Beware of Sideways Markets - Vitaly Kastenelson blog link

http://www.institutionalinvestor.com/blogarticle/3211140/Blog/Beware-of-Sideways-Markets.html

Blackstone courts bold trades for new fund

Blackstone is preparing to launch a “super” hedge fund to cherry-pick the best trades from the hundreds of third-party hedge funds it invests with in return for paying them a commission.

The new vehicle will invite managers with whom Blackstone already invests via its $48bn fund of funds platform to submit their boldest and most interesting trading ideas in return for a fee. It will be run by former Duquesne Capital partner, Greg Geiling.

Blackstone declined to comment.The fund will raise eyebrows in an industry known for its secrecy. Managers’ reluctance to disclose details of their trades or portfolios has often been stretched to the point of nervous paranoia: even big investors can be left unaware of what a manager is doing with their money.

“It’s a sort of Harlem Globetrotters’ fund of the best ideas from across the spectrum,” said one person familiar with the plans – comparing the project to the famous US exhibition basketball team.

Third-party fund managers are incentivised to hand over their ideas because risk constraints within their own groups often mean they can rarely gamble as much as they would like to on their best trades.

With investment yields at lows worldwide, Blackstone believes that the appetite for risk and big returns from hedge funds is growing. It has already quietly been running the new fund as a prototype open to investments from its biggest institutional clients for several months, during which it has outperformed the average hedge fund.

Pressured by volatile markets, sweeping new regulations and a more conservative, institutional investor base many hedge funds have struggled in recent years to pull off big returns.

According to Hedge Fund Research, the average hedge fund manager has made only 11 per cent over the course of the past three years combined.

Blue blood hedge fund billionaires such as George Soros and Louis Bacon havereturned clients’ capital, while others have quietly hunkered down and now eschew the kind of venturesome bets that formerly earned the industry its reputation for pluck and rapacity.

Recent bets that the fund has taken include trades to help reduce banks’ capital ratios, short positions against the yen, activist corporate positions and holdings of US mortgage bonds.

An R-Squared Chart Taxonomy: Seeing is Not Believing

Often financial analysts are presented with statistical charts that purport to demonstrate an important — and, of course, investable — relationship between data points. These charts are supposed to be worth a thousand words and thousands of shares traded. But invariably these charts do not have an r-squared for the data displayed, or any other descriptive statistical data; just the seductive image. What is needed to help the (often) beleaguered analyst is an r-squared taxonomy, or catalog.

Take-aways:

• A better sense of what different r-squareds actually look like.
• How radically different looking charts generate similar r-squareds.
• Why it is crucial to use multiple tools, including charts, when analyzing data.

A Better Sense of What Different R-Squareds Actually Look Like

As an introduction take a look at the following chart:

While the graph shows a hypothetical performance for a hypothetical stock index and for a hypothetical sovereign 10-year Treasury note, I think you will agree with me that it is typical of a finance industry chart.

Take a look at how the data are only roughly related to one another between January 2008 to April 2010, and then they appear to track each other very closely. I could continue using flowery language and a successful analyst pedigree to try and convince you to trade with my firm. Sound familiar?

Would it surprise you to learn that the r-squared for the above chart is a lowly 2.18%?! To better educate you as to what different r-squareds look like here is an r-squared taxonomy compiled using a random chart generator, based in real-world data, and after thousands of trials. [Keep at it, too, there is more analysis at the bottom of the post.]

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R-Squared = 0.00%

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How can it be that this chart has an r-squared of 0.00% when between July 2009 and January 2011 it looks as if there is so much similarity? Remember that r-squared is a summary measure and that it is calculated as 1 − (sum of squared errors ÷ sum of squares total). Consequently, data can cancel one another out and affect the calculation positively or negatively.

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R-Squared = 10.00%

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R-Squared = 20.01%

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R-Squared = 29.97%

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R-Squared = 40.01%

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R-Squared = 49.99%

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R-Squared = 60.00%

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R-Squared = 70.04%

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R-Squared = 80.03%

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R-Squared = 90.00%

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How Radically Different Looking Charts Generate Similar R-Squareds

Most of the time when financial analysts think of r-squared they think of similarity, rather than relatedness or causality. The preceding charts show that the higher the r-squared the more closely the lines tend to track one another. But this is very dangerous thinking! In the thousands of trials done in order to create this post the highest r-squared chart randomly generated was a whopping 93.37%. But take a look at its chart below.

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R-Squared = 93.37%

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I bet you are surprised by the above result because, as I said, analysts tend to think of r-squared as similarity. However, the above chart demonstrates very high negative correlation of −95.29%. If you look at the chart above you will see a vintage of chart that recurred throughout the r-squared random trials: a scissors pattern. Count me among the educated by this experiment as I have never looked for scissors patterns when sifting through charts for causal relationships.

Take a look at various manifestations of scissors brethren.

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R-Squared = 50.07%

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Interestingly, look at the difference between the 50.07% and the 49.99% chart from before. While separated by only 0.08%, the two charts could hardly look more different.

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R-Squared = 69.99%

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Again, compare the 69.99% and the 70.04% r-squared charts, separated by just 0.05%. Last, compare the 90.81% r-squared graph below with the 90.00% chart above. What a dramatic difference.

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R-Squared = 90.81%

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Like everything in finance, reading charts is more complicated than just memorizing several heuristics, like “be on the look out for the scissors pattern.” For example, look at these very different looking, but similar r-squareds that do not adhere to the scissors pattern.

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R-Squared = 50.30%

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To me, the above chart “looks like” it would have a lower r-squared than the preceding 49.99% r-squared chart; yet, it is higher! Or what about the 92.31% r-squared below which looks to have a lower r-squared than the 90.0% chart:

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R-Squared = 92.31%

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For another interesting comparison look at the original 2.18% chart and compare it to the 10.0% r-squared chart. To further demonstrate how exactly the same r-squareds can look radically different compare these three very different ways of generating a theoretical 100.00% r-squared.

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R-Squared = 100.00%, Identically Similar Movement

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Here both data series move identically with one another; so much so, in fact, that you cannot distinguish the movement of the hypothetical stock market from the movement of the 10-Year Treasury Note Yield. [Note: For the skeptics, the presence of the left-hand scale indicates that the stock market close time series is present, just “underneath” the 10-year Treasury Note Yield series]

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R-Squared = 100.00%, Scissors Movement (i.e., Negative Correlation)

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R-Squared = 100.00%, Negative Correlation

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Why It Is Crucial to Use Multiple Tools, Including Charts, When Analyzing Data

Hopefully I have demonstrated to you the futility of trusting your eyes when looking at chart data — seeing is not believing! It behooves analysts to study the r-squared taxonomy to ensure developing a feeling for what actual relationships of particular degrees look like. Chartists should broaden their scope to include data that demonstrate a scissors pattern/negative correlation and not just charts that track one another like dancers on a dance floor. Going forward it is obvious that understanding data well requires a combination of visuals and statistical measures.

Is Tax Loss Harvesting Overvalued?

Capital loss harvesting has long been a staple of investment tax strategy - so much that the Internal Revenue Code has special "wash sale" rules to ensure that the technique is not overly abused. Fortunately, though, the wash sale rules can be navigated effectively, allowing taxpayers some means to take advantage of available tax losses.

However, while tax loss harvesting remains a viable strategy, it is often greatly overvalued, as the true benefit is not the tax savings from harvesting a loss but merely the benefit of deferring those gains. In the meantime, the strategy has a non-trivial exposure to several risks, including the potential for the alternative investment held during the 30-day wash rule period underperforming the original investment, the possibility of negative tax arbitrage if the investment rebounds in the near term, and the danger that harvesting losses too effectively over time will drive the client's future capital gains into a higher tax bracket! In addition, the fact remains that capital loss harvesting produces no benefits for clients who are eligible for 0% capital gains tax rates, and in fact potentially harms them; in such scenarios, clients should actually be harvesting gains, not losses!
Ultimately, this doesn't mean that harvesting capital losses is a bad strategy, but it is a strategy where the risks must be carefully considered, as they can easily outweigh the relatively modest benefits!

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Tax Deferral, Not Tax Savings

One of the fundamental points of confusion about capital loss harvesting is that it doesn't permanently save taxes, it merely saves them temporarily - in essence, it just defers them. The reason is that when capital losses are harvested, the new investment position after loss harvesting has a new,lower cost basis - which means if the investment is ever intended to be sold or consumed during life, someday the taxes will still be due.
For example, assume an investment was purchased for $100,000, but is now worth only $90,000 due to a significant market decline. The investor harvests the $10,000 capital loss, which generates a $10,000 loss deduction resulting in $1,500 of current tax savings at a 15% tax rate. However, after harvesting the loss, the investment only has a cost basis of $90,000, which means if the investment ever recovers to $100,000 again, there will be a $10,000 gain, resulting in a $1,500 tax liability at the same 15% tax rate. Thus, in the end the $1,500 tax savings now is offset by a $1,500 tax increase in the future, and the net result is $0 of tax savings (which makes sense, since the investment started at $100,000 and ended at $100,000)!
Of course, the caveat is that the tax deduction occurs now, and the tax liability for the recovery occurs in the future. Thus, the true value of harvesting the capital loss is the opportunity to invest the near-term tax savings for growth. For instance, if the $1,500 tax savings (which was 1.67% of the original investment, or $1,500 / $90,000) can be invested at an 8% growth rate, then the investor can earn a $120/year of economic value. However, relative to an investment that was worth $90,000, this true economic value of loss harvesting is a remarkably small benefit of only about 13 basis points (0.13%) per year! And of course, the benefits must be weighed against the potential costs to complete the transaction; with a $90,000 investment it might be appealing, but with a smaller investment position like one worth only $9,000 (and therefore an economic value of only $12/year of tax dollar) the raw trading cost to execute the sales and (re-)purchases may exceed the entire benefit!
In addition, there are also important indirect costs and risks to consider...

Tracking Error Risk During Wash Sale Period

One challenge to harvesting losses is that under the "wash sale" rules, the client who sells an investment for a loss must allocate the money elsewhere for 30 days to avoid having the loss disallowed. If a "substantially similar" investment under IRC Section 1091(a) is purchased during the interim time period, the loss cannot be claimed, and instead is added to the cost basis of the replacement investment (which means the loss is ultimately deferred to the future). The wash sale rules can be avoided by investing in something else that is similar - but not "substantially" similar - or by simply keeping the money in cash or something else completely different.
Of course, if the goal is to remain invested, taking the money out of the market and into cash or a completely different investment is unappealing. In fact, owning anything that is materially different than the original investment may be unappealing - after all, if the investor wanted to actually own something different, the investment could have just been sold outright in the first place. The whole point of "loss harvesting" is to capture the loss without materially changing the investment!
As a result, investors try to buy something that is as similar as possible to the original investment, without running afoul of the rules. Historically, this was done by buying another stock in a similar industry - for instance, harvesting a loss in Ford and buying GM during the intervening time period, or harvesting a Merck loss and buying Pfizer instead. In today's world of pooled investment vehicles, the lines have blurred a bit, and it's less clear about what exactly constitutes an investment that is not"substantially similar" - selling a large-cap index and buying a small-cap index would almost certainly be fine, but it's less clear in the case of selling a large-cap index like the S&P 500 and buying a total market index instead, given that the returns of both will be dominated by the same set of (cap-weighted) stocks.
The reason why this matters is that if the investment results are too different - even just for a period of 30 days - there's a risk that the entire 13 basis points of economic value for harvesting the loss will be potentially lost by return differences as the temporary new investment fails to track the original investment effectively (not to mention merely any potential drag due to possible differences in expense ratio). Of course, the goal of many loss harvesting investors is to purchase an investment similar enough to reduce any exposure to significant tracking error. Yet the reality is that if the investments track tooperfectly, it runs afoul of the wash sale rules!
In other words, avoiding the "substantially similar" wash sale rules essentially requires the investor to be exposed to a material amount of tracking error! Of course, there's also a possibility that the replacement investment could outperform rather than underperform - not all "tracking error" is bad! - yet nonetheless the reality is that almost by definition, the investor can only harvest a loss if the replacement investment places the entire value of loss harvesting at risk to a comparable or greater amount of tracking error!

The Risk Of Negative Tax Arbitrage

In addition to the risk of tracking error overwhelming the economic value of harvesting a loss, a secondary challenge is the risk that the investment rises in value during the 30-day period, effectively converting a long-term capital loss into a short-term capital gain.
For instance, if an investment purchased 2 years ago for $100,000 has fallen to $90,000, and the $10,000 long-term capital loss is harvested, but during the interim period the investment rebounds to $98,000 and the client wants to switch back to the original investment, the rebound will trigger an $8,000 short-term capital gain. Fortunately, the loss can offset the gain if they fall in the same tax year, but notably the capital gain/loss ordering rules require long-term losses to offset long-term gains first. As a result, if the client already had $10,000 of other long-term capital gains, the loss harvesting transaction effectively converts a $10,000 long-term capital gain into an $8,000 short-term capital gain. If the client is subject to a 25% ordinary income tax rate (along with a 15% long-term capital gains tax rate), the client actually turned a $1,500 tax liability (15% of $10,000 long-term gain) into a $2,000 tax liability (25% on $8,000 of short-term gain)! This is essentially a form of negative tax arbitrage - the investments don't materially change, but the tax rate moves in the wrong direction! Of course, as with the tracking error scenario, it's possible that the investment won't change in value, or that it will go down even further and that there will be an additional short-term loss to harvest. Nonetheless, the scenario represents another form of risk to the loss harvesting transaction - and with volatile investments, a potentially material risk given how small the benefits of loss harvesting are in the first place! In addition, there's always the risk that within a year after the wash sale is completed, the investment will be sold after rising in value, triggering a(nother) short-term gain on the original investment that would have been long-term if the loss was never harvested in the first place!
An even greater form of negative tax arbitrage emerges from the fact that in today's tax environment,there are effectively four long-term capital gains tax brackets. As a result, if an investor systematically harvests $10,000 of losses from a portfolio every year - reducing cost basis by $10,000/year in the process - after a decade of the strategy a subsequent liquidation could trigger a whopping $100,000 capital gain in a single year (or much more when accounting for not just recovery back to the original purchase price, but real growth on top of that). If the loss harvesting occurs enough times over enough years, it creates the potential of such large capital gains in the future that the client ends out in a higher capital gains tax bracket down the road! Thus, if the capital losses are harvested at a 15% tax rate, but they create so much more gain in the future that eventually the recovery is taxed at 18.8% (with the new 3.8% Medicare surtax) or even at 23.8%, the client could destroy far more value by boosting the tax rate than was ever gained in benefit from the loss harvesting strategy itself! And the negative tax arbitrage is even worse if the losses are accidentally harvested for clients in the bottom two tax brackets - who are actually eligible for 0% long-term capital gains rates, and should actually be harvesting gains instead!
Of course, if investments are ultimately held until death, they receive a step-up in basis, which is a form of positive tax arbitrage (as the gains are effectively at 0% but the losses were harvested at some more favorable rate). Nonetheless, if the client ever intends to sell the investment to spend during life - and/or ever anticipates making an investment change - then the reality is that a step-up in basis is not really an option, but the risk of negative tax arbitrage remains a danger.
Ultimately, none of this means that capital loss harvesting doesn't have any value - there is still some benefit, and the larger the loss (or the higher the tax rate) the greater the value (although the recent proposal to require average cost accounting for all investments would partially limit the ability to harvest losses strategically). But the reality is that unless the tax rate is very high or the loss is very large, the benefit is actually quite limited, as it is based not on the amount of tax savings, but only on the economic value of deferring those taxes to the future! And in the meantime, the risks remain; in fact, some risks like exposure to tracking error are essentially a requirement to avoid the wash sale rule in the first place, and while larger losses create a greater harvesting benefit they also create a greater exposure to negative tax arbitrage and higher rates in the future! And that's before accounting for the raw transaction costs of loss harvesting in the first place, which may be fairly low in today's low-cost trading environment, but still represents an important threshold when considering how small of a loss is worth harvesting at all. In the end, all of this doesn't take loss harvesting off the table altogether... but it does mean the (limited) benefits must be weighed carefully against the costs and risks inherent in the strategy.

GMO Now 50% in Cash

James Montier said that GMO’s 7 year asset allocation model for US stocks is now predicting  negative returns. GMO are now 50% in cash.  While they've been known to hold higher levels of cash than most investors, this seems to be taking things a step further.  They still hold some investments in Japan but he  indicated that they are likely to be selling over the next couple of months.

He said that a year ago the model was indicating good returns in Europe but now it only suggests  2.5% real return per annum. He said that they are a bit frightened to follow the model in Europe  because of the leverage at the company level, particularly in the financial sector.

Their model suggests that the best value is in emerging markets where 6% real is forecast. However,  he mentioned that the research by his colleague, Edward Chancellor, which has identified an asset  bubble in Chinese real estate, has made GMO cautious and led them to allocate less to EM than the  model would suggest.

It is clear that at certain times GMO are prepared to overrule their  quantitative asset allocation models when other evidence suggests caution.

Stanley Druckenmiller's Sohn Conference Presentation: Commodities Conundrum, Short Australian Dollar

US Market & Quantitative Easing

Druckenmiller noted everyone is saying, "love the market long term, looking for a correction." He believes the opposite, loves market short-term, but hates it long term. Strongly disagrees with quantitative easing by Bernanke now. Only agreed with the first QE.

"His bond buying is controlling the most important price in the US economy." Says it will end badly, despite money-printing being beneficial to financial assets currently. When Fed slightly tightens, that will hurt things he says. Bernanke completely ignored strong economic data in January and February, but with slightly soft data later, he printed even more money. Expects a "melt-up" in the short-term, due to Fed's current policy.


On Japan

He feels this could be the beginning of a secular bull market in Japan.  Kuroda in Japan is doing QE x3 of the US relative to equity market capitalization. He actually thinks the Japanese QE makes sense, because they've been in deflation, particularly their currency strengthening against everyone else in the world.

He believes when the US economy improves and the Fed tightens, it will overwhelm the growth and cause the market to crash. He does not expect that in Japan, because it has been in a long-term deflation. Expects an 18-month run in Japanese stocks. Could be beginning of a new secular bull market for Japan.


Commodities Conundrum 

Why have commodity prices gone down, with this explosion in monetary base around the world? He believes it is due to changes in China, slowing economic growth, and mix shift to economic activity away from commodity consumption. Huge surge of supply going forward.

He is betting that this is the end of the "supercycle" for commodities. China has huge credit growth, "shadow banking" growth, just like the US had right before the 2008 crash. Timing is uncertain, but China is possibly going to have a financial crisis.

"Commodities tend to go down while stocks go up” they hug the cost curve, which goes down over time. This was interrupted by a once in a lifetime burst of growth in China. Chinese consumption has exploded, and as they built their infrastructure, they were literally 50% of all commodity demand. They also used a huge stimulus in 2008, which crowded out productive investments, but most important mining companies ramped up production as if this growth rate would continue forever.

No matter how much Central Banks prints money over the next few years, it won't overwhelm the huge supply gains.


Druckenmiller's Picks

- Own companies that benefit from lower commodity prices, short the opposite.

- Growth over value.

- Avoid Brazil, Canada currencies.

- Short the Australian dollar. There is massive foreign ownership of Australian bonds.

- Long Japan; real estate, banks.

- Long: Google (GOOG), one of his biggest positions. In best 2 areas: search/data, and mobility. "Unlike other massive tech stocks engaged in financial engineering  prodded by hedge fund managers." Obviously, a dig at AAPL. "By the way, Google doesn't have any exposure to China." (Technically they do, via Android).

On the dangers of micromanging your asset allocation

Why do investors in balanced funds, i.e. those that hold a number of asset classes, hold their funds longer than those investors in more narrowly based funds? The answer is mental accounting. The investors in balanced funds with their lower volatility have fewer periods of negative performance therefore buttressing their ability to hold their funds over the long run.
However the challenge for investors is when they take a deeper peek into their portfolio components. Frequent looks at the portfolio will show some assets going up and some going down. In so doing the temptation, as always, is to dump those assets that are underperforming. Within an overall asset allocation strategy this is counterproductive.
The whole premise of asset allocation is to hold a mix of assets that over an economy cycle provide the highest risk-adjusted returns. By definition this will mean that some assets do better than others. The rise in popularity of the permanent portfolio or the all-weather portfolio since the end of the financial crisis show a desire on the part of investors to have in place an asset allocation strategy for the long run.
James Picerno at the Capital Spectator shows how challenging it is for investors to let their asset allocation strategy run through its paces. He notes the importance of investors to take a ‘holistic approach’ to their portfolios and focus on the bottom line results as opposed to the machinations of the components. Picerno writes:

Many investors aren’t focusing on these issues, in part because they’re too often focused on the pieces at the expense of the whole. But it’s the overall portfolio that defines success or failure, and so to minimize the holistic review is akin to driving with one eye closed. You may be ok, but you’re still courting disaster, and needlessly so.

The whole point of asset allocation is to own assets that perform differently under different scenarios. It might be better to think of this as ‘differsication’ as opposed to diversification. Jason Zweig at Total Return notes that finding true differsication is more difficult that commonly thought. He notes one of the biggest challenges if finding assets that will do well in light of higher inflation.

In an earlier post I wrote skeptically about the idea of all-weather portfolios. In part because at the time I thought they were being oversold as a solution to investor fears. In my book I write that there is no perfect asset class. Nor is there any perfect asset allocation. What I wrotes in an earlier post still holds:

The first is to accept the limitations of asset allocation.  Develop a low cost, well-diversified portfolio of assets with the intent of re-balancing the asset allocation over time.  Provided that this approach includes some risk-free assets, it has the ability of tempering the losses in bear market.  However one need accept that no asset allocation plan can prevent losses in each and every time frame.

It is at times like these when a market, today US equities, is making a huge run when investors most want to flee their previously drawn up plans to dive head long into what is hot. We are admittedly living in unusual financial times, but investors need to recognize that they put their portfolio strategy in place for a reason. Tossing out underperforming assets in this light is usually a mistake and is tantamount to market timing. Investors should try their best to look holistically at their portfolios over time and let their portfolio components do what were enlisted to do in the first place.

Items mentioned above:
Permanent portfolio derivation and historical performance.  (CSS Analytics)
The ‘all weather’ portfolio derivation.  (CSS Analytics)
The whole and the parts.  (Capital Spectator)
‘Differsication’: the sequal.  (Total Return)
The myth of the all-weather portfolio.  (Abnormal Returns)

Graham & Doddsville Newsletter: Interview With Li Lu (Columbia Business School)

YOU CAN DOWNLOAD A COPY HERE

Columbia Business School is out with its Graham & Doddsville investment newsletter for Spring 2013.  It features an interview with Li Lu of Himalaya Capital, a man who was dubbed one of Charlie Munger's favorite investment managers.

This interview is really fantastic as he touches on investment process a lot so we'd recommend reading the whole thing below.  But for those pressed for time, here are the takeaways:


Highlights From Li Lu's Interview

On value investing: "There are few people that switch in between or get it gradually.  They either get it right away or they don't get it at all.  I never really tried anything else.  The first time I heard it, it just made sense; and I heard it from the best."

On defining yourself as an investor:  Lu also touched on how you still have to find your own style of investing that matches your personality.  He says, "The game of investing is a process of discovering: who you are, what you're interested in, what you're good at, what you love to do, then magnifying that until you gain a sizable edge over all the other people."  He also added that, "The only way to gain an edge is through long and hard work."

On why he doesn't short anymore:  He listed 3 reasons:  "Three things about shorting make it a miserable business. On the long side, you have 100% downside but unlimited upside. On the short side, you have 100% upside and unlimited down-side. I do not like that math. Second, the best short has some element of fraud. However, a fraud can be perpetrated for a longtime. Of course you borrow to short, so they could really just wear you down. That’s why I could be 100% right and bankrupt at the same time. But, you know what, you go bankrupt first! Lastly, it screws up your mind. Shorts just grab your mind and take away from the concentrated effort that is required to do proper long investing."

On how he finds ideas: "Ideas come to me from all sources, principally from reading and talking."  What's interesting is he doesn't really talk to other investors that much.  He's more keen on chatting with people running businesses.

On the importance of management teams: "(They) always have a big influence on your success, no matter how good or how bad the business is itself.  Management is always part of the equation of making the company successful, so the quality of management always matters.  But to assess that quality is not always easy."

On decision making:  "I think you want to avoid wrong decisions as much or more than you want to get it approximately right.  If you avoid the wrong decisions, you'll probably come out okay over time."

The issue also features pitches from Columbia Business School MBA students on: Motors Liquidation Company (MTLQU), Precision Castparts (PCP), Hertz (HTZ), Advance Auto Parts (AAP), Dollar Tree (DLTR), Stanley Black & Decker (SWK), & Yum Brands (YUM).

Fund flows show investors still cautious

With data as of last week, ICI's tally of equity fund flows shows no net inflows for the past two months, even as equity prices have hit new all-time highs. Bond funds, meanwhile, continue to enjoy strong inflows, even as bond yields remain very near all-time lows. Mutual fund flows thus reflect a market that is still dominated by caution.

The chart below is a reminder of just how low 10-yr Treasury yields are from a long-term historical perspective:

The chart below is a reminder that the real yield on TIPS tends to track the economy's health:

Negative real yields imply that investors have very pessimistic assumptions for economic growth over the next few years. This jibes with the dearth of equity fund inflows. There is a real shortage of optimism out there.

2013 Hedge Fund Performance Numbers: Q1 YTD

Long/Short Equity / Equity Diversified

Greenlight Capital (David Einhorn): 5.78%

Maverick Capital (Lee Ainslie): 2.30%

Lansdowne (Paul Ruddock & Steve Heinz): 7.01%

Passport Global (John Burbank): 5.95%

Cobalt Offshore (Wayne Cooperman): 5.17%

Elm Ridge Value (Ronald Gutfleish): 8.31%

Eminence Fund (Ricky Sandler): 6.33%

Glenview Capital (Larry Robbins): 17.94%

Ivory Capital (Curtis Macnguyen): 3.35%

Omega Overseas (Leon Cooperman): 6.55%

Joho Capital (Robert Karr): 12.21%

GLG European Long Short (Pierre Lagrange): 2.38%

Marshall Wace Core (Ernesto Fragomeni): 5.82%

Odey European (Crispin Odey): 15.29%

Kingdon Offshore (Mark Kingdon): 9.69%

Renaissance Institutional Equities (Jim Simons): 11.42%

Zweig-Dimenna: 6.92%


Event-Driven

Marcato International (Mick McGuire): 6.52%


Merger Arbitrage

Paulon Enhanced (John Paulson): 11.56%


Macro 

Brevan Howard Emerging Market Strategies: (3.17%)

Caxton Global (Andrew Law): 6.39%

Discovery Global Opportunity (Robert Citrone): 14.64%

Eclectica Fund (Hugh Hendry): 3.40%

Moore Global (Louis Bacon): 6.63%

Tudor BVI Global Fund (Paul Tudor Jones): 8.68%


Multi-Strategy

Davidson Kempner: 4.08%

Owl Creek Overseas (Jeffrey Altman): 15.17%

Paulson Advantage (John Paulson): 2.84%

Paulson Advantage Plus (John Paulson): 3.47%

Paulson Recovery Fund (John Paulson): 14.11%

Perry Partners (Richard Perry): 8.18%

Pershing Square International (Bill Ackman): 4.64%

Third Point Offshore (Dan Loeb): 10.44%

Third Point Ultra (Dan Loeb): 15.44%

York Investment Ltd (Jamie Dinan): 4.69%

Millennium International (Israel Englander): 3.65%


Credit

BlueMountain Long Short Credit: 3.17%

Appaloosa Management (David Tepper's Palomino Fund): 10.58%

Saba Capiatl (Boaz Weinstein): 0.56%


Fixed Income/Global

Pine River (Steve Kuhn): 7.04%


Distressed

King Street Europe: 4.95%

Canyon Value Realization Fund (Mitch Julis): 8.02%

Cerberus International (Steve Feinberg): 2.46%

Contrarian Capital (Jon Bauer): 4.56%

King Street Capital: 5.28%

Paulson Credit Opportunities (John Paulson): 10.17%

Will Indexing Kill the Market?

One of the fundamental laws of investing is that when everyone agrees on something there is something important they are not seeing. There are few if any observers today who don’t hold that indexing is as perfect an investment strategy as has ever existed: simple, cheap, effective, and with little to no downside (other than the market itself). Try Googling “risks of indexing” or any other permutation of the phrase. The results (or lack of them) are a powerful testimonial of how one-sided is our perception of indexing.
There is a robust intellectual, experiential and statistical foundation for this belief. Indexing just might be the most brilliant investment insight of the last 50 years. Yet hidden in the shadows of indexing’s monumental success is a growing body of evidence that this truly elegant idea not only has the potential to threaten the stability of the market, but has already changed market behavior in ways few if any investors understand.
Historic Rise
For most of its life, indexing was a peripheral strategy with a market share rarely rising above the low teens. But over the last decade the popularity of ETFs has pushed that share to more than a third. The Financial Times reported last year that institutional indexing of U.S. equities could increase its market share to 50% as early as the end of 2014. Pensions and Investments recently reported that CalPERS, the largest pension fund in the U.S., had begun a five-month review of all of its investments to see if it is worth continuing with any active managers. And if CalPERS is considering it, you can be sure that they are not alone.
Up until now potential negatives from indexing were mostly academic observations. NYU professor Jeffrey Wurgler’s 2010 paper “On the Economic Consequences of Index-Linked Investing” summarizes nearly 40 studies about indexing that go back as far as 1986. He shows us quite convincingly how and why indexing has been affecting the market and its components for decades.
When a stock becomes part of an index its behavior changes instantly. “It is as if it has joined a new school of fish,” Wurgler writes. In summarizing the implication of all of these studies he turns the conventional wisdom about indexing on its head: “The popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average to beat the index; it may actually be contributing to their underperformance.” If Wurgler is even close to being right, our perception of indexing may be due for a major adjustment.
Some observers have suggested that indexing will never become large enough to pose a systemic threat to the market because there will always be enough investors to offset the mispricing that excessive indexing might produce. However, in the real world extreme behavior in markets is driven by powerful forces and rarely has a benign end. I’m reminded of the quote, often attributed to Lord Keynes, that “Markets can remain irrational longer than you can remain solvent.”
Wurgler notes that the more popular indexing becomes, the harder it will become for active managers to beat it. If that scenario plays out, and indexing continues to trounce active management, it would reinforce the growing conclusion among large institutional investors that their only sensible choice is to increase their exposure to passive strategies, setting the stage for an index-driven investment bubble (or if Wurgler’s hypothesis is correct, exacerbating the one that has been in existence perhaps for years).
But there’s more: When investors like CalPERS consider eliminating all active strategies, what is the real message of that choice? By choosing to index, they are, in effect, saying that attributes like intelligence, experience, expertise, wisdom, intuition, patience and discernment—which we all prize as guides for every other aspect of our lives—don’t apply to investing.
They are saying that there is no good reason to understand the difference between a good business and a bad one, between a good CEO and a thief, between a healthy balance sheet and a dangerous one, between a temporary problem and one that can lead to devastation. There is no reason to understand what a business does, who works there, what they make, whether it’s a good product or a bad product. They say it doesn’t matter, because if you just own the whole market you’ll make more money.
Logical Extremes
One way to evaluate the legitimacy of any idea is to take it to its logical conclusion—an intellectual stress-test. If it maintains its rational and intellectual integrity at the extreme, that is one way of evaluating and eliminating possible risk. If CalPERS is considering the active versus passive choice, so should we; and by taking both to their logical extremes we might be able to see them more clearly.
What would the investment world be like if it was all active, if everyone was trying their hardest to make good choices? It probably wouldn’t look much different than it has looked since modern stock markets emerged less than a hundred years ago. Some investors would do very well, some would do horribly, and most investors would probably be somewhere close to above or below average. More importantly, the market mechanism would reflect that diversity and the elements for an efficient market would be in place.
And what would the investment world be like if it was all passive—if everyone was indexed? No one knows because the idea is absurd. Without active investors—without optimists or pessimists, without long-term investors and short-term traders, without people actually making value judgments about the businesses whose stocks are publically listed—there would be no supply or demand, there would be no efficient market, and more importantly, there would be no average to index.
As long as indexing appears to be the perfect solution, to have no particular risk (other than the market itself), the choice to index is close to self-evident. But if indexing is really not such a perfect solution, and its increasing success is actually perverting the supply and demand of the market itself, perhaps dangerously, then underperforming that market may no longer be the badge of shame it appears to be. In fact, underperforming the market could turn out to be a low-risk way to avoid climbing on a mechanical strategy whose endgame is chasing an abstraction that it is in the very process of destroying.
Investors who are attracted to indexing because it avoids the risks of human judgment should reflect for a moment that it also avoids the benefits.

Apple iBonds

2013...
CEO of Apple, Tim Cook (TC): Just got another call from a hedge fund manager screaming for a dividend cos' he got his short wrong.
CFO of Apple, Peter Oppenheimer (PO): Just been sent an email from Microsoft saying they are looking to buy us out because they see us as a distressed stock.
TC: Looks like we have got to get our stock price up and pay some dividends. Any ideas?
PO: Not sure about dividends as once you pay them the investors expect them to go up every year. And anyway, our cash is stuck offshore and if we bring it to the US, our tax liability will bring us down. What we need is to flip their equity into debt.
TC: How do we do that then?
PO: We call a friendly bank with lots of free ECB, BoE and Fed cash wanting to lend it out at a few bips and then we use this to buy back truck loads of our stock. We then issue debt and pay the banks back and pay the coupons with US generated income.
TC: So we get to keep our rainy day cash in Cayman. Excellent.
PO: Its what I call the iSucker trade. We can continue to avoid paying tax, use free printed money provided by our new best investment banking friends who will do us favors and ensure their analysts pump out Buy recommendations, we keep our jobs, our stock options come into the money and everyone is a winner.
TC: Using government money to pump up our stock price... Jobs would be proud of you.