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Thursday, May 28, 2009

"Wisdom" From the Morningstar Conference


Morningstar is in the midst of its annual investment conference where the best and the brightest of the mutual fund industry presents their views. I must say I am not impressed.

Take a look at the quotes below and see if they match up to the often made assertion that unlike index investing active investors will know when to get out of the market to avoid market declines and will be able to choose outperforming stocks.

Mea culpa: Fund managers pinpoint where they went wrong in the crash
‘We could have done more but we weren’t fast enough,’ one said
By Lisa Shidler
May 28, 2009
Top fund managers admitted they’ve made several mistakes in managing funds during this economic downturn.
They acknowledged missed buying opportunities and, on the other end of the spectrum, waiting too long to sell certain funds, the managers said today at Chicago-based Morningstar Inc.’s annual investment conference in that city.

The ups and downs of the market roller coaster happened so suddenly that Bruce Berkowitz, founder of Fairholme Capital Management LLC of Miami, admits much of his time was spent trying to react to the market.

“We could have done more but we weren’t fast enough,” he said.

“There was so much defense going on that it’s hard to get focused on offense at that darkest point.”

Meanwhile, Wally Weitz, president of Omaha, Neb.-based Wallace R. Weitz & Co., said he regrets not selling many stocks when his firm recognized the start of the recession more than a year and a half ago.

Meggan Walsh, Houston-based senior portfolio manager and lead portfolio manager of the Aim Diversified Dividend Fund of Houston-based Invesco Aim Management Group Inc., said she’s wondering whether her firm erred when it purchased shares of Capital One Financial Corp. of McLean, Va.

“Capital One is our problem child,” she said. “It’s too soon to tell if it’s a mistake.”

But Bill Nygren, portfolio manager of the Oakmark Fund for Chicago-based Harris Associates LP, said he’s sticking with Capital One, although he admits the regulatory environment could cause problems. He believes consumers want these types of companies to exist and that ultimately Capital One has potential for great value
.

capital one chart is at top

Friday, May 22, 2009

It Helps to Know What You Own Before You Change Your Asset Allocation





The WSJ yesterday presented the personal story of a wsj writer who has altered his investment portfolio in his 401k in light of recent market losses. Parts of it are fairly logical. His portfolio dropped 35% from the fall of 2007 to march 2009 and he reassessed his risk tolerance.

His reaction:

Some couldn't take the brutal drop and sold off all their stocks. Others have shrugged off their losses and are hanging on. Toughing it out could turn out to be very smart if markets continue recovering, as they've done in the past couple of months. But I suspect many will end up like me, pursuing a middle route. I want the higher returns of stocks and the protection they should give my portfolio from inflation, over time. But I don't ever again want to feel as I did on March 9.
Now that makes sense, if one realizes that his risk tolerance is not as high as it seemed. It makes sense to dial down the risk. But here is what I find puzzling. He writes that his portfolio 50% stocks and 50% bonds yet his portfolio declined in value 35% during a period when the s+p 500 fell around 50% (you can even use the global equity number of -60%) which he uses. In any case it is clear that he lost money on the bond portion of his portfolio as well and curiously he writes.
My company retirement accounts, despite what I thought was a relatively conservative mix, were down close to 35% in early March from the fall of 2007....

It didn't play out that way this past time. The drop was quicker, steeper and much more widespread. I had a quarter of my money in foreign stocks, which, because of the falling dollar, were crunched worse than domestic stocks. I had another quarter of my money in inflation-protected Treasurys, which also got hammered.




Something seems quite amiss in this reporter's understanding of his own portfolio.

Inflation protected bonds at least in the instruments I use for my clients etfs or the Vanguard Inflation Protected Securiityes Fund (VIPSX) did nothing close to "getting hammered" over the period mentioned vanguard fund measured fell around 4%, the etf (without counting dividends) fell 7%. And as you can see from the lower of the two graphs at the top of this post comparing the vanguard inflation protected securities fund (vipsx) vs. the s+p 500 (spy) and developed international stocks (efa) the tips did exactly what they were meant to do in lowering the risk of a portfolio otherwise invested in US stocks. Which leads one to believe that either 1. there was some error in reporting of the portfolio’s performance or 2. the fund in the firms 401k that was supposed to be investing in tips was not really doing so.


The chart at top is the vanguard inflation protected fund vs. sp 500 and developed intlernational etf (efa) As they say a picture is worth a thousand words and to argue the the tips "got hammered" just like the stocks is simply wrong

Furthermore it is unclear what the author did with the rest of his bond investments, but clearly he had losses. It seems quite likely he made the mistake many investors make especially in their 401ks. Simply choosing a bond fund (or even a bond etf) does not at all guarantee that it will serve as a stable anchor during a period of extreme market instability. As noted in a previous post actively managed bond funds have a whole set of problems related to the managers own strategy. But even among index instruments there is only one category that is sure to provide a safe haven for the investment portfolio: short term government bonds and specifically treasury bills anything of longer maturity or lower credit quality injects risk (credit risk and interest rate risk) into the portfolio. Many investors seem to miss this point and think all combinations of 60% stocks/40% bonds are equal in terms of risk and return. This can be illustrated by the top chart at the top of this post which compares the s+p 500, the investment grade corporate bond etf (lqd) and the short term treasury etf (shy). Even more unfortunate is the many 401k administrators do not understand this point and don’t offer within the investment choices for the plan a simple low risk bond investment vehicle.




It is unfortunate that the WSJ reporter either didn’t understand his 401k allocation or didn’t present it clearly. But it is more important that his way of looking at his bond allocation while incorrect, is not at all unique

Wednesday, May 20, 2009

Good Advice: Keep Emotions Out of Investing



James B Stewart of the WSJ offers real world observations on the tendency of investors to let their emotions dictate their actions and as a consequence often chase the market in reaction to short term moves.


Fear and Greed: 2 Things You Shouldn't Invest In
By JAMES B. STEWART

.... From their lows on March 9, stocks have registered some of their steepest gains since the 1930s, which takes us back to the Depression for comparisons.

So why aren't more investors celebrating?

True, stocks are still down 40% from their highs of 2007, so most people don't feel nearly as wealthy as they did back then, even after the historic rally. But I sense that isn't the reason that so many investors are feeling so cranky. It's because they missed it.

If fear and greed are the defining emotions of investing, then there's nothing like a missed opportunity to bring out the greed. Many usually sober people bought into the doomsday scenarios so prevalent in January and February. They weren't just unwilling to bet on stocks recovering any time soon; they actually bet against the market -- piling into safe-haven U.S. Treasurys, moving heavily into cash, and even, in extreme cases, shorting the market. And then they sat back to wait for their actions to be vindicated.

So far, they have waited in vain. As stocks have soared, those super-safe Treasurys have slumped, dropping in value about 20% since the first of the year as interest rates have risen. No wonder these people are feeling testy.

You rarely hear these people bemoaning their fate. That's why I was impressed by a Wall Street Journal article this week in which several investors candidly acknowledged that they couldn't take the pain of a plunging stock market and had bailed out, in some cases at or near the market bottom in March. I appreciate their honesty, and I'm sure their sentiments were shared by many others less forthcoming.

There is no reason to be ashamed of a decision simply because the market moves against you. No one is right all the time, and there's no way to predict where markets are headed, which is why I resolutely avoid such forecasts. But these are important learning experiences that should help people untangle their emotions from rational investing.

In my experience, investment decisions based on emotion, however satisfying in the moment, almost always turn out to be mistakes. As stock markets continue to rally, greed is emerging as the dominant emotion, and it's just as pernicious as fear. I hear it from the many people who have been asking me if it is too late to buy stocks now, who clearly want to hear that it isn't. At least they're asking, which suggests some degree of caution and willingness to think through the decision. Others are buying now, thinking about it later.

This is why I believe disciplined systems can be so helpful at separating emotion from reason. Asset-allocation models serve this function, in addition to providing welcome diversity. If you follow an asset-allocation plan, the recent stock market rally has driven up the value of your equity portion, and the slump in Treasurys has dragged that portion down. All else being equal, if you were at your equity allocation in March, you are now over it. To bring it into balance, you would have to sell -- not buy -- stocks now
.


I think the above statement about discipline and asset allocation is crucially important. At times I think the greates value of having someone with a personal relationship manage your investments with low cost index instruments instead of spending investment fees on an active manager of funds with no relationship with an individual comes with the discipline it provides.If course I am totally biased since that is what I do. Although ultimately of course it is the clients money the advisor can work very hard to limit the emotions involved in investing and making rash changes in reaction to market movements. Oftentimes I tell clients they are paying me not to let them make radical changes in their investments in reaction to short term movements. But generally after the third discussion I reluctantly make the change they want, as I noted ultimately it is their money.

Tuesday, May 19, 2009

The Risks in Actively Managed Funds, Bond Edition


I have also noted that when picking an actively managed fund one is actually increasing risks relative to the index fund. With the actively managed fund the investor doesn't really know what he is buying, the holdings can differ significantly from the "style category" and description of the fund. A large value fund could own mostly growth stocks, a domestic stock fund could own a significant % of non US stocks etc.

For the above reason one runs the risk that the funds returns will differ significantly from the asset category. And a portfolio that may seem diversified not be, and one might "miss" capturing the returns of the asset category even though one thought it had exposute to that asset class.

Finally one has what I call "manager risk". In an index based portfolio one only has the exposure to the asset class and will capture its risk and return (beta for those so inclined). By using an active manager one is adding "alpha risk" a fancy way of saying the investor has taken a leap of faith that the manager will deliver better than market returns.

Much of this is often seen as relevant only to the quity portion of the portfolio. It is implicitly assumed that bonds are a sleepy part of active management and that active managers might add a bit to returns and if they don't the negative outcome will be minimal.

Nothing could be farther from the truth. Just as in the case of stocks a bond fund may hold types of bonds that would not be expected from the funds title. And actively managed total bond market funds can take very big bets in terms of maturities and types of securities.

Investors in Oppenheimer bond funds have certainly learned these lessons the hard way as reported in the trade publication Investment News my bolds

With the battered performance of its bond funds creating a financial nightmare for investors, OppenheimerFunds Inc. is fighting to rebuild its image...
The company's bond funds lost an average of 29% last year, compared with a 7.9% average decline for all bond mutual funds, according to Morningstar.

The firm is working diligently to "rebuild the trust advisers had in us for a number of years." The $1.11 billion Oppenheimer Core Bond Fund (OPIGX) was hit particularly hard, losing 37.6% last year. The benchmark index for the fund, the Lehman Brothers (now Barclay's Capital) Aggregate Bond Index, rose 5%.

A big reason for the poor performance was the bets that OppenheimerFunds managers made on commercial-mortgage-backed bonds — bets that were amplified because of the use of derivatives to attain leverage.


And apparently even an "expert" in choosing mutual funds missed the boat and didnt avoid Oppenheimer bond funds.

Despite assurances that OppenheimerFunds had addressed the issues that led its bond funds to implode, Adam Bold, chief executive of The Mutual Fund Store, said that it may still pull clients out of two recommended OppenheimerFunds bond funds.

“It's not just the performance problems,” he said. “My concerns are on the risk-management and corporate-governance side.”



The problems reach into 529 plans as well

In addition, Oregon Attorney General John Kroger filed a lawsuit against the company last month, seeking to recover $36.2 million that the state claims that investors in a Section 529 college savings plan lost because OppenheimerFunds' Core Bond Fund took “extreme risks in a search for speculative large returns” (InvestmentNews, May 4).

At least four other states — Illinois, Maine, New Mexico and Texas — are also looking into possible legal action.


The problems don't end there either:

Oppenheimer Funds also faces a spate of class actions related to various bond funds.

Actions have been filed related to losses incurred in the Oppenheimer California Municipal Fund (OPCAX)(-28.49 1 yr through apr 30) and the Oppenheimer Champion Income Fund (OPCHX)(-79.28 i yr throught apr 30). The lawsuits claim that the risks associated with investments in the funds weren't disclosed to investors.

It Seems All Those Stock Analysts Do Is Tell You What You Already Know



From tStudy finds analyst tips don’t move pricesBy Francesco Guerrera and Anuj Gangahar in New York

Published: May 17 2009 23:33 |

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Analysts’ “buy” and “sell” tips have almost no effect on share prices, according to research that confounds long-held beliefs over the influence of stock-pickers and calls into question investors’ and banks’ need to pay for their service

The study will fuel the debate over the role of research at a time when the the crisis has forced cash-strapped financial groups to slash budgets and lay off thousands of analysts.

academic studies found that when an analyst changes views on a company, its shares move by up to 4 per cent in the direction of the new recommendation.

But after looking at more than 44,000 changes in recommendations between 1997 and 2003, the authors of the study – Oya AltinkiliƧ of the University of Pittsburgh and Robert Hansen of Tulane University – concluded the effect was minimal, about 0.03 per cent either way.

Unlike other studies, which looked at longer timeframes, the two academics focused on share prices 20 minutes before and after the issuance of a recommendation to filter out the effects of events such as company news and market movements.

“Our results suggest that analysts aren’t the market movers and shakers the world has come to think of them as being – not by a long shot,” said Prof Hansen. “Analysts’ recommendations don’t add much value and investors know it.”

The two academics said the large movements in share prices detected by previous studies resulted from the fact that recommendations were “piggy-backing” on other news.

Almost 80 per cent of analysts’ changes in recommendations, for example, came AFTER corporate events, such as the release of earnings, which led investors to buy or sell shares of their own accord.
“Analysts’ revisions are typically information-free,” the study concluded. Some research professionals defended analysts’ role, saying they were not just stock-pickers and helped their employers’ bottom line by encouraging investors to trade with their banks.

But hope springs eternal (or the editors of the FT don't read their own articles) The following article is linked to the article above.

“EDITOR’S CHOICE
Award-winning analysts prove their worth - May-14Award for excellence – Judy Hong of Goldman Sachs - May-

Saturday, May 16, 2009

I Couldn't Make This Up


From th NYT interview with Nobel Prize winner Myron Scholes (My bolds)


Q After leaving academia, you helped found Long-Term Capital Management, a hedge fund that lost $4 billion in four months and became a symbol of ’90s-style financial failure.
A.Obviously, you prefer not to have lost money for investors.

A. What are you doing these days?
I split my time between giving talks around the world and running a hedge fund, Platinum Grove Asset Management


Deborah Solomon the interviewr understates the import of LTCM's collapse. It was deemed of such potentially disastrous consequences to the world financial system, that the Federal Reserve engineered a plan to prevent a collapse of the markets.

Suffice it to say I am with Nassem Taleeb (author of Fooled By Randomness and The Black Swan) on all his critiques of Scholes Those more academically inclined might be interested in the following:

Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula (fifth version)
Espen Gaarder Haug

Nassim Nicholas Taleb
NYU-Poly Institute

Behavioral Finance in action



In an appropriately titled blog entry(see below) the WSJ's market beat blog notes investors (surprise) chasing an asset class that has already had a big run up and (surprise again) a new even more risky etf to chase that asset class. A broad emerging market not enough bank for you ? a single country broad market index not good enough for ? someone is happy to offer risk on steroids in this case small cap Brazilian stocks etf. We'll pass on this one. In fact we would be more inclined to rebalance our emerging markets holding by selling off a bit of our holdings.

I'm surprised the 2x emerging market etf hasn't come to market yet but I am sure it is in the works.

Brazil and overall emerging etf charts are at the top of the page. From the WSJ

Watch for Falling BRICs.Emerging-market stocks have returned to life — but how long can it last?

MSCI’s emerging-market index is up about 23% this year, down from year-to-date gains of about 28% last Friday. Investors have poured into emerging-market stocks and currencies as they redevelop a taste for risk. Brazil is one case in point — lately, run-ups there have been so sharp that central banker Henrique Meirelles said recently that an excess of optimism could be dangerous, and lead to disappointment at the first negative number.

Brazil’s Bovespa stock index is up about 32% so far this year. Yesterday, Van Eck Global launched an exchange-traded fund of Brazilian small-cap stocks, an investment play on Brazil’s growing consumer class. The ETF includes shares of domestically focused companies — a rental car company, retailers, builders — rather than commodities and materials bets, which hinge on exports.

The ETF was up about 1% in trading on Friday, at around $24.70. Thursday was its first day of trade.

An assumption of higher long-term domestic growth has driven much of the recent ride in emerging markets. For gains to continue over the longer haul, company earnings will have to rebound, says David Semple, director, international equity, at Van Eck. Most emerging markets now appear “fully valued” on a forward basis, but earnings should also be troughing, he says. Rising earnings and estimates would presumably keep valuations attractive going forward, helping the rally continue.

Some investors “have been caught napping” by the recent bounce, Semple adds. Many “were defensive going into this, but I suspect people are scrambling to buy on dips.”

Over the longer term, gains could wither, he adds, if some exogenous risks occur — lower long-term growth in developed markets could hurt emerging markets, as could falling U.S. and European demand


Brazil etf chart is at the top of the page, emerging markets underneath both ytd

Friday, May 15, 2009

Always Late to the Party


The NYT writes about how investors that fled stocks at the end of the year are now, after the s+p 500 has risen about 32% since early March getting back into stocks (see the s+p ytd above). Human nature never changes and people often perceive risk incorrectly seeing stocks as less risky after a big move up and more risky after a big move down. In fact the reverse is the case and those like us that never fully liquidated our stocks were in for the quick rally.

The crowd will probably give the market some more upward momentum which we are happy to ride. But fairly soon we will sell off some of our gains to kept our asset allocation in line and buy more if there is a significant market drop to keep at our asset allocation. Of course if experience is any indicator many individual investors will be buying more on the further rally and selling at the selloff.

And note how the individual investors mentioned ignore some basic rules to avoid: over concentration in a single industry, avoiding lottery ticket small cap growth stocks which have a good story but dont necessarily make good stocks. Unlike Peter Lynch's advice years ago to buy stocks based on your experience with the product evidence shows it is ofen not the case (sirius and xm, boston chicken etc)

From the NYT(my bolds)

May 16, 2009
Testing Wall St.’s Waters, but Not Getting in Too Deep
By JACK HEALY

A woman on Long Island opened an Ameritrade account and started buying stock in mining companies. In Chicago, a developer in advertising is betting heavily on oil. And outside Seattle, a Microsoft employee is snapping up shares of technology firms and retailers.

After being pummeled in Wall Street’s plunge last year, many small investors pulled out of stocks. But the stock market’s recent rally — one of the sharpest since World War II — is starting to beckon some of them back.

So step by nervous step, some smaller investors are beginning to tiptoe back in. They are pulling money out of their savings accounts and money market funds and buying stocks and bonds, fingers crossed....


Still, some investors smell profits in the wind, and are ready to come out of hiding and try to make money again. In Wall Street’s endless battle between fear and greed, they are starting to feel the tug of greed.

Investments in safe but low-yielding money market mutual funds have fallen by $117 billion from their record highs in mid-January through this week, according to iMoneyNet. As people began to look for higher returns on their money, some $47 billion surged into mutual funds tied to stocks and bonds in April, according to the Investment Company Institute. It was the largest influx of money since 2007.


“We’ve been a lot more active in the last six weeks than we were in the last six months,” said Mitchell Slater, a financial adviser at Smith Barney in Florham Park, N.J. “It’s not everybody on the boat, but we’re definitely seeing some of our clients realize, at least in their minds, there’s opportunity now.”

.”

But others returning to the financial casino have not done as well.

....And other investors said in interviews that they had made familiar mistakes: waiting too long to buy, getting in at the top of a small peak, bailing out just before a falling stock turned around.





The WSJ had a similar article today headlined

Many Bought Shares High, Sold Low

I think know what the rest of the article is like

Sunday, May 10, 2009

Want Your Portfolio Managed Well Give It to A Woman...





...or someone that thinks like one with regards to investing

Jason Zweig in the WSJ

It is worth pointing out, this Mother's Day weekend, how different things might be if the financial world were female.

Finance professors Brad Barber and Terrance Odean have found that women's risk-adjusted returns beat those of men by an average of about one percentage point annually. In short, women trade less frequently, hold less volatile portfolios and expect lower returns than men do.

On the other hand, in the testosterone-poisoned sandbox of the male investor, the most important thing is beating the other guy; the second most important: bragging about it. The long term is somebody else's problem, and asking for advice is an admission of inferiority. Worrying about risk is for sissies. Leverage is good, since it raises returns -- while the market goes up. Is it any wonder the male-dominated world of Wall Street has boomed and busted every few years for more than two centuries?
....

The results of a nationwide survey of hundreds of investors conducted in March, just days after the Dow bottomed at 6547, show how anger and fear in the minds of men and women can affect their financial decisions. Men were far more likely than women to say they were "more angry than fearful" about the financial crisis. And one in eight men, but only one in every 40 women, had "made riskier investments looking for long-term growth" in the previous week. Female investors were twice as likely to expect the return on stocks over the coming year to be zero or negative and to think stocks will return 5% or less per year over the next 10 years.

"The women were more concerned but took fewer actions," said psychologist Ellen Peters of the University of Oregon, who co-directed the survey. "They were also more pessimistic -- or realistic? -- about what to expect from the market."

Stocks are up 35% since March, so the women's fears haven't yet come to pass. But their inaction already looks wise. And their realism can't hurt, either. "The essential traits and qualities of the male," H.L. Mencken once wrote, "are at the same time the hall-marks of the numskull. ... Women, in fact, are the supreme realists of the race."

Friday, May 8, 2009

Sorry If I'm Not Impressed

NYT Deal Book
May 7, 2009, 5:24 pm
H

Hedge Funds Rise 3.8 Percent in April

Hedge funds posted gains of 3.8 percent in April as the stock market continued its rally and commodities began rising, according to a preliminary report from Hedge Fund Research.

Year-to-date, hedge funds have gained 4.2%, with the best performance coming from firms that specialize in energy and basic materials. Funds that were short the market were hammered in April, falling 7.5 percent on average.

The hedge fund industry faced its worst year on record in 2008, although the average fund still outperformed the overall stock market. Over 1,000 funds were forced to liquidate and halt withdrawals last year.

Firms have also suffered a barrage of criticism from politicians and the public recently, leading many firms to brace for increased regulation
.

Year-to-date, fixed-income/convertible arbitrage funds remained the year’s best performers, returning 5.7 percent last month to put 2009’s advance at around 18 percent. The gains, which were fueled by a general rally in the market, come after the sector was the worst performer last year, falling 35 percent.

Just for Comparison

April Returns for some major indices:

S & P 500 +9.4%
Wilshire 5000 total US market +10.5%
Nasdaq +12.3%
MSCI Emerging Markets +15.6%
EAFE (Developed Foreign) 11.5%

Thursday, May 7, 2009

Here's Some Useless Information

From the WSJ article listing the "top analysts of 2008"

MAY 7, 2009, ET.Best on the Street

In a Difficult Year, Success Is Knowing When to Say Sell

By ANNELENA LOBB
This year's Best on the Street analysts knew when to scream "sell."

Stocks took an epic tumble in 2008, the year covered in the Wall Street Journal's 17th annual analysts survey, as a cascade of bank failures, bailouts and acquisitions rocked the financial system. The Dow Jones Industrial Average lost 33.8% and the S&P 500-stock index fell 38.5%, with most of the turbulence toward the end of the year.

Best on the StreetFor more details and stories about the winning analysts, see The Journal Report coming May 26.
.
Analysts who based their predictions on a gloomy outlook for the banking system and the global economy often turned out to be right. Consumer spending fell sharply. Problems with the housing market rippled through other parts of the economy, and oil prices peaked and sank. The stock pickers who could forecast the storm were the strongest performers.


An amazing surprise: the people chosen in May 2009 as the best analysts of 2008 were those who "knew when to say sell.". Talk about in sample data ! Would one have expected that the people chosen as the top analysts of 2008 have recommended buying stocks throughout last year. Of course the really interesting question would have been: How did the top analysts of 2007 (chosen in may of 2008) do in their forecasts for 2008 ?

Or how about checking on the recent record of this analyst cited in the article:

Across industries, many of the most prescient calls were early sell recommendations. The top computer-and-office equipment analyst, Mark Moskowitz of J.P. Morgan Chase & Co., put a sell on Sun Microsystems in March 2008, anticipating that companies would delay purchases of costly equipment. The shares lost three-quarters of their value though year end.


Sun Microsystems stock has doubled since the beginning of March (see the chart). Did Mr. Moskowitz make a "prescient call" on when to get back into Sun stock ?

Sunday, May 3, 2009

No Surprise Here

The WSJ writes on the adequacy of "monte carlo analysis" routinely used by financial advisors and individuals to "calculate" the probability of the investment accounts successfully finding their retireement needs. The analysis has proven woefully inadequate in achieving its objective since it underestimates the possibility of large declines in investment value. The problem: the assumption of a "bell curve" normal distribution of investment returns which underestimate3s that investment distributions have "fat tails" and "black swan " events occur more frequently in reality than anticipated by the models.

Inadequacy of "bell cuve shaped "probability distributions in financial modelling...sound familiar ?

Saturday, May 2, 2009

This is Scary

The WSJ personal finance blog: The Wallet elaborates on an article in the newspaper (more on the scary advice in that article in another post i will be writing)about financial advisors changing the investing approach in light of the events of last year. I am not averse taking into account recent events. Certainly strategies should take more cognizance of the need for allocations to reliable safe havens for investors, 2 that I use more of than in the past are TIPS and a true hedged fund the Gateway fund (GATEX) which I have written about in the past. But the role of the advisor is to present reasoned changes in strategies. The advice mentioned here seems little more than irrational reaction to recent events. With surverys showing over 80% of investors "unhappy" with their advisors excuse me if I think that many of these strategies are more a short term business strategy for their practice than a long term investment strategy for their clients

Here's one "strategy"

In January, Jerry Verseput, a financial adviser in Sacramento, Cailf., moved from a conventional model using mutual funds to a sector-based approach using ETFs after his portfolios fell significantly in 2008. He decided to make the switch after running an analysis that showed that correlation among the standard asset classes was over 80% over three, five and 10 years—in other words, they weren’t providing adequate diversification.

Now he’s diversifying across nine equity sectors, such as financials, energy and basic materials, technology, and real estate, where the correlation is only about 20%. He’s also using no-load mutual funds to get fixed-income exposure, since bonds throw off regular dividends. Most of his portfolios are up 2% to 2.5% for the year, he says.


I'm not sure what he is referring to, but I did run an 8 year cross correlation of the equity sectors he mentioned. None had a cross correlation of .20 two had correlations of in the 30s .34 for (energy/financials) and .38 for (real estate/energy). I doubt many would expect these low correlations to be the basis of a long term strategy. The other cross correlations ranged from .60 to .79. And it was hardly surprising that it was financials/real estate that had the highest correlation.

Of course if one held all of these sectors anyone knowing anything about equities would know that one simply owned the market. It would also reason that each of these sectors would have high correlations to the overall market, since the most important determinant of a sector's price is the overally market. Thus the correlations of each asset class to the S+P 500 only one was below 70 (69 for energy) one at 79 (reits which are not equities) and the rest in the high 80s.

So to be perfectly forthright, I have no idea what this advisor is talking about except for the short term bond holdings which are in fact an asset class with a low correlation to equities.

The article goes on to describe 2 other strategies with ascending levels of scariness

Mr. Verseput, for example, uses trailing stop-limit orders. If a particular sector drops by a given percentage, then a sell order is automatically generated and the proceeds are moved to cash. “I don’t have to follow the market every single moment, since these [orders] will automatically lock in gains or will allow me to jump into these rallies much earlier,” he says. Another benefit: “It’s a completely unemotional rule. There’s no guesswork involved
.”

This simply a trading strategy and in fact there is quite a bit of guesswork. I also have no idea when he would reverse his sales and get back into the sector. After falling massively the financial sector rallied almost 26% since the end of March and was the best performing sector last month. If Mr Versput sold financials with a stop loss sale several months ago, what is he doing now ?

Also I am not at all sure what he is referring to when he claims his strategy of stop - limit orders both allows him to "lock in gains and jump into rallies earlier". A stop loss limit order is an order to sell when the marke falls to a designated price (to limit losses). If the market drops to the limit level and then reverses course and begins an upward trend, I have no idea how this strategy would allow him to "get into these rallies much earlier." Sorry, it's totally illogical. And of course it's called a stop loss for a reason: since it is below the current market it often locks in a loss rather than locking in a gain. The strategy may impose some discipline (and expose one to whipsaws) it hardly guarantees profits.


The next one is really scary, it reflects basic lack of knowledge of the instrument he plans to use.

Theodore Feight, a financial adviser in Lansing, Mich., has also used stop-loss orders to get clients out of the market for most of 2008 and 2009, and is now talking to clients about using leveraged ETFs to get back in. “The problem we’ve got with the current asset allocation is that it hasn’t evolved,” he says. “The stops allow you to have some protection


Many individual investors have been burned using the leveraged etfs because they don't understand them. But one would expect an advisor to know better.They reflect a multiple of the daily movement in the index not the longer term return one would get in an index fund or etf. Thus the pro shares ultra etf which returns 2x the daily movement is down -8.8% ytd while the S&P 500 is -2.6%. And to make things more aggravating to the investor that doesn't understand the instrument, those who thought using the ultra (2x) etf designed to produce the inverse of the S&P 500 certainly did not give a hedge of the longer term return of the S&P 500. It is -11% ytd, in other words it moved in the same directon of the S&P and produced a return 5x less. Anyone understanding this instrument would conclude it is really only useful for day traders. The idea of an advisor using this as a way to get back into the market (for more than one day) is, to say the least, extremely surprising.

At least saner voices are being voiced by more mainstream observers (except for those hedge funds which are not a reliable "hedge" of anything):

Investors who are unhappy with their financial pro should have “a really intense conversation with their adviser and make sure their adviser understands what they’re looking for and to make sure they’re not missing something their adviser is doing,” says Diahann Lassus, chair of the National Association of Personal Financial Advisors. She says the chief question investors should be asking is: “What are you doing differently to help manage risk?”

“Many advisers are doing things differently,” she says. “We’re building more cash for safety. We’re adding more to short-term bond funds and
hedge-strategy funds.”


Fortunately there are many advisors advocating rational, low cost, long term strategies. While I would allocate client assets somewhat differently, the allocation presented today in WSJ's monthly investing supplement is far from "scary" and is in fact probably the most reasonable of any of the advisor profiles they have presented in this montly supplement.

Sometimes I'm Correct (Although Maybe A Little Early)






I wrote on December 8 that I thought the yield differential between treasuries and highly rated corporated bonds was unsustainable. Using the relevant etfs for corporate bonds (LQD) and the treasuies the yield differential had widened to 3.99% reflecting a flight to quality that pushed the yield to 3.27.

Currently the yield differential is 2.22%, the investor in the LQD would have gained 2.8% the investor in IEF -2.24% (neither number includes the interest earned).

Worth a look at this point might be HYG the high yield etf with a yield of 11.56% (8.29) over treasuties. It has already gained 9.2% since April 8

charts are above.