Eight Portfolio Potholes to Avoid

Executive Summary

1. Ratings don’t tell the whole story.
2. A basket of bad apples won’t make a good pie.
3. Hidden leverage may sneak up on you.
4. Not all repos are alike.
5. Extension risk may cost you more.
6. Structured notes equal speculation.
7. Do you want to “buy” or “sell” protection?
8. Hedge funds are not for the faint of heart.

Introduction

Financial market disruptions often send investors into shock, denial, and anger. They also invoke pain, disorientation, fear, and ostracism. Disruptions are the “centennial” events that in reality seem to happen every decade. The only predictability of these events is their timing – they occur when greed is rampant and fear is in hiding.
Recent press coverage of subprime mortgage problems, leveraged buyouts, hedge funds, and credit derivatives may have helped raising risk awareness levels, as evidenced by the fact that our clients have started to pay more attention to the credit worthiness of investments in their accounts. As recently as a few months ago, our clients were more interested in how to improve yield potential. This change is a good thing from our vantage point, as we have been uneasy over some cash investors’ insatiable risk appetite for quite a few years.
In this article, we summarize our observations of increased risk in the cash and money market fund industries into eight broad categories. With the recent market jitters, we hope to remind investors that risk and return are two sides of the same coin. Checking for potholes should not be a one time event, but rather an ongoing exercise while the vehicle is on the road. As principal preservation remains the cornerstone of cash investing, we invite all treasury professionals to join us in championing risk conservativism, particularly now.
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