Posts in Denver Business Journal
Municipal Bonds: Should You Build a Portfolio or Invest in a Fund?

Denver Business Journal - by Richard Todd

A prominent economist recommended that high-net-worth investors should never buy municipal bond mutual funds and instead should ladder their own bond portfolios.  (“Laddering” means having a portfolio of investments with holdings that range from short maturities to long ones.)

He argued that owning individual bonds until maturity offers the certainty of regular income payments, without management fees or expense ratios.

Investors should have learned this lesson in the past year: Portfolios’ downside risk should be quantified and carefully considered.  For high-net-worth investors, municipal bonds can be an ideal strategy to reduce portfolio volatility.  However, the approach to implementing and managing a municipal portfolio is an important consideration.

Is the economist correct?

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Madoff Fraud Shifts Focus to Concerns About Hedge Funds

The followings article by Richard M. Todd was recently published in the Denver Business Journal, Volume 60, Number 42, March 27 - April 2, 2009, (Denver Business Journal).

In 2008, hedge funds didn’t protect investors as many had expected. The CS/Tremont Hedge Fund Index, which included Bernie Madoff’s fraud, was down 19.07 percent for the year.

While some of the disappointment was attributed to the financial crisis, investors’ confidence also has been shaken by the depth and significance of Madoff’s fraud. Although Madoff managed separate accounts, his strategies were distributed primarily by feeder funds structured as hedge-fund partnerships.

Many people have written off the hedge-fund business. However, we think otherwise, and believe that solid, risk-adjusted returns should be in store for diversified hedge fund investors...

Click HERE to continue reading.

Congress Expected to Repair Problems with Pension Plans

This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 60, Number 33, January 23-29, 2009, (Denver Business Journal).

Many retirement industry experts expect the 111th Congress to undertake an extensive review of our retirement system.

Time has shown that defined benefit pension plans suffer from a fatal flaw: They spread risk without being clear about how, and by whom, the risks are borne. Surpluses in defined benefit plans lead to employers becoming exempt from the requirement to make their annual contributions, as well as result in plan participants and corporations fighting over the ownership of the surplus. Regulators, and even the courts, often step in to arbitrate the disputes.

Similarly, when surpluses turn to deficits during market collapses, plan participants become at odds with bondholders and shareholders about how the financial shortfall should be allocated.

Please click here to read the full article.

Before Firing Money Manager, Consider these Factors

This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 60, Number 6, July 25, 2008-July 31, 2008, (Denver Business Journal). A reprint of the article may be found at this link (Reprint).

I had a recent conversation with an investor who explained that he was firing a manager for having underperformed his benchmark for two years.

The conversation reminded me of a famous 1984 speech and subsequent article by Warren Buffet for the Columbia Business School. Buffet’s “Super Investors of Graham-and-Doddsville” presented the cumulative track records of nine great investors. His study illustrated the swings in performance of these top managers and how underperformance, at times, can be prolonged and painful.

Similarly, the investment advisory firm Litman/Gregory conducted a thoughtful study of mutual funds’ performance. L/G evaluated the funds that had outperformed their benchmarks for 10 years. Its study concluded that more than 90 percent of these top-performing managers had at least a single three-year period during which they underperformed their respective benchmarks by two percentage points or more. L/G’s evaluation of small-cap mutual fund managers reached a similar conclusion.

In its study of retirement plan sponsors, the institutional consulting firm Watson Wyatt concluded that investment committee members are far too impatient with underperforming managers.

In an ideal world, the decision to terminate managers would precede poor performance, and the hiring of new managers would begin with the uptick in their performance. Significant value would be added. But that’s unrealistic.

According to the investment firm Davis Advisors, the most common thought process with investors — high-net-worth and institutional alike — is, “When a manager does badly for one year, it is acceptable; for two years, it is troubling; for three years, it is time to make a change.” While investors certainly deserve advice beyond “be patient,” in the end, evidence indicates that patience is an investment virtue.

Instead of reacting to recent performance, the due-diligence process should focus on understanding the drivers of investment performance, regardless of whether managers are beating or lagging their benchmarks. Understanding a manager’s strategy and investment approach is paramount to understanding their forward-looking edge over passive management and other active managers. Investors must be clear on their reasons for dumping a poor performer. Nearly always, those reasons should go beyond performance.

Some of the most common reasons to terminate equity managers in today’s market include:

• Concentration — Large positions in sectors can be a big red flag when evaluating most managers, regardless of performance. Managers who had large concentrations in financial stocks were punished for that concentration in the last year. While thematic, top-down managers may deserve special consideration, intensive due diligence and possible termination should be strongly considered when managers have a large overweight in an economic sector or industry.

• Approach deviation — Some domestic equity managers have significant allocations of foreign companies in their domestic portfolios. In the past several years, the weakness of the U.S. dollar has provided a significant boost to those funds holding international stocks. The resulting problem is that an investor’s total portfolio may be pushed to an international stock overweight. Should the dollar strengthen, the portfolio likely would be hurt.

Morningstar classifies equity funds as “domestic,” though as much as 30 percent of the portfolio is comprised of foreign companies. Even lower allocations to non-U.S. companies can cause problems in a diversified portfolio.

• Manager size — Large pools of assets can be a significant detriment to performance, especially with small- and mid-cap managers. Since these managers often invest in stocks that are thinly traded, it’s much more difficult for them to buy or sell large positions without significantly affecting their prices. Managers often take an alternative approach, adding more stocks to the portfolio, which could be a change in the managers’ stripes. It’s better for these managers to close their doors to new business in order to protect the integrity of the product and their investment process.

• Manager change — A key manager leaving can be a gigantic problem. At times, the product’s historical track record should be thrown out the door when a manager departs. If a manager is retiring, there should have been a well-thought-out transition plan that included gradual changes and co-management responsibilities. With the plethora of money-management products in the marketplace, there’s no reason to be a guinea pig with a new manager.

• Ownership change — A merger or outright sale of an investment firm can turn it and its culture upside down. When ownership changes, make certain that the firm’s key managers and analysts have incentives to stay. Understand the potential impact of a manager’s liquidity event, including any lack of motivation to succeed, and to put time and effort into the firm and its investment products. Sudden wealth from an ownership change can alter everyone’s work habits.

Too many investors have an itchy trigger finger, and, as a result, sell low and buy high. All managers have periods of underperformance; the key issue is understanding why poor performance occurred. Carefully monitoring managers in areas beyond performance can lead to more rational replacement decisions.

Market Timing Works; Emotional Investment Doesn't

This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 59, Number 49, May 23, 2008-May 29, 2008, (Denver Business Journal). A reprint of the article may be found at this link (Reprint).

There's no doubt that market timing works. If investors can buy at market bottoms and sell at market tops, they'll add significant value to the bottom line. The converse is also true. Making poor market-timing decisions can have a dire impact on portfolio returns.

The problem with market timing is that the investor (or adviser) must continually link correct decisions in order to add value. There are skillful managers, but we have yet to find one that adds value through market timing.

If professionals can't add value (some claim to, but use faulty statistics to prove it), why do many investors believe that certain experts have this special ability?

Hindsight is always 20/20, and many investors rely on a combination of hindsight and emotional influences. Investment decisions that are based on fear, hope and greed will lead investors to buy when others are buying, and sell when others are selling -- a guaranteed way to generate horrible investment results.

Successful investors do the opposite, and not because they are contrarian or have cast-iron stomachs. Success is a by-product of being process-oriented and having a framework that provides a consistent and methodical basis for making decisions.

During the tech bubble in 1999 and early 2000, investors rationalized new thinking, in which tech companies could sustain incredible growth rates and defy the laws of mathematics. Conversely, in late 2002 and early 2003, investor gloominess was extreme. Many investors had the perception that the investment environment was exceedingly dangerous after the S&P 500 was down nearly 50 percent.

We're reminded of this gloominess today. Many investors prefer investments after periods of strong performance -- typically when valuations are high -- and are afraid of investments after down periods. For instance, why were investors flocking to high yield bonds yielding only 3 percent over Treasurys in fall 2007, and today shun the same bonds yielding 10 percent over Treasurys?

The best way to insulate an investor from the powerful emotions that drive short-term market movements is to have a strict, proven process.

A diversification and asset allocation policy that includes investments with a number of complementary strategies is extremely important. A haphazard approach to diversification can lead to concentrations in areas and lack of exposure to specific opportunities.

A rebalancing strategy is crucial. Rebalancing is the process of reallocating investments back to the original percentage of the portfolio. This approach forces something that most investors lack the discipline to do -- buy low and sell high.

Well-thought-out and reasonable expectations of future investment returns are important as well. Expected rates of returns should be established in advance and risk should be quantified as well. What is the maximum "draw down" or negative return that can be tolerated? This critical question is directly linked to the asset-allocation process and the investor's portfolio design.

A methodical process for monitoring and evaluation is important in the overall process. Patience and a long-term focus must be emphasized. If an investor has a short-term horizon, the likelihood of not meeting goals increases dramatically.

Emotional investing seldom works. Fiduciary law grasps diversification and process -- not market timing. Although the theoretical returns of market timing look compelling, results always have been negative because continually linking successful decisions is impossible.

RAND Report Shows Confusion About Advisers, Brokers

This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 59, Number 36, February 22, 2008-February 28, 2008, (Denver Business Journal). A reprint of the article may be found at this link (Reprint).

The Securities and Exchange Commission's RAND Report offers clear insight as to what many have believed for years.

Investors are confused about the differences between investment advisers and brokers. The problem begins with the many common titles they share, such as consultant, financial consultant, investment consultant, financial adviser and financial planner.

Investment advisers are registered with the SEC, pursuant to the Investment Advisers Act of 1940, and are fiduciaries with respect to their clients. Brokers, who often use labels similar to "investment adviser," aren't bound to the same fiduciary standards.

Investment advisers provide advice; brokers sell products.

The SEC commissioned the RAND Corp. to conduct a survey of more than 650 households; two-thirds of the respondents were classified as "experienced" investors who "held investments outside of retirement accounts, had formal training in finance or investing, or held investments only within retirement accounts, but answered positively to questions gauging their financial understanding."

RAND also collected data from business and economic publications, previous studies and regulatory filings. The result was a 219-page report made public Dec. 31. RAND says its "analysis confirmed findings from previous studies and from personal interviews with stakeholders: Investors have difficulty distinguishing among industry professionals and perceiving the web of relationships among service providers."

The primary concern is the lack of understanding about differences in fiduciary standards between registered investment advisers and broker/dealers.

The industry has become "extremely heterogeneous," offering a range of services not clearly defined. "Investors do not operate with a clear understanding of the different functions and fiduciary responsibilities of the financial professionals," according to the report.

A broker or broker/dealer offers securities and/or investment products for sale, for which they receive a commission. The broker has a responsibility only to find that the investment is suitable for the client. In other words, is the investment suitable for the investor based on their objectives and risk tolerance?

A broker has a securities license, typically a Series 7 for all securities except commodities, and a Series 63 state securities license. Some brokers have only a Series 6 allowing security product sales, typically mutual funds and annuities.

In order to receive a securities license and subsequent commissions, the broker is sponsored by a firm and has passed an examination. The broker is not a fiduciary with respect to his clients.

An investment adviser's firm is registered with the SEC (and possibly the state, for smaller firms) and the adviser passes a Series 65 exam. The adviser offers advice about which investments to buy and sell.

The fiduciary standard is significantly different from the broker -- the adviser's duty is to the client, and the client's best interest is always first. Registered investment advisers are fiduciaries with respect to their clients, and they must disclose all conflicts of interest to the client.

But as RAND notes, investors fail to distinguish the difference, and the lines are blurred between who's advising and who's selling.

Today brokers, including most Wall Street firms, often charge a fee for service, but go back and forth between fee-based services and commission compensation. While disclosure is made in a client agreement or a product prospectus, as RAND notes, it's often unclear to the investor.

Further, some registered investment advisers will charge a fee for their management, and also will collect commissions from the products they're positioning for the client.

Expect some clarification and new regulations regarding the blurry lines of distinction. Although the industry is already highly regulated, better disclosure about commissions, conflicts of interest and fiduciary standards are warranted.

Ask this: "Do you have a securities license?" A "yes" answer means they have the ability to collect commissions for transactions and product sales. A commission compensation structure is a conflict of interest that potentially affects the independence and objectivity of the broker's advice.

Street Yields to 'When Ducks Quack, You Feed Them'

Recently published in the Denver Business Journal, Volume 59, Number 32, January 25, 2008-January 31, 2008, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found at this link (Reprint).

Interest rates have decreased dramatically through the years, and interest-rate spreads between high-grade and low-grade instruments have narrowed significantly.

Investors -- both institutions and individuals -- have clamored for more yield, and Wall Street obliged. After all, the old adage, "When the ducks quack, you feed them," has been the Wall Street rallying cry for years.

Consequently, after years of raking in gigantic fees to create and distribute mortgage-backed structured products to their clients, some of the largest brokerage firms and banks are taking huge write¬downs. Merrill Lynch, Citigroup, JPMorgan Chase, Credit Suisse, Bank of America, Goldman Sachs and Morgan Stanley all have been involved in the subprime debacle by structuring and distributing products, and by holding the paper on their balance sheets.

The blow to shareholder wealth in the financial sector has been staggering. In addition, a number of state government liquidity funds, bond funds and even money-market funds have suffered losses by buying "high quality and investment grade" commercial paper, only to see some of these notes severely downgraded and become illiquid.

Mortgages are typically less predictable than bonds. Pre-payments and payment collections make each mortgage unique. Wall Street firms take bundles of mortgages and transform them into securities that are sliced into a number of "tranches" and sold to investors as Collateralized Debt Obligations (CDOs).

Each CDO tranche has different risk and return characteristics, thereby providing investors with more predictability than a whole mortgage pool. The lowest-quality junior tranches withstand the majority of the defaults and delinquencies in the pool in exchange for generating much higher interest rates. Conversely, the highest-quality and most senior tranches generate a much lower rate and receive the majority of the principal repayments from home sales and refinancing.

Wall Street firms pay rating agencies (primarily Moody's and Standard & Poor's) to evaluate and "rate" the CDOs. The higher the rating, the larger the market of investors and the easier the CDOs are to sell.

In a typical offering of the last couple of years, 80 percent of CDOs' tranches were rated AAA, the same rating as U.S. Treasuries. The remaining 20 percent were expected to absorb any losses from the underlying pools from delinquencies and foreclosures in exchange for much higher rates.

Both Wall Street and the rating agencies were dreadfully wrong. Not only did the lower 20 percent suffer severe losses, but even the former AAA tranches were severely downgraded, and prices were punished.

Critics of the rating agencies argue that a huge conflict of interest exists. The rating agencies make large fees from rating CDOs and are sensitive to angering the issuers who pay these fees. When questioned about their ratings, the agencies waved the "freedom of speech" flag.

According to a recent Barron's article, "Former Clinton Secretary of Labor Robert Reich writes in his blog that the system is tantamount to movie studios hiring critics to review their films and paying them only 'if their reviews are positive enough to get lots of people to see the movie!'" While Reich's remark may be an exaggeration, you get the point.

Fortune Magazine wrote an exposé on a Goldman Sachs mortgage product, GSAMP Trust 2006-53, which was assembled in spring 2006. The average loan-to-value was 99.29 percent (only 0.71 percent in equity!), 58 percent of the loans were no-documentation or low documentation, almost all originated in California, and all the loans were second mortgages.

Sound risky? Goldman sliced the trust into 13 tranches, and Moody's and Standard & Poor's rated 68 percent of the issue AAA (just like a Treasury note) and 93 percent of the trust investment grade.

But by February 2007, the rating agencies had downgraded the top-rated tranches from AAA to BBB, and, by September, 18 percent of all the loans had defaulted.

A Dec. 27, 2007, Wall Street Journal article painted a similar picture about the Merrill Lynch "Norma CDOI, Ltd." Norma had 75 percent of its securities rated AAA in March 2007, only to see them downgraded to "junk" in November.

What are the lessons for investors, individuals and institutions alike?

  • Rearview investing doesn't work. Rating agencies failed to look forward to the potential consequences of poor loan-to-value ratios, lousy documentation, a potential housing bubble (hasn't the frothy housing market been questioned by most analysts the last couple of years?), rising short-term interest rates and poor geographic diversification.

  • Question the "access to deals" pitch made by Wall Street firms, big banks and advisers. Always review investment alternatives and understand the impact from a total portfolio perspective.

  • Understand that brokers and investment advisers may try to hook you up with their own clients, such as money managers. This is a conflict of interest.

If the money manager buys research, accounting, trading and specific products from the broker-adviser, that will taint the latter's opinions in favor of the money manager.

  • Be wary of proprietary products. Although outside products may be available, proprietary products are almost always more profitable to the firm -- and often the firm's adviser.

  • Think diversification. Understand your portfolio's concentrations and focus on diluting excess risk. It's amazing how often investors take gigantic risks without understanding the limited upside potential.

Wall Street will always feel its ducks. But the ducks need to understand what they're eating.

 

Basic Investment Principles can Help Build Portfolio

Recently published in the Denver Business Journal, Volume 59, Number 27, December 28, 2007-January 3, 2008, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found at the Innovest Website (Reprint).

At times, we make investing too complicated. If you follow some basic tenets, you'll be a successful investor.

Here they are:

  • Determine your objectives -- Most investors have no problem determining their broad portfolio objectives, such as capital preservation, retirement, education funding, etc.
    Theoretically, the longer your time frame, the more aggressive (more in stocks) you can be. However, investors can be emotional and -- especially in difficult markets -- make crucial investment mistakes. Therefore, it's important to quantify the downside risk that you can tolerate in a short period of time. This will help determine the amount of conservative investments that should be in your portfolio.


    Although investment-grade bonds don't look like an "opportunity," the worst year for the Lehman Aggregate Index was in 1992, when it lost 2.92 percent. That pales in comparison to some of the worst years in the stock market. Bonds are a preservation tool, typically not an "opportunity."

  • Focus on portfolio design -- Studies show that most of the variability of price performance is attributable to asset allocation.


    A simple example to put this into perspective: You decide to invest with a large-cap equity manager. A year later you returned 10 percent in the investment while its benchmark, the S&P 500, gained 9 percent. Therefore, nine-tenths of the reason you made the 10 percent was your decision to invest in large-cap stocks.

    The overall portfolio allocation should be based on your objectives, which will determine the mix between conservative investments and higher-risk ones.

  • Pay attention to costs -- The portfolio cost is a direct reduction of portfolio returns.

    Commissions and sales expenses can be costly as well, and can be difficult to uncover. Often, they're buried in the internal expenses of an investment product.

    Take advantage of low-cost institutional products that can be made available to even small investors. For some strategies, passive management (indexes) can work well, but aren't a panacea.

    There are passive product peddlers who oversell index-based products. Investors must beware of biases in these products. For instance, "value" indexes recently have been crushed by large concentrations in financial stocks.

    Taxes are a direct portfolio cost. Individuals should prefer products and strategies that are sensitive to the taxable investor. Managers who defer portfolio gains until the next year -- and/or who create long-term capital gains over short-term ones -- should be favored.

  • Focus on consistent managers -- When reviewing investment performance, don't get too caught up with cumulative results. Instead, examine how managers have performed against their benchmark (make sure the benchmark is correct) for one year. A batting average of 70 percent or more is exceptional.


    Make sure the investment fund/manager's organization is stable, and the management team has been in place for some time.

  • Review and re-balance portfolio -- Once the design is established, review portfolio allocation on a consistent basis (preferably quarterly). The markets will take portfolios away from the original allocation, and studies have shown that periodic and consistent re-balancing can add 0.5 percent to 1 percent per year in performance.


    However, don't arbitrarily rebalance with taxable accounts. Make certain that the sales create long-term capital gains, not short-term gains. If not, revisit the impact of delaying re-balancing of the overall risk/return characteristic relative to your goals. It may make sense to delay the rebalancing until a long-term gain is created.

    We prefer putting ranges (typically plus or minus 3 percent) around your asset allocation target and rebalancing once a portion falls outside the range.

  • Focus on an income budget, not income -- For investors who are living off their assets, one school of thought has been to clip coupons from bonds to generate the necessary income. The current low-interest-rate environment has wreaked havoc on the income of investors using this strategy.

    Instead, determine what your income needs are and take a reasonable (generally 5 percent or less) amount from the portfolio by using rebalancing and tax-savings techniques. Take distributions from assets that are overweight relative to your target, take principle when possible to avoid taxation and favor long-term capital gains over taxable income and short-term gains.

    A disciplined portfolio can be built using the basic principles described here, and should produce a better inflation hedge and more consistent income over time.

Investors who make mistakes usually haven't followed one or more of these basic investing principles. By using them, they can dramatically improve the odds of success. Whether a high-net-worth investor or an institution, these investment principles can apply, and also will help ensure sound stewardship.

Hedge-fund Problems Highlight Need for Diversification

Recently published in the Denver Business Journal, Volume 59, Number 22, November 23, 2007-November 26, 2007, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found by clicking (Reprint).

The U.S. subprime market has dominated headlines in the last six months. Countywide Financial, a gigantic home lender, has had well-publicized problems.

Bear Stearns, a prominent Wall Street firm, had to bail out its own credit-based hedge fund.

Sowood Capital, another large, leveraged hedge fund invested in subprime debt, blew up after its losses exceeded 50 percent.

However, during the second week of August, quantitative hedge funds (firms that rely on data-based models driven by computers) employing long/short equity strategies suffered heavy portfolio losses, while hedge funds using other strategies didn't.

As losses mounted, funds reduced risk in their portfolios by selling shares and raising cash, only to see the markets rebound as they sat on that cash.

According to The Wall Street Journal of Aug. 10, "After the close of trading, Renaissance Technologies Corp., a hedge-fund company with one of the best records in recent years, told investors that a key fund lost 8.7 percent so far in August and is down 7.4 percent in 2007. Another big fund company, Highbridge Capital Management, told investors its Highbridge Statistical Opportunities Fund was 16 percent down for the year."

Hedge funds have become dominant market players. It's interesting to note how the trading behavior of a class of hedge funds has affected the performance of other classes of hedge-fund strategies.

The MIT Sloan School of Management studied the August four-day financial storm that caused so much pain to hedge funds and their investors. It has developed an interesting hypothesis about the rapid unwinding of quantitative equity long/short portfolios.

The Sloan researchers concluded other broad factors contributed to the losses in this rapid unwind and will continue to affect investment performance both positively and negatively. Investors -- particularly trustees and fiduciaries -- in hedge funds should pay attention to these factors.

These factors include:


  • They believe that a sudden liquidation of a large multistrategy hedge fund or proprietary trading desk -- which are not made public -- was part of the problem. Speculation that "margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions or discrete change in business lines was a partial case of collapse," the report says.
  • There has been a tremendous growth of long/short and market-neutral hedge-fund strategies.
  • Advances in technology, increased competition and declines in market volatility have made it tougher sledding for quantitative (computer-driven) strategies. If everyone is using the same factors, it's hard to develop an edge over competition, let alone passive strategies.
  • Leverage has increased dramatically as hedge funds reach for higher returns. Investors and advisors can be swayed by great returns generated by leverage without understanding the higher risks.
  • Illiquid credit strategies have led to panic in nearly all markets and strategies. Hedge funds have invested in subprime mortgage, below-investment-grade corporate debt, bank loans and other receivables, such as credit cards, car loans and medical receivables.

Some hedge funds have leveraged these illiquid investments that exacerbated losses as buyers left the market.

It is easy to get lazy (or arrogant) about investments when times are good. Investors and fiduciaries must understand diversification basics with all investment products, especially in the unregulated hedge-fund arena.

Just as with traditional strategies (stocks, bonds; growth, value; small, large; domestic, international), hedge-fund diversification is crucial. Know your hedge-fund characteristics, strategy, approach, expertise and especially leverage.

A Quick Synopsis of the Unraveling of the Credit Market

Recently published in the Denver Business Journal, Volume 59, Number 18, October 26, 2007-November 1, 2007, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found by clicking (Reprint).

The Federal Reserve has begun the loosening process in response primarily to the sudden lack of liquidity in the credit markets and collapse of some financial institutions.

The crisis began in the real estate market, as poorly qualified buyers with little net worth and assets had access to cheap loans. These mortgages were typically aggregated and then divided into sleeves, dividing the risks of the pool. Called Collateralized Debt Obligations (CDOs), they contain tranches that vary depending on the quality of the underlying loans.

On one side, there were tranches with the highest-quality borrowers, which had little chance of default. On the other were tranches that received the first losses of value, made up of more risky loans and borrowers.

Rating agencies, such as Moody's or Standard and Poors, often gave investment-grade ratings to even the riskiest of the pools. Consequently, a flood of investment followed.

The rating agencies typically earned huge fees in rating these pools and were eager to work in this large, new market. After all, this offered subprime or high-risk borrowers access to real estate mortgages for the first time, and mortgage originators were heavily incentivized to meet this demand by lending other people's money.

Last spring, as the housing market began to decline, rating agencies finally downgraded a number of CDOs. Many institutional investors who either relied on the rating agencies or made mistakes in their own due diligence were forced to sell their previously investment-grade holdings (many investors have investment policies that prohibit below investment-grade holdings). The massive selling weakened the CDO market, and subprime CDO issuance virtually stopped. The era of cheap home-mortgage credit came to an end.

The collapse of the CDO market precipitated a domino effect on the credit markets. Investors (mostly hedge funds) that had leveraged their CDO positions faced margin calls, but struggled to sell positions as the market collapsed from the weight of the intense pressure of deleveraging process.

Consequently, these investors were forced to sell more liquid investments. Other fixed-income securities that would be vulnerable in a weakening economy were hit hard as well. Equities, high-yield corporate bonds and Collateralized Loan Obligations (CLOs) used to finance leveraged buyouts and other bank loan products were hit particularly hard.

Investors sought refuge in default-free instruments such as U.S. Treasury bills, forcing yields to fall below 4 percent. Banks became reluctant to lend to one another, sending the spread between three-month LIBOR (London Interbank Offered Rate) -- the rate at which international banks lend to one another -- and three-month Treasury bills to more than two percentage points.

The spread since has narrowed but is still well above the normal spread of 0.25 percent or less.

To address the credit crunch, the Fed reduced the Fed Funds rate from 5.25 percent to 4.75 percent in September to give banks more breathing room if other banks refused to lend.

The sudden need to reduce risk or de-leverage has been difficult for financial institutions. Those with hard-to-value investments -- such as CDOs, CLOs, bank loans and low-grade corporate bonds -- have continued to struggle for funding.

Compared to past credit crunches, the investment-grade bond market is reasonably liquid, and investors have more confidence in the health of companies.

Instruments relating to the housing market are another story. Investors in the lower-grade CDOs face difficult head winds.

Home prices are declining, home¬owners have little or no equity, credit requirements have become stringent, and new funding has evaporated. All of these factors apply even more to the starter home market.

All of this makes it easy for the home¬owner to walk away.

While the global economy is relatively strong and corporations are in good condition, the lousy housing market is affecting not only the economy but also the way securities are priced.

As always, diversification generally has preserved investment portfolios. But risk-seeking investors have been crushed by concentrating on risky areas and investments they don't understand. Plus, they're overleveraged in these investments.

Overconfidence Can be an Investor's Worst Enemy

Recently published in the Denver Business Journal, Volume 59, Number 14, September 28, 2007-October 4, 2007, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found by clicking this link (Reprint).

When a sample of students assessed their own driving skills, 82 percent judged themselves to be in the top 30 percent of the group.

Clearly, a large percentage of the students were overconfident about their driving abilities. The "Lake Wobegon" effect, named for Garrison Keillor's fictional town where "all the children are above average," is widespread.

For almost as long as psychologists have been studying human nature, they have found that people tend to overestimate their abilities, knowledge and skills. People overestimate their ability to do well on tasks, and these estimates increase with the importance of the task.

In financial matters, overconfidence can be costly. It causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events. Overconfidence can lead to problems throughout the investment management process.

Why are investors overconfident?

There are many forces at work that explain the general tendency of overconfidence.

To some extent, it's also a result of the exceptional performance of the investment markets in the past 20 years. Investment professionals often state that "a rising tide lifts all boats" to indicate that even some poor investments go up when the broad market is rising. In other words, many investors give too much weight to the effect of their decisions and too little weight to the strong performance of the investment markets.

Another behavioral bias that increases investor overconfidence is the "illusion of knowledge." When people are given more information on which to base a forecast, the accuracy of the forecast doesn't increase proportionate to the increase in their confidence in the forecast. Additional information can lead to an illusion of knowledge and foster overconfidence.

Investors today have access to vast quantities of investment data, and as a result, are tempted to believe that so much data confers knowledge.

Another behavioral bias that increases investor overconfidence is the "illusion of control." People act as if their own personal involvement can influence the outcome of chance events. Because investors now can place investment orders with little or no intermediation of a live or full-service broker, they may feel that such direct involvement improves their chances of favorable outcomes.

Why does overconfidence persist?

An important question to ask about overconfidence is why it persists even in the face of experience.

In other words, why don't people temper their confidence levels based on their experiences?

People overestimate their own contributions to past positive outcomes. When people expect a certain outcome and that outcome occurs, they often overestimate the degree to which they helped make it happen.

On the other hand, when things happen that conflict with their expectations, they attribute those events to some other cause over which they had no control. In other words, they take credit for the successes, and blame the failures on chance.

Another reason overconfidence persists is that situations don't repeat themselves exactly, so investors are constantly faced with different issues. Unfortunately, life and investing aren't like the movie "Groundhog Day," in which Bill Murray relives the same day repeatedly.

In the context of financial decision-making, the investor may not even know that his overconfidence is resulting in poor investment performance. Considering the average investor's inability to accurately measure and evaluate investment performance, the investor may never realize the true cost of overconfidence.

Be Cautious: Free Advice may not be Worth Even That Much

Recently published in the Denver Business Journal, Volume 59, Number 9, August 24, 2007-August 30, 2007, (Denver Business Journal), by Rich Todd. A reprint of the article may be found at the Innovest Website (Reprint).

Employers should be careful when recommending advisors and brokers to their retirement-plan participants.

A recent settlement between the National Association of Security Dealers (NASD), a self-regulatory body in the brokerage business, and Citigroup illustrates the issue.

The NASD alleged that CitiGroup's advisors used misleading tactics to convince Bell South employees to cash out retirement plans and trust the proceeds with its brokers. CitiGroup will pay more than $15 million in fines and restitution, and individual broker licenses were suspended.

The NASD has issued an investor alert at www.nasd.com titled, "Look Before You Leave: Don't be Misled by Early Retirement Investment Pitches That Promise Too Much."

The problem also can stem from vendors that provide retirement-plan education through commission-based salespeople.

For example, a local employer's defined contribution plan was handled for many years by an insurance company that relied on its salespeople to provide education. When a longtime advisor/salesman left the insurance company, the human resources department became alarmed after learning that he sold numerous insurance and investment products outside the retirement plan to plan participants.

The employer also was surprised that the advisor/salesman earned commissions on these sales. In this field, retirement-plan providers, with the approval of their clients, will offer individuals education on assets that are outside the plan -- thus no commissions are involved.

Occasionally, broker advisors use annuity products to induce participants to cash out of plans upon retirement (sometimes early retirement), or use an in-service withdrawal benefit.

Another local defined contribution plan that was exempt from ERISA (federal law) had a unique option. Participants could cash out of the plan before retirement. A broker peddled immediate annuities to these participants, locking in a fixed income for life for them.

The rub was that the annuity products were high-commission retail products, earning the brokers 5 percent to 10 percent of the participants' account balances in the first year -- often hundreds of thousands of dollars.

For employers who want to provide annuity options to employees, there are low-cost institutional alternatives that will cut brokerage commission costs by 75 percent to 90 percent.

Most investment professionals are honest and ethical, but often can be myopic about what they're selling. They know only what they know.

Employee education has become a much bigger issue to the regulators. The federal Department of Labor considers target-date retirement funds as a safe harbor for employers. The DOL may designate funds as a Qualified Default Investment Alternative, which means they're an option for those who haven't made an option election into their retirement plan.

For younger participants with a long time frame, the options have a large bias toward equities and are gradually made more conservative (more in fixed-income strategies) as a participant approaches their retirement date.

Target-date portfolios can be designed based on the underlying options in the retirement plan or can be separate off-the-shelf products. But know that differences between target-date portfolio products can vary immensely. Plan sponsor fiduciaries must carefully examine fee differences, use of passive or active strategies, philosophy about risk control and the allocation to a firm's proprietary products.

The Pension Protection Act (PPA) has put employee education at the forefront for plan sponsors, and they need to be prudent about making appropriate approaches for participants and employees alike.

The Economy Chugs Along, But Remains Vulnerable

Recently published in the Denver Business Journal, Volume 59, Number 5, July 27, 2007-August 2, 2007, (Denver Business Journal), by Rich Todd. A reprint of the article may be found at the Innovest Website (Reprint).

The U.S. economy has had a terrific run. S&P 500 companies have had 19 consecutive quarters of double-digit earnings increases year over year.

The economy is slowing, as indicated by the almost snail's pace growth of 0.6 percent in the first quarter, but many economists believe the economy is in a trough and see a good year ahead.

The Fed is hoping for yet another Goldilocks -- "not too hot, not too cold." We generally concur, but believe that a shock to the system could spell trouble. Alan Greenspan, the former Federal Reserve chairman, put the odds for a recession at one-in-three.

Where are the problem spots that could stall the U.S. economy?

Unraveling of the credit markets -- The subprime mortgage markets could be the tip of the iceberg. The yield curve has been inverted -- short rates yield higher than long ones. Historically, in this interest-rate environment, lending activity slows dramatically as margins at lending institutions shrink (banks borrow short-term and lend long).

Private equity and hedge funds are competing with the lending of banks and, consequently, have forced them to be more aggressive in an environment where they usually are tightening lending practices.

If leveraged strategies unravel and/or lenders have problems, it will shrink the current abundance of liquidity. This could throw the economy into a recession.

Evaporation of the "wealth effect" -- The U.S. savings rate has been negative for quite some time. In other words, U.S. consumers have been outspending their earnings due to increased asset values in their homes, retirement plans and equity investments.

Arguments can be made about the flaws of the government savings rate statistic, but if housing continues to slump and/or if we have a stock market correction that's sharp or prolonged, the resilient U.S. consumer could be in trouble. Two-thirds of economic growth is consumer-driven, and with the consumer already overspending, a sharp decrease in wealth could push the United States into a recession.

Soaring energy prices -- Higher prices at the gas pump and increased home heating bills are a direct cost to consumers. Further, business will attempt to pass along the cost increases to manufacture or transport goods to their customers.

We're seeing inflation creep into the system as a consequence of higher energy and commodities prices. There's no bigger tax, especially on the middle class, as inflation.

While Federal Reserve Chairman Ben Bernanke is inflation-conscious, he could be placed in a difficult situation -- a slowing economy and higher inflation (known as "stagflation"). Forcing rates higher would help curb inflationary forces, but could shut down economic growth at the same time.

Bad policies in Washington -- The rhetoric is flying about trade policies, and a floating Chinese yuan. While an argument could be made for more favorable treatment by China of our domestic goods and services, America's reliance on China's low-cost goods and labor has helped keep inflation at historical low levels.

Increased protectionism could drive prices higher, and the Fed would be placed in another difficult position. While U.S. labor may have suffered from the global economy, it's started to benefit from China's explosive growth and demand for raw materials, such as steel.

While rattling the saber may be a negotiating ploy, Washington must be careful here. A trade war could collapse our dollar, and put the economy at risk.

Terrorism -- The American economy generally has shrugged off any bad news from the war. However, if terrorists are successful in the United States or Europe, the impact on the economy would be detrimental. Similar to what happened after 9/11, both consumer spending and business spending could drop dramatically, and the economy could stall.

There are certainly other circumstances that would hurt our economy. The inexperienced Fed chairman is key to handling a crisis and the resulting impact on our economy.

The economy looks to be satisfactory in 2007, but corporate earnings are slowing, inflation is rearing its ugly head, and any number of negative surprises could derail our long, steady ride.

IRS is watching 403(b) plans more closely than before

Recently published in the Denver Business Journal, Volume 58, Number 52, June 22, 2007-June 28, 2007, 80 pages (Denver Business Journal), by Rich Todd. A reprint of the article can be found at the Innovest Website (Reprint).

The Internal Revenue Service and the legal community are watching 403(b) plans, which are defined-contribution retirement plans.

Recently, the IRS has targeted 403(b) plans of public school districts to determine their level of compliance with the Internal Revenue Code. The 403(b) plan is available only to nonprofits and governmental entities.

The large majority of employers that offer these plans are in education -- public schools, grades K-12, and colleges and universities -- and in the hospital market.

In most cases, these employers have considered 403(b)s as supplemental to other plans offered (such as defined benefit plans), and many have chosen to provide access to any provider licensed to sell a product. Morningstar calls this the "hog wild" model.

While there may be some cursory criteria for employers to approve, it's typically an elementary analysis, compared to what a typical retirement plan sponsor is legally required to conduct for ERISA (Employee Retirement Income Security Act) plans such as corporate 401(k) and pension plans.

One big problem is that 403(b) investment costs are extremely high compared to the 401(k) market, where the plan sponsor typically uses one provider. Morningstar estimates 403(b) annual internal costs run between 3.75 percent and 4.60 percent of plan assets.

Although Morningstar's estimate may be high, fees in this market can be almost egregious. In many cases, the employer/plan sponsor is seemingly ignorant and unaccountable about vendor costs. However, the employee/participant often can feel comfortable since the product was "approved."

Another common problem is the steep surrender charges that individual participants may be forced to pay should they change their mind about a product or vendor. Surrender charges typically are tied to commissions that the salesman receives. If the participant changes vendors, these charges pay back the vendor for the large commissions paid. The longer and higher the surrender charge, the more the commission paid to the salesman.

Providers of 403(b) argue that competition lowers prices. This is true, but only if the competition occurs at the plan-sponsor level. In a multiple vendor environment, participants lose all economies of scale that come with a consolidated plan level account.

If 403(b) employers negotiated on behalf of participants (like 401(k) employers), individuals would receive increased services and much lower costs. Participants could easily save 1 percent per year in fees by moving from a high-cost individual approach which is most common in the 403(b) market, to an institutional solution. For a participant saving $5,000 per year for 25 years, a 1 percent fee savings equals nearly $60,000 -- and that's just for one participant.

Services to employees also can be improved with a single vendor. Meetings with employees become less focused on which company is better (or has a better salesperson or has the better food at their meetings), and becomes more focused on educating employees about which investment vehicles will meet their goals.

This change in focus is significant. Gone are the rumors and the water-cooler conversations of who is the cheapest vendor, who has the best investment products and who has the best information.

Instead, the employee feels comfortable that they're getting great service and great pricing, and instead can focus on designing the right investment portfolio and achieving retirement goals.

Jefferson County Public Schools, the nation's 26th-largest school district, took a big step last year and consolidated 55 vendors into a single provider.

"It became quite clear that our employees didn't know what fees they were paying, and the district was concerned about the complexity and prudence of dealing with 55 vendors," says Lorie Gillis, chief financial officer of the school district.

Although participants were initially concerned about having choice, it's estimated that each Jeffco participant will save between $10,000 and $100,000 with the new vendor by the time they retire.

While Jeffco made huge strides, not everyone -- namely the 54 vendors that were displaced -- was happy. However, participants no longer have to play the investment guessing game, and their employer has acknowledged its responsibility to its employees.

The time is ripe for employers to revisit their 403(b) plans. Participants should ask employers about their due diligence process, and employers should come to grips with their fiduciary responsibility.

Buyer should beware in structured product deals

Recently published in the Denver Business Journal, Volume 58, Number 48, May 25, 2007-May 31, 2007, 56 pages (Denver Business Journal), by Rich Todd. A reprint of the article can be found at the Innovest Website (Reprint)

In every weekly Denver Business Journal, you will read of closely held companies being sold and often the buyers are public companies.  The transaction is often structured with the seller receiving a substantial stake in the stock of the public company.  This can be beneficial from a tax point of view as an actual taxable event may not occur until shares of the public company are sold.  The seller therefore trades the illiquid, closely held company to a public company receiving the benefit of the liquidity (common stock) of the acquirer.  However, the seller still has a concentrated position in a single stock.

The risks of a concentrated position, whether in a closely held or publicly traded company, are substantial.  One of the benefits of holding shares of a public company may be the ability to hedge that position, but buyers should be cautious.  A seemingly sound structure and strategy may be a commodity in the real world and the prices that are charged and the commissions levied by brokers and banks can vary significantly.

A prepaid variable forward contract (PVF) is one such strategy.  A PVF is typically a guarantee of limited downside risk in a stock position, with some participation in the upside, and a substantial amount of cash be paid upfront to that closely held stock owner.  If structured properly, a taxable event may not be created until the end of the term (can be for many years) and the stockholder has significant liquidity to make other investments and diversify much of the risk that accompanies a single position.  The structure can be very complicated from a tax point of view.  Legal advice should be utilized.

Many banks and brokers will compete for the contract and the terms will be fairly comparable between most high quality institutions.  The problem is that commission rates vary hugely and the client may never know it. 

Case in point – (some of the details have been changed to protect the identity of the investor but general circumstances are accurate). A business seller received $25 million in common stock from the sale of a business and was presented a PVF from his long time securities broker.  The stock would be hedged to limit all downside risk, would receive up to a 40 or 35 percent gain on the stock, and receive the current dividend rate plus 1/3 of any dividend increase, and would have a $15 million loan against the $25 million wired to his bank account to invest in other areas, spend, or leave in the account.  The term was 5 years and at the end of the term the client repays the loan with the shares needed to cover the loan.  They could receive substantially more at the end of the contract, a long term capital gain would be triggered, and Uncle Sam would finally get his due.

The broker “scoured” the universe for the best deal for the client – only going to the best banks and settled on an AAA, high rated institution to guarantee the transaction.  What was not disclosed to the client was that the broker carved out a piece of the deal for himself and was receiving a healthy $1 million in commission.  Luckily for the client, their CPA wanted objective and independent advice on the structure and the deal itself and asked us to re-bid the contract. Many of the same banks were involved in the new bidding process and not surprising; the client was able to put well over $1 million more into his pocket.

We see cases like this time and again – especially when the broker/advisor has a “captive” client.  Relationships are always important with your advisor but be careful to not get too cozy. Commissions corrupt advice and at times it is difficult to know when a commission is paid – let alone the amount of the commission.

Short strategies are worth exploring in portfolio

Recently published in the Denver Business Journal, Volume 58, Number 44, April 27, 2007-May 3, 2007, 72 pages (Denver Business Journal), by Rich Todd. A reprint of the article can be found at this link (Reprint).

Until the bursting of the 1990s technology bubble, many investors felt that the equity markets could consistently deliver double-digit returns. As markets plummeted, shorting stocks became a welcome tool in combination with traditional long-only strategies.

Shorting a stock is the practice of borrowing stock, selling it and hoping to buy it back later at a lower price, then returning the stock to the original owner; that allows investors to make money as a stock declines in value.

Theoretically, shorting a stock is risky, as the potential loss is unlimited since a stock can go up infinitely. Conversely, a stock's appreciation potential when purchased is theoretically infinite, and the maximum loss is the amount of the investment.

Coupled with a long position (meaning you own the stock), shorting strategies can make a total portfolio more conservative. Managers that are successful in long-only investing rely on positive information they have learned about companies.

Long-only managers with negative information about companies just won't buy stock in them. But short-only managers see negative information as an advantage, because they can sell the stock now and expect to buy it back later at a lower price.

Although some managers -- almost always in hedge funds -- manage a short-only portfolio, most shorts are combined with a long portfolio. In a long-only portfolio, most of the portfolio returns are dictated by the market.

Most managers are looking for slight outperformance of their benchmark (for example, the S&P 500, Russell 1000, the EAFE), without taking a big risk. Stock markets can be volatile, and an active manager's long-only portfolio generally will have volatility similar to their benchmark.

However, if a portfolio is comprised of roughly half-long and half-short stocks, the volatility will be reduced dramatically, and the performance no longer will depend on market movements.

An investor expects the manager to utilize positive and negative information appropriately, and that value will be added. This is called a "market-neutral" portfolio and is typically a hedge-fund strategy.

The mechanics of implementing a market-neutral portfolio are simple. In a typical $50 million market-neutral portfolio, the manager sells short $50 million of stock, generating a nearly $50 million position in cash, which is used as collateral.

At the same time, $50 million in stock is purchased. The return will be comprised of the return of the long portfolio, plus the return of the short portfolio, plus the return of the cash portfolio, less the costs of money management and other expenses.

Other managers will have a long bias and will use shorts as a hedge to the portfolio. These long-short managers are typically 60 percent to 80
percent long, and 20 percent to 40 percent short.

The returns of a long-short portfolio are less volatile than the stock market, and typically will underperform in strong markets and be defensive in down markets. Normally, long-short strategies are in hedge-fund vehicles as well.

One approach is called a "short-extension strategy," with formulas such as 120/20 (meaning, 120 percent in long strategy, 20 percent in short), or 130/30. In a 120/20 strategy, a $50 million portfolio would be comprised of $60 million in stocks that are purchased and $10 million in stocks simultaneously sold short.

This portfolio has no cash and is net 100 percent long, the same as the market or typical long-only portfolio. It simply allows a manager to not only buy on positive information, but short on negative information as well.

Hedge funds have used the short-extension strategy for years, and mutual funds began using the strategy in the last couple of years.

Shorting isn't a dirty word and can be helpful in reducing portfolio volatility and allowing managers to better use negative information to benefit a portfolio.

Perhaps investors should warm up to these strategies, as stocks have not only gone almost straight up since late 2002, but can be a sound hedge in the long term.