Let’s think for a few about QE2

Posted on October 19, 2010 by Rick Lesan, CFA

While Frontier Advisors is about the long-term evolution of the markets, we still need to consider the short term risks to the economic environment so I do spend considerable time (too much, I’m sure) thinking about the issues of the day.  Lately there has been significant discussion about a second round of monetary stimulus from the Fed, termed QE2.  The US markets are clearly in favor of more monetary stimulus, bidding up prices any time a member of the Fed’s policy-setting committee even hints of it.  While I am not as convinced as most that QE2 is imminent (I do think it is likely, however), I am even less convinced that it is necessary or at all helpful to our current situation.

My explanation is rather simple.  We are facing an extreme lack of confidence in our economy, and not only will more monetary stimulus fail to cure that lack of confidence, it may actually give us another reason or two to lack confidence even more.  Consider some of the reasons behind this lack of confidence:

  • Uncertainty about future taxes
  • Uncertainty about the cost of healthcare
  • Uncertainty about the vaguely-written financial reform package
  • Uncertainty about who will be in power after the November elections
  • A gargantuan and growing deficit
  • Near bankrupt state coffers
  • Official unemployment near 10% (and true unemployment likely far higher)
  • An impending currency war
  • Little progress in housing and/or mortgages

Pumping more liquidity into the system offers no solution to any of the above and may actually exacerbate a few of them.  By all accounts, businesses are awash in capital right now, hoarding it until they see a good reason to put it to work.  Individuals, on the other hand, may have capital to spend or may not, but asset purchases by the Fed are going to do nothing to change an individual’s cash position, nor will they convince him or her to head to the mall and spend any more than they are likely to already.  Add to that the concerns of Fed Chairman Ben Bernanke himself that “we are still learning about the efficacy and appropriate management of these alternative tools” and it seems clear that further stimulus at this time does not make much sense.

Unfortunately, the market has already priced in additional stimulus measures.  Therefore, if the Fed does actually decide to do nothing for now, the market will react negatively once it figures out it guessed incorrectly.  We are clearly in a damned if you do, damned if you don’t situation that requires patience and an ability to stay the course while the powers that be navigate these waters as best they can.  The only thing that to me seems certain is additional volatility in the markets.  Let’s hope it has an upside trend to it.

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Einsteinian investing

Posted on August 30, 2010 by Rick Lesan, CFA

Einstein once said, “Everything should be made as simple as possible, but not simpler”.  This bit of wisdom works exceptionally well in so many areas of life, but it is particularly good advice for investing.  Unfortunately, most investment firms do not heed this advice when constructing portfolios for their clients, building all kinds of unnecessary complexity into them.  Perhaps it is human nature to believe that a more complex solution is better in investing, that a simple solution cannot possibly be as effective.  While the point at which additional complexity adds no incremental value is debatable, adding complexity always increases costs, reduces transparency and control, and sometimes hampers liquidity, all of which are bad for the investor.  Therefore, a close examination of the level of complexity found in each and every portfolio is always a good idea.

Consider hedge funds.  People with enough wealth to qualify as hedge fund investors often want them in their portfolio.  Many think of hedge funds as magical structures that offer investors high, uncorrelated returns with low risk, although the data on them do not support such a view.  There was a very good article this weekend in the Financial Times that discusses how many of the risks to hedge fund investing are overlooked and that the expected high returns and low correlations are fleeting, especially after considering fees and taxes.  The article also cites another bit of research that concludes that investors in hedge funds actually earn 3-7% less than what is published because of the timing of cash flows in and out of them.  Most investors only invest in a hedge fund after it is able to post exceptional returns, but those returns rarely persist and so investors don’t experience performance that matches their reason for investing in the hedge fund in the first place (incidentally, this is the case in mutual fund investing, too).

Investors may be catching on, however.  Institutional investors, those large pension funds and endowments who have been regular clients of the hedge fund industry, are rethinking their exposure to this and other complex areas of finance and are reallocating substantial portions of their portfolios to passive strategies in an effort to make things “as simple as possible, but not simpler”.  Interestingly, many hedge fund managers are themselves throwing in the towel.  Most recently, Stanley Druckenmiller, a legend in the hedge fund industry, bowed out after determining he is unlikely to be able to meet return expectations going forward.

But this post is not meant to be an indictment of the hedge fund industry, per se.  The true enemy to the Einsteinian investment model is the investment industry itself.  In order to feed its own need for high profit margins to pay for the existing armies of salespeople, consultants, and analysts, as well as to keep everyone in opulent office space, offer outrageous pay packages to executives, and pay fines to the SEC, the industry must keep complexity the name of the game.  It is impossible for the industry to charge what it currently charges for investment services by selling what I argue is a far more rational and effective approach to the markets.  So, when you are introduced to the latest and greatest must-have additions to your portfolio – hedge funds, commodities, gold, currency and interest rate hedging vehicles, structured products, unified managed accounts and overlay strategies – make Einstein proud and get a second opinion from a knowledgeable and credible source.  Chances are your portfolio will fare much better without the additional cost and complexity that those things bring with them.

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What to do with today’s bond market

Posted on August 20, 2010 by Rick Lesan, CFA

In my previous post I made the point that one should carefully consider any advice that suggests a particular market is about to move strongly in any direction, no matter the source.  The underlying impetus for the post was an article on certain “geniuses” saying the sky was about to fall on Treasuries.  While I think I made my point about market timing and geniuses, I avoided offering any opinion on Treasuries themselves.  Nor did I offer any advice about how one might want to position their fixed income portfolios in this relatively bleak bond environment.  Let me offer a few thoughts on those issues now.

First, let me start with how I think about fixed income investing in general.  For most investors looking to grow their portfolios, bonds are there to offset the risk one takes in equities and to offer a little income along the way.  They are not there for growth, as that is the job of the allocation to equities.  Very simply, these investors should seek bond investments with three main attributes: (1) low risk, (2) a solid likelihood of beating inflation over a reasonable time period, and (3) low correlation to stocks, most specifically during difficult periods in the equity markets.  Following this line of thinking, most fixed income sectors are off-limits because most areas of fixed income involve far too much risk and not enough equity-diversification benefit to be useful.  Basically, we’re left with Treasuries and municipal bonds.  So with Treasuries at their current levels, do we remove that option, too?

I do actually agree that long-term Treasuries are at extremely lofty levels, and that is very apparent when you look at today’s yields relative to history.  There are numerous arguments that go far beyond looking at historical yields to support the view that Treasuries will come down dramatically at some point, but the trouble is always in figuring out when.  This poses a dilemma for portfolio construction when we are already facing limited options for fixed income.

Luckily, however, there is an offsetting issue with the municipal bond market.  Everyone is extremely worried about state and municipal budgets, leading to an underappreciated muni bond market.  Just as one can make a clear case that Treasuries are overvalued, one can also make a case that municipal bonds are undervalued if you believe, as I do, that the fears of rapidly rising default rates are overblown.  I am not saying that state budgets are remotely healthy or that municipalities are properly funded, what I am saying is that even with all the problems states are facing, they are highly unlikely to let their bonds go into default except in the most dire of circumstances, and those instances will be far less numerous than investors currently believe.  A well-diversified portfolio of top-rated municipal bonds will offer adequate protection from the defaults the national market will eventually realize, all while giving investors a better pre- and post-tax return than Treasuries.  When the Treasury bubble eventually bursts and people feel more comfortable with the muni market, it will be time to reevaluate our positioning in each of these sectors and it will likely be time to reorient fixed income portfolios along more traditional lines (Treasures in tax-free or tax-deferred accounts and municipal bonds in taxable accounts).  And, in the case I am wrong, the risk to one’s portfolio of a muni-centric bond positioning is still fairly low since I do not believe that either market will implode on investors as long as one stays at the near-end of the yield curve, meaning short and intermediate durations.

What I must offer strong caution against in today’s environment is the temptation to “reach for yield.”  People who are used to getting 4-5% from their bonds simply have to accept that it isn’t possible in today’s environment without taking on a rather extreme amount of additional risk.  Once you begin to take on those additional risks in your bond portfolio (going out further on the yield curve, dipping into lower quality issues, buying exotic bond offerings, etc.), it ceases to do the job for which it is designed and you end up putting your overall portfolio at risk.

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Beware “geniuses”

Posted on August 15, 2010 by Rick Lesan, CFA

I just came across this short piece that quotes six well-known investment gurus who have been exceptionally wrong about US Treasuries (Julian Robertson – hedge fund guru, Nassim Taleb – author of The Black Swan, Marc Faber – investment newsletter writer and pundit, Jim Grant – well-known credit/bond expert, Bill Gross – founder and CIO of Pimco, and Paulo Pelligrini – the analyst for John Paulson who came up with the idea to short mortgages).  They each advised investors within the last year to immediately sell Treasuries before huge but certain losses occur.

Well, so far Treasuries have held up well, although who knows what will happen going forward.  But, that’s exactly the point.  Instead of using an objective analysis of how Treasuries have performed over their long history (which would have informed them that Treasuries have so far never been a disaster, no matter the time period), these six investment “geniuses” decided to advise investors to basically speculate on a short-term directional play.  Had one heeded their advice and taken a leveraged short seller’s bet against intermediate-term Treasuries using the exchange traded fund PST, that investor would be down over 24% so far this year and down over 30% if he went longer out on the Treasury yield curve with the leveraged long-term Treasury exchange traded fund TBT.

Since 1987 (the inception date of the Barclays Treasury index series), intermediate term Treasuries have performed no worse over a 12-month period than -1.77%.  Their long-term brethren, always more volatile, returned -12.94% at their worst 12-month period but still no disaster.

So, while we don’t know what will happen with US Treasuries going forward, I do think it is safe to say that investment “geniuses” are only as smart as their most recent pronouncement.  It’s best to remain objective, look at the data, and stick with what we know rather than speculate on what we don’t.  Remember, the sky is always “about to fall” somewhere if you ask enough people, smart or otherwise.  I think we should remember the teachings of Socrates and take solace in “knowing that we don’t know” while doing our best to ignore those who are less aware.

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Quick comments on several issues…

Posted on June 28, 2010 by Rick Lesan, CFA

It’s an understatement to say that much has happened recently in the capital markets and in areas that impact the capital markets.  There are a few topics in particular that continue to come up so let me quickly address them in case you are one of those who have wondered similar things but have not gotten around to asking yet.

1.  Will the effect of FinReg on Frontier Advisors be positive, negative, or neutral?
To the extent the financial regulation legislation solves some of the larger problems with financial sector culpability, excessive risk-taking, and a lack of proper regulatory oversight, the effect will be positive for anyone touched by the capital markets, which means everyone.  Unfortunately, there is far too much yet to be determined given FinReg’s vagueness for me to be confident that it will, in fact, solve those larger problems.  If pressed, my sense is that we are in for additional difficulties as we try to deal with specific issues under this legislation, but we’ll have to wait and see.  As for some of the attempted provisions such as the Volcker Rule (restricting banks from speculative investing in their proprietary accounts), increasing transparency within hedge funds and the trading of certain derivatives, and requiring that all financial advisors operate under a fiduciary standard, Frontier Advisors welcomes each of those ideas because they support what we as a firm are all about – reducing systemic risk in the global financial commons, increasing transparency whenever and wherever possible, and ensuring that the incentives of asset managers are aligned 100% with their clients.  Systemic risk is beyond our purview, but with respect to transparency and client alignment, Frontier receives top marks on both counts and it’s time for the rest of the industry to move in that direction.

2.  It has been reported that the Flash Crash of May 6 hit exchange traded funds (ETFs) particularly hard.  Given that Frontier is an advocate and heavy user of ETFs in client portfolios, did its clients suffer excessively and what has Frontier done to avoid another Flash Crash?
It is absolutely true that ETFs accounted for around 70% of the canceled trades that occurred during the 20 minutes of insanity on May 6th (IWD, the Russell 1000 Value ETF, went from around $60 to $.08 in minutes before coming back; no, we do not and did not own IWD in any client accounts!).  But ETFs reacted exactly as I would have expected during such an environment and I remain absolutely confident in them as the best way to get exposure to many of the most fundamental markets for client portfolios.  However, the Flash Crash does highlight the fact that ETFs are not to be taken lightly or thought of as foolproof any more than any other investment should be.  No client of Frontier was negatively affected by the Flash Crash because our strategy is an investment strategy and not a trading strategy, and as long as one is of that mindset and knows to stay out of the markets during such periods, there is nothing to fear.  That is not to say that improved circuit breakers and other changes shouldn’t be investigated to help markets avoid such events in the future, it just means that there is much to say about keeping one’s head during those periods and to avoid getting too fearful or greedy.

3.  In light of global economic conditions, is Frontier bullish or bearish and why?  How is that outlook reflected in your portfolios?
This answer is hard to keep brief, but I will try.  Let me first answer the question the way I normally do – my own near-term market expectations should be taken with a grain of salt since I have as much or as little a chance of being correct as any other investor, professional or amateur, human or monkey, about what will happen in either the economy or the markets over the next few months or even a few years.  Having said that, however, I do expect the developed markets to be largely range-bound for quite some time as we work through the macroeconomic problems that continue to go mostly unaddressed such as excessive leverage, high deficits, and high unemployment.  I don’t foresee the equity markets testing the previous lows of early 2009 (but I could be wrong about that, too!), nor do I see them pushing strongly forward again for a while – I think a reasonable range to expect is 950-1250 on the S&P 500 although I hate to put a number on it.  I don’t expect much out of other asset classes for a while, either, giving market-timers little in the way of exciting opportunities although that won’t stop them or the financial press from talking up the asset class of the week.  Commodities, by the way, will continue to get far too much attention as mainstream investments and it is best to steer clear of them except through the equity markets (companies and countries that are commodity-oriented).
So how is that reflected in our clients’ portfolios?  First, it is not translating into any particular shift in asset allocation because our portfolio positioning already reflects a market environment where developed economies will do less well going forward than they have in the recent past, where large cap US stocks will exhibit more risk and volatility than most account for, and where the developing economies appear to be at least as interesting as they have in the past because of their more stable fiscal positions relative to the developed markets and their own history.  Second, given our expectations of range-bound markets, we are examining tightening our rebalancing rules to take advantage, to some small degree, of range-bound volatility.  It might make sense to be even more vigilant about rebalancing when allocation targets get out of alignment as long as the cost of rebalancing is not excessive.  When markets are trending strongly in one direction or another, rebalancing will induce drag on an upward trending portfolio and increase losses on a downward trending portfolio; but when range-bound rebalancing can help reposition portfolios to reduce losses before a downward adjustment and increase gains during an upward adjustment (and if the timing is off and the costs are insignificant, no harm is done).  There is plenty to argue about this idea, however, and we are sorting through those various arguments while continuing to monitor our portfolios’ allocations relative to their targets.

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Myths about asset allocation

Posted on June 16, 2010 by Rick Lesan, CFA

I wanted to forward along the attached article, 5 Myths About Asset Allocation, from Forbes that a friend and colleague forwarded to me earlier today.  I think it does a terrific job of pointing out some of the common misconceptions out there about asset allocation.  It’s a quick read but offers a lot to think about and discuss.

The author of the article, Rick Ferri, is one of the good guys in this industry.  He heads an investment firm just outside of Detroit (Portfolio Solutions, LLC) with an investment philosophy very similar to Frontier’s.  Our clientele are slightly different as are our service models, but our approach to investing is ultimately very similar even if there are differences in execution.  Bottom line, my list of investment professional endorsements is rather short, but Rick is certainly on it and I think he’s worth listening to.

Feel free to send me a note or give me a call if you are interested in my explanation or interpretation of anything in this article, or if you would like to know more about Frontier’s investment approach and how we do or don’t differ from Mr. Ferri’s.

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A few thoughts in the midst of mayem…

Posted on May 26, 2010 by Rick Lesan, CFA

I got up today to find the markets poised for another decently sized sell-off and that is what is happening as I write this – the S&P is around 1050 and the Dow is at 9849 with all the gains since November wiped away.  The VIX, a gauge of market volatility and hence “fear”, is hovering around 40 (the same levels we saw after 9/11, Long-Term Capital, the Russian financial crisis, and the WorldCom bankruptcy filing).  The worries are the sovereign debt problems in Europe will soon engulf Spain and that the recovery here in the UK may not be as assured as many hoped. If your business needs help, use the next link to find about the best UK IVA Companies.

And yet I find myself feeling a significant amount of relief.  While I’m certainly not happy to see those gains since November wiped away (and possibly more – it’s still not even noon), I have been uncomfortable for months on end as the markets relentlessly plodded upward while none of the underlying reasons for the recession have been adequately dealt with.  There has been a significant disconnect with what was happening in the equity markets and what was not happening with financial regulation, debt levels, toxic assets, or austerity measures.  Now, perhaps, the markets may finally be catching on and that is a very good thing.

It is a good thing because it hopefully brings rational thought back to the forefront.  It means that we may be entering a period when the necessary changes can actually be instituted and not blocked or watered down by ridiculous politics.  Here in the U.S. we are getting much closer to passing the most sweeping financial regulatory reform in decades.  I’m not saying they will get everything right, but it is a step in the right direction.  By getting closer to the brink in Europe we are beginning to come to grips with their problems, too, although we are likely at the beginning of working our way through that.  The point is, we are finally…hopefully…beginning to be honest with ourselves.  Do I think we will continue to remain honest and objective?  Certainly not.  But the last 13 months of persistent irrationality have actually been quite painful for me and I am finally getting some relief, albeit in a rather backwards sort of way.

So, we should all do ourselves a favor and try to embrace the short term fluctuations we are now experiencing as something strangely positive.  Maintain an eye toward the longer term and take solace in the hope that we are getting closer to a market environment where long term development issues can actually be a part of the discussion (just look in today’s Financial Times for examples about shale gas “changing the world” and emerging markets helping the developed world avoid a “lost decade”).  Don’t waste your time worrying about which asset class will be most protective over the next day/week/month or how to capitalize from this market sell-off because your chances (or your active manager’s chances) of being right are probably less than 50/50 for reasons I’d be happy to discuss.  Do not be attracted to those alternative asset classes that have become so popular during uncertain times such as commodities, currencies, and all the strategies around them – let the “experts” get their shirts handed to them and stick to the markets and asset classes that actually create tangible value for investors over the long-term.  Rebalance as necessary and trust your long-term asset allocation if it was well conceived in the first place, and if it wasn’t or you’re not sure then please get in touch.  I’ll be happy to help.

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A quick note about the markets…

Posted on May 4, 2010 by Rick Lesan, CFA

I just wanted to send a quick note about the recent volatility in the global markets.  We’ll see where today’s markets end up, but as I am writing this email we’re down around 2% in the US and the European markets are off even more.  We may be seeing something we’ve seen time and again where the small investor, after having just gotten back in the market following a significant upward movement off of last year’s lows, gets hammered in yet another sell-off.  The small, do-it-yourselfer will get scared all over again and sell after losing another 3-5% of his assets and not get back in until the markets mostly recover.  We see it every time the markets correct and fickleness behind those who don’t have someone providing objective advice is probably the most significant cause of wealth deterioration in the public markets.  So let me offer some objective advice…

First, a word or two about what is likely going on.  While most of the economic data out of the US has been positive, we are still missing the all important recovery in jobs, income, and housing.  The productivity numbers and early signs of business spending are real, but the increased spending by consumers can evaporate as quickly as it returned and there is still a real concern that housing foreclosures are going to increase in a major way.  While most think a broad recovery is underway (I include myself in this group), it is still in its infancy, is very tenuous, and the markets know it.  But while we may see a light at the end of the tunnel here in the US, we’re seeing serious signs of weakness in sovereign debt over in Europe and there are significant concerns that Greece will eventually go bankrupt and other countries may soon follow: Spain, Portugal, Italy, and yes, even the UK is being included in the group of contagion concerns because of its fiscal imbalances.

The situation in Europe is what has me most concerned, and trouble there is most definitely causing trouble here in the US markets.  We could be at the beginning of an overall unraveling of the European Union, although I expect that is highly unlikely.  Nevertheless, it is concerns such as these that are likely driving the markets lower and it may take a while for them to calm down again since the trouble in Europe will take considerable time to figure out.

However, “sell in May and go away” is not the solution.  While it will likely appear to be the right call many times over the course of the summer, remember that getting out of the markets always involves the dilemma of when to get back in.  Let me tell you from experience that knowing either side of that decision with any certainty is practically impossible and any true investment professional will agree with me wholeheartedly.  The better solution, and what we already have in place here at Frontier, is to have your portfolio properly allocated so that the risks to the most dangerous areas of the global marketplace are reduced and you have some form of protection against an equity sell-off via bonds.  Our equity portfolios are and have been underweight Europe since we launched last year, and our current weighting in Greece (within equities) is almost non-existent at around 10 basis points, or one tenth of one percent of the equity portfolio.  The MSCI All Country World Index (MSCI ACWI) at the end of March had a weighting in Europe of nearly 27% but ours was at 15%.  The underweight in Europe needs to be accounted for elsewhere, of course, and our portfolios have overweights relative to the MSCI ACWI in both the US and the Emerging Markets.  So while we clearly have our own risks to confront, we think they are much wiser given the state of the global economy and what we think are the true opportunities over the next 3-5 years.

And do not forgo your bond allocation.  Unfortunately it is a very uncomfortable time within fixed income, too.  Treasury bond-watchers are waiting for a sell-off any day due to our own fiscal imbalances here in the US, and it seems no one is comfortable with the status of the municipal bond markets, either, since many states are near bankruptcy themselves.  And forget about investing in sovereign debt since that is the main cause of the trouble with European equities!  Nevertheless, bonds and stocks to continue to offer a certain amount of low and even negative correlation so it is important to maintain the overall target allocation between stocks and bonds during turbulent markets.  For fixed income, Frontier clients are strictly in US bonds since I prefer to leave international risks to the equity portfolio, and within the US bond markets I feel that municipal debt is the better place to be right now due to higher yields per equivalent credit quality.  While the risk of default has increased relative to history, I’m still comfortable enough with the high quality US bond sectors overall.

So stay in the markets but continue to monitor your portfolio so that you can take advantage of any rebalancing opportunities that might present themselves as the markets gyrate.  No one said investing is easy, but staying on top of things and remaining unemotional will pay off in the long run.

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The true cost of investing

Posted on March 4, 2010 by Rick Lesan, CFA

By now many of you are aware that I try to get people to think about their relationship with their investment advisor in terms of three things: advice, portfolio construction/management, and fees/costs.  I recently distributed a shortpaper that covered all three to some degree, but it focused primarily on advice and portfolio construction/management.  Attached is another paper (The True Cost of Investing) that goes into detail about the various costs an investor faces as s/he seeks to capitalize on what the public markets offer.  The sum of these costs is far greater than most realize, and the effect on one’s portfolio value over the long term is astounding.  There is good news, however.  These costs can be significantly reduced and the savings put back to work for the investor, giving that investor a much better chance of reaching his financial objectives.

While this paper is a clear endorsement for how we manage assets at Frontier, this information is useful to anyone regardless of where your assets are held.  What is important is that we all become more knowledgeable investors and consumers of investment services so that we improve our odds of attaining whatever investment objectives we set for ourselves.  I hope you find this paper useful, and please pass it along to anyone else you think might find value in it.

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Evaluating investment firms

Posted on February 3, 2010 by Rick Lesan, CFA

There are certain topics that are crucial for investors to fully understand.  Attached is a shortpaper I authored, Evaluating Investment Firms, that covers some of the fundamental topics any investor should consider before hiring an individual or firm as a steward for their hard earned assets, either in part or in total.  I find that most private investors have no evaluation framework whatsoever, and for those who do, their framework leaves much out.  I created the framework discussed in this paper as an insider in the investment business and one who knows a bit about “where the bodies are buried,” so it covers a considerable amount and helps the reader ask tough and important questions of those being evaluated.

Also, this is the framework I used when creating the Frontier Advisors business model, so you can be sure that my firm has good answers to everything raised in this shortpaper (feel free to ask!).

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