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Monday, December 29, 2008

Does Anyone Else See the Disconnect Here ?

WSJ December 26 On Pension Funds Sticking With Their Hedge Fund Investments:

DECEMBER 26, 2008 Public Pension Funds Don't Flee
Some Say They'll Keep Hedge Investments Despite the Madoff ScandalArticle

Hedge funds have suffered through their worst year in more than a decade, punctuated by the Bernard Madoff scandal. But some public pension funds aren't writing them off, at least not yet.
Chief investment officers for pension funds note that despite some worrisome drawbacks, hedge funds continue to outperform stocks, and by a good margin. Hedge funds are down less than 18% this year, while the Standard & Poor's 500 index has dropped close to 41%.
Still in Hedge Funds
The News: Even after the Madoff scandal, some public pension funds are sticking with investments in hedge funds.Reasoning: The pension managers say hedge funds outperform stocks, so they need to invest in them.Caution: Most everyone agrees not to expect the level of returns of the glory days.Moreover, these funds have a mandate to make a healthy return, leaving them little choice but to keep a portion of their portfolio, often between 3% and 10%, in hedge funds because they offer the potential for large gains, even if the returns are currently negative.
Where Else to Turn?
"We have an 8.5% actuarial assumption, and ... we have to look for programs that can reach that level," said Alan Van Noord, chief investment officer at the $54.7 billion Pennsylvania Public School Employees' Retirement System. "There are very few asset classes that you can get [returns] above 8%."That pension funds remain committed to hedge funds may be a surprise given the industry's recent problems, where total assets have shrunk to about $1.5 trillion from nearly $2 trillion in June.
As stock markets crashed late in the summer, many investors in hedge funds sought to remedy liquidity problems by cashing out. That forced many hedge funds to tell investors they couldn't redeem their funds completely.

Pension managers were startled by the case against Bernard Madoff, shown leaving court on Dec. 17, but many will stick with hedge funds.
Despite many redemption requests being blocked, hedge-fund investors still cashed out more than $100 billion from September through November, the most ever in a three-month period. Some analysts say a smaller hedge-fund industry will be less able to generate huge returns.
Even some pension funds that cashed out of hedge funds recently are now returning. A few months ago, the $8.5 billion School Employees Retirement System of Ohio, or SERS, shelved its investments in hedge funds. Last week, the pension fund's board approved moving

WSJ December 26 On Corporate Bond Yields:

'Rebalance' Time? No, Says Bond Side
Corporate Debt May Still Beat Stocks

Falling stock prices this year have left many investors' portfolio balances out of whack. But some managers argue against the need to rebalance holdings.
Mark Kiesel, executive vice president at bond-fund giant Pimco, a unit of Allianz SE, says the relative values of high-grade corporate debt compared with stocks means that selling bonds and buying stocks would be a mistake.
"We're in a unique situation where you can get 8% to 10% returns in high-quality corporate bonds, while stock returns are unlikely to do that for the next couple of years," Mr. Kiesel says. "If I asked you, 'Do you want 8% to 10% or 5% [from stocks], with three times the volatility,' which would you want?"

Wednesday, December 24, 2008

My Article on The Madoff Affair and Investment Management at Not for Profit Organizations

The following is my article that appeared in the Los Angeles Jewish Journal

The Jewish Journal

December 23, 2008
Can you say fiduciary duty? Jewish nonprofits must follow new rules

By Lawrence Weinman

Based on all reports, the evil criminality of Bernard Madoff has decimated the portfolios of hundreds of individuals and charitable organizations. The consequences for ongoing charitable programs and future gifts will be felt for many years to come.

While there should be no limit to the outrage at Madoff, the Jewish not-for-profit community must recognize that this crisis has highlighted grave shortcomings in professional controls in place related to the investment of their funds. Judging from press reports and public communications from numerous institutions, it seems apparent that the basic standards of fiduciary oversight were not in place. Both professional staff and lay leadership should undertake comprehensive reviews of their policies and take responsibility for their shortcomings.

Complete Madoff CoverageAs the community looks forward, it is imperative that the oversight of investments be executed in a manner that meets the highest fiduciary standards. After all, those responsible for overseeing the investments quite literally have the future of many of the most important programs in the Jewish community in their hands.

The large, often undiversified allocations to Madoff indicate that the foundations fell into the worst pitfalls that trap individuals into unwise investments. Among these are: lack of diversification, belief in "genius managers" who promise to deliver above market returns with minimal risk, not understanding the strategy of the funds in which they invest, investing based on reputation rather than doing due diligence and not monitoring the investment activity. While it is bad enough to find individuals who fall into some or all of these traps, to find evidence that those overseeing large sums for the community were no better is very disturbing, to put it mildly.

It also seems from this affair and my research on the investing policies of not-for-profits that many of these institutions joined with the fad of not-for-profits investing in "alternative investments." Enticed by the success of Yale and Harvard's enormous endowments they sought to "be like Yale and Harvard" and invest in hedge funds, private equity funds, venture capital, commodity funds and other products despite little real knowledge or professional staff. Yet even David Swensen, Yale's esteemed manager, has written that neither individuals nor small institutions should follow Yale's strategies since they lack the large professional staff and resources required to properly screen and manage such investments.Yale has 19 full time professionals overseeing their investments, Harvard Management has a full- time staff well over 100.

A Business Week article in May 2006, "Big Risk on Campus," reported on smaller endowments investing like the big guys, noting that larger endowments (averaging $1 billion or more) had an average of 21.7 percent of their assets in hedge funds. In second position in the article's table of smaller endowments with big hedge fund stakes was Yeshiva University's $1.1 billion endowment with 65.3 percent. Yale's allocation to hedge funds is 23 percent; Harvard's, 18 percent.

Ironically, while many foundations concentrated on seeking out exotic, high-risk "alternative" investments, they did not look into allocating a portion of their investments to a better "alternative," such as investments that would not have entailed above-average risks. Examples would include: socially responsible index funds, a broadly diversified index fund of Israeli stocks or investments in indices of companies investing in clean energy. The vast majority of foundations ignored the opportunity for "doing well by doing good" in their quest to find a "hot hand" to manage their money.

Looking forward, it is imperative that our institutions draft clear investment policy statements and establish appropriate policies and controls. Ideally, the foundations would wind up with an investment portfolio in line with the "best practices" of investment strategy and not much different than that of a prudent individual: broadly diversified with low cost, transparent and liquid index instruments. The parameters of such policies would include:

* A target allocation for the portfolio among international and domestic stocks, bonds and cash, along with controls for keeping the portfolio within those parameters.
* No investments in bonds below investment grade.
* Restrictions on investments in asset- backed securities.
* Restrictions prohibiting any investments that make use of leverage or derivatives.
* Restrictions on investments in illiquid investments, such as venture capital and private equity, and on investments that do not have transparent pricing and valuation.
* No investments in any entities affiliated with members of the investment committee, the board or the professional staff. As a consequence of this one policy, the New York Jewish Community Foundation had no investments with Madoff.
* Ability to price all investments in the portfolio on a daily basis. Confirmations of all transactions by the next business day.
* Transactional activity and financial reporting performed by different individuals.
* Monthly performance reports available to all investment committee members.
* Annual audit of all investments and procedures by an independent third party.

In addition to the above, serious consideration should be given to an even higher level of transparency: complete posting on the Internet of the full portfolio and its value and performance. Given the extreme lack of controls evidenced by the Madoff affair, such an easily implemented step would go a long way to restoring confidence in the community and in fact may be essential for any success in raising the funds necessary to keep many programs afloat.

Lawrence Weinman is an independent registered investment advisor working with individuals and institutions. He teaches a course on investment management for nonprofits at the AJU and has worked with Jewish nonprofits in their investment strategies. He blogs at

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Tuesday, December 23, 2008

I'm Not Surprised By This: The Bond Market Corrects A Bit

I wrote on December 7 about what I felt was the irrationality in the bond market particularly in terms of the spread between investment grade corporate bonds and treasuries. That gap has narrowed considerable as of late. This can be seen in the movement of LQD ( 6 month chart at left) the ishares investment grade corporate bond etf which is uo 5.76% in the past week and 10.53% in the past month. Returns of he treasury etf representing the same maturity, IEF (chart at right)is up 2.36% for one week and 7.21% for the past month.

Wednesday, December 17, 2008

Names of Mutual Funds Are Meaningless: Exhibit A

In an article on the problems in the fixed income group at Oppenheimer funds. The WSJ mentions the following

The OppenheimerFunds Inc. executive who oversaw big leveraged bets that backfired has left the company.
Senior Vice President Angelo Manioudakis, who headed the firm's Core Plus team, resigned Friday. The team managed more than $16 billion in individual-investor-oriented fund assets. Under Mr. Manioudakis, investments in the likes of mortgage-backed securities and credit-default swaps went awry.

Those woes fueled an 82% drop at its flagship junk-bond mutual fund, Oppenheimer Champion Income, one of the worst showings among the roughly 150 U.S. junk funds that invest in high yield, or below-investment-grade, bonds. The average junk-bond fund is down 32% in 2008.
…..The bet "backfired in unprecedented ways" as "what had been the most liquid part of the market turned out to be the most illiquid," Mr. Webman says.
…..The fund spread pain beyond its own immediate investors. More than 10% of the fund also was recently held by other OppenheimerFunds offerings. This includes several funds of funds that bundle various products from the firm and at least one target-date retirement offering.
One of the hardest hit has been the $290 million Oppenheimer Conservative Investor Fund, which had 4% in the Champion Income fund through November. It is down almost 40% this year, making it one of the worst-performing conservative allocation funds followed by fund tracker Morningstar Inc.
(maybe that's because the fund didn't have a conservative allocation)

on the oppenheimer funds website, the fund is described as follows

This fund might be right for investors who plan to start withdrawing money in the short term and need an investment with relatively low risk.


Calpers and Its Alternative Investment Strategy

Calpers, the nation's largest pension fund, is another victim of the aggressive use of "alternative assets" by pension funds (I recently posted on the problems in Pennsylvania).As in the case of university endowments, the "state of the art" invesmtment strategy moved from a "boring : portfolio including large holdings of investment grade bonds along with marketable equities has been replaced by one including generous helpings of "non traditional asset classes" which were promised to increase returns without increasing risk.

The WSJ reports on the conseqeunces for CALPERS
, (my bolds) and I am afraid we the taxpayers of Califormia will be called upon to maker up for any shortfalls. Unlike PA which reported large losses due to hedge fund investments, this article reports on the ill fated real estate investments at CALPERS, although I strongly suspect they took hits in the hedge fund arena as well.

Risky, Ill-Timed Land Deals Hit Calpers


At the height of the property bubble, California's giant pension fund, Calpers, made a fateful decision: It aggressively poured money into real estate. As a result, today it's one of the biggest owners of undeveloped residential land in America.
Bad Bets

Partly because of these investments, California Public Employees' Retirement System is struggling to avoid one of its worst annual declines since its 1932 inception. Calpers has lost almost a quarter of its assets since July 1, the start of the current fiscal year.

The problems come at a time of uncertainty for the nation's largest public pension fund, which has been without its top two executives for nearly half a year. Calpers is poised to appoint a new chief executive as early as this week, people familiar with the matter said.

Calpers is now warning California's cities, towns and schools that they may have to cough up more money to cover the retirement and other benefits the fund provides for 1.6 million state workers. Some towns are already cutting municipal services, and at least one is partly blaming the Calpers fees.

Calpers in recent weeks said it expects to report paper losses of 103% on its housing investments in the fiscal year ended June 30. That's because Calpers invested not only its own money, but billions of dollars of borrowed money that must be repaid even if the investment fails. In some deals, as much as 80% of the money invested by Calpers was borrowed.....

With $239 billion in assets as of June, Calpers's portfolio was bigger than the government-run funds of Russia, South Korea, Dubai and Chile combined. In recent years, Calpers became much more aggressive than other pension funds in making nontraditional investments -- real estate, foreign stocks, even forestland....

Alicia Munnell of the Center for Retirement Research, Boston College, says the economic slump will likely force other pension funds besides Calpers to pass on the financial pain. "Even under the best-case scenario...taxpayers are still going to have to put more money into pension funds."...

Just one particularly bad year for investments can have serious consequences for California governments in the retirement system. Calpers recently estimated that if its declines for the current fiscal year are greater than 20%, it would trigger an increase of 2% to 5% of an employer's payroll.

Currently, the average employer-contribution rate for public agencies, including cities and counties, is 13% of payroll, Calpers said, which is already on the high side for state pension funds, according to industry analysts. A 5% increase in California's rate would be the largest increase to hit public employers since the dot-com bust....

Real-estate losses aren't the primary reason Calpers is taking a hit. Its biggest declines have been in the stock market: Its stock portfolio is down 41% so far this fiscal year.

But Calpers has targeted less money in bonds, and about double the allocation to private-equity investments and real-estate deals, than the average public pension fund, according to Calpers documents and an industry survey.

Calpers got more aggressive in real estate amid the tech-stock selloff of 2000-02. Its board decided to increase its investments in real estate and private equity, shifting some money out of safer, but lower-yielding, holdings like bonds.

Robert Carlson, a former Calpers board member who left the board earlier this year, said publicly at that time, "We believe taking no risk is the biggest risk you can take."

Yale (IMO not Completely ) Reports Its Damage from The Black Swan

I knew this was coming....

I noted on December 3 the large losses experienced by the Harvard Endowment. At the time I noted that Harvard and. to an even greater extent, Yale are considered the gold standard in investment management among not for profits. They were pioneers in the extensive use of "alternative assets" such as hedge funds, private equity and venture capital while significantly reducing the exposure to conventional bonds to generate what was praised as higher return and less risk. Needless to say those asset classes have taken big hits as of late and in fact have in many cases turned illiquid and even in some cases a market value cannot be determined for them.

I also noted that Yale's manager David Swensen is interviewed in the current issue of Worth magazine stating that he didn't know the returns for the portfolio at present and that he wouldn't know till fiscal year end on June 30. I voiced skepticism at the time noting. I thought that was unlikely and was proven correct. From today's WSJ

* DECEMBER 17, 2008

Yale to Trim Budget as Its Endowment Falls 25%


Yale University, a much-emulated college investor, estimated its endowment has fallen 25% since June 30, prompting the school to trim its budget.

The Ivy League school, higher education's second-richest, said its endowment now stands at roughly $17 billion, down from $22.9 billion on June 30. The $5.9 billion decline is more than the total investment funds of most other U.S. colleges.

A number of wealthy schools have reported investment declines in similar ranges, including Harvard University, which has the largest fund. In a recent report, Moody's Investors Service said Massachusetts Institute of Technology had told the rating agency that the school's endowment, valued at $10.1 billion as of June 30, had declined 20% to 25% by Oct. 31. The school declined to comment. Across the country, losses are leading to budget cuts and hiring freezes.

In a letter to the faculty and staff Tuesday, Yale President Richard C. Levin said the school's endowment had declined "significantly less than market indexes." From June 30 through Oct. 31,

Dr. Levin said the value of marketable securities had fallen 13%. That compares with a 24% decline for the Standard & Poor's 500 stock-index in those four months.

I find Dr. Levin's math a bit fuzzy a "20 -25% loss" (which, see below is likely to revised downwards) is not "signficantly less than market indices" when the S+P 500 declined 24% over the same period. A reasonable benchmark for an endowment would be a blended number including at a minimum 25% bonds. Given that a broad bond index would have declined far less than 24%, I think Dr. Levin's assertion can be fairly regarded with skepticism)

note that in a similar letter Harvard's President wrote the following (my bold):

Harvard Management Company, using standard industry practices for valuing assets, has calculated investment losses of approximately 22 percent from July 1 through October 31. Yet even that sobering figure is unlikely to capture the full extent of actual losses for this period, because it does not reflect fully updated valuations in certain externally managed asset classes, most notably private equity and real estate. HMC expects that as we receive more comprehensive valuations in these asset classes from our external managers, the endowment will realize further declines in value.

The Harvard returns number is close to that of Yale's and we know that Yale had similar exposure to the above noted asset classes. For that reason I think it is reasonable to assume that Yale faces the same valuation issues and that, as in the case of Harvard, the reported loss number will be ultimately be larger than this initial number.

More on this issue later but in preparation for my class on investment management for not for profits class we will be raising the issue on whether we are entering a new era for endowment management and discussing whether the old stodgy strategy of large doses of marketable bonds combined with some listed equities will become the new state of the art. Let's just say the discussions of the case studies on Harvard, Yale and other endowments in which we questioned whether extensive use of "alternative asset classes" was appropriate for smaller endowments will be likely be a bit more one sided this year.....

and we will have a good case study on the importance of controls by discussing the Madoff affair (more on that one later as well).

Monday, December 15, 2008

WSJ on The Treasury Bubble Today

The Wsj has an article about the bubble in treasury bonds today. Although it notes that since the mkt can be manipulated by the Fed and Treasury, it doesn't necessarily mean prices will collapse in a big bursting of the bubble.

As you might suspect I am full agreement with these observations in the article:

And while the U.S. government's access to cheap money helps its efforts to stimulate the economy, it also may crowd out other borrowers. Municipalities and companies with good credit histories are paying exorbitant rates to borrow, arguably extending the pain of the credit crunch.

"We have a remarkable situation in which a 30-year loan to the U.S. government with a taxable instrument pays you 3% and a loan to the state of Ohio pays you 5% tax-free," said David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J.

Eventually, investors will demand a higher yield for Treasurys. It could happen when risk appetite returns, or if the cash the Fed is pumping into the economy sparks inflation. Some worry a snapback could be as brutal as the popping of any bubble, sending interest rates soaring and short-circuiting any economic recovery.

Tuesday, December 9, 2008

The Bond Market's Irrationality Causes More Problems for Harvard

I wrote on December 3 that Harvard University's planned to issue long term bonds to fund current expenses as a consequence of the investment losses by its endowment. I wrote that by trading on its AAA credit rating and the historic low levels of long term treasury interest rates the decision would like turn out to be quite a good bond "trade" as the university would lock in very low borrowing rates. I expected their AAA credit rating (there are only a handful of US corporations with a credit rating of AAA) and the unlikely scenario that Harvard would default on its bonds would let them borrow at a small spread over treasuries......

Well I was wrong, big time. Bond market investors demanded a massive spread over treasuries on the Harvard bonds. The WSJ reports

Harvard Sells $1.5 Billion in Bonds


Harvard University raised $1.5 billion Friday in taxable bonds, with proceeds earmarked to repay short-term debt and to terminate certain interest-rate swap agreements, among other purposes.

The sale comes as the Ivy League university prepares to sell $600 million of tax-exempt bonds in the coming week to redeem debt such as short-term variable-demand obligations as well as to close out interest-rate swap contracts. Both the taxable and tax-free bonds received triple-A ratings from Standard & Poor's.

The fund raising comes days after Harvard reported that its endowment fund had investment loses of at least 22% in the first four months of the school's fiscal year.

The university raised $500 million each in five-year, 10-year and 30-year maturities. The five-year portion was priced to yield 3.35 percentage points above Treasurys, while the other maturities yielded 3.375 percentage points more than Treasurys . Based on recent prices, the 30-year bond would yield around 6.41%.

(To put the above number in perspective: as recently as last June below investment grade (junk) bonds carried a yield 2.5% above treasuries).

the article continues:

"It's a good pricing, coming right on top of single-A corporates like IBM," said Gary Pollack, head of fixed-income trade and research at Deutsche Bank Private Wealth Management. IBM five-year notes trade about three full percentage points over comparable Treasurys, "so you're getting a triple-A bond for the same level."

I assume he meant good pricing for the investory which it is. Talk about irrationality a buyer of these bonds can upgrade from a single A credit to AAA Harvard and increase his yield by .35% If and IBM bond default is unlikely, how unlikely is a default by Harvard University ?

Harvard spokesman John Longbrake declined to comment on the bond sale.

The university's financial report on its fiscal year ended in June, attached to the bond prospectus, noted that it lost $15.6 million in that year on interest-rate swap contracts, up from a loss of $7.9 million in the previous year. It entered into these agreements to manage interest-rate risk when converting variable-rate borrowings into fixed-rate debt, not for trading or speculative purposes, the prospectus said.

(translation of the above: Harvard locked in fixed rate borrowings based on rates for treasury bonds last year that were far higher than current rates. Now it will be hit with a double whammy effectively realizing the loss on its bet on the direction of treasury rates but also paying an interest rate premium over treasuries on its bond issuance which is in the range of 2.75% higher than it would have been a year ago.)

Monday, December 8, 2008

My Favorite Financial Author.....

Nassim Nicholas Taleb (Fooled By Randomness, The Black Swan)is never shy about challenging conventiol ways of looking at financial markets.

In today's Financial Times he is at his brilliant,incisive best, An excerpt

Bystanders to this financial crime were many
By Nassim Nicholas Taleb and Pablo Triana

Published: December 7 2008 19:18 |

… the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods).

Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes.

Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.

Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

For those interested in financial markets I recommend Taleb's book Fooled By Randomness rather than the more popular Black Swan

Talebs Website is here

Sunday, December 7, 2008

More on Irrationality in the Bond Market

James Grant, always an astute and skeptical observer of the financial markets, write in no uncertain terms about the irrationality of current treasury yields in the Financial Times.

Here's part of what he has to say:

Insight: Return-free risk

By James Grant

Published: December 4 2008 17:39

US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all.

“Super-safe Treasuries”, the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. “Toxic assets” is how the same papers characterise orphaned mortgage-backed securities—or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur.

“There are no bad bonds, only bad prices,” the traders used to say. They should say it again, only louder. In the spring of 1984, long-dated Treasuries went begging at yields of nearly 14 per cent in the context of an inflation rate of just 4 per cent. Those, too, were fearful times, the recollected horror being the great inflation of the 1970s. Inflation was ineradicable, the bondphobes said. Now a new generation of creditors espouses the opposite proposition. Deflation is baked in the cake, they say.

The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price.....

We can’t know, but we can at least observe. What I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before – in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?

Evidently, they are—at least, forward swap rates betray no such concern. The market’s best guess as to what the 10-year Treasury will yield in 10 years’ time is 2.78 per cent, never mind the famous (and now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars out of a helicopter in a deflationary pinch.

The non-Treasury departments of the credit markets have crashed. No surprise then that prices and values are deranged. Market makers have closed up shop for the year, while hedge funds cower in fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent.

In corporate debt and mortgages, anomalies and non sequiturs

.... Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as “anything not guaranteed by Uncle Sam”.

“Risk-free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”

The Economist recently made similar observations on the relationship between corporate bond yields and US treasuries.

An appetising spread

The chart at the top of the page shows 5 years of data for two ishares bond etfs: LQD the investment grade corporate bond etf (n red) and IEF the intermendiate term US treasury etf (in blue), both instruments have roughly the same duration. Bond prices move inversely to yield. In normal markets as can be seen in the chart throug late 2007 prices should move in the same direction with the differential between the price movements representing changes in credit spreads. Yet beginning in late 2007 anc accelerating this year one finds a radical divergence in price as treasury prices rally sharply (yields decline) while corporate bonds move in the opposite direction creating the large differential in yiess.

An irrational anomaly ? it seems so. Could it continue and infact increase ? History has told us that it can happen.
Nov 13th 2008
From The Economist print edition

The corporate-bond market is discounting very bad news
Illustration by S. Kambayashi

SHERLOCK HOLMES might have called it “the curious case of the corporate-bond market”. Most commentators agree that bonds issued by companies offer spreads over treasuries that more than compensate for the risk that the issuer might default. But few investors are tempted to buy.

The reason has more to do with the problems of investors than the deteriorating finances of issuers. About 20 years ago, the main buyers of corporate debt were pension funds and insurance companies. They would buy the bonds of creditworthy, investment-grade companies and then hold them till maturity. It made for a reliable-but-dull asset class.

The use of leverage, or borrowed money, changed that. All that hedge funds, and other speculative investors, needed to do was to buy bonds on yields greater than their cost of finance. The difference, or carry, would be the main source of return; if the bonds rose in price as well, so much the better.

Indeed, by early 2007 corporate-bond spreads were ridiculously low, offering a return that failed to compensate investors for the likely level of defaults. Borrowers rode roughshod over investors. ....

The market has now swung to the other extreme. According to Moody’s, a rating agency, investment-grade firms are now paying double the spread over government bonds that speculative, or junk, issuers were paying back in June 2007.

Junk issuers are now paying around 15 percentage points more than treasuries, compared with just two-and-a-half points in June last year. Investment-grade firms are now paying a spread of more than five percentage points, compared with less than one point in February 2007.

That might seem unsurprising, given the deteriorating economic outlook and the defaults we have already seen in the financial sector. But John Lonski, an economist at Moody’s, reckons that spreads are signalling the expectation of default levels not seen since the Depression. And Stephen Dulake of JPMorgan calculates that spreads are more than wide enough to compensate for the impact of a 2.5% fall in the American economy next year....

.....But the biggest question-mark is over those leveraged investors. Some hedge funds have been forced to sell bonds to raise cash so they can repay investors who are unhappy with their returns this year. Others have been forced to cut back because of restrictions imposed by their prime brokers, their main source of finance. And even those that are able to borrow money are finding it more expensive; Barclays Capital reckons that funding costs have risen by more than a percentage point since last year.

For such investors, corporate bonds may not be all that cheap once all the costs have been taken into account. In addition, there is always the risk that bond prices could fall (and spreads could widen) further in the short-term.

However, that still creates an opportunity for old-fashioned investors who do not rely on borrowed money and who can buy on the basis of a five-year time horizon. One such investor is Kathleen Gaffney, a portfolio manager at Loomis Sayles, a fund-management group. “We have moved beyond fear of financial Armageddon to thinking about the steps to recovery,” she says. But for the moment Ms Gaffney is the exception, not the rule.

The graph at the top of the page shows 5 years of data for two bond etfs. In red is the chart for IEF, the intermediate term treasuty etf. In blue is the investment grafe corporate bond etf LQD. Note that up until late 2007 the two instruments moved in tandem with the overall price level (price moves in the opposite direction of yield) with small movement in the price differentials reflecting the yield spread between the instruments. Yet beginning at end of 2007 and accelerating this year treasury prices have rallied sharply (yields falling) while the corporate bond prices have collapsed creating extreme values for differentials in yields between the two.

An irrational anomaly in the credit markets that will reverse at some point in the future ? it seems likely. Could this persist and even indrease ? quite possibly

Friday, December 5, 2008

It's Not Just Equity Markets That Can Get Irrational

For all those that think markets are always efficient and rational, I suggest they take a look at the current yields on US Treasuries:

3 months .005%
2 Year .92%
5 Year 1.66$
10 Year 2.65%

The lower chart shows the movement in yields over the past 12 months.

Bloomberg reports on market activity

Dec. 3 (Bloomberg) -- Thirty-year Treasury bond yields fell to record lows for a third consecutive day after the Federal Reserve said it plans to make weekly purchases of the debt of mortgage issuers to drive borrowings costs lower.

Yields have dropped every day since the central bank announced on Nov. 25 that it will buy as much as $500 billion in agency and mortgage securities of government-sponsored enterprises including Fannie Mae. Gains accelerated two days ago, when Fed Chairman Ben S. Bernanke said he would consider buying Treasuries and target long-term interest rates to combat a deepening recession.

“They’re going to be buying GSE debt and they’re going to be buying mortgage debt,” said David Ader, head of U.S. government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut, one of the 17 primary dealers that trades directly with the central bank. “That’s the propellant today.”

The 30-year note yield fell one basis point to 3.17 percent at 4:15 p.m. in New York, according to BGCantor Market Data. The yield touched 3.1564 percent, the lowest since the Treasury first started selling the securities in 1977. The 4.5 percent security due May 2038 rose 10/32, or $3.13 per $1,000 face amount, to 125 9/32.

Yields have dropped 119 basis points over the last 21 days, the biggest rally since the stock market crash of 1987. Treasury 30-year bonds yielded about 9 percent in November 1987.

Ten-year note yields fell three basis points to 2.67 percent, near the lowest level since the Fed started keeping daily records in 1962. Two-year note yields were little changed at 0.89 percent.

At the same time the real yield on 10 year treaury inflation protected bonds TIPS is 2.2^% that is a guaranteed after inflation yield ;

The difference between rates on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes, which reflects the outlook among traders for consumer prices, was 41 basis points. The spread narrowed from this year’s high of 268 basis points in March

The above means that as long as inflation is above .41% the tip will offer superior return to the conventional treasury bond.

A couple of other reference points to put the treasury yields in perspective:

Dividend yield for the S+P 500 = 2.9 %
Yield on ishares 7 -10 Year US Tresury ETF (IEF)duration 6.97 years =3.27%
YIeld on Ishares Investment Grade Bond ETF (LQD) duration 6.7 years = 7.26%

Seems like the words bubble and overshoot need to be applied to the market in US treasury bonds. At least parts of the market exhibit some rationality With the risk free (treasury interest rate at historic lows it shouldn't be surprising that stocks have staged a decent sized rally.

The charts show the ten year treasury yield at left and the s+p 500 at right. Betweem Nov 14 and today the ten year treasury yield went from a high of 4.27 to 2.65. On Nov 21 the sp 500 hit it's recent closing low of 752 and closed today 16.5% higher.

The S+P 500 price movements are shown on the chart is the upper chart at the top of the page.

Thursday, December 4, 2008

I'm Quoted Again in the Local Press

This time in an article on the potential problems for the economy from credit card defauls. The article is here.

Wednesday, December 3, 2008

Harvard's Endowment Gets Hit By A Black Swan

Harvard University,along with Yale has been a pioneer in using "alternative" asset classes in their portfolios: private equity, hedge funds, venture capital and commodities. In fact the allocation to to publicly traded securities at Harvard is 33% According to the most recent annual report available from the Yale Endowment, the allocation to Bonds is 4% domestic equities 11% and foreign equities 14%, th rest went to alternatives and these numbers have been fairly stable for years.

This strategy has been widely emulated by other university endowments and pension funds (as in the case of the state of Pennsylvania described in yesterday's post). It seems that the riskiness of these strategies has hit with a venegance, not only in terms of large losses but also because these asset classes which were touted as having low correlation with each other and with traditional asset classes (stocks an bonds). As many in the financial markets have discovered in the past months, nothing goes up in a down market except correlation. In the case of the alternative asset classes almost all were dependent on leverage and/or access to easy credit and as the crisis has intensified these asset classes have suffered even more than the more liquid unleveraged positions in stocks and bonds. The WSJ reports that the Harvard Endowment has reported losses of 22% in the last 4 months and in fact even that number may be understated.

Harvard's Endowment Drops 22% in 4 Months

Harvard University's endowment suffered investment losses of at least 22% in the first four months of the school's fiscal year, (as you will see below the number is actually far higher on a mark to marke basis) the latest evidence of the financial woes facing higher education.

The Harvard endowment, the biggest of any university, stood at $36.9 billion as of June 30, meaning the loss amounts to about $8 billion. That's more than the entire endowments of all but six colleges, according to the latest official tally.
Other university endowments also are suffering, and many states are cutting public funding of higher education. Colleges are instituting hiring freezes, planning enrollment cuts and discussing steep tuition increases, intensifying worries about the impact of the recession and financial crisis on college access.

(As noted other universities moved from more conservative investment strategies to portfolios similar to those at Harvard and Yale. Not surprisingly the results have not been pretty as of late:)

The University of Virginia Investment Management Co. said it lost nearly $1 billion, or 18%, of its endowment over the four-month period, reducing it to $4.2 billion. In Vermont, Middlebury College says its endowment fell 14.4%, to $724 million. In Iowa, Grinnell College's endowment dropped 25%, to $1.2 billion. In Massachusetts, Amherst College says its endowment, $1.7 billion as of June 30, also fell by 25%.
The letter from the office of the Harvard President shows things may be far worse than the 22% loss.
The Harvard letter said the 22% loss, from July 1 through October 31, understates the actual decline in the endowment because it doesn't reflect certain assets, including private equity and real estate, whose declines couldn't yet be estimated. Currently, endowment income funds 35% of Harvard's $3.5 billion budget.
The letter said Harvard is planning for a 30% decline for the fiscal year ending in June 2009. That would eclipse the loss of 12.2% in 1974, the worst over the last 40 years.
Harvard's loss marks a sharp reversal from the endowment's formerly chart-topping performance. Harvard and Yale University -- which hasn't disclosed its endowment's recent performance -- pioneered an investment approach that de-emphasized U.S. stocks and bonds and placed large sums in more exotic and illiquid investments, including timberland, real estate and private-equity funds. That strategy, which was widely copied, helped the schools avoid significant losses after the technology boom ended in 2000.
But the current market has been far less favorable, partly because both Harvard and Yale have relatively small holdings of bonds, such as U.S. Treasurys, one of the few assets that have performed well. Harvard began its fiscal year with a target of having 33% invested in publicly traded shares, split among U.S. stocks, which have dropped 24% in the four months through October, and international stocks, which have fared worse.
Other investments, such as commodities, which were a boon to Harvard in past years, have turned negative in recent weeks. Harvard has sought to sell off about $1.5 billion in investments with private-equity firms, which typically use their assets to fund corporate takeovers, according to people familiar with the situation. That would be one of the largest sales ever of a private-equity stake. But its private-equity partnerships received bids of only around 50 cents on the dollar, according to other people familiar with the matter.
Daniel Jick, chief executive officer at Boston-based HighVista Strategies, which handles money for some endowments, says that in some prior years, investments such as real estate and private equity have helped buffer endowments against losses on stocks. "But this time, they are not providing as much help as expected," he says.

The nyt reports on the endowment losses here,

Here is the text of the Harvard letter. Note that their strategy. Note that to meet cashflow needs Harvard intends to tap the credit markets with new borrowings.

the Office of the President

Financial Update

To: Council of Deans
From: Drew Faust and Ed Forst
Cambridge, Mass.
December 2, 2008

As we navigate our way through these turbulent economic times, we are writing with some further information on the University’s endowment performance and an update on our broader financial strategy for the time ahead. We look forward to our continued work with the Council of Deans as we address these challenges together.
Endowment Update

As has been reported, the value of the University’s endowment was $36.9 billion on June 30, 2008, the end of the last fiscal year. Since then, the severe turmoil in the world’s financial markets has affected all major asset classes in which the endowment is invested.

While historically Harvard has reported investment returns only at the end of the fiscal year, in the current extraordinary circumstances we believe it is critical that our efforts to plan responsibly be informed by a more widely shared understanding of what we expect.

Harvard Management Company, using standard industry practices for valuing assets, has calculated investment losses of approximately 22 percent from July 1 through October 31. Yet even that sobering figure is unlikely to capture the full extent of actual losses for this period, because it does not reflect fully updated valuations in certain externally managed asset classes, most notably private equity and real estate. HMC expects that as we receive more comprehensive valuations in these asset classes from our external managers, the endowment will realize further declines in value. With those considerations in mind, and in view of the uncertain outlook ahead
, we continue to plan for a scenario in which our endowment is down 30 percent in value for the year.
To put a loss of that size in historical context, over the last at least forty years, Harvard’s worst single-year endowment return was a negative 12.2 percent in 1974, and at that time our endowment stood at less than $1 billion and funded a much less significant proportion of University operations. Since that time, there have been only three years of negative performance, with returns ranging from -0.5 percent to -3 percent. We will of course hope to do better this year than we are now planning, but we need to plan with a clear-eyed view of the reality that confronts us, as best we can gauge it.

Income distributed from the endowment now funds roughly 35 percent of the University’s overall operating budget, and some of our Schools rely on endowment income to cover more than 50 percent of their expenses. The prospect of significant endowment losses therefore has major implications for our budgets and planning, especially since our other principal revenue streams also stand to be challenged by the economic crisis. The implications will differ in degree from school to school and department to department. But all of us will need not merely to contemplate changes at the margins, but to take a more fundamental look at how to align our spending with revenues that will be significantly reduced from what we had imagined just a few months ago.
Financial Strategy

In so fluid and unpredictable a financial environment, it is particularly important to maximize our flexibility and minimize risk so that we can respond to changing circumstances. Toward that end, we are planning to take advantage of Harvard’s strong credit ratings to increase the University’s flexible cash resources in the near term.

The major rating agencies, Moody’s and Standard & Poor’s, rate Harvard as Aaa/AAA – the highest credit ratings available. With the benefit of those ratings, we are planning to issue a substantial amount of new taxable fixed-rate debt. This will help us sustain flexibility and momentum in addressing our academic and research priorities, including financial aid, as we work to absorb the impact of anticipated losses in revenue. We also intend to convert a substantial amount of existing short-term tax-exempt debt into bonds with longer maturities, so we can reduce our exposure to volatility in the credit markets and provide a measure of greater predictability in a time of extraordinary flux. These moves will strengthen our capacity to fund ongoing operations and critical academic and research priorities.

(while this strategy seems perfectly reasonable under current circumstances, it will be interesting to see how successful the Harvard bond offering will be, With ten year treasuries under 3% it could prove to be a very savvy move for harvard to lengthen the maturities of their debt if they are able to borrow at reasonably low spreads over treasuries. In fact it may prove to be the best move Harvard will ever make in the financial markets.)

The letter concludes:

Given our planning assumption about endowment losses and our desire to buffer the near-term impact to a reasonable extent, we also expect that we will be spending a higher percentage of the endowment next year than we have in the recent past.
Budgets and Planning

While the steps outlined above will help, they do not obviate the need to reduce expenses, beginning this fiscal year. To ensure that we are in the best position to respond to this new set of financial realities, we are working with each School to focus on a range of capital and operating budget-reduction scenarios. This approach will enable each School to make choices among its strategic objectives in the context of reduced budgets, yet preserve our collective, institutional flexibility to make adjustments as conditions evolve. We are reconsidering the scale and pace of planned capital projects, including the University’s development in Allston, and are taking a hard look at hiring, staffing levels and compensation to consider how we can reduce overall spending while at the same time invest in the academic programs that are vital to Harvard today and will propel us forward tomorrow.
University-wide Coordination and Communication

We are grateful to you, and your colleagues, for all you have been doing to analyze and understand our changed financial landscape and to share ideas about how best to chart our forward course. Especially at times like these, each of us can learn from one another's insights and approaches, and all of us stand to benefit from seeing local challenges in a broader institutional context. In addition, our new financial realities call on us to consider more intently whether certain activities we have tended to pursue separately might better be pursued cooperatively – as we seek not just to assure our financial well-being but to continue our momentum in creating more fruitful connections among different parts of the University.

Many of you have been in touch with your School communities, through some combination of letters and meetings, to give people your perspectives on how the economic crisis bears on your own School’s activities. Please let us know how we can be most useful to you in those continuing efforts. Meanwhile, we intend to post this memorandum to the Web, so that people throughout the Harvard community will know more about our present situation and some of the steps being taken to address it.

In closing, we want to express our appreciation for the diligence and spirit of partnership with which you and your staff, as well as those who work with us in the University’s central administration, are approaching these tasks.

As for Yale's Endowment the Chief Investment Officer David Swensen has an interview in the current issue of Worth Magazine( I couldn't find in outline)in whic he states he wont know the year to date losses on the endowment and won't have a number for Yale's performance till June 30 the fiscal year end. Right now he has "no idea" what many of their assets in illiquid mkts are worth. He also indicated now doubts about Yale's overall strategy.

Tuesday, December 2, 2008

Another "Can't Miss" Investment Strategy That Missed

The massive losses across the financial markets have exposed the flaws behind many of the esoteric strategies with unrealistic promises created by the wizards of wall street. One of these was the "portable alpha" strategy. I teach a course in an MBA program for non profits in which we did a Harvard Business School case about an endowment using this "strategy" and even these students who had limited background in finance viewed this strategy with skepticism (with much encouragement from me)

The strategy draws its name from the purported ability to capture alpha (the excess return over the market index) regardless of market risk. For example one could go short the s+p 500 index with futures and then use the cash to invest with a manager who would generate alpha (excess return over the s+P 500) Since the short position in the s+p 500 offsets the market risk in the alpha manager's portfolio, the strategy has separated out the exposure to the manager's skill (alpha) from the market risk. And since the manager has such great skill we are told, this offers the opportunity to generate returns from the stock market regardless as to what the market does. (yes it is hard to believe but $billions were invested based on this pitch)

What could go wrong ? As my students 7 weeks into their first investment class figured out: the investment manager could fail to generate alpha and his underperformance relative to the market would mean the strategy would lose money.
Stripped of all the marketing material and jargon the strategy is just one big leveraged bet that the genius manager you give money to will generate above market returns with below market other words they will turn lead into gold.

Apparently the investment officers at several pension funds and endowments underestimated this risk as the wsj reported yesterday (my bolds, my comments in italics)
And as is always the case it seems Wall Street collected its fees and taxpayers will make up for the lack of fiduciary responsibility by public employees .

'Alpha' Bets Turn Sour
Pennsylvania Pension Now Faces Billions in Losses


The stock-market downturn could force the Pennsylvania state employees' pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.

The potential hit to the $27 billion pension fund is the result of an exotic strategy used to help finance $9.2 billion in hedge-fund investments. Those bets helped the pension fund beat the market when stocks were rising, but backfired when the market sank.

Use of the aggressive strategy, called "portable alpha," has been cut in half, with officials of the Pennsylvania State Employees Retirement System acknowledging that the pension fund's exposure was "too large." (now there's an understatement)

Since stocks began falling, the fund has had to pay out $1.5 billion. Based on current market values of derivatives still outstanding, Pennsylvania could owe another $1 billion, a fund spokesman says. With the pension fund down about 14% in the first nine months of 2008, it is possible that the state will have to quadruple its annual contribution to roughly $1 billion in 2012, according to people familiar with the situation.

The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.

An estimated $75 billion or more has been invested using portable alpha
. Other pension funds that used the strategy include the San Diego County Employees Retirement Association, with $8.1 billion in total assets, and funds in Kansas, Massachusetts and South Carolina.

Sean Mathis, a partner at business-valuation firm Mathis & Co., believes some pension funds were pulled into portable alpha programs without fully realizing the risk. "(another major understatement) When all the hand-waving is done, what investors ended up with is a highly leveraged bet on the market and a slug of money in hedge funds," he said.

Barring a turnaround, pension funds and other devotees of portable alpha "may find out that all they've done is paid a lot of fees and maybe lost a lot of money to boot," Mr. Mathis adds.

The idea behind portable alpha is that it's easy to match the market. If you do it using derivatives like futures, you can tie up less cash and get the same return you would using an index fund. Then you can use the rest of your cash to beat the market. The strategy gets its name from the ability to generate alpha, or above-market returns. As long as the returns on the remainder of your cash beat the futures' cost, you outperform the market. Typically, investors turned to hedge funds that are supposed to beat the market in good times and bad to invest that cash.

Last year, Pennsylvania pension-fund officials said the strategy would pay off as long as returns on the hedge-fund investments topped the interest rate owed on the investments.
That is what happened when the market was rising. From 2003 to 2006, the pension fund's U.S. stock assets beat the market by an annual average of 6.2 percentage points.

But this year, the portable alpha portion of their portfolio, worth about $6.4 billion at the start of the year, is trailing the market by an estimated 15 percentage points, indicating that with U.S. and world markets down by 41%, they have lost more than 55% of their value. Fund officials say that, even with that setback, the strategy has generated $500 million in cumulative above-market returns.

Pennsylvania's portable-alpha strategy was put into place by the fund's former chief investment officer, Peter Gilbert, who built the program over a decade but stepped down in mid-2007 to become chief of the Lehigh University endowment. A Lehigh spokesman said Mr. Gilbert declined to comment.( I wonder why)

Pennsylvania invested more in hedge funds than any other state pension fund. Those hedge funds returned 2.8% for the year ended in June, but their performance turned negative in the third quarter and has remained so thus far in the fourth quarter, according to a spokesman for the pension fund.

Pennsylvania spokesman Robert Gentzel says the pension fund has had to sell liquid assets to make cash payouts on swaps it used to implement the strategy, but that such sales weren't unexpected. Assets had been set aside as collateral for the swaps, he adds. Portable alpha was pioneered in the mid- to late 1980s at Pacific Investment Management Co., led by famed bond manager William Gross, and by corporate pension-fund manager Marvin Damsma at Amoco Oil Co., according to the book "Capital Ideas Evolving" by Peter Bernstein.

(Not content to peddle this stuff to "sophisticated" institutional investors it seems individuals had the "opportunity " to access the strategy as well:)

A Pimco stock mutual fund using portable alpha has trailed the market by more than 10 percentage points this year. A spokesman for Pimco, a unit of German insurer Allianz SE, which has $1.5 billion in mutual funds using the strategy and another $30 billion for institutional investors, declined to comment.

Other bond managers with funds that used portable alpha to boost returns also have suffered. Among them is the Western Asset Management unit of Legg Mason Inc. Assets in the unit's $5 billion U.S. Index Plus accounts were invested mostly in mortgage, asset-backed and corporate securities, which have been clobbered amid the market's meltdown.

"I think this particular strategy is going to be pretty widely discussed, debated and re-evaluated," (a(and either tossed in the trash bin or "improved and remarketed "in a couple years three guesses which will happen) says Jim Hirschmann, chief executive of Western Asset Management.

Open Invitation to Powerliners

I often post comments on the popular conservative blog powerline often challenging the views on matters financial and economic. So here's an invite to denizens of that blog to post their comments on financial or economic matters here. Open mike except that offensive language and silly clipart will be deleted as is often not the case over there. Let the comments begin

Wednesday, November 26, 2008

Some Brilliant Words About Economists and their Forecasts

Blown off course by butterflies
By John Kay Financial Times

Published: November 26 2008 02:00 | Last updated: November 26 2008 02:00

In the 1980s, it seemed that computers held the key to economic forecasting. With large models and sufficient processing power, predictions would become more and more accurate.

This dream did not last long. We now understand that economies are complex, dynamic, non-linear systems in which small differences to initial conditions can make large differences to final outcomes - the proverbial flapping of a butterfly's wings that causes a hurricane.

So economic crystal ball-gazing remains unscientific. The trend is the forecaster's friend. Extrapolation assumes that the future will be like the past, only more so. We project current preoccupations - the rise of China and India, global terror, climate change - with exaggerated speed and to an exaggerated degree.

We forget that our preoccupations change. The people who worry about these issues today would 20 years ago have worried about the coming economic hegemony of Japan and the cold war. These issues were resolved in ways that few predicted.

It is a safe prediction - and the only one I shall make - that the topics that grab our attention 20 years from now will differ from those that consume us today and, if anyone has guessed what they are, it is only by accident. The future is unknowable. As Karl Popper observed, to predict the creation of the wheel is to invent it. To anticipate a new political force or economic theory, or even a new product, is to take the main step in bringing it into being.

If extrapolation is the forecaster's friend, mean reversion is the forecaster's crutch. Much of the time, you can predict that next year's figure will be somewhere between this year's level and the long-run average. But mean reversion never anticipates anything out of the ordinary. Every few years, out-of-the-ordinary things happen. They just have.
Still, you might think there would be large rewards for those who succeed in anticipating these events. You would be wrong. People who worried before 2000 that the "new economy" was a bubble, or warned of the terrorist threat before September 11 2001, or saw that credit expansion was out of control in 2006, were not popular. They were killjoys.

Nor were they popular after these events. If these people had been right, then others had been blind or negligent, and the latter preferred to represent themselves as victims of unforeseeable events. As John Maynard Keynes observed, it is usually better to be conventionally wrong than unconventionally right

Wednesday, November 5, 2008

More on the Failure of the Quants and Their Models

The NYT had a great article today on the perils of financial models and how their failures contributed to the current crisis. The lesson is also relevant to individual’s portfolios both in not relying on hedge fund “genius managers” that use quantitative models which purport to provide “free alpha” i.e. increased return with no increase in risk. And it should be a cautionary note even in constructing portfolios of more conventional assets even using index instruments. Past performance and correlations of asset classes is not a prediction of future performance.

In Modeling Risk, the Human Factor Was Left Out
Today’s economic turmoil, it seems, is an implicit indictment of the arcane field of financial engineering — a blend of mathematics, statistics and computing. Its practitioners devised not only the exotic, mortgage-backed securities that proved so troublesome, but also the mathematical models of risk that suggested these securities were safe.
What happened?
The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities, the resulting intricate web of risk and the dimensions of the danger.
But the larger failure, they say, was human — in how the risk models were applied, understood and managed. Some respected quantitative finance analysts, or quants, as financial engineers are known, had begun pointing to warning signs years ago. But while markets were booming, the incentives on Wall Street were to keep chasing profits by trading more and more sophisticated securities, piling on more debt and making larger and larger bets.
“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”….
….The miss by Wall Street analysts shows how models can be precise out to several decimal places, and yet be totally off base. The analysts, according to the Fed paper, doggedly clung to the optimists’ mantra that nominal housing prices in the United States had not declined in decades — even though house prices did fall nationally, adjusted for inflation, in the 1970s, and there are many sizable regional declines over the years.
Besides, the formation of a housing bubble was well under way. Until 2003, prices moved in line with employment, incomes and migration patterns, but then they departed from the economic fundamentals.
The Wall Street models, said Paul S. Willen, an economist at the Federal Reserve in Boston, included a lot of wishful thinking about house prices. But, he added, it is also true that asset price trends are difficult to predict. “The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs,” he observed. “It’s these hierarchies of beliefs — these behavioral factors — that are so hard to model.”
Indeed, the behavioral uncertainty added to the escalating complexity of financial markets help explain the failure in risk management. The quantitative models typically have their origins in academia and often the physical sciences. In academia, the focus is on problems that can be solved, proved and published — not messy, intractable challenges. In science, the models derive from particle flows in a liquid or a gas, which conform to the neat, crisp laws of physics.

Not so in financial modeling. Emanuel Derman is a physicist who became a managing director at Goldman Sachs, a quant whose name is on a few financial models and author of “My Life as a Quant — Reflections on Physics and Finance” (Wiley, 2004). In a paper that will be published next year in a professional journal, Mr. Derman writes, “To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”…..
….Among quants, some recognized the gathering storm. Mr. Lo, the director of M.I.T. Laboratory for Financial Engineering, co-wrote a paper that he presented in October 2004 at a National Bureau of Economic Research conference. The research paper warned of the rising systemic risk to financial markets and particularly focused on the potential liquidity, leverage and counterparty risk from hedge funds.
Over the next two years, Mr. Lo also made presentations to Federal Reserve officials in New York and Washington, and before the European Central Bank in Brussels. Among economists and academics, he said, the research was well received. “On the industry side, it was dismissed,” he recalled.
The dismissive response, Mr. Lo said, was not really surprising because Wall Street was going to chase profits in the good times. The path to sensible restraint, he said, will include not only better risk models, but also more regulation. Like others, Mr. Lo recommends higher capital requirements for banks and the use of exchanges or clearinghouses for the trade of exotic securities, so that prices and risks are more visible. Any hedge fund with more than $1 billion in assets, he added, should be compelled to report its holdings to regulators.
Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.
“We’ve learned the hard way that the consequences can be catastrophic, even if statistically improbable,” he said.

One of my favorite authors Nassim Taleb, has been a constant critic of such models….and has made outsized returns as of late, as the wsj reported(below). His earlier book Fooled by Randomness is more directly relevant to finance than The Black Swan.

• NOVEMBER 3, 2008
October Pain Was 'Black Swan' Gain

or most of October, it seemed nearly everything that could go wrong with the markets did. But the rout turned into a jackpot for author and investor Nassim Nicholas Taleb.
Mr. Taleb last year published "The Black Swan," a best-selling book about the impact of extreme events on the world and the financial markets. He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.

Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.
A professor of mathematical finance at New York University, Mr. Taleb believes investors often ignore the risk of extreme moves in the market, especially when times are good and volatility is low, as it was for several years leading up to the current turmoil. "Black swan" alludes to the belief, once widespread, that all swans are white -- a notion that was proven false when European explorers discovered black swans in Australia. A black-swan event is something that is highly unexpected…..
To execute its strategy, Universa buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn. They become extremely valuable in a market decline of 20% or more in a one-month period.
When times are good, such options are cheap and Universa gobbles them up, taking small losses along the way. When the market makes a quick, steep turn south, as it has recently, Universa's positions gain value as investors scramble to protect themselves in the downturn by buying puts. The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility…..
While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil.
The task for the fund's managers is to persuade clients to stick around after their big gains. Historically, such dramatic downturns have been rare events, occurring only once or twice a decade.

Tuesday, October 21, 2008

I am Quoted in Some Local SoCal Newspapers

This article on coping with the current market appeared in the Pasadena Star-News and the San Gabriel Valley News. Not exactly earthshaking advice in the quotes, but I thought I would post the link anyway.

The Fund Outflows Keep Coming

The mutual fund outflows for the first 2 weeks of October exceeded those of the entire month of September. And the money came out of stock AND bond funds indicating utter panic as the money basically is moving into cash equivalents, one step away from going under the mattress. My gut feeling at this point is that a significant market recovery around dow 10,000, s+P 500 around 1000)and/or a testing of the lows (around 8,000 on the dow,s+p500 around 850) will spark more outflows, flushing out most of the remaining "weak hands".

At that point there would be what is probably close to record amounts of cash on the sidelines, which when put back into the market by market chasing individual investors would lead to a significant market rally.

But please take this, like any other short term market forecast, with a massive amount of skepticism.

Friday, October 3, 2008

Actually This is A Good Sign

As the research of economists of the behavioral finance school have shown, individual investors are consistently very poor at timing the markets. Hence recent data on the behavior of mutual fund investors gives a glimmer of optimim amidst the barrage of bad news. And should certainly give hesitancy to anyone looking to liquidate their mutual fund portfolio.

Equity mutual fund outflows for the month of september were a bit under $50 billion compared to outflows of $75 billion in outflows for the first eight months of 2008, Outflows from international funds accounted for 58% of all stock fund outflows last week and 92% of all stock fund outflows last week.

This data on individual investors has proven over time to be a fairly reliable contrary indicator. Individual investors historically sell at the bottom and buy at the top.

BOSTON -- TrimTabs Investment Research on Tuesday reported that for the month of September through last Friday, stock mutual funds have seen outflows of $41 billion, while $22 billion have been redeemed from bond funds. The data don't include Monday's market sell-off. TrimTabs said the September fund flows through Sept. 26 compare with outflows from equity funds of $75 billion and inflows of $95 billion into bond funds for the eight months of 2008 through August 31. "Money is leaving the stock market and money market funds for the equivalent of the mattress, seeking safety in Treasurys and accounts in strong banks," said TrimTabs CEO Charles Biderman. "Individuals are scared and have no confidence in our system and whether our leaders know what they are doing. There is a huge amount of sideline cash that wants to return to the stock market. What's necessary for that to happen is a return of confidence in the system."{8679A4BF-31C3-4536-BFD6-696748550A58}&dist=hpmp

Stock Mutual Funds Saw $7.16 Billion Outflow Thursday-Wed - TrimTabs

NEW YORK -(Dow Jones)- Stock mutual funds saw an outflow of $7.16 billion during the week ended Wednesday, compared with an outflow of $6.33 billion during the previous week, according to TrimTabs Investment Research estimates.
For the week ended Wednesday, domestic funds saw an outflow of $3.29 billion, compared with an outflow of $492 million during the previous week. International stock funds saw an outflow of $3.87 billion, compared with an outflow of $5.84 billion during the previous week.
Separately, bond funds posted outflows of $8.14 billion, compared with outflows of $5.95 billion during the previous week. Hybrid funds, which mix stocks and bonds, posted outflows of $3.82 billion, compared with outflows of $ 2.26 billion during the previous week.

Thursday, September 25, 2008

About Those Hedge Funds

The current market turmoil has, to say the least, created significant problems for hedge funds They often make use of short selling which, under current regulations, is severely restricted. As a consequence the financial times reports :

Hedge funds charging hefty fees for sophisticated trading strategies aimed at outperforming the wider market have collectively parked $100bn in simple money market funds typically used by investors seeking safe rather than spectacular returns.

Citigroup estimates that hedge funds have now placed $600bn in cash, and that $100bn of this is held in money market funds,

normally seen as some of the safest places to invest cash.

However, last week, those money funds became embroiled in the wider financial crisis to the point that the US Treasury was forced to offer a blanket guarantee on them as part of its attempts to prevent the spillover of the financial crisis into the $3,400bn sector.

The extreme measures taken by the Treasury followed mounting fears that retail investors in the sector could be starting to panic and might withdraw funds on a large scale.

But some analysts say the extent of hedge fund investment in money market funds shows how scarce attractive investment opportunities and safe havens have become.

In other words investors are paying a fee of 2% +20% of profits and the investment managers are partking the cash in money market funds yielding around 2$.

The WSJ noted the difficulty if not impossibilty for some funds to implement their strategies


Hedge Funds Wrestle With Short-Sale Ban

The short-selling ban is taking the "hedge" out of hedge funds.

The Securities and Exchange Commission has banned short sales of roughly 950 financial-related stocks until Oct. 2, a list that ranges from Goldman Sachs Group Inc. to International Business Machines Corp., which was added Wednesday.

With their hands tied on those stocks and the algorithms that do much of their trading running into technical hitches, many quantitative and other "market-neutral" hedge funds are significantly reducing trading activity, according to people on Wall Street. Once major buyers and sellers on the stock market, these funds may have to reinvent their models in the event the rule is stretched beyond the Oct. 2 deadline.

Such an extension is expected. The top executive at New York Stock Exchange parent NYSE Euronext said Wednesday he believes the emergency short-selling ban on the U.S.-listed financial stocks will be extended....

That would be continued bad news for most hedge funds. "There are very, very few short-only funds on Wall Street, so the ban mainly removed long/short funds from the market," said Dan Mathisson, head of the algorithmic-trading unit at Credit Suisse Group. "If they can't put on their short positions, they can't put on their long positions, either."

Market-neutral funds offset the risk of random market swings that they take when buying stocks by short selling, or selling borrowed stock, in an equivalent dollar amount of other shares. That way, as long as they choose their stocks well, they will make money whether the market goes up or down.

Many of these funds are "quantitative," and use mathematical models to identify relative strength and weakness in the market. Often, automated "algorithmic" trading programs keep their portfolios balanced between the long and the short side. Removing a large chunk of the "shortable" universe upsets that cosmic balance.

Wednesday, September 24, 2008

As I Expected

On Septemeber 22 I pointed out that the new short selling rules would create mega problems for the hottest new product from the mutual fund industry : 130/30 and other long short funds.

Wall Street Journal
SEPTEMBER 24, 2008

Short-Sale Ban Is Hitting Mutual Funds

Some Managers Say They Aim to Avoid Big Cash Amounts

A new ban on short sales of financial stocks is hitting many mutual funds and exchange-traded funds that make bets against these shares.
Mutual funds that bill themselves as "market neutral," "long-short" or "bear" funds often short stocks, which typically means they sell borrowed shares in the hope of buying them back later at a lower price. The Securities and Exchange Commission late last week issued a temporary ban on new financial-stock short sales in a bid to maintain orderly markets.

Many fund managers are still assessing how they will be affected by the ban, which is in effect through Oct. 2. Some say they will avoid accepting large amounts of new cash from investors or adding to conventional financial-stock "long" positions during the term of the ban. Among the funds most affected are ETFs that don't even short stocks themselves but use swaps and other complex financial instruments to make bets against financials.

Fund companies in recent years have rushed to roll out new funds that mimic hedge funds' strategies, including short selling. Investment research firm Morningstar Inc. now tracks 64 long-short funds, which typically blend short positions with traditional outright stock purchases, and 41 bear-market funds, which are designed to perform well when stocks fall.

The SEC's ban has become even more complex for funds in recent days as the original no-short-sale list of nearly 800 companies has expanded rapidly. Among the stocks that joined the list Monday are Ford Motor Co., General Motors Corp. and General Electric Co. "Trying to keep up with that list is a pretty challenging feat," says Barry James, co-manager of James Market Neutral Fund. "We don't like having more and more [stocks] taken away from us."

Some managers with significant financial short positions say they will avoid taking in much new cash for now. Ric Dillon, chief executive and chief investment officer of Diamond Hill Investment Group, says he would have to turn away any substantial new investment in his Diamond Hill Financial Long-Short Fund during the term of the ban, since he would be able to put that money to work only on the long side. Mr. Dillon calls the SEC's action "misguided" and says his own publicly traded company asked to be removed from the no-short-sale list. "What you've done by eliminating the short sellers is eliminated information content," Mr. Dillon says. "That's bad for markets."

This leaves the investors in what is now a long only financial services fund with an annual management fee of 2,56%, The long only Vanguard financial services exchange traded fund has a management fee of .25%.

More broadly diversified fund managers say they will continue taking in new money but will avoid the financial sector for now because they don't want to upset their balance of longs and shorts. Kurt Borgwardt, manager of the American Century Long-Short Market Neutral Fund, says he would put any significant new cash to work in nonfinancial sectors because he likes to keep his long and short positions within each sector roughly equal……

Many fund managers are concerned the short-sale ban could be broadened to include even more stocks or extended to a longer period. "Hopefully it's not the beginning of something larger," says John Boich, portfolio manager at Security Global Investors. "If it is, then you're talking about a wholesale change in how alternative strategies are managed