For some background, we faced a financial crisis of enormous proportions in 2008 that resulted in a recession affecting most global developed economies.  In order to combat this, the Federal Reserve Bank here in the U.S, as well as central banks of other developed nations, took measures to stimulate growth.  They did so in both conventional and less conventional ways.  Not only were interest rates reduced but governments injected capital into troubled organizations, created massive spending programs to offset declining employment rates, purchased securities in the open market to keep long term interest rates low and support prices, and kept the door open for additional spending.  The government intervention was greatest in the U.S. and in Europe where large banking institutions were the most damaged.  The magnitude of the global spending has been unprecedented and has resulted in heightened levels of concern about its future inflationary impact.

If, when and how inflation occurs are questions on the minds of not only investment professionals but economists around the globe.  The debate is fierce and bifurcated with some predicting Japanese style deflation while others predicting inflation at levels we've never seen here in the U.S.  While we ourselves are not economists, we are monitoring the debates and certainly understand the reasons for the differing views. And, as those debates continue, we look ahead to understand how either inflation or deflation may impact our clients' portfolios.

With the wealth that our clients have built over their lifetimes, inflation could be detrimental as the purchasing power of their assets declines over time.  If a client's portfolio does not increase with the level of inflation, it is very difficult to make up for that loss in purchasing power as prices don't generally cycle up and down like asset values.  That is why we have built in an expected level of inflation into the foundation of our asset allocation policy.  This seems pretty basic but it is important in understanding our long term approach to addressing inflation.

Acknowledging inflation in our clients' long term strategic asset allocation policy is only one way of protecting against inflation.  In addition to this, many of our clients have built into their policy an allowance for real growth (that is, growth after the impact of inflation).  How this growth is achieved is generally through heavy reliance on equity investments where stock prices are expected to increase faster than inflation.  By building in this cushion for real growth, our clients can be protected when short term inflation exceeds the long term expected rate already built into their asset allocation.

But all of this is done to protect from a general (or gradual) increase in the level of inflation, not necessarily a sudden increase or sustained level of high inflation.  Also, it does not acknowledge the type of inflation taking hold.  For example, oil prices increased from $19 a barrel in 2001 to $147 a barrel in 2008.  This 674% price increase had disparate effects on the population.  If you were a consumer of oil, you were severely hurt as this dramatic price change increased your cost of living or your cost of doing business.  The higher your use, the more you were effected.  Incomes did not generally go up to help overcome this price increase nor were many businesses able to pass on the higher costs if oil was a cost of production.  If you were an investor in oil, you benefited.  If you were simultaneously invested in oil and a user of oil, oil price increases may have been a non-event to you as your appreciated investment offset the increase in your oil costs.

The oil price inflation described above is just one of many types of inflation that can take hold.  There are other single sources of inflation like real estate, healthcare, raw materials, and other types of energy.  Protecting yourself against those areas of inflation that have the greatest impact on you is optimal-for example, many companies hedge themselves against future price increases of supplies.  The question becomes: so why can't you?  The answer is you can, but it can be costly and perhaps unnecessarily bumpy.  For example, in the oil example above, after oil hit its peak of $147, it came crashing down 80% only 6 months later.  In addition, there is an opportunity cost of hedging because as with any type of insurance, you forgo an opportunity elsewhere by paying the insurance premium.  For clients who have particular spending needs tied to areas where inflation expectations are high, targeted hedging is generally recommended as the benefits generally outweigh the costs.   For most clients, however, it is usually enough to try to protect from overall price increases, recognizing that while there can be pockets of high inflation, they are generally outweighed by areas where inflation is more moderate.  In our oil example above, our clients generally did not need to hedge themselves against the increasing price of oil because of its relatively minor allocation in their overall respective budgets.

We've covered inflation hedging for single sources of inflation, but what if government stimulus creates inflation across the board?  There are a couple of ways our clients are protected through their strategic asset allocation.  For one, their characteristically healthy allocation to equities will necessarily include companies that are able to weather inflationary periods by either passing along price increases to customers or, perhaps, even benefiting from inflation themselves.  If inflation results in a decline in the U.S dollar, our clients' international equities should benefit, offsetting any price increases associated with the dollar's decline.

Finally, our preference for active, third party managers as opposed to Indexing strategies adds a layer of protection from the impact of macroeconomic issues like inflation.  As a reminder, we recommend our clients invest with exceptional third party investment managers, each of whom has an expertise in their respective areas of investing.   For example, we have a traditional small cap growth manager who was able to identify a great company that was a supplier to the oil industry, and was therefore able to benefit not only from their own organic business growth but also from the increase in oil prices that helped to drive demand in their industry.  Because that company was strong irrespective of the change in oil prices, its stock price did not experience anywhere near the 80% drawdown that oil did between June 2008 and February 2009.  In addition to traditional managers, Hedge*Fund managers have the most tools at their disposal to navigate the macro environment, buying Stocks or Bonds that they believe will appreciate while shorting those that they believe over-valued.  To address the macro economic issues we are facing, some of those managers can invest in other areas outside of Stocks and Bonds and have, in fact, invested in such areas as gold and some have even shorted sovereign credit.  We are relying on them to help us navigate a potential inflationary situation by not only protecting their respective portfolios but by also investing to benefit from inflation.

We've discussed our strategic asset allocation process and our recommendation of active third party managers as two ways our clients can get protection against inflation.  If we find ourselves in a situation where this is not enough, we can act accordingly.  For example, adding real assets like commodities, real estate, and timber will typically combat high inflation since the price of these assets will move directly with inflation.  However, real assets are usually illiquid and volatile so we need to be certain of sustained high inflation before adding these assets.  What about Treasury Inflation Protected Securities (TIPs)?  It is not clear whether these will provide better inflation protection than our clients' equity allocations.  Unfortunately they do not necessarily measure the true levels of inflation, which, combined with the fact that the opportunity cost of holding these 2% yielding securities is so high, we have chosen to pass on this type of instrument for now.  Also, we have explored various types of insurance like derivatives and even some of the more esoteric strategies that should do well in inflationary environments, however, the costs outweigh the benefits given the fact that inflation does not appear to be imminent at this point in time.

The debate over inflation continues and we are correspondingly attentive to the pertinent issues.  Between our multi-dimensional asset allocation process and our reliance on exceptional third party managers, we believe that we have the tools to help weather most economic and market environments.  If we feel that these two factors will not be enough, we will thoughtfully intervene to help further protect our clients' portfolios.

We'd like to share a deep, dark secret with you.  As much as we focus endlessly on investments, and as much as we have whole groups of people at Federal Street Advisors who do little else than asset allocation, manager due diligence and portfolio management, the core group of us are as interested in our clients' family history as we are their investable assets.  You might think that we'd shy away from this "touchy-feely stuff" and focus exclusively on hard-core investment strategy or estate planning, but over the years, we have found the value we can add from taking the time to understand our clients, and in doing so, gain insight into their family histories, is immeasurable.

Most of you are old enough to recognize the line above from "Tommy" by The Who.  But, how many of you remember the refrain:

Following you I climb the mountain.
I get excitement at your feet!
Right behind you I see the millions.
On you I see the glory.
From you I get opinions.
From you I get the story.

In the opening days of a client/advisor relationship, it is not easy to dive right into  the highly personal, but we do, and we look to get below the surface quickly.  What we find there helps us better serve the client.  We want insights into clients' hopes, and we've learned over the years that it is also essential to understand their fears.  We have a series of questions we use to start a conversation.  These are not easy questions to answer and some clients refuse to discuss them, which is of course their prerogative.  And, it is very important that we give both partners, in the case of couples, their own platform to speak.  As some of you surely know from your own experiences, this is not a gift that spouses always give to each other.

Some of our opening questions include:

• Describe your childhood, especially in terms of dealing with money?
• What lessons did you learn from money growing up?
• Was money an issue or a source of conflict when you were growing up?
• Tell us about your parents and your siblings, as well as your own background.
• Do you have any guidelines, rules or guiding principals you follow regarding your wealth and your money? (Notice the distinction between wealth and money, which if not understood, we explain.)
• Do you have a philosophy about money and if so, who was your greatest influence in developing this philosophy?
• How did you accumulate the wealth you have today? What is the most important thing that your money gives to you?
• What have been some of the best financial decisions you have made in the past? The worst?

This list goes on, and the answers we receive prompt new questions that often take us deeper and deeper into understanding and appreciating our clients.

The objective of this approach is to learn about our clients as the people they are and not the balance sheets they often present themselves to be - what keeps them up at night, what concerns them, especially about their money, and why.  With this approach, we can be better advisors - by understanding the past, we help clients pursue and achieve a less stressful future. 

People often ask for examples as to how this knowledge helps us serve our clients better.  For instance, a client recently expressed concerns about cancelling his life insurance policy, in spite of the fact that there was no objective reason for it given his family's liquid wealth and rather limited spending.  Years ago, in our initial conversation, this client had expressed fears of leaving the family penniless.  He admitted to a moment of anxiety every time he checked the ATM balance due to years of finding no pennies in the bank.  So, three years later, in a conversation about life insurance, we understood the underlying issues immediately, which had absolutely nothing to do with insurance, and came up with an approach that was both financially prudent and emotionally acceptable to this client.  Had we not had that background, we might have gone on and on using analytical "advisor brains," all the while thinking we were doing the right thing.  What we would really have done is alienate this client and cause him undue stress and consternation, which can eat away at even the strongest and most productive relationships.

In another case, we heard a colorful story from a client raised by a father with a severe gambling habit. So much so that he went from rags to riches a number of times.  As a child, this client watched his father's Cadillac convertible, chrome wheels and all, be lifted and dragged away by the Repo Man. When this client showed a penchant for borrowing on margin to bolster his stock market returns, believing that the market would only go up and that Stocks such as CITI could never go down (this was August 2007 folks!), we were able to better understand his gambling tendencies and remind him of his past, in order to help steer him away from a future that easily could have been a repeat of his past. 

We could write a great American novel populated with the stories we have heard and the issues we have uncovered in these conversations.  We have heard many times about fathers dying when our clients were young, leaving them to fend for themselves as teenagers, about families that had little money but great wealth and values and persevered in tough times to not only survive but to thrive, about addictions that can be rampant in some families, about affairs, about growing up in families in which the topic of wealth was a greater taboo than the topic of sex, about sibling rivalries that tore families apart, and sibling bonding that surely kept families together.  In every case, we heard these stories because we asked, and we used these insights to better understand and advise the clients who had the courage to share such personal details with us.

We don't expect any client to walk through the doors of 50 Federal Street, no matter how much they trust us, shouting "see me, feel me, touch me, heal me" - not now and not ever.  But most clients enter a new relationship hoping that the advisor will at least understand them enough to be effective from the beginning and more and more over time.  To be effective we must understand the person that our client is, which means understanding where they came from, how they became who they are, and how their relationships and experiences now and in the past affect the decisions they will make in the future.  Those relationships are with family, friends, partners, mentors, rivals, advisors like you who are receiving this letter and on and on.  When we are effective at delving deeper than the quantitative elements of the client that can be laid out on paper, we can serve as a true Wealth Advisor rather than only an investment specialist.  And we can truly make a difference.

While generally declining less than the overall market, positive returns from Hedge*Funds were the exception rather than the norm.  Not only did Hedge*Fund performance suffer, but Hedge*Funds were blamed, in part, for the sudden market drop in the third and fourth quarters. 

The purpose of this article is to discuss the drivers of 2008 performance and separate fact from fiction to answer a number of questions: 

• Why did Hedge*Funds not "hedge" as well as expected in 2008? 
• Were Hedge*Funds to blame in any way for the market's performance?
• What is the future of the Hedge*Fund industry and what are the risks?

We will discuss how massive deleveraging in the markets offered nowhere for even Hedge*Funds to hide, how short selling by Hedge*Fund managers was not to blame for the market downturn, and how with a thorough due diligence program Hedge*Funds can continue to play an important role in diversifying the risks inherent in an investment portfolio.

The perfect balance lies between a benchmark that is easy to understand and one that captures the way in which Hedge*Fund returns are expected to be realized.  Investment advisors have been struggling with this issue for a long time.  In this paper, we will introduce a new method for benchmarking long/short equity manager returns in a way that strikes an appropriate balance between effectiveness and usability. 

The Private*Equity asset class has grown substantially over the past two decades.  The industry is today estimated to have $1 trillion under management, two thirds of which is managed by buyout funds. Fundraising has grown significantly over the past two decades, from $5 billion in 1980 to $400 billion in 2006. Many institutional and high net worth investors continue to believe that Private*Equity investing offers the potential for both higher risk adjusted returns and diversification.  However, recent research points out that the average net returns to investors and diversification benefits may be less favorable than commonly believed. This paper will address the issues of performance net and gross of fees, what the performance drivers are for funds, and what investors should look for in selecting a GP.  Furthermore, it will summarize current thinking and perspectives of LP investors in this space, and make suggestions for promising areas for future investment opportunities.

According to a recent 2005 study by Kaplan &  Schoar, returns net of fees in the Private Equity space averaged 18.0% over the past 25 years, with Venture Capital returning 17% and Buyouts returning 18.0%, roughly in line with the public equity market.  This result is even less impressive given the higher risk levels and leverage associated with this asset class.  A similar study conducted in 2006 by Phalippou and Gottschalg, which corrected for a sampling bias in the Kaplan study, found that average performance net of fees was even lower, about 3% below the S&P 500 Index. Interestingly, the latter study found that managers in this space exhibited skill, and generated a gross of fees Alpha of approximately 4% per year.  The big problem for investors is that the typical fee structure (2% management and 20% profits) in the industry results in very high fees in practice, estimated at about 7 percent per year.  Another study found effective fees to be even higher, at 12% (see Swensen, 2000).  The results indicate that, on average, the managers themselves capture much of their excess returns.

The commodities asset class has gained the attention of both retail and institutional investors over the past few years, and increasingly looks like the asset class “du jour” given the renewed fears of inflation and hype regarding increased demand for basic materials and agricultural commodities in the emerging markets. Despite the renewed attention and substantial asset flows into a range of new products linked to commodities futures, the asset class and its characteristics remain poorly understood by many investors. This paper will attempt to answer some basic questions about the asset class, including the following: 1) What are the mechanics of a commodities futures investment? 2) What have the historical returns been, and how should these be measured? 3) Can investors expect to earn a risk premium or gain a diversification benefit from an investment in commodities? 4) Are commodities an inflation hedge, and if so, can investors expect them to continue to be? 5) Does supply (years of underinvestment in new production) and demand (China, EM, etc.) make a commodities futures investment any more compelling today than in the past? 6) How does speculative demand for commodities futures influence price formation and prospective returns? 7) What is the best way to invest in commodities, if at all? What types of strategies are used in today’s available investment vehicles?

Emerging markets as an asset class has evolved considerably over the past couple decades and most rapidly over the past few years. Practitioners and asset managers today must understand the shifts in fundamentals that have occurred in order to properly understand prospective returns for both equities and fixed income investments. One of the critical changes has been a vast improvement in the macroeconomic environment. This improvement is rooted in a surge in both global growth and liquidity, but is also complemented by improvements in fiscal and monetary policy management by many emerging markets countries. These improvements in fundamentals have lowered risk premiums for sovereign Bonds, enabled countries to restructure debt, and provided the foundation for the development of corporate issuance and the birth of consumer credit markets. While macroeconomic risks have receded, corporate governance risks continue to be higher for emerging markets, and a reliance on commodities for some countries may make their economies volatile. Valuations in sovereign Bonds may already discount these changes in risk premiums, and publicly traded equities have also become more expensive. However, current valuations at around 16-17 times earnings are not substantially beyond the long term average, especially given the healthy long term outlooks for growth and reduced macroeconomic risks. Compound returns of over 40% in the past three years were largely driven by earnings growth. In the Private*Equity space, tremendous opportunities remain as a free flow of equity may not have occurred as rapidly as in the public markets. Countries which have recently established long term credit and mortgage markets may offer the best opportunities. Sophisticated investors such as endowments and pension funds are very bullish on the prospects, but many still cite a lack of experienced GP’s as an obstacle to accessing these opportunities.

Hedge Fund Benchmarking is a complex process which must account for both traditional and alternative Beta factors. Proper benchmarking of individual Hedge*Funds differs depending on strategy, and may include factors beyond the typical buy and hold factors used to benchmark traditional long only equity and fixed income investments. The proper technique for Hedge*Fund benchmarking may also depend on whether one is trying to benchmark a fund of funds or an individual fund. For individual funds, peer group benchmarking makes little sense. Peer groups of individual funds come with significant biases, such as survivorship, instant history or “back fill”, selection and stale pricing. Furthermore, peer groups, even after adjusting for biases, are not appropriate for making mean-variance return comparisons with individual managers whose systematic risk exposures may differ in a meaningful way. For this, a strategy benchmark based on individual risk factors, including non-traditional Beta factors, is critical. Funds of Funds can be better benchmarked against a set of peer group indices which capture the underlying risk factors. Peer groups of funds of funds are not subject to the same biases as peer groups of individual funds. However, such comparisons must still be risk adjusted and are only valid for evaluating relative peer group performance. Furthermore, a strategy benchmark might still be appropriate depending on how closely the peer group factor loadings fit (R-squared) to the individual funds of funds.

Investment Consultants typically provide two core areas of advice to their clients. The first and most important piece of advice comes from setting and maintaining an Asset Allocation, and the second and more controversial from selecting active managers for performance and risk characteristics. Recent research provides several insights into how advisors can increase the potential for realized Alpha and customize portfolio characteristics through the selection of active managers. The value proposition that consultants have to offer is derived from both developing and maintaining discipline in the asset allocation and selecting the active managers within it. Asset Allocation requires a disciplined and consistent approach. Success in selecting active managers requires that consultants are free to select highly skilled, relatively concentrated managers via an unbiased selection process. Furthermore, it requires that consultants compose portfolios for their clients utilizing what is known about predictability in risk and tracking error characteristics, and provide the perspectives necessary for clients to know when to “stay the course” and realize the benefits of this strategy. Furthermore, the best opportunities may lie in identifying and selecting skilled managers with limited histories or with underperformance early in their track records, making them temporarily immune to the fee increases and fund flows that tend to capture the economic rents of great talent.

In recent years, enormous endowments like those of Harvard and Yale, as well as many large foundations, have been devoting increasing portions of their investment portfolios to “hedge funds” and other alternative investments. As widely reported, many of these large institutional investors have also experienced stellar risk-adjusted returns, attributable in substantial part to their alternative investments. Many smaller foundations and endowments have largely avoided alternative investments, assuming that they are too exotic, or too risky, or that the necessary resources to select and monitor them are not available at reasonable cost. In our view, on close examination, this assumption usually proves unfounded, and there is a place for Hedge*Funds, and perhaps other alternatives as well, in the investment portfolios of many mid-sized foundations and smaller foundations with investment assets of at least $25 million.

The drumbeat of people calling for the demise of the Hedge*Fund industry continues to pound with greater consistency and intensity. Not a single week passes without someone speculating that Hedge*Funds are the next asset bubble ready to burst or that returns from the Hedge*Fund managers will be lower in the future than they have been in the past. Their arguments are premised on the beliefs that the Alpha pool is limited and as more players enter the Hedge*Fund space there will be less Alpha to go around. I recently had the pleasure of hearing Elaine Crocker, President of Moore Capital, speak. Ms. Crocker opened her speech by saying that historians have attributed the oldest profession to the wrong artisans; in fact she said that the oldest profession firmly belongs to the doomsayers and their record is not good. While in my view the prospects for Hedge*Funds as a group may be murky, the prospects for well-selected individual managers have never been clearer and they are far from gloomy.

I am a firm believer in the theory that it would be nearly impossible to identify a well-orchestrated fraudulent Hedge*Fund scheme in time to prevent the fraud. That said, most of the recently reported Hedge*Fund frauds have been far from well-orchestrated. In many cases, the most basic level of due diligence would have exposed these investments as being unsuitable or at the very least questionable. I have always been willing to walk away from a Hedge*Fund manager with the potential for high returns if I could not get completely comfortable with their operation. I can speak specifically about my experience with Bayou Management, LLC. During the first half of 2005 I looked into Bayou as a potential investment recommendation for our clients. I had come across them in one of the many public Hedge*Fund databases. Their strong performance history led me to take closer look into how they were generating their returns. It didn’t take long before I made the decision to pass on Bayou. I did not know or believe that Bayou was a fraudulent firm when I decided to pass on them, but as I will discuss below, I uncovered several issues that eliminated them from further consideration.

Hedge funds have long played a material role in the investment portfolios of ultra high net worth individuals in the United States. There has been a metamorphosis in Hedge*Funds since Alfred Winslow Jones pioneered the concept back in 1949. Initially, Hedge*Funds were designed to be focused on returns first and risk second. As more and more institutions have made their way into the marketplace, the emphasis has shifted from being return-focused to risk-focused. This shift, ironically, has made Hedge*Funds less suitable for individuals. The role of Hedge*Funds in the portfolios of the ultra high net worth individuals (loosely defined as assets in excess of $50 million) is notably different from that of large institutional investors (a substantial percentage of which are tax-exempt). Larger institutions tend to be focused on stable and consistent returns, whereas many wealthy individuals are looking for excess return above the market. Institutions tend to favour stable returns because they have to make substantial annual payouts (5% for foundations and up to 7.5% for some pensions) and budget for future expenditures.