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Saturday, October 31, 2009

As I Have Said Before I'm No Fan of Target Date Funds....

and it seems that I am not alone WSJ on a new senate report which found (surprise) high fees,low levels of disclosure and conflicts of interest my bolds

Target Date' Funds Get Senate Scrutiny


A Senate committee report identified three main concerns with "target date" funds: lack of disclosure and consistency in their design; excessive fees; and conflicts of interest.

It also raised the possibility of greater regulatory oversight of the funds....

The committee found that the date in the name of target-date funds isn't consistent with their design, making them difficult for investors to evaluate and compare, and that asset allocation varies among funds with the same dates. It also found that in addition to varying expense ratios within the funds, pension-plan service providers or the various outside companies also may charge fees that are deducted from an individual's savings.

The report also raised issues about possible conflicts of interest. Plan sponsors generally don't have a choice in selecting underlying funds, and instead choose from a portfolio of proprietary funds typically constructed by the firm, the report said. "As a result, some investment firms may include low-performing funds in their portfolio in an effort to garner more assets," it said....

The SEC's Division of Investment Management is focusing on fund names and sales materials, Mr. Donahue said. The simplicity of marketing messages "at times belies the fact that target-date fund managers have adopted very different asset-allocation strategies, and that investments that are appropriate for an investor depend not only on his or her retirement date, but on other factors."

The Mutual Fund Industry Is Afraid That Lower Fees Might Be Bad For You

The mutual fund industry is replete with conflicts of interest. One that is being challenged in a case that is going to the supreme court is the issue of the independence of the fund board of directors who are supposed to represent investors in negotiating management fees with the fund managers. As can be seen in this legal case it seems that there is great potential for conflicts of interest.

from the wsj: my bolds and italics

Fees Case Strikes at Heart of Mutual Funds
Supreme Court to Weigh How Much Money-Management Firms Can Charge; Defining Fiduciary Duty

The money-management fees that drive the mutual-fund industry are at stake Monday when the Supreme Court hears a case that asks how much is too much.
A ruling for shareholders could push down fees that last year approached $100 billion by some estimates in the $10 trillion industry. That could reduce the multimillion-dollar paydays of some fund advisers. The industry warns that its defeat could invite a wave of lawsuits challenging advisory fees, rewarding plaintiff lawyers more than investors and driving talented managers from the mutual-fund business.

Supreme Court: Hears arguments Nov. 2; decision expected by June.
The case, Jones v. Harris Associates, strikes at the heart of the workings of the mutual-fund industry, whose products are owned by more than 50 million American households. Typically, the investment-advisory company that manages a mutual fund takes a percentage of the assets, say 1%. That fee is negotiated with the mutual-fund board, which is set up to represent investors.

Doing Their Duty?
In 1970, Congress imposed on investment advisers "a fiduciary duty with respect to ... compensation for services." Advisers said that means they should disclose fees, costs and profits to the mutual-fund board, which can then strike a deal on behalf of investors. The existence of nearly 8,000 mutual funds gives investors plenty of alternatives if they believe fees are too high, the mutual-fund industry said.
The shareholder plaintiffs, backed by the Securities and Exchange Commission, argue that fund boards often are too closely tied to the advisers to drive hard bargains. They have a different definition of fiduciary duty, saying in their brief that Congress meant the fees "must be fair" to investors and "comparable to an arms-length deal."

"The law, as it stands now, just went down the wrong road and let management fees get totally out of hand," said John Bogle, founder of mutual-fund company Vanguard Group Inc., which sells mostly low-fee index funds. Mr. Bogle filed a friend-of-the-court brief backing

The case was filed in 2004 by three shareholders in the Oakmark Funds, which were developed and run by Harris Associates LP, a Chicago firm that said it oversees about $48 billion in assets. The plaintiffs said Harris charged Oakmark an effective rate of 0.88% on $6.3 billion in assets, nearly twice the 0.45% rate for an unrelated institutional client like a pension fund.

The fee for independent clients, plaintiffs argue, should be a benchmark for what an arm's-length transaction would look like. Harris responds that servicing the Oakmark Funds is more demanding than work for independent clients.
According to the plaintiffs' data, Oakmark's manager, William C. Nygren, took home $12 million in 2002, compared with the average portfolio manager's pay of $800,000. Mr. Nygren couldn't be reached to comment. A Harris Associates spokesman had no comment.
The dispute divided two influential judges, Frank Easterbrook and Richard Posner, who are both known for their market-based views of the law but differed on whether the market works well in this case.
Judge Easterbrook wrote the opinion for the Seventh U.S. Circuit Court of Appeals in Chicago rejecting the shareholder suit.
"Holding costs down is vital" for mutual funds, he wrote, because "management fees are a substantial component" of the costs and even small differences in rates can have a big impact on returns. He said that gives fund boards a reason to keep fees low, or investment advisers an incentive to deliver net returns that justify extraordinary pay.
"It won't do to reply that most investors are unsophisticated and don't compare prices," Judge Easterbrook said. "The sophisticated investors who do shop create a competitive pressure that protects the rest."

The plaintiffs asked the full Seventh Circuit to reconsider the ruling, but fell a vote short. Writing for five dissenters, Judge Posner delivered a critique of the free-market theory.
The Easterbrook opinion rests "mainly on an economic analysis that is ripe for re-examination," Judge Posner wrote, citing evidence that company boards have done little to rein in executive compensation. "Mutual funds are a component of the financial services industry, where abuses have been rampant," he wrote.
He argued that the existence of thousands of mutual funds was no barrier to excessive management fees because virtually all funds shared a structure riddled with conflicts of interest: The investment adviser creates the fund and its board of directors, which then is "captive" to its adviser.
Conflicts Alleged
The plaintiffs allege several "conflicting business and personal relationships among the trustees and Harris personnel." The Oakmark board's chairman, despite being classified as an "independent" director, was a former Harris partner who continued to earn six-figure sums in deferred compensation from the firm.
Judge Easterbrook dismissed allegations regarding the board chairman's independence, ridiculing arguments that he "possessed some Svengali-like sway over the other trustees" who approved Harris's fees unanimously.
Harvard law professor Jesse Fried, a corporate-governance specialist, said a shareholder win would encourage plaintiff lawyers, "for their own selfish reasons, [to] monitor compensation structures in these firms," filing suits when pay looks out of line. "That will keep the compensation down," he said.

Friday, October 30, 2009

Rational Markets ?

The range between the high and low for the emerging markets ishares etf over the past 2 days = 4.7%. Excuse me if I don't think this represents a rational adjustment to new information.

Thursday, October 29, 2009

James B Stewart of the WSJ Engages In A "Hedging Experiment" And It's A Bad One.

James B. Stewart writes the "Common Sense" column for the WSJ which is sometimes interesting but seldom particularly useful. He seems to give advice for trading based on this "system" but like most media personalities of this type never really gives a precise accounting of his buys and sells and thus of his success.

Generally his columns and decisions have some kind of logic. But this week's column on his "experiment" in hedging using pro shares inverse etfs is so ill informed as to be dangerous to individual investors. Thankfully he advises them to wait to see the results of his strategy before considering implementing it. One would have hoped that his broker would have followed the guidelines recently issued by FINRA with regards to warning investors about the use of short etfs. I have written about the perils of short etfs in previous posts.

Even the title is confusing he titles it "An Experiment in Taking More Risk" but then describes a hedging strategy designed to reduce risk.

my bolds, my comments in italics
An Experiment in Taking More Risk


The Dow Jones Industrial Average may have recently crossed 10000, but the Nasdaq Composite has remained stubbornly below my next selling threshold, 2200. While waiting for this milestone, which would mark a 75% gain for the Nasdaq since its March low, I've had time to explore options for reducing my exposure to the stock market. That has led me into new territory, at least for a relatively cautious

Strictly from a historical perspective, this market is overdue for a correction. As a result, I found myself examining the many offerings in the ProShares family of exchange-traded funds that let investors profit from market declines. I came away convinced that in unusual circumstances, some of these funds can play a useful role.
These short ETFs essentially offer a hedging tool and a way to profit from falls without having to sell short (selling borrowed shares in the expectation that the price will fall and they can be bought back at a lower price) or wade into options. I never short stocks or indexes because they carry the risk of unlimited loss. The ProShares ETFs I'm concerned with here don't sell short, either. They use derivatives, such as swaps (where two parties agree to exchange the returns on underlying investments). They may also add leverage to magnify gains, and losses. While options have fixed expiration dates, the ETFs offer the flexibility of selling whenever an investor chooses.

Well the above is missing alot of logic. If the investor is holding a portfolio of stocks and wishes to hedge all or part of the portfolio against drops in the overall market for any period more than one day, then the choice is obvious and it is not the short etfs. The direct hedge which is guaranteed to offset the index performance for the holding period is to short the relevant etf (SPY for instance in the case of the S+P 500).

While Stewart may be theoretically correct that there is potential for unlimited loss in a short position, that only holds for a naked short position when one does not own the underlying stock(or index). But that is clearly NOT the case when one combines a short position in the overall market with a portfolio of stocks. The short position will move one to one with the overall index rising in value when the market falls while the rest of the portfolio will decline in value. It is absolutely impossible to have exposure to "unlimited losses" when combining a long position in stocks with a short position of equal or smaller size in the overall index. That's why it's called a hedged portfolio Mr. Stewart. Short index + long stock portfolio = hedged position.
Mr. Stewart's vehicle of choice is an imperfect hedge. While the short etf position will move inversely to the overall index over whatever period the position is held the inverse etf is an imperfect hedge for any period longer than one day:

The ProShares short funds are designed to be the inverse of the relevant index; the leveraged ultra-short funds aim to be twice the inverse. So if the Standard & Poor's 500-stock index dropped 10%, the ProShares Short S&P500 would hope to gain 10%; the UltraShort S&P500, 20%. Losses, of course, are also magnified.
ProShares warns investors that it aims to have the funds' movements correspond to the inverse of the relevant market indicator on a daily basis. Over more time, the effects of compounding can (and generally will) dilute or enhance the results. For the second quarter, when the S&P 500 gained 15.93%, the Short S&P500 lost 16.03%. Year-to-date the total return for the S&P 500 is up 20.10%, but the short fund is down 22.63%.

No one should expect the funds to achieve a precise inverse correlation. Nor should they be long-term holdings. Given that the historical market trend is up, and that bear markets on average are much shorter than bull markets, they should be used only for short-term hedging strategies. And they should be monitored closely.
Except in rare cases, I can't see owning one of these. But as the Nasdaq creeps up, I decided to see if now is one of those times. I bought a modest position in the UltraShort S&P500 ETF as an experiment. I'm deliberately calling this an experiment, not a recommendation, and suggest conservative investors let me be the guinea pig. I'll keep you posted.

Mr. Stewart is cognizant of the shortcomings of this instrument (explained quite clearly on the proshares website) and still makes them his instrument of choice for short term hedging even though they will not give a precise inverse correlation.
Here is ytd data through Oct. 29

ytd sp 500 etf (spy) +19.65% inverse etf (SH) -22.81

The goal of hedging is to create a position that offsets exactly the change in value of the underlying position.

The hedge with the proshares short etf had an offsetting change in value that captured was -1.16 x (-19.65 vs +16.2%)the move in the underlying meaning it was not very good hedging vehicle . This is compared to a simple short of the spy etf which would produced the inverse of the move in the sp 500 exactly.

There is little reason not to think that Mr. Stewart's "hedging strategy" will turn out similarly.

So why use the etf and not a simple short in the spy. ?

The only possible reason would be lack of comfort with a margin account. But if the short margin position is matched by a long positin there is no possibility of "losing all your money" unless you unwind one position without unwinding the other.

In fact given the market of the last few days, if Stewart entered into his "experiment" on the day the article was published, the divergence between the changes in the value of the etf and that of the underlying value would be even greater. That is because the inverse etf is based on the daily move of the index and volatility is the enemy of hedging with the inverse etfs

href="">On their website Proshares explains the negative consequence of volatility for hedging with the inverse etfs:

When “10 + -10 = -1”
In a volatile market, compounding can result in longer-term returns that are less than the sum of the individual daily returns.
An investor who starts with $100 in an investment that rises 10% on one day and declines 10% the next would have $99, or a -1% return. This is less than the sum of the individual day returns, or 0%.

So I wish all the best to Mr. Stewart on his "experiment" but anyone that undertands hedging would know beforehand how this will work out. His hedging strategy will have "slippage" between the underlying and the hedge, shorting the sp 500 etf(spy) would not.

—James B. Stewart, a columnist for SmartMoney magazine and, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For past columns, see:

Wednesday, October 28, 2009

Some Interesting Thoughts On Yale's Investment Strategy and The Markets of the Future From Someone On The Inside

Courtesy of the folks from ishares I attended a presentation that included a lunch talk by Fareed Zakharia of Newsweek and CNN. I have heard many speakers at occasions of this type and never have I heard anything close in terms of clarity intelligence and content.

The theme was the growth of the developing (emerging market world)While he certainly is not an investment strategist, he was asked by a questioner what investing strategy he would recommend. To my surprise he didnt bow out of answering the question.

He mentioned that he is on the board of the Yale Endowment and certainly thinks their strategy over the last 15 years was well chosen and phenomenally successful. He also said that the strategy benefitted tremendously from access to cheap borrowing something which will not continue.

Noting that he agreed with Swensen that asset allocation is 90% of the game in investing. US investors have too much of a home country bias in his views and those that raise their allocation to emerging markets will outperform achieve superior returns. The specific investments are less importance than making this allocation choicenot

Unfortunately for the hosts, he did not specifically implementing this approach using ishares etfs :-)

Typical of his interesting data with regard to developing markets: auto sales in India rose 25% year on year in 2008.

Obviously I think all this is advice that merits great consideration.

Sunday, October 25, 2009

WSJ Presentsss A Great Quote From Benjamin Graham...But Leaves Out Another One That is Even More Important

Jason Zweig of the WSJ has a nice article on individual investors and short term professional traders in the market. He points out correctly that individual than individual investors benefit from the growth of high speed automatic traders.:
Paradoxically, their frenzy renders you a service as a buy-and-hold investor: On the very rare occasions when you do need to trade, you will be able to do so more efficiently than ever before.

my bolds:

Investors unltimately benefit from the growth of high speed traders who in effect tighten spreads and make transactions less expensive. If they make some money from that activity it is nothing new. Market makers have always made spreads in exchange for providing liquidity> The high speed automatic traders executing extremely high volumes seking to make fractions of a cent on the spread make the real cost of trading (spreads not commissions) that much smaller. The markets are more efficient(in the true definition of the word) and everyone is better off than in the days of floor traders and larger spreads. And the impact of their activity is felt in the spreads of etfs and the spreads paid by index funds so one need not have a portfolio of individual stocks to benefit.

And Zweig correctly points out that most of the short term trading represents what I call "noise" relative to long term trends with exagerated movements to news and rumours (like the ones reported on that business channel) For the patient investor looking to exercise a little bit of discretion in implementing a long term strategy this can represent an opportunity (though not a riskless one of course). As nobel prize winning economist Joseph Stiglitz has pointed out in his critiques of the argument that prices our always rational and reflect all available information, there would only be a need for a few minutes of trading each day so that the prices of stocks with relevant new information were adjusted accordingly. In other words those short term movements in the daily churning usually has nothing to do with any rational market activity.

From the point of view of an investor, all this frantic trading is just noise. In 1976, the great financial analyst Benjamin Graham declared that "the stock market resembles a huge laundry in which institutions take in large blocks of each other's washing ... without rhyme or reason." Mr. Graham died that year, but today he would laugh at the speed of the spin cycle. He would then ignore the momentary vibrations in a company's stock price and go right back to analyzing the value of its business

good advice, but Zweig imo should have included the following quote from Graham late in his career:
“I have little confidence even in the ability of analysts, let alone untrained investors, to select common stocks that will give better than average results. Consequently, I feel that the standard portfolio should be to duplicate, more or less, the DJIA.”

-Benjamin Graham in The Memoirs of the Dean of Wall Street

Friday, October 23, 2009

Another Reason to Turn Off That Business Channel

from the WSJ

Prominent banking analyst Dick Bove, who caused a stir Wednesday with seemingly contradictory remarks on Wells Fargo, has decided he’ll no longer provide immediate earnings commentary on air.

“I’m not going to do it anymore. I’m going to have to see the numbers before I go on air,” Bove told Dow Jones Newswires Thursday. “It creates an untenable situation.”

Appearing on CNBC immediately after the San Francisco bank’s 8:00 a.m. EDT Wednesday earnings release, the Rochdale Securities analyst included Wells among “standout” banks when asked to name a few. Bove, who appears regularly on business news programs, said the earnings news suggested Wells had its loan losses “under control.” The comments left many with the impression that Bove
favored the bank.

Later in the day, Bove made waves when he downgraded Wells to “sell” from “neutral.” In an interview Wednesday with Dow Jones Newswires immediately after the downgrade, Bove called the bank’s earnings “pretty poor,” and said mortgage hedging and unsustainable tax cuts inflated earnings.

The downgrade sent Wells shares sharply lower, and weighed on the broader stock market.... The Dow Jones Industrial Average finished the session lower after spending most of the day in positive territory.

Bove, a prolific analyst who is widely followed but doesn’t usually generate such a big reaction with his research, said Thursday that it took him six hours to digest Wells Fargo’s quarterly earnings after his CNBC appearance. He also acknowledged the risks of rapid-fire earnings comments on television.
“Once I went through the numbers, it was evident to me that this company’s earning power was lower,” Bove said Thursday.

Late Wednesday, he had said that what CNBC wants “is a quick reaction to a number, that’s what they want,” contending there wasn’t a conflict between the statements.

CNBC declined to comment Thursday on Bove.

Bove appeared on Fox Business Network Thursday morning. He recapped his Wells Fargo downgrade and discussed banking earnings, though he didn’t mention PNC

Wednesday, October 21, 2009

No I Didn't Make This Up (and He didn't even need to become a "genius" as verified by

From the financial times my bolds

Meriwether in new hedge fund

By Sam Jones in New York

Published: October 22 2009 00:03 | Last updated: October 22 2009 00:03

John Meriwether(left pic), the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.

The move comes barely three months after Mr Meriwether decided to close his second fund manager, JWM Partners, which was wound down after clients saw the value of their investments fall by more than 44 per cent over the course of the financial crisis.

JWM Partners was set up soon after the collapse in 1998 of Mr Meriwether’s first – and most infamous – fund, LTCM, which triggered a wave of panic across the world’s markets and prompted the US Federal Reserve to take the then-unprecedented step of orchestrating a multi-billion dollar bail-out.

Mr Meriwether’s new venture, named JM Advisors Management, will, like both of his previous hedge fund management companies, be based in Greenwich, Connecticut.

People with knowledge of the situation say the fund is not likely to be ready to launch until next year.

The fund is expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.

The strategy, described by the Nobel Prize-winning economist Myron Scholes(right pic) as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations.

Relative value trades profit by betting on unusual pricing relationships between securities, anticipating a return to an historically modelled “normal” state between them.

Traders say the strategy has the potential to deliver huge returns in the current market, with many banks’ proprietary trading desks having scaled back their operations and far fewer hedge funds in existence.

Their absence is leading to “inefficiencies” according to many market participants....

However, as Mr Meriwether’s experience shows, relative value strategies are not without their pitfalls.

The strategy typically has a high “blow-up” risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.

At its peak, LTCM borrowed 25 times more than it had in investor’s capital in order to ratchet-up its returns.

JWM boasted a more conservative 10 times leverage ratio.

The hedge fund industry average is estimated at between two and three times.

Monday, October 19, 2009 Looks Like ATerrible Way to Pick a Money Manager: More Likely a Case of "Fooled By Randomness" than a Good Way to Find "Genius" Managers

NYT today has an article on a new investment website named kaching that purports to offer a better way to invest with a money manager by following the trades of an investing "genius." Needless to say I am EXTREMELY skeptical. IMO it is virtually guaranteed to send investors to chasing performance and jumping from strategy. In addition frankly I'm not sure at all how it would actually work in practice. And I certainly have problems with their methodology for determining who is a genius.

my bolds and italics

from the nyt
october 19, 2009
Site Lets Investors See and Copy Experts’ Trades

SAN FRANCISCO — The trouble with mutual funds is that investors can feel as though they have put their money in a black box. The 90 million Americans with money in funds know little about fees, what securities their money is invested in and who is in charge.

As you will see imo this website trades one type of opacity for another.

....On Monday, KaChing is to add a new twist. Customers can set up brokerage accounts that automatically mirror the trades of a money manager, some of them professionals.

“The idea of an asset manager showing all his research, his holdings — it’s unheard-of,” said Mr. Carroll, now 27 and the vice president for business development at KaChing. “In the financial industry, the idea is that information is currency; they protect it with their lives.”

Individuals are desperate for advice and transparency from people who help them manage their money, and mutual funds do not provide enough, said Andy Rachleff, KaChing’s chief executive and a longtime venture capitalist who co-founded Benchmark Capital.

“The mutual fund industry is a $10 trillion industry that has seen no innovation for 25 years. The Internet has had no impact,” Mr. Rachleff said.

Boy is that off the mark ! there are now index funds for global and domestic indices that never existed 25 years ago not to mention exchange traded funds which though not mutual funds are certainly a low cost and transparent investment vehicle available to the individual investor with virtually any size investment account....

KaChing has attracted a roster of prominent early investors from Silicon Valley who have financed the company with $3 million. ....
The angel investors have also been investing their own money through KaChing during the pilot period. “The concept is great — the ability to tap into not just the wisdom of the crowd, but to be able to identify and invest with the particular geniuses in the crowd that stand out,” said Mr. Andreessen, who has invested $100,000 using the site.

By various reports Andreessen's net worth in the hundreds of millions making a $100,000 investment account with kaching little more than a marketing expense (and it worked: look how they use it in their pr)

Customers will be able to open a brokerage account with Interactive Brokers and link their account with their choice of investors on KaChing. KaChing charges customers a single management fee of 0.25 percent to 3 percent, set by each investor. KaChing keeps a quarter of the fee, and the investors get the rest.

Each time the investors make a trade, KaChing will automatically make the same trades for the customer. Customers can log on whenever they want to check their portfolio’s performance. They can send the investor private messages and receive alerts if the investor does something unusual. With the click of a mouse, customers can stop mirroring an investor.

A few operational questions ?

A quick glance at the "genius " portfolios shows investment portfolios with 20 or more stocks and long and short positions. How could an investor with $50,000 or less invest with this strategy ? will he hold positions as small as 5 shares or less ? I assume clients must have margin accounts to implement the shorts, yet margin accounts under the "know your customer rules" should only be approved for sophisticated investors are all new account applicants screened for that ? How are any margin calls executed ? What is the mechanism for block trading. The investor certainly has transparency, but how comfortable will he be when large numbers of short position show up in the account particularly when the stocks or the overall market become very volatile ?

and how scary is this ?

Only a dozen people have qualified as genius investors so far. They include a retired lawyer in Omaha, a student at Chapman University and the founder of a Bay Area investment firm.

For investors, KaChing is a way to make some money on the side or expand their existing business. Andrew F. Mathieson, founder of the investment firm Fairview Capital in Greenbrae, Calif., said he hoped to use KaChing to cater to people who did not meet the firm’s million-dollar minimum.

And a Few ?s on how they screen for managers

here's how they explain their methodology on their website

kaChing operates an investing talent marketplace where you can "invest like a Genius" in your real brokerage account. On kaChing, a Genius is an investor who, not surprisingly, earned an Investing IQ greater than 140, built a track record over more than a year and agreed to live by the same personal trading restrictions as a classic mutual fund manager. Investing IQ is the first objective metric to evaluate whether an investor is lucky or good. It's based on the same 3 factors used by the Ivy League Endowment managers, the world's premier evaluators of investing talent, to rate their prospective investment managers:

1. Risk adjusted returns – based on an investor's information ratio
2. Sticks to Strategy – based on an analysis of how an investor made returns
3. Quality of rationale – based on a kaChing behavioral algorithm that measures community response to an investor's research

To call the above the methodology of "ivy league management" is inaccurate if not outright deceptive. Let me count some of the ways:

1. No responsible endowment investment manager would base his choice of money.
manager based on performance of as little as one year.
2. I assume the kaching folk are referring to the Yale model. As documented in David Swensen's book Pioneering Portfolio Management. Yale uses an intensive screening process including interviews and visits to the prospective manager's offices before selecting a manager.
3. The key determinant of the strong long term performance (and recent setbacks) of the Ivy league funds was the large allocations to alternative investments such as direct investments in commodities and real estate,venture capital,and private equity. This is nothing like the kaching portfolios which are composed solely of traded equities.
4. While the kaching folk purport to be totally transparent they don't make clear their methodology for determining geniuses in any detailed manner. They also don't give their criteria for taking a manager off the "genius" list. Sorry but criteria descriptions listed above don't cut it for me. While the holdings may be transparent real time the methodology for choosing geniuses certainly is not.
5. Many of the portfolios are concentrated by industry or otherwise. Yet the kaching site gives no guidance that such a portfolio should represent only a small part of one's investment holdings.

Most important the kaching strategy has the potential for giving an investor a lighted match next to a stack of open gasoline barrels particularly given the known behavioral tendencies of investors to chase performance. I saw no guidelines on the kaching site for building a portfolio: riskiness of concentrated and long/short portfolios, importance of balancing an overall portfolio with lower risk fixed income and broad index funds, the advantages of globally diversification. There was also no mention of the potentially high tax bill from latching on to a strategy that incorporates lots of short term trading.

The potential for kaching clients to jump from hot hand "genius investor" with eye popping short term returns (a quick glance at the list of "geniuses" shows investors with one year returns from 80-179% you guess where investors will put their money. And knowing investment behavior they will dump the genius when he invetiably drops down the list of high returning geniuses and move on to the next one.

I was asked if something like kaching might "put me out of business". Since I put together low cost (some kaching managers charge 1.25% or more), globally diversified portfolios, managed to minimize taxes and tailored to my clients personal situation and tax status....I'm not too worried.

But best of luck to the kaching investors. As my readers know I don't think there is such a thing as an "investment gehius". Once again check Taleeb's Fooled By Randomness.

Sunday, October 18, 2009

Brokers (Finally) Figure Out It Makes Sense to Use ETFs

Barron's this week published a gushing section on the growth and virtues of etfs (i guess they have been asleep for the last 5 years or more).

In an article entitled Why the Rich Like These Bare-Bones Products, Barron's writes how adviors to wealthy individuals have lately "discovered" how useful etfs are in structuring portfolios. In fact independent advisors like myself have been constructing portfolios primarily consisting of etfs for years.

The article mentions mostly "advisors" (read brokers) from the major "full service" brokerage firms that are just beginning to use the products.

The reasons mentioned in the article the newfound realization of the flexibility of the product (something independent advisors have know for years) and disappointment with actively managed mutual funds (something we independent advisors have know for years). Oh, and one more reason: their clients demanded them in their portfolios.

From the article my bolds and italics:

EXCHANGE-TRADED FUNDS don't exactly shout "I've arrived!" the way hedge-fund holdings or private-bank accounts do. But the well-heeled, as much as any investor, seem to appreciate ETFs' basic virtues: tax efficiency, low cost, transparency and liquidity.....

Ira Walker, a UBS advisor in Red Bank, N.J., uses ETFs to build entire customer portfolios. "With the push of a button, I can reallocate a portfolio, or I can diversify a portfolio into all asset classes," says Walker, who manages about $500 million of exchange-traded fund assets.

Firms like Morgan Stanley Smith Barney say that more and more of their clients are interested in ETFs;

ETFs can come in handy for tax harvesting, too. In a typical scenario, a group of stocks from a particular sector is sold at a loss, creating a tax-loss carry forward that mitigates a future capital gain. "We can replace that group of stocks by using an industry-specific ETF so we can maintain exposure to the sector," says Krasnoff

DISSATISFACTION WITH THE performance of some active managers prompted Jonathan Harris, executive director at Morgan Stanley Private Wealth Management in San Francisco, to start exploring ETFs about six years ago. "We had some clients back then who were frustrated," says Harris, whose team oversees about $2 billion. "They had some active managers who were not keeping up with the overall market and they were asking us how else we could approach things." That led to using ETFs in discretionary accounts, often for broad global-equity exposure.

None of the above should be new information for anyone that is a professional in asset management it has been apparent for close to a decade. I don't know if I should be shocked that Barron's just caught up with this or that the advisors at major brokerafe firms are just realizing it, or both

The unspoken reason for the adoption of exchange traded after years of resistance: they finally figured out a way to get paid for using etfs which pay no fees to brokers and can be bought with minimal commissions. You can read between the lines in this quote:

some private banks are even creating for their clients internal distribution platforms for ETFs. The financial meltdown, and scandals such as Bernie Madoff's Ponzi scheme, seem to have increased the appeal of plain-vanilla ETFs for those with millions at stake

But it seems like many "advisors" (i.e.brokers) still can't shake their old ways and still retain the myth that active funds belong in the portfolios:

High-net-worth advisors increasingly are experimenting with ETFs, which, unlike mutual funds, can be traded throughout the day. "We typically don't use ETFs for the core portion of a portfolio," says Mary Deatherage, managing director at Morgan Stanley Smith Barney in Little Falls, N.J. "We are more interested in using ETFs to complement the core holdings."

Of course if there were any justification at all for some use of active funds it would be in a portfolio structure exactly the opposite of that stated above. It would use etfs as the core holdings and perhaps, perhaps a couple active funds as a small (and likely fruitless) attempt to gain some alpha.

As we know hope springs eternal.

Thursday, October 15, 2009

A Few Pictures Give a Great Summary of the State of The Investing World

As part of their great future of investing series the FT published an excellent series of charts summarizing the failures and challenges to investment theory.

Two of the more interesting charts are here(click to enlarge).
The top graph shown here presents the growth in passively managed assets, which has grown from around 8% in 1989 to 18% in 2009. btw I would guess the slight dip in passively managed assets between 2007-2009 marks the rush to hedge funds, something that will likely be reversed going forward.

The second graph (click to enlarge) shows the relative growth in market cap for various international asset classes. Emerging was steady at around 5% in both 1989 and 1999 (the first two bars) but by 2009 was around 20%.

Wednesday, October 14, 2009

Does Market Timing Work ?

I wonder how many people that believe in market timing successfully timed these moves (2 year charts developed international (efa), emerging international(eem) and s+p 500 (spy)) Note that the emerging and developed international have come close to doubling since March of this year. Such a move would literally be a once in a lifetime opportunity.

Given my knowledge of behavioral finance it would seem quite likely to me that there will be significant inflows into stocks in an effort to chase the trend and "make back" money that was lost in the market downturn. This is particularly likely with Dow having crossed the (meaningless) 10,000 level today. Will these investors be "buying at the top" ? Since I don't believe in market timing I have no idea. But I do know for a certainty that many who have tried to time the market missed a massive rally so far this year.

(I also wonder whether those actively managed behavioral finance funds have been selling into the recent rally to avoid herding....or would they have been better off joining the herd and riding the momentum ?)

Monday, October 12, 2009

Behavioral Finance Is Very Useful..But I'm Not So Sure About Actively Managed Funds Based On Behavioral Fianance

As readers here know I am a big believer that behavioral finance offers some extremely important insights. In my view behavioral finance offers some insights that pretty decisively make the case that markets are not always the "rational" market posited by what is called the strong form of the efficient markets theory.

On the other hand I find it hard to argue against with Richard Roll of UCLA and others that have pointed out that the insights of behavioral finance do not discover "inefficiencies" in the market that can be systematically exploited for profit. In other words the "weak form" of the efficient markets theory still holds it is very very very difficult to systematically beat the market with any investment strategy.

Hence I am quite skeptical that investors will find much consistent success in moving their monies from index investments to the group of actively managed funds, using the insights of behavioral finance in their strategies The nyt ran an interesting article on these funds.

my bolds and italics

October 11, 2009
When Emotions Move the Markets


....Some portfolio managers, adherents of an academic discipline called behavioral finance, say that there is no “if” about it. They contend that investors are driven largely by emotions, the sort so vividly on display in the stock market during the last year.

Those emotions cause investors to misjudge the impact of events in systematic ways, the theory goes. Identifying these patterns and trading against them, the managers say, allows them to enhance performance.

“Humans are emotional individuals, and that gets exaggerated when it comes to taking risks,” said Christopher Blum, chief investment officer of the U.S. Behavioral Finance Group at J.P. Morgan Funds. “There are errors that investors make. We try to exploit anomalies in valuations and momentum” arising from those errors, he added.

Behavioral finance funds in Morgan’s Intrepid and Undiscovered Managers series and in the Highmark, LSV and Allianz Nicholas-Applegate families, among others, often use “quant” or “black box” models. These are software programs that sift through data on thousands of stocks in a quest for those affected by such investor traits as “anchoring” and “herding.”

Anchoring occurs when new information about a company’s prospects arrives and analysts are reluctant to alter their forecasts, which would be a tacit acknowledgment that their initial efforts were off the mark. The absorption of changed circumstances is drawn out enough to allow funds that react fairly early to benefit, managers say.

“Investors tend to underreact to positive fundamental change,” said Horacio Valeiras, chief investment officer of Nicholas-Applegate Capital Management. The full response to events “comes over time,” he said, as investors abandon “behaviors that are weighing them down.”

This seems to be arguing that not only does the market systematically "misprice" assets as prices do not adjust to new information, but that there is a way to systematically detect these mispricings and profit from them. This may be trued on occasion but as Keynes has pointed outone can run out of money before the market proves you right. Of course if this strategy is not implemented on a leveraged basis or with shorting, one may not run out of money but one must be willing to ride out long periods of losses. And again the fact that such mispricings may occur doesn't mean that a particular strategy will find and profit from them on a consistent basis.

Herding amounts to investors collectively saying, “I’ll have what he’s having.” A trend develops and newcomers latch onto it, reinforcing it and making it look profitable. That brings in more investors, and the cycle continues until valuations are stretched, often to nonsensical extremes, before snapping back when little money remains to keep it going.

The tech bubble in the late 1990s was a notorious example. Another, in reverse, was the overall market collapse last fall and winter. Selling begat selling, and the lower prices went, the more it confirmed — for a while — that selling was the right thing to do.

When herding occurs in a market, behavioral finance funds try to profit by recognizing that the valuation extremes are unjustified, and buying or selling accordingly.

This one presents a bit of a a paradox as well. Firstly the same problem exists here as with the earlier strategy. The "herding" can continue for a long time and if the strategy entails shorting the overvalued assets
one can run into the keynes dilemma.

Research has pretty definitively found that there is a momentum factor in markets and certainly a strong case can be made that it is best explained by behavioral economics.

However it does not at all follow that the best strategy in light of this herding phenomenon is to buy or sell in the opposite direction of the herd. In fact many studies (and a significant number of traders) would argue the best strategy is to ride the momentum along with the herd (and presumably get out before the inevitable bursting of the bubble). For example a recent study of hedge fund behavior during the tech bubble found they were heavy buyers of what were the most highly valuesd stocks. In other words a significant number of the "highly skilled" traders saw the best strategy as riding with the herd rather than following it. And many value traders such as the legendary Julian Robertson lost masses amounts of money shorting tech stocks too early,Secondly one could argue that the recognition of herding in financial markets would argue for a strategy that would attempt to identify stocks or sectors with high levels of positive price momentum and to "ride" the momentum rather than to try to short the overvalued stock with positive momementum.

So once again behavioral finance has given us an important counter to the "strong form " of the efficient markets theory that price reflects value with the evidence of herding and momementum which creates bubbles and busts. But the "weak form" of the efficient market theory seems to still win out. Knowing that bubbles and busts occurs does not mean that one can spot extreme overvaluation or undervaluation, nor does it rule out a strategy of riding mommentum rather than trading against it.

So I was not surprised that when tested with mutual funds it seems clear thatjust because one has identified behavioral distortions in the market doesn't mean one has identified a path to profits:

Although the role of emotion in investment may seem undeniable, especially lately, behavioral finance remains a niche discipline among investment professionals and academics. (Funds in Morgan’s Undiscovered Managers series have “behavioral” in their name, but many others that use behavioral techniques don’t.)

The more popular school of thought, the efficient-market theory, is based on the idea that asset pricing is rational and nearly perfectly reflects available economic and corporate information.

The main point in favor of efficient markets is the widely observed inability of active portfolio managers to beat market averages. If markets were inefficient, there should be more evidence that investors with certain skills could beat their peers consistently and predictably.

Followers of behavioral finance see high volatility and trading volume as confirmation that emotion plays a significant role in markets. If everyone has the same information and understanding, why do markets move at all, except for the few minutes or hours after major news? And what is the point of trading securities at any other time?

The above is a bit of a simplistic dichotomy between efficient markets theory and behavioral finance. One can believe (as I do) that behavioral finance has much to say about how markets behave, that overshooting and herding (momentum) exist without believing that investors have the skill to systematically beat the market>

Prof Goetzman (cited below) is certainly far more knowledgeable than I am, although I did search for any writings by him that support his quote below:

Will Goetzmann, director of the International Center for Finance at Yale and an authority on behavioral finance, said advocates of efficient markets had begun to concede that there is a sizable psychological component to trading. And a grudging recognition is emerging that there are meaningful differences in talent, he said.

“There has been a reversal of this notion that there isn’t any skill out there” among fund managers, Mr. Goetzmann said. “Research is finding that there are managers that have more skill than others and provide risk-adjusted value.”

Furthermore even if there are managers that are able to provide higher risk adjusted returns (that elusive alpha),it seems doubtful that individual investors will be able to benefit from that alpha through the retail behavioral finance oriented funds:

Whether many of those who run behavioral finance funds are among them is questionable. Many have produced results over the last 12 months that are in line with the broad stock market. They have also displayed slightly higher volatility. And as paradoxical as it seems, the comparative performance of these funds tends to diminish during periods of peak emotion. Managers point out that behavioral finance techniques work better when the craziness that distorts markets abates, not while it is in full force.

The funds tend to be small, too, and therefore can have high expenses, often close to 2 percent of assets. That erodes returns even in the best of times.

Academic research has certainly identified that there is a momentum effect as well as a small and value premium. Eugene Fama, the researcher most responsible for identifying the small and value premium is also considered the father of the efficient market hypothesis. Thus for Fama the only explanation for the outperformance of small and value stocks was that they must be riskier.

Yet many researchers from the behavioral school accepted the outperformance of small and value stocks but attributed this to behavioral factors: investors flock to "glamour stocks" bid up their prices and valuations until they ultimately collapse in price, while undiscovered value stocks are ignored until they return to a value that more reflects their fundamentals. Hence the behavioralists become advocates of value strategies but with a rationale far different than that of the researcher than initially discovered this "anomaly". Fama's firm Dimensional Fund Advisors was the first to offer low cost passive (index) instruments concentrating on small and value stocks. Interestingly (DFA) has also begun to incorporate a bit of a momentum weighting in their investment strategies.

So where does this leave an investor who is looking for a way to possibly take advantage of the insights of behavioral finance in his investing strategy. It seems to me there is an alternative to investing in an expense black box strategy. Incorporating a position in one's portfolio with a small cap value index instrument would be a way to exploit the markets tendency to undervalue this sector. But of course this comes with the caveat that one must have the patience to hold this position during the inevitable periods of underperformance.

A morningstar analyst quoted in the nyt makes a similar point:

Christopher Davis, senior fund analyst at Morningstar, is reserving judgment on behavioral finance funds, which he considers to be undergoing their trial run. But he is generally unimpressed so far. “It’s fair to say that it’s an emerging academic discipline,” he said, “and its application as an investment discipline isn’t all that far along.”

It’s not clear what significant advantage can be gained from understanding the mechanisms driving investors’ psyches. Just as someone sitting in a tree does not have to be Isaac Newton to know that falling out of it can hurt, an investor ignorant of the inner workings of his peers’ minds can still recognize the merits of a stock that’s cheap relative to the company’s profits.

“The bottom line here is that there’s a fancy theory underlying all these funds, but what they’re doing isn’t all that revolutionary,” Mr. Davis said. “TThey use quant screens to look for the cheapest stocks, but that’s what fund managers have been doing for a long time.”

And of course there is a low cost way to buy "cheap" stocks: a value oriented index fund or etf.

And then there is the behavioral paradox of any investing strategy whether using a value weighted index instrument or an active behavioral fund:

“Be sure you aren’t falling into any of the behavioral traps,” Mr. Davis advised. “It would be really kind of ironic if you invested in a fund based on behavioral finance and you sold it after the fund had a big loss or added to it after it was up 50 percent.”

“It’s hard not to be human,” he added.

Behavioral finance has given us great insights into the factors that produce market volatility, momentum and overshooting and asset bubbles. It does not seem that it may provide a means for capturing that elusive alpha by exploiting these phenomena on a systematic basis. Adding a bit of a value "tilt" through an index instrument may be one approach. There may be some promise to incorporating some recognition of momentum into a strategy.

In other words if there is a way to profit from the phenomena found by behavioral finance the best way to do so may be with a low cost value index instrument rather than an expensive actively managed behavioral finance mutual fund.

But the best use of behavioral finance may be in recognizing when one's investment behavior corresponds to one of the pitfalls identified by these researchers:

Resist the temptation to follow the herd and buy high and sell low.
Resist the temptation to buy highly valued glamour stocks.

Dr. Swensen Speaks and His Bottom Line: Don't Try to "Be Like Yale"

David Swensen, head of Yale Investments gave an extensive interview to the Financial Times He certainly displayed no remorse over his investment strategy. Yet at the same time he advised (as he has done before) that most investors both individual and institutional are far better off pursuing an investment strategy utilizing liquid,transparent index funds and etfs.
My bolds and italics.

Lunch with the FT: David Swensen
By Chrystia Freeland
Published: October 8 2009 18:50 | Last updated: October 12 2009 17:18

For almost one-quarter of a century, David Swensen, head of Yale University’s $16bn endowment, has been one of the most influential figures in US finance. Because of his extraordinary success in managing the Yale fund, Swensen has been described as the biggest “donor” in Yale’s history.

...Swensen commands more financial firepower than most of the more gilded combatants on Wall Street, just a 90- minute train ride away. In the 10 years to June 30 2008, Yale’s endowment fund posted average annual gains of 16.3 per cent, including banner returns of 41 per cent in 2000 and 28 per cent in 2007. It is a performance that has had fund managers clamouring to look after Yale’s money (like most big endowments, Yale entrusts most of its wealth to outside money managers). A Swensen investment became one of Wall Street’s most coveted seals of approval.
Swensen’s approach transformed the management of university endowments and other big public funds, inspiring them to follow his strategy of shifting from putting all their money into traditional investments in shares and fixed-income bonds, and instead moving partly into so-called alternative investments such as private equity or real estate. His investment style is so well-known – perhaps second only to the “value investing” approach of Warren Buffett – that it is often simply called the “Yale model” or the “Swensen model”....

The financial crisis and the sharp public censure that it provoked of Wall Street’s culture of excess and instant gratification was, in some ways, a vindication of Swensen’s Lutheran ethos of self-restraint and his philosophy of investing for the long-term. But the crash brought pain to Yale, too: in the fiscal year ending June 30 2009, its endowment was down 24.6 per cent, a wrenching $5.6bn investment loss for the university and an unprecedented setback for Swensen.
Swensen traces the origins of his career back to a precocious interest in capital. ..
Does Swensen feel he anticipated the crisis?

“Late in 2007, Yale took all of its operating cash and moved it out of money market funds and put it into Treasury bills, so we were absolutely aware of potential issues. And that was months before Bear Sterns,” he says. “But, that said, we weren’t prepared for the magnitude of the crisis, or its duration.”
This mild assertion of prescience in late 2007 makes me wonder whether the crisis has prompted Swensen to reconsider his big idea – investing in illiquid assets. If more of Yale’s assets had been easier to cash in at that time, surely Swensen would have moved more money into T-bills [ultra-secure US government bonds] and hence suffered a smaller loss? (Partly thanks to doing just that, the University of Pennsylvania’s endowment reported one of the smallest losses in the year to June 30 2009, and fell by 15.7 per cent.)
Swensen has a monosyllabic reply to this speculation: “No.” I try again. Swensen is still terse: “No, we never would have done that.”
I try a third time, but it isn’t until the fourth version of the question that Swensen offers a more expansive response: “There have been some articles that have criticised the Yale model and my role in managing the endowment. And I think that’s odd ... What’s the alternative? Aside from the heroic impossible alternative of being 100 per cent in T-bills?” Over the longer run, he says, Yale’s diversified strategy handily beats a classic 70/30 allocation in stocks and bonds.
The larger point, Swensen believes, is that even though moments of radical disruption, such as the 2007 financial crisis, reward investors who make a big bet on major change, “ultimately, market timing is an exercise in futility. When you’ve got dramatic movements in the markets you can identify after the fact a handful of investors that succeeded in the short run. But making big, aggressive asset allocation moves isn’t a strategy that’s likely to prove successful in the long run.”
Years of steady, exceptional performance have made Swensen an investing legend among the cognoscenti and largely insulated him against questions, such as these, about his investing approach. ...

Dr. Swensen is a far wiser and more experienced than I am but I am not sure the questions or the answer really probed the more important issues related to the Yale model. Those would include the issues of liquidity, leverage and transparency related to the alternative investment vehicles. After accounting for those additional risks was the portfolio adequately compensated relative to a portfolio of more liquid transparent instruments with no leverage ? Wouldn't a proper alternative (pun intended) portfolio to the Yale model be one that holds allocations of global stocks, commodities, and various types of fixed income through liquid and transparent vehicles such as etfs combined with a cash cushion to meet liquidity needs ? Dr. Swensen seems to acknowledge that such a strategy is probably best for most investors and he seems to argue that the best thing to learn from the Yale investment experience is how difficult if not impossible it is to replicate :

....He says the crisis has reinforced his view that the most important investing advice is “you should invest only in things that you understand. That should be the starting point and the finishing point.”
For most investors the practical application of this axiom is to invest in index funds (low-fee investments that aim to mirror the performance of a particular stock market index). “The overwhelming number of investors, individual and institutional, should be completely in low-cost index funds because that’s easy to understand.”
Even after the battering of 2007 and 2008, Swensen is not optimistic that many will follow his advice: “The investment community is hopeful – hopeful’s probably too weak a word – wildly optimistic about their particular chances ... Never underestimate the gullibility of large pools of money.”

Swensen says his criteria for selecting outside money managers are simple: “The most important thing is character and the quality of people. That’s also the second most important thing and the third most important thing. It’s everything.” Assessing character involves such deep background checks that, says Swensen, “Some of our managers will tease us about having tracked down their high school geometry teacher.”
Such basic research would have protected investors from the convicted fraudster Bernie Madoff, Swensen says: “If you sat down and had a conversation with him about his investment activities and couldn’t figure out that he was being evasive, shame on you.”

Thursday, October 8, 2009

Searching For Alpha ? Don't Look For It in An Active Mutual Funds

Kudos to Morningstar for producing an in depth study of whether active mutual funds produce additional returns on a risk adjusted basis.

Despite the fact that Morningstar's core business is to review and rate actively managed mutual funds, one has to sit up and take notice when they reach the following conclusion (although I would hardly have expected them to come up with a different result from their research).

As the WSJ reported (my bolds and italics)

While it's been established that most actively-managed mutual funds lag their indexes over time, a new study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis.

The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn't justify the returns they earned. Not only should that be a warning sign for investors -- because greater risk means greater volatility -- but it also suggests that fund managers aren't living up to what's expected of them.

The study by Morningstar Inc. found that while about half of actively-managed funds outperformed their respective Morningstar style indexes over the past three years, only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns

Although few would enter into the strategy listed below, it makes perfect sense. Active managers have no consistent skill in outperforming the market yet charge for managing money much greater than and index fund. Therefore the most direct way to increase risk in the quest for greater return is to simply leverage up the index investment. Of course we know that leverage has other potential drawbacks but that is the subject that I have dealt with in outher posts.

The key to thinking of risk in terms of returns versus an index, he said, is that in theory if an investor wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk -- and do so at cheaper cost to most actively managed funds. It's against this standard that actively managed funds should be judged, he said

Interestingly although I am certainly a skeptic of modern portfolio theory (MPT)
and the efficient market theory, in this case the above comment is both accurrate and consistent with that theory. If one believes, as I do, that the "weak form" of the efficient market theory is true = it is near impossible to significantly beat the market (the benchmark index) then the only way to reasonably hope generate excess return over the maket(index) return other than increasing risk through leverage.

Excuse the jargon but a portfolio composed of 100% of an S+P 500 index fund for example with 10% of the portfolio borrowed on margin and invested in the index would create effectively a 110% holding in the S+P 500. The portfolio would have an expected return of 1.1 times the index (both on the up and downside) and would have a beta (risk measure ) 1.1 or 1.1. times the risk of the S+P 500. No additional risk= no higher expected return.

Of course Morningstar's research guru can't articulate the logical conclusion from the study: ignore the idea of picking an active fund and stick to an indexed portfolio. Instead quite illogically he states:

Russ Kinnel, director of research at Morningstar, suggested investors looking for active management should head into the less risky funds.

"It's generally better to be in a lower risk fund," he said. "There's more consistency [of performance] and timing when you invest is less critical [in determining your returns]."

Human nature also plays a part, said Kinnel.

"It's harder for people to stay with funds that go up and down extremes," he said.

But Portfolio theory and the same logic that lead the Morningstar analyst to suggest that the most reliable way to avoid extreme fluctuations in a portfolio is not to try to choose less volatile actively managed funds. It is the mirror image of the
leveraged strategy described above. By increasing the % holdings of the risk free asset (tbills) and reducing the % holdings in the risky asset (the index
dex fund) one reduces the volatility of the portfolio along with the expected return.

So if investors understand their risk tolerance they can vary the percentage of their portfolio in an index fund (including leveaging to hold more than 100%)
with their holdings in risk free tbills as the most efficient and reliable way to manage risk and expected return

All of this is the bare bones of modern portfolio theory from Markowitz a basic concept that is pretty indisputable if you belief that alpha (excess reurn without excess risk) is not achievable on a systematic basis. The Morningstar study certainly seems to give evidence that alpha doesn't exist

The full Morningstar study is here
Some other pointsiliom the study:

Over a trailing five year period the odds were about even that an active fund would beat a passive one in the 9 morningstar style categories.But for both 3 and 5 year periods active funds did not add returns on a risk adjusted basis (i.e. there was no alpha)

Excuse the geekiness but Morningstar used both the Jensen and the Fama French alpha. The latter gives a better measure of how much the fund outperformed the index,rather than generating excess returns by holding assets outside its category, (he style drift I have disucess before). Using the Fama French alpha only 37% outperformed on a risk adjusted basis vs. 41% for the Jensen measure. And the Fama French alpha does not fully capture the effect of style drift.

Cash holdings are consistent across funds in contrast to the oft cited claim of those touting active funds that unlike an index active managers will know when to raise cash by selling stock and when to reinvest.

One more interesting finding: larger funds have lower alphas illustrating the well known phenomenon of closet indexing particularly for large funds. But here is an interesting wrinkle to that fact: Investors are know to chase performance, so when they learn of a fund that has performed well recently (from Morningstar,cnbc or other parts of the financial press) they rush to invest in that fund often one with a small asset base. The assets go up the fund becomes a closet indexer and whatever short term alpha might have existed is gone. Investors are chasing both performance and perceived alpha based on past data. But the likelihood is that they will put assets into the fund just when its alpha measure goes down.

In Response to Samuel's Comment (and maybe this will help some other readers)

I do plead guilty to aiming the level of this blog above that of the novice investor, although I think they will find much useful here.

My objectives are:

1. Not to offer short term market commentary, individual stock recommendations or recommendations among active funds.

2. To reinforce the importance of implementing a well diversified portfolio of low cost instruments and avoiding attempts at market timing.

3. To debunk material from the industry and in the press that touts strategies that don't meet the above.

4. Commentary on evolving trends in academic finance as it applies to investment portfolios.

5. Since I teach a course in investment management for not for profits, I have a special interest in that area and do comment on it. The recent developments in this area btw have great relevance to the overall investment world.

Despite the large number of books that tout the strategies I disagree with, there are a number of good books that at least provide the logic behing the "plain vanilla" version of my approach. A couple recommendations:

anything on investing by John Bogle
the Gone Fishin' Portfolio by Alexander Green and his website
The Wall Street Self Defense Manual by Henry Blodgett
The Four Pillars of Investing by William Bernstein (a bit more advanced)

So to be honest my blog is aimed at those who are pretty comfortable with the content above and probably even the material that would be taught in an introductory finance class and probably someone that reads the money and investing section of the WSJ fairly regularly (and avoids CNBC and especially Cramer).

But please keep reading and post questions in the comment sections, I will try to respond

Wednesday, October 7, 2009

A Must Read

From the excellent Financial Times article on the future of investing:

A great review of the shortcomings of Modern Portfolio Theory and the quest for a nwew model.

Wanted: A New Model for Markets

An Interesting Example of A Different Way of Looking at Risk....and A Sign Hope Still Springs Eternal

The Financial Times (FT) has been running a great series on investing with one theme being the need for a new model. One theme in the articles is the idea which now (finally) seems to be widely accepted, that MPT (modern portfolio) and its partner the efficient markets theory, while elegant in academia have shown little correlation (pun intended) to what goes on in the real world of financial markets. As John Authers the excellent writer for the FT points out in one of the articles:(my italics and bolds)

In the past 10 years, these models have become much more sophisticated, as investors add new asset classes that appear to have a low correlation with equities or bonds. Most prominently, this has involved diving into commodities and currency trading. But it has also been popular to try out esoteric strategies used by hedge funds, that were designed not to correlate with the market, as well as highly illiquid investments in forestry or energy.
Last year this approach came catastrophically unstuck, as virtually all of these asset classes fell in unison. This was a disaster for institutional fund managers.
“The correlation between supposedly uncorrelated assets was higher in the up market and much higher during the down market than they had been led to believe,” says Amin Rajan, of CREATE Research of in Kent, southern England, who said that many institutions wanted to follow the trail blazed successfully by big endowments such as that of Yale University. “These models hadn’t been stress-tested. They went into it on the principle that these opportunities existed, and there was a first-mover advantage. But they had no governance structures and no skill sets to manage those risky assets.” Asset allocation previously proceeded on the assumption that correlations between different asset classes were relatively stable over time. One implication of the crash is, therefore, likely to be that the alternative asset classes, such as commodities, that gained favour because they appeared to have a low correlation with stocks and bonds could now lose popularity....

The article cites an interesting different way of risk proposed by Wells Fargo Asset Management I couldn't agree more:

.... of “alternative risk budgeting”, comes from Wells Fargo, a company that was in the forefront of developing modern portfolio theory a generation ago.
All look at the risk of outright loss, rather than the volatility of returns.
This requires asset allocators to look at nine different kinds of risk: concentration risk (the risk that many investors have crowded into the same strategy, making it more prone to sudden busts); leverage risk (which multiplies both gains and losses); liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price); transparency risk (if the investment structure is too complex to understand, Wells Fargo suggests, it is too risky); sensitivity to the overall equity market, and bond market; event risk (the danger an unforeseen event could pose); volatility risk (the extent to which returns vary); and operational risk, which includes various risks of businesses failing to perform.

The article mentions as "similar" the following approach from Pimco. I find far less substance to the Pimco approach but more on that in a future post.

Mohamed El-Erian, head of the large bond management group Pimco, suggests that asset allocation should be about the “risk factors” of different investments, rather than about asset classes. “The same risk factor can apply in different asset classes,” he says. For example, there is an equity risk factor in corporate bonds. “What makes this interesting is that it’s not just about the classic factors like equity, or default, or interest rates, or inflation or liquidity. There’s also a risk factor, which is public policy. Whether we like it or not, government has become an integral part of markets

I'm not quite sure what the above means...more later.

Mr. Authers is a very bright man yet even he falls into the camp of "looking for alpha" arguing that most of a portfolio should be indexed but that a small % should be allocated to "genius managers" Needless to say I agree with the former and strongly disagree with the latter.

Auther writes

Other changes are afoot. The steady shift towards passive investing (merely attempting to replicate a benchmark, rather than to beat it, and saving on expenses) is likely to stay intact. ....
There will also be a change in the way brokers analyse retail mutual funds, and the way pension consultants analyse institutions. Over the past 10 years the “style box” approach has predominated..... managers have skill, and then to give the truly gifted managers greater autonomy. Rather than “closet indexing” – staying close to a benchmark – the idea is that assets should be truly passive, or entrusted to managers with skill. ...
““You’ll see a move away from the practice of constraining managers and towards absolute returns, as opposed to relative nonsense.”
Ill have more to say in a future post about "absolute returns" funds which to me is a fad. Firstly few of these "absolute return" managers fared will in the recent crash, they proved to be heavy in leverage and illiquid assets. In fact they were high in virtually all of the risk categories listed by Wells (above).

So in my view the search for extremely talented go anywhere investors will prove no more successful than those within categories. There is likely to be little consistency in returns and in fact rather than having skill in a narrow niche of the market these absolute return investors must have even broader skills. As Naseem Taleeb writes in Followed By Randomness manager luck is often misinterpreted as skill.

Finally as the head of one of the largest absolute return managers writes, these managers will likely be more conservative going forward eliminating one of their major tools for outperformance :
Investors will also be more conservative, particularly when it comes to leverage. Clifford Asness, founder of AQR, says: “For the foreseeable future, I think people will be much more sensitive about getting into a leveraged trade. While leverage will still be a useful tool, all-else-equal, the smarter investor will always prefer the less leveraged trade, and more so going forward.”

I still feel that while MPT is oversold, a prudently diversified portfolio with passive vehicles is the best approach. Importantly it guarantees avoiding all of the key risk factors cited by Wells...somethin absolute return managers cannot assure/ Searching for "absolute returns" is just another word for the elusive quest of "searching for alpha". In my view absolute return funds are simply a fancy way of saying "we have a genius manager, trust us and give us your money to manage" thanks.

Tuesday, October 6, 2009

Stanford Goes For Liquidity...and Others May Have to Mark Down Their Portfolios

Stanford has decided to try to sell off some of its venture capital holdings in an effort to raise cash. As noted in the nyt today, this move could have wide expectations for its fellow university endowments.

First off, the move represents a further retreat from the "Yale model" which incorpates large holdings in alternative investments such as private equity, hedge funds, commodities, and real estate. As I have noted in earlier posts, the financial market's meltdown revealed several unanticipated aspects of the strategy. The alternative assets did not provide the desired diversification relative to conventional asset classes. Additionally, the consequences of the lack of liquidity in these altertaive asset classes meant that the endowments had to either borrow or sell more liquid assets to raise funds for current expenditures. Selling off the liquid assets of course would make the alternative assets an even larger percentage of the portfolio holdings.

Stanford's solution is to sell of parts of its private equity investments to third parties since it cannot liquidate the holdings with the private equity firms. As noted in the nyt article(below), the transactions are likely to be consummated at price levels far below reported values. Harvard reportedly shopped around some of its private equity holdings and balked after receiving bids for 50 cents on the dollar.

The potential sale raises some interesting questions:

1. If Stanford sells of some of its private equtiy holdings at deep discounts to their reported value will it be able to justify valuing its remaining private equity holdings without factoring in a discount to reported value ?

2. Even more evident, as noted in the article, are the consequences for other universities that hold investments in the same private equity firms. If Stanford has established that fair market value for the holdings is way below reported value, how will the other endowments justify not "marking to market" their holdings.

Although college endowments are allowed to value their assets at a hold to the maturity value will the trustees of these schools accept such a methodology. And even more important, should a University doing financial planning use an endowment value they know is way above market values.

Will Universities wind up using "shadow accounting" with internal planning based on an endowment value well below the externally reported value ? And what will the Univesities use in fundraising: a low number in an effort to indicate the importance of raising new monies (thus acknowleding larger than reported investment losses) or a higher number which would make the university look unrealistically financially secure.

Ironically the above issues are quite similar to the ones that arose when the major banks balked at selling off their "toxic assets" through some type of market mechanism. Once a market price is established it is difficult to argue that the whole asset class shouldn't be marked to market. And the dispute between mark to market vs another "fair value" (or mark to myth to the skeptics) as a method for valuation was a key feature of the debate over bank balance sheets.

my bolds my comments in italics

October 6, 2009
Investment Indigestion at Stanford

Stanford University is holding a garage sale....

During the boom times, Stanford Management, joined other endowments in a rush to plow increasingly large percentages of their funds into private equity, real estate and other illiquid investments — committing some $12.6 billion of the university’s endowment.

But then the market soured, and Stanford’s endowment lost $4.6 billion in value in its last fiscal year, a decline of 27 percent. So it now seems to be suffering from investor’s remorse.

Its plan to sell part of its stakes in private equity firms — a bid to raise $1 billion or more — appears to be an attempt to cut losses on current investments and a way to get out of committing more money to future deals....

Harvard, whose endowment shrank 27.3 percent last year, looked to sell some assets earlier this year. But given the lukewarm response, it struggled in a bid to sell about $1 billion of assets before pulling the sale. The California Public Employees’ Retirement System has been looking to sell, too....

Stanford isn’t planning to sell stakes in individual private equity deals. Rather, it wants to sell its place as an investor in private equity firms. (The funds, of course, won’t just let endowments out of their commitments.)....

.. it’s a rare chance to get a portfolio of this quality and of this size.”

Even so, Stanford’s decision will send a chill through the halls of endowment offices at other universities. By trying to sell such a large position all at once, Stanford will invariably depress prices for any institution considering a similar move....

it did,in fact, already take out an expensive $1 billion line of credit as a cushion in the event that it needed help keeping the lights on for students. Its decision, according to people who have been briefed on the university’s thinking, is a strategic one — it wants to reduce its exposure to future private equity deals.

But taking this step suggests that Stanford wants to distance itself from other endowments like that of Yale, led by David F. Swensen, who pioneered the push toward universities holding illiquid investments.

That strategy is often called the Swensen model. His fund has been decimated as well, falling $5.6 billion, or 24.6 percent, in the last year. (The average large university endowment dropped 17.2 percent in that period, according to the Wilshire Trust Universe Comparison Service.) But unlike Stanford, Mr. Swensen is not changing course and selling assets — at least not yet.

Stanford will be trying to sell to a group with some pretty hardball techniques when clsing deals:

When Stanford tries to sell its stakes in private equity portfolios, it will be entering a netherworld of secondary deals inhabited by a small cadre of investors looking to buy stakes on the cheap. They include AlpInvest Partners, Coller Capital, Credit Suisse, HarbourVest Partners, Goldman Sachs and Lexington Partners. The auction is being handled by Cogent Partners.

Nyppex, which tracks secondary deals, said that earlier this year such deals were made at 29.3 cents on the dollar, based on net asset value.

That number has moved up in recent months as confidence has returned to the markets, and Nyppex’s latest estimation indicates that recent deals have gone for an average of 51.58 percent of net asset value.

One question that has vexed the endowment industry is how to determine the value of portfolios. At the end of every quarter, private equity firms typically send out current valuations of their portfolios and the endowments accept them at face value.

But what happens if Stanford is able to sell its stake at only 50 cents on the dollar, for example, when K.K.R. is listing it at 80 cents? If other endowments hold similar stakes, what happens to their value?

This is still a hypothetical, because unlike investment banks, endowments don’t have to mark to market. Instead, they value their assets on a hold-to-maturity basis, which means they should not have to reduce the value of those portfolios in the short term.

But if things get worse, will they have to?
Universities specialize in the art of big-picture questions. This probably isn’t one they want to contemplate.