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Chinese proverb: "If small money does not go out, big money will not come in."
If people realize these long-term growth-rate numbers are largely fictional, then a pillar of support for the market's valuation - the S&P 500 currently trades at a P/E of 18.5 based on 02 earnings - could go out of the stock market, sending prices lower. Of the 91 tech companies in the S&P 500, analysts expect 82 to grow faster than 10% a year, and 18 to grow better than 20% a year. Related article: 03 Profit Estimates - Ken Brown, WSJ
The study, which covers 1977 to 2002, shows not only that the stocks of companies who try to thwart short sellers are generally overpriced, but also that short sellers are often dead right. During the 25 years that Mr. Lamont tracked, he found 326 incidents at some 270 companies. The study divides the tactics used against short sellers into three types: belligerent statements, which include claims of a short seller's conspiracies or of lies spread by the pessimists; taking legal or regulatory action against short sellers; and making technical moves to prevent short selling, like urging shareholders to register stock in their names rather than in those of their brokerage firms, so that shares cannot be lent to short sellers. Companies also try to get big stakes into friendly hands, so short sellers cannot borrow them. The negative returns varied depending on the strategy, the study showed. Companies that urged shareholders to take delivery of their stock lagged the market by 3.17 percent a month in the following year. Those that worked to get their stock into friendly hands underperformed the market by almost 5 percent a month. Short sellers are not the enemy of investors. And Mr. Lamont noted, "Many firms accuse short sellers of fraud, but are in fact themselves guilty of fraud." The fact is, short sellers actually reduce volatility in the market. Their selling helps keep stocks from flying too high, and when they close out their trades, the buying often gives beleaguered stocks support. "If there had been more short selling of tech stocks in 1999, the market wouldn't have gone up so much," Mr. Lamont said. "And it wouldn't have gone down so much because short sellers would have provided a floor." Prior Research Short-sale constraints can prevent negative information or opinions from being expressed in stock prices, as [found] in Miller [Miller, E. 'Risk, uncertainty, and divergence of opinion'. Journal of Finance vol 32, 1977]. Sorescu [Sorescu, S. 'The effect of options on stock prices: 1973 to 1995'. Journal of Finance v55, 2000] finds that in the period 1981 to 1995 the introduction of options for a specific stock causes its price to fall, consistent with the idea that options allow negative information to become impounded into the stock price. Figlewski [Figlewski, S. 'The informational effects of restrictions on short sales: some empirical evidence'. Journal of Financial and Quantitative Analysis v16, 1981] Figlewski and Webb [Figlewski, S., Webb, G., 'Options, short sales, and market completeness'. Journal of Finance v48, 1993], and Dechow [Dechow, P., Hutton, A., Meulbroek, L., Sloan, R. 'Short-sellers, fundamental analysis, and stock returns'. Journal of Financial Economics v61, 2001] show that stocks with high short interest have low subsequent returns. Unfortunately, using short interest as a proxy for shorting demand is problematic, because the quantity of shorting represents the intersection of supply and demand. Demand for shorting should respond to both the cost and benefit of shorting the stock, so that stocks that are very costly to short will have low short interest. Stocks that are impossible to short have an infinite shorting cost, yet the level of short interest is zero. Lamont and Thaler (unpublished 2001), for example, examine a sample of technology carve-outs that appear to be overpriced. In their sample, the apparent overpricing and the implied cost of shorting fall over time, while the level of short interest rises. Thus short interest can be negatively correlated with shorting demand, overpricing, and shorting costs. The problematic nature of short interest leads to weak empirical results. Figlewski and Webb (1993), for example, find that short interest predicts stock returns in the 1973 to 1979 period but not in the 1979 to 1983 period. In modern data, short-selling is relatively rare and the amount of shares sold short is small. Figlewski and Webb (1993) report average short interest as a percent of shares outstanding of 0.2% for the 1973 to 1983 period. Similarly, Dechow et al. (2001) report that between 1976 and 1993, less than 2% of all stocks have short interest of greater than 5%.
According to a calculations by Ark Funds, a Baltimore mutual-fund company, a portfolio returning a modest 4 percent a year will last for 42 years if only 5 percent is withdrawn each year. This is because only a small amount of principal is tapped with each withdrawal. It would last 14 years if 10 percent were withdrawn annually, and 10 years if 13 percent were taken out. Increase the annual return to 6 percent, and the fund will last forever so long as you take out less than 6 percent a year. Take 7 percent, and it will last 34 years, take 10 percent, and it will go for 16 years, and take 13 percent, and it'll last for 11 years. Bump the annual return up to 8 percent, and the portfolio will last 29 years if you take 9 percent, 21 years if you withdraw 10 percent, and 13 years if you take 13 percent. For a more sophisticated look at a portfolio's endurance, use a program like Quicken 2003, the finance software, which takes taxes and inflation into account. Microsoft Money 2003 Deluxe has similar features.
The net worth of most families - the value of their assets minus their debts - also rose strongly, with the median climbing 10.4%, to $86,100, over the three-year survey period. Among blacks it rose 13.1%, to $19,000 from $16,800. But the net worth of the wealthiest families climbed even more. The median among those in the top 10 percent leapt to $833,600 from $492,400, while the mean soared to $2.26 million, from $1.68 million three years before. These families' median income leapt 19.3%, to $169,600, during the same period. Even after their gains, median income of the poorest 20% of families was only $10,300, up from $9,000 three years earlier, and the net worth of these families rose only to $7,900, from $6,300. The median income for black families was $25,500, compared with $21,200 in 1997. Hispanic families' median income declined to $24,700 from $25,600, and median net worth rose only to $11,300, from $10,700. Families' debt grew rapidly over the three years in the survey, but assets grew more rapidly, resulting in a decline in the ratio of debt to assets. The survey found that debt equaled 12.1% of assets, down from 14.3% in 1998. The average balance among those borrowing on credit cards was $1,900, unchanged from 1998. Changes in the nation's pension system may be causing wealth figures to appear to rise more than they have. The value of workers' rights in traditional pensions are not included in the wealth figures, in part because they are so difficult to value. But 401(k) and other types of plans are included. Thus, if a worker's company switches from a traditional pension to a 401(k), the worker might seem wealthier in the survey though in fact he has simply substituted one pension asset for another. More Stats from Survey of Consumer Finances Federal Reserve Bank, 1-17-03 Before-tax Family Income, in thousands of 2001 Dollars
The bottom line: Sale prices - which were once available to all shoppers - are now mostly restricted to card holders in stores with cards and are called "card specials." In our experience, items not covered by card discounts tended to be more expensive than at nearby noncard stores. As a result, we paid more at card stores than at noncard stores. According to industry experts, our shopping experience was typical, because cards are designed to make customers feel like they got a bargain, without actually lowering prices overall. Several limited studies by the grass-roots anticard group NoCards.org have found that stores with club cards are pricier than stores without them, according to founder Katherine Albrecht. Cards do generate more revenue for stores, however. About 10% of shoppers at card stores don't use the cards, so they pay full price for things that are actually on sale. That is a windfall for stores because of the way grocery discounting works: Manufacturers - not stores - provide most discounts; the stores just pass along the savings. So, if you are paying full price for an item the store got at a discount, the store can pocket the difference. For shoppers, none of this is small potatoes. The average grocery bill accounts for nearly 11% of a family's disposable income, or more than $4,500 a year.
Some big U.S. companies last week seemed to back up his view. Microsoft and IBM both reported better-than-expected quarterly earnings, but both also indicated a lack of visibility for their businesses in the months ahead. GE reported Friday that its 2003 earnings may grow anywhere from 3% to 13%, acknowledging the difficulty of forecasting in the current environment. This means, Mr. Bernstein suggests, that investors need to value stocks based on trailing earnings, rather than on hazy profit forecasts. While that approach sounds logical enough, it turns one of the basic precepts of investing on its ear - the notion that the stock market reflects a company's future earnings prospects, rather than what it has done in the past. But looking backward could be a big mistake. Some of the stocks poised to gain under a rebounding economy include a number with some weak trailing earnings, like many cyclical stocks from chip makers to some banks and financials. "The use of past information can be most dangerous at transition points," says Richard Hoey, chief investment strategist for Dreyfus. But Mr. Bernstein counters that even taking into account Merrill Lynch's forecast of 2.5% economic growth in 2003, stock prices at 30 times look unsustainable. "My argument isn't that the economy won't strengthen, but rather that the market is pricing in an another economic boom," he says. "That means investors are more likely to get a negative surprise than a positive one." On thing is clear: Analysts watching forward-looking numbers are predicting a powerful recovery in the second half of the year, despite mostly guarded profit forecasts from companies so far. Consensus analyst estimates call for about a 10% rise in profits for the first two quarters, but the figure climbs to 16% for the third quarter and 21% for the fourth.
One of the first economists to delineate the perils of debt bubbles was Yale's Irving Fisher, who wrote the seminal academic article on the subject in 1933, near the depth of the Great Depression. In his 1933 article, Fisher asserted that gross "over-indebtedness" lay behind America's three biggest economic calamities to that time - the Panics of 1837 and 1873 and the Crash of 1929. In each, the debt explosions were sparked by technological developments that transformed the economic landscape (canals in 1837, railroads in 1873, autos and radio in 1929), the advent of new industries, the exciting prospects of new lands or markets (e.g., the Homestead Act's opening of the West in the 1870s), or some combination of these factors. The new developments fired investors' imaginations, Fisher contended, encouraging overconfidence - and greed. Fraudulent claims entice people, too, although there's generally "a very real basis for the 'New Era' psychology before it runs away with its victims," Fisher acidly commented. Sound familiar? At what level does debt turn lethal? No one knows for sure. Some contend that today's debt level of $31 trillion, or 295% of current GDP of $10.5 trillion, is somewhat artificial. About $10 trillion of the debt consists of the borrowings of financial players -- banks, savings institutions, finance companies, issuers of asset-backed securities and government-sponsored enterprises such as Fannie Mae and Freddie Mac. So, in a sense, about a third of today's aggregate debt total is being double-counted. That wasn't true in the early 'Thirties, when the ratio of U.S. debt-to-GDP hit its previous high of 264%, because the financial sector was far less developed at the time. Current government debt - federal, state and local - stands at $5 trillion, with Uncle Sam accounting for $3.5 trillion of that. Fortunately, the federal budget stringency of the past decade and spirited economic growth in the late 'Nineties has driven total U.S. governmental debt down to under 50% of total GDP, versus 70% in the early 'Fifties and 65% in the mid-'Nineties. The U.S. has a long way to go before governmental debt proves damaging by "crowding out" private credit demand and boosting interest rates. Other developed nations have far higher government debt-to-GDP figures; Japan's is about 150% yet its 10-year government bond yields less than 1%. Meanwhile, the non-financial corporate-debt market, accounting for $4.9 trillion of the U.S. debt total, has been a charnel house for investors over the past two years. Defaults have skyrocketed. Corporate revenues, the raw material of debt service, have fallen to just 113% of corporate debt levels - the second worst reading in debt-repayment capacity since the Great Depression. It ran 130% to 145% in the mid-'Nineties. One saving grace: Corporate credit growth has slowed to a crawl of late (it was up 1.8% in the third quarter), as companies strive to use internal cash flow to deleverage their balance sheets. If the U.S. debt bomb ever explodes, the detonator probably will be the residential mortgage market. Home loans account for $5.8 trillion, or nearly 70%, of the U.S.'s $8.2 billion in household debt. Home prices have been on a tear, rising nearly 50% nationwide over the past six years. Refinancings have totaled $2.5 trillion over the past two years. In addition, Americans' home-equity loans stand at around $800 billion. At the same time, Americans' equity in their homes, net of debt, has dwindled to 57%, compared with 85% a half-century ago, even with the recent powerful surge in home prices. Economist Gary Shilling calculates that 39% of U.S. homes are owned free and clear - and that the remaining homeowners have debt burdens exceeding 80% of the value of their homes. In other words, many Americans have little margin of safety should home prices level off or should they fall as much as 20%, as they did in many overheated areas in the late 'Eighties. Goldman Sachs economist Jan Hatzius estimates that, in last year's third quarter, on an annualized basis, Americans sucked out $320 billion more in equity from their homes than they reinvested in real estate. With refinancings slowing, the Goldman economist sees consumer spending rising only 2% or less this year. By his reckoning, home values are at record levels, compared with either rents or median household incomes. Hatzius worries that housing is now highly vulnerable, owing to the likelihood of higher interest rates, rising unemployment and lower home prices. And if the housing bubble bursts, instead of gently deflating, the nation's economy could be in for a major meltdown. In essence, then, the American home is a bulwark for the economy. As long as housing values stay high, the nation is sheltered from a detonation of the debt bomb. Dueling Stats Jesse Eisinger, WSJ 1-31 The Fed's quarterly aggregate data show debt service rising from 13.4% of disposable personal income in 1998 to 14% during the first nine months of 2002. But, the Fed's survey of 4,449 households, part of a big triennial Fed effort, shows debt service falling to 12.1% as a percentage of assets from 14.3% in 1998. Which to believe? The survey is older and just a poll. But the more recent data are an arcane agglomeration from many sources. Economist Joe Lavorgna of Deutsche Bank leans toward the survey, which is more optimistic about the consumer. The survey helps explain why consumer spending has held up well; either debt service has declined, or is perceived to have declined. But Northern Trust's Paul Kasriel isn't convinced. Consumer spending isn't growing as fast as the rise in disposable income would suggest. Why? If people want to "retire before they expire, their savings rate has to go up," he says. "The Fed can put out these studies or whatever, but for households as a whole, their financial situation has deteriorated in the past three years." Related articles: Don't Worry About Consumer Debt - Gene Epstein, Barrons, The Debt Debate - Caroline Baum, Bloomberg, Consumer Debts May Slow Recovery - Sapsford & Barta, WSJ, Corporate Debts May Slow Recovery - Gregory Zuckerman, WSJ
The focus of the regulatory activity is ''breakpoints,'' the level of investment where a broker's commission gets cut if you invest big chunks of money. On class A shares - those where investors pay a commission at the time of purchase, and the specific class singled out in the NASD's alert - breakpoints can start at anywhere from $25,000 to $50,000. By investing past the first breakpoint, a load of 4.5 percent might be dropped to a 4 percent charge, for example. It is worth noting that there are no breakpoints for shares in the B and C classes, which carry deferred sales charges and/or higher ongoing fees. Financial advisers who uphold their own commission by putting big-dollar investors into those classes rather than into lower-cost A shares have been pursued by regulators for fraud. Ultimately, if you invested large amounts in A shares and don't believe you received appropriate discounts, be prepared to demand that your financial adviser review the account activity and the breakpoint rules. From there, don't be afraid to complain to the NASD - www.nasdr.com - to try to set a case in motion. More on Fund Loads Kathleen Day, Washington Post 1-17 A preliminary review by regulators last year found that this "break-point" system was riddled with potential problems, including inconsistent or incomplete recordkeeping of the aggregate amounts individual clients invest in particular funds and a hodge-podge tracking system to make sure investors were charged the lowest rates they were entitled to. Eighty percent of new mutual fund sales are made through brokers or other financial intermediaries, according to the Investment Company Institute. That means most new money going into mutual funds travels through a system that is poor at tracking who should get discounts, according to the SEC. Proxy Reform Ian McDonald, WSJ 1-23 The SEC passed new rules Thursday requiring funds to disclose how they vote corporate proxies. The new rules require open-end mutual funds, closed-end mutual funds, and investment advisers to explain proxy-voting policies and procedures in public filings. Funds also must report their proxy-voting record annually to the SEC, making the information available to shareholders free of charge, upon request. The rules will be enacted in July, in time for the 2004 proxy season. More on Fund Fees Aaron Lucchetti, WSJ 1-15 The two congressmen, Rep. Michael G. Oxley (R., Ohio), head of the House Financial Services Committee, and Rep. Richard H. Baker (R., La.), head of the Subcommittee on Capital Markets, are expected to send a letter Wednesday asking for an investigation by the General Accounting Office. They want to know whether investors are paying too much in fund fees [do not confuse with LOADS]. The government review, which the congressmen want to be completed by April, would follow up on findings of a similar GAO report issued in 2000 that urged better disclosure of fund fees. The median expense ratio for diversified stock funds that have reported their data to Lipper increased to 1.46% of assets in 2002 from 1.37% in 2000. Rep. Oxley's letter to the GAO asks for information about current trends in mutual-fund advisory fees and so-called 12(b)1 fees that go toward the marketing and distribution costs of a fund. The letter also raises the question of whether trading commissions of mutual funds should be included in an overall expense ratio that would show investors the overall costs of investing in a fund. Many funds use "soft dollar" arrangements in which brokerage firms provide research or other services to the fund in return for trading commissions. Such trading costs factor into overall performance of a fund but aren't included in the annual expense ratio. And More on Fees Charles Jaffe, Boston Globe 1-23 A General Accounting Office study released less than three years ago that noted that investors might reap the most benefit from better disclosure of fee structures and the dollar amounts involved. Specifically, the GAO recommended that fund companies be required to disclose, in dollars, the amount you have actually paid them in fees, and that the disclosure should be made right at the bottom of an investor's regular account statement. Effectively, the line beneath your current account value and year-to-date performance would show your year-to-date fees in real dollar terms. That would eliminate the guesswork and the confusion that surrounds these fees. An investor would know the absolute cost for holding a fund, regardless of its performance. That is what the politicians should be pushing for now, instead of a study where the outcome is a foregone conclusion. And Even More on Fees Hope Yen, AP via Washington Post 1-29 The letter asks the GAO to examine what are called soft-dollar arrangements, in which mutual funds may select brokerages that charge higher commissions in exchange for extra services such as research reports and access to analysts. The SEC has found cases where soft money was illegally used to benefit the fund adviser rather than the investor. Roy Weitz, publisher of FundAlarm.com, said he believes fund fees are excessive. He said that while fund firms might be incurring additional costs in recent years, fees are still disproportionately higher in relation to a fund's asset base than they were 10 years ago. "If you look at what happened to the asset growth in the industry, if you have any belief in economies of scale, the question should be why have they not dramatically fallen," he said. "There may be a little bit of political grandstanding here," Weitz said. "But it shows the mutual fund industry that they are starting to sniff around in very touchy areas. . . . It's going to wake these guys up." Related article: Fund's Must Do 'Certification' - Burns & McDonald, WSJ
The Four Forces of Inflation: (1) The Federal Reserve is holding short-term interest rates at 40-year lows and has made clear it can do even more to stimulate borrowing and spending if that's what is needed to spur the economy and keep the general level of prices from eroding. (2) The Bush administration is pressing for an ambitious economic-stimulus program that would cut income tax rates for everyone and put more money in investors' pockets by eliminating taxes on dividends. (3) Many also see foresees deficit spending by Uncle Sam for years to come, in part to pay for the expected war with Iraq. Historically, "wars and big government spending campaigns are how you get inflation," said Paul Kasriel, economist at Northern Trust in Chicago. (4) The dollar is tumbling against the euro, the yen and other leading rivals. A weak dollar is potentially inflationary because it makes imported goods more expensive. A weak dollar also helps inflate commodity prices. Prices of major commodities have risen sharply during the last 12 months, driving the CRB/Reuters index of 17 key commodities up 27%. Kasriel argues that investors who don't expect the world to end anytime soon ought to be betting that the stage is set for a turn-up in inflation in a year or two, to possibly 3% or 4%. That could be good for corporate pricing power, earnings and the stock market, he said, but bad for Treasury bonds. Some analysts believe the greater risk remains deflation, not inflation. Steve Roach, an economist at Morgan Stanley in New York, said the global economy remains mired in a "post-bubble period of excess supply and depressed demand." In that kind of environment, he said, even the "mother of all stimulus packages" is unlikely to gain much traction. He still believes the trend in prices of many goods and services is down.
Barry found that every one of the 16 funds beat the benchmark S&P 500 in 2002. Fifteen of the 16 also beat the S&P in both 2001 and 2000. At a time when mutual funds have been under attack for poor performance, these figures are incredible. But true. Over the past three years, the average namesake fund whipped the S&P by more than 10 percentage points. For the past 10 years, the namesakes returned an annual average of 12%, compared with 9.3% for the index fund. A $10,000 investment in the average namesake 10 years ago was worth $31,600 last week. The same investment in the index fund was worth $24,300. Fourteen of the 16 namesakes beat the index fund over the past five years, and 11 out of 12 beat it over the past 10 years (the other four funds were started less than 10 years ago). The only fund that trailed the index fund in both those periods was Nicholas, but it beat 80% of all funds.
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If the tax treatment of dividends is changed, portfolio allocations could also change, and a complete analysis has to examine the impact of such adjustments. Let's briefly review the theory of portfolio choice in the presence of tax-deferred accounts. Suppose an investor has a tax-deferred account and a taxable account. He can invest in a risky asset (stocks) or a safe asset (corporate bonds). Stocks tend to have most of their payout in the form of capital gains, which are taxed relatively lightly. Bonds pay out interest, which is highly taxed. Hence it makes sense to put the bonds in the tax-deferred account, holding the lightly taxed stocks in the taxable portfolio. A neat theory, but, unfortunately, it doesn't hold up empirically. Professor Poterba, along with two other professors, John Shoven of Stanford University and Clemens Sialm of the University of Michigan, looked at the consequences of various investment strategies, using the actual returns on various mutual stock and bond funds over the last 36 years. Contrary to the conventional wisdom, they found that allocating stocks to the tax-deferred account, and holding extra income in non-taxed municipal bonds, was far and away the best strategy. There are two reasons for this discrepancy between theory and practice. First, most managed mutual funds are highly "tax inefficient." They typically pay dividends and capital gains distributions quarterly or yearly, making investors pay taxes they would rather defer. Second, municipal bonds typically have attractive yields compared with the after-tax yields on corporate bonds, particularly for investors in high tax brackets. Taken together, these two facts turn conventional wisdom on its head. Still, the conventional wisdom holds true for some mutual funds. If you invest in an index fund, a highly tax-efficient vehicle, the economists show that it is best to hold it outside your tax-deferred portfolio. Since index funds, and other tax-optimized funds, have become more popular in recent years, the conventional wisdom is looking much wiser these days. If taxes on dividends were eliminated, there would be an even greater incentive to hold stocks outside a tax-sheltered portfolio. Previous Studies The actual behavior of individuals investing in tax-qualified accounts and taxable accounts is discussed by Bodie and Crane [Bodie, Z. and D. B. Crane. 'Personal Investing: Advice, Theory, and Evidence'. Financial Analysts Journal, November 1997], Poterba and Samwick [Poterba, J. M. and A. A. Samwick. 'Household Portfolio Allocation Over The Life Cycle'. 2001), Barber and Odean [Barber, B. M. and T. Odean. 'Are Individual Investors Tax Savvy?' 2001], and Bergstresser and Poterba [Bergstresser, D. and J. M. Poterba. 'Asset Allocation and Asset Location Decisions: Evidence from the Survey of Consumer Finances' 2001]. These papers show that a large proportion of individual investors do not appear to take advantage of the potential benefits of optimal asset location. Huang [Huang, J. 'Taxable or Tax-Deferred Account? Portfolio Decision with Multiple Investment Goals' 2000] and Dammon, Spatt, and Zhang [Dammon, R. M., C. S. Spatt, and H. H. Zhang. 'Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing' 2001] show that taxable bonds have a preferred location in the tax-deferred account and stocks in the taxable account. Different management styles impose very different tax burdens on investors in taxable accounts as previously shown by Dickson and Shoven [Dickson, J. M. and J. B. Shoven. 'Taxation and Mutual Funds: An Investor Perspective' 1995] and Dickson, Shoven, and Sialm [Dickson, J. M., J. B. Shoven, and C. Sialm. 'Tax Externalities of Equity Mutual Funds'. National Tax Journal V 53, 2000]. Shoven and Sialm's Findings We show that the optimal location of stocks can switch from the taxable account to the tax-deferred account if tax-exempt municipal bonds are available and if the stock portfolio is sufficiently tax-inefficient. For high income -thus higher tax rate - investors, if stocks are sufficiently tax-inefficient and distribute more than 68.6% of their annual returns, their preferred location shifts from the CSA (conventional savings accounts) to the TDA (tax deferred accounts). Most of the actively managed equity funds in [their research] distributed more than 68.6%, and should therefore be located in the TDA. Passively managed index funds should be located in the CSA. The optimal asset location choice depends on the investment horizon. For example, the critical distribution level equals 54.0% if the horizon is 5 years and 73.1% if the horizon is 50 years. This effect is justified by the relatively lower effective taxation of stock mutual funds at longer time horizons, because the tax on the unrealized capital gains of stocks can be deferred for a longer period. [There is a large variation in the amount of distributions among the large mutual funds.] The Dreyfus fund distributed on average 93.9% of its annual returns over the period from 1979-1998, whereas the Investment Company of America fund distributed only an average of 52.8% over the same period. Actively managed funds with high asset turnover tend to distribute more than index funds. The Vanguard Index fund distributed on average only 32.5% of its annual total return over the period between 1979-1998. Medium-income individuals (should) hold fewer stocks than high-income individuals because the tax advantage of stocks (specifically capital gains) is relatively smaller for medium-income individuals than for high-income individuals. For a medium-income individual, the preferred location of stocks shifts to the TDA and municipal bonds in the CSA replace taxable bonds in the TDA if stocks distribute more than 88.5%.
There is room for rebuttal of these findings. The six years covered in this study were a time of high volatility and a stunning bull market. Also, Morningstar's system has gotten a significant facelift since the years this study covers. Since the system's 1985 start, Morningstar compared funds in four categories: U.S. stock, foreign stock, taxable bond, and municipal bond. But this past summer the firm began comparing funds in 48 narrower stock and bond-fund categories. The narrower categories avoid one group dominating top-ratings when in favor, such as when 90% of rated tech funds had five stars at the end of 1999. "Whatever rating system you use, there's a degree of performance-chasing," says Don Cassidy, a senior analyst with Lipper, Inc. "Funds that have performed well in the recent past will look good. But market leadership rotates, so you can't predict how long one fund or another will do well." Cash flows to highly-rated funds and unrated funds dwarfed those of funds with weak ratings. Figures in table below are in billions of dollars. (Ian McDonald, WSJ 1-15)
[Morey reported] three main findings [from his study]. First, low ratings from Morningstar generally indicate relatively poor future performance. Second, for the most part, there is little statistical evidence that Morningstar's highest-rated funds outperform the next-to-highest and median-rated funds. Third, Morningstar ratings do no better than the 'na‹ve' predictor for predicting fund performance. Simple historical average monthly returns were used as this predictor. Finally, it should be noted that these results do not refute the Morningstar rating system. Previous Studies A study in 1995, reported in both the Boston Globe and the Wall Street Journal, found that 97% of the money flowing into no-load equity funds between January and August 1995 was invested into funds which were rated as 5-star or 4-star funds by Morningstar, while funds with less than 3 stars suffered a net outflow of funds during the same period. Khorana and Nelling (Khorana, Ajay and Edward Nelling, 'The Determinants and Predictive Ability of Mutual Fund Ratings.' The Journal of Investing, Nov 1998) examine the question of persistence of the Morningstar ratings themselves. Specifically, the authors compare the Morningstar ratings from a group of funds in December 1992 to the ratings the funds received in June 1995. They find evidence of persistence, in that highly rated funds are still highly rated and low-rated funds are still low rated. However, there are a number of problems in that study. First, there is a survivorship bias problem, since the funds were selected at the end of the sample period rather than at beginning. Hence, any fund which had merged, liquidated or changed its name between the beginning and ending of the sample period was not included in the sample. Second, because Morningstar uses a 10-year risk-adjusted return as a major component of its ratings, and because there are only 2.5 years of data between the beginning and end of their sample, the ratings are based on overlapping data. [The Khorana and Nelling finding study is contradicted in a later study. See 'Longevity of Mutual Funds' Star Ratings' in the next article.] Selecting the Data [Given that Morningstar is changing how it ranks funds, I am including 'data selection' to show that Morey's findings should reflect future - as well as past - performance of Morningstar's predictive ability.] For selecting the mutual funds for our sample we use the beginning-of-the-year Morningstar On-Disk or Principia programs from 1992 to 1997. From the beginning-of-the-year disks we then selected only growth equity funds as identified by Morningstar. We choose only the growth investment category for three reasons. One, growth funds always have represented the largest number of funds in any one Morningstar investment objective and hence were more likely to reflect the average investor's choices. Second, a number of studies, (e.g. Brown (1999), Brown and Goetzmann [Brown, Stephen J. and William Goetzmann, 'Mutual Fund Styles', Journal of Financial Economics, 1997], Goetzmann and Ibbotson, [Goetzmann, William N. and Roger G. Ibbotson, 'Do Winners Repeat?' Journal of Portfolio Management, Winter 1994]), state that performance predictability may by due to the style of funds examined rather than skill. We attempt to control for this by only examining growth funds. Third, because we are examining the out-of-sample forecasting ability, each fund listed by Morningstar had to be identified with out-of-sample returns. Morningstar's Methodology Morningstar takes a weighted average of the 3-year, 5-year and 10-year risk adjusted returns. The 3-year number receives a 20% weighting, the 5-year a 30% weighting, and the 10-year a 50% weighting. For each time horizon, the Morningstar Risk scores are then subtracted from the Morningstar Return scores. Morningstar believes that for most investors their greatest fear is losing money which they define as under performing the risk-free rate of return an investor can earn from the 90 day Treasury Bill. Hence, their risk measure only focuses on downside risk. To calculate the Morningstar risk, they plot the monthly returns in relation to T-bill returns. They add up the amounts by which the fund trails the T-Bill return each month and then divide that total by the time horizon's total number of months. This number, the average monthly underperformance statistic, is then compared with those of other funds in the same broad investment category to assign the risk scores. It should noted that Morningstar also provides summary ratings for funds with less than 10 years of monthly returns: funds with more than 5 years of returns but less than 10 years use a 40% weighting on the 3 year risk-adjusted return and a 60% weighting on the 5 year risk-adjusted return; funds with less than 5 years of return data use a 100% weighting on the 3 year risk-adjusted returns; funds with less than 3 years of returns are not rated. Blume [Blume, Marshall, 'An Anatomy of Morningstar Ratings.' Financial Analysts Journal, 1998] provides evidence to suggest that funds with less than 10 years of returns are more likely to be rated as 5-star or 1-star since their weightings are based upon shorter samples. [In this paper, Morey summarizes the findings of previous studies. Portions of this article are quoted below to illuminated the findings in the article/study quoted above.] Star Ratings and Longevity of Mutual Funds In January 1997, Morningstar surveyed 7,857 funds of which 5,342 had less than 5 years' worth of returns (68% of the total funds surveyed). By comparison, in January 1993, Morningstar surveyed 2,532 funds, of which 958 had less than 5 years of returns (38% of the funds surveyed). Does Class Break-Down Matter? In November 1996, Morningstar developed a broad asset class breakdown in which the international equity funds had their own class. When this international equity class was developed, many international funds suddenly had considerably different star ratings because they were now compared to other international equity funds rather than all equity funds. For example, one international equity fund was rated as a 3-star fund in October 1996; yet in January 1997, after the broad asset class reorganization, the same fund received a 5-star rating. Another international equity fund was rated as a 2-star fund in October 1996 and yet in January 1997 received a 4-star rating. Hence, the star rating is somewhat dependent upon the broad asset class used. Longevity of Mutual Funds' Star Ratings In recent research, Warshawsky, Mullen, and DeCarlantonio (Warshawsky, Mark; Mullen, Lisa; and DeCarlantonio, Mary, 'The Persistence of Morningstar Ratings', TIAA-CREF Institute Working Paper, 2000) report that highly rated funds do not remain highly rated funds for very long after the time they are rated. Indeed, they find that less than half of all mutual funds rated 4 or 5 stars at the beginning of 1998 still held either of those high ratings at the end of 1998. Just the Facts Beware of High Dividends? Investors' renewed interest in dividends - fueled by the Bush administration's proposal to stop taxing those cash payments - could have dangerous implications. A high yield on a common stock - say, 5% or more - can indicate that the market doesn't believe the dividend can be sustained. What's more, many experts maintain that the best investment strategy with dividend-paying stocks is to pick companies that have a strong likelihood of raising their payments each year. An above-average yield usually is an indication that Wall Street believes a company is a slow grower. (Tom Petruno, LA Times 1-21) A Ceiling is on the Market For several weeks we have pointed out that just about all of the key indexes still have formidable overhead resistance to contend with - which is clearly in evidence at the Aug. 22, 2002, recovery highs. The sole exception was the NASDAQ, which made one sortie through its August peak but has since pulled back. Our advice at this point is to continue to sit tight while this scenario plays out. Remember, all of the intermittent rallies over the past two years have ended in failure, with lower prices prevailing and, in many instances, sharply lower prices. (Dan Sullivan, The Chartist via Washington Post 1-19) The 401(k) Trap The trusty old 401(k) has a surprising tax pitfall for many retirees - a rule that triggers taxes on Social Security payments. Social Security benefits start getting taxed when so-called "provisional income" exceeds $25,000 for taxpayers filing as a single person or a head of household, and $32,000 for married couples filing a joint return. If "provisional income" exceeds $34,000 for single and head-of-household taxpayers, or $44,000 for married taxpayers filing jointly, then up to 85% of Social Security benefits is taxed. Once all 85% of your Social Security benefits are taxed, then your tax rate starts to drop back down to the listed marginal rate corresponding to your income. In effect, this makes for a possible top marginal tax rate on your non-Social Security income of 50%. In 1985, some $9.6 million in Social Security benefits was subject to taxation, affecting about 3 million Americans, the IRS says. By 2000, 10.6 million taxpayers reported $90 million in taxable Social Security benefits. (Pamela Yip, Dallas Morning News 1-19) Roll-Overs 101 If you change employers and choose to roll over your 401(k) into an IRA, do a direct transfer of the money. If your employer makes the check payable to you, the company has to withhold 20% of the money for payment to the IRS. To transfer funds directly, all you have to do is fill out an application for a rollover IRA and send it to the financial institution of your choice; the new IRA custodian will process the transfer for you. Also, if the amount in your account is over $5,000, your former employer can't force you to cash out. If you stay in that plan, you'll still be able to direct where the money is invested, but you won't be able to borrow from your account. Tax-law changes in 2001 allow portability between retirement plans, so it's now possible to roll money from your retirement account into a new employer's plan, even if it's not the same type of plan [like a 457 government retirement plan or a 403(b) annuity]. (Michelle Singletary, Washington Post 1-19) 401(k) & Fund Statements Only about 10% of the financial-services companies that operate retirement plans tell investors in quarterly statements how much money they have made or lost during the life of the portfolio, according to a survey released last month by Dalbar Inc. About 55% of 401(k) providers show investors their personalized rate of return -- a measure that takes into account fund performance as well as investor contributions and withdrawals, according to the survey. But on many statements, those personalized figures are included only for the most recent quarter or year, but not since the start of the account. The upshot is that most investors have only a vague idea how well their retirement accounts have done over the long term. They can see that their account balance today totals, say, $52,600, but it is hard to tell whether they have gotten to that point after investing $40,000 that grew or by investing $60,000 that shrank. (Aaron Lucchetti, WSJ 1-17) Quick Facts, Stats & Opinions According to unofficial estimates by industry analysts, stock funds are headed for an outflow this month of $700 million or more (TrimTabs says funds are on pace for a $1.5-billion outflow). If that trend holds, it would mean the first January of net redemptions since 1990, when $274 million was pulled. About 18% of the roughly $666-billion net inflow to stock funds during the last five years came during January, according to ICI data. In 2002, for example, there was a January inflow of $19.4 billion, making it the year's second-strongest month. In January 2000, near the peak of the bull market for stocks, $44.5 billion poured in. (Josh Friedman, LA Times 1-30) `The experts misled me,' says a writer in the New York Times Magazine. `They forgot to mention that, in certain markets, aggressively investing for a rainy day can actually bring about a rainy day.' No, no, the experts didn't mislead us. The bull market reverberated all the way up with cautions such as Alan Greenspan's famous `irrational exuberance' comments in December 1996. (Chet Currier, Bloomberg 1-28) Through the end of November, foreign stock mutual funds had taken in more than $6 billion in 2002, compared to a more than $19 billion net outflow for domestic equity funds according to ICI. The average foreign stock fund's portfolio holdings trade at about 20 times their earnings over the past 12 months, compared to 25 times for the average U.S. stock fund, according to Morningstar. (Ian McDonald, WSJ 1-28) As of late last week, about 60% of tech companies had reported quarterly earnings, and their profits rose an average of almost 4% from the fourth quarter of 2001. In contrast, the earnings of consumer-staples companies are up more than 16% on average, with profits for companies that sell so-called consumer discretionary items up a heady 58% from a year earlier. (Gregory Zuckerman, WSJ 1-26) Some $43 million in fake currency was circulated nationwide in 2002, said Philip Elston of the Secret Service's LA office. That's down from the record year 2001, when more than $47 million in counterfeit currency was passed, but up 40% from 1996, when U.S. dollar bills underwent a major redesign to add more security features. Counterfeiting continues to be such a problem that the Bureau of Engraving and Printing is planning to revamp the currency again this year - and expects to continue making changes every few years in an effort to stay ahead of developments in printing technology. (Kathy Kristof, LA Times 1-26) A study by finance professors Brad Barber and Terrance Odean that appeared in the April 2000 Journal of Finance looked at the performance of customers at a discount-brokerage firm over the six years through January 1997. Their study found little difference in the pre-cost performance of those who traded the most and those who traded the least. But the difference in after-cost performance was staggering. The 20% of investors who traded the most earned 11.4% a year, while the 20% who traded the least garnered 18.5%. Meanwhile, the market returned 17.9% annually. (Jonathn Clements, WSJ 1-26) Reality shows won 15 of 18 half-hour time periods on Monday, Tuesday and Wednesday nights, and finished second in the other three time slots. (Bill Carter, NY Times 1-25) Half the 1,002 adults surveyed in a Jan. 10-12 USA Today/CNN/Gallup poll said the federal income tax they pay is about right. It's the first time in 40 years that Gallup said it found Americans to be comfortable with the share of their income they fork over to the federal government in taxes. (Caroline Baum, Bloomberg 1-22) For the fiscal year 2002, which ended on Sept. 30, non- defense discretionary spending, a category that excludes outlays for entitlements and other mandatory programs, rose 12.3%, according to the Congressional Budget Office. Appropriations for the Department of Education increased 18%. (Caroline Baum, Bloomberg 1-22) A survey released last year by Hewitt Associates showed that 80.5% of 401(k) participants didn't make any changes in their investment allocations in 2001. Most financial advisers recommend that investors review and rebalance accounts at least once a year. [It is safe to presume that some of the 19.5% who changed their 401(k)'s did not 'rebalance', but 'un-balanced'.] (NY Times 1-19) About 55% of 401(k) providers show investors their personalized rate of return - a measure that takes into account fund performance as well as investor contributions and withdrawals, according a survey by Dalbar Inc. The upshot is that most investors have only a vague idea how well their retirement accounts have done over the long term. John Markese, president of the American Association of Individual Investors, says that it's "almost impossible for average investors to calculate how they're doing." (Aaron Lucchetti, WSJ 1-17) `The idea that there can be no meaningful rebound in capital spending because of all of the excess capacity in the economy is a beautiful theory, but it's not supported by some ugly facts,' says Paul Kasriel, director of economic research at the Northern Trust. `Business equipment spending historically has led manufacturing capacity utilization, not the other way around.' (Caroline Baum, Bloomberg 1-17) The life expectancy of many smaller companies is growing shorter as today's fast-moving economy produces opportunities and then almost immediately begins destroying them. What's driving the trend? The strong downward pressure on prices that global and technological competition brings is collapsing profit margins across many industries, leaving fewer crumbs for small companies to capture. (Jeff Bailey, WSJ 1-14) When faced with an ambiguous situation, according to experts, most people will predict a negative outcome rather than a positive outcome. (Ira Hadnot, Dallas Morning News 1-5) Tech Tips & News SPOT Microsoft hopes to revolutionize the wristwatch with its Smart Personal Object Technology (Spot), which can send Web-based information over a radio frequency to miniature devices. Next on the agenda for Spot: high-tech refrigerator magnets that display customized data pulled from the Web. (Amey Stone, BusinessWeek 1-23) Claim Your Refund As the clock ticks toward a March 3 deadline to file a claim, states are promoting terms of a 4-month-old class-action lawsuit settlement with the music industry. The deal enables people who feel they were ripped off when they bought a compact disc recording to receive as much as $20 - no strings attached. No receipt is required. Consumers can apply for a refund over the Internet (www.musiccdsettlement.com) or call 877-347-4782. (Tim Jones, Chicago Tribune 1-20) Home Page Previous Factoid Top Sites
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