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.
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.
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).
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).
In financial terms, a derivative security is generally referred to as a financial contract whose value is derived from changes in the value of an underlying asset, or simply "the underlying," over a predetermined period of time. Today, derivatives are traded on a wide variety of financial and non-financial assets, including specific stocks, equity indices, currency cross rates, fixed-income instruments, expected volatility embedded in market prices, commodities, credit events, and even other derivative contracts. Depending on the type of underlying, the value of a derivative contract can be derived from changes in the value of the underlying equity prices, interest or inflation rates, foreign exchange fluctuations, commodity price changes, market sentiment, and the probabilities of certain credit events.
Participants in the derivative markets are typically classified into one of two categories: they're either grouped with the "hedgers" or the "speculators." Hedgers enter a derivative contract to protect against adverse changes in the value of their assets or liabilities. For instance, a U.S.-based conglomerate selling to retailers abroad in the emerging markets and extending credit with typically terms (such as net 30 or net 60 day payment) will produce these goods with costs denominated in the U.S. dollar, yet they won't be paid for another 30 or 60 days, in the Argentine Peso or the Turkish Lire -- with the inherent volatility in these currencies, if my sale today amounts to a required payment in 30-60 days of 1,000 Argentine Peso, today this is worth around $65. But, the Argentine Peso could be cut in half over the next 60 days, making my receivable of 1,000 ARS worth only $32.5 when translated back to USD, meaning I suffer a significant loss. In this case, I would want to hedge this exposure to fluctuation in the Argentine peso by entering into a contract with a "speculator" or another hedger who has a future liability to pay in Argentine peso and seeks to protect his purchasing power.
"Speculators," on the other hand, seek to profit from anticipated changes in equity prices, credit markets, interest rates or inflation / foreign exchange, defaults on credit instruments or a lack thereof, or changing commodity prices, among other things.
There are four main types of derivatives (without getting into the more exotic types): (1) Forwards, (2) Futures, (3) Options, and (4) Swaps.
Forwards and Futures are similar as both represent an agreement to buy or sell a specified quantity of an asset at a specified price with delivery at a specified date in the future. The differences in futures vs. forwards is that futures are exchange-traded, standardized agreements with daily settlement for changes in the value of the underlying. In contrast, forwards are what's referred to as "Over-the-Counter" contracts, which are agreed upon between two parties and loosely regulated (since they're not exchange traded and no clearinghouse exists for these contracts).
In an Options transaction, the purchaser pays the seller - or "writer" - of the option for the right to buy or sell the underlying asset at a specified price (the "exercise" or "strike" price) in a specified quantity anytime prior to the option's expiration (the "expiration date"). Note this refers only to "American-Style" options, whereas "European-style" options allow the buyer the option to buy/sell the underlying only on the expiration date. Options can either be in the form of "calls" or "puts." A call option gives the option-buyer the right to buy the asset at the strike price any time prior to expiration, such that if the price of the underlying rises over the option's term, the option rises in value. If the underlying's price rises above the strike price, the option will be exercised, at which point the buyer receives the difference between the excess of the price of the underlying over the exercise price, multiplied by 100 (reflecting the leverage inherent in options trading). On the flipside, a "put" option gives the option-buyer the right to sell an asset at a predetermined price (the "exercise price") over the option's term. Those who expect the underlying to appreciate in value will buy calls, while those anticipating the underlying's value will fall buy put options. Option writers, or those guaranteeing the option, receive an option "premium" in exchange for the inherent value of the option. Those who buy options (calls or puts) anticipate volatility in the underlying asset, whether to the upside or to the downside. Conversely, option writers expect little movement in value of the underlying, such that the option will expire worthless (otherwise known as "out-of-the-money").
Swaps are agreements between two parties to exchange a series of cash payments for a stated period of time. The period payments can be exchanged based on the receipt of cash flows using the differential between fixed and floating interest rates, multiplied by an agreed upon amount, called the "notional value" of the swap.
Now that I've explained the basics, I can address your question as to the impact of derivatives of stock and mutual fund portfolios. Hedging or speculating is not the only drivers of derivatives transactions today.
Fund mangers often use derivatives to achieve specific asset allocation targets for their portfolios. Mutual funds today come in a variety of forms and pursue a variety of different strategies. A bond fund manager may hold interest rate derivatives to protect the total portfolio from declines in the value of fixed income investments resulting from a hike in the Fed Funds Rate or a general tightening in the credit markets. A mutual fund pursuing a global macro strategy (more common to hedge funds, but certain mutual funds pursue this strategy) may hold a significant share of derivatives, reflecting the fund manager's expectations for the direction of interest rates in various geographies and the corresponding monetary policy action, foreign exchange movement, and economic activity. Mutual funds pursuing a long equity strategy may used some "covered calls" to boost returns. With a covered call, upside is limited if the stock takes off big, but if it rises in value without going beyond the strike price on the short call (with a short call, a fund manager agrees to give the counter-party the option to buy 100 shares of the stock he holds at a price above its current price, over a pre-specified time period, and receives a premium in exchange). As long as the option held by the counter-party is never exercised, the fund manager pockets the premium and boosts returns on his overall equity portfolio.