Investor update 2013

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.

Our ApproachPSF’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 ClassesSeparating 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.

History is used to help understand the relationship between asset classes and determine if classes are correlated in any way. If two classes are positively correlated with each other then we can expect them to move in the same direction together. If they are negatively correlated then we can expect them to react inversely, from each other, to changes in economic conditions. Of course between theses two extremes is zero correlation which says, when one asset class moves we can’t make any assumption about how the other class will move.

This is very valuable knowledge indeed. Imagine we want to invest in two investments for a long term however, they are very volatile. They could gain or loose 20% of their value in any given year. If we combine them into a portfolio and they are negatively correlated then their movements will have a canceling effect on each other. That is, the movement of the portfolio will be a lot smoother (i.e. less volatile) than either one of the individual investments.

1 Charles D. Ellis, “Winning the Loser’s Game” Timeless Strategies for Successful Investing, 3d ed.

CONTENTS

Our Approach

Asset Classes

Passive v Active Investing

Finding Good Managers

Fixed Income Portfolios

Real Estate Investments

Park Street Financial GroupINVESTOR UPDATE 2013

Park Street Financial Group (PSF) is a private, objective, Registered Investment Advisor which manages 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 the decision making process.

Asset Class

Real Return

Standard Deviation

Absolute Return 6.0% 10%

Domestic Equity 6.0% 20%

Fixed Income 2.0% 10%

Emerging Equity 8.0% 25%

Real Assets 6.0% 14%

Private Equity 11% 28%

Figure 1. Asset Classes and their expected returns and standard deviations.

Correlations between asset classes are expressed through correlation values which are calculated using historical data. Savvy investors have learned that relying purely on history to help forecast the future is only so good. So to improve the effectiveness of using correlations as a tool we modify correlation values to reflect our assumptions of future economic, political, and market conditions. For example, many investors believe as Emerging Markets become more developed they will tend to become more positively correlated with the developed world. This will in turn reduce some of the benefit of diversifying across Emerging Markets and will tend to drive up the expected volatility (aka risk) of a portfolio.

The table in Figure 2 shows our assumptions of changes in expected correlation between different asset classes. Red, up pointing arrows indicate that we expect asset class pairs to become more positively correlated. Down facing green arrows indicate the pair is expected to become less positively correlated.

Passive versus Active InvestingPassive investing in a market means to invest in a broad basket of securities which represent that entire market and only trade when a security is no longer considered a member of that market. Passive Investing means you are not trying to guess the winners or losers or trying to time when to buy or when to sell. ETFs (Exchange Traded Funds) are the most common passive investment. They are are basket securities, commonly run by a computer, which simply follow market indexes. ETFs are very efficient, low cost instruments. Today there are thousands of them and at least one for every index which tracks publicly traded markets.

Figure 3 shows the ticker symbol for each ETF we use. Each ETF tracks some index. For example, IWB tracks the Russell 1000 index. SPY tracks the S&P 500 index.

Active investment management means a person is making the investment decisions and is typically trying to outperform an index. The investment manager relies on research and experience to make decisions on what and when to buy and then when to sell.

When we have the option of a passive vehicle for an asset class and we choose an active manager then we are expecting that manager to do better than the passive vehicle. Essentially, there is an implicit mandate on that manager to outperform the asset class as a whole. We are expecting him/her to provide enough additional value to cover his costs and give us some excess return. In our final analysis we are looking for strong indicators which support a managers ability to meet or exceed that mandate. If we don’t find that support we choose a passive route.

Finding Good ManagersThere 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 2013

U.S.Equity

FixedIncome

Emerging Equity

Absolute Return

Private Equity

Real Assets

U.S. Equity

1.00

Fixed Income 1.00

Emerging Equity 1.00

Absolute Return 1.00

Private Equity 1.00

Real Assets

1.00

Figure 2. Expected changes in correlation between different asset class pairs. Data provided by Yale Investment Management Office.

ASSET CLASSASSET CLASS

Domestic EquityDomestic EquityLarge Cap Equity

US Large Core PassiveUS Large Value ActiveUS Large Growth Active

Small Cap EquityUS Small CapUS Small Cap ValueUS Small Cap Growth

Micro Cap EquityUS Micro Cap

Foreign EquityForeign EquityDeveloped Int’l Equity

Developed Lg CapDeveloped All CapDeveloped Small Cap

Emerging MarketsEmerging Markets

Fixed IncomeFixed IncomeFixed Income

Taxable Fixed IncomeCash

Absolute ReturnAbsolute ReturnAbsolute Return

Absolute ReturnHedged EquityHedged Equity

Hedged EquityHedged Equity

Real AssetsReal AssetsReal Assets

Real Estate

CLASS INDEX ETF TICKER

Russell 1000 IWBRussell 1000 Value IWBRussell 1000 Growth IWF

Russell 2000 IWMRussell 2000Russell 2000

Russell Micro Cap IWC

MSCI ACWI ex. US ACWXMSCI ACWI ex. USFTSE Developed Sm Cap ex. US IFSM

MSCI Emerging Markets EEM

BarCap Intermediate Govt./Credit GVI

S&P 500 SPY

S&P 500 SPY

Cohen & Steers Realty Majors ICF

Figure 3. Filters applied to Emerging Markets managers.

through this ever expanding, changing pool of managers can be very time consuming and nerve racking without a quantitative based process and good tools.

Our process has two stages. The first stage produces an “A” list of managers for each asset class. We start with a pool of 29,000+ public funds, segregate them by investment focus and strategy and then begin to apply filters. The filters are designed to eliminate the low quality managers. Figure 4 shows some of the metrics we use to filter Emerging Markets managers.

Sharpe Ratio - is a measure of how much additional return an investment has been generating for the amount of measured volatility. For riskier investments like Emerging Markets stocks the Sharpe Ratio tends to average lower than for riskier investment types. We like this ratio because it shows good market intelligence. Managers who can generate equal or more return and do that with less risk tend to be smarter and execute better than the rest.

Upside and Downside Capture Ratio - compares a manager to his benchmark in both up and down markets. For us to invest with a manager we look for him to perform better than the benchmark in up markets which means his capture ratio should exceed 100% of the market. In down markets we look for managers to not loose as much and therefore drop less than 100% of the market.

“A” List 2

Figure 5 below shows a small sample of an A-List of managers. This list helps us contrast an investment with its benchmark. For each metric a value is given for the investment and for the benchmark. The Trailing Return columns show which one returned more the investment or the benchmark. If the investment did better then the value is positive. If the benchmark outperformed the investment

then the value is shown in red. For example, PIMCO Total Return fund outperformed its benchmark in 2009 by 11.9 more percentage points 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 will have one to five managers in the A-List). We then look for how well our select manager is performing relative to the benchmark and the other managers. This is where we make investment decisions, whether to continue with a manager or to replace him with another manager or with an ETF for the asset class. The decision is mostly quantitative driven however, its also balanced against capital gains tax 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.

Filter Metric Description

Sharpe Ratio > 40%

Ratio of excess return divided by the variability of the portfolio. Excess return is equal to the portfolio return minus the return on a short term risk free bond like a 6 month US Treasury. In short its the return generated by taking on risk divided by the risk measured as volatility.

Upside Capture Ratio (5 Yr) > 100%

Ratio of Managers Return to a market benchmark during periods of rising markets. Measures a managers performance in up markets. Greater than 100% means the manager returned more than the asset class.

Downside Capture Ratio (5 Yr) < 100%

Ratio of Managers Return to a market benchmark during declining periods. Measures a managers performance in up markets. Greater than 100% means the manager returned more than the asset class.

Figure 4. Filters applied to Emerging Markets managers.

Figure 5. A-List example of managers for Emerging Markets and Fixed Income asset groups. Trailing returns shows differences with the benchmark ETF for each asset class.

Manager Analysis A-ListManager Analysis A-ListManager Analysis A-ListManager Analysis A-ListManager Analysis A-ListManager Analysis A-List Annual ReturnsAnnual ReturnsAnnual ReturnsAnnual ReturnsAnnual Returns Trailing ReturnsTrailing ReturnsTrailing ReturnsTrailing ReturnsTrailing Returns

Investment Ticker Symbol

Return (YTD)

Return (3Yr)

Return (5Yr)

Std. Dev (3Yr)

Std. Dev (5Yr)

2011 2010 2009 2008 2007 2011 2010 2009 2008 2007

Emerging MarketsEmerging MarketsEmerging 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) 33.1

Fixed IncomeFixed IncomeFixed 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 -

Fixed Income PortfoliosFor some institutional and individual clients PSF manages low risk fixed income portfolios in separate accounts3. This practice focuses on strategies which maximize return while meeting the policy driven risk mandates of treasury cash equivalent accounts, reserve funds, foundations, endowments, and some trust accounts.

Fixed income investments like certificates of deposit (CDs), treasuries, municipal bonds, and corporate bonds typically pay a dividend and then return the principal at maturity. As with all investments there is risk. All fixed income investments decline in value as interest rates rise. Therefore, the risk is in selling when rates are rising rather than holding to maturity. In addition, they all have loss of principal risk except for those which are secured by the Federal Government namely CDs and treasuries. As is evident in the markets today even 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 by spreading investments over longer maturities. We call this “maturity laddering” and its an effective strategy when cash requirements are well understood. Following is a fixed income laddering example which demonstrates this point.

Real Estate InvestmentsA strategic focus of our group is sourcing and managing indirect and direct investments in commercial real estate for both capital growth and income needs4. We focus on finding, building relationships with, and ultimately investing in highly skilled real estate developers. Finding such developers with the solid financial practices we seek is very hard indeed. Most are small private companies who 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 strategy that does not typically carry a mandate to preserve principal. Therefore, we pursue a little higher return by investing with select managers like PIMCO. These managers invest in all different types of bonds like corporates, munis, and other countries government issued bonds.

4 As with fixed income, within clients diversified investment accounts we also invest in real estate, typically through REITs or funds of REITs. In these accounts REITs are used strategically to balance and to diversify.

A Few Key Points on CDsWe only buy CDs issued by FDIC insured banksWe use “traditional” CDs which have fixed interest rates.In order to maximize FDIC insurance we stay under the $250K FDIC insurance limit per insured bank.

Condominium Reserve Fund - Strategy

1YR CD 2YR CD 3YR CD 4YR CD 5YR CD Bank Invested

Invested

Yield Range

$200,000 $200,000 $200,000 $300,000 $300,000 GE MONEY BANK $154,175

.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

GE CAPITAL RETAIL BK $147,145

ALLY BK $47,931

DISCOVER BANK $168,343

AMER EXP CENT BK $51,426

MORTON CMNTY $8,568

REPUBLIC BANK $10,589

BARCLAYS BANK NA $48,521

BMW NA $52,607

OHIO VALLEY BANK $8,322

LEHMAN COML BANK $37,306

MIDFIRST BANK $11,314

CAPITAL ONE $95,917

Client: Condominium Reserve Fund.

Fund: $1.4 million

Results: Using laddering we achieved a 1.47% annualized return versus the .25% return they had been receiving in a money market fund.

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 across CDs with maturities ranging from 1 to 5 years in the amounts shown above. For this account we purchased over 1000 small CDs. It sounds like a lot but the yield on smaller denominated CDs is typically slightly higher than for the larger ones. And there are no transaction fees.

Note: While 1.47% is not a lot of return it is six times what was being achieved. Using this strategy over time through different interest rate regimes does maximize return while not compromising principal.

Through creative development and re-marketing efforts skilled developers of real estate can add significant value to properties resulting in compounded ROI. One of the developers in which we have invested has consistently grown equity at 20% or higher over 20+ years. Because real estate tends to be driven in large part by local economics a developer's skill comes from significant experience and relationships in a specific market. A developer’s skills in finance are also a major factor in long term success. The root cause of many developer’s failures is bad financial practices.

When searching for new asset managers we look for developers,

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 guided, redevelopment and re-marketing efforts.

Who focus on the Washington D.C. metro area including Northern Virginia and Baltimore, 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 of the asset class and we believe good, niche focused developers can outperform the market by a significant margin. However, because of the inefficiencies in commercial real estate and the complexities in structuring private investments investors must have a long-term focus. Typical investments take 1 to 2 years to structure and then 5 to 8 years to mature. Below highlights a recent investment in a redevelopment project located in one of the prime submarkets of Washington, D.C.

- Thomas Morris Managing Director

CONTACT INFORMATION

Park Street Financial Group

115 Park Street Suite 200Vienna, Virginia 22180

Office: +1 703 662 1283Fax: +1 703 562 8405

Email: [email protected]://www.psfgp.com


Arlington Hotel - RedevelopmentStrategy Value Added - Capital Growth

Property Type Hotel

Location Arlington VA. Prime sub market of D.C.

Min Investment $125,000

Maturity Max 8 years with 2 optional years.

Expected ROI 25% compounded.

Term Closing July 2011Hotel rendering along Wilson Avenue. Building is designed to step down in the back 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 existing retail space are in a prime spot in Arlington, Virginia located just a short walk from a major metro line, providing easy access to Washington D.C. and the metro area. The developer had stabilized the existing retail space which provided sufficient cash flow to cover the existing note. Our investment entered the project during the early redevelopment stage when significant entitlement work was underway. Entitlement risk was still there which is typically a risk institutional investors will shun. Because of our deep knowledge of the developer, the project, and the market we viewed the risk as a lot less significant than others would have.

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 a

series of courses on investing and risk analysis at the Ollie Osher Institute. Prior to forming Park Street Financial Group Thomas was a 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’s degree in Physics from Auburn University.


Economy & Finance

Investor update 2013