Category: Investments

Comments on the SVP debacle

High interest rates did not cause the SVB collapse because interest rates remain below their historic average. Management of SVB and possibly other banks failed to implement their core responsibility – matching the duration of assets and liabilities. Efforts to deal with bank insolvencies will lead to higher and more prolonged inflation.


Prologue:  In 1991, the Treasury Department reviewed potential risks to the financial stability of Fannie Mae and Freddie Mac.  A government model had concluded that the companies would not face problems due to an increase in interest rates until rates rose to the 24 percent or 28 percent level.  

My review of this model found that the model understated interest rate risks for two reasons.  First, the model omitted information about annual and lifetime payment caps on Adjustable-Rate Mortgages, which reduce bank revenue when interest rates rise.  Second, the model did not fully consider the impact of interest rates on defaults and other outcomes that could exacerbate financial stress when interest rates rose.  

A revised version of the government model that I put together concluded an interest rate shock in the 12-14 percent range would lead to financial problems for the two companies.  Treasury officials were grateful for this input but were largely unconcerned because interest rates were on a downward trajectory.

The current generation of management at many banks takes extremely low interest rates for granted and understates risk associated, which exist when the duration of their asserts do not match the duration of their liabilities.

The 10-year Treasury interest rate a couple of years prior to the 2008 insolvency of Freddie Mac and Fannie Mae was around 5 percent, far lower than the interest rates that prevailed in most of the 1990s.

The 10-year interest rate at the time of the SVB debacle was around 4.0 percent and is now at 3.7 percent, below its historic average.

Comments

Comment One:  Don’t blame the Fed or high interest rates for this debacle.  High interest rates did not cause the SVP collapse because interest rates are not high as discussed in the post Should the Fed Pivot?

Comment Two:  It is hard to understand why anyone, let alone a sophisticated financial institution with short term obligations, would tie up funds in long-term bonds when the yield on the 10-year government bond was lower than 1.0 percent during the pandemic and remains below the long-term average. More information on the type of investments that lead to this debacle is needed. Note, even short-term bond ETFs invested in inflation protection bonds like VIPSX, VTIP, and STIP, have lost substantial value in the past year. Go herefor a discussion a discussion of use of bond ETFs in a low interest environment. The collapse of a bank due to an interest rate exposure when the 10-year bond yield remained at 4.5 percent could have occurred if the bank’s analysts had grossly miscalculated the impact of interest rates on certain assets.

 Bank officials purchasing these bonds and bond funds should have more carefully researched the impact of interest rates on all of their investments and realized there was more downside risk than upside potential from investing in fixed income assets when interest rates were at such a low

Comment Three:  SVP may be the canary in the coal mine.  The insolvencies of Freddie Mac and Fannie Mae were preceded by insolvencies of some smaller private mortgage insurers. The SVB closure occurred very quickly after the public became aware of the problems at the bank because there was a run for deposits.  The First Republic Bank, is now losing deposits.  Transparency causes depositors to flee but is necessary to assure better investments.

Comment Four:  Regulators need to actively monitor a second potential stress point — crypto Ponzi schemes like the ones at FTX and Silvergate.  Did crypto play a role in the SVB debacle? I wonder what impact if any exposure to crypto had on the SVB collapse.

Comment Five:  The CEO of SVB sold $3.5 million in stocks prior to the sale of the bank.  Federal regulators should move to claw back the proceeds of this gain.

Comment Six:  The blame game has started.  Republicans are blaming lax fiscal and monetary policy and have conveniently ignored their role.  Yes, Jerome Powell should have increased interest rates sooner.  However, there is a lot blame to be shared here.  The Trump era tax cuts and Trump’s threats to fire Chairman Powell if he did not lower interest rates had a major impact on the nation’s fiscal and monetary condition.  Also, Republicans have consistently argued for less regulation, a position that is hard to defend.   

Comment Seven:  The Fed is now in a tight box.  Inflation and the labor market remain robust.  A move by the Fed to prevent insolvencies, by lowering the cost of credit or by purchasing some of the long-term bonds owned by SVB, will lead to more inflation.  Bill Ackman is making the case that SVB is too big to fail and the Fed should consider some sort of bailout.   Dealing with the banking crisis could lead to higher inflation over a prolonged period.

The Choice Between Fixed Income Funds and Direct Purchases of Bonds

Whenever possible investors should seek out tax-preferred savings vehicles, which allow for direct investments into Treasury securities and hold Treasury bonds and notes instead of fixed-income funds. People saving for retirement or higher education can minimize risk by matching future obligations with specific bonds.


Introduction:

Many tax-preferred retirement accounts and 529 funds restrict investment choices to a small set of stock and bond ETFs or mutual funds.  The allowable investments inside a 401(k) plan are selected by the plans sponsor. For example, the Thrift Savings Plan (TSP) offered to federal employees has several funds and an option for mutual fund investing but does not allow workers to purchase Treasury Securities directly through the Treasury or through a broker.

Most individual retirement accounts (IRAs) and brokerage accounts allow for direct investments in the stock of individual companies, Treasury securities, agency securities, and corporate bonds.  Individual investors at Fidelity and Vanguard with an IRA account can purchase the same assets as investors with a brokerage account at the firm.

Individuals saving in plans that are not tax preferred can purchase bonds either through a brokerage account or through Treasury Direct.  Series I savings bonds can only be purchased directly from the Treasury and are therefore not available for retirement savers or for people utilizing 529 plans for college savings.

Retirement savers with an IRA can purchase Treasury Inflation Protected Securities (TIPs) through their brokerage company.   Whether this option is available through a 401(k) plan depends on the investment options chosen by the plan’s provider.  Most 401(k) plans that I am aware of do not allow for direct purchases of TIPs. 

Many financial advisors, including one mentioned in this CNBC article, favor the use of bond ETFs over direct purchases of Treasury securities.  The prices of the bond funds touted in this article appear highly variable. 

The use of bond funds instead of direct investments in bonds often results in inferior financial results.  Both bond prices and bond ETF or mutual fund prices vary inversely with interest rates.  The difference in financial exposure stemming from holding a bond and the financial exposure from holding a bond fund is that the bond holder can avoid losses by holding the bond until the maturity while returns for the holder of the bond funds are always dependent on interest rates.

All 401(K) plans have bond fund options. Many 401(k) plans have an option for short-term bonds that primarily invest in inflation protection securities.  However, even short-maturity bond funds designed to protect investors from the eroding effect of inflation can result in substantial financial losses for investors.

The returns for VIPSX are -10.45 % over a one-year holding period and 1.02 percent over a 10-year holding period.  Other short-term bond funds seeking to protect investors from inflation including STPZ and VTIP do not appear to be meeting their objective in the current macroeconomic environment.

There is one sure fire way to insulate your portfolio from inflation, the purchase of Series I bonds.  However, the IRS imposes an annual limit on the purchase of Series I bonds, and Series I bonds cannot be purchased in IRAs, 401(k) plans or 529 plans. Most household with most of their financial portfolio inside a retirement plan cannot purchase enough Series I Savings bonds to insulate themselves from inflation.

The performance of both long-term Treasury bonds and bond funds has also been miserable.  See BND, AGG, and FNBGX and look at the chart with the longest time span of historical prices.

Advantages of Direct Investments in Treasury Securities:

Investors who purchase a Treasury security at a positive yield and hold the Treasury security to maturity will never experience a nominal loss on the security.  

However, many investors will sell a long-term security prior to its maturity.

Investors should not purchase either a long-term bond or a long-term bond fund when interest rates are extremely low, as they were during the pandemic, since at that time interest rates were certain to rise and bond prices certain to fall.

Investors can spread out bond purchases over several months to assure monthly access to liquid retirement assets.  The purchase of six-month Treasury bills on six consecutive months would allow for monthly access to liquid assets.

The price risk of a Treasury security goes towards zero when the security nears its maturity date.  An investor needing funds shortly before the maturity date could sell the asset without a substantial loss, even if interest rates rise. By contrast, short-term bond funds have no maturity date, hence the price of the fund will fall if interest rates rise.

Investors can match the maturity of bonds that they hold with future liabilities.   This is an especially important feature for parents saving for college tuition who could match bond maturities with tuition payment due dates. 

However, 529 plans commonly used for saving for college generally do not have an option allowing for direct investments in Treasury securities.  Instead, the plans allocate investments into bond and stock ETFs or mutual funds.   The price of funds inside college 529 plans, even the short-term bond funds, vary substantially with market conditions.

Both savers in 529 plans and savers in retirement plans often save through a life-cycle fund that shifts assets from stocks to bonds as investors near retirement.  However, the component of the Lifecycle fund invested in a bond portfolio will fall in value when interest rates rise. 

Both bond and stock funds fell in tandem during the past year.  Lifecycle investing did not protect investors during the latest market downturn. 

Most retirees put all funds in instruments without a maturity date and base disbursements on a guideline like the four percent rule.  The four percent rule is not going to work if the value of both your stocks and bond funds simultaneously declines as they did most recently.

Retirees could and should purchase Treasury bonds and schedule the maturity of the bond for different dates each year.  The retiree would even consumption and reduce depletion of retirement assets by consuming from maturing bonds when the stock market is low and consuming from stock ETF distributions when the stock market is high.

Retirees with assets in bonds that mature on specific dates are better prepared for retirement than retirees with assets that have all savings tied up in funds without maturity dates.

Concluding Remarks:  The tax code provides preferences for investments in tax-preferred retirement accounts and 529 plans.  Congress recently passed legislation mandating automatic contributions to 401(k) plans. Financial advisors strongly recommend use of these tax-preferred savings vehicles.

Tax preferred savings vehicle often have limited investment options.

Tax-preferred savings plans often do not allow for the direct purchase of Treasury or government agency fixed-income securities with specific maturity dates, which could be matched with spending obligations.  

Moreover, financial advisors often advocate the use of bond funds instead of bonds with specific maturity date. 

Congress, through the tax code and their mandates and financial advisors through their insights guide investors to suboptimal higher-risk financial choices.

David Bernstein an economist living in Denver Colorado has written extensively on health and financial policy including a recent article outlining a 2024 Health Care Reform Proposal and an evaluation of President Biden’s student debt discharge proposal.

What is going on at the lower end of the yield curve?

Why is the 6-month T-bill rate so much higher than the 4-week T-bill rate?

Why is the 6-month T-bill rate so much higher than the 4-week T-bill rate?

Many analysts are concerned about the inversion between the 2-year and 10-year bond rate because such inversions typically foretell a recession.  There is a different story at the lower part of the yield curve.

The 6-month T-bill rate was 83 basis points over the 4-week T-bill rate in December 2022.  The average spread over 2001 to 2022 period was 17 basis points.  The median spread, 10 basis points.

The 6-month to 4-week spread had been elevated throughout 2022.

Why is the 6-month interest rate now so elevated compared to the 4-week rate? 

Investors could place 1/6 of their short-term assets in separate 6-month assets purchased at the beginning of each of 6 months.  This staggered schedule would allow access, if needed, to 1/6 of short-term assets each month.

The only reason why investors would choose to put all funds in a 4-week asset is the desire for increased liquidity without any price risk from selling an asset.  Why are investors now turning down the 83 basis points to put more funds in a 4-week T-Bill rather than staggering investments into 6-month T-bills with purchase and maturity dates in six consecutive months?

The author, an economist in Denver Colorado, has written a 2024 Health Care Proposal, which can be downloaded at Sellwire, https://app.sellwire.net/p/2Uv and at kindle https://www.amazon.co.uk/2024-Health-Care-Reform-Proposal-ebook/dp/B09YPBT7YS

How far can ARKK sink?

The ARKK fund is down over 60 percent for the year but is still overvalued and is not a buy. Investors interested in the tech sector should consider individual holdings or a more stable ETF.

Introduction:   ETF investors often buy when the fund price declines and sell when it rises. However, a decline in the asset price does not mean the asset is correctly valued.

Even though ARKK has fallen more than 60 percent in the past year, it contains several holdings that are still overvalued, and its PE ratio is undefined because of negative overall earnings.

Empirical Analysis of Current ARKK Holdings:  The ARKK fund is an actively managed fund that invests exclusively in companies that the fund manager believes will disrupt the economy.  Data on the holdings of the fund was obtained from Zachs.  It has 34 companies and a small amount in a fund that has government securities.   Financial data on the 34 equities in the funds was obtained from CNBC.  Here is the link to financial data for Tesla the fund’s largest holding.

Financial variables for the 34 ARKK holdings indicates that despite large declines in share prices most of the holdings in the ARKK fund remain overvalued.

  • Only four of the 34 holdings (Tesla, Zoom, Nvidia, and Materialise), around 17 percent of the holdings of the fund, reported positive earnings per share.  

The weighted average of net earnings was negative making it impossible to report a PE ratio for ARKK. Firm PE ratios are undefined for firms with negative earnings. ETF PE ratios are undefined when the denominator of the PE ratio, a weighted average of earnings per share is negative.  

An alternative valuation metric used when earnings are negative is the difference between share price and earnings per share price over share price.  High values of (P-E)/p correspond to high valuation measures.  

A value of (P-E)/P equal to 0.98 is equivalent to a PE ratio of 50.  A value of (P-E)/P greater than 1.0 is undefined due to negative earnings.  The use of (P-E)/P allows for the inclusion of firms with negative earnings in comparisons of portfolio valuations. Go here for a discussion of the alternative valuation statistic.

  • The value of (P-E)/P for ARKK is 1.082.

High valuation measures are acceptable when firms are investing and growing.  Early investors in firms like Apple and Amazon did quite well despite years of high valuations.  The ARKK holdings are not similarly situated.

  • 33 of the 34 ARKK stocks experienced a decline in price over the past 52 weeks.  The average stock price over the last 52 weeks was down 63.1 percent.   The lower stock price makes it expensive for these firms to raise additional funds in equity markets. 
  • 9 of the 34 companies had an earnings per share loss that exceeded 25 percent of the stock price.   The existence of larger losses relative to share price could be indicative of concerns about future liquidity. 
  • ARKK owns more than 5.0 percent of the shares in 16 of its holdings.   These relatively high stakes could limit the ability of ARRK to reallocate and reduce exposure without exacerbating declines in stock prices. 

The empirical analysis reveals several red lights on the future of ARKK including — high valuations, previous large stock price declines, existence of several holding with large losses compared to equity, and high exposure in some positions.

Discussion of ARKK holdings:  The rationale behind investing in potential disruptors is the likelihood of one or more large successes leading to large returns.  Some of the ARKK investments are interesting and could be considered once the tech market nears a bottom.  However, ARKK has a lot of companies that are unlikely to prosper.

I looked at some of the news and analyst on the 10 largest ARKK holdings.  Here is what I found. 

Tesla: symbol TSLA Tesla is the largest position and ARKK’s most successful investment.  Tesla has been a true disruptor.  However, its valuation is high $642.3 billion more than the rest of the world’s auto industry.  Tesla sold fewer than a million vehicles in 2021 compared to over 9 million by Toyota alone.  Tesla makes most of its money from the sale of cars but does have some other energy streams.  Tesla is the leader in electric vehicles, but Porsche may have the better high-end car and other firms are entering.  At current stock prices Tesla is a better buy than ARKK but may not be a good long term buy.  Even with other income streams it is difficult to justify a price on Tesla that makes a relatively small auto company more valuable than the rest of the industry. I am not currently a buyer of either the TSLA or ARKK.

Zoom: symbol ZM, Zoom did extremely well due to at-home work during the pandemic, but the pandemic growth rate is over, and the company is facing new competition from Microsoft and possibly other larger firms.

Roku: symbol ROKU, Roku attempts to make it easier and more affordable for people to watch multiple TV shows.  ROKU’s top competitors are Apple, Net Flix, Amazon, and Microsoft.  Stock price is falling.  If you google ROKU and problems, you get several links on how to deal with technical ROKU issues.  Other applications and services may be more reliable than ROKU.   I have no reason to believe that ROKU will win this competition.

Unity:  Unity Software, symbol U. is a software developer and may benefit from the metaverse.  The company might be acquired by a larger firm.  A speculator might be better off purchasing a small amount of U rather than ARKK.

Block inc., symbol SQ, is a financial services firm.  Visa and Paypal appear to be better positioned than Square.

Teledoc, symbol TDOC, has several active competitors.   Go here for one list.  Two funds owned by Cathie Wood have invested in Teledoc.  She may not be able to get out of these positions without causing a large decline.  I would not buy Teledoc either by itself of through ARKK.

UI Path, symbol Path, is an artificial intelligence company that helps automate routine tasks.  It has viable products but it stock price has fallen by nearly 80 percent.  Path is a company that might be worth looking at once the tech sector bottoms.  ARKK bought it too soon.

CRISPR, symbol CRSP and BEAM therapeutic, symbol Beam: are two gene editing companies owned by ARKK.  Combined they are around 8.5 percent of ARKK holdings.  Hard to understand why ARKK holds so much of these two firms and no Moderna.

Coinbase, Symbol COIN:  Coinbase is a bad apple in an industry that is looking for a reason to exist.  Google Coinbase and allegations and get this.

Some of the ARKK holdings deserve consideration, but ARKK is not the best way to participate in these opportunities.  Interested investors should consider purchasing the better companies directly or investing in a more diversified tech fund, like VGT.

 Concluding Remarks:

I have nothing against a fund that seeks out disruptive firms but believe ARKK is poorly designed and not an appropriate investment vehicle.

The ARKK fund did well when expectations of tech returns were high and interest rates were abnormally low. It is wrong to attribute the sinking of ARKK over the past year to higher interest rates since rates today are still below their historic medians.

The investment philosophy behind ARKK is reminiscent of the gamblers ruin problem.  The gambler playing a game, or in this case several highly correlated games, with a negative expected value will eventually go broke.  

The disruptor fund might put 50 percent in a small number of disruptors and 50 percent in a safe asset.  The fund would take profits and invest in the safe asset in successful years and invest in bargains during downturns.

Authors Note:  David Bernstein has written Financial Decisions for a Secure and Happy Life, a manifesto that will improve your life and save you tens if not hundreds of thousands of dollars.

How to Insulate Your Portfolio from Inflation

Annual limits on the purchase of Series I is more than $10,000 if you have a tax refund or some other entity like a Trust or business. Additional inflation protection can be obtained through the purchase of Treasury Inflation Protection Securities (TIPS).

Question: I am worried that my retirement plan will not keep up with inflation and would like to increase my holdings of Series I savings bonds.  However, there is a $10,000 annual limit on purchase of these assets. What can I do?

Answer:   The purchase of Series I savings bonds is the single best way to protect yourself and your household against inflation. Series I Bonds are literally the only thing working in most portfolios today, a situation that will unfortunately persist unless inflation drastically recedes.

The Treasury limits direct purchases of Series I Bonds from Treasury Direct to $10,000.  However, taxpayers with a tax refund can purchase an additional $5,000 in Series I Bonds. Go here for a discussion of how to do this.   You can also purchase Series I bonds through a Trust or a business.   The first step is to go to Treasury Direct and set up an entity account.

The annual limits prevent most households from quickly increasing their holdings of Series I bonds in response to a sudden shift in inflationary expectations.

Additional protection against inflation can be obtained by purchasing Treasury Inflation Protection Securities (TIPs). There is $10 million dollar limit on each TIPS security for each auction.  I am not worried about every being constrained by this limit.

The price of TIPS varies with interest rates and inflationary expectations, and you can lose money on TIPS. But price risk can be managed by staggering the purchase dates and maturity dates of the TIPS bonds and holding the bonds until maturity.

Series I Bonds are sold at par and never fall in value.    The semi-annual rate can go up and down with inflation, however, the bonds will not fall in value with inflation.  Go here for Series I FAQs from Treasury Direct.  Go here for a comparison of Series Bonds and TIPS.Authors Note:  The paper Financial Decisions for a Secure and Happy Life  is a collection of eight essays.  One of the essays provides a lot of information on Series I bonds and Tips.  The author has also written extensively on health care with his most recent paper outlining potential 2024 care reform proposals

Will Congress Change Retirement Savings Rules?

Retirement plan proposals currently under consideration by Congress will increase profits for Wall Street firms by increasing the use of high-cost 401(k) plans. These proposals do not assist the people having the hardest time saving for retirement. This memo evaluates the pension changes under consideration by Congress and presents alternative proposals.


Introduction:

A recent CNN article describes several bills before Congress designed to change rules governing retirement plans including the Secure Act 2.0, a bill that has been passed by the House, and several proposals drawn up in the Senate. This memo outlines these legislative proposals and evaluates their potential financial impacts.

Features of the House Secure Act 2.0 bill:

  • Requires automatic enrollment in 401(k) plans, sets an initial contribution rate at 3.0 percent of salary, and increases contribution rate by 1.0 percent per year of service,
  • Increases catch-up contributions for people aged 62-64 and invest catch-up contributions in Roth accounts.
  • Allows employer matching 401(k) contributions on student loan payments,
  • Increases initiation age for required minimum distributions (RMDs) from retirement plans,
  • Require employers cover part-time workers working at least 500 hours per year for two years,

Discussion of bills in the United States Senate: 

The CNN article discusses several Senate bills addressing pension issues, which could be coupled with the bill that has already passed the House.

  • A bill offered by Senator Cardin and Senator Portman differs from the Secure Act 2.0 bill by excluding the automatic enrollment provision and its tax treatment of catch-up contributions.
  • A bill under construction by Senator Murray and Senator Burr may include provisions for new emergency savings options and annuity purchases by workers.
  • The starter K-bill offered by Senator Carper and Senator Barrasso facilitates creation of low-cost retirement plans, for small businesses and startups.  Proposed plans would have a $6,000 annual contribution limit and would allow automatic enrollment.

Analysis:

Comment One:  The automatic enrollment provisions in Secure Act 2.0 could lead to suboptimal savings outcomes for some workers.  It could lead to workers placing funds in a high-cost 401 (k) rather than a low-cost IRA.   (High 401(k) fees can decimate retirement savings as discussed here.)  Workers with substantial debt may be better off foregoing retirement contributions and rapidly repaying loans as discussed here. Many workers need to prioritize contributions to health savings accounts over additional contributions to 401(k) plans as discussed here.   This article makes the case for investments in Series I bonds outside of a retirement account instead of conventional bonds inside a retirement account.

Automatic enrollment into suboptimal financial options is bad policy.  The Cardin-Portman bill without an automatic enrollment provision would be preferable to the House bill.   A compromise bill would limit automatic enrollment to the amount needed to maximize receipt of the employer match and automatically enroll workers at firms without an employer match into IRAs.

Comment Two: An empirical analysis of the finances of people choosing to currently make catch-up contributions could determine if an expansion of catch-up contributions helps people who need to catch up or people already ahead.  It is likely expanded catch-up contributions for people in the 62-64 age group will primarily assist people who have little or no debt and are already well prepared for retirement.  People with debt should retire debt rather than increase contributions to their 401(k) because one of the worse financial outcomes is to enter retirement with outstanding debt and all financial asset inside a 401(k) plan.  

Comment Three:  It seems unusual to require catch-up contributions near retirement be made in Roth rather than conventional accounts.  I generally favor the use of Roth accounts instead of conventional account, but Roth contributions are most effective for young workers in low marginal tax brackets, not older workers nearing retirement.

Comment Four:  The proposal to increase the age of mandatory RMDs will benefit wealthier households capable of living by consuming from assets outside their retirement plans.  Less wealthy households will disburse their retirement assets earlier in life out of necessity. Households that delay distributions from their retirement plan because of the change in RMD rules will have to increase distributions and could pay higher tax later in life.

Comment Five:  The Secure Act 2.0 provision allowing employer matching contributions for workers making student debt payments will have a limited impact on savings incentives for most student borrowers and is not the most effective way to assist student borrowers.  Many young adults with student debt work at firms that either do not offer 401(k) firms or offer a plan without an employer match.  Young student borrowers that switch jobs prior to the employer contribution vesting will lose the contribution.  A rule allowing employer matching contributions into an IRA and allowing matching contributions for student debt payments would assist more student borrowers than the student-debt provision in Secure Act 2.0.

Comment Six:  The goal of increasing retirement savings for part-time workers would be better achieved by automatic IRA contributions instead of expanded 401(K) eligibility and automatic 401(k) contributions.   It would also be useful to change IRA rules to allow employer contributions into an IRA.   The participation of part-time workers into 401(k) plans will increase 401(k) fees.   Workers that use IRAs are free to select a low-cost highly diversified fund.

Comment Seven:  The goal of increasing retirement saving for workers at small firms that do not have a 401(K) plan would be better achieved through automatic enrollment in IRAS than by the creation of streamlined 401(k) plans.  Workers could seek out a low-cost IRA and are less likely to close the IRA than the 401(k) when they move to a new position. Also, the streamlined 401(K) option created by the Carper/Barrasso bill could displace more comprehensive 401(k) plans both among new and existing firms.  

Comment Eight: Many people currently withdraw a substantial portion of their retirement funds prior to retirement.  Around 60 percent of young adults have borrowed from their 401(k) plan.  It is unclear how the Murray/Burr bill will facilitate savings for emergencies while increasing saving for retirement.  One way to address this tradeoff is to encourage a shift in retirement savings from conventional accounts to Roth accounts.  Roth accounts allow disbursements of contributions without penalty and tax prior to age 59 ½ while conventional accounts apply penalty and taxes to all early disbursements.

Current retirement plan rules allow the worker to disburse all funds at any age if she is willing to pay an additional tax and penalty.  My view is any expansion of the use of retirement funds for emergencies without penalty or tax should be combined with a rule change that requires a portion of funds contributed to the retirement plan remain allocated for use after age 59 ½. 

Comment Nine:  An alternative to the Murray/Burr proposal for the purchase of annuities in a retirement plan is a program, like Oregon Saves, that allows workers to contribute to the state pension fund.  The Oregon Saves program also obviates the need for creation of retirement plans by small businesses.

Concluding Remark:  Proposals altering the retirement savings system currently in Congress favor the use of high-fee 401(k) plans over low-fee IRAs. The primary beneficiary of these changes is Wall Street, not households experiencing the most difficult saving for retirement.

The comments presented here support the view that rules allowing employer contributions into IRAs and automatic enrollment into IRAs instead of 401(k) plans are superior to the enlarged role of 401(K) plan offered by current Congressional proposals.   

Authors Note:  David Bernstein recently published a 2024 Health Care Reform Proposal, which differs substantially from the ACA modifications favored by the Biden Administration and the Medicare for All proposal favored by the progressives.  The program outlined in this paper available on Kindle would bring the United States close to universal coverage and would substantially improve health and financial outcomes for people with low-cost health insurance policies.

Lessons from the fall of ARKK

ARK funds are in free fall. Is there a better way to invest in high-risk startups?

Introduction:  ARKK, the ARK innovation ETF had fallen 58 percent from its all-time high by late January 2022.    The fund is experiencing massive outflows.  

What could Cathie Woods have done differently? 

Is there a way to create a fund that targets the most innovative companies but takes on less risk and does not experience this type of massive decline in value when things turn south?

Analysis:  Two Problems with the ARKK Investment Approach:

There are two problems with the ARKK investment model that led to this debacle.

The first problem involves an incorrect perception of the extent of diversification of the ARKK fund.

The ARKK fund, despite having 153 holdings, is not highly diversified.  The ARKK holdings have similar characteristics.  The firms are young, innovative, and risky. 

When risk appetites fall, as they are currently these firms fall in tandem.   

A portfolio manager could have a reasonably diversified portfolio based on either 153 randomly selected firms or 153 firms selected from different sectors of the economy. Much less diversification is obtained from a 153 similarly situated firms.

(It is sort of analogous to a person applying to all IVY league schools thinking one acceptance is in the bag because of the law of large numbers. The number of applications is not determinative when all institutions have similar decision rules.)

The tech fund could increase diversification of its holdings by holding 20 percent to 40 percent of its assets in a market portfolio perhaps through a Vanguard S&P 500 fund like VOO.   Alternatively, the tech fund could consider putting 20 percent to 40 percent of its assets in more stable value stocks, live VOOV, a fund that is uncorrelated with the startup sector.

A fund investing in high-tech startups needs to hold substantial funds in the general market or better yet invest substantial funds in the market that is not high tech.  A fund that invests 50 percent in innovative firms and 50 percent in startups would be able to reallocate assets when tech prices are elevated and make additional purchases during market downturns.

This approach is similar to the approach used by FBALX, a fund that balances stocks and bonds to provide more stable income in one fund.  The FBALX fund did well during the 2008 market downturn.

An ETF with both a tech portfolio and a market or value portfolio creates a better risk-return tradeoff than a pure tech startup portfolio.   The professional portfolio manager would reallocate assets from the tech component to the value component when tech was high and purchase tech assets when prices crash.

The person managing a combined tech/value ETF would probably be picking tech stocks at bargain prices right now rather than dealing with panic-driven withdrawals.

The second problem Impacting the risk of ARKK involves the existence of some very large positions inside several companies and a general lack of transparency exhibited by most ETFs (not just ARKK) on overall risk.

It is not accidental that Michael Burry, famous for the Big Short, was the first investor to highlight potential problems with ARRK.   Michael Burry is famous for looking at the quality of investments inside an ETF. 

I quickly looked at some of ARKK holdings.  My analysis for this post was limited to 10 holding found on the third tab of a listing by ZACKS.  The 10 holdings I looked at were – Fate Theraputics, 10 X Genomics, Docusign, Robinhood, Pacific Bioscience, Pager Duty, Iridium Communications, Tusimple Holdings, Gingko Bioworks, and Twist Bioscience.

My quick analysis found many ARKK ventures were highly speculative and were in the red.

Furthermore, ARKK had extremely large positions in some firms.

  • None of the 10 funds had positive earnings; hence, the PE ratio is undefined for all 10 firms.
  • The ARK management group was the largest shareholder for 4 of the 10 firms, was the second largest shareholder in one firm, was the third largest shareholder in two firms, was the fifth largest shareholder in one firm and the seventh largest shareholder in another.

ARK is a relatively small fund manager compared to firms like Vanguard, Fidelity, Blackstone, and T Rowe Price. ARKK is a relatively small fund compared to other tach and small-firm growth funds offered by larger firms.

Withdrawals from ARKK leading to the sale of company stock could exacerbate downward pressure on stocks when ARKK had an oversized position.

The recent withdrawals from ARKK and other ARK funds could have and likely did result in additional selling and downward pressure on stocks where ARK had a large position.

In a rational market the fundamentals of the stock prices determine the value of the ETF.  My concern is that selling by a risky ETF could spill over and impact the price of certain stocks.

Concluding Remarks:   The ARK funds allow investors to get exposure to innovative firms without taking on single-stock risk.  However, the amount of diversification offered by ARKK is not as large as some investors believe. The high stakes held by ARK funds likely exacerbated selling and downward price of some tech firms and the innovative company sector. 

One additional lesson from this post is that just as one should not judge a book by its cover one should not judge a fund by its profile.

Financial Tip #7: Invest in Series I Savings Bonds whenever possible

Middle income households should purchase some Series I Bonds from the Treasury annually.

Tip #7: Series I Savings Bonds should be included in every investor’s portfolio.  This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Characteristics and rules governing Series I bonds:   The Series I bond, an accrual bond issued by the U.S. Treasury tied to inflation, is described here.  

Key Features of Series I Bonds:

  • Backed by the full faith of the U.S. Treasury
  • Cannot be redeemed until one year after issue.
  • Redemptions prior to five years from issue date forfeiture of one quarter of interest.
  • The composite interest rate changes every six months,
  • The interest rate is based on two components – a fixed rate and the inflation rate.   
  • The composite rate is guaranteed to not fall below zero.
  • The interest is taxed when the bond is redeemed.
  • Bond matures and stops paying interest after 30 years.
  • The Treasury limits annual purchases of the bonds to $15,000 per person with a limit of $10,000 on electronic purchases and $5,000 on paper purchases.  The paper Series I bonds can only be purchased through refunds from the IRS.

Reasons for Purchasing Series I Bonds:

  • Series I Bonds, unlike traditional bonds and bond ETFs, do not fall in value.
  • In the current low-interest rate high valuation environment, traditional bonds and stock prices are almost certain to decline in value.  
  • A retired person with I-Bonds outside of a 401(k) plan can respond to a market downturn by using proceeds from the redemption of I-bonds to fund current consumption rather than disburse funds from a 401(k) plan, which could be temporarily down in value.
  • The Series I Bond is a riskless asset.  Investors with this asset can reduce holdings of traditional bonds and cash and increase investments in equities.

Difference Between Series I Bonds and TIPS:

Treasury Inflation Protection Securities (TIPS also allow investors to protect returns when inflation and interest rates rise.

Key differences between TIPS and a Series I bond as explained here:

  • The TIPS value can fall in an era of deflation.  The Series I bond never falls in value.
  • The tax on interest from TIPS is paid annually and not deferred to redemption
  • TIPS bonds can be sold without forfeiture of any interest at any time.  The redemption of a Series I bond is not allowed until after a year from the purchase date and sales prior to five years from the purchase date involve a forfeiture of a 3 months of interest.  
  • All TIPS can be counted as a liquid asset.   Only Series I older than 5 years from issue should be considered liquid.
  • Up to $5.0 million in TIPS can be purchased in a single auction.  The annual limit on the purchase of Series I Bonds is $15,000.

Thoughts on Series I interest rates:

  • The current fixed interest rate on a Series I Bond is 0 percent.  The current composite fixed + inflation component on bonds purchased prior to May 2022 is 7.12%.  A delay in the purchase of a Series I bond until the second half of the year could result in a permanently higher fixed rate.  However, investors would lose an annualized return of 7.12% accruing in May. 
  • Bonds purchased years ago in a high interest rate environment have a higher current composite rate because the fixed component is higher.  People are currently aware of I-Bonds because of the elevated inflation rate.  The purchase of I-bonds also makes sense when inflation is low and interest rates are high because the investor will obtain both a higher fixed rate and increases in interest when inflation returns.

Concluding Thoughts:  Investors should purchase a Series I bond every year.  Investors who maximize receipt of the employer matching contributions to a 401(k) plan can then divert additional investments to a Roth IRA or a Series I Bond.  People without a 401(k) plan that allows matching contributions should contribute to a Roth, invest Roth contributions in equities, and divert some funds to the purchase of Series I bonds.

Financial Tip #3: Maximize use of after-tax Roth IRAs

Tip number 3:  Most households use traditional retirement accounts instead of Roth accounts.  The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA.  According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.  

More people should choose a Roth retirement plan over a traditional one.  People should use Roth accounts in the following circumstances.

  • Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
  • Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
  • Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
  • Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
  • Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.

Comments:

  • Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.  
  • Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½. 
  • The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
  • Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
  • One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
  • Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA.  Workers with income above these contribution limits should contribute to a Roth IRA.  Other workers should use a backdoor IRA.

Readers should remember to open their Roth IRA early in life as explained in financial tip number one.

Financial Tip #1: Open and fund a Roth IRA early in your career

Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.

  • People who open a Roth IRA early in life have a long investment horizon.   The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
  • A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year.   The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year.  This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
  • Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
  • The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65.   This is not always possible.   The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time.   The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
  • All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.

Concluding Thoughts:  Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA.  Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax.  My view, expressed here and in several future posts, is that the Roth IRA should become the default option.