At Federal Street Advisors we help clients navigate these challenging issues and in fact we spend much of our time on the "softer" side.  In this white paper, we will explore some of the strategies that we and other advisors can use to help families preserve both wealth and family harmony - and create a meaningful legacy.

• The family patriarch dies, leaving a successful business, a wife who was never involved in the decision making and four children, only one of whom works in the family business.
• A couple with two 20-something children has never been able to talk to them about money. The kids are completely unprepared for their inheritance and have no experience managing assets.
• The family*foundation is well funded, but the trustees (including the founder's four children) have never participated in the decision making. In fact, they - and their spouses - don't communicate well with one another.
• Years ago, a wealthy couple set up ample trust funds for their children, one of whom cannot live within a budget. She is approaching bankruptcy and turns once again to her widowed mother for rescue.

These are familiar scenarios to all of us who work with high net worth families - and we've all seen how sadly these scenarios can deteriorate over time.  The fact is that all families have disagreements and conflicts - and wealth can exacerbate these conflicts.  Because wealth often creates shared assets, joint decisions are required.  And not infrequently, the children of wealth may not be as financially motivated as were earlier generations. 

A family governance structure establishes rules and a code of conduct

So how can families of wealth ensure that what they have worked so hard to achieve is not squandered by future generations? The answer lies in creating a governance structure - a system that allocates power, defines a method for making decisions and establishes a code of conduct. In the context of a family, it is also a way for a family to establish its identity and sustain its culture and wealth for multiple generations.

One popular governance structure, advocated by many advisors, is the Family Council.  In small families, this council may include all family stakeholders.  In large families, the council may include appointed or elected representatives from each branch of the family.  The council's responsibilities vary depending on the family's priorities, but often include:

• Developing the Family Mission Statement
• Keeping the family informed about the business and other family issues
• Helping the family reach decisions
• Documenting the family history
• Creating policies
• Holding educational events
• Planning family social gatherings

The most successful family governance structures foster communication.

A family council or other governance structure can improve the quality of family interactions by keeping family members connected with each other - and informed about the status of both the family and the family business.  It can be used to facilitate discussions about family business leadership transition and the estate plan of the senior generation.  And it encourages family members to address issues constructively rather than leaving them to fester into larger issues.

One of the most positive aspects of a family governance structure is that it fosters financial maturity by including children early in some basic financial decisions.

Sometimes outside facilitation is required to help families talk productively with one another.  One of our challenges as advisors is to know when it's time to reach beyond our considerable competence and recommend the assistance of an expert family psychologist or family transition specialist.

Recognizing that family capital is more than financial is a good place to start

The family council's work often begins by helping the family define and value wealth differently by acknowledging that there are several types of family capital:

• Financial capital - the most familiar to most of us
• Human capital - the individual competencies and personality attributes of individuals within the family
• Intellectual capital - the family's collective experiences and wisdom
• Social capital - how the family defines itself within the community. (Philanthropy can play a large role here.)

The types of family capital are explored thoroughly in several excellent books on the subject, notably Charles Collier's Wealth in Families and James Hughes Family Wealth:  Keeping it in the Family. (See the reading list at the end of this white paper.)

The Family Mission Statement

One of the most valuable exercises a multigenerational family can undertake - with or without a formal family council structure - is the formulation of a Family Mission Statement (or Constitution).  Writing a family mission statement can be a powerful tool in bringing the family together.  It allows family members to acknowledge shared family goals and values and establishes a code of conduct based on those values.  It reflects the family's history and attitudes about the relationship between financial capital and individual initiative (an often sensitive subject for hard-driving patriarchs with less financially motivated offspring).

Deciding Who to Include in Family Decision Making Is Often Challenging

As always, the devil is in the details - and some of the details have the potential to be explosive if not handled properly.  Deciding who is to be included in the family governance structure is one of those.  Are spouses to be involved?  What is the minimum age for participation?

Do we need to involve an outside advisor who can listen objectively to each family member to learn the culture and values of the entire family and help us suspend the family's normal decision-making patterns?  And what's the optimal venue for discussion?  Some families prefer formal, scheduled family meetings on an annual or quarterly basis.  Others opt for family retreats conducted over multiple days at an off-site location.

Our Role as Advisors

Federal Street Advisors acts as a facilitator and quarterback for our complex multi-generational clients.  We keep our eye on the whole field of issues, spot areas of both opportunity and vulnerability, and closely coordinate our efforts with other teammates - our clients' attorneys, accountants and other family advisors. We pride ourselves on knowing when to engage special teams - be they investment bankers or a family psychologist.  It is an honor and a privilege to play this role, and our long-term client relationships have reflected this active participation.

In our decades of experience working with clients, we have been continually struck by their ever-increasing focus on legacy.  Preserving and passing on wealth is vitally important, of course, but most are equally concerned with philanthropy and the readiness of the next generation to be good stewards of their inheritance.  Creating a solid family governance structure is one of the most effective tools for sustaining a meaningful family legacy - one that honors and preserves both wealth and core values. 

We invite you to learn more about Federal Street Advisors work with multigenerational families.  Please call Charlie Walsh at 617-350-8999.

Reading List - Wealth and Families

Family Wealth--Keeping It in the Family: How Family Members and Their Advisers Preserve Human, Intellectual, and Financial Assets for Generations
- by James Hughes

We highly recommend this acclaimed book, which covers creating a family mission statement, instituting a family bank or private trust company, mentoring the next generation, family governance, philanthropy and much more.

Wealth in Families
- by Charles W. Collier

This is one of the best books we have read to date dealing with raising children in wealthy households. It is an excellent book on a critical topic.

Best Intentions: Ensuring That Your Estate Plan Delivers Both Wealth and Wisdom
- by Colleen Barney, Esq. and Victoria Collins, Ph.D., CFP

This really wonderful book is told from the point of view of those who inherit money. It really explains how people interpret wills from a personal point for view, and provides fascinating insights into this very complicated topic.

Beyond the Grave: The Right Way and the Wrong Way of Leaving Your Money to Your Children (And Others)
- by Gerald M. Condon, Esq. and Jeffrey L. Condon, Esq.

This book is designed to open the reader's eyes to the myriad of family issues and problems that occur in the inheritance arena.  Hopefully, those who take the time to read this book will be able to avoid some of the more common problems and conflicts that typically arise when family wealth passes to the next generation.  And, at the very least, this book should demystify the numerous complicated terms often used by professionals in this area.

Navigating the Dark Side of Wealth: A Life Guide for Inheritors
- by Thayer Cheatham Willis

This is an excellent but rather dark book, and some may be offended by the strong religious overtones.  However, readers struggling with how to raise children in a too plentiful world will find it insightful.  Born into great wealth and now a counselor, Thayer shares her own experiences and insights as well as stories about her clients.

We invite you to visit our website reading list for more recommendations.

According to hedge*fund data provider Hedge Fund Research Inc., more than 1,400 hedge*funds closed in 2008. Back then, we discussed the drivers of hedge*fund performance and looked forward to better times ahead. But the headwinds to hedge*fund performance did not stop blowing. Despite posting healthy absolute returns, hedge*funds overall trailed the rebounding major equity indices from the 2+ year period from March 2009 through May 2011, leaving many investors asking the question, "Why do I even bother with hedge*funds?"

What is the secret to investing in hedge*funds that both hedge and provide exceptional long term results?

With the market's recent decline, it's worth revisiting that question. With the recent equity market sell-off, have hedge*funds offered better protection better than they did in 2008? What is the secret to investing in hedge*funds that both hedge and provide exceptional long term results?

Recent press coverage gives the impression that we are experiencing more of what we did in 2008 -- hedge*funds failing to protect when the markets decline. On August 29th, The Financial Times published an article on their website entitled, "Market turmoil lands hedge*funds with big losses," and on September 2nd, Reuters followed up with an article entitled, "August was rotten for many hedge managers." Both articles point anecdotally to several prominent hedge*funds with big recent losses, such as Whitney Tilson's T2 Partners, which was down 22% year-to-date through the end of August, and John Paulson's Paulson Advantage Plus fund, which an October 10th Wall Street Journal article reported was down nearly 47% year-to-date.

These headlines, however, are not representative of the entire universe and do not reflect either our approach or our experience here at Federal Street.

ETFs are designed to deliver the return of an overall market segment in a "passive" manner, without input from an "active" manager to choose the individual securities.  They have lower management fees and offer the relative predictability of traditional index funds with the added feature that they are priced and traded throughout the day.  ETFs now represent a $1.2 trillion market, having doubled in size the past five years.

The use and design of many ETFs have evolved over the years

Originally, ETFs were viewed as a simple, convenient and low-cost approach to investing in the capital markets, much like their index mutual fund predecessors.

An ETF is an investment fund that holds assets such as stocks, commodities or bonds that track an index.  

These derivatives, if used properly, do offer benefits to investors, and Federal Street has recommended them on a selective basis in the past. However, many investors use ETFs as short-term trading instruments. In addition, day traders have embraced more complex versions of ETFs in recent years, such as leveraged ETFs that allow investors to bet on a market move with borrowed money. Leveraged ETFs are rebalanced each day to provide a return that is two or three times as great as the movement of a targeted market segment; thus their appeal for a short-term investment horizon.

Basket trading ignores the fundamental differences between companies

What is the impact on long-term investors of the explosive growth in ETFs and other strategies trading baskets of stocks?  In the short run, it's not necessarily benign.  Market volatility increases (which is unsettling for investors) and good stocks go down with bad.  Basket trading ignores the fundamental differences among companies, making it harder for investors who do care, and stock picking becomes more difficult. We saw this during the liquidity crisis in 2008 and we are seeing that now.

Jack Bogle, pioneer of indexing and founder of The Vanguard Group, "has warned for years that ETFs are so easy to buy and sell that they could lead to excessive speculation," writes Mike Forster of the Dow Jones Financial News.

We think rapid trading presents a growing opportunity for active managers

Indexing was founded on the premise of efficient markets, so it is ironic that the increased use of ETFs can lead to a greater disconnect between price and value.  As played out during the market rebound across 2009-2010, rapid trading activity rooted in ETFs and computer-based models presents an opportunity for firms like Federal Street Advisors.  We have always emphasized exceptional investment managers that actively research individual companies, identify the weak and the strong, and establish positions that benefit from mispricing.  

With more market participants ignoring business fundamentals and fewer taking a long term perspective, investors that do focus on business fundamentals should have a greater advantage as the valuation gap widens.

One could argue that markets cycle between periods of "trading" and "investing." At Federal Street, we continue to believe that the long-term benefits of fundamental investing outweigh the short-term risks of trading.

We see the best opportunities in managers who invest with a longer time horizon, continually review the relative attractiveness of securities, and maintain or increase their portfolio's exposure to securities that are fundamentally sound and attractively priced.  Experience has shown this approach can help clients grow their wealth and achieve their long-term financial goals.

Teamwork must be more than a buzzword; it must be central to effective working relationships.  In this article, we'll explore how we use "teamwork" to engage with clients' attorneys, accountants and other service professionals.  And because real examples are often more illuminating than theory, we'll end with a client case study - to illustrate how teamwork turned into action for a family's benefit.

Respect pre-existing advisory relationships

Most clients come to an organization like ours with multiple professional service relationships already in place.  These relationships typically include a trust and estate attorney and a tax advisor, but can also include specialists involved in developing and executing plans for charitable giving, insurance, family wealth planning, succession planning with the next generation, and other facets of a client's often-complex personal and financial affairs.

Find the value in a well-coordinated team

While there can be a tendency for experienced, busy professionals to operate in silos, it has been our experience that regular, open and respectful dialogue among different types of advisors leads to more informed decision making by and for clients.  A team approach helps the financial and other advisors by providing perspective that leads to a fuller understanding of a client's financial history and present circumstances.  It also promotes more and better ideas for assisting clients in the growth and disposition of their wealth.  This is especially true in developing strategies for preserving assets on an after-tax basis, and passing wealth down to future generations.

Actively initiate team meetings throughout the year

It goes without saying that client meetings are common in our business.  More accurately, they are essential.  They present an opportunity to engage with clients and their other advisors at various points during the year.  In some cases, these meetings are scheduled well in advance, but other meetings are arranged in response to new opportunities or changes in a client's situation.

When we are involved in a team meeting, the focus is typically on the integration of investment decisions with income tax and estate planning considerations such as:

• What is the best timing for making portfolio changes?
• Should securities be sold or gifted?
• When should GRATs and other specialized transfer techniques be used?
• Should regular IRAs be converted to Roths?
• How should recent or impending tax legislation be factored into decision making?

The 2010 Tax Act sparked a flurry of advisory team meetings

A common topic these days concerns the opportunities inherent in the 2010 Tax Act, which passed in the final weeks of last year (see Federal Street's recent articles about the Tax Act on our website).  This bill increased to $10 million per couple the amount of assets that could be passed down free of any transfer taxes.  Where increased lifetime gifting is appropriate, many clients are now taking steps to change their estate and tax planning for significant long-term monetary benefit and before the act's provisions automatically terminate at the close of 2012.

Bring in specialists as needed

As a firm, we pride ourselves on knowing what we don't know - and never being afraid to bring in outside resources our clients need in special situations.  For example, we often call in mortgage specialists for the financing or re-financing of a property, and insurance specialists to design programs appropriate for a client's specific estate planning, investment or business needs.

Because clients' needs often extend beyond investment strategy and financial planning, we are prepared to recommend advisors that can assist on a variety of other fronts, including:

• charitable strategic planning
• locating and working with trustees
• educating families on wealth and governance issues
• second and third generation succession planning

Sometimes including a new advisor is in the client's best interest

It is important to be sensitive to clients' long-held advisory relationships, as that history is critical to best serving clients on a go-forward basis.  In some circumstances, however, clients may request assistance in adding new members to the team.  Over our twenty years in business, Federal Street has been well served by our network of high quality professional relationships, which has provided us the experience to suggest advisors who we believe would be a good fit in terms of approach, geography, and areas of specialization.

Since chemistry is always an important component of successful and trusting relationships, we encourage the client to spend time with at least two candidates before engaging a particular advisor.  To help both the client and the candidates prepare for these meetings, we are glad to provide background information that will serve to make the discussions more productive, including an inventory of the client's assets.

Collaboration is a win-win for everyone involved

At Federal Street, we work hard to foster a team approach among our clients' various professional relationships.  Professionals working together and sharing information takes extra time and effort on the part of all parties, including the client, but this added investment pays real dividends over time.  Collaboration among professionals helps limit unpleasant surprises for the client and improves both the quality and timeliness of the advice they receive.

As most of you know, now is the time to take action.  But getting clients to think about these opportunities can sometimes be difficult.  We have already discussed this with many clients and encouraged them to work with their trust and estate attorneys and other advisors to implement a plan.

Tax rates are almost certain to go up in 2013

The primary income tax provisions contained in the 2010 Tax Act are a two-year extension of the 35% maximum individual income tax rate and the 15% long-term capital gain and qualified dividend tax rate.  In addition, a limited IRA charitable rollover was extended through the end of 2011.

By historic standards, a 35% top federal tax bracket is quite low.  In fact, we know that tax rates will go up in 2013 for certain high income taxpayers as a result of the 3.8% additional Medicare tax that will be imposed on investment income topping certain thresholds starting that year.  In addition, we know that if there is no congressional action between now and then, the top bracket will revert to the 39.6% rate that was in effect prior to the Bush tax cuts.

As a result of these two changes, top income earners could see their top income tax bracket increase by 24%, from 35% to 43.4% starting in 2013.  Of course, Congress could take action to change this between now and then, but we can't count on it, particularly with so much pressure to reduce the deficit.  This tends to suggest that, in the right situations, accelerating income by methods such as Roth IRA conversions could make good sense.

Gift, estate and GST exemptions can have enormous impact

The real buzz is around the Tax Act's increase in the gift, estate, and Generation Skipping Transfer (GST) exemptions to $5 million ($10 million for married couples) for 2011 and 2012, with a 35% top tax rate above these.  Notable by its absence was any minimum term or other restriction on Grantor Retained Annuity Trusts (GRATs), which are a known target of the Obama Administration.

The ability for an individual to move $5 million to the next generation - without any transfer taxes - is very powerful, since this also shifts any future growth out of the estate.  A married couple could transfer $10 million to their grandchildren without any gift or GST tax implications.

How gifting $10 million today could = a $60 million estate in 15 years

If our hypothetical couple's $10 million gift tripled by the time they die in 15 years (which would just take an 8% annual rate of return), their estate would have $30 million available for their grandchildren - free of any transfer taxes.  If they had done no gifting, $30 million would still be in their estate, but subject to estate and GST taxes.  By the time the IRS finished collecting, our couple's grandchildren would inherit just $18.5 million.¹

Viewed from another perspective, with no gifting, our couple's estate would need to grow to $60 million by the end of 15 years in order for the grandchildren to receive $30 million.  Turning $10 million into $60 million in 15 years though portfolio gains alone would be a tall order indeed!

And there are still more opportunities for minimizing one's taxable estate.  The $5 million/$10 million gift exemption amounts can be further leveraged through discounts, low cost loans, or the use of GRATs, to name but a few strategies.

Lifetime gifting is not a panacea

In spite of the huge benefits to lifetime gifting, it may not make sense for everyone to take advantage of the current favorable transfer tax environment.  For instance, regardless of the estate tax benefits, you probably should not transfer wealth to the next generation if there is a risk that you will run out of money during your own lifetime.  The younger you are, the greater this risk.  And, if you intend to leave your entire estate to charity, there would be no estate tax anyway; hence no reason to take advantage of the current favorable transfer tax rules.

The Tax Act's advantages are temporary - and likely to go away

The temporary nature of the Act's provisions as well as the Obama administration's stance on the GRAT vehicle, highlight the increasing need to be aware of current tax developments for planning opportunities.  At Federal Street, we are strongly encouraging our clients to evaluate the advantages and disadvantages of lifetime gifting - as well as opportunities to increase their income while tax rates are low.

At Federal Street Advisors, we serve as the family office for many of our clients - which means that we work collaboratively with their accountants, estate planning attorneys and other advisors to ensure a big-picture approach that considers all aspects of their financial lives.

Ultimately, our success lies not just in optimizing our clients' portfolios, but in helping them meet their overall financial, estate and philanthropic objectives.

________________________________________________________________

[1]This assumes current $5m exemptions and 35% maximum tax rates are in effect at the time of the second grandparent's death.  It also assumes the grandparents die in a jurisdiction without a state estate tax.  It would of course be bleaker if there were a state estate tax or rates reverted to higher rates. 

We saw a need... High net worth investors, skittish about the markets and increasingly unhappy with the self-serving practices of so many large financial institutions, were eager for a change.  Federal Street Advisors gave it to them:  great performance, a conflict free fee investment advisory structure, exceptional client service - and the personal attention of a senior, top level advisor.  These hallmarks continue to make us who we are today.

Federal Street Advisors was formed in a period of economic uncertainty that feels all too familiar today.  Despite many obstacles along the way, including financial and real estate markets that reeled from the effects of the Savings & Loans crisis, the dot.com bubble, the horrendous events of 9/11, and the recent collapse of the financial markets, we have led our clients through these difficult times and come through them even better equipped for future crises.

We need no reminder of the global financial collapse of 2008 and its aftermath of domestic unemployment, a devastated housing market, global economic recession and the teetering of the Euro.  Back in 1991, who could have predicted the demise of hundreds of daily newspapers, or that more than 500 million people across the globe would be Facebook users?

Through all these world events, Federal Street Advisors became a leader in a rapidly evolving wealth advisory industry, offering a brand of wealth management services that only the super wealthy had enjoyed in previous decades.  Increasingly sophisticated clients were attracted by our conflict-free fee structure and committed senior staff.  We grew in size and breadth of services, including expertise in alternative investments.

We continue to chart a course for our clients that balances security and opportunity in a way that meets their particular needs.  The wisdom of this strategy has been confirmed over the years.  We continue to listen - and put our client's interest above our own, thus avoiding both the overt and subtle conflicts of interest that taint the advice at so many financial service firms.

Our approach has always been forward looking and we continue looking to the future.  The world around us continues to change as globalization, enabled by the internet, mobile phones and 24 hour news, has led to seismic shifts in industrial production, international politics, and individual connectivity.  We anticipate interest rates to rise at some point, we continue to debate when inflation will occur and what will drive it, and we expect that concern about our finite resources will continue to impact the stock market.

The sweeping scope and pace of change over the past 20 years makes us pleased with Federal Street Advisors' continued success and stability.  We have continued to invest in the smartest people and the latest technology, but have never wavered from our fundamental approach that puts the client's interests first.

We've come a long way since 1991.  Federal Street Advisors currently oversees approximately $4 billion for 80 clients while our affiliate, Old North Advisors, manages another $200 million for an additional 80 clients.  Some of our clients have been with us for almost the entire time and we now advise second and third generation clients who weren't even born when we opened our doors.  We now have a staff of 25 representing a remarkable breadth and depth of knowledge and experience.  Our clients continue to benefit from our long-term performance record, personalized service, direct access to senior staff and remarkably quick turn-around times.

We now serve over 30 foundations and endowments, including many family*foundations.  Our individual clients are more actively engaged in philanthropy than ever before, and many want their investments to be actively aligned with their values.  A new generation of investors is demanding to know the impact of their investing and philanthropy - on more than just their personal net worth.  And thoughtful baby boomers are approaching the transfer of wealth to the next generation with great concern and care.  It is our privilege to provide expert advice and support to these clients.

Fortunately we still have room to grow without compromising the values that have been key to our success.  The good word from our clients and their other advisors remains our primary source of new business.  On behalf of all of us at Federal Street Advisors, we thank you for your continuing support.

In this white paper, we discuss our perspective on this global debate.  We also discuss the complex relationship between interest rates and inflation to illustrate how history may not be the best way to predict the timing and magnitude of future interest rate changes.

Inflation stagnation

It's no secret why inflation here in the U.S remains below the historical average. Sluggish economic and wage growth, persistently high unemployment and a continued weak housing market are definite inflation busters.  Yet, while overall core inflation remains low, the price of food and oil continues to increase, particularly over the last six months as the price of oil has increased over 50%.

Will rising commodity price inflation trickle through the rest of the economy?

Will rising commodity prices create a situation where wages go up, demand for goods and services goes up (out of fear of future price increases), and inflation spirals out of control?  We believe the answer is no.  We believe that this commodity price inflation behaves more like a tax, taking money out of the pockets of consumers of commodities, including companies, governments and individuals, leaving less for discretionary spending and investing for the future.  And as you can imagine, this puts further pressure on the economic recovery and could impact stock prices, particularly those of companies who cannot pass along higher costs to their customers.

If inflation were to gain traction and begin impacting a broad basket of goods and services beyond commodities, then stagflation, an economic environment where growth is low and inflation is high, is not out of the question.

We are primarily concerned with how the current environment will impact our clients' investment portfolios.  In addition to our own monitoring of the environment, the active investment managers we recommend to our clients are constantly evaluating how commodity inflation may impact the companies they purchase in their portfolios.

The active investment managers are looking at the fact that some companies are able to absorb commodity price increases by passing along the costs, while others are not.  Let's take, for example, the spiraling costs of cotton, which have almost doubled since the middle of last summer.  One of our managers has been testing the hypothesis that deep discount retailers selling cotton clothing will lose sales if they increase their prices, or take a hit to profits if they do not.  Brand name, higher-end retailers with their less price-sensitive customer base may be able to better pass along their cost increases without losing sales.  Both traditional, long-only managers and hedge*fund managers are asking similar questions, with the hedge*fund managers better able to act on their findings given their broader tool set.

Inflation and its symbiotic sister - interest rates - are inextricably intertwined

Bear with us while we restate the basics.  When inflation is low, interest rates tend to be low (in part facilitated by the U.S. Federal Reserve).  When rates are low, it's cheaper to borrow.  When inflation rises, interest rates generally rise and borrowing becomes more expensive.  High interest rates generally deliver a high yield for investors' fixed income vehicles, be they bonds, bank CD's or cash.  Rising interest rates, however, can have a detrimental impact on bond prices.  Simplistically, as rates go up, already existing bonds with coupons lower than those being offered at the higher rates suddenly become less attractive.  After all, why would you want to own a bond delivering a 5% coupon when you can find a new bond delivering a 6% coupon?  The demand differential should necessitate a price decline in the older, lower coupon bond.

History is an imperfect guide

A simple look at history would indicate that when interest rates declined to historically low levels, they were generally followed by periods of rate increases, oftentimes negatively impacting bond portfolios.  But anytime history is used as a barometer of what might happen in the future, we have to determine if the future will be so different that we cannot simply rely on the past to guide us.

The challenge for investors (and their advisors) is what to do when faced with this dilemma.  We here at Federal Street are actively debating the topic internally.

We are asking ourselves, do rates have to necessarily go up just because they are so low?  In investing, as in comedy, timing is everything.

Rates over the past few years have never been this low, indicating that there is more room to move up than down.  With every tick down in rates over the last few years, we have become increasingly concerned about the possibility of reversal, some of which we saw late last year as interest rates started to increase.

Defensive strategies for reducing bond investment risk

Because of our belief that rates had more room to move up than down, we saw this asymmetric risk as a reason to make changes to our recommended asset allocation.  As such, even before the fall of 2010, we had already moved to reduce our clients' vulnerability to spikes in interest and inflation rates.  First, the active bond managers we recommend reduced the duration of their portfolios, thereby reducing the negative impact of rising rates.  In addition, we recommended that our clients move a portion of their money away from core bonds into more opportunistic fixed income strategies that have additional flexibility to maneuver through the changing interest rate environment.  The benefits of these two strategies kicked into gear at the end of last year as the major core bond benchmarks posted negative returns.

If interest rates have more room to move up than down, why don't we recommend reducing bond exposure even further?

This is where the relationship between bonds and inflation comes into play.  The level of interest rates is often thought of as the level at which the market thinks economic growth/inflation will be in the future.  Not only are we facing a period of almost record low interest rates, we are also facing a period of low inflation and a wide divergence of expectations for future inflation in different parts of the economy.

Economic growth is low right now here in the U.S. and expectations for growth remain low.  This helps explain why rates remain low.  Economic growth here would have to be greater than what investors are expecting in order for rates to move higher.

What makes interest rates move?

Again, it's worthwhile to review a few basics.  Short term rates are generally set by the Federal Reserve and have been close to zero since 2008 in an effort to spur economic growth.  The raising of short term interest rates is generally one of the more powerful tools governments use to control inflation.

Since inflation right now is below where the government would like it to be, and unemployment is so high, we do not anticipate that the government will raise short term interest rates anytime soon.  In fact, the government wants to see higher inflation levels but has not been able to make that happen.  Despite records amount of government stimulus, companies aren't hiring enough workers, banks are not lending enough money, and/or people aren't borrowing sufficiently to get the economy moving.  If the government raised rates right now, they'd curtail growth even further.

Longer term rates are a more complex story

Longer term rates are set by investors through supply and demand.  If there are more buyers of bonds than sellers, prices will go up and rates will go down and vice versa.  Generally speaking, if investors believe that inflation will increase or that other investors will sell bonds, they, too will sell the bonds, resulting in rates rising and bond prices declining.  Without any clear evidence of sustained inflation on the horizon, there has not been enough fear of inflation to drive investors away from the bond market.

New players in the bond market could also be changing the bond market dynamics

There are new players in the bond market who could influence the direction of interest rates in ways other than what history has shown.  Foreign governments, particularly China and Japan, have stepped up their ownership and own almost 50% of the outstanding debt of the U.S.  Their motivations aren't necessarily clear, with some arguing that their presence in the market provides a stabilizing force to rates while others argue the opposite.  The U.S government stepped in after the financial crisis and started their own buying spree by buying bonds in the open market to keep longer term rates low and spur economic growth.  (In fact, since November, the Federal Reserve has been buying enough to absorb some three-fifths of new debt offerings issued by the U.S. Treasury.)  While this buying program is scheduled to end shortly, it has opened the door to possible future intervention.  Finally, structural forces like aging populations, pension plan reform, global currency moves, and other factors might indicate that demand for bonds stays high, and therefore rates could remain low for an extended period of time.

The ultimate demise of the crystal ball

We've never believed that anyone could accurately predict short term moves in the market, but predictions are especially problematic in today's economic environment.  While it is safe to assume that rates could move higher at some point in the future, the timing and degree of that movement is unknown, particularly because of the structural changes and new entrants into the bond market affecting demand, not to mention recent regional shocks such as turmoil in the Middle East and the natural disasters around Japan.  At the same time, it's conceivable that we could remain in this low interest rate environment for a very long time, either from these developments or from an absence of inflation. 

So what should our clients do with their bonds?

As you might expect, the answer is specific to each client's situation and the role that bonds play in their portfolio.  If our clients sell their bonds, the money will have to go somewhere.  If they move to equities, they're subject to the volatility of the equity market and possibly loss of principal.  If our client is like most investors in the bond market, s/he is invested in bonds because of a need for a reliable source of income and a safe place in the portfolio to "tap" when funds are needed above and beyond the income generated from the bonds.  In this case, equities are not an option.

If, instead, the client sells the bonds and moves to cash or lower maturity bonds, s/he may forgo income, particularly if interest rates stay low or go lower.  If rates stay low for an extended period of time, the income opportunity loss from such a move could be large by moving to a lower maturity posture.  Given our clients' preferences for "no surprises" in the bond segment of their portfolio, this may be one of many feasible approaches, irrespective of the possible income opportunity loss.

Not a time for cookie cutter investing

Our primary focus here at Federal Street Advisors is to help clients evaluate the alternatives and adopt strategies to achieve their respective rate of return objective without taking undue risk.  Since it is not clear when and in what manner interest rates will increase, we are looking even more closely at each of our clients' needs for income, capital preservation, and growth.

The highly uncertain interest rate and economic environment today necessitates intensified, highly individualized portfolio review and planning.  This is not a time for a simplistic approach to bond investing.

 
To explore this discussion more fully, we invite you to contact Kristin Fafard, CFA, Director of Research at Federal Street Advisors.

Financial Advisor: Has the new law impacted the advice you will be giving to clients after Jan. 1, i.e., are any of the provisions immediately actionable?

The increase of estate, gift, and GST exemptions to $5 million per spouse ($10 million per couple) for 2011-2012 provides opportunities for increased lifetime transfers. Likewise, the use of long-term dynasty-type trusts provides the opportunity to protect assets from future transfer taxes. In case exemption amounts decrease starting in 2013, it will make sense to transfer as much of the exemption as possible during this window.

In addition, the low current interest rate environment provides an impetus to make changes now rather than waiting until the end of the two year tax window, since many estate planning vehicles (such as Defective Grantor Trusts and Charitable Lead Annuity Trusts) are optimized in a low interest rate environment. Transfers to DGTs are often accomplished by means of an installment sale from the Grantor. The lower the interest rate, the lower the hurdle rate (i.e., the less that has to be transferred back to the Grantor).

A Charitable Lead Annuity Trust involves a transfer to a trust, which in turn distributes a stream of payments to a charitable beneficiary. The remainder is distributed to noncharitable remaindermen (typically children). The lower the interest rate, the larger the present value of the stream of payments to the charitable beneficiary. Hence, a lower interest rate translates to a larger charitable deduction and a smaller taxable gift to the noncharitable remaindermen.

Given the nation's current focus on lowering the federal budget deficit, it is far from certain that current income and transfer tax rates will remain at 2011-2012 rates indefinitely. We believe that it makes sense to take advantage of the high exemptions and relatively low tax rates while we can.

Financial Advisor: Are you having to undo any previous planning that was done based on the Bush tax cuts expiring?

We made some small changes at the end of 2010, but nothing of note right now. It's not so much undoing previous planning as it is taking a fresh look at estate plans in light of the new tax rates and exemption amounts.

At Federal Street Advisors, we review each client's estate plan on a regular basis, with the frequency depending on the client's situation. Estate plans should be reviewed at least every five years, but more frequent reviews may be warranted if the client's health or financial situation has changed, or if new tax laws would have a significant impact on their existing plan.

We take a team approach to this review, involving the client's estate planning attorney as well as their accountant and life insurance broker as appropriate. The team approach adds value because it allows us to aggregate the knowledge of all of the various players in our clients' lives, leading to more comprehensive life and estate planning solutions.

Financial Advisor: How are the estate tax changes going to impact your estate-planning business, particularly your charitable-giving practice? Will the lower estate tax rate reduce philanthropy? Are there other implications of a lower estate tax?

Any significant estate tax change increases the importance of reviewing client estate plans. Since changes resulting from the Tax Relief Act of 2010 are undoubtedly temporary, it is even more important to conduct the reviews so as not to lose opportunities that may expire after 2012.

I mentioned earlier the opportunity for increased lifetime transfers - letting all future growth in those assets take place outside of the matriarch/patriarch's taxable estate. This could mean transferring significant pieces of the family business, other illiquid business or real estate assets, or simply marketable securities to the next generation or to the grandchildren.

With our clients, we don't foresee reduced charitable giving as a result of the lower estate tax rate, but the verdict is not yet in on that.

Financial Advisor: It's always important to be in touch with clients about major events such as a tax law change. But we've had many major tax laws enacted over the last decade. Is this just another tax act to inform clients about in the usual way, or does this act warrant a change in the approach advisors take when communicating to clients about a tax-law change?

More and more you have to think of taxes as a fluid set of rules - and stand ready to take advantage of opportunities as they present themselves because those opportunities may not be there forever. For instance, the GST tax rate in 2010 was 0% (and we only had certainty about that for the last two weeks of the year). We have clients who have had great success moving assets at no transfer tax cost using two-year rolling Grantor Retained Annuity Trusts (GRATs), but the days of the zeroed-out short-term GRAT may be numbered. Similarly, we do not know if the $5 million GST and gift tax exemptions will be around after 2012, so it may make sense to take advantage of them while you can.

The fluidity of the tax situation drives home the value of a proactive, team approach to estate planning. For example, we arranged an estate review with a $200m client that involved the matriarch/patriarch, their children, estate planning attorney, accountant, and business advisor. In this meeting, the client agreed to proceed with several planning strategies (and in fairness, nixed a few as well). The power of a team approach was apparent. The estate planning attorney later told us that the client had agreed to take more action as a result of that meeting than over the previous 20 years.

In other estate planning team meetings, we have introduced several clients to the concept of a GRAT with the result that our clients have transferred literally tens of millions of dollars to the next generation with little to no tax cost using this strategy.

Not all of our planning causes clients to give more. In one situation, a client's other advisors had made an excellent recommendation involving the transfer of a commercial building which was a significant portion of the client's net worth to a DGT (Defective Grantor Trust) in exchange for a low interest rate note. After running projections, it was agreed by all that the transfer should still take place, but only using a 50% interest in the building.

A team approach to estate planning facilitates a big picture approach, and the cross-pollination of ideas and strategies. It ensures that clients make the optimal decisions given their circumstances - and the perpetually changing tax and interest rate environments.

The most commonly used approaches for streamlining fund manager selection include:

              1) Relying on past performance

              2) Relying on the advice of third party ranking services

              3) Using a checklist to weed out managers with potential problems

This article discusses the problems inherent in solely following these approaches.  We will illustrate how, despite the availability of more information than ever, and the advent of third party ranking services and other short cuts, choosing a truly exceptional investment manager comes down to experience, judgment and knowing what to do with all that information.

Popular Approach #1:  Rely on exceptional past performance

This is the easiest, most straightforward approach to selecting a money manager: select the manager with exceptional past performance over a certain time period.  Indeed, the beauty of this method is its simplicity; it's easy to sell the investment to clients and requires limited investment of time and resources.

So what's wrong with this method?  Looking simply at past performance, one must make a number of assumptions that oftentimes break down after further analysis. First and foremost, it assumes that outperformance will continue into the future.  There's a reason for the fine print listed on any mutual fund prospectus:  "Past performance is no guarantee of future results."  Persistence is in no way guaranteed, especially if we don't understand how the manager outperformed.

Today's winners are often tomorrow's losers

Some even argue that outperformance is oftentimes mean-reverting, and that many managers who have outperformed over one period tend to trail over the next.  From what we have seen, this does often happen.  For example, when we looked at the universe of U.S. large cap value managers for the five years ended June 30, 2009, we saw that a significant number of the "outperformers" followed certain strategies.  They either held cash at the right time (a market-timing move that is incredibly difficult to do consistently), invested in smaller cap stocks (small cap stocks indeed outperformed large cap stocks over that five year period), or invested in high dividend-paying stocks (which held up better than the broad market, particularly during the 2008 financial crisis).

When we ran that screen again for the five year period ended just over a year later, we saw a completely different list of winners, many of whom did not hold up well during the crisis of 2008 but who posted exceptional returns during the post crisis period.  Many of the winners from the screen a year earlier were nowhere near the top any longer.  By picking the best performing managers after the first screen, we could have left a lot of money on the table.

Of course, past performance considerations always play a role in manager selection, because at the end of the day we are looking for managers who have been successful.  If they weren't successful in the past, why would we expect them to be successful in the future?  The point here is that a manager's past performance should be viewed in context with their strategy and process, their level of risk, and the market conditions during the timeframe in which performance is viewed.

Popular Approach #2: Rely on outside opinion

A great business developed years ago: third party evaluation and ranking of mutual funds.   If you understand the limitations of picking managers yourself, it's comforting to let the experts guide you.  Similar to looking at past performance numbers, relying on third party rankings is an easy, straightforward and relatively resource-light approach.  Some third party evaluators do take other factors into account besides performance, making them more valuable but oftentimes more expensive as well.

So what's wrong with solely relying on this method?  Picking managers based on third party rankings might still rely heavily on past performance.  Morningstar is perhaps one of the most widely used third party ranking services for mutual funds.  They categorize managers into sub-groups based on the types of stocks and bonds the manager buys.  They then compile and rank managers by their risk-adjusted returns over multiple time periods.  (Risk in this case is defined by volatility of returns - standard deviation.)

While risk-adjusted performance is a step up from just looking at raw performance numbers, it still just relies on those numbers.  It is faulty to assume that performance will persist into the future.

Strong ranking can actually backfire for high-flying managers

There can also be a dangerous outcome when relying solely on third party rankings.  The managers with the highest rankings typically attract assets from other followers of the ranking services.  Oftentimes a manager sees significant new business after receiving third-party accolades.  This new business, most of which probably would not have existed without the performance-based notoriety, can quickly become lost business if the manager's great performance isn't replicated and the rankings go down.

Followers of the ranking methodology dump the once high flying manager for the next high flyer. The potential rapid decline in assets caused by fickle investors can negatively impact the fund's performance due to the many expenses associated with selling stocks.  In addition, if the manager built up their resources to accommodate all the new business, losing that business may require them to reverse course and cut resources, including staff - the lifeblood of an investment management organization.  We have seen this happen and the impact can be destructive to investment performance.

Moving in and out of funds often means: sell low, buy high

Even Morningstar has come out cautioning investors on the limitations of relying purely on their ranking metrics.  While they have not changed their ranking system in any way, we appreciate this acknowledgement.  Given the confidence many investors have placed on third party metrics, it's no wonder why the average mutual fund investor has drastically underperformed the broad market.  It's not because the mutual funds are drastically underperforming (although some do).  It's that investors move in and out of funds, selling funds after they have hit bumps in the road in favor of funds that just completed a great performance period.  The unfortunate result:  they sell low and buy high.

Indeed some third party ranking services and data providers rely on more than past performance when ranking a manager.  The point, however, is that savvy investors need to understand the limitations of the ranking systems.

Popular approach #3:  Manager due diligence via a checklist

A step beyond relying on performance data alone is the development of a set of "check-the-box" items that help investors answer the question, "How do I know if this manager with great past performance can still perform well in the future?"  By building a checklist that answers "yes" or "no" to basic questions like, "Have there been any changes to the team managing the strategy within the past five years?" you can consider some important facts that go beyond the numbers. The answers can come either from third party databases, or from speaking with the investment management team.

So what's wrong with relying solely on this approach?  Having a number of checklist items that go beyond simple performance measures is certainly a good practice; the more we know about a manager, their strategy, their process and their organization, the better.  Reliance on straightforward yes-or-no answers can, however, lead to a false sense of security.

For example, we once asked a prospective manager if there had been any recent team changes, and he responded "no."  "No" is generally a good response because there is no way to know if that new team can work together and replicate the prior team's past success.  In this instance, however, while there were no changes to the people on the team, the portfolio manager had recently launched three new products, thus drastically reducing his time and focus on the strategy we were considering.  So the "no" answer wasn't good after all.  A simplistic "check the box" system would have led us to a manager who was spending a lot less time on the strategy than he had in the past, minimizing the chance that past performance would persist.

Some managers just tell you what you want to hear

Another problem with this method is that sometimes managers are not as truthful as we would like; in that case, a checklist is simply a waste of time.  We recall asking another manager the same question, and he claimed that no changes had occurred on the money management team.  But when we looked at their organizational chart, we noticed that one of the key members of the team was missing.  When questioned, he admitted that the key member had been terminated, but then claimed the individual was never an integral part of the team - so we shouldn't worry about it.

Let's look at our "team member change" question a different way.  Let's assume that the firm had recently brought in a new team from another firm to replace the old team with the strong track record.  This "yes" response would, to many check-the-boxers, be an automatic deal-breaker, based on the assumption that any change is bad.

We had one experience where a team change was for the better, because the new team had a far superior performance track record and investment process.  By simply just checking the box and moving on, we would have overlooked a potentially great investment opportunity.

While the above examples might seem intuitive and straightforward, the point is that many questions require additional follow-up; what appears on the surface can look very different and therefore lead to a different conclusion once all the stones are turned over.

Go beyond a checklist and become a detective!

So what is a savvy investor to do if the more simplistic ways of picking managers are riddled with shortcomings?  Picking an investment manager is no different than making any major decision in life.  You need to fully understand the people managing the money, the firm those people work for, and why those people were able to put up such great returns.  This can only be done by becoming a detective-gathering as much evidence as possible, determining which evidence is important and which is not, questioning the suspects on the pertinent evidence, and coming to a verdict only after a careful evaluation of the facts. This requires a lot of time.

The popular short-cut approaches to choosing investment managers came about in large part because investors do not have the time to do the detective work.  Also, they may not have adequate access to the people who manage the money.  Without a significant amount of money to potentially deliver to these managers, or if the manager is not convinced that you intend to be a long term partner, they may not grant you the time you need for a full evaluation.

So what does a thorough investigation look like?

To illustrate what we think it means to be a detective, let's briefly walk through a manager search Federal Street recently conducted.  We'll show how we determined what information was pertinent, and comment on how more simplistic methods of manager selection would have led us to a potentially different solution.

In early 2009, still in the throes of the financial crisis, we were looking for a small cap equity manager.  The performance track records we were reviewing included the rocky second half of 2008.  We initially compiled a focus list of managers, based on past performance over a three and five year period.  Given the poor market performance in 2008, however, we realized that we had to be careful when looking at this measure.

We were concerned that we might be missing a great manager who may have struggled in 2008 and whose shorter term numbers were not telling the whole story.  We therefore looked out at the longer time periods, to see if there were managers who had great long term track records but whose three and five year returns were impacted tremendously by 2008.

We found a manager who had experienced a difficult 2008 but had an exceptional longer term track record.  Before meeting with the manager, we asked for a list of his current and past stock holdings, and did some detective work on our own.  What we found was that many of the stocks he owned, especially those issued by the smallest of small cap companies, sold off dramatically as investors dumped their "risky" assets.  In fact, at the time we were looking at the manager, we noticed that many of the companies he owned were trading at prices below the companies' net cash on the balance sheet.  It was like buying a piggy bank for a dollar when there was clearly $1.40 in change inside!  So not only were we able to isolate the underperformance to the short term period, we also saw that we had an opportunity to buy into these great companies at an excellent time through this fund.  If we had simply relied on their three or five average annual year performance numbers (which were so impacted by the 2008 performance), we would have walked away from this exceptional manager.

Another "check the box" fact could have made us walk away from the manager.  The database we used for information about the manager indicated that there had been a manager transition in the past few years, and that the person who started the firm and developed the original process had been replaced.  For the check-the-boxers, this would have been another deal-breaker.  Upon questioning the management team, however, we found that the proprietor had actually stepped back almost a decade before.  He had stayed on the strategy as the "named" portfolio manager, purely in an advisory role.  This meant that the current portfolio manager had already been in charge of day-to-day portfolio management and stock selection responsibilities for ten years.  Through in-depth discussion, we became comfortable that the track record we were looking at was in fact that of the current portfolio manager.   All told, we found a truly exceptional manager that at first glance might not have looked promising.  Not surprisingly, this manager went on to deliver a 53% return to our clients in 2009, when the average small cap manager was up 32%.

Once you got ‘em, when do you let ‘em go?

The same popular shortcuts for picking a manager can be used to decide whether or not to keep a manager you are already using.  Wouldn't you rather become a detective and uncover issues before they translate into a performance problem?

Wouldn't you like to have a crystal ball that shows you if a manager's underperformance will reverse or persist?  While we don't proclaim to predict the future, we believe from experience that a robust investigation process can differentiate between a manager's short term performance problem and one that could persist for longer.

Even exceptional managers underperform sometimes

Underperformance is never fun, and is certainly painful - especially when prolonged for more than a year.  It is natural to assume something is very wrong when a manager underperforms, and the easiest response is termination.  When we terminate a manager, we look responsive, and it reassures clients that we are doing "something."  More importantly, we could be getting out of the way of a complete train wreck.

Termination is surely the safest thing to do, but is it what's best for the client?  What if that manager is ready to have explosive outperformance, better than any other option we could put in its place?  By putting on our detective hat and by understanding the drivers of not just the portfolio's performance but overall market conditions, we can better understand what's going on.  Occasional underperformance is a very common occurrence and most exceptional managers have indeed stumbled from time to time relative to their respective benchmarks, only to come back and regain their exceptional performance.

During tough periods, we must ask ourselves, "Is the manager's performance within our range of expectations?"

Do we think this manager can outperform going forward?  Again, let's look at a real-life example.  During the 2005 through 2007 period, one of the international equity managers we recommended trailed the benchmark significantly during a rising market.  The manager invests in high quality, financially strong companies and because she is so discriminating in the types of companies she buys, she did not hold many of the stocks that were increasing significantly in price.

In our evaluation of her performance, we looked at a number of factors. The manager's long track record revealed that her recent performance, while painful, was in fact within expectations.  Next, we looked at how she picked the stocks that were going into her portfolio; had there been any changes that might have caused her underperformance?  The short answer was "no." She had always invested in high quality companies, and most of them were left behind during the 2005-2007 market rally.

Additionally, the manager is very valuation conscious, and she had never paid a high price for the prospect of growth in a stock.  Consequently, the portfolio was not invested in the lower quality, higher priced areas of the market that were strongest during that particular period.   This made sense to us.

We liked this manager because she focused on high quality companies and we believed that those types of companies can not only do well over long periods of time, but should hold up well in a market decline.  Sure enough, when the market declined in the latter half of 2008, her portfolio lost half as much as the broad market, giving our clients the exceptional downside protection we had expected.  If we had used past performance as the sole metric in deciding to keep her, we would have replaced her with a manager who had performed well during the 2005-2007 period.  Our clients would have then lost almost 50% with the market in 2008.

By gathering the facts, understanding the reasons behind her performance, and reaffirming our understanding of the strategy and investment thesis, we were able to continue recommending the strategy to clients.  They were ultimately rewarded with superb downside protection when they needed it most.

There is no reliable short-cut

At Federal Street Advisors, we believe that there is no easy formula for successfully choosing investment managers.  Sure, there are plenty of short cuts, but not only can they lead to sub-par results; they can actually result in extreme underperformance. It is no wonder why so many advisors and individuals have gone the route of Index funds.  Investment manager due diligence takes a lot of time, focus and a rigorous level of judgment and understanding that only come from experience and dedication.  If you are unable to invest the time and resources necessary to become a true due diligence detective, you might as well Index.

We invite you to learn more

To learn more about Federal Street Advisors' manager search and selection processes, we encourage you to visit our website's Research section - or contact Kristin Fafard, Federal Street's Director of Research.

Many of our clients consider their families to be their most valuable capital - and they are determined to attend to that capital as carefully as they do the money that pays the bills and supports philanthropy.

Family as Capital.  Doesn't that recall the days when children were valued for their ability to work on the farm?  Perhaps.  But the seeds enlightened parents sow can bear fruit in fulfilled, productive lives that avoid the stereotypical behavior and attitudes associated with children of the wealthy.  This is no small task.  Having recently reread Children of Paradise, Successful Parenting for Prosperous Families (Lee Hausner, PhD, Jeremy P. Tarcher, Inc., 1990), we appreciate the magnitude of the challenge, and admire even more what a great job many of our clients have done as parents.

Talk of money may be the last taboo

In a society that talks freely about sex and death, talk of money may be the last taboo.  Children don't want parents to think they are looking forward to inheriting; parents don't want children to take the money for granted and become entitled; family members may feel resentful about decisions.  At many large wealth management institutions, staff advisors have little leeway or encouragement to step off the yellow brick road of financial statements and financial transactions to address these "softer" (and more difficult) family issues.  Interaction with clients has to fit into a strict cost-benefit formula.

Federal Street Advisors, as a specialized boutique, has more flexibility to deal with clients as individuals.  We can spend time in ways that add the kind of value that may not be readily apparent to the bottom line.  We can spend time working as interested but objective parties in family discussions about money, values, and legacy.

Teaching, guiding and advising the next generation 

Over the years, we have helped children in their twenties buy their first house and deal with lawyers and mortgages for the very first time.  We have explained the necessity of estate plans and prenuptial agreements to clients' children, and we have shepherded them through the process.  We have advised on the simple (what funds to buy in a 401k) to the esoteric (how to set up an animal breeding business).  And, in some cases, we have tried to serve as our clients' eyes and ears, to give them honest insights into issues we see, and to suggest ways we can work with them and their children over the years.

Opening up the kimono

Perhaps the most gratifying experience is what we call "opening up the kimono."  This is exactly what it sounds like: standing financially uncovered in front of your children, and showing them the good and the bad.  (We admit that for Federal Street clients, it is usually pretty good, but it can be humbling nonetheless!)  Opening the kimono can happen only when a client feels that their children are prepared to handle a complete understanding of the family wealth. 

We, like many other advisors in this field, strongly feel that avoiding the family wealth discussion simply ignores the elephant perched on the dining room table. With the client's direction, we can organize a full family meeting to explain the investment performance, balance sheet and the estate plan, and to facilitate an ongoing dialogue.

Family conversations about money are rarely easy - or comfortable

As Hausner says in her book:

The ability to communicate effectively with your children is one of the most important challenges for every successful, affluent parent.  However, your limited time, your occasionally frayed nerves, and your desire to help your child as much as possible, can all get in the way of creating a healthy communication environment. (p. 193).

Helping families talk about wealth is where Federal Street Advisors plays one of its most valuable roles. 

The best time for this meeting might be when clients' children are in their early 30's, or it might not be until they are in their 40's.  It is a very personal issue that only the clients can decide.  But, when it happens, and when they allow us to consult and work with their children over the years, we find that the next generation ends up much better prepared to deal with their futures, whatever that may mean in terms of expected wealth. 

And, trust us, sometimes what they can expect is surprising.  We will never forget the prospect with an estimated $500 million of net worth who replied to his son's remark that "we are rich."  "Wrong," said the parent to his son, "I'm rich. You are not."

One's legacy is more than the family wealth

We encourage our clients to discuss the heritage they want to leave, as well as the money that will accompany it.  More and more clients are supplementing their legal wills with an "ethical will," a document that expresses the experiences, ideas and values that constitute their legacy as human beings.  Unlike their legal documents, there is no right or wrong way to write an ethical will, and it can be directed to either a general audience or to specific individuals.

Now Federal Street's specialized and highly personal involvement in issues of legacy and family communication doesn't divert attention away from our primary focus:  preserving and growing our clients' wealth. But our expertise and experience with these "softer" but no less important concerns are part of what differentiates Federal Street Advisors from other advisory firms.  Moreover, it's a capability that an increasing number of our individual clients are looking for.

We invite you to learn more

To learn more about our approach and experience in family wealth transition issues, we encourage you to visit our website's Family Office Services section - or contact Randy Hustvedt, Director of Family Office Services, at rhustvedt@federalstreet.com">rhustvedt@federalstreet.com.

We also invite you to visit the Reading List on Federal Street Advisors' website.  Our section on Family and Wealth offers some insightful and thought-provoking writings on this once taboo topic. 

Behavioral finance not only applies to economic decisions but also to health and lifestyle decisions. The core idea is simple:  most humans, except for the rarified few (we can't help but think of Warren Buffett in this category), engage in a number of behavioral patterns that are seemingly irrational. While stories about irrational behavior may be amusing, we would rather focus on the advantage to be gained from understanding that behavior. At Federal Street Advisors and at The Boston Foundation, we believe that our growing knowledge of behavioral finance has led to a better understanding of ourselves, our clients and our donors. By studying why people are hard-wired to make classic investing and charitable giving mistakes, we are at times able to "save them from themselves," as clients sometimes ask us to do.

In this article, we will explore how and why:

• We need to talk clients "off the ledge" in volatile markets
• Irrational behavior challenges the notion of "efficient" markets
• Our ancestral brains are woefully ill equipped for modern financial markets
• People are more distressed about losses than happy about gains
• Whether one sees the cup as half empty or half full drives decision making
• It's easy to miss the big picture by getting fixated on one piece of information
• "Anchoring" afflicts donors as well as investors
• Applying different rules for different pots of money can work either for or against us
• Like the children of Lake Wobegon, we all consider ourselves "above average"
• We can use emotional intelligence to shackle the "lizard brain"

We encourage those of you with an interest in this topic to review our Reading List and to use this fascinating field of study to better understand yourselves and your clients.

Talking clients "off the ledge" in volatile markets

The single most important role of an advisor is often managing a client's behavior, not his or her portfolio. Nick Murray in his recent newsletter writes: "The essence of personal investment advisory is the management of the proclivity to panic. For many of us, the essence of long-term, real-life investment success will turn out to be the suppression of our own impulse to panic. This leads directly to the conclusion that, if we doubt our own capacity single-handedly to overcome our deep susceptibility to panic, the highest and best function of our financial advisor isn't to forecast the markets-something neither she nor anyone else can consistently do-but simply to talk us in off the ledge."

Irrational behavior challenges the notion of "efficient" markets

In order to understand Behavioral Finance, it is important first to understand the Efficient Market Hypothesis (EMH). According to the EMH, major financial markets reflect all relevant information at a given time. The underlying assumptions of the EMH are that investors are rational, although there will be independent deviations from rationality. According to the EMH, these deviations will either cancel each other out, or a group of rational investors will take advantage of the situation. Either way, the market will remain in balance. Therefore, as the old joke goes, there could never be a real $100 bill on the sidewalk. According to the EMH economist, surely, if the bill were real, someone else would have picked it up already. 

The debate over whether or not the markets are efficient continues, and we have no intention of ending, let alone entertaining, that debate in this article. As hard as it might be for those of us schooled for years in the EMH, incontestable evidence exists, both in the lab and in our offices, that people are indeed prone to making irrational decisions when it comes to some of the most important issues in their lives-be it what to eat, how much to exercise, when to sell a stock, how to evaluate a charity and whom to choose as a life partner.

Our ancestral brains are woefully ill equipped for modern financial markets 

As Terry Burnham has said, "We have brains that worked well to solve ancestral problems. Difficulties arise when we take those ancestral instincts to unnatural environments. And there is no more unnatural environment for a human brain than a financial market." In modern markets, and philanthropy to some degree, we are indeed fish out of water. By being aware of these biases and tendencies, we hope to correct them in ourselves and in our clients. In her recent article in Investment Advisor called "The Upside of Irrationality," commentator Olivia Mellan stated that our "irrational" behaviors "...are neither random nor senseless: they are systematic and predictable."

Students of behavioral finance are already familiar with the heuristics (rule of thumb) and cognitive biases often cited that are the core of the field. (For a complete listing, visit the behavioral economics pages on Wikipedia, or pick up one of the many books on the Federal Street Advisors Reading List.)

Why are people more distressed about losses than happy about gains?

Prospect theory is one of the main theories of behavioral finance. The theory posits that people are much more distressed by losses than they are happy about gains. This may be best illustrated with an example. A study was done at Cornell University that we recreated in a recent seminar given at the Boston Foundation with some of the best and brightest advisors in the Boston area in attendance. We asked participants to bet on a coin toss. If the participant loses, she pays $100. Participants were asked how much money they would have to potentially win in order to compete. In other words, how much would they need to win in order to risk losing $100? The study showed that people generally need an upside of $200 - $250 to risk losing $100. This explains the numerous phone calls we received in 2008 as the market was crashing, but the few calls in 2009 as it was rallying. People focus on losses, and it causes them great pain!

This natural aversion to loss is what caused so many people to cash out in 2008. By understanding this tendency and using another technique we'll discuss later on, some financial advisors were able to keep a lot of clients invested in stocks despite their fear. Clients who stayed invested greatly benefited, even with the 2008 crash.

However, not all investors could quell their panic enough to stay invested in the stock market, which explains the massive in-flows into bond funds. The amount Americans put into savings accounts and money markets increased 18% between October 2007 and March 2009.

Is the cup half empty - or half full?  Every decision depends on our perspective.

Framing is another heuristic we often see in ourselves and in our respective clients. Framing dependence states that how a question or problem is described has an effect on how people will answer or react. One classic example is to think about buying a lamp for $100. If you hear the same lamp is on sale 5 blocks away for $75, would you drive the 5 blocks to save $25? Most of us would say yes. Alternatively, after you spent an hour negotiating a car purchase for $25,000, would you drive 5 blocks for the same car on sale for $24,975? This scenario also saves you $25; however few people would bother to save $25 on a $25,000 purchase. Rationally speaking, $25 is $25. If you would choose save $25 on the lamp, you would choose to save $25 on the car. But often we are not rational thinkers.

In our professional careers, we see framing all the time and try to use it in a productive way. For example, you can say to a client: if you follow this strategy, you have a 90% chance of hitting your retirement goals. Clients react positively to this statement. However if you say instead: if you follow this strategy, you have a 10% chance of failure; or, one of out 10 people who followed this strategy went bankrupt, then the response is less favorable. We have learned to try to control framing by reframing the question not just in space but in time. A 20% drop in a client's portfolio in 2008 is awful, but look at the performance over the past 2, 3 and 5 years, and your client's outlook may improve.

It's easy to miss the big picture by getting fixated on one piece of information

Anchoring is another heuristic we find to be prevalent among our client base. With anchoring, a person focuses on one piece of information when making a decision. This piece of information may or may not be relevant to the situation. For example, ask yourself the following: Mary is 31, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues surrounding equality and discrimination. Is it more likely that (1) Mary is a bank clerk or (2) she is a bank clerk and active in the feminist movement? Stop reading and answer whether you think number 1 or number 2 is more likely.

Most people pick number 2 but the correct answer has to be number 1. Number 2 is a subset of number 1 and therefore has a much smaller likelihood of occurring. This example shows how much we are influenced by irrelevant facts, such as that Mary was concerned with equality in college. While this fact alone is not irrelevant to Mary, it is irrelevant to our question, yet it affects our answer. Advisors see this in their work when people focus on the price of a stock at the time it was purchased, and refuse to sell the stock until it reaches that price again. The stock's value is totally irrelevant (think Enron at $90 and the numerous people who rode it all the way down!) but people "anchor" on the price.

Anchoring afflicts donors as well as investors

This phenomenon occurs in philanthropy as well when donors evaluate nonprofit organizations and programs. For example, spending on overhead has become a very important consideration when choosing which organizations to support. Although cost of overhead as a percentage of a nonprofit organization's overall spending is an important factor, it does not tell the whole story. Anchoring on overhead percentage can lead a donor against supporting an organization when comparing only overhead expenses. However not all organizations are the same and overhead costs often depend on the mission of the nonprofit. Clearly it is important to base decisions on more than one fact - and avoid anchoring on a single, possibly irrelevant, issue.

Applying different rules for different pots of money can work either for or against us

Another common heuristic is mental accounting. We all put money into different mental buckets. Some experts believe that this is one reason lottery winners usually spend their winnings within a few years of winning and end up the same or worse off than before. Lottery winnings (or inheritances, which are far more prevalent) are somehow considered to be different from earned income.

Advisors can embrace this bias and use it to their clients' advantage. For example, in 2008 some advisors encouraged clients who were convinced that the world was coming to an end to put aside enough cash and bonds for a few years of living expenses and stop thinking about their stock portfolios. It worked for some, enabling them to stop focusing on their fear of loss. The clients were better positioned to benefit from one of the largest market rallies this country has ever seen.

In some respects, a Donor Advised Fund is nothing more than a fancy word for a "charitable bucket." When clients separated out their charitable dollars, it made it easier for them to continue to give. However, as we know, there is no legal requirement that annual grants be made from a Donor Advised Fund. Since studies also show that giving, and not increased wealth, is a large contributor to one's happiness, this has a dual benefit.

Like the children of Lake Wobegon, we all consider ourselves "above average"

Almost all of us display another behavioral finance heuristic - overconfidence.  If you ask a room of people if they consider themselves to be above average drivers, typically 80% of the people raise their hands. Academics have run studies in which students were asked to rate their own ability to "get along with others." A statistically insignificant number - less than 1% - rated themselves as below average. Furthermore, 60% rated themselves in the top 10%, and one-fourth of respondents rated themselves in the top 1%.

Overconfidence no doubt helped us survive the dark ages, but it is a dangerous tendency when it comes to investing. It is astounding how many people think that they can be better investors than trained money managers, especially when it comes to market timing, something that even the most astute investors like Buffett say they cannot do.

Overconfidence also leads to increased trading - which is usually a losing strategy. Because of transaction costs, even if an investor chooses correctly most of the time, any gains are quickly eaten away by costs associated with trading.

The most effective advisors have the deepest understanding of human behavior

Studying this field can be helpful to advisors in reining in some of our own tendencies, as well as in understanding our clients. Behavioral finance calls into question the way the current system assumes people make decisions. For instance, the EMH assumes everybody is optimizing their choices, which means that they are making choices that grow their bank account balances. However, as we have seen, people often make choices based on other factors, and sometimes the factors are intangible.

Especially in difficult times, as we work with clients to make them better and more patient investors, it is particularly valuable to be familiar with the instincts and behavioral traps that affect how people make decisions.  As Jeremy Siegel so memorably said in the third edition of his classic book, Stocks for the Long Run, "Fear has a greater grasp on human action than does the impressive weight of historical evidence."

Understanding behavioral finance is likewise important to sound charitable giving. Philanthropy involves a choice about money, and the process is the same for people making decisions about how to invest in the market or how to invest in their community. Moreover, philanthropy is social. According to Jonah Lehrer, giving money is not only a rational decision; it is influenced by the social machinery of the brain.

We are social creatures. Sometimes having the highest bank account balance is not what makes us happiest. In fact many studies have shown that people who bought dinner or gifts for friends and family, or who gave money away to charity, were happier than those who did not. It is important that advisors speak with clients about their financial goals. Clearly, as we have seen much too often, the happiest clients are not necessarily those with the biggest bank accounts.

We can use emotional intelligence to shackle the "lizard brain"

As Terry Burnham said, "Because our instincts are exactly out of sync with financial opportunity, markets can be mean.  However, it is the very irrationality of markets that provides the opportunities to make sweet profits. Financial success is based on using emotional intelligence to shackle the lizard brain. Fortunately, emotional intelligence can be increased by diligence, introspection, and discipline. Therefore, any investor willing to work to understand and tame the lizard brain can transform mean markets into money and satisfaction."

We invite you to visit our Recommended Reading page for a list of some of the best (and most entertaining) books on Behavioral Finance.

We'll offer a brief overview of hedge*fund strategies and terminology, explain how they differ from other investment vehicles, discuss why the current market environment is advantageous to hedge*funds, and reveal some of the current opportunities our hedge*fund managers are poised to embrace.  We'll also offer a checklist for fiduciaries to consider when conducting due diligence on hedge*fund managers.

We invite you to read through the entire white paper, or focus on the section that interests you most:      

            The Many Flavors of Hedge Funds

            What's Unique About Hedge Funds?

            Hedge Funds in the Current Market Environment

            There's Gold in Them Thar Hills

            Guidelines for Fiduciaries:  A Due Diligence Checklist

            Conclusion

At Federal Street Advisors, we have long been proponents of active investment management (vs. index investing) because we believe exceptional active managers have the ability to generate better risk adjusted returns. Our best advice, irrespective of the market cycle, includes a healthy allocation to hedge*funds, the most active of investment strategies.  To learn more about our investment philosophy and approach, we encourage you to call us at 617-350-8999.

The Many Flavors of Hedge Funds

Hedge funds are not a separate "asset class" but are simply investment structures that can hold both long and short positions in securities. "Long" refers to buying a security (such as a stock or bond) in anticipation of that security appreciating in price. "Short" refers to borrowing a security from someone else and selling it "short" with the expectation that it will drop in price.  With the ability to sell securities short, a hedge*fund manager is capable of adding value by identifying securities that will do poorly, while simultaneously profiting from those that will do well.  In addition, the "short" position should appreciate when the market declines, largely offsetting a decline in the portfolio's "long" positions, thus resulting in a hedged fund.

Well designed portfolios should include a diversified mix of strategies, or utilize a hedge*fund of funds to achieve this diversification.  When building this diversified portfolio, it is important to understand the following factors for each of the hedge*funds to properly determine how they could impact the overall portfolio:

• Degree of Concentration: Hedge funds vary in their degree of concentration and the degree of desired concentration depends on the role the fund plays in the overall portfolio. If the intent is to reduce risk in the portfolio, a less concentrated, more diversified portfolio is appropriate. If, on the other hand the role of the fund in the overall portfolio is to enhance returns, possibly at the expense of risk reduction, a more concentrated portfolio is acceptable.
• Degree of market exposure: Hedge fund managers can "dial up" or "dial down" the amount of exposure they have to the overall equity or bond markets. For example, some managers are able to find opportunities to short stocks in any environment, thus having a low exposure to the overall market, while others are more nimble, building substantial short positions only during certain environments. Mixing managers with various approaches can keep the portfolio from betting too heavily on the overall market's direction.
• Geographic or sector positioning: Similar to mutual funds, hedge*fund managers can have broad mandates or specialize in particular segments of the market based on factors such as geography, sector, or market capitalization. For example, there are managers who focus on niche areas such as micro-cap, emerging markets, or single sectors, which, on their own, might appear to be risky, but when used in combination with other type of managers, can still offer risk reduction relative to a predominantly long only portfolio.
• Degree of Leverage: Hedge funds have the ability to borrow money and invest that money, creating leverage in the portfolio. This can have a positive impact when the portfolio is doing well and a negative impact when it is doing poorly. The use of excessive leverage, however, can be devastating to a fund where margin calls from lenders force selling of securities that have depressed prices like that which occurred in the market in 2008. Clients need to ask about the degree of leverage a manager is taking, why they are using it and what a worst case scenario looks like. If clients are looking for risk reduction in their hedge*fund portfolio, limited leverage should be used.

Irrespective of the role they are playing in a portfolio, hedge*funds have unique characteristics that are important for clients to understand and for consultants to manage.  They include:

• Fund Structure: The limited partnership structure employed by hedge*funds is quite different than traditional investments in shares of mutual funds or of separate accounts held at a custodian. Liquidity terms of managers can vary widely, with most requiring a "lock-up" of one or two years after an initial investment. Exit dates are typically limited to calendar quarters, although many will restrict exits to year end. In addition, an advance notice of 60 to 90 days is required prior to a trim or redemption. While these terms are intended to minimize the negative effects that cash flows can have on portfolio returns, clients need to plan accordingly to ensure that they have enough liquidity in their portfolio for both immediate needs and even perhaps unforeseen needs. A number of the managers we recommend have responded to clients' concerns in this area by offering more lenient liquidity terms, with some going so far as to offer quarterly liquidity and no lock-up.
• Costs: Investors in hedge*funds pay costs different from those they pay in a more traditional investment strategy. Hedge funds typically use an incentive fee structure, where investors pay a portion of the profit they receive in addition to a flat management fee. These fees are generally much higher than average fees for typical "long-only" equity or fixed income strategies, and clients should therefore expect better results in return.
• Incentives for Fund Managers: If a hedge*fund is successful, the manager is generously rewarded, usually much more so than if they were managing a traditional, long-only strategy. As such, some of the best and brightest minds are managing hedge*funds today. They share financially through performance based fees - and because they often invest their own money in their funds.
  
• Less Regulation: Many hedge*fund managers have not been required to register with the Securities and Exchange Commission, but most will now be required to register under federal regulatory-reform legislation that has just been enacted. Nevertheless, hedge*fund investments will continue to be subject to much less regulation than mutual funds, which must abide by a wide range of restrictions and requirements. Here is a list of some of the key differences between mutual funds and hedge*funds with regard to regulation:
• Differing levels of portfolio transparency: A mutual fund must publish its holdings twice a year through its annual*report and semiannual reports. Hedge funds, even if they are registered with the SEC, have different holdings disclosure mandates. But transparency is a double-edged sword for investment managers, whether long-only or hedged. If the manager provides clients with transparency, it will allow the clients to better understand their process and gain comfort in their approach. On the other hand, a transparent approach in the world of investing can also lower returns as other investors attempt to mimic their strategy, or worse, attempt to front- run prospective trades. Similar to a poker player that does not want to reveal their hand prior to wagering, most hedge*fund managers hold their cards close to their chest. We prefer that both traditional and hedge*fund managers disclose their approach, their holdings, and the drivers of performance for their strategy, but we are aware that full disclosure in real time is neither reasonable nor to our clients' advantage.
• Flexibility: With less regulation comes greater flexibility for a hedge*fund manager to express their views with the goal of delivering a positive rate of return. This flexibility is important because without the ability to short securities or take more concentrated bets, delivering a positive rate of return on a consistent basis is almost impossible because of the volatility and occasional negative returns in the stock and bond markets.
• Private investments: Hedge funds can make investments in private companies (vs. publicly traded securities) without limitation whereas mutual funds are limited. While this can possibly add to returns over the long run, it may create a less liquid portfolio, hindering a manager's ability to balance the fund's liquidity needs. Clients should ask about the proportion of private vs. public investments to better understand the liquidity profile of their fund. Again, if the role of the hedge*fund is risk reduction in the portfolio, then private investments in that portfolio should be minimized.

While their unique characteristics may make the due diligence process for hedge*funds appear more complicated or difficult to understand, it is pretty straightforward if you abide by some guiding principles:  Limit leverage, obtain a reasonable degree of transparency into a portfolio, maintain access to the team managing the money, and understand the costs and liquidity of the funds.  Adherence to these basic concepts can not only maximize risk adjusted returns for clients, but also help them sleep better, especially in periods of market turmoil. 

Hedge Funds in the Current Market Environment

As we've previously covered, hedge*funds have more flexibility than long-only funds.  This can translate into better risk adjusted returns in most environments; however, under periods where volatility is high and the market is not behaving efficiently, hedge*funds should have the upper hand.  Exceptional hedge*fund managers are able to sift through the volatility and pick up great stocks or bonds that, because of the added level of volatility, may be priced at bargain levels.  Alternatively, they can short unattractive securities that long-only managers or index funds are forced into. While they add value to a portfolio in most any environment, we believe that economic and market conditions in the near future will result in heightened market volatility and market inefficiencies.

The economic conditions are ripe for hedge*funds.  The 2008 financial crisis brought to light the extreme levels of consumer, corporate and global government indebtedness that had been built over the prior years.  We believe that the debt unwinding process, some of which drove the markets down so significantly in 2008, still has a long way to go and could hinder economic growth for the foreseeable future. This should create opportunities for hedge*funds because while low economic growth may reduce overall equity market returns, some businesses will thrive while others suffer, creating great buying and shorting opportunities respectively.

The market conditions are also ripe for hedge*funds.  2008 was a tough year for many investment management firms.  Their assets (and their revenues) went down, mostly due to market depreciation but also due to client withdrawals - and many firms are operating with fewer resources than they had in 2008.  With revenues down, the pressure to increase assets is high and some firms are putting pressure on investment managers to make changes that are solely intended to increase assets and revenues. These business decisions force the managers to take their eyes off the market, and with fewer eyes on the market comes more unrecognized opportunities and risks.  Finally, the correlations among stocks globally have gone up significantly as investors are buying and selling the markets as a whole, irrespective of the individual opportunities or risks that exist.  The reasons behind this phenomenon are unclear; however, we believe it is adding to the inefficiencies within the market, which again creates an opportunity for buying and shorting.

There's Gold in Them Thar Hills

Every challenging market offers fresh opportunity, and the best hedge*fund managers are adept at finding ways to benefit from all economic and market conditions.  Here are just a few of the strategies we're hearing about from our hedge*fund managers:  

• In anticipation of fire sales of assets from either the banks or from other hedge*funds, some managers are holding higher levels of cash. This cash not only gives them the dry powder to move quickly when a forced sale occurs, but also has helped buffer their fund during the recent downturn.
  
• Self-imposed restrictions are forcing long-only managers to either sell or hold securities. For example, many hedge*fund managers had been concerned about the European economies for some time and correspondingly shorted European securities before the market fell. Many long-only managers benchmarked to the MSCI EAFE had to stay invested in Europe, irrespective of their outlook on the region, simply because of its heavy weighting in the index. This fear of straying too far from the benchmark's composition is common among long-only managers but seems to have increased even further after 2008, creating more dislocations in the market for hedge*fund managers to take advantage of.
  
• In anticipation of a flat or low growth market, many hedge*fund managers have been stripping out more market exposure from their portfolios by increasing their short positions. If they are correct about the lack of overall market movement and correct about their individual security ideas, they should be able to deliver a better than market return even if the market is flat.
  
• Whether inflation or deflation takes hold, the hedge*fund managers are scouring the globe to find securities poised to benefit from either scenario when the timing is right.
  
• There have been record inflows into bond funds, bond index funds and bond ETFs. This could quickly reverse, especially if fears of inflation or fears of rising interest rates cause bond prices to decline. As such, some managers have been shorting those areas of the bond market that have seen unwarranted price increases.

Guidelines for Fiduciaries:  A Due Diligence Checklist

Hedge funds offer potential risk reduction and return enhancement that may not be available from the exclusive use of long-only managers.  One therefore may argue that fiduciary responsibilities actually require careful consideration of the advantages that can be gained by adding hedge*fund investments to a portfolio.  A diversified group of hedge*funds, limited to an appropriate portion of the total portfolio, may contribute materially to attaining the investment objectives. 

As with any prospective investment, a hedge*fund should be carefully assessed, and ongoing due diligence will be necessary.  The process should involve examination of the hedge*fund's management and investment process, as well as the legal structure, organizational resources, and specific features of the investment.  In general, this involves gaining an understanding of the sources of risk and expected return, the amount and nature of any leverage, the risk controls the manager has in place, and what might go wrong under what sets of circumstances.  Specific factors usually include:

• Background and reference check on key personnel
• Networking and intensive use of industry contacts to understand and evaluate management
• Verification of claimed assets with custodian/prime broker
• Examination of audited financials prepared by reputable auditor
• Close review of private placement memorandum, limited partnership or LLC agreement, and subscription documents
• Evaluation of investment and structural features such as fee provisions, extent of leverage, application of risk controls, transactions with affiliates, other conflicts of interest, key man provisions, and any side letters
• Consistency of historical performance with claimed investment strategy
• After investment, consistency of performance with claimed investment strategy and understanding reasons for any divergence from expectations
• Limitations on liquidity (through redemption opportunities) such as lock-ups, gates, and redemption fees, as well as possible share classes permitting greater liquidity at the cost of somewhat higher fees
• Limitations on timing and extent of transparency provided by fund sponsor
• Valuation of fund investments, including nature of fund assets (publicly traded versus private, with or without redemption opportunities), accounting classification (Level I, II, or III), and valuation process
• Tax characteristics, including character of income and gain for taxable investors, possible UBTI for tax-exempt investors, investor filing requirements, and timeliness of tax information from fund

Conclusion

Investors' concerns and emotions play a major role in their investment portfolio's success or failure.  As investment consultants, we understand that logical and precisely crafted solutions are only valuable if the client is able to "sleep at night".

In recent years investors have tossed and turned in consternation as markets gyrated, the economy tanked, and headlines described doomed investments.   Investors will vary greatly in how they handle the uncertainty of the current economic and market landscapes.   Some will hunker down, go to cash and wait it out.  Others will find opportunities to benefit from the dislocations caused by the uncertainties.

At Federal Street Advisors, we believe that by building a portfolio of talented, active investment managers, investors can maintain their long term strategic asset allocation while being responsive to the current environment.  Hedge funds, the most active of managers, have the most flexibility to deliver on that mandate. In an appropriately diversified portfolio (and vetted through a well defined and administered due diligence process) hedge*funds can play an important role in meeting long term investment objectives.

There are a number of advisory models to choose from and a myriad of issues to be considered. This paper - and the attached Checklist for Choosing an Investment Consultant - can help foundation staff and directors in this process. In this white paper, we will explore the five key roles that investment consultants can play - as well as the critical question:  What value can they add in each of these roles?

        Investment Partner                                        Fiduciary Advisor

        Educator                                                          Administrator

        Supporter

Consultant as Investment Partner

The core benefit of hiring a consultant is receiving investment advice based on strong research. An experienced investment consultant can help you navigate the challenging waters of goal setting, cash flow analysis, asset allocation, risk assessment, manager selection, ongoing portfolio review, and performance reporting.  A consultant can also help address ad hoc financial and related requests that come up from time to time - and that often need to be resolved promptly.

A collaborative approach separates the good from the great

Experienced consultants should be able to handle the basics of developing capital market projections, investment*policy*statements, asset allocation frameworks and manager recommendations.  What separates the good from the great, in our view, is an ability to work in a collaborative and dynamic manner.  While there should be some consistency in the advice delivered across a consulting firm, the advice must be tailored to the client foundation's individual needs and adjusted dynamically in response to a changing market and client circumstances.  Truly, no size fits all.  An investment consultant should act as a partner to the investment committee or board of directors, but also be willing to introduce new ideas and challenge convention.  They must be responsive to clients' requests, yet also lead and educate.

There's no substitute for good chemistry

Chemistry and trust are twin aspects of a successful advisory-client relationship.  Before signing on the dotted line, get to know the individuals who will actually be delivering advice and with whom you will be working on a day-to-day basis.  It does no good to hire what you consider to be a great firm only to be assigned a consultant who does not meet your specifications - or fit your working style.

Like Goldilocks, pick just the right size

Look carefully at the size of the consulting firm's "AUM" - assets under management. Just as Goldilocks assessed three chairs in the Bears' house, find a consultant with the right amount of AUM, neither too large nor too small.  With too few assets, an investment adviser may not have the people and resources in place to provide high quality service and, further, may not have sufficient profitability to reinvest in their business.  By contrast, a firm with huge AUM may be hamstrung from an investment perspective; they may have trouble finding enough top notch investment managers to recommend across their large client base.  For example, let's assume that a consultant has $20 billion in client assets, allocates 10% of that amount or $2 billion to US small-cap managers, wants to limit investment to 10% of a given manager's asset base, and the average manager under consideration has $1 billion in AUM.  That consultant faces the daunting task of having to identify 20 superior management companies when, in fact, it can be a challenge to identify just a handful of excellent managers in this category.

Find out where the incentives are

It's vitally important to understand the fees you will be charged (sometimes not an easy endeavor) and whether those fee arrangements present conflicts of interest.  Many claim that they operate independently when, in truth, they are associated with a larger financial services organization.  It is absolutely critical that you understand their incentives and whether they align with yours - not a small task with many firms.

Consultant as Fiduciary Advisor

To meet their fiduciary responsibilities, foundation boards often lean heavily on the advice, expertise and analysis provided by independent investment consultants.  An experienced consultant can be extremely valuable in the formulation, documentation, and implementation of a rational and meaningful investment process.  Of course, a board cannot merely "rubber stamp" the recommendations received from an investment consultant; the board still must exercise its own judgment in considering the information presented to it in light of the foundation's goals and needs.

The "prudent investor" standard

Various laws impose a duty of care often described as a "prudent investor" standard.  That is, fiduciaries must use prudent judgment in conducting or overseeing investment activities.  In general terms, this standard requires a "total portfolio" approach in structuring a foundation's investments, rather than a focus on individual investments.  Modern portfolio theory often serves as a central basis for this analysis.

Process, rather than result, is the touchstone of meeting fiduciary duties

As a sound fiduciary, a board needs to adopt an overall investment plan based on the foundation's goals, expenditure and other needs, and risk tolerance.  Often articulated in an Investment Policy Statement (IPS), the plan may seek to achieve a desired investment return, consistent with an acceptable level of risk.  This normally involves adequate diversification among several asset classes and investment styles, taking into account expected risks, returns, and the relationship among the various components of the portfolio.  Implementation of the plan may then be delegated to outside investment managers, subject to the board's exercise of appropriate care and diligence in selecting, monitoring and, when necessary, replacing these managers.  It is critical to emphasize that the board's decisions in this regard are evaluated in terms of process, not results.  If the board diligently follows a carefully designed process, documented appropriately, and seeks expert advice where necessary, the board will normally have fully discharged its fiduciary duties.

Consultants should supplement the board's expertise

Engaging professional investment consultants may be required, not merely helpful, if a board does not have sufficient time or investment expertise to handle the vital task of developing an Investment Policy Statement. Consultants also advise the board regarding the managers, funds and other investments they believe are best suited to implement the plan.  Critically, consultants then provide ongoing monitoring and reporting, including performance and risk information evaluated in light of appropriate benchmarks.  This essential input allows the board to make decisions consistent with the prudent investor standard and to document and support the basis for those decisions.

Consultant as Educator

Many small- to mid-size foundations do not have a Chief Investment Officer and have very few investment experts on the board or staff.  As a result, foundation leaders are often left to make complicated and critical decisions without feeling qualified to do so.  A good investment consultant can and should make up this knowledge gap.

Foundations should engage an investment consulting firm that actively educates its foundation clients.  Useful subject areas include investment terminology, the role alternative investments can play in the portfolio, and mission related investing, to name a few.  In addition to structured education programs, an investment consultant plays the role of educator along the way.  The consultant is responsible for setting performance expectations, helping the board understand risks, providing clear choices to the decision makers (finance or investment committee), and assisting the foundation in understanding the consequences of its spending policy.

Consultant as Administrator

The Commonwealth Fund's 2009 Annual Report identified endowment management as the most critical factor affecting portfolio performance.  That said, administrative support is an often overlooked yet critical issue for foundations, many of which work with a limited operating budget and staff.  In some cases, foundation employees work on only a part-time basis.  Those employed by small- to mid-size foundations have a wide range of responsibilities, and their priorities are typically (and appropriately) focused on the foundation's operations, programs and grant making activities.  Staff may not have the time, confidence or expertise to handle finance and operations on their own.  Without outside assistance, investment results can suffer, not only from inappropriate design of portfolio strategy, but also from poor execution and monitoring.

The level of service can vary dramatically

The amount of service support provided by an outside consultant is determined by the relationship established between the advisor and client. Investment advisors who have full discretion in managing funds are, by extension, providing a high degree of administration.  Those operating on a non-discretionary basis can provide either a little or a lot of administrative assistance to the foundation.  Some investment consultants simply are not staffed or trained to provide administrative support or they view their role as delivering investment advice but nothing more.  Yet others in the field view administration as one of their core competencies and integral to the service they provide.  The latter are willing to assist foundation staff in preparing trading instructions, reconciling accounts, investigating operational issues, reviewing investment agreements of all sorts, preparing account applications and interfacing with the foundation's custodian and other professional relationships such as attorneys and auditors.  These investment consultants want to ensure that their advice is implemented correctly and promptly. And, they want to minimize the chance that administrative snafus detract from the relationship.

Not all reporting is equal

Reporting is a related issue.  Investment reviews provided by consultants vary in frequency, length and scope.  Prospective clients should ask to see what they will receive on a periodic basis, how consultants evaluate managers and their own performance, and how they factor in fees and other expenses.  They should also evaluate an investment firm's willingness to deliver, with clarity, interim ad hoc reports as well as to adjust formats to meet an investment committee's particular needs and preferences.  Some consultants provide extensive capital markets commentary and statistics along with asset allocation and performance.  Some board members appreciate this market background while other groups find such information to be unnecessary or cumbersome, actually making the report less useful to them.  Working with a consultant who operates as an extension of the foundation's office cannot be overvalued.

Consultant as Supporter: Philanthropy and Social Commitment

An increasing number of foundations have begun the process of using their investment assets, in addition to their grantmaking, to pursue a philanthropic purpose.  The most common strategies have been shareholder advocacy and proxy voting.  There are many additional forms of Mission Related Investing (MRI), including negative screening (excluding certain securities from their equity portfolios), positive screening (identifying and including market leaders on various social issues), community investment (lending within low-income communities), and other alternative options (social venture capital and green real estate).  Opportunities in MRI encompass a range of programmatic areas including environmental sustainability, climate change, sustainable agriculture, healthcare, community development, human rights (i.e. labor practices), and social entrepreneurship.

Finding a consulting firm who believes that foundations can invest assets to achieve both financial and social returns is the first step. Many investment consulting firms say they offer Mission Related Investing (MRI). However, a look under the hood reveals often that they have recently entered this field, have little expertise, and have very few clients who actually require this knowledge.  

In theory, it may seem a simple task to align the foundation's assets with the mission of the organization.  However, that requires a wide range of resources, tools and expertise, including 1) professionals skilled at working specifically with foundation boards and understanding the complexities and obligations therein; 2) research analysts who have knowledge and access to money managers who invest using social strategies; and 3) a consulting firm that believes you should not and do not have to give up market level returns in order to invest responsibly.

Conclusion

A foundation considering the pros and cons of hiring an investment consultant should look for one that will function as a partner, advisor, administrator, educator, and supporter.  The process for selecting a consultant typically begins with circulating a Request for Proposal (RFP) to a select a group of firms (e.g., four to six) that come recommended by other foundation clients or are known to members of the Board, followed by presentations from two or three finalists.

Below is a checklist that we at Federal Street Advisors believe can be useful to foundations in this selection process. 

For additional readings and dialogue about this topic, we encourage you to e-mail or call Jennifer Christian Murtie, Director of Foundation Services at jmurtie@federalstreet.com or 617-350-8999.

Checklist for Foundations Choosing an Investment Consultant

Finding the right investment consultant can be a daunting task for foundation board members and staff.  This checklist offers some of the questions that you might want to consider when evaluating prospective consultants.

Firm Profile

• What is their AUM (Assets Under Management)?
• What is the range of their clients by size?
• Who are some of their comparable clients?
• Are they experienced working with foundations?
• What is their industry reputation?
• What is their approach to manager selection and asset allocation?
• How do their fees compare to their competitors?
• Do they have the resources to maintain and reinvest in their own business?
• What is the depth of their research and administrative staff?
• What is their experience with MRI - Mission Related Investing?

What Investment Services Do We Need?

• Goal setting
• Cash flow analysis
• Asset allocation
• Risk assessment
• Manager selection
• Ongoing portfolio review
• Performance reporting
• Administrative support
  

What Fiduciary Advisory Services Do We Need?

• Development of the Investment Policy Statement (IPS)
• Selection and review of investment managers
• Performance reporting
• Risk monitoring in light of appropriate benchmarks

What Administrative Services Do We Need?

• Preparing trading instructions
• Reconciling accounts
• Investigating operational issues
• Reviewing investment agreements
• Preparing account applications
• Interfacing with the foundation's custodian
• Interfacing with the foundation's attorneys and auditors

What Reporting Do We Want and Need?

• Performance reporting format and frequency
• Timeliness of quarterly reporting
• Manager evaluation: what level of depth, detail and frequency?
• Willingness to prepare ad hoc reports as needed
• Capital markets commentary and statistics
• Willingness to tailor reporting format, depth and frequency to our needs 

What Will the Working Relationship Be?

• Who will be our primary consultant; what are his/her credentials and experience?
• What is their style of communication?
• Will they value collaboration?
• Is their personality and style a good fit for us?
• Have they worked with similar clients before?
• How easily and quickly will the consultant respond to changing circumstances and ad-hoc requests?
• Do they seem to understand the mission and history of our organization?
• Is there a process in place to monitor their work and recommendations?
• Who backs them up when they are out of the office?

Fee Structure

• Fixed fee
• Percentage of assets
• Performance-based incentives
• Commissions
• Revenue sharing
• Combination of these

Are fees comparable to other consulting firms?

Financial Incentives

• Are there any areas of potential conflict of interest?
• Do advisors recommend only their own products or strategies, or are they entirely free to recommend outside, unaffiliated managers?
• Do they take payments from managers they recommend?
• How are individual consultants compensated?
• Are they willing to share with you a total view of fees and expenses that you will be charged?

Federal Street Advisors' clients have always cared about "giving back," but many today are becoming more sophisticated in their philanthropy - and more eager for our extensive experience in this area.  Our clients want to know that their giving will make a real difference, and they increasingly care about aligning their investments with their personal values.  All of this, of course, within a financial planning and investment framework that maximizes today's lifestyle and tomorrow's wealth.

This white paper showcases how one of our joint clients, Jim and Karen Ansara, is using their philanthropic resources to achieve meaningful and lasting results. The article was written with the Ansaras' express permission; we appreciate their willingness to use their name and tell their story.

High Impact Philanthropy
       What is it and how can a community*foundation help you do it?

Jennifer Christian Murtie, Director of Foundation Services at Federal Street Advisors                    Ruben D. Orduña, Vice President for Development at the Boston Foundation

Much has been written in recent years about a trend in philanthropy to seek greater impact and more measurable results.  Most experts believe this trend is not only here to stay; it's transforming how donors (both individuals and foundations) approach their charitable giving.  Organizations like the Center for High Impact Philanthropy at the University of Pennsylvania and FSG Social Impact Advisors, along with numerous blogs and books like High Impact Philanthropy: How Donors, Boards, and Nonprofit Organizations Can Transform Communities by Kay Sprinkel Grace and Alan Wendroff and Forces for Good: The Six Practices of High-Impact Nonprofits by Leslie Crutchfield and Heather McLeod Grant, are bringing the concept of high impact philanthropy to a broader audience.

So what exactly is "high impact philanthropy" and what is the buzz all about?  The Center for High Impact Philanthropy defines it as "the practice of making charitable contributions with the intention of maximizing social good. The aim is to make the biggest difference possible given the amount of capital invested."  As a donor, how can you have the greatest impact on positive social change?  How can you make your money stretch further?  How do you select organizations that have measurable results?  How do you know if you are having an impact?  These questions and many others have become increasingly important to philanthropists.  After the market turmoil of 2008, many donors have fewer dollars and therefore have been forced to be more strategic with their philanthropy.  Most experts believe this is a positive shift for the philanthropic sector.

Personal Involvement is Key

Foundations and individual donors have always strived to have impact on social change, but this new approach is different in that donors are focused on personal involvement, long term change and are more cognizant of the charitable organization's strategy.  Finding charities that work directly with the people they serve is becoming an increasingly popular funding strategy.  Not only do your charitable dollars address a particular issue, they support an organization that has local people on staff, a long history of success in the region, and an information base that gives them an advantage in solving social problems.

You Don't Need Millions to Have High Impact

It is important to remember that you do not need a large fortune to have high impact; rather, you need commitment, energy, and time to be actively involved.  Creativity goes a long way, and partnering with the right organizations, people, and institutions can create lasting social change.  By definition, high impact philanthropy does not necessarily mean impacting the greatest number of people.  Nor does it mean shifting emphasis to projects that can easily count immediate results (e.g., the most people served).  Rather, the focus is on longer-term, more significant and longer lasting impact, even though that may be more difficult to measure. High impact philanthropy works to permanently improve individuals' and/or communities' circumstances, using effective organizations that have the right strategies.

A New Breed of Hands-On Philanthropists

No one exemplifies this new approach to philanthropy better than a shared client of the Boston Foundation and Federal Street Advisors, Jim and Karen Ansara.  We are humbled by the Ansaras' commitment, passion, and capacity to implement high impact philanthropy and create positive change through their efforts.

The Ansara Family Fund is a donor-advised fund at the Boston Foundation (Greater Boston's community*foundation) with a focus on eradicating global poverty in Latin America and Central Asia.  The Ansara family annually makes 20-30 grants totaling $500,000-$700,000.  This year, with the help of the Boston Foundation, Jim and Karen took their philanthropy to a whole new level.  They asked the Boston Foundation to create for them The Haiti Relief and Reconstruction Fund ("HRRF") in response to the earthquake of January 12, 2010.

In addition, the Ansaras leveraged their money by pledging to match donor contributions dollar for dollar up to $1 million.  They managed to raise $1 million in less than a month, thus creating a $2 million fund in only a few weeks.  Spent over the course of five years, the Fund will devote up to 25% of its resources to immediate disaster relief, and the balance to innovative projects and organizations helping Haiti rebuild livelihoods, reconstruct infrastructure, and promote human rights so that Haitians can have a voice in shaping their own futures.  Another priority for the Ansaras is to support the healing and strengthening of the Boston Haitian community in the aftermath of this disaster, as well to support The Boston Foundation in convening leaders of the local Haitian community to address long term reconstruction issues. 

Focus on a Specific Need

What makes the Ansaras' philanthropy high impact is that they have focused on a specific need and have selected organizations like Partners in Health, whose mission aligns with their philanthropic strategy.  Even more important, they have made a long-term and personal commitment to the cause.  75% of the Ansaras' Fund will go to long term rebuilding efforts, and they are actively involved with not just their money but also with their time.

Strategic Advisors Help Maximize the Impact

The Boston Foundation has facilitated and enhanced the Ansaras' efforts through the structure and administration of the Ansara Family Fund, while Federal Street Advisors has carefully aligned the Fund's investment strategy with the Ansaras' values and goals.  The Boston Foundation set up a donor-advised fund, and now provides grant making advice and support, and helps raise awareness about the Fund.  Because The Boston Foundation handles many of the Fund's administrative burdens, Jim Ansara is free to spend one week a month building clinics and helping doctors in Haiti.  He keeps a blog of his work, providing current and relevant updates to supporters of the Fund.  Karen spends her time fundraising and raising awareness about international poverty issues.

Community Foundations Give Small Family Funds Access to Top-level Resources

A majority of the Ansara Family Fund grant making decisions are made at a semi-annual meeting.  In preparation for the grant meetings, Boston Foundation Donor Services staff respond to inquiries from nonprofit organizations, review proposals, manage grantee communication and oversee the grant making budget for the Ansara Family Fund.  The Boston Foundation staff also performs due diligence to ensure that grantees are qualified non-profit organizations that are exempt from federal income taxes under Section 501(c)(3) of the Internal Revenue code.  (Grants to non-US-based and non-501(c)(3) organizations located outside of the U.S. are made through an intermediary organization such as CAF America.)

For The Haiti Relief and Reconstruction Fund in particular, the Boston Foundation administers all aspects of this fund, including:

• processing over 1,200 gifts of cash, check, credit card and securities
• processing grants
• convening forums for the Greater Boston and Haitian American community
• managing inquiries from donors, press, civic leaders and nonprofit organizations
• convening a grants committee and advisory council to advise grant making raising over $1,000,000
• organizing fundraising and donor reception events
• organizing meetings with civic and nonprofit leaders around development plans in Haiti and support for the Boston community

In the coming months, the Boston Foundation will be reviewing proposals to the HRRF from organizations seeking funding and will be conducting due diligence on all applicants.  With an application deadline of April 23, HRRF received over 80 inquiries from nonprofit organizations.  The partnership between the Boston Foundation and the Ansaras has led to a very successful high impact fund that is focused on meeting the long term needs of the Haitian people.

A New Investment Mentality in Philanthropy 

While investment consultants are not traditionally asked to assist clients with their high impact philanthropy, Federal Street Advisors has found our expertise and resources in this area to be extremely beneficial to our clients.  Federal Street has a long history of supporting our clients' philanthropic goals, and we specialize in servicing clients in this capacity. 

Federal Street is increasingly working with clients to foster a new "investment mentality" in charitable giving,  both by measuring "returns" from those investments in terms of impact, as well as by supporting sustainable and socially focused investment strategies in client portfolios.  Foundations call this new approach "mission related investing" and with the help of their investment advisors they are finding innovative market-rate investment opportunities.  Whether a donor is interested in human rights, the environment, or community development, there are ways to use their investable assets to further social priorities. 

The Ansaras Leadership Continues to Inspire

The Ansaras' commitment to tackling poverty has been written about in the Boston Globe several times, as well as The Wall Street Journal.  The Journal's recent article states "With less to give, donors want to be certain that what they do give goes as far as possible, and many are deciding that means helping people improve their lives and their prospects, not just relieving their immediate suffering."  Jim and Karen truly make us proud to be their partners.  They set a high standard for all of us on how we can have the biggest impact with the resources we have.

Karen quite eloquently states:

"In today's busy modern world it is so easy to lose focus on what's important. Haiti seems to have already disappeared from the headlines, even though the real work of fighting cholera, typhoid, and infection - and rebuilding an entire society - has just begun. That's why we must raise this money now, before Haiti's trauma becomes a mere memory to the outside world, while there is still so much to be done."

The Ansaras are leading by example and we believe their model of philanthropy can be replicated and used by others to fulfill their own philanthropic vision. We at Federal Street Advisors and the Boston Foundation feel privileged to be two of the partners the Ansaras work with to help them further their philanthropic mission.

Where and How to Get Started

There are over 700 community*foundations nationally, and like the Boston Foundation, they offer many ways to help donors meet their charitable giving interests and goals. Their grant making experience and vast knowledge of local issues make community*foundations natural partners for individuals and families interested in high impact philanthropy.

Regardless of your philanthropic budget, you can have a greater social impact with your philanthropy through research, networking, creating an organized process, and selecting effective organizations.  Whether your passion is to support your community, your town, your state, your country or with great ambition our world, you can make an even greater difference.  The Ansaras are leading by example and we believe their model of philanthropy can be replicated and used by others to find their own philanthropic vision.

Aligning your investment portfolio with your giving

Emily Bannister, Senior Research Analyst, Federal Street Advisors  

We at Federal Street Advisors believe that foundations and individuals should invest their investment portfolios for maximum return at an acceptable level of risk.  Fortunately, this objective is not incompatible with mission related investing (MRI).  We have seen evidence that focusing on environmental, social, and governance (ESG) factors does not necessarily result in lower performance.  The FTSE KLD 400 Social Index, for example, uses these factors to create an index of U.S. equities.  It has outperformed the S&P 500 index for the full common time period from May 1990 through March 2010, returning 9.7% annualized versus 8.8% annualized for the S&P 500.

Including MRI in the investment portfolio can amplify a high impact philanthropy strategy since it allows clients to leverage their invested assets to make an even greater difference than they are already making with their grants.

Mission Related Investing (MRI) Requires an Additional Layer of Due Diligence

It is possible to achieve outperformance with a mission focus.  But just like any other investment style, there are good managers and bad managers; our job is to find the exceptional opportunities.  When we research MRI managers, we hold them to the same standards by which we evaluate all managers.  We recommend only managers that offer outstanding risk/reward profiles.  Our research team uses qualitative and quantitative tools to assess whether we believe that managers who have done well relative to peers and benchmarks in the past have the process and team in place to outperform in the future. 

With MRI managers, however, we have an additional layer of due diligence to perform.  We evaluate their approach to integrating ESG issues into the process, as well as the independence and sources of ESG data.  We also look at the resources they offer in terms of proxy voting, thought leadership, and shareholder advocacy.

MRI Can be Broad or Highly Targeted

For some clients, a broad focus on sustainable investing aligns with their philanthropy, since their goals cover a number of issue areas.  For other clients, the mission is more defined.  In these cases, we have successfully found equity, fixed income, private*equity, and hedge*fund solutions that target specific issues.

One key aspect that differentiates high impact philanthropy from general charitable giving is the goal of measuring impact.  At Federal Street Advisors, we have also identified managers who can measure the impact a client's investments are having on a particular issue.  While there is no standardized reporting yet in this area, we work with managers who highlight the tangible results of their advocacy efforts, and report the percentage of their portfolio invested in companies working on issue-specific solutions.

Looking to the Future

At Federal Street Advisors, we have worked hard to find ways to integrate mission related investing (MRI) into client portfolios, allowing them to align their investments with their high impact giving.  As this market grows, we see new strategies being developed all the time - and some of these will turn into exceptional new investment opportunities for our clients.  At Federal Street Advisors, we will continue to use our expertise in this growing field to help align client investment portfolios with their philanthropic goals.

A New Generation Wants Measurable Results

Randy A. Hustvedt, JD; Principal & Director of Family Office Services

Call it high impact philanthropy, strategic philanthropy or even catalytic philanthropy, the commitment to achieving measurable results with charitable giving need not be limited to the large institutional foundations of this world.  More and more, we see our family office clients, whom we typically help with their philanthropic planning, ask about whether they are making an impact and, as importantly, how they can measure success.

The Younger Generation Is Looking for Results

This question is most frequently asked by the younger generation of the family - and we are happy to see this trend.  Recently, the younger generation of one of our family office clients, all in their 20's, asked us to run a session on high impact philanthropy.  They had been giving for over five years.  Year after year, we would ask if they felt that their philanthropy was having a positive impact. For many years, they did not know how to answer that critical question and so it lingered, unanswered. Finally, the family realized that this question was indeed a vital one, even with a $3 million foundation.  Indeed, one could argue that the question of impact is even more, not less, important for a foundation with limited resources.

What Exactly is "High Impact"?

We believe that a high impact nonprofit is one whose efforts have been proven to cause sustainable positive change. Think of your grant as an investment and decide what outcome you'd like to see.  A few key questions to consider are:

• What is the organization trying to achieve and how will it show measurable results in getting there?
• Who are the beneficiaries?
• What benefits do the programs create?
• How is success defined?

To get answers to these critical questions, consider making site*visits, working with other like-minded donors on due diligence, and volunteering to get to know the organization better.

High Impact Does Not Pop Out of an Earnings Statement, Like ROE or ROI

Unfortunately, there are no easy answers.  Each charitable organization is different, and each one can achieve impact in its own unique way. But, we do know that unless and until the question is raised, for foundations big and small, impact is hit or miss.

Maximize Your Impact With a Philanthropic Plan

You can certainly learn a great deal on your own, or you could hire an advisor to help you with the process. Either way, as with any investment strategy, it is important to first have a plan and a goal in mind - and way to measure results.  And, as you evaluate both your giving process and the organizations that will benefit from it, remember the famous words of Henry Davis Thoreau:  "It is not enough to be busy, so are the ants. The question is, 'What are we busy about'?"

"We need cash now to cover operating expenses"

Endowments need liquidity in order to meet their obligations each year with proceeds from their portfolio.  For many endowments, these annual distributions play an important role in meeting an affiliated institution's operating expenses - expenses that annually rise with inflation.  Liquidity also plays an important investment function, enabling the fund to meet capital calls from private*equity commitments and take advantage of extraordinary investment opportunities.

Abundant sources of liquidity

In addition to cash positions, which are highly liquid, liquidity is also provided by coupon payments from bond holdings, rent or lease payments from real property, and dividends from stock holdings.  In addition, fixed income and certificates of deposit can be structured so that their maturity dates align with major anticipated cash flows. 

Finally, liquidity needs are often met by trimming the portfolio's investment positions, including strategies that are invested in equities and fixed income.  In addition to these more plain vanilla approaches, endowments can borrow money by lending their securities - or by using their investment portfolio as collateral in other ways.

Alternative investment backlash

In response to the recent market conditions, many trustees at endowments and foundations have expressed concerns regarding liquidity.  This perspective may translate into a lower level of interest in alternative investment vehicles, which are less liquid as a result of their account structure.  For many investors, however, this reaction may not be entirely rational.

The press has recently highlighted the difficulties that major endowments such as Harvard have had in meeting their liquidity needs, including their need to trim their private*equity commitments and issue debt.  These difficulties are reflected in the following quote from Harvard Management Company's CEO Jane Mendillo in the 2/11/2010 Harvard magazine: "For many years, illiquidity has been our friend.  Now, much greater emphasis must be put on liquidity."

All endowments are not alike

It is important to keep in mind that endowments vary greatly in both their obligations and their portfolio design.  An endowment with a reasonable portion of their portfolio in alternative investments may not need to fear the liquidity crisis that overwhelmed many of the more aggressive and "sophisticated" endowments, since their liquidity profiles are vastly different.

According to the 2009 NACUBO - Commonfund Study of Endowments, 61% of the endowments surveyed had assets of less than $100 million, and these smaller endowments held an average of less than 22% in alternative investments.  This contrasts sharply with the 52 endowments with greater than $1 billion in assets, which held an average of 56% in alternative strategies.

Entering the recent credit crisis, the median university endowment portfolio held less than one-half the weighting in illiquid assets that were held within portfolios of the more aggressive major university endowments. Yet despite their dramatically different liquidity profiles, the fiduciaries at these endowments may anchor their thoughts around the liquidity problems faced by some of the largest and most well known endowments.

All illiquidity is not alike either

It is also important to differentiate between illiquidity resulting from the account structure, due to longer lockups or redemption fees, and illiquidity resulting from the nature of the underlying investments within the account structure.

Although most hedge*funds invest in publicly traded equity and fixed income securities that can be considered "liquid", their account structures have often been designed to promote a long term investment approach through the use of a less liquid account structure.  This seems to be based more on a preference of the manager (and their ability to demand these concessions) rather than on a match between the liquidity of the investments and the liquidity of the account structure.  Unlike private*equity investments, which take years to deploy and years to exit, hedge*fund investments do not necessarily need to be wrapped within a longer term vehicle.

The answer: individualized portfolio design

Each investment portfolio should be individually structured to meet a client's objectives, cash flow requirements, and their tolerance for risk.  When concerns regarding liquidity arise, it is important to objectively review the information and distinguish between valid considerations and concerns that are less well founded.

Similar to diversification across types of assets, market capitalizations, and geographic exposures, a portfolio's liquidity profile is a vitally important consideration in portfolio design.

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.