By Ann Marsh  Financial Planning

FINRA is substantially underestimating the costs to set up a self-regulatory organization for investment advisors, according to a review by an outside consulting firm. In response, FINRA says the review should be viewed with “skepticism and amusement.”

The Boston Consulting Group review is the latest salvo from the Financial Planning Coalition – comprised of FPA, NAPFA, and CFP Board – in its efforts to have lawmakers authorize the SEC and not FINRA to collect user fees to pay for increased investment advisor examinations. The review also was sponsored by the Investment Adviser Association and TD Ameritrade Institutional.

Last year, the coalition released a study conducted by Boston Consulting Group estimating high costs if FINRA were to become the SRO: $200 million to $250 million in startup costs and $460 million to $510 million for ongoing operations. The coalition says these expenses could be passed on to advisors in annual fees to the tune of $51,700, or much more, per firm, depending on its size. By comparison, FINRA recently released a two-page document with much lower estimates: $12 to $15 million in startup costs versus $150 to $155 million in ongoing operating costs. The new review comes in response to these FINRA numbers.

“They have left out important accounting of costs,” Marilyn Mohrman-Gillis, the CFP Board’s managing director of public policy and communications, said as she was on her way to meetings on the matter with members of the U.S. House of Representatives Financial Services Committee. “It would seem to us that they are drawing on their existing oversight operation. This raises concerns that a FINRA SRO would be truly independent.”

House Financial Services Committee Chairman Spencer Bachus (R-AL) introduced legislation last month in the house that could clear the way for FINRA to become the self-regulatory organization for retail investment advisors. The bill is cosponsored by Rep. Carolyn McCarthy (D-NY). The Bachus-McCarthy bill would authorize one or more self-regulatory organizations (SROs) for investment advisers funded by membership fees.

FINRA released its cost estimates on April 25, the same day that the bipartisan bill was introduced. The authority also has retained powerful lobbyist Michael Oxley, of Sarbannes-Oxley fame, to rally support for it to take over SRO functions.

FINRA says the Boston Consulting Group’s new review is inventing numbers out of thin air. “[U]ntil the Boston Consulting Group has at least one conversation with the SEC and FINRA about what it takes to run a nationwide examination program, their numbers should be viewed with skepticism and amusement,” FINRA Spokeswoman Nancy Condon said in an email.

There’s a reason why BCG didn’t contact FINRA or the SEC, according to Skip Schweiss, managing director of Advisor Advocacy for TD Ameritrade Institutional. “My sense is that the Boston Consulting Group wanted to go about its analysis using less partisan numbers and inputs and I think this is why they didn’t consult with FINRA on this,” says The study says it relied on publicly available numbers in making its cost estimates.

Unlike other custodial firms, Schweiss says TD Ameritrade decided to enter the debate by helping to commission the Boston Consulting Group study in December, and subsequent review, in order to get some hard and objective data to inform all parties affected.

“We jumped in because this is an issue of direct impact to our 4,000 investment advisory firms around the country as to how they are regulated and they tell us that this is a very important issue to them,” Schweiss says. The specter of very high annual advisor fees would impose meaningful expenses on small firms, he added. “It’s just a heavy regulatory and expense burden on what we all know these advisory firms are which is small businesses.”

Chris Paulitz, the managing director of communications and media relations at the Financial Services Institute has said that FINRA is the only logical choice for an SRO, given that it’s highly unlikely in the current political environment that the SEC will be adequately funded to sufficiently regulate advisors. With a FINRA SRO, at least many more advisors will be regulated going forward, according to Paulitz.

“Instituting even basic RIA examinations will level the playing field for all advisors, protect consumers and help RIAs flourish as trust is gained in their business model,” Paulitz said today, although he did not address the question of the costs to advisors.

Specifically, the Boston Consulting Group review finds that:

•FINRA’s estimate omits the cost of SEC oversight ($90 to $100 million) and the cost of enforcement ($60 to $70 million), both of which are required by the legislation;

•FINRA’s estimate of $12 to $15 million in setup costs does not include staff costs incurred during the 12-month setup period, specifically the cost of examiners and support staff. FINRA only includes these expenses as part of its ongoing investment once the SRO is up and running. This omission accounts for $180 to $230 million of the difference between the BCG and FINRA estimates;

FINRA’s estimate of the ongoing annual cost of examining 14,500 IA firms once every four years assumes that FINRA’s IA examiners would be able to nearly double the productivity rate of SEC IA examiners, by performing five or more examinations per examiner per year. This compares to SEC IA examiner productivity of three, and FINRA broker-dealer examiner productivity of 2.8. This productivity assumption accounts for $150 to $170 million of the difference between the BCG and FINRA estimates; and

•FINRA’s estimate does not include overhead costs in its estimate of $150 to $155 million of ongoing annual investment. Overhead costs account for $135 to $140 million of the difference between the BCG and FINRA estimates.

A side by side comparison of the cost estimates can be found here.

by Ashutosh Pandey  Reuters

JPMorgan Chase & Co, the biggest U.S. bank by assets, will be able to manage the $2 billion loss from a hedging program that backfired but analysts said it may take far longer to repair the damage to its credibility as a risk manager.

JPMorgan shares were down 8 percent at $37.39 in premarket trading on Thursday, a day after it said its chief investment office had racked up big mark-to-market losses in its synthetic credit portfolio.

“This is a well-owned stock due to the confidence investors have in the JPM risk (management) and some of that confidence was lost yesterday,” Citi analysts said in a note to clients.

Bernstein analysts termed the loss a “big credibility hit” for the lender, which takes pride in its strong risk management.

Citi cut its share price target to $45 from $52, Nomura to $50 from $55 and Goldman Sachs to $48 from $50. FBR Capital Markets lowered its rating on the stock by a notch to “market perform.”

JPMorgan sailed through the financial crisis without reporting a loss, and its strong balance sheet allowed it to take over investment bank Bear Stearns and consumer bank Washington Mutual when they collapsed in 2008.

The bank had $2.32 trillion of assets supported by $190 billion of shareholder equity at the end of March.

Goldman Sachs said that while the direct impact of the loss was manageable, the broader implications were negative, as they highlighted an unfavorable operating environment and raised questions about regulatory scrutiny.

“To regain (credibility), we think JPM needs to go further to explain to investors conceptually how this could happen on such a large scale and the resulting changes that are going to be made,” the Citi analysts said.

FBR said that although core business lines remained strong and intact, the potential risk the credit derivatives portfolio posed to future earnings was a worry.

“Until the company is able to unwind this portfolio, there is little clarity into and a lot of uncertainty surrounding JPMorgan’s future earnings,” FBR said in a note to clients.

(Reporting by Ashutosh Pandey in Bangalore; Editing by Anil D’Silva and Gopakumar Warrier and Ted Kerr)

By Larry Swedroe CBS News

(MoneyWatch) The fact that so many investors fail to diversify properly is distressing given that changes in the stock markets have made diversification more important than ever. Indeed, the meaning of diversification has changed significantly in recent decades.

In December 1968, for instance, an important study concluded that investors need to construct a portfolio containing as few as 15 randomly selected stocks before the benefits of diversification (as measured by standard deviation) were basically exhausted. Related research from the same era found that 90 percent of the diversification benefit came from just 16 stocks, and 95 percent of the benefit could be captured by just 30 stocks.

Almost three decades later, a 1996 study by University of Nevada at Las Vegas finance professors Gerald Newbould and Percy Poon came to a far different conclusion. They found that “investors needed to hold more than 100 small-cap or large-cap stocks to remain within 5 percent of average risk,” which they defined as the average volatility of the 40,000 simulated portfolios created for the study.

Now consider an investor who wants to achieve broad global asset-class diversification. She would need to hold more than 100 small-cap and 100 large-cap stocks. And then she would probably have to add a similar number of small-value and large-value stocks, real estate stocks, foreign stocks (large-cap, small-cap, value, and growth), emerging-market stocks, etc. There’s simply no way to achieve this type of diversification by building your own portfolio of individual stocks.

What is driving this heightened need for diversification? One study, “Have Individual Stocks Become More Volatile?” coauthored among others by Princeton University economists Burton Malkiel and John Campbell, argues that a dramatic increase in the volatility of individual stocks, along with a declining correlation of stocks within the S&P 500 Index, has led to a significant increase in the number of securities needed to achieve the same level of portfolio risk. They found that for the two decades prior to 1985, in order to reduce excess standard deviation (a measure of diversifiable portfolio risk) to 10 percent, a portfolio would have had to consist of at least 20 stocks. From 1986 to 1997, that figure increased to 50.

Whereas the study found that there was a large increase in the volatility of individual stocks, the authors found no increase in overall market volatility or even industry volatility. The implication of the combination of increased volatility of individual stocks and unchanged volatility of the S&P 500 is that correlations between stocks have declined. Reduced correlation between stocks implies that the benefits of, and the need for, portfolio diversification have increased over time.

Perhaps the following is the most dramatic example of why a successful investment strategy requires broad diversification. While the 1990s witnessed one of the greatest bull markets of all time, 22 percent of the 2,397 U.S. stocks in existence throughout the decade had negative returns. Not negative real returns, but negative absolute returns. Even this shocking figure is inaccurately low. The reason is that it includes only stocks that were in existence throughout the decade (thus, there is survivorship bias in the data).

Stocks are much riskier than investors believe. That’s because stock returns aren’t normally distributed. The dispersion of individual stock returns doesn’t resemble a bell curve where the median return is the same as the mean return. If the dispersion of individual stock returns resembled a bell curve, then the returns of half the stocks would be above the mean and half would fall below the mean.

Unfortunately for investors in individual stocks, this isn’t the case. The reason is that while your profits are unlimited, you can only lose 100 percent. Thus, a few big winners (e.g., Google) cause the average return to be above the median return. As a result, there are more stocks that have below “average” returns than there are stocks with above “average” returns. This makes the purchase of individual stocks a loser’s game.

By Liz Davidson Forbes

We all know that the federal government is running a massive budget deficit and looking for ways to cut spending and increase revenue. Some recent proposals intend to do this by targeting the tax benefits of retirement plan contributions, especially for higher income people. After all, those pre-tax contributions you’ve been making to your 401(k) is income the government hasn’t been able to tax…at least not yet.

One idea was suggested to the U.S. Senate Finance Committee last September by William Gale, the director of the Retirement Security Project at the Brookings Institute. Gale’s plan is to replace pre-tax and tax deductible retirement plan contributions by both employers and employees with a flat 18% tax credit that would be deposited directly into the person’s retirement account. Roth accounts and existing pre-tax retirement account balances would be unaffected. This means that you’d have to pay a tax on any income you or your employer contributed to a pre-tax retirement account, essentially ending these accounts as we know them. As a result of these changes, the plan is projected to increase government revenues by $458 billion over the next 10 years.

The main effect of this change would be to provide a larger incentive for lower income people to save at the expense of higher income people. That’s because the break even point between the pre-tax contributions and the tax credit would be the 15% tax bracket. Anyone in a lower bracket would benefit more from the tax credit while those in higher brackets would benefit less than under the current system. Individuals in the 15% tax bracket would come out about the same.

Gale argues that those in the lower income brackets need more of an incentive to save while those in the upper income brackets are likely to save anyway and simply shift that saving from taxable accounts to tax-sheltered accounts. Considering that EBRI’s 2012 Retirement Confidence Survey found that only 35% of workers earning less than $35k per year said they were saving for retirement, any plan that could help lower income individuals save more for retirement would be welcome. Our own primary research shows a general correlation of income to the likelihood of contributing to retirement accounts as well.

However, how much of that discrepancy is due to the lower tax benefit that lower income individuals receive from pre-tax contributions? Our research indicates that other factors are in play too. Employees earning less than $35k per year are more likely to struggle with basic money management issues like living within their means, paying bills on time, dealing with debt, and saving for emergencies. They’re also less likely to have a general understanding of investments and to feel confident that their money is allocated appropriately between those investments. In other words, you’re probably less likely to save for retirement if you’re having trouble managing your day-to-day finances and don’t really understand the investment options available to you.

At the same time, higher income individuals shouldn’t be neglected either. Our research shows that less than half of even those making over $200k a year know that they’re on track to replace the 80% of their income in retirement that many experts suggest as a target. After all, Social Security replaces a smaller percentage of income for those in the higher income levels and could replace even less if proposals for means-testing benefits take effect. Another problem is that higher income doesn’t always translate to the higher savings rates needed for them to sustain that income into retirement.

So what would these changes mean for you? If you’re in the 15% tax bracket or below, the tax credit could be a great opportunity to increase your retirement savings with the additional money from the government, but you’ll need to be in a position to take advantage of that opportunity. Whether you’re struggling with cash flow and debt problems or want to learn more about retirement planning and investing, ask your HR representative if your employer offers financial counseling or education on these issues through an EAP, your retirement plan provider, and/or a financial education company.

If you’re above the 15% bracket, you might be better off switching to a Roth account instead. You’ll want to consult those same resources to help you with that decision. It might also be a good idea to sock away as much money in pre-tax accounts now while you still can.

Proposals like this aren’t necessarily good or bad. Some people will benefit while others will be worse off. The important thing is to adapt to changes as they happen. There was a time when people generally stayed at the same company their entire working life and retired on a company pension. Now, if you’re like most people, you’ll switch jobs and even careers throughout your lifetime and are responsible for saving and investing for your own retirement. Whether we like it or not, times have changed and they are likely to do so again.