Tuesday, September 25, 2007

Q-Group spring 2007 seminar summaries are (almost) all about alpha

25 September 2007

Q Group Rocket Scientists Discussing Quantum AlphaAs you probably know if you are a regular reader, The Institute for Quantitative Research in Finance” (or Q-Group for short) is one of the world’s foremost communities of quant rock-stars from the academic and practitioner communities. In his video interview for the American Finance Association’s “History of Finance” project, William Sharpe tells of how he was actually at a Q-Group annual seminar when he learned of his Nobel Prize.

Well, no one won a Nobel Prize at last spring’s meeting. But the 17 pages of session summaries, now available here, are well worth a read. Here is a selection of what you’ll find:

  • James L. Haskel, Director-Portfolio Strategy, Bridgewater Associates on “Alpha Beta Separation” (see related postings at AllAboutAlpha.com)
  • A panel called ”Exploring Capacity Issues” moderated by Joanne M. Hill, Managing Director, Goldman Sachs & Co. (see related posting). Panelists: Dan Bienvenue, Portfolio Manager-Global Equities, CALPERS, Knut Kjaer, CEO Norges
    Bank Investment Management (see related posting), and Matt Yamini, Managing Director & Head of Global Equity Trading, TIAA-CREF
  • Harry Kat on “The FundCreator Approach to Hedge Fund Return Replication, Fund Creation and Performance Evaluation” (see related postings)
  • “Modeling Alpha” with Eric H. Sorensen, President and CEO PanAgora Asset Management (see related posting)
  • Panel: Future Sources of Alpha moderated by Katrina F. Sherrerd, Principal – Strategic Planning & Affiliate Relations, Research Affiliates. Panelists: Chris Brightman, CEO, University of Virginia Investment Management Company, Craig W. French, Partner, Corbin Capital Partners, L.P., and Harindra de Silva, President, Analytic Investors (see related postings)
  • “Alpha Migration: Issues and Consequences” with Andrew B. Weisman, Managing Director, Hedge Fund Development, Merrill Lynch

Attendees tell us that the bun fight between the irrepressible Rob Arnott (related postings) and Cliff Asness (of AQR) was worth the price of admission. The official summary puts it this way:

“Robert D. Arnott, Chairman, Research Affiliates, LLC and Clifford S. Asness, Managing Principal, AQR Capital Management, LLC, engaged in what some might call a discussion and others a debate over the use of fundamental indexes as a substitute for market weighted indexes.”

(Ed: Although very similar, The Q-Group isn’t related to the similarly prestigious QWAFAFEW)

Arb Spreads Revisited

Just when merger-arbitrage traders thought it was safe to get back into the market, their investments blew out this week like a pair of speakers on an overheated stereo system.

Back on Aug. 15, in the darkest days (so far) of the credit-market malaise, the average difference between the offer prices and the market prices of shares in the 24 largest leveraged-buyout targets was a nearly unprecedented 10.5%, according to Thomson Financial. That meant intrepid traders who do this kind of investing — at such firms as Farallon Capital Management and Stark & Roth — stood to make a bundle if the deals withstood the storm and closed on their original terms.

And make a bundle many of them did. In the ensuing five weeks, as some of the nervousness in the market faded, the average so-called spread collapsed as the value of the stocks skyrocketed. It stood at 5.6% on Sept. 20, according to Thomson.

Then Harman came along and spoiled the party. Since word surfaced Friday, Sept. 21, that the LBO of Harman was in major trouble, arb spreads have blown out again, closing at 7.2% Monday. The fear, of course, is that other private-equity buyers will follow the lead of Kohlberg Kravis Roberts and Goldman Sachs Group and abandon other deals that have been agreed to but have yet to close.

The standouts are Harman (33%), SLM (Sallie Mae — 24%), Acxiom (20%) and Affiliated Computer Services (20%). Whether any of these companies follow in the footsteps of Harman will go a long way toward determining whether the latest setback for arb investors is another opportunity in disguise.

Top Pending U.S. Private Equity LBOs
Target Name Price Spread Offer Price to Closing Price Aug. 1 (%) Price Spread Offer Price to Closing Price Aug. 15 (%) Price Spread Offer Price to Closing Price Aug. 24 (%) Price Spread Offer Price to Closing Price Sept. 20 (%) Price Spread Offer Price to Closing Price Sept. 24 (%)
Harman International -3.38 -6.38 -5.16 -6.46 -33.08
Acxiom -7.64 -16.61 -8.89 -16.64 -24.17
SLM Corp. -18.78 -22.08 -16.92 -19.6 -20.35
Affiliated Computer Services -14.6 -18.89 -21.79 -19.55 -19.84
Penn National Gaming -14.76 -16.15 -12.16 -10.51 -12.42
Cumulus Media -10.89 -20.6 -12.17 -9.79 -11.49
Guitar Center -6.54 -12.7 -6.75 -4.98 -10.83
United Rentals -7.83 -11.88 -5.36 -6.03 -10.49
Clear Channel Communications -5.94 -10.43 -6.12 -4.13 -6.22
Sequa -6.4 -4.86 -2 -3.52 -5.84
Avaya -4.91 -7.26 -3.2 -3.09 -5.71
Alliance Data Systems -6.42 -10.43 -5.63 -2.91 -4.89
Ceridian -6.89 -9.03 -5 -2.64 -4.44
Manor Care -6.04 -8.78 -4.81 -3.16 -4.01
Ryerson -5.25 -11.3 -6.49 -4.46 -3.54
Station Casinos -4.01 -5.79 -2.76 -2.62 -3.44
Harrah’s Entertainment -6.51 -7.61 -4.82 -3.21 -3.42
Catalina Marketing -6.46 -5.45 -3.54 -2.28 -3.11
Alltel -7.27 -7.76 -4.83 -2.6 -2.66
Hilton Hotels -7.47 -6.8 -3.37 -2 -2.46
Bausch & Lomb -3.78 -4.68 -2.54 -2.11 -1.82
TXU -5.63 -8.45 -4.12 -1.62 -1.81
Archstone-Smith -5.88 -8.53 -2.98 -1.73 -1.53
CDW -3.68 -4.6 -1.99 -1.26 -1.33

Source: Thomson Financial

Monday, September 24, 2007

No Fire Exit at the Overcrowded Hedge Fund Party?

Blog - Investing Notes

September 24, 2007

Have hedge funds proliferated, grown and leveraged to the point that groups of them with similar quantitative strategies can crash as they try to exit common positions in response to some external trigger? In their September 2007 paper entitled "What Happened To The Quants In August 2007?", Amir Khandaniy and Andrew Lo investigate the hypothesis that similar market-neutral and long/short equity hedge funds suffered a cascading fire sale liquidation (one-month losses of 5%-30%) during early August 2007. Using daily return data for a broad set of stocks to model hedge fund performance over the period 1/95-8/07, they tentatively conclude that:

  • The profitability of simple contrarian long/short equity strategies has declined steadily since 1995 (see the first table below for a simple example), arguably because the number and size of market-neutral and long/short equity hedge funds has grown dramatically (see the chart below).
  • In the face of eroding returns, hedge funds typically increase leverage. The leverage factor required to maintain the same average daily return from simple contrarian long/short equity strategies increased by 4.5 times from 1998 to 2007.
  • Extreme deviations from the normal return pattern for simple contrarian long/short equity strategies during 8/7/07-8/10/07 (see the second table below) may have caused a large fund to liquidate, thereby triggering a stampede for the exit by funds with similar strategies. A highly leveraged fund using such a strategy would have lost over 25% of its value during 8/7-8/9, and capitulation (de-leveraging) by 8/9 would have precluded recovery on 8/10. In general, hedge funds competing with similar strategies also compete for the same assets and the same liquidity. If they seek liquidity at the same time, there is not enough to go around.
  • Correlations of returns among different types of hedge funds have grown over the past decade, indicating increased financial markets integration and risk of cross-market contagion (for example, from mortgage debt instruments to equities).
  • Hedge fund cascades pose a risk to the financial system. "If we were to develop a Doomsday Clock for the hedge-fund industry's impact on the global financial system, calibrated to 5 minutes to midnight in August 1998, and 15 minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge fund industry is about 11:51pm. For the moment, markets seem to have stabilized, but the clock is ticking..."

The following table, extracted from the paper, shows the steady decline in average daily returns of a simple contrarian hedge strategy that is short (long) yesterday's winners (losers). It also shows that small capitalization stocks have offered the greatest returns for this strategy, neglecting transaction costs and other trading frictions. Due to lack of liquidity in small-capitalization stocks, hedge funds probably concentrate efforts on mid-range capitalizations.

The following chart, taken from the paper, compares 1995-2007 beginning-of-year Assets Under Management (AUM) from a large database of Long/Short Equity Hedge and Equity Market Neutral funds to the average daily returns of the above simple contrarian hedge strategy. As hedge funds assets grow, returns fall. To maintain the returns to fund holders, fund managers have had to increase leverage.

The next table, also extracted from the paper, shows the very unusual behavior of the above simple hedging strategy for four days during early August 2007. Across all capitalizations, the loss during 8-7-8/9 and the gain on 8/10 represent 11-12 standard deviation events. Leveraged funds following such a quantitative strategy could have seen their assets first fall and then rise by more than 20% during these four days. Funds that capitulated by 8/9 would not have rebounded.

The authors note that evidence with regard to their 8/7/07-8/10/07 scenario is largely circumstantial.

In summary, hedge funds may be more risky than their quantitative strategies indicate because the strategies do not account for the effects of fund growth, proliferation of similar funds and increased leverage. The hedge fund party may have become so crowded that, when someone yells "Fire!", the exit door cannot handle the computer-driven panic.

For related research, see Blog Synthesis: Mutual Funds and Hedge Funds.

The Myth of Noncorrelation


[This is a modified version of an article I wrote that appeared in the September issue of Institutional Investor].

With the collapse of the U.S. subprime market and the aftershocks that have been felt in credit and equity markets, there has been a lot of talk about fat tails, 20 standard deviation moves and 100-year event. We seem to hear such descriptions fairly frequently, which suggests that maybe all the talk isn’t really about 100-year events after all. Maybe it is more a reflection of investors’ market views than it is of market reality.

No market veteran should be surprised to see periods when securities prices move violently. The recent rise in credit spreads is nothing compared to what happened in 1998 leading up to and following the collapse of hedge fund Long-Term Capital Management or, for that matter, during the junk bond crisis earlier that decade, when spreads quadrupled.

What catches many investors off guard and leads them to make the “100 year” sort of comment is not the behavior of individual markets, but the concurrent big and unexpected moves among markets. It’s the surprising linkages that suddenly appear between markets that should not have much to do with one other and the failed linkages between those that should march in tandem. That is, investors are not as dumbfounded when volatility skyrockets as when correlations go awry. This may be because investors depend on correlation for hedging and diversifying. And nothing hurts more than to think you are well hedged and then to discover you are not hedged at all.

Surprising Market Linkages

Correlations between markets, however, can shift wildly and in unanticipated ways — and usually at the worst possible time, when there is a crisis with volatility that is out of hand. To see this, think back on some of the unexpected correlations that have haunted us in earlier market crises:

  • The 1987 stock market crash. During the crash, Wall Street junk bond trading desks that had been using Treasury bonds as a hedge were surprised to find that their junk bonds tanked while Treasuries strengthened. They had the double whammy of losing on the junk bond inventory and on the hedge as well. The reason for this is easy to see in retrospect: Investors started to look at junk bonds more as stock-like risk than as interest rate vehicles while Treasuries became a safe haven during the flight to quality and so were bid up.
  • The 1997 Asian crisis. The financial crisis that started in July 1997 with the collapse of the Thai baht sank equity markets across Asia and ended up enveloping Brazil as well. Emerging-markets fund managers who thought they had diversified portfolios — and might have inched up their risk accordingly — found themselves losing on all fronts. The reason was not that these markets had suddenly become economically linked with Brazil, but rather that the banks that were in the middle of the crisis, and that were being forced to reduce leverage, could not do so effectively in the illiquid Asian markets, so they sold off other assets, including sizable holdings in Brazil.
  • The fall of Long-Term Capital Management in 1998. When the LTCM crisis hit, volatility shot up everywhere, as would be expected. Everywhere, that is, but Germany. There, the implied volatility dropped to near historical lows. Not coincidentally, it was in Germany that LTCM and others had sizable long volatility bets; as they closed out of those positions, the derivatives they held dropped in price, and the implied volatility thus dropped as well. Chalk one up for the adage that markets move to inflict the most pain.

And now we get to the crazy markets of August 2007. Stresses in a minor part of the mortgage market — so minor that Federal Reserve Board chairman Ben Bernanke testified before Congress in March that the impact of the problem had been “moderate” — break out not only to affect other mortgages but also to widen credit spreads worldwide. And from there, subprime somehow links to the equity markets. Stock market volatility doubles, the major indexes tumble by 10 percent and, most improbable of all, a host of quantitative equity hedge funds — which use computer models to try scrupulously to be market neutral — are hit by a “100 year” event.

When we see this sort of thing happening, our not very helpful reaction is to shake our heads as if we are looking over a fender bender and point the finger at statistical anomalies like fat tails, 100-year events, black swans, or whatever. This doesn’t add much to the discourse or to our ultimate understanding. It is just more sophisticated ways of saying we just lost a lot of money and were caught by surprise. Instead of simply stating the obvious, that big and unanticipated events occur, we need to try to understand the source of these surprising events. I believe that the unexpected shifts in correlation are caused by the same elements I point to in my book as the major cause of market crises: complexity and tight coupling.


Complexity means that an event can propagate in nonlinear and unanticipated ways. An example of a complex system from the realm of engineering is the operation of a nuclear power plant, where a minor event like a clogged pressure-release valve (as occurred at Three Mile Island) or a shift in the combination of steam production and fuel temperature (as at Chernobyl) can cascade into a meltdown.

For financial markets, complexity is spelled d-e-r-i-v-a-t-i-v-e-s. Many derivatives have nonlinear payoffs, so that a small move in the market might lead to a small move in the price of the derivative in one instance and to a much larger move in the price in another. Many derivatives also lead to unexpected and sometimes unnatural linkages between instruments and markets. Thanks to collateralized debt obligations, this is what is at the root of the first leg of the contagion we observed from the subprime market. Subprimes were included in various CDOs, as were other types of mortgages and corporate bonds. Like a kid who brings his cold to a birthday party, the sickly subprime mortgages mingled with these other instruments.

The result can be unexpected higher correlation. Investors that have to reduce their derivatives exposure or hedge their exposure by taking positions in the underlying bonds will look at them as part of a CDO. It doesn’t matter if one of the underlying bonds is issued by a AA-rated energy company and another by a BB financial; the bonds in a given package will move in lockstep. And although subprime happens to be the culprit this time around, any one of the markets involved in the CDO packaging could have started things off.

Tight Coupling

Tight coupling is a term I have borrowed from systems engineering. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation. Examples of tightly coupled processes include a space shuttle launch, a nuclear power plant moving toward criticality and even something as prosaic as bread baking.

In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.

In the ’87 crash tight coupling arose from the computer-based trading of those running portfolio insurance programs. On Monday, October 19, in response to a nearly 10 percent drop in the U.S. market the previous week, these programs triggered a flood of trades to sell futures to increase the hedge. As those trades hit the market, prices dropped, feeding back to the computers, which ordered yet more rounds of trading.

More commonly, tight coupling comes from leverage. When things start to go badly for a highly leveraged fund and its collateral drops to the point that it no longer has enough assets to meet margin calls, its manager has to start selling assets. This drops prices, so the collateral declines further, forcing yet more sales. The resulting downward cycle is exactly what we saw with the demise of LTCM.

And it gets worse. Just like complexity, the tight coupling born of leverage can lead to surprising linkages between markets. High leverage in one market can end up devastating another, unrelated, perfectly healthy market. This happens when a market under stress becomes illiquid and fund managers must look to other markets: If you can’t sell what you want to sell, you sell what you can. This puts pressure on markets that have nothing to do with the original problem, other than that they happened to be home to securities held by a fund in trouble. Now other highly leveraged funds with similar exposure in these markets are forced to sell, and the cycle continues. This may be how the subprime mess expanded beyond mortgages and credit markets to end up stressing quantitative equity hedge funds, funds that had nothing to do with subprime mortgages.

All of this means that investors cannot put too much stock in correlations. If you depend on diversification or hedges to keep risks under control, then when it matters most it may not work.

Leading quant hedge fund manager sort of explains what went wrong

Cliff Asness of AQR Capital Management, one of the hedge funds briefly caught in the Great Quant Meltdown of August 2007, has been sending around a "working paper" that attempts to explain what the heck happened. As with everything Cliff writes, it's more entertaining than an explanation of quantitative investing has any right to be. (Although be warned: It's still an explanation of quantitative investing.) A few highlights:

Q. How do you know the problem was “deleveraging” vs. just bad stock picking?

... First, the very size of the moves. The world is highly “fat-tailed”, meaning very big events happen more often than most models assume (the so-called “Black Swan” problem), particularly at short horizons. This is not something we just discovered; it always has affected the sizing of our bets. ...

Second, the linear nature of the declines and the comebacks. When they were falling and then when they were rising, these strategies moved in a near straight line throughout the trading day. It looked just like what it was – someone working large orders to take down their risk – and then someone putting that risk back on. It did not look like the random losses or gains of getting many small bets right or wrong.

Third, models are composed of many factors, some of which are low or negatively correlated with each other (value and momentum are the most prominent example of this phenomenon). During this period, all of the more well-known factors performed very poorly. That is a sure sign people were taking down risk in similar models....

He actually gives a fourth reason, but it's pretty closely related to the third. Then there's this:

I have said before that “there is a new risk factor in our world,” but it would have been more accurate if I had said “there is a new risk factor in our world and it is us.” It is our collective action going forward (where “our” refers to quant market-neutral managers or those employing very similar strategies) that now affects a world we didn’t realize we had such influence over, and this is undoubtedly an important short-term risk factor.


Q. On the night quant equity strategies hit their lows, how did you feel getting a phone call from Ken Griffin of Citadel?

I looked up and saw the Valkyries coming and heard the grim reaper’s scythe knocking on my door. I did my best to run to the light.

Tuesday, September 11, 2007

Funny Thing Happened on the Way to Muni Bear Market: Joe Mysak

By Joe Mysak

Sept. 11 (Bloomberg) -- So much for the bear market in municipal bonds.

Back in August, a lot of investors were scratching their heads over just how much the net asset value of their municipal- bond funds had fallen -- more than 1 percent in some cases. What's going on, they asked.

What's going on was selling. Net asset value, or the dollar value of a share in a mutual fund, which is calculated daily, declined because the prices on the bonds in the fund fell. Those fell because some big institutional investors had to sell bonds to satisfy redemptions. And some hedge funds decided to get out of the tender-option bond business. In tender-option bond programs, institutional investors put muni bonds into a trust and sell floating-rate securities, pocketing the difference between short- and long-term yields.

So what you had was a whole bunch of bonds being put out for the bid. When everyone wants the same thing, the price goes up. If everybody wants to sell, the price goes down.

What a difference a few weeks makes.

Consider, for example, Vanguard's Long-Term Tax-Exempt Fund. The average net asset value of the fund this year has been $11.16. On July 31, the NAV was $11.06. After that, the NAV drifted lower, and by mid-August was in a sort of free-fall: $10.96 on Aug. 13, $10.92 on Aug. 15, $10.83 on Aug. 17 -- its low for the year.

On Friday, the NAV of the fund was calculated at $11.10.

Borrowing Costs

The Vanguard fund isn't alone. The NAV on most municipal- bond funds, even the high-yield funds that were hardest hit back in August, like those run by Eaton Vance and Oppenheimer, have rebounded in the same way.

Or consider borrowing costs for municipalities. They also increased during August, so much so that several issuers canceled or postponed their bond sales.

Let's take the oldest gauge of new-issue municipal bond yields, the Bond Buyer 20-General Obligation Bond Index, which measures how much it would cost 20 top-rated municipalities to borrow money for 20 years. The index is calculated weekly. It has averaged 4.38 percent this year, and reached a four-decade low of 4.03 percent on Dec. 7 of last year.

That spurred states and municipalities to sell more bonds, for both new purposes and to refinance outstanding debt, and this year looked like a lock to break the previous record of $408 billion set in 2005.

On Aug. 2, the index was 4.51 percent. It climbed to 4.59 percent on Aug. 9, to 4.74 percent on Aug. 16, and 4.81 percent on Aug. 23. The index is now 4.57 percent.

The Ratio

Of course everyone talked about the ratio between taxable and tax-exempt securities. Normally tax-exempts yield around 85 percent of taxable investments. In August, the tax-exemption went begging, and the ratio shot up to more than 100 percent on some maturities.

The bear market in municipal bonds lasted for about three weeks. By the third week of August, analysts were pointing out the weirdness. George Friedlander, municipal strategist at Citigroup Inc., headlined the firm's Municipal Market Comment on Aug. 20, ``An Important Buying Opportunity has Emerged in Municipals.''

And so it had. Mr. Municipal Market screamed ``Buy Me!'' for about, oh, two weeks. He's back to speaking in a normal tone of voice, and if history is a guide will soon return to his usual reserved whisper.

What's Ahead

Municipal bonds aren't subprime mortgages. They may have their problems. These include the ballooning costs of pension and other post-employment benefits, and a decline in real estate transfer and property taxes. Nobody's suggesting that these will affect states and localities' ability to pay debt service.

There's also a Supreme Court case on states' ability to tax out-of-state bonds. The court is slated to hear the case, Kentucky v. Davis, on Nov. 5, and the decision might throw the market into turmoil.

But right now, municipal bonds look pretty good, especially to those investors in cash or low-yielding money market funds.

Then there's the Fed, which meets next week to consider interest rates. At this point it seems unlikely that the Fed is going to raise rates. Most analysts are calling for a cut.

It looks like things are going to go back to normal in the municipal bond market.

To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net

Last Updated: September 11, 2007 00:02 EDT

August Divergence: Markets Go Up, but Hedge Funds Go Down

September 11, 2007; Page C2

Hedge funds turned in their worst month in more than a year in August -- as credit-crunch-induced volatility racked markets. And many of the problems were their own doing.

Hedge funds lost 1.3% in August, their worst performance since May 2006 and the first losing month this year, dragged down by losses of about 2% in stocks, emerging markets, junk bonds and so-called macro strategies, or funds that make bets on broad global markets, according to Hedge Fund Research Inc., a Chicago hedge-fund research firm. Funds of funds, or funds that invest in other hedge funds, did even worse, losing 2.1% in August. (See Breakingviews analysis.)

The losses weren't dramatic, but they came as overall markets managed to finish the month in the black. The Standard & Poor's 500-stock index gained 1.5% in August, including dividends, while the Lehman Brothers bond index rose 1.4% in the month.

The data are based on reports from about 40% of hedge funds. The rest have yet to call in their numbers, raising questions about whether their results are still worse -- the best performers generally are more eager to quickly own up to their results than troubled funds.

Ken Heinz, president of HFR, noted that many hedge funds trimmed their losses late in the month when many "quantitative" funds, or those that trade based on computer models, staged an impressive turnaround. Still, the losses undermined the argument of hedge funds that they are able to generate profits in all kinds of markets.

The year does remain a positive one so far. Hedge funds gained 6.2% through August, beating the overall market by about one percentage point. In July, hedge funds were able to gain ground, even as the stock market slipped a bit. And some investors expected August to have been an even harsher month for hedgies than it was.

Funds added about $17 billion in assets in July, bringing their total assets under management to $1.76 trillion, according to HFR. It isn't clear if their popularity continued in August, though -- some expect the month to be one of the first to show nervousness about funds on the part of investors.

Still, the growing size of hedge funds was a big reason they did so poorly in August. As the subprime meltdown caused nervousness on Wall Street, a number of hedge funds last month slashed their leverage, or borrowings, to become more cautious, or under pressure from their lenders. That forced them to pare their holdings. Because so many growing hedge funds embraced similar stocks in recent months, when they turned to sell it put extra pressure on holders of these shares -- fellow hedge-fund managers.

To wit, the 20 stocks in the S&P 500 with the highest hedge-fund ownership concentration have tumbled 16% since June 30, compared with a loss of just 3% for the S&P 500 as a whole, according to Goldman Sachs. Concentration is defined as the percentage of a company's market value that is owned by hedge funds.

"Concentrated hedge-fund holdings dramatically underperformed during the recent selloff," said David Kostin, an analyst at Goldman Sachs, in a recent report.

These stocks include Sears Holdings, Borders Group Inc., Wendy's International and Carmike Cinemas. Hedge funds own more than 40% of these shares, as of the end of the second quarter. That has set up some opportunities, Mr. Kostin and others argue, because the selling was due to the de-leveraging, not because of reduced earnings expectations or other fundamental factors that usually weigh on shares.

"Buy these stocks which have dropped due to ownership composition, not necessarily fundamentals," Mr. Kostin said.

It's also made some hedge funds more wary of buying shares of companies that fellow managers own, traders say.

Hedge funds could see "another shoe" drop in the months ahead if investors withdraw money, forcing them to do more selling, says Charles Gradante, co-founder of the Hennessee Group LLC, a hedge-fund advisory group that estimates that hedge funds fell 0.7% in August. Sixteen of the 23 strategies the firm follows lost money in the month.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Monday, September 10, 2007

Brit Punter Buys Some Bear!

As the New York Post might scream. So who is this Lewis guy? According to the SEC, he’s the man behind Aquarian Investments, and he’s spent $860,403,183 buying 8,096,942 shares in Bear Stearns.

That’s seven per cent. And he’s paid for it out of “working capital.” And the filing says he a “private investor,” based in Lyford Cay. Apparently, he’s from Ingerland. And he’s not the dead boxer.

For our American readers….

Joe Lewis is perhaps the most successful British speculator of modern times. Born above a pub, the Roman Arms, in London’s East End, he left school at 15 to work in his father’s catering business. Early enterprises included tourist restaurants, foreign exchange bureau and also a tour operator running some of London’s first red open-topped buses.
He began playing the stock market in the late 60s, before moving into the money markets during the 70s, discovering a special talent for the currency markets. Lewis relocated to the Bahamas in 1979 - for a lower tax rate, as well as the weather.

For many years he retained the lowest of profiles amongst the wealth-hating Brits, but his developing friendship with the new wave of Irish financiers in the late 80s and early 90s, notably Dermot Desmond and members of the so-called Coolmore mafia, such as JP McManus and John Magnier, encouraged him towards investments that would draw intense media interest. (At least on this side of the Atlantic.)

From an early stage, Lewis is said to have enthusiastically backed young entrepreneurs, such Robert Earl and Daniel Levy, with whom he eventually took over Tottenham Hotspur football club in north London before buying a large holding in Scotland’s Glasgow Rangers.

Other holdings through the years have included stakes in Christies, the auction house, and Autonomy, a search software specialist.

Lewis said to be a keen collector of Picassos.

As for collecting stakes in burnt out Wall St banks…well, this story feels as though it has legs.

Shares in Bear were up two per cent during early trade in New York, having fallen by a third so far this year.

[Note to researchers: Given Bear’s subprime related problems, there may be some confusion over the fact that Lewis has been an investor in an entity called Countrywide Properties. This does not relate to US subprime victim, Countrywide Financial. It’s a chain of British estate agents in which Lewis built a stake. After a protracted takeover stuggle, the business was bought out by Apollo earlier this year.]

Friday, September 07, 2007

Down the drain

Sep 6th 2007 | NEW YORK AND LONDON
From The Economist print edition

Illustration by Satoshi Kambayashi
Illustration by Satoshi Kambayashi

The money markets are still blocked. Do central banks have the right tools?

“NOT only is there no God,” said Woody Allen, “but try getting a plumber on weekends.” That just about sums up the problems of today's financial markets. The plumbing is badly blocked, and nobody seems able to fix it, not even the central banks, the market's immortals.

The problem is the apparent reluctance of banks to lend to each other, particularly over three months. That problem arises, in part, from uncertainty about who will pay the bill for America's subprime-mortgage collapse. But it also results from the need for banks to protect their own balance-sheets in the face of some unexpected claims on their capital.

The result is that banks are paying much more to borrow than normal, particularly compared with governments. According to Goldman Sachs, one measure of this gap between American Treasury bills and interbank rates, nicknamed the “Ted spread”, is at a 20-year high. And like other plumbing problems, this could have severe consequences, because when banks pay more to borrow they pass the cost on to consumers and companies.

On September 5th the Bank of England got its monkey wrench out and tackled one issue, the half-percentage-point gap between overnight lending rates and its official benchmark. The Bank promised to lend more money to the market, if necessary, to bring overnight rates down.

Critics argue that the Bank has been time-wasting. The European Central Bank and the Federal Reserve made similar moves last month, and the ECB did so again on September 6th. But the Bank of England's failure to act sooner seems to be part of a general reluctance to be seen to be saving speculators from their mistakes. The Bank made it clear that it was not aiming to bring down three-month lending rates, which are the markets' most acute pressure point. A bank may be good for its money in the morning, but who knows what will have happened by December?

Perhaps central banks cannot solve the problem on their own anyway. They have offered to provide finance to any bank that needs it via mechanisms such as the discount window operated by the Federal Reserve. But banks are understandably reluctant to show any hint of desperation. Borrowing from a central bank in the middle of a liquidity crisis is rather like a schoolboy agreeing to have a sign saying “Kick me” pinned to his shirt-tails.

Even a cut in official rates, as is expected in America later this month, may not clear the blockage. The fundamental problem is that the banks made promises that they did not expect to have to keep. These “contingent liabilities” require banks to take the strain when their clients face problems in finding funding elsewhere. Suddenly, a lot of these bills have come due at once.

According to Dealogic, more than $380 billion of loans and bonds linked to pending leveraged buy-outs need to be shifted now that Wall Street bankers have returned from their holidays. The speed of the market deterioration has been a big part of the problem. Banks made short-term or bridge loans to private-equity buyers with a typical 30-60 day holding period. When the markets were buzzing earlier this year, they assumed nothing could go wrong in such a short time. But they were wrong, and now they face the prospect of having to keep large chunks of the debt on their own books indefinitely, marked at a loss.

How big a loss is hard to gauge. One indication is the discounted price at which leveraged loans are trading in the secondary market (see chart). Another is the tussle over the financing for the takeover of First Data, a transaction-processing company. This has already been postponed once. Banks will try to syndicate it again soon. Investors seem unwilling to pay more than 94-95% of par value for the $14 billion of loans in the package. That would wipe out the banks' fees on the deal and leave them with further losses of 3-4%. One banker involved in the deal says its fate is still clouded in uncertainty: “We still don't know if an avalanche is going to fall on our heads.”

First Data will set the tone for other deals, such as the takeovers of TXU, a utility, and Alltel, a mobile-phone firm. The main obstacle is that the First Data deal “has all the bells and whistles of the bubble era”, says another banker: it is, for instance, “covenant-lite” and offers lenders little protection.

Banks would love to wriggle out of the most egregious deals, or at least get better terms. But that is proving hard. They painted themselves into a corner when the market was booming. Previously, many deals included a “material adverse change” clause that cancelled the financing if severe turbulence hit the markets. These would have been handy today, but the banks stopped insisting on them.

As if the buy-out issue was not bad enough, banks face a bigger danger elsewhere, linked to the subprime-mortgage crisis. This threat involves a series of specialist investment vehicles known as conduits and structured investment vehicles (SIVs). Conduits were mainly set up by banks as “off-balance-sheet” vehicles for themselves and their customers that allowed them to invest in slightly riskier assets. SIVs tend to be independent. Both borrowed partially (but not exclusively) in a form of short-term debt known as asset-backed commercial paper.

The investors who bought this paper are now deciding it is not worth the risk. That gives the conduits and SIVs a problem. Moody's, a rating agency, says many have found funding “either impossible or achievable only at exorbitant levels”. On September 5th the agency downgraded (or placed on review) some $14 billion-worth of bonds as a result.

Some SIVs had back-up banking facilities; some did not. But avoiding this direct liability may be of little help for the banking industry as a whole, since when SIVs cannot get funding, they are forced to sell assets. This pushes down prices and increases the chances of the banks suffering losses elsewhere.

Banks are now finding that these risks are coming racing back onto their balance-sheets. It is an ugly prospect since Tim Bond of Barclays Capital estimates that $1.4 trillion-worth of conduits are out there. Either the banks will have to lend money directly to them, or they will end up owning a ragbag of securities—including some dreaded mortgage-linked bonds.

What seemed a clever wheeze to avoid the scrutiny of the regulators and auditors now looks foolish, since no bank knows the exposure of any other. Worse, none knows the extent to which it will end up on the hook itself. As a result, banks are hoarding their capital rather than lending it in the money markets.

If banks have to borrow at penal rates for some time, the poison will spread. Investment banks, for instance, do not rely on consumer deposits for funding, but on borrowing from commercial banks and others. If the cost of their finance goes up, they will have either to cut the supply, or raise the cost, of finance to important investors such as hedge funds. Those hedge funds will then have to sell assets, which might give the whole system another downward lurch. Where's that plumber when you need him?

Fund-of-Funds Managers Target Stalled Bank Loans

U.S. Subprime Mess
Creates Opportunity
To Snag Cheap Debt
September 7, 2007

GAM, one of the largest fund-of-hedge-funds managers, and rival Thames River Capital are primed to make substantial investments in the stalled bank-loan market, buying debt at a discount from lenders anxious to have it removed from their balance sheets.

The chance to buy loans on the cheap has arisen because banks are struggling to sell debt used to finance leveraged buyouts. Before June, banks had been able to sell leveraged loans within a few weeks, but liquidity in the credit markets has dried up as a result of uncertainty over lenders' exposures to subprime U.S. mortgage loans.

David Smith, chief investment director of the multimanager group at GAM, said there was a window of opportunity within the next six months to snap up bank loans at bargain prices, adding that GAM had lined up six hedge-fund managers to buy the debt.

Investors such as GAM, which are prepared to put their money into leveraged loans, hope to profit at the expense of the investment banks and credit-market participants that are rushing to offload the debt at knock-down prices. The loans pay high yields, more than three percentage points above the London interbank offered rate. However, these investors will be taking on the risk of the borrowers defaulting, which has grown as interest rates have increased.

If the banks can't remove the loans from their balance sheets, they will be unable to do more buyout-lending business, a source of high fees. GAM and others are waiting until banks offer existing loans at a discount to clear their balance sheets as they attempt to offer fresh financing.

Ken Kinsey-Quick, head of multimanager funds at U.K. manager Thames River Capital, said his firm had reopened one of its funds of hedge funds and was raising capital from investors to make bank-loan investments. "To say these debt assets are cheap is an understatement," he said. "The commercial-paper market is pretty much dead. That is a $1 trillion industry that has just died in the past few weeks."

Mr. Kinsey-Quick added: "As much as $500 billion needs to be refinanced in the next six weeks. Even assuming some of that gets away, there will still be the balance of the collateral sitting on banks' balance sheets. This is all triple-A-rated collateral and it will be trading very cheaply. It's a huge opportunity if you have the gunpowder and the liquidity."

Goldman makes $300m from fund rescue

Goldman Sachs made $300m last month from the rescue of one of the investment bank’s troubled hedge funds, even as external investors lost more than a fifth of their money. The bank’s Global Equity Opportunities fund, into which it injected $2bn of its own money as part of a $3bn bail-out last month, recovered strongly after the rescue but still underperformed badly for August as a whole. The paper profit positions Goldman as a big beneficiary of last month’s credit squeeze and will boost quarterly profits when the bank reports 3Q results in a fortnight, although it is also likely to suffer from a drop in the value of debt not yet syndicated.

SIVs in the Citi

So what’s the deal with Citigroup’s SIVs?

On Thursday afternoon, GMT, Citi released its latest figures for the seven SIVs it operates. Together, those seven SIVs corner 25 per cent of the SIV world - with just over $100bn in assets under management.

According to the WSJ:

The problem facing SIVs isn’t the assets they own, which can include securities underpinned by U.S. subprime loans — often mortgages to home buyers with sketchy credit histories. Rather, they can’t raise money because investor demand for commercial paper sold by SIVs is minimal.That means banks such as Citigroup are facing questions as to whether they will step in to provide financial support for the SIVs.

But Citigroup issued a statement with their figures saying that the credit quality of their SIVs remained “very strong” and all had succeeded in funding themselves through August, despite turmoil in the short-term commercial paper markets.

Indeed, the effects of that turbulence vary from one SIV to another. If, like the seven Citi vehicles, you’ve got a big bank behind you, finding buyers for your CP may not be so hard.

The WSJ may insist the trouble with SIVs “isn’t the assets they own” - volatility in the commercial paper market has indeed been the proximate cause of most SIV troubles - but SIV portfolios have been suffering severely too. Cheyne Finance, for example, went under because of a decline in its portfolio’s net asset value (NAV). And Thursday’s 7 rating actions by Moody’s were all a result of NAV declines.

But of course, portfolio trouble isn’t the problem most SIVs are keen on you reporting. Perhaps that’s because negative speculation about portfolio value could make shifting their CP even harder.

In a letter seen by the Journal, Citigroup’s SIV overseers, Paul Stephens and Richard Burrows, said that:

Quite simply, portfolio quality is extremely high and we have no credit concerns about any of the constituent assets… SIVs remain robust and their asset portfolios are performing well.

But look at the filings with the London Stock Exchange and you will see that Citi’s SIVs have seen declines in portfolio net asset value of 17-20 per cent in the past few months. That doesn’t quite sit comfortably with Stephens and Burrows assertion that “asset portfolios are performing well”.

Citi’s SIVs certainly do contain some very strong assets - their direct subprime exposure is accordingly, minimal, and a large chunk of their portfolios is rated highly. SIV managers are trying to stress the quality of their portfolios over their current values. But in a market such as this, that doesn’t necessarily matter, because a whole range of assets are suffering from contagion and fear.

As Mark Fitzgibbon, director of research at Sandler O’Neill & Partners, also told the journal:

Any off-balance-sheet issues are traditionally poorly disclosed, so to some extent, you’re dependent on the insight that the management is willing to provide you and that, frankly, is very limited.

Thursday, September 06, 2007

BUY BUY BUY, Says Morgan Stanley's Draaisma

Could this be the most delirious call on stock prices in the modern era? And when we say “delirious,” we mean in a thoroughly joyous sense. There is no suggestion that the pundit in question might have been on the mescal.

Morgan Stanley’s European strategist Teun Draaisma (who said ‘Sell, Sell, Sell’ back in June) this week issued his latest Euroletter note. Entitled Think Big, it sets out the intellectual underpinning and blue sky optimism behind the bank’s call, on August 13, for investors to go overweight equities.

The contents were previewed earlier, during FT Alphaville’s daily Market Live discussion. But such is the bullish optimism of Draaisma and his team, such is their readiness to make a career-making or breaking prediction, that we’ve decided to reproduce the Draaisma Call in full.

We received a healthy amount of pushback on our call from mid-August to start buying equities again. Pushback is good. We know that we may well be on the right track with a call, when we get a lot of investor pushback. It means we are not consensual. Six to twelve months later, with the benefit of hindsight, we know we will look very silly or very right. We see 12% upside to our 12-month target of 1750 on MSCI Europe,and we recommend investors start building positions now, as it is possible that there will not be a better entry point.

Our bull case, overshoot-type scenario, implies 21% upside from here. Since the market troughed on August 16, MSCI Europe is now up 7.7%. Our preferred sectors are Tech & Telcos, Healthcare, Financials. Our least preferred are Consumer-related areas.

Building the base for a mania? There are many risks at the moment. But imagine that we get through this financial turmoil,and an uptrend in equities resumes, as we expect. In this piece we describe why we think that will be the case. If we are right, then equities could be set for a big, big rally. Bulls will say that this uptrend is unbreakable, after all the trouble that has been thrown at it. “The cycle is dead”, and “this time it’s different” will be heard all over the place. Emerging markets will be seen as the new growth engine that cannot be derailed.

This final leg of the bull market will be characterized by all the things we have not seen yet this decade, including big retail buying of equities, big strategic M&A, an increase in corporate confidence leading to a capex boom and multiple expansion in equity markets. There would also be a real mania in certain concept stocks,probably mostly in those related to commodities, infrastructure and emerging markets. Remember that it was only after the 1998 correction that the likes of Nokia and Ericsson went to 70 times PE multiples.

Of course, it won’t be different this time,and as always it will all end in tears, eventually, probably when higher inflation and rates lead to the next recession. But if we get through the current financial crisis, it is highly likely that the next phase in equities is a mania of epic proportions.

It is of course possible that we have not seen the trough in this correction yet.
There are many uncertainties around, and markets do not like uncertainties. The money and credit market problems are very serious. More financial losses will be uncovered. Large parts of the credit and money markets are dysfunctional. Suddenly investors have to familiarize themselves with concepts such as SIVs and ABCPs. This decade’s bull market has been built, to a large extent, on an appetite for debt and structured products, and that appetite has certainly peaked for years to come. The Anglo-Saxon consumer is likely to be weak in the coming 1-2 years. With so much uncertainty around, it is even more difficult than usual to tell what the future will hold. In 1987 and 1998, two previous periods of severe financial crisis which turned out to be bull market corrections, not the start of recessions, there were double-bottoms in equity markets, and several Fed rate cuts were needed to stabilize markets. In such a bear case scenario, MSCI Europe could fall by some 17% from here, in order to reach crisis valuation levels of -2 standard deviation cheap on our CVI. See Finding the Trough, August 20, for more detail behind our scenario analysis. This suggests that the price of a wait-and-see-approach to today’s market may not be that high, and wait-and-see is indeed what most investors are doing.

Wait-and-see may indeed be sensible and prudent, but everyone is doing it.
The virtually unanimous mantra among investors is: “I am not going to take big risks now. I would like to wait a few weeks to see investment banks report (week of September 17), the Fed act (next FOMC on September 18),and to see the next batch of economic data before committing more money one way or the other (eg, US CPI on September 19).” Even the bulls, those that are convinced that the market will be higher 12 months from now because they think the economic growth outlook outside the US is good and the US slowdown will not be big enough to derail this outlook, even they see no hurry to buy. This wait-and-see approach is quite understandable. Focusing on capital preservation in periods ofuncertainty is prudent and sensible. Especially if you are lucky enough to be sitting on good gains for the year, sitting tight and waiting is undoubtedly a prudent and wise thing to do. But the problem with the wait-and-see approach is that everyone is doing it, and this consensual attitude may well prove to be a mistake.

As a result, there is a good chance that equity markets have already troughed and will not offer a better buying
In bull market corrections you should buy early and sell late. The very fact that everyone is waiting and seeing,increases the chance that we have already seen the equity market trough on August 16, in our view. On the one hand, the biggest pain trade is undoubtedly for markets to keep tanking and to go down by 50% from here. However, a pain trade that would catch market participants off-guard is that there will not be a better buying opportunity, and that the market edges higher day by day, and enters its mania phase next. Two months from now, suddenly, investors would need to scramble back in, having missed the first 10%. Exhibit 13 shows the history of bull market corrections. It is interesting to note that the biggest intra-correction rally has been 6.2% in the 1987 correction. Therefore, the fact that between August 16 and September 4 the market rallied by 7.7% also increases the likelihood that we will not go to new lows in this correction, we think.

The bearish extreme: equities will be down more than 50% in the next recession!
Timing of that next recession is everything, but it will be horrible. We estimate that if the recession starts today, equities could go down as much as 70%. This is because in such an environment ROE will go from its current high of 17% to trough level of 8%. This implies that earnings will approximately halve if book value stays constant. Furthermore, at the end of severe bear markets, the PE multiple often has reached around 10, compared to its current level of 14. This combination implies up to 70% downside. We don’t think this is a very likely outcome in the next 1 or 2 years, as we discuss further on. We do think, however, that of three scenarios: mania, recession, or muddle-through, the muddle-through scenario is the least likely.

We recommend investors start buying equities. The scenario we think is most likely is that this is a bull market correction, and that markets will go to new highs before this bull market finishes. Since mid-August, equities is our preferred asset class, whereas during the months before that cash had been our preferred asset class. We believe that the fallout of the financial crisis will be a US economic slowdown, but as long as growth is positive, mid-cycle slowdowns are bullish for equities, as the positive impact of lower rates is more important than the negative impact of lower growth.

Let’s analyse how we get to that conclusion, using the three pillars in our approach: valuations, sentiment, fundamentals.

Valuations are attractive

Our market timing indicators, which gave us a full house sell signal in June (see A Full House Sell Signal, June 4, 2007), are now at much more attractive levels. We don’t have a strong buy signal yet, at levels of -2 on the CVI or the capitulation indicator for instance, but both these indicators were very close to -1 on August 16. This means that the correction we have experienced was equal to an average bull market correction, and the entry point is attractive. With a score below 0 on our Composite Market Timing Indicator, like we had in the second half of August, the average next 6 month performance in equities has been 7.7%, with the market having been up in 81% of observations.

If you believe the earnings, PE ratios are very low. We are the first to admit that reversion-to-the-mean of margins and earnings levels is inevitable, as the law of economics dictates, but reversion-to-the-mean will only happen in the next recession. As long as top-line growth comes through, cost pressure can be absorbed through growth, and margins can stay close to their current peak levels. This indeed has been the pattern observed in the last few years of previous bull markets. If earnings are roughly right, PE ratios are very attractive.

The share of the market that qualifies as a Benjamin Graham Value stock is at an all-time high, as we show in Exhibit 20. Again, this conclusion does depend on whether earnings are sustainable or whether they will collapse. But there is a marked contrast between how many Benjamin Graham value stocks there were in 1998-2000, and now. The long-term average share of the market that qualifies is 5.0%, versus 16.2% today, which is the highest share of the market to qualify as a Benjamin Graham Value stock since 1992, narrowly beating the previous all-time high of early 2003.

Sentiment is negative

The weekly put-call ratios reached an all-time high in the third week of August, based on weekly data since 1995. The skew — which measures how popular put options are in comparison to call options — reached an all-time high, too, based on data since 2001. These are bullish contrarian signs, with very favourable odds that markets are up in the subsequent 6 months.

Our favourite sentiment indicator for European equities from the futures market is the CFTC data on the NASDAQ. Currently that displays a 1 standard deviation net short. From levels of 1 standard deviation shorts or more, MSCI Europe has gone up an average 9.9% in the following 6 months, up 91% of the time. We like those odds.

Our capitulation indicator, which is based on price action and the breadth of the correction, suggested that there had been capitulation in the middle of August. The reading reached on August 16 (the trough, so far, in this correction) was -0.84, compared with an average trough reading of -1 in bull market corrections in the last 25 years.

Weekly mutual fund flows into emerging market equities showed an outflow in the week following August 16, consistent with market troughs. When the retail investor starts selling it is often a sign of the trough having been reached.

Finally, as mentioned earlier, most people are now staying on the sidelines, waiting for more clear signs as to whether they should be bullish or bearish. Investors who can use leverage to increase their gross exposure are using a much lower amount than usual, and our strong sense is that most deleveraging among stat arb and quant funds has been done. There are plenty of sources of money to be invested in equities, potentially, from asset allocaters, retail investors, hedge funds by increasing their gross exposure, corporates by using their strong balance sheets to embark on strategic M&A or buybacks, sovereign wealth funds and uninvested private equity.

Fundamentals are uncertain and risky, but because inflation is not yet a real problem, rates are flexible and can stabilize the growth outlook, eventually. And remember, if things get less bad, that would be good enough for markets to go higher.

Global growth prospects seem good. Dr KOSPI, Dr Copper and Dr Baltic Dry, all those market barometers of the growth outlook who deserve the title of Dr because of their PhD in economics, are voting with their feet and telling us the global growth outlook is intact and good.

US slowdown. This rosy picture for global growth is in contrast with some of the US-based indicators, which indicate slowing growth. Our US economist Richard Berner expected 1.9% GDP growth in 2007, down from 2.9% in 2006, and 2.6% in 2008 the last time he released his forecasts, in early August.

Soft decoupling is the norm. A US slowdown, provided it is not a severe slowdown, doesn’t usually affect the rest of the world too much. A recent study by the IMF shows this point very nicely. Whenever the US GDP growth deceleration from one calendar year to the next is less than 2 percentage points, the rest of the world has been unaffected historically. Whenever the slowdown has exceeded 2 percentage points, the deceleration in the rest of the world has been very pronounced.

Currently our US economists expect a deceleration of 1%-point in 2007, far below the threshold. In addition, many emerging market specialists, including Stephen Jen and Jonathan Garner, are effectively arguing that the US matters less now than it has in the past, which implies the 2%-point deceleration threshold may even be higher now.

Europe should whether this storm well. In two recent pieces by our European economists they explain that house prices are at similarly stretched levels in Europe as in the US, but the European consumer is in much less precarious situation because its savings rate is high and the subprime market is absent outside the UK (See How Susceptible Is European Housing to US Problems? by David Miles, August 30, 2007). Furthermore, in examining the transmission channels through trade links, credit tightening and house prices, they conclude that the euro area should prove relatively resilient. Within countries, Spain appears to be the most exposed to tighter credit conditions, and Germany is most sensitive to a possible slowdown in global trade (see How Could the US Disease Infect Europe? by Eric Chaney, August 30, 2007).

Core inflation has been easing. The unemployment rate in the US, for instance, at 4.6%, is still some way above the low in 2000 when 3.8% started to create inflationary pressures, and the Fed fund rate reached 6.50%. In a more globalised world the US unemployment rate probably needs to go even lower than that before inflationary pressures are triggered. As long as inflation is not a big problem, rates can act as automatic stabilizers to the growth outlook and ‘solve’ the growth problem, as they have done for years now, time and time again.

Insiders have been buying, and that is bullish. At the end of August we reached the lowest insider selling / buying ratio since the end of 2002.

Quant model says we aren’t heading for a recession. Our quant model to forecast recessions tells us that we are 4 Fed rate hikes away from a recession. And remember, this model has predicted each recession since 1960, and has never given a false signal. The recent peak in this indicator at 50% at the beginning of April was significantly below the 70% threshold below which there has never been a recession. Remember, we use this as a binary indicator: below 70% there has never been a recession, above 70% there has always been one.

European earnings outlook good. We expect 9.0% EPS growth in 2007 and 6.5% in 2008, compared to IBES consensus expectations of 8.9% and 9.8%. We also recently introduced a quant model to forecast earnings for the next 12 months, our EGLI or European Earnings Growth Leading Indicator, in An Earnings Growth Leading Indicator for Europe, June 25, 2007). It takes into account five factors: US earnings growth, ISM New Orders, BNB Business Survey, German 10yr bond yield and Fed Funds target rate. It currently forecasts 17% growth, suggesting that there may actually be upside risks to our forecasts. Our take on this is that we will see downgrades in the next 6 months, in all likelihood, especially among Financials, but as long as EPS growth is positive a mid-cycle slowdown environment is bullish for equities through lower

Credit valuations are more reasonable now. In Sanity Check, May 23, 2007, we published a chart showing how irrational credit markets were. Credit markets were priced such that the weighted average cost of capital (WACC) gets lower with more debt, irrespective of how much debt a company has. Thus, a junk bond rating of BB gives companies the lowest WACC. In other words, no cyclicality of cash flows was priced in, illustrating excessive risk appetite. By now, the optimal point on the credit curve is BBB, followed by A, which is a much more stable situation. The investor we met in May who stated that February 2007 is to credit what March 2000 was to the NASDAQ shared a brilliant insight with us!

Authorities are reacting: central banks are injecting liquidity, and President Bush has announced some measures. We are moving through the usual sequence of events in a crisis. The end of such a crisis is when authorities step in to try to solve the problem. We are well into that phase. With core inflation having eased, there is room for more rate cuts, and they may indeed be needed to stabilize the outlook. Government Sponsored Entities may have to be allowed to inject liquidity and buy up some of the derivatives that are in trouble before a more stable situation in money and credit markets is restored. Ben Bernanke clearly illustrated he is aware of the severity of the situation in his recent Jackson Hole speech.

Many short-term worries. The appetite for LBOs and structured product certainly peaked in Q2. There is a large pipeline of leveraged loans to be placed (~US$500 billion according to Monday’s Financial Times), which hangs over credit market valuations. Real estate is overvalued everywhere. The Anglo-Saxon consumer will slow down. More financial losses will be uncovered — watch in particular the investment banks reporting. Money markets are severely dislocated still, and it is important that they stabilize indeed in the next few weeks, as we expect. Having said that, wages and employment growth are still good, companies have very strong balance sheets, and there is a lot of money around, looking to invest in public equity markets, or in distressed debt markets, including among the new and rapidly growing sovereign wealth funds and uninvested private equity.


Asset Allocation — Overweight equities (3% above benchmark), Neutral cash, Underweight bonds (3% below benchmark). With valuations attractive, sentiment negative and fundamentals likely to improve, in our view, we have turned buyers of equities on August 13 for the first time since January 22, earlier this year.

Sectors — see European Model Portfolio in Exhibit 34. We are now overweight Healthcare (see Making Pharma Our Biggest Overweight, July 2, 2007), Tech & Telco, and Financials (see Financials: Very Contrarian, Decent Value, But Risks Are High, September 3, 2007). We are underweight Consumer-related areas as both the valuation and the outlook for these sectors in general is not good, we think. We are neutral Utilities, Materials, Energy and Industrials, but if our more bullish scenario plays out, Industrials, Materials and Energy should do well, while Healthcare and Telcos may not deserve an overweight in such a scenario.

Styles - Large caps. We believe that 2007 was the start of a multi-year trend of large cap outperformance. The valuation case for large caps is very good, the growth outlook is now quite similar to smaller caps, and the strategic M&A and liquidity phase we are likely to enter now should benefit large caps more, as is often the case in the last few years of a bull market (remember the Nifty Fifty, and TMT?). See Super Size Me: The Case For Large Caps In Detail, May 14, 2007.

Quantitative stocks screens. If we were on the buyside, we would invest maybe one third of our money in quantitative stock screens that we believe in.

Our four favourite such screens are:
1) Benjamin Graham Value Stocks — What Would Benjamin Graham Consider Buying Today? August 6, 2007;
2) Equity Carry stocks — Equity Carry: Financials & Telcos Dominate, August 28, 2007;
3) The Magic Formula / Joel Greenblatt-inspired long-short strategy– What The Magic Formula Advocates Today, August 2, 2007, and
4) Private Equity Screen — Updating Private Equity and 3Us Analysis, April 10, 2007.

And that’s it.

Investors raise funds for leveraged loan sales

Hedge funds, private equity groups and investment banks are raising billions of dollars to buy leveraged loans in the belief that banks will have to sell $250bn of debt on the cheap. Goldman Sachs, Lehman Brothers, Apollo, Texas Pacific, Blackstone, GLG Partners, Oaktree Capital and Blue Mountain are among groups asking investors for money, mostly for “recovery” funds designed to run for one or two years. High-quality senior secured loans are trading at about 95 cents on the dollar for many big-name companies, with some buy-out bridge loans well below that. Assuming all the funds reach their targets, the scale of the fundraising could help banks offload loans they agreed to extend to back buy-outs before the credit crunch. Lehman is looking for about $2bn, Oaktree for up to $5bn and GLG of London $250m, investors said.

Wednesday, September 05, 2007

Bob Arnott: Past is Not Prologue, and Hope Is Not a Strategy

The capital markets of the last quarter century have been incredibly generous to us. Since mid-1982, the S&P 500 index has advanced at a solid 13.9% annual clip, while 10-year Treasury bonds have posted annualized returns of 9.8%. With annual inflation averaging just over 3%, this means that investors have seen their real wealth double every seven years in stocks and every 11 years in bonds. But, past is not prologue.

Would a bond investor, looking at 25-year returns of 10% and current long bond yields of 5% be foolish enough to expect the next 25 years to deliver 10%? Of course not. They'd recognize that yields started in 1982 at 14% and had plunged to 5% over the next 25 years, earning hefty capital gains on top of a yield averaging 7% over this span. With current yields of 5%, they'd expect 5%.

So, if stocks were yielding 6% in 1982, and are now yielding 1.8%, should we expect to repeat the 13.9% of the past quarter-century? Of course not. On average, 5% a year came from capital gains attributable to multiple expansion - over and above what growing earnings and dividends contributed. Take that away, and we're at 9%. After all, that's what we'd have earned if dividend yields still matched the average yield of the quarter century. But, even that's too aggressive. Dividend yields are 2% lower than their average during this span and 4% lower than the starting yield of 1982. Take 2-4% away, and we should expect 5-7% from our stocks in the years ahead.

Over the past century, dividends have provided over two-thirds of the real returns earned in US stocks. Today, they hover well under 2%, while nominal bond yields are in the 5% range. Simple arithmetic points to 5% returns for bonds and 5-7% for stocks - if their respective yields don't rise in the years ahead! Rising yields and shrinking P/E ratios would mean capital losses which would reduce returns below these levels, much as falling yields and rising multiples fueled the wonderful returns of the past 25 years.

A lot of investors, even professional institutional investors, aided and abetted by their consultants and actuaries, don't like this arithmetic. So, they dismiss it, preferring to forecast the future by extrapolating the past. This is perhaps the worst possible way to construct expectations. It led actuaries to assign very low return assumptions (6% was typical) for pension funds in 1982, at a time when 14% could be locked in with government bonds, and when stocks were producing that same 6% in dividend yield alone, without even allowing for any growth, capital appreciation or inflation, all of which could, and did, add mightily atop that 6% yield. Why such low expectations? Because returns from 1965 to 1982 had been wretched.

Extrapolating the past similarly led to 10% and higher return assumptions at the peak of the bubble in 2000, at a time when bond yields were 6% and stocks were offering a scant 1% yield. Why such high expectations in a world of low yields? Because returns from 1982 to 1999 had been truly extraordinary. In 2000, I wrote a short paper entitled "Death of the Risk Premium," with Ron Ryan, which was received with widespread derision, but ultimately proved correct: plain old 10-year government bonds have produced higher returns than stocks since then, by a cumulative margin of over 30%, despite the durable bull market since 2002. And, even if we include the bubble of 1998-2000, stocks have beaten bonds by well under 1% per year over the past decade.

Today, no matter how fuzzy the arithmetic, it is difficult to justify long-term returns from conventional stock and bond balanced portfolios exceeding 5-7%. We can decry the math and its conclusions, but investors can only dismiss it outright at their peril. Since most plan on 8-10% returns (if not more!), the vast majority of long-term investors are confronted with a large shortfall between likely portfolio returns and what they hope to achieve.

Worse, if inflation drains off 2-3% a year - it would be awfully dangerous to count on a more benign long-term inflation outcome than this - and if taxes take away one-third of our 5-7% total return, we're left with pretty close to zero real return, net of taxes and inflation. Yikes.

Many, with spending plans that require 8-9% returns, hope such seemingly-bleak expectations prove off the mark. But hope is not a strategy. Rationally-inclined investors are grudgingly beginning to accept this likely reality. They recognize that it's far more sensible to take an alternative view: 5-7% returns aren't really all that bad, and so perhaps we should hope for more, aspire for more, develop strategies aimed at achieving more, but accept 5-7% as the base case scenario.

Eliminating Negative Alpha

Noting the gap between expected and required returns, many investors increasingly turn to "alpha" (value added from investor skill) as the elixir to cure their long term ailment. Meander through just about any industry publication and it is impossible to avoid the cascade of references on all things alpha - the quest for alpha, bids to increase alpha, alpha overlays, currency alpha, loosening constraints for alpha and the list goes on. It is almost as if manager skill is an assured and harvestable commodity. The very word "alpha" triggers feel-good pheromones in investors, as reliably as chocolate truffles or love. Few people bother to discuss the fact that alpha is a zero-sum game, with an average alpha of zero - less the costs associated with the quest for alpha. This means that most alpha is negative!

In investing, what is comfortable is rarely profitable. If the crowd is hell-bent on unearthing positive alpha, our own contrarian inclination points us in a different direction - very few of today's market participants are focusing as aggressively on eliminating negative alpha. Seeking, identifying and eliminating negative alpha is as profitable as seeking, identifying and employing sources of positive alpha.

We define negative alpha as the slippage investors unnecessarily incur in the ongoing management of their portfolios. A fancier term would be implementation shortfall. Eliminating all these various mistakes is not only profitable, it's vastly easier than competing with the crowd of alpha chasers.

Four major sources of negative alpha will be covered in today's discussion. No doubt, there are countless more that deserve additional consideration. Certainly, cost is an obvious example: all other things equal, the lower fee alternative will outperform; but, I think that is fairly self-evident. These four require a little more discussion as avoiding them requires considerable more effort than simply lining up expense ratios. They are:

1. Equity Concentration
2. Ignoring Rebalancing Opportunities
3. Chasing Winners
4. Cap Weighting in Stocks

Equity Concentration. Holding equities for the long run is a nearly universal mantra in our industry but there are many markets that appear to offer a "risk premium," ranging from commodities to emerging markets bonds, from real estate to timberland. Reliance on significant equity allocations, while ignoring these other markets, limits our ability to reduce portfolio risk through diversification. One of the best kept secrets in investing is the miniscule diversification achieved in the classic 60/40 traditional balanced portfolio. Due to their significantly higher volatility, sizable equity declines overwhelm bonds in this supposedly "balanced" construct. For this reason, the 60/40 mix has very nearly a 99% correlation with the S&P 500! If we use other "risky" markets selectively, opportunistically when they're offering premium yields, and on a scale large enough to matter, we can earn equity-like returns at far lower risk.

Not many recall the current decade as an easy time to make solid profits. Even the bull market from late-2002 until mid-2007 barely recovered the 2000-02 equity market losses for most investors. But as Figure 1 illustrates, for those who were not invested in an equity-dominated portfolio, especially those willing to stray outside of both mainstream stocks and bonds, many asset classes have delivered lofty returns. Indeed, most people would be surprised to learn that the average return of this list of markets was essentially the same: 9.3% per year in the first six years and 8.7% in the more recent six years!

Figure 1. Comparing Fifteen Markets from 1995-2006

Nearly every category produced meaningful positive returns except stocks and equity-centric balanced accounts. In contrast, all the equity indexes were down and a 60/40 passive mix provided a measly 4 percent cumulative return. The problem with 2000-2002 was not a lack of return opportunities but that one asset category (equities) performed poorly and practically everyone was wedded to an equity-centric portfolio with over-promised diversification benefits from small allocations to bonds and trivial allocations to other assets.

How much does this over-investment in equities lead to negative alpha? If we compare the 60/40 portfolio to an equally weighted portfolio of additional- REIT's, commodities, emerging market bonds, TIPS, etc. - asset classes, we find this new True Diversified Portfolio exceeds the 60/40 Portfolio by X.XX% annually over the last XX years with a significant reduction in standard deviation. Adjusting both portfolios for risk, the True Diversified portfolio's Sharpe Ratio of X.X trounces the 60/40's X.X. Which return stream would a rational investor desire? In widening the opportunity set to include meaningful allocations to alternative strategies, we can avoid the negative alpha due to an over-reliance on equities and likely earn meaningful excess returns.

Rebalancing. Buying low and selling high - through rebalancing - is a perennially underrated investment choice. Neglecting this simple exercise is an almost universal source of negative alpha, especially when we take account of risk. The strong tendency of the capital markets to mean revert translates to incremental profits, for those willing to sell their long-term winners and buy their long-term losers.

Still, it's not an easy discipline to embrace. Consider Figure 1 again. Imagine the courage required to sell the S&P 500 and buy Emerging Markets at the start of our current decade, after six years in which US stocks had risen 219% and Emerging Market Stocks had lost one-fourth of their value.

A disciplined rebalancing policy adds about a half-percent to risk-adjusted returns for a well-diversified portfolio. [I have written a couple of articles demonstrating this result, over long spans, which I will send to John and he will post in the future.] Suppose we started in 1995, with $100 in each of the fifteen asset classes listed above. By the end of the 12 years, our $1500 would have grown to $4412. If we did just one rebalance, halfway through the 12 years, putting one-fifteenth of our money in each of these markets, we'd have boosted our final wealth by $165, or 11% of our starting portfolio value! Remarkably, this result required one set of trades totaling just 12% of the portfolio, effectively an average of 1% turnover per year.

Of course, these excess returns solely accrue to those willing to look uncertainty in the eye and follow through. Indeed, eliminating the slippage is far easier said than done. The more comfortable course, "waiting for things to settle down," allows the asset mix to drift with the whims of the capital markets. In so doing, rebalancing opportunities are squandered with the portfolio suffering the associated negative alpha.

Chasing winners. Chasing the latest investment craze is incredibly easy, as we are bombarded with success stories at every turn - the neighbor who got in on the hot IPO, our brother-in-law with his 30% hedge fund return last year, and the advertising campaigns of the top mutual fund companies, proclaiming their latest star performers (how often does a mutual fund company take out ads listing their best and worst five funds?!). Collectively, these stimuli lure us like a siren's song to chase the latest winners, be they asset classes, managed portfolios, or individual stocks. In the case of funds, the investment is often then sold at the bottom of its performance cycle, after it's become a "proven" loser. Inevitably, it is replaced with a "good manager" who has experienced strong results recently. Of course, these replacement firms' performance is near high tide and begins to recede not long after retention.

This practice is the equivalent of selling low and buying high and its damage to investor wealth is devastating. To quantify this negative alpha, we turn to a 2005 study by Russel Kinnel of Morningstar that dramatically illustrates the consequences of chasing winners ("Mind the Gap: How Good Funds Can Yield Bad Results," Morningstar Fund Investor, July). In 17 equity mutual fund categories, the average dollar weighted returns (return to the investors) were compared with time weighted returns (return to the fund) over the previous 10 years. Kinnel found every single category's dollar return trailed its time weighted return with the average slippage amounting to 2.8% annually- a damning indictment of investors' tendency to chase recent performance.

An example is probably in order, to illustrate the simple but nasty mathematics behind this shortfall. A small fund with $100 million of assets produces an excellent three-year return of 21% per year. Investors take note and, consistent with history, move money into this hot new portfolio so that over the next three years the fund's asset base swells to $1 billion. Meanwhile, the strong performance evaporates and the fund finishes with a 0% return in the next three years. On a time weighted basis, the fund delivered an average of 10% per year, compounded. But on a dollar weighted basis the fund earned a scant 1.9%, indicating a slippage of 8.1% per year. Kinnel's study showed annual slippage of over 11% for the average investor in Technology funds. Talk about impatient investors!

The urge to act upon recent successes and abandon yesterday's laggards is so incredibly powerful that most investors, individual and institutional alike, lose the requisite patience and throw away a sizeable portion of the equity market's return.

Cap-Weighting in Stocks. The last source of negative alpha happens to occur in the asset class where most investors have their greatest exposure - equities. As we will see, the indexes that we rely upon, by their very construction, fail to enjoy both of the previous sources of alpha. They do not rebalance when any stocks advance well ahead of - or retreat far below - their fundamentals. And they chase winners, by adding stocks to the portfolio after they've been on a roll and dropping them after they've faltered badly.

The shortfall from traditional active management in stocks is well-known: the combined handicaps of management fees and trading costs cause the average fund to underperform the S&P 500 by 1-2% per year over long periods of time. A revolutionary concept thirty years ago, this is common knowledge today and so investors have been increasingly driven towards index funds.

But stock index funds also incur slippage. Virtually all traditional indexes, and their associated index funds and ETF's, use market capitalization, essentially the total value that Wall Street assigns to the enterprise, to determine the weight each security receives. Those shares priced above their eventual intrinsic value (think AOL in 1999) will have an erroneously high capitalization and, therefore, a high index weighting. An indexed portfolio, weighted by capitalization, will invest most of our money in these stocks, each of which will eventually underperform as the market seeks out the intrinsic value. Stocks priced below eventual intrinsic value will have an erroneously low capitalization, hence index weighting, and will offer a performance boost. However, the relative losses of the overpriced stocks overwhelm the relative gains of the underpriced stocks because the underpriced stocks comprise less of the portfolio. In this manner, linking portfolio weight to security price - so that more than half of a capitalization-weighted portfolio will be in overpriced stocks - introduces a return drag.

Investors on both sides of the active/passive debate should be incredibly frustrated by this phenomenon. Some know there are mispriced stocks and so they seek out well-managed mutual funds to identify underpriced companies. Their hopes are, of course, dashed when these funds fail to perform despite an environment that provides numerous opportunities. Seeing these failures, the indexers eschew the performance game and invest in their cap-weighted market proxies. Their confidence shrinks when over time they see their reliable index reliably load up on shares of companies that are later proven to be dramatically overpriced.

The Fundamental Index concept was developed to address this structural return drag. By weighting securities on fundamental metrics of company size like sales or earnings, we sever the link between our allocation to a stock and its over- or under-valuation. Using a valuation-indifferent weighting scheme should leave the resulting portfolio with roughly equal parts overpriced and underpriced securities, even without knowing which ones are which! As these pricing errors are corrected, the relative gains and losses cancel each other out.

The construction is a relatively simple exercise. For example, if Microsoft's sales represented 4% of the top 1000 sales companies, it would receive a 4% weight in a sales index. In the Research Affiliates Fundamental Index (RAFI(r)), we repeat the same exercise for Microsoft with dividends paid, book value, and free cash flow. Taking a simple average of each company's relative scale in these four financial measures gives us a pretty good indication of its economic footprint. Market capitalization, in contrast, measures Wall Street's estimate of a company's long-term future growth prospects and future economic footprint, for which the market prepays as if that future is a fait accompli!

John Maynard Keynes was not only one of the most important economists ever, he was also a legendary investor. He said that he chose not to invest in speculations and expectations, preferring to invest in what companies own and produce. What better reflects the market's consensus for expectations and speculations than market capitalization weighting? What better reflects what companies own, produce, and deliver to their shareholders, than weighting our portfolio by companies' sales, profits, net assets (book value) and dividends?

In using such "Main Street" size metrics, the resulting Fundamental Index portfolio is largely representative of today's economy. To reflect the changing economy, the index is rebalanced annually. Furthermore, it retains virtually all of the positive attributes normally associated with passive investing - massive diversification, liquidity, transparency, and low turnover.

But most importantly, the structural negative alpha of overweighting overpriced securities and underweighting undervalued shares is gone. What's that worth? Over the forty-five year evaluation period in the US, the Fundamental Index concept produced excess returns of 2% with less volatility than similar cap-weighted indices in large company equities. Interestingly, it makes comparatively little difference which fundamental metric one chooses. Selecting and weighting companies by sales, by profits, by book value, by dividends, even by the number of employees, all produce results within 50 basis points per year of the RAFI composite. The sole outlier, capitalization-weighting, falls 220 basis points per year behind the average Fundamental Index result. That's enough to make the difference between making 80 times our money versus making 200 times our money, over the last 45 years. What an outlier!

Nomura Securities replicated this work in all 23 countries in the MSCI and FTSE developed world indexes, and found that it outpaced capitalization weighting in 23 countries out of 23, with no exceptions, by an average of 2.6% per annum over the span from 1988 to mid-2005. The Fundamental Index portfolio even outpaces capitalization-weighting in all ten of the global market sectors tracked by FTSE (technology, health care, capital goods, etc.), with no exceptions, from 1990 to date.

The Fundamental Index advantage only widens in inefficient markets like small companies and emerging markets. These markets have diminished coverage by Wall Street and institutional managers leading to a greater likelihood of pricing errors. The cap-weighted index suffers a greater return drag as the frequency and magnitude of mispricings proliferate - even more money is allocated to the overvalued and even less is allocated to the undervalued. Imagine a passive strategy outperforming standard benchmarks by 3.5% in small companies and nearly 10% in emerging markets; these are the historical results in these markets! This turns the whole notion of index investing upside down - no longer is the index fund an inferior choice in inefficient markets where the potential returns from active management are greatest.

Practicing What We Preach

Most wealth advisors have seen their clients drawn into the first three errors, the first three sources of negative alpha. Significant positive returns in equities, or any investment category for that matter, tempt clients to forgo proper diversification. Rebalancing often implies adding assets to the worst performers, what many refer to as "watering the weeds." But, as any gardener knows, weeds can grow like crazy! The stellar results of recent winners make them irresistible.

For this reason, investment policies are developed to mitigate these behaviors. The resulting stable asset allocation structures, automatic rebalancing procedures and long-term performance criteria are time-tested and theoretically sound investment practices. One of the main contributions that the best wealth advisors make to their clients' success is to effect these policies and, in so doing, to help their clients avoid simple and costly errors. They ensure patience, discipline, and commitment - three traits vital to long-term investment success.

The return drag associated with cap-weighting, however, is a relatively new concept in portfolio slippage. It has stirred massive controversy in the practitioner and academic communities, because it calls into question some of the core precepts of modern finance and challenges some of the best-respected (and largest) product areas in the investment world. But a sizable portion of the advantage of the Fundamental Index concept, is attributable to the fact that traditional indexes ignore the simple Investing 101 tactics we just reviewed.

The S&P 500 Index chases performance and allocates more of our money to recent winners. A stock that doubles in price gets double the weight solely because it doubled in price. How else to explain Cisco's weight in the index increasing from 0.4% to 4.0% in the last two years of the bubble? Did its weight rise ten-fold because it had become vastly more attractive, as its P/E rose from 30 to 130? Of course not. It's weight rose ten-fold because its price had risen ten-fold relative to the rest of the market. Ironically, as its stock price cratered, the company continued to deliver growth well ahead of the broad economy, but not enough to justify its astronomical multiples at that time.

The cap-weighted index doesn't practice periodic rebalancing, preferring to not buy low and sell high. The only time transactions occur is when new stocks are added and old ones deleted. Very often new stocks will be ones that have done well recently, not necessarily those that will do well in the future. And the deletions, unless they're takeovers, are inevitably companies that have fallen badly relative to the rest of the market.

Combined, the tendency to allocate more to recent darlings and bypassing rebalancing can lead to a relatively less diversified equity portfolio in times of bubbles and fads. As economic sectors surge in price, a natural side effect is a more heavily concentrated cap-weighted index portfolio. In extreme instances like the TMT bubble of 1998-2000, the outstanding diversification typical of traditional index funds is severely compromised. In the past half century, no economic sector that exceeded 25% of the S&P 500 ever delivered enough future success to justify that immense allocation. Technology in 2000 was the latest victim of this pattern.

Why emphasize these time tested methods - diversification, rebalancing and avoiding chasing winners - to asset classes and managers, and then turn around and invest in an index fund that largely ignores them in the cross section of the equity market?

The Fundamental Index concept meanwhile avoids returns chasing behavior, practices rebalancing, and achieves sizeable diversification even when it is out of favor. Stocks that double in price aren't automatically given twice the weight. The annual rebalance ensures discipline and, unlike traditional cap-weighted indexes, forces the portfolio to buy low and sell high. Outperformers are rebalanced back to their economic size with these proceeds invested in shares that have recently fared poorly. As most enterprises' share prices loosely follow their economic scale, annual turnover remains very low - almost as low as with capitalization-weighting. Weighting by fundamental metrics also bypasses the pricing bubbles that occasionally pop up in the equity market. All of this is accomplished in a formulaic and easily replicated manner.

Update - Fundamental Index(tm) Today

The Fundamental Index concept isn't just theory - it is being used by individual equity investors today in a variety of structures. With each passing month, the RAFI methodology is stirring up considerable debate and, we might add, tremendous flows of equity assets. I've never had the privilege to develop an idea which stirred so much controversy and comment, from both practitioners and academics, so quickly. Total RAFI-related assets have grown from less than $1 billion eighteen months ago to nearly $20 billion today (here, I include assets of others' products that we believe may infringe our pending patents).

The Retrospectives below show a handful of Fundamental Index applications, including US large and small, International, Pan-European, Japan, to name a few. There are other indexes, not shown, covering all 23 countries in the FTSE and MSCI developed world indices, NASDAQ companies, international small companies and 12 of the largest Emerging Markets. These are simple, passive index results, not the results for managed funds. RAFI strategies are distributed through our affiliates, who can provide the results on their own products. The Inception-to-Date results go back as far as FTSE, the global index provider has ratified these results; there are longer-term results, not yet confirmed by a major index provider, going back as far as 1940 in the US and 1984 elsewhere, which suggest similar long-term results.

This year, for instance, the RAFI(tm) indexes are ahead in all areas except US large companies. Even in US large companies, they lag by only 0.4%, despite what one hedge fund manager characterized as "the largest de-leveraging in history," which led many quant-value managers to underperform by sometimes immense margins. This small shortfall occurs after outperforming by over 5% cumulatively in the prior two years. The FTSE RAFI 1500 is ahead of the Russell 2000 by 150 basis points despite a nearly 900 basis point edge of small cap growth over small cap value. The diversified overseas variant, the FTSE RAFI Global ex-US Index, also is showing solid value-added amidst the year's volatility and value underperformance.

We think these results are compelling to any but the most committed advocates of efficient markets and conventional indexing. Keep in mind as you review this material that this is not stock picking, nor is it a quantitative active management model. It's just a "fundamentally" different sort of broad market index!

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.