is not an inherently socialistic strategy, as Gave states.

Rather, it is a free-market strategy, because no one is constrained to do it, and it shrinks the economic take of the fund management industry, which is good for outside passive minority investors. ?Let clever active managers earn their relatively high fees, but for most people who can’t identify those managers, let them index.

If indexing did lead to misallocation of capital, we would expect to see non-indexed assets?outperform indexed over the long haul. ?In general, we don’t see that, and so I would argue the indexing is beneficial to the investing public.

I write this as one who makes all of his money off of active value investing, so I have no interest in promoting indexing for its own sake. ?I just agree with Buffett that most people should index?unless they know a clever active manager.

On Being A Forced Seller in a Panic

Posted on 17 April 201517 April 2015 by David Merkel

No one wants to be a forced seller in a panic. So how does anyone get into that situation? ?Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability. ?Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it. ?With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house. ?He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well. ?Then a?significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside. ?Then the shock hits. ?In the midst of the panic he faces one of the following:

The loss of his job (or severe trouble in his business)
Disability with no insurance
An uninsured casualty of some sort
Divorce
Health problems not covered by insurance
Death (and his wife has to pick up the pieces)
Etc.

Guess what? ?Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time. ?His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated. ?Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done? ?Here are a few ideas:

Hold a bigger buffer. ?Maybe toss in some high quality long bonds, as well as cash.
Reduce fixed commitments.
Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
Keep a rolling hedge of protective puts (costly)
Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one. ?As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars. ?The same is true for financial disasters. ?The planning is best done in the good times, like now. ?Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic. ?Eventually you have to trust in God, because no earthly security system is comprehensive.