The economic crisis is not over, yet it’s not too soon to begin exploring the following:
What did we get right? We certainly saw the residential real estate market as overheated and advised caution to clients, particularly in the most extended markets of Florida, Arizona, etc. We never bought a single sub-prime mortgage obligation or a collateralized debt obligation (CDO) prior to the credit crisis. We sold Washington Mutual generally in 2007 (well before its seizure by the FDIC in the fall of 2008). In 2006, we began diversifying into alternative investments (which declined less than traditional investments in 2008 and in the first quarter of 2009). In 2006, we identified “credit spreads” as being dangerously narrow. And as early as 2004, we began warning of the potential for below-average returns going forward in our investment policy statements.
What has been most frustrating? Hugely frustrating to us was that identifying the core problems in advance didn’t really help very much in the end because the credit crisis spread rapidly from its origins to virtually every aspect of markets and the economy. So much so that essentially every investment other than Treasury bonds was crushed.
Equally frustrating was that having patiently waited for a normal bear market sized decline in REITs in an effort to mitigate entry point risk, we initiated small REIT exposure (generally 5%) in 2008 just in time for massive, unprecedented declines that occurred in that normally subdued asset class in late 2008 and early 2009.
Generally, we’ve also been frustrated with floating rate corporate bonds. These are bonds that are protected from inflation since they pay a “floating” coupon equal to the inflation rate plus a specified additional rate. We purchased a significant amount of such bonds for tax free accounts at attractive yields. In the credit crunch, liquidity for these bonds, in particular, dried up and prices fell significantly (in large part due to the demise of Bear Stearns and Lehman Brothers, two large bond dealers), even though they have all continued to pay timely interest. We are comfortable that each bond will continue to pay and that returns from here out will be well above average, but we have been frustrated that the purchase of floating rate bonds which was done to reduce portfolio risk actually had the opposite short term effect.
What have we learned? With respect to bonds, 2008 was nothing less than a paradigm-shifting year. The divergence between Treasuries (which did well) and essentially everything else (which performed horribly) was many times larger than any that we had experienced in more than 25 years of career investment management experience, and was well outside the range of experience in all the historical data we have carefully reviewed. What we gained is a much greater appreciation of the risk control and liquidity benefits of credit risk-free bonds (Treasuries, TIPs, and GNMAs). Similarly, we also gained a greater appreciation of the risk control benefits of sector diversification within bond portfolios.
Beyond that, every market decline raises investor awareness of their own risk tolerances and allows us to learn more about appropriate asset allocation in their specific case. This period has, of course, produced more of that than normal, and we’ve identified a number of clients whom we believe are candidates for reducing risk exposure when conditions are less extreme.
What have we changed? We added two somewhat more sophisticated tools in our evaluation of alternative investments: one measuring tendency to “skewness” in returns, and another measuring correlation with traditional balanced assets rather than with stocks alone. That has resulted in one implemented and two yet to be implemented changes in our selection of absolute return investments, and in a slightly greater target allocation to gold and managed futures relative to diversified long-only commodities investments.
The most significant change remains in the future: our bond portfolios for tax free accounts will hold a larger portion in credit risk free bonds (Treasuries, TIPs, or GNMAs). Treasuries are the only asset class that currently exhibit “bubble” characteristics, so the right shift in the long term appears to be exactly the wrong direction to move in the near term.
We’ve also made a certain number of mistakes. We always will. That’s inevitable. And we’ve made plenty in the past 18 months or so (with lots of company). There are not necessarily lessons to be learned in every mistake (other than to confirm that which needs no confirmation: fallibility). But we always seek “continuous improvement”, and some mistakes do in fact contain lessons. The passage of time and the unfolding of new data always provide the potential for evolving conclusions about optimum portfolio construction. In our view, the unprecedented nature of much that occurred lately has propelled that evolutionary process forward much faster than we’ve ever experienced.