Case Shiller Index Has First Monthly Increase Since 2006

In another sign of economic stabilization, the Case Shiller 20-City Home price index rose 0.5% from April to May. This was the first monthly rise since July 2006, and it provides further ammo for economic bulls who are anticipating an economic rebound. Skeptics, on the other hand, will write off this rise as a seasonal blip and focus on the 17.1% year/year decline. While seasonal factors may be at play, an increase is an increase, and after 34 months without one, we'll take it.

The ETF blowup begins

H/T Zerohedge for drawing attention to the fact that UBS has suspended purchases of leveraged and inverse ETFs. We’ve now got the official statement from UBS:
“UBS Wealth Management Americas has suspended purchases of leveraged and inverse ETFs to our clients, effective immediately, as the short-term nature of these securities is generally inconsistent with the long-term view of investing that UBS advocates when building client portfolios. In addition, recent regulatory guidance on leveraged and inverse ETFs reinforces the short-term nature of these products, particularly in volatile markets. UBS Wealth Management Americas’ financial advisors have been fully briefed and our clients are being contacted regarding these securities.”

This comes on the day the UNG natural gas-tracking ETF — one of the most popular funds of its type — was forced into the over-the-counter bilateral swap market having neared most of its position limits in the regulated sphere. As we noted earlier this introduces a whole new counterparty risk element into the pricing of ETF units.

Market participants have criticised leveraged and inverse ETFs, alongside commodity ETFs, as being too complex for retail investors to understand. In fact, many have said they would prefer to have them billed as structured products. That’s because more often than not — as it turns out — these instruments fail to perform as expected. In most cases, though, a thorough reading of the prospectus would alert professional investors to their unexpected nature.

If UBS sees fit to suspend these products from the market, this raises important questions over the model’s viability and the recent trend towards the ETF-ization of nearly everything.

Are Institutions Participating in the Rally?

We recently broke the S&P 500 into 10 deciles (10 groups of 50 stocks) based on the amount of a stock's shares that are held by institutions. We then calculated the average performance of the stocks in each decile since the rally ramped up again on July 10th. As shown below, the two deciles of stocks with the most institutional ownership are up the most, while the decile of stocks with the lowest institutional ownership is up the least. Based on this analysis, institutional investors do believe in the rally, and maybe even more than individuals.

Treasury Real Yields Highest in 15 Years

Bloomberg reports:

The highest inflation-adjusted yields in 15 years are helping provide the Treasury with record demand at auctions as the U.S. prepares to sell $115 billion of notes this week.

Treasuries are the cheapest relative to inflation since 1994 after consumer prices fell 1.4 percent in June from a year earlier. The real yield, or the difference between rates on government securities and inflation, for 10-year notes was 5.06 percent on July 24, compared with an average of 2.74 percent over the past 20 years.

“Concerns surrounding rising Treasury supply to fund the various U.S. stimulus programs are overblown,” strategists led by Brad Henis in New York at Citigroup Inc., one of the Fed’s 17 primary dealers required to bid at the auctions, wrote in a July 23 research report.

Kass: Updating the Model Portfolio

Doug Kass

07/27/09 - 12:01 PM EDT

This blog post originally appeared on RealMoney Silver on July 27 at 8:38 a.m. EDT.

In late April, I initiated the Kass Model Portfolio, intended to represent the general construction of a long-only model portfolio with a six- to 12-month investment horizon. My hypothetical portfolio depicts an overall equity weighting and positioning relative to S&P 500 industry benchmarks and weightings.

As I did in calling for a generational bottom in early March, I am again adopting a variant and unpopular view, but this time it is a more negative call. It is important to emphasize that in my March call, I expected a resurgence of economic and investment optimism during the summer to be followed by a multiyear period of weak investment returns. Specifically, I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop.

Today's opening missive has another major change in our model portfolio, with a further increase in the cash component of the portfolio from 29% to 43%. I am further reducing both equity and credit exposure after a huge run in both asset classes.

As I see it, the bull market argument is that we are exiting the recession just like the many that preceded the current one. Consequently, corporate profits will exceed consensus forecasts in tandem with:

1. the resumption of revenue growth (seen in three months of improvement in the leading economic indicator, signs of stabilization in housing, etc.);
2. the record fiscal stimulation;
3. an export-led Asian recovery; and
4. the operating leverage associated with productivity gains achieved through draconian cost cuts and influenced by tame wage inflation.

Besides productivity being underestimated the bulls, further argue Say's Law of Production -- that it is business that drives consumer incomes and spending. Finally, the bullish cabal argues that the high-tax health and energy bills introduced by the President have been recently set back as the blue dog democrats and the liberal leadership are already battling.

The bear market argument (that I now endorse) is that we are seeing nothing more than a second derivative recovery and that owing to a temporary replenishment of inventories, the economy is only getting less worse (or getting better from a depressed level). From my perch, the ingredients for a durable and self-sustaining recovery are missing. An economic double-dip grows more likely in a climate of corporate cost cuts, which elevates jobless rates and leads to continued pressure on personal consumption expenditures. The bears reject Say's Law of Production and view consumer incomes and spending as driving business.

Importantly, the economic downturn of 2007-2009 has already been different this time in scope and duration. For example, unlike the other post-depressions/recessions of the last century, we have already witnessed two consecutive quarterly drops in nominal GDP. As well, the 20-month-old recession has resulted in a near 4% drop in real GDP vs. drops of between 2.5% and 3.0% in the mid 1970s and early 1980s recessions. The U.S. economy came out quickly from those prior downturns, with recoveries to new peaks in economic activity taking only three or four quarters.

My view, however, is that it is different this time: The typical self-sustaining economic recovery of the past will not be repeated in the immediate future for 10 important reasons that will come to the fore:

1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
4. The credit aftershock will continue to haunt the economy.
5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain.
6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
7. Commercial real estate has only begun to enter a cyclical downturn.
8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
9. Municipalities have historically provided economic stability -- no more.
10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom.

As I wrote last week, the most disturbing feature of the current business environment is the manner in which corporations are beating estimates. While it enhances the present profit configuration, it has the potential for a long and negative tail to the future. Cost-cutting, like another man's bread, will line the corporation with profits but, in the fullness of time, will not fill the belly of the consumer who is the victim of the realignment of expenses. Costs cuts have a finite life, and, as such, produce an inherently lower quality of earnings and a less positive lever to P/E multiples than does the classical cyclical improvement in top-line or sales growth.

Given the unusual nature and the severity of the downturn, it is hard for me to see anything typical about the domestic economy's rebound compared to previous recovery periods. I do not see the disproportionate role of housing and credit in the prior decade being replaced by anything similar as a growth lever in 2009-2011. Already job losses are unprecedented and cost-cutting's impact on unemployment will exacerbate pressures, acting as a greater drag in the years ahead. Meanwhile, other (nontraditional) headwinds -- such as the likely growth-inhibiting public tax policy, less available credit and an intrusive public sector's interference on the private sector (with attendant regulatory costs and burden) -- will weigh heavily on the economy. So will bloated budgets and poor planning, which have left municipalities in disarray, raise unfamiliar cyclical challenges.

My contacts with corporations are universally more downbeat than the optimism expressed by investors recently. Many in my hedge fund cabal say that this input from the industry is not unexpected, as company managements universally failed to see the coming downturn. This is a fair response, but I suppose they could be right for a change!

For now, the animal spirits are in force. Shorts are covering, and the longs are joining the ever more vocal and growing bullish chorus in the face of the enemy of the rational buyer -- namely, optimism.

In summary, my model portfolio's high cash position reflects a less optimistic view of the sustainability of corporate profit and economic growth as well as a renewal of excessive optimism in sentiment and a move toward more elevated valuation levels (which are not supported by the profit picture I foresee).

S&P Weighting Recommended Weighting Rationale for Weighting Technology 18% 8% Business spending will remain subdued, and the sector is now overowned Financials 13% 7% The risk of a double-dip augurs poorly for credit metrics Energy 13% 5% Commodities, like energy products, are vulnerable to a slowdown Health Care 13% 5% Government intervention threatens pricing Consumer Staples 12% 5% Exposed to generic trade-down as consumer weakens Industrials 10% 5% Shallow and uneven economic recovery remains a headwind Consumer Discretionary 9% 4% Accumulated job losses and wage deflation weigh on consumer Materials 4% 2% Shallow and uneven economic recovery remains a headwind Utilities 4% 2% Exposed to a further spike in interest rates Telecom 4% 4% Secular prospects remain strong Total equities 100% 47% Credit 0% 10% Opportunistic Total exposure 100% 57% Cash 0% 43%

Finally, I have included a shopping list of individual stock candidates (by sector) that could be considered in the aforementioned Kass Model Portfolio.

• Technology: Previous selections Apple (AAPL Quote), Cisco (CSCO Quote), Research In Motion (RIMM Quote) and Oracle (ORCL Quote) are now fully priced and have been dropped from my buy list. Qualcomm (QCOM Quote) had a disappointing quarter and is also out. Remaining are Microsoft (MSFT Quote) and Dell (DELL Quote).
• Financials: I'm dropping SunTrust (STI Quote), Regions Financial (RF Quote), Legg Mason (LM Quote), State Street (STT Quote), Berkshire Hathaway (BRK.A Quote) and Weingarten (WRI Quote) (convertibles). I added JPMorgan Chase (JPM Quote). Remaining are Bank of America (BAC Quote), Prudential (PRU Quote), MetLife (MET Quote), Hartford (HIG Quote), PNC (PNC Quote), Cohen & Steers (CNS Quote), SL Green (SLG Quote) (convertibles), Chubb (CB Quote), Loews (L Quote), National Financial Partners (NFP Quote) (convertibles) and SLM (SLM Quote).
• Energy: I'm dropping extended integrated oils and several oil service companies and keepng Transocean (RIG Quote) and select master limited partnerships.
• Health Care: I'm going with select depressed HMOs, a true contrarian play!
• Consumer Staples: Remaining are Procter & Gamble (PG Quote), General Mills (GIS Quote) and Unilever (UN Quote).
• Industrials: I'm keeping 3M (MMM Quote), PPG (PPG Quote) and Union Pacific (UNP Quote).
• Consumer Discretionary: I have dropped Wal-Mart (WMT Quote), Nike (NKE Quote) and Starbucks (SBUX Quote). Remaining are Home Depot (HD Quote), Lowe's (LOW Quote), Disney (DIS Quote) and eBay (EBAY Quote).
• Materials: I'm dropping BHP Billiton (BHP Quote), and only Freeport-McMoRan Copper & Gold (FCX Quote) remains.
• Utilities: Duke Energy (DUK Quote), Dominion Resources (DRU Quote) and PG&E (PCG Quote) remain.
• Telecom: The model portfolio continues to hold Verizon (VZ Quote) and AT&T (T Quote).
• Credit: I added SLM debt to the other select bank loans/debt and high-yield debt.

Sector P/E Ratios

Below we provide charts of historical P/E ratios (trailing 12-month before extraordinary items) for the S&P 500 and its ten sectors. After getting under 10 briefly in early March, the S&P 500's P/E currently stands at 14.37. On the day of the Lehman Brothers collapse, the index's P/E was at 15.94.

The Financial sector is the only one that currently has a negative P/E. Consumer Discretionary did have the highest P/E when General Motors was still in the sector, but when it got pulled out, the sector's P/E dropped and is currently the second highest behind Technology. Energy has the lowest P/E ratio at 7.81, followed by Telecom (9.83), and Industrials (9.96).

Investment Grade Corporate Bonds Holding Up Well

Even though equity markets have pulled back since the June 12th top, investment grade corporate bonds have continued to perform well. Below is a year-to-date price chart of LQD, which is an ETF that tracks the investment grade corporate bond market. Since bottoming in early March, the ETF has been in a very strong uptrend, bouncing off of the bottom and top of an upward sloping channel as it has worked its way higher. While the S&P 500 is off more than 7% from its recent high, LQD is on the verge of breaking out to a six-month high.

Performance During the Pullback

We recently broke the S&P 500 into deciles (10 groups of 50 stocks) based on stock performance during the last rally (3/9-6/12) to see what impact it has had on performance during the pullback. The market is down more than 7% since June 12th, but the 50 stocks that were up the most during the last rally are down an average of 15.1%. The 50 stocks that were up the least during the rally are only down 2.1%. Investors have clearly been selling or shorting the big winners and moving into more defensive sectors.

Recent Hedge Fund News Summary

We're going to try out our hedge fund news summary style post again as readers seemed to like it last time. Except this time around, we'll focus not only on hedge funds but on prominent market strategists and gurus as well. In our previous shotgun hedge fund update, we touched on the latest from George Soros, Och Ziff, Taleb, and a few others. And now here's your daily double shot of hedge fund & market tequila:

Hedge Funds in general saw returns of 9.73% for the year as of around the end of June. This is on track to their best annual start since way back in 1999.

George Soros (Soros Fund Management): Legendary investor and former Quantum Fund manager George Soros was recently out saying that he thinks the US will see a "stop-go" economy for some time. Eventually, he feels fears of inflation will hike interest rates up and as a result, economic growth will suffer. He went on to say that, "The idea of self-correcting markets is a misconception. You cannot prevent bubbles from forming but prevent them from self-reinforcement." Apparently (unbeknownst to us at least), Soros went back into retirement earlier this year after the whirlwind of 2008. If he really is 'retired' again, then we wonder why he is gracing us with his typical dose of (realistic) cynicism. We'll have to find out more in this regard, as this is the first we've heard of it. We have previously covered Soros' holdings in our hedge fund portfolio tracking series.


Bill Gross (PIMCO): 'Mr. Bonds' over at PIMCO is out with his July 2009 outlook and in it he touches on a fact that many seem to have brushed off the market action as their eyes glaze over with 'hope' (whatever that word means). Gross says,

"I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, 'How do you put together a consumer economy that works when the consumers are out of work?' That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an 'old normal.' As unemployment approaches 10%, what is less well publicized is that the number of 'underutilized' workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model."

He also touched on a phrase we found a bit amusing. Instead of investors typically feasting on asset appreciations and going "Bon Appétit," they are now starving and are going “Non Appétit.” You gotta love silly old Bill with his crazy phrases. We read his outlooks because it makes for good reading, but we kind of gave up on ole Bill a long while ago. Simply put, he thinks that while greed is gone for now, it will certainly be back. You can read his full July outlook here.


Dwight Anderson (Ospraie Funds): This name should ring a bell for Market Folly readers for two reasons. Firstly, because his Ospraie fund blew up and we covered that back in September of 2008. Secondly, you will recall that Anderson was coming back in May and starting two new hedge funds. Well, we're back merely to report that Anderson's new funds went live last month with around $100 million. His new equity fund is focused on companies that are related to commodities and resources while his new commodity fund will invest in the various derivatives related to that asset class. Watch out, the 'bird of prey' is back in the game and they are in-it-to-win-it.


John Meriwether (LTCM, now JWM): Sticking with the hedge fund opening/closure meme, we're happy (?) to report that John Meriwether is shutting down yet another hedge fund. This is really starting to get ridiculous. For those of you unaware, John Meriwether was the founder of Long-Term Capital Management which imploded back in the 1990's and caused a huge ordeal. It was somewhat shocking to see him able to start another fund after such a blowup, but it happened. Yet, we have come full circle again and see that Meriwether's main fund at JWM Partners will be shutting down after it lost 44% between September 2007 and February 2009. Ouch. Oh, and double ouch for the fact that he's shutting down yet another firm. Will this guy ever learn? And, more importantly... will investors ever learn?!


David Rosenberg (Gluskin Sheff & Associates): The notorious market strategist was out with his usual market talk at his new outfit, Gluskin Sheff & Associates. However, he specifically focused on corporate bonds versus equities which intrigued us. He writes, "The comparable yield in the equity market, depending on whether one uses reported or operating P/E multiples on forward or trailing earnings, is little better than 6½%. So corporate debt still trumps stocks. And what this 200 basis point ‘yield gap’ is telling you is that either corporate bond prices will need to rally more down the road or we need to start seeing corporate earnings growth recover sharply enough to pull those multiples down to more attractive levels."

Overall, he thinks that stocks already have a ton of good news priced-in and sees a pullback to 800 on the S&P500. However, he would see that as a buying opportunity and thinks the March lows will hold. The trick here is dealing with an already massive rally in equities from the lows.


Morris Sachs, E.G. Fisher, and Rob Wahl: While these three names might not ring any bells right now, we're here to report that the three gentlemen above will be opening a new hedge fund focused on government bonds named 5:15 Capital Management. The traders have a background at Brevan Howard and RBS Greenwich so they definitely have the credentials. They are starting with around $60 million, with plans to grow it to around $100 million. This hedge fund is intriguing in that its name is derived from a song from the band The Who. The track "5:15" was featured on the album "Quadrophenia" and the founders say they chose the name because they all love the song and band in general.

And, in mocking the hedge fund names typically selected by managers, Sachs said "What are we going to do, try to find another name for the Greek god of money?" Personally, we think someone else out there should create a fund with a name that flat out mocks another hedge fund, to get a little rivalry going. Suggestion: maybe Tontine, due to the irony there. (Confused? See this post).

Fair play to the trio at 5:15 for this random, yet refreshing development. We can't wait to see other new names that pop up now... perhaps 'Enter Sandman Partners'? Or, maybe, in tribute to the king of pop, 'Beat It Capital.' Hmm... we won't hold our breath.


Assan Din: Sticking with the "new-hedge-funds-by-people-you've-probably-never-heard-of" theme, we see that Assan Din is also set to start his own hedge fund after trading for Lehman Brothers. His SaKa Capital will be seeded with $25-50 million and will start trading corporate bonds and derivatives in Singapore in September.


Byron Wien: Just a few days ago, we posted up Pequot Capital strategist Byron Wien's latest commentary. However, this time around he did not deliver his usual dialect regarding the markets. Instead, he took the time to reflect on the closing of the hedge fund firm he was a part of: Pequot Capital. If you haven't read it, we posted up Byron's thoughts here.


Boone Pickens: Although we usually just cover Pickens' hedge fund movements here on Market Folly, this news is still market related in a sense. Remember the "Pickens Plan" and his quest for alternative energy change in the United States? Yea, most people probably don't remember after all this time. To give you a quick refresher, Pickens was seeking the use of various alternatives to replace our dependency on oil and was in the process of building a massive Wind Turbine Farm across Texas.

Well, times are tough because he is suspending plans to build such a farm. While he will still spend $2-3 billion on smaller farms, the grand-daddy plan will have to wait. The delays (per Pickens) were cited to be the drop in natural gas prices and a lack of transmission lines... not to mention the vast slowdown alternative energy companies have seen and the financial turmoil that has affected Pickens as well. After all, when his hedge funds started tanking, he lost a lot of money. So, it looks like we'll have to wait even longer before we see the massive plot of propellers sprawled throughout Texas. This just goes to show how a nice drop in the price of oil (From $140 down to $60) can start to cripple the alternative energy sector. For those interested in Pickens' hedge fund, we recently covered his portfolio here.


Cliff Asness (AQR Capital Management): Yet again, we repeat ourselves: this is starting to get ridiculous. AQR is going to introduce even more "hedge-fund-style mutual funds" starting next month. This is all in a move to continue their expansion into mutual funds in addition to the hedge funds they run. Their AQR Diversified Arbitrage fund launched back in January and this time around they apparently have an arsenal of funds to unleash at the retail investing crowd.

But, then again, this is nothing new as we have seen literally a slew of similar investment vehicles already released. Thus far, we've seen: mutual funds imitating hedge funds, ETFs imitating hedge funds, and even more mutual funds pursuing hedge-like strategies, and then even more ETFs pursuing 'hedgefundesque' strategies. We've covered them all in detail before and we sincerely wonder if this fad will ever cease.

Instead of trying to match hedge fund performances by buying and shorting various index ETFs like those new vehicles do, why not just clone the hedge fund equity portfolios directly like we here at Market Folly have done? After all, with the help of Alphaclone, we've cloned our custom hedge fund portfolio that is seeing 27.9% annualized returns. And no, we're not even joking; check it out.

Winners and Losers Since the 6/12 Market High

The Russell 1,000 is now down 7.19% from its high on June 12th, while the average stock in the index is down 9.11%. For investors wondering which stocks have taken it on the chin the hardest and which ones have held up the best, below is a table of the biggest winners and losers since the 12th.

AIG is down the most at 59.32%, followed by CIT, BPOP, CCO, MBI, VHI, and FST. The sectors represented the most in the loser list are Energy and Financials. Only 14% of the index is up since the 12th, and Oshkosh (OSK) has been the best performing stock with a gain of 39%. Amgen (AMGN) is up the second most at 18.06%, followed by GLG, CI, CLWR, and CPA. Health Care and Consumer Staples stocks make up the bulk of the winners list.

Have a good evening...

How Hollywood, lotteries and mutual funds show that all risk is relative

One of the great ironies in the hedge fund industry is the propensity for many investors to favor relative returns over absolute returns. This is particularly true among retail investors who, by and large, would prefer to lose money along with everyone else than to make less than everyone else. What else could explain the complacency with which investors accept -40% market returns while crying foul at the hedge funds that “under perform” in a bull market.

Research into happiness has dispelled the notion that utility is derived from some absolute level of wealth. Instead, it appears that utility is relative, not absolute - hence the paradox of the retail investor who is petrified of under performing his neighbours, but sanguine about losing his shirt alongside them.

More than some esoteric argument, the phenomenon of relative wealth may actually account for the overwhelming amount of empirical evidence than seems to refute the hallowed Capital Asset Pricing Model. In a paper released last month based on his new book “Finding Alpha“, author Erik Falkenstein argues that:

“The standard assumption that relevant volatility is absolute wealth may be a good normative theory, but a relative wealth orientation generates a more accurate positive theory, and its assumption is generally considered more accurate by those doing research on the essence of subjective well-being..The relative status utility function generates a more accurate description of the world..”

Falkenstein delivers a litany of empirical evidence suggesting that risk and reward are negatively correlated across many asset classes, not positively correlated as the CAPM proposes.

He begins by citing his own 1994 Ph.D. thesis showing how mutual funds with higher idiosyncratic risk actually have a lower annual excess return than those with low idiosyncratic risk.

He then cites research proving that portfolios of high-beta stocks have a lower Sharpe ratio than portfolios of low-beta stocks. In other words, the Security Market Line is downward sloped, not upward sloped (see related post). He shows a similarly negative relationship between risk and return of call options.

But the most interesting part of this paper is Falkenstein’s exploration of non-traditional asset classes. For example, he cites the private equity industry as further proof that the risk and reward are negatively correlated. Research cited in the chart below show that (high risk) privately-owned businesses produce returns that are pretty much the same as a (low risk) diversified public equity portfolio:

As Falkensetin observes:

“Given an investor can invest in a diversified, and liquid equity portfolio, it is puzzling why households willingly invest substantial amounts in an asset with an equivalent return, but much higher volatility, including a positive correlation with the market…Entrepreneurs appear to be taking extra risk, for no extra return.”

The list of so-called CAPM “anomalies” continues with evidence that leveraged companies have lower returns and how the success (until recently) of the carry trade is further proof that risk and reward are not significantly correlated after all.

Even the equity premium in different countries seems to refute the CAPM. As the chart below from the paper shows, there is little relationship between the equity premia and returns in 17 countries:

One of the more “alternative” examples of a CAPM transgression presented by Falkenstein is from Hollywood. He cites research showing that “R” rated movies generated the same average gross returns than “G” rated movies, but with a risk that was nearly 20 time higher.

In other words:

“It seems studio executives are generally betting on the next Titanic, because the very highest grossing movies are R rated.”

Horse betting (where 1-10 odds produce higher returns than 100-1 odds over the long run) and lotteries (which have a -47% return per dollar played) are further proof that “investors” are willing to accept lower long-term returns in exchange for the opportunity to hit the jackpot. (ed: So much for my plan to start a hedge fund that invests in lottery tickets). As Falkenstein observes:

“People who buy lottery tickets seem to prefer those lotteries that offer the worst odds, but the greatest payout.”

In an effort to put these anomalies into formula, Falkenstein presents a simple example showing that absolute risk aversion may be asymmetrical, but that relative risk aversion can still be symmetrical.

For the hedge fund (”absolute return”) industry, the message is familiar: investors may be more concerned about the political and reputational risk of underperformed their peers than they are about the absolute risk to their portfolios - or, as Falkenstein puts it:

“Risk is simply allocating an “unusual” amount of wealth to any asset that would generate a significant deviation from the market portfolio.”

Make Sure You Get This One Right

By Niels C. Jensen

"You can't beat deflation in a credit-based system."

Robert Prechter

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won't have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those 'make or break' decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or 'quantitative easing' as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don't understand the world of finance or you don't want to understand. Shame on those who fall for cheap tactics.

Let's begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won't rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Good question - counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn't go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest 'must have' amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry's leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. 'Get long and get loud' it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

THE COOL WINDS OF JUNE

The weather in June was cool and rainy in the New York region, and something similar prevailed over the capital and commodity markets last month as well.

As our table below shows, June was a month of mixed messages, ranging from a healthy rally in high-yield bonds to loss in REITs. Disappointing, perhaps, given the previous bout of good times. But the arrival of red ink is hardly unexpected. The March-to-May rally, after all, elevated all the major asset classes by dramatic levels. That couldn’t last. But what comes next?

The optimistic interpretation is that June was a month of backing and filling. The markets are reportedly digesting the recent gains and building a foundation to capitalize on the expected economic recovery. Prices got ahead of themselves in recent months, and bit of profit-taking was inevitable.

A less-forgiving outlook is that the recent rally in almost everything was a sucker’s game. The great bear market of 2008 is still with us, runs this line of thinking, and so the rest of the year will suffer.

Your editor tends to come down in the middle of these two extremes. As we’ve been pointing out in more detail in recent issues of The Beta Investment Report, the foreseeable future for returns in the major asset classes looks increasingly unexceptional. The sharp snapback in prices so far this year looks warranted as it became clear that the worst fears for the economy were overdone. All the more so as it appears that the technical end of the recession may be near.

Then again, we can’t be sure. There are still lots of reasons to remain cautious. Forecasts, after all, are created by mere mortals and so predictions are subject to revisions as new information arrives. Meanwhile, the stock market looks fairly valued at the moment, which is to say that it’s no longer undervalued, as it was as this year opened. Similarly, yield spreads, while still attractive, are no longer extraordinarily high.

In short, the markets have rallied on the expectation that the aggressive liquidity injections of governments around the world would bring stability and, eventually, expansion. That still looks like a good bet, but no longer are markets offering massive discounted prices tied to that outlook.

Then again, none of this is a surprise. Expected returns vary, as they must in order to attract buyers through time. No one would be willing to buy risky assets in January 2009 without an unusually high expected risk premium. Now that the macroeconomic risk looks lower, albeit still substantial, assets are priced accordingly.

A Wild Ride So Far

lf you went to sleep at the end of 2008 and just woke up today, you'd see the S&P 500 up 1.78% for the year and probably assume it's been a pretty boring six months in the market. Oh how you'd be wrong, however. As shown below, the market has taken investors for a wild ride so far this year. On March 9th, the index closed the day down 25% for the year. From March 9th through today's close, the index has rallied 36%. Down 25% and then up 36% turns into up 1.78% at the midway point.

And while the S&P 500 is up as a whole, only three of the index's ten major sectors are positive in 2009. Technology has been the big winner so far with a gain of 24.08%. Materials is up the second most at 12.28%, and Consumer Discretionary ranks third at 7.52%. And even though sectors like Industrials and Financials have been going up for months now, both are still down for the year. The Industrials sector is down the most at -7.68%, while Financials are down 4.76%.

While the year started off horribly for the market, it is heading into July in a nice uptrend even though it has been floundering for a few weeks now. While some investors are getting frustrated with the market's inability to break to new highs, they easily forget how bad things were just a few months ago. Up 1.78% in '09 with everything that has happened -- we'll take it!

Wrong Only

The liquidity crisis is over while the credit crisis is still ongoing.
How to make money and to protect capital in this environment remains
to be the question. Dominant forces (partly working against each other)
are de-leveraging, saving and high demand for cash, re-deployment of cash
into equities and risk markets, artificial economic stimulus effects,
inventory liquidation, decreasing earnings due to economic weakness and
and lower leverage.

Long only managers have in particular been challenged, given that most
of them went fully exposed into the downturn. And ironically they had
such large exposure even without the direct application of leverage to
their portfolios. However, since equity is a leveraged asset class per se
(especially when it comes to finanicals) their losses were very competitive
compared to other strategies. Changing risk appetite helped some of them to
partly miss out the upside of the quick bounce. Now a lot have re-deployed
cash which was sitting on the sidelines to chase performance even when
there is very weak fundamental support to the harsh up-move.

How much sense does the long only approach make going forward and how much
faith will investors have? In my view it makes more sense to apply a more
flexible approach. Historical perceptions based on historical data should
give way to a more opportunistic and selective approach. Shortened time
horizons with a focus on price discrepancies and taking money off the table,
when asset getting close to being rich. The use of shorting, hedging, leverage,
and using derivatives all seem to make perfect sense to me.

Killer Chart on foreign investor demand for US government sponsored debt

Look at this chart which shows how foreign investor demand for
Freddie Mac debt has crashed from 50% to 20% within one year!




So far there seemed to have been a common believe that demand for U.S. securities
will hold up sufficiently well. This is mostly based on the fact(oid) that US
securities markets are so deep and liquid, far developed and well ruled by law,...

I broadly agree but submit a few more charts showing the same trend on other
types of U.S. government related debt and I will think twice. And so may others
which would be reflected in market prices. Generally I am optimistic that US
funding will be addressed but there seems to be a fast growing need to work on
and formulate an exit strategy.

Stock Prices Devided by a Ten-Year Moving Average of Earnings, 1880-2009

VIX Makes A New Short-Term Low

Yesterday's equity market rally sent the VIX volatility index to a new short-term low of 26.36. While the VIX made a new low, the S&P 500 still has a ways to go before taking out its recent highs. Hopefully the VIX is a leading indicator that the rally is set to continue.

Individual Investors Most Bearish Since March Lows

It doesn't take much to rattle investors these days. Following a decline of less than 6% from its highs, sentiment of individual investors is at its most bearish level since the March lows. Based on this week's survey from the American Association of Individual Investors (AAII), 28% of investors are bullish while 48.8% are in the bearish camp. The current bull-bear spread of negative 20.8% is the lowest level since the week ending March 12th. While single-day market declines of 6% were commonplace less than six months ago, given the scars of the bear market, a multi-week pullback of less than 6% is enough to send the bulls heading for the hills.

Two Strategists Up Their 2009 Price Targets

Each week Bloomberg surveys Wall Street strategists for their year-end S&P 500 price targets. Since we last updated our table highlighting the various price targets a few weeks ago, two firms have upped their year-end numbers. Deutsche Bank's Binky Chadha upped his price target from 900 to 1,060, while Morgan Stanley's Jason Todd upped his from 825 to 900. The average year-end target for the S&P 500 is now 968, which is 5.59% above the index's current level.

Country Inflation Rates

For those interested, below we highlight a big bar chart showing the most recent inflation rates for 77 countries. The average unweighted inflation rate for all of the countries is 4.11%. Fifty-nine countries are currently seeing prices rise versus a year ago, 14 are seeing prices decline, and 4 are flat. Venezuela has the highest inflation rate at 27.7%, followed by Kenya, Iran, Ukraine, Pakistan, Guatemala, and Russia. Ireland is seeing the most deflation with a year over year decline in prices of 4.7%. China has the third biggest decline in prices at -1.4%, while the US is right behind at -1.3%. Whether or not you use this chart to make any investment decisions, it does provide a good look at where each country stands in regards to price movements.

A two sigma day

A two sigma day on the S&P 500, from Condor Options. Click to enlarge.

Here’s a bit of an explanation from Condor:

The lower part of the chart below shows how far each day’s price movement deviates from its 21-day mean; the dotted lines mark two standard deviations up and down. With SPX at 895.70, today looked to be one of those two sigma days. The last such occurrence was on March 2nd of this year, a few days before what the “green shoots” crowd desperately hopes will have been the market bottom. . . .

A two sigma event isn’t outrageously improbable or anything like that. We’re not really talking fat tails here.

Rather, in this case, it just suggests — perhaps — that volatility is returning to the market or momentum is picking up.

Or maybe, it just suggests that stochastic analysis is bunk.

Either way, we think it’s interesting.

On Goldman’s fat tail risk

Zero Hedge points us in the direction of a risk management presentation from Goldman Sachs.

The majority of slides are typical management-type stuff. There are some impressive Venn diagrams and graphics of interlocked puzzle pieces, as well as a few intriguing comments on mark-to-market accounting, but the most interesting thing, we think, is the slide on fat tails and Value at Risk, or VaR.

VaR is a way of measuring the risk of loss on a portfolio, using observations of historical market movements, with the VaR model used by Goldman Sachs looking at 95 per cent and 99 per cent tail risk. Tail risk is the the ‘unexpected’ losses or gains that happen to the portfolio, assuming normal distributions.

In the three months to March 27, 2009 Goldman’s VaR value was $240m at the 95th percentile. Meaning there was a 5 per cent probability Goldman’s portfolio would fall in value by more than $240m over a one day period. That compares with a VaR value of $197m in the three months to November 28th, 2008, and a VaR of $157m in the three months to February 29th, 2008 (Goldman Sachs, we all remember, conveniently changed its reporting period).

In any case, here’s the fat tail slide from Goldman’s risk presentation:

And here’s Zero Hedge’s commentary:

. . . the fat tail analysis is also somewhat non-self explanatory. As the chart [above] indicates that Goldman is dead set on analyzing the 99 percentile (in addition to the 95%) non-fat tail distribution. Does this explain the meteoric rise in VaR in recent reporting periods? Also - what happens on that rare 100th day, week, month? Especially if there is nobody left to bail you out.

The rise in VaR, we think, is explained by the below slide from the same presentation, which shows the illiquidity in recent market environments and an example of a crowded trade — when investors rush to unwind their positions simultaneously — in the form of the notorious Volkswagen short squeeze of death.

Kass: Three Summer Scenarios

Doug Kass

06/22/09 - 11:00 AM EDT

This blog post originally appeared on RealMoney Silver on June 22 at 7:58 a.m. EDT.

Summer has set in with its usual severity.

Similar to many, I am trying to grapple with the market's outlook for the next few months.

From my perch, the short-term market mosaic is particularly hard to decode. Indecision reins and is reflected in a relatively range-bound market, with the S&P 500 having been contained between 875 and 950 since early May and activity characterized by lackluster volume.

In summary, I have concluded that a sideways correction or a deep correction are most likely, with a combined probability of 75%, and that a continued rally holds about a 25% probability.

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Scenario No. 1: The Sideways Correction (Probability of 40%)

I have previously suggested that a sideways correction remains the most likely market outcome this summer. As a metaphor, consider the market as a big bathtub with little new water (hedge fund and mutual fund inflows) being added into it. The bathtub market's water level remains stable, but the water swishes around from side to side as the bather moves. Industry rotation is the hallmark condition. The market, however, does not take a bath as, over the short term, extended sectors such as industrials, materials and energy will likely correct as more defensive sectors improve in their relative performance. A sideways correction would be intermediate-term healthy in the sense of correcting an overbought from the March lows and will likely presage a move higher in the autumn.

Scenario No. 2: The Deep Correction (Probability of 25%)

Fundamentally, a continued weakness in retail spending could precipitate lost confidence and a deeper dive. So could weakness in business spending (as a byproduct of ever lower capacity utilization rates). Technically, a reversal in the Coppock Curve indicator -- it gave a technical buy at the end of May and is now in a sell mode -- and weakening Lowry's buying power augur for a plunge. It is important to recognize that a deep correction, similar the sideways correction, would also be healthy for the market's back-end-of-the-year market prospects.

Scenario No. 3: The Continued Rally (Probability of 35%)

While giving the scenario only slightly better than a one-third chance, a new up leg is not out of the question. If the replenishment of depleted corporate inventories begins to occur in July, evidence of an impending production boom could be interpreted by market participants as a sustainable economic leg higher (an outcome with which I happen to disagree), which will carry expectations of improving corporate profits. With the appearance that the domestic economy is moving from "less worse" to "better," fixed-income yields would then rise. (The yield on the U.S. 10-year note could as high as 4.25% or 4.50%.) And, as I have emphasized, a large pension fund reallocation out of fixed income into equities could serve as a catalyst to energize stocks and take the averages through the upside of their recent trading range.

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Looking beyond the near term, I would emphasize that I view the two correction scenarios as bolstering the market outlook during the fall-winter period. Both scenarios would serve to build up skepticism, shake up complacency and make it difficult for many investors to get back in. A sideways correction would frustrate the most and wear many investors out. A deep correction would again increase the fear of being "in" compared to the recent fear of being "out." A subsequent rally out of these two scenarios would be fueled by investors chasing strength as even in bear market rallies (1938-1939) there is typically more than one leg higher. By contrast, a continued rally would expose the markets to getting overbought once again and would likely serve to threaten equities in late fall/early winter.

Hedge funds bet on Lehman debt

Top hedge funds have been buying up Lehman Brothers’ debt in hopes that the failed investment bank’s estate can win court battles to recover billions of dollars in collateral held by competitors with whom it did business. The bulk of the potential claims stems from JPMorgan Chase’s role as a clearing bank for Lehman in the repurchase – or repo – markets. Lehman borrowed heavily in the repo markets – a practice that left it susceptible to a loss of confidence.

Study looks at differences between institutional and retail mutual funds

Long-only equity strategies may have recouped most of their 2009 YTD losses, but there is little question the past year has left them with a volatility only their mothers could love. The FT reports this week that UK pensions are “paying the price for an equity bias”. Reports the paper:

“…UK company pension schemes are among the most heavily invested in equities when compared with employers based elsewhere. The average allocation to equities was 48 per cent at the end of 2008 - a figure that reflects the collapse in stock markets - and is higher than that in any other country where the private sector accounts for a significant proportion of pension schemes.”

At the same time, Hedge Funds Review points to a survey showing that pensions continue to allocate to equities. Reports the magazine:

“On the issue of active management, 27% said their allocations to active management would be reduced. A further 37% said they would increase their allocations but only if fee terms rewarded actual, not expected, out performance.”

Meanwhile, Pensions & Investments reports that European pensions are actually giving a “cold shoulder” to equities…

“In Germany…where de facto regulations have forced institutional investors to keep very low levels of investment risk, equity exposures have fallen to new lows…In the U.K., equity allocations have fallen steadily since 2003 to 54% of total assets as of Dec. 31, down from 68%…”

Against this backdrop, the Spring edition of the Journal of Investing contains an interesting article by Kent Baker of The American University, John Haslem of the University of Maryland and David Smith of the State University of New York at Albany called “Performance and Characteristics of Actively Managed Institutional Equity Mutual Funds” (available here).

Retail mutual funds are a roughly $10 trillion business in the United States alone. By comparison, institutional mutual funds manage only about $1.3 trillion according to the authors. (Most US institutions opt for separately managed mandates rather than pooled funds for their allocations.)

The authors examine fees and alpha to determine the value added by these funds. But instead of simply using the posted fees for each fund, they use the “active alpha” expense ratio measure developed by Smith’s SUNY Albany colleague Ross Miller (see must-read paper on this topic).

We have written about Miller’s metric several times. Essentially, it measures the fee paid per unit of active management - ostensibly what an investor us actually paying for (vs. the passive component of returns).

When applied to institutional mutual funds, this technique yields similar findings to those of retail mutual funds - fees per unit of active management are multiples higher than posted fees. We created the chart below from Exhibit 2 in the article to show you what we mean:

As expected, the high correlation between most institutional mutual funds and equity markets means that the fee attributable to active management is actually many times higher than the listed rate. This is about the same as a hedge fund with a 1.5% management fee and a 20% performance fee in a year when the total fund return is 10%. Only the hedge fund fee would drop to 1.5% if the return was 0% while the fee for the mutual fund, of course, remains at the same level.

In any event, the authors also find that larger funds outperform smaller ones - and not just because they enjoy economies of scale. Instead, they suggest that larger funds have more institutional investor oversight. Smaller institutional funds, by contrast are “offered primarily to trust accounts and through for-fee financial advisors.”

Finally, and somewhat counter-intuitively, Baker, Haslem and Smith find that large cash balances are associated with higher returns among institutional mutual funds. The causation remains in question, however, as they propose two hypotheses for this: 1) higher cash balances reduce trading friction surrounding asset inflows and outflows, or 2) better returns leads to more inflows and more uninvested cash.

Unfortunately, the bottom line is that institutional mutual funds as a group, fall victim to the same problems as retail mutual funds. As the authors conclude:

“Consistent with previous studies involving actively managed retail equity mutual funds, we find strong evidence that the average actively managed institutional equity mutual fund cannot beat a representative benchmark after expenses.”