Monday, August 31, 2009

Fiduciary Duty- Now Coming to a Town Near You

The Obama administration has proposed holding the broker/dealer community to a stricter standard than ever before and the brokerage community is furious about it. What is the brokerage community so upset about? What is it that has brokerage firms spending millions of dollars in a battle against the proposal? What sort of egregious proposal did the Obama administration propose that has brokers so enraged?

The Obama administration is proposing that brokers act "in their clients' best interest."

Oh horrors of horrors.

A recent Wall Street Journal article details the inevitable move by brokers towards accepting fiduciary duty when making recommendations to clients. For 70 years, money managers have accepted fiduciary duty regarding their clients. Brokers simply sold securities that clients and money managers wanted. Nowadays, brokers offer themselves out as "financial managers," "investment counselors," and "financial advisors." In their scramble to become more than securities transactors, brokers have crossed the line into money management...and with that ability will come extra responsibility.

As investment advisors, we welcome the additional requirement. A person or firm which provides investment advice should provide that advice in light of a client's best interests, period. Doctors do it, attorneys do it, money managers do it, and brokers will soon do it too if the Obama administration has its way.

Tuesday, August 25, 2009

Cramer is Harmless

Professors Paul Bolster and Emery Trahan of Northeastern University in Boston recently concluded and published a 33 page report examining the popular CNBC Television program Mad Money with Jim Cramer. The program is the most watched program on CNBC and has an estimated 380,000 viewers tuning in per night.

The research looked at the effect that Cramer had on the stocks he mentioned on his show, and the research also examined the success rate that Cramer had in choosing stocks.

The results? Yes, Cramer beats the S&P500...but he does it through beta, not alpha. What does that mean? Well, it means he takes more risk...and therefore gets more reward...than the S&P500. The next question should be "Does Cramer beat an index with similar risk characteristics?" IE, by accepting the same risk tolerance, is a person better off following Cramer or buying an index? The answer is that the person is better off just buying an index...something like the Russell 1000 Growth, the Russell 1000 Value, and a bit of the Russell 2000 Growth. In other words, save the transaction costs, the frenzied buying and selling, the inanity of the television program, and just buy the index.

Cramer did not outperform a similarly styled index, nor did he underperform it by much. He evidently has no stock picking ability, nor is he especially dangerous. As Professor Bolster stated in his conclusion: "He's harmless."

Wednesday, August 12, 2009

Bond Math: High Coupons versus Low Coupons

Recently we have had a few people ask us why we are buying larger coupon rather than smaller coupon bonds and it became evident that many don't understand the effect rising interest rates can have on a bond portfolio. Here is a good example of the price change rising interest rates can have on a bond portfolio:

Let's imagine there are two bonds in the market, both by the same issuer. One bond is a 7% coupon due in 2029 and the other is a 5% coupon due in 2029. Let's also imagine that both are trading at 6% yield to maturity. Now let's move out one year from today...and let's imagine that interest rates have moved up. Let's imagine that both these bonds have now moved to a 7% yield to maturity...so their prices have fallen.

The price of the 5% coupon bond has fallen approximately 10.75%...but the price of the 7% coupon bond has fallen only 10%. In other words, with the same rate of change in interest rates, the lower coupon bond has changed more in price relative to its original price than the higher coupon bond has changed relative to its original price.

What does this mean for the investor's portfolio? Well, for a $1mm portfolio, it means that our decision to buy a larger coupon bond rather than a smaller coupon bond just saved the investor $7500 in portfolio losses.

Wednesday, August 5, 2009

5 Months of Strong Returns

The Standard & Poor's 500 Index returned over 44% in less than 5 months between March 9, 2009 and July 31, 2009. Interest rates, although higher than 6 months ago, remain at historically low levels. Unprecedented amounts of cash are being pumped into the economy by the US Government. Corporate bond spreads have tightened, and municipal bond yields in relation to Treasuries are returning to more normal times. What's ahead? Possibly inflation. How does one mitigate the effects of inflation on one's portfolio? Maintain some exposure to commodities through broad based inexpensive commodity index etfs, and make sure your bonds have enough coupon that they can weather the storm.

There are still enough inefficiencies in the bond market that one can occasionally shorten maturity and pick up yield and still hold the same credit. Maturities can be shortened, coupons can be increased, and some preparation can be made for the upcoming inflationary times.