Tag Archives: investing

Defending Kickbacks

By James Kwak

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

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The Problem with 401(k) Plans

By James Kwak

Apparently my former professor Ian Ayres has made a lot of people upset, at least judging by the Wall Street Journal article about him (and co-author Quinn Curtis) and indignant responses like this one from various interested parties. What Ayres and Curtis did was point out the losses that investors in 401(k) plans incur because of high fees charged at the plan level and high fees charged by individual mutual funds in those plans. The people who should be upset are the employees who are forced to invest in those plans (or lose out on the tax benefits associated with 401(k) plans.)

In their paper, Ayres and Curtis estimate the total losses caused by limited investment menus (small), fees (large), and poor investment choices (large). Those fees include both the high expense ratios and transaction costs charged by actively managed mutual funds and the plan-level administrative fees charged by 401(k) plans.

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Bad Advice

By James Kwak

I’m starting teaching at the UConn law school this fall, so I got a folder of information in the mail about my retirement plan. UConn professors have a choice between a defined benefit plan (SERS, in which I would be a Tier III member) and a defined contribution plan called the Alternate Retirement Program, or ARP. (There’s also a Hybrid Plan that seems to be the defined benefit plan plus a cash-out option at retirement.)

I chose the Alternate Retirement Program for reasons that are complicated (I used a spreadsheet) and that I may get into another time. The main benefit of defined benefit plans is that they do a pretty good job of protecting you from investment risk and inflation risk, since the state bears most of it. The main downside is that if you will work either for a short time or a very long time at your employer, they have a lower expected value, even given conservative return assumptions. The other downside is counterparty risk.

Anyway, the ARP is a pretty good plan. The administrative costs are a flat 10 basis points.  It includes a reasonable number of index funds (although there are also actively-managed funds—more on that later). And the plan had the sense to ask for institutional share classes with low fees. For example, the S&P 500 index fund is the Vanguard Institutional Index Fund – Institutional Plus Shares, which has an expense ratio of 2 basis points. Adding the 10 bp of administrative fees, that’s still only 12 bp.* (Contrast this with Wal-Mart, for example, which, despite being the largest private-sector employer in the country, stuck its employees with retail fees in its 401(k) plan.)

But despite that, the plan then goes and encourages people to put money into expensive, actively-managed funds. I got a brochure subtitled “A Guide to Helping You Choose an Investment Portfolio” that was almost certainly written by ING, the plan administrator. It has the usual stuff about the importance of asset allocation and your tolerance for risk, and then provides “model portfolios” for various investor types.

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Bad Dividend Math

By James Kwak

While working on a new Atlantic column, I came across this article by Donald Luskin (hat tip Felix Salmon/Ben Walsh) arguing that “Taxmageddon” (the expiration of the Bush tax cuts at the end of the year) will cause the stock market to fall by 30 percent.* His argument is basically this: if the marginal tax rate on dividends increases from 15 percent to 43.4 percent, the after-tax yield falls by 33.4 percent, so stock prices should fall by about the same amount.

Ordinarily I don’t bother with faulty claims like this—there are only so many hours in the day—but it bothered me so much it cost me some sleep last night.

The first problem is the only one that Luskin acknowledges: lots of investors don’t pay taxes on dividends. He mentions pension funds; there are also non-profits and anyone with a 401(k) or IRA. According to Luskin, only about one-quarter of dividends are received by people who will pay the top rate. Maybe they are the marginal investors who set prices, he speculates. Well, maybe. But an increase in the tax rate will make dividend-paying stocks more expensive for them but the same price as before for non-taxpaying investors—so as long as we’re going to stick to theory, the former should sell their stocks to the latter for some price between the two.

More important, the price of a stock (in theory, again) is the discounted present value of its future dividend stream aggregated over an infinite horizon. So we need to know what the tax rates will be in all future years. That’s clearly unknowable. If the tax rate goes up on January 1, 2013, that will give us no information about the tax rate in 2113. On the other hand, it will give us very good information about the tax rate in 2013. And it will give us a little bit of information about the tax rate in 2023. In other words, the informational value of a change in tax rates only affects a small part of the summation you have to do if you want to value a stock by its dividend stream. If a company is going to shut down in 2013, liquidate its assets, and return one massive dividend to shareholders, it affects most of the value. If a company is Facebook and is unlikely to pay dividends for a long time, it affects very little of the value. So the impact of such a change on stock prices will be a lot less than the theoretical 33.4 percent that Luskin calculates.

Then there’s the little matter of markets. Luskin’s article chides the “stock market” for ignoring the upcoming change in tax rates on dividends. How does he know? Did he ask the market? More likely, the market is pricing in the possibility of a change in tax policy. In theory, market prices today should reflect the expected future tax level, which is somewhere between 15 percent and 43.4 percent—closer to which one, we don’t know. This is another reason why the actual impact of a tax increase will be smaller than 33.4 percent; the latter assumes that every single investor today is blindly assuming that the tax rate will remain at 15 percent.  (Actually, since the Medicare surtax is already law, every single investor knows that the tax rate will be at least 18.8 percent, not 15 percent.)

But this is all theory. There is actually a way to test these things. To the extent that a change in the dividend tax rate affects stock prices, it should affect high-dividend stocks more than low-dividend stocks. Even on the theory that the value of a stock is the discounted value of its future dividend stream, for a high-dividend stock, much of that value comes from dividends in the next decade, which are likely to be affected by a change in the tax rate. By contrast, for a company that doesn’t pay dividends, the value of its dividend stream is located far out in the future, where a change in today’s tax rate has little expected impact. So if Luskin is right, the 2003 tax cut (which established the 15 percent rate for dividends) should have caused not only a sharp increase in stock prices but also a sharp increase in the price of value stocks relative to growth stocks.

So, courtesy of Yahoo! Finance, here are the closing prices of the Vanguard Value Index (red), which includes high-dividend stocks, and the Vanguard Growth Index (blue), which includes low-dividend stocks, for November 2002 through May 23 2003, the day the final bill was passed by both houses. The question, though, is when the 2003 tax cut would have affected stock prices. There’s no separation between value and growth stocks around November 5, the day the Republicans won the midterm elections.  (Remember, the Democrats had a Senate majority in 2002.) There’s none around January 28, when President Bush called for tax preferences for dividends in his State of the Union address. There’s no reaction around February 27, when the bill that would cut taxes on dividends was introduced.

Now, there is a separation around May 15, when the Senate version initially  passed. (Passage in the House was assured because of the Republican majority there.) This implies that there was significant uncertainty about whether the bill would pass; when the uncertainty cleared, high-dividend stocks gained relative to low-dividend stocks. Score one for Luskin!

But if there was uncertainty that cleared on May 15, and Luskin is right, then two things should have happened: high-dividend stocks should have gained relative to low-dividend stocks, and all stock prices should have shot up. But that’s not what happened. High-dividend stocks went up; low-dividend stocks went down. Investors’ overall appetite for U.S. stocks didn’t change; at the margin, some realized that after-tax dividend yields had just gone up, so they switched from low-dividend to high-dividend stocks.

By May 23, the last date on that chart, passage was a certainty, so the impact of the tax change should have been 100 percent priced in. Do you see a 30 percent increase? I don’t.

Want more evidence? Here are the same two index funds for December 1 through December 17, 2010, when the dividend tax cut was extended for two years. The extension was in serious doubt until December 6, when Democrats and Republicans reached a compromise agreement. Again, you can see an increase in the price of high-dividend stocks relative to the price of low-dividend stocks, starting around December 6. This indicates that the market was reacting to a significant change in the probability of an extension. But there’s no sharp, 30 percent increase in the overall level of stock prices.

So the tax rate on dividends does seem to have a small but visible impact on the relative price of high- and low-dividend stocks. And it may have a small impact on the overall price level, which would make sense. But 30 percent, or anything close to it, is pure fantasy.

So why all this hysteria about a collapse in the stock market on January 1? Well, here’s one hint, from Luskin’s article:

“If there’s a bargaining failure and the scheduled tax hikes on dividends aren’t stopped, we’ll be sorry we’re spending so much political energy now debating about the ’1%’ and their supposed privileges. It’s the 30% down in the stock market we ought be worrying about.”

This is just another attempt to mask the blatant unfairness of the Bush tax cuts by arguing by arguing that that they are good for all of us (well, at least all of us who own stocks, but that’s a matter for another post). They’re not.

* Luskin also talks about “trillions more in new tax hikes under ObamaCare.” Huh? The revenue provisions of the Affordable Care Act are projected to bring in $520 billion over the next decade; even if you include the revenue-increasing coverage provisions (like the excise tax on high-cost health plans), you only get up to $813 billion. That’s not “trillions,” unless you’re talking about an undiscounted infinite horizon.

Money as the Ultimate Giffen Good

This post is contributed by StatsGuy, an occasional guest contributor and commenter.

Monday August 8 2011 witnessed a truly impressive financial spectacle—a natural experiment of the kind we see only once a century or so.  The S&P downgraded US debt, and the price of US Treasuries skyrocketed.

Many pundits were left scratching their heads.  Professional traders tripped over themselves trying to get out of the way.  Macroeconomists at least had an explanation, arguing that the downgrade meant substantially lower growth, and this forced people to shift into Treasuries since bonds rise when growth projections diminish.

While some macroeconomists have an inkling of what is going on, I suspect they got their causation backwards.  Why would an increase in a risk rating on debt directly lower growth projections?  Usually, the increases in risk ratings cause increases in interest rates, and it’s the rate hikes that harm growth.  But, um, nominal interest rates went down, right?  Shouldn’t that have helped growth?  More sophisticated economists will note that when they talk about rates, they mean the real rate (adjusted for inflation), and that if inflation expectations drop more than nominal interest rates, then real interest rates go up and this will slow growth.  However, this did not happen—real interest rates actually declined about 0.2% along most of  the yield curve between Monday the 8th and Tuesday the 9th.  And if real rates declined, how would this cause lower growth?  Instead, I suspect the decline in real rates was the outcome of lower expected growth.  It’s all very circular and confusing, but at least I’m not alone.  Others seem even more confused.

For example, Dick Bove said:  “We have people buying Treasury securities because they’re worried about the Treasury.  We’ve got people selling banks stocks, taking the cash and putting into the banks for safety. It doesn’t make sense. What you’re seeing is this adjustment is occurring and people are not sure how to react to this adjustment.”

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Lessons from the Oracle

By James Kwak

[I wrote this post a month ago but just realized I never clicked "Publish." It's about a book that was published more than two years ago, though, so it shouldn't have gotten any more stale.]

I recently finished reading Snowball, Alice Schroeder’s 2008 biography of Warren Buffett. It wasn’t a bad read, although at over eight hundred pages it was on the long side and began to seem repetitive; the impression I got was that Buffett had the same kinds of relationships with his family and friends for a long time, and not much changed over the decades.

The big question about Buffett for people like me — people who invest in low-cost index funds, that is — is whether he is smart or lucky. After all, since Burton Malkiel’s Random Walk Down Wall Street, the main argument against stock-picking skill has been that in a coin-flipping tournament featuring thousands of players (and with survivorship bias), someone is bound to win time after time after time.

The answer, at least the one from the book, is that Buffett is smart. And that shouldn’t be too surprising. I recently read a pile of papers about active mutual fund management, mainly from the Journal of Finance, and I’d say that while there’s no consensus per se, the general trend has been that there are some mutual fund managers who can beat the indexes and can more than cover their costs.* There aren’t many of them, they are outnumbered by the ones who do worse than the indexes, and they are probably hard for you and me to find, but they exist. And I say this despite the fact I didn’t want it to be true.

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The Power of Conventional Wisdom

The week between Christmas and New Year’s is probably a good time to throw out half-baked ideas on topics I don’t know much about.

First, there’s been a lot of talk about the “lost decade” for stocks. The S&P 500 is below where it was a decade ago. Dividend yields bring you back up to break-even (the Vanguard Total Stock Market Index Fund had average annual returns of 0.18% for the ten years through the end of November, and that’s after about 0.1% in expenses), but inflation sets you back a couple of percentage points per year. (Vanguard’s S&P 500 index fund, however, was negative over those ten years.) James Hamilton, drawing on data from Robert Shiller, has some thoughts on why the stock market did badly; the fundamentals were so-so, but the big factor was that valuations were at their historical peak at the beginning of the decade.

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Is It 1999 All Over Again?

The New York Times’ Bits blog has a post on Trefis, a Web 2.0 startup that apparently makes it easy for you to create your own valuation model for public companies. They give you starter models using public information, and you can then tweak the assumptions to come up with your own valuation. The pitch is that this puts the tools used by research analysts and professional investors in the hands of the retail investor. “Perhaps these new tools will put some added pressure on the sell-side professionals – many of whom are notorious for creating overly optimistic takes on the companies they follow.”

Or maybe they will make retail investors think they have an advantage that they really don’t. Advantages in stock valuation have to be based on superior information, which you can get by doing lots of market research (like some old-fashioned hedge funds do) or by having privileged access to company insiders. Superior information can include superior forecasting ability, so if you have some ability to predict the market size for routers better than anyone else, you can make money from it. But neither of these are things you get from models; they are things you plug into models. I’m sure the founders of Trefis don’t see it this way, but this feels to me like a great way to lure people into individual stock-picking, and thereby a boon to stock brokers everywhere.

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Zvi Bodie on Personal Finance

Occasionally we get personal finance questions. Actually, we’ve gotten fewer of those questions lately, perhaps because readers realize we don’t have much to offer on that score, and that we try to avoid anything that might sound like investment advice.

Zvi Bodie, whose name you may have seen here before, has thought a lot about personal investing, and agrees with some of the positions I’ve offered here: notably, that most information about personal finance available on the market is not worth listening to. Bodie recently posted a series of 3-minute webcasts to the Boston University School of Management website where he lays out some basic advice on saving for retirement, including some of the implications of the current economic crisis. I didn’t watch all of them, but I liked how accessible they were.

By James Kwak