Q4 2013 Newsletter

Q4 2013

“NEVER CONFUSE MOTION WITH ACTION”

- ERNEST HEMINGWAY

INSIDE THIS ISSUE

� BONDS STILL BELONG 1 � THE MERGER FUND 2-3 � EDELIVERY AND PORTAL ACCESS 3 � DURATION RISK 4 � WHAT IT MEANS TO BE AN RIA 5 � AN AFFIRMATION 5 � ANNOUNCEMENTS 6

By Mike Booker, CFP®, ChFC, CFS®

Many investors are concerned about the fate of bonds going forward as interest rates are expected to rise. As you know, when interest rates rise, the market value of most bonds tends to go down in response. This phenomenon is referred to as “Interest Rate Risk” and oc-curs because a bond which someone might hold in their account that is yielding 2% becomes less attractive on the secondary market when newly issued bonds begin paying a higher interest rate (coupon) of say, 2.5%.

So, if interest rates are going up, as they began to do in 2013, should we avoid bonds? Well, let’s back up a bit. Why do we have bonds in our portfolios to begin with? We employ bonds in our client’s accounts because:

They have a low-to-negative correlation to stocks: This is the primary reason-Bonds don’t move in the same direction by the same magnitude as the stock market. Often, as in the bear markets of 2000-2002 and 2008, bonds moved in the opposite direction of stocks making solid positive returns as stocks took deep losses. So, generally speaking, most bonds make money when stocks are tanking simply because they are not stocks - they are not walking the same financial path. This lack of correlation between these two asset classes is the cornerstone of any thoughtful diversified investment strategy.

They aren’t as volatile as stocks: Assuming one is not buying extremely low rated bonds, they can be pleasantly boring while paying out an attractive coupon rate. Even relatively low rated bonds can make sense if the interest rate they offer is substantially higher and worth the extra default risk.

They are liquid: The bond market is huge and investors who wish to buy or sell bonds have a liquid and robust place in which to do so. Many other assets that might provide some diversification benefits against stocks can be illiquid or have limited liquidity such as real estate of a lump of gold or silver.

“But Mike”, you say, “this is all good stuff, but I don’t see that it makes any sense to own bonds if all they are going to do is lose money as rates rise. Why should I take this interest rate risk?” And, “By the way, Mike, on top of all the risk I now have in my bonds due to rising rates, they are paying me a ridiculously low interest rate!” Agreed. In fact, if interest rates rise just 1%, 77% of all bonds are deemed vulnerable to losses (Source: Morningstar 12-31-12). You are right about rates, too. They are still at historic lows paying anemic coupon rates. So, higher risk, lower return. Bad combo. Here is what we have to do:

We have to be smart. We have to be choosey. We have to make changes. The changes we must make are not to dump bonds or bond funds because they are a vital component of our mission to diversify our stock holdings and, therefore, lower our portfolio’s overall risk and volatility. The change we must make is to modify the type of bond fund we will use going forward: funds where the managers have flexibility to seek out bond sectors that are most attractive in terms of risk/reward. Funds that can implement both long and short strategies to mitigate or even eliminate rising interest rate risk.

For example, the Barclays Aggregate Bond index, considered the best indicator of the bond market, lost 2% in 2013. Two “flexible mandate” bond funds that we shifted into mid-year 2013 made 5% and 6%, respectively, for the year. The managers of these funds had the flexibility to move out of the way of the approaching train that was higher interest rates. While delivering these impressive returns, they still provided the traditional diversification benefits of bonds - low correlation to stocks. Doing it the right way makes all the difference.

Bonds still belong in your portfolio.

4265 San Felipe, Suite 1450 | Houston, TX 77027 | PH: (713-623-6600) | http://finsyn.com

Bonds Still Belong in Your Portfolio

2 4265 San Felipe, Suite 1450 | Houston, TX 77027 | PH: (713-623-6600) | http://finsyn.com

The Fund with theOdd NameBy Mike Minter, CFP®, CFS®

When first mentioned in client meetings, the Merger Fund sometimes elicits looks of confusion or curiosity from its name alone. It doesn’t sound like the other names in your portfolio, and it doesn’t act like them either. It’s considered an alterna-tive type of investment because it doesn’t correlate highly to the more traditional asset classes like stocks and bonds.

The Merger Fund’s strategy is very different from the other asset classes in your portfolio, and it requires a vast amount of skill and experience to execute successfully. But the process is straightforward and rather easy to explain.

Their objective is to achieve a return of around 15% per deal. In determin-ing which deals will actually close, their success rate has been about 98%.

We like the Merger Fund as a comple-ment to our bond portfolio, and also as a risk reducer to the stock funds. Since the fund’s inception in 1989 through 12/31/2013, it has produced a stellar 6.81% annualized return, outperform-ing the Barclays Aggregate Bond Index. It has also been 65% less volatile than stocks (S&P 500) over this period. And with a very low correlation to stocks and bonds it makes for a perfect port-folio diversifier.

The Merger Fund has also done an ex-cellent job of protecting its sharehold-ers’ capital in bear markets, as the chart illustrates:

The fund invests in a target company (company being acquired) after a merger/takeover has been publically announced and they feel that the probability of the deal closing is very high. The stock price of the targeted company will have already increased in value on the news of the deal, but it won’t reach the deal’s full price potential until it actually closes. This is where the Merger Fund makes its money – when the deal does close they liquidate their position and walk away with a nice little profit – this is known as an “arbitrage” strategy.

If the deal involves the use of the acquiring company’s stock to purchase the target company, the Merger Fund might short the acquirer’s stock to hedge against a fall in its price.

“A RISK-REDUCER AND DIVERSIFIER”

As you can see from the chart above, during the tech stock crash of 2000-2002 the S&P 500 lost -45%, whereas the Merger Fund lost just -3%. And during the recent financial crisis bear market the S&P lost -51%, whereas the Merger Fund lost just -6%.

Since its inception in 1989 the fund has had only two negative calendar years, the worst being -5.67% in 2002.

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THE FUND WITH THE ODD NAME, CONTINUED...


The fund’s risk management techniques and meticulous deal analysis have led to steady, consistent returns over the long-term. By limiting losses the fund has served its shareholders well.

And finally, with further interest rate increases looming, there is concern about the possible nega-tive impact this will have on investors’ bond portfolios. Merger-arbitrage strategies have historically been positively correlated to interest rates, or the cost of capital; therefore if interest rates rise the Merger Fund could provide a hedge to a reduction in bond values.

At times, observing the movement of the Merger Fund can be like watching paint dry. But remem-ber, it serves a purpose in the portfolio as a risk reducer and diversifier, and will prove to be valuable over the long-term.

Source: Morningstar Direct

Did you know that you can receive your quarterly statement electronically?

You can also see all of the accounts in your Household, your account’s holdings, transactions, and respective asset allocation through our online portal.

If you’re interested in enabling eDelivery or the online portal feature, or would like to know more about it, please call us at 713-623-6600.

Interested in eDelivery or Access to our Online Portal?

4

Duration Risk: What Bond Investors May Not Know

What matters more is where the market is when you need to sell.

By Heath Hightower, CFP®

As Mike Booker mentioned in this quarter’s newsletter, we think bonds still deserve a place in most portfolios. After all, bonds are ultimately one of the greatest diversifiers an investor can own. Historically, conservative investors have allo-cated large percentages of their portfolio to bonds because of their low volatility and consistent positive returns. They’ve actually done quite well over the decades. Our fear, however, is that some bond-heavy portfolios may hold more risk than people realize.

The particular type of risk I’d like to talk about is called Duration Risk. Without realizing it, investors have been adding duration risk to their portfolio.

Duration is a measure of how sensitive a bond is to changes in interest rates. As you may al-ready know, the price of a bond decreases when interest rates go up. The higher a bond’s duration, the more it stands to lose if inter-est rates go up. For instance, if interest rates were to increase by 1% a bond with a 2 year duration would decrease in value by 2%. Likewise, a bond with a 5 year duration would decrease in value by 5%, and so on. Over the last 10 years, the average duration of the bond market has steadily increased from 3.5% to over 5% (see chart above). With interest rates likely on the move, we think this is a risk that conservative in-vestors should consider carefully.

Bond investors need to understand duration risk more than ever before. Here’s why… Most traditional bond mutual funds are handcuffed by their prospectuses to maintain a duration closely tied to a benchmark. The duration of the most widely used bond benchmark is currently slightly above 5% (the Barclays US Aggregate Bond index). That means most core bond funds are contractually obligated to have a duration of about 5% even if they’d prefer to hold less duration. The share price of these bond funds could drop substantially if interest rates were to move higher.

Last year, we decided to move the majority of our fixed income portfolio to talented managers that have the flexibility to minimize duration risk when appropriate. They’re not tied to any particular index. Currently, all of the new bond funds in our portfolios have chosen to keep their durations much lower than the overall bond market. Interestingly enough, all three of these funds made money last year even though the Barclays Aggregate bond index lost over 2%. These managers have proven, long-term track records and we are confident in their ability to navigate what could be a choppy bond market for the foreseeable future.


“BOND INVESTORS NEED TO UNDERSTAND DURATION RISK MORE THAN EVER BEFORE”

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By Marie Villard

When I was home over the holiday break, my father asked me a very important question about why we are different from other large brokerage firms. I simply responded with an impatient answer: “We are an RIA, Dad.” At that moment, I realized that I hadn’t given him an adequate explanation as to what being an RIA truly means. Then it got me thinking, if anyone else were to ask me that question, how would I discuss the distinct differences between us and them, and explain what it means to be an “RIA”?

“RIA” is an abbreviation for "Registered Investment Advisor", which indicates that our firm registered with the Securities and Exchange Commission, and is regulated under the Investment Advisors Act of 1940. Broker-dealers differ in that they are regulated by FINRA, a self-regulated organization (SRO) that is not affiliated with the US Government and is monitored in a different fashion. While some of the regulation differences are subtle, the guidelines to which we adhere are much more stringent and watched more carefully.

As an RIA, we have a fiduciary responsibility to our client. This means that our relationship with our clients is one of ut-most trust and confidence, where we have an obligation to act in our clients’ best interests. The decisions we make in our clients’ portfolios are ones that we believe will best accomplish their financial goals; they are not products we are required to sell (unlike brokers who are paid a commission on products sold). This consideration for our clients is one of the most important distinctions between an RIA and brokers.

Another benefit of being an RIA is that we custody our clients' assets outside of our firm, at Charles Schwab. This adds a layer of protection for both the advisor and the client, due to all the strategic infra-structure and regulations in place at the custodian. The information that we provide our clients is the same information that Schwab provides. These checks and balances allow a greater transparency, and can provide reassurance as to what is happening in our clients’ accounts.

Our website has a plethora of information about RIAs, in addition to this article. We also promote an outside campaign, “RiA Stands for You”, which is a great resource for understanding the RIA model. If you have any questions, feel free to reach out to us or take a look at our website http://finsyn.com/about/ria/

What it Means to Be a “Registered Investment Advisor”


An Affirmation from MorningstarBy Bryan Zschiesche, CFP®, MBA

Morningstar announced last week their selections for their 2013 Fund Manager of the Year awards. We were pleased to learn that Dan Ivascyn and Alfred Murata, managers of the PIMCO Income fund, were selected as Fixed-Income Fund Managers of the Year.

We added this fund to our fixed income lineup during the summer of 2013 after extensive due diligence and conversa-tions with fund management. While we were confident that we made a great selection in PIMCO Income, it was great to have the decision affirmed by Morningstar in the form of this prestigious award.

Here’s an excerpt from Morningstar’s summary on why Ivascyn and Murata were selected:

“Making the most of a tough market is where funds can really help shareholders. While PIMCO won’t get all of its calls right--no one does--its concerted efforts to prevent any single bet from overwhelming performance played out for this fund in 2013. Ivascyn and Murata have also delivered on the fund’s income-oriented goals without returning capital to shareholders since its 2007 inception. That’s a tall order in today’s relatively low-yielding environment, but PIMCO’s vast tool chest and diversified approach instill confidence.”

As Mike pointed out in his cover article, we believe diversification and manager flexibility within the bond market will be crucial as the interest rate environment remains uncertain. PIMCO Income has the flexibility to seek out income sources that appear most attractive in any environment, but it does so with an emphasis on risk management and liquidity. We are confident that the addition of PIMCO Income makes our bond portfolios stronger.

Congratulations Bryan!Bryan Zschiesche celebrated his 10 year anniversary with Financial Syner-gies on November 16th, 2013, and joins Mike Minter and Heath High-tower as a shareholder in Financial Synergies.

Please join us in congratulating him on his accomplishment!

The 2013 Holiday Event & ShowThanks to all who came out for our most recent event at the Alley Theatre. On December 5th , 2013 Financial Synergies entertained clients with a dinner buffet catered by Arcodoro, and a showing of Charles Dickens’ “A Christmas Carol”.

Above are some of the highlights from the evening.

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Q4 2013 Newsletter

Economy & Finance