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Wednesday, February 28, 2007

Chasing Performance: One of the Top Investing Mistakes

An article in Sunday’s New York Times about trends in 401k investment choices included this:

Consider those red-hot emerging-markets stock funds, which have soared 28 percent a year, on average, for the last three years. A study last year by Hewitt Associates found that the typical saver who invests in emerging-markets funds in a 401(k) has more than 16 percent of his or her money stuffed into these high-risk investments. Yet many financial planners warn investors against putting more than 5 percent into such funds.

Even worse, nearly one-third of these investors held more than 20 percent of their nest egg in emerging markets — and 5.5 percent were betting more than half on them.

I’m not positive but I think this is even worse that it appears at first glance. Assuming the investor is 65% stocks 35% bonds having 16% of the portfolio in emerging markets would mean 25% of the stock allocation is in emerging markets.

In yesterday’s market selloff the exchange traded fund linked to the MSCI Emerging Markets Index (EEM, see one year chart is at the top of this post) dropped around 8%, double the tumble of the US market:

I would disagree with the maximum 5% allocation to emerging markets, I would put it closer to 10% of the stock allocation of a portfolio based on this sector’s share of the global markets. But of course, during the 3 years of 25% + returns investors should have rebalancing, selling off some of their holdings to get back to their target allocation. The numbers indicate that instead investors were adding to their emerging market holdings.

I have little doubt that in this go round we will see money flows similar to that of last year in this sector. Last year there were major inflows during the first quarter following an excellent 2005. Then followed a massive outflow in response to a 20% selloff in April. Inevitably the market recovered, the asset class had a 20%+ gain for the year, yet many, many investors found that by chasing the market and then panicking they lost money in the sector.

The WSJ marketbeat blog reports :

The selloff in global equities indeed came at an inopportune time for individual investors. According to data just released by the Investment Company Institute, individuals investing in mutual funds put more money into global equity funds in January than in any month since April, and overall net flows into world equity funds in the last 13 months were nearly ten times the amount into U.S. equity funds.

The ICI said net inflows totaled $21.11 billion in January, after inflows of $149 billion for all of 2006. U.S. funds had a good month as well, with inflows of $7.23 billion, best since March 2006, but inflows into U.S. funds have trailed international funds in every month for the past 13, and in all of 2006 U.S. funds experienced a net inflow of just $11.1 billion.

Doubtless a large % of those flows into international funds was into the emerging market sector.

About Those Morningstar Ratings

It seems they don’t measure much other than how well the fund manager manages his fund to get a high Morningstar rating. Talk about useless.

The WSJ reports:

Mutual Funds AvoidRisk to Lift Ratings

February 28, 2007; Page D2

Is your mutual fund too average? There's a good reason why you might feel that way.
Returns for mutual funds are increasingly congregating around a broad middle -- often failing to equal their benchmarks, according to new research from Goldman Sachs Group Inc. Goldman found that large-company equity mutual funds have consistently failed to beat their benchmarks over the past 20 years. This is a result of fund companies and fund managers sidestepping risk for a variety of reasons, Goldman concludes. One reason: Funds are trying to reduce their price volatility to earn higher Morningstar ratings.
In trying to attract and retain assets, Goldman says it believes fund companies are trying to "reverse engineer the Morningstar process" to earn coveted four- and five-star ratings that consumers often solely rely on when researching mutual-fund investment options. "Morningstar did something thoughtful in evaluating what mutual-fund managers say they're doing," says Don Mulvihill, a managing director at Goldman Sachs. "But the fund industry has reacted to it by trying to game the system to get star ratings." The result: lower risk and returns inside the funds.

And a top Morningstar exec doesn’t even doubt that this gaming of the system is taking place:

Don Phillips, managing director at Chicago-based Morningstar Inc., says the investment-research company has also noticed that funds are clustering around the middle. Part of the reason, he says, "probably is us." But other reasons, he notes, are that "managers who stuck their neck out and lost in recent years, lost their jobs, so risk taking is penalized."

Of course despite this interesting research finding, Goldman Sachs can’t resist the opportunity to fuel the eternal hope that active management can work somewhere. Since they know no one doubts that active management doesn’t work for large cap stocks, they make the feeble argument that it works in other asset classes :

So, how might investors respond? Goldman's Mr. Mulvihill says these results strengthen the argument for pursuing a so-called core-and-satellite portfolio. The core of this approach is built around large-cap U.S. and foreign shares owned through index funds, exchange-traded funds or similar funds that charge low fees and take on little more than the risk of the underlying benchmark. Then, with the satellite investments, you venture into other asset categories such as emerging-market debt, real-estate investment trusts and others where "active management is more likely to earn the fees" with benchmark-beating returns
I would never recommend emerging market debt (the risk/return is too unattractive) but I know little evidence that active management beats indexing for REITS .
This “core and satellite” approach is the latest refuge of the brokerage and mutual fund industry. They can’t fight the argument for indexing, so they argue that the “core” of the portfolio should be indexed and a “satellite” portion of the portfolio should be allocated to active (and high fee) managers such as those managing hedge funds. There is no rationale for their approach.

Friday, February 23, 2007

Morningstar Investment Advice: Proceed With (Much) Caution

Despite its massive influence in the mutual fund industry with millions of individual investors and thousands of financial advisors relying on its mutual fund recommendations, the advice is essentially worthless. Past performance of mutual funds says nothing about future performance and a ” five star” top rating by Morningstar has been shown to be useless in predicting future returns. And although you can find some warm words for indexing buried in morningstar’s website and publications, the overall orientation is to push “hot” actively managed mutual funds. What’s more , in recent years Morningstar has moved into hiring analysts to pick hot stocks as well.

So it wasn’t too surprising for me to find the following on Morningstar’s website

Five Domestic-Equity Managers That Deserve More Attention

These managers aren't as popular as they should be

There are several topnotch managers who are household names among fund investors, and there are lots of pretty good skippers who are quite widely known--sometimes due to their own accomplishments and sometimes due to their fund companies' marketing efforts. But there also are a number of first-rate managers who aren't as well recognized as they should be (even though they may have received some external praise or taken on substantive responsibilities at their firms).

Funny thing is, the actively managed large cap Value funds listed in the article failed to beat the Dimensional Fund Advisors (DFA) Large Cap Value Fund.

Here’s the scorecard:

Index Fund:

1 yr Return

3 yr Return

5 yr Return

DFA Large Value Fund




funds cited in article:

Goldman Sachs Large Cap Value




Diamond Hill Large Cap




Diamond Hill Long Short




Bridgeway Large Value




Neuberger Berman Guardian




Not A Single One of the Funds cited in the article outperformed the index fund over 5 years !!!!

For an interesting insight into the Morningstar agenda there is this fascinating article from San Francisco Magazine about Patrick Geddes a former top executive from Morningstar and moved over from the “dark side” to form Aperio Advisors a top financial advisory firm which employs indexing:

One of the company’s founders, Patrick Geddes, aged 48, is a renegade from the top echelons of his field. For several years he served, first as director of quantitative research, then as CFO, at Morningstar, the nation’s leading company for researching and appraising mutual funds. But when he left, not only was he disenchanted with his own company’s corporate environment, he was also becoming uneasy with the moral underpinning of the entire industry. “Let’s be straight,” says Geddes in his soft-spoken but zealous way. “Being unethical is a good precondition for success in the financial business.”…

Geddes, a modest, unassuming son of a United Church of Christ minister, is its chainsaw massacrer. “We work in the most overcompensated industry in the country,” Geddes admitted before the water was served, “and indexing threatens the revenue flow from managed funds to brokerage houses. That’s why you’ve been kept in the dark about it. This truly is the great secret shame of our business.

“The industry knows they are peddling bad products,” Geddes continued, “and a lot of people making the most money and getting the most prestige are doing so by gouging their customers.” And Geddes is quick to differentiate between “illegal theft”—the sort of industry scandals Spitzer has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after-market trading—and “legal theft,” the stuff built into the cost of doing business that no attorney general can touch, but which in dollar amounts far exceeds investor losses to illegal activity.

Geddes wasn’t always full of such tough talk about the industry. Not that he had any qualms about speaking his mind; in fact, he was let go from Morningstar in 1996 for being openly critical of the company’s internal culture. “I still think of Morningstar as a potentially positive force in the industry,” he says. “But let’s just say they were weak at conflict management, especially at the senior levels.”

Take a look at the Morningstar website, look at the ads, then figure out if they don’t have a vested interest in promoting actively traded funds. Besides if they acknowledged indexing was the answer they wouldn’t have much of a business in recommending active managed funds and individual stocks.

Ironically the only investment vehicles Morningstar is actively involved in running are the ishares exchange traded funds based on indices developed by Morningstar.

Thursday, February 22, 2007

Now This is Scary !

A special Small Business section in the NYT described the process of generating investor interest for companies that go public. The challenge described in the article is to generate awareness from potential investors for companies To get the story out, you need help from firms specializing in investor relations; you also need research and analysis.
The role of the investor relations firm is to foster media interest in your company, get you ready for prime time and introduce you to investors. The firm will write news releases, create a press kit, focus your Web site and organize presentations.
Properly marketed, “boring companies with good numbers are not boring companies,” said Richard L. Stern, of Stern & Company, an investor relations company in New York.
Now here’s the really scary part…would you want this manger running your mutual fund:
Getting investors interested in your stock is literally a year-in, year-out process of talking to them. It’s not very likely that an analyst or portfolio manager will dash out of the room after your presentation and put in a big buy order — although that did happen to Brad Thompson, the chief executive of Oncolytics Biotech, a Canadian company that uses viruses to develop treatments for cancer.

Mr. Thompson was in the middle of an initial presentation to a portfolio manager when, he recalled, the manager said, “Stop.” Then he clicked a few keys on his laptop, looked up and said, “O.K., keep talking.” He had just put in a million-share order. “I said to myself, ‘That will never happen again,’ ” he recalled.
Once is scary enough imo, particularly since this type of stock small growth has consistently performed more poorly than any other sector of the stock market. Over the past 10 years here are the numbers
Annual Return Standard Deviation
Russell Total Stock Market Index 8.26% 15.08
Russell Small Cap Growth Index 4.81% 23.28

In other words the stocks of small “growth” (high price to earnings ratio) stocks gave investors roughly half the return with 50% more risk than the overall market. But these are precisely the type of stocks individual investors (and it seems many portfolio managers) gravitate towards. And the company is a classic case; a biotech company developing a cancer treatment. Investors buy the stock in the hope that it will be the “next amgen”, but history shows it is far more likely to fade into the sunset.

Good Companies = Good Stocks For The Long Term….Usually Not the Case

Whole Foods announcement of plans to purchase Wild Oats markets reminded me of the axiom that good companies seldom make good stocks. Whole Foods is the classic case of the kind of stock my clients come to me and ask about investing in. Everytime they go to the store it is crowded, the prices seem to indicate the company is making healthy profits and the stores seem well run.

Not surprisingly to me Whole Foods has turned out to be a classic near bubble stock. If you were bright (or lucky ) enough to get in before 2004 you would indeed have well outperformed the market. However, if you would have bought the stock anytime since January 2004 and held on you would have ridden a roller coaster to nowhere. The stock went from 50 to a high of 80 and down to its current price of $49, this morning even after a big move up after the acquisition announcement a return of ZERO. S+P 500 for the period +20%.

Tuesday, February 20, 2007

Bulletin from the WSJ: 2007 may be a good year for fund managers who can correctly predict world political and economic developments and make profit

I also predict it will be a good year for sports bettors who can correctly pick the teams that will beat the point spread. But what that has to do with asset allocation of an investment portfolio is not very clear to me.

The WSJ reports that for the hedge fund crowd 2007 may be a good year for “macro strategies “:

Betting on the world's broad economic trends tripped up some high-profile names in the hedge fund industry last year, but such "global macro" investing is poised for a comeback this year, money managers say.

Here’s the convoluted “logic” behind the assertion.

Global macro was among the first widely practiced hedge-fund strategies. It helped popularize these private-investment vehicles after money managers George Soros, Julian Robertson and other early practitioners saw stellar returns by betting on economic trends via investments in currencies, interest rates, shares and other instruments.

In other words because some exceptional individuals made some extraordinary profits during the 1980s and 1990s this “strategy” of diving developments in global markets and staking massive positions on their hunches is likely to come back. No matter that post these traders posted big losses in the late 1990s and closed down their funds. Both have been cited as stating the markets are no longer well suited to the strategies they implemented

Stunningly the article goes on:

The strategy hit a rough patch last year because the world's economies have been relatively calm, gently rising more or less in unison. Moreover, many global-macro investors were caught short by the resilience of the U.S. economy, which they had bet would be weaker than it was. Global macro, like other hedge-fund strategies, profits from bets on big swings, or volatility. If things don't go up or down much, there isn't much money to be made, whether betting on pork bellies or the price of the euro versus the yen.

This year could be different, as many economists predict volatility after an extraordinary period of relative calm.

Now there’s a paragraph and a half of nonsense. The macro strategy didn’t perform poorly because the US market was calm, it performed poorly because it expected the US stock market to go up and it went down. As for their much needed volatility, it was far from absent in 2006: emerging markets took a 20% tumble in the spring before ending the year up over 20%, Chinese stocks nearly doubled as did those in India, oil hit $80 the rest of the energy sector had unprecedented volatility, gold silver and copper had massive bull runs and corrections (i.e. major volatility) and some agricultural commodities hit multi year highs. In other words it wasn’t the lack of volatility that prevented the macro managers from accruing big profits….it was their inability to predict the moves and profit from them.

But hope springs eternal:

Hedge-fund investors surveyed by Deutsche Bank AG are predicting the strategy will be the second-best performer this year, after the plain-vanilla strategy of buying some stocks and shorting others (selling borrowed shares in hopes of replacing them with cheaper ones later and pocketing the difference). About two-thirds said they currently were invested in macro funds, and one-third said they would add to their global-macro exposure in 2007.

And here’s a bit of analytic brilliance from the WSJ

These funds typically have seen their best performances around times of market crises, but they also see their worst performances in such years when managers bet wrong.

In other words the funds make big profits when the managers bet right and suffer big losses when the managers bet wrong….

In other words, when you “invest” in a macro strategy hedge fund you’re really just betting on a “genius” to hit a home run while you’re invested

Allocating funds to the global macro strategy is not really an allocation to an asset class such as fixed income, international stocks or domestic large cap stocks; it’s simply a bet on a “superstrar”

Reading between the lines of the following quote makes this quite clear:

"The real struggle is not how much you want to invest in global macro, but who you allocate to," says Nicolas Campiche, chief executive of Managers Selection Services at Swiss private bank Pictet & Cie., which has about $20 billion invested in hedge funds. Last year, the average return of global-macro funds in Picket’s portfolio was about 10%, yet the results of those funds ranged from a 10% loss to a 44% profit.

And what does one get as the payoff from these superstar bets:

Overall, global-macro funds registered an average return of 8.23% in 2006, compared with a 12.88% gain on Chicago-based Hedge Fund Research Inc.'s composite index of hedge-fund returns and a 13.6% rise in the Standard & Poor's index of 500 big U.S. stocks….

Some global-macro funds managed to generate strong profits last year. New York-based Drake Management LLC returned 41% on its Drake Global Opportunities Fund, in part by betting against U.S., U.K. and Japanese government bonds, the Icelandic krona and the New Zealand dollar in the first half of 2006.

Hmmm…most macro hedge funds fared poorly in 2006 because there was lack of volatility (except in obscure areas like gold, oil, copper and Asian stocks). But some exceptional (or exceptionally lucky) managers found enough volatility to make profits by trading the Icelandic and New Zealand currencies….

But 2007 will be a good year for more macro managers because there will be big macro developments in the world economy which only a few genius managers will identify and successfully exploit for big profits.

….don’t bet on it.

An Excellent Book Unfairly Trashed in the New York Times

Henry Blodget was a poster boy for the internet bubble. As internet stock analyst for Merrill Lynch he was a shameless tout for internet stocks collecting and in his thorties collected annual compensation in the eight figure area in the process. He also was trashing in internal emails the same stocks he was praising in public. Then NY State Attorney General Elliot Spitzer got hold of the emails and Blodget got hold of copies of the emails, Blodget paid major fines and is banned from the securities industry for life. As Blodget himself notes in his book with regard to this “it is what it is”.

Blodget does not shy away from the episode. He doesn not revert to the excuse that “everybody did the same thing” or “that’s how the system worked (and works). While I personally would find neither explanation satisfying, to deny that they are true would be illusory. We are talking about an industry where one of the working mottoes in discussing a deal is IBGBT: “I’ll be gone by then”, in other words by the time the deal blows up the investment bankers will have collected their bonuses and either retired or moved on to bigger and better 9for them) deals.

But Henry Hurt III in the NYT does not hesitate to dwell on Blodget’s past and dismiss out of hand Blodget’s recent career as a financial writer for SLATE, Newsweek and other publications and his excellent new book The Wall Street Self Defense Manual.

MAYBE I’m brain-damaged, but all that just rubs me the wrong way. I believe that everyone has a right to free speech regardless of past transgressions. By the same token, everyone has the right to evaluate speech and speakers, as well as the right to vote with their pocketbooks. The advice that Mr. Blodget now offers may be sound, but it’s also rather mundane. Would a similar book written by Joe Blow attract similar attention?

Which brings us back to the larger question that began our inquiry: whether to invest or not to invest in financial misconduct. I don’t buy That Henry’s rehabilitation, and I don’t recommend that you buy his book. In keeping with publishing-industry custom, I received a free review copy.

I for one strongly disagree with the above. I am in no position to judge Mr. Blodget’s rehabilitation but I certainly give him credit for not going down the road of folks of the Enron, Tyco type that proclaimed innocence all the way through. If Mr. Hurt thinks Blodget’s fine was too small he should have sharp words for now Governor Spitzer, not Mr. Blodget. I don’t recall any plea bargain in which the convicted felon insisted on a higher monetary penalty or time in prison. If Mr. Blodget, in his early forties, has chosen to devote his professional energies to better educating the public on investing, well it may not be up there with working in an AIDS clinic in Africa, but he is providing a public service.

As for Mr. Hurt, his journalistic opus has included NYT columns on the wonders of handmade shoes and suits with prices equal to the per capita income of most of the lesser developed world.

Now to the book and accompanying website themselves. It is the product of what Mr. Blodget calls a reeducation in which he unlearned everything he had learned about “investing” on Wall Street.

As someone who is familiar with most of the available books on investing for the general public, I would definitely put his book near the top. He doesn’t present any radically new advice, there is no reason to, and he just presents the case for true “sensible investing”: use of passive index instruments with no short term trading. He writes well and is quite thorough in his presentation of the case for passive investing, how to evaluate proposals from advisors, the nonsense spouted by the financial press (you know I loved that section) and how to evaluate “track records” by fund managers.

This lengthy except from the book’s introduction is worth posting here (my bolds):

….One benefit of getting tossed out of your industry is that you get to look at it from the outside. (And I should say here that by “industry,” I don’t just mean the brokerage business. I mean the whole brokerage industrial complex—brokerage firms, mutual funds, investment advisors, the investment media, and the dozens of other businesses that operate in and around the markets.) This perspective helped me see that there is still a vast gulf between how most outsiders think the business works and how it really works—a gulf that frustrates not only outsiders but insiders. It helped me discover that many investment practices I thought were worthwhile,were actually a waste of money and time. And it helped me understand how, in a variety of ways, often with good intentions, Wall Street helps many small investors screw themselves.(well, I wouldn’t be quite so charitable about the intentions of the industry)

The Big Secret (Shhh….)

The secret to intelligent investing is not news. It won’t fill you with excitement or make you feel like a market wizard. It won’t make you rich quick or solve your money problems. It won’t relieve you of the need to do what most Americans hate to do (save). It won’t impress your friends or make you the toast of cocktail parties. It will, however, make you a lot of money. Here it is:

Diversify your assets, reduce your costs, and get out of the way.

That’s it. No stock picking. No market timing. No forecasts. No tips. No TV. Why? Because the market odds are in your favor. In a casino, if you play long enough, you will lose. In the financial markets, if you play long enough—and don’t make mistakes—you should win. Unfortunately, not making mistakes is easier said than done.

One problem, much lamented, is that our interests differ from the interests of those who tell us what to do. Despite the squawks of the media, this isn’t scandalous; it’s just reality: There isn’t a business on the planet (including the media business) in which the interests of employees, customers, and owners are perfectly aligned. Another problem is that one size does not fit all: Good advice for a hedge fund might be terrible advice for you. A third problem is that, all else being equal, we would rather have fun than be bored, and investing unintelligently can be really fun. A fourth problem is that we are genetically programmed to make investing mistakes.

The upshot is that most of us throw away thousands of dollars a year on bad advice, shoddy or overpriced investment products, and poor choices—and far more over our lifetimes on subpar returns. If investing were only a diversion—like stamp collecting, say—this wouldn’t matter. Thanks to troubled Medicare and Social Security systems and a shift away from traditional pensions, however, intelligent investing has become critical to our future independence and self-esteem.

We invest unintelligently, in part, because we lack a framework with which to evaluate the bombardment of advice emanating from Wall Street, the media, advisors, and friends. The first part of this book, A Self-Defense Framework, provides one. The second part of the book, Practicing Self-Defense, applies the framework to financial advisors, mutual funds, hedge funds, investment research, and the investment media, and shows why,

despite Wall Street’s dangers, you will always be the biggest risk to your returns. The third part, A Solution, describes an investment plan that allows you to make mistakes but still generate an above average long-term return.

Investment books usually come in two flavors: the you-too-can-be-Warren-Buffett type, which promises to tell you how to get as rich as Croesus, and the what-they-don’t-want-you-to-know type, which portrays Wall Street as a conspiracy of shysters. This book is neither. The average investor will not get tremendously rich in the stock market, and Wall Street is actually not out to screw you.

We love to dream, and we never tire of scandal, so these two genres will always be with us. Unfortunately, neither will tell you what you most need to know to make smarter decisions and get Wall Street working for rather than against you. For that, there’s The Wall Street Self-Defense Manual.

As an investment advisor that charges an annual fee for investment management using the approach he describes I particularly appreciated his instructions for readers on evaluating whether or not to hire a financial advisor to manage their investments.

I fully agreed with Blodget, there are many good reasons not to use a financial advisor: the basic advice is available from very low price or free sources, and an intelligent person could pretty much do it themselves.

On the other hand: there are many people that “don’t want to deal with it”, that might not have the discipline to stick to the strategy and are uncomfortable doing it alone.

In that case Blodget advises that if you can find an advisor that

· Charges less than 1% per annum

· Gives access to investment vehicles not available to the general public (like maybe those of Dimensional Fund Advisors?)

· Makes use of an asset allocation approach with index instruments

· Does not promise to “beat the market”

· Tells you that one of his main functions will be to keep you from making the mistake of acting on emotions and straying from you long term strategy.

It may well be worth working with that person.

Obviously (since this is exactly what I do) I couldn’t agree more.

In a world in which the nonsense of Robert Kiyosaki’s Rich Dad Poor Dad and Jim Cramer’s “Watch TV, Make Money” top the bestseller lists. Henry Blodget’s Wall Street Self Defense Manual is a welcome antidote. Henry himself has some choice words about Cramer, you can read about it here,

or here

I plan to offer a free copy of the book to all my clients and prospects.

Good job Henry!

Wednesday, February 14, 2007

Hedge Funds: Free Call Option for The Manager, Naked Put Option for The Investor

In a recent article in response to the massive success of last week's initial public offering of Fortress Investment Group a recent WSJ article noted that :--.

But some recent research reports point to trouble lurking for the $1 trillion hedge-fund industry.

Hedge funds generally charge their clients -- deep-pocketed individuals and institutions -- fees amounting to 2% of assets under management and 20% of profits. Add in trading costs, and these lightly regulated vehicles need to generate gross annual returns of 18% to 19% to deliver a 10% return to investors, according to a Dresdner Kleinwort paper. And those returns are pre tax. Most funds use mark to market accounting all gains are taxed as ordinary income, so you can knock that after tax return to 6.%, about the same as a 70/30 portfolio of a stock index/bond index portfolio.

One worry relates to hedge-fund trading strategies, which look low-risk but could be dangerous if the market turns quickly….

….Hedge funds can improve returns by adding to investments with borrowed money, getting more bang for their buck. Dresdner estimates hedge-fund borrowing ranges from $900 billion to $4.2 trillion. In other words, for every dollar they have received from their investors, Dresdner estimates hedge funds have added at least a dollar of borrowed money. Leverage makes for high returns, and big losses if things go sour.

Now that is scary, look back on virtually every “blowup” in financial or commodity markets and at the center of the debacle will be one common cause: too much leverage.

In an excellent analogy the wsj writer notes that some analysts:.

liken hedge funds to individuals selling "deep-out-of-the-money" put options. A put option gives an investor the right to sell an asset at a prearranged price should its value fall. For the buyer of a put, it is a hedge against a down market. For the seller, it is a way to turn a profit as long as prices don't fall. Deep-out-of-the-money options look especially safe because prices have to fall a long way to trigger them. When prices do tumble, the losses are steep.

The analogy is quite, apt because if you ask anyone familiar with the options markets what was the cause of major disasters experienced by options traders the answer will be the same: too much selling of out of the money options that wound up “in the money”.

Nassem Taleeb in his brilliant book Fooled by Randomness describes such events as “black swans” unexpected events (the tails in the bell curve) which occur randomly and create disasters.

Thre are many unforseen risks in financial markets that are masked by historical data. In point of fact the only true way to reduce risk in a portfolio is to add short term fixed income and reduce the exposure to equities or to reduce the potential for losses by spending money to purchase put options

“Hedge” funds which make use of esoteric strategies have nothing to do with the true meaning of hedging. Add in leverage and one is doing the exact opposite of hedging. To use the option analogy: a put option buyer has purchased a hedge on his portfolio, he has paid to transfer that risk to the put option seller. The option seller (hedge fund investor) on the other hand has unlimited downside risk.

And here is the ultimate irony: the hedge fund manager has a free call option (actually he is paid for his call option). If the fund scores big he scores big. If the fund blows up, he walks away with the annual fees collected up until the time the fund has blown up. And after that he probably gets a job at another fund. The investors are left licking their wounds and staring at their diminished finances.

Thursday, February 8, 2007

Stock Picking India Style (It Doesn't Work There Either)

In an article entitled As India Stocks Get Pricey, Who Is Picking Them ?” the WSJ, as they say in the newspaper biz, buried the lead: it doesn’t much matter who is picking them. The article goes on to describe the “big debate” among fund management companies over how to staff their actively managed funds:

Many U.S. fund firms are content making stock picks from afar, sending staff in for occasional visits. Some prefer the better oversight they have when portfolio managers are based in the U.S. or in the offices of an investment firm under contract in places like Hong Kong. In particular, many fund companies like their managers' trades to go through a major office, where conflict-of-interest or other quality controls can be better monitored.

Others, the article continues, place their staff in India.

But in reading the article there is little reason to think the location of the analysts makes much difference . In fact it seems quite likely that the analysts are irrelevant and their picks will not beat the index. While one year’s performance (all that is cited in the article) may not be sufficient to draw definitive conclusions, it seems like the analysts at the India funds listed in the article need to justify their existence:

2006 returns

India Index : 47%

Actively managed funds 100% invested in India

Matthews India 36.5%

India Fund 32.9%

Morgan Stanley India Investment 38.3%

While we would not necessarily recommend a single country index instrument for more than a very small portion of a portfolio, that alternative does now exist. Barclays Global Investors offers an exchange traded note that generates the return of an index of the overall Indian market.

Of course the WSJ author is still drinking the active fund management industry kool aid

Prices of many Indian shares have started to approach valuations seen in developed countries, and some analysts think stock picking will be more crucial to success than in the past, when many stocks rose with the market's momentum

Sorry, I fail to see the logic here. I’ve never read that the success of active management has any correlation to the level of valuation in any market. In fact with the boom in stock market investing by both locals and foreigners in the Indian market one would expect stock picking to become less not more important.

The big advocates of active management often argue that in emerging markets which have less liquidity and transparency are places where stock picking should be more important. In the case of India we have seen stock picking has not worked so far. As the market becomes more liquid and transparent (and more like the markets in the US) the markets should become more efficient and the advantages of indexing should increase.

As the world’s capital markets become more globalized and capital flows more freely across the world, the advantages of indexing and the small and value premium are more recognizable across the world in developed and developing markets.