GICs vs. syntheticsIn the Oct. 30, page 48, Portfolio Management article, "Synthetics change game," by C. Jason Psome, there are three main distortions.
He compares long-duration synthetics vs. short-duration guaranteed investment contracts; he compares them during a secular bull market in bonds; and he neglects to mention that increased sensitivity of the credited rate to market interest rates only comes with increased volatility of unamortized gains and loses.
This leads to unfavorable termination experience in rising interest-rate environments, and when bond managers underperform.
I maintain that GICs have a yield advantage over synthetics. They also deliver a needed basket of goods in a single simple package.
There are many product distinctions in synthetics. Some distinctions are that the assets can be managed actively or passively, to a constant duration or fixed term. Mr. Psome discusses one small part of the synthetics market - that of constant duration, actively managed synthetics. He also uses a relatively long duration portfolio in his synthetic.
It is not surprising that over the period 1986 to the present, a long-duration synthetic should outperform a GIC portfolio half its duration by 100 basis points a year. The coupon yield advantage on Treasury securities due to longer fixed-income instruments was about 50 basis points. Rates fell at 30 basis points a year in the relevant maturity range during the period 1986 to the present.
The synthetics should have had excess capital gains of 60 basis points a year. The advantage of longer corporate spreads over shorter GIC spreads was about 40 basis points. Deduct from that wrap and active manager fees of 50 basis points a year, and there is the 100 basis points a year (50 + 60 + 40 - 50) that Mr. Psome claimed was a native advantage of actively managed constant market duration synthetics. It was all due to long duration in a falling interest-rate environment, and little to do with product design.
This assumes the fixed-income managers did well. Most portfolio managers did not beat index portfolios long-haul. On average, investment-grade corporate and mortgage bonds return Treasuries plus 70 basis points. Subtract investment management fees and wrap fees, and the yield is barely above Treasuries. GICs have always outperformed Treasuries, net of defaults.
What if rates had gone the opposite direction? How would synthetics fare in a real bear market, like 1977-1982? If the crediting rate of a synthetic continues to rise through a bear market, it is at a price of widening the difference between book and market values. Unamortized losses rise, or prior unamortized gains fall. Termination provisions begin to look ugly, as they did for plan sponsors in 1994 who bought synthetics in late 1993. Eating unamortized losses is unpleasant at termination. No contract last forever. Who wants to be locked in?
One can get greater responsiveness to market interest rate movements, at a price of volatility of unamortized gains and losses. There is no free lunch with interest-rate crediting. If you buy bonds with yields net of wrap and management fees equivalent to identical GICs, you will get the same total and credited returns at the end of the scenario. Values will differ in between, but at the beginning and the end they must be the same.
Synthetics have advantages over GICs, but not everywhere. Mr. Psome does a disservice to his arguments for synthetics by not telling the whole story, leaving buyers of synthetics open to disappointment when promises made cannot be fulfilled.
David J. Merkel
In his Oct. 30 Portfolio Management article on page 48, "Synthetics change game," C. Jason Psome states that synthetics GICs should outperform traditional guaranteed investment contracts by roughly 100 basis points because: 1) durations on synthetics can be longer; and 2) active management adds value.
Both of these arguments have soft spots:
1) Relative performance measurement should be done on comparable duration portfolios. Traditional GIC durations can easily be lengthened with interest-rate swaps.
2) Active management is a zero-sum. Only about half of all active managers can beat an index (and that's even before expenses are subtracted); the other half don't.
The article also states that credit rates on constant duration synthetics "respond" faster to interest rate changes than a portfolio of laddered GICs. This assertion is problematical for two reasons.
1) The argument is based on a premise that crediting rate mechanisms is a product feature. It would be more correct to say that crediting rate mechanisms is a plan design feature that can be modified to suit the objectives of the plan administrator. And in this connection, the crediting rate mechanism for traditional GICs could be easily modified through restructuring or interest-rate swaps.
2) The more conventional interpretation of "rate responsiveness" is how close the credited rate is to the benchmark rate. In this sense, for any given level of rate volatility, longer-duration portfolios will respond less well than shorter-duration portfolios.
There are many good reasons for using synthetics in a stable value fund, but this article didn't address them.
Senior vice president
Fidelity Management Trust Co.
Information on Newland Capital Advisors was not included in your Oct. 2 real estate directory.
Newland Capital provides gap equity investment in residential land acquisition and development projects producing lots of sale to merchant home builders.
As of June 30, NCA had $66 million in institutional tax-exempt real estate assets, all fully discretionary.
Derek C. Thomas is the chief investment officer; I am the client contact at (619) 455-7503.
LaDonna K. Monsees
Executive vice president
Newland Capital Advisors
La Jolla, Calif.
Rothschild Realty Inc. was omitted from your Oct. 2 real estate directory.
Headquartered in New York, and part of the worldwide Rothschild Asset Management Group, Rothschild Realty is responsible for managing a total of $423 million of real estate equity investments for domestic tax-exempt institutions, of which $390 million is for fully discretionary accounts (assets as of June 30).
John D. McGurk is president; Pike Aloian, managing director, is client contact.
Rothschild Asset Management Inc.
The Nov. 27 editorial talks of having the same set of rules for the government and the governed. Perhaps P&I would like to talk about the large unfunded liability of our federal pension plan known as Social Security which was unfunded by either $7 trillion or $1 trillion in 1990, depending upon the valuation method. It is not an entitlement plan. It should be viewed for what it is: a pension plan.
We also have a federal accident and sickness insurance company known as the Health Care Financing Administration.
Who regulates Social Security or the HCFA? Who is responsible for the looming financial mess involving Medicare, Medicaid, and Social Security?
It would appear that the federal government should have made Social Security and the HCFA stand-alone entities subject to regulation by state insurance departments. Doing so would have obviated much of the financial shenanigans that the federal government has engaged in with these agencies.
There is a moral here. The Constitution was designed to restrain the movements of the federal government. The federal government has no enumerated power via the Constitution granting it a monopoly with respect to running a pension plan or a post-retirement accident and sickness insurance company. Putting a large sum of money such as Social Security next to politicians is questionable. We have only ourselves to blame since we asked Uncle Sam to do so many wonderful things for us, and we forgot the first principles of our contract/compact/covenant - the Constitution.
Charles R. Courtney
Corporate risk manager
CSA Fraternal Life
Oak Brook, Ill.