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Friday, April 30, 2010

As Predicted on March 22 The Little Guy Is Late to the Party...

and gves a nice bonus to those that have been in for the long haul

Wsj today

Funds Take In $12.58 Billion

NEW YORK—Long-term mutual funds had inflows, or net buying, for the latest week on continued strength for bond funds, while stock funds in the U.S. and abroad again reported inflows, according to the Investment Company Institute.
Total estimated inflows were $12.58 billion the week ended April 21. For more than a year, the bulk of investment in mutual funds has gone to bonds, which typically thrive in a lower interest-rate environment. Meanwhile, stock funds have failed to consistently attract new interest despite the stock market's sharp rally.
Stock funds had inflows of $4.76 billion in the latest week, up from $2.14 billion a week earlier. U.S. stock funds had inflows of $2.86 billion, while $1.89 billion was added to foreign stock funds.

The chart below of the SPY the sp 500 etf showsthe largest spike in volume this year since Feb. coincident with the recent mkt rise.

Thursday, April 29, 2010

THE WSJ RedefinesThe World of Finance

Holman Jenkins in the op ed section of the wsj today

First off, no security is more derivative than a share of stock, which is not really ownership of a company (though it's usually claimed so) but merely a right to whatever cash management deigns to share, plus a right to whatever is left over in a bankruptcy, plus a right to participate in corporate governance in whatever limited ways a company's bylaws permit.

from investopedia

Investopedia explains Stock
A holder of stock (a shareholder) has a claim to a part of the corporation's assets and earnings. In other words, a shareholder is an owner of a company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company's assets.

Investopedia explains Equity Derivative
Investors can use equity derivatives to hedge the risk associated with taking a position in stock by setting limits to the losses incurred by either a short or long position in a company's shares. The investor receives this insurance by paying the cost of the derivative contract, which is referred to as a premium. If an investor purchases a stock, he or she can protect against a loss in share value by purchasing a put option. On the other hand, if the investor has shorted shares, he or she can hedge against a gain in share price by purchasing a call option

What Does Underlying Security Mean?
The security on which a derivative derives its value. For example, a call option on Google stock gives the holder the right, but not the obligation, to purchase Google stock at the price specified in the option contract. In this case, Google stock is the underlying security

Mr. Market Gives Its Updated Inflation Forecast

Results of this week's treasury auction

5 year conventional bond: 2.54 % yield
5 year TIP real yield    .55%

implied inflation forecast  1.99%

Thursday, April 22, 2010

About that Schwab Yield Plus Fund

WSJ reports:a settlement in the investor case (and a likely $60 million payday for the attorneys)

Charles Schwab Corp. agreed to pay $200 million to aggrieved investors who claimed the online discount broker had deceived them, but shares rose as investors had feared the final settlement costs would be much higher.
The San Francisco company agreed to pay out to customers in its Schwab YieldPlus Fund, which the plaintiffs said deceived them about the nature of short-term investments on which they posted losses when the credit crisis struck.
Plaintiffs had claimed more than $800 million in damages. Schwab didn't admit liability under the settlement, which needs final court approval.

And this time around Morninstar is urging investors to stay away from the fund....better late than never I guess: from the wsj article

In a research note in late January, Morningstar fund analyst Miriam Sjoblom questioned whether YieldPlus could offer steady returns in the future.
"As the managers have continued to sell bonds to meet redemptions—the now $300 million-in-assets fund has seen $11.6 billion in redemptions since mid-2007—the fund's portfolio mix has been altered, and not for the better," Ms. Sjoblom wrote. "Its top 10 holdings...took up more than half the fund's assets as of the latest portfolio from Aug. 31, 2008." She added that such a "lack of diversification should consign the fund to a bumpy road ahead."

Friday, April 16, 2010

A Good Reason to Keep It Simple In Bond Investments

 The Wsj has a good article reviewing issues related to some bond funds labeled as ultra short term which carry very high credit risk akin to a long term bond in their quest for higher yields.

Probably the most notable in this category is the Schwab Yield Plus Fund.

The Schwab yield plus fund is pretty notorious among the knowledgeable. It was promoted by Schwab as a cash alternative prior to fall 2008 and was adopted as such by both individual investors and advisors as well.

Much to the dismay of all involved the market dislocations of 2008 showed where those high yields came from: increased credit risk even though the duration of the funds holdings was kept short. Essentially the fund held longer term bonds of corporations of low credit quality. Through the use of interest rate swaps they reduced the sensitivity of the holdings to changes of interest rates making the duration (sensitivity of a bond to changes in interst rates) short akin to a short term bond. But since the underlying bonds were of low credit quality and long maturity they reacted to the credit crisis based on the maturity. This study explains this in more depth,  it is from a firm that advises the litigators in a current. At least class action legal action  .

Here's the performance from the Schwab website

Cumulative Growth of a $10,000 Investment (pre-tax) Information Topic Icon

This graph represents the growth of a hypothetical investment of $10,000. It assumes reinvestment of dividends and capital gains, and does not reflect sales loads, redemption fees or the effects of taxes on any capital gains and/or distributions.
Here's how it is described on the website
Investment Goal and Strategy
Seeks to provide a higher yield, with a higher related risk, than a money market fund, and relatively less risk than a longer-term bond fund. YieldPlus seeks to maintain an average portfolio duration of 1 year or less. This fund is not a money fund and its share price will continue to fluctuate.
no mention of the maturity credit risk issue

Morningstar waited till august 2008 to tell investors to dump the fund as reported by Business Week at the time.

my bolds and comments in blue

About Those Alleged Short-Term Funds...

Some Go Long on Bonds, Risk—Study

Two years after surprise losses in auction-rate securities pounded mutual funds, there is new evidence to suggest some funds may be mislabeling what they hold in their portfolios.
According to a study set to be released Thursday, some short- and ultra-short-term bond funds, which purport to invest in fixed-income securities with short maturities, hold long-term bonds as well, sharply increasing risks.....

The study, by Securities Litigation & Consulting Group, a Fairfax, Va., consulting firm that provides expert witnesses to regulators, law firms, banks and brokerages, examined bond funds' holdings in early 2008. The research showed that the weighted average maturity of ultra-short funds washttp://18 years—with 50% of the 43 funds having average maturities greater than 20 years—while the weighted average maturity of short-term bond funds was 12 years.
The credit risk in their long-term bond holdings caused many of the bond funds to post steep losses during the financial crisis later that year, according to the study. Funds that reported the steepest losses in 2008 generally owned securities with the longest average maturities unless the long-term holdings were mostly government securities.

The key problem is that the "effective duration" statistics does not reflect the credit risk in these funds which is the same as in many longer term funds.

And investors apparently can't rely on Morningstar to reflect this risk according to the article:

The issue at the center of the new paper is how bond funds report their "effective duration," a statistical measure of their sensitivity to changes in interest rates. Because many of these funds held floating-rate bonds or used derivatives to convert their fixed coupons to floating-rate coupons, they were able to report effective durations as short as three months—even though their 20- to 30-year average maturities would imply durations of 10 or 15 years, according to the study.Morningstar Inc,a research firm also uses the statistic to categorize funds 
"You've got these long-term bond portfolios that the industry and Morningstar are telling investors are short-term or ultra-short bond funds," said Mr. McCann. "But it's not true for a large portion of these funds. Many, in fact, have the credit risks of long-term bonds."
At one extreme, according to the paper, Charles Schwab Corp.'s YieldPlus Fund, classified as an ultra-short bond fund, had a weighted average maturity between 25 and 30 years. .".....

Although many of the funds have pared back their average maturities since 2008, some funds still hold long average maturities. At the end of 2009, for example, the AMF Ultra Short and Ultra Short Mortgage Funds, which hold mainly mortgage-backed securities, had average maturities of around 20 to 25 years, according to Mr. McCann.
The solution for investors to this dilemma is to choose etfs for their bond investments. These funds clearly stick to their label in terms of credit quality and their average effective duration deviates minimally from their average maturity. For example take these vanguard etfs:
short term investment grade corporate

for the intermediate fund the duration is 6.2 years and the maturity 7.2 years  no holdings rated below Baa

for the short term fund the duration number is 2.8 yrs the maturity 3.1 yrs

My Head Is Spinning Courtesy of the WSJ

WSJ March 20,2010

A Key Volatility Index That Says 'Buy' May Mean 'Bail' 

The stock market's most closely followed volatility index dropped this past week to its lowest level in nearly two years. Some investors who study volatility believe low readings are a bullish indicator for stocks. Historically, the market has tended to rise as volatility falls, and vice versa.
So the latest numbers are a surefire buy signal, right? Not necessarily. Dig a little deeper and you might even spot a contrarian indicator telling you to sell.

WSJ April 14,2010

Falling Volatility Doesn't Mean a Market Top Is Near 

The stock market seems a little too quiet to be near a significant peak.

When trends turn, it's usually after a period of increasing volatility, marked by spikes, drops and sharp intraday reversals. Both bulls and bears have a strong enough conviction to battle it out until one side is forced to capitulate. And that's certainly not the case at the moment.

I guess based on one day's market action one of these two writers would claim they were correct

Today the vix closed at 18.7  14.6% up for the day  Today's  trading range from  highto  low range was 16.1% remember from my previous post this represents an annualized number.

Using the formula in the march 25 post the  18.7  implied volatility represents a market view that the daily volatility has a 66% likelihood of being above 1.18% . Not at all unreasonable if extrapolating and managing option risk based on today's price action:

The S+P 500 closed down 1.6% today trading in a range of 2.13%

So in my view here is the message of the sharp move up in implied volatility: implied volatility moved up alot
  3mos vix and sp 500 charts are here



Friday, April 2, 2010

An Alternative to Alternatives : Some Are Having Second Thoughts...But Not Yale

 The WSJ recently published a very interesting article about the way some institutional investors are rethinking the way they approach "alternative investments. I think it shows a very enlightened rethinking of the use of these type of investments. Many endowments and other institutions( as I have commented upon here) and elsewhere rushed into the "yale model" with very heavy weightings towards these type of investments. Many individuals and advisors to individuals jumped into this type of investing in these categories as well as evidenced by many aritcles in both the popular press and in publications aimed at financial advisors as well. The trend was even evidenced in two books (pictured here)



that had the misfortune to come to press just at the time many institutions and individuals regretted having made the choice to invest like Harvard and Yale.

Many investors who ventured into alternatove investments overlooked or held several misconceptions about these investments particularly private equity and hedge funds:

  • Diversification: many touted hedge funds and private equity funds as "diversifiers" to a portfolio that would go up when stocks went down. This would be the case because the hedge funds had the capability to go short and many engaged in "market neutral strategies".

    In fact, many of these fund proved to be highly correlated to the overall market including the "market neutral " strategies. Scott Patterson's The Quants gives a great description of the demise of many quantitative long/short "market neutra:" funds.

    Even today's NYT report on the eye popping compensation of hedge fund managers illustrates the high correlation between the overall market and hedge funds. Of the top ten earners among hedge fund managers only 3 had up years in both the down market of 2008 and the up market of 2009. One of the top 10: Ken Griffin of Citadel was down 55% in 2008 and up 62% last year  

    From the WSJ: my bolds, my comments in blue

An Alternative to 'Alternative' Assets 


Public pensions are increasingly asking a question that has haunted investors since the financial crisis: When is an alternative investment really more of the same?
So-called alternative investments like private equity and real estate that were supposed to help investors buffer losses in case of market declines in fact fell along with stocks in 2008.
Now some public funds are reconsidering how to categorize their investments. Rather than focus on the type of investment, such as stocks or bonds, they are looking at lumping holdings based on how they might perform under various economic conditions, such as slow economic growth or high inflation.....

The discussions come as investors of all sizes have been rethinking the value of asset allocation and how to do it. The idea of trying to minimize risk by spreading funds across different types of assets has been an investing chestnut for decades. Studies have shown that a portfolio's volatility depends 90% on asset allocation. But when stocks big and small, global and domestic, all fell along with other assets in the fall of 2008, the basic premise disappointed....

If funds conclude investments like private equity or real estate don't add much diversification to a portfolio of stocks, or that they all belong in the same risk category, funds may have less demand for these managers.
There doesn't yet appear to be a widespread movement toward a more situation-based way of thinking about asset allocation. But some consultants who advocate the change say the issue is bubbling up now that funds have some peace from crisis mode to consider it. (Consultants often benefit when a fund changes asset-allocation strategy; the consultant may get hired to help execute the change.)..... also focuses investors on the liquidity of their portfolios, something some found in short supply during the financial crisis.

Liquidity is one issue motivating Calpers to explore a new approach. "Calpers's portfolio did not have meaningful exposure to assets that could have been a hedge in times of financial crisis and provide adequate liquidity to the fund," the fund's chief investment officer, Joseph Dear, said in a report for an investment-committee meeting held Monday....

Mr. Burns(of alaska's fund) said his staff started rethinking the asset classifications in 2008, when it noticed amid the financial crisis that its fixed-income portfolio no longer correlated with relevant interest rates as it historically had done. That caused them to question other assumptions.
In their research, managers came across Denmark's ATP fund. In 2008, that $112 billion pension fund moved from allocating investments based on asset type to what drives risk, a spokesman confirms. For example, it put private and public equities into one category called corporate earnings, which usually perform badly during economic downturns.

I think the above shows that some pension managers are rethinking hedge funds and private equity as "alternative asset classes". As noted private equity and hedge funds are assets that are exposed to the same economic factors as traditional equity funds. The difference is that hedge funds include the additional risks related to leverage and limited liquidty. And compared to index instruments I would add a third additional risk factor, what I call manager or "alpha risk" which I would define as the risk the specific manager in control of your assets underperforms the general category that should move in tandem with corporate earnings and economic growth. Of course the high fees are another negative. In my view adding all these risks and costs I find it  difficult to see a strong rationale for including "alternative investments" in a portfolio, institutional or individual.

also in the same day's wsj a report tha Yale has no intentions of changing its investment policy

Yale Sticks With Investment Model

Anyone expecting a mea culpa from Yale University's investment chief can forget it.

..."Some observers questioned the University's investment philosophy, which rests on the principles of diversification and equity orientation," the report said. But it maintained that Yale's approach still lowered risks and diversified returns.
The endowment in fact increased its allocations to illiquid, or hard to sell, assets that caused some funds trouble when markets cratered, such as private equity and real estate, according to the report, which wasn't signed by any single individual....

... Yale's endowment declined by 24.6% for the fiscal year that ended June 30, and many other schools with similar approaches, like Harvard University, also faced double-digit declines. That caused some observers to question Mr. Swensen's philosophy; some, like Harvard, are now reducing their exposure to real estate and are trying to increase liquidity....
, the target allocation to private equity was increased from 21% to 26%, the report says. That compares to an 8.3% actual allocation of the average educational institution, the report..
    Liquidity is a concern for endowment managers, the report acknowledged. But it said some illiquid assets can be used to create liquidity, for example as collateral for loans.

    In other words, in extremis when the actual investments can't be turned into cash Yale will borrow against them.

    Meanwhile, the "need to provide resources for current operations as well as preserve purchasing power of assets dictates investing for high returns," the report said. "Hence, 96 percent of the Endowment is targeted for investment in assets expected to produce equity-like returns

    Well nobody ever accused Swensen of not holding strong beliefs. And he certainly has more experience and manages far more money than I do. But 96% in growth assets is a massively aggressive allocation for a portfolio which, must generate earnings on a consistent basis to meet Yale's annual expenses.

    Furthermore Swensen is comfortable relying upon investments that use significant leverage and can be illiquid in order to get what he calls equity like returns. A small proportion of the assets allocated to earn "equity like returns" are invested in simple equity vehicles like low cost unleveraged index instruments. Yale writes that these :equity like returns will come ...

    through holdings of domestic and international securities, real assets, and private equity."
    In the 2009 fiscal year, the endowment provided 46% of Yale's $2.56 billion operating income.
    The increases in less liquid asset classes were offset by, among other things, a 5 percentage point drop in the target allocation in foreign equities to 10% and a 2.5 percentage point decline in the domestic equity target to 7.5%
    So while some are rethinking whether hedge funds are really an "alternative " that adds diversification to a portfolio and whether the loss of liquidity is worthwhile (along with the leverage and high fees). Yale has lost no faith in its strategy of large allocation s to these "alternatives" and reliance on active managers to provide superior investments. Label me skeptical.  In fac,t as I have noted before, in both his book on institutional investing: Pioneering Portfolio Management and his book aimed at individiual investors: Unconventional Success Swensen does not suggest others should try to "be like Yale " in investment strategy.