Another "Can't Miss" Investment Strategy That Missed

The massive losses across the financial markets have exposed the flaws behind many of the esoteric strategies with unrealistic promises created by the wizards of wall street. One of these was the "portable alpha" strategy. I teach a course in an MBA program for non profits in which we did a Harvard Business School case about an endowment using this "strategy" and even these students who had limited background in finance viewed this strategy with skepticism (with much encouragement from me)

The strategy draws its name from the purported ability to capture alpha (the excess return over the market index) regardless of market risk. For example one could go short the s+p 500 index with futures and then use the cash to invest with a manager who would generate alpha (excess return over the s+P 500) Since the short position in the s+p 500 offsets the market risk in the alpha manager's portfolio, the strategy has separated out the exposure to the manager's skill (alpha) from the market risk. And since the manager has such great skill we are told, this offers the opportunity to generate returns from the stock market regardless as to what the market does. (yes it is hard to believe but $billions were invested based on this pitch)

What could go wrong ? As my students 7 weeks into their first investment class figured out: the investment manager could fail to generate alpha and his underperformance relative to the market would mean the strategy would lose money.
Stripped of all the marketing material and jargon the strategy is just one big leveraged bet that the genius manager you give money to will generate above market returns with below market risk....in other words they will turn lead into gold.


Apparently the investment officers at several pension funds and endowments underestimated this risk as the wsj reported yesterday (my bolds, my comments in italics)
And as is always the case it seems Wall Street collected its fees and taxpayers will make up for the lack of fiduciary responsibility by public employees .

'Alpha' Bets Turn Sour
Pennsylvania Pension Now Faces Billions in Losses
By RANDALL SMITH



The stock-market downturn could force the Pennsylvania state employees' pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.

The potential hit to the $27 billion pension fund is the result of an exotic strategy used to help finance $9.2 billion in hedge-fund investments. Those bets helped the pension fund beat the market when stocks were rising, but backfired when the market sank.

Use of the aggressive strategy, called "portable alpha," has been cut in half, with officials of the Pennsylvania State Employees Retirement System acknowledging that the pension fund's exposure was "too large." (now there's an understatement)

Since stocks began falling, the fund has had to pay out $1.5 billion. Based on current market values of derivatives still outstanding, Pennsylvania could owe another $1 billion, a fund spokesman says. With the pension fund down about 14% in the first nine months of 2008, it is possible that the state will have to quadruple its annual contribution to roughly $1 billion in 2012, according to people familiar with the situation.

The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.

An estimated $75 billion or more has been invested using portable alpha. Other pension funds that used the strategy include the San Diego County Employees Retirement Association, with $8.1 billion in total assets, and funds in Kansas, Massachusetts and South Carolina.

Sean Mathis, a partner at business-valuation firm Mathis & Co., believes some pension funds were pulled into portable alpha programs without fully realizing the risk. "(another major understatement) When all the hand-waving is done, what investors ended up with is a highly leveraged bet on the market and a slug of money in hedge funds," he said.

Barring a turnaround, pension funds and other devotees of portable alpha "may find out that all they've done is paid a lot of fees and maybe lost a lot of money to boot," Mr. Mathis adds.

The idea behind portable alpha is that it's easy to match the market. If you do it using derivatives like futures, you can tie up less cash and get the same return you would using an index fund. Then you can use the rest of your cash to beat the market. The strategy gets its name from the ability to generate alpha, or above-market returns. As long as the returns on the remainder of your cash beat the futures' cost, you outperform the market. Typically, investors turned to hedge funds that are supposed to beat the market in good times and bad to invest that cash.

Last year, Pennsylvania pension-fund officials said the strategy would pay off as long as returns on the hedge-fund investments topped the interest rate owed on the investments. That is what happened when the market was rising. From 2003 to 2006, the pension fund's U.S. stock assets beat the market by an annual average of 6.2 percentage points.

But this year, the portable alpha portion of their portfolio, worth about $6.4 billion at the start of the year, is trailing the market by an estimated 15 percentage points, indicating that with U.S. and world markets down by 41%, they have lost more than 55% of their value. Fund officials say that, even with that setback, the strategy has generated $500 million in cumulative above-market returns.

Pennsylvania's portable-alpha strategy was put into place by the fund's former chief investment officer, Peter Gilbert, who built the program over a decade but stepped down in mid-2007 to become chief of the Lehigh University endowment. A Lehigh spokesman said Mr. Gilbert declined to comment.( I wonder why)

Pennsylvania invested more in hedge funds than any other state pension fund. Those hedge funds returned 2.8% for the year ended in June, but their performance turned negative in the third quarter and has remained so thus far in the fourth quarter, according to a spokesman for the pension fund.

Pennsylvania spokesman Robert Gentzel says the pension fund has had to sell liquid assets to make cash payouts on swaps it used to implement the strategy, but that such sales weren't unexpected. Assets had been set aside as collateral for the swaps, he adds. Portable alpha was pioneered in the mid- to late 1980s at Pacific Investment Management Co., led by famed bond manager William Gross, and by corporate pension-fund manager Marvin Damsma at Amoco Oil Co., according to the book "Capital Ideas Evolving" by Peter Bernstein.

(Not content to peddle this stuff to "sophisticated" institutional investors it seems individuals had the "opportunity " to access the strategy as well:)

A Pimco stock mutual fund using portable alpha has trailed the market by more than 10 percentage points this year. A spokesman for Pimco, a unit of German insurer Allianz SE, which has $1.5 billion in mutual funds using the strategy and another $30 billion for institutional investors, declined to comment.

Other bond managers with funds that used portable alpha to boost returns also have suffered. Among them is the Western Asset Management unit of Legg Mason Inc. Assets in the unit's $5 billion U.S. Index Plus accounts were invested mostly in mortgage, asset-backed and corporate securities, which have been clobbered amid the market's meltdown.

"I think this particular strategy is going to be pretty widely discussed, debated and re-evaluated," (a(and either tossed in the trash bin or "improved and remarketed "in a couple years three guesses which will happen) says Jim Hirschmann, chief executive of Western Asset Management.

Open Invitation to Powerliners

I often post comments on the popular conservative blog powerline often challenging the views on matters financial and economic. So here's an invite to denizens of that blog to post their comments on financial or economic matters here. Open mike except that offensive language and silly clipart will be deleted as is often not the case over there. Let the comments begin

Some Brilliant Words About Economists and their Forecasts

Blown off course by butterflies
By John Kay Financial Times


Published: November 26 2008 02:00 | Last updated: November 26 2008 02:00

In the 1980s, it seemed that computers held the key to economic forecasting. With large models and sufficient processing power, predictions would become more and more accurate.

This dream did not last long. We now understand that economies are complex, dynamic, non-linear systems in which small differences to initial conditions can make large differences to final outcomes - the proverbial flapping of a butterfly's wings that causes a hurricane.

So economic crystal ball-gazing remains unscientific. The trend is the forecaster's friend. Extrapolation assumes that the future will be like the past, only more so. We project current preoccupations - the rise of China and India, global terror, climate change - with exaggerated speed and to an exaggerated degree.

We forget that our preoccupations change. The people who worry about these issues today would 20 years ago have worried about the coming economic hegemony of Japan and the cold war. These issues were resolved in ways that few predicted.

It is a safe prediction - and the only one I shall make - that the topics that grab our attention 20 years from now will differ from those that consume us today and, if anyone has guessed what they are, it is only by accident. The future is unknowable. As Karl Popper observed, to predict the creation of the wheel is to invent it. To anticipate a new political force or economic theory, or even a new product, is to take the main step in bringing it into being.

If extrapolation is the forecaster's friend, mean reversion is the forecaster's crutch. Much of the time, you can predict that next year's figure will be somewhere between this year's level and the long-run average. But mean reversion never anticipates anything out of the ordinary. Every few years, out-of-the-ordinary things happen. They just have.
Still, you might think there would be large rewards for those who succeed in anticipating these events. You would be wrong. People who worried before 2000 that the "new economy" was a bubble, or warned of the terrorist threat before September 11 2001, or saw that credit expansion was out of control in 2006, were not popular. They were killjoys.

Nor were they popular after these events. If these people had been right, then others had been blind or negligent, and the latter preferred to represent themselves as victims of unforeseeable events. As John Maynard Keynes observed, it is usually better to be conventionally wrong than unconventionally right

More on the Failure of the Quants and Their Models

The NYT had a great article today on the perils of financial models and how their failures contributed to the current crisis. The lesson is also relevant to individual’s portfolios both in not relying on hedge fund “genius managers” that use quantitative models which purport to provide “free alpha” i.e. increased return with no increase in risk. And it should be a cautionary note even in constructing portfolios of more conventional assets even using index instruments. Past performance and correlations of asset classes is not a prediction of future performance.





In Modeling Risk, the Human Factor Was Left Out
By STEVE LOHR

Today’s economic turmoil, it seems, is an implicit indictment of the arcane field of financial engineering — a blend of mathematics, statistics and computing. Its practitioners devised not only the exotic, mortgage-backed securities that proved so troublesome, but also the mathematical models of risk that suggested these securities were safe.
What happened?
The models, according to finance experts and economists, did fail to keep pace with the explosive growth in complex securities, the resulting intricate web of risk and the dimensions of the danger.
But the larger failure, they say, was human — in how the risk models were applied, understood and managed. Some respected quantitative finance analysts, or quants, as financial engineers are known, had begun pointing to warning signs years ago. But while markets were booming, the incentives on Wall Street were to keep chasing profits by trading more and more sophisticated securities, piling on more debt and making larger and larger bets.
“Complexity, transparency, liquidity and leverage have all played a huge role in this crisis,” said Leslie Rahl, president of Capital Market Risk Advisors, a risk-management consulting firm. “And these are things that are not generally modeled as a quantifiable risk.”….
….The miss by Wall Street analysts shows how models can be precise out to several decimal places, and yet be totally off base. The analysts, according to the Fed paper, doggedly clung to the optimists’ mantra that nominal housing prices in the United States had not declined in decades — even though house prices did fall nationally, adjusted for inflation, in the 1970s, and there are many sizable regional declines over the years.
Besides, the formation of a housing bubble was well under way. Until 2003, prices moved in line with employment, incomes and migration patterns, but then they departed from the economic fundamentals.
The Wall Street models, said Paul S. Willen, an economist at the Federal Reserve in Boston, included a lot of wishful thinking about house prices. But, he added, it is also true that asset price trends are difficult to predict. “The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs,” he observed. “It’s these hierarchies of beliefs — these behavioral factors — that are so hard to model.”
Indeed, the behavioral uncertainty added to the escalating complexity of financial markets help explain the failure in risk management. The quantitative models typically have their origins in academia and often the physical sciences. In academia, the focus is on problems that can be solved, proved and published — not messy, intractable challenges. In science, the models derive from particle flows in a liquid or a gas, which conform to the neat, crisp laws of physics.
Not so in financial modeling. Emanuel Derman is a physicist who became a managing director at Goldman Sachs, a quant whose name is on a few financial models and author of “My Life as a Quant — Reflections on Physics and Finance” (Wiley, 2004). In a paper that will be published next year in a professional journal, Mr. Derman writes, “To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”…..
….Among quants, some recognized the gathering storm. Mr. Lo, the director of M.I.T. Laboratory for Financial Engineering, co-wrote a paper that he presented in October 2004 at a National Bureau of Economic Research conference. The research paper warned of the rising systemic risk to financial markets and particularly focused on the potential liquidity, leverage and counterparty risk from hedge funds.
Over the next two years, Mr. Lo also made presentations to Federal Reserve officials in New York and Washington, and before the European Central Bank in Brussels. Among economists and academics, he said, the research was well received. “On the industry side, it was dismissed,” he recalled.
The dismissive response, Mr. Lo said, was not really surprising because Wall Street was going to chase profits in the good times. The path to sensible restraint, he said, will include not only better risk models, but also more regulation. Like others, Mr. Lo recommends higher capital requirements for banks and the use of exchanges or clearinghouses for the trade of exotic securities, so that prices and risks are more visible. Any hedge fund with more than $1 billion in assets, he added, should be compelled to report its holdings to regulators.
Financial regulation, Mr. Lo said, should be seen as similar to fire safety rules in building codes. The chances of any building burning down are slight, but ceiling sprinklers, fire extinguishers and fire escapes are mandated by law.
“We’ve learned the hard way that the consequences can be catastrophic, even if statistically improbable,” he said.

One of my favorite authors Nassim Taleb, has been a constant critic of such models….and has made outsized returns as of late, as the wsj reported(below). His earlier book Fooled by Randomness is more directly relevant to finance than The Black Swan.

• NOVEMBER 3, 2008
October Pain Was 'Black Swan' Gain
By SCOTT PATTERSON
•
F

or most of October, it seemed nearly everything that could go wrong with the markets did. But the rout turned into a jackpot for author and investor Nassim Nicholas Taleb.
Mr. Taleb last year published "The Black Swan," a best-selling book about the impact of extreme events on the world and the financial markets. He also helped start a hedge fund, Universa Investments L.P., which bases many of its strategies on themes in the book, including how to reap big rewards in a sharp market downturn. Like October's.

Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund. "We're discovering the fragility of the financial system," said Mr. Taleb, who says he expects market volatility to continue as more hedge funds run into trouble.
A professor of mathematical finance at New York University, Mr. Taleb believes investors often ignore the risk of extreme moves in the market, especially when times are good and volatility is low, as it was for several years leading up to the current turmoil. "Black swan" alludes to the belief, once widespread, that all swans are white -- a notion that was proven false when European explorers discovered black swans in Australia. A black-swan event is something that is highly unexpected…..
To execute its strategy, Universa buys far-out-of-the-money "put" options on stocks and stock indexes. These are bets that the market will see a sharp, sudden downturn. They become extremely valuable in a market decline of 20% or more in a one-month period.
When times are good, such options are cheap and Universa gobbles them up, taking small losses along the way. When the market makes a quick, steep turn south, as it has recently, Universa's positions gain value as investors scramble to protect themselves in the downturn by buying puts. The strategy, which keeps more than 90% of assets in cash or cash equivalents such as Treasury bonds, either breaks even or loses small amounts in most months while waiting for periodic, infrequent spikes in volatility…..
.
While the black-swan strategy has paid off handsomely this year, it hasn't always. Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility. The strategy may face another test after the current bout of market turmoil.
The task for the fund's managers is to persuade clients to stick around after their big gains. Historically, such dramatic downturns have been rare events, occurring only once or twice a decade.

I am Quoted in Some Local SoCal Newspapers

This article on coping with the current market appeared in the Pasadena Star-News and the San Gabriel Valley News. Not exactly earthshaking advice in the quotes, but I thought I would post the link anyway.

The Fund Outflows Keep Coming

The mutual fund outflows for the first 2 weeks of October exceeded those of the entire month of September. And the money came out of stock AND bond funds indicating utter panic as the money basically is moving into cash equivalents, one step away from going under the mattress. My gut feeling at this point is that a significant market recovery around dow 10,000, s+P 500 around 1000)and/or a testing of the lows (around 8,000 on the dow,s+p500 around 850) will spark more outflows, flushing out most of the remaining "weak hands".

At that point there would be what is probably close to record amounts of cash on the sidelines, which when put back into the market by market chasing individual investors would lead to a significant market rally.

But please take this, like any other short term market forecast, with a massive amount of skepticism.

Actually This is A Good Sign

As the research of economists of the behavioral finance school have shown, individual investors are consistently very poor at timing the markets. Hence recent data on the behavior of mutual fund investors gives a glimmer of optimim amidst the barrage of bad news. And should certainly give hesitancy to anyone looking to liquidate their mutual fund portfolio.


Equity mutual fund outflows for the month of september were a bit under $50 billion compared to outflows of $75 billion in outflows for the first eight months of 2008, Outflows from international funds accounted for 58% of all stock fund outflows last week and 92% of all stock fund outflows last week.

This data on individual investors has proven over time to be a fairly reliable contrary indicator. Individual investors historically sell at the bottom and buy at the top.


BOSTON -- TrimTabs Investment Research on Tuesday reported that for the month of September through last Friday, stock mutual funds have seen outflows of $41 billion, while $22 billion have been redeemed from bond funds. The data don't include Monday's market sell-off. TrimTabs said the September fund flows through Sept. 26 compare with outflows from equity funds of $75 billion and inflows of $95 billion into bond funds for the eight months of 2008 through August 31. "Money is leaving the stock market and money market funds for the equivalent of the mattress, seeking safety in Treasurys and accounts in strong banks," said TrimTabs CEO Charles Biderman. "Individuals are scared and have no confidence in our system and whether our leaders know what they are doing. There is a huge amount of sideline cash that wants to return to the stock market. What's necessary for that to happen is a return of confidence in the system."

http://www.marketwatch.com/news/story/fund-investors-flee-during-september/story.aspx?guid={8679A4BF-31C3-4536-BFD6-696748550A58}&dist=hpmp

Stock Mutual Funds Saw $7.16 Billion Outflow Thursday-Wed - TrimTabs


NEW YORK -(Dow Jones)- Stock mutual funds saw an outflow of $7.16 billion during the week ended Wednesday, compared with an outflow of $6.33 billion during the previous week, according to TrimTabs Investment Research estimates.
For the week ended Wednesday, domestic funds saw an outflow of $3.29 billion, compared with an outflow of $492 million during the previous week. International stock funds saw an outflow of $3.87 billion, compared with an outflow of $5.84 billion during the previous week.
Separately, bond funds posted outflows of $8.14 billion, compared with outflows of $5.95 billion during the previous week. Hybrid funds, which mix stocks and bonds, posted outflows of $3.82 billion, compared with outflows of $ 2.26 billion during the previous week.