Category: Asset Allocation

Managing Illiquid Assets

Managing Illiquid Assets

Posted on by David Merkel

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

  • Banks — too numerous to mention, though FDIC insurance restrains it now.
  • Life insurers, particularly those that write a lot of deferred annuities.
  • AIG and the GSEs — abominations all.
  • Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
  • Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
  • No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.? Some were forced to raise liquidity in costly ways.? Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.? Most alternative asset classes involve additional illiquidity.? That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.? That factor is strategy capacity.? Alternative investments do best when they are new.? Here is my version of the phases that they go through:

  • New — few know about it except some business-minded investors.? Only the best deals get done.
  • Growing — a modest number know about it, and a tiny number of consultants.? Only very good deals get done.
  • Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.? Good deals get done.
  • Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.? All reasonable deals get done.
  • Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
  • Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.? Later adopters abandon the market, and take losses.? Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?? First determine how much of your funding base will never leave over the next 10 years.? When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

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.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.? Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.? Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.? Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.? There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.? The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.? The forecast is the least important item, because it is the toughest to get right.? (An aside: who has been right on bond yields consistently for the last 20+ years?? Hoisington, my favorite deflationists.? Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.? Divide your liabilities in two.? What obligations do you know cannot be changed, except at your discretion?? That group of liabilities can have illiquid assets to fund them.? Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.? You can try to buy assets that change along with the liabilities, but in practice that is hard to do.? (That said, there are no end of clever derivative instruments available to solve the problem in theory.? Caveat emptor.)? The assets have to be liquid for this portfolio.? Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.? A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

  • Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?? As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”? (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
  • Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?? Hard to say.? There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.? It also depends on where you are in the speculation cycle.
  • Liquid public equities to private equity or hedge funds with lockups?? Tough question.? Try to figure out what the unlevered returns are for comparative purposes.? Analyze long-term competitive advantage.? Look at current deal quality and valuation metrics.? For hedge funds, look at how credit spreads moved over their performance horizon.? Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?? Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.? Safety first.? (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.? Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.? Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

The Market Goes to the Dogs, Which Chase Their Tail Risk

The Market Goes to the Dogs, Which Chase Their Tail Risk

Posted on by David Merkel

I’ve read a number of articles on hedging tail risk of late.? Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.? Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?? I can think of three broad categories:

  • Assets that come into existence during the disaster.
  • Ready liquid assets — short-term and high quality.
  • Liabilities that disappear with the disaster.

The first category is the one most people think about.? What can I buy that will do well when the disaster comes?? There are two branches to that question:

  • Do I want my downside clipped on this trade (for a price)?
  • Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.? Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.? Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange? has to remain solvent in order for the trade to work.? Few factor in the cost of insolvency there.? Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.? But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?? I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.? Cash is unique; it can be used for anything; it can be used for almost every contingency.? Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.? Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?? There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.? The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.? Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.? Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.? They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?? Think of it as an odd sort of margin account.? A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.? The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.? If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.? The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.? This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.? Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?? I’m not sure.? This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.? It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.? Nothing beats the flexibility and simplicity of cash in a disaster.? Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.? Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

Brief Reviews of Three Books

Brief Reviews of Three Books

Posted on by David Merkel

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.? It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.? It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.? Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.? It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.? To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.? Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.? For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.? The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.? The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.? It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.? If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.? It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.? A better title would have been: “Fueled: The Effects of? Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.? It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.? Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.? The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.? I review about 80% of the books that get sent to me.

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.

Surviving a Bad Quarter Well

Surviving a Bad Quarter Well

Posted on by David Merkel

To my readers: I am still in the process of blog repair.? I have heard from a few readers that I need larger type and more contrast.? I will fix that.? For now, use Ctrl-+ to expand the font.? I don’t want any of you going blind over me. 😉

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Onto tonight’s topic: asset allocation.? So, we had a bad quarter for equities.? Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.? I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.? At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.? I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?? Next question: cheap relative to what?? It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

  • Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.? Think of Buffett getting excited back in 1974.
  • Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.? But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
  • When there is significant debt deflation going on, determining cheapness is tough.? Better to ignore the market as a whole, and focus on survivability/cheapness.? Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
  • I don’t have a good metric for when equities are cheap/dear to commodities.? Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.? Beyond that, the spread on GSE debt and guaranteed mortgages is thin.? TIPS look attractive, as few care about inflation.? The US dollar has been strong lately, largely due to weakness in the Euro.? I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.? There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.? Also, the private sector looks at the growing debts of the government, and gets concerned.? How will the government deal with it?? Higher taxes, inflation, default?? No good scenarios there.

When an economy is overleveraged, there are no good solutions.? If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.? High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.? Broadly, I am looking at a system that:

  • Considers the credit cycle first.? Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
  • Considers the slopes of the Treasury nominal and TIPS curves.
  • Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
  • Factors in safety provisions for each asset class.? Stocks need the most, then junk bonds, then investment grade.
  • Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.? There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

13 Notes

13 Notes

Posted on by David Merkel

Pardon the infrequency of posting.? I have been having internet issues.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.? My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.? Those looking for clever ways out of this bind will be disappointed by what I write.? When nations are heavily indebted their options decline, particularly when they don’t control their own currency.? For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.? I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.? He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.? From here on out it will be a drag on the federal budget.? Expect Congress to remove it from the federal budget.? It no longer aids the illusion of smaller deficits.? (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.? There only two ways to look at the balance sheet of the US.? Look at explicit debt vs GDP, regardless of who is owed the debt.? Or, look at total liabilities vs GDP.? But never look at explicit debt not used to fund social insurance funds.? It is meaningless.? The total liabilities number tells the whole story.

3) Spain is in trouble.? Their banks are borrowing a lot from the ECB, with no end in sight.?? Perhaps that leads them to push for stress testing across all European banks.? Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.? The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.? The ECB is steps away from monetizing the debts of its governments.? Perhaps they could preserve the Eurozone by destroying the value of the Euro.? Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.? There is no other way.? Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?? The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?? That is what is being tested.? I think that eventually states and municipalities will be forced into bankruptcy because they can?t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.? I have mixed feelings here, because I think that those that can?t pay should not be put there for long, if at all.? Those that can pay but won?t, should go there.? Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.? You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won?t.? More lenders are suing those who won?t pay, and going after their assets.? My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.? It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.? The US would have been better off without them, and will be better off with them in bankruptcy.? The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.? Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.? The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.? There is little reason to borrow now; valuations are relatively high, don?t take your life into your hands.

9) And, occasionally, smart articles, like this one.? If you are in a volatile profession, reduce your risks by investing in high quality bonds.? If you are in a safe profession, invest in stocks.? When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.? But is he right now?? Will stocks revisit their March 2009 lows?? It is possible, but I lean against it.? We would need a situation where most of the developed nations decided to aim for recession and stay there a while.? I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?? If you have to ask, it is usually insolvency.? Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the ?Tragedy of the Commons? Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.? As a part of my ?new mormal,? it is no surprise to me that this is happening.? It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can?t tell you exactly what I know about the demise of Finacorp.? But I can tell you that the article cited is wrong.? Finacorp never carried an inventory of assets.? It only crossed bonds between buyers and sellers.? The failure of Finacorp occurred for far simpler reasons.

The Rules, Part X

The Rules, Part X

Posted on by David Merkel

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.? This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

I was at a conference on Stable Value Funds, I think around 1995.? The meeting hadn’t started? but a few attendees? had arrived.? We were talking about the need to find yield in the market when one said (with an arrogant attitude), “Yield?? Why not total return?”

A tough question, and one none of us were ready for at the time.? My thoughts a few days later were on the order of, “If only it were that simple.? Right, you can generate positive returns over every time horizon worth measuring.? Okay, Houdini, do it.”

Total return investors don’t have long time horizons.? Investors with short time horizons either aim for momentum plays, or aim for yield.? Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

Yield is less volatile than momentum, at least most of the time.? But yield is a promise, and frequently disappoints during times of stress.? Look at all of the dividend cuts over the past two years.

But consider this from a different angle.? Imagine your boss comes to you and says, “I want you to deliver the best returns to me every day versus the S&P 500.”? Okay, beat the S&P 500 every day.? That means the portfolio has to be a lot like the S&P 500, with some tweak that will beat it.? Anything too different from the S&P 500 will miss too frequently.

Now, I would say loosen up, why constrain daily performance?? Aim for great returns over the long haul, and don’t sweat years, much less days.? Great asset management requires a willingness to be wrong over significant periods, with a strong sense of what will work in the long run.

Those with short horizons will tend to index relative to their funding need, whether it is cash, short bonds, or indexed equities.? Note that most managers should have long horizons, but clients evaluate the returns of the past quarter or month, and the manager feels as if he is on a short leash, which makes him look to the next month or quarter, and makes him invest more like an index.

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If you have a good manager, set him free — lengthen the performance horizon; give him room to do things that are unorthodox.? Ignore the consultants with their foolhardy models that constrain manager behavior.? Let me tell you that you are brighter than the consultants, and can better manage managers than they do.? Their models encourage managers who hug the indexes to avoid doing too much worse than them, and so you get index-like performance.

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At turning points, a different breed of investor shows up.? At busts, investors show up who will buy and hold, bringing stability to the market.? They look at fundamental metrics and conclude that their odds of losing money are small.? At the booms, a different investor leaves.? They will sell and sit on cash.? Similarly, they think the odds of losing money, or, not making as much, is large.

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Good money managers think long term, but all of the short-term measurements fight against that.? They force managers to think short term, or else their assets will leave them.? That is a horrible place to be.? Better that clients should ignore the consultants, and aim for the long-term themselves.? You will do much better choosing managers for yourselves and ditching the consultants who (it should be known) merely chase performance.? With help like that, you may as well invest in the hottest stocks with a portion of your portfolio — you might do better than you are doing now.

The Rules, Part VII

The Rules, Part VII

Posted on by David Merkel

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

If I were to change that sentence, I would change the word “corporations” to “organizations.”? Why?? Everyone attributes greed to the corporate sector, but the same is true in different ways of governments and nonprofits.

Year to year, organizations measure progress.? Corporations look at profits.? Politicians look at whether they are still in office or not the success of programs passed.? Those that run non-profits look at how they have done on their missions, amid scarce resources.

But, when things are good for a long time, institutional laziness sets in.? I remember being out at some party at a golf course in Philadephia in 1996, when our best salesman uttered the inanity, “Let the stock market pay your employees.”? Really, he was a decent fellow, and brighter than most who sold for us, but his statement reeked of the bubble logic that assumes that stock markets are magic.? They always go up.? Corporations and individuals come to rely on the stock market going up, because it always beats bonds and cash over long enough periods of time.? That is true, but less so than most think, and the time periods have to be longer than most can tolerate.

Back to topic.? Non-profits are slaves to the stock market.? Giving goes up considerably when there is appreciated stock to give.? People donate more from wages when they are secure in their homes, and they think their retirements will go well, (fools that they are).

Governments are also slaves to rising asset values.? When housing prices fall, sales drop, and transfer taxes plummet.? But real estate taxes fall as well.? My property taxes dropped by 30% — I can hardly believe it, even though I thought they overshot 3 years ago.

Governments also get used to the boom, and begin forecasting increases in wage taxes, capital gains, real estate, and all other taxes.? They rely on the increase, and borrow beyond that.? But more insidiously, since they run on cash accounting they begin to fudge accruals to make the cash accounting look good.

Tough negotiations with the public employees union?? Offer less of a wage increase, and a generous increase to the pension benefit. That will reduce the present cash costs, leaving others to deal with the costs shifted into the future.

Cash costs of paying your debts too high?? Wall Street has many derivatives that can lower your cash cost today, at a price of probably or certainly raising your cash costs in the future.? Ask Jefferson County, Alabama; they will tell you.? Greece and Italy did much the same to enter the Eurozone, amid winks from those that presently disapprove.

“Can’t we raise the spending rate on our endowment?” naive nonprofit board members ask.? Tell them to look at the 10-year Treasury yield — that is a reasonable proxy for sustainable distributions.? Most nonprofit board members don’t know up from down economically; they tend to favor the present over the future.

Corporations are the same, but they do it differently.? They run on accrual accounting, so they tend to tweak accounting to make net income look good, relative to cash flow.?? Also, they buy back stock, which increases leverage.? Even raising the dividend increases leverage, because it is like junior debt, corporations know their stock prices will fall if it isn’t paid or increased.

Buffett says something to the effect of, “Until the tide goes out, you don’t know who is swimming naked in the harbor.”? Bear markets reveal optimistic assumptions and accounting chicanery.? This is true for any organization, because we all rely on the same economy.? Yes, the wealthy support some organizations more than others, but many governments rely on taxes from the wealthy more than they realize.

This even applies to individuals.? Who paid attention to the increases in debts, especially junior debts like home equity lending during the boom?? My last firm did, and I wrote about it at RealMoney, but it felt lonely at the time.? Silent seconds, low LTV lending, mortgage insurance, and other means of getting people into housing that they couldn’t afford looked like like the pinnacle of success for US housing policy.? Now, with all of the wounds the banking system has taken, and all of the foreclosures, past, present and future, many are beginning to think differently, but you can’t see that in government policy.? Many people are not capable of bearing the fixed commitments associated with home ownership, and there is no way that government policy can materially change that.? But the government continues to encourage high home ownership and asset prices, merely delaying the inevitable reconciliation of bad debts and lower housing prices.

It’s the nature of a boom.? Free money brings out the worst in us, leading many to borrow more to get even more prosperity that seems to never end.? When the bust comes, it ends, with interest compounded.? The positive dynamic becomes a negative one, until sufficient debt is compromised, cancelled, or paid off.? There’s no way around it, but our government will fight on hopelessly.? They always do.

On Credit & Equity

On Credit & Equity

Posted on by David Merkel

Jake at Econompic Data had a good post on credit and equity.? (He runs a good site generally.)? They are correlated, but not all of the time.? As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:

http://alephblog.com/wp-content/uploads/2009/11/SEAC_Presentation.pdf

Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.? Here is part of my belated follow-up.

As I noted in my presentation:

  • Credit and equity returns are closely correlated in bear markets.
  • Illiquidity events become more common when equity prices are falling, and credit spreads rising.
  • Complexity and structure raise illiquidity during crises.
  • Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.? But here are some examples, starting with 2007-2009

Picture1

and then 1999-2004:

Picture2

and then 1989-1993:

Picture3

and then 1980-1983:

Picture4

and then 1969-1975:

Picture5

Finally, 1927-1944:

Picture6

What I concluded:

  • Credit booms are different ? equities rise, while credit spreads stay low and stable.
  • There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
  • Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
  • Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an ?up in credit trade.?
  • During the bust phase, illiquid companies and investments get whacked. It is often good to ?leg into? such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
  • Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
  • If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.

Notes:

There are few corporate yield series that date prior to 1990.? Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.? One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.? There are some oddities to that index, but there aren’t many choices if you go back a long way.? It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.? The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.? I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.? I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

Where to Invest, When Interest Rates are so Low

Where to Invest, When Interest Rates are so Low

Posted on by David Merkel

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.? As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.? Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.? But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.? I look at the individual risks and ask whether they are overpriced or underpriced.? Here is my current assessment:

  • Equities ? slightly undervalued at present, particularly high quality stocks.? (US and foreign)
  • Credit ? Investment grade credit and high yield are fairly valued at present.
  • Real Estate ? the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
  • Yield Curve ? Steep.? It is reasonable to lend long, so long as inflation does not take off.
  • Inflation ? Low, but future inflation is probably underestimated.
  • Foreign currency ? One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities ? the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced ? most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.? I would leave more in money market funds than most would as a part of capital preservation.? I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.? I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.? (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.? My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.? Commodities and companies that produce them should play a small role as well.

  • Equities ? somewhat overvalued at present.? (US and foreign)
  • Credit ? Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate ? the future stream of mortgage payments that need to be made is high relative to the present value of properties.? There will be more defaults, both in commercial and residential.
  • Yield Curve ? Steep.? It is reasonable to lend long, so long as inflation does not take off.
  • Inflation ? Low, but future inflation is probably underestimated.
  • Foreign currency ? One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities ? the global economy is not running that hot now.? There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced ? most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.
Book Review: Diary of a Hedge Fund Manager

Book Review: Diary of a Hedge Fund Manager

Posted on by David Merkel

This is a book that gives a feeling for being in hedge fund management, rather than a dry description of what needs to be done if you are in the rare position of being asked to manage a hedge fund.

The author was an ambitious guy.? Growing up in Canada, he wanted to play professional hockey.? He played ably in youth leagues, the minors, and college.? Making the pros was not to be.

So, what does a competitive guy do when he can’t pursue his dream?? He pursues another dream, managing money. He works hard, and gets one break after another, and eventually manages his own firm, which he sells out to a larger one.? He gets a plum job at a firm that proves less than patient with his current performance, and he gets let go.? Even that is a triumph for the author.? He starts his own firm, which is what he is still doing today.

Think of an analogy to sports — every player makes mistakes, but the best players recover from mistakes well and learn from them.? The author definitely got his share of breaks, both good and bad, but he responded to the bad breaks well, and came out the better for it.

Though this book is about hedge funds and other areas of investing, really, this book is about the author.? It tells his story, and as the story gets told, you pick up incidental points along the way:

  • What is it like to be an intern at a trading firm?
  • How do you learn as you go?
  • What was it like inside CSFB during the dot-com bubble?
  • How to interview management teams to get an edge.
  • How to sense if someone is lying.
  • In general, the Fund of hedge funds operators are not desirable clients.
  • Get a sense of the strength of consumers
  • Get a sense of the three time horizons — days/weeks, months, and years.? (He uses other terms than this, but I appreciated his logic here, because it seemed a lot like what I did as a corporate bond manager.? Have a sense of short-term momentum, medium-term trend and long-term mean-reversion.)
  • Very good to good means sell
  • Very bad to bad means buy
  • The value of keeping a trading journal, and reviewing performance.
  • Be careful who you do business with, because eventually they may show you the door for less than good reasons.
  • Surviving the credit bubble’s bust.? Buying back in when people are panicking.

The book runs 204 pages, but roughly 30 don’t have much on them.?? The book is breezy, and though I mentioned a lot of things that I got out of the book, readers less familiar with the subject matter might miss some of the points.? He does not spend a lot of time on the details. On the other hand, a reader less familiar will get a feel for what it is like to be a part of a fast-paced area in investments.

Who would benefit from the book:? Those that would like to read the tale of an interesting guy who had a tiger-by-the-tail initial career in investments.

If you want to but the book, you can get it here: Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.

Full disclosure: The publisher sent me this book. They send me a lot of books, and I review as many as I can. I don’t like every book that I receive, but typically I review the ones that seem the best, and let the rest pile up. Anyone entering Amazon through my site, and buying anything, I get a small commission, but your price does not go up. Such a deal.

PS — the blog for the author’s firm is here.

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