Thursday, March 29, 2007

Focus on “Average” Mutual Fund is a Straw-man Argument: Fidelity Research Institute

Focus on “Average” Mutual Fund is a Straw-man Argument: Fidelity Research Institute

20 March 2007

The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management

By: W.V. Harlow, Fidelity Research Institute & Keith Brown, University of Texas
Published: Fourth Quarter 2006, Journal of Investment Management

The search for alternative beta aims to explain some of the unexplained magic and mystery behind hedge fund management. Once we strip these betas from a hedge fund’s return stream, we often conclude that average hedge fund doesn’t have enough alpha left over to justify its fees. Sure, some funds beat their benchmarks. But on average, many say, managers produce no alpha - or worse yet - negative alpha.

But do you need to invest in the average hedge fund (or actively managed mutual fund)? What if you were better than average at picking good managers? In this study, Harlow and Brown say we shouldn’t get obsessed with the ”average” mutual fund manager. Instead we should simply find “good” managers. They call focusing on the average mutual fund a straw-man argument - chosen by indexers because it’s easy to refute:

“…rather than judging the quality of active management solely on the basis of such factors as how the ‘average’ fund performs relative to its benchmark or where a given manager ranks relative to his or her peer group, it is our contention that investors are better served by concentrating their efforts on finding the subset of available managers who are consistently able to deliver superior risk-adjusted returns.”

But first, you would have to know if ”good” managers even exist. A random distribution of manager luck will always yield winners. But in order for outperformance to graduate from the error term in a regression to the coveted alpha term, a manager needs to be persistently lucky.

Reams of studies over the past 20 years have shown that hedge funds, and more broadly, any actively managed funds lack persistence. But the authors argue that some managers out perform expectations at rates that pure dumb luck could not possibly explain. So even though the annual returns of the universe of managers can be represented with a bell curve, some managers seem to end up on the right side of that curve more than half the time.

The researchers calculated monthly alphas for hundreds of mutual funds based on their trailing 36 month betas. They called this number “PALPHA” (Past Alpha). Then they forecasted the expected returns over the next one-month, three-month and twelve-month periods using each fund’s trailing 36 month beta. They called the difference between this expected return and what actually transpired “FALPHA” (Future Alpha). [ed: not to be confused with Average Linear Future Alpha, “ALFALPHA”;)].

Turns out, the FALPHAs were higher than the PALPHAs. This makes sense when you consider that the PALPHAs for each month were derived from a regression on those very same months. So the “best fit” regression line was, well, the best fit. But it’s not necessarily the best fit for data outside of the initial sample. As a result, forward-looking returns naturally show more “unexplained” returns.

In any case, just because a third to a half of funds showed positive FALPHA doesn’t mean you can identify high FALPHA funds before the fact, right? Apparently, wrong. The researchers regressed FALPHA against: PALPHA, expenses, AUM, turnover, diversification, & volatility and concluded:

“The preceding analysis provides clear evidence that investment performance persistence is a statistically significant and identifiable phenomenon that depends on a multitude of observable factors.”

In fact, the two best predictors of FALPHA were PALPHA and expenses:

“…both a fund’s past performance and its expense ratio are especially important controls to take into account when selecting a manager. Focusing on the best manager cohort defined by these two variables increases the investor’s odds of choosing a superior manager from considerably less than one-in-two to better than breakeven; the odds increase further to three-in-five when additional controls for fund turnover, risk, and assets under management are employed in the selection process.”

But in the end, positive alpha doesn’t mean positive returns. And in the mutual fund industry, positive returns sell. In fact, in the conclusion to their paper, the researchers lament how most investors “chase funds with the highest total returns“:

“…our selection process is not representative of the techniques typically employed by intermediaries who service the investment market. In fact, Morey (2005) demonstrates that more easily observable measures of fund quality (i.e., a five-star Morningstar rating) may not be a reliable indicator of superior future performance. Second…it is possible that investors do not have a clear understanding of what constitutes true outperformance, opting instead to merely chase funds with the highest total returns in the immediate past (see Capon et al., 1996). However, many funds that attract incremental flows due to higher past returns may simply be taking more risk; Grinold and Kahn (2000) and Waring and Siegel (2003) caution that investors must be able to distinguish a fund’s actual alpha from its beta (i.e., systematic risk) to identify superior managers.”

So whither indexing? Well according to this study, it’s definitely a more efficient way for dart-throwing monkeys to ply their trade:

“…the preceding analysis makes two conclusions abundantly clear, (i) there is a place in an investor’s portfolio for the properly chosen active manager; but that (ii) the investor who selects funds in a random manner will find indexing to be a better alternative.”

Read Full Paper


Hold on, you say, if certain managers consistently out performed, capital would flow to them and away from persistent losers. The persistent losers would eventually shut down and the median would rise until, once again, half underperform and half out perform. So persistence implies some kind of disequilibrium in the asset management industry. In other words, investors seem to support the losers, keeping them in business and allowing winners to persistently beat the resulting lower median.

Fund marketers will often refer to investor “stickiness” (a.k.a. “patience”). We suggest this very stickiness creates (or at least contributes to) the enduring disequilibrium.

- Alpha Male

Wednesday, March 28, 2007

LDI: Portable Alpha’s First Cousin

27 March 2007

On the family tree of modern investment management ”LDI” and “Portable Alpha” are first cousins. Unfortunately, familial affection doesn’t necessarily go both ways. Portable Alpha is beginning to play a critical role in LDI strategies. But LDI isn’t really a prerequisite for portable alpha. As a result, LDI is a topic that is often ignored by the financial media, or worse yet, obfuscated with actuarial mumbo jumbo.

On Monday, Aon Consulting released its latest study of UK pensions and its findings match those of a similar study conducted by Greenwich Associates (covered last month). According to the Aon study, British pension schemes turned toward alpha-generating alternative investments such as real estate, hedge funds and global tactical allocation in 2006. (ed: The British term “scheme” always gets a chuckle in the US where it takes on more nefarious meaning - one that may ironically be more appropriate for pensions that actually have no way in hell of keeping their promises to growing legions of retirees).

But the study also mentions that 11% of pensions adopted some form of Liability Driven Investment (LDI) strategy in 2006. Similarly, the Greenwich study said that a whopping 37% of pensions were “considering” Asset/Liability Matching.

For those non-actuaries out there, LDI (a.k.a. Asset Liability Matching or “ALM”) essentially recognizes that pensioners don’t give a hoot what the S&P 500 or FTSE did last year. All they care about is getting paid as promised after they retire. As a result, the benchmark against which pensions ought to be measured are specific streams of liabilities. For example, beating the market won’t help if long term rates (i.e. the discount rates applied to determine the present value of a pension’s future liability stream) fall, pushing up the pension’s payout requirements.

Cutting through the LDI hyperbole are two interesting reports published this month - one by Standard Life in the UK and the other by Integra Capital in Canada.

The Standard Life report does an excellent job of putting LDI in an everyday context by comparing it to retail financial planning. The report goes on to state that the challenge facing pensions, is that…

“Pension fund liabilities can be considered as a set of defined payments, or cash flows, due to be paid in the future. They are tricky to model precisely - because of the need for assumptions about pension scheme demographics, implied guarantees offered to clients and salary (and general) inflation. They can vary in value with the stroke of a pen: a change in assumptions can easily lead to a surprisingly large change in the value of liabilities, and thus a large swing in the asset liability matching position, often revealing a fund deficit.”

While this has always been the case, recent accounting standards changes in the UK require pensions to report both their assets and their liabilities - increasing the transparency into the pension underfunding problem. The trick is to exactly off-set the nature and characteristics of a customized “liability benchmark” with corresponding investments. That set of liability-matching securities becomes the new “beta” in the pension’s portfolio. So alpha/beta separation becomes critical to LDI success. Continues Standard Life:

“…the funds must have benchmarks which are close to established futures markets. This permits ‘alpha transfer’, allowing the physical investment to be disconnected from the market risks desired by the fund managers, by using the liquid futures markets to shed or acquire market exposure.”

While the Greenwich study showed US pensions were less concerned with LDI compared to the British, these accounting standards changes are making their way across the Atlantic. In time for the expected scramble, Integra Capital brings together the heads of pensions at Nortel, The Royal Bank of Canada and Hydro One, one of North America’s largest utilities for an LDI roundtable.

Integra’s Tris Lett sums up the advantages of LDI with long term rates fluctuating as they have over the past 5 years:

“A critical improvement with LDI is that you remove that question and simply do what is right relative to the liabilities and not relative to the market.”

Using a quintessentially Canadian metaphor, he expresses concern that pensions think rising interest rates will simply “skate their liabilities back onside”.

Royal Bank’s Adam Bomers ties portable alpha into the discussion:

“The concept of separating alpha from beta is coming into play in the LDI process, as well. A lot of people are talking about things like portable alpha, where they have synthetic exposure to their liabilities through long bonds, and then introduce a fund of funds that looks to generate alpha on top of that. So, it’s really the separation of the two.”

…and John Poos of Nortel reminds us of the family resemblance shared by LDI and alpha-centric investing:

“Alpha, in and of itself, is an interesting piece because we all talk about it as if it’s just there. It’s easy, just go out and buy it. However, investing is a serious game. Someone is winning and someone is losing. If everyone was winning, it would be an easy chore to add alpha. But that’s not the case. For every winner there has to be a loser.”

Tuesday, March 27, 2007

Why Gurus Go to Extremes

March 27, 2007 - Why Gurus Go to Extremes

Are stock market forecasters prone to hyperbole? Is there logic to predicting plunges and melt-ups at probabilities unjustified by rigorous empirical analysis? In their February 2007 paper entitled "Probability Elicitation, Scoring Rules, and Competition among Forecasters", Kenneth Lichtendahl, Jr. and Robert Winkler apply game theory to model the behavior of forecasters who pit themselves not only against the data, but also against each other. In other words, they examine the logical behavior of a forecaster whose reward depends not only on own accuracy but also on the accuracies of competing forecasters. When forecasters compete, they conclude that:

  • Forecasters who want to do better than other forecasters rationally assert extreme probabilities. They are willing to sacrifice raw forecasting performance to optimize relative performance. Forecasters who are more competitive tend to greater hyperbole.
  • This strategy of exaggerating probabilities makes forecasters in general behave as if overconfident.
  • Decision makers can adjust for this motivational bias by revising the probabilities asserted by experts toward 50%.

In summary, forecasters trying to beat other forecasters tend to take extreme public positions that reflect the motivational bias of competition. An investor considering the public forecasts of gurus should probably shift asserted probabilities away from 0% and 100% toward 50%.

Note that the gurus may be unaware of this bias.

More broadly, being correct at the highest possible frequency is not the only game of forecasters. For example, their forecasts may be:

  • Marketing ploys designed to capture fearful or greedy naive prospects, safe in the knowledge that quack detection is difficult when it hard to distinguish skill from luck. (One "big call" may anecdotally outweigh an otherwise extended record of mediocrity.)
  • Attention-getters for the media, designed to boost readership/viewership and thereby advertising revenue.
  • Attempts to manipulate others in support of existing or planned trades.

The tendency to hyperbole seems obvious in the discourse of other fields, such as politics and sports. Perhaps there is a common underlying imperative driving the inhabitants of all environments, both physical and abstract, to expand into every possible niche.

For related research, see Blog Synthesis: The Wisdom of Analysts, Experts and Gurus. See especially our blog entries of 2/16/07 on the diversity and persistence of quacks and 1/17/07 on the apparent lack of relationship between forecasting accuracy and attention.

For examples of extreme stock market forecasts, browse some individual guru forecasting records.

Bill Gross | April 2007

Investment Outlook
Bill Gross | April 2007
Grim Reality

Life, it seems, has become one giant reality show – or is it vice versa? Which is truth and which is the illusion or have both simply morphed into a uni-consciousness that feeds off information from different computers – one the living kind with two arms and two legs, the other more stationary with a plasma and keyboard. My Apple screensaver for instance features a stunning series of pictures of our galaxy and beyond, from detailed midnight close-ups of the moon’s craters to spinning supernovas of unimaginable beauty. While everyone “knows” that those objects are really “out there,” it’s possible to admit that they’re also in “there.” My legs, like Thoreau’s at Walden Pond, can take me outside at midnight to perceive nature from one perspective, or my hands like Carl Sagan’s can move a computer mouse to perceive it from another. Deciding which is the reality though is not straightforward because both are visual images that enter my consciousness as a series of “bits.” It’s only my past experience that commonsensically points to the “out there” as real and the “in there” as an illustration. If I’d been raised and confined in a room with nothing but a computer, the tilt of perception would most likely be in the other direction.

Am I really suggesting that life might lie within “2001’s” HAL as well as on Walden Pond? Modernity is certainly moving in that direction. There is an online virtual world of its own called Second Life, one of many metaverses that can now be accessed via the Internet. On it, or in it, inhabitants can create another life for themselves that goes beyond just the playing of a video game. Inhabitants are displayed as avatars capable of communicating and relating to other avatars in cyberspace. They can walk, cohabit, start businesses, buy homes – in short do just about anything someone can do “out there.” An IBM spokesman, whose company is leading this invasion into a second world, is quoted in the Financial Times as saying “These are real people. Sometimes people see an avatar and think they are watching an animated movie. They are not. Behind every avatar there is a person.” Have you messed up your first life? Why not try a second one. Get a different job, buy another house, become the Henny Youngman of cyberspace – “take my wife – please” – and exchange her for a new one. Success and that illusive happiness can be just around the virtual corner. All very confusing isn’t it. Old worlders would say it’s just a game, because you can’t touch its images. New worlders would say it’s a reality because everything’s just bits of information streaming into a consciousness. They might not have had computers at Thoreau’s Walden Pond, but they do in 2007, and the mystery of life and what defines living somehow has become ever more complex.

Such complexity is also evident in the financing of the U.S. housing market. Long ago and far away there used to be an old “20% down” reality that morphed somehow into a subprime/Alt A cyberspace free-for-all (literally “free for all”). Talk about a second life! U.S. homeownership has expanded from 65% to 69% of households since the turn of the century, in part because it became so easy, and so cheap to finance a home. No avatars in that bunch – they were living, breathing U.S. citizens who yes, might knowingly or unknowingly have taken advantage of “low doc” or “no doc” applications, who might have taken out a “liar loan” in the face of “full disclosure” documentation required of their mortgage lenders, or who simply might just have jumped on board the 1% Fed Funds financing train of 2003. No matter. They bought a house, began living the American dream by making money with someone else’s money, and expected to live happily ever after. Well, not so fast, at least for some of them, it seems. Home prices, as measured by the National Association of Realtors, have gone down by 2% nationally over the past 15 months and there’s fear in the air that it could get worse. It most assuredly will.

The problem with housing, however, is not the frequently heralded increase in subprime delinquencies or defaults. Of course write-offs, CDO price drops, and even corporate bankruptcies of subprime originators and servicers will not help an already faltering U.S. economy. But foreclosure losses as a percentage of existing loans will be small and the majority of homeowners have substantial amounts of equity in their homes. Because this is the reality of our U.S. housing market, analysts and pundits now claim we’re out of the woods: the subprime crisis is or has been isolated and identified for what it is – a small part of the U.S. economy.

It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses. To a certain extent this reluctance to extend credit is a typical response to end-of-cycle exuberance run amok. And if one had to measure this cycle’s exuberance on a scale of 1-10, double-digits would be the overwhelming vote. Anyone could get a loan because shabby credits were ultimately being camouflaged within CDOs that in turn were being sold to unsophisticated foreign lenders in need of yield as opposed to ¼% bank deposits (read Japan/Yen carry trade). But there is something else in play now that resembles in part the Carter Administration’s Depository Institutions and Monetary Control Act of 1980. Lender fears of potential new regulations can do nothing but begin to restrict additional lending at the margin, as will headlines heralding alleged predatory lending practices in recent years. After doubling over 18 months between 2005 and the first half of 2006, non-traditional loan growth has recently turned negative, and lenders’ attitudes are turning decidedly conservative as shown in Chart 1.

Bulls and bears argue over websites as to the percentage of all lending that subprime and alternative mortgage loans provide but while important, the argument obscures the critical conclusion that tighter lending standards and increased regulation will change the housing outlook for some years to come. As past marginal buyers are forced to sell their home to prevent foreclosures, so too will future marginal buyers be restricted from buying them. No one really knows the amount that homes must fall in order to balance supply and demand nor the time it will take to do so, but if one had to hazard a conclusion, it would have to be based in substantial part on affordability statistics that in turn depend on financing yields and home price levels in a series of different scenarios as outlined in Chart 2. The chart shows the amount that home prices or mortgage rates (or a combination of the two) need to decline in order to revert back to affordability levels in 2003, a year which might have been the last to be described as a “normal” year for home price appreciation. Since then, 10+ annual gains have been the rule whereas average historical estimates provided by Robert Shiller may have suggested something on the order of 4-5%. By that measure alone, homes are likely 15-20% overvalued (3 years x 5%+ annual overpricing). Chart 2, in addition suggests much the same thing. If mortgage rates don’t come down, home prices need to decline by 20% in order to reach prior affordability levels. If rates do come down, home prices will drop less.

Chart 2, while somewhat subjective and time dependent, introduces the critical connection between home prices and interest rates. PIMCO cares about housing and its fortunes, but primarily because of its influence on yields. And while the Fed may be willing to allow U.S. homeowners to suffer a little pain as indeed they have in recent quarters, a double-digit decline would risk consequences that few central banks would be willing to underwrite. So a forecast of home prices almost implicitly carries with it a forecast for interest rates. To prevent a double-digit decline in prices, PIMCO’s statistical chart suggests that mortgage rates must decline a minimum of 60 basis points and the sooner the better. The longer yields stay at current levels, the more downward pricing pressure will build as foreclosures/desperate sellers dominate price trends as opposed to prospective buyers. While the Fed, as pointed out in last month’s Investment Outlook must be cognizant of an array of asset prices in addition to housing, homes are the key to future equitization trends, and fundamental therefore to the outlook for consumption.

You may want to take this looming grim reality with a grain of salt or suggest as old worlders do that it’s not real at all if it can’t be touched or if it doesn’t touch you. Not so. Don’t take my word for it though. Investigate the Fed’s own study, written in September of 2005 (Monetary Policy and House Prices: A Cross-Country Study) covering housing cycles in aggregate and individually for 18 countries over the past 35 years. This study’s important conclusion for PIMCO and our clients is that if home prices in the U.S. have peaked, and are expected to stay below that peak on a real price basis for the next three years, then the Fed will cut rates and cut them significantly over the next few years in order to revigorate an anemic U.S. economy. Strong global growth (not part of this study’s assumptions) may temper historical parallels and provide a higher floor than would otherwise be the case. Nonetheless, prices for houses that I can see and touch every day outside my office are morphing with bond yields inside my computer screen to produce a reality show that speaks to an ongoing bond bull market of still undefined proportions.

William H. Gross

Managing Director

Monday, March 26, 2007

Morgan: Asian Decoupling Unlikely

Asian Decoupling Unlikely
March 26, 2007

By Stephen S. Roach | New York

As the US economy slows, most believe that Asia’s growth machine will fill the void. Don’t count on it. Policy makers in China and India are shifting toward restraint, tilting growth risks in the region’s fastest-growing economies to the downside. Nor is an externally-dependent Japanese economy likely to provide much compensation. To the extent the case for global decoupling is dependent on an Asian offset, prepare to be disappointed.

After years of doubt, convictions are deep that both China and India will stay the course of hyper-growth. There has been talk for years about the coming Chinese slowdown, but so far the downshift has failed to materialize. The 10.7% increase in Chinese GDP in 2007 was the fastest since 1995, when the size of the economy was less than one-third what it is today. Moreover, with India now showing impressive improvement in its macro foundations of growth – especially saving, infrastructure, and foreign direct investment – there is good reason to believe that there may be considerable staying power to the recent acceleration in economic growth that averaged 9% during the 2005-06 interval.

Incoming data give little reason to doubt the staying power of the Asian growth machine. Chinese industrial output growth has reaccelerated to an 18.5% y-o-y pace over the January-February period – up from the sub-15% comparison in the final period of 2006 and only a shade slower than the 19.5% gains recorded last June. While India’s industrial production growth is certainly not as brisk as China’s, the 10% y-o-y comparison in early 2007 remains well above the 7¼% pace that was evident in late 2005 and early 2006. Needless to say, if China and India stay their present course, the global economy would barely skip a beat in the face of a US slowdown. Collectively, China and India account for about 21% of world GDP, as measured by the IMF’s purchasing power parity framework – essentially equal to the 20% share the statisticians assign to the United States. Add in the recent acceleration in the Japanese economy – a 5.5% annualized increase in the final quarter of CY2006 for an economy that accounts for another 6% of PPP-based world GDP – and there is good reason to believe that the impact of America’s downshift could well be neutralized by the ongoing vigor of the Asian growth machine.

The Asian offset, in conjunction with a modest cyclical uplift in a long sluggish European economy, is the essence of the case for global decoupling – a world economy that has finally weaned itself from the great American growth engine. A key presumption of that conclusion is that Asia can stay its present course. There are two flaws in that argument, in my view – the first being that internal pressures are now building in Asia’s fastest-growing economies that could be sowing the seeds for slower growth ahead. In particular, both the Chinese and Indian economies are now displaying worrisome signs of overheating. In China, the symptoms have manifested themselves in the form of imbalances in the mix of the real economy, widening disparities in the income distribution, and a large and growing current-account surplus – to say nothing of the negative externalities of environmental degradation and excess resource consumption. In India, the overheating has surfaced in the form of a cyclical resurgence of inflation, with the CPI running at a 6.8% y-o-y rate in early 2007 – a sharp acceleration from the 3.8% pace of 2002-05.

In recent weeks, I have met with senior policy makers in both China and India. It is clear to me that in both cases the authorities are in the process of shifting their policy arsenals toward meaningful restraint. In China, the direction comes from the top in the form of growing concerns expressed by Premier Wen Jiabao about a Chinese economy that he has explicitly characterized as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch of the same name). Since those words were first uttered at the end of the National People’s Congress on 15 March, Chinese authorities have been quick to respond. There was a monetary tightening the very next day and the securities industry regulators have issued new rules that prevent companies from purchasing equities with proceeds from share sales. The former move is aimed at cooling off an overheated investment sector while the latter move is addressed at dealing with a frothy domestic stock market that increased by 100% in the six months ending in late February. I am more convinced than ever that Beijing is now deadly serious in attempting to regain control over its rapidly growing economy in an effort to shift the focus from the quantity to the quality of growth. This is good news for China but could be disappointing for the decoupling camp that expects rapid Chinese economic growth to remain resistant to any downside pressures.

India is similarly positioned. The Reserve Bank of India does not take overheating and cyclical inflationary pressures lightly. I was actually in Mumbai the day the RBI tightened monetary policy last month (13 February), and it was clear to me in my discussions at the central bank that it meant business. The RBI’s official statement following that action said it all: “(A) determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion.” Our Indian economics team underscores the risk of another monetary tightening prior to the 24 April policy meeting. At the same time, the government’s annual budget contained measures that would cut tariffs on food and other price-sensitive manufactured products. Indian authorities are fixated on a mounting cyclical inflation problem and appear more than willing to take a haircut on economic growth to achieve such an objective. Our current economic forecast reflects just such an outcome – a downshift to 6.9% GDP growth in 2008 following average gains of 8.7% over the 2005-07 period.

There is a second factor at work that is also likely to challenge the view that hyper growth is here to stay in Asia – the region’s persistent reliance on external demand as a major driver of economic growth. This is less a story for India, with its relatively small trade sector, and more a story for the rest of Asia. China is at the top of the external vulnerability chain. Its export sector, which rose to nearly 37% of GDP in 2006, surged at a 41% y-o-y rate in the first two months of 2007. Moreover – and this is an absolutely critical point in the decoupling debate – the United States is China’s largest export market, accounting for 21% of RMB-based exports. As the US economy now slows, the biggest piece of China’s export dynamic is at risk. So, too, are the large external sectors of China’s pan-Asian supply chain – especially Taiwan, Korea, and even Japan. Lacking in self-sustaining support from private consumption, the Asian growth dynamic remains highly vulnerable to an external shock. That’s yet another important reason to be very suspicious of the case for global decoupling.

Decoupling and global rebalancing go hand in hand. A decoupled world is very much a rebalanced world – and vice versa. Recent trends admittedly lend some support to the decoupling thesis – especially a booming Asia economy but also a seemingly remarkable cyclical revival in Europe. The European upsurge is a welcome development, but perspective is key. At most, it will add 0.2 to 0.3 percentage point to our baseline case for world economic growth. Asia, especially China and India, is a very different story. This is a much larger segment of the global economy and is growing at rates that are three times as fast as those in the developed world. An Asian economy that only barely widens its growth multiple relative to the rest of the world could well drive global decoupling on its own.

That’s unlikely to be the case, in my view. Not only does Asia remain vulnerable to a US-centric external shock, but the region’s two most powerful growth stories – China and India – are now both very focused on matters of internal sustainability. The Premier of China has put his reputation on the line in attempting to bring an unstable, unbalanced, uncoordinated, and unsustainable Chinese economy under control. The Indian government is equally focused on an anti-inflationary policy tightening. Looking backward, both of these economies have been on an exceptionally strong growth path that – if left to its own devices – could play an increasingly important role in powering a decoupled world. Looking forward, however, it’s likely to be a very different story. With growth prospects in China and India tipping to the downside at the same time the US economy is slowing, the global economy is likely to be a good deal weaker than the decoupling crowd would lead you to believe.

Sunday, March 25, 2007

Smart Investment With Harvard?

The Wall Street Journal

March 24, 2007

Smart Investment With Harvard?

Retirees Give and Get Back
With University Trusts
March 24, 2007; Page B2

Rita Schneider and Ron Alberts wanted to give something back to Harvard University after working there for many years -- and they also wanted to pump up their retirement portfolio.

The couple found a way to meet both their goals through an option that allows charitable trusts to be invested alongside Harvard's high-performing endowment. Harvard was the first to offer such an option, in 2003. Other top schools, including Stanford University, the University of Notre Dame and the Massachusetts Institute of Technology, have been granted permission by the Internal Revenue Service to allow donors to invest with their endowments.

The Issue: A Harvard program that allows donors to reap the benefits of the school's well-regarded endowment fund has attracted much attention since its 2003 introduction.

How It Works: Donors typically transfer money in the form of a charitable trust and receive a regular distribution until death. The remainder of the assets goes to the schools.

What's New: Other schools, including MIT and Notre Dame, have received approval from the IRS to offer donors the trust option.

Stanford and Notre Dame began offering the option this year, and MIT plans to in the future. "Having the endowment option will be a win-win situation for both MIT and our alumni," says Judy Sager, director of gift planning at MIT.

The trust option allows donors to share in the returns earned by university endowments, which often have access to investments that are hard for individuals to hold on their own.

After a donor dies, the trust proceeds go to the university. One possible drawback: Tax rates on payments from the trust may be higher than some other investment options.

The strategy has worked for Ms. Schneider and Mr. Alberts, self-described "beach bums" who now live in Miami Beach. "As far as I know, this is about the best place to invest and be able to sleep at night," says Ms. Schneider.

The couple had strong ties to the school. Ms. Schneider, 56 years old, had taught French and Spanish to theology students at the Harvard Divinity School for 13 years in a summer program; Mr. Alberts, 59, was a staff assistant in the registrar's office.

They funded three trusts at Harvard from the sale of appreciated real estate. The trusts pay them a handsome income, and what is left when they die will go to Harvard.

University endowments are among the most successful investors. The Harvard endowment returned an annualized 15.2% over the 10 years ended last June 30, according to the school. The S&P 500-stock index's annualized total return over that period was 8.3%.

Higher-education endowment funds earned an average one-year return rate of 10.7% for the year ended June 30, according to a recent survey conducted by the National Association of College and University Business Officers in conjunction with TIAA-CREF. The S&P 500 returned 8.6% over that period.

Harvard and other schools have gotten these good results through an aggressive strategy that puts money into widely diverse assets such as hedge funds, private equity, real estate and even timber.

"You get a higher rate of return with less volatility," said David W. Scudder, the chairman of Aureus Asset Management, a Boston-based wealth-management firm. Mr. Scudder previously oversaw trusts at the Harvard Management Co., which runs the Harvard endowment. "Endowments are in all these different asset classes that have very little correlation to one another."

To invest alongside an endowment fund, donors typically use a specialized version of a "charitable remainder trust," in which donors put money and receive a regular distribution for a set period of time, usually for life. After the trust ends, the remainder of the assets must go to the charity.

Donors who invest in charitable-remainder trusts typically get an immediate deduction for the amount that is expected to ultimately end up with the charity. Some of the annual distribution that the donor receives, however, may be taxed as ordinary income, rather than capital gains. A donor could pay as much as 35% tax on distributions, rather than the 15% capital-gains rate. But for many people, the tax burden is offset by the higher returns endowments offer.

The option has been hugely popular at Harvard: The university has $1.5 billion in its planned-giving program, and about $900 million of that is invested through its approximately 700 charitable-remainder trusts. About 60% of the trust assets are invested through the endowment option.

"Having the endowment investment option has been tremendously beneficial for Harvard and our donors," said Anne D. McClintock, executive director of University Planned Giving at Harvard. "It's something that our donors have asked about for many, many years."

Indeed, it was demand from Harvard alumni that drove Harvard and Mr. Scudder to devise the arrangement.

"In the first year or two I was there, the Harvard endowment was doing quite well relative to the S&P, and I can't tell you how many alumni came to me saying, 'Can you get us into the endowment?' " says Mr. Scudder, who left Harvard in 2005.

Universities and donors both like the arrangement. Ms. Schneider and Mr. Alberts are particularly pleased that they were able to stipulate that when they die, the trust will go to the Harvard Divinity School to fund education on genocide.

"My father's side of the family perished in the Holocaust, and I wanted to honor them, and especially to devote my life earnings to the teaching of tolerance," says Ms. Schneider.

Write to Arden Dale at arden.dale@dowjones.com1

What's it all about, alpha?


What's it all about, alpha?
Mar 22nd 2007
From The Economist print edition

Demystifying fund managers' returns

TOO many notes. That's what Emperor Joseph II famously said to Mozart on seeing his opera “The Marriage of Figaro”. But surely to think of a musical work as just a series of notes is to miss the magic.

Could the same be said about fund management? It is the fashion these days to separate beta (the systematic return delivered by the market) from alpha (the manager's skill). Investors are happy to pay high fees for the skill, but regard the market return as a commodity. Distinguishing the two is, however, difficult.

A fund manager might beat the market because of luck or recklessness, rather than skill, for example. Suppose he packed his portfolio with oil stocks. When the crude price rises that would pay off, but it would be a pretty risky portfolio. More generally, alpha sceptics often attribute eye-catching returns to “style bias”, such as favouring stocks with a high dividend yield.

But should they be biased against style bias? After all, the only portfolio utterly free of bias would be one that included the entire market. Were a Britain portfolio to exclude just one stock, such as BP, it would have a small-cap bias, a sector bias and a currency bias (most of BP's revenue is in dollars). Hence any excess return must stem from some element of style.

Academics have entered this debate, trying to pin down the factors that drive a fund's performance. These might include the difference in returns between small-cap and large-cap stocks (fund managers tend to favour the former) or the level of credit spreads and so on. Bill Fung and Narayan Naik of London Business School have come up with a seven-factor model which, they say, can explain the bulk of hedge-fund performance. After allowing for these factors, the average fund of hedge funds has not produced any alpha in the past decade, except during the dotcom bubble.

This approach suggests the whole idea of alpha might be an illusion. Academics can explain most of it, and the only reason they cannot explain all of it is because they are not clever enough to think of the missing factors.

However, it is also possible to take the opposite tack. This type of analysis gives managers no credit for choosing the systematic factors—the betas—that drive their portfolios. Yes, these betas could often have been bought for very low fees. But would an investor have been able to put them together in the right combination?

It is as if a diner in Gordon Ramsay's restaurants were brave enough to tell the irascible chef: “This meal was delicious. But chemical analysis shows it is 65% chicken, 20% carrot, 10% flour and 5% milk. I could have bought those ingredients for £1.50. Why should I pay £20?” The chef's reply, shorn of its expletives, might be: “The secret is in the mixing.”

This debate matters because people are now trying to replicate the performance of hedge funds with cloned portfolios. Indeed Messrs Fung and Naik have shown that their model would have produced an annual return over the past four years of 11.6%, well ahead of the average fund of hedge funds. Their performance was purely theoretical. But Goldman Sachs and Merrill Lynch have launched cloned hedge funds on the market.

There are two potential criticisms of the cloned approach. One is that it will simply reproduce all the systematic returns that hedge funds generate and none of their idiosyncratic magic. However, this “magic” is hard to pin down. Even if it does exist, Messrs Fung and Naik suggest it may be worth no more than the fees hedge funds charge, so the managers are the only ones to benefit from their skills.

The second criticism is that the clones will always be a step behind the smart money. You cannot clone a hedge fund until you know where it has been. But by then it may have moved on. As a result, the clones may pile into assets that the hedge funds are selling, making the classic mistake of buying at the top. This may not be a fatal flaw, however. It is possible to imagine some clones taking contrary bets, buying the betas that seem temporarily out of favour, in the hope that they will be purchasing what the hedge funds are about to buy.

There are some nice ironies at work here. Hedge-fund managers often rely on secretive “black box” models: the investor puts his money in at one end and sees the returns spat out at the other, but no more than that. Now, armed with just that information, academics are coming up with their own models, which almost match the hedge funds' performance.

Mozart might have sympathised. His operas were more than the sum of his notes. But even if the great composer had no peers, he has had plenty of imitators.

Copyright © 2007 The Economist Newspaper and The Economist Group. All rights reserved.

Friday, March 23, 2007

Veryan: Blackstone IPO and irrational investors

by Veryan Allen

Hedge Fund


Blackstone IPO? Markets, technology and financial products may innovate BUT investor behavior remains a reliable constant. It is comforting to see such irrationality surrounding such an obviously predictable event. A firm that extols the virtues of going private decides to go public itself! Naturally, the Blackstone IPO will be wildly overpriced by the underwriters but still more wildly oversubscribed. A few weeks later analysts at those same investment banks will then produce glowing reports saying Blackstone is cheap. Wonder what Goldman did to annoy Stephen Schwarzmann; did they dare to use GS stock in the comparables valuation pitch? Apart from some Fortress specifics, all I wrote on the Fortress IPO applies to the Blackstone IPO, only more so.

More irrationality abounds elsewhere, as Brian Hunter and Nick Maounis of Amaranth fame busily market their new funds. This is excellent news for good hedge fund managers and professional traders, especially in the energy complex. Let's hope they both raise $800 million, preferably $8 billion. The more dumb money out there, the more opportunity for smart money to exploit it. I haven't seen their presentation materials yet but no doubt there are plenty of "one off event, thousand year storm, just bad luck, never happen again, strict risk control" slides in there. Sorry but genuine top traders do not lose $6 billion, EVER. But it is terrific that there is a good amount of irrational money out there prepared to back them, even when there are 10,000 superior hedge funds already available.

Yet more irrational is that, as usual, hedge funds are now being blamed by some for the recent volatility. Since "hedge funds" comprise an extremely heterogenous range of strategies, doing different things in different time frames, short and long, it is difficult to see how "hedge funds" had much to do with it. If anything the mini-correction would have been a major correction were it not for hedge funds covering shorts. We have also seen weaker hedge fund managers blaming everyone but themselves for performing poorly. Here's a small tip for every market participant: if you lose money, it is YOUR fault. No-one else's. Events happen and risks are always present; if you are competent, you prepare for ANYTHING.

Shockingly, 83 hedge funds shut down last year! This is portayed as a negative for the industry which I find very odd. Firstly "shut down" does not mean "lost all the money", though, of course, a few did do exactly that, but that was due to uncooperative fund administrators or uncooperative weather, right?! Secondly, beta still bails out so many funds. We ought to lose easily the bottom decile if not bottom quartile ie 1000-2500 fund shut downs each year, but it is remarkable how few funds have disappeared. Hopefully the next bear stock market, credit collapse, economic recession will identify who has been swimming naked in the outgoing tide.

However, all of the above is good news for those with investment skill. Alpha can ONLY be generated when many others are wrong. It is a necessary condition for there to be as much greed, fear, illogicality, stupidity and emotion as possible in the markets. I would really start to worry and consider another career if no-one bought Blackstone stock, no-one gave money to Solengo Capital, and everyone loved hedge funds and blamed themselves for losing money. It would concern me if humans had suddenly become rational, calculating robots coldly optimising their utility. The markets might well become efficient and fairly valued. Thankfully this is clearly not remotely the case. Phew!

The best investments are often those that others consider crazy at the time. The most correct opinions are usually the ones most vehemently opposed by the "experts". Investors also have to be careful not to confuse intelligence with rationality. Some of the cleverest people around are very irrational. As John Maynard Keynes alluded to with beauty contests, don't buy the things you personally think are good, buy what others think are good. As LTCM and Amaranth found out, being intelligent and rational does not help very much if the market is stupid and irrational.

I use a lot of artificial intelligence to model and forecast the markets and hedge fund returns, but is "intelligence" the correct word. Sometimes it is artificial stupidity that is needed to identify and capture the vast inefficiencies created in the emotional financial markets. Contrarian investing is fine, but sometimes you have to be contrarian to the contrarian and just go with the flow. So while neither I, nor any of the Middle Eastern and Russian subscribers to this site, will be giving any money to Brian Hunter, I might try giving Blackstone some cash. But if I get in the IPO allocation, I'll be selling soon as possible and probably going short. Perhaps that birthday party will one day be looked back on like we now regard the Predators Ball.

Wednesday, March 21, 2007

March 20, 2007 Credit Spreads

Here's an interesting look at credit spreads over the past few years:


Notice how much closer the lines are today compared with five years ago. That's a big reason for the private equity boom.

Posted by edelfenbein at March 20, 2007 11:42 AM

Tuesday, March 20, 2007

Ask the expert: investment risks

The recent turbulence in global markets and the woes of the US subprime mortgage market have refocused investors on investment risks. Glenn Reynolds, chief executive and co-founder of CreditSight, an independent credit research fiirm, responded to readers’ queries on the high-yield bond market, emerging market funds and private equity.

Q: Is the high-yield bond market fundamentally overvalued?
A: We say yes…Whether it is too much money and too many originators going after subprime loans or going after high yield deals, the end of this story is hardly a new one in historical perspective. The “deal too far” gets done, the underwriters dance a little too close to the fire on the quality of the asset brought to market (the “we are all big boys” rationalization) and then the market gets set up for a re-pricing of risk on some event or series of events. With default rates down near historical lows, the direction of the next trade is pretty clear. The incubation period for the usual post-CCC-wave nightmare has been perhaps artificially extended with the boom in global liquidity.

Q: Does the increase in the proportion of lower rated debt mean we are necessarily headed for a big spike in defaults?

GR: Typically during boom periods of high yield you get a spate of marginal issuers coming to market that wouldn’t normally get financing. The classic example of this from the last boom is Iridium, the satellite company which issued debt into the market during the heyday of the mania for anything technology or anything wireless. That company ended up going bust and returning only cents on the dollar to the bank creditors even as litigation waves tortured underwriters throughout. This is obviously an extreme example but if you look at the shape of cumulative default curve for CCC-rated companies, it is steepest in the 3-7 years. This suggests to us that if credit markets do start to tighten, we should start to see a tick up in default rates and in less investor-friendly workouts.

Q: Is there a significant difference between what you see in the cash and derivatives markets in high yield, or crossover?

GR: As the high yield market is usually dollar based and less sensitive to spreads over LIBOR and more granular with smaller cash issues (and thus less liquidity) than investment grade, we have noticed that the basis (the credit derivatives spread minus the LIBOR spreads of the cash bonds) tends to be more negative — i.e. cash bonds are cheap in many cases versus credit derivatives as a rule. We would expect this to gradually correct as the high yield CDS market matures and the significant differences are arbitraged out by the market. An exception to the negative basis trade during a period of heightened volatility would be some of the liquid fallen angel names such as the US auto names.

Q: Is this a good time to invest in a highly diversified emerging market fund? Is it too late to “buy low and sell high”?

GR: Our view is that most of the value has been squeezed out of a lot of the emerging markets over the last year or two, and now is probably not the best time to put a lot of fresh money to work in the sector. Many EM countries have seen important improvements in their fundamentals over the last few years, so we do not expect emerging markets to suffer a full-blown crisis in the immediate near term. There are pockets of overheating and overlending in a few of the major emerging markets countries, however, and we do not think investors are being adequately compensated for those risks. Over the very long term the emerging markets will probably continue to deliver healthy returns, but the volatility in EM should steer most investors to gradually build up exposure rather than investing in EM all at once.

Q:What in your view is the impact of private equity to financial institutions and the financial industry as well. Does private equity have the muscle to reshape the global financial sector, totally eclipsing the status quo?

GR: In short we see the private equity wave as reshaping the status quo and nature of the institutional investor asset allocation process, but not eclipsing the status quo. After all, the status quo structure also provides the take-out bid for the deals later. So the private equity players are in the end pretty dependent on the current global structure of the exchanges to take their profits. Those exchanges may be configured differently in future years and in terms of who wins by region (London vs. New York is always a fun debate), but in the end that is the system that the private equity players themselves are leaning on as well.

In terms of the current “global bulge,” we do not see that as changing all that dramatically either in that regard. Someone still has to provide backstop financing, distribute and disintermediate the risk, provide counterparty lines and financing, and they will be in there taking their slice of deals through their merchant banking wings just like they always have. The menu may change, but the same group of chefs will be doing the cooking.

There is no question that the soaring base of private equity investors and readily available supply of bank loan and high yield credit have fostered a very favourable backdrop for this base of funds to drive a lot of deal activity. That said, the continuation of record deal size and hitting all-new records for deal totals still is somewhat tied to a benign liquidity backdrop, a favourable yield curve, and robust credit fundamentals. That may hardly be the case by 2008, and the ability to drive a hefty deal flow may not be anywhere as favourable as it is now. Right now we are seeing a confluence of very favourable conditions for private equity deals. The best asset class out there right now with the flat-to-inverted curve and solid demand for credit is a leveraged 1st lien loan, not an investment grade corporate bond with weak covenants. That has prompted an asset allocation shift in the marketplace that has fuelled the recent wave. Add a recession, a steep curve and tighter credit (tighter in liquidity, structure, and less generous pricing), and people will see deal flow altered dramatically. In fact, more leveraged funds will be back in the distressed business by then, and more private equity funds will be as well.

When everything is correlated, diversification takes imagination

You’ve heard it before - “uncorrelated assets are now correlated“, it’s the end of diversification as we know it and everyone should get out of equities and into bonds. But there is another way, albeit one that requires a bit of homework and imagination, writes John Dizard in the FT.

When credit, equity, forex, emerging markets, and even precious metals are all moving as one, “hedged” positions turned into concrete blocks that were tied to daily profit and loss statements - with more losses than profits given recent market upheavals.

Yet when speculators recovered equilibrium, they all went back to the same markets, as if the same thing were not likely to happen next time there is even a mild uptick in volatility, writes Dizard. If hedge funds et al really wanted diversification, they would look further afield.

Where to? Well, take electricity trading for instance. Not just the contracts traded on futures exchanges in the US, but on the electronic markets that are now run by the authorities that manage electric grids, known as Regional Transmission Organisations, or RTOs.

The second largest RTO is the Midwest Independent System Operator. A non-profit company based in Indiana, it manages the transmission system in a 13-state region and controls the dispatch of more than 137,000 megawatts of power generation. Miso administers trading for three products: a “virtual”, or cash-settled day-ahead market for electric power in the 1,500 “nodes”, or delivery points on the system; a “real time”, or physical market, for power on the day of delivery; and a market for “financial transmission rights”, another cash market that allows generators or load-serving utilities to hedge the price risk of congested power lines.

The essential problem is that electricity cannot be easily stored and is produced and delivered by large lumps of capital in the form of generators and power lines. The function of Miso’s markets from the point of view of the public interest is to break up the monopoly power of the capital owners, allow for efficient price discovery and lower the overall cost of electricity. The function from the trader’s point of view is to provide arbitrages and speculative opportunities.

Since Miso’s markets started operating in April 2005, both sets of objectives have been met. Miso end-user costs are lower, reliability is higher and some traders are making a lot of money.

Likes James Williamson, who started out with $25,000 in collateral for the Miso clearing system and expenditure of about $5,000 on used computers and software. He now has a net worth in the low seven figures and employs a handful of people in his office outside Denver, Colorado. In addition to trading the Miso market, he trades in the Texas and California electric markets and has enough collateral to trade on the ICE electronic energy exchange. He has also increased his collateral posting on Miso to $150,000, though, as he says, “there are ways to manage your position so the credit risk the system measures is minimised. On that amount of credit, I expect to make about 2,000 per cent annually.”

Of course, the business requires an obsessive attention to detail and a careful eye on regulations and Miso’s business practices. How can he compete with the likes of Morgan Stanley or UBS?

“The markets have proven a lot more insensitive to trading volume than I would have thought,” he says. “My advantage is that I can spend all my time trying to make money, not sending e-mails or stuff like that. In the stock market, if you see a pricing inefficiency it will be hit by a computer program in seconds. Here you can have [arbitrages] that last for days. There is just so much fruit lying on the ground here.”

One might add that it is fruit that has little correlation with other markets. What matters are generator outages, weather and congested transmission lines, along with seasonal use patterns.

Why don’t larger institutions get more involved? “If you don’t make $50m a year in a bank you’re nothing. You can make $15m or $20m, but that’s small in a big bank,” Mr Williamson says. It is more, though, than the negative figures that a lot of hedge fund partners will receive in the post next month.

If the power trade doesn’t spark your interest, there’s always wine. Just don’t forget to invite FT Alphaville round for a sip of the profits.

How bad is subprime going to get?

There is a wide range of opinions on how bad subprime is going to get. Although the ABX index seems to have stabilized, its still trading at a distressed level. Corporate bonds have widened and stock prices have fallen. Bearish economists believe that delinquent subprime loans will turn into a large increase in homes for sale, further depressing home values. This will cause consumers generally to become pinched, not just those with poor credit, and lead to a recession.

While the bearish argument is logical, I find a more moderate scenario most compelling. Consider the following.

1) According to the MBA, 13.3% of all subprime mortgages are delinquent. The all-time low is 10.3%, so at worst, there are 3% more subprime mortgages delinquent today vs. years past.

2) In 2006, 3.9% of subprime mortgages were foreclosed upon. The June 2006 delinquency figure was 11.7%, so exactly 1/3 of the delinquent loans were foreclosed upon. This ratio has been relatively consistent over the last 3 years. If that ratio holds into the future, then the number of homes for sale due to foreclosure has only increased by 1%

3) If we assume that delinquencies increase by 50% in 2007, and half of those loans are foreclosed upon (as opposed to 1/3), then the foreclosure rate would increase from 3.9% to 10.0%. That's a marginal increase of 6.1%

4) Also according to the MBA, there are about 7.5 million homes with subprime mortgages. Units, not dollars.

5) Multiply the marginal increase in foreclosures by the homes with subprime mortgages, and you get 457,500 new units are for sale.

6) According to J.P. Morgan, there are 4.1 million new and existing homes for sale. So the new foreclosures result in an 11% increase in homes for sale.

7) We know that home builders are going to scale way back in 2007. Building permits have declined by 624,000 over the last 12 months. If we assume that this represents an eventual decline in homes available for sale, there would actually be a net decrease in home supply.

8) Of course, we know that there is a serious overhang in home inventory currently. But that has been a problem for several months now. The home builders are all reducing or eliminating building homes on spec. I believe its highly unlikely that new home building outpaces new home sales over the next year.

9) So it seems as though there will be little or no net increase in homes available for sale in 2007, even under a very bearish scenario for subprime foreclosures.

10) If there is no increase in supply, how can you estimate a large and pervasive decrease in home prices? I can believe that foreclosure sales will occur at relatively weak prices, and this might depress market prices somewhat. But with foreclosures accounting for something like 10% of all sales, its hard to envision the foreclosure discount effect as creating a large and pervasive change in prices.

11) What about tightening lending standards? Won't this cause a decrease in demand from first time home buyers? Perhaps, but I think a moderate decline in interest rates will overwhelm this effect. If the Fed does cut once or twice and the 10-year stays around 4.50%, mortgage rates will fall. First time home buyers with spotty credit might be priced out of the market, but low rates will price more prime borrowers into the market.

12) Besides, nationwide the job situation remains strong. The long-term evidence is that job growth drives home sales. While we may be in a unique situation with home prices coming off a bubble, strong job growth should create a floor beyond which prices are unlikely to fall.

No meaningful increase in supply, no meaningful decrease in demand. I think the housing market will suffer at worst a mild correction.

Small is beautiful in China’s burgeoning private equity market

The difficulties encountered by Carlyle, the US private equity group, in its struggle to acquire control of Xugong Construction Machinery, the Chinese state-owned construction machinery maker, should not deter private equity investors from shopping in China — the art is in buying small and “staying below the radar”, the FT says.

Amid mounting political pressure, Carlyle first reduced its intended investment from 85 per cent to a 50-50 joint venture. This week it scaled down its plans to a 45 per cent minority holding. But Volvo had no such trouble when it acquired a 70 per cent stake in Lingong Construction Machinery earlier this year, a company which makes similar products.

And new figures suggest the deal-flow remains robust. According to the Centre for Asia Private Equity Research, there were 120 completed venture capital and buy-out deals by foreign firms in China in 2005 with a combined deal value of $3.3bn. Last year, the completed deal flow had climbed to 141, with a value of $6.9bn - although the valuation figure was swollen by Goldman Sachs’ $2.8bn pre-IPO investment in Industrial and Commercial Bank of China. So far this year, there have been 22 completed deals with a value of $1bn.

Buying small is one way of avoiding regulatory problems. Indeed, Carlyle itself has been a pioneer of this strategy, making a number of $10m-$50m investments in China and elsewhere in Asia through its Asia Growth Capital Fund.

Investment funds have been taking advantage of new stock market rules that allow foreign investors to buy significant stakes in listed companies directly. Goldman Sachs announced three such investments in December, taking stakes of about 10 per cent in Fuyao Glass, Midea Electronic Appliances and Chengdu Yangzhiguang, a maker of aluminium foil.

Buy-out firms will also be given a new opportunity to invest in listed companies amid continuing reform of the shareholder structure of the Chinese market. Under the plan, a huge overhang of non-tradable shares is being converted into shares that can be bought and sold on exchanges. The lock-up period for selling those shares is gradually ending and some of the owners could be looking to unload stakes to financial buyers.

Columnist throws out alpha baby with beta bathwater

18 March 2007

Bloomberg’s Chet Currier is generally in tune with alpha-centric investing. In a column last fall, he quite correctly observed:

“The very model of a mutual fund is indeed outmoded, argues a large and growing group of financial researchers and professional money managers who are busy describing, building and proselytizing for a different way of doing things…The alpha-beta community already has been years in the growing. It will be years more before it penetrates, say, the 401(k) retirement-savings market where mutual funds reign now. But a real challenge has been laid down, and it isn’t going away.”

But he has thrown out the baby with the bathwater in his latest critique of active management. Earlier this month, Currier referred to alpha as a “mirage”. His thesis:

“…pure alpha may prove an illusory quest. The pursuit of it twists the original purposes of investing, and turns it into a game most players can’t win.”

The Bathwater: Alternative Beta

Before we take issue with this generalization, here’s what we agree on: Currier is absolutely right when he links alpha-centric investing to the emergence of hedge funds:

“An active manager only began to earn his keep when his results emerged from the beta background and began to produce alpha…This way of looking at things contributed mightily to the boom in hedge funds. While many standard long-only mutual funds are effectively fettered to the indexes they try to beat, hedge funds are free to pursue pure alpha from whatever angle they wish…”

This, we argue, is why hedge funds are not a fad, but a fundamental step forward in the evolution of asset management.

We also agree with Currier that alpha morphs into beta as previously unknown information (and trading strategies) become widely adopted. And yes, “hedge fund replication” illustrates that what was once believed to be alpha may be partly alternative beta.

The Baby: Pure Alpha

But branding alpha a simple “illusion” is a dramatic misrepresentation.

The heart of the problem is Currier’s use of a popular, yet inaccurate mining analogy to describe beta. He says:

“Imagine a mineral deposit where 10 miners are extracting silver, all at the same market-equaling return. An 11th party, noticing something the others are missing, begins bringing out gold. At first the extra payoff from the gold is almost all alpha…In short order, the other miners begin going after the gold as well. By the time everybody is mining it, the rewards to be had from the gold have completely dissolved into beta.”

This analogy assumes alpha is finite. But in actuality, markets are constantly evolving. New geographies, new securities and new inefficiencies replenish the global alpha opportunity as quickly as it can be arbitraged away. Obviously anticipating this counter-argument, Currier continues:

“Okay, you may say, the market-beating miner now moves on to platinum. As long as he stays a step ahead of the rest, alpha shall be his. Alas, there are only so many metallic elements in the periodic table…”

Sure, there may be a finite number of elements on the periodic table, but alpha is created from constantly evolving market inefficiencies mixed with inexhaustible human ingenuity. Proclaiming the end of alpha is like saying that all the music than can be written has been written. It reminds us of the famous prophecy attributed to Charles Duell, Commissioner of the US Patent Office in 1899, “Everything that can be invented has been invented.”

Even if markets for many individual securities are efficient, inefficiencies can also exist on a macro scale. In a recent interview, Peter Bernstein characterized markets as ”macro-inefficient”:

“The market is hard to beat. Nobody says it isn’t. But the markets are macro-inefficient and this means that risk and return for the market as a whole can go haywire.”

Alexander Ineichen echoes this assertion in his book Asymmetric Returns. Ineichen recently told All About Alpha:

“I believe you can view the tech bubble of the 1990’s as a massive market inefficiency. But (on the other hand) inefficiencies in smaller markets can be arbitraged away much easier and faster.”

Cleaning the Baby: the original purpose of the bathwater

We are prepared to give Currier some slack because he is obviously a believer in alpha/beta bifurcation. We also accept many of his concerns about the pursuit of alpha (“most player can’t win” - after fees). But we just can’t get around the populist tone (e.g. alpha “in the hands of a few elite”) and his apparent belief that the “original purpose of investing” doesn’t include trying to generate alpha. On the contrary, the pursuit of alpha was the original purpose of investing.

- Alpha Male

Monday, March 19, 2007

Indexing confronts uncertainty principle

The international newspaper of money management March 19, 2007

Posted: February 19, 2007, 6:01 AM EST

By Seymour N. Lotsoff

In 1927 Werner Heisenberg introduced the Heisenberg Uncertainty Principle in one of the foundation papers of quantum mechanics. He was awarded the Nobel Prize in physics primarily because of it. The HUP might appear to have nothing to do with investing. But I believe the HUP is as critical to the strong disagreements about indexation as it was to quantum mechanics.

Simply put, the "uncertainty principle" states that any and every measurement process affects and alters the state of any entity being measured. One cannot, therefore, ever know at any given moment with certainty all there is to know because the measurement process must in itself alter those statistics.

The HUP becomes important whenever the interaction energy is large enough to significantly affect the state of the object under observation. And that is exactly what I believe has happened in the equity markets because of indexation.

A HUP for financial markets suggests one can't invest in the market without altering the market.

The headlong rush into indexation is a self-defeating investment fad, not a lasting model. Markets always correct the excesses of fads and bubbles. Indexation will always have its appropriate applications, but its adherents will be less numerous and less enthusiastic.

Gradually, substantial advantage will accrue to investors who allocate capital to the best companies while avoiding the worst. Demanding manager tracking error to an index will be slowly discarded. Managers will look more like Warren Buffett in concept and monitoring managers like him will require much greater sophistication and more in-depth communication.

There is no doubt that a modest amount of money invested in an idealized index will have little impact.

But as indexing becomes dominant, capital markets lose their effectiveness as risk capital allocators. The consequences of widespread portfolio indexation would include:

cthe end of new public issues;

cthe end of public markets as an efficient means of allocating capital. The growth of the economy as a whole would slow to an important degree and the index returns would fall. No one would beat the market, but no one may care; and

cthe excessive overpricing or underpricing of just about every stock as the balancing between informed buyers and sellers for individual issues would cease to exist.

Fortunately everyone does not index.

Advocates of nearly universal indexing refer to $3 trillion in capitalization-weighted index funds as a measure of their argument's strength. That number is a measure of trouble.

The current size of indexed assets is understated. It misses assets involved in the enhanced index programs. It does not take into account "closet" indexing, or active managers who operate with very low tracking error mandates that effectively require 90%-plus indexing. It does not take into account index derivatives that require substantial index hedging of the derivative provider's risk.

Also, the flood of money from individual investors and financial planners into a variety of exchange-traded index funds has further extended the influence of indexation on market characteristics.

We may be nearer to self-defeating conditions than generally thought, as shown by a number of observable index distortion symptoms.

Significant mispricing of index stocks: Capitalization-weighted indexing has come under fire for overweighting overvalued stocks but index proponents claim this to be a temporary problem. The evidence indicates the opposite. There are many classic examples, such as Royal Dutch Petroleum Co. (in the Standard & Poor's 500 index) consistently trading at a 5% to 20% premium over Shell Transport & Trading Co. (not in the index) until the two issues were combined in 2005 to create Royal Dutch Shell PLC. (Foreign companies were removed from the S&P 500 in 2002.) Since then the greater use of indexation could only mean distortions have gotten worse.

The huge arbitrage opportunities associated with being long new index members and being short those issues about to be ejected provide another measure of index market distortion.

In short, the argument for moving more to active management and away from indexing is powerful. That means hard work for investors. But an efficiently functioning economy and sound money management require it.

Seymour N. Lotsoff is senior managing director, Lotsoff Capital Management, Chicago.

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.