Sunday, November 28, 2010

Can China Be Hedged?

There is a difference between people and markets. While both have histories, they are portrayed differently. The experience of people is recorded with lots of emotions, thought processes and personalities. We record market movements whether they are for securities, commodities, real estate or objets d’art in two dimensions, up or down. I believe the study of both are essential for any successful investor. However, the study of people should serve as alerts to those who focus on the history of markets.

Calamities Travel

Once in a while the single tree falling in a forest or an insect flapping her wings could be the start of a world-wide calamity. There are two relatively recent examples that I saw early, but did not fully comprehend until much later, to my accounts’ disadvantage. The first was the collapse of a Greenwich, Connecticut based hedge fund firm called Long Term Capital Management (LTCM). Actually before the founding of LTCM, I was exposed to one of its widely proclaimed “geniuses.” This learned academic gentleman believed that market-based statistics could be used to predict future market prices. He was correct in many instances, but not in each and every instance. He and his associates applied their mathematical skills to foreign treasury instruments with considerable leverage. They were totally “blindsided” when the Russians defaulted on their treasury issues. My mistake was I did not fully understand the implications of this collapse, after all none of my accounts were exposed to Russian paper. Initially I missed two knock on relationships. The first was the contagion effect. LTCM and other leveraged players (more on this shortly) needed to quickly restore their capital base. They quickly sold their other emerging market positions. (I did not foresee how a Russian default would be the cause of Mexican market decline.)

The second relationship, or if you prefer the second order problem that I missed, was the nature of the trading community. LTCM was one of the largest customers of many fixed income trading desks on “The Street.” Initially these desks merely filled the order of their customer rapidly, perhaps in some cases they sold short the securities as part of filling the order. Soon they saw how successful LTCM was and they followed its trading patterns and in some cases put money into LTCM’s funds. The size of these actual or potential losses would have been very large for the trading community if all of The Street’s trading positions had to be liquidated quickly when LTCM problems became known. Unlike the more recent cases of Bear Stearns and Merrill Lynch, the government recognized the problem early, but the Fed did not ride to the rescue of LTCM with saddle bags full of money. The Federal Reserve Bank of New York convened a meeting of all the principal players including a very reluctant Bear Stearns and would not let the participants out of the meeting until they agreed to loan enough money to LTCM so it could be prudently liquidated. Thus Wall Street was saved from its own potential collapse. (In this instance the FRB of New York played the role of J.P. Morgan when he helped end the “Money Panic of 1907,” before the Federal Reserve was created.) Thus, the tree falling in Moscow almost took down the entire trading market in the US and probably elsewhere as well.

The Sub Prime Calamity

While I recognized that far too many people were speculating in real estate and that amateurs often lose to professionals in the market place, I did not appreciate who the real losers would be. (The providers of credit all the way along the line were the losers.) Initially, people began writing about the ballooning sub prime and the “Alt A” mortgages and that they would lead to bankruptcies and a slowdown on the building of new homes. While this was serious, at the time it was not of monumental importance, as new house construction is a small part of our expanding economy. Once again I was not sufficiently conscious of significant changes and how the market place was operating. I did not fully comprehend that the major investment banking houses had become the center of the mortgage origination casino to feed their securitization sales forces. This process was replicated in the UK, Australia, and elsewhere and the resulting production of mortgage slices were owned throughout the world, including places as distant as Norway and China. While in the case of LTCM the infusion of leverage was at the so-called professional level, at almost every stage of the housing chain leverage was induced so there were many more losers, including those living on fixed income from these mortgage tranches. When the various governments started to get inklings as to the size of the looming debt on the way to non-payment status, the governments rode to the rescue to save at least their financial communities, if not their economies. (We can debate whether the rescue attempt was ham-handed and whether the private sector should have been let to sort out the problem, as Mr. Morgan forced in 1907.)

Is China A Potential Calamity?

Recently I spent time thinking about conventional asset allocation strategies. In almost all cases, institutions are attempting to broadly diversify their assets. Often the categories they use are as follows:

  • emerging market equity and debt
  • developed market equity and debt
  • domestic equity and debt
  • commodities including timber
  • domestic and foreign real estate

My unanswered concern is that these diversification attempts are making a common bet and therefore do not have the diversification against a major risk, which suggests there exists a potential for a major dislocation. All of these classes are exposed to China in one way or another. Most emerging markets are increasing their trade with China. General Motors sells more cars in China than the US. Proctor & Gamble, Coca Cola, Microsoft and soon Apple, have important sales and/or facilities in China. “The Middle Kingdom” is the swing buyer or seller of most non-agricultural commodities in the world. Almost all bonds are priced in relationship to US Treasury issues of similar maturities. The Chinese convert much of their trade surplus with the US into the purchase of US bonds, which helps to absorb our increasing deficits. A significant slowdown in China’s purchases, let alone its absence from the market, could send most bond prices down around the world.

I am not an expert on China. I have a great deal of respect for its economic leadership so far. Perhaps these “experts” will continue to manage the population’s needs and desires as they have done in the past, but each year it becomes more difficult. China has replaced the US as the locomotive for global growth. This is not a prediction but an observation that at some point it is conceivable that the engine will perceptively slow down or even temporarily go off its planned track. With so much of the world dependent on the continued growth of the Chinese economy, a slight flicker or a rumor of an unexpected result could cause all markets to react.

How Does One Hedge The Chinese Risk?

Granted we don’t know for sure that there is such a risk, but we should have learned from the LTCM and sub prime examples that calamities can happen. As a professional investor I would like to identify a satisfactory hedge against the possibility of a Chinese calamity. I would like to do this on two counts. First, I am in the market for some insurance. Second, if there was a recognized hedge, its price action could be a clue to a the current market’s perception of the risk.

I have reviewed all of the current asset allocation categories and have found to varying degrees each is dependent on developments within China. At the moment I can not find an independent hedge. Perhaps you will share your thoughts with me on such a hedge or at least your leading indicator of Chinese problems.

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Sunday, November 21, 2010

Have We Created New Fiduciary Standards?

I am fortunate to be a member of various non-profit investment committees along with a number of very keen investors. In these settings we are able to share our experiences and relevant readings. I hope that this blog community benefits from these associations. An off-setting disadvantage is that perhaps I read too much.

This week I read an excellent review by the renowned law firm Milbank, Tweed, Hadley & McCloy on the enactment by the State of New York of the “Prudent Management of Institutional Funds Act.” All too often laws and regulations have the impact of lowering the investment returns of sophisticated investment institutions. This is not the case this time, at least through my interpretation of the fine Milbank Tweed article.


Diversification or “diworsification” as it is known in some circles, is addressed intelligently in the new regulation. The law appears to require a written investment policy statement to demonstrate compliance with the diversification directive unless the institution determines that it would be better served without diversification. If the institution deems that it would be better served without diversification, that policy needs to be affirmed each year. Mathematically oriented investors might point to the anomaly that if one could find the single best investment, adding a second investment (which by definition would not be as good as the first) would lower the average investment return.

The uncertainty of determining the best possible return suggests that a number of alternatives could improve the potential return over a single investment. For some institutions a thorny issue may be encountered when an over-sized position occurs due to an extra large gift of a security or perhaps more intriguing, a stock position that disrupts diversification due to its way above average performance and expected future growth. Thus, there may be a conflict between diversification and expected benefit to the institution. As an investment advisor as well as a member of various investment committees, I believe the mere fact that the issue of diversification should be regularly reviewed is a breath of fresh air.

The act, and there are similar acts in most states, does not define diversification. In the past, the laws governing investment relied on the 1830 dictate of Judge Putnam, deciding against Harvard College as to what was required to be considered prudent. In effect, he created the whole performance measurement sub-industry that clearly benefited me and perhaps investors, by requiring the prudent investor do those things that other intelligent and prudent investors do with their own money. The recently enacted New York State law appears to define “prudent” as actions that consider eight factors without specific reliance on what others are doing. Thus, trustees need to make their own decisions as to what prudence requires without necessarily being led by others. In many ways this may liberate investors from slavishly following the current popular policies, e.g. emerging markets, private placements or ETFs. At the same time, this freedom is frightening to the less-knowledgeable investment committees. In determining the prudence required, some institutions may want to review the makeup of their investment committees and/or consider the addition of one or more external investment advisors.

The role of each investment

The act, or at least Milbank Tweed’s interpretation, appears to drill down to the individual security position. Apparently each position has to be an integral part of the portfolio. Portfolios can no longer be a mere collection of assets without relation to one another. From my viewpoint, this focus can be extremely useful in the long run. All too often a security that is down in price significantly is an immediate candidate for sale for many investment committees. I believe that all positions should be reviewed for their potential to add, or in the case of down markets, stabilize the future value of the portfolio. One of the ways I and others build portfolios is to include investments that are likely to do well under a certain investment climate. Almost by definition some or all of these “hedges” will do poorly under other market phases. When they do poorly I am reluctant to remove them if I still consider that there is a reasonable chance that the investment wind will shift in their direction. I get extremely nervous when all the securities in appropriately balanced portfolios are going in one direction. At a recent client meeting, I commented that all of our fund investments were producing positive returns for the first ten months of the year, and that I was nervous as there were no losers. In the future this would unlikely be the case.

Spending rate

Perhaps the most significant element in the article is the following quote: “….spending in excess of 7% of the fair market value of a fund (calculated based on quarterly estimates averaged over a five year period) will be presumed imprudent, which presumption may be rebutted.”

There are several important elements to the quote. The first is the identification of an imprudent level. Second, the use of a twenty quarter average return. Third, that the imprudence contention can be rebutted. That the law (or at least Milbank Tweed) is, in effect, rate-setting, goes beyond the normal principles-based regulation. (I find it perhaps ironic that the level chosen is one percent above the old impermissible level of usury at six percent.) The rate chosen is below numerous pension assumptions, thus could be a cause of concern in the business and labor communities.

The suggestion of a five year rolling quarterly measurement device is a step in the right direction. In the institutional community, three years is the most popular measurement period. The cynic in me believes that three years is the shortest period that many consultants use to urge the replacement of a manager and the initiation of another fee generating search. The analyst in me objects to using three years, as often the market can move in one direction for the entire period, which is not representative of longer periods. The SEC appears to agree with me in requiring performance calculations within fund prospectuses to include one, five and ten years along with since-inception reporting. Market historians and at least one major investment management group have found that the best single fit to the statistics is four years. I suspect in part this works because of the US presidential election cycle that some market pundits use.

What is refreshing is while the lawyers have gotten deep into the weeds of setting investment policies, they have accepted that these views can be rebutted successfully.


As investors and investment managers, we must be aware of changes that lawyers and regulators force on the artform of investing. In the case of the Prudent Management of Institutional Funds Act, some of the clarifications are positive and far reaching. As fiduciaries, all involved are going to be held to a higher standard of prudence not just copying what others are doing.

What are your views?
To Members of Mike Lipper's Blog Community:

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Sunday, November 14, 2010

A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

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Sunday, November 7, 2010

Risk Identification is More Important Than Volatility

Up Markets Cause Change in Sales Pitches

Notice how quickly the commentary from numerous money managers has shifted away from quoting so-called “risk adjusted performance.” This shift is a clear sign of two different stances. The first is after seven or eight weeks of rising stock prices, many are identifying the current surge as a rising market. Because we have not topped the historic highs of 2007, few are calling this a new bull market. But they are directing their attention almost exclusively to rising rather than falling prices for stocks and bonds in most markets around the world. From a market standpoint it is almost like shouting, “The king (of the bear market) is dead. Long live the new king (of not yet the bull market).”

Intellectual Dishonesty or “They Should Have Known Better”

To me, the second stance that becomes evident from the dropping of the risk adjusted handle is intellectual dishonesty. This strong statement indicts not only many managers but also their marketing people and many academics. The fallacy started in academia, as finance and investment teachers with their reliance on mathematical formulas wanted to balance potential rewards with potential risks. The problem is that risk is the uncertainty of loss. In their 50 minute lesson-plan world they latched on to the volatility of price movements over a rolling 36 month period. If a stock or a fund had a wider than “normal” variance to the trend of prices or adjusted net asset values it was deemed to be more risky than one that hugged the central tendency line more closely. Thus, index funds are by nature less risky than actively managed aggressive funds. The practice started of adjusting absolute returns by these volatility factors to develop “risk adjusted returns.” These numbers appealed to various consultants and other gate-keepers because they generated a selection screen that eliminated the wild performers. The problem with these exercises is that they had nothing to do with actual risk. The purveyors of these numbers knew or should have known that risk adjusted results had nothing to do with real world risks.

What is Risk?

From an investor's viewpoint, risk is the penalty for being wrong in the future. To me as an investor, investment advisor, and a member or chair of non-profit investment committees, risk is the inability to pay for planned and vital expenditures. In the real world risk is different for each account. For some Ultra High Net Worth investors, risk is all about running out of funds for the fourth generation or the new wing to the hospital (which is likely to be one’s last used medical facility).

There Are Two Risks

In assessing the elements of risk identified above, there are really two risks. The first (and of paramount importance) is running out of cash to accomplish the critical mission. The fourth generation will have to become working stiffs (which could be a good thing compared to their third generation parents); or the new wing will be delayed until other sources of funding are secured; or the hospital or university will be forced to scale back, merge, or close. (Perhaps if the potential patients or students won’t support the expansion, once again the wisdom of the marketplace could be correct compared with a donor’s wishes.) The second risk is not running out of funding, but the more likely outcome of not earning a high enough rate of return to accomplish the planned goal in a timely fashion.

Managing Both Risks on a Time Horizon

The simplest way to handle the risks is to have the investment side control the granting side. One of the foundations that we have managed money for years has largely limited its grants to other charities to the capital earned by the charity in the prior year. Politically that is not how most pots of money are run. In reality, the operating or granting side determines what it wants and the investment side concurs if the spending rate is reasonable in light of the time horizon of its mandates. Most wealthy families or endowments believe that their responsibilities are never ending thus they see their funds need to remain in place forever. Others actually plan (or would allow themselves) to, in effect, die. This extreme, and perhaps irresponsible attitude can be summed up as “expending the last dollar with the last breath.”

A further constraint on managing the twin risks is the importance of planning the time horizon. Actually the addition of a time horizon can make it easier to manage risks.

My Approaches

With a great deal of conversation and work with clients, and even more with investment committees, I try to attach to each planning goal time to completely identify the goal with the client. Even more difficult is to array the various goals in some sort of priority setting. The next step is to determine whether the client wishes to intellectually fund each goal until the capital runs out. In setting the investment returns for each of the goal-oriented portfolios (assuming that the intention is to have the capital last forever), I use the following rules of thumb:

  • If the account is a tax exempt account, a payout ratio of total return income to capital of 4% is reasonable.

  • For a taxable account, a maximum payout ratio might be 3%. In both cases I would reduce the ratios if long-term inflation is expected to be higher than these ratios.

  • For accounts with a limited life or if the account was a beneficiary of new cash flow, somewhat higher spending ratios would be appropriate as long as the net cash flow continues.

  • For investments in equities, whether in the form of individual stocks, funds, private equity or hedge funds, I would expect over time the returns would be between 50% and 75% of the net cash generated by taxable entities.

  • In terms of fixed income, on the very highest-quality paper, yields to maturity might be appropriate if the account could hold the paper until maturity. More specific fixed income approaches are very much account dependent.

Social Media

I urge the members of this blog community to share with me your use of social media.Would it be helpful to you if I used a particular social media outlet for shorter thoughts, perhaps at different time intervals?

I want to stay current with my grandchildren, grandnieces and grandnephews as eventually they will become the clients that will benefit from my work.

To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at