The Quarter in Review

The new year was instantly positive when January opened, and most major stock benchmarks barely looked back.  First quarter gains were +12.6% for the S&P 500 (with dividends), +18.7% for the Nasdaq Composite, and +12.1% for the Russell 2000.

Traders were apparently glad to have 2011 safely behind them.  The year ended, you may recall, with a rally led by the Energy sector.  The Financials sector was in the middle of the pack as 2011 ended while Technology lagged behind – running only slightly ahead of Utilities.  We have a much different picture now.  Here are the sector SPDR results for the most recent quarter.

Utilities is now joined in the basement by previously-leading Energy.  Technology zoomed higher, led by Apple (AAPL), but the biggest gains were found in Financials.  Of course, the +22% quarterly gain should be viewed in context with a -17% loss in calendar year 2011.  It might be better to speak of Financials “recovery” instead of a “rally.”

Whatever you call it, what happened to make Financials turn around?  Signs of at least a mild economic recovery were certainly helpful, as were the resumption of dividends and stock buybacks that were curtailed during the financial crisis.  The bigger factor, we suspect, was monetary policy.  Federal Reserve action caused the yield curve to “steepen,” which means long-term interest rates rose higher in comparison to short-term rates.  Banks make money by borrowing at short-term rates, lending at long-term rates, and pocketing the difference.  The steeper yield curve was a substantial boost to their profit margins.

Can Financials build on this development?  We are dubious.  The Fed seems happy with current policy.  The steepening benefit is already reflected in stock prices.  Meanwhile the crisis in Europe is flaring up again, led this time by Spain.  We already see long-term Treasury rates declining in April as global cash again seeks haven in the U.S.  The second quarter of 2012 seems unlikely to resemble the first.

It is time to step up to the challenge of your job’s main mandate - protecting investors.  Investor confidence in exchange traded funds (“ETFs”) and exchange traded notes (“ETNs”) is at a critical point.  The abuses of a very small number of individual products flaunting regulatory holes can potentially cause irreparable harm to an otherwise beneficial and innovative industry.

I’m not talking about the use of leverage, derivatives, daily rebalancing, and other fully disclosed activities used by various product sponsors to meet their stated objectives.  No, I’m talking about something far more serious – products that prey on investor perception of what constitutes a mutual fund, ETF, or ETN and the disclosures those products are expected to provide.

There are two major areas where regulators appear to be sleeping at the wheel.  The first is in regard to appropriate disclosure of product expenses passed on to shareholders.  The second is allowing broken products to continue to trade.

I provide three specific examples below, along with some potential solutions for you to consider.  Before I get into the specifics, some background information may be helpful.

Background

Ever since the passage of the Investment Company Act of 1940, investors have come to believe that mutual funds (and their ETF and ETN evolutionary offspring) are Regulated Investment Companies (“RICs”).  Additionally, industry practice for most of the past 70 years has perpetuated the perception that these are “pass through” vehicles regarding income and tax consequences.  Furthermore, there is an expectation that all product level expenses are disclosed as annualized expense ratios.  Perhaps these are incorrect perceptions on the part of investors, but these are their perceptions nonetheless.

Another investor perception revolves around what it means for a product to be an ETF or ETN versus a traditional mutual fund or a closed-end fund.  The industry has promulgated the idea that what makes ETFs and ETNs unique is their ability to create and redeem shares on demand through in-kind and cash exchanges with Authorized Participants.  I, and the majority of investors, believe this feature constitutes the soul of an ETF, makes it a unique vehicle, and provides investors with the confidence that these products will trade at prices close to their net asset values.

Now, let’s look at three problem areas where these perceptions are shattered:

Problem 1:  Product expenses disclosed in periods less than one year.

On September 8, 2011, UBS introduced six ETNs with annual expense ratios in excess of 5%.  However, this fact escaped the general public and most professional analysts (even Morningstar lists the expense ratios at 1.35%).  Regulators allowed UBS to state the majority of these fees as weekly expenses instead of annual ones.  The products disclose an annual investor fee of 1.35% per annum and an Event Risk Weekly Hedge cost of 0.077%.  The 0.077% per week works out to about 4% per year according to the small print buried in the UBS documents, making the total annual expense ratio about 5.35%.  Allowing products to state weekly expenses is misleading.  Since regulators have allowed this, what is to stop other products from stating expenses as daily or hourly rates?  The solution to this problem is simple: Require expense disclosures in an annualized format.

Problem 2:  Products that incur internal tax liabilities.

As of August 24, 2010, every ETF and ETN listed for trading on U.S. markets were structured as pass-through entities and therefore did not incur any tax liabilities at the product level.  As previously stated, this is what investors have grown to expect during the 72 years since the passage of the Investment Company Act of 1940.  All that changed on August 25, 2010.  That was the day regulators allowed a listing for a product that called itself an ETF, even though it was structured as a C-corporation and liable for the 35% corporate tax rate on all capital gains and other taxable income.

That first C-corporation to be listed as an ETF was Alerian MLP ETF (AMLP).  Even though AMLP incurs a tax liability in excess of 35% of the daily change of the underlying index, it does not report this as an expense.  This future liability of AMLP becomes an immediate expense to every shareholder in the form of a daily adjustment to the fund’s NAV.  Even though this expense exceeded 5% in calendar year 2011, AMLP reported its “total expense ratio” as 0.85%.

In some small-print footnotes, the AMLP disclosures go on to explain that its future tax liability is unknown and is therefore assumed to be zero.  This is a ludicrous assertion because AMLP knows exactly how much to adjust the NAV each day to account for this liability.  Hiding behind the mere fact that the total dollar amount of future liabilities might be unknown, while the daily impact is known, should not be justification for allowing an assumption of zero.  The cost to shareholders now exceeds $122 million.

Those more knowledgeable of mutual fund accounting laws have suggested that fund level taxes are not required to be included in the total expense ratio.  If that is true, then there is a very large regulatory hole here.  As a result, many investors are unaware of the very high cost they are paying to own a C-corporation disguised as an ETF.  On March 13, 2012, Yorkville High Income MLP (YMLP) became the second ETF structured as a C-corporation instead of a pass-through entity.

Possible solutions: Require all mutual funds, ETFs, ETNs, closed-end funds, and other pooled investment vehicles structured as C-corporations or other non pass-through entities to make it painfully obvious that investors are going to face double taxation.  These corporations are liable for federal and state income taxes and then shareholders are taxed again on an individual level.  Unknown total future dollar amounts are not a valid excuse.  The impact for previous periods is known.  The impact on future daily changes is known (process of adjusting NAV).  If they can’t properly disclose the impact to shareholders, then don’t let these vehicles be called mutual funds or ETFs.

Problem 3:  ETFs and ETNs without share creation and redemption.

As stated above in the background section, any product labeling itself an ETF or ETN is expected to have a functioning creation and redemption mechanism that helps to keep its trading price closely aligned with its NAV.  That is one of the prime advantages touted by the industry.

However, investors are often not aware that it is even possible for this process to be broken.  Furthermore, there is not an easy way to determine if a given ETF or ETN has a broken creation/redemption process.  Investor perception is that ETFs and ETNs trade very close to their NAVs.  As a result, investors can be caught unaware when these broken ETFs and ETNs are trading at premiums as high as 1,000% or more, as was the case for the former ELEMENTS MLCX Gold Index ETN (GOE) back in 2009.

More recent examples of ETFs and ETNs trading as closed-end funds with steep premiums include VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and iPath Dow Jones UBS Natural Gas ETN (GAZ).  I believe many investors and traders purchased these products in recent weeks without knowing they were paying outlandish premiums.

Possible solutions: Halt trading in any “broken” ETF or ETN, where broken is defined as a non-functioning creation or redemption mechanism.  This may seem extreme, but it will force sponsors to further consider the ramifications.  Deutsche Bank and Invesco made the tough but correct decision to return $600 million to investors rather than allow the PowerShares DB Crude Oil Double Long ETN (DXO) to become a broken product.  A less radical solution may be to use a ticker symbol suffix like the “.pk” designation used to identify pink sheet stocks.  Some possible, currently unused suffixes include “.bp” (broken product) or “.tcef” (trading as closed-end fund) to properly alert investors that the product is not functioning as intended.

Sincerely,

Ron Rowland, concerned ETF investor

The proliferation of new ETFs now makes such a portfolio feasible.  However, with more than 200 dividend and income exchange traded products to choose from, you must exercise care when building a sound diversified portfolio that meets your objectives.  Therefore, Capital Cities Asset Management is excited to offer a brand new Dividend and Income Strategy to help investors with their income requirements.

One question that always seems to come up is “how much of my portfolio can I withdraw while increasing the amount each year to keep up with inflation, and at the same time, not run the risk of outliving my portfolio?”

The answer to that question is “it depends.”  It depends on many different criteria, and the answer is going to be different for everyone.  As a starting point, we are going to use the 4% Rule.  Simply stated, the 4% Rule is a rule-of-thumb that suggests limiting withdrawals in your first year of retirement to 4% of your investable portfolio balance.  Thereafter, increase the annual amount you withdraw to offset inflation.  The goal is to minimize the risk of outliving your money.  You can read more about the 4% Rule here.  However, our personalized planning process can help tailor an income plan to your specific needs.

For those of you without a pension, there are four basic approaches to living off your nest egg.  The first two, living off the interest and buying an immediate annuity, will most likely not work in the current low interest rate environment – they struggle to generate enough current income and will almost certainly lose ground to inflation.

The third method is a traditional portfolio total return concept.  With this approach, an investor typically builds a portfolio of 60% stocks and 40% bonds, sells enough holdings each year to meet their financial needs, and then rebalances annually.  This is still a viable approach, but investors must be realistic in their portfolio return assumptions.

The fourth method is an income-generating portfolio, and dividend income has been getting a lot of attention by investors these days.  One of the perceived benefits of this approach is that none of the underlying holdings need to be sold each year.  Instead, retirees can just live off the income stream.

While it sounds nice, there are many pitfalls to this “pure dividend” approach that investors need to consider.  First, the most popular dividend mutual funds and ETFs do not pay enough dividends to meet the first year goal of extracting 4% income.  Second, dividends are not guaranteed – they can be (and have been) reduced.  Third, since the portfolio is 100% invested in stocks, it can be very volatile.

We can design an ETF Dividend & Income portfolio for you that can address these pitfalls and other problems with a pure dividend approach.  We’ve kept what we believe are the best aspects of the dividend methodology and coupled them with the tried and true risk management techniques of the total return approach.

The result is a customized portfolio specifically for you designed to:

• Generate income in excess of 4% the first year
• Provide lower volatility than pure dividend portfolios
• Not lock you in to current low yields
• Take advantage of higher interest rates in the future

If this type of portfolio interests you and you would like more information on Capital Cities Asset Management’s services or portfolios, please call @ 800.767.2595 or email us today.  Thanks and we wish you the very best.

The financial world has rules of thumb, too, and one is garnering more scrutiny as many Americans look towards retirement.  You may have heard about the “4% Rule” for retirement distributions, but few investors understand its genesis and its importance.  Here is a quick primer for those that seek a deeper awareness.

While everyone’s retirement needs vary, the 4% Rule suggests limiting withdrawals in your first year of retirement to 4% of your investable portfolio balance.  Thereafter, increase the amount you withdraw only to offset inflation.  The goal is to minimize the risk of outliving your money.

Like all rules of thumb, this one has fine print.  Here are a few common myths and misunderstandings about the 4% Rule:

1. One size fits all. A rate of 4% (four percent) isn’t a hard and fast rule that applies to every situation.  Remember, it’s a rule of thumb.  Differing needs and moving budgetary targets may dictate a different withdrawal rate for your plan.
2. The 4% Rule lasts forever. The 4% Rule is predicated on a 30-year time horizon – not perpetuity.  Retirees need to be realistic about how long their money can last, even with modest income needs.
3. The 4% Rule will solve your portfolio construction equation. Investors still have to wrestle with asset allocation challenges.  While the 4% Rule can help, other factors will impact this decision going forward.
4. The 4% Rule presumes a world economy. Nope, the study is based on U.S. security returns only.  This is important because U.S. markets have historically had low volatility and strong returns compared to other countries.  International exposure that has become commonplace in portfolios isn’t considered in the study.
5. The 4% Rule is an inflexible dogma.  Again, it’s a rule of thumb – a place to begin.  It can help in your planning.  Still, because the market doesn’t give us straight line returns, there will be times where budgetary surpluses build up.  Conversely, if the market doesn’t cooperate, then a person will need to adjust their spending habits years in advance.
6. This 4% Rule has been used for a long time. The original data used in the study traces back to 1926; however, the study was published in 1998 by three professors from Trinity College in Texas.  It’s a relatively recent planning standard.
7. The 4% Rule is universally accepted. It most certainly is not.  Many economists insist the 4% Rule is not very efficient at all.  While they make a compelling case if you dig into it, deep analysis isn’t very useful if no one can understand and apply it.  The challenge is giving common investors a principle they can understand and build around.  Because of its ease, the rule continues to be one of the better staples of retirement planning.

We hope this helps de-mystify the 4% Rule of thumb for folks.  If used correctly, it gives you a goal worth pursuing.  Still, it’s important to understand the limitations.  If possible, consult a professional to help you work through your retirement plan with the 4% Rule as a reference point.  Good luck and remember to stretch before and after you exercise.