When presenting the arguments for indexing to clients or prospects I often encounter the objection “what about Warren Buffett”. In fact Buffett has often advised prospective investors to invest in index funds. Such was the case at last week’s annual meeting of Berkshire Hataway. Where Jason Zweig of Money magazine reports, the following exchange took place.
Asked what's in store for the economy, Buffett said he doesn't have a clue and doesn't care.
"I haven't the faintest idea," he said. "We never talk about it, it never comes up in our board meetings or other discussions. We're not in that business [of economic forecasting], we don't know how to be in that business. If we knew where the economy was going, we'd do nothing but play the S&P futures market."
His simple point: As an investor, you don't need to predict the economic cycle (or even pay much attention to it). Instead, you should focus on evaluating individual businesses if you pick your own stocks -- or, simply buy the entire market in the form of an index fund. When a shareholder asked for the single best specific investment idea Buffett could recommend to an individual in his 30s, Buffett said: "I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard. Unless I bought during a strong bull market, I would feel confident that I would outperform...and I could just go back and get on with my work."
Buffett also downplayed expectations that he would outperform the overall market going forward. It is also important to note that Berkshire Hathaway’s low funding costs (it basically takes in insurance premiums and invests them), attractive tax status for his insurance entity, heavy investment in privately held companies (which are not marked to market on a daily basis like a mutual fund’s holdings) make a direct comparison between Buffet’s results and those of an open end mutual fund impossible.
One more puzzling thing came out of this year’s annual report . Many indeed have called the Oracle of Omaha incredibly perceptive when he wrote this well before the current financial crisis.
I view derivatives as time bombs, both for the parties that deal in them and the economic system.
I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multimillion-dollar bonus or the CEO who wanted to report impressive 'earnings' (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.
The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
-- Warren Buffett's Letter to Investors, Berkshire Hathaway 2002 Annual Report
Yet here’s what came out of this year’s financial results:
May 3, 2008
Derivatives Hurt Profit at Berkshire Hathaway
By REUTERS
OMAHA (Reuters) — Berkshire Hathaway, Warren E. Buffett’s investment company, said on Friday that first-quarter profit tumbled 64 percent, hurt by $1.6 billion of pretax losses tied to derivatives contracts….
Net income fell to $940 million, or $607 a Class A share, from $2.6 billion, or $1,682, a year earlier….
The derivative losses stemmed from Berkshire’s exposure to contracts aimed at making money if junk bonds stayed out of default and stock indexes rose.
In February, Mr. Buffett revealed that Berkshire ended 2007 with $40 billion of exposure to 94 of these contracts.
Berkshire said it had a $1.2 billion unrealized loss on put options it wrote on the Standard & Poor’s 500-stock index and three foreign stock indexes. It also reported a $490 million unrealized loss on contracts that require payouts if some high-yield bonds default from now to 2013. Other contracts brought the net loss in derivatives down to $1.6 billion.
Accounting rules require the company to report unrealized gains and losses in earnings regularly, Berkshire said.
The exposure may at first seem odd given that, in his shareholder letter in 2003, Mr. Buffett called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
But in his letter this year, Mr. Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that “there is no counterparty risk.”
He also said shareholders should be prepared for gains and losses that could “easily” top $1 billion in a given quarter.
Curious, to put it mildly, it seems even the "rock solid" portfolios contain ticking time bombs
Wednesday, May 7, 2008
Friday, March 28, 2008
There Are No Geniuses Department
I have noted many times that the past records of fund managers, or a top rating from Morningstar or any other financial publication is of little use in picking mutual funds. There is little persistence of returns and even impressive track records for funds seldom give a full picture of the risk adjusted return.
A recent case in point, highlighted in the March 21 WSJ is Bill Miller and his Legg Mason Value Trust (LMVTX). For years this fund had been the darling of the financial press as the manager stacked up 15 consecutive years of beating the S+P 500.
But we were really not surprised to read this in the WSJ:
Bear Is Bill Miller's Latest Setback
Legg Mason Star
'Was Surprised'
By Stock's Plunge
By DIYA GULLAPALLI
March 21, 2008; Page C1
At an investment conference last Friday, legendary stock picker Bill Miller of Legg Mason Inc. was caught off guard by a simple question.
Mr. Miller was speaking at a conference titled "Credit Cycle-What's Next?" in the auditorium of Deutsche Bank in New York. During a 40-minute session, Mr. Miller along with other experts spoke to more than 200 top-tier Deutsche Bank clients about the markets. In particular, he talked at length about why this is a great time to buy financial stocks -- including Bear Stearns Cos.
Burned by Bear Stearns: Bill Miller of Legg Mason
After the presentation, an audience member raised his hand and asked Mr. Miller if he was aware that Bear was collapsing and its stock was down 15% that morning. Mr. Miller looked shocked, according to observers…..
Bear Stearns is emerging as the latest disaster for Mr. Miller, who has also taken a bath on home builders like Pulte Homes Inc. and other financial companies like Countrywide Financial Corp., while missing out on big gains in energy in recent years.
Seems Mr. Miller is not alone among the fallen investment stars
The sudden decline illustrates how quickly the credit crisis is transforming celebrity investors into laggards, as their traditional down-market playbooks are failing. The setback is particularly stinging for Mr. Miller, who has thrived in the past by assembling a portfolio that is very different from other value investors.
Actually, for years Miller’s portfolios had little in common with what is generally considered a value investing strategy as he has loaded up on high p/e stocks like Amazon.
In fact Miller’s decline wasn’t particularly sudden and gives rise once again to the reliability of a strategy of picking funds run by investment “superstars”
Mr. Miller was similarly ahead of the index over the past 15 years on average. His streak concluded in 2005, however, and his fund was down 6.7% last year while the S&P 500 was up 5.5%, including reinvested dividends. Over the past five years, his fund has averaged just 6% annually, little more than half the return for the S&P 500, says Morningstar.
Even when investors were seeing strong performance from Miller’s fund they were taking quite a bit of risk. Miller’s portfolios are marked by large positions in a small number of stocks and often a high concentration in a particular industry
Reviewing statistics for Mr. Miller’s fund (LMVTX) one finds that his fund has a 5 year standard deviation of 14.6 and a return of 8.02%. The Vanguard Total US Stock Market Index (VTSMX) had 9.63 and 11.5% respectively. This means that the Miller fund was s more than1.5 x more volatile than the market index yet produced less return. For ten years the lmvtx beats the vtsmx in return by a small amount 4.83 vs. 4.46 but with considerably more risk. The ten year standard deviation for the Miller fund is 19.8 vs. 15.23 for the total stock market index.
As noted, Miller’s fund has consistently held concentrated positions making it far less diversified than a market index fund. The top ten holdings of the total stock market index fund comprise 16.1% of its assets. Here are the numbers for the Legg Mason Value Trust:
TOP 10 HOLDINGS ( 47.05% OF TOTAL ASSETS)
Company Symbol % Assets YTD Return %
AMAZON.COM INC AMZN
6.91 -30.41
AES CORPORATION AES
6.20 -15.94
UNITEDHEALTH GROUP UNH
5.93 -20.14
AETNA INC. NEW AET
5.20 -14.08
JP MORGAN CHASE CO JPM
4.73 -6.03
QWEST COMM INTL INC Q
4.10 -21.89
SPRINT NXTEL CP S
3.91 -45.85
EBAY INC EBAY
3.46 -20.58
YAHOO INC YHOO
3.43 19.43
GOOGLE GOOG
3.18 -31.87
.
Whatever Miller’s future performance it is clear that it will be the result of taking on quite a bit of risk:
Regarding recent missteps, Mr. Miller is essentially re-employing his strategy from the early 1990s -- an important reference point that's informed some of his boldest buys.
Back then, a similar crisis was unfolding in financial markets and Mr. Miller eventually swooped in to buy money-center banks like Chase Manhattan and Citicorp that he thought were underpriced, as well as insurance companies and mortgage lenders. Financials made up as much as 45% of Mr. Miller's portfolio by the mid-1990s, and helped drive his 15-year winning streak as they rallied over the years…..
Mr. Miller bought financials like Washington Mutual Inc., Wachovia Corp., Merrill Lynch & Co. and Freddie Mac in recent months. He added Bear, Goldman Sachs Group Inc. and NYSE Euronext in the third quarter. Despite gains in recent days, the financial sector of the S&P 500 is down 15% this year.
Mr. Miller is sticking to his guns. Legg Mason Capital Management was the largest holder of Countrywide through December, holding about 12% of company shares. While the stock was the worst performer for the fund last quarter, down 53%, Mr. Miller is betting it is a great buy for Bank of America Corp. in the long run. Mr. Miller was so eager to keep buying the stock, in fact, he petitioned the Office of Thrift Supervision so he could increase the stake to up to 25% of shares outstanding. The permission was granted in mid-January, and he increased its holding.
My conclusion from all this is that once again it is clears that:
1. There are no geniuses: even investment superstars inevitably run into the reality of how difficult it is to beat the market.
2. Even when it seems like a superstar is “crushing the market” he or she is almost surely doing so by taking on far more risk than the overall market.
3. Which means that eventually we will see the consequences in #1 above.
4. Hope springs eternal and articles will soon appear about the new superstar with a track record of crushing the market indices.
A recent case in point, highlighted in the March 21 WSJ is Bill Miller and his Legg Mason Value Trust (LMVTX). For years this fund had been the darling of the financial press as the manager stacked up 15 consecutive years of beating the S+P 500.
But we were really not surprised to read this in the WSJ:
Bear Is Bill Miller's Latest Setback
Legg Mason Star
'Was Surprised'
By Stock's Plunge
By DIYA GULLAPALLI
March 21, 2008; Page C1
At an investment conference last Friday, legendary stock picker Bill Miller of Legg Mason Inc. was caught off guard by a simple question.
Mr. Miller was speaking at a conference titled "Credit Cycle-What's Next?" in the auditorium of Deutsche Bank in New York. During a 40-minute session, Mr. Miller along with other experts spoke to more than 200 top-tier Deutsche Bank clients about the markets. In particular, he talked at length about why this is a great time to buy financial stocks -- including Bear Stearns Cos.
Burned by Bear Stearns: Bill Miller of Legg Mason
After the presentation, an audience member raised his hand and asked Mr. Miller if he was aware that Bear was collapsing and its stock was down 15% that morning. Mr. Miller looked shocked, according to observers…..
Bear Stearns is emerging as the latest disaster for Mr. Miller, who has also taken a bath on home builders like Pulte Homes Inc. and other financial companies like Countrywide Financial Corp., while missing out on big gains in energy in recent years.
Seems Mr. Miller is not alone among the fallen investment stars
The sudden decline illustrates how quickly the credit crisis is transforming celebrity investors into laggards, as their traditional down-market playbooks are failing. The setback is particularly stinging for Mr. Miller, who has thrived in the past by assembling a portfolio that is very different from other value investors.
Actually, for years Miller’s portfolios had little in common with what is generally considered a value investing strategy as he has loaded up on high p/e stocks like Amazon.
In fact Miller’s decline wasn’t particularly sudden and gives rise once again to the reliability of a strategy of picking funds run by investment “superstars”
Mr. Miller was similarly ahead of the index over the past 15 years on average. His streak concluded in 2005, however, and his fund was down 6.7% last year while the S&P 500 was up 5.5%, including reinvested dividends. Over the past five years, his fund has averaged just 6% annually, little more than half the return for the S&P 500, says Morningstar.
Even when investors were seeing strong performance from Miller’s fund they were taking quite a bit of risk. Miller’s portfolios are marked by large positions in a small number of stocks and often a high concentration in a particular industry
Reviewing statistics for Mr. Miller’s fund (LMVTX) one finds that his fund has a 5 year standard deviation of 14.6 and a return of 8.02%. The Vanguard Total US Stock Market Index (VTSMX) had 9.63 and 11.5% respectively. This means that the Miller fund was s more than1.5 x more volatile than the market index yet produced less return. For ten years the lmvtx beats the vtsmx in return by a small amount 4.83 vs. 4.46 but with considerably more risk. The ten year standard deviation for the Miller fund is 19.8 vs. 15.23 for the total stock market index.
As noted, Miller’s fund has consistently held concentrated positions making it far less diversified than a market index fund. The top ten holdings of the total stock market index fund comprise 16.1% of its assets. Here are the numbers for the Legg Mason Value Trust:
TOP 10 HOLDINGS ( 47.05% OF TOTAL ASSETS)
Company Symbol % Assets YTD Return %
AMAZON.COM INC AMZN
6.91 -30.41
AES CORPORATION AES
6.20 -15.94
UNITEDHEALTH GROUP UNH
5.93 -20.14
AETNA INC. NEW AET
5.20 -14.08
JP MORGAN CHASE CO JPM
4.73 -6.03
QWEST COMM INTL INC Q
4.10 -21.89
SPRINT NXTEL CP S
3.91 -45.85
EBAY INC EBAY
3.46 -20.58
YAHOO INC YHOO
3.43 19.43
GOOGLE GOOG
3.18 -31.87
.
Whatever Miller’s future performance it is clear that it will be the result of taking on quite a bit of risk:
Regarding recent missteps, Mr. Miller is essentially re-employing his strategy from the early 1990s -- an important reference point that's informed some of his boldest buys.
Back then, a similar crisis was unfolding in financial markets and Mr. Miller eventually swooped in to buy money-center banks like Chase Manhattan and Citicorp that he thought were underpriced, as well as insurance companies and mortgage lenders. Financials made up as much as 45% of Mr. Miller's portfolio by the mid-1990s, and helped drive his 15-year winning streak as they rallied over the years…..
Mr. Miller bought financials like Washington Mutual Inc., Wachovia Corp., Merrill Lynch & Co. and Freddie Mac in recent months. He added Bear, Goldman Sachs Group Inc. and NYSE Euronext in the third quarter. Despite gains in recent days, the financial sector of the S&P 500 is down 15% this year.
Mr. Miller is sticking to his guns. Legg Mason Capital Management was the largest holder of Countrywide through December, holding about 12% of company shares. While the stock was the worst performer for the fund last quarter, down 53%, Mr. Miller is betting it is a great buy for Bank of America Corp. in the long run. Mr. Miller was so eager to keep buying the stock, in fact, he petitioned the Office of Thrift Supervision so he could increase the stake to up to 25% of shares outstanding. The permission was granted in mid-January, and he increased its holding.
My conclusion from all this is that once again it is clears that:
1. There are no geniuses: even investment superstars inevitably run into the reality of how difficult it is to beat the market.
2. Even when it seems like a superstar is “crushing the market” he or she is almost surely doing so by taking on far more risk than the overall market.
3. Which means that eventually we will see the consequences in #1 above.
4. Hope springs eternal and articles will soon appear about the new superstar with a track record of crushing the market indices.
Wednesday, January 2, 2008
2007 Markets Review and Some Thoughts on 2008
2007 Financial Markets Review
Equity Markets
Needless to say 2007, particularly the second half, was a difficult one in the financial markets. The S+P 500 (total return) ended 2007 +5.49%. The mortgage crisis, first evident in the credit markets, spread to the equity markets as stocks of financial institutions were decimated by massive writeoffs of mortgage related securities on the balance sheets of those companies. The S+P financials index fell 20.84% for the year. Housing stocks suffered severe declines as well.
While the housing market seems far from recovery, the large capital infusions from foreigners into major financial institutions indicates that at least some investors see values in the financial sector. We remain skeptical; the “known unknowns” of more writedowns due to mortgage losses, credit problems in the corporate debt markets, losses in derivatives, or other areas makes us remain cautious.
The impact of the financial stocks’ losses in the equity markets hit value stocks particularly hard as that group carried higher weighting in those sectors. The Russell 1000 large cap value index was -.17% , small cap value was -9.78% for 2007 In contrast export oriented technology stocks led the large cap growth to strong outperformance, posting a gain of 11.81% .
Among other sectors the global growth theme particularly in India and China made materials and commodity stocks a top performing sector. For 2007 Energy stocks (S+P index) rose 32.38% rose materials stocks + 19.98%. Commodities themselves rose as well: oil reaching close to $100, gold rising and agricultural commodities hitting multi year highs.
Internationally, developed and emerging markets diverged. The EAFE (Europe and Far East) index (etf EFA) 9.97 %. Here again the crisis in the credit markets and the large writedowns for financial institutions hit that sector. As a consequence the EAFE growth index (etf efg) was up 15.03% while value (efv) was up only 5.56%. Emerging markets were the star performer investors expressed their confidence in the BRIC countries (Brazil, Russia, India and China) and the MSCI emerging market index (etf seem) rose.33.08%.
Credit Markets
In the credit markets the impact of the mortgage crisis and the threat of recession led to three easing moves by the Fed since September, reducing short term interest rates by 1%. This had little impact on the core of the crisis, which was the availability of credit and level of spreads between treasury bonds and other securities. As a consequence the Fed and other central banks established credit facilities to inject liquidity to limited success. As the year ends limited availability and high costs of credit remain a feature of the markets, and prices of the riskiest credit instruments trade at large spreads over treasuries.
Portfolio Review
Our portfolios shifted a bit from their overweighting in value stocks towards growth stocks in domestic and EAFE markets in response to the first signs of the crisis in financial institutions. Nonetheless, we maintained a core position in value stocks based on their long term record of strong performance. Significant weightings internationally both in developed and emerging international markets helped our performance. We also maintained positions in energy and basic materials throughout the year which was clearly a positive contribution. The REIT positions which we view as core diversifiers suffered along with the rest of real estate.
2008 Outlook
Looking into 2008 US markets continue to face the cloud of recession and the ongoing problems in the financial services and housing/construction industries. These factors are likely to limit market gains. Continued interest rate cuts by the Fed are likely, but as was the case in 2007 will have little stimulative impact.
We would view the most likely scenario for US market returns in 2008 as below, or at best equal to the lower end of US long term stock returns ( 8%- 11). Developed markets, also experiencing similar conditions in the financial sector will likely produce similar returns, with US investors gaining a bit from a lower dollar.
We view last year’s performance in emerging markets as highly unlikely to repeat. The same could be said for energy and commodities. The key question is whether these markets will experience a sharp correction or just a much lower positive return.
It is not uncommon for falls of 20% within a quarter for emerging markets and significant short term falls in commodity prices. We would not be surprised by continued volatility but think resilient investors will be rewarded by an outperformance of emerging markets relative to developed markets here and abroad and thus should maintain a long term allocation to these markets .For similar reasons, a relatively small portion of portfolios should be in stocks tied to energy and other commodities.
In the credit markets, continued Fed easing will take short term interest rates lower. However, long term rates are unlikely to decline. The most important question is how long current anomalies in credit markets continue .Corporate bonds and cds are trading at historically high spreads relative to treasury bonds. Municipal bonds currently have yields at virtually the same rates as treasury bonds of the same maturity. Neither of these relationships is likely to continue for long and investors would be well rewarded to taking advantage of them.
Equity Markets
Needless to say 2007, particularly the second half, was a difficult one in the financial markets. The S+P 500 (total return) ended 2007 +5.49%. The mortgage crisis, first evident in the credit markets, spread to the equity markets as stocks of financial institutions were decimated by massive writeoffs of mortgage related securities on the balance sheets of those companies. The S+P financials index fell 20.84% for the year. Housing stocks suffered severe declines as well.
While the housing market seems far from recovery, the large capital infusions from foreigners into major financial institutions indicates that at least some investors see values in the financial sector. We remain skeptical; the “known unknowns” of more writedowns due to mortgage losses, credit problems in the corporate debt markets, losses in derivatives, or other areas makes us remain cautious.
The impact of the financial stocks’ losses in the equity markets hit value stocks particularly hard as that group carried higher weighting in those sectors. The Russell 1000 large cap value index was -.17% , small cap value was -9.78% for 2007 In contrast export oriented technology stocks led the large cap growth to strong outperformance, posting a gain of 11.81% .
Among other sectors the global growth theme particularly in India and China made materials and commodity stocks a top performing sector. For 2007 Energy stocks (S+P index) rose 32.38% rose materials stocks + 19.98%. Commodities themselves rose as well: oil reaching close to $100, gold rising and agricultural commodities hitting multi year highs.
Internationally, developed and emerging markets diverged. The EAFE (Europe and Far East) index (etf EFA) 9.97 %. Here again the crisis in the credit markets and the large writedowns for financial institutions hit that sector. As a consequence the EAFE growth index (etf efg) was up 15.03% while value (efv) was up only 5.56%. Emerging markets were the star performer investors expressed their confidence in the BRIC countries (Brazil, Russia, India and China) and the MSCI emerging market index (etf seem) rose.33.08%.
Credit Markets
In the credit markets the impact of the mortgage crisis and the threat of recession led to three easing moves by the Fed since September, reducing short term interest rates by 1%. This had little impact on the core of the crisis, which was the availability of credit and level of spreads between treasury bonds and other securities. As a consequence the Fed and other central banks established credit facilities to inject liquidity to limited success. As the year ends limited availability and high costs of credit remain a feature of the markets, and prices of the riskiest credit instruments trade at large spreads over treasuries.
Portfolio Review
Our portfolios shifted a bit from their overweighting in value stocks towards growth stocks in domestic and EAFE markets in response to the first signs of the crisis in financial institutions. Nonetheless, we maintained a core position in value stocks based on their long term record of strong performance. Significant weightings internationally both in developed and emerging international markets helped our performance. We also maintained positions in energy and basic materials throughout the year which was clearly a positive contribution. The REIT positions which we view as core diversifiers suffered along with the rest of real estate.
2008 Outlook
Looking into 2008 US markets continue to face the cloud of recession and the ongoing problems in the financial services and housing/construction industries. These factors are likely to limit market gains. Continued interest rate cuts by the Fed are likely, but as was the case in 2007 will have little stimulative impact.
We would view the most likely scenario for US market returns in 2008 as below, or at best equal to the lower end of US long term stock returns ( 8%- 11). Developed markets, also experiencing similar conditions in the financial sector will likely produce similar returns, with US investors gaining a bit from a lower dollar.
We view last year’s performance in emerging markets as highly unlikely to repeat. The same could be said for energy and commodities. The key question is whether these markets will experience a sharp correction or just a much lower positive return.
It is not uncommon for falls of 20% within a quarter for emerging markets and significant short term falls in commodity prices. We would not be surprised by continued volatility but think resilient investors will be rewarded by an outperformance of emerging markets relative to developed markets here and abroad and thus should maintain a long term allocation to these markets .For similar reasons, a relatively small portion of portfolios should be in stocks tied to energy and other commodities.
In the credit markets, continued Fed easing will take short term interest rates lower. However, long term rates are unlikely to decline. The most important question is how long current anomalies in credit markets continue .Corporate bonds and cds are trading at historically high spreads relative to treasury bonds. Municipal bonds currently have yields at virtually the same rates as treasury bonds of the same maturity. Neither of these relationships is likely to continue for long and investors would be well rewarded to taking advantage of them.
Monday, November 26, 2007
About Those Alternative Asset Classes...
Various experts (almost invariably connected to firms that market or manage these investments) tout the importance of having exposure to hedge funds and private equity in one’s portfolio in order to create returns in excess of the overall stock market.
Being the skeptic I am about such matters I was hardly surprised to find this article in the Financial Times
Private equity underperforms market
By Martin Arnold, Private Equity Correspondent
Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48
Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday…..The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr. Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds.”
And talk about crude math, how about this:
Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.
“So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.
So yes, private equity is a profitable asset class…..for those that manage the private equity funds
Mr Gottschlag admitted that some private equity firms were consistently outperforming the stock market. But he was sceptical about the number of buy-out funds that say they are “top-quartile” in performance rankings.
And private equity seems like Lake Wobegeon where everyone is above average the Professor states:
“I have never met a general partner who was not top-quartile. So I wonder where three-quarters of the industry is hiding,” he said.And remember the data used came before the current period of tight credit where private equity firms have had to walk away from deals due to limited or expensive financing.
Being the skeptic I am about such matters I was hardly surprised to find this article in the Financial Times
Private equity underperforms market
By Martin Arnold, Private Equity Correspondent
Published: November 22 2007 16:48 | Last updated: November 22 2007 16:48
Private equity has on average underperformed the stock market in the last decade, according to a detailed survey of the buy-out industry submitted to the European Parliament on Thursday…..The research – based on data from 6,000 private equity deals and about 1,000 buy-out funds – shows that average private equity returns have underperformed the benchmark S&P 500 share index by 3 per cent, after fees charged to investors.“This does not correspond with the stereotype of the industry making its investors extremely rich,” Mr. Gottschlag told the Financial Times. “Investors have not had much fun in this asset class, even though they have all been obsessed with gaining access to the best-performing funds.”
And talk about crude math, how about this:
Excluding fees and carried interest (a widely used profit sharing scheme), returns from private equity outperformed the S&P 500 by 3 per cent.
“So private equity is generating value somewhere, but its fee structure means the general partners capture double the out-performance they generate,” said Mr Gottschlag, who is also head of research at Peracs, an advisor to buy-out investors.
So yes, private equity is a profitable asset class…..for those that manage the private equity funds
Mr Gottschlag admitted that some private equity firms were consistently outperforming the stock market. But he was sceptical about the number of buy-out funds that say they are “top-quartile” in performance rankings.
And private equity seems like Lake Wobegeon where everyone is above average the Professor states:
“I have never met a general partner who was not top-quartile. So I wonder where three-quarters of the industry is hiding,” he said.And remember the data used came before the current period of tight credit where private equity firms have had to walk away from deals due to limited or expensive financing.
Friday, November 2, 2007
More Strange Advice on Investing
An article on safer alternatives to stock market investing in the Oct 28 NYT entitled:
Shedding Stock-Market Vertigo (but Still Making Some Money)
starts out logically enough ,mentioning some sensible alternatives including CDs and Treasury Inflation Protected Bonds.
Then the article veers off into the strange recommendation of actively managed bond funds. As we have noted before there is nothing particularly safe about these funds. The investor is simply giving his money to a bond “guru” who takes bets across the entire spectrum of fixed income investments. Much as with an actively managed stock fund, you never now what you own and what risks are lurking in the portfolio, particularly in the currently unstable bond market.
The article cites the recommendations of a Morningstar analyst (my bolds):
he has identified two — Metropolitan West Total Return and Pimco Total Return — as likely to benefit from credit market fears.
“They both have a history of opportunistic buying,” he explained. “Great managers love volatility.”
They may love volatility but is that what an investor really wants when he flees from “stock market vertigo”?
Mr. Peterson of Schwab likes Pimco Total Return and the Loomis Sayles Bond fund, which has international exposure, along with high-yield holdings intended to enhance performance.
Translation: they load up on credit, currency and sovereign risk to squeeze out higher returns .
Daniel J. Fuss, the Loomis fund manager, has excelled at finding the optimal mix of investment-grade and junk bond holdings, Mr. Peterson said. “Loomis is more of a credit analysis play,” he said. “They shift between investment grade and high-yield.”
This manager puts the conservative part of your portfolio in the riskiest types of bonds “high yield (junk) bonds. And with many forecasting a recession this is precisely what you do not want to own.
In all, his fund holds 22 percent in below-investment-grade holdings, along with roughly 17 percent in nondollar credits, chiefly in the Brazil real, the New Zealand dollar and the Mexican peso. These issues provide higher yield than dollar-denominated debt and would benefit from a continued decline in the dollar. This year through Thursday, the fund has produced a total return of 9.2 percent and has outperformed its multisector bond category average in each of the last five years.
Junk Bonds, Brazilian Real Bonds and Mexican Peso Bonds....Does that look like a portfolio designed to prevent market vertigo ? It looks to me like an accident ready to happen.
Once again it bears repeating. The only reliable way to reduce the risk of a portfolio is to increase the holdings of short term treasury bonds, treasury inflation protected bonds or investment grade bonds. Anything else is some kind of a bet on the direction of interest rates, credit spreads, currency risk, or sovereign risk. In fact a strong case could be made that even the investment grade bonds should be excluded from the list. Certainly a terrible choice would be an actively managed bond fund where you have no idea what risks the manager is taking.
Shedding Stock-Market Vertigo (but Still Making Some Money)
starts out logically enough ,mentioning some sensible alternatives including CDs and Treasury Inflation Protected Bonds.
Then the article veers off into the strange recommendation of actively managed bond funds. As we have noted before there is nothing particularly safe about these funds. The investor is simply giving his money to a bond “guru” who takes bets across the entire spectrum of fixed income investments. Much as with an actively managed stock fund, you never now what you own and what risks are lurking in the portfolio, particularly in the currently unstable bond market.
The article cites the recommendations of a Morningstar analyst (my bolds):
he has identified two — Metropolitan West Total Return and Pimco Total Return — as likely to benefit from credit market fears.
“They both have a history of opportunistic buying,” he explained. “Great managers love volatility.”
They may love volatility but is that what an investor really wants when he flees from “stock market vertigo”?
Mr. Peterson of Schwab likes Pimco Total Return and the Loomis Sayles Bond fund, which has international exposure, along with high-yield holdings intended to enhance performance.
Translation: they load up on credit, currency and sovereign risk to squeeze out higher returns .
Daniel J. Fuss, the Loomis fund manager, has excelled at finding the optimal mix of investment-grade and junk bond holdings, Mr. Peterson said. “Loomis is more of a credit analysis play,” he said. “They shift between investment grade and high-yield.”
This manager puts the conservative part of your portfolio in the riskiest types of bonds “high yield (junk) bonds. And with many forecasting a recession this is precisely what you do not want to own.
In all, his fund holds 22 percent in below-investment-grade holdings, along with roughly 17 percent in nondollar credits, chiefly in the Brazil real, the New Zealand dollar and the Mexican peso. These issues provide higher yield than dollar-denominated debt and would benefit from a continued decline in the dollar. This year through Thursday, the fund has produced a total return of 9.2 percent and has outperformed its multisector bond category average in each of the last five years.
Junk Bonds, Brazilian Real Bonds and Mexican Peso Bonds....Does that look like a portfolio designed to prevent market vertigo ? It looks to me like an accident ready to happen.
Once again it bears repeating. The only reliable way to reduce the risk of a portfolio is to increase the holdings of short term treasury bonds, treasury inflation protected bonds or investment grade bonds. Anything else is some kind of a bet on the direction of interest rates, credit spreads, currency risk, or sovereign risk. In fact a strong case could be made that even the investment grade bonds should be excluded from the list. Certainly a terrible choice would be an actively managed bond fund where you have no idea what risks the manager is taking.
Thursday, October 18, 2007
Fox Business News: Not Much Business News, But a Good Lesson About the Financial Media
I took a few brief looks at the new Fox Business Channel and was still waiting for the business news before I flipped over to CNBC. John Gapper of the Financial Times impressions are pretty much in line with mine.
Fox is for fun, not investment advice
By John Gapper
,,,,,For me, the highlight of the launch of the Fox Business channel on Monday was when the sound went off as Ivanka Trump displayed the jewellery collection she is selling at her new Madison Avenue store.
The Donald’s daughter was a guest on the first outing for Happy Hour, an evening show on the US cable channel filmed in the Bull and Bear bar at the Waldorf Astoria. The hosts were Cody Willard, a long-haired hedge fund manager (and FT contributor) and Rebecca Gomez, a pneumatic brunette in a short, turquoise dress……
As Fox Business took to the air, preaching its gospel of democracy and bullishness, its anchors were confronted by a 140-point fall in the Dow Jones Industrial Average, prompted by a Treasury-endorsed super-fund to bail out structured investment vehicles holding $400bn of collateralised debt obligations. After a stab at explaining what “it means for your mortgage” they moved on.
But Gapper points out maybe this fluffiness is not so bad after all. For if the more “hard news” approach of CNBC with Cramer and the Fast Money crew giving rapid fire buy and sell recommendations gives the impression that the advice is actually useful it is an illusion.
Cramer himself from an LA Times interview with reporter Tom Petruno
Petruno: Given the sheer number of stocks you suggest either buying or selling in any given show, do you worry that you're encouraging people to trade in and out, even though all the research says the vast majority of investors won't make money as active traders?Let's just say I struggle with it. . . .
Cramer In Year 1 I was much more oriented toward "stock of the day." And I didn't like that. In Year 2 I went away from that. In Year 3, this year, I'm trying to say, listen, there are broader themes, there are broader sectors, you can try to pick the best of breed in the sector.I go back to the fundamental idea that stocks can be interesting. And therefore if you're interested, you will be better off than if you just let the broker handle you. You'll be a better client and a better investor.
Petruno: But you agree that very few people can make a lot of money actively trading?
Cramer:It's a sucker's game
So the FT’s Gapper is bang on when he writes:
Even an investor who confines himself to buying company shares based on Mr Cramer’s stock tips is hopelessly outgunned. He may now be able to make a trade online rather than by phoning up a broker but he is up against a battery of hedge fund quantitative traders whose computers execute trades in milliseconds.
So what is the investor with a 401(k) plan to do? He should start by turning off the television set, or at least by treating Fox Business and CNBC as news and entertainment rather than investment advice…..
Buying individual shares on the basis of what an analyst says on the box – presumably long after he has told his institutional clients – is a mug’s game. The wisest things to do – spread your money across funds, particularly low-cost index funds, rather than individual securities; buy and hold; consult a fee-based adviser, etc – do not require you to watch talking heads and tickers.
Come to think of it, Fox Business is on to something. CNBC, despite its on-screen warnings not to take Mr Cramer’s stock tips over-seriously, has a professional mien. You could almost believe, watching it, that you are getting the inside track on what Wall Street is really doing.There is no such illusion during Happy Hour and that has a bracing honesty to it. You will not discover much about structured finance here but you can see Ivanka Trump in a Manhattan bar. At least you know where you are
Fox is for fun, not investment advice
By John Gapper
,,,,,For me, the highlight of the launch of the Fox Business channel on Monday was when the sound went off as Ivanka Trump displayed the jewellery collection she is selling at her new Madison Avenue store.
The Donald’s daughter was a guest on the first outing for Happy Hour, an evening show on the US cable channel filmed in the Bull and Bear bar at the Waldorf Astoria. The hosts were Cody Willard, a long-haired hedge fund manager (and FT contributor) and Rebecca Gomez, a pneumatic brunette in a short, turquoise dress……
As Fox Business took to the air, preaching its gospel of democracy and bullishness, its anchors were confronted by a 140-point fall in the Dow Jones Industrial Average, prompted by a Treasury-endorsed super-fund to bail out structured investment vehicles holding $400bn of collateralised debt obligations. After a stab at explaining what “it means for your mortgage” they moved on.
But Gapper points out maybe this fluffiness is not so bad after all. For if the more “hard news” approach of CNBC with Cramer and the Fast Money crew giving rapid fire buy and sell recommendations gives the impression that the advice is actually useful it is an illusion.
Cramer himself from an LA Times interview with reporter Tom Petruno
Petruno: Given the sheer number of stocks you suggest either buying or selling in any given show, do you worry that you're encouraging people to trade in and out, even though all the research says the vast majority of investors won't make money as active traders?Let's just say I struggle with it. . . .
Cramer In Year 1 I was much more oriented toward "stock of the day." And I didn't like that. In Year 2 I went away from that. In Year 3, this year, I'm trying to say, listen, there are broader themes, there are broader sectors, you can try to pick the best of breed in the sector.I go back to the fundamental idea that stocks can be interesting. And therefore if you're interested, you will be better off than if you just let the broker handle you. You'll be a better client and a better investor.
Petruno: But you agree that very few people can make a lot of money actively trading?
Cramer:It's a sucker's game
So the FT’s Gapper is bang on when he writes:
Even an investor who confines himself to buying company shares based on Mr Cramer’s stock tips is hopelessly outgunned. He may now be able to make a trade online rather than by phoning up a broker but he is up against a battery of hedge fund quantitative traders whose computers execute trades in milliseconds.
So what is the investor with a 401(k) plan to do? He should start by turning off the television set, or at least by treating Fox Business and CNBC as news and entertainment rather than investment advice…..
Buying individual shares on the basis of what an analyst says on the box – presumably long after he has told his institutional clients – is a mug’s game. The wisest things to do – spread your money across funds, particularly low-cost index funds, rather than individual securities; buy and hold; consult a fee-based adviser, etc – do not require you to watch talking heads and tickers.
Come to think of it, Fox Business is on to something. CNBC, despite its on-screen warnings not to take Mr Cramer’s stock tips over-seriously, has a professional mien. You could almost believe, watching it, that you are getting the inside track on what Wall Street is really doing.There is no such illusion during Happy Hour and that has a bracing honesty to it. You will not discover much about structured finance here but you can see Ivanka Trump in a Manhattan bar. At least you know where you are
Back After Extended Summer Hiatus ! Third Quarter Review
October 9, 2007
Quarterly Market Review
The third quarter experienced another of the increasingly frequent and intense short term stock selloffs. The S+P 500 index fell 11.9% between mid July and mid August. The declines in international markets, emerging and developed, were even more severe. Once again, the markets showed that the only thing that goes up in a down market is correlation. Domestic and international (developed and emerging) small cap and large cap stocks all moved in sync.
While the most apparent cause of the decline was the collapse of the subprime credit market and the housing markets in the US, UK and elsewhere it is difficult to cite a specific event that precipitated the market move. What is clear is that several interrelated factors make each market shock more volatile, more widespread and more violent than the previous one. Among these factors are:
The increase in leverage by hedge funds and private equity firms,
The proliferation of complex derivative instruments, poorly understood by both issuers and buyers.
Short term quantitative trading techniques implemented with leverage by hedge funds. These funds often follow very similar strategies and when they reverse positions trigger a cascade of trading exacerbating short term market movements.
The continuing integration of global markets with the consequence that a crisis such as the recent one related to mortgage lending in the United States can trigger selloffs in markets around the world.
The tendency of market participants to underestimate market risks during periods of stability, increasing leverage and holding of illiquid assets only to find themselves forced into panic liquidations when risk inevitably returns.
None of these developments (described in depth in the recent book Demons of Our Own Design by Richard Bookstaber) are likely to reverse. As a consequence, prudent investment management must include avoidance of leverage and illiquid instruments and recognition that the only sure way to limit the volatility of a portfolio is to raise the holdings of short term US government bonds.
By mid September the Federal Reserve reacted to the market turmoil and the prospective impact of the real estate crisis on the overall US economy and cut short term interest rates by .5%. Markets rebounded strongly and at the time of this writing the broad US market and the major developed and international stock indices are at record highs.
At the end of the quarter the pain of the selloff had been erased for the broad indices:
Listed below for each of the indices is the drop from July intraday high to August intraday low followed by the
third quarter return
S+P 500
-11.9%
1.91%
EAFE Developed Market Index (ishares etf symbol EFA)
-19.4%
2.09%
Emerging Market Index (ishares etf EEM)
-22.7%
13.52%
Reviewing the market action, the following trends emerged:
· Growth stocks strongly outperformed value stocks as investors moved away from financial stocks which weigh heavily in the value sector and instead moved to large multinational corporations which dominate the growth side. We adjusted our portfolios during the quarter reducing our small and value weighting and adding to large cap growth domestically and internationally.
· International and especially emerging markets outperformed US markets as expectations remain that the highest growth will be from outside the US.
· The global growth story continues to fuel rallies in commodities and commodity producers. Our portfolios continue to benefit from our long held positions in this area.
· REITS (real estate investment trusts ) suffered in reaction to the housing crisis, probably to a greater degree than warranted. Lower interest rates and higher demand for rentals should help many REITs, though the outlook for commercial real estate is a more uncertain. By the end of the quarter markets seemed to be recognizing this as REITs recovered from their worst levels. The domestic REIT etf (ticker rwr) ended the quarter with an ytd loss of 5.02%, while international REIT etf (rwx)was up 3.37% for the period. By contrast the etf for the homebuilder’s index (xhb) closed the quarter near its year’s low, down 34%
Going forward, the outlook for the US economy is at best uncertain. The open questions through the end of the year are:
· The performance US economy in the wake of the housing downturn. Consumer behavior in the holiday season will be a good indicator of this.
· Federal Reserve policy in response to developments in the financial markets and the overall economy.
· Will earnings from US multinationals be sufficient to offset any decline in domestic US economic activity?
· Will the growth from the developing world continue to fuel global growth?
· The “known unknown” a political or economic crisis that could have large reverberations on the financial markets
With the overall US market (Russell 3000 index)at the time of this writing up a bit over 10% ytd, developed international market (EAFE index) up 15% and emerging (MSCI emerging index) ahead by over 38%, I would be reluctant to forecast that the year will end with those indices much higher. The main driver in the extremely strong global stock market performance seems to be the flood of liquidity from outside the US particularly sovereign funds such as those from Dubai and China. This trend would be the key factor in extending gains further.
We feel comfortable with our current allocation:
· A reduction in weighting towards value stocks (with their high weighting in financials) and an increase in holdings in large cap growth domestically and
· A significant weighting in developed and emerging international markets (with a tilt towards emerging Asia)
· Weightings in energy and basic materials producers.
· Maintaining our allocation to domestic and international REITs.
Quarterly Market Review
The third quarter experienced another of the increasingly frequent and intense short term stock selloffs. The S+P 500 index fell 11.9% between mid July and mid August. The declines in international markets, emerging and developed, were even more severe. Once again, the markets showed that the only thing that goes up in a down market is correlation. Domestic and international (developed and emerging) small cap and large cap stocks all moved in sync.
While the most apparent cause of the decline was the collapse of the subprime credit market and the housing markets in the US, UK and elsewhere it is difficult to cite a specific event that precipitated the market move. What is clear is that several interrelated factors make each market shock more volatile, more widespread and more violent than the previous one. Among these factors are:
The increase in leverage by hedge funds and private equity firms,
The proliferation of complex derivative instruments, poorly understood by both issuers and buyers.
Short term quantitative trading techniques implemented with leverage by hedge funds. These funds often follow very similar strategies and when they reverse positions trigger a cascade of trading exacerbating short term market movements.
The continuing integration of global markets with the consequence that a crisis such as the recent one related to mortgage lending in the United States can trigger selloffs in markets around the world.
The tendency of market participants to underestimate market risks during periods of stability, increasing leverage and holding of illiquid assets only to find themselves forced into panic liquidations when risk inevitably returns.
None of these developments (described in depth in the recent book Demons of Our Own Design by Richard Bookstaber) are likely to reverse. As a consequence, prudent investment management must include avoidance of leverage and illiquid instruments and recognition that the only sure way to limit the volatility of a portfolio is to raise the holdings of short term US government bonds.
By mid September the Federal Reserve reacted to the market turmoil and the prospective impact of the real estate crisis on the overall US economy and cut short term interest rates by .5%. Markets rebounded strongly and at the time of this writing the broad US market and the major developed and international stock indices are at record highs.
At the end of the quarter the pain of the selloff had been erased for the broad indices:
Listed below for each of the indices is the drop from July intraday high to August intraday low followed by the
third quarter return
S+P 500
-11.9%
1.91%
EAFE Developed Market Index (ishares etf symbol EFA)
-19.4%
2.09%
Emerging Market Index (ishares etf EEM)
-22.7%
13.52%
Reviewing the market action, the following trends emerged:
· Growth stocks strongly outperformed value stocks as investors moved away from financial stocks which weigh heavily in the value sector and instead moved to large multinational corporations which dominate the growth side. We adjusted our portfolios during the quarter reducing our small and value weighting and adding to large cap growth domestically and internationally.
· International and especially emerging markets outperformed US markets as expectations remain that the highest growth will be from outside the US.
· The global growth story continues to fuel rallies in commodities and commodity producers. Our portfolios continue to benefit from our long held positions in this area.
· REITS (real estate investment trusts ) suffered in reaction to the housing crisis, probably to a greater degree than warranted. Lower interest rates and higher demand for rentals should help many REITs, though the outlook for commercial real estate is a more uncertain. By the end of the quarter markets seemed to be recognizing this as REITs recovered from their worst levels. The domestic REIT etf (ticker rwr) ended the quarter with an ytd loss of 5.02%, while international REIT etf (rwx)was up 3.37% for the period. By contrast the etf for the homebuilder’s index (xhb) closed the quarter near its year’s low, down 34%
Going forward, the outlook for the US economy is at best uncertain. The open questions through the end of the year are:
· The performance US economy in the wake of the housing downturn. Consumer behavior in the holiday season will be a good indicator of this.
· Federal Reserve policy in response to developments in the financial markets and the overall economy.
· Will earnings from US multinationals be sufficient to offset any decline in domestic US economic activity?
· Will the growth from the developing world continue to fuel global growth?
· The “known unknown” a political or economic crisis that could have large reverberations on the financial markets
With the overall US market (Russell 3000 index)at the time of this writing up a bit over 10% ytd, developed international market (EAFE index) up 15% and emerging (MSCI emerging index) ahead by over 38%, I would be reluctant to forecast that the year will end with those indices much higher. The main driver in the extremely strong global stock market performance seems to be the flood of liquidity from outside the US particularly sovereign funds such as those from Dubai and China. This trend would be the key factor in extending gains further.
We feel comfortable with our current allocation:
· A reduction in weighting towards value stocks (with their high weighting in financials) and an increase in holdings in large cap growth domestically and
· A significant weighting in developed and emerging international markets (with a tilt towards emerging Asia)
· Weightings in energy and basic materials producers.
· Maintaining our allocation to domestic and international REITs.
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