Now Treasury's Involved

In all of the back and forth on the issue, I have been confident that money market funds will be reformed to either have a floating NAV or some sort of capital support provided by the management firm.  That confidence looked misplaced when the proposal failed to achieve the support of a majority of commissioners.  However, I noted that the Financial Stability Oversight Council (FSOC) had expressed the opinion that the money market fund industry represented a systematically important financial institution, and, thus, worthy of regulation to ensure its continuity.

Now, Investment News is reporting that Timothy Geitner is urging the FSOC to issue its own regulations for money market funds.  The article suggests that the FSOC will be more difficult to influence away from reform, presumably because it falls under the Treasury Department's purview.  That may so, but it still appears that money funds will have to either adopt a floating NAV or raise subordinated capital.  perhaps the best that the industry can hope for is a choice.

Vanguard's New Indexes

Investment News carried an story on Vanguard's announcement that they are changing equity index providers from MSCI to CRSP (domestic and balanced) and FTSE (international).  The change in providers will reduce the licensing costs of using the indexes a bit, though I doubt that is the reason for the change (the recent reduction in fees by BlackRock and Schwab notwithstanding).  CRSP has the most comprehensive stock price data, and thus a more robust universe from which to construct its domestic indexes.  FTSE's indexes are expansive, though I am not sure how they compare to MSCI's.  ( The article does mention that FTSE assigns the Korean market to the emerging markets index, while MSCI relegates it to the developed markets index.)

Having worked with Vanguard for over fifteen years, I am certain that this change was studied to death before being adopted.  Some ten years ago, when Vanguard moved for the S&P and Russell indexes to MSCI's, issues of coverage and allocation were modeled for effect on risk and performance.  I expect that any differences in expected performance will be compensated with the reduced fees and reflective of any change in the risk profile.  Overall, I do not expect fund performance under the new indexes to diverge more than a few basis points per quarter from the performance of the old indexes, as adjusted for the an appropriate expense ratio.

Glidepath Investing

The September 2012 issue of Fundamentals, a newsletter of Research Affiliates, addresses the question of glidepath investing, or the systematic adjustment of asset allocation during a person's lifecycle.  Conventional wisdom suggests that an aggressive allocation early in a person's working years gradually becoming more conservative is a prudent course.

Research Affiliates conducted a study comparing the conventional strategy (80/20 to 20/80 glidepath) to a constant 50/50 and a reverse of the conventional wisdom (20/80 to 80/20).  Using data from 141 years of capital markets returns, RA found that the reverse of the conventional strategy would provide for higher wealth at retirement, and that, even though the standard deviation of terminal wealth was higher, the worst case wealth measure was also higher than that of the conventional strategy.

RA correctly attributes the increased wealth to having the largest portfolio invested in the most aggressive allocation.  This will also place a larger investment pool at risk.  RA dismisses this: "(The reverse conventional investor) has to accept more uncertainty late in life as to how much she can spend in retirement—but it’s upside uncertainty!"

If all of this were true, no glidepath would be warranted; an investor maintaining an 80/20 portfolio throughout his career would undoubtedly retire with a superior retirement fund, and the worst potential outcome would most likely be higher than any of the others studied.

So what's missing?  The study is conducted only from the perspective of the twenty-year-old just starting his career.  If that was the only time that a strategy could be set, the study would be valid.  However, investors lifestyles, risk tolerances, and objectives change many times over their lifetimes, and it is imperative to change policies and strategies to reflect the new circumstances.  As these new strategies are adopted, I woulds expect that over time, they will come to resemble the conventional glidepath investing strategy that RA is attempting to discredit.

Update (10/3/12): Financial Advisor carries a story on Folio Investing's Steven Wallman's response to RA analysis. 

On Further Review...

Investment News carries an article indicating that one of the SEC commissioners that had opposed the money market fund reforms may be willing to support just the floating NAV part.  Well why didn't he say so in the first place?

Advisor Managed Portfolios Underperform?

Investment News reported on a study by Cerulli Associates that indicates that portfolios managed by advisors underperform alternative management arrangements.  Cerulli studied the 2010 to 2011 period and determined that advisor managed portfolios returned 4.3%, while programs packaged by broker-dealers had a return of 9.9% and a fixed 60% domestic equity, 10% international equity, and 30% bonds returned 15.9%.  On the face of it, very damning evidence.

However, the article does not mention how the advisor and b-d portfolios compare to the passive portfolio in terms of construction or risk exposure.  Indeed, no risk measure is given.  Nor does the article mention whether the returns are measured before or after management and administrative costs.  Sometimes, advisors take advantage of opportunities to reduce total costs to clients by taking management internal.  Besides which, two years is an awfully short tie period on which to be making judgements on out- or underperfomance.

Also missed is the customization that can take place when the client has direct access to the portfolio manager.  Tax sensitive trading can be executed, liquidity needs addressed   Even short term market risk can be addressed through a dollar cast averaging-like strategy.

Is there any value to e gleaned for the article?  A passive strategy still provides great value for many investors.  Even advisors managing money for the clients.

Credit Where Due

It is easy to be cynical when analyzing alternative investments packaged for retail distribution.  They tend to have high fee structures, lack liquidity, and be quite opaque in terms of structure and governance.  Investment and operating strategies tend to be driven by marketing considerations rather than sound business or investment fundamentals.

That said, I would like to publicly commend American Realty Capital Trust (ARCT) on engineering a liquidity event for investors and an exit for the entire transaction within eighteen months of the close of the offering.  And at prices ($10.50 and $12.20) in excess of the offering share price (as reported in Investment News).

There may be some questions raised about the exit coming so quickly on the heels of the listing.  Just read the Comments below the cited article.  The fact remains that investors received something like a 7% dividend during the holding period, and will recognize anywhere from 5% to a 22% capital appreciation.  All within 18 months of the close of the offering.

Kudos to American Realty Capital Trust and to Nick Schorsch and Wiliam Kahane for their efforts in achieving such a positive outcome for investors.

Money Fund Industry Information Sites

I was directed to this website by a thread on a bulletin board discussing the SEC proposal for money market funds.  The web site includes links to this site and this one as well. The second one is from Federated Investors, a big provider of money funds, especially to institution such as custodial banks and brokerage firms.  Federated obviously has an interest in the proposal, as money finds represent a significant source of revenue.

The first is an effort by the Investment Company Institute.  The only identification is the logo at in the footer of the site.  Investment Company Institute (ICI) is the trade group for mutual fund management companies.  It provides public relations, soft marketing and lobbying for the industry.  As such, the website does a good job on behalf of the industry.  All of the points made are valid. 

Unfortunately, does not identify its sponsor very well.  Even the contact links go to ICI's public relations firm.  Kinda disappointing that ICI does not have the courage of its convictions to conspicuously identify itself with its positions.

All of the arguments being made in favor of retaining money funds in their current form are valid and convincing.  The only problem is that Mary Shapiro is  not charged with securing any of the good things identified with money funds.  Her job is to safeguard individual investors from realizing a loss in an investment designed to avoid losses, and from illiquidity in what is intended to be most liquid of investment funds.  That he Chairman of the Commission has put forth a proposal that can reasonable be expected to achieve these goals is attributed to by the endorsement of the Financial Stability Oversight Board.  I do not believe that this fight is over.

Charlie Ellis On Fees

I am always interested to hear what Charles Ellis has to say.  So when I saw that Investment News had an interview with him (and Mark Cortazzo), I had to hear what he had to say.  The interview focuses on fees, with a 1% (of assets) asset management fee identified as standard for the investment advisory business.  They go through a couple of exercises to try to make a point that advisor fees are actually higher than advertised: Charlie says compared to returns fees are 15%, Mark says due to stair steps the 1% on the last dollar actually turns into 1.67% on all dollars.

Some advisors have their business entirely structured as asset management.  It is at these firms that Ellis' and Cortazzo's comments are aimed.  Management fees of 1% (or more) are unsupportable when this is in the marketplace.  Frankly, the competition to for these firms ranges from Morningstar ($500 to $1500 per year or 1% on a $50,000 to $150,000 portfolio) to mutual fund companies (with asset allocation apps on their websites and  registered and fairly competent representatives available by phone at no extra charge).  Every month, my Charles Schwab account monitors my investments for quality (as defined by Schwab experts) and for allocation outside of some model that has been selected for me.

Where I see more advisors today is providing a very wide range of services on an ongoing basis with their clients.  They charge their clients an "asset management" fee, but portfolio oversight is a small part of the services provided.  It just happens that advisors and client have agreed that it is a fair and transparent way of compensating the advisor while avoiding the piecemeal nature of hourly or project billing.

What the interview reminds me is that the market is highly competitive, and there is no lack for commentators ready to assert that this fee or that charge is too high.  The remedy, of course, is an unassailable value proposition, and constant reminders of it with clients.

Money Fund Vote Withdrawn

Bloomberg published a story late last week that Mary Shapiro is withdrawing the proposal for money market funds to have floating NAVs or have money fund managers support the funds with some capital subordinate to investors'.  Three of the commissioners opposed the proposal, suggesting that fund managers be allowed to refuse redemptions in times of market stress.  One commissioner also suggested that more study is needed before any reforms be adopted.

The call for additional study is a canard, as the issue has been before the commission and the industry for two years.  Allowing fund companies to refuse redemption requests is essentially the situation that we have now, but a little worse.  As the experience with the Primary Fund shows, the first action taken when the buck is broken is to halt redemptions.  The Primary Fund had to get SEC approval, which was immediately forthcoming.  Giving fund managers the authority to close the redemption window will only accelerate the run, with large institutions leading the way at any sign of weakness.

Money market funds with a stable NAV are a product of arcane accounting rules that allow the funds to smooth the effects of short term market movements on short term debt instruments.  Absent these accounting rules the NAV of the fund would fluctuate with market conditions, perhaps a penny in a week, maybe three cents in a year.  Management could limit even that small amount of volatility through risk control techniques.  Could also provide capital to absorb the first dollar loss.

The float or support proposal has backers out side of the SEC.  (See my posts of April 13 and July 16.)  With he support of the Fed and the new Financial Stability Oversight Board  (a creation of the Dood-Frank financial reform bill), the proposal seems assured of adoption, despite the objections of the SEC commissioners and the money fund managers.  It just remains to be seen when it will happen and what the final rules will look like.

A New Asset Mangement Paradigm?

Samuel Lum, CFA, has a piece at Seeking Alpha recounting a presentation on a new construct for portfolio management.  Whereas the traditional asset management model called for portfolio construction based on asset classes, the new paradigm focuses on sources of return, specifically market-related (beta) and skill-related (alpha).  The components of each are identified, and the various investment opportunities are categorized by the attributes and the attribution of their returns.  A portfolio can then be constructed based on a more intuitive risk measure. (The article mentions Maximum Drawdown, but I can see Value at Risk taken into consideration.)

Institutions are adopting this new model, or at least its language.  Allocations to alternatives are increasing, and are becoming more mainstream.  On the other hand, beta exposure is being seen as a commodity, and a greater portion of the institutional portfolio is being indexed.

As the author indicates, the new model is complex; this is a bare summary of the elementary tenets.  A more thorough discussion can likely be found in some of the CAIA curriculum.  There are also alternative investment seminars being given all the time at various locations across the country.

This Is The Reason For The SEC Proposal

Financial Planning is reporting that management companies obtained permission from the SEC to provide support to161 money market funds during the credit crisis/financial market seizure of 2008.  The list of funds and their sponsors was provided to Congress as a follow up to testimony the Mary Shapiro gave to the Senate Banking Committee in June.  Five of the top 10 money fund managers were included on the list.  In all of these cases, the management firms were willing to put up their own capital to allow the money funds to weather the storm.

Of course, the management firms are howling.  Brian Reid, chief economist at the Investment Company Institute responded, "What's troubling about this list is that the reason for the support is completely obscured, and so it gives a false and misleading impression...Now they are trying to use sponsor support as some sort of inference that there's a problem."

Actually, it appears that the SEC is not suggesting that there is always a problem, just there are times when problems occur.  What the proposal does is codify the for all money funds the steps that were taken to allow the 161 funds cited to survive the crisis.  The proposal call for management companies to maintain a capital cushion for their money funds at all times, not just in crisis.  Alternatively, they can allow the funds' NAVs to float on a daily basis.

The article does not say how much capital was committed to saving the money finds, nor the cumulative assets of the funds.  this would give an indication of the reasonableness of the magnitude of the capital requirement.  Otherwise, the number of funds affected four years ago seems to justify the new regulation.

An ETF Shakeout

So it's a shakeout of two minor players.  Investment News has the story that Scottrade and Russell will be exiting the exchange traded fund business. 

Scottrade's exit comes with a change in management.  Its $100 million in FocusShares will cease trading on August 17 and liquidate.  The funds had been introduced as a low cost provider, with expense ratios 1-2 basis points lower than Vanguard.  However, the funds never gained enough investor interest to create critical mass and justify their existence, either as a loss leader or asset management product.

The Russell funds were designed to replicate active strategies through passive replication.  The lineup included 26 funds which seemed to represent legitimate investment strategies.  Only one of the funds is m ore than 15 months old, so it is difficult to tell how well the funds have been representing their strategies.  Technically, Russell is conducting a strategic review, but IN is reporting that 30 related jobs have been cut.  Perhaps another fund family will pick up the funds, one that already licenses Russell indexes, such as iShares or ProShares.

The Money Market Vote is August 29

Two articles in Investment News (here and here) note that the SEC appears to be moving forward on its money market fund proposal, scheduling a commission vote on August 29.  If passed, the proposal will go into a public comment period which will bring heavy lobbying by the investment industry.  The Chair of the Commission, Mary Shapiro, has made it very clear in recent months that the regulatory community is plumping for measures to reduce the likelihood of another fund breaking the buck.

The articles maintain that the outcome of the vote is in question.  I would very surprised if the vote is held and the proposal does not pass.  This has been discussed to death already.  Everyone is clear on the issues.  That the new Financial Oversight Board and the Federal Reserve have publicly declared their support, and outlined regulatory steps to enforce it, suggest the proposal is all but guaranteed passage.

New Real Estate Product

Private Wealth has an article announcing a private label real estate fund designed for high net worth individuals.  Regis Metro Associates is offering to create customized portfolios of real estate on behalf of clients through its joint venture partners.  The private label funds are being offered through wealth advisors, RIAs and multifmaily offices.

A Chilling Prospect

Investment News has a story about a Department of Labor investigation into a JP Morgan Chase (JPMC) stable value product that was included as an investment option in several 401(k) plans.  The DOL is working to determine whether JPMC breached its fiduciary duties under ERISA by investing as much as 13% of the fund's assets in private-mortgage debt that was underwritten and rated by JPMC.  According to the story, "[t]he Labor Department could be examining whether the fund holds investments that are inappropriate and whether such risks were disclosed...."  What seems most obvious is that JPMC is at risk of being found having engaged in self-dealing in violation of its fiduciary duty to act in the sole interest of plan beneficiaries.

The most chnilling aspect of the story is that "[i]f the DOL finds that the firm violated ERISA with respect to the investments within the fund, plan sponsors and advisers who recommended it to 401(k) plans could be on the hook for failure to perform the proper due diligence."  That is, since JPMC violated ERISA in managing the fund, employers and advisors may have violated ERISA for failing to uncover JPMC's activity.  A successful due diligence defense will hinge on the nature and availability of the disclosure, the discovery by plan fiduciaries, and the actions taken upon discovery of the activity.  Other factors that may affect the determination: the relationship between the advisor and JPMC, the relationship between the advisor and the administrator, the relationship between the administrator and JPMC, and the compensation mechanism of each of the service providers.

There was a time when an advisor could rely on the information routinely provided by service provider and money managers to satisfy their due diligence responsibilities.  As advisors have gotten closer to employers and their retirement plans and accepted fiduciary status, whether they knew it or not.  As this story indicates, a fiduciary, the advisor assumes responsibilities requiring investigation far beyond the standard management interviews and review of SEC filings.

The aspect of this story that is truly chilling is that there are forces at work to impose a fiduciary duty on advisors covering all of their client relationships.  There are advisors that embrace the opportunity to work this closely with clients and have structured their practices accordingly.  However, not all clients need or are willing to pay for such a high level of service.  Nor are all advisors prepared to conduct business in such a manner.

Desperate Measures For Desperate Times

The low interest rate environment is leading investors -- and their advisors -- to desperate measures in an attempt to meet retirement income objectives.  An article in Investment News addresses the dilemma faced by retirees and their advisors whose plans are being foiled by flat equity markets and plummeting interest rates.  Three solutions explored are immediate annuities, high yield bonds, and preferred stocks.

An immediate annuity can be a valuable tool to allow a client to meet objections in the short term while allowing capital markets to do their job and provide a reasonable rate of return for risky assets.  Of  course, an investor will forgo the opportunity for increasing income from the capital devoted to the annuity.  However, this assurance of lifetime income frees the remainder of the portfolio to address the risk of inflation.  Absent the annuity, the portfolio runs a real risk of failing to last the lifetime of the retiree.

The article acknowledges the incremental risks of high yield bonds and preferred stock.  Here is how one advisor addresses the risk:

“We invest in a high-yield ETF with 10 or 20 bond positions that have low management fees, which eliminates the need for us to investigate the company,” said (the advisor).
 
“We’ve been in junk bonds since 2009 and they’re great performers. Unless the entire economy implodes, I think they are a fairly good buy,” (the advisor) said. “The risk is that the issuer can default, which we assess beforehand.”

Very scary stuff.  While an ETF provides liquidity for the junk bond position, its pricing will reflect the marketability of the underlying bonds, and if one of the holdings (about 5% if there are twenty holdings) defaults, that pricing will wilt.  The period since 2009 has seen very positive results for high yield bonds, it has been an unusual period.  The assumption that an economic meltdown would be necessary to have a negative effect on high yield bond returns is unduly optimistic, especially in such a concentrated portfolio.

Of course, the two holdings can work very well together.  The inflation protection of the increased coupon of the high yield bonds offsets at least a portion of the cost of living risk of the annuity, and vice versa.  Which is the whole idea of diversification.

Cap Rates Lower Than Advertised

REIT.com interviewed Paul Curbo, portfolio manger for INVESCO, about market conditions for commercial real estate.  The article (and video) include a number of insights into the various sectors of investment real estate.  What caught my eye was the discussion of cap rates and the examples he cited:  apartments changing hands at 5% cap rates, and 4% in California.  While the fundamentals are entirely different today than they were then, this pricing is reminiscent of  the frothy markets 2006 and 2007.  Curbo's observation that a development pipeline will provide immediate value add is true as long as pent up demand for units continues.  At the rate that units are being built and mothballed construction is being restarted, that backlog will not exist for long.

Another Note Program Halts Interest Payments

Investment News has a story about Thompson National Properties (TNP) suspending payment of interest on a program that raised capital in 2008 and 2009, just as TNP was getting started.  The program, TNP 12 Percent Notes Program LLC, was intended to provide working capital for TNP.  The only assets of the program were loans to TNP and affiliates.  TNP provided no credit enhancements or guarantees.  If I remember correctly,  investors are members of the LLC, and the LLC made the loans.  Of course, an affiliate of TNP is the Managing Member of the LLC.

I don;t believe that investors have any immediate recourse, other than to remove the Managing Member, and install one that will act in their interests.  That would take a lot of time and money, and if TNP's forecasts are accurate, interest payments would be flowing again.

On the other hand, Tony Thompson has faced a lot of adverse conditions, has worked hard to resolve them for the benefit of investors, and has made a lot of money for investors and himself along the way.

The comments on the article are very interesting.  They reflect just how polarizing an figure Tony Thompson is.  Tony has just as many fans as he does detractors.

Now The Fed Is Getting In On The Action

I have mentioned before about the proposal to insulate money market funds from runs that would have an adverse impact on markets.  The proposal would have money market funds either 1) have a cushion provided by the management firm, or 2) allow the NAV to float.  Next, the Financial Stability Oversight Board stepped in to say that is the SEC didn't adopt the proposal, it would require the commission to enforce it..

Now, the Federal Reserve has stated its intention of using its bank regulatory powers to accomplish the same objective.  According to Investment News, the Fed is considering reclassifying the funds provided by money market funds to a riskier category.  this would make money funds a less attractive option for funding, possibly limiting the investment available to the money market funds.  Of course, all would be well if the money funds would drop their opposition to the SEC proposals.  Wink,wink, nudge, nudge, knowwhatImean?

Last time I said it's going to happen.  Now it's time for money fund companies to figure out how they will comply.  As a money fund with a floating NAV is not much of a money fund, I expect more than a few funds to announce that they will have the 3% (or so) equity buffer.  Expect any fee waivers that these funds enjoyed to be dropped, and fees to increase once interest rates increase sufficiently to cover them.

Wells Foregoes Fee on REIT II

On June 29, The Rational Realist reported that Wells REIT II had announced that it will not pay to internalize its advisor.  This is a big deal, as the internalization fee was the big payday for a syndicator, and it wasn't subject to such uncontrollable factors as performance.  Wells Real Estate Funds is forgoing probably between $150 and $200 million.

This is not an altruistic move.  Leo Wells is a very charitable man.  However, he is very quick to tell you that Wells Real Estate is not a non-profit organization. 

Nor is this an indication of some newfound backbone by the Board of Wells REIT II.  REIT boards are filled from a good ole boy network, and Leo Wells is the definition of a good ole boy.

Forgoing the internalization fee is the second move that the wells organization is taking to address an issue tat is much bigger to Leo Wells: slumping sales.  at its core, Wells Real Estate Funds is a sales organization, not an investment organization, not a real estate organization.  Every decision is made through a lens pointed at sales trends.  Wells Timberland's capital raise was an enormous disappointment.  The raise for its Mid-Horizon Value-Added fund has been lackluster.  Core Office REIT was on a run rate of about $1 million per day raising just $225 million through December 31, 2011 and $282 million through March 31, 2012.  In May, Wells made wholesale changes in its senior sales personnel.  Now, Wells II has reduced its fees.

What has not happened is the renunciation of internalization fees for the Core Office REIT.  I guess Wells is hoping that the market will pick up the implication that no more internalization fees will be charged.  Their market prospects would improve much more significantly if the Core Office REIT would just adopt that position.

Some Whispers To Improve The Optics

Forbes has a list of 89 business cliches.  Just what we need: all of them gathered together in one place where they can multiply.

Exchange Traded Product Ripe For a Premium?

JPMorgan's Alerian MLP Index ETN (AMJ) has issued its maximum shares, according to a story in Investment News.  As noted in the story, this turns the notes into a closed-end fund.  Now, advisors can expect the note to trade at a premium to NAV, reflecting a very generous yield.  However, that premium could just as easily and quickly disappear when oil and gas related properties fall out of favor.  Or, JPMorgan could just register additional units which would eliminate the premium in one fell swoop, as happened with Credit Suisse VelocityShares Daily 2X VIX Short-Term ETN (TVIX).  An opportunistic advisor would be looking for an alternative to AMJ and establishing a reasonable premium for exit.

Absolute Return, Alpha or Something Else?

The Quest For Absolute Returns: Winning The Loser's Game, from the June 2012 edition of the Hedge Fund Journal (requires registration for a trial subscription), is the latest attempt to differentiate between Absolute Return and Alpha and how each is generated.  He recounts the Charles Ellis' reference to tennis matches in describing the differences.  Just as the highest levels of tennis is a Winner's Game (i.e. the winner being determined by the player who wins the most points), Alpha is generated by the managers who establish the most winning positions.  In contrast, Absolute Return is a Loser's Game, determined by the player making the fewest errors (losing positions).  The author describes the Absolute Return Manager as one who avoids cognitive errors and minimizes behavioral biases in his trading.

There are a lot of funds intending to generate Alpha calling themselves Absolute Return funds.  As this article notes, one very good way to distinguish them is to determine whether they make money by identifying winning trades, or avoiding losing trades.  Absolute Return funds put themselves in a position to avoid losing trades.

I have long maintained that Absolute Return strategies are not investment strategies in the traditional sense.  Absolute Return strategies are not compensated for exposures to risk factors that we normally associate with investment performance: inflation, credit, equity, economic growth, interest rates. m Indeed much of the trading that these funds do is designed specifically avoid these market related risks.  Instead, Absolute Return funds get compensated for performing a service for the market.  Some, such as the arbitrage strategies, provide liquidity to the market, driving price discovery between and across markets.  This is a dealer function, similar to the dealer described in the article.  The goal of these strategies is to be (nearly) net neutral to market forces, while awaiting the markets to reprice the positions to equilibrium.

The other group of strategies provides insurance to the markets.  The carry trade (borrowing short to lend long) is an example.  Others include the Macro strategies, the commodities funds, the short sellers, and the options traders.  They put on trades, often highly complex, to isolate a single element of risk for which they believe that they are compensated very handsomely.

Most of the strategies that I consider Absolute Return can not be executed in a mutual fund format, due to restrictions on concentration, short-selling, turnover, and a host of other techniques and vehicles.  The funds out there claiming the distinction are alpha generators.  They may be good at it, but calling a tail a leg does not make it one.

An Unconstrained, Multi-Strategy, Smart Beta Approach To Ensuring The Realization Of 2 And 20

I found this in the February 18 issue of The Economist.  It is a most amazing and amusing satire of the euphemism and creative wordsmithing I see so often used to obscure the message to be delivered.  Resisting the urge to copy the entire column, I offer this excerpt:

Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.

I encourage my readers to enjoy the whole thing.  You won't regret it.

ETF Trading 301

Financial Advisor magazine, via fa-mag.com, published a column by Stoyan Bojinov, a contributor to ETF database and etfdb.com.  In it he details three trading tips that ought to allow any advisor (or investor, for that matter) to improve trading results and lower trading costs.

1. When trading international funds, trade when the market for the underlying assets is open.  This increases the accuracy of the NAV quote, and improves the quality of the ETF quote in relation to the NAV.
2. Use limit orders to trade inside the spread.  the advice on ETFs has long been to trade only with limit orders.  This is suggested to avoid suffering severe haircuts that occur when electronic order systems encounter those moments when market makers are absent. Well, exchange traded funds also tend to have wider spreads than other securities with similar volume.  Placing a limit order inside the spread may entice a market maker to fill your order, and the with the cost being the potential for a few minutes delay and a few cents adverse movement in the price.
3. Inquire into upcoming distributions.  As Mr. Bokinov notes., ETFs are by their nature tax efficient.  However, some funds, notably leveraged and inverse ETFs, conduct a lot of trading in order to maintain the expected exposures.  This trading can lead to significant distributions.  As with traditional open-ended funds, it may make sense to defer a purchase or accelerate a sale in the face of an imminent dividend.

These tips are valuable reminders that a little bit of planning can create value for a client in even the most mundane task in the investment process.

The SEC Will Be Checking Your Due Diligence Homework

Last year, I noted an article about the Chairman of FINRA voicing the SRO's focus on ensuring that broker/dealers conducted adequate due diligence on investment products sod by their registered reps.  Now, Investment News is reporting on a talk by an SEC official whose job is broker/dealer examination.  His message: "We're looking at due diligence."

The due diligence obligation has many facets.  A broker/dealer must make an inquiry into the material aspects of an investment in order to satisfy itself of the reasonableness of profitability.  The inquiry must include validation of the significant information disclosed in offering and collateral documentation.  The inquiry must be sufficiently detailed as to reasonably uncover any undisclosed facts that a reasonable investor would consider material.  The broker/dealer must be able to demonstrated that the person who conducted the investigation on its behalf has the education and experience to perform the analysis in a way that is likely to achieve these goals.  Finally, the broker/dealer has to be able to communicate the findings to its registered reps in such a way that the rep is knowledgeable about the product, but is also communicating only the approved information to a prospective investor.

A broker/dealer can outsource a lot of the work involved.  However, it remains responsible for ensuring the thoroughness of the inquiry, understanding of the product by management, and proper sales practices by the field force.  As FINRA has said repeatedly over the past few years, the B/D can not outsource its responsibilities.

(Disclosure: Clarity Finance, the sponsor of this blog, provides due diligence services on a consulting basis to broker-dealers and financial advisors)

Guaranteed Retirement Income Without The Variable Annuity

Recently, fa-mag.com published a story about a new product which is an alternative to annuities for guaranteed income.  Named RetireOne, it is from Aria Retirement Solutions (ARS), and it uses insurance contracts to provide a guaranteed income wrapper around a client's investment portfolio.  It will cost between 100 and 175 basis points, and provide an income of 4% to 8% of the capital wrapped by the contracts.  There are some limitations on the composition of the portfolio, but beyond that, the portfolio remains under the control of the RIA and his client.  Aegon is currently the only insurance company involved, but ARS is recruiting others.

This is potentially the biggest development in the retirement income area over the past 25 years.  Given the exit of some of the bigger players in the VA business, this can't come at a better time.  I am anxious to see more.

Longevity Annuities In An IRA?

Financial Planning magazine has an article on the recent decision to provide guidance for IRA holders to use IRA assets to purchase longevity annuities.  While the guidelines have not been written, the decision is important, because it signals that the IRS will allow these annuities to be excluded from the asset base from which minimum distributions must be made, as long as the annuity meets the guidelines.  The two limitations mentioned in the article are that the annuity payments must start by the first day of the month following the IRA owners' 85th birthday, and the total purchase price of all longevity annuities can not exceed the lesser of $100,000 an 25% of the total assets in all IRAs (except Roth IRAs).

The IRA market is an excellent market for longevity annuities.  Expect several of the premier fixed annuity forms to market IRS compliant annuities shortly after the guidelines become finalized.  Then, about three weeks after that, you can expect to see articles by practitioners, exploring creative means to maximize the tax efficiency of these transactions.

Longevity annuities address the biggest uncertainty in the retirement planning process: the planning horizon.  Allowing a retiree to use what is often his largest pool of capital to employ this tool will be a huge benefit for investors.

The Implications Of A Fiduciary Rule

Law firm Davis & Harman conducted a study on the effect of a strict fiduciary standard applied to those who advise IRAs.  Investment News reports that the requirement will have a major negative impact on the holders of small accounts.  The firm found that almost half of the 22 million brokerage IRAs would have insufficient assets to justify migrating to a fee-based platform.  All accounts would face a steep increase in the account fees charged.  What is not clear is how much savings an investor would realize in the elimination of commissions, marketing and shareholder servicing costs.

The notion that an additional liability can be imposed on an industry without increasing the costs to the consumer is spurious.  By and large, investors are able to determine for themselves the appropriate cost effective means for accessing advice.  Mandating a fiduciary responsibility is imposing an unnecessary cost.

Do Not Pass Go, Do Not Collect $200

Investment News is reporting that Joseph J. Lampariello has plead guilty to one count of wire fraud and one count of failure to file a tax return.  Lampariello was sentenced to up to 21 years in prison and ordered to repay $49 million.

Lampariello was the president of Medical Capital, and headed what a court appointed receiver called a "Ponzi-like scheme" which resulted in investors losing $1 billion.  Several broker-dealers shut down as a result of arbitration awards related to the Medical Capital and other private placement scandals.

By no means will this restore the savings of duped investors, nor will it restore the reputations of victimized advisors and broker-dealers.  But sometimes, it is nice to know that the bad guys do get their comeuppance.

Another Nail In The Coffin

FINRA posted a loss for 2011.  So what's its response?  Fee increases, pretty much across the board.  At least that is what seems to be the answer according to a story in Investment News.  The plan:

For this year, Finra will be proposing a hike fees for advertising reviews, corporate financing and new-member applications, Mr. Ketchum told members

In addition, a 25% increase in the trading activity fee will be proposed. For next year, Finra will propose an unspecified "regressive tiered rate" for branch office assessments, and hikes in various registration and disclosure fees.

Overall, the proposed hikes range from around 5% to 50%.

This on top of a $36 million budget cut for 2012.  I suspect that its actually a reduction in the budget growth.

These increased costs are being imposed on broker-dealers, who can ill afford to absorb them.  However, if the B/Ds try to pass them on to advisors, another wave will exit the B/d channel and become independent RIAs.  And the downward spiral continues.

Right now, all of the environmental factors favor advisors becoming independent.  What will it take to reverse the trend?

REITs in Target-Date Portfolios

NAREIT has been promoting a study from Wilshire Associates touting the benefits of including REITs as a specific allocation in target-date funds.  I read about it in a story from Pensions & Investments website, pionline.com.  The white paper is available on reit.com, the NAREIT website.

The conclusion that a portfolio with a REIT component will be more efficient (higher return with the same volatility, or lower volatility in delivering the same return) is intuitive: The introduction of a distinct investment opportunity set with its own risk and return characteristics should add value on a portfolio level.  Thus, Wilshire was able to find that the addition of global REITs could add about 30 basis point of return to a portfolio with a given expected risk, and that domestic REITs could add up to 60 basis points of return.

The study stands only as a suggestion of efficacy though. The statistical analysis is thorough, but neglects to account for the changes in the structure and operation of the capital markets over the past 35 years.  For example, the correlation of REITs to the domestic stock market was relatively low during the 70s and 80s, approximately 0.35 to 0.40.  By the mid 90s, that correlation had risen to about 0.60.  And while I have not seen any statistics on recent performance, I would expect that the correlations have become stronger, given the general convergence of the equity markets.

Another point to recognize is that REITs are added to portfolios at the expense of high yield and non-US bonds and TIPS.  Recognizing that much of a REIT's return comes from dividends, REITs are still equities, often carrying significant leverage.  The mean-variance analysis does not necessarily pick up the equity risks of investing in REITs that are not expressly demonstrated in its volatility of returns.

The last item of note is that by adding a distinct REIT allocation, an overweight to REITs is being deliberately adopted, if not explicitly.  REITs are a part of the equity market, whether domestic or global.  They typically are included in the small-cap sector, where they might represent 10% of capitalization.  Thus, any REIT allocation will duplicate or amplify the market allocation, if no adjustment to the equity allocation is made.  Even if the equity allocation is adjusted, any allocation in excess of 2% or so is an overweight relative to the global capital market.

The paper cites a number of asset managers and retirement plan sponsors that have indicated that the inclusion of REITs in these target-date portfolios.  These changes may make the portfolios more diversified, but investors may not experience additional efficiency.

I recently ran across this blog post by Jason Zweig on WSJ.com.  His premise is that claims of investing in inefficient markets as a course to superior performance are not justified.  As he points out, Standard & Poor's research indicates that fund managers are no more successful in outperforming an appropriate benchmark in inefficient markets than are those in efficient markets.

While it may seem that inefficient markets should offer more and greater opportunities for excess return, those same factors creating the inefficiencies will militate against consistent outperformance.  Fewer and less sophisticated market participants will reduce the probability that a mispriced asset recognize its true value within a time frame that justifies its purchase.  Ultimately, any perceived excess return is most likely the result of an unrecognized risk factor, such as illiquidity.

Recognize that this a critique of the assumption that an inefficient market will benefit an active manager.  Many of these markets add value to the portfolio just through exposure, either through return enhancement or risk reduction.  To add value through active management in these capital market sectors, a manager must exhibit the ability to recognize many opportunities and to convert a high percentage of them into profitable transactions.

If It Walks Like A Duck And Quacks Like A Duck...

Commodity related mutual funds (including exchange-traded funds) have become very popular.  These funds provide a easy way to gain exposure to specific commodities (e.g. gold) or broad baskets (e.g. the energy complex) with a small capital commitment, liquidity, and professional administration and management.  The funds are touted as priding diversification through non-correlated performance and/or inflation protection.

Many of these fund gain exposure to the commodities through futures contracts.  The market is active and deep, providing an efficient means to participate in the price movement of the selected commodity.

Now the Commodities Futures Exchange Commission (CFTC) is asserting its regulatory authority over these funds, according to a story in Investment News.  The funds have relied on a rule exclusion that had allowed the funds to avoid registering with the CFTC. Effective January 1, those funds that invest primarily through the futures markets will be required to register as commodities pools and the fund managers to register as commodities pool operators.

Naturally, the funds are opposed, citing the regulatory oversight by the Securities and Exchange Commission (SEC).  Other negative affects of the move by the CFTC would be the potential application of conflicting regulations, and increased costs.  All of these costs would be to the ultimate detriment of the investor.

Nevertheless, the move is appropriate.  Futures contracts and the exchanges on which they are traded are fundamentally different from stocks and bonds and their respective markets.  In their composition and operation, these funds are clearly more like commodity pools than your typical mutual fund.  So, the additional regulation is relevant, along with SEC oversight of the mutual fund vehicle.

Of course, this will bring up another regulatory question: Who is qualified to recommend the purchase of one of these funds?  Will broker/dealers require advisors to acquire a FINRA Series 3 or 31 registration?  If the B/D is going to be held responsible for CFTC compliance with regard to these products, I would expect it to adopt the requirement.  Of course, since there is no such requirement for an unaffiliated Registered Investment Advisor, it would another nudge down the path of diminishing independent B/D competitiveness.

Into Each Life A Little Levity Must Fall

I know it's a little late, but this Wall Street Journal blog has some very clever April Fool's Day pranks.  A little distraction on Tax Day.  My favorite?  WestJet KargoKids.  Enjoy

Accurate ...But Wrong

Investment News carried a story about the state of municipal finance.  the premise of the article is that Meredith Whitney's analysis of state and local creditworthiness was correct, just her prediction of mass defaults was off a bit.  The story goes on to examine the status of three municipal bankruptcies -- Jefferson County, AL; Harrisburg, PA; and Stockton CA -- and come to the conclusion that bondholders are going to come out all right.Yes, revenue streams for local governments have been negatively affected, and yes all of the easy budget catting has been done.  Of course, there are municipal projects that are struggling to meet debt service.  Still, generally speaking, bondholders appear to in good shape in terms of issuers' willingness and ability to meet their bond requirements.  So, Meredith Whitney got everything right,except the part about the actual investment advice.

In the meantime, Bloomberg's yield tables indicate that AAA rated tax exempts continue to trade at higher yields than Treasuries.  Enjoy them while you can.

In Defense Of Gold

David Merkel writes in Seeking Alpha:

Gold does nothing, and that's good. We need some things in this hectic world that do nothing. What is the value of doing nothing?

Quietness. Pause. Repose. Reflection. Measurement Standard.

As he points out in the article, Merkel is no gold bug.  He doesn't even own any, other than a bit of jewelry.  He defends it against Warren Buffet's straw man of 400 million acres of farmland and 16 ExxonMobils (plus $1 trillion).  Merkel points out that the 68 feet cubed of gold in existence today will still be 68 feet cubed of gold tomorrow, next week, 100 years.  The value of gold is in its constancy.

But constancy does not create a store of value.  In a market economy, value is a relative concept. And value will change over time reflecting changing demand preferences, depletion of scarce resources, introduction of new technologies, and shifting demographics.

This does not mean that gold has no value in our economy.  As commenter notes, gold is a hedge against bad economic policies.  In economic terms, bad policies debase the currency, which is reflected in increased prices for unchanging commodities, such as gold.

However, gold is not an investment in the same sense that a holding of a diversified basket of stocks and interests in income producing real estate is.  This second portfolio is exposed to, and thus respondent to, the changing preferences, resources, technologies, and demographics that affect our economy on a daily basis.

It's Going To Happen

Mary Shapiro, Chair of the SEC, finds herself in an awkward position. As Investment News reports, she is trying to pass regulation that has the potential to keep money market funds from attracting the "systematically significant" label from the Financial Stability Oversight Board.  But she has run into opposition from both the industry and some of her fellow commissioners for proposing a regulatory burden: either provide capital subordinate to the stable NAV shares to absorb fluctuations in asset values, or let the NAV float.  The funny thing is that if the SEC fails in its regulatory efforts, the "systematically significant" designation will carry a consequence at least as burdensome.

I understand the marketing appeal of the stable NAV for a money market fund.  However, I have to wonder about the judiciousness of an investment proposition that relies on an arcane accounting trick to fulfill its objectives.  There are alternatives that have comparable yields, such as bank money market accounts.  It seems that the hadnwriting is on the wall for money market funds.

Right On Cue

As if responding to the protests against speculators (see Tuesday's post), the International Energy Agency has announced that "Oil markets are better supplied for the first time since 2009," according to a Bloomberg article.  OPEC is also signaling that supply is meeting user demand.  Both organizations blame the 12% increase in the price of crude oil on speculation related to geopolitical unrest and the related Iranian embargo.  Supplies are increasing slightly faster than demand, resulting in a decrease in the number of days of demand in inventory to 59.6.

So, even though production has not caught up to demand, that gap is narrowing,  largely due to weakening demand factors.  However, the market is subject to additional risk, partly identified with one participant and partly more amorphous.  This risk is not well defined right now, so speculators have stepped in to help the market find its price.

Note that the speculators are responding to market conditions, not to the availability of an investment vehicle.  Any speculator using ETFs today, would find another vehicle with which to take his positions if ETFs did not exist.  Banning ETFs would have little effect on the price of oil, or any other commodity.

Ready Fire Aim

An article in Financial Advisor magazine describes an attempt by consumer advocates and public interest groups to ban Exchange Traded Funds that invest in commodity related vehicles.  Their rationale is that the speculation represented by the ETFs is pushing the cost of these commodities up and thereby fueling inflation in food and, especially, energy costs.

The complaints are a lot of hot air.  If commodity prices were "too high" sellers, yes speculators, would be providing inventory until the price found its "correct" level.  Current commodity prices reflect supply and demand pressures on both the domestic and global markets, as well expectations for future market stocks based on economic, demographic, and policy trends.

Yes, demand for gasoline is rather inelastic, and $4 per gallon seems high.  But the culprit is not Exchange Traded Funds.  More responsible are the regulations that are mothballing oil refineries, and limiting the exploration for and production of oil within the U.S.

Illiquid Is Not Necessarily Non-Volatile

Investment News recently published a column in its "Other Voices" series attempting to address illiquidity as a characteristic of some alternative investments being marketed today, especially through the broker-dealer channel.  The main idea of the piece is that illiquidity is not necessarily bad; after all a byproduct of this illiquidity is a lack of volatility.

Balderdash.  Just because a n asset is illiquid does not mean that its value does not fluctuate between pricings.  A former boss used to say that if homeowners new how much the value of their homes fluctuated on a daily basis, they would never buy another home.  The value of any business fluctuates as a function of global,n ational, and local economic conditions and demographics, competitive position in the trading area, the presence of potential acquirers, and the cost of acquisition financing.  The extreme example is restricted stock of a publicly traded company, which is priced continuously during market hours (and sometimes during after market trading) but can not be sold until some contingencies are fulfilled.

Illiquidity is risk factor, not a product benefit.  All else being equal, illiquidity should be compensated with incremental return, an illiquidity risk premium.  Volatility is a measurement of sensitivity to risk risk factors.  So, an illiquid investment may actually have MORE volatility in its pricing: it has a greater sensitivity to the pricing of illiquidity risk, so will therefore exhibit MORE volatility than another asset with the same risk profile save for greater liquidity.

The piece is a great disappointment as I have known the author for a long time, and have tremendous respect for him and the organization that he represents.  I would expect both to better understand and communicate the nature of liquidity, volatility, risk and return than this column suggests.

Rob Arnott On Inflation

Investment News recently interviewed Rob Arnott and reported on his views of inflation potential.  Arnott sees inflation returning as soon as economic activity returns to a slow or moderate rate of growth.  He points out that monetary growth  associated with Quantitative Easing 1 and 2 has not been inflationary only because they (and the fiscal stimulus package passed in 2009) have been ineffective.  Specifically,

"Until the velocity of money accelerates, the vastly expanded money supply doesn't turn into inflation,” Mr. Arnott said. “So we've been protected by a sputtering economy. If the economy regains traction and we get slow to moderate growth, we'll see [higher] inflation sooner than we'd like, possibly later this year or into next year.”

 If inflation is too many dollars chasing too few goods, then the injection of liquidity into the economy is bound to be inflationary.  It will take a sustained, if modest, recovery to affect capacity sufficiently that output constraints would be felt.  This is how Arnott arrives at his inflation forecast.

The story reports that Arnott is relying on commodities and emerging market equities (which tend to be commodity related) to hedge inflation risk.  As TIPS yields are so low, this might be the best strategy for inflation protection.  Other options include REITs (look toward property types with short lease terms, like hotels and apartments) and variable rate debt (senior loans and adjustable rate mortgages).  Cash and very short-term bonds will also provide protection.

An Actual Impact Investing Product

Tom Kostigen writes about an investment product that offers an expected return of 4% to 5% (presumably annualized) over a 7 -10 year hold, and where "more than half the downside is covered."  It is an impact investment in the area of health care, which is quite hot right now.  Mr. Kostigen tells how a top financial advisor at a prestigious Wall Street firm is having trouble raising interest in the program among institutions whose mission is health care.  The author relates that the advisor is planning to change his sales pitch to likening the program to investing in the next Viagra.


The broad outline of the this product is some confirmation of my contentions about impact investing in general: capital can accomplish economic returns, non-economic value, or some combination.  To the extent that non-economic value is accomplished, the economic returns will be reduced.  Moreover, to the extent that the value created is non-economic, the risks to the capital increase.  Thus, this (long-term, illiquid, private equity) product provides for a return of at least half of the invested capital, and still provides a maximum expected return of only 5%.


If I were to guess, one big factor in the product's low acceptance is the fact that it sits between the investment and philanthropic goals of the organizations.  Simply put, the product does not qualify for satisfying a foundation's distribution requirements.  In the other hand, the 5% maximum expected return is just enough to cover the required distribution without invading the corpus.  Not to mention the paltry return relative to the risks taken.


This program is a glaring example of a product manufactured to appeal to a trendy notion rather than having economic fundamentals to offer to prospective investors.  I don't doubt that social entrepreneurs are being funded and providing an economic return.  I am not convinced that these investments are sufficiently numerous and scalable for distribution through the advisor channel.  Better to invest to meet the client's investment goals, including any charitable giving to achieve the client's social objectives.

The Retirement Conundrum

Mary Beth Franklin wrote a pretty good piece in Investment News recently.  In it she describes the quandary in which we find ourselves, with Social Security's financial solvency threatened, employer retirement plans all but disappearing, and the personal finances of many individuals ravaged by the recent market meltdown.

The strongest force driving the increasing stress on retirement resources is one of the greats benefits of having lived in the last century -- increased health and longevity.  In the 1930s, when Social Security was created, only a small percentage of workers lived to normal retirement age of 65, and it was rare that anyone would live to be 80.  Now, a planner would be remiss to project retirement income only to 80 years old; the standard is 85 and I usually see projections to 90.  What started as a five year commitment now can stretch for 25.

This enormous societal improvement has had the singular drawback of straining the economic resources devoted to providing an income to retirees.  Fortunately, the longevity has been accompanied by improved health and health care.  Therefore, today's 65-year-old is more productive than one from the Roosevelt era.  And therein lies a large piece of the puzzle to restoring sound retirement financing for our society.  Encouraging our seniors to delay retirement by adopting incentives and removing disincentives.  Every year of delayed retirement reduces the total retirement income required and provides an additional year of earnings on savings dedicated to retirement.  then the discussion can turn to the specific sources and funding mechanisms.

Money Market Funds Revisited

I wrote a post last May about SEC proposals to reform the money market fund industry.  At the time, it appeared that the SEC was considering rules that would either require money funds to maintain a loss reserve, or float the NAV.  My observation was that the proposals would doom money funds as we know them, essentially turning them into short-term bond funds.  Even, so the post listed options for investors that would address most needs.

Now, Investment News has is reporting that the Chair of the SEC notes the objections raised during the comment period for the reforms.  However, the all-knowing SEC has determined that "risk isn't priced into the product" and therefore must kill the product in order to save it.

Fortunately, the options remain.  Most brokerage (and clearing) firms continue to offer FDIC insured cash management accounts, what amounts to a checking account with almost all of the services associated with money market fund accounts.  Forward looking advisors will be preparing their clients to make the switch when  the SEC money market rules are adopted.

The Big MBS Settlement

The legal settlement among investment banks who sold mortgage-backed securities and state attorneys general is ambling toward a conclusion.  The negotiated fines are $25 billion, the largest civil settlement in U.S. history.  These include $20 billion for restructuring, refinancing and loan forgiveness for current homeowners, and $5 billion to states, apparently to compensate homeowners harmed by irregular foreclosure procedures.

The Bloomberg article does not make the source of the funds for the settlement clear, though it does quote a Association of Mortgage Investors statement that anticipates that holders of the securities backed b y the mortgages will bear much of the cost.  This has lead PIMCO to leave the American Securitization Forum in protest (as reported in Investment News).

Meanwhile, The Wall Street Journal reports that a civil trial between of Citigroup relating to a $1 billion mortgage backed bond is in limbo. An appeals court is considering overturning an earlier ruling order the trial, rather than accepting a settlement and fine.

What's interesting is that more attention and concern is being paid to irregular foreclosure procedures than inadequate disclosure accompanying the issuance of the mortgage backed securities.  I understand the populism involved in the state charges against the banks and servicers.  However, I have yet to hear of widespread foreclosures in which homeowners were actually current with all terms of the mortgage. Yes, there are cases of improper procedures, but the loan was in default and a foreclosure was inevitable.  Damages should be hundreds, not hundreds of thousands, of dollars.

On the other hand, the state and municipal retirement plans are big investors in the bonds, and sustained significant losses.  Taxpayers are on the hook for any pension shortfalls due to underestimation of the risks involved in the bonds.  Now these funds (along with other investors) are about to finance the the restructuring of loans for defaulting homeowners.  Talk about irony.

Man Bites Dog!

Investment News ran a story today about an investor ordered to pay the legal bills for a broker-dealer and its representative for bringing a frivolous arbitration claim.  the FINRA arbitration panel found that the investor was experienced and sophisticated and made investment decisions independently.  The investor was ordered to $75,000 of the firm's $110,000 legal costs, and $6,000 of the $7,200 hearing costs.

To say that this is an unusual outcome would be an understatement, especially since FINRA adopted a policy which allowed for all non-industry arbitrators hearing client disputes.  This is a welcome development, even if it is only one in a row.  Now, to set about collecting the award.

RIP Grubb & Ellis

Investment News reported that Grubb & Ellis had sold most of its operating assets and filed for bankruptcy protection.  Thus ends the the ill-timed and ill-fated story of the entry by one of the country's premier commercial real estate brokerage firms into the syndication business.  The beginning of the end began with the merger of Grubb & Ellis with Triple Net Properties just as investment real estate was starting its descent.  The exodus of senior management from the syndication operations, the the emancipation of Health Care Trust of America crippled the company.  The announcement that Grubb & Ellis Healthcare REIT II replaced Grubb & Ellis as advisor and underwriter signaled that the end was near.

Unconventional Advice For Education Funding

The December 5, 2011, edition of Forbes has its 2012 Investment Guide.  This annual special report is the most sound and sophisticated guide published in a general interest periodical.  It leans heavily on conventional wisdom, but always brings an analytical eye to the task, and often has challenging observations.  One suggestion in the section on Generation Xers, caused me to pause because, while it is diametrically opposed to the almost universal standard recommendation, the explanation is elegant and nearly unassailable.

Karen Hand, a financial planner from San Francisco, recommends allocating any funds that would go into an education account into the parent's retirement account.  The economics are such that no parent can reasonably expect to save enough to put multiple children through college on savings plans, and it is perfectly acceptable to expect the child to pay some portion of his educational expenses, either by working while at college or paying off student loans after finishing.  And now the kicker:

Current financial aid formulas don’t consider money in retirement accounts as available to pay the college tab. But when calculating how much parents can pay from their current income, these formulas don’t allow for any retirement savings while the kids are in college—even though parents are likely to be approaching retirement.

That makes it smart to stuff your retirement accounts while your kids are young and then reduce or stop annual contributions while they’re in college to free up cash for tuition payments, say college financial planning experts.

That is, under the financial aid formulas, a parent gets 100% benefit of the dollar he puts in his retirement account, but only a tax effect benefit from a dollar contributed to a 529 account.  The additional funds in the retirement account ill make up for the holiday during the kids' college years by being exposed to a longer compounding period.

And of course, the kids are on their own for any graduate degrees.

The Real Impact Investing Market

Tom Kostigen's latest blog entry on the Financial Advisor website references an article in the Stanford Social Innovation Review.  Kevin Starr of the Mulago Foundation sets down four factors that limit the profitability of investments in impact-focused organizations.  In summary, the costs structures of impact organizations required serving a very large number of "customers" with financial resources to pay for the product or service.  Adding a cost of capital on top of the cost structure aggravates the situation.  Driving the organization to meet the bottom line expectations will further drive the organization away from its intended target market to one that can better achieve the financial objective of the organization.

Kostigen also points to a posting on NextBillion.net.  It is is an account of an interview with Felix Oldenburg, a director with Ashoka, a social change organization.  Oldenburg describes the forces giving rise to the impact investing movement in market driven terms.  Social entrepreneurs search for the cheapest capital with which to fund their impact enterprises.  Philanthropic grants have become scarce, and business plans are cheap and easy to prepare.  Impact investing is a cutting edge social model.  But it does not necessarily deliver the results in the most effective manner.

Mr.Starr's foundation defines impact investing specifically with a less than  market rate of return.  As he puts it,
"Investments that provide a big return don’t count: the market will take care of those, and we don’t need conferences (or industry cheerleaders - C.F.) to get people to put money into them."  Mr Olenberg notes an estimate of $500 billion of capital available for impact investing over the next decade.  This despite low deal flow of enterprises meeting investing criteria.  So there is a gusher of capital chasing a trickle of deals in an arena in which profitability is acknowledged to be difficult and limited.

Kostigen, however, continues to insist that this capital can do double and triple duty, earning market returns and fulfilling social and political agendas.  He rejects the notion that an investment able to generate a market return be considered a mainstream investment, even if tat is where it is most likely to get funded.  Ironically, it is also the enterprise that is most likely to drive the positive social development for the affected constituency in the long run.

Longevity Insurance

Last year, I posted an item about the products that investment banks were developing to assist institutions in hedging their exposure to the longer lifespans of their beneficiaries.  Recently, Investment News had an article on the developing market for longevity insurance, and a column in support of its use in the retirement plans of individuals.

The development of the longevity insurance, actually a deferred fixed annuity, is an enormous benefit for individuals who are at risk of outliving their assets.  When properly coupled with Social Security benefits and immediate annuities, it can ensure that the income provided by an investment portfolio is replaced just as that assets are exhausted.  The biggest drawback has been that there is no recovery of principal on death, even if benefits have not begun.  In response to this objection, some of the products making it to market are including a death benefit or return of principal provision.  The Hartford, MetLife Inc., Symetra Life Insurance Co. and New York Life are mentioned as writing the contracts.

The contracts are apparently getting a boost from regulators.  Both pieces mention that the Labor Department is developing guidelines for offering the contracts in retirement plans.  This would promote the distribution of the contracts as it will make it easier to market the offerings to 401(k) and IRA accounts.  Wider distribution reduces the possibility of adverse selection and promotes more competitive pricing, improving the risk exposure of the companies writing the policies and the prospective income to the individual.

Fundamental Bond Indexing

The Journal of Indexes an article by Shane Shepard of Research Affiliates (RA), laying out the case for using a scheme other than capitalization-weighting for bond indexing.  For those familiar with RA's fundamental indexing for equities, it will sound very familiar.  The premise is that in any market, securities will become subject to pricing errors.  Without conducting continuous valuation analysis on each security in the market, one cannot know which securities are priced incorrectly, nor in which direction n the error is occurring.  RA has addressed the issue by removing the security's price from the weighting mechanism.  In their equity portfolios, securities are weighted by financial statement factors.  Now, in bond portfolios, the securities are weighted by factors that are presumed to reflect credit-worthiness.  Thus portfolios of sovereign debt is weighted on factors such as GDP, population, land area, and energy consumption.  Corporate debt is weighted by sales, cash flow, dividends, and book value of assets.

For the periods studied, the fundamentally weighted portfolios outperformed their cap-weighted counterparts significantly.  The developed country sovereigns notched an 80 basis point average annual advantage over the period January 1997 through June 2011.  The emerging market sovereigns chalked up a 130 basis point of outperformance.  Fundamentally weighted corporate bonds posted similar performance improvement over well-known indexes.

These backtest results do not necessarily mean that the fundamentally weighted bond portfolios are superior to cap weighted funds.  The portfolio weighting scheme was designed specifically to overweight credit quality and liquidity relative to cap weighted indexes.  This testing period is dominated by two rounds of financial stress in which credit quality and liquidity were particularly valuable. Expect RA to publish additional research testing its fundamentally weighted portfolios over other time periods.  pay particular attention to relative performance of, say, 1982-1986 and 1992-1997.

Brian Bollen is reporting that Citi and RA are going to launch a series of global sovereign bond indexes based on the RA methodology.  Look for open en mutual funds and ETFs to follow.

A Quick Primer on Leveraged ETFs

Seeking Alpha had a short article on the mathematics of leveraged ETFs.  It has a demonstration of the classic upside/downside dichotomy (i.e. it takes 100% gain to overcome a 50% decline).  It also mentions, without going into detail, the effect of constant rebalancing to maintain the advertised leverage position.

What is not is that these two mechanisms conspire to frustrate the use of leveraged ETFs as a long term position.  the daily re leveraging of the portfolio exacerbates the tyranny of the upside/downside dichotomy. 
The portfolio sheds leverage after a decline in order to maintain its ratio, just when that leverage would work in the investor's favor in any reversion to the mean.  On the other side, while the portfolio naturally de-levers on an upside move, daily rebalancing adds leverage, to the portfolio's detriment when the markets mean-revert.  Thus, the observation that over a long term holding period, a leveraged ETF will tend to underperform the the underlying asset simply multiplied.

Commodities Are Not For Diversification?

The Maverick Investors Rally Site has a post that refers to a paper by Charoula Daskalaki and George S. Skiadopoulos that investigates whether commodities add value to a portfolio of traditional investment assets.  The professors found that, while there are periods in which commodities holdings provide benefits to portfolios, these benefits are not persistent or predictable.

I have discussed this in an earlier post.  The Maverick Investors Rally put it better than I have: "there is no theoretical basis for commodities per se to provide any return, never mind 'enhance' a portfolio’s return."  Commodities are consumed in the economic process of creating value.  Any return on holding  commodities is the result of price speculation, not economic wealth creation.

Are commodities an asset class?  If defined by a distinct return pattern driven uniquely by economic factors, I would have to say yes.  But the results of the study suggest that it is not an asset class that is worthy of consideration as a permanent part of an investment portfolio.

The Daskalaki and Skiadopoulos paper is the latest to demonstrate that an allocation to commodities does not add value to an investment portfolio.  There  will be more research that will suggest that the conclusion is misplaced.  It will be beneficial to be skeptical.

Treasuries Beat Hedge Funds

Investment News ran this piece, summarizing a book by Simon Lack, a former hedge fund executive at J.P. Morgan.   Other publications ran similar articles, often with a more scandalized tone.

Mr. Lack's headline grabbing finding is that the capital that went into hedge funds would have reaped higher returns if had been invested in Treasury bonds.  He identifies the primary culprit as the "2 and 20" cost structure of the typical hedge fund, aided by difficult capital markets over the last ten years and a highly competitive environment.

I haven't read the book yet, but I would guess that another factor is the amount of dishonesty the industry attracted in the first decade of the 21st century.  Investors that had become accustomed to 20%+ returns of the 1990s realized that they really did not have a high tolerance for risk.  These investors came to believe that a lower risk portfolio should be able to return 12% annually, and a number of shady characters were willing to promise it to them.  100% loss of that capital would have a profound effect on the return on the total capital invested in hedge funds.

At the end of he day, a hedge fund is just an investment vehicle, and an expensive one at that.  Anyone investing in a hedge fund should expect such an high expense ratio be accompanied by a strategy that can not be duplicated in a lower cost form, such as a mutual fund , ETF, REIT, or Unit Investment Trust.  Sophistication could be indicated by high velocity trading, illiquid or privately negotiated investment or derivative contracts, or leverage.  What all of these strategies involve is additional risk.  Not necessarily the risk that we recognize and talk about every day, but incremental risk nonetheless.  And that should come as no surprise, since no investment provides a return unless the investor is willing to assume some level of risk.

Five Trends For Advisors

This article in Financial Advisor magazine does not contain anything new.  Rather, it collects ion one place a number of trends in the advisory community that have been tacking place and developing momentum over the past few years, and discusses them in one place.  That the business of advising is evolving is both obvious and good, and these rends are serving to improve the practice of advising individual investors.  The five trends:

• Fee compensation rather than commissions - This has been on its way for a long time, and the changeover may never be complete.  There are certain clients for whom a gee-based relationship is not the most beneficial.  However, for most clients, a fee-based model works better than one based on commission for so many reasons - alignment of interest, taxes, transparency - that it seems a natural way of doing business.
•  A fiduciary standard of care - Another trend that has been developing for a long time, but in a much more covert manner.  Nearly all of the pressures on practitioners, from regulatory to competitive, have been pointing the industry in this direction. The codes of conduct promulgated by the professional organizations all promote behavior worthy of a fiduciary, even of they do not name it.  Service providers, such as broker/dealers and custodians, are offering packages that address the demands of clients for assurances that their interests are primary.  Even the trend toward fee compensation supports such a rigorous standard.  The major factor delaying a full scale adoption is the lack of mechanisms for managing the tort risk of the heightened responsibility.
• Comprehensive financial planning - Providing comprehensive planning for clients is not so much a trend as it is the realization of a vision.  The leaders of the industry have always conducted their business in a way that promotes sound financial decisions across the entirety of a client's life, not just investments, insurance, or taxes.  Technology is allowing  practitioners to access specialized expertise  in a cost-effective manner to deliver advice that considers all facets of a client's financial life, both currently and in the future.  Clients and other professionals are more willing to form teams to help the client achieve his goals.
• Setting reasonable expectations - There was a time when advisors competed on performance - the highest yield product, the best performing mutual fund, the most recognizable research staff - and a good portion of the market was willing to follow the lead.  More recently, the marketing thrust has shifted, and managing expectations and keeping promises weighs much more heavily in the decision making process. 
• Outstanding service - Really, any advisory firm that is fulfilling the first four points can be described as providing outstanding service.  Setting achievable holistic goals, meeting them while putting the client's best interest first, and getting paid a reasonable and transparent fee reflecting the time, effort and expertise of the advisor is the very model of an effective relationship.

I can';t say that I agree that advisors must adapt their practices to these trends.  Carriage manufacturers and buggy whip makers are still in business and make some money.  But they are now specialty products made for a small market niche, rather than a mass market operation.  Likewise, there will likely be a market for commission based, product oriented advisors for a select group of individuals.  However, the larger market will be attracted to sophisticated professionals whose practices reflect the above characteristics.