Mutual Fund Archives

How long will “January Effect” last?

Now that the politicians on both sides of the aisle have decided to take a bit more of the private economy in taxes and keep piling up debts for future generations, it is time for markets to return to normal seasonality and resume weighing up the prospects for different investment classes without constant reference to the hot political winds gusting out of Washington.

The question most investors should be contemplating is whether we will see a repeat of last year when the equity markets extended the “January Effect” through the entire first quarter of the year.

The FundLogik application indicates that now is the time allocate a larger portion of your assets towards the “risk” end of the spectrum. Whether that momentum peters our in February or steams on until the beginning of April remains to be seen.

In the 6 ETF FundLogik Portfolio, Non-US large cap equities (represented by EFA) and the Emerging Market Equities (represented by EEM) are ahead of SPY, TLT and DBC with QQQ bringing up the rear. However, if the January Effect does stretch further into the first quarter, it would be logical to expect QQQ to move up smartly in the rankings.

In the sample bond portfolio, Convertibles and Emerging Market debt funds are leading the pack. This suggests an appetite for more risk and a reach for yield.

In the sample equity portfolio, European Equities ranks at the top while Emerging Markets replaces Developed Markets, largely mirroring the FundLogik Portfolio ranking.

In the Blended ETF Portfolio, China (FXI) and International Real Estate (RWX) come out at the top of the list. China was volatile for most of last year but picked up steam after the leadership transition was completed. Real Estate is both a yield play and a capital gains play.

Political Risks will resurface

There are still a few more “political crises” to come, all of them just as manufactured as the one that was “narrowly averted” in the wee hours of the New Year. Whatever one’s political leanings, most can agree that the resolutions are of the “kick the can down the road” variety. Despite the promises to do better next time, the bottom line is that the new political line up in Washington looks the same as the old line up. There is little reason to expect a different outcome next time.

So, what does this mean for investors?

“January effect” should be fairly well pronounced this year. A combination of tax loss harvesting from a volatile 2012, the rehashing of the Euro crisis, leadership change in China and the political drama in the US means that institutions entered 2013 with a bias towards safe assets. Don’t be surprised to see money flowing back into QQQ and SPY favorites as fund managers rebalance for first quarter optimism.

Last year, the “risk off” trade was US Treasuries, the US dollar and, at times, precious metals. But these asset classes have rallied hard in recent years. It is hard to see how there is much upside left in these assets, particularly US Treasuries. The conditions which support the high prices will persist: a still massive US current account deficit, FED purchases of Treasuries and the fact that many other major currencies, particularly the Euro, don’t look very promising relative to the US dollar. Since none of those conditions appear ripe for change in the near term, one can expect continued fund flows towards two of the largest asset classes. There will continue to be “worry pieces” in the financial media about China, Japan or Middle East sovereign wealth funds looking to “dump” their Treasuries. The outcome will be no different; these large holders can shift at the margin but cannot dump. US dollars flowing out through the Current Account will flow back into US Treasuries and other similarly overpriced assets for the foreseeable future.

That does not mean there will be no volatility. Given the fact that both the household and government sectors are still massively in debt, even small shock events will continue to be magnified by the excessive leverage that remains in the system.

The real question is that of rebalancing. Will institutions remain happy to add to their piles of low yielding US Treasuries and cash as well as their non-yielding hoards of Gold? Or will we see more shifting towards riskier assets? At the margin, it is not the foreign sovereign wealth fund that drives the asset allocation but the large US institutions. If a consensus forms that equities and real estate assets are a better value than US Treasuries (ie. not just lip service but actual shifts in asset allocations), then we could see a rise in interest rates combined with a strong surge of liquidity into the stock and property markets. The stock markets will react positively while the US real estate market would probably just accelerate the digestion of the inventory hangover of the last 5 years.

At this point it is hard to say which way the balance will swing. Low growth in the G-8 economies could give comfort to asset allocators that the lofty values at the long end of the Treasury market will be supported by the FED’s commitment to “twisting” the yield curve. A change to the delicate balance however could send investors scrambling. The bloated FED balance sheet plus Bernanke’s commitment to keep interest rates low for as long as possible may not be enough to stem the rush for the exits.

For now, the FundLogik application is pointing towards a healthy “January Effect”. Position yourself accordingly.

A Different Kind of Short Squeeze

Ever since the markets started to destabilize in late 2007, regulators around the world have come up with new edicts to ban short selling, particularly of bank stocks. By squeezing out the shorts and making it tougher for new negative bets to be put on, the fervent hope of the regulators in the US and Europe was to buy the banks enough breathing space for the crisis to pass.

When it became obvious, in the darker hours of 2008, that the problem was not a short term one, Central Banks and Governments stepped around the equity markets and went directly to the source of the funding problem. The answer was to guarantee the liabilities of the banking system. In the US, this happens with depositors automatically through the FDIC but this was the first time such a massive, coordinated effort was undertaken to guarantee all bank creditors, even those with subordinate claims.

The gambit allowed most banking systems to start the rebuilding process although in countries like Ireland, it has landed the tax payer with a crushing new liability (estimated at nearly 40% of GDP). The financial authorities also recapitalized selected banks and in the case of the Federal Reserve, threw open the short term lending windows to push liquidity out on terms not seen in several generations.

This last week, we have now seen the advent of a new type of short squeeze, and most likely an unintended one at that. By changing the game for the CDS (Credit Default Swap) market (a voluntary writedown of Greek debt is not a default event), the EU has caused the issuers of CDS’s to change their view of the cover they need. Since CDS’s are unlikely to be triggered, the need for the CDS writer (typically an investment bank) to hedge is much diminished.

In the case of Euro sovereign debt, that means there is less need to hold short positions on the big banks that would get whacked by a sovereign default. The unwind of those shorts is part of the reason why the markets have greeted an otherwise unimpressive announcement from the EU with such enthusiasm.

How “Wall Street” really works

As we have argued in the past, the bulk of the professional financial world does not view the markets the way the mainstream financial press would have you believe. The trading floors are not populated with swaggering “Masters of the Universe” betting the balance sheet on single ideas.

Although there is the occasional story of tremendous profits (Soros breaking the British pound, Paulson betting against home mortgages), the bulk of financial firm profits derive from managing risk (and charging for the service). Firms take on liabilities (derivatives agreements, for example) and then try to match off the risks in correlated assets. If done correctly, the firm can profit by exploiting the different prices available in the market. At the bigger firms, a whole department is charged with adding up all these assets and liabilities on a real time basis so that managers can determine just how exposed the firm is at any one time.

The plan goes wrong from time to time in one of three ways: fraud, overconfidence and liquidity squeezes.

For fraud, we have an excellent recent example in the UBS case in September. A trader, Kweku Adoboli, managed to “fool” the system and blow a $2.3 billion hole in the bank’s finances (to say nothing of the reputational damage).

For overconfidence, the emerging story of how former Goldman Chairman, Jon Corzine has transformed MF Global from a profitable derivative broker into a flailing investment bank is a fresh take on an old problem.

But the most common pitfall is liquidity squeeze. Since the margins between the liabilities and assets which banks use are often very small (due to the competitive market forces), investment firms leverage their balance sheets to make their activities sufficiently profitable (on an equity basis). Leverage ratios of 20:1 are considered very prudent in most parts of the professional financial world (whereas individual experience is usually limited to an 80% Loan To Value mortgage which equates to a 5:1 ratio). Going into the Global Financial Crisis, many top tier names were sporting leverage ratios above 40:1. When markets are stable and funding is abundant, this is a formula for minting money. Indeed as late as 2006, financial firms accounted for over 40% of corporate profits in the US. However, when market values become volatile and funding dries up, leverage works against the system, losses pile up quickly and insolvency is a serious risk.

Why does this matter?

Since better than 80% of market transactions are initiated by financial intermediaries, it is important to understand what drives their behaviour. Listening to Financial “Captains of Industry” waffle on about capital raising and discovering tomorrow’s new opportunities will tell you as much about their firms’ trading plans as Coke’s latest ad campaign will tell you about the risk of getting fat. That doesn’t mean you should not invest any more than it means you cannot enjoy a sugary cola from time to time. It does mean that you need to make sure you tone out the marketing fluff and concentrate on the useful information available in the market.

That is why using objective tools to measure the market is so important. If we rely on emotions, which is what financial news writers get paid to stir up, we will end up most despondent at the bottom of the price range and most euphoric at the top.

Curbing your enthusiasm

If we look at the Fund King rankings, it is still evident that the “melt up” (yes, the mainstream financial media is working hard to peddle that as a legitimate term) is still looking very short term in nature. When you consider that the latest source of buying pressure is driven by trading desks rebalancing their risk exposure, one can see that this is not a typical building block for a multi-year bull market. We would expect a serious lack of follow through this week.

Two Fund King Portfolios to look at:

The Global ETF Portfolio would only have you positioned in Bonds, Gold and Japanese Yen.

Global ETF Ranking

The T Rowe Price portfolio, which boasts some top performing equity funds would have you all in cash.

T Rowe Price Rankings

Risky Business

After 30 years of a mummified political existence, the Egyptian political scene exploded into protests and unrest last week, threatening to destabilize the Arab world’s largest country.

Although the Egyptian financial markets barely register from a global perspective, the unrest reminded investors that the world remains a risky place. The US dollar rose, gold perked up and oil, which is not a big Egyptian export, was back on the rise.

If you read Stratfor.com’s excellent coverage of the crisis, you will note that the most likely outcome for this crisis is a fresh face from the military who will rapidly move to:

  1. close down the Muslim Brotherhood,
  2. shore up the US alliance, and
  3. quietly assure Israel that the 1977 Peace Deal is still in effect.

But the fireworks along the Northern bit of Africa are not the only worry in the world.

US Growth

In a detailed letter this week, John Mauldin takes apart the latest US GDP numbers and finds that there were more statistics than recovery in the numbers. It makes for interesting reading, especially when one considers how the inventory numbers change because of the change in oil prices over the quarter. The issue of US growth is tremendously important because much of the world’s monetary policy (in particular, the fast growing developing markets like China) are tied to the FED through fixed or nearly fixed exchange rates. Weak growth means that the FED will continue to err on the side of accommodation, which means that US interest rates will remain low until the bond market rebels and/or inflation becomes too obvious to hide.

The US economy is starting to pick up but at a growth rate well below that of previous post recession recoveries.

Inflation

Related to the sluggish US growth rates and resultant accommodative monetary policy, it looks like we will see commodities surge ahead once again. In this week’s rankings, Silver (SLV) and Food (DBA) score highly with Base Metals (DBB) and Oil (OIL) putting in lower but respectable scores. Commodity Related ETFs like Russia (RSX), Global Energy (IXC), and Fidelity Funds like Select Energy (FSENX) and Natural Resources (FNARX) are also near the top of our various portfolio lists.

The strength is due to the solid demand for these commodities which is driven in no small part by the massive supply of dollars floating around the globe. The desire to turn the seemingly unlimited supply of dollars into more supply restrained commodities looks set to remain a theme for the foreseeable future. Higher prices will eventually entice more suppliers onto the market but the lag should be prolonged enough to make some money from the next leg of the commodities rally.

Sovereign Debt Crisis: Japan

Another story that should have caused more concern than it did was the downgrade of Japan’s long term debt by S&P. The rating drop from AA to AA- doesn’t seem momentous compared with some of the sovereign crises we have experienced over the past couple of years. However, two things bear watching. The first is that ratings agencies historically have been behind the curve in downgrading sovereign debt. If S&P is downgrading now, this may be the start of a more serious cycle. The second question to ask is: “Who will buy Japanese debt?” In the past, this was not a terribly interesting question because the bulk of JGBs (around 94%) were absorbed domestically. With the aging of Japan, it is not unreasonable to expect that the robust savings rate, which allowed Japan to self fund its government debt, will shift into reverse. Last year the Japan Post Bank (the biggest owner of JGBs at more than 20% of the total) announced that it would no longer be a net buyer from 2011. According to the Economist, gross debt to GDP is an eye watering 190% and rising (although other sources already quote figures in the 200% plus range) so having a major buyer like the world’s largest bank (by deposits) pull out of the market is not a small issue. The pricing mechanism for JGBs looks set to change as foreign investors are asked to bid for bigger slices of Japanese debt. On the negative side, it will not take much of an interest rate hike to overwhelm Japan’s fiscal budget with interest expenses. On the positive side, the pressure from the bond market could be enough to spur Japan to enact much needed but unpopular reforms that could set the stage for an escape from two lost decades. However, any good news will only come after a period of painful adjustment.

So what should an investor do?

We think the best approach is not to run away from risk but to manage it. The recovery from the Global Financial Crisis has been rocky and looking around at some of the overheating in China, the rolling sovereign debt crises along the rim of the EU and now the turbulence in the Arab world, it is obvious that some of these trends will lead to trouble down the line. We think the solution lies in identifying and monitoring a fairly broad universe of asset classes and recognizing that the institutional money in the market will be draw towards and scared away from different asset classes at different times. By deploying one’s investment funds in the asset classes that are benefitting from the rising tide and avoiding those where sentiment is draining away, we think one can achieve a solid return on one’s portfolio despite the generally directionless but highly volatile overall direction of the financial markets.

CIVETS anyone?

We have received a number of questions about the CIVETS market (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and how they compare to the previous emerging markets grouping, the BRICs (Brazil, Russia, India and China). We decided to see how far along in the cycle we might be by using the System to pick when and where to invest in each grouping.

CIVETS markets

So, if you were wondering if it was too late to jump on the bandwagon, this chart suggests that there is still some money to be made in CIVETS.

Selecting an Asset Universe

The Fund King System is all about promoting systematic investment as a way to reduce the emotional component of investing that so often ends up hurting out portfolio’s performance.

This week, in response to several users’ comments, I am going to outline how to construct an Asset Universe that will suit my needs and also work well in the Fund King System. I fully expect that someone else would follow the same process and come up with a different mix at the end of the process.

I approach the process in a top down manner because my role is to be the Asset Allocator for my investment funds. Other people are going to execute trades, hold the securities and decide which securities will meet their obligations to me. By leveraging off of that expertise (which I am already paying for in commissions, custodian charges and management fees), I can invest in a broad range of asset classes without having to visit a single factory.

To do “top down” correctly, I need to start broadly and then trim down my options to get a portfolio.

The first question to start with is: What do I know? Am I stronger in equities, bonds, commodities, currencies or real estate?

The second question is: What can I learn about? Are there any areas that I could expand into with a reasonable amount of effort?

Third, check for holes. Going forward it is reasonable to expect periods where developed market stocks and bonds may be stuck in a downtrend. At that point, I want to have some commodities, metals and/or currency opportunities to continue making money while more traditional asset classes sit on the sidelines.

This should give us a good list of sectors from which we can build up a shopping list of mutual funds, ETFs and/or ETNs.

Investing in what you know

Most of us have grown up with equity investment but some have cut their teeth on the bond market over the last three decades of almost uninterrupted bull market. Perhaps you have a strong feeling about precious metals as a hedge against paper money. You might think that the world is going to end up paying much more for foodstuffs or maybe you want to buy into real estate.

As an economic participant in the markets every day, you actually have access to a tremendous amount of information. Start building up your universe of investment opportunities with ones that you know well. If the universe starts to get too crowded or you find something more exciting in the next two steps, you can always substitute.

Try to keep things as broad as possible. You may be tempted to start picking individual ETFs or fund families but you will end up with a stronger universe and a better refresh process if you take the time to evaluate a broad spectrum of products, ideas and opportunities.

Investing in what you can learn about

It is unlikely that any one of us will possess enough information to feel equally comfortable with every asset class. However, since we are looking at funds (mutual funds and ETFs) a lot of the nitty gritty details are dealt with by the fund manager whom we are paying with a management fee.

This is where most of us have to step outside our comfort zone. But it is important to remember that we are not going to be auditing Eastern European bank balance sheets, Asian petrochemical refineries and South American airframe manufacturers. The idea here is to find assets that may grow in the coming few years. The emphasis is on “may”. If we pick one or two dud assets in our universe, it will not matter overly much because our trading system will keep us invested in the most promising assets. But we do not want to get too complacent. If we pick too many similar or underperforming assets, the system will just be choosing between mediocre investments. As any chef will tell you, no amount of culinary skill will make a great meal out of lousy ingredients.

If we have been primarily US bond investors, it is time to venture into equities (domestic and foreign), emerging market debt, commodities and perhaps even currencies.

What if I don’t like junk bonds?

I don’t like JNK…do I have to include it? No. In fact, decide to actively exclude it. What do I mean by actively? Just admit you don’t like JNK and move on. When your neighbor brags about how he made money one week in the future trading JNK on margin, you can nod politely and imagine all the loss making positions that he neglected to bring up with you. The idea is to make money on the whole portfolio. The actual assets are just tools towards that goal.

If you have a bag of preconceptions that you have brought to the investment process, this is the one place where you can unpack and use them. It may make sense for you to include Russian Equities or a soft commodity ETF in your universe from a pure asset allocation point of view. However, if the idea of dabbling in commodities or investing in Russia makes you uncomfortable for whatever reason (logical or otherwise), then it makes sense to exclude them from consideration at this point in the process.

As a live example, I included home builders (XHB) and Spain (EWP) in my universe as the Global Financial Crisis started on the logic that they would fall sharply and then have some sort of recovery. Both eventually staged rebounds significant enough to be ranked in my System. But because I had strong negative feelings about the underlying assets, I not once but twice (because the rebounds happened at different times) hesitated to buy when the signal came up, kicked myself and bought just as each was peaking and did not cut my losses immediately when they fell back into the general pool. As a result, I allowed my emotions to interfere with what was otherwise a pretty decent investment strategy designed to capture a meaningful rebound in two bombed out assets. After these two helpings of humble pie, I decided to eject the offending ETFs from my universe. There was nothing wrong with the ETFs or the way they performed. The problem was me. So, with plenty of other investment fish in the sea, I took my lumps and moved on.

Leveraged ETNs may be a good category to exclude in the beginning. The reason leveraged ETFs cause trouble is not because they are inherently bad investments but because most retail investors do not understand how to use them and do not have the time (or inclination) to watch them throughout the trading session.

Where are the holes?

We have all heard about diversification and its benefits. Those benefits exist but they were a bit oversold during the “Great Moderation” in the 80s and 90s when most asset classes were in a bull market. We approach diversification in a different way. Rather than holding a diverse basket of assets, we concentrate our investment dollars on the assets that look the most promising. However, to do that, we must consider a broad range of assets in the first place, rerank our universe regularly and invest according to the system (ie. do not let “gut feelings” intervene). Diversification for us means having enough different assets to prepare for the different market conditions that are likely to crop up over the medium term (3-5 years).

So, look for holes in your list of potential assets. You do not need to add a lot of currencies but if you are US based, why not add the Japanese Yen or Euro? You do not need to aspire to becoming a pit trader in Chicago to include some precious metals , industrial metals or a soft commodity basket. And, although you may fancy yourself as a risk taking equity person, there is no reason not to include some short and medium term government bond funds for those times when no one is making money in equities no matter how aggressive your trading stance. Also, you might want to consider some sector funds. While the market has been volatile, the overall direction has been neither particularly positive nor negative over the last decade. Investment flows have become “rotational” as professional investors seek to eke out performance by chasing down the next hot sector.

OK, now that you know where to look, how do you find the funds and ETFs that meet your criteria?

The first place to look is your online broker. TD Ameritrade, Schwab, Fidelity, Vanguard and all the other providers all have excellent tools which can help you zero in on funds and ETFs that match your shopping list.

You want to check beta vs. the index, and if you can see it, the top 10 holdings (just to make sure that what you read on the label of the fund is what you think should be inside). For ETFs, you should check the daily volume. If you are going to be a major (over 5% of daily volume) trader by placing a buy or sell order, you might want to look for a more liquid alternative. ETFs have a bid-ask spread which can get unacceptably wide if the Similarly, you should also make sure that any mutual fund you invest in has a decent amount of Assets under Management (AUM). You do not want AUM to drop to a point that the fund manager decides to close the fund or merge it with another. Nor do you want to be in a position where one large redemption will impact your interest.

ETNs have one more level of due diligence since they are senior obligations of the bank/sponsor that issues them. Whereas the assets in a fund belong to the share or unit holders even if the management company goes under, the assets of an ETN are part of the bank balance sheet that has to satisfy all creditors. If we had not just gone through the Global Financial Crisis, most people would not care about the difference. Now that we know better, just make sure that you are comfortable with the counter-party risk. If in doubt, leave the ETN on the cutting floor and move on.

How many assets to you want to watch?

Try to whittle the list down to 20. Why 20? Because this is an active process and trimming the list to just 20 assets will force you to think carefully about each one. What if you chose a mid cap value ETF over a mid cap growth? If the equity markets are not in a cooperative mood, the System will tell you not to hold either.

Remember, more does not always equal better. If you have 5 tech funds in your universe, they will all move pretty much together relative to non-correlated assets like Silver or Treasuries.

If you are stuck for ideas, ETFdb.com has just put out a page with a number of useful sources that can help you. Check out this page of 50 free ETF tools.

So what is the final result?

For my “Seeking Alpha” Portfolio, I have come up with this. Is this the end of the process? Hardly. I plan to review this list once a quarter to fill holes and make sure that I have all of my investment bases covered. For example, I might want to drop one of my developed and one of my emerging markets and replace them with a Real Estate and another Fixed Income choice. That would add better balance to the universe.

Equities

Developed Markets
SPY – US Equity Market
FEZ – European Equity Market
EWH – Hong Kong Equity Market
EWY – Korean Equity Market
EWT – Taiwan Equity Market
Sectors
IXC – Global Energy Sector
IXG – Global Financial Sector
XPH – Pharmaceutical Sector
Emerging Markets
EWZ – Brazilian Equity Market
RSX – Russian Equity Market
EPI – Indian Equity Market
FXI – Chinese Equity Market
EWW – Mexican Equity Market
TUR – Turkish Equity Market

Fixed Income

TLT – 20+ Year US Treasuries

Currencies

FXY – Japanese Yen
FXE – European Euro
FXA – Australian Dollar

Commodities

DBA – Agricultural Futures
GLD – Gold
Weekly Ranking of the Seeking Alpha Universe

The Seeking Alpha Portfolio

As mentioned in last week’s post, we switched out of 370 shares of EPI (Indian Equities) to invest in 320 shares of DBA (Agricultural Commodities Basket). The EPI netted us $9190.25 (and a short term capital loss of $710.95) and we bought the DBA for $9371.15. Our cash balance falls to $345.95.

Last week, we participated in the general rebound to the tune of +4.11%. Overall, we are still down 3.53% from our starting point on November 15th.

There are no changes in the ranking this week so we will see how our portfolio of Hong Kong, Turkey and Agriculture fares in the choppy markets that seem destined to persist for the foreseeable future.

One final note

Just to follow up on an issue we explored earlier, it seems that hedge fund performance has generally not lived up to expectations (Bloomberg article). This might lead to some sell off in some of the favorite names. One of the biggest, AAPL, may be in for a bit of profit taking as the year closes and redemptions need to be paid out. We do not hold AAPL (long or short) nor are we suggesting that you should take any action. We are using the stock simply as an indication of the magnitude of the Hedge Fund redemptions.

Featherbedding

For any American who travels in Europe or Japan, one of the more striking contrasts comes with the train system. The trains are a clean, efficient and even enjoyable form of intercity transport. The nagging question for decades is why we don’t have the same level of train service in the US.

French Train

There are many reasons (cultural, geographic, and political) but the one I want to zero in on is featherbedding because some of the issues tie directly to today’s financial industry and has implications for us as investors.

Up until the 1940s, railroads (passenger and freight) were every bit as prevalent in the US as they were in Europe. However, in the 1950’s, the technology of transport started to change once again. On the railway front, new safety and management techniques were developed and implemented to improve the efficiency of the railroads for both passengers and freight. At the same time, the airline industry, the long haul trucking industry and the interstate system were also developing quickly to compete for business.

By and large, the railway industry responded to the outside pressure by imposing barriers, complex work rules and unnecessary procedures to stem the employment losses which resulted from the productivity enhancing new technologies. Whether those rules were imposed from a federal level (Interstate Commerce Commission) or by railway unions (featherbedding), the results were the same. Cabooses rode at the back of every freight train with a full crew well into the 1980s in both the US and Canada, decades after their usefulness had been replaced by simple technologies. In one famous business study of the Union Pacific Railroad, it was found that 14 layers of approval were required to ship a product on a freight car even though the stationmaster on site had all the information and tools necessary. Featherbedding not only involved creating make-work schemes for unionized staff, it also meant creating overly complex procedures and overpaying for management as well.

Mainstream economists are not particularly bothered by the practice of “featherbedding” or at least not the bits that arise from collective bargaining rather than government regulation. The comfort with the practice rests on the idea of “economic rents” (profit in excess of what one might expect theoretically) and how the “economic rents” are shared. Whether it goes to the CEO, shareholders or the staff, it is income and is generally treated the same in most models. That is fine for a short time when an industry is making large profits (or even super-normal profits, if you subscribe to that notion). The car companies formerly know at the Big Three were able to sustain multiple layers of featherbedding for decades while European, Japanese and now Korean car makers chipped away at the US market. On the government side, the politically protected and overmanned US Post Office, with offices in every zip code, was unable conceive of much less offer overnight delivery. A small company called Federal Express operating after hours from the airport in Memphis invented a whole new business service in that gap.

What does all this have to do with Finance?

Well, the same things that happened to the Railroad, Automobile and US Post Office are happening now to the large financial firms. Just as people from the 40’s couldn’t imagine a world without the big railways, people from the 60’s couldn’t picture a car industry not dominated by Detroit and people from the 70’s could not imagine anyone but the postman delivering a letter, we are now faced with the TBTF (Too Big To Fail) financial giants.

There was a time before debit cards and PayPal when we depended upon bank tellers to get cash and checkbooks to pay bills. The need for solid banks with vaults in every town was obvious. Financial information was difficult to gather and analyze, so there was a significant premium attached to those firms which had the scope to do the job. Size was all important. With size comes complexity but also efficiencies which, in a fully competitive market, are passed as savings to the consumer. But stocks are not socks and bank accounts are not household appliances (despite an early to mid-80s diversification attempt by Sears). The industry, always piously invoking concern for the security of the public’s money entrusted to these same institutions, erected legal, statutory, industry and procedural barriers to entry in order to maintain pricing power. The fact that much of the excess profits thus created ended up in bonus pools has in no small way shaped the career trajectory of most MBA graduates in the last two decades.

Prior to the improvements in technology and information availability, there was nothing much one could do about the situation. Indeed, financial services grew from 4% of the US economy in the 1970’s to 8.3% in 2006. From a pretax profit point of view, growth was even more dramatic, rising from 13% of pretax profits in 1980 to 27% in 2007. Demand for financial services increased and the industry responded by doubling as a proportion of the US economy. Some of that growth was necessary but as the accompanying graph to the Stern Report shows, the future trajectory is far from assured.

From Stern Business School Blog

So, what will drive change? On the one hand, deleveraging should reduce the demand for financial services and products as the US consumer rediscovers savings and reduces risk appetite. On the other hand, the ability to access information and track investments on a personal computer is superior to what was available on the most high end dealing floors only a few years ago. The industry is already responding by offering financial products at significantly lower cost (low or no-load mutual funds, ETFs, low commission trading, online banking and other services). Although only time will tell, the initial indications are that the low cost products can be as good or better than the older, high cost products that they replace. We have already seen the exit of many hedge fund managers who were unable to deliver on the core promise to make money in all types of markets. Like the HELOC junkies in the residential market, it appears that most hedge funds grew primarily on the back of the loose money regime and benevolent markets that largely prevailed from the Asian and LTCM crises onwards.

How will this affect you?

Since long term investment returns can be severely impacted by costs (fees paid out are not available for compounding over multiple years of investing), the ability to find the right product at the right cost will be more important than ever. Mutual funds with 5% loads, insurance products with 8% fees baked in and 2/20 hedge funds will still exist. The question is whether they continue to offer value for money or whether the extra money you pay over a lower cost option is only going towards featherbedding someone else’s retirement.

The financial technology is changing and how you react as a consumer of financial products will have a large impact on the final result of your investment program. Companies and individuals who did not take advantage of the advances in long haul trucking, overnight delivery, air travel and efficient Japanese cars definitely missed out on opportunities. The same thing is happening today in the financial arena. Not all new products will be good ones and certainly some of the old ones deserve their reputations but a critical evaluation of those products will lead to better investment outcomes.

Many in the financial industry can’t or won’t see the shift. They are blinded by their own self interest which, when challenged, is recast as a greater societal interest. Over and over again, we have been told that America needs a strong steel industry, a strong auto manufacturing industry, a strong textile industry, a strong semiconductor industry, a strong pharmaceutical industry and so on. While these may be true statements, often the price for maintaining strength beyond what the market can bear comes in the form of protectionist barriers (in the manufacturing areas) , direct taxpayer subsidy (in the case of the TARP or the car companies) or indirect cost (in the case of the current quantitative easing program). The risk of massive financial failure means that we will never know what would have happened if a Resolution Trust regime had been imposed to wind down overextended bank balance sheets (certainly lending shrank anyway). The cash has been printed and doled out, the bonds have been issued and the debt will be on the books for us and future generations to pay as taxpayers.

But as consumers of investment services, we need not further subsidize the financial industry by continuing to buy overpriced product. With the information and technologies available today, the ability to pay for the investment value actually provided has increased dramatically. If you chose not to take advantage of these new capabilities, you certainly won’t hear any complaints from TBTF financial institutions. But don’t expect any “thank you” cards either. One critical element of “featherbedding” is the sense of institutional entitlement that drives the implementation and maintenance of such schemes well beyond their economic justification.