Thursday, March 27, 2008

When is food not food?

Or why, as agricultural commodites have flown, have consumer price rises for food in the OECD stayed relatively low? Food price increases have caused much angst as a principal driver of rising inflation in developed economies, but food CPI has remained contained against sky-rocketing prices for wheat and rice.

969.jpgFood prices in the developed world, point out UBS in a new report, have very little to do with food.

It is instead about people, packaging, and processes, as well as marketing, advertising and transport. The actual food, in terms of agricultural commodities, accounts for only about 20 per cent of consumer spending. Data from the US and the UK indicates that the food componenet of food spending has remained pretty static over the past four or five years.

Even milk, UBS’s economists note, subject to limited processing, has a food commodity component of less than 50 per cent.

We wonder then if that means that food price inflation driven by agriculatural commodity inflation has a tendency to feel greater in the nation’s shops than it actually is, because the benchmarks - a pint of milk or a loaf of bread - tend to be those with the highest commodity component.

Emerging markets are a different matter, as UBS demonstrates with a some pictures liable to get the dreaded Gillian McKeith on the warpath. Food will play a greater role in overall consumer spending, and commodity price inflation will be a more significant driver of emerging economy food inflation.

As an economy develops, consumer spending on food will increase.This does not mean that consumer spending on agricultural commodities will increase (or, at least, that it will increase by the same amount).

971.jpg 975.jpg
The UBS conclusion:

With the prospect of a labour market that continues to weaken, and where demand for lower skilled (lower income) labour is likely to be limited, it is unlikely that labour costs will support higher food price inflation. Coupled with mixed pricing power from food manufacturers and food retailers, this suggests that even if agricultural commodity price inflation stays at its current elevated level and commodity prices rise as dramatically in 2008 as they did in 2007, OECD foodprice inflation (at a CPI level) will slow.

Wednesday, March 26, 2008

Portable alpha demoted to “low opportunity” in new survey of consultants

25 March 2008

Regular readers will remember that in 2007, portable alpha and 130/30 were deemed to be “up and coming” by management consultancy Casey Quirk & Associates (see related posting). The firm surveyed 49 North American investment consulting firms and found that portable alpha, liability-driven investing and 130/30 “may not represent a search focus, but see rising interest in conducting search activity.”

Casey Quirk just released the results of its 2008 survey. And this new edition concludes that 130/30 and LDI remain “up and coming”, but portable alpha has been told to clear out its desk and move to “low opportunity” with commodities and fixed income. (”Low opportunity” is defined by the report as any asset class “faced with declining interest and little focus from the consultants in 2008.”)

Here is how Casey Quirk saw the world back in March 2007…

Ah, those were heady days for portable alpha. But it’s all a distant memory now. Check out this year’s opportunity map…

Portable alpha was actually the only asset class to switch categories over the year. So what happened? Did portable alpha get a little too big for its britches? Did consultants lose interest? Or have investors internalized the concept so much that it has ceased to be the central focus of their manager searches?

Philip Kim, one of the report’s authors tells us that the focus on portable alpha fell for several reasons during 2007. First, it succumbed to the general hesitation over derivatives and leverage in 2007 (both key ingredients in portable alpha); second, it became more difficult to define as portable alpha variants proliferated; and third, many investors began executing portable alpha strategies on their own using hedge funds of funds (meaning they did not actually search for a “portable alpha manager”).

A further read of the 2008 edition also reveals an interesting split between large investment consultants and small ones. Apparently, portable alpha’s demotion was primarily a result of small investment consultants reducing their forecasts for portable alpha searches in 2008…

As you can see, last year more small consultants expected to focus on portable alpha, while this year, more large consultants expect to focus on portable alpha. Says the report…

“The number of large consultants focusing on portable alpha will grow substantially in 2008. Twenty-two percent of the large consultants expect to focus on this area in 2008, up from 13% in 2007. A number of these large consulting firms have committed to build dedicated groups specifically for educating the investment community about portable alpha and assisting with portable alpha searches.”

On the flip side, Casey Quirk describes the decrease in small consultants’ portable alpha interest as “a significant drop”. And with 70% of respondents falling into that “under $100 billion” category, the writing was on the wall for portable alpha

Interesting, it seems that small consultants’ interest in 130/30 was also far lower than the interest expressed by their larger counterparts…

However, with nearly two-thirds of respondents falling into the “over $25 billion” category, 130/30 safely retained its “up and coming” status. (The same was also true for LDI.)

When all is said and done, portable alpha’s apparent losing streak may have more to do with nomenclature than with any fundamental issues. Only time will tell. But as Casey Quirk’s Kim told us earlier today, “Portable alpha is alive and well”.

Historical Rolling 10-Year Total Return of the S&P 500

Today's front page of the Wall Street Journal has an article highlighting the "lost decade" for US stocks. The article mentions that the S&P 500 is "up just 1.3% over the last ten years, factoring in inflation and dividends." In early March, we performed a similar analysis in our "The Lost Decade" post that highlighted the weak performance in equities since the new millennium began.

We took the 10-year total return performance of the S&P 500 back to 1900 (non-inflation adjusted) and charted the results below. When the line is highlighted in red, 10-year returns were lower than they are now. As shown, periods where returns were lower occurred in 1914, 1921, 1932, 1938, 1974 and 1977. We also highlight years where returns peaked -- 1929, 1959, 1992 and 2000. While the returns could easily get worse, periods that have been this bad have not lasted longer than 4 years (1937-1941) before they've started to get better.


Updated S&P/Case-Shiller Housing Numbers

Caseshillertable_2The January 2008 S&P/Case-Shiller housing numbers were released yesterday for 20 US cities. Over the past few days, we've seen some better than expected housing numbers, indicating that things might be getting "less worse," so it's important to note that these numbers lag by three months. If things have begun to get better, these numbers will be the last to show it. Regardless, it's important to highlight which areas of the country have been hit the hardest.

As shown in the table at right, home prices in Las Vegas and Miami fell the most from January '07 to January '08. Las Vegas also fell the most from December '07 to January '08. Over that one-month period, Las Vegas fell sharply at 5.1%. Phoenix was the second worst performer month-over-month at -4.05%. Charlotte was the only city that saw year-over-year gains at +1.75%. Charlotte also fell the least month-over-month at -0.15%. The Composite 20-City index fell 10.71% year-over-year and 2.28% month-over-month.

Below we highlight historical monthly year-over-year changes for all 20 cities and the two Composite indices.






financial times

Hedge funds and institutional investors are starting to launch distressed mortgage funds to take advantage of an “unbelievable” buying opportunity, but they say they are running into resistance from risk-averse prime brokers.

Steve Persky, a principal at Dalton Investments, said his group was starting a distressed mortgage strategy for high net worth and institutional investors. “This is one of the best distressed sector opportunities I have seen in my lifetime,” said Mr Persky, who has been investing for more than 20 years.

“Prices have collapsed to such a level that some securities assume you will never get any capital back....It is an incredible buyers' market. Institutions are desperate to sell. There is such a huge flight to quality, it has gotten very extreme.”

But some investors said it was too soon to start buying distressed mortgages.

Kent Wosepka, who heads absolute return strategies at Standish Asset Management, said: “We have been talking about this for six months but I think it is a bit early. Prices are down a lot, but we're likely to see home prices depreciate by 15 per cent in 2008. There are a few macro things that need to be more firmly in place before we would do a mortgage fund.”

He said Standish had been buying opportunistically, picking up distressed securities at 5 cents in the dollar.

Merrill boosts prime brokerage

Merrill Lynch boosted its hedge fund clientele by 50% in a year and is targeting multi-strategy funds seeking to do business with more than one prime broker, managing director Jeff Penney said, reports Bloomberg. Merrill, the biggest US brokerage, aims to benefit as hedge funds move away from relying on a single prime brokerage. After Bear Stearns’ collapse last week, Merrill fielded calls from more than 20 hedge funds in three days looking to do business, said Penney.

S&P 500 Closes Above 50-Day Two Days in A Row!

You know it has been a bad market when the first quarter is nearly over and the S&P 500 is just now closing above its 50-day moving average for the first time. We'll take what we can get though. Following today's intraday rebound after the much weaker than expected Consumer Confidence report, the S&P managed to close above its 50-day for the second day in a row! In addition, the index also broke above its downtrend line which had been in place since late November. As the market digests its gains of the last few days, one sign of the market's health will be a hold above these levels.


While the 58 consecutive trading days that the S&P 500 traded below its 50-day moving average may have seemed like an eternity, since 1928, there have actually been 28 other streaks where the index went as long or longer without trading above it. The most recent streak ended in August 2002, when the S&P 500 went 86 days without trading above its 50-day.

Tuesday, March 25, 2008

Calling the bottom - in pictures

Punk Ziegel in the US last week told us this was a once in a generation opportunity to buy banks. Now in Europe Teun Draaisma and colleagues at Morgan Stanley say its time to purcahase top notch credit. On Tuesday, during early trade in London, not a single Footsie stock languished in negative territory as the FTSE 100 jumped 3 per cent.

How brave is this call? After all, pinpointing a market turning point is supposed to be a mugs game. Consider a few charts from Sempra Metals’ John Kemp:

US equity and bond markets

Yield spread - corporate AAA over 10 year treasuries

Yield spread - 10yr treasuries over Fed funds

1yr Treasury yield

VIX index

US$ trade weighted

Monday, March 24, 2008

Bonds Taking a Beating

Bonds are having their worst day since January today as the yield on the Ten-Year Treasury is back above 3.5%. Below we have updated our trading range charts of international long-term interest rates. As shown, with the exception of Australia, rates remain in downtrends near their lowest levels in a year. So while today and the next few days may be tough for bond investors, the longer-term trend in interest rates remains down.




Homebuilder (XHB) Breakout

Up 23.3% year to date and 56.4% from its intraday low in early January, the S&P Homebuilder ETF (XHB) has made a nice breakout to new highs this morning after better than expected housing numbers were released. We've been positive on the group since the end of 2007, and we mentioned our bullishness once again in this week's Business Week. We'll be even more bullish if the ETF can hold this breakout over the next couple of days.


The Decoupling Continues -- In Reverse

Below we highlight the year to date returns of the major equity indices for a number of key countries. Using prices from this morning, the United States' S&P 500 and Dow 30 are down much less than the rest of the countries analyzed. China is down 27.7%, India is down 24.6%, Hong Kong is down 24% and Germany is down 21.7%. Leading up to the peak in global equity markets last year, many people thought that countries were finally strong enough to decouple from the US and perform well even if the US went down the tubes. These days, however, the US is the one doing the decoupling on the upside. Equity324

The Timing Performance of Expert Futures Traders

Do Commodity Trading Advisors (CTAs), generally associated with the "managed futures" hedge fund style, successfully time their chosen markets? These traders take long or short positions in investment vehicles with low transaction cost (such as futures contracts) to exploit trends in commodity prices, exchanges rates, interest rates and equity prices. In the February 2008 version of their paper entitled "Market Timing of CTAs: An Examination of Systematic CTAs vs. Discretionary CTAs", Hossein Kazemi and Ying Li investigate the return and volatility timing ability of CTAs and examine whether there is a difference in market timing abilities between systematic and discretionary traders. To this end, they develop a set of risk factors based on returns from the most heavily traded futures contracts. Using monthly, net-of-fees return data for 1994-2004 (encompassing 278 live and 622 defunct CTA funds), they conclude that:

  • CTAs exhibit both return and volatility market timing ability in many declared market specialties, most notably for currencies, interest rates and
    commodities. However, stock index CTAs display negative return timing.
  • Systematic traders are generally better market timers than discretionary traders.
    • Systematic traders show timing ability for the best performing currency futures and and physical product (corn, crude oil, natural gas and gold) futures.
    • Discretionary show timing ability for physical product futures in aggregate.
  • As a group, CTAs generate returns from market timing than security selection.

The following chart, taken from the paper, plots the average 36-month returns for discretionary and systematic futures traders according to the contemporaneous performance of MSCI World equity index ordered from worst (1) to best (5). Results show that managed futures tend to perform best when equities perform worst and that the performance of systematic traders is more negatively related to that of equities.

In summary, expert futures traders exhibit some market timing ability, and those who employ trading systems out-time those who do not. Market timing is more important to futures traders than securities selection.

Friday, March 21, 2008

Central banks float rescue ideas

By Chris Giles and Krishna Guha in London

Published: March 21 2008 22:02 | Last updated: March 21 2008 22:02

Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, the fact that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system.

It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.

The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.

Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments.

One argument among policymakers and bankers has been that new international rules have exacerbated the credit squeeze by requiring assets to be valued at their current record lows rather than at face value.

But a strongly held view at one European central bank is that it is not “mark-to-market” accounting that is to blame for severe weaknesses in banks’ balance sheets but that prices of MBS securities have fallen to levels that imply unrealistically high rates of default.

If public authorities were to buy and hold sufficient mortgage-backed securities – rather than simply lend against them as they have until now – at prices well below face value but above current prices, they would set a floor in the MBS market.

The Fed does not believe that the point has yet been reached when such drastic action is necessary and considers the discussions it has had with its counterparts to represent “blue-sky thinking” rather than the formulation of a definitive policy proposal.

Fed officials are monitoring the impact of the latest barrage of Fed liquidity moves and interest rate cuts. They also believe the US has not exhausted all the options short of wholesale public intervention and further intermediate steps are available to them.

These could include still more aggressive use of the Fed’s own balance sheet to boost liquidity in the markets.

Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.

The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. The UK government has already become heavily involved in buying mortgages since September with the recent nationalisation of Northern Rock, the mortgage lender.

Michael Coogan, the director-general of the UK’s Council of Mortgage Lenders, said this week: “Demand for mortgages remains strong but cannot be fully met from existing funding sources.” He predicted higher prices and reduced lending.

It is not just central banks that think the MBS market prices are too low and imply a unrealistic level of mortgage default. Some US states’ pension funds are investing small sums in the mortgage market.

Robert Gentzel, a spokesman for the Pennsylvania State Employees’ Retirement System, told the AP news agency: “Some of the securities that have dropped in value were really very solid securities.”

Thursday, March 20, 2008

More Sorrow (and Losses) for Meriwether

The fates of finance, it seems, do not look kindly upon John W. Meriwether.

Citing unnamed sources, Bloomberg News reported on Thursday that the former Salomon Brothers executive who founded Long-Term Capital Management has reported a 24 percent loss at one of his bond hedge funds for the year through March 14.

JWM Partners‘ Relative Value Opportunity Fund appears to have suffered from the same market turmoil that has shaken up hedge funds and investment banks alike. In this case, Bloomberg reported, JWM had to sell securities to meet margin calls, but didn’t default on any loans.

The timing of the report is rich with resonant irony. Long-Term Capital’s bailout in 1998 is the stuff of legend, as Wall Street’s elite were forced to rescue the fund in order to save themselves from ruin. Long-Term Capital’s sin was its dependence on debt to generate its massive profits, gleaned from bets on bonds, and virtually every major brokerage stood to lose scads of money if it failed. But the only firm that refused to help out was Bear Stearns.

Of course, today it is Bear Stearns that needed a rescue, as its overlevered bets on mortgages threatened to swamp the U.S. financial system.

That may come as cold comfort to Mr. Meriwether however.

One and Two Percent Days Becoming the Norm

A whopping 44 of the last 90 trading days have been moves of 1% (+/-) or more in the S&P 500. Fifteen of the last 90 trading days have been 2% days. Below we provide a historical rolling 90-day sum of 1% and 2% days in the index. While we've been constantly reading and hearing that the current period of volatility is unlike anything ever seen before, it isn't. As shown, the number of 1% days reached 64 out of 90 back in October 2002, 56 out of 90 back in 1988, and 54 out of 90 back in 1974. And the 15 out of 90 that have been 2% days are nowhere near the highs reached during those periods either. The reason why so many people are so frantic about volatility is because it was extremely low preceding the current period. As shown, it was rare to see a 1% day from about 2004 to 2007, and 2% days were non-existent.


Commodity Snapshot

With commodities down sharply once again today, and the news media already asking everyone and their mother's if this is the end of the boom, below we highlight our trading range charts of major commodities. The green shading represents two standard deviations above and below the commodity's 50-day moving average. When the price moves above the green shading, it is considered overbought (oversold when below). We provide trend and support lines where necessary.

Just as $100 per barrel was a key resistance point for oil on the way up, it is now acting as key support. Oil is currently trading below $100 at $99.25, and if it closes below the $100 support level today, the bears will remain in charge for the time being. Natural gas hasn't quite tested its support level yet.


Bespoke readers surely remember our post a couple of weeks ago highlighting the CEO of Barrick Gold saying he would not hedge gold when it was near $1000, and that it "has a lot of room to run." He reiterated those statements once again on March 13th. While he may be right and gold could still rally significantly, if a few days ago was the top, it would sure be ironic. As shown below, gold has broken one of its shorter-term uptrend lines in recent days, but it still needs to get down to the $900 level to test its longer-term uptrend line.


Platinum rose a lot more than gold did in recent months, and its decline has been steeper as well. Because it went parabolic, it has a ways to go to get to the bottom of its uptrend. Copper, on the other hand, never really got going on the upside, and it recently broke support.


While other commodities rallied in recent months, orange juice fell. In recent days, it even took out its lows from last summer. Coffee has really taken a hit since it peaked in early March. As shown below, it broke its uptrend as well.



“Once in a Generation Opportunity to Buy Bank Stocks” - Punk Ziegel

Despair not. It’s the Easter weekend. Salvation may be upon us. The financial crisis is over, says Richard Bove of US brokerage Punk Ziegel & Co.

This comment sounds ridiculous given the conviction on the part of most commentators that the worst is yet to come; the extent of the decline is unknown; and that the length of the decline is similarly unclear. However, I do, in fact, believe that the crisis is over. There will be more negative developments but they will be meaningless. Further, let me be clear even though the financial crisis is over the problems facing the economy are not.

Bove’s broad thesis:

A crisis builds up over an extended period of time. It ultimately reaches a crescendo when an event occurs that is so devastating that even the staunchest skeptics become fearful. At this point, the government and participants in the impacted sector get together and start to take actions that will ameliorate the crisis. At this point, the only question is whether the solutions being offered have any chance of working. However, if the solutions are powerful enough, the crisis ends.

In the current crisis, the triggering event was clearly the insolvency of Bear Stearns (BSC/$5.26/Market Perform). This event sent so much fear through the markets that action was taken. The President of the United States was involved, as was the Treasury Secretary, the Chairman of the Federal Reserve, the President of the Federal Reserve of New York, and key industry executives.

The actions taken by the Federal Reserve were innovative, dramatic, and, in my view, brilliant because they went right to the problem.

Bove accepts that hurdles remain.

The first doubt is whether it has the money to succeed in this effort. The Federal Reserve only has $921 billion in assets… In my view, the Fed needs support from foreign central banks to achieve its goals. This help is quite likely because the dollar is plunging in value…

A second fear is that the Federal Reserve will take in so many bad securities through swaps and as loan collateral that bad debts will rise costing the taxpayer money. This is doubtful and is simply fear overwhelming logic…

The Federal Reserve has actually created a template that will increase liquidity in the banking system and, just as importantly, bank profits.

But understand this:

Every study I have read is convinced that housing prices will continue to drop for an extended period. This is as dead wrong as the reports that argued some years ago that housing prices would keep rising for an extended period. Think of this:

• Money supply is growing rapidly;

• Commodity prices are soaring;

• The dollar is falling sharply; and

• Real estate prices are falling.

Does this last line make sense? When was the last time real estate prices fell in a general period of commodity inflation? I cannot think of such a time. I live in Florida where foreigners can and are buying prime real estate at deeply depressed prices with very, very cheap dollars. This may turn out to be the bargain of the century and I mean century.

So, to recap, with the help of President Bush, brilliant Ben Bernanke has created a situation that will pump profits into the US banking system. Foreigners will cheer this on so as to halt the dollar rot. “This is a once in a generation opportunity.”

Wednesday, March 19, 2008

Bottom Calling Abounds

Yesterday's gains seem to have been met with plenty of bottom calling. Granted, this is anecdotal evidence from what we've heard on CNBC and other media outlets on Wall Street, but it's important to remember that we're not out of the woods yet. Below we highlight a chart of the S&P 500 and an index that measures the default risk that investors are placing on high-grade corporate debt. As shown, the S&P 500 (red line) remains in a severe downtrend, and it has a lot of work to do to get out of it. While the credit default risk index had a huge decline yesterday, it barely put a dent in the strong uptrend that it's currently in. When the market gains 400+ points in one day, it's easy to selectively remember the good and forget the bad. While we hope a bottom has indeed been made, it's still important to tread these waters carefully.


Short Covering Rally?

Was today real buying or short covering? As shown below, today's best performing stocks in the S&P 500 were also the ones with the highest short interest as a percentage of float. On the other hand, stocks with the lowest short interest underperformed.


Bear Stearns, the conspiracy…

You know what? That 86 year old Wall Street brokerage might actually have been put out of business or sold or whatever by people spreading false rumours. Apparently, they bought things that are known as out-of-the-money put options which allowed them to just pay a few cents for the right (but not the obligation) to sell shares in Bear Stearns at a level way below the prevailing share price. And then they put so many stories around the market about Bear going bust that everyone took their money out and the share price DID collapse. Apparently, it’s know as a bear raid, hehe. It could turn out that these were the same people who took out put options in airline stocks before the Twin Towers got hit. The SEC is looking into it. They should hang the bloody lot of them.

From Bloomberg:

SEC spokesman John Nester and NYSE spokesman Scott Peterson declined to comment. Bear Stearns spokesman Russell Sherman didn’t return a phone call seeking comment. The SEC is seeking to question traders who profited from options or short sales, one of the people familiar with the probe said.

The case underscores regulators’ concern that malicious rumors have the potential to fuel market panic and exacerbate shareholder losses on financial stocks. Bear Stearns had more than $17 billion in cash and salable assets on March 11 when lenders and customers began removing funds, the SEC said in a March 14 statement.

Related links:
Interfluidity - Bair raid in plain sight?
Alea - on Bear and the SEC

Tuesday, March 18, 2008

High Yield Spreads Defying Gravity

Yesterday, we heard several commentators suggest that JP Morgan's no-obligation purchase of Bear Stearns (was the $2 to cover shipping and handling?) had helped to calm tensions in the credit markets. However, based on the movements of high yield bond spreads (using Merrill Lynch data), conditions remain tense. As shown below, the spread between the interest rate on high yield bonds and comparable US Treasuries has risen to 862 bps, which is the highest level since 2002. To put this in perspective, at their lows in June 2007, spreads were at 241 bps.


"Once In A Lifetime" Moves?

Volatilebrokers1_2The action in many Financial stocks over the last couple of days has been truly amazing. In the table at right, we highlight the percentage change from the close last Thursday to the lows yesterday, along with the change from the lows yesterday to current price levels. While Bear Stearns is in a world of its own, big names like LEH, MS, MER, GS and C saw declines of 15% to 50%, only to be followed with gains of 20% to 100%. Yesterday, Lehman traded from $34 down to $20 and back up to $34 in a couple of hours. That's billions and billions of dollars wiped out and then suddenly found again. It usually takes 5 to 10 years for these stocks to move this far down and this far up again. In the current market environment, it takes less than 24 hours.


The America premium? This could hurt

Is this the new point of stress in the global financial system?

The 30-year, yen basis swap, after rising gradually away from zero since the beginning of the year, has suddenly spiked - and it seems likely that macro funds will be hurting.

If we understand this correctly, a basis swap transposes the floating rate in one currency for the floating rate in the other, such as yen libor for dollar libor. So a fund invested in Japanese government bonds might opt to swap the fixed JGB rate for a floating yen rate, before swapping that again to the dollar rate. In this instance, the investor would usually received libor minus the swap spread.

Such a deal is sometimes described as getting the same credit in another currency. But within the trade there remains an element of counterparty risk.

The last time the swap moved in this fashion was back in the 1990s, when concerns about the Japanese banks prompted the so-called “Japan premium.”

Now the situation appears reversed. Counterparty concerns about the US banks may have prompted funds to start unwinding their trades. Now it’s starting to look like a stampede to get out, with no bid on the swap.

What potential for damage does the emergence of an “America premium” have? Significant we’re told.

According to those with skin in this particular financial game, the recent dramatic move suggests significant potential losses. Anecdotally, one fund is said to have kissed goodbye to about a year’s profit getting out of this trade.

And as the macro funds get squeezed, their banks will start upping margin requirements. That we’re already familiar with.

Sunday, March 16, 2008

Fear and the Flight to Safety

There are many ways of thinking about the current credit crisis, but today I thought I’d offer a visual depiction of one that I’m fairly certain has never been posted anywhere else. The chart below shows the ratio of the VIX to the yield on the 10 Year Treasury Note. By way of commentary, consider this to be a loose proxy for fear divided by the propensity of investors to flee to the safest investment alternatives. Needless to say, the graphic shows that the ratio is currently at levels seen only during extreme crisis or panic market environments.

Friday, March 14, 2008

InvestHedge Funds of Hedge Funds Awards

Sixth annual gongs, handed out in New York on Thursday night:

US Strategies
Lyrical Multi-Manager Fund
Asian Strategies
Persistent Edge Asia Partners
Emerging Markets
H21 BRIC Plus
Global Equity
Berens Global Value Fund

Global Multi-Strategy Fund ($100m - $500m)
The Merriwell Fund Limited Partnership
Global Multi-Strategy Fund (over $500m)
Thames River Warrior
European Equity
RMF Long/Short Equity Europe
European Multi-Strategy
Orbita European Growth Strategy
SSARIS Relative Value Strategy
Event Driven & Distressed
GEMS Recovery Portfolio
Global Macro
Trading Capital Holdings
Commodities & Natural Resources
Permal Multi-Manager Natural Resources Fund
Fixed Income & Credit
Mont Blanc Fixed Income Fund
Asset Based Lending & Finance
Mont Blanc Select
Emerging Managers
Protégé Partners
10-Year Performance Awards
Archstone Partners

Group of the Year
The Capital Holdings Funds/LCF Rothschild Group
Institutional Firm of the Year
Blackstone Alternative Asset Management
New Fund of the Year
H21 BRIC Plus
Fund of the Year
GEMS Recovery Portfolio

“L/S Manager Says 130/30 Funds Create Negative Alpha”

WASHINGTON (—Investors may get alpha with a 130/30 fund, but it won’t be free. In fact, the cost may end up being prohibitive, according to one long/short equity fund manager.

Implementing 130/30 strategies creates negative alpha from the start, said Thomas Kirchner, a portfolio manager at Pennsylvania Avenue Event-Driven Fund, a Washington, D.C.-based mutual fund that practices short selling. On his blog, The Deal Sleuth, Mr. Kirchner posted a paper he wrote that stands in stark contrast to the recent hype around 130/30 products in the asset management industry.

In the post “Negative Alpha Is Built Into 130/30 Funds,” Mr. Kirchner wrote that the problem with 130/30 funds is that they invest all the money they have. So in order to short, they have to borrow. And that comes at a cost.

In theory, the manager of a 130/30 fund goes long using 30% leverage and then shorts the same amount, which gives the portfolio a total long/net exposure of 100%.

But in an interview, Mr. Kirchner said that most of the advocates of 130/30 funds—prime brokers, asset managers and sell-side analysts—fail to provide the whole picture. The investor, he said, is told that in addition to placing 100% of his principal in an index, 30% of the invested amount will be sold short, and that the proceeds of the short sales will be used to acquire a 130% long position. The net exposure is still only 100% and generates pure beta, while the long/short component of the portfolio is supposed to generate some alpha. That’s the concept.

The reality can be quite different, he said. Since all of the money is invested in long positions, the manager must deposit the proceeds of the short sale (or some of them) with the broker that holds the short sale. In comparison, a hedge fund running a market neutral strategy will have 100% shorts and 100% long and will be able to use his long position as collateral for the short sales.

Mr. Kirchner offered another way to explain his concept. An investor in a 130/30 fund is fully invested in an index fund and acquires an additional alpha-generating overlay. Because the money is fully invested, the investor cannot obtain additional returns out of nothing without incurring a cost, he said. This cost comes from borrowing the securities for the short sales. Mr. Kirchner called it “negative alpha” because it eats up whatever alpha is generated.

Josh Galper, managing principal at Vodia Group LLC, a New York-based research firm that has produced research reports on securities lending, agreed with the technical argument offered by Mr. Kirchner. “It’s true that in the case of a 130/30 strategy, you have to jump the margin hurdle for that extra 30%. That is absolutely correct,” he said.

Since the 130/30 manager needs to borrow collateral—due to the fact that the long position exceeds the shorts—the manager must then pay the broker interest, which is the cost of borrowing the securities. This cost is lessened by another factor, though. The fund manager earns some money for letting the broker use the short sale proceeds as what would be the equivalent of a deposit. This is known as the “short rebate” in industry parlance. However, Mr. Kirchner said, the difference between what the manager pays in interest to the broker as his borrowing cost and the short rebate he earns from the broker is negative. As a result, the implementation of a 130/30 strategy starts with negative alpha, he said.

That argument may not be popular. 130/30 funds are the latest fad to hit the money management industry, and hardly a week goes by without a big mutual fund company or a well-known quantitative investment manager launching an “extension strategy,” as 130/30 funds are also known.

They are in demand today because institutional investors want some alpha without having to make a first foray into hedge fund investing or without having to ask their boards for permission to boost allocations to the hedge fund bucket. Implementing a 130/30 strategy is a smoother transition into alternative investing for many pensions, one that can nicely fit into an existing equity bucket.

Prime brokers love it, too, as they can attract new lending business. 130/30 funds can be large, since they can be sold as mutual funds or in the form of separate accounts to large pension funds. It is certainly an additional source of earnings for the banks that already make nice profits lending to hedge funds, though the lending business has slowed down recently due to the credit crunch.

A number of sell-side research departments have produced research papers on 130/30 funds, including Goldman Sachs Group Inc., one of the first banks to implement the concept.

But Mr. Kirchner said the cost of shorting is simply ignored in 130/30 literature. This cost is hard to assess, said Mr. Kirchner, because it depends on so many different variables such as the extent of the long/short portion, the interest rate spread and the amount of short sale proceeds withheld by the broker. For instance, Mr. Kirchner said he saw some of the short rebates vary between 0% and 2%.

But the worst problem is the lack of disclosure regarding the cost of shorting, not just in the sales presentations touting short extension strategies, but even in the prospectuses. Often figures in footnotes will be too vague or incomplete, he said. In other cases, the disclosure—for instance in master funds—will be of no use because the prospectus will wrap several funds into one filing, making it impossible to know where the collateral sits or what the amount of the short rebate is, he said.

“The logic behind these 130/30 strategies is that you get 100% exposure to the market, and on top of that you get alpha for free,” Mr. Kirchner said. “But there is a cost in implementing those strategies that ultimately shows up in the return.” That cost, however, is not generally part of the sales presentation.

Hedge funds are more upfront about the cost of alpha, Mr. Kirchner said. “A hedge fund does not promise that you’ll get alpha plus something. The concept is that you’ll capture whatever comes from the long and short trades. Whatever alpha is generated you’ll pay for it. It’s understood as being the cost of getting alpha,” he said.

So while investors may not be fully aware of how much the short-selling part of a 130/30 strategy costs them, prime brokers are fully conscious that they’re increasing and diversifying their revenues with this new securities lending jackpot.

It’s no wonder the banks are pushing 130/30 products so hard, said Mr. Kirchner. But what’s in it for investors is another question, he said.

“Investors in 130/30 funds should be wary of funds offered by large financial services institutions with affiliated brokerage and lending operations,” he said. “The temptation of squeezing extra margin out of a 130/30 fund through low short rebates and high lending rates could be too great for bonus-hungry executives to resist. . . . We would look at short extension funds for the next big mutual fund scandal.”

To make matters worse, there is no real performance data on 130/30 funds since they are so new, even though some theoretical studies have been made based on back testing. But then again, Mr. Kirchner said he is skeptical of those quantitative studies, arguing that they fail to take the cost borrowing cost into consideration.

Investors’ fascination with 130/30 funds is likely to continue for a while, though. “The financial industry is a cyclical fashion industry,” Mr. Kirchner said. “Why did everybody do subprime and residential mortgage securities? And why are they doing 130/30 today? Tomorrow, they’ll be doing something else.”

85% Of Pension Funds Choose RE

03-14-2008 | Source: Hedge Fund Daily

Real estate is by far the most popular alternative investment among public pension plans in the U.S. and Canada. According to a survey by Bear Stearns’ Pension, Endowment and Foundations Services Group and the Government Finance Officers Association, 85% of respondents identified real estate as their favorite alternatives asset class, followed by private equity (60%), venture capital (44%) and hedge funds (42%). Overall the study found that 52% of the 150 public pension plans polled either invest or plan to invest in alts. The 48% that do not invest in alts explain that either they are barred by law or by investment policy from doing so or other reasons, such as the conservative nature of their board of trustees. In other findings:

  • 35% of plans invest directly in hedge funds, with the top three strategies being multi-strategy, long/short equity and market neutral.
  • 53% invest in funds of hedge funds.
  • 12% say they use 130/30 strategies, with 58% responding that they were considering it and 30% nixing them altogether.
  • 80% of the plans are advised by consultants for investment decisions, while 70% use consultants to perform due diligence on prospective manager.
  • 15% say they are not currently using any risk-management tools, while 5% replied that they have internal measures in place.
  • Firm reputation was mentioned as the most important trait for a hedge fund manager, with performance and quality of HF personnel tied for second.

Thursday, March 13, 2008

Gold/Dollar Ratio Has Gone Parabolic

Below we highlight the Gold/Dollar ratio since 1975. This divides the US Dollar index (DXY) into the price of an ounce of Gold. As shown, recently we took out the prior highs of the ratio made in January 1980, and things have now gone completely parabolic. Things don't stay like this forever, and those who have recently joined the party and entered the long Gold/short Dollar trade should tread very carefully.


Tuesday, March 11, 2008

Largest Positive Point Days Ever For The Dow

Today's gain of 415 points ranks 4th on the list of the top positive point days for the Dow. Below we highlight all +300 point days for the Dow. While investors should really look at the daily percentage change for comparison's sake, big up days based on points are significant because of their impact on investor sentiment.


Double Bottom?

Based on the bounce off the January intraday lows that we are seeing today, technicals suggest a rally to the top of the downtrend line as shown in the chart below. If we can break through that downward channel, it will be a good sign for the bulls (and mark one of the prettiest double bottoms that we've seen in awhile). However, it's still important to not treat this as anything but a rally in a downtrend unless the downtrend is broken.


Short Covering Rally?

The average stock in the Russell 1,000 is up 1.75% today. We broke the index into deciles based on stocks' short interest as a percentage of float (100 stocks in each decile) and calculated the average change of each decile on the day. As shown below, the deciles of stocks that are most heavily shorted are outperforming the deciles of stocks with the least short interest. While the differences are not that extreme, it does indicate that short covering can be attributed to some of today's moves. Expect this trend to continue when the market gets bounces like this. With so many shorts out there, it doesn't take much for the skittish ones to run for the hills.


Below we highlight the best performing stocks in the Russell 1,000 on the day. As shown, TMA is up a whopping 50% to just over one whole dollar. CFC and IMB are up more than 12%, and DFS is up 10%. Other notables on the list of today's winners are MOS, WM, MS, FRE, LEH and C.


Monday, March 10, 2008

Warren Buffett's search for alpha - Veryan Allen

Warren Buffett, the world's richest person, seems to prefer security selection to asset allocation. He searches for alpha because he doesn't expect beta to deliver enough. Ye olde split of simple 60/40 stock and bond beta driven asset allocation is just not going to cut it and is needlessly risky anyway. Fortunately for investors there is a solution - adding to the portfolio the absolute returns generated from the security selection, risk management and market timing abilities of the world's best and most "expensive" fund managers. Diversify away that systemic risk and stagflation damage with new investment strategies. If beta DOES deliver great but we need the hedge of alpha in case it doesn't.

With the separation of alpha and beta there is less attention on the fact that beta itself splits into PRICE beta and DIVIDEND beta. And alpha comes from the RELATIVE alpha of good traditional funds and the much more valuable ABSOLUTE alpha produced by quality hedge funds. As Warren points out both betas are unlikely to provide the performance of the past. Hopefully beta might contribute one day but in the meantime investors need a triple portion of absolute alpha in their portfolios:

Alpha 1: buying securities that will go up and knowing when to book those gains
Alpha 2: shorting securities that will go down and knowing when to book those gains
Alpha 3: figuring out which managers can do 1. and 2. consistently

Berkshire Hathaway's annual letter to shareholders which is written by Warren Buffett was as insightful as ever. Apart from "the party is over" the most salient quote was "You can occasionally find markets that are ridiculously inefficient or at least you can find them anywhere except the finance departments of some leading business schools". There are even professors with tenure who think Warren's returns are from luck or simply the "reward" for taking higher risk. Actually he took less risk than "the market" and his investment skill is the reason for all the alpha he has generated over the years.

Warren says to avoid the 2 and 20 crowd. He's right. It is the 2 and 20 alpha stars AHEAD of the crowd we need. Adding alpha from security, strategy and manager selection is essential. He has been adapting to the changing opportunities in the markets for several decades. The oracle of Omaha goes long the Brazilian Real, various commodities, trades Chinese oil stocks and short sells options. Warren Buffett, the derivatives trader - "derivative contracts that I manage" - and pioneer of the alpha seeking multistrategy hedge fund. "Beware the glib helper who fills your head with fantasies while he fills his pockets with fees." Absolutely correct. Only pay fees for alpha since beta exposure is effectively free. Fees for luck, not skill, are unacceptably high.

In aggregate the entire group of active managers WILL underperform their benchmarks. "Hedge funds" consisting of the entire set of products that say they are hedge funds won't, on average, be any good. I can't think of any reason why an investor would want to invest in a hedge fund index of "all" hedge funds anymore than an "all" stock index. But just like Benjamin Graham and several Nebraskan doctors spotted Warren's talents BEFORE he went on to great things, it is possible to identify other good managers with the skills to perform over the long term, even if their strategy itself is short term. Fees are irrelevant if the AFTER fee performance meets targets. Those 1950s Nebraskans had no complaints about Warren keeping 25% of "their" profits because he worked hard for them.

Stock market past performance, in aggregate, provides little indication of future performance. 8.2 years into the century and a negative TOTAL return from most developed market betas! How long should we wait and how poor must investors become before the "equity markets go up over time" mantra materialises? No-one I know is prepared to wait around to find out if stocks WILL go up over time. Be inpatient for absolute returns from ANY fund manager. Despite his buy and hold persona Warren expects his holdings to perform in a reasonable time frame or he dumps them and rightly so. Many investors can't afford to tie up capital in steeply declining asset classes and why should they endure such high volatility in the first place?

From 1900-1949 the Dow rose from 66 to 200 for a 2.25% annual return from price appreciation. Dividends added a lot in those days. From 1950-1999 the rise from 200-11,497 equated to 8.45% annually. Index appreciation over even very long periods is not stable and very temporally dependent. This century the Dow has "grown" a little from 11,497 but dividends are much lower nowadays. If there were some inherent "expected" price appreciation in stock markets should not the two 50 year periods' price appreciation be more similar? Shouldn't we have already have seen more sustained appreciation this century by now? With such long term variability and derisory dividends beta does not look good going forward. In sum seek absolute alpha because beta might not be there for us. Performance is what you keep NOT what you make and then give back.

Absolute returns are more useful to investors than relative returns. That's returns AFTER inflation. Inflation varies also but inevitably takes its toll so most portfolios CANNOT afford a big drawdown from an extended bear market. The PPI and CPI now known as the Preposterous Price Index and the Completely Preposterous Index are underestimating REAL inflation. The inflation you and I see at the supermarket and gas station. Even TIPS won't help as much as hoped since they track what authorities say "core" inflation is NOT what it ACTUALLY is. In the real world food and energy DO impact purchasing power so there may be significant basis risk with TIPS. Most investors can't ride out a long bear market WHILE inflation erodes their purchasing power and why should they?

The Economist magazine recently ran an advertorial for "passive" funds, emphasizing the "high" fees of "active" management. Beating the market is indeed very difficult, requires hard work and expensive expertise. But why try to beat the market when the market is going down? Investors would be better off with reliable ABSOLUTE returns that far outpace inflation EACH and EVERY year. Meanwhile Kenneth French tries to count the cost of active investing but fails to note the vastly bigger opportunity costs and losses in "passive" funds. 2 and 20 for hedged absolute alpha is a bargain compared to 0.20 for unhedged beta. Beta has lost at least 17% or several trillion so far.

There are always cheaper "products" in any space but that does not cause higher end players to lower fees. No proper hedge fund manager worries about cheaper funds. I'll happily pay 2 and 20 for consistent performance from a blend of skilled investment strategies than endure potentially decades of OPPORTUNITY COST wasting time in "bargain" beta. Did Lamborghini or Maserati panic about their pricing because Tata Motors just launched a $2,500 car? Of course not. Performance comes at a price. I shall keep an eye on the Economics Journals for a paper about the money we "waste" on cars just like all the cash we apparently "waste" on active fees.

History is a great persuader but terrible predictor. The 20th century was ultimately the "triumph of the optimists" aided and abetted by the anomalous bubble of the 1980s/90s. But those returns do not guarantee that the 21st century won't be the "revenge of the pessimists". There is scant evidence that "buy and hold the equity benchmark" WILL work. Mostly just historical data erroneously extrapolated into the future. It is fascinating observing those who "know" everything will turn out just fine decades from now and say we can ignore the path along the way. Optimism is fine but overoptimism is dangerous, just as we are seeing right now in real estate, credit AND stock markets.

Predictably the Economist cites
John Bogle
that the S&P 500 returned 12.3% annually from 1980-2005 but no mention of the 70% loss after inflation that investors "received" from 1965-1980. It also writes of a hedge fund that dares to charge 5% fees and 44% of profits but curiously omits the 38% a year since 1990 AFTER fees that fund generated. Such data snooping is typical of the long only beta brigade. I have looked at the full data set and the fact is that it is SECURITY AND STRATEGY SELECTION not ASSET ALLOCATION that will drive portfolio performance. Skilled alpha seekers do have losing periods, even Warren Buffett or James Simons, but when alpha returns drop below high water marks they are shallower and shorter than the deep extended drawdowns of beta. Of course proper manager due diligence, portfolio construction and diversification are ESSENTIAL in identifying that skill.

Warren points out in his blog letter that the Dow only grew 5.3% per year in price appreciation last century. We have been treading water since so I updated Warren's numbers to include the "growth" this century. The Dow closed at 65.73 on 29 Dec 1899 and 12,266.39 on 29 Feb 2008 so we are down to a miserable 4.95% annually over the last 1298 months. But let's look closer at this alleged "expected return" from "stocks".

The Dow does not include dividends which is misleading considering dividends WERE such an important contributor to the total return. If 2% dividends had been paid since 1900 the Dow really closed at about 100,000 on 29 Feb 2008. AVERAGE dividends over the 108 1/6 year period were as high as 5% which gets us to a 10% total return which equates to the Dow NOW being around 2,000,000 IF it included dividends. So for those shocked by 100-200 point intraday swings the total return Dow is ACTUALLY experiencing 25,000 to 50,000 point fluctuations each day. Just type 65.73*1.10^108.2 into Google GOOG to see what 65.73 invested at 10% compounds to. But that provides NO information on what $65.73 TODAY will be in 108 years if you put it into stock market index beta. We don't know THAT result.

HISTORICAL performance was indeed quite good assuming someone survived the non-growth from 1900-1932, 1929-1954, 1965-1982 and 2000-...? Of course that is restricting analysis to stock markets that DID survive the entire period. Just like many individual equities go to zero, several large countries' stock AND bond markets went to what was effectively zero last century. I am not being apocalyptic, just reiterating that risk management, diversification and hedging for ANY scenario are necessary. Let's hope world wars and depressions are gone forever. A year ago inflation and real estate crashes seemed like they were gone "forever". No-one knows the long term.

If you had invested in 1900 then 33 years later you would still have been waiting for that equity risk premium to kick in. High dividends and the post war baby-boomer bull market meant that by the mid-60s it seemed like "stocks" had an inherent upward drift especially if you only use data starting from 1926 which led to the financial "theories" of the late 60s and early 70s. Forget about alpha because the market is efficient and random so beta will arbitrage away any new information! Later the 80s/90s mega bull market "confirmed" the over 10% a year from beta hypothesis just in time for the current bear market that BEGAN in 2000. Few real scientists would have fallen for such a spurious conclusion or make such a non-predictive data mining error but many orthodox economists continue to believe it. The "expected" return from stock markets is considerably lower.

Did anyone actually put $65.73 into the Dow on the last trading day of 1899 and now has $2 million? Of course not. It is too long term to be useful information. Most investors need real returns quicker than beta can be assumed to deliver. 39,510 days ago there were no academics ranting on about "expected returns from risky asset classes" - a classic case of outcome bias. Those who claim "stocks" rise over time only "know" that because they are looking at the result. No-one in 1900 recommended buying the DJIA because they had no idea it would go on to perform so well. Knowing the past doesn't mean you know the future. All I know is some stocks go up and some go down.

Warren points out that index growth will NOT be like the previous "wonderful" century, that beta and income are not going to be sufficient to meet assumed target returns. Despite the 10% returns at 20% volatility, a 90% implosion and several 50% drawdowns, we are STILL urged by the random walkers to risk our hard earned cash on equity beta! Even with the "performance" of the PAST what kind of return on risk is that? Alpha advocates would be laughed out of the room with such risk-adjusted returns but not the beta bandits.

Recently some have started pushing "commodities" or "currencies" as supposedly having an expected return. Commodities have been in a bull market so the long term return NOW does indeed look good but there is no "expected return" from commodities any more than stocks. Trading oil, gold or wheat is an alpha decision that requires high skill and domain expertise. "Currencies" are not an asset class and their performance is relative to where YOU are. For Japanese and US investors "foreign exchange" has been a great "investment" but for Brazilians, Australians and most Europeans investing in other currencies has been a loser. Risky assets classes like equities, credit, commodities and currencies are security selection instruments. Choosing managers who can figure out what and when to buy and short sell within each asset class.

Risks and liabilities change so return sources and portfolio construction must also change. Why are investors urged to keep to a static asset class split when markets and economies fluctuate so widely? Don't the opportunities and risks change? Warren is right that 8% probably can't be achieved with traditional beta but it IS possible with a properly constructed dynamic portfolio of beta AND absolute alpha that changes as conditions require. Derivatives are indeed weapons of financial destruction in the wrong hands but there are many risk reduction benefits from the competent use of derivatives. Hedging and diversification with strategies is the safer and more certain route to the target return.

Worrying for shareholders in Berkshire Hathaway is the short sales of credit default options and long dated puts on various stock market indices. Warren is hoping that investing the premiums will exceed any liabilities at expiration. He says Dexter shoes was a bad trade but the option trades are potentially much worse. Surely Warren is aware that 33 years into last century on 29 Dec 1932 the Dow closed at 59.12. No gain in the bellwether index for the first third of last century. Could you wait till after 2032 for beta to start working its "magic"? BRKA might end up owing plenty of cash to those who purchased those options.

High downside but limited upside doesn't look like a typical Warren trade. Has he stress tested or Monte Carlo simulated for the S&P 500 being below 500 on expiry date? AIG also short sold credit default options on securities that someone thinks deserved to be "rated" AAA and had to mark to what there currently is of a market. Japanese insurance companies short sold similar instruments in the 90s and also thought they could reinvest the premium and wouldn't have to pay out. They were wrong. There is much to learn from the Japan experience. It was driven by a network of credit crossholdings backed by wrongly priced real estate "collateral". Mark to market is a cruel BUT necessary discipline.

Buy foreign equities? Since history is claimed to be helpful let's not forget what happened to investors in China, Russia, Germany and Japan in the first half of last century. Those markets suffered a 100% drawdown while USA ONLY had 90% but even the USA had to shut down for a while in 1914. Parts of the credit markets are effectively closed right now. Perhaps things are different(!) but a simple ukase to "buy foreign" is wrong. It is ALWAYS time to buy good foreign securities and short sell bad foreign securities. Bottom up stock picking may be a fine strategy but geopolitics and macro economics can NEVER be ignored. EVERY component in the Dow is now an enormous GLOBAL company so is likely as good a proxy for world growth as any other index. The MSCI "World" includes just 23 countries by the way.

The performance of ALL alpha seekers will sum to zero as fees and execution costs undermine the journeyman's attempt at something that is so difficult. An index of "all" hedge funds is like an index of "all" stocks; why invest when they are CERTAIN to include many underperformers? Some securities are good but others are bad. Some fund managers are good but such investment talent is rare. Equity indices are unhedged, have no skill, lose money too often for long periods with unacceptable volatility. Reinvestment of the relatively high dividends paid in earlier decades were a key contributor to long term compounded returns. Prior to 1982 dividends were the largest component of the total return in many stock markets. You can do a dividend swap to bet on rising or falling dividends.

Invest in the leaders not the followers. Pick the good funds or hire someone with the experience, analytical resources and domain expertise to pick alpha generators whose FUTURE risk adjusted returns will make management and incentive fees trivial. I too wish it were still possible to achieve 8% per annum with a simple portfolio of "stocks" and "bonds" but unfortunately it won't be. "Equities" and "real estate" might indeed go up over time but I just don't want to take the chance they don't. Every investor needs to be activist with their own portfolio. Security triage is essential. The only things investment grade are those where the returns are higher than the risks.

It is not so much the unknown unknowns that worry me as much as the known "knowns" that are wrong. We don't need two quarters of negative "growth" to know we have entered a recession. Real estate and credit prices are stronger indicators of economic strength and consumer sentiment than stock markets. Ben Bernanke is right there is no danger of 1970s stagflation. Instead we have 2000s style stagflation and the remedy won't be easy to find. Banks continue to report VaR as if such numbers were indicative of the risks and exposures they have on. You can have low Var but enormous risk and vice versa.

There will always be hedge funds that lose money and a few that implode. Some stocks go bankrupt so avoid ALL stocks? A house once burnt down somewhere so NEVER buy real estate? Cuba and North Korea defaulted on their government debt so don't buy treasuries and JGBs? Sounds silly but that is what we hear whenever a single hedge fund goes under. Everyone accepts that specific securities blowing up does not mean avoid all the opportunities available in the asset class. But skepticism of any investment strategy other than long only still reigns. In any era there are ALWAYS opportunities for alpha even when beta disappoints.

An investment strategy should be robust to structural changes in the market and financial regime shifts. I am tired of fundamental stock pickers who claim reg FD made things more difficult. Or quant types who complain about decimalization or trading algorithm copycats. Good investors make do with what current conditions are and innovate their strategies. Market evolution is certain so an investment process must be fortified and robust. There will be many more changes in the future. The markets are providing an ideal environment to show who has skill and who has previously been lucky.

Hedge fund blow ups and large losses from speculators marketing themselves as "hedge funds" are portayed as negatives when in fact shaking out the weak STRENGTHENS the industry and confirms the case for investing in the good funds. Lots of poor quality hedge funds shut down in the first oil crisis of the mid 70s but the good ones thrived. Plenty of funds closed or imploded in 1994 and 1998. It just emphasizes that skill is rare while thorough due diligence and manager AND strategy diversification is essential.

The hedge fund bubble is bursting? No. January was bad but February was good on "average". Trouble in a few specific areas of hedge fund land? Sure. Overdue volatility and a bear market was bound to catch out some overleveraged players. Carlyle Capital craters, DB Zwirn shuts down, Sailfish implodes, Richmond Capital loses 50% and AQR suffers from the same model development DNA as Goldman Sachs' Global Alpha. Losses and meltdowns for some poor funds just transports alpha to the good funds. That is the great thing about real portable alpha; the weak funds package alpha up and "port" it over to the good funds as if they had written the check themselves.

Invest in the breakaway leadership group NOT the the peloton. The Peloton hedge fund founders apparently couldn't keep an eye on their own millions in a simple bank account so could never have been expected to be able to manage client billions. The trouble with a cycling peloton is that if the riders at the front of the pack trip up they also disrupt the followers. It's the yellow jersey winners and kings of the mountains to give your money to. Unlike stock indices the best cyclist this year IS predictive for the best cyclist next year.

It is curious how when "hedge funds" have a generally rough month some say redeem and the "bubble" is over but when long only funds lose a few trillion those same experts urge investors to stay in for the long haul. Some even have the effrontery to say don't pay attention to market declines! Just ride out that volatility and hope the market will make it back in the dim and distant future. Even if you hate hedge funds I don't think anyone could say they haven't changed financial markets and consequently the assumptions that underlie so many portfolio postulates.

There are many dilettantes in investing and as in any industry and hedge funds obey the 80/20 rule. At least 8,000 of the products that say they are "hedge funds" are no good. Finance isn't rocket science; it is much more complicated than that. Too many employ hubristic heuristics to make their miserable models tractable. Equations that allegedly fully describe ALL market phenomena. The silly simplifications are what causes the problems in the first place. It is complexity that solves them. The trouble with much investment "advice" to individual investors is that it is too simple to work. Reliable rule of thumb; if the math is easy then the model is wrong.

The assumption that stock markets can be relied on to go up over time is a classic Type 1 statistical error. A false positive. Stocks generally went up therefore they will? Investors need time in the market since "no-one" can time the market! A rare few can and those fund managers can often be identified in advance. Claiming the market can't be consistently timed is like saying no-one can consistently run the hundred in under ten seconds, can't consistently hit basketball three pointers or shoot under par on the golf course. Warren has been successfully seeking alpha for a long time and the 1000-2000 bona fide hedge funds will also be delivering for their clients for many decades in the future as will good ones yet to be established.

Economists set great store in the anatocism of the past. Compound interest that was not expected in advance. Practitioners like Warren Buffett are pragmatists and adapt to current conditions as they see fit. I realise many investors still BELIEVE they will eventually be compensated for the risk of equities. I hope they are right but I can't afford to trust so I need to verify as well. I HAVE verified that investment skill exists AND persists INTO the future beyond any statistical and practical doubt. I HAVE not been able to verify the same for beta. Perhaps one day I will. Stock market price appreciation AND dividends are unstable so we need alpha as well, just in case.

Asset allocation is unlikely to be the main driver of performance over time. The primary factor willl be security, strategy and manager selection. Fund managers that work hard to find securities that will go up and those that will go down and managing risk in case they are wrong. The VARIABILITY of portfolio performance is dominated by hedging, risk management and the appropriate use of derivatives. The path DOES matter for the long term achievement of investment objectives at the LOWEST volatility. As Benjamin Graham wrote many years ago "The essence of investment management is the management of risks".

Diversification with many securities is not hedging. You can own 10,000 stocks and bonds and not be properly diversified. Alpha sources need to be FRONT and CENTER in EVERY portfolio. I don't know whether the Dow will be at 24 million or back down to 65.73 in 2099 but I can tell you for certain that a lot of alpha will have been created along the way. Alpha returns are complementary to beta returns. I would rather chase skill than chase performance because skill is persistent.

Although I have been pessimistic about the markets for the past year or so, I am an optimist at least with respect to the ongoing existence of some humans with the talent to trade successfully no matter how far the stock market drops. And they can impose whatever fees they want as long as they perform to demanding requirements. Produce 8% of absolute alpha above REAL inflation with careful control of risk satisfies a lot of investor requirements.

There is $64 trillion in money management and just $2 trillion in "hedge funds". The proportion is going to be a LOT higher and yes there is always going to be a bottom decile of "hedge funds" that get themselves into trouble. That does not change the optimistic outlook for the hedge fund industry. A proper hedge fund should relish an equity or credit bear market. Even if you don't like shorting, it also creates opportunities to buy value cheaper as Warren Buffett has done many times in his search for alpha for his shareholders. It is a market of stocks NOT a stock market. Some go up, some go down. Why invest in them all?

Friday, March 07, 2008

S&P 500 P/E Ratio Ticking Higher

As the S&P 500 has been making new lows, its p/e ratio has been making new highs! Unfortunately, that's what happens when earnings decline at a faster pace than the index does. And it's pretty hard to fathom something falling faster than the market in this environment.


Thursday, March 06, 2008

The 'middle-class millionaire'

The 'middle-class millionaire'
Those with net worth of $1 million to $10 million reshape U.S. culture
SANTA MONICA, Calif. (MarketWatch) -- Those with a net worth of between $1 million and $10 million -- that they have earned rather than inherited -- are being dubbed "middle-class millionaires," a group that has grown on the heels of the economic boom over the past couple decades.
Middle-class millionaires now account for 10% of the U.S. population, according Russ Alan Prince and Lewis Schiff, who coined the term for research purposes and a new book by that name. They studied almost 4,000 households to better understand attitudes, values and purchasing patterns.
Their findings include:
  • 7.6% of American households, or 8.4 million households are middle-class millionaires
  • The average middle-class millionaire works 70 hours per week
  • Middle-class millionaires are five times more likely than the average worker to say they are always available for work
  • 89% believes that anyone can attain wealth through hard work
  • 62% believes that networking, or knowing many people, is the key to financial success
  • Nine out of 10 middle-class millionaires say they made a bad career or business move, but almost three-fourths say that was crucial to their business success
  • They are five times more likely than the average middle-class person to continue on in the same business course in spite an earlier failure
  • 65% of middle-class millionaires characterize their approach to negotiating as "doing whatever you need to do to win"
  • They say they need a net worth of $24 million to feel wealthy, and $13.4 million to be considered rich.
Prince and Schiff also found that almost half of middle-class millionaires believe a child's academic achievements reflect one's success as a parent. Seventy-five percent of this group chose their home because of its school system. And only 14% of them trust the government.
This separates middle-class millionaires from the middle class in general: Only 16% of middle-class households were ready to put their own reputation on the lines when it comes to their kids' academic record, according to Prince and Schiff. More than half of middle-class households chose their homes because it was close to work. And an almost equal amount believes the government has their back, Prince and Schiff say.
The differences may be stark, but Prince and Schiff see that changing. They describe middle-class millionaires as "the rise of the new rich and how they are changing America." The changes they see are evident in four areas: hard work, networking, persistence and financial self-interest.
Trickle-down effect
These traits may differ from those in the middle class but their offspring, in the form of goods and services, are making their way "downstream."
"From life coaches to luxury vacation rentals, concierge medical care to high dollar prep course into the Ivy League [these things] are making their way downstream, steadily becoming available to a much broader population," Prince and Schiff say. "What was once the province of only the super rich is now being created and packaged for the 'downline' population or for those with fewer zeros in their net worth, but similar aspirations."
Collectively, the authors say, middle-class millionaires are influencing, advocating and reshaping the social, cultural and commercial landscape of our world.
It's a whole new level of keeping up with the Joneses.
Take the OnStar navigation system. It began as an emergency road service for high-end luxury vehicles. Now it's even offered on midrange trucks. Similar trends are occurring in real estate, vacations, airline travel and other services.
We may have to begin adding some new class structures in America. Otherwise we may all soon belong to the same one. End of Story

Wednesday, March 05, 2008

Bill Gross' comments (the part that you care about)

From his letter (cutting out all the usual B.S.), here's the conclusion:

This leads me to #3 on my list of action plans. What should an investor do – desperately trying to avoid the Old Maids, yet trapped with good Treasury cards at yields inappropriately low in a mildly inflationary future environment? The answer lies in managing a transition to riskier assets while being acutely aware, as my CIO partner Mohamed El-Erian is quick to point out, that such a transition will be characterized by technical purges of Old Maid and even higher quality assets that in many cases produce price levels significantly below what might at first seem reasonable. Minsky moments – the unwinding of levered assets – produce as many surprises on the downside as do $5 million dollar homes in Silicon Valley and NASDAQ 5,000 point stocks on the upside. Patience and cognizance of flows, El-Erian counsels, are as critical to the equation as is the recognition of the Old Maids in the first place.

Still, we would both agree that value is returning to many parts of the bond market. If an investor requires 5%+ yields to compensate for future inflation, then they can increasingly be found in authentic AAA assets – not disguised Old Maids. There’s not a hint of plastic surgery in agency-backed FNMA and FHLMC mortgages at 5¾%, although their actual ages (average lives) may be somewhat in doubt. Similarly, SBA government-guaranteed loans at LIBOR+ 125 basis point yields are beginning to entice, as are some of those bank loans when priced in the high 80s as opposed to 95 cents on the dollar. If capitalism is a going enterprise – and we think it is – then investors will eventually return to play similar, perhaps more conservative games – much as they have in the past. And if Washington gets off its high “moral hazard” horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table – to provide an attractive return on your money (no matter what the asset class) as well as a return of your money. No Old Maids. No silicone AAA ratings. And ladies – no crotchety old bachelors either. The game, as well as the name of the game, is changing. It’s no country for Old Maids anymore.

William H. Gross

Managing Director

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.