July 15, 2014

Target-Date Funds:  Disaster Waiting?

The Investment View from Prescott, Arizona

Target-date funds are sometimes called lifestyle funds.  You’ll know if you have one by the year appearing in the fund name.  These funds have become very popular because they make investing seem easy.  

You tell the fund company when you plan to retire; and as time progresses, the fund manager will gradually adjust your stock/bond investment mix cutting back on stocks and adding more bonds as you get closer to retirement, following traditional investment advice.  The problem is that rules of thumb like this are generalizations that often don’t work.  My research tells me that over the next decade or two generalizations are not going to work for target-date funds, here’s why.

The portfolio changes in target-date funds are fairly mechanical, following a pre-set formula described in fund prospectuses.  The fund managers have so very little discretion about how to manage the fund that the term management seems wrong – but I digress.  After opening a target-date fund, you don’t have to make any further decisions – at least that is how the pitch goes.

Morningstar’s 2013 Target-Date Series Research Paper compares different target-date fund offerings, but the report falls short by failing to compare their performance to other asset categories.  With the looming disaster awaiting target-date fund investors, I liken it to a discussion about which seat to choose on the Titanic.

Morningstar speaks highly of the fact that if turned to income at the investor’s age of 65, most target-date funds are not likely to run out of money before age 85; but they say that after that, “results diverge greatly.”

Considering a retiree at age 65 could withdraw 5% per year and have the funds last until 85 with no earnings at all, the Morningstar report seems to be just putting lipstick on this pig.

Rising stock markets in 2012 and 2013 helped target-date funds realize strong returns, but this just puts a smoke screen around the fact that the bond portion of target-date fund portfolios have underperformed their long term averages over the past two years, a trend which is expected to continue as interest rates rise.  

The combination of falling bond prices as interest rates rise and a formulaic investment plan that keeps moving more of your money into this poorly performing asset class will cause millions of investors to be disappointed by the returns they get from target-date funds.  

As the prospectus says, “Past performance does not assure future results.”  But past performance is what most investors look at before investing – that and the Siren’s song, “Make only one decision and the rest happens automatically.”

History strongly suggests that we will experience a prolonged period of generally rising interest rates.  We just finished 30 years of falling interest rates which pushed bond prices up.  The returns of target-date funds increased with them, but that is what is changing.  

Over the next decade or two, we may see another wave of dashed retirement hopes similar to what we saw in 2002 and 2008 due to the growing number of IRA, 401k and retirement plan investors holding with target-date funds that were destined to disappoint.

The solution is active management, not a passive formula or indexed approach.  Make sure your portfolio is actively managed.  This way your portfolio can hold fewer declining assets instead of more of them.

 How’s the Market Doing?

Don’t Fight the Fed

Despite talk of the Federal Reserve Board cutting back on the amount of new money they are injecting into the economy, the end has not arrived.  The stock market continues to trudge ahead as of this writing on July 14th.  Even the old “sell in May, then go away” adage isn’t working this year.  

These sayings can seem more factual because they rhyme; something I call the Jacksonian Fallacy after The Reverend Jesse Jackson’s penchant for making all of his sound bites rhyme to draw more attention to them.

Although the money printing has slowed down somewhat, the Fed is still expected to inject $19 billion into the economy during July of this year.  That is still an amount that would be eye-popping in normal times; but compared to the radically high rate of monetary stimulus of the past two years, it can seem downright depressing to some folks.  

As my buddy Tom McClellan says, “There are only two things that matter for investors: how much money there is and how willing people are to invest it.”  The government is still ensuring there is a lot of money floating around, so keep the faith.

My point is, do not react too soon to Fed tapering.  Despite it being natural to think that the stock market party will end someday, the stock market may not contract until after all stimulus is halted.  No one really knows, so use a proactive investment style which can react to what is actually happening, not speculative guess work about what might happen when and if, etc., etc.

Bond prices have firmed up the past few months, but the long term trend is still down.

Gold has also rallied, but a cyclical decline expected over the next month could change that.

 A Slice of Life

My Boston trip earlier this month was great fun, seeing Old Ironsides, Lexington and Concord, plus getting to re-enact the Boston Tea Party.  By being indoors for the conference, we even dodged the hurricane.

My presentation to the American Mensa Society was a huge success with standing room only in the large room.  People even sat on the floor to listen.  This is the fourth time I have been invited to speak to the Mensans, and it gets to be more fun each time I do it.

I wrapped up the trip by having a lunch (lobster roll) in the charming town of Ogunquit, Maine with my college roommate, whom I had not seen in almost 45 years.  Then I finished the day with frozen custard at Culver’s in Prescott Valley.  Yep, I grazed my way across the country that day!

 What’s Going On In Your Portfolio?

June was a good month for both our Shock Absorber Growth model* and our Flexible Income model* and for all accounts that follow those models.  Naturally, if you have Adaptive Balance* or Adaptive Growth* as your strategy, you had gains on both sides of your portfolio.

Due to continued strength in the stock markets, Adaptive Balance* and Adaptive Growth* portfolios have the maximum allocation to stocks, 50 percent and 80 percent respectively.

Certainly, some of the gains in June were due to stock market strength, but in June the Shock Absorber Growth* model significantly outperformed the S&P 500 Index**.  This outperformance was attributable to the addition of a new growth strategy that uses an index fund which is leveraged to add pop, but which is used in small amounts (currently about 30 percent of the portfolio) to control risk.  

The rest of the Shock Absorber Growth* portfolios are made up of energy, health care, transportation and real estate stocks and stock funds.

Flexible Income* portfolios include high yield (sometimes called junk), emerging markets, floating rate and diversified bond funds, as well as a preferred stock fund, which acts more like a bond than a stock and pays a 4.95% dividend.  We also have about 14 percent cash in Flexible Income* from the recent sale of an inverse government bond fund that was not going in the right direction.

Our Municipal Income* model portfolio flattened out in June, but is still having a terrific year; so I will be patient with that strategy.

 The Retirement Question

In initial client consultations, I often get asked, “What happens to my account if you get run over by a beer truck?”  Perhaps a Brinks truck is more in keeping with my business, but you get the idea.

This question goes hand-in-hand with the question, “Is Will ever going to retire?”  Let me answer both of these questions.

The brief answer to the second question is, “No, I don’t think I’ll ever retire.”

I realized a dozen years ago that if I were to retire right then I would still do the same thing every morning – after getting my cup of coffee and shuffling into my home office (often before I’m out of my PJs), I’m turning the dials and knobs on investments.  It dawned on me that since I was never going to quit doing the work, why would I plan on walking away from my business?

My mom and dad both lived to 90; I had a great aunt who lived to be 107 back in 1963 when centenarians were still pretty rare; so I have longevity to plan around.

My epiphany a dozen years ago caused me to streamline the business from a 10 person shop with me having to ride herd on five investment reps to today’s smaller but well oiled machine.  The women I work for (so-to-speak), Operations Manager Yvette Romero, Front Office Manager Sheri Congdon, IT Coordinator Laurel Taylor Fitzhugh and Bookkeeper/Admin specialist Mary O’Neil are why my life has so little stress and strain, despite the responsibility I have for watching your accounts.

This low strain is what (I hope) will allow me to continue doing my work for another ten or 20 years, at least.

Besides, I already travel as often as I please, play golf at least once every week and get to play with two wonderful grandchildren when I want to; so what more would I retire to? I’m not sure how much better life can get.

But, the beer truck question is an issue that every sole practitioner deals with, whether it is your doctor, tax preparer or your money manager; so it is a good question.

In my case, I have a sophisticated system in place to protect your account if something were to happen to me.  I set “stop loss” prices for any security we hold in client accounts.  A “stop,” as it is called, is one that triggers a sale if prices drop down to the price I specify.  I enter our stop loss prices into a program that monitors pricing and will send an email to the office staff telling them to sell the security in question if the price falls below one of my stops.

If an email from this program is sent, the staff contacts me to be sure I am aware of the price decline.  But if I am out of touch or out of action, the staff is authorized to sell that holding moving the value into cash.

I, however, am the only one who makes buy decisions, so cash accumulated this way would not be reinvested until my replacement is on the job, which I expect to be within days.  

If I were to die (God forbid), your investments will either continue to rise or if they decline, they will be moved into cash.  This gives you time to interview my replacement or move your account.  The important thing to note is that your money will not be at risk during this time.

And I do have other managers lined up who can step into my shoes if the beer truck really does me in.  The bottom line is your life should not be disrupted if I were to depart this plane of existence.

This is a service business, and planning ahead is part of that service.

  Scottsdale Office Date

 Will is happy to meet with you in Scottsdale for your convenience.  Please call the office to schedule an appointment.  928 778-4000

 I’m Never Too Busy for my Friends or Family

Although I am a specialist these days, limiting my practice to portfolio management, and although I spend my time in three different offices (and occasionally the golf course), I am never too busy to sit down with you and review accounts or answer your questions in other areas.  It is very important to me to keep a close tab on my clients’ goals.

I spent many years practising as a Certified Financial Planner; and although I no longer hold myself out to the public as a planner, I still retain many of those skills for the benefit of existing clients.  Membership has its privileges, so to speak.  So, if you have any financial questions, I would be happy to help you with them.

I am also happy to meet with your friends who might have questions.  If I can help them, I will.  If not, I can probably suggest who may be able to help them.

One of the nicest compliments you can give me is to tell your friends about my work.  An easy way to do this is to use the link provided in this newsletter to forward this letter to your friends.

 Our Spotlight Strategy

With our Adaptive Balance Strategy we strive to provide high total return from a combination of investments in both the equity and income markets with an emphasis on the income markets.

Our proprietary indicators are used to determine a stock market exposure that adapts to both strength and weakness in the market, directing exposure to the HCM Shock Absorber Growth strategy from 0% to a maximum of 50% of account value.  The balance, 50% to 100% of account value, is invested in the Flexible Income Strategy.  The HCM Safety Net indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.

If you would like a current copy of our SEC Form ADV, Part 2 or our Privacy Policy, they are on our website atwww.hepburncapital.com/PR/form-adv.pdf  and www.hepburncapital.com/images/PrivacyPolicy.pdf respectively.

 *    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Performance and activity in client accounts may be different from that in the model because of the amount in each investment, specific timing of trades and the actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  Indexes are unmanaged lists of stocks considered representative of a broad stock market segment.  Investors cannot invest directly in an Index.

Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Growth

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve uncertainties, known and unknown risks and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however, we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.