Managed futures fund finds a way to hide some fees

Operational shift allows fund to stop disclosing some fees and show lower expense ratio

The $126 million Grant Park Managed Futures Fund Ticker:GPFAX has changed the way it accesses commodity-trading advisers, allowing it to stop disclosing certain fees and show a lower expense ratio.
Through a regulatory loophole, the fund's investment adviser, Knollwood Investment Advisors LLC, has found a way to hide a chunk of the fees it charges, according to Nadia Papagiannis, alternatives analyst at Morningstar Inc., and other such funds are likely to do the same.
The Grant Park Fund, like about half of the 35 managed-futures funds available, is a fund of commodity-trading advisers, or CTAs, which manage commodity futures.
The fund has to use these vehicles because mutual funds are not allowed to hold more than 10% of commodity futures directly.
In a major change, the fund has begun using swap agreements to access CTAs rather than having the CTAs manage a portion of the fund, Ms. Papagiannis said. By doing so, the fund no longer has to disclose many of the management and performance fees it pays.
Previously, the fund had accessed its underlying CTAs through separately managed accounts. Each account acted like an individual investor in the CTA, so it was charged an expense ratio and a performance fee.
Those fees were disclosed in its prospectus as underlying fund fees, and the maximum performance fee was noted in a footnote.
“They were disclosing it, now they're hiding it,” Ms. Papagiannis said of the fees.
David Kavanagh, chairman and chief investment officer of Knollwood, declined to comment.
In addition to no longer disclosing the fees, the fund is also taking on the extra cost of paying for the swap agreement and taking on additional counter-party risk.
The Grant Park Fund is not likely to be the only managed-futures fund to make the switch to swap agreements to shelter some of their management costs.
“The vast majority of these funds are leaning toward it,” said Aisha Hunt, partner in the financial services practice at Dechert LLP. “If they don't, they're going to be at a competitive disadvantage. It's a marketing issue.”
Beyond their fees, managed-futures funds have struggled with performance since the financial crisis, which ironically, is what put them on many investors' radar screens.
Because they employ trend-following strategies, managed-futures funds have suffered in the macro-driven, risk-on, risk-off environment that been a market benchmark since 2008.
The managed-futures-fund category at Morningstar has a three-year annualized return of -5.63, and year-to-date through mid-November, the category was down almost 8%.
In spite of the performance struggles, the category continues to attract dollars, though flows have slowed down tremendously. The funds had $652 million of inflows year-to-date through October, compared with $3.2 billion of inflows for all of 2011, according to Morningstar.
For the second year in a row, advisers ranked managed futures as the strategy they were most likely to add, according to this year's Morningstar & Barron's
Alternative Investment Survey.
Managed-futures funds have the financial crash to thank for their sticking power. It was then, while the world seemed to be falling apart, that the strategies' diversification benefits were most apparent. The average managed-futures strategy returned more than 15% in 2008 when the S&P 500 fell about 37%.
“No one was talking about them in 2007,” said Lee Munson, principal at Portfolio LLC. “They've always existed, but because they were investing in other things than the stock market, all of a sudden they got popular. The performance in 2008 was what got people interested, but they need a big, fat tail to trend.”

FPA doesn't mind holding cash

It has been gratifying that a piece I wrote on cash for the CFA Institute has gotten a fair bit of attention.  It is called, “Cash as Trash, Cash as King, and Cash as a Weapon.”  As you can see from today’s title, we’re going to revisit the theme.

One reader had worked with Bob Rodriguez when he was at the helm of the FPA Capital Fund (FPPTX).  Rodriguez was not afraid to have cash build up in the portfolio when it didn’t make sense to be buying — a note from the reader said cash reached 45% in 2006.  Rodriguez is now an advisor to the fund rather than the lead manager, but the fund currently has 31% cash, according to its website.

It’s instructive to read the policy statement for the strategy.  Regarding cash:  “When there is a lack of investments that satisfy our criteria for absolute valuation and return possibility, cash will build as we await better opportunities.  Cash, or liquidity, is just the residual of investment opportunity.  We do not set out on our investment journey with a particular cash level in mind.”

Thus, it fits squarely into one of the categories that I mentioned in my CFA Institute article, wherein cash levels are a residual of a disciplined investment process.  The record illustrated above speaks for itself as to how the strategy has worked over time.

To be clear, I haven’t done due diligence on this fund and I would have plenty of questions if I did.  But I wouldn’t make the mistake that most gatekeepers do today, envisioning an “investment journey with a particular cash level in mind.”  That is, very little of it under any circumstances, thinking that managers can’t be trusted to use it wisely and well.

While it’s a byproduct of another part of the process, the cash in FPA Capital appears to have been effectively used as a weapon.  Why would you want to take it away?  (Chart:  Bloomberg terminal.)

Charlie Rose Talks to Jeremy Grantham

How do you see the global economy today? 
I’ve been obsessing about the shift in resource prices that started 10 years ago, which is reducing the growth rate of everybody. We calculated the percentage of global GDP that was going to resources, and it declined beautifully, forever, until 2002, when it hit some very low number like 9 percent. The price of pretty well everything has doubled and tripled since then. This has taken a bite of three points out of global GDP.

And the world is underestimating the bite of a declining population. They think that growth is going to bounce back after this mess. And it just ain’t so. The growth rate in the global population—let’s say the peak was 1971, 2.1 percent global growth—is now 1.2. In 30 years it’s going to be zero.

Zero?
Yeah, the global population is generally reckoned to peak in about 2040, 2050, maybe 2060. In addition, people are working fewer hours. And the aging of our population is severe, starting about now. So per capita, you simply have fewer people in the 20-to-65 age group, population slowing, working less hours—it’s becoming a pretty decent-size drag on the economy.

What about gains in productivity?
Productivity has been eroding, not that fast but pretty steadily. And part of it is just the maturing of society. There’s no way we’re going to recapture that robustness that you get from a huge surge in manufacturing. It’s quite different for the developing markets. They probably have 20 years before they cool down. But it’s a big factor for the U.S. Every five years, you’ve dropped another point in manufacturing and replaced it with people cutting each others’ hair.

How about the fiscal cliff and Europe’s debt crisis?
I don’t want to disappoint you, but I think that the debt situation is exaggerated. The things we should focus on are the level of education, the amount of capital spending, the quality of innovation, technology.

As an investor, what do you do?
I’ve hero-worshipped the presidential cycle. Going back to 1932, if you take the first and second year together, they’ve had no real return in the market. All of the return has been compressed into a gigantic Year Three and a respectable Year Four. For us, the cycle years start on October 1st. So now we’re in the dreaded first year. And we have Republicans threatening to add fiscal constraints into a very fragile economy. We have the European situation. We have China stumbling in an incredible slow-motion style. I think it’s a really good year to keep your head down.

So Mitt Romney would reduce corporate profits?
Profit margins are abnormal. Anyone can see that, given the weak economy. Paying down the debt will allow them to become more normal. In the old days, theInternational Papers (IP) of the world would break our hearts because just as they were getting decent margins, they’d build another plant. We’d say, “Why the hell are you doing that?” And they’d say, “Oh, it’s market share. We’re going to crush everybody.” It wasn’t great for profits, but it was magnificent for employment and the economy. Now they say, “Oh, I’m not going to build a new plant. We’re going to build up a war chest, buy our stock back because that’s highly correlated with my personal rewards: push up the shares, and hit my bonus.” The bonus culture has changed the flavor of how we do business.

What if Obama is elected?
History speaks pretty clearly that the markets do better with Democrats. Republicans’ ideas of what constitutes fiscal responsibility simply are not good for the stock market. Democrats have many tendencies, but one of them is to look after the workers, and actually that tends to be good for demand and good for markets. These capitalists who are desperate to elect Republicans should study their history books.

So what will you do next year with all that money you manage?
I am going to be careful, particularly for the first half of next year. Great brands of blue chips are not so bad in the U.S. Emerging countries are about fair price. Beaten-down European stocks, particularly the so-called value stocks, are probably a little cheap, although risky. And resource stocks, once they reflect the weak economy—and we’ll get another whack-down—will be a wonderful long-term purchase. Farmland and forests, which should be the backbone of any long-term, serious portfolio. … It will also be a good time to buy in.

What’s Jeffrey Gundlach Doing?

Few bond fund managers attract as much attention as DoubleLine Capital’s Jeffrey Gundlach. His firm has seen its assets under management grow to more than $45 billion in just over two years since its founding. Although these assets span a multitude of fund vehicles, by far the largest is the DoubleLine Total Return Fund (DBLTX), which held almost $35 billion as of 25 October. I am always anxious to see portfolio changes made in this fund, and I recently had the opportunity to take a close look at the fund holdings as of 30 September, which can give some valuable insight into how fixed income investors might consider positioning their portfolios.
He’s Made a Bigger Move into CMBS
During the month of September, DBLTX’s percentage allocation to commercial mortgage-backed securities (CMBS) rose to 4.5%, up from 3.6% in August. That means he bought almost $300 million of CMBS.
CMBS are also a favorite in the DoubleLine Low Duration Bond Fund (DBLSX); they make up 19.7% of the fund. The rally in CMBS has been strong, particularly since QE3 (the third round of “quantitative easing”). Annaly Capital Management wrote a summary of market action that describes it clearly:

During the quarter ended September 30, 2012, 10-year AAA new issue spreads have rallied from swaps +150/160 basis points (bps) to a level of swaps +85/95 bps. 10-year AAA legacy CMBS have likewise benefited, rallying from approximately swaps +230/235 bps to swaps +155/160 bps. Mezzanine bonds rated BBB and BBB- have seen spread tightening on the magnitude of 125 bps and 200 to 225 bps, respectively. . . . Commercial mortgages, even at current historically low rates, still exhibit good relative value against other fixed income alternatives.

Remember that bond yields move inversely with bond prices, so a fall in yield from a spread of +150/160 bps to +85/95 bps corresponds to a price increase of about 5%.

His Portfolio Is Low Duration with Plenty of Cash
It is no secret that Gundlach believes yields on U.S. Treasury bonds offer a poor risk–return proposition. With a modified duration of 1.59 (i.e., the fund would lose 1.59% in value during an instantaneous 100 bp rise in interest rates), DoubleLine is exposed to much less interest rate risk than its peers.
The PIMCO Total Return Fund, for instance, has a modified duration of 4.02 and would thus likely perform better if Treasury yields were to reach new lows.
Given the significant rally in both agency and non-agency MBS, it appears that Gundlach is keeping a healthy cash allocation (≈16% as of 30 September 2012) to deploy if either U.S. Treasury yields quickly rise or non-agency MBS prices fall. In short, the combination of a high cash balance and low modified duration leaves him both more flexible for future opportunities and less sensitive to changes in rates.
He’s Bought Some Long Duration to Hedge
As I mentioned earlier, the aggregate portfolio of DBLTX has a modified duration of only 1.59. However, when Gundlach and his team do buy bonds with high duration, they buy extremely long and less negatively convex MBS.
Their latest strategy in accomplishing this has been adding mortgage pools that are backed by Home Affordable Refinance Program (HARP) loans. These pools exhibit less negative convexity because the borrowers typically have a loan-to-value ratio in excess of 100% If interest rates were to fall again and hit new lows, mortgage pools such as these would become more valuable and would result in fewer prepayments than an average bond , since borrowers cannot reduce interest rates by refinancing into a conforming mortgage.
He’s Reduced Exposure to Non-Agency MBS
Month over month, the allocation to non-agency MBS fell from 30.4% to 30.0%. There were inflows of ≈$1.7 billion into DBLTX during September 2012 and a net reduction in non-agency MBS. According to DoubleLine, this occurred because the firm diverted principal run-off and new cash inflows into other asset classes.
This change in allocation might seem small to people who aren’t focused on this market, but I think it says a lot about Gundlach’s current view on non-agency MBSs in general. A dramatic run-up in prices has occurred in 2012, and DoubleLine has been a huge beneficiary of it.
As quantitative easing has continued to push investors out of agency MBS and further down the credit risk spectrum, non-agency MBS have seen a surge of new interest from investors seeking yield, and consequently, the prices have risen dramatically. Many new entrants to the non-agency space have enjoyed strong returns by chasing the riskier subprime section of the market, but Gundlach by and large prefers the prime and Alt-A segments. I’d guess that Gundlach will continue to be cautious in adding incremental non-agency MBS given the recent run-up.
The Big Picture
The recent moves in DBLTX indicate that Gundlach is currently cautious on both credit and duration risks. Because the fund has a large cash allocation, it is well positioned to capitalize on a potential “risk-off” event in the markets or a rise in interest rates.
Overall, I like the positioning that DBLTX has at the current time. It hasn’t chased yield in non-agencies and has kept a good balance by adding long government-backed MBS to hedge while keeping dry powder for opportunities that come up.

Is Your Manager Skillful…or Just Lucky?

There's no way to be sure, but Michael Mauboussin offers pointers on how to sort it out

Investors can track, to a hundredth of a percentage point, how individual mutual funds are performing relative to their market benchmarks. But they are largely powerless in determining the degree to which a fund manager's results are a function of skill—and how much they are attributable to just plain luck.
To explore that, we spoke with Michael Mauboussin, the chief investment strategist at Legg Mason Inc.'s LM +2.63% Legg Mason Capital Management unit and the author of a new book, "The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing."
The following are edited excerpts of the conversation with Mr. Mauboussin, who has worked at the fund-management firm since 2004 and has been an adjunct professor of finance at Columbia Business School for 20 years.

Abundance of Skill

WSJ: In the book, when you put certain activities on a continuum from being all luck to all skill, you show investing as having a much larger quotient of luck than winning at football or baseball or chess. You say that is partly because so many smart people play the investing game?

Enlarge Image

Andrew Kist

Michael Mauboussin

Mr. Mauboussin: Exactly. It's very counterintuitive. The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That's precisely what happens in the world of investing.
The reason that luck is so important isn't that investing skill isn't relevant. It's that skill is very high and consistent. That said, over longer periods, skill has a much better chance of shining through.
In the short term you may experience good or bad luck [and that can overwhelm skill], but in the long term luck tends to even out and skill determines results.
WSJ: You say people generally aren't very good at distinguishing the role of luck and skill in investing and other activities. Why not?

Michael Mauboussin

Mr. Mauboussin: Our minds are really good at linking cause to effect. So if I show you an effect that is success, your mind is naturally going to say I need a cause for that. And often you are going to attribute it to the individual or skill rather than to luck.
Also, humans love narratives, they love stories. An essential element of a story is the notion of causality: This caused that, this person did that.
So when you put those two together, we are very poor at discriminating between the relative contributions of skill and luck in outcomes.
WSJ: If I accept that a big part of investing success is luck, not skill, isn't that a strong argument to simply go with index funds and not try to pick active managers?
Mr. Mauboussin: Indeed. For someone who has little motivation to try to identify those who have differential skill, indexing makes a lot of sense.

Spotting a Winner

WSJ: Is it possible for individual investors to identify in advance mutual-fund managers who are truly skilled and not just lucky?
Mr. Mauboussin: You can make a credible effort if you are motivated, yes.
A manager may do the right things and get bad outcomes or do the wrong things and get good outcomes. So investment results can be very deceptive.
The better way to do it is to focus on the process of decision making that managers use and to look for numerical measures that can be proxies for that.
The one that is the most interesting candidate currently is "active share." Active share is a measure of how different your portfolio is than the benchmark to which you are compared.
We are now taking a concrete step toward trying to identify process versus simply results.
WSJ: You joined Legg Mason near the end of Bill Miller's 15-year streak of beating the Standard & Poor's 500-stock index with his Legg Mason Capital Management Value Trust, which was followed by years of poor performance.
How much of his strong investment performance was just good luck?
Mr. Mauboussin: If you look at streaks, not just in investing but in any endeavor, almost by definition they combine skill and luck. You have to have above-average skill and above-average luck to have a streak. If you look at it in the realm of sports, all the streaks are held by the most skillful players, although not all skillful players have streaks.
When Bill has been posed this question, he has attributed a good chunk of his streak to luck.
It is almost axiomatic that that has to be true.
WSJ: Is it also possible that some of the really awful results more recently [before Mr. Miller stepped down as portfolio manager earlier this year] were bad luck?
Mr. Mauboussin: Yes, it's very likely that was a substantial contributing factor.

Managed Futures: still the Better Diversifier?

A decade ago, Cass Business School Professor Harry M. Kat wrote a paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. In the paper Kat studied the impact of adding managed futures to traditional bond/stock portfolio allocations.
In comparison to hedge funds, Kat found that:

Apart from their lower expected returns, managed futures appear to be more effective diversifiers than hedge funds.

This is obviously an interesting paper but it starts to date; and blog reader Tom Rollinger from Sunrise Capital had the good idea to update the numbers in his paper entitled Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven.
Quite a lot has happened since 2002. In the markets in general and the alternative investment space in particular. So checking how Kat’s findings have held up was an obviously interesting follow-up. A sort of “out-of-sample” testing.
In the paper, Rollinger applies the same methodology used by Kat to measure the effect of adding managed futures to the traditional portfolios, then combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios.

First: a Managed Futures Definition

Trend followers, CTAs and managed futures are terms usually used inter-changeably, and Rollinger establishes this (emphasis mine):

Managed futures traders are commonly referred to as “Commodity Trading Advisors” or “CTAs” [...]
somewhat misleading since CTAs are not restricted to trading only commodity futures. [...]
Moreover many investors generically say “managed futures” or “CTAs” when they more precisely mean “systematic CTAs who employ trend following strategies”. This paper focuses on CTAs utilizing systematic trend following strategies.

The index used by Rollinger for Managed Futures is the Barclay Systematic Traders Index. The other asset classes are represented by:
- Bonds: Barclays U.S. Aggregate Bond Index
- Stocks: S&P 500 Total Return Index
- Hedge Funds: HFRI Fund Weighted Composite Index
This is different from Kat’s data/choice of indices but Rollinger shows in his Appendix B that for the period covered by Kat (June 1994–May 2001), the results “closely resemble” the original when using these different indexes.

Results of the “out-of-sample” test, a decade after Kat

Both papers simulate different portfolio allocations between the “traditional” 50/50 Bond/Stock portfolio and the “alternatives”, either Managed Futures, Hedge Funds or combination of both. The impact on the return distribution can then be observed.
It seems that the findings have stayed very similar since Kat published his paper. Adding managed futures to stocks and bonds helps more and quicker than do hedge funds, and do not bring on the negative side effect from hedge funds – increased tail risk.
From Rollinger’s paper (emphasis on Kat’s quote mine):

Managed futures have continued to be very valuable diversifiers. Throughout our analysis, and similar to Kat, we found that adding managed futures to portfolios of stocks and bonds reduced portfolio standard deviation to a greater degree and more quickly than did hedge funds alone, and without the undesirable side effects on skewness and kurtosis.
[...]
As the contribution to alternatives increases, all four moments of the return distribution benefit:
1) Mean return increases
2) Standard deviation decreases
3) Skewness increases
4) Kurtosis decreases
Overall, our analysis is best summarized by the following quote from Dr. Kat (regarding his own findings almost 10 years ago): “Investing in managed futures can improve the overall risk profile of a portfolio far beyond what can be achieved with hedge funds alone“.

The Papers

Here is a link to Kat’s original paper on SSRN:
Managed Futures and Hedge Funds: A Match Made in Heaven
Its abstract:

In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio’s standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50% of the alternatives allocation is allocated to managed futures, this again will not have any negative side-effects on skewness and kurtosis.

And here is the link to Rollinger’s paper:
Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven
Abstract:

In November 2002, Cass Business School Professor Harry M. Kat, Ph.D. began to circulate a Working Paper entitled Managed Futures and Hedge Funds: A Match Made in Heaven. The Journal of Investment Management subsequently published the paper in the First Quarter of 2004. In the paper, Kat noted that while adding hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility, it also produced an undesired side effect — increased tail risk (lower skew and higher kurtosis). He went on to analyze the effects of adding managed futures to the traditional portfolios, and then of combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios. He found that managed futures were better diversifiers than hedge funds; that they reduced the portfolio’s volatility to a greater degree and more quickly than did hedge funds, and without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with the traditional portfolios. Kat’s original period of study was June 1994–May 2001. In this paper, we revisit and update Kat’s original work. Using similar data for the period June 2001–December 2011, we find that his observations continue to hold true more than 10 years later. During the subsequent 101⁄2 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for portfolios of stocks and bonds than have hedge funds.

I have just noticed Attain have also written up a piece comparing both papers. You can read more on their site:
Between kat and rollinger: blending managed futures and hedge funds

Rich Stuck as Salient Curbs Withdrawals for Investors

Salient Partners LP, whose $3.3 billion Endowment Fund mimics the strategy of sophisticated institutions like Yale University and the Ford Foundation, is limiting withdrawals after clients pulled more than $1 billion this year amid lackluster returns.
Instead of allowing investors to redeem at their discretion, the fund will return 5 percent of assets as of Dec. 31, according to a letter to clients obtained by Bloomberg News. Clients who want to keep their money in the fund may be able to reinvest the cash they receive.
“The board determined that allowing the prior pace of net outflows to continue would likely result in the illiquid asset percentage reaching a level that would disadvantage the fund’s remaining investors,” Salient said in the letter dated Oct. 26, adding that the fund has 35 percent of assets in hard-to-sell investments.
The Endowment Fund, whose slogan is “democratizing investing,” is designed to offer wealthy individuals a strategy that has historically been open only to the most sophisticated institutions, investing in assets ranging from stocks and bonds to hedge funds, private equity and real estate. Now these investors are getting the same treatment that endowments and foundations received in 2008: A manager is blocking them from getting their money out.

No ‘Emergency’

“When investors bought this fund they had no expectations that they would be restricted in pulling their money unless there was some sort of emergency,” said Geoff Bobroff, a fund consultant based in East Greenwich, Rhode Island. “I’m not sure this is an emergency.”
The fund did not say in the letter when it would allow full redemptions again. While Houston-based Salient sells the fund, it is managed by Mark Yusko’s Morgan Creek Capital Management LLC in Chapel Hill, North Carolina. Before starting Morgan Creek in July 2004, Yusko was the chief investment officer at the University of North Carolina. He also spent five years at the University of Notre Dame Investment Office.
Morgan Creek, which offers its own fund of funds, limited withdrawals in its Morgan Creek Absolute Return Fund in 2008, according to an investor, who asked not to be named because the fund is private. As of October of that year, about 18 percent of the hedge fund industry’s assets were subject to withdrawal restrictions, according to GFIA Pte, a Singapore-based hedge fund consulting firm.

Minimum Investments

While investors must have a net worth of at least $1 million to put money into the Endowment Fund, the minimum investments are much lower than other vehicles such as hedge funds, helping the fund to attract $5.5 billion as of mid-2011, according to a regulatory filing. The minimum initial investment is $100,000, and additional investments are as low as $25,000 according to a fund sales document. The fund had 17,035 investors, according to a fund letter dated Sept. 28.
The Endowment Fund is among the larger funds registered with the U.S. Securities and Exchange Commission that offer alternative investments to wealthy clients. Banks including Morgan Stanley (MS) and JPMorgan Chase & Co. also sell registered funds that invest in hedge funds.
Yusko and Chris Moon, a spokesman for Salient, declined to comment.
The Endowment Fund has been sold by brokers at Merrill Lynch & Co., now a part of Bank of America Corp. The bank has put the sale of the fund on hold, according to the Wall Street Journal, which first reported the withdrawal limits on Oct. 26.
The Endowment Fund doesn’t come cheap. The clients pay a 2 percent management fee, in addition to the underlying fees of managers that averaged 1.3 percent of assets and 16 percent of profits, according to an Endowment Fund sales document.

Merrill Clients

Clients of Merrill Lynch brokers paid a 2.5 percent sales fee for an investment up to $150,000, with fees dropping as the investment size grew. They were also charged an additional 2 percent fee if they withdrew their money before the end of the first year.
The Endowment Fund has returned an annualized 5.6 percent since its inception in April 2003, underperforming stocks and a portfolio of 60 percent stocks and 40 percent bonds, according to a September letter to clients, while beating a Hedge Fund Research Inc. index that tracks funds of hedge funds. Its goal is to return 7 percent above inflation with less volatility than stock or bond markets.

Seth Klarman Goes Nuts On The Fed In His Latest Investor Letter

Seth Klarman, the legendary head of Boston based hedge fund Baupost Group, sent out his letter to investors this week.
He reports that his fund is up for the month, quarter, and year, but is sending out specifics in separate quarterly reports.
That said: The juicy part of this letter has nothing to do with specific investments or anything like that. What's interesting is that, like some of his industry peers (David Einhorn), Klarman has words for the Fed, and those words are all about QE3.
He said that like QE1 and QE2, QE3 is no lasting solution. He sees it, instead, as "attempted manipulation of Americans' behavior."

From the letter:

While anyone would be glad to have a cheaper mortgage as a result of QE3, would they
really believe this would make their home worth more? It’s more of a credit holiday, whereby
the government offers you better terms than previously available. In addition to making explicit
the implicit U.S. government guarantee of more and more of the U.S. residential mortgage
market, the rousing stock market approval of this measure is seen as a free lunch. But of course
it is not free....

What kind of policy is this: untested; inflationary; eroding free market signals, diverting more of the  country’s resources toward housing at the expense of priorities such as infrastructure, technology, or  science and medical research; and inevitably only a temporary fix with no enduring benefit?...

Finally, we must the morality of Fed programs that trick people (as if they were Pavlov’s dogs) into behaviors that are adverse to their own long-term best interest. What kind of government entity cajoles' savers to spend, when years of and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees’ savings to Zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should 

play this large a role in the economy.

So yeah, let it be put on the record. Seth Klarman does not like QE3.

Sign Of Capitulation: Are We There Yet?

Market Notes

Source: Merrill Lynch

• Latest EPFR fund flow data shows that Bonds recorded the highest ever weekly inflow. The bond bubble is definitely approaching its maturity, so those who are piling into these assets right now will most likely be "slaughtered" in the up-and-coming months and quarters. Having said that, the majority of investors view this as a contrarian buy signal for equities, but in my opinion those investors aren't doing their homework. The majority of the retail fund inflows are going into the Corporate & Junk bond sectors, which indicates retail investors chasing risky assets. In particular, due to euphoric inflows (and record issuance) into the Junk Bond sector, high yield is now reaching all time record low interest rates. It should be noted that these riskier bond assets correlate very positively with equities. With that in mind, the bursting of the Bond Bubble will actually spell disaster for corporates, especially the high yield junk market, as well as mark the end of the equity bull market that started in March 2009. We are late in the business cycle and on the edge of a recession, as corporate revenues start disappointing with margins mean reverting.

 Source: Skandinaviska Enskilda Banken (SEB)

• Despite upbeat consensus forecasts, I remain in the recession camp for the 2013/14 period. Globally, capex is falling (usually the first sign of a recession), with manufactured capital good orders in contraction mode for the G3 economies. While the Eurozone is already in a recession that is about to get worse next year, I am also of an opinion that the other G3 economies will follow down the same path. De-coupling has always been a dangerous word and it is not used in my forecasts. The world's third largest economy - Japan - is witnessing a rapid fall in industrial production, with machinery orders signalling the country could already be in a recession. With two out of the three G3s already in a slowdown, it is only a matter of time before the US becomes affected too. The first signs of major weakness came as US durable goods orders collapsed in September. Furthermore, inventories are now becoming a net drag on growth, for the first time since 2008. Global growth is at stall speed at best with global demand for goods falling, as already seen by Asian export growth. In my opinion, the current release of "upbeat data" is not to be completely trusted, especially because good news tends to be published around leadership change overs (US & China) to smoothen out the transition - a perfect example of  Machiavellianism.

Source: Short Side Of Long

• The latest CFTC Commitment of Traders report showed that Small Speculators, also known as Dumb Money, are shorting Sugar as of Tuesday of last week. At the same time, the Daily Sentiment Index (DSI), a measure of optimism from futures traders, is approaching single digit readings. From a contrarian point of view, these sentiment readings indicate that Sugar could be close to an intermediate bottom. Furthermore, as already discussed in a recent in-depth article, Sugar's prolonged bear market, which  is currently almost two years old, is creating a good demand & supply equation as farmers cut production, while demand returns with price down more than 45% from the February 2011 peak.

Source: HSBC

• The chart above shows how ever year consensus forecasts have been too bearish and consistently wrong on the Japanese Yen. I personally believe that the Yen will surprise consensus once again, as the global economy slows and eventually enters a synchronised recession sometime next year. Despite a powerful bull market since 2007, according to the recent Merrill Lynch survey, global fund managers remain least exposed to the Japanese Yen out of all the major currencies. Furthermore, recent CFTC Commitment of Traders report showed that hedge funds are now pilling into bearish bets against the Yen. Furthermore, small speculators also known as Dumb Money, now sit on all time record high net short bets against the Japanese Yen. Historically, these market participants have been a great contrary indicator. Finally, from the technical perspective, the Japanese Yen is currently oversold and most likely in a process of putting in an intermediate bottom.

Featured Article

It has come to my attention that various market participants are calling for the end of a correction. The majority of the CNBC & Bloomberg crowd, usually consisting of various fund managers, has declared the correction over. They claim that a run of a mill 5 to 7% correction has now run its course and it is time to buy back in as the bull market continues. From what I have been reading coming out of investment banks like UBS and Merrill Lynch, technical analysts are also claiming the same. Finally, various bloggers aren't too bearish either, as they see stocks currently oversold and bottoming in the coming days or weeks. From everything I track, I do not think there are any major signs of capitulation yet. Let me explain.

I personally believe there is no holy grail indicator or tool out there to tell us when the market is in capitulation mode and about to bottom out. At least I haven't found one just yet, but if you have - make sure you email me immediately (but do not tell anyone else haha)! Therefore, what we need to do is put together a lot of sentiment and technical indicators to see if and when they confirm each other. When the majority of basic indicators signal oversold and over pessimistic conditions, most likely it pays to be a contrarian. Just as the annoying kid consistently asks his parents that infamous question, we too want to know, "Are we there yet"?

Source: Short Side Of Long

One of the easiest and most straight forward ways we can see that the market has witnessed a fear or panic capitulation moment is by tracking the ever popular Volatility Index, also known as the VIX. A weekly closing spike above 35 usually does the job. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Furthermore, I personally think that the VIX still remains in the so called danger zone. This means that the current market conditions are described as very complacent, which usually signals an intermediate top instead of a bottom.

Source: Merrill Lynch

Global volatility indices for other asset classes also show a similar picture. It is as if the markets have paused for the time being as US and China roll through their leadership changeovers, before we get back to business. Global equity volatility, foreign exchange volatility and commodity volatility are all at their lowest levels since at least 2007. In my opinion, this is a very worrying signal.

Source: Short Side Of Long

Connected very closely to volatility are various credit spreads in the bond market. My personal favourite is the spread between Merrill Lynch High Yield and equal maturity US Treasury Bond known as the ML High Yield Master Index. With spreads back to May 2011 lows (last equity market top) and Junk Bond yields at record lows, trouble could be brewing ahead. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Investment advisors are also not too worried right now. Recent Investor Intelligence Bear readings have remained at complacent levels for months and months... and months. This is usually a signal that we are closer to an intermediate top rather than a bottom. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Confirming this view are various cash level readings of market participants. One of my favourites to track is the AAII Asset Allocation survey, which comes out once a month and is a less volatile measure than the weekly survey. With cash levels of retail investors falling to the lows of May 2011 (last equity market top), I think market participants are just way too complacent. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Another way to track what retail investors are doing, instead of thinking, is to look at the fund flows at the Rydex funds. One of the most popular measures of market sentiment is known as the Nova Ursa indicator and for the last few months, it has been signalling investor's appetite for stocks, which is very high. Looking at the chart above, it could be said that we have been given a contrarian sell signal with an intermediate top in place. Verdict: in my opinion we are not there yet.

Source: SentimenTrader

Generally, the risk appetite has been extremely strong since July 2012, as we can see in the chart above thanks to SentimenTrader website. Investors everywhere have been chasing risk assets due to various fundamental and technical reasons. This has created a group think mood of stock price extrapolation into the future. On the other hand, the chart above signals that the risk appetite readings could most likely be a contrarian sell signal. Verdict: in my opinion we are not there yet.

Source: Index Indicators

Moving away from various sentiment readings, the stock market internals (breadth) are also not yet washed out. Consider the very simple chart above, which measures the short term readings of all S&P 500 stocks above the 20 day moving average. Currently, there are still 43% of components above this short term MA and for the market to turn oversold, we usually need to see readings drop below 10% or 2 standard deviations from the mean of 56%. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Another short term breadth measure is an a very basic indicator I created called Weekly Internals. It tracks cumulative weekly readings of the NYSE advancers minus decliners and up volume minus down volume. In other words, it is the smoothed weekly buying and selling pressure. The capitulation zone usually occurs when 70% or more of all stocks and their volumes move on the downside during the week. Currently sitting in a neutral zone, we are not anywhere close to oversold readings. Verdict: in my opinion we are not there yet.

Source: StockCharts / Short Side Of Long

Other short term breadth measures I usually track are shown in the chart above. They are the percentage of stocks above 50 day MA, McClellan Oscillator and daily TRIN readings. All three indicators have a basic oversold level and all three indicators are not signalling oversold conditions. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Longer term breadth measures also show the same picture. The long term advance decline line, averaged over 21 days or one month of trading, shows that we are currently at neutral readings and nowhere near oversold levels. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

The percentage of stocks above the longer term 200 day moving average is also nowhere near oversold levels. As a matter of fact, the smoothed 21 day average of the readings above, shows that the breadth strength is now rolling over and starting to narrow. Furthermore, we can see that a bearish divergence between lower breadth readings and higher stock prices into September 2012. All of these are usually typical signs of a downtrend at its beginning and not at its end. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Moving along, we can also see that the NYSE 52 week high low ratio, averaged over 21 days or one trading month, shows that readings have just exited overbought territory. That itself signalled an intermediate top and a correction in progress. When does that correction end? During bull markets, correction readings fall below 50%, but if I am right in forecasting a bear market, readings might go much lower towards the true oversold zone of 10%. Verdict: in my opinion we are not there yet.

Source: Cobra Market View

Moving away from breadth and towards basic technical price action, we can see in the chart above that we have a classic non confirmation in the Dow Theory. These usually get resolved to the downside, especially when stocks remain in a long term secular bear market. Verdict: in my opinion we are not there yet.

Source: StockCharts / Short Side Of Long

I am definitely not an expert in technical analysis and momentum readings, and I rather not be because charts have very lousy prediction probabilities unless you incorporate them together with the fundamentals of the business cycle as well as sentiment readings. Having said that, just looking at the weekly basics, I see no minor or major oversold readings right now. As a matter of fact it seems to me that the weekly MACD is now giving us a selling signal instead. Verdict: in my opinion we are not there yet.

Source: Short Side Of Long

Finally, away from the stock market indicators, the bond market readings of future inflation expectations, also known as Break Even rates, have been overheating for a few weeks now. That tells us the current inflation trade is looking somewhat overcooked and mainly a consensus bet. Historically, a deflation trade (long Treasuries, Dollar, Yen, VIX) surprise tends to be just around the corner, as market participants start cutting risk exposure rather quickly. Furthermore, I personally think the Fed engaged into QE3 prematurely, instead of waiting for Break Even rates to fall back down to 2% range. This has now most likely topped the risk on trade, just like we saw in April 2010, November 2010 and between February & May of 2011. Verdict: in my opinion we are not there yet.

Seth Klarman Goes Nuts On The Fed In His Latest Investor Letter

Seth Klarman, the legendary head of Boston based hedge fund Baupost Group, sent out his letter to investors this week.
He reports that his fund is up for the month, quarter, and year, but is sending out specifics in separate quarterly reports.
That said: The juicy part of this letter has nothing to do with specific investments or anything like that. What's interesting is that, like some of his industry peers (David Einhorn), Klarman has words for the Fed, and those words are all about QE3.
He said that like QE1 and QE2, QE3 is no lasting solution. He sees it, instead, as "attempted manipulation of Americans' behavior."

From the letter:

While anyone would be glad to have a cheaper mortgage as a result of QE3, would they
really believe this would make their home worth more? It’s more of a credit holiday, whereby
the government offers you better terms than previously available. In addition to making explicit
the implicit U.S. government guarantee of more and more of the U.S. residential mortgage
market, the rousing stock market approval of this measure is seen as a free lunch. But of course
it is not free....

What kind of policy is this: untested; inflationary; eroding free market signals, diverting more of the  country’s resources toward housing at the expense of priorities such as infrastructure, technology, or  science and medical research; and inevitably only a temporary fix with no enduring benefit?...

Finally, we must the morality of Fed programs that trick people (as if they were Pavlov’s dogs) into behaviors that are adverse to their own long-term best interest. What kind of government entity cajoles' savers to spend, when years of and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees’ savings to Zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should 

play this large a role in the economy.

So yeah, let it be put on the record. Seth Klarman does not like QE3.

Inflation, deflation, and the iPad mini

The debate over inflation—which ranges all the way from those who see the imminent risk of deflation to those who see hyperinflation just around the corner—continues, and with good reason. Inflation is alive and well in the services and nondurable sectors of the economy, while deflation is the "new normal" in the durable sector of the economy. Some prices are going up, but others are going down; on average, the government is telling us that inflation is only about 2%. That's a calm surface on a body of water that is roiling underneath.

The first of these two charts shows the average price level for each major sector. Service sector prices have risen about 60% over the past 18 years, while the price of nondurables are up a little over 50%. But durable goods prices have fallen steadily, and are now down a total of 28%. In the entire history of these series, there has never been a sustained period of declining prices except for the past 18 years in the durables sector. Not coincidentally, that period corresponds to the emergence of China as a powerhouse producer of durable goods (e.g., computers and TVs). Memo to Romney and Obama: China has done us a great service by producing products so cheaply.

If we make the assumption that the price of services is a proxy for wages and salaries, then what we see here is arguably the most incredible increase in workers' purchasing power in the history of the world. Do the math: over the past 18 years, services are up 161% and durables are down 28%. 161/.72 = 223.9. Salaries have more than doubled relative to durable goods. Put another way, an hours' worth of work now buys more than twice as much in the way of durable goods as it did 18 years ago—it takes 55% less work today to buy the typical durable good than it did 18 years ago. Bottom line, labor has become a whole lot more valuable and more expensive than things, especially very sophisticated and powerful things like computers.

Which leaves me puzzled as to the brouhaha over whether the iPad mini—the newest durable good to be offered to the public—is a whole lot more expensive, at a price of $329, than the Amazon Kindle Fire HD at $199. As the link demonstrates, there are some significant differences in features between the two devices. My point is whether the price of those differences—$130—is a huge amount. Is a 35% larger screen + a 5 mp camera + greater video compatibility + hundreds of thousands of extra apps + aluminum construction (vs. plastic) worth an extra $130? Consider what $130 gets you these days: a dinner for two with a bottle of wine at an upscale restaurant; a pair of jeans at Nordstrom; two tanks of gasoline; admission for one to Disneyland; a bottle of Dom Perignon; a small basket of groceries.

The average person now has available to him or her gadgets that 18 years ago would have been considered magical, if not impossible. With only one week's worth of minimum wages in California ($8/hr), you can buy yourself an iPad mini: a device that connects you to all information in the world; that holds and displays and edits and takes thousands of videos and photos; that holds your entire music library; that lets you read millions of books; that holds and displays maps of the entire world; that lets you explore the cosmos by simply pointing at the stars at night; that lets you read hundreds of newspapers; that lets you plan and reserve flights and hotels all over the world for free; that let's you play and record all kinds of music; that gives you access to thousands of video games that never before existed; that let's you correspond with people instantly all over the world; that's lets you fly dozens of planes realistically. I could go on, but I hope my point is clear. 18 years ago a device like the iPad mini would have been inconceivable no matter how much it cost. Today, in contrast, we are quibbling about whether such a device should cost $200, $250 or $330, when the difference is almost insignificant for the vast majority of people.

It is undeniably deflationary when a week's worth of work at minimum wage buys you things that only 18 years ago would have been unavailable to even the richest person on the planet. But at the same time, it costs an employer 2.2 times as much to hire that minimum wage worker, and it costs us all 5 times more to fill our tanks with gasoline. That's a lot of inflation. Or is it?

No wonder the debate rages.

Rich Stuck as Salient Curbs Withdrawals for Investors

Salient Partners LP, whose $3.3 billion Endowment Fund mimics the strategy of sophisticated institutions like Yale University and the Ford Foundation, is limiting withdrawals after clients pulled more than $1 billion this year amid lackluster returns.
Instead of allowing investors to redeem at their discretion, the fund will return 5 percent of assets as of Dec. 31, according to a letter to clients obtained by Bloomberg News. Clients who want to keep their money in the fund may be able to reinvest the cash they receive.
“The board determined that allowing the prior pace of net outflows to continue would likely result in the illiquid asset percentage reaching a level that would disadvantage the fund’s remaining investors,” Salient said in the letter dated Oct. 26, adding that the fund has 35 percent of assets in hard-to-sell investments.
The Endowment Fund, whose slogan is “democratizing investing,” is designed to offer wealthy individuals a strategy that has historically been open only to the most sophisticated institutions, investing in assets ranging from stocks and bonds to hedge funds, private equity and real estate. Now these investors are getting the same treatment that endowments and foundations received in 2008: A manager is blocking them from getting their money out.

No ‘Emergency’

“When investors bought this fund they had no expectations that they would be restricted in pulling their money unless there was some sort of emergency,” said Geoff Bobroff, a fund consultant based in East Greenwich, Rhode Island. “I’m not sure this is an emergency.”
The fund did not say in the letter when it would allow full redemptions again. While Houston-based Salient sells the fund, it is managed by Mark Yusko’s Morgan Creek Capital Management LLC in Chapel Hill, North Carolina. Before starting Morgan Creek in July 2004, Yusko was the chief investment officer at the University of North Carolina. He also spent five years at the University of Notre Dame Investment Office.
Morgan Creek, which offers its own fund of funds, limited withdrawals in its Morgan Creek Absolute Return Fund in 2008, according to an investor, who asked not to be named because the fund is private. As of October of that year, about 18 percent of the hedge fund industry’s assets were subject to withdrawal restrictions, according to GFIA Pte, a Singapore-based hedge fund consulting firm.

Minimum Investments

While investors must have a net worth of at least $1 million to put money into the Endowment Fund, the minimum investments are much lower than other vehicles such as hedge funds, helping the fund to attract $5.5 billion as of mid-2011, according to a regulatory filing. The minimum initial investment is $100,000, and additional investments are as low as $25,000 according to a fund sales document. The fund had 17,035 investors, according to a fund letter dated Sept. 28.
The Endowment Fund is among the larger funds registered with the U.S. Securities and Exchange Commission that offer alternative investments to wealthy clients. Banks including Morgan Stanley (MS) and JPMorgan Chase & Co. also sell registered funds that invest in hedge funds.
Yusko and Chris Moon, a spokesman for Salient, declined to comment.
The Endowment Fund has been sold by brokers at Merrill Lynch & Co., now a part of Bank of America Corp. The bank has put the sale of the fund on hold, according to the Wall Street Journal, which first reported the withdrawal limits on Oct. 26.
The Endowment Fund doesn’t come cheap. The clients pay a 2 percent management fee, in addition to the underlying fees of managers that averaged 1.3 percent of assets and 16 percent of profits, according to an Endowment Fund sales document.

Merrill Clients

Clients of Merrill Lynch brokers paid a 2.5 percent sales fee for an investment up to $150,000, with fees dropping as the investment size grew. They were also charged an additional 2 percent fee if they withdrew their money before the end of the first year.
The Endowment Fund has returned an annualized 5.6 percent since its inception in April 2003, underperforming stocks and a portfolio of 60 percent stocks and 40 percent bonds, according to a September letter to clients, while beating a Hedge Fund Research Inc. index that tracks funds of hedge funds. Its goal is to return 7 percent above inflation with less volatility than stock or bond markets.

S&P 500 5% Corrections: Current Bull Market

Following Friday's decline, it is hard to believe that the S&P 500 is down less than 5% from its bull market closing high on September 14th.  The table below highlights the S&P 500's 16 prior declines of 5% or more (without a 5% rally) since the bull market began.  If the S&P 500 closes below1,392.5, this current pullback will mark the 17th 5% decline.

Looking at the average and median magnitude and length of the prior declines during the current market shows that the S&P 500 typically pulls back between 7.7% and 8.3% over a period of between 19 and 22 days.  Given the fact that the most recent high was 40 days ago, the current pullback would rank as the third longest of the bull market.  For the sake of reference, if the current pullback were to reach 'average' or 'median' levels, that would imply a decline to about 1,350.