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.
Tuesday, February 21, 2012
Monday, February 20, 2012
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.
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.
Sunday, February 12, 2012
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.
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.
Tuesday, January 24, 2012
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.
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.
Thursday, January 12, 2012
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.
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.
Tuesday, January 10, 2012
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.
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.
Monday, January 9, 2012
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.
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