Monday, April 30, 2007

Top 100 Law Firms: Behind the Numbers

The American Lawyer

Behind the Numbers

Vivia Chen
The American Lawyer

They may lament that they are the poor cousins of hedge fund managers and private equity stakeholders, but law firm partners are hardly suffering.

In 2006, for the first time since The American Lawyer started measuring the financial performance of law firms 22 years ago, a majority of America’s 100 top-grossing firms had profits per equity partner of $1 million or more. And one, Washington, D.C.’s Wiley Rein, notched the highest profits per partner ever recorded by the magazine.

In fact, almost all indicators were on an upswing in 2006, according to just-released results from The Am Law 100, The American Lawyer’s annual survey of law firm finances. (Full results appear in the May issue of the magazine.)

Compared to 2005, average revenue per lawyer went up 7.3 percent (to $779,000, from $726,000), and average gross revenue shot up 11.4 percent (to $567 million, from $509 million). Lawyer head count also grew by 3.9 percent.

More Am Law 100 lawyers are making megabucks than ever before. Of the 59 firms in the $1 million–plus category, 15 had profits per partner of $2 million or more (in 2005, there were ten such firms). And in the $3 million–plus club, Wachtell, Lipton, Rosen & Katz—whose average profits per equity partner have exceeded $3 million since 2004—got some company: Cravath, Swaine & Moore ($3 million) and Wiley Rein ($4.4 million).

How did firms hit such sky-high profits per partner levels? Contingency fees helped fuel the incredible profit growth at Wiley Rein (which posted a 465 percent increase), as well as at Akin Gump Strauss Hauer & Feld (a 34.2 percent increase), Quinn Emanuel Urquhart Oliver & Hedges (a 27.6 percent increase), and Finnegan, Henderson, Farabow, Garrett & Dunner (a 21.8 percent increase).

There was also more work on everyone’s plate. Litigation, transactions (including private equity and hedge funds), and real estate were all very busy. “It was secular growth everywhere,” says Cravath presiding partner Evan Chesler. “It’s not attributable to any one factor; we were very busy in litigation and corporate.”

For some firms, reducing the size of the equity partnership helped spike per-partner profits. Of the 28 firms that posted profits per equity partner increases of 15 percent or more in 2006, 15 had a decrease in the number of equity partners. (Last year 17 Am Law 100 firms had more nonequity partners than equity partners.)

Paradoxically, some firms that increased their profits per partner and purged their partnerships somehow managed to end up with a net gain in number of equity partners anyway. One is Pillsbury Winthrop Shaw Pittman, which increased both profits per partner (up 14.4 percent) and the number of equity partners (up 38.3 percent). However, Pillsbury cut head count by 13 percent and the size of its total partnership, both equity and nonequity, by 10 percent.

Chairman James Rishwain, Jr., insists that the axed partners were not a major factor in the firm’s profitability gains. “Our increase in 2006 was not derived from partners leaving the firm,” he says, adding that Pillsbury has become “more nimble” and “more focused on key industries,” such as energy, technology, financial services, and real estate. His summary of 2006: “Our attorneys just worked harder.”

Being cruel to be kind also describes management choices at Chadbourne & Parke and Holland & Knight. Both firms sheared their partnership ranks by almost 10 percent before ending 2006 with big surges in profits per partner (Chadbourne’s went up by 12.4 percent; Holland & Knight’s by 14.8 percent) and equity partners (Chadbourne’s rose by 9.3 percent; Holland & Knight’s by 7.6 percent).

Chadbourne managing partner Charles O’Neill says that firing partners was a “hard decision” but that the firm, coming out of a disappointing 2005, “decided we need to do things differently [because] this is a business.” Getting rid of partners who didn’t perform up to snuff, O’Neill says, made room in the equity ranks for those most able to boost the firm’s profitability. That seems to be Holland & Knight’s strategy, too. The firm shrank its lawyer count by almost 13 percent and closed unprofitable offices. For the 35 percent of Holland’s partnership with equity, profits per partner topped $700,000 in 2006—an increase of almost $100,000 from the year before.

The bottom line: It’s a great time to be a an equity partner at an Am Law 100 firm. But getting there—and staying there—can be brutal.


Fundamental indexing superiority disputed

The international newspaper of money management April 30, 2007

Claim of cap-weighting’s drag on return is ‘false’

By Douglas Appell

Posted: April 30, 2007, 6:01 AM EST

Fundamental indexing — touted as a “better mousetrap” alternative to capital-weighted market indexes — won’t necessarily catch more mice, according to Andre Perold.

In a draft paper titled “Fundamentally Flawed Indexing,” Mr. Perold, the George Gund Professor of Finance and Banking at Harvard Business School, argues that a pillar of the fundamental indexing sales pitch — that cap-weighted indexes deliver “inferior” returns by overweighting overvalued companies and underweighting undervalued companies — doesn’t stand up to scrutiny.

Marshaling the same models and two-stock portfolios used by proponents to make their case, Mr. Perold’s paper concludes by saying the idea “that capitalization weighting imposes an intrinsic drag on performance is false.”

The argument that cap-weighted indexes deliver suboptimal returns has helped money management firms such as Research Affiliates LLC, Pasadena, Calif., and WisdomTree Investments Inc., New York, garner billions of dollars in assets for strategies offering superior returns by using “fundamental” metrics such as dividend payouts and sales, rather than market capitalization, to determine a stock’s index weighting.

Research Affiliates says back-tested data show its fundamental indexes outperforming leading cap-weighted indexes by more than two percentage points a year for large-cap domestic equities; by roughly 3.5 percentage points a year for international equities; and by more than 10 percentage points a year for emerging market equities.

Robert D. Arnott, Research Affiliates’ chairman, said his firm and its licensees, including Pacific Investment Management Co., Nomura Asset Management Co. and PowerShares Inc., have seen their fundamental indexing assets under management surge over the past 12 months to $9 billion from less than $1 billion, with new inflows clocking in at roughly $1 billion a month. Research Affiliates has a patent application pending for its non-capitalization based indexes.

Jeremy Siegel, senior investment strategy adviser with WisdomTree and the Russell E. Palmer Professor of Finance at the University of Pennsylvania’s Wharton School, said WisdomTree’s various fundamental indexing-based exchange-traded funds have gathered $3.5 billion in assets since the firm launched its first ETF offerings in June 2006.

Scrutiny intensifies

An initial wave of critics dismissed fundamental indexing as a glorified value-tilt quant strategy, but scrutiny of the theories behind the challenge to cap-weighted indexes is just now becoming more intense. “A lot more people are looking at it more closely,” said Harindra de Silva, president of Los Angeles-based Analytic Investors Inc.

The debate finds proponents and critics jousting over a variety of assumptions, including how efficient capital markets are and how prices revert to fair value.

Mr. Arnott said the outcome of the academic wrangling over fundamental indexing is important to him, as it “has a bearing on many of the core precepts of modern finance.”

Mr. Perold said the key point of his paper is that if nothing is known about fair value, then any stock, regardless of capitalization, is just as likely to be overvalued as undervalued. Consequently, holding stocks in proportion to their market capitalization doesn’t systematically result in performance drag, he said.

Quant managers who have seen Mr. Perold’s paper say it’s a strong argument. To make the case for fundamental indexing, you have to presume that “large-cap stocks are overvalued, and you don’t know that,” said Eric H. Sorensen, president and chief executive officer of Boston-based PanAgora Asset Management Inc.

Value tilt

Mr. Arnott said his firm’s composite fundamental index strategy, which uses dividend payouts, sales, cash flow and book equity value to determine a stock’s weight in the index, derives roughly a quarter of its value added from its dynamic value tilt, with dynamic size and sector tilts accounting for the remainder.

Mr. Arnott called Mr. Perold’s critique of fundamental indexing “a little frustrating: in my view, he puts words into my mouth, and then disproves what he says I say.” Mr. Perold’s assumptions are consistent with efficient markets, and Research Affiliate’s assumptions are consistent with inefficient markets and the proposition that fair value isn’t infinitely uncertain, Mr. Arnott said.

In an interview, Mr. Siegel said Mr. Perold’s arguments hold true under “a very restrictive set of assumptions” but fail on the most relevant points. For example, he says, even Mr. Perold concedes that fundamental indexing delivers superior returns if there is mean reversion in stock returns.

Mr. Perold replied that mean reversion would allow fundamental indexing to deliver superior returns if it coincided with index rebalancing, but there’s no reason to expect that to happen. “We do not know which stock will mean revert in the future vs. which will underreact in the future,” he said.

In the end, Mr. Perold says his paper is attacking the proposition that investors can garner better returns than those offered by a cap-weighted index without relying on skill in distinguishing overvalued stocks from undervalued stocks.

If fundamental indexing proponents such as Mr. Arnott would say they “truly know something about market cap that is not reflected in current prices” and can improve on cap-weighted index returns, that would be a different story, said Mr. Perold. “Of course, you are then in the realm of active management, and you should be held accountable to the same standards as everyone,” such as being judged by one’s live track record, he said.

In addition to his academic work, Mr. Perold is investment committee chairman for Boston-based HighVista Strategies LLC, which manages more than $1 billion for endowments, foundations, institutions and private clients in a diversified and integrated portfolio of marketable and alternative asset classes, including hedge funds and private equity.

Not giving in

Mr. Arnott isn’t ready to concede the argument. His team at Research Affiliates is working on a paper on fundamental indexing, in tandem with Harry Markowitz, that should come out soon, he said. Mr. Markowitz won a Nobel Prize for his pioneering work on modern portfolio theory.

Whoever wins the academic argument, some observers say fundamental indexing could remain in demand. Even if it’s finally seen as a particular implementation of a value-oriented strategy, the fact that it’s well-constructed, transparent and a low-fee way of capturing the market’s value premium will attract investors, said Mr. de Silva.

Verizon on alternatives edge

The international newspaper of money management April 30, 2007

Adds absolute return and private real estate to 401(k)

By Jenna Gottlieb

Posted: April 30, 2007, 6:01 AM EST

STAMFORD, Conn. — Verizon Communications Inc. added private real estate and absolute-return investment options to its 401(k) plans for salaried employees, making the telecommunications company the first non-financial plan sponsor offering the alternatives to plan participants.

Verizon is in a league of its own, said Martha Spano, senior consultant for Watson Wyatt Worldwide, Washington. Defined benefit plans — which are considered more sophisticated with investments — only are “now starting to add private equity to their lineup; for most DC plans, it’s a trend about 10 years off,” she said.

Verizon Investment Management Co. added the strategies — plus a new emerging markets equity investment option — to the $9.5 billion business and management 401(k) plans in the first quarter. The emerging markets option is being unitized from the company’s defined benefit plans, said Michael Riak, director of Verizon’s savings plans.

“From the Verizon Investment Management side, we wanted to fill in the investments available to participants and to give them the opportunity to earn pension-like returns,” said David Beik, executive director for investment management at company’s money management unit, which oversees investments for Verizon’s $62.6 billion in total retirement assets. “We wanted to help avoid the situation where DC plan participants are too conservative.”

The changes were made following Verizon’s decision to freeze its $39 billion cash balance plan for management employees in June 2006.

Verizon’s move is history-making, consultants said. William Schneider, managing director at DiMeo Schneider & Associates LLC, Chicago, said adding absolute return and private real estate options in a DC plan is virtually unheard of.

“In a DC environment, it’s about what vehicle” you use for real estate and absolute return, he said. “Some vendors have those types of products, but they’re not the premier vendors. We’re not seeing interest in private real estate. A lot of our clients have had REITs since 2000, but not private real estate,” Mr. Schneider added.

Stacy Schaus, senior vice president and defined contribution practice leader for Pacific Investment Management Co., Newport Beach, Calif., said that while more plan sponsors are discussing these asset classes, none besides Verizon has added the options.

“There’s tremendous hesitance in the marketplace and it will be a while before we see these strategies taking off,” said Ms. Schaus.

Liquidity issues

Interest is limited in those asset classes because it is challenging to include them in DC plans, said Mr. Schneider.

“The whole essence of private real estate is that it’s private. There are no public appraisals. For REITs, you’re so far removed” from actual property holdings, he said.

Adding absolute return and private real estate options typically pose redemption and liquidity challenges for DC plans. Verizon’s plan, however, has overcome those hurdles, but Mr. Riak declined to provide details.

“The absolute return strategy and the private real estate funds are both daily-valued and are available for daily trading to the participants. There are no restrictions in trading in either fund. They both have cash and more liquid securities attached to them, which allow for daily cash flows,” said Mr. Riak.

The same goes for absolute-return strategies, he said.

“It is unique,” said Mr. Schneider. “It would have to be a very large plan sponsor, like a Verizon, to do this.”

“We’re going to see this evolving,” said Watson Wyatt’s Ms. Spano. “Plan sponsors are struggling right now to get participants to invest in equity for the most part. I’ve had clients ask about private equity, but none of the committees feel comfortable yet.”

It is common for financial services companies to provide alternative investments as part of their internal DC plans. Prudential Financial Inc., Newark, N.J., for example, has a private real estate option managed by the firm in its $5.3 billion 401(k) plan, confirmed spokesman Darrell Oliver. Goldman Sachs Group Inc., New York, reportedly provides an absolute-return option in its internal 401(k) plan.

Four managers

In Verizon’s plan, Prudential manages the real estate option, while three managers provide the absolute-return strategy, said Mr. Riak. He would not identify the managers.

Verizon also added an emerging markets equity strategy, an asset class many large DC plans have added or considered recently. That strategy is managed by Morgan Stanley Investment Management, New York; AllianceBernstein Institutional Investments, New York; and Dimensional Fund Advisors, Santa Monica, Calif., Mr. Riak said.

“We do tend to steer towards institutional commingled and separate accounts. If there is a change with the fund, we could have more control. And it’s a lower-cost option for us,” said Mr. Riak.

Besides increasing the total number of core investment options to 23 from 20, Verizon officials implemented automatic enrollment and increased the company’s match to one dollar for every dollar contributed by employees up to 6% of salary, from a dollar-for-dollar match up to 5% of salary. Verizon also added a Roth 401(k) contribution feature and added target-date asset allocation funds managed by Russell Investment Group, Tacoma, Wash.

Matt Smith, managing director of retirement services at Russell Investment Group, said Verizon’s plan design is very different from most large corporate plans. “It feels like the early ’80s when everything was new,” he said, regarding the new investment options.

More changes possible

Phil Storms, director of human resources for Verizon, said managed account services and investment advice also are being considered for the two 401(k) plans.

“Managed accounts are something we have talked about. It’s not out of the picture and may be something we consider in the future. We’re trying not to overwhelm employees with too much.” Mr. Storms added that Verizon is considering adding investment advice: “We do have a significant population that would be interested.”

The changes do not affect Verizon’s three union plans, said Mr. Riak, adding that subject to union negotiations, those plans, with a combined $8 billion in assets, could undergo design changes. “If the union wanted to pursue changes, it’s something that could happen in the future,” he said.

A Legend Lashes Out

Barron's Online
Monday, April 30, 2007

A Legend Lashes Out

Michael Steinhardt, hedge-fund pioneer and philanthropist

MICHAEL STEINHARDT, WHO LAUNCHED his hedge-fund firm 40 years ago and quickly became an industry giant, doesn't think much of some of the people making huge fortunes in the business today.

Back when he started, he says, hedge-fund chiefs were members of "a very limited, elite group that had mystery and excitement and élan. Now, it's all about making money for the managers." Steinhardt, who routinely made 20%-plus annually for his investors, adds that a lot of his modern counterparts are far better at gathering assets -- a key factor for their pay -- than they are at generating investment gains. "If I made 11% in a year, I'd be committing hara-kiri. These guys make 11% in a year and they are overjoyed."

He's even more critical of mutual funds, whose collective performance he denounces as a "disgrace."

Currently, there are more than 9,000 hedge funds, with some $1.4 trillion of assets and a raft of hotshot MBAs salivating over staff openings. In contrast, "we were not a mainstream institution," says Steinhardt, who recalls there being just a handful of hedge-fund managers when he set up shop in 1967. "We were viewed askance by almost everybody. We were the gunslingers, the wise guys, the people who screwed up markets" -- second-class citizens in the then-clubby world of investment management.

There was nothing second-class about the results generated by Steinhardt's rapid-fire trading. Over the next 28 years, his firm earned a compound annual return of 24.2%, net of fees. It lost money in only three fiscal years -- 1969, 1972 and 1994, which saw a brutal downswing of nearly 34%.

Steinhardt, 66, who spoke with Barron's in his Madison Avenue office in Manhattan, now devotes much of his time to philanthropy. He retired from active money management in 1995. But he still cuts a big figure in hedge-fund circles, partly because he was a pioneer.


One of his first institutional clients was the Common Fund, set up in 1971, mainly for college endowments. "He recognized early the advantage of having good short positions, as well as long positions," says George Keane, who helped to organize the Common Fund, which allocated money to Steinhardt in the early 1980s. "His edge was his research and understanding the large U.S. companies inside and out." One of Steinhardt's investment precepts, Keane recalls, was that interest rates would fall, as they did eventually.

With managers now collecting management fees of 1% to 2% -- or even higher -- on billions of dollars, "they are extraordinarily well-compensated," says Steinhardt. "I used to say that I should not make a dime unless my investors made a dime, and the 1% [management fee] was supposed to be enough just to pay expenses." However, he adds, "This is a free market" and investors sign up "of their own free will. So one shouldn't feel sorry for them."

Oscar Schafer, a Barron's Roundtable member and hedge-fund manager who worked for Steinhardt in the 1970s and early 1980s, says that his old boss brought to the office "an intensity and a desire to win every day."

In fact, Steinhardt's combative personality was legendary on Wall Street. He didn't suffer fools gladly, and he didn't hesitate to tear apart an analyst's thesis on a stock. "He had a special feel for what really made a stock go up and down," Schafer relates. "He reduced me to tears several times, [but] he was as hard on himself as he was on everyone else."

Says Tony Cilluffo, who worked on Steinhardt's trading desk in the 1970s: "Michael was basically a skeptic from day one. He did not buy the BS that the Street used to peddle." Aspiring hedgies take note: Steinhardt doesn't think superior portfolio management can be taught. "The greatest teacher is experience," he says, noting that his own stock-trading days began at 13 when his father gave him more than $5,000 in shares of two companies. "By the time I graduated from Wharton [the University of Pennsylvania's finance school] at the age of 19, I had more trading experience than most people have at the age of 30 or 35," he says. "I made more mistakes by the age of 19 than most people make 10 or 20 years later into their lives."

It's important for a hedge-fund manager "to really feel miserable" for their mistakes and to be galvanized by "the sense that their own personal security is at risk. I felt that more than once," he adds, implying that these factors are missing in today's more comfortable and well-compensated hedge-fund world.

Steinhardt's biggest investing regrets include not preparing his portfolio better for the October 1987 market crash, even though he had written to his investors earlier that year that the market looked overextended. The big hit he took in 1994 also was a result of inaction. "Without knowing it, our confidence had lured us into becoming too big" in the international bond markets," Steinhardt wrote in his book No Bull: My Life In and Out of Markets.

The early days of Steinhardt's career were spent working at New York brokerages, including Loeb Rhoades, where he learned about fundamental stock research. Confident in his own stock-picking abilities, he opened his own firm, Steinhardt, Fine, Berkowitz & Co., at age 27. It was a small shop with eight employees and $7.7 million under management. Even though he traded aggressively, Steinhardt emphasized to his charges that fundamental research was king, regardless of whether they were making short- or long-term bets.

"He came into the office every day expecting to make money," says John Lattanzio, who was Steinhardt's head trader for many years.

Steinhardt liked to make contrarian calls and to invest in just a small number of stocks, especially those not well-covered on Wall Street. "You're not going to bring anything to the party on IBM," says Lattanzio. "They will tell the same thing to everybody. It doesn't mean it's a bad investment. But he liked to find things that were different." And, he adds, Steinhardt "was very good at understanding if there was an edge there."

Steinhardt typically would work out his macro view, and then build up his stock positions. There were times he instructed Lattanzio to liquidate the entire portfolio, and then they would start over. Over time, Steinhardt added fixed-income holdings.

Steinhardt still keeps his hand in investment management, though he's now focused on exchange-traded funds. In 2004, he led a group that backed a fledgling venture called WisdomTree, which has rolled out a series of ETFs weighted by fundamental factors like dividends and earnings. In contrast, many index funds are weighted by market capitalization.

Steinhardt says he "was attracted to the idea of an investment product that would be superior in its performance and have at the same time low cost, great liquidity and total transparency." What also made these ETFs appealing is that they offered a good product to average investors, which in his view have not been well-served by mutual funds. "Mutual funds have been a disgrace, and if they were really measured in terms of their real performance, the disgrace would be much bigger," he says.

Steinhardt has a range of interests, from horticulture to collecting ancient art. Nowadays, he spends a lot of time on philanthropy. The Steinhardt School of Culture, Education, and Human Development at New York University bears his name. One of his pet projects is Birthright Israel, which pays for young Jewish people to visit Israel. He is particularly interested in Judaism's history and culture. He wants, as he puts it, to help "create a Jewish future that is exciting and vibrant and will capture the values that have made Judaism so special."

What's his take on today's stock market? "The bell is beginning to ring," he says. "We're not too far from the end of the bull market."

Investors, take note. It's probably not a good idea to bet against this guy.

Wednesday, April 25, 2007

Why hedge fund replication might be giving you a deja vu

Why hedge fund replication might be giving you a deja vu

24 April 2007

In case you don’t usually read the bi-monthly report “Financial Stability Review” from the Banque de France, you might be interested to know that April’s edition (now on newsstands everywhere) is dedicated to hedge funds. A portion of it dealing with hedge fund replication has interesting parallels to the mutual fund industry.

Professors Bill Fung and David Hsieh provide their usual commentary on hedge fund replication for the report (not that dissimilar to their report to the Federal Reserve last year). But buried in the “state of the industry” treatise is a nuanced argument about the very raison d’etre for hedge fund replication. Essentially, Fung & Hsieh advocate hedge fund replication as a way to keep managers honest. In other words, (cheap) hedge fund replication can and should be used as a benchmark to accurately define true alpha. But ironically, argues the duo, investable hedge fund replication fees have been marked to prevailing hedge fund fees, not the other way around. In their report, they conclude:

“Since the early days…numerous innovative trading strategies have been created…(But) despite the differences in risk taken by hedge fund managers to generate profit for their investors, their compensation structures remained remarkably similar across a broad range of investment styles. There is practically a ‘one-size fits all’ formula where hedge fund managers are paid a fixed fee proportional to the capital they manage and participates in the trading profits they generate without any reference to risk. One plausible explanation is that, unlike conventional long-only strategies, the absence of suitable benchmarks – against which the manager’s skill, alpha, can be separated from passive beta bets – makes it difficult to establish suitable performance hurdles that properly reflect the passive component of hedge fund returns. The arrival of HF clones could have a profound influence on how hedge fund managers are compensated. Armed with this alternative way of accessing passive hedge fund returns, investors can point to investable performance benchmarks that separate alpha returns from passive beta bets. Incentive fee contract can now be structured to reward skill, or alpha, differently from passive index-like returns.

“The existence of these index-like hedge fund products can also act as catalysts to improve the price discovery process in the hedge fund industry – more efficient fee structure with equitable risk-return sharing between investors and managers. This is in fact a healthy development for the hedge fund industry, one where alpha producers with limited capacity can be sufficiently compensated for their skills and beta-only products will regress to being index-like alternatives at lower fees.”

Alas, replicated hedge funds are being offered as an alternative to hedge funds (and priced accordingly), rather than as a way to measure true alpha.

In our view, this is not dissimilar to the introduction of ETF’s to the mutual fund industry. Uninvestable indices like the Morningstar style boxes originally helped benchmark managers and determine value-added. But now that BGI manages ETFs based on each Morningstar style box, are we to conclude that mutual funds are toast? Or are we to simply conclude that mutual fund managers ought to drop their fees to a level that is commensurate with the amount of alpha they produce?

Naturally, we believe the latter - that ETF’s shine a harsh light on the mutual fund industry, revealing the fee being implicitly paid therein for active management. While this implicit fee was easy enough to calculate prior to the emergence of ETFs, we now have the liquid financial “technologies” required to arbitrage between mutual funds and equivalent portfolios of ETFs & hedge funds. And this management fee arbitrage puts downward pressure on mutual fund fees.

But while ETFs can go a long way toward isolating true value-added and the fees charged for it, they don’t actually tell us the fair market value for that embedded active management. However, there is an established market for “active management” - hedge fund investors have been paying for “high-alpha-proportion” funds for years (assuming for a moment that hedge fund alpha is actually alpha). It turns out that the active management in many mutual funds is priced higher than the analogous active management sold as a bona fide hedge fund(!)

Unfortunately, no such market for “true alpha” exists against which we can benchmark the (ex-alternative beta-) hedge fund fees. So we are stuck with the fees implied by a hedge fund’s proportion of (cheap) alternative beta. With hedge fund fees running at, say, 4 or 5% (all-in) and alternative beta explaining over half of their return movement, that fee will almost certainly be higher for that totally unreplicatable je ne sais quoi.

This type of analysis has already been conducted on the mutual fund industry and it will only be a matter of time until it will be conducted on hedge funds - once investable alternative betas become ubiquitous.

How do you say “deja vu” in French?

- Alpha Male

Natural international hedges


Academics and investment planners have pitching the value of international portfolio diversification to individual investors for quite some time now. The last few years have seen a surge in individual asset flows into international equity mutual funds. Undoubtedly the increase in international investment vehicles, like the dozens of ETFs, has made this process all the easier and transparent.

The question is whether this surge in international investment is simply a means of catching up to the commonly recommended 20-40% equity allocation. Or is it simply another case in the long line of individual investors chasing hot performance? We will not know the answer to that question until we have a notable market break, but until then there are plenty of issues to deal with on the international investing front.

Chet Currier at notes the fact that mutual fund investors have put substantially more into global equity funds than domestic equity funds in 2005, 2006 and 2007 year-to-date. That brings allocations up to seemingly “normal” levels.

At last report, by my calculations, the FRC data show world fund assets at 26.5 percent of the total in equity funds. That number doesn’t look excessive if we recall that numerous advisers have long been urging U.S. fund buyers to put 20 percent to 30 percent of our stock money in international funds.

This begs the question as to whether most investors really know what they are getting themselves into. David Merkel at the Aleph Blog notes a handful of “micro” issues that investors should take into account when they invest overseas. In short,

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.

One area that investors have embraced is the emerging markets. While many will cite the higher growth rates as the attraction of the emerging markets, something else is going on. FT Alphaville cites a Merrill Lynch report on the emerging markets that notes the changing nature of the emerging markets. Now instead of being a source of instability they may now be a ’safer haven’ in light of an U.S. economic slowdown.

The underlying fundamentals in emerging markets are “superb”, says Merrill: “We continue to believe the asset class is undercapitalised, under-leveraged, under-owned and under-valued.”

So, in a mirror image of 1998, emerging markets are the asset to buy in increasingly frequent bouts of market volatility. Credit problems are now in the US rather than in emerging markets. Liquidity to ease the US credit problem will be redirected toward emerging markets , just as liquidity to ease the Asia/LTCM problems last decade was redirected toward the tech sector.

If that really is the case then not only will the so-called BRIC countries benefit, but frontier markets will as well. Gregg Wolper at reports on how fund managers are adding frontier markets into their portfolios. He notes how most managers divide the emerging markets into tiers with the most established markets at the top with the smaller markets at the bottom.

The fact of the matter is that this process of integrating frontier-type markets into the mainstream has been happening for a long time. The names change, some markets ‘emerge’ and then sink back down to ‘frontier’ status while other countries simply become developed. The indices will always be a step or two behind the cutting edge. That is where Wolpper notes an effective manager can add value:

Given that a mutual fund investing in India or Poland might have seemed a radical idea not too long ago, it’s important to recognize that what now seems hopelessly exotic can easily become commonplace. More to the point, if you want your fund to beat the index and outpace rival funds–and it must in order to earn its fees–then you have to allow its manager some freedom to deviate from the index and peers and accept the risks that come with that.

Much has been made about the rising correlation between the U.S. and international markets. (Although there may be some reversal in that trend.) Those higher correlations may mitigate some of the benefits of international diversifcation. Indeed those correlations will change over time. Focusing to closely on those zigs and zags is a mug’s game.

What is more important is the strategic role that international diversification, specifically non-dollar, unhedged exposure may have. We discussed last year when the energy markets were going ballistic that an exposure to commodities, like energy, can serve as a natural hedge of your ongoing energy needs. It would take some fancy math to figure out the exact exposure needed, but it makes intuitive sense that when energy prices rise, your personal expenditures go up, as would the value of any energy investments.

The same “natural hedge” argument* could be made about international investments as well. Even a cursory glance at your expenditures would show significant spending on a number of foreign products. In our minds it makes some sense to ‘hedge’ a (potential) longer term slide in the dollar with some foreign exposure. The amount and nature of that allocation is, of course, up to you.

International investment is by no means a portfolio panacea or a perfect ‘hedge’ by any means. Despite the recent run-up in the world markets there will come a time when the international markets underperform. However a well-conceived notion of why you have diversified your portfolio internationally in the first place, will serve you well in more tumultuous times.

*Dedicated readers of Abnormal Returns will note that we made a similar argument as a part of the Big Picture’s Blogger’s Take on the state of the U.S. dollar.

Tuesday, April 24, 2007

Best Fund You Never Heard Of

By Brett Arends
Mutual Funds Columnist

4/23/2007 11:25 AM EDT


Who has had the most successful "general" stock fund over the past few years? Legg Mason (LM) ? Fidelity? American Funds? Nope. You've probably never heard of Kailash Birmiwal, or of his tiny Birmiwal Oasis (BIRMX) fund. But Lipper and Morningstar say this obscure and mysterious fund is shooting out the lights. Oasis opened for business only four years ago, but Lipper calculates that it has already turned $10,000 into $28,000. That's three times the profits you would have made in an S&P index fund over that period. Morningstar, which gives Oasis a five-star rating, believes the performance figure is even higher. They are, incidentally, unable to explain the discrepancy. Birmiwal, who runs the fund, probably holds the answer, but he is hard to track down ... and when I finally reached him, he refused to be interviewed. Best guess: The fund hands back such a huge chunk of its profits to investors each year that this may be confusing the "total return" calculations. Either way, both Lipper and Morningstar say the fund is a superstar. It's up another 9.24% already this year. Oasis, alas, closed to new investors in January of last year -- less than three years after opening. Such apparent success inevitably piqued my interest. Birmiwal's refusal to talk made me even more intrigued. So I went hunting through the public filings to find out what I could. And they revealed a lot about the elements of successful investing. With apologies to Leo Tolstoy, every unhappy mutual fund is unhappy in its own way, while all happy mutual funds are alike. The manager's name is on the door. Kailash Birmiwal isn't trying to work his way up a career ladder in someone else's company. He's not playing office politics, covering his rear or answering to a committee every quarter. The company is his, and he's answerable to one group of people alone: the customers. The manager is eating his own cooking. Published biographical data says Birmiwal actually began his investment career running his personal stock portfolio. After a decade, he had been apparently been so successful that he opened a small fund to run some outside investors' money as well. There is no guarantee that the two go hand in hand, but it's a reasonable conclusion to draw -- especially as the mutual fund is doing so well. The manager has a free hand to invest where he wants. Foreign, domestic, big companies, small companies, he goes wherever there's value. And he doesn't have to shop for the sake of shopping. As of Dec. 31, the fund's most recent filing, it had 20% of its assets in cash. He can also go short: Nearly 2% of the fund is betting on a fall in the Nasdaq 100 index. The fund is concentrated. A third of the money is invested in the top 10 holdings. Concentration makes returns more volatile, but if fund managers knows what they are doing, letting them make big bets where they are most confident should produce better returns over time. If they don't know what they are doing, they shouldn't be running a fund at all. The manager plays to his forehand. Birmiwal is a former professor of electrical engineering (at the University of Southern Illinois). And a review of his current stock holdings show a strong bias toward industries where a technical background would be an advantage. As of Dec. 31, his fund has 13% of its money in computer-chip makers, 8% in software and nearly 6% more in business and IT services. He also has large holdings in mining and chemicals. The fund has stayed small and nimble. In fact, at $20 million. it's tiny. And by closing it to new investors and paying out huge dividends each year, Birmiwal keeps it that way. Compare that with most mutual fund companies, which want their funds to be as big as possible, even if that dilutes returns. Fees are linked to performance. In a fund this small, fees are always going to be high as a percentage of net assets. They came to 3% in 2005, the last year for which we have data. But nearly half of those were linked to performance. Birmiwal has one other feature I like. I have a theory -- so far it is purely anecdotal -- that the further an investment manager is from Wall Street, the better it is likely to be. Think Warren Buffett (Nebraska), Dodge & Cox (San Francisco), Longleaf (Memphis). The distance helps soundproof them from the day-to-day noise that is the enemy of a long-term investor. Birmiwal Oasis is run from Bellevue, Wash. -- a suburb of Seattle. Bottom line: Where is he putting his money right now? Many of the holdings seem to be small, little-known leveraged plays on big trends. As of Dec. 31, his top holding, representing 6% of total assets, was ChipMOS Technologies (IMOS) , a play on the boom in LCD and other flat-panel displays, including TVs. ChipMOS, based in China, tests the computer chips that run those displays. He had 5% in Optionable (OPBL) , a play on the energy derivatives market. Optionable, a micro-cap that is traded over the counter, provides services to energy derivatives brokers, and it launched the OPEX electronic trading platform. Birmiwal has 4.4% invested in Bodisen Biotech (BBCZ) , a way to play the economic revolution in China. Bodisen, which Forbes calls the 16th-fastest-growing company in China, is a manufacturer of environmentally friendly bio-fertilizer there. The stock's primary listing is in London. Birmiwal also has 3.9% invested in Webzen (WZEN) , a Korean developer of multiplayer, online role-playing games. Other large stakes include Indian pharmaceutical Dr. Reddy's Laboratories (RDY) , Argentine gold and copper miner Northern Orion Resources (NTO) and California's Credence Systems (CMOS) , which provides equipment and services for computer-chip makers.

John Henry: Part 1

April 23, 2007

Henry’s real ‘life extension’ challenge I

A buy signal? On a perilous—but well-trod—path

The conclusion of this two-part article will be published tomorrow.

StormflagsSearch the phrase ‘“Red Sox” +immortal’ and Google helpfully pops up 182,000 references, more than a few pointing the general direction of the late slugger Ted Williams, today safely nestled in an Arizona cryogenic facility. Now, Red Sox principal owner, and investment manager—in that order, these days—John W. Henry has his own interests in the life extension business as the largest shareholder in Sirtris Pharmaceuticals, according to a recent Boston Globe article.

But on the life extension front, Henry’s real concern should be with John W. Henry & Co, his famously volatile commodity trading advisor, now confronting the biggest gut-check in its gut-check checkered 25-year history. Hedge Fund Alert reported Apr. 11 that Merrill Lynch Alternative Investments had ordered its financial advisors to stop putting their clients into JWH products.

It’s not like John Bogle decided that conventional index investing is a silly idea. But it’s close. Merrill Lynch has been a key contributor to JWH’s asset base since the 1980s. Its recent call almost certainly reflected two-years-and-counting of brutal performance, possibly compounded by this year’s round of senior management changes, apparently triggered by efforts to address those performance concerns. [JWH general counsel and spokesman David Kozak did not respond to an email message (Apr. 13), or a telephone call (Apr. 20) by pixel time].

It’s never a good time for an asset manager to get cut off by Merrill, and this moment was spectacularly inopportune. Perhaps for Merrill and its customers, because JWH’s current decline—near 40 percent in its flagship Strategic Allocation program—is in the neighborhood of an historically reliable buy signal.

But definitely for JWH, where some familiar storm flags—performance issues, management turnover, the owner’s flash toys, all early chapters in Due Diligence for Dummies—are flapping loudly. Together.

Two years of losses, and counting
The great amorphous Red Sox Nation celebrated the World Series win in 2004, which ended an 86-year drought and the legendary ‘Curse of the Bambino.’ But the curse didn’t leave; it simply infected the team’s current ownership.

Seven of JWH’s eight active programs are already down double-digits for 2007, through Mar. 31, with the one-time flagship Financial & Metals dropping almost 20 per cent. Over three years, the portfolios are all in the red, by as much as almost 18 percent, annualized. The Strategic Allocation program, which has in recent years accounted for the bulk of JWH’s assets, is down almost 12 percent, after losing 13 percent in 2006 and almost 25 percent in 2005.

The declines are one thing. Their duration is extraordinary. SAP’s decline, through Mar. 31, has run 27 months and is now just a whisker under 40 percent. F&M is off more than 40 percent over more than three years.

Intriguingly, if only coincidentally, stock in The New York Times Co is also off by around 40 percent since Dec. 2004. The Times has 20 percent of the Henry-controlled New England Sport Ventures, which owns the Red Sox and 80 percent of the New England Sports Network regional cable television channel.

Inevitably, the performance has taken its toll on JWH’s assets under management, which have dropped to roughly $1.3 billion at Mar. 31, down from $1.7 billion at Dec. 31 2006, and less than half of the $2.8 billion it managed in Dec. 2005.

Of course, market conditions have been far from ideal for JWH’s relatively long-term trend-following style. As Ken Webster, recently promoted to president, put it in the firm’s 2006 Year in Review newsletter, in Jan. 2007: unfortunate coupling of historically low volatility and trendless markets plagued by strong and sharp reversals…were fueled by the uncertainty surrounding the economic health of the majority of the world’s industrialized nations. This uncertainty led to a year of negative performance in the JWH programs. Market conviction and direction were replaced by doubt and ambiguity in 2006 as markets overreacted to any and all possible economic precursors. We look forward to a return to trending market cycles in 2007...

The proximate cause, according to Mark Rzepczynski, Webster’s recently-departed immediate predecessor explaining the miserable 2005, and the eternal test of long-term trend-followers:

…the extent and number of trends were below what we have encountered historically. Additionally, the markets that did have strong moves were coupled with significant reversals along the trend path. This reduced our profit potential as we adjusted to changing risk or hit stop-loss levels…In between the rough first quarter and the last month of the year, monthly returns showed a relatively good pattern of small gains, but those cumulative gains were not enough to offset the extreme reversal months.

Those conditions have also affected JWH’s competitors, but to a much more limited extent. FME Large, the flagship of Baltimore-based Campbell and Co, was down 6.3 percent through Mar. 31, or just over half SAP’s year-to-date loss. But the program was profitable in both 2005 and 2006, when it made 11 percent and 5.5 percent respectively.

JWH cut the leverage in SAP in Jan. 2007, reducing “existing positions by 25 percent and limiting by 25 percent new positions as they are established…for the foreseeable future,” according to its latest disclosure document. It’s not the first time the company has tweaked its leverage, but the decision wasn’t unanimous and had consequences.

Shuffling the deck chairs
Rzepczynski, who joined the company in 1998 and became president in 2001, left on Jan.12: “It was an amicable separation in terms of the decision by the company to pursue the development of lower leveraged programs and strategies going forward,” said JWH general counsel David Kozak, according to the UK-based HFM Week. In other words, Rzepczynski lost a fight over the firm’s future direction.

Others shown the door at much the same time as Rzepczynski included long-time marketing executive Ted Parkhill; Bill Dinon, head of sales; and Andrew Willard, director of technology. Webster, with JWH since 1995, added the president’s title to his chief operating officer role, while head trader Matt Driscoll was named chief investment officer, a title formerly on Rzepczynski’s business card.

Most recently, long-time Henry aide Mark Mitchell cut his ties with the investment operation, where he was vice chairman, for a role with New England Sport Ventures.

Like those stomach-churning drawdowns, management turnover is nothing new at JWH. Before Rzepczynski’s record tenure ended in January, past holders of the president title included Verne Sedlacek, now president and chief executive officer of Commonfund; Bruce Nemirow, now a principal of Capital Growth Partners, a third-party marketing company; and Ken Tropin, who, after a distinctly less than amicable split with Henry, went on to found Graham Capital Mgt Inc in 1994. That firm’s assets passed JWH’s several years ago.

Between Nemirow and Sedlacek, Peter Karpen, a former chairman of the Futures Industry Association; and David Bailin, now head of alternative investments at US Trust, held similar responsibilities, without the title of president.

It would seem a stretch to compare Henry—usually described as polite, softly spoken, press-shy, modest and similar terms—with the once impatient, headline-demanding, bombastic and eternally meddlesome New York Yankees owner George Steinbrenner. After all, in his hey-day, Steinbrenner never broke down in public when he lost a general manager, as Henry famously did when the Red Sox briefly parted ways with Theo Epstein in 2005.

But even Henry concedes, euphemistically, an inner Steinbrenner, never seen in public: according to a profile published in Institutional Investor in 1996:

“For his part, Henry readily admits that he demands a lot of his employees. ‘We’re driven to excel,’ he says, ‘and that’s necessarily going to occasionally create differences of opinion.’”

Since Tropin—the last person to hold the chief executive title—left some 15 years ago, and despite the lengthening list of distractions, nobody’s been under any illusion which differing opinion will out.

Tomorrow: The distractions; Falling behind the crowd; A buy signal?

Part 2: John Henry - Commentary, etc.

April 24, 2007

Henry’s real ‘life extension’ challenge II

Distractions; falling behind; and the buy signal

The first part of this article, looking at the challenges and questions confronting trading advisor John W. Henry & Co, and its eponymous owner, appeared yesterday.

StormflagsIt’s not exactly last week that Henry started enjoying the fruits of his investment prowess, and he’s hardly the first investment manager to have time-consuming interests away from the golden goose. According to the JWH disclosure document: “Since the beginning of 1987, [Henry] has devoted, and will continue to devote, a substantial amount of time to business other than JWH and its affiliates.”

His heavy-duty distractions did not begin until he became involved in major league baseball, although he had earlier owned a minor league franchise and was involved in a failed venture to secure an NHL expansion franchise in Florida.

Henry bought the Florida Marlins in 1998. After losing a bruising political fight over public financing for a new stadium for the Miami-based team, he upgraded to the Red Sox in 2002. His sporting interests expanded again last year, when he bought a 50 percent stake in the Jack Roush NASCAR team. Among his other ventures, apart from the Sirtris Pharmaceuticals stake:, set up to “create the world's most authentic, most sophisticated, most accurate PC-based racing simulations and grow a new branch of motor sport through real-time, online competition.”

Despite these distractions, he still keeps a close eye on the goose.

According to the disclosure document, “Henry oversees trading program design and composition, reviews and approves research and system development proposals prior to implementation in trading, reviews and approves of decisions involving the strategic direction of the firm, and discusses trading activities with trading supervisors.”

That’s a lot of hand on the helm for an owner who spends “a substantial amount of time” not merely off the bridge, but on different ships in far oceans. An obvious due diligence concern, and given Henry’s past achievements as one of sector’s great innovators, probably a substantial contributor to another longstanding question in JWH’s record.

Falling behind the crowd
Even before its current sustained performance decline, JWH had largely missed out on the asset eruption in managed futures, specifically, and hedge funds, generally. The 25-year-old business comes from the same generation of managers as Bruce Kovner’s Caxton Corp, Paul Jones’ Tudor Investment Corp and Louis Bacon’s Moore Capital Management, all of which, despite regularly returning capital to investors, now have assets in the $10 billion range.

But those firms have diversified far from their ‘managed futures’ roots, into equity markets and a plethora of other financial strategies. A more valid comparison is with Baltimore-based Campbell & Co Inc, which, like JWH, has stayed true to its roots of trading global futures markets using medium- and long-term trend-following strategies. Like Henry, it has a long-standing relationship with Merrill Lynch. But Campbell now runs over $12 billion—nearly 10 times Henry’s current assets—with $10.3 billion of that in its long-running FME Large portfolio.

Campbell offers other contrasts. Its senior leadership has been stable since founder Keith Campbell began withdrawing from day-to-day involvement in the mid-1990s. Bruce Cleland was named president in 1994, and chief executive in 1997; when forced to step aside earlier this month to battle a recurrence of cancer, he was replaced by Terri Becks, chief financial officer for 16 years.

It has also, like other quant-oriented managers with long records of admirable performance—Jim Simons’ Renaissance Technologies and Man Investments’ AHL spring to mind—invested heavily in research, and aggressively promotes those efforts as a key component in its success. While their mileage has varied, with Renaissance a clear leader in the pack, none has come close to inflicting the kind of pain JWH has imposed on its faithful.

By contrast with its peers and competitors, the firm seems almost complacent.

“JWH generally has not changed the fundamental elements of the portfolios due to short-term performance, although adjustments may be, and have been, made over time. In addition, JWH has not changed the basic methodologies that identify signals in the markets for each program. JWH believes that its long-term track record has benefited substantially from its adherence to its models during and after periods of negative returns; however, adherence to its strategy may lead to prolonged periods of market losses and high risk,” according to its current disclosure document.

History supports that contentment. But the magnitude, and especially the duration, of the current decline now leaves JWH at a crossroads where the Mints and the Trendstats and other once-proud names diverge from the Campbells and the AHLs.

The putative buy signal
“It’s different this time” are the four most expensive words in investment history. And if it is exactly the same, Merrill Lynch Alternative Investments did its clients no favor by ordering its financial advisors to stop putting their clients into JWH products. The old saw was “Buy Henry when he’s down 20 percent, and buy some more when he’s down 40 percent, because there’s a new high coming.”

That buy signal is here. At Mar. 31, the 27-month decline in the Strategic Allocation program had reached 39.4 percent; its previous peak to valley drawdown, between May 2003 and Aug. 2004, was 31.7 percent. (Emphasizing JWH’s volatility, that program was profitable in both those years, making 8.4 percent in 2003 and 13.7 percent in 2004).

Financial & Metals, down almost 20 percent so far this year, is off more than 40 percent in a decline that began in Mar. 2004. Since inception, in 1986, it has returned almost 25 percent annualized despite having beaten that number just once since 1996; its largest decline was 43.6 percent, incurred over 15 months between Jul. 1999 and Sep. 2000.

Of course, it’s always tempting to take the other side of any Merrill call, especially one targeting its retail investors. But JWH faces a tough climb back.

Merrill’s decision will likely trigger additional redemptions as its financial advisors churn their clients out of JWH products. And, without those same brokers pounding the phones, that money won’t be easily replaced.

JWH’s principal response—“to pursue the development of lower leveraged programs and strategies”—has come late in the day. When markets do turn in its favor, the leverage cuts will slow the slog back to the new high that, historically, arrived so reliably. It’s also a trick that’s been tried before, with mixed results, when the firm turned down the volatility volume in an unlikely, and largely futile, bid to attract institutional assets.

Webster, for one, remains confident. Reviewing Mar. 2007, he said that “turmoil has the potential to be a positive development” as short-term market dislocations “can be a harbinger of a major shift in trends.” And April has surely, to date, been relatively kind, with the steady ramp in stock markets worldwide, and dollar weakness, providing conditions in which JWH can, in fact, excel.

Henry’s place in investment history is secure. A member of the Futures Industry Association’s Hall of Fame. A Lifetime Achievement Award from Alternative Investment News. When traders talk about the pioneers and the performers, his name still resonates, even if its long-term performance record speaks louder of past glories than recent realities.

But one month—and one that’s not over yet—is not going to answer the questions about whether Henry’s drive to excel still includes his investment business. Another round of blood-letting? Another leverage tweak? Not enough, it seems, to have satisfied one of JWH’s most important customers, and certainly not enough to restore the firm to its once undisputed place in the investment firmament.

John Henry’s Longtime Lieutenant Is Out
Hedge Fund Alert Apr. 11 2007

John Henry’s bid to manage the future
by Michael Peltz
Institutional Investor Aug. 1996 (via

John W. Henry & Co Performance

John W. Henry & Co Monthly Commentary Archive

John W. Henry’s Wikipedia page

Veryan Allen: Hedge funds and interest rates

Hedge Fund Blog


The hedge fund industry has benefited in many ways from the low interest rates of the past decade. "Risk free" investments had insufficient returns to present much competition. Funding costs have been advantageous allowing cheaper exploitation of market anomalies. With investment grade bond yields so low and unhedged equity fund returns poor until very recently, there was natural demand for better risk/reward products to fill the vacuum. Unfortunately some popular alternative investment strategies will not do well should we enter a period of interest rate volatility.

While a lot of time is spent on the alpha versus beta debate, little consideration is given to another equally important but often ignored greek letter - rho; the sensitivity to changes in interest rates. Some hedge fund strategies are exposed to negative rho, that is depend on interest rates remaining low and benign. Ironically pension funds have positive rho as rising rates permit them to use a higher number to discount future liabilities. That is a pyrrhic victory because on the asset side of the balance sheet their portfolios of stocks and bonds often drop in such times. It therefore makes sense for investors to identify and diversify with strategies that tend to perform well in a RISING interest rate environment.

Leverage has been cheap for a long time. The infamous yen carry trade makes leverage almost free for those prepared to take on or remain ignorant of the fx risk. In steeper yield curve currencies, many borrow short term to invest in the long and often illiquid end of the curve. It is ages since we had genuine interest rate volatility and even longer since double digit risk free rates. The last time we had real US rate volatility was 1994, a year in which several "hedge funds" that had been considered skilled were revealed as not being skilled. The search for yield has reduced credit spreads enormously yet such spreads will not do well should turbulence return. Private equity and real estate is also very dependent on low borrowing and mortgage costs.

Hedge fund performance is not indexed to inflation. Should interest rates and bond yields rise this will present significant issues. In 1980s many risk free rates round the world were in double figures. Hedge funds in those days HAD to target much higher returns to be worth investing in. A few strategies do benefit from rising rates; for example managed futures and short biased funds have large cash balances. Put option prices drop as rates rise so some hedging costs reduce. But some hedge fund strategies are negatively exposed to rising rates, costlier credit, steeper yield curve twists and shifts and reduced and less reliable interest rate differentials between currencies.

Some fund of hedge funds target returns like LIBOR+500bp and not an absolute return. This sounds institutional but ignores what risk free means. In Japan that implies a pathetic 5.5% a year, in New Zealand that means 12.5%. Surely an absolute return strategy necessitates an absolute return target. It is not as though most hedge fund returns will magically ratchet up as rates rise. It would be better to aim for 10% or 15% depending on the risk profile than some relative benchmark. Some "market neutral" hedge funds tout their alleged dollar, market cap, beta and delta neutrality but are not rho neutral. And is a single digit target return even worth allocating to when you can get 5% without risk in the US and more elsewhere in some cases?

Hedge fund performance measures also have negative rho. Sharpe, Sortino and Information ratios change significantly depending on what risk free rate is selected. All go lower as the risk free rate in the numerator rises. Yield curves are pretty flat but oftentimes choosing the lowest point on the curve makes a significant difference. The same hedge fund performance will have very different reward to risk ratios depending on the rate and base currency. In the early 80s there were very good hedge funds around with negative Sharpe ratios because risk free rates were in the high teens.

Given the strong earnings and growth round the world, rising demand and commodity prices, it seems difficult to believe that an overdue bout of inflation or at least precautionary and preemptive interest rate hikes will not occur, sometime. While of course interest rates have fluctuated somewhat, it is a long time since true uncertainty and turbulence hit the markets. Most monthly economic numbers still show inflation to be relatively benign so perhaps globalization and "smarter" overheated growth fighting has permanently locked the inflation genie away. But sooner or later there will likely come a time when hikes are not a "well-discounted 0.25%" but become "surprise 0.50% and even 1% rises".

There is a good number of central bankers, CDO and CPDO structurers, credit derivatives traders, private equity spreadsheet junkies and negative rho positioned hedge fund managers that have little experience of such conditions. Parsing Bernanke and Fukui comments or ECB and Bank of England minutes will be of renewed importance should rapid and untelegraphed anti-inflationary moves become necessary. The bond and credit markets may not even wait for them.

Negative rho can be as dangerous as negative gamma but many investors don't even realise how short rho they are in their total portfolios. Rho has been safely ignored for a long time by many market participants. We entered 2007 with much commentary on the "Fed was done" with easing "later in the year" nonsense while now the directional probability seems much less clear and many countries are already in the process of renewed tightening. Stress tests for interest rate sensitivity are always necessary. The BEST hedge funds do this but NOT all hedge funds, sadly.

It’s about time..

It’s about time..

“Never think that God’s delays are God’s denials. Hold on; hold fast; hold out. Patience is genius.” – Comte de Buffon.

Interviewed by Steven Drobny in 2006 (“Inside the house of money”, John Wiley & Sons), Barclays Capital’s portfolio director John Porter made the following comments about his trading activities:

“What I am doing at Barclays nowadays is engaging in time horizon arbitrage. All investors these days are replicating the same very short-term style. Whether it is hedge funds, funds of funds, prop desks or real money, the good old days of a strategy session to discuss portfolio changes are over.

“Nobody can do that now. Everybody is held to parameters that don’t allow for any volatility in earnings. To me, that’s a good thing, as long as I don’t have to follow that formula. I believe that by executing a strategy that nobody else can, I will outperform. Does that make me any better ? Not necessarily, but it gives me an edge.”

In the same book, Falcon Management’s Jim Leitner makes an almost identical point. The capital markets are busily channelling billions of dollars towards hedge funds with monthly or quarterly redemption terms which forces the managers of those funds to manage their liquidity accordingly:

“If all investors allocate money to a one-month time frame, by definition there are going to be fewer opportunities there.. there’s just too much competition over short-term trading, which is a timing-driven business. With timing, sometimes you’re going to be right and sometimes you’re going to be wrong, but it’s not going to be consistent over time.. Meanwhile, the longer-term opportunities still exist because there hasn’t been that much money allocated with multi-year lockups.. That’s not happening yet and probably won’t because investors are way too nervous and shortsighted.”

Longer term investors with a wholly unnecessary requirement for liquidity (see also: sceptics of private equity funds) should be careful what they wish for. With a largely irrelevant penchant for rapid access to capital, allied with a bizarre aversion to even modest short-run mark to market losses, they run the risk of sacrificing thousands of basis points in longer term returns.

Portfolio manager Arne Alsin makes a very similar observation in the Financial Times (“When analytics, not time, is truly of the essence”). Alsin reduces successful stock market investing to two fundamental questions: “What does it cost ?” and “How much is it worth ?” The breathtakingly simple conclusion is that investors capable of answering these two questions to their own satisfaction – and with some degree of analytical precision - can stop there. Nothing more is required to be successful in equity investing. The problem, of course, is that investors invariably allow the extra variable of time to enter the equation. The problem is compounded by the inevitable pricing noise that arises from the interactions of multiple investors within a market.

In this respect, the long-term value investor who has some ability in cost / value analysis runs only one real risk: the risk of being early into the investment. On the basis that this investor is also attracted to higher-yielding, income-distributive situations which are likely to be out of favour (having already encountered previous selling pressure from his impatient rivals), even the risk of being too early is hardly likely to be fatal. Where carry contributes during the holding period, the likelihood of significant profit impairment is further reduced.

A number of investment commentators have written about the malign impact of timing pressure on portfolio performance. This pressure has been exacerbated by rapid improvements in global communications and transactional efficiency (read: the Internet), and it is doubtful whether our ‘cave brains’ are well suited to adapting to this new, quasi-instantaneous trading and feedback culture, even whilst increasing information transparency acts as a lure to our baser instincts to overtrade. This week provided a handy example. Within minutes of the release of buoyant Chinese economic data, European stock markets were tumbling– for at least the second time this year, spooked by unsubstantiated and largely wordless Asian fears. Perhaps the most instructive creation warning of the siren effect of timing, allied with redundant information flow, is Nassim Nicholas Taleb’s retired dentist, who is guaranteed to earn 15% per annum from his portfolio with 10% volatility. If this investor monitors his portfolio in real time, however, depending on the frequency with which he observes his holdings, he will encounter various degrees of happiness and distress. (The behavioural financiers tell us that the pain of loss of capital is approximately 2.5 times as severe as the pleasure created by gain.) The frequency of portfolio observation versus probability of pleasurable outcome chart for our dentist friend is shown below:

Timescale - frequency of portfolio monitoring: Probability of favourable outcome:

1 second 50.02%

1 minute 50.17%

1 hour 51.30%

1 day 54%

1 month 67%

1 quarter 77%

1 year 93%

(source: Fooled by Randomness by Nassim Nicholas Taleb, Texere Publishing.)

In other words, if Taleb’s dentist turns day trader and monitors his portfolio throughout the entire session, he will very quickly become emotionally exhausted. If he merely restricts the frequency of his portfolio observations, he will boost his chances of incurring a positive emotional outcome even though nothing has changed about the constitution of his portfolio. Conclusion: investors determined to watch the pot may end up scalding themselves.

In terms of profit potential, index-trackers are handing opportunities to generate alpha over to intelligent active investors in control of their emotions. Similarly, hot money investors with constraints over liquidity and a limited short-run tolerance for loss are handing alpha opportunities over to long-term investors with emotional discipline. Given the $2 trillion now widely accredited to hedge funds (and the likely associated leverage), ‘crowding out’ and hyper-competition within the short-run trading community (or at least those managers offering apparently attractive liquidity terms) may now represent a compelling opportunity for longer term real money investors with a reasonable sense of patience and emotional discipline.

Merrill: It’s back to the future in emerging markets

Merrill: It’s back to the future in emerging markets

It’s 1998 in reverse, according to a new research report from Merrill Lynch, which neatly explains how any easing of rates by the Fed to soothe pain in the US subprime mortgage sector could fuel the biggest bull run ever seen in emerging markets.

In other words, US subprime lenders are going to help inflate an emerging-markets asset bubble and according to Merrill, the ride is going to be sweet.

The 4.5 year bull run in emerging markets remains young by historical standards, the report reasons. And yes, such “secular”bull markets as the ones we saw for US small caps, Japanese equities and tech stocks tend to culminate in a bubble phase characterised by “greed, leverage and egregious valuations”. We know what happens after that.

But before any sticky endings, there are alluring returns to be made, says Merrill. If the Fed eases rates due to US housing woes in 2007-08, the investment bubble will begin, and emerging market returns in the coming year “may pale in comparison with recent years”.
The MSCI emerging markets index could soar to 2010 by 2010 — a 20 percent annualised return from its current level of 964, the report predicts.

The underlying fundamentals in emerging markets are “superb”, says Merrill: “We continue to believe the asset class is undercapitalised, under-leveraged, under-owned and under-valued.”

So, in a mirror image of 1998, emerging markets are the asset to buy in increasingly frequent bouts of market volatility. Credit problems are now in the US rather than in emerging markets. Liquidity to ease the US credit problem will be redirected toward emerging markets , just as liquidity to ease the Asia/LTCM problems last decade was redirected toward the tech sector.

But we’re not yet in that golden bubble phase, says the report. Leadership is still broad within the equity markets, there are no signs that equities are ignoring rising yields/inflation in the bond markets, and complacency and certainty is still scarce - so long as people keep asking “can emerging markets survive a US slowdown?” Merrill is bullish.

Monday, April 23, 2007

Bob Arnott - Baron's

Barron's Online
Friday, April 20, 2007
ELECTRONIC Q&A | Online Exclusive

ETF Pro Says Stocks Aren't Worth the Risk


ROBERT ARNOTT LOVES COLLECTING motorcycles dating back to the 'Twenties and traveling the world in pursuit of solar eclipses.

But Arnott, the manager of the $12 billion-asset Pimco All Asset Fund1, finds nothing sunny about the prospects for stocks in the coming years.

"I think we are more likely than not to have a bear market sometime this year,'' he says.

In a wide-ranging interview with Barron's Online, Arnott, the chairman of Research Affiliates, a Pasadena, Calif.-based subadviser to Pimco, talked about how investors can successfully diversify their portfolios from a classic reliance on stocks and fixed-income instruments lacking inflation protection.

He also talked about why exchange-traded funds based on fundamental measures such as dividends, profits and book value are simply a better mousetrap than the more traditional market-weighted kind.

Indeed, a number of the funds he developed that are now being marketed by PowerShares are easily outperforming their market-cap weighted equivalents. Recently, Charles Schwab began offering "fundamental index" ETFs in partnership with Arnott's firm, so it's clear that the concept has gone mainstream.

Barron's Online: In your role as an asset-allocation fund manager, you've been very bearish on stocks. Why?

Arnott: The earnings of an S&P company is about 50% above the 10-year average historically, and that is never a foundation for good earnings growth. And so unless we buck that historical norm, we're in for some serious earnings surprises in the next couple of years. And valuation levels are high relative to a historical average over the past decade. We are also looking at the cost of capital that is fairly substantial in real terms. The fed-funds rate is now 4% above core inflation -- that's a pretty high real rate. And we also have consequences of what some have characterized as a real-estate bubble, but was really a lending bubble. It is not that real estate so much soared on its own. It is that real estate was fueled by lending excesses, lending to people who had no basis to borrow.

Q: Can you tell me what the stock weighting is as a percentage of total assets of the Pimco All Asset Fund?
A: I'm only allowed to talk about year-end allocations. As of then, we had only about 11% or 12% of the portfolio in stocks. And our charter allows us to go up to 50%.

Q: I know that your decision in late 2005 to lower your equity rating resulted in fairly low positive returns for your fund in the past couple of years. You basically weren't that exposed to the bull market. Do you have regrets?
A: Yeah. But what is interesting is that the benchmark for the All Asset Fund is not stock and bonds but TIPs, or inflation-protected Treasuries. This fund is intended not as a balanced stock/bond portfolio, but as a diversification away from mainstream stocks and bonds. And as such, if what you are looking for is real returns, TIPS are the natural way to do that. We beat the TIPS market by 3%. We've beaten the TIPS market every single year since we launched the strategy.

Q: What are the best assets for investors to diversify their traditional stock and bond portfolios?

A: I'd pick three asset classes. I'd start with commodities, which are negatively correlated with mainstream stocks and bonds. They aren't necessarily a brilliantly attractive play for high returns, but they are sure going to reduce your volatility.

The second is TIPS. [Editor's Note: Like regular Treasuries, a TIP pays interest every six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the consumer price index or CPI.] And the third are international bonds in their home currency. The other big risk that most investors in the U.S. have absolutely no defense against is the tumbling dollar. And so these are three asset classics that most investors have far too little invested in. These three assets comprise roughly half the money in the All Asset Fund.

Q: If you had to give yourself a grade about how good an asset allocator you've been in the past three years, what would it be and why?
A: I would say a B-minus. The big miss was being cautious on equities a little too soon. We did leave some chips on the table. Still, we did make some very timely shifts in the commodities arena turning cautious on commodities last spring and becoming much more enthusiastic on commodities by year end. We did make some very timely shifts in the emerging markets. So I feel good about how we've done in delivering respectable real returns at a very modest level of risk.

Q: I suspect that you would give yourself a much better grade these days as a creator of fundamental or enhanced ETFs. Many of these fundamental indexes are outperforming traditional cap-weighted indexes. And Smart Money magazine recently named the PowerShares FTSE RAFI US 1000 Portfolio (ticker: PRF) as the best ETF of 2006. Why are fundamental indexes a better mousetrap than a typical market-weighted index ETF like the iShares S&P 500 Index Fund2? Why is it worth paying an extra 50 basis points in annual expense?

A: With conventional indexes, you are weighting the index by the total market value of the stock. So with market-capitalization weighting, which is the classic framework for indexes, you are going to put most of your money in overvalued companies. In using fundamentals to create the index instead of market weighting: Let's suppose, a company's dividend is 4% of the dividends of all publicly traded companies and 3% of earnings of all profits of publicly traded companies and 1% by book value, and 2% of sales. We could just average the four numbers and say, you know, this company is about 2½% of the economy. Let's use that average as the basis for our weighting. By doing that you smooth out the rough edges of a single metric approach.

Any of the measures -- whether you are using sales, profits, book value, or dividends -- deliver drastically better performance than market-cap weighting going back 45 years in the U.S. We've tested it. The idea is remarkably robust across multiple markets. So what we find is that whatever measure you are using, it winds up producing a much superior index because it severs the link between the weight of the portfolio and over or undervaluation.

Q: How often is the index updated?

A: The index as published by FTSE [a British-based provider of stock indexes] and is reconstituted once a year in March, and it doesn't have to be done more often than that because the turnover is only 10% a year.

Q: What's the single biggest mistake that investors routinely make and should avoid at all costs?
A: Chasing recent past returns.

Q: What is your long-term view of the stock market looking out five or 10 years?
A I would expect 10-year returns on stocks to be 5% or 6% annualized. And you can get [almost] that on Treasuries right now.

Q: So why take the risk?
A: So why take the risk.

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.