Category: Asset Allocation

Ten Notes on Current Market Risks

Ten Notes on Current Market Risks

Posted on by David Merkel

1)? You hear me talk about this more than most, but liquidity risk needs more emphasis.? This is true whether you are a retail or institutional investor.? As the old saying goes, “Only invest what you can afford to lose.”? The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance.? The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets.? I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research.? Once markets do not trade continuously, the math gets tough.

2)? Insiders are selling, should you worry?? Perhaps a little, but I would wait until the price momentum starts to fail.? Like value investors, insiders tend to be early.

3)? What works in a time of rising leverage will not work well when leverage is decreasing.? Or, a strategy that requires liquid markets does not so well in a time of deleveraging.? Consider Citadel, then.? The period from 1991-2007 was pretty care-free.? What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap.? In 2008, the trap was sprung and Citadel had a lousy year.? Amid the carnage, they were forced to sell into? falling market.? Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4)? Average retail investors don’t understand regulated investments well enough to invest in them.? It would be stupid to allow them to invest in hedge funds, then.? If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime.? The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much.? (The culture abhors little investors being fleeced by bigger institutions.)

5)? Auction rate preferred securities — when I was younger, I wondered how they worked.? By the time I figured that out, the market failed.? Now the lawsuits fly.? Yes, they were marketed as money market equivalents, but none of them made it into money market funds.? Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance.? Few believed them because it had worked so well for so long.? My view is this — investors needed to read the “risk factors,” and did not.? ARPS were designed to be investment vehicles that could survive a storm, but not a tornado.? Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6)? My, but the high yield market and lower investment-grade corporate markets have moved higher.? What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog.? Systemic risk is still high.

7)? Spreads have fallen for high yield; I have previous suggested to lose the overweight in credit.? I now suggest that credit be underweighted.? This is not a time to stretch for yield.

8 )? After many other crises, junior debt gets grabbed when seniors have rallied a great deal.? The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield.? When does the rally end? Now?? Typically near a market peak, there is confusion, and a diminution in volume.? I think we are close to the end, but as I usually say, honor the momentum.? If it is still going up, hold it.

10)? This article is a little unusual for me, but it points out something that I often talk about in different terms.? Trees don’t grow to the sky.? In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless.? Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve.? So it is with business, and much of finance.

When the Sirens Sing, How to Avoid Giving in…

When the Sirens Sing, How to Avoid Giving in…

Posted on by David Merkel

When I wrote What Stories Aren?t Being Told?, I did not expect a big response.? But I got 53 responses, more than double the responses of my next-most-responded-to article.? Many bloggers linked to it, and responses continued on for almost four days.

But after Dr. Jeff’s comment, I decided to write a second piece, What is Going Right? Now, part of that also sprang from an e-mail that Rolfe Winkler sent asking what is going right, but I did it as a kind of test to see if asking for optimism would yield a response.

Alas, but only eleven responses came and a few were negative in nature.? I only received one link.? What should that tell me?? The most obvious answer to me is that people by nature are more inclined to complain than to praise.? Though I could resort to the Bible for proof here, instead I will cite two researchers I first bumped into 28 years ago (before they were cool), Daniel Kahneman and Amos Tversky.? They found that losses delivered roughly three times the pain, when compared to pleasures of an equal-sized gain.? (Side note: this has many applications, and in our day and age, most of them are politically incorrect.? As investors, though, we know it — avoiding losses is a better motivator than seeking gains.? At least, those that avoid losses stay in the game.)

Look, I see it in myself.? I tend toward the negative in this era, because I think it is under-told.? Would it surprise you if you knew that I was one of the more bullish guys in my last three firms (1998-2007)?? But even if under-told, there is something that always makes the bear case sound smarter.? Skeptics almost always seem smarter than optimists.? But, the optimists usually win, except when there is war on your home soil, famine, plague, or extreme socialism.

Where does that leave me?? It leaves me with rules.? I have trading rules.? I have asset allocation rules.? I can lean against something that I think is wrong, but I can’t put all of my weight on it.? I listen to the Sirens, but I tie myself to the mast.? Discipline trumps conviction.

So, to close, I offer an old CC post to illustrate:


 David Merkel
I Listen to the Sirens, but Like Ulysses, my Hands Are Tied to the Mast
12/27/2006 2:31 PM EST

When I had dinner with Cody two weeks ago, he asked me (something to the effect of): “If we have so many problems, why are you so net long?”

I told him about a hedge fund friend of mine who let his bearishness drive his macro bets over the last four years. The only thing that has bailed him out is that his analysts are really good stock-pickers… their fund has been in the plus column despite being an average of 25% net short, but not positive by much.

I tie my hands when it comes to asset allocation policy. After determining what I think the neutral policy should be for someone that I advise, I allow myself to tweak it by no more than 10% to reflect my overall levels of bullishness or bearishness. This keeps my emotions from taking over, and protects me and those that I manage for.

Besides, absent a major war on home soil, or a Communist takeover, markets have a tendency to eventually bounce back. (even if the bounce takes 25-odd years, as in the Great Depression). The question is whether one’s asset allocation is conservative enough to be around for the “bounce back.” So, it generally pays to play along with the optimists in the long run. Or, as Cramer has said, the bear case always sounds more intelligent. That can trap bright people who let legitimate fears of something that may happen a ways out get treated as a clear and present danger.

At present I am slightly bullish on the US markets and think that 2007 will produce moderate gains, 5-10%. There are things to worry about, but don’t let it blind you to opportunities that will emerge if disaster doesn’t happen. Instead, diversify. Stocks and high quality bonds. (Maybe even some municipal bonds.) Domestic stocks and foreign. There are ways to reduce risk that don’t cost that much in terms of performance. Use them, and don’t worry about the big, bad event. That event will happen, but it will usually be further out, and less bad than expected.

Position: none

Cramer wrote a piece two days later where he said:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

I asked him via e-mail whether he had read my piece, and he said he had not. Quite a coincidence. Before I asked him, though, I wrote this response:


 David Merkel
More Things Can Go Wrong Than Will Go Wrong
12/29/2006 1:21 PM EST

I reflected on what I recently wrote when I read this bit of Jim’s piece this morning:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

At my last firm, we conflated two maxims into: “Great minds think alike, but fools seldom differ.” Jim and I disagree on housing. In this case, though I still have many reasons to be bearish on housing, I don’t let it affect my investing to any great degree. For my broad market portfolio, I still own Cemex, Lafarge, and St. Joe. I even own a mortgage REIT, Deerfield Triarc. I’m not bullish on the consumer, but I still own Sonic Automotive and Lithia Motors.

The point is, it’s too easy to say “I’m too worried about the macro environment,” or, “I can’t find anything cheap enough to buy.” Will there be down years? Yes. Might the first decade of the 2000s have a negative total return? Possible, but unlikely. Like the farmer in Ecclesiastes 11, we have to cast the seed into the muddy spring soil, and not worry about the bad weather that might come. Diversification reduces risk, but not taking risk is possibly the biggest risk of all. The advantage belongs to those who take prudent risks.

Now, after all this, if you still want to worry, the biggest risks among the somewhat likely risks out there a breakdown in global trade and an error in Fed policy. I watch these things, but I’m not losing sleep over them.

PS — regarding Ulysses, he put wax in the ears of his sailors, but he tied himself up so that he could listen to the Sirens, but not do anything… it’s a tough discipline to maintain, but it helps me do better in the markets.

Position: Long CX LR JOE DFR SAH LAD

A very different era, that, but I am now bearish, and Cramer is still bullish.? I try not to change my positions often, and even then, I limit my behavior.? Discipline triumphs over conviction.

Alternative Investments, Illiquidity, and Endowment Management

Alternative Investments, Illiquidity, and Endowment Management

Posted on by David Merkel

I am a risk manager first, and a profit maker second.? I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?? Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.? A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.? A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.? I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.? In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?? Illiquid debt?? If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.? WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.? There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.? At the end of fiscal 2008, those that managed Harvard Management Company were heroes.? The largest university endowment, stupendous returns, etc.? Who could ask for more?

The risk manager could ask for more.? With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.? Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.? Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.?? If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.? Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.? Thus they moved to sell illiquid investments, and take a haircut on them.? They reduced their forward commitments by $3 billion.? They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.? What else might indicate that?? Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.? But that also implies that those endowed will not make abnormal demands on the endowment.? That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.? Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.? (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)? Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.? Even if cash doesn’t return anything, it is still valuable.? You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.? The horizon for an endowment is infinite only under conditions of permanent prosperity.? Well, anyone can invest forever under conditions of permanent prosperity.? The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.? There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.? That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.? But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).? That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.? With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!? Trouble is, knowledge travels, and success breeds imitators.? The imitators typically bring deals that will have lower returns or higher risks than the original deals.? But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.? Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.? That? gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.? In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.? The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.? Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

  • Liquidity is valuable, and should not be surrendered without proper compensation.
  • Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
  • After failure, they tend to be more correlated with other risk assets.
  • Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
  • Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.? Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.? Better safe than sorry.

Articles on the Harvard Endowment

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.? So it goes.

Ten Notes on Risk in the Markets

Ten Notes on Risk in the Markets

Posted on by David Merkel

1) Credit cycles tend to persist for more than just one year.? That is one reason why I am skeptical of the run in the high yield corporate bond market at present.? Sharp short moves are very unusual.? To use 2001-2003 as an example, we got faked out twice before the final rally commenced.? So, as I look at record high defaults after a significant rally, I am left uneasy.? Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.? S&P is still bearish on default rates.? I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament.? Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.? Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be?? Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.? Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.? For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.? Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market.? When there are more savers/investors vs. spenders, equity markets do better.? I’ve seen this analysis done in other forms.? So we buy Japan?? I’m not ready for that yet.

5) Illiquid assets require a premium return.? After the infallibility of the Harvard/Yale model, that rule is on display.? As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.? Harvard and Yale may indeed have gotten a premium return versus equities.? It’s hard to say, the track record is so short.? One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.? As such, investors in alternative investments are looking for more liquidity and transparency.

6)? There are limits to arbitrage.? As an example, consider long swap rates.? 30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.? When managements are confident, we see that; managements are not yet confident.

8 ) I would be wary of buying into a distressed debt fund.? Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.? I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

Book Review: Finding Alpha

Book Review: Finding Alpha

Posted on by David Merkel

I found this book both easy and hard to review.? Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero.? Hard, because the book needed a better editor, and plods in the middle.? I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book.? I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net.? It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds).? Junk underperforms investment grade bonds on average.? Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity.? Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return.? Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly.? See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit.? Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.? Helpfully, Falkenstein defines alpha as comparative advantage.? Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself.? This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield.? They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default.? Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities.? Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that.? He encourages readers to devise their own methods in areas where there is not a lot of competition.? Alpha? comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful.? They look for the big wins and ignore smaller ways to make extra money.? They swing for the fences and get an “out,” rather than blooping singles with some regularity.? I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40.? The sticker price is $95, though it can be obtained for less than $60.? Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman.? Klarman’s book is not worth $1000.? Falkenstein’s book is not worth $95.? Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation.? Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers.? The books are often different from what the PR flacks encourage reviewers to think.? If you enter Amazon through my site and buy anything, I get a small commission.

Avoid Risk; Make Money.

Avoid Risk; Make Money.

Posted on by David Merkel

Sometimes a single article can change my direction for publishing for an evening.? So it was for this article, Hedge Fund Keeps Reins on Risk.? I had not heard of Graham Capital Management until today, but given what I read, I like what they do — they focus on risk.

I am currently reading Eric Falkenstein’s book, Finding Alpha, and I am a little less than half through it, but he makes the point quite ably that the way to make money is to avoid risk, and that those that do avoid risk tend to do better than those that take a lot of risk.? I know that this is tough to understand for those that have bee indoctrinated by Modern Portfolio Theory, but I will phrase it my own way.? Take risk when you are paid to take it; avoid undercompensated risks.

Here’s the money quote from the WSJ story:

The firm’s risk manager Bill Pertusi leads a meeting at 9:30 a.m. each day in a large room in Graham’s 93-year-old Irish Tudor mansion. There, a group of seven or so people — always including Messrs. Tropin and Pertusi — discusses all aspects of risk: market risks, risks in individual traders’ portfolios and how they have changed since the day before, risks to the way the firm is investing its cash, counterparty risk — or risk that the firm on another side of a trade will fail, even evaluations of whether traders’ are in positions that are “crowded” with other hedge funds.

“I’m not aware of anyone who has a daily meeting just to talk about risk in the absence of talking about opportunity,” according to Leslie Rahl, managing partner of risk-management firm Capital Market Risk Advisors.

Graham requires managers of some of its funds to fill in a survey every Friday, answering the question: “How much money would we lose if you had to completely liquidate your portfolio in one, three or five days, in both normal and stressed environments?”

Risks are multi-dimensional, and a wise manager thinks through all aspects of his risks.

  • How creditworthy are my counterparties?
  • How readily can I convert my portfolio to cash if I had to?
  • What are my competitors doing?? Are my positions in strong hands or weak hands?? How many are making the same bet that I am?
  • Have the fundamentals of my positions changed?? Have the views of other major players in the market changed?
  • Has the time horizon of other investors alongside of me changed?
  • What cash flow yield am I likely to get, and how might that vary?
  • What should we do about major moves in the markets that we trade — go with the trend, or resist it, or ignore the move?
  • Am I implicitly taking the same bet through seemingly different? areas of my portfolio?

Limit the downside, and the upside will provide for you.? I am not saying to avoid risk, but to take prudent risks.

Now, I try to avoid making a lot of market calls, because those who do make a lot of calls are incautious at best.? I do believe that this is a time for caution with respect to the equity markets and the corporate bond markets.? I agree with Jason Zweig here, it is a time to trim risk positions.

On another front, consider illiquidity.? Taking on illiquid investments is a bet the the future will be very good; there will be no reason to liquidate funds.? This is why there should be a substantial yield or likely return premium for investing where there is no liquid public market.? The university endowments have stumbled here; they needed more liquidity than they thought.?? So have pension plans, who aimed for high returns at the worst possible moment.

That said, some pension plans are taking money off the table in stocks in the present environment.? Good move, I think.? Even the venerable Value Line is recommending lower commitments to common stocks.

Human nature does not change, and that is what makes behavioral finance and value investing stronger.? As the market moves up, shorts cover, but greed and envy drive people to invest more in the hot sectors.

This is not limited to retail investors, though.? Even investment banks are getting into the act.? Add to the leverage and let’s take some sweet bets!? Devil take the hindmost!

I get it, and I don’t get it.? This is a time to decrease risk, even though I might be early.? The troubles of our financial sector are not solved.? Our consumers are still overleveraged.? I don’t see how we get sustainable decent returns on capital in the present environment, aside from stable sectors of the global economy.? Avoid risk; make money.

Questions and Answers

Questions and Answers

Posted on by David Merkel

This may become a series, but I’m going to post some questions I have been asked, and the answers that I gave.? Anyway, here goes:

Has anyone prepared a summary of US Treasury bonds, say five years ago and now and looked at average maturity, etc.

GE was taken to task by the investment community in 2002-03 for using very short term money to fund long term lending/capital needs.? Was the investment community right?

Where is the US government right now ? Are they playing the short end of the maturity ladder, if so what could be the reasons why and what are the implications for the investment community?

Thanks for all of your insight.

Average Maturity

This is a graph of the average maturity in months of the marketable portion of US Government debt.? Reagan really lengthened the debt, and Bush, Jr. shortened it.? (Just another bad legacy for that economic liberal, Bush, Jr.)? The most notable aspect of that was the elimination of the 30-year bond in 2001, and its subsequent reappearance in 2006.? The Obama Administration is not a known quantity in these matters yet.

The sharp drop from June 2008 to September 2008 I believe is due to the creation of a lot of short-dated debt that was given to the Fed to allow it to grow its balance sheet.

With respect to GE, yes, the lending community was right.? Prudent borrowers match assets and liabilities.? I recently criticized GE for borrowing with too much short-term debt for their finance arm.? As it is, GE has had a wild ride in its stock price, dipping below six this year.? Without the TLGP, who knows?? GE might have had to send GE Capital into insolvency.

In general, I have been an advocate of lengthening the maturity structure of the US government’s debts.? Governments are supposed to try to be permanent; thus they should finance long.? Governments like the generally lower cost of short debt, and so they sometimes finance shorter than they ought to in an effort to save money.? Governments that don’t finance long enough can be subject to runs, such as Mexico in 1994.

I hope the US government takes the opportunity to finance long while it is still cheap to do so.? My guess is that the opportunity gets wasted; not that the average maturity shrinks a lot, but that it doesn’t grow much.

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What does your husband say about this? Small investors don’t bother?

> http://money.cnn.com/2009/07/29/pf/steve_lehman_federated_investors.fortune/index.htm

This one came to my wife for me.? Quoting from the article, my response was:

>>So what’s a retail investor to do? Lehman’s answer: Leave it to the pros. “It’s never been more difficult [to invest],” he says, “and it will remain more challenging than ever. Unless someone really has a flare for investing and enjoys doing it, I would say don’t waste your time.”<<

Small investors should probably use low cost index funds and vanilla Exchange Traded Funds.? That will lower their costs, which will raise their returns.? It is rare for outperformance to persist in funds management, particularly as the funds under management for any manager grows.? There are some value managers that are worthy of being invested in over the long haul for equities, and if you want a list, I will provide one.

David

PS — to the editors at Money — “flare” s/b “flair”

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We have a certificate of deposit that we are cashing out and are wondering if buying some gold would be a better way to protect our savings? Considering the way the government is spending money, it seems the only way to be safe from the inflation that is coming.

This is a tough one. A lot depends on whether the government inflates their way out of this or not. I almost think they have to, but they could have done it in the Great Depression/WWII, and did not. They raised taxes, and the best investment was government bonds for a long while.

This situation is probably different. Gold will preserve purchasing power over the long haul, but it rarely does more than that. Sometimes, that’s the best you can do.

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I don’t have a good place to post this last bit, so here it goes: here is a recent audio interview of me. I only wish we had focused more on investing topics. For those interested, I had my notes in front of me, which cited a number of my articles.

Full disclosure: I don’t own any gold, aside from my wedding band.

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management

Posted on by David Merkel

This piece is one of my experiments where I try to straddle two different investment worlds in an effort to bring more understanding.? The two world are stable value funds and commodity ETFs.

Commodity ETFs have a hard job, in that they are supposed to replicate the returns on spot commodities.? Given the difficulty of storage, only a few commodities — gold and silver, can be physically stored — they don’t deteriorate.? Unlike government promises, they are uniquely suitable for being money.? (Sorry, had to say that.)

Other commodities require futures markets or off-exchange markets where swaps get traded.? The swaps introduce counterparty risk, which is a common risk in many currency and commodity-linked funds.? I’ve written about that before, along with criticisms of exchange-traded notes.

One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple.? “Buy the front month futures contract, and roll to the second month contract before the front month expires.”? Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy.

So, what do the other investors do?? They take the opposite side of the trade early, in order to make it more expensive to do the roll.? Buy the second month contract, and short the first.? As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract.? What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market.

Compounding Money Slowly

If you want to keep your money safe, and earn a little bit, what should you do?? Invest in a money market fund.? “Wait a minute,” some intrepid investor would say, “I can do better than that.? I don’t need all of my money for immediate liquidity.? I can ladder my funds out over a longer period.? I can invest surplus funds out to the end of my period, and earn a better yield, and over time, my funds will mature bit by bit.? I will have liquidity in a regular basis, and I will get a higher yield because yield curves slope up on average.”

Leaving aside the wrap agreements that a stable value fund buys, stable value funds build a bond ladder with and average maturity of 1.0 to 4.5 years.? Commonly, it averages around 2.0 years.

The funds could invest everything short and give up yield.? That would give them certainty, but lose yield.? That is what the commodity funds are doing.

What could go wrong?? There could be a large demand to withdraw funds when longer-dated contracts are priced below amortized cost, and the fund might not be able to meet all withdrawal requests.? So far that has not happened with stable value funds.

The Fusion Solution

Whether in war or in business, it is not wise to be too predictable; opponents will take advantage of you.? In this particular example, I would urge commodity funds to look at their liquidity needs over the next month, and leave an amount maturing in the next three months equal to 4-6x that amount.? Then spread the remainder of funds according to advantage, looking at the tradeoff of time into the future versus yield of the futures contracts versus spot.? Longer dated futures do not move as tightly with the spot markets, but they often offer more yield.

Ideally, a commodity fund ends up looking like a bond ladder, and as excess funds mature, they don’t get invested in the new front month contract, instead, they get invested in the longer dated contracts, near the end of the ladder, as a stable value fund would do.

This maximizes returns for the bond/stable value funds, and I believe it would work for commodity funds as well.? Please pass this on to those who might benefit from it.

A Closing Aside:

Back in the late 90s, I ran one of my interest rate models to try to determine what the best investment strategy would be.? I found that the humble bond ladder was almost always the second best strategy, regardless of the scenario, because it was always throwing off cash that could be reinvested out to the end of the ladder.

Again, please pass this along, and commodity fund managers that don’t get this, please e-mail me.? I will help you.

Book Review: Mr. Market Miscalculates

Book Review: Mr. Market Miscalculates

Posted on by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?? Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

Seven Notes on the Current Market Mess

Seven Notes on the Current Market Mess

Posted on by David Merkel

1)? Avoid short-cycle data.? When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.? After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.? I don’t have a TV.? I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.? There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.? Why?

  • Most bloggers are not anonymous, like me.
  • Many of us are experts in our? specialty areas.
  • Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.? They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.? The print media is better at that than television or radio — bloggers can go either way.? For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.? It is better to consider longer-term trends, and use those to shape decisions.? There are too many trying to arb the short run.? The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.? Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)? Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.? Give FASB some credit — they are bringing the issue back.? My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)? Very, very, weird.? I cannot think of a man that I am more likely to disagree with than Barney Frank.? But I agree with the direction of his proposal on CDS.? My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.? Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.? What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.? Every legitimate derivative trade has a hedger leading the transaction.

4)? I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.? It is not only the level of debt that matters, but how quickly the debt reprices.? Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.? The shorter the maturity structure, the more likely a currency panic.

5)? Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up? the shortfall of liabilities over assets.? This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)? Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.? Simon Johnson distinguishes between three types of bubbles — I’m less certain there.? Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.? It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.? The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.? In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.? Without debt, it is hard to get a big bubble going.? Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.? That’s just the worry behind my point 4 above.? The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.?? Last week was a tough one for me personally; let’s see if this week goes better.

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