Bernie Madoff, Toxic Securities, and Your Portfolio

It is understandable to become unnerved by the news of alleged criminal activity where investors lost all of their money and by investments that were supposedly secure and that are now valued at a fraction of their face value. You must ask yourself if you are vulnerable to the same fate in your portfolio. That is a legitimate question and one that we will attempt to answer in this newsletter.

Potential Fraud and Conversion of Clients’ Funds

Bernie Madoff ran a hedge fund that purported to offer positive returns through all time periods – good and bad. Hedge funds often seek to “hedge” bad market periods by using securities and investment strategies that run counter to the investment tide running at a given point in time. Based on my 37 years in the investment business and extensive study on the subject and fraternization with some of the best investment minds in our country, I categorically state that there is no way to consistently do that. And that is why none of your investment funds with us have ever been invested in such strategies.

So, how could Madoff get away with his alleged scheme? Well, that type of fund is not regulated the way that the funds we utilize in the management of your portfolios are regulated. The funds we use are publicly traded and subject to the highest levels of regulatory oversight by government and industry regulators. Madoff-style hedge funds are private funds and do not receive that level of scrutiny. That is another reason we don’t use them for your portfolios. We use publicly-traded stocks, bonds and no-load mutual funds for your portfolios and the selections are made by our Investment Management Department. No one individual in our firm can make investment selection decisions for you and the selections that our Investment Management Department makes are uniformly applied throughout our clients’ portfolios. Individual clients may have differing portfolio allocations but, in each of the sectors utilized, the same securities are used for all clients throughout. That is one of the many ways that we strive to assure uniform quality and heightened safety in our portfolios.

Another important consideration is that your funds and your investments are not housed with us. We contract with an independent broker/dealer, LPL Financial. This means we do not have access to your money or your investments. Bernard Madoff’s firm held money and securities. Additionally, we are subject to random audits by the Compliance areas of LPL as well as by several regulatory bodies. Finally, your portfolios are covered by Security Investors Protection Corporation (SIPC) insurance as well as multi-million dollar fraud and conversion bonds. ¹ These safeguards did not exist for the investors of Bernie Madoff’s hedge fund.

Toxic Securities

How did securities become “toxic?” It came by way of a daisy-linked chain of sequential action. First, according to news reports, mortgage lenders stretched their standards to allow mortgages to be made to borrowers who were under-qualified for the mortgages they were given and also stretched the values of the homes upon which the mortgages were made. If it had stayed with just that action, the current situation would have been limited to a real estate industry-specific downturn. But the mortgages were then packaged in “pools” of mortgages and sold as a security by investment bankers. Because those pools are often government-backed, the poorly constructed, but undetected, mortgages were lumped with the good ones. The pool received a high credit rating, and then sold as securities in the marketplace. Even at that, the problem would have been localized to the bond market.

You must understand that investment bankers are very different from investment managers such as Fragasso Advisors. The investment bankers are creators of products that are then sold to investors. We don’t have such proprietary products.

Now the linked chain gets worse. The mortgage-backed securities were bought by hedge funds for their high yields relative to other types of bonds and then used as collateral to borrow or buy other, more risky securities. Finally, the buyers of those mortgage-backed securities sought to hedge the investment by buying default insurance from major insurance companies. That action is referred to as buying Credit Default Swaps. The insurance company stands to lose in the case of a default. The insurance companies did not envision the extent of the risk they were assuming, obviously.

We used none of those supposedly sophisticated instruments in your portfolios, as there was no need for them. Further, we shortened the duration of the bond funds we used in your portfolios to help keep the maturity dates of the underlying bonds short. We did that because interest rates were rising and that action helps to protect principal.

When the mortgage bubble burst and the daisy-linked chain of securities and insurance unraveled, the extent of the problem was truly a surprise to the regulators, our legislators, and even the issuers of the securities as each link in the chain only saw their own part.

Your Portfolio

What does this mean for your portfolios with us? First, we did not use hedged or toxic securities in your portfolios. We are plain vanilla, down the middle, traditional portfolio managers who use time tested, and “unsophisticated” investments for our clients. We have seen others “go to New York” for sophisticated and trendy investments and strategies. Good luck with that. And we have seen the results of such quests over 37 years of observation.

Secondly, you are diversified in your portfolios and that helps protect against loss. We asset allocate your portfolio among multiple categories. This goes way beyond diversification and spreads your investments over many diverse sectors so that you are not unduly exposed to the risks of one, two, or even three sectors. Clients who went through the crash of the technology bubble in the late 1990s appreciate this fact. It is important to remember that diversification does not assure a profit or protect against loss.

But your portfolios still went down in value as the entire market went into paralysis over the scope and severity of all of the above circumstances. We measure that decline for individual portfolios and for our portfolios in total. In general, our clients’ portfolios went down far less than the market indices, but they did decline. What is important is that the portfolios did not become valueless as did those of Bernie Madoff’s clients, the portfolios of major investment banking houses that created the toxic securities, or the insurance companies that insured them against default. Our portfolios are populated by securities representing functioning companies who make and do things for a profit, which we believe have the potential to recover nicely along with the economy.

The Economy

The economy will recover, in our opinion, directly related to the success of the various recovery programs in, or being put in, place. Those are: 1) the TARP program; the $700
billion meant to stabilize lenders and soak up toxic mortgage-backed securities; 2) The auto industry bailout and 3) the upcoming Obama administration recovery plan. History going back to the early 1930s indicates that stabilizing financial institutions, our economy’s structure, and flooding the economy with money, especially in a way that preserves and creates jobs, will cause a recovery. The investment markets lead that recovery. Markets do not wait to validate recovery in retrospect. So, 2009 will be a pivotal year, and we believe history indicates for the better.

Purveyors of Investment and Financial Planning Advice and You

The investment industry evolved when the old fixed commission days ended on May 1st 1975 (still referred to as, “May Day! May Day!”). The result has been a diverse grouping of methods of delivering finance products and advice. Let’s break them apart so as to understand how you may navigate to the correct form of investment advice and acquisition.

Once commissions became unfixed on May 1, 1975 (akin to airline fare deregulation), the industry had to find a reason to exist. It no longer commanded the portal to investment acquisition. The industry broke into three basic divisions:

• Discount brokerage. Commissions, subject to competition, will float to the lowest rate possible. That is good for the consumer. Some investment providers exist only on that basis and eschew financial planning advice to the investor. When paying only for the execution of a transaction, and working as one’s own advisor, the investor is smart to seek the lowest commission. However, the investor becomes his or her own investment advisor. Few investors are equipped to do that properly, in our opinion.
  
  
• Full service brokerage. This was the old model, but with lower commissions spurred by competition. So some brokerage firms sought ways to add value that would allow commissions or fees to remain higher than the discount brokerage competitors. One of the ways that was accomplished was for those brokerage firms to create the products that they market. So investment firms began their own mutual funds and bought insurance companies whose products they could market to their clients. The manufacturing profit thusly derived was meant to make up for the decrease in commission revenue.
  
  
  
• Independent investment advisor. This is the route we have chosen to serve our clients. We are a fee-based investment manager whose portfolios are individualized for each client based on an intensive financial planning process. We work for the client, charging an annual investment management fee, based on assets under management, and we take responsibility for evaluating the client’s situation via a personalized financial plan. We then implement the plan using no-load mutual funds* and individual securities. There are no commissions involved and we gain no revenues from the product manufacturers, so there is no conflict of interest in that regard. We take full responsibility for investment management, keeping our clients continually aware of the actions taken in the account and the performance relative to market indices and the clients’ goals.
  
  
  *nominal fees and 12b-1 fees may apply.

Considering the three fundamental avenues available for gaining financial planning advice and guidance, and investment management, we believe that the last, our way, is the best.

Please feel free to call or email me to discuss this further if you are not now enjoying the benefits of independent advisor guidance or if you just have more questions about the material presented in this e-newsletter. We at Fragasso Financial Advisors wish you a happy and prosperous 2009. Please allow us to assist you in making that happen.