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.
Saturday, March 24, 2012
Thursday, March 22, 2012
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,
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.
"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.
Wednesday, March 21, 2012
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 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.
Tuesday, March 20, 2012
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.
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.
Monday, March 19, 2012
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.
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.
Friday, March 16, 2012
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.
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.
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