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Alan E. Rosenfield
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Alan Rosenfield brings 29 years of experience to private discretionary asset management. He currently is the managing director at Harmony Asset Management, a registered RIA. The firm uses a “GARP” investment style and multi-asset class strategies which includes equities, fixed-income, real... More
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Harmony Asset Management LLC
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  • Looking Ahead

    Looking Ahead:

    The Fed has announced a second round of spending (QE2), this time a mere $600 billion over the next seven months. Funny, but it was not too long ago the Fed was talking about balance sheet after having expanded it so dramatically in the past two years. The market’s reaction has been rather interesting.

    1) During this period, speculators have bid up the price of TIPS to a negative yield.

     

    2) In the past month and a half since it became clear that the Fed would do a second round of financing, rates have risen dramatically along the curve (see Chart 1).

    3) Oil prices rose for a week before falling on fears of economic slowdowns in China and Brazil and the possibility of a bailout for Ireland. Gold did the same thing (see Chart 2).

    4) Stocks rallied for a day and have sold off since then (see Chart 3).  The Fed argues that by spending $600b on intermediate treasuries, they will keep interest rates low, which will help increase housing prices (without which growth in the U.S. will be almost impossible) and increase inflation by raising equity valuations. I have only one problem with the strategy – it won’t work. Furthermore, it has very quickly backfired; rates have not gone down but up, while stocks and commodity prices have come down, not gone up.

    At this point, I had written a somewhat lengthy, very detailed, and definitely winding commentary on what Bernanke may or may not be thinking and why I didn’t think it would work, along with lots of examples. But, it finally occurred to me that what he thinks, what he is trying to accomplish, and all the reasons why it will backfire are really irrelevant. What really matters is how we address the obvious investment issues. So, luckily for you, the reader, this will be much shorter and a great deal more concise.

    The current investment climate has elements of inflation working through the system, but also has deflation working through the system, and at the same time is exposed to potential black swan scenarios (atypical, high risk situations). During such times, the typical diversification strategies do not work, as the financial meltdown of 2008-2009 and the flash-crash in 2010 have shown. We are in a highly unusual situation when looking back over the past 60 years, and a combination of strategies will be required.

    Typically, a good strategy when worried about conflicting economic cycles would be to use a multi-asset class portfolio. Combining equities with fixed income and either real estate or commodities would protect the portfolio from the various economic crosswinds. However, when getting hit by unexpected highly volatile situations, we have seen that these disparate asset classes all correlate very closely as investors seek liquidity from any and all sources.

                                           Chart 1          Change in Treasury Yields




                                                  Oil (red) vs. Gold (yellow)

     




    S&P 500 (red) vs DJIA (yellow)
                                            S&P 500 (red) vs. DJIA (yellow)


    Thus, a closer examination of the portfolio will be required. The risk of each position will need to be more closely evaluated in an attempt to understand and mitigate fat-tail risks. This must then be combined with strategies that may be less familiar to many investors.

    For instance, some exposure to private investments may also help stabilize an investor’s portfolio.  The lack of liquidity which made many investors hesitant to make such investments may provide a source of stability during volatile markets, presuming of course, that the private company is not in need for additional financing at the time.

    Another strategy is the use of option strategies such as spread trades or synthetic principal protected notes. Such strategies allow a portfolio to have exposure to an equity position but with far less capital at risk. The extra capital that would have had to be exposed if a straight equity position had been taken can be set aside in cash or short term fixed income securities, providing some additional return, but more importantly, providing the portfolio with dramatically less volatility.

    For example, earlier this year, instead of buying Apple stock we invested in an Apple synthetic note trade. Apple was at $249. The portfolio had a total value of ~$1,000,000. If we had purchased the stock outright, a 5% beginning position would have cost $50,000. Instead, we bought three Jan 2012 240 calls, sold three Jan 2012 300 calls and sold three Jan 2012 200 puts. The client was paid $1,515 for taking the position – they had no capital in the deal. Here is the potential outcome:


     

    Apple Option Strategy
    Apple PriceApple ValueJan 240 Call ValJan 300 Call ValJan 200 Put Val
    190($11,800)$0$0$0
    $250$200$3,000$0$0
    $300$10,200$18,000$0$0
    $400$30,200$48,000$(30,000)$0

    Just buying the stock provided a 5% exposure. At $190, the stock would have lost 23%, impacting the portfolio by -1.2%. The option strategy would have cost $1,485, a -0.15% impact on the portfolio. At $250, the stock would be flat, adding no return, but the option would have provided $1500 (about 7 times the return while our capital was still earning returns in short term bonds or cash). At $300, the stock would earn a 20% return and add 1% to the portfolio while the options added 1.95% to the portfolio. The stock would break even with the option strategy at $346.50. So while there is the chance to earn more in the stock, it requires to have much higher exposure, which increases the portfolio’s volatility. Furthermore, the additional downside risk counters the additional upside potential of the stock, thus making it even less attractive. And since the portfolio still has the capital sitting in cash, if the stock were to drop to $200 short term, we have the capital to buy the stock and take on the exposure, but with 20% of the risk already taken out.

    This is, of course, simply one example. But similar trades can be found in many stocks which an investor might have interest in and even though the numbers will vary case to case, we have been able to duplicate this strategy numerous times.

    The Bottom Line…

    Given the current worldwide economic and investment climate, utilizing a more defensive portfolio strategy makes sense. But the typical diversification by asset class is not likely to provide enough of a hedge. A portfolio that utilizes multiple asset classes combined with some private investments, some option strategies and some cash is likely to perform better.

    Yes, one should expect muted returns in such a portfolio. However, when the alternative is losing money – as most investors have managed for the past ten years – a more subdued return is far more desirable. As the co-president at PIMCO, Mohammed El-Erian, pointed out in a recent interview, one down year of 15% in ten years can reduce returns by as much as 50% for the entire time period. Thus, discretion, being the better part of valor, leads us to accepting lower returns in exchange for substantially reducing client portfolio risk.

    Finally, cash, even though it provides only minor returns, does make sense given this investment environment. If the markets get whipsawed once again, portfolios with cash are able to take advantage of the volatility when prices are very attractive.

    An excerpt from Harmony Asset Management LLC's "Notes on the Quarter" #4
    By Alan E. Rosenfield



    Disclosure: I am long AAPL.
    Dec 23 1:09 PM | Link | Comment!
  • New rules for corporate sponsored retirement plans
    Any company, regardless of the number of employees or other measure of size, that provide their employees with self-directed retirement plans will have to comply with new disclosure rules as of November 1, 2011. That seems like a lot of time until you consider the mass of detailed work and training that must be completed before that date.
    With the best of intentions, the Department of Labor has presented American companies with an overwhelming set of problems. The new requirement for retirement plan structure and fee disclosure seems straightforward enough--even a good idea. That is, until you realize what is actually required.
    Problem One:
    Any and all of the costs associated with any plan a company offers employees must be specifically stated. This must also include the costs associated with the investments in the plan, which as many already know, is difficult at best to analyze, as many fees are hidden or lumped together and effectively hidden. In addition, if a company provides more than one type of retirement plan, the formats explaining the plans and their fees must be identical; “Apples to Apples” is what DOL says. Making them “identical” is up to individual plan administrators at the company.
    Problem Two:
    While in the past, the plan sponsor had to provide information on the plan to all eligible participants, now the plan sponsor is also charged with ensuring that all eligible participants understand what is given to them to ensure that they can make fully informed decisions.   The question is, “how do you prove to the DOL that the participants understand the material?” 
    This is complicated to achieve. Plan administrators are either going to have to create a testing mechanism, perhaps with eligible participant signatures, showing individual eligible’s level of understanding or find an automated system developed by some third party. 
    We expect that many of the large plan providers, such as Fidelity Investments, Schwab and the mutual fund companies will create some type of electronic format to provide plan sponsors such testing, but it will still be the plan sponsor’s responsibility to ensure this covers their new-found responsibilities.
    Furthermore, we expect some parts of this will end up being tested in court. But as most plan sponsors would like it to be someone else getting tested in court, you will want to make sure you have accurate records of employee getting and understanding the education materials and, you may want to require they sign off that they understand the information each year they participate.
     
    The Bottom Line: The new education and disclosure rules for self-directed company sponsored retirement plans adds a new level of responsibility and potential financial liability to plan sponsors. While the detailed explanation of plan fees is something we heartily endorse, these rules will be onerous and plan sponsors who ignore or dismiss them will do so at their peril.
    By Chester Wright, Chief Compliance Officer
    Harmony Asset Management LLC
     
     


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Dec 23 12:18 PM | Link | Comment!
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