The Float

Wednesday Reading

The bulls seem to want it today. Very interesting times...

• Two items from Slate's Daniel Gross: "The Bailout Will Be a Bargain" and "Flat Is the New Up."
• Crude prices may be turning lower today, but that pesky consumer price index is heading the other direction.
• Yves Smith takes a cold, hard look at the possibility of a "financing crisis" for the U.S.
• Interesting news on David Tice's sale of his Prudent Bear and Prudent Global Income funds. Key passage from BusinessWeek.com's account: "People see a bear fund's trailing 12-month returns and compare it to their portfolios. They say 'I wish I owned that,'" Kathman says. "That's usually a pretty bad time to get into a bear fund."
• Ritholtz removes gloves, drops some serious science on those most responsible (if not accountable) for our current financial crisis.

Target-Date Funds Under the Microscope

Not enough time this afternoon to give this the full treatment (in part because Typepad just ate the first version of this post, which, yes, is a problem that's easily overcome with a preemptive copy-and-paste...but still...very annoying). But we ran across two items interesting pieces on target-date funds, which have been frequent topics of discussion in this space for three primary reasons:

1. They're increasingly prominent features of defined-contribution plans, and thus increasingly important ingredients in the future retirement security of millions of Americans.
2. Like 401(k) plans themselves, target-date funds are loaded with potential...and plagued by a few non-trivial (and easily avoidable) shortcomings, most of which can be traced back to non-fiduciary practices in the financial services industry and lack of awareness among sponsors and participants.
3. Whenever fund companies get excited about selling a particular type of product, it's time to add an extra layer of vigilance.

We'll have some analysis of these two pieces as soon as time permits (tomorrow morning's looking good from here). Until then, both are worth a few minutes of your time if you're interested in such things: "Twelve observations on target date funds" and "New Study Finds Target Date Industry Has Serious Shortcomings."

Monday Reading

Traders: Fannie and Freddie get a bailout! Send the futures higher! Fannie and Freddie need a bailout? Send the futures lower!

• Tough weekend in retirement studies: Hewitt Associates and Ernst & Young crunch the numbers and confirm the ugly truth: Most Americans are financially ill-prepared for retirement. Eat less, exercise more. Spend less, save more. Words to live by.
• In the WSJ's Deal Journal, Heidi Moore makes an obvious/important point: The feds' backstop reflects the very premise of the GSE.
• And on the topic of federal intervention in general, David Gaffen has assembled a handy chart of such efforts over the last several months.
• And more on the Fed/Treasury announcement concerning Freddie and Fannie, from Real Time Economics' usual cast of economists.
• As we noted back in November, bear markets can happen during a rate-cutting cycle. Barry Ritholtz makes a similar observation today: Fade the Fed!

Galactically Lame Headline Watch

Just seen on CNBC's Power Lunch:

Is Every Short Seller a Criminal

We are not making this up.

BreakingViews on Hedge Fund Performance

A little perspective on hedge funds from BreakingViews (emphasis added in bold):

Some investors might want hedge funds to return consistent, positive returns after fees -- the absolute return model. In reality, many of today's funds actually have plenty of market exposure, be it to stocks, bonds or other asset types. Compared with most of those markets, hedge funds haven't done so badly.

Of course, investors who handed money to a hedge fund rather than making what could have been a stunning 50%-odd return on oil won't be feeling too clever. But the Standard & Poor's 500 stock index, for instance, fell 13% in the first half. That makes the average hedge fund's tiny loss look like a decent performance.

Six turbulent months don't prove much. There are, though, a couple of messages. Any investors who still think hedge-fund returns are uncorrelated to major markets are wrong. Most funds' performance will be to some extent linked with market benchmarks.

Meanwhile, hedge-fund managers might note that, even if they handily outperform a weak stock market, their fee structure -- typically 2% of assets and 20% of any profit -- will start to look even more expensive if net returns hover around zero for long.

A couple points: Insofar as avoiding big losses is the single most important ingredient in long-term investment success, an average loss of 0.75% after expenses in the first half of the year is more than "decent." It's flat-out superb.

As we noted on Tuesday, manager performance is necessarily linked to market benchmarks, though to widely varying degrees. The key to alpha-seeking money management is to let skillful managers put their abilities (i.e., perspective, temperament, judgment) to work on the widest possible opportunity set.

Source

John Foley and Richard Beales, "InBev Courts the Tax Man," Wall Street Journal, July 10, 2008

Friday Reading

Special Friday bailout edition--floodwaters here in Wisconsin, Fannie and Freddie in Washington...

• CNBC's Melissa Lee introduced this morning's University of Michigan numbers as "better than expected." Perhaps, but given the absolute level of consumer sentiment, "better than expected" is pretty thin gruel.
• Bloomberg's Caroline Baum seems a bit frustrated that policymakers have put taxpayers on the hook in the midst of the housing/credit meltdown. But The Washington Post's Steve Pearlstein makes a perfectly sensible point: "A financial crisis is not a morality play. What matters most isn't the precedents that are set, the amount of taxpayer money that's implicated or whether people are made to suffer fully for their financial misjudgments. In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact." Our only amendment would be that getting through it "quickly" really isn't the point. It's the intact part that matters most.
• Yves Smith wonders if the way out of all this is through a Japan-style "lost decade."
• Barry Ritholtz notices a not-so-surprising fact: The companies that are brought low by "rumor-mongers" and short-sellers tend to have pretty substantial problems.
• Here's a very interesting think piece on the future of the suburbs from Reuters' Helen Chernikoff.

El-Erian on Squawk Box

As we've noted in this space (here and here, for example), we think PIMCO's Mohamed El-Erian is one of the sanest voices on Wall Street. So when he appeared on yesterday's Squawk Box, we put the DVR to work so we could pass along a few of his most incisive observations. Here's our collection of El-Erian's highlights:

• "Things are bad because the credit crisis has morphed into an economic crisis. Things are bad because policymakers don't have easy solution. No matter how well-intentioned they are, they will create collateral damage."
• "As long as you can underwrite the volatility, there are major bargains out there...things high up in the capital structure."
• "If you're going to recapitalize the financial system, which has to be recapitalized, you're going to dilute somebody. And who are you going to dilute? You're going to dilute existing shareholders."
• "It takes time to recapitalize the financial system. It doesn't happen overnight."
• "You need to be able to hold on when it gets bumpy, because this is not a linear journey."
• "If you get an unexpected rise in prices that people are not ready for, the next move will be up. It's what economists call perverse [unintelligible]. When prices go up, people demand more rather than less; when prices go up, people supply less rather than more. It builds on itself, it feeds on itself, until it exhausts itself. The big question is: Do you break something in the process. It will exhaust itself at some point, but what is the collateral damage?"
• "It's been a puzzle to many of us how 2-and-20 has lasted so long, given that most hedge funds don’t do that well. There are a few hedge funds that deserve it, but many that don't. And at some point investors will wake up and investors will realize that they can get the same service from more conventional providers of investment services. And I think another few quarters of disappointing returns, that will be the wake-up call."
• "There are times, as they say, when you work about the return on your capital, and there are times when you worry about the return of your capital. These days you should worry about the return of your capital."

Wise stuff from Mr. El-Erian.

Wednesday Reading

Mid-week restoration-of-order (commodity-driven stocks higher, broad market lower...for now!) edition:

• Hedge-fund-apalooza: It was a tough first half for the hedgies...and fewer new funds are launching in this environment...but the survivors are hiring.
• We haven't understood the enthusiasm for technology shares for...well, for a very long time (with the exception of Apple on a couple occasions). But where in the wide, wide world did the idea that techs would be insulated from the broader economic downturn come from?
• It's been a debate-through-the-looking-glass for a few months now, but Caroline Baum is right: It's a recession.
• Floyd Norris makes an important point about housing inventories: They're falling very, very slowly.
• Stephen Rosenberg notes that "state pension plans aren't necessarily the best place to put private sector 401(k) money." Read between the lines for an interesting riff on the chord known as "unintended consequences."

David Rosenberg on Corporate Earnings

Whatever the squiggly lines look like in the short run--and they're plenty squiggly today, now up sharply on some sort of financials-driven rally--the medium-term prospects for equities are driven by two things: corporate earnings and market multiples. On those all-important questions, here's Merrill's David Rosenberg, a confirmed member of the reality-based community:

Prospects for a profit plunge are palpable

In the final analysis, only two things go into the forecast for the S&P 500 -- earnings and the multiple that investors are willing to pay for that future earnings stream. While it is normal to see corporate profits decline 30% in a recession, what makes the current and prospective backdrop more sinister is that we headed into this recession with profit margins at sky-high levels. The ratio of pretax profits to nominal GDP has already started to recede from its nearby 55-year high of 14% as we headed into recession to 12.2% currently, but consider that recession troughs usually occur just south of 7% on this metric. If we overlay this with S&P 500 earnings per share, what we are then talking about is the strong possibility that profits end up being cut in half during this bear market -- which would mean an ultimate low of around $45 on operating earnings (in other words, we are only one-third of the way through the earnings turndown at a time when the consensus seems to priced for the bottom being right about now!).

Now to put this into some sort of perspective, the 4-quarter trailing EPS in the 2001 recession hit a trough of around $38 and in 1991 the trough was jut over $18 so we are not talking about Armageddon here but rather offering up some analysis highlighting the what the risks are the outlook. We will bottom at levels much higher than the troughs in the past, that is the good news. The not-so-good news is that the level of the S&P 500 in the past that tended to coincide with $45 earnings was right around the 1,000 mark; and if we were slap on a typical trough multiple of 10x-12x on that earnings stream, then...well, you do the calculation. Either way, as economists judging the earnings landscape, it is extremely difficult for us to be calling for a bottom in this market outside of the intermediate oversold lows that are the domain of technical analysts and generally prove to be very temporary as we saw back in January and March of this year. One of the biggest fundamental hurdles to the market, we're afraid, is going to be the risk of continued negative earnings surprises, especially with the consensus predicting earnings growth of 13% the second quarter and 59% in the fourth.

Source

David Rosenberg, "Morning Market Memo," Merrill Lynch, July 7, 2008

Alpha and Beta Exposures

We've argued repeatedly that investors and advisors should be more aware of the distinction between alpha (idiosyncratic, manager-driven returns that are relatively uncorrelated to any underlying asset class or benchmark) and beta (systematic, market-driven returns that track underlying asset classes or benchmarks).

Two recent items suggest that such awareness is on the rise among institutional and individual investors. Here's an excerpt from Pensions and Investments:

Some institutional investors are betting on highly concentrated equity portfolios to gain more alpha while at the same time expanding allocations to their core passive strategies, according to consultants, managers and pension fund executives.

As global equity markets are showing signs of a lengthy slowdown and investors are more cautious about costs, a new approach to the traditional core-satellite strategy is spreading across the world. The idea is anchored on the premise that investors in active equity strategies that hug a particular benchmark might be paying for alpha but getting mostly "closet" beta, consultants and managers said.

Another contributing factor is the poor performance of enhanced indexing and quantitative risk-control strategies. Once considered as a reliable way of harvesting alpha, many of these strategies -- which tend to make a large number of small bets against an index -- have nosedived in performance, driving investors to seek different sources of return, consultants said.

According to proponents of the updated core-satellite approach, investors should use a largely passive core portfolio coupled with more concentrated bets to maximize alpha in a cost-efficient way by using one or more concentrated managers.

And here's more from Advisor Perspectives:

Distinguishing alpha from beta matters because fees for beta from well-established asset classes should be very low, while fees for alpha are very high. Furthermore, you should select alpha providers carefully so the fees are worth it! Separating alpha from beta (in a clearly defined measurement or evaluative sense, not necessarily by investing separately in them) insures[*] you will pay high fees only for positive expected alpha, not for the delivery of a beta along with random, unskillful alpha production.

The point here isn't to argue for some super-strict separation in which alpha-seeking instruments must have zero beta (which, even if theoretically possible, is vanishingly unlikely in practical terms). It's to argue that there's a lot of beta out there masquerading as alpha. Investors and advisors who know the difference, and resist paying for one while receiving the other, should do better, on balance, than those who don't.

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

* Pedantic diction-related aside: The word here should be ensured, which implies making something sure, not insured, which implies the business of insurance.

Sources

Thao Hua, "Finding Alpha With Few Bets," Pensions and Investments, June 23, 2008

Robert Huebscher, "Don't Pay Alpha Fees for Beta Performance," Advisor Perspectives, July 8, 2008