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.
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).
You cannot buy shares directly in the index, but you have several options to mimic the index (some more precise than others):
1) Most Accurate (should mirror performance of the DJIA to the tee):
Create a portfolio with precisely the same composition as the DJIA by buying up the Index's 30 stocks, which are published daily in the Wall Street Journal. If you want to understand why simply adding the value of each of those stock prices does not give you the current value of the index, you must understand that stock splits, reverse splits, and other share-count adjustments which have no impact on value but significantly change the price per share (while the number of shares outstanding either rises or falls, exactly offsetting the change in price, as stock splits or reverse splits don't impact value). Because of the numerous splits and reverse splits, etc. executed by several of the companies within the DJIA over the years, the Wall Street Journal continuously updates a "Dow Divisor" figure to calculate the appropriate level of the price index, so that it doesn't give an inaccurate representation of index performance due to distortions to price caused solely from changes in a given company's share count. For example, if McDonald's (a member of the DJIA) was trading at $10/share and issued a 2-for-1 split, its share price would go to $5 while each shareholder would receive an additional share of stock, leaving their ownership value unchanged. Because the DJIA is a price-weighted index, without adjustment the index would look to have performed worse than in actuality due to this unadjusted, 50% decline in the value of 1 share of McDonalds' stock. The Divisor accounts for the cumulative value of splits and reverse splits over time, to keep a proper representation of index performance. But, if you just want to replicate index performance, you can simply create a portfolio comprised of the 30 stocks included in the dow, namely: MRK, KO, BA, JPM, MSFT, CSCO, PFE, HD, GE, UNH, GS, INTC, DD, WMT, DIS, CVX, AAPL, TRV, VZ, MMM, CAT, AAPL, UTX, AXP, NKE, PG, IBM, V, MCD, JNJ.
If you want to prove to yourself that your return performance each day mimics that of the DJIA, divide the daily return performance of your portfolio by the Dow Divisor provided daily in the Wall Street Journal or on the CBOE's website.
2) Very little tracking error, but not exact DJIA Performance:
Purchase the ETF with the lowest tracking error relative to the DJIA - for 2016, the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA) takes the cake. It is also the one index that seeks to completely mimic the index composition, so the only tracking error (or difference in ETF returns vs. the actual performance of the index) comes from its very low Total Expense Ratio (TER) at only 0.17%. DIA is the largest and most liquid tracking fund. The fund’s only purpose is to track the daily performance of the DJIA.
Tracking error SPECIFICALLY FOR THE DJIA, not to be confused with ETFs tracking other indexes with different weighting methodologies or asset classes, is primarily driven by the expense ratio of the ETF, as the Dow is otherwise relatively easy to replicate. You simply buy all 30 stocks that comprise the index, and re-balance where necessary.
3) Can achieve returns exactly correlated with movements in the DJIA, but magnified on the upside and on the downside. If we want to find a way to essentially "invest in the DJIA," which is a non-investable benchmark index, we can get the exact returns on a long position in the DJIA (as if it were investable), magnified by 5x, by taking a long position in the E-mini DJIA futures contract. An investor can obtain five times the leveraged exposure to all the stocks in the DJIA for less than $5000 with margin trading on the E-Mini DJIA contract. The E-Mini contract represents $5 x the DJIA. So, for instance, the dow closed up 40 points to $18,203 today. The E-Mini DJIA contract returned exactly 5 times this amount, or $200 on the day. Futures on the DJIA trade quarterly, with nearly all the trading volume taking place in the nearest expiration month.
4) You can also take a long position in the DJIA, though the upside will be magnified by 100, by taking long positions in call options on the index. Downside is limited only to the premium you pay for the option (if you think the index will rise, you buy calls; if you anticipate it will fall, you buy puts), giving you a beautifully asymmetric trade weighted to the upside. Losses are capped at the option premium, while gains are magnified by 100 (leverage) and are theoretically unlimited. Of course, for those unexperienced with trading, be sure to understand how options work before executing any positions as these can be considered risky investment vehicles.
If a bond is trading at a premium, this simply means it is selling for more than its face value. Why would a bond trade above par (face value)? Because the fixed coupon rate on the bond trading at a premium exceeds the prevailing market rate, or the rate you could otherwise obtain by buying another bond of comparable credit quality and the same duration. As a result, the excess interest payments on the bond that trades at a premium (relative to comparable bonds offered at par) compensate for its higher price.
The premium has nothing to do with whether the bond is a good investment. Bond investments should be evaluated in the context of expected future short and long-term interest rates, whether the interest rate is adequate given the bond's relative default risk, expected inflation, bond duration (i.e. interest rate risk associated with the length of the bond term) and price sensitivity relative to changes in the shape of the yield curve. You should also consider the bond’s coupon relative to the risk free rate; returns that can be generated in the equity market - are equities priced so low that they become a better risk/reward tradeoff? Consider the opportunity cost of funds tied up in the bond that could otherwise be invested elsewhere; expected or potential foreign currency fluctuations (bonds with bullet payments at maturity are more susceptible to FX risk); these, among many other items, should be considered in assessing whether a given bond is a “good” investment. In the end, anything with the potential to impact cash flows on the bond, as well as its risk-adjusted return profile, should be evaluated relative to potential investment alternatives.
Of course, one should also consider the bond investment’s suitability with their investment objectives, as certain investments will be more suitable than others for different people depending on their unique financial situation, investment goals, and tolerance for risk. Investors seeking current income with a low risk tolerance should probably stick to high-quality bonds, whereas those with a longer-term profile and a healthy appetite for risk might prefer the riskier, yet generally higher, current income that can be earned by investing in a Master Limited Partnership (MLP). Those who can afford to lose their investment in an instrument, provided losses are limited to the cost of the instrument and the potential upside is far greater, may want to consider taking long positions in options. Call options have a risk profile that’s asymmetric, weighted heavily to the upside, while losses are limited to the premium paid.
In summary, to evaluate whether an investment, in this case in a bond trading at a premium, is a “good” one requires in-depth analysis of credit risk, FX and interest rate risk, macroeconomic considerations that could impact repayment patterns, the opportunity cost of the investment, and your unique investment objectives and risk tolerance.
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.