Beware of Hedge Funds

The Monday August 4, 2008 Wall Street Journal had an article on the performance of hedge funds. The title of the article was “Hedge-Fund Sluggers Strike Out.” Hedge funds are leveraged funds that tend to lack the diversification represented in Ecclesiastes 11:2.

A Hedge fund typically uses leverage, such as options, where a relatively small amount of money can control a lot more of a security. A person who can predict the future correctly can make a lot of money. Unfortunately, I do not know of anyone who can predict the future with 100% accuracy.

What this means is that when things are going up they go up faster than the rest of the market. Conversely, when things are going down they go down faster than the rest of the market. This is illustrated by the Boyer Allen Pacific fund that is down 28% for the year while it was up 52% during 2007.

At first glance it appears that this fund is up 24%, 52% - 28%. However, this is not true and can be illustrated by starting with $1.00. If it goes up 52% then the value is $1.52. When $1.52 goes down 28% the end value is $1.52 times 0.72 = $1.08. This fund is up 8%. Everyone is happy with a 52% return. Few people are happy with a 28% drop. At a 34% drop this fund will be even.

This year some hedge funds have reportedly gone bankrupt and some hedge fund managers have been arrested. Since nobody knows the future investing in hedge funds more closely resembles a form of gambling rather than a form of investing.

The lessons learned from this article are:

• Understand what you are investing in.
• Do not chase phenomenal returns made by a fund in one year because it may very well be followed by a phenomenal correction after you purchase it. Remember the story of the tortoise and the hare.
• Buying of a hedge fund is to be avoided by the average investor who can not afford to take this much risk

Barron's Financial Statistics

The August 4, 2008 edition of Barron's had useful financial statistics. We hear some statistics and their interpretation in the news but what are the rest of the numbers and what do they mean.

2nd Quarter GDP = 1.9%, 1st Quarter GDP = 0.9%: What does this mean? We are not in a recession

June rate of inflation = 5% annualized: What does this mean? We are not in a recession

Index of Coincident and Leading Indicators = Flat during the 2nd Quarter: What does this mean: We are not in a recession.

What are going up: Business Sales, Consumer Spending, Durable Goods, Factory Shipments, Non-Durable Good, Public Spending, Non-Residential Spending, & Exports to name some. These are all good things.

What are going down: Imports, Petroleum Capacity (Not producing at as high a rate to keep prices up), Auto Sales (In the news), & Residential spending (In the news).

What does this mean? Besides the news on auto sales and residential spending things are better than what most people would think. Do not focus on the news and recession fears and keep investing.

Retirement Savings Statistics

Retirement savings statistics are published on a regular basis in newspapers and magazines. Recently, some statistics were published on the front page of the Business section in the August 2, 2008 Charlotte Observer. The paper reported on a study done by Ernst & Young LLP done for the Americans for Secure Retirement.

• Nearly 3 out of 4 middle income households in the Carolinas that plan to retire in the next 7 years will outlive their retirement savings.
• 3 out of 5 new middle class retirees would run out of savings and have to reduce their standard of living by nearly 25%.
• Those planning to retire in the next decade would need to reduce their standard of living by more than 1/3rd.

Retirees will run out of savings because of fluctuating investment returns and longer lives.

My guess is that these statistics also hold for the rest of the country, not just for the Carolinas.This should be a wake-up call that all of us need to have a financial plan for retirement. The future is never predictable and we need to be prepared.

Frequent Social Security Questions

Answers to Social Security related questions can be found at www.socialsecurity.gov. Here are the most frequently asked questions that I have been asked recently.

Do I have to pay income tax on my Social Security benefits?

You will have to pay federal taxes on your benefits if you file a federal tax return as an "individual" and your total income is more than $25,000. If you file a joint return, you will have to pay taxes if you and your spouse have a total income that is more than $32,000.

How much will a widow or widower receive?

The amount you will get is a percentage of the deceased's basic Social Security benefit. The percentage depends on your age and the type of benefit you are eligible for. A widow or widower, full retirement age or older, will receive 100 percent of the deceased's basic Social Security benefit.
A widow or widower can receive full benefits at age 65 or older (if born before January 2, 1940) or reduced benefits as early as age 60. The age for receiving full benefits is increasing for widows and widowers born after 1939 until it reaches age 67 for people born in 1962 and later.

How are my retirement benefits calculated?

Social Security benefits are based on earnings averaged over most of a worker's lifetime. Your actual earnings are first adjusted or "indexed" to account for changes in average wages since the year the earnings were received. Then we calculate your average monthly indexed earnings during the 35 years in which you earned the most. We apply a formula to these earnings and arrive at your basic benefit, or "primary insurance amount" (PIA). This is the amount you would receive at your full retirement age, for most people, age 65. However, beginning with people born in 1938 or later, that age will gradually increase until it reaches 67 for people born after 1959.

I have worked as a stay at home parent and part time while my spouse has worked full time. What will my benefits be?

You can be entitled to as much as one-half of your spouse's benefit amount when you reach full retirement age. If you want to get Social Security retirement benefits before you reach full retirement age, the amount of your benefit is reduced permanently. The amount of reduction depends on when you will reach full retirement age.

Credit Card Offers for College Students

The topic of the previous blog was credit cards for undergraduate college students. My daughter who enters college this fall got 3 credit card offers: BB&T, Discover, and Capital One. From the offers it is apparent that she is considered a high financial risk by all 3 issuers, which is probably justified given her current level of income.

All 3 offers offer no annual fee and lots of other benefits.

Discover stated "Don't delay - start building your credit history today." Captital One stated "Keep in mind, we may increase your APR if you pay us late twice within 12 months."

These offers in the order of BB&T, Discover, & Capital One are presented below:

Annual Percentage Rate (APR) : It is a variable rate at the prime rate + ___% with a current rate of 17.9%, 16.99%, 19.8%.
Cash Advance APR: 24.15%, 23.99% with a default rate of 30.99%, 22.9% with a default rate of 24.9%.
Transaction fee for cash advance: 3% ($5 minimum), 3% ($5 minimum), 3% ($10 minimum).

Assuming a $500 credit limit here are the rest of the fees:

Late payment fee: $35, $39, $39
Over the credit limit fee: $35 and no overlimit paid, $39, $29.

For illustration sake lets use $35 for both the late payment fee and the over the credit limit fee.

Let's assume my daughter buys $350 worth of books and school supplies in a single transaction, probably a low amount. The first thing that happens is this amount is authorized and reserved by the issuer. Later the account is settled. The process of reserving and settling this account will essentially double book this account for a period and the credit card account will show a balance of $700.

For this $350 transaction and $35 fee will be assessed for the month. If the credit card is paid late another $35 fee is assessed. This single transaction can have $70 worth of fees. This is 20% of the transaction amount for a month and if this annualized by multiplying by 12 it becomes 240%. The account balance has now grown to $420+.

The largest potential problem with a credit card is with the fees, 240% annualized, not the APR of about 20%.

Just say NO to credit card offers for undergraduate college students.