Thursday, July 24, 2008

BUY OR SELL SOMEBODY WINS AND LOSES


YOUR BUY IS MY SELL!

I had an interesting discussion with my broker today about a stock that was underperforming the expectations we had when we bought it. Coincidentaly at the same time I was reading an analyst review of the same security in the newspaper. It got me to thinking about how the industry handles analysis and recommendations on securities.

Let’s say you work with a portfolio manager who has every initial after his name. Your portfolio is a diversified mix of 30 securities. Your portfolio manager/advisor has 120 clients; all unique just like you! Allowing for overlap, your advisor needs to track and analyze say about 125 securities. If each security is given 5 hours of review quarterly that means approximately 2500 hours of work! Of course, you want your advisor looking at new securities and opportunities too, as well as meeting with you quarterly and of course she needs to prospect for new clients to stay in business. It becomes clear that analysis is truly a full time job for the research team not the advisor!

That is why they have specialists who utilize their CFA degrees and statistical skills to probe deeply into each security in a given sector. Far from your advisor being a one person show, they have the benefit of the brilliant minds and skills of all the top analysts. That obviously explains why we never lose money on a recommended stock selection! Just kidding folks.
With all the geniuses burning through the data and a skilled advisor reviewing the data it’s just like having a guarantee of performance! So why doesn’t it work that way? Well we all can make a mistake so maybe it’s not so much a guarantee as an extremely likely outcome that we will not lose money! Okay, that’s not really how it seems to work either…..what gives?

Well to get back to my discussion with the advisor; after a lot of discussion over several months we finally decided to unload a phone stock that was not adding value. The advisor had done their homework and provided the research results from the in-house sector expert who after following the stock for years had finally put up the sell sign. We were getting out with a small loss and a couple of years wasted.

What was interesting is that the newspaper I was reading was quoting a telecom analyst of some renown who had just reviewed the stock in depth and switched from a “hold” (industry code for a sell recommendation) to a vigorous “buy”. Hang on folks; they reviewed the same material, used the same math, and likely have the same accreditation. So how does it end up that they both come to the decision they had previously been wrong and it was time for a change in recommendation? And then, they both come to the exact opposite decision from the same data!

Just think; one of them will be considered brilliant and one will be considered a moron! Which one am I listening to? Well the obvious answer to those who know the industry is that they are both wrong! The data is obviously not clear and both are making bets on how things will end up. The thing is they are betting with my money and your money! The investor is the pawn in the game; the sucker with the money in many cases.

So who wins? Well the security industry wins of course. I sold and thus generated a commission and somebody bought my security based upon the opposite analysis and paid a commission. So are the analysts and brokers in cahoots to get our money? Not really. They all think they are right and they all think they are helping us get rich!

In six months I will let you know how it comes out! Until then I will keep reminding myself that my advisor has guessed right more often than not. How do I know that? Look up composite benchmark and then start tracking the performance of your advisor. Hopefully my advisor is doing the same with her researcher! As my friend John Home says, “You get what you inspect; not what you expect”!
Tracking results, SOIS MIKE

Friday, July 4, 2008

GAFFLEGAB COSTS MONEY


Today we are going to talk about how the challenges of today will inspire the financial wizkids of tomorrow! Most recently we have felt the impact of the "skill" or perhaps more appropriately, the "cunning" of financial engineering. The increase in "structured" solutions has come at a tremendous cost as we have all seen with the Sub Prime situation and ABCP fiasco.

While rationale minds might think that would lead to the sale of more "vanilla" securities like stocks and bonds and Index funds, that is not likely to happen any time soon. Financial engineering is "industry speak" for hiding the fees behind the concept. So whats coming next.....

What will actually happen is that the financial "engineers" will construct more of the same structured stuff that got us into trouble today! If real engineers and construction firms worked the same way as financial engineers, houses would be falling down all around us as I write. But one needs to assume we are not crazy enough to buy the same risky securities as the ABCP and bad mortgage products we bought; so this time around the engineers will have a whole new approach to the products. Look for the word "GUARANTEED" to become prevalent in the sale of the "new" structured products! Having just been burned they know we are all looking for a "sure thing" before we dip our investing toe back into the shark tank.

How will they manage this engineering feat? Think of a rundown dilapidated house, but with a new coat of paint and new vinyl siding! The risks and future repairs are hidden by the cheap covering to provide a sense of quality that is not there.

Securities are actually quite basic. They are investments upon which you earn a rate of return determined by rent and risk.
Rent is the return you could get from a zero risk investment such as a short term government guaranteed treasury bill. That is known as the "risk free rate of return".
The "risk" portion is the additional return you get for accepting volatility and some amount of uncertainty in your return. As an example with bonds that risk portion would be the credit risk of the issuer and the impact of interest rate changes on the bond value.

So, if somebody is offering you returns above the risk free rate, and suggesting you have a guarantee, then where did the risk end up? The return over and above the T-Bill rate means there is risk, but the guarantee means somebody else is taking the risk for you! Sounds great! So, just one question(?) what are they getting in return?

Well, for the most part they are getting a significant chunk of the return you might think you will be getting! The neat thing, for the engineers, is you are the only one putting money into the proposition! They are taking a per cent of your positive returns and none of the negative returns because the guarantee is paid for from your deposit. Perhaps now you can see where the cunning comes into the equation!Perhaps these products need to come with a warning on the label:

CAUTION: Guarantees may significantly reduce the value of your investment while drastically increasing your costs!

While that is never likely to happen, the real disgrace is that these products will be sold to those seeking the least risk and who can often least afford the costs.

So what should you be watching for:

Guarantees: Unless you are buying a bank GIC with CDIC coverage or a short term Government Bond, do NOT ever trust a guarantee.

GaffleGab: If you do not understand a product, do NOT think it is because you are stupid. There is a great chance the confusion is intentional and a pretty good chance your advisor does not really understand it either.

Fees: Structured products are often designed to hide fees. Ask for a clear description of all fees in writing from your advisor along with comparable fees without the guarantee. In fact ask your advisor why they can not create the same product for you from standard easy to understand securities.

The attached leads to a great Ken Hawkins article on structured products for those wanting to learn more!

sois mike

http://www.investopedia.com/articles/financial-theory/08/structured-products.asp

If the article does not open when you click the address, paste the address in your browser