Simple Portfolio Strategy from Forbes Magazine

William Baldwin provides a simple portfolio strategy in the January 17 issue of Forbes.  It is the prototypical long-term horizon recommendation that the asset allocation calculators all over the web give you.  What's different is that his rationale is simple.  Consider that equities are likely to earn 5% per year after inflation, bonds about 2%.  Put the bonds in a tax deferred account and carefully manage the realized gains in the taxable equity account, and you can avoid paying taxes currently.  A 50-50 portfolio will return 3.5% plus inflation over the long term.  If you invest when P/E ratios are high (> 20) , it will be a little bit less; when P/Es are low, a little bit more.  The S&P 500 is trading at a P/E of 16.3 based on 2010 earnings as of today's close.

Now, this is not a retiree's portfolio.  The markets is too volatile to confidently predict this kind of return over the next ten years.  And portfolio that is producing current income is so sensitive to market movements that one early year of underpeformance can cripple the income potential for the remainder of retirement.  But for people still in their accumulation years,  this can be a valuable framework for portfolio construction.

FINRA is Looking into Wells ... Again

On April 10, Investment News had a note that FINRA had made a preliminary decision to recommend disciplinary action against Wells Investment Securities.  The information was contained in a SEC filing by Wells Timberland REIT.  The REIT reported that:

On August 25, 2010, the Enforcement Department of the Financial Industry Regulatory Authority, Inc. (“FINRA”) notified Wells Investment Securities, Inc. (“WIS”), the dealer manager for the initial public offering of common stock of the Registrant and for the Registrant's current follow-on offering, that FINRA had made a preliminary determination that disciplinary action be brought against WIS for (1) using various sales materials related to the Registrant's public offerings that allegedly failed to comply with the content standards of FINRA's advertising rules, (2) allegedly failing to implement its supervisory system in an effective manner in order to achieve compliance with FINRA's advertising rules, and (3) allegedly failing to maintain written supervisory systems and procedures that were reasonably designed to safeguard customer information. FINRA stayed its August notification and requested additional information from WIS regarding its investigation. On March 1, 2011, the FINRA Enforcement Department notified WIS that FINRA had made a preliminary determination to recommend that disciplinary action be brought against WIS for allegedly failing to inform FINRA that the board of directors of the Registrant approved the deferral of the Registrant's election of REIT status, which was done in connection with its acquisition of the Mahrt Timberland in 2007. FINRA also proposed a censure of WIS and a fine. Before FINRA seeks authorization to issue a formal complaint, WIS has the opportunity to provide a statement to FINRA indicating why no disciplinary action should be brought. WIS intends to make such a submission responsive to the issues raised in both the August 2010 and March 2011 notifications on or before April 11, 2011. WIS intends to vigorously defend these charges.

Wells Core Office REIT made a similar filing.

This is the third time that Wells' sales practices have been questioned by FINRA.  In March 2001, Wells entered a written undertakings that it would not violate compensation regulations in conducting sales and due diligence conferences.  In August 2003, Wells consented to sanctions relating to the improper conduct of sales and due diligence conferences.

Wells is a very aggressive sales organization.  That aggressiveness has brought success in raising capital.  Unfortunately, the returns on that capital have been spotty, as a review of Wells' record in liquidated properties and full cycle programs would attest.

Meflation

I had saved this article from The Wall Street Journal last September, figuring that it would be a good launching point for a post.  Jason Zweig quotes Larry Swedroe, director of research at Buckingham Asset Management, with the central message of the piece: 

"What matters isn't whether somebody's forecast for inflation or deflation is more convincing to you.  Instead, what matters is which of these risks would be most damaging to you."

Zweig goes on to compare the extremes of two investors.  A young professional with a stock portfolio and  mortgaged home will do OK in an inflationary environment, but could be devastated in a deflationary one.  On the other hand, the retiree on a fixed income, a balanced portfolio and a home that has been paid off is at great risk that inflation will erode the purchasing power of his income and savings, but will welcome deflation.  How my standard of living will be affected by a scenario, the "Meflation," is more important than the precise measurement of the scenario.

This is not particular news to the professional advisor; it is likely intuitive.  My point in raising it again is to connect it to the Investment Policy lessons of Charles Ellis.  If the primary objective of the investment portfolio is to ensure sufficient income to maintain a living standard in retirement, positioning the portfolio to protect against the ravages of inflation is more important than outperforming the S&P 500 by 100 basis points.

Absolute Return Funds

Saw an article on  Bloomberg.com, about absolute return funds.  The premise of the story is that "Absolute Return"  does not describe a strategy so much as a desired outcome.  This makes comparing funds difficult.  What the heck, let's give it a go anyway.

First, a li8ttle ground work.  Absolute return strategies are common in the hedge fund arena, describing funds that attempt to provide a positive return each month.  Most of the strategies are either arbitrage or market neutral in their approach.  (There are some funds investing in illiquid assets calling themselves absolute return, but the illiquidity masks the volatility of the asset values.)  These strategies rely on techniques that greatly reduce the risks associated with specific market exposure.  Portfolios tend to have roughly equal long and short exposures.

I ran a screen on Morningstar's Principia product, seeking funds in the Morningstar categories "Market Neutral" and "Long-Short".  We searched for distinct portfolios only that had started operations before January 1, 2008, and had a= 3-year annualized return through March 31, 2011 greater than 0%.  The screen returned 24 funds.

Since we are looking for returns that are not correlated with any markets, I checked the Best Fit R-Squared and found five funds with a score below 30.  One was closed and one showed no assets (?).  One has very relatively volatile returns. The two remaining look interesting.

JP Morgan Research Market Neutral (JMNAX, Cl A) is managed by JP Morgan in a market- and sector- neutral strategy.  Through March 21, 2011, it has a 3-year annualized return of 2.20% including -1.06% in 2008.  Its best Fit R-Square is 8.  It has an expense ratio of 1.50% (capped until  2/29/2012).

Managers AMG FQ Global Alternatives (MGAAX, Cl A) is managed by First Quadrant L.P. in a quantitative strategy that seeks to remain neutral across markets, sectors, and currencies.  The fund returned 1.16% annualized for the 3 years ending March 31, 2011, including 4.84% in 2008.  It has a Bet Fit R-Squared of 22w and an expense ratio of  1.99% (capped until 3/31/2012).

These two funds are available in multiple shares classes, so an advisor should be able to find the fund that meets the all client goals.  Either fund should provide some dampening of capital volatility while producing a return well in excess of cash equivalents.

The End of QE2?

Investment News has a piece quoting Dave Paquet, president of MPI Investment Management Inc., about what he sees as the Fed starting to reverse its direction.  Pacquet notes a March 18 announcement of the sale of a $142 million portfolio of mortgage-backed securities.  He also points to a March 23 announcement of a "a new, 'gradually expanding' round of small reverse-repurchase transactions." This in advance of the June expiration of the second round of quantitative easing.  All of these events will have the effect of taking currency out of circulation, putting upward pressure on interest rates. Pay attention while Ben Barnanke addresses the press corps after the Fed policy meetings next week.  Get the Mortgage refi completed and hold off on any major bond allocations for about sixty days.

Pay For Success Bonds

President Barack Obama's proposed FY 2012 budget included a provision that provides for up to $100 million of Pay for Performance bonds, the US incarnation of Britain's Social Impact Bonds.  The bonds will be issued by local governments (or other entities) to fund programs designed to attack America's thornier social problems.  It allows for long term capital to be committed where  government resources can only be appropriated one year at a time.  The bonds are paid off under contract from the governmental entity based on the success of the program funded, yielding up to 13.5% if the UK model is followed.

Observations:

1. These bonds provide all of the funding for the enterprise.  Thus investors are assuming equity risk is the investment.
2. The tax provisions for these bonds are not addressed in any of the materials that I have read.  The tax treatment could have a huge impact on the pool of capital available for these instruments.
3. The bonds will be subject to appropriation risk in addition to enterprise risk.  Unless there is some escrow of funds, there can be no assurance that funds will be available to pay off the bonds regardless of the success of the project.
4. Bonds will be highly illiquid.
5. This "investment"  amounts to venture capital in the non-profit sector.  A typical venture capitalist would not consider a 13.5% cap on return as attractive.  Highly favorable tax treatment would be required to make the investment economically attractive.
6. On the other hand, favorable tax treatment is irrelevant to non-profits who would would be natural candidates for providing this kind of funding.  These institutions are already providing funding, through grants, to those programs deemed most likely to succeed.  Therefore, these bonds could have the perverse effect of funding marginal programs which are likely to have a low success rate.

It seems to me that the major benefit of this vehicle is to bridge the timing factor of government appropriations, and assist a program in raising capital to put into place infrastructure to deliver services to the community.  It occurs to me, though, that if the services are useful and truly valuable, creating a revenue stream should be rather straightforward, and capitalizing the revenue stream could be handled by the private markets.  As described, these bonds provide seed capital for start up businesses, with very low potential profits.  I see the potential market for these bonds as very small.

Inflation Revisited

I have written about investing in an inflationary environment before.  It seems that all markets have priced in a significant inflation expectation (see TIPS, gold).

Along comes an article on BusinessInsider.com that seems to start out making a case that expected inflation is not an issue that is dominating economic thinking.  The piece goes to reference a survey of institutional consultants which suggests that more inflation hedging is contemplated for 2011, and concludes that maybe there is something to this trend. 

So I took a look at some of the data.  The Bureau of Labor statistics released its CPI data earlier today.  The full index was up 0.5% month over month in march with a increase of 2.7% over the trailing twelve month period.  Core inflation, the full index less energy and food, was1.2% for the trailing twelve months, core prices increasing only 0.1% from the previous month.  So, inflation has been tame over the past year, and, at least for the past month, has not been particularly virulent.  This seems to validate the view of several Fed governors and Fed Chirman Barnanke that inflation is not the imminent threat.

What about the QE1 and QE2, the systematic pumping of liquidity into the economy?  We can see from Fed statistics that indeed, money has been injected with the force of a fire hose.  However, the money has not found its way into checking accounts and money market funds.  The  money multiplier has plummeted to less than 1!  All this indicates an enormous delevering of the economy: banks have taken free cash and bought treasury bills rather than lending to business; business is taking its profits and paying downs loans; lenders are building cash balances against an uncertain future.  Looking at the graph of monetary velocity, we can see that recent trrends are the opposite of what they were in the 70s and 80s, the last time the US experienced significant inflation:

Ben Bernanke has been telling anyone that will listen that the greater economic risk was deflation rather than inflation.  The monetary data seems to confirm this.  In fact, the inflationary impact of the quantitative easing may have been just enough to offset the deflationary forces unleashed in the recession.  That would suggest that no strenuous tightening will be necessary to avoid a bout of inflation when a full recovery commences.