No Stars For the Morningstar Rating System!

By Arianna Capital

There are two aspects to Morningstar's rating system. The first one is their star system. This one is based on past performance for active managers. The second one is an analyst forecast for the future.

The first aspect definitely deserves zero stars, and here is why.

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This shows that after an actively managed fund reaches the pinnacle of performance it usually does not do so again.

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The same is true for fixed income. So, the five star rating is definitely misleading for investors who invest using these generally high-cost funds.

Our second aspect of the Morningstar rating system is also flawed, but for a different reason. It has been found, that neither individuals that do it themselves nor analysts at institutions can consistently outperform the market by forecasting the future. This is not surprising, however, here is the evidence.

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Even Morningstar's Director of Research, John Rekenthaler says, "We should have more answers. There is suprisingly little that we can say for sure about how to find top-notch stock funds." And, commenting on whether investors should pay attention to mutual fund advertisements he stated, "...to be fair, I don't think that you'd want to pay much attention to Morningstar's rating system either."

Is Your Manager One of the Best?

By Arianna Capital

Although it would be great if we could all hire above average active managers, that only happens in Lake Wobegon. Superior managers may exist, but most investors might as well be picking their managers at random. This video describes the challenge of differentiating luck from skill, and explain how intense competition among investors makes the problem even more difficult.

Create Your Own Annuity

By Allan Roth

Equity investing is risky, unless you have a real safety net. And I’m not talking about those ugly Equity Indexed Annuities, I’m suggesting building your own safety net annuity, bypassing the insurance company and creating far more tax-efficiency. Here’s how you construct this portfolio, using $10,000 as an example.

CDs are the Foundation
Last week, I wrote about CDs to protect against a possible bond bubble. What’s not to love about being paid more to take on less risk? Then, Jason Zweig, writer of the Intelligent Investor column for The Wall Street Journal, contacted me about using this strategy to build your own annuity, which he wrote about last Saturday in Downside Protection has its Downsides.

How it Works

Using Discover Bank’s 3.25 percent APY 10 year CD, you could put $7,263 in the CD, and the remaining $2,737 in a low cost index fund such as Vanguard’s Total Stock Market Index Fund (VTI). I arrived at the CD amount so that in ten years, the CD would be worth $10,000, or the total amount you started with. Thus, you will get your total amount back even if the S&P 500 theoretically closes at 0.00 points, should the US government still be in business.

The amount you ultimately earn depends upon the stock market return. For instance, another lost decade of flat stocks would still yield a 2.45 percent annual return, while a 10 percent annual market gain would earn 5.51% annually.

The real value of this strategy comes from the psychological impact of being able to stay in the stock market throughout all of this volatility, knowing that you will always get your money back, over the ten year period.

Three Annuity Bonuses

Every annuity salesperson knows that the bonuses are the clincher in getting the client to sign on the dotted line. Well the “build it yourself annuity” actually has three bonuses.
Bonus # 1 - Free interest rate option

By using CDs from institutions that have low early withdrawal penalties, one can pay that penalty and buy a new CD at the higher rate, should interest rates spike.

This could be the case if, for example, after two years the experts are proven right and we have a bond bubble where interest rates spike by three percent. Should this happen, you would make more money by paying the penalty and earning the extra three percent annually. Your returns now look as follows:In this scenario, you get an annualized bonus return of between 1.16 percentage points and 2.03 percentage points. Not too shabby!

Bonus #2 - You pay less income taxes

As good as this deal is looking after bonus #1, it gets even better. Ordinary annuities are taxed at ordinary income. The “build it yourself annuity” has the dividends from VTI taxed at a lower rate (at least for now) and defers capital gains, which will be taxed at a lower rate.

The way to minimize taxes is to open the CD in your IRA account and put the VTI fund in your taxable account. In this way, you end up keeping more of the gain.

Bonus #3 - Free Death Benefit Rider

Finally, should you pass away during this ten year period, Uncle Sam will give you a free death benefit in the form of the step up basis on the VTI, thereby eliminating any taxes paid on the gain.

So where’s the catch?

You may be thinking that this “build it yourself annuity” seems too good to be true. It’s not, but there is one catch. It’s not as easy to construct your own annuity as it is to be sold one.To be sold one, all that is required is to write out a check and sign a document saying you’ve read and fully understood the 373 page disclosure. Without that annuity salesperson driving the time-line and telling you this must be signed today, you have to overcome inertia, a powerful force, and set it up yourself.

Why this isn’t too good to be true

Real Equity Indexed Annuities have high costs and commissions. The “build it yourself annuity” pays no commissions and has a weighted average expense ratio of 0.02% annually, approaching the US Government’s Thrift Savings Plan (TSP) costs.

This strategy doesn’t have the endorsement of the National Association of Fixed Annuities (NAFA), and I’m pretty sure no annuity salesperson will like it either. If these two non-endorsements don’t clinch the deal, I don’t know what will!

Unemployment Data - "Investment Pornography"?

By Arianna Capital

Investors may closely watch economic data to decipher what that means for their investment portfolios. While the data may prove useful in some respects, it does not offer much insight into the potential length, severity, or timing of a recession or rebound. Sound a lot like the mug's game of market timing? That's because it is.

If history is any indicator of what financial news we should and shouldn't worry about, unemployment numbers are a wave in an ocean for long-term investors. The following slides graph the S&P 500 Index’s total return over the past four recessions and in the current downturn. Although each recession was unique, they all share certain traits. For instance, each was not recognized until many months after it started. Meanwhile, the stock market began to rebound even though many indicators, including employment, were still in decline and did not show an uptick until well after the recessions were over.

It is the nature of economic data to look at the past, while stock markets look forward. This is why investors should not let current business sentiment in any cycle affect their long-term investment decisions - stick to your plan and relax.

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In both the mid 1970s and early 1980s, the recessions last 17 moths each, while in the early 1990s and 2000, the recessions lasted nine months each, but all were not announced until after they were over. Moreover, the NBER (National Bureau of Economic Research) did not announce each recession’s end until almost two years later. The take away: unemployment also peaked in the months prior to the official end. Consideration: this is not a pattern to necessarily look for, rather an observation from the data.

In the 1970s, 1980s, and 1990s recessions, the market began its recovery before the end, while the market languished for two years before rebounding after the 2001 downturn. This provides additional evidence that the stock market does not behave predictably through business cycles.

Now, to the most recent recession.

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The current economic downturn began in December 2007, although it was not officially announced until a year later, in December 2008. NBER has concluded that the recession officially ended in June 2009, drawing end to a 18-month blunder.

Of course, no one can offer a reliable forecast in the future. As the previous slides suggest, a recovery will only be identified many months after the fact and the market may recover long before unemployment peaks or the NBER announces an economic expansion.

With this in mind, investors should concentrate on maintaining discipline throughout business cycles rather than attempting to time them. Unemployment numbers in the Wall Street Journal are a number, and they represent just merely that, a number. There is no reliable way to identify when stocks are poised for recovery, and past business activity does not offer any insight. The stock market looks to the future and incorporates information into prices more quickly and efficiently than experts can collect business data and analyze it. Individual investors will fare better watching the latest clip of SportsCenter, rather than be influenced by financial "pornography" - that's the Arianna Capital solution.

So, You’ve Heard The Bad News, Eh?

By Arianna Capital

By now, you have most likely read about dollar inflation, potential Medicare/Medicaid cuts, social security lost for future generations, declining government services, or an increase in taxes. Sounds dismal doesn’t it? Yet, this should not affect the way you invest or the positive hope that you have about the future.

First, you must understand that all of the previous problems are caused by, not solely but mainly, a single factor – the present value of the government’s liabilities minus its assets at approximately 120 trillion dollars. Yikes, and thank God for the present yet seemingly declining reserve currency status.

Second, it is important to understand that this should not change the way you invest. It does mean that you should factor some of these problems into your financial plan, however, but your portfolio should remain relatively the same – assuming you have a diversified portfolio of low cost index funds invested in equities and bonds that is. Now the rest of what your portfolio should look like and why is quite technical. I recommend giving us a call so we can see if your portfolio is right for you.

Third, sure it sounds bad, but find one instance where doom and gloom ever helped anyone. Doom and gloom generally only serves to motivate the bravest or most fearful to action. But, in general the attitude only slows us down. So the situation is bad, but being doomy and gloomy only makes it worse. Instead, have hope – look for solutions – there are plenty!

Finding and Knowing That This is the Right Advisor For You

By Larry Swedroe

I saw the video by our MoneyWatch editorial director Eric Schurenberg on “How to Find an Advisor,” and I quickly thought about the principles I recommend you follow when trying to find an advisor you can trust. I thought it might be helpful to share this list with you. The following are 11 principles your advisor should live by.

Please note that I touched on a few of these in my post “How to Choose a Financial Advisor,” but I thought the full list would be beneficial as well.

Act in the best interests of clients
This should go without saying, and thus should be your advisor’s guiding principle.

Follow a fiduciary standard of care
This goes along with my first point. Many advisors (including broker-dealers) only have to follow a suitability standard, meaning the investments they recommend only have to be suitable for you and not necessarily in your best interest. There’s no reason why you should accept a suitability standard. If an advisor will not provide a fiduciary standard in writing, run.

Deliver attentive service
You want to work with an advisor who will develop a strong personal relationship with you and your family. This becomes especially important during times of stress. I know that there will be times when the conversation won’t be pleasant (like many I’ve had during the market decline), but that’s when it’s most important to be discussing the issues. Thus, you want to make sure you are working with someone who will be communicating even more during such periods.

Build customized investment plans
All investors have unique abilities, willingnesses and needs to take risk. Your investment plan should reflect those unique characteristics.

Give advice that is goal-oriented, not returns oriented
Your investment plan runs into danger when you focus on the short term instead of the long term (and your goals). That’s why advice should be focused on your goals and not on the noise of the market or the product du jour.

Seek out experts when needed
When I think of your investing needs, I think of the App Store for Apple’s iPhone: “There’s an expert for that.” Those experts should be leveraged to make sure you’re getting the best advice possible. No one can be an expert on everything. There should be a team or the advisor should be able to leverage strategic relationships to provide you that expertise.

Focus on advice, not products
It’s more important to figure out your needs, and then find the most appropriate investment vehicles to meet those needs.

Make sure fee structure is in your best interests
You want to minimize the potential conflicts of interest between yourself and your advisor. A fee-only structure is the best way to do that.

Practice full disclosure
For those conflicts that still exist, make sure they are fully disclosed and explained.

Take advantage of academic research
Make sure that the advice given is based on the latest scientific research, not on opinions.

Practice what I preach
Why would you work with an advisor who doesn’t invest in the same vehicles he or she recommends?

Commodities Are Fun to Eat and Use - Now How Do I Gain Exposure For My Portfolio?

EFF/KRF: Many companies have long positions in commodities and gain when commodity prices rise. Energy companies, for example, have reserves of oil, gas, and coal, and profit when energy prices rise. Other companies, such as airlines, buy commodities and suffer when prices rise.

Conceptually, investors can manage their exposure to commodity prices by increasing or reducing their ownership of firms that are positively or negatively exposed to commodity prices. This is probably not, however, an efficient way to manage commodity exposure. Few firms' fortunes are driven solely or even predominantly by commodity prices. Oil refiners and airlines, for example, are both affected by labor costs, regulations, taxes, economic conditions, and many other factors. An investor who adjusts his exposure to oil by increasing his allocation to either oil refiners or airlines also changes his exposure to all these other factors.