In This Issue

Summer Steaming?

I offer some thoughts on recent market performance and portfolio construction.

Inflation/Deflation

“Location, Location, Location” Is Not Just For Real Estate

 Active Managers Get the Cold Shoulder

          Inflation/Deflation

There is currently a tension between those expecting inflation, as a result of the huge stimulus, and those anticipating deflation.  Thus it should not be surprising to see that volatility has remained a part of investors’ landscape. 

The deleveraging of the capital markets in 2008 caused a temporary deflationary cycle.  US Fed Chairman, Ben Bernanke, a student of deflation, defined as a negative inflation rate, has stated that some inflation is preferable to deflation.  The policy he has implemented has been driven in part by the desire to avoid a lengthy deflationary period.  Once started, a deflationary cycle can be very difficult to halt.  Consumers put off purchases expecting lower prices in the future. This reduces GDP and can lead to a vicious cycle.

It is not known how the massive stimulus will impact the money supply, the economy, or inflation.  (According to Bloomberg news, as of March 31^st 2009, the US government and the Fed spent, lent, or committed almost $13 trillion.)  But its sheer magnitude has investors understandably concerned about future inflation risks.  Investors looking to protect themselves from inflation have historically benefited from investing in:

• Equities

• Short-term bonds

• Treasury Inflation Protected Securities (TIPS). 

Each of these asset classes have historically done well in the sense of providing a positive real return in an inflationary environment.  Over long periods, US equities have provided a positive real return after adjusting for inflation.  Even in those emerging markets that have had some bouts of huge rates of inflation, equities have usually provided a positive return after inflation.  Short-term bonds, which are less sensitive to interest rate changes, have also been a good hedge during periods of rising rates.  Meanwhile, TIPS help to preserve purchasing power as their return is linked to the CPI Index.  They are also great diversifiers as they have a negative correlation with equities and a low correlation with most other asset classes.

As for commodities, they are often touted as a good hedge against inflation.  In addition, they have acted as a portfolio diversifier and up until recently their performance approached that of equity-like returns.  The story, however, is more complex.  In attempting to use commodities as an inflation hedge, one must be aware that the volatility of commodities is many times that of the underlying inflation rate.  As a hedge, they are a rather “blunt” instrument.  As for their expected returns, much of the performance in recent decades was due to factors that were not directly tied to the underlying spot prices of commodities.  For example, many investors use a commodity futures contract as their means of accessing commodities.  The returns on these contracts are a function of: 1) the collateral earned, 2) the gain or loss associated with rolling into a futures contract as the current one expires, and 3) the spot commodity prices.  The factors that have historically caused commodity futures to have such attractive returns may in fact not be present today.  An in-depth explanation of these issues goes well beyond the scope of this newsletter.  Please contact us for a few excellent papers on the subject.  Notwithstanding these caveats, commodities can play a useful role as a diversifier in one’s portfolio.  And of course many investors already have significant commodity exposure as part of their equity portfolio.  Alone they may be a risky asset class.  But in the context of one’s portfolio they can help to reduce volatility.  But they are not the inflation hedge panacea that one often reads about in the press.

          “Location, Location, Location” Is Not Just For Real Estate

Real estate investors often quote the adage, “There are three things that matter in property: location, location, location.”  In the investment world location is also important.  Does that mean one should look for stocks in the beautiful mountains of Switzerland or that one should avoid bonds supporting municipal waste projects?  No.  It refers to the tax location of investments. 

Many investors have a combination of taxable and tax-deferred investments.  An example of a tax-deferred investment would be an IRA or a 401(k).  It is important to consider tax consequences in choosing where to place one’s investments.  Some investments, e.g. passive equity investments, are very tax-efficient, part of which means that turnover is low compared with active equity funds and gains tend to be long-term not short-term.  This is a very simplified explanation but gives you an idea of tax efficiency.  Therefore, other things equal, tax efficient investments should be placed in your taxable accounts.  Risky assets also often benefit from being in your taxable account as losses can be deducted from one’s taxes.  On the other hand, investments such as TIPS (Treasury Inflation Protected Securities) and REITs (Real Estate Investment Trusts) are highly tax-inefficient, due to the higher tax rates that these investments are often subject to.  Therefore, with these tax-inefficient investments, investors should house them in a tax-deferred account. 

Some other considerations:

• It may not be appropriate to sell existing low basis positions just to reallocate the assets among taxable and tax-deferred accounts.

• Future tax rates are unknown and could very well increase.

• If assets are going to be passed onto future generations current tax laws allow for a step-up in cost basis.

Having said all of the above, investors still shouldn’t put the tax “cart before the horse.”  Taxes are important but not as important as asset allocation.  The goal should be to maximize after-tax returns, not to minimize taxes paid.  Complicating these considerations is the fact that clients typically don’t have the optimal balance between their taxable and tax-deferred accounts.  There may not be enough “capacity” in the tax-deferred accounts for the optimal tax efficiency. 

This is far from an exhaustive discussion of the factors determining the appropriate tax placement of assets.   Please contact us for more information regarding this topic.

When it is appropriate, Red Lighthouse will work with a client’s trust and estate attorney.

          Active Managers Get the Cold Shoulder

A recent survey by Greenwich Associates polled 152 US institutional investors.  They surveyed 97 corporate pension plans, 34 public funds, and 21 foundations and endowments and found that, over the prior 12 months, more than 20% of the institutions had shifted assets from active to passive strategies.  Furthermore, another 20% expected to do so within the coming year.  Why are these transitions from active to passive management important?  For three reasons, these institutional investors should have been able to select an investment management firm that could deliver above market results.  First, by virtue of their size, these plans could command very low fees.  Second, the staff at these firms should be well equipped to evaluate the credentials of the many firms knocking on their doors.  Third, many of these investors were usually exempt from taxes (active management is typically much less tax efficient).  Surely if anyone can successfully select an investment management firm to deliver above market results it should be these sorts of institutional investors.  Yet increasingly these plans are shunning active management in favor of a passive approach.  These institutional investors are clearly dissatisfied with the active management approach, despite their apparent advantages over an individual investor.

 As reported by Craig Karmin in the Wall Street Journal in a recent article titled Active Managers Get the Cold Shoulder, a growing number of institutional investors are moving to passive management.  “Active managers have not given us the added performance in a down market that we hoped for,” says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment.  Michael Travaglini, executive director of the $51 billion Massachusetts Pensions Reserves Investment Management Board stated, “We’ve been around since 1985 and when you look at that entire track record, there were 12 years where our active domestic equity managers added value and 12 years when they detracted value.”  Given the countless studies that have shown how difficult it is to select managers whose risk adjusted performance is above the relevant benchmark, it should come as no surprise that institutional investors are dropping active managers in favor a passive approach.

Disclaimer: This newsletter is for information purposes only.  Past performance is no guarantee of future results.  While the information and data contained herein is believed to be reliable, we do not represent it as accurate.  Any opinions expressed herein are subject to change without notice.  Nothing contained herein should be considered a recommendation to buy or sell any security or fund. 

Red Lighthouse Investment Management, LLC is a fee-only registered investment advisory firm based in New York City.

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