An Idea Whose Time Has Come

Laurence Siegel et al of his ilk have really thrown a gauntlet to the financial services industry.

But first: I don't like Laurence's close ties and basic advocacy of insurance products and insurance companies - because I don't trust them (they are run by actuaries with ROI hurdle rates on products). Because insurance companies can't control market returns they control their shareholder returns by embedding high costs into their products to cover their business and market risk.

Having said that, Laurence has outlined a simple, robust way for the industry to meet and support the post retirement needs of retirees. To this end he advocates the creation of new low cost annuity companies insulated from corporate default risk structured as follows:

• Separate corporate structure insulated from financial exposure to affiliated companies.
• All reserves held in default-free Treasury bonds and TIPS and properly hedged to the liability as closely as possible at all times.
• “Participating” policies, so that any longevity surprises are used to reduce annuity benefits proportionally instead of forcing the insurer to default entirely on some of the benefits (after going bankrupt)
  Advocate for setting up a 20 year TIPS ladder based on expected withdrawal rate complemented by a deferred income life annuity to protect against longevity risk.
  
• Very broad participation so there is little adverse selection.
  Withdrawal rate or spending rate based upon an annually recalculated variable annuity (ARVA).
   

The retirement investment structure that we’ve been describing doesn’t need teams of “quants” or financial engineers to create it. Mostly it involves a lot of effort in changing the culture of the investment business, refocusing it on doing what’s best for the consumer. The needed changes are not only cultural but also institutional, legal and regulatory. And, once the products are built, an incentive structure needs to be developed that motivates advisors and salespeople to place investors in these products. (and therein lies the problem)

These ideas are something the industry should, and can easily do, but won't because it can't make money from it. Someone will no doubt have a go at it but are likely to struggle. It will be a number of years before the industry mutates toward this model.

Too Binary, Too Static...Not Out Ahead Of It

It is not that I don't know the main factors related to financial markets and investment decision making or the nuances with respect to said factors, but I find myself too binary in my thinking. All too often I read an article which highlights an important principle or issue which I was aware of and/or agree with, and wonder to myself why didn't I write that.

I find myself too binary. Too static. Even though I know all the issues and am aware of the balls in play, I struggle to get ahead of the herd.

M&A Activity - Blistering (In More Ways Than One)

3G Capital (Warren Buffett) in talks to buy Kraft foods. Seems to me we are seeing no let up in acquisitions or mergers. This leads me to believe we are still some way from the bull market capitulation. Usually 6-9 months after the last major deals.

We have seen 297 deals in the $1b+ range over the last year, 211 in the $500m-$1b range, and 326 in the $250m-$500m range. Collectively, more than $1.86 trillion in deals over the last year.

Lots of deals. Lots in the healthcare space. A lot of misallocated capital coming down the pike.

6 Year Bull Market Covers Over Essence

A rising market blinds. Everyone who has held a long position in the market is a genius.

It blinds you to who is skillful and who is just riding the trend. Hint: 95% are riding the trend (but attributing their good fortune to their own skill).

The next major market correction will provide another flush. That is how markets work. Not because they have some innate mental calculation embedded in them, but because markets and their extremes are a reflection of human nature and human psychology.

Many amateur wannabes will be caught in the downdraft because they misunderstood that their returns were due to serendipitous good fortune and not of their own making.

Buffett was right"only when the tide goes out do you discover who has been swimming naked."

The Blinders of Thinking You Did It Yourself

We attribute good results to our own intelligence and good decisions, and we attribute bad results to poor luck or circumstance. This is the nature of man.

Cassandra Does Tokyo captures some of the fallacy of this narcissism in a recent post:

Giving is easy - taking is hard
http://nihoncassandra.blogspot.com/2015/03/giving-is-easy-taking-is-hard.html
...How quickly investors forget. If you'd asked large asset owners in late 2008, or early 2009: "Would you give up a tranche of the future capital gains in asset prices in exchange for a floor under prevailing prices, and the near-assuredness of significantly higher asset prices in the future?", I am quite sure of the answer, given the widespread systemic fears and paucity of alternatives at the time. Investors, after all, pay 2&20 to HFs and PE for essentially the same (pre-tax) premise. Was not QE effectively the same proposition multiplied across the entire economy? The liquidationist alternative was clearly unpalatable to asset owners, and sub-optimal for nearly everyone else. IF, as the result of a policy directive, you bestow large windfall gains, it would be only fair to harvest a an additional share of those for the Public's Interest, since the goal of QE policy was NOT to further stoke inequality, nor accelerate the growth of fortunes for existing asset owners, but rather to prevent unnecessary liquidation, and deflation so private-sector balance sheet deleveraging could work its course, and to foster stability, so reviving private investment decisions in the real economy. But, as it happens, giving is far easier than taking away - irrespective if you're a welfare deadbeat (not my language) or a leveraged rentier...
...Asset owners peculiarly act as if such windfalls somehow resulted from their own brilliance. Many, through every over-leveraged fault of their own, were a pubic-hair's breadth away from financial obliteration, saved by US - and I don't mean the United States, but rather you, and I, as representations of the taxpayer, or bag-holder as the ultimate underwriter of newly issued debt. Others - particularly in the tech world and on the left coast - are blind to the benefits wrought by munificence of The People, and the abundant liquidity finding its way into every inane crevice, and spilling over to provide VC's and PE investors exits at multiples unimagined even three years ago. And the "thanks" that all those west-coast libertarians afflicted with self-attribution bias, is to piss on the under-class who serve them, and wish for a Randian offshore tax-haven to insure they share as little as possible with the undeserving multitudes. These gripes are academic, but asset-owners would do well to reflect upon their self-attribution bias...

Red herring - Yield that counts

Red herring - distracting attention from an issue by introducing an irrelevant issue or one that is only superficially related to the one being discussed.

I am not sure that is the right fallacy to be using here, but I am sure a fallacy is carried out when investors focus on dividend yields or buyback yield and neglect the true yield (Earnings or FCF Yield).

The equivalent canard in done in the return area when investors focus on dividend yield or buyback yield when they should be looking at total return (capital appreciation + income).

The yield (equity) investors should be concerned with is the earnings yield (not the dividend yield and/or the buyback yield).

With investors searching for, and in many cases chasing yield, they are often focused on the wrong thing.

Earnings yield translates into ROE.

Keep that in mind the next time someone wants to talk about dividends and yields. Yield chasers are making an error of false alternatives by neglecting to focus on total yield (aka Earnings Yield).

Reaching For Yield

For the past forty years, investors were accustomed to bond yields sufficient to generate enough income to cover the traditional 4% withdrawal rate. With the 30 yr bond trading below 3% and the 10 yr bond trading below 2.5%, this approach has become much harder to achieve in current markets. 

Bonds are still a portfolio diversifier, but with in the current low yield environment they offer lower returns and less portfolio protection than they have in the past. As a result, many investors are seeking higher yields elsewhere and in the process are incurring higher risks than what they may have bargained for. Here are the main trade-offs:

Action                                                           Effect
Overweight high-yield bonds                                                           Increases credit risk/increased volatility

Overweight longer term bonds (extend duration)                            Increases interest rate risk

Overweight dividend paying stocks                                                 Skews exposure to certain sectors

Shift from bonds to dividend paying stocks                                     Increases portfolio's overall volatility and risk


Investors need to keep in mind that concentrating assets in higher yielding investments can lead to increased risk and volatility. These strategies can be damaging to your portfolio's overall health.

An alternative to reaching for yield by moving out on the risk-return spectrum is to take a total return approach (viewing your portfolio from both a capital appreciation and a yield perspective), harvesting capital gains (which incidentally is often more tax efficient than receiving interest income) to make up withdrawal needs.