Brighton Perspective

Separating the Wheat from the Chaff

We haven't separated the wheat from the chaff yet. Market performance on Friday and Monday confirms we still have sorting to complete. Companies such as GM and Chrysler still have to demonstrate they can stand on their own or fall into bankruptcy. The markets still need to demonstrate they can withstand such an event and banks still need to demonstrate they finish the strong January-February results. None of this has been accomplished, so while market performance over the last 3 weeks has been uplifting, it's still incomplete. If any of these items, and these are just a few of the relevant issues, are deemed failures, we'll revisit 660 and probably plumb the depths of Jeremy Grantham's original call of 600 on the S&P 500. There is still much work to be done before we can look back with hindsight and acknowledge we hit bottom and are moving uphill. As I've said before, carefully cost-averaging back into equities is a responsible action right now but don't forget high-quality corporates and alternatives as opportunities. (As always, understand your own financial position and risk tolerance and incorporate these issues into your decision making process).

Why is Bankruptcy a Dirty Word Now?

In the six months since Lehman failed, it's become de rigueur to claim that such and such company is "too big" to fail, that bankruptcy is not an option. We really need to put an end to this! Finally, GM is facing up to the fact that they haven't had competent upper management in decades and that the various times they've faced bankruptcy over the past 20 years have been the result of poor decision making. It is not the responsibility of the U.S. government to bailout every management team that fails to perform their duties adequately. What if we actually allowed GM or Chrysler or AIG or Citigroup or Morgan Stanley or Bank of America, etc to fail? What would happen? Would we all still wake up the next morning? My guess is yes, yes, we would. And, after the collective anticipatory shudder, we'll discover that the capital markets have a mechanism for dealing with bankruptcy and that it works well when left to its own means.
Enough with the "too big" to fail argument. Let the poor companies collapse and let the market deal with the remains. We'll survive and prosper as a result.

Market Timing: Should You Attempt It?: Peter Bernstein Favors Market Timing?

Market Timing: Should You Attempt It?: Peter Bernstein Favors Market Timing?.

Sounds topical, right? If you click on the link, you'll discover this was written in 2003 based on a presentation by Peter Bernstein during which he suggested "market timing" might make sense. His underlying premise is that the traditional definition of asset allocation, essentially, buy and hold, didn't work and that rebalancing decisions are just as difficult at market timing. This article reviewed in context with this article and this discussion - http://www.cxoadvisory.com/blog/external/blog2-17-09/ suggest that building low variance, asset allocated portfolios involving less underlying active management and a willingness to rebalance somewhat more frequently can be useful.

Asset allocation isn't dead, just wounded. Many believe it didn't fulfill its responsibility in 2008, yet most acknowledge that only short-term Treasuries and cash did well. My research suggests that most asset allocation strategies did better than all equity portfolios and worse than all fixed portfolios. And, yes, they were negative for the year. It appears to me that the critics of asset allocation are suggesting that asset allocation strategies are, or were portrayed as, absolute return strategies. Clearly incorrect. Long-only strategies will be subject to declines. Asset allocation, with market timing to cash, would have performed well, but few are fully committed to the strategy espoused by Bernstein in 2003. I prefer an asset allocation approach that combines long-only equity and fixed strategies with absolute return oriented strategies. I believe these produce the lower-variance portfolios that can better withstand fat tail events. And, yes, tactical rebalancing (market timing) may make sense as well. The challenge, of course, is knowing when to do so. 

Dear AIG

Like most everyone, I've read the letter to the editor in the NY Times addressed to Ed Liddy. My take, for what little it's worth, is that the letter is self-serving and sanctimonious. It's an attempt by the writer to portray himself as a martyr. First, what's the point of releasing the letter to the NY Times but to call attention to yourself. However, I think he reveals his true motivations several times - "during which A.I.G. reassured us many times we would be rewarded in March 2009", "nor am I being paid to do so", "we have worked 12 months under these contracts and now deserve to be paid", "Many employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.'s assurances that the contracts would be honored". Truth be told, the writer and is associates were not motivated by a desire to rectify the mistakes others in his unit, A.I.G.-F.P, made, but to get big paydays in 2009. Further, he notes that "some might argue that the members of my profession have been overpaid, and I wouldn't disagree", then goes on to say "that is whay I have decided to donate 100% of the effective after-tax proceeds of my retention payment". This isn't an altruistic decision, this is mud-in-your-eye. The writer is essentially saying, in my opinion, 'I can't have it, damned if I'm giving it back to the government. and what a pity it'll be if what gets donated is just pennies after the big tax'.

I don't have any issues with pay for performance and don't care how much the comp is if its earned - check the competing story today on hedge fund payouts in 08 for the best performers. But when you are a member of a group and a company that damn near imploded the global economy, you don't deserve a dime no matter how well you did individually. The sentiments expressed in the letter effectively dismiss the poor performance of the rest of the group as "not my problem". AIG was notorious for an aggressive, me-first mentality and I think that's clearly on display in this letter.

I appreciate he feels maligned by the publicity and vote seeking AGs of CT and NY and sold out by his own CEO (who was brought in to clean up the mess and thus really owes no duty of loyalty to the old guard at A.I.G.) and he and his peers have been unfairly persecuted by politicians seeking to improve their popularity ratings and garner future votes. I'm sure it really bites to give back $750,000 but my guess is he's done well enough that it won't cause him to move into a cardboard box any time soon. His outrage almost matches that of Congress. Both are more than a bit hypocritical.

In fact, as I've said in other posts, it's time to let AIG fail. It's been staggering like a cartoon boxer for a year. Vultures have had plenty of time to size up which pieces they want and are just waiting for the carcas to drop. They have no incentive to overpay and A.I.G., as long as the government stands behind it, has no incentive to drop its prices. I am not as informed as the Fed Chairman or the Secretary of the Treasury but I wouldn't be surprised if the market absorbed AIG rather effortlessly if it were allowed to fail now.  It's time to move on.

Thoughts on Market Performance

The market response to the new Treasury plan yesterday was interesting. The majority of the talking heads, even Krugman, settled against it while market participants appeared to applaud it. Who's right? The cop-out answer is time will tell. From what I could gather, it has positives and negatives and whether it works or not will be dependent on which trumps the other.

I do like the intent to allow experienced managers to run the 5 PPIPs. Yes, this introduces the fox into the hen house, but frankly, that's what's needed at this point. While the Fed continues is quantitative easing strategy, which appears to be helpful, we need a better effort from Treasury. Allowing pros to determine what assets to auction and what the valuation would be is a credible approach. Obviously, in light of the AIG bonus debacle, the pro's will rightly expect Treasury to allow them to make money on the deal and to stay out of their compensation strategies. Let's not forget we're in a capitalistic Democracy still.

The downside to this approach is that there's little motivation for banks to bring their assets to the table. Keep in mind, this group wants mark-to-market eliminated because they claim they can't properly value these assets. If they bring the assets to this market and the PPIPs value the assets, now they have a fair market value at which they can reasonably be expected to mark-to-market. The problem arises when these assets are valued BELOW the bank's current assessment of the assets. Such as scenario would result in the banks marking down these assets which could create solvency issues. Hence, those banks that know their current valuations are too high will have to be dragged to the table as they won't go willingly.

As I mentioned Sunday, I think the best action so far has been taken by the Fed. I believe we need to continue to let the Fed pursue its course of action and bolster it with better action by the Treasury. This plan is superior to the "Stimulus" bill in innumerable ways. Consider the following chart,

Source: John Hussman

Clearly, there is a causal link between government spending and inflation. The stimulus bill will lead to inflation. Unless we're in a period of severe deflation when it kicks in, it won't be pretty. The Fed actions, which have many people worried as well, can be reined in more effectively and more quickly when the economy recovers. As it does, the Fed can gradually sell off its balance sheet and retire the cash it receives. Japan did this effectively and I have no reason to believe our Fed can't do so either.

Finally, the rally of the past several weeks is welcome relief. It appears we haven't had such a rally since the end of September 2001. The challenge is determining if this is truly the beginning of a market recovery or simply another step. We still have, at best, mixed economic signals. We have much good news but still appear to lack confirmation. For example, Citi, JP Morgan, BofA and Wells have all suggested 1Q09 is looking good, however, commentators such as Meredith Whitney have noted, they haven't marked-to-market yet and won't do so until 3/31. These commentators believe that that event will be decidely negative and will result in a negative surprise for market participants as these banks announce earnings in April/May. Additionally, we haven't seen a consistent pattern of good consumer related news to demonstrate that consumers are fully confident in their near futures. Continue to be cautious, continue to consider dollar-cost-averaging into equities and continue to research alternatives such as commodities and TIPS. The skies may appear to be clearing but remember the weather looks great in the eye of a hurricane while the front and back ends ain't so pretty.

Mature Boomers - Overconfident?

I was reading the results of a survey conducted by the Financial Planning Association and Ameriprise Value of Financial Planning last night. The survey placed respondents in 3 categories - Gen X (30 to 43 years old), Baby Boomer (44 to 62 years old) and Mature Boomer (63 and above). The focus was mostly on Gen X, but I found the Mature Boomers results most fascinating. For example, 41% believed they were on track toward their retirement planning goal and 51% were on track toward their goal of wealth accumulation. It get's better - 86% stated they understood the financial risks related to retirement and 75% believed they understood financial issues yet only 23% actually knew how much they needed to save for retirement. Baby boomers fell into this same trap by the way.

Not surprisingly, when asked why the didn't work with an advisor, 35% of Mature Boomers believed they didn't need the services of a financial advisor (almost double that of Gen X) and 28% believed they could do a better job themselves. So, of course, 62% believed they were very or completely in control of their financial future and 60% were very or extremely confident in their financial future. Both percentages were substantially higher than Gen X or Baby Boomers.

Now, I'll get to the punchline. The survey was conducted between June and July 2008! How many still believe they're very or completely in control and remain confident about their financial futures?

True, many people are well-educated on financial matters and do understand what they're doing. But for the majority that don't, financial advisors can provide a valuable service. They can help you determine if you are, in fact, saving enough for retirement, help identify potential issues, such as too much or too little insurance, and whether you need to address estate planning. They can also help restructure your investments to align them with your risk tolerance, return objectives, time horizon and liquidity needs. How many Mature Boomers don't go to the doctor because they can heal themselves? We all have confidence in our abilities but sometimes we need to recognize when outside assistance is useful. Don't fall into this trap of assuming you know all there is to know about financial issues and thus don't need any help. If you were in camp pre-September 2008 and now find yourself unsure of how to proceed, give some thought to sitting down with a financial advisor.

Let the Fed Run with the Ball

I think we need to let the Fed run with the ball. Yes, there is concern that its actions are debasing the dollar, but I think Bernanke's actions have been more aggressive and more accurate than any other government official whether Bush, Paulson, Obama or Geithner. Ideally, the Administration backs off and lets Bernanke pursue the course of action he believes best without any counterveiling action from Congress or the Administration.

Related thoughts - the attempt by Congress to tax AIG bonuses and the White House suggestion that compensation in any industry be capped is hypocritical and counterproductive. It is also a scary harbinger of potential future non-Democratic actions. If Congress can ignore the Constitution in an effort to extact "justice" from a small group of people and the White House believes it has the authority to regulate compensation of all citizen's, it's only a matter of time before both are determining how we conduct our daily lives. The AIG bonuses are a mistake and never should have been paid, but what's done is done. Government intervention is worse than the AIG bonuses.

Investing with Mutual Funds

Most of us have experience investing with mutual funds. For most of us, they are the preferred vehicle for building our portfolios. They enable us to diversify our portfolios easily and can be more cost effective than trading individual securities. However, the challenge for most is identifying good quality funds in which to invest. A simple Principia screen on "Distinct Portfolios Only" identified 6,957 open end mutual funds. How can one possibly narrow that field down to a manageable number?

Here is a simple screen that can help accomplish that feat. This can be done using the Morningstar website or possibly through your investment firm's (Fidelity, TD Ameritrade, etc) website if they provide mutual fund research options.

1) Manager Tenure greater than 5 years

2) Net Expense Ratio less than 1.0%

3) Morningstar Risk Rating equal to Below Average

4) Total Fund Assets less than or equal to $5 billion

5) Minimum initial purchase less than or equal to $5,000

6) Turnover ratio less than or equal to 50%

7) Distinct Portfolios Only

8) Open Funds Only

Allow me to explain the rationale for each criterion:

1) Manager tenure greater than 5 years demonstrates stability of personnel and provides comfort that the track record of the fund, for at least the last 5 years, belongs to the current management team. Managers with less tenure can be outstanding, but frequently, they're still finding their way as managers. For investors without the time to do a deep dive this narrows the field quickly and beneficially.

2) It's always better to pay less than more when possible. There is a wide disparity in net expense ratios among funds in the same category. All else equal favor funds with lower expenses.

3) Managing risk should be a high priority now both for the fund manager and for the investor. This has often been overlooked in the past, yet, I believe, managers focused on generating return while also managing risk, whether defined as tracking error or total volatility, tend to provide better performance for their investors.

4) Smaller funds tend to be more nimble than larger funds with regard to trading in and out of positions. They are also less likely to be subject to style or size drift which can introduce unintended biases into an investor's portfolio. Most managers would prefer not to place more than 5% of fund assets in a single stock or own more than 5% of a company's outstanding shares. Both involve additional reporting that managers often find irritating.  Thus to avoid these issues, larger funds must either broadly diversify by owning many stocks, which can make them closet index funds, or invest in larger companies, which introduces size drift. Thus, smaller funds tend to be truer to their purpose. The $5 billion cut-off isn't perfect, in fact small cap funds should be much smaller than that, but it serves a purpose.

5) Obviously, if an investor goes through the trouble of identifying potential investments, he/she wants to be able to actually invest in them. Many funds are available but have very high minimum requirements that most individual investors can't meet. This can be lowered to meet your specific needs.

6) Low turnover tends to be more tax-efficient. A rough rule of thumb for determining average holding period is to calculate 1/turnover. So, a 50% turnover ratio roughly equates to a 2 year average hold for holdings in the portfolio. This suggests most capital gains in the fund will be long-term. Further, it suggests high conviction by the manager in his/her approach. They're not swayed by short-term market noise.

7) This eliminates multiple share classes so the investor can focus on one class. It clears the clutter.

8) Same as minimum investment. If you're going to take the time to research the fund, you want to be able to invest in it. So, screening only open funds eliminates those not available to the investor.

So what does this screen identify? On March 19, it identified 114 funds covering 43 Morningstar categories including the most of the critical ones necessary for an appropriate asset allocation. As for performance, 98 of 114 were above median for the trailing 1 year, 100 were above median for 3 years and 95 were above median for 5 years. How about tax efficiency? The median 3 year tax cost ratio (what percent of annualized total return was lost to taxes) was 0.84% vs a median of 1.22% for the full mutual fund universe. Style consistency? There were 49 equity funds in the screen and 34 (69%) had high equity style consistency.This compares to just 31% for the broad universe. Finally, for those who follow Morningstar star ratings, 50% were rated 4 stars or better and 88% were rated 3 stars or better. This compares to 23% and 47% respectively for the broad universe.

Thus, this screen helps investors identify funds that are better tenured, more style consistent, more tax-efficient, lower cost and better performing than the broad universe of funds. It gives investors a good starting point for further refining their research to meet their specific needs. I've left out closed-end funds and ETFs for now but they're worthy of consideration as well. Again, consider this screen a good starting point for building a healthier portfolio.

Still Building Toward Critical Mass

More good news today on housing starts (apparently mostly condo related) adds to the accumulation of data building toward critical mass. Several major banks have discussed potentially positive first quarters, retail sales were respectable, hedge fund deleveraging appears close to complete and over 920 hedge funds closed in 2008 as the industry continued to perge hedge fund wannabes. According to HFR, 70% of the 6,800+ funds still in existance suffered a loss in 2008, so expect still more to close. In fact, Mohamed El-Erian, CEO of PIMCO, predicts as much as 50% will close over the next 2 years via merger or liquidation. The retail fund industry, too, should see consolidation. Back to the general point, this all contributes toward the critical mass of generally positive information needed to reach a tipping point. I don't believe we're there yet, but we do appear to be progressing in the right direction. I think we'll need more better-than-expected news on Q1 results in mid to late April before we reach that key tipping point. However, dollar-cost averaging back into an equity position, for those in cash, may be something to consider now.

Lending and Spending

An interesting post from Ilian Mihov today - "Will there be Hyperinflation?". The emphasis of their article is another topic but I think one of their charts supports Barry Ritholtz's commentary - "Humpty Dumpty". Look at the following chart:

Source: Antonio Fatas and Ilian Mihov on the Global Economy (http://fatasmihov.blogspot.com)

Essentially, Bernanke (on 60 Minutes last night) argued that the path to economic recovery begins with "fixing" the financial sector. However, as this chart shows, banks have lots of cash. They just won't lend it. They won't lend because they're concerned about their exposure to counterparty risk. That is, the potential that the borrower will default. Bottom line, as Ritholtz states, that borrowers are the issue rather than banks. I once heard someone describe a doctor's responsibility as treating the illness, not the symptoms. Focusing on "fixing" banks doesn't treat the illness - focusing on "fixing" borrowers could.

Market Timing Doesn't Work

Most of know this and many of us preach it daily - market timing doesn't work. We may be right on one end of the decision but will likely be wrong on the other end of that decision. A recent survey released by Dalbar highlights the inability of investors to get the market timing decision right. In 2008, according to Dalbar, investors bought and sold at the right time just 42% of the time. This is the third lowest result in the survey's history. The first and second lowest results were in 2002 and 1989 respectively. It is noticeable that the two of the three lowest recordings were in weak market years - 2002 was the last of the 3 down years to open the decade and last year we know about. Investor's may be more knowledgable than in the past but emotion still plays an enormous role in our decision-making process, particularly when it's "our" money we're investing.

Dalbar also reported on the average performance of equity, fixed income and asset allocation funds in 2008. The average equity fund lost 41% versus 37% for the S&P 500. The average fixed income fund lost 11.7% vs a gain of over 5% for the Barclays Aggregate Index and the average asset allocation fund lost 30%. This highlights the value of asset allocation for the long-term investor. Yes, such an investor would have still been down 30% on average but that's 11% better than the pure equity investor. Unfortunately, too many long-term investors, defined here, as 10+ years until retirement, were grossly overweight in equities. If you're in that category, the markets may have helped correct your imbalance. You're likely overweight fixed income now. Consider dollar-cost averaging back toward an appropriate asset allocation given your risk tolerance and personal situation. Don't try to time the market!

AIG is one screwed up company

It's astonishing that the CEO of AIG would inform the Secretary of the Treasury that he's going to pay bonuses to the unit that nearly sunk AIG and that his "hands are tied". That's about as offensive as it gets! I'm a proponent of pay for performance and this is as far from that as it gets. Your corporate performance stunk, your unit's performance stunk even more, so not only are you not getting a bonus, neither is anyone else at the company. I come from the asset management industry and this was the way the formula worked - your performance + your unit's performance + the company's performance. If all were great, so was your bonus. If any suffered, so did your bonus. To suggest you have to pay bonuses to incompetent employees and that your hands are tied is an affront to every taxpayer. Just as sadly, Summers expresses outrage but says there's little he can do? Here's a suggestion, stop giving AIG money until they terminate every employee who has the audicity to accept said bonus and start with the CEO! It's time to face facts - AIG is one screwed up company. It no longer deserves to be "bailed-out".

Custodial 529s

Section 529 college savings plans gained prominence in 2001 with the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001. Prior to 2001, many parents with the foresight to think about funding college expenses had used established Uniform Transfer to Minors Accounts (UTMA) or Uniform Gifts to Minors Accounts (UGMA). These accounts were established with good intents but, today, have become problematic for many families. Two significant reasons for this are:

1) the assets in the UTMA or UGMA belong to the child. Thus when the child reaches the designated age, the assets can be claimed by said child and used for any purpose they wish. So that college fund just became the travel around the world fund and the parents can't do anything about it.

2) the assets in these accounts are included as student income and assets when completing the FAFSA and PROFILE forms for financial aid. The student is expected to contribute a larger portion of his/her assets and income to fund college expenses. Thus, these accounts, in effect, penalize families for saving for college.

One partial solution is to establish custodial 529 accounts. It's a partial solution because it doesn't remove the child as the owner of the account. However, it does enable the account to grow on a tax-deferred basis (as long as assets are used to fund college expenses). It also changes the FAFSA calculation as the custodial 529 is treated as an asset of the parents rather than the student. Since parents are expected to contribute a smaller percentage of their assets and income it can improve the chance for an aid package.

There are tax issues to consider (aren't there always tax issues to consider?). 529s can only be funded with cash. Thus, if the UTMA or UGMA account has other types of holdings, these will need to be sold and taxes paid on the disposition. The timing might be good, though, in 2009 since market conditions over the past 12 months have been very poor. There may be losses generated which can be used to offset potential gains generated.

So, if you have UTMA or UGMA accounts, it is worth examining the potential advantages and disadvantages of established custodial 529s for these accounts. As always, talk with your financial advisor and your accountant before making a final decision. Final thought - establish a traditional 529 at the same time you establish the custodial 529 and fund that one going forward. The traditional 529 enables you to change the beneficiary so you can continue to save for college and still maintain control of the assets.

"We are Seeing the Market Bottom"

Kind of a trick heading but its to prove a point. That statement was made 5 months ago to the day by Mark Mobius, lead PM for at Templeton. The S&P 500 closed that day at 1,003 or 248 points (24.8%) higher than it is today, which is itself 66 points above what may be A bottom. So the market declined 33% after Mobius' statement that "we are seeing the market bottom". My point is we won't truly know the bottom until its in the rear-view mirror. Signs are positive right now - we're hearing better news from troubled corporations and economic data is marginally better than expected. So maybe we're getting the tailwinds we need. But, maybe its just another bump in the road. Another tidbit - if we close flat or up today, it'll be a 10%+ gain for the week. It'll be the 3rd time in 5 months we've had such a week. Yet, following each of the prior two, the market went on to post a decline for the following week.

Not a pretty chart. Interestingly, the 00-03 decline took roughly 36 months to accomplish what the 08-09 did in roughly 6 months. The 02-03 recovery took time. The market initially bottomed around 800 in July 02, then dropped to 780 in October 02, then finally re-tested 800 in March 03 (5 months in all) before turning higher. I'm not really a chartist, but, we had a possible first bottom in November 08, possibly a second here in March 09, could we re-test 700 in the near future before we move higher?

It's okay to start feeling more confident, to consider getting back into equities. It's also okay to be hesitant. I'd like to see another good close today and good news over the weekend. If that builds into a positive week next week, then maybe we've got something we can run with. However, it's still prudential to take your time re-entering the market. As I've noted frequently, review your asset allocation and make changes only if they make sense and are consistent with your personal outlook. I still believe the credit markets will rally earlier and more significantly than equity markets when the time comes. Thus, I remain more focused on opportunities in fixed income. I don't mind if I'm late to the equity party.

3 and Counting....

Citi, BofA and JPMorgan have all stated in the last several days that through the first two months of 09, they're profitable. These statements don't ensure the bottom has been found but they give promise. As I've noted earlier, financial lead into a recession and they lead out. The market has baked in bad news so only truly unexpected bad news will negatively impact equity prices, in my opinion, while any good news will be a tremendous relief. Statements about profitability from banks, and from GM refusing government money, are contributions to critical mass. Consider these statements as contributing to a work in progress..

Government Spending

Geithner and Summer's demands that the world start spending are falling on deaf ears. Why? IMHO, the primary reason is because when government spending increases to replace consumer spending, consumers who, at least in the U.S., comprise 2/3rds of GDP, recognize the penalty that will be paid in the future. Government spending must be financed at some point via higher taxes or issuance of more currency. Neither is beneficial. Higher taxes reduce disposable income for consumers and increased money supply can be expected to lead to inflation. Consumers, smarter than most government officials believe, save their current after-tax dollars knowing they'll need these dollars later to either pay taxes or to pay more for common goods. Europe and most developing countries have enough problems without adding in higher taxation or higher inflation caused by U.S. demands to help us out.

Monetary Authority

Fed Chairman Ben Bernanke called for establishment of a "super" agency to "regulate the financial system as a whole". For several years I managed my investment group's relationship with the Monetary Authority of Singapore. This organization is, I believe, exactly the type of regulatory authority Bernanke has in mind. MAS has overarching responsibility for monetary policy and financial services supervision for the country. Anecdotally, MAS has done a superior job of managing its responsibilities and has contributed to Singapore maintaining its position as a premier financial center in Asia. This brochure , published in 1999, discusses MAS' responsibilities and, interestingly, highlights why the financial sector is so important to an economy.

It makes sense to combine the various regulatory authorities we have today into one group provided communication channels are established properly and utilized. For example, the Madoff debacle can be traced to two agencies - SEC and FINRA - which failed to communicate effectively with each other. Further, neither, publicly, believes it was its responsibility to oversee Madoff. An overarching regulatory authority responsible for ALL financial services could have prevented a Madoff from existing as long as the scam did. I think there' enough evidence to suggest the regulatory answer is not more supervision but better supervision. A singular organization, like MAS, could better coordinate activities and provide better supervision. Combine FINRA, OCC, SEC, and the FED (note that MAS doesn't issue currency), keep it independent of governmental (read Executive and Legislative) meddling and go from there.

Spending vs. Savings

Another excellent post from Antonio Fatas and Ilian Mihov on the Global Economy. They note that household consumption in the U.S. grew significantly from 1970 to 2006. Much faster than it should for a developed economy. Nothing new here but they do discuss some of the reasons why. The reasons, taken together, are consistent with Behavioral Finance theories on extrapolation. Everyone assumed the good times would continue - incomes would keep going up, housing prices would keep going up, etc. Now, expect everyone to assume the bad times will continue in perpetuity. This will lead to household saving increasing. That's not good but it isn't likely to change in the near future - if households assume incomes will fall (lost jobs) and/or taxes will increase and/or prices will increase (inflation), they will save to ensure they can pay these essentials. Demanding people spend, Mr. Summers, won't get people to spend when they are acutely aware of the potential bills coming due in the near future and are worried they won't have the cash to pay.

Fama & French

Eugene Fama and Ken French have posted a series of interesting Q&A's on their blog Fama/French Forum. Very good read. 

Absolute Return

I am a firm believer in integrating absolute return oriented strategies into portfolios. For that matter, I'm a believer in integrating non-traditional assets into portfolios. This category, for me, includes absolute return oriented strategies, real estate, commodities, and timber. For most investors, our options are limited to open and closed end funds and exchange traded funds. Closed end funds and ETFs can provide coverage for real estate, commodities (including currency) and timber, as well as other natural resources. Neither offers much in the way of absolute return (long/short) strategies yet, though I wouldn't be surprised if they're on their way. I have experience researching and developing potential "active" ETF strategies and, while they're difficult to implement, long/short strategies will be here soon.

Absolute return strategies have taken a media beating in early 2009 for not "living up" to their reputation. Several media pundits have lambasted the strategies as failures with high fees because they didn't deliver a positive return in 2009. This reminds me of my early days at my last firm as the hedge fund market exploded. Many institutional investors wanted exposure but needed transparency and liquidity so they turned to institutionalized hedge fund strategies. There was a common misperception among this group that an absolute return strategy would ALWAYS generate a positive return. After all, that's what absolute return means, right? However, absolute return is the OBJECTIVE of the strategy. The only strategy that I know of that ALWAYS returns a positive return, legally, is rolling 3 month t-bills. Those holding the belief that absolute return strategies are failures if they don't provide always a positive return are missing the bigger picture.

Absolute return strategies (AR) do offer very real benefits when added to traditional asset allocated portfolios. The better strategies are poorly correlated with equity and fixed markets and thus help reduce overall volatility. Almost all AR strategies have short exposure. This exposure reduces the beta of the strategy relative to long-only indexes and strategies tied to them. This is key to reducing overall volatility. These strategies are also poorly correlated to each other. The introduction of short exposure and optimization techniques used by many managers reduce intended exposures to only those in which the managers believe they have skill. AR strategies are very well suited to a pseudo "fund of funds" approach because of their lack of correlation to each other. This is the rationale behind Hedge Fund of Funds. Integrating several strategies, theoretically, can reduce overall risk substantially. This combined portfolio can then be plugged into the broad portfolio and really drop overall volatility. The key is to ensure these strategies truly are as poorly correlated as they appear to be.

So, AR strategies reduce portfolio volatility. The second benefit is the absolute return potential of these strategies. This objective can provide downside protection for a portfolio otherwise oriented to long-only strategies. 2008 demonstrates the damaging effects of long-only strategies on personal wealth. Adding strategies designed to truncate the downside can mean the difference between devastation and just plain disappointment with portfolio performance.

I scanned Principia and identified 31 absolute return oriented strategies. These covered equity market neutral, low-net (long-biased but the long exposure is well below 100%), merger arbitrage, global macro and fund of funds approaches. The average return for 2008 for these funds was (9.04%) so they did not generate a positive return. Given that only cash and Treasuries had positive returns in 2008, this shouldn't surprise anyone. Yet, I would guess in hindsigt that almost every investor would accept a (9.04%) average return for 2008 if offered the opportunity. This "portfolio" had positive returns in 8 of the past 10 years (the other negative year was 2002 down (0.93%)). Trailing returns through January 31, 2009 are similar - down (8.80%) for 1 year, up 0.17% for 3 years, up 2.13% for 5 years and up 3.45% for 10 years. This portfolio beats the S&P in every time period by at least 6.00% net of all fees. The 3 year R2 for this portfolio is 5 and the beta (both to the S&P 500) is -2.74 with a 3 year standard deviation of 7.54%. What that means is this portfolio is largely uncorrelated with equity markets and thus would have dropped overall volatility. That is a good thing.

If I was implementing an alternative approach, I'd screen further to eliminate the higher fee, load share strategies. I'd also dig deeply into the process and management. Is the process understandable and is it repeatable? Look for lurking size and style beta exposures. Does management have experience shorting assets (not as easy as it may seem)? Keep in mind as well, that these strategies are not designed to blow the lid off in good markets. Frequently, they're designed to out-perform 3 month T-bills (proxy for cash) by a certain rate, for example cash + 4%. That means, very high returns are unlikely, unless cash is also returning at a high rate (which wouldn't be a good thing because that suggests very high inflation or a deep lack of faith in the U.S. government!) I know there are good options available which are undeserving of the scorn currently being heaped on them. These strategies aren't for everyone but if you have the knowledge (or your advisor does) and you have the risk tolerance, consider adding absolute return strategies to your portfolio.

 

Citigroup is Important, but...

Citi's announcement last night that it's having a bang-up first quarter is very important. Citi was at the core of the late fall meltdown in the credit markets and is vital to the recovery of the same markets. If Citi does, in fact, post a solid first quarter by following up a strong February with a good or better March, it could be the tipping point. However, it will be only a potential tipping point. It will still be necessary for other financial institutions to follow suit and post their own improving performance. Today's rally was nice, 6 to 8% rallies are nice, but we'll need more evidence of broader improvement among financials before we can get comfortable returning to equities. Financials lead the way into recessions and they lead the way out.

Markets look forward

Brief post for now - market participants are forward looking. Common equity holders have a claim on the future after-tax net earnings of the corporation which has issued the shares. Knowing this, common equity holders are acutely aware of any higher claims to a company's earnings and make adjustments accordingly. Higher future taxes and lower growth lead to lower after-tax earnings for common equity holders. This isn't rocket science! As such, common equity holders reduce the valuation of the common equity commensurate with their expectations of lower future claims. They may over-react and under-price these shares, in fact, they will, but the basic fact still remains. Higher taxes and lower growth contribute DIRECTLY to lower stock prices. You can draw your own conclusions from here.

Valuations are Getting Better

I ran a screen today, using Morningstar Principia, to try and develop a sense as to whether equities were getting to something resembling fair value. I am a value-oriented equity investor so I'm also searching for good names for my portfolio. Personally, I like strong balance sheets, good free cash flow and reasonable valuations. I won't go so far as to make a market bottom call but I did find some interesting companies worthy of further research.

I started by screening out non-stocks in the Stocks database. So my initial starting point was 5,499 stocks. I then screened for companies over $30 million in market cap. Anything under that is generally highly illiquid and subject to potential manipulation as well as market impact from trading. So, I generally avoid these really small companies. From there I screened for stocks with a current Price/Book ratio equal to or less than 1.0. Central to Ben Graham's investment approach was a belief that investors should never own a stock trading at greater than book value. The metric has lost some luster of the years for various reasons but still retains some shine as a core measure of "value". At 1/31/09, 2,178 stocks, or almost 40% of the available universe, were trading at less than book value. I can recall very recent years in which only the walking dead traded at LESS than book value. Now, nearly half the universe is!

Next, I screened on balance sheet cash greater than total liabilities. This is a liquidation valuation - we could liquidate all liabilities using available cash and all remaining assets would be left to equity holders. In the past, excess cash has been considered a liability by investors who argued the company should either reinvest in capital projects or pay a dividend. Now, to me, its a sign of potential strength. Companies with excess cash may be less dependent on debt markets to finance operations which means they're more likely to weather the recession. Only 224 companies make this cut.

I then screened by trailing twelve month cash flow greater than zero. This means that companies are generating positive free cash flow which can be directed toward new projects, dividends, or added to the balance sheet. It also strengthens the cash argument as companies aren't burning through their available cash to finance operations. If they're generating positive free cash flow and have cash on the their balance sheets they should be well positioned to not only weather the recession but prosper from it by acquiring competitors. Only 126 companies made this screen.

Finally, I screened on a net-net basis. Essentially, net current assets greater than current market cap. At a prior firm, w routinely screened on similar criteria to determine potential net-net candidates. For years, the only firm that met the criteria was Circuit City Stores, which now is liquidating, so it has drawbacks. Then again, all valuation criteria have drawbacks - some stocks are cheap for a reason.

Only 83 companies met this final screen. These are companies that I would consider both "cheap" in a valuation sense and "viable" as a going concerns using this screen. Others may agree/disagree with this assessment, or course. The bottom line for me is that equities are getting closer to fair value as Graham would have defined it on at least the P/B variable. I'd like to see more companies with the balance sheet strength and free cashflow to with the cheap valuations but that might be a pipe dream. Again, this is just a screen, more work needs to be done to determine whether these are investment worthy names but it is a start.

Keep looking for companies with strong balance sheets (ex. lost of cash, low debt/equity ratios, high current ratio), good free cash flow (for older companies include pension liability) and good valuations. I'm intentionally leaving out Price/Earnings ratios, or as some call it "Price and Earnings Ratios" because i don't have comfort in forward estimates at the moment. Happy hunting!

Madoff Lessons Learned

Most people are, by now, well aware of Bernard Madoff. He is the “hedge fund” manager who, in reality, was running a large Ponzi scheme. Charles Ponzi didn’t invent the scheme but was the first to raise substantial amounts of money using it. Essentially, in a Ponzi scheme, investors are promised specific returns over time. Frequently, the investment process is not disclosed by the investment advisor but returns are shown to justify performance. These returns are often very stable over time, high returns/low risk, leading people and institutions to commit large sums of money. Purportedly, Madoff had over $50 billion. However, the reality is that the returns are fraudulent. Early investors are paid with funds provided the operator, Madoff in this case, by later investors. This circular effect continues as long as the operator can bring in new funds. When new investors can no longer be found, the scheme begins to collapse. In most cases, this happens quickly and spectacularly. Unfortunately, it is more common than it should be. However, there are steps you can take to ensure you are not a victim of such a scheme.

First, conduct your own due diligence. Ask your advisor about his/her philosophy, process, people, and performance. The Advisor’s answers should be transparent and understandable. Avoid advisors who claim their process is “proprietary” or a “trade secret”. As for performance, risk and return coexist. You cannot increase return without increasing risk. Understanding this relationship should make a skeptic of anyone who hears a pitch similar to Madoff. Long-term consistent positive returns with low volatility, even in bear markets, are unachievable. Further, each investment advisor will provide you with information on his/her firm and their Form ADV part II. This is a document firms file with the U.S. Securities and Exchange Commission to register as Registered Investment Advisors. It provides information on  process, people, fees, and history. Form ADV part I covers the advisor’s education, business and disciplinary history over the past 10 year and is available online via the SEC website – www.sec.gov.

Second, do not accept statements only from the advisor. Your assets are held by a third party custodian, such as Charles Schwab, Pershing or State Street. The custodian provides statements on a regular basis, usually monthly. Require your advisor to ensure the custodian provides you at least quarterly statements. Review these statements to ensure they make sense. Question anything that appears unusual to you, such as an increase in trading or unusual cash flows. This is your best audit statement of an advisor’s performance. Do not accept statements only from the advisor. It can, however, be a good audit step, to receive and reconcile statements from the advisor and from the custodian.

Third, continue to stay diversified. Diversification not only helps to mitigate the volatility of investment markets but it helps to minimize the damage done by one poor investment decision. Most mutual funds, and indeed most hedge funds, will hold numerous positions for this reason. While the managers are confident in their abilities, they know they will not be right all the time, thus they hedge their own bets via diversification. Just as location, location, location is the mantra of the real estate industry, diversify, diversify, diversify should be the mantra for investors.

Finally, don’t lose faith in financial advisors. The vast majority are honest, hard-working professionals with their client’s best interests at heart. The financial system operates on trust backed up by regulation. Ronald Reagan had a slogan which is applicable here – “Trust but verify”. Further, many advisors operate under a standard of care. Many are members of organizations with strict Codes of Conduct, such as the Financial Planners Association (issues the CFP designation), and the CFA Institute (issues the CFA designation). Both organizations have strict standards of practice to which advisors must adhere to maintain their designations.

Bernie Madoff proved to be a very destructive force. In short order he damaged the financial security of numerous investors, including his own family, damaged the credibility of financial advisors and, in doing so, damaged the trust implicit in the financial industry and necessary to investors long-term success. However, he also provided very real lessons which when applied, can ensure you won’t share his company.

Should You Refinance?

Mortgage interest rates have fallen significantly in recent months as a result of the economic recession and decline in the housing market. Challenges do remain regarding refinancing. For example, while interest rates are low, housing prices have fallen, in some area dramatically. Further, while money is available from mortgage lenders, standards have returned to the more stringent requirements of the pre-2000 era. That means, among other criteria, strong credit scores and lower loan-to-value ratios. I'm hearing and reading that very few banks are willing to lend with an LTV greater than 80%. Finally, even if you meet these standards, you should consider how much you still owe on your current mortgage and how many years remain on that mortgage. If you're nearly done paying it off or your balance is very low and it's the only mortgage you have, you might consider retiring rather than refinancing it.

Conversely, if you have years to go, a higher balance and/or more than one mortgage, it might be beneficial to pursue refinancing. Consider the following example, let's assume you have one 30 year mortgage with an original balance of $475,000. You bought your house, a really nice house, in 1999, the interest rate was 6.75% (about what it was in February 1999) so you have 10 years remaining on a mortgage with a monthly payment of $3,081 (excluding insurance and taxes). The remaining balance is now $405,180. Over 10 years, thanks to the 30 year amortization schedule, you've succeeded in paying down only $70,000 (15%). However, the good news is you now have a loan balance that qualifies for the conforming loan category, so you can refinance using a conforming loan (better rates). The objective here is to match or shorten the term of the loan so don't take a mortgage with a term greater than 20 years. A 15 year mortgage with an initial balance of $405,000 at 4.5% (prevailing rate today) would be a monthly payment of $3,098. For effectively the same payment, you've cut 5 years off the original loan and, most importantly, saved over $182,000 in future interest. Imagine what you can do in retirement with an additional $182,000!

This scenario can be reworked in several ways - you can refinance 2 mortgages so that both fit the conforming loan category, refinance to 20 years and reduce your current payment, etc. The bottom line is it makes sense now to review your options. If you can reduce the term at the same payment or matching the remaining term but cut your monthly payment you're benefiting by taking action. You'll reduce future interest paid, and potentially free up current income. Either way, you win. Remember, this discussion is not applicable to everyone - consider your personal situation before pursuing any changes. This link is to an online mortgage amortization calculator that can help you model potential loans. Consider your options in light of your personal financial position; this won't work for everyone. By the way, this calculator is good for any amortizing loan, such as a car loan, so its a good bookmark for future needs.

Hedge Fund Leverage and Market Performance

Much has been made about the hedge fund de-leveraging in late 08 and it's contribution to market performance. Essentially, as Bear Stearns and Lehman failed, hedge funds were forced (or willfully) de-levered their portfolios, mostly to meet margin calls from their prime brokers, who no longer wanted or could manage the counter-part risk. De-levering portfolios required selling assets, generally the most liquid assets, into an already declining market, thus exaserbating the decline.

Source:Bridgewater Associates; www.allaboutalpha.com

This chart highlights how dramatic the the initial levering up phase was (2003-early 2008) and just how quickly it was unwound. This clearly impacted the overall decline experienced in global markets during the last half of 2008. Most of the capital raised was returned to prime brokers to pay off margin debt. More was paid out to investors who redeemed their interests in the various funds. Yet, cash still remains.

Note cash balances have increased from less than 15% in late 2007 to almost 25% in late 2008. The question, then, is when will this cash leave the sidelines and re-enter equity markets? It is entirely possible, given performance during the first quarter of 2009, that it won't return. Managers clearly had to hold cash to meet expected redemptions a year-end, which would have been paid out by mid-February. However, if cash remains near 25%, it will eventually be employed in some manner. Cash on hedge fund balance sheets is not the only cash on the sidelines. Expect as this cash is put to work by hedge fund managers, cash will follow from other sources. It's just a matter of when?

How to Design a Portfolio

The fundamentals of portfolio management are applicable whether you’re Warren Buffet building a portfolio of subsidiaries to Berkshire Hathaway, Peter Lynch building a portfolio of equities for the Fidelity Magellan Fund, or you and I building our portfolios using mutual funds, stocks, bonds, and ETFs. If you're just starting out, pick a good balanced fund, like Oakmark, and let the fund managers handle the asset allocation for you. As our assets grow, we can assume more responsibility for our portfolios. As they grow even more, it makes sense to incorporate an advisor or consultant into the process to ensure we have covered the right classes and to gain access to certain investment vehicles.

A guiding principle of asset allocation is to provide adequate diversification in the portfolio. This is achieved by incorporating securities that have different risk and return profiles and thus perform differently under similar circumstances. This is referred to as correlation. Ideally, each portfolio holding has a poor or negative correlation with every other holding.

Let's start by addressing two critical inputs - risk tolerance and return objectives. There are no free lunches - that is we cannot make money without assuming risk. It's not gonna happen! So, how much risk can we accept?. This can mean how much of a roller-coaster ride are wewilling to endure, how much of a paper loss are we willing to assume? Risk tolerance is a very personal matter, its unique to each investor. Along with risk tolerance, we need to determine what our return objectives are. What positive return do we want/need for our portfolios?

To determine our return objectives and risk tolerance we'll also need to determine our liquidity needs, our time horizon, and any special circumstances involved. For example, a 42 year old married, working couple with pre-teen children will evaluate these criteria differently than a 70 year old widow with no dependents. With risk tolerance and return objectives defined, we can address the high level asset allocation. What does that mean? Starting with 100% of your portfolio assets, we'll decide how much should be in equities, how much should be in fixed income and how much should be in alternatives. I consider alternatives a separate asset class. The classic rule of thumb is to start with your age in fixed income. We'll use a 40 year old as a case study. So, 40% in fixed income and 60% in equity. Adding alternatives changes that mix slightly. A good starting point is 20% for alternatives. Whether to take that from equities or fixed or both is an individual decision. For this exercise, we'll take it evenly from both. So the final top level allocation is 50% equities, 30% fixed income and 20% alternatives.

The next decision is the sub-asset class allocations. Within equity, that would be domestic/international, large/small, and value/growth. Strategically, I favor value over growth and smaller over large (though tactically, i.e., short-term, this can and does change). I believe U.S. investors should always have non-U.S. exposure as well. This crisis has clearly highlighted how interwined the global economies are today. Further, the U.S. markets are very rarely the best or worst performing markets. Within fixed income, it would be domestic/international, long/intermediate/short-term, corporate/government, quality (high yield or high quality). I favor high quality, intermediate term bonds with a reasonably even distribution among corporates and government issues. High Yield and other specialty fixed income securities can have roles as well on a more tactical basis. Within alternatives, it would be market neutral/merger arbitrage/commodities/real estate/timber/precious metals.

Finally, we decide on investment vehicle. It is much easier to implement an asset allocation for a portfolio using commingled funds rather than individual stocks or bonds. Thus, in most cases for me, the decision is whether to use open end mutual funds, closed end mutual funds or Exchange Traded Funds (ETFs). All can play a meaningful role in your portfolio. Considerations include liquidity, fees, management expertise, and availability.

Asset allocation can make a valuable contribution to performance. Consider that for 2008, while the S&P 500 was down 37%, 142 of 187 institutional balanced strategies (moderate allocation as defined by Morningstar) were down less than 17%! Yes, still a loss but given the widespread losses for almost all asset classes that’s not surprising. The key is that a loss of 17% or less can be recovered much more quickly than a loss of 37%. Asset allocation should provide this kind of downside hedge while still enabling us to participate in positive returns.

As our portfolios grows in size, portfolio management becomes more complex. Thus, using an advisor can be worthwhile. Asset allocation becomes more challenging to implement, tax implications should be considered, liquidity needs become more variable, investment vehicle options grow to include institutional separate accounts and/or commingled funds, estate issues become more meaningful, etc. Start on your own, learn as you go and don't hesitate to retain an advisor when you no longer have the time or knowledge (or the desire to commit the time!) to successfully manage the portfolio.

5 Stages of Grief

We're all aware that the economic and investment markets news over the last half of 2008 was unrelentingly negative. Equity markets were down in late October almost 50% from the level at which they entered the year and the fixed income markets offered almost no safety. Aside from cash and Treasuries, there were precious few safe havens. Consequently, many, if not most, investors have suffered rather significant losses. If you did have in place an effective asset allocation, you mitigated some of the losses but still, you were probably underwater for the year. You're not alone.

I believe market participants are moving through the 5 stages of grief originally proposed by Elizabeth Kubler Ross in 1969. She applied the five stages to any traumatic life event. I think it's fair to say that 2008 was a traumatic life event for most everyone:

Consider:

Stage 1 - Denial - as the crisis began to build in early 07 and into 08 (really it was earlier than that but it reached national consciousness in 07), most investors either overlooked or ignored the news assuming the fallout would not reach them. Even Fed Chairman Ben Bernanke denied the depth of the impending crisis by suggesting they had the sub-prime crisis well contained. However, the reality, in retrospect, is that we, as market participants, were simply in the denial stage.

Stage 2 - Anger - as we entered the fall, we moved from denial to anger as first Bear Stearns, then Lehman, then Wachovia, Merrill Lynch, Citigroup, Washington Mutual, and so on, failed or approached the brink of failure. We watched as the first "bailout" vote failed and our representatives expressed anger regarding the "socialization" of the financial sector. Further, we watched as certain members of Congress refused to acknowledge their own roles in the unfurling crisis and anger and resentment grew. The Anger stage lasted at least through early November (really, this one isn't over yet!).

Stage 3 - Bargaining - post-election, many thought the new President-elect would solve everything, that the bail-out funds would get banks lending again, that the coordinated global action would release pent-up liquidity. Market participants began to bargain - more regulatory oversight for more liquidity, etc. Whatever it takes!

Stage 4 - As we entered 2009, the unrelenting drumbeat of negative economic data continued. Poor retail sales, more layoffs, recession, depression, double-digit unemployment, etc, etc. How could it get any worse? Why bother even trying to make things better? What's the point? Give up on the markets and invest everything in cash!! Sounds familiar, right? Whether you or someone you know, you've heard those comments somewhere over the last month. We're now in stage four of grief - depression. This is, I think, the point at which market participants are scraping the bottom. That doesn't mean we're done, but I do think it's time to move on to stage 5.

Stage 5 - Acceptance. Some participants have gotten to this stage and are searching for opportunities to move forward, some at still moving through the Anger stage, some may never leave the Anger stage. Wherever you are in this process, whether you have losses you don't want to realize or you're dissatisfied with the advice or service (or utter lack of service) you've received to date, it's time to accept the financial tragedy that 2008 embodied and move forward.

As the first quarter of 2009 draws to a close, now is the time to sit down and review your financial plan, implement a new plan, change your asset allocation, and develop a process for gradually implementing the plan over the course of 2009. Do so deliberately, methodically and rationally. Losses can be realized responsibly, if necessary, and new strategies, designed with an intent to get you back on track, can be implemented. If you're not happy with your current advisor, or with yourself as your advisor, consider bringing in a new one or schedule a meeting with your current advisor and express your concerns. Doing so doesn't mean liquidating your portfolio, realizing all of the losses and starting from scratch. A competent advisor will work with you to transition your portfolio constructively and on your timeframe. Don't let the sense of fear driving the current economic and investment climate paralyze you.

It's time, finally, to let go of the grief you feel for your current portfolio, and challenge yourself and your advisor to start back on the road to recovery!

Investment Policy Statements

This article discusses Investment Policy Statements and makes several excellent points. IPS are commonplace among defined benefit plans and endowment/foundations in the institutional world. They are the foundation upon which the Trustees, as fiduciaries, build, manage and monitor their portfolios. The IPS states the return objectives, risk tolerance, time horizon, liquidity needs, investment parameters and benchmarks and any special items that must be considered. From this document, every party involved in managing the portfolio can derive their responsibilities. It matters.

Yet, it is almost non-existent for individual investors and for defined contribution plans. I've noted before it is at the top of the list of DOL requests when the DOL audits a DC plan. So, it should be top of mind for the fiduciaries involved in managing the DC plan - management, consultant, managers, etc. It is just as relevant to individual investors, who I believe, should view their portfolios as endowments. The IPS lays out the same critical guidelines as for institutional plans and provides the reference material for all participants. If you have not created an IPS yet, do so. If you have, review it and make sure its up to date. If your advisor hasn't suggested creating one or has dismissed suggestions to do so, consider a new advisor. Many are loath to admit, but once we assume responsibility for managing client assets, my believe is we assume fiduciary duty to perform in the best interests of our clients (individual or plan participants in a DC plan). The IPS should be step 1.

Zombies!!!

Jim Baker wrote an essay yesterday reminding readers of the "Zombie" banks of Japan during the 1990's. Japan suffered a financial crisis in late 90-91 following their own real estate bubble. Zombie banks are defined as financial institutions whose liabilities outweigh their assets such that their net worth is less than zero. They continue to exist because, as in Japan, the government props them up. U.S. advice to Japan during this period was to let these banks fail and be absorbed by stronger banks. We need to take our own advice and let institutions like AIG fail and be absorbed. AIG has been staggering for nearly a year now, more than enough time, for competitors to determine what they may want to acquire of the company. However, they have no incentive to acquire anything as long as the government continues to prop AIG up. This enables AIG to demand sales prices that are unacceptable to potential buyers - hence, no one's buying. If AIG files for bankruptcy, companies can negotiate more favorable terms. This is Darwinistic - survival of the fittest, but it's the way Capitalism works. The government has a role in capital markets, creating Zombies is not one of them.