Dion Money Management Blog   Money Management for Retirees and Their Families

One set of data receiving a lot of spin is the unemployment figure from the U.S. government. Weekly claims for unemployment have drifted slightly lower, and this has the bulls calling a bottom in the recession. On the other side are the skeptics, who point out that unemployment is still increasing by more than 600,000 people each week and lifting the total unemployment rate. Then there are the bears, who dig through the unemployment figures and look at line U-6.

The unemployment numbers reported in the press are on line U-3 of the Bureau of Labor Statistics report, and these exclude discouraged workers, part-time workers who want full-time jobs, and “marginally attached workers,” which are people who are not looking for work but are not discouraged; U-6 includes all these people. U-3 unemployment rose from 5.0 percent in April 2008 to 8.9 percent in April 2009. U-6 unemployment went from 9.2 percent in April 2008 to 15.8 percent in April 2009.

Increased uncertainty about the direction of the economy allows for outlandish claims on both sides of the debate. The bulls are certainly underplaying the risks in the economy, and the bulls’ optimism is itself pushing the bears further down the path of doomsday predictions.

There is reason for optimism in the economy. If the numbers have hit bottom, it means there will be improvement in the coming months. Nonetheless, the bearish arguments are not without merit in isolation. Maybe higher unemployment will damage the overall economy enough to derail the recovery, but rising unemployment will lead to mortgage foreclosures and credit card defaults, two things that will hurt the financial sector.

Additionally, the U.S economy has fundamentally changed, and when it emerges from this recession, it will not be the economy of 2001-2007. Current stock market optimism appears to be focused on rebounds in the worst hit sectors, but these are the sectors most likely to continue to underperform. They have bounced back from their oversold condition, but the next bull market will be led by new sectors of the economy. Investors seem to recognize this, as the rally has run out of steam along with the financials. Until investors sort out where to put their money, the next week will likely resemble the previous two.

Disclaimer

Congress met in late March to discuss rules governing 401(k) advice now slated to take effect May 22. The new rules, which would allow financial advisers affiliated with mutual funds and brokerage firms to dispense investment advice to IRA and 401(k) holders, were finalized in January and recently put on hold by the Obama administration. Experts have rallied both for and against the new legislation, and the recent debate has raised more fundamental questions about the nature of financial advice and the impact of conflicts of interest.

New 401(k) and IRA advisory rules would allow a financial services firm, like Fidelity, to offer retirement planning advice while promoting its own products. Those in favor of the new legislation argue that significant safeguards would be in place to protect investors, including fee disclosure and fund selection methodology. In the past, financial services firms have been restricted to offering general investment advice to investors in lieu of more specific investment recommendations.

Supporters of the legislation argue that now more than ever retirement plan participants need independent professional advice and recommendations to manage their savings. Melanie Franco Nussdorf spoke on behalf of the Securities Industry and Financial Markets Association during the March 24 hearing, arguing that plan participants have been requesting more professional advice. “Our member firms hear every day that benefit-plan clients would like additional advice and support on retirement planning, investment allocation and strategies,” Nussdorf noted.

Opponents of the legislation argue that conflicts of interest could affect the way that financial advice is dispensed to retirement plan participants. “The exemption will have the effect of suppressing the providing of independent advice to participants while encouraging participants to rely on advisers whose incentives are to maximize their own compensation at the expense of participants,” noted Mercer Bullard, associate professor of law at the University of Mississippi.

The Investment Company Institute reported in February that U.S. workers had $15.9 trillion in retirement assets at the end of 2008, a decrease of $1 trillion dollars from a June 30, 2008, estimate. While the legislation is slated for May release, rules regarding the specifics of the advice have not yet been released. Some financial services companies are now arguing that the implementation of new regulations, including annual audits, could prove too burdensome even if the new rules are passed.

When the Labor Department first released the final version of the new rules on Jan. 16, it was noted that the Labor Department stated in its Jan. 16 release that “access to professional investment advice is particularly important now for workers as they manage their 401(k) plans and IRAs in changing and volatile financial markets.” While experts continue to debate the most effective means of delivering such advice, 55 million Americans will continue to manage their own defined-benefit accounts in volatile economic conditions unless they take the initiative themselves and seek out private help.

Disclaimer

If you missed my conference call yesterday with Paul Frank, manager of ETF Market Opportunity Fund (ETFOX), you can listen to a replay of the call by visiting www.fidelityadivser.com or by clicking here: ETFOX Conference Call Replay.
This week, I would like to review another core holding, Federated’s Strategic Income (STIAX). Even as economic uncertainty drove investors from the equity markets, funds such as STIAX benefited in the wake of the flight to safety. STIAX, which has garnered a three-star rating from Morningstar, has helped investors capture returns in recent months despite the market slide. Year to date, the fund is up 13.28%, and over the last three months, the fund has gained more than 9%. As ongoing concerns plague U.S. financial markets and the world economy at large, bond funds such as STIAX that negotiate varying levels of risk could profit well into 2009.

STIAX uses three types of bonds—U.S. government, high-yield and international—to provide a high level of current income to investors. While the presence of high-yield bonds in the fund provides a greater level of risk to the investor, this risk can be tempered, in accordance with market conditions, by U.S. government investments.

In recent months, emerging-market debt and corporate debt have seen a resurgence. The top three holdings in STIAX are bonds from Brazil, Russia and Mexico. The slow stabilization of the peso and real against the dollar has helped investors gain the confidence needed to reenter these emerging bond markets.

Also among STIAX’s top ten holdings are bonds from eurozone countries France and Germany. As the European economic crisis deepens, more pressure is placed on the larger European countries, such as France and Germany, to consider bailout programs for smaller members of the union. Larger European bond markets are becoming more vulnerable, and as the bailout debate continues, analysts are reflecting on lessons already learned abroad.

The trillions of dollars flooding into the market from the federal government and the Federal Reserve will likely continue to tighten the spreads in corporate debt, potentially prolonging an upswing in the corresponding bonds. The riskiest bond investments will most likely benefit the most from the influx, and with 48.1% of STIAX classified as “high yield,” fund investors could continue to see the value of their shares rise as spreads tighten. At the same time, projected default rates on bonds rated B1a and below are expected to escalate in the next several years as companies facing bankruptcy and restructuring struggle to find financing. STIAX’s investors will face the rewards of tightening junk bond spreads and the increasing risk of default on some of the investments.

The intersection and interplay between the various bond types that compose STIAX make this fund a particularly interesting investment in 2009. USA Today recently noted that fund manager Joe Balestrino believes that lower Treasury rates could force pension fund and mutual fund investors to move out of Treasuries and into such other investments as corporate bonds. If STIAX continues to maintain an overweight position in high-yield securities, Balestrino could see his theory reap returns for STIAX investors in the months ahead.

Disclaimer

The popularity of target date funds, also known as life cycle funds, is on the rise, according to a new study from the Employee Benefit Research Institute (EBRI). According to the new data, 37% of 401(k) participants who are offered target date funds as an investment option elect to allocate some of their assets to the funds. In addition to traditional target date mutual funds, investors now have the option of new target date ETFs. While these target date funds provide a quick and easy solution for some investors looking to track the historical returns of the market, the simplicity of the target date fund model can also prove detrimental. As investors grapple with recent losses in their 401(k) portfolios and consider target date funds as a potential piece of their future investment strategies, it will become even more important for individuals to differentiate between the different available funds and understand positive and negative aspects of target date investments.

EBRI’s latest study shows that target date investments have become popular among a younger, less wealthy, investment profile. According to the study, 44% of 401(k) participants younger than 30 had a portion of their assets in a target date fund, opposed to only 27% of investors 60 and older. New target date investors are also generally younger and have relatively lower incomes. On average, the study found that target date investors are approximately 2.5 years younger than their non-target date investing peers and make about $11,000 less in salary. These younger target date investors have, on average, $25,000 less in their retirement accounts and have generally smaller plans.

In 2006, target date funds were approved as a type of “default fund” for 401(k) investment plans. This status allows target date funds to be used as an allocation method when a participant does not select a particular fund strategy on his or her own. Now, with an estimated $2.4 trillion lost from retirement accounts this past year, lawmakers and regulators have set their sights on target date fund advisers. Target date fund assets totaled $152.8 billion in 2008, compared with $177.7 billion in 2007. According to Morningstar, the Target 2010 fund from DWS Investments was the best-performing fund for the one-year period ending March 26, losing a mere 6.22%. In comparison, the Oppenheimer Transition 2010 fund lost more than 40% in the same period.

When investing in a typical target date fund or ETF, individuals pick the fund that correlates with their estimated retirement date. Over time, the fund rebalances and adjusts to mimic the changing risk tolerance that a typical investor might have—more aggressive earlier in life and more conservative near the retirement date. The typical target date mutual fund has recently faced some competition from the target date ETF spectrum. These ETFs, like the target date funds recently offered by iShares, now promise different sub-strategies for more aggressive or passive investors. Target date ETFs, while adding transparency and lower fees, further remove the participant from human intervention. When investing in these ETFs, investors should formulate an idea of what kinds of asset allocation, indexes and funds match their risk tolerance.

While target date funds are growing in popularity, some investment advisers are questioning their appropriateness as an investment strategy. Russell McAlmond, president and chief investment officer of Evergreen Capital Management Inc., recently noted, “Common sense will tell you just picking a year to retire should not be the basis for constructing an investment portfolio.” Advisers like McAlmond argue that the one-size-fits-all investment strategy does not easily match everyone’s needs. “The most important information you need to know about a plan participant is their risk tolerance, not which year they plan to retire.” McAlmond added, “As a financial adviser and 401(k) plan consultant, it is my ethical and legal obligation to know a client’s risk tolerance before ever recommending an investment.”

Risk tolerance is arguably the most important factor when developing a personal investment strategy—a factor that target date funds ignore. For both target date mutual funds and ETFs, investors simply provide the time frame in which they want to retire and enter into a prepackaged risk strategy for the long haul. As investors grow older, the funds are generally rebalanced to include a greater percentage of bonds and a lower percentage of equities—mitigating risk as investors draw closer to retirement. This strategy does not always work, however, and the recent market history demonstrates how the good intentions of target date funds can back investors into a corner. Consider a target date fund that exposed investors to the equity downturn of 2008 but is now rebalancing the portfolio toward safer investment strategies. In this case, investors would be exposed to the equity downturn without hope of an equity upswing. A regular evaluation of risk tolerance and market conditions could help investors to better time their investments and respond to changing life needs.

While the “set it and forget it” strategy of target date funds may not be appropriate for every investor, many of the new available strategies could help young investors alleviate the stress of rebalancing their retirement accounts in a difficult economy. Investors should remember that no single strategy is a cure-all for the time and energy necessary to formulate an individualized and complete portfolio. Target date fund investors should monitor their holdings, and track the performance of the funds relative to broader market benchmarks. When the rebalance arrives, the results are telling, and investors should keep a close eye on whether the objectives of the fund match those of their investment philosophy.

Disclaimer

On Thursday, May 7, 2009, at 3:00 p.m. ET, I will conduct a conference call with Paul Frank, manager of ETF Market Opportunity Fund (ETFOX), which has continued to perform well in your diversified portfolios. To participate, please dial 866-939-8416 or, if you are calling from outside the U.S., 678-302-3534. When prompted, please dial the following access code 4273178, followed by the # sign.
While Frank’s ETF-based mutual fund has grown dramatically, his methodology has remained consistent, and he continues to attribute his success to both the transparency of ETFs and the fundamental oversight that a mutual fund provides. In a follow up interview conducted on April 15, provided below, Frank provided timely insight into recent changes in his fund holdings and explained how market events have impacted ETFOX.
Q: How have recent market conditions, including the March rally, impacted the composition of your portfolio?
A: ETFOX is designed to react to market movement, so several of my positions have changed along with the market in recent weeks. My model led me to trim my exposure to fixed income, and while I dropped the Proshares UltraShort 20+ Year Treasury Fund (TBT) in March, I began buying shares again on April 14. At the beginning of the March rally, I added large-value ETFs to the fund but have since moved to small cap growth. Technology ETFs have performed well, and I have added Vanguard Information Technology ETF (VGT) to the fund, while increasing my position in iShares S&P North American Tech-Semiconductors (IGW). The core of ETFOX is still large growth funds.
Q: Will the size of the fund impact your investment decisions?
A: Short answer: no. One of the most important benefits that ETFOX continues to bring investors is a fundamental filter for the increasingly large pool of ETF products. Over time my fundamental work has eliminated thinly traded or poorly managed ETFs from my rankings. My fund structure allows me to easily add or drop ETFs as my rankings change. This flexibility has actually allowed me to add a little more diversification to the fund.
Q: Have any ETFs made unexpected moves in your rankings? Which ETFs have gained or lost recently according to your formula?
A: While value ETFs had a pop in mid March due to their large percentage of financial services, small cap ETFs have recently advanced in my rankings. I currently own Vanguard Small Cap (VB), Vanguard Small Cap Growth (VBK) and ProShares Ultra Russell 2000 (UWM). iShares Dow Jones US Aerospace & Defense (ITA) has also been climbing in my rankings, and I’m slowly accumulating shares. iShares MSCI Hong Kong Index (EWH) has also moved up my rankings quickly, and we’re experiencing nice gains in that fund.
Q: What are the fund’s top holdings as of April 15th?
•    PowerShares QQQ 14.31%
•    iShares Russell 1000 Growth Index 10.17%
•    Vanguard Growth 9.41%
•    Vanguard Small Cap 8.44%
•    iShares G.S. Semiconductor 7.94%
•    Vanguard Info. Tech. 7.00%
•    Vanguard Value 5.03%
•    iShares Dow Energy 4.55%
•    Vanguard Small Cap Growth 4.27%
•    Ultra Russell 2000 Proshares 3.27%

Disclaimer