A Different Way to Look at Portfolio Risk

Recent data from the Federal Reserve highlights that the U.S. saw a 12.5% increase in the population aged 55 to 64 between 2004 and 2007. Near retirement, and typically beyond their largest earning years, this group faces tough decisions about their investing and spending even in good times. Today, because of large declines in the value of the stock market and residential real estate, those decisions are harder than ever. Traditional assessments of portfolio risk have been inadequate for a long time, but for this group it is even more relevant to discuss the importance of relating the assets to the liabilities of the investor.

I recently came across a compilation of articles from the Journal of Portfolio Management that were published in a 1998 compendium called Streetwise (Princeton University Press). A 1984 article, "A New Paradigm for Portfolio Risk," by Robert Jeffrey, caught my eye.

In "A New Paradigm..." Jeffrey argues against using only portfolio volatility as the measure of portfolio risk. His underlying assertion is that risk is a function of a portfolio's liabilities as well as its assets, and in particular of the cash flow relationship between the two over time.

The new paradigm that Jeffrey argued for in his 1984 article never occurred. For the past 25 years it has been standard for individuals to construct portfolios that offer the promise of the greatest return for the maximum tolerable amount of risk, defined as portfolio volatility.

For the most part, individuals have not been encouraged by mutual fund companies and large brokerage firms to think about their portfolio risk in terms of their liabilities. The business models of these firms can be called "manufacture and distribute." What they manufacture are the mutual funds and other products that they market to individual and institutional investors. Most likely, the asset based approach to risk management, generally advocated by these firms, is a product of the fact that portfolio assets are what they manufacture. Yes large brokerage houses do offer mortgages, but in my experience this is a discreet function, perhaps facilitated by the client's sales rep, but not incorporated into the portfolio risk discussion.

The problem with volatility based risk measures, as Jeffrey points out, is that they say nothing about what is being risked as a result of the volatility. Said another way in the same article, "the determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."

The 50 or 60 Something investor, who faces tough decisions about investing and spending, needs to be considering the consequence of loss as highlighted above. This is a very personal exercise that requires a thoughtful breakdown of the timing, magnitude and predictability of future cash requirements. A competent advisor who works with the proper incentives can be an invaluable resource in this process by asking the right questions and highlighting opportunities for savings or realignment of assets. An objective, knowledgeable advisor is in a position to show investors the best of what is out there to meet their needs.

As always, investors should "consider the source" when receiving investment advice. In addition to educational background and years of experience, some key questions are; How much time does the person that I am working with spend trying to understand my whole financial picture? How is the advisor compensated? Does the advisor offer an "open architecture," or are the recommendations constrained by his or her firm's product line? Does my advisor receive commissions when I purchase something that may color his or her incentives? Is he charged with acting as a fiduciary?

Individual client risk management is improved by considering assets and liabilities together. Advisors who practice this approach can be invaluable in helping their clients with this.

U.S. Royalty Trusts for Income-Oriented Investors

There are several publicly traded U.S. Royalty Trusts with interests in the oil and natural gas sector that are worth a look for investors seeking high current income. Their projected next twelve month yields are in the range of 8-10%. They also hold appeal for investors who would like to own assets whose performance is linked to the change in oil and natural gas prices without exposure to a leveraged corporate balance sheet, or the potential for poor corporate management.

San Juan Basin Royalty Trust (NYSE: SJT), and Permian Basin Royalty Trust (NYSE: PBT) are the two U.S. Royalty Trusts that this article will focus on, though there are a number of others. There are detailed descriptions of the trusts available on the trust websites and in documents available at the SEC website (http://www.sec.gov/). The goal of this piece is to provide a concise description of each, and a summary of why it might be an attractive investment.

San Juan Basin Royalty Trust:

Principal Asset:

This trust owns a 75% net overriding royalty interest in certain properties located in Northwestern New Mexico. These properties are virtually 100% natural gas producing.

Unit Information:

Recent Price $14.99 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $698,665,852

2008 Distributions $3.069833

Most Recent Monthly Distribution $0.09889 per unit paid 3/13/2009

History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. The income producing properties are operated by Burlington Resources Oil and Gas (BROG), a division of Conoco Phillips. BROG retains a 25% interest in the properties.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $15.83 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $5.18 yet actual distributions per unit have totaled $20.40 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of SJT at its 1998 high price of $9.37, and still held it today would have received $20.40 in distributions and would own a unit with a market price of $14.99. Today the estimated future net revenue per unit is $15.83 and the current unit market price is $14.99, so the units are available at a multiple of estimated future net revenue of 0.95x. This compares with a multiple of estimated future revenue of 1.8x in 1998, so on this basis the units are cheap relative to that time.

Income Potential in the near term

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $1.25 (http://www.mcdep.com/). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 8.33%. While only an estimated income based on estimated monthly distributions, this is an appealing yield relative to many other income-related alternatives, particularly since this comes with no balance sheet leverage.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Permian Basin Royalty Trust:

Principal Asset:

The trust’s principal assets are a 75% net overriding royalty interest in oil and gas producing properties in Crane County Texas and a 95% net overriding royalty interest in other oil and gas producing properties carved out by Southland Royalty Company from its properties in Texas. The production from these properties is approximately 2/3 oil and 1/3 natural gas.

Unit Information:

Recent Price $9.94 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $463,291,432

2008 Distributions $2.39136

Most Recent Monthly Distribution $0.04356 per unit paid 3/13/2009


History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. Burlington Resources Oil and Gas is the operator of record for the properties in Crane County, Texas. The Texas Royalty Properties consist of royalty interests in mature producing oil fields. They contain approximately 303,000 gross and approximately 51,000 net producing acres. Riverhill Energy performs all accounting operations related to these properties and Schlumberger Technology Corp. performs summary reporting of monthly results.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $6.906 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $2.01 at that time yet actual distributions per unit have totaled $10.96 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of PBT at its 1998 high price of $5.19, and still held it today would have received $10.96 in distributions and would own a unit with a market price of $9.94. Today the estimated future net revenue per unit is $6.906 and the current unit price is $9.94 so the units are available at a multiple of estimated future net revenue of 1.44x. This compares with a multiple of estimated future revenue of 2.6x in 1998, so on this basis the units are cheap relative to their valuation in 1998.

Income Potential

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $0.97 (http://www.mcdep.com). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 9.8%. Given that this comes with no balance sheet leverage, this is appealing relative to many alternatives in the market place. Of course, the risk cuts both ways in that if commodity prices fall further then the yield will not be earned as expected.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Note: As of 3/23/2009 clients and principals of South Shore Capital Advisors are now holders of San Juan Trust (SJT)

Municipal Bonds relative safety highlighted in WSJ "Heard on the Street"

How Safe are Municipal Bonds?

As highlighted in the WSJ "Heard on the Street" column above, a Moody's study found muni credit loss rates across 1970 - 2000 were lower than for triple A rated corporate bonds. Among general obligation and essential-service bonds - 60% of issuers surveyed - the default rate was exactly zero.

However, we should go back to the Great Depression to obtain a deeper perspective. When we do that the data still look very good.

The above WSJ piece highlights a study by Professor George Hempel who found that the default rate on municipal bonds across the period from 1929-37 was 16.2% of outstanding debt, but the estimated loss rate was just 0.5%. Further, using a recent example in Orange County, CA from 1994, bond holders recovered 100% of principal and interest.

There are counterpoints to this arguement. In a recent Forbes article the same issue was handled somewhat less optimistically. The article notes that creditors who hung in there during the Great Depression by and large received their principal and interest. However, the legal rights of municipal bond investors are not entirely clear according to Georgetown Law Professor, noted bankruptcy expert, and Dartmouth College Trustee Todd Zywicki. In one specific example, however, it is noted that the General Obligation bonds of the State of California enjoy a lien on state revenue second only to education spending.

Where is the investment opportunity? If the favorable risk profile, and attractive relative valuation creates increased demand for munis, there is room for the relative outperformance versus treasury bonds. In 1988 munis peaked at 4.5% of household and non profit organization assets while today they are just 2%. According to the WSJ, if they were to grow to 4.5% of holdings again, that would imply an extra $1.15 trillion of demand, equivalent to 43% of the total amount of muni debt outstanding and well over double the likely issuance this year.

Treasury Bonds May be in a Bubble, but Most Investors Will Want to Think Twice Before Shorting Them

There has been a lot of discussion in the media about a "bubble" in the price of treasury bonds - i.e. the yields on treasury bonds are at unsustainably low levels. This has increased the focus on opportunities available to the individual investor who wants to try to make money from shorting treasury bonds. There are a number of vehicles available to individual investors who would like to do this. Here is a link to my analysis of the potential payoff. It illustrates why someone might want to think twice before making this trade.

When it's Time To Cash in that Variable Annuity -

Abstract:

Today, with the stock market at levels not seen in 12 years, many equity-oriented variable annuities have passed their surrender penalty periods and have no earnings to be taxed. Now may be the time to get out from under those fees and look for better options.

Not long ago I spent a number of hours helping a client in her sixties review her holdings in order to develop a strategy for generating income and assets to fund her retirement. One of her holdings was a variable annuity from an insurance company called Allmerica, the Allmerica Advantage. I studied this annuity in detail, and for the life of me I couldn't see the "advantage" for her (sorry for the bad joke).

This annuity had been purchased by her husband many years before as a savings vehicle. The logic seemed straight forward. The owner earns tax free returns on the appreciation of a basket of mutual funds chosen from a predetermined group of options. Also, there is a death benefit feature that would pay out to his beneficiaries at least as much as the owner put into the annuity . In exchange for this death benefit, the owner pays fees and accepts a "surrender period" - in this instance 9 years, during which he will be penalized for withdrawing his assets.

In this situation the annuity transferred to the wife upon the death of her husband. It had passed the surrender period. Further, due to the poor performance of the stock market during the past 12 years, it had no earnings since its value was less than the amount invested in the various mutual funds. Therefore the cost to redeem was zero from a tax perspective and zero from a surrender charge perspective. The one catch was that it was below its death benefit.

This particular annuity had a series of fees that were as follows:

Mortality and Expense: 1.25%
Administrative Charge: 0.20%
Fund Mgmt Expenses: 1.01%

Total Expenses 2.46%

Recognizing that there was a death benefit, but given the above fee structure, and the recognition that her goals were retirement income-oriented, my advice was the following:

If your primary concern is not the size of the inheritance you are going to leave, but how you are going to enjoy the next twenty or thirty years, cash it in and have it managed by a fiduciary (Registered Investment Advisor) who will charge you much lower fees and give you advice in the process.

Also, I see shedding the high fees of the annuity as a "life benefit." A savings of 1-1.25% per year for many people is enough to pay for a few nice weekend getaways or an emergency car repair if needed.

Aren't we missing the option to annuitize? Yes, a single premium annuity is an attracitve option to some, and in her case. If we were to visit the Website of Bekshire Hathaway Direct, we would learn that for her life she could lock in a yield of 3.65% and that it would be tax advantaged for the first 18.5 years because during that period the IRS will consider 75.7% of each monthly payment a return of principal.

A key catch is inflation.

Assuming 3% inflation - one's purchasing power will go down by 50% over the next 12 years, so the $1639 monthly payment will only seem like $819.50 in today's dollars when this annuitant is 79 years old. Further, once the money is in the annuity, the annuitant must prove financial hardship to access the principal, and if she passes away in two years, the insurance company "wins the bet."

An alternative would be to purchase a U.S. Treasury 20 year inflation protected security. According to Bloomberg, the 20 Year TIP currently offers a real yield of 2.4%. Combine that with a 3% inflation rate and the holder receives 5.4% for holding the bond. Additionally, as a Treasury bond it offers the backing of the U.S. government, combined with this built-in hedge against inflation. Not bad right! Further, should one want to be more aggressive and maintain some investments in the stock market, a portfolio of blue chip stocks would offer a growing (one hopes) 2.5-3.0% dividend yield. If these dividends grow at a 3% rate of inflation, then the payout will feel like 3.75 - 4.5% in 12 years time.

Amidst the market turmoil, this is one opportunity to look at a widely held instrument (the variable annuity) in a new light.