Category Archives: Investment firms

world financial center survey: London, New York, Hong Kong tied at the top

September 23, 2010 By in Asian economic development, Banks, economics, emerging markets, Industry Analysis, Investment firms, Securities regulation, Surveying Tags: , , , , , , , , Leave a comment

Z/Yen

A London-based consulting group called Z/Yen (the name is supposed to mean risk/reward) has been compiling rankings of the world’s financial centers semiannually for the past four years. The first seven lists were underwritten by the City of London, the latest by the Financial Center Authority of Qatar.

The results

The September 2010 shows a virtual dead heat for first place among global financial centers among:

–London

–New York, and

–Hong Kong.

The remainder of the top ten, in descending order, are:

–Singapore

–Tokyo

–Shanghai

–Chicago

–Zurich

–Geneva

–Sydney.

The bottom of the pile of 75 cities rated are, again in descending order:

–Athens

–Tallinn

–Reykjavik

patterns

Although the survey has been going on for only a short period of time, a number pf patterns have begun to emerge:

the steady rise of Asian centers.

— Z/Yen predicts that Singapore will soon emerge as a world co-leader with the present top three.

–Hong Kong and Shanghai have shown the most improvement from list to list

–survey participants name Shenzhen, Shanghai and Singapore as their picks for the cities with the most upward potential

tax havens losing favor

–The Cayman Islands and the Bahamas are among the havens showing the greatest falls in ranking, all all tax-favored centers are declining. Oddly, Scandinavia is the other area on the wane.

methodology

The ranking is obtained by combining the results of an internet survey of financial professionals with an analysis of “instrumental factors” selected to describe the objective working conditions in a given city.

For this list, Z/Yen obtained input from 1,876 survey participants, who made a total of 33,023 city rankings.

The instrumental factors fall into five groups: people, business environment, infrastructure, market access and general competitiveness. Specific factors include things like office rents, personal and corporate income tax rates, and indices of corruption and regulatory opacity.

quirks

All of the top names on the list—down almost to the middle, in fact—exhibit a reputational glow. That is to say, the ratings derived from the online survey questionnaire are significantly higher than those obtained from statistical analysis of the instrumental factors alone, although the rank order remains the same. My guess is this is because the survey participants rank on average just shy of twenty cities. How can they know that many?

The perennial question about internet surveys (see my posts on surveying) is that there’s no way of telling whether the respondents to the survey are characteristic of the overall group whose opinion you want to obtain. Relative to the survey results that, say, the Census Bureau, get, online surveys have to be regarded as not 100% reliable.

On particular items in the survey, one section looks at the regional breakdown of favorable and unfavorable ratings. Everyone agrees that London and New York are the top two financial centers. Europeans, however, are very skeptical of Asian financial cities. The US joins Europe in worries about Shanghai. No one likes the tax havens other than the havens themselves.

my thoughts

My guess is that the list is fairly reliable.

The rise of Hong Hong doesn’t surprise me too much, since that entrepreneurial city has constantly reinvented itself over the years. It still has an advantage over the mainland in support services for financial professionals.

I find the emergence of Singapore interesting, although that city-state has been undergoing a thorough makeover during the past decade.

No reversion to the mean?: El-Erian (II)

September 17, 2010 By in Constructing a Portfolio, Current Market Thoughts, growth vs value, Industry Analysis, inflation vs deflation, Investment firms, Strategy Tags: , , , , , , , , , , , Leave a comment

In yesterday’s post, I outlined the Pimco investment case, contained in a Financial Times article, which boils down to:  we’re in a time of great uncertainty, so buy government bonds.

my thoughts

For what it’s worth, I think the world is a lot less uncertain place than it was two years ago.  In a way, uncertainty is old news.  That isn’t to say our situation is good, but we now know:

1.  world governments will act to avoid the worst economic outcomes (this is the #1 worry in any macroeconomic crisis)

2.  financial regulators in the US and the EU have been doing a terrible job

3.  banks are weaker companies than we thought, and generally poorly managed, to boot.

In my opinion, a lot of this news is already reflected in security and currency prices.

What uncertainties still exist?

1.  Economically speaking, the developed world is still a fragile place.  The effects of the large excess supply of housing and business space created in the US and UK over the past few years, and of those countries stopping adding to it, are still with us.

2.  The steps that policymakers may take, and the economic effects of those actions, are hard to foresee.  The world has used up much (all?) of its safety margin for dealing with mistakes.

3.  The econometric models that economists use in predicting how our economic future will play out–essentially, elaborate trend-following devices–don’t work well in times of economic transition.  They also didn’t predict the financial meltdown.   So a major tool (bond) portfolio managers have wielded in plying their trade is out of action.  Managers are now working in a room whose lights have been turned out.  (If you believe Nobel laureate Joseph Stiglitz, however, these models were radically flawed from the outset–and were a contributing cause to our economic woes.)

3.  The behavior of economic agents, especially portfolio investors, is harder to predict.  In particular, the chances of extreme, far-from-consensus, and really bad, outcomes has increased.

What does the article conclude from this litany of sorrows?  –we are in a “world where the realized return rarely (emphasis added) equals the expected valuation.”

a curious argument

Okay.  Now comes the weird part.

We’re in a world where no one can tell how the world economy will play out and where investment managers’ portfolios are going to blow up in their faces.  But luckily for us, Mssrs. Clarida and El-Erian are affected by none of this.  They know (no explanation given) how the US economy will develop–very low growth and structural unemployment for as far as the eye can see.  They also know that while virtually every other investment strategy founders on the rocks of uncertainty, one–buy government bonds–will not.  Again, no explanation given.  Just by coincidence, both authors happen to work for a bond fund manager and have this product available for sale to us.

Another point:  The thrust of the Clarida- El-Erian argument is that economic circumstances demand that investors carefully rethink their investment strategies, because macroeconomic conditions today are radically different from what they’ve been before.  Their actual conclusion, however, is far different.  It is that investors will almost never (rarely) be able to figure things out.  In the paragraph above, I’ve pointed out that they think this situation applies to everyone except them.

My  point here is that they provide no support for the actual conclusion they draw.  What they write looks like an argument in support of a conclusion, followed by the conclusion as a logical consequence of what they said before.  But that’s just a kind of sleight of hand.  The idea that no one (except themselves) will be able to figure out what’s going on is a bald assertion, no more.

extreme outcomes don’t all favor bonds

I think it is right to give extra thought to the possibility of extreme outcomes.  In can imagine three, although I’m sure there are more:

1.  The US and EU play out like Japan since 1990.  This would mean bonds would be fine   Stocks would have a period of stability followed by maybe another 30% decline.

2.  The US and EU recover faster than we now think.  Stocks might go up by 25%.  Government bonds would fall, maybe by 15%.

3.  The rest of the world loses faith in the US and EU.  Their currencies fall by 15% vs. the rest of the world and their bond yields rise.  In this case, safety would lie in stocks, not bonds.  Stocks +35%, bonds -15%.

To me, it seems that the possibility of extreme outcomes is an argument for diversification, not  concentration in one asset class.

the authors seem to know nothing about stocks

If we exclude financial Armageddon, equity investors can operate successfully under a wide variety of economic conditions.   In particular:

Value investors do use reversion to the mean, but in a narrower sense than is used in the Pimco article.  The value investor looks for assets that are worth $100 that he can buy for $30 and hopes to sell for $60-$70.  Given that stocks are the cheapest they’ve been vs. bonds (a proxy for the cost of financing purchase of such assets) in about sixty years, this should be a fertile ground to work in.

Growth investors do have deep economic concerns, but they’re  generally microeconomic, not macro.  Will, for example, well off thirty- and forty-somethings continue to buy iPhones and iPads?  Will TIF continue to sell jewelry to Europeans trading down or to newly affluent Asians trading up?  Will the casinos in Macau keep on booming?

Yes, if world economies implode again, equities will be in trouble, at least for a while.  But equity investors don’t need to understand the entire globe to be successful.  All they need is a stable playing field and one or two places where they’re ahead of the consensus.

No more reversion to the mean?–Mohamed El-Erian (I)

September 16, 2010 By in Absolute vs. relative performance, Banks, Current Market Thoughts, Industry Analysis, Investment firms, Strategy Tags: , , , , , , , , , , Leave a comment

“uncertainty changing investment landscape”

The other day I was paging through some old newspapers that I never got to during August (yes, I read the business news on paper).  Sometimes it gives you a sense of perspective to read, a couple of weeks after the event, what trivial things people were thrilled or fearful about at a certain moment.  But mostly I got lazy when the weather got hot and read novels instead of news.  So I was catching up.

I ran across an article from August 2nd with the above title in the Financial Times. It was written by Mohamed El-Erian and Richard Clarida, a professor of economics at Columbia.  Mr. El-Erian is the chief executive of the mammoth bond manager Pimco and an occasional columnist for the FT; Mr. Clarida consults for Pimco.

I usually skip over what Mr. El-Erian writes.  It typically reflects the economic consensus.  Besides that, Mr. El-Erian has seldom been known to use one small word when six or eight big ones will do the same job.  He’s also the public marketing face of Pimco, so we know in advance what his investment conclusion will be namely:

–The global economic landscape will be bleak for many years to come.

–Therefore bonds, even at today’s super-expensive levels, are still a buy; stocks, which are the same price today as a decade ago and the cheapest they’ve been vs. bonds for sixty years, are still a sell.  Pimco’s only change to this mantra over the past year or so has been to kick dividend paying stocks off the approved list.

Nevertheless, I did read this piece.  Despite the fact Mr. El-Erian comes to his usual (horribly incorrect, in my opinion) conclusion about stocks and bonds, I’m glad I did.  For once, Mr. El-Erian wrote something really thought provoking.

I’m going to write about this in two posts.  Today I’ll outline what Mr. El-Erian says.  Tomorrow I’ll write about where I disagree.

the article

The article makes five points.  Four of them are different facets of the same idea–that the disinflationary era that began with the appointment of Paul Volcker as Fed chairman in the US almost thirty years ago is over.  As a result, we can no longer depend on continuingly rising bond prices and falling yields to bail us out of investment mistakes.  Investors have to rethink and retest their strategies.

That isn’t the interesting part.  Equity investors have been soulsearching about excessive leverage and unwarranted risk-taking since the collapse of the Internet bubble in 2000.  (If so, how did the financial meltdown happen?  Investors made three basic mistakes:  we assumed the banks’ accounting statements were reasonably accurate; we wildly overestimated the capabilities and appetite of the regulators to enforce banking and securities laws; and we attributed to bank managements a level of integrity and risk-management competence that most American industrialists possess but many in this industry didn’t.)

The intriguing point is Mr. El-Erian’s first, that “investing on ‘mean reversion’ will be less compelling” in the future.  He implicitly describes the (bond) investing process over the past twenty-five years as having two steps:

–determine the consensus economic forecast, and

–find securities whose valuations imply an outcome that deviates markedly from the consensus.  If the imbedded expectations are too pessimistic, buy the security; if they are too optimistic, sell it short.

Why won’t this work anymore?  In the past, a compilation of expectations from professional economists would form a bell curve, with the areas at and around the mean having very high probability.  The “tails” of the distribution, that is, the forecasts that deviate a lot from the consensus, were short and stubby, that is, highly unlikely and increasingly so the farther away from the consensus they were.

Today, the compilation of forecasts looks less like a bell with a sharp, fat peak in the middle, and more like a straight line with a small bump up in the center.  The economic situation around the world is so uncertain, and the policy actions governments may take to stabilize their countries so unpredictable, that there is, in effect, no solid macroeconomic consensus to bet against.  Not only that, but the more extreme “long tail” outcomes, both bad and good, have become much more likely.

What do you do in a world like this?  Mr El-Erian’s answer is (surprise, surprise)–buy bonds, sell stocks.  You do so because (government) bonds are liquid and default-free.  Therefore, they protect you against the world going to hell in a handbasket.  I guess this means individual investors haven’t been panicking over the past year or more but responding rationally to the current situation by dumping their stocks and embracing bonds.  I suppose that if you really wanted to secure yourself against the worst, you should also think about a cabin in the woods, stocked with freeze-dried food and near a good source of water, maybe with a bow and arrows in case you need to hunt.  Maybe people are.

I’m with Mr. El-Erian up until his conclusion, with which, to put it mildly, I disagree.  Not so surprising, since I’ve spent all my investing life on Wall Street.  The real question, the thought-provoking aspect of the article I’ve linked to above, is to be able to say why I disagree.  What’s wrong with what he’s saying?

More tomorrow.

high-frequency trading vs. computer-driven trading: the Trillium fine

September 15, 2010 By in Current Market Thoughts, Industry Analysis, Investment firms, Securities regulation Tags: , , , , , , , , Leave a comment

In the aftermath of the “flash crash” of a few months ago, regulatory authorities have been, almost frantically, looking for a cause.  My guess is they won’t be successful.  If there is a single culprit, I think he’s highly unlikely to come forward himself.  (Would you, if you thought you would be made a scapegoat and driven from the business?  Neither would I.)  And the complexity of Wall Street–almost any business, for that matter–comes from taking relatively simple ideas and repeating them over and over again, sometimes with subtle variations.  The result is an end product that’s difficult to unravel by anyone not immersed every day in that line of work.

But the search for an answer has apparently turned up non-related market abuses.  One of the is is the case of Trillium, a small brokerage house and some of its proprietary traders just disciplined by FINRA (the Financial INdustry Regulatory Authority).

to step back a minute

High-frequency trading (admittedly not an area I’m very familiar with, so leave comments if you want) seems to me to come in two flavors:

arbitrage This is the computer-driven search for pricing discrepancies that provide risk-free or low-risk trading opportunities.  These can be as simple as quirks in the bid-asked spreads of different market makers in the same security.  Or they can be differences in the prices of derivatives linked to the same underlying security, or closely-related securities.  Or they can be differences in the prices of a given theoretical financial attribute as contained in different securities or derivatives.

This activity isn’t particularly new.  Harry Markowitz started the ball rolling in the early 1950s.

order execution A large money management institution deals in very large position sizes.  It has two basic choices in controlling its buying and selling.  It can deal in the traditional way, by developing a staff of highly-skilled (and highly compensated) professional human traders, or it can use computers.  I’ve only worked in firms that took the former strategy, so I can’t say from experience how the latter works.

There are two (maybe three) problems with using human traders:  the buying and selling process can be slow, and the firm’s intentions can easily leak into the market through the counterparty before the transaction is completed.

Firms using computers break large orders down into many small ones which they hope to execute quickly with a number of different counterparties and on various trading platforms.  So they hope to get the trading done before information about their intentions has spread, and therefore with limited market impact.  As I mentioned above, I have no idea whether this works well or not.

The third issue, which I haven’t seen discussed anywhere, is who pays for the trading.  A traditional buy-side trading staff can easily cost several million dollars a year, money that is paid by the management company out of its management fees.  My guess is that high speed automated trading systems get poorer executions but are much less expensive to run.  If so, the management company saves the traders’ salaries and the clients pay the economic cost of trading through higher buy prices and lower sell prices.   On the other hand, if the blitzkrieg approach gets better executions, everybody (except the displaced traders) wins.

returning to Trillium

According to the FINRA documents linked above, what Trillium did was this:

Let’s say the best (highest) bid for stock ABC was $50 and the best (lowest) offer for ABC was $50.25.

Trillium traders would decide they wanted to sell ABC.  They would place a limit order to sell just inside the best offer, say, at $50.24.  They would then rapidly place a bunch of orders to buy ABC at different prices just below the best bid.  These orders were “often in substantial size relative to a stock’s over all legitimate pending order volume.”

The Trillium traders never intended to buy ABC.  What they wanted to do was use the false impression of rapidly building buy volume to trick day traders into thinking a powerful upward movement was about to start.  They wanted short-term traders to rush in to buy the stock to ride the impending uptrend.  Of course, the first shares to be bought would be the ones Trillium had pre-placed in the market through their limit order.

As soon as the limit order was executed, the Trillium traders cancelled their phony buy orders.

This is a boiler room operator’s ploy that’s as old as the hills.  It’s the kind of market manipulation the syndicates of the 1920s-1930s did, though on a far larger scale than Trillium.  And it’s one of the abuses that Depression-era reform of the securities markets was intended to stamp out.

is this high-frequency trading?

What does this have to do with high-frequency trading, though?  Nothing that I can see.

Yes, the Trillium traders probably used computers to enter their orders, both real and fake.  And they worked this scam over 46,000 times during the three months FINRA cited in its disciplinary action.  That’s about once every 30 seconds while Wall Street was open for business.  Otherwise, what’s the connection?

More interesting, what would cause the Huffington Post, or the Financial Times, or Fortune to say there’s one?  I don’t know.  The Fortune Street Sweep blog does have a clue, though.   In its post on Trillium, it quotes FINRA’s Thomas Gira, who’s identified on the FINRA website as executive vp of the Market Regulation Department as saying (as I read it) that Trillium’s is a high-frequency trading abuse.

Maybe there is a dark side to high-frequency trading, but I don’t see Trillium as a case in point.  I don’t get why FINRA would say it is, other than the agency must be under pressure to do something.

large realized losses (II): how to find out

September 13, 2010 By in Accounting, book value, Constructing a Portfolio, Current Market Thoughts, ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Portfolio management, Stock ideas, Strategy, Trading Tags: , , , , , , , , , Leave a comment

don’t look in marketing materials

There are two ways for a mutual fund or ETF to have amassed large realized investment losses:

–they’ve had a very weak or very unlucky portfolio manager in charge of a fund, with the result that it has made losses in a benign investment environment, or

–the fund has simply existed during a period of great euphoria, when all the money flowed in, and a subsequent panic, when that money flowed back out at a loss.

The past several years have been such a period and have, by and large, produced the situation funds and ETFs are now in.

No one is going to advertise “Great news!!  We’ve lost billions since 2007, so you have a built-in tax shelter for future gains.  It’s so big your gains will be tax free for years.”

Quite the contrary.  A fund management company will provide this important information only when forced–that is to say, only in its official reports to shareholders and to the SEC.  You have to dig it out.

get the annual/semi-annual report

You can usually get the official reports on a fund company website.  You don’t want a summary report, or an abbreviated “fact sheet.”  That won’t have what you’re looking for.

Or you can go to the SEC’s EDGAR website.  Here’s the link.

On the Filings and Forms page, select the red “Search for Company Filings” link.  That will bring you to the search page.

Click on the red “company or fund name…” link.  That will bring you to an “Enter your search information” box, where you can enter either the fund name or its ticker symbol.  (This is the same search function you’d use for any publicly listed company.)

Clicking the “find companies” button will take you to a list of the fund’s SEC filings.

Look for the Certified Shareholder Report, form N-CSR, or semi-annual report, form N-CSRS.  That’s what you want.

inside the report

Go to the financial statements.  Note the date of the report, since all figures will be as of that date.

Statement of Assets and Liabilities

Find the “Statement of Assets and Liabilities.”

It will have three sections:  Assets, Liabilities and Net Assets.  Net Assets is the one you want.

There are two lines you should be interested in:

–“Accumulated undistributed net realized gain (loss) on investments and foreign exchange transactions.”  This is the figure you want! If it’s a loss, it will be in parentheses, like (2,345,678).  No parentheses if it’s a gain.

–“Net unrealized appreciation (depreciation) on investments and assets and liabilities in foreign currencies.”  This will show you whether the fund has an aggregate gain or loss stored up in the securities it still holds and has not yet sold.  This is a nice-to-know number, but it needs further refinement (see below).

schedules/tax footnote

There are two more pieces of information you should have.  There’s no standard place to find them, so you may have to do some poking around for yourself.  They are most likely either in a schedule immediately after the Statement of Assets and Liabilities or in a tax footnote.

The first item is when the tax losses expire.  This must be disclosed if it’s relevant, but need not be if it isn’t.  What I mean by relevant is, say, that the fund has unrealized gains of $250 million and accumulated losses of $2 billion that expire in December 2010.  In this case, the tax losses will likely expire unused.

The second is the gross unrealized gains and gross unrealized losses.  A fund may have $250 million in net unrealized gains, but that may be composed of $500 million in unrealized gains and $250 million in unrealized losses.  The gross unrealized gains show the real ability of the fund to generate gains that will use up the realized losses.

how to use this information

The first, and obvious, comment is that the foremost criteria for selecting a fund are its suitability for you, given your goals, risk tolerance and financial situation.  Tax benefits are nice to have, but they’re a second- or third-order consideration.  Better to have a fund run by a skilled manager inside a firm with strong dedication to good performance, with no tax losses, than one with tons of tax benefits but a weak manager and a deficient corporate culture.

In most cases, the losses funds have today have been caused by the market action of the past few years.  It’s possible, though, that in some cases losses have been generated by bad management (I know. I’ve been hired more than once to clean up a mess someone else has made).  These turnaround situations can have, I think, great profit potential.  But with so many funds with strong management being in a loss position that has significant value, I see no reason to take the extra risk.

A fund example: I was looking at a mutual fund the other day as I was preparing for these posts that had roughly the following characteristics:

Assets:  $2 billion

Accumulated realized losses:  ($1.8 billion)

Unrealized net gains:  $700 million, consisting of $1 billion in gross unrealized gains and $300 million in gross unrealized losses.

A rough calculation of the value of these losses:

Assuming a federal tax rate of 15% on capital gains and (in my case) a state tax of 10%, the ability of (my share of) $1.8 billion in losses to shelter realized gains from being distributed to me as taxable income would be worth (my share of) $1.8 billion x .25 = (my share of) $450 million, or 22.5% of (my share of) the net assets of the fund.  That’s a lot.

This raises two other points:  don’t forget to include state taxes in your calculation; at this point it looks as if capital gains taxes will be going up for individuals with more than $250,000 in yearly income.  That would make a fund like I describe more valuable to the wealthy.

what can go wrong?

The worst problems would come from selecting a fund with poor management.  Let’s exclude this issue.  There are still potential pitfalls.

1.  The stock market stays in the doldrums.  As a result, it remains difficult for any manager to make gains to use up the tax losses before they expire.

2.  The fund manager doesn’t “get” the value of the tax losses.  Normally a manager sensitive to tax efficiency tries to avoid short-term trading.  When you have a big loss position, a somewhat greater trading orientation–provided you have the temperament and skills–is appropriate.

3.  Investors pour tons of new money into the fund you select, either because they realize the value of the tax losses or for some other reason.  The issue is this:  in the example above, the net assets of the fund are $2 billion.  If I put even $1 million into the fund, that represents only .05% of the fund assets, so portion of the tax losses that existing shareholders are entitled to is basically unchanged.  But if another $2 billion in new money comes in, then the entitlement of each existing share is cut in half.

How likely is this “unfavorable” outcome?  It’s hard to tell.  In my experience, only one thing will attract new shareholders–sharp price gains.  But that will also trigger outflows from existing shareholders who have decided to hold on to underwater shares until they’re back at breakeven.

4.  Your fund is merged into another one.  Fund companies will many times merge funds that are perceived to have weak records, or which can’t seem to attract new money, into other “healthier” funds.  The rules on what happens to tax losses in this case are complex, but the basic idea is that the ability of the successor fund to use the losses is severely restricted.  So not only do you have to share the losses with the holders of the other fund, but their present value is diminished.  It’s of course possible that the fund you’re merged into will have a bigger tax loss position that yours, but I wouldn’t count on it.

As a practical matter, I think #4 is the biggest risk.  Fund boards may have no understanding of the value of the tax losses.  And they generally tend to go along with the wishes of the fund management company.

On the other hand, if you have a choice between two roughly equivalent funds, one with large realized tax losses and one without them, I think the decision is a no-brainer.