Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.

In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds’ reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds’ risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.

Morningstar uses a fund-provided statistic – the average effective duration – to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds’ unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds.

Published in the PIABA Bar Journal, 19 (3): 373-392, 2012.

Tenants-in-common interests are passive real estate investments which are sold based on two claimed benefits: stable “cash on cash” returns and deferral of capital gains tax through 1031 exchanges. The “cash on cash” returns are found in financial projections in TIC offering documents. Using a stylized TIC cash flow projection based on our review of these materials, we show that TICs use aggressive assumptions to inflate the apparent returns to investors.

Projected cash flows must be discounted to determine whether a TIC investment is reasonably priced or not. A TIC’s projected cash flows should be subject to sensitivity analysis to determine the risk of unrealistic projections. This traditional risk-return analysis, as part of a reasonable basis suitability analysis, would have determined that TICs had expected returns which were insufficient to compensate for the risk of their leveraged investments in undiversified real estate and that the claimed tax deferral benefits were small compared to the mispricing in TIC offerings.

Reverse convertibles are short term, unsecured notes issued by brokerage firms including JP Morgan, Barclays, Citigroup, Morgan Stanley, Wachovia, Lehman Brothers, and RBC that pay less than the notes’ face value at maturity if the price of the reference stock or the level of the reference stock index declines substantially during the term of the note. The SLCG study finds that brokerage firms overcharge for reverse convertibles so significantly that the expected return on these complex investments is actually negative and that reverse convertibles continue to be sold at inflated prices only because investors do not fully understand these products.

The SLCG study reports that despite substantial overpricing in the offerings and the significant losses on the reverse convertible notes in 2008 and 2009, there have been a substantial number of new issues of these dubious investments by JP Morgan, Barclays and many others brokerage firms in 2010. The study illustrates its main themes with JP Morgan’s May 14, 2010 TiVo-linked reverse convertible.