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Risk-Management : Portfolio Rebalancing : Arbitrage Pricing Theory : Thought Leader

Corporate Portfolio Rebalancing Strategies & Techniques In 2009
May 24, 2010 12:00 PM

By Jerry Grenough
Jerry Grenough
Principal
Taylor Forensics

Reuters has recently announced that harsh downgrades are on the way that will reduce formerly AAA-rated investment securities to below investment grade, which may require sale or mark-down depending on the type of institution holding the paper.  According to one Citigroup analyst AAA bonds during the peak years of 2006 and 2007 are targeted for downgrades of 79% and 100%.  Institutional portfolio managers have both a liquidity and portfolio crisis to manage such as they’ve never seen in their generation. 

The Arbitrage Pricing Theory (APT) states that, though many different firm-specific forces can influence the return on any individual stock or bond portfolio, these idiosyncratic effects tend to cancel out in large and well-diversified portfolios.  This cancellation is called the principle of diversification.  However, large, well-diversified portfolios are not risk free there are macro economic forces that pervasively influence their performance and these forces are not eliminated by diversification.  In the APT model, these forces are called pervasive risks. 

Pervasive risks include:
  1. Inflation risk: Countries which have resorted to printing currency and government-issued debt have an empirically high incidence of this debt being followed by inflation, which drives interest rates higher.  Higher interest rates can have a devastating effect on bond portfolios, as well as financial recovery in general.
  2. Business cycle risks: unanticipated changes in the real level of business activity.  We can compare this risk to the recent contraction numbers in the Gross Domestic Product.  
  3. Market timing risk: this is the most misunderstood.  Market timing does not necessarily mean repositioning of assets to cash and treasury positions but the re-sectoring of assets in a tactical allocation strategy.  All stocks and bonds have a positive exposure to Market timing risk.
Properly designed and executed monitoring of a portfolio requires planning that leads to the evaluation of persuasive information, which is both suitable and sufficient to the circumstances.  The mitigation of systematic or pervasive risks is required under the Business Judgment Rule, which immunizes management and Boards from liability where there is reasonable basis to indicate due care and due diligence has been performed.

Gobind Daryanani has stated in a study that the only validated strategy to mitigate pervasive risks is Sector Rotation and Opportunistic Portfolio Rebalancing.  He has stated that investments in a portfolio will perform according to the market, and when a portfolio’s current asset allocation moves away from target allocation, then the portfolio can be subject to high measures of risk. 

Portfolio rebalancing should be practiced on a minimum basis of annually, with some variation.  For example, if your investment charter requires the majority of your holdings in bonds, you can allocate among the four main sectors: Treasuries, International (AAA investment grade, sovereign and corporate), Mortgage Backed Securities and US Corporate Issues.  If your current allocation is weighted in favor of an under-performing sector, rebalancing is called for.  Let’s take a look at 2008 and then potential 2009 strategies.

A term which has recently come to popularity is the shadow financial system. Economist Roubini in testifying before Congress utilized this term.  It is this which has created the current crisis that we’re in.  The shadow financial system consists of non-bank financial institutions that, like banks, borrow short, and in liquid forms, and lend or invest long in less liquid assets.  They are able to do this via the use of credit derivative instruments.  The system includes SIVs (Structured Investment Vehicles), money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions.  These are subject to market risk, credit risk and particularly liquidity risk.

We have learned that Investment Banks (and active managers in general, such as hedge funds) cannot protect from bear markets.  They themselves were unprotected.  One exception (if you consider a 2-year history) were the Paulson Credit Opportunities and Paulson Credit Opportunities II hedge funds, which produced net returns of about 590% and 352% in 2007 and lesser returns of about 19% and 16% in 2008.  The Paulson Event Arbitrage Fund returned 100%, and the Paulson Merger Arbitrage fund returned 52.0% in 2007. These funds generated tens of billions of dollars in profit in 2007. If the fund operates with a traditional "2 and 20" (2% management fee, and 20% performance fee), that means that the fund likely generated at least 3-4 billion dollars in profits for the principals. The primary leverage against the sub-prime market was effectively utilized in 2007 by these funds.

The opposite of this thinking is reflected in how the State I happen to be from lost $ 61.4 Billion in state-administered funds last year and a half.  The State Board of Administration protects $ 97.3 billion in pension money for retired state employees, and invests another $ 25.3 billion for school districts and state and local governments.  Auditors warned them year after year about complex and high-risk investments but these warnings were ignored.  In the last 18 months $ 61.4 Billion was wiped out.  The chief internal auditor who wrote one of the more recent reports stated “Risk is an inherent component of doing business.  To appropriately manage risks, organizations should have mechanisms to identify, measure and monitor relevant key risks not only at the business or product level, but at the institutional level.”  The SBA took on real estate and private partnership investments, and added leverage to the equation.  One investment, $ 5.4 Billion into an apartment complex in Manhattan, is now valued at 10% and Wall Street credit firms have downgraded bonds tied to the deal.  They were also using complicated financial instruments called derivates, which investor Warren Buffet once called “financial weapons of mass destruction.” 

In the 18-month period covered by the audit, the unit handled $ 1.1 trillion of transactions with limited oversight.  One trader bet $ 1.4 billion on a single trade.  The audit also revealed that the unit let an unauthorized trader, a trainee, deal a total of $ 30 billion in securities. While they delayed finalizing the audit, the 2006 State Legislature passed two bills allowing the SBA to use even riskier financial strategies, and the other made it more difficult for outsiders to scrutinize some SBA investments.  In August 2007 they were finally required to attend risk training.  A former senior investment analyst at one of Canada’s largest pension funds says our state is on a “disaster course.”  Deloitte & Touche  recently completed a $ 198,750. Investment Performance Risk Review and another firm has been hired for an approximately $ 182,500 contract (plus expenses).  The SBA says it’s a pittance and “money well spent.”

The auction-rate securities market, hundreds of billions, seized up in 2008.  Indy Mac failed in 2008. Some of the major bank failures were not on the FDIC watch list. Lehman left the country with a $ 168 Billion bankruptcy in 2008.  The AIG entry into the credit default swap field required a government bailout in 2008.  Hedge fund losses were huge, the worst in 15 years in 2008.  The current crop of LBOs for the most part failed in 2008. 

Let’s look at Mortgage Backed Securities and CDOs.  The complex market for asset-backed securities took a major blow.  A U.S. Federal Judge ruled to dismiss a claim by Deutsche Bank National Trust Company.  The US subsidiary was seeking to take possession of fourteen homes from Cleveland residents living in them, in order to claim the assets.  The Judge asked DB to show documents proving title.  No mortgage was produced, needless to say.  The net result is that hundreds of billions of dollars worth of CMOs in the past seven years are not securitized.  One source places the number at $ 6.5 Trillion. 

Global securitization was a phantom idea – when large banks bought tens of thousands of mortgages, bundled them into Jumbo securities and then had them rated prior to sale to pension funds or accredited investors, they believed they were selling (and the counterparties believed they were buying) AAA or at the least investment grade quality.  They never realized the bundle contained a significant toxic factor rated “sub-prime.”  No one opened the risk models of those who bundled them. 

In 2008 Investment Banks took on more risk than they had ability.  Their baskets of risk were highly correlated.  The leverage made no sense.  When LTCM fell in 1998, this is exactly what happened.  Banks as you know leverage 10:1 or greater. A $200 Billion loss in the financial system leads to a $2 Trillion contraction of credit.  Lehman was at least 30:1 with just assets.  Off-balance sheet risks were not considered which probably brought the leverage to over 100:1.  Systemic damage has been done.

This is the worst financial crises this generation has ever faced.  The housing sector is literally in free fall. New home sales started to fall since the beginning of 2006 and in some regions they are down over 30% since a year ago. The statistics are amazing.  Calculated Risk, a very credible web site, estimates that a 10% drop in prices will create 10.7 million households in default.  A cumulative fall in home prices of 20% implies 13.7 million households with negative equity while a cumulative fall of 30% implies 20.3 million households with negative equity.  What is the size of these losses for financial institutions and investors?  If a 15% total price decline occurs, and a 50% average loss per mortgage, the losses for lenders and investors is in the $ 1 Trillion category.  Assuming a 30% price decline you can double that.  The whole spectrum of financial and credit markets is being effected.  Commercial real estate is following the trend of residential, with vacancy rates at an all-time high.

A corporation has to consider geostrategic and long-term issues before allocating assets.  This would include foreign policy, energy supply risks and G7 bond and stock markets. Financial deleveraging on the currency market is also a prime consideration in order to diversify currency holdings.  Directors need to game out the scenarios of the IMF on this chess board, among many other players. 

A synopsis of deductive logic from Mike Shedlock’s Global Economic Analysis site:
“Roubini nailed three reasons for a severe recession but dismisses "L" because the U.S. acted faster than Japan. I do not buy that argument for these reasons:

  • U.S consumers are in much worse debt shape than Japan.
  • There is global wage arbitrage now that did not exist to a huge degree in the mid to late 1990's. Even white collar jobs are increasingly at risk.
  • The savings rate in the US is in far more need of repair than what Japan faced. This will be a huge drag on future spending and slow any recovery attempts.
  • Japan faced a huge asset bubble (valuation) problem. The US faces both a valuation problem (what debt on the books is worth) and a rampant overcapacity issue as well.
  • Japan had an internet boom to help smooth things out. There is no tech revolution on the horizon that will provide a huge source of jobs.”
93% of stock market newsletters lost major capital for the readers last year.  As opposed to market newsletters, at a recent conference in Dubai a speaker said that credit crisis losses could hit $ 3.6 trillion, up from $ 1 trillion worth of writedowns and losses estimated by Bloomberg.  If losses are this great, the U.S. banking system is effectively not solvent since it starts with a capital of $ 1.4 trillion.  The Royal Bank of Scotland is facing an estimated $41 billion loss.

In fact, this has indirectly caused a boom in the class-action field.  In 2008, the number of federal securities filings reached a six-year high, with 267 filings.  That’s a 37% increase from the previous year.  Almost half were related to the credit crisis.  Investors are claiming they have lost approximately $ 856 billion, according to the Stanford Law School Securities Class Action Clearinghouse.  That’s a 27% increase over 2007.  Most of the actions are against firms in the financial industry.  A director of Stanford Clearinghouse said he hasn’t seen this much litigation against a single industry in over a decade.  One-third of all major financial firms were named as defendants in these actions.  Most of the cases allege securities fraud, or altering values.  Underwriting practices were allegedly misrepresented.  The firms that sold auction-rate securities, bonds with interest rates reset by bidding, were all hit with class-actions, as the market completely dried up last year.

California is bankrupt ($42 billion deficit) and it is public knowledge that it is delaying payments as of February 1st on vendor payments and tax refunds.  Active mutual fund managers cannot protect anyone.  In the last twelve months their returns have approached in some cases 50% losses, and greater.  To re-balance a portfolio requires due diligence with a Performance Review and the gaming out of scenarios just like the CIA does every day.  I wrote one of the most detailed treatises of Corporate Risk Management, and the Enron debacle ever published (by the parent company – Thomson Reuters) – a book called “Protecting Your Company Against Civil and Criminal Liability.”  I learned you cannot trust your future to economic professors – they work best only in ivory towers. 

With regard to bailouts, US dollar injections have not so far encouraged the market.  Unless they are handled properly they can trigger a major devaluation of the dollar or lead the nation further into stagflation, then deflation and ultimately depression.  The UN has predicted a dollar collapse in 2009, according to a team of UN economists who foresaw a year go that this US downturn would bring the economy to a standstill.  They have stated that the US debt position is approaching unsustainable levels. 

Let’s take a brief look at 2008:
  • Housing – down 18% nationally and 30% plus in cities
  • Emerging market funds – down 55%
  • Bonds – Rates on 10 year Treasuries dropped 42%
  • US Treasury yields – very low and for a time close to zero
  • Bond values – down 6-24% on average depending on the funds and quality of bonds
  • DJIA – down 33%
  • S & P 500 – down 38%
  • NASDAQ – down 40%
  • Financial sector ETFs – down 55%
Very weak economic data reflecting deteriorating economies continues to be released from the U.S. and the U.K.  In the U.S., the S&P/Case Shiller home price index experienced its largest single-month drop in November, indicating no bottom was near in the housing market.  The Conference Board reported that the January consumer confidence index fell to an historic low.  US retail sales fell for a sixth consecutive month in December – retail sales were down by 2.7%.  According to the Federal Reserve’s Beige Book the economy is expected to weaken further into 2009.  The Fed funds rates are expected to be kept at 0 to .25% as the Committee continues to anticipate that economic conditions warrant low levels for Fed funds rates for some time.  US GDP figures indicate the economy contracted by 3.8% in the fourth quarter of 2008.  A recent Federal loan survey indicated tightened lending standards for 60% of the banks on credit card and consumer loans.  Moreover, 80% said they tightened lending standards on commercial real estate loans.  The commercial sector has significant excess capacity.  Standard & Poors, based on a substantial worsening of the economy and financial environment, expects the default rate in the US corporate speculative-grade segment to catapult to an all-time high of 13.9%, meaning 209 issuers may default by December 2009.

Rebalancing may involve sector strategies including, but not limited to:
  • Oil & Energy Sector
  • World Gold Shares
  • The London Exchange
  • Hard Currencies
  • International AAA Bonds
  • Hedge and Short Fund Investing Strategies
  • Inverse ETFs in order to hedge without derivative risks
Entire bond portfolios can be adequately hedged without the necessity of investing in a hedge fund or exposure to derivatives, usually for a 5-10% allocation.  The Wharton School recently discussed at an Investment Consultants Association Program that institutional investment managers expect to increase their hedge fund allocations 25-50% over the next couple of years for reasons of diversification.  Currently institutional managers place about ten percent of their portfolios in hedge funds, up from five percent just two years ago.  Over the next two years those allocations may rise to between 12.5% and 15% of their portfolios. 

ETFs create no risk beyond the initial principal, and exist in 1:1, 2:1 and triple leveraged instruments.  These index-like funds can be used to hedge positions in oil, gold, bonds or any stock market sector, such as the S & P index.  If the corporate portfolio is entirely long at this point, a hedging structure is imperative to protect against market fluctuations in the coming years.  These strategies are often referred to as contrarian sector strategies, and probably the best known contrarian investor is Warren Buffet and his firm Berkshire Hathaway.  Mitigation of portfolio risks is an absolute necessity in 2009 for the protection of Director’s interests and corporate longevity.






Jerry Grenough
Principal
Taylor Forensics

J.T. Grenough is a founder of Taylor Forensics, an investigative firm which consults on topics of corporate governance and investment performance strategy studies.

He graduated from the University of Louisville, maintains a CPA license in the Midwest, and has performed expert witness testimony. He has published articles for the Sarbanes Oxley Compliance Journal and the Institute of Internal Auditors. He has handled six major Sarbanes-Oxley assignments for Fortune 2000 companies, and served as a regional audit director for a Fortune 500 company, assisting the audit committee in the performance of their duties






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