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Friday, January 30, 2009

Sometimes You Need to Turn Off the Computer and Look at the Markets

John Kay columnist for the Financial Times had an excellent piece on the virtues and limits of academic finance in the real world of investing. I couldn’t agree more. My comments in italics.

Financial models are no excuse for resting your brain
By John Kay

Published: January 28 2009 02:00 | Last updated: January 28 2009 02:00

US universities have been widely admired in the past two decades for their investment performance. They were early supporters of private equity and hedge funds and the Yale model has attracted interest among sophisticated investors. But Yale reported in December that its endowment had lost a quarter of its value in the preceding six months. Other institutions are in worse straits.
The model seems to be in question. But the idea behind it - that careful diversification can combine good returns with low risk - is as valid as ever. The problem is that some supporters of that approach put too much blame on sophisticated modelling techniques at the expense of their own knowledge and judgment. Banks made the same error in their risk assessments: their value-at-risk models had similar structure and origins to those in portfolio planning.

Quantitative portfolio management relies on measures of correlations between asset classes. These historical correlations are not universal constants but the products of particular economic conditions. Unless you understand the behaviour that produced them, you cannot assess their durability. In 2007-08, assets that had been uncorrelated were strongly correlated and many portfolio managers were surprised when the diversification they sought proved illusory.”

As many have noted, the only thing that goes up in a down market is correlation.

Underlying causal relations had changed, as they frequently do in business. In the new economy bubble of the 1990s, equities roared ahead while property languished. But during 2003-2008, the availability of underpriced credit, followed by its abrupt withdrawal, affected property and shares in similar ways. Anyone in the financial world knew these things: but computers, churning through reams of data, did not.”

Another interesting aspect of financial markets which makes historical data is suspect is that the actions of investors themselves changes the likelihood that past data relationships will continue into the future. Thus the flood of money into hedge funds and private equities created a condition of too much cash chasing too few profitable opportunities. Thus the potential for attractive returns diminished and the asset class behaved more like conventional assets such as equity mutual funds.:

Asset classifications change their meaning. The alternative asset classes that yielded strong returns in the 1990s for Harvard and Yale were hedge funds and private equity. But the increase in the number of hedge funds and the volume of their assets meant that an investment in the sector - once a bet on an individual's idiosyncratic skills - became more similar to a general investment fund. Hedge fund returns were therefore increasingly correlated with those of other investments..
Private equity was once a punt on small entrepreneurs. A manager with good judgment could make money from a few hits in a diversified portfolio. But by 2006 the sheer size of private-equity funds led them to focus on well established businesses. Such investments were a geared play on the stock market. They no longer spread risk: they concentrated it. Worse, many uncorrelated assets appeared uncorrelated in the past only because they were thinly traded and infrequently valued. Pressures to "mark to market" revealed the underlying correlations.

For alternative asset classes such as hedge funds and private equity whatever excess returns might have existed disappeared when adjusted for the risk caused by leverage, the lack of liquidity and the lack of transparency (inability to value the investments in a naccurrate and timely manner). The liquidity risk has come to the fore as hedge funds have erected “gates” invoking clauses in their contract which allow them to suspend client withdrawals and private equity funds have invoked clauses that require investors to provide more capital to the funds The lack of transparency is apparent in the difficulty of both types of managers to value their portfolio. And with the lack of access to credit many are no longer able to use leverage to generate excess returns. In fact when one adjusts for the risk of leverage, the liquidity and transparency issues, it would be difficult to argue that these “alternatives” off an attractive risk/reward profile relative to traditional asset classes.

In contrast to the more exotic “uncorrelated assets” as hedges in a financial crisis, it seems the more traditional assets, particularly government bonds have held up well. Personallay I am not as confident of gold as a hedge.
But, during the credit crunch, traditional forms of diversification have done what they are supposed to do. Gold, trading at about $650 per ounce before the credit crunch, is nearing $850. UK government stocks show a total return of 23 per cent from conventional bonds and 15 per cent from indexed bonds from July 2007 to December 2008: for global sovereign bonds, the sterling returns are 75 per cent and 41 per cent.”

I would add one more example. One of the more consistent “anomalies” in financial market is that “value” stocks provide higher returns that the overall market without a significant increase in risk (as measured by standard deviation). Probably the most common means of screening for value is the use the measure for book to market. The higher reported book value to the market price of the stock the deeper “value” the stock is. Yet large cap value stocks performed dismally in the current crisis.
The reason would be apparent to anyone that turned off the computer and opened the newspaper. If one used reported book to value to screen for value stocks a large number of financial stocks would show up as “value stocks”. Yet the “value” proved illusory, the reported book value kept getting revised downwards. The stock prices were low relative to reported book value because the market was skeptical of the reported book. With each markdown of assets the stock price fell and the financial sttocks had a more “attractive” book to market leaving more of the in the quantitatively generated value portfolio Furthermore the fate of these stocks and their companies is most dependent on factors outside of the financial markets namely the actions of government decision makers (not exactly a risk facor that is easily quantified). The value of equity in these companies could be wiped out or propped up as a result of such decisions.
The consequences of not taking into account the overweighting of vulnerable financials created by the book to market screening were apparent during recent months. For the last six months of 2008 a major index fund using this methodology underperformed the overall market by just under 7%. Yet looking at longer term data the value portfolio outperforms the overall market with only slightly more volatility for 5,10 and 15 years.
John Kay’ss conclusions should be taped over the computer screen of everyone working in investing:
“Diversification is a matter of judgment not statistics. A model will tell you only what you have already told the model and can never replace, though it can enhance, an understanding of market psychology and the factors that make for successful business. As a student of finance, I never expected to see the efficient risk-return frontiers I drew on the blackboard feature in PowerPoint presentations to meetings of trustees: or that these trustees would view the numbers that emerged as statements of fact rather than illustrations of possibilities
People who were persuaded by these analyses have been badly hurt. Some will never pay heed to quantitative investment analysis again. Others will place equally blind faith in some new and fanciful construction. Both reactions are mistakes. Financial models are indispensable. So is scepticism in their application.”

John Kay's latest book on finance and investment, The Long and the Short of It, was published on January 20

Thursday, January 29, 2009

Alot of This Makes Sense

From the WSJ. I highlighted the ideas I found most interestng

ANUARY 29, 2009
Where the Financial Gurus Are Putting Their Own Money

In times of market strife, financial gurus often tell investors to think long-term and stay the course. Some of them even put their own money where their mouth is.
A sampling of high-profile industry veterans, academics and brokerage-firm chiefs reveals that many are hanging on to holdings battered by last year's market slide and busily hunting down new opportunities, particularly among bonds and beaten-down value stocks. Some are snapping up municipal bonds, inflation-indexed securities and steady-Eddie dividend-paying stocks.

And they're generally upbeat about the prospects for long-term retirement savers.
"I think this is a marvelous time to be investing," says Rob Arnott, the 54-year-old chairman of Research Affiliates LLC, an investment-management firm in Newport Beach, Calif. "There are more interesting opportunities out there now than any of today's investors have ever seen."....

“Certain parts of the bond market are priced for a scenario that's worse than the Great Depression.” Rob Arnott, Research Affiliates....

They do appear to have one thing in common, though: patience -- a trait many small investors lack. Last year, 401(k) participants shifted around 5.7% of their balances, compared with just over 3% in a typical year, according to consulting firm Hewitt Associates. Money flowed out of stock funds and into bond investments, money-market funds and stable-value products. And many fed-up and tapped-out investors have stopped contributing to retirement accounts altogether....

Here's how some top investing experts are now allocating their own retirement savings and handling the heavy blows being dealt by a volatile market.
While many financial gurus say they're starting to spot some great opportunities in stocks, they believe the bargains in select corners of the bond market are even better. "Certain parts of the bond market are priced for a scenario that's worse than the Great Depression," Mr. Arnott says....

One favored area is Treasury Inflation-Protected Securities, or TIPS, a type of Treasury bond whose principal is adjusted based on changes in the inflation rate. Ten-year Treasurys currently yield only about 0.9 percentage point more than 10-year TIPS, indicating that investors believe inflation will remain quite low in the coming years. Mr. Arnott says he boosted his TIPS allocation "in a very big way" in his personal taxable account toward the end of last year because he expects a substantial increase in inflation in the next three to five years.
Municipal bonds also look attractive to many longtime investors. Munis are typically exempt from federal and, in many cases, state and local income taxes. Many are now yielding substantially more than comparable Treasury bonds. In his taxable account, Mr. Bogle holds two muni-bond funds: Vanguard Limited-Term Tax-Exempt and Vanguard Intermediate-Term Tax-Exempt....

Burton Malkiel, a 76-year-old economics professor at Princeton University and author of "A Random Walk Down Wall Street," says he boosted his allocation to highly rated tax-exempt bonds in his taxable account late last year, since yields available on some of these bonds were "unheard of."

Some market watchers believe that it's time to take on more risk in their bond portfolios. Even investment-grade corporate bonds offer high yields, and below-investment-grade junk bonds yield far more than that. Mr. Arnott boosted his allocation to investment-grade corporate bonds in his personal taxable account late last year because the market had reached "irrationally high yields," he says. And Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School and senior adviser to exchange-traded-fund management firm WisdomTree Investments, has recently raised his allocation for junk bonds.
"Stocks and high-yield bonds will move together as the crisis passes," rebounding from their depressed levels, the 63-year-old Mr. Siegel says.
Financial gurus are picking through the wreckage of last year's stock-market meltdown to find the best bargains.
Emerging-markets stocks have 'gotten cheap enough to really give value now.'” Jeremy Siegel, the Wharton School

Some are looking for companies with strong market positions and juicy dividends. Muriel Siebert, founder and chairwoman of brokerage firm Muriel Siebert & Co., .....Other experts say that emerging-markets stocks, which were hit especially hard last year, are starting to look tempting. If these shares take another dip, they could become "extremely interesting," Mr. Arnott says. Mr. Siegel keeps one-quarter to one-third of his foreign-stock allocation in emerging markets, and "they've gotten cheap enough to really give value now," he says. He has bought some more of these shares as they've declined in recent months.
Jim Rogers, a 66-year-old veteran commodities investor based in Singapore, is putting new money into Chinese shares. He's focusing on sectors of the economy that the Chinese are pushing to develop, such as agriculture, water, infrastructure and tourism.

Market gurus are also finding some bargains among alternative investments. Mr. Rogers is putting some new money into commodities, particularly agricultural commodities. "We're burning a lot of our food in fuel tanks right now," he says. And Mr. Siegel recently added some U.S. real estate investment trusts to his portfolio, which got "very cheap" after declining sharply last year, he says

I am not a big fan of Morningstar and I must say I find this (below) mystifying:

Don Phillips, managing director at investment research firm Morningstar Inc., says he invests his entire individual retirement account in the Clipper Fund, a large-cap stock fund that lost about 50% last year. Early this year, he made the maximum IRA contribution to that fund, just as he has for the last 20 years. "It's long-term money, and you have to look at it that way," he says.

Of course I find an actively managed fund unattractive as a general rule and one hopes that his IRA is a small part of his overall portfolio and that the clipper fund makes up a small part of his US stock allocation.

Morningstar's Mr. Phillips, 46, has made it easier to stay the course. He has relinquished responsibility for allocating his 401(k) account, leaving those decisions in the hands of a managed-account program run by a unit of Morningstar. The program, which he started using in 2007, has "actually been very good for me," Mr. Phillips says. "They started putting me into things like TIPS and high-quality bond funds that I'd never had in the portfolio before."
And when they do suffer substantial losses, they tend not to panic. Mr. Phillips remains committed to his battered Clipper Fund, though it lagged the Standard & Poor's 500-stock index by about 13 percentage points last year. Ms. Siebert says she took a "very substantial loss" in Wachovia Corp. stock, which plummeted last year before the company was sold to Wells Fargo & Co., but she's hanging on to the Wells Fargo stock she received "until I see a reason not to."

But this is hardly the time to hunker down and take bets off the table, financial pros say. Don Phillips, managing director at investment research firm Morningstar Inc., says he invests his entire individual retirement account in the Clipper Fund, a large-cap stock fund that lost about 50% last year. Early this year, he made the maximum IRA contribution to that fund, just as he has for the last 20 years. "It's long-term money, and you have to look at it that way," he says.

Tuesday, January 27, 2009

Wisdom From Yale Endowment's Top Man

David Swensen, highly respected head of the Yale Endowment always had interesting views on investing. As was clear from his book for indvudyak investors, Unvonventional Success abd his book for institutional investors Unconventional Success (just revised) he thinks the investment industry often doesnt have the best interests of the investor in miond, I couldn't agree more. From the article in the Financial Times.

Top investor calls for Wall St 'moderation'
By Deborah Brewster in New Haven

Published: January 26 2009 02:00 |

The financial crisis has exposed greed, predatory behaviour and conflicts of interest in Wall Street banks and investment firms, one of the top investors in the US has said.

David Swensen, the chief investment officer of Yale University's endowment - who has achieved near-legendary fame as an investor, said he hoped some "moderation of compensation" on Wall Street would be a result of the crisis.

"Even if the returns they generated were real, they were paid too much, and in the context of the absolutely disastrous performance of these institutions their pay was obscene," he said....

In the 25 years since he took the helm, Mr Swensen turned the traditional endowment model, which had 80 per cent of the money in US stocks and bonds, on its head, putting most of the money into private equity, hedge funds, non-US securities and property.

Despite allocating money to 100 managers, he is highly critical of the money management industry.

Mr Swensen recently revised his book - Pioneering Portfolio Management - that outlines his philosophy and packed it with recent examples of venality.

Fortress, Goldman Sachs, Microsoft, Morgan Stanley and large buy-out funds are among those which he criticises for self-interested actions at the expense of their investors....

"This bad, predatory behaviour - unilaterally changing marks, asking for more collateral, etc - it seems the financial crisis stripped off this veneer and caused them all to behave in more venal ways," said Mr Swensen.

"The overwhelming number of investors fail because the fees charged by the investment management industry are egregious relative to the amount of value that is added. It is really quite stunning," he said.

Mr Swensen said nobody at all should use hedge funds of funds, which take investor money and, for an additional fee, allocate it to a range of hedge funds.

"You can't make sensible investment decisions with fund of funds or consultants. Madoff is just a great example of the dangers of making an investment and not understanding where the money is going."

He said the $17bn Yale endowment was shifting as much available money as possible into distressed debt.

Monday, January 26, 2009

Proceed With (Much) Caution But Some Reasonable Thoughts on Forecasting

Jason Zweig has a nice article on the perils of forecasting in the WSJ
Why Market Forecasts Keep Missing the Mark

Fish gotta swim, birds gotta fly and analysts and market strategists gotta try predicting what stocks will do every year. But you don't gotta act on those predictions -- at least not before you ask how likely they are to hit the bullseye.
Nonetheless he cant resist presenting one method for forecasting which one can at least call reasonable if not necessarily guaranteed to be accurate:
So is all prediction pointless? Not quite. In an important new study for the National Bureau of Economic Research, finance professors Miguel Ferreira and Pedro Santa-Clara of Universidade Nova in Lisbon, Portugal, have developed a sophisticated method to predict future results.

You can do a roll-your-own version. Take the dividend yield on stocks (3.4%), then add the annual rate of earnings growth over the past 20 years (3.4%). That's 6.8%, what John C. Bogle, founder of the Vanguard funds, calls the "investment return."
Next, factor in the "speculative return." The price/earnings ratio on the S&P 500 is around 15. If investors pay more than 15 times earnings for stocks down the road, the market will rise more than 6.8% a year; if they set lower P/Es, the overall return will be less.

Earnings are likely to keep falling, and investors are unlikely to set higher valuations anytime soon, so 6.8% is probably high. For 2009, Messrs. Ferreira and Santa-Clara forecast a 4.2% return. But over the longer term -- five years and beyond -- I think stocks could gain at least 7% a year. That would be worth sticking around for.

Along the way, the Dow might slump to 6000, or drop 10% or more in a day. But just as huge losses often come out of a clear blue sky, gains can arrive when the world seems darkest. If you forecast the market with your gut feelings alone, you may never hit the target.

In my view here is something to ponder given this forecast. With funds like the Vanguard Intermediate Term Corporate Bond Fund yielding 5.86 and the ishares Investment Corporate Bond Fund (lqd) yielding 5.55% may merit an allocation in your portfolio. (this is not a recommendation and personal objectives must be considered when investing)

The chart at the top of the page is a ten year chart of the S&P 500 for the last ten years. Proceed with extreme caution and humility when forecasting.

Saturday, January 24, 2009

130/30 Funds....As I Was Saying...

here's the title of my blog post on Sept 1 2008:
Monday, September 1, 2008
New "Product" From the Mutual Fund Industry: Not a Good Idear for You

and here's the WSJ on the same type of funds on Jan 24,2009

Leverage Shakes Up Mutual Funds, Which Discover a Strategy's Downside

In recent years, more mutual funds have used borrowed money to juice returns and lure investors. Now, they are discovering the downside of leverage, and some are cutting back.
Early last year, Wall Street was heavily promoting several new types of funds that rely on borrowing money. These include so-called 130/30 funds that aim to amplify market returns by betting against some stocks,
Two Sides to Leverage

While borrowing money can improve returns in good times, it also widens losses in bad times, and that is what happened in 2008. Some of these funds ended the year with even greater losses than the market as a whole. For instance, of the 15 mutual funds that apply the 130/30 strategy for U.S. stocks, only a third beat the Standard & Poor's 500-stock index in 2008, according to Morningstar Inc. Some of the laggards fell behind the index by five percentage points."

And other mutual funds attempting to mimic hedge funds by using leverage had dismal results. In my view leverage funds have no place in portfolios.

Even some traditional mutual funds that use leverage opportunistically have been hurt. The $1.5 billion Baron Partners Fund, which uses bank borrowing to increase its stock bets, fell 46.7% in 2008, nearly 10 points worse than the S&P 500's total return. Fund manager Ron Baron declined to comment. In a recent shareholder note, Mr. Baron said he believes that the companies his funds' invest in will "recover their value over the next several years."

Of course, leverage has shaken up a lot more than the fund industry. Excess leverage on Wall Street is a big reason for last year's market meltdown. A number of hedge funds, which had borrowed heavily to turn a mound of equity into a mountain of assets, were forced to sell their positions to meet demands from creditors. This depressed various stock, bond and commodity markets.

And it seems that those marketers at the mutual fund companies are having second thoughts on their formerly "hot product":

There's going to be a move toward simplicity after this market downturn," says John Rekenthaler, vice president of research at Morningstar. He thinks the 130/30 funds are going to struggle to grow from here on.
"It's a new type of fund, with fairly aggressive promises, complicated strategy, and they didn't perform well in the bear market,
" Mr. Rekenthaler says. " ... To me, that all spells investors and advisers saying, 'What's the point?' "
How do 130/30 funds work? For every $100 invested, the fund will borrow stocks valued at $30 to sell "short" and invest this cash raised in the market, thus making the gross investment equal to $130.

Paul Quinsee, who heads the team managing the largest 130/30 mutual fund, JPMorgan U.S. Large Cap Core Plus fund, expects the investing strategy to survive. His fund dropped about two points less than the S&P 500's total return last year, making it among the best performers amid such funds.

Mr. Quinsee says the fund managers cut back on the amount of leverage in the fund, bringing it to less than 120/20. He declined to specify the funds' short positions but said his fund did what it's supposed to do.

Some other 130/30 funds didn't fare as well. Funds that lagged behind the overall market included the Old Mutual Analytic U.S. Long/Short fund, the Dreyfus 130/30 Growth fund, RiverSource 120/20 Contrarian Equity Fund and the UBS U.S. Equity Alpha mutual fund.
Scott Bondurant, co-manager of the UBS mutual fund, said his fund was hurt particularly after September, as panicked investors dumped some of the stocks owned by the fund to gravitate toward stocks of companies perceived to be safe during a recession. Currently, its strategy is down to 125/25.

Managers of the other funds declined to comment.

The biggest users of leverage are closed-end funds, versions of mutual funds that trade like a stock. About 72% of the 600-odd funds use leverage, according to Cecilia Gondor of Thomas Herzfeld Advisors Inc. They borrow money at lower, short-term rates and invest it in securities that they expect will earn them higher returns

Under Pressure
However, this strategy came under pressure early last year, as their main route for borrowing, auction-rate securities, froze up. Since then, the closed-end funds have been paying higher rates on their borrowing.
Later in the year, as net asset values declined, several funds had to deleverage or get rid of borrowing entirely to meet legal requirements. Closed-end funds are required by law to maintain $3 of assets for every $1 borrowed as debt, and $2 for every $1 issued as preferred shares.

Tuesday, January 20, 2009

If Your Money Manager Is Just Figuring This Out, You Should Have Changed Managers Long Ago

The NYT carries a long article on how M&T Bank lost $80 million on an investment vehicle peddled to them by Deutsche Bank. M&T Bank is suing claiming it was "duped".

The article contains this jaw dropping quote

Some investors say the collapse of deals like Gemstone is a wakeup call for money managers. “It’s finally dawning on market players and investors that Wall Street’s interest and those of investors have never been aligned,” said Thomas C. Priore, chief executive of ICP Capital, an investment firm that specializes in credit markets. “Investors are beginning to say to themselves: ‘Hey, there is someone who will benefit if this doesn’t go well.’ ”

Wow, not being aware of that fact and being a money manager imo is akin to a batter not knowing that the pitcher's job is to try to strike him out.

Put me down as agreeing 100% with this fellow:

Others on Wall Street say that investment banks’ potential conflicts should have been apparent. “As an institutional investor, your first duty is to do your own work,” said Ron D’Vari, who is chief executive of NewOak Capital and previously managed the C.D.O. business at BlackRock. “You have to do your own due diligence.”

Sunday, January 18, 2009

My Alma Mater Has A Pretty Strange (and Quite Risky) Asset Allocation

Columbia University has taken what I consider very high risks with extremely large allocations to the risky asset classes of private equity and hedge funds. As Jason Zweig in the WSJ points out, not only is the strategy risky, the illiquid nature of these asset classes can put a cash squeeze on individual and institutional investstos who are looking to make annual withdrawals from their portfolio.

Smart Money Takes a Dive on Alternative Assets

....Now, with billions of dollars trapped in illiquid investments, many colleges and charities are cutting budgets at the worst imaginable time.

How did the "smart money" get into this fix? As bond yields shrank in the 1990s and stocks shriveled soon after, institutional investors began looking for assets that would generate solid returns no matter what.

The solution was "alternative investments" -- hedge funds, real estate, venture capital, private-equity funds and natural resources. Between 2000 and 2002, as stocks collapsed, endowments led by Yale University beat the Standard & Poor's 500-stock index by huge margins thanks to their stake in alternatives.

Word got around. In 1995, according to Managing Director Celia Dallas of the consulting firm Cambridge Associates, endowments had less than 10% of assets in alternatives; by 2008, that average had climbed to more than 30%.

. As of last June, 41% of Columbia University's $7 billion endowment was in hedge funds and 40% in private equity, with only 4% in U.S. stocks, 4% in cash and a piddly 1% in bonds. That is light-years away from the old-time institutional rule of 60% stocks, 40% bonds.(yikes !!)

So what? Many hedge funds lock up investors' money for as long as three years. The typical private-equity fund makes "capital calls," requiring investors to pony up another 50 cents to 75 cents for every dollar they already have committed. Columbia is on the hook for another $1.6 billion in capital calls through 2012. When all goes well, as it had for years, endowments pay for capital calls with gains elsewhere in their portfolios.

Now, however, all isn't well. With no gains to be found, many institutions are short on liquidity just when they need it most. A recent survey of college and university presidents found that 50% have, or will soon, put in a hiring freeze. Nearly 7% admitted selling assets into a bear market; another 9% have been forced to borrow money at punitive rates.

Sadly, they didn't have to plunge into a pool that is run dry.....

Even institutional investors move in herds, and it is always hard to think amid the sound of hoofbeats. Your peers, feeling the need to rationalize their own commitment, will try to drag you into the pack. If you take too long to commit, all the best opportunities may disappear....

So, no matter how big or small an investor you are, take a couple of hours to take an inventory of all your assets: stocks, bonds, your home, your business and anything else you own. Size up what it would cost, and how long it would take, to turn each of them into cash. If one part of your portfolio takes a dive, you want to make sure you don't crash-land on dry concrete.

I Couldn't Agree More...

Prof Robert Shiller of Yale in the nyt

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism, going back to Adam Smith over 200 years ago, sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Friday, January 16, 2009

It Wasn't That Difficult That Madoffs Reported Strategy Could Produce the Reported Results

One of the more mystifying elements (among many) regading l’affaire Madoff is the number of professionals such as fund screeners such as “funds of funds” to identify the returns reported by Madoff as impossible with his strategy. A basic knowledge of options would lead one to the conclusion that his relatively basic strategy would produce lower returns and less volatility than the market, but would not produce years without a single annual loss. It shouldn’t have taken a major research project such as the one described in this wsj article to make that discovery:

Madoff Strategy Put to Test
Credit Suisse Sees Gains of 8.6%; Factoring In a Collar
If Bernard Madoff had employed the investment strategy that he allegedly told investors he was using, then what would his returns have actually looked like?
According to a study by Credit Suisse, the tactics that Mr. Madoff purported to use -- incorporating trades in both stocks and options -- would have generated an annual average return of 8.6%, beating the Standard & Poor's 500-stock index.
Several of Mr. Madoff's investors have said they were told they had gains of about 10% for many years.
In determining the estimated returns, Credit Suisse developed a simulation of Mr. Madoff's investment strategy going back to 1995, incorporating the use of the "split-strike conversion" that Mr. Madoff allegedly said he was using.
Commonly known as a collar, the strategy involves the purchase of stock, the sale of call options and the purchase of put options. Calls convey the right to buy a company's stock at fixed prices, while puts convey the right to sell it.
Although viewed with some suspicion since Mr. Madoff's arrest in December, the collar strategy is routinely employed by professional investors who want to protect their stock holdings against declines…..
After conducting the study, Ed Tom, Credit Suisse's head of equity derivatives strategy, said the level of returns that Mr. Madoff said he produced is far less startling than the risk-return ratio, or the consistency by which he produced them. Even if Mr. Madoff pursued collar strategies, Mr. Tom said, it would be nearly impossible to protect a stock portfolio against the normal fits and starts of the market.
"I think it's important going forward that people know what the return characteristics look like," Mr. Tom said.

In fact there is an existing public mutual funds which makes public its strategy and holdings and is available to every investor at non exorbitant fees. The fund, the Gateway Fund (GATEX) which I make use of in my client portfolios is a true “hedged fund” that reduces volatility but potentially sacrifices big returns.
The fund strategy is described as follows by the manager:

• A hedged equity portfolio that seeks to generate better risk-adjusted returns than "long-only" equities or core fixed-income funds.
• The fund seeks to generate cash flow by selling index calls against a diversified equity portfolio while purchasing protective index puts to help reduce downside exposure.
• Historically has outpaced inflation and the bond market while seeking to generate equity-like returns with bond-like volatility.1
• Potential diversifier for almost any portfolio due to its historically attractive risk/return profile, low beta relative to the S&P 500, and low correlation relative to the Lehman Aggregate Bond Index.
(sound familiar ? look again at the description of Madoff’s (supposed) strategy above.

The result of the strategy:
Lower volatility than a long only positions
Better returns than the market during down years for the mkt or during very stable markets.
Lower returns than the market when the market performs very strongly.
Cannot guarantee that there will be no negative years for the fund.
Average annual returns – Class A shares2 as of 12/31/08

1 yr 5 yrs. 10 yrs. Since 1/1/88*

Total return at NAV1 -13.92% 2.75% 3.52% 7.80%
Total return with MSC2 -18.88 1.55 2.91 7.50
S&P 500 Index3 -37.00 -2.19 -1.38 8.80
Barclays Agg Bond Index 5.24 4.65 5.63 7.45

In sum, the purported Madoff strategy can make sense for part of a portfolio and is readily available in a public mutual fund. The returns Madoff reported for this strategy were impossible to achieve. And any responsible advisor with a basic knowledge of options should have known that.

(The above is not a recommendation to purchase any security or fund.)

Wednesday, January 14, 2009

The Very Rich Learn that Basic Investment Rules Apply to Them Too

The famous line from F.Scott Fitzgerald was "The rich are different than you and I, they have more money."

When it comes to money management it seems that the "privilege" of having access to "alternative investments" such as hedge funds and private equity through the elite "wealth management divisions" at large banks and brokerage firms didnt give them an investment edge.

It also seems the very wealthy were no more thorough in making sure they actually understood their investments. And when their investments went sour it seems they were not hesitant to blame it all on their investment advisor.

In other words when it comes to investments the very rich should also follow the same simple rules as the rest of us : invest in a diversified portfolio of low cost investment vehicles that you understand

from the Financial Times my bolds my comments in italics

span style="font-weight:bold;">The rich rethink concept of risk

By Lauren Foster

Published: January 13 2009 0

Over the years, Tiger 21, a New York-based peer education group of self-made multimillionaires, has held sporadic conference calls for members to discuss investment topics. But as the global financial crisis worsened last summer, and many scrambled to understand the unfolding disaster, the organisation began to schedule calls on alternate Friday afternoons, immediately after the market close....

"Many members who had unblemished track records as entrepreneurs really had not fully appreciated the risks in their portfolios," says Michael Sonnenfeldt, founder of Tiger 21, a group whose 170 members manage personal investment portfolios from $10m to $700m. "One of the biggest surprises was how complex the world of finance is. [The crisis] has exacted not just a financial toll but often an emotional toll and a family toll."

From Wall Street to the City of London, the message is the same. "There is almost no escaping it," says David Craig, chief investment officer and managing director at Sand Aire, a London-based multi-family office. "Wealthy families are not immune and their wealth faces some of the same threats as others. There is the potential for some to find themselves poorer as a result of these extraordinary circumstances."....

.... At the very least, the financial crisis has put renewed emphasis on understanding risk - be it counterparty risk, operational risk or leverage - and a premium on wealth preservation.

"[Clients] want to understand the embedded risk in their portfolio to a much greater extent," says Gayle Schumacher, chief investment officer at Coutts, the UK private bank. "The past [few months] have really focused people on their tolerance of risk."

For some wealthy clients, recent events have provided a painful lesson in the perils of excessive borrowing.......

As a result, wealthy clients who had too much leverage are rethinking their exposure and are seeking advice on what is the prudent amount.

"The theme that is emerging is risk management," says Paul Patterson, head of RBC Wealth Management, British Isles. "Leverage has always been something that by its nature increased the returns and increased the risks. We had such a long run that people started [to forget] about the risks of leverage.".....

While private clients generally understand the relationship between risk and return, many of the sophisticated financial instruments they invested in were so complex that the risks were not always obvious.

"Ultra-high net worth clients are pretty savvy - they typically understand what they are investing in and the risks they are taking," says Mr Patterson. "But what this crisis has shown is that no one is infallible." (does this mean these people thought some investors were infallible up until last year ?)

Dean Junkans, chief investment officer for Wells Fargo Private Bank, thinks some clients will opt for more straightforward investments. "Investors are saying: 'Let's make sure we know what we own and pay attention to things like operational risks and knowing the prime broker and the counterparty in a structured product, and the amount of leverage'," he says. "I think that if clients didn't pay attention to that before, certainly they will be paying attention going forward. (in other words when it comes to investments the very rich were no different than most other investors) Advisers will get less pressure from clients for complex products."b(call me a cynic but is it just possible than the advisors were incentivized to sell those high fee complex products and therefor pushed them more than the "straightforward investments")

Mr Sonnenfeldt says for many Tiger 21 members it is "very much a back-to-basics kind of situation"....

Some wealthy investors are rethinking their exposure to hedge funds and private equity.

A survey in October by the New York-based Institute for Private Investors, a peer networking organisation for ultra-wealthy families, found more than three-quarters of respondents said "few" to "none" of their absolute return managers had produced positive returns in this down market. More than 70 per cent said they "feel less inclined to hire a hedge fund manager".

IPI members, who have a minimum portfolio size of $30m, reported a similar feeling about hiring private equity managers.

(and in the out of touch (or is it let's keep the fees rolling in department):

JPMorgan's Mr Duffy, however, does not believe disaffection with alternative assets is widespread among the ultra-wealthy. "In a time when everything does seem so complicated there is definitely a sub-set who would like life to be a bit simpler. But I wouldn't say we've heard that in a very loud way," he says.

"I think people understand the risk benefits of the alternative asset class. It's a case of not wanting to throw the baby out with the bathwater. There are going to be managers who don't come back from their challenges - that happens in every business cycle.

According to a survey by Prince & Associates, a US wealth research firm, 81 per cent of investors with $1m or more in investable assets planned to take money away from their adviser, while 86 per cent said they would tell other investors to avoid the firm of their adviser.

Only 2 per cent would recommend their firm to others.

(somehow I dont think the numbers were nearly the same when these advisors were recommending high fee, leveraged investments that were performing well and the client did not fully understand. While I certainly am criticial of my peers it is hard to believe that many of the 86% who would not recommend their current advisor, simply were unrealistic in their expectations of investment performance)......

(but I am not surprised by the following, although as a "non brand" advisor I am certainly biased. In my view "brand companies are more likely to push higher fee investment vehicles both conventional and "alternative")

The dissatisfaction was higher at "brand" companies than at "non-brand" or boutique wealth advisers. Seventy per cent of clients of brand firms plan to leave their adviser, compared with 29 per cent at non-brands.

"Over the years we have found there is a high degree of inertia with the client/adviser relationship, and unless something goes terribly wrong, the client won't change things," says Hannah Grove, principal of HSGrove Private Wealth Consultancy and an equity partner of Prince & Associates. Often it takes a trigger event, like the recent market meltdown, for them to take action."

"A lot of the ultra-wealthy are shocked at the fact that some of the companies they were working with have disappeared," she says.

"There is a real loss of confidence in some of the traditional providers."

Financial advisers suffer pain in the blame game

US millionaires are disenchanted with their financial advisers after losing 30 to 40 per cent of their net worth since mid-August, according to a report by Spectrem Group, a consultancy specialising in the affluent and retirement markets.

(Now that's interesting, these investors are disenchanted with their advisors after their accounts suffered losses pretty much in line with the market)....

..."While they blame the government and Wall Street directly for the situation,(and some apparently do) many millionaires are not happy with their advisers' performance and few say they will increase the work they give to advisers."

Indeed, just 36 per cent of respondents felt their adviser performed well during the crisis and only 14 per cent said they would increase their use of financial advisers in the future.

The report says advisers "are on trial" and investors will reassess how they perform over the next year.....

Nearly all the millionaires surveyed - 90 per cent - feared a prolonged economic downturn lasting up to another two years.


Tuesday, January 13, 2009

Some Investors Seem To Be Getting the Message

The message seems to be getting through to some people as the wsj reports today

my bolds and my (italics)

Index-Tracker ETFs Gain Investor Favor
Volatility Drives Shift Toward Stability


Investors are abandoning riskier stock strategies in favor of the relative calm and lower costs of plain-vanilla exchange-traded funds.

Through November, ETFs posted net buying, or inflows, of $138 billion for 2008, while long-term mutual funds saw an exodus of $185 billion, according to consultants Financial Research Corp.

"Last year was strong for flows in indexed products as investors preferred funds with lower fees and more stability," said Rob Ivanoff, an analyst at FRC. "Many actively managed funds haven't performed well, and some star managers didn't live up to their fame."

To be sure, market-tracking ETFs took their lumps as well. The largest ETF -- SPDR S&P 500 ETF -- lost 37.2% last year, according to investment researcher Morningstar Inc. Other exchange-traded funds and notes that track stocks and commodities also were socked.
Healthy Inflows

Still, the products continued to enjoy healthy inflows, even though total assets fell during last year's selloff. Overall, ETF assets dropped by more than 20% in 2008 through November to about $482 billion, despite the $138 billion in net inflows for the period, according to FRC. There are more than 800 ETFs listed in the U.S.

In recent months, investors have been moving into index funds managed by Vanguard Group, Fidelity Investments and other fund giants, experts say.

What is behind the trend?

Firstly, many financial advisers and investors use passive funds and indexed ETFs as part of a conservative asset-allocation plan. In general, they have a long-term perspective and haven't been selling during the market downturn. "These investors haven't been panicking," said Scott Burns, Morningstar's director of ETF analysis.

For example, he noted that during November's market nosedive, money actually departed popular bond ETFs such as iShares Lehman Aggregate Bond Fund in favor of ETFs that track stocks. Mr. Burns attributed this to investors with asset-allocation plans rebalancing their portfolios by purchasing stocks.

Secondly,(well this isn't a particularly good idea) short-term traders have been driving trading volume to ETFs, which are baskets of securities that can be bought and sold during the day. For example, overall ETF trading volume spiked this fall along with market volatility. "When markets are this volatile, investors tend to trade whole sectors with ETFs rather than individual stocks," Mr. Burns said.

Finally, in bear markets, many investors go back to basics and focus more on tax efficiency and the fees they are paying, which matter even more in low-return environments. "The same thing happened after the dot-com bust, and snake-bitten investors went into index funds and focused more on asset allocation," Mr. Burns said......

Yale's Investment Manager: Don't Try to Do What We Do

Coinciding with the release of the new edition of his book Pioneering Portfolio Management, Yale Endowment CIO David Swensen gave an interesting interview to the WSJ

my bolds
, my comments in italics

* JANUARY 13, 2009

Yale's Investor Keeps Playbook
In Line for First Loss Since '88, Mr. Swensen Still Champions 'Alternatives'


He isn't a household name. But as the Yale University's endowment's chief investment officer for two decades, David Swensen has earned a reputation as one of the world's savviest and most successful investors.

He pioneered an approach that de-emphasized stocks and bonds while embracing less-traditional fare like hedge funds, private equity, and oil and gas. During his tenure, Yale has had an average annual return of 16% for the past 10 years through June, compared with a 2% average for the Standard & Poor's 500-stock index. Yale's assets more than tripled over that period to $23 billion, trailing only Harvard University's in size.

View Full Image
David Swensen
Joe Fornabaio/The Wall Street Journal

David Swensen, investment chief for Yale University's endowment, says institutional investors should be built for growth, not to withstand stock-market downturns.
David Swensen
David Swensen

Yet even Yale hasn't escaped the financial crisis.

The university estimated late last month that the endowment had lost 25% of its value since the end of June. That is expected to lead to budget cuts and puts Mr. Swensen in line for his first negative fiscal year since 1988. Other endowments that have set out to follow the strategy he has advocated are also suffering.

Nonetheless, Mr. Swensen is sticking to the same investment approach that he's used in the past. He describes that process in detail in his book, "Pioneering Portfolio Management," which he revised and which was reissued this month....

Wall Street Journal: As you revised your book, first published in 2000, did any sections strike you as dated?

David Swensen: It was more in the other direction. The book talked about an approach to investing that has succeeded over the past decade. In the '90s, all you had to do was put your money in the S&P 500. In the ensuing decade, a diversified strategy just crushed the S&P. The book talks about a sensible approach that was also profitable."

WSJ: Yet, other endowments have attempted a Yale-like approach, usually with less success. What goes wrong?

Mr. Swensen: A lot of institutional investors think they are emulating Yale, but they are not. Most endowments use fund of funds and consultants, rather than making their own well-informed decisions. You can divide institutional investors into two camps: those who can hire high-quality, active-management investors and those who can't. If you are going to invest in alternatives, you should be all in, and do it the way Yale does it -- with 20 to 25 investment professionals who devote their careers to looking for investment opportunities. Or you belong at the other end, with a portfolio exclusively in index funds with low fees. If you're not going to put together a team that can make high-quality decisions, your best alternative is passive investing. With a casual attempt to beat the market, you're going to fail.

If someone looked at what we're doing superficially and made superficial attempts to copy us, then I have little sympathy for them. It's a much more complicated process than that, and I explain it in detail in the book. If someone read my book and failed, I'd have some sympathy.

WSJ: What about fund of funds and consultants? Can they be a solution?

Mr. Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There's also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as much resources were it not for fund of funds.

Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.....

WSJ: With hedge funds suffering their worst year on record, will institutional investors have more power to demand lower fees?

Mr. Swensen: Put that in the category of wishful thinking. It would be nice if fees were not so onerous. But you still have investors who are happy to pay a high price in hopes of getting the holy grail of extraordinary returns.

WSJ: Many hedge funds share little information with investors beyond their general strategy. Is that acceptable?

Mr. Swensen: We require complete transparency. We either know every position, or we don't invest. I have access to every position in every hedge fund in which we're invested. If they won't trust us with that information, why should we trust them with our money?

Saturday, January 10, 2009

2008 Market Review and 2009 Outlook

Clearly 2008 was a dismal one for investors with virtually every asset class suffering severe declines. The S & P 500 index fell 37% for the year. International markets declined even more sharply: developed markets as measured by the ishares developed market etf (symbol efa) fell 42.7 emerging markets (exchange traded fund eem) declined by 53.3% Commodities, after rising sharply early in the year reversed direction the exchange traded fund representing the S+P/GSCI commodity index ended -46.5% for 2008.

In the credit markets a flight to quality caused sharp declines in corporate bonds of all types both investment grade and high yield, Reflecting the extreme nervousness in the market treasury bonds were the sole asset class to show gains. The ishares etf for long term treasury bonds gained 33.7% for the year while the etf for investment grade bonds rose only 1%.

There is no doubt that economic conditions deteriorated significantly throughout the year and the market declines were in response to those economic fundamentals. However, it is also important to recognize other factors that determined market movements during 2008. Rather presenting another review of those economic developments this analysis will focus on factors internal to the financial markets which contributed to the extremely high volatity and the massive declines across asset classes.

First and foremost is the massive deleveraging which occurred across the markets. Easy access to credit had allowed participants to leverage themselves (borrow heavily) in every sector of the economy : individual borrowers, financial institutions, hedge funds, commodity funds, private equity, real estate investors and others. This led them to take on large scale investments and purchases which in turn fuelled the massive increase in assets across the board and a consequent buildup of risky positions on balance sheets. As the credit crisis hit, this massive borrowing machine shifted sharply into reverse in massive deleveraging as access to credit was severely rationed.

In order to pay back borrowed funds investors had to engage in large scale liquidation of positions. Financial institutions, hedge funds and others had to meet what was in effect a global margin call, they were obligated to sell assets and reduce their level of leverage to meet the demands of their financiers. These were often forced liquidations.

In order to reduce their leverage investors would often engage in sales of assets on an often indiscriminate basis, thus correlations among asset classes increased considerably even if the fundamentals may not have fully justified the move. “The only thing that goes up in a down market is correlation” is an old market maxim and it was certainly true this year as investors simply raised cash selling off assets. As we looked across the financial markets there was carnage across the board: domestic large cap, small cap, growth and value, international developed and emerging, commodities, and corporate bonds. In fact due to the severely depressed prices and lack of liquidity in the markets for the riskiest assets, it was often the less risky assets with the highest potential long term value which were sold first.

The credit markets saw a flight to quality in which investors were interested in owning little else other than US treasury obligations. As a consequence the differential in yields (“the spread”) between investment grade corporate and municipal bonds and US treasuries increased reached levels seldom seen in the market.

In the process of this selling many institutions and hedge funds encountered severe lack of liquidity in many markets. The markets for the more esoteric financial instruments favored by these professional traders such as mortgage backed securities, credit default swaps, and other derivatives simply dried up as there were no counterparties willing to buy these assets in any significant volume. Faced with these conditions and a need to raise capital, these investors sold their positions in the more liquid markets of listed equities, commodities and investment grade bonds.. This fuelled further selling in those markets and in turn unprecedented levels of volatility.

Finally, one must always take into the account the all important impact of investor psychology on the financial markets. All of the above factors worked together into a negative feedback loop which was intensified as investor psychology turned massively negative. In 2008 individual investors took more money out of equity mutual funds than at any time in history and hedge funds experienced net outflows for the first time in well over a decade. since Of course the fund managers had to make forced sales to meet the investor redemptions further fuelling the negative cycle.

Advocates of actively managed funds have often argued that their funds would outperform index funds in down years, since the index funds are obligated to be fully invested in the stocks composing their index at all times. Yet once again actively managed funds failed to outperform. John Bogle of Vanguard noted in the Wall Street Journal

Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks. This continues the pattern -- with some variations -- that goes back to the start of the first index fund 33 years ago. The bond index fund did even better. Its return of 5% for 2008 outpaced more than 80% of all taxable bond funds.

Looking at stock prices at year end, it is impossible to clearly determine whether the declines in stock prices represent an “overshoot” beyond some objective “fair value,” In the credit markets however, it is a bit easier to point to price relationships that are best explained as anomalous or even irrational: long term investment grade bonds carry yields close to 6% above those of similar maturity treasuries

2009 Outlook

Bearing in mind the warnings of John Bogle of Vanguard: that one should“beware of market forecasts “ here are some of my thoughts:

Looking at the factors that caused the market decimation in 2008 and the conditions they have now created leaves me cautiously optimistic for 2009.

Valuations: In the indiscriminate liquidations in 2008 left many company’s stocks were pushed down to values that are unjustified by their underlying business or even their cash or other assets on hand. Furthermore a large portion of the decline in the major market indices came from the massive losses in the financial sector.. While the financial sector will be constrained from ever achieving the growth rates of the past, the lower weighting in the major indices and the evidence that the government considers the largest players “too big to fall” places some limits on the potential impact of further negatives in the financial sector. Many other sectors of the market have potential to gain significantly from economic rebound when it occurs in both developed and emerging markets and from the fiscal stimulus in the US.

Government Policy After numerous false starts during 2008, it does seem that authorities have a more cohesive approach to both fiscal stimulus and monetary policy in place, one which has the potential for stimulating the economy towards recovery in 2010. Equity markets always turn up in advance of an economic recovery.

Money Flows: In my view much of the forced liquidation by hedge funds of listed equities has already occurred as has the panic selling of equity mutual funds by individual investors. There are also high levels of cash in the hands of equity fund managers. As the market stabilizes and begins to rise and investors are faced with the alternative of 2% rates on Cds and below 1% on their money market fund there is potential for a large flow of money back into the stock market.

The large scale deleveraging and sales that have occurred already makes similar volatility and indiscriminate selling less likely in 2009. There are simply fewer large leveraged positions left to be liquidated and little credit available to build new leveraged positions.

Emerging Markets Although these countries, particularlyChina are heavily dependent on exports to the United States, they are far better positioned than the US in many ways. There is significant potential to benefit from the growth of the middle class both domestically and in the rest of the developing world. And the large surpluses accumulated through exports could be increasingly invested domestically to stimulate their economy. Also the current depressed commodity prices are a boon to the developing world. Emerging markets will be well positioned when the recovery comes to the developed world.


I see little reason to expect a recovery in housing prices. At best one could hope for a stabilization 10 -20% below current levels aided by government policies to limit future foreclosures and push rates on mortgages lower. The stabilization in prices after that drop would likely be followed by an extended period of up to ten years with minimal or no price appreciation. Such a scenario would put prices back in line with their long term hisroy of home price appreciation which Professor Robert Schiller of Yale and others have found to be equal to the rate of inflation,

Consumer spendg; the inhigh levels of unemployment, the end of the home equity piggy bank, and even a modest increase in household savings will put a limit on consumer spending which traditionally had been the key driver of US economic growth. This is unlikely to improve before 2010 at the earliest.

“Known Unknowns”: The list of things that could go wrong and derail any positive performance in the equity markets is, unfortunately, a long one. It would include: failure of US government policy to revive the economy, political instability abroad, major bankruptcies, international conflicts, major economic crises abroad, and a sharp rise in inflation (or widespreade deflation).

Investing themes

While we maintain broadly diversified portfolios across the markets, we are positioning within that strategy to take advantage of the following:

Financials remain vulnerable and therefore we are investing in broad indices which underweight financials.

Developing economies have potential to benefit from growth within their own markets and do not carry the burdens of credit overextension, budget deficits or current account deficits. We maintain a significant weighting in this sector with a slight overweighting towards Asian emerging markets.

Small cap value stocks tend to be the first beneficiaries of recoveries in the stock market therefore we have an overweighting in this area.

We have small positions in etfs concentrated in clean energy and consumer staples.

The high yields on investment grade corporate and municipal bonds offer an attractive investment opportunity . Many have noted that high grade corporate bonds have potential with long term equity returns in the area of 8% based on current yields over 6% and the potential for capital appreciation should yields fall and/or spreads to treasuries narrow. Some of that narrowing has begun late late in 2008.

Finally I would like to remind you of some basic investment principles that were presented by John Bogle (generally regarded as the inventor of the index fund) in a recent Wall Street Journal article entitled : 6 Lessons for Investors

1. Beware of Market Forecasts
2. Never underrate the importance of diversification
3. Mutual funds with superior performance records often fail to repeat.
4. Owning the market remains the strategy of choice.f asset allocation

5. Look before you leap into alternative asset classes

6. 6) Beware of financial innovation. Why? Because most of it is designed to enrich the innovators, not investors.

Best Wishes for the New Year

Friday, January 9, 2009

More Wisdom From John Bogle

John Bogle considered the father of the index fund had some wise words on investing in the WSJ

some excerpts

Six Lessons for Investors
Be diversified and don't assume past performance will continue.


There is almost no limit to the ability of investors to ignore the lessons of the past. This cost them dearly last year. Here are six of the most important of these lessons:

1) Beware of market forecasts, even by experts. As 2008 began, strategists from Wall Street's 12 major firms forecast the end-of-the-year closing level and earnings of the Standard and Poor's 500 Stock Index. On average, the forecast was for a year-end price of 1,640 and earnings of $97. There was remarkably little disparity of opinion among these sages.

Reality: the S&P closed the year at 903, with reported earnings estimated at $50....

2) Never underrate the importance of asset allocation. Investing is not about owning only common stocks. Nor are historical stock returns a sound guide to future returns. Virtually all investors should keep some "dry powder" in their portfolios in the form of high-grade short- and intermediate-term bonds. Investors who failed to learn that lesson fell on especially hard times in 2008.....

3) Mutual funds with superior performance records often falter. Last year was an extreme example. With the S&P 500 off 37% for the year, Legg Mason Value Trust fell by 55%. Fidelity Magellan Fund, after a good 2007, was off 49%. Funds managed by proven long-term pros felt the pain -- Dodge and Cox Stock down 43%; Third Avenue Value down 46%; CGM Focus down 48%; Clipper down 50%; Longleaf Partners down 51%. (Full disclosure: Four of Vanguard's actively-managed equity funds also lagged the market by wide margins.).....

4) Owning the market remains the strategy of choice. Such a strategy guarantees a return that lags the market return by a minuscule amount, and exceeds the return captured by active equity-fund managers as a group by a substantial amount. Why? Because the heavy costs incurred by investors in actively managed equity funds can easily amount to 2% to 3% annually. Typical expense ratios run from 1% to 1.5%; the hidden costs of portfolio turnover often come to 0.5% to 1.0%; a 5% front-end sales load, amortized over a holding period of five to 10 years, adds another 0.5% to 1.0% per year in costs....

Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks. This continues the pattern -- with some variations -- that goes back to the start of the first index fund 33 years ago. The bond index fund did even better. Its return of 5% for 2008 outpaced more than 80% of all taxable bond funds.

In sum, active management strategies as a group lose because they are expensive. Passive indexing strategies win because they are cheap.

5) Look before you leap into alternative asset classes. ....
6) Beware of financial innovation. Why? Because most of it is designed to enrich the innovators, not investors. Just think of the multiple layers of fees to the salespersons, servicers, banks, underwriters and brokers selling mortgage-backed debt obligations. These new products (credit default swaps are another example) enriched their marketers during 2005-07, only to impoverish the clients who held them in 2008.

Mr. Bogle is the founder and former chief executive of the Vanguard Group of Mutual Funds. His newest book, "Enough. True Measures of Money, Business, and Life," was published by Wiley in November.

Thursday, January 8, 2009

Index Funds vs Active Funds, the "Debate" Continues

These kind of articles appear at least once a year in various publications and I never understand the arguments presented for not using index funds and etfs. My comments in parantheses ( ) and italics and my bolds.from the wsj

JANUARY 4, 2009, 9:28 P.M. ET Fundamentals of Investing

Active or Index Funds for '09? The downturn has been rough on stock-picking managers. Now, professionals debate which type of fund will do better when stocks eventually bounce back.Article

As return-hungry investors prepare for a stock-market rebound -- yes, analysts say the market will rise again -- they face some difficult questions about what types of mutual funds will help put their portfolios back on track the fastest. (?)...

."We recently replaced any actively managed funds with passive or index funds to ensure a full participation in an eventual recovery," says Steven Condon, director of investment advisory services at Truepoint Capital LLC in Cincinnati, a firm that typically recommends a mix of actively managed and index funds.
Mr. Condon says that in an index fund, your money is fully invested and will fully benefit from gains as soon as the market turns around. In contrast, many actively managed funds have built up large cash positions in recent months -- in some cases as much as 40% or more -- to try to cushion losses. Since no one can predict when the bottom of the market will occur, active managers sitting on piles of cash are likely to miss out on the early stages of a recovery, Mr. Condon says, pointing out that the early stages of a recovery are critical.Indeed, a look at bull markets since 1929 shows that an average 48% of the overall gain occurred in the first one-third of the bull-market time period, according to Ned Davis Research, a financial-research firm in Venice, Fla. (makes sense to me)

Using Cash Wisely

But some investors argue that by investing in a fund that mirrors an index you are holding not only the fastest-rising sectors but also the laggards. An active manager may be able (or not) to avoid the low performers and use cash to nimbly pick up shares of companies that are growing ahead of the market.
Fairholme Fund is notorious for holding large stores of cash -- but it uses the cash to buy when investors are fearful, says Wenli Tan, a Morningstar Inc. mutual-fund analyst. "The fund's stock selection has been so strong that it has been able to be at the top of its class even with a big cash stake," Ms. Tan says. (except in a year like last year when they were heavily weighted in financials as the wsj reported the fund was down 24$ in the last 3 months of 2008)....
In the recoveries from the past three bear markets, index funds have come out ahead of managed funds on average, according to data from researchers Lipper Inc. and Morningstar.

Over the 12-month period following the most recent bear market that ended in March 2002, less than 30% of actively managed funds beat their benchmarks, according to Morningstar.But don't assume history will repeat itself, cautions Christopher Cordaro, an investment adviser at RegentAtlantic Capital LLC in Morristown, N.J. He believes the rebound following the current bear market will be different -- and that active managers will have an edge -- largely because of the character of the recent market drop.
"In the type of selloff we've just had, everything got sold because liquidity had to be raised, so there was no looking at whether to sell stock A or B -- it was an indiscriminate selloff," Mr. Cordaro says. "That has created huge price anomalies. You would expect that an active manager would be able to exploit these price anomalies and produce better returns than you'd get just buying an index." (but history proves it is not the case)
Actively managed funds certainly didn't shine versus index funds last year, with some 58% of actively managed U.S. stock funds failing to beat their benchmark indexes in 2008, according to Morningstar.But Erik Ristuben, chief investment strategist at Russell Investments in Tacoma, Wash., agrees with Mr. Cordaro that things will be different for stock pickers going forward.
He says that active managers tend to struggle significantly when sentiment is driving the markets -- as has been the case recently. When the market is pricing companies "based on fear -- or euphoria -- you are in an environment where managers may have a hard time keeping up," Mr. Ristuben says. Recently, "stock prices have had not a great deal to do with the actual likely economic value of the corporations." (one could easily, less expensively and more reliably take advantage of this through a position in value index etfs or funds)He believes a rebound will be driven by a recognition of strong fundamentals at individual companies, which will benefit active managers.A Balanced Approach

So what is the average investor to do? Unless you are wedded to an all-index or all-active management approach, your best bet is to take advantage of both types of funds, says Peggy Ruhlin, an investment adviser at Budros, Ruhlin & Roe Inc. in Columbus, Ohio. ( I don't get the logic, history shows the active funds are unlikely to outperform)As a rule of thumb, use an index mutual fund or exchange-traded fund to get exposure to a broad segment of the stock market, and go with an actively managed fund for exposure to a particular segment of the market, Ms. Ruhlin says.
"Certain managers can add value with an expertise in either a certain region or segment -- foreign tech stocks, for example," Ms. Ruhlin says. "But if we're just trying to make a play on China, then we use an index fund or an ETF." (so certain managers may have an expertise in certain regions, but to invest in china she indexes. So certain managers have expertise in regions, but not in individual countries ? So if I invest in an asia fund that is actively managed I look for manager expertise, but their expertise in china would have been inferior to an index ?)Mr. Winer says actively managed funds shouldn't "be painted with a broad stroke." Some are designed to cushion a market decline, but will lag behind the overall market during upswings. Others have only a handful of holdings, and this highly aggressive position results in massive gains in some years and huge declines in others. The important thing is to understand what part an actively managed fund should play in your portfolio, he says.
With a blend of index and managed funds, you eliminate the chance of being left out of a market comeback -- and add the possibility of rising ahead of the tide.—(actually you increase the possibility you will miss part of a market recovery with the active fund since it can hold cash unlike an index instrument) Ms. Hube is a writer in Westport, Conn. She can be reached at

Tuesday, January 6, 2009

This Is No Surprise

From the WSJ's Investing in Funds Section

Actively managed funds certainly didn't shine versus index funds last year, with some 58% of actively managed U.S. stock funds failing to beat their benchmark indexes in 2008, according to Morningstar.

Saturday, January 3, 2009

"Decouplng" and The Future of Global Markets

Those that hoped that emerging markets had decoupled from those of the developed world were severely disappointed last year as the economic and financial crisis in the developed world hit emerging markets hard. In fact for 2008 the broad index of emerging markets fell a full 10% more than the S+P 500.

The NYT today gives a nice overview of the debate on the future of global markets. Among those cited is Jeremy Grantham an astute analyst and one of those who was quite early to predict the current crisis. I think Grantham makes excellent points when he argues:

He does not think that the world’s economies are unrelated to one another. The expansion of global trade and capital flows, which could be the most significant economic development of the last 20 years, means “we’re all horribly coupled,” he said.

BUT that connection has created a widening disconnection, in his view, not between the United States and everything else but between emerging and developing economies.

“Growth rates in the developed world have been slowing without much fanfare for the last dozen years,” Mr. Grantham said. “I expect emerging markets to do much better and become the only game in town.”

His version of decoupling may seem at odds with Mr. Sri-Kumar’s, but they can be compatible. All it takes is time.....

, Mr. Grantham expects emerging markets to shine only after the “current unpleasantness” in the global economy and financial system abates and a recovery is under way.

Mr. Grantham is so optimistic about long-run prospects for the developing world because its economies and societies are decoupling in important ways from those in mature countries. Population growth, university graduation rates, the ratio of workers to retirees, rates of saving and investment — all factors that determine long-term growth rates — are higher in the emerging world. In many cases they are rising there and falling in the West and Japan. With the outlook so promising in emerging markets, Mr. Grantham said, “why wouldn’t you invest there?”

It Seems Some Pension Funds See Alternative Investments A Bit Differently

Today the WSJ reports on some pension fund managers that view the world a bit differently than those cited in the previous post

JANUARY 3, 2009 Once Burned, Twice Shy: Pension Funds
Calstrs and Calpers, Among Others, Rethink Bets on 'Alternative' Investments After a Tough '08
After suffering through 2008, some big pension funds are having second thoughts about their exposure to private-equity firms, hedge funds and other nontraditional investments.
Across the U.S., pension-fund managers and investment officers have been scrutinizing their asset allocations, especially toward alternative investments. In addition to wilted returns, pension funds are leery because some hedge funds have made it hard to cash out, including by postponing redemption requests from investors.

(while hedge funds have made things difficult by not letting investors pull money out, private equity funds have been hitting investors for their contractual obligations to invest more capital into the funds- lw)
Other pension funds that barreled into private equity have been crunched by capital calls, or demands to deliver cash that are often conditions of investment with private-equity firms. While those obligations aren't a surprise, many pension funds expected to offset the payments with returns from other private-equity investments. Such gains have been rare.

Christopher Ailman of the California State Teachers' Retirement System said exposure to alternative investments is burdening pension plans.
"What we saw as an asset before, we now see as a liability," says Christopher Ailman, chief investment officer of the California State Teachers' Retirement System, the country's second-largest public pension fund by assets.
About 14% of Calstrs's roughly $129 billion in assets are in private equity. The pension fund will review those holdings as part of a broader asset-allocation review in February.
It is doubtful that retirement behemoths with billions in assets will retreat completely from alternative investments, partly because returns should improve once the economy pulls out of the recession. Still, some pension funds are likely to reduce their positions or put the brakes on plans to invest more. Other funds feel compelled to hoard cash to compensate for the lack of liquidity.

Few bets turned out well for pension-fund managers in 2008. But alternative investments were doubly painful, partly because ill-timed capital calls from private-equity firms forced some pension funds to sell stocks into the falling market.
Such sales are one reason why the California Public Employees' Retirement System is speeding up its asset-allocation review to early 2009
. Previously, the nation's largest public pension fund wasn't scheduled to review its asset weightings until 2010.
"We want to make sure that our assumptions made at the end of 2007 are still valid," says Pat Macht, a Calpers spokeswoman.

"Cash is the biggest challenge," says Bill Atwood, executive director at the Illinois State Board of Investment. While the $9 billion pension fund has entered redemption notices for construction loans and other funds, Mr. Atwood doesn't anticipate seeing that money for as long as six months.
Meantime, he is girding for capital calls from private-equity, real-estate and infrastructure funds. The Illinois fund also has been selling Treasurys, usually a core holding for safety-minded pension plans, to meet cash needs in recent weeks.