MARKET INSIGHTS

Forest fires are terrifying to witness. Having lived in California for a couple of years in the mid 2000’s, I didn’t have to go far to find traces of nature’s fury given the dry climate. Once started, forest fires have little hope of being extinguished by human efforts – only contained. The goal of the heroic fire crews that battle the inferno is to “control burn” as much fuel in advance of the actual blaze so that there is nothing left to burn once the fire arrives. There is no doubt, on seeing an actual forest fire from a distance or its aftermath, that the intensity is high, the path is indiscriminate, and the damage is quick but severe.

Activity in global equities over the past three trading sessions (February 2nd, 5th, and 6th) is allegorical to forest fires, seeing steep daily declines in stocks for seemingly no reason. Yet, was there really no reason for the recent declines? As we’ve indicated since Q4 of 2017, the fuel for the recent forest fire was created through the combination of (1) excessively high investor sentiment, (2) exceedingly low volatility (e.g., VIX), and (3) large money flows into stocks. Each one of these, alone, was not problematic, but all combined made a different situation entirely. Incidentally, observation of the conditions above led our Investment Committee to recommend a portfolio rebalance prior to the recent drop.

What sparked the sell-off?

While pinpointing the exact reason is almost impossible, the most likely source of the recent selling pressure has been the upward movement in US interest rates. As can be seen in the chart below, recent moves in the 10yr US Treasury bond have brought rates to near 3%, a level not seen since 2013 during the so-called “taper tantrum.” Higher rates become an issue because, at some point, bonds become competitive with stocks for portfolio allocations.

In our opinion, the other root cause of the sell-off has to do with the unwinding of the short volatility trade that has been very popular with both hedge funds and pension funds. Essentially, since the “flash crash” (which occurred in late 2015), volatility in the options markets (as measured by the VIX index, seen below) has moved to extremely low levels. This low reading in the VIX index signals that portfolio hedging with options has not been occurring to any significant degree. Further, this expectation of low future volatility was being speculated on by many (to include pension funds) as a way to enhance return in a portfolio. The problem with this strategy, however, is that once investors begin to unwind these speculative VIX positions, this process creates a positive feedback loop sending volatility higher. Many taking these speculative positions may have only fully realized the risks inherent in such a strategy once the sell-off began.

Where do we go from here?

Just like in a forest fire, while the intensity is high and the moves are erratic, we don’t see the selling pressure lasting for much longer once the fuel of interest rate movements and VIX position unwinding dissipates. That is not to say that equity markets could not move lower from here over the near term. But given the tinder of suppressed volatility, low interest rates, and excessive investor sentiment, a garden variety correction in the 5-10% range makes sense. On the other side of this current corrective phase for equity markets, the excesses will have been cleared out, allowing investors to focus on some of the positive factors present in the markets. In our view, global equity markets can move higher over the remainder of the year based on a combination of the following positive dynamics:

(1) Global earnings and revenue growth are strong
(2) All major economic regions around the globe are in a synchronized expansion
(3) US Interest rates aren’t rising in a disorderly manner
(4) High Yield bonds aren’t signaling duress
(5) Global inflation remains modest (between 2-3%)

In summary, as we await the culmination of the current corrective phase in equity markets, we would like to highlight that periods like this underscore the need for diversified investment portfolios. This diversification includes allocations to cash, fixed income and, where appropriate, alternative assets. Specific to cash holdings, most portfolios have been positioned with elevated cash levels due to our recent rebalancing activity. This cash will give us optionality in the case that equity prices decide to move markedly further from current levels. We’ll look to redeploy this cash as opportunities arise.

As we approach the final stages of the current bull market, episodes like the one we currently find ourselves in should be considered the norm as opposed to the exception. This heightened level of equity volatility will test resolve and challenge investor convictions, which is why we’ve been revisiting client risk profiles and cash flow goals in recent months. Rest assured, we are mindful of many of the risks being discussed in the equity markets. If the fundamentals of this aging economic recovery change then we will take appropriate action. For now, we need to let the fire burn the accumulated tinder on the forest floor so that we can move higher from here.

Authored By:

Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of February 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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“There is an art to science, and a science in art: the two are not enemies, but different aspects of the whole.”  —Isaac Asimov

“Rely on the ordinary virtues that intelligent, balanced human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance.”  — John C. Bogle

“Never buy anything from someone who is out of breath.”  —Burton Malkiel

Patrick Nolan, CAIA, Portfolio Manager – Private Markets  — At Gratus Capital, my role includes sourcing and screening investments, conducting due diligence, negotiating investment terms and monitoring performance of private investment opportunities.  In this post, I want to describe the process I use and share some interesting experiences I have encountered along the way.

Sourcing, Screening and Due Diligence

Due diligence is the research and analysis of a company or organization done in preparation for a business transaction [i].  Of the “investable universe,” select firms are identified as potential investment candidates.  Of these, fewer make it through a preliminary screening and are reviewed more deeply.  From the firms selected for review, only a small portion are selected for a full due diligence review.

I introduce this process to demonstrate that conducting due diligence according to a standard requires considerable effort.  After sourcing and screening, I use metrics to disqualify managers and judge the best from the rest.  I developed this due diligence process from my experience in institutional-level timberland and apartment investing.  In addition to my experience, I rely heavily on the Institutional Limited Partners Association’s (ILPA) [ii] sample Due Diligence Questionnaire and Chartered Alternative Investment Analyst Association publications.

According to Brown, Fraser and Liang, the cost of due diligence depends on a series of factors, including the time spent, the level of thoroughness and whether accounting firms, law firms, third-party service providers and consulting firms are used. These authors assume “a conservative cost of due diligence of $50,000 to $100,000 [per single institutional hedge fund allocation]” but contend that effective due diligence of funds in the selection of fund managers can generate alpha for an investor’s portfolio [iii].

I’ve heard that there is an art and a science behind any worthwhile endeavor.  Gratus’s due diligence process has a solid foundation in the “science” of private investing.  Having proper procedures in place is critical, but so is a focus on the spirit of the task.  Procedure must not cloud the goal of judging the worthiness of a manager and the overall attractiveness of an opportunity.  To demonstrate the two sides of due diligence, I’ll list some of the questions behind the “science” and then share the more interesting anecdotes that make up the “art”.

The “Science” of Due Diligence

Below are a few of the ILPA’s recommended BASIC questions for Limited Partners to present to Investment Managers:

  • Will Placement Agents be used during the fundraising process?
  • Were there any carry clawback situations in any of the Firm’s prior funds?
  • Are any investments in the Firm’s track record excluded from provided materials?

And a sampling of recommended DETAILED questions to an Investment Manager:

  • Describe any significant staff departures that are expected to occur between now and the end of the Fund’s investment period.
  • How will investment opportunities be allocated between active funds? Discuss any funds and/or separate accounts with potential allocation considerations.
  • During deal structuring, what is the process for integrating ESG-related consideration into the deal documentation and/ or the post-investment action plan? (ESG: Environmental, Social and corporate Governance)

In addition to 15 pages of similar questions, the ILPA goes on to provide multi-page templates for reporting portfolio investments, funds, professional references and team member biographies.  To top it all off, the ILPA ends with a list of 33 requested documents including Firm budgets, a list of LP secondary sales, and annual meeting presentations for the last 2 years!  Lastly, third-party auditors, custodians, accountants and investigators are suggested in order to triangulate and verify the subject’s response.  The result is a pile of information that may be erroneous or even fraudulent.  The process may create value, but it may also only create a false sense of security.

The “Art” of Due Diligence

Clearly the ILPA provides a road map for thorough institutional private investment due diligence.  The inclusion of third-parties to verify facts creates another layer of confidence.  But at what cost?  What resources are required of both the interviewer and interviewee to conduct such a review?  What great opportunities are missed if the ILPA is followed too closely?  Clearly there is a role for these questions if the investor is a public institution that is highly sensitive to any type of headline risk.  But many investors are not political targets with a large public presence.  Additionally, most investments only carry a small portion of the possible risks covered by the ILPA.  Common sense is in order.  Relying too heavily on the ILPA would be counterproductive for some investors’ task at hand.  This is where I value the “art” rather than the “science” of due diligence.  Below I’ve categorized some examples that capture the subtleties of properly evaluating a manager and a potential private investment.

Lack of Professionalism

  • What should you do when a manager is unreliable during the due diligence process?  Do they say they will do things and not follow through?  Can you responsibly trust a manager to conduct themselves professionally after they’ve been awarded your money if they are unreliable before they’ve received your money?  Better to pass on the relationship.
  • How should you approach an opportunity with incomplete information?  Many popular managers request verbal commitments prior to having finalized legal documents.  This tells me a few things: either they are well-seasoned and have numerous relationships or they are trying to pressure investors into a deal while withholding details. Verbal commitments with pre-existing managers is one thing, but making first-time investments with a manager that requires commitments prior to providing complete information is a bad idea.  Lastly, this may reveal that the manager’s clients have become complacent and are relying on the persistence of past performance. These are signs of a mature and well-worn strategy that may be better to avoid [iv].

Misleading Marketing

  • Sloppy marketing materials are a sign that the manager is likely sloppy in other facets of their business and possibly in their investment underwriting.  When I find marketing materials that specifically contradict or do not mesh with corresponding legal documents, I penalize accordingly.  While these mistakes are likely careless, they may also be purposefully misleading.  I don’t want to deal with a manager that is guilty of either.
  • I’ve come across managers that sell a popular trend, even when it isn’t entirely accurate. For example, one office manager suggested that a property was in the currently en vogue market of Nashville, TN.  Technically the property was a part of the greater metro-area, but it was 17 miles from downtown.  Not exactly an honest description.
  • I often see project-level returns in marketing materials.  This is clearly misleading, because clients will receive the performance net of fees and expenses.
  • Optimism is not a strategy.  I often see deals where the entire strategy is the assumption that past performance will persist or that there will be increased demand for the product in the future.  For me to become comfortable with a deal, I want to see a model with flat or decreasing demand, a.k.a. cap rate expansion.
  • “Cash-On-Cash” return.  What if you gave me $10 today and I gave you $1 each year for 10 years. Does that sound like 10% “Cash-on-Cash” return?  Or even worse, an average of 12.9% “Cash-On-Cash” return?  There are more realistic examples, but I see this line of reasoning often when managers quote “Cash-On-Cash” return.  The confusion stems from unreported losses, return of capital that is not income, or a reduction of capital account balance. Distributions are meaningless if you don’t know whether they represent income or return of capital.  Often, one cannot be certain until the asset is sold and fully realized. Solution: Ask for equity multiples and IRR returns.

Unattractive Terms

  • Conflicts of interest are sometimes unavoidable.  If they are small and are properly transparent, then conflicts of interest will not disqualify a deal. Three conflicts that I recently found were unnecessary and were a somewhat dubious effort to sneak additional fees out of the deal.
    • Fees based on Potential Rent.  Why not compensate on actual rent?  Potential rent can be set by the manager as a benchmark.  ‘Fees based on Potential Rent’ is synonymous with giving the manager a blank check.
    • Acquisition fees based on purchase price. This is pervasive in real estate, but I think it should be challenged more often.  Once a manager has client capital secured, they are actually incentivized to pay more for a property!  I don’t see this going away, but I also like to bring it up with managers and let them know that I do not like this form of compensation.  A better solution might be a percentage of equity, as this would incentivize the manager to balance the proper mix of debt and equity.
    • Fees on construction costs.  This is another perverse misalignment of interests, and managers should be pressured to seek compensation elsewhere [v].
  • Catch-up clauses.  I will try not to get lost in the details here, but catch-up clauses on carried interest are an additional layer of fees that managers often use.  I suspect that many investors do not fully realize the hidden expense of a catch-up clause.  Put simply, think of a catch-up clause as retroactively removing the performance hurdle after it has been achieved.  This is sometimes referred to as a soft hurdle (catch-up) or a hard hurdle (no catch-up).  Consider a 20% carried interest (often called the ‘promote’) and an 8% hurdle (often called the ‘preferred return’).  If there is a 13% return after management fees and expenses, then with no catch-up, the manger would receive 1% (20% of the return above 8%).  With a catch-up, the manager would receive every dollar from 8% to 10% in order to ensure that they receive 20% of all profits, and then 20% of profits from 10% to 13%.  This catch-up comes to 2.6%.  This equates to a 10.4% return for the LP investor instead of 12%.  This also means that the manager has less incentive after a gross return of 10%, because they’ve received most of their compensation already.
  • Lastly, how long do you want to be invested in a deal?  Managers say they will be out of a deal in 5 years, but when you ask for it in writing in the documents, sometimes they won’t agree.  If a manager will not put a 10-year maximum term on a 5-year business plan, then I have less trust in their business plan.  Managers often want full flexibility to hold a property and avoid selling into a poor market.  I’ve worked around this problem by agreeing on buy-out clauses.  In short, a manager’s legal documents should reflect the business plan.

In all, I hope this description relays my view of both the art and the science of private investment due diligence.  The science is certainly an important and necessary step in reviewing an opportunity, but thinking creatively is also important when seeking the best possible managers and investments.   As an alternative asset manager, we will continue to strive to bring both aspects of the process together for the long-term benefit of our clients.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice.  The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results.  In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses.  There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.  Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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[i] Merriam Webster Dictionary defines due diligence as: research and analysis of a company or organization done in preparation for a business transaction.

[ii]  “The ILPA is the only global, member-driven organization dedicated exclusively to advancing the interests of private equity Limited Partners through industry-leading education programs, independent research, best practices, networking opportunities and global collaborations.  Initially founded as an informal networking group, the ILPA is a voluntary association funded by its members. The ILPA membership has grown to include over 400 member organizations from around the world representing over US $1 trillion of private assets globally.” https://ilpa.org/

[iii] Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy https://ilpa.org/wp-content/uploads/2016/09/ILPA_Due_Diligence_Questionnaire_v1.1.pdf

[iv] I have noticed this behavior in many apartment community investments.

[v] I often see these fees on projects sponsored by vertically integrated operators.

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Not so long ago, only the ultra-wealthy and large institutions such as banks and public pensions had access to alternative investment opportunities. Today, almost any individual investor has access to these versatile investment tools. However, the key question is, are alternative investments right for you?

Before deciding, let’s take a look at what an alternative investment really is and its potential impact on an individual investor’s financial portfolio.

According to the Huffington Post[i], alternative investments are investments in assets other than stocks, bonds and cash, essentially investments using strategies that go beyond traditional ways of investing. Gratus Capital Chartered Alternative Investment Analyst and Director of Investments Todd Jones, MBA, CAIA agrees.

However, Jones takes the definition a step further.

“At Gratus Capital, to be considered an alternative investment, the investment vehicle must not exhibit a correlation of greater than 0.60 to either the stock or bond markets in any rolling three-year period,” said Jones. “Otherwise, we exclude the investment from our universe of alternative investments when making selections for client portfolios. Alternative investments are meant to provide diversification and a unique income stream return. In fact, we don’t expect alternative investments to outperform the equities or fixed income markets. Instead, our approach is to identify alternative investments that, on average, have returns that are no greater than the equities markets and no lower than the fixed income markets.”

Jones also believes that almost every portfolio should include at least a small amount of alternative investments because of the diversification value typically generated by this asset type.

Legitimacy of Alternative Investments

“There has been a multitude of alternative investments entering the financial marketplace compared to just three years ago,” said Jones. “Individual investors should be very cautious. Roughly 95 percent of alternative investments available today engage in strategies that provide minimal benefit to a portfolio. Far too often the investment doesn’t perform as described, the return is too low, or the fees are too high.”

Types of Alternative Investments

There are many different types of alternative investments. Sang H. Lee of The Street offers the following examples:

  • Venture Capital
  • Private Equity
  • Hedge Funds
  • Real Estate Investment Trust (REITs)
  • Commodities
  • Real Assets: precious metals, rare coins, wine and art

Jones cautions investors who are contemplating alternative investments such as art, rare stamps, or wine, because the values of these assets are mostly driven by personal taste and sentiment. Instead, Jones recommends that investors focus on alternative assets that can be deeply analyzed: specifically, assets that have ample data to forecast valuations and output key metrics and trends.

Today, we’ll discuss three alternative investment strategies:

#1 – Interval Mutual Funds

InvestmentNews offers the following definition: Interval Mutual Funds[ii] are mutual funds that offer daily purchase for investment but liquidity for limited redemptions at specific intervals (usually quarterly). This change to the mutual fund structure creates large advantages: the fund can simultaneously invest in both private and public assets in a structure that has a liquidity feature and a daily net asset value. This allows the sponsor to create a portfolio of investments that may provide higher levels of yield and noncorrelation to equities, but without the illiquidity and lack of price transparency.

#2 – Private Equity

Financial news giant Investopedia provides the following definition: Private Equity[iii] is capital that is not noted on a public exchange. Private Equity is composed of funds and investors that directly invest in private companies or that engage in buyouts of public companies, resulting in the delisting of public equity.

Typically, private equity investments have been limited to large institutional investors or a person or organization that can allocate at least five million dollars to one single idea or asset. However, access to private equity investments is becoming more of a necessity for mass affluent investors, said Jones.

Why?

Recent news coverage of disappointing IPO offerings for private companies such as Blue Apron[iv] and Snapchat[v] is spurring other profitable private companies to remain private, limiting investment opportunities for investors.

“Now, quality companies that would typically go public early in their business lifecycle are remaining private much longer,” said Jones. “This is problematic for investors, since it limits investment opportunities, especially ones that substantially help an investor to diversify their portfolio.”

For Example:

Amazon went public in 1997. The company’s valuation at the time was approximately $300 million.  Today, it’s roughly a $300 billion dollar company. However, all the growth that has happened since Amazon’s public offering has led to massive investment opportunity and growth for individual investors, according to Jones.

With many large private companies retaining their private status, financial advisory firms are creating new opportunities for their clients.

“Back in 2013, Gratus Capital began formulating ways to gain access to private investment returns,” said Jones. “We began forming limited partnerships for our accredited investors, in order to gain access to existing private investments. This past June, we raised capital and closed our first fund that focuses on private debt and credit as well as private real estate. Our subsequent funds will more likely have a capital appreciation focus. We see these limited partnerships as a necessary evolution of our services if we’re to help our clients achieve targeted rates of return. Specifically, we’re seeking to access illiquid markets that are private and that generate above-average market returns.”

#3 – Hedge Funds

Hedge funds use pooled funds of underlying securities to earn returns for investors. According to Investopedia[vi], the most cited reason to include them in any portfolio is their ability to reduce risk and add diversification. Also, a hedge fund that provides consistent returns increases the level of portfolio stability when traditional investments are underperforming or, at most, are highly unpredictable.

BarclayHedge[vii] reminds investors that hedge funds are not currently regulated by the U.S. Securities and Exchange Commission (SEC). The financial research firm adds that hedge funds can invest in a wider range of securities than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks and bonds,  they are best known for using more sophisticated (and risky) investments and techniques.

Choose Alternative Investments that Align with Individual Goals

BlackRock[viii] recommends investors choose alternatives that align with their distinctive goals. The investment giant gives four common objectives:

  1. To mitigate the effects of stock market volatility
  2. To lower correlation to traditional stock and bond markets
  3. To invest capital for a longer time frame in exchange for higher return potential
  4. To hedge a portfolio against inflation or rising interest rates

In Closing

At Gratus Capital, we believe that almost every financial portfolio should include some level of alternative investments specifically to sustain diversification and separation from the stock and bond markets.

Alternative investment strategies are not to be taken lightly, particularly when deciding between liquid and illiquid assets. Overall, it’s important to focus on what you’re seeking to achieve within your financial plan and how much risk you’re willing to take.

Alternative investments tend to come with higher risk; however, they can also come with greater than average returns. If you have questions about alternative investments or your overall lifetime financial plan, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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[i] http://www.huffingtonpost.com/madelaine-dangelo/5-common-alternative-inve_b_14366582.html

[ii] http://www.investmentnews.com/article/20140506/BLOG09/140509948/the-rise-of-interval-funds-mutual-funds-for-alternative-investing

[iii] http://www.investopedia.com/terms/p/privateequity.asp

[iv] http://money.cnn.com/2017/06/28/investing/blue-apron-ipo-price-range-cut/index.html

[v] http://www.cnbc.com/2017/06/26/snap-shares-may-be-unable-able-to-stay-above-ipo-price.html

[vi] http://www.investopedia.com/university/hedge-fund/place-in-portfolio.asp?lgl=rira-baseline-vertical

[vii] https://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/what-is-a-hedge-fund.html

[viii] https://www.blackrock.com/investing/resources/education/alternative-investments-education-center/how-can-i-use-alternative-investments

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When one considers Dennis Rodman, what typically comes to mind are his off-court exploits – most notably his trips to the communist state of North Korea[1]. It’s hard to tell what Rodman is bringing to the table during these meetings other than something akin to being a court jester. But in this update, we’ll focus on Rodman’s on-court exploits and what he did for basketball teams he played for during the late 1980s and early 1990s.

What relevance does Dennis Rodman have to an investment portfolio? According to teammates and opponents, Dennis Rodman brought a valuable combination of defense and second-chance opportunities. In our mind, defense and second-chance opportunities in the NBA translate into investment portfolio benefits such as diversification, staying power, and optionality. We’ll discuss each of these concepts below, but the overarching concept is that all portfolios could use more Dennis Rodman.

Diversification

We’ve written about the concept of diversification in recent publications as the S&P 500 has been one of the best-performing equity indices over the last eight years. There was a confluence of factors, to include stable currency, political stability, and savvy corporate management, that contributed to this positive outcome for US equities. Yet, as we sit here at the midyear point in 2017, the winds of change are blowing in favor of companies domiciled outside the United States. Consequently, in many alternative strategies we have implemented in portfolios, the correlation/diversification benefits are starting to become more apparent.

The crux of the argument relating to diversification benefits is seen clearly in the mathematics of a portfolio drawdown. We illustrate this concept below, displaying the return required to get back to even based on various levels of portfolio drawdown.

Essentially, if you can construct a portfolio in a way that reduces the drawdown by owning non-correlated assets, you allow the math to work in your favor.  We believe alternative assets/strategies are an effective way to mitigate portfolio risk.

Staying Power

This concept may be new to many clients but it is one that we’ve been thinking a lot about recently.  Staying power is a behavioral concept that has application to every long-term investment portfolio and refers to the idea that portfolios will either succeed or fail due to investor behavior during stressful market periods.  As we’ve all witnessed over the years, we know people who can’t handle watching their portfolio losing money.  How many people do you know that sold out of all their equity exposure during the financial crisis and haven’t repurchased yet, or they have only recently added it back while equity markets are at all-time highs?

All this being said, if a portfolio contains assets/strategies that are zigging when the market is zagging, an investor’s ability to remain invested in the “riskier” portion of their portfolio goes up dramatically.  This staying power could be seen in the win/loss record of almost every team Dennis Rodman was on over his career, due to the fact that Rodman was a master at keeping his teams in the game with both tenacious defense and rebounding.  These two traits took the pressure off the superstars that surrounded Rodman.  We believe that a properly diversified allocation to alternative assets/strategies has the potential to reduce pressure on the more volatile segments of a portfolio (typically equities) over a full market cycle.

Optionality

Finally, we believe that all portfolios should be constructed with a degree of optionality.  Optionality is the flexibility a portfolio has to make changes or adjustments during significant stress periods in the financial markets.  The way in which most portfolios possess optionality is via a cash position.  Cash is said to have a high degree of optionality because the “price” of cash does not fluctuate and is readily accessible to redeploy in the event opportunities arise on very short notice.

Optionality is an important characteristic to have in a portfolio primarily because it allows investment decisions to be made without external influences.  For example, we believe investors like Warren Buffett and Seth Klarman have enjoyed success partly due to the fact that their portfolios carry a significant amount of cash (optionality) at almost every point in time.  In the case of Seth Klarman (via his investment vehicle Baupost LLC) the average level of cash over the last 30yrs has been 20%.  In the case of Buffett (via his investment vehicle Berkshire Hathaway) that cash level has been even higher!  The point in mentioning these levels is that both Klarman and Buffett have been able to succeed because they are almost always investing in opportunities based on merit.  Further, when they are making investments, they do not need to sell something to free up capital.  In this way, they are making only one difficult decision (what to buy) and not two (what to buy and what to sell).  Optionality is something investors should consider, as we currently find many equity and fixed income markets at extended valuation levels.

In summary, every team needs a Dennis Rodman, just as every portfolio could benefit from alternative holdings that generate a return that is different from traditional stocks and bonds.  While the benefits described (diversification, staying power, optionality) above may not be intuitive in the midst of an eight-year bull market, these benefits are invaluable during periods of significant market distress.  To that end, even though we have no way of knowing when the next significant downturn will come in the financial markets, that doesn’t mean we shouldn’t begin preparing for the next occurrence.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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[1] In fairness, I cannot claim credit for the idea of correlating Dennis Rodman with alternative strategies.  That idea came from Chris Cole of Artemis Capital.  On the Artemis Capital website under “Market Views,” you’ll find a very interesting publication entitled “Dennis Rodman and the Art of Portfolio Optimization.”

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Most financial advisors advocate maximizing employer-sponsored 401(k) accounts or municipal 403(b)s. Generally, we agree. However, you could be missing out on tax savings if you aren’t careful.

Before going any further, let’s be clear on what we mean by tax efficient. According to Wikipedia, a financial process is said to be tax efficient[1] if it is taxed at a lower rate than an alternative financial process that achieves the same end.

The collaborative encyclopedia offers two tax efficient examples:

#1 – Passing one’s assets on to one’s heirs using a Grantor Retained Annuity Trust, for example, is potentially more tax efficient than simply letting the heirs inherit the assets.

#2 – An exchange-traded fund (ETF) that follows the S&P 500 Index generates fewer “taxable events” than a mutual fund that follows the same index.

Another Viewpoint

Financial educational portal The Balance[2] uses the term tax diversification and offers the following definition: Tax diversification is a financial term that refers to the allocation of investment dollars to more than one account type.

The Balance clarifies the term further by adding, “Tax diversification is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.”

Tax Efficient or Tax Diversification

For the purposes of this post, we’ll use the two terms interchangeably, since they both seek the same end result. To help you more effectively evaluate tax efficient strategies, we asked Gratus Capital Director of Financial Planning Kevin Woods, CFP® for some advice.

Lack of Tax Diversification Negatively Impacts Retirement

“One of the reasons tax diversification is important for investment portfolios is due to the need to minimize paying taxes during retirement,” says Woods. “Keep in mind that if you place all of your money in tax-deferred investment vehicles, such as a 401(k) or Individual Retirement Account (IRA), you could end up paying more in taxes as compared to if you’d placed some money in taxable accounts today.”

Avoidable Yet Common Mistake

According to Woods, there are many people who only save for retirement using a traditional tax-deferred retirement account, such as an IRA, and never accumulate savings through an additional investment brokerage account.

“Placing all your money in tax-deferred retirement accounts imposes a built-in liability,” says Woods. “Essentially, a percentage of your retirement savings must go towards paying taxes.”

On the flip side is someone who invests in both traditional tax-deferred retirement accounts as well as other investments through a brokerage account. The investor who only saved using an IRA has to pay ordinary income tax on all of their withdrawals during retirement. Not true for an individual who saved using both an IRA and an investment brokerage account. This investor has a more tax efficient retirement portfolio, since he or she has saved their money in different types of investment accounts that have varying tax implications.

For example, the investor now has the ability to withdraw 50 percent from their IRA and the balance of what they need from a brokerage account and only pay taxes on what they withdrew from their IRA.

Detailed Scenario:

The White Coat Investor[3] provides a detailed example of two retired physicians who each draw $100,000 for the year from their financial savings vehicles. One physician placed all his money in a tax-deferred IRA account, and the other used a mix of tax-deferred and taxed accounts. Ultimately, the physician who used both tax-deferred and taxed accounts ends up paying less in taxes. The end result of the example is: One doctor pays an overall tax rate of 12.5 percent, while the tax-diversified doctor pays 1.9 percent.  

4 Different Tax Planning Investment Accounts

To build a tax-efficient investment portfolio, it’s important to distinguish among the four different types of investment accounts used for tax diversification, says Woods.

These include:

Taxed-Deferred (Pre-Taxed) – such as a 401(k) or 403(b). These vehicles are considered qualified investment accounts and have several benefits. Investopedia provides a simple explanation to help differentiate between qualified and non-qualified[4] investment accounts.

Why are tax-deferred accounts so popular? Woods isolates three key benefits:

“First, tax-deferred accounts enable you to lower the amount of income you pay taxes on now, increasing your take-home pay,” says Woods. “Second, since you’re deferring taxes until you withdraw funds during retirement, your investments grow tax-free during the years you’re making contributions. Finally, most retired investors are in a lower tax bracket as compared to when they were working, lowering their tax obligations when they begin withdrawing.”

After-Tax – such as a Roth IRA, Roth 401(k) or Variable Annuity. There are no upfront tax deductions when you contribute to these retirement accounts; however, you pay no taxes on withdrawals during retirement, and investment growth is tax-free.

“As a rule-of-thumb, if you’re age 55 or younger, a Roth 401(k) or Roth IRA makes sense to the extent that you’re not in the highest tax bracket,” says Woods. “Roths generally make more sense when you have more time to invest before retiring and you’re in a lower tax bracket.”

Taxable – such as stocks, mutual funds, bonds, CDs and money markets. Contributing to these taxable accounts means that you pay taxes each year on the dividends, interest and realized capital gains, rather than when you withdraw these funds during retirement.

Tax-Advantaged – such as municipal bonds or life insurance. These financial vehicles typically include a mix of tax-deductible, tax-deferred, and tax-free as well as other tax benefits.

Possible Diversification Strategies

“There are a number of strategies you can use with your portfolio management to strive for tax efficiency,” says Woods. “One approach is to have all your income-producing investments in your retirement account, thereby not requiring you to pay taxes on your interest each year. What’s more, you can also put all your stocks in taxable accounts, helping to provide a preferred lower tax rate on your dividends and long-term capital gains.”

In Closing

While saving for retirement may seem like a straightforward process, complexities arise when it comes to tax liabilities. “There are a myriad of variables to consider when trying to lower your tax liability both for today and during retirement,” says Woods. “I encourage all individual investors to seek the help of both a CPA and a financial advisor.”

Why both?

Because a CPA is an expert in tax laws and the tax preparation process, whereas a financial advisor is an expert at looking at an individual’s overall financial life. The latter includes financial and estate planning, as well as risk and investment management. Investors need both advocates to help ensure a tax efficient financial portfolio, says Woods.

Woods’ number one recommendation for investors, “Have more than just an employer-sponsored retirement account,” says Woods. “If that’s all you have, then it’s likely your portfolio is not tax efficient.”

At Gratus Capital, our team is made up of CPAs, MBAs and Certified Financial Planners. We believe that it takes a well-diversified skill set and team approach to ultimately guide individuals to financial freedom while lowering their tax burden. If you have questions regarding tax diversification or any other financial concerns, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

[1] https://en.wikipedia.org/wiki/Tax_efficiency

[2] https://www.thebalance.com/tax-diversification-with-investing-2466705

[3] https://www.whitecoatinvestor.com/taxes/tax-diversification-2/

[4] http://www.investopedia.com/ask/answers/206.asp

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Most investors think quality, as opposed to price, is the determinant of whether something is risky.  But high-quality assets can be risky, and low-quality assets can be safe.  It’s just a matter of the price paid for them.

– Howard Marks (Sept 2015)

It seems not a day goes by where a media outlet or publication doesn’t run a story on the death of active management. Whether these stories note the current tidal wave of money being dumped into low-cost index mutual funds and exchange traded funds (ETFs) or the idea that some large percentage of active managers fail to beat their benchmark, it’s all the same story.  Even notable investing legend Warren Buffett in his annual letter to shareholders[1] recommended that individuals allocate almost all their investable assets to an S&P 500 index.  Everywhere you turn, the drumbeat of passive investing is audible.  But is it a siren’s song?

Doesn’t it strike you as odd that humans spend countless hours getting the “best deal” on items to include toothpaste, cable bills, gasoline, and groceries, and yet do not put in equal amounts of effort to a far more critical commodity: their financial assets?  Put another way, the word “deal” as described in the prior sentence is meant to imply a recognition of price consciousness.  The passive approach to investing mandates that you ignore your inner drive for price consciousness.  To me, this behavior seems a little strange, but recent flow of funds data[2] would suggest that many investors are, in fact, eschewing price consciousness in favor of simple “market exposure”….just as the equity markets touch new all-time highs.

As with other manias in financial markets history, we think what is really going on here is momentum investing.  In financial markets, the phenomenon of momentum refers to the positive feedback loop that is created by prices that go up over a short/intermediate-term time frame.  This upward bias in prices draws in additional investors near the mid-to-latter stages of the cycle as FOMO (Fear Of Missing Out) creates a buying frenzy.  Investor memories can be myopic, and you don’t have to look hard for examples of this activity.  Some would include: technology stocks in the late 1990s, single family homes in the mid-2000s, master limited partnerships (MLPs) in the 2010s, and the soup du jour is exchange traded funds (ETFs) based on indices.

So why is it a problem that so many investors are now price insensitive, and how are we (Gratus) accounting for this new potential risk?  We touched on this topic in an update last year, but I believe it’s time to revisit the issue as the answer may not seem obvious.

Low Cost ≠ Low Risk

We’ve put this idea first, as we think it is the most important concept to consider when thinking about an ETF or index mutual fund.  Just because the vehicle is low cost (ETF/index mutual fund) does not mean that the assets underlying the vehicle do not carry risk of over-valuation.  Many in the financial media will eschew this point by saying something nebulous like “in the long run” or “over a full market cycle” to indicate why your entry point is irrelevant.  To us, these phrases are meaningless, because every investor’s time horizon is different and considerations around their financial assets are unique to some degree.  So to reinforce the point, just because you can buy an index that has a low management fee does not mean you aren’t paying too much for the underlying assets.

Someone Needs To Do The Hard Work

To us (as we’ve mentioned in prior publications) successful investing all comes down to basic probability analysis and, by extension, risk/reward.  The only way we know how to pass judgment on risk versus reward is to relate an investment to its valuation (i.e. is this investment a good deal relative to how good a deal the investment was at various points in the past or to its future prospects?).  There are many ways to gauge value, but for simplicity’s sake, we will use the price-to-earnings (P/E) ratio.  Simply stated, the P/E ratio relates the share price of a company to the earnings it generates.  The higher the P/E ratio, the worse of a value it becomes and the lower the probability becomes that the subject company shares can perform in line with historical norms.  This is a gross simplification of all the variables that go into the P/E and a rigorous company valuation, but the concept helps underscore a point.  The only investors that undertake company valuation analysis are active investors….not passive index or smart beta investors.  Therefore, if fewer and fewer investors are willing to undertake valuation assessments, then who is judging whether a company is overpriced or not?  Clearly, it’s not the index/ETF contingent.  

Ease of Trading ≠ Better Investment Outcomes

Just because you can trade an ETF (buy or sell) intraday, whenever you feel like it, doesn’t mean that this liquidity is a good attribute.  In fact, Gratus (and others like Credit Suisse Global Strategist Michael Mauboussin) would argue that the more liquid an investment, the more likely it is that an investor will trade that investment.  This is partly due to loss aversion, whereby losses that an investor experiences (whether realized or unrealized) feel three times worse than gains of an equal amount.  Behavioral psychologists Daniel Kahneman and Amos Tversky documented this concept (known as prospect theory) in their academic paper.[3]

Leaving loss aversion aside, buying a low cost index ETF does not guarantee a good investment outcome because the purchase of an ETF implicitly involves investment decisions to include what size companies to purchase (small v. large), where those companies should be domiciled (US v. international), type of company to be purchased (growth v. value), currency exposure, % weighting in the portfolio (overweight v .underweight), among others.

Next, there are instances of equity index /ETFs that actually trade at premiums to the companies within the index they are replicating.  In this way, investing in these select ETFs means you are paying more than you would if you were to buy the underlying constituents.  This is not supposed to happen in an ETF.  Admittedly, this doesn’t happen very often, but when it does (as was the case with the Van Eck Junior Gold Miners) it makes news as the ETF marketing machines have placed considerable emphasis on minimal premiums and low cost.

Contrast the high-frequency trading of ETFs with some of the most successful investment programs, and we believe that the intra-day liquidity of ETFs is more of a marketing tool than an actual benefit to investors.  In the case of Gratus, we prefer to hold our equity/ETF positions multiple years (if not decades). 

Market Structure Degradation

I’ve left this section for last as it may be a little less intuitive than the sections above.  I won’t go into too much detail here but wanted to show a chart that may shed some light on this section.  Put simply, we now have a dynamic where an increasing number of ETFs are being created while the number of underlying stocks are declining.  What new risks does this dynamic present?

Next, obtaining diversification within a portfolio of indices/ETFs is now harder to obtain.  Take the case of ExxonMobil.  It’s a mega-cap energy stock with ample amounts of trading liquidity in its shares and an above-market dividend yield (3.8%).  Due to these qualities and the way these attributes are weighted in both market capitalization as well as factor-based indices, ExxonMobil finds its shares a top 10 holding in a surprising number of ETFs, to include iShares Core Dividend Growth ETF, iShares Russell 1000 Value ETF, PowerShares BuyWrite ETF, SPDR MSCI USA Quality Mix ETF, Goldman Sachs Active Beta US Large Cap Equity ETF, John Hancock Multifactor Large Cap ETF, SPDR S&P 1500 Momentum Tilt ETF.[4]  Does ExxonMobil really fit the requirements of all these types of investment vehicles?  You can see the issue in trying to reduce overlap in an ETF portfolio where a single stock is held in many different indices.  True diversification is harder to attain, which is why at Gratus we are migrating our portfolios to more active approaches.

Finally, within the context of market structure degradation, we will spend a little time on factor-based approaches to ETF/index construction.  In the media, factor-based approaches are commonly referred to as “smart beta”.  While the concept of smart beta is a valid approach to index construction (whereby stocks are selected not just by size but also other factors to include dividend yield, volatility, valuation, momentum) the problem lies with the mass adoption of the concept.  I would note that most major investment firms, to include behemoths like Dimensional Fund Advisors (DFA), now have smart beta index ETFs as a product offering.  Observing this build-up in enthusiasm, our thoughts turn to the risks: if we all agree that equities are trading at elevated valuation levels generally, then what good does weighing by slightly lower P/E or slightly higher dividend yield provide…… if everything is overvalued?  This is where an active manager’s decision on what constitutes absolute value from the smart beta relative value becomes important.  This distinction can be seen very clearly in periods approaching major turning points in the equity markets (e.g. 1929, 1970, 2001).

Conclusion

In summary, as we have outlined above, there are many reasons to be wary of the passive investment revolution.  So how are we addressing this potential issue in our portfolios?  First, by recognizing that index mutual funds and ETFs have advantages and disadvantages.  This is a big first step because the financial media and marketing machines like Vanguard and Blackrock have powerful platforms to spread their message which usually revolves around the ideas that (1) there is nothing to fear with index investments and (2) cost is the only area where an investor should focus.  This, of course, is way too short-sighted.  As even Vanguard founder Jack Bogle would admit, there are limits as to how many market participants could engage in indexing.

The simple fact is, no one knows the exact percentage amount where passive ownership in equity indices becomes problematic.  We would argue that the math of index investing indicates we are closer to this problem area than many realize.  As an investment firm, and not a marketing firm, Gratus has no preference in favor of any investment vehicle.  Our concern is to provide high quality investment counsel and identify the appropriate strategies to achieve specified goals and objectives with the least amount of risk.  For many of the reasons listed above, Gratus has been migrating toward select active investments as we believe better opportunity lies ahead for active strategies with a discernable value proposition.  In an era where price is seemingly becoming increasingly irrelevant, we at Gratus Capital remain committed to the concepts of a value-oriented approach, as we believe that value (or price consciousness) is one of the few time-tested investment strategies leading to long-term success.

[1] http://www.berkshirehathaway.com/reports.html

[2] Investment Company Institute 2017 Factbook

[3] Prospect Theory:  An Analysis of Decision Under Risk (1979).

[4] Horizon Kinetics, “Indexation: Capitalist Tool”, October 4, 2016

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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In the first quarter of 2017, the bull market seemed unstoppable. The Dow Jones Industrial Average soared past 20,000 and closed at all-time highs on 12 consecutive trading days. The Nasdaq Composite gained almost 10% in three months.1

An eight-year-old bull market is rare. This current bull is the second longest since the end of World War II; only the 1990-2000 bull run surpasses it. Since 1945, the average bull market has lasted 57 months.2

Everyone knows this bull market will someday end – but who wants to acknowledge that fact when equities have performed so well?

Overly exuberant investors might want to pay attention to the words of Sam Stovall, a longtime, bullish investment strategist, and market analyst. Stovall, who used to work for Standard & Poor’s and now works for CFRA, has seen bull and bear markets come and go. As he recently noted to Fortune, epic bull markets usually end “with a bang and not a whimper. Like an incandescent light bulb, they tend to glow brightest just before they go out.”2

History is riddled with examples. Think of the dot-com bust of 2000, the credit crisis of 2008, and the skyrocketing inflation of 1974. These developments wiped out bull markets; this bull market could potentially end as dramatically as those three did.3

A 20% correction would take the Dow down into the 16,000s. Emotionally, that would feel like a much more significant market drop – after all, the last time the blue chips fell 4,000 points was during the 2007-09 bear market.4

Investors must prepare for the worst, even as they celebrate the best. A stock portfolio is not a retirement plan. A diversified investment mix of equity and fixed-income vehicles, augmented by a strong cash position, is wise in any market climate. Those entering retirement should have realistic assessments of the annual income they can withdraw from their savings and the potential returns from their invested assets.

Now is not the time to be greedy. With the markets near historic peaks, diversification still matters, and it can potentially provide a degree of financial insulation when stocks fall. Many investors are tempted to chase the return right now, but their real mission should be chasing their retirement objectives in line with the strategy defined in their retirement plans. In a sense, this record-setting bull market amounts to a distraction – a distraction worth celebrating, but a distraction, nonetheless.

At Gratus, we provide sound asset allocation advice, from determining each client’s initial allocation (“getting it right”) to ongoing strategic asset allocation (“keeping it right”).  We offer our clients balanced and comprehensive investment advice, complete objectivity and a personalized investment strategy. We apply a value-orientation (absolute not relative) to all facets of the investment decision-making process. This approach informs both the asset class and underlying strategy decisions in asset allocation construction.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of April 2017 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.  All indices are unmanaged and are not illustrative of any particular investment.  This article was prepared by MarketingPro, Inc. This information has been derived from sources believed to be accurate. This article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice.  Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

Citations.

1 – money.cnn.com/2017/03/31/investing/trump-rally-first-quarter-wall-street/index.html [3/31/17]

2 – fortune.com/2017/03/09/stock-market-bull-market-longest/ [3/9/17]

3 – kiplinger.com/article/investing/T052-C008-S002-5-reasons-bull-markets-end.html [4/3/14]

4 – thebalance.com/stock-market-crash-of-2008-3305535 [4/3/17]

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March 2017 Update: Dallas We've Had a Problem

“Houston, we’ve had a problem here.”  – Jack Swigert (Apollo 13 astronaut)

It was April 13, 1970, and the Apollo 13 mission to the moon was approaching the point at which the lunar lander was preparing for descent.  All of a sudden, an oxygen tank exploded which crippled the service module and effectively aborted the mission.  It was only after great effort and sacrifice that the crew of Apollo 13 was able to return the spacecraft safely back to earth.  In many ways, we believe that the Apollo 13 mission is a useful metaphor for the state of the US pension system.

What does Apollo 13 have to do with the pension system, and why should you care?  Just substitute “Dallas” for Houston and the metaphor will translate well.  For those that haven’t been watching what is happening in the city of Dallas, there’s reason to be interested…..especially for municipal bond investors.  Here’s a brief summary of what has happened.

The $2 billion Dallas Fire and Police Pension (DFPP) Fund finds itself at ground zero of the brewing pension issues on the horizon.  Essentially, DFPP made some bad real estate investments on behalf of its pensioners in the mid-2000s to include Hawaiian villas, Uruguayan timber and undeveloped land in Arizona.  These poor investments caused the pension fund to incur average annual losses of -1.5%/yr for the last five years, as opposed to the assumed return of 8.5%, to cover promised benefits.  These losses created a ~$7 billion shortfall that caused Moody’s and S&P to downgrade the credit rating of Dallas in early January.

Sensing that the pension was in crisis, many beneficiaries opted to take out lump sum distributions in lieu of the monthly payment.  This snowballing of fear caused ~$500 million in lump sum distributions in just the first few weeks of 2017, exacerbating the shortfall and causing the mayor of Dallas to halt all lump sum payments.  Now the city of Dallas/DFPP are in grueling negotiations to try and figure out where to go from here.

This brings us back to our original questions posed above:  What does Apollo 13 have to do with the pension system, and why should you care?  In short, we believe many investors are (1) overlooking large, unfunded liabilities, and (2) still relying on credit ratings and simplistic rules of thumb when making investment decisions on municipal bond offerings.  I’ll hear phrases like “I don’t have to worry about XYZ city because it’s a general obligation bond” or “this bond is AAA, so why would I be concerned”.  These are dangerous phrases to throw around.  In the case of Dallas, Texas, Moody’s has downgraded its general obligation (GO) bonds from Aa1 to A1 (three levels) in under 12 months due to pension concerns.  At Gratus, we approach a municipal bond portfolio with risk as a primary consideration.  To that end, below are a few considerations we keep in mind when constructing a municipal bond program.

1. Financial deterioration can happen quickly. Rarely is it the case that a municipality or state will jump from a high quality to low-quality bond overnight.  Yet, details are important to monitor.  One detail that we find useful is the rate of return (a.k.a discount rate) assumption being used by a municipal pension.  According to Piper Jaffray & Company, the median rate of return assumption being made by most municipalities is 7.75%.  In other words, the municipality is expecting the pension asset pool to earn 7.75% in perpetuity.  Obviously, this is far too high given where interest rates currently sit.  The problem, however, is more insidious.  If the municipality lowers its return assumptions, this increases the unfunded liabilities amount given that more assets are needed to generate the same return.  The table below illustrates this dynamic well. 

Discount Rate 7.6% 7% 6% 5% 4%
Total Liabilities ($tn) 4.5 5.1 5.8 6.6 7.5
Assets ($tn) 3.4 3.4 3.4 3.4 3.4
Unfunded Liability ($tn) 1.2 1.8 2.5 3.3 4.1

All this is to say, when interest rates were higher, there was more margin for error on investment returns.  Now with interest rates hovering around historically low levels, there is far less margin for error.

2. You can’t outsource your due diligence to a credit rating agency. While one would think companies providing insurance to municipal bonds have learned a valuable lesson in the credit crisis, we never rely on this insurance when making a municipal bond investment.  Certainly, the quality of municipal insurers has improved since 2008 with the entrance of behemoths such as Berkshire Hathaway, White Mountains Insurance and others.  Yet municipal bond insurance is often a reason I hear for not doing credit analysis under the idea that if Berkshire Hathaway is insuring the bond then it’s as good as an obligation of Berkshire.  Certainly, this will be the case longer term, but if an investor is relying on timely principal and interest payments as part of their income, any disruption (whether for a month or six months) to a payment can be difficult to endure.

3. Most municipalities display warning signals in advance of distress. As Wayne Gretzky once said, “A good hockey player plays where the puck is.  A great hockey player plays where the puck is going to be.”  Our thought on the current pension situation is simply to avoid investing in municipalities/states where the unfunded liabilities are large relative to the size of the pension and tax base.  Furthermore, to reduce the risk of a pension disaster, we can look at essential service bonds which have zero pension/benefit obligations.  An example of this would be a municipal bond whose principal and interest is derived from a utility bill or special purpose tax.  Good examples of municipalities that were displaying warning signals well in advance of bankruptcy were:  City of Detroit (2013), City of Stockton (2012), City of Vallejo (2008), Puerto Rico (2016).

Current municipalities flashing warning signals include the following:  State of Illinois, City of Chicago, Cook County, Marshall Islands, American Samoa, State of Connecticut, City of Hartford, State of Rhode Island, City of Providence, State of New Jersey, among others.

In summary, our point in publishing this article is not to scare clients into thinking that there is some action that needs to be taken; it’s merely to describe the new world order in the municipal marketplace.  In our opinion, rules of thumb can be dangerous.  As with the Apollo 13 mission, the problem is not terminal, but it’s pretty close to dire for certain municipalities.  Unless dramatic and swift action is taken at the municipal level to right-size pension obligations, there will be identifiable losers over the medium term:  bond holders and pensioners of the problem issuers.  We are (and have been) proceeding with caution in the municipal marketplace as we see certain geographies that could have problems in the future.

Post Script:  After I wrote the piece above I looked into the situation for union pension plans.  As it turns out, the first union pension plan declared bankruptcy (NY Teamster Local 707) earlier this year.  According to industry estimates, a further 200 union plans are on the brink of insolvency. 

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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February 2017 Update - New President, New Outlook_Gratus

“It’s tough to make predictions, especially about the future”.  – Yogi Berra

“Economists are often asked to predict what the economy is going to do. But economic predictions require predicting what politicians are going to do – and nothing is more unpredictable.”  – Thomas Sowell

At this juncture, we continue to believe that making financial market predictions is a dangerous business.  Not only is there economic uncertainty relating to the fact that we are now in our eighth year of expansion during this cycle, but we also have obvious political risks percolating around the world.  To that end, political uncertainty now inhabits the White House with aspirations of undoing most of what has been done over the last eight years.  This US-specific political risk is one of many global political risks that stems from burgeoning nationalist movements in Western Europe and elsewhere.  These nationalist movements have the potential to be disruptive to economies over the short term.

Why does political risk matter now?  In our view, it’s simply because outcomes in many western economies are now even more difficult to forecast.  In other words, recent historical norms around free trade (TPP/NAFTA), immigration policy, and military unity (NATO) are coming into question.  In the spirit of a New Year and new president, we thought we’d collect and opine on President Trump’s priorities for 2017.

  • Roll back “regulation” because there is too much regulation in all areas of business

Trump’s Transition Team (TTT) has indicated that upwards of 75% of all regulation is unnecessary.  Financial markets are betting that a large portion of Dodd Frank gets rolled back.  This can be seen in the performance of most financial sector companies, which have responded very positively post-election.

INVESTMENT IMPACT:  Likely beneficiaries of reduced regulation would be heavily regulated sectors like energy and mining, as well as the financial sector.  Recent share price movements in metals/mining/energy shares certainly indicate it may be easier to mine/drill in more ecologically sensitive areas than previously thought.  Interestingly, nuclear companies are performing well, with the idea that no one energy source is favored over another.  Until recently, nuclear has been discouraged due to the nuclear waste disposal issue.

  • Overseas cash repatriation.

The idea is that US companies would be able to bring their overseas cash back to the United States at a low tax rate.  This proposal is fairly straightforward and has a high likelihood of passing through Congress without much obstruction.  Repatriation would give corporations access to much-needed liquidity in the event they decided they wanted to pursue M&A activity, increase share repurchases or increase dividend payments.

INVESTMENT IMPACT:  The investment impact of this policy would be relatively limited if we use the template of the first overseas cash repatriation that occurred in 2004.  Under that template, cash that came back was mostly paid out in dividends….not reinvested in the company.  Furthermore, overseas earnings that are being converted back into US dollars could cause the US dollar to move higher, which would crimp future earnings from those same overseas subsidiaries and, potentially, kick start the next recession. 

  • Reduction in tax rates at both the individual and corporate levels. 

There’s still a lot of distance to close within the Republican ranks as President Trump and Speaker Ryan have publicly proposed plans that are different.  Both men have proposed unique plans for corporate taxes as well as individual taxes.  The key is that they both believe something needs to be done.  This area of tax reform has, in my opinion, the highest possibility of getting Congressional approval.

INVESTMENT IMPACT:  As tax reform legislation works its way through the approval process, equity markets in the US will likely respond positively.  Goldman Sachs estimates that tax reform alone could add up to 4.8% in earnings per share or roughly $6 to 2017 S&P 500 earnings.  The downside, I believe, is that most of this benefit has been priced into equities already as exemplified by the move in small company stocks since election day.

  • Repeal and replace the Affordable Care Act (ACA).

President Trump has already issued an executive order to minimize the ACA’s impact at both the state and federal levels.  The US House of Representatives and the Senate have initiated legislative proceedings to defund the ACA at the same time.  It looks like this repeal and replace is the highest priority for most Republicans in D.C. right now.  The problem, of course, is that even with 3+ years of time to come up with a transition plan for the ACA, there is still no cohesive legislative solution to fill the ACA’s void.

INVESTMENT IMPACT:  It’s still too early to tell, but clearly there will be segments of the healthcare complex that stand to lose if the ACA is repealed without any solution (hospitals, pharmaceutical companies, etc).  Outside of healthcare, I don’t see much by way of immediate market impact until more details are known.

  • Massive infrastructure spending bill to rebuild America.

Again, nothing is really new here as both candidates Trump and Clinton had infrastructure spending proposals.  Clinton proposed an Infrastructure Bank while Trump proposed opening up US infrastructure to public private partnerships (PPP).  PPPs are a unique way to raise private capital for public projects but, effectively, these new PPPs act as new taxes on people that use those facilities.  Further, most infrastructure spending would get pushed down to the state/local levels.  From the time a funding measure for infrastructure would be passed to seeing shovels in the ground could take as long as 2 years given the permitting, environmental, and governmental approval process.

INVESMENT IMPACT:  Likely very little impact in the first four years of the Trump presidency.  To fund the level of infrastructure being tossed around (~$1 trillion), a lot of new debt would need to be issued and absorbed by the markets.  The Federal Reserve could buy that debt directly, but this may interject new risks to the financial system if the bond mark loses faith in the Federal Reserve.  On the positive side, the sheer scale of the program would likely lead to higher levels of employment which could have a positive effect on consumer sentiment thereby providing support for risk assets.

In summary it would appear, based on our initial analysis that much of what is being proposed above as stimulus to the economy has been accounted for in current market prices.  This makes intuitive sense as equity markets typically function with a 6-12 month forward-looking discount mechanism.  (For example, while the S&P 500 bottomed out in March of 2009, S&P 500 earnings didn’t start their upward movement until August/September of 2009).  Further, most of the above has to actually occur for the equity market to maintain its current valuations!  Said another way, don’t get pulled into the hyperbole of the 24-hour news cycle, and keep your focus on the long term.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

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Your Family’s Investment Strategy: Why It’s Time to Take Stock

Feeling less than confident about your family’s investment strategy?  Trying to help adult children make the most of their portfolios?

You’re not alone—especially if your kids were born during the 1980’s or 1990’s. Recent data shows many Americans are still a little market leery, almost a decade removed from the 2008 downturn. Specifically, according to surveys from Bankrate.com and Capital One/ShareBuilder, we know:

  • 93% of Millennials express both a distrust of the markets and a lack of investing knowledge.
  • 39% of Americans ages 18-29 list “cash” as their preferred method of investing, when it comes to money they won’t touch for 10 years. 

If you recognize these attitudes in your children or your grandchildren, the following Q&A offers a helpful primer. Investment strategist and portfolio manager Marc Heilweil (MH) explains why the stock market remains a very sound place for the preservation and growth of capital—and indeed why it may become the only reliable way for the next generation to build wealth over time. Share his insights with your family members.

In simple terms, why should people invest?

MH: Major U.S. traded companies grow their profits by an average of  7% per year. If you’re an investor, you’re going to participate in that growth.

Do you think a sound investment strategy is as important today as it was for past generations?

MH: If anything, it’s more important. French economist Thomas Piketty published a book in 2014 titled, Capital in the Twenty-First Century. His thesis is basically that returns on invested capital grow faster than wage growth. So if you want to get ahead and stay ahead that’s why you invest.

How do you advise clients who want to employ an active trading strategy for some portion of their portfolio?

MH: I ask them to do that on their own. It’s hard enough to be a good investor. To be a good trader is an entirely different ball game. Except for maybe a few savvy individuals, who are very close to the market and have access to sophisticated tools, people will typically run into large downdrafts that effectively eliminate most successes over time.

What are the fundamentals of a good investment strategy?

MH: Being a good investor means starting off with the three R’s:

  1. Return on Invested Capital
  2. Retention Rate
  3. Return on Equity

Return on invested capital (or assets) is the net income of a corporation divided by total assets. Retention rate is an interesting part of today’s market because this is how much profit a company returns after stock buy-backs and after dividends. Overall, companies aren’t retaining an awful lot of their profits, and therefore investors should be concerned about how prospective opportunities will grow their business in the long term. Return on equity is the shareholder’s return on the stock value of the company. This is the least important of the three because it can be affected by many variables and sometimes ignores key features of the company in question.

Beyond the three R’s, investors should dig into the business itself to see if the metrics are sustainable over time. Is senior management capable? Is the company culture healthy and thriving? Do leaders have shareholders’ long-term best interests at heart? Some companies/industries are inherently unyielding and do not deliver good opportunities. Others are exceptional organizations that can reliably produce good returns.

Who has time to do all this research?

MH: Clients can contribute to the process if they have a good head for business. But mostly this is the value that investment managers bring to the table—their experience, judgment, and familiarity with what’s out there.

When taking a long-term approach, how often should individuals revisit their investments and earnings reports?

MH: You’re not looking at immediate results of investments. So if your advisor tends to recommend companies that are undervalued or out of favor, you may not see returns right away. Returns get better down the road. Investing requires patience. At the same time, you’re constantly evaluating what you own and seeing if it meets your expectations.

Should a person’s investment strategy change as they age, or as different milestones come into view?

MH: The notion that your investment goals change as you get older is somewhat overstated. A good investment is always a good investment—one that has a reasonable margin of safety. Any money you’re investing should have a long-term horizon. If you need money in the short term, don’t invest.

When choosing an investment manager, what kind of homework should investors be doing?

MH: When evaluating an investment advisor, be aware of how he or she has done over a bull market cycle and a bear market cycle.  Some may preserve capital a lot better in bear markets.  In our case for example, we also manage mutual funds, so that aspect of our performance (Marathon Value Portfolio) is a matter of public record.  You can also conduct research on a firm and the individuals in the firm by visiting these sites:   http://brokercheck.finra.org/ and https://adviserinfo.sec.gov/.

Any final words of advice?

MH: It’s been said that a “price” is what you pay, and “value” is what you get. This is an important perspective that every investor needs to adopt. Don’t confuse a rising price with a good investment. You need to understand the value of what you own.

Do you have questions about your portfolio or investment strategy? Don’t hesitate to contact the Gratus Capital team!

Disclosures:
Blog may include forward-looking statements.  All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”).  Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct.  Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Any information provided by Gratus regarding historical market performance is for illustrative and education purposes only.  Clients or prospective clients should not assume that their performance will equal or exceed historical market results and/or averages.

Past performance is not indicative of any specific investment or future results.  Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.

The material listed is current as of the date noted, and is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Any information is for illustrative purposes only, and is not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Results will vary, and no suggestion is made about how any specific solution or strategy performed in reality.

Gratus Capital LLC, the investment advisor to the Marathon Value Portfolio Fund, is registered with the Securities and Exchange Commission pursuant to the Investment Advisers Act of 1940.

Ticker symbol: MVPFX.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Marathon Value Portfolio Fund.  This and other important information about the Fund is contained in the prospectus, which can be obtained by calling 1-800-788-6086.  The prospectus should be read carefully before investing.  The Marathon Value Portfolio Fund is distributed by Northern Lights Distributors, LLC member FINRA/SIPC.  Gratus Capital, LLC is not affiliated with Northern Lights Distributors, LLC.

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Gratus Capital, LLC
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