Friday, August 20, 2010

You Want The Truth? You Can't Handle The Truth!

(No, this isn't about Iceland, as promised.  I'm collecting data!)

With all due respect to Jack Nicholson, does the SEC really want to hear the truth about their proposals?  In this story, we hear that the SEC has very few comments on "life cycle" mutual fund regulation.

Life cycle mutual funds are those collections of mutual funds with distant years on them.  You pick one based on your target retirement year.  Or, you pick one based on your age.  Makes sense, right?  Haven't we always heard "older people" should hold more bonds than stocks, and you need to take less risk when you're older?  Isn't this what fancy-pants portfolio theory says?

Not really.  Two employers back, I faced this problem.  I was asked to construct life cycle funds for my employer's 401(k) plan.  This made little sense to me.  Portfolio theory says that there exists an efficient portfolio that is the optimal mix of risky assets.  This mix should give the investor the highest expected return per unit of risk for her investment dollars.  Theory also says that this portfolio does not depend on your age.  It doesn't even depend on your desire to take more (or less) risk.

Why's that?  You take this efficient portfolio and you leverage it up to take more risk (by borrowing money to invest,) or you leverage it down (i.e. hold cash) to take less risk.  This portfolio, by the way, has nothing to do with holding a broad basket of stocks.  It must hold a broad basket of everything.

So, that's what we did for the 401(k) plan!  We had always offered what we believed was close to "the efficient portfolio" given our investment options.  (Lots of funky stuff in the mix.)

We also happened to offer a number of "leveraged" portfolios.  (I put leverage in quotes because a 401(k) plan cannot borrow money to obtain leverage.  However, for the advanced reader, a 401(k) plan may (a) buy futures, and (b) enter into buy/sellback agreements, which are effectively the same as swaps, but they legally are not swaps, because swaps involve borrowing money!)

So, this allowed us to offer "conservative", "moderate" and "aggressive" portfolios that offered the same asset allocation with different levels of risk.  Exactly what the doctor (well, PhD!) ordered.

Why don't you get this advice and portfolio construction from your mutual fund company?  Why doesn't the SEC encourage this superior portfolio construction?  Fees.  Oh, and people's fear of looking like a sissy at cocktail parties.

First, fees: If I run a mutual fund company, the last thing I want to do is encourage people to hold more money in my lowest margin portfolios.  Those would be money market funds.  Especially today, when money market funds actually lose money for their providers.

Suppose the right thing for my 67 year old father to do is hold the exact same portfolio as I hold, at age 41, except that he holds 75% cash along side it, to take the risk way down.  While the mutual fund company (assuming I did this) might earn 1% management fees on my whole portfolio, they'd only earn 1% on 25% of my dad's, and they'd lose money on the other 75%.  Bad marketing plan.  So, they advise all their clients to keep as much money as they can (while holding a straight face) in the highest margin products. 

Second, cocktail party sissy: The last thing a 67 year old wants to say, when hanging out with friends talking investments, is that 3/4 of his money is in cash.  Sounds wimpy.  Oh, and guess what?  Most people have trigger fingers that are too itchy to really stick with this plan.

So, there are my comments to the SEC on life cycle fund regulations.  Don't talk to me about silly disclosures of underlying funds and fees.  I don't care about "allocation glide paths" because they should be about cash holdings, not asset mixes.  Let's talk about the logical way to construct efficient portfolios with the right level of risk for different investors.

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