INVESTOR UPDATE 2013 Park Street Financial Group Park Street Financial Group (PSF) is a private, objective, Registered Investment Advisor which manages CONTENTS portfolios of public equities, ﬁxed income, and commercial real estate for both individual and institutional investors. We focus on strategy, investment selection, and holistic reporting to support Our Approach the decision making process. Asset Classes Passive v Active Investing In this Investor Update I wanted to review a few of the key aspects of our approach to portfolio management and present some details on how we research equity managers, manage ﬁxed income portfolios, and source direct real estate investments. Finding Good Managers Fixed Income Portfolios Our Approach Real Estate Investments PSF’s approach to portfolio management is modeled after top university endowment management practices. We take a long-term, methodical approach to investing and believe this will yield more consistent results. We do not invest in hot stocks nor do we attempt to time the market. Comparatively we are kind of boring when standing beside stock jockeys or the hot hedge fund of the day. Historical analysis tends to support a long-term strategy overwhelmingly. In a study by Charles Ellis1 he says that market timing represents a loosing strategy. “There is no evidence of any large institutions having anything like consistent ability to get in when the market is low and get out when the market is high. Attempts to switch between stocks and bonds, or between stocks and cash, in anticipation of market moves have been unsuccessful much more often than they have been successful.” Three basic tenets form the foundation of our investing strategy. First, we believe smart diversiﬁcation helps reduce risk and achieve more consistent returns. Second, although we are skeptical of active management, we will employ active managers where we believe the chance for market outperformance is good and when our research surfaces exceptional skill. Finally, we will default to passive investing when we have the option and when good managers can’t be found. Asset Classes Separating investments into different asset classes and studying their relationships is one of the key tools that sophisticated investors use. It enables us to better leverage market knowledge to improve portfolio performance and reduce risk. A few examples of different asset classes are bonds, stocks, and real estate. We separate them into classes because as groups they behave differently from each other as economic conditions change. Figure 1 shows a list of the major asset classes we use along with their expected real returns and standard deviations. Real returns are adjusted for inﬂation. Asset Real Standard Class Return Deviation History is used to help understand the relationship between asset classes and determine if classes are correlated in any way. Absolute 6.0% 10% Return If two classes are positively correlated with each other then we can expect them to move in the same direction together. If they Domestic 6.0% 20% are negatively correlated then we can expect them to react Equity inversely, from each other, to changes in economic conditions. Fixed Of course between theses two extremes is zero correlation 2.0% 10% Income which says, when one asset class moves we can’t make any assumption about how the other class will move. Emerging 8.0% 25% Equity This is very valuable knowledge indeed. Imagine we want to Real invest in two investments for a long term however, they are very 6.0% 14% Assets volatile. They could gain or loose 20% of their value in any Private given year. If we combine them into a portfolio and they are Equity 11% 28% negatively correlated then their movements will have a canceling effect on each other. That is, the movement of the Figure 1. Asset Classes and their expected returns and standard portfolio will be a lot smoother (i.e. less volatile) than either one deviations. of the individual investments.1 Charles D. Ellis, “Winning the Loser’s Game” Timeless Strategies for Successful Investing, 3d ed.
INVESTOR UPDATE 2013Correlations between asset classes are expressed through correlation U.S. Fixed Emerging Absolute Private Realvalues which are calculated using historical data. Savvy investors Equity Income Equity Return Equity Assetshave learned that relying purely on history to help forecast thefuture is only so good. So to improve the effectiveness of using U.S. 1.00 Equitycorrelations as a tool we modify correlation values to reﬂect ourassumptions of future economic, political, and market conditions. Fixed 1.00 IncomeFor example, many investors believe as Emerging Markets becomemore developed they will tend to become more positively correlated Emerging 1.00with the developed world. This will in turn reduce some of the Equitybeneﬁt of diversifying across Emerging Markets and will tend to Absolutedrive up the expected volatility (aka risk) of a portfolio. Return 1.00The table in Figure 2 shows our assumptions of changes in Private Equity 1.00expected correlation between different asset classes. Red, uppointing arrows indicate that we expect asset class pairs to become Real 1.00more positively correlated. Down facing green arrows indicate the Assetspair is expected to become less positively correlated. Figure 2. Expected changes in correlation between different asset class pairs. Data provided by Yale Investment Management Ofﬁce.ASSET CLASS CLASS INDEX ETF Passive versus Active Investing TICKERDomestic Equity Passive investing in a market means to invest in a broad Large Cap Equity basket of securities which represent that entire market and only US Large Core Passive Russell 1000 IWB trade when a security is no longer considered a member of that market. Passive Investing means you are not trying to guess the US Large Value Active Russell 1000 Value IWB winners or losers or trying to time when to buy or when to sell. US Large Growth Active Russell 1000 Growth IWF ETFs (Exchange Traded Funds) are the most common passive Small Cap Equity investment. They are are basket securities, commonly run by a US Small Cap Russell 2000 IWM computer, which simply follow market indexes. ETFs are very US Small Cap Value Russell 2000 efﬁcient, low cost instruments. Today there are thousands of US Small Cap Growth Russell 2000 them and at least one for every index which tracks publicly Micro Cap Equity traded markets. US Micro Cap Russell Micro Cap IWCForeign Equity Figure 3 shows the ticker symbol for each ETF we use. Each Developed Int’l Equity ETF tracks some index. For example, IWB tracks the Russell Developed Lg Cap MSCI ACWI ex. US ACWX 1000 index. SPY tracks the S&P 500 index. Developed All Cap MSCI ACWI ex. US Active investment management means a person is making Developed Small Cap FTSE Developed Sm Cap ex. US IFSM the investment decisions and is typically trying to outperform an Emerging Markets index. The investment manager relies on research and Emerging Markets MSCI Emerging Markets EEM experience to make decisions on what and when to buy andFixed Income then when to sell. Fixed Income Taxable Fixed Income BarCap Intermediate Govt./Credit GVI When we have the option of a passive vehicle for an asset class Cash and we choose an active manager then we are expecting thatAbsolute Return manager to do better than the passive vehicle. Essentially, there Absolute Return is an implicit mandate on that manager to outperform the asset class as a whole. We are expecting him/her to provide enough Absolute Return S&P 500 SPY additional value to cover his costs and give us some excessHedged Equity return. In our ﬁnal analysis we are looking for strong indicators Hedged Equity which support a managers ability to meet or exceed that Hedged Equity S&P 500 SPY mandate. If we don’t ﬁnd that support we choose a passiveReal Assets route. Real Assets Real Estate Cohen & Steers Realty Majors ICF Finding Good ManagersFigure 3. Filters applied to Emerging Markets managers. There are literally thousands of money managers of publicly traded securities. Managers range from small one or two person shops to large teams of analysts. Some are very focused whereas others may diversify across asset types. Filtering
INVESTOR UPDATE 2013through this ever expanding, changing pool of managerscan be very time consuming and nerve racking without a Filter Metric Descriptionquantitative based process and good tools. Ratio of excess return divided by the variabilityOur process has two stages. The ﬁrst stage produces an of the portfolio. Excess return is equal to the“A” list of managers for each asset class. We start with a portfolio return minus the return on a short termpool of 29,000+ public funds, segregate them by Sharpe Ratio > 40% risk free bond like a 6 month US Treasury. Ininvestment focus and strategy and then begin to apply short its the return generated by taking on riskﬁlters. The ﬁlters are designed to eliminate the low divided by the risk measured as volatility.quality managers. Figure 4 shows some of the metricswe use to ﬁlter Emerging Markets managers. Ratio of Managers Return to a marketSharpe Ratio - is a measure of how much additional benchmark during periods of rising markets. Upside Capturereturn an investment has been generating for the > 100% Measures a managers performance in up Ratio (5 Yr)amount of measured volatility. For riskier investments markets. Greater than 100% means the manager returned more than the asset class.like Emerging Markets stocks the Sharpe Ratio tends toaverage lower than for riskier investment types. We likethis ratio because it shows good market intelligence. Ratio of Managers Return to a marketManagers who can generate equal or more return and benchmark during declining periods. Measuresdo that with less risk tend to be smarter and execute Downside Capture < 100% a managers performance in up markets. Greater Ratio (5 Yr)better than the rest. than 100% means the manager returned more than the asset class.Upside and Downside Capture Ratio - compares amanager to his benchmark in both up and down Figure 4. Filters applied to Emerging Markets managers.markets. For us to invest with a manager we look for himto perform better than the benchmark in up marketswhich means his capture ratio should exceed 100% of themarket. In down markets we look for managers to not loose as much and therefore drop less than 100% of the market.“A” List 2Figure 5 below shows a small sample of an A-List of managers. This list helps us contrast an investment with its benchmark. For eachmetric a value is given for the investment and for the benchmark. The Trailing Return columns show which one returned more theinvestment or the benchmark. If the investment did better then the value is positive. If the benchmark outperformed the investmentManager Analysis A-List Annual Returns Trailing Returns Investment Ticker Return Return Return Std. Dev Std. Dev 2011 2010 2009 2008 2007 2011 2010 2009 2008 2007 Symbol (YTD) (3Yr) (5Yr) (3Yr) (5Yr)Emerging Markets Eaton Vance Parametric EITEX 13.6 6.5 (0.1) 19.7 27.2 (18.1) 23.3 68.2 (51.0) 40.2 0.8 6.8 (0.7) (2.1) 7.0 iShares MSCI Emerging EEM 10.3 3.9 (1.7) 24.3 30.3 (18.8) 16.5 68.9 (48.9) 33.1Fixed Income PIMCO Total Return PTTRX 9.1 7.7 8.9 3.4 4.3 4.2 8.8 13.8 4.8 9.1 (1.8) 3.4 11.9 (3.4) iShares Barclays Interm GVI 3.1 4.8 5.6 2.4 4.2 6.0 5.5 2.0 8.2 -Figure 5. A-List example of managers for Emerging Markets and Fixed Income asset groups. Trailing returns shows differences with thebenchmark ETF for each asset class.then the value is shown in red. For example, PIMCO Total Return fund outperformed its benchmark in 2009 by 11.9 more percentagepoints and underperformed by 3.4 less percentage points in the previous year.Each quarter we update the A-List with new managers who have surfaced from the ﬁrst stage of ﬁltering (typically each asset class willhave one to ﬁve managers in the A-List). We then look for how well our select manager is performing relative to the benchmark andthe other managers. This is where we make investment decisions, whether to continue with a manager or to replace him with anothermanager or with an ETF for the asset class. The decision is mostly quantitative driven however, its also balanced against capital gainstax implications and whether we believe a manager will recover lost ground over the next six to twelve months.2 Each quarters reﬁned A-List can be downloaded from our website.
INVESTOR UPDATE 2013Fixed Income PortfoliosFor some institutional and individual clients PSF manages low risk ﬁxed income portfolios A Few Key Points on CDsin separate accounts 3. This practice focuses on strategies which maximize return while We only buy CDs issued by FDICmeeting the policy driven risk mandates of treasury cash equivalent accounts, reserve insured banksfunds, foundations, endowments, and some trust accounts. We use “traditional” CDs which haveFixed income investments like certiﬁcates of deposit (CDs), treasuries, municipal bonds, ﬁxed interest rates. In order to maximize FDIC insuranceand corporate bonds typically pay a dividend and then return the principal at maturity. As we stay under the $250K FDICwith all investments there is risk. All ﬁxed income investments decline in value as interest insurance limit per insured bank.rates rise. Therefore, the risk is in selling when rates are rising rather than holding tomaturity. In addition, they all have loss of principal risk except for those which are securedby the Federal Government namely CDs and treasuries. As is evident in the markets todayeven U.S State municipalities can default on debt.Our practice focuses on strategies which meet a “preservation of principal” policy requirement. This restricts our investments to“traditional” CDs and U.S. treasuries. However, even with a limited selection of investments, higher returns can still be engineered byspreading investments over longer maturities. We call this “maturity laddering” and its an effective strategy when cash requirementsare well understood. Following is a ﬁxed income laddering example which demonstrates this point. Condominium Reserve Fund - Strategy 1YR CD 2YR CD 3YR CD 4YR CD 5YR CD Bank Invested Invested $200,000 $200,000 $200,000 $300,000 $300,000 GE MONEY BANK $154,175 Yield Range .72% - .845% .97%-1.1% 1.31%-1.48% 1.62%-1.73% 1.88%-2.29% GOLDMAN SACHS BK $196,453 GE CAP FINL INC $181,706 Client: Condominium Reserve Fund. $147,145 GE CAPITAL RETAIL BK Fund: $1.4 million ALLY BK $47,931 DISCOVER BANK $168,343 Results: Using laddering we achieved a 1.47% annualized return versus the .25% return they had been receiving in a money market fund. AMER EXP CENT BK $51,426 MORTON CMNTY $8,568 Strategy: Based on the results of a current reserve study we determined the annual cash requirements for capital expenditures over the next 5 years. We then laddered the investments REPUBLIC BANK $10,589 across CDs with maturities ranging from 1 to 5 years in the amounts shown above. BARCLAYS BANK NA $48,521 For this account we purchased over 1000 small CDs. It sounds like a lot but the yield on smaller BMW NA $52,607 denominated CDs is typically slightly higher than for the larger ones. And there are no transaction OHIO VALLEY BANK $8,322 fees. LEHMAN COML BANK $37,306 Note: While 1.47% is not a lot of return it is six times what was being achieved. Using this strategy MIDFIRST BANK $11,314 over time through diﬀerent interest rate regimes does maximize return while not compromising principal. CAPITAL ONE $95,917Real Estate InvestmentsA strategic focus of our group is sourcing and managing indirect and direct investments in commercial real estate for both capitalgrowth and income needs 4. We focus on ﬁnding, building relationships with, and ultimately investing in highly skilled real estatedevelopers. Finding such developers with the solid ﬁnancial practices we seek is very hard indeed. Most are small private companieswho do not advertise themselves.3 Within clients diversiﬁed investment accounts we also invest in ﬁxed income. However, in those cases the investment is part of a balanced risk/return strategythat does not typically carry a mandate to preserve principal. Therefore, we pursue a little higher return by investing with select managers like PIMCO. Thesemanagers invest in all different types of bonds like corporates, munis, and other countries government issued bonds.4As with ﬁxed income, within clients diversiﬁed investment accounts we also invest in real estate, typically through REITs or funds of REITs. In these accountsREITs are used strategically to balance and to diversify.
INVESTOR UPDATE 2013Through creative development and re-marketing efforts skilled developers of real estate can addsigniﬁcant value to properties resulting in compounded ROI. One of the developers in which we have CONTACTinvested has consistently grown equity at 20% or higher over 20+ years. Because real estate tends to be INFORMATIONdriven in large part by local economics a developers skill comes from signiﬁcant experience andrelationships in a speciﬁc market. A developer’s skills in ﬁnance are also a major factor in long term Park Street Financial Groupsuccess. The root cause of many developer’s failures is bad ﬁnancial practices. 115 Park StreetWhen searching for new asset managers we look for developers, Suite 200 Vienna, Virginia 22180 With a solid track record of entrepreneurial investing i.e. acquiring under-valued, under- performing, un-loved, properties and increasing their valuation through creative, experience Ofﬁce: +1 703 662 1283 guided, redevelopment and re-marketing efforts. Fax: +1 703 562 8405 Email: firstname.lastname@example.org Who focus on the Washington D.C. metro area including Northern Virginia and Baltimore, http://www.psfgp.com Maryland and mainly the primary sub-markets are Arlington, Alexandria, and Vienna Virginia. Who use leverage conservatively and creatively to enhance investment performance and to enable sufﬁcient portfolio diversiﬁcation, mitigating idiosyncratic risk. Who minimize performance impairment from lease defaults by following a strict tenant due- diligence process. Tenant due-diligence is essentially a risk/return analysis for each potential tenant e.g. who has a higher probability of surviving an economic downturn.Sourcing opportunistic private real estate investments for our clients is a unique part of our practice.We do this because we believe strongly in the long term potential and inﬂation mitigating aspects ofthe asset class and we believe good, niche focused developers can outperform the market by asigniﬁcant margin. However, because of the inefﬁciencies in commercial real estate and thecomplexities in structuring private investments investors must have a long-term focus. Typicalinvestments take 1 to 2 years to structure and then 5 to 8 years to mature. Below highlights a recentinvestment in a redevelopment project located in one of the prime submarkets of Washington, D.C.Arlington Hotel - RedevelopmentStrategy Value Added - Capital GrowthProperty Type HotelLocation Arlington VA. Prime sub market of D.C.Min Investment $125,000Maturity Max 8 years with 2 optional years.Expected ROI 25% compounded. Hotel rendering along Wilson Avenue. Building is designed to step down in the backTerm Closing July 2011 in order to blend better with the adjoining neighborhood.This was an entrepreneurial investment in one of the fastest growing regions of the U.S. The parcel and existingretail space are in a prime spot in Arlington, Virginia located just a short walk from a major metro line, providingeasy access to Washington D.C. and the metro area. The developer had stabilized the existing retail space whichprovided suﬃcient cash ﬂow to cover the existing note. Our investment entered the project during the earlyredevelopment stage when signiﬁcant entitlement work was underway. Entitlement risk was still there which istypically a risk institutional investors will shun. Because of our deep knowledge of the developer, the project, andthe market we viewed the risk as a lot less signiﬁcant than others would have.- Thomas Morris Managing Director
INVESTOR UPDATE 2013 Thomas Morris is an instructor of ﬁnance and adjunct professor at George Mason University, an independent ﬁnance consultant, and owner of Park Street Financial Group, a registered investment advisory based in Vienna, Virginia. Thomas consults on matters of capital formation, investment strategy, and valuation. He has consulted to high-net-worth individuals, start-up technology companies, asset managers, and organizations operating as ﬁduciaries of capital. Through Park Street Financial Group Thomas manages portfolios for a small group of private investors. A focus of his practice is sourcing, valuing, and structuring off market real estate investments in prime sub-markets of Washington D.C. At George Mason University Thomas teaches course work in real estate ﬁnance. He has also taught Financial Planning to graduate medical students at George Washington University and has delivered aseries of courses on investing and risk analysis at the Ollie Osher Institute. Prior to forming Park Street Financial Group Thomas wasa Portfolio Manager with Citigroup Smith Barney where managed portfolios for individual and institutional clients.Thomas is semi-ﬂuent in German, and holds a Master’s of Quantitative Finance from George Washington University and a Bachelor’sdegree in Physics from Auburn University.