Weekend Reading for Financial Planners (Mar 17-18)

Posted by Michael Kitces on Friday, March 16th, 9:00 pm, 2012 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition highlights an interesting article about the benefits and risks of exchange-traded notes, and two new articles about retirement spending and how to consider more flexible retirement spending plans. We also look at two striking investment pieces, one from Morningstar Advisor that highlights upcoming research about how the rise of index trading may be increasing the correlation of markets and reducing the benefits of diversification, and Mauldin's weekly update suggesting that Greece's restructuring deal is not the end of the European debt crisis. We wrap up with a nice article from Bob Veres about what it takes to be a successful financial planner, some tips from a recent Harvard Business Review blog about how to make yourself more focused and productive to reduce feelings of burnout, and the big media news of the week - the very public resignation of a Goldman Sachs executive director named Greg Smith, suggesting that the company has lost its moral bearing. Enjoy the reading!

Weekend reading for March 17th/18th:

Pros and Cons of Exchange-Traded Notes - This article from Financial Advisor magazine highlights some of the benefits and risks of advisors using exchange-traded notes (ETNs) in portfolios. An offshoot of the ETF marketplace, ETNs don't actually buy underlying securities - instead, they are backed by a bond from the issuing company, and a swap derivative that produces the returns of the targeted index. The upside to this is the opportunity to get exposure to potentially narrow or illiquid asset classes or indices, and the elimination of tracking error; the structure can also be simpler for investments like a Master Limited Partership (MLP), which has tax reporting complexities because of the partnership structure that are eliminated when invested in ETN form. However, the article emphasizes there are real risks. ETNs are ultimately backed by unsecured debt of the issuer - which is a material risk, given that some ETNs were issued by Lehman prior to 2008! - and their returns are only as good as the counterparty to the swap (which may not be known at all). This exposure to the credit quality is perhaps even more concerning, given that four of the five largest ETN issuers are major European banks, which continue to struggle through the European debt crisis! Perhaps even more concerning, the article notes that not all E&O providers will cover ETNs (for many of the aforementioned reasons), so be cautious that you're not exposing your own personal business to increased liability risk as well!

How Do Spending Needs Evolve During Retirement - This article by Wade Pfau in Advisor Perspectives explores some of the research over the past decade from Ty Bernicke in the Journal of Financial Planning, and Somnath Basu in the Financial Counseling and Planning Journal, regarding how spending evolves in retirement (along with a recent article from this blog). Bernicke's research based on the Consumer Expenditure Survey (which Pfau replicates using more recent data) suggests that the 'average' American materially decreases spending in the later years, with expenditures for those who are age 75+ running 26% less than those aged 65-74. And significant reductions in consumer in the later years can have a material impact, boosting the safe withdrawal rate as high as 5.5%! Rather than flat reductions by age, Basu's approach suggests breaking spending into categories (e.g., Health Care vs Leisure vs Basic Living) with adjustments to the category with age (for instance, in later years Health Care might rise 25% while Leisure drops 50%), while also adjusting for inflation. Pfau's ultimate conclusion is that the jury is still out for this issue, but that some gradual real spending declines are probably reasonable, and Basu's age banding approach may ultimately be the best.

Spending Flexibility and Safe Withdrawal Rates - This article by Michael Finke, Wade Pfau, and Duncan Williams in the Journal of Financial Planning explore how a client's risk tolerance might change not simply their portfolio asset allocation, but their retirement spending and safe withdrawal rate decisions. In other words, the authors examine a client's 'willingness to adjust' spending as a form of risk tolerance. This is accomplished by creating a utility function for the client that balances willingness to adjust and have shortfalls with the desire (or lack thereof) to leave a significant legacy left over. Although much of the math and detail in this article may be a bit dense for many readers, I suggest reading through at least the introduction and conclusion, which provides some perspective on the general results - most notably, building a stronger foundation for the idea that clients who are risk tolerant might be willing to spend more and take greater spending adjustments than risk averse clients. On the other hand, it's still unclear exactly how an advisor might measure such client trade-off willingness in practice.

How Index Trading Increases Market Vulnerability - This article from Morningstar Advisor - a brief overview of what will be a more in-depth article later this year in the Financial Analysts Journal - explores how as index investing has become more popular with the advent of index mutual funds and then ETFs, stocks across the board are becoming increasingly more correlated, with betas that move more and more in sync, especially since the late 1990s. Instead of buying individual securities - which fall in and out of favor - investors buying index funds get a full basket of securities, and as a result investor flows don't simply move individual stocks, but instead move the market in the aggregate in an increasingly correlated fashion. Xiong's research confirms this does appear to be occurring in the marketplace as the share of passive trading relative to the total market rises. This implications of the research are that investors require more stocks to sufficiently diversify - the rule of thumb that it takes 20 stocks to effectively diversify might now be closer to 40 - and that diversifying within different types of equity asset classes still may be less effective than it was in the past.

There Will Be Contagion - In his weekly missive, reproduced on Advisor Perspectives, John Mauldin notes that with the Greek restructuring deal now official, the European crisis is not over. In fact, Mauldin notes that the new debt Greece is supposed to get, as a part of their restructuring, is already trading at a whopping 70%+ discount, even after the 53% haircut already imposed. In other words, the market is already suggesting that this won't be the last restructuring for Greece! Beyond Greece, though, the focus is now shifting to the question: who's next? Mauldin's article notes that the situation continue to deteriorate in Portugal and Spain. And if you're a borrower in Spain or Portugal that just witnessed Greece restructure a huge portion of their debt, it raises the question: "Shouldn't we get to restructure our debt, too?" The important caveat, though, is that unlike Greece, the losses in those countries pose much more sizable and serious systemic concerns. And by the middle of the decade, the problem could shift to France - which is ultimately "too big to save" and poses even more concerning risks.

Success Really Has Three C's - In his monthly column for Financial Planning magazine, Bob Veres discusses what it takes for newer advisors to ultimately reach success. After gathering feedback from others, Veres ultimately found the key was "the three C's" of courage, confidence, and commitment. Courage means everything from the courage to invest in your business when it still feels scary to do so, to the courage to really ask for what you're worth when setting prices/fees for your services with clients. Similarly, Veres also notes the importance of having confidence in our value, pointing out that when we provide our expertise over and over again, we often forget just how unique our value really is. The final C is commitment - which means really investing your time and energy into the business; evenings are spent not watching TV, but fiddling on that next letter to clients or looking at software demos.

The Magic of Doing One Thing At A Time - This article by Tony Schwartz in the Harvard Business Review makes the simple point that while many professionals feel overwhelmed and burnt out, it may have more to do with poor productivity than the sheer volume of work, in a world where technology makes everything both increasingly accessible and increasingly distracting. Schwartz offers three policies for businesses to address this: hold shorter but more focused meetings that start on time, end on time, and don't allow digital devices during the meeting; stop insisting that employees respond so promptly (if it's really THAT urgent, call, don't email); and encourage staff to take a brief personal renewal break at some point during the day. On a personal level, Schwartz also encourages three personal behaviors: do the most important thing first in the morning, preferably without interruption, for 60-90 minutes with a clear start and stop time; establish regular, scheduled times to think long-term and creatively; and take regular, real vacations, as the research shows that people who utilize their vacation time tend ultimately to be healthier and more productive.

Why I Am Leaving Goldman Sachs - This article in the New York Times Op-Ed section was written by Greg Smith, a Goldman Sachs executive director and head of the firm's United States equity derivatives business in Europe, the Middle East, and Africa. In the piece, Smith explains why he has chosen to resign from Goldman Sachs - suggesting that the firm has lost its client-centric focus, simply rewards people who make the firm the most money, and has too many "morally bankrupt" people in positions of leadership. Smith notes how some of the firm's leadership refer to their own clients as "muppets" to be manipulated and taken advantage of - not that Goldman Sachs is engaging in illegal activity, but that "people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client's goals... Every day, in fact." Smith's very public resignation letter has created a furor, with over 3 million pageviews of the story in the first day or two alone, and spawning a Darth Vader resignation letter parody as well; expect to hear more about it in the coming weeks.

I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column! And click here to sign up for a delivery of all blog posts from Nerd's Eye View - including Weekend Reading - directly to your email!

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