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Archive for November, 2008

Bailouts are Unfair to Those Who are not Bailed Out

Saturday, November 29th, 2008

If you run a large corporation in trouble, there is a drill that you must follow.

  • In measured tones, tell the public that liquidity is no issue, and that you are more than capable of meeting all obligations.
  • Scream loud behind closed doors to Congress/regulators, saying that you have been a prudent manager, but the economic environment is beyond belief.  You need help and you need it now, and the change in administration might be too late for you.
  • Explain how many other jobs would be lost if you disappeared.  (A canard, because the company won’t disappear.  The equity might be canceled, and some factories closed and jobs lost, but most of the jobs and factories will continue with the bondholders as the new owners.)
  • In the crisis atmosphere, judgment will be suspended (as it was before the Iraq war and at the debates over the bailout), and legislators will vote for something that won’t work, but must be done out of the appearance that Congress must be doing something to fix matters.  Anything to justify their existence…
  • Receive the bailout, and thank them for their wise decision on behalf of the American people.
  • When the bailout monies fail ask for more.  (Think of AIG; you might even get really soft terms.)
  • Because Congress has bought into the original premise of bailing you out, they will do it again to protect their investment.  Regret has set in, and Congress will easily “double down” to throw good money after bad protect their investment.  Remember, Congressmen are facile at speaking to the ignorant populace, but aside from Ron Paul, few have any significant understanding of economics.  As my best boss once said, “I wouldn’t trust him to run a hot dog stand.”

As a CEO with a company in trouble, the objective is to get your foot in the bailout door.  Once inside, it will be difficult for the government to turn its back on you.

And, that is why Congress should refuse to bail out firms, even those that are too big to fail, unless they are taken through bankruptcy first.  Congress invariably throws good money after bad, and we as a nation are the poorer for them doing it.  I have no doubt that the automakers will get bailed out, but it is the wrong decision.  Better they should go through the bankruptcy process so that they can reconcile their cost structures, than that the US government should subsidize unionized auto workers.

Regarding Leveraged ETFs

Friday, November 28th, 2008

I am a skeptic on leveraged ETFs in one way.  My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.

To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index.  There is also slippage from rolling futures from month to month.

Here’s my challenge, and I may do this myself, or, though I encourage others to do it.  Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage.  If there is no friction or fees, they should do as well as T-bills.  My guess is the higher the leverage the lower the aggregate returns.

Let the games begin.  Does anyone want to run this analysis before I do it, say, six months from now?

Book Review: Co-opetition

Friday, November 28th, 2008

Again, I don’t just do book reviews of new books.  I do reviews of new books, and older books that I think are significant.  One strategic management book that has helped me is Co-opetition.  Co-opetition is the use of both co-operation and competition in an effort to better your business.

Similar to Michael Porter’s Five Forces framework, Co-opetition aims to describe a business or industry as part of a broader system, and design business strategy through competition and alliances with other economic actors that affect your business.

That broader system is called the “value net,” and is composed of the firm in question, their customers, suppliers, competitors, and complementors.  Complementor was a term they created to describe those parties who produce products or services that help make your customers more likely to buy from you.  As the book describes it, think of hot dogs and mustard.

When I was a bond manager, I intuitively understood co-opetition.  Most managers/traders played the game very sharply, and argued for every basis point.  I realized that I had to be careful, and show that I was no pushover, but I found a variety of co-operative strategies that got my brokers working for me, not against me.

1) Helping them out when they were short a bond.  I did not sell my bonds to them cheaply, but I did not gouge their eyes out (a technical bond market term) either.  They were grateful to me, and Wall Street does have its own brand of loyalty.  It protects friends.

2) I let brokers know what I was up to in general, while reserving discretion.  I was more open than other managers, realizing that it would be hard to imitate what I was doing, and no one broker had the full picture.  I let brokers truly know what my motives were for selling a bond, whether it was relative value, or needing to raise cash.

3) My brokers knew that my word was my bond.  I did not break trades.  When I uttered the word “done” it did not change.

4) My brokers knew that I would give them frank feedback.  If they were way out of kilter with the market, I would give them one chance to change their position after I told them what I knew.

5) I would show “love” on occasions when they had badly mis-bid for my bonds.  I would give them back one-third of the difference between their bid and the second place bid.

That’s my main example from my own life.  When a large part of my competitors viewed brokers as their competitors, I viewed them more as suppliers, and tried to find ways to work with them, and not against them.

I also found ways when working in the Pension Division of Provident Mutual, to use our small size and flexibility as an advantage versus our larger rivals.  Understanding the competitive landscape was a real advantage, particularly in finding those that could aid us — where there would be mutual benefit.

I could write at length over the individual strategies in the book.  They are all significant, though only a subset applies at any given time.  The book gives a good strategic manager tools, and he has to decide which are relevant to his situation.

If you want it, you can find it here: Co-Opetition : A Revolution Mindset That Combines Competition and Cooperation : The Game Theory Strategy That’s Changing the Game of Business

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  My objective is to aid my readers, and not explicitly take money from them.

The Occasional Seemingly Free Lunch

Wednesday, November 26th, 2008

hmf asks, “David – if possible, whenever you have a chance, could you please explain why there is any spread whatsoever between govt-guaranteed bank-issued debt (e.g., the GS TLGP bonds) and comparable treasuries.  It would seem they’re one and the same – thus no default risk.  Thank you very much!”

I left a comment on this on John Hempton’s blog, who also addressed this question.  The comment is still in moderation, so I will attempt to recreate my argument.

There are many US Government securities, some of which are “Full Faith and Credit” [FFC] that trade with a spread over on-the-run Treasury securities:

  • Off-the-run Treasuries trade at a discounted price (higher yield) due to illiquidity.  Note: On-the-run securities are the ones that have recently been issued.  They are often used by Wall Street for hedging purposes in other bond issuance, which adds to the liquidity (most of the time).
  • Title XI shipping bonds (full faith and credit) trade at a spread to a ladder of similar maturity Treasuries.  They are less liquid, but there is usually good demand for this paper.
  • Aid to Israel and TVA bonds are full faith and credit [FFC] and usually trade at a spread over Treasuries.
  • Overseas Private Investment Corp bonds (FFC) often trade at a spread over Treasuries.  I once bought some OPIC put bonds where the option adjusted spread was 2% over Treasuries.  I had to buy the whole issue, so, again, it was illiquid, because anyone you would try to sell it to you would have to educate them on the bond.  Not easy, why should the seller trust your explanation, particularly as you no longer want the bond?  (That’s what brokers are for…)
  • I used to manage a portfolio of Credit Tenant Leases.  Most of my leases were on buildings leased by agencies of the US Government, and the lease payments were not subject to appropriation, so I did not have to worry about the budgeting process of Congress.  These were not FFC, I had a cut-through claim to the lease payments; I had priority over the building owner in getting paid.  If the US were to fail to pay, I had recourse to the building owner (can’t squeeze blood from a stone, though), and failing that, I could take possession of the building.  So with a hard asset behind the loan, I was doing secured lending to the US Government, and getting 1.5-2.0% over Treasuries to boot.  Though the CTLs were fungible, they were definitely illiquid.  But when you think about the extra spread versus the possibility of loss — the property was high quality, the return was disproportionate to the risk.
  • Another [not FFC] piece of paper was a first mortgage note on a building that served a critical government purpose, where the government could not move because of old computers which they could not move due to fragility and security reasons.  We got roughly 3% over Treasuries in a small deal where I ended up buying 20% of the issue.
  • Are Fannie and Freddie guaranteed by the government?  They seem to be, but you can pick up an additional 100-140 bps if you lend to them.

So, it’s not unusual for FFC securities to trade at spreads over Treasuries.  And, it is normal for pseudo-government securities to so trade.  But it is weird for the 3+ year Goldman Sachs securities to be issued at 2.2% over the relevant Treasury security.  It’s not an illiquid issue — $5 billion is a big deal.  There is a little structural complexity, but it is in the nature of a financial guarantee from the government.

There is the matter as to whether the Government would ever selectively default on FFC guaranteed issues, but the courts would have something to say on that, unless Congress deleted their authority on the matter.  You can’t fight city hall; you certainly can’t fight the US Government, and it has been behaving erratically of late.

So, if I were managing insurance/bank assets, would I buy these issues with a FFC guarantee from the FDIC.  Yes, all day long unil I was full of them.  The reasons cited for not buying them don’t add up, and they seem really cheap.  I would use them as a substitute for Treasury and Agency securities.

PS — A note to the new administration: want to save money?  Easy.  Create a capital account for the budget, and borrow using Treasuries to buy the buildings that you use.  Don’t do CTLs anymore.

Here’s a bonus idea off of yesterday’s post.  Offer longer-dated floating-rate debt indexed to 3-month T-bills.  It would be a TIPS substitute, and cheaper.

Update: 10/27 10AM: Bond Newbie is correct. TVA securities are not FFC — I slipped on that one because of a project that I worked on long ago, and my knowledge was garbled. Here is an incomplete list of all FFC securities:

  • Farmers Home Administration Certificates of beneficial ownership
  • General Services Administration Participation certificates
  • U.S. Maritime Administration Guaranteed Title XI financing
  • Small Business Administration Guaranteed participation certificates and Guaranteed pool certificates
  • Government National Mortgage Association (GNMA) —  GNMA-guaranteed mortgage-backed securities, and GNMA-guaranteed participation certificates
  • U.S. Department of Housing & Urban Development Local authority bonds
  • Washington Metropolitan Area Transit Authority Guaranteed transit bonds

If anyone knows where there is a full list, I would be happy to post it.

Issuing Debt for as Long as Our Republic Will Last

Tuesday, November 25th, 2008

So Jimmy Rogers thinks the US dollar is going down?  He might be right.  There are few roads out of this crisis (more than one can be used):

  • High inflation (raise the nominal value of collateral behind loans, maybe?)
  • Internal Default (with depression)
  • External Default (including currency controls, and forced conversion to a new currency)
  • Large rise in taxation (leading to deep depression).
  • The Japan game, where the government attempts to force liquidity into the economy, leading to a low- or no-growth malaise.

At present, I think the government is pursuing the last of those, and avoiding inflation for now.  It is not in the DNA of the Fed to inflate, ever since the era of the ’70s.

Now, there is one idea floating around that I would like to suggest that we don’t do, or, if we do do it, let’s do it in limited amounts, like TIPS.  There is a proposal for Obama bonds — bonds issued by the Treasury in a currency other than dollars, such as the Japanese Yen.  It’s been done before; but I would urge against it because it gives up a key advantage that all of our debt is denominated in a currency that we think we control.  Why outsource that advantage to another central bank?

Anyway, I’ve discussed this earlier:


David Merkel
A Modest Proposal for Balancing the US Budget in the Short-Run
1/9/2007 11:06 AM EST

This is not meant seriously, but an easy way to balance the US Budget in the short run is to issue Japanese Yen-denominated debt. Current interest costs would drop rapidly, and the budget would balance.

What’s that you say? What if the Yen appreciates versus the Dollar? The US has an ill-disclosed balance sheet, with many of its liabilities omitted, or merely disclosed as footnotes… Medicare, Social Security, the old Federal Employee defined benefit plan, etc., are all off the balance sheet. (And on the plus side, so is the value of most of the property of the government, as well as the present value of its taxation capabilities.)

Leaving aside other things that are off-budget (e.g., Iraq, Katrina relief), borrowing in foreign currencies is just another tool that the Federal government can use to put off today’s costs off to a future date. It’s something that our government does well.

Position: none, though I own TIPS, realizing that they are only second best to developed market foreign currency debt, and the US Labor department controls the CPI calculation…

My Idea

Lest I merely seem to be a critic, I have another idea that I think is more powerful: Issue 40-, 50-, 75-, and 100-year bonds.  Issue TIPS versions as well.  Hey, issue a perpetual — Consols!  As I have said earlier:


David Merkel
Now Let’s Have a Treasury Century Bond!
8/3/2005 9:30 AM EDT

George, I’m really glad to see that the Treasury has finally gotten a lick of sense, and is re-issuing the 30-year, which they should be able to at yields lower then the current long bond maturing in 2031 (probably 10 basis points lower).

Timing is anyone’s guess, but I would suspect two auctions — in November 2005 and February 2006 — in order to give the new benchmark bond sufficient liquidity. Given the absence of long issuance, demand for this bond will be very strong in the hedging community.

Now, the Treasury won’t do this, but my guess is that there is even more demand for a 50-year, or even a century bond (100 years). It would help pension funds and structured settlement writers match their liabilities. Those bonds could sell at yields less than the 10-year. Won’t happen, but I can dream.

Final note, this removes one of my reasons for lower long rates, but I am still biased toward lower long rates. The other reasons still hold.

none mentioned, though I own Treasury Securities of various sorts, both directly and indirectly (don’t we all?)

There is a decent amount of demand for safe long-dated debt from pension plans, life insurance companies, and other long-term fixed income investors.  These bonds would likely have lower yields than the 30-year bond, because of buyers that like long fixed income because of its reliability in a crisis.  (And, for bond geeks — high positive convexity.)

Personally, I think the market would happily digest a lot of really long debt from a seemingly strong entity like the US Government.  What, are we going to let the Europeans have a monopoly on long sovereign debt here? ;)  US Treasury, be innovative — show the world how confident we are in the future of the US by issuing debt as long as we think this republic will last.  Surely that is longer than 30 years.

The More Things Change, The More They Remain The Same

Tuesday, November 25th, 2008

I’ve been asked by a number of readers for my opinion on the economic team being put together by the incoming Obama administration.  I’m not that excited, but then Bush Junior’s economic team was pretty consistently disappointing.  What we have is a bunch of Clinton-era retreads in Summers, Orszag, and Geithner.  Bob Rubin may not be there, but those that learned from him are there.

And, this is change.  I have sixty cents sitting next to me.  That’s change also.  Moving from Paulson to Rubin’s students is exchanging one part of the intellectual framework of Goldman Sachs for its cousin.  As Ron Smith said to me off the air when I was recently on WBAL, the economic advisors of Bush and Obama are members of the same intellectual country club.  There is little real change there.

But, look at it on the bright side.  The best part of the Clinton administration was the Treasury Department and the affiliated entities.  Perhaps that will be true of the Obama administration as well — pragmatism ruling over dogmatism, and a fear of freaking out the bond market.  Could be worse.  Save us from misguided idealists (perhaps Bernanke — a pity he didn’t pick a different dissertation topic), who think they know how to fight economic depression, but really don’t, and waste a lot of time and money in the process.

As it is we get two new programs this morning that are more of the same:  Keep expanding the Fed’s balance sheet; don’t think about the eventual unwind.  Create more protected lending programs that encourage lenders to flee unprotected areas of the market for protected areas.  Do anything to shift debt from private to public hands; but don’t do anything that truly reconciles bad debt.

I do have a beef with the selection of Geithner, though.  This Bloomberg piece gives a sympathetic rendering of his attempts to deal with derivatives.  He tried to achieve consensus of all parties.  My view is that the areas where he could achieve compromise were areas that were important but not critical.  He needed to take a bigger view and question the incredible amounts of leverage, both visible and hidden, that we were building up and focus on what regulatory structures could properly contain the increased leverage, lest the gears of finance grind to a halt, as they have done today.

We can be less sympathetic, though.  Chris Whalen’s (Institutional Risk Analytics) opinion of him is quite low, or, as he was quoted in this NYT article:

“We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,” said Christopher Whalen of Institutional Risk Analytics. “Throw in the Bear Stearns/Maiden Lane fiasco for good measure,” he said.

“All of these ‘rescues’ are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.”

Ouch.

“He was in the room at every turn of the crisis,” said another executive who participated in several such confidential meetings with Mr. Geithner. “You can look at that both ways.”

This Wall Street Journal editorial is similarly bearish.  Geithner was in the room on every bad decision, and a few non-decisions.

Or, just consider some of the questions that should be put to Geithner.  They are significant.

My view is that he is a bright guy who is out of his league in trying to deal with the aftermath of the buildup in leverage, that has lead to the collapse in leverage that we all face.  Now, I can’t be that critical of him, because he has been cleaning up after the errors of many, a small fraction of which he bears some responsibility for.

No one is equal to solving this crisis.  It is bigger than our government, which made an intellectual mistake in thinking that it could promote prosperity through Greenspan-like monetary policies, which almost everyone lionized while they were going on, except a few worrywarts like me, James Grant, etc., who followed the buildup of leverage in the Brave New World.  Now we face its collapse; let’s just hope and pray  that it doesn’t lead to worse government than what we have now.

PS — If I were offered the opportunity to fix things, I would take it, and:

The last one I like the least, but I’m afraid it would have to be done.  Phase two would be:

  • Move to a currency that is gold-backed.
  • Replace the Fed with a currency board.
  • Create a new unified regulator of all depositary institutions.
  • Slowly raise bank capital requirements, and make them countercyclical.
  • Bring all agreements onto the balance sheet with full disclosure.
  • Enforce a strict separation between regulated and non-regulated financials.  No cross-ownership, no cross-lending, no derivative agreements between them.
  • Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
  • Move back to balanced budgets, and prepare for the pensions/entitlements crisis.

On that last one, there are few good solutions there, but we would have to try anyway.  So it goes.

Book Review: A History of Interest Rates

Monday, November 24th, 2008

This book is big, very big at ~700 pages. It is a testimony to the idea that history doesn’t repeat itself, but it often rhymes.

The book is arranged chronologically, and geographically within each time period.  Time is spent on each are roughly in proportion to the amount of unique data that we have from each era.  Thus, the recent past gets more pages per year.  Roughly one-quarter of the book goes from ancient times to 1800, and one quarter to the 19th century.  Half of the book is 1900-2005.

There are several things that the book points out, common to each time and area investigated.

1) It is very difficult to eliminate interest.  Even when governments or religions try to restrict interest, either in rate charged or in entire, systems arise to create promises to pay more in the future that than full payment today.

2) The more technologically advanced economies get, the lower interest rates tend to get.

3) Boom/bust cycles are impossible to avoid.

4) Governments introduce currencies and often cheat on them (debasement, or inflation of a fiat currency).

5) Governments do sometimes fail, whether due to a lost war, civil war, or default, taking their currencies and debt promises with them.

6) The economic cycle across the world is usually more correlated than most people believe at any given point in time, even in ancient times.  (How much more today… decoupling indeed…)

7) Cultures that allowed for a moderate amount of debt financing prospered the most, in general.

Those are my summary points after reading the book.  Homer and Sylla drew some but not all of those conclusions.  It’s an ambitious book and and ambitious read.  Sidney Homer did a lot of significant work researching from the past to the middle of the 20th century, and Richard Sylla did an admirable job giving the grand sweep of the increasing complexity of the bond markets as the 20th century progressed until 2005, which was an interesting point at which to end the fourth edition.  The fifth edition, should there be one, will prove even more interesting as it surveys the end of the housing and credit bubbles, and the shape of the financial system in their aftermath.

This book is a must for those that like economic history.  I really enjoyed it.  For those without such an interest, it’s a big, somewhat-expensive, show-off book that will be occasionally useful as a reference.

If you want, you can find it here: A History of Interest Rates, Fourth Edition (Wiley Finance)

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  I’m not out to sell things to you, so much as provide a service.  Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books.  I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.

The Citi was Asleep, is Asleep, and I Hope They Don’t Cause Us to Sleep

Monday, November 24th, 2008

Time moves fast in a crisis.  It surprises me that it was only seven weeks ago that I wrote, What A Fine Mess You Have Gotten Us Into, where I commented:

  • What the FDIC did with WaMu affects other banks like Wachovia.  Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.  Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
  • We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.  If one of them fails, the game is over.  Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.  Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

What I meant by “the game is over” is that the idea that you can keep laying off risk on increasingly large and complex banks would be over as a strategy.  Also, the ability of the US Government to continue to bail out every decrepit entity would be tested, and possibly found wanting.

Or, as I noted on Friday, in my piece Broken…:

There are still more oddities to the current bond market, most of which involve parties that can’t take certain risks any more.  We can expand that to banks, and toss in Citi.  Citi is trading like it is going out of business.  Now, Citi is one of the “too big to fail” [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.  If they are in trouble, I’m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.  Is there a foreign bank that wants them?  I doubt it.  This would be another area where a new TBTF chapter of the bankruptcy code would be useful.

So now we have a bailout of Citi by the US Treasury and FDIC.  At present the rescue of Citi is a plus to the markets, because it takes a short-term problem off the table, leaving behind a more ill-defined long-term problem: how much can the US Government borrow/guarantee?  Also, what of their derivative exposures, and the state of the other TBTF banks?  It’s difficult to get that big in a credit boom without absorbing the seeds of the credit bust.

So, I am selling a little into the euphoria.  We will see where all of this leads, but my guess is that it is just one more step on the road to credit failure for the US Government.

Book Review: How to Be the Family CFO

Saturday, November 22nd, 2008

This review will be short, because my view of How to be the Family CFO, is mixed.  Let me start by saying that I preferred the book Easy Money, by Liz Pulliam Weston, because it had more concrete  advice than did Family CFO, by Kim Snider.

Also, I did not feel that I was being “marketed to” in Easy Money, but I did in Family CFO, particularly toward the end of the book, where the dividend-oriented Snider Investment Method (R), is discussed.  What put me off was the promotional nature of the writing, and the lack of detail, particularly any information on capital gains and losses from the strategy.  Definitely not Global Investment Performance Standards-compliant.  Also, the strategy would be undiversified, in my opinion, by being overexposed to income factors.

Now, there is one major positive to the book, a place in which it is superior to Easy Money.  It motivates the “why” of getting your financial life in order, while Easy Money is better with the “how.”  What I admire about the author is that after failure, she grew up, and learned to be a serious adult about planning for the future, and using money wisely.

Most of my readers I expect are good at handling their money, but perhaps you have family or friends with self-inflicted money troubles.  If they lack motivation, you could get them a copy of Family CFO (with my caveats).  If they have motivation but lack knowledge, you could give them Easy Money.

Both are available from Amazon:

How to Be the Family CFO

Easy Money: How to Simplify Your Finances and Get What You Want out of Life (Liz Pulliam Weston)

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  If you wanted to get it anyway, it is good for both of us…

Book Review: The Only Guide to Alternative Investments You’ll Ever Need

Saturday, November 22nd, 2008

I’m taking a brief break from “all crisis, all the time” writing.  I’m backlogged on book reviews, and it is time to write some.

When I get a book on asset allocation, I suck in my gut and say, “Oh no, not another book that falls into the common traps of only relying on past history, and doesn’t consider structural factors….”  I was surprised this time, and I have a book on asset allocation that I can wholeheartedly endorse.

Messrs. Swedroe and Kizer have distinguished between asset classes in sophisticated ways.  With annuities they classify immediate annuities as good, variable annuities as bad, and equity indexed annuities as ugly.  I could not have said it better.

They identify real traps for the retail investor: avoiding the structured product that Wall Street tries to feed retail investors.  They always find new ways to cheat you, encouraging you to sell options that seem cheap, but are quite valuable.

They also describe areas of the asset markets that are less correlated with domestic stocks and bonds — Real Estate, TIPS, Stable Value (I would note the over a long period stable value and bonds do equally well), Commodities, International Stocks, and Immediate Annuities.

Assets that are hybrid between equity and debt tend not to offer much diversification to a balanced core portfolio, so junk bonds, convertible bonds, and preferred stock do not offer much of a diversification advantage.  Similarly, Private Equity is highly correlated with public equity returns over a intermediate-to-long time horizon.  (I would note that any of those assets classes may present relative valuation advantages at certain points in time, and that expert managers can add value, if you can find them.  As for now, high yield is attractive, and there is value in busted convertibles trading for their fixed income value only.)

Hedge funds are difficult to consider as an asset class.  Their is much variability across hedge fund types, and within each type of hedge fund.  There are a lot of difficulties with survivorship bias in analyzing the effectiveness of hedge funds as a group.

The book has several strengths:

  • How do the costs of an asset class affect performance? (e.g. Variable Annuities)
  • How do taxes affect performance? (e.g. covered calls)
  • How does complexity affect performance? (e.g. Structured products)
  • How do personal factors like age and risk averseness affect what products might work well?
  • How does inflation affect performance?

Now, this is only indirectly a book on asset allocation.  It is not going to give you a set of procedures to tell you how to analyze your personal situation, the relative attractiveness of various classes at present, and the macroeconomic environment, and calculate a reasonable asset allocation for yourself, your DB plan, or endowment.  But it will give you the necessary building blocks to see how each alternative asset class fits into an overall asset allocation.

If you want to, you can buy it here: The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly

PS — Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra.  Such a deal if you wanted to get it anyway…

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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