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October 2017 Newsletter

Dear Clients and Friends, 

Everyone seems to have a favorite season.  Many fans in the Mid-Atlantic region rejoice as the humidity fades, leaves turn, and football season arrives.  As children return to the seriousness of school work, many adults often follow suit by focusing their efforts in getting things crossed off their to-do lists.  Let us know how we can help you take care of any open financial tasks or concerns.

Financial Security in the Digital Age

The recent security breach at Equifax, one of the major credit bureaus, has placed the safeguarding of personal information in the spotlight and deservingly so.   Some of the most significant examples of private information breaches include: Yahoo (2013-2014) 3 billion users, eBay (2014) 145 million users, Equifax (2017) 143 million users, Target Stores (2013) 110 million users, and JP Morgan Chase (2014) 76 million households.

Many of you recall the movie, Catch Me If You Can, starring Leonardo DiCaprio. It’s a fascinating true to life tale of a young con man named Frank Abagnale.  After several years in prison, Abagnale worked for the FBI and now has his own financial fraud consulting firm. 

At a conference in Minnesota, Abagnale told attendees: “It is amazing the information we give away. We make it easier and easier for criminals…If on your Facebook page you happen to tell me where you were born and your birthday, then I’m 98 percent of the way to stealing your identity. “

Here are his most recent recommendations to reduce the risk that you will be a victim of financial fraud: 

  • Shred everything with personal information, even junk mail.
  • Use a credit monitoring service.
  • Stop using a debit card. According to Abagnale, the safest form of payment is a credit card.
  • When writing checks or other documents, use a uni-ball®207™pen. It uses smooth pigment ink that cannot be washed off with chemicals.*
  • Use high-security checks that offer several safety features.
  • Utilize a bank’s bill pay service.
  • Limit information shared on social media such as birthdates, place you were born and personal telephone numbers.

* In the movie you will recall that Frank was able to wash off the payee on the checks of victims and insert his name or cash in its place.
The message here is to be vigilant and err on the side of caution whenever your personal information is provided to others.
Financial Markets
Prices of stocks, bonds and real estate continue their ascent.  Valuations get richer and richer.  We all know that asset prices do not advance forever and that corrections (declines) are inevitable.  Investors have a natural tendency to focus on what is going down when everything else is going up. For that reason, we have prepared the following commentary on the Reinsurance Risk Premium fund.
Stone Ridge Reinsurance Risk Premium Fund (SRRIX)
One of our jobs as investment advisors and fiduciaries is to build a portfolio that will provide clients with the greatest chance of not outliving their assets.  The mathematical data point that captures the most public attention is return.  Risk, which also matters a great deal, is often the forgotten metric.  Why? Because it is not something we can easily wrap our heads around.  One of the easiest ways to demonstrate risk is by analyzing 2 sets of the identical annual returns, but with different ordering of those returns over a set period.   Assume there are 2 investors (Vincent and Ravi) that each have a $1 million portfolio and withdraw $50,000 per year for living expenses.   Both earn a 10-year annualized return of 5%, but Vincent’s sequence of annual returns are as follows:  -15%, -6%, -5%, 6%, 6%, 10%, 13%, 13%, 15% and 18%.  Ravi’s returns are the same as Vincent’s but happen in the exact opposite order.  After 10 years, Vincent’s portfolio is worth $785,000 compared to Ravi’s portfolio of $1,144,000, or 46% less at the end of 10 years.  
How does one minimize risk in a portfolio?  The standard answer is by diversifying, but what exactly does this mean?  It means choosing investments that do not move in tandem with one another (or correlate, in statistical speak).  The consequence of true diversification is that not all investments will move up or down at the same time.  In other words, diversification requires the acceptance that one or more investments in the portfolio will underperform or perform negatively over various periods.  A truly diversified portfolio will have a smoother return stream than one that is less diversified.  What is the cost for the smoother ride?  A truly diversified portfolio’s returns can deviate from the returns of one or more of the mainstream asset classes, namely stock and bonds, in a material manner.
The Stone Ridge Reinsurance fund is a great example of meaningful diversification.  This fund was added to client portfolios for the following reasons:
1) stock and bond valuations are at elevated levels versus history
2) long-term returns of reinsurance look relatively attractive and
3) there is little correlation between reinsurance with the rest of the portfolio (stock market crashes and interest rate increases do not cause hurricanes and earthquakes and vice versa).
That being said, reinsurance will incur steep losses (drawdowns) when there are large catastrophic loss years.  The decline to the fund’s price or NAV (Net Asset Value) can be quick, as evidenced by the impact of Hurricane Irma.  In most months, this fund will produce returns similar to high-yielding bonds, but in months with major catastrophes, losses will be sharp.  This can make investors uncomfortable.  Note, however, that the fund participates in insurance contracts that are written annually.  Consequently, when losses occur, premiums (earnings to the fund) reset in the near term to higher levels to compensate insurers for continuing to provide coverage, even though their capital has been recently impaired.    
Similar to other asset classes, sharp losses in the reinsurance world should be viewed as an opportunity to increase exposure.  There is strong inverse correlation between large insured losses and future premium increases.  In fact, the best time to sell insurance is after a large loss event occurs (selling the proverbial umbrella after a series of rainy days).  As investors alongside the largest reinsurers, we must be emotionally prepared to increase exposure (even though our natural survival instinct is telling us to bail) after large loss years to take advantage of the premium repricing.
Q and A:
Why invest in reinsurance prior to hurricane season, instead of after?
Premiums do not accrue to insurers evenly throughout the year.  In other words, premiums that accrue in the 2ndhalf of the year are higher, given the elevated loss exposure resulting from U.S. hurricane season.  There is no way to game the timing of this fund, other than to add or increase participation after catastrophic events to take advantage of premium increases.
Why do we believe that reinsurance is an attractive asset class to add to a portfolio?
The correlation of reinsurance to stocks and bonds is extremely low.  The prevailing risks to stocks is generally economic risk (a recession) and for bonds, interest rate risk (rates rise).  
What is the long-term return of this asset class?
Historically, the returns from reinsurance and other insurance linked securities have been in the high single digits over time.  This is comparable to the long-term return of high-yield bonds and stocks.
Why do many advisors not recommend alternative assets, like reinsurance?
Much of the avoidance has to do with career risk.   Why rock the boat?   Advisors know that their clients are much more comfortable following the herd or failing conventionally, than unconventionally.  Note that emerging markets were considered an “alternative” investment in the ‘90s and the beginning of this century.  The size of the emerging market stock index went from virtually non-existent to almost $5 trillion from 1992 to today.   Emerging market stocks outperformed the conventional S&P 500 by a cumulative 200% from 2000 to 2010.  Each $1 invested in emerging markets turned into $3 while the S&P remained at $1.
Medicare Open Enrollment

Medicare’s fall open enrollment period runs from October 15 through December 7. During this window you can make changes to your Medicare Part D drug plan or Medicare Advantage plan.  You should receive an Annual Notice of Change (ANOC) and/or Evidence of Coverage (EOC) from your plan.  Review these notices for any changes to your benefits for 2018.  You may see changes in: cost, the providers and pharmacies in your network, and covered medications in your drug plan. Even if you are satisfied with your current coverage, it’s possible that better and/or more affordable coverage is available.  The location of your primary residence will determine the coverage options available to you. Please review these options carefully.

Medical insurance decisions for individuals over 65, who are either employed and covered by an employer’s plan or covered by a retirement health plan, are complicated by Medicare enrollment requirements.  While we do not claim to be experts in Medicare planning, please contact your Schiavi + Dattani service advisor if you fall into either of the categories listed above.  Your advisor will work with you and insurance professionals to lessen the probability of costly election mistakes.

We continue to work daily to earn your trust and confidence.

Best Regards,                                         

Vincent A. Schiavi, CFP®, CPA/ PFS                            Ravi P. Dattani, CFP®, CPA

President                                                                       Vice President