Asset Allocation – Page 10

When to Worry — An Asset-Liability Management Perspective on Financial Macroeconomics

Posted on 13 December 2013 by David Merkel

At the end of the day, the world is net flat.? Every asset is owned 100%; every liability is someone else’s asset.

If everything is 100% owned, why are there ever crises?? Financial companies owning illiquid assets financed by short, liquid liabilities.? Liquidity crises are credit crises; a company going through a liquidity crisis did not do sufficient stress testing to realize that they were weakly financed.

Crises are never accidents, aside from things like Hurricane Katrina and Superstorm Sandy.? And guess what?? How many insurers failed from those two events?? None.

Crises happen because things are inverted.? Under ordinary circumstances, prudence dictates that long-term assets be financed by equity or long-term debt.? Before a crisis, long-term assets are owned with short-term debt, and wealthy guys like Buffett and Klarman hold cash and shun long-term assets.? That’s inverted.? Those that should not be bearing risk are bearing risk, and those the could bear risk aren’t.? Why?? Because the prices on risk assets are high, and smart investors lighten the boat as the envious buy into momentum at the end of a doomed rally.? Ben Graham’s weighing machine takes over from the voting machine.

So what are reasons to worry?? Here are a dozen, not in any order:

The combined balance sheets of investment banks grow, and the complexity of their assets rises.
The repo market grows, as less liquid assets are financed by very liquid liabilities.
Poor-to-middle class people begin taking risk by buying homes, or speculating in stocks.? These people have weak liability structures, because they live paycheck to paycheck.
Mortgage finance moves to ARMs or even more exotic loans.
Downpayments on homes get low.
Rich hold more cash while the poor and middle-class borrow.? The rich can take losses — they have long time horizons.? When they play defense, it is a time to be concerned.
In a given sector there has been a large increase in debt, and there are concerns over ability to repay.
Shadow banking has increased dramatically.
Financial commercial paper issuance has increased dramatically.
People rely on certain large financial firms to not default, even if they have taken on too much credit risk relative to their capital.? (Think of Fannie and Freddie.)
Increased financial complexity makes everything opaque.? Bad things happen in the dark.
The credit cycle gets long in the tooth, and credit spreads/yields tighten to levels that are far too low for the risk taken on.

Now, I leave aside pure macroeconomic concerns like the possibility that the Fed might face a greater problem with stagflation than it did in the ’70s.? When long illiquid assets are financed by short liabilities, all sorts of bad things can happen.? Keep your eyes open.? Hey, aren’t Buffett and Klarman letting cash levels rise?

What is Liquidity? (Part VI)

Posted on 6 December 20134 July 2014 by David Merkel

Here are the predecessor posts in this series:

This series has been very irregular.? But it does include the first real post at this blog.? It is something that I think about frequently, and my best summary for what liquidity means is:

What does it cost to enter or exit fixed commitments?

Tonight I want to take a slightly different approach, and talk about two aspects of liquidity: assets and liabilities.

On the liability side, we can look at publicly traded assets and say that they are liquid, though many may only be fungible.? When I was a bond manager there were some trades that took days or weeks to set up.? Some were public bonds coming to market that were complex, others were asset- and mortgage-backed bonds that took some time to research.? Some were pure privates where you were trading the whole chunk or nothing — it was not far distant from being a bank.

With many investments, there is a liability structure.? Yearly, quarterly, monthly, daily liquidity.? Funds are locked up for three or five years.? Funds are locked up until assets are liquidated, and you might be paid in kind, not cash.

The ability to get cash is an important aspect of liquidity.? But so is the ability to preserve value, and that is the asset side of the question.? After all, liquidity means that you have assets that preserve value, such that you can liquidate and spend it.

From an asset standpoint, stocks are liquid as far as trading goes, but not liquid in terms of preserving value in the short-to-intermediate run.? Equity is illiquid, whether public or private.? It offers no protection of value.? Think of it this way: if you were going to buy a house in a few months, would you invest your down payment in stocks?? It would not be wise to do that.

There are various ways of owning equities, and other investments.? It is more important to understand the riskiness of the assets, than the shell in which the assets are held.? The shell may offer liquidity at intervals, but that has no effect on the underlying value of the assets.

Thus I will say it it is far more important to focus on the value of the assets, than on when cash will be released to you.? As one of my bosses said to me:

Liquidity follows quality.? The better the asset is, the more liquid it becomes.

As a result, those wanting to do best in investment management should keep a supply of short-to-intermediate high-quality debt as the performance of risk assets may vary considerably, which will affect the ability to achieve fixed commitments.

Liquidity is the ability to preserve value for near-term spending.? Thus both asset and liability aspects of investments have to be considered when considering liquidity — it is not only ability to liquidate, but to receive value back in real terms.

Book Review: Retirement GPS

Posted on 4 December 2013 by David Merkel

This book encourages you to invest most of your savings abroad, away from the imperfect but good protections offered by US law.? I wrote a piece on this idea a few years ago that pointed out the problems with this idea.? (Note to those reading this at Amazon.com, Google “Aleph In Defense of Home Bias” and you will find my article.)

Now don’t get me wrong — I invest in foreign companies.? One-third of the assets that I run are invested abroad, in both developed and emerging markets.? International investment is good, but it is not a panacea.? There is no inherent advantage to investing abroad versus investing in the US.? Even if emerging markets are growing more rapidly, that doesn’t mean they are better to buy. because valuations are higher, and government policies are more fickle.

This book is rather facile about problems in emerging markets.? Problems with Brazil led me to sell my stocks when Dilma Rousseff was elected President.? Lula promoted markets, Dilma did not.

I found this book to be long on cliches, and short on sharp ideas.? If you try to take the advice as an amateur, you will have a hard time doing it.? If you decide to hire an advisor other then the authors, you won’t get what the book offers.? Thus I can tell you that the book is merely a marketing pitch for their services, and so I tell you to avoid it.

Quibbles

Already expressed, though I would also add that the book didn’t feel right.? Too casual in the way that it treated topics.

Who would benefit from this book: Few would benefit from the book; the theory is flawed.? If you want to, you can buy it here: Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.

Full disclosure: The publisher sent me the book after asking me if I wanted it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

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

Book Review: Code Red

Posted on 30 November 20131 December 2013 by David Merkel

This is a tough book to review.? It is correct in analysis of what went wrong, but overpromises in what its main goal is — protecting assets before the next financial crisis.

Let me take a step back, and describe the structure of the book.? A major goal of neoclassical macroeconomics is to try to eliminate the business cycle, and end up with smooth growth that minimizes unemployment.

As a result, central bankers, since they have a freer hand than politicians, as they are appointed, not elected, act to try to stimulate demand by lower interest rates.? They did that from 1982 to 2008, until they came to the bottom rung of their ladder, and realized they could go no further.

Thus “Code Red” — a situation that is an emergency.? Many central banks felt they needed to act in an emergency to create liquidity to pump up economies with significant financial bankruptcies.

Would it work?? When the central bankers started, all they had was theory, and? Japan.? Japan had tried out their theory, and it did them no good.

The academics argued that Japan did not do it right, and sadly, one was the Chairman of the Fed.? Would that Bernanke had done his Ph.D. dissertation on another unrelated topic.? Some historical accidents are real killers, and this was one.? (As an aside: always be wary of academic researchers that have a lot invested in an idea.? They cease to be neutral, and cause contrary data to be ignored, because you can always find a method to twist the data.)

Anyway, that is the first and longer part of the book explaining how bankrupt. untested theories led us to a situation where debt levels are high with governments, and central banks are ultra-loose.? In such a situation, nations will try to weaken their currencies to gain a nominal advantage over other nations, so that they can export more.? Eventually, it could lead to a currency war of competitive devaluations, or worse, a trade war of competing tariffs.

If central banks cooperate with their governments, they can repress people financially, making the rate that they can invest in with safety to be lower than the inflation rate.? The authors believe that governments will try to do that and eventually fail, because credit creation will eventually lead to significant inflation.

One virtue of the book is that it shows that economists with influence over policy don’t know what they are doing, but make a bold show of it.? Particularly telling is Bernanke on page 135 saying the Fed can mop up excess liquidity at the right time, and he is 100% confident of that.? The Fed has never succeeded at that before, so who is he kidding?

The second half of the book deals with how to protect your assets — half is generous here, because it is 25% of the book.? It goes over the permanent portfolio idea of Harry Browne, and then a series of non-solutions in Chapter 10, essentially arguing that diversification is called for.

Chapter 11 argues for inflation protection through buying shares of companies that have moats, such as:

Valuable Intellectual Property
Benefit from strong network effects
Are low cost producers
Have lock-in, and customers can’t switch easily
Natural monopolies and monopolies of market niches

These are good ideas, in my opinion, but difficult to continually implement.? The book gives companies that presently fit the ideas of the authors, but updating it, and knowing how to trade it is tough.? We’ve been through eras like the early ’70s, where companies like this have cratered, so this strategy does not come without the possibility where it becomes too popular, and gets abandoned.

Chapter 12 goes through commodities and gold, and is bearish on them, arguing that the commodities supercycle is dead, and that gold is tied to real interest rates.

In short, the second half of the book is thin.? If you are looking for protection, maybe the book should have said, there aren’t a lot of great ways to seek protection against the monstrous economic policies of the developed world and China, but that wouldn’t have sold many books.

Quibbles

I disagree with the first chapter that we had to have bailouts.? The government could have protected regulated subsidiaries of the banks, and derivative counterparties, and let the holding companies fail.? I also disagree that we had to have abnormal monetary policy to stem the crisis — so long as there is a positive yield curve, there is stimulus, but once you get down near zero, perverse effects kick in.

The rest of my disagreements are already expressed.? To summarize: the first half of the book is good, but the second half is thin gruel if you want to protect your assets.

Who would benefit from this book: If you want to understand the causes of the crisis this is a great book to buy.? For protection of your assets, it will give you a few ideas, but no solution.? If you want to, you can buy it here: Code Red: How to Protect Your Savings From the Coming Crisis.

Full disclosure: I asked the publisher for a copy of the book, and he sent one.

On Liabilities in Asset Allocation

Posted on 17 October 2013 by David Merkel

From an e-mail from one of my readers:

I?m not sure if you have the time to respond to this, but figured I?d send to you and just see!…

(Just FYI, I?m not an investment professional of any sort, so I don?t have any ?skin in the game? as they say, just a geek who follows the markets and DIY financial-planning issues and long-time reader of the Aleph blog)

I recently read an FP article by a guy I?ve read a lot (Alan Roth).? He suggested that, when your analyzing an investment portfolio and making asset-allocation decisions, you need to treat mortgage debt as an ?inverse-bond? or an ?anti-bond??such that any mortgage debt held would dollar-for-dollar negate or reduce your actual bond investment holdings.? And the result is that this made the investor?s actual portfolio risker than they realized, since their ?true? bond allocation was smaller than they had considered.

I thought it was a novel concept, but I found some problems with that approach, within the context of asset-allocation.? My main point was that the primary purpose of analyzing a portfolio?s asset allocation is to manage risk through diversification of assets (generalizing here in interests of being concise).?? The pinnacle of diversification is non-correlation: generally in economic environments where equities soar, bonds will underperform, and vice versa.? However, classifying a debt as an ?anti-bond? doesn?t actually provide any portfolio diversification, or introduce any non-correlation.? It won?t actually negate the amount that your bonds would rise, and it won?t actually offset the amount your bonds would fall, in those respective market environments.? And even if you consider that the real value of the debt is decreased if inflation rises (as the NPV calculation would be using a greater discount rate), that doesn?t have any real-world effect on the portfolio and it?s risk and return behavior.? Since borrowers aren?t allowed to ?mark-to-market? their mortgages, that debt holding value does not fluctuate?it is fixed, and amortized from its historical cost, regardless of any market conditions or any theoretical NPV/DCF changes. ?Therefore, the inverse- or anti- bond holding in the portfolio has zero impact on the portfolio?s actual risk/return behavior, and so it seems to me it doesn?t add any functional value to frame debt as an ?anti? portfolio holding of some sort.

Also, if you were going to do that, to be fair and complete, you must apply that same principle to every single debt the client has (otherwise, it would be rather arbitrary just selecting the mortgage debt).? This adds unnecessary complexity in the asset allocation analysis.

Instead, the appropriate (and only) way to analyze debt is, separate from investable portfolio assets, on the cash-flow side of things.? Simply asking what is the ?optimal? use of the available capital; i.e. what net ?return? do you earn by using capital to eliminate debt, versus what net return could you earn if you kept the debt and employed the capital elsewhere (this will be different for each investor and their unique situations).? This is the way to analyze and evaluate debt, not to mingle it in with your invested assets and classify it as an ?anti-bond? holding within your portfolio.

I was just curious your take on this, and if I am misunderstanding or missing something.? Do you ever consider client?s debt as ?inverse-? or ?anti-? bonds in the context of asset allocation?

Thanks!

When you manage money financial firms, if you do it right, you consider the promises that your firm needs to fulfill.? When will cash be needed to pay obligations?? That helps drive asset allocation, because assets should broadly match liabilities.

Now, I am not a financial planner.? That said, the same principles apply to personal asset allocation.? If someone has a large mortgage or other debts, and he can’t invest his fixed income assets at levels that exceed the yields on those debts with reasonable risk, he should not invest in bonds — he should pay down his debt.? In the case of 401(k)s or IRAs, where there might be matches or tax advantages, the calculation becomes more complicated.? You have to weigh the match and tax deferral vs the negative arb on bond yields vs the mortgage and personal debts.

There is another factor here — how stable is your job?? If stable, it is bond-like, and you can take more equity risk with investments.? If your job has payoffs that vary a great deal with the market — commissions, bonuses, etc., it is stock-like, and you should take less risk in your investing — take excess earnings and pay down the mortgage.? I did that when I went from being a bond manager inside an insurance company, to being an equity analyst inside a hedge fund.? I paid off my mortgage in full, so that I would be free to take risks for my new employer.

As for the article, the concept is not novel.? It is well-known and practiced by institutional asset managers who manage money to the horizons needed by their clients.? As an example, the cash flows of a pension plan are relatively determinate, and the discount rate calculates the value of the liability.? The portfolio should throw off cash when needed in order to minimize risk.

In some cases, where bonds don’t offer enough yield, and equity prices are depressed, it might make sense to tactically mismatch, betting that equities will offer better returns versus the liabilities than bonds would on a risk-adjusted basis.

This argument has made its rounds for the last 20 years in insurance and pension management?? Do we match asset and liability cash flows, or do we trust in the equity premium, and invest in risk assets?? The correct answer is hybrid.? In general, match assets and liabilities, but if there is a significant tactical advantage to not match, then do that.? Think of buying junk bonds in late 1998.? Time to throw matching out the window.? And then in mid-1999, buy equities.

Now, not all clients will allow for that much risk-taking.? Many institutional investors will not let the asset manager take advantage of temporary dislocations.

In general, I think Mr. Roth is correct, but with an adjustment.

In extraordinary times, where bonds yield more than the earnings yields of stocks (think 1987 & 2000), buy bonds heavily, even if you have mortgage and other debts.
In extraordinary times, where stocks earnings yields are much higher than bonds, mismatch and own more stocks relative to bonds.? Just beware deflation, with falling future earnings.
In normal times, an indebted investor should not add to his leverage, but should invest in bonds, or better, pay down his debt.? Being debt-free is an excellent thing, and allows the investor to take more risks when the market is offering bargains.

Debt is either something to be funded by bond assets, or funds a margin account where you outperform the yield, or die.? All of this depends on where the market is in its risk cycle.? Only take risk where it is rewarded.

The Rules, Part LV

Posted on 14 October 2013 by David Merkel

Financial intermediation reduces volatility.? In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.? They do even better if they save and invest, but really, they don’t know what to do.? Market returns are like magic to them.? They don’t know why they occur, positively or negatively.? Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.? That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.? People need vehicles in which to park excess cash that are more predictable than direct investing.? Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.? Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.? But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.? After losses, they seek guarantees.? That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.? When easy money is being made by amateurs, the temptation comes to imitate.

If my stupid brother-in-law can make money flipping houses, so can I.
If my stupid cousins can make money buying dot-com stocks, so can I.
If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.? Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.? Don’t follow the crowd.? Develop the mindset of? a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.? Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.? The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.? Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.

Taleb Versus Reality

Posted on 11 October 2013 by David Merkel

I looked for this article out on the web, and at the CFA Institute website, and didn?t find it.? I asked for permission to use this and no one responded after more than one week.? The following was excerpted from an interview with Nassim Taleb by Rhea Wessel in the September/October 2013 issue of the CFA Institute Magazine on pages 40-43.? CFA Institute, I consider this fair use.?? If it is not, let me know, and I will take it down.

Is there an investment strategy that fits with the idea?

I will get there. Let me make some investment rules in general.

Number 1: I introduced earlier the 1/n rule?be as broad as you can in whatever risky assets you are investing in to minimize the risk.

The second trick, or rule, [is to] implement that barbell to reduce your fragility. Because if you see the barbell, then no fragility is in the tail. In other words, if you are “bar- belied,” putting a floor on your losses at 90%, the maximum you could lose is 10%. If the markets go down 20%, you don’t lose twice as much as [you would] if the market went down 10%. You lose much less. That puts you in the antifragile category. [For a third rule] I’d say, look for companies that have optionality.

What is optionality?

Optionality means to have more upside than downside because the company has options. An “option” in this sense acts like a financial option, and a financial option is an instrument of antifragility because you pay a premium and you have all this upside and very little downside.

The companies make more from the upside of something than from the downside. Make sure the optionality is not priced by the market. And of course, go away from companies that have negative optionality.

An optionality that is priced in the market is, for example, buying energy companies and gold companies before a rally in gold. Instead of investing in gold, people invested in companies that made a lot more than gold. But after a while, this got priced in. In other words, if you’re wrong on gold, you do a lot better than those who invested in gold outright. If you’re right on gold, you do a lot better than those who invested in gold.

You have to avoid the lottery-ticket effect of investing in companies that are overpriced because people are looking at the big upside.

So, now we have three rules [1/n, implement the barbell, and pursue optionality].

Let me make one more?never invest in company stocks or strategies that have very low volatility without ascertaining that there’s a floor on the return.

[Consider that] a Sharpe ratio measures return divided by risk, as measured by past variation. You have to be wary of companies that exhibit no volatility yet have a high return, unless they are genuinely low volatility. Most of them are fake low volatility.

What do you mean by “fake low volatility?

You know the funds of Bear Stearns that blew up in the subprime crisis? They were funds that never had a down month. A lot of people who blew up in subprime did not have a down month?ever. And people rushed to invest in them because they were low volatility. And then they blew up.

Typically, I never get close to anything that has no volatility, unless it’s justified, like Treasury bonds. If you go to a balance sheet, you can see why there is low volatility, whether it is genuine. The company can have a barbell. The company can have very, very low leverage. Or you might discover that a company is doing the equivalent of selling remote options, and the company can lose a lot of money in one blow.

Let’s link it to make it more intuitive: In general, I can say that a system that has very, very low volatility is likely to blow up. Take the example of Syria. Syria had no political volatility for 40 years, and look what happened.

Forests that never have fires are likely to be completely eradicated by fires when they happen. Forests that have regular fires are much more stable.

You mentioned the concept of leverage. You could make another investment rule regarding debt?

Yes. You know the rule?what you don’t do is more important than what you do. In natural systems, you need redundancy to make the system work better. People think that redundancies are inefficient. I think they’re the most efficient thing in the world, if you do them right.

Redundancy is bad if you buy the same morning newspaper twice or if you have two subscriptions to the same website. But redundancy is fine if you have a stock of cash in the bank or if you’re a company that needs oil and you have extra oil.

Let’s assume that you have cash in the bank and there’s a big crisis. You have dry powder. It will make you antifragile to have the extra dry powder if nobody else has money. You can buy anything you want. Cash is the opposite of leverage.

In fact, the number one indicator of fragility is leverage. It can be operational or financial. Leverage corresponds to people’s overconfidence about the future.

Most people who have leverage will be completely squeezed in a crisis, and you will have cash.

Whose compensation models do you agree with?

Most investment advisers are not harmed by the downside. The only people who have a good compensation model are hedge fund managers. Typically, when I managed money, I was harmed 50 times more than any of my clients as a percentage of my net worth.

The hedge fund managers I know are typically far more invested than their average client. When that person is on board calling the shots, I sleep like a baby. You don’t get this with fund managers.

Okay, Taleb has offered up six ideas for us to consider regarding risk control.? Here they are:

1/n
Barbell ? safe & risky
Positive optionality
Want a floor ? no ?fake low volatility?
Avoid leverage ? operational & financial
Alignment of Interests

Let’s take them one-by-one, but before we do, every risk mitigation scheme has to pass the test: “what would happen if everyone did this?”

1/n

This is a fancy way of saying equal-weight everything.? In such a scheme, ExxonMobil and Apple get the same weight as Phoenix Companies and American Independence Corp.? Nifty idea until too many people follow it.? This is an idea that cannot scale.? Yes, owning small companies and the debts of small companies have yielded high returns, but if many people do that, it will cease to be true.

Barbell ? safe & risky

Yes, owning safe and risky investments is a bright idea — that’s where the 60/40 stocks/bonds came from.? You get positive optionality and your downside is clipped.? Taleb argues for a lower risk version of this.? But again, this can’t scale.? Most assets are in-between — they carry moderate risks.? What is the risk premium at which you buy moderate risks?

Positive optionality

Everyone wants the best of both worlds, but how much are we willing to pay to get it?? Options normally carry a cost.? When you can get them for free, rejoice.? The market is competitive, and there are few places where free options exist.

Want a floor ? no ?fake low volatility?

Taleb is looking for guarantees, or near-guarantees.? He does not trust low volatility investments, and I agree.? He wants something that tells him that that floor for the asset price is not too far below the current price.? Makes him sound like a value investor.

Avoid leverage ? operational & financial

Margin of safety is the credo of all good value investors.? That makes us avoid financial leverage, and to a lesser extent operating leverage.? As I have stated before, good investing takes moderate risks.? Low risks avail little, while high risks take too many losses.? Moderate risks have a greater probability that humans can deal with them.

Alignment of Interests

Yes, it is important that management and fund managers have incentives aligned with shareholders.? I aim for this and have no argument against this, unless it costs too much to get this.

The Main Point

If something in the markets is a good thing, it will get bought, and the price of it will go up.? Free optionality is rare.? Assets that offer easy guarantees are also rare.

Thus I think the advice of Nassim Taleb is vacuous, because the methods that he recommends for safety are risk factors which have prices.? They are great ideas when they can be executed at no cost.? But most of the time, there are costs.

In 2002, we had the ?we eat asbestos for lunch? trade.? After aversion to asbestos risk, some were willing to take the risk because they thought it was overstated.

Any risk can be overplayed.? There are fair levels for taking and avoiding risk.? Good investors and businessmen understand this.

A New Look at Endowment Investing

Posted on 5 October 20137 October 2013 by David Merkel

I’ve written at least two significant pieces on endowment investing:

Alternative Investments, Illiquidity, and Endowment Management
The Forever Fund
Oh, toss in one more: Managing Illiquid Assets

Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project.? This was partially in response to Matthew Klein’s excellent article,?Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.

The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions.? If you are interested, it is worth a read.? The remainder of this piece expresses ways that I think their views could be sharpened.? Here goes:

1) Don’t Think in Terms of Time Horizon, but Time Horizons

2008-9 proved that liquidity matters.? The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.

Choose a length of time over which you think you have a full market cycle, with a boom and a bust.? I like 10 years, but that might be too long for many.?? As I said in Managing Illiquid Assets:

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.? Invest that much in short to intermediate bond investments.? You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

I include all risk assets in illiquid assets here.? The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell.? There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.

2) Look to the Underlying Drivers of Value

Hedge funds aren’t magic.? They are just limited partnerships that invest.? Look through the LPs to the actual investments.? It is those actual investments that will drive value, not the form in which they are held.? Get as granular as you can.? Ask: what is the margin of safety in these endeavors?? What is the likely return under bad and moderate conditions?

3) Ignore Correlations

It is far more important to focus on margin of safety than to look at diversification benefits.? Correlation coefficients on returns are not generally stable.? Do not assume any correlation benefits from risky investments.? Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.

4) On Leverage & Insurance

Unless they are mispriced, borrowing money or getting insurance does not add value.? Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.

Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).

5) Mark-to-Market Losses Might Matter

Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.

6) Insource Assets

The best firms I have worked for built up internal expertise, rather than outsource everything.? The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced.? As you gain experience, insource more.

7) Thematic Investing is Usually Growth Investing

Avoid looking at themes.? Unless you are the first on the scene, themes are expensive.? Rather, look at margin of safety.? Look for businesses where you can’t lose much, and you might get good gains.

8) Look to the Underlying Value of the Business, or Asset Class

Cash flows are what matter.? Look at he likely internal rate of return on all of your investments, and the worst case scenario.? Buy cheap assets with a margin of safety, and don’t look further than that.? Buying safe assets cheap overcomes all diversification advantages.

Those are my differences on what was otherwise a good paper.? I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.

With Jeremy Siegel at CFA Institute Baltimore

Posted on 5 October 2013 by David Merkel

At the CFA Institute at Baltimore, we had the pleasure of having Jeremy Siegel come speak to us this past Thursday.? He was lively, engaging, and utterly convinced of his theses.? Thanks to Wisdom Tree for helping fund the endeavor.

He openly asked us to poke holes in his theories.? This article is an effort to do that.

1) Stock tends to get bought in when it is undervalued, and sold via IPOs when it is overvalued.? Thus the time-weighted rate of return exceeds the dollar-weighted rates of return by a few percent.? This dents the main premise of ?Stocks for the Long Run.?? Buying and holding is not possible, because valuable stocks are lost at the troughs, giving us cash, and we are forced to buy more near peaks, of overvalued stocks.

Dollar-weighted returns are what we eat, and they don?t vary much versus time-weighted returns when considering bonds or cash.

Also, in the present day, private equity plays a larger role, and they exacerbate the degree to which stocks get IPOed dear, and acquired cheap.

2) He spent a lot of time defending the concept of the CAPE Ratio, but not its execution.? He began a long argument about how accounting rules for financials were behind the drop in earnings for the S&P 500, and that AIG, Bank of America, and Citi were to blame for all of it.

Sadly, he seems not to know financial accounting so well.? What was liberal in the early and mid-2000s was corrected 2007-2009.? In aggregate the accounting was fair across the decade.? Remember that accounting exists to try to measure change in value of net worth across short periods, and net worth at points in time.

Really, if we were trying to be exact, when a writedown occurs, we would spread it over prior periods, because prior accounting was too liberal ? the incidence of the loss occurred over many years prior to the writedown.

Thus I find his argument regarding specialness of financial company accounting to be bogus ? he is just searching for a way to justify valuations off of current earnings, rather than off of longer term measures.

3) The longer?term measures agree with CAPE:

Q-Ratio
Market Cap/ GDP
Price-to-Resources
Financial Stress indexes
Eddy-Elfenbein?s Stock Market if valued like a bond measure

All of these point to an overvalued market.? But markets can be overvalued for a while.? Why might that be in this case?

4) Because profit margins may remain high for some time.? In an era where the prices for labor and resources are cheap, should it be surprising that profit margins are high?? Those conditions will eventually change, but not soon.

With that, I would simply say that:

Stocks do outperform bonds and cash over the long run, but not by as much as Dr. Siegel thinks.
Stocks are overvalued by long-term balance sheet-oriented measures at present.
But stocks may stay high because profit margins are likely to stay high ? there will be regression to the mean, but not now.

Finally I would note that he was one of the most graceful and generous speakers to come speak to us in some time, took a long Q&A, staying longer than he needed to, and happily signing the books he had written.? I showed him my First Edition version of his book, signed by him after speaking to the Philadelphia AAII chapter in 1995, and said, ?We were much younger then.?? He smiled and said, ?Yes, we were.?

I may disagree with him on some points, but he is one very bright and personable guy.

It’s Not What You Earn, It’s What You Keep

Posted on 29 August 2013 by David Merkel

I like questions from readers, if they are general enough for a blog post.? Here’s one for tonight:

Mr. Merkel,

Following reading your blog here:

http://alephblog.com/2013/01/30/how-to-become-super-rich/

It occurs to me that attaining money in the first place is only half the battle.? A well known fellow among engineers; Nicolai Tesla was great at this.? He made many millions in his life.? He also constantly reinvested most of his income into new inventions and new ideas.? When he died, he was pretty much destitute.

Starting a gas station requires about $300,000 ($150-200k to buy the store/land, 40k to furnish the store, 40k to buy the gas) in startup capital.? In technology, and in software; you can start making money with a good idea and next to no start-up capital… assuming you don’t get crushed by a larger company in the process.

How do the super rich store their massive income?? How do they invest it?? Buying up ever more companies and taking their profits off the top?? What is a minimum threshold amount of money that you need to start to do this?? Can you recommend any good books?

There are several classes of assets that the wealthy like to preserve their wealth.? Here are some examples:

Real Estate
Municipal Bonds
Businesses in necessary industries that throw off a lot of cash flow.
Businesses in which they have significant inside knowledge, and can continue to benefit from the knowledge.
Occasional equity investments in private ventures that seem promising.

After a certain amount of wealth is acquired, intelligent wealthy people tend to turn to things that have predictable cash flows, rather than take a large amount of business risk.? They’ve made their fortune.? Now it is time to conserve it, and receive what some consider to be rents — passive income that comes with little volatility.

Even Goldman Sachs did this with excess profits, buying safe securities, and throwing them into the BONY box. [BONY == Bank of New York, now BNY Mellon]

In essence, the wealth is converted to ownership in what is likely to be a growing income stream.? What is not used is reinvested.? That is how wealth is preserved during the life of the wealthy.

As for books, you can look at “The Millionaire Next Door,” and its series. Also, Rich Like Them.

But remember, not all rich try to preserve their wealth.? Some lose it through over-consumption, and others through bad investments.? The investments that I list above require a degree of humility, and thus, only wise rich people will follow such a strategy.