New commodity ETF launch: actively managed, but long-only

I won’t complain about having more possible commodity investment vehicles, and I like the concept behind this new ETF, but I’m not a huge fan of the idea because it’s long-only, and I prefer a long/short approach. The new fund will track the SummerHaven Dynamic Commodity Index, which we be rebalanced monthly. The “based on observable price signals” line sounds to me like a trend following model, just like the LSC ETF I prefer, but this new fund will be long-only. Full disclosure: they don’t have a ticker for the fund yet, so I’ll update this post when they have one.

The announcement press release:

SummerHaven Index Management Announces Launch of the SummerHaven Dynamic Commodity Index

STAMFORD, Conn., Dec. 18 /PRNewswire/ — SummerHaven Index Management, LLC announces the launch of the SummerHaven Dynamic Commodity Index (“SDCI”) – an innovative approach to commodity investing that uses fundamental signals about underlying physical markets to create an active benchmark for commodity futures investors. The index builds on academic research by professors from Yale University and the University of Tokyo. The SDCI tracks the performance of a fully collateralized portfolio of 14 commodity futures, selected each month from a universe of 27 eligible commodities based on observable price signals, subject to a diversification requirement across major commodity sectors.

The SDCI is composed of commodity futures contracts for which active and liquid contracts are traded on futures exchanges in major industrialized countries. The commodities are denominated in U.S. dollars. The commodity sectors for the Index include precious metals, industrial metals, energy and agricultural products including livestock, softs, and grains.

The First Long-Only Active Benchmark for Commodity Investors

The SDCI was designed as an active commodity benchmark index with the investor in mind. The index construction embeds active re-balancing instead of passive weights because not all commodities are expected to contribute equally to the overall performance of a commodities portfolio. The SDCI focuses on a subset of the commodity universe based on a periodic evaluation of fundamental signals, while at the same time maintaining a diversified exposure to the global commodity complex. Professor K. Geert Rouwenhorst of the Yale School of Management commented “Over the past decade commodities have gained acceptance by investors as an important element of the investment universe. As the asset class has matured, investor interest has naturally shifted towards active management. The SDCI design incorporates research ideas from two academic studies, Facts and Fantasies about Commodity Futures and the Fundamentals of Commodities Futures Returns, into a practical and implementable investment benchmark for investors.”

The SDCI is the first commodity index designed by SummerHaven Index Management. SummerHaven Index Management, LLC is the owner of the Index.

About SummerHaven Index Management

Headquartered in Stamford, CT, SummerHaven Index Management is focused on creating innovative commodity indices. The firm is led by a seasoned management team with over 50 years of collective financial markets experience with commodity futures, capital markets, investment management, and exchange traded products.

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The link to the announcement press release: http://www.prnewswire.com/news-releases/summerhaven-index-management-announces-launch-of-the-summerhaven-dynamic-commodity-index-79605862.html

The link to the fund’s latest prospectus filed with the SEC: http://www.sec.gov/Archives/edgar/data/1479247/000114420409066339/v169761_s1.htm#tPS

Closed end fund (CEF) arbitrage and premium/discount theory

I found this excellent paper through the Simoleon Sense blog, which I think very highly of and read attentively. Their post: http://www.simoleonsense.com/attention-graham-dodders-new-paper-closed-end-funds-activist-investors-whats-the-attraction/

The link to the paper they discuss: http://yesandnotyes.com/blog/wp-content/uploads/2009/12/deo-Closed-End-Funds-and-Activist-Investors.pdf

The Simoleon Sense post:

Attention Graham & Dodders: New Paper Closed End Funds & Activist Investors: Whats The Attraction?

January 2, 2010

One of my very good friends Doug has put together a  paper on activist investing and closed end funds. Doug is the mastermind behind the yes & not yes blog.

Click Here To Read: Closed End Funds & Activist Investors: Whats The Attraction?

Abstract (Via Douglas E. Ott, II @ Yes & Not Yes)

This paper offers a basic description of why activist investors are attracted to closed-end funds and how this affects the rights of the closed-end fund shareholders. Part II provides a general description of the closed-end fund structure and a review of the research that attempts to answer why most closed-end funds trade at discounts to their net asset value (NAV). Part III outlines the reasons closed-end funds are attractive opportunities for activist investors. Part III also provides a detailed account of three proxy contests that occurred between activist investors and incumbent directors of closed-end funds: (1) the activists failed in their contest and there were no positive effects for shareholders as a result of their efforts; (2) the activists failed in their contest and there were positive effects for shareholders as a result of their efforts; and (3) the activists were successful in their contest and were able to enact measures that benefited shareholders. These real-life examples illustrate the motivations of the activists (e.g., return on and of their investments, concern for shareholders’ rights) and also the problems that seem inimical to closed-end funds (e.g., unitary boards, conflicts of interest, fund shares that trade at large discounts to NAV). Part IV argues that, contrary to the feelings of the managers and directors of closed end funds, activist investors can be a desirable element for all investors in the targeted closed-end funds as they may be able elect directors that are more independent and are often able to decrease the discount to NAV just with an announcement of a proxy contest.

Great read: Innoculated Investor’s “Enduring Lessons of the Last Ten Years”

Innoculated Investor is one of the best blogs out there and you should definitely check it out. I found this excellent piece that compiles a bunch of the author’s own “enduring lessons” about investing from the last decade. It’s not a short piece, so I’ll let people read and evaluate for themselves and I’ll skip commenting on where I agree or the few places where I disagree. The URL to their post is: http://inoculatedinvestor.blogspot.com/2009/12/enduring-lessons-of-last-ten-years.html

They write:

The Enduring Lessons of the Last Ten Years

As the ‘naughties’ (what a perfectly descriptive name for the 2000-2009 period) come to a somewhat anti-climactic close, it is important for those of us in the investment community to take stock of what new lessons have been learned, what immutable laws have been reinforced, and what changes in policy, strategy and execution need to occur in order to avoid a repeat of the booms and busts of the last decade. The reason I think such an analysis is critical is that I do not believe most investors are cognizant enough of the dangers lurking in the world’s financial markets. Memories are very short and despite suffering through a number of serious market downturns over the last 10 years, I worry that we have already started a snowball rolling that has the potential to cause even more lasting damage than the dot com bubble or the real estate bubble and subsequent financial collapse. Therefore, it may be true that only by understanding the past can we hope to avoid such a fate.

The following list is not meant to be all encompassing. I’m sure each individual investor can come up with additional items and could justifiably disagree with some of my conclusions. Also, you will surely recognize some of these rules and guidelines as often repeated clichés. That is the point. I am not trying to re-invent the wheel or point out things that are not relatively obvious. However, I do believe that people who keep these beautifully simplistic lessons in mind have a much better chance of successfully navigating through persistently treacherous financial waters than those who ignore the past.

1. Trees cannot grow to the sky: This rule is number one for a reason. No matter how many times this idea is repeated or shown to be true in the market setting, another hot investment invariably comes along that causes people to forget that appreciation has its limits. However silly it may sound at a time of irrational exuberance, the restrictions on unending price increases consist of these pesky little things called fundamentals. For example, since no company can compound revenue growth at 20% indefinitely, fundamentals rarely justify paying exorbitant price to earnings multiples for stocks, regardless of the sell side’s bullish extrapolations. Or, since rents often do not increase by more much than CPI inflation on a yearly basis, real estate price appreciation that is significantly above the inflation rate is not likely to be sustainable. Basically, aside from commodities that are valued mostly based on supply and demand dynamics, most assets need to be valued based on the cash flows they can produce. It really is that simple. Accordingly, when price increases become decoupled from cash flow growth, the ensuing bubble is likely to eventually explode and devastate those who forgot that those annoying fundamentals will invariably win out.

This is a lesson that was reinforced a number of times over the last ten years within a number of disparate asset classes. However, this is the one lesson that is never sufficiently learned. As true as it is that the sun will rise in the east and will set in the west, investors will inevitably be willing to pay far too much for certain assets based on unrealistic assumptions about growth. Therefore, the solution for prudent asset allocators is to find investments in which it is possible to buy at a price less than intrinsic value and get any future growth for free.

1. Fighting the Fed means you can lose your shirt: All I can say is that I totally underestimated what near zero interest rates, a flood of bank liquidity, and an implicit government backstop of all risky assets would do to the price of everything but the US dollar. In retrospect the valuations of many stocks at the 666 low on the S&P in March reflected a draconian outcome for the US economy that was probably unlikely, especially with the Fed stepping up to the plate. It is now abundantly obvious to me that incredibly low interest rates punish savers and force people to go further out on the risk curve. Even worse, historically low rates apparently can cause lasting distortions when it comes to asset prices. Thus, it was foolish not to expect some rally in stocks. The length of the current rally has been impressive and clearly driven by some extent by the Fed’s money printing. Anybody who was significantly short during the last nine months has suffered mightily at the hands of the Fed’s attempt to reflate all asset classes (but the dollar) simultaneously.

Accordingly, this is a lesson that any and all short sellers should take to heart. When both the Fed and the officials in charge of fiscal policy make known their intentions to throw money at a situation with impunity, it likely to be very profitable to cover and go long risk, regardless of the underlying fundamentals. For investors who shun such speculation, when the Fed gasses up the Helicopter and loads up the money bags, it appears that the best course of action is to take short exposure way down and if valuations are right, add more to existing long positions.

Now the question facing all investors is whether or not the Fed’s actions will continue to stimulate price appreciation in various asset classes. My guess is that the corollary to the above rule is also true: when the Fed is eventually forced to take away the punch bowl, it is the longs who are bound to suffer while the shorts prosper. Therefore, it may be prudent for long-biased investors to take some profits if and when the Fed finally starts to consider hiking interest rates and shutting down the money spigot.

1. Ignore the warnings of The Oracle of Omaha at your own peril: I am just about finished with Alice Schroeder’s epic biography of Warren Buffett entitled The Snowball. The book serves as a fabulous reminder that investors should heed the advice of their elders. At the annual Sun Valley meeting in 1999 Buffett notoriously warned the crowd that technology stocks and the equity markets appeared overvalued and that stocks were poised to deliver mediocre returns in the coming years. What happened? You might recall that the tech bubble burst and many people, especially retail investors, experienced severe wealth diminution. Then, over the next few years Buffett wrote about and spoke of derivatives as weapons of mass destruction and indicated that he believed some kind of crash would come as a result of their proliferation. If you can’t see the prescience imbedded in those statements I suggest that you review what happened to AIG and what that company’s near demise did the global financial markets.

Recently, Buffett has made “all in” bets on America after his October 2008 op-ed piece in the NY Times and his enormous purchase of Burlington Northern Railroad (BNI) in 2009. What he hasn’t said directly about some of his recent moves (but has discussed in other contexts) is that these investments are actually hedges against inflation. In an inflationary scenario the best assets to own are solid businesses that have the ability to raise prices and those that will benefit from spikes in the prices of commodities (railroads for example). The Oracle is telling people to be positioned for coming inflation. After the number of things he has gotten right over the past 10 years it would be absolutely foolish to dismiss his words this time.

1. While being early may look and feel a lot like being wrong, investors must stick to their convictions: John Paulson knows this better than anyone and the tremendous profits he made shorting the housing market serve as an example of the need for investors to stick to their guns. I saw Paulson speak in New York earlier this year and the insight into his thought process during the 2006-2008 period was invaluable. From what I recall, Paulson was early in making bets against the RMBS market and actually closed out some shorts at a loss. However, he then discovered the magic of credit default swaps as a way to profit if the housing market tanked and by staying with his investment thesis was able to make billions of dollars for his fund and himself in 2007. It would have been easy to have gotten scared out of these contrarian positions, especially when people like Ben Bernanke were swearing that a widespread housing crisis in the US was just about impossible (isn’t it amazing this guy kept his job AND got re-nominated for another four years?). Fortunately for Paulson, he had done the necessary in-depth research and understood the dynamics and risks inherent in the RMBS market better than central bankers, policy makers, investment banks and institutional investors.

What current investors need to remember is that markets are absolutely not efficient all the time and the herd can potentially be wrong for an extended period. Thus, as long as you can stay solvent longer than the market remains irrational (a big if for firms that employ a lot of leverage), you can make fistfuls of money when your thesis plays out, even if you are a bit early.

1. Risk is not the same as volatility: The distinction between risk and volatility is crucial and investors must always be on the lookout for opportunities that arise from a general lack of understanding of the difference. Risk should always be defined as the potential for permanent capital impairment. Specifically, risk implies a drop in the value of an asset. In contrast, measures of volatility are derived from fluctuations in prices and have nothing to do with a change in intrinsic value of an asset. For reasons that have to do with behavioral and structural biases, investors continue to confuse these concepts and subsequently sell assets whose price has dropped but whose value has remained intact. Situations in which selling is based solely on declines in prices are the best times to be a value investor because companies with solid balance sheets and distinct competitive advantages can fall out of favor when sentiment turns against them. This creates an opportunity for knowledgeable investors who focus on the measurement of intrinsic value to back up the truck and load up on shares of their favorite companies. Accordingly, volatility is the friend of a value investor while risk is something that needs to be guarded against. If we have learned anything in recent years it is that it’s imperative to spend time attempting to evaluate the cash flows a company will generate as opposed to a completely useless metric such as a stock’s beta.
2. Never forget that politicians’ main objective is to get reelected: What this very sobering lesson implies is that there is almost never the political will to make tough choices that will lead to short term suffering even if current sacrifices are likely to lead to future prosperity. As a group, lawmakers seem to be consistently unwilling to risk their political aspirations for the good of the country or to hold to true to their beliefs. This is especially true in elections years like 2010. However, as a result of the exorbitant cost of running a political campaign, even in non-election years our elected officials are forced to continue to raise money and become even further indebted to special interests and powerful lobbyists.

The takeaway from this perverse situation and overwhelming desire to be reelected at any cost is that investors can count on legislators and the White House to kick the can as far down the road as possible and even create laws that exacerbate the problem in the long run but serve as a potential quick fix. The perfect example of this behavior was the passing of the Medicare part D legislation, a program that Paul Krugman argues created an $9.4 trillion unfunded liability over the next 75 years. Such giveaways are a nice way to get reelected, may help boost the stock market temporarily, but could end of bankrupting future generations of Americans. Therefore, long term oriented investors must be prepared to deal with the lasting secular trends that result from knee-jerk reactions to cyclical events.

1. Relying on so-called experts—central bankers, economists, and financial pundits—can lead investors down a slippery slope: If you turn on CNBC you have the wonderful luxury of being able to hear the opinions of hundreds of people who work with the markets on a day to day basis. Since these folks spend all of their time living and breathing financial markets, they should know best, right? Well, it turns out that experts are often wrong; not necessarily because they are bad people or are fools, but because accurately predicting the future is incredibly difficult. Accordingly, investors should remember that any prognostication, no matter who it comes from, needs to be taken with a grain of salt and that person’s particular incentives and biases must be taken into account as well. In the end people need to make up their own minds based on the facts in front of them and the extensive research they have performed. Making investments by relying on the advice of strangers or as a result of minimal time invested in understanding underlying valuations and fundamentals is not much better than random speculation. As the past ten years have shown, such behavior is a fantastic way to lose money.
2. When a market dynamic does not make sense fundamentally, that probably means the trend will not last: I think this is one of the most important takeaways from the numerous bubbles we have witnesses in the past decade. If you can’t understand the rational for specific trend or the fundamentals fly in the face of that trend, you have to believe that a severe reversal or correction is inevitable. On great example I remember of one such situation occurred in early 2008 with Martin Marietta Materials (MLM). With the stock trading well above $100 a share I continued to read sell side analyst reports touting the strength of the company’s aggregate reserves and resilient revenue stream. Unfortunately, at the time the US economy was going into the tank AND there was a huge supply of aggregates coming online over the next year. Not very bullish fundamentals for a company whose stock price depended on the price of aggregates. Predictably, the subsequent free fall in the US economy caused demand to decline dramatically at the same time the company had ramped up production. Despite the bullish predictions of sell side analysts the stock proceeded to go from close to $120 in September 2008 to just over $60 in November. Now, I have nothing against the company and have no opinion about the current stock price. But, at the time the gravity defying price of the stock did not make any sense based on the very obvious headwinds facing the company.

So, when you see zombie companies like Fannie, Freddie and AIG trading way up one day or notice their prices consistently climbing higher, keep in mind that if the reason for such activity completely confounds you, it is unlikely to be based on sustainable fundamentals.

1. Sexy financial and economic models often fail to capture the idiosyncrasies of actual functioning markets: Honestly, I don’t think I can do this topic sufficient justice. If you need a refresher on why intricate models have failed so badly, check our Nassim Taleb’s recent testimony in front of Congress. Let’s just say that cute models look great on paper but when irrational people get involved, they often fail to predict how markets will react. You would think that the world would have figured this out when LTCM blew up and almost dragged all the banks down along with it. The sad thing is that companies continue to use flawed models like Value at Risk (VaR) to assess risk. Shouldn’t we have realized the models’ limits when David Viniar of Goldman Sachs admitted that the company was seeing 25 standard deviation events several days in a row? No, the world was not experiencing some tectonic shift that caused asset prices to do things that should happen once every 100,000 years. The models were just wrong and continuing to rely on them is only going to enhance the risk of an extreme tail event that would even make a black swan blush.
2. When it becomes impossible to distinguish economic theory from religious theology, economists are likely to become blinded by their own beliefs: Why did so few economists see the financial crisis coming? Maybe they were too busy calling each other names to see the unsustainable debt levels and financial company excesses building up in plain sight. While the financial crisis has allowed the behavioral economists to gain deserved popularity, it is an indictment of the entire economics community that so many people who dismissed the rational actor fallacy were marginalized by the mainstream. Now, in spite of compelling conclusions about the way irrational people impact markets, somehow many neo-classical economists continue to hide behind their theories in a curious attempt to try to explain away the recent financial crisis.

Now on to the disciples of John Maynard Keynes. Could it be that the neo-Keynesians are so wedded to the belief that unlimited fiscal stimulus and deficit spending are the only paths back to sustained prosperity that they have lost sight of the risks of such profligacy? What if the Keynesian response to the recession was the correct reaction but the magnitude of the fiscal policy was far too strong and will eventually lead to some very unpleasant outcomes? With Keynes no longer alive but still deified by his followers, could the true believers even see it if they had it all wrong?

In my view, the constant bickering between the saltwater and freshwater economists and complete inability to see the to the other side of the argument (not to mention the absolute dismissal of the Austrian school’s tenets) seems more like an entrenched religious battle in which each side believes only one methodology can be right. Unfortunately, unlike arguments about the existence of god, market outcomes are not necessarily binary and the nuanced truth could lie in between economic theories. Thus, people who are willing to defend their position in the face of mountains of contrary evidence are likely to be so biased that they cannot be trusted to assess the state of the economy.

Even more concerning is this article in the Huffington Post that argues that the Fed effectively controls, monitors and censors what is published in economic journals. That’s the last thing the US needs: formerly autonomous and free thinking economists being controlled by the banking oligarchs who have a definite inflationary and Wall Street bias. We have already seen where that has gotten us and it is not pretty.

The conclusion that needs to be drawn about those who belong to what appears to be a very closed-minded and divided economic establishment in the US is that many have been compromised and may not be the most reliable evaluators of the past, present or future global economy.

1. Leverage is miraculous on the way up and a killer on the way down: My favorite analogy regarding the risks of too much leverage comes from none other than Warren Buffett. Buffett likens carrying too much debt to driving a car with a dagger attached to the steering wheel pointed at your heart. Everything is fine until you hit a bump and that dagger goes right into your chest. Of course if you are lucky and there are no bumps for a while you can make an incredible return on your equity. However, eventually that bump in the road is going to come and smart companies and households never put themselves in a position to allow that bump to be life threatening. Further, there is some compelling data that suggests that financial bubbles are almost always driven by too much leverage. The good news is that by in large companies have solidified their balance sheets over the last two years and households are finally starting to deleverage a bit. Thus, at least in the private sector and among consumers, the dagger is slowly being pushed further away.

However, I do worry that there is one particular institution that has ignored the above lesson and has taken on far too much leverage. Who is that you ask? Why the US government of course. One risk is that something unexpected happens, the government is forced to print even more money, the deficit spirals out of control, and in the end the quality of life for all Americans is impacted. We are already fighting two wars, have thrown trillions into the financial markets, have huge Social Security and Medicare obligations and on top of all that have passed stimulus legislation in an attempt to prevent a depression. Therefore, we can ill afford any unexpected expenditures. Even now it is hard to imagine how the US will live up to all of its obligations. Let’s just hope that the economy improves, tax revenues come back, and our foreign creditors are somewhat appeased before we hit that next inevitable bump. If not, both equity and bond markets could be devastated by the fallout.

1. Wall Street wins whether the economy prospers or fails and whether markets go up or down: This may sound like populist propaganda, but it is hard to argue that this is not precisely how the last few years played out. Yes, Lehman and Bear are gone and Merrill Lynch is now a part of Ken Lewis’s failed empire. There have clearly been a few losers in the aftermath of the dramatic financial crisis. But, in aggregate, Wall Street has not only survived, but has also prospered immensely at the expense of American taxpayers and businesses. Expected record bonuses this year are only icing on the cake. When many Americans spent this Christmas wondering if they were going to lose their jobs or whether they will be able to feed their families, I’m sure many on Wall Street enjoyed a very comfortable holiday. If this seems unjust given the fact that without government assistance many firms might not exist anymore, that’s because it unequivocally is.

At the center of all of this (but not alone) is Goldman Sachs. First, Matt Taibbi documented the success of Goldman in up and down markets in his July 2009 piece. Then, just before Christmas Gretchen Morgenson alerted the masses to what the investment community already knew: Goldman consistently bet against the same clients it was selling dodgy assets to. Don’t forget that despite unemployment rising above 10% Goldman somehow managed to only lose money on trading on one singular day in the 3^rd quarter of this year. If a baseball player batted .900 or higher for 3 straight months he would quickly be crowned the greatest hitter who has ever played the game. But when Goldman accomplishes a similar feat in what used to be a zero sum game, we don’t even blink anymore.

What all of this means is that through their political connections and too big to fail status, Wall Street firms are just about guaranteed to receive favorable treatment relative to the rest of us no matter how well or how poorly the economy is doing. Thus, investors who short these firms are at the mercy of the actions of a Fed and Treasury that do very little to protect against moral hazard. In fact, at a certain point, regardless of the dubious activities such as high frequency trading and so called trade huddles, it almost makes sense for investors to give in any say, “if you can’t beat ‘em, join ‘em.” Well, I said almost.

1. The most dangerous words in investing are “this time is different” but this economic cycle in the US may really and truly be different than the recent ones: The book by Carmen Reinhart and Ken Rogoff entitled This Time is Different is on my seemingly endless reading list but I have yet to get to it. But, from the reviews and commentary I have read, the authors do a great job analyzing past boom and bust cycles and disproving the notion that individual situations are different and thus certain countries can avoid experiencing the devastating and enduring impacts of financial crises. The title of the book is obviously ironic in that the authors show that there are common factors that cause financial debacles. Surprisingly, people make the same mistakes over and over again under the false premise that their own personal or country-specific circumstances will allow for a different outcome than others have experienced. Inevitably, such beliefs end in tears.

What does this have to do with the current economic and fiscal situation the US finds itself in? Everything. First off, the duo provides lessons about governments accumulating too much debt and pinpoints what leads to sovereign defaults. Second, if the US is following the same path as Japan (as the authors assert) in terms of dealing with the insolvent banking system, why should we expect a different outcome? These are just two of the topics addressed in the book that give investors a way to understand the risks associated with investing in government debt and bank stocks, for example.

In the end, my real worry is that the title of the book has a double meaning. While financial crises and the associated lasting effects on economies may be similar, I am concerned that many policy makers are viewing this downturn as if it were a typical inventory recession that can be cured by low interest rates and some targeted government stimulus. I fear that it may be that this recession is actually different from ones like the post-September 11^th slump. Accordingly, if Reinhart and Rogoff are right and this financial crisis is going to play out like others have around the globe, the template suggests that the US’s experience this time may be dramatically different from other recent domestic recessions. What that could mean for investors is a long slog of mediocre GDP growth and substandard returns on equities as the powers that be prolong making the tough choices needed to purge the system of debt and get back to fiscal sanity.

As the ‘naughties’ (what a perfectly descriptive name for the 2000-2009 period) come to a somewhat anti-climactic close, it is important for those of us in the investment community to take stock of what new lessons have been learned, what immutable laws have been reinforced, and what changes in policy, strategy and execution need to occur in order to avoid a repeat of the booms and busts of the last decade. The reason I think such an analysis is critical is that I do not believe most investors are cognizant enough of the dangers lurking in the world’s financial markets. Memories are very short and despite suffering through a number of serious market downturns over the last 10 years, I worry that we have already started a snowball rolling that has the potential to cause even more lasting damage than the dot com bubble or the real estate bubble and subsequent financial collapse. Therefore, it may be true that only by understanding the past can we hope to avoid such a fate.

The following list is not meant to be all encompassing. I’m sure each individual investor can come up with additional items and could justifiably disagree with some of my conclusions. Also, you will surely recognize some of these rules and guidelines as often repeated clichés. That is the point. I am not trying to re-invent the wheel or point out things that are not relatively obvious. However, I do believe that people who keep these beautifully simplistic lessons in mind have a much better chance of successfully navigating through persistently treacherous financial waters than those who ignore the past.

1. Trees cannot grow to the sky: This rule is number one for a reason. No matter how many times this idea is repeated or shown to be true in the market setting, another hot investment invariably comes along that causes people to forget that appreciation has its limits. However silly it may sound at a time of irrational exuberance, the restrictions on unending price increases consist of these pesky little things called fundamentals. For example, since no company can compound revenue growth at 20% indefinitely, fundamentals rarely justify paying exorbitant price to earnings multiples for stocks, regardless of the sell side’s bullish extrapolations. Or, since rents often do not increase by more much than CPI inflation on a yearly basis, real estate price appreciation that is significantly above the inflation rate is not likely to be sustainable. Basically, aside from commodities that are valued mostly based on supply and demand dynamics, most assets need to be valued based on the cash flows they can produce. It really is that simple. Accordingly, when price increases become decoupled from cash flow growth, the ensuing bubble is likely to eventually explode and devastate those who forgot that those annoying fundamentals will invariably win out.

This is a lesson that was reinforced a number of times over the last ten years within a number of disparate asset classes. However, this is the one lesson that is never sufficiently learned. As true as it is that the sun will rise in the east and will set in the west, investors will inevitably be willing to pay far too much for certain assets based on unrealistic assumptions about growth. Therefore, the solution for prudent asset allocators is to find investments in which it is possible to buy at a price less than intrinsic value and get any future growth for free.

1. Fighting the Fed means you can lose your shirt: All I can say is that I totally underestimated what near zero interest rates, a flood of bank liquidity, and an implicit government backstop of all risky assets would do to the price of everything but the US dollar. In retrospect the valuations of many stocks at the 666 low on the S&P in March reflected a draconian outcome for the US economy that was probably unlikely, especially with the Fed stepping up to the plate. It is now abundantly obvious to me that incredibly low interest rates punish savers and force people to go further out on the risk curve. Even worse, historically low rates apparently can cause lasting distortions when it comes to asset prices. Thus, it was foolish not to expect some rally in stocks. The length of the current rally has been impressive and clearly driven by some extent by the Fed’s money printing. Anybody who was significantly short during the last nine months has suffered mightily at the hands of the Fed’s attempt to reflate all asset classes (but the dollar) simultaneously.

Accordingly, this is a lesson that any and all short sellers should take to heart. When both the Fed and the officials in charge of fiscal policy make known their intentions to throw money at a situation with impunity, it likely to be very profitable to cover and go long risk, regardless of the underlying fundamentals. For investors who shun such speculation, when the Fed gasses up the Helicopter and loads up the money bags, it appears that the best course of action is to take short exposure way down and if valuations are right, add more to existing long positions.

Now the question facing all investors is whether or not the Fed’s actions will continue to stimulate price appreciation in various asset classes. My guess is that the corollary to the above rule is also true: when the Fed is eventually forced to take away the punch bowl, it is the longs who are bound to suffer while the shorts prosper. Therefore, it may be prudent for long-biased investors to take some profits if and when the Fed finally starts to consider hiking interest rates and shutting down the money spigot.

1. Ignore the warnings of The Oracle of Omaha at your own peril: I am just about finished with Alice Schroeder’s epic biography of Warren Buffett entitled The Snowball. The book serves as a fabulous reminder that investors should heed the advice of their elders. At the annual Sun Valley meeting in 1999 Buffett notoriously warned the crowd that technology stocks and the equity markets appeared overvalued and that stocks were poised to deliver mediocre returns in the coming years. What happened? You might recall that the tech bubble burst and many people, especially retail investors, experienced severe wealth diminution. Then, over the next few years Buffett wrote about and spoke of derivatives as weapons of mass destruction and indicated that he believed some kind of crash would come as a result of their proliferation. If you can’t see the prescience imbedded in those statements I suggest that you review what happened to AIG and what that company’s near demise did the global financial markets.

Recently, Buffett has made “all in” bets on America after his October 2008 op-ed piece in the NY Times and his enormous purchase of Burlington Northern Railroad (BNI) in 2009. What he hasn’t said directly about some of his recent moves (but has discussed in other contexts) is that these investments are actually hedges against inflation. In an inflationary scenario the best assets to own are solid businesses that have the ability to raise prices and those that will benefit from spikes in the prices of commodities (railroads for example). The Oracle is telling people to be positioned for coming inflation. After the number of things he has gotten right over the past 10 years it would be absolutely foolish to dismiss his words this time.

1. While being early may look and feel a lot like being wrong, investors must stick to their convictions: John Paulson knows this better than anyone and the tremendous profits he made shorting the housing market serve as an example of the need for investors to stick to their guns. I saw Paulson speak in New York earlier this year and the insight into his thought process during the 2006-2008 period was invaluable. From what I recall, Paulson was early in making bets against the RMBS market and actually closed out some shorts at a loss. However, he then discovered the magic of credit default swaps as a way to profit if the housing market tanked and by staying with his investment thesis was able to make billions of dollars for his fund and himself in 2007. It would have been easy to have gotten scared out of these contrarian positions, especially when people like Ben Bernanke were swearing that a widespread housing crisis in the US was just about impossible (isn’t it amazing this guy kept his job AND got re-nominated for another four years?). Fortunately for Paulson, he had done the necessary in-depth research and understood the dynamics and risks inherent in the RMBS market better than central bankers, policy makers, investment banks and institutional investors.

What current investors need to remember is that markets are absolutely not efficient all the time and the herd can potentially be wrong for an extended period. Thus, as long as you can stay solvent longer than the market remains irrational (a big if for firms that employ a lot of leverage), you can make fistfuls of money when your thesis plays out, even if you are a bit early.

1. Risk is not the same as volatility: The distinction between risk and volatility is crucial and investors must always be on the lookout for opportunities that arise from a general lack of understanding of the difference. Risk should always be defined as the potential for permanent capital impairment. Specifically, risk implies a drop in the value of an asset. In contrast, measures of volatility are derived from fluctuations in prices and have nothing to do with a change in intrinsic value of an asset. For reasons that have to do with behavioral and structural biases, investors continue to confuse these concepts and subsequently sell assets whose price has dropped but whose value has remained intact. Situations in which selling is based solely on declines in prices are the best times to be a value investor because companies with solid balance sheets and distinct competitive advantages can fall out of favor when sentiment turns against them. This creates an opportunity for knowledgeable investors who focus on the measurement of intrinsic value to back up the truck and load up on shares of their favorite companies. Accordingly, volatility is the friend of a value investor while risk is something that needs to be guarded against. If we have learned anything in recent years it is that it’s imperative to spend time attempting to evaluate the cash flows a company will generate as opposed to a completely useless metric such as a stock’s beta.
2. Never forget that politicians’ main objective is to get reelected: What this very sobering lesson implies is that there is almost never the political will to make tough choices that will lead to short term suffering even if current sacrifices are likely to lead to future prosperity. As a group, lawmakers seem to be consistently unwilling to risk their political aspirations for the good of the country or to hold to true to their beliefs. This is especially true in elections years like 2010. However, as a result of the exorbitant cost of running a political campaign, even in non-election years our elected officials are forced to continue to raise money and become even further indebted to special interests and powerful lobbyists.

The takeaway from this perverse situation and overwhelming desire to be reelected at any cost is that investors can count on legislators and the White House to kick the can as far down the road as possible and even create laws that exacerbate the problem in the long run but serve as a potential quick fix. The perfect example of this behavior was the passing of the Medicare part D legislation, a program that Paul Krugman argues created an $9.4 trillion unfunded liability over the next 75 years. Such giveaways are a nice way to get reelected, may help boost the stock market temporarily, but could end of bankrupting future generations of Americans. Therefore, long term oriented investors must be prepared to deal with the lasting secular trends that result from knee-jerk reactions to cyclical events.

1. Relying on so-called experts—central bankers, economists, and financial pundits—can lead investors down a slippery slope: If you turn on CNBC you have the wonderful luxury of being able to hear the opinions of hundreds of people who work with the markets on a day to day basis. Since these folks spend all of their time living and breathing financial markets, they should know best, right? Well, it turns out that experts are often wrong; not necessarily because they are bad people or are fools, but because accurately predicting the future is incredibly difficult. Accordingly, investors should remember that any prognostication, no matter who it comes from, needs to be taken with a grain of salt and that person’s particular incentives and biases must be taken into account as well. In the end people need to make up their own minds based on the facts in front of them and the extensive research they have performed. Making investments by relying on the advice of strangers or as a result of minimal time invested in understanding underlying valuations and fundamentals is not much better than random speculation. As the past ten years have shown, such behavior is a fantastic way to lose money.
2. When a market dynamic does not make sense fundamentally, that probably means the trend will not last: I think this is one of the most important takeaways from the numerous bubbles we have witnesses in the past decade. If you can’t understand the rational for specific trend or the fundamentals fly in the face of that trend, you have to believe that a severe reversal or correction is inevitable. On great example I remember of one such situation occurred in early 2008 with Martin Marietta Materials (MLM). With the stock trading well above $100 a share I continued to read sell side analyst reports touting the strength of the company’s aggregate reserves and resilient revenue stream. Unfortunately, at the time the US economy was going into the tank AND there was a huge supply of aggregates coming online over the next year. Not very bullish fundamentals for a company whose stock price depended on the price of aggregates. Predictably, the subsequent free fall in the US economy caused demand to decline dramatically at the same time the company had ramped up production. Despite the bullish predictions of sell side analysts the stock proceeded to go from close to $120 in September 2008 to just over $60 in November. Now, I have nothing against the company and have no opinion about the current stock price. But, at the time the gravity defying price of the stock did not make any sense based on the very obvious headwinds facing the company.

So, when you see zombie companies like Fannie, Freddie and AIG trading way up one day or notice their prices consistently climbing higher, keep in mind that if the reason for such activity completely confounds you, it is unlikely to be based on sustainable fundamentals.

1. Sexy financial and economic models often fail to capture the idiosyncrasies of actual functioning markets: Honestly, I don’t think I can do this topic sufficient justice. If you need a refresher on why intricate models have failed so badly, check our Nassim Taleb’s recent testimony in front of Congress. Let’s just say that cute models look great on paper but when irrational people get involved, they often fail to predict how markets will react. You would think that the world would have figured this out when LTCM blew up and almost dragged all the banks down along with it. The sad thing is that companies continue to use flawed models like Value at Risk (VaR) to assess risk. Shouldn’t we have realized the models’ limits when David Viniar of Goldman Sachs admitted that the company was seeing 25 standard deviation events several days in a row? No, the world was not experiencing some tectonic shift that caused asset prices to do things that should happen once every 100,000 years. The models were just wrong and continuing to rely on them is only going to enhance the risk of an extreme tail event that would even make a black swan blush.
2. When it becomes impossible to distinguish economic theory from religious theology, economists are likely to become blinded by their own beliefs: Why did so few economists see the financial crisis coming? Maybe they were too busy calling each other names to see the unsustainable debt levels and financial company excesses building up in plain sight. While the financial crisis has allowed the behavioral economists to gain deserved popularity, it is an indictment of the entire economics community that so many people who dismissed the rational actor fallacy were marginalized by the mainstream. Now, in spite of compelling conclusions about the way irrational people impact markets, somehow many neo-classical economists continue to hide behind their theories in a curious attempt to try to explain away the recent financial crisis.

Now on to the disciples of John Maynard Keynes. Could it be that the neo-Keynesians are so wedded to the belief that unlimited fiscal stimulus and deficit spending are the only paths back to sustained prosperity that they have lost sight of the risks of such profligacy? What if the Keynesian response to the recession was the correct reaction but the magnitude of the fiscal policy was far too strong and will eventually lead to some very unpleasant outcomes? With Keynes no longer alive but still deified by his followers, could the true believers even see it if they had it all wrong?

In my view, the constant bickering between the saltwater and freshwater economists and complete inability to see the to the other side of the argument (not to mention the absolute dismissal of the Austrian school’s tenets) seems more like an entrenched religious battle in which each side believes only one methodology can be right. Unfortunately, unlike arguments about the existence of god, market outcomes are not necessarily binary and the nuanced truth could lie in between economic theories. Thus, people who are willing to defend their position in the face of mountains of contrary evidence are likely to be so biased that they cannot be trusted to assess the state of the economy.

Even more concerning is this article in the Huffington Post that argues that the Fed effectively controls, monitors and censors what is published in economic journals. That’s the last thing the US needs: formerly autonomous and free thinking economists being controlled by the banking oligarchs who have a definite inflationary and Wall Street bias. We have already seen where that has gotten us and it is not pretty.

The conclusion that needs to be drawn about those who belong to what appears to be a very closed-minded and divided economic establishment in the US is that many have been compromised and may not be the most reliable evaluators of the past, present or future global economy.

1. Leverage is miraculous on the way up and a killer on the way down: My favorite analogy regarding the risks of too much leverage comes from none other than Warren Buffett. Buffett likens carrying too much debt to driving a car with a dagger attached to the steering wheel pointed at your heart. Everything is fine until you hit a bump and that dagger goes right into your chest. Of course if you are lucky and there are no bumps for a while you can make an incredible return on your equity. However, eventually that bump in the road is going to come and smart companies and households never put themselves in a position to allow that bump to be life threatening. Further, there is some compelling data that suggests that financial bubbles are almost always driven by too much leverage. The good news is that by in large companies have solidified their balance sheets over the last two years and households are finally starting to deleverage a bit. Thus, at least in the private sector and among consumers, the dagger is slowly being pushed further away.

However, I do worry that there is one particular institution that has ignored the above lesson and has taken on far too much leverage. Who is that you ask? Why the US government of course. One risk is that something unexpected happens, the government is forced to print even more money, the deficit spirals out of control, and in the end the quality of life for all Americans is impacted. We are already fighting two wars, have thrown trillions into the financial markets, have huge Social Security and Medicare obligations and on top of all that have passed stimulus legislation in an attempt to prevent a depression. Therefore, we can ill afford any unexpected expenditures. Even now it is hard to imagine how the US will live up to all of its obligations. Let’s just hope that the economy improves, tax revenues come back, and our foreign creditors are somewhat appeased before we hit that next inevitable bump. If not, both equity and bond markets could be devastated by the fallout.

1. Wall Street wins whether the economy prospers or fails and whether markets go up or down: This may sound like populist propaganda, but it is hard to argue that this is not precisely how the last few years played out. Yes, Lehman and Bear are gone and Merrill Lynch is now a part of Ken Lewis’s failed empire. There have clearly been a few losers in the aftermath of the dramatic financial crisis. But, in aggregate, Wall Street has not only survived, but has also prospered immensely at the expense of American taxpayers and businesses. Expected record bonuses this year are only icing on the cake. When many Americans spent this Christmas wondering if they were going to lose their jobs or whether they will be able to feed their families, I’m sure many on Wall Street enjoyed a very comfortable holiday. If this seems unjust given the fact that without government assistance many firms might not exist anymore, that’s because it unequivocally is.

At the center of all of this (but not alone) is Goldman Sachs. First, Matt Taibbi documented the success of Goldman in up and down markets in his July 2009 piece. Then, just before Christmas Gretchen Morgenson alerted the masses to what the investment community already knew: Goldman consistently bet against the same clients it was selling dodgy assets to. Don’t forget that despite unemployment rising above 10% Goldman somehow managed to only lose money on trading on one singular day in the 3^rd quarter of this year. If a baseball player batted .900 or higher for 3 straight months he would quickly be crowned the greatest hitter who has ever played the game. But when Goldman accomplishes a similar feat in what used to be a zero sum game, we don’t even blink anymore.

What all of this means is that through their political connections and too big to fail status, Wall Street firms are just about guaranteed to receive favorable treatment relative to the rest of us no matter how well or how poorly the economy is doing. Thus, investors who short these firms are at the mercy of the actions of a Fed and Treasury that do very little to protect against moral hazard. In fact, at a certain point, regardless of the dubious activities such as high frequency trading and so called trade huddles, it almost makes sense for investors to give in any say, “if you can’t beat ‘em, join ‘em.” Well, I said almost.

1. The most dangerous words in investing are “this time is different” but this economic cycle in the US may really and truly be different than the recent ones: The book by Carmen Reinhart and Ken Rogoff entitled This Time is Different is on my seemingly endless reading list but I have yet to get to it. But, from the reviews and commentary I have read, the authors do a great job analyzing past boom and bust cycles and disproving the notion that individual situations are different and thus certain countries can avoid experiencing the devastating and enduring impacts of financial crises. The title of the book is obviously ironic in that the authors show that there are common factors that cause financial debacles. Surprisingly, people make the same mistakes over and over again under the false premise that their own personal or country-specific circumstances will allow for a different outcome than others have experienced. Inevitably, such beliefs end in tears.

What does this have to do with the current economic and fiscal situation the US finds itself in? Everything. First off, the duo provides lessons about governments accumulating too much debt and pinpoints what leads to sovereign defaults. Second, if the US is following the same path as Japan (as the authors assert) in terms of dealing with the insolvent banking system, why should we expect a different outcome? These are just two of the topics addressed in the book that give investors a way to understand the risks associated with investing in government debt and bank stocks, for example.

In the end, my real worry is that the title of the book has a double meaning. While financial crises and the associated lasting effects on economies may be similar, I am concerned that many policy makers are viewing this downturn as if it were a typical inventory recession that can be cured by low interest rates and some targeted government stimulus. I fear that it may be that this recession is actually different from ones like the post-September 11^th slump. Accordingly, if Reinhart and Rogoff are right and this financial crisis is going to play out like others have around the globe, the template suggests that the US’s experience this time may be dramatically different from other recent domestic recessions. What that could mean for investors is a long slog of mediocre GDP growth and substandard returns on equities as the powers that be prolong making the tough choices needed to purge the system of debt and get back to fiscal sanity.

Bespoke Investment Group’s 2010 roundtable discussing asset class expectations

The 2010 Bespoke Roundtable is out, and as always, they’ve done some interesting work. I think it’s extremely insightful. the link to their full post is here: http://bespokepremium.com/roundtable/

They present the aggregated “up or down” predictions very clearly in this table:

I have a few quick comments:

-The up/down prediction for the S&P 500 is mostly “up” with only a couple “experts” disagreeing. Who knows? No one has EVER been able to successfully profit from trying to time the market over a reasonable time period. There are a zillion studies that reach that conclusion, and my summary of the Morningstar book has their conclusions based on their data that confirms the same thing. SO what do you do? Well, I think  you try to capture potential upside from equities by having some long-equity exposure, but you keep long-equity allocations to a minority of your portfolio, and instead spread your assets across multiple asset classes, with a preference for long/short strategies, and you try to generate current income (all the while trying to focus on uncorrelated investment returns).

-Long bonds: everyone polled agreed that they should have a negative return in 2010. There could be multiple reasons: rising interest rates, higher default rates, less attractive yields/valuations…the list goes on and on. This is why I prefer munis that are insured and through closed end funds that are trading at a discount: you reduce your tax liability and you reduce your default risk. The rising interest rate or rising inflation scenario is why I like floating / variable rate debt. You get income from being long debt, but the interest payments increase in size as overall interest rate levels rise.

-Junk bonds: not for me. I don’t know of any consistent and low-risk funds that have demonstrated success in the junk bond / high-yield debt space that I would consider for my portfolio at this present time. I say “at this present time” because entire asset classes can occasionally get cheap enough that you don’t really need to worry about the skill of a fund’s active asset management, but given the recent run-up in junk bonds and the uncertain default risk trend I just can’t stomach purchasing high-yield debt now when I can get similar income generation from other asset classes and can lower the tax impact by going with municipal bonds. Sure, junk bond prices can rise much more when they do rise versus munis or other higher-credit quality debt, but the reason junk bonds rally is usually because of optimism about near-to-medium term economic prospects, and I think that the best case scenario is already reflected in the massive recent appreciation of both junk bonds and equities.

-Gold & Oil: The roundtable has mixed expectations for the next year. I think that’s why I prefer a long/short commodity strategy and a long-term investment horizon. Commodities are an important asset class to have in your portfolio, so you don’t want to forget to have some exposure, even if it’s only a little. If inflation does become an issue, regardless of what macroeconomic demand is, then commodities will benefit.

-The US Dollar: The roundtable is uncertain and so am I about what the Dollar will do in the next year. Over the medium-to-long-term, however, I have very high conviction that the US Dollar will continue to lose its purchasing power and will continue to decline against other currencies, just like it has done over the last 50+ years. This is why I like an absolute-return strategy currency allocation. Currencies are a very, very tricky asset to trade profitably, and I would advise non-expert investors to let the experts handle it and go with a good mutual fund.

-China: Who knows what happens. I will probably always keep a portion of my assets in Chinese equities (I hold HAO), although I have recently trimmed my allocation after the very large run up in Chinese equity prices. Regardless, China has much more attractive prospects for equity investment returns over the long-term than the US does, so I will always hold some China and will look to buy more over time when the overall indexes decline.

GMO’s 7 year asset class forecasts: US less attractive than international (but neither are very impressive)

GMO recently released its 7 year asset class return forecasts, and I think they’re extremely interesting. Jeremy Grantham, who is chairman of GMO, is close to God-Status in my book because his views are always well thought-out and detail-oriented, so even when I don’t agree with him I can follow his logic and evaluate how he comes to his conclusions. You can find GMO’s published piece on their website (which requires registration) at: http://www.gmo.com/America/

My bottom line takeaway from GMO’s forecasts are simple: I agree that US equity and bond returns will most likely underperform international and emerging market returns. I also agree that active management will probably produce a slight benefit over that period, as deep-dive analysis will be more valuable given the uncertain macro situation and uncertainty about the equity markets overall. I’d point out that these forecasts are “real returns” which means they are net of the negative impact from inflation on real-world gains in value/wealth.

I heard about the forecasts from Scott’s Investments, a blog I check frequently. Their post is here: http://scottsinvestments.blogspot.com/2009/12/gmo-7-year-asset-class-forecasts.html and they note that:

Real return forecasts before any extra returns gained from active management (estimated returns with active management listed in parenthesis). Compare these results to previous months I’ve posted on my blog (search ‘GMO’ on the blog) and you will see projections continue to decrease. Where is an investor to seek long term returns in this type of environment?

Equities
Large Cap US: 1.6% (3.4%)
Small Cap US: 1.7% (3.5%)
US High Quality: 7.8% (9.6%)
Large International: 5.5% (7.8%)
Small International: 5.4% (7.7%)
Emerging: 4.4% (8.1%)

Bonds
US Govt: .7% (1.6%)
Intl Govt: .2% (1.1%)
Emerging: 2.1% (5.0%)
Inflation Indexed: .8% (1.7%)
US Treasury (30 days to 2yrs): -.5% (.9%)

Other
Managed Timber: 6% (7.5%)

Hedge fund replication: the WSJ discusses its growing popularity

In a recent article in the WSJ entitled “Hedge-Fund Clones Draw Investors,” the obvious is highlighted: interest in hedge fund replication and “hedge fund clones” is increasing. The reasons are many-fold, and the WSJ points to the obvious benefit of avoiding high fees by holding “passive” hedge fund strategies instead of paying them with “active” strategies involving direct hedge fund investments.

I’ve discussed the idea of hedge fund replication previously and why I think it’s a good idea for the average individual investor at the present time. My previous post is here: https://knowledgecapitalist.wordpress.com/2009/12/14/strategies-for-uncertain-times-uncertainty-supports-hedge-fund-replication-strategies/

The URL for the WSJ story is: http://online.wsj.com/article/SB10001424052748704718204574615980132871774.html

They state: “Wall Street is trying to lure investors with investment vehicles designed to deliver hedge-fund-like returns without hedge-fund fees or hassles. But they have their own drawbacks.

These hedge-fund clones, called replicators, typically aim to mimic returns of broad hedge-fund indexes using easily traded instruments like exchange-traded funds and futures contracts. Some are structured as mutual funds or ETFs, others as separate accounts and other vehicles.

Investors, many weary of hedge funds’ high fees and long lock-up periods, are diving into replicators. Goldman Sachs Group, which launched a clone in 2007, now has roughly $2 billion tracking its replicator. State Street Corp. entered the replication business around the same time and now has more than $400 million in these products. Even start-up money manager IndexIQ has about $200 million in replication assets.

Investors are likely to hear more about clones in the coming months. Credit Suisse Group plans to launch two new clone indexes in the next few months, while Goldman Sachs is seeking to expand distribution of its Absolute Return Tracker replication fund through 401(k) plans. And early last month, State Street in a regulatory filing sought permission to launch a hedge replication ETF.

Some pension plans, like the Swedish government’s AP7 fund, are dumping funds that own hedge funds in favor of replicators. And even some funds of hedge funds are investing in the clones.

Cost considerations and high-profile hedge fund blow-ups drove the AP7 fund to invest in a clone last year, said Richard Grottheim, chief investment officer. Through a fund of funds, AP7 invested in Amaranth Advisors, which collapsed after bad natural-gas bets. In clones, “you don’t have that risk,” Mr. Grottheim said.

The firms offering replication products say they will deliver hedge-fund-style returns and diversification in a low-fee, transparent, easily traded package. Many charge fees of 1% to 2% of assets annually. Hedge funds, by comparison, often charge a 2% management fee, 20% of any gains and other expenses.

“We view what we’re doing as what Jack Bogle did at Vanguard in the 1970s” when he popularized index mutual funds, said Andrew Lo, a finance professor at the Massachusetts Institute of Technology and manager of Natixis ASG Global Alternatives, a replicator mutual fund.

Though the hedge-fund clones have a short track record, it’s not clear that they can deliver on their promises. Since they hold easily traded instruments like stocks, they often behave a lot like the traditional investments already held by most investors. Being limited to liquid investments, clones may also lag behind real hedge funds, which get some of their returns from holding hard-to-trade assets. And though most clones have so far kept pace with hedge-fund indexes, they have done so with more volatility, according to recent academic research.

Clones’ popularity is on the rise after a tumultuous year for hedge funds. The HFRI Fund Weighted Composite Index, a broad hedge benchmark, fell 18% last year, and investors yanked a record $155 billion from the funds, according to data provider Hedge Fund Research.

Here’s how clones work: They are typically designed to deliver hedge-fund “beta,” or the part of returns attributed to market exposure, and not “alpha,” returns attributed to manager skill. One common replication approach involves examining the past several years’ worth of hedge-fund index data and essentially reverse-engineering the returns, determining what market factors were driving the performance. The clone will invest in those easily traded instruments that best explain the returns, rebalancing the portfolio each month as it incorporates new data from hedge indexes.

While most clones have so far generally kept pace with broad hedge-fund indexes, their performance has been all over the map. Between March 2008 and Sept. 30 of this year, clones studied by researchers at Haute Ecole de Gestion in Geneva and Bank Julius Baer & Co. delivered annualized returns ranging from -21% to 6%. And some clones this year have sharply underperformed broad hedge indexes. State Street’s Premia Fund was up less than 2% in the first 10 months of this year, compared with a 10% gain for the HFRI Fund of Funds Composite Index.

The underperformance is due to the fund’s built-in risk controls and the fact that it couldn’t hold some less-liquid assets like distressed credit, said Bailey Bishop, vice president at State Street Global Advisors.

Being restricted to easily traded holdings, replicators may not capture a big chunk of hedge-fund performance. Anywhere from 10% to 60% of hedge-fund returns may come from a premium earned by holding illiquid assets, said Mr. Lo, the Natixis fund manager.

Some replicators behave a lot like stocks. Goldman Sachs Absolute Return Tracker mutual fund, for example, had a roughly 80% weekly correlation with the Standard & Poor’s 500-stock index from its launch in May of last year through Oct. 31, according to Morningstar.

“The correlation to any single index like the S&P 500 is going to move around quite a bit” over time, said Glen Casey, managing director at Goldman Sachs Asset Management.”

Strategies For Uncertain Times: Uncertainty supported by data

Econbrowswer has done an excellent job looking at a combination of macroeconomic factors with an equity valuation overlay that I believe supports my thesis that, at the moment, equity investments face tremendous uncertainty. As a result, I will continue to keep my holdings diversified across numerous asset classes and strategies to focus on generating stable returns regardless of what happens with the economy or the stock market. I think their last graph is the most important for investors: valuation isn’t really encouraging or discouraging at the moment, which makes it hard to have a high-conviction call on equity markets as a whole. If conviction is low, I believe that supports the thesis that diversification across strategies and asset classes is the safest way to generate reasonable investment returns while avoiding the possibility of significant draw-downs should equity markets suffer significantly.

Their Lost Decade for Stocks post: http://www.econbrowser.com/archives/2009/12/lost_decade_for.html

They write:

“Why were the aughts so nasty for stocks?

The U.S. ended the decade more or less where it began in terms of total employment.

Source: FRED.

The owners of capital fared no better, with the nominal S&P500 stock price index down 20% for the decade. The dividends stockholders collected made up for some of that, but inflation took away even more.

Blue line: Nominal value of S&P500 stock index, January 1980 to December 2009. Red line: value as of January 2000. Data source: Robert Shiller.

One of the reasons stocks did so badly was that real earnings ended the decade 80% lower than they began. Even when you smooth out cyclical variations by taking a decade-long average as in the dashed blue line below, the downturn in earnings at the end of the decade is still pretty significant.

Green line: Real value (in 2009 dollars) of earnings on the S&P500, January 1980 to December 2009. Dashed blue line: arithmetic average of green line for the preceding 10 years. Data source: Robert Shiller.

But a bigger reason why stocks did so badly was the changed valuation of those earnings. Yale Professor Robert Shiller likes to summarize this by using decade-long averages of real earnings to calculate a price-earnings ratio. In January 2000, this cyclically adjusted P/E ratio was profoundly out of line with the average values we’d seen over the previous century. If you trust the tendency of this series to revert to its long-run average, it means that whenever the blue line is above the red, you should expect stock prices to grow at a slower rate than earnings. If you bought when the blue was as far above the red as it was in January 2000, then I hope there was something else you found to enjoy about the naughty aughts.

Cyclically adjusted P/E over the last century. Blue line: Ratio of real value (in 2009 dollars) of S&P composite index to the arithmetic average value of real earnings over the previous decade, January 1880 to December 2009. Red line: historical average (16.34). Data source: Robert Shiller.

That doesn’t mean you should never buy when the P/E exceeds its historical average. If you buy at those times, you may expect to earn a return below the average historical real yield of 5.5% per year, but it could be that this lower return of, say, 4% would still be better than you can get anywhere else, and good enough for your saving objectives. In 1995, Shiller’s long-run P/E was a bit rich by historical standards at about 20, right where it is today. If you bought at those high prices in 1995 and sold at the even higher prices in 2000, then you did very, very well. But if you’re smart enough to know exactly how to pull that off, then I’m smart enough to know that I’m not you.Shiller’s graph persuaded me to keep extra cash entirely out of stocks for most of the last 15 years. I shared with Econbrowser readers my reasons for going back into the market over November 2008 through the spring of 2009. In retrospect, that was the one brief window over the last 20 years when Shiller’s calculation suggests you could earn above-average historical returns from buying stocks.

Many financial analysts used to give the advice to put steady monthly amounts into stocks and hold for the long term, trusting in the long-run averages eventually to give you that 5.5% annual real return. The experience of the last decade has spooked some people out of that philosophy. I think it still makes sense provided that the long-run P/E doesn’t get above 20; beyond that, you want to be aware of the risks.

Some people have the psychological reaction that when stock prices have been going down, equities are becoming a riskier investment. I take the opposite view– the higher stock prices go, the scarier they look to me.”

Merger arbitrage strategy update

The Reformed Broker cites a very interesting study put out by The Boston Consulting Group (BCG) that suggests that M&A activity is expected to materially increase (they’re looking at European companies, but there are few reasons why the US won’t behave similarly, like FX rates). Bottom line: merger arb strategies need deals to invest in, and more deals means more potential investment opportunities in the merger arb space. The more opportunities, the better the prospects for solid returns, as a low-deal environment forces more crowded trades in the merger arb space which historically is negatively correlated with spreads/discounts to takeover prices. More activity is good for the merger arb funds. There are a number that I’ve discussed previously, including ARBFX, MERFX, GABCX, and GDL.

Their post: http://thereformedbroker.com/2009/12/23/a-european-buyout-frenzy/

They state: “It was only a matter of time.

The recent rally notwithstanding, corporations and their assets denominated in US dollars are lookin’ like lunch meat to the European business world and according to a recent study, a wave of mega-mergers is on the way.

The Boston Consultant Group is out with a survey that indicates 1 in 5 European companies is planning to do a deal in 2010, and that percentage jumps to 1 in 2 companies with market caps in excess of €20 billion.

68% of the companies surveyed were pondering “horizontal” deals, meaning mergers within their own industry segment for the purpose of scale and the easing of competition.

BCG broke the results down by industry group (see chart below):

While to be sure, a great many of these deals will take place on the European continent, something tells me that the Kraft/Cadbury game of footsie we’re witnessing is only the canary in the coalmine in terms of Transatlantic mergers (although in this case, it’s an American company bidding for Euro assets vs Nestle, another European company).

One bright spot for the global economy is the fact that 44% of chemical companies have the urge to merge, as the chemical industry is often seen as a harbinger of economic activity.

Research Recap has the rest of the stats as well as a link to the full report.

Sources:

1 in 5 European Companies Planning M&A Deal in 2010  (Research Recap)“

Hedge fund replication ETFs

A natural extension of the ongoing ETF creation boom, we’re starting to see full-blown “hedge fund” ETFs. After examining the funds (strategy, holdings and expenses) I come away unimpressed. I’m referring to IndexIQ’s two “hedge fund” ETFs: QAI and MCRO. They are not expensive, with total expense ratios around 1.0%, but the logic as to what they hold and why is less than obvious, nor do they appear to be in any way positioned to outperform for any smart/unusual/unique/non-consensus reason.

Here’s IndexIQ’s website: http://www.indexiq.com/etfs/etfsiqh.html

Their HF ETFs at the moment:

1) IQ Hedge Multi-Strategy Tracker ETF (Ticker QAI)

2) Q Hedge Macro Tracker ETF (Ticker MCRO)

The “multi-strat” ETF prospectus says that the ETF will try to match the underlying returns of the IQ Hedge Multi-
Strategy Index. They elaborate a bit more:

“The Index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.”

So basically what you get is a hodge-podge of various hedge fund strategies, although the allocations and composition of the exact holdings is essentially unknown. I’m not a big fan of low-transparency (not that they’re trying to hide anything, you just don’t really know what they hold and what they’re changing and why). The majority of those pieces can be replicated by just separately buying funds that focus on each specific piece. For example, you can buy the emerging market ETF EEM, any number of “event driven” or “special situations” or “merger arbitrage” funds like the other ones I’ve discussed in previous posts, and you can take your pick of long/short equity funds based on YOUR evaluation of the manager and their track record (QAI doesn’t really have a track record at this point b/c it’s young and simulated returns are dangerous to rely on in the vast majority of situations as the past rarely repeats itself). Furthermore, as of their last holdings disclosure, the fund held 42% of assets in long positions in short-term treasuries (like you need them to earn a treasury yield) and 24% of assets were long the EEM ETF exactly with about 10% of assets in the Powershares G10 currency ETF. So…they’re not doing anything you can’t do for yourself (and if you do it yourself you can control things, which may or may not be what you’re looking for).

The macro fund tracks the performance of the IQ Hedge Macro Index. Looking at their top 10 holdings, the macro fund’s portfolio is slightly-more complicated than the QAI portfolio, but pretty straight forward anyway.  28% of the fund’s holdings are just EEM. There’s a tiny short treasuries position, but it’s dwarfed by the long treasuries positions. The “ultra short” real estate position is one of the few distinguishing positions (tho it’s only 3.7% of fund assets) b/c it’s both short and levered, so presumably they have reasonable conviction that there is further downside in real estate. I don’t see anything here that impresses me or suggests to me that this fund does anything beyond simplify the construction and purchase of a portfolio of emerging market stocks, various treasury and corporate bonds (both US and international), currency ETF holdings, and a small position betting against the real estate sector. All in, MCRO doesn’t do it for me, but I’m not you, and maybe you like the idea of one purchase that requires no follow-up maintenance.

TickerName Weight
EEMiShares MSCI Emerging Markets Index Fund 28.43%
SHYiShares Barclays 1-3 Year Treasury Bond Fund 15.90%
LQDiBoxx $ Investment Grade Corporate Bond Fund 13.29%
BWXSPDR Barclays Capital International Treasury Bond ETF5.63%
BSVVanguard Short-Term Bond ETF 5.23%
SHViShares Barclays Short Treasury Bond Fund 3.97%
SRSProShares UltraShort Real Estate 3.69%
DBVPowerShares DB G10 Currency Harvest Fund 3.35%
TWMProShares UltraShort Russell2000 3.29%
BILSPDR Barclays Capital 1-3 Month T-Bill ETF 1.99%

Zero interest rates: what direction will rates move next?

The Fed’s target Fed Funds Rate is still nil.They’re still focused on making sure the economic recovery takes hold and we don’t “double dip” into a prolonged recession. Since rates can’t go negative (although they can stay near zero for a long time, aka Japan) I prefer floating / variable rate debt that will pay higher interest to holders as overall interest rates increase and their payments get reset at higher levels. If rates can’t go down, they can only stay sideways or go up, so I’ll stick with strategies that make money in a “who knows what” environment (low correlation, high current income).

Bespoke had a great writeup of the issue last week and included this great picture that really says it all.

Their post: http://www.bespokeinvest.com/bespoke/2009/12/one-year-at-zero-percent.html

Their analysis:

One Year at Zero Percent

Tomorrow marks the one-year anniversary of the historical decision by the Fed to cut its target rate to 0%-0.25%.  As shown in the first chart below, this is the lowest the rate has been going all the way back to 1934 (prior to 1971 the Discount Rate is used).

The Fed has kept rates unchanged now for 364 days.  This is a very lengthy time period, but it’s not without precedent.  Prior to 1970, the Discount Rate remained unchanged for years at a time.  The longest period where the Fed Funds Rate was left unchanged was 552 days in 1997 and 1998.  For the current period to break the 552-day record, the Fed would have to leave rates unchanged at 0% through at least June 22nd, 2010.  The Fed has signaled that they don’t plan on hiking rates before then, but with inflation numbers coming in hot this morning, the market may force the Fed’s hand sooner than that.