Investors get the bulk of their actionable investment news from paper or electronic means, either with the volume on or off. Because of the squeeze on both the profits of agency brokerage and to some extent hedge fund net compensation, less and less original long-term research is being conducted. Thus many investors are reduced to reacting to various elements of so-called news from media sources. If one learns to search the news for longer-term investing implications, often written between the lines, this limitation might not be so bad. This week’s blog is devoted to several thoughts that I have had from my reading and in one case from an out of town investment committee meeting.
The bulk of our management responsibilities is investing in portfolios of funds; in addition we manage a financial services fund. Please keep that last responsibility in mind when reading this blog post.
Research & Development spending
The Wall Street Journal (subscription required) this week previewed an annual review by the Battelle Memorial Institute. There is some good news and some less happy news which was reported. The headline trumpeted that R&D spending was continuing to grow. A couple of disturbing elements were buried within the article. First, the rate of R&D growth will be less than what was achieved in prior periods, in part due to lower government spending, which might be partially caused by planned lower military spending. Second, if one adjusts the growth figures for inflation, R&D spending is essentially flat. While the US remains by far the global leader in R&D, its share is slipping from 32.8% to 31.1%. Of a global total of $1.4 trillion in 2012, China’s share is estimated to rise to 14.2% from 12%. The smaller Asian countries of Korea, Taiwan, and Singapore are increasing their R&D spending, and are attracting (or re-attracting) many of our better scientific graduates who are being forced to leave the US due to visa issues.
The investment implication from this WSJ article is how one can translate news into potential investment gains. For example, R&D is usually focused on personnel spending. Also, a significant portion of R&D will not produce products that can be produced in large scale production. However, some R&D spending will cause substantial investing in new plant and equipment. Counting competitive reactions, it is my guess that the $1.4 trillion in R&D spending will create several multiples of that amount, and most of it will have to be financed. Thus, in the long run, R&D spending will be good for the financial community that will gather the funding for these projects. The interesting question is, where will this spending take place? I am increasingly of the belief that a good bit of the plant and equipment spending will take place where there is a large population base, educated young workers, and already-established scientific communities with their own fine universities. This thinking is leading me to increase the Asian exposure of many of our portfolios, with a focus on the production and consumption of technology.
MF Global
Though Jon Corzine used to live only two streets away from me, I do not have any special insight as to what happened at MF Global. However, I can focus on the long-term implications of this tragedy. The news is somewhat similar to the ongoing saga of the Lehman Brothers and Madoff bankruptcies, both in terms of the ways that the firms conducted their customers’ business, and the fact that ultimately the costs to the customers will rise. The apparent heart of the MF Global set of problems was the normal hypothecation and re-hypothecation of client funds and securities. As I understand it, the bulk of the clients of the firm borrowed money (margin) against the assets of their accounts. Securities firms loan money at very low interest rates to their clients individually because they can pledge the clients’ accounts against the loans provided by financial institutions, normally banks. In opening a margin account, clients sign a hypothecation agreement that permits this. Also, the agreement permits the institutional lender to itself borrow against the client money and so on without limit. This is called re-hypothecation. What may have happened in this case is that the trail locating the original clients’ securities and money was lost. Just as the aftermath of the Madoff bankruptcy caused business practices and regulations to change, I suspect that in the wake of MF Global they will be “reformed” again, in at least the futures markets, if not the broader securities markets. These changes, which are yet to be worked out, will probably raise the interest costs on margin accounts and reduce the amount that can be borrowed. As a result, firms will be required to have more compliance, risk management, and administrative personnel. All of these changes will cost money that the client will pay, and in a dynamic, integrated economy, pass on these costs to the ultimate consumer. Thus, in some sense we are building additional inflation into our future.
Reverse what forecasters say
In the latest edition of Barron’s (subscription required) magazine, ten stock forecasters were asked what sectors they would invest in and which they would avoid. Please remember my previously-stated bias. I was delighted to see that six out of the ten would avoid financials, and only one would buy them. As an identified contrarian, a six to one bet is a bookmaker’s dream. Clearly the negatives are well known: low short-term interest rates, some exposure to Europe, slow domestic economy, and adverse changes in regulations, etc.
The smartest man
Earlier in the week I was out of town visiting an institutional client we have had the privilege of serving since 1981. I was reminded that Byron Wien occasionally writes about his conversation with a long-term fiend who he has named the “World’s Smartest Man.” My equivalent of Byron’s friend is the chair of this investment committee, who has spent a lifetime being a successful investment leader. Toward the end of our meeting, he intoned that he could not see the stock markets around the world going up without the banks participating, if not leading. As many of the regular readers of this blog know, I credit my securities analysis skills to what I learned handicapping race horses and being a US Marine. With my background, and adding the wise words of my “smartest man,” or put another way, an experienced trainer and six-to-one odds, a bet on the recovery of the financials seems warranted.
Please share with me how you extract investment intelligence from the news media and/or whether you agree about the potential of rising costs for those who utilize futures.
My wife Ruth and our family join me in wishing all a very happy and healthy holiday celebration. This is the time of year when we are most thankful for each other.
____________________________________________________
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Showing posts with label Madoff. Show all posts
Showing posts with label Madoff. Show all posts
Sunday, December 18, 2011
Sunday, October 31, 2010
Risk Reduction is Risky in the Long-Term
We can and should learn from every day of our lives. For those of us that are addicted to the securities markets, non-holiday weekdays are our primary classes. The markets of 2006 through 2010 were extremely difficult for all of the students and quite a number failed to finish. One might call these years a master class. However, very few of my fellow students could be awarded a Master’s Degree for the investment progress they achieved. The reason for the lack of success was not that the period did not offer ample opportunities to achieve some large gains as well as some startling losses, but it was difficult to link the periods where the net results were positive for those invested in equities.
Shorting successfully is difficult over time
The intellectual foundation of hedging initially is that carefully chosen securities will go down more than equally carefully selected securities would go up, so that the net result should be to preserve the larger gains of one’s purchases. The truth in the matter is that shorting is difficult to do well over long periods of time. An examination of various shorting approaches will identify the problems that might occur.
Sell the Frauds and the Fads
Until tried in a competent court of law, (and perhaps not even then) it is difficult to have absolute certainty from the outside that some action is clearly fraudulent. Even with the best forensic accounting practices applied to public financial statements, one can not be sure that there is a fraudulent intent. As we have seen in the Madoff and other cases, guessing when the various authorities will surface a complaint, let alone a conviction of fraud, is difficult. (Please do not confuse intellectual frauds when someone should know that what they are saying is wrong, with the intent to deceive through the use of fraudulent financial statements. Over time, intellectual frauds are dealt with in the market place and not a court of law.)
Throughout history there have been brief periods when a large portion of a population becomes enticed into certain actions, usually purchasing, some object or service of questionable utility. For the more senior members of this blog community a good example would be Hula Hoops. When rotated around one’s body, these plastic hoops were meant to aid in fat reduction and other health and psychic benefits. As only the young seemed to have hip movements that could keep the hoops from falling to the ground the fad died out quickly, but not before there were a few stocks that successfully touted these wonders. (From a potential short seller’s position, it is important to distinguish the difference between a relatively short period of a fad that has no lasting value from a fashion that may last for awhile. Both Nehru and Mao jackets did provide some continuing clothing benefits.) The most successful managers of short selling funds are expert at these two approaches. However, even with their clear insights they do not produce winning results every year.
Pairs
As an analyst, I used to recommend to some hedge funds that they invest in pairs of somewhat similar securities, with the strategy to purchase one and to sell the other short.
One example of this was to recommend for purchase an aerospace company who, in my opinion, was most likely to win a multi-billion dollar defense contract and to short the expected loser. The key to this strategy was not to stay too long, actually it worked best on the day of the announcement. By the time the earnings were expected to be generated by the winner, there was likely to be a recognition that the winner bid the contract at too low a price and would only become significantly profitable from change orders and possibly spare parts reorders. The loser was often free to position itself for the next exciting contract. A somewhat similar pair bet was available every autumn, focused on the Nielsen ratings for television programs. As NBC was buried within RCA, the choice was between CBS and ABC. There have been other event-oriented pair bets. More common is to focus on two large companies within an industry and buy the better-quality company and short the lower-quality company. The only problem with this strategy is that since the bottom of the stock market in March of 2009, often the lower quality stock did materially better than the high-quality competitor. (I am not hearing many pair recommendations either as stocks or as fund formats recently.)
Sector ETF bets
According to the Investment Company Institute (ICI), approximately 20% of the dollars in Exchange Traded Funds (ETF) are in sector or industry funds. Making judgments on sectors is very common today as described in the reports issued by mutual funds and other institutional funds. The funds that make sense to me are those that most of the time select individual stocks that do better than their sectors. Taking this approach further, one could suggest shorting the sector ETF. The problem with this approach is that often the ETF has more low quality names in the portfolio than the individual stock selected. As I have commented above, we have been in a period where the low quality stocks, with their bigger perceived potential, have performed better than the perceived higher quality stock chosen. I suspect that an uncomfortable portion of the transactions involved with ETFs are part of short trades or at least leverage transactions. If I am accurate, this may suggest that a new element of volatility has been introduced.
Market Timing/Macro Investing
The only thing more dangerous than guessing which way the market will go correctly one time is guessing correctly twice. By the time one does it three times in a row you convince yourself and others that you are expert. There are a very small number of professional money managers who do have a record of guessing the overall market trends effectively. Some of the best of these run Macro hedge funds which make big bets through derivatives and other forms of leverage on the sequential changes in direction of the major markets around the world. (I wonder if one made an equal size bet on every Macro fund that began each year and compared its average performance over the next ten year period to that of a collection of broad market indices (adjusted for country bets) which would win? This is not to deny that there will likely be a few spectacular winners, but many won’t finish and therefore for this exercise, they would be declared losers.) Those who are even less successful are called market timers. There is a long history, both at the individual and the institutional levels, as to the lack of success of market timing. Long-term faith in the belief that the trend is one’s friend does not have good results in the stock market, but could in the commodity markets.
Owning Winners
As strange as it seems, one of the best risk reduction approaches is to attempt to own only long-term winning stocks and to accept periodic volatility. (I must admit that it is with difficulty that I attempt to follow this precept.) The concept is one of muted optimism; that throughout our lives there will be an upward bias to stock prices. If one takes the absolute opposite point of view, one believes that long-term bouts of sitting with cash and very high-quality short-term instruments with occasional forays into the market is a correct strategy. Using the Dow Jones Industrial Average as an equity market indicator, in the past we have suffered flat periods of sixteen years and we are in an eleven year flat phase now. I believe that we will breakout on the upside eventually, at least in nominal dollars. And that is how I bet. Each year those that attend the annual meeting of the Board of Trustees at the California Institute of Technology (Caltech) participate in a contest to guess what the DJIA will be selling for at the next year’s meeting. I will almost always be betting for a significant advance because it will happen at some point.
The best way to avoid losing is to Win.
____________________________________________
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 www.MikeLipper.blogspot.com.
Shorting successfully is difficult over time
The intellectual foundation of hedging initially is that carefully chosen securities will go down more than equally carefully selected securities would go up, so that the net result should be to preserve the larger gains of one’s purchases. The truth in the matter is that shorting is difficult to do well over long periods of time. An examination of various shorting approaches will identify the problems that might occur.
Sell the Frauds and the Fads
Until tried in a competent court of law, (and perhaps not even then) it is difficult to have absolute certainty from the outside that some action is clearly fraudulent. Even with the best forensic accounting practices applied to public financial statements, one can not be sure that there is a fraudulent intent. As we have seen in the Madoff and other cases, guessing when the various authorities will surface a complaint, let alone a conviction of fraud, is difficult. (Please do not confuse intellectual frauds when someone should know that what they are saying is wrong, with the intent to deceive through the use of fraudulent financial statements. Over time, intellectual frauds are dealt with in the market place and not a court of law.)
Throughout history there have been brief periods when a large portion of a population becomes enticed into certain actions, usually purchasing, some object or service of questionable utility. For the more senior members of this blog community a good example would be Hula Hoops. When rotated around one’s body, these plastic hoops were meant to aid in fat reduction and other health and psychic benefits. As only the young seemed to have hip movements that could keep the hoops from falling to the ground the fad died out quickly, but not before there were a few stocks that successfully touted these wonders. (From a potential short seller’s position, it is important to distinguish the difference between a relatively short period of a fad that has no lasting value from a fashion that may last for awhile. Both Nehru and Mao jackets did provide some continuing clothing benefits.) The most successful managers of short selling funds are expert at these two approaches. However, even with their clear insights they do not produce winning results every year.
Pairs
As an analyst, I used to recommend to some hedge funds that they invest in pairs of somewhat similar securities, with the strategy to purchase one and to sell the other short.
One example of this was to recommend for purchase an aerospace company who, in my opinion, was most likely to win a multi-billion dollar defense contract and to short the expected loser. The key to this strategy was not to stay too long, actually it worked best on the day of the announcement. By the time the earnings were expected to be generated by the winner, there was likely to be a recognition that the winner bid the contract at too low a price and would only become significantly profitable from change orders and possibly spare parts reorders. The loser was often free to position itself for the next exciting contract. A somewhat similar pair bet was available every autumn, focused on the Nielsen ratings for television programs. As NBC was buried within RCA, the choice was between CBS and ABC. There have been other event-oriented pair bets. More common is to focus on two large companies within an industry and buy the better-quality company and short the lower-quality company. The only problem with this strategy is that since the bottom of the stock market in March of 2009, often the lower quality stock did materially better than the high-quality competitor. (I am not hearing many pair recommendations either as stocks or as fund formats recently.)
Sector ETF bets
According to the Investment Company Institute (ICI), approximately 20% of the dollars in Exchange Traded Funds (ETF) are in sector or industry funds. Making judgments on sectors is very common today as described in the reports issued by mutual funds and other institutional funds. The funds that make sense to me are those that most of the time select individual stocks that do better than their sectors. Taking this approach further, one could suggest shorting the sector ETF. The problem with this approach is that often the ETF has more low quality names in the portfolio than the individual stock selected. As I have commented above, we have been in a period where the low quality stocks, with their bigger perceived potential, have performed better than the perceived higher quality stock chosen. I suspect that an uncomfortable portion of the transactions involved with ETFs are part of short trades or at least leverage transactions. If I am accurate, this may suggest that a new element of volatility has been introduced.
Market Timing/Macro Investing
The only thing more dangerous than guessing which way the market will go correctly one time is guessing correctly twice. By the time one does it three times in a row you convince yourself and others that you are expert. There are a very small number of professional money managers who do have a record of guessing the overall market trends effectively. Some of the best of these run Macro hedge funds which make big bets through derivatives and other forms of leverage on the sequential changes in direction of the major markets around the world. (I wonder if one made an equal size bet on every Macro fund that began each year and compared its average performance over the next ten year period to that of a collection of broad market indices (adjusted for country bets) which would win? This is not to deny that there will likely be a few spectacular winners, but many won’t finish and therefore for this exercise, they would be declared losers.) Those who are even less successful are called market timers. There is a long history, both at the individual and the institutional levels, as to the lack of success of market timing. Long-term faith in the belief that the trend is one’s friend does not have good results in the stock market, but could in the commodity markets.
Owning Winners
As strange as it seems, one of the best risk reduction approaches is to attempt to own only long-term winning stocks and to accept periodic volatility. (I must admit that it is with difficulty that I attempt to follow this precept.) The concept is one of muted optimism; that throughout our lives there will be an upward bias to stock prices. If one takes the absolute opposite point of view, one believes that long-term bouts of sitting with cash and very high-quality short-term instruments with occasional forays into the market is a correct strategy. Using the Dow Jones Industrial Average as an equity market indicator, in the past we have suffered flat periods of sixteen years and we are in an eleven year flat phase now. I believe that we will breakout on the upside eventually, at least in nominal dollars. And that is how I bet. Each year those that attend the annual meeting of the Board of Trustees at the California Institute of Technology (Caltech) participate in a contest to guess what the DJIA will be selling for at the next year’s meeting. I will almost always be betting for a significant advance because it will happen at some point.
The best way to avoid losing is to Win.
____________________________________________
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 www.MikeLipper.blogspot.com.
Sunday, May 3, 2009
Could the “Stress Test” be a Big Trap?
Beginning Monday and perhaps lasting for a week, savers and investors will look forward to the publication of the results of a series of stress tests on the 19 largest domestic financial institutions as to their safety and soundness of their capital. While I do not know the details of the measurement of these tests, the absolute reliance on them seems to me like a dance at the “Mad Hatter’s Tea Party.” In my book MONEYWISE, I identify one of the causes of risk of loss of permanent capital is unanticipated events. These warnings were written in 2007 before both the recognition of the sub-prime mortgage collapse and the recognition of various Ponzi schemes, most of all Bernie Madoff’s. In these cases there were numbers trending in the expected direction and the future was expected to follow predicted patterns.
I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.
The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.
Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.
The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.
Let the games begin this week.
I hope that I am wrong about the statistical stress tests being applied by the government and that in the near term future, all of the financial institutions tested with their present or augmented capital prove to be safe and sound. As humans, as well as many animals, are conscious (or more likely unconscious) odds makers, the odds on the outcome of the tests are somewhat less than completely perfect.
The intent of the tests is to supposedly give us comfort in continuing to leave our capital with these institutions and perhaps more importantly be willing to advance additional capital in the form of deposits, loans, various forms of equity, and counter-party risk assumptions. This exercise is similar to, but not identical, with an acquisition study. In one way or another I have participated on both sides of the acquisition mating dance. Only at the first level of these discussions are the various numbers significant. Additional scenarios are often produced as variants of the original data. These are similar to the stress tests we are all awaiting. However, in an acquisition exercise there are many other analyses performed. Perhaps the single most important analysis is to evaluate management, to determine how much of the past was created by the leadership rather than the environment, and what is management’s expected roles in the future. The 19 financial institutions are all in competitive businesses among themselves as well as other domestic and global competitors. As an odds-maker, I put the probability of significant changes of price and other terms of trade as almost a certainty. (Unless the government will attempt to put into place monopolistic pricing discipline, under some other name, to protect its investment in these financial institutions.) There are many other elements to a good acquisition analysis. There remains one more critical screen and that is trust.
Both financial and intellectual frauds often start as business in the late stages of expansion to make up for earlier, smaller losses. The frauds are expected to be short lived by the perpetrators until assets are returned in full with interest, or when various market share or sales targets are met. Most frauds are begun by previously honest individuals or organizations. I am not suggesting any of the 19 institutions are doing anything fraudulent. However, I wonder if the stress test is leaving enough of a cushion to keep each of the 19 in a safe and sound condition if there has been undiscovered fraud committed by employees or customers/counter-parties. The odds of such occurrences are favorable; the frauds have not been discovered yet, and the people committing the fraud in some aspects may have superior data systems knowledge and capabilities than each of the 19.
The bottom line as a manager of a financial services fund: I look forward to the coming week and the enthusiasm generated by the expected results. However, I am willing to bet a year to three years from now that we will discover that the stress test failed to identify the specific stress that one or more of the financial institutions will go through. For the others that are addicted to investing in stocks and bonds of financial service companies, they may wish to widen their selections and include both large and smaller companies.
Let the games begin this week.
Sunday, February 1, 2009
The Next Big One - FX
The Madoff scandal and other similar grand thefts come as a complete surprise to people, but they shouldn’t. Why? Bad behavior is part of the human condition. Large scandals happen because they can happen. Investors believe first in people, and second in their own understanding of the perpetrator’s personality. In the back of these investors’ minds is a belief that there are effective, long-established controls that would prevent any large frauds to take place. Often the mind of an outright criminal, or more likely someone who “temporarily borrows money” from the unsuspecting, is smarter than the best of the designers of financial/trading controls. Most of the large losses experienced over the last ten years grew because the perpetrator(s) understood “the back office” systems better than those in charge of various compliance functions. Some may have actually been motivated by the battle of man vs. machine, where the lone mind can beat the machines and their watchdogs. I will let the lawyers and the forensic accountants supply the blueprints to the Madoff scandal, if they can. I am attempting to spot the next big, unexpected fraud.
One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.
Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.
Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.
The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.
Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.
The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.
My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.
One of the attributes of securities fraud is that the ultimate size of the transfer of wealth is usually large. In most cases of embezzlement, the initial transfer is small and is designed to cover an error or unauthorized trading loss. However, once the person learns how easy it is to cover the tracks, the need to fill an ever larger hole or desire often prompts a continuation of the transfers. Until conditions and compliance functions change, these activities will continue. Most of these frauds “go with the flow” of enthusiasm in rising markets.
Showing both my age and my experience as an aerospace analyst, I was attracted to the competition to build the next experimental fighter aircraft, which led to a procurement of thousands of aircraft, translating into tens of billions of dollars. Another, larger weapon system is also labeled “FX,” and has a similar order of magnitude cost. This second FX is Foreign Exchange transactions, not a weapon that can travel the world in supersonic speed, but one that can span the globe in milliseconds.
Even in today’s world of expanding global trades, and the need to pay for goods and services in different currencies, the share of the FX market needed to settle these transactions is believed to be a small part of the total FX market.
The bulk of the FX market is made up of two components. The first is the exchange of currencies required to settle securities trades, e.g. the American buyer of a German bank share. The second component is those transactions that are undertaken to make a profit. In the most recent weekend edition of the Financial Times there is a long interview with George Soros, who I knew years ago as a struggling defense/aerospace analyst. The article includes a brief description of his $10 billion trade against the pound sterling. As a result, he and his funds made $ 1 billion, and received the title, “The man who broke the Bank of England.” The bank was on the other side of the trade, trying to support the pound. What is not publicly known is how much of the position was equity, and how much was borrowed. In those days and today, one can borrow up to 99% against currency collateral.
Numerous advertisements on financial cable channels point out that the FX market trades more each day than any other financial market, and is never closed. These purveyors will make their money by loaning capital to the retail investor who wants to take the relatively small daily changes in currencies and multiply it by the use of margin. The ads focus on the lack of regulation. In the scheme of things these activities can be described as small potatoes.
The big enchilada is the trades with and among the banks. To gain some insight into this size, we can learn from the fourth quarter statement of 3 trust banks that have large custodian business and whose foreign exchange earnings were in the hundreds of millions of dollars (one of the few earnings plusses for the quarter). The unknown players in this market are the investment banks’ FICC Groups (Fixed Income, Currency and Commodities), dealing through their proprietary desks and other hedge funds. Some or all of these use various derivatives including currency forwards.
My bottom line is that the FX markets are huge, largely unregulated, with complex compliance procedures which may not be fully water-proofed, and fueled by the prospect of large gains and oversized bonuses. As with my aerospace days, FX can be a major weapon of destruction. Don’t say that you weren’t warned.
Sunday, January 11, 2009
Did Fixed Income Confusion Create Madoff Victims?
There are three principal reasons to own individual fixed income securities or funds. The first is capital preservation. In the balanced accounts that we manage for institutions and wealthy people, capital preservation is our primary concern in our use of fixed income. For these accounts, fixed income is meant to be a strategic reserve against the chance of significant loss from irreparable declines in equities. For more than a year we have executed this strategy by directly owning very short term treasuries, or totally pure US Treasury money market funds. At some point in the future we will have to extend maturities a bit as yields go up.
The second reason to own fixed income is the need to produce income. Neither equities nor high quality bonds are producing enough income today to meet normal endowment and foundation pay-out needs on their own, and certainly not enough income for balanced accounts that are also invested in future-oriented equities. However, the yields on fixed income come closer to the goal than equities do.
The third reason to own fixed income securities in a managed account or fund is to make a bet on the skills of a manager to anticipate interest rate moves, or to rotate through the various sectors or types of fixed income securities. There are managers that have records of making these shifts successfully, however over the long term these skills are probably even rarer than selecting successful rotations by stock portfolio managers.
Each of these three basic reasons is modified by two other considerations. If one believes, as I do, that inflation is a major concern in the long term, then inflation-adjusted paper should be considered in this part of the portfolio or possibly in the equity portion. The second consideration is taxes, which may suggest to some a heavy portion of tax exempt bonds and an understanding of how inflation-adjusted paper increases taxable income without immediate cash generation.
Many investors are challenged by wanting to own fixed income to fulfill all three needs. No single instrument can deliver at the same time on these requirements. Many investors, both individual and institutional, recognize the problem and turn their money over to a manager or fund to accomplish the task. In the end they want capital preservation, largely predictable income, and the ability to take advantage of the rotation of values, both on the long and short side.
While neither Mr. Madoff nor the feeder funds or operations he used ever pitched their investments as fixed income, the supposed record was long enough, and co-investors comfortable enough, to generate fixed-income like confidence. Madoff’s stated performance results in most periods were not as good as what leading equity managers produced, however (at least on paper), Madoff’s results were such that some investors could view his product as a fixed income alternative. Even if true, the performance was supposedly based on the skill of the manager, which should have been a warning that there was a lot more specific risk.
I believe many of these investors should have been investing in dull, boring fixed income, with some portion invested for capital preservation, a smaller portion in the generation of income and a very small bet on manager skills.
The second reason to own fixed income is the need to produce income. Neither equities nor high quality bonds are producing enough income today to meet normal endowment and foundation pay-out needs on their own, and certainly not enough income for balanced accounts that are also invested in future-oriented equities. However, the yields on fixed income come closer to the goal than equities do.
The third reason to own fixed income securities in a managed account or fund is to make a bet on the skills of a manager to anticipate interest rate moves, or to rotate through the various sectors or types of fixed income securities. There are managers that have records of making these shifts successfully, however over the long term these skills are probably even rarer than selecting successful rotations by stock portfolio managers.
Each of these three basic reasons is modified by two other considerations. If one believes, as I do, that inflation is a major concern in the long term, then inflation-adjusted paper should be considered in this part of the portfolio or possibly in the equity portion. The second consideration is taxes, which may suggest to some a heavy portion of tax exempt bonds and an understanding of how inflation-adjusted paper increases taxable income without immediate cash generation.
Many investors are challenged by wanting to own fixed income to fulfill all three needs. No single instrument can deliver at the same time on these requirements. Many investors, both individual and institutional, recognize the problem and turn their money over to a manager or fund to accomplish the task. In the end they want capital preservation, largely predictable income, and the ability to take advantage of the rotation of values, both on the long and short side.
While neither Mr. Madoff nor the feeder funds or operations he used ever pitched their investments as fixed income, the supposed record was long enough, and co-investors comfortable enough, to generate fixed-income like confidence. Madoff’s stated performance results in most periods were not as good as what leading equity managers produced, however (at least on paper), Madoff’s results were such that some investors could view his product as a fixed income alternative. Even if true, the performance was supposedly based on the skill of the manager, which should have been a warning that there was a lot more specific risk.
I believe many of these investors should have been investing in dull, boring fixed income, with some portion invested for capital preservation, a smaller portion in the generation of income and a very small bet on manager skills.
Sunday, December 28, 2008
General Misperceptions of “The Madoff Affair”
I had not intended to devote another blog to what the French have called “The Madoff Affair” before securing additional perspective and information. However, recent writings and holiday party discussions have highlighted a lack of understanding about the workings of the investment world. In this context, I offer the following points which have not been covered in the press.
Bernie Madoff entered the brokerage world as a proprietor of an Over-the-Counter dealer in Puts and Calls, one of the first types of derivatives traded beyond the stricter rules of exchange-traded securities. The price spreads between the Bid and Asked at the same strike price (face value) could be quite large, as there was little in the way of competitive bids and offers at the same strike price. Much of the Put & Call business came from retail oriented firms who were incentivized to concentrate their business with one or more dealers by being paid for their order flow. Many of the Put & Call Dealers were attempting to lock in the spread. In order to get more people involved, dealers sold combinations of Puts and Calls, either in or out of the money. (Meaning at least one side of the trade approached profitability if it were not for the premium paid for the option.) If you find this description a bit hard to follow, so did the regulators, leading this portion of the market to be aptly described as the “Wild West.” Regulators did not have the appropriate tools or business knowledge to oversee Madoff’s activities.
Bernie learned his trade well. With the founding of the Chicago Board of Options Exchange (CBOE), the game changed as spreads narrowed and trades were recorded for all to see. Bernie adapted quite well. He used the payment for order flow approach plus a significant investment in some of the faster computer software and hardware available to earn a significant share in all principal markets in the country. Some people thought he substituted his own capital through the use of options to offset imbalances. If there was any such activity, I believe now, it was the use of his investment firms' orders that had the advantage.
Madoff created two separate firms according to function. The first and by far the largest in terms of employees and image was the old Put & Call firm, which was one of the country’s largest brokerage firms, trading a large share of orders, probably not volume. One of the key benefits of this arrangement was that the brokerage firm could act as a custodian for customer securities. Most investors are familiar receiving monthly account statements, though only recently have these reports included performance calculations. Many smaller, non-publicly owned brokers like Madoff, are only audited once a year, conducted by less prominent accounting firms, and publishing only a statement of financial condition, not a profit and loss statement. Except by sampling, individual accounts are not reviewed.
The second firm that Bernie Madoff created was a registered investment adviser. This was a very unusual firm in that it did not charge for its services. The given reason was that the combination of the firms would make its profits from the trading in the brokerage firm. (Perhaps this distinction may play a role in their legal defense. The courts will have to decide whether the investment firm actually gave advice to these brokerage accounts.
Apparently most of the money that was “managed” came in through what is called “feeder funds.” Feeder funds are a common way for hedge funds and offshore funds to receive capital indirectly. There has not been enough disclosure as to what multiple functions these feeder funds supposedly provided to Madoff. The range of possibilities include some or all of the following: (a) an introducer to a disclosed adviser or fund, (b) a purported fund of funds with only one sub-fund, or (c) a bank or brokerage firm providing leverage at the fund or account level. It will be the jurisdiction of the various regulators or courts to determine what functions were actually offered or performed, and who had what level of knowledge regarding fraud.
Undoubtedly the biggest misperception was that the investments could regularly produce, with very rare deviations or losses, a predictably performing vehicle capable of producing higher returns than bonds with less volatility than stocks. In the aftermath of the Tech Bubble, and the more recent liquidity/credit collapse, investors felt comfortable, indeed conservative, putting so much of their wealth into this wonder. How could they be wrong when so many of the most respected people and organizations in their world also invested knowingly in Bernie Madoff’s wonderful money maker?
Not enough time has passed and the disclosure has been too limited to draw conclusive lessons from this great tragedy. Two lessons are of paramount importance: First, that diversification should be an absolute requirement for all portfolios, particularly institutional accounts. Second, one should search for investment advisers who have disclosed skills and a history of competitive investing.
I am currently in the process of helping a non-profit organization who has been hurt in this affair.
Bernie Madoff entered the brokerage world as a proprietor of an Over-the-Counter dealer in Puts and Calls, one of the first types of derivatives traded beyond the stricter rules of exchange-traded securities. The price spreads between the Bid and Asked at the same strike price (face value) could be quite large, as there was little in the way of competitive bids and offers at the same strike price. Much of the Put & Call business came from retail oriented firms who were incentivized to concentrate their business with one or more dealers by being paid for their order flow. Many of the Put & Call Dealers were attempting to lock in the spread. In order to get more people involved, dealers sold combinations of Puts and Calls, either in or out of the money. (Meaning at least one side of the trade approached profitability if it were not for the premium paid for the option.) If you find this description a bit hard to follow, so did the regulators, leading this portion of the market to be aptly described as the “Wild West.” Regulators did not have the appropriate tools or business knowledge to oversee Madoff’s activities.
Bernie learned his trade well. With the founding of the Chicago Board of Options Exchange (CBOE), the game changed as spreads narrowed and trades were recorded for all to see. Bernie adapted quite well. He used the payment for order flow approach plus a significant investment in some of the faster computer software and hardware available to earn a significant share in all principal markets in the country. Some people thought he substituted his own capital through the use of options to offset imbalances. If there was any such activity, I believe now, it was the use of his investment firms' orders that had the advantage.
Madoff created two separate firms according to function. The first and by far the largest in terms of employees and image was the old Put & Call firm, which was one of the country’s largest brokerage firms, trading a large share of orders, probably not volume. One of the key benefits of this arrangement was that the brokerage firm could act as a custodian for customer securities. Most investors are familiar receiving monthly account statements, though only recently have these reports included performance calculations. Many smaller, non-publicly owned brokers like Madoff, are only audited once a year, conducted by less prominent accounting firms, and publishing only a statement of financial condition, not a profit and loss statement. Except by sampling, individual accounts are not reviewed.
The second firm that Bernie Madoff created was a registered investment adviser. This was a very unusual firm in that it did not charge for its services. The given reason was that the combination of the firms would make its profits from the trading in the brokerage firm. (Perhaps this distinction may play a role in their legal defense. The courts will have to decide whether the investment firm actually gave advice to these brokerage accounts.
Apparently most of the money that was “managed” came in through what is called “feeder funds.” Feeder funds are a common way for hedge funds and offshore funds to receive capital indirectly. There has not been enough disclosure as to what multiple functions these feeder funds supposedly provided to Madoff. The range of possibilities include some or all of the following: (a) an introducer to a disclosed adviser or fund, (b) a purported fund of funds with only one sub-fund, or (c) a bank or brokerage firm providing leverage at the fund or account level. It will be the jurisdiction of the various regulators or courts to determine what functions were actually offered or performed, and who had what level of knowledge regarding fraud.
Undoubtedly the biggest misperception was that the investments could regularly produce, with very rare deviations or losses, a predictably performing vehicle capable of producing higher returns than bonds with less volatility than stocks. In the aftermath of the Tech Bubble, and the more recent liquidity/credit collapse, investors felt comfortable, indeed conservative, putting so much of their wealth into this wonder. How could they be wrong when so many of the most respected people and organizations in their world also invested knowingly in Bernie Madoff’s wonderful money maker?
Not enough time has passed and the disclosure has been too limited to draw conclusive lessons from this great tragedy. Two lessons are of paramount importance: First, that diversification should be an absolute requirement for all portfolios, particularly institutional accounts. Second, one should search for investment advisers who have disclosed skills and a history of competitive investing.
I am currently in the process of helping a non-profit organization who has been hurt in this affair.
Monday, December 15, 2008
Round Peg in Square Hole Produces Splinters
After a shocked weekend dealing with what the French will call “The Madoff Affair,” Sunday night finds me thinking about the lessons that have been forgotten. First and foremost, is the lesson that unbelievably good results do not overcome the need for due diligence. The appropriate outlook is the one that cautious investors have relied on since the beginning of handing one’s own money to another: Unbelievably good results ARE unbelievable. Part of the unquenchable belief is imbedded in the alchemy of academics, confusing volatility with risk. In my book MONEY WISE, I try to focus readers’ attention on the real meaning of risk. The real meaning of risk is the large, permanent loss of assets that can change one’s ability to meet life’s goals. In the Madoff case, investors experienced few fluctuations in their consistently high monthly returns. With little or no volatility, the resulting returns produced unbelievably high risk-adjusted returns. We have seen this action occur previously, right before the last Act’s denouement.
Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.
The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.
With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.
P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.
Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.
The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.
With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.
P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.
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