Tuesday, June 26, 2007

‘Make-up, six-inch hooker heels and a tramp stamp’: Gross on subprime

“Whew, that was a close one,” exclaims Pimco’s Bill Gross, in his July investment outlook. The one in question is, of course, poor old Bear Stearns and its subprime woes.

Shame on you Mr. Stearns, or whoever you were, for scaring us investors like that and moving the Blackstone IPO to the second page of the WSJ. We should have had a week of revelry and celebration of levered risk taking. Instead you forced us to remember Long Term Capital Management and acknowledge once again (although infrequently) that genius, when combined with borrowed money, can fail.

But what was the problem he wonders? Surely, given the investment grade, or even AAA, rating of these RMBSs, CDOs and the like, the architects were prudent men? Perhaps not.

AAA? You were wooed Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a “tramp stamp.” Many of these good looking girls are not high-class assets worth 100 cents on the dollar. . And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone?

Gross has struck upon another strand to this particular tale. One London hedge fund type was musing to FT Alphaville just this morning that we’ll have a few, painful weeks while the effects of marking this stuff to market filters through the system. But next come the serious questions to the likes of S&P and Moody’s - and the conclusion that assessing such instruments in a rear-view-mirror fashion, on their limited history is - well - not very robust at all.

But it gets worse, says Gross. Those that point to a crisis are looking in all the wrong places - houses is where it’s at. The rows of homes financed with cheap, and in some cases gratuitous money in 2004, 2005 and 2006. Currently, he adds, 7 per cent of subprime loans are in default. That percentage is set to grow and grow like a week in your backyard tomato patch.

AAAs? Folks the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times.

Of course this will all hit the US economy, says Gross. And other areas - high yield, bank loans and so on - should feel the cooling winds of a liquidity constriction. This may be what the Fed has been looking for - easy credit becoming less easy; excessive liquidity returning to more rational levels. But he’s looking for an “insurance policy” from the Fed in the form of a lower benchmark rate over the next 6 month. He concludes:

This problem — aided and abetted by Wall Street — ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address — Main Street.

The Benefits of a Bubble, Even When Burst

Daniel Gross is a very good and quite prolific writer on the economy, from his “Moneybox” columns in Slate to his “Economic View” columns in the New York Times; soon, he will be taking his skills to Newsweek. His new book, Pop! Why Bubbles are Great for the Economy, tells the story of various American investment bubbles, from frenzied railroad overbuilding in the 1880s to the dot-com delirium of the 1990s. His conclusion: notwithstanding the damage to individual companies, and perhaps millions of stockholders, bubbles play a determinedly healthy role in the continuing success of U.S. industry. The following excerpt sums up his argument quite well:

[I]f you take the long view … it’s possible to detect a pattern that emerges in bubbles and their aftermaths. Especially bubbles that leave behind a new commercial and consumer infrastructure. With apologies to Oliver Stone, these bubbles, for lack of a better word, are good. These bubbles are right; these bubbles work. Thanks to the American penchant for creative destruction and the U.S. bankruptcy system, investors — and the economy at large — tend to get over bubbles quickly. … The stuff built during infrastructure bubbles — housing and telegraph wire, fiber-optic cable and railroads — doesn’t get plowed under when its owners go bankrupt. It gets reused — and quickly — by entrepreneurs with new business plans, lower cost bases, and better capital structures. And when new services and businesses are rolled out over the new infrastructure, entrepreneurs can tap into the legions of users who were coaxed into the market during the bubble. This dynamic is precisely what has made Google the “it” company of this decade …

Looking back, many similarly iconic companies and industries that have stimulated economic growth, and that helped define America’s commercial culture, were either formed in those hothouse bubble environments or can trace their origins to their aftermaths. Consumer packaged goods and mass retailing, data services and mass media, the vast financial services sector, tourism, telecom, and what venture capitalists still call “the Internet space.” Sears, the Associated Press, Western Union, Fidelity Investments, Google — they may all have developed anyway. But they certainly would not have developed as they did without the Pop! dynamic.

Wednesday, June 20, 2007

Institutional Money Tops 25% Of Assets

For Immediate Release - June 18, 2007

Monday, June 18, 2007 Greenwich, CT USA — Direct investments by endowments, foundations, corporate pension funds and public pensions together represent a quarter of the assets of the world's largest hedge funds, up from 22% in 2006 and 20% in 2005.

The results of a new study conducted by Greenwich Associates in conjunction with Global Custodian magazine illustrate the growing importance of institutional investors to hedge funds with more than $1 billion in assets under management. "The 25% of assets attributed to direct investment by endowments, foundations and pensions actually understates the institutional component of the hedge fund asset base by a considerable margin," says Greenwich Associates consultant John Feng. "Institutions are also big investors in hedge funds of funds, which represent another 25% of hedge fund assets."

In fact, the new study reveals that funds of funds have topped high net-worth individuals and family offices as a source of assets for these large hedge funds, with high net-worth individuals and family offices contributing 21% of total assets. "Institutions choose to invest in funds of funds to access their diversification, risk controls and general industry expertise. The largest institutions may also use funds of funds to put allocated dollars to work as they search for opportunities for direct investments," says Greenwich Associates Hedge Fund Specialist Karan Sampson.

Institutional Growth
The share of institutional assets invested in hedge funds has been growing slowly but steadily for the past several years. In 2006, U.S. institutions allocated 2.1% of total assets to hedge funds and funds of funds, up from 1.9% in 2005 and 1.6% in 2004. That number may sound trifling, until one considers the sums involved. The total institutional asset pool among the more than 1,900 institutional investors included in Greenwich Associates' institutional research universe is $6.6 trillion.

Obviously, big hedge funds — with sufficient infrastructure and capacity to attract sizable institutional money — are anxious to increase their institutional business. Gauged by three-year institutional trend lines, the big funds' chances look promising. U.S. institutional allocations to hedge funds are now more than double where they stood in 2001. Asked by Greenwich Associates if they invest in hedge funds, some 36% of U.S. institutions responded affirmatively in 2006, up from 32% in 2005 and 29% in 2004. Asked the same question about funds of funds, 25% answered yes in 2006, up from 23% in 2005 and 19% in 2004. What is more, some 22% of the institutions participating in Greenwich Associates' 2006 research said they plan to increase their hedge fund allocation by 2009, versus only 2% that said they plan to decrease that allocation.

June 19, 2007 - Hiring and Firing Investment Managers

The sponsors of retirement/endowment plans (public and corporate pension plans, unions, foundations and endowments) retain professionals to manage their funds. Do their decisions to hire and fire such professionals pan out? In other words, do their plans outperform the market after they change managers? In their May 2006 paper entitled "The Selection and Termination of Investment Management Firms by Plan Sponsors", Amit Goyal and Sunil Wahal examine this question. Using data for 8,204/910 hiring/firing decisions by 3,591 plan sponsors during 1994-2003, they conclude that:
  • Plan sponsors hire investment managers after large positive excess returns during the past three years, but these new hires do not subsequently outperform the market on average. The average three-year pre-hiring (post-hiring) cumulative excess return for plans mandating investment in domestic equities is 12.0% (0.7%).
  • However, for plans mandating investment in international equities, pre-hiring outperformance persists, with average three-year pre-hiring (post-hiring) cumulative excess returns of 15.5% (9.8%).
  • Also, (more sophisticated?) large-plan sponsors average positive post-hiring excess returns (a cumulative 3.2% over three years).
  • Average excess returns are larger for plan sponsors who retain consultants to assist with the investment manager selection process.
  • Generally, the pre-firing underperformance of investment managers terminated by plan sponsors due to poor past returns is statistically insignificant. These managers subsequently generate an average three-year cumulative post-firing excess return of 4.3% elsewhere.
  • A subsample of 660 matched firing/hiring decisions indicates that plan sponsors would have achieved larger excess returns on average had they not changed investment managers, even without including costs of perhaps 1%-2% for switching.

In summary, the sponsors of retirement/endowment plans show little timing ability in hiring and firing investment managers. There is some evidence that more sophisticated sponsors (of large plans and of plans that invest internationally) make better decisions.

Results suggest that individual investors in mutual/hedge funds should consider more than just recent past returns in making decisions to switch funds.

For related research, see Blog Synthesis: The Wisdom of Analysts, Experts and Gurus and Blog Synthesis: Mutual Funds and Hedge Funds.

Eveillard: A value maestro's encore

For almost 30 years, global fund manager Jean-Marie Eveillard made a lot of money bucking trends. After a two-year break, he's back.

By John Birger, Fortune Magazine senior writer

(Fortune Magazine) -- As Jean-Marie Eveillard strolled the streets of Paris on the first night of this spring, coming out of retirement was the furthest thing from his mind. He and his wife had just enjoyed a performance of La Juive at Paris's Bastille opera house, followed by a late dinner.

But on returning to their apartment, Eveillard was greeted by a half-dozen messages from his former employer, New York City's Arnhold & S. Bleichroeder Advisors. "They wanted to know if I could be back in the office on Monday," he recalls.

Jean-Marie Eveillard

The 67-year-old Eveillard had been one of Wall Street's best value investors, leading Bleichroeder's First Eagle Global fund to a 15.8% average annual return - compared with 13.7% for the S&P 500 - over his 26 years at the helm, according to Morningstar. (The fund, launched as SoGen International, was renamed seven years ago when Bleichroeder bought it from Société Générale.)

Eveillard retired in 2004, turning the fund over to longtime protégé Charles de Vaulx. And de Vaulx kept the ball rolling, with 14.9% returns in 2005 and 20.5% last year.

Then de Vaulx quit abruptly in March. (Contacted by Fortune Magazine, De Vaulx declined to discuss his reasons for leaving.) Soon after, Eveillard agreed to retake the reins temporarily and boarded a plane for New York.

In addition to Global, with $22.1 billion in assets, Eveillard is back running three other First Eagle funds - $1.1 billion Gold, $11.9 billion Overseas, and $677 million U.S. Value. (Only U.S. Value is open to new investors.) He agreed to stay on full-time for a year, after which associate portfolio manager Charles de Lardemelle will take over.

Eveillard says he came out of retirement to protect funds that "were a little bit my babies."

He can be very protective. Global lost money only twice during his tenure: a trifling 1.3% in 1990 and 0.26% in 1998. And while Eveillard underperformed the market during the late 1990s, fans see that as less a failure than a show of character.

"In the late 1990s - when I think his fund shrank to half its former size because he was not buying the crazy tech stocks that were doing so well - he stuck with his strategy," says Bruce Greenwald, a finance professor at Columbia Business School, where Eveillard has lectured. "That really made his reputation later on."

Indeed, Global was a post-crash standout, returning 10.5% in both 2001 and 2002, 38% in 2003, and 18.7% in 2004.

In his first major interview since coming back, Eveillard made it clear that his two-year hiatus didn't do anything to soften his contrarian streak.

Fortune: Did Charles de Vaulx ever tell you why he quit?

It's still a puzzle to me. He called me a week after, but it was a conversation where he said little and I didn't want to pry. But it had nothing to do with the returns of the fund. It was entirely voluntary. I think he left in a huff for reasons that escape me.

Fortune: Were you managing any money over the past two years - your own portfolio, perhaps?

Shortly after I retired, a friend of mine who's in the business said to me, "Ah, well now you'll have plenty of time to run your own portfolio."

I told him no. I kept my money in my funds - or what used to be my funds - because it would not have shown great confidence in Charles if I had taken my money off the table.

Also, one thing about Americans - something I think is very positive - is there's this idea that God did not put us on this earth to do nothing. No matter your age. Whereas Europeans believe that once you retire, there is nothing wrong with doing nothing.

I was reading the financial newspapers, I helped teach a course on value investing at Columbia Business School, but otherwise I did not have a very active retirement.

Fortune: So what were you doing?

Are you familiar with Sudoku? [Laughs.]

My wife and I have been collecting drawings for a few years, so we went to auctions. I traveled.

Fortune: Today's art market must be tough to swallow for someone with a value mindset like yours.

Whether you're investing in art or in securities, no one should confuse value and price. Today there is lots of contemporary art that sells for tens of millions of dollars and is not very good. And there is also sometimes very good art that sells for very little.

Fortune: Anything that has surprised you upon your return to the investing world?

The stock market in the U.S. and outside the U.S. has been going up for four years, which usually does not present investors with a great many new opportunities. To paraphrase [value investing pioneer] Ben Graham, the markets seem high, they are high, and they are as high as they seem.

Fortune: But you don't buy markets.

No, we don't buy markets. We buy specific securities. But I see that lack of opportunity from the bottom up as well.

Some of the stocks we own have gone up to the point that they're very close, if not above, what we consider their intrinsic value. And when we look at new names, new ideas, we seldom end up buying.

Contrary to many mutual fund managers, we do not believe we have to be fully invested 100% of the time.

Fortune: Morningstar puts your cash position at about 18%. Is that still accurate?

Yeah, although we don't decide to be 5%, 10%, or 25% in cash. If we find enough investment opportunities, the cash will go down.

Fortune: You pay a lot of attention to companies' tax rates. Why?

Particularly in the U.S., I don't like companies with very low tax rates, because it's a sign either that the Internal Revenue Service will catch up with them someday or that the profits they report are overstated.

The average corporate tax rate is 35%. Any company that has a tax rate of 15% or 20% looks suspicious to me.

Fortune: I keep waiting for a brave contrarian fund manager to dive into homebuilder stocks. Any interest?

Before I came back, Charles [de Vaulx] had one of the analysts look at it, but we didn't buy anything. I've always thought it was very hard to value homebuilding stocks. In normal times, the price/earnings ratio looks so low, but it's because it includes a lot of gains on land.

So no, we're not looking at homebuilding stocks. I think there was a housing bubble, and as a consequence of the subprime meltdown, I think that housing is not about to recover anytime soon.

Fortune: I'm guessing then that you aren't rushing to buy bank stocks either.

No. We're at the tail end of a global credit boom. Financial stocks now account for 25% or 30% of the S&P, and the financial world has become almost as important as the real world of industry and commerce.

Some excesses have appeared, subprime housing being the last though not the least. Private equity too.

Fortune: Do you think the current buyout boom is going to end badly for all these private-equity firms?

Of course. I think there are some private-equity firms that are fully aware of that, but, hey, they've got money to spend. I think the next question for private equity and hedge funds is going to be, "Where are the customers' yachts?"

Fortune: The last time I interviewed you, four years ago, you were very bullish on gold. Since then gold prices have doubled, and yet you're still bullish, with 5% of your portfolio in gold bullion or mining stocks. Hasn't the run-up in gold prices tempered your enthusiasm?

We look at it as insurance. The fact that the price is up means that the insurance premium has become more expensive.

Two things that struck me when I came back several weeks ago - one, many of the stocks we owned are not particularly undervalued, at least outside Japan and South Korea.

Second, there has been a terrific credit boom, and man, what happens when the credit cycle turns?

The basic idea with gold is that under most circumstances in which the stock market goes down, it would be good for gold. Gold would provide a partial offset to the hit we would take in the equity portfolio.

Fortune: Some gold fans are buying on the premise that rising demand for gold jewelry in the developing world will be good for commodity prices. Do you subscribe to that idea?

When we started our gold fund in 1993 - which proved to be six or seven years too soon - I mistakenly thought that my downside was protected by the fact that jewelry demand was fairly vibrant. But I was wrong. I think gold moves up and down based on investment demand mostly.

Fortune: What's so special about Japan and South Korea?

We have less trouble finding stocks in those markets.

For Korea, I think it's a result of the well-known "Korean discount," which I think is no longer justified. After the Asian crisis in 1997, what we found very interesting is that the Koreans changed their ways considerably.

They were much better able to adapt than the Japanese - the government, the corporations, the people. They changed their ways for the better. [Korean stocks that Eveillard owns include Samsung, SK Telecom, and Lotte Confectionery Co.]

Fortune: And Japan?

I think there are opportunities, because before 2003 Japan went through a 13-year bear market. And in a 13-year bear market every stock - and I mean every one - gets buried. They were resurrected in 2003, 2004, and 2005, but I think that many opportunities remain.

Fortune: You've been quoted a lot recently about Dow Jones, opining that the Wall Street Journal's publisher should accept Rupert Murdoch's buyout offer. [FORTUNE interviewed Eveillard in late May.]

I'm not sure why [reporters] call me, because we were not one of the very large shareholders in Dow Jones (Charts). Though I am surprised we haven't gotten a call from the SEC, because we happened to buy over 100,000 shares on the day before the announcement [of Murdoch's offer].

We just felt that the intrinsic value was between $45 and $50 a share, which is why we were buyers in the low 30s.

Fortune: Do you have any philosophical opposition to the dual share classes that so far have kept Dow Jones out of Murdoch's reach?

Not really, because I'm not forced to buy it if I don't like the dual structure, which of course protects the [Bancroft] family.

Anyway, we sold most of our stock in the mid-50s, which was way above what we thought the business was worth. And I think there is a genuine risk that the family will say no, in which case the stock goes back to $35. Top of page

Thursday, June 14, 2007

By Lawrence Carrel
TheStreet.com Senior Writer

6/13/2007 12:05 PM EDT

URL: http://www.thestreet.com/funds/savingscenter/10362121.html

A year ago this week, when WisdomTree Investments (WSDT ) launched its first 20 exchange-traded funds, it threw down the gauntlet in the rarified world of indexing. At the time, it was the largest number of ETFs tracking indices based on fundamental criteria -- primarily dividends -- rather than stock prices. It was also a challenge to Rob Arnott, the godfather of fundamental indexing. Arnott's investment firm, Research Affiliates, had licensed the first ETF based on a fundamental index a year earlier and filed a patent application for all indices based on fundamentals. But WisdomTree didn't seek Arnott's blessing for its new products. In essence, the firm was saying that fundamentally weighted indexing isn't the property of Research Affiliates but of the entire world. Typical indices weight companies according to their stock market valuation, also known as market capitalization. This value is calculated by multiplying the total number of outstanding shares by the stock's price. The criteria give a greater weighting to large companies and higher-priced stocks over small companies and lower-priced stocks. It's the basis for the S&P 500 and most other market benchmarks. The theory behind fundamental indexing is that market-cap-weighted indices were overweighted with overpriced stocks, while fundamentally-weighted indices captured better returns with lower volatility. WisdomTree promoted the new ETFs with a splashy marketing campaign, including newspaper and TV ads featuring endorsements from two of its famous backers, legendary hedge-fund manager Michael Steinhardt and Wharton finance professor Jeremy Siegel. But the highlight of the marketing blitz was an opinion piece on The Wall Street Journal's op-ed page in which Siegel lobbed a grenade at the "efficient-market theory," the philosophical foundation for the market-cap indices. The theory is that at any one point in time, a stock's price represents the best, unbiased estimate of its true value. Siegel countered that "a new paradigm claims that the prices of securities are not always the best estimate of the true underlying value." This touched off a lot of sturm and drang in the indexing community. John Bogle, the founder of the Vanguard 500 (VFINX), the first index mutual fund, and Burton Malkiel, author of A Random Walk Down Wall Street, the book that brought the efficient-market theory to the masses, issued a stinging rebuttal. They said fundamental indexing wasn't a new paradigm but merely a more expensive index with a bias toward small-cap and value stocks. But amid all this excitement, Arnott was noticeably silent. Arnott literally wrote the book on fundamental indexing. In the March 2005 issue of the Financial Analysts Journal, he and two associates published a paper called "Fundamental Indexation." In it, he concluded that market portfolios constructed using metrics of company size other than cap-weighting outperformed the S&P 500 over a 43-year span by an average of 2 percentage points. As chairman of Research Affiliates, an investment management firm in Pasadena, Calif., Arnott also realized he had a marketable investment strategy. He trademarked the name Fundamental Index and created the Research Affiliates Fundamental Index, or RAFI, based on four fundamental metrics: revenue, book value, free cash flow and gross dividends. One year after the challenge from WisdomTree, Research Affiliates' patent is still pending, and no lawsuit has been filed. And variations on his trademark "Fundamental Index" are quickly becoming the way to describe this new movement in indexing. Realizing it may be a long and difficult fight, Arnott is playing it cool. "We're swimming upstream on protecting our brand name, but I leave this in the hands of our 'intellectual property' team and don't devote much time or attention to it," he says in an interview. "And competition is fine. But I'm less comfortable when people can't come up with their own ideas or their own brand name for a product. But we aren't trying to get into fights. My goal is to reach amicable agreement with those who want to pursue similar ideas." Bruce Lavine, president and chief operating officer of WisdomTree, counters that the concept of fundamental weighting has been around for 20 years. "There are many people who did this prior to Rob Arnott getting involved," he says. "This goes back to the late 1980s with Robert Jones at Goldman Sachs (GS) and David Morris in the United Kingdom. Barclay's iShares developed a dividend fund in 2003 that is clearly not a cap-weighted fund. We feel very comfortable that there is prior art here in many areas." "There is no action between us, because nobody has any patent rights," says Lavine. "We have our own patent application. We have great confidence that we have independently developed our IP and won't have an issue on the patent side. But this will play out over the long term." Even if RAFI's patent application fails, fundamental indexing has caught the imagination of investors, and there should be enough business to go around for both firms. Especially since the two firms have different business models. WisdomTree creates its own indices and issues its own funds. It currently has 37 ETFs with $4 billion in assets under management. Meanwhile, Research Affiliates' business is to license its index to many ETF issuers. Powershares has 11 ETFs linked to RAFI indices in the U.S., Claymore Investments has five in Canada, and there are a total of nine offered in Europe by Lyxor and XACT, a unit of Handelsbanken. In addition, Pimco, Charles Schwab (SCH) and Pro Financial of Canada each offer three mutual funds based on the RAFI index. The combined total assets under management for all licensees of the RAFI concept are over $10 billion.

PIMCO in Theory and Practice


Posted in General, Bonds, Macroeconomics at 11:46 pm by David Merkel

There’s been a certain amount of chatter lately over some of the comments made by Bill Gross regarding the long end of the market. Others have discussed that; I’d like to bring up a different point.

Leaving aside the rumors that Bill Gross talks his book in order to create better entry and exit positions (many in the bond market believe it, I’m not so sure), I have criticized his (and PIMCO’s) forecasting abilities in the past.

Fortunately for PIMCO clients, Mr. Gross does not depend on his Macro forecasting to earn returns. Sitting on my desk next to me is a copy of the September/October 2005 Financial Analysts Journal. In it Mr Gross has an article, “Consistent Alpha Generation Through Structure.” That article encapsulates the core of PIMCO’s franchise. Essentially, they write unlevered out-of the money options on a variety of fixed income instruments, go short volatility through residential mortgages, and try to take advantage of the carry trade through the cheap float that their strategies generate.

So there’s a free lunch here? Well, not exactly. In a scenario where rates move very rapidly up or down, PIMCO will be hurt. But the move would have to be severe and very rapid. Even then, unlike LTCM, which had many of these same trades on but in a levered fashion, a bad year for PIMCO would ruin their track record, but most of their clients would deem the losses mild in comparison with whatever happened to the rest of the asset markets during a crisis that moved interest rates so severely.

That is the genius of Bill Gross, and I mean that sincerely. As for what he says on the tube, well, that’s just to aid marketing of the funds. He’s an entertaining guy, and on TV, those that invite you don’t care so much that you are right or wrong; they care that you say interesting things that keep the ratings up.

So, ignore Gross and McCulley on macroeconomic predictions, but their funds are generally worthy investments (leave aside for a moment that they are having a tough time this year). That said, if I’m buying an open end bond fund, I go to Vanguard. Low expenses win with bond investing, and it is a more durable advantage than advanced quantitative strategies.

Active ETF Update

By IndexUniverse Staff - Wednesday, 13 June 2007

Ian Salisbury of Dow Jones provides the latest update on active ETFs in today’s Wall Street Journal. Salisbury profiles the early SEC filings of two members of the active ETF vanguard—AER Advisors and XShares Advisors—both of whom have filed exemptive relief requests to launch active ETFs. Exemptive relief is a stage before a fund company files a prospectus, when they ask the SEC to adjust certain rules to allow their funds to list.

The specific filings are not available online—they’re only available as paper filings—but Salisbury gives the gist.

“Both companies made filings on their proposals in May and emphasize that they differ only slightly from existing funds, which may make them palatable to the SEC,” writes Salisbury.

The big issue with actively managed ETFs is front-running. We’re told that active managers are loath to disclose their holdings for fear that others will either mimic them or, worse, jump in front of them purchases and drive up the prices of the underlying stocks (“front-running”). That’s a problem because ETFs must disclose their holdings to allow arbitrageurs to keep the ETF share price in-line with the underlying components. That arbitrage ability is what separates ETFs from closed-end funds.

To get around this problem, AER will impose restrictions on its fund managers: they can only make changes to their portfolios once a week, and they must announce those changes on Friday and implement them the following Monday. Apparently, AER thinks this will limit the impact of front-running, although it seems unlikely to eliminate it entirely (assuming that front-running really exists).

The XShares proposal, in contrast, would allow managers to make changes intraday … but would only announce those changes at day-end, after the markets’ closed. That might complicate the work of arbs and lead to bigger bid/ask spreads on the ETF, but it would generally work and would avoid the front-running problem for all but the largest trades.

Other active ETF filings, not covered in the Wall Street Journal article, would create proxy portfolios that reflect the value of the underlying ETF but with different components.

Of course, all of these proposals beg an important question: Why do we want active ETFs in the first place? The track record of actively managed mutual funds is poor, with the vast majority trailing index funds over the long haul. The fact that the majority of investors choose these funds says that there is demand, and ETFs would deliver those returns in a slightly cheaper, slightly more tax efficient package. But the issue of long-term performance will remain.

Inefficient Market: Blackstone Letter

Inefficient market: By Edward Chancellor

1 June 2012

The Blackstone Group
345 Park Avenue,
New York NY 10154

Ladies and Gentlemen:

I am, together with my general partners and funds managed by our firm, pleased to propose to acquire, for a purchase price of $15 in cash per unit, all of the outstanding common units, representing limited partners' interests in Blackstone Group L.P. (the "Group"). Our offer to acquire the Chinese government's minority stake in the Group for the same price has already been accepted. Our proposal provides a substantial premium for all of the Group's common unit holders. If this offer is accepted, Blackstone Group will de-list from the New York Stock Exchange ("NYSE").

Conditions in our business have not been easy in the five years since we first issued securities on the NYSE. To many unit holders, who bought into the initial public offering and are now sitting on a large capital loss, that may seem like an understatement. Yet although we have made our share of mistakes, the substantial decline in the value of Blackstone's securities is largely a result of factors beyond our control.

Looking back over this difficult period, most of our problems can be ascribed to deteriorating economic conditions; extraordinary convulsions in the credit markets; a worsening political and legal environment for the buyout industry; and the consequences of what is now commonly referred to as the "private equity bubble." I will briefly examine each of these issues in turn.

1. The Macro-Economic Climate: When Blackstone came to the market in the summer of 2007, economic conditions were remarkably benign. Most economists agree that the decision by Congress to impose punitive tariffs on Chinese imports during the first year of the Clinton Administration represented a turning point. Since that date, consumer price inflation has returned to levels not witnessed for two decades. Both nominal and real interest rates have soared as Asian savings were no longer recycled into dollar-denominated assets. These developments have had a negative impact on the prices of all long-dated assets. Our real estate business has been particularly badly hit by the collapse of property prices.

Blackstone, along with other private equity firms, was prepared for a downturn. We had hedged against a rise in interest rates. Weak covenants on many of our loans and the increased use of payment-in-kind notes provided a respite for many of our portfolio companies when the hard times began. However, the severity of the recession of 2010, which was statistically a three-standard deviation event, was worse than our models had anticipated. Even though we have experienced only a handful of bankruptcies among our companies, many of the survivors are currently valued by the market at less than we paid for them.

2. The Credit Market Crisis: You will all be familiar with the convulsions of the credit markets in recent years. During the buyout boom, loans to finance LBOs were available in seemingly limitless quantities and risk premiums were absurdly low. This was largely a consequence of the recycling of Asian savings and innovations in the credit markets.
In those days, hedge funds had a stupendous appetite for leveraged loans which were bundled into securities, such as collateralized debt obligations. This market had never been stress-tested by a recession. During the late financial crisis, however, many credit hedge funds blew up. Since then, the rating agencies have become stricter in their ratings of CDOs. As a result, the market for securitizations of corporate loans has contracted. Furthermore, commercial banks are now wary of our industry after several of them experienced sizeable losses on their bridge loans to LBOs. Today credit is less available and risk premiums on leveraged loans have risen - permanently, I fear.

3. The Buyout Backlash: By early 2007, it was clear that the rapid growth of private equity was inciting a wave of public opposition in both the US and Europe. That is why our industry established the Private Equity Council in Washington to explain our case. At the time, I personally expended much time and effort educating the media on this subject.
I wish our efforts had been more successful. Since 2007 two tax changes have hurt our industry's profitability. Several countries in Europe, including Germany, have followed Denmark's lead in removing the tax deductibility of interest payments for leveraged buyouts. Although the US did not follow, the Internal Revenue Service has succeeded in forcing a change in the tax treatment of private equity's performance fees (known as the "carried interest"). Previously, the carried interest was taxed at the capital gains tax rate of 15%. After this tax loophole was closed, these fees have been taxed at corporate rate. This change wiped nearly 20% off our 2008 earnings.

The buyout backlash worsened after the recession, which was accompanied by bankruptcies at several high profile LBOs. During the Senate hearings into the private equity industry, the dismal performance of many buyout funds, especially the 2006 and 2007 vintages, came under scrutiny. The fees charged by private equity firms were also widely criticized in the light of losses experienced by many pension funds. It is scarcely an exaggeration to say that private equity has become the scapegoat for all our economic woes. The upshot was that public pension plans have been forbidden by federal law from making any further buyout investments. This has been a serious blow. Up to that date, public pensions accounted for around 40% of Blackstone's investor base.

4. The "Private Equity Bubble": The entire buyout industry, including Blackstone, must accept its share of responsibility for our current woes. At the time of our IPO, corporate valuations and profits had for several years been rising in tandem. This created a golden age for buyouts. With hindsight, it's clear that we became overconfident.

At the time, too much private equity money was chasing too few opportunities. We found it difficult to resist the urge to raise ever larger funds. And we put that money to work too quickly. In the takeover frenzy, many private equity firms became overstretched. There was a collective loss of investment discipline. Too many businesses were bought at large premiums when profits were approaching a cyclical peak. Given the fees on offer and the ease of flipping assets only months after acquiring them, our behaviour is understandable.

Not only have corporate valuations substantially declined, it has become more difficult to exit from LBOs. Blackstone's own success in rapidly cashing out of its $39bn investments in Equity Office Properties back in early 2007, encouraged others to pursue even bigger targets. Since the IPO market has been closed these past years, many private equity firms, including Blackstone, have been stuck with their mega-cap acquisitions.

When competition heated up during the "bubble" period, private equity firms were also driven into buying more cyclical businesses. The dramatic failure of Freescale Semiconductor, in which Blackstone was a minority investor, provides a cautionary tale against the dangers of putting too much debt on companies with volatile earnings streams. Furthermore, in order to boost returns, we piled too much debt onto companies.
Personally, I blame the banks which towards the end of the boom would offer to lend more than we estimated the businesses were worth. Still, had macro-economic conditions remained favourable, these investments would have proved extremely profitable. Alas, that has not been the case.

Finally, I would like to comment briefly on Blackstone's own performance over the past five years. Although our recent investment record is disappointing by historic standards, Blackstone has retained its position among the top quartile of private equity firms. We have also experienced fewer bankruptcies pro rata than our competitors.

Despite recent losses, I am pleased to say that Blackstone has substantially outperformed the Dow Jones Private Equity Index, which comprises around dozen firms, including Apollo, Carlyle, Macquarie, and TPG, as well as a number of listed buyout funds. Nevertheless, we believe the market substantially undervalues our business. At the time of our IPO, Blackstone was valued at nearly 50% of assets under management. Today, it commands a small premium to traditional investment firms.

Although the private equity industry will never again be as profitable as it was a few years back, I believe opportunities remain. But our historic business model of leverage-and-flip no longer works. As Cerberus has shown with its successful investment in Chrysler, private equity really can add value when it tackles difficult situations. At Blackstone, we intend to roll up our sleeves and work harder in future.

However, we now view the stock market listing as a distraction. Although we have eschewed providing guidance to analysts, the quarterly Wall Street reviews have hampered our ability to take a long-term view with our investments. Activists investors have demanded that we change the status of our listed "units" into normal shares, with voting and other traditional rights accorded to shareholders.

This is not acceptable to us. Nor can we comply with the demands by our Chinese minority investors for senior management changes. Instead, my partners and I are offering to purchase all the Group's outstanding common units. Although the offer is well below the flotation price, it represents a substantial premium to where the securities have traded lately.

Of course, no binding obligation on the part of the undersigned or the Group shall arise with respect to the proposal or any transaction unless and until a definitive agreement satisfactory to us and recommended by the Special Committee and approved by the Board of Directors is executed and delivered.

We look forward to discussing our proposal with you further in the near future.

Very truly yours,
Stephen Schwarzman

Author: Edward Chancellor
Email: Edward.Chancellor@breakingviews.com

Daniel Loeb’s edited highlights

News that Third Point, the activist hedge fund led by Daniel Loeb, is to list a €500m-€700m fund in London brings the undisputed master of the poison pen to the UK’s shores.

Known for his abrasive turn of phrase,and venomous tongue, Loeb is among the highest profile, and surely the most entertaining, activists at work in the US. So this is an excellent time to look back at some of his finest work.


There is, from last year, a letter to Nabi Biopharmaceutials in which he wrote: “Rest assured: our silence since receiving your flaccid response should not be interpreted as reduced focus on our position in Nabi….. you hide your heads in the nearest warm aperture in an apparent “ostrich defense” and ignore your shareholders (the top three now owning over 28% of your shares in aggregate) in the hope that the Company’s owners will go away before your next annual meeting.”

Also, there’s an open letter to Salton from 2005: “What is most astounding about the Company’s apparent death spiral is Mr. Dreimann’s inexplicably insouciant attitude and the fact that he remains in charge….

“The conference call debacle pales in comparison to what I witnessed last summer when I attended the U.S. Open tennis final. You can only imagine my consternation when I looked around the stadium and saw the Salton name emblazoned all around the interior of the stadium walls next to such robust companies as IBM, JP Morgan and Mass Mutual. I had to wonder how much precious capital had been squandered in such a poorly conceived marketing scheme to promote the Salton name when the Company was in such dire financial straits. My bewilderment quickly turned to anger when I saw the crowd seeking autographs from the Olsen twins just below the private box that seemed to be occupied by Mr. Dreimann and others who were enjoying the match and summer sun while hobnobbing, snacking on shrimp cocktails and sipping chilled Gewurztraminer.”

He wrote earlier this year in a missive to PDL Biopharma, “many fund managers who have been similarly rebuffed, and who have detected such a deficit in talent, probity and judgement as we have come to find in Mr McDade, might come to the logical conclusion to “cut and run”…..Instead we have come to a different view: we concluded that the Board of Directors has no choice but to immediately terminate Mr McDade,” before going on to attack the company’s corporate head quarters, dubbing them the “Taj Mahal,” and accusing Mr McDade of being “fixated” on when his berth in the adjacent marina would be ready.

Companies are not the only recipients of Mr Loeb’s sarcasm and aggressive prose. He fell out with Ken Griffin in 2005, after the Citadel boss snared an analyst from a rival firm.

Also infamous is his email exchange with a potential recruit, where he levelled this accusation at the hapless applicant: “We find most brits are a bit set in their ways and prefer to knock back a pint at the pub and go shooting on weekend rather than work hard.”

We won’t take it personally. Welcome to Blighty.

Tuesday, June 12, 2007

Click Picture: 131 - US States Renamed For Countries With Similar GDPs

10 Surprising ETF Facts

By Dan Culloton | 06-12-07 | 06:00 AM

My colleagues and I parse a lot of numbers while analyzing conventional and exchange-traded funds. Not all of the numbers make it into our published work. In the past we've shared lists of some of the more interesting mutual fund factoids we have run across. What follows is ETF statistical potpourri that will amuse, enlighten, or shock. Some of the numbers speak for themselves, others require a little explanation. Enjoy.

The percentage of all domestically listed ETFs that have been launched in the last six months.

163 vs. 134
The raw number of ETFs launched in the last six months versus the number of ETFs launched in first 10 years (1993 to 2003) of the ETF business' existence.

19 of 25
LeBron James' shooting performance in NBA Eastern Conference playoff games? Not quite. More than three fourths of all bond ETFs available (19 out of 25), hit the market this year.

23 of 93
Ouch. James' shooting performance, so far, in the NBA finals? Close, but no. Of the 93 international ETFs on the market, only 23 are diversified funds that invest across a range of countries, regions, and sectors. The rest are country- or region-specific or international-sector funds.

The average expense ratio of ETFs launched in the last six months, many of which were leveraged index funds; sector, industry, or niche funds (ophthalmology, for instance); and offerings tracking specialized or custom-made benchmarks.

The average expense ratio of all the ETFs launched before December 2006.

$84 million
Management fees paid in 2006 by Barclays' largest ETF and the second-largest ETF in the business, the $46 billion in assets iShares MSCI EAFE Index EFA , according to its most recent Statement of Additional Information. It paid more in management fees last year than half of all ETFs currently have in total assets. At the end of May 2007, 49.6% of the more than 500 ETFs in Morningstar's database had less than $84 million in assets.

$284 billion vs. $196 billion
What my youngest sons will need to pay for college in 14 to 16 years? If so, they better be able to shoot like LeBron. No, it's Barclays' share of the ETF industry versus everybody else's.

You better duck when a once-a-decade hack like me yells that on a golf course. Four is also the number of holdings left in the smallest ETF stock portfolio. B2B Internet HOLDRs BHH , which back in the halcyon days of the Internet craze included nearly 20 companies, now owns only Checkfree CKFR , Ariba ARBA , Agile AGIL , and Internet Capital Group ICGE (and Checkfree gobbles up more than two thirds of the portfolio's assets). The rest have succumbed to bankruptcy, delisting, mergers and acquisitions, or some combination thereof.

This dramatizes the inherent weirdness of Merrill Lynch's HOLDRs, which don't track indexes like normal ETFs. HOLDRs are baskets of about 20 or so stocks selected by Merrill Lynch to represent a market, sector, subsector, or industry. The only time they change is when there is a merger, acquisition, or bankruptcy affecting one of the holdings. That methodological oddity has had a corrosive effect on an index full of business-to-business internet companies whose turn-of-the-century promise never turned up.

60187 and 60532
Zip codes from DuPage County, a suburban area west of Chicago that is home to three of the most aggressive young ETF families: PowerShares is headquartered in Wheaton, Ill., and First Trust Advisors and Claymore Advisors are located just a couple of miles away in Lisle, Ill.

DuPage also is home to at least one ETF analyst who hates golf almost as much as golf hates him. There must not be enough to do there.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior fund analyst for Morningstar. He welcomes e-mail but cannot give investment advice.

Fortress, the traditional asset manager…

It’s natural perhaps, if you’re in the business of alternative investment, with your own alternative stock rating, alternative capital structure, and alternative pay-grade — that you have the urge to come up with alternative names for very un-alternative things, like trying to pick stocks that are going to go up.

Witness Fortress Investment Group, the New York-listed alternative manager, with $36bn under its respected belt.

Henry McVey, chief US investment strategist at Morgan Stanley, has agreed to join Fortress as a managing director, leading its “new business efforts focused on deep value public equity investing.”

Deep value public equity investing? That sounds suspiciously like the business of buying out-of-favour stocks that should come good in the long-term. It sounds suspiciously like the business equity fund managers have been involved in the world over for as long as equity markets have existed.

It sounds like old, well-worn, investment hat — long-only value investment.

While McVey is quite a name, and quite a catch for Fortress, the Morgan Stanley man will be adopting a client fee structure that will make his job rather taxing. The great masters of value investment — men like Warren Buffett — have struggled to achieve annualised rates of much more than 20 per cent over the years. And they never dreamt charging their clients 2 and 20.

Whatever McVey’s talents, this smacks of selling investment mutton dressed up as financial spring lamb.

Sunday, June 10, 2007

Veryan skewers Bogle...

John Bogle and index funds

The S&P 500 index is back at an all time high after 7 long years and a multitrillion dollar drawdown so it seems appropriate to review John Bogle's new novel "The Little Book of Common Sense Investing". I say novel because it would be worrying if anyone considered this book anything but fiction. Despite its title I couldn't find a single page about common sense investing. No-one disputes that index funds will likely do better than the AVERAGE long only manager over time but that reflects the fact that UNHEDGED funds are too constrained and that anyone who has investment skill is likely to be at a hedge fund NOT a mutual fund. John, the 70s are over; there's a lot more SAFER ways to make money these days than just holding stocks.

I wouldn't want to be in a car driven by John Bogle. I guess he would just put a brick on the accelerator, remove the steering wheel, stare out of the back window and sit back for the nice destination he anticipates. No need to worry about turns and obstacles in the path when nirvana awaits in the so-called long term. Just ride out that volatility? Is it really common sense to own every stock Standard and Poor's happen to choose no matter what the underlying economic conditions and business environment for those companies? Is it really common sense to imply investment skill does NOT exist and investors should not bother trying to identify good fund managers? Is it really common sense to buy and hold value destroying corporations when you could be shorting or actively engaging them?

He claims index investing is the "only way to guarantee stock market returns". Really? I think absolute returns is what a common sense investor wants not guaranteeing their fair share of stock market crashes, drawdowns, horrendous volatility and years, sometimes decades, of losses. There is no need to take outright market risk when there are so many inefficiencies and mispricings to exploit in global financial markets. Skill does exist and CAN be identified ahead of time. Alpha is actually more reliable than beta. Risk management and hedging are surely more sensible than rear view mirror speculation.

He doesn't mention hedge funds until the "Funny Money" section on Page 203 of a 214 page book. His negativity and misunderstanding of hedge funds is quite remarkable. "Too much hype"! Really? Most hedge fund commentary is negative so what hype is he referring to? Does he mean the hype of delivering absolute returns each and every year after fees unlike the "bargain" toxic waste he advocates? "Too many different strategies". Wow! That's a criticism!? You want as many strategies as possible; it is a strength of the industry not a weakness. But that is what you get from someone who recommends a risky, unhedged single strategy like his. Some managers are successful and closed because their investors made far, far more. Index funds are the compensation strategy - you don't have to do anything but you still receive your 18bp! The extra layer of fees of a good fund of funds more than justifies itself in paying for evaluation, due diligence and monitoring of common sense investments like hedge funds.

He extols the merits of owning all the nation's publicly held companies. Which nation? All of them or just the biggest firms? Why just the public ones? Most companies are private. Good venture capital and focused (smaller!) private equity funds offer excellent performance. By the time a company makes it to public status most of its growth is often over so why shouldn't investors access private companies. By the time a firm makes into the S&P 500 it has already been a winner for many years.

Although considered passive the S&P 500 is actually actively managed as holdings go bankrupt or get taken over. Interestingly if you had bought the ORIGINAL 500 components and held on with no adjustments whatsoever you would have outperformed the "real" S&P 500 even though only 86 names survived the past 50 years. That has to be a very strong argument for TRUE indexation but John Bogle doesn't mention it in the book, prefering the constantly updated product that the firm he founded, Vanguard, sells. Of course he is also not a fan of the better fundamental index innovations that have emerged in recent years.

Another broad market index got going in the 1950s: the Japanese Nikkei which over the long term has vastly outperformed the US S&P 500, though of course not over the short or medium term! Even though still far from its high and having trod water for 17 years, US investors would have done much better buying and holding Japanese stocks the last 50 years than US stocks. John Bogle does not mention this either and is generally quite negative on "foreign" stocks. Japan "outperformed" because in the 1950s it was a frontier market similar to some opportunity-rich countries today. But based on his relentless rules of humble arithmetic the dollar return on the Nikkei has been much higher than the dollar return on the S&P. In the book, his "advice" to have only 20% invested outside USA equities is simply wrong. The world has moved on and such geographic constraints make no sense these days.

Successful practitioners like Warren Buffett and David Swensen join the pro-index fray despite avoiding index funds themselves. This "Do as I say, not as I do" is ridiculous. Why does Warren have a quote on the book's cover supporting index funds when he has been successfully managing a macro, foreign exchange, commodities trading, merger arb, event driven, distressed securities, bid for LTCM, own a few core stocks multistrategy hedge fund called Berkshire Hathaway and outperformed the S&P 500 since inception? In actions, not words, his is an argument against "passive" indexing.

Investing is not simple. Bogle mentions Occam's Razor where the simplest solution is considered optimal. Unfortunately William of Occam has been misinterpreted and as Bogle accurately notes actually said "Entities should not be multiplied unnecessarily". It is not simple solutions but actually the simplest choice amongst complicated solutions that works. Index funds are too simple to be a "solution" as the last 7 years has demonstrated. The simplest viable solution is multiple strategies within and across multiple asset classes and reducing risk as much as possible. In 1320 gold index funds were available in Occam yet not long afterwards gold entered the 700 year bear market from which it has yet to recover. William would have seen hedge funds as the solution not the non-solution of holding assets. Entia non sunt multiplicanda praeter necessitatem as they used to say.

Bogle also talks of the miracle of compounding but fails to mention the misery of negative compounding. Then there is tyranny of fees. For what you are getting in terms of risk-adjusted absolute returns hedge funds fees are actually lower than index fund fees. But whether it is Vanguard charging 18bp for its VFINX or less for institutional managers there is a much higher cost called opportunity cost. While trillions have been languishing for nearly a decade in index funds, huge absolute return money making opportunities have been missed. The "common sense" option of index funds is extremely expensive as this dead money waits for the supposed upward trend to reassert itself.

Bogle relies greatly on history. Long term performance has little to do with long term investing. In fact some investors with the best long term track records have the shortest holding periods. Slow and steady does indeed the win the race but index funds are anything but slow and steady. Hedge funds are the reliable tortoise to the volatile index hare. You can read the John Bogle blog and the first chapter of the book. After reading it why anyone would become a Boglehead boggles the mind. Past is not prologue and staying the course only makes sense if you know the destination and the route. Common sense surely means going with investment skill and the hedging of risk not this index fund non-sense. Investors need to guarantee their fair share of ABSOLUTE RETURNS not necessarily stock market returns. They ONLY way to do that is with good hedge funds.

Friday, June 08, 2007

Bond guru Gross turns bearish

PIMCO manager says strong economic growth worldwide should push up interest rates and yields.

By Grace Wong, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Legendary bond investor Bill Gross expects strong economic growth worldwide to push up global interest rates and put a damper on the Treasury market.

A long time bond market bull, the PIMCO manager says he's now a "bear market manager" and has raised his forecast range for the benchmark 10-year U.S. yield to 4 percent to 6.5 percent. That's up from last year's forecast range of 4 percent to 5.5 percent.

PIMCO's Bill Gross

Gross, manager of the world's largest bond fund, discussed his economic and investment view at an annual PIMCO event. His comments were made available on PIMCO's Web site Thursday.

Private equity in China receives helping hand

China’s leaders often lament the fact that up to 90 per cent of corporate financing in the country still comes from bank loans — pointing to the need for more efficient capital markets and a domestic private equity industry, write Jamil Anderlini and Sundeep Tucker.

Now, it has established a legal framework that is expected to boost the development of China’s nascent domestic private equity players — with significant consequences for their foreign competitors.

Investments in mainland companies in 2006 doubled to $7.3bn (€5.4bn, £3.7bn) from a year earlier, says the Centre for Asia Private Equity Research. Unfortunately — from Beijing’s perspective — the sector has been dominated by foreign giants such as Carlyle Group and Texas Pacific Group. But it is well aware that a dearth of local expertise means it cannot shut the foreigners out as Tokyo and Seoul have largely managed to do.

Beijing is hoping new regulations, which went into effect on June 1, will lead to private equity funds being raised and invested in the local currency, the renminbi.

The government wants investors to use renminbi to invest in Chinese companies and, when they sell their stakes, to list them on mainland stock markets, rather than taking the country’s best to offshore stock exchanges where Chinese citizens are still not allowed to invest directly.

The new regulation establishes the first legal framework for local private equity and venture capital funds in China — recognising their unique structure and simplifying the taxes they have to pay.

Industry players expect it to cause Chinese money to pour into domestic private equity and venture capital funds in the coming years, especially from giant institutional investors such as insurance companies, banks and securities firms now sitting on hundreds of billions of renminbi.

Meanwhile, as stocks falter, Beijing mulls the chances of an investor backlash, writes Geoff Dyer.

Further sharp declines cannot be ruled out. “If it falls 30 per cent, that would be the moment that warning bells would go off in Beijing,” says Stephen Green, an economist at Standard Chartered in Shanghai.A 30 per cent drop would bring the market down to around 3,000 points, a level it last saw on March 19. Since then, more than 17m new trading accounts have been opened, many of which would be showing losses.

As well as the potential for discontent from middle-class investors, a sharper fall in the market would also damage the government’s plans for financial reform. Over the last two years, Wen Jiabao, the prime minister, has made one of his priorities the creation of a strong capital market in order to take pressure off the banks, promote more stable economic growth and to provide a platform for the development of pension assets.

One part of that strategy was to encourage citizens to put some of their bank deposits into equities and bonds. However, if the new retail investors end up with heavy losses, it could push back reform several years.

There could also be pressure on the government to bail out various parts of the public sector. While the small investors have been grabbing all the attention, some analysts believe there have been much bigger investments by state-owned companies, local governments, the police and the army.

Yet even though the authorities could face an uncomfortable backlash from some investors if there is another sharp drop in share prices, few China-watchers believe that the stock market has the ability seriously to undermine the government and generate broader political instability.

Friday, June 01, 2007

AllAboutAlpha Exclusive: New Northwater study finds HF replication techniques to be “limited”

31 May 2007

For nearly a year now, the hedge fund industry has been poked and prodded by ”hedge fund replicators”. Wave after wave of academic research seemed to show that hedge funds weren’t that special after all. When it looked like factor modeling might face some limitations, a new technique known as “distributional replication” was heralded by some as the proverbial nail in the coffin of the hedge fund industry.

The truth about hedge fund replication likely lies somewhere between the mythical “pure alpha” hedge fund manager and the black box hedge fund “clone”. But, sometimes the hedge fund industry seemed to be caught off-balance by the replicators - unable to produce the “counter-research” that cogently makes their side of the argument (perhaps because the industry was doing just fine and had no economic reason to respond).

Now one company has released a comprehensive analysis of both replication techniques (factor modeling and distributional replication). Toronto-based fund of funds manager Northwater Capital Management has just completed a rather extensive report that may give the hedge fund industry what it’s looking for - quantitative research giving another side of the replication story. Northwater’s thesis is that both underlying approaches to hedge fund replication are “limited in their ability to access the performance of hedge funds”.

Northwater has traditionally held its cards close to its chest, but has broken with tradition and allowed us to exclusively provide the report at AllAboutAlpha.com (here).

The firm argues that linear factor replication has reasonable success when applied to broad-based hedge fund indices that already possess significant linear dependence on market factors. However, they say linear replication is not successful where market factors are unable to explain a large proportion of the return series. This is not dissimilar to Professor Harry Kat’s recently published view that factor replication works well for the entire HFRI, but not so well for its individual sub-indices.

But Northwater departs from Kat’s view of the world when it comes to the critical issue of distributional replication models. As regular readers know, Professor Kat of the Cass Business School at City University (London) has developed a method of replicating - not the monthly returns - but the statistical characteristics of return distributions (e.g. standard deviation, skew, correlation to any selected portfolio). It turns out, argues Kat, that the return generated by synthetically-created distributions with similar characteristics to real hedge funds is remarkably close to the return actually generated by those real hedge funds. In fact, the returns from the “clone” portfolio actually beat the returns of the original funds up to 80% of the time.

Northwater tests Kat’s theory (the “Kat-Palaro” or “KP” approach) in this paper and draws several interesting conclusions…

Choice of “Reserve Asset” is Critical

As students of replication know, Kat’s replicated portfolios are created by applying complex dynamic trading strategies to a small number of very straightforward futures contracts - called the “reserve asset” in aggregate (S&P, commodities, fixed income etc.). Kat describes the reserve asset this way:

“…The next step is the selection of the “reserve asset” (which is) the main source of uncertainty in the fund. Although allocations to the reserve asset will change over time, the strategy will never sell the reserve asset short. As such, it can be interpreted as the core portfolio of the fund.”

Northwater wondered if the resulting mean returns from these new distributions are actually just a result of the specific futures contracts selected for the “reserve asset”. After creating a model that it says closely approximates Kat’s, Northwater concludes that the choice of “reserve asset” is actually critical to the very success of the enterprise:

“The risk-adjusted returns achieved from distributional replication are dependent upon the selection of market factors utilized within the replication process. Alteration of the market factors results in large differences in risk-adjusted performance.”

The firm runs their distributional replication model on 11 hedge fund sub-indices. As they illustrate using the following chart, the model produces a fund of the same volatility and correlation (to a predefined “target portfolio”) as the 11 sub-indices (not shown) and also generates very similar mean return as Kat’s approach (shown). So far, so good.

But when Northwater removed the Russell 2000 and the GSCI from the “reserve asset” and added in the poorly performing S&P Information Technology and Telecommunications Services Index, look what happened to the mean return (in blue):

(Note they leave the original KP results on the chart for comparison purposes.)

As you can see, the reader is left to conclude that either a) Northwater’s distributional replication approach is materially different that Kat’s or b) that the hedge fund-beating returns generated by the KP approach are primarily the result of astute asset class selection, not the approach itself.

Replicas’ Correlations Matched vis a vis Investor’s Portfolio

Professor Kat’s methodology creates synthetic funds that not only match the target fund’s volatility and skew, but also its correlation to a pre-defined portfolio owned by the investor.

Northwater’s research shows that the correlation similarities end there, however. While the replicated funds may indeed possess the same correlation to one pre-defined portfolio, they rarely also posses the same correlation to other assets. Thus the synthetic fund’s correlation to gold, for example, might be very different from the target fund’s own correlation to gold. Says the report:

“The return series of the replica may possess a large correlation to market factors included within the replication process but excluded from the correlation specifications, and a factor analysis would indicate a large R-squared.”

The paper includes the following illustrative example related to a dedicated short-selling index. Note that the replica’s correlation to a “50/50 portfolio” is very similar to that of the index, yet its correlation to other assets is quite different. This makes intuitive sense when you consider that the actual monthly returns of the distributional replica are not meant to actually match those of the hedge fund index.

Bottom-Line: Distributional Replicas Fundamentally Same as Plain Vanilla Mean-Variance

Finally, Northwater argues that the addition of dynamically-traded reserve assets such as S&P futures, commodities, etc. only serves to increase an investor’s exposure to these assets. Thus, the resulting portfolio is very analogous to an actively managed and optimized portfolio.

In the report’s words:

“Construction of optimal portfolios using replicas leads to the same solution that can be achieved using traditional mean-variance portfolio design, indicating a redundancy associated with correlation targeting.”

The Value of Distributional Replication

But while Northwater says distributional replication may have led us back to square one, they say it does serve a useful purpose. It provides a framework that can be used to compare the returns from different distributions. An example of this can be found on the Fund Creator website where Kat provides the mean return from several distributions including a normal distribution, a positively skewed distribution, and a distribution with a monthly return floor of -5%. It turns out the effect of the -5% floor and a skew of 2.0 have the same effect on mean return - shaving off approximately 3% per annum each.

Ergo, says Northwater, one can represent the returns from a synthetically-generated fund in terms of the volatility of the replica vs. the “reserve asset” (a la CAPM), the cost of the positive skewness (”P dist”), the cost to give the distribution a certain correlation (”P corr”) and transaction costs (”C trans“).

Northwater explains it this way:

“Separation of the two components of distributional replication and various numerical experiments has led us to develop a comparative framework for benchmarking the performance of distributional replication. The results of the following sections demonstrate that the performance of replication is dependent upon the selection of the market factors utilized within the reserve portfolio and therefore dependent on the excess return of the reserve portfolio. Distributional adjustments alter the distributional characteristics of an underlying portfolio of market factors. A daily trading process equivalent to delta hedging is required to achieve the desired distributional characteristics. An implicit net option premium and payoff, P-dist will result from distributional adjustments. Targeting a negative correlation to an investor’s portfolio will have a cost associated with paying away risk premium, referred to as a correlation premium, P-corr.”

According to Northwater, distributional replication can be a useful analytical framework and they continue to pursue it as an analytical instrument. However, they say, claims of out-performance seem to be predicted on picking the right inputs.

So it appears the old adage “garbage in garbage out” might apply here.

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.