Financial page

Is Portfolio Theory Harming Your Portfolio?

2011-07-09T03:07:00.001-04:00

Abstract:
Modern Portfolio Theory (MPT) teaches us that active equity managers who use judgment to make investment decisions won’t be able to match the returns (after fees and expenses) of blindly-invested, passively-managed index funds. Data on returns supports the theory, so it’s no surprise that investors are leaving actively managed funds in droves for the better average returns of super-diversified index strategies. Yet the reality is much murkier than we’ve been led to believe.

It turns out that the portfolio theories which inspired the creation and popularity of index funds and top-down, quantitatively-driven index-like strategies, are both flawed and impractical. There’s compelling evidence, moreover, that a subset of active managers do persistently outperform indexes. However, this important fact has been lost because we allow MPT to define the debate in its own misleading terms, tilting the field in its favor and hiding the reality about active manager performance in a complex game of circular arguments.

MPT relies on a number of unrealistic assumptions including an inaccurate definition of risk. Yet this characterization of risk sets the rules for comparing active vs. passive strategies, often causing active strategies to appear more risky and less efficient than their index counterparts. The same flawed logic is used to risk-adjust returns, biasing them downward for more active, concentrated managers, and rendering this highly important measure highly suspect. Furthermore, reliance on MPT’s measure of risk pressures active managers to super-diversify. The average active fund is thus disfigured to the point where the typical "active" manager is not very active at all, casting the fund in an unfavorable light in a beauty contest versus super-efficient index funds.

Stripping away the influence of portfolio theory involves isolating and evaluating the relatively small group of equity managers who rely heavily on judgment to build concentrated equity portfolios. Empirical data from multiple studies show that these concentrated managers, in fact, persistently outperform indexes. The implications of this statement are enormous. Concentrated manager returns present the best test of whether human judgment can add value in allocating capital, and they win, convincingly. Yet while judgment has prevailed over passive investing, few have taken notice. Most investors continue to look at average active manager returns, not recognizing that these returns are minimally influenced by judgment.

Regardless of MPT’s shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. MPT is deeply woven into the fabric of our financial system, its mathematical grounding and precise answers inspire confidence. Further, its application is crucial in bringing increased scale and profitability to the financial services industry. Few want to see change. As such, common sense and judgment will continue to diminish in importance as top-down, quantitative strategies and blind diversification gain investment dollars.

An informed investor should welcome this shift. As highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals. Individual investors, seeking to exploit these inefficiencies and outperform indexes, should invest in several concentrated funds with strong track records. Managers of these funds have proven themselves adept at turning inefficiencies into strong returns for their investors, and persistence data demonstrates that past performance can indicate which managers are likely to continue to outperform. Concentrated fund returns may exhibit more volatility than indexes, but we now have proof that over the long-term, good judgment will be rewarded.

Vincent, Scott, Is Portfolio Theory Harming Your Portfolio? (April 29, 2011). Available at SSRN: http://ssrn.com/abstract=1840734

What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed

2011-07-09T03:00:00.002-04:00

Two views of pension funds; prospectively and current status:

Abstract:
It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.

Faber, Mebane T., What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed (June 10, 2011). Cambria Quantitative Research Monthly, Issue 2, June 2011. Available at SSRN: http://ssrn.com/abstract=1862355

The Funding of State and Local Pensions in 2010

Introduction

The financial crisis of 2008-09 was a major setback for state and local pension plans, as plummeting asset values caused their funded ratios to drop significantly. The initial impact of the crisis on plan health was covered in a brief published last year. Since that time, several new developments have had a mixed effect on the current and future health of public plans. On the positive side, the stock market has risen significantly from the 2009 trough. And many states have introduced reforms to increase pension contributions and reduce future costs. On the negative side, recent growth in liabilities has outpaced growth in actuarial assets (because these values smooth market gains and losses over a five-year period). Moreover, the recession that accompanied the financial crisis has made it more difficult for states and localities to contribute the full amount of their required pension contribution. This brief explores how all of these developments affected the funded status of state and local plans in 2010..

by Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, Madeline Medenica, and Laura Quinby, May 2011; SLP#17

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

2009-08-27T13:09:00.001-04:00

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

Abstract:
The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and assetweighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds. The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data. To accommodate CRSP release schedules, SPIVA is now published semi-annually with a 6 to 8 week lag. As a result of the market volatility over the past year, domestic and international equity funds have performed in line or marginally ahead of benchmarks. However, both taxable and tax exempt fixed income funds’ assetweighted returns trail benchmarks by large margins. The latest five-year SPIVA data for equity funds can be interpreted favorably by proponents of both active and passive management. Passive management believers can point out that indices have outperformed a majority of active managers across all major domestic and international equity categories, with real estate being the lone exception. Proponents of active management can point to asset-weighted averages suggesting a more level playing field, with active managers level or ahead of benchmarks in most categories, with the exception of midcaps and emerging markets. The five-year data is unequivocal for fixed income funds. Across all categories except emerging market debt, more than three-fourths of active managers have failed to beat fixed income benchmarks. Similarly, five-year assetweighted average returns are lower for active funds in all but two categories. The turmoil of the past year saw 9% of domestic equity funds, 5% of international equity funds and 6% of fixed income funds merge or liquidate.

Standard & Poor's, Index and Portfolio Services, ,Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009(August 27, 2009). Available at SSRN: http://ssrn.com/abstract=1462712

Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates)

2009-07-22T14:01:00.002-04:00

Hu, Wei-Yin, Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates) (May 27, 2009). Available at SSRN: http://ssrn.com/abstract=1410821

Abstract:
The advent of the Roth 401(k) significantly expanded opportunities for tax-preferred retirement saving, but at the same time it created much confusion for individual savers regarding whether to save in the form of pre-tax or Roth dollars. The financial community’s conventional wisdom is based on comparing current and future tax rates. We show how relying solely on the conventional wisdom can be wrong. We first show that comparing different saving strategies requires making an apples-to-apples comparison, which can be achieved by keeping take-home pay constant. An individual currently saving pre-tax can maintain the same take-home pay by switching to a lower amount of Roth saving. However, some important rules imposed by either 401(k) plans or the IRS encourage “tax illusion” by treating pre-tax and Roth dollars as if they were equivalent. First, moderate savers need to take care to understand how switching to Roth saving could lose them free money through employer matching contributions. Second, the IRS limit on annual 401(k) contributions means that aggressive savers who save Roth dollars can save more in a tax-advantaged way than those who save pre-tax dollars. For both of these groups, the conventional wisdom can be completely reversed under fairly normal circumstances

The Microstructure of a U.S. Treasury ECN: The Brokertec Platform

2009-07-19T13:58:00.002-04:00

Fleming, Michael J. and Mizrach, Bruce, The Microstructure of a U.S. Treasury ECN: The Brokertec Platform (July 13, 2009). Available at SSRN: http://ssrn.com/abstract=1433488

Abstract:
This paper assesses the microstructure of the U.S. Treasury securities market using tick data from the BrokerTec electronic trading platform. We examine trading activity, bid-ask spreads, and depth for the on-the-run 2-, 3-, 5-, 10- and 30-year securities and find that liquidity is markedly greater than that reported by earlier studies using data from GovPX. We analyze the price impact of trades and find that the effects are overstated if order book changes are ignored, and that order book changes affect prices by themselves. We also explore a novel feature of this platform, the ability to enter 'iceberg' orders, and find that such orders are more common when price volatility is higher, as'predicted by theory.

The Case for Tips: An Examination of the Costs and Benefits

2009-07-17T14:08:00.005-04:00

Dudley, William, Roush, Jennifer E. and Steinberg, Michelle, The Case for Tips: An Examination of the Costs and Benefits (July 1, 2009). Economic Policy Review, Vol. 15, No. 1, July 2009. Available at SSRN: http://ssrn.com/abstract=1434111

Abstract:
Slightly more than a decade has passed since the introduction of the Treasury Inflation-Protected Securities (TIPS) program, through which the U.S. Treasury Department issues inflation-indexed debt. Several studies have suggested that the program has been a financial disappointment for the Treasury and by extension U.S. taxpayers. Relying on ex post analysis, the studies argue that a more cost effective strategy remains the issuance of nominal Treasury securities. This article proposes that evaluations of the TIPS program be more comprehensive, and instead focus on the ex ante costs of TIPS issuance compared with nominal Treasury issuance. The authors contend that ex ante analysis is a more effective way to assess the costs of TIPS over the long run. Furthermore, relative cost calculations, whether ex post or ex ante, are just one aspect of a comprehensive analysis of the costs and benefits of the TIPS program. TIPS issuance provides other benefits that should be taken into account when evaluating the program, especially when TIPS are only marginally more expensive or about as expensive to issue as nominal Treasury securities.

Standard & Poor's Indices Versus Active Funds Scorecard, Mid Year 2008

2008-11-14T10:24:00.003-05:00

Standard & Poor's Indices Versus Active Funds Scorecard, Mid Year 2008

􀂉 The S&P Indices Versus Active Funds (SPIVA) Scorecard report performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency covering actively managed U.S. equity, international equity and fixed income mutual funds.
􀂉 Starting with this report, we reintroduce an enhanced SPIVA with broader asset class coverage. Data for enhanced SPIVA is from the CRSP Survivor-Bias-Free U.S. Mutual Fund Database. To accommodate CRSP release schedules, the new SPIVA will be published semi-annually with a fourteen week lag.
􀂉 Over five years ending June 2008, S&P 500 outperformed 68.6% of actively managed large cap funds, S&P MidCap 400 outperformed 75.9% of mid cap funds and S&P SmallCap 600 outperformed 77.8% of small cap funds.
􀂉 Among global equity funds, five-year results show S&P Global 1200 outperforming 70.1% of global equity funds, S&P 700 outperforming 86.5% of international equity funds, and S&P IFCI
Composite outperforming 73.9% of emerging market funds.
􀂉 Among fixed income funds, indices outperformed twelve of thirteen categories over a five-year horizon. Only emerging market bond funds outperformed their benchmark index.
􀂉 Funds disappear at a meaningful rate. Over five years, 26.8% of U.S. equity funds, 22.5% of global equity funds and 24.7% of fixed income funds have been merged or liquidated. This highlights the importance of addressing survivorship bias in mutual fund analysis.

ARE RETIREMENT SAVINGS TOO EXPOSED TO MARKET RISK?

2008-10-24T03:08:00.005-04:00

ARE RETIREMENT SAVINGS TOO EXPOSED TO MARKET RISK?

by Alicia H. Munnell and Dan Muldoon

IB#8-16

Introduction

The stock market, as measured by the broad-based Wilshire 5000, declined by 42 percent between its peak in October 9, 2007 and October 9, 2008. Over that one-year period, the value of equities in pension plans and household portfolios fell by $7.4 trillion. Of that $7.4 trillion decline, $2.0 trillion occurred in 401(k)s and Individual Retirement Accounts (IRAs), $1.9 trillion in public and private defined benefit plans, and $3.6 trillion in household non-pension assets.
This brief documents where the declines occurred. This information is interesting and important in its own right. But the declines also highlight the fragility of our emerging pension arrangements. Today the declines were divided equally between defined benefit and defined contribution plans, but in the future individuals will bear the full brunt of market turmoil as the shift to 401(k)s continues. Much of the reform discussion regarding private sector employer-sponsored pensions has focused on extending coverage. But the current financial tsunami also underlines the need to construct arrangements where the full market risk does not fall on pension participants.

The Hewitt 401(k) Index™ Observations

2008-10-24T03:02:00.002-04:00

The Hewitt 401(k) Index™ Observations

Amid the market turmoil, 401(k) participant activity was high and transfers were significant out of equities during September, according to the results of the Hewitt 401(k) Index™. A total of $921 million moved out of equities and into fixed income investments during the month. The directions of the transfers were fixed income oriented during 76% of the total days, and nearly all of the days in the second half of the month.

While activity was relatively high, the vast majority of 401(k) participants stayed calm. The overall transfer activity level in September was only slightly higher than the average transfers of the trailing 12 months — 0.06% of balances were transferred on a net daily basis in September versus 0.05% of balances transferred during the past year.

Five days of the month had above normal* level of transfers, with four out of the five days showing up in the latter half of the month. All four days were strongly fixed income oriented and followed significant market drops. On September 16th, the day following the news of the collapse of Lehman Brothers and the credit-rating downgrade of AIG, the index transfer activity was nearly three times as high as the usual level — with 0.13% of balances transferred. On September 29th, the financial rescue plan was defeated on Capitol Hill and the markets broadly dropped, and participant transfers were 2 to 3 times the normal levels on the following two days.

The three fixed income asset classes received nearly the entire inflows (96%) in September. Approximately $733 million moved into GIC/stable value funds, representing 68% of the net transfers in September. Bond and money market funds also received $178 million (16% of net transfers) and $133 million (12% of net transfers), respectively.

As the MSCI EAFE Index declined over 14% in September, international funds experienced the largest outflows, with nearly $330 million transferring out of this asset class. Large U.S. equities also experienced $234 million in outflows, followed by lifestyle funds ($141 million) and balanced funds ($137 million).

For the third quarter, a total of $1.9 billion moved from equities to fixed income investments, mainly from international funds ($700 million) and U.S. equities ($478 million) into stable value funds ($1.7 billion).

Due to both participant transfers and market decline, participants' overall equity exposure has dropped to its lowest level since April 2003, at 58.8%. It was down by 3.7% for the quarter.

Employee equity contributions (participant discretionary contribution) also declined 2.9% during the quarter to 62.4% by the end of September.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

The Impact of PPA on Retirement Savings for 401(k)Participants

2008-07-09T00:07:00.003-04:00

The Impact of PPA on Retirement Savings for 401(k)Participants

By Jack VanDerhei and Craig Copeland, EBRI

• Modeling of auto-enrollment results: This Issue Brief simulates (under several assumptions) the likely impact of 401(k) plan sponsors switching from voluntary enrollment systems to automatic enrollment designs with automatic escalation of contributions for a significant portion of workers (not just current 401(k) participants or those eligible to participate).
• PPA implemented a concept long studied: The concept of auto-enrollment has been studied since the mid-1990s. Support for the concept grew as various studies showed relatively low participation rates among young and low-income workers, and as more defined benefit plan sponsors began freezing their plans for future (and sometimes current) employees. The Pension Protection Act of 2006 (PPA) created incentives for plan sponsors to implement this concept with its 401(k) safe-harbor auto-enrollment and auto-escalation provisions.
• Significant impact, especially for low-income: This analysis indicates that even under the most
conservative assumptions for auto-escalation of contributions, switching 401(k) plans to auto-enrollment is likely to have a very significant positive impact in generating additional retirement savings for many workers, especially for low-income workers.
• Range of increases under auto-enrollment: When results are aggregated across all income categories, the increase in the value of 401(k) accumulations at age 65 as a multiple of final earnings for those currently ages 25–29 would be approximately 2.4 to 2.6 times final salary by switching from voluntary enrollment to automatic enrollment.
• Higher-paid unlikely to benefit as much: Although the aggregate results favor automatic enrollment, distributional analysis of the differences between the two systems indicates that the higher paid are not likely to benefit as much from such a change.
• Lowest-paid likely to see significantly higher 401(k) accumulations: The median 401(k) accumulations for the lowest-income quartile of these workers (assuming all 401(k) plans were voluntary enrollment) would only be 0.1 times final earnings at age 65 (this is largely due to the fact that 41 percent of workers—as opposed to participants—were assumed to have zero balances at age 65). However, if all 401(k) plans are assumed to be using the auto-enrollment provisions under PPA, the median 401(k) accumulations for the lowest-income quartile jumps to 2.5 times final earnings under the most conservative assumptions and 4.5 times final earnings under the most beneficial assumptions. Even for the top 25 percent of these workers (when ranked by 401(k) accumulations as a multiple of final earnings), there are large increases: the multiple under a voluntary enrollment scenario is 1.8 times final earnings, whereas auto-enrollment provides multiples ranging from 6.5 to 10.4, depending on auto escalation of contributions.
• For many, higher assets from auto-enrollment will still not be enough: Comparing income replacement targets generated in previous EBRI work with these simulated 401(k) accumulations shows that, even with the large increases that can be expected for many workers under the safe harbor auto-enrollment plans introduced by PPA, and with current-law Social Security benefits, additional resources will still be needed for some of them.

ICI: 2008 Investment Company Factbook

2008-06-19T11:46:00.002-04:00

ICI 2008 Investment Company Factbook

The 2008 Investment Company Fact Book provides an entry point to our extensive body of research and statistics on retirement savings, as well as statistics on, and analysis of, all types of registered investment companies and their investors, collectively referred to as funds and fund investors.

Iboxx Rebalancing Report: June

2008-06-19T01:55:00.003-04:00

Iboxx Rebalancing Report: June

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

Iboxx Rebalancing Reports:May

2008-05-19T02:04:00.001-04:00

Iboxx Rebalancing Reports: May

Contents

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

The Hewitt 401(k) Index™ Observations

2008-04-28T00:09:00.002-04:00

The Hewitt 401(k) Index™ Observations (March)
401(k) participant transfers remained fixed income oriented in the month of March, according to the results of the Hewitt 401(k) Index™. Participants moved assets from equities to fixed income investments during 80% of the days. As a result, a total of $864 million shifted out of equities throughout the month.

In fact, during the first quarter of 2008, participants transferred $2.8 billion from equities to fixed income investments on a net basis, which is the largest quarterly equity outflow during the history of the Hewitt 401(k) Index.

In March, fixed income asset classes received nearly 100% of the net transfers. GIC/stable value funds received approximately two-thirds of the inflows, with $608 million moving into this asset class. Bond and money market funds split the rest of the inflows. GIC/stable value funds have been the biggest winner during the past three months, with $1.7 billion flew into these funds, which led to a 2.5% increase in overall allocation in this asset class.

On the other hand, large U.S. equity had $277 million transferring out in March. During the first quarter of 2008, this asset class lost $879 million in net transfers. The asset allocation in large U.S. equity declined from 20.6% at the end of December 2007 to 18.8% at the end of the first quarter of 2008.

As the performance of international funds lagged behind recently, we saw significant amount ($193 million) transferring out of these funds in March. A total of $756 million moved out of international equity during the quarter.

In March, the overall transfer activity level was slightly above the 12 month trailing average — 0.05% of balances were transferred on a daily basis. Five days of the month experienced above normal* transfer activity.

During the first quarter of 2008, employee discretionary equity contribution went down slightly each month. By the end of March, 66.7% of discretionary contributions were made to equities compared to 68.4% at the end of 2007.

We observed a much larger declined in total equity allocation versus participant contribution during the first quarter of 2008, due to market weakness and participant transfers. Participant overall allocation to equities went down 3.8% by the end of March.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

Iboxx Rebalancing Report (April 2008)

2008-04-02T05:15:00.002-04:00

Iboxx Rebalancing Report (April 2008)

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

Should the SEC Rid Mutual Fund Investors of 12b-1 Fees?

2008-04-02T05:01:00.001-04:00

Should the SEC Rid Mutual Fund Investors of 12b-1 Fees?

Haslem, John A., (March 31, 2008).

Abstract:
The stated and objective empirical findings in this study (and others) are generally consistent. There is no evidence that mutual fund shareholders benefit from Rule 12b-1 plans, which provide a serious conflict of interest.

The promise that 12b-1 fees would be used to increase mutual fund assets and thereby lower fund shareholder expenses appears to have been a cynical industry effort to gain SEC approval, while the intended beneficiary was (and is) fund management - and what a bonanza it has been.

The opportunity to prohibit 12b-1 fees, as both abusive and costly conflicts of interest to mutual fund shareholders, will never be better than now. The major question is not so much whether Chairman Cox is determined to prohibit or drastically change 12b-1 fees for the better, but, rather, if he will be able to prevail over the opposition of the industry's supporters in Washington.

The Subprime Credit Crisis of 07

2008-03-26T11:35:00.004-04:00

The Subprime Credit Crisis of 07

Crouhy, Michel and Turnbull, Stuart M., (March 5, 2008).

Abstract:

This paper examines the different factors that have contributed to the subprime mortgage credit crisis: the search for yield enhancement, agency problems, lax underwriting standards, failure by the rating agencies to identify a changing environment, poor risk management by financial institutions, lack of transparency, the limitation of extant valuation models and the failure of regulators to understand the implications of the changing environment for the financial system. The paper addresses the different issues and offers suggestions on how to move forward.

Preferred Stock: Some Insights into Capital Structure

2008-03-26T11:07:00.001-04:00

Preferred Stock: Some Insights into Capital Structure

Liu, Crocker H., Kallberg, Jarl G. and Villupuram, Sriram V., (March 18, 2008).

Abstract:

Capital structure theory and empirical analysis has focused almost exclusively on the choice between debt and equity. Preferred stock has received relatively little attention, in contrast, even though this market, in the U.S., represented $868 billion in new capital during the period 1999 to 2005. This empirical study focuses on the reactions of equity holders through an event study analysis and of debt holders through a default spread analysis to the announcement of 427 preferred issues. We find that the equity abnormal announcement returns are positive for straight preferred stock announcements, when they are combined with convertible preferred announcements, the equity abnormal returns are -0.65%, which is much closer to zero than to the magnitude of SEO announcements; furthermore, these returns are higher for firms with greater earnings potential and lower financial distress risk. We also find that credit default swap spreads decrease upon announcement of a preferred issue. These results are consistent with the hypothesis that equity holders interpret the preferred issue, on average, as debt, since the magnitude of the usual negative reaction to seasoned equity issuance is not found and bondholders interpret the preferred issue as equity, since the issuance does not increase the firm‘s default risk.

The Shareholder Base and Payout Policy

2008-03-26T10:51:00.004-04:00

The Shareholder Base and Payout Policy

Bodnaruk, Andriy and Östberg, Per, (February 2007)

Abstract:

Merton's (1987) investor recognition hypothesis implies that there should be a negative relationship between the size of the firm's shareholder base and its cost of capital. Consistent with this, we find that firms with smaller shareholder bases payout less of their net income, have higher cash holdings and lower capital expenditures. Additionally, Merton predicts that a reduction in the shareholder base has a higher price impact on firms with small shareholder bases. We find that firms with small shareholder bases are less likely to undertake a repurchase (reduce the shareholder base) and repurchase a lower fraction of shares outstanding.

The Cost of Active Investing

2008-03-18T04:53:00.001-04:00

The Cost of Active Investing

French, Kenneth R., (March 13, 2008)

Abstract:
How much do investors spend trying to beat the market? I compare the fees, expenses, and trading costs paid to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980 to 2006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. If the expected real return on U.S. equity is roughly 6.7% and we assume these costs will not continue to grow with the market, society's capitalized cost of price discovery is about 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980 to 2006 period if he switched to a passive market portfolio

Normative Transparency of Mutual Fund Disclosure

2008-03-14T04:14:00.001-04:00

Normative Transparency of Mutual Fund Disclosure

Haslem, John A., (2008)

Abstract:

The Investment Company Act of 1940 states that the interests of shareholders are compromised when mutual funds are operated in the interest of fund managers. In this regard, one of the Act's major objectives is to ensure investors receive adequate and accurate information. For this reason, Congress, the SEC. individual funds, and the fund industry must focus on the goal of requiring and attaining normative transparency of disclosure. Normative transparency of disclosure is defined as the degree of mutual fund voluntary and proactive disclosure and also new and revised legal and regulatory disclosure required for shareholders to be able to make information efficient fund investment decisions. The attainment of normative transparency of disclosure requires major changes and prohibitions in current fund practices, laws, and regulation that are inconsistent with or contrary to this goal.

If Congress and the SEC were to enact and require, respectively, laws and regulations requiring normative transparency of disclosure, these mandates would be all that should be required. While additional laws and regulatory disclosure are likely to be forthcoming, it is most unlikely that the political process will achieve normative transparency. However, the political obstacles are much more likely to be overcome if individual mutual funds and funds collectively work vigorously and proactively in cooperation with Congress and the SEC.

Thus, the achievement of normative transparency of disclosure requires mutual fund managers and independent directors to work vigorously, proactively, and collectively to achieve this goal. However, it is also highly unlikely that these efforts will be collectively optimized as normatively transparent. Further, what is normative transparency of disclosure today will evolve over time as individual fund, fund industry, shareholder, and legal and regulatory conditions change. Thus, there is need to continually benchmark normative transparency in order to maintain normative and improve fund disclosure.

The goal of normative transparency disclosure at the fund level requires stated prohibition of inappropriate fund and fund industry practices and actions, including those permitted by regulations, such as 12b-1 fees, soft dollars, and revenue sharing. Further, it requires supplementary disclosure of those regulations that currently provide incorrect accounting, incomplete, missing, misleading and perfunctory disclosure.

To attain normative transparency of disclosure, mutual fund managers and independent directors must begin by voluntarily and collectively becoming vigorously proactive in serving and protecting shareholders. But, the initial move towards this goal, pending action by Congress, the SEC, fund managers and the fund industry, rests with proactively motivated independent directors empowered to pursue vigorously their fiduciary mandate of shareholder "watchdogs."

The Hewitt 401(k) Index™ Observations (February)

2008-03-13T10:47:00.002-04:00

The Hewitt 401(k) Index™ Observations (February)
In February, the weak stock market again led 401(k) participants to move balances away from stock investments and into fixed income funds, according to the results of the Hewitt 401(k) Index™.

401(k) participant net transfers were fixed income oriented during 70% of the days in February. However, overall participant activity slowed down significantly as compared to January. Only 0.04% of plan balances transferred on a daily basis in February, which was in line with the twelve month trailing average, and much lower than the 0.09% daily transfer experienced during January 2008. For the entire month of February, transfer activity was above normal* level on merely two days.

By month end, nearly $219 million in balances transferred out of equities and into fixed income investments on a net basis. Approximately 80% of the net transfers flowed into GIC/stable value funds.

Interestingly, lifestyle funds received the second largest net inflow of $46 million. During times of significant market volatility, these pre-diversified funds may help to protect participants' assets against large swings.

Similar to January, large U.S. equity funds took the biggest hit as a total of $80 million transferred out on a net basis during the course of February. However, the activity was much less significant than the $521 million net outflows experienced in January. International funds, which attracted nearly $1.2 billion in 2007, also experienced net outflows of $74 million in February, following its substantial January outflows of $489 million. Company stock funds had $68 million transferring out in February.

Participants' discretionary equity contribution, another measurement of participant sentiment, went down by 0.8% to 67.0% by the end of February.

As for participants total equity allocation, it also declined slightly to 64.0%, which was the result of both market weakness and participant transfers. This is now back to nearly the same level as experienced in July 2004.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months

What Do We Know About the Universe of State and Local Plans

2008-03-06T23:43:00.001-05:00

What Do We Know About the Universe of State and Local Plans

by Alicia H. Munnell, Kelly Haverstick, Mauricio Soto, and Jean-Pierre Aubry SLP#4

Introduction

Several surveys report data on public pension plans, but they tend to focus on the 120 major state systems and some include a sampling of locally administered plans. The Census of Governments is the only source that reports on the entire universe of state administered plans, in addition to more than 2,000 locally administered plans. This brief describes that population, reports on the investment performance of different types of public plans, and compares the investment performance of public and private plans.

Iboxx Rebalancing Reports: March 2008

2008-03-06T23:37:00.002-05:00

Iboxx Rebalancing Reports: March 2008

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

Evaluating and implementing target-date portfolios: Four key considerations

2008-03-06T23:31:00.002-05:00

Evaluating and implementing target-date portfolios: Four key considerations

Michael Hess
John Ameriks, Ph.D.
Scott J. Donaldson, CFA, CFP
Vanguard Investment Research & Counseling

The recent growth in popularity of target date funds (TDFs) has led to greater product differentiation and complexity. Target date offerings are becoming more specialized and vary significantly in terms of investment methodology and portfolio construction.

This new Vanguard® white paper provides a road map for plan sponsors in selecting the best target date products for their participants. Authored by Vanguard Investment Counseling & Research, this paper identifies and explores four key considerations for plan sponsors when evaluating and implementing TDFs:

The right asset allocation glide path for plan participants.
The pros and cons of indexing versus active management.
The choice between packaged and customized solutions.
The impact of TDFs on participant portfolios and adoption rates.

Removing the Long-Only Constraint:he Appeal and Challenges of Implementing 130/30 and Other Long-Short Strategies

2008-03-06T23:21:00.003-05:00

Removing the Long-Only Constraint: The Appeal and Challenges of Implementing 130/30 and Other Long-Short Strategies

Christopher B. Philips, CFA
Francis M. Kinniry Jr., CFA
Vanguard Investment Research & Counseling

Executive summary. Since the 1990s, the investment management industry has witnessed unprecedented change in the portfolio management process. Technological and computing advancements, increases in the number and quality of competitors, lower leverage costs, innovations in financial engineering, and changes in regulatory structures have led portfolio managers to implement new processes for trading, security and strategy analysis, and implementation. As a result, quantitative investment strategies have taken off, fueled by the ability to screen, manage, sort, and evaluate thousands of securities at previously unavailable frequencies. The combination of widely available technology and seemingly limitless investment strategies has not only given rise to quantitative investing, but has also naturally led to an expansion of the traditional long-only portfolio to include shorting, leverage, derivatives, and alpha porting. For many investors, these new strategies are most often recognized as one of a range of new products including, but not limited to, market-neutral, 130/30 (or 120/20, 150/50, etc.), and long-short funds.

In this paper, we explore the rationale behind moving from a traditional long-only active quantitative portfolio to a similar strategy that permits short selling1 and leverage. We also explore the challenges associated with such a strategy, including the risks, costs, and implementation hurdles. We conclude that:
• Removing the long-only constraint theoretically permits managers to apply information more symmetrically and efficiently.
• The decision to remove the long-only constraint is grounded in the expectation that a given manager will consistently produce excess returns, net of cost.
• Because of the higher costs and implementation risks associated with short selling and leverage, diligent risk control is necessary, and even then long-only managers may still outperform unconstrained managers.

Economics Approach to Financial Planning

2008-02-29T18:51:00.004-05:00

Economics’ Approach to Financial Planning
by Laurence J. Kotlikoff, Ph.D., FPA Journal, March 2008

Executive Summary

Economists long have shown that when it comes to consuming lifetime economic resources, households seek to neither splurge nor hoard, but rather to achieve a smooth living standard over time. Consumption smoothing not only underlies the economics approach to spending and saving, it is central to the field’s analysis of insurance decisions and portfolio choice.
Smoothing a household's living standard requires using a sophisticated mathematical technique called dynamic programming to solve a number of difficult and interconnected problems. Advances in dynamic programming coupled with today's computers are permitting economists to move from describing financial problems to prescribing financial solutions.
Conventional planning’s targeted liability approach has some surface similarities to consumption smoothing. But the method used to find retirement- and survivor-spending targets is virtually guaranteed to disrupt, rather than smooth, a household’s living standard as it ages. Moreover, even very small targeting mistakes will suffice to produce major consumption disruption for the simple reason that the wrong targets are being set for all years of retirement and potential survivorship.
But with this economics approach, planners can not only smooth their clients’ living standards, but also raise them. For example, they can determine precisely by how much living standards will rise if their clients wait to take Social Security, contribute more to a retirement account, choose job A over job B, or invest in more education—or how much their living standards will decline if they retire early, have another child, buy a cabin cruiser, or make regular gifts to their kids.
Finally, the economics-based living standard risk/reward diagram will replace the conventional mean-variance diagram as the standard framework for seeing the potential pain and pleasure from risky investing. In focusing on what can happen to a household’s living standard as opposed to what can happen simply to its financial assets, the new diagram incorporates the risk of other economic resources such as labor earnings and Social Security benefits.

Health Care Costs Drive Up the National Retirement Risk Index

2008-02-19T12:38:00.002-05:00

Health Care Costs Drive Up the National Retirement Risk Index

Alicia H. Munnell, Mauricio Soto, Anthony Webb, Francesca Golub-Sass, and Dan Muldoon

IB#8-3

Introduction

The National Retirement Risk Index has shown that even if households work to age 65 and annuitize all their financial assets, including the receipts from reverse mortgages on their homes, 44 percent will be ‘at risk’ of being unable to maintain their standard of living in retirement. More realistic assumptions regarding earlier retirement and reluctance to annuitize 401(k) balances or tap housing equity would put the percentage ‘at risk’ even higher. But these previous analyses have not addressed rapidly rising health care costs. When these costs are included explicitly, the percentage of households ‘at risk’ increases dramatically.

This brief explores how rapidly rising health care costs enter the NRRI calculations. It begins with a recap of the NRRI, then describes the health care landscape facing older Americans, and finally reports the results of incorporating retirement health care costs explicitly into the Index. The results show that once health care is considered explicitly, the percentage of households that will be ‘at risk’ rises from 44 percent to 61 percent. As always, the percent ‘at risk’ is greater for those at the low end of the income distribution. And later cohorts show more ‘at risk’ than earlier ones due to the combined effect of a contracting retirement income system and continually rising health care requirements.

The Hewitt 401(k) Index™ Observations

2008-02-17T07:48:00.001-05:00

The Hewitt 401(k) Index™ Observations (January)

* 401(k) participants sought shelter into fixed income investments in January, in response to market volatility, news on subprime related losses and worries about economy, according to the results of the Hewitt 401(k) Index™.

* Nearly 100% of the monthly net transfers moved out of a variety of equity investments and into the three fixed income asset classes: money market, GIC/stable value and bond. The total net transfers out of equities totaled $1.75 billion, which is the highest monthly equity transfer amount (in or out) since the beginning of the Hewitt 401(k) Index in 1997.

* In addition, the daily net transfer activity for January reached the highest level since late 2002 with an average of 0.09% of balances transferring on a daily basis. For the month, the Hewitt 401(k) index experienced above normal* level of transfer activity during 10 days — nearly all of them were fixed income oriented.

* Monies moved out of equities and towards fixed income investments during 86% of the business days in January. In fact, on January 22, after the Fed cuts interest rates by 75 basis points and the DJIA declined over 500 points during intraday trading, transfers were 11 times the normal level and were strongly fixed income oriented.

* During the course of the month, Large U.S. equities saw the largest outflows among all asset classes with $521 million transferring out. Contrary to the trends of continuing inflows into international funds during the past several years, this asset class also experienced significant outflows of $489 million. Middle and small U.S. equity had another $370 million transferring out.

* At the same time, GIC/stable value received the largest inflows of $888 million. Interestingly, bonds received almost as much inflows as stable value, with $862 million transferring to these funds. Money market had the lowest amount among all three fixed income asset classes, but still had $114 million shifting to this asset class.

* Both market decline and participant transfers resulted in a 2.5% decrease in participant overall allocation to equity. By the end of January, participant equity allocation slid to three year low at 64.4%.

* Participant discretionary contribution to equity also declined, from 68.4% at the end of last year to 67.8% at the end of January.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

The following tables show Hewitt 401(k) Index statistics and the returns of major market indices for the month of January 2008:

Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?

2008-02-15T00:56:00.004-05:00

Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?

Ulrike Malmendier,UC Berkeley and NBER and Stefan Nagel Stanford University and NBER
(August 2007)

Abstract
We investigate whether differences in individuals’ experiences of macro-economic shocks affect longterm risk attitudes, as is often suggested for the generation that experienced the Great Depression. Using data from the Survey of Consumer Finances from 1964-2004, we find that birth-cohorts that have experienced high stock market returns throughout their life report lower risk aversion, are more likely to be stock market participants, and, if they participate, invest a higher fraction of liquid wealth in stocks. We also find that cohorts that have experience high inflation are less likely to hold bonds. These results are estimated controlling for age, year effects, and a broad set of household characteristics. Our estimates indicate that stock market returns and inflation early in life affect risk-taking several decades later. However, more recent returns have a stronger effect, which fades away slowly as time progresses. Thus, the experience of risky asset payoffs over the course of an individuals’ life affects subsequent risk-taking. Our results explain, for example, the relatively low rates of stock market participation among young households in the early 1980s (following the disappointing stock market returns in the 1970s depression) and the relatively high participation rates of young investors in the late 1990s (following the boom years in the 1990s).

An "Elastic" Earliest Eligibility Age for Social Security

2008-02-10T14:40:00.000-05:00

An "Elastic"Earliest Eligibility Age for Social Security

by Natalia Zhivan, Steven A. Sass, Margarita Sapozhnikov, and Kelly Haverstick , February 2008

Introduction

In the early 1980s, Congress responded to the Social Security program’s long-term financing shortfall, in part, by raising the Full Retirement Age (FRA) from 65 to 67. When fully phased in, for those who turn 62 in 2022, workers will have to wait an additional two years to get the same monthly benefit. If they do not postpone claiming, the increase in the FRA will cut their benefits by about 13 percent.

Congress did not change the earliest age at which workers can claim. This Earliest Eligibility Age (EEA) remains 62. When the increase in the FRA is fully phased in, workers who claim at 62 will get 70 percent, rather than 80 percent, of their FRA benefit. This has raised concerns that benefits claimed at the EEA will be too low, especially as retirees age and other sources of income decline. One response would be to raise the EEA from 62 to 64, in line with the two-year rise in the FRA.

There are, however, two important objections to an increase in the EEA. The primary concern is that it would create hardship for those unable to work or find employment and who lack the resources to support themselves without working until age 64. A second objection is that raising the EEA is unfair to disadvantaged groups with low life expectancy. This brief addresses these concerns by considering an “Elastic” EEA, which gives different workers different earliest eligibility ages.

Iboxx Rebalancing Report:February 2008

2008-02-04T05:22:00.000-05:00

Iboxx Rebalancing Report: February 2008

Asia
Euro
Euro High Yield
Inflation Linked
Sterling
US Dollar

Retirement Annuity and Employment-Based Pension

2008-01-31T12:07:00.000-05:00

Retirement Annuity and Employment-Based Pension Income, Among Individuals Age 50 and Over: 2006,

Executive Summary:
Retirement Annuity and Employment-Based Pension Income, Among Individuals
Age 50 and Over: 2006
• Demographics affect pension income: The most recent data from the March 2007 Current Population Survey confirm earlier findings that gender, marital status, age, education, and other demographic variables have a significant impact on the likelihood of a worker receiving a retirement annuity and/or employment-based pension income in retirement.
• Educational differences: In 2006, 27.5 percent of men age 50 and older with a graduate-level education received an annuity and/or pension income, compared with 21.7 percent of men without a high school diploma—a differential of almost 6 percentage points. Men with graduate level degrees received nearly three times the median annuity and/or pension income of men without a high school diploma.
• Gender differences still big but shrinking: A woman age 65 or over in 2006 was almost two thirds as likely to receive an annuity and/or pension payment as her male counterpart; if she did
receive one, her mean benefit was likely to be about 65 percent of that received by a man in the same age group. However, as other EBRI research has shown, women’s participation in retirement plans has risen significantly relative to men in recent years, closing the “gender gap” in retirement plan participation—even though retirement plan participation has been declining for both men and women. Hence, the aggregate pension and annuity recipiency for women and the amounts they receive are likely to increase over time as these younger generations retire.

Finances of Employee Benefits, 1950−2006
• Total spending: In 2006, both public and private employers spent a gross total of about $2.33 trillion for major employee benefit programs. This is up almost 50 percent from 2000. • Retirement still #1, but health catching up fast: Of the 2006 total spent on benefits, retirement benefit payments of $1.17 trillion accounted for 50.0 percent of total benefit payments, and health benefit payments of $1.01 trillion accounted for 43.5 percent. Health costs are growing fast and are likely to soon outstrip retirement and become the major source of benefits expense.

The Hewitt 401(k) Index™ Observations-December

2008-01-16T12:26:00.000-05:00

The Hewitt 401(k) Index™ Observations-December

Despite of the slight negative market return in December, participants favored equity investments on 65% of the days during the month, according to the results of the Hewitt 401(k) Index™. In terms of net dollar transfers, a total of $50 million transferred out of fixed income investments and into diversified equities during the month.
December was also a quiet month with regards to participant transfer activity. On average, 0.03% of balances shifted per day on a net basis (this is the below the 12 month trailing average of 0.04%). Transfer activity was above normal* during only one day of the month.
For all of 2007, a modest 0.04% of balances transferred on a daily basis. However, there were more above normal level transfer days in 2007 than in the past four years, which is likely in reaction to increased market volatility. During 2007, a total of 41 days had transfer activity exceeding the trailing 12-month average, compared to 28 days in 2006, 22 days in 2005 and 2004, and only 8 days in 2003.
Similar to the past years, 401(k) participant continued to favor international equities over domestic equities in 2007. In fact, monies were consistently moved out of domestic equities (large U.S. equity, small U.S. equity and company stock) into to either international equities or fixed income investments throughout the year.
With the MSCI EAFE Index gaining twice as much as the S&P 500 Index during 2007, participants transferred $1.2 billion into international equities during the year, which added up to a total of $4.2 billion of inflows to this asset class since 2002. As a result, the average allocation to international equities went up to 9.8% by the end 2007 — an almost 2% increase from the end of 2006.
Interestingly, GIC/stable value funds received almost as much inflows as international funds throughout the year. Nearly $1.2 billion moved to GIC/stable value funds, which reached the highest level of inflows to this asset class since 2003. Other fixed income asset classes also received inflows for the year, with $659 million shifting into bond and $352 million into money market.
Contrary to international equities, both large U.S. equity and small U.S. equity experienced net outflows for the year. Participants moved $574 million out of large U.S. equity and $605 million out of small U.S. equity. Again, company stock was the biggest loser of the year with $2.9 billion transferring out of this asset class. It is the largest amount of yearly net outflows for this asset class since the beginning of the 401(k) Index.
By the end of the year, participants' total equity allocation declined to 66.9%, declining 1.7% from the beginning of the year. This was mostly due to the significant drop in company stock exposure (down 4.3%).
On the other hand, participants' discretionary contributions to equity went up slightly from 67.5% at the end of 2006 to 68.4% at the end of 2007.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

Measuring the effectiveness of automatic enrollment

2008-01-11T04:12:00.000-05:00

Measuring the effectiveness of automatic enrollment

William E. Nessmith, Stephen P. Utkus, Jean A. Young, The Vanguard Center for Retirement Research, 01/09/2008.

A Vanguard analysis of about 50 plans adopting automatic enrollment confirms that the feature does improve plan participation rates, particularly among low-income and younger employees. Yet in 4 of 10 plans, total employer and employee contribution rates remain at less than 9%, a level considered too low to generate adequate retirement savings.

Vanguard Center for Retirement Research addresses this concern in a new report, “Measuring the Effectiveness of Automatic Enrollment.” As more plan sponsors adopt or consider automatic enrollment, this research report can help you attain the plan participation rates and participant contribution rates you desire.

Pension Wealth and Income: 1992, 1998, and 2004

2008-01-08T12:55:00.000-05:00

Pension Wealth and Income: 1992, 1998, and 2004

by Olga Sorokina, Anthony Webb, and Dan Muldoon, IB#8-1

Introduction

What is the impact of the shift from defined benefit to defined contribution plans on the pension wealth of households approaching retirement? Using data from the Health and Retirement Study, this brief documents this shift and compares employer-sponsored pension wealth across households with heads age 51-56 in 1992, 1998, and 2004. The results show that, for the average household, both pension wealth and replacement rates — the ratio of annual benefits to pre-retirement earnings — fell between 1992 and 2004.

Iboxx Rebalancing Report: January

2008-01-03T04:05:00.000-05:00

Iboxx Rebalancing Report: January

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

Broadbased, Record Declines in Home Prices in October According to the Case-Shiller Indices

2007-12-26T10:02:00.000-05:00

Broadbased, Record Declines in Home Prices in October According to the S&P/Case-Shiller® Home Price Indices

New York, December 26, 2007 – Data through October 2007, released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, show broadbased declines in the prices of existing single family homes across the United States, marking the 10th consecutive month of negative annual returns and the 23rd consecutive month of decelerating returns.

The 10-City Composite’s annual decline of 6.7% is a record low. The previous largest decline on record was 6.3% recorded in April 1991. In October, the 20-City Composite recorded an annual decline of 6.1%.

Miami surpassed Tampa in October, reporting a double-digit annual decline of 12.4%. Tampa followed with -11.8%, Detroit with -11.2% and San Diego with -11.1%. Six of the metro areas are now posting double digit declines in their annual growth rates. Atlanta and Dallas finally entered negative territory, with declines of 0.7% and 0.1%, respectively, leaving only Charlotte, Portland and Seattle as the MSAs still experiencing positive annual growth rates

Trading Volume Liquidity and Investment Styles

2007-12-24T12:22:00.000-05:00

Trading Volume Liquidity and Investment Styles

Brown, Jeff, Crocker, Douglas K. and Foerster , Stephen R.,(December 20, 2007).

Abstract
The purpose of this study is to better understand stock market trading volume liquidity, measured at the individual stock level, and its relationship with and potential impact on stock performance for a variety of well-known investment styles. We focus on two universes of generally liquid stocks (chosen because they are a primary focus of U.S. institutional investors such as mutual fund managers and pension fund managers), the stocks that make up the Standard & Poor's (S&P) 500 Index, and a broader index of the top 1,000 stocks measured by market capitalization (closely mimicking the Russell 1000 Index stocks). We show that three liquidity-related measures - trailing 3-month trading volume (i.e., shares), dollar value of trading volume, and turnover - are monotonically related to price-to-book (PB) and market capitalization (MKT), and momentum strategies based on both past 6-month "winners" and "losers" (MOM) tend to experience higher liquidity. When we sort stocks based on each of these liquidity measures we find that the more liquid stocks based on trading volume and turnover tend to have higher subsequent returns (1 through 12-month holding periods) than the less liquid stocks, although the reverse is true based on dollar volume. We then focus on the trading volume measure (which produces the greatest dispersion of returns) and run CAPM and Fama-French (3-factor and 4-factor) model regressions that show that the most heavily traded quintile of stocks experiences significant superior performance. We create a new measure that we call the trading volume factor, in the spirit of the Fama-French factors, and investigate its properties. We find that its beta is generally significant when added to the Fama-French 4-factor model, regressed against portfolio quintile returns based on PB, MKT and MOM sorts.

Evolving U.S. inflation dynamics: Explanations and investment implications

2007-12-22T18:57:00.000-05:00

Evolving U.S. inflation dynamics: Explanations and investment implications

Vanguard Investment Counseling & Research, 12/20/2007

Executive summary. Inflation is a fundamental macroeconomic risk factor for a broad range of asset classes. Since the 1980s, global inflation has generally trended lower and inflation shocks have become less persistent despite, at times, considerable commodity-price volatility. This shift toward lower and more stable inflation is among the most significant global economic developments of the past several decades. In the years ahead, a critical question for investors will be whether the trend can persist in the face of secular inflationary forces, including high energy prices, fiscal and trade imbalances, demographic dynamics, and the rapid industrial development of China, India, and other emerging-market economies. In this paper, we examine the evolving dynamics of inflation in the United States. We attribute the profound changes in U.S. inflation persistence to more effective and credible monetary policy, rather than “globalization” or other structural changes in the economy. Our empirical analysis implies that a low and more stable inflation environment is highly likely to persist, conditional on appropriate monetary policy. We then discuss the potential implications for future short-term interest rates, long-term bonds, and inflation-hedging instruments.

Iboxx Rebalancing Report: December

2007-12-20T12:22:00.000-05:00

Iboxx Rebalancing Report: December

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

The Hewitt 401(k) Index™ Observations

2007-12-17T14:12:00.000-05:00

The Hewitt 401(k) Index™ Observations

401(k) participant transfers were bearish in November due to the weakness of the stock market, according to the results of the Hewitt 401(k) Index™. Almost all equity asset classes (except international) experienced net outflows, with $553 million shifting out of equities and into fixed income investments during the month.

The three fixed income asset classes (money market, stable value, and bond) received over $600 million of inflows. Nearly 60% of transferring 401(k) money moved into GIC/stable value during the month. Year to date, stable value funds have received $1.23 billion of net inflows. Bond funds also received $178 million in transfers in November.

As for outflows, large U.S. equity was the biggest loser of the month. As the S&P 500 Index declined 4.2% in November, participants moved a total of $231 million out of this asset class. The performance of small U.S. equities was even worse with the Russell 2000 Index losing 7% in November. As a result, this asset class saw $158 million transferring out for the month. Since June of this year, small U.S. equity has experienced a sum of $467 million in outflows.

Overall, transfer activity was modest in November. On average, 0.04% of balances were transferred on a daily basis, which is in line with the trailing twelve-month average.

Four days of the month experienced above normal* level of transfers, each of which was fixed income oriented. In total, participants moved monies out of equities and into fixed income investments on 76% of the days of the month.

At the end of November, participants' overall allocation to equity investments was 67.1%, which was down significantly from 68.1% (down 1%) from the end of October. This is primarily due to participant transfers and market weakness.

On the other hand, participants' discretionary equity contribution was 69.2%, almost unchanged since the end of October.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

Investor Timing and Fund Distribution Channel

2007-12-17T11:37:00.000-05:00

Investor Timing and Fund Distribution Channel

Bullard, Mercer, Friesen, Geoffrey C. and Sapp, Travis, (December 2007)

Abstract
This study examines the investment timing performance of equity mutual fund investors and its relationship to the distribution arrangement of the fund. We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds. Investors in all three principal load-carrying retail share classes (A, B, and C) significantly underperform a buy-and-hold strategy. Among all load funds, Class B investors suffer from the poorest cash flow timing, underperforming a buy-and-hold strategy by 2.28% annually, compared with annual underperformance of 0.78% for investors in pure no-load funds. No-load index funds are the only funds found to show no evidence of poor investor timing. Although investors are ultimately responsible for their own investment choices, these findings question the value being added by investment professionals who sell mutual fund shares through conventional distribution arrangements.

Understanding the Securitization of Subprime Mortgage Credit

2007-12-17T11:32:00.001-05:00

Understanding the Securitization of Subprime Mortgage Credit

Ashcraft, Adam B. and Schuermann, Til, (December 4, 2007). Wharton Financial Institutions Center Working Paper No. 07-4

Abstract
In this paper we provide an overview of the subprime mortgage securitization process and the seven key informational frictions which arise. We discuss how market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how the rating agencies assign credit ratings to mortgagebacked securities, and outline how the agencies monitor the performance of mortgage pools over time. Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century during 2006.

Journal of Indexes: Jan./Feb, 2008

2007-12-13T02:45:00.000-05:00

Editor's Note
Is China For Real?
Jim Wiandt

Articles
The Chinese Market Considered
Burton Malkiel

The privatization of equity shares
International Equities
Steven A. Schoenfeld and Stefanie Jaron

Seeking a more complete definition
The Value Of Currencies
Tom Haines

New exchange-traded vehicles provide entry into the FX market
China Forum
Matthew Hougan

A survey of leading experts in the field
A Window On The Chinese Markets
Heather Bell

The Hang Seng Indexes And The Growth Of China
Talking Indexes - Liquidity
David M. Blitzer

Gauging the trade-off between liquidity and complete market coverage.
Benchmarks For Fiduciaries
Brian J. Jacobsen

Creating real benchmarks for real-world portfolio possibilities.
The Curmudgeon - The Great Wheel of China
Brad Zigler

What goes 'round, comes 'round.

Why Have Defined Benefit Plans Survived in the Public Sector?

2007-12-12T02:50:00.000-05:00

Why Have Defined Benefit Plans Survived in the Public Sector?

by Alicia H. Munnell, Kelly Haverstick, and Mauricio Soto SLP#2

Introduction

While 401(k) plans now dominate the private sector, defined benefit plans remain the norm among state and local governments. Why have public sector employers not shifted from defined benefit plans to 401(k)s like their private sector counterparts?

This brief examines the unique factors affecting the two sectors that may explain their very different patterns of pension coverage. State and local governments have an older, less mobile and more risk-averse workforce, with a higher degree of unionization to press for benefits that satisfy the needs of these workers. The nature of the employer is also fundamentally different. Unlike private sector firms, state and local governments are perpetual entities. They do not disappear — like many of the large manufacturing firms — taking their plans with them, and they are much less concerned about the financial volatility associated with defined benefit plans. States and localities can also increase required employee contributions to keep the plan’s finances under control. Finally, the public sector has not had comprehensive pension regulation like the Employee Retirement Income Security Act of 1974; the absence of such regulation lowers administrative costs and enables later vesting.

Mutual Fund Industry Selection and Persistence

2007-12-10T04:20:00.000-05:00

Mutual Fund Industry Selection and Persistence

Busse, Jeffrey A. and Tong, Qing, (December 2007)

Abstract:

We analyze mutual fund industry selectivity - the ability of funds to skillfully allocate assets across industries. We estimate that industry selection influences mutual fund performance about as much as individual stock selection. We find that persistence across the full range of performance deciles is attributable to industry selection. After removing industry effects from gross mutual fund returns, we find that the performance of poorly performing funds strongly reverses. We also find that, unlike individual-stock-selection ability, industry selectivity is not subject to diminishing returns to scale.

Case-Shiller Third Quarter Report

2007-11-28T11:53:00.000-05:00

The S&P/Case-Shiller® U.S. National Home Price Index Posts a Record Annual Decline in the 3rd Quarter of 2007

New York, November 27, 2007 – Data through September 2007, released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, shows continued negative annual returns in the U.S. National Home Price Index, the 10-City Composite and the 20-City Composite, as well as 15 of the 20 metro area indices.

The U.S. National Home Price Index, the 10-City Composite, and the 20-City Composite shows all three still yielding negative returns as of September 2007. The quarterly S&P/Case-Shiller® U.S. National Home Price Index -- which covers all nine U.S. census divisions -- was down 1.7% from Q2 2007 and down 4.5% from Q3 2006.

All 20 metro areas were in decline in September over August. Even the five metro areas that still have positive annual growth rates -- Atlanta, Charlotte, Dallas, Portland and Seattle -- show continued deceleration in returns.

While Tampa remains the metro area with the largest annual decline, at -11.1%, Miami surpassed Detroit in September, reporting a decline of 10% over the past 12 months. Detroit and San Diego followed with -9.6% each. While the mix is slightly different, once again eight of the 20 metro areas reported their lowest recorded annual returns – these cities are Atlanta, Chicago, Las Vegas, Miami, Minneapolis, Phoenix, San Diego, Tampa, & Washington D.C.

130/30 Funds: What is Behind the Commercial Offensive ?

2007-11-26T12:13:00.000-05:00

Interest in 130/30 investment strategies has been steadily rising. S&P announces the introduction of a new Strategy Index to reflect this trend:

Introducing a Framework for 130/30 Indexation :The S&P 500 130/30 Strategy Index

As active extension strategies become more widely used, Standard & Poor’s has introduced a framework for 130/30 strategy indexation. The first index in Standard & Poor’s global family of 130/30 indices is the S&P 500 130/30 Strategy Index.
The family is part of Standard & Poor’s strategy index suite. Strategy indices are not benchmarks for active portfolios. Rather, they provide beta plus exposure or seek alpha in a transparent, cost efficient format.
The index offers beta one, risk-controlled long/short exposure with the prospect of risk-adjusted out-performance.
The index over-weights a long basket of 30 stocks versus its S&P 500 benchmark weight by 1% each, and under-weights a short basket of 30 stocks versus its S&P 500 benchmark weight by 1% each. The remaining stocks retain benchmark weights.
To arrive at the long and short baskets, the index employs a transparent, rules-driven framework that leverages qualitative and quantitative fundamental factors.
Historical results suggest the index delivers risk-controlled out-performance. Over 3-, 5-, 7-, and 10-year periods the index out-performs the benchmark S&P 500 with beta exposures close to one.
Additional source materials are available:

S&P 500 130/30 Strategy Index Factsheet
S&P 500 130/30 Strategy Index Methodology

The following paper examines the strategy:

130/30 Funds: What is Behind the Commercial Offensive ?

Géhin, Walter, (October 2007)

Abstract:

High-conviction funds, beta-one funds, short extension funds, limited-shorting funds, long-enhanced funds, active extension funds, hedge-fund lite: there is a wide range of terms for what is most frequently called 130/30. Broadly, this strategy initially invests 100% in an index, sells short 30%, and uses the proceeds from the shorts to buy an additional 30% likely to beat the benchmark.

In this paper, we examine some crucial points related to these funds: their theoretical foundation, the optimal level of shorting, the distinction between the quantitative and fundamental approaches, whether these funds are natural extensions of long-only funds, and finally the risk of neglecting their risk.

The Hewitt 401(k) Index™ Observations-October

2007-11-24T07:33:00.000-05:00

The Hewitt 401(k) Index™ Observations-October

Participants continued to react to the strong performance within the international and emerging market equity asset classes in October and moved a combined $295 million into these two asset classes, according to the results of the Hewitt 401(k) Index™. These movements represented nearly 66% of the total net transfers in October.

Both international and emerging markets had very strong returns in October: the MSCI EAFE Index (international) gained nearly 4% and the MSCI Emerging Markets Free Index had an enormous return of 11%. As a result, we saw nearly $240 million moved to international funds and $55 million to emerging markets funds. In fact, international funds have received net inflows during eight out of ten months in 2007, with a total of $1.1 billion transferring in year-to-date. Emerging markets had more volatile performance. The asset class had a few months of net outflows during the beginning of the year, but still received over $103 million in total by October.

Due to both net inflows and market returns, the asset allocation to international equities rose from 8.2% at the beginning of the year to 10.0% by the end of October. Emerging markets allocation also increased from 0.9% to 1.6% during the same period.

Lifestyle funds also continued to receive strong inflows, with $91 million moving in during October. So far this year, nearly $300 million has transferred into this asset class.

As a result of the large international inflows, participant net transfer activity was primarily equity oriented on 57% of days during the month and $264 million moved into diversified equities. At the same time, stable value funds experienced the largest outflows of nearly $158 million.

The net transfer activity in October was modest, with an average of 0.04% of balances transferred on a daily basis. Three days of the month experienced above normal* transfer activity, which is the lowest number of above-normal days since June.

The overall equity allocation in Hewitt 401(k) index increased slightly by 0.3% to 68.1% at the end of October, due to both equity-oriented transfers and positive stock market returns.

Participant discretionary equity contribution also rose just slightly from 68.6% at the end of September to 68.9% at the end of October.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months

Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts

2007-11-21T05:01:00.000-05:00

Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts

Gary R. Mottola, Stephen P. Utkus, Vanguard Center for Retirement Research (November 2007)

We assess the lump-sum versus annuity payout choices made by retirement-age participants in two Fortune 500 defined benefit plans (one a traditional final-average-pay plan, the other a cash balance plan). Annuitization rates are generally low but rise with age. Also, in contrast to the inertia that typically characterizes participant behavior in retirement plans, many married participants work actively to “deannuitize”—to choose a DB lump sum over the federally mandated default of a joint-and-survivor annuity.

Annuitization rates and cash-outs. Twenty seven percent of lump-sum-eligible participants in the traditional plan chose an annuity, versus 17% in the cash balance plan. These figures exclude sponsor-initiated cash-outs of lump-sum distributions less than $5,000. Cash-outs represent a large percentage of the distributions in both plans, and can artificially inflate overall measures of participant behavior.

Demographics and choice. Older participants were much more likely to annuitize than their younger counterparts. Approximately half of the participants age 70 and older chose an annuity compared with less than 20% for participants between ages 55 and 60. In addition, high-net-worth and male participants were also less likely to annuitize.

Actively overcoming defaults. Less than one-quarter of married participants in our study chose an annuity, even though it is the federally mandated default option for married couples. Married participants worked actively to overcome the default annuity option by submitting a written, notarized waiver.

Implications. The desire among married participant in their 50s and 60s to “deannuitize” a DB plan distribution appears to be quite strong, and stands in sharp contrast to the inertia typically displayed by defined contribution participants in the accumulation phase. As a result, plan design and policy efforts that rely on inertia and default choices to encourage annuitization within retirement plans are likely to have only modest effects. Meanwhile, the fact that annuitization rates rise with age suggests that the demand for traditional annuities may arise later in life, at an age when many participants have already retired and left their employers’ retirement plans. Also, annuity demand may increase in tandem with the broader trend toward taking a later retirement.

The Efficiency of International Information Flow: Evidence from the ETF and CEF Prices

2007-11-16T13:09:00.000-05:00

The Efficiency of International Information Flow: Evidence from the ETF and CEF Prices

Hughen, John Christopher and Mathew, Prem G. G., (November 13, 2007)

Abstract:

While similar in their trading and organization, closed-end funds (CEFs) and exchange-traded funds (ETFs) differ in their liquidity and ease of arbitrage. We compare their price transmission dynamics using a sample of funds that invest in foreign securities and are most likely to show the deficiencies in the manner in which they process information. Our analysis shows that ETF returns are more closely related to their portfolio returns than CEF returns. However, both fund types underreact to portfolio returns but overreact to domestic stock market returns. A simple trading strategy using these results is profitable with roundtrip trading costs less than 1.38% for CEFs and 0.71% for ETFs.

S&P Publishes Indices that Track Low-, Mid- and High Price Homes in the U.S.

2007-11-13T04:09:00.000-05:00

S&P Publishes Indices that Track Low-, Mid- and High Price Homes in the U.S.

New York, November 8, 2007 – Standard & Poor’s, the world’s leading index provider and publisher of the widely followed S&P/Case-Shiller® Home Price Indices, announced today that it is now publishing indices designed to track changes in the average price of low-, mid- and high price homes for 17 major metropolitan markets across the United States. In addition, Standard & Poor’s is now publishing sale pairs data measuring the number of observations used in calculating the S&P/Case-Shiller Home Price Indices. The new data are examples of the granularity and statistics available for the S&P/Case-Shiller Home Price Indices.
“Experience with residential real estate suggests that home prices behave differently for more- or less-expensive homes. The new data covering low, medium and high priced homes demonstrates just that,” says David Blitzer, Managing Director and Chairman of the Index Committee at Standard & Poor’s. “These new data series will help home owners, insurance companies, investors and others better understand the value of homes within these three price segments.”
The data published today by Standard & Poor’s includes a low price housing series, a middle price housing series and a high price housing series for 17 of the 20 metropolitan areas currently covered by the index family. Each tier represents approximately one-third of the number of sales transactions recorded in each respective market. For example, for each market, Standard & Poor’s defines low, medium and high by defining breakpoints in one- third intervals for all sales found at each point in time. The methodology looks at the first sale in a given sale pair to define the price level.
In addition, Standard & Poor’s has published sale pair counts for each of the 20 metropolitan areas and the two composite indices. A sale pair is comprised of two arms-length transaction prices for a specific home at two distinct points in time.
“Sale pairs are the building blocks of the repeat sales technique used for the S&P/Case-Shiller Home Price Indices,” says Robert Shiller, Chief Economist of MacroMarkets LLC. “Repeat sales data are critical to creating consistent quality, mix-adjusted measurements of residential real estate values.”

Two Papers on Mortgage Backed Securities

2007-11-08T12:40:00.000-05:00

Two recent papers on Mortgage Backed Securities:

How Resilient are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?

Mason, Joseph R. and Rosner, Josh, (February 13, 2007)

Abstract:

The mortgage-backed securities (MBS) market has experienced significant changes over the past couple of years. Non-agency ("private label") securities, which are not guaranteed by the government or the government sponsored enterprises, now account for the majority of MBS issued. In this report, we review the rise of collateralized debt obligations (CDOs), the relaxation of lending standards, and the implementation of loan mitigation practices. We analyze whether these structural changes have created an environment of understated risk to investors of MBS. We also measure the efficacy of ratings agencies when it comes to assessing market risk rather than credit risk. Our findings imply that even investment grade rated CDOs will experience significant losses if home prices depreciate. We conclude by providing several policy implications of our findings.

Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions

Mason, Joseph R. and Rosner, Josh, (May 3, 2007)

Abstract:
Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. We conclude by providing several policy implications of our findings

The Evolving Relation between Earnings, Dividends, and Stock Repurchases

2007-11-04T13:45:00.000-05:00

The Evolving Relation between Earnings, Dividends, and Stock Repurchases

Skinner, Douglas J., Journal of Financial Economics, Forthcoming

Abstract:

This paper examines how the relation between earnings and payout policy has evolved over the last three decades. Three principal groups of payers have emerged: firms that pay dividends and make regular repurchases, firms that make regular repurchases, and firms that make occasional repurchases. Firms that only pay dividends are largely extinct. Repurchases are increasingly used in place of dividends, even for firms that continue to pay dividends. While other factors help explain the timing of repurchases, the overall level of repurchases is fundamentally determined by earnings. The results suggest that repurchases are now the dominant form of payout.

“High Standards of Commercial Honor . . .

2007-11-02T03:36:00.000-04:00

“High Standards of Commercial Honor . . .Just and Equitable Principles of Trade . . .
Fair Dealing with Investors”

Remarks by
John C. Bogle, Founder and former Chief Executive, The Vanguard Group
Before the
Financial Industry Regulatory Authority
at its first Joint Meeting
Washington D.C.
October 15, 2007

The Hewitt 401(k) Index™ Observations; September

2007-11-02T03:13:00.000-04:00

The Hewitt 401(k) Index™ Observations: September
Despite market volatility in September, participant transfers were still modest — with, on average, 0.05% of balances transferring on any given day, according to the results of the Hewitt 401(k) Index™. This is slightly above trailing 12-month average daily net transfer activity levels of 0.04%.
During five days of the month, transfer activities were above normal levels*. On September 18th, when the Fed cut rates and the DJIA** climbed 2.5%, the 401(k) Index transfers were 2.5 times the normal level. Due to the many large market swings during the third quarter, we saw above normal levels of transfer activities during 17 days — which makes it the busiest quarter since 2002.
Although 401(k) participants moved their account balances out of equities and into fixed income funds on a majority of days (58%) during September, the net dollars transferred went the opposite direction. A total of $126 million was transferred out of fixed income investments and into diversified equities (equities excluding company stock).
Continuing the trend, company stock saw the largest outflows in September, totaling $324 million. The return on small cap has lagged behind international and large cap during the third quarter. As a result, 401(k) participants have moved away from this asset class — with $63 million moving out in September and nearly $260 million shifted out during the quarter.
On the other hand, international equity was again one of the best performing asset classes for the month. As a result, it received the largest inflows with $95 million transferring in during the month. Lifestyle funds were back in favor with large inflows of $83 million. Further, GIC/Stable value also received $85 million in September.
Although the equity markets did well during September, participants' overall equity allocation was only slightly up by 0.1% to 67.8%. This was mainly due to the large outflows coming out of company stock funds.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

IBoxx Rebalancing Reports-November 2007

2007-11-01T23:45:00.000-04:00

IBoxx Rebalancing Reports-November 2007

Asia
Euro
Euro HighYield
Inflation-Linked.
Sterling
U.S. Dollar

Alternative Benchmarks for Evaluating REIT Mutual Fund Performance

2007-11-01T13:35:00.000-04:00

Alternative Benchmarks for Evaluating REIT Mutual Fund Performance

Hartzell, Jay C., Muhlhofer, Tobias and Titman, Sheridan , (October 29, 2007)

Abstract:

While Real Estate Investment Trusts (REITs) have experienced very high growth rates over the past 15 years, the growth in mutual funds that invest in REITs has been even more dramatic. REIT mutual fund returns are typically presented relative to the return on a simple value-weighted REIT index. We ask whether including additional factors when benchmarking funds' returns can improve the explanatory power of the models and offer more precise estimates of alpha. We investigate three sets of REIT-based benchmarks, plus an index of returns derived from non-REIT real estate firms, namely homebuilders, and real estate operating companies. The REIT-based factors are a set of characteristic factors, a set of property-type factors, and a set of statistical factors. Using traditional single index benchmarks, we find that about six percent of the REIT funds exhibit significant positive performance using traditional significance levels, which is more than twice what random chance would predict. However, with the multiple index benchmarks that we prefer, this falls considerably, to only 0.7 percent. In addition, we find that these sets of factors and the non-REIT indices better explain the month-to-month returns of the REIT mutual funds. This suggests that investors or researchers evaluating REIT mutual fund performance may benefit from a multiple benchmark approach

S&P Case/Shiller October Report

2007-10-31T13:19:00.000-04:00

S&P Case/Shiller October Report

New York, October 30, 2007 – Data through August 2007, released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, show further declines in the prices of existing single family homes across the United States, marking the 8th consecutive month of negative annual returns and the 21st consecutive month of decelerating returns.

The 10-City Composite’s annual decline of 5.0% is at a rate not seen since June 1991. The lowest on record was an annual decline of 6.3% recorded in April 1991. In August, the 20-City Composite recorded an annual decline of 4.4%

Home Bias in International Equity Portfolios: A Review

2007-10-30T12:44:00.000-04:00

Home Bias in International Equity Portfolios: A Review

Sercu, Piet M.F.A. and Vanpee, Rosanne, (August 2007).

Abstract:

This paper reviews the recent literature on equity home bias (the empirical finding that people overinvest in domestic stocks relative to the theoretically optimal investment portfolio.) We cover different home bias measures and we illustrate the extent and the evolution of equity home bias both with recent portfolio holdings data and longer time series. Institutional-based and behavior-based explanations for the puzzle are considered and discussed. We conclude that none of the proposed theories can explain the full extent of the bias by itself, thus we argue that international portfolio choice should be explained by a mixture of rational and irrational behavior.

Vangaurd Investment Perspectives; Fall/Winter 2007

2007-10-29T23:03:00.000-04:00

Vanguard Investment Perspectives: Fall/Winter 2007, Vol. 2

This semiannual journal offers excerpts from recent research by Vanguard Investment Counseling & Research and the Vanguard Center for Retirement Research on topical issues and timeless challenges in portfolio design.

In this edition, we discuss the challenges of benchmarking target-date funds and propose a potential solution. We also examine the opportunities and challenges associated with pursuing the efficient frontier, real estate investment trusts (REITs) as an effective proxy for commercial real estate, how emotional intelligence relates to investment behavior, and the investment implications of evolving U.S. inflation dynamics.

Volatility Risk Premium, Risk Aversion and the Cross-Section of Stock Returns

2007-10-25T12:49:00.000-04:00

Volatility Risk Premium, Risk Aversion and the Cross-Section of Stock Returns

Nyberg, Peter M. and Wilhelmsson, Anders, (October 24, 2007)

Abstract:

We test if innovations in investor risk aversion are a priced factor in the stock market as is predicted by models incorporating habit formation in preferences. Our proxy for time-varying risk aversion is based on the volatility risk premium series constructed by Bollerslev et al. (2007). Time-series tests show that a mimicking portfolio tracking innovations in risk aversion partly captures the strong momentum effect in stock returns and produces only two significant alphas for 25 momentum portfolios. Furthermore, using 25 portfolios sorted on book-to-market and size as test assets in Fama-MacBeth regressions, our new factor together with the market factor explains 64% of the variation in average returns compared to 60% for the Fama-French three factor model. The new factor is generally significant with an estimated risk premium close to its time series mean also when industry portfolios and portfolios sorted on previous returns are included among the test assets. Finally, sorting the stocks in the CRSP database into five portfolios based on their sensitivities to innovations in the risk aversion series produces a realized return differential of more than 0.5% per month between the portfolio with the highest and lowest loadings. The finding is robust to controls for other risk factors.

Black Monday and Black Swans

2007-10-25T11:52:00.000-04:00

Black Monday and Black Swans

Remarks by John C. Bogle, Founder and former chief executive, The Vanguard Group
before the Risk Management Association
Boca Raton, Florida
October 11, 2007

John Bogle's latest speech.

Average Returns, B/M, and Share Issues

2007-10-18T12:39:00.000-04:00

Average Returns, B/M, and Share Issues

Fama, Eugene F. and French, Kenneth R., (May 2007). CRSP Working Paper

Abstract:

The book-to-market ratio, B/M, is a noisy measure of expected stock returns because B/M also varies with expected cashflows. Our hypothesis is that the evolution of B/M, in terms of past changes in book equity and price, contains independent information about expected cashflows that can be used to improve estimates of expected returns. The tests support this hypothesis, with results that are largely but not entirely similar for Microcap stocks (below the 20th NYSE market capitalization percentile) and All but Micro stocks.

Momentum and Credit Rating

2007-10-17T13:25:00.000-04:00

Momentum and Credit Rating

Doran Avramov, Tarun Chorrdia, Gergana Jostava, and Alexander Philipov, (Jan. 22,2006)

Abstract

This paper establishes a strong link between momentum and firm credit rating. Momentum profitability is statistically significant and economically large among low-grade firms, but it is nonexistent among high-grade firms. The momentum payoffs documented in the literature are generated by low rated firms that account for less than four percent of the overall market capitalization of rated firms. For loser (winner) stocks in the low rating category, profit margins, sales growth, operating cash flows, and interest coverage decrease (increase) over the formationand holdings periods, while illiquidity and volatility increase (decrease). This operating performance of the winner and loser stocks is not anticipated by the market as evidenced by the earnings surprises and analyst forecast revisions. As the market observes the deteriorating (improving) conditions there is a pressure to sell (buy) losers (winners), which precipitates gains among high risk winners and losses among high risk losers. Indeed, institutions buy winners and sell losers during one year into the holding period.

Vernimmen Newsletter(Oct/Nov)

2007-10-17T11:10:00.000-04:00

Vernimmen Newsletter(Oct/Nov)

COM•NEWS: Kyoto and carbon trading
THIS MONTH'S TABLE: One share = one vote?
RESEARCH: The impact of pension plans on betas
Q&A: Should change in working capital be calculated as a gross or net figure on the cash flow statement

The Promise and Peril of Corporate Governance Indices

2007-10-14T23:20:00.000-04:00

The Promise and Peril of Corporate Governance Indices

Bhagat, Sanjai, Bolton, Brian J. and Romano, Roberta, (October 7, 2007

Abstract:

Financial economists and commercial providers of governance services have in recent years created measures of the quality of firms' corporate governance which collapse into a single number (a governance index or rating) the multiple dimensions of a company's governance. The aim of this paper is twofold, to analyze the performance of corporate governance indices in predicting corporate performance, and to consider the implications for public policy that follow from that assessment. We highlight methodological shortcomings of the extant papers that claim a relation between particular governance measures and corporate performance. Our core conclusion is that there is no consistent relation between governance indices and measures of corporate performance. Namely, there is no one “best” measure of corporate governance: the most effective governance institution appears to depend on context, and on firms' specific circumstances. It would therefore be difficult for an index, or any one variable, to capture critical nuances for making informed decisions. As a consequence, we conclude that governance indices are highly imperfect instruments for determining how to vote corporate proxies, let alone for portfolio investment decisions, and that investors and policymakers should exercise caution in attempting to draw inferences regarding a firm's quality or future stock market performance from its ranking on any particular corporate governance measure. Most important, the implication of our analysis is that corporate governance is an area where a regulatory regime of ample flexible variation across firms that eschews governance mandates is particularly desirable, because there is considerable variation in the relation between the indices and measures of corporate performance.

Two Papers From Vanguard Retirement Research

2007-10-11T23:26:00.000-04:00

Red, Yellow, and Green: Measuring the Quality of 401(k) Portfolio Choices
Gary R. Mottola and Stephen P. Utkus (August 2007)

We estimate that 43% of participants construct “green” portfolios with balanced exposure to diversified equities, while 26% construct “yellow” portfolios with possibly too-aggressive or too-conservative equity holdings. Another three in ten participants make egregious errors and have “red” portfolios—either holding nothing in equities or overconcentrating their accounts in employer stock. Portfolio errors cost participants 60 to 350 basis points in expected real return per year, depending on the initial portfolio held. Female participants or those with low income or low wealth are more likely to experience the largest gains from improved portfolios, given their tendency to hold less aggressive portfolios.

Literacy, Trust And 401(K) Savings Behavior
Julie R. Agnew, Lisa Szykman, Stephen P. Utkus, and Jean A. Young,{May 2007)

Abstract

At three large firms offering 401(k) plans, we assess the impact of financial literacy and trust on 401(k) savings behavior in voluntary and automatic enrollment 401(k) plans. Financial literacy plays a critical role in improving 401(k) savings behavior — it reduces both the proportion of non-joiners in voluntary 401(k) plans and the proportion of quitters in automatic enrollment plans. Trust is critical as well in improving quit rates in automatic enrollment plans. Both financial literacy and trust appear to have more sizeable marginal effects than do those from income. We also find no initial evidence that non-participants are low-income rational agents who fail to participate in a 401(k) plan due to anticipated income support from Social Security. Our findings underscore the importance of ongoing workplace education for both voluntary and}automatic enrollment plans and highlight the unique issue of trust in automatic enrollment plans.

Papers from Vanguard Investment Counseling & Research

2007-10-11T11:42:00.000-04:00

Three recent papers from Vanguard Investment Counseling & Research:

Tax-efficient investing—Solutions for maximizing after-tax returns

Scott J. Donaldson, CFA, CFP and Francis M. Kinniry Jr., CFA, Vanguard Investment Counseling & Research, (08/17/2007)

Executive Summary We compare the tax-efficiency of conventional index funds and multiple-share-class exchange-traded funds (ETFs), stand-alone ETFs, tax-managed funds, and separately managed accounts (SMAs), while considering factors such as investor behavior, portfolio management, turnover and trading strategies, and cost. We show how a broad-market index fund/ETF or tax-managed fund is likely to produce after-tax returns that outpace those of a typical actively managed mutual fund or SMA, a reflection of their strong relative performance on a pre-tax basis and the intrinsic tax-efficiency of broad-market indexing. We also address several misconceptions regarding tax-efficiency and conventional index mutual funds. We base these conclusions on our analysis of certain Vanguard® mutual funds, which offer long-term, specific, and readily available data.

Asset Location For Taxable Investors

Colleen M. Jaconetti, CPA, CFP, Vanguard Investment Counseling & Research, 09/12/2007

Executive summary. It has long been understood that asset allocation, based on an investor’s goals, risk tolerance, and investment horizon, is one of the most important determinants of long-term portfolio performance. Proper diversification, low relative costs, and rebalancing are also critical to realizing the benefits of the selected asset allocation. Perhaps less understood is the impact of asset location. Asset location refers to where or in which type of account (taxable or tax-deferred) an investor should purchase stocks and bonds. After determining the appropriate asset allocation, the investor should decide whether the primary goal is to maximize after-tax return by forgoing tax-inefficient investments or strategies (for example, active equity mandates, real estate investment trusts [REITS], commodities, or other alternative investments) or to include these tax-inefficient assets or strategies in the hope of adding performance or reducing the portfolio’s risk.

Spending From a Portfolio: Implications of a Total-Return Approach Versus an Income Approach for Taxable Investors

Colleen M. Jaconetti, CPA, CFP, Vanguard Investment Counseling & Research, (09/12/2007)

Executive summary. During the accumulation years, many investors build retirement savings in both tax-advantaged accounts, such as IRAs or 401(k)s, and regular taxable accounts. When these investors reach retirement, they face decisions about how to spend from their investment portfolios—how much to spend yearly, which accounts to draw from, and how to keep the balance of the assets invested. In this paper, we explore the most common spending strategies, review best practices, and discuss some pitfalls that investors should avoid. Investors spending from a retirement portfolio typically employ one of two well known methods: the total return approach or the income approach. Historically these approaches have been discussed as mutually exclusive—an investor follows either one or the other. In reality, the two approaches are similar in many ways, and in fact operate identically up to a point. Using the total-return approach, the investor spends from both the principal and income components of his or her portfolio. Under the income approach, the investor typically spends only the income generated by the portfolio, which often is not sufficient to meet spending needs. To make up for the shortfall, many investors elect to either increase their allocation to bonds, tilt their bond holdings toward high-yield bonds, or tilt their equity holdings toward higher-dividend-paying stocks—none of which are preferred strategies for maintaining inflation-adjusted spending over long periods. Because the decision regarding a withdrawal strategy depends upon the investor’s spending goals, as well as upon his or her asset allocation, we have included an appendix that provides general spending guidelines based on various allocations, time horizons, and success rates.

Understanding the Subprime Mortgage Crisis

2007-10-11T03:06:00.002-04:00

Understanding the Subprime Mortgage Crisis

Demyanyk, Yuliya and van Hemert, Otto, (October 9, 2007)

Abstract:
We analyze the subprime mortgage crisis: an unusually large fraction of subprime mortgages originated in 2006 being delinquent or in foreclosure only months later. We utilize a loan-level database, covering about half of all US subprime mortgages, and identify two major causes. First, over the past five years, high loan-to-value borrowers increasingly became high-risk borrowers, in terms of elevated delinquency and foreclosure rates. Lenders were aware of this and adjusted mortgage rates accordingly over time. Second, the below-average house price appreciation in 2006-2007 further contributed to the crisis.

Journal of Indexes: October/November 2007

2007-10-10T23:16:00.000-04:00

November / December 2007
Correlation

Journal of Indexes: October/November 2007

Editor's Note: The Science of Indexing
Jim Wiandt

International Small Cap: A Distinct Asset Class
Frank Nielsen, CFA

The Benefits of Low Correlation

Craig Israelsen

That Was Then, This Is Now

John Bogle, David Blitzer, Kathleen Moriarty, Floyd Norris and Richard Shiller

Mapping A Market For Correlation
David Krein

Tracking Error And The Efficient Frontier
Brian C. Blanchett and David M. Blanchett

The New 130/30
Andrew White,CFA

Talking Indexes: When The Data Change

David Blitzer

The Curmudgeon: Marrying Vice And Virtue
Brad Zigler

Decision-Making: A Neuroeconomic Perspective

2007-10-09T12:59:00.000-04:00

Decision-Making: A Neuroeconomic Perspective

Hardy-Vallée, Benoit, "Decision-Making: A Neuroeconomic Perspective" . Philosophy Compass, Forthcoming

This article introduces and discusses from a philosophical point of view the nascent field of neuroeconomics, which is the study of neural mechanisms involved in decision-making and their economic significance. Following a survey of the ways in which decision-making is usually construed in philosophy, economics and psychology, I review many important findings in neuroeconomics to show that they suggest a revised picture of decision-making and ourselves as choosing agents. Finally, I outline a neuroeconomic account of irrationality.

Morningstar Indexes 2007

2007-10-02T01:33:00.000-04:00

Morningstar Indexes 2007

The goal of this annual publication is to share with you Morningstar’s perspectives on the trends in the indexing industry and highlight the research that forms the bedrock of our indexes. We hope that this will lead to more informed and responsible investing decisions. This year’s edition explains upcoming advances to Morningstar Indexes. The lead article is a commentary by Don Phillips on the state of the exchange-traded fund industry. Don discusses some ominous signs that should cause concern for investors. In The Next Generation of Commodity Indexes, we discuss the economic rationale behind long/short commodity investing and how to build a better benchmark. In Bond Power to the People, author Eric Jacobson reveals our new bond index family. The notion of market-cap-weighted indexes is increasingly challenged by alternative weighting schemes that use fundamental factors. In Collared Weighting: A Hybrid Approach, we offer a new weighting scheme that marries the best of both. In Purity of Purpose, we update the results of our study conducted four years ago to show that our approach leads to the most meaningful style distinctions.

IBoxx Rebalancing Reports: October

2007-10-02T01:23:00.000-04:00

Iboxx Rebalancing Reports: October

Asia
Euro
Euro High Yield
Inflation-Linked.
Sterling
U.S. Dollar

Promoting Work: Implications of Raising Social Security's Early Retirement Age

2007-09-30T22:53:00.000-04:00

Promoting Work: Implications of Raising Social Security's Early Retirement Age

by John A. Turner WOB#12

Introduction

Preparing for retirement is becoming more challenging for today’s workers as traditional sources of income, such as Social Security and employer-sponsored pensions, are declining while life expectancy and health care costs are rising. One powerful antidote to income shortfalls in retirement is working longer. But many analysts believe that the availability of early Social Security benefits at age 62 induces many workers to leave the labor force at or near that time. In fact, over 50 percent of both men and women do claim Social Security at 62 and the average retirement age is 63 for men and 62 for women. Therefore, raising Social Security’s Early Eligibility Age (EEA) could encourage many to work longer.

This brief addresses the question of whether today’s workers would be able to work longer without undue hardship if the EEA were raised. Answering this question requires exploring trends in both the health of older workers and the nature of jobs. In examining these areas, the brief focuses in particular on economically vulnerable groups — women and minorities.

Understanding Recent Trends in House Prices and Home Ownership

2007-09-28T02:15:00.000-04:00

Understanding Recent Trends in House Prices and Home Ownership

Shiller, Robert J.,(September 14, 2007). Cowles Foundation Discussion Paper No. 1630

Abstract:

This paper looks at a broad array of evidence concerning the recent boom in home prices, and considers what this means for future home prices and the economy. It does not appear possible to explain the boom in terms of fundamentals such as rents or construction costs. A psychological theory, that represents the boom as taking place because of a feedback mechanism or social epidemic that encourages a view of housing as an important investment opportunity, fits the evidence better. Three case studies of past booms are considered for comparison: the US housing boom of 1950, the US farmland boom of the 1970s, and the temporary interruption 2004-5 of the UK housing boom. The paper concludes that while it is possible that prices will continue to go up as is commonly expected, there is a high probability of steady and substantial real home price declines extending over years to come.

What Happened to the Quants in August 2007

2007-09-22T07:27:00.000-04:00

What Happened to the Quants in August 2007?

Khandani, Amir E and Lo, Andrew W., (September 20, 2007)
Abstract
During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere--apparently in a completely unrelated set of markets and instruments--suggests that systemic risk in the hedge-fund industry may have increased in recent years.

The Hewitt 401(k) Index™ Observations

2007-09-21T01:24:00.000-04:00

The Hewitt 401(k) Index™ Observations

August 2007
401(k) participants sought shelter from the equity markets in August as DJIA dropped below 13,000 mark for the first time since April. According to the results of the Hewitt 401(k) Index™, monies were transferred out of equities and into fixed income investments on 70% of the days during the month.
In addition, with the market volatility in August we also saw the greatest number of above-normal* transfer activity days in over four years — a total of seven days during the month had moderate or high volumes of transfers. This trend was particularly notable on August 16th when the DJIA ended the day at 12,846 — index transfers were 8.6 times the average level on this day (toward fixed income). In addition, six out of the seven days were fixed income oriented.
In August, a total of $765 million was shifted out of equity funds. This trend was apparent across all equities asset classes and into all fixed income asset classes. Such a clear-cut direction seldom occurs in Hewitt 401(k) index.
Again, company stock experienced the largest outflows in August, with $172 million moving out. But contrary to the trend we've seen so far this year, international equities also experienced large outflows. International equities have been one of the top performers for several years, and money flowed heavily into this asset class during the first half of the year. However, as the returns in international funds turned negative in August, participants began to pull back and took $165 million out of this asset class.
Large U.S. equity and small U.S. equity funds also experienced large transfers with $163 million and $140 million shifted out of these two asset classes, respectively, in August.
On the other hand, all three fixed income asset classes had inflows in August. GIC/stable value funds received the largest transfers of more than $620 million. Bond and money market also received a combination of $195 million.
Clearly, the significant fixed income oriented transfers reduced participants' overall equity allocations. By the end of August, about 67.7% of participants' balances were allocated to equities, which was 0.5% lower than that of the end of July.
Employee only equity contributions were also slightly lower with 69.5% of the new contributions going into equity investments, as compared to 69.7% at the end of July.
Although participants were quite active during some days of the month, on average, the net transfer activity was only slightly higher for the month — with 0.05% of balances transferred on a daily basis.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

Morningstar's Commodity Indexes

2007-09-21T01:12:00.000-04:00

Morningstar introduces a suite of Commodity Indexes:

Morningstar's Commodity Indexes

Long-only commodity futures strategies often prove inadequate in providing exposure to commodities per se. Unlike stock shares, which have a net positive supply, commodity futures (as opposed to the underlying commodities) have a net supply of zero. Someone is short a commodity futures contract for every long one. This relationship among various players in the futures market can create situations in which long-only strategies may fail to generate consistent risk premiums, even in commodity bull markets. Professional Commodity Trading Advisors (CTAs) tend to take both long and short positions in commodity futures, often based on current trends in prices. We think it is time for a new approach to passive commodity investing. We believe investors will be better served by passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most popular commodity indexes. In this article, we first discuss the economic rationale behind long/short commodity futures investing. We then provide an overview of the methodology for the Morningstar Commodity Index family and examine the risk and return characteristics of the indexes vis-à-vis other popular commodity indexes.

Here is the Methodology Statement .

The Housing Finance Revolution

2007-09-20T12:55:00.000-04:00

The Housing Finance Revolution

Richard K. Green and Susan M Wachter ( August 31,2007)

This paper examines the historical development of the international mortgage financing system.

The Expected Impact of Automatic Escalation of 401(k) Contributions on Retirement Income

2007-09-13T13:23:00.000-04:00

The Expected Impact of Automatic Escalation of 401(k) Contributions on Retirement Income

• RCS data used to gauge impact of auto-escalation: This report uses data from the 2007 Retirement Confidence Survey (RCS), fielded several months after the enactment of Pension Protection Act of 2006 (PPA), to ascertain how high workers are likely to allow their default 401(k) contributions to go in plans with an automatic escalation feature. The result is a first approximation for the expected impact of automatic escalation under the PPA safe harbors for a number of different assumptions about worker and employer reactions.

• Previous EBRI research: EBRI has done extensive modeling of the retirement income prospects for future generations of retirees, with results ranging from very bleak for substantial portions of the U.S. population to fairly positive for 401(k) participants with continuous coverage throughout their working careers.

• Replacement rate estimates for automatic enrollment: Assuming that all 401(k) plan sponsors would adopt automatic enrollment immediately (in 2005), the median replacement rates for the lowest-income quartile increased to 37 percent (from the 23 per-cent baseline) even under the conservative assumptions of a 3 percent default contribution rate and a money market default investment. When the default contribution rate was increased to 6 percent and the default investment was changed to a life-cycle fund, the median replacement rate for this group increased further to 52 percent.

• Auto-escalation is likely to result in major improvement for low-income workers: Results from the 2007 RCS suggest that the introduction of automatic escalation will result in a significant increase in 401(k) accumulations—especially for low-income workers—compared with estimates previously determined for automatic enrollment. Under the assumptions and scenarios modeled in this article, the automatic escalation feature is likely to increase overall 401(k) accumulations between 11–28 percent for participants in the lowest-income quartile, and between 5–12 percent for those in the highest-income quartile.

Shock Options: The Stock Options Backdating Scandal of 2006 and the SEC's Response

2007-09-07T11:16:00.000-04:00

Shock Options: The Stock Options Backdating Scandal of 2006 and the SEC's Response

McWilliams, John Nolan, (July 4, 2007)

Abstract:

This paper summarizes the recent stock options backdating scandal from the perspective of the Securities and Exchange Commission. The paper begins with a brief history of the stock options expensing debate. The paper continues with a discussion of the academic research that propelled the phenomenon of options backdating into the media and regulatory spotlight. The paper then examines three case studies of companies and executives charged by the Commission. The paper concludes with a brief analysis of the Commission's recent policy regarding company fines.

Additional posts on this topic can be found at Backdating Options

How America Saves 2007 : A report on Vanguard 2006 defined contribution plan data

2007-09-05T23:58:00.000-04:00

How America Saves 2007: A report on Vanguard 2006 defined contribution plan data

The Vanguard Center for Retirement Research
08/29/2007

Executive Summary

Eligibility and plan participation (page 9)

Almost half of plans allow, and more than half of employees qualify for, immediate eligibility for employee-elective contributions. Eligibility rules are more restrictive for employer contributions to the plan—a one-year eligibility rule is common. Participation rates are essentially unchanged since 2000. The average plan participation rate for Vanguard® defined contribution (DC) plans with an employee-contributory feature was 74% in 2006. The composite participation rate for all eligible participants across all Vanguard employeecontributory DC plans was 64%. In other words, one-third of eligible employees failed to join their workforce savings plan—a statistic indicative of the savings challenge facing America’s workers. Older or better-paid workers are more likely than younger or lower-paid workers to participate in their employer’s plan. At all income levels, women are more likely than men to join their employer’s plan. Participation rates varied dramatically by industry in 2006—ranging from 58% in transportation, utilities, and communications to 74% in manufacturing.

Employee contributions (page 13)

Vanguard participants voluntarily contributed an average of 7.3% of their incomes to their employers’ DC plans in 2006. The median employee contribution was 6.0%. Employee savings rates have remained essentially unchanged since 2000. As with participation rates, income, age, and gender were key determinants of savings behavior. Employee contribution rates varied widely in 2006, with one-quarter of participants saving 10% or more and about one-quarter of participants saving 4% or less. Only 10% of Vanguard participants saved the maximum amount allowed under the Internal Revenue Code. Fourteen percent of eligible participants took advantage of the catch-up contribution feature. The Roth 401(k) feature became available in 2006. The Roth feature was adopted by 14% of Vanguard plans and 5% of participants within these plans elected the option. Early Roth adopters included new plan enrollees, high savers, Web-registered participants, and high-income households.

Employer contributions (page 21)

In 2006, 91% of plans provided an employer contribution and 97% of participants were in plans with an employer contribution. The most common employer contribution was a matching contribution. The type and design of employer contributionsvaried substantially across plans—in 2006 Vanguard administered more than 200 distinct matching formulas for plans offering an employer match. The most common match was $0.50 on the dollar on the first 6% of pay—23% of plans provided this match and 28% of participants were in plans with this match.

Automatic enrollment designs (page 26)

Twelve percent of Vanguard DC plans with employee elective contributions have adopted automatic enrollment and 9 in 10 plans with automatic enrollment use a balanced fund as the default fund. Among plans with automatic enrollment, 6 in 10 use a full autopilot design: automatic enrollment, automatic savings increases, with a balanced or life-cycle fund as the default investment.

Plan investment options (page 29)

Virtually all Vanguard DC plans offer an array of investment options covering the four majorinvestment categories: equity, bond, balanced, and money market or stable value. The average number of plan options rose to 20 in 2006, up from 13 in 2000, but participants continued to adopt new choices at a slower rate than employers introduced them. Most of the growth in the number of options offered has occurred as plans have introduced series of life-cycle funds. Three-quarters of plans offered life-cycle funds (either of the static-allocation or targeted-maturity variety) in 2006, with 28% of participants in these plans holding life-cycle funds. Only 34% of participants owning life-cycle funds used them as the intended “one-stop shopping” investment choice. In 2006, the percentage of plans offering the targeted-maturityvariety slightly surpassed those offering the static allocation funds for the first time. Two-thirds of plan sponsors with automatic enrollment utilized age based targeted-maturity funds as the default option. Eleven percent of plans offered company stock as an investment option. Because large firms are more likely to offer company stock, 39% of Vanguard participants had access to company stock in their employer’s plan. About one-quarter of Vanguard plans offering company stock had a concentrated position exceeding 20% of plan assets. Within plans actively offering company stock, 38% of participants had concentrated holdings exceeding 20% of their account balances.

Participant investment decisions (page 37)

As of 2006, approximately 70% of plan assets and participant contributions were invested in equities— an appropriate level of risk-taking in light of the plans’ retirement goals. Beneath these averages there are still areas of concern: 13% of participants had their entire account invested in fixed income securities; 18% held all-equity portfolios; and 14% of all participants had more than 20% of their account balance invested in company stock. While nearly all participants were offered a U.S. equity index fund, only half used that option.

Account balances and returns (page 43)

The average account balance for Vanguard participants was nearly $76,000 at year-end 2006; the median was $26,000. One-third of participants had $10,000 or less in their current employer’s DC plan at year-end 2006, while 1 in 5 participants had account balances of more than $100,000. As household income, age, and job tenure rose, so did account balances. It is important to place the median account balance of $26,000 in perspective. The typical participant is male, age 45, with income of $62,000. He is saving 6% and receives employer matching contributions of 3%. He also has 20-plus years to continue saving until retirement. As of December 31, 2006, personalized returns for DC participants were positive across one-, three-, and five-year periods. Five-year returns were positive or break-even for virtually all participants.

Exchange provisions (page 48)

Trading activity remained modest. During 2006, 14% of participants made a trade (exchange), shifting 15% of recordkeeping assets. We estimate that one-third this activity occurred when plan sponsors changed investment options within their plans. In any given month, participants who trade typically take equal and offsetting bets both for and against the equity market—with only marginal differences in participant sentiment determining net flows. In 2006, participants on a net basis shifted assets to fixed income, yet the money movement accounted for just 0.3% of average recordkeeping assets.

Access methods and the Internet (page 50)

Half of participants did not contact Vanguard regarding their plan accounts in 2006. Participants who did contact Vanguard were more likely to log on to the Internet than call a phone associate. Sixty-nine percent of all transactions were directly processed by participants via the Internet.

Plan loans (page 55)

Despite the common view that young participants are responsible for the bulk of 401(k) loans, in fact, loan use is quite constant across the active participant population. Participants in their 30s, 40s, and even early 50s are just as likely to take a loan as are participants in their 20s. On average, participants with loans borrowed a modest 12% of their account balance.

In-service withdrawals (page 59)

In 2006, only 4% of Vanguard participants in plans providing in-service withdrawals used the feature. However, about 4 in 10 of these participants have taken in-service withdrawals in each of the past two years.

Plan distributions and rollovers (page 60)

More than two-thirds of participants leaving their employer during 2006 preserved their assets for retirement. Nine of 10 dollars available for distribution stayed within the retirement system. This figure incorporates participants who chose to keep their assets in their employer’s plan upon job change or retirement. Nearly half of participants, and more than half of assets, remained within the employer’s plan in 2006—far more than the percentage choosing a cash distribution or an IRA rollover.

Promoting Work: Implications of Raising Social Security's Early Retirement Age

2007-09-04T13:02:00.000-04:00

Promoting Work: Implications of Raising Social Security's Early Retirement Age

by John A. Turner, WOB#12

Introduction

Preparing for retirement is becoming more challenging for today’s workers as traditional sources of income, such as Social Security and employer-sponsored pensions, are declining while life expectancy and health care costs are rising. One powerful antidote to income shortfalls in retirement is working longer. But many analysts believe that the availability of early Social Security benefits at age 62 induces many workers to leave the labor force at or near that time. In fact, over 50 percent of both men and women do claim Social Security at 62 and the average retirement age is 63 for men and 62 for women. Therefore, raising Social Security’s Early Eligibility Age (EEA) could encourage many to work longer.

This brief addresses the question of whether today’s workers would be able to work longer without undue hardship if the EEA were raised. Answering this question requires exploring trends in both the health of older workers and the nature of jobs. In examining these areas, the brief focuses in particular on economically vulnerable groups — women and minorities.

Iboxx Rebalancing Reports:September 2007

2007-09-03T22:18:00.000-04:00

Iboxx Rebalancing Reports:September 2007

Asia
Euro
Euro High Yield
Inflation-Linked
Sterling
U.S. Dollar

The Iboxx Indexes are described in the following brief document:

Iboxx Bond Indexes

Structuring Income for Retirement

2007-08-31T02:50:00.000-04:00

Structuring Income for Retirement

W. Van Harlow, Ph.D., CFA Managing Director Fidelity Research InstituteSM; Moshe A. Milevsky, Ph.D. Professor, Schulich School of Business, York University Executive Director of The IFID Centre, Toronto, Canada

INTRODUCTION
New Year’s Day, 2008, will mark another milestone in America’s growing retirement finance challenge. That is when the oldest members of the Baby Boom generation,those born in 1946, will begin turning 62,the average age for retirement in America today, and become eligible to draw Social Security income. As all 76 million Baby Boomers cross that same age threshold over the next generation, America’s retirement finance structure will continue a profound, long-term structural change. Traditional sources of “guaranteed” income — Social Security and defined benefit pensions — will replace a smaller and smaller share of pre-retirement income. A guaranteed income “gap” worth many billions of dollars a year will yawn open and widen steadily — into the indefinite future. Guaranteed income, simply put, is income you cannot outlive. For this reason, it is also referred to as longevity insurance, since it insures against the possibility of outliving one’s financial resources. Millions of individuals will therefore have to decide how to use their own life savings and investments to create income streams they can’t outlive — insuring themselves against “longevity risk.”This very predictable challenge is already “baked” into American demographics, law and financial trends. Current Social Security law, for example, mandates bothsteadily rising retirement age eligibility and increasing deductions from future Social Security checks to cover rising Medicare costs. The system is thus on track to replace less than 30% of pre-retirement incomes for retirees by the 2030’s — a long, steady fall from today’s 39% replacement rate. As Exhibit 1 shows, the percentage of private sector active workers covered by defined benefit (pension) plans that provide them with assured income at retirement has been declining dramatically — from 84% in 1979 to just 37% in 2005. This shift has been offset to some degree by the rise of defined contribution workplace savings plans such as 401(k)s, which now reach about 90% of all workers. A critical difference, however, is that workers in defined benefit plans have some of their retirement income planning done for them, in effect, by their employer’s pension fund, which gives them a guaranteed monthly income for life. Workers in defined contribution plans (as well as individual retirement savers in general) must make their own plans for creating — or buying — lifetime income streams. This inevitable decline in guaranteed or “annuitized” income will be offset to some degree by the rising wealth that future retirees are building today in defined contribution workplace savings and individual retirement savings. But even if these savings prove large enough to fill the gap, more and more Americans every year will need to consciously calculate how large a share of their life savings to commit to securing guaranteed income, what investment vehicles to use to meet their income goals, and how they might change the allocation of their remaining “non-annuitized” assets to ensure optimal results. The purpose of this report is to review these financial challenges and provide new insights into investment solutions that will provide individuals with a solid retirement plan. In particular, this report describes a conceptual framework that addresses the complex interplay between the uncertainty of future investment returns, the uncertainty around life expectancy and the role that guaranteed income can play in helping retirees to achieve a financially secure retirement. We explore ways to structure income for retirement given the tradeoffs among spending rates, retirement risk, and bequest desires.

Journal of Indexes Sept/Oct Issue

2007-08-30T14:24:00.000-04:00

Journal of Indexes Sept/Oct Issue

Addressing Fundamental Issues
Jim Wiandt

Articles
Fundamental Indexing Smackdown
Rob Arnott, Gus Sauter, Jeremy Siegel
Debating the merits of alternative weighting methodologies.
The S&P’s Alpha
Edward F.McQuarrie
Can you do better than a total market index fund?
Quieting The Noise
Matthew Hougan
Andre Perold takes on the noisy markets hypothesis.
A Fundamental Challenge
Luciano Siracusano
Is there a better way to index?
Talking Indexes - Boxing The Complexity Of ETFs
David Blitzer
Investors need a roadmap to navigate the fast-growing ETF market.
Cavaet Emptor
Ronald Ryan
The need for custom liability indexes in the pension market.
Bond Power To The People
Arijit Dutta,Eric Jacobson
Taking bond indexing from Wall Street to Main Street.
Professor’s Reading Room
John Haslem
Measuring The True Cost Of Active Management.
A synopsis of recent research with implications for indexing.
The Curmudgeon - H U M O R

The S&P/Case-Shiller® U.S. National Home Price Index Posts a Record Annual Decline in the 2nd Quarter of 2007

2007-08-28T23:52:00.000-04:00

The S&P/Case-Shiller® U.S. National Home Price Index Posts a Record Annual Decline in the 2nd Quarter of 2007

New York, August 28, 2007 – Data through June released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, shows continued negative annual returns in the U.S. National Home Price Index, the 10-City Composite and the 20-City Composite, as well as 15 of the 20 metro area indices.

The U.S. National Home Price Index, the 10-City Composite, and the 20-City Composite [are all] still yielding negative returns as of June 2007. The quarterly S&P/Case-Shiller® U.S. National Home Price Index - which covers all nine U.S. census divisions - was down 0.9% from Q1 2007 and down 3.2% from Q2 2006.

“The pullback in the U.S. residential real estate market is showing no signs of slowing down,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “The year-over-year decline reported in the 2nd quarter of 2007 for the National Home Price Index is the lowest point in its reported history, which dates back to January 1987. On a regional level 17 of the 20 metro areas are showing declines in their annual growth rate from what was reported in May.”

During this cycle, Boston was the first metro area to report negative year-over-year returns, back in April 2006. In June 2007, Boston showed an improvement in its annual rate of decline from the value reported in May, –3.9% versus –4.3% reported in May. Boston has shown improvement since the beginning of the year, where its annual growth rate measured –5.5%. More data however, is needed to determine whether
Boston, whose growth rate turned negative before other metro areas, is truly the first metro area to turn around.

Vanguard Index Fund Tax Attributes: Semiannual Report

2007-08-28T23:12:00.001-04:00

With Vanguard's issuance of Semiannual 2007 Reports, we are able to produce brief monographs providing updates on Vanguard Passive Fund tax attributes. We have added these monographs to the Financial Page Reader. Here are the links:

Vanguard Index Fund Tax Attributes-Semiannual 2007

Vanguard International Index Fund Tax Attributes-Semiannual 2007

Vanguard TM Fund Tax Attributes-Semiannual 2007

Vanguard Equity Income Index Fund Tax Attributes-Semiannual 2007

Consultation on the Potential Creation of Frontier Markets Indices

2007-08-26T19:05:00.000-04:00

Consultation on the Potential Creation of Frontier Markets Indices

MSCI Barra to Consult on a Proposal to Construct Indices for the “Frontier Markets”Countries

Geneva – August 23, 2007 - MSCI Barra, a leading global provider of benchmark indices and risk management analytics products, announced today that it will consult with the investment community on a proposal to construct indices for the “frontier markets” countries. In particular, MSCI Barra will seek feedback on the definition of the frontier markets universe, the investment process needs relating to frontier markets investing, and the objectives as well as the design of any proposed frontier markets indices. MSCI Barra has posted a consultation document describing the proposed frontier markets indices on MSCI Barra’s web site at Consultation on the Potential Creation of Frontier Markets Indices and welcomes any feedback from the investment community. MSCI Barra also plans to directly contact certain market participants to solicit feedback. Please note that this consultation may or may not lead to the creation of any frontier markets indices as proposed in the consultation document. MSCI Barra’s final decision will be announced in advance of the launch of such indices if it occurs.

Target date funds and goal-based benchmarks

2007-08-26T13:42:00.000-04:00

Target date funds and goal-based benchmarks

Vanguard Investment Counseling & Research

Executive summary. Over the past five years, target date portfolios have been one of the fastest-growing segments of the mutual fund industry. At year-end 2006, these funds held $114.3 billion in assets, up from $12.3 billion in 2001, according to the Investment Company Institute. The growth of these portfolios reflects broad-based demand for funds designed to meet a single goal-based objective: to help investors achieve financial security in retirement. Oddly enough, investors have no meaningful measures for tracking the funds’ progress toward this goal. Instead, providers typically report short term performance relative to peer groups or market indexes. As target date funds continue to assume a larger role in workplace retirement plans, the need for benchmarks that can help investors assess their progress toward a financially secure retirement will become more pronounced. We describe and analyze a complementary approach to benchmarking that reflects the unique objective of target date funds. This approach could potentially help investors obtain a clearer picture of the long-term returns a fund provider expects to deliver, a fund’s track record relative to those expectations, and the relationship between fund returns and a “typical” investor’s ability to finance retirement. The ideas outlined here may eventually lead to new forms of performance reporting and, ultimately, to better outcomes for retirement investors.

Final Regulations Under Section 403(b)

2007-08-15T22:53:00.000-04:00

Final Regulations Under Section 403(b)

On July 26, 2007, the Treasury Department and the Internal Revenue Service (IRS) issued final regulations under section 403(b) of the Internal Revenue Code that provide updated guidance on section 403(b) contracts and custodial accounts available to employees of public schools and certain taxexempt organizations. The final regulations, which had been proposed in November 2004, represent the first comprehensive guidance issued under section 403(b) since 1964.

Should Public Plans Engage in Social Investing?

2007-08-15T22:44:00.000-04:00

Should Public Plans Engage in Social Investing?

by Alicia H. Munnell

Introduction

Social investing is a movement that advocates incorporating social and environmental considerations, as well as financial factors, when making investment decisions. The most recent incarnation of this movement is the initiative by state legislatures to force public pension funds to sell their holdings of companies doing business in Sudan. The effort to divest Sudan-linked stocks began in 2004 after the U.S. government characterized the killing and displacement in Darfur province as genocide. Riding on the coattails of the success of the Sudan effort, state legislatures have now targeted Iran, with a goal of “terror-free” investing. The emotional appeal of such actions is powerful. Over 2 million civilians have been displaced and more than 200,000 slaughtered in Darfur since 2003. And Iran refuses to back away from its pursuit of nuclear weapons. But strong arguments also exist against using public pension plans to accomplish foreign policy goals. This brief explores the current world of social investing, the recent efforts regarding the Sudan and Iran, the likely impact of social investing on the target firms, and the reasons why such activity may be inappropriate for public pension plans.

The Hewitt 401(k) Index™ Observations: July 2007

2007-08-15T22:36:00.000-04:00

The Hewitt 401(k) Index™ Observations: July 2007

In July, the stock market reached historical highs, with the DJIA closed above 14,000 during the month. However, later in the month, markets retreated posting one of the worst weeks in 2007. Although market volatility was significant, the transfer volumes in 401(k) plans remained low, up only slightly from June — approximately 0.04% of balances were traded on a daily basis, according to the results of the Hewitt 401(k) Index™.
During the month, five days experienced above normal levels of movements*. In particular, the net transfer activity level was high on July 12th, when the DJIA gained 2.1 percent for the day. The movements were also above normal level when the DJIA closed over 14,000 on July 19th. Conversely, the activity level was within normal limits on July 27th when the index dropped almost 2.9 percent.
Despite of the market volatility, participants shifted monies out of fixed income investments and toward equities on 62% of the days. For the month, a total of $223 million were transferred into diversified equities.
The majority of the movements to equities continued to be dominated by the strong-performing international and emerging markets equity sectors. A total of approximately $200 million was moved toward international funds during the month, which was almost 2% of such funds' balances. In fact, this popular asset class has received inflows during six out of seven months this year — we've seen the overall allocation to this asset class increased from 8.1% to 9.3% during the year. Notably, emerging market funds also received $58 million of net transfers in July. Lifestyle funds were back in favor with nearly $40 million inflows into this asset class for the month.
On the other hand, company stock, GIC/stable value and small U.S. equity funds all experienced large outflows in July. A total of $169 million were moved out of company stock funds during the month. GIC/stable value also experienced net outflows of $58 million. In addition, $55 million were transferred out of small U.S. equity funds, as the small-cap markets dropped substantially in July.
While net flows were positive, due to market weakness the overall allocation to equity investments decreased slightly to 68.2% by the end of July, from 68.9% at the end of June.
Interestingly, participant discretionary contribution to equity (employee only contribution), which is another measurement of participant sentiment, actually increased by 0.7% to 69.7% by the end of July.

*A "normal" level of relative transfer activity is when the net daily movement of participants' balances as a percent of total 401(k) balances within the Hewitt 401(k) Index equals between 0.3 times and 1.5 times the average daily net activity of the preceding 12 months. A "high" relative transfer activity day is when the net daily movement exceeds two times the average daily net activity. A "moderate" relative transfer activity day is when the net daily movement is between 1.5 and two times the average daily net activity of the preceding 12 months.

403b Update: 90-24 Transfers To End on September 25, 2007

2007-08-09T10:14:00.000-04:00

The ability to transfer in service 403b plan assets to an outside vendor, currently available to 403b planholders under the 90-24 transfer rule is set to be eliminated on September 25, 2007. All 90-24 exchanges must be completed by September 24, 2007.

The 90-24 provision allowed investors to move 403b monies from high cost annuity plans to an investor's preferred fiduciary. The 90-24 provision disappears with the New Finalized Regulations governing 403b plans.

Two links announcing the September cutoff are available on 403bwise:

New 403b Transfer Rules
New Transfer Rules Require Immediate Action.

Securities Regulation in Low-Tier Listing Venues: The Rise of the Alternative Investment Market

2007-08-06T11:39:00.000-04:00

Securities Regulation in Low-Tier Listing Venues: The Rise of the Alternative Investment Market

Mendoza, Jose Miguel, (August 2007).

Abstract
As stock exchanges face escalating pressures for convergence and private equity and hedge funds rampage across jurisdictions in their quest for absolute returns, the success of a London-based junior listing venue -the Alternative Investment Market (AIM)- has drawn the collective attention of international market participants. Despite AIM's astounding results in recent years, the causes underlying its growth have not been the object of extensive academic analysis. This paper will focus on the recent outbreak of low-cost listing venues in international financial centers and AIM's dominance in this particular niche. It will be contended here that AIM covered a funding gap for companies whose specific characteristics preclude them from listing in senior markets such as NASDAQ, the New York Exchange or the London Stock Exchange. This paper also endeavors to show that AIM's regulatory model is optimal -imposing low compliance costs on firms, but ensuring adequate disclosure and transparency levels- given the type of companies that seek an AIM listing and the sophisticated nature of its investors.

Late Spring Numbers Bring Chilly Returns According to the S&P/Case-Shiller Home Price Indices

2007-08-03T04:18:00.000-04:00

Late Spring Numbers Bring Chilly Returns According to the S&P/Case-Shiller® Home Price Indices

New York, July 31, 2007 – Data through May 2007, released today by Standard & Poor’s for its S&P/Case-Shiller® Home Price Indices, the leading measure of U.S. home prices, shows the annual growth rate in prices of existing single family homes across the United States continue their decline, marking their 18th consecutive decline in the growth rate, beginning in December 2005.

Iboxx Rebalancing Report: August 2007

2007-08-03T04:13:00.000-04:00

Iboxx Rebalancing Report: August 2007

Asia
Euro
Euro HighYield
Inflation-Linked
Sterling
U.S. Dollar

IS THERE REALLY A RETIREMENT SAVINGS CRISIS? AN NRRI ANALYSIS

2007-08-01T03:41:00.000-04:00

IS THERE REALLY A RETIREMENT SAVINGS CRISIS? AN NRRI ANALYSIS
By Alicia H. Munnell, Anthony Webb, and Francesca Golub-Sass

The National Retirement Risk Index (NRRI) has shown that even if households work to age 65 and annuitize all their financial assets, including the receipts from reverse mortgages on their homes, nearly 45 percent will be ‘at risk’ of being unable to maintain their standard of living in retirement. That is, these households are projected to have replacement rates — retirement income as a share of pre-retirement income — that fall more than 10 percent short of a target rate designed to maintain their pre-retirement living standard. More realistic assumptions regarding earlier retirement and reluctance to annuitize 401(k) balances or tap housing equity would put the percentage ‘at risk’ considerably higher, as would the inclusion of rapidly growing health care costs. Yet, recent academic articles and press stories question whether Americans are facing a retirement income crisis...
This brief summarizes an exercise that reconciles these seemingly contradictory conclusions. It demonstrates the importance of the age group and time period being examined. The academic literature showing no problem is generally based on the Health and Retirement Study (HRS), a nationally representative sample of households age 51 to 61 in 1992. The NRRI is based on the 2004 Survey of Consumer Finances,* which includes households of all ages. Applying the NRRI methodology to the HRS age group produces very similar results to recent academic studies. That is, only about 20 percent of households age 51-61 in 1992 were ‘at risk.’

Fast forward to 2004 and calculate the NRRI in that year for those 51-61, and the at ‘risk’ population increases to 32 percent. This increase reflects declining Social Security replacement rates, lower real interest rates, and the continued shift from defined benefit to 401(k) plans.
Revisiting 1992 highlights the fact that the retirement landscape is changing over time, and that a good report card for older households in 1992 does not preclude serious problems.

* Survey of Consumer Finances 2004

Financial page

Is Portfolio Theory Harming Your Portfolio?

What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

Who Should Save in a Roth 401(K)? (It’s Not Just About Tax Rates)

The Microstructure of a U.S. Treasury ECN: The Brokertec Platform

The Case for Tips: An Examination of the Costs and Benefits

Standard & Poor's Indices Versus Active Funds Scorecard, Mid Year 2008

ARE RETIREMENT SAVINGS TOO EXPOSED TO MARKET RISK?

Introduction

The Hewitt 401(k) Index™ Observations

The Impact of PPA on Retirement Savings for 401(k)Participants

ICI: 2008 Investment Company Factbook

Iboxx Rebalancing Report: June

Iboxx Rebalancing Reports:May

The Hewitt 401(k) Index™ Observations

Iboxx Rebalancing Report (April 2008)

Should the SEC Rid Mutual Fund Investors of 12b-1 Fees?

The Subprime Credit Crisis of 07

Preferred Stock: Some Insights into Capital Structure

The Shareholder Base and Payout Policy

The Cost of Active Investing

Normative Transparency of Mutual Fund Disclosure

The Hewitt 401(k) Index™ Observations (February)

What Do We Know About the Universe of State and Local Plans

Introduction

Iboxx Rebalancing Reports: March 2008

Evaluating and implementing target-date portfolios: Four key considerations

Removing the Long-Only Constraint:he Appeal and Challenges of Implementing 130/30 and Other Long-Short Strategies

Economics Approach to Financial Planning

Health Care Costs Drive Up the National Retirement Risk Index

Introduction

The Hewitt 401(k) Index™ Observations

Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?

An "Elastic" Earliest Eligibility Age for Social Security

Introduction

Iboxx Rebalancing Report:February 2008

Retirement Annuity and Employment-Based Pension

The Hewitt 401(k) Index™ Observations-December

Measuring the effectiveness of automatic enrollment

Pension Wealth and Income: 1992, 1998, and 2004

Introduction

Iboxx Rebalancing Report: January

Broadbased, Record Declines in Home Prices in October According to the Case-Shiller Indices

Trading Volume Liquidity and Investment Styles

Evolving U.S. inflation dynamics: Explanations and investment implications

Iboxx Rebalancing Report: December

The Hewitt 401(k) Index™ Observations

Investor Timing and Fund Distribution Channel

Understanding the Securitization of Subprime Mortgage Credit

Journal of Indexes: Jan./Feb, 2008

Jim Wiandt

Burton Malkiel

Steven A. Schoenfeld and Stefanie Jaron

Tom Haines

Matthew Hougan

Heather Bell

David M. Blitzer

Brian J. Jacobsen

Brad Zigler

Why Have Defined Benefit Plans Survived in the Public Sector?

Introduction

Mutual Fund Industry Selection and Persistence

Case-Shiller Third Quarter Report

130/30 Funds: What is Behind the Commercial Offensive ?

The Hewitt 401(k) Index™ Observations-October

Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts

The Efficiency of International Information Flow: Evidence from the ETF and CEF Prices

S&P Publishes Indices that Track Low-, Mid- and High Price Homes in the U.S.

Two Papers on Mortgage Backed Securities

The Evolving Relation between Earnings, Dividends, and Stock Repurchases

“High Standards of Commercial Honor . . .

The Hewitt 401(k) Index™ Observations; September

IBoxx Rebalancing Reports-November 2007

Alternative Benchmarks for Evaluating REIT Mutual Fund Performance

S&P Case/Shiller October Report

Home Bias in International Equity Portfolios: A Review

Vangaurd Investment Perspectives; Fall/Winter 2007

Volatility Risk Premium, Risk Aversion and the Cross-Section of Stock Returns

Black Monday and Black Swans