Tuesday, December 30, 2008

Top Ten Dear Investor Letters (Know Your Enemy Edition)

In the topsy-turvy world of contrite investment apology, split-second recognition of the language in a "Dear Investor" letter bearing bad tidings can mean the difference between slow malingering death in the face of debilitating investor lockups, or a quick escape to the islands where you will also conveniently avoid the jealous rage of your (former) fellow limiteds (and the phrase "fraudulent transfer").

To sharpen your skills, and now that 2008 is drawing to a close, we bring you this DealBreaker quiz on the top ranking Dear Investor letter prose for the year. Match the prose to the firm and the world will be your oyster (in this case "world" is substituted for "present" and "oyster" is exchanged with "Attractive DealBreaker 'don't short me bro!' mug."

"There may be residual assets in Madoff to be
distributed or, alternatively, there may be no assets."

"We would like to think that you will remember the returns that we have delivered in the past...."

"For most of the past 3 1/2 hears we have felt good about the job we have done in delivering returns...."
Fairfield Sentry

"We believe ... the steel industry will earn more than the public generally believes in 2009 and 2010."

"Of course we are totally biased, but we believe that if we continue to get the support from investors as we always have had, we will fall into this category."
Ladhe Capital

"This represents a month-to-date net decrease of -9.44% from the final October 31, 2008 net asset value per share of US$649.64 and a year-to-date net return of -43.66%."
Tontine Associates

"The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking."
Tontine Associates

"We recognize how a suspension impacts our investors, especially those with current financial obligations of their own to meet."
Tosca Fund (Link Removed)

This conference call may not be recorded, rebroadcast or transcribed without the expressed, written consent of [firm].
TPG-Axon Capital

"We do strongly urge all of you to please keep our communications confidential; it is not in the fund's nor our joint interest to have details widely leaked to the outside world, particularly in a dangerous environment."
TPG-Axon Capital

Ready? Go!

Kass: 20 Surprises for 2009

Doug Kass

12/29/08 - 11:59 AM EST
This blog post originally appeared on RealMoney Silver on Dec. 29 at 8:49 a.m. EST.

"Never make predictions, especially about the future."

-- Casey Stengel

In late December over the past six years, I have taken a page from former Morgan Stanley strategist Byron Wien (now the chief investment strategist at Pequot Capital Management) and prepared a list of possible surprises for the coming year.

These are not intended to be predictions but rather events that have a reasonable chance of occurring despite the general perception that the odds are very long. I call these "possible improbable" events.

The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs. After all, the quality of Wall Street research has deteriorated (in some measure because of brokerage industry consolidation) and remains, more than ever, maintenance-oriented, conventional and "groupthink," even despite the mandated reforms over the past several years. Mainstream and consensus expectations are just that, and in most cases they are deeply imbedded into today's stock prices. If I succeed in at least making you think about outlier events, then the exercise has been worthwhile.

Our surprise list for 2008 proved to be our most successful ever, with 60% of last year's "possible improbables" proving to be materially on target. Almost half of the prior year's predicted surprises actually came to pass, up from one-third in 2006 and from 20% in 2005. Nearly of one-half 2004's prognostications proved prescient and about one-third in the first year of our surprises for 2003.

Investing based on some of my outlier events over the past 12 months would have yielded good absolute and relative returns and would have protected investors somewhat from the market's downdraft.

My surprise list for 2008 hit on a number of themes that dominated the investment landscape this year: the extent of the weakness in worldwide economic activity, the severity of the housing downturn, the collapse of retail spending, the obliteration of the hedge fund industry, the reawakening of market volatility, the spike in oil, the cessation of private equity deals and the steady drop in large bank shares.

  • "The housing depression of 2007 morphs into the retailing depression of 2008."
  • "With a continuation of the credit and liquidity crises and an increased recognition that financial retrenchment will take years (not months), volatility pushes even higher. Daily moves of 1% to 2% become more commonplace, serving to further alienate the individual investor."
  • "The hedge fund community is disintermediated in 2008. Outflows accelerate, abetting an already conspicuous trend of rising volatility in a market that behaves more like a commodity than ever."
  • "Job losses begin in mid-2008."
  • "An unprecedented and abrupt drop in personal consumption expenditures occurs."
  • "Retail stocks, especially women's apparel, are among the worst-performing stocks in 2008."
  • "The Federal Reserve embarks upon a series of moves to ease monetary policy in 2008. Nearly every meeting is accompanied by a 25-basis-point decrease in the federal funds rate, even despite continued inflationary pressures. Nevertheless, the economy fails to revive as the Fed pushes on a string."
  • "Growth in the Western European economies deteriorates throughout the year."
  • "Financial stocks fail to recover. No financial company is immune to the eroding market conditions, spike in market volatility, the uneven direction in commodities and currency prices. Even the Leader of the Pack, Goldman Sachs (GS Quote - Cramer on GS - Stock Picks), makes several bad bets in the derivative, currency and commodity markets, and its shares begin to underperform its peers as profit forecasts move lower. Citigroup (C Quote - Cramer on C - Stock Picks) halves its dividend.... Asset sales and writedowns leave the bank crippled."
  • "Bear Stearns investor Joe Lewis loses nearly $350 million on his near 10% position in the brokerage firm."
  • "Mutual fund outflows and uncertainty regarding the integrity of money market funds result in the asset management stocks being among the worst-performing sectors in 2008."
  • "With private equity deals at a standstill, Blackstone (BX Quote - Cramer on BX - Stock Picks) shares trade down close to $10 a share."
  • "Reversing its recent strength, the U.S. dollar's value falls by over 10% in 2008, and gold rises to over $1,000 an ounce."
  • "The price of crude oil eclipses $135 a barrel."
  • "There are several major Enron-like accounting scandals in 2008, causing investor confidence to plummet; these will come in some large financial companies in Europe."

Without further ado, here is my list of 20 surprises for 2009. In doing so, we start the new year with the surprising story that ended the old year, the alleged Madoff Ponzi scheme.

    1. The Russian mafia and Russian oligarchs are found to be large investors with Madoff. During the next few weeks, a well-known CNBC investigative reporter documents that the Russian oligarchs, certain members of the Russian mafia and several Colombian drug cartel families have invested and laundered more than $2 billion in Madoff's strategy through offshore master feeders and through several fund of funds. There are several unsuccessful attempts made on Madoff and/or his family's lives. With the large Russian investments in Madoff having gone sour and in light of the subsequent acts of violence against his family, U.S./Russian relations, which already were at a low point, are threatened. Madoff's lawyers disclose that he has cancer, and his trial is delayed indefinitely as he undergoes chemotherapy.

    2. Housing stabilizes sooner than expected. President Obama, under the aegis of Larry Summers, initiates a massive and unprecedented Marshall Plan to turn the housing market around. His plan includes several unconventional measures: Among other items is a $25,000 tax credit on all home purchases as well as a large tax credit and other subsidies to the financial intermediaries that provide the mortgage loans and commitments. This, combined with a lowering in mortgage rates (and a boom in refinancing), the bankruptcy/financial restructuring of three public homebuilders (which serves to lessen new home supply) and a flip-flop in the benefits of ownership vs. the merits of renting, trigger a second-quarter 2009 improvement in national housing activity, but the rebound is uneven. While the middle market rebounds, the high-end coastal housing markets remain moribund, as they impacted adversely by the Wall Street layoffs and the carnage in the hedge fund industry.

    3. The nation's commercial real estate markets experience only a shallow pricing downturn in the first half of 2009. President Obama's broad-ranging housing legislation incorporates tax credits and other unconventional remedies directed toward nonresidential lending and borrowing. Banks become more active in office lending (as they do in residential real estate lending), and the commercial mortgage-backed securities market never experiences anything like the weakness exhibited in the 2007 to 2008 market. Office REIT shares, similar to housing-related equities, rebound dramatically, with several doubling in the new year's first six months.

    4. The U.S. economy stabilizes sooner than expected. After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008's black hole), the massive and creative stimulus instituted by the newly elected President begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profits growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds and labor costs are well under control.

    5. The U.S. stock market rises by close to 20% in the year's first half. Housing-related stocks (title insurance, home remodeling, mortgage servicers and REITs) exhibit outsized and market-leading gains during the January-to-June interval. Heavily shorted retail and financial stocks also advance smartly. The year's first-half market rise of about 20% is surprisingly orderly throughout the six-month period, as volatility moves back down to pre-2008 levels, but rising domestic interest rates, still weak European economies and a halt to China's economic growth limit the stock market's progress in the back half of the year.

    6. A second quarter "growth scare" bursts the bubble in the government bond market. The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall, putting a ceiling on the first-half recovery in the U.S. stock market, which is range-bound for the remainder of the year, settling up by approximately 20% for the 12-month period ending Dec. 31, 2009. Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008's year-end at 62% and down from 70% only five years ago. China's 2008 economic growth proves to be greatly exaggerated as unemployment surprisingly rises in early 2009 and the rate of growth in China's real GDP moves towards zero by the second quarter. Unlike more developed countries, the absence of a social safety net turns China's fiscal economic policy inward and aggressively so. Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into it's piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.

    7. Commodities markets remain subdued. Despite an improving domestic economy, a further erosion in the Western European and Chinese economies weighs on the world's commodities markets. Gold never reaches $1,000 an ounce and trades at $500 an ounce at some point during the year. (Gold-related shares are among 2009's worst stock market performers.) The price of crude oil briefly rallies early in the year after a step up in the violence in the Middle East but trades in a broad $25 to $65 range for all of 2009 as President Obama successfully introduces aggressive and meaningful legislation aimed at reducing our reliance on imported oil. The price of gasoline briefly breaches $1.00 a gallon sometime in the year. The U.S. dollar outperforms most of the world's currencies as the U.S. regains its place as an economic and political powerhouse.

    8. Capital spending disappoints further. Despite an improving economy, large-scale capital spending projects continue to be delayed in favor of maintenance spending. Technology shares continue to lag badly, and Advanced Micro Devices (AMD Quote - Cramer on AMD - Stock Picks) files bankruptcy.

    9. The hedge fund and fund of funds industries do not recover in 2009. The Madoff fraud, poor hedge fund performance and renewed controversy regarding private equity marks (particularly among a number of high-profile colleges like Harvard and Yale) prove to be a short-term death knell to the alternative investments industry. As well, the gating of redemption requests disaffects high net worth, pension plan, endowment and University investors to both traditional hedge funds and to private equity (which suffers from a series of questionable and subjective marking of private equity deal pricings at several leading funds). Three of the 10 largest hedge funds close their doors as numerous hedge funds reduce their fee structures in order to retain investors. Faced with an increasingly uncertain investor base, several big hedge funds merge with like-sized competitors in a quickening hedge fund industry consolidation. By year-end, the number of hedge funds is down by well over 50%.

    10. Mutual fund redemptions from 2008 reverse into inflows in 2009. The mutual fund industry does not suffer the same fate as the hedge fund industry. In fact, a renaissance of interest in mutual funds (especially of a passive/indexed kind) develops. Fidelity is the largest employer of the graduating classes (May 2009) at the Wharton and Harvard Business Schools; it goes public in late 2009 in the year's largest IPO. Shares of T. Rowe Price (TROW Quote - Cramer on TROW - Stock Picks) and AllianceBernstein (AB Quote - Cramer on AB - Stock Picks) enjoy sharp price gains in the new year. Bill Miller retires from active fund management at Legg Mason (LM Quote - Cramer on LM - Stock Picks).

    11. State and municipal imbalances and deficits mushroom. The municipal bond market seizes up in the face of poor fiscal management, revenue shortfalls and rising budgets at state and local levels. Municipal bond yields spike higher. A new Municipal TARP totaling $2 trillion is introduced in the year's second half.

    12. The automakers and the UAW come to an agreement over wages. Under the pressure of late first-quarter bankruptcies, the UAW agrees to bring compensation in line with non-U.S. competitors and exchanges a reduction in retiree health care benefits for equity in the major automobile manufacturers.

    13. The new administration replaces SEC Commissioner Cox. Upon his inauguration, President Obama immediately replaces SEC Commissioner Christopher Cox with Yale professor Dr. Jeffrey Sonnenfeld. The new SEC commissioner recommends that the uptick rule be reinstated and undertakes a yearlong investigation/analysis into the impact of Ultra Bear ETFs on the market. Later in the year, the administration recommends that the SEC be abolished and folded into the Treasury Department. Dr. Sonnenfeld returns to Yale University.

    14. Large merger of equals deals multiply. Economies of scale and mergers of equals become the M&A mantras in 2009, and niche investment banking boutiques such as Evercore (EVR Quote - Cramer on EVR - Stock Picks), Lazard (LAZ Quote - Cramer on LAZ - Stock Picks) and Greenhill (GHL Quote - Cramer on GHL - Stock Picks) flourish. Goldman Sachs and Citigroup announce a merger of equals, but Goldman maintains management control of the combined entity. Morgan Stanley (MS Quote - Cramer on MS - Stock Picks) acquires Blackstone. Disney (DIS Quote - Cramer on DIS - Stock Picks) purchases Carnival (CCL Quote - Cramer on CCL - Stock Picks). Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) acquires Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) at $5 a share.

    15. Focus shifts for several media darlings. Though continuing on CNBC, Jim "El Capitan" Cramer announces his own reality show that will air on NBC in the fall. At the time his reality show premieres, he also writes a new book, Stay Mad for Life: How to Prosper From a Buy/Hold Investment Strategy. Dr. Nouriel Roubini continues to talk depression, but the price of his speaking engagements are cut in half. He writes a new book, The New Depression: How Leverage's Long Tail Will Result in Bread Lines. "Kudlow & Company's" Larry Kudlow proclaims that it's time to harvest the "mustard seeds" of growth and, in an admission of the Democrats' growing economic successes, officially leaves the ranks of the Republican party and returns to his Democratic roots. Yale's Dr. Robert Shiller adopts a variant and positive view on housing and the economy, joining the bullish ranks, and writes a new book, The New Financial Order: Economic Opportunity in the 21st Century.

    16. The Internet becomes the tactical nuke of the digital age. The Web is invaded on many levels as governments, consumers and investors freak out. First, an act of cyberterrorism occurs that compromises the security of a major government (similar to the attacks this year emanating from the Chinese military aimed at the German Chancellery) or uses DoS against media and e-commerce sites. Second, a major data center will fail and will be far worse than the 1988 Cornell student incident that infected about 5% of the Unix boxes on the early Internet. Third, cybercrime explodes exponentially in 2008. Financial markets will be exposed to hackers using elaborate fraud schemes (such as liquidating and sweeping online brokerage accounts and shorting stocks, then employing a denial-of-service attack against the company). Fourth, Storm Trojan reappears. (Same as last year.)

    17. A handful of sports franchises file bankruptcy. Three Major League Baseball teams fail in the middle of the season and seek government bailouts in order to complete the season. The Wilpon family, victimized by Madoff, sells the New York Mets to SAC's Steve Cohen. The New York Yankees are undefeated in the 2009 season, and Madonna and A-Rod have a child together (out of wedlock).

    18. The Fox Business Network closes. Racked by large losses, Rupert Murdoch abandons the Fox Business Network. CNBC rehires several prior employees and expands its programming into complete weekend coverage. Two popular CNBC commentators "go mainstream" and become regulars on NBC news programs.

    19. Old, leveraged media implode. The worlds of leverage and old media collide in a massive flameout of previous leveraged deals. Univision and Clear Channel go bankrupt. The New York Times (NYT Quote - Cramer on NYT - Stock Picks) teeters financially.

    20. The Middle East's infrastructure build-out is abruptly halted owing to "market conditions." Lower oil prices, weakening European economies and a broad overexpansion wreak havoc with the Middle East's markets and economies.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.

Monday, December 29, 2008

High Yield Spreads Contract 10% From December Highs

While it may be cold outside, the thaw we have been seeing in the credit markets reached a notable milestone on Friday. Based on data from Merrill Lynch indices, high yield spreads tightened from 1,979 to 1,955 basis points. From their peak reading of 2,182 basis points on December 15th, high yield spreads have now contracted by 10.4%. While these levels are still extremely high, they are moving in the right direction. The hope now for the bulls is that this move is sustainable in the new year, when trading desks are back at fully staffed levels.

High Yield Spreads 122908

Sunday, December 28, 2008

Hedge fund operational due diligence

The Operational Due Diligence Process
Operational Due Diligence within the hedge fund world typically is done to verify that the fund is doing what they say they are doing and to ensure that the fund is following industry regulations and best practices.

As long as we continue to allow the financial executives to “creatively” spin their ideas of fraud into alpha generation we will continue to see crisis after crisis. Unfortunately our regulators come up with solutions like SOX and FAS 157 after the damage is done. The regulators in our industry need to be proactive and not reactive to these types of double dealings.

With that being said, let me first say how sorry I am to all of the people who have been affected by the actions of the executives in the financial firms that have put us in this hellish situation. It seems that in executive speak - marketing is synonymous with lying and retention payment is synonymous with bonus. Since or current regulatory environment allows the Madoffs of the world to make fools of the fund of funds, hedge funds and other asset managers it seems that this is a good time to discuss operational due diligence.

I am not blaming the regulatory agencies for the losses we have seen in this mess. I am saying they could have done a lot to help prevent to current situation if we had rigorous regulation in the certain markets, specifically the swaps market. Unfortunately since there is no accountability for the Wall Street executives we will continue to see these firms grossly mismanaged again and again with bailout after bailout until we hold the executives and board members are held accountable or until it drags our country into a depression. Given all of the financial events that have occurred since 9/15/2008 (the day Lehman filed bankruptcy) through today, we are going to have to rely on ourselves for longevity. We will achieve this only through extensive operational due diligence within our industry.

Let's first discuss Mr. Madoff. It is exceptionally difficult to find any sympathy for the financial institutions that invested with Mr. Madoff. These financial institutions are supposed to verify numerous operational components of any type of investment vehicle they invest in. No one is sure what due diligence was done by these firms, we are only sure that it was offensively inadequate. They only logical explanation that I can see is that these firms were impressed with his background as Chairman of the NASDAQ and other moving accolades. There is certainly a place in my heart for all of the non-sophisticated investors (even though they might be classified as sophisticated because of income or net worth) who did not have the staff or knowledge to look into this Ponzi scheme.

I was recently asked to draft an operational due diligence manual to show the complete depth of OPDD. As I pondered the task I quickly came to the conclusion that each manual would be different. Conducting OPDD on a trend following CTA would be entirely different from a distressed debt shop, convertible arbitrage, market neutral and every other type of strategy. Of course you would have plenty of similarity in the basic questions, number of employees, who are the principals, what sectors do you trade, etc. I clearly understand the reason for secrecy in the hedge fund world. OPDD is not about getting the recipe to the secret sauce used in McDonalds hamburgers, rather it is to verify that there is a sauce, a hamburger, customers, and all of the other components that make a successful transaction in today’s markets. After almost 40 pages into my 1st manual for one strategy it became clear that this project could grow to about 150 pages. So not to bore you with all of the details I will try to provide you with a very high level overview of OPDD. So here we go, Before examining the core aspects of any operational components of a hedge fund we should look at the fundamental characteristics that will give us a better feel for the overall evaluation of the fund in question. Due Diligence starts before the front door, understand the prospect and their strategy before having in-depth conversations. Request offering documents and marketing literature.
  1. Articles – There are many media circulations (Hedge Fund Alert, Infovest 21, MAR Hedge, Finalternatives.com, hedgefund.net, etc) that can provide general information about the individuals and their backgrounds. These articles can be a great starting point, but the information found in them should not be taken as gospel. The characteristic to look for: If the hedge fund tabloids find a launch story to be news worthy there may be some credibility to given to the fund managers. The sword cuts both ways, often you can find articles that take a negative spin. Read as many articles as you can and ask questions about the article as you can. Often you will get valuable information that you were not even looking for.
  2. People – a) Who are they?
    b) Are they known among credible peers or unknown?
    c) What is their pedigree?
    d) What type of significant investment experience do they possess?
    e) What were the key elements in the inception of the fund?
    f) Education?
  3. The Story – tell us how you got started in finance and what has lead you to this point. (Take notes)
    a) You want to make sure the story makes sense.
    b) You are checking the story for consistency as you will discuss
    their story more detail later.
    c) The story gives you the opportunity to take your discussion in any direction.
  4. The Strategy – Generally speaking, strong managers can articulate a robust and compelling strategy. (Most successful managers will offer significant amounts of information about their strategy because they know how difficult it is to replicate and to find the people to do it, successful managers usually will leave out small amounts of key information that constitute trader secret information)
    a) Being vague is a red flag.
    b) Managers who are unwilling or unable to discuss the strategy,
    are often amateurs or hobbyists.
    c) The manager should be an expert in the strategy and should
    be able to answer any question. d) What is the capacity of the strategy?
  5. Performance History (absolute and relative)- Performance history is subjective since it is correlated with risk. Example: A fund with a 2 yr track record that shows a +10% return at the end of both years might not be a good fit if it was riding 40 % drawdowns during the return period. Generally speaking, a minimum of a 2 consecutive year double digit positive return would be acceptable to move forward. As we discussed, this area is subjective for numerous reasons. Is the performance audited or verifiable in any way?
  6. Risk Management – After the Amaranth Advisors debacle and other financial disasters, it is critical to insure that risk managers are reporting and explaining all risk exposure to fund managers and others.
    a) Does the Manager use Incremental Var?
    b) Does the Manager use Marginal Var?
    c) Does the Manager use stress tests?
    d) Does the Manager apply its risk management methodology into its back testing?
  7. Traded Instruments and Liquidity – Illiquid markets can be difficult to enter
    and exit.
    a) What is the trading ability of the manager to execute trades in the described markets?
  8. Service Providers – Weaker managers will often use unknown service
    providers to reduce cost whilst sacrificing on proper service. More well
    known service providers arrange an on boarding team that will help new
    managers with many of the launching pitfalls?
    a) What law firm represents the manager?
    b) Who is the Auditor?
    c) Who is the Fund Administrator?
    d) Who is the Prime Broker?
  9. Transparency – Transparency is critical to investors today so they can see a
    day by day actual P&L.
    a) What types of transparency does the manager offer?
    b) What internal controls is the manager willing to share with the investor?
    c) What is the policy on trading errors?
    d) Does the fund have an error account?
    e) Does the manager offer managed accounts?

The offering document
The offering documentation structure can be different for every hedge fund and is almost completely different in context. The legal documentation of a hedge fund defines how the business and the fund will operate. Since every hedge fund is different (generally) and there are many good law firms with many good lawyers (each have a different flair for creating documentation). The general structure(an LLC is the GP of the LPA) is the same. The list of documents below will provide you with a general description and how they apply to the organizational and operational structure of the fund.
  • Operating Agreement – The operating agreement of an LLC defines how the business will operate. They are usually contain dissolution strategies (in the event of partnership disputes), allocations, distributions, capital commitments, management, fiscal matters, transfer of interest and more.
  • Private Placement Memorandum (PPM) – also known as the private offering memorandum. This memorandum specifies that this is a private offering that contains information about the investment process, management, ERISA and other regulatory issues, subscriptions, tax considerations, and more.
  • Limited Partnership Agreement (LPA)– This agreement defines the responsibilities and liabilities of the limited partners and the general partner. The LPA will discuss issues about key man risk, liquidation of assets and will also contain much of the same information contained in the PPM and the operating agreement.
  • Subscription Agreement – The subscription agreement allows the subscriber to identify what type of investor they are. (HNW, QEP, Foundation, Family Office, Institutional Investor, etc.)
  • Risk Disclosure Document – Often called a “D-Doc”, this document is designed to talk about the types in investing and the risks associated.
  • Business Plan – The Business Plan is a guide that the business follows in order to grow it’s business. They often detail the expenses for the first 2 yrs, number of employees, at what stage with assets under management will more employees be hired and more.
  • Marketing Document – This document will define how the fund and the managers are different from others. This document will also explain the investment philosophy and the key personnel involved.

You should keep in mind that you will see redundant information in theses documents. You are looking for inconsistencies within these documents and the DDQ that you will review later. Compare the DDQ to the notes that you have gather from the onsite visit (done later) along with the notes you have taken during your phone conversations.

Other documents that you could find along with the listed offering documents:
Investment Management Agreement
Investment Management Fees
Acknowledgement of Receipt
Trading Authorization
Arbitration Agreement
Form of Notional Funds Letter
Give-Up Agreement
Payment Authorization

The few topic we discussed are the tip of the iceberg. If you are interested in reading more about OPDD please post a response or email me directly. Or fell free to tell me to keep my trap shut and my opinions to myself.

Thank you for reading.

Wednesday, December 24, 2008

L'Affaire Madoff

Based in Montreal, our primary paper is La Presse. Their editorial cartoon certainly summed up one aspect of the "Madoff Affair".

(Translation: The American authorities hadn't seen anything - "absolutely no trace")


Tuesday, December 23, 2008

Madoff's Volatility

A longtime reader of this blog got himself Bernie Madoff's return series from a Fairfield Sentry marketing document and plugged it into an Excel spreadsheet; he then graphed the one-year rolling volatility of Madoff's returns. The results are interesting: click on them for a bigger, easier-to-read version.


It seems to me (and the annotations are all mine) that this graph is consistent with Justin Fox's theory that Madoff was artificially smoothing his returns until the dot-com blowup, at which point he went Full Ponzi.

In other words, Madoff was never fully legitimate -- or at least, looking at this chart, he seems to have been pretty illegitimate from at least 1995 onwards. But he might not have been actively stealing his clients' money until he blew up at the beginning of this decade, and subsequently moved from being a dishonest fund manager to the operator of a fully-fledged Ponzi scheme.

Mortgage activity surges at US banks

US banks are having trouble handling a surge of mortgage applications spurred by dramatically lower interest rates, after record loan defaults and thousands of job cuts have stretched mortgage industry resources to the limit.

Applications for home loans more than doubled in the two weeks after the Federal Reserve said it would buy mortgage bonds to help stabilise the market, prompting mortgage rates to fall by more than three-quarters of a percentage point.

With average rates for a 30-year, fixed-rate mortgage now at about 5.2 per cent, growing numbers of borrowers have an incentive to refinance to bring down their mortgage costs.

But tighter underwriting standards for prospective borrowers, combined with funding and staffing difficulties for mortgage originators, are likely to restrict the supply of new mortgages.

“The mortgage industry is collectively unprepared to deal with a cascade of business; staffs were pared to the bone as the market for mortgages shrank over the past year,” analysts at HSH Associates wrote in a note to clients.

Mahesh Swaminathan, mortgage analyst at Credit Suisse, said that as a result, lower rates would not necessarily create a wave of mortgage refinancing on the scale that was seen in 2003, when credit markets were healthy.

“There is a lot of pipeline congestion. Originators don’t have the staffing or the credit lines to fund a lot of loans,” said Mr Swaminathan. “You have more due diligence which requires more staffing. It is not something that can be changed overnight.”

Part of the problem is that banks have directed the bulk of their manpower toward their servicing arms in a bid to stem the tide of mortgage defaults and foreclosures.

While banks have pledged to use capital they have received from the US Treasury to boost consumer lending, they are also under intense political pressure to modify loan terms for struggling borrowers. Loan modifications have continued to grow more quickly than other strategies such as subsidy programmes or refinancing into government loans, according to the Office of the Comptroller of the Currency.

The number of new loan modifications grew 16 per cent in the third quarter to more than 133,000, said the OCC. The rate of loan modification is likely to be even higher in fourth-quarter data, say analysts, as a result of recent initiatives by Fannie Mae and Freddie Mac, the two large mortgage financiers.

Not Everything Was Down Yesterday

While the S&P 500 and Nasdaq were both notoriously weak yesterday given the usual positive bias during the Christmas week, not everything was down. In the credit markets, corporate bonds had a strong day, and if these trends continue, it will bode well for stocks. As shown below, using the iBoxx ETFs as a proxy, both investment grade (LQD) and high yield (HYG) corporate bonds had decent gains yesterday after rallying nicely over the past week as well. The stock market has really played second fiddle to the credit markets during this downturn. Many investors have been waiting for the corporate bond market to show signs of life before getting back into more risky assets. From the looks of these two ETFs, the credit markets are finally gaining some positive traction.



Monday, December 22, 2008

The Dollar Crisis Begins

The Dollar Crisis Begins

John P. Hussman, Ph.D.

On Tuesday, the Federal Reserve took the somewhat expected but extreme step "to establish a target range for the federal funds rate of 0 to 1/4 percent." Included in its policy statement was an additional bit – “The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”

Think about that for a second. We've got 10-year Treasury bonds yielding only about 2%, and the Federal Reserve is “evaluating the potential benefits” of purchasing them? While that statement may have been intended to encourage a further easing in long-term interest rates (to which mortgage rates are tied), the prospect of suppressed interest rates at every maturity sent the U.S. dollar index into a free-fall. If the Fed ends up buying long-term Treasuries, it will almost certainly be a bad trade, but it may be required in order to absorb the supply from foreign holders set on dumping them.

And for good reason. The panic in the financial markets in recent months has driven Treasury bond prices to speculative extremes. Unfortunately, unlike the stock market, where hopes and dreams about future cash flows can often sustain speculative markets for years, it is very difficult to sustain speculative runs in bond prices. The stream of payments for bonds is fixed and known in advance. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. dollar, coupled with astoundingly low yields to maturity, have created a perfect time to get out.

In the next several months, we're likely to observe one of two things. If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it.

As I noted earlier this year, a continued flight to safety in Treasury bonds, coupled with a continued massive current account deficit, “ places the U.S. in the difficult position of having to finance an enormous volume of capital needs from foreigners, particularly for Treasury debt, yet without being able to offer competitive yields or strong prospects for additional capital gains. My impression is that the markets will respond to this difficulty with what MIT economist Rudiger Dornbusch referred to in 1976 as “exchange rate overshooting.” In the present context, that means a dollar crisis. Specifically, if there is a weak prospect that foreign lenders will achieve a total return on U.S. Treasuries competitive with what they can earn in their own country, and every prospect that short-term interest rates in the U.S. will remain depressed or fall even further, the only way to attract capital is to immediately drive the value of the U.S. dollar to such a sharply depressed level that it will be expected to appreciate over time.”

I don't expect that the likely depreciation of the U.S. dollar will compound the current recession as much as it will simply reflect it. Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable. Nevertheless, the introduction of additional sources of volatility from bond price and currency adjustments will probably extend the likely trading range we experience before sustainable market gains are likely.

For our part, we continue to prefer Treasury inflation-protected securities, largely because TIPS prices now reflect the prospect of sustained deflation over the next decade, in the face of a government that is issuing enormous volumes of liabilities and has nearly doubled the balance sheet of the Federal Reserve over the past 3 months. There is little question that we will observe near-term deflation in the CPI, particularly given that oil prices have plunged to a quarter of the level we observed at the speculative peak several months ago (Malthus Schmalthus). Still, with TIPS priced to deliver real after-inflation yields of 3-4% (higher for shorter maturities, but with greater risk in the event that the CPI drops for more than a few months), the combination of growth in purchasing power and relatively low duration risk is very reasonable. Corporate yields remain high, but have far more risk. Historically, corporates have not tended to bottom far in advance of the general stock market, since they are largely driven by the same risk factors and investor perceptions. A significant shift in exposure toward corporates would be, to some extent, a “bottom call” on U.S. stocks. While it's certainly possible that the November lows were the final lows of the market's decline, we would not invest on that basis, and we certainly don't have the evidence to indicate that investors have adopted a robust and sustained preference toward market risk.

As for stocks, whether or not the November lows were the final lows, I would expect that the market will remain in a very wide trading range of about 25-35% while the economy sorts through the still considerable uncertainties of the current recession. I continue to view stocks as undervalued, but am also very aware of the tendency for valuations to overshoot as much to the downside as they often do to the upside. In the Strategic Growth Fund, we remain well-hedged against major and unexpected market losses, while managing our option hedges to allow for moderate participation in more “local” fluctuations.

For now, near-term conditions still appear relatively constructive. Investors are breathing a sigh of relief as we get some distance away from the financial panic of October and November. The short-term help extended to the auto industry last week was also helpful in removing some important uncertainties. Moreover, with 2008 soon coming to an end, there some chance of a fairly hard “short squeeze” here. My impression is that many investors and investment managers believed that it was prudent to “lighten up” on stocks as they were plunging in October and November, locking in significant losses. The only thing worse than locking in a loss in a declining market is to miss the subsequent recovery as well. That prospect, coupled with the generally lighter trading volume around the holidays, makes the market particularly amenable to a good squeeze. We don't invest on that basis, of course, and are maintaining a moderate investment stance. That stance will continue until we observe less attractive valuations, a deterioration of market internals, or both.

Market Climate

As of last week, the Market Climate for stocks was characterized by favorable valuations, moderately unfavorable market action on the basis of broad measures, but further improvement in “early” measures of market action. Essentially, stocks appear undervalued, and investors – while not evidently adopting a robust preference for taking on market risk – are at least backing away from the extreme risk aversion they had several weeks ago. The easing of risk aversion is certainly helpful, though as an economist, it still appears somewhat early to begin “looking across the valley” toward an economic recovery. Most likely, in my view, the market will continue to move within a wide trading range for several more months at least, while the ebb-and-flow of information about the economy gradually clarifies the longer-term outlook.

As I noted in April (04/14/08 – Which “Inning” of the Mortgage Crisis are We In?), I expected the second, third, and fourth quarters of 2008 to be the “heavy hitters” in terms of foreclosures, with the foreclosure rate peaking between about November 2008 and January of 2009. I continue to believe that the foreclosure rate is currently near its peak, and will ease as we move through 2009. However, I also noted that a second spike of mortgage resets will occur the third quarter of 2010, which means that the foreclosure rate (and associated loan writedowns) will most probably pick up again in the first quarter of 2011. So if the stock market does enjoy a new bull market as we move through 2009 (which is my expectation, though we'll take the evidence as it comes), my sense is that it will be one of the shorter-lived variety, much like some of the cyclical bull rallies we observe during the “secular” bear market from 1965 to 1982. That isn't to say that such an advance would be disappointing – even if the next bull market, whenever it occurs, simply peaks at the 2007 highs, stocks will have doubled from their recent lows.

As a reminder, a “secular” bear market comprises a whole series of bull-bear cycles, with the characteristic that each successive bear market tends to achieve a lower level of valuation at its trough, on the basis of P/E multiples, price/revenue multiples and so forth (even if actual prices don't break to new lows in each successive bear).

In bonds, the Market Climate last week was characterized by unusually unfavorable yield levels, and generally favorable yield pressures. As I've noted before, the return/risk profile in bonds is much more determined by by yield levels than by market action, because sustained periods of speculation in bonds are unusual. At this point, my reservations about long-term Treasury bonds here should be probably articulated as an outright warning: regardless of short-term factors, long-term Treasury bonds (nominal, not inflation-protected) face unusually steep price risk here.

For our part, the Strategic Total Return Fund continues to be invested primarily in Treasury inflation-protected securities, with about 25% of assets allocated to foreign currencies, utility stocks, and precious metals shares (where we modestly clipped our exposure further, to about 10% of Fund assets, on recent price strength).

Peace on Earth

Wishing you a Merry Christmas, and a bright, happy Hanukkah.

Form ADV: Would hedge fund registration have helped Madoff investors?

Could regulation of the hedge fund industry have prevented the Madoff fiasco? Perhaps. But likely not the specific type of regulation envisioned in the SEC’s failed attempt to regulate hedge funds back in 2006.

Ironically, Madoff’s investment advisory business “voluntarily” registered with the SEC that year. That was right around the Commission’s failed bid to have all hedge fund advisers register with it. Many other hedge funds had already done so when Phil Goldstein’s suit against the SEC eventually vacated the ruling. However, the surfeit of fund information that resulted from the registration drive provided academics with a unique chance to compare operational risk factors with more traditional investment risk factors. Stephen Brown, William Goetzmann, Bing Liang, and Christopher Schwarz did just that in this paper called “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration”. (Brown was recently asked about the topic in this AP piece on Sunday)

The abandoned plan would have seen all hedge fund managers submit a form “ADV” to the SEC containing operational information (see Madoff’s Form ADV here). According to the authors the form was designed as a “deterrence of fraud”:

“The Form ADVs for this larger sample contain a wealth of information, previously unavailable for many managers, about fund characteristics such as potential conflicts of interest and past legal and regulatory problems. Both of these relate directly to the stated purpose of the disclosure, which includes “deterrence of fraud,” “keeping unfit persons from using hedge funds to perpetrate fraud,” “adoption of compliance controls,” or more generally, the “avoidance of operational risk.”

Given the assumption that many hedge fund investors also conduct some of their own due diligence on hedge fund investments, the authors ask the following question:

“…are Form ADV filings simply redundant and expensive, or do they provide valuable, otherwise inaccessible information to participants in the market for hedge fund services, thereby helping them avoid investing in potentially fraudulent firms?”

Stamp of Approval

Last year we wondered if voluntary SEC registration for hedge funds could be misused as a “seal of approval” when marketing hedge funds. The authors of this paper wondered the same thing a year earlier and hypothesized that voluntary registration could be framed as a “signal of quality”…

“…we find evidence that the information in the form has the potential to add value to the investor decision-making process. Hedge funds operated by managers filing Form ADV in 2006 had better past performance and had more assets than those operated by managers who did not file either because they were technically exempt from the filing requirement, or because they simply chose not to file. This result suggests that filing alone may be a potential signal of quality.

Time’s Justin Fox recently expounded on the moral hazard created by the registration of Madoff’s funds and related brokerage:

“…regulation of such investment funds ‘communicates confidence in a product that is riskier than normal investors should get involved in,’ as then Treasury undersecretary Robert Steel put it at a conference on hedge fund regulation last year.”

“For some investors and fund-of-funds managers, the regulatory imprimatur that the SEC gave Madoff’s brokerage may have communicated confidence in the investment products he sold on the side.”

Potential Conflicts of Interest

According to Brown, Goetzmann, Liang and Schwarz, Form ADV was meant to reveal potential conflicts of interest…

“A number of variables relating to potential conflicts of interest are required by Form ADV. In particular, the form asks whether any employee or entity controlled by the firm is affiliated with another type of financial institution such as a broker-dealer, mutual fund, or limited partnership. It asks about participation in clients’ transactions, including proprietary interest in transactions, sales interest in transactions, brokerage discretion, and custody of client assets. In each of these cases, the potential exists for the manager to influence client decisions, or make decisions on the client’s behalf that benefit the manager at the expense of the client.”

In “Five Ways to Avoid a Ponzi Scheme: Madoff Edition“, U.S. News & World Report recommends that investors “dig deep” by looking at Form ADV. Unfortunately, Madoff’s ADV clearly states that it is affiliates with a broker-dealer. This was a well known fact among many investors who also performed their own due diligence and it did not on its own disqualify their allocation of capital to the fund. Many of the investors who chose to invest in the fund were also aware of this fact. The extent to which the Form ADV was, in fact, instrumental in revealing this information remains a big question mark.

“Problem Funds”

Brown et al divide the roughly 2000 hedge fund ADV forms studied into “non-problem” funds (funds answering “no” to at least one regulatory infraction Section 11) and “problem” funds (funds that answered “yes” at least once - no matter how minor). Approximately 15% of hedge funds were tagged as “problem” funds - about the same percentage as the number of “problem” advisers overall (hedge and traditional).

Interestingly, the “problem” funds had a lower leverage, volatility and return than the “non-problem” funds. As the chart from the paper below shows, problem funds were also slightly bigger and older, and had slightly lower incentive fees and lock-up periods.

Madoff would have been tagged as a “problem fund” by this methodology due to a minor 2005 NASD violation detailed on the ADV. In keeping with other “problem” funds, Madoff was also relatively old and large, and had lower incentive fees (0%).

The study goes on to show that “problem funds” have much higher “external conflicting relationships” - 73% of problem funds are affiliated with a broker dealer, vs. only 24% of “non-problem” funds. (This may not come as a huge surprise given the fact that increased business complexity leads to greater probability of operational infractions.)

To test whether Form ADV is actually redundant, the authors of this examine whether “problem” funds have trouble raising capital. If “problem” funds had trouble raising capital, that might suggest that investors were generally already aware of the fund’s previous infractions or its potential conflicts of interest.

Surprisingly, it turns out that “problem” funds did not actually have trouble raising capital. While this may suggest that investors must have been unaware of the information revealed by Form ADV, it could also just reflect the fact that a fund-raising handicap was off-set by the marketing benefits of being bigger, older, less leveraged, and less volatile.

Prophetically, on February 1, 2006, the day the (late) SEC hedge fund registration rule came into effect, CNNMoney.com noted:

“Opponents also question whether SEC registration will help protect investors against fraudulent managers, especially since some of the SEC’s hedge fund enforcement actions were levied at firms that were already registered with the SEC.”

In the end, Form ADV may indeed have contained information that was material to investors’ decisions on Madoff. But it remains far from clear that Form ADV was, in fact, a critical source for that information or whether it was simply restating what was already known to investors.

PBGC hires 3 firms to run $2.5 billion

By Doug Halonen

Source: Pensions & Investments
Date: December 22, 2008

The PBGC committed $2.5 billion to three investment firms to serve as strategic partners and invest in private equity and real estate, said Charles E.F. Millard, director.

Separate commitments of $900 million each were made to BlackRock and JPMorgan and $700 million was given to Goldman Sachs Asset Management, said PBGC spokesman Jeffrey Speicher. He would not say how much each firm would run in private equity or real estate.

Mr. Millard said in an interview that the firms are providing the Pension Benefit Guaranty Corp. with advice on risk management, consolidated reporting and education of investment PBGC staff. “We’ve got all three firms meeting in the same room, giving us their best advice,” Mr. Millard said.

The PBGC received 16 applications in response to an RFP issued July 31, Mr. Millard said. The search followed an asset allocation policy adopted in February that permits the agency to invest up to 10% of the $55 billion it has available for investment in private equity and real estate for the first time.

The new asset allocation is designed to help close the PBGC’s $14 billion deficit over the next 10 to 20 years. Under the new policy, 45% of assets will be in equities, 45% in fixed income and 10% in alternatives. Previously, 75% to 85% was in fixed income in a strategy designed to better match assets with liabilities. The remainder of the portfolio was invested in stocks.

Goldman’s d-e-e-e-e-p look at Madoff

Did due diligence before Tremont sale

Banned Madoff “more than a decade ago”


Investigators looking into Bernard L. Madoff Investment Services LLC should probably drop off a subpoena at 85 Broad. Goldman Sachs — representing MassMutual subsidiary OppenheimerFunds in its 2001 purchase of Tremont Advisers Inc — was part of a due diligence team which, according to a source familiar with the situation, spent three days in Madoff’s offices in mid-2001.

The investment bank was accompanied by representatives of Weil, Gotshal & Manges, OppenheimerFunds’ counsel, and OppenheimerFunds. Then Tremont president and co-chief executive officer Robert Schulman, Tremont’s lead liaison with Madoff, was also present for the review.

The Madoff relationship accounted for roughly 40 per cent of Tremont’s revenues at the time, making it a crucial part of the transaction. Virtually all of Tremont’s $1.5 billion in customer assets were invested in the Rye Select Broad Market fund, a Madoff feeder, and it also had a fee-sharing arrangement with London-based Kingate Global, another leading Madoff feeder. The balance of Tremont’s assets were in institutional alternative investment consulting arrangements that paid no more than 50 bps, and in most cases a lot less.

OppenheimerFunds paid $19 a share for Tremont, valuing the company at around $145 million, in a deal announced Jul. 10 2001. The rich valuation — more than 12-times EBITDA, and 5.5-times asset management fees, at the top end of then current prices in comparable transactions according to the proxy — was largely driven by OppenheimerFunds’ enthusiasm for the perceived strategic benefits of entering the fund of hedge funds market. The sale closed Oct. 1 2001.

(Tremont last week said that clients had $3.1 billion, or 53 per cent of its total $5.8 billion in client assets, in Madoff exposure through its various Broad Market products; Kingate Global reportedly had $2.8 billion with Madoff. Maxam Investment Management, the latest venture of former Tremont chairman and co-chief executive Sandra Manzke, had $280 million with Madoff.)

Apart from verifying Madoff’s performance, the pre-acquisition review probably addressed two other issues: the scalability of Madoff’s purported split-strike investment strategy, and the concern that at least some of Madoff’s purported returns may have came from gaming information culled from his brokerage order flow.

“Even if whatever he was doing was not illegal by the strict letter of the law, there was the chance that the brokers he was paying for order flow might send their business elsewhere, and that would be the end of his information advantage,” the source said.

The fact that the notoriously secretive Madoff even allowed OppenheimerFunds’ advisors on the premises, and that the Tremont transaction subsequently went forward, “lends credence to the theory that strategy was substantially what it was purported to be up until at least 2001. It was another reason why Tremont and Oppenheimer were comfortable with Madoff being a big part of revenues after the deal,” according to the source.

The alternative explanation is that it was just another missed chance to uncover the fraud, especially given that Goldman Sachs’ equity derivatives, prime brokerage and asset management units had severe reservations about Madoff. Among them:

Whistle-blower Harry Markopolos told the SEC that “a managing director at Goldman Sachs prime brokerage operation told me that his firm doubts Bernie Madoff is legitimate so they don’t deal with him.

Markopolos also named Joanne Hill PhD, “vice-president and global head of equity derivatives research” at Goldman Sachs among three equity derivatives professionals who could provide insights into the math behind their belief “that the split-strike conversion strategy that BM runs is an outright fraud and cannot possibly achieve 12% annual returns with only 7 down months during a 14½ year time period.”

It’s unclear from the Markopolos report just when his sources expressed those reservations, but at least some date to well before Goldman Sachs was involved in the Madoff due diligence review. According to The Daily Telegraph, London, yesterday:

More than a decade ago bankers from Goldman Sachs’ asset management division were despatched to Bernard Madoff Investment Securities to discover how the legendary fund manager maintained such consistently good returns...

...One former Goldman partner said: “I remember the guys came back baffled. Madoff refused to let them do any due diligence on the funds and when they asked about the firm’s investment strategy they couldn’t understand it. Goldman not only black-listed Madoff in the asset management division but banned the brokering side from trading with the firm too.”

Forget what they missed, or didn’t miss, at Madoff. Seems like someone forgot to check the restricted lists.

Sunday, December 21, 2008

Madoff: As Consistent a Golfer as He Was an Investor

They say you can tell a lot about a businessman from his golf game. Perhaps golf partners should have paid more attention to Bernard Madoff’s handicap.

CNBC found records of Mr. Madoff’s golf scores from the Golf Handicap and Information Network. Between 1998 and 2000 Mr. Madoff registered 20 scores from games played at the Palm Beach Country Club, Atlantic Golf Club and Fresh Meadow Country Club. The score report is below.

INSERT DESCRIPTIONScreen grab from ghin.com.

Note how eerily consistent he was, even after not playing for an entire year from 1999 to 2000. The CNBC reporter Darren Rovell notes that Mr. Madoff’s handicap was a 12 — which is about the same return Mr. Madoff guaranteed investors.

Does this mean he cheated in these games? Not necessarily; perhaps he just didn’t report his less impressive scores to the association. Which also might not be entirely out of character, I suppose.

Saturday, December 20, 2008

How to Play a 'Take-No-Prisoners' Market Rob Arnott, Founder and Chairman, Research Affiliates


AN INTERVIEW WITH ROB ARNOTT: Given the abundance of low-hanging fruit, it's a mistake to stick with things that will soon go out of style, such as Treasuries. Promising areas: emerging-markets and convertible debt.

ROB ARNOTT, FOUNDER AND CHAIRMAN OF ASSET MANAGER Research Affiliates in Newport Beach, Calif., is one of the big thinkers in finance today.

A former editor of the prestigious Financial Analysts Journal, Arnott, 54, has developed expertise in asset allocation, indexing, and pension funds, among other topics. He's a fierce proponent of fundamental indexing -- in which metrics such as aggregate sales and cash flow are used to weight companies in an index, as opposed to market capitalization.

With the markets in tatters, Barron's turned last week to Arnott, who in a wide-ranging conversation had plenty to say about fundamental indexing and many other subjects. "This is not a time to shy away from taking risks," says Arnott, who maintains that the market's upheaval has created great investment opportunities, including value stocks and convertible bonds. "The markets are priced right now to reward risk-bearing more than any time in many, many years," he says. Hence, he sees Treasuries, which had a relatively strong '08, as the worst place to put money next year.

Ian White for Barron's
"A year from now, investors in convertible bonds are likely to be very pleased with what they see in terms of prices and yields." – Rob Arnott

While the fundamental index Arnott uses smartly outran the Standard & Poor's 500 from 2000 to 2006, it underperformed the S&P in '07 by three percentage points and is behind in '08, as value stocks got shellacked. Yet Arnott's faith in the approach remains unshaken. To find out why, please read on:

Barron's: What are your thoughts on this year's dismal market?

What we've seen is the consequence of reckless indebtedness. Subprime was the tip of the iceberg. I found it interesting that folks in government were dismissive of subprime as being not a terribly important issue as recently as late 2007 and even early this year. There's been this pattern of aggregate indebtedness at the corporate level, at the household level and at the government level. It's dismissive of the need to pay things back. As a result, when things started to go sour on some of this debt, beginning with subprime, the cascading effect was beyond what most people could have anticipated. I was a bear coming into this credit crunch, and I actually was labeled a perma-bear. And yet this contagion effect went a lot further than I would have predicted, and there are very few observers who expected anything this severe. But the seeds of it were sown quite aggressively over the last decade.

How did all of that fall into place?

The indebtedness of the United States rose from five times [gross domestic product] to eight times GDP in 10 years. That is reckless, but that's what has been going on. That sowed the seeds for what we have seen. The deleveraging that has taken place has cascading effects that can come from a lot of different directions and can afflict a lot of different markets.

What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally in November, we saw the beginnings of a rationalization where some markets did begin to recover -- but some markets had been hit beyond any rational valuation of the risks associated with those assets.

What should investors be doing differently in the wake of this huge market downturn?

As shown by the collapse of Bernard Madoff's firm, investors should act with due diligence -- that is, they should be more alert to the risks. We have had a cult of equities develop over the last 20 years in which equities were seen more as the low-risk asset, even the risk-fee asset for those who had a long-term orientation, and that is foolishness. If you are bearing risk, you should get paid for it. If you are picking up nickels in front of a steamroller, trying to identify opportunities to add one-tenth of a percent to your return by taking risks that could cost a 100 times that, that doesn't make sense. People need to be more disciplined about that. That includes individuals, corporations, and banks.

In light of what's happened this year, what's the best way to approach asset allocation?

Almost everybody, retail investors and institutional investors alike, invests with their eyes in the rearview mirror, favoring what has worked best in the past. But there is a very powerful pattern of mean-reversion in the markets. What has done spectacularly well often takes a rest or it takes a bear market to get back to normal. So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors. That goes for your readers, and it goes nearly as much for highly sophisticated institutional investors. This temptation to buy what has done well is the single greatest pitfall in investing, and it is the single reason that a disciplined approach to asset allocation can actually work very, very well.

What's an example of a promising area hit hard?

The average convertible-arbitrage hedge fund was down about 50% year-to-date at the end of last week. But that result for a long-short absolute-return, fully hedged strategy makes no sense. The temptation is to get out, which is what a lot of investors are doing. The other way to look at it is that the forced liquidations of these hedge-fund positions create new opportunities, namely convertible debt priced at extraordinarily attractive yields. The same thing holds true for emerging market stocks and bonds, along with TIPS [Treasury inflation-protected securities].

A year ago, folks were probably getting tired of hearing me say there is no low-hanging fruit and that there are no attractively priced markets, both relative to other markets and relative to their own history. I also was saying not to expect double-digit returns and to take risk off the table.

What's your view now?

It's pretty much the opposite; this is the richest environment of low-hanging fruit I've seen in my career. And you would have to go back to 1973, 1974 or even, in some markets, to the Great Depression to find markets priced as attractively as now. This is not a time to be hunkering down in the safety and comfort of the Treasury curve. There are tremendous opportunities right now. It is so tempting in a bear market to focus on the glass being half-empty and on how much has been lost. But the glass being half full side is largely ignored.

What kind of an asset-allocation mix makes sense to you?

First of all, most investors think that putting some money in growth stocks, some money in value stocks and some money in international stocks is a well-diversified portfolio. It's not. Diversification means taking on risk in markets that are uncorrelated and that can go up when other markets go down. So a well-diversified portfolio should look at multiple sources of risk, not just in stocks.

Where do you see opportunities?

A year from now, investors in convertible bonds are likely to be very pleased with what they [see] in terms of prices and yields. The same holds for emerging-market debt denominated in the local currency, which I prefer to dollar-denominated debt. You get a premium yield for emerging-market debt and an additional premium for investing in the local currency. Tacitly, that's a dollar bet, but I don't see how the dollar can do well on a long-term basis when we have indebtedness that is eight times our national income. Imagine an individual going to a bank and saying, "I owe eight times my income and I would like to borrow more." The reaction would be immediate and drastic: "Give us your credit cards; we will slice them up." But as a nation we still have our credit cards, and we are still using them aggressively.

What other kinds of investments look good to you in terms of asset allocation?

I also like TIPS. How can we get out of this current mess without renewed inflation? A lot of folks are deeply concerned about the risk of deflation. The temptation is to look at history, especially the Great Depression, which was a deflationary depression and which started with very, very low national indebtedness. If you have very little debt and you have a depression, it is likely to be deflationary. If you have very high debt and you have a depression, it is likely to be massively inflationary. The contrast with Germany in the 1920s is noteworthy; they had massive indebtedness and hyperinflation. I'm not suggesting a risk of hyperinflation. But I am suggesting that people are too glib about tossing aside the risk of inflation, which was front and center less than six months ago for most investors.

What's your sense of opportunities in value stocks versus growth stocks?

When you look at price-to-book values, the spread between growth stocks and value stocks was at its narrowest ever, just two years ago; now, it's the widest spread ever with the sole exception of the bubble year, in 2000, and we saw what happened after that: seven years in which value drastically and reliably outperformed growth. We could see something similar [now], whereby value sharply outperforms growth. The value side of the market, like much of the bond market, is priced for a depression. The growth side of the market is priced for recession.

You are a big believer in fundamental indexing, in which metrics such as dividends and book values are used to determine a stock's weighting. That's in contrast to weighting an index by market capitalization, such as the S&P 500. The FTSE RAFI 1000 Index, which takes a fundamental approach, trailed the S&P 500 this year by about three percentage points, as of Dec. 16 -- although it has outperformed over longer time horizons. What caused that underperformance this year?

It's due entirely to value [stocks] getting shellacked. The capitalization-weighted indexes put more money into companies if they are trading at high-valuation multiples. So, cap-weighting systematically puts most of your money in growth companies, while a fundamental index has a value tilt relative to the market. Value was savaged in '07 and '08. So the fundamental index underperformed surprisingly modestly.

In contrast, the FTSE RAFI All World 3000 was down 39.46% year-to-date as of Dec. 16, more than 200 basis points ahead of the MSCI All Country World Index. And it outperformed last year as well. So [fundamental indexing] has won worldwide in extremely difficult markets. It has not won in the U.S. in '07 and '08, but the shortfalls are pretty mild -- considering how severe things have been on the value side of the market.

You've said that investors can't bank on equities returning 10% every year, on average. What's a realistic target?

The yield for U.S. stocks is around 3.5%. Historically, earnings and dividends have grown about 4.5% per annum. So if you have 4.5% growth and a 3.5% yield, that's an 8% return. I'm sure your readers would love to hear a forecast of double-digit returns, especially given the biggest bear market since the 1930s. However, our starting point was from valuation levels that were so very rich that we are now merely back to levels that could provide long-term returns of around 8% from current levels. There are segments of the bond market where we can almost assuredly do better.

You don't sound like you are sold on stocks, Rob, even after this huge selloff.

The problem I have with stocks -- and it is a very simple problem -- is that while stocks are nicely priced, they aren't attractively priced relative to their own bonds. The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.

Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return? The stocks will, if they show earnings and dividend growth faster than 6% -- but historically that's a stretch. So the bonds have been savaged worse than the stocks have, and actually represent the most interesting opportunity.

So you are talking about investment-grade bonds?

Yes, investment-grade bonds. But for bonds below investment grade, the spreads are quite extraordinary. By the end of November, spreads had widened out to nearly 20 percentage points above Treasuries and also above the corresponding stock yields. Suppose 40% of those bonds go bust next year. And suppose that you get 50 cents on the dollar back on the bonds that go bust. By that point, you have lost your spread of 20 percentage points.

But such a scenario has to happen every year, until the high-yield bonds mature, in order to merely match Treasury returns. A 40% default rate every year for several years would be truly without precedent. So I view 2009 as an "ABT" year -- Anything but Treasuries. The less you hold in Treasuries, the better you are likely to do.

Has the market bottomed out?

There is a slightly better than 50-50 chance that we see another leg down in the stock market. That's because the deleveraging in the economy is only partly under way, and there is a lot more of it to come. The mass liquidation of hedge funds is not done. As for the economy, I'm expecting 2009 to be a bit worse than people expect. I see the housing market turning in late 2010 or early 2011, definitely not next year. It would surprise me quite a bit, however, if the risky categories of bonds take another significant leg down.

It's been a tough time for indexing, given that so many index returns are negative this year. What kind of an impact will this down-market have on indexing?

People put money into index funds partly because indexes beat most active managers. Nothing is going to change that because, collectively, active managers hold essentially the same assets as the indexes. So collectively, their returns have to be the same, minus costs, which are larger. As a result, indexes will continue to win on a long-term basis. When they underperform, they tend to underperform by less than they win when they outperform. All of this means that demand for indexing is not going away, and it will continue to be a major source of growth among institutional and retail investors. We will see more index offerings so that people can choose different kinds of indexing, such as fundamental weighting.

What's ahead for hedge funds?

There are a lot of good hedge funds out there. But the situation regarding Bernard Madoff's firm illustrates that hedge funds have very little transparency and that their customers don't demand transparency.

I think the aftermath of this will be that some form of regulation in the hedge-fund world is coming. The more the industry embraces and tries to steer that dialogue, the less displeased they will be with the outcome. Still, a lot of investors have had multiple wake-up calls this year about the need to ask more questions and the need for basic due diligence. Too much of the hedge-fund community, however, is still a wealth-transfer vehicle from client to manager. We will continue to see substantial liquidations, which will continue to exacerbate the deleveraging problems we have right now.

Could you elaborate on your point about hedge funds being a wealth-transfer vehicle?

If a hedge fund charges a 2% management fee plus 20% of the gains, that is the classic fee structure. If a hedge fund is extraordinarily good, it is worth the cost. But the fees don't make the manager good; it is the other way around -- it's the skill of the manager that justifies the fees. A lot folks go into these funds thinking, "Well, if these guys can charge 2% plus 20%, it must be good." And some of these funds are good. There are 10,000 hedge funds out there, and maybe 500 of them are good. But 400 of those funds are closed. So finding the 100 that are open and good in a universe of 10,000 managers is highly implausible.

Thanks, Rob.

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.