Author Archives: Matthew Arndt CFA CPA CFP

U.S. Senate Waters-down Insider Trading Law

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Late last week the U.S. Senate, following the House passed a weakened version of the “Stop Trading on Congressional Knowledge” (STOCK) Act, which aims to eliminate congressional insider trading. The bill doesn’t address the political intelligence industry, which collects non-public information from members of Congress for trading purposes.

Senate Majority Leader Harry Reid (D-Nev.) took a page out of House Majority Leader Eric Cantor’s (R-Va.) playbook by forcing the Senate to approve a watered-down bill that will supposedly ban congressional insider trading.

Wall Street lobbied hard to block the political-intelligence provision and found friends in Reid and Cantor, both of whom receive large campaign contributions from Wall Street firms. Cantor stripped the stronger version of the political intelligence and anti-corruption enforcement provisions and sent the watered-down House bill to Reid, who did much of the same to the Senate version.

Variable Annuities: All Downside, No Upside

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I’ve heard variable annuities (VA’s) pitched as “safe” alternatives to investing in the stock market and as a safe way to get market like returns without the risk. This is malarkey of the highest order and greatest magnitude. There is nothing worse for investors and nothing that eats away at your wealth like VA’s. Hopefully you haven’t bought one of these toxic “investments.” If you have, I apologize I wasn’t there to stop you.

For starters, these are not investments. These are insurance contracts and their guarantees are only as good as the company standing behind them. And let’s not forget insurance companies can and do go bankrupt. If the company that issued your annuity goes bust, your contract may only be worth a doughnut and change.

VA’s are sold as a safe way to attain growth without market downside. In reality nothing could be further from the truth. These are insurance contracts with mutual fund investments (called sub-accounts) wrapped into the contract. The fees alone are money killers and cash burners that will eat you alive and bleed you dry leaving you with little upside potential.

Fees, fees and more fees; VA’s are notorious for the exorbitant fees they charge. One reason Wall Street corporations have to charge you large fees are so that they can cover the large commissions they pay their brokers that sell these products. Typically, the salesperson (i.e. your advisor) receives 6 to 10 percent of total dollars put into a VA in the form of a commission. In some contracts these commissions can run as high as 14 percent! For example, if you put $1 million into a VA, your broker may receive $100,000 or more for a single sale without doing much work other than perfecting the sales pitch. In other words, if you buy one of these, you are placing a BMW M6 Convertible in your broker’s driveway or helping put his kid through college.

It’s true that VA’s can have the benefit of tax-deferred growth, but ironically, many investors buy and hold these in their IRA (i.e. an account that already allows tax-deferred growth) defeating this very reason to buy the VA; analogous to holding two umbrellas in a rainstorm. Moreover, since withdrawals from a VA are considered income, any growth inside the annuity is taxed at ordinary income tax rates, not at the more preferable long-term capital gains rates.

If you have the ability, I would recommend getting out these as quickly as possible, and staying out of them. VA’s are like a bad marriage and divorce seems impossible, but through proper evaluation there are ways to get out. Annuity salesmen know how to sell these and make them sound safe and promising. Don’t believe their advertising and public relations. Wall Street companies spend billions of dollars to make us think they’re nice and they just want to help us out. They want us to think they have all the solutions. They don’t. Also, these are not a smart alternative to investment growth because whatever growth you receive will have to compete against the huge fees you will be paying to the Wall Street corporations.

The Cost of Crony Capitalism

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Insider trading is illegal and morally wrong. Unless of course if you are a member of Congress. Then it is just “honest graft” which sounds innocent enough. Honest graft allows members of Congress to enrich themselves in a way that is legal and for which a politician would say is nothing more than taking advantage of the money-making opportunities that might arise while holding public office. Honest graft is as much an oxymoron as “harmless embezzlement.”

Should we allow college athletes to bet and gamble on games in which they are playing? Is it acceptable for Tiger Woods to wager on PGA tournaments in which he is competing? Of course not. It would undermine the integrity of the game. People would scream with outrage that these athletes have a stake in the outcome and staggering financial conflicts of interest. But this is exactly what we are allowing politicians in Washington to do. Currently, members of Congress are allowed to introduce a piece of legislation and then trade on the company’s stock that will benefit or be hurt by this legislation. Insider trading in Congress is not only routine but apparently legal. Committee members frequently participate in sweetheart IPOs and make trades in stocks on the companies they regulate.

If you are a federal judge who owns more than $25 worth of stock in a company, you are required to recuse yourself from any case involving your company because of a possible conflict of interest or lack of impartiality. Yet, we allow members of Congress who own millions of dollars of healthcare or energy companies to write bills that affect their respective industries they regulate and subsequently make trades based on what’s in these bills before this information is released to the public.

Two or three lines in an energy bill can have a massive effect on a company’s stock price. If politicians possess this information and are allowed to trade on it before anyone else, they have an unfair and powerful advantage. It damages the integrity of the markets; it undermines any sense of fairness; and it puts the average investor at an extreme disadvantage.

The much ballyhooed (by politicians) “Stop Trading on Congressional Knowledge” (STOCK) Act would be an attempt at prohibiting Members of Congress, employees of Congress, and all federal employees from using any nonpublic information derived from the individual’s position as a Member of Congress or employee of Congress.

Both chambers almost unanimously passed the STOCK Act, but there is still no law. And according to experts even if it becomes law there appears to be sufficient holes in the STOCK Act such that those who wish to circumvent it will be able to do so. For instance, House Majority Leader Eric Cantor stripped a provision requiring those that collect financial information and sell it to Wall Street to register the same way lobbyists do, which means it’s still okay to provide insider legislative knowledge to ultra-high-net worth investors.

With a Congress like this who needs Bernie Madoff?

Are Mutual Funds Eroding Your Wealth?

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You may not realize this, but if you own mutual funds in your portfolio then you may be paying substantial fees to each mutual fund manager every year, in addition to an annual advisory fee to your investment advisor (An advisor simultaneously collecting both a commission and an advisory fee on the same portfolio is an extremely unethical act known as Double Dipping, please see my earlier post).

Mutual funds charge annual management fees and hidden 12b-1 expenses that can cost you on average about 1.5% a year and many of these funds may not provide you any better diversification than an index fund or ETF that only costs you 0.20%. Imagine if you are paying your advisor an additional 1.5% annually to put you into these funds; your annual investment cost would reach 3% per year. These may not seem like big numbers, but compounded over decades these fees could erode a very large portion of the value of your portfolio.

Costs matter – tremendously.

Experts say Stock will Keep Climbing in 2011

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Barron’s surveyed 10 investment managers and strategists, who said that 2011 should be a good year for stocks.

This is from Barron’s December 18, 2007 issue:

[BARRON'S FEATURE

2008 Outlook by Kopin Tan
Wall Street strategists remain bullish about stocks, despite their tepid forecasts for the U.S. economy.]

Need I say more?

The Revolving Door

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As head of the Office of Management and Budget, Peter Orszag played a powerful and key role in shaping public policies such as the first stimulus package and the recent health-care reform legislation. Recently he has stepped down as OMB director to accept a senior position in the investment banking arm at Citigroup, an institution that received massive infusions of taxpayers’ dollars.

In his new role at Citigroup, Mr. Orszag’s annual salary alone has been ball-parked in the millions of dollars. This ability to effortlessly glide through the revolving door between Washington and Wall Street seems improper in the very least and demonstrates the potential for corruption and abuse. Do you wonder why the recent financial reform that was suppose to rein in reckless risk-taking by the very same institutions that brought this country to the brink of collapse, lacks teeth? Do you wonder why a law that was suppose to do away with “Too-big-to-fail” has had little effect? Why did our politicians accept such lax financial reform when a staggering majority of Americans wanted far greater and extensive measures ?

Mr. Orszag no doubt understands how the positions he takes and the policies he helps shape while in government will affect his future career options. The potential for such huge paychecks and the prospect of a big paying job on Wall Street and elsewhere undoubtedly influences government policy-makers positions on key legislation that impacts its respective industries. It’s no wonder our politicians are unable or unwilling to get any sensible legislation passed that would benefit the masses instead of a select few special interests.

U.S to Lose Triple A Rating?

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It seems that news sources have been inundating us with the opinions of economists that have stated if the Bush tax cuts are not maintained that we will all be in trouble. These economists all claim to be “experts” at determining where the economy is going. These are the very same experts that did not predict the 2008 financial crisis and did not foresee the current mess we are in. But now these experts are telling us to listen to them or else. I have to confess that I have studied economics and I haven’t found it very useful for prophesying, and I don’t believe economists are very good at predicting anything with the exception of the past.

An ominous side effect of the tax deal being approved is the lost of the United States’ triple A bond rating. In a Reuters headline, Moody’s warns of possibly reducing U.S.’s Aaa rating because of Tax Deal, the rating agency said it may lower the U.S.’s Aaa rating if the compromise on the Bush tax cuts and the extension of unemployment benefits becomes law. The agency’s concern is the increase debt levels, which would make a rating reduction more likely in the next 12 to 18 months. Then again, Moody’s, along with others, was giving sub-prime mortgage-back securities triple-A ratings that clearly did not deserve such a high grade. Just another alleged “expert’s” opinion.

The Fed Bailed-out more than Banks

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After congressional coercion, the Fed has finally revealed what it did with $3.3 trillion in emergency aid in 2008 and 2009. It’s clear why the Fed has been so reluctant to reveal what it did with our money. Banks turned to the Fed for help almost daily in the fall of 2008 as the central bank lowered its lending standards, but its actions benefited more than Wall Street financial institutions. Companies like Harley Davison, General Electric, and Toyota all wallowed at the trough filled with taxpayer dollars.

It all adds up to just more corporate welfare. It’s apparent that the government has become firmly on the hook for the cost of bailing out big companies that get into trouble. The too-big-to-fail banks are bigger than ever, and the financial reform law didn’t do anything to curtail reckless risk-taking and hold irresponsible financial institutions accountable for their actions. In the case of companies like AIG and Bear Stearns, stock-holders should have been wiped out, bondholders should have suffered significant losses and upper-level management should have been fired; this would have instilled market discipline and upheld the principles of capitalism. Instead, the exact opposite has happened. Many of those that tout capitalism and free markets are the very same people that accepted vast amounts of government aid.

More Wall Street Alchemy

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This is a critique to an article (Using Managed Futures to Diversify a Portfolio by Jeffrey L. Stouffer) that professes the benefits of managed futures, and a response to some misguided statements.

“Any financial advisor could present an Ibbottson chart showing the long-term performance of equities and cite the expected 10% return from investing in equities.”

This does not take into account the volatility in the sequence of returns and the survivorship bias that plagues an index that tries to track a group of stocks. For example, of the 500 largest U.S. companies in 1957, only 74 were still part of the S&P 500 forty years later in 1997. I can’t locate the statistics, but I know it’s become even more dire for the survivors if you consider the loss of the dotcoms, Enron, Worldcom, Bear Stearns, AIG, General Motors (before bankruptcy), Lehman Brothers, etc. just to name a few. This is survivor ship bias, and this should make just about every investor highly suspicious of anyone (e.g. an “expert” financial advisor) showing long-term index returns. It should also make most investors queasy about taking large amounts of risk.

“The problem with this is that a chart showing a track record since the end of the eighteenth century just did not match the client’s life span.”

This is the least of the investors’ problems. Any index that could track such a span would be severely plagued with survivorship bias (see above). And thus, the index would greatly overstate the true returns and greatly understate the true risk experience by investors.

“One asset class has been the savior of several institutional and high-net-worth individuals. Managed futures, as a group, have clearly outperformed equities and fixed income investments, especially during 2008.”

Read the fine print: Most managed futures prospectuses have a disclaimer that states the spectacular returns that are being shown over the last, say, ten years were not achieved with any significant amount of capital, and the fund only started accepting outside investors in the most recent month (e.g. October 2010). In other words, We started a bunch of funds (maybe 100′s or even 1,000′s) with a small amount of seed capital. When we found the lucky one that showed great performance, we capitalized that one and sold it to investors misleading them to believe the fund managers risked a larger amount of capital than they actually did during the preceding 10 to 20 years. This is more alchemy than sound strategy, which is disingenuous to say the least. Even scarier, investors are starting to flock to these arguably fraudulent investment arrangements. Anyone who would recommend these products are either misinformed or a fraud.