Protecting Your Finances Following the Equifax Data Breach

Equifax, one of the major credit reporting bureaus, has announced that on July 29 it discovered a data breach affecting as many as 143 million U.S. consumers. Tim Maurer goes on NBR to discuss some steps you can take next if you think your information was compromised.

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Active Management Falls Short With Bonds, Too

In a July 2017 Q&A with WealthManagement.com, Western Asset Management CIO Ken Leech asserts that passive investing is unlikely to play as large a role in fixed income as it does now in equities, because active managers outperform their benchmarks much more in the bond market than they do in the stock market.

While the trend toward passive/index investing has been just as strong in the bond market as it has in the stock market, with passive bond mutual funds and ETFs experiencing a net inflow of $185.8 billion during the 12 months through May, according to Morningstar data cited in the article, Leech claims we’ve “been fortunate that the record of active beating passive is strong in fixed income.”

He added: “The index is around the bottom quartile of the active community, in terms of performance. We’re hopeful that evidence is compelling, and that active management will continue to play a dominant role.”

When asked why active strategies have done better in the bond market than in the stock market, Leech responded: “Government and government-sponsored agency bonds make up more than half of indices. Most studies suggest that overweighting high-quality bonds with higher yields than Treasuries gives you a powerful advantage over time compared to indices.”

Let’s see if Leech’s claims hold up to scrutiny, or if they are—like most claims about the success of active management—nothing more than what journalist and author Jane Bryant Quinn called “investment porn.”

Checking In With SPIVA

While the poor performance of actively managed equity funds is well-known, the performance of actively managed bond funds tends to receive less attention. To check Leech’s assertions, we will look to the S&P Dow Jones Indices year-end 2016 SPIVA U.S. Scorecard, which has 15 years of performance data on actively managed bond funds.

Following is a summary of the report’s findings:

  • The worst performance was in long-term government bond funds and long-term investment-grade bond funds, as just 3% of active funds in those categories beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, active funds underperformed the index by a shocking 3.3 percentage points (2.7 percentage points) and 2.2 percentage points (2 percentage points), respectively. Active high-yield funds didn’t fare much better, with just 4% outperforming. On an equal-weighted (asset-weighted) basis, the outperformance was an also-shocking 2 percentage points (1.7 percentage points).
  • For domestic funds, the least-poor performance was in intermediate investment-grade and short-term investment-grade bond funds. In both these cases, “only” 73% of actively managed funds underperformed. On an equal-weighted basis, the underperformance in both categories was 0.3 percentage points. However, on an asset-weighted basis, they managed to outperform by 0.7 percentage points and 0.3 percentage points, respectively. That is possibly explained by their holding longer maturities and/or holding lower-rated bonds (taking more risk) than the benchmarks. A factor regression would provide us with that evidence.
  • Domestic high-yield bond funds performed almost as poorly as long-term government bond funds and long-term investment-grade bond funds, with just 4% of actively managed funds outperforming their benchmarks. On an equal-weighted basis, the underperformance was 1.9 percentage points. On an asset-weighted basis, they managed to outperform by 1.6 percentage points.
  • Emerging market bond funds also fared poorly, as 76% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.2 percentage points.

Believe Vs. Evidence

Contrast the actual performance of active fund managers with Leech’s assertion that indexes were in the bottom quartile of performance: Leech was right about one thing—the evidence is compelling, just not in the direction he meant.

Even though the SPIVA scorecards clearly provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance), active managers continue to claim otherwise.

As author Upton Sinclair noted: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” The claim that active management works in the bond markets is just as much a canard as the claim that it works in emerging markets (as I show in another recent article) or, for that matter, any other market.

The actual evidence provides compelling support for Charles Ellis’ observation that while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try—which is why he called it the “loser’s game.”

This commentary originally appeared August 7 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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The Characteristics of Value versus Growth Investors

One of the great debates in finance is whether the source of the value premium is risk-based or behavioral-based. Extensive empirical literature on the value premium, which provides support for both explanations, has focused primarily on stock returns and the manner in which they are related to macroeconomic and corporate variables.

Value/Growth Investor Demographics

Sebastien Betermier, Laurent Calvet and Paolo Sodini, who contribute to the literature on this issue with the study “Who Are the Value and Growth Investors?”, published in the February 2017 issue of The Journal of Finance, took a different approach. Their paper investigated value and growth investing among Swedish residents over the period 1999 through 2007.

Following is a summary of their findings:

  • Households are not heavily tilted toward stocks in their employment sector. The average direct stockholder allocates 16% of their stock portfolio to professionally similar companies.
  • Value investors are substantially older, more likely to be female, have higher financial and real estate wealth, and have lower leverage, income risk and human capital than the average growth investor—investors with high human capital and high exposure to macroeconomic risk tilt their portfolios away from value.
  • Men, entrepreneurs and educated investors are more likely to invest in growth stocks.
  • These patterns are evident in both stock and mutual fund holdings.
  • The explanatory power of socioeconomic characteristics is highest for households that invest directly in at least five companies, a wealthy subgroup that owns the bulk of aggregate equity and may therefore have the greatest influence on prices.
  • Over their life cycles, households progressively shift from growth to value investing as they become older and their balance sheets improve, with 60% of the value ladder explained by changes in age, 20% due to changes in the balance sheet and 20% due to changes in human capital.
  • Households with high financial wealth, low debt and low background risk tend to invest their wealth aggressively in risky assets and select risky portfolios with a value tilt.
  • Households with high current income and high human capital levels tend to tilt their portfolios toward growth stocks. So do households with high income volatility and a self-employed or unemployed head. Further, households with members working in cyclical sectors tend to reduce their portfolios’ value tilts.

Betermier, Calvet and Sodini concluded that their findings “appear remarkably consistent with the portfolio implications of risk-based theories. The strong negative relationship between a household’s value loading and its macroeconomic exposure provides direct support for the hedging motive. Households in cyclical sectors go growth, which reduces their overall exposure to aggregate income risk.”

They add: “The value ladder [increasing exposure to value as investors age] provides further validation of the hedging motive. Over the life cycle, the household becomes less dependent on human capital and its hedging demand should get progressively weaker.”

Further Conclusions

The authors also found that sound balance sheets have positive effects on portfolio value tilts, providing further support for the risk-based explanation of value. This aligns with portfolio theory, as more financially secure households generally should be better able to tolerate investment risk.

Betermier, Calvet and Sodini note that their findings were not all one-sided in favor of a risk-based explanation. For example, overconfidence—which is more prevalent among men than women—is consistent with their finding of a growth tilt among male investors. They also found that, as “attention theory predicts, a majority of direct stockholders hold a small number of popular stocks.”

In addition, some of their evidence can be explained by complementary risk-based and psychological stories—the growth tilt among entrepreneurs, for instance, can be attributed to marked overconfidence in own decision-making skills.

Summary

While the results of their study provide strong support for a risk-based explanation of the value premium, as the authors observe, it’s not a one-sided story. In other words, their results, while providing support for the idea that the value premium is not a free lunch, also offer support for the idea that it just might be at least a free stop at the dessert tray.

There’s one last point to consider. Their finding of a value ladder, combined with the aging demographics of the U.S. investor population, might indicate we should expect an increased demand for value stocks. All else equal, that would lead to a larger realized value premium.

This commentary originally appeared July 5 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Annuities … The Good, the Bad and the Ugly

Too often, I’ve heard this all-too-familiar story. A client brings in an annuity policy to review, either for themselves or a family member. They bought it to create a steady annual flow of income on later life, as insurance against unexpected longevity.

But what we see is a jaw-dropping set of numbers that reveal poor performance, high commissions paid to brokers, misleading benefits and ridiculously high expenses. Unfortunately, too many investors purchase an expensive annuity that doesn’t fit their needs.

How do so many fall into this trap? There are a few key reasons.

Great for the Seller: Commissions

As an investor, the first thing to be wary of is the possibility that a broker, or agent, is pointing you in the direction of a product that’s in their interests more than yours. Exhibit A is the annuity. An insurance product rather than a securities package, annuities are sold by insurance agents rather than brokers. It is sometimes the best option an insurance-only agent (not securities licensed) can offer.

There is nothing wrong with selling annuities, nor is there anything wrong with insurance agents earning commissions. However, when a product has particularly high commissions, it is all the more important to ask the agent directly whether annuities are in your best interests.

Strictly speaking, agents don’t have to act in your best interests because they are not subject to federal fiduciary rules that govern financial advisors. They also pay out among the highest commissions in the financial service industry. The highest rates are paid for longer surrender periods, years during which policy holders are charged for withdrawals above the approved limit.

With so many common options that benefit the seller at the expense of the buyer, it can be tempting for unscrupulous agents to speak to the benefits of annuities while omitting the risks.

Stability for the Buyer

The main benefit of the annuity is the option to guarantee a minimum return. Investors tend to fixate on the apparent risk-free nature of annuities as they plan to enjoy fixed payments after a pre-arranged waiting period.

In reality, this describes just one type of annuity, a fixed annuity. Similar to a Certificate of Deposit (CD), investors sacrifice the potential for a higher rate of return for the guarantee of a smaller one. Unlike a CD, there are generally complex fees and conditions attached to fixed annuities that reduce the value of the annuity.

For example, while tax is deferred as your annuity is accumulating, once you begin to withdraw accumulated funds you’ll have to pay taxes at your ordinary tax rate rather than the lower, applicable, long-term capital gains tax rate. (If you invested $100,000, your annuity grows to $150,000 and you’re in the 35 percent tax bracket. You’ll pay 35 percent on the first $50,000 you take out, 20 percent more than on capital gains at 15 percent.)

More Complex Options May Increase Return

Other types include indexed annuities and variable annuities. These appear to offer the potential for higher returns: indexed annuities because the rate of return is tied to a specific market benchmark, such as the performance of the S&P 500; variable annuities because they allow premium payments to be reinvested, somewhat like a mutual fund.

Unfortunately, these types of annuities often have performance caps to offset the risk the firm takes on by guaranteeing a performance floor. These can significantly reduce expected returns. Participation rate is another factor that limits what investors earn, as it governs what share of returns go to the firm and what share goes to the annuity holder. (For example, a 70 percent participation rate means if the market gains 10 percent, your gain is 7 percent while the firm keeps 3 percent.)

The above limitations on rate of return don’t take into account the additional premium investors must pay for riders to secure some of the benefits of these annuities, which further reduce actual return on investment.

Bottom Line: Insurance, Not Investment

Annuity performance often pales in comparison with a balanced portfolio of stocks and bonds, yet we routinely hear of “new and improved” annuities that insurance agents counsel clients to convert into, via a 1035 tax-free rollover. That only serves to fatten the agent’s wallet while further locking up a client’s ability to earn real income.

The good news is investors are starting to wise up to this. Annuity sales saw a 17% drop between Q4 2015 and Q4 2016. (It is still a $51 billion industry. So, investor beware.)

Does all this mean that you should definitely not purchase an annuity? No. What is important to understand is that while an annuity can act as a hedge against running out of income as you live longer, it is not the same as an investment portfolio geared toward the best possible return at the lowest possible expense.

Be cautious, and always speak with an advisor bound by a fiduciary obligation to act in your best interests before you purchase any kind of annuity.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

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Understanding Different Types of Risks

Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.

Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.

Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).

Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.

Managing Financial, Not Just Investment, Risks

When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.

Human Capital Risk

We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?

The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.

The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.

For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).

This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.

A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

Correlation, Health And Mortality

The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.

This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.

The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).

There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.

Risk Tolerance And Adaptability

Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.

Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.

Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.

Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.

We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

This commentary originally appeared April 12 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The BAM Alliance

Posted by:

The BAM Alliance

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