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August 16, 2007

Duration Mismatch at Sentinel
by Mike Shedlock

The investment objective and allowable investments in Sentinel's 125 portfolio are rather interesting.

Investment Objective:

The 125 Portfolio is intended to provide Sentinel's FCM clients with a short-term investment alternative that combines safety of principal, liquidity and competitive yields compliant with the CFTC's Rule 1.25. An investment in the 125 Portfolio provides an indirect, undivided pro-rata interest in the underlying securities.

Allowable Investments:

• Obligations of the U.S. Treasury and GNMA
• Short term commercial paper rated A1/P1
• Medium and long term debt rated AA or higher
• Bank time deposits
• Repurchase agreements collateralized by the above

In order to accommodate the liquidity needs of FCM clients, this portfolio will, typically, hold forty to fifty percent of its assets in the form of overnight repurchase agreements (repos). Special market conditions may dictate higher or lower percentages as prudent departures from the norm.

The problems should be easy enough to spot.
The investment objective clearly states "short-term".
Allowed instruments clearly states "Medium and long term debt rated AA or higher".

Sentinel thought it could "accommodate the liquidity needs of FCM clients" by holding a mere 40% to 50% of its assets in overnight repos. Presumably the rest (50%-60%) could be held in any of the other "allowable investments".

I touched on this yesterday in Excuses at Sentinel Don't Fly when Sentinel halted redemption in its $1.5 billion fund. In a letter to clients Sentinel made this claim: "We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

Questions:
Why are they holding medium and long term paper for in the first place?
How much of it are they holding?

The Bloomberg article Sentinel Management Group Halts Client Redemptions addresses the second question:

The firm's Prime Portfolio pooled account had 82 percent of its assets in floaters, or debt that pays floating-rate interest, as of June 30, according to the Web site. The weighted-average maturity of securities in the fund was 33 years, mostly in corporate securities. Only about 6 percent of assets were in overnight loans.

"Maintaining very short duration helps ensure stable values even in volatile market conditions," according to the Web site.

"They're not honoring withdrawal requests, and the plan is over time to get out of positions," Jeff Barclay, a lawyer with Chicago-based Schuyler, Roche & Zwirner who represents Sentinel clients, said in an interview today. "Their intent is to return money to clients, which is an admirable position, but it's a breach of contract and bad for a client that needs the money tomorrow for a margin call," Barclay said after speaking with members of the firm's legal staff today.

MarketWatch cited Sentinel's website and had this to say:

Sentinel has two main pools of money that it oversees for clients such as commodity and currency traders, hedge funds and wealthy individuals.

The Prime Portfolio had a weighted average maturity of 396 months, or more than 30 years, at the end of June, according to Sentinel's Web site. The weighted average duration of that portfolio stood at 20 months.

The other pool, called the 125 Portfolio, had a weighted average maturity of 19 months and a weighted average duration of five months at the end of June, the Web site said.

Sentinel's FAQ Yanked

I am told by some that the link to Sentinel's FAQ is not working. Here is a Copy of Sentinels' FAQ. Let's take a look at some snips. Bolding below is by Sentinel.

Sentinel uses four techniques to earn high interest without additional risk: Most importantly, Sentinel invests client cash mostly in the overnight market.

Exactly what happens to the cash invested by Sentinel?

The 125 Portfolio and Prime Portfolio consist of money market securities issued by U.S. government agencies, corporations, or short term bank time deposits, all of which meet Sentinel's requirements for liquidity and low risk. Although Sentinel strives to obtain a high yield from all portfolios, the primary emphasis is on safety (low risk) and liquidity.

How is Sentinel different from a money market mutual fund?

Most importantly, clients have immediate access to their cash, regardless of market conditions. (A mutual fund is allowed to postpone redemptions up to five business days in unstable market conditions.)

How frequently can I deposit or withdraw cash?

Sentinel clients can withdraw 100% of their cash daily. Sentinel accepts deposits of any amount daily. A cutoff time of 4:00PM (eastern time) applies for notification of intent to redeem or make deposits same day.

I cannot find the Investment Objectives for Sentinel's Prime Portfolio but I am quite sure that a weighted average of 30+ years does not provide much in the way of either safety or liquidity. To have a weighted average of that duration, it almost seems that Sentinel was banking on clients practically never wanting their money back.

Furthermore it is clear that the FAQ statement "Sentinel invests client cash mostly in the overnight market" is a gross distortion of reality.

What Sentinel investors are sadly finding out is corporate bonds make very poor cash substitutes. And the longer Sentinel waits to liquidate the worse things are likely to get. Sentinel is not doing its clients any favors by halting redemptions especially if "it's a breach of contract" as Jeff Barclay, a lawyer with Chicago-based Schuyler, Roche & Zwirner thinks.

I suspect quite a few "cash management" firms are finding out the same thing that Sentinel is: There is simply no good substitute for cash in a liquidity crisis. At SitkaPacific we were concerned about this before this all happened, not after. Cash in brokerage accounts is held in cash in an account at Citibank, and not in a money market fund or other short-term investments.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

Copyright © 2005-2008 Mike Shedlock

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