William Ackman and Automatic Data Processing (ADP)

Pershing Square, the hedge fund founded by well-known investor William Ackman, established a position in business services company ADP earlier this year.  Arguing that ADP was poorly managed–a problem Ackman said he could fix–he nominated himself and two associates for election to the board of directors of the firm.

Results of voting were released last week.  None of the three Pershing Square nominees were elected to the ADP board, despite Ackman being recommended by the three major shareholder advisory firms (the other Pershing Square nominees were recommended by two of the three).

Ackman has proclaimed this result as a victory for him, in that his nominees received about a quarter of the votes cast.

I’m not convinced.  Here’s why:

In early days of my career, institutional investors generally didn’t pay much attention to voting on corporate proposals. Generally, if they voted, they cast their ballots with management.  In the early 1990s, though, the SEC criticized the industry for this attitude and strongly reminded investment managers of their fiduciary obligation to study corporate issues carefully and vote their shares in the best interest of their customers.


I witnessed the early days of dealing with this new requirement.  Time had to be found for a meeting of all the portfolio managers who held a given stock. Consensus was very often hard to come by.   On the other hand, having having a money manager cast votes on both sides of an issue was at best a dubious proposition.  Lots of lawyers, both inside and outside counsel–none of whom had any clue about the relevant investment issues–had to get involved, as well.  A real mess.


Proxy solicitation firms saw a chance to radically transform their business.  They began to provide third-party voting advice, which was formulated by newly-hired teams of specialists in investment law.  These services were an instant hit.  Portfolio managers could get back to the work they knew best; investment management firms could rest easy, knowing that their taking advice from an objective third party would be a good  defense against any complaint they were not taking their fiduciary obligations seriously.

For at least the past twenty years, the policy of money management companies has been to follow the advice of firms like ISS, Glass Lewis and Egan-Jones, unless there are very strong reasons to do otherwise.  All three recommended that institutions vote to elect Ackman to the board.  Yet, despite the fact that institutions own 83% of ADP’s shares (according to Google Finance) neither Ackman nor the rest of his slate were elected.

This is not even a moral victory, in my eyes.  Just the opposite–it’s a surprisingly weak showing.  Of course,  the fact that the shares of JC Penney (JCP) are now trading below $3, can’t have helped.  JCP was another high-profile turnaround target of Pershing Square’s at $25 or so a few years ago,

daily volatility, non-correlation …and beta (ii)

This post is about hedge funds.

hedge funds:  a purist’s view

To a purist, a hedge fund is about hedging.  That is, it’s about running a portfolio with offsetting long and short positions.

Conceptually, this can be done either by assembling pair trades (one long, one short, often both in the same industry) or by creating opposing portfolios of good ideas and clunkers.  By using the money obtained from borrowing, and then selling, the hoped-for clunker stocks to fund the hopefully strong-performing good ones, the hedge fund manager ends up with no net exposure to the securities market he’s working in.  His return consists in the spread, if any, between the performance of the aggregate long portfolio and the shorts.  In a perfect world, he never loses money, although the amount he makes in a given year is up in the air.  It depends on the relative valuations of the “good” and “bad” securities that his market gives him.

(By the way, I worked on, and briefly ran, a very successful short-only portfolio for an innovative institutional client in the early 1980s. We pruned “bad” stocks from an S&P 500  index fund and reinvested the money in the rest of the index.)

today’s version

In today’s world, hedge funds are a motley group of mostly strongly net long, mostly highly concentrated portfolio strategies.  They do have common characteristics, though.  They charge very high fees, and as a group they’ve underperformed the S&P 500 pretty continually for more than a decade.  Also, many times it’s hard to get your money back if you no longer want to participate.

why institutional support, despite weak returns?

Why do pension funds continue to support hedge funds with a tolerance for weak performance they would never exhibit with long-only managers?

Two reasons:

–the claim of non-correlation with stocks and/or bonds.  This is basically a rerun of the fallacy of gold as a zero-beta asset, and

–the low expected return from stocks and bonds.  To pluck numbers out of the air, let’s say that over the next five years we can expect returns of 2% annually from bonds and 6% from stocks.  A portfolio made up of equal portions of both asset classes would have an expected return of 4% per year.  Suppose the actuarial assumption of a plan sponsor is that the plan is fully- or mostly-funded if the plan can achieve of 5% annual returns–or maybe 6%.  The plan managers, who hire outside portfolio help, have no way of get to either goal using conventional long-only investments.  That’s even going all in on stocks, which sponsors find too risky.  So the managers can either tell the sponsoring organization to add more money to the pension plan   …or they can hire hedge fund managers with pie-in-the-sky stories of high potential returns.  Until very recently, my observation is that they’ve by and large chosen the latter.





uncorrelated returns: hedge funds as the new gold

Every stock market person knows what beta is.

It comes from a regression analysis, y = α + βx, where y is the return on a stock and x the return on the market).  It shows how a given stock’s past tendency to rise and fall is linked to fluctuations in the market in general.  A stock with a beta of 1.4, for example, has tended to rise and fall in the some direction as the market, but move 40% more in either direction; a stock with a beta of 0.8 has tended to exhibit only 80% of the market’s ups and downs.

The professor in a financial theory course I took in business school asked one day what it meant that gold stocks had, at the time, a beta of zero.

The thoughtless answer is that it means they aren’t risky, or that they don’t go up and down.

A consequence of this thinking is that you can lower the beta, and therefore the risk, of your investment portfolio by mixing in some gold stocks.What’s interesting is that in the early days of beta analysis that’s what some institutional portfolio managers actually did with their clients’ money.

That didn’t work out well at all.

What should have been obvious, but wasn’t, is that the zero beta didn’t mean no risk–or that gold stocks are/were a good investment.  It meant what the regression literally indicates–that none of the movement in gold stocks could be explained by movements in the stock market in general.

The riskiness of gold stocks is there, but it came/comes in other dimensions, like:  how mines develop new supply, the ruminations of the gnomes of Zürich (in today’s world, Mumbai and Shanghai), the potential for emerging country craziness, the propensity of the industry to fraud.

Why write about this now?

I heard a Bloomberg report that institutional investors as a whole are upping their exposure to hedge funds, despite the wretched performance of the asset class.  Their rationale?   …uncorrelated returns.

It sounds sooo familiar.

Admittedly, there may be a deeper game in progress.  It’s impossible to say your plan is fully funded by projecting a gazillion percent return on stocks or bonds.  But who’s to say that a hedge fund can’t do that?



paradox of thrift; paradox of indexing?

The paradox of thrift is the idea that the common sensical approach individuals take in bad economic times–that is, to save a lot more–actually reduces overall consumption and ends up making a bad situation worse.


People are beginning to talk about the same sort of situation happening with investing and index funds.

The idea of indexing was initially popularized by Charles Ellis, who argued that large numbers of well-trained, well-educated, highly motivated, highly compensated portfolio managers were battling it out with one another every day in the active management world.  Therefore, he argued, none would be able to maintain a clear competitive advantage over any of the others.  And they would all be running up costs in their (futile) attempts to do so.  Therefore, the wisest course for anyone would be to take the lowest-cost route–simply buying the index.

Of course, it took Vanguard to provide the means and many years for the idea to be accepted.

Today, in contrast, it’s accepted that the lowest risk course of action, and likely the highest return one as well, is to buy an index ETF or mutual fund.

Over recent years, there has been a steady flow of assets away from traditional active managers in the US and into index products–meaning less money from management fees to fund active manager research.  In addition, the recent recession has triggered the mass layoff of seasoned brokerage house equity analysts.  (This is due to the contraction in assets under active management, regulatory constraints on the use of “soft dollar” commissions and the dominance of trading over research in brokerage firm office politics.)

Are we at the point where indexing has culled the herd of active managers enough that the fierce competition which has made the US stock market super efficient over the past generation is no longer functioning?

No, not yet.  2014 was the worst year in a long time for active managers, as far as outperformance is concerned.  And we know that hedge funds have rarely been able to keep up with the S&P.

However, today’s Wall Street seems to me to be much more reactive than proactive when it comes to company news.  That is to say, the market seems to react more strongly to company announcements of good or bad news, rather to have anticipated them from leading indicators.  Take, for example, the shock Wall Street showed when firms had weak 4Q14 results because of euro weakness–even though the size of the firms’ EU business was well-known and the change in value of the euro is shown in currency trading every day.

So something has changed.  It may simply be that brokerage research departments were much more important to the smooth functioning of the equity market than has been commonly perceived.

My question:  will individual investors take the place of active managers in keeping markets efficient?


hedge funds and investment research

On Monday, the Wall Street Journal ran an interesting article, “Hedge Funds Learn Secrets Not So Safe.”  It’s about brokerage house research reports on individual companies.

Brokers provide research to customers either by giving them access to a research website, which contains all a broker’s research reports, and/or by responding to requests for specific research items, including meetings with analysts.  The problem with this is that brokers collect and analyze all their points of contact for the information they contain.  Conclusions will certainly wind up on the firm’s sales desk and can easily end up on the firm’s proprietary trading desk, too.

The same written  information is also available to authorized customers through third-party information services like Bloomberg.  I can use my Bloomberg account not only to call up a chart of a company’s stock price, see summary financial statistics and find out who a company’s major suppliers and customers are.  I can also read brokerage research from the brokers I do business with.  Not having read the service agreements they’ve signed, hedge funds have apparently assumed that if they read brokerage house report on a given target investment using a third-party information service, the broker never finds out.  By doing so, they’ve outwitted the broker and avoided information leakage.

Not so.

The third-party information providers supply such usage data to brokers, sometimes being as specific as what person at a given firm has accessed a report.  In fact, the article cites an instance of an unnamed analyst finding out his research wasn’t as stealthy as he’d thought when the broker whose report he’d been reading called him up and offered to arrange a meeting with the target company.


What I find odd is that there’s an obvious way to prevent information leakage–do the research yourself.  There’s a ton of relevent information available from the SEC’s Edgar site, as well as from government agencies and industry trade associations.  There are also suppliers and customers to talk to.  There’s gossip on the internet, too.

In my experience, except for a narrow set of highly technical areas (where you can always hire a consultant), the picture you create yourself will be more accurate, relevant and in-depth than anything a brokerage report can provide.  Yes, the brokerage analyst may be willing to say things on the phone or in person that he wouldn’t care to commit to paper, but that’s another issue.

Two issues:  compiling a thorough analysis of a company may take a week or two, as opposed to taking an hour to read someone else’s work.  Also, the analyst has to have the skill and experience to do independent work.

I can’t imagine that taking an extra week is the crucial variable.  That leaves the possibility that the firms the WSJ is writing about are so weak they don’t know how to do research themselves.  Hard to fathom.  I guess they’re just great marketers.





reading the paper yesterday morning…

I’m postponing writing about my early days as an oil analyst until tomorrow.

An article in the Wall Street Journal,  “Investor Bind:  How Low Can Oil Go?,” struck my eye as I was waiting a doctor’s office yesterday morning.  Two aspects:

The article quotes a Swiss oil trader as saying the current market for petroleum is “irrational.”  He explained that the craziness consisted in the market concentrating solely on bad news and ignoring any possible ray of sunshine.

Yes, this is irrational.  But, more to the point, this is the essence of a bear market, that good news gets ignored and only bad news gets factored into prices.  (A bull market is just the opposite.  In a bull market, all the bad news goes in one ear and out the other; only the good news has an influence on prices.)  I wonder why he didn’t just say that.  Maybe he did, but the reporter didn’t understand.  On the other hand, maybe he didn’t realize.

Second, the article leads off with hedge fund Tusker Capital, LLC of Manhattan Beach, California.  The fund had been betting heavily on a decline in crude oil prices since at least the middle of last year and has just cashed in its chips after cleaning up oin a major way on the subsequent 60% fall in the oil price.

According to the article, Tusker gained 17% overall in 2014 and is up by 10% for 2015 through mid-January.  Implied, but not explicitly stated, is that the largest part of the +10% this year comes from the bet against the price of crude., with is down by 8.6%.  Why else would it be the lead in a sotry about a crashing oil quote.

The occupational disease of analysts is that they analyze.  As I sat in the waiting room–and waited–it became increasingly clear that I couldn’t make the Tusker numbers make sense.

Tusker has “roughly” $100 million under management now (I take that statement to mean the assets under management are just shy of $100 million, but let’s say $100 million is the right figure).  This means it had $91 million under management on December 31st and $78 million at the end of 2013–assuming no inflows or outflows.

Let’s say all of the $11 million gain in assets under management in early 2015 comes from the negative bet on oil.  If the same bet were maintained through the second half of 2014, it should have produced a gain of about $55 million.  But Tusker’s assets were only up by $13 million in 2014.  Either a lot of customer money left, or something really horrible happened in the rest of the portfolio, or “all” is too high a number.  My hunch is that at least the last is correct.

Let’s say half the 2015 gain comes from the negative bet on oil (regular readers will know that 1/2 is my default guess on most things).  If so, then the bet should have produced a profit of around $27 million in 2014.  Same story, although with somewhat less draconian figures–something else happened that caused $14 million in assets to disappear–disaster or withdrawals, or both–or maybe Tusker initially had a much smaller bet gainst oil that it expanded as crude began to sink.

I later Googled Tusker and found an article, from the New York Post, of all places, that said Tusker had assets of $105 million at the end of June 2013 and that the firm strongly believed that the end of quantitative easing in the US would cause a collapse in commodities prices.

To sum up: Tusker made a hugely successful bet against oil that likely made it $40 million – $70 million.  Yet it now has less money under management than it did 18 months ago (a period during which the S&P 500 went up by about 30%).  There’s certainly a story here.  It may not be about oil, though.




Mainstay Marketfield (iii): dollars and sense

the Mainstay/Marketfield deal

When the Marketfield fund sold itself to Mainstay in mid-2012, it got two things:

–the legitimation of being part of a large financial company, New York Life; and, more important,

–it got access to NYL’s powerful distribution capabilities.

NYL, in turn, obtained a new “hot” product, with $2 billion under management, a respectable (if short) track record and a five-star Morningstar rating (btw, according to the Financial Times, Morningstar is now calling the fund a “gateway drug.”  It has also taken away two of the fund’s stars.).


I don’t know.  I imagine it consisted of an upfront cash payment to Marketfield, plus a continuing share of the management fee, which is 1.40% for the first $7.5 billion of assets, declining to 1.36% for assets over $15 billion.   Doubtless, Marketfield can’t create a competing product.

the product launch

I haven’t seen them, either.  I would imagine, though, that the sales pitch would be some version of the free lunch idea–that you get all the upside of an index fund plus considerable downside protection in bad times from the portfolio managers’ ability to sell short

the fund economics

Mainstay Marketfield is a load fund, meaning investors typically pay a sales charge to get their money into it.  The rules for how the charge is assessed are complicated.  Basically, though, if you have at least $1 million in assets in the Mainstay fund complex after your purchase, you get in for free. If you have $500,000+, the charge is 2% of your investment;  below $250,000 it’s 3.5%; below $50,000, it’s 5.5%.

In 2013, Mainstay Marketfield took in $13 billion+ in new money, according to the FT.  Let’s say that the average sales charge was 2% (my experience working for a load fund complex suggests the real figure is more like double that, but there may have been sales to large institutions, and anyway let’s be conservative).  If so, that total for the year would be $260 million in sales charges.  Roughly half would be paid to the selling brokers, meaning NYL netted $130 million.

Let’s say average assets under management for 1013 were around $10 billion.  A 1.39% management fee would amount to another $140 million, of which some part, let’s say 25%, would go to Marketfield.  That would leave $105 million for Mainstay.  (More complications:  Total fund expenses, including management, 12b1 fees and short-selling expenses, are around 3% annually.  To aid its sales efforts, Mainstay placed a short-term cap on expenses.  I’m not sure what expenses are included under that cap or how the costs may be shared with Marketfield.  So I’m noting, but ignoring, this.)

Let’s do what securities analysts always do.  My sales charge figures is probably too low; my management fee figure is probably too high.  We’ll cross our fingers and hope the two errors cancel each other out.  If so, Mainstay netted a cool $235 million from owning Marketfield in 2013.  Marketfield took in $35 million as well.

2014 and beyond?

2014 will likely prove to be a very profitable year, something along the lines of 2013, despite the fund’s recent woes.  Remember, average assets for the year will probably be around $15 billion–meaning management fees would have been 50% higher than in 2013.  And there were likely at least some sales in the first half.

I think a lot depends on whether the PMs can stabilize the fund’s performance, and thereby put a halt to redemptions.

If so, the fund may end up with, say, $7 billion in assets–and generate $100 million in yearly management fees.

If not, my guess is that Mainstay will try to sell the fund back to Marketfield or, as mutual fund complexes often do, fold it into another fund concept and have the Marketfield name disappear from the Mainstay stable that way.

It’s pretty clear what needs to be done.  The big question is whether the PMs have the willingness.