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Copyright © 2008 by Institute of Business & Finance. All rights reserved. v2.0
INSTITUTE OF BUSINESS & FINANCE
QUARTERLY UPDATES
Q4 2007
Quarterly Updates
Table of Contents
MUTUAL FUNDS
MUTUAL FUND DIRECTORS 1.1
MORNINGSTAR RATING SYSTEM 1.1
TARGET-DATE FUNDS AND FOREIGN EXPOSURE 1.2
VALUE VS. GROWTH 1.2
STEWARDSHIP RANKINGS 1.2
AFTER-TAX PERFORMERS 1.3
MULTIPLE ASSET CLASS INVESTING 1.4
MUNICIPAL BOND DEFAULT RATE 1.6
INTERNATIONAL EQUITIES 1.7
MAKING A CASE FOR UTILITIES 1.7
STRUCTURED NOTES 1.8
30 YEARS OF WITHDRAWALS 1.10
RETIREMENT
MORNINGSTAR’S 401(K) PLAN 2.1
FUND FAMILY MANAGER RETENTION RATES 2.1
529 PLANS VS. ROTH IRAS 2.2
ANNUITIES
INCOME ANNUITIZATION 3.1
ONLINE ANNUITY RESOURCES 3.1
IMPROPER ANNUITY CONTRACT STRUCTURE 3.2
REAL ESTATE
GNMA ISSUES REVERSE MORTGAGE BONDS 4.1
REVERSE MORTGAGE CHOICES 4.1
REIT WEBSITES 4.2
REAL ESTATE LOSSES 4.3
REAL ESTATE GAINS 4.3
CLOSED-END FUNDS
CLOSED-END FUND FACTS 5.1
COVERED CALL CEFS 5.1
ETFS
MUNICIPAL BOND ETFS 6.1
ETN RUSH 6.1
FREE ETF AND MUTUAL FUND TOOLS 6.2
FOREIGN BOND ETFS 6.3
MISC.
NO OIL SHORTAGE 7.1
HEDGE FUND TRADING 7.1
FUND CURRENCY HEDGING 7.2
CORPORATE PROFITS 7.2
PRESCRIPTION DRUG COVERAGE 7.2
RATING HOSPITAL CARE 7.3
LONGER LIFE EXPECTANCY 7.4
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MUTUAL FUNDS
1.1 MUTUAL FUNDS
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1.MUTUAL FUND DIRECTORS
Mutual fund directors can negotiate lower fees for shareholders, fire fund managers, and
merge a fund into another. Directors also oversee the valuation of hard-to-price securities
and 12b-1 fees. Fund directors must also assess their own performance, explain their
reasons for approving advisory contracts, and have policies designed to prevent securities
law violations.
Fund boards typically meet 4-5 times a year; the median director compensation for the
largest fund families was $172,000, according to a Management Practice survey. A third
of the directors surveyed said they spend more than 50 hours per quarter on board work.
A study by Binghamton University and Cornell University found that funds that received
good Morningstar governance grades outperformed those with bad grades by 1.2 to 1.9
percentage points a year between late 2004 and the end of 2006. Another study indicated
that more independent boards have less patience with poorly performing funds and are
more likely to merge them with other funds.
MORNINGSTAR RATING SYSTEM
The Morningstar star rating system is a way advisors and investors can easily see a
mutual fund’s long-term risk-adjusted performance over the past three-, five-, and 10-
years. Each fund is compared to its category (vs. a broader asset-class that was used until
2002). Thus, a small cap value fund is now compared to other small cap value funds. The
system is based on the assumption that at any given risk level, investors are happy to
reduce their risk level in return for less return potential (vs. the old rating system which
looked only at a single point on the risk/reward curve). Funds that charge a commission
are penalized under the star rating system.
At the end of June each year, Morningstar does a comparison to see how accurate their
ratings have been. Generally, 5-star funds have slightly outperformed 4-star funds, 4-star
funds have slightly outperformed 3-star offerings, and so on. When you compare 5-star
with 1-star funds, the differences become noticeable. For example, for the 5-year period
ending 6/30/2007, 5-star domestic stock funds beat their 1-star peers by 1.5% annualized;
in the case of foreign stock funds, the difference was 0.90% per year difference. The
ratings for the past five years have worked best for balanced funds, where a 5-star rating
resulted in an average performance advance of 3.1% annualized over 1-star balanced
funds. Taxable bond funds rating 5-star outperformed 1-star funds by 0.7% per year;
1.1% in the case of municipal bond funds. Morningstar also looked at expense ratios,
“Funds that are both 5-star and low cost have a significantly lower standard deviation
than those that are just five stars.”
MUTUAL FUNDS 1.2
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TARGET-DATE FUNDS AND FOREIGN EXPOSURE
Even though about half the value of the world’s total stock market value is outside the
U.S., few advisors would feel comfortable with such a high exposure for their clients.
Two areas that target-date funds have been criticized are too little exposure to equities
(given the multi-decade time horizon of their typical investor) and not having enough
foreign exposure. Ibbotson Associates recommends a 30% international weighting for
long-term investors; Vanguard suggests 20% of the portfolio should be overseas, while
Fidelity is closer to 25%, Putnam is around 30%, and AllianceBernstein is above 35%.
VALUE VS. GROWTH
According to the book, “What Works on Wall Street,” from 1963 to 2005, high p/e stocks
returned 6.9% a year, compared with 15.0% for low p/e stocks. The book’s author, James
O’Shaughnessy, points out that low price-to-sales stocks returned 5.6% versus 2.6% for
their high price-to-sales peers. From 1927 to 2006, large cap value stocks returned 12.0%
a year, compared to 9.1% for large cap growth, while small cap value returned 14.8% a
year versus 9.6% for small cap growth. For the period 1927 to 2004, value stocks
returned 12.5% a year versus 9.0% for growth stocks, based on price to book value,
according to Morningstar.
STEWARDSHIP RANKINGS
Morningstar ranks mutual fund families in five areas (corporate culture, fund manager
incentives, board of directors oversight, fees, and regulatory history) to arrive at
Stewardship Grade. Of the five criteria, “corporate culture” counts for up to four of the
10 possible points a fund family can receive. Regulatory compliance receives zero points,
but can count for up to two negative points if a family ignores its regulatory obligations.
The October 2007 table below shows the fund families that have the highest stewardship
ratings; the number of funds in the family are shown in parentheses.
1.3 MUTUAL FUNDS
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2007 Stewardship Grades
Fund Family Grade Fund Family Grade
Clipper (1) A FPA (5) B
Davis/Selected (7) A Vanguard (96) B
Dodge & Cox (4) A Primecap (3) B
Diamond Hill (3) A American Funds (24) B
T. Rowe Price (69) B Royce (11) B
AFTER-TAX PERFORMERS
When deciding whether or not to use an index fund or ETF, one of the considerations is
its performance compared to a benchmark, on a before and after tax basis. The table
below shows the percent of active domestic stock fund managers who have outperformed
their respective index on a before tax and after tax basis. The results were based on 10-
year annualized figures (1987-2006). The figures shown in parentheses represent the
percentage of actively-managed U.S. stock funds that have outperformed their benchmark
on an after tax basis.
Active Management vs. Index [1997-2006]
Value Blend Growth
Large Cap 15% (4%) 31% (14%) 63% (44%)
Mid Cap 13% (0%) 46% (16%) 54% (30%)
Small Cap 35% (7%) 81% (53%) 82% (69%)
As you can see, the chances of a fund manager outperforming its value benchmark on an
after-tax basis ranges from 0-7%, while the odds of a small cap growth or blend active
manager having better after-tax returns ranges from 53% to 69%. This means that over
the past 10 years, the vast majority of advisors interested in value stocks would have been
better off using an index fund or ETF.
MUTUAL FUNDS 1.4
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MULTIPLE ASSET CLASS INVESTING
A study by Roger Gibson covering the 25-year period from 1986 to the end of 2005
shows the benefits of structuring client portfolios using multiple asset categories,
particularly real estate and commodities. A quote from Talmud (circa 1200 B.C.-500
A.D.) supports this view: “Let every man divide his money into three parts, and invest a
third in land, a third in business, and a third let him keep in reserve.” As of the end of
2005, the world’s total investable capital market was valued at $93.4 trillion, according to
UBS Global Asset Management. As you can see, the U.S. represents close to half the
world’s investable capital (25.5% + 16.9% + 6.2% + a portion of “cash equivalents”).
$93.4 Trillion Capital Market Breakdown [12-31-2005]
U.S. Bonds 25.5% Cash Equivalents 4.1%
Non-U.S. Bonds 21.5% Emerging Market Bonds 2.9%
Non-U.S. Stocks 20.7% Emerging Market Stocks 1.8%
U.S. Stocks 16.9% Private Markets 0.3%
U.S. Real Estate 6.2%
The Gibson study which looks at every 25-year rolling period ending 1997 through 2005,
includes a number of exhibits that can be summarized as follows:
[A] For every 25-year period, a pure long-term bond portfolio has the least amount of risk
when its composition is 70% in U.S. corporate bonds and 30% in foreign bonds, almost
always resulting in slightly lower returns. However, in all cases, when the foreign bond
exposure was increased from 0% to 10%, 20% or 30%, the small loss in returns was more
than offset by a correspondingly higher percentage drop in risk.
[B] Stock diversification into foreign equities usually resulted in a lower standard
deviation; an increase from 20% to 30% in foreign stocks made virtually no difference.
Thus, historically the advisor did not increase or decrease risk or reward by altering the
international equity weighting from 20% to 30% or from 30% to 20%. However, adding
foreign stocks to a pure U.S. stock portfolio did decrease risk by 1-7%, usually adding
nothing or little to annualized returns. Specifically, over every 25-year period, portfolio
volatility was lower with a foreign equity allocation of 10% or 20%; in almost every 25-
year period, volatility was also lower with a 30% allocation to international stocks.
1.5 MUTUAL FUNDS
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[C] Looking at every possible 1-4 asset class portfolio (U.S. stocks, foreign stocks, real
estate securities, and commodities) and reviewing every 25-year rolling period from 1972
to the end of 2005: (1) two-asset portfolios generally had less risk and better returns than
single asset portfolios; (2) three-asset portfolios had better risk/return characteristics than
two asset class portfolios; and (3) the four-asset-class portfolio (25% in U.S. stocks, 25%
in foreign stocks, 25% in real estate securities, and 25% in commodities) had less risk
than any combination of 1-3 asset classes (except an equal weighting in U.S. stocks, real
estate securities, and commodities) and a higher annualized return (over 13%) than most
combinations.
As an example, a portfolio with an equal weighting in all four asset classes had a return
very similar to a 100% investment in real estate securities (which was the number one
performer over the 25-year rolling periods) but with 1/3rd
less risk. This is quite a surprise
since the other three asset classes (U.S. stocks, foreign stocks, and commodities) had
lower returns and more volatility than real estate securities.
The table below shows the returns of the 15 equity portfolios described in “[C]” above
for all 25-year rolling periods from 1972 through 2005 (note: U = U.S. stocks, F =
foreign stocks, R = real estate securities, and C = commodities). All of the annualized
return figures have been rounded off to the nearest ½%, with the exception of the Sharpe
Ratio, which was rounded off to the nearest 1/10th
).
Returns and Risk for 15 Different Equity Portfolios [1972-2005]
Portfolio Return Portfolio Std. Dev. Portfolio Sharpe
RC 14.0% URC 11.0% URC 0.7
FRC 13.5% UFRC 11.5% FRC 0.7
URC 13.5% FRC 12.0% UFRC 0.7
R 13.5% UFC 13.0% RC 0.6
UFRC 13.5% UC 13.0% UR 0.6
FC 13.0% RC 13.5% UFC 0.6
FR 13.0% UR 14.5% UR 0.5
UR 13.0% UFR 15.0% FC 0.5
UFR 13.0% FC 15.5% R 0.5
UR 12.5% FR 15.5% FR 0.5
UFR 12.5% R 16.5% UFR 0.5
C 12.0% U 17.5% UF 0.4
UF 11.5% UF 17.5% U 0.4
F 11.5% F 22.0% C 0.3
U 11.0% C 24.5% F 0.3
MUTUAL FUNDS 1.6
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Returns and Risk for 1-4 Asset Portfolios [1972-2005]
Portfolio Return Portfolio Std. Dev. Portfolio Sharpe
4 assets 13.5% 4 assets 11.5% 4 assets 0.7
3 assets 13.0% 3 assets 12.5% 3 assets 0.6
2 assets 13.0% 2 assets 15.0% 2 assets 0.5
1 asset 12.0% 1 asset 20.0% 1 asset 0.4
As you can see from the summary table above, the four-asset-class portfolio had the
highest returns, the least risk, and the best Sharpe Ratio. This table clearly shows the
advantages of asset class diversification. The final table below shows the five worst
calendar years during the 1972-2005 period for each of the four asset classes as well as a
portfolio with an equal weighting in each (U.S. stocks, foreign stocks, real estate
securities, and commodities). As you can see, there is a huge difference between a single
asset category portfolio and one with all four asset classes.
Five Worst Years [1972-2005]
U.S. Stocks Foreign Stocks R.E. Securities Commodities Equal Allocation
-26% (1974) -23% (1990) -21% (1974) -36% (1998) -13% (2001)
-22% (2002) -22% (1974) -18% (1998) -32% (2001) -8% (1974)
-15% (1973) -21% (2001) -16% (1973) -23% (1981) -6% (1981)
-12% (2001) -16% (2002) -15% (1990) -17% (1975) -3% (1990)
-9% (2000) -14% (1973) -5% (1999) -14% (1997) -1% (1998)
MUNICIPAL BOND DEFAULT RATE
Between 1970 and 2006, only 41 municipal bonds defaulted. The default rate for the 10-
year period 1997-2006 was just 0.1%, versus a 0.5% default rate for AAA-rated corporate
bonds and 2.1% for investment-grade bonds, according to Moody’s. According to a
PIMCO report, high-yield municipal bonds had a 16% correlation to stocks and a 41%
correlation to high-yield corporate bonds over the 10 years ending September 2006.
1.7 MUTUAL FUNDS
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INTERNATIONAL EQUITIES
Since 1975, adding foreign stocks (MSCI EAFE Index) has almost always produced a
diversification benefit, lowering volatility over three-year holding periods. Historical data
indicates that the average returns and volatility for the EAFE Index and S&P 500 have
been very similar when looking at the period 1971 through 2005. For example, during
this time period, the S&P 500 averaged 12.1% per year and had a standard deviation of
16%, while the EAFE averaged 12.6% with a standard deviation of 17%.
MAKING A CASE FOR UTILITIES
Utility funds are often ignored by advisors and brokers, yet, this conservative sector asset
category can add needed portfolio diversification, a proven stream of comparatively high
dividends, and total return figures that rival the S&P 500, with similar risk. For example,
the table below compares annualized returns for large cap blend with utility funds.
Large Cap Blend Funds vs. Utility Funds
[periods ending December 31st, 2007]
3 year 5 year 10 year 15 year
Utility Funds 21.5% 11.5% 10.2% 9.7%
Large Cap Blend Funds 10.1% 6.0% 7.7% 9.9%
A desired effect of adding any asset category is the hope of reduced portfolio volatility, a
result of either a lower correlation coefficient or the risk characteristics of the investment
itself. Surprisingly, the standard deviation for utility funds is slightly greater than that of
large cap blend or value funds (8 vs. 7), but lower than large cap growth funds (10 vs. 8),
even though utilities have a much lower beta (0.6 vs. 1.0 for large cap blend and 1.3 for
large cap growth funds).
MUTUAL FUNDS 1.8
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With an R-squared of just 25 (vs. 85 for large cap blend funds and 100 for the S&P 500),
it is easy to see the possible diversification benefits. Moreover, such diversification is
needed now that it appears the correlation coefficient between blend, growth, and value
domestic funds is quite high, as shown in the table below.
Correlation to the S&P 500
[3 years ending 6/30/07]
Value Blend Growth
Large 0.97 0.99 0.94
Mid 0.90 0.90 0.87
Small 0.84 0.84 0.83
For the 15-year period ending 6/30/2007, utility funds had a 0.34 correlation to the S&P
500 (vs. 0.15 for gold, 0.51 for energy, and 0.28 for REITs). Over these same 15 years,
the S&P 500 experienced 60 months of negative returns; utility funds outperformed the
S&P 500 60% of time when the S&P 500 had a negative month.
STRUCTURED NOTES
Structured products usually combine some type of downside protection along with some
degree of upside potential. Typically, a structured note uses derivatives to either add or
remove risk from a specific asset such as a stock, market index, commodity, or currency.
During the 2006 calendar year, U.S. investors bought over $64 billion of these products
(vs. over $190 billion in Europe), a 32% increase from the previous year. There are three
basic types of structured notes: principal protection notes, enhanced yield products, and
reverse convertibles; the AMEX website defines 54 different subsets of the structured
products it trades in.
Principal Protection Notes PPNs offer investors equity exposure without risk to principal. These notes usually have a
five year maturity and 100% market participation along with 100% principal protection.
For example, a Merrill Lynch note that tracks the S&P 500, the Nikkei 225, and the Euro
50 indexes guaranteed a minimum return of at least 5% along with FDIC insurance.
1.9 MUTUAL FUNDS
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The correlation between U.S. stocks and other developed stock markets has generally
been higher during U.S. bear markets. Yet, even when the correlation is high,
international investing may provide the short-benefit of higher returns, as during most
U.S. bear markets, or lower volatility, as during the technology bubble. As you can see
from the table below, even excluding the 1987 Crash, the returns of the S&P 500 and
EAFE Index has generally been high during bear markets.
S&P 500 and EAFE Correlation
1971-2005 1971-1986 1988-2005
Bear Bull Bear Bull Bear Bull
65% 47% 52% 39% 75% 54%
During six of the eight U.S. bear markets since 1971, a 20% allocation to EAFE stocks
provided an average 2.2% greater return and just 0.7% less volatility than 100% invested
in the S&P 500. During bull markets during this same period, a 20% EAFE weighting
resulted in 0.8% less return and 1% lower volatility.
MUTUAL FUNDS 1.10
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30 YEARS OF WITHDRAWALS
Suppose you have clients who believe their remaining life expectancy is 30 years and
have little or no donative intent. With a goal of structuring a portfolio that will least 30+
years, given a consistent annual withdrawal amount (meaning no adjustment for
inflation), the table below shows the odds of obtaining that goal.
The table below shows the odds of someone not outliving their nest egg using different
withdrawal rates. All of the percentage figures, which range from 72% to 100% are based
on Monte Carlo probability analysis using stock, bond, and cash equivalent indexes over
the past 25-80 years (20 years in the case of EAFE stocks and 80 years in the case of all
other asset categories). The 5,000 simulations done to obtain these percentages (odds of
success) did not factor in any expense ratios or other costs associated with a brokerage or
mutual fund account.
— Annual Withdrawal Rate —
3% 4% 5% 6%
Asset Mix
S&P 500….100%
Long-term corporate bonds….0%
99% 98% 95% 89%
S&P 500….50%
Long-term corporate bonds….50%
100% 99% 98% 93%
S&P 500….50%
Long-term corporate bonds….50%
100% 99% 92% 72%
S&P 500….28%
EAFE Index….12%
Long-term corporate bonds….40%
Cash (90-day T-bills)….20%
100% 100% 99% 94%
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RETIREMENT
2.1 RETIREMENT
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2.MORNINGSTAR’S 401(K) PLAN
The table below shows the mutual funds that Morningstar uses for their own 401(k) plan,
as of the third quarter of 2007. Funds that include “**” indicate a portfolio weighting of
15-20%, a “*” means a weighting of 3-8% (note: it appears that no fund has a weighting
of 9-14%).
American Beacon Small Value (AVPAX) * T. Rowe Price High-Yield (PRHYX)
American Funds New World (NEWFX) T. Rowe Price Small-Cap Stock (OTCFX) *
Brandywine (BRWIX) Tweedy, Browne Global Value (TBGVX) *
Harbor Capital Appreciation (HACAX) ** Vanguard Institutional Index (VINIX)
Oakmark Select (OAKLX) ** Vanguard FTSE Social Index (VFTSX) *
PIMCO Real Return Insl (PRRIX) * Vanguard International Growth (VWIGX) **
PIMCO Total Return (PTTRX) Vanguard LifeStrategy Growth (VASGX)
Primecap Odyssey Agg. Growth (POAGX) * Vanguard Selected Value (VASVX) *
Selected American D (SLADX)
FUND FAMILY MANAGER RETENTION RATES
Mutual fund advisory firms generally agree that performance and manager retention are
closely related. Fund companies that have a high retention rate are usually near the top
when it comes to peer group performance. Similarly, funds near the bottom when it
comes to retention are often poor performers. The table below shows the five-year
average manager retention rate of 24 of the largest mutual fund families, for the period
2002-2006). The retention rate was determined by looking at who was listed as a fund
manager of a fund within a family at the beginning of the year and then seeing if that
person was still listed as a manager of the fund at the end of the year (note: if a manager
stayed with the parent company but was no longer listed as the fund’s manager, it was
still considered a departure).
RETIREMENT 2.2
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2007 Fund Manager 5-Year Retention Rate
95-100% retention 85-89% retention
Dodge & Cox PIMCO
American Funds Van Kampen
T. Rowe Price Columbia
90-94% retention Fidelity
Janus ING
Vanguard AIM
Oppenheimer John Hancock
Franklin Temnpleton Principal Investors
Hartford BlackRock
American Century 79-84% retention
GMO MFS
AllianceBernstein JP Morgan
DWS-Scudder
Putnam
529 PLANS VS. ROTH IRAS
A Roth IRA may be a better alternative to a 529 Plan when it comes to funding a child’s
education. Withdrawals from a Roth IRA are tax-free and penalty-free whenever it is
used to fund higher education, versus restrictions for 529 Plan withdrawals. The biggest
advantage of a 529 Plan is that it is funded with pre-tax dollars, while a Roth IRA uses
after-tax dollars; the biggest advantage the Roth has is that its flexibility is much greater.
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ANNUITIES
3.1 ANNUITIES
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3.INCOME ANNUITIZATION
A 2007 study by Wharton and New York Life Insurance shows that an income annuity
can provide an income stream for life at a cost of as much as 40% less than a traditional
stock, bond, and cash mix. Phrased another way, the study shows that someone who
needs a $1 million next egg can maintain the same lifestyle by purchasing a $600,000
lifetime annuity. A 65-year-old male will receive about $86,000 a year, while $1 million
invested in a traditional securities portfolio would generate $40,000-$50,000 annually,
depending on the withdrawal rate.
Even though a 65-year-old man is expected to live to age 85, about half of these men will
live well past age 85, some may even reach 100. Retirement income planning tends to
“break down” for those that live longer than expected, according to Wharton School
Professor David Babbel and Brigham Young Professor Craig Merrill, the two authors of
the study. According to Babbel, “The best strategy is to invest enough in an annuity early
in retirement to cover basic fixed costs. That allows you to invest the remainder of your
portfolio more aggressively.” The Wharton study is available at investmentnews.
com/retirementcenter/annuities.
ONLINE ANNUITY RESOURCES
The following online sources can help you determine if a client should invest in annuities
and, if so, how much:
immediateannuities.com
Instant quotes for monthly payouts from immediate fixed-rate annuities
longevityalliance.com
Describes different types of annuities and sends quotes, via email or telephone, for
immediate annuities.
incomesolutions.com/annuityfaq.asp
Answers basic questions about immediate fixed-rate annuities.
ANNUITIES 3.2
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sec.gov/investor/pubs/varannty.htm
The SEC publication, “Variable Annuities: What You Should Know.”
naic.org/documents/consumer_alert_annuities_senior_citizens.htm
The National Association of Insurance Commissioners description of the different types
of annuities, whether annuities are the right choice, and warnings about deceptive sales
practices.
IMPROPER ANNUITY CONTRACT STRUCTURE
According to Advanced Sales Corp. (ASC), from 2002 to 2006, 38% of variable annuity
contracts were improperly structured (who should be the owner, annuitant and
beneficiary). The most common shortcoming has been not naming any beneficiary. The
second most common mistake was naming someone as beneficiary other than the person
who was intended to inherit the contract, usually the client’s spouse. There are over 600
different variable annuity contracts. Four simple rules to keep in mind are: [1] every
annuity pays out when any contract owner dies, unless spousal continuation is allowed;
[2] with an owner-driven contract, the death of annuitant means nothing—there is no
death benefit payout; [3] with an annuitant-driven contract and the sole annuitant dies, the
contract must pay out; and [4] every rule can have an exception.
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REAL ESTATE
4.1 REAL ESTATE
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4.GNMA ISSUES REVERSE MORTGAGE BONDS
The U.S. Government insures about 90% of all reverse mortgages, according to the
Federal Housing Administration. Since 2003, the number of reverse mortgages that are
backed by the federal government has increased from 20,000 to 108,000 (as of 9-30-
2007). GNMA announced in early November 2007 that it will soon offer the “first
standardized” bond issue backed by reverse mortgages. The first offering is expected to
be about $120 million and will consist of more than 1,000 government insured reverse
mortgages.
REVERSE MORTGAGE CHOICES
Close to 120,000 reverse mortgages were originated in 2007, up from less than 80,000 in
2006; 90% of all such loans are insured by FHA. As the marketplace for reverse
mortgages becomes more popular, the number of lenders and product structure has also
opened up. For example, one lender has reduced the minimum age requirement from 62
to 60; another lender is going after “jumbo” reverse mortgages for homes valued as much
as $10 million (borrowers can receive up to 65% of this amount). Most reverse mortgages
are variable rate, but some institutions also offer a fixed-rate option.
Upfront fees from well-known reverse mortgage lenders such as Wells Fargo and Bank
of America can be as high as 5% or more of the home’s value. Practitioners advising
clients about reverse mortgages should ask the prospective lender what index is used for
the reverse mortgage (some use Libor and others use the CMT index, which is based on
U.S. Treasury bonds). The advisor should also find out the total amount of fees that are to
be paid.
For example, toward the end of 2007, someone in Georgia with a $500,000 house could
receive a reverse mortgage for up to $148,300 with a 7.8% loan (rough 1-1.5% higher
than a conventional first mortgage loan backed by GNMA or FNMA); the fees paid
would equal about $7,000 (or 1.4% of the home’s value). The same borrowers could get
up to $140,600 through a FHA-backed reverse mortgage, pay $13,260 in fees and receive
a 4.9% loan.
REAL ESTATE 4.2
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REIT WEBSITES
www.nareit.com
The national REIT trade group (NAREIT) provides daily market information, index data,
historical returns, updates, and real estate news.
www.investinreits.com
Operated by NAREIT, this site includes information on 200 REIT stocks, real estate
mutual funds and ETFs, as well as closed-end REITs.
www.nareit.com/portfoliomag/
NAREIT’s print publication, Real Estate Portfolio, includes stories and news about
specific REITs and information on foreign REITs.
http://biz.yahoo.com/industry/
This Yahoo Industry Center provides links to REIT company news, earnings releases,
and other information.
www.wilshire.com/Indexes/RealEstate
The latest news on stock indexes such as the Dow Jones Wilshire Real Estate Securities
Index, provided by Wilshire Associates.
www.inman.com
Headline news on the real estate industry, provided by an independent source.
www.cushwake.com
The Cushman & Wakefield website includes annually updated research reports, headline
news, industry analysis and rental/vacancy rates from around the world.
www.rer.org
The trade group, Real Estate Roundtable, represents owners of $700 billion in properties.
The site highlights the latest political and economic topics affecting the real estate
industry; website links to other industry groups are also included.
4.3 REAL ESTATE
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REAL ESTATE LOSSES
A December 2007 report from the Organization for Economic Cooperation and
Development estimated that investors lost $300 billion related to real estate mortgages.
According to Stanford professor Michael Boskin, “Even if two million households facing
subprime resets reduced their consumption 25%, overall national consumption would
decrease just 0.3%. Consumer spending accounts for 70% of the GDP for the U.S.
In a December 12th
, 2007 letter addressed to The Wall Street Journal, former chairperson
of the Federal Reserve, Alan Greenspan noted: “The value of equities traded on the
world’s major stock exchanges has risen to more than $50 trillion, double what it was in
2002….The market value of global long-term securities is approaching $100
trillion….Although central banks appear to have lost control of longer term interest rates,
they continue to dominate in the market for assets with shorter maturities…The current
credit crisis will come to an end when the overhand of inventories of newly built homes
is largely liquidated, and home price deflation comes to an end. That will stabilize the
now-uncertain value of the home equity that acts as a buffer for all home mortgages, but
most importantly for those held as collateral for residential mortgage-backed securities.”
REAL ESTATE GAINS
According to the National Association of Realtors, from 2002 through the end of 2005,
the national existing median home price rose 33%. The gains for 2006 were estimated to
be in the 5% range, but the number is questionable since it now appears prices peaked
during the second or third quarter of 2006. However, even including a 2006 estimated
gain of 5%, the cumulative gain for 2002 through the end of 2006 was just under 40%.
Even strong real estate advocates and real brokers would agree that these 3-4 years have
been some of the very best for home appreciation. However, as shown by the table below,
one could make the argument that stocks were an even better option during this same
period.
Starting with 1995 year-end values, appreciation for the median existing U.S. home was a
cumulative 100% for the 11-year period, 1996 through 2006. During this same period, the
S&P 500 had a cumulative appreciation of 178%; small stocks had a total return of 321%.
REAL ESTATE 4.4
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U.S. Median Home Price Appreciation vs. Stocks [1996-2006]
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
homes 5% 5% 5% 5% 5% 6% 6% 9% 9% 12% 5%
S&P 500 23% 33% 29% 21% -9% -12% -22% 29% 11% 5% 16%
Small stocks 18% 23% -7% 30% -4% 23% -13% 61% 18% 6% 16%
The case for stocks becomes even stronger for this time frame when you factor in
the costs of homeownership (e.g., debt service, fire insurance, property taxes,
maintenance, remodeling, etc.). For example, subtracting 2% annually for homeowner
expenses (a conservative estimate since annual property taxes alone are 1-2%+ of
the home’s value), the cumulative return for median home appreciation drops from
100% down to 63%.
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CLOSED-END FUNDS
5.1 CLOSED-END FUNDS
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5.CLOSED-END FUND FACTS
According to the Closed-End Fund Association, a trade association located in Kansas
City, the first closed-end fund (CEF) was introduced in the U.S. in 1893, more than 30
years before the first open-end fund. As of the third quarter of 2007, over $350 billion
was invested in closed-end funds (CEFs), versus more than $11 trillion in traditional
mutual funds. The average expense ratio for a mutual fund is 1.29% versus 1.26% for the
average CEF.
The average U.S. household has $60,000 invested in financial assets; the average
household that owns mutual funds has a typical balance of $125,000—the average
household owning CEFs has $370,000 invested in closed-end funds. Municipal bond
funds are the largest category of CEFs ($95 billion), followed by stock CEFs ($87
billion) and U.S. taxable bond CEFs ($68 billion). As of the middle of 2007, the average
discount for a CEF was 5.6%. The IPO volume for CEFs for 2007 may reach an all-time
high, surpassing the 2003 record of $31 billion.
COVERED CALL CEFS
Since 2004, over 40 stock funds have launched a covered call, or “buy-write,” strategy;
most of the offerings have been closed-end funds (CEFs). Many of these funds that focus
on covered call writing promote their double-digit yields instead of total return. The
selling of covered calls is what generates the vast majority of the funds’ current yield.
Over half of the buy-write funds have NAVs that are below their initial offering price,
meaning capital gains have suffered. One argument against covered call writing is that
the best performing stocks get called away; a number of funds counter this argument by
selling covered calls against a market index such as the S&P 500.
Advisors who are attracted to a covered call strategy using CEFs should never buy the
IPO, since the majority of all CEFs end up trading at a discount that reflects a
commission premium (typically 4.8%) and liquidity. For example, a buy-write fund could
show a 12% annual return for the past 2-3 years but only a 7% return for initial investors
who paid a premium for the IPO. Two of the bigger participants that utilize a covered call
strategy are Eaton Vance and Nuveen.
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ETFS
6.1 ETFS
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6.MUNICIPAL BOND ETFS
The first municipal bond ETF was introduced in September 2007 (iShares S&P National
Municipal Bond Fund). Barclay’s bases this ETF on the S&P National Municipal Bond
Index of 3,069 issues with a rating of BBB- or better from at least one of the major rating
services. The Barclay’s ETF contains about 36 (7 year duration) of the 3,069 issues.
State Street’s SPDR Lehman Municipal Bond ETF is benchmarked against the Lehman
Brothers Municipal Managed Money Index; the index is comprised of over 22,000 muni
bonds rated AA3/AA- or higher. State Street’s ETF will use about 37 (8 year duration) of
the 22,000 index securities. PowerShares uses a customized Merrill Lynch muni index.
Illiquid securities can behave quite differently than liquid bonds in the same index. State
Street expects a tracking error of 0.50% to 0.75%; any “error” could either benefit or hurt
investors. The 1,929 municipal bond funds tracked by Morningstar have an average
expense ratio of 1.1%, versus 0.25% for the Barclay’s ETF and 0.2% for the State Street
ETF.
ETN RUSH
Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) both track an index
and trade throughout the day. The ETN is a way for a financial institution to repackage
and sell “structured notes,” which previously were only available to wealthy investors or
institutions. ETNs do not have to adhere to some of the regulations that apply to ETFs
and traditional mutual funds. ETNs: [1] are traded throughout the day, [2] can be bought
on margin, [3] can be shorted, and [4] are registered under the Securities Act of 1933.
ETNs do not have a net asset value; their daily value is based on indexes published by the
issuer. Perhaps the biggest appeal of an ETN is that they allow investors to
participate in asset classes and geographical areas that they cannot directly invest,
due to lack of accessibility or restrictions.
Unlike ETFs, ETNs are not backed by a specific pool of assets; an ETN represents a
promise by its issuer to match the returns of a particular index or commodity. Because
ETNs are backed by the issuer’s promise, investors need to keep abreast of the issuer’s
credit rating. IF the ETN issuer had financial difficulty, investors might have to get in
line with other creditors. ETNs are considered to be “senior, unsubordinated, unsecured
debt securities.” ETNs are registered with the SEC, but do not have to comply with
Investment Company Act regulations (e.g., no board of directors is required). The tax
status of ETNs is still uncertain. The current belief is that investors should only realize a
capital gain or loss upon the sale, redemption, or maturity of their ETN. A number of
ETNs have a 30-year maturity date.
ETFS 6.2
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Because an ETN owns no securities or commodities, all trading costs can be avoided.
And, since no stocks or bonds are owned, there are no taxable distributions (the status of
this was still uncertain as of November 2007). ETNs are not actually “notes;” they are
prepaid forward futures contracts. Institutions can sell an ETN back to the issuer at
anytime; the issuer pledges to pay an amount exactly equal to the benchmark minus
expenses. Individual investors must go through a broker and pay a commission. The
typical bid-ask spread of an ETN is 5-10 basis points. The total value of outstanding
ETNs was $3 billion by the fourth quarter of 2007. The table below shows some of the
ETNs currently trading.
Name Investment Expense Ratio
iPath CBOE S&P 500 Buywrite (BWV) Covered calls 0.75%
iPath Dow Jones-AIG Commodity (DJP) commodities 0.75%
iPath EUR/USE Exchange Rate (ERO) currency 0.40%
iPath MSCI India Index (INP) emerging markets 0.89%
iPath S&P GSCI (GSP) commodities 0.75%
A number of banks are launching exchange-traded notes (ETNs): Barclays (commodities,
currency, and other investments), Goldman Sachs (enhanced commodity index), Bear
Sterns (index of master limited partnerships), Deutsche Bank (Morningstar Wide Moat
Focus Total Return Index), and J.P. Morgan Chase (commodity and other products).
FREE ETF AND MUTUAL FUND TOOLS
Fundgrades.com grades ETFs and funds ranging from A+ to F on expenses, return, and
risk. The ratings are based on a comparison between the fund selected and its peer group.
The free service also compares the ETF or fund against the broad universe of U.S. stocks.
For example, SPY (iShares S&P 500) is described as, “Almost no risk of substantially
underperforming the large-blend asset class, but a significant risk of lagging behind the
broader pool of U.S. stocks.”
Another web site, etfguide.com/beta helps investors understand the foundation of any
ETF strategy. Indexuniverse.com has a “fundamental ETF screener” that lists ETFs that
weight holdings based on fundamental factors. For advisors who cannot decide between a
mutual and ETF, the web site rydexinvestments.com (look for “investor resources”) does
a cost comparison based on how often trades are expected and commissions paid.
6.3 ETFS
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FOREIGN BOND ETFS
For advisors who wish to diversify their clients’ fixed-income or simply profit from a
falling U.S. dollar, there are ETFs that are based on foreign government bonds. The
SPDR Lehman International Treasury Bond ETF (BWX) is based on a Lehman Brothers
index of government bonds of 18 countries denominated in 11 currencies.
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MISC.
MISC. 7.1
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7.NO OIL SHORTAGE
As of November 2007, the amount of oil in storage tanks around the world was 4.2
billion barrels. According to British Petroleum, the world’s proven reserves are
now 1.4 trillion barrels, up 12% in the past 10 years. Additionally, there is an
estimated 1.7 trillion barrels of oil that can be extracted from Venezuela’s Orinoco
tar sands. Combined (1.4 + 1.7 trillion), this represents 100 years of production at
current rates. There are now 45% more oil rigs in service today than there were
three years ago.
It is estimated that it costs Saudi Arabia $4-$5 a barrel to produce a barrel of oil.
The full cost of new production, even in a “challenging” area such as Canada’s oil
sands is about $30 a barrel. Iran is not likely to end exports, which account for
50% of their GDP and 90% of its hard currency earnings.
HEDGE FUND TRADING
As the list below shows, hedge funds are responsible for quite a bit of the trading
activity for a number of securities and derivatives. Sometimes, these unregulated
pools of capital are responsible for more trading than banks, mutual funds, or
insurance companies. The figures below come from a 2007 study by Greenwich
Associates, who polled 1,333 U.S. institutions, questioning them about their debt
instrument trading.
Hedge Fund Debt Trading
Asset % of total trading volume
emerging markets debt 55%
Investment-grade derivatives 55%
Junk rated derivatives 80%
Distressed debt 85%
All fixed-income 30%
7.2 MISC.
FUND CURRENCY HEDGING
Most mutual fund prospectuses give funds quite a bit of leeway when it comes to
currency hedging. The majority of international funds, including Fidelity,
American Funds, and Vanguard index funds, do no hedging. Some fund families,
such as Janus, Oakmark, and First Eagle, have flexible hedging policies. For
example, management at First Eagle have no view on currencies so they split the
difference between the two extremes and hedge about 50% of their overseas
portfolios. Still other fund families, such as Tweedy Browne, Longleaf Partners,
and Mutual Series are either mostly or fully hedged all the time.
CORPORATE PROFITS
Over the past 25 years (1982-2006), the economy’s average annual growth rate
has been 5.9%, versus a 10.3% annual appreciation rate for S&P 500 stocks; if you
add dividends, the annualized return for the S&P 500 has been 13.4%. In 2006,
corporate profits represented 13% of national income, versus 9% in 1990 and 7%
in 1982. The last time such profits represented 13%+ of the economy was in 1965.
S&P 500 companies receive 40% of their earnings from abroad. However, the
surge in earnings has also come at the expense of employees. The percentage of
corporate profits going to employee wages and salaries has dropped from 56% in
1980 to 52% in 2006. All of this suggests corporate profits will likely slow in the
future, meaning advisors may want to consider increasing their clients’ exposure
to bonds, cash equivalents, and foreign equities.
PRESCRIPTION DRUG COVERAGE
Roughly 24 million seniors and others eligible for Medicare benefits have signed
up for the Medicare drug benefit. The average monthly premiums for the top three
Medicare drug benefit plans are expected to rise to $29 in 2008, representing an
increase of over 25% from 2007. The average 2008 premium among the top 10
carriers are expected to range from $20.70 to $40.35 per month. Many plans will
require those covered to shoulder a larger share of the cost of drugs covered.
However, a few insurers are lowering their fees for 2008. United-Health Group
and Humana control about 44% of the drug-benefit market.
MISC. 7.3
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When advising your clients about this benefit, compare monthly premium costs,
the list of drugs covered by the insurer as well as the cost-sharing requirement.
The class of drugs most severely affected in 2008 is “nonpreferred” brand-name
drugs (e.g., Zocor and Celebrex). Medicare offers online tools
(www.mymedicare.gov or www.medicare. gov) that include report cards that rate
plans based on a number of factors, including customer service, drug pricing, ease
of getting a prescription filled, out-of-pocket cost comparisons, and pharmacy
networks in the area. Information can also be obtained by calling 1-800-medicare.
RATING HOSPITAL CARE
One of the best sources for hospital data is www.hospitalcompare.hhs.gov.
Hospital Care is a web site set up by the federal Centers for Medicare and
Medicaid Services, hospitals, and other groups. Your clients can search by city,
state, or other criteria and compare more than 5,000 hospitals against one another.
Much of the “best practices” data provided by Hospital Care comes from Medicare
data and focuses on three of the most common areas of hospital care: heart attack,
pneumonia, and surgery. The table below provides a list of resources to help the
advisor find quality hospitals.
Hospital Care Online Sources
Source Description
Hospital Compare
www.hospitalcompare.hhs.gov
Hospital adherence to practices that improve patient
care—no rating on how well patients do after treatment.
Leapfrog Group
www.leapfroggroup.org
Consistency of how 1,300 hospitals follow 30
practices—only covers a fraction of the country’s 6,000
hospitals.
Nat’l Assoc. of Health Data
www.nahdo.org/qualityreports.aspx
Which states provide consumer-friendly hospital data—
no link to a state agency’s web site.
Agency for Healthcare Research
www.talkingquality.gov/compendium/
Links to state agencies offering reports, databases, and
other information on hospitals and health care
organizations—some information is dated.
Health Grades
www.healthgrades.com
Compare 5,000+ hospitals on 32 conditions and
procedures, including complications and death rates—
much information is free, but extensive reports are $18
Dartmouth Atlas
www.dartmouthatlas.com
How hospitals care for patients shortly before they die,
including hospice transfers and time spent in ICU—
very detailed data makes searches complex.
7.4 MISC.
LONGER LIFE EXPECTANCY
A big mistake retirees make is underestimating their life expectancy. According to
2000 Census and American Society of Actuary data, there is a 25% chance that a
65-year-old couple will see one spouse live to age 97. According to the
Department of Biological Sciences at Stanford University, it is estimated that life
expectancies will increase by 20 additional years between 2010 and 2030,
assuming anti-aging therapies become widespread.