Friday, August 26, 2011

Market volatility and the “Rebalancing Frown”

Given all the market volatility, a lot of folks are wondering about whether now might be the right time to rebalance their portfolio.
Vanguard researchers present an in-depth discussion of rebalancing in this paperOpen new window. This analysis emphasizes that historically, rebalancing once or twice a year—and only doing so when a portfolio had wandered from its asset-allocation target by at least 5%—produced absolute return/risk results quite close to those resulting from more frequent, complicated, and time-consuming rebalancing efforts. The “take away” is that when it comes to rebalancing, doing it once or twice a year can be useful—and for many investors, there’s little point in making it more complicated than that.
But assuming your financial schedule is such that you’re due for your “once or twice a year” rebalancing right about now, how likely is it that your portfolio is out of whack by 5% or more and actually needs an adjustment?
My colleague Joel Dickson put together a neat little chart* that may give a quick answer. For any given initial portfolio allocation to stocks (on the horizontal axis) in a stock/bond portfolio, the chart shows how far the equity portion would have to slide before the portfolio’s allocation changed by 5% or more. The chart assumes that the non-equity portion of the portfolio has increased by 6%, which is close to the change on the Lehman Aggregate Bond Index year-to-date through Friday, August 19, 2011.
Equity decline to trigger rebalance at 5% interval
The Rebalancing Frown
It’s kind of a neat picture for a couple reasons. First, it clearly shows that unless and until the equity portion has dropped by more than about 13 %, you won’t be at that 5% trigger level with any initial equity allocation. (Through August 19, 2011, year-to-date, the MSCI US Broad Market Index hasn’t been down more than 10.5% at the close.)
Secondly, the chart shows very clearly the obvious relationship between the level of equity exposure in a portfolio and the need to rebalance: as stocks make up more or less of a portfolio, larger and larger market swings are needed to move the allocation by 5%.
If your strategy is really conservative or really aggressive, much larger market declines are needed to “trigger” rebalance.
Given the shape of the line, Joel likes to refer to this chart as the “Rebalancing Frown”—which is certainly how most of us feel about the markets lately. I told him we just need wait for the market to recover, and we can “turn your frown upside down,” as you’d get a similar picture that looks like a smile in the case of positive market changes. (You don’t hang out in the Vanguard research departments for the humor.)
Bottom line, while many of us are frowning a lot about market volatility, my conclusion is that “Don’t just do something, stand there!” still makes a lot of sense for an awful lot of investors—yours truly included.
Note: All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk.
* For the mathematically inclined among you, here’s a detailed look at the calculations behind the chart above.
General case: (all fractions/percentages expressed as decimals, e.g., 5% = .05)

Initial equity allocation: alpha
Rebalance trigger/threshold (always a positive number): tau

Return on non-equity portion: r sub n
The formula that applies when the market is declining is different from when the market is rising:
Formula 1
For 50%, 5%, 6%, you get (.5–.05)*(.5)*(1.06)/((1+.05–.5)*.5)–1 = –.1327
The return on equity required to trigger rebalance (selling equity) in the case of a market increase is:
Formula 2
For 50%, 5%, 6% you get (.5+.05)*(.5)*(1.06)/((1–.05–.5)*.5)–1 = .2956

Gundlach’s DoubleLine Will Hold Cash Until Everyone in ‘Fear’

Jeffrey Gundlach’s DoubleLine Capital LP is favoring cash over almost all investments including corporate bonds, wagering that relative yields will widen even after expanding to the most since October 2009.
“I want fear,” Gundlach, the founder and head of Los Angeles-based DoubleLine, said in an Aug. 24 telephone interview. “I want to buy things when people are afraid of it, not when they think that it’s a gift being handed to them,” he said of speculative-grade bonds.
Some of DoubleLine’s funds, which usually don’t hold any cash, currently are allocating 15 percent, said Gundlach, who managed the top-rated intermediate-term U.S. bond mutual fund for 15 years. DoubleLine’s Multi-Asset Growth fund, which can invest across asset classes and market sectors, holds 30 percent in cash, he said.
DoubleLine has attracted about $14 billion since its December 2009 inception. Gundlach previously co-managed the TCW Total Return Bond Fund (TGLMX) with Philip Barach. Gains averaged 7.5 percent annually in the five years ended Dec. 4, 2009, which compares with 7 percent for the Total Return Fund run by Bill Gross of Newport Beach, California-based Pacific Investment Management Co., the world’s largest bond fund. Barach is also at DoubleLine.
The firm, which has grown from $3.1 billion in June 2010, increased cash holdings as a rally in U.S. Treasuries pushed down yields, Gundlach said.

Spreads Widen

U.S. investment grade corporate bonds are paying 3.78 percent down from 4.16 percent in April, according to Bank of America Merrill Lynch’s U.S. Corporate Master Index. The debt has lost 0.3 percent in August, paring 2011 gains to 5.3 percent, according to Bank of America Merrill Lynch index data.
The extra premium investors demand to hold the debt instead of U.S. Treasuries expanded to 227 basis points on Aug. 24, the most since October 2009, the index data show. Relative yields rose 59 basis points this month to 225 basis points through yesterday. Spreads peaked at 656 basis points in December 2008 after Lehman Brothers Holdings Inc. failed and credit markets seized up.
Waning confidence in the economy and Europe’s worsening sovereign debt crisis have sent investors fleeing from risky assets and made it harder for companies to access capital markets. Sales of corporate debt in the U.S. have dropped to $46.6 billion this month, compared with $98.4 billion in the same period last year, according to data compiled by Bloomberg.
This week, there were no offerings of junk bonds, ranked below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s. That’s left sales in August at $1 billion, compared with the monthly average this year of $28.5 billion, Bloomberg data show.

‘Something Looks Broken’

“Something funny is going on in the world of corporate bonds now -- something looks broken,” he said. “It seems there’s less willingness all of a sudden to be lending money to corporations, maybe because the absolute yields are so low. You’re starting to see that saturation point.”
Junk bonds have plunged 5 percent this month paring gains for the year to 0.9 percent, Bank of America Merrill Lynch index data show. Spreads on speculative-grade company notes, rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s, have widened 185 basis points this month to 743 basis points.

Thursday, August 25, 2011

How to get $12 billion of gold to Venezuela

Ever since the news broke last week that Hugo Chávez wanted to transport 211 tons of physical gold from Europe to Caracas, I’ve been wondering how on earth he possibly intends to do such a thing.
There are 99 tons already being held at the Bank of England; according to the FT, the plan is to transfer other gold to the Bank of England from custodians such as Barclays, HSBC, and Standard Chartered; then, once it’s all in one place, um, well, nobody has a clue what might happen. Here’s the best guess from the FT:
Venezuela would need to transport the gold in several trips, traders said, since the high value of gold means it would be impossible to insure a single aircraft carrying 211 tonnes. It could take about 40 shipments to move the gold back to Caracas, traders estimated.
“It’s going to be quite a task. Logistically, I’m not sure if the central bank realises the magnitude of the task ahead of them,” said one senior gold banker.
I put the ever-resourceful Nick Rizzo on the task, but he came up with little more: the market in physical gold is tiny, and largely comprised of nutcases. The last (and only) known case of this kind of quantity of gold being transported across state lines took place almost exactly 75 years ago, in 1936, when the government of Spain removed 560 tons of gold from Madrid to Moscow as the armies of Francisco Franco approached. Most of the gold was exchanged for Russian weaponry, with the Soviet Union keeping 2.1% of the funds in the form of commissions and brokerage, and an additional 1.2% in the form of transport, deposit, melting, and refining expenses.
It’s not much of a precedent, but it’s the only precedent we’ve got; my gut feeling is that Venezuela would be do well to get away with paying 3.3% of the total value of the gold in total expenses. Given that the gold is worth some $12.3 billion, the cost of Chávez’s gesture politics might reasonably be put at $400 million or so.
It seems to me that Chávez has four main choices here. He can go the FT’s route, and just fly the gold to Caracas while insuring each shipment for its market value. He can go the Spanish route, and try to transport the gold himself, perhaps making use of the Venezuelan navy. He could attempt the mother of all repo transactions. Or he could get clever.
In the first instance, the main cost would be paid by Venezuela to a big insurance company. I have no idea how many insurers there are in the world who would be willing to take on this job, but it can’t be very many, and it might well be zero. If Venezuela wanted just one five-ton shipment flown to Caracas in conditions of great secrecy, that would be one thing. But Chávez’s intentions have been well telegraphed at this point, making secrecy all but impossible. And even if the insurer got the first shipment through intact, there would be another, and another, and another — each one surely the target of criminally-inclined elements both inside and outside the Venezuelan government. Gold is the perfect heist: anonymous, untraceable, hugely valuable. Successfully intercepting just one of the shipments would yield a haul of more than $300 million, making it one of the greatest robberies of all time. And you’d have 39 chances to repeat the feat.
Would any insurer voluntarily hang a “come get me” sign around its neck like that? They’d have to be very well paid to do so. So maybe Chávez intends to take matters into his own hands, and just sail the booty back to Venezuela on one of his own naval ships. Again, the theft risk is obvious — seamen can be greedy too — and this time there would be no insurance. Chávez is pretty crazy, but I don’t think he’d risk $12 billion that way.
Which leaves one final alternative. Gold is fungible, and people are actually willing to pay a premium to buy gold which is sitting in the Bank of England’s ultra-secure vaults. So why bother transporting that gold at all? Venezuela could enter into an intercontinental repo transaction, where it sells its gold in the Bank of England to some counterparty, and then promises to buy it all back at a modest discount, on condition that it’s physically delivered to the Venezuelan central bank in Caracas. It would then be up to the counterparty to work out how to get 211 tons of gold to Caracas by a certain date. That gold could be sourced anywhere in the world, and transported in any conceivable manner — being much less predictable and transparent, those shipments would also be much harder to hijack.
How much of a discount would a counterparty require to enter into this kind of transaction? Much more than 3.3%, is my guess. And again, it’s not entirely clear who would even be willing to entertain the idea. Glencore, perhaps?
But here’s one last idea: why doesn’t Chávez crowdsource the problem? He could simply open a gold window at the Banco Central de Venezuela, where anybody at all could deliver standard gold bars. In return, the central bank would transfer to that person an equal number of gold bars in the custody of the Bank of England, plus a modest bounty of say 2% — that’s over $15,000 per 400-ounce bar, at current rates.
It would take a little while, but eventually the gold would start trickling in: if you’re willing to pay a constant premium of 2% over the market price for a good, you can be sure that the good in question will ultimately find its way to your door. And the 2% cost of acquiring all that gold would surely be much lower than the cost of insuring and shipping it from England. It would be an elegant market-based solution to an artificial and ideologically-driven problem; I daresay Chávez might even chuckle at the irony of it. He’d just need to watch out for a rise in Andean banditry, as thieves tried to steal the bars on their disparate journeys into Venezuela.

How yields track nominal GDP changes

Yes, we know what happened today: gold down, dollar up, 10-year Treasury yields climbed to 2.30 per cent.
We heard. Jeeeeest a bit less room for Bernanke to let us down on Friday.
But if you think treasury yields are about to make a sustained, meaningful move upwards, you might want to look at this first:

And a few thoughts to go with it from Moody’s Analytics
Previous economic recoveries produced faster growth than will likely be seen anytime soon, and rates reflected these higher rates of output and inflation. In the 1990s expansion nominal growth averaged 5.7% as the 10 year Treasury yield averaged 6.3%. In the 2001-2007 upturn, growth averaged 5.2% as the 10 year Treasury averaged 4.4%. Growth currently stands at 3.7% with a 2.1% Treasury yield. Below trend growth naturally lowers rates, while robust international demand for dollar assets and aggressive monetary policy drive yields down further.

Managed Futures Funds Shine In August Rout

Managed futures hedge funds are making out quite nicely amidst the market carnage this month.
"Black box" funds are up 4.2% this month, Hedge Fund Research data shows, almost a mirror image of the average hedge fund, which is down 4% on the month.
The biggest of the black boxes, Man Group's flagship AHL strategy, is a case in point: The strategy was up 4.3% in the week ended Monday, bringing the US$23.9 billion fund breathlessly close—it needs an additional return of just 0.3%—to reaching its performance fee hurdle.
"These are the environments in which we're expected to perform," AHL manager Harry Skaliotis told Reuters.
Others are also doing well, including Winton Capital Management's flagship, up 2.2% in August and 7% on the year, and SMN Investment Services' Diversified Futures Fund, which is up 13.7% this month.
Even the losing managed futures funds are beating their average peer. BlueCrest Capital Management's Bluetrend Fund is down just 1.7% this month, leaving it up 4.2% on the year.

Tuesday, August 23, 2011

Kass: Selling Storm Might Be Clearing

The hedge fund de-risking and mutual fund redemptions will probably slow the growing ambiguity of worldwide economic growth, a negative feedback loop engendered by the political circus in Washington, D.C., and signs of an increasingly fragile European banking industry have (in large part) contributed to the recent selloff in the world's markets. I am convinced, however, that several noneconomic, temporary and artificial influences have conspired to accelerate the recent drop of stock prices.

A General De-risking by Hedge Funds

The recent selling bout has occurred at a time when, according to the ISI Hedge Survey, hedge funds were already reducing their net equity exposure. ISI's latest numbers (based on "the actual exposures at 35 funds capturing $86 billion in long/short assets") indicate that net hedge fund exposure has moved to about 45.8% -- that's the lowest exposure in two years. Hedge funds have cut back based on growing losses (and the trading associated with the discipline of limiting losses) as well as in response to the marked rise in the VIX, which creates a higher VAR (dollar value at risk per day). The swiftness and magnitude of the drop has begotten more and more selling by the hedge fund community.

Recent Hedge Fund Redemptions

I am personally aware of some large redemption requests in the hedge fund community. This has led to further selling pressure. Many of those hedge funds had a large exposure in the financial sector, and this could explain the outsized drop in bank stocks and other non-bank financials.

A Nearly Unprecedented Liquidation of Domestic Equity Funds

Last month, individual investors fled equity funds in a massive move toward the flight-to-safety trade. In July, over $25 billion was redeemed. A week ago, over $20 billion was pulled. Surprisingly, assets were taken out of every mutual fund asset class (equities, taxable and nontaxable bond funds) and went into money market funds. I estimate that individual investors will pull out at least $35 billion in August, representing the second-highest liquidation on record since the series of data began to be accumulated in 1979. It is almost a certainty that 2011 will represent the fifth consecutive year of liquidations -- something that has never happened in mutual fund history.
I think the high-frequency trading is a major negative for the stock market. It is a major negative for the economy, and it does not do anything for the economy. It does not add any value to the economy. It doesn't add any social value. Charles Munger, Warren Buffett's partner, in an interview on CNN in May, essentially said the same thing.These high-frequency traders begin the day owning nothing and end the day owning nothing in terms of common stocks. During the day, they are accounting between 50% and 60% of the volume.
There was a terrific article in The Wall Street Journal on Tuesday. The headline was "A Wild Ride to Profits." The article talked about what happened on Aug. 8, when the S&P 500 index was down 6.8%. That day happened to be the single most profitable day in the history of high-frequency trading. These high frequency traders made an estimated $65 million. While on that day, the stock market lost $850 billion of value....
The liquidity that they add to is useless liquidity. It has no lasting value. It consists of orders that are placed and that are quickly retracted. It heavily, heavily consists of front-running.
It is amazing to me the New York Stock Exchange puts up a facility right next door to their computers in New Jersey and then they lease out space to 10 or 15 or 20 of the highest so-called co-locations so that those individuals putting their computers there can get a microsecond of an advantage over their competition. If the New York Stock Exchange thinks this is a smart idea, in order to generate volume, I don't think so.
But can I go back to something else? There was no high-frequency trading four years ago. What permitted high-frequency trading, in my opinion, to occur was when the SEC removed the uptick rule -- on July 7, I think, 2007.
Right now, I ask a question, where are the regulatory bodies? We have had a major destruction in confidence. You can help restore confidence to the markets tremendously, in my opinion. If the SEC would consider reinstating the uptick rule, reinstating the uptick rule -- if you reinstate the uptick rule, you don't have to do anything else. That will bring high-frequency trading to a screeching halt, but understand that the New York Stock Exchange may not be in favor of it. The major investment banking firms won't be in favor of it. The hedge funds, most of them, won't be in favor of it.
-- Marvin Schwartz (Neuberger Berman) on CNBC's "Strategy Session" (Aug. 18, 2011)

The influence of these factors has been to produce a dearth and vacuum of normal retail and institutional trading flows and activity. The absence in the marketplace of these more stable classes of intermediate- to long-term investors has brought on heightened volatility, producing a perfect storm of selling as the increased presence and disproportionate role of high-frequency, momentum-based trading strategies has exacerbated both the up and (mostly the more common) down moves during the month of August.
This unfortunate set of affairs has, in essence, transformed a relatively stable marketplace into a casino-like environment, as investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms.
The bad news is that the SEC is remarkably unresponsive and apparently unaware of the damage being wrought by the quants and by the kings of high-frequency trading during these difficult times for most investors. The good news is that it is likely that the hedge fund de-risking and mutual fund redemptions are growing mature, might be materially behind us and will probably slow in influence in the period ahead.

S&P500 Faces a Fork in the Road

“When you come to a fork in the road, take it.” – Yogi Berra

Lot’s of chatter out there about the 2008 and 2010 analog for the S&P500 so we constructed a tracking chart for you.   Note the index is right at the return of the 2008 analog and faces similar events, which caused a nonstop year-end rally in 2010 and swan dive in 2008.
As all eyes are on Bernanke looking for clues of a new round a quonto we’ll be more focused on Trichet.  The future of Europe and the global banking system is highly dependent on his policies over the next few months.    Stay tuned.

Friday, August 19, 2011


“A little dab will do ya,” goes the old Dippity Doo ad, but it might be that a little dab will kill ya, if you were a fund of hedge funds and the dabs you had weren’t the right mixture. Some funds of funds managers without the right mix and glue found their portfolios gone the way of a bouffant hairdo in the rain.
Implicit in the recent financial market yo-yo that caught hedge funds and investors alike off guard was the notion that diversification – as simple as being allocated to both stocks and bonds and as complex as having money in numerous strategies and concepts – should in the end generate offer both returns and protection.
Yet while early indications are that hedge funds managed to weather the early August rout in decent form, indications are that FoHFs may once again have felt the pain of being tied into managers and strategies that didn’t provide the kind of returns or protection they were supposed to.
Indeed, according to a recent academic paper, for funds of hedge funds (FoHFs) in particular having too much moderation is actually a bad thing, in that different hedge fund managers and strategies spread out across the food chain, so to speak, is actually bad for investors’ health.
While logically it would make sense that investors would be protected by being with a FoHF that is well diversified, the research finds that FoHF portfolios with more than 25 underlying managers have weaker performance and increased tail risk.
The study, written by Stephen Brown, Greg Gregoriou and Razvan Pascalau of New York University’s Stern School of Business (click here to download from SSRN), notes that a misplaced emphasis on diversification may be contributing to performance degradation and increased tail risk in FoHFs.
“FoHFs that efficiently diversify away business risk considerations do not necessarily provide any protection against the common factor represented by left tail market risk exposure. Indeed, FoHFs diversification concentrates this risk,” notes the study. “We would expect that the larger the number of underlying hedge funds in the FoHFs, the more exposed the FoHFs should be to these negative market conditions.”
To prove their case, Brown and his research team analyzed the impact of diversification on the performance of 3,767 FoHFs that reported monthly returns and the number of their underlying fund holdings to the BarclayHedge database between January 2000 and March 2010.
What they found was that the benefits of diversification in terms of reducing monthly standard deviation tended to hit a wall at between 10 and 20 underlying hedge funds, while diversification beyond 25 funds in most cases led to a significant reduction in relative performance. The chart below illustrates performance as a function of the number of underlying hedge funds.

Their analysis also revealed “over-diversification” across 25 or more hedge funds actually increased left tail risk for FoHFs.
The results of the study indicate many FoHFs are over-diversified. According to the authors’ findings, almost half the FoHFs in the BarclayHedge database had more than 20 underlying funds – the point at which the risk-reducing benefits of diversification tend to plateau.
More than a third of FoHFs held more than 25 underlying funds where diversification has a negative impact on performance and tail risk, the paper notes.

Key in the study’s findings is the fact that all hedge fund strategies are in some form or other exposed to liquidity risk, which as most know from 2008 – and were reminded of in early August 2011 – trumps all else when investors are running for the exits.
Another key factor: due diligence costs. It doesn’t take a rocket scientist to figure out that the more underlying managers to monitor, the more it’s going to cost, which in turn is dictated by the amount of assets under management the FoHF has.
“The larger the FoHF, the more likely they can afford more diversification, because they have greater economies of scale,” according to the report.
As due diligence is costly and information on hedge funds is difficult to obtain, Brown argued smaller hedge funds should specialize and invest only in the funds for which they have sufficient information. This implies smaller FoHFs may actually capture more alpha if they were relatively under-diversified.
The performance fee model also provides another reason to keep diversification within limits. As the authors note, the bigger the number of underlying funds, the larger the accumulation of incentive fees, which becomes a fixed charge payable by the investor whether or not the FoHF performs poorly.
To be sure, spreading out risk and not putting all your eggs in one basket is still advisable. It’s just better not to have too many baskets – or frankly too many eggs. Besides, what do “they” know anyway?

How Reliable are Yields?

The beauty of a traditional bond is that yield wins in the long run... while performance may fluctuate year to year, if you buy a bond and get the credit work right (i.e. it doesn't default), you get a nominal annualized return roughly equal to the yield over a period that matches the duration of the bond (this is the main reason I called out those claiming bonds were in a bubble around this time last year... don't hear much from those guys these days).
The chart below details this feature using bond data from Shiller going back 140 years. To be specific, it shows the Treasury yield at each point in time, then the forward return on an investment in a bond index eight years forward (close to the average duration of a ten year Treasury). While the below does show some noise due to a fluctuating durations (when yields are low, duration is higher) and reinvestment risk, the correlation is 0.92 over that 140 year period (i.e. strong to quite strong). In other words, do not expect to earn more than 2% annualized from an investment in a ten year Treasury bond.
Equities are a much more difficult beast. There have been countless studies on whether equities actually have duration (one such study showed that equities have a duration of more than 20 years with a standard deviation of 30 years). For this post I ran the 140 years of equity data through an analysis to determine which duration provided the highest correlation between earnings yield and annualized return.
As the following chart details, the winner is.... 10 years.

While ten years was best, eight years was close (and the duration used above for fixed income). Another thought was that if we are to compare earnings yield to the yield of a Treasury bond for relative value, we need an apples to apples comparison... so the chart below uses eight years.
And what do we find... a chart with a pretty strong (~0.45 correlation) relationship. The difference of course lies in the fact that an investor in equities is guaranteed nothing (earnings can fall) and is at risk to multiple (i.e. P/E) contraction, but also shares in the "upside" (i.e. earnings growth) and potential for multiple expansion.

So.... is there a value in comparing the relative attractiveness of equities to fixed income? Sure. I would say the likelihood of equities outperforming Treasuries over the next eight years is high. But don't confuse relative attractiveness and attractive. Ten year Treasuries are currently yielding just 2%, so the 4% "excess" yield of the S&P translates to only 6% on a non-cyclically adjusted basis (using cyclically adjusted earnings it's less than 5%). As the chart above indicates, there have been plenty of occasions where equity performance has significantly under performed its yield, even over extended periods.

QE2 "Investment" Performance

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.