Hurricane Katrina will prove to be the worst national disaster in U.S. history, far greater than the nightmare of 9/11, both in terms of lives lost and property destroyed.  The rebuilding effort is now estimated at $150 billion, and that number is likely to be low.  An estimated 700,000 people are out of work across the Gulf Coast, and that number could increase significantly.  This disaster has occurred while oil and gasoline prices have hit new record highs, further exacerbating our economic problems due to the hurricane.

Over the last month or so, most economists raised their GDP forecasts for the second half of this year to 4% or above. Consumer spending and confidence rose, unexpectedly, in August despite soaring oil and gasoline prices.  Now, however, it is almost certain that GDP will slow, perhaps significantly, for the rest of the year due to the impact of the hurricane and soaring oil and gasoline prices.  Most economists suggest that GDP will be shaved by 1-2%.

At present, it does not appear that the economy is headed for a recession, just a marked slowdown.  However, if oil prices soar to $100 a barrel, there is a very good chance that a recession will follow.  While I do not expect oil prices to reach $100, nothing can be ruled out at this point.

It remains to be seen whether the Fed will halt its interest rate hiking cycle as a result of the national disaster.  The next FOMC meeting is  September 20, at which time we will know for sure.  I will be surprised and disappointed if the Fed continues to raise rates in this dicey environment.

The stock markets have held up amazingly well in the face of record oil and gasoline prices and even despite the hurricane and the devastation across the middle Gulf Coast.  Yet despite the firmness of the equity markets in recent days, I expect the most likely scenario is that stocks break out of the long trading range to the downside in the weeks ahead.  I recommend reducing positions in stocks and equity mutual funds now, unless those assets are directed by professionals using “active” management strategies.

Given all the uncertainties that now exist, it is more important than ever to have successful professional managers overseeing much of your investment portfolio.  In this issue of F&T, I will share with you many of the tools we use in evaluating and selecting the professional money managers we recommend.  These tools will help you to evaluate almost any type of investment that you may consider in the future.

OUR HEARTS & PRAYERS GO OUT TO ALL OF THE HURRICANE VICTIMS .

The Economy

Thus far, the US economy has weathered soaring oil and gas prices quite well.   Consumer confidence and spending were both up in August, to the surprise of many.  Over the last month or so, most economists were revising upward their estimates for the second half of this year and the first half of next year.  Most of the revised estimates are for GDP to grow by at least 4% for the second half of 2005 and first half 2006.

But that was before oil spiked to $70 a barrel, before gasoline surged above $3 per gallon and before Hurricane Katrina wiped out much of the Gulf Coast.   These events make it all but certain that the US economy is going to go through another “soft patch” in the coming months.  Hopefully, it will only be a soft patch and not a recession.

While some economists disagree, there seems to be a general consensus that for every $10 the price of oil rises above $50, that shaves apprx. 0.5% off of GDP.  So at $70 oil, that would reduce GDP by 1% or so.  While I am not an economist, I think another big variable in this kind of analysis is how long  oil prices remain above $50.  If oil prices remain well above $50 a barrel for the next six months or longer, then I believe the effects on the economy will be more serious than 1% off of GDP.  Again, hopefully not enough to throw us into a recession.

The Hurricane Fallout

Obviously, the hurricane fallout will be negative for the economy.  How negative, we do not yet know.  It remains to be seen how long it will take to get the Gulf Coast ports operational.  Over one-fourth of the nation’s imports and exports pass through these ports.  The longer it takes, the worse it is for the economy.  Ditto for the refineries and the offshore drilling rigs.

It is estimated that apprx. 700,000 Americans were instantly (and indefinitely) put out of work by the hurricane.  This will cause an immediate spike in the national unemployment rate, which had fallen to 4.9% in August.  Likewise, the loss of tens of thousands of businesses along the Gulf Coast and miles inland will be a drag on GDP. 

The bottom line is that we should expect to see disappointing economic numbers through at least the end of the year.  The good news is that my best sources, including The Bank Credit Analyst, believe that the US economy is strong enough to avoid a recession, unless oil soars above $100 a barrel and unless more negative shocks occur.

A convincing case can be made that the economy will rebound strongly early next year as the rebuilding of the Gulf Coast gets into high gear.  The government looks poised to pump at least $100 billion into the rebuilding effort.  This will create jobs and stimulate the economy next year.

Bad News For Stocks - Reduce Positions

The stock markets have held up amazingly well as oil prices soared to $70 and gas prices to $3 a gallon.  Normally, this would be a very bullish indicator.  But Ifear that the coming months of disappointing economic news will begin to weigh on the equity markets. There is a high probability that the broad markets will break out of the 18-month trading range to the downside.  I hope I am wrong.

The Bank Credit Analyst has a similar view, and in their September issue, the editors recommended that clients and subscribers reduce equity positions to “below average” weightings in their portfolios.

Neither BCA nor I believe that we are headed for a new bear market in stocks.   It could be that the equity markets are resilient enough to simply continue in the broad trading range.  Yet as noted above, I think the most likely scenario is a breakout below the trading range.  If so, there is likely to be follow-on selling that drives the market lower for a period of time.

You may recall that Iturned bullish on stocks in February 2003, just before the war in Iraq began.  If you followed my advice and moved to a fully invested position in stocks and equity mutual funds at that time, you have done very well. If you bought an S&P 500 index fund back in February of 2003, you should be up apprx. 40% (or more) at this point. 

If you followed my advice in February 2003 (just before the war) to move to a fully-invested position in stocks and/or mutual funds, I would now take at least partial profits.  You might consider taking all your profits off the table, or at least use a "trailing stop." 

For those of you who have money invested with "active" managers who move out of the market (or hedge) from time to time, you don't need to do anything.  As usual, you will look to your professional money managers to make those decisions. 

For those of you who are more aggressive, and want a way to "short" the market, you may want to take a fresh look at THIRD DAY ADVISORS, LLC.  Third Day is one of the newest additions to our stable of recommended equity money managers.  Third Day will actually short the stock market from time to time.

As noted above, I do not believe that stocks are headed into a new bear market.  The good news is that if stocks break out of the trading range to the downside, and a lot of selling ensues, that could present us with another outstanding buying opportunity.

Real Estate - Time To Sell?

Ithink we can all agree that the housing market is indeed a “bubble” at this point.  Whether that bubble bursts as many predict, or rather it just slowly loses steam, remains to be seen.  I won’t speculate on that, other than to say that most bubbles end badly, especially for the players who came late to the game.

We are already seeing a slowdown in the rate of increase in home prices and real estate in general. The disappointing economic news we are likely to see over the next several months will not be good news for the real estate market in general.  If you have real estate that you are holding for investment purposes, I would strongly consider selling it now.

The Politics Of The Hurricane

Normally, America comes together in a time of national disaster.  Our “can-do” mentality normally unites us across party lines.  But there was little that was normal about Hurricane Katrina.  Rather than help rescue their brethren, thousands of New Orleans residents who stayed in the city turned into ruthless thugs who looted the city, raped young women, murdered fellow citizens and terrorized the shelters.  It is a sad testament to the utter failure of the Welfare System in this country.  The looters said they deserved what they stole.  In my view, they deserved to be shot!

Members of the liberal left in this country could not even wait until all the dead bodies were recovered to use the misery of others for political gain.  The Bush Haters saw this disaster as a new weapon to use against the President.  President Bush, to his credit, did admit that some mistakes were made at the federal level in the disaster relief effort.  In my estimation, the National Guard and the military arrived only one day later than had everything gone correctly.  And if Bush had rushed in the troops before the Mayor and the Governor asked for them, he would have been roundly criticized for usurping state and local authorities.  Either way, Bush loses.

What the media refuses to discuss is the fact that the city of New Orleans had a master disaster plan, including a complete evacuation protocol.  But they never implemented the plan.  There was plenty of time and resources to evacuate those who could not leave on their own.  We’ve all seen the photos of hundreds of flooded school buses that could have been used had the disaster plan been in place.  The Mayor of New Orleans failed his people.  Likewise, our troops could have been there a day sooner had Governor Blanco not hesitated for 24 hours to authorize them.

As you know, I have been a political observer in these pages for over 20 years.  I’ve seen a lot and reported on same over those years.  But I never expected the left to stoop so low as to use this national disaster for their own gain.  I sincerely hope it backfires on them in 2006 and 2008!  The latest CNN/Gallup poll certainly looks like a backfire.  Good!

Now more than ever, I believe you should consider professional money managers for a significant portion of your investment portfolio.  Evaluating money managers is not an easy task.  I've been doing it for over 25 years, and it is a continuing learning process.  In the pages that follow I'll share some of the basics of evaluating and selecting professional money managers.

The “Due Diligence” Process

There are countless articles, studies and entire books on the subject of selecting money managers. Yet because there are so many different types of money managers, and so many different styles of money management, there are many additional tips and nuances that are not even discussed in these books and articles.  While these sources are certainly helpful, there is no substitute for decades of experience in hands-on analysis of money managers, also known as "due diligence." 

At times, interviewing money managers is like giving your teenage kids the third degree after they stayed out until 3:00 in the morning.  They won't necessarily lie to you, but you have to ask the right questions to get the whole truth.  I have made a business out of asking the tough questions and getting the answers from money managers.  

It is a mistake to assume that money managers, or mutual funds for that matter, will provide you all of their pertinent information voluntarily, especially if some of that information is negative.  You have to know how to dig for the pertinent information, how to ask the right questions and press until you get the real answers. 

Please note that the comments below relate mostly to independent professional money managers, but the principles can be used for virtually any type of investment offering.  Be aware that these guidelines tips won't necessarily help with evaluating online investment advice or investment newsletters that do not actually manage money.  These services offer advice, but are usually not licensed as Investment Advisors and do not manage client assets.  As a result, they generally are not covered by regulations governing appropriate performance reporting, etc. and you should be very careful when evaluating their performance claims.

Typical promotions by these services include boasts of phenomenal gains.  However, what they may not be telling you is that they had phenomenal losses as well.  Any time you are tempted to subscribe to a newsletter or online E-letter, you should insist on a complete record of all of the prior recommendations over the past 5 years.  Or better yet, check them out in Hulbert Financial Digest, an impartial rating service for investment newsletters.

Now let's begin the steps of a typical due diligence process.

1.  Is The Performance Record For Real?

Assuming the Investment Advisor you are considering actually manages money, the firm will have a performance record of some sort.  The first thing to determine is whether the performance is "actual" or "hypothetical" with numbers derived from a practice called "back-testing" or a combination of both.  Obviously, an actual track record (that really happened with real money) is preferable to anything hypothetical (a simulation that didn't really happen with real money).

In over 25 years, I have never seen a hypothetical track record that didn't look phenomenal, outstanding, etc.  Why?  Who would advertise a bad one? No one.  Yet very few hypothetical track records actually succeed in real time.

For starters, there are some in the investment world who will simply make up a completely bogus hypothetical performance record and try to pass it off as real, hoping to fool unsophisticated investors.  Fortunately, this practice is on the decline.

Now, let's go back to the more recent practice of 'back-testing' as noted above.  Back-testing is a process whereby an Advisor takes its actual strategy and resulting recommendations and applies those signals to past market data before it began to manage real money in real market conditions.  The obvious weakness to back-testing is that it implies that future market conditions will be similar to the past.  We all know that future market conditions are unpredictable.

But it gets worse, unfortunately.  While the practice of back-testing is meant to provide a confirmation that the strategy works, we often find that the Advisor has - consciously or unconsciously - tweaked the system to fit the historical data.  With the benefit of hindsight, the Advisor may see that some minor modifications to its strategy would have produced greatly enhanced returns in the past.  How convenient!  But as we all know, the future is not likely to be the same as in the past.

Don't get me wrong.  Back-tested results can be very useful in certain situations, especially when you have a well established, highly successful Advisor who, for example, is using back-testing to test a new program it wants to introduce.  Just know that this practice can be badly abused.

BOTTOM LINE:  NOTHING BEATS        
           ACTUAL PERFORMANCE.

Since most Registered Investment Advisors (RIAs) are not subject to the rigid performance reporting criteria applicable to mutual funds, a careful review (or 'audit' as we call it) of the performance numbers given by the Advisor is imperative.  In recent years, many successful RIAs have already taken that step and spent the money to have their performance record audited annually by independent accounting firms. 

Where an independent audit is not available, there are other alternatives.  One such resource is the CFA Institute, formerly known as the Association for Investment Management and Research (AIMR).  Advisors whose performance is "AIMR compliant" can represent that they adhere to the high ethical standards for creating performance information that ensure fair and accurate representation as well as full disclosure.  Over the last few years, AIMR compliant performance reporting has increasingly become the an industry standard for professional money managers. 

While my company knows how to verify if an Advisor's performance is AIMR compliant or not, most investors do not know how to confirm this.  Recent studies have shown that some advisory firms are claiming to be AIMR compliant when in fact they are not.  This presents just one more disclosure hurdle that most investors are not prepared to verify.

In cases when there is no independent audit and no AIMR compliant reporting, my company requires the Advisor to provide detailed records of actual customer accounts, randomly selected, usually in the form of monthly brokerage or mutual fund statements.  We compare the actual results in the customers' accounts to see if they match the performance record provided by the Advisor.  Believe me, they don't always match! 

On more than one occasion, we have visited Advisors that advertised outstanding results, but when we looked at the actual account statements, we found that the real performance was very disappointing.  If so, we pack up and leave, right then and there.

It is important to note that individual investors may find it difficult or impossible to get this kind of information from an Advisor.  While Advisors regularly provide such detailed information to another RIA like my company, which represents thousands of investors, many are hesitant to provide such detailed information to a single prospective client, unless it is a very large investment. 

One last point on the performance record issue.  Often in the past, I have had Advisors tell me that they could not show me their customer account statements for confidentiality reasons.  Let me tell you, that's a crock!   The routine practice is to "white-out" the names on the customer account statements.  If an Advisor tells you he can't do this, consider that a big red flag!

2.  What Is The Manager's “Methodology”?

Once you have verified that the performance advertised by the Advisor is for real, the next step is to understand generally how the Advisor's investment system works.  There are many different types of investing and trading systems.  Some are fundamentally based; some are technically based; some are discretionary; and many are a combination of these approaches.  Likewise, the use of computers and software varies widely.

Most successful money managers have a well-developed "methodology" that drives their systems.  While successful Advisors tend to protect their "secrets" (certain information is proprietary), they should be willing to explain generally to you how their systems work. 

If the Advisor cannot explain to us generally how the system works, that raises several questions for us: 1) Is there really a methodology and a system at all, or does the Advisor simply trade "by the seat of his pants"?; and  2) Is the system so complicated that maybe even the Advisor himself doesn't fully understand it? 

The point is, you need to have at least a general understanding of how the Advisor's system works, how decisions are made, how it gets in and out, etc.

3.  Is There A Strong “Back-Office” To Handle Administrative Issues, Customer Service, Etc.?

Successful Advisors must have a good performance record - that's a given.  But that's just where it starts.  Once an Advisor generates a signal to buy or sell, the administrative staff must be sufficient to implement the trades, see that they are executed properly and make sure they are allocated in the correct amounts to all the Advisor's various clients.  This operation is commonly referred to as the "back-office."   In addition to the back-office, there must be adequate administrative staff to be able to interface with clients and firms, like my company, that recommend the Advisor's investment programs.

The best way to determine the sufficiency of the back-office operation is to conduct an on-site visit to the Advisors offices.  Meet the key people in person. In such a visit, many facets of the administrative side of the business are reviewed.  This includes everything from how the system works, to trade execution to client statement generation, and all other elements of the business.

In particular, it is important to determine that the Advisor's staff is equipped to handle not only the current assets under management, but even more.   Remember, if an Advisor continues to be successful, it will almost certainly accumulate a larger number of accounts and more assets under management.  Ideally, the Advisor will have a long-term growth plan for adding administrative personnel at successive levels of increased assets under management. 

We also like to see that the Advisor has a serious commitment to the latest computer hardware, software, technology and the personnel to run it.

This is not to say that an Advisor must have a large number of employees to be considered successful.  Many Advisors have outsourced administrative tasks to independent custodians such as trust companies, brokerage firms and even mutual fund families.  The on-site due diligence review helps to confirm that these resources, coupled with the Advisor's internal staff, can handle significant growth in assets under management that we or others may bring about.  The on-site visit has another beneficial outcome.  It allows us to meet and talk with all of the principals and staff, and get a good feel for the organization as a whole.  

4.  Regulatory Skeletons In The Closet?

Most professional money managers are registered with the Securities & Exchange Commission as Registered Investment Advisors.  The SEC has strict regulations that must be complied with in order to avoid regulatory problems.  Not all firms are compliant.  You want a money manager that is serious about compliance with all applicable rules and regulations.

Appropriate due diligence requires that the regulatory history of the Advisor be examined to see if there have been any compliance problems in the past.  Key personnel of the Advisor should be checked out as well.  This is accomplished through review of required disclosure information, a search of the SEC regulatory database, background checks and a review of any reports from on-site SEC examinations.

It is important to realize that many Advisors also have affiliated companies that may be registered under other regulatory bodies such as the National Association of Securities Dealers (NASD), etc. The due diligence process should include a review of the regulatory histories of all such related entities. 

In addition to regulatory background checks, the principal traders should also be questioned about any significant personal situations that may have occurred in the recent past.  An Advisor's performance can be affected by a significant personal event, such as the death of a loved one, marriage, divorce or geographical move.  All of these factors are also taken into consideration while doing a background check of the Advisor.

5.  Does The Manager Have A
Backup Plan In Case Of Emergency?

Ideally, an Advisor will have a back-up plan in case of emergency.  This could mean anything from a medical emergency or death, to an extended vacation, or even a power outage.  We want to see that trading can continue and that client accounts will continue to be serviced.  Some Advisors are "one-man shops" with no such backup, so they are generally overlooked when considering potential Advisors for our clients.

Even if an Advisor has a good administrative staff or has outsourced back-office operations, this is no guarantee that they could trade effectively in the absence of one or more of the Advisor's principals.  The optimum situation is that the Advisor has at least two or more individuals who are familiar with the trading methodology and the system and can continue the investment programs in the absence of the primary trader.

As a bare minimum, an Advisor should have someone designated who could unwind existing trades and take the program to cash, especially in the situation where the Advisor has died or will be out of the office for an extended period of time.  This gives investors more assurance that their accounts will not be locked into a trade during unfavorable market conditions because of the Advisor's absence.

The recent news about Hurricane Katrina also brings about another point:  What happens if an Investment Advisor can no longer access his or her office and systems?  The SEC now requires all Investment Advisors to have a Business Continuation Plan.  A review of this plan is an important part of all due diligence reviews that we perform, and it should be on your list of questions to ask as well.

6.  Does The Manager Continually Monitor
The System & Make Adjustments?  

A due diligence review of an Advisor should also determine if the Advisor is using an antiquated system that never changes, or constantly monitors and adjusts the system for current conditions.  In the last few years, we have seen market conditions that have no parallel in the past.  Therefore, some Advisors' trading systems were blindsided and generated large losses.  Being able to adapt to ever-changing markets and market conditions is one of the most important due diligence requirements we have.

This is not to say that the Advisor should tinker with the trading system so much that the program may be significantly different from one year to the next.  The types of changes I am talking about involve periodic adjustments and refinements to the program to stay current with the ever-changing markets, technologies and information flow.

In addition, we require all recommended Advisors to notify us prior to implementing any material changes to the trading system.  In addition, we monitor test accounts established with each Advisor on a daily basis in an effort to pick up on any changes in the trading methodology that the Advisor may have neglected to tell us about.

7.  Do They Invest Their Own Money?

Of all of the additional due diligence requirements that I have, this is one of the most important.  It needs little explanation.  Simply put, if I am going to entrust my clients' money, and my own money, to an Advisor, I want to know they have a substantial percentage of their own money in their programs.  If an Advisor doesn't have his own money in his program, I consider that to be a major red flag.

Interestingly, most of the successful Advisors I have met have a huge amount of their own money invested in their programs - often more than they should.   I am certainly no exception to this rule as I have a substantial amount of my net worth invested in the programs we recommend.  It is my money invested in every program we recommend that serves as our "test accounts" which we use to monitor the results.

Finding The Really Successful Advisors

There are thousands of Registered Investment Advisors in the US.  I can tell you, there are a lot of bad ones, a lot of mediocre ones, and only a relatively small number of truly successful ones.  Most RIAs don't advertise.  So to find the truly successful money managers (unless you just get lucky), you must have a serious commitment of time and money to do so.

At my company, we have a serious annual budget for identifying successful money managers.  We subscribe to expensive databases that include information on RIAs and other money managers.  In addition, we attend conferences each year where RIAs and other money managers gather.  And as discussed above, we conduct an on-site due diligence visit with the RIAs before we recommend them to our clients.

Most individual investors simply do not have the time, the experience or the money to travel the country as we do in search of truly successful money managers.  

Conclusions

This analysis of due diligence considerations should give you a pretty good idea of what it takes to evaluate mutual fund managers, managed account Advisors and hedge fund managers.  Now all you have to do is apply these principles to the thousands of available funds and Advisors in the marketplace.

Unfortunately, most investors never take the time to ask even a fraction of the questions necessary to get the information discussed in this article.  Most also have no desire to travel all over the country and conduct this type of intense due diligence.  Even if they did, most investors are not equipped to evaluate the answers given to many of the questions discussed above or the operations of funds and Advisors. 

This is not to say that most investors are not capable of asking the right questions and demanding honest answers.  It's just a LOT of work, and a great deal of experience is necessary.  I have been continuously evaluating money managers and funds for over 25 years.  Today, more than ever, it is still a continuous learning experience, even for me.  Experience is a precious commodity, as we all know.

As noted earlier, some Advisors will simply not make all of the information discussed above available to an individual investor, especially one who is interested in opening up only a relatively small account.  As a result, individual efforts to perform effective due diligence on funds and Advisors usually ends up in only partial success.

The good news is that ProFutures already has the staff, expertise, experience and the annual budget necessary to search for successful money managers and engage in the due diligence process on behalf of our clients.  We also have the necessary hardware, software and database applications to be able to monitor performance on a daily basis as well as identify new prospective Advisors. 

We do our daily monitoring , by the way, by tracking my personal accounts with every Advisor we recommend.  I have my own accounts in every program we recommend to you.  As they say, I eat my own cooking.

If you are interested in the programs I recommend, give one of our Investor Representatives a call at 800-348-3601.  You may also contact us via e-mail at mail@profutures.com.  You can also visit our website at www.profutures.com to learn more about the kinds of investment programs we offer.