Wednesday, October 31, 2012
Killing Fundamental Reform: Money Market Funds
Today money market funds are like pilotless airplanes. The money manager operates the fund from the safety of his office. As long as markets are stable, the passengers (investors) are just fine. If the fund encounters a turbulent patch, the investors are at risk. In a financial crisis, all those pilotless drones pose a risk to the financial system. Over the last several years, the government was supposed to do something about this.
|Angel Investing 1 (2001)|
This post illustrates the power of the money management industry to oppose and stall regulation even when there is an overwhelming problem that threatens our long-term financial stability.
When you deposit money in a money market fund, you expect that you’ll get every one of your dollars back whenever you want. During the credit crisis, many money market funds incurred losses and faced the choice of freezing the fund (no or limited withdrawals) or returning less than a dollar to their investors. The government stepped in to guarantee everyone’s principal in money market funds, and everyone breathed a sigh of relief.
However, a government guarantee is an entirely inappropriate way to protect investors, as it gives the money manager license to make inappropriate and risky bets. If his bets don’t work out, the taxpayers will be forced to bailout the money market fund. Money market funds aren’t bank deposits, and thus shouldn’t enjoy the type of protection offered by the FDIC. Moreover, taxpayers do not fund the FDIC’s guarantee. It is covered by premiums paid by the banks.
In 2009, the SEC adopted a series of reforms to require money managers to invest money market funds more conservatively. Later in 2009, the SEC sought comment on methods of protecting mutual fund investors during periods of crisis. After numerous meetings, roundtables, and comment periods, the SEC tried to bring forward two concepts (not even proposed rules) in September of this year. The mutual fund industry vehemently opposed both concepts, and the SEC chairman was unable to muster the three votes necessary even to put them forward.
Here are the two ideas. First, the SEC wanted to propose that the value of a money market fund float, just like every other mutual fund. Under normal circumstances, you’d get your dollar back, but in times of stress you’d simply get whatever the fund was worth (e.g. 94¢ or 95¢ on the dollar). The industry, of course, fears that folks like you wouldn’t invest in money market funds if this concept were adopted. I have to admit that I would reduce my money market balances if this idea became a rule.
The second idea would require money market funds to hold 1% of their assets in cash (with more cash set aside if the fund’s strategy is riskier) as a buffer and require it to pay 97¢ in times of distress and the remaining 3¢ within 30 days of the withdrawal request. The industry objected to this idea, because it would hurt yields (the cash wouldn’t earn a return) and therefore diminish the marketability of money market funds.
After the SEC’s proposal collapsed, pressure quickly built. It’s been over three years and nothing has been done to address the liquidity problems of money market funds in periods of the distress. The Federal Stability Oversight Committee created by Dodd-Frank threatened to have the Federal Reserve regulate money market funds if the SEC cannot promulgate reform measures. This threat got the industry to respond and re-initiate discussions. The industry has proposed that investors should pay an “exit charge” of 1% or 2% during periods of distress. In other words, if a money market fund is in distress, you’d have to pay a fee in order to get your money. I’m not surprised by this proposal as it puts the entire burden on you and none on the industry. The manager should be managing risk instead of imposing the risk on money market investors.
I have an idea that the SEC should adopt. It’s an idea the industry will hate. Money managers should have to put a percentage of their own money into their money market funds. The money should come from both the corporate sponsor (a bank, insurance company, or mutual fund advisor) as well as the senior executives. If the fund enters a period of distress, the firm and the money managers should be the last ones permitted to exit the fund. Under my proposal, the airplane would not longer be pilotless. We’d have a captain onboard, and he would be the last one to go down the emergency chute in the event of a water landing.
Tuesday, October 30, 2012
Overweight Duck: The Laden Version of the Endowment Model
In the wake of the poor equity markets of the last decade, many wealthy individuals and small endowments sought the magic of the investment model pioneered at Yale University and emulated at other endowments. The Yale model uses an assortment of hedge funds, private equity, and other alternatives with only a smattering of conventional stocks and bonds. For Yale the result has been a serene duck: steady performance without the tumult of the stock market over the span of past thirty years. Dozens of universities have copied the Yale model with varying degrees of success. After developing the model for their university endowments, many university CIOs decided that there was more money to be made by forming their own firms in order to offer the endowment model to outside investors. Instead of being paid $500,000 or more for their services, the CIOs bet they could earn millions in fees and performance bonuses.
|Y2K Meeting (1999)|
University CIOs generally don’t manage money directly, so their product was going to have to be offered as a fund of funds (a fund that invests in other managers’ funds), which contains multiple levels of fees. Moreover, few of these ex-CIOs are as gifted as David Swenson, the long-time leader at Yale. Their strategy is to construct a portfolio of highly diverse managers, so that the ebbs and flows of the managers’ investment performance are as unsynchronized as possible (known as low correlation). They also employ managers who deliberately hedge certain risks in order to further dampen volatility. In theory, this strategy should produce a serene duck. However, in practice, investing in this manner produces an overweight duck that is burdened with excessively high fees.
In recent days, the Endowment Fund run by Salient Partners has severely limited the ability of its investors to withdraw their funds. It seems there’s been something of a run on the Endowment Fund as some $2.8 billion has been withdrawn in the last 2½ years from what was a $5.2 million fund. As investors have asked for their money back, the fund has become more and more illiquid, and Salient has been forced to stop withdrawals.
What went wrong? Just about everything. First off, investors gave up on good old stocks and bonds just about the time that the financial markets bottomed out. In other words, they sought refuge in products like the Endowment Fund only after the stock market had been on a long losing streak. As they jumped onto the back of the serene duck, the stock market took off, and the Endowment Fund and similar products were bound to disappoint investors.
Second, billions of dollars poured into these endowment-type strategies, and as per usual, too much money turned reasonable investments into mediocre ones. As a result, the alternative managers failed to deliver, and the duck, while serene, started to ride low in the water.
Third, fees burdened these “endowment” funds. The Prospectus for Salient Alternative Strategies Fund, which feeds investor money into the Endowment Fund, lists a management fee of 0.75%, a service fee of 1.00%, borrowing costs of 0.32%, and other expenses of 1.62%. In short, 3.64% of an investor’s money goes to various fund expenses. The duck is taking on water. However, the expenses thus far haven’t accounted for the cost of investing with the underlying money managers. These managers add another 1.63% in management fees, 0.38% in performance fees and 2.37% in other expenses. When you add it all up, the duck is completely underwater, as there are 7.24% in total fees to be paid before Salient’s investors make any money. If you checked my math, the total is 8.06%, but Salient has graciously offered a rebate of 0.82%. However, the true burden is even higher as the fund has experienced about 55% turnover in its assets and managers, which probably adds another 2% or 3% in costs to investors.
Just for this duck to earn 7% for its investors, which would on the low end of expectations, the underlying managers would need to produce an average gross return of 15% or 16%. They didn’t come anywhere close, and it’s highly unlikely that they ever would over any meaningful period of time. As a result, investors decided to redeem their capital.
Let’s be clear about two things. Investors were offered plenty of documentation about the fees and expenses of the Endowment Fund. This is a product that was going to be ridiculously expensive from the very start. As per usual, the only ones who made great money on this product were money managers and their service providers. At its peak, the Endowment Fund was probably throwing off about $140 to $150 million per year to money managers and another $225 million to service providers. I bet the marketing pitch was compelling and was delivered in some posh settings. Of course, the fees gave managers plenty of cash for the marketing extravaganza.
While a portfolio that consists of 60% in stocks and 40% in bonds will never be a serene duck, it is a reasonable long-term way for most investors to deploy their capital. If investors use index funds or exchange-traded funds (ETFs), it can be inexpensive as well. There’s one shortcoming; investors won’t be able to brag that they’ve got their money invested in “sophisticated” strategies with brilliant hedge fund managers in a serene duck. On the other hand, a viable strategy is better than drowning water fowl.
Posted by Andy Silton at 6:53 AM
Monday, October 29, 2012
Peering Beneath the Surface: Uncovering A Fraud
At one point in my career, my firm was the sponsor of a high yield mutual fund that garnered a highly desirable five-star rating from Morningstar. Brokers were eager to recommend the fund to their clients, and hundreds of millions of dollars flowed into it. The fund was a “serene duck.” Its investment performance was outstanding, and it barely bobbed as the credit market rose and fell. At first, I thought this was one of those rare circumstances where a money manager had legitimately constructed a high return, low volatility product. The returns were driven by a series of bets on telecommunications bonds, which were benefitting from the emergence of the Internet. The serenity appeared to be the result of some fairly mundane credits that were thinly traded or privately placed. The prices of those bonds didn’t move very much, creating the calm appearance of the portfolio. My colleagues told me that the portfolio manager was really smart, but they couldn’t describe her investment method in any detail.
|High Yield (1999)|
As this was a rather unique portfolio, I thought it made sense to get to know the manager better and obtain some insight her methods. I wanted to understand how she evaluated and monitored her telecomm holdings, and how she conducted due diligence and sourced her private placements. She’d been invited to our headquarters for a celebration as the fund had reached $500 million in assets. By the time the celebration occurred a few weeks later, the fund had more than $700 million in assets. I asked if she’d be willing to meet me for breakfast or lunch. She didn’t have time. I asked if she could meet in my office. She didn’t have time. A few weeks later, I traveled out to her office to meet with a bunch of her associates who managed a lot of other fixed income products. Once again, I asked her for a meeting. Yup, you guessed it: too busy.
Her evasiveness was starting to worry me. I decided to analyze her portfolio myself. For three or four evenings, I sat at a Bloomberg terminal and studied each of the portfolios holdings. The risk and return characteristics of the big telecom holdings and other large positions were readily apparent. The illiquid securities and private placements only contained a modest amount of information as I expected, and our portfolio accounting unit had suitable and multiple sources for pricing these securities. However, there were several bonds that did not show up when I entered the bond’s name, security number and CUSIP (a nine digit alphanumeric code assigned to every security). I wasn’t too concerned, as some small private placements don’t have any information in financial databases such as Bloomberg.
I found a bit of information on the Internet about companies that had the same names as the securities in the portfolio. I called two of the companies. They told me that they did not have any debt outstanding. There was one security for which I couldn’t find any information, so I contacted the Secretary of State’s office, where I thought the company might be incorporated (the company had the state’s name in its name). Once again, there was no record.
My concerns were rising. I asked our portfolio accounting people for the name of the broker that was helping to price the securities. I figured they might be able to provide me with some research and insight. When I called the broker, they said someone would get right back to me. About ten minutes, later the portfolio manager called my boss and said she didn’t want me trying to contact the broker (her language was much more colorful). There wasn’t much more I could do for the moment as I was headed to Europe for the remainder of the week. As I was traversing the Pittsburgh airport, I was paged (I was a late adopter of the cell phone). I found a pay phone, and called the office. The portfolio manager had come into work, cleaned out her desk, and walked out.
Our compliance professionals secured her files and discovered that she had colluded with the broker to create a series of fictitious companies. It turned out she’d originally made legitimate investments in some very risky businesses. When those businesses began to fail, she didn’t want to recognize the losses, so she conspired with the broker to create “new companies” that would buy the failing securities at par (full price). For accounting purposes, everything looked fine. However, the paperwork in her desk told a different story. It turned out that the serene duck had been paddling furiously beneath the surface and trying very hard to keep anyone from looking beneath the water.
My firm made the investors whole by injecting cash into the mutual fund to cover the losses. The SEC barred the portfolio manager from managing money. As far as I know, the portfolio manager never received any personal benefit from creating the fraud. Apparently she wanted to protect her investment track record and five-star reputation. I don’t think the fund ever again achieved the same level of success or recognition. It was just another high yield duck.
Sunday, October 28, 2012
Gretchen Morgenson of the New York Times writes that money management (the subject of most of my posts), along with the mortgage business are the two biggest sources for the undue influence of finance in our economy. She cites a paper from the Harvard Business School by Scharfstein and Greenwood entitled "The Growth of Modern Finance". What Morgenson doesn't explore is the relationship of money managers to the excesses in the mortgage industry. Who do you think owned the stocks of all those mortgage brokers, government sponsored enterprises, and over leveraged banks? Money managers. And who bought the mortgage backed securities, and mis-analyzed their contents? Money managers.
Posted by Andy Silton at 6:43 AM
Saturday, October 27, 2012
Beware of Serene Ducks
Imagine spotting a duck swimming serenely in turbulent waters. You might say, “That’s one amazing duck. How does he do it?” You’d be even more astounded if all the other ducks were struggling to stay afloat. If the duck were an investment manager, you’d be attempted to give him all of your money to manage. Moreover, the rating services like Morningstar would most assuredly assign the duck five stars. After all, this investment duck is something we all dream about for our retirement savings or our favorite endowment’s investment fund. We want an investment that will rise in value, without inducing the nausea that comes when the financial markets become unstable.
|Fund Launch (1999)|
As I mentioned most people are immediately drawn to this miraculous duck for their investment portfolio. In fact, most investors not only make commitments to this type of investment, they tend not too pay much attention to it once the money has been committed. If the money manager is producing consistent returns in unpredictable markets, he must be one of your winners. Most investors focus all of their concern on the mere mortals who are producing inconsistent or even poor returns during volatile periods. The instinct to ignore the outstanding manager and focus on the laggard is completely wrong, and gets investors into deep financial trouble.
When an investment sails through volatile markets without bobbing, investors should become highly suspicious rather than complacent. This is the very investment that should keep you up at night. Something is going on beneath the surface to make that duck defy the laws of nature and investments.
Unless you are prepared to do a great deal of investigation, you should always avoid an investment that offers attractive, steady long-term returns with very low year-to-year variation. It is going to be hard to resist making the commitment, because brokers and advisors are going to say that the manager of this investment product is absolutely brilliant. Matter of fact, you should tune out any investment pitch in which someone is claiming that a money manager is a genius. You are also going to be wooed by a claim that this is a limited or even rare opportunity, and that only a few chosen investors will get to invest with the duck. By now you will be trembling with excitement as you reach for your checkbook to invest in this outstanding, low risk product managed by an investment “wunderduck.” Put your checkbook back in your pocket and walk away.
At its worst, this duck is a complete fraud like Bernard Madoff. However, it’s also entirely possible that the duck is a legitimate investment feigning stability, and is, in fact, filled with esoteric derivatives that are eventually going to result in the duck drowning altogether and taking your investment with it. On very rare occasions, you might actually hit upon this perfect duck, as for brief periods of time a money manager may produce consistent returns in volatile markets. The reason you should stay away, however, is that it is nearly impossible to differentiate the legitimate from the illegitimate. The legitimate is extremely rare, and seldom marketed to non-ducks.
Take the most egregious case of a fraud. In almost every fraud the money manager manipulates the accounting system that prices securities and delivers investment reports to you. So on the surface, the performance looks good, and there may be lots of details (trades, analysis, commentary) to back up the report. However, beneath the surface, the manager is going to be furiously paddling his little webbed feet to keep himself afloat. The task of the investor is to get beneath the surface of the water, because the feet are a dead give away. The problem is that the duck is going to do everything possible to keep the investor from plumbing the depths.
Amazingly, most investment frauds don’t start out as such. Typically the manager delivers legitimate performance or even superior performance. However, after a time, things start to go wrong, and the manager doesn’t want to confess his sins to his investors. So he begins to manipulate the accounting system, and thus the losses in your account aren’t apparent. As long as you don’t ask for your money back and/or new investors continue to commit new money to the manager, he will be able to perpetuate the fraud.
However, if new money stops flowing into his funds, and someone asks for their money, the manager has got a problem. He needs to pay them based on the accounting statements, which say that they made a steady return, even though he has sustained losses. Once he pays them, he has even less money available to cover what you believe are the steady profits in your account. So when you eventually ask for your money back, he’s got a huge problem, because he can’t cover what the accounting statement says he owes you. All of a sudden and without warning the serene duck is a dead duck, and so are you.
In the next post, we’ll look at a real example of the serene duck, and how it can be uncovered.
Posted by Andy Silton at 7:47 AM