The Finance Professionals' Post

How and Where Should You Invest in Emerging Markets?

As the new year failed to ring in a solution to the debt crisis that has transfixed the eurozone, investors are left wondering whether now is the time to place their bets on potentially risky growth opportunities or to keep their assets in safe havens. Beyond Europe’s sovereign credit issues, other factors such as massive debt overhang, the threat of double-dip recessions, and ongoing money printing by central banks in the developed world call into question the traditional definition of “safe.” In this environment, some money managers are asking whether investing in emerging economies may, in fact, be safer than committing assets to developed markets.

Book Review: The Hedge Fund Mirage

If you want the truth about hedge funds and how to invest in them, The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True is a must read. An especially important picture of a major part of financial services, this book provides insight into a field of which little information is publicly available.

Despite the increased fortune hedge funds produce, their investors barely profit. As the book reads, “investors would have made more putting their money into treasury bills instead.” Currently risks and returns favor the hedge fund managers. Of course, this was not always the case. During the 1990s, there were fewer hedge fund investors, which, to some degree, allowed for greater profitability. Owing to this shocking truth, author and hedge fund expert Simon Lack provides an in-depth inside look into the world of hedge funds in an effort to help put the investors back on top.

Regaining Investor Confidence for US-Listed Chinese Companies

A number of high profile scandals such as Longtop Financial Technologies and Sino-Forest have given Chinese companies a bad name among US investors. Portfolio managers who previously held extensive investments in US-listed Chinese equities now avoid the sector and some of the previously largest underwriters of US-listed Chinese equities have exited this market.

Between 2006 and 2010, a total of 339 Chinese companies listed on the major US stock markets, 106 on NYSE and 233 on NASDAQ. During this period of high interest in investing in Chinese companies, few anticipated the coming scandals and delistings.

Video: Myths to Energy Investing

There are various myths circulating about investing in energy and natural resources—one of them being "peak oil." As Bernard J. Picchi, CFA, a portfolio manager at Palisade Capital Management, explains in this clip from the New York Society of Security Analysts' "Future of Energy Investing" Conference, the truth about the notion of "peak oil" is there have only been 9 of the last 60 years in which oil production has declined. Each of these occurrences have been due to "artificial" interruptions, recessions, or wars—not physical production capabilities of the wells. In fact, some countries have doubled their oil production.

How Psychological Pitfalls Generated the Global Financial Crisis

ABSTRACT

The root cause of the financial crisis that erupted in 2008 is psychological. In the events which led up to the crisis, heuristics, biases, and framing effects strongly influenced the judgments and decisions of financial firms, rating agencies, elected officials, government regulators, and institutional investors. Examples involving UBS, Merrill Lynch, Citigroup, Standard & Poor’s, the SEC, and end investors illustrate this point. Among the many lessons to be learned from the crisis is the importance of focusing on the behavioral aspects of organizational process.

Acknowledgments: I thank Mark Lawrence for his insightful comments about UBS; Marc Heerkens from UBS; participants at seminars I gave at the University of Lugano and at the University of California, Los Angeles; and participants in the Executive Master of Science in Risk Management program at the Amsterdam Institute of Finance, a program cosponsored with New York University. I also express my appreciation to Rodney Sullivan and Larry Siegel for their comments on previous drafts.

How Bond Plays Work in a Market of Global Systemic Uncertainty

We recently spoke with Glenn Reynolds, CEO of CreditSights, who offered us some straight talk on how global credit market risk is impacting the broad capital markets. Reynolds will be a speaker at the upcoming NYSSA conference, Market Forecast: Turbulent Times, to be held on January 5.

Here he explains why he recommends a blended strategy of investing in high-yield corporate bonds as an equity surrogate and investment grade bonds as a defensive play to navigate what is likely to be continuing systemic market uncertainties.

Recent Research: Highlights from December 2011

A Comment on “Better Beta Explained: Demystifying Alternative Equity Index Strategies”
The Journal of Index Investing (Winter 2011)
Noël Amenc

Cap-weighted indices have been subjected to increasing criticism. Empirical evidence suggests that cap-weighted indices deliver poor risk-adjusted performance. It has also been questioned whether market cap is a reliable proxy for the size and economic influence of a company. The fact that cap-weighted indices have been found to be neither representative nor efficient has led to the development of various alternative weighting schemes. However, how to best replace cap-weighted indices remains an open question. In an article from the Summer 2011 issue of The Journal of Index Investing, Robert Arnott discusses an empirical analysis of several alternative indexing methodologies that he broadly classifies as relying on heuristics or on portfolio optimization. Although an analysis of competing non-capweighted indices should, in principle, provide useful insights, the results reported by Arnott suffer from a flawed methodology and may confuse readers about the issues with different non-cap-weighted indices in practice.

The State of China’s Economy and US-Listed Chinese Companies

Ten years ago, when you read The Wall Street Journal, you barely noticed articles about Chinese public companies. Today, when you click your iPad app, WSJ.Com, China-related news generates daily headlines. On Oct 24 2011, the New York Society of Security Analysts (NYSSA) joined with China Council for International Investment Promotion (CCIIP) to host “2011 Chinese Companies Listed on US Market Development Forum”, which provided an opportunity for US investors to have an open dialogue with several Chinese companies. Not surprisingly, this forum drew a lot of attention from an audience that including both private and institutional investors. When analyzing the complex interdependent relationship between the fast-growing Chinese economy and the globally dominant US economy, one must understand three key points.

Recent Research: Highlights from November 2011

"Breadth, Skill, and Time"
The Journal of Portfolio Management (Fall 2011)
Richard C. Grinold and Ronald N. Kahn

The information ratio determines the potential of an investment process to add value, and according to the fundamental law of active management, adding value depends on a combination of skill and breadth. Grinold and Kahn use an equilibrium dynamic model to provide insight into the concept of breadth, as well as a refined notion of skill. In equilibrium, the arrival rate of new information exactly balances the decay rate of old information. Grinold and Kahn denote the information turnover rate g. It is relatively easy to measure for any investment process. If the investment process forecasts returns on N assets, the breadth of the strategy i is g · N. Skill—the correlation of forecasts and returns—increases with the return horizon for small horizons, but then asymptotically decays to zero for very long horizons. The authors’ main result is that the ex ante information ratio is  , where κ is a measure of skill.

Secrets to Investment Report Writing: What Successful Analysts Know

Your career depends on your ability to communicate effectively.  If you can write investment research reports that your clients find both useful and thought-provoking, you have a powerful career advantage.  

Here are four top tips for you on how to advise your clients on that critical decision: buy or sell?

• Research widely and deeply.  
  
  What industry is the company in? Who are the key competitors? How are globalization, technology, demographic trends and competition affecting the industry's future? Is the company well-run? Does it have a smart strategy? Do its products and services meet the needs of today's customers?  Is it an ethical company? Does it have a reputation for integrity and social responsibility? What do its employees say about it? Does its culture foster innovative risk-taking—or is it a culture of fear? Do not fall for the company's self-promoting rhetoric.  

Russia: Some BRICs Are Different

Russia has always been different from the rest of the world. Even 20 years after the end of the Soviet Union and the Cold War, this author still finds it a little strange to find Russia grouped with other BRICs, or most emerging market countries. The others—China, India, and Brazil—all have very large portions of their populations struggling with poverty, and are characterized by historically limited, but now improving, access to technology. Not Russia.

Not So Great Expectations

Oddly enough, the day after Steve Jobs died was the first time that I had been in Silicon Valley in decades.  Finding myself with a rental car and time on my hands, I drove to Apple headquarters. The scene was very much like that for other cultural icons that have passed on: a row of TV trucks, a large pile of notes, photos, flowers, and mementos, and the flags at half staff. There were spots available in the visitor parking area adjacent to the building, and people milling around—even going into the building—but I didn’t join them.

Martin L. Leibowitz: Alpha Orbits

Let us ponder, for a moment, a hypothetical market consisting of only two assets: (1) cash and (2) one big Treasury bond. To keep things simple, let’s make the bond a perpetual with a 5 percent coupon and a current yield of 5 percent so that its price is 100. Further, let us assume that there is no credit risk whatsoever.

Now let us suppose that some investors own only cash, some own only the bond, and others own a mix of both.

We all know what happens to the bond price when the yield goes up or down: If the bond yield rose to 6 percent, the price would drop from 100 to 5/(0.06) = 83.33; if the yield fell to 4 percent, the price would rise to 5/(0.04) = 125.

But we also know that when the price goes up for any reason, the bond’s yield must fall.

In our hypothetical model, the all-cash investors are risk averse as a group, probably believing that bonds are simply not the “right kind” of asset for their highly risk-averse type of fund. But now let’s suppose that one of these all-cash funds suddenly receives an unanticipated contribution that raises its portfolio asset value to a level that modestly increases its risk tolerance. The fund decides to break out of its all-cash stance and buy some bonds, which nudges the bond price up to 101.

Then, a second all-cash fund, noticing that an all-cash fund’s buying bonds has become more acceptable, proceeds to take a nibble. The price moves up to 102.

When a third all-cash fund sees that owning a few bonds has become reasonably respectable, its bond purchases move the price up to 104.

At a cocktail reception at the next All-Cash Funds Conference, these few radical bondholders are the “talk of the town.” Having at least a small bond allocation quickly changes from being a novelty to being downright fashionable.

With this new surge in motivated buying, the price moves up to 107.

Some momentum investors observe this price action and begin to salivate. They don’t hesitate long, and their purchases raise the price to 110.

(Let’s not muddy the waters by wondering who is selling these beautiful bonds. A few contrarians are always lurking in the wings.)

Thus, over the course of a year, the bond’s 5 percent coupon, plus the 10 percent price appreciation, produces a hefty 15 percent total return.

Now let us consider a long-term investor with a 50/50 cash/bond portfolio. The assumed expected return for the bond was set at 5 percent in the last mean–variance optimization. With the dramatic shift in the structure of market returns, the fund decides to call for a new study.

Continue reading "Martin L. Leibowitz: Alpha Orbits" >>

Making Rare Earth Element Disclosure Transparent and Compliant

"Getting the Most Out of other Organizations’ Practices"

When prices for rare earth metals rose sharply over the last five years, we saw junior mining companies take on rare earth projects and seek financing to explore them on the equity markets.

Such events would not normally create a compliance problem. But, in the rare earth business, there were a few new twists that made clear disclosure harder to do. One such twist was that there were just so many rare earths; another was that the term had been popularly stretched to cover other metals that were not rare earths at all. Rare earth elements are the lanthanide series (lanthanum through lutetium, elements 57-71 on that long-neglected row of the periodic table atop thorium, uranium and the Lawrence Labs synthetics), plus yttrium, which occurs with the lanthanides and shares most of their chemical characteristics.

Investment Advisors Respond to Market Paradigm Shifts in an Age of Uncertainty

As extraordinary uncertainty continues to characterize the global investment markets, “paradigm shift” has become the catchphrase of the moment. Investment managers are interpreting this shift in a variety of ways and responding to it with a diversity of new tools and strategies. We spoke to three investment advisors who will be speaking at NYSSA’s upcoming "10th Annual Wealth Management Summit" for their views.

Investors Step Up Pressure for Integrated Reporting

We live in a world of rapid human population growth and consumption,  heightened resource scarcity, and the attendant stresses placed by all these factors, not to mention our "business as usual" economy on the earth's ecosystem.   Corporations must acknowledge this and can no longer afford to operate without closely monitoring, managing, and disclosing their environmental, social, and [corporate] governance (ESG) risks—any one of which can explode into a crisis with very material financial consequences. Asset managers who fail to require the companies in which they invest to step up to the plate and take on this responsibility are rightfully being viewed as shirking their own fiduciary duty. 

Converting Mission-Related Investing into Action in the Foundation World

The global economy appears to be settling into a period of protracted sluggish growth where “outsized” returns will be harder to come by. At the same time, trust in the conventional financial markets has sunk to an all-time low. The moment may therefore have arrived for foundations to move in a meaningful way beyond granting making and the occasional program-related investment (PRI) as the sole tool for expressing their missions and to begin deploying their endowments in the service of their missions through mission-related investing.

Rare Earths in Rare Lands

THE IMPORTANCE OF RARE EARTHS

Count Otto von Bismarck was not only the most visible European politician of his generation, but also a famous wiseacre. Driving home a point on the importance of hard power, he said that “if Germany will be weak, no armies of diplomats besieging European courts will further its interests. If on the contrary, it will be strong, its diplomatic representation can be delegated to the international corporation of dentists“ (cited from memory).

Today, the People’s Republic of China packs enough hard power for its diplomats to go into dentistry. It produces 97% of the world’s rare earth elements, which are essential components in many industries. When Japanese prime minister Naoto Kan tried to whip up nationalist sentiment by denying the wartime atrocities of the Japanese military against Chinese civilians, China instituted a technical shutdown of some of its rare earth mines. Several industries in Japan including automotive immediately felt the punch. Rare earths are necessary for the magnets used in cars’ electric motors, among many other technologies.

Recent Research: Highlights from August 2011

Risk-Based Asset Allocation: A New Answer to an Old Question? The Journal of Portfolio Management (Summer 2011). Wai Lee.

In recent years, we have witnessed an alarmingly large and growing amount of literature on portfolio construction approaches focused on risks and diversification rather than on estimating expected returns. Numerous simulations applied to different universes have been documented in support of these approaches based on their apparent outperformance versus passive market capitalization–weighted or static fixed-weight portfolios. Many studies attribute the better performance of these risk-based asset allocation approaches to superior diversification. Given the absence of clearly defined investment objective functions behind these approaches as well as the metrics used by these studies to evaluate ex post performance, Lee puts these approaches into the same context of mean-variance efficiency in an attempt to understand their theoretical underpinnings. In doing so, he hopes to shed some light on what these approaches attempt to achieve and on the characteristics of the investment universe, if indeed these approaches are meant to approximate mean-variance efficiency. Rather than adding to the already large collection of simulation results, Lee uses some simple examples to compare and contrast the portfolio and risk characteristics of these approaches. He also reiterates that any portfolio which deviates from the market capitalization–weighted portfolio is an active portfolio. He concludes that there is no theory to predict, ex ante, that any of these risk-based approaches should outperform.

Peru (Part II): Currency and Equities

CURRENCY: SHEDDING LIGHT ON THE NUEVO SOL | ACCESSING PERU'S EQUITIES | PERUVIAN EQUITY PERFORMANCE | EQUITIES, LOOKING FORWARD

Part I of Worldview’s Peru coverage discussed Peru’s recent macroeconomic history and political economy, noting that Peru has been an impressive economic story that has stayed largely under the media radar. The recent election of Ollanta Humala, a candidate with a history on the far left of the political spectrum has cast the future performance of the economy into question, even if—as part of his runoff campaign—he has promised to govern the country from center-left policies rather than the far-left of Peru’s political spectrum and his base coalition. This piece examines the performance of Peru’s currency and equity markets and considers the attractiveness of the asset markets going forward.

Peru: Inca Gold Still Powers a People

PERU IN COMPARATIVE PERSPECTIVE | ECONOMIC GROWTH PATTERNS IN PERU | THE PERUVIAN POLITICAL-ECONOMIC SITUATION | 2011 ELECTIONS CONCERNS | PERU’S MACRO SUMMARY

While its neighbors Brazil and Chile capture much of the world’s attention, Peru has quietly grown into a star performer among emerging markets. Whether this continues as its newly elected leftist president Ollanta Humala takes the helm remains to be seen, but preliminary signs are hopeful, even if growth becomes more muted than in the recent past.

Peru has been known as a commodity exporter for much of its history, and this has been both a blessing and a curse. Properly managed, Peru’s resource wealth presents great opportunities, but countries whose economies are based on extractive industries tend to be wealth concentrators. The profits from concentrating industries are not always reinvested optimally and can become the enabler of corruption networks. Peru has struggled with this dynamic through much of the last century and even before, at times rising above it, and at other times becoming overwhelmed. Its most recent track record has been positive, however, and there are reasons to hope that it will continue.

Recent Research: Highlights from July 2011

“The Role of Speculators During Times of Financial Distress.” The Journal of Alternative Investments (Summer 2011). Naomi E. Boyd, Jeffrey H. Harris, and Arkadiusz Nowak.

One of the best-known and largest hedge fund failures was the 2006 failure of Amaranth Advisors, LLC. The authors use detailed, trader-level data to examine the role of speculators during times of financial distress—in this case, the failure of Amaranth. They find that speculators served as a stabilizing force during the period by maintaining or increasing long positions, even while prices fell. The authors develop two testable propositions regarding liquidation versus transfer of positions and conclude that the probability of transfer was more likely for distant contract expirations and for contracts more dominantly held by the distressed trader. The article also examines the role of speculators in providing liquidity and mitigating the effects of liquidity risk by evaluating the change in the number of traders, the size and time between trades, and a Herfindahl measure of speculative trader concentration during the crisis period.

Astrology and Economic Forecasts

John Galbraith once said that “The only function of economic forecasting is to make astrology look respectable.” Although many of us are avid readers of economic forecasts issued by the OECD, the IMF, and the EU (the government’s forecasts attend to suffer from a general lack of creditability), it is questionable if our confidence in them is well founded. In my opinion, which is based on my experience, it is not.

Are Buy-Backs on a Rising Market Always a Bad Move?

In an article in the Financial Times, “Buy-backs on a rising market are always a bad move” on Monday, June 13, 2011, Tony Jackson made the argument that share buybacks are a failed strategy because companies are buying back stock more frequently when stock prices are high than when they are low. He framed the argument in terms of recent actions by ExxonMobil to use stock to buy XTO Energy last summer and subsequently to increase its buyback program. He stated “Logically, the first action made sense only if Exxon thought its stock was over-valued. The second made sense only if it thought the opposite.”

Robert Litterman: Who Should Hedge Tail Risk?

In a somewhat ironic turn of events, many investment banks began selling insurance against equity tail risk to institutional investors following the financial crisis. Ironic because one might expect that investment banks, with high leverage and quarterly earnings reports to worry about, would be the natural buyers of such insurance and long-horizon investors the natural sellers.

Surely, those with deep pockets and long horizons, who would be little affected by the crisis, should be selling insurance to those with short horizons and leveraged positions, who would be most highly affected.

Of course, there will always be a price low enough that a given investor would be willing to buy insurance, and there will always be a price high enough that the same investor would be willing to sell insurance. But investors who have long horizons, sufficient liquidity, and low leverage should consider carefully whether, in practice, the price at any given time is low enough that buying tail-risk insurance makes sense for them. That scenario is unlikely because long-horizon investors are not natural buyers of tail-risk insurance.

Continue reading "Who Should Hedge Tail Risk?" »

From the Arcives: Benjamin Graham on Being Right in Security Analysis

Benjamin Graham, the man widely recognized as the father of security analysis, wrote the following article in 1946. Though the market has changed dramatically since then, his approach to judging the success of an analyst’s recommendations remain just as valid today.

ON BEING RIGHT IN SECURITY ANALYSIS

The most interesting and important work of the senior ana­lyst leads up to and includes the recommendation that one or more common stocks be purchased. How can we tell whether such a recommendation has been right or wrong?

Historical Scenarios with Fully Flexible Probabilities

After reviewing the parametric and scenario-based approaches to risk management, we discuss a methodology to enhance the flexibility of the scenario-based approach. We change the probability of each scenario, and then we compute the ensuing p&l distribution and all relevant statistics such as VaR and volatility. The probabilities can be changed to reflect specific market conditions, advanced estimation techniques, or partial information, using the entropy-based Fully Flexible Views technique in Meucci (2008). The implementation of this approach is trivial, as no costly repricing is needed.

The Arithmetic of Reading and Writing: The Paradox of the College Savings Account

Tuition at American universities, both private and public, has been increasing at an average annual rate of 7.6% (private) and 7.87% (public) over the period 1976–2005. For 1976–2008, these averages declined slightly to 7.47% for private universities and 7.72% for public universities.

High tuition rate increases create financial hardship for many attempting to save for college. But college savings plans that invest solely in government bonds are unlikely to generate the necessary amounts. And as investors have recently and painfully experienced, investing solely in stocks is a risky proposition because equities may not outperform government bonds over any given period. Nor is a combination of stocks and government bonds a viable, risk-managed college tuition saving strategy.

Suggestions for Modern Security Analysts

Economics is the social science that most identifies itself with the natural sciences. There is much that can be written about this statement in light of the events that unfolded in the 2007–2008 credit crisis, but this article focuses on the consequences pertaining to the field of Security Analysis, which is an economics-based discipline.

Security Analysis seeks to value firms based on the goods and services sold to customers via the assets (tangible and intangible) and obligations (liabilities) generated to support those sales. Despite the simplicity of this exposition, and the related simplicity of cash flow-based valuation, assessing value can be extremely difficult. The difficulty stems from the well-known fact that value is subjective, and from the equally well-known fact that the future is uncertain. Subjectivity and uncertainty means that Security Analysis requires many working assumptions, which is important because modern economics is currently grounded in mathematics that accommodates only a limited number of assumptions. As a purely theoretical, science-like endeavor this may (or may not) work, but Security Analysis is a profession, and professions are concerned with decision-making in contrast to science, which is concerned with prediction.

Future of Microcap Rally Uncertain in 2011

As is traditional when an economy begins to recover, microcap and smallcap stocks have ruled during the past several years. From the spring of 2008 until this spring, the Russell 2000 Index of smallcap companies has outperformed the S&P 500 by a staggering margin. While the S&P 500 has returned just 2 percent on an average annual basis during that time, smallcaps have returned 9 percent.

BP’s Failure to Debias: Underscoring the Importance of Behavioral Corporate Finance

“BP has a systemic problem with its culture that runs deep.”

–Ending the Management Illusion, Shefrin (2008), p. 95.

“In the view of the Commission, these findings highlight the importance of organizational culture and a consistent commitment to safety by industry, from the highest management levels on down.”

–Report to the President, National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, (2011), p. ix.

1. INTRODUCTION

In this paper, we apply key concepts from behavioral finance to document how psychological biases and framing effects impacted corporate culture and management decisions at energy firm BP. On April 20, 2010, an accident drilling BP’s Macondo well in the Gulf of Mexico produced the worst environmental disaster in US history, an event which dominated the daily news during the spring and summer of 2010. In itself, this event makes for the study of BP’s decision making of interest, prompting the question of whether the April 20 accident was simply an unfavorable chance event or instead the result of biased decision making.

Liquidity Level or Liquidity Risk? Evidence from the Financial Crisis

Although generally considered safe assets, liquid stocks underperformed illiquid stocks during the financial crisis of 2008–2009. The performance of stocks during the crisis can be better explained by their historical liquidity betas (risk) than by their historical liquidity levels. Stocks with different historical liquidity levels did not experience different returns after controlling for liquidity risk. The authors’ findings highlight the importance of accounting for both liquidity level and liquidity risk in risk management applications.

Continue reading "Liquidity Level or Liquidity Risk?" »

Sliced & Diced: A Taste of Structured Investments

A May 2009 report from Research and Markets of Dublin notes that “structured products are among the fastest growing investment classes in world financial markets.” Although not really an asset class, structured investment products represent an array of investment tools for retail and institutional investors. They can enhance the returns of traditional asset classes, provide exposure to hard-to-reach sectors and markets, and often mitigate investors’ risk of losing some or all of their principal.

Another Clue to Volatility

Financial economists treat volatility as a function of investors’ responses to new information. They generally presume that if an asset class is more volatile in one geographical region than in another, it is attributable to a difference in either the local version of the asset class or the economic environment. A case study involving high-yield bond volatility in Europe and the United States suggests that cultural differences may also contribute to disparities in volatility.

Continue reading "Another Clue to Volatility" »

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A New Approach to Calculating Risk-Adjusted Returns

"People don’t perceive that they are going to be the one in a crash,” laments Russ Rader, media director at the IIHS (Insurance Institute for Highway Safety). “They believe that they are in control when they’re behind the wheel. They don’t sense how high the risk actually is.” The IIHS, a Virginia-based, national nonprofit that has helped significantly increase seat belt usage in the last twenty years, has a simple objective: lessen the risk taken in everyday driving behavior. The risk-measurement approach it employs has the potential to revolutionize how the investment community evaluates manager performance.

Mental Aspects of Day Trading

Throughout my years in the futures industry, I have come to a conclusion in regards to the difference between winning and losing as a trader. In my opinion, the primary characteristic of successful traders is the ability to stay calm through thick and thin. This means avoiding the panic feeling that overcomes logic when trades are going against the speculation, and resisting the over-confidence that can come with a few winning endeavors. Each of these symptoms can have a severely negative impact on future trading decisions and profitability.

The Possible Misdiagnosis of a Crisis

The illness underlying the 2007–08 financial crisis might have been misdiagnosed, as is strongly suggested by some elementary principles of finance and development economics. Moreover, there is an explanation for the crisis that is fully consistent with rational beliefs and well-functioning markets. If this explanation is true, public policy prescriptions should be reexamined because there is a danger that the attempted cure is worse than the disease.

Continue reading "The Possible Misdiagnosis of a Crisis" »

Rethinking Portfolio Management and Measurement Based on Clients’ True Financial Goals

Clients’ true financial goals—generating cash flow for spending and preserving principal—often become obscured in today’s world of sophisticated portfolio management and performance analysis. Clients are better served when portfolios are managed with spending goals in mind and success is measured in dollars, not just basis points.

Read the full article for free at the CFA Institute site. 

BRICs versus CIVETS

The acronym BRIC—Brazil, Russia, India, and China—coined by the Goldman Sachs economist Jim O’Neill (2001) is now a widely accepted and understood term. The justification for such a grouping is clear, as the BRICs are comparable in terms of territory, population, GDP, stock markets, and sociopolitical factors (see Table 1). The acronym CIVETS—Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa—was conceived in 2009 by Robert Ward, director of global forecasting for the Economist Intelligence Unit (see Economist 2009), and popularized by Michael Geoghegan (2010), group chief executive of HSBC Holdings plc, shortly after. As the newer term makes its way into the investment lexicon, we need to ask whether these six countries merit such a grouping.

Investing in Indonesia (Part II)

INDONESIAN EQUITIES IMPRESS | RUMINATIONS ON THE RUPIAH | CONCLUSION

Worldview’s last piece on Indonesia highlighted the historical development of Indonesia’s economy and the success of its export-led growth model in spite of high corruption levels, legacy state-controlled enterprises, and political uncertainty in the aftermath of the Asian currency crisis and subsequent rise of Indonesian democracy. This follow-up article covers the recent performance of Indonesia’s equity and currency markets, putting Indonesia’s phenomenal gains in greater context.

Black-Litterman's Model: Portfolio's Friend or Foe?

The traditional MVO (mean-variance optimization) of Harry Markowitz (1952) and the versions that followed constitute an analytical approach to identifying optimal asset allocations from the universe of investable securities. The data needed for the traditional MVO are the expected rates of return, the risks of individual securities, and the covariance among securities. The outcome of this approach is usually illustrated as a curve on which optimal portfolios lie. Each portfolio on this curve, known as the efficient frontier, has the smallest degree of risk for its level of expected return. Markowitz’s traditional MVO was extended and simplified by William Sharpe (1963), in Sharpe’s well-known CAPM (capital asset pricing model). For an intuitive explanation of CAPM and portfolio optimization, refer to Markowitz’s “Crisis Mode” in the Spring 2009 issue of the Investment Professional.

Nothing Ventured, Nothing Gained: The Rise of Canada’s Unique Capital Market for Start-Ups

Many people know of the historic dinner where bitter foes Alexander Hamilton and Thomas Jefferson, moderated by James Madison, hashed out a compromise that put the United States on a sound economic footing over many bottles of claret: federal assumption of the states’ Revolutionary War debts in exchange for a new capital to be built in the South. Although it was not quite so momentous, a similar evening of earnest discussion and good wine enabled the various regional stock exchanges in Canada to combine to form what is today the Venture Exchange. While that institution is formally only 12 years old, its predecessor exchanges trace their heritage back more than a century.

Three Paths to a Prosperous Future

The first decade of the twenty-first century has not been kind to investors. On average, stocks lost about 1% per year over the ten-year period or more than 10% for the entire decade. During the decade we saw the collapse of three bubbles: the dot-com boom came to an end in 2000, the meteoric rise in housing prices in the middle years of the decade reversed sharply in 2007, and then in 2008 the massive over-leveraging of the banking system came home to roost, very nearly destroying the economy.

Financial Reforms, Future Risk Management, and Developing Investment Opportunities

The financial bubbles and crises that have affected the world’s markets and economies during the past five years have created many credit-related investment opportunities. Looking ahead, the dislocations that still exist will have to be resolved in some way. With good analysis, investors can benefit from the likely realignments associated with the imminent “global reset.”

Click here to read the full article. 

MRCI December/May Cotton Spread Study

Previously we looked at the spread and how it cut volatility in an otherwise very strong directional market. The spread itself was flat when all the contracts were off about 7 points. Today, we’ll look at how to trade that spread courtesy of my friends at Moore Research Center, Inc (MRCI).

Investing in Indonesia: The Tune of the Gamelan

INDONESIA IN CONTEXT | ECONOMIC AND POLITICAL HISTORY | ECONOMIC STRUCTURE AND RECENT PERFORMANCE | ECONOMIC, POLITICAL, AND NATURAL RISKS

The post-crisis performance of Indonesia has been phenomenal. With its overall economy virtually untouched by the financial crisis and its equity markets rapidly rebounding, Indonesia has outperformed virtually all major emerging-market competition, including Brazil. What characteristics have brought about this growth and expansion, and to what extent are these trends likely to continue?

Novo Nordisk's Annual Report Stresses Value Creation In a Resource-Stressed Economy

Corporations frequently report that one of their biggest frustrations is that their social and environmental sustainability initiatives are largely ignored by a mainstream investment community focused on short-term financial performance. At the same time, stellar short-term performance often masks hidden risks that are being ignored internally when sustainability goals are not imbedded in a company’s business model.

To counterbalance this short-sighted short-termism, and in the run-up to NYSSA’s Second Annual Healthcare Conference, it might be worthwhile to highlight the activities of Novo Nordisk, a global pharmaceutical company that has not only made a long-term commitment to sustainable practices but is also using a new way of reporting to raise the investment community’s awareness of the strong linkages between sustainable practices and value creation.

Michael Covel on Trend Following

Accepting the inevitability of change is the first step to understanding trend following philosophy. One trend follower described it:

“But what won’t change? Change. When a period of difficult performance continues, however, most investors’ natural conclusion is that something must be done to fix the problem. Having been through these draw downs before, we know that they are unpleasant, but they do not signal that something is necessarily wrong with the future. During these periods, almost everyone asks the same question in these exact words: ‘Have the markets changed?’ I always tell them the truth: ‘Yes.’ Not only have they changed, but they will continue to change as they have throughout history and certainly throughout our 19 years. Trend following presupposes change. It is based on change.”

Markets go up, down, and sideways. They trend. They flow. They surprise. No one can forecast a trend’s beginning or end until it becomes a matter of record, just like the weather. However, if your trading strategy is designed to adapt to change, you can take advantage of the changes to make money.

Recent Research: Highlights from February 2011

“Policy Portfolios and Rebalancing Behavior.” The Journal of Portfolio Management (Winter 2011). Martin L. Leibowitz and Anthony Bova.

An institutional fund typically has a multi-asset allocation—the policy portfolio—that is maintained over time. When allocations shift, the fund rebalances back to the policy portfolio. The discipline of the policy portfolio has many benefits: simplicity, convenient benchmarking, and a minimum of organizational frictions. Its very routine nature can lead, however, to an overemphasis on relative returns and an insensitivity to fundamental changes in fund status and market structure. In 2003, the late Peter Bernstein questioned whether rigid adherence to the policy portfolio made sense, given frequent market dislocations and high levels of volatility. In this article, Liebowitz and Bova attempt to shed further light on the Bernstein question by analyzing the risk tolerance and return assumptions of a basic two-asset (equity and cash) fund. One key finding is that policy portfolio rebalancing implicitly assumes that the risk tolerance and return premiums remain fixed over time. But few funds have the sponsorship, liquidity, or organizational conviction to keep such a constant risk tolerance in the face of severely adverse markets. One argument for the policy portfolio rebalancing is that assets become “cheaper” after a decline, but this is inconsistent with a constant return premium. Moreover, “cheaper” assets should actually call for rebalancing beyond the original policy portfolio to a more aggressive allocation. One idea for a more pro-active, market-sensitive process is to develop pre-planned contingency actions for various market scenarios.

Four Investing Fundamentals Everyone Needs

The majority of investors—even those who swear they follow fundamental indicators—tend to act on and react to the market chaos seen in the daily action of the DJIA and stock prices. The short-term price movement in the market is always chaotic and, as confusing as this is, it can become your greatest advantage.

If you pick stocks based on the identification of four key fundamental indicators, you narrow down your list to the best companies. If you then time your entry on the price dips in the market, you can buy those companies at bargain prices. Two key rules should always be kept in mind. First, pick companies and stocks based on sound fundamental analysis. Second, time your purchase based on value and avoid relying on passing fads.