Friday, March 26, 2010

Asset Allocation: Investing's Only Free Lunch

Along with fees, asset allocation has the greatest influence on the returns of your investment portfolio.

While everyone dreams about getting rich by buying the next hot-tech stock or jumping into a booming foreign market, successful stock-picking and market-timing are extremely difficult for even the savviest professional investor. For the do-it-yourself investor who can't spend every waking hour crunching numbers and studying the market, it is all but impossible. For those investors, it should be a comfort to know the long-run returns on your investment portfolio depend more on other factors in your control. After the impact of fees, asset allocation is the greatest factor influencing your investment portfolio's returns, and it is a relatively simple concept to put into practice with the use of exchange-traded funds.

The main idea behind asset allocation is that over any timeframe some asset classes will go down while others will go up, but no one knows in advance which will do what. The trick is not to try and guess where to put your money, but to spread out your portfolio to gain exposure to any bull markets and avoid the full brunt of a bear market. This asset diversification minimizes the risk of large losses while not giving up much in expected long-term return. Psychologically, sticking to a well-defined asset allocation will help you to avoid selling out after a large loss, which is probably the worst move an investor can make. Just ask anyone who exited the equity markets at the end of 2008 and completely missed 2009's big rally.

Asset allocation can even explain why some funds do well and others don't. Numerous academic studies show that asset allocation explains a significant percentage of the variation of returns across funds, including Morningstar Ibbotson's own 2000 study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" While we don't want to get into the nitty-gritty behind these studies, if we accept the premise that active management adds little value that investors can't get themselves through prudent asset allocation, then ETFs become a great investment vehicle for do-it-yourself investors.

The special strength of asset allocation comes from rebalancing (redistributing assets from overheated asset classes to those that are out of favor, which can increase returns while minimizing risks in your portfolio). We can demonstrate the incredible power of diversification and rebalancing by creating a simple example of a hypothetical portfolio using four major asset classes: three regional stock indexes and global bonds. To represent a broad array of stocks we use the S&P 500 Total Return Index for large-cap U.S. companies, the STOXX 50 Total Return Index for large-cap European companies, and the MSCI Emerging Markets Gross Return Index for large-cap emerging-markets equities. For bonds, we use the Barclays Capital Intermediate Global Total Return Index. Investors can access all these indexes by choosing from multiple ETFs.

We used a 22-year timeframe for our hypothetical portfolio, starting from the beginning of 1988 and ended February 2010. This period is a good sample because it included both bull and bear markets, allowing the power of diversification to really shine through. The best-performing index over this timeframe was the MSCI Emerging Markets Index, with a 13.5% annualized return, which was aided by the U.S. dollar's relative weakness over the last decade. Unsurprisingly for such a long time period, the bond index was, with a 6.7% annualized return, the worst performer among our examples.

Now let's create our two hypothetical portfolios with an initial investment in 1988 spread equally among these four indexes. A properly balanced portfolio wouldn't blindly divide equally among these four asset classes, especially as it produces an aggressive, stock-heavy portfolio with large emerging-markets exposure, but for illustrative purposes, this hypothetical portfolio will work beautifully. After investing two portfolios equally in each of the four indexes, we will have the first portfolio be strictly buy-and-hold, while the second one will annually rebalance to return the portfolio to its initial mix.

After 22 years have passed, the buy-and-hold portfolio would have increased an investor's wealth by 10.4% annually, a better result than three out of the four indexes. While there was little to gain by rebalancing through the 1990s, eventually it proved to be a wise move as the second portfolio ended up with an annualized return of 11.1%. While this doesn't sound like a large difference, keep in mind that the extra 70 basis points of performance compounded over 22 years increased our hypothetical portfolio by more than 100% of the initial investment! When you're compounding returns, every extra little bit counts.

While a straight investment in the MSCI Emerging Market Index would have provided a greater return than either of our diversified portfolios, an investor shouldn't ignore risk in evaluating investment opportunities. Using standard deviation of returns as a proxy for risk, our buy-and-hold portfolio was much less volatile than the MSCI Emerging Markets Index, and our rebalanced portfolio was a steadier ride than any of the three all-stock indexes or our pure buy-and-hold portfolio. On a risk-adjusted basis, a strict asset-allocation strategy with regular rebalancing is hard to beat.

Of course, not many people invest a large chunk of cash at one time without ever adding to it. To reflect additional savings as people add to their portfolio, we created two more hypothetical portfolios, which included monthly contributions of 1% of the initial investment. Once again, we created a buy-and-hold portfolio, as well as a portfolio that annually reallocated equally among our four indexes. Just as in our last example, investors who rebalanced regularly would have been pleased with that decision, as both returns and risk were superior to the buy-and-hold strategy.

Obviously, both of our examples were simplified; we ignored the effects of transaction costs, taxes, and other important considerations. Counting the costs of buying new ETF stakes would not have weighed on the rebalancing strategy sufficiently to make the pure buy-and-hold portfolio superior but would have substantial effects on the cost efficiency of monthly new investments. Still, we believe the evidence is clear that over a long-term horizon, asset allocation, including a regular rebalancing program, is a powerful tactic for investors.

So if you've accepted the arguments in favor of asset allocation, how do you go about optimizing your portfolio? Morningstar has several tools available to help in making asset-allocation decisions, ranging from's Instant X-Ray tool to Morningstar EnCorr for institutional users. In addition, consider using ETFs in forming your portfolio as there are multiple options available for all of the major asset classes, including fixed income, equities, cash, commodities, real estate, and foreign currencies.

There is no "right" answer when it comes to asset allocation, as it can vary greatly depending on an investor's own circumstances. Age, risk tolerance, other sources of income, and other factors need to be accounted for. The most important point to keep in mind is that investors need to set realistic financial goals, create a plan to meet them, and then stick to that plan through the ups and downs of the market.

When is diversification important?

There has been some minor buzz in the blogosphere over a studyshowing that the benefits of international equity diversification are falling (see comments from Paul Kedrosky and FT Alphaville). Moreover, I recently had a discussion with another investment professional about issues surrounding portfolio construction and diversification. His comment to me was a textbook one: “I would rather try and get… reduction in volatility through more diversification.”

Diversification when you need it the most
To someone as simple-minded as me, diversification during "normal" periods is nice and the higher correlations exhibited by global stock markets is a minor concern, but the most valuable form of diversification occurs during panics and crisis episodes - when virtually all asset classes go down. That's when you want something in your portfolio to save you.

Consider example of the crisis in 2008. During that and other periods of financial stress, the correlations of seemingly uncorrelated asset classes tend to converge to 1. Balanced fund portfolios, which were advertised as to be sufficiently diversified to withstand these kinds of shocks, were down 20-30%.

Max Darnell of First Quadrant addressed this diversification problem by explaining that you have to take a bet somewhere. Even though you may be diversifying your asset betas across asset classes, the fact that you are taking on beta generally means that you are making a bet on risk [emphasis mine]:

In short, diversification is not intended to be a tool for risk avoidance. Rather, it is meant to be used as though it were an acid that dissolves away impurities, i.e., uncompensated risk, leaving a pure risk that is more desirable principally because we are rewarded for holding it. The remaining risk will be risky. Otherwise, we wouldn’t be compensated for it.

Correlation isn’t causality
I wrote before that you shouldn’t confuse correlation with causality. Standard MPT style correlation analysis of asset returns are based on statistical correlations. Statistical correlations will tend to move around. Most critical to downside risk protection, don’t expect statistical correlations to hold up in accordance with historical experience during periods of extreme global volatility.

I prefer to look for diversification more analytically. For example, hard assets tend to perform well during periods of rising inflationary expectations, but default-free fixed income assets such as government bonds will perform poorly. Conversely, we can expect that during a credit crisis, which is associated with heightened default risk, prices of default-free government bonds with good credit will rise, while hard asset prices would be under pressure.

Alpha from beta?
Supposing you had a model that could identify macro-economic regimes, then a strategy of buying hard assets during periods of inflation; default-free assets during periods of deflation; and equities during periods of benign macro-economic risk would make good sense.

That would be creating alpha from diversification beta

Wednesday, March 17, 2010

What exactly is a “sophisticated” investor anyway?

One of the most overused words in hedge fund sales is “sophisticated.” If we had a nickel for every time a hedge fund marketing sheet proclaimed that a fund was for “sophisticated investors,” we’d be running a hedge fund for, well, sophisticated investors.

But what exactly does it mean to be sophisticated? This is a question addressed by Jan de Dreu of RBS and Jacob Bikker of De Nederlandsche Bank in a study of Dutch pension plans. The duo bases its analysis on the fair assumption that “sophisticated” means “not succumbing to behavioural finance biases.” While many studies have examined behavioural biases in individual in private investors, they write, “much less is known about professional parties.”

They focus their attention on three cues of (the lack of) sophistication:

  • “Gross Investment Rounding” (i.e. choosing asset allocation percentages that end in 5% or 10%)
  • “Lack of Diversification” (basically, the lack of idiosyncratic risk such as that found in alternative investments)
  • “Home Bias” (the tendency to invest close to home, where opportunities are more familiar)

They also examine overall risk as a sign of sophistication, but purposely avoid overall returns since they are beyond the direct control of investment professionals.

Totally “Gross”

Institutional investors such as pension funds tend to use traditional “60/40″ or “70/30″ splits between equities and fixed income. While the average numbers across all investors tend to shift slightly each year (see related post), many institutions stick stubbornly to simple proportions like these – ones that end in a zero or a five.

But modern portfolio theory dictates that optimal allocations to various asset classes can and should be dynamic and are rarely nice even numbers like these. (Although, like a broken clock, we suppose that a “60/40″ allocation is correct on the odd occasion).

Consultants and hedge fund sales people know all too well the inertia they face when they argue that optimizers recommend that alternative asset allocations should comprise 40, 50 or even 100% of a client’s portfolio. Instead of adopting the “optimal” solution, investment committees will often default to something more plausible – say, 10%. In a sense, they are effectively adding a “career-risk” variable to the optimization. (After all, idiosyncratic risk has a much greater influence over career than systematic risk).

When they examined nearly 750 Dutch pension funds, they found that the vast majority had policy allocations to equities that ended in multiples of five. In fact, there even seemed to be a tendency for policy allocations to end in “0″, instead of “5″.

Rather than optimally dividing the remainder of the portfolio between bonds and other assets (alternatives, cash etc.), even the bond allocation percentages seemed pretty engineered…

You don’t need to be a finance Ph.D. to see that such allocations look pretty fishy – suggesting that they were created by humans, rather than portfolio optimizers.

But de Dreu and Bikker also point out something else in these charts: that there is very little agreement on the appropriate allocation to equities and bonds. “60/40″ is by no means the standard allocation.

When they dove into these results further, they found that large (“sophisticated”) funds tended not to use multiples of 5% as much as their smaller counterparts. (chart below created using data in the paper)

One might expect that larger investors might have a lower propensity to use “gross rounding”. But we were struck by the gradual increase in the gross rounding over time of the largest institutions. Are they becoming less sophisticated? And did the small and medium-sized institutions become more sophisticated between 2004 and 2006?

Who knows. But here’s a theory: After taking a bath in the equity market, small and medium-sized plans called in the consultants to conduct ALM studies…

Alternative Reality

Okay, so it’s a bit self-referential for us to argue that the use of alternative investments signals “sophistication” and then say that alternative investments tend to attract “sophisticated investors”. But in any event, de Dreu and Bikker confirm the intuition that large investors tend to hold more alternative investments than small ones. (chart below created with data from paper).

As you might also guess, funds that did not use gross rounding for policy allocations were twice as likely to use alternative investments. (We wondered if this is because of greater sophistication or simply because the introduction of a third asset class – alternative investments – simply forces investment committees to tweak their existing gross roundings.)

Home Sweet Home

Finally, de Dreu and Bikker examine whether small or unsophisticated funds tend to invest a higher proportion of their portfolios in Europe.

As you might guess due to their relative lack of investment manpower, smaller funds do indeed invest more in Europe. But the duo also finds that nearly half of funds that use gross rounding (allocations ending in multiples of 5%), invest in the EMU. This compares to only about a third of funds that do not use gross rounding – suggesting that “sophisticated” pension funds tend to invest more outside of Europe that their less sophisticated brethren.

The paper includes several other notable observations about the behaviour of different types of and sizes of pension funds. Assuming the Dutch aren’t all that different from the rest of us, these results should help explain a lot of the frustration faced by consultants and hedge fund sales people as they try to make the case for alternative investments.

Global macro trend is your friend, alternative investors say

The hedge fund industry did not wither and die during the 2008 market collapse and great liquidity crunch. Despite calls to the contrary, there are still thousands of hedge funds and funds of hedge funds out there, focused on producing decent returns in ways that other types of investment managers simply cannot.

Which brings us to a bit of good news about the state of the hedge fund industry: Investors were already putting money back into both hedge funds and funds of hedge funds in the final quarter of 2009, according to to the latest quarterly survey by Brighton House Associates, released earlier this month. The even better news for hedge fund industry participants: They were putting money into strategies that they felt would be good long-term bets rather than just a way to recover their 2008 losses.

The report, which surveys more than 1300 alternative investment managers every quarter, has become a useful snapshot of what investors are thinking and where their intentions lie in terms of alternative investment allocations. And the latest report was certainly no let-down.

According to the results global macro and commodities were among the top strategy picks of investors in the final three months of last year – a sign that investors are looking for hedge fund managers focused on trends related to the global economic recovery – and not just any recovery. (see chart highlighting investor strategy interests below.)

Source: Brighton House Associates

Funds taking advantage of opportunities in the secondaries space were also of interest to investors, according to the survey results, as were funds of hedge of funds, which after suffering from additional outflows through the first half of last year finally began to level off and recover. Of those investors interested in funds of hedge funds, the family office set proved the most keen -a reflection of the sobering post-crisis reality that trying to build a portfolio of managers and strategies on your own is not only difficult and costly but also potentially hazardous.

Source: Brighton House Associates

Real estate funds also benefited from a fourth-quarter market rebound, especially in the US and Europe where investors were interested in sourcing fund opportunities in commercial real estate, according to the survey. Interest in CTA / managed futures funds of funds also gained traction, thanks in large part to rising prices for gold and other commodities. Investors even expressed interest in private equity funds, particularly those focused on buyout opportunities.

Source: Brighton House Associates

And in all the talk about increased investor interest, rising inflows and diversification into various alternatives strategies, the bad news?

There isn’t any, according to the report.

“Early indications for 2010 are that the loosening of credit is finally beginning to have a significant impact on the alternative investment community as capital is beginning to flow back into the industry following the redemptions sparked by the crisis in 2008.”

Let’s all hope so.

What up with the Hedge Funds of Funds Index last year? Theories abound.

Academics and researchers who study the hedge fund industry sometimes say that the best way to gauge the average performance of hedge funds is to look at an index of funds of funds (FoFs), not an index of hedge funds themselves. The funds of funds, the argument goes, contain many funds that do not report to any databases – and would therefore be missed by indexes of single hedge funds. In addition, an index of funds of funds is more diversified and is therefore a better representation of so-called “hedge fund beta.”

The HFRI Composite routinely shellacked the FoF Index in the 1990s. But since the turn of the century, the FoF index has generally exhibited performance that resembled the broader indexes – with lower volatility…

HFRI Fund of Funds Correlation 2b

While it may not look like it due to the absolute performance disparity between the two indexes, the FoF Index actually has a high correlation to the Composite Index…

HFRI Fund of Funds Correlation cYou can see this tight relationship in spades if you simply multiple each FoF Index monthly return by 1.4…

HFRI Fund of Funds Correlation 3b

So in a sense, the HFRI FoF is a deleveraged version of the Composite Index. Or, put another way: a portfolio containing roughly 66% Composite Index and 33% cash.

This tight relationship held up until last year when the HFRI FoF underperformed the HFRI Composite Index by a whopping 8.5%, even higher than 2003’s 7.9% under-performance (note that 2003, like 2009, was another barn-burner for the Composite Index.)

So what happened? Theories abound. Author and industry commentator Cathleen Rittereiser recently told Dow Jones:

“Arguably, funds of funds, could and should have reinvested their cash in hedge funds a lot earlier, especially if anecdotes are true that every fund in creation was open.”

Rittereiser is reflecting a common view of last year’s FoF under-performance – that funds of funds were sitting on mattresses full of cash they hoarded in case of massive withdrawals. This cash cushion apparently came back to haunt them.

A new study from Fitch Ratings backs up this hypothesis. The following chart from the firm’s recent Q1, 2010 Quarterly Hedge Fund Report shows that funds of funds actually performed in line with single hedge funds on a risk-adjusted basis. (If you draw a Capital Market Line between the HFRI Composite (green triangle) and, say, a 2% risk free rate, the FoF index isn’t really that far below it). (Click to enlarge chart)

funds of funds 1sm

Some say it wasn’t the mattresses full of cash that were the problems for FoFs, it was their return-chasing (or “safety-chasing”) behaviour. After watching global macro stay afloat in a stormy 2008, funds may have sought refuge in the strategy. Kristoffer Houlihan, Director of Risk Management at PAAMCO told the FT as much recently. According to the FT:

“…some managers sought refuge in global macro, a generally conservative, steady strategy. In 2008, global macro funds were off only fractionally, beating the industry average by more than 20 percentage points. This year, as of November, global macro has registered gains just north of 8 per cent, trailing the industry by 13.5 percentage points. The strategy delivered absolute returns, but in the context of the 2009 bull market its performance looked sluggish.”

Whatever the reason for last year’s anomaly, it will be very interesting to see if fund of funds indexes come back in line in 2010. Things are off to a good start. The difference between the HFRI Composite and the HFRI FoF Index in January: 1 bp.

Who said hedge funds don’t like chaos?

Critics of hedge funds often charge that they simply sell insurance (“volatility”) for a premium and cross their fingers that they never have to pay up. Hedge funds, they say, are “short vol.” When volatility goes up, they go down, and vice versa.

But there may be a little more to the story than meets the eye.

Studies have shown that, in theory, active management thrives during periods of time when stocks are less correlated – when the so-called “cross-sectional dispersion” between stock returns is highest (i.e. their average correlation is lowest).

Back in late 2008, we covered a presentation by Steve Sapra of Analytic Investors that contained the following chart showing the average stock-by-stock correlation of US equities (blue line)


Note that correlations were low around the turn of the century. This makes intuitive sense for anyone investing around then. Stocks seemed to have a mind of their own as some sectors bubbled, then blow-up while others held the line. Indeed, as the orange line shows, average stock volatility peaked in the Halcyon days of March 2000. This combination provided unprecedented opportunities for those who could read the tea leaves at the time.

But does high volatility always lead to opportunities for the most active managers of all, hedge funds? A report published by Moody’s recently contains an interesting appendix that seems to say “yes.”

The following chart from the report ranks monthly hedge fund industry returns from lowest to highest and shows the corresponding change in the VIX for that month. (Click to enlarge)

If anything, this chart shows that hedge funds have performed better in times of relative calm – that as a whole, they are “short vol.” When the markets get wonky, hedge fund managers apparently have just as much trouble as the next guy. Explains Moody’s:

“…although it is true that risk exposures of funds can vary substantially, they are participants in the financial markets and a sudden re-pricing of risk across the board can catch managers off guard, in the same way as other market participants…”

Still, as Moody’s points out, hedge funds are quick learners and are able to adjust their positioning faster than traditional managers. As a result, they don’t stumble as far and their cumulative performance tends to recover quicker (as the following chart from the report shows – click to enlarge).

So hedge funds may thrive in relative stability. But they also seem to perform “less poorly” during market upheavals. This seems to support the argument that active management beats passive management in times of chaos.

However, as Sapra points out, that chaos must be accompanied by cross-sectional dispersion in order for active management to fully realize its potential.

During the ‘99-’03 pop in average stock volatility, hedge funds did okay. But during the 2008 jump in vol, hedge funds took a pie in the face.

The difference? Average stock correlation was low in the ‘99-’03 time period and was astronomical in 2008.

So the bottom line seems to be that high volatility might only be bad for hedge funds when cross-sectional volatility is also high. Unfortunately the Moody’s report did not account for this variable.

Thursday, March 11, 2010

Hedge Funds Favor Growth & High Quality Stocks: Trend Monitor Report

Bank of America Merrill Lynch is out with their weekly summary of hedge fund exposure levels so we thought we'd take a look. They note that hedge funds in general were buying the Nasdaq and oil. Also, we see that some hedge funds began to cover short positions in the Euro. There has been a big deal made lately about hedge funds "ganging up" on the euro. So, it appears that some funds have covered now after the currency had been heavily shorted over a two-week period.

Let's now take a look at their findings regarding market exposure levels. In the past, we had pointed out how long/short equity hedge funds had reduced their exposure to below historical levels. There was a multi-week period where hedge funds were largely de-risking and it appears that trend has reversed. They have slowly started adding back exposure and are around the 34-35% net long level (approaching the historical average of 35-40%).

BofA also outlined how hedge funds are proceeding in their specific strategies. Turning to market neutral funds, they find that these funds are favoring growth names and still have positive inflationary expectations. While their market exposure has fallen, it still remains above the average levels. Long/short equity hedge funds, on the other hand, continue to increase market exposure and have growth & high quality tilts. This is largely what we've seen out of hedgies lately as they see more compelling opportunities in 'high quality' stocks. In fact, the vast majority of the most important stocks for hedge funds fit this description.

Embedded below is Bank of America Merrill Lynch's hedge fund trend monitor report in its entirety:

You can directly download a .pdf here.

In the end, this data largely draws the same conclusions we've seen in recent weeks: hedgies love growth names and are partial to high quality stocks. We've seen this exact sentiment long echoed in our hedge fund portfolio tracking series. Some of the most prominent managers have sizable stakes in strong bluechip type companies like Microsoft (MSFT), Pfizer (PFE), Wells Fargo (WFC), etc. And, on the growth front, many funds favor stocks like Apple (AAPL), DirecTV (DTV), Mastercard (MA), & Monsanto (MON). These findings fall largely in line with the stocks listed on Goldman Sachs' VIP list as well.

For more research from BofA, we've previously posted up their research from the beginning of the year as they recommended to overweight equities and underweight bonds.

Lessons from a Dow Decade

A year ago yesterday, the world almost ended. The stock market was in free fall, with the Dow Jones Industrial Average bottoming out at 6547, down from its Oct. 9, 2007 peak of 14164. Financials were in a death spiral and there was even talk of nationalization. Citigroup hit $1.05, GE traded at $7.41 and golden Goldman Sachs was given away at $73.95. A bear market extraordinaire.

Contrast this with 10 years ago today, when the dot-com-laden NASDAQ peaked at 5048. Then we had the opposite mentality—companies like were going to fundamentally reshape the economy in the new millennium through a nirvana of spectacular growth and well being. Or something like that. A bull run extraordinaire.

No one would blame you for thinking the market is a textbook delusional-paranoid-schizophrenic, not knowing the difference between the real and unreal. And you'd be right. But you'd miss a valuable lesson. Misallocation of capital is everywhere and anywhere a fallout of bad government policy. The South Sea Company, a government sponsored entity with a monopoly on trade, caused the South Sea Bubble in 1720.

The late '90s Internet love fest was crazy enough, driven by former FCC Chairman Reed Hundt's misguided telecom reform that had the effect of keeping data rates artificially high. This created a gold rush to install fiber and build applications that didn't make economic sense (though electronic commerce, online banking, as well as wireless and broadband deployment would eventually prove productive over the next decade). Bad policy meant capital got overallocated and too quickly, as momentum mutual funds (momos) and day traders furiously drove up stock prices of every company with dot-com in its name for no fundamental reasons. Wall Street trading was broken.

Then, adding insult to injury, Alan Greenspan and the Federal Reserve flooded the system with money, fearing that banks would face a run brought on by the Y2K problem. The problem and the run never happened. The money ended up in the market. Mopping up that money burst the bubble. The market bottomed out on Oct. 9, 2002, when the Nasdaq hit 1114.

And the world after 9/11? Unfortunately, the accounting scandals at Enron, WorldCom and elsewhere brought us the costly Sarbanes-Oxley law, adding a complex regulatory burden so that many companies fear going public. We also got a decoupling of research from investment banking because of an alleged conflict of interest, and a Federal Reserve whose nightmare fears of deflation ushered in a long era of cheap credit.


Instead of finishing what the dot-com era started to deliver—a productive, wealth-producing economy—capital was seduced into the financial lair of private equity and real-estate mortgages. Trillions were pumped into unneeded housing stock. Fannie and Freddie fanned the flames, and then fizzled and failed. And leveraged buyouts reigned. Even in 2007, one Blackstone private equity fund raised almost as much money as all of the venture capital industry.

And now? The bear market of a year ago may have ended because of the Geithner Plan, Treasury stress tests and TARP money injected onto bank balance sheets. You can go with that narrative if you'd like. Or maybe it was a change in the mark-to-market rules so banks no longer had to write down their toxic subprime loans. But the reality is that on March 18, 2009, Ben Bernanke and the Federal Reserve began their $1.2 trillion quantitative easing, buying Treasurys and mortgages and pumping dollars into a deleveraging economy. Hair of the dog. More cheap credit that again ended up in the market, helping banks refinance.

Today, we are still left with almost no initial public offerings. While private equity fund-raising was down 68% in 2009 to $96 billion, venture capital barely raised $13 billion.

Capital gains taxes are set to return to 20% on Jan. 1, 2011. And worse, investing is as uncertain as ever. No one wants to fund health care, medical devices or even much biotech if they can't figure out how they are going to be paid via reimbursements from ObamaCare. Energy investing is also a mess. And while "green" investing is booming, with few exceptions that is about efficiency rather than productivity. There's a big difference: You can make the Post Office more efficient while email makes us more productive and wealthier.

Big regulated oligopolists control our communications infrastructure. Startups are nowhere to be found. Few are willing to take the risk of true venture investing.

Associated Press

It's been 10 long years since the economy has created real wealth, as opposed to easy-credit induced real-estate or paper wealth. Amidst all the current confusion over health care and tax rates and energy and banking reforms, maybe it's time that the market transitions back to investments that drive productivity and increase living standards rather than just paper profits.

I'm not saying the market should transition or it ought to—you don't tell the market what to do. As we know from one and 10 years ago, the market works in weird ways and makes these transitions in the fog of something else, in this case it's the Fed's life support that is misallocating capital. When that ends, look for new eras to begin.

Mr. Kessler, a former hedge fund manager, is the author of "How We Got Here" (Collins, 2005).

Firing the $70 billion man: Full version

On November 19, 2009 Jeffrey Gundlach was named a finalist for Morningstar's award for bond fund manager of the decade. For Gundlach, the nomination recognized 10 years of stellar results, exceeding even the returns of the legendary king of bonds, Bill Gross.

Two weeks later Gundlach was confronted, fired, and then pursued on foot out of a Los Angeles skyscraper by two lawyers working for TCW, the money management firm with $110 billion in assets where Gundlach had worked for 24 years.

Not only did TCW oust Gundlach, but the firm also announced that it was acquiring an entire company -- crosstown rival Metropolitan West Asset Management -- to replace him. That in turn set off a wave of defections from TCW, as 45 of the 60 staffers who had worked for Gundlach streamed out the door to join him at a new firm that he had opened within days of leaving.

Then things really turned nasty. TCW filed an incendiary lawsuit in January accusing Gundlach of conspiring with confederates at TCW to steal proprietary information as part of a long-running plot to form their own competing firm. The suit added a salacious twist of the knife, perfectly calibrated for maximum media interest -- Gundlach had allegedly stashed a trove of illicit material in his office: 70 pornographic magazines and videos, 12 "sexual devices," and several bags of marijuana.

Gundlach has countered with his own lawsuit. He charges TCW and its owner, the French bank Société Générale, with pushing him out so that they can get their hands on his lucrative fees. In addition to his mutual funds, Gundlach had managed what were effectively two hedge funds for TCW, each of which commanded the amped-up fees typical of those vehicles. Gundlach calculates that he would have personally reaped $600 million to $1.2 billion over the next few years.

What in the name of Peter Lynch is going on here? Sure, we've come to expect shenanigans from Wall Street. But even if the mutual fund world hasn't been exactly pristine (remember the market-timing scandals a few years ago?), more often than not its managers and executives have been well-behaved schoolboys compared with the leather-clad (in spirit, anyway) rock stars among the investment bankers and hedge funders.

But unlike most mutual fund companies, TCW has always aspired to a Wall Street culture. In particular, it cultivated a star system. The company grew by importing ambitious money managers and granting them autonomy. They could invest as they liked; TCW would handle sales and marketing. The two sides would then split the fees, with each manager cutting an individual deal. The result could be huge rewards for managers -- Gundlach made $134 million over the past five years -- but some came to view themselves essentially as sole proprietors.

TCW seemed content with the arrangement and did little to tie its managers' fates to the company as a whole. Few of them, for example, received significant stakes in TCW. That bred frustration in multiple generations of standout performers, who viewed corporate executives (some of whom did receive ownership shares) as getting rich off their toil.

So it went for Gundlach, a bona fide investing star who, by the end, oversaw about 70% of TCW's assets, some $70 billion, putting him in charge of one of the biggest pots of money in the country. Gundlach didn't just generate steady returns; he avoided the blowup of the century. A specialist in mortgage-backed securities, he publicly warned in 2007 that "the subprime mortgage market is a total, unmitigated disaster, and it's going to get worse." He invested accordingly, not only delivering positive returns in the blighted year of 2008 but also earning himself a growing role as a media sage. His ego grew along with it.

There are few people like Jeffrey Gundlach in the mutual fund world -- or in any world. A former rock-and-roll drummer, Gundlach, 50, is a math whiz (but not a quant). He views everything in binary terms: Either you perform to his standards or you don't, and he won't hesitate to let you know which category you fall into. Nor is he shy in articulating his view of himself. "I was by far the biggest revenue generator at TCW, by far the biggest performer," he says. "I created $4 billion in value for clients in '09. If telling you that is self-promotion, so be it. It's just a fact."

With Gundlach, it's hard to tell which is largest: his brain, his self-regard -- or his resentment of TCW. He claims that his recent firing was actually the third time the company tried to get rid of him. "All three of them were an attempt to just steal the economics," Gundlach contends. "And this time they did it. Except they didn't steal the economics. They blew it up. They blew it up. They tried to steal the economics, but they didn't understand. They never understood."

TCW customers, meanwhile, have been watching the blood feud in disbelief. Investors have fled, with assets shrinking $25 billion since Gundlach was fired. For those who have remained, it seems that their patience is limited. "I'm aware of the investment prowess of both [Gundlach and the new TCW team]," says Mansco Perry III, CIO of the Maryland State Retirement and Pension System, which has $50 million invested in TCW. "But right now I don't believe they're acting in the best interest of their clients."

frey Gundlach is the sort of boss who inspires sharply divided opinion. He fostered loyalty among the members of his60-person team at TCW, handing out generous bonuses to his group. He also openly mocked the company's other divisions, especially its stock team.

Many outside Gundlach's orbit viewed him as an ill-tempered bully. He subjected subordinates to withering cross examinations and relished pointing out errors. Some in TCW's New York offices celebrated his dethroning by posting printouts of his scathing e-mails in the halls.

By contrast, loyalists valued his directness. Some would preserve his occasional written compliments as treasured mementos. "You don't have to guess where you stand with him," says Bonnie Baha, a portfolio manager who followed Gundlach to his new firm, called DoubleLine.

An interview with Jeffrey Gundlach is less like conversation than like listening to a manic stream-of-consciousness monologue. Consider Gundlach's description of his aborted stint in a math Ph.D. program at Yale (after getting an undergraduate degree in the same subject at Dartmouth): "It was a four-year Ph.D. deal. And they gave me a full scholarship, and it was very hard to get into. There were only seven people accepted, and they had hundreds of applicants. And one of the guys, he was Korean, he had come in via Toronto. I was the only American left. The other American had flunked out. There was a Chinese guy who had polio. That guy was smart. That guy was something else. He had crutches. He had horrible dandruff. He never took a shower, but he was one smart motherf----r, let me tell you. That guy is probably the smartest guy I ever met in my life. And he was my friend. I was the only guy he would be friends with, and there was this other guy, this Korean guy out of Korea, out of Toronto, and I didn't like him very much, and I was walking down the street, and there he was. It was like, 'Hey, Jeff!' They called me Jeff in the day. 'Hey!' You know, good to see you. I was Ike -- I had this really heebie-jeebie feeling, and he goes, 'Let's go to the bookstore and get our books.' And I was like, 'Uh, I don't know.' And he was like, 'What do you mean?' I said, 'Uh, I don't know.' And it hit me right then. I said, 'I'm not going back. I'm not doing it. I can't do it. This is pointless.' "

Gundlach's mind combines that feverish quality with a near-total recall of endless minutiae. But somehow, when it comes to investing, he's able to process huge quantities of details and extract a big-picture message. The result has been superb performance: His flagship $12 billion TCW Total Return Bond Fund returned nearly 8% annually over the past decade. Those results beat 99% of competitors, and his nonpublic funds have done even better.

For all Gundlach's prowess with numbers, it was anything but obvious that he'd go into finance. He grew up outside Buffalo in a family of modest means. Their only savings, he says, consisted of some Xerox stock, courtesy of their uncle, Robert Gundlach, the inventor of the modern photocopier. "We owned Xerox, and it went way, way up, and for the first time it actually felt like we had a little money. And then it crashed," Gundlach says. He was 12 or 13 at the time. "It was my first experience with a bear market, and I remember it really well. The rallies are pennies, and the selloffs are dollars, and that's always the way bear markets behave."

In his mid-twenties Gundlach played drums in a variety of rock bands that performed in L.A. clubs but never made the big time. Meanwhile he was holding down a dreary day job in the actuarial department at Transamerica. One night in 1985 he was watching an episode of "Lifestyles of the Rich and Famous," that described the most lucrative careers. Gundlach decided he would, as he told one interviewer, "figure out my life."

The program identified investment banking as the richest occupation. Gundlach didn't know what investment bankers did, but he contacted 23 firms. Impressed by his math credentials, TCW invited him in and offered him a $30,000-a-year job as a research assistant in the firm's bond department. (This despite the fact that, according to Gundlach, he didn't even know what a bond was at the time.)

Gundlach was thrilled. He loved wearing a suit and tie to TCW's elegant offices. He became fascinated by bonds. "I felt like I was in the middle of something that was important and exciting," he says. "I loved it! When I would walk into a meeting and be able to say, 'I'm from TCW and here's my business card,' I was proud."

As a young analyst, Gundlach zeroed in on the mortgage market. By age 27, he says, he had developed a reputation in his niche as a "young hotshot." After four years at TCW, he was promoted to co-chair of a new division -- mortgage Bonds -- and then made a managing director in 1991. "That doesn't happen," he says. "You don't go from a trainee to managing director in seven years. I was running the most important department at the firm, but the firm didn't like the fact that I was growing so much." Gundlach is getting ahead of the story, but it appears he would later be right.

When Gundlach arrived -- and still to a large extent today -- TCW seemed like a museum version of a Wall Street firm. Even in ultra-casual Southern California, for example, the firm had a suit-and-tie dress code. Gracious meals were served in its white-linen dining room.

TCW was founded in 1971 as Trust Co. of the West by Robert Day, who inherited millions as the heir to the Superior Oil fortune and hobnobbed with the Martha's Vineyard elite. Day was a hard-nosed boss who used to smack errant employees on the head with his cigar, Gundlach says. (Day says he doesn't remember doing so.) In those days 80% of TCW's assets were in stocks, the rest in bonds. By the end of Gundlach's tenure, the ratio would almost flip.

Day built the firm by luring in Wall Street talent. One prominent star, who joined in 1985, was Howard Marks, a junk bond manager who came over from Citicorp. Marks thrived, accumulating $7 billion in assets, about 15% of TCW's total at the time. But he grew increasingly dissatisfied with having to fork over half his fees to TCW. And he resented the fact that TCW would give him no more than a nominal stake in the company. In 1995 he announced that he was leaving and taking his team with him.

Marks' departure was a less lurid, but still bitter, harbinger of what would occur with Gundlach almost 15 years later. Day sent a furious letter to clients blasting Marks' exit as "disloyal at the very least," according to press accounts at the time. TCW then quickly replaced Marks' team by purchasing Crescent Capital, a small high yield bond firm in West Los Angeles.

The equity issue took on new importance when TCW decided to sell itself. In 2001, Société Générale bought 51% of TCW for $880 million. The deal, former employees say, meant lucrative paydays for a cadre of executives, including the founders of Crescent, who had received large chunks of the company. Some longtime TCW employees were embittered by the newcomers' windfall.

Management tried to mend the problems that led to Marks' departure, but the lack of equity for many managers remained a sore point. SocGen announced it would escalate its ownership to 70% and leave 30% for TCW employees. But that 30% turned out to consist of SocGen stock options rather than TCW shares. By 2007 the French bank owned 100% of the company.

Meanwhile Gundlach was accruing more and more influence and renown. In 2005 he was promoted to chief investment officer of TCW. And he was named Morningstar fund manager of the year in 2006. His decision to pull his mutual funds out of riskier debt and his accurate forecast of a looming recession brought him favorable publicity and a steady presence in the press. (Another division of TCW, also under Gundlach's umbrella but not his main focus, was a giant issuer of CDOs, many of which imploded.)

It was Gundlach's time. His reputation was growing, and bonds were beginning to enjoy their moment in the sun. The result: Investments in his funds swelled. So, too, did his ego, according to former co-workers. "He started to think of himself as a god," says one who worked with Gundlach during that period.

Gundlach remained mostly satisfied until January 2009, when SocGen announced that it intended to take TCW public in five years. The uncertainty, he says, made it harder to drum up new business. And he grew even more vexed a few months later when he was passed over for the job of TCW's new CEO. Instead, the position went to the company's former president Marc Stern, who came out of retirement to assume the position.

Gundlach was infuriated by Stern's return. He was offered the job of president but turned it down. Always outspoken, Gundlach grew openly critical of TCW's management, even deriding executives while they sat a few feet away in the company dining room.

Rumors began to circulate that Gundlach would be fired. By the summer of 2009, he says, it had become difficult to work under that stress, as well as to face TCW's uncertain future. In September, Gundlach met with Stern and offered to purchase the firm at a valuation of $700 million. TCW says Stern passed the offer onto SocGen, which rejected it.

TCW and Gundlach disagree about exactly what was said at the meeting. What's clear is that Gundlach at least broached the possibility of taking his team and leaving. TCW interpreted the statement as a threat and prepared for combat: The company hired investigators to look into the affairs of Gundlach and his closest lieutenants, tapping their office phones and monitoring their e-mails. At the same time they initiated clandestine talks with MetWest, the $30 billion bond house that would eventually replace Gundlach's team.

Gundlach was preparing too. He and his "co- conspirators" began e-mailing one another in September about their plot to steal information, according to TCW's complaint. The suit alleges that the group referred to Gundlach as "the Pope" and "the Godfather" and swiped 9 million pages' worth of client contacts, trade tickets, and software routines used to process the complex data that go into analyzing mortgages. They retained a realtor to find an office space with 50 trading desks.

Gundlach acknowledges that his team looked at commercial real estate. It made him feel better, he says, to be making plans when he knew he was going to be fired. "I felt powerless," he says. He insists, however, that he had no knowledge of the downloading, his e-mails prove otherwise. Gundlach says he hired a third party to expunge his employees' computers of TCW data and returned all their hardware to the company.

The crescendo of rumors -- of his ouster, of a sale -- was wearing on Gundlach. Still, he had no inkling of what was in store for him on Dec. 4, 2009. At 1 p.m. that day, when the markets closed on the East Coast, he was summoned to the 17th floor of TCW's headquarters. Michael Cahill, the company's general counsel, was waiting for him in a conference room with John Quinn, one of Los Angeles' top litigators.

Cahill told Gundlach that TCW was putting him on administrative leave. Gundlach argued that the move would cause a disastrous customer exodus unless they negotiated a settlement that resolved various fee and management issues. The lawyers asked him to read a draft of the complaint TCW was planning to file against him. When Quinn tried to place the papers in his hands, Gundlach got angry.

He stormed out of the room and began walking down the stairs. Quinn and Cahill trailed him, thinking he was headed for the trading floor one level down, but Gundlach kept going. It was a surreal procession, says Quinn; they marched down 17 stories in total silence. The lawyers followed Gundlach out of the building and onto the street until Gundlach finally turned around and told them he wasn't planning on stopping anytime soon.

While all this was happening, chaos had erupted on TCW's trading floor. CEO Stern sent out a companywide e-mail announcing Gundlach's termination and the acquisition of MetWest. Then Stern appeared to reiterate the news in person. Analysts watched in shock as a team of private detectives and attorneys descended. Gundlach's suspected conspirators were herded into offices and conference rooms, where the investigators interrogated them and seized laptops and records. Some company-owned BlackBerrys went dark without warning. Nervous employees scurried around the floor, trying to figure out who had been terminated. By the end of the day, the tally was five.

TCW proved inept in its efforts to stanch the turmoil caused by Gundlach's departure. On the rainy Monday morning after he was fired, TCW employees gathered in conference rooms for a companywide conference call. CEO Stern told his troops that the downpour was a sign of renewal, and that TCW would emerge as "a firm that has respect for everyone within the firm."

But Day, TCW's founder and chairman, was less temperate in his remarks. He told the employees that he had been through this before -- i.e., with Marks -- and that there was no other choice. "It sort of reminds me a bit of General Washington crossing the Delaware," he said. "The general was in the back of the boat. It would be like a soldier getting up, trying to rock the boat, expecting to sink the boat. His choices are very simple. You shoot the soldier. You throw him off the boat."

After a pause, nervous laughter emanated over the speakers. Some of Gundlach's former colleagues were horrified. A few started crying. Others walked out. "Whatever people may say about [Gundlach], here's a guy that has been working for his company for over 20 years and has made a lot of money for investors," says Luz Padilla, a fund manager at the company. "After that call, I was just incensed."

Padilla hadn't been set on leaving TCW, she says, until she realized the current imbroglio bore an uncanny resemblance to the Howard Marks controversy -- a talented manager leaves after a fight over money, and a new team takes control. "It was a different set of players," she says, "but almost the same movie." There was also the fear that the arrival of the MetWest group would make the current bond team redundant. Dozens more followed Padilla out.

Then came the surge of customer defections. By late February TCW's assets had dropped by some $25 billion. The most prominent deserter was the U.S. Treasury, which pulled out of the $4.1 billion Public Private Investment Fund it had started with Gundlach.

Less than two weeks after he was fired, Gundlach announced that his new firm, DoubleLine, was partnering with a respected L.A. money manager: none other than Howard Marks. The onetime TCW star has thrived on his own, building a firm called Oaktree Capital with $70 billion in assets. Marks is buying 22% of DoubleLine and in exchange will provide the administrative backbone for Gundlach's new operation. Needless to say, an alliance between two of its former stars is also a not-so-subtle poke in the eye to TCW.

After weeks of relative silence, TCW struck back. On Jan. 7 the company filed its explosive complaint. It emphasized the alleged plot to steal information. It also tarred Gundlach personally, referring to the pornography, sexual devices, and marijuana retrieved from his office. TCW justified the inclusion of the prurient material in the suit under the whisper- thin pretext that it constituted a breach of company policy. Asked about the contents of his office, Gundlach offers only the mildest of quibbles: "Not all of the items are mine." In a letter to investors, he noted, "I had every expectation of privacy in these spaces, which stored vestiges of closed chapters of my life."

On a recent Thursday afternoon, Marc Stern sits in one of TCW's dining rooms with Jacques Ripoll, the head of SocGen's asset management division. The two couldn't look more different. Stern, 65, is barrel-chested with white hair and a loud, raspy laugh. Ripoll, 43, has a slick, dark coiffure and a heavy French accent. As Stern talks about growing up on a vegetable farm in New Jersey, one can't help but notice that his story resembles Gundlach's. Both were gifted kids who came from working-class families, and both share a love of art (Gundlach has an extensive collection of contemporary paintings; Stern is the chairman of the L.A. Opera, a passion he developed while riding on his father's tractor and listening to opera on the radio).

Despite the controversy, Stern insists that TCW is better positioned than ever, and its new team, he pointedly adds, is "delighted to be here." Stern predicts that TCW will double its assets in three years. He stresses the importance of having "mechanisms where people share information and are willing to help each other." While not specifically naming Gundlach, the message is clear: The star manager didn't play well with others. TCW's new head of fixed income is MetWest founder Tad Rivelle, a self-effacing, professorial type -- the anti- Gundlach -- and no slouch as a manager. His Total Return bond fund has beaten 94% of its peers over the past decade.

"TCW is ready for growth," Ripoll says. "To be transparent -- this was not possible before." And what of Gundlach's long-desired equity stake? TCW is giving shares to the new team from MetWest (as it did with the Crescent group) but is less definite about handing it to others. "When you have a company like TCW, it is very important that you have equity held by the employees," Ripoll says. "That is what we are putting in place."

TCW's basic business model -- a collection of autonomous managers -- seems unlikely to change. In a separate interview, the founder and chairman defends the approach. "I started the company with $2 million, and it has $115 billion today," says Day. "The formula that has worked for 40 years is going to continue to work." (Day also insists Gundlach really didn't care about an equity stake; when given the choice, he always opted for more fees.)

Gundlach, meanwhile, is still setting up shop. He has been through a lot of late. He showed up at meetings in January with a black eye and cuts on his face, which he says came from tripping and colliding with his desk at home. On Feb. 1, his wife of more than 20 years, Nancy, filed for divorce. And Bill Gross was named fixed-income fund manager of the decade; Gundlach thinks he would have taken the prize if he hadn't been fired. That said, Morningstar clearly still views him as legitimate: The organization invited Gundlach to deliver the keynote address at its annual investors conference this summer.

DoubleLine has registered three mutual funds with the SEC, and it expects $10 billion in new accounts this spring. Gundlach says the most gratifying thing about the firing and its aftermath is that 45 people followed him from TCW -- proof, he says, that he isn't such a difficult guy to work with. As Gundlach walks through his new firm's offices, he looks happy. To reign there, it seems, is better than to serve at TCW. To top of page

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.