Category: Academic Finance

Toward a New Concept of Asset Allocation

Toward a New Concept of Asset Allocation

Posted on by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

  • It assumes there is one type of risk, the occurence of which is random.
  • It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
  • Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
  • In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
  • Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
  • It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
  • Risk is the same for all people, and their decision-making time horizons are the same as well.
  • And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

  • Where am I getting paid to take risk?
  • Where am I getting paid to avoid risk?
  • What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
  • Where options are available, how is implied volatility relative to long-term averages?
  • What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

  • Are corporate spreads narrow or wide?
  • How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
  • How steep is the yield curve, and where is Fed policy?
  • What is the speculative feel of the market now?? Bold? Scared? Normal?
  • Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
  • If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
  • Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

  • Where is the sector in its speculative cycle?? Where are secondary interests being sold?
  • How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
  • Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Sorry, Doctor Shiller, not Everything can be Hedged

Sorry, Doctor Shiller, not Everything can be Hedged

Posted on by David Merkel

Many people don’t think through questions systematically.? That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh.? And this from an esteemed professor at a significant university?? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures.? I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under.? But who would be directly affected if IBM went under?

  • Stockholders, both preferred and common
  • Bondholders
  • Banks that have loaned money
  • Trade creditors
  • Workers

Let’s talk about the bondholders.? They could buy protection via credit default swaps [CDS] to hedge their potential losses.? In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already.? It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered.? I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets.? There is no risk transfer, but only a bet.? My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house.? Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes.? So what is there to hedge here?? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house.? If I knew that there were many people betting on the value of my house, I might become concerned.? What actions might people take against me in bad or good times?

But maybe no one would have interest in my house.? It’s just one house, after all.? Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average? in your area.? That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling.? There is no significant natural exposure hedged.? It is only a betting market.

And such it would be for most real assets.? Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%.? Everything else is a side-bet.? Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system.? No tail chasing the dog.? Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin.? The concept that everything can be hedged assumes deep markets everywhere, which is not the case.? Time for you to step outside the university bubble and taste the real world.? It’s not as hedgeable as you might imagine.

Post 1000

Post 1000

Posted on by David Merkel

Every 100 posts or so, I stop to talk to my readers more personally, thank them for reading me, reflect on where we have been, and where we might be headed.

From my heart, I thank you for reading me.? You have many things to do with your time, and you deign to read me.? Thanks.? In some ways, my blog is an acquired taste.? I cover many areas thinly, because I have a broad range of interests in finance, business and economics.? I’m sure that the average reader has to endure (or ignore) 50% of what I write, and that’s fine.

Where have we been

I am reminded of Psalm 66, verse 12 in the era we have been through: Thou hast caused men to ride over our heads; we went through fire and through water: but thou broughtest us out into a wealthy place. [KJV]? The wealthy place is not yet here.? This has been a chaotic time.? We have seen markets destroyed, and come back to life in more limited ways.? There has been a bounce-back from panic, but options are reduced compared to where we were when I started writing this blog.? Areas of over-leverage have been revealed, even in seemingly safe areas.? There is nothing certain in such an environment.? All of the old certainties get questioned, even if they survive.

Where we are now

Though I am a value investor, and a quantitative investor, I don’t write much about my stock picks, mainly because you don’t get much praise for it, and you get a lot of complaints when you are wrong.? I wrote a piece at RealMoney that reflected my frustration in writing there about my investments.? It was called: Investing Is About the Whole Portfolio.? Too many people are looking for stock picks, when they should be looking to learn thought processes.? With a stock pick, you don’t know what to do as markets change.? Learning the thought processes is more complex, but it prepares you in how to understand the market as it changes, albeit imperfectly.

I spend a lot of time on macroeconomic and fixed income issues.? Why?? The bond market is bigger than the stock market, and has a big effect on the stock market.? I keep toying with an idea that would replace Modern Portfolio Theory, with something that would use contingent claims theory to develop a consistent cost of capital model for enterprises.? Essentially, it says that in ordinary circumstances, the more risk one takes in the capital structure of a company, the higher the return required to invest.? Estimate the implied volatility of the assets, and then apply that to the liabilities and equity.

Another way of saying it is that we can learn more from the shape of the yield curve and credit spreads than by looking at backward-looking estimates of asset class returns.? I continue to be amazed at those that use historical averages for asset allocation.? Start with the yield curve.? That will give you a good estimate on bond returns.? When credit spreads are high, typically it is better to be in corporate bonds rather than stocks, but it does imply that stocks might be cheap relative to Treasury bonds.

Most of the time the markets as a group tell the same story.? It gets interesting where one is out of line from the others.? My current example is banks exposed to commercial real estate versus REIT stocks and bonds, and CMBS.? The banks are not reflecting the future losses, but the REITs and CMBS are reflecting the losses.? Chalk it up to accounting rules for the banks.

Where are we going?

Demographics is destiny, to some degree.? Countries that shrink, or have large pension/healthcare promises will have a hard time of it.

Defaults are rising in both the corporate and consumer sectors.? Anyone who thinks the financials are out of the woods is wrong.? Even as new housing sales rise, there are many defaulting on their mortgages because they can’t afford their mortgages, or think that they are stuck with too much payment for too little house.? Add onto that continuing problems with commercial mortgage defaults and corporate defaults.

The Dollar is a problem in search of a solution.? None of the solutions are any good, so changes get delayed until the pain can’t be stood anymore.? This could be decades or years — but the Dollar is in decline.

The world has more laborers, the same amount of capital, and declining resources.? Relatively, the price of labor should go down, and the price of resources up.? The value of capital will fluctuate in-between.

Where is this blog headed?

We are going in my own idiosyncratic direction.? That means when crises hit, I will be there.? Aside from that, I will talk about the issues that affect the markets more generally.? There will be book reviews.? The next two are from Justin Fox, and James Grant.

I have more models that I will trot out.? For example, I have a short-term investment model that I am developing, and I hope it will come out in the next six months.? I might also roll out my alternative to Modern Portfolio Theory, if I work it out (I am dubious that I will get there).? I also have a review of the people on the FOMC coming out.? There’s more… I always have a list of articles that I want to get to, but time is short.

Time is short.? My apologies to all who have written to me, but I have not responded to.? I can’t answer all of my e-mails.? I do read all of them, and I appreciate that you write to me.? I don’t read comments on other sites that repulish my works, so I urge you to write to me here if you want to bring something to my attention.

One last bit of thanks

I could have stayed behind the pay wall at RealMoney, but I wanted to interact with a broader audience.? Amid some criticism, the investment blogosphere is a very intelligent place, and more attuned to the real situation than most of the mainstream news media.? Give the New York Times, the Wall Street Journal, Bloomberg, and Reuters their due, but the world needs investment bloggers — we point out truths that are missed by many.? I am not speaking for me, but for the many that I respect in blogging.

And as for readers, I thank the following selection of institutions where I have readers:

  • Alexander & Alexander
  • AllianceBernstein L.P. (US)
  • AMAZON.COM (US)
  • American International Group
  • Bank of America (GB)
  • Banque Paribas (US)
  • Barclays Capital (GB)
  • Bharti Broadband (IN)
  • BLOOMBERG, LLP (US)
  • Bridgewater Associates
  • Cambridge MAN Customers (GB)
  • Charles Schwab & Co. (US)
  • CIBC World Markets (CA)
  • Citadel Investment Group
  • Citicorp Global Information
  • Credit Suisse Group
  • DBS VICKERS SECURITIES
  • Dean Witter Financial Services
  • DEUTSCHE BANK (US)
  • Dow Jones-Telerate (US)
  • Dresdner Kleinwort Wasserstein
  • Federal Home Loan Mortgage
  • Federal Reserve Board (US)
  • Fidelity Investments (US)
  • GOLDMAN SACHS COMPANY (US)
  • Google (US)
  • H&R Block (US)
  • Harvard University (US)
  • Hewlett-Packard Company (US)
  • HSBC Bank plc, UK (GB)
  • Intel Corporation (US)
  • INTERNAL REVENUE SERVICE (US)
  • Jefferies & Company (US)
  • Johns Hopkins University
  • JPMorgan Chase & Co. (US)
  • Knight Capital Group (US)
  • KOCH INDUSTRIES (US)
  • KPMG LLP (US)
  • LEHMAN BROTHERS (US)
  • MAN Financial (US)
  • Merrill Lynch and Company (US)
  • Michigan State Government (US)
  • Microsoft Corp (US)
  • MILLENIUM PARTNERS, L.P. (US)
  • Moody’s Investors Service (US)
  • Morgan Stanley Group (US)
  • Morningstar (US)
  • Mutual of Omaha Insurance
  • Nat West Bank Group (GB)
  • Nesbitt Burns (CA)
  • Nomura International plc
  • Northern Trust Company (US)
  • RBC CAPITAL MARKETS
  • Repubblica e Cantone Ticino
  • Royal Bank of Canada (CA)
  • Salomon (US)
  • Societe Generale (FR)
  • Speakeasy (US)
  • Stanford University (US)
  • STARBUCKS COFFEE COMPANY (US)
  • The St. Paul Travelers Companies
  • The Vanguard Group (US)
  • Thomson Financial Services (US)
  • UBS AG (US)
  • Union Bank of California (US)
  • United States Senate (US)
  • University of Chicago (US)
  • University of Virginia (US)
  • US Department of the Treasury
  • Watson Wyatt
  • WELLS FARGO BANK (US)
  • Yale University (US)

What a group.? I am honored.? Again, thanks for reading me, whoever you are, and whoever you work for.

Final note

I am still looking for a lead institutional investor for my equity fund, which is available in both a long only, and market-neutral form.? (I’ve beaten the S&P 500 8 out of the last 9 years.)? If any of my readers have a lead on any institutional investor who might want to invest $1 million or more in my fund, please e-mail me, and I will send you my pitchbook.? Whoever gets me my first institutional investor gets my undying gratitude.? Help me if you can.

Efficient Markets as a Limiting Concept; There are Conceptual Limits to Efficient Markets

Efficient Markets as a Limiting Concept; There are Conceptual Limits to Efficient Markets

Posted on by David Merkel

I do and don’t believe in the efficient markets hypothesis [EMH].? I do believe in the adaptive markets hypothesis [AMH].?? The efficient markets hypothesis posits that:

  • Past price-related information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
  • Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
  • Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong? form, while the investment community holds to the weak form.? One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true.? The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole.? I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free.? They are not free.? Also, it implicitly assumes that a dominant number of investors understand what information drives the markets.? Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH.? When the competition is tough, finding excess returns is hard.? This makes it a limiting concept.? We never get there, but effort to find above-average returns gets us closer to that ideal.? Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

  • It lowers their costs.
  • It is tax-efficient.
  • Most people aren’t very good at picking equity managers.? They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now.? They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have.?? The best managers are the smaller specialists running their own funds, and who eat their own cooking.? They are also inconvenient to use.
  • It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them.? Most people are bad at most investment decision-making.? Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it?s not worth the search costs any more.

And so it is for those of us who are active managers.? We have a twofold task:

  • Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
  • Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors.? (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine.? My example would be Enron-like structures 2001-2002.? Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron.? We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result.? What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor.? It happens to all of us.? Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers.? If you adjust infrequntly (once a year or less), prune your winners and add to your losers.? In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself.? If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate.? If you have conquered those emotions, you can potentially do better yourself in investing.? But ask yourself what your sustainable competitive advantage is in investing.? If you don’t have one, better to index.

Overleverage, and a Failure of Credit

Overleverage, and a Failure of Credit

Posted on by David Merkel

Just a brief post here.? The Economist features a simple symmetric model to try to explain cycles in the financial markets.? Cute model, but it can’t explain booms and busts.? The key missing feature is credit that can default.? Defaults are asymmetric.? With bonds you can make a little with high certainty, or lose a lot with low certainty.? This is true of all lending, leaving aside convertibles.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.? During booms, some? firms magnify the results by levering up (borrowing more).? This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.

What is the Sound of One Hand Clapping? What is the Right Price when there is no Market?

What is the Sound of One Hand Clapping? What is the Right Price when there is no Market?

Posted on by David Merkel

No, this isn’t another discussion of SFAS 157, though there are some similarities.? There has been a bit of a brouhaha over repayment of TARP options.? Isn’t the government getting shortchanged?

Maybe.? Maybe not.? This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.? Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].? Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:? the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.? Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.? What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.? What if we purchased the future hedges today?? A few problems with that:

  1. We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
  2. But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.? There’s a reason for that.? The longer-dated the option, the harder it is to hedge.? There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.? Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).? But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.? Not hedging in full bit them hard, and they lost a lot of money.? Penny wise, pound foolish.

So what about the TARP options?? Did the US Government get taken to the cleaners on Old National Bank?? Is Linus Wilson correct in his allegations and calculations?? Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.? Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated? over different intervals.? Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.? It tends to revert to mean.? With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.? That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.? Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.? Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.? I had several assumptions more conservative than Mr. Wilson:

  • In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.? (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
  • I set dividends at their current level, and assumed they would increase at 5% per year.
  • I modeled in the dilution from warrant issuance.

But I was more liberal in one area.? I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.? If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.? That’s nice, but what’s the right assumption?

There is no right assumption.? Short-frequency estimates are much higher, even assuming mean reversion.? Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .? After all, Old National is a boring southern Indiana bank.? This is not a growth business.? If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.? Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.? I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.? Wrong!? We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.? I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.? Is it more work?? Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

One Dozen Notes on our Current Situation in the Markets

One Dozen Notes on our Current Situation in the Markets

Posted on by David Merkel

I’m leaving for two days.? I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.? (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.? Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.? Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.? I have sold bit-by-bit as the market has risen.? I’m planning on buying more of my losers, or finding a few new names to throw in.? Will the current “bull market” evaporate?? There are some sentiment measures that say so.? Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.? Are we facing crash-like risks now?? I don’t think so, but I can’t rule it out.? My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.? My initial opinion was that he would be a disaster.? Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.? It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.? Such a recovery is not possible while 20%+ of all residential properties are under water.? Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”? Sell them short, and you won’t have to pay anything back.? Though Ford is prospering for now, GM is declining rapidly.? In bankruptcy the common is a zonk.? With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.? First, I am concerned over contract law.? The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.? I worry when the government tampers with that.? I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

8) I have almost always liked TIPS.? Do I like them now?? Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?? Of course many did.? No surprise here.

11) The EMH exists in a dynamic tension with its opposite.?? Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.? So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.? Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.? To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.? What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.? Major shareholders with secondary interests are often painful.? With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.? May the Lord watch over you.

Book Review: Trend Following (4)

Book Review: Trend Following (4)

Posted on by David Merkel

While reading the book Trend Following, I was reminded of something that I read in The Intelligent Investor (I have the Fourth Revised Edition.)? These are two very different books.? What could be the same?

Fortunately, you don’t have to have a copy of The Intelligent Investor to see this.? Appendix 1 of the book is, the edited transcript of Warren Buffett’s talk that he gave at Columbia University in 1984 for the 50th anniversary of publication of Security Analysis can be found here.? The PDF version can be found here — it has the tables, but will take a while to load.

Buffett chooses 9 investors in the mold of Ben Graham, all value investors, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

In appendix B of his book, Michael Covel chooses 14 (or so) investors who are trend followers, and shows how they have soundly trounced the market over their tenures.? He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

See the similarity?? Now, I think that both approaches work to some degree, though not all of the time.? I have known a number of managers that have married the two approaches, usually with some success.? (As Humble Student Cam Hui points out, marrying the two may be more difficult than it seems.? I’m going to have to dig up that copy of the Financial Analysts Journal.)

I would criticize one aspect of Buffett’s logic, and the same would apply to Covel.? I’ve known my share of bad value investors.? Usually they overemphasize cheapness, and forget “margin of safety” as the key intellectual concept of value investing.? It’s easy to come up with a group of great managers following a certain strategy in hindsight.? Where is the grand study of all investors of that class, be it value investing or trend following?? Almost any strategy could be made to look good if one can cherry-pick the investors with the advantage of hindsight.

So, what would qualify as a valid study?? You’d need a relatively complete census of the group following a given strategy, including those that failed and dropped out.? After that, audited returns would help, as Mr. Covel likes to point out.? An alternative would be to follow a smaller closed cohort of managers following a certain management style.? The problem with that is you yourself might have a really good eye for management talent apart from the investment style.

Another alternative would be an academic-style study where the researcher defines the buy and sell criteria and then sees if the method beats the market, whether adjusted for risk or not.? Now, regarding risk, that is one of many places where I agree with Mr. Covel.? Standard deviation does not measure it; beta doesn’t measure it; tracking error doesn’t measure it.? Maximum drawdown, or maybe some obscure statistic from extreme value theory would probably be the best measure.

Why drawdown?? It best measures the ability of a manager to continue his strategy without panicking.? Most of us would question our sanity after a certain level of loss, and give up.? For different investors, the number is different.? For those managing external money, it is more important, because normal investing processes get destroyed when investors pull their money.? Where is that maximum level where investors will stay on board?? It depends on how they were sold on investing their money with the manager.

What are the problems with doing an academic-style study?

  • Often does not include costs of commisions, market impact, etc.? Liquidity is implicitly free, while in the real world, it is costly, particularly for undervalued oddball securities.
  • Data-mining may allow anomalous result that are noise to be reported as signal.
  • Managers using the style being modeled argue that it does not truly represent what they do.
  • Some studies get skewed by using calendar-year-end dates, where trading is often unusual.

Does that mean doing? definitive studies of trading strategies is impossible?? No, but it is quite expensive to do, so those interested in questions like this often resort to shortcuts, such as academic studies, limited peer group studies, etc.

Now, fairly comprehensive studies for things like growth and value managers exist (tsst… value wins), and some studies for CTAs exist.? But I’m not aware of any comprehensive studies for trend followers.? The academic studies show that price momentum is an important factor in market returns, and many investors with good returns use momentum.

It begs the question, if price momentum, or trend following is a panacea, why is it not more broadly embraced by the money management community?? That is tomorrow’s essay.

The Ecology of Investment Strategies

The Ecology of Investment Strategies

Posted on by David Merkel

Any investment strategy can be overused.? Part of the job of a portfolio manager is to ask the question “To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?”

Few managers are conscious of the water that they swim in.? They assume their strategies provide consistent advantage, when in truth the advantage is periodic, even if it works better than average over the long haul.? The truth is that every strategy has limits, and when too many parties apply a strategy, the excess returns disappear, or even go negative.

All investors have to sit down and ask the question, “What aspects of the market will I try to take advantage of?” with the corresponding question, “What will I ignore?”? Adding to that, “How much of the market can I invest in, given my advantage?” (What is the carrying capacity of my strategy?)

Most value managers don’t care for momentum.?? Most growth managers don’t care much about valuations.? Some things will be ignored.

It is tough to be a institutional asset manager.? The competition is fierce.? What’s worse, you and all of your competition comprise 80% or so of the market.

Further, you know what side your bread is buttered on.? If you have average, or at least not fourth quartile performance, the assets will stick with you, and your firm will make money off them.? The economics of the business are simple.? For the most part, risk-taking is not rewarded, and risk-reduction has some stickiness.

Adding to the problem are the investment manager consultants.? Because most of them are a net loss, they gravitate to what is unchangable.? Modern Portfolio Theory, though wrong, is a respected basis from which academics and some others make investment decisions.? Using Sharpe ratios, and other objective bits of investment nonsense, they winnow the field of investment managers.

The thing is, for those managers that submit to this mularkey, it enforces mediocrity at best.? For those that don’t accept it, not much money flows to them, whether the manager is good or bad.? They don’t fit the model that doesn’t represent reality.

Never underestimate the power of a simple model to overwhelm the minds of simple-minded people.? Most consultants, and most academics, would rather have a wrong model that allows them make money, or publish, than get things right.? Truth is, the right answer is hard to get to, and doesn’t fold into simple mathematics easily.

Technical analysis is akin to voodoo in the minds of most professional investors.? Mention it prominently, and you are kicked out of the game.? There are close substitutes though: for growth investing there is price momentum, and for value investing there are behavioral finance anomalies.

In closing, these two articles that ask why mutual funds don’t adopt technical trading methods illustrate the problems with large scale investing.? Smaller investors can take advantage of market anomalies that bigger firms pass up.? Imagine for a moment that Fidelity, Vanguard, and Capital Group decided to apply the full range of identified anomalies across the entirety of their portfolios, and trade them as aggressively as smaller players might.? The prospective excess profits from the anomalies would disappear rapidly, and might go negative as enough money chased them.? Most players would eventually abandon applying the strategies because they stopped working.? Too much money chasing them.

The lesson for most of us smaller players is to be aware of how much money is using strategies like ours, and adapt when the space where we thought we had a durable competitive advantage has become crowded.? That’s not easy, but then, regular outperformance is tough to do, and tougher, the more money one manages.

Twenty Comments on the Current Economic Scene

Twenty Comments on the Current Economic Scene

Posted on by David Merkel

1) There are firsts for everything.? Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.? America has always been a pro-debt and pro-debtor nation.? It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.? But, the Pilgrims did extinguish the debt.? Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.? With the decline in housing values, the fall in the ratio was inevitable.? The low ratio puts downward pressure on home prices, because it means that more homes are underwater.? Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.? Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?? How many will cut fees?? How many will break the buck, and credit negative interest?? An unintended consequence of monetary policy.? Another unintended consequence reduces liquidity in the repo markets.? Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.? If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.? But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.? It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.? My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”? So it is for the TARP bailout.? Policy made hastily rarely works.? Spend more time, get it right.? The market won’t die as you work it out.

9) But will AIG die, or the automakers?

10) Even VCs are looking at the survivability of their portfolio holdings.? Who can survive and become cash-flow positive in a tough environment.? Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.? Watch the loan covenants, so that you can get good recoveries in a default.? If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.? For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.? Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.? This is a tough time for anyone taking credit risk.? That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.? I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.? He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.? Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.? Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.? Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off? portions of loan balances.? Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.? Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.? More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.? With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.? (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.? Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.? As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.? Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.? Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.? For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

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