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Monday, June 29, 2009

A Strange One From Jason Zweig

Jason Zweig, now of the WSJ, is definitely one of the "good guys" among journalists writing about personal finance having. He crossed over from the dark side(as writer for Money Magazine) of what the folks at Dimenesional Fund Advisors call "financial pornography". His most recent article had some interesting information on protecting a portfolio from inflation but he also adds a strange twist.

JUNE 30, 2009
The Time to Tame Inflation Is Well Before It Strikes

Insurance is often most worth having when it seems least necessary.
Right now, you might feel you don't need any insurance against a rise in the cost of living. Inflation, as measured by the Consumer Price Index, is running at negative-1.3% over the past 12 months; with oil and real estate down drastically, there are few signs of rising prices in daily life.
But the cost of living mightn't fall for much longer. So it is a good time to look at inflation insurance, in the form of U.S. Treasury Inflation-Protected Securities, or TIPS. The principal value of TIPS increases or decreases with the cost of living. Unlike normal bonds, TIPS don't get hammered when inflation rises.....
There is a historic tug of war under way between inflation and deflation, with the federal government borrowing $1.9 trillion in the past 12 months even as prices of many goods and services continue to fall.
"Inflation uncertainty is probably wider today than at any time before the financial crisis," says John Hollyer, co-manager of the $22 billion Vanguard Inflation-Protected Securities fund. "So having that protection in your portfolio is still valuable."
Even when prices are going up, many people fall prey to what is called "money illusion" -- the tendency to overlook the corrosive effects of a rising cost of living. You would probably rather have a 2% raise in a time of 4% inflation than a 2% pay cut in a time of zero inflation. The pay raise feels more positive and will make you happier than the pay cut -- even though both alternatives are economically identical, leaving you 2% poorer after inflation.
So if people are prone to this fallacy, why are TIPS funds hot? Through May, inflation-protected bond funds accounted for $10.4 billion, or 11%, of all the new money that flowed into stock and bond funds this year.
I worry that at least some buyers of these funds may be doing the right thing for the wrong reason. It seems implausible that, at the very moment when inflation seems to be least threatening, investors would get a sudden collective urge to protect against it. Instead of trying to protect against future inflation, many of these new investors may be chasing past performance. TIPS have gained 5.3% in 2009, versus a 4.4% loss on Treasurys overall, according to Vanguard. But, says Gang Hu, co-manager of Pimco Real Return fund, "a TIPS fund should be something you invest in for insurance, not for income."

My comments:

I'm not sure Zweig is right about the returns chasing in the purchase of TIPs funds. There is definitely more concern about inflation among investors and more investors are learning about and thus using TIPs. And at least based on my experience there is relatively little knowledge among individual investors (and sad to say investment "professionals) of TIPs and their importance as a core portfolio holding. In many ways TIPs are the "perfect" fixed income investment as they eliminate the worst risk to a fixed income portfolio: locking into a fixed stream of interest income that doesn't keep up with inflation (negative real (after inflation) returns. Because of that imo they should be a permanent part of one's fixed income holdings.

Zweig continues:

.... the cost of living might rise faster than you expect; TIPS are priced as if inflation will run at an average rate over the next five years of no higher than 1%, and then will rise to 2.5% annually over the following five years. If those expectations are too low, TIPS will protect you.
TIPS offer baseline insurance against a rise in all the costs of living. However, TIPS aren't customizable. The official inflation basket consists of housing costs (43%), food (16%), transportation (15%), health care and recreation (6% each), apparel (4%) and education, communication and "other" (3% apiece). If the basket of goods and services that you pay for is significantly different from the CPI, then TIPS won't fully insure you.

So think about what makes up your personal inflation mix. If you are unlikely to qualify for financial aid, then the costs of educating your children could wildly exceed 3% of your expenses. So you might consider a prepaid college tuition program like the Independent "529 plan," assuming you are confident your child will be able to get into one of the participating schools.

my view

The point about tutition is totally logical and what is called a "pure hedge"= worried about rising tuition costs lock in the cost of tuition.

But Zweig enters into specious reasoning with his proposed "hedge for future nursing home costs:

If you have aging parents, an assisted-living facility already costs an average of $3,000 a month; a semiprivate room in a nursing home runs more than $5,600 monthly. You can partially hedge against those rising costs with a stake in an exchange-traded fund like Vanguard Health Care or iShares Dow Jones U.S. Healthcare Providers Index.

The logic here totally escapes me

Why would shares of healthcare companies be a hedge against healthcare costs ? Listed below are the top ten holdings of the healthcare exchange traded fund (IYH)Healthcare costs rise largely because the costs of the inputs rise not because the healthcare companies are increasing their profit margins. Costs go up revenues of healthcare costs go up and profit margins remain unchanged. The growth in revenues on the top line of the healthcare companies doesn't mean increased profitiability therefore the healthcare stocks should go up no more than the general stock market. Their revenues may be (somewhat correlated) to inflation in healthcare costs but their profitability and future stock prices aren't. In fact Zweig is engaging in a bit of "money illusion" higher revenues mean nothing for a company if costs are going up as well.

More importantly, the major cost inputs for a nursing home are food, labor, real estate utilities and building maintenance. Listed below are the top ten holdings in the ishares healthcare etf. Ask any nursing home operator about the impact of price changes on these products is on the cost of a month in a nursing home. I suspect the answer will be zero, Virtually all of the costs of the products from these companies are covered by medicare or the patient individually, they are not included in that monthly nursing home bill

4.78% WYETH
4.54% MERCK&CO. INC.
*Holdings are subject to change.
Top Sectors as of 6/26/2009
65.44% Pharmaceuticals & Biotechnology
34.40% Health Care Equipment & Services

Thursday, June 25, 2009

The Economist Magazine on Fund Management

my bolds full article here

...The general rule of fund-management consolidations is that they may be a good deal for the companies, but they rarely bring much benefit to investors, for two reasons. First, retail fund managers compete on past performance rather than price. Alas, a good performance one year tends not to be repeated the next; but the fees carry on. Second, because of their inertia, retail investors tend not to buy funds; funds are sold to them. Fund managers must pay banks and brokers to distribute their products, and they claim back that money from investors. As a result the bestselling funds often have the highest charges; other things being equal, they represent the worst deal for investors.
The price is wrong

That second factor helps explain why there is a stark difference between America and Europe. In America, where retail investors are more willing to buy funds directly, the expense ratios of mutual funds have declined for four successive years, according to Lipper, a provider of financial information. But in Europe, where funds are largely sold through banks, annual management fees have steadily risen, from 1.3% in 1994 to 1.6% last year. Retail fund-managers have fed themselves well, but their investors have been left with the scraps.

Even institutional investors such as pension funds and insurance companies, which ought to have the clout to force down fees, are paying more. A survey by Watson Wyatt, a consulting firm, found that the cost of running a pension scheme increased by around half between 2003 and 2008. That was because schemes allocated more of their portfolios to hedge funds and private-equity managers, which charge much higher fees. Chasing performance by paying higher fees might work for individual investors, but in aggregate it is doomed to fail. The return to the average investor is the market return minus costs; if costs rise, returns must fall.

Retail investors, in particular, would do well to learn that lesson, and take responsibility for their own finances. Just as they shop around to find the best estate agent, they can seek out low-charging vehicles such as exchange-traded funds. If enough investors focus on cost, not performance, the fund-management industry will have to give them a better deal.

Interesting Graph

From the folks at the journal of indexing

Tuesday, June 23, 2009

Leveraged ETFs... You Know They Are a Bad Idea When......

.... the regulatory agency responsible for the investment industry issues a strong warning about their use. I have pointed out on May 2 and again on May 31 the dangers of these products before and I can't recall FINRA ever issuing a similar warning with regard to such a widely used products. And the fact that the warning is issued to brokers and registered investment advisors (the supposedly knowledgeable operators in the financial markets) and not just to individual investors imo says volumes about the level of knowledge and fiduciary standards of many in the financial services industry. My May 2 entry noted that advisors are apparently using these instruments as part of their "investment strategies".

From the wsj (my bolds)

Finra Urges Caution on Leveraged Funds
The Perils of Holding for More Than a Day


Regulators appear to be turning a critical eye to sales of leveraged and inverse exchange-traded funds, complex instruments that can magnify not only investors' returns but their risks as well.

The Financial Industry Regulatory Authority has reminded brokers and registered investment advisers about their fiduciary duties when selling ETFs that offer leverage, are designed to perform inversely to the index or benchmark they track, or both. In a notice posted to its Web site earlier this month, Finra reminded the brokers and advisers that these instruments are complex and typically unsuitable for retail investors who plan to hold them longer than one trading session.

"While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis," the notice said. "Due to effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective."

In my May 2 post I noted that some registered investment advisors are making use of these instruments with the objective of augmenting returns for holding periods longer than a single day. As I pointed out then and as the last paragraph above notes, these instruments are not appropriate for such a strategy. That FINRA effectively had to issue a bulletin to brokers and investment advisors explaining obvious points about how leveraged etfs work imo doesnt reflect well on many in those professions.

Monday, June 22, 2009

Are Some People STILL Debating This ?

From the WSJ more folk seem to have left the ranks of those with the "hope that springs eternal" that they can find an active manager that consistently beats the market, (my bolds) (my comments in bold italics)

Active Managers Get the Cold Shoulder


A growing number of big investors are concluding that stock and bond pickers failed to add any value during the market turmoil and are shifting to index funds, a move that threatens to cut profits for asset managers.

"Active managers have not given us the added performance in a down market that we hoped for," says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment. Disappointing returns by some large- and small-stock managers led his fund to move about $400 million to index funds.

"Now that we think we're close to the bottom, we feel we can access the upside just as well with index managers," Mr. Atwood says.(of course the future direction of the market should be irrelevant to the choice of active or passive manager but that's a discussion for another time)

The move toward more-passive investments is part of a broader reconsideration by many investors about what went wrong in 2008 and how they can reposition their portfolios to avoid a rerun of that dismal performance. ....A

In a recent survey by Greenwich Associates, a Greenwich, Conn., consulting firm, about one in five institutional investors said they have recently shifted money away from active managers and into passive index strategies. That is up from just 4% who expected to make that shift when asked from July to October 2008.....

Mr. Keleher says the moves primarily involve switching from traditional "long-only" active asset managers who invest in stocks and bonds but generally don't hedge or use derivatives, rather than from hedge funds or private-equity firms.

A change of heart in the $2.3 trillion public pension industry could quickly slice profits for the large asset managers that serve them. Stock index funds may charge annual fees of less than 0.1% of the money they manage, rarely topping 0.5%; stock pickers charge fees that can range from roughly 0.3% up to 2% of assets. Fees for bond managers are generally lower.

Greenwich Associates says that not all of the switches to index funds will be permanent and that some investors will stash their money in index funds until they find new managers.

That is partly true for the Fire & Police Pension Association of Colorado, a $2.5 billion pension fund. Chief Investment Officer Scott Simon says he is winding down a derivative-related program, known as portable alpha, and holding those assets for the time being in stock-index funds. The Colorado fund has about 60% of its stock holdings in index funds, up from 40% in 2008.

While that figure may come down, he says he intends to maintain a greater index bias going forward. "I see passive being a bigger piece of the portfolio than it has been in past," he says. "More managers seem unable to beat their index."

Mellon has found that some pension investors are doing the same thing with their debt holdings. Historically, the difference in performance between the top quartile and bottom quartile of bond funds was about half a percentage point, Mr. Keleher says.

Last year, that gap widened to about six percentage points. Rather than try to pick winners, many institutional investors are more worried about being stuck with losers, so they now are choosing index funds.

All of the above makes perfect sense to me yet in the WSJ's blog "the wallet". We get more of the illogic constantly presented by the mutual fund industry to justify active management. Here is part of the entry:

The Big Money’s Moving Into Index Funds. Should You?

Journal reporter Jeff D. Opdyke writes:

In recent weeks, big institutional investors—the folks paid to invest money on behalf of others—have been making some noteworthy changes to their portfolios. And that has us wondering whether those of us who manage our own 401(k) and brokerage accounts should be shadowing the so-called smart money these days?

As a WSJ story notes today, a new survey by Greenwich Associates shows that roughly one in five institutional managers has shifted money to cheaper, passively managed index funds and away from more-expensive, actively managed funds. Their thinking holds that active fund managers failed to add much value as asset markets the world over imploded during the meltdown, so why pay high fees for mediocre performance?

That report prompts us to wonder: Should everyday investors consider falling in line with the pros?

Indexing is widely considered a smarter way to go, and not just because it’s a cheaper way to invest. Most of us individual dart-throwers don’t have the time or inclination to properly manage a portfolio of individual stocks and bonds, and with indexing there’s not a whole lot of need for that....

But there is a flaw in the logic. From Oct. 9, 2007 (when the S&P peaked at 1565) to Mar. 5, 2009 (the S&P trough of 682), passively managed, or index, funds actually underperformed their active counterparts, according to Morningstar data. The score: passive funds were down 45% on an annualized basis, while active funds were down 43.5%. Since the March low, active funds have risen 37.7%, while index funds are up 41%....

The reason index funds lagged on the way down and have done better so far on the way up could be that an index fund has a mandate to remain fully invested in the index it tracks, no matter what. That means it cannot dive out of underperforming sectors.

Active managers, by contrast, can flee bad investments and go to cash, though too often those moves come a tad late. In down markets that means index funds may suffer more, though in the initial stages of a rebound an index fund’s full exposure means it’s likely to benefit sooner as the active crowd remains on the sideline.

Thus, there’s not really a clear-cut answer as to whether you should be following the smart money into index funds.

(sorry if i missed the logic here: On the downside active managers can "flee to cash though too often they do so too late" and by being late in getting back into the market they often miss the move up compared to the fully invested index funds. So it seems that simple logic would argue it is more risky to depend on that active manager being correct in timing when to go from cash to stocks and vice versa rather than to index)

Going into an index can make a lot of sense for investors who feel burned by their own investment missteps in recent years. Then again, if you find an active manager with a long history of outperforming the indexes, even if the fees are greater, skipping the passive for the active can still be better for your portfolio.

The logic above also escapes me. Volumes of research shows that past performance of mutual funds is a poor predictor of future performance. So finding an active manager with a long history of outperforming the indexes and then investing with him instead of indexing would not be a particularly sound investment decision. Ask those who invested recently with the Bill Miller's Legg Mason Value Trust. But I guess you can add this WSJ blogger to the "hope springs eternal" camp.

Tuesday, June 9, 2009

Bill Gross Criticizes The Yale/Harvard Investment Strategy (But Wait ...Wasn't His Co CIO Running Harvard Management Using This Strategy ?)

I have written several times about the perils of the Harvard/Yale endowment strategy which was copied by numerous other universities. The funds held large allocations to "alternative investments". Last year the funds not only suffered in terms of returns but also found that many lof these alternative investments are very illiquid.

my bolds

Pimco’s Gross Says Harvard, Yale May Need to Alter Investments

By Sree Vidya Bhaktavatsalam and Gillian Wee

May 29 (Bloomberg) -- Yale University and Harvard University may have to cut investments in hedge funds and private equity because the risks of holding the hard-to-sell assets outweigh the returns, said Bill Gross, co-chief investment officer of Pacific Investment Management Co.

“The Yale and Harvard portfolios, which have succeeded enormously over the past 10 or 20 years in terms of the emphasis on illiquidity and private investments and risk-taking -- you have to question that model,” Gross said yesterday at an industry conference in Chicago.

The two Ivy League schools had more than half of their endowments in hedge funds, private equity, real estate and hard assets such as commodities at June 30. Gross, who manages the $150 billion Pimco Total Return Fund, the world’s biggest bond mutual fund, recommended in March buying securities that provide stable income this year rather than more speculative and illiquid investments, as slowing economic growth and higher unemployment depress returns.

“Everything in this ‘new normal’ world should be questioned in terms of the returns going forward,” Gross, 65, told the audience at Morningstar Inc.’s annual fund-industry conference.

“New normal” in the global economy means heightened government regulation, slower growth and a shrinking role for the U.S., Mohamed El-Erian, who shares the position of investment chief with Gross at Newport Beach, California-based Pimco, said earlier this month.....

Endowment Managers

The Yale endowment is run by Chief Investment Officer David Swensen. Harvard’s endowment, managed since July by Jane Mendillo, was overseen by El-Erian from February 2006 to December 2007.

El-Erian didn’t respond to a request for comment
. John Longbrake, a spokesman for Harvard in Cambridge, Massachusetts,

Investment losses since September have forced colleges such as Harvard and Yale to freeze salaries, delay construction projects or borrow money to meet their budgets. Endowments have held onto illiquid holdings such as private-equity stakes as investor demand has waned and prices have plunged.

Yale plans for its endowment to support 44 percent of the university’s budget this fiscal year. Harvard depended on the endowment for about 35 percent of its revenue during the fiscal year ended June 30.

Decline at Yale

Yale’s endowment was valued at $17 billion in December, a decline of 25 percent since June 30. It’s the second-largest U.S. college fund after Harvard’s, which stood at $28.8 billion in December after losing 22 percent since June.

Swensen boosted Yale’s long-term returns by cutting the fund’s holdings of stocks and bonds and buying more real estate, private equity and hedge funds, a strategy that has been copied by endowment managers across the nation. His guiding principle is that the best stock and bond pickers don’t outperform bottom- rated managers by much.

Yale had 29 percent of its investments in hard assets such as oil, gas, timber and real estate as of June, according to the school’s annual report. Twenty-five percent was devoted to absolute-return strategies such as hedge funds, with 20 percent in private equity. Domestic stocks, bonds and cash made up 10 percent of its assets, while the remainder of the portfolio was held in stocks outside the U.S.

Asset Mix

Harvard had 11 percent of its portfolio allocated to private equity, 26 percent to commodities, timber and real estate and 18 percent in absolute-return strategies for the year ended June 30.
Harvard, projecting an endowment loss of as much as 30 percent this fiscal year, has frozen hiring and salaries and fired staff. Harvard raised cash by issuing $2.5 billion in bonds in December after failing to sell $1.5 billion in private- equity stakes.

About 51 percent of endowment assets was allocated to alternative investments as of Dec. 31, an increase from 46 percent six months earlier, according to a March survey released by Commonfund Institute in Wilton, Connecticut.

Monday, June 8, 2009

"Diversification Doesn't Work"

This has been a common refrain in the popular press (and even according to some advisors)
The portfolios using bonds were 70% stocks 30% bonds, the global allocation was 15% developed international 15% emerging international

Sunday, June 7, 2009

Hope Springs Eternal For Active Management....And is Once Again Disappointed

It seems that investors, be they individuals or institutions are constantly swayed by the promise of active managers that they will consistently outpeform their relevant indices and yet are they are constantly disappointed. It seems this well documented pattern in the US has its counterpart in Europe. From the WSJ (my bolds)

JUNE 3, 2009.In Europe, Are 'Active' Managers Worth It? .ArticleCommentsmore in Europe

As they ruefully watch their poor performance, pension funds in Europe are questioning whether some stock and bond pickers are worth their fees.
Since the start of 2008, Norway's government pension fund, one of the world's biggest with €232 billion ($328.47 billion) in assets, has dropped 16 of the 22 firms that managed its fixed-income investing, according to its Web site. Most of these have active-management strategies, many with exposure to securitized U.S. debt, which suffered heavy losses last year. Norway's Ministry of Finance is undertaking a review of whether active management is cost-effective.

Italian bank UniCredit SpA in March moved some of its €1.8 billion pension fund's holdings from active to passive strategies. The €2.5 billion Dutch pension for the hotel and catering industry in December shifted €400 million from an actively managed mandate to index-tracking. The Swedish government has asked the country's four big state pension funds to reconsider their use of active fund management, following big investment losses last year.
"We have learned lessons in risk management over recent months. We realized our measurement of risk in fixed income has not been sufficiently robust," said Thomas Ekeli, an investment director in Norway's Ministry of Finance, at a conference in London in March.

The ministry owns the pension fund, which is huge as a result of tax receipts from Norway's extensive oil reserves.

The virtues of active versus passive management is one of the evergreen debates of investing. Active managers pick stocks, bonds or other investments for a fee and maintain they can deliver outsize returns often with the same or less risk of a broader index. Fans of passive management -- designed to mirror an index and keep fees low -- insist that over time it is a rare manager who can beat the market, and that the cost savings of index tracking can't be beat.

Huge amounts are at stake. Institutional money managers can make far more selling their skills as active managers than selling products that track an index.

But down markets are when their clients often count on active managers most to minimize losses, and -- amid the financial crisis -- many didn't deliver. The Norway fund's 2008 annual report said it underperformed its benchmark in equities by what it deemed an "acceptable" 1.2 percentage points, but in fixed income it undershot by 6.6 percentage points. The fund lost 23.3% of its value last year.

Public pension experts say they aren't seeing similar trends in the U.S. Keith Brainard, research director at the National Association of State Retirement Administrators, says active and passive investing styles at public pensions are typically in a "state of flux. It's not unusual on any given day to hear that one fund is moving toward active investing from passive and the other way around."

California's giant pension, the California Public Employees' Retirement System, has historically relied on passive investing in its publicly traded equity portfolio, whereas fixed income is actively managed. Calpers has found that, for equities, passive investment is preferable because the market has been fairly efficient.

Based on this last part of the article it seems that in the US just as hope for active managers springs among one institutional investor, another throws in the towel and goes passive.

Friday, June 5, 2009

The Strange Case of An "Outstanding" Active Manager

I found an interesting article about fund manager Robert Rodriguez in the WSJ last week. But when I did a little more research about this "star fund manager" the story became more interesting.

According to the WSJ last week Rodriguez one of the "top" active mangers in the mutual fund arena doesn't seem to fee that either he or his colleagues have been showing much skill and value added. From the WSJ (my bolds) my comments in bold italics

FUND TRACKJUNE 5, 2009.Fund Managers in '08: 'We Stunk'
FPA's Rodriguez Doesn't Mince Words


One of the best-known mutual-fund managers minced no words with his industry colleagues, criticizing their poor performance last year.

Managers should learn from their mistakes and adjust accordingly, or face losing clients and possibly going out of business, said Bob Rodriguez, manager of FPA Capital Fund (trading symbol FPPTX).

While the Standard & Poor's 500-stock index was down about 38% in 2008, the vast majority of actively managed stock funds lagged behind that mark.

"Let's be frank about last year's performance," Mr. Rodriguez said. "In a word, we stunk. We managers did not deliver the goods and we must explain why."

In remarks to fund managers and investment advisers at the Morningstar Investment Conference last week, Mr. Rodriguez said part of the problem was that fund managers didn't appreciate the magnitude of the financial crisis. "Whether in stocks or bonds, it seems as though the same old strategies were followed -- be fully invested...and don't diverge from your benchmark too far," he said.

"If active managers maintain this course, I fear the long-term outlook for their funds, as well as their employment, will be at high risk," Mr. Rodriguez cautioned.

His criticisms were aimed at all fund managers, Mr. Rodriguez said, and he added that he accepted his own poor performance: FPA Capital Fund was down 35% last year. But he said that in his letter to shareholders he'd explain why he thought the losses were only temporary.

In other words I have faith in my own skills and I will outperform in the future, trust me, I will.

The fund is up about 25% so far this year.

more on that "stellar" performance below

"If portfolio managers and analysts cannot recognize the greatest credit blowoff in the last 80 years, when will they?" asked Mr. Rodriguez.

Mr. Rodriguez wondered what new procedures firms have put in place to make sure they don't make the same mistakes.

"These are questions that must be answered in order to regain and retain investor trust," he said.

Mr. Rodriguez said he's lost business since 2007 because he'd gone into cash. The losses included one $300 million client that left because his approach upset their asset-allocation model.

So his fund was down 34.8% in 2008 (compared to the S+P 500's -38%) even though he was heavily in cash ? He must have made some really terrible calls with the portion of his fund that was invested )

"We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk," he said.

Talk about lack of self awareness. His "precautionary mesures" still left his fund
-34.8% in 2008 and he was penalized for taking the appropriate "precaustionay measures"

(Mr. Rodriquez said in early March that from Jan. 1, 2010, he'll be taking a year's sabbatical to recharge his batteries. He plans to return on Jan. 1, 2011.)

Mr. Rodriguez said that he's once again bucking consensus, and late last year and early this year went hard into the market. Some 67% of his buys during that period were energy stocks.

More than half of his fund's stocks are energy-related -- a strategy that reflects his view of a changing world....

Mr. Rodriguez said that in the new world of lower returns, diversified mutual funds may struggle to beat their averages and benchmarks. "A more-focused strategy will be necessary to excel," he said. "If active managers continue to adhere to their old practices, we should see a contraction in the active mutual-fund management universe in the next five to 10 years."

So Mr. Rodrigues' solution to the market penalizing him for taking "precautionary measures" ramp up the risk with a heavily concentrated portfolio with 50% in energy stocks. This may work in the short term and it has so far this year, but he has clearly created a very risky portfolio. And if he continues to do what he said active managers need to do his portfolio performance will be highly dependent on his being successful when he takes extremely large sector bets.

I must say I find this speech given a few days ago rather surprising (to say th eleast ) considering the following interview he gave to Barron's in Feb of 2009

Barron's: Before we look ahead, let's review last year's equity market. What is your take?
Rodriguez: The equity market didn't surprise me. I warned that 2008 was going to be very tough -- and that the second half was going to be a lot rougher than the first half when the realization hit that corporate profits were going to be substantially less than expected. I also expected that the credit crisis was going to not only get worse, but that it was going to extend through 2008 and into 2009, which was not what a lot of people were expecting.


. Throughout '07 and '08, we had just under $1.2 billion of redemptions in all of the equity accounts, including the mutual fund, so we were fighting a rear-guard action.(WOW, apparently something changed in June 2009 (see above) about what he did in 2008)In the third quarter of '08, we had $300 million flow out from one account, a large banking relationship. The reasons given were that, all of a sudden, we had too much cash -- and that was upsetting their asset-allocation modeling. Secondly, they couldn't decide whether we were a small-cap value manager or a mid-cap value manager. So I said, 'May the pinheads of the world unite.

I have noted before that the literature from a fund company or categories from services such as Morningstar are seldom useful in evaluating actively managed fund.
The FPA Capital Fund mentioned in the above article is categorized by Morningstar as a mid cap value fund. Yet its portfolio which is 50% energy related has little in common with mid value indices: the state street spdr mid value etf is 7.8% energy, the vanguard energy etf is 9.1%.

And the literature from the fund company itself is of limited usefulness

Here is the description of the FPA Capital Fund's investment strategy on their website my bolds.

This price-driven equity style attempts to exploit market inefficiencies among stocks of smaller companies. Intense research is required to build the high level of knowledge and confidence necessary to realistically evaluate unpopular situations. Great attention is paid to the minimization of potential risk. The disciplined selection process is designed to minimize business risk by applying specific fundamental criteria: strong balance sheets, free cashflow, an understandable and successful business strategy under capable management, and unique business characteristics, which may include proprietary technology or a dominant market position. Qualifying companies have a history of generating high return on equity or demonstrate the potential to do so. FPA's value bias focuses on companies with long-term records; over 70% of holdings have at least 10-year histories.

Research concentrates on economic and market sectors either heavily discounted or simply ignored and involves basic computer screens for balance sheet and return data, the study of industry periodicals and research reports from select Wall Street sources, and in-depth interviews with company principals. Valuation considerations are applied to this list of potential investments, seeking to minimize market risk during the process of accumulation. New purchases are concentrated in companies with relatively low Price/Normalized Earnings, low Price/Pretax Cashflow, low Price/Book Value, low Price/Replacement Value and low Market Cap/Total Revenues. A contrarian outlook allows ownership of companies at prices already reflecting a negative perception by the marketplace. FPA believes this to be a relatively low-risk approach to the smaller cap markets given a reasonable time horizon.
Sorry but imo holding a portfolio that is 50% energy related does not consist of "sectors...simply ignored" by other investors or evidence of a "contrarian outlook".

Interestingly I also found this article

The best fund manager of our time

Robert Rodriguez has accomplished the unheard-of-feat: driving staggering returns in both a stock and a bond fund for more than two decades.
By Jason Zweig, Money Magazine senior writer/columnist

(note the byline: Jason Zweig now of the WSJ intelligent investor column and a frequent advocate of index investing)

April 8, 2008: 9:43 AM EDT
(Money Magazine) -- To invest in a mutual fund is to make a bet on the future. Whether that bet pays off is a function of how skillful the fund manager is, how lucky he is, how well the market does and how well the manager treats you.

The first two factors are very difficult to measure or predict, and the third is impossible to know in advance. But the fourth is quite easy to evaluate. You want a fund manager who will charge reasonable fees, keep his fund from growing too big for your own good, think independently and courageously and communicate his actions and intentions clearly....

Last June (2007), Rodriguez gave a speech that warned of the coming credit crisis so accurately that it reads with hindsight as if he had been peering into a crystal ball.
Taking his own warnings to heart, Rodriguez raised cash to levels high enough to withstand a nuclear war: 43% in FPA Capital and roughly 66% in New Income. In December he declared a formal moratorium on buying any stocks or high-yield bonds until he felt it was safe to invest again - essentially putting both portfolios into a state of suspended animation. As of press time he has not lifted that moratorium.

Sorry but the above is almost impossible to understand: his cash levels were high enough "to withstand nuclear war" yet his fund lost 34.8% in 2008. Doing a little back of the envelope calculation and assuming the cash position as having zero retun that would mean that his stock holdings in 65% of his portfolio would have to have lost 53.5% !....

and despite his anticipating the financial crisis and "nuclear proofing" his portfolio by his own assessment his performance in 2008 was terrible (at least in the second round of public retrospection).

Bottom line:

Even "great active managers" have difficulty timing the market

Active managers often hold portfolios far different than the category assigned to the fund or the strategy described in fund literature.
Fund managers often take big risks by holding heavily concentrated portfolios (by industry or individual stock)...this "star manager" advocates this as the best future investing strategy for active fund managers. His logic: in order to outperform indices. In Rodrigues' words:
in the new world of lower returns, diversified mutual funds may struggle to beat their averages and benchmarks. "A more-focused strategy will be necessary to excel," he said.

Well the above is really a tautology: in order to beat their averages significantly a manager will have to hold a concentrated portfolio than the index. Of course that is true and of course if the manager is wrong he will significantly underperform the index. And from Finance 101 we know that the more concentrated portfolio the riskier the portfolio. So Rodrigues prescription for the fund manager of the future:
take more risks and assume you will be right. Let the buyer (fund investor) beware.

note the byline: Jason Zweig, now of the WSJ and a frequent advocate of index investing investing. I guess his hope for active managers has faded as well

Monday, June 1, 2009

More On The Risks in Actively Managed Bond Funds

I wrote on May 19 about how using an active, as opposed to passively managed bond fund can be very dangerous to your portfolio. Even though most writing about indexing deals with equities, an article in the WSJ's monthly review on fund investing highlights that indexing is crucial for bond investing as well.

my bolds, my comments in bold italicsFUND FIEND
No Diversification: How Bond Funds Let Investors Down


Losses in bond mutual funds last year caught many investors off guard. But the warning signs were there, and the performance of those funds provides a cautionary note about how much—or how little—cushion they offer against a big drop in the stock market.

Theoretically, bond funds should have been a haven from the bear market in stocks. The most widely used investment-grade bond-market benchmark, the Barclays Capital Aggregate Index (formerly the Lehman Aggregate), gained 5.2% in 2008. Yet the average intermediate-bond fund—the Morningstar Inc. category closest to the index—lost 4.7%.

And the amount by which funds fell far outstripped the gains of top performers. Funds in the bottom 95% of peers trailed the index by an average 20.7 points—losing about 15%—while those in the top 5% beat the index by a meager 1.2 points.

What went wrong? Most intermediate funds held far fewer of the safest bonds than were inthe index. Worse, as the credit crisis unfolded and prices of risky bonds collapsed, many managers boosted holdings of low-quality debt.

As of June 2006, the average intermediate-bond fund had 64% of assets in triple-A-rated securities. By June 2008, that was down to 62%, Morningstar says. Meanwhile, within the index, the percentage of triple-A debt was moving higher, to 75.5% as of June 2008, Morningstar says. The average intermediate-bond fund held at least 5% in junk bonds—while the Barclays index has none.
“They were all buying credit risk and they were all buying liquidity risk,” says Michele Gambera, chief economist at Ibbotson Associates. “It’s been an expensive eye-opener for the industry and investors.”

I will offer another explanation for the above. Many many bond fund investors seek the highest yielding funds within a given category. Bond fund managers know this, and they are compensated based on the assets under management in their fund. Thus I am not surprised that active fund managers would move to riskier higher yielding assets in the quest to gain assets and push themselves to the top of the listings in terms of yields. And as the paragraph below notes, the strategy seldom works to the investors' favor.

On the one hand, these managers aren’t collecting big salaries for simply mimicking an index. But since 1999, there’s been only one year when the average fund topped the index. That was 2003, when the stock market was starting a rebound.

It just so happens that this year the average intermediate-bond fund is ahead of the index. But is it worth owning a fund that may outperform only when the stock market is recovering? That isn’t much help in diversifying a portfolio.

It may be yet another reason to buy an index fund: to know what you’re getting

The last line is of course the most crucial one. In allocating the bond portion of a portfolio the quest is usually for less risky assets to counter the riskier portions of the portfolio in equities and other asset classes. In my view this should include only conventional treasuries, inflation protected treasury bonds, and government agency and high grade corporate bonds with maturities of at most five years to limit interest rate risk. To illustrate this point take a look at the chart at the top of the page and compare the volatility of the exchange traded fund for treasuries 20 yrs+ in maturity (TLT in black) to the 1 -3 year treasury etf in brown.

(High yield bonds if held at all would be considered part of the equity allocation given their risk/return characteristics).

Therefore it is crucial that the funds chosen to implement the bomb allocation must be transparent and that its holdings match the goals for the portfolio allocation. As pointed out in the article above and in a manner similar to equity funds the mere label for the fund does not give sufficient guarantees as to the content of the fund. For that reason bond index funds or bond exchange traded funds which have fixed allocations to specific parts of the bond market are the best way to implement a bond allocation. I wrote earlier about the problems with "go anywhere" bond funds that can invest in literally any kind of fixed income instrument in any country, currency, maturity, or credit rating. The article above shows that even if one picks an actively managed bond mutual fund with a more limited strategy indicated in its title, there still may be problems.

As I Was Saying About Leveraged ETFs

I wrote on May 2 that leveraged etfs do not deliver what investors are looking to attain causing great disappointment to those that enter into them. Even more scary I wrote were financial advisors like this one mentioned in the WSJ (below) who displayed a lack of knowledge of how the instruments work.

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

Financial Times reports today on the perils of leveraged exchanged traded funds.
(my bolds, my comments in bold italics)

Investors warned about niche ETFs
By Steve Johnson

Published: May 31 2009 15:41 | Last updated: May 31 2009 15:41

Industry analysts and consumer advocates are warning investors of the dangers of a class of exchange traded funds that is “exploding“ in popularity.

Leveraged and inverse ETFs – which claim to generate two or three times the return of an underlying index or a multiple of the inverse of the index – have amassed $30bn (£19bn, €21bn) of assets in the past two years and now account for 40 per cent of the volume of US equity trading.

But many of these ETFs spectacularly fail to provide the expected return if held for more than a very short period – typically more than a day for equity-based funds.

“Very bad things can happen whenever you hold these ETFs longer than their indicated compounding period, typically one day for stock-based ETFs,” said Paul Justice, ETF strategist at Morningstar. “Many people are learning through horrible experiences.

“They are appropriate for less than 1 per cent of the investing community. Considering these funds have attracted billions of dollars over the past year, it’s obvious that too many people are using these incorrectly.”

and in Canada regulators are looking to put a warning label on these products

Ermanno Pascutto, executive director of Canada’s Foundation for Advancement of Investor Rights, (Fair) which is calling for regulators to warn investors of the dangers of these products, said: “The longer you hold a leveraged or inverse ETF, the greater the likelihood that you will lose money, regardless of which direction you bet.”

In a report entitled Heads You Lose, Tails You Lose, Fair said that while an index of gold stocks rose 1 per cent in the year to March 31, a Horizons BetaPro Bull ETF, providing two times leverage, lost 46.4 per cent over the same period, while a two times inverse Bear ETF fell 86.7 per cent.

Similarly an Energy Bear ETF lost 25.4 per cent despite the underlying energy index falling 39.4 per cent, although other oil and natural gas Bear ETFs have produced strong returns.

Morningstar quoted the example of ProShares’ UltraShort MSCI Emerging Markets ETF, which aims to deliver twice the inverse of the MSCI EM index. While the index lost 54.5 per cent last year, the ETF fell 25 per cent. “It’s clear to me that many people have held these products and not understood how they work,” said Deborah Fuhr, global head of ETF research at Barclays Global Investors (BGI), which said in a recent report: “If volatility is sufficiently high, the median investor will experience a long-run erosion in value in a leveraged or inverse ETF.”

and here imo is the most disturbing point:

Mr Justice said it was not just novice investors that had been caught out: a number of US financial advisers had put their clients into these funds without understanding the consequences.
Leveraged and inverse ETFs have grown rapidly in the US, where there are 94 products, according to BGI, offered by the likes of ProShares, Direxion, and Rydex.

Yale's Swensen Speaks on Individual Investors...

In this video interview

and as in his book Unconventional Success, warns the reporter from Investment News magazine that individuals should avoid actively managed mutual funds. The reported breathlessly introduces the interview as an unusual opportunity to hear from a brilliant investing mind.

But of course financial journalism being what it is, the rest of the interviews on the website are from 8 -10 active managers explaining their strategy to outperform the markets for individual investors.