The Rules, Part XIII, subpart A

The need for income naturally biases a portfolio long.? It is difficult to earn income without beneficial ownership of an asset ? positive carry trades will almost always be net long, absent major distress or dislocation in the markets.? Those who need income to survive must then hope for a bull market.? They cannot live well without one, absent an interest rate spike like the late 70s/early 80s.? But in order to benefit in that scenario, they had to stay short.

My paternal Grandfather invested in CDs through the interest rate? spike of the late 70s and early 80s.? He looked pretty smart for a time, but he never shifted to take risk when there was a reward to do so.? Contrast my Mom, who had her 50/50 mix of utility stocks and growth stocks (a clever strategy, which as far as I know, she thought up herself).? As she once said to me, “My utilities are my bonds.”? Though my Mom’s strategy underperformed my Grandfather’s in the short run, in the intermediate term it soundly beat his strategy.? Long term?? No contest.

There is something about yield.? Almost everyone wants to have it, and have more than what would be average.? My own equity portfolio throws off more yield than the S&P 500, even with 19% earning nothing in cash.? There is something tangible about yield: cash in hand, vs. uncertain capital gains, even if the dividend leads the stock price to drop.

There is a sense that yield is free, like harvesting eggs from your chicken coop in the morning.? Mentally, that is the way that many view it.? They may adjust the yield for risk of nonpayment, but there is a tendency to assume that the yield will come in.

Here’s an example: in 1999-2000, Morgan Stanley did a piece on some corporate bonds that they called, “The Dirty Thirty.”? They were the worst of BBB-rated bonds, but they argued off of a limited period of past returns, that the widening in yield spreads over Treasuries was not justified, so but them because they survive and outperform.? Very bad timing, I must say.? Many of the companies defaulted 2000-2002, and enough came under severe stress, that those with weak balance sheets kicked them out at the wrong time, for fear of their possible insolvency.

This was a prime example of a brokerage providing advice that was technically correct off of history, but deadly wrong with respect to the situation at hand.? Now, was Morgan Stanley trying to lighten its inventory of Dirty Thirty bonds?? I don’t know, but I suspect not.? Most corporate bonds of large corporations are liquid enough that they can be bought and sold easily.

Truth is, if you are a bond manager, you get lots of sell side research telling you how to get a higher yield.? To clients who report on a book value basis, like banks or insurers, that is manna, or pennies from Heaven.? Yield goes straight to the bottom line.? Capital gains or losses can be deferred, at least until default or maturity, and even if they are realized, analysts exclude them from operating earnings.

Thus the tendency for many regulated financial institutions to be yield hogs, unless the management team has religion regarding risk control.? As for me, I held the unique position of being risk manager and leading corporate bond manager at one job.? There was a conflict of interest there, but for me, it enabled me to be more cautious, and more risk-taking at appropriate times.? Gaining real market experience is something most risk managers never get, but it imparts knowledge of likely ways in which asset management can go astray.

It can easily go astray.? As Warren Buffett says, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”? Goes double for trading with the main desks on Wall Street.? They look for weaknesses, and the leading weakness is being a yield hog.? They will more than happily dig up yieldy securities that are more risky than normal for such a client, because the client wants it, and it is easy to find those securities.

The investment banker may think the client is dumb, but he is under no obligation to tell him so.? And besides, in investments, who knows?? The client may know things that the investment bank does not.

To illustrate, I got cheated on my first corporate bond trade with CSFB.? It looked like a good trade to me.? It would gain incremental yield on a seemingly similar security.? My boss was gone, so I, the new assistant, made the trade.? On a $5M trade, I lost $20K instantly.? My boss was leaving for another job in a week, but he chewed me out anyway, and told me at some firms I would have been fired for what I had done.

I took it to heart, and hyperanalyzed the trade to understand all of my errors.? I did not make those errors again, and I was very diligent to be a skeptic regarding the trades that I did with the big firms.? That did not mean that I did not trade, but that I drove the trades that I did, rather than accepting the trades that the Street suggested.

Instead, I relied on our in-house analysts to do our digging, and I became persistent at pursuing what we wanted, and enlisted second-tier brokers that could help us.

I would often do swap trades that gave up yield, if I saw a greater improvement in the risk profile.? That is rare among bond traders.? Even among professionals, there is a bias toward more yield.? I ended up preserving capital for our main client, allowing me to reinvest at favorable yields as the crisis was cresting.

The bias for yield among individual investors is worse, and Wall Street readily takes advantage of individual investors in order to hedge expensive options by offering seemingly high yields through structured products.? The credit and interest rate risks take away what the yield offers, and more.? That’s the business, and smart investors stay away.? Don’t be the patsy at the investment poker game.

5 thoughts on “The Rules, Part XIII, subpart A

  1. Sure, KD. The CSFB trader knew that I was a neophyte. A certain deal was coming to market on a bond that was close to a “museum piece.” They didn’t offer debt often. We held some of their last deal, and we liked the credit, but we were close to the maximum amount that we could hold.

    My boss was gone, and nominally, trading authority was in my hands, but I had never done a corporate trade before — MBS, CMBS, ABS, yes, but not corporates.

    The broker encouraged me to swap our old bonds for the new ones. Now, I eventually became very good at relative value trades, but I had no idea of the nuances at that point, particularly for a bond that had few liquid pricing comparisons.

    I entered into the trade for not enough incremental yield on the swap. I should have gotten $20,000 more for the bond that I swapped. I went over it with the high yield manager afterward, and we independently concluded that we should have gotten $20,000 more on the bond that I sold.

    I chalked it up to market tuition. Shame that the client paid the tuition, but I earned far more for them after that. One more note: eventually that broker and I learned to work well together, and I did a lot of business with him.

  2. One more thing, there was the pressure that a decision “had to be made today.” May or may not have been true; I would have rather left it to the boss, because it was his trade. He was royally annoyed that I had acted in his absence.

  3. saw no other way to get in touch. Great that you’re a Covenanter!

    Media queries:
    William Barack, Ph.D
    Barack Capital Management
    bill@barackcapitalmanagement.com // 440-892-9956

    Gerry Wisz, GW Communications
    gerry@gwcom.biz //201-280-2816

    UNIQUE INVESTMENT STRATEGY BASED ON `VOLATILITY OF VOLATILITY CAPTURES NAAIM WAGNER AWARD

    NAAIM Awards $10,000 Prize to New Zealand Statistician Tony Cooper for Paper Uncovering Optimal Leverage Levels Through Volatility Analysis

    Littleton, CO, Orlando, FL — May 3, 2010 The National Association of Active Investment Managers (NAAIM) announced today that Tony Cooper, managing director Double-Digit Numerics in Auckland, New Zealand, is the 2010 first-place winner of the $10,000 Wagner Award for Advancements in Active Investment Management. In their second year, NAAIM’s Wagner Awards promote the effectiveness of active investment management strategies; this year’s entries have come to NAAIM from all over the world.

    “Mr. Coopers paper is a significant addition to the body of knowledge on active investment management,” said Jerry Wagner, president of Flexible Plan Investments, Ltd. and co-chair of NAAIMs 2010 Wagner Awards Committee. “He was able to mathematically synthesize a formula for determining optimal leverage of a portfolio. I believe his advancement has multiple applications for the investment management industry”

    The winning paper, “Alpha Generation and Risk-Smoothing Using Volatility of Volatility,” explains a method for predicting volatility in a tradable data series. Under the premise that volatility is easier to predict than price, Cooper suggests several methods for predicting volatility to specify levels of leverage that can increase performance with limited risk.

    “Volatility has long been an important element of market analysis,” explained Dr. William Barack, president of Barack Capital Management, a member of the judging panel and co-chair of the 2010 Wagner Awards committee. “Rising volatility is typically a sign of uncertainty, and often precedes market declines, while low volatility tends to occur in rising markets. Coopers approach digs deeper into volatility, beyond analyzing VIX charts and other volatility measures, to predict volatility and apply that knowledge to a leveraged investment approach.”

    Mr. Cooper has a distinguished academic record, including having won the IBM Prize in Computer Science and the G.H. Bennett Prize in Statistics at Massey University; he was a recipient of the National Research Advisory Council Fellowship to study at Stanford University. His professional career includes experience as a consulting statistician for the Applied Mathematics Division of the New Zealand Department of Scientific and Industrial Research, significant IT experience at New Zealand Funds Management, as well as quantitative experience at Wellington, NZ, hedge fund Crema Capital. A volunteer for Team New Zealand, Mr. Cooper has conducted wind field interpolation studies for the America’s Cup. He has a graduate degree in Statistics from Stanford University.

    In 2004, Cooper founded Double-Digit Numerics, an independent quantitative research and consulting firm, with the mission of strengthening the science infrastructure of New Zealand and applying quantitative and other specialized skills in statistics to business, especially those in the finance industry.

    The 2010 Wagner Awards attracted entries from the U.S., Great Britain, Canada and New Zealand. Second-place in the competition is George Yang for his paper, “Buy-Write or Put-Write: An Active Portfolio to Strike It Right,” followed by third-place winner Bruce Greig for his paper, “Alternative Overlay for a Traditional Managed Equity Portfolio.”

    Top papers will be published on the NAAIM website at http://www.NAAIM.org, following the associations May 2010 annual conference in Orlando, Florida at the Hilton Bonnet Creek Resort.

    About the Wagner Awards
    In honor of the vision and work of NAAIM founding member, and president and CEO of Flexible Plan Investments, Ltd., Jerry Wagner, the Wagner Awards for Advancements in Active Investment Management annually awards $10,000 to a first-place paper providing evidence of the validity of an active investing approach using a trading system that outperforms the market by some well accepted metric, such as risk-adjusted return, annual return, or draw-downs. Second-place and third-place winners are awarded $3,000 and $1,000, respectively.

    The top prize in 2009 went to independent trader and quantitative trading consultant Justin Lent for his paper, “Tactical Equity Allocation Model (T.E.A.M.): A Quantitative Approach for Investing in Long-Term Trends by Using Short-Term Mean-Reversion Techniques to Optimize Risk-Adjusted Return.”

    About NAAIM
    The National Association of Active Investment Managers or NAAIM is a non-profit trade group of nearly 200 registered investment advisor firms that collectively manage over $16 billion in assets. NAAIM member firms provide active money management services to their clients to produce favorable, risk-adjusted returns as an alternative to more passive, buy-and-hold investment strategies. NAAIM publishes the weekly Survey of Manager Sentiment, the NAAIM Active Mutual Fund (AMF) Index, and sponsors the annual Uncommon Knowledge conference along with smaller conferences on managing portfolios, trading techniques for various instruments and markets, regulation and compliance, and other topics of interest to its membership. For more information, visit http://www.NAAIM.org.

  4. How much of the success or relative lack of success of your grandparents have to do with risk, really, and how much with pure luck? I think you refer to market risk, but in fact, the risk that made the difference was political risk. Market risk can be dealt with rationally, Black Swans put to the side. Political risk cannot be — it’s more like “luck.” Who knows what economic or social policy with triumph, usually for reasons that have nothing to do with financial markets in the first instance, e.g., The Reagan Revolution. So I would say your GrandMom lucky — she benefited from an explicit but not-predictable monetary policy espoused by powerful political interests to discourage savers like Grandpa. Every time Grandma’s portfolio was threatened, Grandpa was punished by 1% interest rates. Of course Alan Greenspan and Ben Bernanke didn’t give a hoot about people like Grandma. She merely benefited by picking the right side in a game she could not possibly have understood. Glad it worked out for her. Not so glad for Grandpa, but his type may just have the luck next time around. Or not…

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