The Float

Friday Reading

A few items for the road...

• The Economist's Buttonwood summarizes the potential consequences of elevated crude oil prices. More on oil: David Gaffen at MarketBeat. 
• Two interesting items via Calculated Risk: Fed Governor Mishkin on preemptive bubble-popping and a warning on festering problems in the HELOC market.
• Two interesting items from Barry Ritholtz: Merrill's strange new rating rules and a hugely important observation on the employment situation from Merrill's David Rosenberg.
• What if politics on the sub-continent was less about a nuclear standoff between India and Pakistan and more about...food prices?
• Behavioral finance? Here's a useful missive from John Mauldin on "investors behaving badly" (originally written a few years ago, with updates to reflect recent events).

Learning from Bill Miller

In yesterday's reading list, we included a recent New York Times piece on Legg Mason's Bill Miller, the renowned fund manager whose flagship fund beat the S&P 500 for 15 consecutive years, from 1991 through 2005.

The story's premise--that Miller has been chastened a bit by his fund's recent underperformance--is fascinating enough as a study in manager psychology. More interesting (to us, anyway!) is the fact Geraldine Fabrikant's piece features a few arguments that we've made repeatedly in this space.

First, there's the big picture phenomenon of reversion to the mean. In relatively efficient markets, it's just enormously difficult to sustain significant departures from the performance of a fund's underlying asset class. Many efficient-market absolutists will suggest that Miller's successful run may well have been little more than coin-flipping luck. With so many managers in the field, they might say, a small number of coin-flippers will come up heads 15 times in a row. We think there is such a thing as investment skill, often more temperamental than technical. But we fully acknowledge that luck is part of the game as well, and we suspect Miller was both good and lucky for many years. There's no reason to suspect he's any less skilled now than he was five years ago, but his randomized draws from the bag full of luck has clearly turned against him.

Second, there are the intertwined problems of asset bloat and market impact. Here's Fabrikant:

SOME longtime market experts think that fund size is the most daunting challenge he faces. Regardless of periodic ups and downs, he may simply be managing too much money to continue to produce outsized gains, they say.

"The number of investment opportunities just shrinks radically" when a fund swells, says John C. Bogle, the founder of the Vanguard Group, the mutual fund powerhouse, who describes himself as a fan of Mr. Miller. "The bigger you get, the fewer the number of stocks you can hold with a meaningful position."

Indeed, Mr. Miller holds a relatively concentrated portfolio, and the bad news has kept coming for some of his major picks. Last week, after Microsoft's proposed buyout of Yahoo fell apart, Yahoo's stock plunged 11.5 percent last week. Legg Mason holds a 6.7 percent stake in Yahoo. Countrywide Financial, another big holding, has been slammed by the mortgage crisis and errant lending. Its stock has fallen 87.9 percent over the last 12 months. And Mr. Miller amassed a sizable position in Bear Stearns, the investment bank gone to the grave.

We remember one of Miller's annual letters in which he freely acknowledged the constraints of running a portfolio that was at once enormous and highly concentrated. (He was aware of the problem then, but, in Fabrikant's telling, seems to dismiss it as a cause of his recent underperformance.) Because asset bloat is a structural problem, there's not much he can do about it, unless he diversifies his holdings. Which he and his team appear to be considering:

At Legg Mason, Mr. Miller has been stress-testing his investment theses -- the way he and his colleagues picks stocks -- and is considering a move away from concentrating his bets on dozens rather than hundreds of stocks.

"The question we are asking ourselves is: Should we think more broadly now about probability, about high-impact events and protecting against them by having broader exposure to the market?" he says.

Which leads us to the third point: Chasing "hot" managers is not a particularly wise game, at least not after they're both hot and pretty much universally recognized as such. Paying managers to pick positions and manage risk actively isn't inherently unwise, but it should be done with great care, and such services should be delivered in products and programs that have a relatively high probability of delivering what investors are paying for. There can be no guarantees, of course, but piling into enormous funds with a relatively high likelihood of mean-reversion strikes us as an approach that makes a difficult game that much harder.

Source

Geraldine Fabrikant, "Humbler, After a Streak of Magic," New York Times, May 11, 2008

One Great Ad

You may have seen the spot, but if you haven't, or if you like it as much as we do, and therefore want to see it again, we recommend the "Love Sweet Love" ad from Barclays Global Investors' iShares unit, a clever spin on the Hal David/Burt Bacharach tune. You can see it here. Because they're so perfectly apt, we've transcribed the lyrics here:

What the world needs now, is clarity, a little tax-efficiency, and much more transparency. What the world needs now, is fresh ideas, more complete advice, and shelter from all the nonsense. They're the only things that there's just too little of.

There's plenty not to like about the financial services industry's advertising efforts. This one, however, is worth celebrating.

Wednesday Reading

That wasn't particularly bullish action this afternoon...

• How 'bout the bizarro world of BLS inflation data? Barry Ritholtz has a reality check.
• Here's Reuters' Emily Kaiser interrogating the data on gasoline prices in particular.
• Foreclosures: Climbing, and fast.
• Yves Smith has some fun (if that's the word for it) with several charts on housing and credit markets.
• Interesting NYT piece on Bill Miller's recent struggles at Legg Mason. Note the accompanying chart for a classic case of reversion to the mean.

Cash Levels and Active Management

In yesterday's reading list, we mentioned a Jonathan Burton story on varying levels of cash in mutual funds. Burton mentions a few funds that have maintained relatively high levels of cash in recent weeks, noting that some of these funds have performed well even as the equity markets have rebounded off their January and March lows.

Here are a couple relevant excerpts:

The volatile stock market and the weak economy have derailed many mutual-fund managers, but without the ability to bet against stocks, some are playing defense the only way they can -- by holding more cash.

In recent months that's been a smart move. Cash is king when stocks head south. A sizeable allotment to short-term Treasury bills and other cash-equivalent vehicles can dodge the worst blows of a down market and absorb its unpredictable shocks. Moreover, money on the sidelines lets a cost-conscious manager scoop up bargains as they appear.

...

Yet this seemingly safe route is not without its own risk. Cash is trash when stocks rebound. Clinging to cash at those times creates a drag that can transform a leading fund into a laggard. Since no one knows when markets will turn, and given the constant pressure -- from both their shareholders and their bosses -- to outdo a benchmark index, most fund managers stay as close to fully invested as possible; the average diversified U.S. stock fund keeps only about 4% of its assets in cash, according to Morningstar.

Financial advisers in particular look askance at funds with outsized cash positions. Advisers set and adjust portfolio allocations between stocks, bonds, cash and other investments based on a client's risk profile. A cash-rich fund can upset those plans, says Dan Moisand, an investment manager at Spraker Fitzgerald Tamayo & Moisand LLC in Melbourne, Fla.

"If you're hiring managers to buy and sell stocks, that's what they should be doing," he says. "We should be making the cash decisions, because we're closer to the client."

Now, this leads to an interesting and important discussion.

In one sense, Dan Moisand is entirely right: Advisors are closer to their clients, and they should make the big asset allocation decisions. But there's another sense in which we think Moisand is on the wrong track.

When clients want active management (i.e., the explicit pursuit of alpha through some combination of outperformance in strong markets and capital preservation in weak ones), we think they should get it in a framework that's meaningfully different from the typical mash-up of active and passive exposure delivered by conventional long-only funds.

One of the key differences between tracking-error minimizers and true active managers is that the latter are less constrained than the former, in particular in the sense that their investment mandates do not require them to be (more or less) fully invested in all market conditions. After all, money management is risk management, and managing risk can be done in one of two ways: (1) strategic asset allocation and radical diversification or (2) active hedging of one sort or another (using options, short positions, cash levels, &c.). Both methods are perfectly legitimate. But they're different! And they need to be understood, pursued, and sold differently.

Burton's certainly right that large cash positions can weigh on performance during strong market episodes. But the essence of successful money management is in delivering market-beating returns for the same level of risk or market-like returns for a lower level of risk.

If advisors are frustrated with fund managers who maintain high cash levels (or whose cash levels vary somewhat unpredictably), they should look elsewhere for pure asset-class exposure, in particular to the inexpensive ETFs and index funds designed to provide exactly that.

If they want active managers, and are willing pay for same, they should know that varying levels of exposure to risky assets is part of what any self- and investor-respecting money manager should deliver.

Source

Jonathan Burton, "Kings of Cash," MarketWatch, May 11, 2008

Monday Reading

Some interesting stuff to start a new week...

• From Sunday's New York Times: Peter Bernstein on the challenges inherent in managing the macroeconomy with monetary policy.
• More on the Fed, via Yves Smith: "Halt the Fed's Mission Creep."
• All About Alpha is right again: "[A]ctively-managed mutual funds are essentially a marketing package for two fundamentally different formations: a large deposit of beta and a vein of pure alpha."
• Chuck Jaffe ruminates on the meaning of risk in the financial markets--and the ways in which investors don't fully grasp its multiple dimensions.
• From a Jonathan Burton piece on cash levels in mutual funds: "Strong conviction in your investments, infrequent trading and a highly concentrated portfolio are keys." More on this topic later today tomorrow.

Thinking About Housing

Some say a recession has arrived. Some say it hasn't yet but will. Some say it never will.

Notwithstanding all the disagreement about where we are not, we've detected near-unanimity on the need for the housing market to stabilize (or "bottom") before the economy stages any kind of meaningful recovery. Which, as far as it goes, is almost certainly true. But the argument has assumed a normative dimension, with many observers claiming that it would be an affirmatively good thing for housing to bottom. Alas, this a question that gets too little attention in the current debate: Should we make extraordinary efforts to force the bottom into place right here, right now?

We think the answer is a definitive no. In the long run, the U.S. economy would be better-served if home prices fell further--much further in some markets, a little further in others--in order to reach market-clearing levels without short-term gimmicks and unsustainable subsidies.

After all, the big problem these days is that too many Americans became overleveraged to acquire (or, more accurately, occupy) unproductive assets. This, we think, is a gross mis-allocation of public and private resources. And all this so Americans could stake partial/leveraged claims to an asset class that historically has been a relatively poor performer.*

Three caveats:

1. We are not of the "let them eat cake" school of economics. Not at all. But the castles-in-the-sky fantasies of the last few years served Americans of moderate means very poorly. These are people whose real wages are lower now than they were when we embarked on this outrageous real estate bubble. So bringing real estate prices back to some reasonable level of affordability, for all the dislocations it will cause in the short run, is very much in the long-term interests of working- and middle-class America.
2. We aren't reflexively anti-government. By its very existence, government "intervenes" in markets...by creating them!** We do think that extraordinary interventions should have clearly stated objectives and plausible likelihoods of achieving those objectives. But we do think it's entirely legitimate for government to try to smooth out the roughest edges, and mitigate the negative externalities, of market cycles.
3. We freely and fully acknowledge that falling home prices do and will hurt in the short run. But we'd rather take the responsible position of focusing on the long-term requirements of economic growth than just applying an expensive short-term salve to the wounds created by the last bubble.

And what are those requirements of growth? Here we'll focus on just one: A higher rate of domestic saving. By slashing interest rates, the Fed has punished saving (of which we need more) and encouraged borrowing (of which we need less). These days, the marginal spent dollar is the marginal borrowed dollar. They're the same thing!***

Only in the most short-sighted sense is a bottom in housing (which we intend to mean a stabilization in the price of residential real estate) necessary or good. A further purging of the truly perverse excesses that have barnacled the American economy over over the last few years would serve us all better in the long run. Less leverage. More affordability. Higher savings rates. More discretionary income for other stuff. More productivity.

No self-respecting elected official will touch this argument, and we understand why. But let's be honest: That doesn't make it any less compelling.

~~~~~~~~~~~~~~~~

* Thanks in part to exceptionally high "expense ratios." If we included the true costs of homeownership (interest payments, property taxes, maintenance, &c.), the return on equity from residential real estate would, in all but the most unusual circumstances (of the sort we witnessed from 2000 to 2005), be remarkably low, even negative in many instances. That doesn't mean real estate is inherently a "bad investment." For several reasons, economic and otherwise, we like the idea of homeownership as much as anyone. But it does mean that as an investment per se, residential real estate isn't especially attractive.

** Through the establishment and preservation of physical and intellectual property rights, the enforcement of contracts, and the maintenance of infrastructure and public safety, among other things. 

*** Those stimulus checks now flying toward a mailbox near you? Those are borrowed too, and the feds want you to spend 'em.

Sources

Alison Vekshin, "U.S. House Passes Anti-Foreclosure Bill Facing Bush Veto Threat," Bloomberg, May 9, 2008