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Tuesday, March 31, 2009

Now He Tells US !

Myron Scholes winner of the Nobel Prize in economics was one of the founding partners of Long Term Capital, the hedge fund that almost took down the world's financial system in 1998 due to the massive leverage of their fund. Ten + years later he was one of the participants in a Wall Street Journal sponsored forum on the Future Of Finance. Scholes was one of the main members of the working group on the future of credit markets. One of the five recommendations:

So the third point was about leverage.

MR. SCHOLES: Yes, the idea that the amount of leverage should be reduced or the amount of capital increased to match the risk of the enterprise, and the amount of capital required for the same level of risk be increased.

We believe that having more capital underlie the actual activities of the banks and other financial institutions is not that expensive

Roger Lowenstein's When Genius Failed, a classic of financial writing presents a great history of LTCM's demise.

Monday, March 16, 2009

Morningstar Strikes Again

The Morningstar advisor website features a comprehensive analysis of the failure of active managers to outperform their respective indices despite the bear market conditions when active managers were supposed to shine:

Bearly' Winning

by Daniel Culloton | 03-03-09

This is the big one; a bear market so fierce and unrelenting that it'll expose index funds for the dumb investments they are and allow active managers to show their quality.

Or maybe not.

I recently looked at how actively managed funds have fared versus similarly styled benchmarks thus far in this the worst stock market crash since the Great Depression. What I saw probably won't end up in any actively managed fund's marketing materials. While the typical active manager has beaten certain benchmarks from when the major market averages peaked on Oct. 9, 2007, through the end of January 2009, the victory hasn't been clear-cut. Also the typical stock-picker's inability to beat the Standard & Poor's style benchmarks in most categories undercuts the argument that active managers would hold up better in a severe downturn by favoring so-called higher-quality stocks.

Advantage, Market
There have been individual managers, management teams, and strategies that have limited the damage during this bear market. As the bear market drags on, active managers collectively also could improve their relative standing somewhat. And losing 37.1% in an S&P 500 fund instead of 37.2% in an actively managed large-cap blend fund shouldn't make anyone feel happy. But the average active manager's absolute and relative performance so far makes it hard, to paraphrase Vanguard founder and index fund creator Jack Bogle, for the active funds to claim superiority over the market averages.

But talk about disconnect !the same website contains an article about an "undiscovered" active manager with great returns and the curren issure of the affiliated magazine Morningstar Advisor contains an article entitled "Four Picks for the Present" three of the four funds are actively managed,

Sunday, March 15, 2009

I Think We Have Heard This Song Before...

from the LA Times

Getty slashes operating budget after severe investment losses
By Mike Boehm
Los Angeles Times Staff Writer
March 15, 2009

The J. Paul Getty Trust, envied as the economic Goliath of the museum world, is cutting its operating budget nearly 25 percent for the coming fiscal year -- an emergency response to investment losses that have totaled $1.5 billion since July and nearly $2 billion since mid-2007.

President James Wood said the financial stability of the Getty, the world's richest arts institution, could "fall off a huge cliff" if it delayed drastic cuts and hard times continue.

The Getty relies almost exclusively on investment earnings to cover expenses for its two Los Angeles art museums as well as the research, art-conservation and grant-making operations that extend the trust's reach around the world.

Its investment portfolio dropped 25 percent during the last half of 2008from $6 billion to $4.5 billion. ....

..... James Williams, the Getty's chief investment officer since 2002, said there was no plan to change the investment strategy the trust has pursued since the middle of this decade, betting heavily on "alternative investments" such as hedge funds, private partnerships, raw materials and "distressed" companies trying to emerge from Chapter 11 reorganization. Williams said the Getty's approach, which de-emphasizes holdings in publicly traded stocks and bonds, was safer because it allows greater investment diversity.

The strategy is known as the endowment model or the Yale model, in deference to the university that pioneered it in the 1980s, reaping huge returns and begetting many imitators among universities and other nonprofit institutions that can afford to invest huge sums over a long term. Williams said that over the past year and a half, the Getty has tried to minimize what he considers the approach's two pitfalls: investing in ventures that are loaded down with debt and tying up too much money in assets that are hard to sell quickly.

I will give them credit for the alight adjustment. But I still dont understand why it was so distateful for these institutions to do what I recommend to individuals keep funds needed in the next 3 years or more in very stable liquid assets like short term bond funds or tbills.

Friday, March 13, 2009

The Definitive Reason to Turn Off That Business Channel

Cramer vs Stewart mano a mano. Here's the full interview as posted on the Comedy Central Website including outakes not shown on the program :

stewart "we're both snake oil salesman to an extent"

cramer: "I don't disagree"....

stewart: "I know you want to make finance entertaining, but it's not a f#### game"....

Cramer: "There's a market for it (shows like "Fast Money")
Stewart: "There's a market for cocaine and prostitution too."

Monday, March 9, 2009

The NY Times on the Quants

Seems Everyone is "discovering" the role that the failure of academic financial modles had in the debacle in the financial markets. The NYT presents a nice overview.
and my favorite observer Nasem Taleeb is mentioned as on of the lone critics

Bere is an excerpt

Another consequence is that when you need financial models the most — on days like Black Monday in 1987 when the Dow dropped 20 percent — they might break down. The risks of relying on simple models are heightened by investors’ desire to increase their leverage by playing with borrowed money. In that case one bad bet can doom a hedge fund. Dr. Merton and Dr. Scholes won the Nobel in economic science in 1997 (pictured above) for the stock options model. Only a year later Long Term Capital Management, a highly leveraged hedge fund whose directors included the two Nobelists, collapsed and had to be bailed out to the tune of $3.65 billion by a group of banks.

Afterward a Merrill Lynch memorandum noted that the financial models “may provide a greater sense of security than warranted; therefore reliance on these models should be limited.”

That was a lesson apparently not learned.

Respect for Nerds

Given the state of the world, you might ask whether quants have any idea at all what they are doing.

Comparing quants to the scientists who had built the atomic bomb and therefore had a duty to warn the world of its dangers, a group of Wall Streeters and academics, led by Mike Brown, a former chairman of Nasdaq and chief financial officer of Microsoft, published a critique of modern finance on the Web site last fall calling on scientists to reinvent economics.

Lee Smolin, a physicist at the Perimeter Institute for Theoretical Physics in Waterloo, Ontario, who was one of the authors, said, “What is amazing to me as I learn about this is how flimsy was the theoretical basis of the claims that derivatives and other complex financial instruments reduced risk, when their use in fact brought on instabilities.”

But it is not so easy to get new ideas into the economic literature, many quants complain. J. Doyne Farmer, a physicist and professor at the Santa Fe Institute, and the founder and former chief scientist of the Prediction Company, said he was shocked when he started reading finance literature at how backward it was, comparing it to Middle-Ages theories of fire. “They were talking about phlogiston — not the right metaphor,” Dr. Farmer said.

One of the most outspoken critics is Nassim Nicholas Taleb, a former trader and now a professor at New York University. He got a rock-star reception at the World Economic Forum in Davos this winter. In his best-selling book “The Black Swan” (Random House, 2007), Dr. Taleb, who made a fortune trading currency on Black Monday, argues that finance and history are dominated by rare and unpredictable events.

“Every trader will tell you that every risk manager is a fraud,” he said, and options traders used to get along fine before Black-Scholes. “We never had any respect for nerds.”

Sunday, March 8, 2009

Efficient Market Theory Redux: Just Because It's Flawed Doesn't Mean You Can Pick A Manager That Will Beat The Market

From the Economist

Mar 5th 2009

How efficient-market theory has been proved both wrong and right

THE past ten years have dealt a series of blows to efficient-market
theory, the idea that asset prices accurately reflect all available
information. In the late 1990s dotcom companies with no profits
and barely any earnings were valued in billions of dollars; and in 2006
investors massively underestimated the risks in bundling together
portfolios of American subprime mortgages.

There is now widespread acceptance that investors can behave
irrationally, creating very large anomalies. Take the momentum effect, the practice of buying the stockmarket's best performers over
the previous time period. A study by the London Business School found that,
since 1900, buying British stocks with the best momentum would have turned GBP1 into GBP1.95m (before costs and tax) by the end of last year; the same sum invested in the worst performers would have grown to just GBP31. In efficient markets, such an anomaly should be arbitraged away....

But it is important not to throw out all the insights of
efficient-market enthusiasts. Although it is theoretically possible to make money by outperforming the markets, it is extremely difficult in practice
That ought to have made investors suspicious of the
smoothness of the returns of Bernard Madoff, who has been accused of a vast fraud. His strategy, as advertised, might have produced less
volatile returns than the index, but the absence of negative months
suggested almost perfect market timing.

Some fund managers have beaten the markets over long periods. The problem is to identify them in advance. Picking them after
they have outperformed may be too late, as those who backed Legg Mason's Bill Miller have recently discovered
. Why is this? Fund managers are human too and subject to behavioural biases. In addition, the larger their funds become (as their reputation spreads), the more difficult it is to outperform

The temptation has also been to assume that fees are positively correlated with performance--that if mutual fund managers charging 1.5%
are good, hedge-fund managers charging 2% (and 20% of performance) are even better. Because investors cannot beat the market in aggregate, all this means is that money is transferred from investors to fund managers. Even David Swensen, the man who led the drive into alternative assets at Yale University, thinks most investors should rely on low-cost index-tracking funds

Saturday, March 7, 2009

Peter Lynch: I'm Confused

Peter Lynch, just after he retired from managing the Magellan Fund, as well as the legendary Warren Buffett, admitted that most investors would be better off in an index fund rather than investing in an actively managed equity mutual fund.
-- Burton Malkiel in A Random Walk Down Wall Street (p.144 in the 2007 edition)

Mr. Lynch said that even after this market decline, he would stick to the view that no one should hold stocks unless they could afford to lose an additional 50 percent. And he said he had not deviated from his faith in “bottom-down stock picking,” in which investors who have done their research buy shares of just five or six well-priced companies with strong balance sheets and “compelling stories.”

nyt march 7,2009

About those Expert Forecasts.....

beware,beware, beware:

strong>March 8, 2009
Even for Market Veterans, It’s Uncharted Territory

AFTER the steepest decline since the Great Depression, unalloyed optimism among veteran stock market hands is hard to find.

Byron Wien, chief investment strategist at Pequot Capital Management, says he is an optimist. Yet he advises small investors to buy gold and corporate bonds, not equities, which, he said, may be too risky right now.

Barton M. Biggs, managing partner at Traxis Partners, a hedge fund, places himself in the optimists’ camp, too. Yet he advises well-to-do investors to arm themselves — with shotguns, if need be — against the possibility of a deepening downturn and accompanying “social unrest.” ......

What should investors do under these circumstances? Buy high-quality corporate bonds, which fell sharply over the last year or so, and which are likely to rise in a market recovery. That makes sense to Dr. Kaufman, as well as Messrs. Wien, Biggs and Lynch. Bonds have the merit of providing steady income, at rates that are now very high; they tend to be less volatile than stocks; and they have a higher legal claim on a company’s assets.

FOR investors with a truly long-term view, probably 20 years or more, the market will be worthwhile, they said, because stocks should outperform other asset classes. To one degree or another, though, they said investors should be extremely cautious over the short term.

Mr. Biggs said he thinks it’s “50-50” as to whether the economy begins to recover over the next year or “whether we are going into a depression and a deflation,” which could conceivably be as painful as the 1930s.

“If we’re going into the 1930s,” he said, “it’ll be survivalism, and we’ll have very substantial social unrest.”

Attention should be paid of course. After all this is major "expert" with decades of experience:

Buy American: Barton Biggs increasing holdings of U.S. equities
Traxis Partners co-founder says market is close to the bottom; shares ‘very, very cheap’

February 11, 2008 12:47 PM ET

Barton Biggs, co-founder of hedge fund Traxis Partners, said he's “gradually increasing” his holdings of U.S. equities because he doesn't expect a recession and shares are “very, very cheap.”

Mr. Biggs, the former global investment strategist for Morgan Stanley, said in a Bloomberg Television interview that the market is “at or very close to an important bottom'' and may be led higher by banks and brokerages when a rally occurs. Some financial companies may advance 20% to 25% over periods of two to three weeks, said Biggs, who helps manage $1.5 billion in Greenwich, Connecticut. The Standard & Poor's 500 Index fell 6.1% in January, its biggest monthly decline since September 2002 and its worst start to a year since 1990. During the month the index fell as much as 16% from its Oct. 9 record.

Financial companies in the index fell almost 21% in 2007, the worst performance among 10 industry groups and their biggest drop since 1990. They trade for 14.8 times profits, compared with an average price-earnings ratio of 15.5 this decade, according to data compiled by Bloomberg.

The S&P 500 trades for 18.1 times earnings, 31% below its monthly average this decade, according to data compiled by Bloomberg.

Mr. Biggs correctly forecast U.S. equities would rebound from declines in March and August last year. On March 16, following a 5% decline by the S&P 500 from its Feb. 20 peak, he said stocks were approaching a bottom and predicted a gain of as much as 15% for the index in 2007.

The S&P 500 rose as much as 12% from that level before retreating to end the year with a 3.5% gain.

On Aug. 16, after a 9% decline by the index, Biggs said it was bottoming and predicted a rebound. The benchmark rose almost 11% over the next seven weeks

Feb 11, 2008 DJIA: 12,182 S+P 500 1321 IYF (financials etf)86.71

March 5, 2009 DJIA 6626 S+P 50 683.38 IYF 24.10

Friday, March 6, 2009

He's Back With a Mini Rant About Those Business Channels

Jon Stewart was on Dave Letterman's show with more of his views of financial journalism ....on all 3 business channels.

Putting Their Money On The Black Swan....And Making Lots of It

From Bloomberg

36 South Plans Inflation Hedge Fund After 236% Black Swan Gain By Netty Ismail

March 6 (Bloomberg) -- 36 South Investment Managers Ltd., a New Zealand-based hedge fund firm set up by derivatives traders, will close its Black Swan Fund after it gained 236 percent in the last 12 months and start a fund that wagers on inflation.

36 South will move to London from Auckland in May to boost its assets under management as investors have overlooked the manager because of its location, said Jerry Haworth, co-founder of the firm that manages more than $40 million.

“. ......

36 South buys long-dated options it considers cheap in global currency, fixed-income, equities and commodity markets, betting that rare and unforeseen events would generate unusually large profits. It doesn’t invest in options with less than a year to maturity.

Options, contracts to buy or sell shares by a certain date at a specific price, “serve as an early warning system for an impending crisis,” Haworth said. “It’s an amazingly lucrative niche and there are very few players in it.”

Making Money

The Black Swan Fund profited from bets on interest-rate cuts in Australia and New Zealand, and the purchase of put options on major stocks around the world, including the so- called BRIC nations of Brazil, Russia, India and China, Haworth said. The manager also bought put options on commodities. Put options gives the buyer the right, though not the obligation, to sell a specific quantity of a security by a set date. ....

“What can I say? They made a great deal of money,” said Peter Douglas, principal at Singapore-based hedge-fund consulting firm GFIA Pte, which runs a unit that invests in hedge funds. “We were invested in Black Swan, which made our clients happy. It was conceived and executed as a disaster hedge, and clearly last year was full of disasters.”

Black Swan

36 South plans to close its Black Swan Fund within the next two months and return the money to investors as options are now “very expensive” and are unlikely to produce “significant returns,” Haworth said.

Boy do I admire these guys for their integrity. They only managed $40 million a pittance in the hedge fund world. And at a point that they clearly could raise hundreds of millions and generate a fortune in fees, they are willing to close the fund based on their reading of market conditions.

“The market has gone from under-pricing risk to over- pricing it,” he said. “On a risk-reward point of view, I can’t put my hand on my heart to investors and say ‘listen, this is a good investment to be buying options at this juncture,’ because I don’t believe it.”

The fund, named after a theory developed by Nassim Nicholas Taleb, a professor of risk engineering at New York University, sought to protect client investments against “black swans,” those highly improbable events that can cause havoc. Taleb wrote a book called “Black Swan: The Impact of the Highly Improbable,” published in May 2007.

36 South will start a fund in the second half of the year that will return “well over 100 percent” if there’s “significant” inflation worldwide, Haworth said. Billionaire Warren Buffett said in his annual letter to Berkshire Hathaway Inc. shareholders Feb. 28 that U.S. bailouts will likely lead to “an onslaught of inflation”.

On and by the way, I don't think these guys based their strategy on the efficient markets hypothesis.

"A Theory So Stupid Only an Expert Could Believe It" ?

Brett Arends has a great column in the WSJ entitled

Has Fear Blinded Investors to Value?
Meet the evil twin of the efficient market hypothesis: Efficient market hypnosis

You should read the whole article. I love this quote

The "efficient market hypothesis" used to claim that, when it came to the stock market, "the price was always right" – in other words if, say, ", Inc." was trading at $180 a share, then by golly, that's what it should be trading at, and who could possibly say it was overvalued?

If you think that's a pretty silly line of thinking, you're right. But many people in finance really did believe it, including some otherwise intelligent ones - dotcom mania and all.

It was something so stupid only an expert could believe it.

That theory may be pretty much dead today. But we are all at risk – and I include myself – from its insidious evil twin: Efficient market hypnosis.

This is where the market simply lulls us into submission by constant repetition. You can't fight the tape. If a perfectly good stock has fallen 40% in value, then, by golly, efficient market hypnosis makes us think there must be an excellent reason for it.

Anyone minded to accept the verdict of the stock market should remember that it was at work a couple of years ago in exactly the opposite direction. Lots of people – and I was not immune – were lulled by the overpowering force of the tape upwards

Arends is right ... "only an expert could believe it."

but he is certainly wrong that "That theory may be pretty much dead today." Because it is taught in every finance class in the world and the competing approaches of behavioral economics are far in the minority among academic "experts".
The NYT makes this clear in its article about academic economists

... prominent economics professors say their academic discipline isn’t shifting nearly as much as some people might think. Free market theory, mathematical models and hostility to government regulation still reign in most economics departments at colleges and universities around the country. True, some new approaches have been explored in recent years, particularly by behavioral economists who argue that human psychology is a crucial element in economic decision making. But the belief that people make rational economic decisions and the market automatically adjusts to respond to them still prevails.

The University of Chicago is considered the birthplace and bastion of the efficient market hypothesis. Although Prof Richard Thaler (pictured above) a prominent behavioral economist has breached the walls of the University I don't think he has convinced many of his colleagues to shake their views.

Thursday, March 5, 2009

A Money Flow That Makes Sense

Despite the hype of the actively managed fund mutual fund machine it seems that the advantages of indexing are reaching more and more investors. From the WSJ:

Active vs. Passive: Indexing Wins '08
Benchmarked Mutual Funds Pick Up Share
Mutual-fund investors in 2008 yanked more money out of actively managed stock-funds than they put in for only the third time ever, and index-fund rivals took some of the spoils.
The switch reflects a budding sentiment among many investors -- especially after a devastating 12 months -- that active fund management isn't always worth its higher fees. Index funds track a market benchmark and so provide average performance, typically at a much lower cost than actively run counterparts that try to beat the market on the upside and cushion blows on the downside.
Most managers fail to outperform their benchmark in a given year, however, and this bear market is no exception. Average losses for stock-index funds last year were 39.1%, while actively managed funds lost 40.5% on average, according to investment researcher Morningstar Inc.

(Don't ask me however why the Morningstar folk never just come out and tell people they would be better off ignoring all their "ratings" of active funds rather than sifting through their endless material evaluating and rating actively managed mututal funds).....

As well as the lower returns, Mr. Burns said that investors in actively run funds are more likely to chase performance and less likely to be focused on asset allocation. As such, they are quicker to dispose of their holdings.

Index-fund investors, meanwhile, more often use those funds as part of an asset-allocation strategy that see them through tough times in the markets, Mr. Burns said

Nonetheless hope springs eternal fuelled by the active mutual fund marketing machine and aided by fund "analysts" and personal finance magazines.

Index funds' share of the marketplace rose by 1.4 percentage points in 2008 to 13.2% from 11.8% a year earlier. Total assets in index funds at year's end were $490 billion; actively managed stock funds held $3.2 trillion, according to Lipper.
The change in market share doesn't include one growing player in the stock-fund world: exchange-traded funds, which mostly are indexed portfolios that trade on an exchange like stocks.

The biggest revolution in index (or passive or asset class) investing is the growth of the exchange traded fund (etfs) market. While there are doubtless too many etfs and many that are totally inappropriate such as leveraged and inverse etfs the proper use of these instruments allows investors to construct low cost transparent portfolios. While institutional investors and financial advisors are not the source of all investment wisdom, in this case I think they have been ahead of the curve (especially since I have been in this group :-):

ETFs are enormously popular with institutional investors and financial advisers, and lately with individual investors as well. Total assets in stock ETFs grew from $15.6 billion at the end of 1998 to $473.9 billion at the end of 2008, according to the Investment Company Institute. When ETF assets are included in index funds' market share, the total slice of the pie grows to 21.4%, and the challenge from indexed investment strategies to actively managed funds becomes even clearer.
"ETFs offer a broad range of indexes for investors," said Tom Roseen, senior analyst at Lipper. "Investors now have access to indexed strategies that didn't exist with mutual funds."
Other years in which stock funds saw net outflows were 1998 and 2002. And while investors subsequently returned, actively managed stock funds surrendered market share to index funds each time.

As I Said On Feb. 16....Turn Off That Business Channel.....But Don't Miss This :

Tuesday, March 3, 2009

"An Errror Laden Machine"

John Plender in the FT presents a nice summary of "what went wrong" including many of the points that have been highlighted here several times. I did find his description of the financial decision making process as "an error laden machine" and its tendency towards disaster myopia (which is pretty much the same as underestimating the "black swans")

....The message of all this misery is summed up by Michael Lewitt of Harch Capital Management, a fund manager who was quick to identify the risks in the credit bubble. "Virtually every strategy institutional investors followed, or were advised to follow by their consultants or funds of funds", he says, "turned out to be a complete disaster". Even if that verdict errs on the sweeping side, it is clear that mainstream investment strategies failed to deliver. Why - and what needs to change to prevent a repetition?

A good diagnostic starting point is the phenomenon that academics call "disaster myopia" - the tendency to underestimate the probability of disastrous outcomes, especially for lowfrequency events last experienced in the distant past. The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the "great moderation". Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned. Their response was to search for yield in riskier areas of the market and then try to enhance returns through leverage, or borrowings.

and this myopia created a lack of awareness of risk:

The sedative was exacerbated in the bubble, according to a recent paper by Andrew Haldane, director for financial stability at the Bank of England, by badly flawed risk models. "With hindsight, the stress-tests required by the authorities over the past few years were too heavily influenced by behaviour during the golden decade" of 1998-2007, he says. So many risk management models were pre-programmed to induce disaster myopia. The input into the models was based on highly unusual macroeconomic circumstances that differed materially from longer-term historical experience. Risk was thus mispriced on a dramatic scale because of model-enhanced myopia

And then there is the issue of compensation. Plender writes:

Among hedge funds, disaster myopia is more cynically entrenched by a poor alignment of interests between managers and their investors. Hedge fund fee structures rarely allow investors to claw back fees if years of profits are wiped out by a single year's giant loss. Research by Harry Kat, professor of risk management at the Cass Business School in London, confirms just what this would lead one to suspect. Many hedge fund managers take on "tail" risks in derivatives markets, which produce a positive return most of the time as compensation for a very rare negative return. In effect, the funds have been writing catastrophe insurance.Then the catastrophe happened. Arbitrage strategies that took market liquidity for granted also foundered

(In fact the situation was even more insidious: traders within financial institutions, as well as hedge funds were all incentivized to take on the aforementined tail risk. And since the trades created positive returns "most" of the time there was tremendous incentive to leverage these positions. ....And when things blew up and took down the institutions the losses were so great that the financial system was endangered and the companies were too big too fail. AIG took enormous leveraged bets on tail risks and ironically based on its high credit rating based on its "stable" core insurance business. Was able to leverage those bets with cheap credit.)

The error laden machine was alive and well in portfolio aqnagement as well

Equally unfortunate has been a botched approach to portfolio diversification. This powerful tool allows investors to achieve higher rewards for a given degree of risk, or the same reward for a lower level of risk. Yet in alternative asset categories it has failed to do that, despite the use of sophisticated mathematical modelling of correlations between asset classes. Hedge funds, private equities and commodities have underperformed in unison.

John Kay, a fellow Financial Times columnist, points out in The Long And The Short Of It , a new book on investment, that the endowments of Harvard and Yale did well in hedge funds and private equity in the 1990s. But asset classifications can change their meaning. As the sector grew, hedge funds became less a bet on an individual's skills, more a conventional run-of-the-mill fund.

At the same time, private equity firms, bloated on credit, turned into a highly borrowed play on the stock market. Returns became increasingly correlated with other investments. The endowments, along with other investors who accepted consultants' conventional wisdom on alternative assets, have suffered in consequence. Prof Kay's message is that diversification is a matter of judgment, not statistics, and that a model will tell you only what you have already told the model. It can never replace an understanding of market psychology and the factors that make for successful business.

A more fundamental point is simply that diversification cannot work well in a credit bubble because virtually all asset categories are driven up by leverage. Then when the bubble bursts, deleveraging affects asset categories indiscriminately. Equally fundamental is that fund managers tend to move in herds because that reduces the risk of their losing client mandates. Minimising business risk takes priority over the interests of beneficiaries.

(This dependence on leverage imo is fundamental to the difficulties of "alternative asset classes" during the deleveraging. Private equity, hedge funds ,real estate were not generating superior returns through manager skill (alpha) they were simply leveraging themselves to generate higher return. There was no true alpha (superior risk adjusted return)...just more return delivered with more risk. When the credit was no longer easily available and everyone had to liquidate at the same Warren Buffett says "when the tide runs out you lear who is swimming naked".)

It is hard to argue with the articles conclusions:

So despite the complexity of today's markets, the lessons in all this are oddly homespun. Mathematical models should not be relied on without a proper understanding of the economic conditions and behaviour that fed them. It is foolish to put blind faith in credit rating agencies. Do not invest in what you cannot understand. Shun arbitrage strategies that assume permanent access to liquidity. Avoid investment vehicles that inflict swingeing charges in exchange for what in most cases will amount to market performance or worse. Treat leverage with due care. Recognise that the conventional wisdom of the consulting fraternity is not conducive to contrarian behaviour, one of the keys to successful investing. Above all, beware what Charles Mackay, the 19th-century historian, called the madness of crowds.

"The Value Trap"

I mentioned in my Jan 30 post that quantittive screens to identify value stocks based on measures of book to market suffered s they identified mny financial stocks as ttractive. A recent WSJ article explores this problem s a mjor factor in the poor performance as of late of value vs growth (the chart above left shows the underperformance of large growth vs lrge value)

Even the 'Value' Investors Can't Beat This Bear
Steve Dininno
This downturn, however, has been especially cruel to "value" investors, those who search for companies they believe are priced lower than they should be.
The concept of value investing was invented around the time of that 1929-32 bear market by Columbia University professor Benjamin Graham. The current patron saint is Warren Buffett, widely considered one of the wisest men in finance.

But Mr. Buffett's investment vehicle, Berkshire Hathaway, is down 43% in the past year. Other famous value investors, such as Bill Miller of Legg Mason funds, have taken unprecedented poundings.

To be sure, there have been few safe harbors for stock-market investors of any stripe in this downturn. But value stocks have been the unsafest of all. Since the market peak in October 2007, an iShares exchange-traded fund designed to mimic value stocks in the S&P 500 is down some 56%, compared with 53% for the S&P 500 itself. The iShares ETF that mimics "growth" stocks -- those with fast earnings or price growth -- is down about 44%.

Recessions Are Tough on 'Value'
Contrary to popular belief, value strategies often do poorly during recessions, especially relative to growth strategies.
The reason is simple: When growth is scarce, as it is in a recession, then investors pay a premium for companies that manage to keep growing. One memorable exception was the recession of 2001, when investors dumped growth companies -- mostly overpriced technology stocks -- as if they were toxic.
"It's not unusual for value to suffer in a recession," says Joseph Mezrich, head of quantitative research at Nomura Securities International. "What's unusual this time is the magnitude" of the suffering. In this recession, the value-stock barrel has been spoiled mainly by a bunch of very bad apples: banks.

Value investors often hunt for companies that have a low ratio of stock price to "book value," which is roughly the value of their assets minus their liabilities. For various reasons, banks typically have very low price-to-book ratios, so they often turn up on the radar screens of value investors.
When the banks started taking heavy losses in late 2007 on mortgage bets gone bad, their share prices fell, which made their price-to-book ratios even lower, making them even more irresistible to value investors.
The trouble was the "book" part of that ratio: Trillions of dollars of the assets on bank balance sheets were tied up in mortgage debt, which was rapidly declining in value. That made book value a target that was moving fast in the wrong direction: down.
Misreading the Downturn
And that meant the stocks weren't nearly the bargains they seemed and just kept falling -- a phenomenon some analysts call a "value trap."
"A lot of people were buying these stocks all the way down," says Bill King, chief market strategist at M. Ramsey King Securities. "Their models couldn't pick up what was garbage, so they couldn't adjust quickly enough."

Numerous false springs, usually triggered by government bailouts and interventions, have lured more investors into the value trap. Financial stocks have rallied briefly several times, only to later fall to fresh new lows. And the more their stock prices fall, the easier it becomes for them to generate eye-popping rallies that may overstate their true strength.

Meaningless Bounces
For example, a 50-cent increase in Citigroup's share price in October 2007, when it was about $44, would have been a healthy but unspectacular 1% gain. A 50-cent increase in Citi's $2.50 share price -- as happened on Feb. 24 -- would be a 20% gain. That's a bull market, by some definitions, but isn't really meaningful, given the uncertainty surrounding Citi's future. (The stock closed at $1.50 Friday.)
Most value investors in the Graham/Buffett mold care little about the short term and hope to pick up bargains that will pay off in the long run.

But buying financials likely won't start to pay off until all the toxic assets are cleared off their balance sheets, they start lending again and the recession ends. If you buy financials today, you will likely have to be willing and able to wait until the end of 2009, at least, to see that happen.
Other value stocks -- including home builders and other companies tied to consumer spending -- will also likely have to wait before they start to rise again, as their survival also depends on a growing economy.

Interestingly, Two of the premier academic exponents of value investing Eugene Fama of the University of Chicago and Kenneth French of Dartmouth University retain what I view as the “value trap” view of the financial sector:

DEC 11, 2008
Q & A
Q&A: Book Value
What is the validity of book value in today's environment, especially as it applies to financial firms?
There is always an issue about how to "properly" measure value. But all the work we have done says that at least for diversified portfolios, it doesn't much matter.
Alternative price ratios, like earnings/price and cashflow/price, work about as well as book/price, in terms of identifying value stocks and growth stocks. Every ratio has its problems because whatever fundamental one puts in the numerator has its own accounting issues. As a result, there are inevitable misclassifications of stocks, but they should wash out in diversified portfolios like ours.
We don't see any special problems with the book/price ratios of financial companies. —EFF/KRF
(the chart at the right top is the etf for financial services (iyf))