The Volatility Scare

January 24, 2016

Last week I wrote that I smelled capitulation.  When the Dow Jones (DJIA) dropped more than 500 points on Wednesday, I smelled burnt barbeque.  Historically, there is a weak correlation between the price of oil and the stock market.  In the past few weeks the 20 day correlation between the oil commodity ETF USO and the SP500 is .97, meaning that they are chained to each other in lockstep.  If that relationship continues throughout the month, investors can expect a continued bumpy ride.

Several factors helped indexes recover in the latter part of the week. After dropping near $26 a barrel, oil rebounded above $30 at the end of the week.  Mario Draghi, head of the European Central Bank (ECB), indicated that the bank was prepared for additional stimulus.  Sales of existing homes climbed in December, indicating a level of confidence among U.S. families.

Since the first of the year, investors have withdrawn $26 billion from equity mutual funds and ETFs (Lipper), offsetting the $10 billion inflow into equities in the last week of 2015.  Fund giants Fidelity and Vanguard report that their customers have been net buyers of equities despite the turbulence.

Volatility (VIX or ^VIX at Yahoo Finance) in the last half of the week dropped to the 8 year average of about 22.  We have enjoyed such low volatility in the past few years (mid-teens) that investors are especially sensitive to price swings.  For a long term perspective, here is a chart showing some multi-year averages of volatility.

A few weeks ago, I noticed an acronym for the 2008 Global Financial Crisis – GFC.  The memory wound is still fresh for many. Older investors with their working years largely behind them may feel even more vulnerable in times of higher market volatility.


Fund Fees

Employees in 401K plans may not know how much money they are paying in fees each year.  One of the charges is what is called a 12b-1 fee, and you will need to breathe slowly into a paper bag while you read about this one.  Each fund has an investment advisor to administer the fund’s investments and the fund pays a fee for this service.  In addition, under some plans, the advisor charges the fund holders a separate marketing and distribution fee, the so called 12b-1 charge, to promote the fund through sales materials or broker incentives.  Wait, you might ask.  Shouldn’t marketing expenses be part of the advisor’s fee? Well, you would think so.

The Annual Report that accompanies your 401K statement might list one of the funds you are invested in as “Blah-Blah-Blah Growth Fund, Class R-1,” hoping you are going to sleep.  The R-1 class means the fund is charging you 1% for marketing and distribution fees. Here is a glossary of the classes of mutual funds and the percentages of 12b-1 fees.  In addition, funds have  varying sales or redemption fees which are denoted by a letter class for the fund, i.e. Class A, B, C.  The Securities and Exchange Commission (SEC) explains these here.

The  SEC has a FAQ sheet explaining the various fees.  These charges might seem small but they add up over a working lifetime.  The SEC provides an example  of the 20% difference in value between a fund that charges 1.5% fee each year and one that charges .5%.  FINRA, the industry group that certifies and regulates financial planners, has a mutual fund expense calculator that enables an investor to compare fund expenses by their ticker symbols.

I compared an American Funds Class A Balanced Fund ABALX that might be found in a 401K with a Vangard Admiral Balanced Index Fund VBIAX over a ten year period.  Taking the default assumptions of a 5% return on an initial investment of $10K, I had $1670 more in the Vanguard fund after the ten year period, or an additional 3 years of return.

Some 401K plans make it more difficult to compare performance or fees.  They may list a fund whose ticker symbol is not listed on any exchange but is a “wrapper” for a fund that is listed.  The only way to find out that information would be to look at the prospectus or other materials for the 401K fund or visit the web site of the 401K plan administrator.  How likely are many participants to do that?  That’s the point.

Summer Swoon

August 10, 2014

Consistent Investing

After two unsettled weeks and a 6% drop in the market, let’s revisit a prediction made in August 2010 – impending doom.  Even when doom does show up as it did in late 2008, there are inevitably predictions of even more doom.  When doom does not show up as scheduled, it is a bubble which portends catastrophic doom.  Those who sound a cautionary note do not seem to get the same headlines as the doom predictors.

Each year the Employment Benefit Research Institute (EBRI) analyzes the activity of more than 20 million 401(K) participants.  In their most recent analysis of 2012 data,   EBRI found that a third of participants are “consistent participants”, i.e. employees who participate regularly in 401(K) programs despite the market environment. The portfolios of consistent participants overwhelmingly outperformed the two-thirds who were not as consistent.

Analysis of a consistent group of 401(k) participants highlights the impact of ongoing participation in 401(k) plans. At year-end 2012, the average account balance among consistent participants was 67 percent higher than the average account balance among all participants” in the EBRI/ICI 401(k) database. The consistent group’s median balance was almost three times [my emphasis] the median balance across all participants at year-end 2012.

This data did not include the 30% rise in the stock market in 2013, which only reinforces the point – it pays to participate regularly in a 401(K).   EBRI found that the superior returns of consistent participants was not due to any asset selection.  Their allocation was about the same as the entire group, about 60/40 stocks and bonds.


Investor Sentiment

An indicator of investor sentiment is the price reaction to upside and downside earnings reports.  If a company reports earnings that are better than average expectations, that is an upside.  Conversely, if a company’s quarterly earnings fall below mean estimates, that is a downside. As the majority of companies in the SP500 have reported earnings for the 2nd quarter that ended in June, FactSet compared investor reaction to this quarter’s  earnings surprises with the average reaction over the past five years.  The sentiment overall has been negative.  There has been little positive reaction to positive earnings surprises and a more than average negative reaction to disappointing earnings reports.


Target Funds

Some funds, called Target Funds, designate a specific year when an investor will need to start drawing some or all of the money from the investment.  As the fund approaches its target year, the fund adjusts its allocation to a more conservative blend of bonds and stocks.  A fund with a target year that is 12 – 15 years in the future may have a stock bond mix of 75/25.  A fund with a target date 5 years in the future may have a 60/40 stock bond mix. Vanguard’s VTHRX (2030) and VTWNX (2020) are examples which illustrate the difference in allocations.

The appeal of “set it and forget it” has helped these funds grow in popularity.  According to the Investment Company Institute (ICI) the number of target funds has grown from 6 in 1995 to almost 500 in 2013 (Table 53)  At the end of 2008, assets in target funds totaled $160 billion.  Five years later, in 2013, total assets had almost quadrupled to $618 billion.  New investment in these funds peaked in 2007 at $56 billion, then fell to $42 billion per year from 2008 through 2011.  New investment rose again to $52 billion in 2012 and 2013.

Because these funds have a blend of stocks and bonds, most investors would assume that the risk adjusted return (RAR) would be better than a fund fully invested in the stock market.  The Sharpe ratio, a common measure of RAR, computes a ratio of excess return to the volatility of the investment.  Excess return is the extra amount an investment earns compared to a risk free investment like Treasury bills.  If an investment has a Sharpe ratio of 1, then the investor got what they paid for in worry.  A ratio greater than 1 means that the investor got more than they paid for.  The 5 year Sharpe ratio of the SP500 is 1.24, meaning that an investor got about 25% more return than the volatility of the market. Keep in mind that the bull market is almost 5-1/2 years old. Over ten years, the Sharpe ratio of the SP500 was less than .5, meaning that an investor got half as much return for the amount of worry it cost them.  Many target funds do not have a long enough history to compute a ten year ratio.

An investor comparing the 5 year Sharpe ratio of their target fund may be surprised if their fund has a lower RAR than the SP500. Check the expense ratios on the fund.  Target funds that use indexes as their underlying investment may charge as little as $170 per year on a $100,000 investment in the fund. Some funds may charge $800 or more on the same investment. Lastly, what is the correlation between a target fund and the stock market?  A correlation of 1.00 means that the prices of two investments move in lockstep. let’s an investor compare the one year correlation of their fund with the SP500. A target fund with a correlation of .99, a high expense ratio and a lower than market Sharpe ratio might lead an investor to question the value of that fund.


Constant Weighted Purchasing Index

As anticipated, ISM reported strong numbers in July for both the manufacturing and service sectors.  Employment and New Orders, two key components of the Purchasing Managers Index (PMI), were robust in the manufacturing sector at a reading near 65.  In the service sectors, which comprise most of the nation’s economy, employment did not get the same high marks but remains strong at 56.  The combination of new orders and employment in the services sector stands just below 60.

The composite of both manufacturing and services rose to 63.3, continuing the upward climb in this part of a cyclic trend that has been in place for more than three years.

If this pattern continues, we could expect further strong reports into the fall, before declining in October or November.



Production and employment numbers are strong, causing some worry that the Federal Reserve may raise interest rates sooner than mid 2015.  A growing number of mid and short term investors feel that any near term upside has already been priced into the market.

Tax Myths

Like many people I believed in several tax myths.  Twenty years ago, my accountant helped me better understand some of the things I took for granted as true.  I had started a contracting business a few years before.

Myth: Tax rate. I believed that, because I was in a 28% tax bracket, I paid 28% of my income in taxes. 
“Too many people confuse their marginal tax rate, which is 28% in your case, with their effective tax rate,” my accountant said.  We were reviewing my corporate and personal income tax returns.  She pointed me to the Taxable Income line on my personal tax return. 
“That’s your taxable income,” she said.  Then she pointed me to the Tax line that followed.  “That’s your tax.  What is the percentage of the tax to your taxable income?” she asked. 
“About 16%,” I replied. 
“That’s your effective tax rate,” she said.

She continued, “I have other contractor clients who want to buy a new truck.  They reason that, because they can deduct the purchase from their taxable income and they are in a similar tax bracket as you, the government is effectively paying for 30% of the cost of the truck.  It sounds like a great deal to them and justifies the cost of a new truck.  I ask them whether the first dollar they make or the last dollar they make will go to the new truck payment.  This sounds puzzling at first. If the first dollar they make goes to the truck payment and that first dollar is taxed at only 10%, then the government is only picking up 10% of the cost for the new truck.  Is the extra cost of a new truck justified if the government only picks up 10%?  Do you see what my point is?  You can’t say that you buy groceries and other necessities with the first dollar you make and then say you’ll  buy the truck with the last dollar you make.”  I nodded.

“The decision whether to buy a new truck,” she said, “should be based on a number of factors: additional work capability, reliability, less down time, savings from truck repairs, to name a few.  Any tax savings is just one of those factors.  It shouldn’t be the prime factor.  Unless you pay cash for the truck, you’ll have interest charges that will add about 15% to the purchase price.  At your effective tax rate, the government is simply picking up the interest you would pay on a truck loan.”

Myth:  Capital Gains Tax. In the middle nineties, I wanted to sell some part of a mutual fund and put the money in a different mutual fund to diversify a little bit. I was a reasonably new and unsophisticated investor who had read that diversification was good.  I had held off selling any shares in the fund for about a year because I didn’t want to pay the capital gains tax on the sale.  Once again, my accountant gave me another tax lesson. 
“Many people don’t realize that when they sell a mutual fund, they often pay little in capital gains tax or they may report a loss.  For many funds, you have been paying the tax each year on any capital gains the fund has realized.” 
That surprised me. She pointed me to a form in my tax return (Schedule D).
“Here’s the capital gains your fund had this year,” she said.  That increased your taxable income and you paid tax on it.  For many people, tax considerations should not be the prime reason they buy or sell a mutual fund, especially a stock fund.  There are some bond funds and other less common investments which are not taxable and that’s a different story.”

Myth:  Tax deferred accounts. In the mid nineties, I considered whether my company should set up a 401K retirement plan but the administrative costs and restrictions were impractical for a company my size.
“For employees  the tax deferral feature and any matching employer contribution to a 401K plan are a big plus.  For small companies with just a few employees, you lose the benefit of the employer contribution because you are the employer.” 
“But what about the tax advantages?” I asked. 
“Unlike many employees whose work hours are more or less fixed,” she replied, “you can offset the tax advantage of a 401K by working a few extra hours a week.  In effect you are paying the taxes now so that you won’t have to pay them in the future.  30 years from now you won’t remember the extra hours you worked.  You will have more control of your retirement funds.  Who knows what Congress will decide to do with IRAs and 401Ks 30 years from now?” 
“But,” I asked, “I’ll be in a lower tax bracket when I’m retired and I’ll pay less taxes on the money I take out of my IRA or 401K.”
“That’s true.  But there is the matter of how a tax rate feels.  When you are 75 years old and are on a fixed income, believe me, a 10% income tax rate feels like 20% or 30%.  At a 10% tax rate, you have to take over $1100 out of your IRA or 401K to net $1000 to meet your expenses.  At that age, you are very conscious of your dwindling savings.  In your 30s, 40s and 50s, you can command more money for your labor than you can in your 60s, 70s and 80s.   You can work a little extra now in order to buy peace of mind later and hopefully avoid having to get a part time job in your 70s to make ends meet.”

Stay the Course

In a mid 2009 survey of 3000 investors, the giant fund group Vanguard found that 21% of stock investors had sold some of their holdings during the recent downturn. Almost as many, 17%, had increased their holdings during the crisis. Only 28% of respondents said that they were completely taken off guard by the crisis. Three-quarters of those surveyed said that they would reduce spending in response to any shortfalls in their retirement savings. Half of the respondents said they would save more and almost that many admitted that they might have to work longer before retirement.

Vanguard reported that, in 2008, 401K participants reduced their equity positions from 73% to 61% but that only 2% of participants had sold all their equities.


In a 5/6/09 WSJ “Fund Track” article, Jennifer Levitz reviewed proposed changes to 401K retirement plans, which are the primary savings for 60% of workers.

One proposal is a listing of 401K fees on investors’ statements. A second proposal is a more automatic access to retirement plan participation. Obama’s budget “calls for the future establishment of a program in which all workers would be automatically enrolled in employers’ retirement plans.” There would also be a mandate for those employers without retirement plans to “enroll their employees in a direct-deposit individual retirement account.” Employees will have the choice to opt out of these plans.

Some industry proposals would limit equity investments in target-date funds. These funds are supposed to change their investment mix to be more conservative as the current date approaches the target date, when an investor presumably needs income from the fund. These funds are used for retirement and for college savings. This bear market revealed that some funds with target dates of 2010 had 60% of the fund in stocks, an inappropriately aggessive mix that prompted large declines in value as the stock market sank.

Other industry proposals are greater tax incentives for workers and employers who participate in 401K plans, and the creation of government insured annuities that would provide a dependable source of income for retired workers.