I’ve written a lot about Buffett over the years.  I think this is the eighth shareholder letter that I have written about.  I have the unique perspective of being both an actuary and a value investor.  I get what Buffett is doing, though by no means am I his equal.  This is a commentary on his 2010 shareholder letter.

Buffett begins with the transformational merger of Burlington Northern.  I spoke well of this merger that many dissed in my piece, The Forever Fund.  Face it — where could you find such a big business that is inflation-protected, and with such a large moat?  No one could replicate BN at the price that Berky paid.  This acquisition reshaped Berky, making it far more of an industrial firm, albeit one financed with insurance float.

Measuring Performance

From page 2:

In Berkshire’s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn’t possible.

To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books. (Later in this report, we’ll present a case study.) But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.

This is a wise way to measure performance, and many value-oriented insurance companies do this.  But Berky isn’t just an insurance company, and book value isn’t a perfect metric.  But change in book value plus dividends is a much better metric than earnings, so using that is a reasonable metric to evaluate Berky.  On that score Berky has done very well over the years, and I would argue that Buffett has done even better in his later years because it is increasingly difficult to deploy a large amount of money and still beat the averages.  Look at what I call “dollar alpha.”  The amount of outperformance is limited, but Buffett is absorbing a large portion of the alpha in the market.  (Of course aggregate alpha is zero, but if a large player continues to do well, that has a disproportionate effect on the rest of the market.)

Capital Management

Our flexibility in respect to capital allocation has accounted for much of our progress to date. We have been able to take money we earn from, say, See’s Candies or Business Wire (two of our best-run businesses, but also two offering limited reinvestment opportunities) and use it as part of the stake we needed to buy BNSF.

Buffett understands the difference between businesses that have reinvestment opportunities, and those that don’t.


Our final advantage is the hard-to-duplicate culture that permeates Berkshire. And in businesses, culture counts.

To start with, the directors who represent you think and act like owners. They receive token compensation: no options, no restricted stock and, for that matter, virtually no cash. We do not provide them directors and officers liability insurance, a given at almost every other large public company. If they mess up with your money, they will lose their money as well. Leaving my holdings aside, directors and their families own Berkshire shares worth more than $3 billion. Our directors, therefore, monitor Berkshire’s actions and results with keen interest and an owner’s eye. You and I are lucky to have them as stewards.

This same owner-orientation prevails among our managers. In many cases, these are people who have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner’s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage.

Cultures self-propagate. Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior. (As one wag put it, “You know you’re no longer CEO when you get in the back seat of your car and it doesn’t move.”) At Berkshire’s “World Headquarters” our annual rent is $270,212. Moreover, the home-office investment in furniture, art, Coke dispenser, lunch room, high-tech equipment – you name it – totals $301,363. As long as Charlie and I treat your money as if it were our own, Berkshire’s managers are likely to be careful with it as well.

Berky is one of the few companies where they have the interests of the outside passive minority shareholder at heart.  The company runs thin; excess expenses are small to nonexistent.


He gives his usual praise of Ajit Jain who I have met.  A genuinely bright guy, and friendly as well.

With Gen Re, he emphasizes pricing discipline — the willingness to walk away, and not write business.  This is the core of good insurance management.  Never intentionally write business for an underwriting loss.

Manufacturing, Service and Retailing Operations

He talks abut the improvement at NetJets, which had been quite a dog for Berky.  David Sokol had quite an impact there.  But beyond that, Berky has a wide number of businesses that do very well.

He also discusses the black box that is Marmon, that Berky owns a majority of, and will own the whole thing by 2014 at latest.  It is also doing well.

Regulated, Capital-Intensive Businesses

BNSF and MidAmerican Energy fill out this segment.  Buffett is more than logical to put them together, because their enterprises are subject to their regulators, but enough distant from insurers that they get a different classification.  Why?

Like insurance, you don’t have perfect freedom to redirect earnings as you wish.  Some earnings must be reinvested into maintenance, and with discretion, into growth.

What Matters Least at Berky

The public investments, large as they are, are a small part of what makes Berky run.  People pore over the investments that Berky makes, but the guts of Berky are not investing, but managing a conglomerate of businesses funded by cash flow from insurance.

Todd Combs

While at a prior employer, I came to know Todd Combs, and we traded a bunch of ideas in the insurance space.  He was a bright guy.  I have little doubt that he will do well for Berky.  I remain available for any additional mandate that Berky might  require.  (I giggle as I write this, because though I have done well, why should Warren want a shmoe like me?)  That said, I am willing to manage any assets of Berky at my bottom rate of 0.1%/year.


Buffett describes how he has use derivatives to his advantage.  Amid the criticisms, he has made money there as the stock markets of the world have recovered.

Life and Debt

Buffett explains how avoidance of debt is wise. And after that:

We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.”

True, utterly true.  And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.  Yield is the decision of the company, but what you should  ask is what is the increase in value of the company.  Look for investments that increase your net worth the most.

When you are in the bust phase of the credit cycle, there are no good solutions.  Do you try to reflate?  You can try to, and you will succeed (sort of), if the Fed Funds rate maintains a respectable positive value that does not kill savers.  But you might not succeed, because there is not enough interest margin available to capitalize today.  That is where we are today, and so the Fed moves on to QE, where any asset can be financed via the Fed’s fiat.

The best policy focuses on the booms, and seeks to limit excesses.  It seeks to deliver pain in the bust phase to those who made bad lending decisions.  Had the Fed allowed real pain to be delivered to the banks in the late 80s and early 90s, we wouldn’t be having our current problems.  The Fed lowered rates far lower than was needed, and kept them there until a crisis erupted, forcing change.

Had the Treasury and the Fed let Mexico fail in 1994, and let the stupid Americans who had put money into cetes lose money, we would have been better off now.  If losses are not delivered to those who deserve them imbalances build up.

The same applies to the 1997 Asian crisis, Russia/LTCM, the popping of the tech bubble, and the response of the Fed flooding the system with liquidity.  Too much, and too long — it set us up for the housing/financial bubble of which we are now in the aftermath.

So, when the latest crisis hit in 2008, I took up the lonely position of suggesting failure was the better solution.  If the government had to get involved, let it be a DIP lender.  If it had to meddle in the creation of credit, create a bunch of new mutual banks.

But as I mentioned in the first paragraph, when the big bust hits, and Fed funds drops to zero, all solutions are pretty useless.  At that level, normal monetary policy can no longer cause revaluations of asset prices (and liabilities), allowing the reflation of assets with low ROAs.  That is, until QE appears, leading to temporary inflation of assets through sucking in a decent chunk of the safest part of the intermediate fixed-income universe, forcing a temporary increase in risk taking.

I would argue that the best thing one can do in the bust, whether as an individual/policymaker is to ask what you would like the next boom to look like. Parallel examples (Individual/Policymaker)

  • What level of safety will you maintain? / are you willing to see the economy grow more slowly in the short-run, if it leads to better long-term growth?
  • How will you avoid getting caught up in euphoria? / how will you resist the political pressure from concentrated interests asking you to twist regulation/legislation their way?
  • Will you avoid too much debt, particularly short-term debt? / Will you fight to keep systemic leverage low, and keep the asset-liability mismatch at the banks low?

And more for policymakers:

  • Do you want the unaccountable (to the voters, and also Congress) Fed to have such influence?
  • Will you adopt policies that discourage steep yield curves?
  • Will you raise FDIC fees to economically fair levels, till you begin to see a few banks walk away?
  • Are you willing to invest in a regulatory structure that can and will say no to the banks?
  • Or, are you willing to break the banks up, end interstate banking, and let the states regulate the banks?  (Remember, state insurance regulators did relatively well through this crisis… AIG was mainly a derivatives failure.)
  • Are you willing to regulate derivatives as insurance contracts, with something similar to an insurable interest doctrine?
  • Do you really want to continue to farm out credit policy to the rating agencies?
  • Are you willing to create a better accounting system based on current net worth, rather than dated historical cost figures?

In the same mold, I would add that it is during the boom that you want to consider what you want the next bust to look like. For example, will you accept more frequent and sharper small busts in order to avoid a big bust?

You can limitedly control your own exposure to the next boom/bust; it depends how much you want to manage your time horizons, and limit your potential outcomes.  As for policymakers, I am less optimistic due to regulatory capture, and short-term opportunism.  Regardless, you are better off if you plan for the longer term; society as a whole would be better off if policymakers did the same.

This is a continuation of an irregular series which you can find here.  Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.  I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.  They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.  My three comments to them were:

  • Prohibitive for life insurers to hold equities
  • At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
  • The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.  They looked in the rearview mirror and said that we were doing fabulous.  Why change success?

I was outvoted; I was a one-man minority.  There are a lot of people who would have loved to make that change in hindsight, but done is done.  I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.  We may be headed for significant inflation or deflation; it is difficult to tell which.  Bonds offer little competition to equities here.  Commodities and cash may be better, but I am reluctant to be too dogmatic.  If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

  • That we can use simple models to forecast future outcomes.
  • That average people are capable of avoiding fear and greed when it comes to investing.
  • That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
  • Over long periods of time, average investors can beat long Treasuries by more than 2%/year.  (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
  • That financial markets are expressions of what is going on in the real economy.
  • That the real economy tends toward stability
  • That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.  And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.  If a large portion of the population wants to convert assets into a stream of income — guess what?  They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.  As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.  What they say is true, but the same is true of other types of defined contribution and defined benefit plans.  When assets underperform, and/or investors make bad choices, guess what?  The pain has to be compensated for somehow:

  • 401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
  • Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.  Also same as 401(k)…
  • Private sector DB plans: employers may contribute more, or they may terminate them.
  • Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”  First, risk and return are virtually uncorrelated in practice.  Only when enough people realize that might risk and return become positively correlated.  Second, there are times to increase and decrease risk exposure.  Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.  The time to add to high risk assets is when no one wants to touch a high yield bond.  More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.  Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.  At present, investment opportunities are average-ish.  I would be wary of stretching for yield here, or raising my risk exposure in equities.  Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.  I have a simple formula for how much one could take from an endowment at maximum:

  • 10 Year Treasury Yield
  • Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
  • less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.  At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.  This attempts to marry withdrawals to alternative uses for capital in the market.  You may withdraw more when opportunities are high, and less when they are low.  (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.  Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.  In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.  (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)  The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.  We’ve spent years on the illusions generated by assuming high returns off of financial assets.  Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.  Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

August-October 2008 was a tough era to blog in as the crisis broke.  It was the height of popularity for my blog, I haven’t had that level of readership since.

Rather than go chronologically, this era lends itself to being topical.


The Crisis

Nonidentical Twins: Solvency and Liquidity

How Much Can the US Government Guarantee?

Oppose The Treasury’s Bailout Plan

We Need Oversight, and Compensation to the Taxpayers

Don’t Rush It

Let the Current Bailout Die

What A Fine Mess You Have Gotten Us Into

Oppose the Current Bailout Plan, Redux

I tried to fight the bailout.  I do not accept the idea that the bailout helped, regardless of losses of profits, because it skews future actions of those who think they will be bailed out.

The Aftermath of the Crisis

Blame Game

Blame Game, Redux

Blame Game III

There are many to blame from the crisis, including me.  I don’t go in for simple crisis explanations; the crisis was societal, global even.

Market Dynamics

The Fundamentals of Market Bottoms

The Fundamentals of Market Bottoms, Part 2

The Fundamentals of Market Bottoms, Part 3 (Final)

The Fundamentals of Residential Real Estate Market Bottoms

These pieces finished off a series of four for me.  Market dynamics are tough, and most people don’t get them.

Fannie & Freddie

A Way to Make Money Off of Fannie and Freddie

Margin of Safety

Another Look At Fannie and Freddie

If you listened to me, you made money off of the failure, and avoided losses as well.  No joke; I hit that one out of the park, Bill Miller!

Monetary Policy

Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages

Liquidity for the Government and no Liquidity for Anyone Else

FOMC: Forking Out More Currency

Entering the Endgame for Monetary Policy

A Note on the Greenspan Legacy

NOT Born and Bred in the Briar Patch

The Fed continued its “brain dead” policy, until the crisis broke, and then began to catch up.


Analyzing Growth in Firm Value

Accounting Rules Do Not Affect Cash Flows

Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

IFRS: Incomparable Flexible Reporting Standards.

A variety of articles dealing with understanding accounting, from a man who has not had a single accounting course in his life, but had to do financial reporting for 12 years.

Stable Value and Money Market Funds

A Proposal for Money Market Funds, and More

A Maximum of One Year of Interest Lost

There are alternative ways of assuring a stable net asset value.

Miscellaneous Financials

Puncturing Pensions

Residential Real Estate Will Not Have A “V” Bottom

The Banking Industry Should Learn from the Insurance Industry

Investing in Financial Stocks is Tough

Too Bad for Preferred Stock

Industries Don’t Learn From Each Other on Credit Issues

Financials are tough because there is nothing that stands behind them, except for willingness to pay.

Big Think Pieces

Financial Bloggers: The Conscience of Wall Street?

Finance When You Can, Not When You Have To

Capitalism <> Greed — Capitalism = Service

Rethinking Insurable Interest

Good pieces all.  Read them at your convenience.  They will still be valuable 50 years from now.

When I came to work at Provident Mutual, I gained a friend who reported to me.  Roy was a real character.  He had his rules for life, and they all made sense to some degree.  When he opined on why we did business the way we did in the pension division, he would say,”We’re the good guys.  We are out to save the world for 0.25% on assets plus postage and handling.”

I like working with the good guys; that is my style, if I can achieve it.  Too many are purely out for personal enrichment, leaving aside the harm/good they do to others.

Roddy Boyd is one of the good guys.  If you haven’t read his stuff before in the papers/magazines in which he has written, you will benefit from his book on AIG.

This book has some real insight to it.  It focuses on the years where AIG stopped being a mere insurer, and started being a player in the capital markets.

That said, it contains new data on M. R. Greenberg, especially regarding his war years.  I found it very insightful, and helped me understand why he was the boss that he was. (I worked at AIG 1989-1992.)  He was one tough man in both war and business.

Boyd interviewed as many as would talk with him, and excluded material that would not be confirmed by two parties.  I felt that was an ethical way to deal with information not yet publicly known.

The driving force behind AIG’s push into financial services was a need for income uncorrelated with the P&C insurance cycle.  That also led to derivatives, commodities trading, airplane leasing, and expansion of the domestic life business, by purchasing SunAmerica and American General (both mistakes via overpayment in my opinion, and I know this business).

This expansion took a toll on AIG and as it could not grow profitably organically anymore at a 15% rate, it began to borrow money, both explicitly and implicitly, so as to lever a falling ROA (return on assets) into a 15% ROE (return on equity).

Greenberg oversaw the expansion into financial services, though not the imprudent risk taking after he was kicked out.  He also managed the increase in debt and implicit debt — most of that occurred under his watch.  But those that followed him were nowhere near his equals.  They could not manage that which was unmanagable by lesser mortals.  Martin Sullivan should have broken up the company on day one; that was his failure.  No one but Greenberg could manage the monstrosity.  If he had remained there, I suspect the company would have blown up in 2010-2015, with him screaming all the way down.  I think it was a mercy to him that he got kicked out.

When everything blew apart, no one could grasp the whole picture.  Greenberg was gone.  AIG was undermanaged.  No one knew the whole story, and all of the correlations hinging on subprime lending: direct lending through the consumer finance arm, investments in the insurance companies, guarantees through the mortgage insurance subsidiaries , securities lending collateralized by subprime in the domestic life companies, and guarantees at AIG Financial Products.

The effort at diversification ended up being an exercise in concentration.  Nothing grows to the sky.  Big firms tend to rot from within and that was the case for AIG, Greenberg or no.  I think Greenberg got sucked into the Wall Street earnings game, and it eventually got too big for him.  It was certainly too big for his successors.

This was a great book.  I loved every minute of reading it.  I could not put it down.  Roddy is one of the “good guys” and fights for what is right.  But he is fair; he does not take someone to task unless he has incontrovertible evidence.  Thus those who are suspected, but have no ironclad case against them walk, which is as it should be.

One more note, this book had a really good balance in how it would leave the main story to explain a concept, and the broader financial world.  It left the main focus on AIG, while explaining how it fit into the broader picture.


The book is not available yet.  I read an advance version, and there were some small errors that I expect will be eradicated when it goes to print.

Who would benefit from this book:

Anyone who wants to know more about AIG wold benefit.  This is the best AIG crisis book yet.  Beyond that, readers wanting to understand the complexity of the financial system, and how it led up to the crisis will benefit, as AIG was a microcosm of the greater panic.

If you want to, you can buy it here: Fatal Risk: A Cautionary Tale of AIG’s Corporate Suicide.

Full disclosure: This book was sent to me by the author, unsolicited.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Eddy Elfenbein wrote an interesting post on the market doubling from its bottom.  But given all of the odd things going on in the markets, and one of my mottoes is “Weird begets weird,” I asked how unusual the fall was  before the rise.  Over the last 61 years, it is unprecedented.  Here’s the table:

Return table

This table lists all of the major turning points as I see them.  The summary statistics are these: bull markets last 3.5x as long as bear markets on average.  Bear markets move at 1.9x the rate of bull markets. (double speed)

But now consider cumulative bear markets as I define them:

Cumulative Loasses

and the monthly losses versus the number of days for the loss.

The longer the losses go on, the less intense the losses are on an annualized basis.  But the loss level is higher per unit time than for gains — the amount of time spent in gains is 3.5x that of the losses.  Look at the cumulative gains:

Though the gains clump around doubling, there are two results in the triple to quadruple area — makes up for a lot of losses.

As one might expect, short rallies tend to be more intense than long rallies.  Normal rallies since 1950 tend to double the index value.  Abnormal falls cuts the index in half.

But for today that leaves us overextended.  Yes, levels have rapidly doubled versus the low.  That’s unusual; it undoes a harder than normal fall.  But it would be unprecedented for the market to continue to advance at a 3% pace from here.  That would be uncharted waters.

Consider trimming some of your hottest positions.

When you start a business, no matter how much research you do, you don’t know all of the issues that you will run into. What has struck me since I wrote the piece On Bonds in Retail Accounts is that I need to run a bond strategy.

Now, I played with synthetic alternatives, and I may still offer some of them.  I could offer clients that I partially hedge my equity holdings.  Synthetically, on the hedged portion they earn something close to a t-bill rate on average, which is near zero these days, and after my fees negative, though after my performance, hopefully positive. Here is what I ended up writing to a couple clients of mine:

I think I’ve said it before, but market-timing is not a core skill of mine.  Can’t do it.  What I can do is pick stocks.  I’ve had discussions like this with a few others, and if they have a taxable account, and want to hedge their positions, I’ve been toying with an idea, and I’d like to bounce it off you.  For taxable accounts, I offer long only and market neutral, but there’s no reason why I couldn’t offer any percentage hedging in-between zero and full. That would allow people to implement their view of the markets, and if their views change, hopefully not at the wrong time, they could change their hedge amount.

I hedge by shorting Spiders [SPY] against the longs in the portfolio.  My beta seems to be around 0.95, even with the cash I hold, so a fully hedged account of $100,000 looks something like this:

$ 85,000 stocks

$110,000 cash

-$95,000 SPY

I’ve thought about this three ways.  Someone could say to me:

1) Take down the SPY hedge bit by bit over ## months

2) Leave me ##% hedged until I tell you otherwise

3) Here’s a schedule of how much net equity exposure I want at various levels of the S&P 500.

And, I think I could do any of those for clients.  Remember, this is only for taxable accounts at present.  I have not figured out a cost-effective way for doing this on tax deferred accounts.  I suppose I could do it by going to cash or high quality bonds, but is that something people would want for their IRAs?

But when I think about it, the synthetic strategies are only for those who believe deeply in my stock picking abilities, to the degree that any sort of bond strategy versus cash is blown away by the alpha of my stock picking.  In the past, that would have been true.  In the future who can tell?  My good performance could have all been “luck.”

At a prior employer in the mid-2000s, I ran a balanced strategy that was 50% my stock strategy and 50% a bond strategy that I developed.  Though the stock strategy provided most of the alpha, the bond strategy provided much more alpha than most bond strategies did.

In basic, my bond strategy is this: analyze bond spreads relative to likely losses.  Invest accordingly.  If all of the major risk factors are underpriced, invest in foreign bonds, analyzing which countries are willing to accept appreciation of their currency.  I don’t want to put words in the mouth of PIMCO, but this is what I think their unconstrained strategy looks like.

As for me, with smaller accounts, I will be using ETFs and CEFs. The fees will be a lot lower than what I charge for equities.  There are accounts that need bonds as well as equities and don’t want to have multiple accounts.  I am facing that reality, and have come to the conclusion that I have to offer a bond strategy.

To my readers, do you have any advice for me?  Since I am mainly serving individuals, I think I have to go this way, and not be “equities only.”  Let me know.

I don’t have all the resources that I would want in order to do complex analyses.  Give me the database, and the right software, and I can do amazing things.

Even with limited data, and cruddy software, I still have something interesting this evening.  On January 21st, I made measurements of domestic equity ETFs to try to analyze what percentage of domestic equities were held by ETFs.

In order to limit my efforts, I polled the largest 61 domestic stock ETFs, excluding funds that are leveraged or inverse.  (those don’t buy/sell the equities directly, but use derivatives.  Granted, the derivative seller has to hedge, but he very well may cross hedge, messing up the estimates.)  That accounted for 90% of the markets cap of ETFs.  I then took the actual stock holdings of the ETFs and aggregated them, and then compared those holdings to the market capitalizations of the underlying stocks themselves, ending with a percentage of each stock held by the top 90% of ETFs.

I then ran a regression of that variable on several other variables.

Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
df SS MS F Significance





Coefficients Standard
t Stat P-value Lower 95% Upper 95%


0.000000000 0.001728610 0.002766546
shr insd


0.000000593 (0.000120865) (0.000052764)


0.000000000 0.001326567 0.002041335
shr inst


0.000282660 0.000302866


0.879555010 (0.000000039) 0.000000033
3m avg volume


0.199780706 (0.000000006) 0.000000001
3m realized volatility


0.000000000 0.000065014 0.000087616


0.673613846 (0.000004325) 0.000006693

In short, I learned that ETF holdings of stocks were:

  • Inversely proportional insider holdings
  • Proportional to the stock’s beta, realized volatility, and amount held by institutions, and
  • Seemingly not related to market cap, trading volume or float.

Even the intercept term has some value as it is near the actual average percentage of market cap held by the top 90% of ETFs, which was 2.15%.  Assuming the same proportion applies to the last 10% that would mean that domestic stock ETFs own 2.39% of domestic stocks.  That’s enough to affect pricing at the margin.

Now, that percentage held by the top 90% of domestic ETFs in any common stock was as high as 17.9%, and as low as zero.  In terms of percentage of market capitalization held by the top 90% of domestic ETFs, we hit zero at stock 2912.


  • Domestic stock ETFs tend to pick more volatile stocks.
  • Domestic stock ETFs tend to pick stocks held by major institutions.
  • Domestic stock ETFs tend to pick stocks less held by insiders.  (They tend to be more boring.)

My summary is that those who create ETFs, even the big successful ones, tend to follow trends.  By their nature, they are extrapolating from what worked in the past, but in the process of doing so, end up overchoosing some names, and in the process add to their volatility.

That’s all for now, I still don’t feel well.

To my readers: I have not been feeling well over the last week.  Ordinarily, I feel quite healthy, and I am grateful to God for the general health I have had over the last 10 years.  But this sickness has made it difficult for me to concentrate, headaches, etc.  Haven’t had headaches in a long time — 5-10 years or so, can’t remember the last time.

So, hopefully I will be writing more soon.  During the downtime I have read a lot, and spent time monitoring and thinking about my business.  But I feel utterly unproductive, tired, and subdued.

Just letting you all know why I have been so quiet.  I have a lot of good stuff to trot out, but getting the focus is difficult when your head is pounding.

This segment takes us through the period May-July of 2008, as the crisis slowly built to the peak of its cashflow deficit, with many saying that it was a liquidity crisis, not a solvency crisis.  Anyway here is my best from that era:

What is Liquidity? (Part II)

Goes through the three definitions of liquidity, and shows how they are related, particularly when liquidity is scarce, even though they are different phenomena when liquidity is plentiful.

Why Do I Blog?

Many are writing about this topic now, and this is what I wrote about it then, unbidden by others.  From the piece:

Blogging is in many ways tougher than being a young journalist. A blogger starts with no audience, whereas a young journalist has an audience from the publication. The young journalist will be guided in what to write about by his superiors, and will automatically get edited. The blogger has to figure out what he can adequately say, and whether anyone really wants to read him. The young journalist will have discipline imposed on him, whereas most successful bloggers have to develop their own discipline — one consistent with their posting style and frequency. Blog audiences decay rapidly with lack of attention, and there is a lot of competition to be heard. Journalists succeed or fail as a group, and the individual journalist does not have a lot of effect on that.

Seven-Plus Years of Trading for the Broad Market Portfolio

Losing Money is Part of the Game (Part I)

Losing Money is Part of the Game (Part II)

Average? I Like Average, if It’s My Average. (Part I)

Average? I Like Average, if It’s My Average. (Part II)

My Best Investments Over the Last 7+ Years

Concluding the Current Portfolio Management Series

The seven articles listed above involved a lot of work, explaining how I mostly made money on my portfolio, but how I also had my share of losses, en route  to doing very well over 7+ years.  I am still managing money the same way today, with reasonable success versus the market.
Blowing the Bubble Bigger

My summary of Kindleberger’s paradigm:

  • Loose monetary policy
  • People chase the performance of the speculative asset
  • Speculators make fixed commitments buying the speculative asset
  • The speculative asset’s price gets bid up to the point where it costs money to hold the positions
  • A shock hits the system, a default occurs, or monetary policy starts contracting
  • The system unwinds, and the price of the speculative asset falls leading to
  • Insolvencies of those that borrowed to finance the assets
  • A lender of last resort appears to end the cycle

Facilitating the Dreams of Politicians

This wasn’t my first article on municipal pensions.  I think the first one was three years earlier at RealMoney, and I had a few a Aleph Blog.  The greatest way that municipalities cheated on their finances was through underfunding their pensions.

Abandon the Playbook; Adopt the Global Playbook; Adjust the Playbooks for Valuations

The idea here is that the old ideas for industry cycles should be abandoned, because we no longer live in a world where the US is all that matters.  We need to look at global demand, not US demand.  The same for supply.

Ten Notes on Crude Oil: The Fixation

Surprisingly, this is the most read article on my blog.  I could not have predicted this, but with oil prices going through the roof, my post that was neutral on the price action was hot for the market as a whole.  As I re-read it, I see why it was a great article, taking into account a wide number of disparate views.  This is close to blogging at its best.

Avoid Debt Unless it is to Purchase an Appreciating Asset

There are a lot of dopey opinions on saving, particularly from macroeconomists.   Debt is a curse, unless the opportunity is compelling.

Saving at young ages sets the tone for the rest of life.  The lifecycle saving hypothesis (of Milton Friedman) is wrong, because most people don’t possess the discipline to switch between being a borrower to being a saver.  Many do it, but not the majority. I saved money when I was a grad student, though most of my colleagues did not.

The Four Stages of Investment Knowledge

This is true in many disciplines.  Seeming knowledge gives way to disappointment, leading to greater knowledge in the long run.

Rethinking Comparable Worth

Sadly, one one of my most important pieces, explaining why the developed world should in general should expect shrinking incomes in the face of an expanding global capitalist system.

Fannie, Freddie, and the Financing Methods of Last Resort

Anticipates what will happen in a few months.

General Motors = General Malaise

I predict that GM will die, and not for the first time.

Buy Agency Mortgage Bonds

I don’t often offer categorical buy signals but the few I do offer are typically good.

Thinking About Dividends

Are dividends the unique way to tilt portfolios?  I don’t think so.

The Nature of a Crowded Trade

Holding an asset with a short time horizon for disposal is a crowded trade, if many others have a similar idea.

You Can Sue, But You Won’t Win

More on the Financial Insurers — losses were inevitable.

The Fundamentals of Market Bottoms, Part 1

Bottoms and tops are different, what can I say?

Covering Covered Bonds

Covered bonds were cool for a moment in the US, and I covered it.

What are the Limits? Are there Limits?!

With deficits that are low by today’s standards, this piece was pessmistic.