The oldest members of the baby boom generation (born between 1946 and 1964) turned 65 in 2011. While these boomers were in the workforce, a seismic shift had been taking place. The 1980s and 1990s witnessed employers moving away from defined benefit plans and toward defined contribution plans such as 401(k) plans. According to the Urban Institute, in 2013, investors have surpassed the $10 trillion mark in their defined contribution plans and IRAs, whereas defined benefit plans hold about $2.5 trillion in assets. The result is potentially the largest transfer of wealth from company plans to individually controlled accounts in history.

What are the options?
For individuals retiring, there are three basic options for how to handle the assets accumulated in company-sponsored retirement plans:

• Keep the funds in the plan for as long as the plan allows.
• Roll the funds over to an IRA.
• Withdraw the funds in the form of a lump sum distribution to a taxable account.

Keeping the funds in the plan

The advantages of keeping assets in a company retirement plan (whether left in an old plan or transferred to a new plan) are that it will continue to enjoy tax-deferred growth. In addition, participants may be able to borrow against the funds, should they need them. And for boomers who remain employed, some plans will not require that participants take distributions after they reach age 70 ½ as long as they continue to work, thus allowing for longer periods of tax-deferred growth.

The major disadvantage, however, to leaving the funds in a company retirement plan is that the individual is giving up control and flexibility. For example:

• Investment choices are often limited to those selected by the employer plan. As a result, the investor may not have access to investments he or she prefers; it is also possible that the options inside the plan have higher expenses than those available outside the plan.
• For some plans, if the participant is over a set retirement age, the company may force him or her to start taking distributions, and at whatever rate that plan guidelines mandate.
• Many plans do not allow stretch options that IRA rules permit. For example, a company plan may require non-spouse beneficiaries to take inherited money in an immediately taxable lump sum, with no option to instead have it distributed over their lifetimes.
• The guidelines of the plan are always subject to change. There is no guarantee that they will stay the same, especially if the company is sold or merges.
• Fees associated with the administration of the 401(k) plan may be greater than for other account types.

Rolling funds into an IRA

A retirement plan rollover is an attractive strategy to continue tax-deferred growth and gain more control and flexibility over retirement funds. There are two types of rollovers. A direct rollover occurs when assets transfer from an employer-sponsored plan directly into a rollover IRA. An indirect rollover is when the employer-sponsored plan issues a check payable to the former participant, and he or she distributes the money to an IRA within 60 days from the day the check is received.

There are many benefits of a rollover to a traditional IRA such as a large amount of available investment options, allowing an individual to customize his or her investment choices. Additionally with this option, assets continue to grow tax-deferred and consolidating several plans into one IRA is easier to manage.

Rolling over at least a portion of 401(k) plan assets into a Roth IRA may be worth considering, as there are no required minimum distributions, and all withdrawals are tax-free. However, the percentage of the amount rolled over representing gains in the account would be taxed at the individual’s ordinary income rate.

Taking a lump-sum distribution

The lump-sum-distribution option can be enticing because it gives an individual instant access to the cash in their retirement plan and the most flexibility with how to use it.

For individuals with a large percentage of company stock in their retirement plan, the IRS gives a special tax break for taking a lump-sum distribution of this stock. Under this net unrealized appreciation (NUA) rule, an individual is allowed to take company stock from his or her qualified plan and pay ordinary income tax on the original cost of the stock rather than its fair market value at the time of withdrawal. Once the stock is sold, the individual pays capital gains taxes on this appreciation only.

The costs for choosing the lump-sum option are perhaps the steepest of any of the options, and there is a 10 percent premature distribution penalty that applies on top of the taxes if the participant is under the age of 59 ½. Perhaps most important of all, the distribution will result in the loss of tax-deferred growth of the assets.

Thus, if there is no immediate need for the cash, and the NUA rule does not apply, taking a lump-sum distribution out of the tax-deferred environment and subjecting the funds to taxes and potential penalties should be a last option.

The Bottom Line

Coverage by traditional defined benefit pension plans has slowly been replaced by the rise of account-based defined contribution plans. This will result in making the retirement security of boomers and future generations more dependent on individual saving and rates of return as guaranteed sources of income become less available. These individuals will need to take on more responsibility for planning for the creation of income in retirement. As a result, they will need to understand the financial issues surrounding planning for retirement, both in accumulating sufficient assets as well as learning to effectively draw them down during what could be a relatively long period of time.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2013, The BAM ALLIANCE.

The post What Do I Do With My Retirement Plan Accounts? appeared first on JMF Capstone Wealth Management.

The Importance of Education
It is our desire and intent to educate clients about how capital markets work and to provide them with the information necessary for their financial well-being.

The advice to invest in passively managed funds is significantly different from most of the advice heard on Wall Street and in the financial media. It also is different from the strategy followed by the typical individual investor. Therefore, we believe it is extremely important to be aware of the academic research demonstrating that markets are generally highly efficient.

Studies have shown that it is highly unlikely investors will be able to exploit market inefficiencies after accounting for the expenses of the effort. It is essential to know how a well-diversified portfolio can help manage risk, a message that often bears repeating as asset classes come in and out of favor over time. The same sentiment applies to understanding how attempts to time the market — either in terms of individual securities or asset classes — typically lead to realizing lower returns than those available from a buy, hold and rebalance strategy.

Because our investment approach is different from the average investment advisor, it is crucial for you to understand why we recommend it. Put simply, knowledge is the key to discipline. For example, in the late 1990s, when the growth asset class outperformed the value asset class, it became tempting to pour everything into that single asset class. Those who do not possess a basic understanding of passive investing are more likely to quickly become dissatisfied when their portfolio underperforms the latest hot asset class.

Essential Investment Education
What is the minimum basic knowledge needed to remain a disciplined passive investor? We believe the following five concepts form a strong foundation from which to build.

Point 1: Markets Are Efficient
Public information is of little fundamental value. New information is so quickly incorporated into asset prices that use of this knowledge cannot be expected to consistently yield superior risk-adjusted returns. Information that is not public is also of no value, because it is illegal to trade on it.

Point 2: Risk and Expected Reward Are Related
Investors who expect or need to achieve higher returns must accept the associated risk. Equity-like returns do not come without commensurate risks. When it comes to investing, there’s no such thing as a “free lunch”; there is no promise of high returns without high risk. Anyone who tells you different is peddling a “free meal” you don’t want to eat.

Point 3: Diversification Works
Global diversification across a variety of imperfectly correlated asset classes is the most effective way to reduce risk. (Correlation is how similarly different investments perform. The higher the correlation, the more similar the performance and, thus, the lower the diversification.)

Diversification is always working, whether we are pleased with the immediate results. Diversification should be thought of as the equivalent of buying insurance against having all of one’s investment eggs in the wrong basket.

Point 4: Markets Are Unpredictable in the Short Run and Even in the Long Run
In the short (or even long) run, anything is possible. In the long run, we expect that equity markets will rise more than fall. Individuals who correctly predict short-term market movements should likely attribute their results to luck rather than skill.

Point 5: Discipline Is Key to Successful Investing
For far too many investors, the variable that ultimately determines the results of their portfolio is not investment returns but investor behavior. Emotions can lead investors to make poor decisions at the wrong times. It is easy to remain disciplined during bull markets. However, it is far more important to do so in bear markets and avoid the far-too-human propensity to sell at market bottoms. Thus, the role emotion plays in the success of an investment strategy cannot be overemphasized. Education is key to ignoring one’s emotional reactions and staying the course.

Summary
If you understand the above concepts, you will be well ahead of the majority of the investing public. No matter where your plan goes, we will continue to place importance on evaluating risk tolerance, building a globally diversified portfolio and implementing regular, disciplined rebalancing techniques. Having such knowledge changes the way you approach investing.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2013, The BAM ALLIANCE

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Our advice has always been — and will always be — based on the scientific evidence, not on our opinions about where the markets may be headed.

In light of the recent market drop, it is no wonder many investors seem to be worn out and wary of the market. Investors experience a rally, only to see another crisis and another dramatic drop. Making matters worse, the yields on safe, high-quality fixed income investments (the only kind you should consider) have risen, causing prices to drop.

What is an investor to do? Our advice is simple: If you have a well-developed plan, one that doesn’t take more risk than you have the ability, willingness and need to take, then you should stick to it.

Market Efficiency

For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to first be convinced that markets are no longer efficient, that the market is now mispricing assets and is reacting slowly to new information. It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. We believe the market was and continues to be highly efficient, and we encourage investors to keep the longer term in mind.

Market Timing

As for trying to time the market, we again rely on the historical evidence. When a client suggests just getting out until things are clear again, we point out that the evidence on market timing is even worse than on stock selection.

One reason market timing fails is because so much of the market’s return occurs during very brief and unpredictable periods. Recall the litany of problems the markets faced from March 9, 2009, through March 30, 2011. There was never a green light letting investors know it was safe. It was red the entire time. That’s why investors were pulling out hundreds of billions of dollars from the market, and many missed the greatest rally since the 1930s when the S&P 500 provided a return of more than 100 percent.

Another reason is because investors have to be right not once, but twice. Deciding to get out is easy compared with deciding when to get back in. Investors who go to cash may be “whipsawed.” They will get out after a severe drop, miss a big rally and jump back in only to experience another severe loss. They end up worse than if they simply stayed the course.

What are the chances an investor can succeed following this pattern of jumping in and out of the market? That is the problem with trying to time the market.

The Difference Between Information and Wisdom

We can define information as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess (above market) profits. When we ask people why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices?

Many investors considered selling in 2011 and 2012 because of concerns about the Greek crisis, more recently, the fear of contagion throughout Europe and concerns about the U.S.’s long-term financial stability and health. The emotions created by crises cause us to lose perspective — like forgetting that fairly regular crises are actually the norm. Should investors sell? To answer that question, one must understand these concerns are well known by the market and are already reflected in prices. As Wall Street legend Bernard Baruch once stated, “Something that everyone knows isn’t worth knowing.”

Summary

It can be difficult to hear the message to stay the course. But it is a message worth repeating because it is the best advice. History provides us with that evidence. Thus, our advice will continue to be the same, because the science demonstrates that this is the most likely way to achieve one’s goals.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2013, The BAM ALLIANCE.

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The following investing guidelines may be instrumental in giving investors the best chance of achieving their financial goals.

Constructing an Investment Plan

• Recognize that the ability, willingness and need to take risk is different for everyone. Plans fail because investors take excessive risks. The risks unexpectedly show up and the plan is abandoned. When developing a plan, investors should consider their investment horizon, stability of income, ability to tolerate losses and the required rate of return.
• Don’t invest in any security without fully understanding the nature of all of the risks. If investors cannot explain the risks to their friends, they should not invest. It’s critical to understand the nature of the risks being taken.
• A well-designed investment plan has many elements. It should integrate portfolio management with tax planning, estate planning and risk management.
• Don’t treat the highly improbable as impossible, nor the highly likely as certain. Investors assume that if their horizon is long enough, there is little or no risk. The result is they take too much risk. Stocks are risky no matter the horizon.
• Only work with advisors who will provide a fiduciary standard of care. That is the only way to ensure that the advice provided is in the investors’ best interest. There is no reason not to insist on a fiduciary standard.

Maintaining an Investment Plan

• The more complex the investment, the faster investors should run. Complex products are designed to be sold, not bought. Investors can be sure the complexity is designed to favor the issuer, not the investor. Investment firms do not simply give away higher returns.
• The only thing worse than having to pay taxes is not having to pay them. The “too-many-eggs-in-one-basket” problem often results from holding a large amount of stock with a low cost basis. Fortunes have been lost because of the refusal to pay taxes.
• The safest port in a sea of uncertainty is diversification. Portfolios should include allocations to the asset classes of large-cap and small-cap stocks, value and growth stocks, real estate, international developed markets, emerging markets, commodities and the appropriate amount of bonds.
• Owning individual stocks and sector funds is more like speculating than investing. The market compensates investors for risks that cannot be diversified away, such as the risk of investing in stocks versus bonds. Investors should not expect compensation for diversifiable risk­, such as the unique risk related to owning one stock or sector fund. Prudent investors only accept risk for which they are compensated with higher expected returns.
• Take risk with equities. The role of bonds is to provide the anchor to the portfolio, reducing overall portfolio risk to the appropriate level.

Staying the Course

• The consequences of decisions should dominate the probability of outcomes. Investors should ask themselves if they can live with the outcome, regardless of how small of a chance there is of the outcome occurring.
• The strategy to get rich is entirely different than the strategy to stay rich. One gets rich through inheritance or by taking risk. One stays rich by minimizing risk, diversifying and not spending too much.
• The four most dangerous investment words are “This time, it’s different.” Getting caught up in the mania of the “new thing” is why the surest way to create a small fortune after starting out with a large one.
• If it sounds too good to be true, it probably is. Investment decisions should be based on the evidence from peer-reviewed academic journals.
• Keep a diary of market predictions. After a while, investors will likely conclude that they should not act on their “insights.”
• Good advice does not have to be expensive, but bad advice always costs dearly no matter how little is paid for it. Smart people do not simply choose services based on cost (the cheapest doctor or CPA). Costs matter; but it is the value added relative to the cost of the advice that ultimately matters.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2013, The BAM ALLIANCE

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The New Year’s holiday is a great time to reflect on what’s really important to us. Spending time with family and friends can help us get focused on where we’re at right now and where we want to be in a year. We have the time to ask questions and make sure things like our investment strategy still match our goals. It’s also a natural time to think about making changes.

But we have a hard time sticking to our New Year’s resolutions. People tend to make big goals, and when they don’t reach them right away, many give up trying.

Look at what usually falls on the list of most popular resolutions: exercise more, lose weight, start a healthy diet, quit smoking, save more and spend less. As most of us have experienced, these goals are often easier said than done.

It doesn’t have to be this way. Here are four suggestions to help you stick with your resolutions in 2013:

Give yourself a break. Resolve to make changes, but accept that it’s a process, not a one-time event. For some reason, that feels different than the usual New Year’s resolution. Plan to resolve again and again throughout the year because it’s about course corrections. This holiday encourages us to focus clearly on the road before us. Don’t be the driver who ends up driving into a lake because the GPS sees an on-ramp there instead. Things change, and you can adapt to those changes without giving up on your resolutions.

Find a few guardrails. If you’re trying to avoid sugar, get it out of your house. If you want to exercise regularly, schedule it. Removing temptation and giving yourself structure can help you avoid failing early on and support your long-term efforts.

Make tiny changes. BJ Fogg, who directs research at Stanford University’s Persuasive Technology Lab, says if you want to create a lasting habit, start by making a tiny change. For example, if you want a habit of flossing your teeth, commit to flossing one tooth. It works because it feels manageable. Of course you can find the time to floss one tooth, and then we know what happens next: You’re flossing all your teeth. If you want to get stronger, do one push-up after you get dressed. It’s the same principle. Build on your small achievements to reach the bigger one.

Start a winning streak. Winning streaks have power. One push-up every day for seven days in a row is a winning streak. By the eighth day, it just makes sense to keep going. Jerry Seinfeld created a visual winning streak by taking a year-at-a-glance calendar and marking a red “X” through all the days he wrote new material. With each day he wrote, he added another link to his chain. You’ll find that you don’t want to break your chain, either.

Take the opportunity at the beginning of this new year to figure out the changes that matter most to you. Then decide what you need to do to make them stick. It’s a change we could all use.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not uaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2012, The BAM ALLIANCE.

The post Resolutions for 2013 appeared first on JMF Capstone Wealth Management.

Introduction

Over the majority of 2012, our collective attention was focused on several events:

• Our continuing fiscal deficits and our ability to continue to fund them

• What would happen regarding the fiscal cliff

• Who would win the presidential election

• The increased possibility of rapid inflation caused by the fiscal and monetary stimulus

• The European fiscal crisis and the potential for sovereign defaults and the breakup of the Eurozone

• Rapidly slowing growth in China and other developing nations

Together, these events made for a worrisome year. But the dire outcomes predicted throughout the year didn’t occur. The following are the big lessons that came from this year’s events and, in many cases, non-events.

Lesson 1:Make Sure Your Investment Plan Incorporates the Virtual Certainty That Crises Will Occur and Will Do So With Great Frequency

There are some things we know and some things we don’t know. We know that emotions created by crises can cause us to lose perspective — like forgetting that fairly regular crises are actually the norm. We cannot know what form crises will take, when they will occur, how deep they will be or how long they will last. However, we do know they will occur.

Therefore, you must be sure to avoid taking more risk than you have the ability, willingness and need to take. If you do not, you are likely to allow emotions such as fear and panic and the noise of the markets to cause you to abandon your plan. And, once you sell, there is never a green light that will let you know that it is once again safe to invest.

Lesson 2: Practice Stage-Two Thinking

Some investors see a crisis and the risks, but they cannot see beyond that. This type of stage-one thinking leads to sales of assets as investors assume the bad news means prices are surely going lower. They assume the only light at the end of the tunnel is a truck coming the other way. The result: Sales occur after prices have already fallen, reflecting the bad news. Those sales occur when prices are low and expected returns are high (reflecting the high perception of risk).

On the other hand, stage-two thinking involves seeing beyond the crisis. For example, while there is no certainty, we should expect that a crisis would lead governments and central banks to come up with solutions to try to address the problem. If the crisis worsens, they would be more likely to act with urgency and scale. We saw this in the remaining days of 2012 as Congress dealt with and averted the fiscal cliff.

We also saw this take place in Europe. Over the past two years, Europe has been caught in the eye of a financial storm. In 2011, European equities experienced sharp losses and bond yields on sovereign debts soared as credit ratings were slashed.

In response to the crisis, European governments and the European Central Bank took action —slashing budgets, cutting rates and implementing bond-buying programs. When the first actions were not sufficient, they took further ones and that continued throughout the year. (Note that these actions were a virtual replay of actions taken by the Federal Reserve during our fiscal crisis.) Despite the fact that there is still no clear resolution, European equities fared well in 2012. For example, from January 1, 2012 through December 31, 2012, the MSCI Europe Index had a total return of 19.1 percent.

Stage-two thinking allows one to see that the light at the end of the tunnel might not be a truck coming the other way. Instead, it might be actions to resolve the crisis.

Lesson 3: Last Year’s Winners Are Just as Likely To Be This Year’s Dogs as to Repeat

The historical evidence demonstrates individual investors are performance chasers — they watch yesterday’s winners and then buy (after their great performance) and watch yesterday’s losers and then sell (after the loss has already been incurred). This causes investors to buy high and sell low — not exactly a recipe for investment success. This behavior is consistent with findings that investors actually underperform the very mutual funds they invest in by significant margins.

Using Dimensional Fund Advisors’ passive asset class funds, the following table compares the returns of various asset classes in 2011 and 2012. Sometimes, the winners of 2011 repeated, but other times, they became losers. For example, the top two performers among asset classes in 2011 finished 11th and 13th in 2012 of the 14 funds shown.

While there are streaks in asset class returns, they occur randomly relative to expectations. The streaks have no more meaning than streaks at the craps table — a good (poor) return in one year does not predict a good (poor) return the next year.

In fact, great returns lower future expected returns and below-average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp. The postage stamp does only one thing, but it does it exceedingly well — it adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation).

Adhering to one’s plan does not mean just buying and holding. It means buying, holding and rebalancing — the process of restoring your portfolio’s asset allocation to the plan’s targeted levels.

Lesson 4: Hedge Funds Are Compensation Schemes, Not Investment Vehicles

Yet again, 2012 was another year that demonstrated that hedge funds have more in common with compensation schemes than prudent investment vehicles. For the year, the HRFX Global Hedge Fund Index returned 3.5 percent. It underperformed all the major domestic equity and international asset classes by at least 11 percent, though, by small margins, it did outperform short-term (3.3 percent), intermediate-term (2.9 percent) and long-term U.S. Treasuries (0.2 percent).

Hedge funds often tout the freedom to move across asset classes as their big advantage, so one would expect that “advantage” to show up. The problem is that the efficiency of the market, as well as the costs of the efforts, changes that supposed advantage into a handicap.

Lesson 5: The Economy and the Stock Market Are Very Different

It was a very nervous year for most investors. The Eurozone crisis was threatening in headlines the entire year. The U.S. unemployment rate stayed high. The fiscal cliff went right down to the wire. But the market responded positively, in part because these outcomes were better than expected. This is separate from the economic reality of these events. For example, although the unemployment figure was lower than expected, millions of people remain unemployed.

For another example, we turn again to Europe. The outlook for Europe was that it would be in a severe recession and the Greek default would lead to other defaults.

While Europe is in a recession, it’s not a severe recession, except for Greece and, to a lesser extent, Spain. Growth of Europe’s economy has slowed, but it was nowhere near as bad an outcome as expected because the governments got together to address the problem and provided lending support to Greece. They forced Greece to raise taxes and cut spending. And, central banks have been taking steps to solve the banking crisis. They’re providing liquidity support just like the Fed did. That’s stage-two thinking in action. And the markets responded positively.

Greece didn’t leave the Euro. It didn’t spill over: Spain and Portugal and Italy were not forced to leave the Eurozone. There weren’t big defaults besides Greece. That was a big deal. And the markets responded positively with interest rates on European government debt falling sharply because the news was better than expected.

So, even with all this bad news, this was a remarkably good year for stocks. But many investors ended up missing out. We know this because again in 2012 money flowed out of U.S. equity mutual funds, continuing a trend of outflows from domestic stocks in the hundreds of billions since 2008.

Conclusion

Perhaps the most notable lesson this year would be that it’s wise to ignore economic and market forecasters, the noise of the market and the emotions that noise can cause. With the time you’ll get back, you’ll have more time to spend on the truly important things in your life.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2013, The BAM ALLIANCE.

The post Lessons From 2012 appeared first on JMF Capstone Wealth Management.

Medicare health insurance is a dense topic. Each of the various options have specific coverage and enrollment periods. To select the best coverage for you, it helps to have a better understanding of the program. This knowledge can help you and your loved ones iron out the areas that tend to cause the most confusion.

The Basics
Medicare is available for U.S. citizens who are 65 or older, those under the age of 65 but have certain disabilities and those of any age with end-stage renal disease.

Different Parts
There are five main options for Medicare and each serves a purpose:

• Medicare Part A: Coverage for hospital inpatient care, hospice care, inpatient skilled nursing facility and home health care. In most cases, this is a free benefit paid for with Medicare taxes.

• Medicare Part B: Coverage for physician services, outpatient care, home health and medical services, and some preventative services to help maintain health. There is a premium charge for this coverage.

• Medicare Part D: Coverage for prescription drugs through Medicare-approved private insurance. There is a premium charge for this coverage.

• Medicare Supplement Insurance (Medigap): Health insurance sold by private companies. Its role is to fill the gaps in Medicare plan coverage. There is a premium charge for this coverage.

• Medicare Part C: Single plan offered by private insurance companies that combines coverage for Part A and Part B, and sometimes Part D. In some plans, additional benefits such as dental or vision are provided. There is a premium charge for this coverage.

How to Enroll

There are several ways to enroll in Medicare: 1) visit www.Medicare.gov, 2) call 800.MEDICARE or 3) visit your local Social Security office. Wealth advisors or topic experts are other resources when planning to enroll in Medicare. They can assist you in making sure your enrollment is submitted correctly as well as offer guidance throughout the process.

Enrollment Periods and Penalties
It is important to understand the different Medicare enrollment periods and subsequent penalties to avoid late fees and make the overall experience less daunting.

Medicare Part A and Part B
If you are currently receiving benefits from Social Security, you are automatically enrolled in Part A and Part B on the first day of the month you turn 65. If you are receiving disability insurance, you are automatically enrolled in Medicare Part A and Part B on the first day of the 25th month after your Social Security benefits begin. If you are not currently receiving benefits from Social Security, you are still eligible for enrollment upon reaching age 65.

The initial enrollment period for Medicare Part A and Part B includes the three months before the month you turn 65, the month you turn 65 and the three months after you turn 65. For those covered under a group plan through your current employer, you do not need to enroll in Part A or Part B. Instead, there is a special enrollment period that includes the eight-month period beginning the month after your group coverage ends or your employment terminates.

Moreover, if you do not sign up for Part A and/or Part B during your initial enrollment period, you can sign up during the general enrollment period, which takes place each year from January 1–March 31. If you sign up during this period, your coverage will begin on July 1.

The initial enrollment period is a time frame specific to when you turn 65; the general enrollment period takes place from January 1–March 31 each year.

Late enrollment penalties can significantly increase your monthly payments for coverage, but they are easily avoided. For most recipients, Part A is free, making late enrollment penalties an insignificant issue. For Part B, though, the late enrollment penalty is 10 percent for each 12-month period that a member could have signed up for Part B but did not. For example, if a member’s coverage ended December 31, 2009, but he or she waited to enroll until the general enrollment period of March 2012, the premium penalty would be 20 percent. In most situations, the penalty for Part B late enrollment does not end.

Medicare Supplement Insurance (Medigap)
The open enrollment period for Medicare supplement insurance is a six-month period that begins the first month you are 65 and enrolled in Medicare Part B. Additionally, the Medigap special enrollment period is similar to that of Part A and Part B. Special enrollment for Medigap occurs once your group coverage has ended and you are enrolled in Part B. Your enrollment period is the six months following termination of your group plan. If you miss the period to enroll, you may be subject to answering underwriting insurance questions — an extensive examination of your current health status and medical records.

Medicare Part C and Part D
For Medicare Part C and Part D, the initial enrollment period takes place during the seven-month period that starts three months before the month you turn 65, includes the month you turn 65 and ends three months after the month you turn 65. For Part C and Part D, there is an open/annual enrollment period from October 15–December 7, which allows you to change plans without penalty or underwriting. Similarly for these parts, there is also a special enrollment period. This period applies if you leave coverage from your employer or union. Your chance to join lasts for two full months after the month your coverage ends.

The enrollment penalty for Part D includes something called the “national base premium.” Late enrollees have to pay 1 percent of the national base premium, which was $31.08 for 2012. That
1 percent of the base premium is then multiplied by the number of months you were without coverage. This resulting amount is ultimately added to the Part D premium each month and is applied until coverage is no longer necessary.

Additional Information
There are various resources available to assist you with answering your Medicare questions. Call 800.MEDICARE or visit www.medicare.gov for additional information, or speak with a wealth advisor.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2013, The BAM ALLIANCE.

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Reductions and Credits

First of all, if you apply prior to your full retirement age (FRA), you will receive a reduction in your benefits. For example, if your FRA is 66 and your full benefit is $1,000 a month, then you will receive $1,000 month if you claim at 66. However, if you claim at age 62, that benefit is reduced by 25 percent to $750 per month. On the other hand, you will receive delayed retirement credits for every year you delay taking benefits after your FRA. For individuals with an FRA of 66, this means an 8 percent increase each year. So by delaying to age 70 (or the age at which you would receive the maximum benefit), you would receive a 32 percent increase over your full benefit. Using the example above, you would now be entitled to $1,320 per month ($1,000 x 132 percent) for the rest of your life.

Finally, claiming early doesn’t give you any additional benefit, provided you have an average life expectancy. Regardless of your claiming age, your benefits are calculated so you’ll receive the same total benefit as long as you live to your average life expectancy. So if there is any chance you might live longer than average, delaying benefits is like buying longevity insurance — something to protect you from outliving your assets.

It’s Not Just About You

If you take $1,320 at age 70 instead of $750 at age 62, you’ll have to live to age 80 to make that decision worthwhile. So maybe you don’t think you’ll live that long and choose to claim early. But if you’re married and claim early, you could be reducing your spouse’s benefit as well.

That’s because if your benefit is higher, your spouse receives your benefit in the form of a survivor’s benefit should he or she outlive you. For example, if your spouse outlives you by five years, the survivor benefit would be $45,000 (if you claimed at 62) versus $79,200 (if you claimed at 70), which is equal to a 76 percent increase.

The Investment Game

You may be considering drawing benefits early and investing the money so that the gains would offset the benefits of delaying. But remember, for each year you delay past FRA, you earn eight percent per year. That benefit is not only guaranteed but also indexed to inflation. It is unlikely you would be able to find a similar investment vehicle without taking on additional risk.

The Costs of Delaying

For each year you delay, there is a “cost” equal to the amount of the forgone benefit. If you are age 66 and you delay filing for just one year, you’ve given up $12,000 ($1,000 monthly benefit x 12 months) for a $12,960 annual benefit at age 67. Is that additional $960 per year for the rest of your life (and possibly your spouse’s) worth $12,000?

To approximate the cost, you could buy an immediate annuity at age 67 that will give you $960 per year for the rest of your life, is indexed to inflation and has a 100 percent survivor’s death benefit. However, such an annuity costs more than $21,000, not $12,000. And while the Social Security benefit is guaranteed by the U.S. government, your annuity relies on the credit quality of the insurance company.

Summary

When considering when to start taking your Social Security benefits, your decision should best fit your situation. If the security of receiving benefits now helps you to sleep better at night, then that may be the right decision for you. This is especially true if you have no other sources of income and can’t afford to delay Social Security benefits.

However, if you can afford to delay claiming, carefully consider the benefits of delaying and the costs of claiming early. Make sure that you plan not only for your lifetime but your spouse’s as well. And most importantly, try not to focus on what happens by delaying filing and dying early. Instead, focus on the possibility that you and your spouse might live a long time and ensure that you have the right strategy in place.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2010, Buckingham Family of Financial Services.

The post Delaying Social Security Benefits appeared first on JMF Capstone Wealth Management.

• They are generally available only to high net worth individuals.
• Unlike the typical broadly diversified mutual fund, they generally have large, highly concentrated positions in just a few securities.
• They have broad latitude to make large bets (either long or short) on almost any type of asset, be it a commodity, real estate, currency, country debt, stock and so on.
• Management generally has a significant stake in the fund.
•  Management has strong financial incentives. Fees typically range from 1–2 percent per year, plus 20 percent of profits (above a specified benchmark).
• Management is subject to less regulatory oversight than mutual fund managers.

Myth #1: Historically, hedge fund investors have received superior returns.

Debunking the Myth: In a February 2004 article in the Journal of Financial Planning, William Jahnke stated, “The impressive performance numbers reported for various hedge fund strategies create a distorted impression because participation in performance databases is elective, and one can safely assume that hedge fund managers opt to participate only after a period of good past performance.”³ Since hedge funds are not required to report their performance, funds can choose to skip reporting after a period of underperformance, or report returns after a period of outperformance and then “back fill” data for previous years. When fund managers choose to report performance and subsequently fill in data for years past, this creates an instant history that can be misleading.

Hedge fund managers seek to outperform market indexes such as the S&P 500 Index by exploiting what they perceive to be market mispricings. Studying their performance would seem to be one way of testing the Efficient Market Hypothesis (EMH); if markets are largely efficient, then active managers should have little ability to outperform their respective benchmarks. (The EMH states that in a market that includes many well-informed and rational investors, all seeking to maximize profit, securities will be appropriately priced and reflect all available information. In an efficient market, no information or analysis can be expected to result in outperformance of an appropriate benchmark.)

A 2006 study, “The A, B, Cs of Hedge Funds: Alphas, Betas and Costs,” covered the period January 1995 through March 2006. The authors found that the average hedge fund returned 9.0 percent per year, lagging the S&P 500 by 2.6 percent per year.⁴ Equally important, this study includes the bear market of 2000 to 2002 (the type of market when hedge funds are supposed to perform the best).

One example of how quickly good funds can go bad is Peloton Partners. The hedge fund management company, founded in 2005 by two former Goldman Sachs partners, showed significant gains on bets against the U.S. housing market. Peloton reported an 87 percent return in 2007, and the company won two awards at a ceremony hosted by trade publication EuroHedge.⁵

However, the firm began betting that highly rated mortgage securities would ultimately pay off, despite the heavy turmoil rocking the housing markets. Those bets unraveled quickly, and the Wall Street Journal reported that Peloton lost about $17 billion in a matter of days around the end of February 2008.⁶

Another measure of an investment’s risk is its likelihood for survival. Survivorship bias occurs when the returns of a poorly performing fund escape consideration as fund managers either eliminate the fund or merge it with a better-performing fund. Studies that fail to account for funds that have been dropped or merged during the study period introduce survivorship bias in the findings. A study by Burton Malkiel and Atanu Saha found that survivorship bias in the reported data on hedge funds creates an upward bias of 4.4 percent per year.⁷ Yet, inflated, biased numbers can be the ones reported to unknowing investors.

Such data indicates that the likelihood of a hedge fund not surviving is a legitimate risk. How long are hedge funds likely to survive? In the study, “Hedge Fund Survival Lifetimes,” the author summarized the findings of several earlier studies conducted on the topic. The results of those studies included the following data:

•  The attrition rate for hedge funds since 1994 was almost 15 percent per year.

•  The probability of a hedge fund failing in its first year was 7.4 percent. Failure probability then increased to more than 20 percent in the second year.

•  About 30 percent of hedge funds do not make it past three years.

The results of the “Hedge Fund Survival Lifetimes” study, which covered 1990–2001, concluded that 50 percent of hedge funds do not make it to the sixth year following their first reporting.⁹ Given that average investors are highly risk averse, these do not seem to be very attractive odds. Even by selecting only hedge funds that have survived at least five years, the risk of failure is not significantly minimized. How does survivorship bias relate to the superior returns myth? If, as suggested by the study, approximately 50 percent of the hedge funds did not celebrate their sixth anniversaries, we could assume that investors in those funds may have lost some or all of their original investment.

Cases in which fund managers have fabricated return figures to lure new investors to a fund have been reported, such as the Florida case where a hedge fund “sent out monthly e-mails boasting of 200% returns in three years.”¹⁰ Investors flocked to the fund, and the SEC charged the fund managers with fraud, halting the fund’s activities with a series of emergency orders in February 2004. According to an SEC announcement, the fund managers allegedly “charged investors fraudulent fund performance fees based on the fictitious gains.”¹¹ The fund accumulated $10 million but lost much of the value of the fund on speculative trading with an end value of approximately $2 million.

Yes, a few hedge managers succeed. However, we encourage investors to ask the following questions when deciding whether an investment’s potential rewards are worth its risks:

•  Does the approach succeed more frequently than can be expected from random luck?

•  Is there persistence in performance?

The historical record suggests that the answer to both questions regarding hedge funds is, “No.”

Myth #2: Hedge funds are special opportunities for high net worth investors.

Debunking the Myth: Hedge fund investing appeals to many high net worth investors because of its exclusive nature. It also offers a potential for great rewards, and these rewards are often dangled in front of investors as the media showers the latest superstar performers with attention. “The hedge fund offers an irresistible velvet rope, the allure of investing where most everyone else hasn’t been invited to invest.”¹² Unfortunately, evidence has shown that these fund managers demonstrate no greater ability to deliver above-market returns than do active mutual fund managers.

Exclusivity may be eroding anyway, as the hedge fund industry has been casting a wider net to find investors. Generally, only “accredited investors” — those individuals who have earned a minimum of $200,000 in annual income for at least two years or have a net worth of at least $1 million — have been able to invest in a hedge fund. However, the introduction of funds of hedge funds offers investment opportunities in hedge funds with lower minimums and no limits on eligibility. Some have suggested that hedge fund investors might consider a fund of funds to try to minimize survivorship risk and return dispersion via diversification. But, unfortunately, this results in an additional layer of expenses, added to fees that are often already steep.

It is possible that the popularity of funds of funds could damage the foundation of the hedge fund “club mentality.” Funds that reduce minimums in an effort to boost membership could dent the image of exclusivity, or the increased availability of funds of funds could make hedge funds seem less exotic and more commonplace. While funds of funds might discourage a few high net worth investors from participating in hedge funds, lowered minimums could expose a new group of investors to extremely risky investment vehicles. We share the SEC’s concerns that “less sophisticated investors … may not possess the understanding or market power to engage a hedge fund adviser [sic] to provide the necessary information to make an informed investment decision.”¹³ We might even go a step further and express similar concern for any investor considering hedge funds. While passive funds may be perceived as “boring” because of their low cost and common availability, we would suggest they make better investment vehicles.

Myth #3: A hedge fund manager’s ownership interest in a fund aligns interest with the investor’s regarding acceptable levels of risk.

Debunking the Myth: A manager’s alignment of interests based on ownership is only as strong as the dollar value of that original investment. Depending on the amount of a manager’s personal investment in a fund relative to the fees he or she may potentially earn, a manager may decide to take additional strategic risks.

Another important but typically overlooked risk related to hedge funds is the compensation structure for hedge funds, which creates what is known as agency risk.

Most managers receive their compensation in the form of incentive pay (usually 20 percent of profits above a specified benchmark, in addition to the typical 1–2 percent operating fee). This means investors take 100 percent of the downside risk, but they do not participate fully in an upside gain. It also leads to potential agency risk when a manager is approaching the end of a year and has not yet achieved the benchmark level above which incentive compensation is paid. This can create disparate incentives between the manager and the investor. If the manager wins by taking on large risks in an attempt to beat the benchmark, he or she will receive incentive pay. But if the manager’s risk-taking loses, the fund’s operating expense fee will still be paid. This can create a misalignment of interests and an incentive for the fund manager to take on greater risk in an “I win big/I don’t entirely lose” game.

Such practices have led to the eventual destruction of several hedge funds. For example, a manager takes a big position that loses and then decides to double up in an effort to recover from the loss. If the market keeps going against the manager, he or she might double again, until the game ends. The study “Hedge Fund Survival Lifetimes” found that managers did, in fact, assume greater risk in the last month of operations than they did six and 12 months prior to closing.¹⁴ This finding confirms those of another study, which found that funds performing poorly in the first half-year exhibit increased volatility during the subsequent half-year.¹⁵

Myth #4: The hedge fund industry has operated for many years without SEC regulations, so any new regulations imposed by the SEC are excessive.

Debunking the Myth: “Hedge fund investors are big enough to look out for themselves.”¹⁶ Investors who assume the SEC is monitoring hedge funds for wrongdoing might be surprised to learn that in its September 2003 report “Implications of the Growth of Hedge Funds,” the SEC stated it was unsure of the overall size of the industry: “Despite the growth of the hedge fund industry in the last decade, we do not have accurate information about how many hedge funds operate in the United States, their assets, or who controls them.”¹⁷

In October 2004, the SEC voted 3–2 in favor of requiring hedge funds to be regulated more like Registered Investment Advisor firms and mutual funds. However, opponents of the registration rule quickly expressed their displeasure, even within the SEC itself. SEC Commissioner Cynthia Glassman voted against the rule and said after the vote, “I am disappointed with the approach that was chosen … I believe it is the wrong solution to an undefined problem.”¹⁸ In June 2006, a U.S. Court of Appeals struck down the rule.

Subsequent attempts by the SEC to provide additional regulations on hedge funds have also been met with significant opposition. For example, the SEC has proposed raising the minimum amount of assets needed to invest in hedge funds to be $2.5 million excluding real estate, up from $1 million including home values. The proposal triggered a round of letters from individual investors commenting on the move, which is unusual as most such comments come from lobbyists or interest groups. One investor wrote, “Stay out of my wallet, stop trying to protect me from myself, stop presuming to know more than I do about my own life, risk-tolerance and financial sophistication.”¹⁹

We are very concerned with these regulatory issues: 1) hedge fund misconduct could involve theft or misappropriation of investor funds, 2) current reporting requirements could allow the possibility that some hedge funds might create instant histories, and 3) investors will invest before they learn some of the reasons why hedge funds are higher-risk investments. We would suggest that issues of transparency and regular reporting rules continue to be addressed and ultimately regulated in a fair and consistent manner by an appropriate entity.

Myth #5: A hedge fund is a great way to diversify, because it provides low correlation with the equity markets.

Debunking the Myth: Correlation refers to the degree to which one security or asset class follows another security, asset class or inflation. The goal is to diversify a total portfolio across asset classes that have low (or negative) correlation, so they do not all rise and fall simultaneously. When discussing the theory at the heart of Myth #5, we might ask: How can investors be sure hedge funds have low correlation with the equity markets? If the SEC has stated that it cannot clearly define a hedge fund, and hedge funds are not required to disclose investment strategies, investors may find it difficult to verify.

Some question the very existence of a low correlation between equities and hedge funds. In his aforementioned article in the February 2004 Journal of Financial Planning, William Jahnke concluded: “Most hedge fund strategies are highly correlated with the stock market when the stock market is performing badly … because a significant decline in the stock market is often associated with a widening of credit spreads, an increase in market volatility, and a decline in market liquidity.”²⁰ Often, a fund will use returns and reporting data to demonstrate a correlation but that data may not always be accurate because of the reporting methods hedge funds use (see Myth #1 for complete details). Moreover, a flight to quality (a phenomenon that most often occurs in bear markets during which investors rush to move their assets to safer investments) can cause additional problems for hedge funds trying to achieve low correlation.

One reason that hedge funds fail to provide proper diversification relates to “lock-out” periods. During these “lock-out” periods — specified in a fund’s prospectus — hedge fund rules prohibit investors from removing their assets (whether the fund is outperforming or underperforming). Investors wishing to perform annual portfolio rebalancing or experiencing changes in financial or life circumstances may not be able to make changes to assets inside their portfolios because the assets are unavailable for withdrawal from a hedge fund. Finally, investors who believe hedge funds provide diversification might want to reconsider their decision to hold them for that reason because, as indicated above, they do not seem to provide low correlation with equities.

Myth #6: “This one’s different.” (Investors think they’ve found the hedge fund exception to the rule.)

Debunking the Myth: Some investors might effectively dismiss some of the evidence against hedge funds by arguing that the hedge funds they are considering today are different from the troubled hedge funds of yesterday. Sometimes, potential investors can be convinced that a fund is unique by the very composition of a fund — with either different investment products or strategies. However, any investment vehicle that takes tremendous risks to capitalize on market mispricings is taking on a type of risk that academic evidence has shown cannot be expected to generate premium returns. Studies have shown that asset allocation determines the vast majority of portfolio performance.

Some of the newest hedge fund styles and garden-variety hedge funds include:

• Long only
• Long/short
• Short only
• Global macro
• Event driven/merger arbitrage
• Convertible arbitrage 
• Financial arbitrage
• Currency
• Commodities
• Emerging markets
• Private placement
• Distressed securities

These strategies all share similar structures under which the funds are operating: exposing investors to agency risk and investing large, highly concentrated positions in just a few securities. However, our preferred strategy is to build an appropriately diversified portfolio of various asset class funds.

The following tale recounts the spectacular collapse of Amaranth Advisors, one of the (if not, the single) largest hedge fund collapse in nearly a decade.

Amaranth was one of the brightest stars in the hedge fund galaxy. The fund, which held more than $9 billion at its peak, not only rewarded investors with excellent returns, but did so when other markets were lagging. During the bear market of 2002, the major indexes fell 17 percent or more that year, while Amaranth produced returns of 11.3 percent. It even outdid its peers. The average hedge fund lost 1.5 percent, according to Hedge Fund Research.²¹

According to the New York Times, Amaranth delivered solid returns over the next two years, then again trounced its benchmarks in 2005. The hedge fund returned more than 18 percent, while the S&P 500 Index returned 4.9 percent and the average hedge fund returned 6.2 percent.²²

Much of Amaranth’s success came from its energy desk. In 2005, trading-related profits from energy totaled nearly $1.3 billion and produced nearly $2.2 billion from January 2006 to August 2006.²³

The sweet success quickly turned sour for Amaranth. The fund had a big bet that the spread between natural gas futures for March 2007 and April 2007 would rise. Instead, it collapsed. As the New York Times points out, “Once the trade went sour, Amaranth was trapped: selling into a falling market, scrambling to meet margin calls from nervous lenders, stuck in a position in a market where — to use a common phrase on Wall Street — ‘you get your face ripped off.'”²⁴

By the time Amaranth sold its energy book, the fund informed its investors it had fallen 65 percent — or $6 billion — in a single month. Nicholas Maounis, the fund’s founder, summed up the spectacular collapse during a conference call with investors shortly afterward: “Sometimes, even the highly improbable happens.”²⁵

Conclusion
Hedge funds are complex investment vehicles with less transparency, and their management has been subject to less regulatory oversight than mutual fund managers. The exclusive nature of these products combined with the potential for exceptional rewards trumpeted by those in the industry may tempt some high net worth investors, who would not normally consider investing in such risky investments.

Hedge fund investors accept all the downside risk inherent in such funds; yet they generally participate in less than 80 percent of the reward, as fund managers receive their typical 20 percent upside compensation. A considerable and mounting body of data suggests that hedge funds have not outperformed their appropriate benchmarks, partly due to the prevalence of excessive fees (for hedge funds and funds of funds), use of higher-risk strategies to achieve above-market returns, and incorporation of additional risks, such as agency risk. Taking all the hedge fund’s uncompensated risks into account — and realizing that these risks have not resulted in risk-adjusted return premiums — we conclude that hedge funds more closely resemble speculative products than prudent investment vehicles, and that they warrant no position in a well-structured, globally diversified portfolio, regardless of the investor’s net worth.

1 An Expensive Touch of Glamour; Funds of Hedge Funds. The Economist (London), September 20, 2003.
2 Update of the FSF Report on Highly Leveraged Institutions. Financial Stability Forum, May 19, 2007.
3 William Jahnke, Hedge Funds Aren’t Beautiful. Journal of Financial Planning, February 2004.
4 Roger Ibbotson and Peng Chen, The A, B, Cs of Hedge Funds: Alphas, Betas and Costs. September 2006.
5 Cassell Bryan-Low, Carrick Mollenkamp and Gregory Zuckerman, Peloton Flew High, Fell Fast. Wall Street Journal, May 12, 2008.
6 Ibid.
7 Burton Malkiel and Atanu Saha, Hedge Funds: Risk and Return. Financial Analysts Journal, November/December 2005.
8 Greg Gregoriou, Hedge Fund Survival Lifetimes. Journal of Asset Management, December 2002.
9 Ibid.
10 Bernard Condon and Neil Weinberg, The Sleaziest Show on Earth. Forbes, May 24, 2004.
11 SEC News Digest, SEC Sues Ft. Myers-Based Investment Advisor and Others in $10 Million Hedge Fund Fraud. www.sec.gov/news/digest/dig030104.txt, March 1, 2004.
12 Condon and Weinberg.
13 Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds. www.sec.gov, September 2003.
14 Gregoriou.
15 Stephen J. Brown, William N. Goetzmann and James Park, Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry. Journal of Finance, October 2001.
16 Mr. Donaldson’s Hedge Funds. Wall Street Journal, October 10, 2003.
17 Implications of the Growth of Hedge Funds.
18 Robert Schmidt, Divided SEC Adopts Rules Subjecting Hedge Funds to Oversight. Bloomberg, October 26, 2004.
19 Kara Scannell, On the Outside of Hedge Funds Looking in. Wall Street Journal, September 1, 2007.
20 Jahnke.
21 Jenny Anderson, Betting the House and Losing Big. New York Times, September 23, 2006.
22 Ibid.
23 Ibid.
24 Ibid.
25 Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a registered investment advisor. Copyright © 2008, Buckingham Family of Financial Services.

The post Debunking Hedge Fund Myths appeared first on JMF Capstone Wealth Management.

There Is Nothing New in Investing, Only the Investment History You Don’t Know
The exclusive nature of the hedge fund “club” creates an aura that seems to attract investors the way swim-up bars attract guests at all-inclusive resorts. Investors seem to value the sense of membership in an exclusive club. They yearn to be members of the “in crowd.” In addition to their “sex appeal,” hedge funds lure investors with the ever-present hope of market-beating returns. Many aspects of the Madoff affair are depressingly familiar:

• Trust in the promoter due to some social affiliation encourages investment.
• There is a lack of complete transparency of the investment strategy.
• Investors received returns that seemed too good to be true and a lack of audited financial statements.
• The whole affair unraveled at an amazing speed.

Investors should also have been aware that the very consistent returns reported by Madoff were inconsistent with his particular strategy of buying puts and selling covered call options on stocks in the portfolio. During bear markets, the strategy should have resulted in losses, though less than that of the overall market. Yet, Madoff was reporting consistent profits. That alone should have alerted investors (In fact, some potential investors were scared off).

There is an old saying about something being too good to be true. But if that were not enough, the number of trades that would have been required to execute the strategy far exceeded the number of trades reported on the entire exchange.

In addition to these problems, hedge funds have not only had a hard time keeping up with the risk-adjusted returns of riskless Treasury bills, there is no evidence of any persistence of performance beyond the randomly expected.¹ Therefore, there is no way to identify ahead of time the few winners (who receive all the press).

Perhaps it was the combination of the aforementioned problems and the historical evidence on returns that led Professor Eugene Fama, in an interview with Bloomberg Wealth Manager in November 2002, to state with great prescience: “If you want to invest in something (hedge funds) where they steal your money and don’t tell you what they’re doing, be my guest.”²

Principles of Prudent Investing
At the very heart of our firm’s investment philosophy is that our advice is based on scientific research, not our opinions. Strict adherence to that principle has served our clients well. We are just as proud of the investments we have helped our clients avoid as we are of the ones we have recommended.

Our management efforts are focused on the only thing we can control: risk. We do that by designing portfolios that provide our clients with the greatest chance of achieving their financial goals without taking more risk than they have the ability, willingness or need to take.

The scientific research also led us to conclude that the prudent strategy was to capture the returns markets provide. We recognized that while doing so basically meant giving up the hope of outperforming the market, it also meant that we would avoid the risk of underperforming the market (and the evidence demonstrated that this was the far greater likelihood). Thus, the only equity funds we recommend are those that are low-cost, tax-efficient, passively managed asset class funds (such as those of Dimensional Fund Advisors (DFA)). And our fixed income strategy is based on the same principle of earning market returns.

“Pay No Attention to That Man Behind the Curtain”
Madoff was able to execute his massive fraud because he operated behind “a curtain.” On the other hand, publicly traded mutual funds operate with a high degree of transparency. Among the advantages of investing in publicly traded investment vehicles are:

• Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission. Hedge funds are basically unregulated.
• Mutual funds are required to have audited financial statements. The audits verify the financial statements of the mutual funds including correspondence with the custodians, brokers and transfer agent of the funds that confirms the securities held. In the case of DFA, PricewaterhouseCoopers LLP, a major accounting firm, performs annual audits.
• Mutual funds do not act as custodian of the assets. In the case of our clients, their funds are primarily custodied at either Schwab or Fidelity.
• Mutual funds do not perform the fund’s accounting themselves. In the case of DFA, fund accounting is performed by PNC Bank.

In addition to these benefits, the following is also an important consideration. There is no incentive for DFA to take risks to try to outperform (The failure of such efforts often leads down the path to perdition as fund managers seek to recoup losses). DFA does not attract assets the way hedge funds do by weaving stories about how they can beat the market or earn market rates of return while taking less risk. DFA’s goal is simply to earn market rates of return. There are no incentive fees (to tempt managers to take risks) as is the case with hedge funds. And the historical evidence demonstrates that the returns earned by DFA’s funds are consistent with their stated strategy. There are no episodes of either dramatic outperformance or underperformance beyond that which would be randomly expected.

Eggs and Tennis Balls
If you drop an egg and a tennis ball off the table, the egg will shatter while the tennis ball will bounce back. Investors who made the mistake of investing in opaque investments with Madoff have seen their portfolios shatter like the dropped egg. Once shattered, there is no recovering. On the other hand, those investors that have suffered losses in their public equity holdings at least have the opportunity to see their asset values bounce back, like the tennis ball. And history suggests that if they have the discipline to stay the course, the odds greatly favor their being rewarded for their patience.

Summary
Among those who experienced the greatest losses from the fraud perpetrated by Madoff are some of the largest banks and some of the largest hedge funds. Each of them touted their ability to identify the money managers who would deliver market-beating returns on a risk-adjusted basis. They proudly discussed their superior due diligence efforts that serve to protect investors. As the academic evidence has demonstrated, such claims are without merit.

The saddest part of this great tragedy is that if investors had known the historical evidence and followed the basic rules of prudent investing, this tragedy would have been avoided. It is hard to understand why anyone would give their hard-earned assets to someone who:

• Invests those assets in a way that is not completely transparent
• Lets investors take 100 percent of the risks while taking 22 percent of the returns
• Provides returns to investors in a tax-inefficient manner
• Demonstrates no evidence of any persistence of performance beyond the randomly expected

Simply put, it is the triumph of hype and hope over wisdom and experience. And hope is not an investment strategy.

1 For more information on hedge funds, see Chapter 15 of The Only Guide to Alternative Investments You’ll Ever Need.
2 Lynn O’Shaughnessy, Brain Trust. Bloomberg Wealth Manager, November 2002.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2008, Buckingham Family of Financial Services.

The post Madoff Scandal Draws Attention to Hedge Fund Risks appeared first on JMF Capstone Wealth Management.