The Unpredictable Markets

A traveling salesman arrives in a small town and mesmerizes the Locals. They buy his magic elixir believing it will cure all of their ailments. It is the timeless art of deception. When a salesman is successful in making a product seem revolutionary and exciting, it’s hard not to be drawn in. Even when it sounds too good to be true we are very likely to lay our money down anyway. Then the talented salesman moves on to the next town.

Robert C. Merton shared the 1997 “Nobel Prize in Economics.” He and a select group of financial superstars developed complex mathematical models that were designed to virtually guarantee big profits in the hedge fund business. Their company, Long-Term Capital Management attracted big dollar investors from around the world. For a period of time their fund performed extremely well, providing quite a thrill for their enthusiastic investors. Someone had finally come along who was smart enough to beat the markets. They were convinced they had the perfect strategy that would generate endless returns. The longer the schemed worked, the more willing they were to take chances. But eventually (1998) the markets threw them an unanticipated curve ball, and their high stakes experiment fell apart almost overnight. Not only did their investors lose most of their money, they set off a worldwide liquidity crises. The world’s largest banks and the U.S. Federal Reserve had to bail them out.

In the business world some things just never change. Charismatic salesmen keep coming around making bold claims, and people continue to believe them. During the past few years the big banks and investment firms pursued a clever strategy of issuing mortgages to home buyers with limited resources and bad credit ratings. Financial sector stocks soared as the industry raked in the profits. To maintain a steady supply of new cash for their easy credit, they bundled the so-called sub-prime loans and sold securities to institutional investors, money market funds and others. If you were looking for a low risk fixed investment offering a better than average yield, this was a very attractive solution. For the salesmen, these products practically sold themselves. Somewhere along the way the investment bankers themselves got caught up in the excitement. Citigroup for example had nearly $100 billion in seven affiliated funds that held these types of mortgage related securities (and other receivables). Unfortunately, during the past 18 months or so the market for this kind of debt has all but dried up. Big banks have a real mess on their hands at the moment. Once again, the Federal Reserve is bailing Wall Street out of a jam in order to avoid a worldwide credit crisis.

It’s interesting to note that Citigroup and other firms didn’t actually hold these mortgage-backed securities on their own balance sheets. Instead they were treated as “off balance sheet” liabilities. Now where else have we heard that accounting term? Off balance sheet liabilities contributed to the 2001 collapse of Enron Corp.

Does any of this have a direct impact on you and I as individual investors? Yes it does affect us in a significant way. Wall Street’s credit mess has made it difficult to evaluate risk in certain investments. For example, how safe are money market funds these days? The price per share for most money market funds remains at $1.00 per share, year in and year out. They are managed to be stable, safe and predictable. Historically money market funds have been very reliable and safe, and I’m sure most still are. However, in recent months some market watchers have questioned whether or not they are as safe now as they have been in the past.

With interest rates hovering near rock bottom the past couple of years, money market funds haven’t given us much to cheer about. As you would expect, investors have been demanding something better. Always eager to please, brokers have responded by recommending ultra short-term bond funds. Most people think of these funds as pumped up money market funds that provide a slightly higher yield while still keeping the risk low. But it’s important to realize that these ultra short bond funds are not the same as money market funds. They are managed and regulated differently.

The Schwab Yield Plus Bond Fund is an ultra short bond fund. It invests in fixed income securities with maturities ranging from 4 years to less than 12 months. Their marketing material offered this investment product as a “fund that provides higher yields on your cash with only marginally higher risk” (as compared to money market funds). Investors frustrated with microscopic returns from money market funds eagerly poured their cash into this fund. Up until 2007 the Schwab Yield Plus Fund lived up to expectations by providing a decent return and minimal volatility. Then things went horribly wrong. In 2007 the fund lost 1.24%. Over the past 12 months (looking back from May 2008) Schwab Yield Plus shares have lost an estimated 28% of their value.

What went wrong? The fund invested about 9% of its assets in subprime loan securities similar to the ones held by the Citigroup affiliates mentioned earlier. Another 38% of fund assets were invested in non-subprime mortgage securities that were not guaranteed by government agencies such as Fannie Mae or Freddie Mac. During the past year foreclosures have gone through the roof and the market for mortgage-backed debt has collapsed. Since the Schwab Yield Plus Fund was overly weighted in that sector, shareholders got nailed. The fund was sold as a safe alternative to money market funds, and yet investors have lost almost a third of their value.

Not all ultra short bond funds have experienced these kinds of losses. And so far I haven’t read about any traditional money market funds that have allowed their share price to lose value. But the Schwab Yield Plus fiasco certainly has safety conscious investors on edge. The easy credit policies, the subprime mortgage blow up, and the resulting instability in the credit markets have been nerve racking for investors, to say the very least.

How can you earn a decent rate of return right now while keeping your level of risk under control? A recent article in the “Wall Street Journal Online” by Ian Salisbury, titled “Thin Yields Weigh on Investors” quotes a New Jersey financial advisor. He says his “clients have been kicking and screaming about low yields on CD’s and money market funds,” but he is advising them to wait it out because of the current uncertainties in the fixed income market (highlighted by the Schwab Yield Plus situation). In other words, if you want safety, stick with CD’s and solid money market funds for a while longer; these are frustrating times for investors.

Be sure to contact me if you would like to talk about your finances. The HPOPS Financial Planning Service is a sales free service available to all HPOPS members, free of charge.

Richard Gable, CFP
© HPOPS
rgable@hpops.org
ph. 713-869-8734