Download June 13th 2008 - Neil H. Gendreau, CFP

06/13/2008
Re: Three Dimensional Investing
During the past several months, we have witnessed one of the most schizophrenic periods of market
behavior since the turn of the decade. While we have not experienced a spiraling decline like during ’00
– ‘03, the inconsistency we face today can be equally disconcerting, especially for those of you who are
approaching retirement or drawing against your portfolio without the dependency of positive returns.
You may similarly recall devaluation of the dollar and rapidly increasing energy and commodity prices
during the 1970s. But today, rather than tighten monetary policy through increased interest rates, the
Federal Reserve has overextended its credit worthiness by bailing out banks and brokerage firms with
freshly printed money, actions which only seem to accelerate the migration of investment dollars to
hard assets.
Meanwhile, we find ourselves in a global economy inflicted by the relocation of jobs and production
overseas with consequences that have become increasingly foreign to us, including a widening trade
deficit and declining dollar. As the third world expands its production capacity at the expense of ours,
greater demand for limited natural resources accentuate rising commodity prices with greater inflation.
And while shareholders errantly focus on quarterly earnings reports rather than long term shareholder
value, don’t expect these volatile trends to end anytime soon.
What impact will these trends have on your portfolio? How many years of flat or declining returns can
you afford while still achieving your objectives? Buying equities to beat inflation and bonds to generate
current income may not prove so reliable an approach as bond yields deteriorate while inflation erodes
buying power. Therefore, more sophisticated measures must be introduced to protect your wealth.
Volatility has two components – amplitude and direction. While a combination of domestic stocks and
bonds offers less volatility than stocks alone, both asset categories frequently perform in tandem, either
increasing or decreasing together. By introducing a third category such as commodities, a category that
performs better during periods of inflation, the volatility of the portfolio is reduced even more, because
although commodities are more volatile than stocks and bonds, commodities perform in opposition to
financial investments.
The behavior of an investment relative to another is known as correlation. If an investor desires a
portfolio with more consistent performance, then a combination of investments should be owned with
different correlations. That means a combination of both traditional and non-traditional investments.
And as with anything else in life, an investor’s success may be determined by his or her willingness to
accept constructive criticism, and change those habits which are no longer productive by means of the
economy. The paradox of conservatism is that it may no longer exist within the confines of traditional
thinking.
Attached you will find a list of all asset categories I have identified as potential components to a prudent
asset allocation strategy*, with both traditional and non-traditional investments. How many categories
do you have represented in your portfolio? How many are missing?
For those of you less familiar with non-traditional (alternative) investments, here is a brief description:
1. High Yield Bonds – otherwise known as junk bonds. As a consequence of recent devaluations,
the spread on junk bond yields over treasury yields have become quite enticing, especially as an
income producing agent. While less than investment grade corporate credit has a higher chance
of default than investment grade debt, default risk can be more effectively managed through a
mutual fund rather than purchasing individual bonds.
2. Loan Participation Notes – Issued by banks to non-public companies who do not have ready
access to the fixed income market. These bank notes are normally collateralized and issued at
variable rates. Though rates have decreased, so have valuations for these notes, which are not
publicly traded, but sometimes exchanged between financial institutions, and often purchased
by mutual funds. Yields on these notes will increase as future rates may.
3. Global, International, & Emerging Market Debt – Investors who purchase debt issued by
overseas governments and corporations can benefit by currency fluctuations against the dollar,
in addition to the underlying bond yields. These securities can be issued at various credit grades
with increasing yields at lower ratings. Since no viable credit market exists for foreign issues, it’s
best to purchase this asset category using a well managed mutual fund.
4. Convertible Securities – Corporate bonds or preferred stocks issued with the privilege to
convert the note to an equivalent number of common stock shares. The convertible privilege is
attached as an incentive to buy the note. If the underlying stock price improves, the note will
become more valuable as common stock, and can be converted to the common stock shares.
After writing off significant loan losses, many prominent financial institutions are now issuing
convertible notes as a way to raise additional capital and help offset the “credit crunch”.
5. Non-Publicly Traded (Commercial) Real Estate – otherwise known as Real Estate Investment
Trusts (REITs). REITs are a pass through entity similar to a limited partnership whose function it
is to purchase real estate, usually through sale-leaseback transactions. The lease income paid by
tenants generates a competitive yield, partially tax deferred as depreciation is passed through to
shareholders (paid as capital gains or recapture at liquidation). Since the REITs are not publicly
traded, their share prices do not fluctuate daily yet will tend to appreciate as periodic property
appraisals are made. After the holding period, the REIT will provide liquidity through property
sale, listing shares on a public exchange, or a combination of these events. Since commercial
tenants are bound by long term lease contracts, the underlying property is less sensitive to
devaluation unless the tenants default.
6. Energy Stocks & Partnerships – While most traditional stocks flounder with inflation, energy
stocks that engage in exploration, drilling, refinery, and distribution of fuels and natural gas are
a noted exception to this trend as energy prices increase. Oil partnerships may be purchased
which offer the added advantage of tax deferred cash flow from depreciation and depletion
allowances. As with REITs, some oil partnerships trade publicly and can be bought without
compromise to liquidity.
7. Long/Short Equity – In the simplest of terms “long” refers to buying an investment with the
expectation it will increase in value while “short” implies selling with an expectation the price
will decline. If an investor believes a decline is imminent, the investor may borrow the security,
sell it in advance of the expected decline, and buy it back for a profit at a lower price, referred to
as a “short sale”. A short sale can be made against any stock, bond, index, or ETF. Furthermore,
some mutual funds or hedge funds may be purchased that specialize in a particular short selling
strategy, or a combination of strategies. Furthermore, options may be traded against the value
of most stocks and many ETFs, which are simply contracts to purchase or sell the underlying
investment at a specified price before the expiration date. Options can be implemented to
hedge against unexpected price fluctuations, to generate additional investment income, to
liquidate the underlying security within a specific price range, or purely for speculation. The
level of risk depends in part on the fluctuation of the underlying security, but also on which
strategy is deployed. When properly implemented, stock options can help reduce the risk of
owning individual stocks, especially with concentrated positions.
8. Swaps/Futures – A swap contract is when one party accepts a fixed price or interest rate while
the other party accepts the fluctuation. Futures, like options, are one sided instruments which
lock the price at which a currency, debt obligation, commodity, or index may be bought or sold
before the expiration date. These features allow an investor to hedge against future price
fluctuations, which may be an important factor for any investor with significant concentrations
in their portfolio, or otherwise may allow the investor to speculate.
Over the last several years, hedge funds have received notoriety for their unique investment styles
which sometimes have yielded great rewards, other times unforeseen disasters. In essence, hedge
funds are limited partnerships which do not trade on a public exchange, nor are they reviewed by the
SEC, nor subject to SEC approval, and therefore are available only to accredited investors who meet
minimum standards of net worth and/or annual income. Hedge funds typically feature strategies that
involve the following investment categories – distressed securities, options, futures contracts, and
swaps. General partners who manage the fund offer limited liquidity on a periodic basis and since many
transactions involve obscure investments; there is very little information available to determine what
the general partners are holding at any particular time. Therefore, limited partners must rely upon the
assertions of general partners for periodic valuations, which can change dramatically, and at a moments
notice well before any updates are aptly communicated.
Other downsides to using hedge funds as an alternative investment are the excessive fees and
incentives involved for management. In addition to the standard 1% wrap fees, performance incentives
for the fund manager may be 25% in excess of a specified base return. Furthermore, an advisor like me
who recommends a hedge fund to you will usually receive another 1%. “Funds of funds” have also been
created by certain financial institutions which maintain a portfolio of hedge funds to diversify strategic
and managerial risks. These fund manager intermediaries will also charge another 1%. Therefore, to
benefit from a relatively diverse offering of hedging strategies, investors must pay up to 3% annually,
plus performance incentives of up to 25% annually in excess of specified returns.
More recently, there has been an explosion of low cost ETFs which enable investors to participate in
similar hedging indices including certain commodity futures and short sales without the extensive fee
structures inherent in a typical hedge fund. Furthermore, options may be purchased or written against
some ETFs, and may be sold short in margin accounts, luxuries which are not available for hedge funds
that find themselves suddenly against the tide. This has been my more recent approach for the longshort, commodities, and futures portions of my client portfolios rather than using hedge funds, along
with increased concentrations of high yield bond and loan participation funds, international bond funds,
convertible securities, high quality non-publicly traded commercial REITs, and energy stocks/mutual
funds to compliment the more commonly held traditional investments. I had also been using several
mutual funds which specialize in mining stocks, but since the majority of these invest in companies that
mine only gold, but since gold has hit a relative peak with little intrinsic economic value, I have recently
recommended clients re-allocate those holdings among ETFs that match a broader index of industrial
metals futures.
Some of this material may represent unfamiliar territory, or perhaps you may have read similar
information before but thought these ideas would not be appropriate for you. Not all of these concepts
are appropriate for everyone, but many may be useful to consider within the context of a well designed
investment strategy. Otherwise, there are no clear cut panaceas or sacred cows. However, one should
consider a methodical approach that is unique to their circumstances.
Here is the consultative process I use to advise my clients on developing an investment strategy that is
conducive with their needs.
1. Through financial analysis, determine an investor’s required return to accomplish their lifetime
financial objectives.
2. Balance the investor’s need for total return need between current yield and appreciation
3. Target an asset allocation model* that is most likely to provide the investor’s required return at
least risk (risk = volatility = standard deviation) to their financial objectives, periodically adjusted
for changes to their personal circumstances or to the economy.
4. Select investments for each asset allocation category using the following criteria (in order of
importance):
a. Fundamental analysis to appraise the business risk of a security (i.e. individual stocks).
b. Industry concentrations relative to the macro economic environment.
i. Mutual funds
ii. Closed end funds
iii. Separately managed accounts
c. Specific positions held by the manager
i. Mutual funds
ii. Closed end funds
iii. Separately managed accounts
d. Managerial expertise and performance, net of fees.
i. Mutual funds
ii. Closed end funds
iii. Separately Managed Accounts
iv. REITs & Partnerships
e. Income Tax Considerations
i. Taxable Investments
1. Turnover ratio on taxable investments
2. Cost basis of existing portfolio
3. Capital gains vs. ordinary income
4. Taxable vs. tax exempt yield
a. Municipal bonds
b. Treasury securities (state tax exempt)
5. Taxable vs. tax deferred yield
a. REITs
b. Partnerships
ii. Possible Unrelated Business Taxable Income for Qualified Accounts
5. Review findings with client, discuss alternatives, & develop a comprehensive strategy
6. Implement the plan.
7. Review the plan periodically and adjust for changes to personal circumstances or the economy,
rebalancing and repositioning investments as appropriate.
There are many reasons to rationalize why it may be easier to take a simpler approach that is less
expensive and time consuming. Most likely, you may be able to continue your current course without
disruption to your financial independence. The prevailing question is, how important is your financial
independence, and are you ready for the challenge?
Some of you may prefer to leave all your money in the bank where it is “safe”. You may do that, but
meanwhile and especially over the long haul, you will be losing ground to inflation, which means less
money for you and your family.
Some of you may be fully invested and may prefer to leave everything the way it is as a matter of
convenience. After all, the market should recover eventually. It probably will, but convenience and
consistency are two different parameters. The margin of error inflicted by whim of the markets or the
economy is likely to be more significant than the effort required for a thorough and proactive response.
Some of you may decide to pursue management on your own as you may better trust your judgment
rather than an independent opinion. I fully encourage my clients to engage in the investment process. I
trust your judgment too and appreciate your feedback. My role is to communicate objective insight and
high caliber advice that can facilitate timely and effective decisions on your part.
Some of you may already be working with an advisor because you like what they had to say. They
match your values. For instance, they may recommend only index funds because they are low in cost,
and they work with you to quibble over whether you pay capital gains this year or next, but capital gain
rates are usually the same each year, and how diversified* was that portfolio anyway? So are you in
cash or index funds now? There are currently more index funds than ever, but still not enough to
constitute a diversified portfolio. Your goals are important to me, and while the responsibility for
decisions is always yours, I’m most interested in offering productive advice.
Therefore, whatever frustrations you may have experienced recently, I invite you the opportunity to
gain more control over your outcomes at greater convenience and peace of mind.
Respectfully,
Neil H. Gendreau, CFP,ChFC
Excel Attachment: “Eligible Asset Allocation Categories*”
*Neither Asset Allocation nor diversification guarantee against investment loss. These methods are
used to help manage investment risk.