Category Archives: Getting financial advice

“Are You a Stock or a Bond?”

April 16, 2012 By in Constructing a Portfolio, Getting financial advice, Portfolio management Tags: , , , , , , , Leave a comment

That’s the title of a book a friend gave me recently to read.  It’s written by Moshe A. Milevsky, a finance professor at York University in Toronto.   It’s well worth reading.

insurance as a hedge

Mr. Milevsky has had a life-long fascination with insurance.  So the book has comments on the role of insurance as a hedge against loss of a family breadwinner’s income.  There’s also a section on using annuities to stabilize retirement income flows.  There’s even a brief discussion of a precursor of the annuity, the tontine–an arrangement (devised by Lorenzo Tonti) where a number of elderly people invest money jointly and meet after a specified time to split the proceeds among the survivors–as one basis of the annuity’s appeal.

There’s also the usual academic nonsense about efficient securities markets, although that’s not crucial to the book’s message.

human capital

The most important aspect of the book, to my mind, is that it points out the crucial importance of considering one’s human capital when making a personal or family investment plan.  For almost everyone, a lifetime’s earnings from working will be their largest single source of economic wealth.  Yet people tend to take a very narrow approach when planning for diversifying their financial assets and ignore their human capital completely.  As a result, they overlook two important considerations:

1.  Are you, seen as your human capital, a stock or a bond?  That is, does your income have the potential to swing significantly from year to year and is your continuing employment highly contingent on continuing strong performance?   …or are you in a job where your future income is very predictable and where you’re highly unlikely to be forced out of work?

Entertainers, salesmen or money managers are like stocks;  tenured professors are the ultimate bonds.

People with very conservative preferences may be attracted to bond-like professions, and the less risk-averse to stock-like ones.  If each treats his allocation of financial assets as a completely separate topic from his choice of a career, then both will end up with incompletely diversified economic portfolios.  The professor will end up with too much bond exposure, the investment banker too much stock.

2.  How old are you?  Milevsky’s analysis here arrives at the conventional result.  A 22-year old college graduate has an immense economic resource in the present value of his future earning power.  So he can take a lot of risk with his financial assets.  For a retiree, on the other hand, the earnings gas tank is at empty.  So his financial asset allocation must be more conservative–both relative to his own past allocations and in an absolute sense.

(Are You a Stock or a Bond?:  Create Your Own Pension Plan for a Secure Financial Future, Moshe A. Milsvsky, PhD, FT Press, New Jersey, 2009)

 

 

why is it so hard to stay ahead of a rising market?

April 3, 2012 By in Absolute vs. relative performance, Constructing a Portfolio, developing competence as an investor, Getting financial advice, growth vs value, Portfolio management Tags: , , , , , , Leave a comment

staying ahead of a rising market is difficult

That’s the cliché, anyway.  And, for what it may be worth, my experience is it’s true.  It’s much harder to stay ahead of a rising market than a falling one.

but why?

Let’s first get a technical, or maybe a definitional, point out of the way.

The world consists of growth investors and value investors–both, by the way, claiming to be in the minority (because that’s cooler than being run-of-the-mill).  Value investors stress defense.  They’re more risk averse.  As a result, they typically make their outperformance during the part of a market cycle when stocks are going down.  Of course, they’d like to outperform an uptrending market.  But because they put defense first, deep down they know they should be satisfied (even ecstatic) to keep pace in a rising market.  Their approach to the stock market, their longer term strategy, is to protect against possible downside.  So they know that not falling too far behind is the best they can realistically hope for. Let’s not count them.

So our question really is:  why is so hard for growth investors, whose strategy calls for them to make their outperformance in an up market, to do so?

I think a lot is due to the fact that a rising market attracts substantial amounts of new money to stocks.  Not only that, but the new money doesn’t come in all at once; it arrives at different times.  depending on timing, new money can create demand for many stocks, not necessarily those best positioned to benefit from the bull run.

For example:

– (Almost) every professional investor is taught from day one not to “chase” stocks that have already risen a lot before he starts to look at them.  Instead, he’s told, look for stocks that may not be quite as good but which haven’t moved yet.

Someone late to the smartphone party might not buy Apple or ARM Holdings.  He might buy Qualcomm instead.  Money arriving later still might gravitate toward a contract manufacturer like Hon Hai, or to Intel, or maybe even Verizon or Sprint, on the idea that smartphones or tablets will add oomph to those businesses.

These latter stocks may not necessarily be the purest plays or the greatest companies, but buyers will tell themselves (sometimes rightly, other times wrongly) that the risk/reward tradeoff is better for them than for the more expensive “pure play” stock like AAPL or ARMH.

Put another way, when the leading lights of an industry make a major move upward, they tend to drag a lot of the lesser lights along with them–at least to some degree, from time to time and with a lag.  It’s very hard psychologically–and arguably not the best idea financially–for someone who has identified a trend early and holds all the major players to rotate away from them and dip down into second-line stocks to play these ripples.  But during a period while others are playing catch-up by bidding up the minor stocks, the holder of industry leaders will underperform.

–There’s also a more general arbitrage in an up market–in any market, really, but more so when stocks are moving up.  It’s not only among relative valuations of participants in an industry which is on Wall Street’s center stage, but between that industry and other sectors/ industries/stocks.

Let’s say that tech stocks have gone up 40% in the past six months, while healthcare names have lost 5% of their value.  At some point, even tech investors will start to say that healthcare stocks look relatively cheap.  As this perception spreads, the market will direct its new money flows to healthcare.  Investors may even begin to rebalance–selling some of their tech stocks, and using the funds to buy healthcare, until a better relationship in valuation is restored.  While this is going on, anyone overweight tech and underweight healthcare will probably underperform.

should you want to outperform all the time?

If there were no tradeoffs, the answer would be easy.  But there are.

–All of us have different goals and objectives.  Younger investors, for instance, will probably want maximum growth of capital.  Older investors may want preservation of income, instead.  The former objective is consistent with trying to shoot the lights out in a bull market.  For the latter, that strategy is too risky.

-Not everyone has the temperament to be good at investing.  That’s just the way it is.  Someone who falls below the market return year in and year out should realize that for him active management is an expensive hobby.  Index funds would be a better wealth-building alternative.

–We also have different knowledge bases, aptitudes and interests.  That may make us better at defense than offense, or better at value investing than growth.  As in just about everything else, we should play to our strengths, not our weaknesses.

–Contrary to the wishes of the marketing departments of investment firms, no investor–not even the best professional–outperforms 100% of the time.  The other team eventually gets a turn at bat.  If you can outperform for two or three years out of five, and if your overall results match or exceed the market return for the half-decade, that’s more than enough.  That would put you deep in the top half of all professionals.

I don’t think this last is a crazy expectation for a non-professional.  Investing is a craft skill, like, say, baseball or shoe repair.  It can be learned.  Knowing a few things better than the market does will likely bring better than average long-term returns, even with occasional bouts of underperformance.

TVIX: an expensive lesson about an exotic exchange traded note

March 30, 2012 By in Derivative instruments, ETFs Vs. Mutual Funds, Getting financial advice, short selling, Where are the customers' yachts? Tags: , , , , , , , , Leave a comment

TVIX

TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

why do pension plans choose hedge fund and private equity managers?

January 27, 2012 By in Getting financial advice, hedge funds, Private equity Tags: , , , , , , Leave a comment

private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?

correlation

The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

the SEC, Citigroup and moral hazard

December 1, 2011 By in Banks, Derivative instruments, Industry Analysis, Investment firms, moral hazard, securities markets, Securities regulation, short selling, Where are the customers' yachts? Tags: , , , , , , , Leave a comment

This is an update and elaboration on my November 11th post about Judge Jed S. Rakoff, the SEC and Citigroup.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Follow

Get every new post delivered to your Inbox.

Join 100 other followers