Retirement Planning: Mutual Funds are a Risk But Not a Risk

Are mutual funds a systemically important financial risk? It seems that so far, the answer is no. To explain what this dreaded SIFI label actually means, the NYU Stern School of Business has developed a risk indicator and alist of the top banks and CEOs capable of bringing the whole system down should their activities run into problems.

Senator Chris Dodd and Rep. Barney Frank, authors of the Dodd-Frank comprehensive financial reform law began identifying which institutions could be the most troublesome for the economy as a whole should they fail. It was one thing suggesting that all banks with $50 billion plus in assets be labeled as SIFI. But other institutions could also create risk and in the time since the creation of the reform law, other large entities have scrambled to get out of the way. Ideally, the right balance, not too many and not too few, something the Brookings Institute suggests as a Goldilocks problem, is what the law is aiming to create.

At a recent conference held in February, Doug Elliot asked the question: "So, if you’re going to define systemically important financial institutions you have to have some concept of what systemic risk is.  And you have to have some way of measuring it, at least in some subjective manner.  And are then setting a threshold to say where does something go from having too little systemic risk to worry about to enough that it should be treated separately here?" Mr. Elliot is well known as a former investment banker, former head and founder of COFFI, his own think tank, and a very prolific and insightful writer on financial reform issues with a book soon to be published titled "Uncle Sam in Pinstripes".

The biggest fear is what is known as a domino effect. Essentially, if a number of SIFI act in unison or a number of institutions engage in the same financial activities with an SIFI labeled entity, failure would knock one, then the next over, creating a systematic breakdown. But identifying who is at the greatest risk is a lot tougher than it sounds. Mr. Elliot points out that both irrational panic, such as a run on a bank creates, and rational panic, such as identifying the problem but making a wrongheaded assumption that whatever the problem is, it isn't really that bad, can both add to the systematic tumbling of one institution, and then another.

The recent crisis had a component about it that it turns out isn't all that unusual. In fact, most of the problems in the recent history all possess the same problems: assets that were overvalued and folks knew it and leverage that was chasing it, even if it knew it was overvalued. This embracing of risk is what causes systems to break and in some cases, have the potential for bringing the whole of the economy down with it.

Given their size, mutual funds were considered as well in the discussion (which can be found here). They are not directly leveraged nor are they intermediaries (such as insurers and re-insurers) or affiliates of larger financial institutions. In fact, mutual funds are generally referred to as pass-through entities. But some funds have worried regulators based on their size. But that size is not threatening if it isn't used as leverage.

The one exception Mr. Elliot pointed out was the money market mutual fund, an entity that many believe is, or should I say, was, as a safe as a bank - at least in the mind of the average investor. A buck, they thought was always a buck, until one moment during the financial crisis, when a MMF declared ti wasn't. Investors were told that there was risk. But with this sort of situation having never occurred, the risk was set aside for most investors.

While mutual funds may have escaped the scrutiny of those studying these financial risks, hedge funds, institutional investors (pensions) and some investment firms have not. Just because some funds fit some of the criteria, of which six are listed, doesn't mean that the Frank-Dodd regulations would necessarily miss this group altogether. They do have size but because of the number of funds available, they provide numerous substitutes for the services and products they provide investors.

There is an adequate degree of separation from other financial firms, an borrowing that they may do (leverage) is clearly stated by most funds in their charter. While many of the largest funds do face some liquidity risk if investors lose faith in the ability of the fund to perform, it usually occurs as a dribble of discontent rather than a one day sell-off. Mutual funds tend to keep a limited amount of cash on hand so a sell-off would be something that whole of the marketplace would be experiencing rather than just a handful of large funds (which all tend to be indexed to the market and not actively managed entities. In truth, funds that become too large, tend to lumber when attempting to move in either direction.

Those large index funds are passive. But some large bond funds may not be but their size keeps any sort of maturity mismatch from occurring. And the existing level of regulatory oversight provided by the SEC is seen as adequate to protect the overall system from any imminent problems.

Although MMF aren't necessarily problematic, as the Investment Company Institute, the lobby arm of the industry points out: "a liquidity backstop could provide reassurance to investors and thereby limit the risk that liquidity concerns in a single fund might spur in-creased redemptions".  There is a possibility that hedge funds might see this as an opportunity to roll what they do into into mutual funds. But the regulations provided by the SEC make this not as attractive.

It may be too soon for the mutual fund industry to breath a sigh of relief. While one or more of the 243 rules and 59 studies commissioned by Dodd-Frank may still find mutual funds in the crosshairs of the reform law, the industry believes that this will not happen.

Retirement Planning: The Answer is Yes

Yes, you can retire to which you answer: "how?" All of the pundits from every corner of the planet suggest that this is simply not possible, you continue adding that the retirement you envision will simply not be possible. And I listen intently looking for signs of your willingness to compromise. Oddly, you don't mention anything of the sort despite having accustomed yourself to years of doing just that.

Granted, the compromises you made throughout your life were, at best minor ones. You may have come to grips with numerous economic realities that gave way to great stories at the Christmas dinner table or perhaps among friends and family that shared those experiences. Many of these financial tales do not begin with 'remember when we had money' but more like 'no one knew how poor we were'. That's because pulled by the bootstraps stories are far more interesting to the listener and the teller of the tale when there is some drama, some obstacle to overcome.

So we are beginning to tell a tale of woe long before the story is finished. The vast majority of us did not begin our financial journey with money. We may have been given a little bit of a boost by parents who spent their hard-earned money, money they probably could ill-afford to spend, to help us. But the quest for more money would become the only job many of us will have ever had. What we did should have been the great modifier of how far that quest could have taken us. But access to credit sort of screwed that dynamic up; not permanently.


So when I hear forty-year olds tell me that they know they will never retire, adding to the chorus of those who really have a problem as the approach sixty, I wonder whether they aren't telling the tale too soon. And if that is the case, are they listening to the story they are telling?

Here is the problem and the solution in three steps:

One: You probably have the resources available to live on less. I'm not suggesting you go frugal by any stretch - that would probably take some sort of intervention. Instead, understand what your money is going for and how long it took for you to get it. In the good old days, folks saved for the things they wanted. Suppose you approached each item over one hundred dollars with the same thought. Suppose you work 2000 hours in a  given year and you net about $50,000. That's about $25 an hour. So each purchase in excess of a hundred dollars would cost you four hours of labor.


In all likelihood, you throw out about one-fifth of the food you buy either as leftovers or simply because you failed to consume it. You may have worked about an hour or two for nothing, depending on your grocery bill. Each month, you probably work ten hours to pay for your cable (TV, internet, phone), a possibly ten to fifteen to pay for utilities. And that is based on $25 an hour for your work, which is above the national pay-per-hour median and mean average salary reported by the Bureau of Labor Statistics.

Now the answer to this dilemma resides in imagining you earn less. The rich do this quite often and bank the difference. It is often called a cushion, such as when there is more money being brought in but less dollars relegated to the budget, more or less forcing more austere measures on the household.

Two: The what-to-do-with-the-extra-cash basically solves the retirement puzzle. But only in part. Most of us have access to retirement plans but the quality and the cost of those plans varies widely or should I say wildly from one plan to the next. If you are married and don't work for the same employer, you have the ability to pick and choose the better of the two plans.


While many 401(k) plans have been making strides in reducing the cost of the funds being offered in their plans, they have turned around and raised their administrative costs. If you are married, fully funding the best of the two and picking and choosing with the second best plan. This is good couple time and a chance to review how your tale is beng written.

If you are single, the choices are more narrow but not without benefits. You have no co-author for your story and therefore, you are the sole writer of the ending. Even if you have never written a word, you probably have read. Good writers give you several subplots, characters you want to know and a conclusion that both satisfies and amazes.

Your subplots are already in place (kid perhaps, college debt, etc.) and how you handled each one developed your characters (were they handled well or are they going to be redeemed) and as you head towards your conclusion, will the person reading your financial life empathize, sympathize or simply suggest that had you done this or that along the way, the story could have been better.

Three: You are your own critic. Churchill once said: "Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things.” being critical of your work thus far is essential in negating the pain and getting to healthy. Once you resign yourself to hear only the downside of possibilities, you entertain no hope of redemption. If you were reading your life, would you be thinking that this particular tome is not worth the time or effort.


Good writers seed this despair with hope. If you suggest that retirement is simply not possible, for instance, what is the ending going to look like? Are you the reader anxious to read further? Probably not. So you think about the positive endings that could take place, list them out and how plausible they might be and choose one. You have all of the information to finish this book by the half-way mark of your working life. You can look at your parents and grandparents and project the potential for your own life expectancy. You can look at how far you've come and know how far you need to go. All that's left is the plan to get to the end.


Yes you can retire. Yes you should retire. Yes, you have the money. This is the ending, you the reader wants.

The Weight of Indexing

Even simple is no longer so. And when it comes to index funds, that often suggested answer for everything an investor should do but doesn't, the boringly mundane investment that tracks rather than participates, the it-beats-actively-managed-funds choice of the passively prone, there are now choices. There have been for years in the form of exchange traded funds (ETFs) sold as shares of stock on the open market. But this might be different in ways that deceive rather than simply suggest there are nuances.

Index funds rely on the ability to price securities efficiently. Unfortunately, the markets are not as efficient as they should be with investors often making decisions that make little sense when it comes to determining what a security is worth. And when those bad decisions are made, other investors follow. But that flaw can be overlooked in favor of the low fees (no trading means no costs unless the index changes), low turnover (no trading means the portfolio stays intact) and good diversification (spread out across a wide swath of the market).

Yet if it were only that simple. Those low fees can vary wildly over various index funds and those same index funds may appear to be the same. Buy an S&P 500 index fund you so often hear experts suggest and although they make no effort to hide the average-ness of this investment, in fact, heralding its mundaneness as the very reason you should buy it, that isn't enough.

Traditional index fund are market weighted. This simply means that these funds have holdings that are based on the amount of investor dollars each holds or the company's capitalization. The top 10 companies in an index fund often make up the lion's share of the invested index (20%). So if a market swing like the one that happened in 2008 occur, the whole index stumbles, brought down by the behemoths at the top. That can be problem and it can impact the investor's interpretation of average.

So enter the revamped index fund. The "alternate-index" fund hopes to realign the weighting in these funds to equal, offering the investor an equal share of every stock in the top 500. That means that the largest stock would only get 0.2% of the invested dollar while the stock on the cusp, the one that barely has a presence in the weighted index, would also have 0.2%.

These funds hope to keep the image of low cost and low turnover (considered a tax advantage) in place. By equally weighting the fund, the goal is to outperform the weighted index. There are other entrants to the index world, all hoping to take advantage of what is seen as flaws. That's right, in order to sell the idea that one ndex fund is different than the other, you must point out why.

The alternate index fund arena has spawned other types of funds that offer indexed stocks based on the dividends they pay or even the earnings they post, sometimes even as a combination. The chase to out-perform might seem like a worthwhile idea, but the reality is quite different. When you begin to slice these indexes in different fashions, you expose different opportunities for volatility. And keep in mind, this is the stock market we are talking about.

Unlike their weighted brethren, many of the alternative-index funds rebalance more often due to shifts in stock prices. They also benefit over traditional index funds when the marketplace favors the mid-sized and small-cap companies in the index. if the investor is seeing opportunity in smaller more nimble members of the index, the index does better. Quarterly rebalancing shifts the index back to its 0.2% of each strategy but in doing so, sells winners (losing the tax advantage somewhat and increasing turnover during incredibly volatile times).

Are these worth a look? Possibly if you believe the value will remain in the smaller and mid-sized members of the index. If you are anticipating a large-cap rally, the the traditional index fund will prevail. The question is: do downturns such as the most recent one favor one or the other? In terms of raw numbers, yes. When the markets stumble in tandem, the alternative-index funds tend to do worse, even with a mostly short-term record. But even though the fall is equally as difficult to stomach, it is the recovery that most investors focus on. And during a recovery, the alternative-index fund tends to do better.

Just when you thought the index fund was your friend, it turns out that it has a split personality. Does this mean you should avoid index funds? Not at all. In fact, if you do want to own them, I suggest (which is different than advise) you do so in a Roth IRA rather than in a 401(k) type of account. Their tax efficiency is not worth the trouble in a tax-deferred account as long as capital gains taxes remain low.