Ascend Investment Partners
Senior Investment Strategist and Junior PM
Emma Muhleman, CFA, CPA is a Junior Portfolio Manager and Macroeconomic Strategist at Ascend Investment Partners. Emma and her team specialize in understanding the dynamics that underlie and drive investment performance in today’s global financial markets. Following the global financial crisis, expansionary monetary policies of unprecedented scale implemented by major central banks across the globe (primarily those of the so-called “core economies”) have completely redefined the ways in which the global markets operate. At Ascend, it is precisely Emma and her colleagues' unique expertise in the “macroeconomics of today” that enables them to evaluate the domestic and global landscape through a lens misunderstood by the masses, leading to abundant investment opportunity.
Emma's professional experience to date includes working for several years picking stocks (long and short) according to a global macro, event-driven long/short equity strategy. She began her career performing business valuations for Deloitte's valuation consulting group, and thereafter worked as a stock picker for Allianz SE, one of the largest global investment managers with total AUM exceeding $1.7 trillion. She has also developed several client relationships of her own within the private equity (PE) and venture capital (VC) investment realm ranging from Roth Capital's Venture Group to KKR and several others, and has extensive experience performing investment analysis and due diligence, negotiation and deal structuring as part of the evaluation process associated with Leveraged Buyouts (LBOs), Early- and Growth-Equity Stage Venture investments, and potential buyouts of distressed loan portfolios and/or turnarounds of businesses under duress.
MS, Accounting and Finance, University of Notre Dame
MS, Taxation, University of Notre Dame
Harvard, School of Engineering & Applied Sciences (SEAS)
The opinion expressed represents the views of the author and should not be seen as the opinion or views of Ascend Investment Partners. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.
401(k) plans are tax-deferred retirement savings accounts offered by private (non-government), for-profit employers, while 457 plans are offered only to public employees (working for schools, charities, colleges/universities, and state & local governments), and other tax-exempt entities under 501(c)(3) of the Internal Revenue Code.
Similar to 401(k) plans, 457 plans provide a way for employees to save money for retirement by deducting from pre-tax income employee contributions to the plan, which are then invested and taxed only upon withdrawal in retirement, at which point the retiree's ordinary income tax rate is applied. Since we have no active earnings in retirement (though we may have some passive income from investments or annuities and the like), our ordinary income tax rate is generally very low post-retirement and much higher while we're still part of the workforce. Accordingly, the tax deferral associated with 401(k)s and 457 plans can provide meaningful tax savings.
With a 457 plan, employees make pre-tax contributions in the form of payroll deductions, and that money grows tax-deferred until retirement. Many public and non-profit employers offer both a 457 and 403(b) plan, as well as a separate, primary retirement plan - often a Defined Benefit pension. With Defined Benefit pension plans, the employer contributes to the plan, and the plan is required to pay pre-specified installments ("defined benefits") to employees in retirement, versus Defined Contribution plans (such as 401(k)s, 457 and 403(b) plans) under which employers agree to make matching contributions but have no liability for ultimate payments or cash available upon retirement. 457 plans allow for double deferral when coupled with a 403(b), as employees can legally contribute twice the annual contribution limit by combining the two. For example, an employee can reach the contribution limit for a 403(b) plan, which in 2016 is $18,000 (and also represents the maximum allowable contribution from pre-tax income to 401(k) accounts), and still contribute the entire contribution limit to a separate 457 plan (or another $18,000 in 2016, for $36,000 in total pre-tax contributions). 401(k) plans do not offer any double deferral opportunities, and contributions are capped out at the annual limit of $18K. As previously noted, many public employees with access to 403(b) and 457 plans also have a defined benefit pension plan from which they will receive retirement income. In this manner, employees who can afford to make large pre-tax contributions (up to the maximum, double-deferral) could choose to accumulate far more employer-sponsored retirement income than most employed by corporations (or others working in the for-profit sector).
As with all Defined Contribution plans, growth is tax deferred. Upon taking approved distributions, people pay ordinary income tax on approved 457 distributions. The key difference between 403(b) or 401(k) and 457 plans involves the distribution rules. 457 plans allow individuals to withdraw funds early without having to pay the 10% early withdrawal penalty imposed on 401(k) or 403(b) holders, but only in the event that they switch employers. The drawback with a 457 plan is its strict age-related distribution limitations. Anyone still working for the sponsor of the 457 plan may not withdraw funds without penalty until age 70.5. If they wish to withdraw funds before then, they must either switch employers or be penalized for early distribution. In contrast, individuals can take 401(k) distributions without penalty any time after they've reached the age 59.5. The incremental 20 years employees must wait before making eligible withdrawals free of penalty under a 457 plan can be onerous.
Where applicable, anyone can contribute to a 403(b) plan, a 457 plan, both plans, or neither. Generally speaking, its more common for younger employees to make 457 plans their primary plan because they can take distributions at any age when they stop working for the sponsor-employer. On the other hand, those approaching the retirement age may not want to switch jobs or commit to a plan that would require they do so to avoid penalties, fearing a lower salary elsewhere. As a result, older employees generally make 403(b) plans their primary, and use 457 plans as a supplement in the event they wish to contribute more than the annual contribution limit.
I would recommend avoiding the use of robo-advisors to create your long-term asset allocation. As a Chartered Financial Analyst (CFA) and a CPA, I have learned over the years that the metrics upon which traditional asset allocation methods and quant-based models used by robo's, which generally rely on backward-looking measures of 'correlation' are fatally flawed. As I'm sure you're well aware, rising geopolitical risk across the globe, the trend toward 'anti-globalization,' and unprecedented leverage across the international monetary system create a wide distribution of potential macroeconomic outcomes over the coming year (and beyond). Investors are only in the early, early stages of catching on. Volatility can be traded in the financial markets (as can just about anything), and currently sits at astonishing low levels as consumer confidence in the US has surged following Trump's election and subsequent announcement for pro-growth fiscal policy, defined by individual and corporate tax cuts and deregulation. This confidence has already begun to wane, and should only continue to do so in the coming months - in other words, the 'hope trade' is overdone.
So how would an individual investor take advantage of such an environment? Using history a guide, it's useful to note that insanity can continue for an extended period of time, continuing to drive rallying equity markets - but once confidence is lost, you don't get it back. You just don't. Markets tank, and not just the equity markets. You see, here's where the correlation measure gets investors in trouble: during episodes of financial panic, historical correlations break down entirely, and asset classes that historically exhibited low correlation (e.g. Stocks vs. bonds vs. commodities) suddenly move decisively in the same direction ... down, fast. For example, in 2008, you couldn't even find a buyer for investment grade corporate bonds for a sustained period of time. Even Treasuries were forced to be sold at fire-sale prices - any time debt overwhelms real economic growth for a sustained period of time, you may hear things like "it's just a liquidity problem." "Liquidity problems are virtually synonymous with insolvency.
Episodes of extreme financial panic happen roughly once a century, and curiously they're always driven by borrowings to fund over-consumption to the nth degree. This simply means we're overdue for the next financial 'breakout' - which could happen in 2017, 2018, only time will tell. But one thing is certain it WILL happen, it's simply a matter of WHEN.
You can capitalize on this by buying shares in the various long volatility ETFs. During the Crisis of 08/09, when equities fell 40%, the volatility index surged some 300%+. So you needn't own a TON of long volatility positions to reap large profits from a coming uptick in recognized volatility in the global financial markets -- if you do, you may reap handsome rewards. But if you're more risk-averse, you can buy, say, 10% of the portfolio in long volatility positions - while holding a significant positions in domestic SPDRs (I recommend the Biotech SPDR, Healthcare, and Technology, and strongly urge you to avoid Financial Services - the derivatives risk inside the world's 12 largest banks, or the 'weapons of mass destruction,' as coined by Warren Buffet, are inconceivable. Derivative exposures alone could drive a collapse in the entire monetary system.
Stay away from emerging markets, whose debt burdens denominated in a strengthening USD and weakening currencies are crippling the prospects for economic growth. Avoid China altogether - the country is going broke, and this is second grade math. At the end of 2015 it had $4 trillion in reserves. At the end of 2016, this fell to $3 trillion, by and large due to capital flight, legal and illegal. Of the $3 trillion the country currently has, $1 trillion is tied up in illiquid investments such as hedge funds by the banks. Another trillion is borrowed funds. Now, the country is burning through $80 billion yuan/month, meaning, as the math simply illustrates, the country will be broke by the end of 2017. Major restructuring, and bailout by global lenders (likely to drive contagion, particularly into Europe and Japan) will be required.
When investor sentiment reverses, the shift typically happens abruptly and can cause investors like yourselves to lose much of your savings, including those in your 401(K)s, 403(b)s and 457(b)s -and I wouldn't count on your pension - the US (and global) pension funds face a crisis that can only be fixed in one of two ways: (i) bailout by the government, through the creation of ever more new money (from thin air), handed to the pension funds to pay out retiree benefits, but by the time you'll be eligible to receive such benefits inflation will act as a hidden tax, making the same, dollar-denominated promised benefit payments worth far less from a purchasing power perspective; or (ii) the pension funds will simply go broke, and default on their promises. In any case, I'd be remiss if I didn't advise you to rely on non-pension sources of retirement income. In your other accounts, I recommend only holding exposure to domestic (U.S.) equities, and only through the NASDAQ (NOT the S&P 500, because the Nasdaq does not include Financials). This can be done by buying QQQ. You can hedge your risk of global catastrophe with long volatility positions in a selection of ETFs or ETNs, which can be found here: http://etfdb.com/etfdb-category/volatility/. I recommend VIIZ. Don't fall into the investor's trap, saying, well, that hasn't done so well lately. Well yes, that's precisely why it's cheap, and what makes it attractive. As Buffet once said, do you buy a more expensive house rather than a comparable house that's recently declined in value, simply because it's gone up in price? Of course not, this thinking is backwards, and should be kept in mind when investing in the stock markets.
Hope this helps. Please touch base if you would like further financial advise, my contact information (including email, phone) should be listed along with my profile page.
If you knew without a drop of uncertainty that Yellen and her cohorts at the FOMC will announce a rate hike at the coming Fed meeting (and the market did not possess such knowledge), it would be wise to wait and invest in bonds after the rate hike. Why? Rising interest rates, no matter how small the coupon or how short the bond's duration, hurt the value of fixed rate bonds - when the prevailing market rate rises, it makes the coupon on fixed rate bonds inherently less valuable. For example, suppose the Fed meeting is tomorrow, and I buy a 5% semi-annual bond at par ($100). Tomorrow the Fed comes out and says they're hiking rates from 25-50bps to 50-75bps, with subtle hints at a more rapid upward interest rate trajectory. The market may very well take these hints as if they were set in stone, causing a sell-off in fixed rate bonds as investors overreact to the news (standard procedure, especially when it comes to the Fed). In this case, the bond I bought yesterday for $100 may decline to $98 in value, in which case I would have been better off buying the debt on the cheap after the Fed's announcement.
What's important to note though is that the Fed, under Chair Yellen, is infamous for acting as though they plan to raise rates but coming up with consistent excuses to do nothing. For almost the entirety of 2014, Chair Yellen had the market believing at each successive meeting the FOMC would hike rates, but it wasn't until the end of 2015 when they finally did something, marked by a measly 25 basis point hike to the Fed Funds Rate. Despite all the empty promises, the market continued to overestimate the likelihood of a rate hike throughout 2014 and 2015, time and time again. As a result, I would be remiss if I didn't mention the likelihood the Fed comes up with another excuse to do nothing, leaving you wishing you would've bought those bonds before the meeting - fixed rate bonds would likely rise in value after a no-action announcement as the market resets its expectations for the interest rate trajectory.
The Fed will continue to tinker with market expectations, but I expect they will keep a tight lid on interest rates accompanied by a loose policy stance over the coming years. During recent testimony after the last Fed meeting, Chair Yellen even suggested the Fed may eventually considering going out and buying up stocks in the open market. Monetary policy doesn't get more accommodative, with the exception of negative interest rates (which FOMC members have also suggested they would consider). Accommodative monetary policy is bad for the value of fixed payments to be received in the future, as it typically results in dollar devaluation, making future dollars inherently less valuable than those held today. This makes sense, logically. If you flood the market with newly printed dollars created from thin air, the supply of dollars in circulation goes up while demand for it stays flat. As a result, this increase on the supply side should lead to a lower overall value, provided other countries aren't also printing equivalent amounts (or more) of their respective currencies.
Considering the composition of the Fed today, it's not going to change its stance - we're likely to see continued accommodation for some time, which should support equity markets but won't help fixed income. If you're looking for a hedge against equity exposure, there are alternatives that work better than fixed income. For instance, the VIX, or the volatility index, which is considered the equity market's "fear guage," has a large, inverse correlation with equities. It went through the roof in 2008/09, and call options on the index (which can be purchased on the CBOE) made their holders rich (or very, very high returns at the time). Investing in options is risky, however, as you face the potential to lose your investment in the option premium, so please make sure you understand what you're investing in before considering investing in options (and I'd recommend longer-dated expires when it comes to VIX).
A hedge fund is a privately managed investment vehicle, typically structured as a Limited Liability Partnership (LLP), that has a broadly-stated investment mandate and the ability to invest in a wide range of relatively liquid financial instruments (ranging from long and short equity positions to futures and options on commodities, interest rates, currency pairs, volatility levels, market indexes, and more). Additionally, some hedge fund strategies focus primarily on debt/credit markets, while others focus primarily on taking advantage of unique knowledge with respect to anticipated macroeconomic, market, or company-specific events (Event-Driven strategies).
Unlike hedge funds, private equity funds hold illiquid positions (for which there is no active secondary market) and typically only invest in the equity and debt of target companies, which are generally taken private and brought under the private equity manager's control.
While the private equity investor looks at an investment prospect as investing in a company, hedge fund managers often look at equity positions as investing in the company’s stock (whose performance has its own, unique set of drivers). A company's success is determined over the long-run by the performance of its products, its business model, and whether it can develop a sustainable competitive edge. A stock's success often diverges from the company's fundamental performance, especially in the short-to-medium term, due to behavioral biases, irrational behavior among investors, emotional decision-making, market hype, and supply and demand imbalances in the market for the company's shares (i.e. varying liquidity conditions).
Hedge funds typically allow quarterly redemptions, giving their managers a shorter-term mindset (generally speaking, though there are notable exceptions to this) than a private equity fund manager. The private equity manager receives capital commitments that cannot be withdrawn for a standard ten-year term (often with a two-year extension available at the General Partner’s discretion). This partially explains hedge funds’ tendency to focus more on the short-term, as they face the threat of large redemptions, even if they only underperform for a single quarter.
Similar to hedge fund structures, private equity funds often organize as an LLP, but the Limited Liability Companies (LLC) structure is also common. Both hedge funds and private equity funds typically charge a management fee against total assets under management (AUM), ranging from 1%-3% of invested capital, and take a profit share called “carried interest” or “carry,” which ranges from 20% (by far the most common) to 30% (rare). With carried interest, suppose a hedge fund began operations with $100 million AUM at the start of 2015 (1/1/2015), and had no contributions or withdrawals during the year. If the fund’s Net Asset Value (NAV) rose to $130 million at the end of the year, the fund manager would be entitled to carried interest of $6 million (20% x $30 million profits). If the fund subsequently loses all profits earned and more throughout 2016, the fund manager likely will not receive any carried interest due to high-water mark provisions (not applicable to private equity).
While there are different types of annuities, they all boil down to essentially the same thing: an insurance contract that offers guaranteed income, often for life and sometimes with some capital appreciation. Annuities are meant to supplement income from a traditional stock and bond portfolio. Annuities are by their nature illiquid and as such, it is never advisable to invest more than 50% of an investment portfolio in annuities. Annuities make the most sense as an investment vehicle for pre-retirees and retirees who wish to minimize concerns regarding the potential impact of a bear market while they're living on the retirement portfolio. Annuities provide retirees with assurance they will have a specified stream of income, regardless of how the markets perform. They offer certainty in an uncertain world. There are hundreds of annuities on the market. They typically provide higher income than bonds, but many have materially higher fees and their payments - reflecting today's ultra-low interest rate environment - aren't as attractive as they once were.
5 PRIMARY TYPES OF ANNUITIES -
FIXED RATE ANNUITIES (ALSO CALLED MULTI-YEAR GUARANTEE ANNUITY OR "MYGA"):
These are fixed interest investments issued by insurance companies. They pay guaranteed rates of interest, typically higher than bank CDs, and holders can elect to defer income or begin to draw income immediately. A Multi Year Guaranteed Rate Annuity (MYGA) pays a constant and guaranteed rate of interest each year during the selected period. The annuity investor can either spend the interest as income, or allow it to compound inside the contract on a tax-deferred basis. Benefits of standard fixed rate annuities are their simplicity and predictability of the income stream, allowing for many different uses including RMD distributions, wealth transfer and accumulation. As with any annuity it’s important to understand the differences between annuity products. A common mistake is taking the highest interest rate without considering the liquidity provisions and duration of the commitment.
Standard fixed rate annuities have no fees.
A variable annuity is a contract between you and an insurance company. You open an account with funds typically earmarked for your retirement. The insurance company then invests your money in a selection of mutual fund-like investments (subaccounts), and your account value can grow or shrink with the underlying investments. Available fund subaccounts typically range from conservative bond funds to aggressive stock funds, in addition to asset allocation models.
These allow investors to choose from a basket of subaccounts (mutual funds). Ultimately, the value of the account is determined by the performance of the selected mutual funds. A rider can be purchased on top of this to lock-in a guaranteed income stream regardless of market performance, which is a critical hedge in the event the mutual funds perform poorly. These are popular among retirees and pre-retirees seeking a greater shot at capital appreciation in conjunction with guaranteed lifetime income.
Variable annuities can vary widely in their fund and benefit offerings as well as fees, so be certain to hire a qualified, professional financial advisor with a thorough understanding of annuities prior to purchase.
Among the various types of annuities, variable annuities typically have the highest fees.
A fixed-indexed annuity is a type of annuity that grows at the greater of (a) an annual, guaranteed minimum rate of return; or (b) the return on a specified market index (e.g. the S&P 500), less certain expenses and formulas. At contract opening, a term is selected, representing the number of years required to pass before the principal is guaranteed and the surrender period has passed. In a robust equity market, you will not achieve the actual index performance due to the formulas, spreads, participation rates, and caps applied to fixed-indexed annuities, and also due to the absence of dividends (see below). But, in a down market, you never lose any of your principal investment. Many investors find that fixed-indexed annuity returns more closely approximate CDs, traditional fixed annuities, or high grade bonds, but with the potential for a small hedge against inflation in an up market.
Fixed income annuities relative to the other types have moderate fee levels.
FIXED VS. FIXED-INDEXED ANNUITIES:
Technically speaking, fixed-indexed annuities are a type of fixed annuity. But a fixed-indexed annuity is different than a standard fixed annuity in the way that earnings are credited to the annuity. For a standard fixed annuity, the issuing insurance company guarantees a minimum interest rate. The focus is on safety of principal and stable, predictable investment returns. With fixed-indexed annuities, the contract return is the greater of a) an annual minimum rate, or b) the return of a stock market index, less fees & expenses and other items mentioned previously. If the chosen index rises sufficiently during a specified period, a greater return is credited to the owner’s account for that period. If the stock market index does not rise sufficiently, or even declines, the lower minimum rate is credited (usually 0% – 2%). The owner is guaranteed to receive back at least all principal less withdrawals (provided of course that the owner has held the contract for the minimum period of time specified in the contract).
These are essentially equivalent to a life insurance policy. Instead of paying regular premiums to an insurer that makes a lump-sum payment upon death, the investor gives the insurer a lump sum in return for regular income payments until death, or for a specified period of time, typically starting one to 12 months after receipt of the investment. Payments are typically higher than other annuities because they include principal, as well as interest, and so also offer favorable tax treatment. These are popular among retirees and pre-retirees who need a higher-than-average stream of income and are comfortable sacrificing principal in exchange for higher lifelong income.
Immediate annuities have no fees.
Deferred annuities delay payments until a future date, greater than one year from contract initiation. These annuities enable individuals to increase their income stream later in life for less money, as the insurance company isn’t on the hook for as lengthy a period of time when income payments are deferred. These people to those seeking guaranteed income in the future but do not need anything now and/or those seeking to build a ladder of income over different periods later in life. For instance, an individual may want to work while retired but knows that eventually, they’ll be forced to stop working and at that point, but not prior to that time, they will need income from an annuity.
Relative to other forms of annuities described above, deferred annuities have moderate fee rates.