christopher t. vincent, principal, cfa lessons from the financial crisis and a blueprint for...
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Christopher T. Vincent, Principal, CFA
Lessons From The Financial Crisis and a Blueprint for Investing in the Current Environment
CFA West Michigan Society
Luncheon Presentation: Thursday, November 11th, 2010
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Outline
I. Lessons: Risk, Innovation, Liquidity, Policies, Dodd-Frank
II. Environment: Fiscal, Legislation, Monetary Policy – QE2
III. Asset Mix: Equity Risk Premium
IV. Fixed Income Portfolio: 2009, 2010, 2011
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Risk in Bond Funds
Difficult to discern Ex-Ante
Core vs Core Plus
Mean/Average Morningstar Intermediate Fund: (4.7%) in 2008
Lehman Brothers Aggregate Bond Index: 5.2% in 2008
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The Morningstar Intermediate-Term Bond Category represents the average annual composite performance of all mutual funds listed in the Intermediate-Term Bond Category by Morningstar.
The Barclays Capital U.S. Aggregate Index (formerly Lehman Brothers Aggregate Bond Index) is an unmanaged index that represents the investment grade bond market. It is composed of securities from the Barclays Capital Treasury, Government-Related, Corporate and Securitized Indices.
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Innovation
Technological/Scientific Progressive1
Financial Cyclical1
Most frequently is found in bond portfolios
ABS (“Shadow Banking System”)
Credit (Rating) Crisis2
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1 “Risks and Rewards or Financial Innovation: Creative Destruction Or Destructive Creation?” Loyola University Chicago Symposium, 10/4/10
2 FRB Chicago; Agarwal Barrett, et al. The ABS Markets, The Crisis and TALF
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Liquidity (Confidence)
Fractional Reserve Banking System
“But the crisis demonstrated that, in a crunch, shortages of liquidity can be just as
hazardous as shortages of capital. Indeed, it was often hard to tell one from the other.” 1
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1 WSJ OP/ED by Alan S. Blinder on Basel III
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Liquidity
Q: “How did you go bankrupt?”
A: “Gradually and then suddenly.”
AIG versus Lehman Brothers
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Hemingway, The Sun Also Rises
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FOMC Policies
TLGP
TALF
MMF Pricing
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Dodd-Frank
www.FCIC.gov
Systemic risk: Determining the level of such risk will largely “remain subjective”.
Ben S. Bernanke, Federal Reserve Chairman
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Dodd-Frank
Law will prevent taxpayers from ever “again having to foot the bill for Wall Street’s mistakes.”1
Unsecured creditors will “bear losses.”2
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1 President Obama signing the 2 Wall Street Reform and Consumer Protection Act
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Dodd-Frank
CFA Institute Survey1:
75% did not believe the law would prevent future crises
66% graded Congress’s reform efforts “poor” or “failing”
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1 Guest editorial by James Allen, CFA in the September/October issue of FAJ; Vol. 66, Number 5
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Investment Environment
Fiscal stimulus winding down (1.0%-1.5% GDP hit per quarter)
? Bush tax cuts extension
? Fiscal commission
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1 ISI Morning Policy Report; 10/26/10
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Investment Environment
Legislative/Regulation: ↓/? Dodd-Frank
↓/? Basel III
↓/? Health Care
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Investment Environment
Monetary Policy: QE2 to address deflation concerns
$600 billion package
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Investment Environment
QE2 Scenarios:
Fail Success Too SuccessfulDeflation Growth with Low Inflation Inflation (Expectations) Rise
Investment Investment InvestmentLong HG Debt Equities TIPS/Commodities/RE
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Asset Mix
Equity Risk Premium; Increased due to:
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A. Two bear markets in a decade/“Flash Crash”
B. Demographics
C. Household B/S
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Household Balance Sheet Volatility
Rolling 5-year standard deviation of % changes in household net worth
This is another powerful force depressing (household sector) sponsorship of the stock market
Household balance sheet volatility
Source: Federal reserve, Credit Suisse.
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The volatility of household net worth has risen because of equity volatility and house price declines
Source: Credit Suisse, Haver Analytics
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Rolling 10-year volatility of Household Net Worth
Fixed Income Demand
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Source: Barclays Capital. Data as of November 1, 2010
0
500
1,000
1,500
2,000
2,500Ja
n-07
Apr
-07
Jul-0
7
Oct
-07
Jan-
08
Apr
-08
Jul-0
8
Oct
-08
Jan-
09
Apr
-09
Jul-0
9
Oct
-09
Jan-
10
Apr
-10
Jul-1
0
Oct
-10
OAS
(Bas
is P
oint
s)
Investment-Grade Corporate Bonds vs. High Yield Corporate Bonds Option-Adjusted Spread
Inv.-Grade Corporate
High Yield Corporate
Corporate Bond Risk Premiums
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“Trade of the Year” in 2009
Source: Bloomberg. Data retrieved November 9, 2010
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“Trade of the Year” in 2010
Source: Bloomberg. Data retrieved November 9, 2010
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Bond Portfolio
Duration: Short
Inflation: TIPS
Quality: High Yield
Quality: BBBs
Sectors: Energy, Materials, Commodities, REITS
Sectors: Yankees
Structure Amortizing Securities, Floaters
Low Duration
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Questions?
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