Thursday, January 29, 2015

Hedge Fund Industry Profits To Fall 30 Percent: Citi

Although little changed in terms of fees and expenses in the hedge fund industry, performance took a bite out of profits in 2014

The hedge fund industry saw a decline of 29.8% in profitability in 2014, according to Citi’s 2014-15 Annual Hedge Fund Operating Metrics Survey. Citi found that in 2013, profits from the hedge fund industry were $31.2 billion, but in 2014, they fell to just $21.9 billion.

Little change in hedge fund fees

The firm’s analysts found, however, that very little changed within the industry. They did discover a “modest improvement” in operating margins despite there being little to no changes in the management fees Hedge Fundsare charging.
Total fees ranged from 1.55% to 1.73% last year, compared to 2013’s range of between 1.53% and 1.76%. Citi reports that hedge funds with between $7.5 billion and $14 billion in assets under management continued to charge the most in management fees. In 2013, the firm said the biggest hedge funds in their survey, which are those with more than $14 billion in assets under management, were charging the least amount of fees.
However, that changed in 2014, with the smallest hedge funds, or those with an average of $100 million in assets under management, becoming the funds with the lowest fees. Citi researchers said this demonstrates the necessity of the funds to “use economics” to attract funds.
“Not too much should be read into this shift, however, since the changes were so modest as to be statistically insignificant,” they added though.

Little change in hedge fund expenses either

Citi also didn’t find much change in average management company expenses. In 2014, the firm had 149 firms representing $580.9 billion in assets under managementin its data pool. In 2013, the data pool contained 114 firms with $415.2 billion in assets under management. (All graphs are courtesy Citi.)
Hedge funds Citi
However, even though Citi expanded its data pool, the firm said there wasn’t much change in operating expenses, as they remained within 7 basis points of where they were in 2013 for all firms that managed more than $350 million in assets.
Hedge funds Citi
Smaller hedge funds did see a noticeable decline in expenses though, as they fell from 244 basis points to 224 basis points for this category. Their average headcount remained at 10, although compensation was down in all categories except for compliance in 2014. Third-party expenses also fell, declining 23 basis points, and marketing expenses fell 20 basis points.
However an increase in technology spending partially offset those declines, as it rose 26 basis points.
Hedge funds Citi

Hedge fund performance plunges

Citi also found that the performance of the hedge funds in its study fell off “sharply” in 2013 in every tier of fund according to assets under management. Performance ranged from 2.9% to 5.5%, compared to 2013’s 8% to 13% performance.
Hedge funds Citi
As a result, the firm expects all hedge fund tiers to see “significantly” lower revenues from performance fees. This will especially impact smaller hedge funds, which Citi analysts believe will see their total performance fee pool fall from $6.7 billion to $2.9 billion in 2014.

Hedge fund industry profits

Based on the findings of the survey, Citi states that small hedge funds will see operating expense shortfalls of about $3.5 billion across the full tier, leaving them with only $2.9 billion in revenues from performance fees. Since all of that is needed to cover the shortfall, they remove it from “any potential measure of industry profits.”
Hedge funds
That means there’s $18.3 billion left in their pool, and they expect half of that will be used to cover bonuses for hedge fund employees. The rest of it, they think will be carried forward as profit and thus be taxed at about 20% for capital gains. Their after-bonus, after-tax measure of performance fee profits is $7.3 billion. They combine that with the $14.6 billion they estimate in profits for management fees, thus resulting in their expectation of $21.9 billion in profits for the hedge fund industry, a nearly 30% year over year decline.
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Sunday, January 25, 2015

Median Stock in MSCI World Down YTD (thru Mid-Dec)

The median year-to-date performance in the MSCI World Index with two weeks of trading left is -1%. The median stock was up 20% at this point last year and was up 13% at this point in 2012.


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The developed country with the worst median performance YTD is MSCI Portugal. The median stock is down 35%. The developed country with the best median performance YTD is MSCI New Zealand. The median stock in MSCI New Zealand is up 14% in USD terms.

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The major country indices in Europe are all unsurprisingly negative year-to-date. The median stock in MSCI Germany is down 10%, in MSCI France is down 10%, in MSCI Italy is down 12% and in MSCI Spain is 8%

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The median performance year-to-date in the MSCI USA is 9%. The only other developed country indices with positive median performance YTD are MSCI Hong Kong (6%) and MSCI Ireland (6%).

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Stock Market Leadership on a Country Basis Has Never Been Narrower

The United States stock market has been the only game in town. The US the only major developed country to have outperformed the MSCI World Index over the last year, joined only by the much smaller markets of New Zealand and Hong Kong.

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Performance of Developed Market Countries Relative to MSCI World Index in USD:
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Monday, January 12, 2015

The Wild, Wild East: Risks and Opportunities in Russia

Annexing Crimea, sponsoring a violent separatist movement in eastern Ukraine, and provoking many countries to impose economic sanctions—Russia has been in the headlines for the past nine months. In December the ruble fell by 32% in two days and the stock market fell by 22%. Both have since bounced back, largely recovering the short-term losses. While prudence cautions against concentrating one’s investments in Russia, current market prices offer alluring risk premiums. The ruble is cheap, interest rates are high, and dividend yields of Russian companies are among the highest in the world. 

Investing in Russia has never been easy. In the 20th century, Russia defaulted twice, massively. Early in the century, the Bolsheviks seized all private capital. The previous owners lost not only their property but also their lives, if the Bolsheviks could find them. The disintegration of the Soviet Union at the end of the century produced a series of defaults. Western investors recall the 1998 default on government obligations that resulted in the collapse of Long-Term Capital Management. Those inside Russia remember the hyperinflation of the 1990s, which had the economic substance of a default by reallocating wealth from citizens to the government, and “privatization,” the redistribution of public property to a small group of new owners. 
Today, Russia presents extreme risks and plentiful opportunities. The economic risk of low oil prices is compounded by risks arising from the country’s foreign policies and internal politics. The actions of Russia’s nationalist government in its ongoing conflict with Ukraine and the resulting economic sanctions imposed by the West are raising the odds of default. And yet, while markets are rightly fearful, Russia needs western capital and is willing to pay dearly for it.
Political Risk
With its vast and thinly populated area, Russia always feels threatened. Its political elite employs a security apparatus that seems paranoid to outsiders. Reflecting the fear that other powers plan to dismember the country, Russian foreign policy is oriented toward promoting puppet regimes in bordering countries. The leader of Kazakhstan has been in power for 25 years and the leader of Belarus for 20 years. These pro-Russian regimes in former Soviet states are undemocratic dictatorships, some with strong criminal inclinations.
Russia’s “friendly bordering dictator” doctrine is unstable and tends to backfire. When the populations of these bordering countries become fed up with the Russian-supported dictator and try to install a more responsive government, Russian authorities interpret the political movements as anti-Russian plots instigated by foreign intelligence services to undermine Russian security.
Internally, Russia’s political and civil institutions are centralized and archaic. Russia does not have an effective multiparty democracy; it is a one-party state. United Russia is a political machine for Vladimir Putin to direct the bureaucracy and drive legislation through the parliament. The principle competition is the Communist party, whose agenda is to re-nationalize the economy. The third largest party represents ultranationalists who espouse even harsher militaristic policies than Putin’s. To be sure, these other parties are more political theater than serious opposition.
Putin and his “party” control the Russian media. The stories told on TV remind western observers of Orwell’s novels. Russia tolerates a small nongovernmental media sector that allows independent voices to let off steam—but in a controlled way. The Russian government has learned that countenancing the appearance of unhampered thought enables it to control information even more effectively. Orwell did not foresee this tactic.
The Russian legal system is subservient to its political leadership. As a result, Russian companies, both state-owned and private, suffer from official corruption. Investors need to take financial reports with a grain of salt. A telling fact, in 2002 Gazprom received an Ig Nobel prize in economics for “adapting the mathematical concept of imaginary numbers for use in the business world.” To be fair, Gazprom shared its prize with Enron and many other companies. Nevertheless, investors scrutinize Russian financial reports with skepticism. As in other emerging markets (and a few developed markets too), the regime often redirects cash flow to its political priorities and away from investors.
Economic Risk
On a map of the world, Russia is hard to miss. It is the largest country by surface area. Nonetheless, Russia is sparsely populated and has an undiversified economy.1 Covering one-sixth of the dry surface of the earth, Russia holds huge reserves of mineral deposits. In international trade, Russia mainly focuses on exporting its natural resources. Close to 70% of Russian exports are energy related (see Figure 1). When energy prices fall, the country’s revenue stream tends to dry up.

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The price of oil fell from $100 at the end of June 2014 to $60 in December 2014. This dramatic drop in fossil fuel prices is partly explained by technological advancements in natural gas and oil extraction in the United States, boosting supply, and partly by temporarily depressed demand due to slowing growth in China and Europe. The lower price of energy, Russia’s principle export, has certainly caused economic pain. But that’s not the whole story. Other countries that are heavily dependent on oil export revenues—for example, Norway and the United Arab Emirates—are not experiencing Russia’s levels of inflation, currency turmoil, and stock market instability.
Default Risk
Why do investors fear a Russian default? To begin to understand today’s default risk, consider the structure of the Russian debt to outsiders, shown in Figure 2.

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Russia’s current foreign debt is not large: $731 billion, or about 34% of Russia’s annual GDP. Direct government debt is $73 billion and state-owned banks and corporations owe an additional $304 billion. By international standards this is benign. U.S. external debt is close to 100% of GDP, for example. In consideration of Russia’s $478 billion currency reserves, accumulated over the past decade, it seems absurd to worry about default.2 Events in Ukraine, as much as the drop in oil prices, are the catalyst for the current Russian financial crisis. When Ukrainians decided to oppose the transformation of their government into another “friendly bordering dictator” regime, Russia annexed Crimea and instigated a militant separatist movement in eastern Ukraine. While the Georgian conflict in 2008 was short and limited in its effect on the Russian economy (Lawton and Beck, 2014), the Ukrainian conflict has had a much bigger impact. Russian and pro-Russian maneuvers resulted in thousands of deaths (including the 283 passengers and 15 crew members aboard a Malaysian airliner that was shot down in September 2014). In response, Western powers imposed economic sanctions. 
To date, the sanctions have been relatively mild. They are nowhere close to the sanctions imposed on Iran, Cuba, or North Korea. Many countries, notably Germany, rely heavily on energy imports from Russia and oppose outright trade restrictions. European banks are ill positioned to absorb defaults on Russian debt. If the present Russian military line persists or becomes more aggressive, then there is room for significantly harsher sanctions; but under the comparatively weak sanctions now in force, Russian companies still generate sufficient revenue to service their debts. 
Thus the present crisis is a solvency problem, not an inability to service debts. Many Russian companies need to refinance their hard-currency debts. Sanctions prohibit this refinancing. Russia’s biggest oil company, Rosneft, seems to have created the turmoil which caused the ruble to drop so sharply in December. According to the Financial Times (2014), Rosneft has $19.5 billion in debt due next year. If oil prices stay at the current $60 a barrel level, its revenue will cover only $15 billion; it is short $4.5 billion. Rosneft recently placed the equivalent of $10.8 billion in a ruble-denominated bond offering, and it is rumored that the company substantially converted the proceeds into dollars to replenish its reserves. Apparently, this transaction caused the recent panic in the currency and stock markets.
Rating agencies forecast a chain of bankruptcies and have already lowered Russian sovereign and private credit ratings. The Russian central bank has resorted to emergency measures. In addition to facilitating the Rosneft bond deal, it raised interest rates to 17% (from 10.5%) to make ruble accounts more attractive and discourage residents from converting rubles into foreign currencies.
Opportunity for Investors
Logically, this crisis should pass. Russia has ample internal reserves. Europe relies on Russian energy and it will take decades of infrastructure investment to lower this dependence. Russia needs foreign capital and foreign technology to improve its economic efficiency. Many sectors of the Russian economy are shockingly unproductive: A Russian worker is about 70% as productive as a Chinese worker and about 17% as productive as a U.S. worker.3 If the Russian government does not further escalate its intervention in Ukraine, or even softens its political position, then investors might profit handsomely from the current investment opportunities. 
The Russian government can also afford, however, to advance a significantly tougher military policy in Ukraine. Russian citizens have endured rougher economic environments. When in the 1990s the income of ordinary Russians fell to African levels, many relied on homegrown vegetables to survive. Putin’s approval ratings today are at all-time highs (close to 85%). Those considering investing in Russia should recognize the rising risk of loss through default and/or nationalization. In investing, what is comfortable is rarely profitable. Investing in Russia now is definitely discomfiting, but it might pay off in the long run.
Endnotes
1. Russia is the ninth largest country in the world (between Bangladesh, the eighth, and Japan, the tenth). Its population is mostly concentrated in the European part of the country. Russia is also ninth by total GDP (between Italy, the eighth, and India, the tenth).
2. To understand incentives to default, it is helpful to consider the net investment position of Russia, or how much Russia owns outside its borders minus how much Russia owes to foreigners. The net investment position of Russia is approximately positive 9% (as of June 2014)—Russia owns more than it owes—and it is therefore not in its interest to default. For comparison, the net investment position of the United States is –38% (as of September 2014). Data sources: The Central Bank of the Russian Federation, the World Bank, and the U.S. Department of Commerce Bureau of Economic Analysis. 
3. Bush (2009) attributes the figures mentioned here to Strategy Partners, a Moscow management consultancy. He also refers to a survey conducted by McKinsey estimating a somewhat higher level of productivity: a Russian worker is 26% as productive as a U.S. worker.
References
Bush, Jason. 2009. “Why Is Russia’s Productivity So Low?” Bloomberg Businessweek (May 8).
Financial Times. 2014. “Rosneft and BP: Trading Problems. December 17. 
Lawton, Philip, and Noah Beck. 2014. “The Ukrainian Crisis: Should Investors Avoid the Russian Stock Market?” Research Affiliates (April).
Please note that transactions in new issues of certain Russian debt and equity securities are subject to directives issued by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) and certain transactions involving specifically listed individuals and securities are prohibited by law. More information regarding these sanctions and related directives can be found at http://www.treasury.gov/resource-center/sanctions/Programs/Pages/ukraine.aspx.

The Danger of One Year Performance Numbers


“Investment wisdom begins with the realization that long-term returns are the only ones that matter.” – William Bernstein
Now that 2014 is in the books, I’m starting to see the usual flood of annual performance reviews to show what worked and what didn’t. I’ll save you some time – U.S. large cap stocks and long-term U.S. treasury bonds were the place to be and outperformed just about everything else to some degree.
As you read these pieces you get the sense that the authors are shaming you for not being invested exclusively in only the best performing assets. This myopic view of a single annual period completely misses the point of long-term investing and it’s the reason most people fail when implementing a portfolio strategy.
Assuming you have a legitimate investment plan in place, you should never feel ashamed that your portfolio doesn’t keep up year-in and year-out with the best performing strategies. It’s madness to think that way. It can only lead to stress and future pain from chasing the wrong types of investments.
Everyone preaches risk management right up to the point that annual performance figures are updated. That’s when the insanity of the performance chase and second guessing begins. Every single year long-term investment strategies “die” or “fail to work.” And every single year gullible investors fall into the trap of assuming they’ll be able to pick and choose the best performing asset classes.
The best long-term investment strategies will never be the best performers in any given year. They only show their true colors over much longer periods.
As Rick Ferri once said, “Asset allocation is for patient people.”

Monday, January 05, 2015

How did CAPE do in 2014?

The median stock market had a negative year in 2013 of -1.33%
The average of cheap markets (defined as cheapest 25%) declined -12.88%
The average of expensive markets gained 1.36%.
The names have shifted around a little bit (I sent updated values to Idea Farm members earlier today) but the cheap ranks are still dominated by the continent across the Atlantic, and Russia and Brazil…
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Buggin out in 2014

Barry Ritholtz said something that really hit home. He eloquently stated, “In a diversified portfolio some asset classes will be lagging, and some leading; this is a feature not a bug.” With dividends reinvested and no fees, the S&P 500 returned over 13% in 2014. The portfolios I manage garnered less than half of that. Though I did not violate Warren Buffet’s two cardinal rules of investing: Don’t lose money and always refer to rule number one, this was a disappointing outcome. What the hell happened? In the words of James Osborne, “Diversification sucks!” 

Strike One – In 2014, a globally diversified portfolio returned about 2%; emerging markets lost 3% and developed foreign markets lost 7%. I am a firm believer in index funds and a smart passive investing strategy. I am first to admit, I have no idea what asset classes are going to outperform, so I buy lots of them to be safe. I don’t want to get on the bad side of Cullen Roche, so I try to create portfolios similar to world stock market capitalization. The U.S. represents less than 50% of all value, so to be true to my word, a hefty portion of clients’ assets is invested outside our borders. I may have had a sucky year but no one can accuse me of home country bias! This became an enormous drag on returns. A 50% allocation earning 11% in the U.S., combined with a 50% component losing 7% in foreign markets leads to a return of 2% for your equity allocation. We are all supposed to hate something in our portfolios but this is a bit much.
Strike Two – At the beginning of the year it seemed like foreign markets were cheaper than those in the U.S. I look at the CAPE ratio and follow Mebane Faber‘s stuff. I even included GVAL, an ETF that invests in the world’s cheapest markets in some portfolios, including my own. While I strongly believe this will work out in the long term and is well constructed, my brilliant allocation to these nations has led to double-digit losses in the short term. Cheap markets can get cheaper and expensive markets can get more expensive. Lesson learned. The good thing was I had a lot of tax loss material in the taxable accounts, which I replaced with similar funds to avoid the wash sale rule. In a year of massive suckdom, I will take what I can get.
Strike Three – I, along with pretty much everyone else, thought interest rates would rise this year. If you didn’t think that, you are either a liar or Jeff Gundlach. Therefore, I was terrified of long-term bonds, which rewarded my timidity with a return of 30%! Keeping duration short, and leaving cash available to take advantage of the predetermined spike in rates, left a return of about 0% for this asset class. Lesson learned, the consensus is always wrong.
So in order to have a tremendous year, an all-U.S. large-cap equity portfolio would have needed to be combined with a long-term U.S. bond fund plus a dash of REITS, which returned about 30%. Full disclosure, I am not a complete nincompoop and had a 5% allocation here. Looking back, I would I have never created such a portfolio. I can sleep comfortably knowing that I am not a victim of hindsight bias.
What to do going forward? Rush into large cap U.S. stocks, Long Term Treasuries and REITS like there is no tomorrow? Maybe I should jettison my most hated nemesis, emerging market ETFs and their partners in crime in Europe and Asia? All of the short-term bond funds and cash could be deployed into high duration funds to take advantage of the permanent collapse in interest rates. Maybe I should purchase triple leverage U.S. dollar funds to brilliantly play the trend that the dollar will continue to rocket skyward? After all, many commercials say foreign exchange trading is pretty easy (full disclosure: I was an FX trader; I can assure you, it is not). Allocating a huge portion of portfolios to the utility sector, which was the best performer in the S&P last year, cannot be done any sooner (though they are selling at historic nose-bleed valuations). Damn the torpedoes and full speed ahead! Should I make these moves on the opening bell January 2, 2015? In the words of LL Cool J,” I don’t think so!”
I have a strong belief that a globally diversified portfolio is man’s best chance in the turbulent and unpredictable world of investing. As Michael Blatnick has proven with brilliant research, most well-thought out strategies work if you stick with them. Falling victim to the “recency effect” will guarantee massive nonperformance proven by the behavior gap that afflicts the majority of individual investors. Market timing is impossible. As far as forecasts go, Ben Carlson sums it up perfectly with his quote, “Genius must be proven. “Looking at these alternatives, a globally diversified portfolio looks pretty good for the long term, warts and all. 

The markets will do what they will do and investing is not for the meek. Rick Ferri recently stated, “Opportunities outside the U.S. are at least as good inside.” I hope he is right. The old saying regarding investing still holds sway: If it feels good, you are probably doing something wrong. This too shall pass and mean reversion will eventually arrive. In the meantime, I cannot get the words from Run- D.M.C. out of my head, “‘Mary, Mary, why ya buggin?”

Futures Market Winners/Losers of 2014

This year was anything but boring in the futures markets. There were plenty of major moves in multiple markets, and it seems just about every market not at 5 year highs (stocks, the US Dollar, and cattle) was at 5 year lows (Crude, Copper, Yen).  That’s in stark contrast to the past few years, where there’s been more markets up than down.  But it was two black liquids stealing the headlines – with Coffee leading the way on the upside, and Crude Oil the big loser on the downside. All those who had the Long Coffee/Short Oil trade on, take a bow – that’s a winner! (What could we call that – the Texas Latte, the Beans over Barrel spread?)

[Please note – Finviz does some weird things around contract rolls, which can make their percentage gains over longer periods different than what would be found using a continuous contract or the cash/spot market, nonetheless, we feel it is representative of each market’s 2013 movements]:
2014 YTD Futures(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Finviz
  • It was a mostly down year, with 63% of markets down; compared with 51% up in ‘13, 80% up in ‘12, and 85% up in 2010
  • While it seemed more volatile this year, just 15 markets finished up or down more than 15% (compared with 16 last year).
  • Having said that – VIX futures finished about 20% higher than where they started the year, despite stocks at all time highs (curious)
  • US Stocks & US Bonds turned in near identical performances in 2014, both up around 12%. Not every day you see that.
  • Commodity markets were routed. Crude made the headlines, but Cotton, Soybeans, Rice, Oats, Platinum, Sugar and more were all down double digits.
  • Gold, for all the headlines, was basically unchanged
  • Currencies were in play, for the first time in what seems like forever, with the USD making a very sneaky move up to multi year highs; the Japanese Yen and Canadian Dollar hitting 5 year lows, and the Euro, Aussie, and Swiss testing multi-year lows.
  • The headliner Coffee was up impressively, but despite being up around 50%, it’s still about 50% below its 2011 highs (needs to rise 100% or so to get there)
  • Many markets are at 5 year lows, including:  energy futures (Crude, Heating, Gasoline), many metals (Silver, Platinum, & Copper), currencies (Jap Yen and Canadian Dollar), and a few random like Cotton,
  • Wheat & Corn – Despite being some of the most volatile futures markets, you wouldn’t know it by this chart, down only (-1.9% and 4.7%) this year
So what will 2015 bring? A big rebound in Oil prices (a rise back to $80/barrel would be a gain of about 60%)? The much expected sell off in US treasuries? A commodity rebound in metals, softs, and grains? None of the above?
Luckily, professional managers don’t need to know the answers in order to have a successful 2015. They just need to be able to identify and capture any such moves when they happen (no small task, to be sure; as we’ve seen in recent years….but more than a few will be up to the task).

Monday, December 29, 2014

Various anecdotes

  • Barring a disastrous year-end, the S&P will log its 3rd year of double-digit gains. Haven't done that since '95-'99.
  • Last 2 Years - S&P vs. FTSE All-World Ex-US ---- S&P up 50%, Intl' Stocks up 20%. (see chart)


  • There have been 4 times since 1970 when the S&P outperformed international equities at the rate witnessed in 2014. Each time, in following year, world ex-US beat US by average of 14%.
  • Jim Grant's Holiday Card (see picture):



  • Greece 10 Year Bonds:
    • December: 9.7%
    • November: 8.2%
    • October: 7.1%
    • September: 5.5%
  • US Stocks vs. Bank Loans (SPY vs. BKLN): +12.8% vs. -3.8% (someone's wrong...)
  • 100% of 94 economists expect higher US bond yields in 2015, 96% see US growth above 2.5% (Bloomberg survey)
  • The massive investment into stocks for the week ended December 24th was largest since Lipper started tracking the weekly statistic in 1992.
  • NASDAQ is within 5% of reaching its 2000 peak (15 yrs...)

We had everything before us, we had nothing before us…

While the S&P 500 is on track to conclude another stellar year of gains, those who sought to beat the index are poised to finish with a more dubious distinction. According to Lipper, 85% of all active stock mutual fund managers had been trailing their benchmarks through the end of November. In a typical year, there are nearly twice as many managers outperforming, with only around two thirds of funds struggling to catch up. Lipper says this is the worst year for active managers relative to the market in three decades.
Stock pickers encountered difficulty this year in part because of concentration at the top of the market. Just five stocks—Apple, Berkshire Hathaway, Johnson & Johnson, Microsoft, and Intel— accounted for 20% of the market’s gains. If you weren’t at least equally weighted toward them, you had virtually no shot at making up for missing their enormous, index-driving gains. A majority of the market’s stocks did not perform nearly as well. According to the Leuthold Group, only 30% of S&P 1500 stocks posted gains exceeding the index itself. You’d have to go back to 1999 to see anything like this.
Fund shareholders weren’t wasting any time reacting to this year of disappointment. Collectively, they’ve added just $35 billion to active stock-picking funds in the last 11 months, less than a quarter of the $162 billion they added in 2013, which was the first year of positive flows for the industry since 2007. This is not to say that they were sitting still. ETFs and passive index funds took in over $206 billion in net deposits through Thanksgiving, and Vanguard surpassed the $3 trillion mark sometime in late summer. Investors seem to have decided that they’d rather bet on the horses than the jockeys, after all.
The malaise was not confined to those picking individual stock winners. Through December 1, aggregate hedge fund returns trailed the market to the point of farce. According to data compiled by Bloomberg, hedge funds were up an average of 2% on the year, just barely offering the coupon rate of a risk-free 10-year Treasury note. Over 1,000 funds are on track to close down in 2014, the worst year for liquidations since 2009.
Among the gargantuan hedge funds that make up a majority of the industry’s assets under management, dispersion of returns shot up to notable levels. And for every big winner, like William Ackman’s Pershing Square, there was a big loser to counterbalance it, like John Paulson’s Advantage Fund. Investors choose hedge funds for their “non-correlated returns,” meaning a tendency to move opposite from the general market’s direction. They certainly got such returns this year, unfortunately.
Financial advisors and asset allocators who had been hoping to see some benefit this year from tactical strategies were also not spared the punishment of a capricious market. Of the top three tactical strategies in the country (Mainstay Marketfield, Good Harbor U.S. Tactical Core, F-Squared Premium AlphaSector Index), two had nearly imploded with double-digit losses while the third found itself under SEC investigation for misleading the public about its historical returns. The other giant tactical manager, Schwab’s $9 billion Windhaven Diversified Growth product, looks to end 2014 with a return close to zero. So much for tactics.

Junk Bond Risk Appetites Imply Stocks Should Fall At Least 13%

Since the bull market was born in March of 2009 until this summer high-yield risk appetites (as measure by the ratio of the high-yield ETF to the 5-year treasury bond) and stock prices have had a 98% correlation coefficient.

sc-6Clearly, the chart above demonstrates that the strength in junk risk appetites led stocks off the lows back in 2009. Over the past summer, however, junk bonds started to lag stocks for the first time since the bull began (or lead lower, depending on your perspective). Since then the divergence has only gotten wider with each subsequent new high in the stock market:
sc-7So what’s going on? Why the sudden shift in equity risk appetites relative to high-yield?
Well, the popular explanation has been that the junk market has a much higher exposure to energy so the oil crash will have a much larger impact. For that reason, stocks are rightly “decoupling” from the junk market, or so it goes.
To me this argument sounds more than a little specious. The energy component in junk is about 14%. This compares to an 11% weighting in the S&P 500 so there’s a difference there, to be sure, but not a very significant one.
And as Howard Marks recently wrote, “It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general ‘contagion.'”
The energy boom over the past few years, driven by fracking technology, has been a major boon to the overall economy. The fact that fracking is now unprofitable means that boom is likely to bust. Believing that the boom was a positive but the bust won’t be is wishful thinking at best.
Interestingly, this morning T. Boone Pickens said he believed that weak demand was more to blame for the crash in the price of oil than excess supply. If this is the case it has much greater implications for the economy than if supply were the main culprit.
But setting the energy debate aside, investors should also consider the action in investment grade yield spreads which have widened, as well. They only have 6% exposure to energy so are much less exposed to the potential bust.
Leveraged loans are only made up of 4% energy. Still, risk appetites there have been just as weak as those in high-yield:
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To me, this all points to broader risk appetites responding to growing risks within AND beyond the energy sector or what Marks refers to as, “contagion.”
But why should these risks matter to equities? The answer is because high-yield bond investors and equity investors face the very same risks. What is the ultimate risk in owning a high-yield bond? It is the risk of the company falling into a situation where their income can no longer support their debt and they are forced to default.
The ultimate risk for equity investors is just the same. However, bond holders have seniority over equity investors. Equity investors, in fact, face even greater risk of loss of principal than high-yield or leveraged loan investors do because bond holders usually have some sort of covenants that hopefully ensure recuperation of their principal to some degree. This is not the case for equity investors.
You would think, then, that when bond holders begin pricing in greater risk of default equity investors should sit up and pay attention (at least some do). So I find it very fascinating that while investors in the debt markets are pricing in greater risks, equity investors feel comfortable in paying ever higher prices (accepting less and less “margin of safety”).
Historically, it’s equity investors that prove to be oblivious to the growing risks that high-yield investors begin to pay attention to rather than high-yield investors overreacting. As I’ve written before, high-yield spreads widened dramatically prior to equities topping in out in both 2000 and 2007 . In those cases, bond investors obviously proved to be fairly prescient. Today’s divergence between the two is even greater than those past episodes.
Given that the correlation between the two is so high and for good reason, it’s interesting to note that junk bond risk appetites now imply a level of 1800 on the S&P 500 (based on their daily correlation over the past five years of 98%), fully 13.5% below its current price. Now I don’t know how this gap will be closed, whether stocks will decline or high-yield risk appetites will recover or some combination of both. I do believe, however, that the bond markets are pricing in increasing risks that some have been warning about for quite some time and that the equity market, for the moment, is ignoring.
So who are these indiscriminate buyers in equities? It’s not retail investors. As Jason Goepfert pointed out in his letter last night, outflows from mutual funds and ETFs have been above average even for December, a month where we typically see outflows.
My guess is that it could be a various group of the dumbest of the dumb money. In that group I would include indexers who are value agnostic. (Don’t get me wrong; I’m a fan of roboadvisors but I recognize the risk their growing popularity poses.) I would also include algorithmic trading, which buys and sells stocks based on who knows what (a couple of words in the Fed statement?), certainly not any kind of traditional investment philosophy. Finally, I would point to foreign buyers who are desperate to escape the confines of their weakening economies, plunging currencies and falling equity markets at home.
Again, I’ll refer to the brilliant Howard Marks:
For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion.
This is definitely now occurring the fixed income markets. In the equity markets I believe they are still, ‘moving out the risk curve without cognizance of the risks they are taking.’ But if Marks is right and we are now switching from a period of “risk on” to “risk off,” the widening in high-yield spreads (inverted) may have much farther to go:
fredgraph-2
And if that’s the case, 1800 on the S&P 500 may be only the beginning.

Monday, December 22, 2014

Howard Marks - Oaktree Memo: Lessons of Oil

http://www.oaktreecapital.com/MemoTree/The%20Lessons%20of%20Oil.pdf

Value Investing: Digging Manager Graveyards Since 1900.


Following value strategies can be hazardous to one's wealth in the short run.

Oil stocks are a great example of the challenge value investors face:
The stocks are down big--and getting cheaper--but could go down even further!

Successful value investors are able to buy and hold cheap stocks for a number of years and avoid short-run noise.

However, if you are an emotional and impatient investor, you should think twice before you invest in a value strategy.

Here is an article we wrote on this subject:
We dig a bit deeper into this concept in this post.

Preliminary Details

Here we construct a value portfolio of mid/large cap stocks (formally above the 40th percentile for NYSE market capitalization). We select the top 10% of stocks in the universe based on EBIT/TEV, and rebalance the portfolio annually. The portfolio parameters specifics are similar to those outlined in our valuation horse race paper. We want to examine, at a monthly level, how much a value strategy can outperform as well as underperform.

So What Do the Monthly Spreads Look Like?

This graph shows the spread in returns between our value portfolio and the SP500. Monthly spreads can be huge!!!

2014-11-25 09_29_32-Microsoft Excel (Product Activation Failed) - tracking error.xlsxThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Below is a table showing the top 20 best and worst spreads:

2014-11-25 09_33_13-Microsoft Excel (Product Activation Failed) - tracking error.xlsx

2014-11-25 09_34_34-Microsoft Excel (Product Activation Failed) - tracking error.xlsx

Tracking error:

The annualized "Tracking Error" for the value portfolio (Top 10% EBIT/TEV) with the S&P 500 is about 9.38%. "Tracking Error" here is calculated as the Standard Deviation of the difference of the returns between value stocks and the S&P500 benchmark. Compared with many passive ETFs, which have ~zero tracking error, 9.38% is large. Roughly translated, this implies that in any given year, the value portfolio will be all over the map relative to the S&P 500.

Can you imagine a month where your portfolio gets beat by over 5% relative to the benchmark?

As a value investor, this isn't abnormal, you can expect it!

Taking on tracking error is a great way to get fired as an asset manager. As an individual, it is a great way to break your confidence and sell your hated value stocks.

Yuck!

But what is the Upside of Tracking Error Pain?

In a nutshell, the benefit of taking on the pain of tracking error is higher expected performance.

But expect a crazy ride! The markets are generally efficient and there is always a catch: Value investing can work, but it requires a serious commitment!

2014-11-24 14_48_09-Microsoft Excel (Product Activation Failed) - Book1

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.