Thursday, May 17, 2007

Credit Complacency = Fiduciary Risk

Much has been written about the potential impact of the sub-prime mortgage sector meltdown and the impact that tighter credit and falling home values might have on the economy. However, a weakening credit discipline due to the growing role and appetite of leveraged investors and an increase in the sophistication and complexity of credit instruments should also be of concern to investors.

The credit derivatives market has not captured investors’ attention because it has been dominated by private over the counter deals organized primarily by large investment banks. According to the International Swap Dealers Association the credit derivative market has doubled in each of the last 5 years and totaled $34 trillion in notional value at the end of 2006. Hedge funds also play a large role in this market. Lehman Brothers estimated they account for over 50% of the trading volume in this market.

Credit derivatives are simple in concept. They provided insurance against corporate bond defaults. Credit derivatives have become popular because they allow corporate lenders and bond investors to reduce and/or actively manage their credit risk by separating out the credit risk part of these investments and selling it to others. These sales contracts are called credit default swaps. The loans or bonds don’t change hands but derivatives dealers will make an agreement to insure them against a credit default for a fee. The dealers often pass along these risks by bundling these credit exposures into what are known as a synthetic collateralized debt obligation (CDO). Slices of the CDO are rated by rating agencies and then sold to hedge funds and institutional investors. CDO’s soaked up $150 billion of mortgage backed bonds last year, the majority of which included sub-prime mortgages according to Deutsche Bank.

As these risks are packaged, leveraged and structured in ever more complex ways, the nature of the resulting risks may not be transparent or fully disclosed and can be misunderstood, mis-modeled and inappropriately executed and priced. The typical borrower-lender relationship changes as the underwriters of the risk and the eventual risk bearers become disconnected. Risk sellers may be financially motivated to understate credit risk. Because of these issues, the market puts substantial reliance on credit rating agencies. However, the ratings agencies, whose role is to evaluate the risks of these structures, can suffer from both limited information and financial conflicts of interest[1].

Clearly the phenomenal growth of the structured credit markets has been due in part to easy credit and investors’ demand for yield. Many argue that the growth of the credit derivatives market should disperse credit risk amongst a broader and more diverse investor base thus making the credit markets more resilient to credit ”events”. However, the democratization of credit risk may also help disguise risk and transmit financial contagion much more efficiently. The real concern is that no-one really knows that these risks aren’t accumulating in an inappropriate way or aren’t being concentrated in areas which won’t be sustainable through an inevitable normalization or downward leg of the credit cycle.

Private equity, hedge funds, real estate and credit derivatives have all benefited from cheap capital and a strong economy. It is likely that the demand for these assets over the last few years has limited demand for traditional risky investments such as large cap stocks. Time will tell whether the ex ante risk reward expectations driving these investments is founded on sustainable fundamentals or just plain old leverage and perfunctory risk disciplines. For now, investment fiduciaries should be more cautious than usual about credit risk, leverage and lack of transparency in their portfolios.


[1] Frank Partnoy The Paradox of Credit Ratings / How & Why Credit Rating Agencies are not Like Other Gatekeepers.

Friday, May 11, 2007

SEC's Perspective on 12b-1 fees

Comments from SEC Chairman Christopher Cox in an address to the Mutual Fund Directors Forum.

"What the SEC had in mind in 1980 is that requiring current investors to subsidize the sale of fund shares to new investors could be a good thing - even from the standpoint of the current investors - because increasing overall fund size could help better diversify their holdings, and also proportionally reduce
the burden of administrative costs that might now be spread over a wider pool of investors. After all, higher expense ratios reduce investors' returns percentage point for percentage point.
But whether, in fact, a fund's current investors are getting a break depends upon how the investment advisory contract is written. If increasing the size of the fund simply enlarges the fees earned by the investment adviser, the supposed benefits from economies of scale are undone. So one of the things that independent directors must concern themselves with in reviewing the propriety of any 12b-1 fees used for distribution is whether the fees paid to the management company and other vendors, as a percentage of total fund assets, has risen or fallen as the fund has grown. If the size of the fund is increasing, but the expense ratio isn't falling, then using a 12b-1 fee for marketing and distribution expenses is very likely harming, not helping, the current investors.There are other reasons to
question the continued vitality of Rule 12b-1. Today the mutual fund industry is no longer at risk of suffering crib death, as was the case years ago when rule 12b-1 was adopted. At more than $10 trillion and counting, the survival of the mutual fund industry is plainly no longer at issue. Indeed, we have learned by this point in the 21st century that it can be just as big a problem for investors when a fund grows too large as when it is too small. The assumption can't always be made that growth in total assets inevitably assists existing investors. When funds grow too big, they can lose flexibility, with the result that investors get lower returns.For all of these reasons, the original premises of Rule 12b-1 seem highly suspect in today's world. If ever it was justified to indulge an irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund shares, that time surely has passed. Collecting an annual fee from mutual fund investors that is supposed to be used
for marketing is no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers."

Tuesday, May 08, 2007

First Quarter Commentary

Global Equity Markets “Shanghaied”
Along with a reminder that S---[1] happens, the capital markets provided diversified pension investors with a 1.6% return for the quarter, slightly under their pro-rated 8% annual target return. The quarter’s activity also left investors feeling, at least temporarily, more vulnerable due to the collapsing sub-prime mortgage market, declining corporate profitability and the increasingly obvious bipolarity of the Fed’s goals to both stimulate growth and throttle inflation.
The global equity markets, after being “shanghaied” on February 27, rebounded to finish the quarter in positive territory. The uniformity of the February drop indicated no particular geographical or style origin, though financials led the slump. Continued losses in the financial sector for the quarter (-3.4%) confirms that sub-prime fears more than anything triggered the event. The S&P 500 bottomed at -5.9% below its previous high for the year, though it regained over 6.7% as of tax day.

Within the US equity markets, large cap stocks returned +0.6% for the quarter per the S&P 500 index. Style distinctions were trivial, though the overall market returns masked a specific preference for smaller names (Russell Midcap +4.4%) and general distain for mega caps (Russell Top 200 -0.1%). Mid cap stocks lead the US equity market based on the energy sector as oil prices rose 11% during the quarter. The pricing support implied by private equity acquisitions also drove mid caps higher. Utilities and materials, also value sectors, performed well. Small caps returned +2.0% per the Russell 2000, though growth (+2.5%), lead by technology and healthcare, outperformed value (+1.5%).

The fact that investors continue to be indifferent to large caps is puzzling given they have long been considered to be the equity asset class of choice in uncertain times and also have a valuation advantage over smaller caps.

We think institutional investors’ fascination with alternative assets and retail investors’ propensity to chase performance account for some of this lack of interest. Alternative assets (i.e. real estate, private equity and hedge funds) now account for 10% of defined benefit plan assets. The growth in M&A and in particular private equity also appear to be a defining trend in this market. Private equity groups still have hordes of cash to put to work and can continue to shop the market as long as cash-flow yields exceed financing rates. However, their target size hasn’t yet reached the level of US blue chips, leaving large caps with little prospects beyond being proxies for global growth.

In international markets, US dollar investors enjoyed both strong local market returns and the positive foreign currency effect of a declining dollar. MSCI EAFE quarterly returns were +3.4% locally and +4.2% for un-hedged dollar investors. Small and mid caps ( MSCI EAFE Small Cap +7.2%) outperformed large caps internationally as well. The Pacific markets ex Japan generally outperformed Europe. The emerging markets, down -1.6% in February, snapped back in March returning +2.4% for the quarter per MSCI EM. The popular BRIC index didn’t recover from the quarter’s sell-off (-0.4%) as 3 of its 4 constituents ended the quarter down (Russia -3.0%, India -3.4%, China -2.3%, Brazil +6.2%).

Real estate was up just over 2% for the quarter ( NAREIT composite), though money flows were negative as investors feared further sub-prime damage. Hedge funds turned in a respectable quarter, adding 2.3% per the Hennessee Hedge Fund Index. Not surprisingly, merger arbitrage and distressed debt funds lead first quarter performance.

The quarter’s bond market returns don’t fully reflect yield volatility through the quarter. The Fed left short rates unchanged, though the yield curve oscillated with the unveiling of each new piece of economic data and Fed nuance throughout the quarter. Overall, rates fell across the curve, except for the long end, and the curve steepened by quarter end. The curve steepening presents a dilemma. If long rates continue to respond to higher expected inflation, this could act to further constrain economic growth forcing the Fed to cut rates more then might be necessary, sparking additional inflation fears. Returns dispersion across the fixed income sectors was tight Despite the quarter’s general shift in risk appetite, high yield provided the best quarterly returns among US fixed income at +2.7% per the Merrill Lynch High Yield index as defaults remained low. Credit spreads widened somewhat after the market dip in later February. The Lehman US TIPS index returned +2.5% for the quarter as inflation data surprised on the high side. The investment grade mortgage sector returned +1.5% for the quarter per the Merrill Lynch mortgage Master. It is predominantly AAA credits (i.e. Freddie Mac, Fannie Mae) and was minimally impacted by the sub-prime mortgage meltdown. Other domestic bond sectors bunched up in the +1.0% to +1.5% return range for the quarter. International bonds benefited from the quarter’s dollar decline returning +1.2% per the Merrill Lynch Global Broad Market ex US.

[1] Standard deviation