Each business day HedgeCo.Net keeps you informed with the top hedge fund industry news, opinion and insight from around the globe. From the latest hedge fund launches, to the impact of regulation, competition, and investor activism - we track the topics and people that make a difference to you.
New York (HedgeCo.net) – Federal and State securities law recognizes a finder as “someone who finds, interests, introduces and brings parties together for a business transaction that the parties themselves negotiate and consummate.” Unlike a broker, a finder has no duty to bring the parties to an agreement, but instead acts as an intermediary or middleman. Finders find potential buyers or sellers, stimulate interest and bring parties together. Brokers bring the parties to an agreement on particular terms.” In the corporate financing context, a finder’s compensation is generally based on a percentage of the amount invested by one party or, in circumstances involving mergers and acquisitions, a percentage of the transaction value.
When A Finder Must Register As A Broker-Dealer, Or Use A Broker-Dealer:
The federal securities laws generally govern whether a finder must register as a broker-dealer, or conduct its activities through a registered broker-dealer. Section 3(a) (4) of the Exchange Act defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 3(a) (5) of the Exchange Act defines “dealer” as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” Section 15(a)(1) of the Securities Exchange Act of 1934 (the “Exchange Act”) provides that it is unlawful for any broker or dealer to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security unless such broker or dealer is registered with the Securities & Exchange Commission.
Difference Between Broker Versus And An Intermediary:
As one commentator has noted, although a pure finder may “induce the purchase or sale of” a security within the meaning of Section 15(a) (1), he or she is not normally a “broker” because he or she effects no transactions. In addition, the staff of the Securities and Exchange Commission has issued certain no-action letters further interpreting these provisions. For example, in a no- action letter the staff explained:
[A]n intermediary who did nothing more than bring merger or acquisition-minded people or entities together and did not participate in negotiations or settlements between them probably would not be a broker in securities and not subject to the registration requirements of
Section 15 of the Exchange Act; on the other hand, an intermediary who plays an integral role in negotiating and effecting mergers or acquisitions that involve transactions in securities generally would be deemed to be a broker and required to register with the Commission.
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In light of the SEC’s no-action letter, potential finders should be wary of performing anything more than an intermediary role in bringing parties together for the purposes of consummating business transactions involving the purchase or sale of securities, otherwise they run the risk of being deemed unregistered brokers pursuant to the federal securities laws. In particular, finders should avoid offering investment advice in connection with their services. Accordingly, finders and drafters of finder’s fee agreements should preliminarily determine what the finder’s role will be in connection with any potential finder’s arrangement. Furthermore, finders and drafters of finder’s fee agreements should explore whether the finder’s role will be restricted to merely bringing two parties together for a business transaction or whether the finder will assume a more active role in negotiating and structuring the ultimate financing arrangement. Only by examining the finder’s duties can the practitioner determine whether the finder must register as a broker pursuant to the federal securities laws.
While the use of finder’s fee agreements have become commonplace, finders and practitioners alike must be wary of potential pitfalls that may arise from such agreements. Before drafting any finder’s agreement, the practitioner should first determine the extent of the finder’s role in consummating the transaction at issue. In addition, the practitioner should evaluate whether the finder may be subject to regulation under the federal securities law. Finally, after the practitioner has addressed these considerations, the practitioner may want to include a provision in the
finder’s fee agreement to ensure that the finder will be compensated from transactions that
culminated from a chain of introductions initiated by the finder.
About the Authors:
James C. Brennan, J.D., is an experienced trial attorney in practice for 30 years. Jim provides risk analysis and other advice and professional services to the global hedge fund community. Jim served with the United States Department of Justice in Washington, D.C. as a Trial Attorney from 1982 through 2006. There he handled all phases of complex litigation. From 1975 through 1982, Jim was an analyst in the Counter-Intelligence Division of Federal Bureau of Investigation in Washington, D.C. Jim is a welcome addition to Capital Management Services Group and brings a wealth of expertise, counsel, and wisdom to our practice. Jim received his Juris Doctor in 1982 from George Mason University School of Law,
located in Arlington, Virginia. He graduated from King’s College, located in Wilkes-Barre, Pennsylvania,
in 1975 with a B.A. in Government.
Hannah Terhune, J.D., LL.M, has nearly twenty years of solid experience working closely with people and businesses as an international tax and investment law (private investment fund) attorney. Her prior professional experience includes working as a tax law expert with two of the largest accounting firms in the world and with the United States Tax Court. She has an advanced law degree in taxation from The New York University School of Law (Legum Magister 1991) and a law degree from George Mason University (Juris Doctor 1989). She has a Bachelor of Arts degree in Communications from The American University (1985). She has served as an Associate Lecturer in taxation and business at George Mason University in Virginia and at Catholic University in Washington, DC. Her prior military service includes serving as Judge Advocate and Aide-de-Camp in the U.S. Army Special Forces. She has numerous testimonials to her credit. Ms. Terhune has written over 100 published articles and white papers on U.S. and offshore tax planning and private investment funds (hedge fund).
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NYT – Our leaders have asked for “shared sacrifice.” But when they did the asking, they spared me. I checked with my mega-rich friends to learn what pain they were expecting. They, too, were left untouched.
While the poor and middle class fight for us in Afghanistan, and while most Americans struggle to make ends meet, we mega-rich continue to get our extraordinary tax breaks. Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as “carried interest,” thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.
New York (HedgeCo.net) – The global hedge fund association, AIMA, has responded to the temporary short selling bans introduced by France, Italy, Belgium and Spain.
“We do not think these bans will help the current market situation.” The Alternative Investment Management Association CEO Andrew Baker said, “Past experience has shown that bans on short selling do not prevent market falls and indeed can exacerbate volatility. Independent academic research also supports this conclusion.”
“Short-selling is a legitimate market practice which helps capital markets function effectively. It was only last year that the Committee of European Securities Regulators, the predecessor to ESMA, recognised in an official report that ‘legitimate short selling plays an important role in financial markets. It contributes to efficient price discovery, increases market liquidity, facilitates hedging and other risk management activities and can possibly help mitigate market bubbles’.”
AIMA also supported a statement by the European Securities and Markets Authority (ESMA) on market abuse which emphasised that market abuse is prohibited.
“Of course market abuse is illegal and has always been condemned by our industry. If there is any proof of market abuse having taken place then the authorities should take appropriate action against the perpetrators. If there is any suggestion of market abuse, however, then it may be appropriate to take more targeted action rather than impose blanket bans of this sort.” Andrew Baker concluded.
Editing by Alex Akesson
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New York (HedgeCo.net) – A new white paper entitled, “Commodities Outlook: Increased Volatility, Increased Opportunity?” has been released by Credit Suisse’s Asset Management division. The paper examines the recent rise in the volatility of commodity prices within the context of a longer-term, secular trend of increasing volatility and how investors can best position their hedge fund portfolios in this environment going forward.
The paper is written by Credit Suisse hedge fund managers Nelson Louie, Global Head of the Commodities Group within Asset Management, and Christopher Burton, Senior Portfolio Manager, who believe that a sustained level of volatility may actually benefit long-term commodity investors for the following reasons:
Tightening supply/demand conditions may exacerbate commodity volatility, but may also potentially lead to higher returns over the long term;
Return drivers for commodities are distinct from those of traditional equity and fixed income markets and relate to their idiosyncratic supply/demand functions; and
Investors can potentially capitalize on the shape of the futures curve by taking advantage of short-term supply shocks to potentially generate alpha.
In addition, the white paper focuses on the drivers of commodity volatility and makes the case for what may be a prolonged period of supply/demand imbalance. Louie and Burton also address the impact of this imbalance on prices, and how certain events such as extreme weather, economic expansion, labor disputes or geopolitical risk can exacerbate price volatility.
New Yorker – After the prime-time drama of showdowns on Capitol Hill, agita in the West Wing, and a doomsday deadline averted comes the local news, wherein bad things happen to real people. Friday’s payroll report for July showed that nearly fourteen million Americans are out of work, and more than six million of them have been jobless for more than six months.
Those figures were slightly better than expected, but that just reflects how low expectations have sunk. Arriving a day after the Dow tumbled more than five hundred points—and just hours before Standard & Poor’s took the unprecedented step of downgrading the U.S. bond rating—the figures confirmed, if further confirmation was needed, that the country is facing an immediate economic crisis.
New York (HedgeCo.net) – Despite fears over the European debt crisis, many investors ramped up their hedge fund allocations during the second quarter, according to the Brighton House Associates Q2 2011 Research Report.
Wealth advisors were among those who increased their commitments. The number of mandates BHA collected from wealth advisors this quarter rose by nearly 4% when compared with the results from the first quarter.
Investors seemed to also gravitate towards funds that were focused on the U.S., perhaps in light of fears over European debt. During the second quarter, the number of mandates gathered by BHA analysts for U.S.-focused funds increased by 8.1% over the first quarter.
The secondaries market presented investors with additional opportunities. Hedge fund side pockets were being offered at deep discounts in the second quarter, with the average hedge fund stake selling for only a fraction of its net asset value.
BHA analysts saw a decrease in the number of fund of hedge funds mandates, but identified an increasingly popular trend. More investors are seeking out fund of funds firms to design custom-made hedge fund portfolios that address their specific needs. A number of industry leaders seem poised to take advantage of this new trend.
The second quarter of 2011 was characterized by tumultuous global markets and uncertainty regarding the financial well-being of a number of euro-zone countries as well as the U.S. Still, investors remained interested in hedge funds and allocated $30 billion to the asset class during the quarter, a small decline from the $32 billion allocated in the first quarter.1 Despite lackluster returns and markets that proved challenging for hedge fund managers, funds saw strong investment inflows.
Many investors who had been sitting on the sidelines became more active in the hedge fund space. In a conversation with BHA analysts, a wealth advisor investing on behalf of a large U.S. insurance firm noted that for the past three years, the firm had not been allocating to the hedge fund space. In the second quarter, however, the firm met with new managers, and it anticipates adding three or four global macro and CTA managers, as well as two new long/short equity funds, to its portfolio by the end of the year.
Other investors increased their single-manager hedge fund exposure at the expense of their fund of hedge funds allocations. An insurance firm in Bermuda, which has traditionally invested in funds of hedge funds, confirmed that it is planning on investing solely in single-manager funds going forward. In fact, the firm plans on increasing its hedge fund allocation from its current $350 million to $800 million over the next two years. Still other investors were increasing their hedge fund exposure by employing firms to create customized funds of funds on their behalf, essentially designing tailor-made hedge fund portfolios.
In the private equity space, investors were increasingly interested in sector-focused funds. While interest in funds with diversified sector exposure fell, investor demand grew for funds with exposure to the energy, technology, and clean-technology sectors. Compared with the first quarter of 2011, demand for these funds grew by 53.6%, 33.1%, and 36.4% respectively.
Finally, analysts noted rising interest in real-asset funds as well as funds designed to hedge against inflation. In the second quarter, demand for commodities, timber, natural resources, and other such funds increased by more than 50% over the first quarter. This jump was driven by investors’ desire for funds with a low or even negative correlation to equity and bond markets that could offer the potential for enhanced returns.
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Business Insider – The Dodd-Frank bill has the predicted response from the dirty players in the financial system. The main dirty player is the Fed. Law.Hukuki.net has an article devoted to a really dirty guy, Fed Governor Daniel Tarullo.
This guy makes the incredible statements that: 1. All firms pose systemical risk under stress. 2. the list, therefore, of hedge funds and mutual funds that should be on the systemic list should be a short one!
New York (HedgeCo.net) – A recent decision issued by the New York Tax Appeals Tribunal which further expands the definition of “permanent place of abode” (PPA) opens the door to increased taxation for out-of-staters who own a second home in New York State, according to hedge fund law firm Anchin’s tax controversy services team.
The Tribunal ruled (in Matter of Gaied) that a New Jersey resident, who worked in Staten Island and bought his elderly parents a home there, is subject to pay New York resident income taxes. Prior to this decision, the determination of a PPA was based on a detailed assessment of a taxpayer’s use, access, and relationship to a specific dwelling, not merely their ownership status.
“This is a frightening ruling with widespread ramifications,” according to Sharon Ackerman, Anchin’s Director of Tax Controversy Services. “The ruling means you can now be taxed as New York State resident based solely upon property ownership. Prior to this ruling, under the current residency statutory regime, taxation was based upon usage. Anyone who maintained a PPA and spent more than 183 days (including working days) in the state could be taxed as a resident, regardless of the location of their primary residence. It will be interesting to see if this new ruling holds up under appeal.”
“Prior to this ruling, determinations of PPA were guided by Matter of Evans, which stipulated that an intensive and fact-based analysis must be performed to establish whether an abode was actually “permanent.”
The Matter of Gaied involved an individual who owned an apartment which he maintained for the use of his elderly parents. After losing on the administrative judge level, and then winning an appeal, the taxpayer lost in a final re-argument delivered by the New York State Tax Department. The department successfully made the case that ownership or property rights in a dwelling outweigh all other facts and contingencies and automatically qualify the abode as permanent. In its ruling, the Tribunal held that: “where a taxpayer has a property right to the subject premises, it is neither necessary nor appropriate to look beyond the physical aspects of the dwelling place to inquire into the taxpayers’ subjective use of the premises.”
“This reversal of previous policy creates significant uncertainty in how the Tax Department will apply this new formula for the statutory residence test,” Ackerman said. “Conceivably, if a taxpayer has any property rights over a residence, whether or not he or she uses it for any purpose or even sets foot in it, the residence could be classified as a PPA and, coupled with the 183-day rule, may qualify the person as a New York statutory resident.”
This ruling marks the second time in recent months that the Tribunal has ruled against an out-of-state taxpayer. In an earlier ruling, the Tribunal held that a Connecticut man who worked in Manhattan and owned a rarely used Long Island summer home owed $1 million in additional taxes.
“This posture on behalf of the State is clear evidence that New York State is getting tougher on individuals with part-time homes or home ownership in the State,” Ackerman said. “It is part of a concerted effort by the State to increase revenue by finding untapped sources of tax revenue.”
New York (HedgeCo.net) – In the July 25, 2011, issue of The New Yorker, in “Mastering the Machine”, John Cassidy talks to Ray Dalio and gets an exclusive look inside Bridgewater Associates, the world’s biggest hedge fund, of which Dalio is the founder.
Dalio, in the tradition of George Soros and Julian Robertson—famous speculators who ranged across markets—is a “macro” investor, which means that he bets mainly on economic trends, such as changes in exchange rates, inflation, and G.D.P. growth, and he has made a number of spot-on predictions (in late 2007, he told the Bush Administration that many of the world’s largest banks were on the verge of insolvency—a warning that was ignored).
Dalio insists that what he calls Bridgewater’s culture of “radical transparency,” in which he encourages people to challenge one another’s views openly, regardless of rank, is central to the firm’s success. “I believe that the biggest problem that humanity faces is an ego sensitivity to finding out whether one is right or wrong and identifying what one’s strengths and weaknesses are,” he tells Cassidy.
His philosophy—which he’s summed up in “Principles,” a hundred-page text that is required reading for Bridgewater’s new hires, and, Cassidy writes, is “partly a self-help book, partly a management manual, and partly a treatise on the principles of natural selection as they apply to business”—has “created a workplace that some call creepy,” and some critics refer to Bridgewater as a cult.
Dalio says, however, that the specific culture of Bridgewater is “why we made money for our clients during the financial crisis when most others went over the cliff. . . . Our greatest power is that we know that we don’t know and we are open to being wrong and learning.”
Dalio “doesn’t pretend that Bridgewater is a typical workplace, but he is sensitive to criticism,” Cassidy writes. “I’ve been surprised that there’s been so much controversy about us having such clearly set-out principles, especially since they’re all about being truthful and transparent to do good work and have meaningful relationships,” Dalio says. “Most of the people who don’t like us having them haven’t read them—they just assume that us having a lot of principles makes us a cult.”
James Comey, Bridgewater’s top lawyer who is a relatively new hire, tells Cassidy that it took him a while to get used to dealing with Dalio. “It took me three months to realize that when Ray says, ‘I think you are wrong,’ he really means ‘I think you are wrong.’ He’s not trying to provoke you, or anything else.” Comey was initially struck by how long it took Bridgewater to make decisions, because of the ceaseless internal debates. But, he says, laughing, “the mind control is working. I’ve come to believe that all the probing actually reduces inefficiencies over the long run, because it prevents bad decisions from being made.”
Part of Dalio’s innovation, Cassidy writes, has been to build a hedge fund that caters principally to institutional investors rather than to rich people; of the roughly one hundred billion dollars invested in Bridgewater, only a small proportion comes from wealthy families, with the rest coming from public and corporate pension funds and government-run sovereign wealth funds. “
Making money on a constant basis is the holy grail, and Ray and Bridgewater have done that,” Ng Kok-Song, the chief investment officer of the Government Investment Corporation of Singapore, which invests with Bridgewater. “They are consistently innovating—constantly soul-searching and asking, ‘Have we got this right?’ . . . I am constantly asking myself, ‘If Bridgewater is doing this, shouldn’t we be doing the same thing?’?” Dalio is in constant communication with his clients.
“When a lot of folks were very, very secretive, Ray could see the value in creating something that was more open, something that was attractive to very large streams of money,” Robert Johnson, a former senior executive at Soros Fund Management, who now runs the Institute for New Economic Thinking, says. “In that sense, he was a visionary.” Cassidy writes that after the near implosion of the financial system brought about a deep recession, some policymakers came to respect Dalio’s analysis as well.
This spring, Dalio told Cassidy that economic growth in the United States and Europe was set to slow again; now that the slowdown appears to have arrived, Dalio thinks it will be prolonged. “We are still in a deleveraging period,” he says. “We will be in a deleveraging period for ten years or more.” He believes that some heavily indebted countries, including the United States, will eventually opt for printing money as a way to deal with their debts, which will lead to a collapse in their currency and in their bond markets.
“People concentrate on the particular thing of the moment, and they forget the larger underlying forces,” he says. “That’s what got us into the debt crisis. It’s just today, today . . . I think late 2012 or early 2013 is going to be another very difficult period.”
New York (HedgeCo.net) – The June 27, 2011, issue of The New Yorker, on page 42, “A Dirty Business”, George Packer, writes about the biggest insider-trading case in history, and has an exclusive interview with Preet Bharara, the United States Attorney for the Southern District of New York, whose office pursued the investigation.
When Bharara took office, in 2009, he made it clear that he would go after Wall Street greed, and the Galleon case helps to illustrate the broader culture of the financial world, in which, “over the past decade, cheating and self-dealing became a principal way to succeed,” Packer writes. But some Wall Street observers have called the Galleon case—which included thousands of taped phone calls by the government and more than two hundred and thirty subpoenas for phone numbers by the S.E.C.—a sideshow.
The case centers around Raj Rajaratnam, the head of Galleon, a multibillion-dollar hedge fund, and Anil Kumar, a former senior executive with the consulting firm McKinsey, who, in 2003, secretly agreed to be an outside consultant to Rajaratnam. In seducing Kumar, Packer writes, Rajaratnam “made a valuable addition to the network that he had built up over the years.”
Initially, Kumar believed that he’d be passing information to Rajaratnam legally, but it wasn’t long before he realized that Rajaratnam wanted tips that he could convert into profitable stock trades, and Kumar began breaking both McKinsey’s confidentiality rules and the securities laws that forbid such exchanges. When Kumar was arrested and subsequently handcuffed, Packer writes, “He fainted, hitting his head against a wall. He had to be treated at a local hospital before he could be brought in for booking.” Later that day, Rajaratnam’s wife sent a text message to Kumar’s wife, which read, “I’m sorry.”
On May 11th, Rajaratnam was pronounced guilty on all charges, but his defense team has vowed to appeal. His attorney, John Dowd, accused Kumar “of being the biggest liar in the history of the Southern District federal courthouse,” Packer writes. After a Wall Street Journal article suggested that his team had been caught off guard by a cross-examination, Dowd shot off an e-mail to the reporter, which read, “This is the worst piece of whoring journalism I have read in a long time. How long are you going to suck Preet’s teat? . . . . Preet is scared shitless he is going to lose this case so he feeds his whores at the WSJ.”
Some people have criticized Bharara’s focus on an insider-trading scandal, given that the financial crisis was caused primarily by shoddy mortgages and the cynical trading of those irresponsible loans.
Bharara, who, until now, hasn’t spoken at length about the lack of financial-crisis prosecutions, tells Packer, “It bothers me a little bit when people suggest, without knowing anything, that we’re not even bothering to look. We have grand-jury secrecy—I don’t go out and announce my investigations. But I got to tell you something: where there’s smoke, we take a look. Do you have any idea how much people want to bring the case if it exists? So, what could be the reason we haven’t? Sometimes people say, ‘It’s because you’re beholden to these guys,’ which doesn’t make any sense. Do we look like we’re afraid to prosecute anyone?”
Packer, after recounting in detail the story of the investigation of Galleon, explains why it wouldn’t be easy to build prosecutions directly tied to the financial crisis. Top bank executives, with the assistance of lawyers and accountants, took care to insulate themselves from the fraudulent activities of mortgage lenders and other low-level players.
The Department of Justice, under George W. Bush’s attorney general, Michael Mukasey, “also played a role in inhibiting vigorous prosecutions,” Packer writes, by distributing the major new investigations across different offices and largely cutting out New York’s Southern District, which has superior experience and expertise in accounting fraud.
Several financial-fraud experts tell Packer that a task force, made up of assistant United States attorneys adept at financial investigations, should have been created, especially in New York’s Southern District, and given two or three years to investigate a single bank. Such a major initiative needed to come from Washington, “but investigating Wall Street’s big banks seems not to have been a top priority,” Packer writes.
The principal accomplishments of President Obama’s interagency Financial Fraud Enforcement Task Force, which was created in November, 2009, have been press releases claiming credit for cases that often predated the financial crisis and involve low-level Ponzi and mortgage-fraud schemes.
“It’s just very hard for me to understand why there haven’t been more indictments,” Ted Kaufman, a former senator from Delaware, tells Packer. “I am incredibly disappointed.” Jeff Connaughton, Kaufman’s former chief of staff, tells Packer that Attorney General Eric Holder “said in his swearing-in that he would make it a priority. We thought we were making sure that they were doing the right thing, and they said all the right things in hearings, and nothing happened.
I feel gamed by it.” Packer writes, “Perhaps indictments couldn’t be brought against top bank executives, but Bharara could take down Rajaratnam, and he went out of his way to give the case a high profile. It was his best chance to deter the pervasive corruption of Wall Street.”
The market “has become more of an exclusive gambling club for the very rich than a level playing field open to the ordinary investor.” But Bharara’s campaign of deterrence “has had a particularly strong effect on hedge funds.” “There are a lot of nervous people out in the Hamptons,” one criminal lawyer says.
And Stanley Sporkin, a retired judge who was regarded as one of the S.E.C.’s most aggressive enforcement chiefs when he served, tells Packer, “People on Wall Street are going to be coming to work with brown pants on. It’s going to change the way they work for a long time.”
New York (HedgeCo.net) – Bloomberg Markets Magazine has announced plans to unveil an exclusive list of the most influential people who move the world’s markets, Bloomberg Markets 50, in their October 2011 issue.
The list will include business and financial executives, investors, bankers, government leaders, hedge fund managers, economists, and analysts who influence the value of everything from corporations to currencies, commodities and economies.
To coincide with the issue, the magazine is joining forces with Bloomberg LINK to host the inaugural Bloomberg Markets 50 Summit, a day-long event, to be held on Thursday, September 15, 2011 at New York City’s Morgan Library.
The Summit will provide attendees with access to the men and women who matter most in financial markets worldwide — the individuals who can help make sense of a global economy in flux. Speakers from candidates for the Bloomberg Markets 50 will discuss monetary policy, economic outlook, financial reform, commodities, inflation, finance, and alternative investments.
The “Backstage from the Bloomberg Markets 50 Summit” live audio web conference will feature speakers from the Summit discussing related topics.
“The most powerful people in the world of finance read Bloomberg Markets and appear in its pages,” said Ronald Henkoff, the magazine’s editor. “For the first time, we’re going to rank the Top 50 and bring many of them together in one place. We expect some lively discussions.”
New York (HedgeCo.net) – Hedge fund investor adviser, Hennessee Group LLC, has put out a new Whitepaper analyzing the historical relationship between inflation and equity prices dating back to the 1970’s.
According to Hennessee Group’s research, the equity market, represented by the S&P 500 TR, has generated a return of over +700 basis points above inflation on an annualized basis since the 1970’s.
“Rarely do equity market pundits focus on real performance returns (nominal returns less core inflation). ” Charles Gradante, Managing Principal at Hennessee Group, said. “Reporting nominal returns, rather than real returns, is the standard of measurement for the media. However, it can be misleading to the average investor who may assume that a +12% nominal return is better than a +9% nominal return since they do not consider the “core inflation rate”.”
“A +12% nominal return with +7% core inflation is actually worse than a +9% nominal return with +2% core inflation. The real return of the first period is +5%, while the real return for the second period is +7%. While the concept of nominal versus real returns is common knowledge for professionals, it is not for most investors. Furthermore, it is not a standard of measurement routinely discussed when pundits analyze market returns in the media.
“In 2009 and 2010, real returns were +23.8% and +13.6%, respectively, and +18.5% annualized. However, despite the great performance of equity markets since the credit crisis ended, the markets still generated a negative real return of -3.48% from 2000 to 2009, the worst decade in the last 40 years. This was 200 basis points worse than the 1970’s decade, which is remembered for periods of hyper inflation and a -40% correction from 1973 to 1974.
“Investors should be encouraged by the above average real return the equity markets have provided during the past two years. Equity markets have stabilized, generating double digit returns for investors in two consecutive years while inflation has averaged only +2%. Through May, the S&P 500 is up over +7% this year relative to a core inflation reading of below +2%, generating a real return in line with historical averages.
“The Hennessee Group believes this recent performance is part of a long term reversion to the mean in the spread between inflation and the equity markets and expects further improvement in 2011. With reasonable year-over-year earnings growth for S&P 500 of +17%, an improving global economy, an accommodative Fed, and muted inflationary pressures at the core level, the Hennessee Group believes the outlook for real returns above +7% remains favorable through the election in 2012. Beyond that point, pundits are polarized with some predicting inflation and others deflation depending on job creation, velocity of money and housing (to name a few).” Gradante said.
Conclusion
In the Hennessee Group ’s opinion, the investment community should discuss real returns, which are hardly, if ever, a topic of coverage in the media. A chart showing the direction of real returns, albeit sometimes frustrating in light of headline inflation (especially related to commodities), would offer the investor another dimension to their understanding of the real value added or lost in the equity markets.
The media and pundits should discuss and debate both nominal performance and the real return above inflation. Lower inflation coupled with lower performance does not necessarily translate to lower purchasing power. This research paper is intended to shed light in a corner often ignored and encourage a more in depth and consistent discussion of real returns over nominal returns by the media and market pundits.
The Hennessee Group purposely avoided incorporating QE2, headline inflation, taxes and pension liabilities in order to make a general point about real returns without inordinate complexity.
