The richest one percent of this country owns half our country's wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It's bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.
Beta comes in different shapes and sizes: plain vanilla and exotic, bull beta and bear beta. Alpha is no different and positive crisis alpha avoids the Achilles’ heel of other varieties: it doesn’t disappear when you most need it.
The Chicago Mercantile Exchange (“CME”) in this new paper defines crisis alpha as performance during equity bear phases, such as late 1998, 2000-2002 and 2008. Unsurprisingly, the two equity hedge fund strategies that avoid long exposure to equities have produced positive crisis alpha: equity short biased and equity market neutral managers. CTAs, which can be long or short equities, are the other only hedge fund strategy that delivered positive crisis alpha – so say the CME. Every other hedge fund strategy, according to the BarclayHedge indices, suffers from negative crisis alpha, as the chart below shows. (Click the chart to enlarge.)
What is more striking is that CTAs actually need crises to generate their returns. Strip out crisis periods and you can cut in half the BarclayHedge CTA index returns, as the graph below illustrates.
And precisely the opposite applies to hedge funds in general: exclude the crisis periods and the returns will double.
You don’t need to be a Nobel prize winner to figure out that CTAs can act as crisis insurance by effectively neutralising the negative periods for the other strategies. That said, Harvard’s 1990 Nobel Prize Winner and “Father of the Capital Asset Pricing Model” John Lintner did make such a case for CTAs as diversifiers long ago in 1983 with this antique typewriter-written paper. (Editor’s Note: Think weird kind of printer with keyboard attached and no wifi…)
Where is the crisis alpha coming from? To answer that, the CME splits investment risk into three categories – price risk, credit risk and liquidity risk – that are normally pretty independent of one another. But in a crisis like 2008, liquidity and credit risk take the driving seat and synchronise investor behaviour which manifests itself in heightened price risk for most investors– but strong trends for some to follow. CTAs, which mostly follow trends, are well positioned to latch onto the big moves, which is why 2008 was their best year since 2002 or 1998, depending on which index you look at.
Some investors, the CME implies, may have overlooked CTAs by focusing on their easily visible price risk and relatively low standalone Sharpe ratios as shown below (to the exclusion of less obvious credit and liquidity risks, which we already discussed on AAA here and here).
The CME argues that CTAs are exposed to more price risk, but less liquidity and credit risk – in fact they reap their greatest rewards during credit crises. Price risk, displayed against crisis alpha below, is measured by the degree of mean reversion in return patterns, liquidity risk by the level of serial or month-to-month correlation in returns, and credit risk by correlation with the gap between swap spreads (which face bank credit risk) and US Treasuries (which have historically had no credit risk notwithstanding Standard and Poors’ negative outlook on the US Government and its substantial ownership of banks).
Cynics might say that as the world’s largest clearer of futures, clipping a small fee on each and every contract traded, the CME has a vested interest in seeing investors allocate more money to CTAs that trade futures – the skeptics might have a point. However, going forward, regulators are migrating all kinds of other derivatives onto exchanges, including credit derivatives, and the CME is not making any special case for credit funds. Besides, not all CTAs have to trade futures: some specialise in currencies, which still trade mainly over the counter and could very well continue to do so.
One point the CME did not make is that synthetic replication approaches may also be to recreate a CTA return profile, and these do not always involve trading futures. One of the oldest replication techniques identified by Fung and Hsieh in this 2001 paper involves owning a basket of look-back straddles (puts and calls both at the money) that would probably be traded OTC bypassing exchanges. So, the CME is educating investors about the benefits of CTA strategies, but the educated investor also has a menu of vehicles at their disposal to access positive crisis alpha from such strategies.
The concept for today’s chart comes from Ned Davis Research. This is its chart AA144, in which the value in the bottom panel is called an “equity risk premium proxy.” It is the spread between the Moody’s Baa yield to maturity and that of the Treasury ten-year note.
In the top panel is the ratio of the Russell 2000 to the Russell 1000 — an ascending line means that the smaller stocks are outperforming. They lagged badly in the late 1990s as the large caps got pushed to huge valuations, but small has been beautiful ever since.
One of the great things about NDR’s work is that it provides statistics on performance related to the variables pictured in the charts. (If you want those details, you’ll have to subscribe.) For this one, small caps do the best on a relative basis when the risk proxy is high and when it’s falling. Big stocks generally do better when it’s low or rising.
That begs the question as to whether the indicator is low or high. Well, that and where it’s likely to go from here and why. Some hints may come from looking at the layers below the surface of this picture — at the somewhat unusual interest rate structure of the day and at the relative valuation of the two indexes.
How close are we to the long-awaited time when large stocks as a group look pretty again? It may make sense to keep an eye out for what’s happening in the bond market to help you decide. (Chart: Bloomberg terminal.)
The billion-dollar aphorisms of Ray Dalio, who built the world’s biggest hedge fund by running it like a cult.
(Photo: Matthew Furman. Photo treatment by Gluekit)
If you want to understand Bridgewater Associates, the world’s largest and indisputably weirdest hedge fund, you might start with the story of the peas.
It goes like this: In 2005, while the rest of the financial sector was busy pumping rocket-grade helium into the credit bubble, a young Bridgewater investment associate named Holden Karnofsky was complaining to his colleagues about the food at the firm’s Westport, Connecticut, headquarters. Particularly bad, he said, were the peas in the cafeteria salad bar. At other offices, a bottom-rung underling would probably shrug off such a misfortune and move on to the grape tomatoes, but Karnofsky, who came to Bridgewater via Harvard, felt empowered to post his grievance on the firm’s internal message board. “I didn’t mince words,” Karnofsky recalls. “I told them there was a lot that needed improving.”
Lousy peas may seem inconsequential when billions of dollars are being wagered. But at Bridgewater, a pea is never just a pea. Karnofsky’s complaint made its way to Ray Dalio, Bridgewater’s founder, chief executive, and chief investment officer, who brought it up with other members of the firm’s executive team. According to a person familiar with the episode, Hope Woodhouse, then Bridgewater’s chief operating officer, chided Dalio for paying so much attention to a vegetable mishap, saying, “This is ridiculous. I shouldn’t be spending my time on this.”
Dalio disagreed. He’s decreed that at Bridgewater—which has 1,100 employees and a stupefying $94 billion under management—there is no such thing as a small problem. “By the time I left,” says Karnofsky, “the food definitely got much better.” Dalio, a tall, gaunt 61-year-old man with a swoop of gray hair, is an adherent of “radical transparency,” a management theory that calls for total honesty and accountability. He’s also a longtime practitioner of Transcendental Meditation and has built its precepts on self-actualization into Bridgewater’s office culture. (He’s even brought in David Lynch, the film director and unofficial TM spokesman, to lead a seminar for his staff.) Dalio expects employees to openly criticize not just the cafeteria fare but also each other; behind-the-back gossip is strictly prohibited. “Issue logs” track mistakes ranging from significant (poorly executed trades) to small (one employee is said to have been issue-logged for failing to wash his hands after a trip to the bathroom) and can result in “drilldowns,” intense sessions—one insider compares them to a cross between a white-collar deposition and the Spanish Inquisition—during which managers diagnose problems, identify responsible parties (“RPs,” in Daliospeak), and issue blunt correctives. Other employees can withdraw recordings of these proceedings from the firm’s “transparency library.”
Should Bridgewater employees need a refresher on the house rules, they can consult their copy of Principles, the 110-page manifesto Dalio has written to codify his philosophies about life, work, and the pursuit of greatness. The book used to be given to all Bridgewater employees in paper form and is now distributed via a custom app. Dalio’s axioms are studied with Talmudic intensity at the firm, and conversations with employees tend to be sprinkled with company jargon: “ego-barrier,” “probe,” and the ultimate Bridgewater insult, “suboptimal.”
“Empathy and kindness aren’t a top priority there,” says a former Bridgewater employee. The firm’s culture of absolute candor is designed to strip out emotional considerations and emphasize cold, Vulcan logic in all decision-making—the thin-skinned need not apply. But firm loyalists insist it sounds worse than it is. “Every organization is absolutely riddled with problems,” says one, “but we have a way of fixing them.” Dalio’s Principles, acolytes say, allow the firm’s researchers and traders to sidestep office politics and ego-stroking and focus on what really matters: beating the markets.
Which Bridgewater has certainly done. Last year, the firm put up the best numbers in its 36-year history, notching a nearly 45 percent gain in its most aggressive fund on its way to a total haul of more than $15 billion. Those returns—which CNBC noted were greater than the 2010 profits of Google, Amazon, Yahoo, and eBay combined—vaulted Bridgewater even further ahead in the hedge-fund rankings and reportedly netted Dalio a personal windfall of more than $3 billion.
Post-Madoff, billion-dollar paydays have a way of putting targets on backs, especially amid the insider-trading scandals now hitting the hedge-fund sector. “They’re just out there in Connecticut, not really part of the scene,” says one Goldman Sachs employee. “But they had a killer year, and with that big a fund …” The Goldmanite trails off. “What do they do? No, seriously. Do you know?” Bridgewater makes it hard to answer that question. Like a lot of hedge funds, it requires its employees to sign nondisclosure agreements designed to keep trading strategies under wraps. Even more than its peers, it cultivates a paranoia in its ranks, monitoring e-mails and phone calls and keeping tabs on employees via a network of overhead cameras. Most of the current and former Bridgewater employees contacted for this article, along with several nonstaffers who were afraid of angering the firm, spoke on the condition of anonymity. But nobody is accusing Dalio of misconduct, and Bridgewater’s reputation among institutional investors is spotless—a recent survey by analytics firm Preqin ranked the firm as the global favorite of public-pension funds.
With nothing scandalous to spread around, finance-world gossips have been left to focus on what a strange, strange place Bridgewater is. When the blog Dealbreaker posted leaked excerpts from Principles last May, the industry got a window into Dalio from his calls for his employees to “humiliate themselves” in pursuit of the truth and his comparison of the process of self-improvement to “when a pack of hyenas takes down a young wildebeest.” Dalio responded by posting the full Principles on the Bridgewater website, but if he thought his ideas would be judged more kindly in context, he was mistaken. “I’m sure our reputation on the Street is that we’re completely insane,” says a current Bridgewater employee. An executive recruiter who works with hedge funds confirms that suspicion, describing Bridgewater as a “bunch of fucking nutcases.”
At the same time, that $94 billion raises a question: What if the nutcases are on to something? “Bridgewater is a very quirky place, and you have to drink the Kool-Aid to fit in,” says another headhunter. “But clearly something is working for them.” Dalio began his investing career at age 12, when he sunk $300 he’d earned as a golf caddie near his Long Island home into shares of the now-defunct Northeast Airlines. Soon after, the company went through a merger, and its $5 stock price tripled.
Dalio’s parents, a jazz musician and a stay-at-home mom, supported his passion for the markets. After college, he took a summer job on the floor of the New York Stock Exchange and eventually became fascinated by commodities futures—derivatives used by Wall Street firms to reduce their exposure to oil, metals, crops, and other resources vulnerable to price swings. It was at the time an unsexy specialty, but in the early seventies, when the Bretton Woods currency crisis sent the stock markets spinning, investors flocked to commodities, and Dalio’s budding expertise was suddenly in demand.
Don’t pick your battles. Fight them all.
Treat your life like a game.
Manage as someone designing and operating a machine rather than as someone doing tasks.
In 1974, after getting his M.B.A. from Harvard Business School, Dalio went to work trading futures for Wall Street legend-in-the-making Sandy Weill. Dalio stayed at Weill’s brokerage, then called Shearson Hayden Stone, for only a year. (Dalio declined to comment for this article, but several people familiar with the matter said he was fired after bringing a stripper to a client presentation.) He decided to strike out on his own, opening a small advisory boutique with a friend from his rugby team. Neither man had much experience managing money, but the market briefings Dalio sent out were impressive enough to land Bridgewater its first major investors, large pension funds that committed several million dollars apiece. (Today, the firm’s “Daily Observations,”multipage bulletins that include reflections on everything from bond yields to the potential market effects of swine flu, are required reading for pension managers and central bankers around the world.)
While his client base was expanding, Dalio began crafting the investing theory that would make him a multibillionaire. The global economy was a giant machine, he observed, with certain cycles that repeated themselves during economic and political transitions. If you identified those patterns, as well as the smaller events that seemed to trigger them—a LIBOR blip here, a rising debt ratio there—you could build a computerized system that could predict booms and busts. The approach served Bridgewater well: The firm’s flagship fund has lost money in only three years since its founding and boasts an average annualized return of 18 percent since 1991.
In 2006, Bridgewater’s computers began to indicate that the American economy seemed to be heading for what Dalio calls a “D-process,” a sort of national bankruptcy proceeding in which debt-service payments rise relative to incomes until, under the threat of default, the government is forced to print tons of money and buy up long-term assets. The firm’s traders piled into investments that would be most affected, including, at various times, U.S. Treasury bonds, gold, and the yen. They also studied Japan’s “lost decade” and the Latin American debt crisis of the eighties and used what they learned to program red flags into Bridgewater’s trading system. In the spring of 2008, one of these flags, a risk metric for credit-default spreads, prompted Bridgewater to pull its entire positions in several banks—including Lehman Brothers and Bear Stearns—the week before Bear Stearns imploded. In the years since, seeing the crisis coming has become the hedge-fund version of having been at Woodstock, but Dalio and his team actually did it.
Throughout 2010, the D-process continued to unfold. By the end of the year, 80 percent of Bridgewater’s bets were in the black, and even critics who’d mocked Dalio’s eccentricities had to acknowledge his brilliance as an investor. The path to Principles began early in Bridgewater’s history, when Dalio began to think that employees, like economies, could be understood as following patterns. Transcendental Meditation informed his belief that a person’s main obstacle to improvement was his own fragile ego; at his firm, he would make constant, unvarnished criticism the norm, until critiques weren’t taken personally and no one held back a good idea for fear of being wrong. Dalio’s chosen investment system depended on such behavior. Unlike at a hedge fund such as Steven Cohen’s SAC Capital, where star traders are given chunks of the firm’s capital to run quasi-independent desks (and offset each other’s losses), everyone at Bridgewater essentially contributes to the same strategy as they work under Dalio and his longtime confidants and co-CIOs Bob Prince and Greg Jensen. Dalio thought radical transparency could optimize the hive mind. “The culture makes you have to listen to other people,” says Giselle Wagner, a former Bridgewater chief operating officer.
But six years ago, as his growing firm continued to take on hundreds of new staffers, Dalio saw that culture slipping away. He began pecking out notes on his BlackBerry after meetings in which he felt a core value being misunderstood or neglected. The notes piled up. Eventually, Dalio added an introduction and some explanatory material and distributed the collection to his employees.
A corporate gospel isn’t novel—The Bloomberg Way was required reading for Bloomberg News employees years before Dalio set down his ideas. But Principles is no mere training manual. The first half of the book, “My Most Fundamental Principles,” contains Dalio’s abridged autobiography, an apologia for radical transparency, and a step-by-step guide to “personal evolution.” The precepts in this section—many of them written in a digressive, self-serious style that reads as if Ayn Rand and Deepak Chopra had collaborated on a line of fortune cookies—are never about making money, at least not openly. They’re about following rules, learning from mistakes, reaching your goals. Doing things in the Bridgewater way is thought to be the best—and possibly only—way of achieving these objectives. If you live rightly, whatever happens is okay, since, as he wrote, “self-interest and society’s interests are generally symbiotic.” If the hyenas take down a young wildebeest, well, c’est la vie.
The document’s second half, “My Management Principles,” contains Dalio’s 277 workplace rules: To hold more productive meetings, “enforce the logic of conversations.” When coaching subordinates, “manage as someone designing and operating a machine rather than as someone doing tasks.” And so on.
There is nothing to fear from truth.
When a pack of hyenas takes down a young wildebeest, is this good or bad?
Ask yourself whether you have earned the right to have an opinion.
A skeptic might point out that the primary benefit Dalio believes his maxims deliver—greater efficiency in the search for truth—might be canceled out as man-hours are burned issue-logging and drilling down, and that many of his rules are confusingly contradictory: He admonishes against sweating the small stuff but also encourages gripes about peas. Some employees also note that no-problem-is-too-small can become license to micromanage. (“If I were worth $10 billion, I’d spend more time on my yacht and less time sending e-mails at 3 A.M.,” one grumbles.) But if Dalio’s rules make it desirable to be unsparing in pursuit of excellence, they are explicitly less tolerant of dissent to his principles themselves. “We don’t want to change the culture to make it comfortable for people who are uncomfortable with it,” he writes, “because changing it would redefine the norm … and slow the adaptation process.” Dalio is confident that for those willing to buy in, full acclimation is only a matter of time. “With their increased usage, not only will they be understood, but they will evolve from ‘Ray’s principles’ to ‘my principles,’ and ‘Ray’ will fade out of the picture in much the same way as memories of one’s ski instructor or basketball coach fade and people pay attention only to what works.” Bridgewater’s headquarters is a set of three stone-and-glass buildings built around a creek tucked deep in the woods, a few hundred yards past an unmarked turnoff. It’s a low-key setting for a money palace, and the cars in its parking lot reflect a similar ostentatious humility—lots of Civics, fewer Carreras. Dalio’s office sits next to other managers’ on the third floor of the main building.
Getting a job at Bridgewater isn’t easy. Applicants are given Myers-Briggs tests (“Not a lot of F-types there,” says one former employee) and some are asked to conduct mock debates with other candidates for the same job. One ex-candidate, who was not offered a position, summarizes Bridgewater’s group interview process as “John, what are Bob’s flaws? Bob, what are John’s flaws?”
Most hedge funds hire primarily more-experienced investors, but Dalio is said to prefer recent undergrads from schools like Princeton and Dartmouth, who may not know how to price rate swaps but bring other advantages. “Young people are more malleable,” says one employee. “If you take someone who’s led a thousand-person group at a bank and bring them to a place where they can be challenged by their 28-year-old analyst, it’s not going to be easy for them.” Even with those measures in place, Bridgewater life proves just too bizarre for a lot of recruits. Thirty percent of new employees are said to quit or get fired within two years.
For the employees who remain, the payoffs can be sizable: generous (though not industry-leading) pay and a full slate of perks, including quarterly blowouts at which Dalio has been known to take a direct role in the revelry. (“He’s a bit of a frat boy,” says a former employee who recalled hoisting tequila shots with him.) A fancy bus takes employees back to Manhattan after work and returns them to Westport the next morning, though many of Bridgewater’s young employees room together in local rentals. Many current and former employees speak convincingly of the bonds formed by unbridled honesty. Some compare Bridgewater to a family that can, when the time comes, be hard to leave. “I miss it,” says one former employee. “It’s almost like I was a more effective thinker when I was there.”
At bottom, Principles might be most effective at obscuring the fact that Bridgewater’s real mission is not to cultivate more finely tuned minds but to continue to make billions. To Dalio’s defenders, though, there’s nothing that odd about how the place functions. “Sure, Bridgewater could be defined as cultish,” says an ex-employee who has since decamped to Silicon Valley. “But companies like Google and Apple are also cults. Goldman Sachs is a cult. If you’re creating a strong corporate culture, to some extent you’re creating a cult.” By hedge-fund standards, Dalio’s lifestyle is almost monastic. He lives with his wife of 35-plus years in a 5,550-square-foot home that’s a flophouse compared to some of their Greenwich neighbors. (Investor kingpin Paul Tudor Jones III has a 13,000-square-foot mansion nearby.) He dresses casually for work in button-downs and rumpled khakis. He bundled money for John McCain’s 2008 presidential campaign but has otherwise expressed no interest in being a power broker. Former employees speak of the charity donations he makes in each staffer’s name during the holidays, and some recalled his practice of lending out his vacation homes.
Bridgewater’s institutional clients, most of whom would invest with Gary Busey if it meant a 45 percent return, seem happy to overlook the hoopla surrounding Principles. But according to people who know him, Dalio has been hurt by the suggestions that he’s basically running a mind-control operation. After an article last month in Absolute Return + Alpha magazine lambasted Bridgewater’s culture as “brutal” and “demoralizing,” Dalio made an exceedingly rare TV appearance on CNBC’s Squawk Box. Part of the defense he gave was tactical—Dalio indicated that the hype surrounding Principles had made hiring more difficult. But it also seems that Dalio might now be coming around to the idea that not all battles are worth fighting, after all.
Last month, a slightly tweaked version of Principles appeared on Bridgewater’s website. The document’s revised title: Principles (That Might Be Right or Wrong, for You to Take or Leave).
Get an umbrella! Or at least buy yourself some dirt-cheap portfolio protection!
The gist is pretty intuitive: Stocks have had a ridiculously surprising run over the last two years, and the headwinds are huge.
Oil is surging.
Other input prices are surging.
The dollar is going to garbage.
Unemployment is structural and will stay high
The housing market still sucks.
Plus, there's the fact that the training wheels are coming off, as we've been writing about all morning.
So what to do given that shorting is killing so many people?
My advice is to buy insurance (or volatility) -- it's cheap, more attractive on a risk/reward basis, less frustrating than shorting "the market" and, if timed well, provides huge upside. As an acquaintance in Europe said to me, shorting equities is like a "leaky water pistol," and employing the increasingly popular VIX tactic that follows is like detonating "two sticks of dynamite" in a dynamite factory.
It goes like this:
Find the sweet spot of the curve, which is usually eight to 15 weeks out to expiration, where "roll yield does not eat into your returns and you can still see an explosive upside to your investment."
Sell an out-of-the-money call option on the VIX.
Use the call premium (in step No. 2), and buy two calls that are further out-of-the-money.
At the time, the three options are out of the "sweet spot" -- take them all off and put the options back on that reside back in the "sweet spot."
Every year, the Loomis Sayles PR team drags its top fund managers down to New York for lunch with the wonkier end of the financial-journalism spectrum: there’s lots of talk of curve-flatteners in a rising interest-rate environment, that kind of thing. The main attraction for me is always David Rolley, the droll and super-smart fund manager on the global fixed-income side of things, and someone who’s always good at making you look at the world in new and interesting ways.
This year’s lunch took place yesterday, and kicked off with Loomis vice chairman Dan Fuss coming up with a very interesting macroeconomic point. Right now, he said, about 56% of Americans over the age of 16 are gainfully employed. If that percentage were to rise to 64%, Fuss reckons, then the budget deficit disappears entirely. We’re not going to get there. But theoretically it’s possible, if the unemployment rate comes down and if people retire later, as is happening in Japan. And more generally it’s an important reminder that unemployment is a fiscal issue, and that anybody who wants to take the budget deficit seriously should put a lot of effort into increasing the number of Americans with jobs.
Rolley then gave a short talk about QE2 and its effects, which he reckons have been large and global. It’s “the most important single factor that explains why markets are where they are now”, he said. And it was always intended to move markets: the idea wasn’t to move long-term interest rates, said Rolley, but rather to create jobs by sending stocks up and the dollar down. That way companies can boost employment through trade revenues, rather than from money made by selling goods and services to overstretched US consumers.
The result, said Rolley, is that “inflation tolerance globally is being recalibrated”: the Fed has succeeded in giving markets a bit more of an inflation appetite than they’ve had in recent years.
That was the good news. As for the biggest risk to the system, Rolley said that a huge amount of the liquidity pumped into global assets by QE2 was finding its way, in one form or another, into leveraged bets that China will continue to grow at roughly a 9% pace. Which is a reasonable assumption — nearly all forecasters believe it, and Rolley’s no exception. But in the unlikely event that China doesn’t continue to grow that fast, there could be serious repercussions, with a flight out of risk assets and into safer areas like Treasury bonds and JGBs.
Right now almost no one is betting that long rates in the US and Japan are going to go down rather than up, and as a result there’s a technical bias for government bond markets to rally. At the same time, however, as Dan Fuss pointed out, long-term rates are going to revert to the mean sooner or later, which means a significant rise in yields which could happen quite suddenly and dramatically.
All of which is very good reason for individual investors to shy away from investing in the bond market directly, and instead pick a big and sophisticated bond fund. Managing risks in this market is really hard at the best of times, and pretty much impossible if you have less than a few billion dollars to play with.
And one last thought from Rolley, who said that he was wary of single-name credit default swaps because managing the counterparty risk was so onerous. If such swaps became centrally cleared, he said, he’d write a lot more of them. And what’s more, such a move would be good for the banks as well, since his counterparty exposure to them would fall significantly, freeing him up to buy things like Coco bonds from them. I doubt many banks in the CDS market would buy that argument, though.
Unconstrained strategies for bonds are hot now with yields so low. But wait. Let’s take a step back. What do we mean by a constrained strategy?
A constrained strategy is one that limits the investments one can engage in either through:
Specifying an index that the manager is charged with beating
Specifying percentage limits for investments, split by categories such as credit quality, interest rate sensitivity, asset subclasses (ABS, RMBS, CMBS, Corporates, Agencies, etc.), and other variables
Barring investment in more funky fixed income instruments such as preferred stock, trust preferreds, junior debts, CDOs, ABS, RMBS, CMBS, etc.
Or some combination of the above.
There have been unconstrained strategies in fixed income before — they just weren’t called that. Many value investors in the old days didn’t care what the legal form of the investment was — they only looked for an adequate margin of safety. Their portfolios were a hodgepodge of debt and equity instruments. Specialization in only doing debt instruments wasn’t common.
Most debt-only investments were constrained, particularly those from bank trust departments. Of course, this was an era where investing in junk debt was not respectable for all but the most intrepid of investors.
With the advent of the 1980s we had two innovations: junk bonds and bond index funds. The first took the world by storm with the demand for yield; I experienced that at the first insurance company that I worked for — they overloaded on junk bonds. This was before the regulators began regulating bond credit quality more strictly.
The second took a longer time to germinate. The first bond index fund came into existence in 1986 at Vanguard. They couldn’t call it a bond index fund, because they could not exactly replicate the index. There were too many bonds that were illiquid, and they could not buy them at any reasonable price. Instead, they took an approach that we would call “enhanced indexing” today. Match the interest rate sensitivity of the index, and the credit quality, but choose bonds that had more potential than the bonds in the index.
In that sense, though the SEC allows bond funds to be called index funds today, all bond index funds are enhanced index funds because there is no way to source all of the bonds. And from my own days as a corporate bond manager, I learned that bonds in major indexes always trade rich. From my piece, The Education of a Corporate Bond Manager, Part IX:
There was another example where I crossed bonds where it was legitimate — if it was done to help a broker in distress. One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se. After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them. He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went). The whole set of two transactions took 15 minutes, and made $15,000 for my client. What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids. They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say “Hi,” ending with the then three-year old girl who squeaked “Hi.” He said something to the effect of, “I knew you had a large family, but it only really struck me now.”
That three-year old is now a beauty at twelve, and bright as anything, but I digress. (They grow so fast… the nine-year old girl is cute as a button too.)
Bond management was once unconstrained by those who looked for total returns in the old days, and constrained in the old days by those who looked for yield. (Many managers would not buy bonds that traded at a premium.) Then the bond indexes became popular as a management tool. In one sense, it freed bond management, because rather than hard constraints, they matched credit and interest rate sensitivities of the index.
But what that constrains is credit policy and interest rate policy. One managing to beat a benchmark index has limited options. What if you want to position for:
Widening credit spreads
Narrowing credit spreads
Rising interest rates
Falling interest rates
Yield curve steepening
Yield curve flattening
Outperformance/underperfomance of a given sector
Any sort of directional bet could go wrong, and more often than bonds that fit the idea of replicating the index parameters, but are special in ways that the index does not appreciate. So rather than going “whole hog” with the bet, you merely lean toward it, such that if you are wrong, you won’t destroy the outperformance versus the index.
But in this modern world where derivatives are widely accepted as fixed income instruments, a la Pimco, fixed income managers can do a lot more. There is more freedom to make or lose a lot of money.
The unconstrained strategy can be thought of in two ways: always trying to earn a positive return with high probability (T-bills are the benchmark, if any), or being willing to accept equity-like volatility while the bond manager sources obscure bonds, or takes large interest rate or credit risks.
I prefer the first idea, because it is more conservative, and fixed income management should aim for safety on average. As I have said before, I only believe in taking risks that are well-compensated.
But here’s a hard one. With the yield curve so wide, shouldn’t a bond manager with an unconstrained mandate put a little into long bonds or long zeroes? I would think so, but I wouldn’t put a lot there unless the momentum started to favor it.
I like the concept of the unconstrained strategy; indeed, it is what I am doing for clients, but it is of the first variety, try to make money for clients in all markets, and not just be a wild man in search of yield or total return.
I find the move to unconstrained mandates to be a return to what value managers did long ago, but in a more complex fixed income environment. I wonder though, as to whether the future failures will invalidate the idea for most. It is tough to manage any asset class while adjusting the risk level to reflect what should not be done in a given era, whether in equities or debt. The danger comes from trying to maintain yield levels that are higher than what is sustainable.
The long awaited and prophesied correction was surprisingly shallow. And it seems to be over already. The s&P 500 index from its peak to its trough retraced appx. 7% which is in line with the average correction for a bull market.
Yet, it must be noted that this limited and shallow correction arrived much later than it was anticipated by most market participants. As well, the S&P 500 has almost totally made back what it lost.
If we look behind the headline numbers of the S&P 500 index, the same underlying strength that we’ve seen for quite some time is evident. The cumulative advance decline line for the S&P 500 index which is a broad measure of strength has already surpassed its February highs and gone on to make new highs:
This indicator has been consistently signalling in the strongest way possible that this is a strong and healthy bull market. As long as we continue to see the average individual stock rise higher and higher, there is a low probability that the bull market will fool us and die suddenly.
Instead, the fact that the cumulative advance decline line for the broad index continues to lead the actual index itself (as it has for several months now) speaks to the longevity of this bull market. No one can make predictions about how long this condition will last. But what we do know is that we are still within ‘normal’ parameters based on historical bull market ages.
Tomorrow or next week the market might crash or enter into a bear market but that type of action would be very rare based on the characteristics that we’ve observed in previous cycles. Usually we received an early warning from this and other similar breadth indicators. This can be as short as a few weeks or as long as a few months. But the fact remains that no such pattern is present and in its stead, we have a clear indication of market strength.
Talk about hopping on the bandwagon. In the latest weekly survey of investment advisor sentiment from Investors Intelligence, bears declined by 32% from 23.1% down to 15.7%. Going back to 1975, there have now been just 16 other periods where bearish sentiment declined by more than 30% in a single week. Earlier today, we sent out a report to Bespoke Premium clients detailing the S&P 500's average return following similar large drops in bearish sentiment. Premium members wishing to view today's report can click on the following link: Large Drops in Bearish Sentiment. If you are not yet a Bespoke Premium subscriber and wish to view today's report, click here to sign up today.
As euphoria surrounding the emerging markets growth story settles, investors are looking for increasingly sophisticated strategies to squeeze new earnings out of their EM portfolios. There are two contrasting schools of thought. One says you should aim for developed market multinational companies with exposure to emerging markets. The other says that if you believe emerging markets are set to outperform, you should invest directly in EM.
So who is right?
The answer, it seems, lies in whether you take a long-term view or a short-term view.
In a recent strategy report, Goldman Sachs threw its weight behind the DM multinational story.
GS recommended investors take long positions in several indices: one, an index of European companies with high exposure to EM and another, the Bric Nifty 50 index, composed of global DM corporations with exposure to Brazil, Russia, India and China.
“We would not be surprised to see companies with high exposure to these areas to trade at a premium compared to companies exposed to a lackluster domestic market,” the authors of a Strategy Matters report wrote.
But not all investors are convinced that investing in EM-exposed DM equities offers any meaningful exposure to emerging markets.
Allan Conway, head of global emerging market equities at Shroders told beyondbrics: “If you believe in the EM story and you want EM exposure then what you must do is invest in EM.” Referring to the strategy of gaining EM exposure through DM stocks Conway said: “When you invest in that basket you’re buying exposure to developed markets.”
Robert Holderith, president and founder of Emerging Global Advisors, agrees with this view and told beyondbrics his EM fund assets are invested directly in those countries.
“We believe that the sentiment for emerging markets in the long term story is better than ever,” Holderith said, explaining EGA’s view that by investing in developed market multinationals with EM exposure, “you get earnings dilution, currency dilution and executive pay dilution.”
He said: “EM has become more attractive on its own merits.”
So which view is an investor to believe?
beyondbrics has plotted a chart to test the theory, using the FTSE emerging market index and the FTSE developed multinationals index, which includes multinationals that derive 30 per cent or more of their revenues from outside their home economic region, to see whether returns are correlated and which index yields higher returns
What we’ve found is that if you plot a chart to begin in January 2009 there is indeed strong correlation between the FTSE EM and FTSE developed multinational index.
(see Chart 1 below)
But if we rebase the chart to begin at the start of 2000, we get a very different picture and investing in emerging markets looks to have been the smarter choice. (see Chart 2 below)
And what about the future? Investors are better off going to a fortune teller for that kind of information.
More and more Americans are dabbling in currency trading and losing in spectacular fashion. Experts say the structure of the currency market makes it hard for amateurs to beat the house.
By Nathaniel Popper, Los Angeles Times
April 3, 2011
Reporting from New York
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Dorothy Ouma began trading foreign currencies after seeing a TV commercial touting it as a way to make extra money, something she could use as a single mother raising three children.
"The ads made me think, 'This is easy,'" said Ouma, 52, an administrator with the Grand Prairie, Texas, police department.
Ouma used her credit card to fund an account with an online currency broker. Within a few weeks of swapping dollars for yen and euros, she said, her $3,000 of borrowed money was gone.
"Even if you make money for a little while, eventually you just end up losing," she said.
Ouma made two mistakes: investing on credit and trying to make a buck by predicting changes in currency exchange rates, something best left to professionals, according to personal finance experts. But she has plenty of company.
An estimated 615,000 Americans are dabbling in foreign currency trading, encouraged by advertising from the two biggest U.S. brokers, FXCM Inc. and Gain Capital Holdings Inc., both based in New York.
Combined, FXCM and Gain have about 260,000 accounts, a third of them in the U.S.
These customers are losing money in spectacular fashion.
At FXCM, 75% to 77% of customers lost money each quarter last year, according to newly required disclosures to the Commodity Futures Trading Commission. At Gain, which operates through http://www.forex.com, the number of unprofitable customers hovered between 72% and 79% every quarter last year, according to its filing.
Lots of leverage, lots of turnover
As if those statistics weren't scary enough, the rules of currency trading allow investors to leverage every dollar they bet on a 50-to-1 ratio. This allows them to bet money they don't have — a tactic that can boost profits but also losses.
The losses have triggered recent lawsuits and regulatory scrutiny — but haven't stopped the swift growth of the industry, which barely existed a decade ago. Gain and FXCM went public on the New York Stock Exchange last December.
Executives with both firms say that they simply provide a conduit for people who want to trade currency, and that customers are given full disclosure of the risk.
"The majority of people today are on a quarterly basis not doing well," Drew Niv, FXCM's chief executive, acknowledged in an interview. "There's lots of education showing, 'Here's how to do it right.' … Do most people heed the advice? No, of course not."
Trading experts, however, argue that the companies use aggressive advertising to lure inexperienced investors into an unusually opaque market.
"The business model for forex trading is to burn the customer and then find another one," said Larry Harris, a USC professor and the former chief economist at the Securities and Exchange Commission.
FXCM's own statistics show that its customer turnover is about four times higher than that of an ordinary retail stock broker. Gain does not release turnover statistics, but its securities filings show that most of its customers at the end of last year were different from the ones it started with, also suggesting high turnover.
'At the mercy of the dealer'
Experts say the unusual structure of the currency market makes it hard for amateurs to beat the house.
With stocks, brokerages typically send customer orders out to be executed at an independent exchange and charge a set commission for each trade, no matter whether the customer wins or loses.
That's not the case in foreign currency markets. Because there is no centralized currency exchange, the brokers must fill customer orders themselves. This enables them to make money in two ways.
The first is by buying a currency at one price and selling it at a higher price — netting the so-called spread between the two. Unlike the set commissions charged by stockbrokers, these spreads can be set at whatever level the currency broker chooses.
The second way the broker-dealers make money is by sitting on the opposite side of every customer trade, like a blackjack dealer sitting across from a gambler.
For instance, suppose a customer buys 10,000 euros at $1.45 each and sells them back to the broker at $1.50 apiece. That would net the customer a profit of $500 — and give the currency dealer a loss of $500.
More commonly, however, it's the customers who lose out on these transactions, despite required disclosure statements that warn investors: "Your dealer is your trading partner, which is a direct conflict of interest."
Gain ended up making an average of $2,913 from every active trader it had last year, even though the average customer account contained only $3,000, according to the company's financial data.
FXCM made $2,641 for every active trader, while the average customer had $3,658.
When foreign currency trading got going in the 1970s it was accessible only to banks and institutions. As a result, regulators allowed banks to swap currencies among themselves rather than on the type of regulated exchange that was standard for stocks, futures and commodities.
In the 1990s, a few fly-by-night companies began trading currencies for amateur investors, without any regulatory oversight.
Online trading technology exploded, and in 2000 Congress put currency brokers under the CFTC's watch. But there is still no transparent exchange for currencies, so brokers also serve as dealers for their customers. The lack of an exchange, where data on prices and trades would be stored, also makes it harder for customers to determine whether they are getting a good price from their dealer.
"Once you have things that are done off exchange you are pretty much at the mercy of the dealer — telling you what the price is, telling you what you owe," said Michael Greenberger, a University of Maryland professor and former head of trading and markets at the CFTC. "Anybody I cared about — I'd say, 'Stay away from this.'"
An opaque market riddled with scams
The unusual structure of the market has made it a popular target for outright fraud. In a typical scam, clients are drawn in by advertisements promising big returns, but once the deposits are in, the company disappears.
CFTC Chairman Gary Gensler recently said it was the "largest area of retail fraud" his agency oversees.
Gensler's agency has tried to rein in the problems with a set of rules for currency trading that went into effect last October. These required the brokers to be more transparent but did not change the fundamental setup of the market.
The CFTC has delegated most of its regulatory responsibilities to the National Futures Assn., an agency established by Congress that is funded by the brokers themselves.
NFA spokesman Larry Dyekman said his group is trying to do more active supervision, but he said the NFA had a difficult job. "It's not as transparent" as other trading markets, he said.
Still, the NFA fined Gain $459,000 last October after issuing a complaint that detailed what it called abusive practices "that benefited Gain to the detriment of its customers."
The NFA complaint alleged that Gain set its trading program to allow certain trades when they went in Gain's favor, while not allowing the same trades when they went in the customer's favor, costing clients $169,502 during one three-month stretch in 2009.
The NFA also alleged that another Gain practice caused $425,000 in customer losses over three days.
Gain CEO Glenn Stevens said that the settings affected only a small portion of customer trades and that they "were since very quickly rectified and changed."
FXCM has tried to set itself apart from Gain and most other brokers by creating a system that it says removes the conflict of interest. FXCM is still always on the other side of every customer trade, but the company says that it takes trades only if it can immediately move them to outside banks so that FXCM does not stand to benefit from its customers' losses.
"Most people felt the market was less fair than the one for [stocks] — and that is a fair observation, historically, for sure," Niv said. "That is why we are trying to go public and differentiate from the pack."
FXCM has faced many of the same complaints as Gain, however, including in a lawsuit filed in federal court in New York in February by an Oklahoma man who claims to have lost more than $150,000.
FXCM operates "a platform predicated upon deceit and trickery that systematically looted the accounts of customers," and has used this to take "hundreds of millions of dollars from hundreds of thousands of unsuspecting customers," according to the suit, which seeks class-action status.
Niv said the suit is a form of "extortion" and "an utter fabrication."
Aside from concerns about fraud, market experts warn that the unusual rules of the foreign currency game make it an unsuitable investment strategy for anyone who cannot afford to lose money.
The leverage ratio of 50 to 1 was taken down by the CFTC from 100 to 1 a few years ago, but it is still 25 times as much leverage as retail stock traders are allowed to use, and many times more than what most professional currency traders employ.
"When things change, it's a sudden fall off the cliff," said Aswath Damodaran, a finance professor at New York University.
No limits on who can place a bet
Finally, while some types of risky investments, such as hedge funds, are restricted to so-called sophisticated investors, there are no limits on who can get involved in foreign currency trading.
FXCM allows customers to start trading with as little as $50, and its ads target novices — a recent banner on CNBC's website said, "Trading the Euro can be EASY! See how with a FREE PRACTICE ACCOUNT."
Both companies offer practice accounts designed to help customers learn how foreign currency trading works, but these practice accounts operate under simpler rules than the real accounts.
In another marketing effort, Gain and FXCM teamed up to sponsor a weekly show on CNBC about foreign exchange, which debuted Feb. 25. The show, "Money in Motion," hypes the wonders of currency trading. "Now, more than ever before, currencies are emerging as the everyday investor's weapon of choice in the battle to gain an edge," marketing material for the show said.
A CNBC spokesman pointed to the standard disclaimer that runs with the show and noted that the network has the most affluent and educated viewers of any cable network.
Ouma, the Texas woman who lost $3,000, began trading after seeing an ad during a local newscast. She said that when she was trading with FXCM, a number of problems cropped up whenever she was making any profit, resulting in sudden big losses.
"They always had tricks to take my money," Ouma said.
FXCM said it would not comment on individual customers. After The Times contacted the company, however, Ouma said FXCM called her and offered to refund her losses.
For some people, of course, the risk is part of the thrill.
Jeff Goodwin, a 23-year-old Internet entrepreneur in New Hampshire, said that after a few years of losing money in the market, he recently found a strategy that has been turning a steady profit. But the potential for big losses is what makes it fun.
"Is it gambling? Yeah," Goodwin said. "You easily get addicted."
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.
The CME argues that CTAs are exposed to more price risk, but less liquidity and credit risk – in fact they reap their greatest rewards during credit crises. Price risk, displayed against crisis alpha below, is measured by the degree of mean reversion in return patterns, liquidity risk by the level of serial or month-to-month correlation in returns, and credit risk by correlation with the gap between swap spreads (which face bank credit risk) and US Treasuries (which have historically had no credit risk notwithstanding Standard and Poors’ negative outlook on the US Government and its substantial ownership of banks).
The concept for today’s chart comes from Ned Davis Research. This is its chart AA144, in which the value in the bottom panel is called an “equity risk premium proxy.” It is the spread between the Moody’s Baa yield to maturity and that of the Treasury ten-year note.
In the top panel is the ratio of the Russell 2000 to the Russell 1000 — an ascending line means that the smaller stocks are outperforming. They lagged badly in the late 1990s as the large caps got pushed to huge valuations, but small has been beautiful ever since.
One of the great things about NDR’s work is that it provides statistics on performance related to the variables pictured in the charts. (If you want those details, you’ll have to subscribe.) For this one, small caps do the best on a relative basis when the risk proxy is high and when it’s falling. Big stocks generally do better when it’s low or rising.
That begs the question as to whether the indicator is low or high. Well, that and where it’s likely to go from here and why. Some hints may come from looking at the layers below the surface of this picture — at the somewhat unusual interest rate structure of the day and at the relative valuation of the two indexes.
How close are we to the long-awaited time when large stocks as a group look pretty again? It may make sense to keep an eye out for what’s happening in the bond market to help you decide. (Chart: Bloomberg terminal.)
