It Seems the Quants Have Struck Again...Still No Explanation for The "Flash Crash"

We are just short of a week since the 8.5% intraday drop in the S+P 500  of May 6. We have yet to hear an explanation from regulators or exchanges As for the market the S+P 500 closed today virtually unchanged from the market open on that chaotic day. So does that mean the whole episode is just something to shrug ones shoulders over and move on.......I hardly think so.

I have no doubt the explanation lies in the complex of computerized,trading, derivative products and leveraged investment fund although I don't know the specific trigger and at this point doubt than anyone ever will..

 I am sure though that the mechanics and drivers (or programmers of the autopilot command) of these hyperactive trading vehicles are at the cockpit of machines that the regulators don't even have the faintest notion of. I am also sure that the folks using these tools don't really know how they will behave when they hit terrain ("market data points") that weren't considered when designing the machines and the autopilot system. 

It seems we have a constant cycle of  people far smarter than I  that get burned by designing leveraged trading strategies based on past data, lose massive sums when the proverbial "black swan hits. There are then the postmortems on how financial engineering "ain't physics" and there are no immutable rules. The quants may be chastened for a brief moment but they return to their engineering bench to build a better trading mousetrap and the cycle begins again.  

In the meantime markets, portfolios, corporations and entire economies suffer the blowback from these adventures in engineering.

Something is terribly broken. I am developing the concept of a "volatility tax" which is being taken out of returns to investors and cost of capital to corporations throught this activity (this is different than an actual tax levied by a govt ). I am not actually sure any entity is even profiting from this tax or whether it is just a "dead weight" cost to the economy. More on that later.

At the end of his book:

The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It     by Scott Patterson

video here interview with Patterson

In which he dissects how the quantitative traders took massive losses on their own books and contributed mightily to the market turmoil of 2008 he describes how they were less chastened than interested in moving onto the newest new thing, The new frontier for these guys was lighting fast high speed trading. Patterson points out in interviews that this was likely a new accident waiting to happen. That certainly seems to be the case

WSJ:

Computer Trading Is Eyed

Debate Turns to Absence of Circuit Breakers, Market Makers as Mystery Plunge Is Probed

Traders parsing the mystery of Thursday's stomach-churning stock-market plunge are focusing on whether rapid-fire computer trading, coupled with the market's complex trading systems, triggered a free fall that appears to have begun with an order to sell a single stock...

Over the past two decades, stock trading has gone from a relatively transparent network of human "market makers" executing buy and sell orders at a handful of exchanges to an almost entirely computer-driven system fragmented among dozens of players. And regulators don't have the ability to directly monitor many of these new players.

 Forbes

The Quants' Computers All Sold At The Same Time

And in what may be the ultimate feedback loop some see the hedge fund connected with black swan guru Naseem Taleeb as responsible at least in part for last week's black swan 900 point drop in the dow.
I have no way to judge the impact of the specific trades but the scenario is  a not uncommon one to varying degrees and certainly played a role in the 1987 stock market crash with the impact of portfolio insurance.

Any time there is extreme price movement in the market those that are short derivative positions that are options or have options like characterstics need to sell (buy) into a declining (rising) market in order to hedge their short positions that are essentially puts (calls), this selling (buying) then can push the market down (up) further triggering more hedging orders and exacerbating the market move.

The phenomenon is well known the author calls it a tsunami of orders, It occurs in "mini" form in markets for various securities and futures particularly at the expiry of options when the underlying is trading very close to a price where there are large holdings of options at the same level (strike price close to market price at option expiry date)


WSJ:

Did a Big Bet Help Trigger 'Black Swan' Stock Swoon?

By SCOTT PATTERSON And TOM LAURICELLA

Shortly after 2:15 p.m. Eastern time last Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.

On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.

The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.

Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market. The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.

Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders.

In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.

"Universa alone couldn't have caused the meltdown," said Mark Spitznagel, Universa's founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.

CNBC website today

Black Swan" author Naseem Taleb told CNBC he had no knowledge of a trade that may have caused last week's stock market meltdown even though he advises the hedge fund that is believed to have made it.

According to the Wall Street Journal, a hedge fund named Universa Investments made a $7.5 million options bet last Thursday afternoon that the S&P 500 Index would plunge to 800 by June. Regulators are examining whether that trade may have triggered the mysterious drop of nearly 1,000 points in the Dow Jones Industrial Average .

Taleb said in an intereview that he advises Universa but does not have specific knowledge of the firm's strategy. Taleb rose to prominence with his "Black Swan" book in 2007 that laid out the circumstances leading to the collapse of the financial system.

"I am in general a risk adviser to Universa," he said. "I don't know their positions, I'm not involved in trading."

Black Swan /Volatility Hedge Update

The strategy of buying volatility etns has worked well during the current downturn. Since april 30:

VXX short term vix futures etn +31.5% (top leftt chart)
VXZ meditum term futures vix etn +11.5% (top right)
vix index  +28.4% (below left)
s+p 500  -2.5% (below right)

Clearly the black swan hedge with the etns has worked well


A couple points of note

• . A quick google for VXX will lead many articles decrying the vxx as a terrible instrument that doesnt give the holder benefit when volatility increases. They fixated on  recent  past performance, never a good practice in investing  An example of this is from an "expert" on etns and etfs at the "authoritative" index universe website  who wrote on april 26

But neither the ETNs nor the proposed ETFs will fully benefit fully from any rebound in the VIX. That’s because the market for volatility futures right now is already pricing in the likelihood that volatility will be higher tomorrow than it is today. The Spot VIX is currently trading at 16.62, while May futures are priced at 18.50. In order for VXX (which currently holds the May contract) to appreciate in value, spot VIX must rise above 18.50 next month. In other words, investors need an 11 percent increase in volatility next month just to break even!

It gets worse in July, where the futures are pricing in a VIX of 20.75.

Well the vix is at 28.32 , the vxx is at 25.63 and the long vxx position returned 37% in the 2 weeks since that post more than overecoming what he saw as the insurmountable premium between the spot index and the futures.  And that differential between the spot vix and the july futures (even worse)  that he pointed out on april 26 ? The market has now flipped with the cash vix at 28.32 and the july futures at 27.10 (more on that later)


Seems to me this writer and others missed the whole point of owning the vxx. It is something designed to make money in extreme market turbulence. Judging its efficacy and writing it off based on how it disappointed during a stable market is, to put it charitably premature. The instrument wasnt around during the fall of 2008 but imo it performed quite well during its first test in extreme market turbulence.

•  The short term etn the vxx is more sensitive to changes in the and actual market volatility. It will generate a return that is a higher multiple of the decline in the stock market. It is a more leveraged hedge but it will also drop far more sharply in response to drops in the vix and lower actual volatility

• . The vxz based on the medium terms futures is a less leveraged hedge it also drops in price slower in response to falls in actual volatility and the vix

•  The above makes the vxx more of a short term play on volatility the vxz more of a longer term hedge agains the black swan. IMO under current conditions some of the vxx should be held in addition to the longer term vxz hedge position.

•  One thing that has bedeviled holders of the vxx in the past has been the cost of the "roll " of the futures on the value of their position. This can bee seen by the steady decline in the value of the vxx far more than the underlying index the vix.

This is because the vixx represents a long position in the near dated vix futures. As the futures approach expiration the etn provider must sell the futures nearing expiration and buy the next date futures. For most of the history of the futures index the market has been in "contango" the near date futures traded at a discount to the futher out date makin the roll costly often in excess of 10%.

The chart below illustrates the difference between the may and june futures and reflects the patterns between near date and next date futures contracts. A positive number means the june futures costs more than the may futures, meaning that the "roll" selling the near futures and buying the next date resulted in a loss. This dragged down the value of the vxx contract. More data on this can be found a this paper from S+P here


Now look at what has happened in the last week. The further date futures had moved to a discount to the expiring future (june is chearper than may) this reflects high demand for near term futures. This is exactly what happened during the fall of 2008 (black swan event) when the near date futures reached a premium of 20% over the further out dates (see the s+p paper). A fellow blogger gives a good explanation of the roll factor here although i dont agree on his conclusion about not using the vxx

What it means for vxx holders is that they are no longer penalized each time the ertn provider must "roll" their futures position. In fact what had been a drag on performance may in fact add a bit to the returns of the contract. In any case it means there will not be as large disconnect between the changes in the value of the vix and the vxx.



It also means that those long the vxx going into an extreme period of actual and implied volatility get an extra boost to the appreciation of their position as the futures curve shifts to backwardation (near date premium to far date futures) instead of the opposite = cotango.


Interestingly this movement also belies the conclusions of many in the blogosphere argued against every owning the vxx. As volatility goes to extremes the futures curve flips yielding a bit of a windfall gain as the futures are rolled. In other words when things get bad for those short volatility either literally or methaphorically those already long through the etns reap the benefit. The same thing happened in the futures in the fall of 2008. But since this was before the advent of the vxx etn, it seems many analysts discounted this happening. It is a "black swan" in the volatility futures market to coincide with the "black swan "in the underlying market.

Think the Growth of High Speed Electronic Trading and Derivatives Doesn't Increase Market Volatility....

think again. SPY one minute chart today

Emerging Markets Bonds....The Money Flows In : An Accident Ready to Happen

The Wsj has an article today

Emerging Markets' Low Yields Still Find Fans

Debt Interest Rates Plumb the Depths As Investors Flock

About the continued rush of investors into emerging markets bonds with the consequence that the countries in this category are able to borrow at rates that are extremely attractive for the issuers. For the investors not so much.

Some current yields on 10 year bonds mentioned in the article
Mexico and Turkey: 5.125%
Egypt 5.75%

10 yr US treasuries are at 3.55, Australia at 5.66

The highest on the list is Lithuania which is in the midst of Greeklike austerity measures: 7%

The emerging markets etf (EMB) yields 4.94%

I can't see how these investments offer poor relative returns to other bonds I dont like to use the word bubble but the word comes to mind.

The risk return on the emerging markets play: a small pickup in yield based on a bet that even with the crisis in europe emerging market economies will hold up well. From the article

Ripples from the European markets have spread this week, sending prices on emerging-market bonds lower. But many investors think the selloff will be short-lived unless the European situation grows much worse.
In the past, emerging markets have suffered worse than developed markets during financial crises. But that dynamic is changing, says Keith Gardner, head of the emerging-markets group at Western Asset Management in Pasadena, Calif. Emerging-market debt "is not immune to a global crisis," he says. However, thanks to their stronger fundamental outlooks, "they should perform much better than historically has been the case."

Yet the warning signs that this may not turn out to be the case are certainly around...even on the next page in the WSJ:

Another Reason for Trouble in Asia 

HONG KONG—Jitters over Europe's growing debt problems are adding to Asia's stock-market malaise, as investors wonder whether the region's surprisingly strong recovery has peaked already....

The contagion of Greece's problems to elsewhere in Europe could crimp trade with Asia. The weak euro already is making Asian goods more expensive in Europe. The euro has fallen 13% against the South Korean won this year, 11% against the Singapore dollar and 9.6% against the Chinese yuan, which tracks the U.S. dollar. Hong Kong and Singapore, both trading hubs, count euro-area exports as 13.2% and 11% of gross domestic product, respectively, according to Nomura economists. China's euro-area exports total 3.6% of GDP.
For now, a bigger concern is that Asia's future growth will slow as policy makers tighten the monetary screws. China has made several moves to cool its housing market. It restricted bank activity for the third time this year on Sunday by raising the percentage of deposits banks must hold against their loans.
At the same time, some early signs are showing that the recovery in Asia is beginning to pull back from its roaring postcrisis bounce over the past two quarters

Here are some alternatives in US $ etfs and their yields(all have durations considerably shorter than 10 years thus less interest rate risk):

High Yield: (JNK) 9.14
Inter Term Corporate (vcit) 4.62
Intermediate Term Govt (vgit) 2.52

A portfolio spllit equally among the 3 etfs above would carry a yield of  5.43. I certainly would rather hold that then the EMB.


I am of the view that one day moves may not be indicative of long term trends but on a day like today (May 6) the relative movements of securities is a good indication of correlations in crises and of relative riskiness.

So today's price movements may be instructive:

emb -4.51%
vcit +.27%
jnk -2.68%
vgit  +1.31%

and the "black swan" trades

vxx+11.94%
vxz   +4.84%

Emerging Market Bonds During a European Economic Crisis (or pretty much any othe time)?....No Thanks

 Two major international bond managers have been touting their heavy weighting of emerging market bonds in their global bond portfolios. Count me as skeptical of using these as part of any investors bond asset allocation.

In a previous post I wrote about the Templeton bond fund, praised in the WSJ for "thining different" in the words of the iconic Apple computer commercial.

Pimco, the bond powerhouse has also been aggressively promoting a bond fund with a heavy allocation to emerging markets.

Pimco launched its Global Advantage Bond Fund this year based on the index it created in 2009. The fund is listed on their website as a core bond holding and has a 30% weighting in emerging markets markets.

In fact larger holdings in emerging markets has emerged (pun intended) as a key part of their fixed income strategy. The WSJ reported

my bolds my comments from here on in blue

Pacific Investment Management Co., the world's biggest bond-fund manager, is increasingly investing in emerging-market corporate debt, part of a broader move to ramp up exposure to the fastest growing economies in the world and assets with the highest returns.
Pimco's clients, including pensions funds and insurance companies that are often the slowest to warm to the developing world, have progressively expressed more interest in this group of bonds, said Ramin Toloui, an emerging market portfolio manager at Pimco's Newport Beach, Calif., office. He was speaking via telephone en route to Washington for the International Monetary Fund's spring meetings.
Pimco, a unit of Allianz SE, has overall identified emerging markets as a growing opportunity, and last month increased its benchmark Total Return mutual fund's exposure from 5% to 6%.
However, the launch of Pimco's Global Advantage Bond Index last year is indicative of how much Pimco thinks investors should be exposed, said Mr. Toloui.
That index has a 30% allocation in emerging markets, he said.

Pimco has a research paper that makes the argument for the high weighting emerging markets vs developed and thus using a gdp weighted as opposed to cap weighted index as the basis for a portfolio. The arguments are familiar by know: large budget deficits in the developed world, questions on sovereign creditworthiness in other words Greece(and spain and portugal)  are just the beginning .

And unlike the 1990s and early 2000s theconditions in the emerging world in terms of macro economic conditions are better. Fair enough if one is venturing into international bonds it makes sense to weigh emerging bonds more heavily than indicated by a cap weighted bond index.

Also not surprising Pimco is able to trot out data showing that a heavy weighting in emerging market bonds increases returns without increasing risk..

Just as might be the case for emerging market bonds, high yield bonds may at times provide higher returns than the holdings on the bucket/umbrella side of the portfolio. But when I manage portfolios I hardly look at that lower return as an opportunity loss. I would compare the emerging market bonds to the rest of the risk assets in terms of risk total return and the diversification they provided.

Furthermore in terms of rirks protection we know that in times of crisis all risk assets become correlated and moved down. We saw this with emerging market bonds and stocks in 2008. There is little doubt in my mind that if a major capital markets crisis occurred again emerging market sovereign debt will perform worse than tresury bills.

I think we have seen this before. Researchers give a strong case for emerging markets outperforming other parts of the world based on stronger fundamentals and assume that past data on correlations and risk and return that the portfolio with a heavy weight to emerging markets will behave in the futures as it did in the past.

In fact it is quite likely that if there is a severe crisis anywhere in the financial markets emerging markets fixed income will suffer along with the rest of the world. and that the only safe haven will be in US treasuries. It certainly seems that way based on the 2 most recent major crises,

In August 1988 Russia defaulted on its bonds but the contagion spread across emerging markets, Emerging markets bonds fell 28% US govt bonds +2.6%

In the most recent crisis with minimal fundamental problems in the developing world relative to the developed, Oct 2008 saw emerging bonds -14% the US aggregate bond index fell -.3%

In other words everything goes down in a down market except correlation...this holds for bonds and stocks.

In the wake of the 2008 crisis there has been alot of rethinking about portfolio theory and portfolio management and its limitations. Probably the most useful conclusion is as to the limit utility of diversification as commonly referred to in finance. Diversification comes from the low correlation of asset classes a measurement of how much assets/asset classes move togehter. According to theory adding assets with low correlation to each other to a portfolio offers the potential for increasing return without increasing risk. But experiences shows that it is very often not the case, particularly in times of financial stress.

Diversification is not the same as risk management. It is undeniable from looking at the data that correlations go up during sharp market declines. In other words the kind of diversification that one might hope for based on statistics with regard to correlation fades away just when one needs it the most. Mark Kritzman of MIT and Windward Capital has written about the Myth of Diversification. He has pointed out that most people in the real world look at "good correlation and bad correlation" good correlation being assets that offer protection during a down market and bad correlation assets that pull down returns when the overall market is rallying. He akins the conventional way of looking at risk management through correlation to someone putting their head in an oven and their feet in a bucket of ice in order to create a moderate body temperature.

I agree completely and therefore only view the safest fixed income strictly defined as tbill asn tips and a hedge with an asymmetic payoff such as long puts and long volatility as risk reducing diversifiers.

A portfolio with a high weighting of emerging market bonds certainly does not fall into this category it is simply adding to the risk asset side of the portfolio.

 I agree with most of the arguments for long term outperformance in the emerging markets and have positioned the equity allocation of my portfolios accordingly. But I dont find the argument for emerging market bonds as an addition or alternative particularly convincing. First of there is minimal debt to be had from some of the fastest growing emerging economies, judging by the list of countries in the FTs table of emerging markets Singapore, Hong Kong, China and India have minimal outstanding bonds. In fact despite all the publicity and literature surrounding the fund and the growing parts of the emerging economies a review of the portfolios holdings on the website shows less than 1% of holdiing in remimbi bonds, nothing from India, Singapore or Hong Kong (but plenty of holdings in Europe, Mexico and Brazil)..Obviously this is far different than the country exposure one would structure with equity etfs or even active funds if one's investing thesis woas to position to participate in the high economic growth in emerging markets and emerging asia in particular.

As a consequence of the fact that there are virtually no bonds to buy from the fastest growing emerging asian. For that reason the Pimco bond fund takes outright currency positions in order to get exposure to China , South Korea and Taiwan. The rationale is expressed below. But since the chinese currency is no freely exposed to market conditions the chinese yuan positions amounts to a bet on future government policy. Sorry but I would rather be directly exposed to the economy's growth through equities.

Pimco is pushing this idea of emerging market bonds across its products. Another fund the Pimco Unconstratined Bond Strategy which can hold up to 50% emerging markets also ventures into this area but winds up with slim pickings in emerging asia debt and instead looks to outright currency positions.

from Pimco:

On the currency front, we are long a basket of Asian currencies, anchored by the Chinese yuan and with satellite positions in the South Korea won and Taiwan dollar. We believe these regions’ currency appreciation is a natural response to the fundamental need of China to shift from an export-oriented toward a more consumer-led economy. The Asian region has fared relatively well recovering from the latest bouts of global recession, and has the resources, labor force and rising total factor productivity that we believe will lead to a currency correction. We also hold positions that may benefit from expected weakness in the British pound and euro currencies.

Secondly the yield spreads are so minimal as to offer extremely limited risk return vs US bonds the highest yielding asia bond was indonesia 1t less that 2% over treasuries ...and there is certainly potential for political instability there. I would much rather hold emerging market stocks for my emerging portfolio and  if I were to put any fixed income on the risk side of the asset allocation do it through a purchase of a liquid high yield US dollar instrument like the HYG with a yield differential of well over 4.5% over treasuries.

A bond fund is in fact a very poor way to try to get a benefit from the growth in emerging markets.

In my view the new  products that incorporate large allocations to emerging markets bonds are a classic case of a "product" that has to be "sold" as opposed to a financial instrument that actually makes asset allocation cheaper and better.

Interestingly in an interrview on the pimco website  Lisa Kim one of their managers states the following:

In thinking about where this strategy fits in an investor’s asset allocation, consider why investors buy bonds in the first place. Typically, they are looking for (1) capital preservation, (2) diversification from equities, (3) income, (4) liquidity and (5) impact mitigation from an economic downturn. A core fixed income strategy and the Unconstrained Bond Strategy should really be no different in how they address each of the first four concerns.

the manager furthermore argues that in an inflationary rising rate environment their fund would do better than a standard bond fund

My response to the Pimco manager would be "maybe yes and maybe no" especially since the investor has no idea what the fund owns at any given point in time.

On the other hand I love the economic/scientific term occam's razor thks to wikipedia for this 

law of economy or law of succinctness). When competing hypotheses are equal in other respects, the principle recommends selection of the hypothesis that introduces the fewest assumptions and postulates the fewest entities while still sufficiently answering the question.. 

So if I were to refer back to the quotation above from Ms. Kim on why investors hold bonds and would be faced with the choice of:

a. A pimco actively managed portfolio that could contain foreign currency, emerging market bonds, mortgage backed securities, corporate bonds, taxable munis like the Unconstrained Bond Fund, the Global Advantage Bond Fund or even the flagship Pimco Total Return Fund

or

b. a mix of tbills and US Tips

It seems pretty self evident where occam's razor would point me

Want German Bonds With That Greek Crisis....I Don't

Pimco guru Mohammed el Arian gives good overview of the Greek and European crisis in this week's Barrons:(my bolds , my comments in blue)

Barron's: This week we saw Greece's credit rating cut to junk status, Portugal and Spain downgraded and the head of the OECD liken the debt crisis to the Ebola virus. What happens next?

El-Erian: This past week the market came under pressure from late sellers, people who recognized that Greece isn't interest-rate risk but a volatile credit risk and thus needed to trim positions. It blew out spreads significantly and made the market highly illiquid. That led to a scramble among the International Monetary Fund, the European Union and Greece, and we had the image of [IMF Chief] Dominique Strauss-Kahn and [European Central Bank President] Jean-Claude Trichet going to Germany, where all the decisions are being made, which was very reminiscent of [Federal Reserve Chairman Ben] Bernanke and [former Treasury Secretary Henry] Paulson going to Congress. We enter the weekend with the Germans considering how much of a bailout they can finance. I suspect that behind closed doors, the other question is how you involve the private sector, whether it's willing to buy new Greek bonds and treasury bills, or whether it's involuntary, where the private sector contributes not by putting in new money but by not being repaid. Nobody in Europe wants to talk openly about this. Greece isn't just a liquidity problem; it's a liquidity and solvency problem. Greece alone can't resolve its solvency issue. The longer the delay in putting together both domestic adjustment and external financing, the higher the probability of a debt restructuring.

It's important for investors to have Plan A and Plan B. Under Plan A, ultimately, the Germans will need to finance most of this large bailout package and cover Greece for two to three years. That would give a bid to risk assets. Under Plan B, the Germans will be reluctant to write large checks for so long that it would make restructuring a higher probability. This would shock the risk markets, spread the problem to European countries, contaminate European banks, reduce liquidity in the system. So you plan for both, scale your positions so they can adjust quickly to either scenario. The market on average has bet on Plan A.

The delay in solving Greece has disrupted Spain and Portugal. It's a real possibility that Spain and Portugal may need to receive a bailout from Germany. It's a low-probability scenario that Germany will sign up for that bailout, so that's why getting Greece right is so important. Otherwise, the number of attractive options for Europe diminishes. Germany is able to financially write these checks but unwilling to be the funder of a three-year bailout for these three countries.

If the issues for the peripheral European countries aren't resolved, it's a bigger problem for Europe-wide issues, including the euro. Next, you ask the question of what happens to the euro zone itself. What happens to the euro zone should be taken seriously as a risk scenario. This is about 10 steps away from what the market is willing to recognize.

For too long, markets have priced in what we called at Pimco an immaculate recovery for Greece -- this notion that the private sector would continue to buy into artificial growth and long-promised fiscal adjustment on the part of Greece and would provide so much financing that it would lower Greece's borrowing costs to such low levels that you could get both fiscal adjustment and growth. We sold Greek holdings early on and stayed on the sidelines rather than participate in the various bond issuances that Greece has made and that have subsequently gone down in value. 

El Arian notes that Pimco holds no positions bonds of Greece, Spain or Portugal

But interestingly later in the interview he states:(my bold)

What do you like these days in the emerging and developed markets?

At Pimco, we have been and are going up in the capital structure, migrating up the quality side in corporate paper. I like equity and credit exposure in Australia and Canada, interest-rate exposure in Germany. In the U.S. and U.K., I'd look to add inflation exposure on attractive pricing.

El Arian is responsible for managing far more money than me but I can't see how holding any German paper follows from the analysis he gave of the European situation. (top Pimco honcho also indicated a preference for German bonds in his april commentary) The only possible situation for holding German interest rate risk would be a bit of a perverse one: a massive decline in German growth and the need to bailout German banks would lead the ECB to flood the market with liquidity. Of course the consequences to the Euro would be dire leaving dollar based  investors in euro denominated paper with large currency losses. What are the prospects for a bank bailout in Germany ? the nyt gives an estimate of German exposure to the weaklings of Europe

German Banks Have Big Investment in Greece

April 28, 2010, 5:20 PM

There may be a good reason why German taxpayers are so unhappy about having to lend money to Greece. In effect, they already have. Germany’s financial institutions hold some 28 billion euros, or $37 billion, in Greek bonds, Barclays Capital estimates, extrapolating from International Monetary Fund data,  Jack Ewing of The New York Times reports from Frankfurt.

A quick survey of Germany’s largest banks on Wednesday indicates that probably half of that debt — rated “junk” by Standard & Poor’s since Tuesday — sits on the balance sheets of institutions that are owned or controlled by the government. The percentage could be much higher, but outsiders have no way of knowing for sure because bank regulators and many of the banks refuse to disclose precise numbers.

Germany’s existing exposure to Greek debt easily exceeds the 8.3 billion euros that the country would lend to Greece as part of a European Union plan to help the country avoid default on its debt — though not the 24 billion euros that may eventually be needed from Germany. Hypo Real Estate Group alone holds 7.9 billion euros worth of Greek debt. And, after a bailout last year, the taxpayers own Hypo Real Estate.

Germany’s direct exposure to Greek debt provides another reason  the country’s problems are very much Europe’s problems. “It’s not just a question of paying for Greece’s luxury pensions. There are intrinsically strong German interests as well,” said Alessandro Leipold, former acting director of the I.M.F.’s European Department.

In my view this peek into Pimco's thinking points out a more fundamental issue related to Pimco's active bond management and use of their funds.

But should one be venturing into non US and especially non dollar bonds at all? I don't think so. Pimcos fixed income managers are confined in their holdings to fixed income yet unrestricted within that category and as their largest fund title indicates they are looking for the greatest total return. But is that really the purpose of the bond part of most investors' portfolios ? I would argue no.

The fixed income portion of a portfolio consisting of equities, bonds and perhaps alternatives like commodities is to provide the anchor of a portfolio. I like very much Peter Stanyer's concept in his book of umbrellas and ..... To me this is the purpose of the bond part of the portfolio. Steady extremely low risk earnings with emphasis on capital preservation and tbills held for liquidity more than earnings.

The ideal holding for the umbrella part of the portfolio would be TIPS which carry US sovereign risk and no risk of loss of real return due to inflation.While in is true that perceptions of sovereign credit risk has declined I reject the idea that there is meaningful risk of a US bond default. If such an event would occur the magnitude of the financial crisis would make 2008 look mild and would leave no room to run for cover. Short term treasuries and highly rated investment grade bonds might be a part of the portfolio for the slightly adventurous.

 International bonds in my view belong on the other side of the asset  allocation that is in the risk asset section along with equities, reits and commodities. A good comparison would be with domestic high yield bonds which may have risk rather to yield characteristics that at time merit additions to a portfolio but they are not part of the bucket and umbrella part of the portfolio. Pimco's managers may be quite skilled at moving things around with freedom to roam anywhere around the world and around the the yield curve, credit spreads and types of issuers, But is that what one really wants for the defense side of ones portfolio in the bond allocation ?

Nevertheless Pimco promotes its flagship total return bond portfolio as a core fixed income holding and puts its new Global Advantage Bond Fund with a 30% allocation to emerging market bonds in the same category of core bond holding. I'll pass using those for that purpose.


 But it seems that some of my well known colleagues look at things differently. Here's the bond allocation from a firm highlighted in today's WSJ. I would say only the Pimco Low Duration fund provides anything clost to the "liquidity "bucket" or "umbrella" to withstand financial storms that I look for in my bond allocation

BONDS: There is a 36% allocation to bonds, primarily through bond powerhouse Pacific Investment Management Co., whose funds the advisers have used for more than a decade.

Mr. Voicu allocates 9% to Pimco Total Return, which primarily buys high-quality medium-term bonds, and 6% to Pimco Low Duration, which buys bonds of shorter maturities. The portfolio has two multisector funds that can buy various types of bonds, including risky low-quality bonds. They are Loomis Sayles Bond, at 4%, and Pimco Unconstrained Bond, at 9%. The portfolio's 8% foreign-bond allocation is in Pimco Emerging Local Bond, which buys medium-term bonds of governments and companies in developing countries.

Interestingly the same month end investing in funds section of the WSJ prevents a glowing review of another bond fund that I would never hold as part of my bond allocation for the same reasons outlined above.

A Top Bond Manager Wins by Ignoring His Benchmark

By TOM LAURICELLA

Michael Hasenstab has led the Templeton Global Bond fund to the top of Morningstar Inc.'s world-bond category over the past decade. He got to No. 1 partly by saying no. No, that is, to strictly modeling his portfolio after a bond index, ...

Mr. Hasenstab is more than willing to own big slugs of bonds from countries that have virtually no representation in the fund's benchmark, the Citigroup World Government Bond Index, as long as they have strong fiscal policies and healthy economies. That's a move that in most fund companies would have marketing executives complaining about "style drift." For Mr. Hasenstab it has meant stakes in Brazil, Australia and South Korea.

I took a little peek under the hood of the fund  at the Franklin Templeton website and found a couple of things that caused me further pause. The fund carries a 4.25% initial sales charge and a .96% management fee. According to the website that chops the funds effective one year return from an impressive 26.23 to 20.89. Still very impressive but still, fees cut the net return by 1/4.


The fund's top ten holdings include Korea, Poland and Russia t fee and depending on share class a front end or deferred load, meaning the fund must outperform an index by more than 1.5% before yielding any net benefit to the investors. The fund also owns California munis, venezuelan and mexican govt paper.


A possible holding for people that believe in aggressive active management for part of their portfolio ? I guess so. But it is certainly not something for the bond part of any portfolio I would manage.