ibf - updates - 2012 (q3 v1.1)

© 2012 by Institute of Business & Finance. All rights reserved. v1.1

QUARTERLY UPDATES

Q3 2012

Quarterly Updates

Table of Contents

INVESTMENTS

MUNICIPAL BOND STRATEGY 1.1

VENTURE CAPITAL 1.1

HEDGE FUNDS 1.1

ROYALTY TRUSTS 1.2

THE VIX AND FUTURES 1.3

MUTUAL FUNDS

MUTUAL FUND RETURNS 2.1

MUTUAL FUND MANAGER CHANGES 2.1

MORNINGSTAR TRACKING ERROR 2.1

SHORT-TERM HIGH-YIELD BOND FUNDS 2.2

WSJ FUND ANALYSIS 2.2

ADOPTED MUTUAL FUNDS 2.3

ANNUITIES

2011 ANNUITY SALES 3.1

VARIABLE ANNUITY SHARE CLASSES 3.1

ANNUITY PRODUCT TRENDS FOR 2012 3.3

FIXED-RATE ANNUITIES 3.3

STOCKS

DIVIDEND-PAYING STOCKS 4.1

RISK LEVEL OF DIVIDEND-PAYING STOCKS 4.1

PREFERRED STOCKS 4.1

SEPTEMBER, OCTOBER, AND NOVEMBER 4.2

FINANCIAL PLANNING

U.S. ENERGY 5.1

GIFTS AND 529 PLANS 5.1

FINANCIAL PLANNING (CONT.)

STATE ESTATE TAXES 5.2

MEDICARE STRATEGY 5.2

HOMEOWNERSHIP RATES 5.2

HEALTH INSURANCE COSTS 5.3

HOUSING PRICE UPDATE [SEPTEMBER 26, 2012] 5.3

HOUSEHOLD NET WORTH 5.4

MISCELLANEOUS STATISTICS 5.4

CLIENT PRIMER: INVESTMENT THEORY 5.4

CLIENT PRIMER: WHY DIVERSIFY 5.6 THE LAST BEAR MARKET 5.8 HIGH PRICE OF BAD TIMING 5.8 BUILDING A DIVERSIFIED PORTFOLIO 5.9 REBALANCING MAY HELP 5.10

AGE-BASED 529 PLANS 5.10

LIFE EXPECTANCY 5.10

HEALTH CARE COSTS 5.11

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INVESTMENTS

Investments 1.1

QUARTERLY UPDATES

IBF | GRADUATE SERIES

1.MUNICIPAL BOND STRATEGY

Starting with the 2013 tax year, high earners will start paying an extra 3.8 percentage

points on investment income (to help pay for health care overhaul); this tax does not

apply to municipal bond interest.

VENTURE CAPITAL

According to a September 2012 article in The Wall Street Journal, the “common rule of

thumb is that of 10 start-ups, only 3–4 fail completely.” The National Venture Capital

Association believes 25–30% of venture-backed businesses fail. There are different

definitions of “failure.”

If “failure” is defined as an investor losing 100% of his investment in venture capital, it is

likely 30–40% of high-potential start-ups fail. However, if “failure” is described as

investors not getting the kind of projected return (e.g., a certain growth rate or return of

principal by a specified date), then > 95% of start-ups fail.

According to a Harvard professor, venture-backed companies tend to fail after their

fourth year—when investors have stopped adding money to the business. Looking at all

U.S. start-ups, ~60% survive for years and last approximately 10 years (source: U.S.

Bureau of Labor Statistics). Of those that do not “survive,” some are acquired, and others

simply languish. According to Dow Jones, of the over 6,600 U.S.-based companies

initially funded by venture capital from 2006 and 2011, 84% are currently

independently operated, 11% were acquired or had an IPO, and 4% went out of

business.

HEDGE FUNDS

As of September 2012, there were ~10,000 hedge funds, which collectively held $2.5

trillion in assets (source: eVentment/HFN). From 1980 through 2008, hedge funds

averaged 12.6% a year (source: Ilia Dichev, Emory University, and Gwen Yu,

Harvard). However, hedge fund investors only experienced a net return of 6.0% per year

(largely due to chasing top performers after they experienced a large return). Over the

same period, mutual fund investors underperformed mutual fund benchmarks by 1.5%

per year by chasing hot performers (e.g., 9.4% vs. 10.9% for the S&P 500).

Investments 1.2

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One way to view hedge funds is that they generally fall into one of two categories:

risk reducers or return enhancers. Morningstar lists over 250 mutual funds as

“alternatives”—funds that use a hedge fund–type approach. Investors also have the

option of using “replicator” mutual funds and ETFs (e.g., Goldman Sachs Absolute

Return Tracker, Natixis ASG Global Alternatives, IQ Alpha Hedge Strategy, Marketfield

Fund, and Merger Fund).

Recent research shows hedge funds receive much of their return by owning assets that

lack liquidity during market panics. This “liquidity-risk premium” translated into 10.6%

annual returns from 1996 through 2009 versus 4.1% per year for hedge funds that had

much more liquidity (source: Ronnie Sadka, Boston College).

Red flags all hedge fund investors and advisors should be concerned with often

center around “operational risks” (e.g., fund uses a little-known accounting firm, relies

on its own model to value assets, and makes trades using its own brokerage arm).

ROYALTY TRUSTS

A royalty trust collects and distributes income from oil and gas or mining operations.

There are ~30 royalty trusts in the U.S. with a combined market value of ~$12 billion.

Most are designed to self-liquidate in 20 years or less; these trusts have no employees

or physical assets. A royalty trust holds the right to receive income from a fixed

number of properties.

Once established, the trust is frozen and cannot acquire any new assets. Since oil and

gas as well as mines are depleting assets, yields from royalty trusts almost always decline

as years pass by. When no money is left, these trusts disappear; unlike bonds, there is no

remaining underlying principal. A number of investors do not realize that royalty

trusts are not really a fixed-income alternative.

Royalty trusts describe the likely income an investor will receive over the life of the trust.

For example, one trust shows future available cash for distribution to be an estimated

$1.4 billion, yet total market value was $2.3 billion. Another trust projects future payouts

of $109 million and a market value of $123 million. Both sets of numbers show that

investors will not even receive their principal back over the life of the trust, based on

current market valuations.

Investments 1.3

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If total payouts are expected to be $1.4 billion and market value is $2.3 billion,

investors appear to be willing to pay 61% more up front than what they will be

cumulatively receiving over the trust’s life (remember, there is no return of principal at

the end). This example would be a great opportunity for short sellers to arbitrage the

difference, but royalty trusts are very thinly traded.

THE VIX AND FUTURES

Investors often worry about market volatility. One hedging strategy is to look for

investments that increase in value when markets decline in order to get some downside

protection.

VIX is an abbreviation for “volatility index.” Its actual calculation is complicated, but the

basic goal is to measure how much volatility investors expect to see in the S&P 500 over

the next 30 days, based on prices of S&P 500 Index options. When options traders think

the stock market is likely to be calm, the VIX is low; when they expect big swings in the

market, the VIX goes up.

VIX Index

[Select Dates during Select Years]

1995 13 2007 10

1998 36 2008 61

2000 20 2010 19

2002 20 2011 16

2004 15 2012 19

During times of high market turmoil, the VIX has tended to rise. The VIX index moved

steadily higher as the market approached the peak of the late 1990s technology bubble,

calmed down during the steady growth period of 2003–2007, then spiked during the 2008

credit crisis and also in the latter half of 2011. Because of this pattern of behavior, the

VIX is sometimes referred to as the fear index; when market participants are worried

about the market, the VIX tends to rise.

Investors who see the VIX having increased sharply while the market went down might

be tempted to seek an investment in the VIX as a source of potential protection during

market turbulence.

Investments 1.4

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Like all indexes, you cannot directly buy. Moreover, unlike a stock index such as the

S&P 500, you cannot buy a basket of underlying components to mimic the VIX. Instead,

the only way investors can access the VIX is through futures contracts.

Index futures, such as those tied to the value of an index like the S&P or VIX, do not

involve the actual delivery of anything when the futures contract matures. Instead, they

use a cash delivery tied to the value of the index on the delivery date.

Contango The potential problem, as with any futures contract, is contango—when the futures price

for something is > its current price. For example, if VIX is at 15 today and a one-month

VIX futures contract is trading at 16, the VIX futures market is in contango.

Imagine your goal is to always have a certain part of your portfolio invested in VIX

futures. If the futures contracts are always more expensive than the current VIX

level, then you pay a premium every time you buy futures. You are essentially buying

high and selling low, which erodes the value of your investment over time.

Contango is not purely academic. VIX futures contracts have often been more expensive

than the VIX index. According to Bloomberg, in 50 of the past 73 months, the three-

month VIX futures contract was above the VIX level—68% of the time over a period just

over six years.

In the table below, you can see what $10,000 would be worth if it had been invested in

the VIX itself versus a portfolio of short-term VIX futures contracts. These portfolios are

based on actual ETFs that buy VIX futures contracts.

Value of $10,000 Investment

[Short-Term VIX Futures vs. VIX Index]

S.T. VIX VIX Index S.T. VIX VIX Index

Apr. 2011 $10k $10k Jan. 2012 $12k $14k

July 2011 $10k $11k Apr. 2012 $7k $11k

Oct. 2011 $24k $28k July 2012 $5k $13k

Investments 1.5

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Since April 2011, the futures contracts have lagged significantly behind the value of the

VIX index. By the end of the time period, the value of $10,000 hypothetically invested in

the VIX itself would have risen to almost $13,000 while the portfolios of futures

contracts were worth $5,500. Had an investor actually been able to buy the VIX, the

investment would have paid off during this time period; the actual investable instruments

lost significant amounts of money.

Just because an investment has VIX in its name does not mean that it will move in line

with the VIX index. The VIX itself can be extremely volatile—the index lost 64% of its

value between September 2011 and March 2012.

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MUTUAL FUNDS

Mutual Funds 2.1

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2.MUTUAL FUND RETURNS

Over the past decade, 57% of active mutual fund managers failed to beat their benchmark

indexes. For 2011, 84% underperformed (source: S&P).

MUTUAL FUND MANAGER CHANGES

Advisors often wonder what to do when a favored mutual fund manager leaves a fund or

simply retires. According to studies, when a new manager steps in, subsequent returns are

somewhat mixed. For example, an August 2012 study from the University of Rochester

shows there is, overall, no difference in returns. However, funds that trailed their

benchmarks tended to perform better after the management change—an enhanced

performance may likely be due to any fund’s returns that revert to the mean after periods

of ups and downs. This also coincides with what happens when a manager of an above-

average performing fund leaves—returns tend to decline (reversion to the mean).

Advisors who wish to take a different approach to a manager departing should

consider the following:

[1] Is the departing manager a core driver for fund performance?

[2] How closely did the new manager work with the departing manager?

[3] How much do sector weightings change with the new manager?

[4] How many of the 10 largest holdings change with the new manager?

[5] Has the fund’s overall turnover rate changed much?

MORNINGSTAR TRACKING ERROR

According to Morningstar, “tracking error” is the amount a fund’s returns veer from its

benchmark. For the 12-month period ending August 31, 2012, tracking error for bond

funds was 2.2% (vs. 2% for the same period ending in 2011). For the five-year period

before the 2008 meltdown, the deviation averaged 1.4% for a 12-month period.

Mutual Funds 2.2

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SHORT-TERM HIGH-YIELD BOND FUNDS

Although rarely discussed, a diversified short-term high-yield bond fund may be the

answer for advisors seeking to maximize return while staying somewhat conservative. For

example, the Wells Fargo Advantage Short-Term High-Yield Bond Fund lost < 6%

while the average high-yield fund was down > 26% in 2008. Although the Wells Fargo

fund has been around for > 15 years, almost all short-term high-yield funds have been in

existence for < a couple of years, including: SPDR Barclays Capital Short Term, PIMCO

0–5 Year High-Yield Corporate Bond Index ETF, and the RiverPark Short Term High

Yield.

According to Lipper, over the past 20 years, the worst 12-month period for equity-

income funds was March 2008 to February 2009 (-41%). The average real estate mutual

fund lost 48% in just three months between September and November 2008. The worst

12 months for real estate funds was April 2009 to March 2009 (-59%). From March

2008 to February 2009, the typical emerging markets stock fund returned -58%. For

high-yield bond funds, the worst 12 months over the past 20 years (1992–2011) was

December 2007 to November 2008 (-29%).

WSJ FUND ANALYSIS

An October 2012 article in The Wall Street Journal (WSJ) recommends the following

approach for overseeing a mutual fund:

[1] Set realistic return expectations.

[2] Top managers often have mediocre returns in ~3 out of every 10 years.

[3] If a fund falters, give it at least two years to recover.

[4] Large fund inflows may result in poorer returns in the future.

[5] Look for funds that just had one to two years of bad returns.

[6] If a client tends to panic during downturns, consider a balanced fund.

Mutual Funds 2.3

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The WSJ article also included a survey of WSJ readers who listed the mistakes they most

often made with their mutual fund positions:

Biggest Mistake % of Respondents

Being Too Cautious 44%

Buying Too Late, Post Run-Up 18%

Picking a Volatile, Niche Fund 14%

Not Firing a Fund Soon Enough 14%

Not Diversifying Enough 7%

Firing a Manager Too Soon 3%

ADOPTED MUTUAL FUNDS

In the typical adoption, a large mutual fund company takes over the management of one

or more funds from a smaller firm, retaining the fund’s investment managers as

subadvisors. There is usually a cash payment to the smaller firm based on the size of the

fund, its track record, and the length of the track record. These “adoptions” are

considered a prudent way for a fund family to expand its lineup.

The average fund being adopted has $500 million to $2 billion in assets; some adopted

funds have just $25 million. For the small funds, their managers may have more of a

passion for the management of money and not for the management of the business.

Adopted funds tend to have high ratings when it comes to returns. Fund adoptions usually

require shareholder approval. Advisors should look for fee changes and possible changes

in the fund’s investment objective.

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ANNUITIES

ANNUITIES 3.1

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3.2011 ANNUITY SALES

Total annuity sales for 2011 were $231 billion ($155 in variable annuities [VAs] and the

balance in fixed-rate annuities). Of this $231 billion total for 2011, $223 billion was

invested in deferred annuities and less than $9 billion to immediate annuities. The vast

majority of variable annuity sales are from 1035 exchanges (not new money). The

ratio of net flow to total sales for 2011 was under 18%. Variable annuity net flows

(new money) were < $28 billion of the $155 billion in total sales (new money +

exchanges). In 2002, total net assets of annuities (fixed and variable) totaled $1.2 trillion,

$2 trillion in 2007, and $2.2 trillion ($1.5 in VAs and $0.7 in fixed) by 2011. The table

below shows the top 10 VA sellers for 2011 (source: Morningstar).

2011 Variable Annuity Sales [In Billions]

Top 10 Sellers

Company Total Sales % of 2011 Sales

MetLife $29.5 19%

Prudential Financial $20.2 13%

Jackson National $17.5 11%

TIAA-CREF $13.5 9%

Lincoln Financial Group $9.4 6%

SunAmerica/VALIC $8.0 5%

Nationwide $7.7 5%

AXA Equitable $7.0 5%

Ameriprise Financial $6.4 4%

AEGON/Transamerica $5.4 3%

Source: Morningstar

VARIABLE ANNUITY SHARE CLASSES

A-Share Variable Annuities A-share annuities are similar to A-share mutual funds: an up-front sales charge, but no

surrender charges. The commission charge is a percentage of each premium payment. A

shares offer breakpoint pricing. Additionally, some companies include an investor’s

purchase of other products offered by the company when computing breakpoints.

Generally, A-share contracts have lower annual M&E fees than annuities with surrender

charges. A shares are not nearly as popular as B shares.

ANNUITIES 3.2

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C-Share Variable Annuities Similar to C-share mutual funds, C-share VAs have no up-front or back-end fee. The

investor can liquidate any or all shares at any time without cost or fee.

L-Share Variable Annuities There is no up-front sales charge with L shares, but there is usually a 3- to 4-year

surrender period with fees. L shares often have M&E and admin fees higher than other

share classes.

O Shares O shares combine features of A and B shares. O shares are designed for long-term

investors. This share class is only offered by a very small number of insurers. An O share

has no up-front charges (unlike A shares) but does have a deferred sales charge (just like

B shares). During the surrender period, M&E expenses decline until they reach a level

similar to M&E expenses for A shares (which is typically lower than M&E costs for B

shares). The issue for brokers and advisors is likely to be a reduction in any commission

trails.

X-Share Variable Annuities X-share VAs credit the contract with an additional amount (bonus), calculated as a

percentage (1–6%) of the initial premium. For example, an investor’s initial investment

of $100,000 might become $103,000 when the contract is first issued. X-share contracts

typically have a longer surrender period and higher ongoing costs than contracts

that do not offer a bonus. From a purely math perspective, the bonus (and any

resulting compounding) makes sense only if the investor assumes an overall annual

net return of 6–8% per year.

Some of these products allow the insurer to recapture part or all of any bonus if the

contract is surrendered within the first few years. There are also VA contracts that credit

additional amounts to the contract if the investor adds money to the contract within the

first several years. These are classified as persistency bonuses.

ANNUITIES 3.3

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Variable Annuity Sales

Year

#

Unique Products

# Companies Selling

Variable Annuities

Average Funds

Per Contract Type

2005 1,008 45 44

2008 1,491 40 51

2009 1,591 40 49

2010 1,694 40 50

2011 1,951 41 62

Source: Morningstar

VA sales for 2011: B shares = 60% / L shares = 24% / X shares = 7% / A shares = 3% /

C shares = < 3% / I shares = < 3%

ANNUITY PRODUCT TRENDS FOR 2012

EIA sales have greatly benefited from three innovations: bonuses (percentage of initial

premium purchase), GLWBs, and GMDBs. These three factors provide a strong incentive

for 1035 exchanges. Less-used innovations include: income account/benefit base bonuses

(money added to the amount from which future guaranteed lifetime income withdrawals

are made), a bonus vesting schedule (lowers insurer’s cost and provides an incentive for

investor to hold the contract), persistency bonuses (reward contract owners for keeping

their contract), and annuitization bonuses (reward owners annuitizing their contracts).

Here are some additional examples of product innovations and trends with annuities in

general: [1] dual-sleeve guaranteed withdrawal structures (AXA, Allianz), [2] percentage

and step-ups tied to U.S. Treasury rates (AXA, Allianz), [3] step-ups during the

withdrawal phase (SunLife), [4] guarantee tied to account value and increasing

withdrawal percentage (Protective), [5] long-term care rider (Lincoln), [6] VIX-based fee

structure on a withdrawal benefit (SunAmerica), [7] O shares (Pru, SunLife,

SunAmerica), and [8] fee-based I shares (various insurers).

FIXED-RATE ANNUITIES

No insurer has ever missed an annuity payment. In 2011, the GAO endorsed fixed-

rate annuities as a source of income for middle-income retirees.

ANNUITIES 3.4

QUARTERLY UPDATES


Fixed-Rate Annuity Sales

Year Billions Sold

2007 $57

2008 $107

2009 $104

2010 $76

2011 $76

Source: Beacon Research

Long-Term Care/Confinement Benefits

Linked-benefit annuities cover costs of long-term care insurance by providing a benefit

that is a multiple or percentage of the annuity contract’s value. The insurer (annuity

issuer) pays for this benefit by taking a fee from the contract. This type of long-term care

protection usually costs quite a bit less than an individual long-term care policy; if the

long-term care benefit annuity rider is never used, the contract owner still has something

of value (the annuity).

A potential advantage of a linked-benefit annuity is gaining protection without having to

complete a medical questionnaire or pass a medical exam. During 2011, a modest number

of fixed-rate annuities included GLWBs that doubled or tripled in value if long-term care

was needed.

Long-term care insurance (LTCI) is purchased by individuals or through a company’s

group benefit plan. Individually sold policies accounted for > 75% of LTCI premiums

collected in 2011. Only a modest number (7.2 million) of Americans have LTCI.

Retirement Middle-income baby boomers have a number of concerns about future retirement: 21%

have little or no confidence, 48% question their knowledge about investing, and 57%

have not used an advisor or broker to coordinate their long-term finances.

People retiring today face two problems: retirement has become more expensive

(longevity and health care costs) while traditional retirement income sources have

diminished as the age to receive maximum Social Security benefits has increased and

fewer Americans are covered by traditional pension plans and retiree health insurance.

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STOCKS

Stocks 4.1

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4.DIVIDEND-PAYING STOCKS

Of the 500 stocks in the S&P 500, 402 now pay a quarterly dividend, the highest level

since 1999. S&P 500 dividends represent an average of 33% of earnings for these

companies; historically, S&P dividends have been 50% of earnings (source: S&P).

RISK LEVEL OF DIVIDEND-PAYING STOCKS

There is a perception that dividend-paying stocks are safer than the market as a whole; if

stocks suffer a large loss, dividend payers will drop less. However, the 100 highest

dividend-paying stocks in the Russell 1000 Index have a beta of 0.96, making their

market-related risk almost the same as the S&P 500 (which always has a beta of 1.0).

With this presumption of increased safety by going into dividend-paying stocks comes a

trade-off often not considered: swapping one risk for another. For example, seeking

higher dividends may mean a much higher concentration in just a few sectors. Telecom

(21 P/E), utilities (17 P/E), and consumer staples (15 P/E) are considered “defensive

sectors.” But these three sectors have P/E ratios higher than the S&P 500’s (source: 12-

month trailing P/Es, as reported by FactSet in September 2012).

Consider another sector: food, beverage, and tobacco companies. This group has a

trailing P/E of 18.7 as of mid-September 2012 (vs. 14.5 for S&P 500). Yet some of the

companies in this group have a P/E as high as 32.

PREFERRED STOCKS

As of September 2012, the preferred stock market was valued at $500 billion. The yield

of the S&P U.S. Preferred Stock Index was 6% versus ~2% for the S&P 500. These

hybrid securities often have a call feature. Some preferreds can be converted to common

stock. But just like common stocks, the dividend can be cut or cancelled without notice

by the company’s board of directors.

During the financial crisis, the preferred stock index fell 63% from July 2008 to the

market low in March 2009. Over the same period, the S&P 500 dropped 46%. This

greater loss was largely due to the fact that many preferreds have a junk rating. Banks

and other financial firms issue most preferreds. Financing for these companies is no

problem during decent economic times, but money can dry up when credit is tight.

Stocks 4.2

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As a generality, just 5–10% (or less) of a client’s fixed-income portion of a portfolio

should be considered for preferreds. Examples of preferred funds include:

PowerShares Preferred ETF, Market Vectors Preferred Securities ex-Financials, Global X

“Super Income” Preferred ETF, and iShares S&P Preferred Stock Index.

SEPTEMBER, OCTOBER, AND NOVEMBER

Since 1926, large company stocks (S&P 500) have gone up an average of 0.9% per

month. In September, these same stocks have lost an average of 0.8%. Large cap

stocks have risen in just 50% of every September since 1926, far below the average of

62% for all months. The table below shows how three broad categories of U.S. stocks

have fared since 1926 (source: Bank of America Merrill Lynch).

Average Monthly Returns for U.S. Stocks [1926–2011]

Sept. Oct. Nov.

Large Cap -0.8% 0.5% 1.4%

Mid Cap 0.8% 0.0% 1.8%

Small Cap -0.5% -0.5% 1.6%

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FINANCIAL PLANNING

Financial Planning 5.1

QUARTERLY UPDATES


5.U.S. ENERGY

During September 2012, natural gas was selling for $2.50 to $3.00 per thousand cubic

feet. Production costs for natural gas have fallen dramatically over the past few years,

largely due to advances in directional drilling and hydraulic fracturing. Fracturing is the

process of injecting enormous amounts of fluid (90% water, < 10% sand, and < 1%

chemical additives) into the ground below the water table.

It is likely that natural gas will provide the cheapest source of energy—projected to be six

cents a kilowatt-hour: > 20% cheaper than new coal and nuclear or most renewable

alternatives. Exporting natural gas has its own set of economics (per thousand cubic feet):

[1] add 15% to the cost due to gas loss during the liquidation process, [2] liquidation

costs are between $2.50 and $3.00, [3] shipping ranges from $0.85 to $2.80, depending

on whether the liquefied gas is going to Europe or Asia, and [4] converting the liquefied

gas back to natural gas costs an additional $0.40.

Historically, the ratio between the cost of natural gas and oil on an energy-equivalent

basis has been one to six. Today, that ratio is far higher due to the greatly decreased price

for natural gas.

The North Dakota Bakken/Three Rivers field produces 600,000 barrels of oil a day, up

from 250,000 barrels in 2008. It is now estimated that the U.S. can economically (selling

at $70 a barrel) and technically recover 45 billion barrels of oil, representing 10% of total

North America oil in place.

GIFTS AND 529 PLANS

There are 18 states (plus D.C.) that have an estate tax lower than the federal amount; only

Connecticut has a gift tax (for annual gifts > $13,000), according to CCH.

Surprisingly, a gift made to a 529 plan for someone other than your spouse is

excluded from the donor’s estate even though the donor can access account principal

for his own personal use without penalty or taxation. The donor can also access 529

plan earnings but will incur income taxes and a possible 10% penalty on such growth.

What makes this “surprising” is that the donor, who is the custodian of the 529 account,

still has a constructive receipt, yet the account value is not considered part of the

donor’s estate.


QUARTERLY UPDATES


STATE ESTATE TAXES

In 2001, all 50 states had a death tax. By the summer of 2012, only 19 states still had

such a tax.

MEDICARE STRATEGY

Medigap insurance covers the 20% of costs not covered by Medicare Part B. These

optional supplemental plans cover nine types of standardized policies offered by

companies such as AARP and Blue Cross/Blue Shield. Medicare Part D (prescription

drugs) is not standardized; the drugs covered and their costs vary by policy.

Medicare Part C, sometimes called an Advantage Plan, allows your clients to opt out

of traditional Medicare and sign up for a private version. Part C is intended to

provide equivalent services of Medicare Parts A, B, and D and Medigap. Part C is

promoted as a less-expensive alternative because the patient is limited as to what

providers can be used. If a Part C participant uses a doctor or hospital outside the

network, costs can be considerably more.

Financial advisors may wish to use the services of outside consultants when helping

clients with Medicare questions. The U.S. government funds a nationwide network of

free State Health Insurance Assistance Programs (SHIPs). These companies provide

information about Medicare enrollment, plan selection, claims, disputes, and appeals. For

$80 to $150 an hour, patients with a more complex situation may consider using for-

profit organizations.

HOMEOWNERSHIP RATES

According to the Census Bureau, homeownership in the U.S. was 65.4% in March 2012,

the same level it was in early 1997. The rate peaked at 69.2% at the end of 2004. The rate

has steadily fallen since housing prices started to decline in 2006. Median rent for Q1

2012 was $721, its highest level since early 2009.


QUARTERLY UPDATES


HEALTH INSURANCE COSTS

For 2012, the average cost for health care insurance for a family was $15,745 (source: Health Research & Educational Trust). Workers contributed an average $4,316

toward the cost of a family plan (28% of total premium). Employer premiums for a single

person were $5,615 for 2012.

HOUSING PRICE UPDATE [SEPTEMBER 26, 2012]

For the first six months of 2012, home prices increased 5.9%, according to the

S&P/Case-Shiller 20-City Index. The index tracks 20 metropolitan areas and reports on a

two-month delay. The index was among the first to use repeat sales as its methodology—

measuring prices of the same homes that have two or more recorded sales. Home sale

pairs are accumulated in rolling three-month periods to keep sample sizes large enough.

Before Case-Shiller, the most widely watched home-price measure was from the National

Association of Realtors (NAR). NAR uses a median sales price for thousands of different

types of homes in hundreds of locations that sell in a given period. Median prices can be

skewed when there is a shift in the “mix” of what is selling: the number can turn higher in

months where more expensive homes are sold, revealing little about the direction of

prices.

CoreLogic Inc. and the Federal Housing Finance Agency (FHFA) also use repeat-sales

measures. CoreLogic covers transactions in ~80% of the country, a wider scope than

Case-Shiller’s. The FHFA index is based on the sales of homes which Fannie Mae and

Freddie Mac guarantee or purchase the loan. As a result, it does not track more expensive

homes. The FHFA index is unit-weighted, meaning all sales count equally. Case-

Shiller is value-weighted, giving greater emphasis to more expensive properties;

high-cost markets such as New York and Los Angeles have an outsize effect.

The FHFA index shows prices rose 34% from 2003 to 2007; prices are now ~16% below

their peak. Case-Shiller shows a 52% gain from 2003 until peaking in mid-2006; prices

are still ~30% of their peak (as of September 2012).


QUARTERLY UPDATES


HOUSEHOLD NET WORTH

As of the end of June 2012, the market value of U.S. household real estate was $19.1

trillion, still below its all-time high of $25 trillion in the mid-2000s. Owners’ equity as a

percentage of the market value of household real estate was 43.1% as of the end of the

second quarter of 2012. Stocks and real estate each represented 25% of household-

sector assets; the remaining 50% of household assets were in pension funds, life

insurance cash values, bonds, cash, and savings accounts.

MISCELLANEOUS STATISTICS

Since 1946, there have been 11 bear markets for the S&P 500; these market drops of at

least 20% occur at an average of one out of every six years.

Total foreign spending by the U.S. ($37 billion) represents < 1% of its $3.8 trillion

budget (source: Office of Management and Budget).

The country’s largest public pension fund (California Public Employees’ Retirement

System) reduced its target rate return from 7.75% to 7.50% in March 2012.

The average licensed driver logs in 12,700 miles per year. This translates into 18 hours

and 31 minutes spent during the week behind the wheel of a car.

For the 12 months ending March 31, 2011, 73,000 reverse mortgages were completed in

the U.S. From 2005 to 2009, the use of federally insured reverse mortgages increased

170% (source: SmartMoney magazine, November 2010).

CLIENT PRIMER: INVESTMENT THEORY

An early description of theory and markets came from the 1900 dissertation of French

mathematician Louis Bachelier: “Past, present, and event discounted future events are

reflected in market price … the determination of these fluctuations depends on an infinite

number of factors; it is therefore impossible to aspire to mathematical prediction of it

…”


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A few decades later, the Cowles Commission for Research in Economics (home to

academics such as Nobel laureates James Tobin and Harry Markowitz) published its

research on market forecasting by summarizing that the markets outperformed

forecasters.

A 1934 landmark publication, Security Analysis by Graham and Dodd, heralded the age

of fundamental analysis. Graham and Dodd stressed balance sheet analysis (the

“fundamentals”). The authors strongly recommended that a stock should only be

purchased when its fundamentals met or exceeded a number of criteria. Their focus was

on individual stocks, not the portfolio.

The most famous and successful disciple of Graham and Dodd has been Warren Buffett:

“Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset

pricing model, or covariance in returns among securities. These are not subjects of any

interest to them. In fact, most of them would have difficulty defining those terms. The

investors simply focus on two variables: price and value…. While they differ greatly in

style, these investors are mentally always buying the business, not buying the stock.”

Using a far different approach, Harry Markowitz—beginning with his 14-page March

1952 article in the Journal of Finance, “Portfolio Analysis with Factors and Scenarios”—

wrote, “You should be interested in risk as well as return.” Markowitz’s premise was

simply genius: risk is central to investing; and the portfolio, not a particular position, is

fundamental for investment management. Harry’s original article evolved into his 1955

thesis; the full description was published in 1959 as Portfolio Selection: Efficient

Diversification of Investments. This work is now referred to as modern portfolio theory.

Suppose you have two stocks or even two asset categories; each position has an expected

return of 10% a year and a standard deviation of 10%. Prior to Markowitz, the standard

deviation of a 50/50 portfolio of these two assets was believed to be 10%. In fact, the

standard deviation of such a portfolio would only be 10% if the two positions had a

perfect correlation coefficient (1.0). Suppose the correlation were 0.5 (considered

random). The standard deviation for the portfolio would then drop to 8.7% (a 13%

decrease). Now consider an equally weighted two-asset class portfolio constructed from

two of the following three investments:

Return Std. Dev. Correlation with A

Investment A 8% 15%

Investment B 6% 10% 0.3

Investment C 6% 8% 0.9


QUARTERLY UPDATES


Here, the focus should be on correlation coefficients, particularly since B + C are

expected to have the same return. And even though C has a standard deviation higher

than B, the advisor should choose A + B because the overall portfolio’s risk level is lower

than it is with A + C.

Return Std. Dev.

Investment A + B 7% 10.2%

Investment A + C 7% 11.2%

When looking at systematic risk (which cannot be diversified away) and unsystematic

risk (which can be completely eliminated), it has been shown that a portfolio of 10–12

poorly correlated stocks eliminates the vast majority of unsystematic risk. This is quite

desirable since there is no net benefit to having unsystematic risk.

Markowitz’s efficient frontier, which shows the most efficient (highest) return for each

level of risk, presents numerous important concepts:

There is no perfect portfolio.

There are an infinite number of efficient portfolios.

Efficient portfolios fall along the efficient frontier.

Current portfolios may be improved by repositioning assets resulting in

o greater return with the same risk level as the current portfolio,

o same return but less risk than the current portfolio, or

o greater return and sometimes less risk.

CLIENT PRIMER: WHY DIVERSIFY

The goal of diversification is not to boost performance—it will not ensure gains or

guarantee against losses—but it can help set the appropriate level of risk for an

investor’s time horizon, financial goals, and tolerance for portfolio volatility. At the heart

of diversification lies the concept of correlation. Simply put, correlation is a measure of

how returns of two assets move together (i.e., whether their returns move in the same or

in opposite directions and how often).


QUARTERLY UPDATES


Correlation is a number from -100% to 100% that is computed using historical returns. A

correlation of 50% between two stocks, for example, means that in the past when

the return on one stock was going up, then about 50% of the time, the return on the

other stock was going up too. A correlation of -70% tells you that historically 70% of

the time, they were moving in opposite directions—one stock was going up, and the other

was going down.

When you put assets together in a portfolio that have low correlations, you may be able to

get more returns while taking on the same level of risk or the same returns with less risk.

The less correlated the assets are in your portfolio, the more efficient the trade-off

between risk and return.

To build a diversified portfolio, an investor should look for assets whose returns have not

historically moved in the same direction and, ideally, assets whose returns move in the

opposite direction. That way, even if a portion of a portfolio is declining, the rest of the

portfolio may be growing. Thus, you can potentially dampen the impact of poor market

performance on your overall portfolio.

Another important aspect of building a well-diversified portfolio is to stay diversified

within each type of investment. Within individual equity holdings, beware of

overconcentration in a single stock. For instance, you may not want one stock to make up

more than 5% of your stock portfolio. It is also smart to diversify across stocks by

capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps,

sectors, and regions prosper at the same time; so you can help reduce portfolio risk by

spreading your assets. If you are investing in funds, you may want to consider a mix of

styles, such as growth at a reasonable price, quality growth, and aggressive growth.

Similarly, if you need to increase your bond allocation, consider bonds with varying

maturities, styles, and sensitivities to inflation and interest rate changes.

If you are investing in funds, you will want to consider whether they have been strong,

consistent performers relative to their stated objectives and styles. Just because your

investments have not been historically correlated when you choose them, that does not

mean they will stay that way. Correlation can change dramatically and rapidly in volatile

markets. Assets can become highly correlated, meaning their returns move in the same

direction. This reduces the short-term benefit of diversification, which is what happened

during the bear market downturn of 2008–2009, but it does not reduce the long-term

appeal of diversification.


QUARTERLY UPDATES


The Last Bear Market

During the 2008–2009 bear market, the correlations of U.S. stocks (Dow Jones Wilshire

5000) to virtually every type of asset except Treasury bonds (not shown below) increased

sharply. As the chart below shows, correlations of U.S. stocks to international stocks and

high-yield bonds jumped to nearly 90%. Investment-grade bonds and cash went from

being negatively correlated to U.S. stocks to being positively correlated. All of this

reduced the effectiveness of diversification during this period.

Correlation to U.S. Stocks

September 2008 February 2009

Foreign Stocks 81% 91%

Emerging Markets Stocks 76% 83%

U.S. High-Quality Bonds -14% 29%

U.S. High-Yield Bonds 54% 89%

Cash -4% 24%

High Price of Bad Timing

Unfortunately, many investors struggle to realize the benefits of their investment strategy

because they sell out of stocks when they are falling or change their investment mix to

chase the returns of a rising stock market—a practice known as market timing.

Trying to time the market is notoriously difficult. A study by Dalbar has shown that

investors trail the market significantly. This means the decisions investors make about

diversification and when to get into or out of the market, as well as fees, cause them to

generate far lower returns than the overall market. The table below (source: QAIB and

Dalbar) shows returns for a 20-year period (1991–2010). Although the S&P 500

outperformed a 60/40 mix (9.1% vs. 8.8%), it did so with far greater volatility. The table

also shows how mutual fund investors have fared poorly compared with their

respective index (3.8% vs. 9.1%, 2.6% vs. 6.8%, and 1.0% vs. 6.9%).


QUARTERLY UPDATES


January 1, 1991 to December 31, 2010

Investment Annualized Return

S&P 500 9.1%

Average Equity Fund Investor 3.8%

60% S&P 500 + 40% Barclays Bond Index 8.8%

Average Asset Allocation Fund Investor 2.6%

Barclays Aggregate Bond Index 6.9%

Average Fixed-Income Fund Investor 1.0%

Building a Diversified Portfolio

The investment mix (e.g., stocks, bonds, and short-term investments) should be aligned to

your investment time frame, financial needs, and comfort with volatility. The sample

target asset mixes below show some asset allocation strategies that blend stock, bond, and

short-term investments to achieve different levels of risk and return potential.

Portfolio Returns: 1926–2010

Best

1 Year

Worst

1 Year

Best

5 Years

Worst

5 Years

Average

(1926-2010)

Short-Term 15% 0% 11% 0% 4%

Conservative 31% -18% 17% 0% 6%

Balanced 77% -41% 23% -6% 8%

Growth 110% -53% 27% -10% 9%

Aggressive Growth 137% -61% 32% -14% 9%

Very Aggressive 163% -68% 36% -17% 10%

Note: Short-Term = U.S. T-Bills / Conservative = 50% bonds, 30% T-Bills, 14% S&P 500, and 6% foreign stocks / Balanced =

40% bonds, 35% S&P 500, 15% foreign stocks, and 10% T-Bills / Growth = 49% S&P 500, 25% bonds, 21% foreign stocks, and 5%

T-Bills / Aggressive Growth = 60% S&P 500, 25% foreign stocks, and 15% bonds / Very Aggressive = 70% S&P 500 and 30%

foreign stocks.


QUARTERLY UPDATES


Rebalancing May Help Just diversifying is not enough. Once you have a target mix, keep it on track with

periodic checkups and rebalancing. If you do not rebalance, a good run in stocks

could leave your portfolio with a risk level inconsistent with your goal and strategy.

Consider a hypothetical growth portfolio with 70% in stocks (49% U.S. and 21%

foreign), 25% bonds, and 5% short-term investments in March 1992. A decade later, at

the end of March 2002, the bull market of the late 1990s would have changed the

investment mix dramatically to nearly 80% in stocks (64% U.S. and 14% foreign), 19%

in bonds, and 3% in short-term investments. The portfolio’s risk level as of March 2002

was 12% greater than that of the target mix due to changes in the asset allocation

associated with the relative returns of stocks, bonds, and cash.

By the end of March 2012, changes in the stock market would have reduced the

allocation slightly for stocks to 77%, closer to the target but still significantly above it.

The stock mix also shifted significantly to 61% in the U.S. and 16% in other parts of the

world. The bond and short-term allocations were also off. This added to a portfolio risk

level 10% higher than the target due to changes in investment mix.

AGE-BASED 529 PLANS

As of September 2012, there were 170 age-based investment tracks within 529 plans

(source: WSJ). The difference between fund offerings can be wide. For example, one

aggressive age-based option leaves 28% of the portfolio in equity funds when a child is in

college; the least aggressive offering has 0% in stocks at the time.

For individual investors and advisors, there are a few sources that can help them decide

which age-based track to select. Morningstar and Savingforcollege.com both rate 529

plans and include online comparison tools.

LIFE EXPECTANCY

Life expectancy has increased dramatically; a person born in 2010 can expect to live to

age 79, 32 years longer than a person born in 1900. More importantly, there has been

an increase in the life expectancy of a 65-year-old. In 1980, the average life expectancy

for a 65-year-old male was 79.1 years. In 2010, this number increased to age 82.7. These

extra three years has a great impact on retirement security.


QUARTERLY UPDATES


Say a person has annual expenses of $50,000 in retirement; expenses for 14 years total

$700,000. If this 65-year-old lives 17 years (instead of 14), the three additional years

adds another $150,000 (a 21% increase). Now factor in inflation. For someone living 14

years (65 to age 79), a 3% annual inflation rate means $854,000 will be needed; adding

another three years (to age 82) increases the total needed expenses to $1,088,000 (27%

higher).

HEALTH CARE COSTS

In 2010, health care costs accounted for 17% of the GDP; it is projected to reach ~20%

by 2017. The typical person covered by Medicare will have out-of-pocket medical

expenses of more than $4,300 per year ($8,600 for a couple). These figures include

health care premiums, copays, and expenditures not covered by Medicare. It is estimated

a healthy 65-year-old couple will need $260,000 to pay for health care and LTC costs for

the remainder of their lives.

The cost of nursing home care is expensive: national average rates for a private room are

$1,250 daily or $90,000 annually in 2010; the national average rate in 2010 for a

semiprivate room was $78,000 a year.

Premiums for Medicare Part B are taking a growing bite out of Social Security checks.

For 2012, Medicare Part B premiums will account for 8.2% of the average Social

Security benefit, up from 5.1% in 2000. While the average Social Security check is 31%

higher than it was in 2001, premiums for Medicare Part B have doubled.

ibf - updates - 2012 (q3 v1.1)

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