True learning only comes through pain, Aristotle observed. If that's the case, investors endured one heck of an education last year. The source of their illumination was the financial crisis of 2008, of course, an event that exposed any number of flaws, misguided expectations and plain old blunders in the money game. More than a few notions about money management that looked brilliant back in the day were stressed and tested to extremes last year, leaving a glut of discouraging and even fatal results.
So it goes when a global financial debacle of historic proportion lays low the best laid plans of mice and men. But having suffered at the hand of Mr. Market once again, are we any the wiser for the grief? Perhaps, but only time knows for sure. Don't hold your breath. The inertia of emotion and habit isn't easily conquered in money matters, history reminds. As GMO's Jeremy Grantham recently told Barron's on the prospects for the crowd's capacity to learn from the turmoil: "We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term."
There are exceptions, of course, some of which are in the wealth management business, an industry that has towed a fairly conservative line in portfolio matters, or so anecdotal evidence suggests. Diversification across conventional asset classes and disciplined rebalancing strategies, for instance, are common in this corner of finance. That alone represents progress compared to the grand sweep of what've passed as prudent investment ideas over the years. Still, even diversification didn't spare investors from the market's wrath. Short of putting most or all of one's portfolio in T-bills ahead of the storm, a fair amount of client communication since last September has been centered on explaining the explosion of negative signs on investment statements.
Was it all in vain? In search of answers, or at least some intriguing stories, we recently talked with four wealth managers and put them on the spot by asking for lessons learned. To their credit, they all responded candidly, discussing how last year's extraordinary events altered their thinking and what they'll do differently going forward. Unsurprisingly, the common theme is that troubles can and do arise, even if you're prudent. Risk, in other words, comes in many forms, and it's not always obvious in advance.
Just ask George Feiger, CEO of Contango Capital Advisors in Berkeley, Calif. "In terms of what we're not willing to do any more is using leveraged investment strategies," he says. The source of his attitude adjustment: the recent troubles in collateralized loan obligations (CLOs). Having previously allocated a small portion of some client portfolios to high-quality CLO pools with modest levering, Feiger has since had an intellectual reckoning with the idea.
Ironically, Contango's revised thinking wasn't prompted by defaults, which in their case remained conspicuously low, Feiger reports. "We were very picky about credit quality," he says. Increasingly suspicious of an approaching change in the credit and business cycles, the firm focused on the high-grade credits ahead of the market troubles. Defaults, as a result, were minimal for Contango's investments. Rather, liquidity became an issue--a big issue, as 2008 unfolded.
"If you look at our pools, there were hardly any defaults--and yet the loans [at one point] traded anywhere between 50 cents and 80 cents on the dollar." He recalls one loan that was priced at 50 cents on the dollar--a loan that eventually paid off at par. The story was common to Contango's ventures into CLOs, he admits.
In other words, the extraordinary became ordinary. For a fateful stretch during last September and October, rationality seemed to take a holiday in pricing credits. When everyone wants to sell, fair value gives way to raising cash. Price, as a result, becomes irrelevant as traders take leave of their senses. "We didn't make a bad credit judgment, but we sure didn't anticipate the degree of illiquidity and hysteria," Feiger recalls. Neither, it seems, did anyone else.
Contango's CLO-induced pain is small, Feiger notes, but the associated lessons run deep. "The problem with anything that's leveraged," he explains, "is that if the collateral value falls enough, you lose 100% of the principal. To get a few points of extra yield you could lose 100% of the principal. That's a risk that we're not willing to take anymore."
And yet those risks looked reasonable if not compelling before the market came apart. For roughly two decades, CLOs yielded LIBOR plus 500 basis points, net of all fees, he says. It looked "very reliable," Feiger summarizes. Adding to the presumed safety cushion was the fact that the securities owned by Contango were "the most credit-worthy senior loans--the bread and butter business of banks," he emphasizes. Similar strategies were available in publicly traded closed-end funds.
"In a period of illiquidity, however, it doesn't matter how conservative you are on the credit side," Feiger reminds, speaking from experience and with the financial scars to prove it. "Anything that's leveraged is subject to margin calls, and once you have a margin call in one of these structures, you've suddenly got to organize a whole lot of investors and convince them to put in more money. That's difficult to do in the middle of a panic."
Jeff Troutner never used leverage in client portfolios, but he has other regrets in the wake of last year's financial drama. "I'm spending a lot of time researching this Fannie Mae and Freddie Mac thing," says the managing director at Equius Partners, a wealth management firm in Novato, Calif. "I'm pretty convinced that that debacle introduced a systemic risk to the market that a lot of people missed." A risk, he adds, "that I don't want to miss in the future."
Troutner's not alone in seeing Fannie and Freddie as key factors behind the real estate catastrophe that ultimately sent waves of agony through the financial markets. He's quick to point out that there's plenty of blame to go around, including Wall Street's huge blunders with so-called risk management. He also cites a "bipartisan political interference with the free markets" that led Fannie and Freddie to buy lower-grade mortgages from banks. In turn, questionable mortgages were repackaged into the now infamous subprime mortgage pools, courtesy of Wall Street's wizards. The rest, as they say, is history--and tragedy.
"We have to pay attention to the fact that we had a couple of trillion-dollar monsters that we created, that the politicians created and that Wall Street happily abetted with their distortion of risk and the introduction of a massive systemic risk into the markets," asserts Troutner. "We have to do something to make sure it doesn't happen again."
With the benefit of hindsight, Troutner says he might have been more cautious had he known the full extent of the systemic risk posed by Fannie, Freddie and real estate problems in general. "That's one regret," he says, although he admits that the warning signs were there. "I had been reading these damned Wall Street Journal editorial articles for the last couple of years that had been consistently beating the drum against Fannie and Freddie, and I didn't get it!"
Even so, Troutner says his basic strategy remains unchanged. "We're aggressively rebalancing. We're shifting from our high-quality bond portfolio to stocks." That's primarily a function of the unintentional adjustments on the strategic allocation that comes by way of the dramatic market moves of late. "We're doing the opposite of what we were doing in 1999 and 2000," he says. "We're actually buying stocks and selling bonds."
Jerry Miccolis emphasizes that regardless of the market environment, "there's some long-term strategic thinking that shouldn't change" for portfolio management. Examples of enduring principles: Broad diversification, owning asset classes that move independently to some degree, and rebalancing that takes advantage of market volatility, says the senior financial advisor at Brinton Eaton Wealth Advisors in Madison, N.J., adding, "Those are long-term fundamental things that shouldn't change." But sometimes extraordinary events inspire bending--if not exactly breaking--otherwise fundamental rules.
The remarkable events of September and October triggered a temporary suspension of rebalancing actions for portfolios managed by Brinton Eaton, says Miccolis. "It seemed not to make too much sense to rebalance when everything was moving in the same direction,"--namely, down.
The firm's reasoning starts by reviewing the basic catalyst for rebalancing, including so-called mean reversion. That's shorthand for the tendency for asset class returns to move back to their long-term average, he says. During bull markets, mean reversion implies lower returns in the future; in bear markets, it suggests higher returns are coming. But no rule is absolute, it seems, and so-- with virtually everything in or near free fall--the folks at Brinton Eaton decided to temporarily suspend their mean-reversion-informed view of money management.
Other core principles--such as expecting certain asset classes to move independently of one another--were put on hiatus during the crisis, albeit temporarily. "It didn't seem wise or prudent to rebalance just out of habit when some of the key assumptions that support [the concept] were suspended," Miccolis explains.
Learning to expect the unexpected also earns a bit more respect these days at Mountain Hill Investment Partners in Atlantic Highlands, N.J. The source of this new-found perspective comes after a highly improbable event: the breaking of the buck in a money market fund. There have been only two cases since the product was invented in 1970. The second instance came last September. "We had exposure to the Reserve Fund," says Mountain Hill's president and founder, Andrew Kaiser, speaking of the product that nicked his accounts.
The damage, he estimates, will be 3%--modest, given the losses swirling about in recent months, but stinging nonetheless, especially for Mountain Hill. Last year, ahead of the market collapse, Kaiser says he was raising cash levels to 30% in client accounts. It's painful to think that the strategy was right but the implementation choice tripped you up, he adds. "I've been using money markets since my first communion and I always thought it was a safe place to park money. I think we learned differently."
Suffice it to say, Kaiser and many others have taken a fresh look at the formerly subtle distinction between a U.S. Treasury money market fund and its less disciplined alternatives.
"Being in cash in the past year was a great call," Kaiser says. "The problem was being exposed to the Reserve Fund, which we thought was a great call, too." As Kaiser and others learned the hard way, sometimes being right just isn't enough.
James Picerno (jpicerno@sbmedia.com) is senior writer at Wealth Manager.
