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Following 23 years with JPMorgan, Simon Lack founded SL Advisors, LLC, a Registered Investment Advisor, in 2009. Much of Simon Lack’s career with JPMorgan was spent in North American Fixed Income Derivatives and Forward FX trading, a business that he ran successfully through several bank mergers... More
My company:
SL Advisors, LLC
My blog:
In Pursuit of Value
My book:
The Hedge Fund Mirage – The Illusion of Big Money and Why It’s Too Good to Be True
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  • Bonds Are Not Forever

    Later this month John Wiley will release Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. Some might say that one book is enough for anybody to write, but I must confess the experience following release of The Hedge Fund Mirage in late 2011 was sufficiently positive that I decided to indulge my audience's patience once more. Recent sales and media coverage related to The Hedge Fund Mirage have no doubt been supported by continued mediocre hedge fund returns delivered at great expense. The industry remains a soft target.

    (click to enlarge)

    Bonds are harder to criticize. For one thing, bond investors really have done well for a very long time. There is no "Bond Mirage" to be written. Bill Gross may have had a hand in more wealth creation for clients than anybody. However, as comfortable as it is to invest in what's been working well, the math of current yields represents a substantial constraint on anything like past performance repeating itself.

    The most important step to getting a book published is a business plan which should include an assessment of other books on the topic. Although ruinously low interest rates are a topic on which millions of savers can quickly commiserate, Amazon's offerings of bond books are heavily biased towards telling you how to buy bonds and which ones. The view that fixed income deserves a radically small portion of an investor's assets is not one that has many proponents. As with hedge funds, much of the continuing support for owning bonds comes from those with a self-interest to maintain. In the last few months we have come across some extraordinarily poor advice.

    One large firm acknowledged the poor return prospects in fixed income but still valued their diversification qualities (i.e. they'll lose money when your other investments are profitable, which is supposed to be helpful). Another published a chart showing the uncannily strong relationship between the yield on ten year treasuries and the subsequent ten year holding period return (yes, really!). The author of that particular insight probably also marvels at just how reliably bond yields rise when prices fall (and vice-versa). Whether fixed income returns after taxes and inflation are modestly negative (the most likely outcome) or worse, the originators of the insights listed above will work hard to present the results to clients positively. They'll need to avoid numbers though, because that's unlikely to help. Adjectives such as "decent", "acceptable under the circumstances" or "OK" will be favored over more measurable assessments.

    One friend showed us a taxable trust for which she's the beneficiary that retains a substantial fixed income holding yielding 1.5% -- coincidentally the same as the management fee charged by the trust company (pun intended). The U.S. Treasury and managers of the trust are both doing well out of this arrangement, although unfortunately my friend is not.

    While there's plenty wrong with low interest rates, the approximately thirty year bull market in bonds has coincided with two other evolutionary shifts. One is that debt outstanding has, by any measure, soared to levels that until recent years would have been believed unsustainable. When other significant public obligations such as Medicare and unfunded public pensions are included along with consumer debt we collectively owe more than twice the size of the U.S. economy. The second is the steady growth in financial services, including securities trading, money management and banking of all kinds. Since the peak in inflation in the early 1980s we have a substantially bigger banking sector and far more debt, but approximately unchanged median per capita GDP. In short, there's not a lot to show for all this borrowed money and frantic trading.

    How this all resolves itself is unclear, but the Federal Reserve sees ultra-low interest rates as part of the solution. Indeed there is so much debt and so many borrowers that providing a return above inflation would seem to be against the public interest, a needless waste of money. To the extent that the Fed, and by extension the U.S. government, can control it they're likely to side with borrowers over lenders and maintain low rates. The evidence so far is that they can pursue such a strategy indefinitely. Inflation is a time-honored solution to excessive debt. Combined with financial repression, a regime of rates maintained artificially low, this can allow debt to be repaid at a negative real cost. Whether rates and inflation move up together or remain low together, yields below inflation plus taxes appear inevitable.

    The growth in financial services supported the growth in debt, through financial engineering that sliced up obligations to meet every conceivable investor's taste. Markets developed for derivatives of all kinds from interest rate to credit risk and complexity combined with leverage in a profitable waltz until the music stopped in 2008. Although the benefits of this bigger financial sector are hard to identify in the rest of the economy, banks were hardly to blame for the financial crisis. Government policies that subsidized debt and promoted overinvestment in housing were a significant factor. However, the aftermath which included the TARP program created a popular perception that Wall Street nearly blew up Main Street.

    The public policy response against banking is well under way, justified by the imperative of avoiding a repeat. Under such circumstances it's hard to imagine a return to the pre-2008 interest rate regimes that generally provided reasonable returns to lenders. A "better bargain for the middle class" for which President Obama recently called, probably excludes interest rates high enough to compensate lenders for inflation and taxes. Bonds Are Not Forever does not take political sides. Saving for the future transcends politics, and both blue and red investors need to coolly assess the populist shift in Washington's policy response to banking.

    The question facing bond investors is, how to respond to this steady transfer of real wealth from savers to borrowers. Three central banks (U.S. China and Japan) own almost $6 trillion of U.S. government debt and they remain significant buyers. In addition, by maintaining short term rates at virtually 0% the Fed keeps additional downward pressure on longer term rates. Their motivation is not commercial, but low benchmark rates tug most other rates down, limiting the opportunities for a commercially driven bond investor.(click to enlarge)

    Hence, the radical advice to abandon the bond market as irretrievably distorted by government activity. If the Fed wants to own bonds so badly, let them own the lot! Take your ball and go elsewhere, to a place where the rules of private sector supply and demand still operate. The Equity Risk Premium, often reproduced on this blog, is a simple visual explanation of our bond-free investment philosophy at SL Advisors as well as the inspiration for the book. Bond yields are highly unattractive compared with the earnings yield on equities. The odds of bonds beating stocks over the long run are extremely poor. Meanwhile, the need for stable investment income is as strong as ever. Bonds Are Not Forever explains why investors should have low expectations for fixed income returns, and SL Advisors runs strategies designed to meet the need for stable investment income without using fixed income. Quite simply, the book explains the philosophy behind our investment business but also seeks to entertain the reader along the way. Clients of SL Advisors can expect to receive their autographed copy within a few weeks.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Aug 02 9:55 AM | Link | Comment!
  • Inland American Realty Runs Its Own Hotel California

    Summer has finally arrived in the north east United States. Cycling to work provides a pleasant reminder that commuting can be enjoyable, accompanied for now by the curious background chorus of billions of buzzing cicadas emerging from their 17 year subterranean slumber. It certainly beats getting on a train.

    The question of the day is, when a company tells you how badly you might expect to be treated as an investor, does that absolve them of any responsibility when they subsequently do what they promised? Well, at least in the Commonwealth of Massachusetts, it turns out that a company's disclosure doesn't eliminate the obligation of a financial advisor to steer their clients away from really bad deals no matter how much the advisor may earn in additional fees.

    Inland American Realty is a registered, unlisted REIT (Real Estate Investment Trust). Registered securities are available to the general public (unlike, say, hedge funds which are generally not registered and are therefore limited to investors with income and investable assets above a certain threshold). Registered securities must conform to more onerous reporting and disclosure requirements, but have a far larger pool of potential investors as a result. Unlisted securities cannot be bought and sold on an exchange (which is true of hedge funds as well as many other private, unregistered securities). Inland American is therefore a curious hybrid - available to anyone who wishes to invest, but with no obvious means of getting your money out. Being unlisted eliminates the interest of Wall Street research analysts to cover such a company, which given management's operating history is just as well.

    To start with, Inland American's original prospectus in 2005 disclosed that, of $5 billion in estimated proceeds from their initial offering, $550 million was going to be used to pay "Selling Commissions", a "Marketing Contribution" and "due diligence expense allowance". Unashamed of this immediate 10.5% payout of their investors' money, the company further disclosed that "actual organization and offering expenses may total 15% of the gross offering proceeds." So your $10,000 initial investment was instantly worth $8,950 and possibly less (assuming, that is, that you could sell it, which you could not).

    No doubt on the basis that, if a 15% fee hasn't put you off many other highly unfavorable features are unlikely to, management went on to disclose additional gems including the complete absence of any prior operating history, conflicts of interest between management and a key service provider, the expected payment of big fees to affiliates of management and the fact that no market would exist in the securities. Full disclosure of anticipated investor-unfriendly acts was evidently an important part of their business model. The 5% dividend has seduced many investors in search of steady income. However, since the company isn't profitable, paying any dividend simply amounts to giving you back some of your own money (i.e. a return OF capital rather than a return ON capital). Among their real estate assets are, appropriately, hotels in California. The Eagles warned investors how hard it could be to leave.

    Perhaps not surprisingly, the investments chosen by this management team didn't turn out that well either. Evidently skill at fleecing the buyers of your stock in broad daylight doesn't correlate that well with real estate acumen. The company's NAV (Net Asset Value) per share duly sank from its IPO price of $10 and was at $4.84 based on their most recent regulatory filing. Of course you can't sell it there because no public market exists. The company will buy shares back from investors, but only under fairly onerous circumstances such as death. Most would no doubt prefer somewhat better liquidity.

    Since 2005 real estate investors have endured some gyrations to say the least. However, the Vanguard REIT Index ETF (VNQ) has risen 35% during this time, so holders of Inland have reason to feel that there were better places to put their money.

    In 2012 the company disclosed that the SEC was investigating several issues including fees paid to affiliates, dividends paid to investors, and valuations. Inland American maintained a mysteriously stable NAV through the 2008 financial crisis which possibly helped them sell additional shares at too high a level. This is, in sum, not a story that reflects well on anybody involved in recommending the investment.

    Which brings us back to Massachusetts, whose securities regulator recently reached a financial settlement with five brokerage firms who had been improperly selling Inland American and other non-traded REITS to investors in that state. The regulator found, "…a pattern of impropriety on the sales of these popular but risky investments." The complaint cited high commissions, conflicts of interest, sporadic valuation and the absence of a public market as sources of additional risk for investors. Evidently a few firms in Massachusetts were not overly burdened by the inconvenience of considering client suitability for their recommendations. One of the firms claimed in its defense that its compliance manuals and training materials included appropriate safeguards throughout the time they were inappropriately selling the securities. They obviously have bigger problems.

    One would think that the features listed above would render Inland American and other similar securities (apparently unlisted REITS are a $10 billion per year industry) unsuitable for the clients of any brokerage firm whose intentions were to promote sound investments. A brief internet search reveals many more unhappy investors outside of Massachusetts who were guided into supposedly "safe" investments by their broker only to find that they were anything but. Several class action lawsuits have already been initiated. Perhaps the SEC and other state regulators will follow up with further sanctions.

    This episode highlights the need for investors to truly understand how their financial adviser or brokerage firm is being paid. Firms recommending securities that result in a hefty share of proceeds to the broker selling them ought to be a clear warning. For a security that takes the public in but doesn't let them out, the time has surely passed.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: reits
    Jun 04 2:25 PM | Link | Comment!
  • Trading Inflation For Growth

    In yesterday's press conference, Steve Liesman from CNBC asked a highly pertinent question of Chairman Bernanke. Steve asked whether the explicit focus on employment meant that the Fed was now willing to tolerate a higher inflation rate than would otherwise be the case. Bernanke answered predictably by noting that the Fed by law has a dual mandate (maximum employment consistent with stable prices). But in thinking about his comments afterwards and the way they've positioned themselves, it seems to be unlikely the Fed will spend any time worrying about inflation until the employment picture improves. Of course there isn't much evidence of inflation anyway, but we are virtually assured, based on his comments, that if or when things do ultimately pick up the Fed will be a long way behind the curve in terms of raising rates. Negative real returns are here to stay for bond investors. Bernanke made the case for real assets yesterday, including gold which we own through our investment in the gold miners ETF (GDX).

    Disclosure: I am long GDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: long-ideas
    Sep 17 2:34 PM | Link | Comment!
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    Oct 4, 2010
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