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Briefly Noted

The NASDAQ’S Rebalancing Act

Last month, NASDAQ OMX announced a rebalancing of its NASDAQ-100 index. Effective May 2, 2011, the index will be reorganized so that each company’s weighting within the index will be more reflective of its relative market capitalization.

This change was made specifically to adjust for the appreciation in shares of Apple (AAPL). When the reorganization was announced, Apple had a weighting in excess of 20%, even though the company’s market capitalization suggested a weighting of closer to 12%. The reason for the difference is that NASDAQ had used adjustment factors set in 1998 to weight the index, instead of a company’s actual number of shares outstanding. Effective with the rebalance, the index securities will be closely linked to a company’s actual market capitalization.

The change may have unintended tax consequences for those of you holding mutual funds in taxable accounts. Capital gains will be generated if the NASDAQ’s rebalancing prompts a fund manager to sell shares of Apple at a profit. Particularly impacted are funds that directly or indirectly track the NASDAQ’s weighting. (Exchange-traded funds, or ETFs, do not have this potential tax issue.)

Though the NASDAQ OMX uses a capitalization-weighted strategy for its index, it is not the only strategy. Indexes can also follow equal-weighting and fundamental-weighting strategies. The Dow Jones industrial average uses a unique methodology of weighting each of its 30 stocks by share price, with the calculation adjusted to account for stock splits.

Capitalization weighting is the strategy used most often by indexes. This strategy does a good job of measuring market value changes, but it also causes the largest components to have greatest influence on the index. Equal-weighted indexes limit the impact any one security can have on the index, but this strategy can result in higher transaction costs. Fundamental indexes step right up to the line of actively selecting stocks. These indexes are tied to a specific strategy for picking stocks, such as valuation, which is dependent on the index creator’s preference.

Sources: NASDAQ OMX, The Wall Street Journal.

The SEC Proposes New Trading Rules

Last month, the Securities and Exchange Commission (SEC) proposed a new mechanism to address intraday volatility in stock prices. A new “limit up-limit down” system would be implemented to prevent large, rapid changes in stock prices. The proposal can be found at sec.gov/news/press/2011/2011-84.htm.

As many of you remember all too well, stock prices rapidly and unexpectedly plunged during the flash crash of May 6, 2010. A series of events, accelerated by electronic trading, caused shares of some large companies, including Accenture (ACN), to fall to as low as a penny a share. Though stock prices did quickly rebound and many trades were canceled, unanticipated sell transactions did occur for investors who had placed orders to sell a stock if its price fell below a specified target.

The new proposal would try to prevent another flash crash from occurring by halting trading. Specifically, if the proposal is enacted, trading would be paused for up to five minutes in stocks that trade outside of a band based on transaction prices for the previous five-minute period. The bands would be 5% above and below the average price for the previous five-minute period for stocks currently under a circuit-breaker pilot program and 10% for most other stocks. The bands would be widened at market open and close, as well as for stocks with prices below $1.

This is a change from the current circuit-breaker pilot program, which pauses trading if a stock experiences a 10% change in the price over the preceding five minutes. These circuit breakers have been tripped by erroneous trades. The new system attempts to resolve this weakness by using “eligible reported transactions,” or transactions that are eligible to update the last sale price of a stock.

At press time, it was unclear if this proposal will be instituted, as the SEC was seeking a 21-day period for public comment. Though the concept seems reasonable, any new system designed to regulate trading has the potential for unanticipated consequences.

Source: Securities and Exchange Commission.

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Retiree Medical Costs to Total $230,000

A couple retiring this year will need $230,000 to cover medical expenses through the rest of their lives, according to Fidelity Investments. The 10th annual Fidelity health care costs estimate assumes retirees qualify for Medicare, but do not have access to employer-provided health care coverage.

There are several factors that should be considered when looking at this number. This is an estimate of total costs for the average retiree. Actual lifespan and health will cause each individual’s costs to vary widely. The projection does not factor in over-the-counter medications, most dental services or long-term care costs.

Furthermore, the costs will be distributed over a number of years, likely in a disproportionate manner. For example, medical issues could require assisted living care late in one’s life. Based on 2010 rates, this would add an additional expense of $3,293 per month, according to Robert Powell, editor of the Retirement Weekly newsletter.

From an investing standpoint, medical costs impact your financial ability to tolerate market risk. Specifically, higher anticipated medical costs lower one’s tolerance for risk. Offsetting medical expenditures and financial risk are any regular cash flows (e.g., Social Security, pension payments, etc.), as well as a person’s overall net worth. The lower medical costs are relative to the size of a retiree’s portfolio, the greater his ability to tolerate market volatility.

Since medical costs are a variable liability with an uncertain time frame, retirees need to strike a balance between wealth preservation, income generation and portfolio growth. Wealth preservation means ensuring that savings will be sufficient to last throughout your lifetime. Portfolio income may be needed to help fund living expenses and cover potential medical costs. Rising prices—medical and other—require a continued focus on portfolio growth during retirement. It is important for a retiree to achieve a rate of return above the rate of inflation, otherwise the purchasing power of his savings will be diminished. Thus retirees should consider using a combination of stocks, investment-grade bonds with varying maturities and other lower-risk income-producing investments to achieve this balance.

Sources: Fidelity Investments, Retirement Weekly.

From the Bookshelf

Jeffrey Hirsch makes a seemingly bold forecast in Super Boom: Why the Dow Will Hit 38,820 and How You Can Profit from It (John Wiley & Sons, 2011). He predicts the Dow Jones industrial average will rise above 38,000 by 2025.

Hirsch spends much of his book discussing past economic growth cycles. He also explains how these correlate with what he believes will drive the next long-term upward move for stocks: innovation, higher rates of inflation and a winding down of military action.

As for Hirsch’s forecast for a Dow of 38,820, it is based on the assumption that the blue-chip average will achieve an 8.4% annualized return from now until 2025. Based on historical data from Ibbotson’s “Stocks, Bonds, Bills, & Inflation Yearbook,” his forecast is optimistic, but not irrational.

Hirsch’s book is not the first to make a provocative forecast, and it won’t be the last. What it does do is show that the power of compounded returns can create wealth, even in periods when inflation is higher than what we are currently experiencing.

The image of a nuclear cloud on its cover adds an ominous tone to “Surviving the Bond Bear Market: Bondland’s Nuclear Winter” (John Wiley & Sons, 2011). Marilyn Cohen and Chris Malburg make their opinion clear in the book’s preface: They expect interest rates to spike.

Cohen, a speaker at our upcoming 2011 Investor Conference, does not provide a specific forecast for when rates will rise. Rather, the authors advise readers to look for a trend of improving economic conditions and changes in bonds yields as signs of a weakening bond market.

This is not a book that will calm the nerves of those of you who are worried about the direction of interest rates, nor do we agree with everything the authors wrote. You will, however, find strategies for adopting a more conservative stance with bonds. These strategies include shortening the duration (a measure of interest rate sensitivity) of bond holdings, seeking higher credit ratings and holding bonds with differing maturity dates.


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