Welcome to the Blue Money Report

Today, we are testing out the beta version of our new feature "At Arm's Length". This new feature will be a brief summary of news heading into the opening business day. It'll be short and to the point and with any luck will also be as crisp as our longer commentaries. Those, by the way, are not going away. I will still offer several columns a week for the sites that have subscribed to our service. This test content will last a month for free before going behind closed doors.

Thank you and enjoy At Arm's Length:

Paul Petillo
Managing Editor

Today's Commentary: 03.12.04
Triple Witching: Will Bulls run from Volatility?

The Bulls may be on the run. With very little prodding, investors have stepped back from the markets taking a look at both positions and the future of those decisions - even in the short term. Will the upcoming triple witching have any effect on how they view the markets?

This unusual event, done with the blessing of the Security and Exchange Commission, happens on the third Friday of the last month of the quarter. The "triple" in this event involves the simultaneous expiration of stock options, index options and index futures. These expirations all take place on the same day, stock options are priced at the close of trading day.

It is probably best to explain how each of these investor tools function. Stock options also referred to as warrants, puts or calls are tradable securities based on an equity's price movement. An "option" allows the investor to buy a stock within a certain time frame and at a set price. The value of this security will change based on the underlying value of the stock and the fluctuation of the price. If the strike price, or the price at which the option was bought is less than the current trading price, the value of those options is higher.

Index options, sold by the Chicago Board Options Exchange (CBOE), are basically the same as stock options. Investors use the "strike price" of an index or basket of stocks and base their trading on the underlying value of the index. The CBOE trades in 40 such indexes. The indexes that are traded here can be both broad based and narrow in scope allowing investors to purchase options in the Dow Jones Industrials and the Russell 2000 to indexes that follow gold, oil, technology, or international equities.

The index option adds to the volatility of a triple witching largely due to the increased activity from investors buying or selling the stocks within the index. Whenever an equity in a index moves, the value of the index changes. The greater the weighting or percentage of that equity in the index, the greater the movement of the index as a whole.

These two activities, happening simultaneously can throw the markets out of whack for a brief period, making investors unsure of the actual value of their investments.

A triple witching occurs and adds to this market disturbance with the additional expiration of index futures. Futures, a highly speculative investment common to commodities such as precious metals, live stock , or oil, is primarily a bet on the future close, whether profitable or not of a stock index.

The investor is faced with many immediate decisions on a Triple Witching day, somtimes called Freaky Friday, that need to be made at the time of expiration. Buying or selling, rolling existing contracts or looking for new ones, leave investors scrambling.

According to Steven V Le, California State University, Long Beach, the "reason that options effect the market so significantly is related to the fact that index futures and options settle for cash, while the common stocks that are used to hedge them settle for actual shares of stock." He adds that. "only the stock side is traded at expiration, while the futures automatically settle for cash without any trading taking place" creating an artificial effect on the stock market.

The volatility comes from the increased volume, the magnitude of the change, and the added pressures of the expirations of options and futures.

Triple Witching Days happen four times a year: the 3rd Friday of March, June, September, and December. The upcoming witching should prove interesting to watch as the markets have moved from their yearly highs.

Today's Commentary: 03.10.04
401K Plans: What To Do When Choices Are Poor

The historical record provided by academic studies is very clear that the winning investment strategy is to invest in funds that are passively managed- index funds, exchange traded funds (ETFs), and passive asset class funds. Unfortunately a conflict of interest is preventing many, if not the vast majority of, individuals from investing passively inside of their 401k or other corporate sponsored savings programs (such as profit sharing plans).

The employer can save a large amount of money by not having to pay for the administration of the employee benefit. Therefore, management is very interested when a fund family that provides high cost, actively managed funds proposes to the employer that they will pick up all of the plan's administrative expenses if the employer makes their fund family the exclusive (or at least dominant) provider of investment alternatives. Unfortunately, the employees lose in the end as they accumulate fewer dollars in their retirement accounts. The reason is that high-cost active management is a loser's game.

If an employee does not have access to low cost, passive investment choices the first thing they should do is to go visit their HR department and request that the plan be changed to include these investment vehicles. They can cite the Prudent Investor Rule as support for their request.

Until passive choices are available employees are faced with the difficult decision of choosing among the active funds that are available-a "lesser of evils" choice. The following are offered as suggestions to help make that decision. We begin by understanding that it is the asset allocation decision that determines the vast majority of risk and returns of a portfolio. Since controlling the risk of a portfolio is of paramount importance, investors should look for funds that "stick to their knitting"-avoiding style drift. Investors should avoid funds that drift between growth and value, small and large, and/or domestic and international. Funds that style drift take the control of risk away from the investor and place it in the hands of the fund manager. Investors should also look for funds that have the lowest total expenses (operating expense ratio and any 12b-1 fees). The reason is that the evidence is clear that expenses incurred in efforts to select securities and/or time the market are highly likely to prove counterproductive.

The bottom line is that investors should look for funds that most closely resemble low cost, passive funds such as index funds. A good example of such a fund is Vanguard's Windsor, which is a good choice for gaining exposure to the asset class of U.S. large value. It is very low cost and very low turnover and does not style drift. There is another suggestion: Consider using the 401k as much as possible for fixed income investing. First, if you are going to hold both equities and fixed income assets, and you have both taxable and tax-deferred accounts, it is preferable from a tax efficiency standpoint to hold the equities in the taxable account (or a Roth account, which is not taxable) and the fixed income assets in the tax-deferred account.

Second, the expense ratio and trading costs of actively managed fixed income funds are generally much lower than they are for equities. Thus you can reduce total expenses, and the drag on returns, by choosing fixed income funds for your 401k plan.

Third, while it is important to build a globally diversified by asset class portfolio, avoiding having all your eggs in one asset class basket (i.e., U.S. large growth), if your only choices are active ones and one index fund (many plans include at least an S&P 500 Index or Total Stock Market fund) invest in the index fund and then diversify your equity holdings outside of the plan. Also if the cost of the active choices that would allow you to diversify is very high, it might be prudent to forego the diversification benefits in favor of the sure savings from lower expenses.

Individuals should not accept poor investment choices inside their 401k plans without "fighting the good fight" to get their employer to provide the best investment vehicles. However, until low cost, passive choices are available it is important that they act to minimize the potential damage done by actively managed funds.