October 2008 Investment Portfolio Review

The September to remember was followed by an October crash. Our members weathered the storm in good shape as they were alerted to impending doom on September 24.

Portfolio Performance

Our model portfolios easily outperformed the S&P 500 Index AND competitors with similar mandates.

CLICK IMAGE TO VIEW PERFORMANCE

For accounting purposes, figures reported for our satellite portfolio reflects moving to 100% cash at the close on September 25, 2008. All core portfolios (U.S. Dollar, Canadian Dollar, and Thrift Savings Plan) remained fully invested.

The Macro Outlook

I mentioned last night that members have been debating the macro picture going forward. Many feel that bond issuance will prove to be inflationary down the road and are hesitant invest in them for fear that the U.S. (and perhaps world) government will attempt to monetize debts. Others suggest using momentum strategies to time the entry and exit of entire asset classes.

I lean toward David Swensen’s view that disciplined investing in carefully chosen asset classes may be more effective than attempting to forecast the macroeconomic picture:

For most people, he recommends a very basic approach: use index funds, exchange-traded funds and other low-cost instruments, and stick to your long-term asset allocation — even when the markets are in tumult. Don’t be distracted by market forecasts, he said. “You have to diversify against the collective ignorance,” he said. “I think nobody is in a position to react to these big macro-issues. Where is the dollar going to be or what is G.D.P. growth going to be in China? For every smart person on one side of the question, there is another smart person on the other side.” — Keep It Simple, Says Yale’s Top Investor

The Issues

While popular opinion leans toward an inflationary future, it may not be the case. Even if it does happen, Pimco’s Clarida sees it in the 3 to 5 year “medium” term.

• Roubini: Get Ready For ‘Stag-Deflation’
  Finally, while in the short run a global recession will be associated with deflationary forces, some ask whether we should worry about rising inflation in the middle run? This argument–that the financial crisis will eventually lead to inflation–is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation. . . . So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.
• NYU’s Roubini Sees ‘Significant Downside Risk’ for Equities [DOWNLOAD PODCAST]
  Oct. 27 (Bloomberg) — Nouriel Roubini, the New York University professor who predicted the financial crisis in 2006, talks with Bloomberg’s Tom Keene and Ken Prewitt about the risk of “stagdeflation,” the global credit crisis and the outlook for stocks.
• Pimco’s Clarida Sees ‘Rough Sledding’ for U.S. Economy [DOWNLOAD PODCAST]
  Oct. 29 (Bloomberg) — Richard Clarida, global strategic adviser at Pacific Investment Management Co., talks with Bloomberg’s Tom Keene in Dubai about the U.S. government’s efforts on the financial crisis, Federal Reserve monetary policy and the U.S. gross domestic product, or GDP.

Our Response

We updated our thoughts this month in Part 9 of Building Your Investment Portfolio. Take a look at the charts below.

Core Model: Monthly Allocations Since 2004

Satellite Model: Weekly Allocations Since 2004

You can see that our dynamic asset allocation is extremely responsive to market conditions. The algorithm adapts to changes in the investment landscape very quickly. Furthermore, we are able to determine the optimal allocation to the core vs. satellite portfolio by analyzing monthly data.

If there is one that investors learned this month, it’s that diversification is the first line of defense under NORMAL market conditions while hedging OR going to cash are the actions of choice under CRASH conditions (identified for members on September 24). That’s why it’s important to know what the market says, to watch volatility clusters and know how to put on a crude hedge.

The Crash of 2008

Here are some articles to memorialize the month that was:

• Goldman fund loses $990m after 10 months
  One of Goldman Sachs‘s flagship hedge funds, run by two of the Wall Street bank’s most talented traders, has lost close to $1bn since its launch in January in further evidence of the crisis facing the industry. Goldman Sachs Investment Partners, which was hailed in January as one of the biggest hedge fund launches, raising more than $6bn, has told investors that it had lost $989m by September. It said the fund was down about 13 per cent in the third quarter. Year-to-date performance fell about 15.5 per cent in the year to September. . . . The fund was launched after a poor year for the bank’s quantitative, or computer-driven, hedge funds which were hit hard in August 2007 forcing the bank to inject $3bn to rescue its Global Equity Opportunities fund. More than half of GS Investment Partners’ losses in the third quarter was from its investments in commodities, basic materials, metals, mining, energy and agriculture. But like many multi-strategy funds diversified across equity, credit markets and convertible bonds, GS Investment Partners was hit hard by losses on convertible bonds – debt instruments that can convert into equity. It said returns from the convertible asset class had been “abysmal”.
• No Place to Hide
  The average diversified mutual fund of U.S. stocks returned a negative 18.7% in October, according to preliminary figures from fund tracker Lipper Inc. . . . The average return for diversified U.S.-stock funds is a negative 34.7% for the first 10 months, which suggests 2008 is shaping up to be the worst year for mutual-fund investors in the nearly 50 years for which Lipper has such data. By comparison, the Standard & Poor’s 500-stock index is down 32.8% so far this year and the Dow Jones Industrial Average is off 28.2%; the figures all include reinvested dividends.
• We now know investing like Yale isn’t easy
  When financial institutions teeter, liquidity is in short supply and correlations between asset classes converge in unexpected ways, even sophisticated investors can be forgiven for questioning some of the fundamental tenets of money management. “Our protection is supposed to be diversification,” said one member of the Institute for Private Investors, a peer networking organisation for ultra-wealthy families, during a recent IPI meeting in New York. “It didn’t protect, and it feels awful.”
• Stock-Fund Investors Pull Record $70.7 Billion, TrimTabs Says
  Redemptions by individual investors and institutions jumped 26 percent from the previous high of $56 billion in September, Conrad Gann, chief operating officer of the Sausalito, California-based firm, said today in an interview. Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, said in a note to clients today that it can take a long time after losses for individual investors to feel comfortable buying stocks. After the 1987 stock market crash, retail stock- trading levels took four years to recover, he said.
• U.S. Eyeing Troubles Of Insurers
  If an insurer faltered, the direct impact on most consumers would probably be minimal. Most policies, such as car and home insurance, would be transferred to another company. But in many states, the cash value of life insurance policies and a widely held retirement insurance product called a fixed annuity is guaranteed only up to $100,000. Insurance firms not only provide financial security and guarantees to many consumers and businesses, but they also use premiums collected to buy and hold vast amounts of securities, helping foster liquidity in the financial markets.
• Leaders’ False Assurances Doom Kuwaiti Investors
  As the global crisis built in September, Fadli sold his two electronics stores and mortgaged his house. He invested everything, $800,000, in futures contracts. “The minister of finance advised us investors to get involved. He said the economy is strong, it’ll go up,” Fadli recounted. This week, Fadli wandered the floor of the Kuwait Stock Exchange with just 24 Kuwaiti dinars, or about $90, left to his name, he said. He has five children younger than 10 and mortgage payments coming due.