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Aurum specializes in designing asset allocation models for both individual clients and corporate retirement plans. The Aurum Asset Allocation Frameworks are focused on reducing volatility through effective diversification of risk. Mission We are committed to being an advocate for our clients'... More
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  • Mom & Pop, "Welcome To The Club
    Mom & Pop, "Welcome to the Club"


    Aurum Weekly Access - 9/5/13

    By Michael McKeown, CFA, CPA - Director of Research

    Large private equity firms are bringing new products to the masses.

    In early August Barron's published "The Next Private-Equity Investors: Mom and Pop" and the Wall Street Journal covered the topic in May with Megafirms Talk about Challenges Catering to Retail Investors.

    This is not news to us since we field calls on a daily basis from asset managers itching to explain the privilege of allocating a portion of our client assets to their next great investment product. Private equity [abbreviated as PE] managers and PE fund of funds (managers that invest in a basket of private equity funds) include themselves on the roll call and have for several years now. Should investors be swooning (with their capital) into the loving arms of PE firms?

    Let's walk through a few important topics.

    1.Investors will be wooed by the high historical IRR (Internal Rate of Return), calculated differently than most other investments since investors do not invest the entire amount of the subscription on day one. Capital is called when needed over the subsequent few years following the subscription and then invested in companies. Eventually, that capital is returned to investors as the underlying businesses are sold to other PE funds or the public markets. In addition, many marketers quote the IRR as gross of fees and often do not include the management fees (2% annually) and incentive fee (20% of profits) that pays the managers.

    Remember the disclosure from every financial firm when you see these charts, 'past performance is not indicative of future results...'

    (click to enlarge)

    Source: Bain & Co., Global Private Equity Report 2013

    2. Generally, the minimum investment for a PE fund ranges from $5 to $25 million, but to allow the masses a chance to invest, minimums are dropping to $100k or so. In that way, wealth managers and marketers can pool a large number of individuals and reach the fundraising goal. Dropping minimums is an initial warning sign, given that most PE funds would prefer to just have institutional relationships. Opening the doors to individuals is the result of having trouble raising assets with the core clientele.

    "I don't want to belong to any club that will accept me as a member." - Groucho Marx, comedian

    We've seen a similar story in other asset classes over time, finally letting retail investors grab a part of the action, only leaving them as the bag holders when it does not work out. Tech club deals in the late 90s and private REITs in the mid-2000s followed a similar pattern, and both were illiquid structures.

    Over the past few years, maintaining the same level of growth in assets continues to be difficult as pensions and endowments become over exposed to private equity. While originally an 'alternative,' PE is largely conventional now to institutional investors. Is *now* the time for retail to jump in?

    (click to enlarge)

    Source: Bain & Co., Global Private Equity Report 2013, Aurum

    Also in the above chart, note the small level of assets raised by the industry prior to 2004. These are the vintage years of outsized returns which managers offer as a compelling reason for investment, however, a low supply of capital and less competitive environment in the 90s and early 2000s does not compare to the same opportunity set for investors today.

    As assets increase performance necessarily does not. In fact, it is typically the opposite...

    pe3

    Source: Bain & Co., Global Private Equity Report 2013

    3. The illiquidity risk premium that investors earn by forsaking the ability to sell out is part of the appeal and reason for private equity's outperformance. Still, understanding the length of commitment to a private equity investment program is important.

    The CEO of the Carlyle Group, the largest PE manager, recommends a 5-10% allocation to PE for individuals in the Barron's article. Let's assume the investor does not want another layer of fees for an 'access' product like a fund of funds that really doesn't do much for manager selection. The differences among private equity managers is even greater than public market managers, so the investor wants to diversify by size among large, mid-size, and small focused funds, regionally with North America and Europe, and style with buyouts, growth, early-stage, mezzanine, and distressed. Assume he can invest in 2 funds per year for $100k each with a target PE portfolio of $1,000,000. So he selects ten funds to allocate $100,000 each over the next five years as he does not want to 'time' his investments, he diversifies over five vintage years. This way he will not catch the top of the average business cycle, nor the bottom. Thus a $1,000,000 program would be a 5% weight for a $20,000,000 portfolio or a 10% weight for a $10,000,000.

    Does a retired baby boomer at age 65 want to make this type of commitment? Perhaps. He should recognize though that the time frame for this private equity program will be about 15 years. Given that the first year vintage will be locked for 10 years along with the other private equity investments over the next 5 years. When the program ends, he will be 80 years old.

    (click to enlarge)

    Here is the actual illiquidity illustrated from real data. North American-focused funds with vintage years of 2002-2004 still have not returned the original amount of invested capital to the limited partners, let alone a return on assets.

    (click to enlarge)

    Source: Bain & Co., Global Private Equity Report 2013

    With this liquidity commitment, investors give up flexibility for rebalancing portfolios in the future. That is, rebalancing away from overvalued assets and increasing allocations to undervalued assets when the opportunity arises during bear markets.

    In the future, as PE managers market to retail investors and 401(k) plan sponsors, managers will offer liquidity to investors perhaps quarterly or annually. Though they may fail to mention in the initial sales of these funds, there will be a discount to the actual value of the business if you want to redeem early. In addition, there is only a small percentage of the underlying fund that can redeem at any single point in time. In actuality, the PE managers are offering the best they can since the underlying companies they fund are not immediately liquid (they are after all, private).

    4. A study of endowment performance by Barber and Wang from the University of California, Davis found that private equity returns are largely explained by two factors, a small cap bias and low price-to-book stocks (value stocks). They go on, "results indicate that private equity investments have average market betas... In short, the insignificant alpha [skill based excess returns] on the private equity benchmark makes it difficult to argue that the returns earned by tilting toward private equity represent alpha."

    Below is the Cambridge U.S. Private Equity Index, quarterly pooled returns, shown net of fees. While the correlation is not perfect due to the lag in Net Asset Values, there is a relationship to the public markets small cap value proxy, the Russell 2000 Value Index.

    (click to enlarge)

    This means that a liquid alternative to PE is using public market small cap value stocks, replicating much of the return and risk profile of PE.

    5. The last consideration individuals should make prior to investment in PE is looking to the very person many financial advisors cite as the reason to invest. David Swenson, the Chief Investment Officer of Yale's Endowment since 1985, revolutionized the institutional investment world with his "Yale Model," allocating to illiquid and diversifying alternative investments resulting in stellar portfolio returns. In his seminal book, Pioneering Portfolio Management, he wrote:

    "Academic research backs up the notion that private equity produces generally mediocre results."

    "Even if investors could purchase the median result in an alternative asset class, the results would likely disappoint. Longer term median historical returns have lagged comparable marketable security results, both in absolute and risk-adjusted terms."
    ---

    Is the allocation to private equity a reaction to frustrating U.S. public equity markets over the last 14 years? What will the marginal money flows to private equity be in five to seven years if public equity markets show average performance? This matters because the marginal flows will be the capital that buys the businesses from the current private equity allocators. When unconventional asset classes become conventional to the majority of portfolios, then the unconventional returns also become conventional, as do the risks.

    To sum up:
    • PE matches similar patterns of previous asset classes in which investors become overexposed.
    • There is a history of retail investors being the last to the party.
    • Long lock up periods results in the inability to rebalance portfolios.
    • The majority of PE's return stream can be replicated in a lower fee and liquid structure.
    • One of the best investors in alternative strategies says to be skeptical.

    Hey Mom & Pop investors, "Welcome to the Club."

    [One last item: We have clients and friends working at private equity firms and as allocators to private equity funds. These bright folks work for institutions and clientele with a perpetual time frame as opposed to most individual private clients who do not. In this note, we aim the discussion at the large mass market approach to PE as an industry as opposed to many folks we know who are intimately involved with the private equity funds and companies in which they invest.]

    Important Disclosures

    This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

    i Barber, Brad & Wang, Gujun. "Do (Some University Endowments Earn Alpha?" UC Davis. May 2013. Page 21.

    ii "U.S. Private Equity Index and Selected Benchmark Statistics." Cambridge Associates LLC. March 31 2013. Page 4.

    Sep 06 1:35 PM | Link | Comment!
  • The Role Of Cash In A Portfolio

    We believe that cash is an important asset class within portfolios. The proper cash allocation is driven by two main factors: (1) liquidity management and (2) opportunity risk management.

    Liquidity management is fancy term for a simple concept, making sure withdrawals over the next year sit in a liquid form and ready to go. Liquid form means cash in an account or a U.S. Treasury money market funds transferable out to other banking institutions; it does not mean a 'safe stock' or bond fund. (For the purposes of this article we will refrain from discussing the requisite 'emergency fund' most financial planning articles cover.)

    The liquidity necessary to meet known withdrawals (living expenses, taxes, insurance payments, etc.( over the next one year period should replenish continually so that at least twelve months of withdrawals are available. Secondarily, assets to meet the spending needs in the 12-36 month timeframe should also be part of liquidity management. We place the incoming interest and dividend payments from underlying stocks and bonds into the secondary portion.

    "If you have trouble imagining a 20% decline in the stock market, you shouldn't be in stocks." John Bogle, founder of Vanguard. Over the last 35 years, the Russell 2000 Index of small caps stocks declined 20% or more 9 times, or about once every four years.

    (click to enlarge)

    Source: Aurum, Informa Zephyr

    Relying on systematic withdrawals from stock portfolios to fund spending needs is not a prudent approach, since being a forced seller into a weak market is not the side of the trade one would prefer.

    ---

    "More money has been lost reaching for yield than at the point of a gun," said Raymond DeVoe Jr., financial market historian. This quote typically serves as a warning to bond investors about downgrading credit quality or extending duration, thereby increasing the original risk target and 'reach' for the yield they 'need.' Nonetheless, it applies to the liquidity management side of portfolio construction.

    The New York Fed just put up a great post, highlighting the 15 largest bond selloffs since 1961. Using a zero-coupon 10 year note, the bond selloff through July ranks 13th out of 15 with the often cited 1994 selloff as the 5th worst. It provides important context about the shakeup in the fixed income world the last few months and the dangers of reaching for yield.

    bond_drawdowns_nyfed

    Understanding the historical volatility of bonds provides more reason for a strategic cash allocation.

    The pushback against our argument for cash as an asset class is easy, "cash earns nothing" and thus should be invested. If one believes this mantra, then extolling the virtues of liquidity and opportunity risk management probably do little good.

    Take a real life example of a couple planning on spending $200,000 of their $5 million portfolio. One might say that the $200,000 should be invested along with the rest of the portfolio. With expected 6.5% expected return over the cycle, investing the spending needs over the next year and systematically monthly withdrawals, one could earn an extra $10,000 (given that the $200k would not be invested for the full year). Conversely, the portfolio has a one in five chance of losing money over the next year, and the 95% confidence interval puts the drawdown potential at negative 15%. So on the extra $200,000 that 'needs' to be invested, the portfolio stands a potential impairment of $30,000. In this scenario, because the couple needs the cash for withdrawals, they must realize the losses on the portfolio and became a forced seller. This impairment of capital would not be permanent had the time horizon for investment correctly matched the duration of the underlying assets. Meaning, had the $200,000 been in cash, an on-demand asset class with zero duration, then the assets and liabilities match would be in unison.

    Combining "opportunity" and "risk" into a single phrase for holding cash boils down to one reason, because the price paid for an asset matters. When valuations of assets are too high, the expected future returns are low. When valuations are too low, the expected future returns are high.

    An example of this below is the Shiller P/E. Named for Professor Robert Shiller, but originating from Ben Graham (Warren Buffett's value investing mentor), the Shiller P/E seeks to average out the ups and downs of the business cycle by normalizing the past ten years of earnings.

    shillerpe

    Source: Asness, Shiller[1]

    It has some efficacy in predicting future returns, but most interestingly, it shows when the starting P/E (valuation) is low (left), historical returns are higher (Average Real 10 Year Return). When the starting P/E (valuation) is high, historical returns are lower.

    "Investing is simple - but not easy." - Warren Buffett

    After a period of outperformance above expectations is typically when values are high and thus future returns low, and thus when one would should trim or sell. Still, this is also the time when our behavioral investing shortcomings as human beings come in to play and makes it difficult to sell. Conversely, after an asset class underperforms dramatically and has news stories saying how terrible of an investment it is, future expected returns are above average. The rational economic agent should buy or increase holdings, but the brain reacts to the danger of losing in the short-term and tells us to stay away.

    Cash should be the default holding when an asset class becomes fully or overvalued, as holding it expecting it to go higher is not investing, but speculating on whether a "greater fool" will come along and buy the asset at an even higher price.

    Hence, cash serves as a risk management tool for portfolio construction. In the same sense, it serves as the dry powder for future opportunity. Waiting for the 'fat pitch' to come down the plate, cash offers optionality to respond to attractive valuations served up by an asset class that falls out of favor for other investors.

    During periods of instability in capital markets, asset prices tend to converge and go down together, precisely when a portfolio needs the diversification benefits of multiple assets. The chart below is the correlation of asset classes with the S&P 500. Distressed periods are months when the S&P 500 fell more than 3%, or the 15% worst performing months.

    (click to enlarge)

    In contrast to many asset classes, a great attribute of cash its zero correlation with other assets - in both normal and distressed markets. This provides the liquidity necessary to take advantage of an attractive 'option' when presented.

    Today, with U.S. equity markets hitting all time highs and large inflows into bond funds the last few years, money markets as a percentage of total assets are at all time lows.

    (click to enlarge)

    This, alone, is not a reason to increase cash as an allocation. Nonetheless, if asset classes deviate from the initial portfolio's target policy ranges, then prudent investors should adhere to the investment process. Holding cash as an opportunity risk management tool makes sense to us as investors with a long-term valuation focus.

    [1] Asness, Clifford, Ph.D., AQR. "An Old Friend: The Stock Market's Shiller P/E." November 2012.

    Important Disclosures

    This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

    Aug 22 9:39 AM | Link | Comment!
  • Getting Real- What's Really Getting Impacted By Rising Rates

    Aurum Weekly Access - 6/28/13

     

    June was a volatile month and a key reason was real interest rates finally going positive as shown by the 10-year TIP below. It spent the last 18 months below 0% until June 7th.

    (click to enlarge)

    With negative real interest rates, investors (especially those who use leverage) feel confident to sell a currency short (like the U.S. dollar) and buy assets expecting to produce a positive real return. This is a popular trade to do with the Yen as well. However, it is a trade that can end badly if interest rates rise or inflation falls, which is precisely what happened. Combined with investors reaching for yield, the Fed discussing the tapering of Quantitative Easing, a slowdown in emerging markets economies, and banking system issues in China made for a Molotov cocktail of volatility.

    The Fed discussing less monetary easing was a theme that began in December 2012 when it moved to a data dependent policy measure, citing the unemployment rate and inflation. A client asked - Does it matter to the economy that QE is ending one day? We side with Richard Koo who studied Japan's many rounds of QE since the late 1990s, who calls QE a "non-event," as it fails to spur inflation or credit growth. Below is the CPI and total credit market growth staying in check. Note that credit growth is below 4% today, while it ranged between 5-15% from 1977-2008.

    (click to enlarge)

    Quantitative Easing affects investors' perception of the future and often asset prices to the upside as well as to the downside when the scenarios do not go as expected.

    While many pundits on business TV yelled at the Fed for being off base in its rhetoric, data seems to be steadily improving for the U.S. economy, or at least outperforming expectations of participants (which is the only thing that matters). Personal consumption grew at 2%, housing prices snapped higher year-over-year (thanks, in part, to private equity investors on the coasts), and job growth continues.

    The Purchasing Manufacturing Index serves as a strong leading indicator and shows improvement abroad. The global recessionary periods are highlighted in grey based on the OECD's data tracking, with the latest episode due to recession in Europe. Note that now 64.5% of countries see higher PMI data from last year, compared to less than 10% a year ago.

    (click to enlarge)

    Source: Ned Davis Research

    Here is an interesting correlation between the average hourly earnings growth and the 10-year Treasury. Note the steady decline in both since 2006 until the second half of 2012, when both troughed. Wage growth trending higher at 2% versus 1% a year ago could be a nice indicator for Treasuries.

    (click to enlarge)

    All of the above are data points to watch as the official Fed tone evolves and impacts capital markets.

    For our previous thoughts on interest rates, please see:

    Aurum Access - Trimming Your Core
    12/20/12 http://www.aurumwealth.com/news/weekly-access/138-aurum-weekly-access-122012

    Aurum Access - Closer to the Q-End
    5/17/13 http://www.aurumwealth.com/news/weekly-access/147-aurum-weekly-access-051713

    Important Disclosures

    This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

    By Michael McKeown, CFA, CPA - Director of Research

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

    Jul 10 3:37 PM | Link | Comment!
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