Tuesday, February 22, 2011

Let's Talk About the Experts!

By Noreena Hertz

We make important decisions every day -- and we often rely on experts to help us decide. But, says economist Noreena Hertz, relying too much on experts can be limiting and even dangerous. She calls for us to start democratizing expertise -- to listen not only to "surgeons and CEOs, but also to shop staff."

By Arianna Capital

The most interesting part of Noreena Hertz's talk is a few facts that she brings into play. She cites an interesting MRI study where peoples' brains were monitored while listening to experts. They noticed that the independent decision making parts of the brain flat-lined when the experts were talking. This is alarming as the same thing may be going on when listening to MSNBC, your financial adviser, or the news.

The main take away for me is to make sure my clients are engaged and independently thinking for themselves. When doing this I am finding more and more that they are asking very good and interesting questions that keeps me on my toes. How lucky is that - to have clients that want to understand your differences?

Trust is a wonderful thing to have, and advisers and experts that know their research are definietely needed in a world like today. However, make sure that caution is exercised and you are remaining engaged in the conversation when making important decisions about your health, wealth, and well-being.

Monday, February 21, 2011

Rich and Poor Serve Their Wall Street Masters

By Dan Solin

I am often accused of being too hard on brokers (usually by brokers!). They say I cherry pick bad portfolios and there are many “hard working, honest brokers” who do the right thing for their clients.

That has some surface appeal and I used to believe it. I no longer do.

I have reviewed thousands of portfolios sent to me by readers of my books and blogs. I have yet to see a globally diversified portfolio in an appropriate asset allocation, invested solely in low cost, high quality, stock and bond index funds, exchange traded funds or passively managed funds. Not one!

I also regularly review findings (misnamed “awards”) issued by the Financial Industry Regulatory Authority (FINRA) which has exclusive jurisdiction over disputes between investors and their brokers. In last week’s blog, I wrote about the experience of Joanne Bohnke, a 74-year-old widow of modest means, who was harmed by the misconduct of her broker. She got partial recompense, which is rare for investors, since these panels tend to either side totally with the securities industry or award only a fraction of the damages suffered by the investor.

Wealthy investors fare even worse, both with their brokers and with FINRA arbitration panels. Lawyers for the broker brand the wealthy as “sophisticated investors”, implying that their financial success in their business life made them fair game for the machinations of their broker. The panels usually buy this defense and rarely make any meaningful awards in these cases.

For this reason, my curiosity was piqued by an award (Case Number: 08-04276) in an arbitration brought by James D. Murphy, a 61-year-old Florida retiree, against Salomon Smith Barney. The panel awarded Mr. Murphy $1,042,986.22, plus interest. This is a big number for a FINRA award.

According to Robert Savage, Tampa based counsel for Mr. Murphy, his client had net losses in his portfolio of almost $2.3 million, representing a significant portion of his initial investment of $4 million. Mr. Murphy had been a conservative investor, with a portfolio consisting almost exclusively of municipal bonds, which he held to maturity. His broker persuaded him to use these bonds as collateral, and buy stocks on margin with the proceeds.

According to the Statement of Claim, the activity in Mr. Murphy’s account was stunning. He started with an average equity in his account of $3.6 million in 2003 and ended with an average equity of $1.3 million in 2008. During this time period, his broker turned over his account thirty times, racked up a whopping $807,301 in margin interest and (according to Mr. Savage) $500,000 in commissions.

When I talk about the transfer of wealth from you to your broker, this is precisely what I have in mind. On an account with an average equity of $3.6 million, the brokerage firm gained $1.3 million (in commissions and margin interest) for “managing” this portfolio. Mr. Murphy’s average equity decreased from $3.6 million to $1.3 million during this period.

Viewed in context, the award of the FINRA tribunal fits into a familiar pattern. The panel simply required the brokerage firm to return most of the gains it made from its wrongful conduct. It should have awarded what are known as “well managed account damages”, which is the difference in the account as managed and what it would have been if the account had been invested in a globally diversified portfolio of low cost stock and bond index funds, in an appropriate asset allocation for Mr. Murphy (or it could have used other appropriate benchmark investments).

There are no circumstances which would justify the excessive trading and margin interest in this account. It would be unsuitable for any investor, except a day trader.

I ran some numbers which are interesting. I assumed the right asset allocation for Mr. Murphy was 60% stocks and 40% bonds, which gives the broker the benefit of the doubt since it is probably too aggressive for someone Mr. Murphy’s age. I used an initial investment of $3.6 million in 2003 and computed the value of the portfolio on December 31, 2008, using a passively managed portfolio of stock and bond funds. The ending value was $5,051,660! The panel should have done a similar calculation and made an award that would have compensated Mr. Murphy for his real losses.

In addition, since there is no justification for this amount of margin (or any margin) or for the excessive trading in this account, the panel should have assessed punitive damages, attorneys’ fees and all costs against Salomon Smith Barney.

Instead, it denied Murphy’s request for attorneys’ fees and for punitive damages. In a final blow, the panel assessed Mr. Murphy $15,300 in hearing fees. It assessed the same amount against Salomon Smith Barney.

Mr. Savage stated there was no settlement offer in this case. I am not surprised. There is no incentive to settle when you are confident you will either prevail at the hearing or, at worst, have to give up just a portion of your ill-gotten gains.

Whether you are rich or poor, you need to understand the present system is set up to transfer your money from your pocket to the coffers of your brokerage firm. They have closed the loop with the cozy FINRA mandatory arbitration scheme. No matter how bad the conduct of your broker, if you recover at all, it will likely be for a small portion of your losses, which will be further reduced by attorneys’ fees.

A corporate representative for the brokerage firm would not respond to questions concerning the case. His comment was limited to noting “respectful disagreement” with the award.

He should have been thrilled with it.

Solin, Danielle. "Rich and Poor Serve Their Wallstreet Masters." Index Funds Advisors Blog. Word Press, 1/26/2011. Web. 21 Feb 2011. .

Friday, February 18, 2011

Some Hedge Fund Mangers Don't Tell the Truth

By Larry Swedroe

When writing The Only Guide to Alternative Investments You’ll Ever Need, I placed hedge funds in the bad category. And that was before I saw a report about how one in five hedge fund managers misrepresent their fund or its performance. (To say nothing of worse behavior, such as the alleged insider trading that led to the recent arrest of hedge-fund manager Raj Rajaratnam.)

According to the Financial Times, New York University’s Stern School of Business reviewed 444 due diligence reports written between 2003 and 2008 and compared hedge fund manager claims to actual data. The study covered funds with up to $8 billion in assets and managers with an average of almost 20 years experience. Thus, the data captures some of the most prominent hedge funds in operation.

They found that managers most commonly misrepresented the amount of money they had entrusted to their funds, their performance and their regulatory and legal histories. In one case, a hedge fund manager overstated the fund’s assets under management by $300 million.

As well as analyzing the occurrence of falsehoods, the Stern School sought to gauge the severity of the problem and its implications. Researchers looked specifically at instances where funds had been in some form of regulatory or legal trouble in the past and found that nearly one in six managers either underplayed or denied the existence of such problems. The researchers found that one fund had lied about the legal records of its partners, as the fund’s two founders both had criminal records.

When I ultimately settled on placing hedge funds in the bad category for my book, I had a number of reasons. I believe you should avoid them because:

  • There’s no evidence of persistent outperformance beyond the randomly expected.
  • Their risk-adjusted returns have been similar to Treasury bills.
  • Their returns exhibit negative skewness and excess kurtosis — traits investors prefer to avoid because they create the opportunity for large losses.
  • They’re highly illiquid due to lock up periods in the contracts.
  • They’re generally tax inefficient.
  • They lack transparency, so investors lose control of risk.
  • Their incentive structure creates agency risk — the risk the manager will act in their interest, not yours.

I’m beginning to think I wasn’t a tough enough critic.

Thursday, February 17, 2011

Wall Street Running Amok

By Jay Franklin

For those who entrust their life savings to the titans of Wall Street, the stories that have emerged in the past few weeks should give some pause. First, we have Merrill Lynch paying $10 million to settle claims that it misused information related to client trade orders. In an interesting twist on the usual story of front-running, Merrill used the information on large client trades to place their own trades afterwards. For example, if the high net worth client sold 100,000 shares of IBM (and thus driven the price down), Merrill would have bought some shares (at the discounted price) after the client’s trade had been completed. The SEC took a dim view of this activity and required Merrill to cough up some bucks which Merrill was only too happy to do since it was, at best, a fraction of the profits they made during the four years of this egregious activity. For the past decade, IFA has ceaselessly pointed out the inherent conflicts of interest that arise when a brokerage firm places trades for its clients and simultaneously trades for its own account. The SEC’s recent recommendation of placing brokers under a fiduciary standard was long overdue.

Next up in our Rogue’s Gallery is the Bank of New York, which overcharged Virginia pension plans by at least $20 million through fraudulent currency trades. Specifically, whenever the pension fund needed to convert a currency to conduct a foreign transaction, BNY consistently gave them the worst price of the day and pocketed the difference. Of course, the hapless bureaucrats in Virginia could not be troubled to check the execution of their currency trades. The whistleblower was a small currency trading firm, FX Analytics. Interestingly, nobody is asking the broader question of why it should even be necessary for a state pension fund to transact in foreign markets where they are so clearly vulnerable. BNY is also charged with defrauding a Florida state pension plan, and in California, similar charges are being pursued against State Street. These cases belie the often-made claim that the dark side of Wall Street is purely on the retail end while everything is hunky dory on the institutional side.

Completing our round-up is J.P. Morgan who got into bed with the Ponzi King Bernie Madoff and woke up about half a billion dollars richer. Quite an accomplishment! Fortunately for them, they smelled a rat before the scheme imploded. Unfortunately, however, they did not have the decency to tell anyone else other than Britain’s Serious Organized Crime Agency which sat on it. Apparently, a potential $50 billion fraud was not quite serious enough to warrant further investigation. The filed report said the performance of Mr. Madoff’s investments appeared to be “too good to be true—meaning that it probably is.” When the house of Morgan pulled out $276 million it had invested in the Madoff feeder funds, it asked those funds to keep the move quiet, no doubt motivated by the hefty fees collected from the “sophisticated investors” they had directed towards those funds.

Please try to stay clear of Wall Street. If you need help in identifying a successful wealth management plan so that you can meet your goals, please, do not hesitate to contact Arianna Capital.

Wednesday, February 9, 2011

Why the Unrest in Egypt Doesn't Matter for Your Portfolio

By Larry Swedroe

Whenever crises pop up — no matter if they’re financial messes, political unrest or natural disasters — I inevitably get plenty of questions about what they mean for the markets. My answer has always and probably will always be the same: We’ve been through this before, and we’ve come out fine every time. Sometimes the markets fall sharply for an extended period because of a crisis, and other times they take a short hit and bounce right back. While we do know that there will be crises, we don’t know when they will occur, how long they will last or how deep they will be.

The political unrest in Egypt has many people seeking answers regarding what this means for their portfolios. Here are some of the headlines I’ve seen:

In other words, we go through this every time. Think back to just a year ago, when the fear regarding Greece defaulting led to panic about its effect on the markets. (The same could be said about the rest of the PIGS — Portugal, Italy and Spain.) Or perhaps the ongoing political issues in Iraq, Iran, Afghanistan and North Korea. Or the financial issues regarding the flash crash, the potential domestic municipal bond crisis and still-deflated housing prices.

The point isn’t that these crises are unimportant. These events are entirely outside of our control, so there’s no point in worrying about them as far as our investments are concerned. What you should do instead is focus on what you can control:

  • The amount of risk you’re taking
  • The costs of your investments
  • The tax efficiency of your portfolio

The fact that these crises occur is why we’ve enjoyed such a high risk premium for investing in stocks. If you start feeling uneasy about market fluctuations, one of two things needs to occur:

  • Remember your plan and why you chose your allocations.
  • Adjust your plan to more appropriately consider your ability, willingness and need to take risk.

What we do know is that the markets have either already accounted for the possibility or will absorb the news very quickly. We also know that there’s no guarantee the markets will fully recover from major events. That’s the nature of risk. If that risk wasn’t present, then stocks wouldn’t be viewed as risky investments. Accordingly, your plan should take this into account as well.

If you’re still worried about what this will mean, ask yourself what great investors such as Warren Buffett would do, and remember Buffett’s classic line about investors: “They should try to be fearful when others are greedy, and greedy when others are fearful.”

Tuesday, February 8, 2011

Addicted to Risk?

Taken from Naomi Klien's TED talk with comments from Arianna Capital.

"We have become far to willing to gamble with things that are precious and irresponsible... and to do so without a backup plan." "Our societies have become addicted to extreme risk in finding new energy, new financial instruments and more ... and too often, we're left to clean up a mess afterward."

Naomi Klien frames risk in terms that most people can actually relate to. Her discussion saves us from getting into an extremely statistical, black-swan event narrative that technically explains how we are addicted to risk.

She explains that the main ingredients to this addiction seem to be greed, hubris, but most importantly a story that we tell ourselves and have been conditioned to believe. Greed and hubris are cited most frequently, and we can clearly see how they are at play. But, the way she explains this story element is most profound.

Klien claims that we are hooked in a loop that there will always be more or we will be saved at the last minute like in most Hollywood movies. This is a conditioned story from media, family, and society as a whole, and it seems to work against real behavioral change.

Now, what is the link here to finance - after all, this is a blog about Wealth Management practices and getting you to your goals. What is your story? Why do you trust your Financial Planner? Why do you believe investing should be done the way it should be done? Is it because the person that refereed you is smart and you trust them? Is it because fate brought you the right person at the right time?

We believe that most people do not really know why they have the manager that they have. It is also starting to become prevalent that many do not even know their real cumulative return, the fees they pay their adviser, or the types of risks that they are even exposed to. If you were going to be exposed to polio in the next few minutes wouldn't you want to know so you could do something about it? It is time to take a long hard look at this so that we can stop gambling on the precious lives that we support through our own livelihood. It is time to expose the story that you have been living regarding investing so that if it is too much of a risk a new solution can get you and your family to your goals.

To get started in the right direction, read a few areas of our blog that can help make a change:
This is but a handful of the wealth of information on this blog that relates to finding the right solution for yourself. Also, please contact us if you would like a free book that elaborates on what you need to make a Wealth Management Plan that accomplishes your goals.

Enjoy Klien's presentation below!

-Arianna Capital Management