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Wednesday, February 24, 2010

Is Inflation Coming ?

Mr. Market doesnt seem to think so. WSJ reports on the most first  auction of  30 year tips (treasury inflation protected securities) in nearly 10 years. The journal thinks the auction was weak, I read it as saying mr. market doesnt see much prospect for a period of the kind of inflation some are warning about.  My comment in blue

Long-dated Treasury prices fell following a weak auction of $8 billion in 30-year Treasury inflation-protected securities, the first leg of $126 billion in government debt sales this week.
In the first sale of 30-year TIPS in nearly a decade, the government on Monday had to pay to find a home for the securities, though demand was solid at the higher yields.
The absence of a 30-year TIPS sale for some time may have hurt the market's ability to gauge pricing for the auction, traders said.
Timing was also an issue: The sale came after a muted consumer-price-inflation report Friday, which showed the core gauge unexpectedly dropping for the first time in 28 years.
"If you look at the auction under a microscope, it would be considered a bad auction," said Michael Pond, interest-rate strategist at Barclays Capital Inc. That was mostly because of the gap since the last issuance, he said.
"It just created uncertainty, and investors tend to take less risk in uncertain environment," Mr. Pond said.
Monday, the 10-year note was down 4/32 to yield 3.797%. The 30-year bond was down 15/32 to yield 4.731%. The two-year note was up 2/32 to yield 0.891%.
The yield on the new 30-year TIPS came in more than 0.06 percentage point higher than dealers expected—it "tailed," in market speak. The 30-year TIPS came in at a yield of 2.229%, above the 2.164% the market was expecting before the auction. Bond yields rise when prices fall.
Market participants use the difference between the yield on conventional bonds and tips = the breakeven inflation rate as the best proxy for the market's inflation expectation. After all, compared to the scribblings and prognostications of analysts this is something people are putting real money behind.

So based on the 30 year concentional bond yield of 4.731% and the TIP yield of 2.229% on gets an inflation forecast by treasury bond market participants of  2.44%. Interestingly that is very close to the Feds long term inflation target of 2.5%,

I generally pay great respect to the message that Mr. Market is sending. Certainly alot more than to those buy gold inflation is coming ads on tv and radio.

About Those Quants

I just finished The Quants by Scott Peterson, definitely an entertaining account of the rise and demise of  quantitative traders and the role they had in the financial crisis,

What was most striking was that when the models ceased working, the traders scrambled to stop the bleeding on the p/l by reverting to the trading style of the "gut feel" traders with long experience in the markets that they felt they had replaced.

Patterson recounts that Boaz Weinstein the top trader at Deutsche Bank pleaded with his risk managers to "ignore the models" and let him take massive short positions to try to salvage his funds' performance. A quant who argues with his risk managers that the only way to make money is to ignore the quantitative models.

Meanwhile Peter Muller head of Morgan Stanley and others were trying to make use of the skills they had honed at the high stakes poker games the quants loved in order to make their trading decisions. The only difference is that instead of the sums at stake reaching into the high 5 figures the numbers here were in the 10s an 100s of million$. .  The traders were trying to figure out who was liquidating positions, who was waiting to liquidate positions if the market stabilized, or whether the selling had been exhausted and there was a massive buying opportunity. Again the quantitative models were useless they were back to the techniques of poker and the old style market savvy traders.
As Peterson writes:

Muller kept ringing up managers trying to gauge who was selling and who was not . But few were talking. In ways Muller thought it was like poker. Some might be bluffing putting on a brave face while massively dumping positions some might be holding out, hoping to ride out the storm...... 

from AQR co founder John Lew:

It was a little bit lof  a poker game. When you think about the universe of  large quant managers, it's not that big. We all know each other. We were all calling each other and saying 'are you selling ?' 'are you".

Pretty scary: the fate of the worlds financial markets in many ways hanging on the outcome of a few guys playing massively high stakes poker with their lightly regulated hedge funds.

As Patterson notes in his final chapter the quants have moved on , Much as in the early days of their erstwhile quant strategies they seem to be reaping consistent profits with their new strategies based on super fast in and out trading based on quantitative algorithms.

The footprints of the impact of the growth of these strategies was evident in a recent study reported in the financial times. The average trade size on stock exchanges around the world is dropping sharply. For instance in 10 yrs the average trade size at the nyse euronext has dropped from just under $59,000 to $6,442.
The reason: (my bolds my comments in blue)

Orders are being sliced into smaller sizes amid a growth in algorithmic trading, a technique used by high-frequency traders at banks, hedge funds and specialist high-frequency firms.
Via software programs, algorithms decide when, how and where to trade certain financial instruments without human intervention.
High-frequency trading uses algorithms to trade at ultra-fast speeds - often 1,000 times faster than the blink of a human eye - seeking to profit from fleeting opportunities presented by minute price changes.....
And just as in the case of the earlier generation of quant trading the potential exists that these techniques could cause a major destablization in the global financial markets. Another FT article reports on market dislocations that have already been caused by this type of trading which only give a hint of the potential system risk. 

But once again the potential for their actions causing large scale market disruptions definitely hangs over the market.
The transformational extent to which markets are being moved by machines, and the scale of involvement by high-frequency firms, are raising two concerns. First, has technology reached the point where machines pose systemic risks if they go berserk? Second, if business is now dominated by a few participants that have this technology, does this threaten the integrity of the markets, where a broad mixture of traders has long cohabited peacefully?...

The Federal Reserve Bank of Chicago, part of America's central banking system, in a paper published this month, says: "The high-frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than in a floor or screen-based trading environment. Although algorithmic trading errors have occurred, we likely have not yet seen the full breadth, magnitude and speed with which they can be generated

Monday, February 22, 2010

Broker ? Advisor ? Fiduciary ?

 In my last  post I wrote about the "controversy" over extending the fiduciary stndard to insurance salesmen and stockbrokers. This nyt article shows th confusion in action.My bolds my comments in blue

Broker? Adviser? And What’s the Difference?

THE Great Recession has intensified a long-running debate: who is better able to look out for your money, a broker or an independent adviser?
Now that the shock of last year’s losses has worn off, many investors are reconsidering what their financial professionals did — or failed to do — for them. At the same time, many brokers are trying to refocus themselves as advisers. Fed by the discontented, the debate has taken on a new urgency.
At the center of the discussion are business practices and regulatory guidelines that are rarely understood by the client and often blurred in practice. Brokers are governed by the “suitability rule,” which requires them to have “reasonable grounds for believing that the recommendation is suitable,” according to the Financial Industry Regulatory Authority. Registered financial advisers are supposed to adhere to a higher standard — “fiduciary responsibility,” an ethical and legal requirement that the investor’s best interest comes first, not the adviser’s own financial gain.
The conventional view of the two camps goes like this: the brokers at the big firms have access to every product imaginable, but may be pressured to sell you one of them and earn more if they do. They are not obligated to get you the best price for what they advise you to buy or sell — or even to be free of conflicts.
The independent investment advisers proudly promote their independence and lack of conflicts. If their clients feel that the fiduciary responsibility was not met, they have legal recourse through the state courts. Brokers counter that the advisers lack the infrastructure and support of a big firm that would protect clients in the event of irregularities in their accounts or with their advisers.
In practice, though, the two standards seem to confuse investors. Congress is now considering a provision that could alleviate some of this confusion by requiring brokers to act in their clients’ best interest. “I don’t know if more than 10 to 20 percent of my clients understand the difference,” said Susan Fulton, president of FBB Capital Partners, a fee-only adviser outside Washington. “The investment advisory and brokerage businesses don’t make it clear.”....

Most registered investment advisers started at brokerage firms, and many left, they say, because they grew tired of the conflicts of interest. This trend is accelerating, says Schwab Adviser Services, which acts as a custodian for $590 billion in assets managed by 6,000 advisers. It said 2009 was its best year for signing up new advisers, with 172 new teams and $13 billion in assets.

The big brokerage firms, meanwhile, scoff. “I’ve read that advisers are leaving here at record levels, but in the fourth quarter we had historically low attrition levels among our financial advisers,” said Sallie L. Krawcheck, president of Bank of America Global Wealth and Investment Management. She reeled off the advantages to being with a big firm, like continuing education for brokers and products and loans offered by other parts of the firm. 

Well....the largest number of independent advisors work with one or more of three firms Charles Schwab,Fidelity and TD Ameritrade, I can't think of any financial products on couldnt find through them. As for continuing education, my inbox is full of offers of continuing education materials and presentations from the etf providers, mutual funds and others. And I am not obligated to attend any of these that I perceive as more "sales pitch" than "continuing education". Nor I am obligated to attend any "continuing education" that is designed to improve my sales skills rather than my knowledge of the investment world.

“The business has gone through brokerage to investment management to wealth management,” she said. “Now clients want us to take it more broadly than that.”
What may matter more than the array of services is the mind-set of the adviser. When a broker tells a client to buy or sell something, the suitability rule does not mean the broker has to be free of conflicts of interest. After all, the broker’s salary is ultimately paid by the brokerage firm, which has various products to sell. But brokerage firms say they are trying to eradicate that appearance of conflict.....

 others still hold to the traditional distinctions. “There are people who are very successful brokers who do a great job every day,” said Kemp Stickney, chief fiduciary officer at Wilmington Trust, a century-old fee-based trust company. “But if you think about it from an investment point of view, the way a lot of brokerages work is they sell you a bond out of their inventory. Because we’re not an investment banking firm, we have to ask for bids from four, five, six different firms before we buy a bond for our clients.” (Ms. Krawcheck says the array of products that Bank of America keeps in inventory is a benefit to clients.)
Advisers like Mark Matson, chief executive of Matson Money, said brokerage firms should get out of the advisory business altogether. “The problem is they hold themselves out as offering advice and value-added services,” he said. “They should just tell clients, ‘I work for a brokerage and I’m going to suggest some things, and you have to make the decision if they’re right for you.’ ”
This is where the fiduciary standard gets invoked. Rooted in trust law, that standard means that an adviser has to act impartially and solely for the benefit of the client, avoiding conflicts of interest and self-dealing.
“It’s never about us; it’s about our clients and their interests,” said R. Hugh Magill, chief fiduciary officer at Northern Trust. “They entrust their assets to us for management. But the more subtle distinction is they entrust their family to our care.”..

Of course, some investors do not have enough money to attract the interest of a top adviser. It should not come as a surprise that the level of personalized service gets ratcheted up with wealth level. Mr. Rubin’s clients have a minimum of $5 million with him, while Mr. Campbell’s clients have $1.5 million to $2 million. Most registered investment advisers require a minimum investment of $1 million, though some will accept clients with $500,000.
“If you have less than $250,000, you’re not going to get that first-class level of service,” Mr. Oechsli said. “You’ll probably get a review once a year, quarterly contact. There’s nothing wrong with that.”
That means the one looking out for your interests may have to be you.

I generally hold to a cutoff around that $250,000 for investment management services on a full time % of assets under management basis. But that is largely based on the value proposition for the client. Under that amount a fair amount of what I do with asset management isnt very effective. Allocating a $100,000 portfolio across 10 or more etfs and closely managing for rebalancing and tax loss harvesting probably doesnt generate meaningful value added vs a more simplified approach. For that reason I usually do a an asset allocation and consultation for a smaller client for a flat or hourly fee and sent the client off to implement it on their own at a discount broker. This is even more appropriate if a large part of the assets is in a 401k plan with more limited investment choices. I recommend the clients of this service come back for an annual review or there are any major changes in their circumstances. I think this a fair balance for people who dont need a more expensive full time advisor but dont want to be left on their own (or at the mercy of someone looking to generate commissions).

Wednesday, February 17, 2010

Why is This At All Controversial ?

Registered Investment Advisors (like me) are held to a fiduciary standard they are always under a legal obligation to put the customers interests first. Thus it seems to me quite amusing that those not currently held to that standard: stockbrokers and insurance agents would fight so hard against having that standard applied to them. I would certainly plead guilty to being biased but would reading this nyt article on the debate over this issue and financial services reform give one pause before choosing to work with a stockborker or insurance agent  ?  While we wait for financial reform from our legislators it's not a bad idea to give the book pictured above a good read.

My bolds my comments in blue

Struggling Over a Rule for Brokers

While most of the debate about financial overhaul legislation has focused on the impact on how big banks do business, one piece that would affect consumers directly has received little public notice: a requirement that stock and insurance brokers act in their customers’ best interest.
And that provision may not make it into the final overhaul plan.
The insurance industry, in particular, has been fighting the requirement......

At issue is whether brokers should be required to put their clients’ interest first — what is known as fiduciary duty. The professionals known as investment advisers already hold to that standard. But brokers at firms like Merrill Lynch and Morgan Stanley Smith Barney, or those who sell variable annuities, are often held to a lesser standard, one that requires them only to steer their clients to investments that are considered “suitable.” Those investments may be lucrative for the broker at the clients’ expense.
Over the years, it has become more difficult for consumers to understand where their advisers’ loyalties lie, especially as the traditional stock-peddling brokers have started to look and act more like financial advisers. The fact that some brokers can wear two hats with the same client — that is, provide advice as a fiduciary in one moment, but recommend only “suitable” investments in the next — only adds to the confusion, experts said.
So as part of the more sweeping effort to overhaul Wall Street, both houses of Congress included measures that would subject brokers to the tougher standard. On the surface, both the brokerage and financial planning industry appear to agree that advisers of all stripes should be subject to a consistent fiduciary standard. But behind the scenes, the groups are divided on how exactly it should work, while the insurance industry is opposed to a fiduciary standard altogether.....

.....(financial) planners, along with consumer advocates, support the proposal in the original draft of the Senate financial reform bill by Christopher J. Dodd, the Connecticut Democrat who is chairman of the Senate Banking Committee. That proposal would simply erase the brokers’ exemption from the Investment Advisers Act and require them to register as advisers, making them fiduciaries.
“The Dodd bill is broader and stronger,” said John C. Coffee, a professor of securities law at Columbia Law School. “In the full-scale House bill, you see how limited it is. The House makes a new limited fiduciary standard to broker dealers, but only when they are giving personalized investment advice” about securities to a retail customer.
Consumer advocates say the phrase “personalized investment advice” leaves too much room for interpretation. What is more worrisome, they say, is that the House version would also not require brokers to “have a continuing duty of care or loyalty to the customer” after providing that advice. That could lead to “hat switching,” they say, where the broker wears his fiduciary hat when giving advice, but changes to the suitability hat when recommending products. 

The position of the securities industry strikes me as indicating it doesn't have the consumers' interests at heart

We certainly don’t want a watered-down standard,” said Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association, a trade organization. He said the association preferred the House version.
So they don't want a watered down standard but they prefer a stnadard that doesn't require that the broker have "continuing care or loyalty to the customer". In other words a standard less than that of a registered investment advisor even though the broker's business card says "financial advisor" or something similar (no one calls themselves a stockbroker anymore in my experience). Any wonder why people dont trust Wall Street ?

As for the insurance industry they just want nothing to do with the idea of putting the customer's interests first:

The insurance industry, however, is opposed to any additional regulation. ......I
Mr. Bullard said the insurance industry was “apoplectic because if they sell a variable annuity and they are subject to fiduciary duty, that means they will probably have to fully disclose the compensation they are getting.” This, he added, “would make clear the excessive incentives they have to mis-sell the variable annuity, which has been the cause of regulatory problems in that area.”
Richard G. Ketchum, the chief executive of Finra, said there had long been problems with how brokers disclosed their conflicts and how they pushed products “and whether they push products because they have an employee incentive or if it’s a proprietary product.”
The House bill makes sense, he added, in that it outlines a fiduciary standard and then leaves it to the S.E.C. to define it

Bottom line: it seems that even with any proposed changes to regulations governing the financial services industry the standards will not be uniform and only registered investment advisors will be held to the highest standard of placing the clients interests first.

Tuesday, February 16, 2010

Another Argument for Indexing

 Since index funds/etfs are by definition buy and hold they certainly avoiding having the problems listed in this  wsj article associated with your investments. Now all you have to do is keep yourself from rapidly jumping in and out of the hundreds of etfs and index mutual funds now available..In fact it seems that the more the manager of your actively managed mutual fund trades the less likely he is to produce superior performance and he is surely more likely to generate more tax headaches for you.

my bolds below

High Trading Is Bad News For Investors

Buy-and-hold hasn't looked too good lately, but churn-and-burn is no better.
Stocks are sloshing around faster and cheaper than ever. You can trade online for $7.95 or less. Nearly 2 billion shares are handled daily on the NYSE, not counting trades in rival markets. Throw those in, and trading is a tidal wave, averaging 9.4 billion shares so far in February—up from 9.1 billion in January, says Rosenblatt Securities.
Pause before you plunge. Trading costs money, raises your tax bill and can reinforce bad habits. As Benjamin Graham defined it, investing requires "thorough analysis" and "promises safety of principal and an adequate return." Trading on rumors, hunches or fears is antithetical to investing.
Mr. Graham insisted that "the typical individual investor has a great advantage over the large institutions"—largely because individuals, unlike institutions, needn't measure performance over absurdly short horizons. The faster you trade, the more you fritter away that advantage.
A new study by Mercer, the consulting firm, and IRRC Institute, an investing think tank, asked the managers of more than 800 institutional funds how often they traded.
Two-thirds had higher turnover than they predicted; on average, they underestimated their turnover rate by 26 percentage points. Even though most are judged by performance over three-year horizons, their average holding period was about 17 months, and 19% of the managers held the typical stock for one year or less.
One vehemently denied being too focused on the short term, complaining that hedge funds "have caused market-wide turnover to increase" and that "retail investors tend to look at short-term performance and move in and out of funds" too quickly.
Those who live in glass houses shouldn't throw stones; this manager, according to Mercer, holds the typical stock for about 27 weeks at a time.
Even while grousing that the market is too short-term oriented, these experts think they can beat it by being even more short-term oriented themselves. "There's a very deep level of overconfidence," says Danyelle Guyatt, one of the study's co-authors.
For individual and professional investors alike, more trading doesn't ensure higher returns....

According to Morningstar, mutual funds with the highest portfolio turnover rates have underperformed the slowest-trading funds by an annual average of 1.8 percentage points over the past decade. A study of pension-fund stock portfolios found that, on average, the funds would have raised their annual returns by nearly a full percentage point if the managers had gone on a 12-month vacation and never made a single trade.
That is probably because so many investors tend to sell winners too soon. Only later—if ever—might you notice that you replaced a winner with a stock that isn't as good. Meantime, locking in a gain makes you feel that have accomplished something.
"It is difficult to justify your existence [as a money manager] by not taking action," says Jon Lukomnik, a co-author of the Mercer/IRRC study. When markets are wrenching up and down, he adds, "It takes a very secure person to say, 'I don't have to trade.'"
It also is worth recalling what Warren Buffett wrote in February 1992, when the Dow was at 3200: "The stock market serves as a relocation center at which money is moved from the active to the patient."

Wednesday, February 10, 2010

Should This Really Be Your Core Bond Holding ?

Bill Gross (pictured at left) is a far brighter guy that me and is generally regarded as one of if not the top bond market investor. His Pimco Total Return Bond Fund is the largest bond fund in the world and has an impressive track record.

Nevertheless, I do not think it should be a core bond holding for any investors portfolio.In fact it probably takes the place (if there is one) of a hedge fund than bond mutual fund in a portfolio allocation. I say that because the fund literally can go anywhere in the area of fixed income domestic or interenational, treasury agency or corporate and any maturity. And because of the way actively managed mutual funds report their holdings one never knows in real time what it holds.

An example of this could be seen in the WSJ yesterday: my comments in blue

Bond-Fund Investors Can Rest Easy, Mostly


to Greece and Its Ilk Is Minimal

Most bond funds will dodge the debt meltdown in Greece, but about a dozen U.S. funds have at least five 5% of their assets there and in other financially troubled European nations, such as Portugal, Ireland and Spain....

Pimco Total Return Fund, often described as the world's largest bond fund with more than $200 billion in assets, recently increased its exposure to international bonds, to about 20% at Dec. 31, from about 9% a month earlier. Because the move was so recent, it wasn't clear precisely what kind of debt the fund bought. A spokesman says portfolio managers have been emphasizing the German government bonds, while issuing warnings about bonds of Greece, Spain and Portugal. So far this year, the fund has returned 1.8%
In my view the above is quite disturbing regardless of returns. For one the fund holds 20% foreign bonds, secondly the fund doubled its international holding in such a short period of time.

The bond allocation in a portfolio should be designed to provide stability and low risk returns. I like the terminology "umbrella" for the bond allocation: something that should shield a portfolio in times of market turmoil . The expected performance of the bond allocation should be low risk and low return.

Based on the above it seems clear to me that the Pimco Total Return should not be a core bond holding since its holdings often deviate from the guidelines for an "unbrella" holding. Furthermore I always strive for "style purity" and transparency in my portfolio holdings. For that reason I use only etfs and bond funds in my portfolios, funds in the appropriate category are available from all the major providers Vanguard etfs are the lowest cost alternative
Despite this I have seen many publications and websites recommend Pimco Total Return as the main bond holding.

 pimco itself describes its fund as follows on its website

Investment professionals recommend building a portfolio diversified with stocks and bonds to help achieve your long-term financial goals. Regardless of whether that diversification strategy leads you to invest in two mutual funds or twelve, PIMCO Total Return Fund can be the foundation of your portfolio's bond holdings. The Fund invests primarily in an intermediate-term portfolio of investment grade securities - a combination that offers investors an attractive risk/reward profile.

Even worse I have seen many 401k plans where Pimco Total Return is the only alternative as a bond holding. i advise readers to do what I do with my clients in such a situation: skip the total return bond fund, put the 401k funds in whatever stock index funds are available. Then put monies in non 401k accounts in the bond etfs or funds of the type described above. Ideally this can be done so the $ amount to be allocated in bonds in your total investment assets can be done through this methodology. If not, obviously things get more complicated.

Not surprisingly the bond ets carry far lower management fees than the Pimco Fund. The retail no load class of the Pimco fund  carries a management fee of . 93 %.The Vanguard bond etfs are around .15%. And a word to the savvy Pimco manages the Harbor bond fund with the same portfolio. The management fee is..76%.  .17% may be alot of money but on the other hand there is absolutely no risk in choosing harbor over the pimco fund..


Thursday, February 4, 2010

Black Swan Hedge Update Feb 4 Market Close

SP 500 -3.1%
EEM (emerging mkts) -4.5%
EFA (developed markets) -4%

VXX volatility etn  +11%

Oh and that hedge for times of uncertainty in the midst of massive stock selloff and talk of major european countries defaulting on their debt:

GLD (gold) -4.1%

Tuesday, February 2, 2010

This Book Is Out Today and I Ordered It

This excerpt in the WSJ and this appearance on NPRs Fresh Air( transcript here)convinced me this will be a great read. The book focuses on the growth of "quants' on wall street  and how their activities in quantitative trading and derivatives contributed much to the market meltdown. And it wasn't the first time. As the author pointed out the first time this happened was in the 1987 market crash when portfolio insurance (essentially a short options position) played a crucial role in the meltdown. Add in LTCM and some other smaller blowups (many disastrous to individual funds or trading desks but not big enough to make the headlines) and the impact of the quants on markets is undeniable.

Another book written by a practitioner and a PhD quant Richard Bookstaber entitled Demons of Our Own Design makes similar points. Bookstaber had been in charge of risk management at several big Wall Street firms. He blogs here. In this recent post(below) he points out the crucial role of liquidity (everyone running to the exits at the same time) is responsible for much of the disastrous impacts of the quants models.

Essentially many of these products have option like characteristics and for many trading desks their positions are essentially short options. For those option geeks that means the trading desks are "short gamma" and as the market moves against them they need to sell increasingly larger positions to stay hedged. But the hedging required is not fixed it is a dynamic number and if there is large scale selling it will create a feedback loop with lower markets generating another round of selling. Hence: "demons of our own design" market demons created by the derivative products. Bookstaber makes these points well in his book.

He makes the same point in this entry on his blog where he argues it wasn't a lack of awareness of the existence of  fat tails
...So, to recap, we all know that there are fat tails; it doesn’t do any good to state the mantra over and over again that securities do not follow a Normal distribution. Really, we all get it. We should be constructive in trying to move risk management beyond the point of simply noting that there are fat tails, beyond admonitions like “hey, you know, shit happens, so be careful.” And that means understanding the dynamics that create the fat tails, in particular, that lead to market crisis and unexpected linkages between markets.
What are these dynamics?
One of them, which I have written about repeatedly, is the liquidity crisis cycle. An exogenous shock occurs in a highly leveraged market, and the resulting forced selling leads to a cascading cycle downward in prices. This then propagates to other markets as those who need to liquidate find the market that is under pressure no longer can support their liquidity needs. Thus there is contagion based not on economic linkages, but based on who is under pressure and what else they are holding. This cycle evolves unrelated to historical relationships, out of the reach of VaR-types of models, but that does not mean it is beyond analysis

I think this dynamic is part of the market puzzle that needs to be considered in addition to behavioral finance. I call it the institutional factor, the existence of large positions in the markets with option like characteristics, hedge funds with similar models of pairing long and short postions (like ltcm) done with leverage all create "demons" that can cause large spikes in volatility and market meltdowns (and meltups). it also happens in all sorts of smaller ways for instance unusual price movements when a particular security trades near a an option strike price where there are large positions, moves on dates of option expiry, unwinding of carry trades and more.

Much of this is well known in the micro world of specific markets but missed by the general public and most financial journalists and academics. I was amused by the excerpt from the Quants in the WSJ where hedge fund players ferverishly  unwinding their paired positions where they were long some stocks and short others in a "market neutral" strategies. As previously weak stocks rose and strong stocks fell the journalists struggled to provide a specious rationale.

Investors on Main Street had little idea that a historic blowup was occurring on Wall Street. AQR risk-management guru Aaron Brown had to laugh watching commentators on CNBC discuss in bewilderment the strange moves stocks were making, with no idea about what was behind the volatility. Truth was, Mr. Brown realized, the quants themselves were still trying to figure it out....

Everyday investors had no insight into the carnage taking place beneath the surface, the billions in hedge fund money evaporating. Of course, there was plenty of evidence that something was seriously amiss. Heavily shorted stocks were zooming higher for no logical reason. Vonage Holdings, a telecom stock that had dropped 85% in the previous year, shot up 10% in a single day on zero news. Online retailer; Taser International, maker of stun guns; the home building giant Beazer Homes USA; and Krispy Kreme Doughnuts—all favorites among short sellers—rose sharply even as the rest of the market tanked.
From a fundamentals perspective, it made no sense. In an economic downturn, risky stocks such as Taser and Krispy Kreme would surely suffer. Beazer was obviously on the ropes due to the housing downturn. But a vicious market-wide short squeeze was causing the stocks to surge.
The huge gains in those shorted stocks created an optical illusion: the market seemed to be rising, even as its pillars were crumbling beneath it.
Both Patterson's journalistic account and Bookstaber's view as a market professional both convince me to have that black swan hedge through a long volatility position as a permanent part of my portfolios.

Monday, February 1, 2010

Is This Actually News to Anyone ? You Can't Pick Hot Fund Managers In Advance

I have a thick file folder of articles on this point but in case this is news to anyone I thought I would highlight this article from the WSJ. Not surprisingly the folks from Morningstar try to spin in both ways and someone from a major brokerage firm tries to argue otherwise. But the bottom line remains the same it is virtually impossible to pick top mutual fund performers based on past data because there is little persistence in manager outperformance . The logical conclusion from the above is that mutual fund manager outperformance is just as likely to be the product of luck as it is to likely to be evidence of superior skill.

my bolds my comments in blue

With Fund Managers, Past Is No Predictor for Future

New studies cast doubt on whether fund-manager skill and past performance are good gauges of future results.
Advisor Perspectives, an e-newsletter for financial advisers, in December published a study suggesting that investment research firm Morningstar Inc.'s star ratings, which are based on past returns, don't provide much predictive value. It also found that many five-star-rated funds were likely to underperform their peers.
Robert Huebscher, chief executive of Advisor Perspectives, randomly selected a fund with a particular rating, and then looked at how it fared against randomly selected funds with lower-star ratings from the third quarter of 2006 through the third quarter of 2009. He found many cases where the lower-rated funds were more likely to outperform those with higher ratings.
Yet, despite those findings, "the public pour money into funds that get higher ratings," Mr. Huebscher says.
The perils of banking on past performance are clear to see. Bill Miller, manager of Legg Mason Capital Management Value Fund (trading symbol: LMVTX), posted an industry-record streak of beating his benchmark for 15 straight years. But investors joining the fund in early 2007 based on that record would have suffered a 6.7% loss that year, followed by a whopping 55% decline in 2008. Further illustrating that past performance isn't a reliable guide, the fund was up almost 41% last year....

Morningstar's vice president of research, John Rekenthaler, questions the time frame the study used. But while he disagreed with some of the details, he says he didn't have an issue with the notion that it is hard to use past performance to predict future results.
This is the often seen Morningstar two step: they have some problems with the study that shows their rankings tell nothing about past performance but they agree that past performance tells you nothing about future fund performance.
Can top managers repeat their performance?
According to a Morgan Stanley Smith Barney's Consulting Group study, the very best managers—the top 10%—can repeat their success; at least, they did in three-year periods from 1994 to 2007 covered in the study. But the study also finds that the worst 20% of performers are also likely to outperform in the future.
The study's author, Frank Nickel, says this is because the bottom funds benefit from changing market cycles: Their holdings were out of favor but then get hot and thus outperform. Mr. Nickel says that, rather than picking a fund based on manager ability, which his study concludes does exist, he would rather pick an unloved area of the market and ride its moves to the top.

Now this is an elaborate and obscure way of saying that their data tell nothing about manager performance they simply reflect the changing fortunes of various market sectors or asset classes. It isnt that the  manager was particularly bad in the bad years or good in the good years it's simply (to give an example) that the small cap value manager did very poorly relative to others when small value performed poorly and vice versa. Doubtles much the same would have occurred among various index instruments. We already know from many other studies that few asset managers outperform their relevant benchmarks and in fact when they do it is usually done by straying from their mandate (value found investing in growth domestic into international for example).
Another study contends that, outside the top 3% of funds, active management lags behind results that would be delivered due simply to chance.(which explains why one of my favorite finance books pictured above argues that we often incorrectly attribute results that are a product of luck to management skill)  This study, published late last year by Eugene Fama, professor of finance at the University of Chicago Booth School of Business, and Kenneth French, professor of finance at Dartmouth College's Tuck School of Business, ran 10,000 simulations of what investors could expect from actively managed funds.
Mr. Fama is one of the pioneers of the efficient-market hypothesis—the idea that securities are priced correctly because they incorporate all the known information relating to a company. So the latest study fits his views in finding that very few people can consistently beat the financial markets.

Some Graphs To Go With The "Black Swan Hedge " Post on Using A Volatility ETN as A Hedge

5 year charts here  on VIX the volatility index, spy (us sp 500), eem(emerging),efa(developed) shows the relationship between the volatility index and the movements in the stock indices