The Float

Words of Wisdom

Two useful items from two of our favorite participant-observers: Mohamed El-Erian and John Hussman. Frist, from El-Erian's interview with Advisor Perspectives (bold text in original):

Another principle you advocate is the separation of alpha and beta in portfolio construction (something we have written about in our publication). Why has this principle gained in importance and how can advisors best implement it?

The dispersion of returns among actively managed strategies has become very large. In the old days, the dispersion resembled a "fan chart." It started with relatively small dispersion in fixed income classes, to larger ones in public equities and very large ones in illiquid asset classes. Today, we are seeing much more dispersion across all asset classes. The result is, unless you are absolutely confident of your active management choices, it is better to go passive.

The cause of this greater dispersion is that markets are more volatile. We came from a period (until the middle of 2007) that was very good to investors. Risk premia across all asset classes were compressing, delivering high returns and declining volatility. As long as investors were exposed and levered they did well. Now investors can get easily caught with the wrong position in a highly volatile environment. The hurdle for active management has gone up. You have to be sure you are actually getting something. You are paying higher fees and being exposed to more risk.

And here's Hussman, on the intertwined roles of government and Wall Street in the unwinding of the credit bubble:

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident -- bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government -- which allowed all of this to occur -- is also what will be called upon to clean up the mess.

Read the whole Hussman comment, especially for his take on the making of the credit bubble. We think it's one of his best efforts.

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

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.

Caution: Reporters Trying to Help

In Sunday's Washington Post, Nancy Trejos assembled a true classic of the "what-should-investors-do-now" journalistic genre. Fortunately, Trejos quotes a couple sane observers, most notably Vanguard's Gus Sauter. But there's enough unhelpfulness in this piece to merit a few observations.

First, even the subtitle--"How to Play Your Stocks When They Keep Falling"--implies a wrong-headed approach to the financial markets. The number of Post readers who should be "playing their stocks" in any environment is vanishingly small. But let's move on to the more substantive elements here. We'll pull a few passages out and add some commentary after each item.

So if your money's tied up in the stock market, what are you to do?

First of all, if you've properly diversified your investments among various sectors and stocks, bonds and mutual funds, strategists suggest you just hold tight.

This isn't a huge deal, but as we've noted on several previous occasions (here, for example), some journalists tend to conflate investment vehicles (in this case, mutual funds) with asset classes. They're different, of course, and reporters should know--and help their readers understand--the difference.

If you decide selling is the right move, make sure you do it a little at a time. "Selling today will lock in that loss. Our recommendation would be to continue to trim but don't do a wholesale fire sale," said William Keller, senior vice president and director of investments for the Washington region at PNC.

This notion of "locking in" losses bothers us a little. A loss is a loss, whether it's realized or not, and though tax considerations might affect one's timing preferences on the margin (in some cases making selling more attractive in order to offset realized gains), selling (or reducing) a position is either a good idea or it isn't. If it is, then lock that loss right in there!* Doing so "a little at a time" is only a good idea if one is scaling out of a position as part of a serious, systematic plan.

Yared, on the other hand, thinks that if it's a real loser, you should not be afraid to dump it. "From an investors' point of view, you have to be somewhat coldhearted," he said.

Do a lot of research beforehand, a rule that applies to both buying and selling, he said. Look at balance sheets, stock prices, growth rates, the history of the company. Read its quarterly and annual reports. All that information and more is available on the Internet, he said.

Yared's plea for coldheartedness is spot-on. But that second paragraph, the Cramer-esque bit about digging into balance sheets, growth rates, and company reports strikes us as decidedly bad advice for the vast majority of the Post's readers, advice that encourages rank-and-file investors to overestimate both their own abilities and the utility of such information in the first place.

Late in her piece, Trejos names four companies: Johnson & Johnson, Wal-Mart (or is it now *Walmart?), General Electric, and Goldman Sachs. Cue the crickets! All that stock-jockeying advice and what do we get? A semi-plausible four-stock proxy for the S&P 500. Go figure.

But let's conclude on a high note:

Of course, each individual investor has to decide how much risk he or she can tolerate and go from there, the strategists said. If all this is too much for you and you just want to hold on to your cash, that might be the right move for you, but consider this: Inflation might be on the way, and if it gets here, it'll take a big bite out of your reserves.

"Cash has its own risks, and the erosion of purchasing power is one of them," Horan said.

That's not to say you shouldn't keep cash. "You need to have a fallback of immediate liquidity whether it's a line of credit or cash at hand," Keller said. "You have to have that because these are rocky times now."

Yes, yes, and yes, with one important amendment: inflation isn't "on the way." It's already here.

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* Of course, one can "lock in" losses if one sells a position (at a relatively low price) and doesn't replace that position until asset prices have risen. But selling X and buying Y more or less at the same time doesn't "lock in a loss" so much as it changes one's exposure from X to Y.

Source

Nancy Trejos, "When You're Tied Up in a Down Market," Washington Post, June 29, 2008

Earnings: The Next 12 Months? Or the Last?

As Barry Ritholtz noted over the weekend, certain media outlets seem determined to find reasons for optimism in equities' recent breakdown. Not that there's anything wrong with that! Who knows. Maybe these will turn out to be "attractive levels."

One of these efforts to find a glimmer of short-term hope--Greg Zuckerman's weekend piece in the Wall Street Journal--revealed one of the stubborn realities of current market conditions.

Here's Zuckerman:

On Thursday, the Dow fell below the level reached in March, when brokerage firm Bear Stearns was fighting for its life, and now stands at levels not seen since September 2006.[*]

The good news is that the overall market now is beginning to look more attractive based on any number of metrics. For example, the S&P 500 now trades at a price-earnings multiple of about 15 times this year's expected earnings.

The 10-year average is 18.7, covering a period of investor exuberance, as well as the 2000-2002 market downturn. The 24-year average P/E ratio is 15, and that includes a period of much higher inflation than now. That all suggests that the market is reasonably priced, though not yet at bargain-basement levels.

Yes, but...

Other measures are more ambiguous. Because future earnings are harder to get right, some look at profits over the past 12 months. On that basis, the price-earnings ratio of the S&P 500 is 21, compared with a long-term average of about 16, according to Birinyi Associates.

This is the big question, at least for equities' medium- and long-term prospects: Where are earnings headed?** What of the potential gap between actual and reported earnings? If corporate earnings fall, will traders and investors take the market multiple lower as well, resulting in a double blow to equity prices?

From where we sit, the probabilities aren't especially bullish. But Zuckerman's reveals just how important one's perspective is at times like these. If backward-looking valuations aren't cheap, and forward-looking estimates are too rich...well, you get the picture.

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* Some perspective: As of Friday, the S&P 500 had returned to the level it reached at the beginning of 1999, 2001, and 2006.

** In the short run, the market will be, as ever, a function of animal spirits, fiscal and monetary policymaking, and a grab-bag of pure contingency.

Source

Gregory Zuckerman, "Snatching Bargains From Bear's Jaws," Wall Street Journal, June 28, 2008

Growth and Value

Sifting through a stack of old newspapers over the weekend, we ran across a Wall Street Journal story that gave us fits. This is the sort of work that diminishes public understanding of financial markets, products, and services. It's three weeks old, but we still feel obligated to shed some light on it.

In a "Fund Track" item on the allegedly mediocre year-to-date performance of several Fidelity mutual funds, Jennifer Levitz opens with this:

Last year, after being needled by analysts for lukewarm performance, Fidelity Investments seemed to regain its footing. But so far this year, only 39% of Fidelity's equity funds are among the top half of their peers, compared with 64% for the same time period last year, according to the Chicago research group Morningstar Inc.

So far, so good...if not especially interesting or important. But the last section of the story gets very strange indeed (emphasis added in bold):

Morningstar analyst Christopher Davis said the numbers may show that what worked for Fidelity last year isn't working this year. After a long dry spell, growth stocks, a Fidelity specialty, surged in 2007, only to stumble this year amid recent market turmoil. Growth funds seek companies that are expected to have outstanding earnings gains.

"The reason they looked so good last year is the same reason that this year they don't -- Fidelity leans toward growth," Mr. Davis said. While Fidelity has "every niche covered" in the fund world, "they need to strengthen" the other categories, he said, adding that Fidelity has many more large-company growth funds than large-company value funds -- which scout for undervalued, cheap stocks.

There are two problems here. First, Fidelity's underperformance most certainly isn't a product of its lean toward growth. Why not? Growth has outperformed value by a comfortable margin this year! Here are the year-to-date performance numbers for two ETFs representing large-cap growth stocks (through June 9th, the day before the Levitz piece was published, not including dividends):

• IVE (S&P 500 Value), -9.70%
• IVW (S&P 500 Growth), -3.77%*

So no, the problem isn't growth per se. But then even if growth had underperformed value, that still wouldn't make the point Levitz seems to want to make. After all, Morningstar's comparisons are within categories (i.e., style boxes), so if Fidelity's three flagship growth funds (Magellan, Contra, and Growth)are lagging, they're doing so relative to other large-cap growth funds, which makes the value/growth comparison moot.

So the story is misleading on two levels: the relative recent performance of growth and value and the nature of the comparisons introduced in the opening paragraph.

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* Through Friday's trading, the year-to-date numbers were -16.93% for IVE (value) and -8.48% for IVW (growth).

Source

Jennifer Levitz, "Fidelity Stumbles in Bid to Regain Footing," Wall Street Journal, June 10, 2008

Bloomberg 401(k) Story

If you're a citizen of this planet, and whether you have assets in a defined-contribution (DC) retirement plan or not, you simply must spend 25 minutes watching Bloomberg's recent report on the extent and effect of hidden expenses in 401(k), 403(b) and 457 plans.

The report is a powerful indictment of the status quo, even as it misses a few points that we think are central to the ongoing argument about what plan participants should pay (and pay for). Here, we'll just point to a few items that we thought were especially apt:

• Bloomberg's Mike Schneider notes early in the feature that a 2007 AARP survey indicated that 8 of 10 respondents said they didn't understand the expenses they paid in their DC plans. We'd hazard a guess that, due to implicit costs (some of which were illuminated by the Bloomberg report), the other 2 of 10 respondents don't know what they're paying either.
• John Hancock, Fidelity, and Nationwide refused to allow their spokespersons to appear on Bloomberg's air. Disappointing. Not surprising, but disappointing. The delicate dances their flacks would have had to do would make good teevee.
• As ever, costs are three-fold: explicit, implicit, and behavioral. We're all for exposing service providers' cynical skimming operations, but we'd like to see more attention paid to the often-disastrous effects of participant decision-making.
• The following statement from the National Education Association is an embarrassment to educators everywhere: "It's hard to deliver a program like this with a low fee because there are commissions paid to agents." No, it's not hard at all. And it's pathetic to suggest otherwise. A good first step would be to eliminate variable annuities from DC plans--or at the very least de-emphasize them in favor of less expensive, more appropriate investment vehicles.
• Greg Kasten notes that revenue-sharing payments are "sort of a pay to play type of arrangement." No doubt! As he says in the story: "The mutual fund has to make a payment to the insurance company, or the insurance company won't recommend the mutual fund." Here's another easy step: Pay for services on a fee-only basis, with no kickbacks or hidden deals whatsoever. That's the only way to ensure that fund selection and replacement are done on the merits.
• This was news to us, and we're not entirely sure what to make of it without a little more context, but Wal-Mart's apparent agreement with Merrill Lynch to not disclose the fee report for the Wal-Mart 401(k) is almost unbelievable. We say "almost" instead of "absolutely" because we've seen too much to disbelieve anything.

We'll be back with more on this topic soon. For now, we give big props to Bloomberg for airing this story. We hope the media stay on this beat. There's still more for reporters, editors, and producers to learn, and thus more for them to teach sponsors and participants alike about this enormously important topic.

We invite you to check out a few of our many discussions of issues related to DC retirement plans.

Source

Mike Schneider, "The Truth Behind Hidden Fees in 401(k) Plans," Bloomberg Television, June 19, 2008

Major Bloomberg Story

Notwithstanding our best-laid plans, this week has turned into a blogging vacuum. Monday we're back at it--with feeling.

Next week we'll give significant attention to the major Bloomberg story on hidden expenses in defined-contribution retirement plans. This is big stuff, important stuff, and we'll give it the full treatment when we're back in the saddle.

For now, we encourage you to take a look at this short preview at 401khelpcenter.com, then watch the televised feature, which, at the moment, is mid-page at Bloomberg.com.

Trading Range?

This weekend's Wall Street Journal featured excerpts from an interview with Barton Biggs, a former chief investment strategist at Morgan Stanley. Here's a classic Wall Street hedge (emphasis added in bold):

Conventional wisdom is that the market will test its lows, and go lower again. A really serious bear like George Soros thinks we've seen just the first part of the bear market. I'm nervous, but my intuition tells me that after this consolidation is over, the next move will be up, not down.

Psychology is involved here. I like the fact that the market is worried. I like that The Wall Street Journal runs articles about that. That's all good. But the puke point has been reached, in March. Because of the problems we're living under, the market should be in a trading range for the rest of the year, between 1250 and 1550 in the S&P 500.

Ummm...a trading range between 1250 and 1550? What kind of trading range has a upper limit that's 24 percent higher than its lower limit? By our lights, that pretty much drains any meaning from the term.

Source

Larry Light, "One Bold Analyst's Latest View: Worst is Over for Economy, Stocks," Wall Street Journal, May 31, 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.