Christopher T. Vincent, Principal, CFA

Lessons From The Financial Crisis and a Blueprint for Investing in the Current Environment

CFA West Michigan Society

Luncheon Presentation: Thursday, November 11th, 2010

Outline

I. Lessons: Risk, Innovation, Liquidity, Policies, Dodd-Frank

II. Environment: Fiscal, Legislation, Monetary Policy – QE2

III. Asset Mix: Equity Risk Premium

IV. Fixed Income Portfolio: 2009, 2010, 2011

2

Risk in Bond Funds

Difficult to discern Ex-Ante

Core vs Core Plus

Mean/Average Morningstar Intermediate Fund: (4.7%) in 2008

Lehman Brothers Aggregate Bond Index: 5.2% in 2008

3

The Morningstar Intermediate-Term Bond Category represents the average annual composite performance of all mutual funds listed in the Intermediate-Term Bond Category by Morningstar.

The Barclays Capital U.S. Aggregate Index (formerly Lehman Brothers Aggregate Bond Index) is an unmanaged index that represents the investment grade bond market. It is composed of securities from the Barclays Capital Treasury, Government-Related, Corporate and Securitized Indices. 

Innovation

Technological/Scientific Progressive1

Financial Cyclical1

Most frequently is found in bond portfolios

ABS (“Shadow Banking System”)

Credit (Rating) Crisis2

4

1 “Risks and Rewards or Financial Innovation: Creative Destruction Or Destructive Creation?” Loyola University Chicago Symposium, 10/4/10

2 FRB Chicago; Agarwal Barrett, et al. The ABS Markets, The Crisis and TALF

Liquidity (Confidence)

Fractional Reserve Banking System

“But the crisis demonstrated that, in a crunch, shortages of liquidity can be just as

hazardous as shortages of capital. Indeed, it was often hard to tell one from the other.” 1

5

1 WSJ OP/ED by Alan S. Blinder on Basel III

Liquidity

Q: “How did you go bankrupt?”

A: “Gradually and then suddenly.”

AIG versus Lehman Brothers

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Hemingway, The Sun Also Rises

FOMC Policies

TLGP

TALF

MMF Pricing

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Dodd-Frank

www.FCIC.gov

Systemic risk: Determining the level of such risk will largely “remain subjective”.

Ben S. Bernanke, Federal Reserve Chairman

8

Dodd-Frank

Law will prevent taxpayers from ever “again having to foot the bill for Wall Street’s mistakes.”1

Unsecured creditors will “bear losses.”2

9

1 President Obama signing the 2 Wall Street Reform and Consumer Protection Act

Dodd-Frank

CFA Institute Survey1:

75% did not believe the law would prevent future crises

66% graded Congress’s reform efforts “poor” or “failing”

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1 Guest editorial by James Allen, CFA in the September/October issue of FAJ; Vol. 66, Number 5

Investment Environment

Fiscal stimulus winding down (1.0%-1.5% GDP hit per quarter)

? Bush tax cuts extension

? Fiscal commission

11

1 ISI Morning Policy Report; 10/26/10

Investment Environment

Legislative/Regulation: ↓/? Dodd-Frank

↓/? Basel III

↓/? Health Care

12

Investment Environment

Monetary Policy: QE2 to address deflation concerns

$600 billion package

13

Investment Environment

QE2 Scenarios:

Fail Success Too SuccessfulDeflation Growth with Low Inflation Inflation (Expectations) Rise

Investment Investment InvestmentLong HG Debt Equities TIPS/Commodities/RE

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Asset Mix

Equity Risk Premium; Increased due to:

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A. Two bear markets in a decade/“Flash Crash”

B. Demographics

C. Household B/S

16

Household Balance Sheet Volatility

Rolling 5-year standard deviation of % changes in household net worth

This is another powerful force depressing (household sector) sponsorship of the stock market

Household balance sheet volatility

Source: Federal reserve, Credit Suisse.

17

The volatility of household net worth has risen because of equity volatility and house price declines

Source: Credit Suisse, Haver Analytics

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Rolling 10-year volatility of Household Net Worth

Fixed Income Demand

Source: Barclays Capital. Data as of November 1, 2010

0

500

1,000

1,500

2,000

2,500Ja

n-07

Apr

-07

Jul-0

7

Oct

-07

Jan-

08

Apr

-08

Jul-0

8

Oct

-08

Jan-

09

Apr

-09

Jul-0

9

Oct

-09

Jan-

10

Apr

-10

Jul-1

0

Oct

-10

OAS

(Bas

is P

oint

s)

Investment-Grade Corporate Bonds vs. High Yield Corporate Bonds Option-Adjusted Spread

Inv.-Grade Corporate

High Yield Corporate

Corporate Bond Risk Premiums

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“Trade of the Year” in 2009

Source: Bloomberg. Data retrieved November 9, 2010

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“Trade of the Year” in 2010

Source: Bloomberg. Data retrieved November 9, 2010

20

Bond Portfolio

Duration: Short

Inflation: TIPS

Quality: High Yield

Quality: BBBs

Sectors: Energy, Materials, Commodities, REITS

Sectors: Yankees

Structure Amortizing Securities, Floaters

Low Duration

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Questions?

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