Sunday, January 11, 2009

Did Fixed Income Confusion Create Madoff Victims?

There are three principal reasons to own individual fixed income securities or funds. The first is capital preservation. In the balanced accounts that we manage for institutions and wealthy people, capital preservation is our primary concern in our use of fixed income. For these accounts, fixed income is meant to be a strategic reserve against the chance of significant loss from irreparable declines in equities. For more than a year we have executed this strategy by directly owning very short term treasuries, or totally pure US Treasury money market funds. At some point in the future we will have to extend maturities a bit as yields go up.

The second reason to own fixed income is the need to produce income. Neither equities nor high quality bonds are producing enough income today to meet normal endowment and foundation pay-out needs on their own, and certainly not enough income for balanced accounts that are also invested in future-oriented equities. However, the yields on fixed income come closer to the goal than equities do.

The third reason to own fixed income securities in a managed account or fund is to make a bet on the skills of a manager to anticipate interest rate moves, or to rotate through the various sectors or types of fixed income securities. There are managers that have records of making these shifts successfully, however over the long term these skills are probably even rarer than selecting successful rotations by stock portfolio managers.

Each of these three basic reasons is modified by two other considerations. If one believes, as I do, that inflation is a major concern in the long term, then inflation-adjusted paper should be considered in this part of the portfolio or possibly in the equity portion. The second consideration is taxes, which may suggest to some a heavy portion of tax exempt bonds and an understanding of how inflation-adjusted paper increases taxable income without immediate cash generation.

Many investors are challenged by wanting to own fixed income to fulfill all three needs. No single instrument can deliver at the same time on these requirements. Many investors, both individual and institutional, recognize the problem and turn their money over to a manager or fund to accomplish the task. In the end they want capital preservation, largely predictable income, and the ability to take advantage of the rotation of values, both on the long and short side.

While neither Mr. Madoff nor the feeder funds or operations he used ever pitched their investments as fixed income, the supposed record was long enough, and co-investors comfortable enough, to generate fixed-income like confidence. Madoff’s stated performance results in most periods were not as good as what leading equity managers produced, however (at least on paper), Madoff’s results were such that some investors could view his product as a fixed income alternative. Even if true, the performance was supposedly based on the skill of the manager, which should have been a warning that there was a lot more specific risk.

I believe many of these investors should have been investing in dull, boring fixed income, with some portion invested for capital preservation, a smaller portion in the generation of income and a very small bet on manager skills.

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