Fundmastery Blog

Kurt Brouwer October 13th, 2009

Exchange traded funds (ETFs) have many of the built-in advantages that mutual funds have, but there are also differences.  In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history.

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

In this piece from the Wall Street Journal [registration may be required], we see problems arising in bond ETFs.  Namely, that it is hard to price some of the underlying bonds in the various ETF portfolios accurately.  Or, it may be difficult for a given ETF to replicate a bond index exactly because the index may hold some bonds that are not traded frequently.

Eleanor Laise at the WSJ spells out some of the issues [emphasis added]:

Bond ETFs Are Popular But Pricing Is a Problem (Wall Street Journal, October 6, 2009, Eleanore Laise)

…Share prices of many bond ETFs are drifting far from the value of their underlying holdings, which can create big trading costs for investors. Some of the funds are straying from their benchmarks, meaning investors aren’t getting the returns they expected.

…ETFs, typically cheap, straightforward products designed to act like index funds, generally track the performance of a benchmark for stocks, bonds or commodities. But they differ from traditional mutual funds because they trade throughout the day on an exchange.

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market…

…State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%…

…The iShares iBoxx $ High Yield Corporate Bond ETF, for example, traded at a 7% premium at one point in April, and traded within 0.5% of its NAV on only five days in the third quarter…

Such wide gaps aren’t generally supposed to appear in ETFs. Big investors can typically buy up the fund’s underlying holdings and swap them for ETF shares, arbitraging away any significant gaps between the ETF share price and NAV.

But bonds can be so tough to trade that large investors become reluctant to perform this function for fixed-income ETFs. Even when they do make the trades, they incur big trading costs that get factored into the price of the ETF shares…

In another WSJ piece, Tom Lauricella adds a bit of detail to this problem:

Bond ETFs Are Usually Priced Higher Than What They’re Worth (Wall Street Journal, October 5, 2009, Tom Lauricella)

On Sept. 30, 39% of U.S.-bond ETFs traded at a premium of greater than 0.5% to NAV, according to Morningstar Inc. To a large degree, these pricing issues reflect the challenge faced by all bond investors. Most bonds don’t trade on exchanges. And the gap between the “offer” price at which you can buy a particular bond and the lower “bid” price at which you can sell it is typically much wider than on stocks.

The headline for Tom Lauricella’s piece is a bit exaggerated, as headlines often are.  And, I’m well aware that the reporter does not generally get to write the headline, so I won’t give Tom a hard time for it.  I would have written, Bond ETFs Often Trade at Slight Premiums or Discounts.  It’s not as exciting though.  The WSJ continues:

Bond ETFs set the NAV based on estimates of the prices they would get if they sold their holdings. Meanwhile, most bond ETFs are bringing in new money now, so the dealers responsible for creating ETF shares need to constantly buy new securities. That takes place at the higher “offer” side. To compensate, dealers will price the ETF shares higher than NAV, resulting in the bias toward a premium.

If it’s a matter of buying and selling at inflated prices, it’s a wash. But sometimes, investors who bought at a premium end up selling at a discount. “If everybody is selling, it’s also a time where there may not be much liquidity in the bond market, and…funds will be trading at NAV or at a discount to NAV,” says Kenneth Volpert, a principal at Vanguard Group.

In fact, when investors fled corporate bonds last fall, many bond ETFs traded at meaningful discounts. This year, some $25 billion has gone into bond ETFs, a good portion of which is chasing big returns in high-yield bonds, which are notoriously difficult to trade in tough times. How would ETF prices handle that money being pulled out in a flash?…

So far, the discrepancies between a given ETF’s share price and its net asset value (NAV) seem to be manageable.  As anyone who has ever purchased bonds knows, bond traders do a good job of exacting their pound of flesh, particularly for thinly-traded securities.  So, the cost of putting together a portfolio that matches a given index would be very difficult and costly.

This last point is a good one though.  If all the investors in a given ETF want to get out at the same time, raising cash may be an issue.  And, if a given ETF has to raise a lot of cash quickly, it will probably get dinged a bit on those securities that it sells.

• ETF , Investing , Mutual Funds
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Kurt Brouwer October 12th, 2009

As we have noted before, Congress has a tendency to underestimate the costs of a program it is considering.  In yet another example of this, this chart demonstrates that Medicare costs have been significantly underestimated by Congress at the time of enactment:

Source: Carpe Diem

Medicare: What will it really cost?

The ironic part about the current discussions of healthcare reform costs is that proponents of the plan initially said — and some are continuing to say — that healthcare reform would save money.  Unfortunately for them, the Congressional Budget Office (CBO) pointed out that the legislation before the House of Representatives (H.R. 3200) would actually add significantly to the deficit by as much as $1 trillion over the next 10 years.

That news caused many in Congress to gulp hard, yet the CBO estimate is almost certainly low if history is a guide.  I thought it would be useful to look at how far off previous estimates from Congress on Medicare costs have been  in the past.

When Medicare was passed, various future estimates of costs were made by Congress.  Those estimates were wildly off base, so much so that it is doubtful that Medicare would have passed, had there been an accurate cost estimate.  The chart above shows that the actual costs for Medicare programs run from a minimum of 200% over budget up to 1700% over budget.

Lyndon Johnson & Medicare cost estimates

There is an interesting interview on National Public Radio [emphasis added] which presents evidence that President Johnson deliberately underestimated the cost of Medicare to get it passed.  The interview is with James Morone, co-author of the Heart of Power: Health and Politics in the White House.   In it, the show’s host, Renee Montagne, asks the author about comments President Johnson made about the original cost estimates for Medicare.

Democrats Could Learn From LBJ’s Medicare Push (National Public Radio/Morning Edition, August 26, 2009, Renee Montagne)

[NPR-Montagne]: There are tapes of Johnson showing a different side of how he worked [Medicare’s passage].

[James Morone, co-author of The Heart of Power: Health and Politics in the Oval Office]: Johnson maneuvered every step of the way getting this bill through Congress, and one of the things he did — and this is a little dicey in today’s climate — was suppress the costs. So this young kid gets elected from Massachusetts, Ted Kennedy, in 1962, and Johnson is explaining to him [over the phone] how you get a health bill through. And what he tells him is don’t let them get the costs projected too far out because it will scare other people:

“A health program yesterday runs $300 million, but the fools had to go to projecting it down the road five or six years, and when you project it the first year, it runs $900 million. Now I don’t know whether I would approve $900 million second year or not. I might approve 450 or 500. But the first thing Dick Russell comes running in saying, ‘My God, you’ve got a billion-dollar program for next year on health, therefore I’m against any of it now.’ Do you follow me?”

[JM]: We believe, after looking at the evidence, my co-author [David Blumenthal] and I, that if the true cost of Medicare had been known — if Johnson hadn’t basically hidden them — the program would never have passed. America’s second-most beloved program would never have happened, if we had had genuine cost estimates…

That is an amazing piece of history and it seems authentic as it is based on tapes LBJ made of his various conversations.  Most people don’t realize this, but the various pieces of healthcare reform legislation now before Congress use an interesting technique of which LBJ might approve.  Taxes and fines and Medicare cuts would start right away, but spending on the program would be delayed until 2013 or so.  So, the 10-year estimate only has 6 or 7 years of actual expenditures built in.  Nice.

Can we trust Congress?

For a variety of reasons, estimating costs of government-run health insurance reform seems to be quite difficult, even assuming our leaders are trying to do so fairly and honestly.  So, I would not take current estimates of the cost of health insurance reform as being cast in stone.  In fact, I would assume they are very low as Congressional estimates for Medicare have always been in the past.

• Economy , Geopolitics , Money , Personal Finance , deficit , healthcare
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Kurt Brouwer October 9th, 2009

We frequently are told by politicians that the only solution to our budget deficits at the Federal, state and local levels is to raise taxes.  I might buy this argument if those same politicians had made efforts to cut government spending that is not needed or is wasteful.  Unfortunately, those types of efforts get short shrift except when it is time to campaign.

From the Foundry blog, here are 10 examples of eggregious government waste:

50 Examples of Government Waste. (Foundry, October 6, 2009, Brian A. Riedl)

…Reducing wasteful spending is not easy. Even the most useless programs are passionately supported by the armies of recipients, administrators, and lobbyists that benefit from their existence. Identifying inefficiencies and abuses is much easier than devising a system to fix them. Many lawmakers focus more on bringing home earmarks than on performing the less exciting task of government oversight. Exasperated taxpayers see the cost of government rise with no end in sight.

Of course, eliminating waste cannot balance the budget. Lawmakers must also rein in spending by reforming Social Security and Medicare and by eliminating government activities that are no longer affordable. Yet government waste is the low-hanging fruit that lawmakers must clean up in order to build credibility with the public for larger reforms…

I have not cherrypicked these items, just took the first 10 from the Foundry’s list and added three bonus items from further down the list: [emphasis in the original]:

1. The federal government made at least $72 billion in improper payments in 2008.[1]

Okey dokey.  Has anyone thought of asking for these improper payments back?

2. Washington spends $92 billion on corporate welfare (excluding TARP) versus $71 billion on homeland security.[2]

We should be able to get to bipartisan agreement on this one.  Some don’t like waste, some don’t like welfare and some don’t like corporations.  It’s a match made in heaven.

3. Washington spends $25 billion annually maintaining unused or vacant federal properties.[3]

D’uh…Why not sell these properties?  We’d save $25 billion a year in maintenance savings alone plus the value of the properties, which are undoubtedly worth something.

4. Government auditors spent the past five years examining all federal programs and found that 22 percent of them–costing taxpayers a total of $123 billion annually–fail to show any positive impact on the populations they serve.[4]

Unfortunately, lawmakers do not seem to feel that positive impact from government spending is critical.  Witness the Cash for Clunkers program and many others.  Nonetheless, this is definitely low hanging fruit.  But still, $123 billion for programs that show no positive impact?

5. The Congressional Budget Office published a “Budget Options” series identifying more than $100 billion in potential spending cuts.[5]

This report from the CBO contains hundreds of recommendations to cut spending.  Again, we’re talking $100 billion per year.  $100 billion here and $100 billion there.  After a while, it adds up to real money.

6. Examples from multiple Government Accountability Office (GAO) reports of wasteful duplication include 342 economic development programs; 130 programs serving the disabled; 130 programs serving at-risk youth; 90 early childhood development programs; 75 programs funding international education, cultural, and training exchange activities; and 72 safe water programs.[6]

Do we really need 342 Federal economic development programs?

7. Washington will spend $2.6 million training Chinese prostitutes to drink more responsibly on the job.[7]

We previously said all we had to say on this one here: In this era of budgetary constraint and fiscal rectitude, we are pleased to report that our political leaders and bureaucratic chieftains have really gotten the message.  Otherwise, they would fund all kinds of crazy things.  Oops.

U.S. Will Pay $2.6 Million to Train Chinese Prostitutes to Drink Responsibly on the Job (CNS News, May 12, 2009, Edwin Mora)

The National Institute of Alcohol Abuse and Alcoholism (NIAA), a part of the National Institutes of Health (NIH), will pay $2.6 million in U.S. tax dollars to train Chinese prostitutes to drink responsibly on the job.

Dr. Xiaoming Li, the researcher conducting the program, is director of the Prevention Research Center at Wayne State University School of Medicine in Detroit.

The grant, made last November, refers to prostitutes as ”female sex workers”–or FSW–and their handlers as “gatekeepers.”

“Previous studies in Asia and Africa and our own data from FSWs [female sex workers] in China suggest that the social norms and institutional policy within commercial sex venues as well as agents overseeing the FSWs (i.e., the ‘gatekeepers’, defined as persons who manage the establishments and/or sex workers) are potentially of great importance in influencing alcohol use and sexual behavior among establishment-based FSWs,” says the NIH grant abstract submitted by Dr. Li…

This study certainly seems essential doesn’t it?  After all, what could be more important to people in Detroit, home of Wayne State University, than that Chinese prostitutes drink responsibly?  And, since this ’study’ is funded by the Federal government, it’s not as though we have any problems closer to home, right?

8. A GAO audit classified nearly half of all purchases on government credit cards as improper, fraudulent, or embezzled. Examples of taxpayer-funded purchases include gambling, mortgage payments, liquor, lingerie, iPods, Xboxes, jewelry, Internet dating services, and Hawaiian vacations. In one extraordinary example, the Postal Service spent $13,500 on one dinner at a Ruth’s Chris Steakhouse, including “over 200 appetizers and over $3,000 of alcohol, including more than 40 bottles of wine costing more than $50 each and brand-name liquor such as Courvoisier, Belvedere and Johnny Walker Gold.” The 81 guests consumed an average of $167 worth of food and drink apiece.[8]

It has been found over and over again that government employees abuse credit cards to the point where they really should be given out sparingly.  No doubt there are plenty of responsible bureaucrats who do not abuse cards, but nearly half of all purchases are either improper, fraudulent or embezzled?  C’mon.  Cut up the cards.

9. Federal agencies are delinquent on nearly 20 percent of employee travel charge cards, costing taxpayers hundreds of millions of dollars annually.[9]

Apparently, Federal employee not only abuse credit cards, but their agencies are also frequently delinquent in paying the bill.  From the link for this item #9, we read:

The most stunning revelation concerns not how the cards are used but rather how long it takes the government to pay its bill — and what those delays are costing taxpayers.

According to the most recent data from the Office of Management and Budget, in January 2009, governmentwide delinquency rate for centrally billed card accounts — those paid by an agency rather than an employee — was 19.23 percent. The average delinquency rate for individually billed cards was 6.25 percent, data showed.

A card is considered delinquent if a bill is outstanding for more than 60 days.

“A private travel agency would be out of business running this kind of operation,” said Scott Amey, POGO’s general counsel. “This report summarizes problems with individual transactions and, more important, with government agencies that aren’t safeguarding taxpayer dollars.”…

10. The Securities and Exchange Commission spent $3.9 million rearranging desks and offices at its Washington, D.C., headquarters.[10]

Now, in all fairness, the SEC has been given some new responsibilities, but that is still a lot of dough for a pretty modest task.

And, here are three bonus items:

12.  Over half of all farm subsidies go to commercial farms, which report average household incomes of $200,000.[12]

I have never understood this farm subsidy concept in which we pay well-to-do folks not to do something.  What does it take to kill off something as silly as this?

13.  Health care fraud is estimated to cost taxpayers more than $60 billion annually.[13]

Much has been made of this as a source of ‘found’ money to help pay the cost of health insurance reform.  OK, fine.  Why not just fix this problem first, if it’s so easy.  See this post, Why Not Fix Medicare First? for more on this issue.

And, finally, the Pentagon’s procurement group should be summarily fired. Of course, Congress shares some of the blame for this one because Congressional leaders have frequently put great pressure on the Pentagon to allow wasteful cost overruns.

14.  GAO audit found that 95 Pentagon weapons systems suffered from a combined $295 billion in cost overruns.[14]

This should also be a Congressional ‘no brainer’ because some in Congress don’t like waste and some don’t like the Pentagon.  I don’t want to undercut our military men and women at all.  They do a difficult and often dangerous job and I would like to make sure they have adequate resources.  Yet, cost overruns on big projects do no one any good.

It looks to me as though savings in just these 13 items would be in the hundreds of billions per year.

That’s enough to give insurance tax credits or vouchers to all those who do not have health insurance, with some spare change left over.  No need to do more deficit spending or to raise taxes.  Just cut the waste and do it first.  What’s not to like?

• Blogging , Business , Geopolitics , Money , debt , deficit , income taxes
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Kurt Brouwer October 7th, 2009

Most of us have experienced a medical insurance claim denial.  On the form from the insurance company, we see a big zero in the amount the insurer will pay.

In all the furor over the many and varied health insurance reform proposals, we have heard over and over again about how heartless private insurance companies are when it comes to denying insurance claims.  We are left with the impression that a government insurance program would be much less likely to deny insurance claims.

However, statistics on claims denial among various insurance providers may tell a different story.   A 2008 report from the American Medical Association was on The Drudge Report and it has been picked up in many other places:

2008 National Health Insurer Report Card  (American Medical Association)

The purpose of the AMA’s National Health Insurer Report Card (NHIRC) is to provide physicians and the general public a reliable and defensible source of critical metrics concerning the timeliness, transparency and accuracy of claims processing by the health insurance companies that are responsible for paying these claims…

The chart below is based on statistics from this AMA report.  Specifically, it covers the percentage of insurance claims that are denied completely.  That is, where the insurance payment is zero.  Here is how the AMA report describes claims denial:

…Percentages of claim lines (i.e., records) denied

Description: What percentage of records submitted are denied by the payer for reasons other than a claim edit? A denial is defined as: allowed amount equal to the billed charge and the payment equals $0…

Data: American Medical Assocation

Chart: Carpe Diem

Medicare claims denial — Is it 6.85% or 4.0%?

I suspect many readers will be surprised by this data because they might have thought that overall claims denial was much higher, across all insurers.  And, many would also be surprised that Medicare was the highest insurer for claims denied.  The next highest was very close — Aetna at 6.8%.  However, the average for all private insurers on this chart was 3.89%, including Aetna.  That’s just a bit more than half of the Medicare rate for claims denial.

2009 AMA National Health Insurer Report Card

To see if the denial rates had changed. I also looked at the AMA’s 2009 National Health Insurer Report Card.   In general, the story is the same, although most insurers had lower rates.

For the 2009 report, Anthem BCBS (i.e. Blue Cross/Blue Shield) was the highest at 4.34% and Medicare was next at 4%.  Aetna was the lowest at 1.81%.  The private company denial average was 2.79% versus Medicare at 4%.  So, Medicare was above average versus private insurers, but Medicare definitely closed the gap quite a bit.

As the Healthcare Economist wrote about this data in a post from last year [emphasis added]:

…the fact that Medicare denies more claims than commercial insurers should dispel the myth that the government is simply a benevolent entity, while commercial insurers are ruthless, profit-hungry wolves…

I don’t want to make too much of this particular report because there are many other issues involved in the healthcare or the health insurance debate.  Nonetheless, this information from the AMA certainly flies in the face of conventional wisdom found in Washington DC and in the media.

See also:

Healthcare: Underestimating the cost

• Business , Economy , Personal Finance
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Kurt Brouwer October 6th, 2009

The absolute size of our Federal government stuns me.  It was big — really big — before, but in the past few years it has been supersized.  Check out these charts from a new website and blog called Downsizing Government.

Chart 1: Federal Spending in Dollars

Source: Downsizing Government

Since the year 2000, Federal government spending has doubled.  Doubled.  And, the growth in spending is accelerating.  The increase in this fiscal year, 2009, that just ended was around $670 billion.  That’s just the increase.

Chart 2: Federal Spending as Percentage of GDP

Source: Downsizing Government

In Chart 2, we see Federal spending as a percentage of Gross Domestic Product (GDP) or total economic activity.  Chart 2 shows steady growth in the size of government, with a huge jump from 1970-76 and an enormous jump in the past two years or so.

Surprisingly, two spending categories — defense and net interest costs — are not contributing to the increased size and scope of government.  I shudder to think what will happen if interest rates go up substantially.

See also:

Households Cut Back; Government Debt Grows

Don’t Tell Congress What Comes After Trillion

Government: It ain’t broke yet, but just wait

• Economy , Geopolitics , debt , deficit
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