Saturday, May 28, 2011

Too Bad the Institutional School Of Economics Is Dead

Quotes from two Friday readings

Item one:

The entire article “Pensions Leap Back to Hedge Funds,” WALL STREET JOURNAL, May 27, 2011 by Steve Eder, Gregory Zuckerman and Michael Corkery is worth reading. However, for those without access, here’s an interesting quote:
“Public pension plans are lifting hedge-fund investment, seeking to boost long-term returns despite losses suffered in some funds in the financial crisis.
Also, pension officials are using the historically strong returns of hedge funds to justify a rosier future outlook for their investment returns. By generating more gains from their investments, pension funds can avoid the politically unpalatable position of having to raise more money via higher taxes or bigger contributions from employees or reducing benefits for the current or future retirees.”

Item two:
The article worth reading is “Fire your hedge fund, hire your congressman” BARRONS, UP AND DOWN WALL STREET, May 26, 2011 by Randall W. Forsyth, subtitled “House members outperform the stock market, though not as much as Senators, study finds. The ultimate insiders?” Again, however, the interesting quote is:
“You'd think that Republicans would have the better investment results since the GOP is seen as the party of Wall Street. You'd be wrong. The Democrats did four times as well as the Republicans, generating excess returns of 73 basis points per months versus 18 basis points.
The study's authors' interpretation: during the period covered by the study, Democrats controlled the House for 10 of 17 years. ‘Furthermore, Democrats were deeply entrenched in the leadership of the House for decades prior to the study. Thus when Republicans finally took control in 1995, they arguably had far less experience at handling the reins of power and may therefore have been unable to immediately enjoy all its perquisites,’ the academics write.”

The Hedged Economist’s observation:

With a little observation of institutions, the academics wouldn’t be so naïve as to believe Republicans are the party of Wall Street. As hinted at in item one, some Wall Street industries would hardly exist without Democrat public sector pensions. The hedge fund industry is a prime example. Absent pension funds and academic endowments, the hedge fund industry would be much smaller. Further, a strong argument can be made that hedge fund fees would be lower, but that’s a theoretical argument while the capital flow from pensions to hedge funds is a fact. In general, pension funds are a blatant example of just turning money over to Wall Street, and who are the traditional defenders of defined benefits pensions? It’s not the Republicans.

The Democratic Party’s ties to Wall Street go way beyond hedge funds. If the author of the study read a few histories of investment banks, they’d recognize a long history of Democratic ties. More recently they might learn something from the difficulty Republicans have had recruiting Wall Street types. It was close to traumatic for Henry Paulson to cross party lines to go from Goldman to a Republican administration. Even in commercial banking, it’s hard to find a Republican at the executive level in a Wall Street bank; community banks yes. They’re far more representative of the voting public in general, but we’re talking Wall Street.

If the authors of the study approached the finding objectively they wouldn’t need an elaborate years in control / entrenched power explanation. There are deep philosophical reasons for the relationship. Both Wall Street and Democrats thrive on other people’s money, both believe in entitlement, and both believe in their superiority to the masses. In the authors’ defense, the authors state that Republicans “may therefore have been unable to immediately enjoy all its perquisites.” Perhaps that is just a polite way of saying Democrats are better crooks because they had more time at it. A Republican would respond that it isn’t time; it’s philosophy. Now there’s a debate for a political blog. Let’s hope any such debate is based on facts, analysis and observation not the blind acceptance of mistaken conventional wisdom.

Thursday, May 19, 2011

On Investing: Part 14

Real estate, starting with home sweet home.

All the other postings on investing included a musical reference. With a home, a musical reference would be too easy and a cheap shot. The same would be true of any reference to “Our House.” (Oops). But, it is a very, very fine house, even if it isn’t on the range.

Seriously, real estate should be a part of any portfolio. Problem is that it is hard to separate real estate investments from leverage issues. Nevertheless, there are a number of misconceptions about real estate that commentators repeat. They are now mouthed more frequently than the wisdom repeated back in 2006 that a general home price decline couldn’t occur. They should be noted by anyone serious about the issue. The nonsense said about housing and the potential financial mistakes it causes will be the subject of the next few postings.

One that’s particularly interesting is statements like “for most consumers a house is their biggest investment” or “a home is most people’s biggest asset.” First note that these are two very different statements. The value of an asset is quite different from the amount invested in the asset. People who take a 100% mortgage have nothing invested; it’s just a big asset with an offsetting liability. However, the interesting thing is neither statement (i.e., biggest investment nor biggest asset) is accurate.

First, at any given point in time “most” people don’t have a lot invested in a home. For starters, 35% to 40% of households rent. In addition, a lot of “owners” haven’t built up much equity by paying principal. They may be consuming a lot of housing by living in a big house, but they aren’t investing in it unless they’re paying down principal. If they made a down payment, that constitutes an investment, but the days of 20% down as the norm went away over a decade ago.

So, in fact, it is probably more accurate to say a large MINORITY of people have a large investment in their house. For each one, over time it will become a larger investment and MAY become their largest investment, but there is a good chance it will be less than what they spend to borrow money for cars, their house, education (theirs and/or their kids’), and other consumption. Over their lifetime, most Americans spend more to consume tomorrow’s income than they invest in housing.

How about the largest asset claim? That claim is on less shaky ground, but still questionable. The validity of the claim depends on one’s definition of asset, and in particular, asset liquidity. An asset doesn’t have to be liquid. In fact, one definition of an asset is anything that produces a steam of benefits.

Real estate is not a particularly liquid asset. One definition of liquidity focuses on the cost of converting to money. Real estate is very illiquid by that definition. If you doubt it, compare the transaction cost on a stock verses real estate. The commission on a stock trade isn’t even in the same ballpark as real estate closing costs. Another dimension of liquidity is the time it takes to convert to money. Buying or selling real estate takes time. The most sophisticated (i.e., broadest) definitions take into account cost, time, volume, price stability, uniformity or interchangeability of offerings, and even information flows. Real estate is illiquid by each measure. Finally, even more serious is the fact that real estate markets aren’t guaranteed to clear. Governments may intervene to stop foreclosures from clearing, as is currently happening, or buyers and sellers may refuse to trade at current prices, also currently happening.

With real estate we’re dealing with an illiquid asset. In a previous posting, “Data is no substitute for thinking,” The Hedged Economist made the passing comment “…Shiller hasn’t gotten over the housing bubble; he still talks about housing prices as if one’s home where an asset rather than a place to live.” Technically it should have said “liquid asset.” Once one focuses on a home as a place to live it become analogous to any other stream of benefits (i.e., real income). A house is far from the largest stream of benefits. One’s income is the largest stream of benefits for “most people.” Thus, for MOST people the discounted present value of the income stream is their largest asset.

Nothing can ruin an investor’s day, or for that matter an economic and financial system, quicker than mistaken assumptions about the liquidity of assets. However, a close second is not knowing what has been invested and what has been consumed. Anyone who lets these misconceptions about housing influence their thinking is risking both mistakes. That’s true of investors and equally true of policy makers.

Sunday, May 15, 2011

Sometimes even a blind squirrel finds a nut

But, beware; pigs will root around in a forest looking for nuts

“Sen. Charles Schumer told regulators that sophisticated electronic traders should bear the cost of monitoring their dealings, with special fees assessed to firms that issue and then rapidly cancel securities orders.” (Fee Pitched for Fast Firms, Senator: High-Speed Traders Should Bear Cost of Oversight, WALL STREET JOURNAL, 5/9/2011)

Well, Chuckie may be on to something. Back in January 2010, well before the flash crash, The Hedged Economist pointed out that a trading fee could benefit financial markets. But, as “Efficient capital allocation doesn’t require perfect liquidity” pointed out, the great danger is Governments’ addiction to other people’s money.

After the flash crash of May 6th , a number of the postings in May 2010 also mentioned fees as a remedy. Throughout The Hedged Economist’s discussions of fees, the emphasis has been on the functioning of the financial markets. Unfortunately, Chuckie has other ideas as borne out by statements like: “bear the cost” or “such charges could defray the expense of building a new system to track in real time the orders.”

Clearly, Chuckie is more akin to the pig rooting around for grub than a squirrel that discovered a treasure. It’s scary that a Congressman thinks of the economy as just an instrument for supporting Government. Why build a new system for tracking orders in real time when a properly designed fee structure, one designed with market functioning in mind, would eliminate the need for the tracking?

Chuckie seems more interested in tracking problems than avoiding them. It’s enough to cause reasonable voters to abandon good ideas in order to keep people like Chuckie from perverting them.

Friday, May 13, 2011

This is either wrong or a new threat to national security

If this is accurate, Congress and the Administration should begin an investigation immediately

This posting quotes from “SEC Is Pressed on Firms' Disclosures of Cyberattacks,” WALL STREET JOURNAL, 5/12/2011. The source being used is important because this is so unbelievable. Here’s the background.

“The lawmakers want the SEC, by issuing guidance, to make it more clear [clearer] when attacks or data breaches rise to the material level and become subject to disclosure, rather than the current approach of relying on a company's interpretation of when an incident is material.” That seems reasonable, but here’s the problem: “Specifically, the lawmakers want to ensure that firms disclose when they have suffered a ‘material network breach,’ which would be a cyberattack or data theft that would affect the average investor's decision to purchase or sell a stock.”

That’s ridiculous. What would affect investor’s decision to purchase or sell a stock can’t be known ahead of time; ridiculous, yes, but not unbelievable. It’s just the foolishness typical of Congress.

Here’s the national security threat. “A Commerce Committee review of recent SEC disclosures found companies that did report their information-security-risk exposure were inconsistent in the level of detail they provided, the lawmakers said. None provided information on steps that were being taken by the corporation to close potential security gaps, they added.”

We actually appear to have someone advocating that we force companies to disclose steps they take to thwart cyberattacts. Someone should investigate. Seems to me that if the staff of the Commerce Committee or the SEC has been infiltrated by the cyberterrorists, we need to know it.

Wednesday, May 11, 2011

Data is no substitute for thinking

Bubble, bubble, toil and trouble

Robert Shiller argues that the last two recessions could have been avoided if we had better data on financial markets and the economy (See: Needed: A Clearer Crystal Ball). That is self-serving nonsense. The problem wasn’t measurement; it was interpretation. In addition, one cannot ignore counterproductive responses even among people who correctly interpret the available information.

It seems curious that Shiller, of all people, would be arguing that the bubbles in stocks during the internet bubble or housing during the housing bubble could not be seen from existing data. Shiller, after all, saw both bubbles in existing data. Perhaps the issue is that Shiller sees a bubble in any data he analyzes, just as some people never see a bubble no matter what data they see. More data won’t solve that problem.

There will always be differences of opinion no matter how much data is available. People can look at the same data and react differently. There are people who can’t resist participating in a bubble. Some see it as a bubble and want to “game” the bubble. Others think it’s a new world and don’t see it as a bubble at all. However, even when the interpretations are the same, reactions differ. Some people move away from bubbles. Others feel they can’t stop dancing while the music is playing, to paraphrase Charles Price who destroyed Citi Bank with his dancing.

The emphasis on more data seems to originate from a naïve belief that if we all had better information there would be an obvious path we’d all want to follow. Yet, given history, there’s no reason to think that would be the case. For example, there are numerous people who consider the years of the internet bubble a glorious period. Just ask a Democrat about the Clinton era if you doubt it. Similarly, even Shiller hasn’t gotten over the housing bubble; he still talks about housing prices as if one’s home where an asset rather than a place to live.

It seems to me that the call for more data is based on the strong desire for more group think. Witness the negative reaction to those who publicly refuse to participate in a bubble or invest in ways to profit despite the bubble. The truly dangerous trend isn’t lack of data needed to identify bubbles. It’s the people who demonize those who see a bubble and act on that knowledge; then there are those like Shiller who pretend the bubble itself is the problem.

Saturday, May 7, 2011

Round two, just for fun

They’re still at it

If you missed round one, check out Round Two.
Fight of the Century: Keynes vs. Hayek Round Two

For my two cents, check out the posting from September of last year.

Thursday, May 5, 2011

Up, up and away in my beautiful balloon, or is it a bubble?

Gold may float like a butterfly, but remember the rest of the line.

The Hedged Economist recently participated in a discussion of gold verses dividend growth stocks entitled simply “Gold vs. Dividend Stocks.” The website,, is actually more like a collection of websites on different financial topics.

Since the discussion mentioned above, a number of people have asked about gold or touted it as an investment. Nothing that has occurred since the previous posting on gold has changed. (Gold: Be sure you know what you’ve hedged,Gold again,
and Worth repeating and, yes, gold again)
The price goes up and down, and gold remains a shiny yellow metal. It still hedges the same risks, has the same risks of ownership, and doesn’t produce a thing.

Some of the exchanges are presented below mainly in order to add perspective to the previous postings on this blog. In general, I find it interesting to talk with people who have actually followed gold and looked at its price over alternative holding periods. It’s a lot easier than talking with someone who only knows that he or she bought gold in at $800 in ‘79 and has a negative return after inflation. The really hopeless ones are people who discovered gold in 2006. Talking to them is like talking to the dot com believers of the late ‘90’s or people who bought stuff they didn’t need because their house had made them rich.

Comment received:

• I've still got the first 1 oz. Kruggerand I ever bought back in the mid-80's. It cost me a bit over $250.
According to the BLS inflation calculator $250 in 1985 would buy $519.14 today. I guess the spot price of $1453 today means I've done reasonably well over 26 years with an equivalent 'yield' of 4% above 'official' inflation compounding annually.
(1453 / 519.14 ) (1/26) = 1.0403 -> 4.03%
Not great, but it beats a poke in the eye. ;-)

The Hedged Economist’s response:

I have a similar story. However, using inflation as the risk and differences in return after inflation as the measure of performance, it appears 7.64% is the real compound average annual growth rate on the S&P when dividends were reinvested if the investment were made January 1, 1985, and 6.96% if made December 31. Those figures are as of end of year 2010. I can't claim I did the calculation. The data are from a website entitled Money Chimp (

The chimp says it uses the Shiller stock performance data and CPI as the inflation factor. I apologize for not knowing which CPI. If I explored the website a little more, I might be able to find it, but the reference was fine for the posting on timing investments that I was writing back in January. (Actually, I was checking my performance against that legendary chimp that often beats the professional investors. Don’t know if this is that particular chimp, but periodically the market makes a monkey out of most of us, so I thought I consult one).

The 4% return is why I refer to gold as a hedge similar to insurance. (See: Gold: Be sure you know what you’ve hedged) A 4% real return on an insurance policy would be nice to have. So, your K-rand makes sense from that perspective. (I didn’t check your math).

The only thing I accomplish by moving between mining stocks, gold miners, gold, etc. is to smooth the ride a bit (gold bounced around a lot). Also, occasionally looking for hedges that serve as alternatives to gold also keeps the amount invested lower than it would be if a gold exposure were the only thing one used. For example, for a while in the late ‘90s TIPS with over 3.5% real rates were available. Holding them gives one both an inflation hedge and interest rate exposure (two things one gets from gold). For me that allows me to keep more in stocks with growing dividends (d-g stocks). I also figure some d-g stocks, like energy producers, provide an inflation hedge.

There are things physical commodities hedge that no financial instrument hedges, namely a financial market freeze. But, then one still has to trade the gold. For many other risks, the choice between a 4% real return on gold or, for example, a +3.5% on a TIPS (when the TIPS offers a cash flow) is not a layup shot. For me, a stock’s return is more appealing for almost all my capital. I take the risk of a financial market freeze to get the greater return, but forgoing the higher return on the K-rand in storage isn’t going to bust most investors.

Another exchange on gold:

Comment received:

I have quadrupled my investments in gold coins and gold stocks in the past 10 years. Also, you can write covered calls on gold mining stocks, such as Goldcorp, to generate a 10 to 20 percent profit annually. So, do not tell me that gold does not produce an income. It certainly does. You just have to be knowledgeable and not prejudiced against gold like most people on this board.

The Hedged Economist’s comment:

Congratulations on Goldcorp (GG): it has been an excellent mining investment. But, also look at Barrick Gold (ABX) or Newmont Mining (NEM). It wasn't gold as much as a very successful miner. Now, in the precious metal space look at Silver Wheaton (SLW). Successful new ventures / stock issues in this space can do phenomenally well. Great pick.

I'm not real good at analyzing new issues of mining companies, so for new ventures and new issues I stick to other industries. In that space (i.e., new ventures) GG's performance would be a success -- but, the type of success one targets because not every new venture works out.

"The gold doesn't produce income" refers to physical gold. That will change if the regulatory proposal to allow gold as collateral on repo's is adopted. Right now I'm not aware of any way to write covered calls on physical gold. I would think it would be allowed on the ETFs. If you’re aware of something else, we're always interested in learning.

Nobody here is prejudiced against making money. We just each share our limited experience.

Another comment received:

With all of the talk above about gold being a hedge against various things (generally apocalyptic stuff), what's the hedge against gold losing its value? It's always been considered valuable, but its price has gone down from time to time (as noted above). What's the defense against that?

Full disclosure: I am by nature not prone to insure against risks other than the most obvious ones. I have car insurance and homeowner's insurance. I have enough life insurance to tide my wife over should I die. I have health insurance. That's it. None of my investments are hedged, unless you count sell-stops under my capital-gains investments as "hedging." I guess I don't find life nearly as much fun to live if I sit around all day thinking of all the things that could go wrong and then figuring out how to insure against every one of those risks. As lots of fear-mongers proclaim (and make a good living at proclaiming), the risks are endless. It seems like such a negative way to live.

I understand that therefore, I am unprotected against certain rare events that others are protected against. I'll take that trade.

The Hedged Economist’s comment:

For me, a hedge usually ends up being a long in something else. I'm always looking for something that zigs when other things zag. For me, the hedge to falling gold prices has been mainly stocks.

You mention "gold being a hedge against various things." I'd word it differently. I'd say "gold is USED as a hedge against various things." But, it isn't the only, or best, hedge for many of them.

If you’ll indulge me, let me give some examples. I’ve used other mineral miners to address some of the risks that gold is often used to hedge (long BHP, FCX). The stock of a senior gold producer whose cost per is below the price of gold will behave differently from a junior miner engaged in exploration or developing a new mine (long NEM). In a comment on another article I mentioned using TIPS (bought when they had attractive real interest rates) as a hedge against inflation. Many people use gold for that purpose.

Like you say, one should allocate resources based on probabilities. That's why I said I don't like the 5% in gold as a hard and fast rule. I can’t see any risk with a stable 5% probability that only gold addresses.

I have a slightly different philosophy. If I see a risk that I can eliminate at a low cost or with a positive return, I get rid of it. Then…“relax and enjoy life.”

EPOGOLG: This posting and the exchanges it reports were written between March 30 and May 1. Given developments this week, one additional comment: as the saying goes, “don’t try to catch a falling knife.”

Wednesday, May 4, 2011

Investing PART 13: Mutual funds (contd.)

Other fund categories: A fund for each season, but not for all seasons.

So far, funds have been discussed in terms of assets held in the funds. It’s a logical starting point: after all, the assets one owns are important. However, a mutual fund makes ownership an indirect affair. So, this posting address some categories of mutual funds based on characteristics of the fund one is letting own one’s assets. That is also important.

Let’s quickly dispense with load verses no-load funds by reviewing a little history. Load funds charge a fee / commission to buy the shares. Originally funds with a load tried to sell directly to the public. Competition from no-load funds killed that fast. Mutual fund salesmen where able to keep load funds alive for a while, but then the “mutual fund salesman” went the way of the dinosaur. The fund companies shifted to stock brokers and insurance salesmen as sales agents. Why anyone would buy based on a broker’s recommendation for a mutual fund escapes me. The history of the industry on stock recommendations should at least provide a caution. It’s equally curious that anyone would think representing a good insurance company qualifies a person to pick mutual funds.

The most recent incarnation of the mutual fund salesman is the financial planner. This is a true disgrace. It’s one thing for a person to say they’re a salesman (as are brokers and insurance salesmen) to then sell you something. It’s disgraceful to represent oneself as providing a planning service when in fact you’re a commissioned salesman. Fortunately, fee-based planners and wrap fees (an annual fee based on assets being managed) are creating pressure on commissions.

Alas, however, there are planners who “double dip” (i.e., charging a fee and taking commissions). One suspects that the days of double dipping are numbered. What this little tour down memory lane should make clear is that the existence of mutual funds with loads involves an unnecessary sales cost. People who plan to invest should just avoid them as a general rule.

Another way the mutual fund offering can be segmented is based on whether they are closed-end or open-end. Closed-end funds have a fixed number of shares trading on the stock exchanges. The shares trade at prices that can substantially differ from their Net Asset Value (NAV). There can be many reasons why the fund may trade at a price that differs from the value of its assets. People who trade closed-end funds tend to become specialists on the topic of NAV-to-price gaps. More power to ‘em, but the phrase “trade closed-end funds” sums up the issue. Closed-end fund trading is different from long-run holding.

There is another important point. Some closed-end funds in both the stock and the bond fund space use leverage. They borrow in order to expand their asset base. Letting someone manage the leverage in one’s portfolio doesn’t seem like a good long-run strategy. At times, using short-run loans to purchase longer-run assets makes sense, and closed-end funds may be able to access markets that most investors can’t access such as the repo market. However, the use of leverage as a tactic or even as a strategy is very different from just turning it over to a fund manager.

Just to round out this list of things not to like, let’s look at Exchange Traded Funds (ETFs). Most people don’t get past the lower fees when they consider ETFs. Then many people trade in and out so quickly they never benefit from the lower management fees. Those lower fees CAN be a big benefit if the ETF is liquid, but one has to hold the ETF long enough for the lower fees to offset trading costs. Remember there are bid-ask spreads and potential brokerage fees (currently waived on the ETF trade by some brokers for some or all customers).

Stop for a moment and consider why a money manager would create an ETF. The first thing you’ll notice is that many of the initial ETFs weren’t created by pure money managers. They involved organizations with an interest in making a market (i.e., organizations that make money based on the volume of transactions). Consider this perfectly reasonable spawn-of-the-devil explanation for their origin:

A bunch of market makers get together to commiserate about how hard it is to earn a decent 7 figure bonus when investors just buy an S&P 500 index (or any mutual fund) and don’t trade. When that happens, the only time the market maker earns any money is when the stocks trade in order to accommodate a fund being liquidated by an investor. Since index funds buy the entire index, they don’t even impact relative performance which would at least produce some trades as the composition of the index changed.

Finally Stanley turns to Morgan and says, “If only we could get investors to trade the index.” Morgan being trained as a market maker says, “Yes, and in a way we can get more than one transaction out of it. We could really leverage our high frequency trading platform then. We could take some when they trade the index AND when the stocks in the index get traded.” Just then Stanley jumps up and shouts “I’ve got it! The problem is they need a way to do it.” Thus, a first was born: an investment vehicle perfectly tailored for investors who don’t want to commit to their investment for a full day.

Suddenly Morgan’s mouth starts to water. “To heck with just tapping the S&P index, we’ll spawn a whole family of indexes, use any old index we have laying around and create new ones if we have to.” Stanley senses irrational exuberance and realizes he had better interject some reality into Morgan’s get-rich-quick scheme. “Remember the index fund industry is competitive. We’ll get some boost from the trading, but we’ll be stuck managing a bunch of low fee funds.”

Now, Morgan’s true brilliance shows through. “Stanley you’re not thinking outside the box. We can double the benchmarks; one trade of the ETF will result in multiple trades of the underlying assets. The leverage possibilities are boundless and won’t even involve margin restriction. People may not even recognize how leveraged they are.” Morgan’s on a roll now: “Better yet, we’ll create perishables: we’ll offer ETFs with options as the underlying asset. Even offer ETFs that only track a benchmark for as little as a day. We’ll invent day trading in mutual funds. We’ll be famous. No, come to think of it, let’s stay anonymous. This is going to blow up for some traders. We’ll just take the money.”

Stanley, now infected with the sprit, but trained as a broker rather than a market maker, interjects a flash of brilliance. “With stocks, it’s really hard to churn-and-burn anymore. But, with asset classes, it’s a brave new world. I’ll bet with a little ‘education’ we can get the account holders to do the churning. We’ve got historical data on returns for different asset classes. All we have to do is show historically how moving assets between classes improved returns. It won’t be hard; it IS history after all.”

Morgan, ever the optimist where his ideas are concerned, suggests they might get a book out of it if they can think of a sexy name for it. “We’ll wait to publish. After all, having all those added assets moving between asset classes, especially with the added trading leverage, will make all the assets more volatile. If it works and produces more volatility, a little more history will make it look even better.”

Did this conversation take place? No, but it’s probably a decent reflection of someone’s thinking. Yet, spawn of the devil or not, some investors have learned how to make ETFs work for the investor. In so doing, here are a few things to keep in mind.

Having the commission on an ETF trade waived doesn’t make the trade costless. There can be an explicit bid-ask spread. High frequency traders with access to order flow (i.e., the buy and sell orders) can front-run the trade in the ETF. The same process can be repeated on the underlying assets if they need to be traded in order to manage the ETF’s NAV to price relationship. Further, there can be commissions on the trades of the underlying assets. Those commissions are a cost that the investors will bear. For the ETF purchaser, trading cost may be hard to identify and manage. Thus, the entire churn-and-burn damage could go undetected.

Even without churn-and-burn, ETFs aren’t cheaper than a decent stock portfolio. I recently saw this example, “The all-ETF portfolio might reduce hassle, but it is going to be FAR MORE EXPENSIVE for most! (It may be cheaper for some "just getting started" investors.)

DLN is listed at 0.28% and DGS at 0.63% expense ratio. [DLN and DGS are two stock ETFs.] By the time you have $30,000 invested equally between those two ETFs, you will be paying $273 per year (and climbing as your portfolio grows, we hope). $273/year is more than I pay in trading costs, and my portfolio is significantly more than $30,000 and I am spread between 6 accounts! (I used $30,000 because in the article $20-$30K is the range where no holding will be over 10% of the portfolio.)

[Stock] investing is not about trading, so trading costs are already minimal which means investment expenses of even a cheap fund look high.”

There is tail risk with EFTs. No one can predict how they will perform under stress conditions. ETFs are somewhere between a closed-end fund and an open-end fund. If trading in the ETF is too brisk, the ETF may not be able to keep the price equal to the benchmark (i.e., NAV and price may drift apart). There already are examples of these disparities continuing for months in some specialized ETFs. Even if the NAV and price don’t drift apart, the cost of keeping them aligned could skyrocket if bid-ask spreads on the underlying assets open up.

While most ETFs are like other mutual funds, some commodity-based ETFs are treated differently from other mutual funds for tax purposes. However, that is only an indication of a deeper problem an ETF investor has to consider. It seems market makers will generate an ETF for anything they think people will trade. They have no incentive to restrict their attention to investment vehicles. Thus, knowing what an ETF holds is even more important than with other mutual funds.

The very proliferation of types of ETFs is often advanced as a blessing ETFs make available. Investors can use ETFs to take positions in all sorts of exotica. But, it seems, those investors holding stocks and some bonds of companies that make things people want often get better portfolio returns. But, as always, it depends on the time frame picked and the length of the holding period. Yet, those who tout ETFs because of the range of assets they offer don’t realize that “more options” is NOT the same as “better options.”

Tuesday, May 3, 2011

Investing PART 13: Mutual funds (contd.)

Bond funds: But don’t form a lasting bond.

Bond funds present even more problems the stock funds. With a managed bond fund, at a minimum, one is betting that the fund manager can forecast (i.e., guess) the direction of rate changes. Further, the manager will then use that guess to achieve performance that is relatively good compared to his or her benchmark. That benchmark may have nothing to do with why you own the fund.

If the fund isn’t restricted to a particular type of bond (e.g., government, corporate, prime, high yield, etc.), one is also betting on the managers’ ability to anticipate and capitalize on changes in spreads (i.e., the differences in rates on different types of bonds). If it’s an international bond fund, it often contains currency risks based on the value of the holders’ currency verses every other currency in the portfolio. If the manager tries to hedge out the currency risk, the hedge itself introduces its own risks (i.e., performance, liquidity, counterparty).

Overlay on that bundle of risks the main issue which is the analysis of the financials of the institution issuing the bonds in the portfolio. Given all the considerations, it isn’t too surprising that many bond funds just skipped doing the financial analysis and relied on ratings. But, bond fund fees are often significant. One has to wonder how the fees were spent if not for analyses of the investments being made.

However, the most important thing to remember about bond funds is that they fluctuate in value. Many advisors recommend adding bond funds to a portfolio in order to get more stability in the value of the portfolio. The important point is that their objective is to add volatility in the value of individual assets that offsets the cycles in stocks. The logic is based on modern portfolio theory (MPT). MPT implies that two volatile assets that fluctuate in different patterns, one going up when the other is going down, will produce a better return than a single more stable asset. It’s all very logical if one accepts the basic thesis that more volatile assets have better returns. The historical evidence is that it seems to be true. The historical exceptions are so narrowly defined that they are considered more the exceptions that prove the rule than a cause to question the usefulness of MPT. Since the historical data is the input into the analysis used to develop the theory (i.e., MPT) that isn’t too surprising.
There are three things to dislike about an approach that relies on bond funds. First, it is very hard to find a bond fund that makes money after inflation “through-the-cycle.” Most, bond funds have major downturns at various points in the business cycle. If held for long periods of time (through the default cycle and the interest rate cycle), they just barely earn more than inflation or lose real value. Note that the logic of adding them to a portfolio depends on rebalancing, a crude form of timing.

The second thing to dislike is that as an asset class bond funds are often presented as stable. They are NOT stable. Prices and yields fluctuate. They fluctuate because bond prices, interest rates, and default rates all fluctuate. Further, they aren’t CDs. Bonds in the fund are traded. The bonds in the fund have the same trading risk as stocks as well as greater liquidity risk than broadly-traded common stocks.

The last reason to dislike bond funds concerns substitutes. It is just too easy for an average Joe to buy better alternatives. A group of bonds organized so that maturities coincide with life events reduce uncertainty vary efficiently. Value at target dates is known, current market price is known, yield is known, and if the intent is to hold the bonds, yield to maturity is known. With a bond fund market price is known and current yield is known. In exchange for knowing future yield and future price, one gets liquidity, fees and a bond trader.

From what has been said you probably figured out that The Hedged Economist is not a fan of either general stock funds or almost any bond fund. That covers a lot of territory. There are other ways to segment the mutual fund industry. They’re the topic of a future posting.

Monday, May 2, 2011

Investing PART 13: Mutual funds (contd.)

Stock funds: It is amazing they get away with this stuff (i.e., their sales pitches)

This series on investing started with a reference to an article that talked about asset mix. It used mutual funds in the illustration. Note that the definition used throughout the series has included all types of funds including Exchange Traded Funds (ETF)s.

The previous posting discussed some potentially positive uses of mutual funds. This posting starts a discussion of some misconceptions and downright destructive aspects of mutual funds. Since there is a lot to cover, it’s going to be broken down based on broad categories of funds. The first category and the subject of this posting is stock funds.

It is very important to note that in the first part of this posting diversification was NOT among the reasons for owning a mutual fund. A mutual fund can provide diversification, but usually only within an asset class and, in most cases, far beyond any reasonable level. Using large cap stocks as an example one could chose 10 to 20 stocks with an eye toward avoiding industry overlap and companies with similar reactions to the economy. The resulting portfolio would provide more of the benefits of diversification than most mutual funds.

Mutual funds make it more complicated, not less. There are more mutual funds trading stocks than there are stocks on the New York Stock Exchange. So, the belief that it’s easier to pick a mutual fund than a stock rings hollow. Further, with mutual funds there’s less performance data. For historical data, with a mutual fund one basically gets price data, unless it’s a new fund, in which case, one may not even get that. For most funds digging to get historical cost data beyond a few years or historical holdings is far from easy. Tenures of fund managers aren’t easier to forecast than management tenure at a corporation. It would seem that who is going to run the place is worth knowing. Getting historical data on dividends and capital gains distributions for a mutual fund seems a lot harder than getting data on the history of a corporation’s dividend. Dividends and capital gains are basic information on the cash flow generated for investors.

Basically, if you’re willing to make the long shot bet that the fund manager is going to pick winners, managed mutual funds make sense. But, it’s a long shot. Most fund managers don’t beat the market even before fees. One should be careful how one interprets such statistics. Keep in mind that not all mutual funds try to beat the overall market. But, the fact remains.

Some people advocate index funds as a response to the underperformance risk. Index funds, a specific type of mutual fund, are specifically designed to reflect the value of a specific type of asset. Generally they do. That’s almost always true of traditional index mutual funds and generally true of index ETFs.

Bogle, the founder of Vanguard, argues that it’s folly for anyone, professional or individual investor, to try to manage a stock portfolio. When boiled down, his argument is based on the assumption that the performance of a capitalization-weighted index should be one’s objective. That’s ridiculous. Why not seek a lower volatility or some other objective? Others have argued for other weights, but the entire logic hinges on some weighting scheme matching one’s objective. That’s equally silly. Ultimately, no weighting scheme can match your timing requirements, tolerance of volatility, etc.

Joel Greenblatt, founder of New York hedge fund Gotham Capital and author of 2005's "The Little Book That Beats the Market," launched a family of mutual funds. He obviously has skin in the game since he’s launched his own index fund based on his weights. Nevertheless, his critique of cap-weighted funds is worth noting. Weight uses market capitalization to decide how much importance to put on individual stocks, after adjusting for the amount of shares available for the public to trade. Cap-weighted funds, he argues, are forced to overpay for wildly popular stocks.

About all index funds have going for themselves is low expense ratios, But that’s no guarantee the expenses will be lower than a self-managed portfolio. For example, it isn’t that hard to pick a portfolio of a dozen stocks that would pretty much track the S&P 500 over a decade or two with no costs other than the initial commissions. The important point though isn’t just cost. The important thing is what the index represents. If it’s a stock index, it will be just as volatile as stocks. If it is held long run, expect big down years. If it’s a bond index fund, it is just an interest rate play and one you don’t control.

With index funds, it gets especially important to know what makes up the index and how the fund imitates the index if the index is for a specialized sector. Sector ETFs are a case in point. They often are proxies for a few company stocks, including stocks one might not buy if presented separately along with their financial data.

Thus, while there are ways to use stock mutual funds, an awful lot of what’s said about their benefits is non-sense. Sales pitches have content. Generally, the more content the better the pitch. But, they’re a pitch, not financial advice. Don’t confuse one for the other.