Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with some industry regulatory news, including the potential that Congress may soon approve NARAB (creating the National Association of Registered Agents and Brokers) to better facilitate multi-state insurance licensing, and that the SEC is considering whether to require large RIAs to have a business continuity and succession plan in place (following on a similar proposal by NASAA earlier this year for state RIAs to be subject to such a rule as well).
Also in the news this week are a number of articles related to year-end planning, both for advisors and clients, including a discussion of the rules for determining when a charitable gift is made and "delivered" for end-of-year charitable donations, an overview of why almost 10% of ETFs are actually making long-term capital gains distributions this year despite their typical tax-efficiency, some tips for advisors giving gifts to clients about mistakes to avoid, and some guidance about how to execute good employee performance and compensation reviews.
From there, we have a few investment-related articles this week, including: a discussion of how nontraded REITs really work, their potential conflicts of interest, and why advisors should perhaps be wary of them; a look at a new AQR "alternatives" fund that actually seeks to capture the return premium by investing in risk factors without taking on the underlying risks of the investments; and a look at the explosive growth of "securities-based lending" for higher net worth individuals - often as an alternative to more traditional mortgage lending - and the problems that it may create the next time there's a market downturn.
We wrap up with three interesting articles: the first looks at how as service professionals we tend to underestimate the value of the component parts of what we do, leading us to package together a "value beast" that may be so complex to explain and difficult to deliver that it would have been better to just provide clients the component parts instead; the second provides a reminder that when there's an elephant in the room - like recent market volatility - it's always better to acknowledge the elephant and talk about the issue than to ignore it and wait/hope it goes away; and the last provides an interesting look at how even 5-year periods of returns can drastically differ from what financial theory expects for stocks, bonds, and commodities, yet over the long haul (e.g., multi-decade time periods) financial theory still holds up far better than we typically give it credit for.
And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end, including coverage of the 2014 Advisor Tech Survey, Fidelity's collaboration with LearnVest, and a new "Direct Indexing" solution from Wealthfront! Enjoy the reading!
Weekend reading for December 13th/14th:
House Passes NARAB II Broker Licensing Bill (Melissa Winn, Employee Benefit Adviser) - After getting approved in the House of Representatives on Wednesday, Congress is set to approve the creation of NARAB, the National Association of Registered Agents and Brokers, a central clearinghouse organization that will facilitate the cross-state licensing of insurance agents. The newly created NARAB will not supplant state regulation over consumer protections, market conduct, and unfair trade practices, and states will retain their rights over resident licensing and supervision; instead, the purpose of NARAB is specifically to facilitate reciprocity of state insurance licenses across state lines (increasingly necessary as clients relocate and advisors work with a geographically more diverse range of clients), cutting down on state-by-state licensing red tape and streamlining the process of getting a non-resident insurance license. Notably, though, a related article suggests that even once the legislation is final, it will probably take two years before NARAB is really ready to issue its first license.
SEC Works On Rule Requiring Practice Transition Plans (Mark Schoeff, Investment News) - In a prior issue of Weekend Reading, we highlight that NASAA (the state securities regulators) are looking to fast-track a proposal that would require small RIAs to have a business continuity and succession/transition plan in the event of death or disability; now, SEC Chairwoman Mary Jo White has stated that the SEC is working on a similar measure for SEC-Registered Investment Advisers as well, especially those who either hold illiquid assets or impose liquidity limitations on their clients. According to the SEC's Regulatory Agenda, a proposed rule could come by next October.
Charitable Gifts: Date Of Delivery Rules (Conrad Teitell, Wealth Management) - As the end of the year approaches, it's crucial to remember how the rules work for clients making year-end charitable contributions who wish to claim the charitable tax deduction in the current year. Under the Internal Revenue Code, a charitable gift is considered made on the "date of delivery" (which also becomes the binding date for valuing the gift), but the date-of-delivery rules vary depending on the type of property being contributed and how it's transmitted. For securities, if they're transferred electronically or reissued into the charity's name, the delivery date is when the stock actually shows up in the charity's account (remember with a mutual fund, that can take some time to complete!); if a stock certificate is hand-delivered, the date it is handed over is the delivery date; if a stock certificate is mailed, then under the so-called "mailbox rule" the delivery date is the date it is mailed (but only if sent via U.S. Postal Service!). The aforementioned "mailbox rule" also applies to gifts by check if the check is mailed to the charity (though bear in mind the controlling date is when the U.S. Postal Service stamps it, not the date of a private postage meter!). The article also covers the delivery date rules for tangible works of art and real estate (both generally delivered the date the transfer is completed, including recording a change in legal title), and donations through a credit card (generally deductible when the bank pays the charity, even if the cardholder doesn't pay off the credit card until later).
What Kinds of ETFs Are Making Capital Gains Distributions This Year? (Robert Goldsborough, Morningstar) - One of the most popular features of ETFs is their tax efficiency, brought about both by the fact that most are passive low-turnover vehicles, and because the creation/redemption process for ETFs allows ETF managers to redeem securities in-kind and swap out low-cost-basis securities without realizing gains. However, that doesn't mean ETFs are 100% immune to capital gains distributions, and in fact 2014 looks to be a year where a number of ETF sponsors do anticipate at least some capital gains distributions. Overall, the distributions are relatively small - less than 1% of the affected ETFs' net asset value - and only 74 of the 712 ETFs at the 7 largest ETF providers have announced capital gains distributions at all. Nonetheless, there are some capital gains coming from ETFs this year, and Morningstar generally finds the ETFs most likely to issue capital gains are those that trade more heavily (possibly due to dynamic formulas for the allocation to underlying investments, or because their underlying index went through significant composition changes), those that use futures contracts (e.g., leveraged or inverse ETFs), or those that hold fixed-income securities (where bonds are maturing regularly and must be replaced). Thus, for instance, both AGG and BND will have capital gains distributions (albeit at a tiny 0.10% and 0.27% of NAV, respectively) along with a number of other bond ETFs, and some foreign ETFs that have had big runs or composition changes are actually facing quite large distributions (e.g., the SPRD S&P International Small Cap ETF has a 9.7% capital gain distribution coming, and the iShares MSCI Frontier 100 will have a distribution around 7%). Overall, the leading ETF providers are all showing a similar or slight uptick in ETF capital gains distributions this year, although State Street ETFs have turned out to have the highest percentage of ETFs anticipatd to make distributions in 2014.
Save Your Business From Bad Client Gifts (Suleman Din & Ralph Ortega, Financial Planning) - 'Tis the season for client gifts, but this article cautions that advisors need to be thoughtful about the gifts that they give their clients, or they could do more harm than good in the process. For instance, if your firm overall has a brand of high-end quality, be cautious about sending "cheap" gifts like pens, generic cards with mass-printed messages, etc. Similarly, be cautious about giving gifts heavily branded with your corporate logo that make the gift seem more about you and the firm than the client who's receiving it. Also, be cautious about gifts of food; a customized food gift can be nice, but be certain you're not gifting something the client is allergic to, or sending a perishable food gift while the client will be away on vacation (no one wants to come home to rotting food on the doorstep!). Other gift caveats to consider in the article: be cautious about gift certificates that just put a (low) monetary value on the relationship; be cognizant about the message that the gift is sending, and whether it is too overtly religious if not all your clients are of the same religion; and most important, be certain not to commit to any gifts that you don't follow through on.
Performance Reviews That Don't Stink (Kelli Cruz, Financial Planning) - As the end of the year approaches, many firms are going through their process of employee performance reviews. A central component for most employee reviews is a compensation review, and Cruz suggests that firms need to spend time considering their "compensation philosophy" and whether their compensation structure overall is properly rewarding and incentivizing employees for the right behaviors; in addition, using industry benchmarking studies to determine whether your compensation (both salary and incentives) is competitive for each position in the firm. Notably, Cruz points out that in the end, employees should be paid for the work they're doing, not just "reimbursing them for their cost of living"; accordingly, Cruz actually discourages annual cost-of-living adjustments at all, and increase suggests that employee base salaries should only increase because they actually exceeded their objectives. Beyond compensation, Cruz suggests that the next aspect to consider in an employee review is the precise role and goals for the employee in hte first place; does the employee really have a clear job description of what they're supposed to do, along with goals of what is expected above and beyond their basic job tasks? If you haven't created a formal review process yet in the first place, Cruz suggests starting by inviting employees to identify for themselves their top 3-5 accomplishments for the year, 1-2 things they could have done better, and 2-3 areas they want to develop/improve in the coming year, and then engage in a conversation with the employees about their responses. (Michael's Note: For some additional tips on doing Performance Reviews, also check out this article from Andrea Schlapia at Advisor Perspectives.)
Are Nontraded REITs Right For Clients? (Michael Finke, Research Magazine) - A nontraded REIT is created when a sponsor solicits investments that it will pool together to invest into real estate; the sponsor typically has a subsidiary broker that actually solicits the funds from investors, in exchange for marketing expenses and commissions that may amount to as much as 10%-12% of the initial investment. Once assets have been gathered, the remaining $88-per-$100 of net funds is then invested by the sponsor, either by investing directly, hiring someone to purchase the properties, or creating yet another subsidiary whose job is to buy the properties (and take a fee for the purchase). The sponsor will then either manage the nontraded REIT, or again may either hire someone outside to do so, or create another subsidiary that will do the work, in exchange for (another) management fee. Ultimately, the exit plan for the REIT is to either sell off the property, or sell the entire investment pool into the public markets (as public REITs often trade at a premium to net assets, providing a "pop" in value for the private REIT to go public), and the sponsor takes a final slice for successfully executing the IPO/exit. The caveat to this structure, as Finke points out, is the long series of potential conflicts of interest, especially when the sponsor of the nontraded REIT uses its own subsidiaries for all the intermediary functions, without necessarily having much of any third party oversight (even oversight from FINRA and the SEC is limited to some domains but not others); in fact, while nontraded REITs are lauded for not being publicly traded, and therefore not experiencing significant price volatility, the public markets trading of REITs itself can provide some level of oversight (investors can kick out board members if there are problems, and badly priced/managed REITs will be punished by market sellers) that is not present in nontraded REITs. Ultimately, Finke notes that many investors have been lured by the stable values and high dividends of nontraded REITs, especially in a world where it's not feasible for the average investor to buy a fraction of an apartment building or strip mall (due to everything from lack of experience in investing, lack of time to manage the property, and lack of capital to invest enough to buy in at all) but nontraded REITs have relatively low minimums and can pool together investor dollars to overcome the aforementioned problems. However, given what is fundamentally a private-equity-style investment, the challenge with nontraded REITs is their lack of transparency, and some have even suggested that nontraded REITs are benefitting unfairly from the positive public perception of traditional REITs even though they lack the same level of accountability. Similarly, because of the opacity of nontraded REITs, it's not always clear whether the REITs are really even generating favorable income, or are simply paying distributions from principal as it comes in during the offering period. Fortunately, a recent new FINRA rule requiring nontraded REIT valuations to account for marketing and selling expenses, and early distributions from principal, may at least better highlight which nontraded REITs have the most excessive costs.
How AQR's New Fund Add Value - An Alternative Approach To Alternatives: Investing With Style (Larry Swedroe, Advisor Perspectives) - Most investors seek out alternative investments as an "alternative" to core equity and fixed income allocations, but unfortunately many of the "traditional" alternatives from private equity and hedge funds to REITs and infrastructure funds have either ended out with a high correlation to equities anyway, weak returns, or both. To contrast these types of alternative investments, Swedroe highlights an interesting new option in this space, the AQR Style Premia Alternative Fund (QSPIX), a form of long-short fund designed to keep a net exposure to beta of zero, but obtain (hedged) exposures to four separate risk premia: value (the tendency for cheap assets to outperform expensive ones), carry (the tendency for higher-yielding assets to provide higher returns than lower-yielding assets), momentum (the tendency for an asset's recent relative performance to continue in the near future), and defensive (the tendency for lower-risk and higher-quality assets to generate higher risk-adjusted returns). Swedroe notes that each of these risk premia not only have a strong base of academic research to their historical results and validity, but they also exhibit a relatively low correlation to each other as well. These 'market neutral' risk premia exposures are then implemented across a wide range of asset classes, including equities, bonds, interest rate futures, commodities, and currencies; because some of these asset classes naturally have lower returns, the underlying investments are then (moderately) leveraged to target an annual volatility of 10%, with the goal of producing equity-like returns (minus a 1.5% expense ratio) with about half the market volatility over time (and because of the associated turnover, the fund is best held in a tax-deferred account). Given these parameters, if the fund is used as an alternative to equities it would theoretically produce similar returns with lower risk, while use as an alternative to bonds would produce an increase in return and also risk (and a roughly stable Sharpe ratio). There is also a recently launched lower volatility version of the fund - QSLIX - that targets half the volatility, and only charges about half the fee (0.85%). (Michael's Note: For more in-depth comments about the fund, check out the APViewpoint discussion thread with Swedroe and other thought leaders here [registration required].)
The Rise Of Rich Man's Subprime (Josh Brown, Fortune) - This article highlights the current boom in securities-based lending (also known as "non-purpose lending"), dubbed "Wall Street's hottest business" where high-net-worth investors are being enticed to take out loans against their brokerage accounts. The pace of loan activity has jumped significantly in recent years, with wirehouses sending out anywhere from 55 cents to 80 cents in loans for every dollar of client deposits, and Brown notes that wirehouses are now stoking the activity even further, offering bonuses to brokers who drum up significant loan growth. Securities-based loans themselves are simply personal loans by investors where the portfolio is used as collateral for the loan (so the funds remain invested for growth even as they're used as collateral for the loan proceeds), and borrowers can draw anywhere from 50% to 95% of the portfolio value (depending on the asset allocation of the portfolio) at ultra-low interest rates between 2% and 5%; notably, unlike margin loans which are used to purchase additional securities, the whole point of securities-based lending is to not reinvest the loan proceeds into more portfolio securities, but instead to use the funds elsewhere, such as to support a small business, fund the purchase or artwork or real estate, or refinance higher-rate loans (including mortgages). The use of securities-based lending as an alternative to mortgages appears to be especially popular right now, as there is little underwriting or due diligence necessary for the loan (nor even paperwork), as the lender already has the portfolio assets as collateral sitting at the firm and can turn the loan around in as little as 36 hours. Brown points out that the explosion in securities-based lending has been driven indirectly by Dodd-Frank reforms, which adversely impacted a lot of other profitable Wall Street business lines but makes it easy for banks to "safely" profit from securities-based lending since they can simply liquidate the portfolios held directly with the firm if market volatility ticks up (and conversely, makes portfolio assets "sticky" when investors can't transfer portfolios to a competing firm because of the loans attached to the accounts). Yet Brown points out that this ultimately could be very dangerous for the markets and economy overall, as higher-net-worth clients are now "re-leveraging" themselves (even as the other 90% of Americans are still deleveraging), egged on by the Wall Street machine driving the trend to a possible extreme, and may leave investors especially exposed to a new wave of margin calls when the next bear market shows up.
Let My Mistake Be Your Gain (Baz Gardner, The Social Adviser) - As service professionals, Gardner suggests that we routinely undervalue the component parts of what we do, leading us to package each item together into a "giant value beast" we call our "service offering" for clients. The idea is that the full packaged solution must be so great that any rational client will clearly want it... and it feels more comfortable as an advisor to ask people to pay a 'modest' price for something we are confident is worth so much more. Yet the problem is that by making an incredibly comprehensive service offering, it can become so complex to explain, difficult to get people on board with the "whole" solution, and challenging to stick to when there's so much to be done, that Gardner suggests in the end we actually end out just making life harder for ourselves and delivering even less value to clients. So how do you escape this "value beast" that you may have created? Gardner suggests that the first step is to really value the parts of what you do - recognizing that from the client's perspective, those smaller pieces may be even more valuable than the whole - and then decide how to break them apart. Gardner is going through the process himself with his own "value beast" - a practice management advice offering for advisors called the Market Leaders Program - but the point is equally salient for financial advisors as well!
Acknowledge The Elephant (Deena Katz, Financial Advisor) - When markets get volatile, communicating proactively to clients is crucial to retaining them; yet at the same time, many advisors are wary to contact clients for fear that it may be overreacting to the situation and that it may blow over all by itself after just a few days. Yet Katz suggests that not reaching out to clients immediately is just denying the elephant in the room; the market volatility is happening, and you can't control or manage client behavior by just ignoring it and waiting/hoping it will blow over. In turn, Katz suggests her own steps to handle the situation, or better yet reduce the risk of potential problems in the first place. For instance, recognize that clients likely already fear making a big investment into the market and the potential that it will decline shortly thereafter (a behavioral finance phenomenon called "anticipatory regret theory"), so you can address the issue upfront by recognizing the fear and pointing out its absurdity ("that's right, your investment will singlehandedly cause the entire stock market to go down 20%! Ha!"). More generally, if you're proactive in reaching out to clients in times of market volatility ("Mr. Client, I am sure you noticed the hiccup in the market yesterday, and that's why I am calling you..."), you'll see a few different responses; for many, the call itself and assuredness that you're still there with them will be enough; for others, they may be a bit more uncomfortable, and some "on-the-spot stress-testing" of their plan may be helpful to frame for them how big of a decline would be necessary to trigger real changes in their plan; and even with some upfront preparation, the most difficult conversations usually are with clients who are new to the firm, and their first experience with you is one of stress and market volatility, where it's especially important to be proactive and recognize the elephant in the room, have the conversation, frame the losses appropriately, and give the client a chance to vent and get comfortable with the situation.
Efficient Frontier "Theory" For The Long Run (Cliff Asness, AQR) - A lot of financial theory takes abuse because we tend to judge ideas over the short term, even while we acknowledge that they may only play out over the long term. A simple case in point is the belief that bonds (10-year government bonds) will have lower volatility and lower expected returns, while equities (S&P 500) will have higher volatility and higher expected returns, and commodities (GSCI) will fall somewhere in between on return with a high amount of volatility (though the expected risk/return of commodities is subject to much debate). Yet if we look at the risk and return of these three asset classes in 5-year increments since 1970 as they actually occurred, we see a great deal of variability; for instance, 1970-74 saw commodities with a stunningly high return while bonds were near zero and equities were negative, and the subsequent 5-year period wasn't much "better" as commodities again had a high return and both equities and bonds have negative returns; The subsequent 5 years (early 1980s) turned around again, with stocks and bonds exhibiting the "right" expected returns, but bonds had unusually high volatility and commodities were now hugely negative; and it's only by the late 1980s that the 5-year returns finally line up "properly" for bonds, commodities, and equities; yet in the following 5-year period the numbers are "wacky" again, with stocks showing little equity risk premium over bonds and commodities being both volatile and negative; continuing the exercise for each subsequent 5-year period (up through current 2010-2014) similarly shows that the normal expected returns for bonds, stocks, and commodities is virtually never present in any particular 5-year period. Yet despite one "wrong" 5-year period after another, when Asness looks at the returns over the entire 45-year period, the results line up perfectly as expected, with bonds getting a moderate premium over cash, stocks earning a healthy premium over bonds but with higher risk, and commodities generating a return somewhere in between stocks and bonds but with even more volatility. The bottom line: 5 years may feel like a long time in real time, but it's not really the "long term" for asset class risks and returns to manifest, but over the long haul the basic parts of financial theory continue to look surprisingly good, and we should all be more respectful of what the theories really tell us - with the caveat that the "long haul" for them to manifest their results may really be a very long time indeed.
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!
In the meantime, if you're interested in more news and information regarding advisor technology I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!
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