September 2019 Newsletter
Since we last wrote, the markets had quite a volatile month of August, but markets overall are generally at the same levels as they were back then. The usual worries remain: trade tensions, the addiction to low interest rates, and fears of a recession. Every day it seems we get a new prediction from one of the market experts on the probability of a recession coming. Useless information for the long-term investor…
Many of the same trends within the markets remain in place: interest rates are very low, US Stocks are performing better than International Stocks, and defensive stocks (real estate, utilities) are performing better than cyclical stocks.
What has potentially changed is a rotation in styles. Value stocks (stocks that are lower priced based on valuation metrics) have recently outperformed growth stocks--think highly priced, highly popular technology stocks. For years, just as passive has outperformed active management, growth and high-momentum stocks have outperformed out-of-favor value stocks. But as defined as those stocks which trade at a discount to fundamental metrics such as Price-to-Earnings (P/E), etc., value stocks have begun to gain some momentum. Historically, the relationship between growth stocks and value stocks has been much closer than it has been over the last few years; in fact, over time, value stocks have actually outperformed growth stocks. Nonetheless, whether this “reversion to the mean” between growth and value has legs, the rotation back into value stocks may give the market more fuel to move higher.
Investment Strategy Backfires
In another case of not knowing “what you own,” clients lost at least $60 million in an options strategy that was pitched as low-risk by stockbrokers at a major investment firm (WSJ, Aug 23, 2019.)
It is first important to note that options can be a very useful tool for investors. In fact, at NCM Capital, we utilize options to increase income on securities by selling call options. However, although this strategy takes a certain amount of understanding and attention, “covered-call writing”—as this tactic is called—is widely considered to be quite conservative.
However, in this recently reported case, the particular strategy being used by the firm not only involved options, but also leverage. Red flag #1- never use leverage when investing in options! That potentially exposes the investor to unlimited risk. The strategy also employed “uncovered" options. Mix together uncovered options and leverage and you have a recipe for disaster and that’s what happened.
In short, most large investment firms are always looking to create sophisticated products to enhance returns for their clients. But many times, these “opaque” investments are often accompanied by higher fees; in this case, clients were charged nearly 2% to participate in this strategy.
And with complex strategies, it is also not uncommon for the broker and advisor who recommend the products to not fully realize the potential downside. As one of the clients that lost money in the failed strategy (listed above) said that her broker told her: “If the world came to an end tomorrow, you’d be the only one with any money left.” Well, the world has yet to come to an end, but this particular client’s (alleged) loss is $750,000.
Just another example of why most investors are better off keeping things much simpler with their investment strategy.
Regarding Investments: Is Anything Really Free?
Many investors probably may not realize the impact that interest rates have on brokerage companies. Often collecting a significant portion of their profits by acting as a bank, these firms can raise lending rates, while keeping interest on clients’ cash balances low. Some large well-known firms who have brought in billions of new client assets over the last few years generate as much as 50% of their revenue in this area.
And as interest rates began to increase in 2015, this strategy really paid off. In fact, for many of their advertised “no-charge” investment strategies, these firms required that a significant amount of cash be kept in client account portfolios. In many ways, the free services that were offered by these firms were subsidized by the profitable cash balances that the firms directed to be held in client accounts within the managed portfolios.
But “free” investment advice comes with a cost to both clients….and employees. Not only may clients in these free managed programs be disadvantaged by being forced to hold more low-yielding cash balances, but as the profit margins from this lucrative business begin to erode, so does the need for employees; recently, a large firm announced the elimination of a significant number of employees who were expected to come from its retail investment group.
As always, free is not always free. Usually when a firm offers something for free, chances are they are making up that lost revenue somewhere else, as was the case in this situation, or the cost is hidden somewhere and not disclosed. And it is our view that these “free services” will become even more exposed when we have the next sustained downturn in the markets.
Financial Planning: At 62, Take from IRA or Social Security?
For those who are contemplating retiring before full-retirement age (FRA), they often face the question of whether to begin taking social security early or take funds from their IRA and allow their social security benefit to increase over time.
After an excellent analysis done by expert retirement planner Jim Blankenship, the results show that actually waiting on your Social Security benefits to grow—as they will each year until you hit FRA and for four years thereafter—is the more tax-efficient strategy over time. The primary reason for this is because not 100% of your Social Security is subject to tax, as are the funds withdrawn from an IRA. As such, the higher amount of your retirement income that can be derived from Social Security the less tax will be paid.
Of course, every situation is unique, but in general, waiting for at least full-retirement age to collect Social Security can be helpful in the long-term. We stress that each client’s circumstances are different, though, and there are many other factors to consider before we advise clients in this area. Also note that this analysis solely looked at the tax aspect of the decision. Just like most of personal financial planning, this type of analysis is not “one size fits all.” The advice we provide in this area is highly personalized because it has to be.
Is Passive Investing Creating a Bubble?
The latest attack on index funds comes from comments made by hedge fund manager Michael Burry, who rose to fame on his warning of---and profiting from---the housing crisis.
For quite some time, investors have been shifting money into passive investments which are considered index or exchange-traded funds (ETFs). These funds track an index and are automatically rebalanced from time to time to match that index; there is little, if any, human decision-making. Conversely, “active” funds hold positions that are solely at the discretion of a manager. The question that consistently is raised is whether passive funds will eventually create a bubble in the market as more and more investors put their money into these strategies, while these strategies hold increasingly similar assets.
Burry contends that prices have been completely distorted by massive inflows to index funds; he believes that during the next market decline, the effects will be made much worse as more and more investors who are piling into the same funds will eventually have to exit.
Whether passive funds will truly exacerbate a future market correction is somewhat academic. However, what is true is that both active and passive managers will “talk their own books.” We can expect hedge funds who collect large fees to support active management, while firms like Vanguard insist indexing is the only way to go. As independent advisors, we feel the subject is much more nuanced and, fortunately, are able to take a more moderate approach.
As an example of how each side can debate the effects of indexing on the market, just this week, Fed-Ex, a good proxy for the state of the US economy, announced terrible earnings; its price plummeted. Years ago, this type of stock decline in such a big name would have had ripple effects throughout the market; however, for the day, the averages were largely unchanged. Was this because the multitude of index funds continued to have investor in-flows to equities and were forced to buy the market? And because these funds don’t use discretion, would Fed-Ex’s stock have dropped MORE if it was not included as a top holding in so many of these ETFs and index funds?
But let’s look at another perspective, if index funds are distorting prices then shouldn’t active managers feast on these types of mis-pricings? In other words, if Fed-Ex “must” be bought by index funds, then shouldn’t an active manager be able to purchase a similar basket of stocks without Fed-Ex, thereby outperforming the index?
Yes, this seems to be hotly debated issue. However, a compelling case can be made for passive, index investing; tax efficiency and lower fees are both great advantages. And it is true that at this point, the evidence indicates that active funds continue to underperform index funds over time. As such, our view is that index funds should be core pieces in a well-diversified portfolio. But at the same time, this does not have to be an “either-or” proposition. There are also reasons to include active strategies in a financial plan. Again, these decisions are client specific.
NCM Celebrates 10-year Anniversary
It’s been a quick 10 years as our advisory firm was launched in August 2009: Time flies when you are having fun!
It wasn’t a great time to launch an advisory firm in 2009 as we were just starting to recover from the “Great Recession” and investors were still in shock. But based on investors’ disappointing experiences with Wall Street, we believed that the demand for quality financial advice provided by independent, fee-only, fiduciary-based firms would increase. We thought that investors would seek out advisors that they could build a more trusting relationship with--advisors that would put their clients’ interest first and not be swayed by Wall Street sales pressures. If anything, we underestimated the explosive growth in the RIA model that was to come.
We would like to thank our clients tremendously for making this a gratifying journey. As life-long North Jersey residents, we also have to acknowledge and express our appreciation for the relationships we have built with other professional organizations in the area (i.e., attorneys, accountants, insurance agents, bankers, etc.). Because we don’t spend our time marketing and prospecting, we’ve been fortunate to continue to grow relying on these two referral channels.
We look forward to the next 10 years with enthusiasm and optimism!
All the best,
Nick