Dear ,
Welcome to the February 2009 edition of the Brighton Bulletin. This edition will incorporate the findings of my first survey. I truly appreciate the responses I received and hope that the "new and improved" Bulletin will adequately reflect everyone's input. As always, please feel free to contact me with questions/comments, etc. Enjoy!
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Monthly Retrospective
"January Effect?"
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January is just not a great month. Sure, you have the NFL playoffs but you've got the post-holiday hangover, the holiday AMEX bill is due and its cold, really cold outside for most of us. For years, academics have researched and speculators have gambled on an anomaly referred to as the "January effect". The theory is that institutional investors, principally mutual fund managers, sell of their under-achievers late in the prior calendar year to avoid reporting them on their annual reports. After waiting 31 days, they re-purchase these securities for various reasons. Thus, these "under-achievers" out-perform in January. These are typically poor quality, small to micro cap stocks. It doesn't appear that it worked this year, not surprisingly. A secondary anomaly is that as January goes so goes the year. Let's hope that one doesn't hold in 2009!
January continued the negative trend of the last 6 months as what hasn't performed well didn't perform well and what has performed well performed well. What does that mean? Equities were down. Financials and REITS in particular. The Financial sector of the S&P 500 is now down (67%) for the last 12 months! Global equities were down with the MSCI World Index matching the performance of the S&P 500 (down 8.94%). Intermediate and Long-term Fixed Income was down, though not much. Short-term Treasuries were up and Municipal Bonds were up. The surprise to me was High Yield Bonds were up as well. Why is that surprising?
I've written a bit about the corporate bond market in the last couple of months. By late November, market participants were so worn out trying to evaluate default risk in corporate bonds and so fearful of being left standing when the music stopped they had oversold corporate bonds to the extent that the implied default rate exceeded highest annual default rate during the Depression (16% in 1932 according to Moody's)! Even now, Moody's estimates speculative grade defaults to exceed 12% in 2009 and it's distressed index is at an all-time high. Given that level of risk, why would high-yield bond perform well? I don't know.
Standard and Poor's aggregate earnings estimates suggest the economy could find a bottom in the 2nd quarter of 2009. Historically, equity prices have found their own bottom roughly 4 to 6 months prior the the economic bottom. IF S&P is correct, we could have found the bottom in November (around 740) or in the next few weeks. It wouldn't be surprising to see around 650 as a bottom. However, by year-end we could climb to as high as 950. I know, we started the year around 930 so that's only a 4 to 5% return - not really what we all have in mind coming off of 2008! Now, however, the corporate bond market may offer more upside. Given the possibility of an oversold market, any sign of recovery may reduce default risk which will lead to improved performance. There are high quality, highly rated global bond funds yielding 16% right now. As always, everyone should periodically review and adjust their asset allocation. As I noted in my prior commentary, the beginning of the new year is a good time for that review. Most likely, you're now overweight in fixed income. It might make sense for some, tactically, to remain overweight in fixed income for 09. It may also make sense, for some, to shift to an overweight for the year. To me, the key is to be in global bond funds favoring high quality issuers. Again, other considerations play a role so don't hesitate to get your advisor involved.
I remain pessimistic regarding equities for 2009 overall but continue to believe we're bouncing along or near the bottom now. The later half of 2009 could be more promising. Within equities, I'd favor value over growth, large or small, and would monitor the emerging markets closely. They could recover more quickly as the global recession eases. Within fixed income, I'd favor high quality over high yield. However, if you have the risk tolerance, distressed debt could be intriguing. Finally, I am a proponent of alternatives in portfolios. I continue to believe in market neutral, merger arbitrage, commodities and wouldn't under-estimate global real estate.
I would be happy to sit down with you to discuss your current allocation, objectives and risk tolerance and work with you to revise your allocations, if necessary. Sometimes an objective second opinion can be enlightening. This can include a review of your 401k as well. It's surprising how many 401k portfolios drifted toward U.S. Large Cap Growth! Click below to email me and schedule a meeting.
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Financial Advisor Survey
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I have added a VERY BRIEF survey designed to determine if we're providing the right services and communications for our clients and potential clients. I've also added a fun question at the end. Please take a moment to complete the survey. Your responses are very helpful to me!
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Small Business Corner Retirement Plan Options
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Retirement plans are usually either IRA-based (like SEPs and SIMPLE IRAs) or "qualified" (like 401(k)s,
profit-sharing plans, and defined benefit plans). Qualified plans are generally more complicated and expensive to maintain than IRA-based plans because they have to comply with specific Internal Revenue Code and ERISA (the Employee Retirement Income Security Act of 1974) requirements in order to qualify for their tax
benefits. Also, qualified plan assets must be held either in trust or by an insurance company. With IRA-based plans, your employees own (i.e., "vest" in) your contributions immediately. With qualified plans, you can generally require that your
employees work a certain numbers of years before they vest.
With a dizzying array of retirement plans to choose from, each with unique advantages and disadvantages, you'll need to clearly define your goals before attempting to choose a plan.
For example, do you want:
· To maximize the amount you can save for your own
retirement?
· A plan funded by employer contributions? By employee
contributions? Both?
· A plan that allows you and your employees to make
pretax and/or Roth contributions?
· The flexibility to skip employer contributions in some
years?
· A plan with the lowest cost? Easiest administration?
Simplified employee pension (SEP) plan
A SEP allows you to set up an IRA (a "SEP-IRA") for
yourself and each of your eligible employees. You contribute a uniform percentage of pay for each employee, although you don't have to make contributions every year, offering you some flexibility when business conditions vary. For 2009, your contributions for each employee are limited to the lesser of 25% of pay or $49,000. Most employers, including those who are self-employed, can establish a SEP. SEPs have low start-up and operating costs
and
can be established using an easy two-page form. The plan must
cover any employee aged 21 or older who has worked for you for three of the last five years and who earns $550 or more.
SIMPLE IRA plan
The SIMPLE IRA plan is available if you have 100 or fewer
employees. Employees can elect to make pretax contributions in 2009 of up to $11,500 of pay ($14,000 if age 50 or older). You must either match your employees' contributions dollar for dollar--up to 3% of each employee's compensation--or make a fixed contribution of 2% of compensation for each eligible
employee. (The 3% match can be reduced to 1% in any two of five years.) Each employee who earned $5,000 or more in any two prior years, and who is expected to earn at least $5,000 in
the current year, must be allowed to participate in the plan.
SIMPLE IRA plans are easy to set up. You fill out a short form to establish a plan and ensure that SIMPLE IRAs are set up for each employee. A financial advisor can do much of the paperwork. Additionally, administrative costs are low.
Profit-sharing plan
Typically, only you, not your employees, contribute to a qualified profit-sharing plan. Your contributions are discretionary-- there's usually no set amount you need to contribute each year, and you have the flexibility to contribute nothing at all in a given year if you so choose (although your contributions must be "substantial and recurring" for your plan to
remain qualified). The plan must contain a formula for determining how your contributions are allocated among plan participants. A separate account is established for each participant that holds your contributions and any investment gains or losses.
Generally, each employee with a year of service is eligible to participate (although you can require two years of service if your contributions are immediately vested).
401(k) plan
The 401(k) plan (technically, a qualified profit-sharing plan with a cash or deferred feature) has become a hugely popular retirement savings vehicle for small businesses. According to the Department
of Labor, an estimated 48 million American workers are enrolled in 401(k) plans with total assets of about 2.4 trillion dollars. With a
401(k) plan,
Employees can make pretax contributions in 2009 of up to $16,500
of pay ($22,000 if age 50 or older). These deferrals go into a separate account for each employee and aren't taxed until distributed.
Generally, each
employee with a year of service must be allowed to contribute to
the plan. You can also make employer contributions to your 401(k) plan--either matching contributions or discretionary profitsharing
contributions. Combined employer and employee contributions for any employee in 2009 can't exceed the lesser of $49,000 (plus catch-up contributions of up to $5,500 if your employee is age 50 or older) or 100% of the employee's
compensation. In general, each employee with a year of service is eligible to receive employer contributions, but you can require two years of service if your contributions are immediately vested. 401(k) plans are required to perform somewhat complicated testing each year to make sure benefits aren't disproportionately
weighted toward higher paid employees. However, you
don't have to perform discrimination testing if you adopt a
"safe harbor" 401(k) plan. With a safe harbor 401(k) plan, you
generally have to either match your employees' contributions (100% of employee deferrals up to 3% of compensation, and 50% of deferrals between 3 and 5% of compensation), or make a fixed contribution of 3% of compensation for all eligible employees, regardless of whether they contribute to the plan. Your contributions must be fully vested.
An advisor is not necessary to establish a plan. You can do it on your own with a number of firms such as Vanguard. However, an advisor can be highly beneficial regarding plan selection, implementation and on-going maintenance. I recently spoke with an individual that spent 6 months evaluating 6 different retirement plans for this small business while also trying to run the business! He didn't exactly find this a stimulating exercise. The advisor can manage this process for you so you can do what you do best - grow your business!
As an employer, you have an important role to play in helping your employee's save for the future. Now is the time to look into retirement plan programs for you and your employees.
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How to Build a Portfolio
Fun is Fun but Safety First
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 The fundamentals of portfolio management are applicable whether you are Warren Buffet building a portfolio of subsidiaries to Berkshire Hathaway, Peter Lynch building a portfolio of equities for the Fidelity Magellen Fund, or you and I building our portfolios using mutual funds, stocks, bonds, and ETFs.
If you're just starting out, pick a good balanced fund, like Oakmark, and let the fund managers handle the asset allocation for you. As your assets grow, you can assume more responsibility for your portfolio. As you grow even more, you can bring in an expert to provide even more diversification.
A guiding principle of asset allocation is to provide adequate diversification in the portfolio. This is achieved by incorporating securities that have different risk and return profiles and thus perform differently under similar circumstances. This is refered to as correlation. Ideally, each portfolio holding as a poor or negative correlation with every other holding. An example of correlation is one I use with my children all the time - the more you study the better your grades.
Let's start by addressing two critical inputs - risk tolerance and return objectives. There are no free lunches - that is you cannot make money without assuming risk. It's not gonna happen! So, how much risk can you handle. This can mean how much of a roller-coaster ride are you willing to endure, how much of a paper loss are willing to assume. Risk tolerance is a very personal matter, its unique to each investor. Along with risk tolerance, you need to determine what your return objectives are. What positive return do you want/need for your portfolio?
To determine our return objectives and risk tolerance we'll also need to determine our liquidity needs, our time horizon, and any special circumstances involved. For example, a 42 year old married, working couple with pre-teen children will evaluate these criteria differently than a 70 year old widow with no dependents.
With risk tolerance and return objectives defined, we can address the high level asset allocation. What does that mean? Starting with 100% of your portfolio assets, we'll decide how much should be in equities, how much should be in fixed income and how much should be in alternatives. I consider alternatives a separate asset class. The classic rule of thumb is to start with your age in fixed income. We'll use a 40 year old as a case study. So, 40% in fixed income and 60% in equity. Adding alternatives changes that mix slightly. A good starting point is 20% for alternatives. Whether to take that from equities or fixed or both is an individual decision. For this exercise, we'll take it evenly from both. So the final top level allocation is 50% equities, 30% fixed income and 20% alternatives.
The next decision is the sub-asset class allocations. Within equity, that would be domestic/international, large/small, and value/growth. Strategically, I favor value over growth and smaller over large (though tactically, i.e., short-term, this can and does change). I believe U.S. investors should always have non-U.S. exposure as well. This crisis has clearly highlighted how interwined the global economies are today. Further, the U.S. markets are very rarely the best or worst performing markets. Within fixed income, it would be domestic/international, long/intermediate/short-term, corporate/government, quality (high yield or high quality). I favor high quality, intermediate term bonds with a reasonably even distribution among corporates and governement issues. High Yield and other specialty fixed income securities can have roles as well on a more tactical basis. Within alternatives, it would be market neutral/merger arbitrage/commodities/real estate/timber/precious metals.
Finally, we decide on investment vehicle. It is much easier to implement an asset allocation for a portfolio using commingled funds rather than individual stocks or bonds. Thus, in most cases for me, the decision is whether to use open end mutual funds, closed end mutual funds or Exchange Traded Funds (ETFs). All can play a meaningful role in your portfolio. Considerations include liquidity, fees, management expertise, and availability.
As your portfolio grows in size, portfolio management becomes more complex. Thus, using an advisor can be worthwhile. Asset allocation becomes more challenging to implement, tax implications should be considered, liquidity needs become more variable, estate issues become more meaninful, etc. Start on your own, learn as you go and don't hesitate to retain an advisor when you no longer have the time or knowledge (or the desire to commit the time!) to successfully manage the portfolio. I'm here to help!
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I hope you found this month's Bulletin informative and useful. Please let me know if there is anything I can do for you.
Sincerely,
John
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Spotlight
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It generally doesn't pay to borrow from your 401k plan. Why?
Consider the following example: You borrow $20,000 at 4% for 50 years. At the end of 5 years, the loan is paid in full and you've paid $2,100 in interest. So your total return is $22,100. Not bad, right? Not really! That return is equivalent to investing $20,000 at 2% annualized for 5 years! If you believe you can get a better return in other investments (most money markets would have been better in the last 5 years), then don't borrow.
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