Each morning at the CFA annual conference, there were “sponsored corporate presentations.”  I attended one put on by the CBOE, part of which concerned volatility indexes and related trading (investment?) vehicles.  A brochure used in that part of the talk is available online — its title is “Key Tools for Hedging and Tail Risk Management.”

The chart above illustrates some of the points discussed during the session.

Top:  This shows the S&P 500 versus the CBOE VIX Tail Hedge Index (VXTH), showing one strategy for dealing with the spikes in volatility, specifically by owning the S&P plus “one-month 30-delta” VIX calls.  The weight of those calls varies in the mix, although the rules are not explained in detail, just that the weighting is based upon the “perceived likelihood” that a black swan could occur.  Hmmm.  I wonder how that works.

Middle:  Here are the returns on various CBOE volatility indexes over the last few years; more details on each strategy can be found in the brochure.

Bottom:  The debut and fall of two very popular volatility ETNs are chronicled in this panel.

So, what to make of all of this?  Volatility is a pervasive concern.  How can you effectively manage portfolios in a volatile world?  Is volatility an asset class?  What strategies should you consider related to volatility?  What other kinds of risks are you entertaining when you do?  What products should be made available to retail investors so that they can attempt to dampen the effects of volatility?  Is there a way to be less reactive in investment strategies so that volatility can be managed differently?

Some investment professionals are concentrating mightily on avoiding volatility, others trying to capture it, and still others are mostly just trying to ignore it and go about their business.  (Although their clients may not let them.)  One thing seems certain:  It’s not going away as an issue.  (Chart:  Bloomberg terminal.)

the flaws of finance

The keynote speech at the conference was given by James Montier, who talked about “the flaws of finance,” which I summarized in my latest essay.  (Subsequent to that, Montier published a white paper with that title, which is available if you register on the GMO website.  Links to all of my postings about the conference to date can be found in this PDF index.)

This is the first posting in a series inspired by the CFA Institute’s annual conference.  Unlike other series I have done, this one will jump back and forth between this site and essays about the research puzzle.  (A PDF index of the postings will be updated as each is published.)

As is always the case, a good conference overwhelms you with ideas, and this one surely did.  So let’s start simply, by focusing on what is likely the most important investment issue extant:  low interest rates.  At a preliminary “research for the practitioner” seminar, Gary Brinson commented on the “financial repression” of negative real interest rates in our economy — a phrase that was used in various contexts thereafter by others.  He said that “we will pay for it.”

Many speakers alluded to the bad bet that bonds seem to be at this point in time.  A contrarian might hear that and think that there’s more room to go — and investors need to consider all scenarios.  But professionals are clearly worried about fixed income investments.

Retail investors have piled in, most unaware of the bond math that makes their expectations hard to realize.  Bond managers are caught between the risk in the market and career risk (not unlike that for stock managers trying to deal with Apple).  And many institutional investors have huge holdings in bonds and limited flexibility in minimizing the risk.

The chart above, using the Barclays Aggregate (the ETF for which is AGG) , summarizes the situation.  Returns have been great on bonds for a long time, resulting in emotional comfort and solid looking-backward results, the one-two punch for many investment decisions.  Christopher Ailman, the chief investment officer of CalSTRS, reminded the audience that the decline in yields that led to those results (and which had actually started eight years prior to the period shown) had another effect, for some first learned when they studied for the CFA Level I exam.

All else being equal, the duration of bonds increases as rates go down.  All else isn’t equal, of course, and the series above includes changes in sector composition, movements across time, and even methodology adjustments.  Lengthy handbooks are written about such things.  Here’s the executive summary:  If interest rates rise, it won’t be good.  (Chart:  Bloomberg terminal.)

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“Can’t trust that day,” The Mommas and The Poppas famously sang.  In the markets, we remember Black Monday, some of us very vividly.  And some Merger Mondays have propelled the markets in the other direction, although not nearly as much.

The weekend gives us time to think and a chance for news to develop.  Mondays can be monumental.

We are at a time when things seem particularly difficult to read.  Politically that’s true in the U.S. — and geopolitically too.  In the markets, it feels like we are perched on a fulcrum, with the economic, fundamental, and technical indicators in remarkable balance, teetering one way for a time and tottering the other thereafter.

Given the finish on Friday, this Monday could be an interesting day indeed.  However, I’ll be at the CFA annual conference rather than in the puzzle cave.  (You can follow my tweets on the conference at @researchpuzzler, or via the hashtag #CFA12.)  The last time I was at a large CFA event, it was a fixed income conference when the bond markets were essentially frozen during the financial crisis.  I can only hope that this gathering is as interesting as that one was.  (I got a nice series of postings out of it.)

In any case, when thinking about Mondays, imagine my surprise to find the GSMR Monday Index on Bloomberg, shown above since its inception.  But what is it?  There is no description available, only a link to a Goldman Sachs page for “Synthetic Basket Solutions.”  These days, you can usually find good index information just doing searches online, but I had trouble finding anything and almost gave up.

Finally, I found a footnote in a filing for the AllianceBernstein Unconstrained Bond Fund that describes the Monday Index (and those of the other days of the week) as serving this purpose:  “The total return swap underlying is the Goldman Sachs Mean Reversion (‘GSMR’) strategy.  This strategy involves buying daily variance swaps and simultaneously selling weekly variance swaps on the S&P 500 Index over the same period.”

So there you have it.  I have no idea what the data series pictured above actually means.  And it is somehow fitting that this posting features a bond fund investing in swaps on a stock index created by a broker-dealer, just as I go searching for the heart and soul of my profession.

Have a good Monday.  (Chart:  Bloomberg terminal.)

There have been a number of articles lately about Man Group, including one in the New York Times.  As “the world’s largest publicly traded hedge fund,” it gets a lot of attention, but not much of it good these days.  The top panel of the chart shows its total return since the end of 1999, including the dramatic rise and equally dramatic fall.

Now everyone is watching the assets under management total, as the firm tries to win business in the face of weak performance and money flowing out.

Back in the glory days of 2007, a couple of other hedge fund managers came public too.  As seen in the lower panel, they haven’t fared well since then either.

Money management firms can be incredible cash machines, even if they are charging something less than the “3 and 20″ that Man gets on its flagship fund.  But it’s easy to get expenses out of whack during the good times and firms can struggle to get back to an operating model that makes sense if the market doesn’t cooperate.

That’s true for a variety of firms right now, but this one is in the public eye and looking particularly blue.  (Chart:  Bloomberg terminal.)

Integrity Research has a great posting on the situation involving Huabao.  The performance of the ADR for the stock (HUIHY) since its inception is presented in the top panel above.

The stock was halted in the wake of a report by Anonymous Analytics.  Integrity called it “an excellent example [of] old fashioned equity research,” although it had questions about the entity that produced it.  What to make of its relationship with “Anonymous,” which by now needs no introduction, or the methods of the researchers and how they make money?  In fact, nothing is really known about them.

But Huabao has been covered by a number of the most prominent brokerage firms, who have been positive on it as a group.  Integrity says, “What this graphically illustrates is the sorry state of sell side research.”

The bottom panel of the chart shows Herbalife (HLF) over the same time period.  The performance is vastly better — pretty much straight up until Tuesday, when David Einhorn started asking questions on the firm’s conference call.  While HLF isn’t followed by the big brokers like HUIHY has been, Bloomberg lists twelve firms following it, all buys of one flavor or another.

Yesterday, before I was aware of either of these situations, I mentioned to someone how sell-side analysts will look past certain things for long periods of time — and buy-side clients will too.  Then something happens that quickly changes the dynamics and the price.

Questions.  They might be from a shadowy group or a billionaire hedge fund manager, but isn’t it interesting that it is outsiders who trigger the reappraisals, often with simple and obvious questions?  That tells you something very important about how investment decision making happens — and why it is the focus of much of my work.

I will be at the CFA annual conference in Chicago next week and would like to have the chance to meet you if you are in attendance.

How have stocks done versus bonds?  Well, of course, it depends.

In the top panel, you see the relative performance of three bond ETFs versus the S&P 500, indexed to a value of 100 at the start.  You can see how the results differ if you’re looking at interest rate risk (via TLT) or primarily credit risk (via HYG) or a broader measure of the U.S. bond market (AGG).  All did better than the S&P.

The graph begins when HYG started trading, since it’s the youngest of the funds.  That happened to be just as there were some initial financial system wobbles before the full-fledged crisis of 2008-09.

The bottom panel shows the same information, but indexed to 12/31/08 instead.  Quite a different look to it, starting with the fact that the scales don’t match at all.  Oh, and the S&P comes out ahead.

There are lots of ways to look at bonds versus stocks — and many charts of the comparisons can be misleading.  As for all charts, remember that the starting point is the most important thing, that different scales from one chart to another can deceive, and that charts using two different axes within the same panel are often particularly misleading.

Along that line, watch out for charts that conflate price and yield.  Plus, make sure that total return is used for performance, given that income is critical to bond returns.  And, as the chart shows, “bonds” come in different flavors — just as “stocks” do.

Enough cautions and caveats?  The bottom line:  Be careful that the visual power of a chart doesn’t overwhelm your understanding of what it really displays.  (Chart:  Bloomberg terminal.)

new issue

The latest edition of The Prudent Fiduciary Digest is out, featuring links to pieces by Ashby Monk, who writes regular dispatches about and for institutional investors.  (If you want to be on the distribution list of this free newsletter or to see past issues, please visit the sign-up page.)

I had lunch with a successful hedge fund manager the other day and we talked a bit about career risk (I had just published my piece on the pressures on the decision making of asset managers related to Apple).  He said that clients and therefore managers are getting more and more short term in their thinking.  We talked about the effect on the business and how to get past that.

Then I happened to see the quarterly report for Longleaf Partners Fund (LLPFX).  The narrative portion focused on how the managers of the fund think about risk — and how they try to reduce it.  Conspicuously absent was the notion of career risk, for the managers court it rather than avoid it, seeing the opportunity that can come from not playing the market’s game.  The performance numbers that were given tell the tale of what has resulted:  A great long-term track record, but some intervals that featured outperformance and some of notable underperformance.  Exactly the kind of pattern that drives gatekeepers nuts, at least the ones who prize consistency above all else.

This is an interesting case study for due diligence.  The fund is concentrated and uses a value mentality, but ends up in the “large blend” part of the Morningstar grid and at times even “large growth.”  Which is probably fine with the portfolio managers, since one of them was quoted in 2003 as saying, “Investments can’t be divided into value and growth.  It’s insane to think that way.”

Speaking of Morningstar, this fund illustrates the differences in its rating systems.  Under the new forward-looking system, the analyst rates the fund as “Gold,” but it only gets two stars because of its lumpy performance record.

That record is shown above (from the earliest information I have; the fund started in 1987).  The top panel shows the fund’s total return, along with that of the S&P 500, the benchmark it uses for comparison.  The lower panel is the relative performance, where the good times and the bad times can be readily seen.

The fund seems destined to run against the wind of market expediency.  Whether that will result in good numbers this quarter or this year I have no idea, but I’m sure that’s not the right question.  (Chart:  Bloomberg terminal.)

When it comes to stocks, the Goliaths have been getting beaten up by the Davids for years now.  The top panel in the chart shows the returns on the S&P 100 versus that of the S&P 600.  The bottom panel shows the woeful cumulative relative performance of the giant stocks that make up the 100.

They are a hundred times bigger on average in market cap than the stocks in the S&P 600, and it seems like they are aggregating both economic power and political power.  But investors could care less.

The big underperformance came early in the period shown, as the large stocks retreated from a historic level of overvaluation.  As a result, small beat large and equal-weighted indexes beat market-weighted ones — and investors fell out of love with the mega stocks that they had swooned over in the 1990s.

I didn’t calculate the effect, but imagine how much worse it would be if Apple’s contribution was taken out of the S&P 100.  Since it was added on May 31, 2007, it is up in excess of 400% and now represents seven percent of the index value.

Should you want to bet on one side or another in this battle, iShares has ETFs for the 100 (OEF) and the 600 (IJR).  (Chart:  Bloomberg terminal.)

to infinity and beyond

Speaking of Apple, the latest dispatch on the research puzzle deals with the investment process issues that arise when a stock dominates the attention of asset managers.  To quote:  “Every decision is magnified, every emotion is amplified.  It can all become more behavioral than analytical.”  The stock may go to infinity and beyond or it may fade away, but the decision matrix for it right now is different than for everything else.

The May edition of Bloomberg Magazine features a section entitled, “The Best-Performing Mutual Funds.”  Here they are, the best in each category that the publication provided.

Frequent readers will know that I don’t go in much for performance derbies, since you can shoot holes in them pretty easily and they incent the wrong behavior among managers and investors.  So, yes, today’s title is sarcastic.

The methodology entailed using the Bloomberg categorization scheme and scoring on a combination of returns for one, three, and five years, plus Sharpe ratios for the latter two.  Share classes weren’t provided — and three of these appear to only have institutional classes.

The chart shows returns from the start of the period for comparison.  In reverse order of performance, the winner in each category:

E) Global equities:  Nuveen Tradewinds Value Opportunities.

D) Global bonds:  Prudential Total Return Bond.

C) U.S. Small Cap:  SouthernSun Small Cap.

B) Diversified U.S. Equities:  Robeco Boston Partners Long/Short Equity.  I have a lot of questions about this one, starting with whether it should even appear in this category.

And, most interesting of all, the “best of the best”:

A) U.S. Bonds:  American Century Investment Zero Coupon 2020.  An outstanding example of how these comparisons can go wrong.  It is a portfolio of zeros, after all, with the target date approaching year by year, after a period that had a big decline in interest rates.  That’s the very definition of something that’s not going to perform in the future as it did in the past.  It’s bond math, zero coupon division.

The magazine even got the portfolio managers to pose for an embarrassing photo with a cheesy trophy.  One of them was quoted as saying that they don’t expect investors to flee, even if rates rise, since many have locked in a rate of return.

Yes, but.  They have a variety of options on how to deal with their early windfall.  More importantly, rankings like these can entice the unwary that haven’t had that benefit.  All they come in with is high expectations and no idea that they have been led astray.  (Chart:  Bloomberg terminal.)

the checklist series

The Checklist Manifesto by Atul Gawande is less than two hundred pages long, and is an interesting and thought-provoking read.  I managed to get five postings out of it — or at least inspired by it, since I tried to convey not just the book’s contents but the kind of ideas it got me considering in regard to investment process and organizations.  A short description of each posting and link to it are found on this PDF summary.

The low rate environment trudges on.  This chart shows what has happened to ten-year rates since the turn of the century.

Top:  Yields on the benchmark Treasury have been in steady decline, along with those on similarly-dated Treasury Inflation-Protected Securities (TIPS).  Much has been made of the negative yields on TIPS now, but the expectation is that the boost you’ll get from the inflation adjustment will give you a similar (but still meager) return as the regular variety of Treasury note.

Middle:  The breakeven rate is the difference between the two lines in the top panel, and it serves as one measure of expectations regarding future inflation.  You can see that the breakeven yield is right about where it has been over time.  A whiff of deflation presented a great buying opportunity in early 2009 and TIPS have done very well since then as the spread reverted to normal.

Bottom:  The real yield on ten-year bonds has been negative for quite a while now.  (This the ten-year yield minus the CPI; other real yield calculations may use different inflation measures.)

The future path of these lines will tell the tale for the performance of a variety of asset classes going forward:  Bonds of all stripes, of course, but equities too and certainly precious metals and other “hard” assets.  (Bloomberg terminal.  Monthly observations.)