Monthly Archives: February 2010

Kindle economics (I)

February 10, 2010 By in Books, e-readers, Industry Analysis, Publishing Tags: , , , 2 Comments

As a consumer,

I’m still not sure whether e-readers will have staying power and become mass-market devices, or whether they’ll be superceded by some more general device, like a netbook or smartbook or tablet, for which reading will be one of many functions.

I happen to own a Sony e-reader, one of the smaller-sized new models, which I like.  I don’t miss the feel of the paper, or the larger size of the pages, or the tactile message of how much of the book I’ve read.  The most striking negative–for me, anyway–is the lack of a backlist (an issue of publication rights and the subject of a later post).  And, of course, I can’t look for better prices from Barnes and Noble or Amazon, nor can I consider buying a used book instead of a new one.

As an investor,

on the other hand, these questions may not be relevant.  The investment issue is whether there’s a way to make money from thinking through the phenomenon of e-readers and figuring out who, if anyone, will profit from them.  It would be an added bonus if the conclusions were not yet widely known.

Let’s start the process by looking at the Kindle from Amazon.

The Kindle

Two perspectives: Continue reading →

State Street’s Limited Duration Bond Fund: an ironic name for a cascade of poor judgments

February 9, 2010 By in Banks, Getting financial advice, hedge funds, Industry Analysis, Where are the customers' yachts? Tags: , , , , , , Leave a comment

The demise of hedge fund investment pools

I’ve been watching the demise of hedge funds over the past few years with what one might call a morbid mix of horror and fascination at the potent mix of marketing savvy, personal arrogance, snake oil and stunning technical incompetence the principals involved have displayed.

…and then there’s State Street

The case of State Street and its Limited Duration Bond Fund is an odd one.   The fund was sold as the equivalent of a money market fund, but ended up making speculative investments (which it misled investors about) using large amounts of leverage. It lost 80% of its value in the last twelve months it was in operation.

State Street recently settled SEC and State of Massachusetts charges by paying fines and reimbursing investors.

It’s rare in today’s world to see a large company, particularly one that projects an image of all-American values and stodgy reliability, to show itself to have no internal moral/ethical compass–nor, it would seem, either a compliance department or any deep knowledge of securities laws.  Also, no one seems to care.

The New York Times article

I first read about State Street’s settlement with the SEC and the state of Massachusetts in an article in the New York Times, titled “State Street Gave Some of Its Clients Better Data.” Huh?  Maybe its reporter/reader fatigue.  Maybe the blowup of a sub-prime mortgage investment pool isn’t news any more.  Maybe a disaster has to be big enough to bankrupt a company–which this wasn’t–to get any attention.

I find three things surprising:

–top management either had no clue about what was going on in the investment management business, or turned a blind eye;

–no one involved in the affair–no portfolio managers, compliance people, supervisors, marketers…stood up at any point and said “What we’re doing is wrong.” (you’ll see what I mean if you read the details below); and

–State Street got a slap on the wrist, and nothing more, from the regulators.

Here’s the story:

..or at least my summary version of it.  (You can get the full details from the State of Massachusetts consent order or the SEC “cease and desist” order.)

1. In 2002 State Street began offering the Limited Duration Bond Fund to institutional investors as an “enhanced cash fund.”  The marketing pitch was that it had all the safety of a money market fund, but with higher returns.  It could do this because it was investing in short-term asset-backed securities and some derivative instruments.  The fund might have some day-to-day volatility.  But it would remain widely diversified, more so than the typical money market fund, would restrict itself to high-quality credits and would use only “modest” leverage, if any, to achieve its goals.

(The idea of a “free lunch” is probably as old as investing itself.  People love it.  Invariably, I think, the investment strategy is based on a market anomaly that gradually disappears.  Then the concept blows up.)

As time passed, the fund increased its exposure to sub-prime mortgages, apparently figuring this was the only way it could generate yield. By the end of 2006, sub-prime had become the majority of the fund’s investments.

Shareholders, however, continued to be informed that the fund was widely diversified and involved only with high-quality credits.

(Where were the compliance people, the internal regulators who are supposed to make sure something like this can’t happen?  How could any responsible person sign the letters to shareholders?)

2. In 2005, State Street changed the way it disclosed portfolio contents to clients.  Previously it had shown the amount of leverage employed by having the portfolio contents add up to a number higher than 100%.  So if the portfolio was 115% invested, for example, that would mean that its market exposure was equal to 115% of the assets under management.  The extra 15% would be achieved through option-like derivatives.

From that point on, however, it showed the funds weightings only as a percent of the total market exposure, without reporting the amount of leverage in the fund.  All investors saw was market exposures adding to 100%.

According to the SEC, by 2007 the fund was no longer using “modest” leverage.  Routinely, 150%+ of assets were invested in sub-prime mortgages.  The new reporting format meant investors couldn’t see this change.

(Compliance?  Management?  who doesn’t see the red flag? could the change to less disclosure have merely been a coincidence?)

3. At some point, State Street decided to allow other internal finds to invest up to 25% of their assets in Limited Duration.  Through contact with the common trading room, membership on the firm’s investment committee and special detailed in-house reports not made available to outside clients, these internal customers learned the true situation with Limited Duration.  As a result, a number withdrew their funds during the summer of 2007.

State Street did not tell outsiders that insiders were selling.   Instead, it continued to assure them that nothing was wrong.  At no time, however, did it reveal the extent of the fund’s sub-prime holdings or its high leverage.  In fact, some external client contact agents told regulators that they were unaware there was any sub-prime exposure.

In one case where an external client withdrew money and then sued, State Street blamed the client for creating the losses by panicking out of the fund at the wrong time!

(Being a fiduciary means taking care of your client before you take care of yourself.  New concept for State Street.)

4. To add insult to injury, when State Street withdrew its internal money, Limited Duration portfolio managers used the most liquid securities to pay them–leaving the least liquid assets for the trusting outside customers.

(Maybe they had no choice, although the SEC says the investment committee discussed how to raise cash to meet anticipated redemptions.  Normally, a portfolio manager works first on selling the least attractive, less liquid assets.  This is partly because selling may take longer, but it’s mostly to avoid the outcome of being stuck with only unsaleable assets in the portfolio.)

Another look at the EU’s problems with Greece

February 8, 2010 By in Current Market Thoughts, hedge funds, Recent Market Action Tags: , , , , 2 Comments

The European Union vs. the Eurozone

Speaking in the most general terms, the EU is the post-WWII federation of European (including the UK) nations with three main objectives:

1.  promoting closer social, cultural and political integration, in order to deter future pan-European warfare;

2.  encouraging faster economic growth, and the development of large-scale European-owned enterprises that would have the size to compete in an increasingly global world (read: to counter developments in the US), and, at the same time

3. preserving national political institutions (because no politician wants to give up his job).

The Platinum Elite form of membership in the EU is to be part of the Eurozone, meaning adopting the € as a currency and becoming subject to the monetary policy determined by the European Central Bank.

qualifying for the Eurozone Continue reading →

More hedge fund fudging

February 5, 2010 By in hedge funds Tags: , , , Leave a comment

BlueBay Asset Management is a “leading specialist manager of fixed income credit” for “institutional” investors, based on London.

According to an article in the Financial Times yesterday, the former manager of the firm’s emerging markets fund (since shut down) has been disciplined for deliberately misstating the price of securities in his portfolio during the summer and fall of 2008.  Apparently, the manager got prices from one or more of his brokers, went into his office, altered the figures to provide a more favorable picture, and passed the “enhanced” numbers to his back office for processing.  According to the FT he then lied to regulators when they came to investigate.

The penalty for doing this?–a lifetime ban from the investment management industry and a fine of £$200,000 (less a 30% discount for prompt payment).

Does this episode sound as weird to you as it does to me?  How so?

1.  In dealing with a long-only manager, standard procedure for institutions is to have a custodian for their funds who’s separate from the asset manager and who prices and reports performance directly to the client.  It sounds like this didn’t happen here.

Maybe this preserves the hedge fund mystique.  It certainly prevents the client from seeing that the high-fee manager and the conventional one may have basically the same holdings, and in the same proportions.

2.  What kind of institution would allow this?  Maybe, BlueBay has a very broad idea of what an “institution” is, since this not getting independent pricing sounds more like the behavior of an inexperienced high net worth individual.

2.  Who prices internally any more?  Twenty-five years ago, it was common in the US for smaller asset management companies to price portfolios themselves.  But the junk bond crisis of the late Eighties brought home that the potential liability from doing this with illiquid assets was too great.  Yes, asset managers still run their own pricing, but as a check on the official pricing done by the custodian or third-party pricing service.

3.  No sane portfolio manager wants to be a key element in the process of pricing his own portfolio.  There’s no upside.  The only thing that can happen is bad–questions after the fact about the accuracy of the pricing.  It doesn’t matter whether the prices are alleged to be too high or two low.  Someone buying the portfolio is disadvantaged in the first case, a seller in the second.

It’s true that third parties don’t always do a stellar pricing job.  I had a custodian once (a famous firm on the East Coast of the US) who kept mixing up Malaysian ringgit and Singapore dollars.  Depending on which currency they would input for my Singapore holdings, the value could swing by 50% from day to day.  The firm was also not very good at first in accounting for Asian stock splits.  But the reconciliation of the manager’s records with the custodians will find and fix problems like this.  And over the years pricing services, at least for equities, have gotten a lot better.

4.  The Financial Services Authority, the SEC of the UK, took no action against BlueBay itself.  I find this strange, too.  Maybe the practice of having the manager price his own fund is acceptable in the UK.  It may well have been permissable in the US at one time.  But it hasn’t been for at least twenty years.  I think in New York the firm would be found negligent for failing to have even elementary, easy-to-implement procedures–like having the trading desk or the back office get the price quotes directly–to avoid this conflict of interest.