Albert Edwards (SocGen) is Bullish.....on US Treasuries

Albert Edwards is bullish.

Bullish on US Treasuries that is, which the SocGen strategist expects to hit record levels before before government profligacy and the Fed’s printing presses take the world back to both double-digit inflation and bond yields.

From Edwards’ latest Strategy Weekly:

Many think I am mad. But I am not the only commentator expecting a deflationary bust the sort of bust that will take the S&P down to 400 from the current 1300. I recently watched John Authers of the FT Lex and Long View columns interview Russell Napier, formally [sic] of CSLA and a leading stockmarket historian. Russell's views are as interesting as ever and well worth 11 minutes of watching time. His views are similar to mine, although he articulates his thoughts far more clearly than I – Long View: Historian sees S&P fall to 400 – ft.com 16 May.

For those of you who cannot see the video let me try and paraphrase Russell. He believes massive central bank balance-sheet expansion has failed to boost broad money in the west, but rather this huge monetary stimulus has been transferred to emerging markets (EM) via foreign exchange (FX) intervention to peg EM currencies to a weakening US dollar (most notably the Chinese Renminbi). Together with the impact of a weak dollar driving commodity prices higher, the emerging markets’ own version of QE has led to overheating and inflation. EM countries are now far more inclined to aggressive monetary tightening, including allowing currency appreciation, which will halt the flow of EM-driven demand for US Treasuries. The creditor Chinese and other EM nations will tighten global liquidity, not the debtor US. This will cause what Russell terms “The Great Reset” which will drive US real bond yields higher and, amid a deflationary bust send the S&P down to its ultimate bottom – commensurate with levels of compelling cheapness represented on the Shiller PE at around 400 on the S&P.

(For reference, at pixel time the S&P 500 was at 1,316.)
Here’s more:

Where I diverge slightly from Russell is that the world he describes sounds pretty recessionary to me. Clearly the S&P falling to 400 destroys household balance sheets and consumption anew. And EM liquidity tightening could cause hard landings. In China, for example, a recent calculation showed FX intervention accounted for around one half of the country’s runaway money supply which has helped propel the boom). My own view would be that despite the cessation of the EMs need to buy US Treasury debt as they curtail liquidity, weak economic fundamentals will drive US Treasury yields still lower in the near term. The printing presses being turned off will hit risk assets hard and that should boost Treasuries. So in my world, 400 on the S&P goes hand-in-hand with lower, not higher US bond yields. Ultimately I would concur that there is also going to be “The Great Reset” on US yields as well, but that will come after a frenzied orgy of balance sheet debauchment (both Fed and Federal) which will make events over the last three years look like an afternoon tea-party with the Vestal Virgins.

Crikey. Fresh lows for government bond yields!

And there was us thinking they might push higher after the Fed’s latest bond buying programme ends in June.



Apparently not.

Ira Sohn Conference Notes: Hedge Fund Manager Presentations Part 2

Steve Eisman / FrontPoint Partners: Eisman was profiled in Michael Lewis' great book, The Big Short as one of the big winners in the subprime trade. Last year at Ira Sohn, he said to short for-profit education stocks and that trade paid off as many stocks were down anywhere from 25% to 72% over the past year.

This time around, Eisman focused on US financials, asking "are financials dead forever?" He notes that credit quality is improved but interest margins will most likely continue to contract.

Eisman likes property and casualty insurers, citing the potential for commercial policy pricing to improve. He noted that his year has been particularly hard hit with natural disasters, leading to large insurance losses. He thinks P&C insurers are a 'buy' even if there's another big disaster.

He says the least risky way to play this is via insurance brokers like Marsh & McLennan (MMC), Willis Group (WSH), and Aon (AON). You can read an in-depth analysis of AON in the free sample of our Hedge Fund Wisdom newsletter (direct .pdf download link).

For riskier plays, Eisman points to pure reinsurers based in Bermuda and pulled up a list of them, the most well-known of which is probably Ace (ACE).


Bill Ackman / Pershing Square Capital: Ackman said to buy Family Dollar (FDO). He likes the dollar-store chain because it is like Walmart, but there's room to grow. He also notes the company's solid return on capital as they can build plenty of new stores. Many of Ackman's plays are retail or real estate focused and this one is no different.

FDO actually received a bid to go private from Nelson Peltz's Trian Fund, who offered between $55 to $60 per share in February. They are one of the largest shareholders, owning almost 8% of FDO's shares. Ackman believes that FDO is an attractive target for a leveraged buyout.

Ackman notes that Family Dollar has fallen behind competitor Dollar General (DG) ever since KKR bought DG and now FDO has to improve. The Pershing Square manager thinks shares will trade as much as 70% higher (FDO currently trades around $55 and Ackman thinks it's worth up to $92 including dividends). He also mentioned that his hedge fund was even buying shares today.

We also covered that Ackman started an activist position in Alexander & Baldwin (ALEX).


Joel Greenblatt / Gotham Capital: The value investor talked about the advantage of having a long-term investment horizon. He emphasizes investments that fall under the 'time arbitrage' classification. Market Folly readers will recall that Blue Ridge Capital's founder and hedge fund manager John Griffin also uses this approach. He classifies investments as either time arbitrage or catalyst driven.

Greenblatt's picks included a myriad of names, including: WellPoint (WLP), GameStop (GME), Intel (INTC), Walgreens (WAG), Nordstrom (JWN), Bed Bath & Beyond (BBBY), and Humana (HUM).

He also has a new book out entitled, The Big Secret for the Small Investor: A New Route to Long-Term Investment Success. You can also check out his recommended reading list here.


David Einhorn / Greenlight Capital: Einhorn's presentation laid out the bull case for life insurer Delta Lloyd (AMS: DL), traded in the Netherlands. This is one of his hedge fund's largest positions.

His second pick was Microsoft (MSFT). The tech giant has attracted lots of value investors as of late and you can view fellow hedge fund T2 Partners' presentation on MSFT here. Einhorn says the company still has a shot at the smartphone market with its partnership with Nokia (NOK). He also notes that it is trading at a discount as the market isn't giving them credit for their solid position in cloud computing.

Einhorn also said that CEO Steve Ballmer doesn't care what Wall Street thinks and that could possibly be a good thing. However, he conceded that Ballmer is "stuck in the past" and said that Ballmer's "continued presence is the biggest overhang on Microsoft's stock." It's very clear Einhorn wants Ballmer fired.

We've also detailed Greenlight Capital's recent letter to investors for insight into their new positions in Yahoo! (YHOO) and Best Buy (BBY).


Carl Icahn / Icahn Partners: The legendary rabblerouser began his presentation by saying he's made a fortune by studying natural stupidity. Icahn said that "activism" in the old-school sense of the word is dead; there aren't anymore true corporate raiders anymore. He says that there's tons of money to be made by shaking things up at a company.

He went on to talk about why he returned outside investor capital in his funds. He simply didn't want to be responsible for the losses of others like he was during the 2008 crisis. Icahn fears further problems will arise in the markets in a year or two. His pitch at the conference? His holding company: Icahn Enterprises (IEP).


Mark Hart III / Corriente Advisors: If you're unfamiliar with Hart, then all you need to know is that he created subprime mortgage and sovereign debt funds well before the crises happened, profiting handsomely from the events that followed.

In his speech, Hart said to short China and this isn't the first time he's made this case. He argues that it is a credit fueled bubble and there are many misconceptions out there. It seems his conviction is high here as he says that China's bust will be much larger than the Asian crisis in the 90's.

Hart argues that inflation will end China's credit growth. This isn't the first time we've seen this argument. Hedge fund Kleinheinz Capital has in the past said that inflation is the biggest threat to emerging markets. Coincidentally, both Kleinheinz and Corriente operate out of Fort Worth, TX. Lastly, Hart mentioned he was buying puts on the renminbi.


Jeffrey Gundlach / DoubleLine: He used an Andy Warhol car crash painting as an illustration for the housing market. He said that Bank of America $BAC is a proxy for the ABX and says it's going lower. Gundlach likes natural gas.

Interestingly enough, Gundlach said that gold is too heavy to carry around to use as a form of currency to pay for things. Instead, he said to use gems to protect against a crash and uncertainty because they are more portable, noting that you can carry a ruby in your shoe. Gundlach prefers holding cash or gems instead of gold or silver.

As an aside, it's worth noting that diamond prices have been heading higher in recent months. They are not a publicly traded commodity and high demand from India and China seems to be driving prices there.


Marc Faber / Gloom Boom & Doom Report: Faber is very clearly not a fan of Ben Bernanke. He says that the Federal Reserve Chairman is a student of history regarding the Depression, but that Bernanke unfortunately doesn't know what caused it. Faber notes that as the Fed prints more money, cash and bonds obviously aren't good investments. He also joked that if everyone at Ira Sohn complained, Bernanke would come in and drop a trillion dollars right there.

Faber said not to own US government debt, even if the deflationists end up being right. He is also an advocate of owning gold but not storing it in one place. Faber says you need to store gold all over the world in Australia, Switzerland, etc. He also disputed Gundlach's notion to own gems over gold and said people will always value gold, even if you're in a jungle or desert because everyone knows what it is.


Steve Feinberg / Cerberus: He pitched residential mortgage backed securities (RMBS) as a compelling opportunity and labeled them 'cheap,' given the high amount of underwater loans and depressed home prices.


Peter May / Trian Fund Management: Peter May of Nelson Peltz's Trian Fund pitched upscale jeweler Tiffany & Co (TIF), citing "enormous price appreciation" ahead. Catalysts for TIF include new store openings, vertical integration, new watches, and increased analyst coverage and he said shares could see $100 (they currently trade around $70.)

Ira Sohn Conference Notes: Hedge Fund Manager Presentations

Part 1:


Erez Kalir / Sabretooth Capital: His pick was a long of MBIA (MBI) as a 'favorably asymmetric' play. His presentation was entitled, "Economic Death as a Special Situation." He feels that MBIA has 100%-200% upside with only 30% downside at worst, so the risk/reward skew is favorable.

He also likes Argentina as a compelling investment arena since its default in the early 2000's. In particular, he's looking at energy exploration & production names. He points to stocks like YPF SA (YPF) and Crown Point Ventures (CWV).

On the topic of inflation hedging, Kalir doesn't like gold. In fact, he warned against owning it. He also dislikes shorting treasuries. Instead, he prefers to buy farmland. This stance no doubt echoes the sentiment of Jim Rogers, the ex-Quantum fund manager who has also been a staunch advocate of owning farmland. Additionally, we've detailed how subprime profiteer Michael Burry also bought farmland.


Dinakar Singh / TPG-Axon Capital: Singh thinks the current market is a great environment for stockpicking and fancies shares of wireless provider Sprint (S), which David Einhorn's Greenlight Capital also likes (see Einhorn's thoughts here). Singh cites the company's low valuation and it's his favorite turnaround story.

He says S needs to consolidate its two networks starting now with the next generation phones. Singh actually feels like the T-Mobile / AT&T (T) merger is good for Sprint because it removes their largest competitor. Singh notes that the US wireless market could offer defensiveness like utility stocks, but with the added benefit of growth. He thinks S could have 40-70% upside, saying its worth $8-14 per share (currently trading around $6).

TPG-Axon's leading man cited Zhongpin (HOGS) as a compelling investment due to its top line growth and the fact that it's trading at 7x earnings.

Singh also mentioned he thinks that Orkla (OSL: ORK) has a fair value of $65 to $80 as the company was mismanaged and restructuring could unlock value.


Jeff Aronson / Centerbridge Partners: His pick was to go long shares of CIT Group (CIT). This has been a hedge-fund-favorite as some of the largest owners also include Bruce Berkowitz's Fairholme Capital, Howard Marks' Oaktree Capital, David Einhorn's Greenlight Capital, Marc Lasry's Avenue Capital, and Dan Loeb's Third Point. Before Chapter 11, Centerbridge was buying CIT debt. Since then, they've been buying the equity.

Aronson says that the company's intrinsic book value is $59 per share and notes that they have $12 billion in cash on their balance sheet. He highlights that CIT has publicly stated it could buy a retail bank (whose deposits would boost earnings). As a takeout candidate, Centerbridge thinks CIT could be worth as much as $65 (shares trade around $41 currently.)


Robert Howard / KKR: Howard (representing KKR's new equity team) pitched shares of Wabco (WBC), a company that produces anti-lock braking systems among other things. He cites three major trends that WBC can benefit from: cyclical recovery (US & Europe trucking recovery), emerging market growth, as well as tighter safety rules. Howard mentions the company is often overlooked by investors too.

KKR's man also pitched HSN, Inc (HSNI), otherwise known as the Home Shopping Network. He likes their demographic of 30-55 year old women with solid annual income to spend. Howard thinks that John Malone's Liberty Media could make a play for the company too, as he points out that Liberty owns 30% of HSNI and all of QVC, the other major player in the shopping-via-television arena.


Phil Falcone / Harbinger Capital Partners: Falcone talked about his wireless venture, LightSquared. We've covered this play numerous times and while it's not publicly traded yet, Falcone says that it will be some day. Essentially, this is Harbinger's concentrated bet on a 4G network.

Numerous hedge funds have invested in the 'more mobile data usage' theme via various plays. Some have elected to buy the wireless tower operators like American Tower, (AMT), Crown Castle (CCI), and SBA Communications (SBAC). Falcone, on the other hand, has elected to straight up build out his own network as his hedge fund has morphed into a semi-private equity-like fund. He noted that they've accumulated spectrum and are looking at a 4G terrestrial network.

Falcone also likes Crosstex Energy (XTXI). We covered his investment in XTXI back in December and the Harbinger manager likes it due to its complex financial structure. A master limited partnership owns the assets and then XTXI owns that partnership. He drew attention to the fact that this isn't a company that pulls gas out of the ground, but rather a play on gas processing and transmission. Falcone thinks XTXI is worth double what it's trading at now or more (around $9.50 currently).


Jim Chanos / Kynikos Associates: The well-known short-seller attacked alternative energy 'green' plays with a presentation entitled, "Does Solar and Wind = Hot Air?" Chanos said that, "wind is 50% more expensive than natural gas, and solar is 4 times more expensive" and that natural gas prices have essentially shot an "economic arrow" into alternative energy.

In particular, Chanos mentioned Denmark-based Vestas (CPH:VWS or PINK: VWDRY), a company focused on wind power that might be worth looking at for a short.

However, he is most excited about shorting solar power via First Solar (FSLR), a company he believes has outdated technology. Chanos was recently on television talking negatively about this name as well. He points out that Spain and Italy utilize solar power the most. But, the problem there is that the demand is highly subsidized. Also, he points to the management exodus at FSLR as a warning sign for investors to exit shares.

Fairholme's Bruce Berkowitz Is Beating Hedge Fund Managers At Their Own Game

Every once in a while, there’s a saga on Wall Street that captures everyone’s attention. The fight over Florida real estate development company St. Joe Co. earlier this year was that kind of saga. On one side was Bruce Berkowitz, founder of Miami-based mutual fund manager Fairholme Capital Management, St. Joe’s largest shareholder, with a nearly 30 percent stake, who believed that the company’s future would be bright once the real estate market recovered and poor management was out of the way. On the other was David Einhorn of Greenlight Capital, a New York–based hedge fund manager who had presciently shorted Lehman Brothers Holdings before it collapsed and was equally outspoken in betting against St. Joe.
In the fall and winter, the two publicly battled under the glare of the media spotlight. Fortune magazine dubbed Berkowitz “the megamind of Miami,” while the Atlantic, not known for its business coverage, sent a writer to the Florida Panhandle to track down a development at the heart of the Berkowitz-Einhorn showdown. In March, in a battle so short you might have missed it if you blinked, Berkowitz and Fairholme won control of St. Joe, gaining four seats on its board of directors and forcing the departure of its CEO. The mutual fund manager had beaten the hedge fund manager at the game.
St. Joe may not seem like a major prize in the big scheme of things, with a market value of just $2.4 billion, but Berkowitz and Charles Fernandez, his No. 2 at Fairholme for the past three and a half years, saw a huge opportunity. Not only did they think that the company’s real estate operations could be worth a lot more in the future, they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett’s Berkshire Hathaway.
“We’re trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders,” Berkowitz says.
Given the financial uncertainty of the postcrash world, where pockets of opportunity may be found in all kinds of places, flexibility is essential. Hedge fund managers like Einhorn have long known this. But Berkowitz has learned it too, growing Fairholme to more than $20 billion in assets since founding the firm nearly a dozen years ago.
In many ways, Berkowitz (who along with Fernandez and other insiders has some $300 million invested in Fairholme) is a traditional value investor who plows through piles of paperwork and reams of financial data to find unappreciated companies. Like Buffett, he follows the principles of Benjamin Graham, the legendary value investor who focused on a company’s assets and ability to generate cash. But his strategy stands apart, marked by extremely concentrated holdings and a willingness to go where others fear to tread, and then to wait, often doubling down as stocks fall in the short term.
Fairholme is the largest investor in American International Group, after the U.S. government. The reviled insurer represents 7.5 percent of  Fairholme Fund’s portfolio, which is loaded up with financials and other loathed sectors. Additional big holdings include Bank of America Corp., CIT Group, Citigroup, Goldman Sachs Group, Morgan Stanley and Regions Financial Corp. Consumer names are sparse, and the one that is there is the retailer almost no one wants: Sears Holdings Corp. “I’m a premature accumulator,” Berkowitz says, laughing. To counter any risk that the portfolio might crater, and to take advantage of opportunities fast, Berkowitz keeps massive amounts of cash on hand — 23 percent of  Fairholme’s assets as of March 31.
“Bruce is very bright, very hardworking, and he marches to his own drummer,” says hedge fund billionaire Leon Cooperman, who has known Berkowitz for more than a decade. “He’s a guy whose investing views I respect.”
“He comes from a very modest background, and he loves to invest,” adds Michael van Biema, a former Columbia Business School professor who now runs Van Biema Value Partners, a New York–based fund-of-hedge-funds firm that invests with small, deep-value-oriented managers. “To us, the single most important characteristic for a manager is this absolute passion for investing.”
The returns of Berkowitz’s strategy have been terrific. Since the Fairholme Fund launched in December 1999, it has beaten the market every year except one; from inception through the end of last year, the fund had an annualized return of 14.47 percent, versus just 0.45 percent for the Standard & Poor’s 500 index. By comparison, Hedge Fund Research’s HFRI fund-weighted composite index returned 6.75 percent annualized over that period. An investor who’d put $1 million in Fairholme at the start would have ended 2010 with $4.4 million. That success earned Berkowitz the title of “domestic stock fund manager of the decade” last year from fund tracker Morningstar.
But the financial world has changed since Berkowitz started investing two decades ago, and he and Fernandez expect that many of the best opportunities going forward won’t involve domestic stocks — the mainstay of  Fairholme over the past decade — but will exist in various corporate restructuring efforts as companies around the globe unwind their debts and shore up their balance sheets. At the same time, Fairholme faces the constraints of its own success: Its ballooning asset size means that bets will need to be ever larger and that investments in smaller companies won’t make a meaningful enough contribution to returns. For the first four months of this year, the Fairholme Fund lagged the S&P 500 — down 2.7 percent versus the index’s 8.4 percent rise — a rare period in which it has not only underperformed but lost money for investors.
“It’s sheer fantasy to think that someone could go up consistently every month for years upon years,” Berkowitz says. “It is just insane to think that a four-month period is anything.”
Operating in Miami, where the firm is based, and nearby Coral Gables, where Berkowitz, 52, and Fernandez, 48, live next door to each other, Fairholme isn’t caught up in the Wall Street vortex. Berkowitz and Fernandez rarely go to the office, preferring to catch up over long predawn walks (Black­Berries in hand) and then work from their oceanfront homes or their favorite Italian restaurant. The firm comprises just 28 people, mostly in administration and compliance. There’s no army of salespeople pitching the fund to
401(k)s, where its presence is de minimis, nor are there lots of researchers and junior portfolio managers on staff. Instead, research is largely outsourced to consultants as needed. The setup is reminiscent of that of    Warren Buffett and his right-hand man, Charles Munger, operating Berkshire Hathaway from the middle of nowhere in Omaha, Nebraska.
“I think Bruce has modeled himself to a great degree after Warren Buffett, and it is an enormous competitive advantage,” says William Ackman, founder of New York–based hedge fund firm Pershing Square Capital Management, who worked with Fairholme and Canada’s Brookfield Asset Management to bring real estate developer General Growth Properties out of bankruptcy last year. Berkowitz’s word, like Buffett’s, can be counted on, a rarity in the fast-moving world of finance, Ackman notes. “If you are not partnered with the right people, they can take advantage of the changes to retrade the deal,” he says. With Berkowitz and Fernandez, “every time there was a twist or turn, they were willing to work with us and the company.”
As the world’s businesses recover from the financial crisis and get their balance sheets back in order, Berkowitz and Fernandez hope to find more opportunities like General Growth. In that case, they bought the company’s debt and then agreed to invest $2.7 billion in the restructuring during a 45-minute meeting with Ackman and the folks at Brookfield. They’re moving further afield, traveling to Asia to check out the business landscape there, while focusing on St. Joe at home. Fernandez, a restructuring expert who has worked with a number of companies affiliated with Miami billionaire Phillip Frost, brings an operator’s mind-set to Fairholme.
The bottom line, however, remains the same: As with other more-traditional value managers, Berkowitz and Fernandez focus on the downside, seeking a large margin of safety in case things go wrong, even as they seek out new opportunities. “You don’t play Russian roulette,” Berkowitz explains. “Sometimes people invest based on probabilities. But what good is probability theory once you blow your brains out? You can’t play again once you’re dead. I don’t want to invest in a company where death is an option.”
BRUCE BERKOWITZ, LIKE SOME of the best investors on Wall Street, didn’t seem destined to become a money manager. He grew up in Chelsea, Massachusetts, a formerly industrial town just outside Boston that had slid into economic decline, and was the first in his family to go to college. His father ran a corner grocery store and was a part-time bookie; young Bruce learned the odds when he had to take over the operation for a few months after his dad had a heart attack.
Berkowitz recalls making his first investment, circa 1973, as a teenager, in a whole life insurance policy from Mutual of New York. Unlike term insurance, which pays out only upon death, whole life insurance is partly an investment in which the cash value accumulates over time tax-free. “Why I did it, I don’t know; it was less money to spend on cigarettes,” Berkowitz says. “I like to see that little table on page 72. It’s like a zero-coupon bond; the discounting is huge. It was the equivalent of going to Filene’s Basement and getting a discount.”
After earning a BA in economics from the University of Massachusetts Amherst in 1980, Berkowitz went to work for the Strategic Planning Institute, a consulting firm, and moved with his wife, Tracey, to England. Bored, he started trading stocks in his spare time. In 1983, at the age of 25, he joined Merrill Lynch & Co.’s London brokerage office, where, thanks to charm and long hours, he became the top fixed-income salesman. By 1987, Berkowitz had a core of 200 wealthy clients, and Lehman Brothers recruited him to start a new office for high-net-worth investors in London. He returned to the U.S. in 1989 and four years later moved from Lehman to Smith Barney Investment Advisors.
From the beginning, Berkowitz’s investing style was clear: He liked to make bets on just a few companies, and he was savvy about financial stocks, which many value investors shun for their complexity. At one point in 1994, he owned shares in just two companies: Berkshire Hathaway and Fireman’s Fund Insurance Co. Nearly a decade earlier he’d learned of Berkshire from Jack Byrne — Fireman’s legendary chief executive, who had previously run Geico and brought it back from the brink with an investment from Buffett — and Berkowitz bought the stock as a baby gift for his first child 25 years ago.
“Jack would always be talking about Warren Buffett,” says Berkowitz. “Berkshire Hathaway is an outstanding model.”
By the late 1990s, however, Berkowitz was chafing under the constraints of working for a big Wall Street firm and itching to go out on his own. In 1999 he recruited two men who would join him at Fairholme: Keith Trauner, a longtime value manager, and Larry Pitkowsky, a PaineWebber broker who’d been managing money on the side. Berkowitz established Fairholme, named after the street he’d lived on in London, in December 1999.
The new firm set up shop in tony Short Hills, New Jersey, operating out of the same building where value investor Michael Price ran the Mutual Series funds. “We all sat in a little room together for a long time,” says Trauner, 53, who had originally met Berkowitz at a shareholder meeting of financial holding company Leucadia National Corp., in which they were both invested. At first, as with most start-up mutual funds, no one paid much attention to Fairholme. “The mutual fund idea was just to throw spaghetti against the wall and see if it stuck,” Berkowitz says.
In its first semiannual report to shareholders, on May 31, 2000, Fairholme, with just $6.2 million in assets, reported that more than 50 percent of the portfolio was in property/­casualty insurers. “These companies fall within our circle of competence and were bought at multi-year lows,” according to that report. Or as Berkowitz, who has sat on the boards of directors of various insurers over the years, says, “I’m addicted to buying life insurance.”
In an early distressed investment, which may be typical of things to come, Fairholme began accumulating the debt of     WorldCom on the cheap after the telecommunications company — as reviled then as AIG is now — filed for bankruptcy in July 2002. That eventually became a hefty position in the shares of MCI, which itself was sold to Verizon Communications in January 2006. “Bruce makes bets where other people don’t see it,” says Cooperman, chairman of New York–based Omega Advisors, which was also heavily invested in MCI stock at the time. “He does his own homework.”
In 2006, Berkowitz relocated Fairholme to Miami, where there’s sunny weather, no income tax and very little Wall Street chatter. Trauner moved to Florida too, while Pitkowsky stayed in suburban New Jersey, but by 2008 they had both left the firm. (Trauner and Pitkowsky recently launched their own money management operation, GoodHaven Capital Management, with backing from Markel Corp., a large insurance company.)
That same year, Berkowitz bailed from financial stocks. He sold positions in Countrywide Financial Corp. and Freddie Mac because their balance sheets had become overleveraged and lending had gone wild. As Fairholme noted in its 2007 annual report to shareholders, well before the financial collapse: “Worldwide, financial institutions may ultimately write off hundreds of billions and are being forced to raise equity to survive — if they can. Almost certainly, there will be high-profile restructurings and continued stress.”
Instead, Berkowitz tilted Fairholme’s portfolio first toward energy stocks and then to drugmakers and defense companies. To help make sense of the defense industry, an area that Fairholme has not typically favored, Berkowitz hired a panel of former generals and admirals to study procurement. “We said, ‘Tell us why we’re being idiots,’ ” he recalls. The process of testing every potential investment against all that might go wrong has been critical to Fairholme’s success.
Fernandez, who is married to a cousin of Berkowitz’s, joined Fairholme as president in January 2008. A 1985 graduate of Florida International University, Fernandez had worked with Frost, a dermatologist-turned-entrepreneur, on a number of companies, including Continucare Corp., IVAX Corp. (which was sold to Teva Pharmaceutical Industries) and Big City Radio, where he’d become chief executive after the enterprise acquired his Frost-backed company, Hispanic Internet Holdings.
“I was an operator; I’m here to fix something, not grow it,” says Fernandez, describing his relationship with Berkowitz. “Our skill sets are similar but different, and that’s key to making us work as a team. When you come to the same conclusions from two different directions, it’s a check and redundancy.”
Around the time that Berkowitz moved Fairholme to Florida, he amended the prospectus for the Fairholme Fund to eliminate rules that restricted investments in non-U.S. securities and “special situations” to no more than 25 percent of the portfolio and to get rid of wording that the fund’s assets would normally be invested 75 percent in U.S. common stocks. “Such changes,” Fairholme told shareholders in 2006, “may help the Fund better achieve its objectives under certain potential economic and market conditions.” (Fairholme’s investing mentality may be similar to Berkshire Hathaway’s, but Berkowitz’s annual reports lack the chattiness of Buffett’s.)
As the firm grew, Berkowitz began appearing regularly on business news programs and in the press. Although Fairholme counts a number of large institutional accounts, the vast majority of its more than 500,000 shareholders and clients are individuals. “Up until about five years ago, I don’t think we had one institutional account,” Berkowitz says. “It was basically moms and pops, some just built up to large-sized owners over 20 years.”
Unlike bigger firms, with their array of salespeople and lower-cost share classes for institutional investors, Fairholme offers the same share class — no-load, with a 1 percent management fee — to all comers. Unusual for funds of its size and track record, Fairholme Fund is barely visible in the $3 trillion 401(k) market: Just 146 companies, including Nike and Xerox Corp., offered it in their lineups, for a total of some $138 million in assets, according to the most recently available data from 401(k) tracking firm BrightScope.
Edward Kuresman, a principal and portfolio manager at Madison Wealth Management, a Cincinnati-based advisory firm with $300 million under management, started putting money with Fairholme in 2009. He needed to replace a deep-value equity manager whose fund manager had left, and went to Miami to check out Fairholme. “We’d certainly heard of Bruce Berko­witz and Fairholme,” says Kuresman, who now has $8 million invested in Fairholme. “His performance was outstanding, he’d started to make headlines, and I was curious. We wanted something different from your typical large-cap value manager.”
When the markets collapsed in 2008, Berkowitz saw a massive opportunity to return to the sector that had long been his mainstay. He sat up at night reading congressional testimony and filings from the government’s Troubled Asset Relief Program, and listening to company conference calls over and over again on high-end headphones. In November 2009, Fairholme started buying financials with Citigroup, taking comfort in the government’s bailout of the then-struggling bank. Its total stake is now worth about $900 million.
In the first quarter of this year, Citi reported net income of $3 billion, a 32 percent decline from the same period in 2010; though losses on troubled loans fell, so did profits in its trading and investment banking businesses. Berkowitz argues that the results show how far along Citigroup has come in fixing its balance sheet and that it’s unrealistic to expect growth so quickly. “A year ago they were an institution that people didn’t know would make it,” he says. “They are profitable now and building their balance sheet and increasing tangible book value and making loans. Their bad loans are declining. Everything is going the right way. I don’t understand where the negatives are.”
Other financial investments followed — AIG, Bank of America, CIT, Goldman Sachs, Morgan Stanley, Regions Financial — until Berkowitz had shifted about half of the firm’s growing assets into financials, a giant bet on Wall Street and the future of the system. In many cases, Fairholme is the largest or second-largest investor in the stock, holding hugely outsize positions. “There are plenty of people out there who think we’re crazy for being in banks and brokers and AIG,” Berkowitz says.
In early 2010, Fairholme began buying AIG bonds, stock and preferred shares. The conventional wisdom at the time was that AIG would never repay the government the $180 billion in bailout money it had received. Institutional investors shunned it. Berkowitz, who had loved AIG since his earliest days of investing, felt there was still good value in its core operations. Whereas others saw the failure of the derivatives unit and the subsequent bailout, he saw an insurance business that had remained large and strong throughout that disaster. “There’s been an intense focus on the liability side of the balance sheet,” Berkowitz says. “It’s time to look at the asset side.”
Although financials have made Berko­witz and Fairholme’s investors rich over the years, they have not done well in 2011. Through April, Bank of America was down 7.9 percent, Citigroup was off 3 percent, Goldman Sachs had fallen 10 percent, and AIG had dropped a whopping 46 percent (though the last number is misleading because the share price fell significantly after AIG issued warrants to nongovernmental shareholders). Still, Berkowitz is undeterred.
“We’re only in the third inning,” he says. “The last time I was heavily involved with the banks, it was a five- to ten-year period. And I’m always early, which in a way is a good thing because if you were right on day one, you’d have a much smaller position.”
If he’s right, the size of the bet on financials will make it a huge win for investors, but there are risks to Berkowitz’s focused strategy and to Fairholme’s ballooning asset base. Money has poured in since Morningstar named Berkowitz manager of the decade in January 2010. In the 12 months through February of this year, investors put $4.6 billion in new money into the flagship Fairholme Fund, according to Morningstar.
Managing massive inflows is difficult, says Ken Kam, founder and CEO of Market­ocracy, a Los Altos, California–based research and investment firm that identifies some of the best investors in the world and builds model funds based on their portfolios. During the 1990s, Kam was co–portfolio manager of Firsthand Funds’ Technology Value Fund, which experienced a flood of money during the tech-stock bubble. “Berkowitz has a broader mandate than we did, but he still has the same problem,” Kam explains. “He’s got to make pretty big changes, and on the whole they have to be right.”
Fairholme has launched two new funds over the past 18 months that have already garnered more than $700 million in assets: Fairholme Focused Income, which buys bonds, and Fairholme Allocation, which focuses on smaller companies. Some Fairholme investors worry that Berko­witz may be stretched too thin. In March, after years of inflows, investors pulled out $300 million, according to Morningstar. Among them was Barry Ritholtz, CEO of online quantitative research firm FusionIQ and a popular blogger at the Big Picture. In early April he posted on his blog that he’d ditched Fairholme from one of his portfolios, but not because of concerns about its size: “[The fight over St. Joe] appears to have been a distraction to Berkowitz, and Fairholme Funds performance has suffered. So we fired him.”
the ST. JOE CO. ONCE DEFINED Flor ida. Assembled with early land purchases by Alfred duPont, St. Joe began in 1936 as a paper company in the Florida Panhandle, at a time when pine trees were plentiful and logging was big business. By the late 1990s, however, the company was focused on its real estate — and on developing vast tracts of beautiful but not easily accessible land that had been acquired on the cheap by duPont’s brother-in-law, Edward Ball. Its fortunes rose and fell with Florida real estate. “St. Joe is nothing less than the history of real estate in the United States,” Berkowitz says.
The Florida Panhandle is one of those areas with beautiful beaches that seem always to be on the verge of happening, but it never really took off. In 1997, St. Joe brought in a former Walt Disney Co. development executive, Peter Rummell, as CEO to turn St. Joe into a real estate powerhouse. Under Rummell’s leadership the company sold off old divisions, developed beachfront communities and laid the groundwork for an airport to serve the region. Between 1998 and 2005, St. Joe’s annual net income jumped from $29 million to $127 million. But by 2008, the year Rummell left and was replaced by Britt Greene, the real estate downturn had hit Florida hard. Sales of St. Joe’s high-end vacation homes had slumped, and the company was making money by selling off parcels of rural land. In 2009, St. Joe lost $130 million. Its shares, which had traded as high as $85 in July 2005, fell below $15 in March 2009.
Fairholme started buying St. Joe shares in 2007 at a price of $32.33 and has since accumulated 29 percent of the company, a stake worth more than $600 million. Berko­witz knew about the Panhandle because of his earlier investments in Leucadia, which had developed Rosemary Beach, and he knew what a big deal St. Joe was in the region. Its scale, in geographic terms, is huge: The company holds some 574,000 acres of land, including beachfront property, and has built or is in the process of developing 31,000 residential lots.
Fairholme’s logic is relatively simple: St. Joe’s fortunes will rise again when real estate does; the land was purchased cheaply, paying them to wait; the new airport, on land donated by the company, will spur development in the Panhandle; and new company management will help. With Northwest Florida Beaches International Airport opened last May, the region should be able to develop not just as a vacation spot but as a commercial hub, Berkowitz contends. “All you need now is for the economy to get going,” he says. “Once you stop the bleeding, time becomes our friend rather than our enemy.”
Hedge fund manager David Einhorn has been very public in his derision of St. Joe. In a 139-slide presentation at the Value Investing Congress in New York last fall, Einhorn set out the reasons he believed that St. Joe, which was then trading at about $25 a share, was worth just $7 to $10. Einhorn showed spectacular photos of Hilton Head Island, Nantucket and Napa Valley — to which St. Joe CEO Rummell had compared the area — followed by images of the undeveloped beaches and run-down streets of Port St. Joe and Windmark Beach, Florida, to much laughter from the crowd. As developments have stalled, Einhorn argued, the company should be valuing its large real estate holdings as rural timberland.
“The problem is that the company is stuck,” said Einhorn, who declined to be interviewed for this story. “If they were to do the best thing for shareholders, which I’m sure shareholders wouldn’t appreciate, they would just sell it right now to someone who would operate it on a low-cost basis as a rural timber company.”
Investors rushed to sell: St. Joe’s shares fell 10 percent, to $22.16, by the end of the day in heavy trading. Afterward, Berkowitz — who snapped up an additional 135,600 shares that day — thanked Einhorn. “I want to send him a box of chocolates,” he told Reuters at the time.
Fairholme moved quickly from there. In January, Berkowitz and Fernandez joined the St. Joe board. Six weeks later, on Valentine’s Day, they resigned, saying they would not stand for reelection until a majority of directors were “committed to shareholder value, pay for performance and effective corporate governance.” On February 16, in a letter to St. Joe shareholders that was included in a securities filing, Fairholme said it had retained executive search firm Spencer Stuart to begin a director search to fill a seven- or nine-member board, whose slate would include Berkowitz, Fernandez, former Florida governor Charlie Crist and Carnival Corp. chief operating officer Howard Frank. “While a written consent will be the simplest way to change the board, it may become appropriate to hold a special meeting of shareholders,” Fairholme wrote. “Of course, Joe’s current directors can immediately step down and appoint our slate in order to save us all much time and expense.”
In a shockingly fast denouement, Fairholme and St. Joe reached a compromise agreement. On February 28, CEO Greene and three other directors resigned (other managers would follow), and Fairholme’s team gained control of the board. Three other directors, including then-chairman Hugh Durden, who would become interim chief executive, remained. The new chairman and vice chairman, as of March 4: Berkowitz and Fernandez, respectively.
On March 3 the company reported its delayed year-end results: a loss of $36 million, an improvement over the previous year’s $130 million in red ink. Sheila McGrath, an analyst at Keefe, Bruyette & Woods in New York, noted that the fourth quarter had a meaningful pickup in residential activity and lauded the company’s focus on commercial real estate opportunities. Later that month, St. Joe appointed a new chief operating officer, Park Brady, former chief executive of vacation-rental company ResortQuest International. By the end of April, shares had recovered to $26.
McGrath now has a price target of $33, below her calculation of $41 in net asset value for the real estate. “For investors to focus beyond that discount valuation, St. Joe needs to mitigate the cash burn,” she says. “While they did cut expenses, it wasn’t enough given the severity and duration of the economic downturn. There is more of a sense of urgency now, and more focus on recurring revenues.”
Berkowitz’s bet is that once the real estate market recovers, St. Joe’s business will rebound, helped by new management, and that the risks of waiting are low because the company has more than $200 million in cash. At the same time, he hopes to bring more economic development to northwest Florida, which has been largely reliant on tourism and the military — perhaps even turning the area around the airport into a new “international city,” in which manufacturers could get tax breaks for setting up in an economic zone. “If it’s six months, a year or 18 months, it doesn’t matter,” Berkowitz says. “Normally at Fairholme, we don’t talk about how much we’re going to make but about how much we might lose. Given our position in St. Joe, I don’t see how we can hurt ourselves.”
But Berkowitz and Fernandez’s vision for St. Joe is much bigger than that. As an asset manager in its own right, St. Joe, which has owned everything from railroads to banks, would give Fairholme a way to play corporate restructurings and do private investments that would not be permitted directly under securities laws regulating mutual funds. Because Fairholme is set up as a mutual fund rather than a hedge fund, it faces restrictions on owning real estate or other illiquid assets — a potential disadvantage for a mutual fund going up against hedge funds as restructurings become more important. But if St. Joe owned it, they could. “We could own a company whose shares are liquid that owns illiquid assets,” Berkowitz says.
Like a mini–Berkshire Hathaway?
“It could be,” Berkowitz says. “That’s an interesting way of describing it. Except the shareholders of Fairholme will benefit, as opposed to Charlie and myself directly. We’ll benefit through our participation in the fund.”
Although St. Joe currently represents less than 3 percent of Fairholme’s assets, Berkowitz hopes to make it a more significant holding. “Our game plan will be to make it a bigger part of the portfolio,” he says. “We’re not wasting our time or our shareholders’ or partners’ time. I hope one day St. Joe is our largest position.”
St. Joe, however, is just one piece of the Fairholme strategy. Berkowitz and Fernandez have been looking east: Over the past year they have flown to Asia four times, using Goldman Sachs to get introductions to sovereign wealth funds and business luminaries in China, Hong Kong, Indonesia, Singapore and South Korea.
For many years, Asia has lured growth investors with its promise of a huge and increasing middle class. Value investors, however, have until recently been less interested, as betting on this growth often meant paying up for it. Now even Buffett is traveling to Asia in search of new investment opportunities. Berkowitz dubs his latest thinking “the bridge” — meaning the connection between the U.S. and Asia — and he’s looking for ways to capitalize on it.
He started with what he knew: insurance. When AIG spun off AIA Group, its Asian life insurance unit, last fall in a highly anticipated and oversubscribed initial public offering on the Hong Kong Stock Exchange, Fairholme put in an order for $1 billion worth of stock. It’s unusual for a value manager to invest in an IPO, but the business was one that Berkowitz understood well. AIA had been considered one of the crown jewels of AIG, and it was being spun off to raise money to repay the U.S. government. Berkowitz jumped at the chance to get in on life insurance in Asia, a way to play the emerging middle class. “You can’t ignore what’s going on in Asia,” he says. “The market is so underserved.”
One thing led to another. When Carlyle Group sold its shares in China Pacific Insurance (Group) Co. late last year, Fairholme bought $700 million worth. “I have studied insurance companies for 30 years, and this one is right up there with Berkshire Hathaway,” Berkowitz says. China Pacific Insurance chairman Gao Guofu — whom Berkowitz and Fernandez had first met at a dinner in Hong Kong — flew from Shanghai to Miami with a team of 15 executives to give them a full presentation.
Berkowitz expects that other Asian investments will follow, though he’s mum on what or when. “There’s a lot of money in Asia, and a lot of clout there,” says Kevin McDevitt, who follows Fairholme for Morningstar, which gives it its highest five-star rating. “I think he just wants access to the information flow that comes from Asia and to be more tied in there.”
The fund’s $4 billion cash hoard gives Berkowitz and Fernandez the ability to invest quickly in any situation — as Buffett has long been able to do — whether in Asia or in overleveraged companies closer to home. “Cash is valuable when other people don’t have it, and it makes the phone ring,” Fernandez says.
At the same time, the cash buffers Fairholme against a liquidity crisis should it stumble and find itself with a large number of investors simultaneously rushing for the exits. Many managers didn’t have such a safety net in the financial crisis and were forced to sell positions at a loss to cover redemptions. “We were very lucky in 2008,” Berkowitz says. “But if something bad happens in the world and people need money, we have to be prepared to give them liquidity.”
For a value manager, especially for one as concentrated as Berkowitz, there are going to be good years and bad. There are few investors who can consistently beat the market, no matter what the strategy. But academic research shows that focused portfolios may outperform — and that’s the arena where Berkowitz wants to play. “Charlie Munger once said, ‘You don’t need too many ideas to do well,’ ” he notes. “It can’t be more complex than that. There’s only two of us.”

The Vigilante: Why the man who runs the world's largest mutual fund sold all his Treasury bonds

In February 1993, as the fledgling Clinton administration grappled with the nation’s budget woes, campaign adviser James Carville groused to The Wall Street Journal: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.” If Carville were serving in the Obama administration today, he’d be seeking reincarnation as Bill Gross. The founder and co–chief investment officer of PIMCO, Gross runs his firm’s Total Return Fund—the world’s largest mutual fund, with holdings entirely in bonds. And for some time, he has been an outspoken critic of U.S. economic policy.
Gross demurred when I suggested that James Carville might want to be him. “I thought the remark was striking at the time,” he said, “but no, I didn’t feel that they were catering to us at every turn.”
But Democrats wrestling with the legacy of Ronald Reagan’s deficits resented the influence of what the analyst Ed Yardeni had dubbed “the bond vigilantes”: the investors who enforce fiscal and monetary discipline when governments won’t. If your political system inflates its currency, or fails to align its spending with its tax revenues, the bond vigilantes will raise your interest rates until you either get it together … or catapult into a crisis.
In the 1990s, we chose to get it together; thanks to tax hikes under both Bush I and Clinton, and a massive influx of capital-gains-tax revenue from the stock-market bubble, we even enjoyed a brief surplus. The bond vigilantes retreated over the horizon. But now deficits are back—and bigger than ever. In 2010, the United States spent $1.3 trillion more than it took in.
This year, the Congressional Budget Office expects us to borrow another $1.5 trillion. In just two years, we will have borrowed almost 20 percent of gross domestic product, or more than $9,000 for every person in the United States. But we won’t be borrowing it from Bill Gross. For some time, he’d been selling his Treasury holdings, and by early March, he had reportedly dumped all of them. Then in mid-April, Gross upped the ante by placing bets against U.S. bonds in the market, a move that pushed the Total Return Fund’s holdings of U.S. debt to the equivalent of minus 3 percent. If the bond vigilantes really are getting the gang back together, then the size of Gross’s funds—and his recent divestment—would seem to make him their leader. With economists and politicians warning about the dire consequences of out-of-control deficits, it seemed like a good time to sit down and ask Gross how dire the situation was. Is the United States really heading for an epic showdown with the debt markets? And if it comes, how badly will we be hurt?
A trim, gentle-seeming 67-year-old, Bill Gross doesn’t look much like a vigilante. He speaks so quietly that my voice recorder gave up and turned itself off. PIMCO’s Newport Beach, California, office has the understated elegance of one of those five-star western resorts where executives go to de-stress. The tranquility extends even to the trading floor, where Gross still sits for most of the day. I spent the latter half of the 1990s installing networks on New York trading floors, and even the smallest of them operated at a low roar. But PIMCO’s 100-seat floor is so eerily silent that I half-expected to see the traders communicating in sign language. Showdowns with PIMCO come, not with a bang, but with the almost imperceptible clicks of traders calmly keying in their sell orders.
I started by asking Gross the questions on the mind of every economic pundit in Washington these days: Why did he sell? Does he think the U.S. will default on its debt?
Gross shook his head (gently). “Actual default is unimaginable.” He must be pretty confident in that judgment, because he confirmed rumors that he’s made a sizable bet against a default. “We’ve taken probably $1 billion worth of U.S. credit-default swaps on the long side at a yield of 0.5 percent per year, which is more than the 0.25 percent being offered by the feds.” Effectively, Gross is selling insurance on U.S. bonds—and getting a better return than he would by buying those bonds.
Default is the most obvious risk that bond investors face, but not the only one—they also need to worry about things like inflation. Gross has left Treasuries simply because he thinks the yield offered is no longer high enough to compensate him for things like inflation risk. “Global savers have earned yields of 1 percent over inflation over the last half century,” he told me. “Now you’re not earning the historical rate.”
Gross is known for getting out when the getting isn’t good. You can perhaps credit his Canadian parentage for his remarkable discipline. Canada’s banking system is one of the few entities that skirted the financial crisis—as did the funds run by Bill Gross, who was worrying about a mortgage crisis as early as 2005, and positioned his funds accordingly. Yet even with solid Canadian genes, that discipline wasn’t always easy to maintain. “In 2006 and 2007, we were sort of questioning our own judgment, because we were half a percentage point behind our peers … You question whether you’re just really being a stubborn donkey, or your premises are right.”
Unfortunately, they were; they usually are—the Total Return Fund has averaged 7 percent returns over the past 10 years, ranking it third among intermediate-term bond funds. Gross says the essential trick is being “a contrarian, but not an extreme contrarian … a pessimist, but not an extreme pessimist.” Being right too early, he points out, is almost as bad as being wrong—as the folks who shorted the stock market in 1996 can attest. Yet the predictions he’s making now sound pretty pessimistic: after a 30-year rally in the stock and bond markets, he thinks we now have to adjust to a “new normal” of slower growth and lower returns.
In some ways, this is just Gross’s “old normal.” He started investing in the early 1970s, when inflation was soaring. Inflation is bad for bonds, because they have a fixed payout—as money loses value, the real value of your interest payments declines, and worse, people want to buy the bonds from you only at a discount. “The first 10 years, it was ‘Preserve capital, preserve capital, preserve capital,’” Gross told me, adding glumly, “Now we’re back to that.”
But in between, he profited greatly off a long rally, which has spanned most of his career. In 1980, the Fed finally got tough on inflation, which declined, along with interest rates, slowly but steadily for most of the next three decades. It was the 1970s in reverse. As Gross says, “Investors got used to being on this magical journey, with bonds not only producing a nice yield, but some capital gains too.” In 1984, the yield on a 10-year Treasury note averaged 12.46 percent. By 2001, it was 5.02 percent.
But now the rally has ended, as it had to (inflation couldn’t fall forever). Indeed, yields are even lower than you’d expect. As of mid-March, they were around 3.3 percent—lower than they were in 1962, when inflation averaged just 1.3 percent. These low yields are partly due to a global “flight to quality,” which has pushed up the demand for safe assets. U.S. Treasuries are a prime destination for capital refugees, because our government’s default risk is low, and our economy is very, very large. Especially with the Obama administration obligingly running record deficits, we’ve had a lot of Treasury debt to go around. Thus, the financial crisis that started in our financial markets has ironically made borrowing much cheaper for our government.
Gross argues that increased demand is not the only factor pushing down yields. To fight the crisis, the Federal Reserve has aggressively expanded the money supply, in large part by dumping new money into the Treasury market. “We’ve been supporting Treasuries almost one for one,” he tells me. “At 8 a.m., the Fed calls up and asks our Treasuries desk for offers to buy, and one hour later, the Fed’s asking for bids to sell them.” The Fed, complains Gross, is “picking the pockets” of investors. Though he can’t quite bring himself to blame the financial powers that be. “God bless Ben Bernanke and Tim Geithner for what they’re trying to do, but the net result of a lot of what they’re doing is to take money out of the hands of savers.”
This outcome was perhaps predictable. According to Carmen Reinhart and Ken Rogoff, the authors of This Time Is Different, a 500-page encyclopedia of the disasters that have beset overindebted governments and economies, the ratio of government debt to gross domestic product usually doubles after a crisis. Reinhart, now a senior fellow at the Peterson Institute for International Economics, just released, with Rogoff, a global forecast of government debt levels over the next 25 years. Even in their “optimistic” scenario, total U.S. government debt rises from 43 percent of GDP in 2005 to 86 percent in 2015.
And after that? I asked Reinhart the same question I asked Bill Gross: Is the U.S. government going to default on its debt?
Like Gross, she thinks such a scenario—​which she calls “debt with drama”—is unlikely. Instead, she predicts that the United States will engage in “financial repression,” a sort of stealth default. Financial repression relies on inflation, regulation, and fancy accounting instead of forced restructurings, or outright refusal to pay. In 1932, for example, New Zealand did a “voluntary” debt swap that converted short-term debt to longer-term debt at lower interest rates. “You look at this deal and you ask yourself, ‘Why would anyone do this? It’s insane,’” says Reinhart. “And then you see that they changed the tax rules, so that if you didn’t do the swap, you’d lose a ton of money.”
Here and now, she thinks much of the debt will be “monetized,” or inflated away, by means of regulations that “encourage” the financial sector not to sell its government debt in the face of inflation. That means regulations such as the new set of international bank-capital standards known as Basel III, which heavily favor government debt, or Britain’s recent move to increase the percentage of each bank’s reserves that must be held in government bonds.
This strategy will probably work for Japan, which owes something like 95 percent of its massive debt to domestic savers and financial firms. Unfortunately, about half of all publicly issued U.S. debt is owned by foreign entities, such as central banks that buy a lot of dollars in order to keep their own currency artificially cheap. Then there are the free agents such as Gross. Will they really stand by as we let inflation—or a sinking dollar—eat away most of the value of their investments?
Given how much money we’re borrowing, we need them to both hold on to the Treasuries they have and keep buying more. Even the optimistic projections of the Obama administration show us borrowing $735 billion by 2020. And foreign central banks, and investors like Bill Gross, are already expressing reluctance to keep financing our deficits.
Some observers point to our current low interest rates and ask, “Why worry about deficits right now?” Paul Krugman, for example, regularly derides the people who are worried about the “invisible bond vigilantes.” But of course, as Gross says, what’s keeping Treasury-note prices low is not so much the free market as the behavior of central banks, which are buying for reasons that have nothing to do with their assessment of our fiscal rectitude.
Reinhart, who has done extensive research on the topic, was even more dismissive of Krugman’s analysis. “Are interest rates a good indicator of impending crises? The resounding answer is no.” Deficit doves seem to assume that bond interest rates will act as a sort of early warning system: when they start to creep up, then we should start cutting our deficits. But Reinhart argues, “Before the crisis, Ireland’s rates were imperceptibly higher than Germany’s.” By November 2010, the Irish were paying an extra 6 percent annual interest to borrow money. “I certainly wouldn’t call this my baseline scenario for the U.S.—but the message is: think the unthinkable.”
This sort of “jump shift” would probably be less disastrous for us than it was for Ireland, but it would still be a terrible reckoning. Even if the Fed monetized part of the debt, the tax hikes and spending cuts would be sudden, drastic, and slapdash. And economies that punish people for saving and investing tend to have trouble building up the kind of productive infrastructure that can “win the future.”
Indeed, even the belief that the government will expropriate and/or inflate away savings can be enough to stunt investment. Gross has already voted with his feet, and he expects at least a few others to follow. “Sale of Treasury bonds is the easiest way of staging a mini-revolution and saying ‘Hell no, we won’t go,’” he told me, still with an almost beatifically mild expression.
So what does Gross need to see before he’s willing to unsaddle his horse and return to the Treasury market? “Higher yields!” he said promptly—but he’s also watching the deficit. Like Reinhart, he worries that the government will try various ways to stealthily reduce the value of its debt—and the larger the deficit, the more likely, and more drastic, such actions become. “Debt-to-GDP is not egregious,” he said, “but it’s moving up the list.” And worse, “I’ve seen no willingness to tackle the difficult problem of entitlements from any political party.”
This is exactly the problem, really. Our national conversation about deficits is about politics—about ideology—not math. It’s a proxy war in our eternal battle over how much to tax and spend. Republicans care about deficits when spending is on the table, but as soon as they get a chance to pass some tax cuts, they forget they ever cared. Meanwhile, Democrats, who were outraged—outraged!—when the deficit averaged less than 3 percent of GDP under George W. Bush, are now silent about deficits that are running three times as high, and that are projected to stay above Bush’s even after Obama has left office. Very few true deficit hawks are left in America—only deficit vultures.
Unfortunately, no matter which ideological path we head down, we still must ultimately persuade people like Bill Gross to come along for the journey. I asked Gross whether it matters to him how we close the deficit. He shrugged and said that obviously we need to raise taxes on the rich by quite a bit. But he doesn’t really have any particular political prescription other than doing whatever it takes—tax hikes or spending cuts or both—to bring the budget back in line. “In the developed world,” he said, “the credit bubble is at an end, and investors are calling ‘Game over.’”
Yet he’s not bearish on America. “We own U.S. corporates, Fannie and Freddie mortgages—we haven’t left the country, we’ve just left Treasuries.” It would be one thing, he told me, if this were 1943 and we were in World War II; but we’re not, and he has a fiduciary duty to his investors that he can’t violate just because his country doesn’t want to make hard choices about taxes and spending.
And would he have bought the Victory Bonds that the government sold to fund the war effort? For the first time in the interview, Gross obviously tried to hedge. “Well, I’d like to think that the government wouldn’t have picked the pockets of its savers.”
But it did then, just like it is doing now, I pointed out; the government inflated away the value of the bonds so that they yielded negative real returns. Gross smiled.
“Maybe if they framed it as a ‘Victory in Afghanistan’ thing, I might be more favorably disposed.” So the people worried about the bond vigilantes have at least one ray of hope after all. The leader of the gang may be tough—but at heart, he’s still a bit of a patriot. That may not be enough to save us. But perhaps it will buy us some time to clean up our act.

Howard Marks’s Missives, Now for the Masses

The writings of Howard Marks, chairman of Oaktree Capital Management, have a cult following on Wall Street.
Published about six times a year, his memos to Oaktree clients have become required reading in certain investment circles. The dispatches have been praised by everyone from Warren E. Buffett to “Tyler Durden,” the anonymous blogger for Zero Hedge, the popular finance Web site. Mr. Durden recently called Mr. Marks “one of the most thoughtful observers on the markets” and described his recent memo on gold as a “must read.”
After 20 years of churning out the letters, Mr. Marks is now a published author. His book, “The Most Important Thing,” was released last week by Columbia Unversity Press. In 192-pages, he weaves excerpts from two decades’ worth of the missives into a single volume, dispensing gobs of investing insights obtained in his 42-year career.
Oaktree, based in Los Angeles, manages $82 billion for clients, mostly in fixed-income strategies. Mr. Marks and four co-founders started the firm in 1995 after spinning out from the asset manager TCW. Before TCW, Mr. Marks, a native New Yorker, spent 16 years at Citibank, where he began as a stock analyst and later managed convertible and high-yield bond portfolios.
DealBook’s Peter Lattman recently caught up with Mr. Marks, who was back at work in London after returning from his 65th birthday celebration in Spain.

Q.

When did you realize that your memos were reaching a broader audience than just your clients and colleagues?

A.

Well, I wrote the first memo in 1990, and it was two pages about what I called “The Route to Performance,” how it’s through consistency and loss avoidance rather than spectacular achievements. And I had no response. On the first day of 2000, I published one called “Bubble.com,” about how I thought that the tech stocks were a bubble. Within a few months that proved right. I then started to hear from people. So after 10 years I became an overnight success.

Q.

The book’s title comes from your first 19 chapters, each one arguing this thing or that thing is the most important thing in investing. Who came up with that device?

A.

Actually, I’ve used it before. I published a memo several years ago called “The Most Important Thing.” I wrote that I found myself sitting in a client’s office saying the most important thing is controlling risk. And then 15 minutes later I say the most important thing is buying cheap. And then 15 minutes after that, I say the most important thing is realizing that you don’t know what the future holds. So I said these are all the most important things.

Q.

The book draws heavily on newspaper articles and the writings and quotes of famous investors, even Mark Twain. I have this image of your traveling around with a pair of scissors and a burgeoning file of newspaper clippings. Tell me about your writing process.

A.

That’s just what I’ve been doing this morning. I have a clip file spread out on my desk for the next memo. It’s working title is “How Quickly They Forget,” and it’s about short memories and how that dooms people to repeating mistakes. Nobody remembers the crisis anymore.

Q.

I recall a John Kenneth Galbraith quote from your book related to that.

A.

Galbraith said: “Contributing to euphoria are two further factors little noted in our time or past times. The first is extreme brevity of a financial memory. Financial disaster is quickly forgotten. When the same or closely similar circumstances occur again, sometimes only in a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery.” What could be more true of the years leading up to the crisis?

Q.

You call Los Angeles home, but for the past half-decade you and your wife, Nancy, have spent four months a year living in London. What effect has that had on your investment outlook?

A.

I think it has given me, and hopefully the firm, a more global perspective. London is now our second largest office. The other thing is that I find it very interesting to look at the United States from the outside.
I’ll give you one brief example. Think about gold. We tend to think that what’s been happening with the price of gold is that it is now worth more dollars than it used to be. But outside the United States when you talk to people, you see people think that it’s not an increase in the price of gold in terms of dollars but a decrease in the price of dollars in terms of gold. And seeing it reflectively like that I think is very helpful.

Q.

Other than you and your Oaktree colleagues, if you had to pick one person to manage your money who would you choose and why?

A.

In the late ’60s, when I was a rookie analyst following office equipment companies, a portfolio manager asked me, “Who’s the best sell-side analyst on Xerox?” I answered, “The one who thinks most like me is so-and-so.” As far as I can tell, Seth Klarman of the Baupost Group and I think the most alike. His returns are great and his risk control is stellar.

Q.

In your book you mention Michael Milken as a major influence. His creation of the junk bond market played a key role in your career.

A.

Marshall McLuhan said “the medium is the message.” I think high-yield bonds have been the medium for a lot of my philosophy. Your philosophy comes from the events you live through. I started at Citibank in the late ’60s when the bank was what was called a Nifty Fifty investor. It bought the stocks of the best companies in America: IBM, Xerox, Merck, Coke, etc. Once analysts ascertained that the growth prospects were bright, the stocks were bought without regard to valuation and we ended up paying P.E. ratios in the 80s and 90s. A few years later you had lost 90 percent of your money.
Then I met Mike Milken in ‘78, and he said if you buy the bonds of B-rated companies and they survive, all the surprises will be on the upside, and a little light bulb went on. I realized that you could invest in the debt of the worst companies in America and make a lot of money if you were paid an appropriate risk premium. That’s really a big part of the philosophy, that quality investing is not about buying good things, it’s about buying things well. The most important thing is the relationship between price and value. If you can figure out the fair value of an asset and buy it for less, that is the best, most dependable way to invest.

Q.

You mention Milken but not me, which is frankly a bit disappointing because I once make an appearance in one of your memos, albeit anonymously.

A.

That memo was from early October 2008. We were speaking and I told you we were buying aggressively, and you said to me, “You are?!” That conversation became the basis for a memo. We decided that if we’re spending a lot of our clients’ money during what some people thought was about to be the end of the world, we should at least fill them in. So we talked about how this is the third debt crisis we’ve lived through, and to us the pattern was obvious and the wrongness of not buying was obvious. There’s a canard that people retreat behind in a crisis. They say you really shouldn’t try to catch a falling knife and they say we’re waiting for the dust to settle and the uncertainly to be resolved. Then by the time the dust settles and the uncertainty is resolved and the knife clearly stops falling, there are no more bargains.

Howard Marks and Steve Romick notes from Value Investing Congress presentations

Howard Marks (Oaktree Capital): Oaktree manages over $80 billion and we've covered Marks' insightful commentary numerous times. His presentation highlighted the "human side of investing" and the difference between theory and practice. The manager said he splits investors up into two categories: those who know and those who don't, pointing out that it's what investors *think* they know that gets them into trouble. Risk can be introduced when investors overestimate what they know about the future.

Marks says that the main difference between value and growth investors is that value investors focus on the present. He went onto say that, "(The) most important science for investors is psychology. Investors who have their psyches under control will do best." This of course beckons the age old concept of not letting your emotions get in the way of making rational decisions.

He also went on to focus on the importance and difficulty of being contrarian and that market tops typically occur during a time of rampant bullish euphoria. Marks noted that pro-cyclical behavior is a huge mistake.

Oaktree's funds currently have a lot of cash on hand as opportunities are not abundant; Oaktree seems to be doing more selling than buying these days. He also mentioned he thinks that most institutions over-diversify.

Marks said that the gist of his presentation is featured in his new book that we highlighted yesterday, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.



Steve Romick (First Pacific Advisors): Romick noted that enticing opportunities today are scarce and compared it to trying to ski in the middle of summer. The one pocket of snow he does see potential in is large cap stocks as he believes small caps are overvalued.

Romick presented CVS Caremark (CVS) as a business with good tailwinds and a store footprint that's hard to replace. He says the company is undervalued, trading at a P/E of 12.2x net of the pharmacy benefit management (PBM) hedge. He also points out that management owns a lot of stock and that private label is an opportunity for them to grow as it's only 17% of revenue right now.

Interestingly enough, CVS also seems to be under pressure to split up from its previous merger (combining drugstore chain CVS with pharmacy benefit manager Caremark). Numerous analysts and investors believe the break-up value is much higher than CVS' current share price. Rival Walgreen's (WAG) recently sold-off its PBM segment.

Lastly, Romick also gave another investment idea in Hong Kong traded Goldlion (HK 533). It is an apparel and goods manufacturer in China that caters to the mid-high end consumer, akin to Coach or Polo.

Chart(s) of the Day: Length of Recoveries, Interest Rates

Jim Stack of Investech Research ^[1] always uses these terrific, informative simple charts. They are not fancy, but they simply convey an incredible amount of information:
The two below are a month old (April 8, 2011) but still instructive:
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click for larger graphics
^[2]
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This chart tells you almost everything you need to know about the 1982-2000 bull market, the 2003-07 credit driven bear market rally, and the subsequent collapse and bounce back — as well as the demise of the Dollar.
Unbelievably informative.
^[3]

Is Managed Futures an Asset Class?

By Attain Capital

A few weeks ago we posted on Mack Frankfurter of Cervino Capital’s recent discussion of managed futures and whether or not it is an asset class. Mack argues that it is not, resting his case on the logical fallacies prevalent on the other side of the debate. When considering why managed futures were often described as an asset class, Mack’s explanation was simple: people are lazy.

Mack’s Cervino Capital is one of the CTAs we track, and we have a lot of respect for him and his program, so his comments gave us pause. Mack is not alone in this assessment. As Mark Kritzman of Windham Capital Management speculated in 1999,

…some investments take on the status of an asset class simply because the managers of these assets promote them as an asset class. They believe their investors will be more inclined to allocate funds to their products if they are viewed as an asset class rather than merely as an investment strategy.

We frequently refer to managed futures as an asset class on our blog and in our newsletters, so we had to wonder… were we just being lazy? Is “asset class” the wrong descriptor for managed futures?

We decided to research the idea to make our own, informed determination on the subject, but realized as we began our quest that a key ingredient was missing from the equation. It was absent from almost every piece we found, including Mack’s.

We were missing a good definition of an asset class.

Defining an Asset Class

There are a couple of problems with pervasive definitions of asset classes. For one, half of them define asset classes while using the word “asset,” and any good debater will tell you that this practice leads to confusing and vague explanations. The other half of available definitions seem to parametricize asset classes to stocks, bonds and cash, and while most figures in the financial industry will identify these common investments as asset classes in their own right, examples do not a definition make.

If you search beyond the surface definitions, you will find more nuanced and complicated explanations. Even here, finding a warranted explanation was difficult. Many authors simply asserted qualifications for asset class consideration without providing any kind of logic as to why those qualifications were pertinent to the discussion.

To save you from a 200 page literature review, we’ll generally define an asset class as: A grouping of investment opportunities that behave and are treated in a similar manner.

The explanations for this definition presented by Anson, Fabozzi, and Jones (2010), Focardi and Fabozzi (2004), Gibson (2008), Winograd (2004), Hall (2004), Considine  (2004), and Swensen (2005) give versions of the following specific qualifications of an asset class:

1. The asset class should be subject to similar regulatory guidelines.

2. The asset class should have a significant amount of capital allocated to it.

3. The performance of the asset class should not be able to be replicated by other established asset classes.

4. Risk and return characteristics of all portions of the asset class should be similar.

Why these qualifiers? We selected these 4 test points for three reasons. First, traditional asset classes were able to pass all four tests. Second, a plurality of authors described each of these points or a variation therein as a defining factor of an asset class, providing a comfortable consensus for each point. Third, each of these four points, unlike many others proposed in the literature base, had multiple explanations attesting to their significance as a test of value, which gave them more merit than the qualifiers that were merely asserted.

In order to determine whether or not managed futures was an asset class, we evaluated whether or not it met each of these four standards

Testing the Definition

1. Are all portions of ‘Managed Futures’ subject to similar regulatory guidelines?

Managed futures has this one locked up pretty good, with managed futures comprised of those programs managed by professional money managers who are registered as Commodity Trading Advisors (CTAs) with the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA). This registration mandates strict levels of disclosure and reporting, and is applied to nearly all forms of managed futures programs, no matter what strategy they may implement(some very large programs and foreign programs may not register).

But despite some exceptions, no matter if a manager is trading stock index options or Corn spreads, they are subject to the same regulations.

Does managed futures pass this definition of an Asset Class? YES

2. Does ‘Managed Futures’ have a significant amount of capital allocated to it?

BarclayHedge puts assets under management (AUM) at the end of 2010 for Managed Futures at $267.6 Billion. This is after an explosion in managed futures investing following the 2008 financial crisis, and leaves managed futures as the single largest investment strategy amongst hedge fund strategy types (merger arbitrage, global macro, private equity, etc)according to the BarclayHedge data (although some larger funds labeled as managed futures programs in the BarclayHedge database are not solely dedicated to the space)

[The data here is, in part, from new investment, and, in part, from investment gains]

Since 1980, AUM for managed futures has increased over 863%, with an average increase of 27.7% per year. Some managed futures commentators are even predicting that AUM for CTAs will pass $3 trillion by 2021. Whether that happens or not, the data shows that Managed Futures have this requirement easily covered.

Does managed futures pass this definition of an Asset Class? YES

3. Can the performance of ‘Managed Futures’ be replicated by other established asset classes?

Managed Futures are a bit of a slam dunk on this front as well, with their whole purpose in life (seemingly) to perform when other asset classes are not. If they don’t follow what other established asset classes do, they can’t be replicated by those asset classes. For proof of this, one need only look to 2008, when managed futures were up 18.33%, compared to bond returns of 10.77%, and stock market losses of 38.49% [past performance is not necessarily indicative of future results].

For the more statistically inclined, performance replication, in this instance, is best measured in terms of correlation. As a refresher, correlation is a statistical figure with values which range between -1.00 and +1.00, meant to show how inter-related two sets of data (in this case monthly % returns) are. If they have a correlation of 1.00, they are perfectly correlated, meaning when one market rises 1%, the other will do the exact same, and when one loses -1%, so will the other. If they are at -1.00, they are exactly opposite; with one making the exact opposite amount the other loses each day, and vice versa.

Given that the only three asset classes that everyone seems to be able to agree on are stocks, bonds and cash, we calculated the rolling correlation coefficient of managed futures against the monthly performance of each of these classes over the last 15 years to see how managed futures stack up for this definition of an asset class.

[Past performance is not necessarily indicative of future results; Data Source: Stocks = S&P 500; Bonds = Citiworld Bond Index; Managed Futures =BarclayHedge Managed Futures Index]

As we expected, the calculation of 12 month rolling correlations going back over the past 15 years showed the wildly oscillating lines typical of non-correlation. In fact, over the 15 year period, we found managed futures had a correlation of -0.078 to Stocks, -0.140 to Cash and 0.296 to bonds. Statistically speaking, this tells us that the performance of managed futures cannot be explained by the performance of traditionally accepted asset classes. In other words, you cannot replicate managed futures performance with these other asset classes.

Does managed futures pass this definition of an Asset Class? YES

4. Are the risk and return characteristics of all portions of ‘Managed Futures’ similar?

This is the hardest definition for managed futures to meet, as managed futures spans investment strategies as diverse as long term trend following of bond and currency futures, to naked selling of stock index options, to spread trading of grain and energy markets.

Statistically speaking, many of those different types of managed futures investments ARE NOT similar. In fact, many pride themselves on their non-correlation with the main managed futures indices, and market that fact.

At the same time, many of these programs are also not correlated with other asset classes, especially during stress periods for the traditional asset classes. This is because, despite their non-correlation with each other, they generally still share the most common denominator in terms of risk and reward characteristics for managed futures programs - their long volatility profile.

This long volatility profile is what allowed the majority of managed futures programs we track at Attain to post profits in the incredibly volatile markets of 2007 and 2008. One strategy type which does not share this long volatility profile (by design), is option trading. But does one outlier on one of four definitions of an asset class nullify all of managed futures as an asset class? We say no, others may say yes… But consider that not all stocks perform similar, either; nor all bonds (just look at Portugese debt versus US debt right now). If we could kick just kick option sellers out of the managed futures space, and give them their own registration category and regulatory body – we would solve a lot of the issues in meeting this definition.

For more of an outside the box look at managed futures having the same risk and reward characteristics – we can look at the liquidity and transparency of managed futures program (no matter what type of strategy they employ) as key component which links them as an asset class. The ability to see position level detail, to have individually managed accounts, and liquidate an account in hours to days are common themes amongst all managed futures programs (and indeed several of those characteristics are the result of the programs being under the same regulations and rules of conduct).

Does managed futures pass this definition of an Asset Class?  MAYBE

Addressing Objections

At this point, we are ready to confirm managed futures is an asset class, meeting three of the four criteria handily, and suffering only a single outlier on the fourth definition. But we were of the opinion it was an asset class before writing this, and this is a hotly debated topic, so we don’t mind addressing some possible arguments we’ve seen out there against them being an asset class.

Objection 1: Not all managed futures programs react the same way to market events.

This is the ringer for the non-asset class camp, as we discussed above, as, at the base level, there is no way to defend it. Stock index selling managed futures programs, for example, don’t react the same to market crisis periods as traditional managed futures programs, and are more highly correlated with stock market performance than that of the managed futures indices.

Our best rebuttal is that not all stocks and bonds (asset classes by nearly all accounts) react the same to market events, either. For example, airline stocks may fall after a spike in Oil while oil companies stocks rally on higher revenue projections. In bonds, you can easily imagine a bond backed by the revenues of a toll bridge, versus a bond backed by the profits of a shipping company – reacting very differently to market events, and indeed, being not very correlated with one another. How correlated have Greek government bonds and US government bonds been over the past two years, for that matter? We would assume the correlation is at about -0.98 (out of a maximum of -1.00).

Yet despite obvious examples of outliers in the stock and bond asset classes, nobody questions whether they are an asset class.

Objection 2: Managed futures trade stock indices, bonds, and currencies – not just commodities; meaning they are more a part of the hedge fund asset class (essentially global macro funds) than their own.

This is a hasty generalization, in our opinion, that rests upon assumptions about hedge funds even being an asset class. There are two responses here. First, the performance of hedge funds and whether or not they are an asset class has nothing to do with whether or not managed futures are an asset class. Given the fact that managed futures meets the tenets outlined in our definition, our conclusion, we feel, is well-warranted. Second, if you look at hedge funds, one particular tenet of our analysis indicates why they are not included in the asset class, technically.

Hedge funds have been difficult to peg. They operate in a realm where disclosure is often optional, and as such, sufficient data from which to draw conclusions is difficult to find. That being said, Professor Harry Kat of the Cass Business School at City University, London, published a paper in 2007 that collected every shred of data available, and he concluded that hedge funds, more often than not, “have a very high correlation with the stock market and therefore make lousy diversifiers.”

We recently reposted commentary from Welton Investment Corporation in this space as well, which did an excellent job of explaining this diversification problem, showing that most hedge fund strategy types correlate more closely with equities (the stock asset class), that any other asset class. Interestingly, they found that the Global Macro hedge fund strategy type, which those who object to managed futures as an asset class argue should be the category managed futures is assigned to (instead of their own asset class), is more closely linked to managed futures than other hedge fund types.

It’s as if managed futures and hedge funds should do a trade, Global Macro for Option Sellers, putting both of those investment types into asset classes which more closely mirror their risk and return profile.

We can hear the objections now. “You’re saying hedge funds can’t be considered asset classes because they invest in a traditional asset class and, as such, have a high correlation. Couldn’t that be said of commodities and managed futures?”

Objection 2a: Managed Futures invests in commodities and as such is highly correlated (i.e not different) than the commodity asset class.

If you look at commodity performance, the only objective way to do so is to look at it from a long-only perspective as well. This is another way in which managed futures separates itself from the pack, because they can go long and short, making correlation between managed futures and commodities next to impossible. At times managed futures will be correlated with commodities (when they are long commodities), but at times they will be nearly perfectly negatively correlated (when they are short).

Just take correlation between managed futures and the S&P GSCI- which measures returns across commodity sectors from a long only perspective- over the past 15 years. The average correlation we found was only 0.228.

[Past performance is not necessarily indicative of future results]

Objection 3: Managed Futures performance is not easily replicated within the managed futures space.

While replication of the asset class within the asset class was not a definition we happened upon, it is an objection we come across from time to time. And it makes sense. After all, we can pretty easily buy S&P 500 futures, a total stock market mutual fund, or a sector ETF to replicate the stock asset class, and bond futures, funds, or ETFs to replicate the fixed income asset class.

But there aren’t managed futures futures (for those reading at the CME – Attain gets the royalty if you come out with this), and despite the attempts by an increasing number of firms, there haven’t been mutual funds or ETFs which have had success matching the performance of the managed futures indices.

From an individual investor standpoint, this takes on more meaning, as they may be invested in a $50,000 program such asClarke Global Basic- which is down for the year- while managed futures as an asset class is up. Or they may have invested in managed futures in 2008 via an option selling program, only to find steep losses at the end of the year while managed futures as an asset class were up.

This frustration is real, and this objection to managed futures as an asset class is the most damning, in our opinion, as we know how hard it can be for a single investor without a lot of capital to replicate the performance of the managed futures indices in any one month, quarter, or year. The less capital an investor has, the harder it usually is for them to replicate managed futures performance as a whole – because they are forced to rely on a single strategy type. The odds of any one strategy type varying from managed futures as a whole are pretty large.

Our rebuttal to this would be that the same thing can happen in all asset classes, where the performance of a single stock may greatly lag the general market, or a single bond sees its value go to zero on a corporate default while bonds in general post decent returns. The one point we don’t have a rebuttal to is the easy access to the whole asset class via an affordable ETF or mutual fund, like you can get with the SPDR.

Conclusion

The status of managed futures as an asset class has long been in debate, and it is unlikely that this publication, or any other, will put the issue to rest anytime soon. However, based on the literature we’ve reviewed, the data we’ve compiled, and the analysis we’ve conducted, we feel confident in our assessment of managed futures as a distinct asset class.

And despite our point by point methodology outlined above, the best argument for it being an asset class is usually the rather simplistic statement – if it isn’t an asset class, then what is it? We have yet to hear a good response to that question.

Does the conclusion fly in the face of what people understand to be true, intuitively, about asset classes?  Did we skip some points and objections such as benchmark analysis? Sure, but until academia comes up with a better definition for what an asset class is, managed futures, as we understand it, is an asset class.

The real question here is what that conclusion means for potential investors. If managed futures are indeed an asset class, then they should not just be the realm of sophisticated investors and those with risk capital. They should be right up there with the seemingly carved in stone 60/40 stock and bond split that so many of us have been taught and told time and again as the optimal asset allocation mix.

The implication of managed futures being an asset class is that we need to get out the stone grinder and change that stodgy old 60/40 into a more reasonable 33/33/33. We aren’t the only ones who feel this way. In fact, Opalesque recenty published an article that argues that managed futures could actually replace bonds in the traditional portfolio.

When it is all said and done, the whole point of the debate is to decide whether managed futures actually add anything to a portfolio, or whether they are just another way to get the risk and reward profile you get with the traditional asset classes. We’re here to say with confidence that they do a lot more than the traditional asset classes. They will have losing periods, they will run in tandem with the other asset classes at times, but they do meet the definitions of a separate asset class, in our opinion, and, as such, demand consideration as part of a diversified portfolio.

While your stock broker and investment advisor will likely go on and on about the risks involved in futures (and there are substantial risks), we will say that the bigger risk lies in ignoring managed futures as an asset class.

To read more Managed Futures research pieces, visit Attain’s Managed Futures Newsletter archive.  Click Here.