June 14, 2011

Structured Products ‘Absurdly Destructive’

The Investment View from Prescott, Arizona

Unsuspecting investors have lost “at least $113B since 2008 in complex investments called structured products” says a recent study by the nonpartisan policy center Demos and The Nation Institute, a media think tank, as reported in InvestmentNews, on June 10th.

“Structured notes and other derivative products have been marketed by Wall Street as safe and secure investments. Of course, there’s safe and then there’s safe, as $113 billion in losses can illustrate.

“In my three decades of Wall Street experience, I have not seen any other product as absurdly destructive as retail investments linked to structured products,” securities arbitration consultant Louis Straney wrote in the report.

“That’s worrisome, considering brokers appear to be ramping up the sales of these products. Last year saw more than $52 billion go into structured notes, according to the study. In the past, the notes were sold strictly to sophisticated institutional investors. In recent years, however, structured notes have been repackaged and sold to retail investors – often, senior citizens – as a principal protection tool.

“Indeed, structured notes with principal protection are among the most popular products being pitched to income-oriented investors, the study said.  The notes, which pay off based on the performance of the linked index, can provide reasonable returns and upside potential – certainly attractive given today’s puny money market and CD rates.

“But as the name implies, structured products can be complex. Last week, regulators warned investors that structured notes with principal protection may have low guarantees, can tie up money for as long as a decade and come with terms so confusing that many investors cannot understand them.

“The alert from the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. stressed that the investments are not risk-free and that principal-protected notes do not always protect principal.

“Some issuers of principal-protected notes guarantee only a certain amount of the principal – in some cases, as little as 10%. Sometimes, the principal is protected only if a contingency stipulated in the prospectus is met.  Even with stronger guarantees, if the issuer of the note goes bankrupt, such as Lehmann Brothers in 2008, the investor likely will lose all or most of the money invested.”

I would add that structured products also pay brokers some of the bigger commissions.  When you combine the conflict of interest commission-based investments can create, with the extreme complexity of structured products, the average investor becomes a sheep ripe for shearing by unscrupulous or unknowing investment salespeople.

Caveat investor.

A Slice of Life

For 25 years now, Prescott has been very good to me and to Hepburn Capital Management.  Business is very good, thank you.

One way I express my gratitude and give back to our community is to manage money for local non-profit organizations for free. 

If you know of a local board that is not happy with the earnings rate on their savings, I would be happy to speak with them to see if my low-risk methods might provide better results.   Just call the office to schedule an in-office meeting or to have me address a board meeting.  778-4000

Mental Floss

Q: President Clinton is listed as our 41st president, but only 40 men have held the office. Why?

A: Grover Cleveland held office during 2 nonconsecutive terms. He was our 22nd and 24th president. Incidentally, his full name is Stephen Grover Cleveland.

How’s The Market Doing?

As the stock market zig zags its way along, it has begun to display a pattern of stronger down legs, with weaker up legs.  This is a characteristic of a market in decline.

As I have written in the past two newsletters, I expect a significant stock market decline this summer, and in fact, stock markets around the world are in decline.  U.S., China, Japan, Europe, and smaller emerging markets – even media-darling Brazil – have all been declining for weeks or months.

One obvious culprit is the Federal Reserve Bank’s decision to quit buying Treasury bonds, which infuses cash into the economy.  In the past few days, the Fed announced purchases extending through the end of June, which will be the official end of the program.

The past two times the Fed has “taken away the punchbowl”, as the end of easy money policies are referred to, stock market declines took weeks or months to occur.  For a decline to get underway prior to the actual end of Fed intervention is unusual, but perhaps it makes sense since everyone knows ahead of time when the program will end. 

Big money – mutual funds and pension funds – can drive markets up or down by buying and selling in fund-sized amounts. They need a lot of time to reposition holdings without swamping the markets, and starting early would help them be prepared.

My work shows the stock decline not ending until the 4th quarter of this year.  If I am correct, having the decline begin this early means it has a lot of time to gather downward momentum.     

Certainly we will get some rallies this summer – a few upward zigs to go with the downward zags –  but this is not a time to be taking any more risk than necessary.

As Carter Worth, a crack analyst from Oppenheimer & Company, who I met last month in San Diego said, “Respect the primary trend”.  And, the primary trend now appears to be down.

What’s Going On In Your Portfolio?

All of our portfolios have moved into capital preservation mode over the past few weeks.

As of Friday, June 10th, our holdings in gold have been increased across the board, and I have greatly reduced holdings in the stock market for accounts that held stocks. 

Income oriented holdings have shifted to the more conservative side and away from the high yield (junk) bonds that have been so good to us the past two years. 

The risk with high yield bonds and funds that own them is credit risk.  The risk of default is higher with this type of bond, and when they begin to decline in price it says the market is worried about a recession and the increased incidence of defaults that recessions bring.

And, high yield investments have been going down for a couple of weeks now.  Only 1-2% declines for most, but enough to be significant for this class of investment.  This does not mean they can’t turn around and go up, but with all of the other storm clouds on the horizon, the odds of that happening do not appear to be great. 

I have found junk bond funds to be a terrific bell-weather for the market in general and right now they are pointing down.

The Careful Growth Strategies* model name is plural because I use different strategies to pursue growth when the market is going up than when it is going down.  I also layer strategies on top of each other and when their signals reinforce each other I pay close attention.

Two weeks ago I began using a new strategy for a portion of the Careful Growth* model.  It is called Adaptive Balance* and is an evolving series of calculations designed to first tell me how much investment to make in the stock markets vs. the bond markets, and within each of those categories, underlying strategies tell me whether to be using conservative or aggressive investments. 

Adaptive Balance* involves less trading than previous strategies, which is attractive, but also exposes one to greater losses before getting out of the market.  However, back-testing shows that it provides good protection for the type of bear markets we saw in 2000-03 and 2007-09, while making a nice profit in between. 

I’d be happy to show you how it works the next time you are in the office.

Our Spotlight Strategy

The strategy summary sheets posted on our website have performance data and holdings updated quarterly.  We publish them here in the Spotlight Section of the newsletter, once each quarter.

However, since I have five variations of my investment strategies and there are six or seven publishing dates in each quarter, we will have a few issues where we do not spotlight a particular strategy.  This is one of those newsletters.

Instead, let me use this space to review the use of the term “model” or as I often call it, the “strategy”.  

When your account was opened, you gave me some investment objectives.  Models are the templates used to pursue each investment objective.  The model account will show the desired percentages in various investment types to pursue the stated objective.

We strive to have each of your individual accounts follow the model investment within the practical constraints of your account size, cash inflows and outflows, etc. 

As an example, let’s assume that I determine that to pursue your investment objective we should hold 20% of your account in gold.  The type and size of your account will affect how I get you exposure to the gold market, or if I can get it for you at all.

Often I will buy an exchange traded fund (ETF) that holds physical gold bullion.   That type of investment has a $16.50 charge to buy and another $16.50 to sell.  On larger accounts, the drag on performance from these charges is negligible. 

On smaller accounts, it may be more cost effective to instead buy a traditional mutual fund that owns the stocks of gold mining companies and which has no transaction fees.  However, sometimes gold and mining stocks do not act exactly the same, so slightly different amounts of each may be used.  And, some accounts, such those held at variable annuity companies may not offer any gold related investments at all. 

For these reasons, performance from account to account may vary from what is reported for the model portfolio.  This is also why I speak generically in this newsletter about investments we own in your accounts – I frequently use different investments in different accounts to pursue the same objective.

Performance numbers for growth accounts are generated using a hypothetical $100,000 account, and will be affected differently by the fixed trading costs ($16.50) in larger or smaller accounts.

I always apply my maximum (2.5%) management fee when making performance calculations, so performance numbers reflect the results the model produces during that period after deductions of all fees and expenses.  Due to volume discounts for larger account sizes or family and friends group discounts, you may have lower fees which can also skew your performance away from the model performance.

If fees for multiple accounts are billed to only one of the accounts, this will also skew performance among the accounts, sometimes greatly if a small account is paying the fees for larger account(s).

There are many issues affecting performance reporting for model accounts.  I try to do mine as fairly as possible using actual trading; leaving out anything not generated using real money in day-to-day trading.  With this explanation I hope you will understand if there are differences between the numbers I mention and those you see reflected on your statements.

Please call the office if you have any questions about this.  778-4000.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.