Personal Finance – Page 29

Book Review: Trend Following (4)

Posted on 28 April 2009 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Book Review: Trend Following (3)

Posted on 28 April 2009 by David Merkel

What I find interesting about this subject, whether we call it “trend following” or “price momentum,” there has been a confluence of different parties agreeing that price momentum works.? I have reviewed many books recommending momentum strategies (an example), and have usually recommended them (sometimes with reservations).? I will even recommend Trend Following to those who don’t know that positive price momentum aids investment performance about 80% of the time.

What groups of people have come in to support price momentum?

Most quantitative stock screeners/graders use a mix of momentum and valuation factors.
The academics behind behavioral finance support price momentum and valuation factors, in addition to some others.
Many large (and smaller) hedge funds that trade stocks do so using momentum as a positive factor in stock selection, along with valuation, earnings quality, and a host of other factors.

I know, there are still Efficient Markets Hypothesis zealots in the academic community, but they are being outflanked by the behavioral economists who have hard data to support their theories.? The Adaptive Markets Hypothesis describes the way the markets really work.? Rather than using a physics-based analogy, better to use a biological analogy — I view investment strategies through an ecological frame.? Multiple strategies compete to obtain scarce excess investment returns.? The strategies that are least pursued relative to their validity usually have the greatest punch.

Is everyone a fundamentalist?? Momentum strategies win.? Are there a lot of traders chasing momentum?? Value strategies win.? Is there a dominant view to seek dividends?? Growth strategies win.? Is everyone chasing after growth?? Perhaps we should look for dividends.

I don’t know about everyone, but among quantitative investors the opinion is virtually universal that trend following is the right strategy.? Follow price and earnings momentum.? I even put out a small piece weekly on short-term performance of industry groups, which is largely based off of price momentum.

So, if Mr. Covel thinks that trend following is an underfollowed idea, I can simply say that there are a lot of us following it, to the point where the trade might be crowded.? Trend following is a significant part of the total market ecology, and when it becomes dominant, its short-term returns become curtailed, until enough money leaves the trade.

I’ll discuss this more tomorrow, when I discuss how we test the validity of investment strategies.

Book Review: Trend Following (2)

Posted on 25 April 2009 by David Merkel

I had a long debate inside myself before writing my book review last night.? I could have written the review recommending purchase of Trend Following, because it teaches a truth that often gets ignored in the market — following price momentum pays around 80% of the time.? As a value investor, that was a hard lesson for me to learn, but I accepted it once the evidence was clear enough.

Why I did not recommend the purchase of the book was more over tone and style.? Here are two examples: on pages 294-296, he discusses this paper that shows that Commodity Trading Advisor [CTA] performance is little better than T-bills.? There is one substantive complaint, and I agree with it, that the Sharpe ratio is a lousy measure of performance.? Most of the other arguments focus on the author’s affiliations — AIG Financial Products and Vanguard.? It is not valid to dismiss evidence off of the background of the individual.? Deal with his arguments.? So what if he worked for AIGFP?? That doesn’t make him liable for everything done there.? Same for Vanguard.? Merely because you work for Vanguard does not mean that you shill for mutual fund industry in everything that you do.

Humble Student of the Markets Cam Hui raises these objections in his comments to my piece last night.? I object to the ad hominem arguments of Mr. Covel.? If we must argue, let us argue on the basis of principle, and may the best side win.

Now, when Mr. Covel responded to me, it was also an ad hominem argument, tying me to Jim Cramer.? Now note, the first piece has disappeared from the internet, and I know not why.? Perhaps he gets that I am not a Jim Cramer clone.? To my readers I ask, how many of you think that I am like Jim Cramer in the way I advise?? I wrote a long series of articles on using investment advice to inoculate people against using stock tips from the media, partially because as Jim Cramer became more of a media phenomenon, his recommendations became worse.? He is at his best when he writes/says less, and gives you his considered opinion.? Investing and doing something sensational for the media do not mix.? That’s the conundrum of the value proposition for TSCM.

That said, Cramer does use price momentum as one of the factors in his stock selections.? He is generally a “trend follower.”? Cramer also is not a value investor.? Much as I appreciate him giving me a chance to write, we aren’t very similar.? That’s consistent with TSCM philosophy — they want a large range of views.? I wrote there for four years, and was one of their leading writers.? I rarely interacted directly with Cramer, instead, putting forth my own views, which did better (in my opinion).

I’m not Cramer, and he’s not me.? He just gave me a chance to write, for which many are grateful.? (I would tell you that he taught me how to trade corporate bonds, even though he has never traded corporates, but that would be a long story.)

Pressing on

This is not my last article on this topic.? I intend on continuing this discussion, to flesh out where I agree with Mr. Covel, because at many points I do agree, but there are complexities that need further elucidation.

The main areas I will cover in the future include:

When does trend following fail?
What other factors should we consider?
What constitutes adequate proof that a strategy is superior?

I credit Michael Covel for commenting at my blog, and I will answer his question, but not today.? It is a valid question, but there are other questions that can be posed to him as well.? Let the debate commence on a fair basis.

Book Review: Trend Following

Posted on 25 April 2009 by David Merkel

This review is unlikely to make me friends, and likely to generate some negative mail.? Let me start with the conclusion: don’t buy the book.? That said, my reasons for stating this are different from those who typically criticize Michael Covel.? I agree with much of what he says; I disagree with much of his rhetoric.? Let me give you my thoughts:

1) Momentum is a pervasive factor in the markets.? It works about 80% of the time and produces significant excess returns on average.? Behavioral finance points out that people are slow to adapt to new information, so momentum tends to work because the initial moves on new information aren’t sufficient.? That said, when too many are chasing momentum, the market becomes extremely volatile, and the strategy ceases to work, until it shakes out enough momentum-followers.

What is hard, is distinguishing trend following from technical analysis from momentum.? Personally, I think momentum explains the other two.? It’s a much simpler theory, and much as Covel appeals to Occam’s Razor, I apply it back to him here.

2) He draws on a series of investors that have done well in the past, and touts them as proof of his theories.? Hindsight is 20/20.? What of those that have tried to apply trend following and failed?? Is it many or few?? Keeping a tight stop loss for some means the death of a thousand cuts.? The studies that I have seen show that frequency of trading tends to decrease returns.? Now, trend following does not necessarily mean a lot of trading, but for many it ends up being that way.

It is easy to locate a bunch of trend followers in hindsight, and tout their abilities.? What would be harder would be to find the whole universe of people following trends, and see how they do as a whole.

3) Mean reversion is a weaker factor, but still significant in making money.? Value investors typically do well with it, but only reliably when they insist on strong balance sheets.? I’ve studied mean reversion for years, and it exists in almost all markets as a weak factor.? Over enough time, that weak factor has punch, but in the short run, momentum rules on average.

4) Covel spends a lot of time trashing fundamental analysis, without much meat behind it.? Fundamental analysis works well, but doesn’t have so much value because so many are applying it.? It’s not like the situation Ben Graham found, where few were doing it.

Aside from that, technicians implicitly rely on fundamental analysis, because their support and resistance levels stem from the decisions of fundamental investors.? Same for those that follow trends.? The trends exist because fundamental investors react slowly to changes in the fundamentals, and trend followers exploit them.

5) There is no mention of the Adaptive Markets Hypothesis, and little discussion of Behavioral Finance.? These are much richer theories that encompass “trend following.”

6) Covel takes “pot shots” at Buffett over issues that are unrelated to his main point in an effort to discredit him.? Buffett is a bright guy who can criticize derivatives in aggregate, while still using them in specific to his advantage.? (Cough, cough.? Please ignore his put option trades.)

7) There was not enough time spent on “how to trend follow.”? After reading the book, if I didn’t have prior background knowledge, I would be scratching my head to figure out how I could reliably pick investments in a trend following mode in order to make significant excess profits, as well as know where to sell them.

I don’t recommend it, but you can buy it here: Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets

Final note — Covel needs to grow up and learn that there are other factors in the market aside from momentum.? He has become a fundamentalist about “trend following” and does not seem to have the open mind that he harps about.

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? Such a deal if you wanted to get it anyway?

“Do Half”

Posted on 21 April 2009 by David Merkel

Before I start my piece for the evening, I want to explain why my AIG piece is slow in coming.? Short answer: It’s big, and I am still writing it.? There is a lot there, and I am trying to get it right, realizing that I am just a generalist dealing with complex issues and not enough data.? I hope to have the piece finished on Wednesday for Finacorp clients, and out be the end of the week here.

“Do Half”

What I am going to talk about here is annoying to some who always feel that investing is about taking bold actions.? I had one boss that would go nuts when I would talk about this strategy.? Other friends, akin to deep value investors, would get perturbed as well.

I used this strategy extensively when trading corporate bonds 2001-2003.? I was a fairly active trader, unlike what I do with equities today.? Yet, even with equities, my rebalancing trades which have aided me in this volatile market, mimic some of the benefits of this strategy.? Here are some examples:

1) Say you bought a stock and it rapidly rallies, yet not to the point where you think it is at fair value.? Perhaps recent events have made you re-estimate fair value upward.? What to do?? Sell half of the position, and wait.? If the price falls, buy back the position.? If it rallies further, sell the rest.

2) Say you want to buy a stock, but it is plunging like a stone.? You’ve done our homework — the balance sheet is strong enough to self-finance the company for three years, estimated earnings for the next indicate the company is cheap, what to do?? Buy half of a full position, and wait.? If the companies rallies sharply, sell the position.? If it continues to fall, wait until it stabilizes, confirm your fundamental research and buy up to a full position.

3) Say you like a stock, but it has rallied past your buy point.? What to do?? Buy half.? If the stock comes back to the buy point, buy a full position.? If it rallies further, sell the position.

4) Same as number 3, but reversed for shorting.

I would almost always scale in and out of positions as an institutional investor, rather than doing it all at once.? I credit Jim Cramer for teaching me this.? The real Jim Cramer is not the “lightning round, ” but the guy who scales in and scales out.? The lightning round is binary — buy/sell.? The real world is more nuanced — how much to buy and when?

But the real benefit of doing half is the psychology of the situation.? Many investors suffer from fear, greed, and regret.? Doing half short-circuits those responses.? When the stock price moves in favor of profits, be glad of those profits.? When the stock price moves against profits, reanalyze and either a) go flat, recognizing your mistake, and being grateful that it was small, or b) increase the bet to a full position, and be grateful that you didn’t put a full position on initially.

Scaling in and scaling out gives freedom to investors, and removing many of the psychological burdens that they bear.? It doesn’t mean there won’t be losses.? There will always be losses but they will be easier to bear, with no panic that leads to selling off at the lows, or buying at the highs.

Unstable Value Funds? (IV)

Posted on 7 March 20098 March 2009 by David Merkel

This should be my last post on this topic for a while.? I thank those that sent me additional data that agreed with my theses in the piece Unstable Value Funds? (III).? I would like to start by quoting from my piece at RealMoney The Biggest Asset Class You Never Heard Of.

The bonds held in stable value funds can’t be valued at book value, because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book-value loss.

Typically, wrap agreements are only done on the highest-rated bonds, AAA, so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate. Because wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10% per year of assets wrapped. The only risk a wrapper faces is that the interest-rate-related losses on a bond in a rising interest rate scenario are so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above-market yield. There is a risk that in an environment where interest rates have risen sharply, a stable value fund would have a lower market value than book value, with a below-market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields. If that happens to a high degree, it will worsen the gap between the market value and book value of assets. That gap will be covered by the wrappers in the short run but will reduce the fund’s yield as it pays the wrappers back. It is unlikely but possible to get a death spiral here if more and more shareholders leave the pool and the yield sags to zero. It hasn’t happened yet, so this is theoretical for now. In theory, the wrappers would keep paying once the fund’s credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation. There probably would be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability, or negotiate down the amount owed, leaving policyholders with a loss. In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral is further reduced but not eliminated.

Asset Default Risks

For the most part, stable value funds take little credit risk, but it’s little known that this is not universally true. Some of these funds buy corporate bonds or other, more riskily structured product bonds. Some of them take credit risk in hidden ways. For example, there are some exotic, asset- or commercial-mortgage-backed interest-only bonds that are rated AAA by the rating agencies. The agencies rate them AAA because they can’t lose principal; they have no principal to lose. But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened. The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA. If an asset in a stable value fund defaults, the fund probably will temporarily suspend withdrawals while the managers pursue one or two courses of action. If the loss is small, its managers might buy a wrap contract for the loss, which will give a haircut to the yield on the stable value fund for the life of the wrap contract. If the loss is big, they will reduce the NAV and attempt to keep the NAV stable from there. Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.

I want to publicly thank Chris Tobe for writing to me.? He brought me back up to speed on some aspects of stable value that I was not in touch with.? (Any errors here are mine, not his.)? After reading what he sent me, there are two major risks.? One I have described in-depth: credit risk.? The other I described in my RealMoney piece: wrapper risk.

When the market value of assets is lower than the book value of assets, the wrapper covers the difference when withdrawals are made.? But the difference typically gets amortized into the credited rate of the stable value fund, lowering the interest rate credited to pay back the wrapper.

But what if the interest rate were forced to zero?? Then the wrapper would take losses.? Investors take losses is if the wrapper is insolvent when book value is more than market value.? The stable value fund could try to replace the wrapper, but it will come out of the hides of investors, unless the management company bears it.

There aren’t many wrappers today.? Here’s a list:

JP Morgan
State Street
RBC
CDC
AEGON
ING
Pacific Life
AIG (few buying from them)
Rabobank (not accepting new business)

As such, with the current financial stress, wrap fees have doubled.? There is more need for wrap capacity than is currently available.? There is the potential for losses as wrappers could go into insolvency.

But how big is this problem for investors?? The stable value marketplace is very big, though the severity of any loss should be small — under 10% of capital on average (some could be worse than 10%).

There are two troubles here.? First, because the stable value industry does not reveal the market value of their assets under management.? The opaqueness adds to the mystery.? Second, because the stable value funds have more accounting flexibility than most investment options, they can wait much longer than a money maket fund, which must declare a credit event if the NAV of the MMF is under 99.5%.? There is not such a threshold for a stable value fund.? The risk is that a stable value fund engages in wishful thinking, assuming that the value of their bonds will rebound, and the rebound does not happen.

Is a loss of 5% horrible, in an investment that is supposed to be safe?? How about 10%?? 20%?? I can’t go over 20%, the fund managers must act by then.

It is likely that losses will be small in the stable value option, but losses are a real possiblity.? Transferring assets to other fixed income options or other stable options could be smart.

Unstable Value Funds? (III)

Posted on 5 March 2009 by David Merkel

There’s a lot that I don’t know here, but what I do know concerns me.? Stable Value funds are a murky part of the market.? They are murky because they don’t report the value of the underlying assets, but only the smoothed value of assets, and the rate that they are currently crediting.? (Note: for those that want the grand tour of Stable Value Funds, I wrote this piece at RealMoney, The Biggest Asset Class You Never Heard Of.

A New Appreciation for the Plumbing

Posted on 27 February 2009 by David Merkel

I am the son of a plumber, who was the son of a plumber.? My wife gives me a bemused look when I go off to fix a plumbing problem, usually minor, when she asks, “Can you do it?” and I say, “Son of a son of a plumber.”? Truly, my statement means nothing, though I worked with my Dad for two summers that I enjoyed a great deal.? He installed sewers all over southeastern Wisconsin, and was known for doing quality work.? He never got sued once in his 35-year career.

So, I can appreciate plumbing.? Most of us never think about it.? Open the spigot — water!? Flush the toilet — waste gone!? Simple.? Beautiful.? As my Dad, a happy man, would say, “I have brought civilization to southeastern Wisconsin.”? A good man, my Dad.

Figuratively, plumbing exists in many areas of life.? People don’t want to think about the mechanics of how something works; they just want it to work when they need it.? More people drive cars than are mechanics.? More people listen to music than can sing well.? (I love to sing.)

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?
Who checks the results?? (Auditing — should not be a small firm.)
Who has custody of the assets?
Is the trustee a reputable third party?
Is liquidity proportionate to the asset class invested in?
Is this under US law?
Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
Is this marketed to everyone, or just a select few suckers?
Is the profit motive of the sponsor obvious and standard?
How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

When the next bull phase comes, be aware, and avoid slick talkers who have a good private game going, unless it can be verified by many competent independent third parties.? The bear phase is here now, revealing the slick talkers, and those that were taken in by them.? Be aware; you are your first and best line of defense.

Reasons for Optimism, Or Not

Posted on 18 February 2009 by David Merkel

Natively, I tend to be an optimist.? The present environment has given thin gruel for optimism, so I haven’t been as perky as I might otherwise be.? Here are a few reasons for optimism:

Credit spreads have been declining, and more corporate bond deals are getting done in the credit markets.
Commodity prices have fallen and stabilized.
The balance sheet of the Federal Reserve is shrinking.
Money market and other short duration funds seem to be safe.
Equities might be cheap relative to cash, but are still expensive relative to junk and low investment grade bond yields.

On that last point I want to quote Doug Kass, who I respect as an investor:

On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:

The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
Valuations are low vis-?-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

On point 1, I will say that equities are cheap to cash and Treasuries, but not Corporate bonds and bank debt.

For point 2, we have gone through a massive levering up; it would be no surprise to see a leveraging down.

Point 3 — I don’t get it.? Inflation has a small effect on valuations.

Point 4 — This is true but it could go lower because there is no one that wants to buy and hold at present.

Point 5 — In this environment, where there is a lack of buy and hold capacity, why are we satisfied with normal valuations?

Point 6 — True for Treasuries, wrong for corporates.

Point 7 — The 10-year Treasury is artificially low.?? It is not a good metric for dividend yields.

Mr. Kass is a bright man, and probably a better investor than me, but there are reasons to be concerned in this economic environment.? Be careful, and don’t make rash moves in this volatile environment.

Hidden Credit Risk in Currency Funds

Posted on 22 January 200922 January 2009 by David Merkel

With more than a hat tip, but a full bow to my reader Eric, I present a recent comment of his:

Eric Says: Regarding your existing portfolio, you?ve sometimes held FXF and other Proshares Currency funds. Based on the following excerpt, does it seem to you that these funds are too dependent upon the solvency of JP Morgan?

?The Trust has no proprietary rights in or to any specific Swiss Francs held by the Depository and will be an unsecured creditor of the Depository with respect to the Swiss Francs held in the Deposit Accounts in the event of the insolvency of the Depository or the U.S. bank of which it is a branch. In the event the Depository or the U.S. bank of which it is a branch becomes insolvent, the Depository?s assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant for the amount of Swiss Francs deposited by the Trust or the Authorized Participant, in such event, the Trust and any Authorized Participant will generally have no right in or to assets other than those of the Depository. In the case of insolvency of the Depository or JPMorgan Chase Bank, N.A., the U.S. bank of which the Depository is a branch, a liquidator may seek to freeze access to the Swiss Francs held in all accounts by the Depository, including the Deposit Accounts. The Trust and the Authorized Participants could incur expenses and delays in connection with asserting their claims. These problems would be exacerbated by the reality that the Deposit Accounts will not be held in the U.S. but instead will be held at the London branch of a U.S. national bank, where it will be subject to English insolvency law. Further, under U.S. law, in the case of the insolvency of JPMorgan Chase Bank, N.A., the claims of creditors in respect of accounts (such as the Trust?s Deposit Accounts) that are maintained with an overseas branch of JPMorgan Chase Bank, N.A. will be subordinate to claims of creditors in respect of accounts maintained with JPMorgan Chase Bank, N.A. in the U.S., greatly increasing the risk that the Trust and the Trust?s beneficiaries would suffer a loss.?

I have written about credit risk of ETNs before, but now I have to write about credit risks of ETFs. When an investment consists of foreign currency bank deposits of a single bank, there is a concentrated credit risk. In this case, the credit risk is to JP Morgan’s London branch. A default could be messy, with different laws in the UK.

This just highlights the risk involved with esoteric asset classes, where the “cheap” way of getting the exposure comes through credit or derivative agreements.? Be wary as you consider unique ETFs and ETNs; there can be credit risks that you have not considered.