Sunday, June 30, 2013

[REPOST - Link] The cost of mining gold

The cost of mining gold

Wednesday, June 26, 2013

Fear and Liabilities in Las Vegas

An improbable number of Gucci loafers await American Airlines flight 1949, the 7:00 a.m. direct from John F. Kennedy airport to Las Vegas.
"I wonder where you're going," the owner of one pair jokingly asks another as they greet pre-flight in the airport lounge.
"You look tanned—were you in Augusta for the tournament?"
"Nope, didn't make it this year. Got some beach time instead."
It is Tuesday, May 7, and some variation on this conversation will occur countless times as the hedge fund set swarms towards the Bellagio Resort and Casino, the site of the SkyBridge Alternatives conference—SALT, to those in the know. Started in 2009 and now attended by nearly 2,000 people, SALT is the essential social gathering for the world's managers of money.
At least, that's what SALT founder and mastermind Anthony Scaramucci wants you to believe. A hurricane of a man, the diminutive Scaramucci has spent five years cajoling, enticing—and often paying—the likes of Bill Clinton, Sarah Palin, and hedge fund managers from around the world to attend what amounts to The Anthony Scaramucci Show.
But what is SALT? It's "a big networking event" for "meeting funds-of-funds" and "keeping up on the pulse of the industry." But it's also about "the parties, man, the parties," and is "a shit-show, pure and simple". Everyone has advice about SALT: "Don't drink too much," "don't commit too early to a party," "don't forget your badge—you won't get in otherwise," and "attend a few panels, if you can." Everyone compares SALT to something else: It's like fishing, or speed dating, or a financial Davos.
SALT is also about rooms—specifically, rooms you can enter, and rooms you can't. For the proletariat—which is about 95% of attendees—there are rooms for exhibitor booths, for shoeshines, and for intimate assemblies. There are balconies providing fresh-air conclaves, designated business rooms, and sponsored poolside cabanas for more casual encounters. The hallways, littered with over-cushioned couches and lounge chairs, also serve as potential contact points. With so many potential diversions, it's no surprise that actually entering the main conference room—a palatial space that hosts the majority of the official program—is low on many to-do lists.
But it's the rooms that most SALT attendees can't access that most tantalize. When the presenters come on stage, they emerge from an unseen room behind a sky-blue backdrop. At all times, two security guards flank the entrance to the State Street VIP Speakers' Lounge, as it is officially known. Within its walls, Leon Panetta, the former American defense secretary, mingles with his Israeli counterpoint, Ehud Barak. Al Pacino, if he shows up on time and so desires, has the chance to discuss Glengarry Glen Ross with former French President Nicholas Sarkozy. Director Oliver Stone and hedge fund titan John Paulson can huddle together in a corner—although, considering Wall Street: Money Never Sleeps, it might be a frigid conversation.
To enter the VIP Speakers' Lounge, attendees must possess both Scaramucci's blessing and the right credentials. Most possess neither. They are also unlikely to have the good fortune of a chance meeting with one of SALT's headliners at the bar or shoeshine stand. After the panels, Scaramucci hosts the notables at intensely exclusive dinners—the room within the room within the room. Pacino and Panetta and Paulson, being on the inside, are whisked from the VIP Lounge to whatever restaurant the Master of Ceremonies chooses, bypassing the laboring class altogether. To be a true SALT celebrity is to hardly attend SALT at all.
As a result, a Fear Of Missing Out—FOMO, in business school parlance—permeates the Bellagio. Attendees jump from panel to party to penthouse suite in hopes of being where the action is. Yet at SALT, the action is always within a few feet of Scaramucci—and Scaramucci, as ringmaster and an idea, is a moving target.
Oliver Stone declared as much during his public tête-a-tête with Vanity Fair's William Cohen. "If anybody has epitomized the American Dream, it is Anthony—well, and Gatsby, too."

Unlike Jay Gatsby, Scaramucci's origin story is clear. Ask him about it, and he is more than happy to tell you: Born on Long Island to parents without college degrees, he made his way to Harvard Law School, Goldman Sachs, and eventually to SkyBridge Capital, which he cobbled together with his self-made hedge fund-of-funds and the remnants of Citigroup's hedge fund unit, which he bought in 2010.
With $4.5 billion under management, SkyBridge is a middling player in this industry. But its leader, an ever-smiling self-promoter that looks a decade younger than his 49 years, is anything but anonymous. He is known and admired by his peers largely for one reason: Anthony Scaramucci didn't invent the hedge fund boondoggle, but he may have perfected it.
Drexel Burnham had its Predators' Ball, the famed leveraged-buyout summit in the 1980s that preceded the fall—and imprisonment—of its host, junk-bond king Michael Milken. Blackstone's Stephen Schwarzman had his star-studded 60th birthday party, thrown on Park Avenue in 2007 as world financial markets approached a cliff. Scaramucci has SALT.
He also has Ray Nolte. When Scaramucci made the Citigroup purchase, he was, in effect, buying two things: the group's assets and Nolte. The yin to Scaramucci's yang, Nolte—sandy-blonde hair, light eyes, conservative suit—may not be the salesman that his partner is, but he, like every other SALT affiliate, has the origin story down pat.
"One of our partners, Victor Oviedo, walked into Anthony's office in early 2009 and said, 'Let's put on a conference in Las Vegas,'" he recounted during SALT. "The initial reaction was, 'You want to what?' The president had just come out and basically blasted Wall Street for holding conferences in sunny places like Las Vegas. The country is at the height of the financial crisis and [the perception is] that all the Wall Street evil empire wants to do is throw parties in nice places. So you have all the big institutions running for the hills, canceling their conferences." Banks and financial institutions were under public pressure after accepting bailout funds. Some took million dollar hits on committed contracts after canceling last-minute, according to Nolte, because—in these institutions' thinking—"We're not going to be on the front page of any paper for holding a conference."
Good investors make money on the way up and on the way down. With credit markets grinding to a halt and the stock market plummeting, one hedge fund decided to go long in warm-weather finance conferences. "SkyBridge—being a small, entrepreneurial, forward-looking firm—said, 'You know what, let's go and embrace that. We can fill that void. We will put on a conference,'" Nolte recalled.
And so they did. "About 500 people came to the first one," he said. "I don't think SkyBridge would have gotten 500 people to come if everyone else were still holding their conferences. It went very well. The decision was made to do the second one, and numbers expanded. Number three, four and this year's conference really exploded." SALT's eastern offshoot takes on Singapore for the second time in September, and the Bellagio has already been booked for 2014.
"And by the way," Nolte added, "what I think people missed was that by telling Wall Street they couldn't hold a conference in Las Vegas, it didn't hurt Wall Street. It hurt Main Street. It hurt all the people who work in this building. If you take 1,000 rooms out of occupancy, the people who come and take care of those rooms are unemployed. So SkyBridge's view is, let's go help the city of Las Vegas—which is struggling—and at the same time it will be good for us."
Yet like Gatsby's Long Island revelries, the official story of SALT diverges from the reality.
Despite what those in attendance want to believe, SALT is not the Who's Who of the hedge fund world. The man at the helm of the world's largest hedge fund, Bridgewater's Ray Dalio, was nowhere near the fountains of the Bellagio. The beleaguered Steve Cohen, a speaker the previous year, was ensconced in Connecticut, under fire from an aggressive District Attorney and investor redemptions. Bill Ackman and Carl Icahn didn't take their spat to Vegas for the week. The two hedge-fund headliners of the conference—Paulson & Co.'s John Paulson and Third Point's Daniel Loeb—were both featured speakers, likely there as a favor to Scaramucci. SALT, it is clear, is a conference of those dreaming of billions, not of those yet possessing them.

Also noticeably thin on the ground were the preponderance of end investors that hedge funds are so eager to court. While rich white men were once the overwhelming patrons of the hedge fund industry, they have been overtaken in the past decade by pensions, endowments, and sovereign wealth funds—for however rich Bill Gates and Warren Buffet are, the $255 billion California Public Employees' Retirement System is richer. To the cynics in the audience at SALT, it is also less savvy.
Indeed, the fundamental reason for SALT's popularity is not entirely clear. For the Wall Street banks who sponsor the conference, a concrete logic exists: Hedge funds need a plethora of service providers, and many a summer home has been built on the fees hedge funds pay to these middlemen. Yet for all but the smallest fund, BNP Paribas or UBS would happily catch the train to Connecticut to meet hedge funds in their offices. So why do these hedge funds make the trek to the desert?
"I'm not entirely sure why I'm here," Daniel, a late-30-something soon-to-be hedge fund manager, said on the Bellagio's pool balcony, the site of the conference's opening-night cocktail party. (His opener: "Can I talk to you? I don't know a single person here.") Besides his relative anonymity, he was the quintessential SALT Man: Tall, firm, and blessed with a strong jaw-line. He wore the SALT uniform of designer jeans, button-down shirt, blazer, and sock-less loafers with buckles—known derisively as Darien Spurs, after the Connecticut locale that many on the balcony call home. His brown hair was closely cut and firmly in place. His Australian accent was one of the few deviations from the norm.
"I grew up in Perth, but I'm based in Europe—so I just popped over to New York, and now I'm here," he said. When small talk of the richest woman in Australia—mining heiress Gina Rinehart—arose, he grinned the grin that every man knows. "Funny you should mention Gina. I just came from New York, where I took her daughter out to dinner on Friday. She just got $300 million from Mommy, so her place is pretty nice. I left on Sunday to come here…and I'm not quite sure why." He was about to start a small hedge fund, he said, and had commitments from investors. Still, because of SALT being billed as a meeting place for, among others, hedge funds and potential investors, he had decided to attend. "I have yet to actually meet any investors," he mused. "Maybe I should have stayed in New York."
On the other end of the spectrum is Paulson. Few hedge fund managers have ever become as famous as the dour New Yorker, based almost exclusively on his prescient bet against the American housing market before its crash six years ago. Yet even giants stumble: Paulson was speaking at SALT, more than a few people suspected, because Scaramucci's fund-of-funds allocates millions to him at a time when Paulson has many nervous investors on his hands following some severe losses.
Not that Paulson wanted anyone beyond the conference walls to hear what he had to say. The press-shy manager's soft-ball interview the next day was off-the-record, as were, invariably, the more interesting speakers the host had flown in to spice up his agenda. Yet the billionaire could still sporadically be seen in the hallways of the Bellagio, draped in a dark suit and tie, shoulders hunched. Early one evening, Paulson was spotted nearing the almost-timely "Cinco de Mayo" poolside celebration that was the night's official soiree, slouching his way onto a balcony that overlooked the revelers. Nearing its edge, he looked down. Empanadas, Flamenco girls, tequila shooters, and Brooks Brothers met his glare. The Kings of Leon's "Sex on Fire" screamed from speakers. Ever so slightly, Paulson shook his head. He then turned around and walked away. 

“Half of the people in this room are assholes.” That room, a bar masquerading as a library in the Cosmopolitan Hotel, hosted a private pre-party for the poolside extravaganza that came later. Paulson wasn’t at this one, either.
The man quoted had paid dearly to be in that room, to be at SALT. As a service provider, his badge was pricier than any other. The "exclusive" pre-party was also a well-appointed feeding frenzy: Not only did sponsors and service providers jockey for access to the moneymen, but more than a few attendees were not even part of SALT. An investment banker from Los Angeles had flown in to network, later sneaking past security and turning up at the conference's final party. He opened his jacket to reveal the SALT-blue lanyard around his neck with nothing clipped to it except his jacket pocket. A securities lawyer had also been invited, "because other than investors, we're the closest people to these hedge funds." A good word from a trusted attorney on a certain accounting firm or data manager, and you were in.
People left the "library" in pairs and little groups, the successful ones with better company than they arrived with. But between the duck breast tacos of the Cosmopolitan and a fashionably late arrival at the pool party, these Madison Avenue financiers passed through a scrum of low-rent sex trade. "You need a girl tonight?" one shill asked two men in SALT uniform, thrusting at them a card depicting a busty and "Barely Legal!!!" young lady and a phone number. Canadian taxpayers may rest easy: A representative from one of their nation's public pension funds had no interest in "investing" with any of the women on offer.
That's not to say men at SALT—and it's mostly men—aren't interested in the opposite sex. When a young and/or attractive woman would rise during a panel and walk the aisle to a better meeting, undisguised gazes followed her from seat to door, head to toe. Female attendees skewed tall (aided by four-inch heels), slim, expensively dressed, and impeccably groomed; during the day, a row of couches on the patio drew SALT women like animals to a watering hole, eager to take a load off their Louboutins. The hostesses of sponsors' poolside cabanas seem to have been selected as much for their physical endowments as industry expertise. It is, by all accounts, a man's paradise—so much so that one young, single, female hedge fund manager offered a unique complaint: "Meeting men here is difficult," she said, "because it's hard to know who is actually single—and who just has their wedding ring in their pocket." Unlike Davos, SALT is not a bring-your-spouse affair.
At the pool party, minimally dressed cocktail waitresses waited patiently as middle-aged men fumbled through their opening lines ("I manage a hedge fund," being the default introduction). Dancers worked poolside platforms and circulated among the crowd, their crimson plumage and yellow sequins in high contrast to the clustered gray blazers and oft-gray heads. Men smoked cigars and indulged both in the tequila shots and the sight of the women offering them. Partiers lingered longer than might be expected for a group who'd spent much of the night discussing "what's going on next". Banks and other service providers took out groups of clients, and SALT sprinkled out over Las Vegas. Few returned to their rooms for bed. "We went everywhere," one family office manager said, smiling as he recounted the night prior. "Hyde, the Wynn, the Cosmopolitan—everywhere. Just jumped from club to club. I think I got home at about 5:30 a.m." Las Vegas offers endless venues for debauchery, and SALT attendees have the money and attire to unclip any velvet rope.
These men and women have the cojones to ride out a down market with their kids' college funds, but as night fell in Las Vegas, SALT was all speculators and hedged commitments. Scaramucci hosted his private dinners, and sponsors invited clients to their private suites and events. Nobody wanted to reveal if they had a less-than-packed dance card. Everyone was open to a better offer.

"Tonight? Everyone spreads out and goes to the clubs. The hottest tonight is Surrender," said Evan Rapoport—conference veteran, CNBC mainstay, and founder of the hedge fund research and service firm HedgeCo—over lunch with potential clients. He did SALT better than most. "I don't stay at the Bellagio any more—the rooms are too far away from the conference. At the hotel just behind us, you're closer and can get a whole suite for the price of a room here." If he had firm plans for the evening, he wasn't tipping his hand.
Rapoport was correct about Surrender, the enormous outdoor pool club at the Wynn. It was a perfect set-up for SALT attendees: opulent, and all the action happened in the private bungalows and cabanas that ring the swimming pool. Depending on the DJ in attendance, each of these white-tiled playpens ran about $3,000 for the night. On that night at SALT, none went unused.

The politics of a SALT Man are not simple. By definition or aspiration, this is the 1%. Yet the hedge fund industry is not solely the domain of default Republicanism, despite what those outside the Bellagio walls might assume. The political leanings of this group are much more nuanced, expedient, and malleable. Take, for example, Anthony Scaramucci.
His history of campaign contribution maps a common political progression. Until 2008, he donated relatively little. His money tended to flow towards Democrats, but the true targets seemed to be local politicians (Senators Joe Lieberman of Connecticut and Chuck Schumer of New York) and balance (he gave to the Bush/Cheney ticket in 2004). Between 2000 and 2006 he gave a significant, but not astounding, total of $34,000 to political campaigns, according to public records.
That changed in 2008. With Barack Obama—a classmate from Harvard Law School—on the ticket and the economy collapsing, Scaramucci upped his involvement. He also took sides. With just two donations—$28,500 each for Obama and the Democratic National Committee—he surpassed his previous eight years of donations. He was now, by any measure, an enthusiastic supporter of Democrats in Washington.
This would not last. By 2010, his largesse began to turn. While Senate Majority Leader Harry Reid of Nevada and Schumer were still included, Senator Scott Brown of Massachusetts and other rising Republican stars were the major beneficiaries of Scaramucci's wallet. By 2012, the turn was complete: Nearly $75,000 flowed towards Republican political action committees, Brown, and Presidential Candidate Mitt Romney. Additionally, Scaramucci was named one of eight national finance committee co-chairs for Romney, a role typically reserved for those who can attract large campaign contributions from wealthy acquaintances.
Scaramucci's rapid embrace and rejection of Obama is superficially unsurprising. In 2008, the world economy was collapsing and many prominent financiers backed Democrats. By 2010, however, these financiers largely felt that an ungrateful Obama had used them as a political foil instead of relying on them for guidance. A televised exchange between Scaramucci and President Obama in September 2010—two years after Lehman Brothers fell and the Dow Jones Industrial Average started sliding towards its March 2009 nadir—explains the hedge funder's pivot.

"This is something a lot of my friends are thinking," Scaramucci said, addressing the president at a CNBC forum. "I represent the Wall Street community. We have felt like a piñata. Maybe you don't feel like you're whacking us with a stick, but we certainly feel like we've been whacked with a stick… When are we going to stop whacking at the Wall Street piñata?"
Obama's response was pointed. "I have been amused over the past couple of years [by] the sense of me beating up on Wall Street. I think most folks on Main Street feel that they got beat up on," he said to applause. "I hear folks who say that somehow we're too tough on Wall Street, but after a huge crisis the top 25 hedge fund managers took home a billion dollars in income that year." He then added, incredulous: "A billion, that's the average for the top 25."
Yet politicians and financial regulators have focused recent reform efforts not on Scaramucci's set, but on large banks and their proprietary trading desks. The much-maligned Volcker Rule, which decreed that the two must part ways, is the most prominent example. Hedge funds largely have been left alone. SALT panelists noticed. "The regulatory environment creates fewer competitors and more opportunities. It's been great," one hedge funder noted on an opening day investment strategy panel. "If you look at the prop desks, they used to be one of our biggest competitors. Now, with the Volcker Rule, they're pretty much gone." Another added: "Prop desks are an abundant resource for recruiting—there's a lot of talent there."
And while the president's opponents will argue causality, America's anti-austerity fiscal and monetary policies have coincided with a financial-market recovery of historic proportions—a tailwind that helped all but the most bearish of SALT attendees. Despite national unemployment remaining stubbornly high and economic growth indolent, stock markets are booming. Piñata or not, any "whacking" taken by hedge funds has been largely rhetorical, not financial, in nature.
This tension was apparent throughout SALT, but never more so than on the third day of the conference. On the morning of May 9, Third Point's Dan Loeb—a man worth $1.5 billion who in 2010 claimed that President Obama was intent on "redistribution rather than growth"—joined Anthony Scaramucci onstage for an intimate discussion. As their conversation wrapped up, at 11:00 a.m. Pacific Time, the Dow Jones Industrial Average crested to a new all-time high of 15,135.

So why do some people not attend SALT?
Larry Schloss could give Scaramucci a run for his money as SALT's Most Popular Person—if Schloss had come to the conference. As the man in charge of investing New York City's $140 billion pool of pension money, he doesn't have to go to managers. They come to him.
"I have the luxury of not having to travel," Schloss judiciously noted in late May when asked why he didn't attend. "There are a lot of great conferences in New York, and managers are happy to come by and share with us what they're doing."
Since mid-2011, Schloss has allocated more than $2 billion to hedge funds. These lucky firms pocket 1.5% to 2% of that—$30 to $40 million—simply as an annual management fee. But big investors expect market-beating performance, and that is how hedge fund managers can get very rich. If one manager could turn New York City's $2 billion into $3 billion over a year, he would take home an extra $180 million. Schloss would smile as he signed that bonus check, because the manager would have earned New York's retired teachers and police officers a much bigger one.
A potential problem, however, lies with the chance that the initial $2 billion could shrink to something smaller. Hedge funds usually take 20% of any gains; they invariably take 0% of any losses. Because they also collect a management fee, they rarely lose money. They thus have an incentive to gamble. It's the equivalent of a SALT attendee striding up to a Bellagio roulette table knowing that whatever happened, the casino pays. He may only make a small amount, but he will never owe the house money. So why not shoot for the moon and bet everything on red?

But this isn't actually why Schloss didn't attend SALT. For a certain set of hedge fund managers, the vast majority of their personal fortune is invested in their funds. With these elite managers, the alignment of interest is better—as good as it gets in asset management, Schloss believes. "My definition of alignment is: 'How much money can the manager lose when I lose?'" he said. Elite managers will have the bulk of their wealth—hundreds of millions or billions—invested alongside New York City's blue-collar set. Schloss wants to know these managers. "We want to meet good managers and build strong relationships. They are important to what we do," he said. But these managers rarely fly to Las Vegas for a conference.
"Looking back, over time the market develops bubbles," Schloss added. "Some of these bubbles you can pick out by where the conferences are held and how extravagant they are. These are not good signs. People don't like to be associated with those, because it suggests you have lost your bearings and lost touch with reality. Unlike conferences, extravagant boondoggles can be an indication of the go-go days."

The air had come out of SALT's tires by Friday morning, the final day of the conference. Scaramucci still roamed the hallways—"Thanks for coming, I really appreciate it, see ya next year"-but even his pressed suit and slicked hair failed to mask his fatigue. Ehud Barak could be seen departing the Bellagio, flanked by a pair of bodyguards. Wrinkled men limped toward McCarran International Airport, hoping to find sleep in the claustrophobic arms of whatever carrier was shuttling them home.
Back in the main conference room, seats had been rearranged to give a sense of consistency with previous days—but nobody would deny that the audience for "Call of Duty: Military Challenges at Home and Abroad" was a small fraction of Nicholas Sarkozy's the night before.
Perhaps it was a coincidence that SALT's most open critic of Wall Street excess was the last speaker on the agenda. Perhaps this friend of Scaramucci and creator of Gordon Gekko had been saved—best for last. The host himself introduced Oliver Stone, who looked loose and authentic to Scaramucci's labored polish.
A clearing-house quality prevailed on the final half-day: sponsors to be given airtime, crowded panels shouting pitches to resigned attendees. Introducing the Wall Street director gave Scaramucci a pretext to plug his book. Stone dutifully played along. "I have had the pleasure of knowing Anthony for quite some time," Stone said, "and I know what he means by the title of his book, Goodbye Mr. G… Mr."—The moderator intercepted: "Goodbye Gordon Gekko." Stone had a rhetorical reason for coming to SALT, but it wasn't to sell Scaramucci's book.
"This obsession with money is very dangerous for the soul of the country," Stone said. The 1980s depicted in Wall Street "were all about individual selfishness and hustling, hustling." Audiences didn't catch Stone's satire in the first film, he has said. Gekko—who famously proclaimed: "Greed is good."—became a hero to legions of aspiring financiers. Stone revisited the franchise in 2010, when he felt the era had ended for good. "I wouldn't have done the picture without the meltdown," he said at the time of release. "There was a sense of karma and ending and definition to this horrible excess and greed we went through."
Three years later—to a hungover audience striving to be, if not Gekko, then Icahn or Dalio—Stone had changed his mind. It wasn't over. And while he previously criticized via satire, he has since changed his tack: Stone and a partner have spent four years and at least $1 million of the director's money producing a 15-hour documentary to discredit American exceptionalism, economic domination, and excess.
"We are a society at risk, and we don't know how to fix it," Stone told SALT, pointing out the nation's deepening divide between rich and poor, Occupy Wall Street, and the financial crisis itself. "This is the Roman Empire. Think about the French Revolution."
Many in the audience rested their elbows on the tables with faces in hands. One man slept in his chair, head tipped back, mouth agape. 

Funds-of-Funds as Advisors: The Next Iteration

In December 2011, with no hedge fund program to speak of, the California State Teachers' Retirement System (CalSTRS) already seemed behind the curve on alternative investing. And then, after 15 months of thought and research, its nascent hedge fund team did something even more old-fashioned: It hired Lyxor Asset Management, a hedge fund-of-funds.
But CalSTRS was not shying away from the slick, impenetrable hedge fund game, choosing to pay Lyxor a premium to do the leg work and decision-making. No, CalSTRS' experimental innovation and risk unit wanted a partner—an extension of its team with the expertise to guide its venture into hedge funds. Lyxor, the group concluded, could do that better than any firm with "Advisors" or "Consulting" in its title.
"Why Lyxor? The breadth of their services really impressed us," says Carrie Lo, a CalSTRS investment officer with the innovation and risk team. "Setting up managed accounts, and trying to understand all of that, was something we were very interested in. They already have the infrastructure and experience to do that. Also, their analysts are really top-notch. Coupling those touch points, we knew it was a good fit." Plus, she adds, "We like that they are institutionally oriented."
Lo brought her own expertise to the search. Prior to joining the $167 billion pension fund in 2008, Lo spent four years at Algert Coldiron Investors, a San Francisco hedge fund founded just two years before she arrived. "I joined when they just had one fund," she recounts, "and I got to see all of the aspects of actual trading and risk management." The head of the innovation and risk group, 20-plus-year CalSTRS veteran Steven Tong, brought deep institutional knowledge to the new unit. Together, Tong and Lo knew they were going against the grain by hiring—not firing—a hedge fund-of-funds.
The number of funds-of-funds has dropped every year since the financial crisis, although the hedge fund industry overall has boomed. The total number in operation has dropped by more than 20% in five years, from a pre-crisis high of roughly 2,400 to fewer than 1,900, according to Hedge Fund Research's latest industry report. More capital has flowed out of the sector than into it for each of the last three years. In 2012's final quarter, less than one in five funds-of-funds secured more new money than it lost in withdrawals. For hedge funds themselves, however—as the infographic here illustrates—-business has been booming. Total assets under management hit $2.69 trillion at the end of April, up 39% since 2008, according to eVestment data. Most of that money has come from institutions, which a Preqin survey found were responsible for 65% of total industry assets in 2012. Like CalSTRS, many endowments, foundations, sovereign funds, and other pensions are simply cutting out the middleman.
"The word on the street with funds-of-funds is 'OK, how are we going to create value in the future?'" says Lyxor's Head of North American Business Development Mike Bernstein. He recently did the rounds at industry conferences, and found the sector is all too aware of its tenuous position. But as he sees it, the last five years have been a Darwinian stage for funds-of-funds: Survival of the fittest. "There has been quite a shakeout. If you've made it up until this point, I think you have a good chance of surviving. You're going to have the large funds-of-funds competing on their ability to negotiate fees and terms, and the small specialized ones that continue to deal in places that are just too painful for investors to do themselves."
Lyxor is one of the big ones: With $22.5 billion under management, the Société Générale offshoot came in sixth on Towers Watson's latest ranking of funds-of-funds. But as an advisor, Lyxor was far from the obvious choice. "It is to CalSTRS' credit that they chose us in the first place," Bernstein says. "We were by no means a household name, and it shows independent thinking."
The Sacramento-based pension issued its request for proposals for a global macro hedge fund consultant on April 6, 2010, the culmination of more than a year of research and strategizing by the innovation and risk team. The unit had been set up to determine what was missing from CalSTRS' portfolio, and to act as an incubator or lab for testing out new ideas on a small scale. Its first mission: hedge funds. A number of other large public funds had already entered the space, and they proved to be a font of practical advice when Tong and Lo came calling. The pair also did extensive quantitative analysis to select the single best hedge fund strategy for diversifying CalSTRS' portfolio. Global macro, they found, had little correlation to equities, and performed well during market downturns. It was 2009, and those were very appealing qualities. "We went to the board and presented our findings, focusing in on global macro," Tong recounts, "and the board said 'That's great, we agree, but we're concerned with investing in the hedge fund space,'"—again, 2009—"And so they asked us to hire a consultant."
Story continues...

More than 10 firms applied for the job, including traditional advisories, consultants, and at least two funds-of-funds. Five applicants made the final round. Lo and Tong knew what they were looking for: Expertise with global macro investing, foremost, as well as capability in portfolio construction, manager selection, and investment term design. They required an advisor willing to have skin in the game as a fiduciary, but insisted that the fund stay in control of manager selection. At no point did the role resemble a typical hedge fund-of-funds arrangement, where asset owners describe their goals, sign the checks, and leave the investment decisions up to the firm.
But over the 15-month-long search process, Tong and Lo say they began to realize that a number of CalSTRS' problems with investing in hedge funds could be solved or lessened by the managed account structure. These pools separate custody of the assets from the manager who invests them, thus reducing an asset owner's exposure if it turns out that "hedge fund" is more of a Ponzi scheme. A hedge fund may also be willing to provide more transparency or reporting to investors in managed accounts than for its main pool. Typically, the structure does make for a more costly investment. "It's important for us to get a certain return," Tong says, "but the risks are tantamount"—headline risk being enemy No. 1.
For all of the advantages managed accounts offer a major public institution like CalSTRS, simplicity is not one of them. Managed accounts are logistically complex, involving a web of counterparties and legal agreements. They can be set up for one investor exclusively or a number of them with similar needs. Some hedge funds will do them happily while others may not-it depends who's asking and what, exactly, they're asking for. If Tong and Lo felt their team could go it alone with basic global macro allocations, they knew CalSTRS could really use an expert hand with managed accounts. Lyxor, one of the five finalists, has an entire platform set up for arranging these side bets. Before the advisory contract had even been finalized and signed, the Innovation and Risk unit was already touting global macro investments via managed accounts in a business plan for the 2011 to 2012 fiscal year.
Mike Bernstein remembers the precise moment when he found out Lyxor would be the lead advisor for CalSTRS' venture into hedge funds. "It was Friday night. I was with a colleague of mine who had offered to give me a ride home. We were in the parking garage, I believe, and a macro manager sent a congratulatory note. Then I saw one of the trade rags had broken the story: 'CalSTRS has awarded Lyxor the mandate,'" he recalls. "It was a big breakthrough for us in the US." Bernstein joined Lyxor in 2009, specifically brought aboard to attract institutional capital to the firm's new US-based fund-of-funds. "It was a big win."
With Lyxor's guidance, the unit has allocated its entire $200 million global macro budget into four managed accounts. Bridgewater Associates' Pure Alpha Major Markets took $50 million into a pre-existing side account. Alphadyne Asset Management and MKP Capital Management each received $50 million. Lo says the group has selected a manager for the remaining $50 million, but couldn't yet reveal its identity. If these and the rest of the group's investments suitably impress CalSTRS' board, hedge funds may go from an experiment to a full investment program in the coming years. "We're already having dialogue with Lyxor about expanding into the total space," Tong says.
Lyxor had something to offer the California pension giant that regular advisors didn't. As an asset allocator, it knows managed accounts and hedge fund investing in practice, not just in theory. But Lyxor also won the contract through sheer effort. Institutional investors in general, and major public pension funds in particular, make demanding and picky clients. At a recent hedge fund conference, one of CalSTRS' investment officers likened the organization to a "high-maintenance girlfriend," needing endless phone calls, reassurance, and attention to be kept happy. Lo, Tong, and Bernstein laugh at the comparison, but they don't deny it.
"It is a credit to us that we could withstand the due diligence," Bernstein says. "It was extreme—a full, open-kimono kind of situation where they saw the good, the bad, and the ugly." Lyxor took a risk in thrusting resources behind its bid for the advisory slot, particularly as an unconventional candidate. The gamble paid off, of course: As an advisor to an institution going direct with its hedge fund investments, Lyxor is capitalizing on a trend that beat up its core business as a fund-of-funds. CalSTRS has not disclosed how much it is paying for the advising—the fund's most recent public report on external investment consulting fees covers the 2010 to 2011 fiscal year. But according to Tong, the fee arrangement with Lyxor is based on assets under advisory. At just $200 million thus far, Lyxor must be crossing its fingers for CalSTRS' board to expand hedge fund investing beyond the incubation stage.
Story continues...

CIOs tend to have the same single complaint about funds-of-funds: the extra layer of fees. One of the first actions Steven Grossman took as Massachusetts state treasurer and chairman of the public pension system was to begin pulling nearly all of its assets from funds-of-funds. “We were paying an extra 84 basis points over standard direct management fees,” Grossman told aiCIO in an August 2012 interview. “On $5 billion, that’s $36 million. We hadn’t been particularly happy with our returns on those investments.” Besides saving on fees, he also wanted to bring the due diligence process in-house. Roughly two years into the transition to direct investing, the number of active funds-of-funds investments in the portfolio has dropped from more than 200 to three—but one of them will be spared from the slaughter. Out of all 200-plus relationships, why is the $53.6 billion Massachusetts retirement system willing to keep paying a premium to Pacific Alternative Asset Management Co.? Exposure to emerging managers, according to Grossman. “That’s an area we want to broaden our outreach to, and we’re doing it through PAAMCO.”
Research backs up Grossman’s bullishness on small and early-stage hedge funds. A 2012 PerTrac study found that funds with less than $100 million under management returned a cumulative average of 558% from 1996 through 2011. Funds with between $100 million and $500 million returned 356%, while those managing more than $500 million gained an average of 307%. (This study and others have attracted criticism for survivorship bias, which industry experts say is difficult to completely control for.) Researchers argue new managers have more incentive to beat benchmarks and deliver alpha, since unlike established giants, they cannot coast on management fees.
If the last five years have been harder on any group in finance than funds-of-funds, it may well be new hedge fund managers. (OK, besides prop desks.) The lion’s share of new institutional allocations goes to funds with more than $5 billion under management, according to Preqin data, and the lion’s share of new capital is institutional. “Pension funds are tough for new managers, unless you connect with one such as CalPERS with a seeding program,” says David Fry, the former head of global markets for Deutsche Bank Canada. Fry and a partner launched credit-focused hedge fund Lawrence Park Capital Partners in March 2012. The eight-person team now manages $250 million in a long-only mandate and $52 million from limited partners. Based on his experience as an early stage manager, Fry points to funds-of-funds as an important conduit for securing capital. “The funds-of-funds”—and he’s met with many—“know how to evaluate a manager starting for zero. Anybody can find Och-Ziff and Bridgewater, but to pick out the new strategies, the niche strategies, and the up-and-comers takes much more work. It is not necessarily feasible for most institutions to take on a direct search in this space.”
Just as Lyxor’s expertise in managed accounts sealed the deal for CalSTRS, funds-of-funds specializing in new managers offer most investors something they can’t do at home. One such firm, Larch Lane Advisors, has been operating this model since 1999. President and COO David Katz says new managers’ appealing fee structures and flexible terms continue to attract investors, despite the industry’s overall malaise. “A lot of the smaller funds offer founders’ shares for discounted fees as a way to reward early investors,” he says. As with Lyxor, Larch Lane has actively sought “value-add” services to compensate for the dreaded extra fee layer and to diversify its business. Katz doesn’t just select promising newcomers—he develops and occasionally bankrolls them. If a fund is not equipped to meet institutional compliance standards, Larch Lane connects it with the right people to bring it up to snuff. Finally, since 2001 the firm has invested nearly $4 billion in seed capital with 26 of the best managers it has come across. In return, Larch Lane gets a share of future revenue.
Both Lyxor’s Bernstein and Larch Lane’s Katz naturally make a point of defending the traditional funds-of-funds model as relevant and still in demand. And yet both firms have ridden out the last five years by edging away from that structure. “Advisory” is a much more common term on their firms’ websites than “fund-of-funds”. Neither man argues that this post-crisis period is just a rough patch for the industry. But perhaps there is more at play than a faulty structure. As Bernstein added just as our interview came to a close, “My real take on all of this is that funds-of-funds have gotten a lot of criticism on all sorts of matters. Funds-of-funds might be the obvious whipping boy, but the fact is hedge fund performance hasn’t been all that good.”

Saturday, June 22, 2013

Blackstone Group’s GSO Capital: Lenders of Last Resort

Blackstone Group’s GSO Capital: Lenders of Last Resort: GSO founders Bennett Goodman, Tripp Smith and Douglas Ostrover have become a key source of capital for non-investment-grade companies struggling to get financing, and in the process they have made a lot of money for themselves; their parent, Blackstone Group; and their investors.

Stanley Druckenmiller On China's Future And Investing In The New Normal

from Goldman Sachs
Stan Druckenmiller is Chairman and Chief Executive Officer of Duquesne Family Office. He founded Duquesne Capital Management in 1981, which he ran until he closed the firm in 2010. Previously, he was a Managing Director at Soros Fund Management, where he served as Lead Portfolio Manager of the Quantum Fund and Chief Investment Officer of Soros
Interview with Stan Druckenmiller
Hugo Scott-Gall: What are the risks of investing in China that are not well understood in your view?
Stan Druckenmiller: The growth in credit at a time when GDP growth is slowing is a problem for China. And I think this is the 2009-11 stimulus coming back to bite. I understand that it had to be done to fund entrepreneurs and the private sector, but it’s easier said than done if you’re channelling funds through local government investment vehicles. I’m a believer in markets. A few men sitting around a table and deciding how to allocate capital goes against everything I’ve ever believed. Not only are they not great at capital allocation, such an exercise also needs to deal with a lack of property rights and corruption. In essence, the frantic stimulus China put together at the end of 2008 sowed the seeds of slower growth in the future by crowding out more productive investments. And now, the system’s building enough leverage and misallocation of resources to warrant risks of a financial crisis, but the timing of that is still uncertain in my mind. What we’ve seen in China since 2009 is similar to what happened in the US in 2005, in terms of credit growth outpacing economic growth.
I think ageing demographics is a bigger issue in China than people think. And the problems it creates should be become evident as early as 2016.
You also need to keep in mind that for China to grow and evolve further, it will need to compete with a more innovative Korea and now a more competitive Japan. I don’t think China can do that with where its exchange rate is today. I think productivity is a key concern too. And I think that could be one of the reasons why the US has been so supportive of Abenomics.
People mention lack of infrastructure as a constraint. But when I go over there, it looks like they have a lot of infrastructure. It seems ahead of the population, not behind. I see expensive apartments in empty cities that 300 mn rural Chinese are expected to migrate to.  That looks very unbalanced to me. Nobody’s ever had investment to GDP at 47%. Japan and Korea peaked at 36%-38%, so as a result I think capacity is way ahead of demand in some areas in China.
Hugo Scott-Gall: If China slows its fixed asset investment, will that have a knock on effect for its commodities demand and thus commodity prices?
Stan Druckenmiller: When I started in 1976, I was taught by my mentor that when cash flow rises equities go up. But commodities are driven by the cost of extraction 90% of the time, and over the long run, technology makes extraction cheaper, pushing the cost curve down and with it commodity prices. But that hasn’t always worked, if I’d followed that advice over the past few decades, I’d be in trouble.
About five years ago, I bought into the peak oil thesis. But then, along comes shale oil and shale technology, reminding me of what my old mentor said 35 years ago. Now I’ve come to think that the oil price is not as vulnerable to China slowing down as it is to ongoing shale supply growth. I regard the ramp up in investment by China as a 10-year aberration, making the last two years more normal and more representative than the previous decade.
I do think China is serious about rebalancing, which means infrastructure investment is going to slow. And obviously, there's been a huge ramp-up in supply around the world in response to the 2009-11 stimulus, which in my view is a massive misread by the suppliers of these commodities. So that’s not good for commodity prices. And then you have innovation. Can technology progress in iron ore and copper, the way it has with shale energy? My guess is it will.
If you look at food, there’s now technology that allows seeds to be drought-proof and disease proof. Yes, there is a demand-supply argument for food prices rising, but the impact of technology on food supply is greater than you think. On the other hand, we are using up more and more good arable land to build cities in China and there is a water problem in China too.
Hugo Scott-Gall: Do you think we underestimate the role of innovation in resolving these global constraints?
Stan Druckenmiller: Even with all the progress we have made in technology in the recent past, I think we are only scratching the surface in terms of innovation. We haven’t seen half of the practical applications of big new technologies yet. And the cost of these technologies will come down too, whether it’s robotics or driverless cars. That has to provide a productivity boost.
But there is a downside to technology-driven productivity surges too. There is improved efficiency, but at the cost of fewer jobs. I think the impact of technology on manufacturing jobs is easy to overlook because of the huge surge in services jobs. But we’re now at a point where the impact of technology is hitting the services sectors too. And not everyone understands this. I recently brought up the possibility of driverless auto technology resulting in zero jobs for truck drivers within the next 20 years and there were gasps of disbelief from the audience of investors. When I mentioned it to a high-tech company CEO from Silicon Valley a few days later, his response was exactly the opposite. The point is that the problem with a tech-driven productivity surge is that the benefits of that are going to accrue to a smaller, narrower group. Already, computer engineers have benefitted from computing and the internet a lot more than the broader population.
You could draw similar conclusions on the impact of technology and automation on investing. I believe that good investors are successful not  because of their IQ, but because they have an investing discipline. But, what is more disciplined than a machine? A well-researched machine can make many average investors redundant, leaving behind only the really good human investors with exceptional intuition and skill. And what happens when machines really take over investing? Do the markets get really efficient? Or will there be competing systems trying to outdo each other? All of this is depressing because there won’t much left to do for humans once machines start doing more and more.
If machines do everything well, including allocating capital and resources efficiently, can that be deflationary, can that eliminate poverty? I don’t know. It’s hard to be very optimistic if you look at how humans have behaved historically. All in all, I don’t think robots and greater automation can bring about a utopian world as I imagined it would as a kid 50 years ago.
Hugo Scott-Gall: If you combine the prospect of fewer jobs with an ageing population, it doesn’t look very good for many economies...
Stan DruckenmillerApart from India, most of the other major economies have worsening demographics to worry about. It’s a big problem for the US too, especially given that relative to many other economies, including Japan, its fiscal gap is much wider. All in all, I don’t think robots and greater automation can bring about a utopian world as I imagined it would as a kid 50 years ago.
You can look at the US debt stock in a few different ways. The official estimate of the total debt may be US$11 tn, but if you include what the Fed has bought (which you should), then the number if closer to US$16 tn. But a better measure of US debt would include some of the off balance sheet items. Laurence Kotlikoff, who is one of the top economists in his field of generational accounting, estimates the present value of US debt including what has been promised to senior citizens, adjusted for the projected tax revenues and the fiscal gap, to be about US$211 tn. That’s staggering.
The US needs to resolve its debt problem politically, otherwise it is headed towards default. I believe the estimates suggest that the US needs to raise all taxes by about 64% in order to be able to support its older population. That’s raising payroll, capital, dividends and income taxes by 64%. The other option is to cut all government spending by 40%. Neither one is a viable option and a combination is not easy either. In 20 years, those numbers will become even tougher. The US will need to raise taxes by 75% or cut spending by 46%.
There has been vigourous debate on the veracity of Rogoff and Reinhart’s research on the consequences of countries exceeding 90% debt-to-GDP. But it doesn’t take away from the fact that historically, such levels of indebtedness has resulted in extreme implications.  Countries tend to go into a full-blown monetisation or a default or inflation on average 23 years after they cross the 90% threshold according to their research. So these debt levels are less relevant for you and me today, but will be extremely crucial for our children. If we continue to borrow and spend like we do now, this can become a serious problem in 15 years.
If machines do everything well, including allocating capital and resources efficiently, can that be deflationary, can that eliminate poverty? I don’t  know.
I understood the need for QE1 because the US economy faced a potential meltdown then. But further easing brings problems of its own, that only come to light in hindsight. All that easing and prolonged negative real interest rates have gone beyond resolving the core issues the economy faced and has led to re-leveraging. I’m not worried about inflation as much as misallocation of investment.
Another consequence of today’s monetary policy is that the US government is not getting any price signals. In any other society, at some point in the next 15-20 years, the markets will give a price signal and the politicians will need to respond. But currently, there is no such impetus for politicians to act. What adds to the problem is that young Americans don't vote. Old people not only vote, but also have incredibly powerful lobbying groups behind them. Entitlements in 1960 were 28% of government outlays, today it is 67%. And the baby boomers have only now begun to retire. Another debate is that this is a huge reason to accelerate immigration, but current policy is moving in the opposite direction. But even with immigration, the US needs to fix this pay-as-you-go system or the consequences could be quite drastic.
Hugo Scott-Gall: Do you think investing is becoming harder now with more government intervention and regulation interfering with market price signals?
Stan Druckenmiller: It has become harder for me, because the importance of my skills is receding. Part of my advantage, is that my strength is economic forecasting, but that only works in free markets, when markets are smarter than people. That’s how I started. I watched the stock market, how equities reacted to change in levels of economic activity and I could understand how price signals worked and how to forecast them. Today, all these price signals are compromised and I’m seriously questioning whether I have any competitive advantage left.
Ten years ago, if the stock market had done what it has just done now, I could practically guarantee you that growth was going to accelerate. Now, it's a possibility, but I would rather say that the market is rigged and people are chasing these assets, without growth necessarily backing confidence. It's not predicting anything the way it used to and that really makes me reconsider my ability to generate superior returns. If the most important price in the most important economy in the world is being rigged, and everything else is priced off it, what am I supposed to read into other price movements?

Banks: What are they good for?

When you get too much regulation, unforeseen consequences happen.

The banks are slowly being strangled and those who are left are squeezing out as much as they can before the banks end up not doing anything at all except sit on legacy IT systems and store unwanted bloomberg terminals. Having followed the digital currency rise of bitcoins and the US trying to hound out the exchanges and scare users into believing they are money launderers (wired), in the real world we have hedge funds now becoming banks.

Hedgies are all about risk management and having ripped apart the world of insurance, its now over to 2% a month please loan notes. Not only are they faster and better than they banks, they actually do lend out. No wonder Highbridge just raised USD3 billion to lend out. A clever way for JP Morgan to gain fees that have nothing to do with lending. You have to applaud them. (wsj)

Thursday, June 20, 2013

The Inflation Hedge Myth

Thought you could hedge your inflation risk with equities, commodities, and infrastructure? Think again.

Only one asset class can claim to be a true and complete hedge for the inflation risk in your portfolio—and there's not enough to go around, research by the Institute and Faculty of Actuaries has found.
Speaking at the organisation's annual risk and investment conference in Brighton, UK, this week, two members from a working party set up to analyse how investors can match this liability had some bad news.
"What has been sold as inflation-linked hedges, we struggle to match with the claims," said Ralph Frank, founder of solutions provider Charlton Frank and Mercer alumnus. "Looking at the UK market alone, there is comfortably £1.5 trillion in inflation liability. This working group was set up to help investors come to their own conclusions on the best match from a range of asset classes."
Frank and Lukas Steyn, a member of the Pensions Solutions Team at Barclays explained to attendees at the conference that each asset class had different aspects, which would make them a better or worse fit as an inflation hedge.
"The most robust hedges are index-linked gilts, along with breakeven inflation swaps," Steyn said. "The maturities for the index-linked gilts may not match exactly, but taking a number of factors into consideration, these two instruments are typically the most robust hedges."
Investors know this; they also know the problem comes with supply. There is barely £450 billion of these government-backed debt instruments in the UK, which is one of the biggest markets, leaving a shortfall of more than two thirds. It translates into a similar picture around the world, which has meant investors have been looking to other asset classes for options.
What about international government-backed debt instruments? No so fast, the working group said. "There is about $2 trillion in overseas, government-backed, inflation-linked bonds, but they are unlikely to have the same profile as foreign investors' liabilities," said Steyn. "Then there is the political, repatriation, and currency risk to consider."
As an aside, if your fund has liabilities in Brazil, it is worth noting that the country has been issuing government-backed, inflation-linked debt since the 1960s and has about $250 billion outstanding.
Inflation-linked corporate debt is a useful option, the group found, but there is very limited issuance and investors have credit default and liquidity considerations to take into account with this asset class.
Let's leave fixed income then. Equities—the price of a stock goes up, that's a proxy for inflation isn't it?
"No," said Frank. "Equities are not a meaningful hedge, despite historical thinking. We have looked at data back to the 1960s, which is as far back as total return records go. Look at first principles: equities are at the bottom of the capital structure, you're only owning a stake in a company—and a pretty risky one at that."
Mining and resources companies? Not much better, according to Steyn, who dispelled the myth of commodities as a perfectly hedging inflation risk.
"There is no link between commodity prices and inflation, despite historical thinking. They provide an input into the overall inflation basket, but the direct link is too small to have a meaningful impact," he said.
In the event of a commodity shock, such as an oil price spike, the input plays a larger role, but these happen relatively occasionally and should not be used as a guide.
And the poster-child of inflation-linked assets—infrastructure?
"What is infrastructure?" asked Frank. "The debt part can be viewed as corporate, inflation-linked, which we have already covered, and the equity part, well, we have looked at this earlier, although income may be linked to inflation, as part of a corporate structure, which includes incentives for directors, and internal costs, so you might find what you earn is different to what you thought."
Members of the audience proffered other suggestions, such as agricultural land, which were all broken down by the pair, and placed into buckets already covered by the presentation.
Frank and Steyn repeated that they did not offer solutions to the dearth of inflation-linked products, but invited investors to read their paper on the subject to make up their own minds on what to choose.
That paper, including methodology behind all of the conclusions above, will appear here soon.
Related content: Who Cares about Inflation?

Tuesday, June 18, 2013

It’s not fair! Sequence of returns risk

You never know what return the wheel of fortune will deliver each year
With the mindset of a long-terminvestor, you avoid a lot of the worries that afflict the frightened hordes.
You’re not scared out by a stock market crash. Nor do you pile in at the top.
Instead you develop the tough-under-fire attitude of a Vietnam veteran on his third tour of duty. When share prices plummet you go surfing, Apocalypse Now-style, while others quiver before CNBC.
“Is that all you’ve got?” you laugh as the stock market falls 10%.
The average after-inflation annual return from shares globally is 5% per year1. So as long as you sit tight and keep the faith, you’ll eventually be rewarded, right?
Well… yes, probably…2

The sequence of returns matters

You’d better know that there’s another kind of risk you need to think about, and it’s potentially nasty.
It’s this: The return you get in your investing career might be different to the return I get – even if we both enjoy the same average 5% real return over three decades on our investments!
I know – it’s counter-intuitive.
It also has a clumsy name. It’s called the sequence of returns risk.
The sequence of returns risk is essentially the risk that fate will deal you a shocking hand – that the timing of bear markets and bull markets will fall less favourably for you than it does for another investor.
It’s why we’re urged to reduce our exposure to the riskiest assets as we approach retirement age.
It’s also why a decade of steep stock market falls could bode well for younger investors who have saved throughout the turmoil.
The best time to get bad hands when you’re regularly putting money into shares is when you’re starting out – because you learn your lessons early, and you’ve got less money to lose.
In contrast, the last thing you would want the day before you retire is to have all your lifetime savings in shares, only for the market to get sliced in half.

How to multiply your money

You might not think it matters what order the market tosses up its treats and its treacherous years.
Returns from investment are multiplicative – you multiply your money!
And every precocious child knows that it doesn’t matter what order you multiply numbers together. You still get the same result.
For example:
1 x 2 x 3 x 4 = 24
4 x 3 x 2 x 1 = 24
3 x 4 x 1 x 2 = 24
It’s exactly the same with investing.
When the market delivers a 20% return, it goes up 1.2 times.
When the market falls 10%, you multiply it by 0.9 times.
1.2 x 0.9 = 1.08
0.9 x 1.2 = 1.08
So why does it matter to us poor strivers exactly when the sturm und drang of a stock market crash hits us?
Well it wouldn’t if you were a member of the landed aristocracy and you were just managing a big pile of loot before passing it onto the next generation (after six or seven decades of compounding and an unsavoury sex scandal or two).
But most of us are investing new money over our lifetimes to ensure our financial futures – and we also have to withdraw our savings in retirement.
And it’s because we add and subtract money from the market over time that the sequence of returns risk can have its wicked way with us.

Here’s one we did earlier

Let’s consider a real world example. Here are the total returns from the FTSE 100 for the five years from 2008 to 2012:
Source: FTSE
Do the sums and you’ll see that’s an average annual return of 3.9% per year.
Now let’s imagine you had invested £100 at the start of 2008. Here’s where your money would have stood at the end of each year:
Note: £100 compounded for five years, as per the returns listed.
The first thing to note is that you’ve ended up with less than you might have expected from the 3.9% average annual return.
Plug 3.9% into a compound interest calculator and you’ll see you might have anticipated £121. You got £10 less.
This is because investment returns are geometric, rather than arithmetic. But that’s another article…

Investing in Bizarro World

Getting back to the sequence of returns, let’s imagine you fell through a wormhole and ended up in an alternative reality, and five years in the past.
(Stay with me here!)
Being a good saver, you shrug off your trip through space and time and make your way to the nearest stockbroker. People still need to save and invest for their retirement it turns out, even in this Bizarro World.
But things aren’t entirely the same.
In this alternative reality, the annual returns you get over the five years from 2008 to 2012 are reversed as follows:
Source: Bizarro World Bank Headquarters broom closet.
This time the big crash comes at the end of the five-year sequence, rather than at the start as it did for us in our reality.
Do the maths and you’ll see you get the same average 3.9% return.
But what about your £100 investment?
Note: £100 compounded for five years on Bizarro World.
As we expected, because returns are multiplicative, we end up with exactly the same £110.56 in Bizarro World as we got on Planet Earth – even though the sequence of returns is reversed.
So far so good!

Adding up the cost of bad luck

The complication comes if you are saving or taking money from your investment over the years.
Let’s say you add £20 at the end of each year to your ongoing investment.
In our reality on Planet Earth, this would have played out as follows:
Note: £100 initially invested, then £20 added at the end of each year.
What about in the alternate reality, where the sequence of returns was reversed?
Here you’d end up with a different result:
Note: Again, £100 in, then £20 added each year. Alternative return sequence.
As you can see, falling through the trouser leg of time3 has reduced your final sum by around 10%.
Now I don’t know how much things cost in Bizarro World, but I’m sure you’d rather have that extra spending money.
More seriously, this is exactly what happens in real life to different investors with slightly different saving schedules. The sequence of returns varies over time, and so two regular savers with the same general strategy but investing over different periods will see different sums accumulated by the end, even if they enjoy the same average annual return.
People who retired in the late 1990s as the stock market soared were laughing.
People who retired in 2003 after several steep market declines?
Not so much.
The science bit: As well as the multiplication, we now have addition in our sums. So the order now matters.

Withdrawal symptoms

More scarily, the same thing happens when you’re withdrawing money.
I say “more scarily” because there’s not much you can do about your savings once you’ve stopped earning.
At least if you’re dealt a rubbish hand while you’re still accumulating money, you can try to find more cash to invest before you retire. You might even enjoy a market rebound on the extra cash you put in.
Once you’re retired though, you’ve no choice but to spend less and cancel your subscription to Caravan Monthly.
Imagine you had £100,000 in 2008. For the sake of this example let’s say you kept it all in the stock market, and you withdrew £4,000 a year.
In the table that follows the third column shows how £100,000 would fare if you kept all your money invested. The fourth column shows the impact of withdrawing £4,000 at the end of each year:
YearReturnHands offWith withdrawal
Note: £100,000 in with no withdrawals, versus £4,000 taken out each year.
It’s no great surprise to see that taking £4,000 out a year reduces how much money you’re left with at the end.
But let’s now shift our telescope to Bizarro World, to see how its alternative sequence of returns plays out with the same £4,000 withdrawal rate:
YearReturnHands offWith withdrawal
Note: Alternate sequence for retirement assets on Bizarro World.
As we saw a few months ago when I began this article with the £100 example, with no withdrawals, the ‘hands off’ pot of £100,000 compounds to the same £110,564 in both sequences of returns.
However in Bizarro World with £4,000 per year withdrawals, the sequence of returns turns out to be more favourable for the retiree. She has £5,000 or so extra in her pot in 2012 than the same investor on Planet Earth.
Interestingly, this is the opposite of what we saw with regular savers on Bizarro World earlier on in this article. They did did worse over the five-year period than we did.
But let’s not get too hung up on these specific numbers.
The point is that the sequence of returns can make a difference to how your retirement plays out. Neither you nor I know exactly what those returns will be.

Don’t risk doing badly

Can you do anything to sidestep the sequence of returns risk?
Not a lot. Its impact is mainly down to luck.
You might try to guess if various markets are cheap and to shift your investments accordingly, but many – probably most – people will do worse using such active strategies than if they had just saved and rebalanced automatically.
I think the main response to sequence of returns risk should be:
  • To de-risk your portfolio by rebalancing towards safer assets as you approach retirement
  • To consider locking in some income – perhaps enough to meet your basic spending needs – when you do retire, perhaps through an annuity.
All investing involves risk. By diversifying your portfolio and playing a bit safer, you can try to reduce the role of luck, and to increase the odds of your plan working out.

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.