HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & WEALTH Advisors
This is the October 2006 monthly Wealth Management
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Is Investment Transparency Important?
When you
invest your money, what guides your decisions?
What guides your expectations?
How do you assess risk? Is there
adequate information available? Will you
receive regular updates? What kind of information
should you receive? How do you develop
trust in the information you’re receiving?
Can too much information work against you? Are you even paying attention to the
information you are receiving?
This past
month, one of the world’s largest hedge funds reported that it was taking a 35%
year to date loss as a result of being on the wrong side of a trade. Did investors know that that could
happen? Did they believe that they would
be exposed to such risk? I bet not.
In case you
hadn’t followed the story, on September 18th, the
When news
of this unfortunate situation spread throughout the financial community, reports
of the chaos created opportunity for quick minded arbitrageurs. This, in turn, caused further pain to Amaranth’s
hedge fund investors. A week after the
news hit, the $9.5 billion hedge fund announced that its losses grew to 70% and
that it was holding a going out of business sale as investors sought to redeem
what was left of their investments in the fund.
Did Amaranth’s investors realize that the fund had concentrated much of
its portfolio exposure into the natural gas sector? Did they believe that once word got out,
other investors would take advantage of their misfortune? From what has been reported in the media, it
doesn’t sound like the fund provided much transparency of information to its
investors. Or did it?
Now, the
need for greater transparency “cry” is being touted in the media and on Capitol
Hill again. But not with the same level
of fervor as when Enron went bankrupt.
As readers of our newsletter well know, wealth management is
the ultimate goal of all that we do at Hoffman, White and Kaelber. Yes, we promote our services; yet, you will
find that we always seek to present thought provoking topics that are relevant
to our wide audience.
With help researching
this topic from our new intern, Jonathan, this month’s newsletter will discuss
the nature of transparency, how much might be enough and how too much
transparency may not be productive for investors and their fiduciaries. Once you’ve read his enlightening piece,
please be sure to spend some time looking over our market comment and
performance for the month past. It will
be well worth the investment.
The Investment Transparency Concept
When we
look up the word transparency, depending upon the context of its use, we can
observe it defined many ways. In fact, I
count many more metaphorical uses of the word than literal. In a literal sense, transparency describes
the physical characteristic of being able to see through an object that has
clear or translucent properties.
Metaphorically, it can be used to describe a desire for having accurate
and timely disclosure of information for public consumption and
decision-making. This latter explanation
is more relevant as applied to investing.
To create a
level playing field, transparency seems necessary from the following sources for
informed decision-making: from
governments and governmental agencies regarding matters of law-making, monetary
and fiscal policies and when reporting economic data; from corporate issuers
regarding the disclosure of financial data and in giving earnings guidance; and
from investment managers in reporting performance statistics and or changes in their
style, strategy, structure or personnel.
To expand
on this a little bit, let’s consider the impact from each.
Today, it
is less unusual – actually, more the norm – to have international exposure in
one’s portfolio. The benefits of
diversification to mitigate market risk and maximize return opportunities compel
us to do so and investors large and small have grown comfortable with the
notion of investing outside our borders.
In a November 2001 WTO staff working paper, authors Drabeck and Payne
discuss the importance of governmental transparency and its impact on
attracting investment in the following context:
“Non-transparency is a term given … to a set of government
policies that increase the risk and uncertainty faced by … foreign
investors. This increase in risk and
uncertainty stems from the presence of bribery and corruption, unstable
economic policies, weak and poorly enforced property rights, and inefficient
government institutions. Our empirical
analysis shows that the degree of non-transparency is an important factor in a
country's attractiveness [or lack thereof] to foreign investors. High levels of non-transparency can greatly
retard the amount of foreign investment that a country might otherwise expect.” From their work, it should come as no
surprise that most professional investors understand the negative implications
of this, but do you think the average investor considers this risk? Probably not, and I’d bet many take the
benefits of this type of transparency for granted.
With regard
to corporate issuers, whether foreign or domestic, investors must be confident
that a company has told them everything they need to know to make an accurate
assessment of the company’s current performance and prospects. And, investors need to trust the information
they are receiving. When investors lack
confidence, stock and bond prices can suffer significantly. One of the most egregious acts against
investor confidence in the recent past was the failure of Enron. In an April 2003 policy brief from the
Brookings Institution, Wei and Milkiewicz write: “At the beginning of 2002, Enron was the
seventh largest company in the United States …Telecommunications giant Global
Crossing operated in twenty-seven countries and two hundred cities on five
continents … both companies collapsed last year under the weight of financial
problems created by the self-dealing of a few corporate insiders and masked by
nontransparent accounting. These …
failures deprived millions of company employees and shareholders of their
lifetime savings and retirement benefits. Stock prices of other U.S. companies also took
a beating, partly in response to the revelation of these scandals … The
practice of opaque self-dealing by a few insiders … has contributed to the
meltdown of the financial markets around the world.”
When we
consider the role of investment managers, we’re discussing a more personal
level of fiduciary care and a more intimate relationship with investors than
the prior two sources. Whether through a
separate account relationship, purchasing mutual fund shares or investing in a
private investment company – often referred to as a “hedge fund” – investors
rely on these professionals to deliver wealth creation within a certain level
of managed risk. This requires investors
to have a great deal of trust. It also
requires that investors understand the manager’s capabilities, strategies,
leverage to be used and the potential risks and rewards to be expected from
that relationship. For the manager,
credibility is the name of the game and more often than not, investors hire a
manager for mismatched reasons. Yet, for
those doing more thorough homework, the reliance on accurate and timely
information can be of utmost importance in creating and maintaining that
credibility factor. And, it doesn’t help
the industry one bit when a manager, whether intentional or not, doesn’t foster
that trust as in the case of the Amaranth debacle cited at the beginning of
this letter.
By now, I’m
sure you would agree that transparency is important for investor confidence and
the industries that serve them. When investors
allow opaqueness – too much privacy – or “smoke and mirror” information, it
undermines the public’s trust and creates disadvantages for everyone involved over
the long term. However, as too much
information may have hurt Amaranth shareholders, you may also want to consider
that having the ability to look through a clear glass window – as revealing as
that may be – also may not always be in your best interest either. Lest we remember, glass windows also come in
varying degrees of translucence. How
much do we really need to see?
How Much Transparency Is Too Much?
As
discussed before, transparency can be used to describe a desire for having
accurate and timely disclosure of information for public consumption and
decision-making purposes. We have
already reviewed how it is important to investors that governments and their
agencies, corporate issuers of securities and investment managers practice some
level of transparency. But how much is really
needed and how much is healthy?
It is
undeniable that a certain level of transparency should be required of corporate
issuers and investment managers so that novice and professional investors alike
have adequate and reliable information to assess past performance data and
future prospects. However, creating
additional levels of transparency for investors does not come without
costs. Every new angle of transparency
to be undertaken brings layers of administrative cost. In addition, requiring greater levels of
transparency can force a company or investment manager into stripping itself of
basic privacy rights to proprietary research and potentially lose its competitive
advantage. Who do you think pays for
this?
Investors
pay for this, of course. But not only
investors pay the price. Employees and
other stakeholders bear these costs as well.
For both parties, the costs associated with providing transparency are
not variable costs, they are fixed costs.
Variable costs are considered the part of a company’s costs that can
change flexibly with varying levels of production; whereas, fixed costs remain
the same at any given level. So, added
transparency laws often saddle a corporate issuer or investment manager with
added fixed costs. These costs reduce
overall profitability and can tie up capital otherwise used for organic growth,
research or innovation.
Consider
the case of corporate issuers – companies that issue economic interests in
themselves in the form of stock and bonds.
The failures of Enron, Global Crossing and WorldCom, is said to have
lost tens of billions of investor dollars.
And, the US Government’s response was to put new laws on the books in
the form of the Sarbanes-Oxley Act of 2002 (“SarbOx”). Now, there is significant debate surrounding
the fact that the costs of conforming to these new SarbOx laws will dwarf the investor
losses that precipitated their enactment.
Does that sound equitable for investors on the whole? Did corporate
And, what
will investors do with additional transparency?
At the
Now, I’m
sure there are plenty of securities analysts that would choose to challenge
Dickhaut’s experiments and the applicability of his findings to their own
work. So, let me introduce another
argument from a Senior Fellow at the Brookings Institution regarding how too
much transparency can be detrimental to investors by fostering price volatility.
In an
October 2002 paper presented to the International Monetary Fund, Shang-Jin Wei
argues “The notion that transparency may not necessarily reduce volatility is
reflected in the recent literature on corporate transparency.” Wei refers: “In particular, Bushee and Noe
(2000) report a positive association between corporate transparency and the
volatility of the firm's stock price. Firms
with higher levels of disclosure tend to attract certain types of institutional
investors which use aggressive, short-term trading strategies which in turn can
raise the volatility of the firm's stock price.” Did you ever hear, in investment circles that
“the trend is your friend”? Well,
volatility is not a friendly trend for investors!
When we
discuss the various types of investment management relationships, both mutual
funds and separately managed accounts offer the most transparent types of
relationships available to their investors.
Not that the transparency in these relationships is perfect, but it
comes pretty darn close. With mutual
funds, transparency issues usually revolve around their fee disclosures,
trading and broker distribution practices, board governance matters, and less
than timely disclosure of holdings data.
Whereas, with separate account arrangements risk disclosures and
performance records are sometimes not fully discussed, however, this is often mitigated
by the fact that all positions are disclosed and therefore trading activity can
be closely monitored. As mutual funds
and separate account relationships are already highly transparent, it doesn’t
make much sense to discuss how much transparency is too much.
When it
comes to hedge funds, however, the desire and debate for transparency take on a
much different tilt. Unlike mutual fund
shares, which are among the most strictly regulated marketable securities,
hedge funds are private investment pools that are subject to far less regulatory
oversight. These regulatory exemptions
are only afforded funds that limit participation to highly sophisticated
investors meeting the SEC’s definition of an “accredited investor”. As such, the level of transparency offered is
measured by how effectively it facilitates the marketing process instead of
being a regulatory compliance matter. In
fact, many young or small hedge funds offer higher levels of transparency and the
larger ones commonly give far less information.
And for investors in the larger funds, it is hard to walk away if you
believe in the people running the fund and their strategy and style of
investing.
How Much Transparency Is Enough?
At the
start of this letter I asked several questions.
When you invest your money, what guides your decisions? What guides your expectations? How do you assess risk? Is there adequate information available? Will you receive regular updates? What kind of information should you
receive? How do you develop trust in the
information you’re receiving? Can too
much information work against you? Are
you even paying attention to the information you are receiving? Your answers elucidate your appetite for
transparency.
In the
final analysis, from an investor’s perspective, transparency is all about
trust. When you choose to put your money
with someone to manage, you want to be able to make a reasoned decision. How will the money be handled in relation to
your issues regarding risk and volatility?
Once you, as an investor, make a decision, you should be able to trust
that the management of the company, its fee and compensation structure, and its
investment strategies are as they are purported to be in the disclosure
documents. A promise has been made. Is it trustworthy? What do you need to know in order to invest
your money?
The CFA Institute
recommends that hedge funds offered to retail investors should offer disclosure
requirements relating to:
The
rational for this information is that it is needed to enable investors to
determine whether the fund meets their risk/return requirements. As fiduciaries, the fund managers have an
obligation to do what they say or to inform investors of a change in their
fundamental strategies.
If you can
invest with this fundamental level of trust then you have the right amount of
transparency for your needs without putting the fund’s operational strategies
at risk.
It is my
opinion that the greatest concern among investment managers, in the public’s
quest for transparency, involves the push to disclose current holdings
data. As the investment management
business is quite competitive, most managers desire to protect themselves and
their investors from the potential of free-riding or sabotage by others. Free-riding occurs when one party who fails
to come up with their own new ideas or opportunities, benefits freely from the
work of another; and, sabotage occurs when one party takes deliberate action to
weaken or reduce the probability of success of another. For an example of sabotage, think back to my
observation of how the publicity of Amaranth’s troubles added to the losses of
their investors. Increasing transparency
so that competitors can anonymously observe the efforts of another can only
serve to encourage theft and misuse of intellectual property. As such, investors should measure the effects
of this concern as well.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
Nothing like lower oil prices to stimulate greater consumer
confidence. Since the summer, investors
found it hard to believe that high oil prices, high commodity prices and the
lagging effect of Fed Funds rate increases weren’t going to precipitate a
recession here in the
During the month of September and into this month, the
For the month ended September 30, 2006, our
one-month performance is up 0.66%, our one-year return is up 5.47%, our
three-year return is up 5.44% and our average annualized return since inception
is up 7.79%. Our since inception risk
measures edged downwards to remain very conservative at +/- 5.81% (+/- 6.29%
and +/- 5.87% for one-year and three-year measures, respectively) and our
Sharpe Ratio (reward for risk taken), while lower, on a comparative basis, is still
very respectable at 0.90. For more performance
information, please see our web site for details.
Is a comfortable retirement or preservation of wealth important to
you?
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Research us on the web at www.hwkfs.com