It’s no secret that Jim Cramer and I have our differences. Our confrontation last year on CNBC’s Power Lunch generated a lot of buzz. My basic gripe with him is that he makes it appear that he has some special insight into the markets which is of value of investors. However, I’m unable to find any evidence that’s the case, and lots of data indicating it isn’t.
So naturally, I was intrigued by this call to action on his web page, thestreet.com: “My charitable trust portfolio was up an amazing 31% in 2009, even when the market was on a wild roller coaster ride. In fact, for years, I’ve made money in good markets and bad.”
I really thought there was nothing about the securities industry that would surprise me. Let’s look at its track record.
Who can forget the Orange County bankruptcy in 1994? Merrill Lynch agreed to pay $30 million to settle a criminal investigation into that firm’s role in underwriting bond offerings for the county.
The crash of technology stocks in 2000, fueled by irresponsible recommendations of brokers, cost investors billions of dollars.
There was the analyst scandal in 2002, where major brokerage firms sold out their retail clients for the benefit of their underwriting clients.
All this pales in comparison to the 2008 market crash, caused by shameless greed, arrogance and incompetence of brokers. This walk on the wild side brought the global economy to the brink of a worldwide depression.
For outright greed and deception, it’s hard to top the 401(k) system. It’s rife with conflicts of interest, exorbitant and often hidden fees, poor investment choices, little participant education and deception about the legal obligations of the brokers and insurance industry to the clueless plan sponsors who retain them. The opposition of the securities industry to the pathetic “interim final regulation” of the Department of Labor is telling. All the new regulation does is require fee disclosure so that employers and plan participants can figure out what they’re paying for their 401(k) plan. Would you buy a car from a dealer who refused to reveal his price?
Nevertheless, the position of Nationwide in its defense of a class action lawsuit is so shocking that I was caught completely off guard.
Here’s the background:
In Haddock v. Nationwide (No. 3:01 cv 1552), filed in the United States District Court for the District of Connecticut, Haddock, a trustee of a retirement plan advised by Nationwide, charges it with accepting “revenue sharing payments” from mutual funds it offered to its annuity contract holders in its retirement plans. Haddock claims the receipt of these payments violates Nationwide ‘s “fiduciary duty,” which Haddock alleges is the duty to act solely in the best interest of the plan participants. The trustee plaintiffs seek to certify a class of all trustees of all 401(k) plans that had variable annuity agreements with Nationwide from the first date Nationwide began receiving payments from mutual funds based on a percentage of the assets invested in the funds by Nationwide. If they succeed, the liability would be enormous.
Nationwide denied any wrongdoing and further denied that it was a fiduciary to the plan. In a preliminary ruling issued Nov. 6, 2009, the Court found Nationwide “may be a fiduciary”, noting that “…by accepting the revenue sharing payments from mutual funds that it selects to be investment options for the Plans and its participants, Nationwide is allegedly placing its interests in collecting revenue sharing payments ahead of selecting the best investment options for the Plans and participants. The revenue sharing payments are an incentive for Nationwide to offer those mutual funds to the Plans as investment options.”
Stung by its efforts to get this massive case thrown out, Nationwide took a legal position which is the equivalent to tossing its clients under the bus. It sought to bring its own class action against all the trustees for the plans that were in the alleged class. It argued that, to the extent the plans were harmed by its revenue sharing arrangement, the trustees (its clients!) were responsible to reimburse them because of their “…failure to exercise reasonable prudence and care.”
Translation: If our conduct caused harm to the plan participants, it was our clients’ fault for not being smart enough to put a stop to it.
In a decision dated July 23, 2010, the Court dismissed this counterclaim.
The fact that Nationwide would seek to blame its clients for its own wrongdoing raises the bar for arrogance and lack of accountability in an industry known for its callous disregard for the interest of its clients. The reality is that trustees of 401(k) plans typically accept the recommendations of advisers without question. Their “ratification” is a mere formality. The ratification requirement is slipped into the plan documents so that advisers can avoid taking legal responsibility for the investment decisions they make. Few employers (or their lawyers), understand the legal significance of this sleight of hand. Hopefully, Nationwide’s effort to avoid fiduciary responsibility and transfer liability to its clients will be a much needed wake-up call.
Employers can avoid these legal issues by insisting their advisers accept in writing full 3(38) ERISA responsibility for investments in the plan. This means the adviser is 100% liable for the selection and monitoring of these investments.
No need to wonder whose side Nationwide is on. Its own.
Investors need to tie themselves to the mast to avoid the daily temptations to get rich quick in the market. The active investor’s addiction to beating the odds is often as strong as any other addiction. Like gambling, active investing can be extraordinarily exciting for investors who get carried away by the adrenaline of winning. Of course, it can create significant agony for those who experience the losing side of risk. One of the biggest mistakes made by the active investor is believing there is skill involved when the stock market proves profitable. Many of today’s day traders are learning this the hard way. There are now approximately 15 million online trading accounts in the United States. Stories of mounting losses are becoming more prevalent as the odds of playing the markets take their toll on this new breed of investors. Just like casino gambling, there are more tales about the winners than the losers, but the stories rarely give an accurate accounting of true net profit.
New studies in the field of neuro-economics confirm the release of dopamine when presented with the opportunity of a surging stock. This validates and confirms the addictive nature of Stockaholics™. The powerful allure of monetary reward leads to the overwhelming urge to trade stocks or funds. It has now been shown through brain imaging studies that the circuits that switch on at the prospect of big profits are the same as the ones that lead to the addictive nature of cocaine, casino gambling, alcohol, chocolate, and sex, just to name a few.
In the October 2002 issue of Money Magazine, the highly respected journalist Jason Zweig writes a ground-breaking article about the new evidence of the release of addiction related dopamine in our brains. He declares, “the dopamine rush we get from long shots is why we play lotto, invest in IPOs, keep too much money in too few stocks and invest with active portfolio managers instead of index funds.” He goes on to say that, “our brains are wired to force us into forecasting; it is a biological imperative. In fact, humans are born with what I’ve come to call “the prediction addiction.” Zweig reports that there are several researchers working on nueroeconomics at this time. At Harvard, Hans Breiter is leading a project and has stated that they have discovered a “striking” similarity between the brain’s reaction to cocaine, morphine, and the prediction of financial rewards. Please take the time to read Jason’s new book on this subject, Your Money & Your Brain. Also see Center for Neuroeconomic Studies Duke University.
A study released by Dalbar in March 2010 came up with similar results, but over a much longer period. The study indicated that during the 20 years from 1990 through 2009, the average stock fund investor earned returns of only 3.17% per year, while the S&P 500 returned 8.21%. On an inflation adjusted return, the average equity fund investor increased to only $108,743 on the value of a $100,000 investment made in 1990, while the inflation adjusted growth of $100,000 invested in the S&P 500 would have been $281,979. Even better, an investor who owned an all-equity, small value tilted, globally diversified index portfolio such as IFA’s iPortfolio 100 would have grown a $100,000 investment to an inflation adjusted $361,064.
Dalbar previously conducted similar studies going back to 1994. Clearly, investor behavior can have a far more negative impact on investment performance than investors realize.
It’s surprising that Upton Sinclair would provide today’s investors with an insight for investing success. He was born on September 20, 1878. His parents were very poor. His father was an alcoholic. His grandparents were quite wealthy. The stark difference in the financial circumstances of his parents and grandparents influenced him to become one of the most prominent socialists of his time. He even ran (without success) as the Socialist’s Party’s candidate for Congress from New Jersey.
What can this avowed socialist teach us about investing? Here’s a quote attributed to him. It says it all:
“It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
The salaries of brokers and insurance company representatives depend on persuading employers with 401(k) plans to include actively managed funds (where the fund manager attempts to beat a designated benchmark) as investment options in the plan. Billions in fees is generated in this way. The overwhelming evidence supports the view that most of this money is wasted. Plan participants would achieve significantly greater returns if no actively managed funds were in their plans. Instead,the plans should offer a limited number of pre-allocated, globally diversified portfolios of low cost index funds, Exchange Traded Funds or passively managed funds.
People who make a living selling actively managed funds react to this news much like a speech by a vegetarian is received at a cattlemen’s convention.
One reader (a broker) patiently explained that I didn’t understand the math. He believes the support for index funds in the press is caused by its willingness to accept glib statements from bloggers (like me). He provided no data to support his view.
Two distinguished finance professors who clearly do “understand the math” are Eugene F. Fama, a Professor of Finance at the University of Chicago, Booth School of Business, and Kenneth F. French, a Professor of Finance at Dartmouth College, Tuck School of Business. In their recent study, Luck Versus Skill in the Cross Section of Mutual Fund Returns, they attribute outperformance of actively managed funds to luck and not skill. Because there is no evidence of skill, it’s not surprising those funds that do perform well over a given period of time typically cannot repeat their stellar performance.
The ramifications of this study hit brokers and insurance companies right where it hurts — in their pockets. If employers understood this data, they would not include actively managed funds in their 401(k) plans because those funds are likely to underperform passive benchmarks by almost 1% per year.
The reaction to studies of this sort is interesting. Another reader explained his strongly held view that “managed funds” should be in all 401(k) plans. He bragged his credentials included an M.B.A. He was a consultant to corporations and boards on how to reduce their fiduciary risk.
I responded with a number of studies (including some by Nobel Prize winners in Economics) rebutting his views. I encouraged him to send me peer reviewed studies with contrary data. I told him I had an easy solution for eliminating fiduciary liability, rather than simply mitigating it: Require investment advisors to 401(k) plans to be 3(38) ERISA fiduciaries and to accept 100% of the liability for the selection and monitoring of plan assets.
Here’s his response: He doesn’t believe in academic studies. He has no confidence in the committee that appoints Nobel Prize winners. He sent me no data.
The pattern is very familiar. Research is responded to with rhetoric, but no contrary data. Unfortunately, their clients often don’t have the sophistication to confront them with studies that demonstrate what they are selling is in their best interest, but not in the best interest of the participants in the plan.
Employers need to appreciate their potential exposure as fiduciaries to plan participants. It’s only a matter of time before an enlightened court reviews the studies and concludes the inclusion of any actively managed fund in a 401(k) plan violates the duty of prudence.
Brokers and insurance companies will never “understand” this evidence. Their salaries depend on their not understanding it.
After a good year for the stock market, a lot of investors are feeling it’s safe to get back in the water. And despite the recent scandals, a lot of money will be going into mutual funds as the economy and market continue to recover. But which funds should you consider?
Study after study finds that indexed funds are superior to managed funds, particularly over a long period of time. In the face of this evidence, why do so many investors still turn to managed funds? Maybe it’s because a lot of people still feel just a little bit foolish buying an indexed fund. How smart can it be to let a computer run your portfolio? How hard can it be to find a manager smart enough to outperform a mindless algorithm?
The emotional and intellectual appeal of managed funds comes from our daily lives, where managing things usually trumps a strategy of letting things take care of themselves. It’s good to organize your monthly bills rather than picking one up whenever you think of it and paying it. It’s good to keep your children away from a hot stove rather than letting them discover the dangers of life by trial and error.
ARMY OF BAKERS. Such real-life experiences can mislead, though, when it comes to some financial decisions. To understand the virtues of an unmanaged indexed fund, consider the world of bagels. Did you ever stop to wonder how it is that in Washington, D.C., where I live, and in every other city of any size in America, bagel shortages never happen? Read more…
From the article, “Once you understand how the bagel market, while imperfect, functions smoothly without a manager, you can begin to appreciate the wisdom of buying an indexed fund. Prices, after all, capture information. The best stocks end up being more expensive than those with worse prospects. The expected return is that of the market as a whole. Bargains can’t be identified in advance. Turns out the best strategy is to avoid the fees and tax consequences of managed funds and take the return of the market as a whole.”
“The typical fund company services [401k plan] participants in the same way that Baby Face Nelson serviced banks.”
- William Bernstein, Riding for a Fall, The 401(k) is likely to turn out to be a defined-chaos retirement plan.
When you head out each morning to work, you have an expectation that your employer is providing a safe environment. There is no heavy object loosely dangling above your desk and the coffee in the break room uses water that has gone through some filtration system. Your employer provides this safe environment at work because while at work they have a responsibility to the well-being of their employees. This responsibility extends beyond your physical and mental health. If they decide to offer you benefits such as a retirement plan, they must place your interests above all else, otherwise known as a fiduciary responsibility. The law has provided some guidance as to what constitutes fiduciary prudence in regards to employer sponsored retirement plans. These are laid out in the Employee Retirement Income Security Act, or ERISA.
A Little History
Gone are the good ole days of your parents’ pension plan. Funding your retirement was so much easier back in the day. Each paycheck, your employer would take out a portion of your earnings and, along with a little extra money from their own pockets, invest the funds for you and your colleagues. At retirement, the pension fund would begin sending you a paycheck every month calculated using a formula that included your years of service and salary. You should notice one important thing missing in that calculation — Investment Return!!! Investment returns were solely the responsibility of your employer. Whether the investments in the fund performed well or poorly, your monthly retirement check calculation would stay the same. Poor investment performance just meant that your employer had to make up the short fall to cover their obligation to you. This did not sit well with employers; they did not want to assume the risk of poor market performance. So, that risk was transferred to the employees utilizing a long standing yet little used section of the code known as the 401(k).
An Employers’ Duty
Now the 401(k) is the norm, and the pension plan is, for the most part, non-existent in private industry. Instituting a 401(k) plan may have transferred investment risk to the employees, but the responsibility to act in the best interest of the employee, or fiduciary prudence, still lies with the employer. The 401(k) plan must provide a reasonable process for selecting investments. Which begs the question, what is a reasonable process? Well, the Uniform Prudent Investor Act spells out that the reasonable process must be rooted in Modern Portfolio Theory. This means the process must take into account three important factors:
the trade-off between risk and return
offer investment products which provide broad diversification both within and across asset classes
charge fees appropriate relative to service
Unfortunately, it seems as though employers have misinterpreted their transfer of investment risk to the employee to also mean a transfer of fiduciary prudence. Too many employer-sponsored 401(k) plans violate nearly all three of the above factors. Investments are chosen based on recent outperformance (which has been proven overtime to be no indication of future performance) while ignoring risk, investment options are narrow and often ignore many asset classes, and fees are excessively large and many times hidden. The silver lining here is that employees are beginning to fight back. Lawsuits against prominent companies are mounting. Names like Wal-Mart, Caterpillar, Unisys, United Technologies, Honda, Boeing, etc. are all seeing their fiduciary prudence being questioned. To be fair, each of these companies has been sued but not all have received a judgment against them. That being said, the accusations tend to include the terms excessive fees, limited options, and even active management without similar passive options.
Grading Your 401(k)
Here are some important questions to research in your plan documents:
Do your fund expenses exceed the following:
0.20% for US Large
0.40% for US Small
0.50% for Real Estate
0.50% for International Large
0.80% for International Small
0.80% for Emerging Markets
0.20% for Fixed Income
Do the expenses include 12b-1 Fees (which are paid to the plan provider but only serve to lower your return)?
Is your plan missing one or more of the above asset classes?
Are you forced to choose from a menu of expensive actively managed funds without index fund alternatives?
Do funds tend to last only for a couple years in the plan, entering after recent good performance then leaving when they cannot replicate the performance?
Are you given little to no guidance on how to put together a risk appropriate portfolio using the fund selections available?
As a plan participant, employees should be unequivocally concerned with the asset allocation of their retirement plan. As an employee, if your retirement plan is unknown to you or poorly performing, a visit to your HR department is in order. You should seek passively managed options through index funds with a low cost structure. Here’s a letter to ask your Plan Sponsor for Index Funds.
The meltdown of the securities industry, and the 2008 market crash, caused even the most die hard advocates of investing as usual to question the current system. They should since it has nothing to support it beyond massive advertising and lobbying budgets. Unfortunately, for many investors, that is enough to keep them in the fold, often to their great detriment.
The current model is built on the demonstrably false premise that brokers and advisers have superior insights into the markets which permits them to manage our money intelligently. This “expertise” is touted in the endless predictions of “financial experts” who peer into their crystal ball and tell the unwashed masses what the future will bring. While Jim Cramer is the best known in this group, there are many others, including James Dines, Bob Brinker, Gary Shilling and Louis Navellier.
Now there is some objective accountability for these predictions. It is a welcome development and a valuable service to the investing public. A scorecard calculating the accuracy of market predictions can be found on the web site of CXO Advisory Group. The analysis covers more than two years, with over 4600 measurements for 51 gurus.
The overall accuracy of the group was a pathetic 48%. You could replicate this performance by flipping a coin.
Cramer had a score of 46%. He strongly objected to the methodology used to rate him. The exchange of e-mails between him and the CXO group is fascinating. You can read them here. Make your own decision about the merits of this debate. I do have to wonder how many investors relied on this comment, which he is quoted as making on October 1, 2007: “I’m now confident that what would have been a given in 2008, a brutal recession…will now be avoided and prosperity assured.”
Relying on financial “experts” who purport to be able to predict the future is insidious. Not only are they as likely to be wrong as right, but listening to them distracts investors from demanding long term historical data which — while also not predictive — would give them an objective basis to make investment decisions.
Instead of asking advisers (who are only too willing to respond) “where do you think the market is headed”, investors would be far better served by insisting on answers to these questions:
What is the long term (10-50 years) risk and return data for the portfolio you are recommending?
How do these risk and returns compare to a comparable portfolio of low cost stock and bond index funds?
If your broker or adviser is recommending individual stocks, ask her this zinger:
A recent study examined the stock picking skill of 2100 fund managers over a 32 year period and concluded that only 0.6% beat the relevant index (which the authors of the study attributed to luck). Are you in the 99.4% of stock pickers with no skill or the 0.6% of stock pickers who believe they have stock picking skill?
No one wants to confront their own mortality. That’s why so many Americans die without a will, which is the worst possible estate planning. For those who act responsibly and retain the services of an estate planning lawyer, a hidden danger lurks.
The standard estate planning advice is geared (as it should be) around minimizing estate taxes and avoiding probate, where appropriate. That’s all well and good. However, a critical area of concern is ignored by every estate planner I have encountered: the management of your assets after death.
Estate planning lawyers receive referrals from major brokerage firms and traditional institutional trustees. The best way to keep these referrals flowing is to refer business back to the source. It all sounds innocuous enough until you understand the devastating consequences of this common practice.
The real money in trust administration is not in the administration fees. It’s in the advisory fees generated by the arm of the trustee that manages the assets in the trust. Well in excess of 90% of institutional trustees also manage trust assets. Not only does this create a conflict of interest (how carefully is one division of the trust administrator really going to review the conduct of another division?), but it practically insures under performance of trust assets.
Notwithstanding the overwhelming evidence demonstrating the superiority of passive management, I know of no trust administrator who follows this Nobel Prize winning investment strategy. Instead, they increase the costs to the trust by engaging in active management, in a usually futile attempt to “beat the markets.” It’s sad that investors who, during their lives, take such care to invest prudently, fall into this trap by following the standard advice of their estate planners.
There is a way to avoid having your assets mismanaged after your death, but don’t expect your estate planner to tell you about it.
Insist that your trust be managed by a “directed trustee.” These are professional trust administrators who only administer trusts. They do not manage money. The leading directed trustees are Advisory Trust of Delaware, Santa Fe Trust, Charles Schwab Trust Services and Wealth Advisors Trust Company.
You will need to give your directed trustee guidance about the kind of financial adviser it should appoint. Here’s language I inserted in my trust:
“The Investment Manager shall be guided by the basic principle known as Modern Portfolio Theory. The Investment Manager should make no effort to “beat the markets.”
The Investment Manager shall focus on the asset allocation of the portfolio. The portfolio shall be globally diversified, using low cost stock and bond index funds, exchange traded funds or passively managed funds. The investment manager shall be guided by the principles set forth in The Intelligent Asset Allocator, by William Bernstein, A Random Walk Down Wall Street, by Burton Malkiel., The Little Book of Common Sense Investing, by John Bogle and The Smartest Investment Book You’ll Ever Read, by Daniel R. Solin”
With the appointment of a directed trustee and the insertion of this (or similar) language in your trust document, you have now protected your assets from being plundered after your death. Based on historical data, the returns of your trust assets could be as much as 300% higher than the historical returns of the average equity investor over the past twenty years.
Of course, you should be following the same investment advice while you are alive. Why should your heirs be the only beneficiaries of Smart Investing?
