Category: Book Reviews

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

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

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…

Book Review: Investing By The Numbers

Book Review: Investing By The Numbers

I’m going to be reviewing a few books on quantitative investing.? Many of these will not be suitable for everyone, and as I do these reviews, I will try to indicate what level of math skills you will need in order to benefit from the book.? For today’s book, you can get most of it if you can remember your Algebra 1, and understand basic statistics.? Knowing regression helps, and a little calculus wouldn’t hurt, but this book is mainly qualitative.? It describes,and there are many graphs, but formulas are not on every page.

Investing By The Numbers has been out a while (1999), and though it is a good book in my opinion, it never sold big.? Oddly, a lot of investment actuaries bought the book because of a review in the Investment Section newsletter, Risk and Returns.? I have one of the few signed copies.? When I met Jarrod Wilcox when he gave a talk to the CFA Society of Washington, DC, he was genuinely surprised when I asked him to sign my copy of the book.

Jarrod Wilcox, Ph.D., CFA, held important roles at PanAgora Asset Management and Batterymarch Financial Management.? He runs his own shop now, focusing on liability-driven investing, something that I have written about at RealMoney, and at this blog.? What do I mean by liability driven investing?? Just that your asset allocation should reflect when you will most likely need the money.

This book does not have one big overarching idea to guide it.? Instead, it has many models to share from different situations in the market.? There is something for every quantitative equity investor here, and I will mention the areas where I benefited the most:

  • Along with a few other books, including some from the Santa Fe Institute, this book confirmed to me that one has to look at investment using an ecological framework.? Many strategies are competing for scarce returns.? Often the best strategy is the one that has few following it, and the worst one is the crowded trade.
  • Why do value methods tend to work?
  • How do you avoid traps in calculating models?
  • How do investors with different goals and expectations affect the market?? What happens when you get too many momentum investors?? Too many growth investors?
  • Difficulties with the Capital Asset Pricing Model [CAPM] and Arbitrage Pricing Theory [APT].
  • If the market tends toward equilibrium, the forces guiding it are weak.
  • Behavioral finance as a means of bridging investment theory and reality.
  • Market microstructure: how do we minimize total trading cost?? Minimize taxes?
  • How is the P/B-ROE model derived?
  • How to model market anomalies?
  • When do different valuation methods pay off well?
  • How does international diversification help?? (Bold in 1999, but a bit dated now.)
  • How to manage foreign currency risk in an equity portfolio?
  • How do neural nets work and what challenges are there in using them?

As a young investor using quantitative methods, I found the book useful, and still use a number of its findings in my current investing. Again, this is not a book for everyone — you have to want to do quantitative investing from primarily a fundamental mindset in order to benefit for this book.

Full Disclosure: Anytime anyone enters Amazon.com through any link on my site and buys anything there, I get a small commission.? This is my version of the tip jar, but best of all, it doesn’t cost you a thing, if you needed to buy it through Amazon already.

Crude Oil: What Goes Up, Must Come Down?

Crude Oil: What Goes Up, Must Come Down?

It was only two months ago when I wrote my surprisingly well-received post, Ten Notes on Crude Oil: The Fixation. It was surprising to me because I’m not an expert on energy issues. I’m just a good generalist portfolio manager who knows a little about a lot. So, I have to be careful what I say, and candidly say that I’m not sure, when that’s the case.

Here’s a graph of the price of crude over the last year.? Over the last two months, it was up fast in month one, and down faster in month two.? What a ride!

One Year Chart of the front month future of WTI Crude Oil
One Year Chart of the front month future of WTI Crude Oil

As prices rose in late June, President Bush called for lifting the restrictions on offshore drilling in the US.? If opening up ANWR was tough, this would be tougher, as there is a visceral feeling against drilling in states with significant coastal populations, even if the rigs can’t be seen from shore.

Another hurdle would be the lack of equipment capable of doing the drilling in the short run.? Think of all the industries with relatively tight capacity constraints that would be stimulated if the ban were lifted.? Drill-ships and rigs, specialty steel, coal, industrial gases… and more.? It would be quite a project.

As crude oil rose over $130/barrel, the exchanges moved to put limits on oil contracts.? Two weeks before the peak, credit conditions were leading shorts to cover positions.? Refiners began to let their crude inventories fall because it was getting more expensive to finance them.? So, as the market approached the price peak, there were a wide number of financing issues pushing the market around.

One week after the price peak, the demise of SemGroup made the headlines.? They were reportedly short the crude oil market, and were forced buyers covering near the peak.? Capitalistic markets are unstable, and that is mostly good thing, because it motivates market players to respond to the need.? At any significant peak/valley, some player that was taking significant chances gets uncovered as a fool who took big risks without a sound capital base, exacerbating the peak, and, the decline, though the fool doesn’t get to benefit.

As the price peak passed, this article posited why we would see oil down below $100.? The summary answer is demand destruction and supply encouragement.? High prices are the solution — users don’t buy as much, and suppliers see reason to produce more.? As for demand destruction, it is well underway in the US, but in places where prices are subsidized, or are artificially high due to taxes, the process is slower.

Every market has momentum players.? Momentum is a really simple strategy; do what the majority are doing.? That exacerbates the swings in the market, but given the needs of hedgers, whether they are producers or users, momentum tends to occur anyway for reasons of fear.

No surprise that high oil prices lead to conservation efforts on the part of corporations, as well as individuals.? High prices solve themselves.

One month after the recent peak, journalists point out the recent price peak.? Hindsight is 20/20, gentlemen.? I understand the need to explain what is going on, but I have more respect for those that take a position before the reversal, when it is painful to do so.

Crude oil is inelastically supplied and demanded, so it it should be no surprise that the price is volatile.? Small changes in expectations can produce big results, as is posited in this article on queueing theory.

I am not a peak oil “true believer.”? I believe that it is more likely than not.? As a result, I offer some time to the other side, because we can learn from them.? How much of the recent price spike is supply and demand, and how much? is speculation?? Hard to disaggregate, because speculation is normal to capitalistic markets.

Buffett: my guess is that he is accumulating a large stake in ConocoPhilips.? I could be wrong here; badly wrong, as he could be selling off.? But COP is cheap, has a large refining capacity, as well as significant E&P efforts around the globe.

Finally, a book review.? I was going to do reviews of two books on opposite sides of the peak oil question, but the book on the negative side was never sent to me.?

As for the pro-peak oil book, Profit from the Peak: The End of Oil and the Greatest Investment Event of the Century, my disappointment was that it was not written by an expert in the industry.? He posits that not only are we at peak oil, but we are at peak energy.? We are at or close to the peak in many forms of energy: coal, uranium, natural gas, etc.

This is a bold claim, an one that I think will be partially falsified, as men make efforts to expand energy with the incentives that come from high energy prices.

Full disclosure: long COP, also anyone entering Amazon.com through a link on my site, and buying anything, ends up giving me a commission.? No increase of cost to you.? It is my version of the tip jar.

Book Review: Super Stocks

Book Review: Super Stocks

When I review books, I don’t just review new books.? I try to share with my readers the books that have helped me become a better thinker on investments.? Fortunately, in this case, the 1984 book Super Stocks was reprinted in 2007.? Perhaps that validates my opinion that this is a valuable book.

Ken Fisher focuses on the concept of Price to Sales [P/S] ratios as a means of analyzing cheapness in companies.? Cheapness, yes, but predicated on the concept that a new product, process improvements, or better management will make more profits from the sales, or improve sales volumes and perhaps profit margins.

Though the examples are from the early 80s, the writing is clear enough that one can get the idea of how it might apply today.? You would get the same feeling from Ben Graham’s classic The Intelligent Investor, where the examples were from the 50s and 60s, but the truths are timeless.

Why choose this book to review now?? Profit margins are artificially high, and will come down somewhat from here, even if they remain above average.? How can we find cheap stocks when profit margins are so high?? Use P/S, or Price-to-Book [P/B].

My own investing looks at a wide number of valuation figures, but across an economic cycle, I give more or less weight to each variable.? When things are bad, I give more weight to P/S and P/B.? During the recovery, I emphasize P/E on a forward basis.? When the bull market is in full swing, I let industry selection dominate, which gives me more market sensitivity. As another example, I play up EV/EBITDA when buyouts are becoming common, and drop it as a criterion when buyouts are not being funded.

So, unlike Peter Lynch, paying attention to the macroeconomic environment can positively affect your performance, if you do it intelligently.

Super Stocks is very consistent with my eight rules, particularly the rules:

  • Stick with higher quality companies for a given industry.
  • Purchase companies appropriately sized to serve their market niches.
  • Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Fisher spends a decent amount of time on balance sheets, market share, competitive advantage, and use of cash flow for future investment.? Though I don’t endorse everything in the book, like his price-to-research ratios, there are a lot of good concepts for the average investor to consider, and benefit from.

Full Disclosure: If you enter Amazon through any of the links on my site (mainly on the leftbar) and buy anything, I get a small commission.? This is my version of the tip jar, and it doesn’t increase your costs at all.

On Management Books

On Management Books

I get e-mails from PR flacks asking me to review books on economics and finance.? I tell them, “No guarantee of a review, and if reviewed, no guarantee of a favorable review.”? I give them my address, and they send me a review copy.

I recently received and read a book on how to manage companies better.? After reading it, I was nonplussed.? On the whole, the book was vague and filled with platitudes.? The author claimed to have been a successful CEO of three companies, but he never named the companies, and what digging I did could not turn that fact up.? So, I’m not doing a review or naming the book.? I do know that giving advice to management teams is a career for the writer in his retirement.

Was the advice in the book bad?? Most of it is common sense stuff like how to manage your time, the time of your employees, developing employees, thinking long-term, communicating a vision to employees, etc.? I am reminded of many firms that I have worked for where the management was less than stellar, but it was usually for a pretty basic reason, which varied across the companies.

1) The management team had no idea of how much risk they were taking.? This book would have no relevance to that company, which went bankrupt.

2) The company was seemingly successful, but pressure from a results-oriented management team seemed to lead to compromises in accounting standards.? This book would have no relevance to that company, which is having its share of troubles now.

3) Senior management was insecure about their abilities, and would not listen to their mid-level staffers as problems arose.? This company has merged out of existence.? This book could have been helpful, but as with so many business problems, it is not know what to do, but being willing to do it.

4) The CEO was managing the company to maximize his own pay at retirement.? He succeeded, but the company did badly after his exit, and has merged out of existence.? This book would not have helped, but what management book could convince a man to give up greed, and look out the good of others?? Oh, yeah, the Bible.? But getting someone to read that is harder still.

5) Another seemingly successful company realizes that it needs critical mass outside of its home country, so it starts buying US financial firms.? They buy bargain assets after inadequate due diligence, and end up paying double what they should have.? This book would have been no use to that firm.

6) A rapidly growing asset manager does not realize that they are getting so large that the informal way that they do things isn’t quite cutting it so well, and they need to become more corporate, and less informal/personal.? This book would have given modest help.

7) A business grown from scratch has a strong leader who limits the organization because he has to be involved in everything.? This book would be useful to the organization and him.

8) An organization that excels in design and manufacturing is mediocre in marketing, and poor in financial management.? This book would not help.

So, when I think of how many organizations that I have been closely involved with could have been helped by the book, it is not that many.

Most management book writers don’t have the erudition of the late Peter Drucker, who has long been my favorite writer in this area.? Consider another popular book Good to Great, which still sells quite well.? I usually find the Guy who wrote Freakonomics to be somewhat tedious, but I agree with him on this.? The firms that went from good to great have not been great investments.? If you want to find good investments, it would be better to invest in companies that go from bad to good.? That is where money is made.? The cost of going from bad to good is small, usually, and the reward is high.? The costs are higher going from good to great, and the incremental rewards are not as great.

So, being great is not so great, but being good is pretty good.? If you need to think about management, read books by Drucker; they are classic, and will teach you more than management, they will help you think better.? Look at Buffett and Munger — they are intelligent men who understand people, and are always learning.? They are atypical, but effective CEOs.

There is no one perfect management style, it varies by the individual and the industry.? I would only say this, build up your people skills, industry knowledge, general knowledge, and ability to understand basic finance, and you can do better as a manager.? Most important, is that you have to want to become a better manager, and from my experience, most managers don’t want to do it.

I do have some more book reviews coming up, one on energy, and another few on quantitative finance.

Full disclosure: if you buy books/things from Amazon please consider doing so by entering Amazon through the links on my leftbar.? It will not increase your costs at all, but I will get a small commission.? This is my version of the “tip jar” and the best part of it is it doesn’t cost you a dime.

Book Review: The Wall Street Waltz

Book Review: The Wall Street Waltz

I’ve mentioned this before at RealMoney, but in early 2000, I was doing some serious thinking about investing. I decided to e-mail Ken Fisher a question that he had touched on in one of his Forbes pieces. That began an e-mail dialog that forced me to ask hard questions about how I did value investing. Personally, I was surprised how much time he was willing to waste on me, but I had read the three books that he had written up to that time, Super Stocks, 100 Minds that Made the Market, and The Wall Street Waltz. I had a good idea of how he approached investing.

He challenged me to throw away the CFA Syllabus and think independently — to focus on my own competitive advantage. That led me to analyze what had worked and failed in my prior efforts in value investing, and that led to what would become the Eight Rules. I did well in the prior era, but much better after my discussion with Ken Fisher.

One more note before I begin the book review. He told me that if something is known, it is not valuable for investing. I have modified that rule to be, “If something true is relied upon by many investors, it is not valuable for smart investors. If something false is relied upon by many investors, it is valuable for smart investors to bet against that.”

The Wall Street Waltz takes you on a graphic tour of economic and financial history. Using beautiful old charts created by multiple sources, he uses them to describe market action in the past, and what they might imply for the present. The original version, of which I have a copy, was written in 1987. The new edition updates Ken’s comments to 2007.

The charts provide a springboard for Fisher to explain a wide number of concepts:

  • Why preferred stocks are suboptimal investments. (Chart 31 — learned that first hand a a little kid as I saw my Litton convertible preferred crater.)
  • How economically linked Canada is to the US (Chart 15)
  • The value of P/E ratios for the market (Charts 1&2)
  • Why you shouldn’t panic over bad political/disaster news. (Chart 24)
  • How inflation is correlated internationally (Chart 49)
  • Gold preserves purchasing power in the long run, but that is about it. (Chart 57)
  • Stocks create value in the long run, despite short/intermediate-term fluctuations. (Chart 88)

I could go on. I chose those pages randomly. There is a wealth of knowledge here. I would like to close with a timely page that I targeted, Chart 64 — Unemployment and the 1 Percent Rule. The stock market tends to rally after the unemployment rate rises 1%, though the challenge is timing when to sell, and I don’t know what the rule should be for that. After the last unemployment report, the rate is more than 1% over the recent low. If correct, it is time to be a buyer, though what is true on average is not always true in specific.

Most investors don’t benefit from an understanding of economic history, which gives a broader skill set for analyzing current problems. This book is an aid in gaining understanding of economic history.

Full disclosure: If anyone enters Amazon through my site and buys something, I get a small commission. Your costs are not increased. This is my equivalent of the “tip jar” and so, if you like what I write, and need to buy through Amazon, please enter Amazon through links on my site.

Book Review: When Genius Failed

Book Review: When Genius Failed

One review of a good Roger Lowenstein book deserves another? Perhaps good things come in pairs. 😉

I decided to review “When Genius Failed,” because reading “While America Aged” reminded me of how much I liked Lowenstein’s writing style, simplifying matters for the average reader.

I was an investment actuary when LTCM was founded, and watched out of the corner of my eye, as I saw articles about their success. Being a risk manager, I was a little skeptical over the leverage employed, but I knew of other firms that had records almost as good, employing esoteric strategies of Residential MBS. That was the era of build a better prepayment model, and the returns will flow. (Perhaps today that would apply to default models…)

When LTCM imploded, I had just joined my first investment department. In the panic that ensued, Treasury yields fell, and my boss asked his new mortgage bond manager, me, why prepayments weren’t accelerating. I suggested that the banks could not borrow at Treasury rates, better to look at single-A bank and financial yields, which were considerably higher. (Surprisingly, I got that one right.) A number of the clever prepayment modelers got their heads handed to them during this era.

The implosion affected all fixed income markets, and it was a lesson to me that markets ordinarily recover from crises starting with short maturities, and moving to longer maturities, and with high quality, and moving to lower quality. We had cash flow, and and provided liquidity at a price.

Um, oh yeah, book review.? LTCM suffered from a number of troubles:

  • They were systemically short liquidity.
  • They did not consider the effect of others mimicking their trades.
  • They were internally disorganized; leadership was weak.
  • They intensified their leverage at the wrong time.

The liquidity aspect is significant.? Illiquid assets that are similar to a liquid asset usually yield more, because the cost of trading is much higher, and the possibility of being trapped is higher also.? LTCM bought the higher-yielding illiquid assets, and hedged them with more-liquid liabilities.? This set the stage for the run-on-the-fund.? Almost all run-on-the-bank scenarios occur from institutions where the ability of depositors to demand cash is greater than the ability to raise cash in the short run.

In the same way, many on Wall Street mimicked the trades of LTCM, but they had risk control desks that forced them to kick out the trades when they went awry, which further intensified the pressure on LTCM, because it forced the asset prices of LTCM lower.

The lack of discipline inside LTCM, was a eye-opener for me, and I would not have appreciated it, were it not for Lowenstein’s book.? Financial businesses that last require tight controls on risk taking.

Another thing captured by Lowenstein was the hubris involved as they cashed out some investors in order to “favor” internal investors and close friends.? They levered up at the wrong time.? The cashed-out investors were offended, but they were the ones who did the best of any; they got the good years, and missed the bad year.

Now, beyond that, Lowenstein delivers the attitudes of LTCM and Wall Street, with all of the fear and greed.? It is entertaining reading, and the book is still timely. Even though there is no dominant investment firm that threatens the financial markets, we have the investment banks as a group taking a great deal of risk in their trading and investment banking.? The assets are illiquid, the liabilities are more liquid.? Their balance sheets are opaque.? Many of them are in the same risk posture.? Many of them are more leveraged than they would like to be.? Bear has already fallen, will Lehman fall next?

Just because investors are smart does not mean that they are infallible.? Any investor playing at a high enough level of leverage can be ruined.? This book inoculates investors against perverse risk-taking, and makes them more skeptical about the claims of hot investors.? Not losing money is a big help in making money, and skepticism in investing is usually a plus.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission, and your costs don’t increase. This is my version of the ?tip jar.? Thanks to all who support me.

Book Review: While America Aged

Book Review: While America Aged

Where were you while America aged? 😉 I’ve been following the issues in this book written by Roger Lowenstein for over 20 years. As an actuary (but not a pension actuary) and a financial analyst, I have written about the issues involved since 1992.

Roger Lowenstein motivates the issues surrounding pensions by telling three stories, those of General Motors, the New York City Subway, and the City of San Diego. He captures the essence of why we have pension problems in a way that anyone can appreciate. I sum it up this way: promises today, payments far in the future. Get through the present difficulty, at the price of mortgaging the future.

If you repeat that recipe often enough, you get into a tough spot, as GM is in today. Give GM credit though, a lesser firm would have declared bankruptcy long before now, and shed its pension liabilities to the Pension Benefit Guaranty Corporation [PBGC].

Given the softness of funding requirements for pension liabilities, the easy road for corporations and municipalities has been to skimp on funding pensions, leaving a bigger problem for others to solve 10+ years later. As for municipalities, review my recent post here.

Now, why didn’t the US Government insist on stricter funding standards for pension plans? Because of pushback from corporations and municipalities. The US Government hoped that their funding methods for corporations would encourage the creation of pension plans, and that corporations would be good corporate citizens, and not play it to the edge.

As for municipalities, which are not subject to ERISA, as corporations are, the government assumed that they would act in their best long-term interests. Alas, but governments are run by men, not angels.

I found each of the three stories in the book to be interesting and instructive. They are tales of people aiming at short-term results, while letting the future suffer. In the case of the NYC Subways, the plan sponsors finally fought back. With GM, they accomodated until they were nearly dead. With San Diego, they compromised until it cost them their bond rating, and many people involved got sent to jail.

As any good author would, the book offers a few solutions at the end, but it recognizes as I do, that we are pretty late in this game — there are no “good” solutions. There are solutions that may aid future generations. An example is making municipalities subject to the funding requirements of ERISA. I agree, and add that we should apply that to Federal DB [defined benefit] plans, and Social Security too. This could be our own Sovereign wealth fund, investing overseas for the good of US retirees. (What, there is no money available to do that? What a shock.)

I would also add that the funding requirements specified in ERISA are weak. The standards for life insurance reserving are stronger. The weak standards were there to encourage the creation of DB plans. Well, you can encourage creation, but maintenance is another thing.

A certain level of overfunding is need in good times, hopefully, with discipline not to increase benefits. That overfunding is hard to achieve, because the IRS discouraged overfunding above a certain level, because it did not want companies to shelter income from taxation by contributing to the DB pension plans.

Now, I have also reviewed the book Pension Dumping. Which one is better? For the average reader, While America Aged motivates the topic better, but if you want to dig into some of the deeper issues, Pension Dumping does more.

Full disclosure: If you enter Amazon through a link on my site and buy something, I get a small commission. This is my version of the “tip jar.” Thanks to all who support me.

PS — In some ways, the actuarial profession comes out with a black eye in books like this, and I would say that it is deserved. I don’t believe in professions, per se. Self-regulating guilds/industries are a fool’s bargain. There are no guilds/industries where if you can’t explain it to a bunch of average folks, there should be no cause for discipline from society at large. What stinks to me, is that there is no hint of discipline to any of the actuaries, and other third party consultants from the actions that they took to support the actions of politicians and corporations where they bent and broke pension funding rules. The ABCD? What a joke.

Book Review: The Fundamental Index

Book Review: The Fundamental Index

The Fundamental IndexThe books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

  • The market is efficient!
  • Keep expenses low!
  • Don’t trade fund positions!
  • Fundholders buy and hold!
  • Tax efficiency!
  • Weight by market cap or float!

For fundamental indexers:

  • The market is inefficient (in specific gameable ways).
  • Keep expenses relatively low.
  • Adjust internal fund positions as valuations change!
  • Fundholders buy and hold!
  • Relative tax efficiency!
  • Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

  • Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
  • The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
  • A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
  • And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Full disclosure: If you buy anything from Amazon after entering Amazon through any link on my leftbar, I get a small commission. It is my version of the tip jar, and it does not increase your costs at all.

Financial Literacy for Children

Financial Literacy for Children

As we were driving down the highway Monday evening, back from our oldest daughter’s symphony concert at U-MD, my wife and I began talking about teaching children about money.? We homeschool, so we have to consider a lot in training our children for the real world.

Some of my children have an interest in the market, some don’t. Personalities differ, but you want to give them some core knowledge that everyone can use. There have been people in our home school get-togethers who when they find out I am an investor, they ask “Do you know of any good books on the stock market for kids?” Lamely, I suggest the out-of-print book by Ken Fisher’s son, Clayton, which is pretty good, but I didn’t think it was definitive.? One has complained to me about the Stock Market Game, which seems to teach speculation, not investment.

That’s true of most stock market contests — the only exception I can think of was the Value Line contest back in 1984 . I managed to place in the top 1%, but not high enough to win. That contest forced you to pick 10 stocks from ten different groups for six months. The stocks were sorted by price volatility deciles, so you had to pick some volatile stocks and tame stocks. The stocks were equal weighted, and there was no trading. Great contest — I would love to run something like that. I have suggested it to The Street.com, but no dice. Hey, maybe Seeking Alpha would like to try it! Nominal prize money, but there would be bragging rights!? (Abnormal Returns, this could work for you as well…)

My wife tells me to think about it. Well, today, as I’m going through my personal e-mail, I run across a note from the Home School Legal Defense Association promoting the National Financial Literacy Challenge. Timely, I think. They are having a competition based off of the national standards published in 2007 by the Jump$tart Coalition for Personal Finance.

So I look at the standards, and I think, “These are pretty detailed… how can you turn this into a usable curriculum?”? I print them out and read a little bit of them to my wife Ruth, who says, “Typical for those that set standards, and aren’t teachers; you can’t work with that stuff.”? My wife was a high school teacher, and despite that hindrance, she still homeschools well.? But she knows the troubles that come to public school teachers as mandates come down from on high.

She asked me, “What would you recommend, then?”? I thought about it and said that the personal finance book that I reviewed recently, Easy Money, would be a good book for high school seniors to read.? It’s not a complex book at all.? Afterward I would discuss it with them.? She asked me why I hadn’t done that for our older two children and I said, “It was published after they went to college.? I’ll ask them to read it this summer.”

For investing, I still think that Buffett’s Annual Reports are understandable to most teens.? Marty Whitman is easy to read as well.? But I always liked Ben Graham, and I think The Intelligent Investor is accessible to the average teenager.? Good investing is not complex… but often we make it so.

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