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Thursday, March 29, 2007

The Right Way to Invest Internationally

As we have pointed out in other posts, our investment strategyis based on the pioneering research of Fama and French and confirmed by the research work of other prominent academics. It takes advantage of the value and size premiums in stock performance. Long term data have shown that value (high book to market) and small cap stocks outperform the overall market with small cap value stocks showing particular outperformance. This outperformance occurs in international markets as well, in fact the value and small value outperformance are more pronounced in those markets. This can likely be attributed to the wide dissemination of this research in the US capital markets and consequent larger number of people employing this strategy, thus lowering the advantage.

A recent WSJ article got the story partially right when it reported the following:

It's a Small World, After All

Global Investors Look
Beyond Big-Cap Issues;
Will Streak Run Out?

March 26, 2007; Page C1

International investors are starting to think smaller. They should have started earlier.

Small and midsize stocks in Europe, Japan and other corners of the developed world have offered some of the best earnings growth anywhere in recent years. These stocks returned 25% a year, on average, for the five years through December, according to Morgan Stanley Capital International.

Like U.S. small-capitalization stocks, small-cap foreign stocks outperformed large-cap foreign stocks for each of the past six years. Up 7% year-to-date, foreign small stocks are ahead again this year.

And the small-cap stock gains came with fewer ups and downs than stocks in developing countries, and with about the same volatility as large foreign or U.S. stocks.

In other ways, the case for these small companies is less compelling. Earnings growth is slowing, smaller stocks have become relatively more expensive than large stocks and any sign that investors are getting nervous about owning riskier securities -- as when markets around the world nose-dived late last month -- usually hits small stocks harder.

Based on price relative to expected earnings, European small-cap stocks are now 19% more expensive than large European companies, according to Citigroup.

Small-cap international stocks offer some unique advantages to U.S. investors. They can provide better portfolio diversification than other foreign-stock categories.

Actually there is a simple solution to the dilemma of “overvalued” small cap international stocks: buy the small cap value stocks. And how should you buy them ? in an index fund. Unfortunately, for most investors there is no international small cap or small cap value fund or etf open to the general public. For those (like my clients) who work with an advisor that has access to Dimensional (DFA) funds, there are available a small cap international and an international small cap valuef und. As can be seen below the outperformance of the small cap value index (vs all intl stocks and small cap stocks) is quite persistent. And the small cap, which premium is quite persistent as well.

In fact looking at the data it may indeed be that the WSJ has, as is frequently the case, missed the real story. For all the periods listed small value stocks outperformed the small cap index (and the overall intl index). And for all but the 5 year period value stocks across all market capitalizations outperformed small cap stocks.

1 Year

3 Years

5 Years

10 Years

MSCI EAFE Index (all intl stocks)





Dimensional International Small Cap Value Index





Dimensional International Value Index(all cap)





Dimensional International Small Cap Index





So the lead in the article on investment strategies in international markets should really be “go value” rather than “go small”

The article also points out correctly that the diversification effect is greater with international small cap (and small value) stocks than the overall international markets, which as we noted in yesterday’s post, have an increasing, and high, correlation with US stocks:

Returns on small-cap foreign stocks were less likely to move in sync with Standard & Poor's 500-stock index in the past 12 years than either emerging-market stocks or large-cap international stocks, according to ING Investment Management. Analysts say this is because small-cap stocks are influenced more by domestic or regional factors than by global factors, such as the price of oil or interest-rate moves by the U.S. Federal Reserve.

ING also found that foreign small-cap stocks have been less volatile over those 12 years than the other hot area in overseas investment, emerging-market stocks. Price moves on foreign small-cap stocks were roughly the same as large-cap foreign and U.S. stocks.

"What all this says to me is that if you want to diversify with relatively low volatility, foreign small stocks are the way to go," says Brian Gendreau, an investment strategist at ING in New York.

Of course almost no WSJ article on investments is complete without buying into the eternal mantra of active management: that stock pickers can outperform the market. As readers of this blog know there is little evidence this is the case. But hope springs eternal :

Although the average market capitalization for foreign small stocks is nearly double that of U.S. small stocks, there is much less analyst coverage of international small-cap companies. Bargain "opportunities are greater when there's less analyst coverage," says Randy Farina, who helps to manage the $1.8 billion Putnam International Capital Opportunities Fund, which invests in foreign small-cap stocks.

Return numbers of the abovementioned fund:

1 yr 25.7 3 yr 26.4 5 yr 18.48 10 yr 16.48

In other words Mr. Farina, whose job it is to pick individual small cap international stocks, fails in all periods to beat the small cap value index.

But hope springs eternal !

Sense and Nonsense on International Investing

A recent WSJ article focused on international stocksand their role in individuals’ portfolios. As is often the case a small amount of good information was buried within a lot of bad information. The consensus among virtually all financial advisors is that Investors should hold an allocation to international stocks developed and emerging markets in their portfolio. The recommended allocation usually is put between 15 – 30%.

However, the rationale for this allocation has changed over time. Conventional wisdom had been based on the idea that international stocks were not highly correlated to US stocks. This argument, however has been less persuasive over time. As the capital markets around the world become more integrated the the correlation between equity markets around the world has risen sharply. Based on the data most readily availability to me. I made the following comparison between correlations between Jan 1998- Jan 2003 and Jan. 2002 – Jan 2007:

S+P 500 correlation to:

Emerging markets: 1998 -2003: .40, 2002 -2007: .77

Developed International 1998-2003: .44, 2002 -2007: .85

Nonetheless, the case for international investing may be made in light of the fact that the US stock markets make up less than 40% of the world’s market capitalization and therefore a portfolio should have exposure to the global markets. The returns data is listed below, while the recent outperformance of the international stocks is impressive, more academically inclined observers would point out the convergence of returns in the 10 year data.

The returns are listed below

1 Year

3 Years

5 Years

10 Years

S&P 500 Index





MSCI Emerging Markets Index (gross div.)





MSCI EAFE Index (gross div.)





One thing is certain however the international markets are unlikely to “zig” when the US market “zags”. As one market saying goes “the only thing that goes up in a down market is correlation”. A glance at the one year charts of EFA (developed international index) vs the S+P 500 (in brown) on the top right and EEM (emerging international) vs S+P 500 on the top left shows the high correlation. Although the international markets outperformed they all moved in sync with the US market. Remember 2 assets can have very different returns and volatility but still be highly correlated. Two assets that experienced rises and declines of 5% and 10% respectively at the same times would be very highly correlated despite the different returns and volatility. Such is the case in both charts above.

So here comes the good news and the bad news. The good news is that investors are incorporating an international allocation into their portfolios:

U.S. investors are shipping lots of money abroad. Last year, flows to international equity funds, including exchange-traded funds, hit a record $121.3 billion, compared with $86.3 billion in 2005, according to AMG Data Services of Arcata, Calif.

The bad news is that (surprise) investors are market timing their international investments:

But after last month's selloff, these funds lost a net $3.4 billion in the week ended March 7, the first significant negative result from a market decline since last summer. Money flows have turned positive again, at $1.5 billion last week.

And here’s the worse news: brokerage firms are giving individual brokers the “enhanced capability” ( or a loaded gun ) to trade individual foreign stocks. Etrade, Schwab, Fidelity and Interactive brokers are offering clients the opportunity to trade online individual stocks in 34 (!!!) countries at low commissions.

Imo these “new options” for individual investors are simply giving investors a weapon with which to shoot themselves in the foot. The likelihood individuals will outperform global indices with their individual stock picks is very small.

And sure enough the investor overconfidence so well recognized by behavioral economists is in evidence

Jon Wilson, a software consultant in Cedar Rapids, Iowa, says the ability to buy stocks directly on the foreign exchanges was a key factor that prompted him to start trading foreign stocks with Interactive Brokers LLC, a brokerage aimed at professional traders. "It's what buys you real-time transaction capabilities and it's what gets you the least fees," he says.

I can assure Mr. Wilson that “real time transactions and low commissions” while not a bad thing will have next to nothing to do with the long term return of his international stock investing, and that the odds he will outperform a broad international index with his individual stock picks is minimal. After all not only does he have to be right in timing the market, stock selection, and industry selection, he now has to be right on the country as well. And all of this with less data than available for domestic stocks. To say the odds are against him is an understatement.

To its credit the WSJ acknowledges a better alternative is available:

For most investors, though, the easiest way to invest overseas is through U.S. mutual funds with an international focus. Although average annual expenses are typically higher for international funds than U.S. stock funds, the boom in international ETFs gives investors access to lower-cost options.

My next entry will be more specific in describing our approach to international investing

Sunday, March 11, 2007

Your Hedge Fund$$ At Work...This Is What They Mean By Investing In "Uncorrelated AssetS"

Your Hedge Fund Investment $ At Work

One of the marketing mantras of Hedge Funds is that they invest in assets “uncorrelated” with conventional asset classes like stocks. Among the asset classes they have delved into is movie production. Not that they had any particular expertise….or that anyone in the industry seriously argues that they have any reliable methodology for consistently producing profitable movies. But that didn’t stop the hedgies. So I wasn’t surprised to find this NY Times article about a hedge fund financed film production company

An Aspiring Mogul’s Quick Rise and Fall

LOS ANGELES, March 7 — The journey of Henry Winterstern is a classic Hollywood tale: of this town’s irresistible lure, the particular hunger it breeds and the hubris that so often leads to a sudden demise..

A gravel-voiced, Canadian-born investor with a flair for turning around ailing companies, Mr. Winterstern arrived two years ago,….. Backed by millions from a New York hedge fund and a blue-chip Wall Street investment bank, much like a new crop of other Hollywood ventures, he wasted little time building his mini-empire….

By last Friday he was gone, done in by a disastrous 2006 at the box office and a taste for spending, with little cash flow to show for it.

While neither First Look Studios nor Prentice Capital Management, the hedge fund that backed him, gave a reason for Mr. Winterstern’s resignation,…

. “There was a divergence of opinion,” he said. “I wanted to build the company and make it

Prentice Capital invested $70 million with Mr. Winterstern to build the studio, in tandem with a credit line of $80 million from Merrill Lynch.


….But Mr. Winterstern’s first movie choices didn’t register with the public. Despite some good reviews, “The Dead Girl,” about a mysterious corpse, took in a paltry $19,000. “Wassup Rockers,” about a group of skater boys, written and directed by Larry Clark (“Kids”), took in just $620,000. The box office returns didn’t deter First Look from moving into the gleaming new building that was erected as headquarters for the Creative Artists Agency. Furnished at a cost of $4 million, …..

Senior executives, who spoke on condition of anonymity for fear of losing their jobs, said the company had $50 million in losses last year. Mr. Winterstern said the loss was not nearly that high but declined to be more specific. .

Mr. Winterstern is not the only comer who has found Hollywood an easy place to enter but a hard place to survive. Philippe Martinez came to Hollywood two years ago backed by capital from London, and has had disastrous results with films like “National Lampoon’s Van Wilder 2: The Rise of Taj,” World

Maybe the hedgies would have better luck spending more times in front of their trading screens and less time in front of movie screens

It was an investment uncorrelated to the financial markets: the global stock markets went up and this investment went to zero.

Tuesday, March 6, 2007

What is The Optimal Allocation to Hedge Funds As Part of Your Portfolio ? Answer = ZERO

I always calculated, based on simple arithmetic, that the numbers were rigged against investors in hedge funds. But an article in the March 4 NYT highlighted academic research that has reached the same conclusion. The fee structure of 2% annual fee + 20% of profits makes it virtually impossible for the investor to do better than simply putting the money into a simple index fund.:

MANY people would jump at the chance to invest in hedge funds, which have mainly been available to only the very wealthy. But a new study finds that the funds’ high fees make it unlikely that investors will improve their long-term performance by putting money into hedge funds.

The study, “Portfolio Efficiency With Performance Fees,” was written by Mark Kritzman, president and chief executive of Windham Capital Management, a money management firm in Boston. appeared in the Feb. 1 issue of Economics and Portfolio Strategy, a newsletter for institutional investors, published by Peter L. Bernstein.

Mr. Kritzman’s article focuses on the effect of the fees that hedge funds charge.

You can follow the link to the article and get the details of the study, but here is the bottom line ..

…..the fees’ effect on the portfolio was so sizable because of the “asymmetry penalty” resulting from the 20 percent cut of profits that the hedge funds earn. The funds do not share in investor losses — but they reap a large share of the profits.

To illustrate how these fees can add up, Mr. Kritzman conducted another experiment. He tried to determine how much a rational investor should allocate to this hypothetical portfolio of 10 hedge funds, when also given the opportunity to invest in a stock index fund and a bond index fund…..

Mr. Kritzman found that, given these assumptions, the investor should allocate nothing to the basket of hedge funds and everything to the two index funds…..

What about so-called funds of hedge funds, which have lower minimums and are therefore available to less-affluent investors? Mr. Kritzman says he finds it difficult to justify any allocation to funds of hedge funds, because they earn fees above and beyond those earned by the hedge funds in which they invest, typically 1 percent of funds under management and 10 percent of profits above a benchmark.

The bottom line, Mr. Kritzman said, is this: “Because of fees, the optimal allocation to a group of hedge funds is a lot lower than you might think it should be.”

In fact the bottom line is even worse. Kritzman’s calculations were based on pre tax returns. Hedge funds generally use “mark to market” accounting which means that all gains are treated as short term income which is taxed at the ordinary income rate of up to 35%, reducing the after tax return for most hedge fund investors by that amount.

Friday, March 2, 2007

Chasing performance II…You Knew this Was Coming

In Mutual Funds
That Buy Overseas,
Latecomers Lose Out


March 1, 2007; Page C1

This one was so predictable that I was tempted not to point this out: WSJ March 1

Richard Laudon, a Boston optometrist, opened accounts in three international-stock mutual funds in January. The results of that decision in the wake of Tuesday's global market dive "look terrible," Mr. Laudon says.

"I lost more money yesterday than some people over 55 have in their retirement accounts," he says.

Far from alone, Mr. Laudon was part of a stampede into mutual funds in January, particularly funds that invest abroad. It was an exceptional case of perverse timing in which individual investors arrived late to the party and wound up paying dearly. "There are times when you feel brilliant and times when you feel like an idiot," he says.

According to fresh data from the Investment Company Institute, a fund-industry trade group, individual investors deposited $46.89 billion in mutual funds in January, a whopping 130% increase from the $20.40 billion invested in funds in December. Particularly popular were mutual funds that invest abroad. These funds had been on a winning streak -- until they took it on the chin this week in the slide that spread partly from China's stock market….

It happens every time:

The performance of global equity funds -- U.S. mutual funds that invest in international markets -- have trounced the gains of purely domestic funds nearly since the start of this decade, making them attractive to investors.

According to the ICI data, net inflows to global equity funds were $21.1 billion in January, a 56% increase from December. It was the largest monthly inflow to the category since January 2006, when the net buying hit $23.5 billion.

Want to check what happened three months after those inflows last year ? Answer a 25% + drop from Mid May to Mid June for the emerging market index (lower chart at top of post). The drop for ( for developed international (upper chart) was 20%. Followed by outflows from the funds, followed by a recovery for the rest of 2006 . Full year 2006 return for emerging international markets : 31.4% for the develop international index it was 26.8% . Net result: many, many investors suffered losses in international investing despite the tremendous gains they would have had if they simply held the index.

While losses were spread broadly across the fund landscape Tuesday, global funds lost more than domestic funds in the downturn, Funds that invest in the Asia-Pacific region, including Japan and China, fell 4.2%. Funds that invest in a wide range of emerging markets were down 5%; and as a whole, the once-hot Latin American category did the worst, falling 7.7% in one day.

"That's always the danger of chasing performance," says Arijit Dutta, another Morningstar analyst. "These funds have done tremendously well -- we have been cautioning people to not expect this trend to continue forever."

Problem is the Morningstar website is not shy in focusing on funds in hot sectors.

Unfortunately as behavioral economists have taught us, many investors will make this mistae again.