The Float

Asset Bloat and Index Hugging

That was timely. Just after we posted this morning's item on asset bloat in mutual funds, the Journal's Marketbeat reported a few findings from a recent Citigroup assessment of the 50 largest actively-managed U.S. stock mutual funds (which, speaking of bloat, manage $1.8 trillion, fully 37 percent of domestic equity fund assets).

Marketbeat provides only a partial list of these big funds' top holdings, but the names are plenty revealing: General Electric, AT&T, Google, AIG, Microsoft, Coca-Cola, and Pepsi are mentioned as prominent positions. According to Barclays Global Investors, those seven stocks are the 2nd, 4th, 20th, 9th, 5th, 26th, and 25th largest positions, respectively, in the S&P 500 index.

These funds tend to behave like their benchmarks because they pretty much are their benchmarks, and we're sure we'd find more of the same if we saw the full results from Citigroup's analysis.

Given their need to move such enormous amounts of money around, the managers of these giant funds simply must invest in the largest, most liquid securities in the market. And given legal limits on the percentage of a stock's float any single fund can own, the biggest funds truly have no alternative but to invest in securities with the largest market caps.

So it's no wonder that such a huge percentage of the variability in these giant funds' returns can be attributed to their underlying benchmarks.

What does all this mean? As Ross Miller has established, investors in these big funds are effectively paying multiples of their stated expense ratios for the incremental slices of true active management those funds deliver. And that doesn't strike us as a particularly attractive cost-benefit equation.

Source

Ben Warwick, "The True Costs of Active Management: Think mutual funds are cheaper than hedge funds? Not a chance," Investment Advisor, February, 2007

The Problem of Asset Bloat

A Wednesday holiday makes for a funky week. Didn't we just get back to work yesterday!?

This is a little dated now, but we just noticed it: a Chet Currier column (from May 15th) on the problem of asset bloat in mutual funds. We've mentioned this issue before and continue to believe investors should take it seriously. Given the realities of market impact, the difference between managing a small, nimble fund and a big, bloated one is a little like the difference between steering a 25' speedboat and an aircraft carrier.

Currier's column is solid--and important--but we don't see the logic in his closing riff on the implications of asset bloat for the choice between actively managed funds and index-based alternatives. Here's Currier:

The problems posed by asset growth are often cited as a reason to shun actively managed funds in favor of index funds, which keep the same shape (that of the index on which they are based) as they grow. Well, index funds aren't immune to the effects of shifts in market conditions.

Funds based on the S&P 500 attracted huge asset flows in the late 1990s. Wouldn't you know, the S&P 500 then embarked on a sustained period of sluggish performance as the big stocks that dominate the index lagged behind small stocks.

That much is true, but the S&P 500 lagging smaller cap stocks doesn't remotely suggest problems with index-based strategies per se. It simply indicates that one asset class (large-cap U.S. stocks) underperformed another (small-cap U.S. stocks) over one particular period. Any intelligent asset allocation discipline--one that uses index-based vehicles as core holdings--would have provided exposure to that outperforming asset class throughout the last several years.*

For investors who chased big-cap performance, the problem wasn't S&P 500 index funds...it was performance-chasing!

Now, as we noted last week, we aren't suggesting that active management is always and forever doomed to underperform. In any given year, of course, some actively managed funds will outperform their benchmark averages by definition. But over longer periods, big, diversified funds will tend to underperform their benchmarks by an amount roughly equal to their (explicit and implicit) costs and tax-inefficiency.

Active management certainly has a role to play in many investors' portfolios. But we think it should be pursued in the right framework: agile (as opposed to bloated), eclectic (as opposed to style-constrained), and a little contrarian (as opposed to purely momentum-chasing). Risk-averse investors might also look for managers who run money with an absolute-return orientation, where capital preservation matters more than performance relative to some benchmark.

Currier is right to point to the problem of asset bloat, but he's not as convincing on the implications of S&P 500 underperformance for index-based investment strategies.

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*Another important note: The problems of asset bloat and market impact can be especially pronounced for small-cap funds because they trade in less-liquid securities.

Source

Chet Currier, "Success May Be Downfall of a Perfectly Good Fund," Bloomberg, May 15, 2007

Tax Changes Coming for Out-of-State Munis?

Plenty of ink has been spilled on potential changes in the federal tax rules affecting private equity shops after they go public. Here's another tax issue to keep an eye on: The constitutionality of state laws that tax interest paid by out-of-state municipal bonds but don't tax interest paid on in-state munis.

On Tuesday, Bloomberg's Joe Mysak devoted his column to the case of Davis v. Kentucky, which the U.S. Supreme Court has scheduled for the session that begins in October. (The Court won't issue its ruling in Davis until sometime in the first half of 2008.)

Mysak is absolutely right that the case could usher in major changes in the way state and local governments issue (and, of course, tax) municipal bonds, the way Wall Street packages and sells those bonds, and the way individual investors buy them. Here's an excerpt:

The U.S. Supreme Court is going to deliver an ugly surprise to state governments: The tax they impose on interest on out-of-state bonds is unconstitutional.

That's the opinion of two law professors who have examined the case, Davis v. Kentucky, to be argued before the nation's top court in the term beginning in October.

Most states tax the interest on bonds issued by other states; some even tax the interest on their own bonds. Should the court decide that they are discriminating against interstate commerce by levying those taxes, the states would have to consider dropping those taxes, or taxing all bonds the same.

And that could lead to a real mess. There are almost 500 single-state bond funds with assets of more than $155 billion, according to the Investment Company Institute. Take away the in- state tax advantage, and you take away the reason to buy those funds. The fund companies would presumably seek to blend those assets into national funds.

Such a court decision would also make it a lot more expensive for high-tax states, such as California and New York, to borrow money. Their captive audience of in-state investors would be free to buy any bonds they wished.

And just imagine the lawsuits to be filed by investors looking to get back the taxes they paid on out-of-state bonds.

For those interested in the questions of constitutional law at stake in Davis, Mysak's piece is worth a look. If you want to dig into the scholarly work on which Mysak based his column, you can download the paper by Ethan Yale and Brian Galle here.

Sources

Emily Chasan, "Tax woes drag on Blackstone," Reuters, June 22, 2007

Joe Mysak, "Scholars Say Top Court May Dismantle Muni Bond Taxes," Bloomberg, July 3, 2007

Ethan Yale and Brian D. Galle, "Municipal Bonds and the Dormant Commerce Clause After United Haulers." Tax Notes, Vol. 115, June 11, 2007

About Those Rating Agencies...

Just onto the wires: A Fortune story about Ohio Attorney General Marc Dann building a case against the three major rating agencies--Standard & Poors, Fitch, and Moody's--for their role in the subprime mortgage/CDO fiasco. (For our recent thoughts on that fiasco, click here, here, and here).

Here's a key passage:

Dann and a growing legion of critics contend that the agencies dropped the ball by issuing investment-grade ratings on securities backed by subprime mortgages they should have known were shaky. To his mind, the seemingly cozy relationship between ratings agencies and investment banks like Bear Stearns only heightens the appearance of impropriety. In addition to receiving fees from bond issuers that want ratings, S&P, Moody's, and Fitch do not vet data provided by these customers - information the agencies use to make their credit assessments. It's a bit like a take-home final. Or as Moody's puts it in its own code of conduct, "Moody's has no obligation to perform, and does not perform, due diligence." The other two agencies have similar provisions.

This is a story worth watching.

UPDATE: Let's not forget that big institutional investors aren't the only ones paying the subprime tariff. (Via Charles Kirk.)

Sources

Katie Benner and Adam Lashinsky, "Subprime contagion?" Fortune, July 5, 2007

Ian Katz, "Brokers' wrong bets cost South Florida seniors millions," South Florida Sun-Sentinel, July 4, 2007

One Headline to Rule Them All

Monday afternoon we noted a long series of Wall Street Journal headlines, stretching over a little more than a week, that together seemed to flash a yellow light for the LBO boom. Then, Tuesday morning, the Journal's Dennis Berman looked to squelch all that talk with this: "Cold Feet Aside, the Buyout Boom Has Legs: Private Equity Adapts Easily to Changing Reality; Just Look at the BCE Deal, the Largest LBO Ever." Here's Berman:

The bad news is piling up for private equity.

Investors are getting cold feet about pouring more money into bonds and loans used to fund takeovers; Congress is demanding buyout shops pay more tax; public investors are clamoring for sweeter prices on take-private transactions. Blackstone Group LP's share price is down 5.6% since its initial public offering.

The end of the buyout boom is nigh!

Not quite.

Then yesterday we get news of Blackstone's $26 billion Hilton takeout. Berman's argument--that private equity players are loaded with cash and plenty adaptable--appears sound from here.

Source

Dennis K. Berman, "Cold Feet Aside, the Buyout Boom Has Legs: Private Equity Adapts Easily to Changing Reality; Just Look at the BCE Deal, the Largest LBO Ever," Wall Street Journal, July 3, 2007

"Hilton would pay $560 mln Blackstone break-up fee," Reuters, July 5, 2007

More on the "Mark-to-Model" Problem

Via Brad DeLong: A June 27th Financial Times story on the problematic valuation of collateralized debt obligations (CDOs). Here's a key excerpt:

Christian Stracke, analyst at CreditSights, a research company, says: "With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess." Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave--as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the "unusually high probability" of events that "could have large effects on market values."

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen's Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used--which had been supplemented with brokers' quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers' discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex. Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits--even when markets fall.

As we noted in our last post, the Bear Stearns fiasco has grabbed most of the headlines...but the larger structural problem of valuation in illiquid markets--where valuation determines manager payouts--reaches well beyond Bear's canary-in-the-coal-mine funds.

UPDATE: Marking to the model is one thing. In brutally illiquid markets, honoring clients' redemption requests appears to be something else entirely. Here's a revealing passage from the Wall Street Journal's update on the United Capital Markets story coming out of Florida today:

Paul Ullman, who runs another high-profile hedge-fund firm in the business, HFH Group LLC, New York, said, "The marketplace for mortgage-related asset-backed securities is characterized by a wide difference between bids and offers, and as a result trading volume has dropped."

A wide difference between bids and offers? No doubt!

Source

Saskia Scholtes and Gillian Tett, "Worries grow about the true value of repackaged debt," Financial Times, June 27, 2007 (subscription required)

Jody Shenn and Jenny Strasburg, "United Capital's Devaney Halts Hedge Fund Withdrawals," Bloomberg, July 3, 2007

Gregory Zuckerman, "United Capital Halts Hedge-Fund Redemptions," Wall Street Journal, July 3, 2007 (subscription required)

"Mark-to-Model" Valuation

Amid all the concern over Bear Stearns' broken hedge funds, the larger issue here is the practice of so-called "mark-to-model" valuation (as distinct from mark-to-market valuation, in which prices are readily available for long and short positions).

As we learned yesterday, Bear plans to announce estimates of the funds' losses on July 16th, so you might want to mark that day on your calendar.

Until then, the investment community is left to ponder the more general implications of so many hedge fund managers marking to their models. Just how good are those models? In highly illiquid markets, how can we know how good they are? Aren't there incentives for managers to deploy models that inflate the value of portfolio assets...and thus their management fees? If this practice is problematic, is there a serviceable solution? If so, what is it?

In today's Globe and Mail, Barrie McKenna responds to all this by arguing for more transparency in the hedge fund world. Here's McKenna's punchline:

The big returns from hedge funds have been one of the main drivers of the private equity takeover binge. If it turns out that at least part of the boom was built on an artifice of inflated asset values, Bear Stearns' pain could become everyone's problem.

As Veryan Allen points out, however, illiquid assets aren't necessarily bad investments as long as the reward justifies the risk...and that risk is properly hedged. The following passages are a bit technical, but Allen's point is hugely important.

You really have to know what you are doing when designing models of prepayment and mortgage credit risks; nothing in the academic literature or public domain works. Credit is neither stochastic nor continuous and when it jumps it really jumps....When a product is very thinly traded, indicative dealer prices are pretty useless. If a fund is investing in illiquid instruments the fund valuation needs to be marked to the real bid, in size. Mark to market is possible only when there is a market.

There is nothing inherently wrong with investing in "untraded" assets provided the risk-adjusted returns are sufficient to compensate. In bearish credit conditions ideally you usually want to be long the liquid and short the illiquid but weaker credit funds and less experienced managers do the opposite.

...

Just as with LTCM, being long the illiquid and short the liquid works well until the market reverses and then years of consistently positive months get given back in one massively negative month. Leverage, liquidity and valuation risks are ONLY worth taking if you are compensated for those risks and plainly this was not the case.

The high-profile Bear Stearns breakdown has captured headlines, but the underlying--and widespread--problem of mark-to-model valuation isn't going away any time soon.

Sources

"Bear Stearns to add up fund losses by July 16: report," Reuters, July 2, 2007

Barrie McKenna, "Murky world of hedge funds in need of more transparency," Globe and Mail, July 3, 2007

Pre-Holiday Reading

With a short trading day and Wall Street's ritualistic exodus to the Hamptons pretty much complete, a few items from around the web...

• Are we stuck in a long-term trading range? A few participants at last week's Morningstar conference seem to think so.
• Economic forecasting is notoriously difficult...but for what it's worth, the conventional wisdom seems to expect a decent Q2 number followed by a weaker second half.
• This sounds painfully familiar: Treasury Secretary Paulson says housing is "at or near the bottom." We think that depends on what your definition of "near" is.
• Today's number on existing home sales? Not a pretty picture.
• The 10-year Treasury note? Flirting with a 4-handle once again.
• What explains the long-term outperformance of stocks over other asset classes? Walter Updegrave offers a few answers--and three solid rules for investors--here.

We Sense a Theme Here...

Here's a selection of headlines from The Wall Street Journal over the last week or so. The big question is whether this flurry of coverage marks the top of the debt-fueled deal-making...or whether it's a contrarian indicator that the frenzy isn't over.

June 23-34, 2007

• "Bear Stearns Bails Out Fund With Big Loan: Injection of $3.2 Billion Caps Days of Drama; Subprime Sector Fears"
• "Risky Debt Issuances Meet Investor Resistance"

June 25, 2007

• "Subprime Crisis Is Likely To Continue Its Sting"

June 26, 2007

• "Behind Buyout Surge, A Debt Market Booms: CLOs Spark Worries Of Volatility and Risk; Loan Standards Loosen"
• "Hard Times for Easy Credit: End of Line Could Be Near Amis Housing-Sector Woes; Mood IS Far From Desperate"

June 27, 2007

• "How Wall Street Stoked The Mortgage Meltdown: Lehman and Others Transformed the Market For Riskiest Borrowers"
• "Bonds Becoming a Tougher Sale: Investors Finally Balk At Prices for Risky Debt; New Rules for LBOs"
• "Is Cheap Debt Drying Up?"

June 28, 2007

• "Market's Jitters Stir Some Fears For Buyout Boom: Takeover-Related Debt Gets Chilly Reception; Hearing 'Wake-Up Call'"
• "Banks on a Bridge Too Far? As Risk Rises in LBOs, Investors Start to Balk; Warning from Overseas"

July 2, 2007

• "Subprime Flu Sheds a Light On Derivatives"
• "Subprime Woes And New Data May Hit Bonds"
• "Is Corporate Credit Party Almost Over? Junk Issuance Jumps But Riskier Debt Starts to Spur Jitters"

UPDATE: More of the same today from CNNMoney's Grace Wong ("Private Equity Shakeout Looms: As investors turn away from risky debt, conditions for leveraged buyouts get tougher; firms with the sharpest elbows will be left standing") and Bloomberg's Michael Tsang and Daniel Hauck ("Stocks Lose Takeover Premium as Buyouts Slump, Bond Yields Rise").

What a Difference a Day Makes

"BlackRock, Despite Trend, Declines Hedge-Fund Lure," Wall Street Journal, June 26, 2007

"Demand for New Funds Spurs BlackRock: Deal With Quellos Group Expands Firm's Offerings Of Alternative Investments," Wall Street Journal, June 27, 2007