Sloppy Due Diligence?

Here is another article about the broker-dealer's due diligence responsibility.  The thrust of the piece is that due diligence must be conducted independently of the issuer.  It takes time, effort and documentation, and may involve some expense.  Using third party experts paid by the issuer can be a part of the process, but it does not satisfy the responsibility for direct investigation.

What has not been tested is the responsibility of the independent RIA in establishing the reasonable basis for a recommendation.  Many suggest that the responsibility is the same as that of a broker-dealer.  Now may be a good time consider whether this responsibility is being met.

Capitalizing Lobbying Expenses

I saw this item in The Economist and it occurred to me that flimsier ideas have formed the basis for stock portfolio strategies.  The notion that greater lobbying expense is correlated with higher returns is intuitively attractive.  Companies don't make such expenditures without an expectation of return.  The companies that "invest" the most in influencing the regulatory environment are the ones that have reap the greatest from the expenditures.

Still, thirteen years is not an extensive test and it would seem that it would be an increment that woulds be arbitraged very easily. That has never been enough to deter product development in the past.  And this may actually have some staying paower.

BDCs versus Mutual Funds and ETFs

I have been looking at the Business Development Companies (BDCs) being offered by Franklin Square and CNL.  Both of these funds are investing in loans made to private companies, primarily floating rate tied to LIBOR.  Each has an affiliation with the lending desk of a major private equity firm.  Each expects to employ leverage.  Each will invest selectively in fixed rate debt.

The structure of each is about the same as well:  10% load and a 2% management fee plus 20% profit participation in excess of some benchmark.

Everything is sounding fine.  Except that there are already funds that invest in these floating rate loans available to investors.  I wrote about bank loan funds back in January.  Except for the leverage and fixed rate debt, the fund portfolios will be invested the same as the BDC portfolios.  The major difference is the structure: No-load with an expense ratio typically around 1%.

Now PowerShares has a floating rate loan ETF, the Senior Loan Portfolio (NYSE:BKLN).  It is designed to track the S&P/LSTA U.S. Leveraged Loan 100 Index.  Since its March 31, 2011 inception, it has tended to trade at a premium of 50 to 100 basis points.  BKLN has an expense ratio of 0.93% which is is currently being subsidized by ten basis points.

There is the choice:  invest in a traditional mutual fund or and ETF at virtually no load and with a 1% expense ratio.  Or invest with a 10% load and a 2/20 management fee.  PLUS direct expenses.

The promoters of the BDCs point to the leverage and illiquidity as investor benefits.  By borrowing at rates lower than is being earned on the portfolio, leverage is expected to enhance the returns.  The illiquidity of the investment will force an investor to hold during times of uncertainty, relieving selling pressure in a weak market.

In fact, leverage and illiquidity are risk factors, not investor benefits.  Indeed, an investment which exhibits these characteristics should be expected to provide incremental returns relative to similar investment which does not have the characteristics.  It seems rather dubious to rely on these additional risk factors to just overcome the BDCs' structural weaknesses and achieve performance parity with traditional funds and ETFs.

A New Asset Class

Courtesy of The Wall Street Journal

Do Money Market Funds Have Anything To Offer?

When  Primary Reserve Fund broke the buck in 2008, everyone panicked.  Now we are seeing regulatory proposals such as the maintenance of a 3% reserve or floating NAV.  And the conditions that caused the crisis at Primary Reserve also resulted in short-term interest rates of 25 basis points and less.

Now along come an article in Investment News about money funds, recounting what we know.  It also points out that some money funds are stretching for yield (like Primary Reserve) by, for example, buying the debt of European banks.

All of this makes a very strong case for bank checking and money market accounts.  Even in a checking account paying no interest, the FDIC insurance certainly has to be worth more than 4 basis points.  From what I have seen, all of the major clearing firms offer some sort of government insured account for cash balances.  Right now, there is not much to recommend money market funds, and it looks like there may be less in the future.

Wells REIT II Valuation

Wells REIT II sent a letter to investors with an updated share valuation.  At $7.47 per share, the new value reflects a significant decline from both the offering price of $10.00 and the DRIP price of $9.55.  It is also notably lower than the estimate share value estimate I gave in an earlier post.

Wells is due some credit for accepting the consultant's valuation unmodified.  The REIT was formed and was making significant acquisitions during a real estate market that was much more robust than current conditions.  Valuations are bound to be lower than par, given the legacy properties in the portfolio.

Unfortunately, the new valuation is also consistent with investor experience with Wells programs.  Investors receive an attractive income stream, but then are subject to a negative surprise on a revaluation or liquidity event.

Special thanks to the Rational Realist.