Market Musings Blog

In our last blog we railed about how everyone calls themselves an ‘investment adviser’ – but many are not. Here is our handy guide to all the folks out there and what they really do.

Broker: Sells product. Paid by commission. Has an incentive to make changes in order to get paid, or at least to sell you in-house mutual funds, annuities, insurance policies with long term, ‘trailing’ commissions where he gets paid for several years after you buy. BEWARE: the broker can turn into a ‘financial adviser’ while sitting at the same desk, and ALSO charge you management fees. Sometimes this will happen if the broker asks to split your account. On one, he takes commissions; on the other, he takes fees. Defense: ask exactly how much you will pay per year, in dollars, if you invest a certain amount of money with the broker. Ask for his performance record.

Financial Planner: No offense to these folks, but many are jack of all trades and master of none. They often charge fees AND commissions. They budget or create a plan for you using a software program purchased from a vendor. Review the plan carefully; I have seen errors like inflation escalators on mortgage payments that are fixed, and totally unrealistic investment return patterns that culminate in showing you that you will be worth six million dollars in twenty years when you start with $500,000. Financial planners may also help you with your insurance needs (read: sell you expensive insurance policies), estate planning and taxes. They are eager to manage your money. Defense: Ask how much you will be charged. Ask what is the underlying theory behind the practice: is the firm aggressive, or conservative? Be sure you understand how the fat book you will receive with fields of numbers and charts relates to YOU. Look for credentials and career persistence in the field of specialty. We generally believe it is better to get tax advice from a CPA, estate planning advice from an estate planning attorney, and investment advice from a professional money manager, because you are then tapping into specific expertise for every facet of your requirements.

Registered Investment Adviser (RIA): This refers only to the requirement that the firm register either in the state where it practices or with the Securities & Exchange Commission. It communicates very little information about what kind of firm or person you are dealing with.

Portfolio Manager: Cascade’s professional staff are all portfolio managers. Like other portfolio managers, we spend 100% of our time determining what clients need to earn to meet their goals, and researching solutions in the form of securities purchases and sales to achieve those goals at an appropriate level of risk. Paid by fee only. “Fee only” generally aligns client interest with the manager’s interest, in that if the asset base does what it is supposed to do, you stay with the manager, and he keeps getting paid. Defense: understand the investment philosophy and why it is supposed to work. Ask how it works in good markets and bad.

Aside from these typical adviser types, you will encounter CPAs, lawyers, and all sorts of other practitioners who want to manage your money. Again, find out how much you will pay, research credentials, and ask for past performance in all market cycles for the type of account you have.

I am passionate about what I do, and I am glad that I bent my career away from economics and towards becoming a money manager. But the ‘advice industry’ as it is now called drives me nuts. Perusing the industry magazines that arrive for free in our mailbox is completely depressing. While a few articles focus on investment ideas – usually the latest expensive product that can generate a ton of commissions like hedge funds or ‘liquid alts’ – the preponderance of the literature is geared towards signing new clients, or acquiring other firms, or how to be acquired. In other news, ‘watchdog’ firms like Morningstar name “managers of the year” who then underperform with great regularity. This serves as a kick in the teeth to investors who try to find managers with true skill.

Speaking of performance, managers do a terrible job differentiating their investment portfolios and philosophies to clients. Index funds are swallowing the industry, and that’s at least partially the fault of the managers who practice our craft. Practitioners make the same mistakes over and over, without discovering a way to outperform. No wonder investors turn to index funds – there is hardly any help for the lay person who might want to try to find a good manager, and the ‘help’ that exists – manager of the year, fund of the year awards – often backfire.

Meanwhile, hardly a week goes by but what some adviser or another doesn’t commit some sort of fraud against clients, causing ever tightening nets of regulation to drop on all of us.

Our own bad habits are perpetuated by our nomenclature. Everyone calls themselves an ‘investment adviser’ – financial planners and brokers who charge commissions, money managers, registered investment advisers. No one can tell the difference.

Next blog, we’ll provide a short guide to the adviser types you might encounter, so that at least you can be armed with that knowledge.

Some years ago, Wall Street decided that Brazil, Russia, India and China would be ‘hot’ markets, with all that growth and development happening. These countries in aggregate were called the BRIC, an acronym coined by Goldman Sachs’ Jim O’Neill. Every conference we attended, we heard BRIC BRIC BRIC. Inevitably, BRIC mutual funds and ETFs proliferated. We checked several well known versions recently – Templeton’s TABRX, iShares CBQ, iShares BKF, and Guggenheim’s EEB. None of these funds have produced returns even close to 1% per year over the last five years. In order to harvest a decent return out of these funds, you would have had to be as nimble as a cat on a hot tin roof, skipping in and out year by year. No one can do that effectively.

Next was hedge funds. Technically we can’t really call these a Wall Street invention. Some hedge funds are run by people who want nothing to do with Wall Street. Still, Wall Street has been more than happy to jump on the bandwagon, spurring the proliferation of these funds beyond all reason. Outrageous fees have aided the trend towards more offerings. Why work for 1% of assets when you can get 2% and then 20% of profits (shorthand: two and twenty). The hedge fund trend has sucked managers from mutual fund companies where they felt they were underpaid, so they can trade in the same securities but pocket more at the expense of the investor. CALPERS, the big California pension fund, came to its senses first, and is excising hedge funds from its investment program. More pension funds will follow. The funds have struggled to beat a plain old 60/40 stock/bond mix. This may be due to the sheer number of funds now picking over every opportunity, and thus arbitraging away all excess return.

What’s next? “Liquid Alts.” This refers to a fund containing investments in normally illiquid, exotic instruments like merger arbitrage, private credit issues, derivatives, and packaged hedge funds. Of course, these cost an arm and a leg, too. The trend to liquid alts was supported by the ‘failure’ of diversification in the ’08/’09 credit crisis. (We’re not going to take up the notion that diversification ‘failed’ here, except to say it didn’t. Most investors, after a long bull market, were simply positioned with too much risk.) Billions of dollars have flowed to these strategies, alarming the SEC, which is conducting examinations of big liquid alt providers to figure out if they will actually be liquid in a very bad market. We bet they won’t. We were completely shocked to read an article in one of the worst publications put out by our industry which very nearly declared that any advisor not using liquid alts was as good as committing malpractice, and that – according to a Goldman rep, who conveniently sells liquid alts – at least 19% of client assets should be in liquid alts.

Don’t fall for this crap. View it like it is: Wall Street’s effort to make you part with more of your money to line their pockets. And possibly, more dangerously, a sore spot that will turn to gangrene when the next bear market visits.

Today, Venezuela begged OPEC to convene a meeting to curtail production and boost oil prices. OPEC turned a deaf ear. In case you hadn’t heard, Venezuela is not doing so well. Inflation is rampant, the poor are getting poorer, basic household goods aren’t available – in short, the ‘revolution’ is failing. Things were good when oil prices were high: the big revenue allowed for handouts, public takeovers of private companies, and most importantly, luxury goods for the political elite. With revenue falling like a rock, politicians are desperate. One answer? Pump oil like mad.

Meanwhile, Russia, struggling with a recession, budget deficits, and a war, is one of the world’s largest oil producers. Oil makes up a third to a half of government revenues. Russia really needs oil to stay above $100 a barrel. But, a short term answer to falling prices is… more oil.

What about ISIS? Apparently, this terror group scrapes money from oil fields, which helps fund its operations. We have no particular confidence economic principals play much of a role in the thought process of ISIS. If you can compel workers to operate the wells, you can merely collect the revenue no matter what it cost to extract. So to keep terrorizing, you pump oil.

It will be interesting how despots react to lower oil prices. In an ironic twist, a reaction geared towards keeping revenues up will benefit the West in a big way. Probably not what they had in mind.

Risk is inextricably tied to return. It is not true that taking higher risk means you will see higher returns, What is true is that higher risk raises the probability that you will harvest higher returns. It also raises the probability of losses (see our last post).

Part of any investment manager’s job is to gauge the potential risk of an asset. If you accept a ‘lock up’ on an investment preventing you from selling it for a time, risk increases. If debt is used to finance the asset, risk increases. If operating results are lousy, risk is high. If an investment has multiple partners, risk can be high depending on entity structure. Merging companies present risk, even building a new plant can be risky. Once you identify sources of risk, the next rule is to get paid for accepting that risk.

You can’t know what future returns will be, but many assets offer clues. A stock that pays a 6% dividend yield when everything else is yielding 3% is probably riskier than normal, but that upfront payment is a good start towards a healthy return – if the payout can persist. Real estate investments that offer net cash flow of 3% or 4% in addition to future rent increases and modest appreciation; bonds that sell at a discount and also pay cash flow of 5% to 6%; private equity investments with ever growing valuations at each new investment round; these are examples of assets that could deliver above average returns.

What’s ‘average’? We benchmark most assets to long term stock returns, which are roughly 9.5% per year since 1926; bad years can shave 45% off your portfolio value. If you are taking stock-like risk in some exotic asset, with potential losses on the table, there had better be a potential return above 9.5%. Bond returns since 1926 – using intermediate corporate issues as our benchmark – are between 5% and 6% per year on average; bad years are not really very bad in the bond department, with losses only amounting to about 5% in the worst year for these maturities. If you finance a real estate development for your buddy, you are essentially issuing a private bond, and you’d better insist on more than 6%.

Using comparisons to historical returns and losses lets you approach risk with eyes wide open.