......don’t give your money to a hedge fund with expertise in energy. It seems you would have been far better off simply putting the money in an index of energy sector stocks through an exchange traded fund(up 8.5% through May), in an exchange traded note linked to energy like JJE (up 37.9% in the same period) or probably the best choice in a diversified portfolio; allocating a small portion of the portfolio to a diversified commodity index instrument like the ipath DJP which is capped at 34% energy holdings (it rose 16.4% jan – may 2008). All seem to have crushed the hedge funds marketed based on their expertise in this area. The WSJ reported the following.
Energy Hedge Funds Missing Oil Boom
Returns Lag Even as Futures Prices Soar,
Undermining Fears of Speculators' Clout
By GREGORY ZUCKERMAN and ERIC BAUM
June 9, 2008;
If speculators are responsible for driving up energy prices, some of them haven't been doing a good job of profiting from the surge.
Hedge funds that focus on energy failed to cash in on huge moves in oil, natural gas, coal and other parts of the energy patch this year. Some were too cautious, bet against crude oil to protect other holdings or bought stocks of oil refiners and producers, many of which have struggled. Exxon Mobil Corp., for example, is down more than 7% this year.
The 97 hedge funds that focus on energy investments were up an average of almost 3% through May, after climbing 16% last year, according to estimates of HedgeFund.net, which tracks fund performance. By contrast, prices of oil-futures contracts are up more than 40% in 2008. And the Standard & Poor's Global Energy Sector Index Fund, an exchange-traded fund that tracks shares of energy companies, was up 8.5% through May. Only about a third of the 97 funds are on track to beat that ETF this year. It is unclear how the funds have fared this month, with oil prices up 9% in June.
Some of the hedge funds having difficulties may have been among those that bet against the price of long-term oil-futures contracts, while at the same time buying near-term oil futures, says Mary Ann Bartels, an analyst at Merrill Lynch. That strategy backfired in recent weeks when long-term energy-futures prices did better than near-term prices.
The strength in crude this year has caught some veteran traders by surprise, in part because oil inventories have been relatively full. "People seemed to get too scared when it neared $100 a barrel that a pullback was possible and have been gun shy getting back in ever since," said one hedge-fund manager.
Wednesday, June 11, 2008
Friday, June 6, 2008
Another Good Reason Not to Buy an Actively Managed Mutual Fund
A key element of constructing a successful investment portfolio is to be diversified across asset classes large and small cap for example. Many investors using actively managed (as opposed to index funds) They (or their broker) begin their research as to which funds to choose in each asset class by reviewing funds labeled as targeting each category using the information either from the fund company in its marketing material or by an organization like Morningstar or Lipper. And when picking the fund to use in each asset class they choose “top performing” funds in each of those categories. As a result, as a stockbroker I met who was poring over Morningstar research reports in a coffee shop stated with certainty, they are creating a “best of breed” portfolio.
Actually the above strategy, although on the surface it seems quite well thought out, is not a good approach to take at all. Why? Because of something called “style drift”. You don’t get truth in labeling with an actively managed fund; they often fill their portfolio with stocks outside their designated asset class. Not only does this make it difficult to construct a diversified portfolio, it makes it difficult to evaluate a fund’s performance. Even the funds listed on the box in my June 4 post may only have beaten their respective index by having a large portion of their portfolio invested in holdings outside that asset class.
To take one example, the a Dodge and Cox Stock Fund is labeled by Morningstar as a domestic large value fund it even gives it their highest 5 star rating over ten years. Yet even Morningstar’s analysis points out that the fund is 18.5% invested in non US stocks. http://online.wsj.com/public/fund/page/fund_snapshot.html?page=9&sym=dodgx Lipper also categorizes the fund as US Large Value and gives it their top rating in 4 of 5 categories. The Dodge and Cox website lists _character.aspthis fund alongside the firm’s international fund so it surely is not marketed as a global fund that has a mandate to invest anywhere in the world. Yet as one can find on the Dodge and Cox website 4 of the funds top ten holdings are foreign stocks, they alone make up 10.6% of the portfolio. The website compares the fund’s performance to the the US S+P 500 not a global index including ex US stocks. Thus they are clearly indicating they want potential investors to evaluate the fund as a domestic US fund.
What is the importance of the above example for an investor:
1. If one is trying to keep a particular allocation % between US and foreign stocks one would have to constantly monitor the extent of foreign holdings in this fund and adjust accordingly by reducing funds that are explicitly foreign stock funds. Of course if those foreign stock funds are active, they might hold some domestic US stocks. I’m getting a headache already. Using active funds in an asset allocation can be like a Rubik’s cube.
2. The performance numbers for this fund are meaningless to compare it to other large value funds or to the index. For example, through the end of May Dodge and Cox was -5.5% ytd a tiny bit better than the -5.6% for the vanguard large value index fund. Clearly, even that minimal difference didn’t come from good stock picking within the large value category. It came from the international holdings. In fact a close look shows that Dodge and Cox in aggregate did a bad job of stock picking among both domestic and international stocks. The vanguard developed international index fund was -2.2 % ytd. So in fact an index portfolio holding 18.5% developed international stocks (as Dodge and Cox does) and the rest large value stocks would have returned -4.96 % ,which is better than DODGX.
As the WSJ article below points out, the situations with Dodge and Cox is not unusual, in fact it is quite common my bolds my comments in (bold parentheses)
Actually the above strategy, although on the surface it seems quite well thought out, is not a good approach to take at all. Why? Because of something called “style drift”. You don’t get truth in labeling with an actively managed fund; they often fill their portfolio with stocks outside their designated asset class. Not only does this make it difficult to construct a diversified portfolio, it makes it difficult to evaluate a fund’s performance. Even the funds listed on the box in my June 4 post may only have beaten their respective index by having a large portion of their portfolio invested in holdings outside that asset class.
To take one example, the a Dodge and Cox Stock Fund is labeled by Morningstar as a domestic large value fund it even gives it their highest 5 star rating over ten years. Yet even Morningstar’s analysis points out that the fund is 18.5% invested in non US stocks. http://online.wsj.com/public/fund/page/fund_snapshot.html?page=9&sym=dodgx Lipper also categorizes the fund as US Large Value and gives it their top rating in 4 of 5 categories. The Dodge and Cox website lists _character.aspthis fund alongside the firm’s international fund so it surely is not marketed as a global fund that has a mandate to invest anywhere in the world. Yet as one can find on the Dodge and Cox website 4 of the funds top ten holdings are foreign stocks, they alone make up 10.6% of the portfolio. The website compares the fund’s performance to the the US S+P 500 not a global index including ex US stocks. Thus they are clearly indicating they want potential investors to evaluate the fund as a domestic US fund.
What is the importance of the above example for an investor:
1. If one is trying to keep a particular allocation % between US and foreign stocks one would have to constantly monitor the extent of foreign holdings in this fund and adjust accordingly by reducing funds that are explicitly foreign stock funds. Of course if those foreign stock funds are active, they might hold some domestic US stocks. I’m getting a headache already. Using active funds in an asset allocation can be like a Rubik’s cube.
2. The performance numbers for this fund are meaningless to compare it to other large value funds or to the index. For example, through the end of May Dodge and Cox was -5.5% ytd a tiny bit better than the -5.6% for the vanguard large value index fund. Clearly, even that minimal difference didn’t come from good stock picking within the large value category. It came from the international holdings. In fact a close look shows that Dodge and Cox in aggregate did a bad job of stock picking among both domestic and international stocks. The vanguard developed international index fund was -2.2 % ytd. So in fact an index portfolio holding 18.5% developed international stocks (as Dodge and Cox does) and the rest large value stocks would have returned -4.96 % ,which is better than DODGX.
As the WSJ article below points out, the situations with Dodge and Cox is not unusual, in fact it is quite common my bolds my comments in (bold parentheses)
<strong>Fundamentals of Investing
The Drifters
You may think you know your fund manager's investment style. But don't be so sure --especially in turbulent times.
By KAREN HUBE
June 2, 2008; Page
As the stock market gyrates, you can take comfort in knowing you have a carefully worked out asset-allocation strategy in your mutual-fund portfolio, right?
Don't be so sure...
Some financial advisers caution that your portfolio may not be invested the way you think. The reason? During sharp shifts in the markets, some managers tend to veer out of their stated investment styles, with more frequency and to a greater degree than in calmer times, says Jeff Tjornehoj, a senior research analyst at data firm Lipper Inc. (although their fund data on the wsj website don’t take account of this) With markets down and highly volatile, "there is more of a temptation for managers to reach outside of what is typical for them in order to find positive returns," he says.
Research by Standard & Poor's Corp. indicates that drift heightens during market shifts. About 32% of all U.S. stock funds had "style drift" during the reasonably calm period in the stock market between March 2004 and March 2007. That compares with 46% during the tumultuous, post-technology-bubble period of June 2000 to June 2003, S&P found. S&P judges a fund's style by comparing the portfolio's total returns with the total returns of various style-based indexes and determining which one it most closely resembles. That is known as a returns-based approach. Other firms determine style based on the characteristics of the fund's underlying securities. That is known as a holdings-based approach.
For those who strategically allocate their money across asset classes and investment styles, a manager with wide discretion "can change the risk characteristics of your portfolio in ways you may not be comfortable with," says Steven Condon, investment director at Truepoint Capital, an investment adviser in Cincinnati.((!!!)
"It gets really problematic for investors if they own several equity funds whose managers are all drifting the same way -- then they are heavily overlapping in certain areas and getting far more exposure than they ever bargained for," says Ross M. Miller, clinical professor of finance at the University at Albany, State University of New York.
Adding Zip
Style drift can occur for positive reasons: Funds focused on small stocks, for example, can migrate into the midcap arena if the stocks they own have risen in price. "That's a good problem to have -- it means your small-cap manager has picked good companies," says Jay Berger, partner at Independent Wealth Management, an investment-advisory firm in Traverse City, Mich. In this instance, you may want to hang onto the fund for your midcap exposure and buy a new one to fill the small-cap space, he says
.(that’s pretty convoluted logic imo and pretty hard to implement: how often do you monitor it ? At what point do you make the adjustment he recommends, holding onto the fund that has more mid caps and buying more another small cap fund. Do you do this when the small cap fund’s holdings have risen to 25%, 50% 75% ? And where do you get the cash to buy another small cap with what cash ? by selling what ? And what about the problem of generating taxes (except in an ira) if you need to generate cash to buy that other small cap fund. My head is spinning already. And this problem would be totally eliminated by using only index funds.)
Some investors might like that their managers take the initiative to capture the best returns possible and add much-needed zip. "I believe the best way to go is with good managers who use their best judgment and invest wherever that takes them," says Jeff Bernier, managing director of TandemGrowth Financial Advisor, a wealth-management firm in Roswell, Ga. (yes if you don’t care much about asset allocation and believe in genius managers.)
An example is CGM Mutual fund, where manager Kenneth Heebner has one of the best 12-month returns of any U.S. mutual fund, up 35.6% through May 29. Earlier this year it had roughly 70% of its money in metals, mining, energy and bank stocks -- and 27% in debt securities. ( and its ten largest holdings make up 57.8% of the total portfolio so the fund is far from diversified, holding this fund is a big bet on the manager being a genius and continuing to make big money on his big concentrated bets. Though classified by Morningstar as a diversified large-stock fund, CGM Mutual says in its prospectus that it sometimes goes heavy on bonds, depending on Mr. Heebner's view of the economy.
Studies have come to different conclusions about whether style drift pays off in superior returns. In a 2002 study, Russ Werners, an associate professor of finance at the University of Maryland's Smith School of Business, found that managers of U.S. stock funds with style drift beat "style-pure" managers by three percentage points a year during the 15 years through 2000.
But Keith C. Brown, a University of Texas finance professor, found that style-pure funds beat drifters by 2.7 percentage points a year over a 12-year period that overlapped with the Maryland study. Mr. Werners used a portfolio-based analysis to determine style, while Mr. Brown used a returns-based one.
Any possible outperformance by drifters is largely irrelevant to those investors in the style-pure camp, because they aren't gunning for the highest possible returns. They say strategic asset allocation delivers high risk-adjusted returns, and they want managers sticking to what they are paid to do.
Don't assume that just because a fund's name specifies a style, it is therefore rigidly purist. Stock funds with names that reference a small-cap, midcap or large-cap style of investing must have at least 80% of their holdings in line with that style, according to a rule passed by the Securities and Exchange Commission in 2001. But there is a loophole: The rule says investment companies can take "temporary defensive positions to avoid losses in response to adverse market, economic, political or other conditions." In addition, the rule permits investment companies "to depart from the 80% investment requirement in other limited, appropriate circumstances, particularly in the case of unusually large cash inflows or redemptions."
"You only have to stick to that 80% during normal market conditions," says Bruce Leto, chairman of the investment-management group at law firm Stradley, Ronon, Stevens & Young LLP in Philadelphia. Because there is no official definition of what normal or abnormal market conditions are, "it's totally subjective to the manager," he says. "If you think the market is going into a tailspin, you can continue to call yourself by the same name and invest less than 80% according to your style." The SEC declined to comment.
Do Your Homework
It is hard to pinpoint style drift precisely as it is happening because information on fund holdings isn't available to investors on a real-time basis, Lipper's Mr. Tjornehoj says. "It's something that's only known for sure upon reflection."
The closest thing to a timely read for many funds is quarterly updates on funds' Web sites and in the SEC's Edgar database online (www.sec.gov4).
The University at Albany's Dr. Miller says investors can look for signs of drift by periodically comparing a fund's performance with that of its benchmark. "If returns aren't behaving the way they used to relative to the benchmark, that should give you cause for concern," he says.
Fund researcher Morningstar helps to pinpoint fund styles by plotting them on a grid of nine style boxes, including small, medium and large capitalizations and "value," "growth" and "blend" characteristics. (Value stocks are those considered cheap in terms of ratios such as stock price to per-share earnings, while growth stocks are those of companies whose earnings are expanding faster than the broader market's. Blend funds include both styles.) This information can be accessed free at www.morningstar.com5.
Morningstar President John Rekenthaler cautions that "the style boxes should be used as a guide, nothing else." If a fund crosses to blend from growth, for example, it doesn't necessarily mean it has made drastic changes. The fund may have been near the edge of the blend box all along, and moved into it after selling a few growth holdings.
Whether you are a style purist or willing to go with the flow of a style buster, there is no shortcut to doing homework on managers(or you could choose index funds in each asset category and not have to worry about this issue), says Steven Rogé, portfolio manager for R. W. Rogé & Co., a money-management firm in Bohemia, N.Y. He recommends reading the fund's prospectus and poring over any old reports of funds previously run by the manager.
Truepoint's Mr. Condon says the best way for most style-pure investors to ensure they get what they want is also the cheapest and least time-consuming: Invest in index funds.--.((obviously I couldn't agree more with that)
-- 6.
Thursday, June 5, 2008
Chutzpah Award of The Day
This Could Only Happen in the Bizarro World of Hedge Funds
From the June 5 WSJ
I don’t think much comment is necessary other than my bolds and my one observation noted in in bold italics. But this is not really atypical of the hedge fund industry
Drake Capital Management
Ending Two Hedge Funds
By MARGOT PATRICK
From the June 5 WSJ
I don’t think much comment is necessary other than my bolds and my one observation noted in in bold italics. But this is not really atypical of the hedge fund industry
Drake Capital Management
Ending Two Hedge Funds
By MARGOT PATRICK
LONDON -- Drake Capital Management LLC is to return roughly $4 billion to investors within the next year, after deciding to wind down its two remaining hedge funds this week.
But showing that heavy losses are no barrier for re-entry in the hedge-fund world, the New York-based firm said it will start accepting cash later this year for new funds following "substantially similar" strategies.
The closure of the two funds comes after Drake told investors in late April it would shut its flagship $2.5 billion Global Opportunities Fund. The firm, a specialist in fixed-income and global-macro investment strategies, had managed as much as $6 billion across the three hedge funds before losing about $2 billion over the past 17 months from poor performance and investor redemptions……
.
In a filing to the Irish Stock Exchange late Tuesday, Drake assured investors there wouldn't be a fire sale of assets, saying the portfolios are "well-positioned to avoid forced sales." A spokesman for the firm declined to make any further comment Wednesday about the funds' closure.
Most investors in the three Drake funds had already asked for their money back after last year's heavy performance losses. In an effort to guard against further losses from asset liquidations to meet the requests, Drake suspended redemptions on the funds earlier this year.
Drake Capital Management was founded in 2001 by Anthony Faillace, who had worked for BlackRock Inc. and bond giant Pacific Investment Management Co., and Steve Luttrell, a former BlackRock director who had also worked at Pimco. Mr. Faillace, the firm's chief investment officer, was lauded for making savvy bets on interest rates and currencies after the Global Opportunities fund clocked a 41% return in 2006.
Global Opportunities went on to lose nearly one-quarter of its capital in 2007,(that gives an investor who was in for 2 years a total return of 5.75%, for the unfortunate soul that chased the 2006 performance and began investing in 2007 he would have to earn 33% on his capital before getting back to breakeven )and Absolute Return was down 14% for the year. Global Opportunities had dropped a further 5% as of mid-May, and Absolute Return was off 12% as of mid-April, according to performance data reviewed by Dow Jones Newswires.
Drake continues to manage several billion dollars in long-only mandates and funds. According to its Web site, total assets under management are more than $10 billion.
As they say risk and return are almost always linked.
Wednesday, June 4, 2008
Why Am I Not Surprised By This ?
The wsj reported this week that despite active managers’ refrain “that it’s a stock picker’s market” (one of the great all purpose clichés of wall street) which is supposed to apply more in down than in up markets, the performance of active managers has been dismal so far this year:
As the article below shows, the useless cliches were coming hard and fast from the active managers (my comments in bolds)
Though Stock Pickers
Struggle, Tech Shares Revive
Managed Funds Fail to Outpace Indexes
By DIYA GULLAPALLI
May 31, 2008;
If this is supposed to be a stock picker's market, the stock pickers need to start picking better stocks.
Bearish periods are touted as stock picker's markets because money managers are supposed to deftly hand-select winning companies rather than rack up losses along with broad benchmarks that are tracked by popular index funds.
Money managers, who charge far higher fees than index funds, have happily promoted this idea. It's "a stock picker's market" that should validate "human-based fundamental analysis," noted one Janus fund in the past year. It's "a stock picker's market" that doesn't "reward broad ownership of sectors or industries," said the $257 million Schroder U.S. Opportunities Fund in a recent filing. It will "continue to be a stock picker's market" since "not every corporation will be able to grow its earnings" in a slower economy, the $22 million Adams Harkness Small Cap Growth Fund said in a recent shareholder letter.
Active funds held up well last year. But so far in 2008, they have fallen behind indexes in six of nine major categories of U.S. stock funds. In the three areas where they are ahead -- small value, small blend and large blend -- it's by about a half-percentage point or less.
Actually the number cited above which is based on aggregate returns in each category is less important than the numbers in the box which show that your odds of picking a fund that outperformed their category ranged from a bit over 2 in 10 to a bit over 6 in 10. And since research has shown that “winners’ seldom persist in beating their relevant index, the argument for active investing is even weaker than it appears from the short term data.
While the data above is only for the first five months of 2008, it is in line with historical experience:
Stock pickers' record during the six bear markets from 1973 to 2007 is three for six, according to research by Vanguard, which pioneered the index fund, but also runs actively managed funds. Beating the market half the time doesn't bolster the case of stock pickers' outperforming during downturns. During economic recoveries, stock pickers beat the market half the time in the 12-month periods following the bear markets. In the bear market from February 2000 to February 2003, active managers in a Lipper general equity average trailed the Dow Jones Wilshire 5000 index by two percentage points…..
That might explain why investors have been looking elsewhere. Last year, nearly 60% of net new cash to funds was captured by index and exchange-traded funds, according to data from the Investment Company Institute. As recently as 2006, index funds and ETFs garnered only 36% of the new dollars.
One hopes that the trend to low cost index and exchange traded funds is a sign of greater knowledge than investors rather than a short term phenomena which will reverse should active funds produce a short period of very strong performance.
Below are the reasons given for this current round of poor performance, but the big picture remains constant: it is very very hard to beat the relevant index.;
A variety of missteps have contributed to fund managers' sluggish results this year. Many value funds that prospered in the past by buying financial stocks on the cheap have done so again in recent quarters only to see financials keep getting pounded. ….
….Meanwhile, many growth funds have resisted buying booming energy stocks, which aren't normally considered growth stocks. Instead, these funds have stuck to typical favorites such as technology and health-care shares, which are down more than the S&P 500 overall.
Active large-growth funds are among those having the toughest time. Only 25% are beating the Russell 1000 Growth Index this year, the lowest percentage since 1996. Mid- and small-growth funds are posting similar results, and are behind their benchmarks by the widest margin of all nine stock-fund categories.
Large-growth funds are seeing some of the widest differences in returns, a situation that often helps a good manager stand out.
Perhaps the growth of index funds and etfs is indication that the tired claims of active management are gaining an increasingly skeptical audience.
Tuesday, May 27, 2008
Inflation and Bond Investing
Food for Thought
Bill Gross of Pimco the world’s largest fixed income manager issues periodic analysis of the markets and the economies. The newly released newsletter is a particularly good one and is highly recommended.
Gross has been in the high inflation camp for several years and in the current piece he levels a high degree of skepticism about official government inflation numbers. He points to data for a representative group of countries developed and emerging which shows an average inflation rate of 7% for both the last 10 years and the past 12 months. Official US government inflation rate for those 2 periods: 2.6% for the last 10 years, 4% for the last 12 months. Gross (and I would agree) find that gap not credible.
Two graphs from his newsletter are at the top of this post.
Gross’ conclusions for investors make sense. Since we are not traders we have integrated emerging market foreign securities and commodities into our portfolios for quite a long time. While Gross’s caveats with regards to TIPS are valid they still make sense in a portfolio and as he notes are far superior to conventional treasuries.
A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate…..
What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.
http://www.ft.com/cms/s/0/37f7e034-2878-11dd-8f1e-000077b07658.html
As for his positioning in his bond fund, Gross (see below as reported in the Financial Times) is implementing his view that US treasuries are extremely unattractive given their negative real yield. Instead he has moved into mortgage backed debt based on the yield spread over treasuries and what he perceives as a strengthened implied government guarantee for Fannie Mae and Freddie Mac. Our portfolios have moved into mortgage backed securities in a more cautious manner by investing in a GNMA bond fund. GNMAs are mortgages which carry the full faith and credit of the US treasury (unlike fannie and freddy) yet it seems the mere word “mortgage has scared away investors and pushed up yields. The Vanguard GNMA fund currently yields 4.76 vs 3.20 for their equivalent maturity treasury bond fund
Pimco's Gross makes big mortgage debt bet
By Deborah Brewster in New York
Published: May 23 2008 03:00
Bill Gross, the manager of the world's biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding of it to more than 60 per cent of the fund…..
Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government's implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.
"Government policy is moving to sanctify the status of the government-sponsored agencies . . . it became a question of which institutions would be sheltered by the government umbrella," he said…..
Mr Gross said Pimco was buying primarily mortgage agency debt and "not the subprime garbage"…..
Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries.
He called Treasuries "the most overvalued asset".
"If there was a bubble, the -popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2 to 3 per cent, there is no real return on that at all," he said.
"This is an asset class that is held by sovereign wealth funds and central banks . . . but that is not any reason to follow them
Wednesday, May 21, 2008
Advice on Inflation Protecting Your Portfolio in the NYT: Proceed With Caution
An article in the May 18 NYT reviewed investors’ options for insulating a portfolio from the effects of inflation but it contained a number of inaccuracies, some of which I will review below
May 18, 2008
How to Stop Inflation From Devouring a Portfolio
By J. ALEX TARQUINIO
Is inflation roaring back with a vengeance? It depends on whom you ask.
“The experience we have had in recent years harks back to the 1970s,” when commodities prices surged, said Zvi Bodie, a professor of finance and economics at the Boston University School of Management. He recommends that investors reposition their bond portfolios, in particular, to try to minimize the ravages of inflation.
The above contains some good and some not so good advice. First off, making changes in a bond portfolio based on a forecast for inflation, just like any other type of market timing is usually a poor move. On the other hand, Prof. Bodie’s suggestion that bond portfolios be positioned to protect against inflation is good advice indeed. And it makes sense in a long term allocation regardless of one’s current economic forecast.
But some strategists say the weak economy may help moderate inflation later this year. “What is holding inflation down, even to this elevated level, is the sluggish economy,” said Stuart A. Schweitzer, the global markets strategist at JPMorgan Private Bank. “And I think growth is likely to stay quite sluggish all this year, in which case inflation should come back down.”
The above is simply an economic forecast, a thin reed to hang an investment strategy on.
In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.
I would label the above statement extremely imprecise if not just plain wrong. In fact there is an investment that would shield retirees from inflation’s ravages. Certainly it provides protection that is even better than the inflation adjustment to social security or most private pensions.
The instrument is TIPS: Treasury Inflation Protected Bonds. These bonds pay a fixed rate (the real return) in addition to an inflation adjustment based on the govts consumer price index (CPI U) thus the bonds return is guaranteed to keep up with the CPI plus pay an addition real return. So an investor holding these bonds would receive a current return based on the CPI (3.9%) + the real return of (currently 1.5% for the ten year bond) That is attractive relative to social security which adjusts to the CPI and most inflation protected pensions which are similarly adjusted. By comparison the current conventional 10 year Treasury bond pays 3.84% with of course, no inflation adjustment. On this bond your interest does not even cover inflation. In economist’s lingo there is “negative real return”.
For bond investors the great enemy is inflation particularly when it creates a situation such as we have presently for treasury bonds: a negative real return. In many ways TIPS are the “perfect” fixed income investment. Even if they do not completely replace conventional bonds in a portfolio they certainly merit a significant allocation. The bonds can easily be bought in low cost mutual funds or etfs.
In my view Professor Bodie is quite right later in the article:
…. Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds’ principal based on changes in the Consumer Price Index.
In fact, he said he would not personally own any bonds now that did not adjust for inflation. “I don’t have to guess with TIPS,” he said. “I can lock that inflation-adjusted return in today.”
Professor Bodie is a major advocate for very large holdings of TIPS in investors’ portfolios in a recent book Worry Free Investing.
As noted below, TIPs have recently had a large runup in price pushing the real yield to historically low levels. While this may not be the best instant to buy TIPs it doesn’t do much to diminish their long term attractiveness.
Compared to the long term argument in favor of TIPs based on the structure of the instrument the comments of JP Morgan’s Mr. Schweitzer seem relatively flimsy
.
Schweitzer pointed out that inflation-protected bonds have already had a very good run. The Morningstar category for inflation-protected bond funds shows that they have returned 11.5 percent, on average, in the last 12 months. Although these bonds may be good for capital preservation, Mr. Schweitzer said that their current rich prices might mean that they will generate disappointing returns in the coming years — unless, of course, the economy is entering a long period of high inflation.
Mr. Schweitzer definitely shows his colors as a two handed economist as he argues inflation protected bonds (tips) may not be a good investment going forward…..or maybe they will.
Another often touted strategy to protect a portfolio is to invest in commodities, particularly gold. The growth of efts and etns (exchange traded notes) tied to individual commodities such as gold,silver and oil or commodity indices has made it far easier to invest in commodities. While it is true that commodities generally rise with inflation. This hedge is certainly not perfect.
Several fund companies have begun offering “real return” strategies in mutual funds that invest in TIPs. Commodities and real estate in with the goal of beating inflation. One major fund company (Fidelity) has a full page ad in the same Sunday issue of the NYT (could that be mere coincidence) for a “strategic real return fund…”that’s designed to outpace inflation”. The fund has only been in existence since September 2005 but the results do not seem particularly encouraging: a return of 4.83 through the end of the first quarter vs. 11.54% for the vanguard inflation protected bond fund. There is a longer track record for another real return fund: The PIMCO Real Return Asset fund. Its one year return is 12.83. The fund ’s 5 year return is 8.14% vs. the vanguard inflation protected bond fund’s 6.27%. But that return comes at considerably more risk: the volatility (as measured by standard deviation ) of the Pimco fund is 8.43 vs. Vanguard’s 5.03.
While it is true that the two asset classes that consistently are positively correlated with inflation are TIPs and commodities, it would probably serve and investor to purchase these two asset classes directly and at lower cost than by purchasing the active managed “real return fund. As is usually the case with an actively managed fund one the investor is paying a higher management fee and is counting on the active manager who will be actively switching between holdings of commodities, tips, real estate and conventional bonds. The PIMCO fund must be altering its strategy at a rapid rate, its portfolio turnover is 489% (!)
Current market conditions for those trying to add inflation protection to their portfolios are difficult. They are a bit late to the party as commodities have increased sharply in value and have been particularly volatile. The real yields on TIPS are at historically low yields a consequence of high inflation expectations and low yields on conventional treasuries. Nonetheless the TIPs are surely more attractive than the conventional treasuries.
Prof Bodie is not far from the mark in stating:
“The bottom line is there is no free lunch,” he said. “If you try to protect yourself against inflation with either or both of these approaches, then you have to either give up return,” by accepting the lower yields that are now available on TIPS, “or take on more risk” in the commodity markets.
His advice certainly makes more sense than this:
“If you are looking to outpace inflation, you should be investing in stocks,” said Sam Stovall, the chief investment strategist at Standard & Poor’s.
For the moment, Mr. Stovall recommends underweighting bonds while maintaining a neutral position on stocks.
The above strategy points out the difference between a long term strategy and a trading orientation. Only 2 asset classes: TIPs and commodities have a long term positive correlation with inflation (i.e. they move up with inflation). US stocks have a negative correlation.
Here’s more of Stovall’s advice :, if an investor keeps 60 percent of her total portfolio in stocks, he might advise that she keep 25 percent of the total in bonds and 15 percent in cash. His usual recommendation would have been to put 30 percent of the portfolio in bonds and just 10 percent in cash.
This”strategy" has nothing to do with a structured strategy to offset inflation as can be seen by the lack of any mention of TIPs in the bond portion of the portfolio.
Moreover, Mr. Stovall said that once investors felt comfortable enough to put more money into the markets, they should buy stocks rather than bonds.
And here is another market guru, ostensibly an expert on inflation and investing who makes a market call rather than recommending a strategy for limiting inflation’s hit on a portfolio.
Jim Floyd, a senior analyst …, who edits Inflation Watch, a monthly newsletter for Leuthold, said he was most concerned about sky-high commodity prices.
Mr. Floyd recommended taking a fresh look at some stocks that have suffered recently. He said that there might be opportunities in consumer products, utilities and financials, including insurance companies, banks and real estate investment trusts. “You want to buy the companies that are beaten down before the good news comes out,” he said.
Another analyst who I generally hold in high regard reaches a conclusion which I find puzzling
Ed Yardeni, the president of Yardeni Research, based in Great Neck, N.Y., said he thought that commodity prices could have further to run. He cited rising demand in developing nations like China and India, combined with dwindling discoveries of raw materials that are relatively easy to extract.
But he warned individual investors against buying commodities, for example, through one of the scores of commodity exchange-traded funds that have sprouted in recent years. Commodity prices are so volatile, he said, that individual investors who bought them would probably not sleep too well at night.
Instead, he advised investors to take a page from the San Francisco gold rush.
If you are an investor who thinks that the commodity boom is far from over, he said, “don’t get yourself dirty digging for gold; open up a shop that sells picks and shovels.”
He said that such “pick-and-shovel” stocks include shares of oil-field services companies, specialty chemical manufacturers, fertilizer makers and other companies that provide the materials or services on which the mining and agricultural industries rely.
I’m not sure I understand all the logic here. Yes commodities can be volatile, but Mr. Yardeni thinks they are likely to go higher. That would seem to me to argue to hold a relatively small allocation in commodities and to rebalance on an ongoing basis, reducing the position and consequently reducing risk on big increases in price and adding on price drops.
The pick and shovel companies he describes might be interesting for stock pickers, but there certainly is more risk that they will disappoint as inflation hedges compared with directly buying an etf based on a basket of commodities. Any number of factors independent of commodity prices could affect the returns of these stocks.
In sum, it seems the best strategy to add some inflation protection to a portfolio is the same as it is for most asset classes: keep the portfolio balanced and invest in instruments that have low costs and transparency and are invested directly in the asset class. In the this case it would be a low cost inflation protected securities fund or etf and a low cost commodity index exchange traded fund or note.
May 18, 2008
How to Stop Inflation From Devouring a Portfolio
By J. ALEX TARQUINIO
Is inflation roaring back with a vengeance? It depends on whom you ask.
“The experience we have had in recent years harks back to the 1970s,” when commodities prices surged, said Zvi Bodie, a professor of finance and economics at the Boston University School of Management. He recommends that investors reposition their bond portfolios, in particular, to try to minimize the ravages of inflation.
The above contains some good and some not so good advice. First off, making changes in a bond portfolio based on a forecast for inflation, just like any other type of market timing is usually a poor move. On the other hand, Prof. Bodie’s suggestion that bond portfolios be positioned to protect against inflation is good advice indeed. And it makes sense in a long term allocation regardless of one’s current economic forecast.
But some strategists say the weak economy may help moderate inflation later this year. “What is holding inflation down, even to this elevated level, is the sluggish economy,” said Stuart A. Schweitzer, the global markets strategist at JPMorgan Private Bank. “And I think growth is likely to stay quite sluggish all this year, in which case inflation should come back down.”
The above is simply an economic forecast, a thin reed to hang an investment strategy on.
In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.
I would label the above statement extremely imprecise if not just plain wrong. In fact there is an investment that would shield retirees from inflation’s ravages. Certainly it provides protection that is even better than the inflation adjustment to social security or most private pensions.
The instrument is TIPS: Treasury Inflation Protected Bonds. These bonds pay a fixed rate (the real return) in addition to an inflation adjustment based on the govts consumer price index (CPI U) thus the bonds return is guaranteed to keep up with the CPI plus pay an addition real return. So an investor holding these bonds would receive a current return based on the CPI (3.9%) + the real return of (currently 1.5% for the ten year bond) That is attractive relative to social security which adjusts to the CPI and most inflation protected pensions which are similarly adjusted. By comparison the current conventional 10 year Treasury bond pays 3.84% with of course, no inflation adjustment. On this bond your interest does not even cover inflation. In economist’s lingo there is “negative real return”.
For bond investors the great enemy is inflation particularly when it creates a situation such as we have presently for treasury bonds: a negative real return. In many ways TIPS are the “perfect” fixed income investment. Even if they do not completely replace conventional bonds in a portfolio they certainly merit a significant allocation. The bonds can easily be bought in low cost mutual funds or etfs.
In my view Professor Bodie is quite right later in the article:
…. Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds’ principal based on changes in the Consumer Price Index.
In fact, he said he would not personally own any bonds now that did not adjust for inflation. “I don’t have to guess with TIPS,” he said. “I can lock that inflation-adjusted return in today.”
Professor Bodie is a major advocate for very large holdings of TIPS in investors’ portfolios in a recent book Worry Free Investing.
As noted below, TIPs have recently had a large runup in price pushing the real yield to historically low levels. While this may not be the best instant to buy TIPs it doesn’t do much to diminish their long term attractiveness.
Compared to the long term argument in favor of TIPs based on the structure of the instrument the comments of JP Morgan’s Mr. Schweitzer seem relatively flimsy
.
Schweitzer pointed out that inflation-protected bonds have already had a very good run. The Morningstar category for inflation-protected bond funds shows that they have returned 11.5 percent, on average, in the last 12 months. Although these bonds may be good for capital preservation, Mr. Schweitzer said that their current rich prices might mean that they will generate disappointing returns in the coming years — unless, of course, the economy is entering a long period of high inflation.
Mr. Schweitzer definitely shows his colors as a two handed economist as he argues inflation protected bonds (tips) may not be a good investment going forward…..or maybe they will.
Another often touted strategy to protect a portfolio is to invest in commodities, particularly gold. The growth of efts and etns (exchange traded notes) tied to individual commodities such as gold,silver and oil or commodity indices has made it far easier to invest in commodities. While it is true that commodities generally rise with inflation. This hedge is certainly not perfect.
Several fund companies have begun offering “real return” strategies in mutual funds that invest in TIPs. Commodities and real estate in with the goal of beating inflation. One major fund company (Fidelity) has a full page ad in the same Sunday issue of the NYT (could that be mere coincidence) for a “strategic real return fund…”that’s designed to outpace inflation”. The fund has only been in existence since September 2005 but the results do not seem particularly encouraging: a return of 4.83 through the end of the first quarter vs. 11.54% for the vanguard inflation protected bond fund. There is a longer track record for another real return fund: The PIMCO Real Return Asset fund. Its one year return is 12.83. The fund ’s 5 year return is 8.14% vs. the vanguard inflation protected bond fund’s 6.27%. But that return comes at considerably more risk: the volatility (as measured by standard deviation ) of the Pimco fund is 8.43 vs. Vanguard’s 5.03.
While it is true that the two asset classes that consistently are positively correlated with inflation are TIPs and commodities, it would probably serve and investor to purchase these two asset classes directly and at lower cost than by purchasing the active managed “real return fund. As is usually the case with an actively managed fund one the investor is paying a higher management fee and is counting on the active manager who will be actively switching between holdings of commodities, tips, real estate and conventional bonds. The PIMCO fund must be altering its strategy at a rapid rate, its portfolio turnover is 489% (!)
Current market conditions for those trying to add inflation protection to their portfolios are difficult. They are a bit late to the party as commodities have increased sharply in value and have been particularly volatile. The real yields on TIPS are at historically low yields a consequence of high inflation expectations and low yields on conventional treasuries. Nonetheless the TIPs are surely more attractive than the conventional treasuries.
Prof Bodie is not far from the mark in stating:
“The bottom line is there is no free lunch,” he said. “If you try to protect yourself against inflation with either or both of these approaches, then you have to either give up return,” by accepting the lower yields that are now available on TIPS, “or take on more risk” in the commodity markets.
His advice certainly makes more sense than this:
“If you are looking to outpace inflation, you should be investing in stocks,” said Sam Stovall, the chief investment strategist at Standard & Poor’s.
For the moment, Mr. Stovall recommends underweighting bonds while maintaining a neutral position on stocks.
The above strategy points out the difference between a long term strategy and a trading orientation. Only 2 asset classes: TIPs and commodities have a long term positive correlation with inflation (i.e. they move up with inflation). US stocks have a negative correlation.
Here’s more of Stovall’s advice :, if an investor keeps 60 percent of her total portfolio in stocks, he might advise that she keep 25 percent of the total in bonds and 15 percent in cash. His usual recommendation would have been to put 30 percent of the portfolio in bonds and just 10 percent in cash.
This”strategy" has nothing to do with a structured strategy to offset inflation as can be seen by the lack of any mention of TIPs in the bond portion of the portfolio.
Moreover, Mr. Stovall said that once investors felt comfortable enough to put more money into the markets, they should buy stocks rather than bonds.
And here is another market guru, ostensibly an expert on inflation and investing who makes a market call rather than recommending a strategy for limiting inflation’s hit on a portfolio.
Jim Floyd, a senior analyst …, who edits Inflation Watch, a monthly newsletter for Leuthold, said he was most concerned about sky-high commodity prices.
Mr. Floyd recommended taking a fresh look at some stocks that have suffered recently. He said that there might be opportunities in consumer products, utilities and financials, including insurance companies, banks and real estate investment trusts. “You want to buy the companies that are beaten down before the good news comes out,” he said.
Another analyst who I generally hold in high regard reaches a conclusion which I find puzzling
Ed Yardeni, the president of Yardeni Research, based in Great Neck, N.Y., said he thought that commodity prices could have further to run. He cited rising demand in developing nations like China and India, combined with dwindling discoveries of raw materials that are relatively easy to extract.
But he warned individual investors against buying commodities, for example, through one of the scores of commodity exchange-traded funds that have sprouted in recent years. Commodity prices are so volatile, he said, that individual investors who bought them would probably not sleep too well at night.
Instead, he advised investors to take a page from the San Francisco gold rush.
If you are an investor who thinks that the commodity boom is far from over, he said, “don’t get yourself dirty digging for gold; open up a shop that sells picks and shovels.”
He said that such “pick-and-shovel” stocks include shares of oil-field services companies, specialty chemical manufacturers, fertilizer makers and other companies that provide the materials or services on which the mining and agricultural industries rely.
I’m not sure I understand all the logic here. Yes commodities can be volatile, but Mr. Yardeni thinks they are likely to go higher. That would seem to me to argue to hold a relatively small allocation in commodities and to rebalance on an ongoing basis, reducing the position and consequently reducing risk on big increases in price and adding on price drops.
The pick and shovel companies he describes might be interesting for stock pickers, but there certainly is more risk that they will disappoint as inflation hedges compared with directly buying an etf based on a basket of commodities. Any number of factors independent of commodity prices could affect the returns of these stocks.
In sum, it seems the best strategy to add some inflation protection to a portfolio is the same as it is for most asset classes: keep the portfolio balanced and invest in instruments that have low costs and transparency and are invested directly in the asset class. In the this case it would be a low cost inflation protected securities fund or etf and a low cost commodity index exchange traded fund or note.
Wednesday, May 7, 2008
Wisdom From the Oracle of Omaha
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
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
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