Alpha versus beta?

Alpha beta separation? Can't beat beta? Beta based asset allocation is supposedly the driver of returns. Many papers claim that it is almost all that matters. That mistake has dominated conventional wisdom for too long. They reached that sample biased conclusion because asset allocation is what the selected investors focused on. Setting a stock/bond/alternatives mix determines variability of returns ONLY if you emphasize it. It is easy to debunk this portfolio construction "axiom" if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in the plan sponsor's equity. Then we would conclude that security selection drove returns. If investors flipped coins each month to be 100% stocks or bonds then market timing would be the factor. You only have to look at a few conventional portfolios to see that "choose your betas" asset allocation needs NEW thinking. Some say that long term investors should have more in risky assets due to the alleged higher "expected" return. Instead investors would be wise to focus on the alpha/beta weight. For anyone with lower risk tolerances and dislike of deep drawdowns, alpha gets the vote.

The true determinant of superior risk-adjusted returns is investment SKILL not the percentage in different UNSKILLED asset classes. If the "seminal" studies had confined their analysis to high frequency portfolios obviously they would find that ability at high frequency trading drives performance! Is it valuable information to "discover" that asset allocators' returns largely depend on their asset allocation? More importantly EVERY high performing portfolio over the long term focused on alpha so why spend so much time and money on beta?

It's been a great decade for the S&P500. No beta for index fund fans but every day had an opportunity set of 500 fluctuating securities to capture alpha. It was an even better 25 years for the Nikkei. Again no beta but vast alpha was generated from security selection and timing by those with skill. In aggregate, "stocks" can and do underperform "bonds" for decades. 60/40 sounded prudent until rephrased as 90/10 risk. Why have a risk appetite when equity indices fail to compensate with sufficient reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a negative total return with even more risk is absurd.

The more vituperative commentary on hedge funds, the more cash one should invest in alpha vendors. Why tie up precious capital in high risk beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to short sell and buy. Most portfolios are still very beta biased while some investors implement a beta plus alpha model. The INEVITABLE progression is to alpha only which has a superior efficient frontier. I do not understand why investors should surrender wealth to the volatility of long only beta.

Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where the markets are going in the long term but will not take the risk of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen-driven ACTION.

Alpha/beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/9. That was the error inherent in the awful portable alpha idea. It was a beta-centric way of getting people into hedge funds but failed because it kept asset allocation front and centre. It diluted the absolute return attribute and changed it into a relative return enhanced index product. The alpha/beta separation framework still has too much risk budget in beta. Why bother with beta at all? Cheap beta is expensive considering its risk. Risk and cost conscious investors favor alpha.

Successful investing is about leveraging your informational, structural and analytical advantages or outsourcing to those that do. Let's look at some portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the high frequency trading of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Munehisa Honma's managed futures fund specialised in trading one security in multiple time frames. Producing alpha depends on the knowledge and technology edge being applied to the appropriate time horizon.

Beta bets drive most portfolios because that is what most investors do. It is like the people who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance! It is false logic similar to the "all swans are white because every swan I encounter is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its weakness. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? Beta people like index funds because they want you to invest in "the market". But the safest way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't time and outsource security selection to benchmark construction firms. They stay fully invested even in bear markets! A beta-centric portfolio is where investors decide a policy or strategic asset allocation and then look around for managers to basically deliver the return from that asset class and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when RISKY beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities over numerous time horizons within and between asset classes. An alpha centric portfolio is where investors hire managers to analyze, trade and hedge. Of course you have to be very good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with any beta. Dismissing all hedge funds is like avoiding all stocks because of Enron, Worldcom and Nortel. Don't invest in fixed-income because some bonds default?

Naturally pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think the "market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want "hedge funds" that outperform? No. I want hedge funds that make money which is a different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity/credit/real estate connection to the economy. I am not concerned whether a hedge fund manager's strategy is "market neutral" or not. But they MUST be able to deliver absolute returns that are "economy neutral".

Alpha is the TRUE diversifier because there are so MANY different ways of generating it. Focus on alpha if you want reliable performance regardless of the economy. Why pay attention to asset classes when investing in different SKILL-BASED STRATEGIES makes more sense? For the risk averse conservative investor alpha and beta is inferior to an alpha only portfolio. And leave the speculators to their beta only bets.

A steeper path to follow

Sovereign debt yield curves are steepening.

On Thursday, US 30-year yields hit four-month highs after a government long-dated auction received poor demand and revived worries over the federal budget deficit.

With reason. Outstanding Treasury debt currently looks like this:

In fact, according to Bloomberg, the Treasury yield curve has now hit its steepest since at least 1980. Here at least is how today’s curves compare to those in 2007.

As they stand today:

And how they stood two years ago:

And for those interested to see how US liabilities have been dispersed, here’s the current distribution of US public debt according to TreasuryDirect:

The death of sec lending in prime brokerages?

Dec 7th, 2009 |

The world is full of middle-men: Walk into a car dealership to purchase a car and you go through a salesperson, who takes a cut for showing you the car; walk through a house or apartment and the real estate broker takes a cut for opening the doors and closets.

Like it or not, and as counter-intuitive as it sometimes may be, it is the way transactions work.

So it’s been with the securities, or “sec” lenders: institutions that have access to “lendable” securities. Asset managers who have securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian have for years taken a nice slice of the pie to lend back out stocks to others who need them.

In its most basic form, sec lending is where a loan results in a transfer of title/ownership to the borrower, who is obligated to return the same type and amount of securities. The loaned securities are collateralized, typically 102-105%, reducing the lender’s credit exposure to the borrower (as illustrated in the chart below provided to AllAboutAlpha.com by automated securities lending and borrowing marketplace Automated Equity Finance Markets (AQS) – click to enlarge).

When the banking and financial systems were functioning normally, all of this was considered par for the course. Indeed, for long/short and short-only hedge funds in particular, the ability to go to their prime broker for their sec lending needs was a value-added proposition not even questioned.

At least until Bear Stearns blew up, Lehman Brothers was allowed to go bankrupt and all H-E-double-hockey-sticks broke loose, bringing into question for the first time the notion of whether too big to fail – and too big not to be concerned with the physical securities your prime broker was lending back out to someone else at a profit – were going to get taken away from you.

It was this kind of talk that dominated the Securities Lending Debate produced by consulting firm Finadium and Markets Media and held in New York last week as part of Markets Media’s Global Markets Summit.

Among the many key points of debate: the use of multiple primes, the need for speed, liquidity and premium pricing in the form of new, accessible platforms, the notion of “bundled” services for hedge funds and the concept of “central” borrowing – literally going back to the old five-day settlement cycle, where all securities going through a central clearing house get settled within a specific period. Also of note, sec lending spreads are still at historically wide standards, meaning there is still profit to be made in lending out securities (as the data below collected by Finadium shows):

But by far the most contentious point of debate were projected changes in prime brokerage – in the sec lending food chain, that is – and what will inevitably mean fundamental changes in the prime brokerage business model.

“I think it’s going to be a significant trend for 2010,” noted Josh Galper, Finadium’s managing principal, who opened up the forum at the Waldorf Astoria hotel last week and hosted the event. “I can see at this time the development of two separate markets: hedge funds borrowing securities lending from prime brokers versus hedge funds engaging in borrowing from electronic markets and other non-prime broker dominated venues.”

Galper said that driving the anticipated trend will be hedge funds who want to go to lenders directly, rather than finagle with their prime brokers. Also driving the trend will inevitably be regulatory oversight of both sec lending and short selling, with the SEC and others recasting rules concerning leverage, margin requirements and how over-the-counter derivatives and other instruments are viewed and regulated.

Of course, speculating on how the sec lending and prime brokerage businesses pan out over the next few years is all about what part of the industry you reside in. For their part, the prime brokers aren’t going to walk away from something that provides both value-added and makes them additional money. At the same time, non-prime broker service providers, in particular custodians and others who are either getting into or expanding their sec lending game, aren’t about to throw away an opportunity either.

There are also new ways to skin cats, so to speak — ways of doing the long/short game that so far only third parties and less-known markets can accommodate.

One thing is for sure: the Lehman debacle – in particular the Lehman UK debacle – has made the entire alternatives industry re-think how it looks at sec lending, and how best orchestrate it safely, securely and cost-efficiently.

The prime brokers that offer it up as value-added service at competitive rates likely won’t have much to worry about. The only thing they’ll need to get used to is some additional competition.

Barrick shuts hedge book as world gold supply runs out

Aaron Regent, president of the Canadian gold giant, said that global output has been falling by roughly 1m ounces a year since the start of the decade. Total mine supply has dropped by 10pc as ore quality erodes, implying that the roaring bull market of the last eight years may have further to run.

"There is a strong case to be made that we are already at 'peak gold'," he told The Daily Telegraph at the RBC's annual gold conference in London.

"Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore," he said.

Ore grades have fallen from around 12 grams per tonne in 1950 to nearer 3 grams in the US, Canada, and Australia. South Africa's output has halved since peaking in 1970.

The supply crunch has helped push gold to an all-time high, reaching $1,118 an ounce at one stage yesterday. The key driver over recent days has been the move by India's central bank to soak up half of the gold being sold by the International Monetary Fund. It is the latest sign that the rising powers of Asia and the commodity bloc are growing wary of Western paper money and debt.

China has quietly doubled holdings to 1,054 tonnes and is thought to be adding gradually on price dips, creating a market floor. Gold remains a tiny fraction of its $2.3 trillion in foreign reserves.

Gold exchange-traded funds (ETFs) – dubbed the "People's Central Bank" – have accumulated 1,778 tonnes, making them the fifth biggest holder after the US, Germany, France, and Italy.

Ross Norman, director of theBullionDesk.com, said exploration budgets had tripled since the start of the decade with stubbornly disappointing results so far.

Output fell a further 14pc in South Africa last year as companies were forced to dig ever deeper - at greater cost - to replace depleted reserves, not helped by "social uplift" rules and power cuts. Harmony Gold said yesterday that it may close two more mines over coming months due to poor ore grades.

Mr Norman said the "false mine of central banks" had been the only new source of gold supply this decade as they auction off reserves, but they are switching sides to become net buyers.

Barrick is moving fast to wind down the remaining 3m ounces of its infamous hedge book over the next twelve months, an implicit bet on rising gold prices over time.

Mr Regent said the company had waited too long to ditch the policy, which has made the company enemy number one among 'gold bug' enthusiasts. The hedges oblige Barrick to deliver part of its gold into futures contracts set long ago at levels far below today's spot prices.

The strategy worked well in the falling market of the 1990s, but has cost the company dear in lost profits this decade. "Hindsight is always 20/20," said Mr Regent, who was appointed from the outside earlier this year.

Barrick bit the bullet in the third quarter, taking a $5.7bn charge against earnings on hedge contracts. Liberation is at last in sight. In 2001 the hedge book topped 20m ounces.

Mr Regent said the hedge policy has weighed badly on the share price and irked investors, becoming a bone of contention at every meeting. The financial crisis brought matters to a head as markets fretted about counterparty risk. "It was clear to me that there were a significant number of institutions who wouldn't invest in Barrick because of the hedge book," he said.

Barrick produced 1.9m ounces of gold last quarter, down from 1.95m a year earlier. Costs have been "trending down" to $456 an ounce, though rising energy prices pose a fresh threat. Total reserves are 139m ounces, far ahead of rival Newmont Mining at 86m.

The hedge book venture has not been a happy one, but those who predicted that Barrick would eventually "blow up" on its contracts may owe the company an apology.

IMF: Dollar Carry-Trade Creating Bubbles Around The World

The International Monetary Fund (IMF) highlighted the fact that low interest rates in the U.S., plus an apparent "one-way" bet against the dollar has created a global dollar carry-trade that is driving capital flows into emerging markets.

If not handled properly, this will lead to emerging market asset bubbles, which arguably have already begun to inflate.

We've highlighted before how places like Hong Kong are seeing property prices go through the roof due to low U.S. interest rates.

The fact that the IMF is increasingly vocal on the subject suggests that this process is really starting to become quite substantial phenomenon in many countries.

IMF: There are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the euro and some emerging economy currencies. Emerging economy authorities have been responding to capital inflows by accumulating reserves, and, in some cases, with capital controls and other measures, to slow the pace of appreciation. Capital flows driven by yield differentials are complicating monetary policy responses in those economies where there may be a need to tighten—particularly in Asia.

...

Some emerging economies may need to absorb capital inflows and at the same time avoid compromising domestic financial and price stability. With interest rates in advanced economies set to remain low for an extended period, and emerging economies poised to recover at a faster pace, the recent flow of capital into these economies may continue.

Read a PDF of the IMF's recent report here.

Stock Market Returns Lost in Translation

One of the side effects of a weaker dollar is that the returns for foreign investors who invest in US assets are diminished. While the value of the asset may rise in dollar terms, if the dollar is losing value, the investor takes a hit when they convert their funds back into their domestic currency. For example, while the S&P 500 has risen 20.2% so far this year in US dollars, investors outside of the US have generally seen much less impressive returns. In the table below, we looked at the YTD returns of the S&P 500 for investors in various currencies. Of the currencies we looked at, the only one that has seen a benefit from the currency translation is the Argentinian Peso. Returns have been diminished once fluctuations are taken into account for all other currencies. And of course some countries have been affected more than others. So far this year, Brazilian investors who bought the S&P 500 at the end of last year have lost nearly 12 reals for every 100 they invested on January 1st.

Short Seller: Dump Munis

By TOM SULLIVAN | MORE ARTICLES BY AUTHOR

A short seller sounds an alarm over states' deficits -- and bonds. Muni managers demur.

JAMES CHANOS, THE FAMED SHORT SELLER who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market -- in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron's staffer Susan Witty, adding that he wouldn't touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It's not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It's all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state's bonds will likely lose their federal tax exemption, he adds.

He didn't mention New York, but he could have. Gov. David Paterson and the state legislature, controlled by the governor's own Democratic Party, are playing a game of chicken about where to find budget cuts to address a soaring deficit now estimated at $3.2 billion. Paterson has also warned that the state could run out of money to pay its bills before the end of the year.

Neighbor New Jersey faces an $8 billion structural deficit next year -- one reasons the normally blue state's voters elected Republican Chris Christie as governor last week. Ex-Governor James McGreevy had bonded for current-account expenses before he resigned, and the bonding was stopped by the state's courts. His Democratic successor, former Goldman Sachs honcho Jon Corzine, promised property-tax relief to the middle class but couldn't deliver, and therefore got the boot.

Given the scope of the problem, "munis are a bad bet," says Chanos.

But some muni asset managers beg to differ: "In the history of the market, going back to the Civil War," there have only been very isolated defaults, says Tom Spalding, senior investment officer at Nuveen Asset Management, with $63 billion of munis under management.

Chanos' retort: "Just because it hasn't happened doesn't mean it won't."

Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management, with $6 billion in munis, says municipal governments, "are in the business of building public projects." To do that, they need access to the capital markets.

Yes, there's headline risk and there's downgrade risk from the credit-rating agencies, says Pollack. "But municipal governments have broad fiscal powers to balance the budget" to meet their payments in a timely fashion.

Moody's chief economist John Lonski says that "2010 will be the year of tax increases by local and state governments to close budgetary gaps."

Read his lips.

THE LATEST EMPLOYMENT DATA, released Friday, showed that the unemployment rate topped 10% (hitting 10.2%, to be exact) in October. That's the first time it exceeded 10% in 26 years.

"You can't doubt the impact of 10% on consumer behavior," especially given the record 5.4% drop in third-quarter employment income, which was first tracked in the 1950s, says Lonski. It also couldn't come at a worse time, just ahead of the holiday shopping season.

Retailers have braced for the worst. The unemployment rate for U.S. retail companies jumped to 9.9% last month, its highest level in the current recession, from 9.2% in September. Some 40,000 jobs were lost.

As for the near-0% interest-rate policy of the Federal Reserve, which it reaffirmed last week, "it would be premature to brace for the inevitable hike in fed funds," says Lonski. He doesn't see rates rising until August 2010 "at the earliest."

That's because the Fed doesn't see the private sector leading the recovery without the Fed's own stimulus programs, and those of the U.S. Treasury. "The Fed is very much concerned about the sustainability of the recovery," he says.

LONG TREASURIES AT FIRST rallied on the unemployment news, including a 190,000 drop in October's payrolls and a revised 219,000 decline in September, but pulled back ahead of this week's humongous supply.

The yield on the benchmark 10-year Treasury note ended the week at 3.50%, up from 3.38% the week before, as Treasury prices, which move inversely to yield, lost ground.

The Treasury Department is scheduled to sell $40 billion in three-year notes, $25 billion in 10-year notes and $16 billion in 30-year bonds as part of the refunding supply to raise cash for the fourth quarter.

Treasury won't have a major buyer this time, as the Fed last month completed its $300 billion Treasury-purchases program, essentially a policy of printing money.

One final note about the employment picture, and it's a positive one: The number of U.S. workers filing new claims for jobless benefits fell in the latest week (ended Oct. 31) more than economists expected -- by 20,000, to 512,000. That's the lowest level since Jan. 3. Economists anticipated a drop of just 5,000, according to Dow Jones Newswires.

The four-week moving average of new claims fell by 3,000, to 523,750, the lowest level since Jan. 10.

"Jobless claims are the best leading indicator" of where the employment picture is heading, says Lonski.

Bond Supply Looms: U.S. government securities were under pressure last week, despite unemployment moving above 10% for the first time in 26 years, as the Treasury Department readied a record $81 billion in new supply for this week.

Current Pullback: S&P Performance Based on Beta Deciles

While it's not surprising, the highest beta stocks are getting killed during the current pullback. As shown below, the 50 stocks in the S&P 500 with the highest betas are down 8.72% since 10/19, while the 50 stocks with the lowest betas are only down 2.11%.

Small Caps Stumble

While the S&P 500 is testing its 50-day moving average today, the smallcap Russell 2,000 looks much worse. As shown below, the Russell 2,000 failed to make a new high along with the S&P 500 earlier this month, and today the index broke below its lows from late September/early October. With the index now below its sideways trading range from the last couple months, the trend looks to be down.

GLD’s mysterious disappearing gold-bar list

There have been some strange goings on in the world of ETF gold bar holdings of late.

Gold bug extraordinaire Professor Antal Fekete shines a light on the case of the SPDR GLD specifically –the largest of the gold-backed ETF funds in the US in terms of money managed. In a report published about two weeks ago Fekete notes the fund’s listed bars shrank rather mysteriously as of October 2.

As he explained:

Another story is about GLD, a leading gold ETF, which publishes its bar-list every Friday at the close of business, reporting the serial number of every bar in inventory. The list is customarily well over a thousand pages long. But, lo and behold, on Friday, October 2, and on Friday, October 9, the bar-list shrank to a mere couple hundred pages, with no explanation offered.

The equally gold-buggy Rob Kirby writing in Market Oracle blog, meanwhile, offered a little more detail on the actual discrepancies:

# on Friday, Sept. 25 — the list was 1,381 pages long
# on Friday, Oct. 2 — the list was 208 pages long
# on Friday, Oct. 9 — the list was 195 pages long
# then, on Wednesday, Oct. 14 — after questions were being raised about the strange machinations with the bar list in chat rooms on the internet — the list was back up to 855 pages long.

The latest October 23 list, though appeared to return to more normal proportions running at some 1291 pages.

So what gives? To be honest, we’re not really sure.

To shed some light, we tried contacting GLD’s marketing agent State Street Global Markets, but haven’t as yet had a definitive reply.

While we wait for one, however, we shall point out that on October 16 the CME exchange group announced that from October 19 it would allow gold to be used as collateral on margin accounts in all its markets as an alternative to debt or equities. According to the CME the move came “in response to customers’ wish to use their gold holdings more efficiently.”

The CME also said that on an initial basis it would use JP Morgan Chase as the only custodian for gold deposited as collateral with the exchange, making the bank one of the key beneficiaries — especially in the event it happened to be in any way short of allocated gold.

JP Morgan, by the way, happens to be a GLD authorised participant, as well as the second largest holder of GLD shares according to SEC filings as monitored by Bloomberg:

The Merrill Lynch High Yield Master II Index, often used when assessing the
state of the broad High Yield market, suggests that Junk bonds have returned
a whooping 51% year-to-date, thereby outperforming the SPX by a cool 29%.



I am notoriously sceptical about indices (reasons include geometric returns
versus dollar weighted returns, index inclusion/exclusion problem, changes
in share of CCC rated paper, etc). Looking at High Yield mutual fund indices
only partly solves such issues as these indices have their own flaws but f.i.
Lipper's HY index ytd return was in the low 40's and thereby almost 10
percentage points (so actually 20%) lower than the Master II's.

Mid August 2008 was the time when the HY market started its bold down
move of -31% in less than three months.


Since that same August 2008 the ML index recovered and has eventually
returned roughly +14%, indicating that everyone in HY land should be well
ahead of their high water marks (which I doubt) and have outperformed the
SPX by 28% during that time.


Issuers went into this period with very high leverage and during that same
period reported earnings plunged to a degree not seen seen since 1871
(by 99%, that is), with y-o-y industrial production at -10.7%, y-o-y retail sales
down -5.3% and capacity utilization at 66.6%.

Defaults have so far come in somewhat below consensus expectation but some
issuers just had their chance to buy some time by extending their maturity
profile selling new crap debt, some did exchange offers and/or were able to raise
some capital. However, things don't nearly look as good as indices may suggest in
my view.

So here is my conundrum, which is actually two-fold:

1) High Yield indexes show stellar performance (even those including only
investable mutual funds, such as Lipper), implying investors in HY land
should be well ahead of their high water marks. Is that actually the case?
And if it is not - which I assume - where has all the positive index performance
come from?

2) A very serious deterioration on the operations front meets a return of some
+14% for the asset class since August 08. Why is it the case? Looks like the
markets are incredibly confident they can buy themselves out of the doldrums.

Not sure if these questions best be addressed by micro- or macro economists
as the former seem to be mostly wrong on particular things with the later being
just as wrong in general.

David P. Goldman has an excellent post, which makes it crystal clear why we saw a housing bubble and the explosion dicey AAA-rated CDOs that caused so much hurt when it all went bust.

No, it wasn't Wall Street greed. As we've seen others put it, blaming greed for Wall Street's collapse is like blaming gravity for a plane crash. It's not an answer.:

Every sort of idiotic expanation is offered by academic economists for the financial crisis. Explaining the crisis has become a major industry. The academics by and large haven’t a clue. Grass might as well grow where their classrooms now stand. Wall Street greed and absence of risk management was the usual answer. That’s silly. The investors who bought subprime assets in 2006 weren’t any greedier than when they bought prime assets in 2004. The difference is that monstrous demand crushed the returns on prime assets.

Uh-oh. This sounds a lot like Alan Greenspan's "Savings Glut" idea. And since we all know that Alan Greenspan must be a total idiot eager to unload any blame for the crisis, it just can't correct.

But let's carry on. Here's a research note he wrote for Cantor Fitzgerald in 2006.

In C.S. Lewis’s “Screwtape Letters,” an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialize, absolute yield levels remain low, and investors enhance returns through leverage.

Investors are not piling into levered synthetic BBB structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth. Investment banks are selling AAA-rated synthetic CDO principal with coupon indexed to the performance of the equity tranche, like the old range accrual notes that brought down Orange County in 1996. Trust Preferreds, REITs, Chinese loans, home equity and a wide variety of other assets have entered the lists of CDO collateral.

That phenomenon, combined with excess savings from Asia -- again, with the same mission of finding yield -- spurred the insane creation of all these structured products.

This chart shows the inverse relationship between foreign purchases and spreads on agency debt. The greater the demand from Asia, the cheaper funding became, and the more mortgages they could write.

He has other charts showing a similer phenomenon. Cash coming in from overseas depressed rates on everything.

As he ominously concludes:

The financial crisis may have calmed down, but the sources of the crisis remain unchanged: the industrial world is unable to fund the greatest retirement wave in history at current returns. Everything that seems to offer yield turns almost instantly into a mini-bubble. This time, as I’ve argued, it’s the “troubled assets” that TARP was supposed to take off banks’ books. They have doubled in price during the past three to four months, just as losses are starting to creep up.

This is all see-able now. Demand for junk, as we've noted several times, is off the charts. And the toxic assets held by the banks, as he notes, have soared. It's hard to imagine a solid, compelling investment not immediately soaring to the moon (followed by a crash) in this environment.

This is also a reminder of how silly and counterproductive the Washington theatrics, and the outrage about bonuses and greed are. They're not the issue, and limiting them won't accomplish jack.

You blinked and you missed it! The best for distressed has apparently come and gone

For several years leading up to the big Credit Crunch of ’08, experts and pundits alike were pointing to hedge funds focused on the distressed market as the next group in line to clean up.

Yet time and again it never seemed to really happen; through the subprime crisis in the summer of ’07 and through the first round of the credit crunch, expectations were that buying up virtually every kind of distressed security would be an easy, no-brainer windfall.

Boy was that an understatement.

Of course, 2008 wasn’t great for distressed guys either, but as the rest of the world focused on trying to keep ahead of the game in ‘09, distressed-focused shops were out there grabbing loot.

Stuart Kovensky, co-COO of New Jersey-based Onex Credit Partners, a distressed debt shop, told attendees at an AIMA luncheon last Thursday that the opportunities this year have been “fantastic”.

“In 2009 we bought debt at fantastic prices – because people had to sell,” noted Kovensky, who along with financial newsletter notables Dennis Gartman and Scivest Capital’s John Schmitz participated in a panel discussion on what’s next for the economy, financial markets, and, of course, hedge funds.

In terms of the amount of distressed debt available at bargain-bin prices, “the sponge – the cash out there – wasn’t big enough to absorb it,” Kovensky said.

The reasons are fairly obvious: starting with the U.S. housing market collapse, which in of itself has generated distressed opportunities, and expanding into other areas as the U.S. and global economies recoiled.

In turn, the amount of defaults and accompanying opportunities to take on unwanted, undervalued, unloved debt have skyrocketed, said Kovensky, who with Gartman and Schmitz tackled everything from the end of the leverage-driven era to why the profit cycle and economic cycle have zero correlation.

Among Kovensky’s firm’s crowning achievements, he says, was buying Las Vegas Sands’ Tier 1 debt at 38 cents on the dollar, backed by the company’s real estate assets. Their year-to-date returns: up more than 48% — more than souble the 22.58% average through September, as measured by Barclay Group in the snapshot above.

But according to Kovensky, the party is already over. While deleveraging is still clearly underway, fire sales are less common as companies find different ways to restructure their debt.

While that still spells opportunity, “it won’t be anything like this year.”

Chapters 22 and 33

There may be opportunity in repeat offenders this year though. A new study by distressed debt guru, professor Ed Altman of NYU (see related posts) says that the number of companies that emerge from bankruptcy only to go back into it (via “Chapter 22″) is growing. According to data cited by Altman and colleagues Tushar Kant and Thongchai Rattanaruengyot even find some companies scoring the mythical hat-trick of bankruptcies (or so-called “Chapter 33″).

Altman concludes that his ubiquitous Z-Score can be used to predict the likelihood of a company slipping back into a coma.

This suggests that the party may not be quite over for distressed debt funds. In fact, Onex last week unveiled that it is planning an IPO of Kovensky’s fund, called the OCP Credit Strategy Fund, giving retail investors the chance to buy a piece of the longer-term payoffs it hopes to achieve.

You blinked – and you missed the distressed debt party. But the after-party is looking like it could be fairly sweet too.

The price of cash

The old-fashioned folding stuff has become the global benchmark of value, according to Jan Loeys of JP Morgan.

Painful as it maybe for the likes of David Rosenberg, the “expensiveness” of cash is forcing up the price of virtually all other assets — and the JPM global asset allocation team reckon that as long as the return on cash remains pegged near zero, and investors continue to see uncertainty falling, money will keep flowing from cash into positive yield assets.

Loeys reckons that trying to use historical returns to place an outright value on such assets is a waste of time. As the strategist declares in the latest edition of the JP Morgan View:

Cash, as the hinge of the risk-return curve, has become the global benchmark of value. If the return on cash does not move, then other assets’ values need to fall in line with the expensiveness of cash.

Here’s the effect in chart form - a risk-return trade-off line for US assets that has just become flatter and flatter:

Here’s the international effect, across assets:

Irving Fisher - Debt Deflation and Depression

As published in 1933:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress selling and to
2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4. A still greater fall in the net worths of business, precipitating bankruptcies and
5. A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make
6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7. Pessimism and loss of confidence, which in turn lead to
8. Hoarding and slowing down still more the velocity of circulation.

   
   

   The above eight changes cause

   
   

9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Direct Link

(incidentally, file is hosted at stlouisfed.org)

THE MUTUAL FUND INDUSTRY – INVESTORS DESERVE BETTER

12 October 2009

I was shocked to see the front page of Barron’s with the image of investing legend Bill Miller titled “He’s Back! - It’s Miller Time”. The article says Miller is back at the top of his game after a disastrous 2 year run. A closer look at Miller’s fund and the mutual fund industry actually shows a pervasive and destructive problem on Wall Street - a total and complete lack of risk management.

The Barrons interview claims that Miller’s fund is worth taking a look at again. Miller himself even says that his patient investors have been rewarded:

“The shareholders who stuck with us believed in our process and have seen us underperform; it has happened before,” Miller told Barron’s in a recent interview. At least “we built up large tax-loss carry forwards, which will mean no capital-gains taxes, which may go up.”

In 2007 Miller lost 6.7% and then lost an astounding 55% in 2008. His fund is up over 36% this year. $100,000 invested with Miller over the last two years would leave you with roughly $60,000 today. Glad you stuck with Miller? Miller goes on to claim that his performance this year is due to superb risk management:

But this time was different. “This turned out to be a collateral-driven crisis caused by underperforming debt,” also known as toxic assets, Miller says. “We’ve analyzed that mistake and tried to make adjustments to risk management and the portfolio-construction process.”

Risk management? Hardly. Read on….Bill Miller is infamous for supposedly outperforming the S&P 500 for 15 straight years. He has made hundreds of millions of dollars due to this performance and essentially built the Legg Mason brand by himself. But a look under the hood shows a massive Wall Street problem. See, Miller is a part of an industry that has been proven to underperform a standard index fund (more than a handful of studies show that over 80% of all mutual funds underperform a comparable apples to apples index).

What mutual funds like Miller’s do is this: they come up with fancy sounding names that give investors the impression they are investing in one thing when in fact they are investing in an index fund clone – meanwhile, they charge you 1-2% more than the index and more often than not, they underperform that index. Miller’s Legg Mason “Value Trust” is a great example. You hear “Value Trust” and you think “ahh, value investing – isn’t that the super safe strategy that Warren Buffett uses?” Well, not exactly. Miller’s fund, like many funds, isn’t exactly a value fund. In fact, at times it is highly aggressive and more comparable to a growth fund. Many of his largest holdings are classic high beta names – Google, Ebay, etc.

Let’s dig a little deeper. What investors don’t account for is risk adjusted returns. You hear “Value Trust” or “Large Cap Blend” and you think it’s safe to do an apples to apples comparison with the S&P 500, right? Wrong. Miller’s fund actually has atrocious risk adjusted returns. His fund has returned 6.8% since inception which is actually slightly worse than the 8% return of the S&P 500 during the same period. To be fair, let’s cherry pick the years and see what we get.

I ran a regression on the last 17 years of performance (in order to include many of Miller’s best performing years in an attempt to overweight the positive results). The results speak for themselves. In a period where the S&P 500 averaged a standard deviation of 21 Miller’s fund averaged 27.5. His 8.4% return during this period sounds remarkable compared to the S&P’s 5.5% return, but the end result of a Sharpe ratio of 0.34 is actually less than impressive. In fact, it proves that Miller is adding little to no value for his investors after you account for risk. I also obtained results using slightly more aggressive future return assumptions. The conclusions are the same. (I should also add that I chose to run a Sharpe ratio over a Sortino ration because Miller’s fund over the period had a fairly balanced level of positive and negative volatility.)

I don’t mean to pick on Miller, but he represents a much larger problem with the current investment world. The Barron’s article is highly misleading and makes the same mistake that most investors make when picking a fund – they don’t actually look under the hood. They just drive the car off the lot and assume that because the MPG and price looked good then the engine must be better than most.

Funds like these are almost always a poor choice over a standard index fund. There are only a handful of funds that actually exercise true risk management and have proven that their performance is better than flipping coins. The problem with this business is that there are more than $26 trillion invested in mutual funds. This means a staggering amount of assets are held hostage to higher fees and poor performance. Many of these assets are in retirement plans where unwitting investors have no choice but to invest in a high fee perennial group of underachievers. Why hasn’t the business evolved beyond this after so many reports have proven that the mutual fund business underperforms?

The financial crisis has unearthed some serious problems with Wall Street and this one shouldn’t be overlooked. The big fund companies are no different than the big banks. They are in the pockets of the insiders, the government and the corporations. As a result the loser is the taxpayer and the little guy. Investors have options in today’s evolving investment world and they deserve to have their hands untied and the gun removed from their temples. Why does this industry continue to wield so much power over the investment world? Investors deserve better.

Sources: Barrons, Morningstar

Asset allocation?

V. Allen -

Asset allocation? The "endowment model" was once seen as the "solution" for how to invest for the long term. Sadly as some universities have found out to their cost, the model was flawed and overexposed to a bad economy. It was heavily long biased, higher risk and not hedged. Despite being asset diversified, it was insufficiently strategy diversified. The ONLY thing to overweight in a portfolio is alpha; not beta and certainly not illiquid alternative betas. A dynamic investment universe cannot be optimally navigated with a static or occasionally rebalanced asset allocation. A bad economy needs a good portfolio.

Economic fluctuations ought not have a deleterious effect on portfolio growth or asset/liability matching whether you have $1,000 or $1 trillion to invest. Many long term investors forgot that they still need SHORT TERM cash and income. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture and adapt to the changing inefficiencies that the market ALWAYS makes available. Why commit so much to 10 year lockups and ongoing capital calls when there is vast alpha available in liquid markets? The OPPORTUNITY cost from overweighting illiquidity was very expensive. And where was the scenario analysis and stress testing to construct a TRULY robust portfolio? When liquid assets sneeze, illiquid assets catch pneumonia.

The percentage in marketable alternatives (hedge funds) was too low while the allocation to long only non-marketable alternatives (private equity, real estate, real assets) was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. The alternative assets weren't very alternative. While you can generally short sell liquid securities, not so with illiquid assets. Non-marketable alternatives still have to be marked to market. The bid-offer spreads on private equity secondaries are wide.

A bear market is no excuse for a fund manager to lose money. Hoping to be compensated for risk is dubious. Expecting to also be compensated for illiquidity is doubly dangerous. Of course the endowment model was better than the obsolete 60/40 stocks/bonds or the "(100-age)% in stocks" pabulum that many people still get sold. But it had no chance of achieving what most endowments, foundations, pension plans, sovereign wealth funds or individual investors actually want. Consistent returns with capital preservation at minimal risk and maximal liquidity EVERY year. For that you need to hedge. And a proper strategy diversification NOT asset allocation.

A long term investor still needs short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Odd how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! The long term investor also cannot ignore short term volatility. Universities using the endowment model might survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met, capital projects funded at the same time as alumni contributions reduce due to the economy.

Many illiquid assets like private equity or real estate give the "appearance" of low volatility because they are valued less frequently. This also leads to a supposedly low correlation to public markets. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy. While liquid security correlations infamously tend to 1 in down markets, that situation is exacerbated with illiquid assets as they can't be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. But their dependence on a good economy was obvious ahead of time.

Real estate has been around a lot longer than stocks and bonds. It is not an alternative investment and relies on economic growth and lots of leverage. Real assets? Long only commodities is an even stranger idea than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading makes more sense. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets over the long term. Gold and cocoa may be at highs while I am writing this but they are trading vehicles NOT long term investments. Inflation? That's what TIPS and inflation derivatives to hedge are for.

Constructing the true All Weather Portfolio requires preparing AND hedging for short term tornados or long term economic ice ages. The endowment model carried almost no insurance against a bad market climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And more attention to proper risk management, not basic VaR and cVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring.

Despite all the exotic beta, there was still a large implied bet on a good economy of rising stocks, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be compensated for taking higher risk. But despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time horizon. Replacing long only public equity with long only private equity was asking for trouble. Private equity is a misnomer anyway; the correct term is private debt with a little equity.

I don't believe in asset allocation. The world has moved on in financial engineering and innovation. As a conservative long term investor I favor strategy diversification and hedging. It works if you know what you are doing. Adapting to market conditions and achieving a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and therefore cannot be fitted into an asset allocation methodology. The only thing to overweight is SKILL not assumed risk premia. Investor wealth should be protected AND increased regardless of the economy.

SocGen: China bigger bubble than Japan

Superb analysis out of SocGen analysts this morning. Dylan Grice says the Chinese economy has many similarities to the Japanese economy before it imploded in the 90’s. He cites 8 reasons why the Chinese economy is likely to be an even larger implosion than the Japanese economy:

Studying the lessons from Japan’s lost decade(s) is key for anyone seeking to understand today’s post-bubble world. But a closer reading of Japan’s financial history illuminates today’s China far more. In the early 1980s, on the eve of its financial liberalisation, Japan was the rising power from the East set to overtake the West. Younger and growing rapidly, it was still a decade away from its climactic and catastrophic bubble peak. This is where China is now.

• Japan’s deflationary experience since its bubble burst haunts policy makers and investors, who are confronted with a bewildering range of theories explaining what has gone wrong and how a similar scenario can or can’t be avoided.

• But the real cause of Japan’s deflation is probably more demographic than debt-related. If so, maybe we should be more worried about the side-effects of an ongoing stimulus overdose aimed at reviving the dead, rather than fighting a more ordinary bout of flu.

• Japan has been the first industrial economy to begin demographic contraction. Indeed, thanks to Deng Xiaoping’s 1979 one child policy, China will soon face the same problem.

• But it is unlikely China will suffer the same immediate fate. In fact, further reflection on the similarities between China and Japan leads one to realise that many of the challenges confronting China today have already been faced by Japan, demography being only one.

• From the strained currency diplomacy to the accusation of favouring exports over domestic demand, from the Western marvelling at Confucian capitalism to the sense of inevitability about the rising of a great power in the East … all were as true for Japan 30 years ago as they are of China today.

• And Japan 30 or so years ago might be a more fruitful analogy altogether. There is a clear historic coincidence of manias and geopolitical shifts. In the 1980s, Japan’s developing financial bubble reflected a shifting of the balance of power in its direction.

• But the geopolitical shift towards China now underway dwarfs that seen in Japan in the 1980s, and probably anything yet seen in the history of the modern world. A commensurately seismic mania would lead to excesses beyond all proportion to the periodic bouts of frothiness seen so far.

• Japan’s experience also hints at what may be the future catalyst unleashing this frenzy: capital account liberalisation. Financial history is filled with financial liberalisations gone wrong and Japan’s bubble can be traced directly to the removal of controls on international capital flows and banking in the early 1980s. Seeking a larger international role for the renminbi, China is now, albeit tentatively, embarking on a similar path. Full liberalisation, when it occurs, could be the starting gun for the biggest bubble the world has ever seen.

Source: SocGen

Hedge-Fund Bets On Hyperinflation

Several sources are reporting on hedge fund Hayman Advisors, L.P.'s latest letter to its clients (via The Pragmatic Capitalist), explaining its latest investment strategy. The hedge fund received attention for having made a killing as the housing bubble popped by betting against subprime mortgages in 2007. As a result, many now heed its managers' economic views. Their latest prediction is somewhat controversial: the U.S. may experience hyperinflation.

Let me take a step back. Many people think that inflation will follow the massive government stimulus (both fiscal and monetary) that responded to the recession and financial crisis. That's not notable. But hyperinflation is a sort of extreme doomsday scenario. That would mean inflation in the ballpark of 30% per year -- at least. Generally hyperinflation is measured by the month or day, not year, because the numbers are so high.

This section from the letter describes the quantitative basis for the hyperinflation worry:

There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

According to the current Office of Management and Budget ("OMB") projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010 with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. One has to ask whether the US reached the critical tipping point?

This is an interesting point, because it's a hyperinflation argument that doesn't seem wacky -- it's rooted in historical observation. And it also has nothing to do with the massive monetary stimulus by the Federal Reserve, which could cause additional inflationary pressures. So even if you believe that the Fed can control their side of the equation, the government spending might still cause inflation to get out of hand, according to the logic presented above.

I remain skeptical, mostly because the U.S. has a more robust, developed and sophisticated economy than most places where hyperinflation has occurred. I find it very hard to believe that fiscal and monetary policy wouldn't be seriously altered to avoid incredible levels of inflation if the U.S. found itself facing such a predicament. Still, successfully keeping inflation as low as it has been in recent years seems unlikely.

So what's the fund management's strategy? They're investing in mortgages and high-yield debt. That combination accounts for 75% of their portfolio. If inflation increases substantially, then debt will be easier for borrowers to keep up with, making the high yields those types of debt provide safer than they would otherwise be. Rising interest rates, the presumed response to significant inflation, would also make refinancing of this debt less likely. They appear to be a bit bearish on the stock market, but also note that they have positions in precious metals and natural resources -- other good bets if you expect inflation.

They're shifting their investment to this mix immediately, rather than later. Given the magnitude of the stimulus, they think inflation will start soon -- not 18 to 24 months after stimulus, what they say is the traditional amount of time it takes. Due to the state of the economy and the possibility of prolonged low growth, I find it hard to believe that price levels will start increasing immediately, however. If we get bad inflation, I would be quite surprised to see it happen much before 2011.

Whether you buy into the fund's logic or not, its letter is an interesting one. It also provides analysis on China and Japan. If you have some time to kill and interest, you might want to give it a read.

Price of Gold in Dollars (Record High), Euros (-10%), and Yen (-10%)

The price of gold closed at record highs today exceeding $1,040 per ounce throughout the day. While gold is at record highs in dollar terms, the commodity is still down 10% from its highs when priced in Euros and Yen. As shown in the charts, the price of gold is up considerably over the last five years, but the recent run has only been strong in dollar terms. This indicates that the strength is solely a function of a weaker dollar rather than any real pickup demand.