Sunday, January 30, 2005

Don't have $37,600?

Didn't get you invitation to the Davos World Economic forum this year? Neither did I but I was interested in seeing what it was all about after reading several articles in the NY Times. Here are some facts from the articles: attendees included 27 heads of state, 72 cabinet level ministers, 500 global business leaders ( ie Tony Blair, Victor Yushchenko, former president Bill Clinton, Bill Gates, Google guys Sergey Brin and Larry Page, George Soros, Michael Dell, "Ace" Greenberg, Laurence Summers, Senator John McCain, Robert Shiller), annual membership dues $37,600, 75 of top 100 corporations in the Fortune 500 are members,2250 participants this year, 66% men, 70% from Europe or North America, 15% from Asian Pacific region, 8% from Middle East, originally founded by Klaus Schwab in 1971 as a mini-business school that tried to replicate MBA programs in the US.

The WEF website is definitely worth a visit given the breadth of topics. Here you can sample a wide variety of thoughts and subjects. Investment favorites were any sessions on China, Hedge Fund Fever Builds Up, Private Equity, Economic Implications of Aging, Those Exchange Rates Again & Spotting the Next Bubble Ahead

Saturday, January 29, 2005

Long Term Expected Capital Market Returns

Traditional asset allocation mean variance optimization is performed based on a set of forward looking capital market inputs which include risk and return parameters. The capital market expectations are generally predicated on the theory that the more systematic risk is inherent in an asset class, the higher the expected return. The chart above provides a sample set of long term expectations that an actuary or investment consultant might use to do a formal asset allocation study. Notice the individual asset class characteristics as they move from southwest to the notheast quadrant, increasing risk and increasing return. The line in the chart is known as the "efficient frontier" and represents the array of portfolios which maximize forecast return for any given risk level (measured as standard deviation). Since these concepts and processes are used extensively, we would expect portfolios generated by these to be similar in rough proportion (taking into acccount other prudent constraints) and only as successful ex post( after the fact) as the underlying ex ante or forecast capital market assumptions. Go to the next Post.

Single Year 2004 Risk/Return

2004 was a trophy year for the portfolios of disciplined asset allocators and the relative risk/return alignment and similarity to long term expectations explains it. The general shape of the "efficient frontier" and the risk/reward relationships (and even many similar absolute values) of asset classes in 2004 was very similar to many long term forecasts. As forecast, the majority of peripheral risky asset classes were big producers. International developed equity as measured by the MCSI EAFE Index returned 20.7%, while emerging equity per the MSCI Emerging Markets Index returned over 25.6%. Real Estate was the best performing domestic asset class returning over 30%. High yield bonds provided a generous 10.9% return and International Bonds delivered over 9% on a US dollar basis while emerging market bonds gained over 12%. This is in stark contrast to the 6-7 years prior to 2003. See the Next Post

6 Year Market cycle 1997-2002

Notice how abberant the relative risk/return relationships became during this boom and bust cycle. Obviously not a good period for equities or diversification where risk taking was punished and risk aversion was rewarded.

Friday, January 28, 2005

Duty to Monitor

Year end investment review meetings are underway for pension fiduciaries. It is always amazing how little useful information is actually provided. Here is what to expect:

Market Overview - An extensive retrospective of prior year activity is traditional. This section of the review is mandatory since; it is presumed you were in a coma over the last year, you need to be reminded of the depth of investment intellect and insight available to you (but unfortunately not applied to your portfolio), there's a 99% chance they will be right and finally what else would you talk about.....real competitive performance?? If you have experienced relationship managers you may also receive an optional forward forecast. The words you will likely hear this year are; Fed raising rates 100 bpts, flattening yield curve, slowing but robust economic growth, moderate inflation, moderating oil, continued weak case you nod off ...simply remember what you were told about last year. The consensus forecast is usually last years review in reverse order.

Stock Talk- during this portion of the meeting you will hear in detail about one or two of the managers best investment theses (bets) in the portfolio. This is designed to illuminate for you how a disciplined investment process will routinely ferret out those companies which will be well-rewarded by the less efficient market. By the way, this is the audience participation phase where you are are encouraged to waste additional time by discussing your own personal investment activity. Once rapport has been established the humility, balance and fair disclosure phase may begin. This is where you will hear about the stock that didn't work. Occasionally things don't work according to thesis. This phase often culminates in the recognition that you might have lost significantly more if it weren't for the nimbleness and insight of your manager.

Performance Review- After there is general acknowledgement that you are running late, you will gallop through an abbreviated quantitative performance review phase. You will recognize this phase by the the introductory remarks along the lines of ..."I don't want to bore you with numbers" or "you can review these later at your leisure". With a desire to minimize your stress as a fiduciary and to end every interaction on a positive note, the manager previously established a benchmark system designed to find the silver lining in any cloud. The general principles of this system are; show all performance before fees, avoid showing aggregate historical performance, compare every stock account regardless of content and risk to the S&P500, compare every bond account regardless of content or risk to the highest credit quality bond benchmark, compare hedge funds to treasuries, provide additional loosely defined peer universes, provide footnotes in invisible print which detail the limitations and inadequacies of the data that is printed visibly.

For fiduciaries and investors, appropriate benchmarking and effective attribution analysis are the singular most important issues in portfolio monitoring and should be the centerpiece of any portfolio review. If you feel vaguely uncomfortable or you don't fully understand your managers is probably by design. I would be interested in hearing about your experiences. Send me an e-mail

Wednesday, January 26, 2005

Two Easy Lessons for $1

As part of the $1.4 billion "global settlement" between the U.S. Securities and Exchange Commission and 10 of the nation's top investment firms, the securities firms promised to contribute $80 million over five years for a not-for-profit investor education program.
About a third of the $80 million will fund state education programs. That leaves about $53 million for a federal investor program to which Charles Ellis was appointed chairman.
According to the SEC, Ellis will receive compensation of $1 a year.

I just finished reading an article by Charles in the Financial Analyst Journal entitled "Investing Success in Two Easy Lessons".

Lesson # 1 - "plan your play and play your plan to win your game. And if you do not think and work that winning way in investing, you will, by default, be playing the loser's game of trying to beat the market - a game that almost every investor will eventually loose."

Lesson #2 - "large losses are forever in investing, teenage driving and in fidelity. If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves. And large losses are almost always caused by trying to get too much by taking too much risk"

As usual, Charles gives us way more than a dollar's worth...but what will we see for the other $52,999,999?

Don't try this at Home

don't try this at home!
According to Plansponsor, the Northern Trust Universe, which represents the performance results of over 300 large institutional investment plans that subscribe to Northern Trust performance measurement services, the median ERISA defined benefit plan in the universe was up 12.2% in 2004, while during the same period public funds also gained 12.2%, and foundations and endowments were up 11.8%. Over a three-year period,the median ERISA plan was up 7.6%, and 3.8% over five years, while public funds and foundations and endowments posted 8.6% and 8.1%, respectively, for three years, and both plan types returned 4.1% for the last 5 years.

Now here's something different!
AP/Forbes reports that SBC Communications Inc. is reversing course and bringing back a traditional pension plan for 55,000 of its managers, replacing newfangled retirement plans similar to those that have drawn criticism at a number of other companies. The switch by the telecommunications giant is the rare exception at a time of great uncertainty for both employers and workers with a stake in traditional pension plans.

Tuesday, January 25, 2005

Peer Pressure

Ron Surz warns investors about the dark side of using peer universe comparisons. According to Ron:
  • "..traditional peer groups are hazardous to our wealth because they are more likely to mislead than to inform, so we make the wrong decisions," he says. "Making hire/fire decisions on the basis of peer-group rankings is fraught with peril."

The world of prudent investment decision making contains very few black and white rules. At best, we can be guided by general principles that over the long run make conceptual sense and have correlated with successful investing. There are no benchmarks, indicators, comparators, algorithms or metrics which, in and of themselves, will always provide the the right decisions. Any of them, if used without discretion, can support the wrong decision. That is why prudent investors generally use many attribution and measurement tools, inclusing peer universe data, over a period of time. Looking at investment performance using a broad range of comparisons such as benchmarks and peer universes, across many characteristics such as style, returns and risk should provide the best comprehensive performance picture for investment decisions. The key is understanding the value and limitations of each tool. While Ron makes some good points, I think he grossly understates the utility of carefully selected peer universe.

Good fiduciaries and investors are by nature and training cynical. When propositions are delivered as absolute truths and in uncompromising terms, you should begin asking lots of questions and searching for ulterior motivations. I think Ron has developed an interesting monte carlo universe (in case you wondered about the motivation) that would have value as an additional analytical tool. However, I would feel more comfortable firing a manager because they underperformed an "imperfect" peer group rather than 100,000 monkeys randomly picking stocks.

Monday, January 24, 2005

Higher Rates (please!)

The average defined benefit pension plan return probably exceeded the average actuarial assumed rate of return for the second calendar year in a row. Despite that good news, Ron Ryan calculates that assets under-performed liabilities for the year by over –.84% using his model assumptions. Now, Ron may not be a particularly skilled asset allocator(... an asset liability expert with 5% cash and 5% international in a model pension portfolio???), since his model portfolio only returned 8.9% in 2004. However, the point remains that the change in liability valuations, biased to historical rates, probably matched positive asset returns for 2004. This leaves pension plans open to another year of sizable contributions. According to the WSJ, the average S&p500 pension plan was underfunded by 13% in 2003, Bear Stearns predicts that the average plan will be overfunded by 2% in 2006 due to rising rates and market returns. We'll see?

By the way, WSJ 's supplement was on benefit plans today. I can barely make it through the regular sections but this one had a few good tidbits on why companies might still favor traditional pension plans ( i.e. to boost earnings).
  • "The expected return Boeing is currently using is 8.75%, so its hefty contribution in 2004 ensures the company a gain of $315 million in 2005 -- or 8.75% multiplied by $3.6 billion.
    Similarly, Deere
    & Co. more than tripled its contributions in 2004 to $1.5 billion "to strengthen its funded status," according to a news release issued in February 2004. Along with improving the health of its plan, the Moline, Ill., heavy-equipment maker's contribution will result in a pretax gain of $50 million in 2004, based on an expected rate of return of 8.5% and taking into account lost interest income from the cash used to make the contribution.""

Sunday, January 23, 2005

Read to Learn...Write to Think

Reading is a wonderful way to learn. I make it a point each year to develop a reading list and then try to fit these "elective" readings around my routine diet of newspapers, magazines, journals, periodicals, websites and research papers. This year I adopted the Barrons best 25 reads of 2004. I only ordered about half of the names on the list since I also wanted to devote more time in 05 to "thinking". I completed George Freidman's America's Secret War, Inside The Hidden Worldwide Struggle Between America and Its Enemies. George is the Founder and Chairman of Stratfor and writes on intelligence and global relations and politics.

This book provides incredible insight into the history and global relationships that brought us to 9/11 and the invasion of Iraq. It is one of those stories that is so full of material and insight that you can easily and enthusiastically re-read it to develop additional appreciation for the complexities that drive our history. The book, as a quick read, is very interesting but will require some concentration if you want to synthesis and internalize all that is in it. If you are interested in obtaining a deeper appreciation for how we got ourselves into Iraq, I would highly recommend you read this one.

Also have read several profiles in They Made Amercia by Harold Evans. According to the New York Times Book Reveiw this weekend:
  • "This is a rich, wide-ranging work, with 50 or so substantial profiles, numerous smaller portraits and anecdotes, an ''Innovators Gallery'' that nods to a hundred other important figures and lots of photographs and drawings. You can feel the Sir Harold History Factory working overtime to crank the thing out (Gail Buckland and David Lefer get a ''with'' credit on the cover), yet the presentation is of the reader-friendly, bite-size variety that encourages you to pick at the book as you would an hors d'oeuvre tray."

This is a great coffee table books that provides inspiring and invigorating stories that fit neatly into those 15 minutes after dinner/before bedtime slots where something lighter than the Journal of Portfolio Management is the right play.

Other Thoughts

A couple of decent articles this morning compliments of Ted "the linkster" over at Fundalarm. The team of Evensky and Katz publish another book and write about core-satellite portfolio design. Diane Berthels has it exactly correct in her article on 401(K) fiduciaries and mutual funds. The proliferation of share classes has made it a chore for people in the business and very difficult for people outside to understand what the fund alternatives are. Her PIMCO example is classic. The large majority of participants and plan sponsors never go beneath the covers to figure out which class they own and as Diane points out, the expense structure makes all the difference in whether positive alpha falls out into the account.

Agency issues and conflicts of interest are as natural to pension plan dynamics as they are on the used car lot plan sponsors would seem to negotiate harder for a $5000 car than for investments and services related to a $100,000,000 pool of assets. I think limitations on knowledge of the issues and time to educate and explore alternatives underlie this paradox......and believe me..the industry takes full advantage of these limitations to reward themselves and their shareholders.

Saturday, January 22, 2005

Better Benchmark?

Interesting twist on indexing in a Barron's article this morning by Lawrence Strauss.

"Bob Arnott and Research Affiliates, (RA) of which Arnott is chairman, has developed a series of indexes whose criteria include trailing five-year average operating income, trailing average sales, trailing average gross dividends and total employment. The Fundamental 1000 Composite, as his signature index is known, reflects sales, cash flow, book value and dividends (if applicable). At least 400 of the companies in the S&P 500 overlap with the new index, Arnott estimates....For his part, Arnott maintains that the new index "captures the average company, while the cap-weighted index captures the average stock. It's not the fundamental index that is skewed. It's the cap-weighted indexes that skew investors with a bias toward high-multiple stocks and companies with high growth expectations, which may or may not be realized."

RA's premise, based on a superficial review of their 39 page research paper, is that cap market weighted indicies are suboptimal because overvalued stocks are overweighted and undervalued stocks are underweighted. Their solution is to create in essence a "fair value" index by using a composite of company fundamental factors to drive stock selection and ranking. Certainly arguable whether this represents "fair value" though the resulting composite portfolio index, according to the research, showed a statistically significant positive excess return over the S&P500. The composite portfolio index has a distinct value bias and may have a smaller size bias ( i.e. mid cap value). It just so happens that historical evidence shows value and smaller capitalization biases have provided better historical returns so the composite portfolio index outperformance may well be attributable to size and style factors as well as or in lieu of market capitalization (ie pricing inefficiencies).

While Bob is an industry leading thinker and there is a serious research base to this idea, there is little, as a practical matter, that separates this "index" from a quantitatively managed portfolio strategy? The reference benchmark for this strategy is still the S&P500.
  • "Research Affiliates has landed one institutional account so far -- $100 million from the South Dakota Retirement System, and the firm is in negotiations with other institutional investors. "We thought it would outperform traditional capital-weighted indexes over time," explains Matt Clark, state investment officer in South Dakota. "We thought the idea would attract other investors, which might give a little boost to early adopters."
    The retirement system pays an annual management fee of 0.18%, plus 20% of the outperformance of the new index versus the S&P 500."

.18% is more than fair for a quantitative enhanced index strategy and a 20% slice of performance is even better considering there may be systematic upside bias built into the portfolio. Seems like a nice deal.....but as is often the case.... very hard for an investor to figure out if they're paying for beta or alpha?

Friday, January 21, 2005

Oakmark/Loomis Sayles Funds

Several interesting investment manager calls this week. Bill Nygren of the Oakmark family is prototypical of the kind of investment manager you should want to have running your active money. He has an uncanny ability, like many great managers, to communicate the "heart and soul" of his investment philosophy and approach. He describes his philosophy and differentiates himself as value manger in this environment in a very simple way. He trys to "buy great companies at average prices" while other value mangers focus on "buying average companies at low prices". He is a fundamental investor with the patience and confidence to wait for the market and stock prices to converge with the fundamental value he sees in a company. He also seems like a humble fellow who can honestly and constructively recognize and address issues in the portfolio. He gave a very rationale explanation for why he chose to eliminate Merck from his portfolio (range of possible outcomes from Vioxx litigation made the downside volatility of future outcomes for this stock greater than other choices in the industry). Bill also seems to have a very distinct investment thesis for each stock in the portfolio and seems very unaffected by the behavioral activity in the market. Bill thinks equities are fairly valued today and finds quality spreads very narrow. He described their rational for the re-opening of the Oakmark Select Fund and carefully described the different target investors they have in mind for both Oakmark and Oakmark Select. Read Bill's quarterly commentary and you will get a strong sense for who he is.

Also found the Bond guys at Loomis Sayles very adept in their markets. Dan Fuss, domestic bonds, seems to share the consensus view that rates will rise in an orderly manner over the next few years ( Fed funds 3%, 10 Year Treasury 5.25%, long Bond 6%). He sees credit spreads as being tight but reasonable given credit trends. He sees leverage as the big problem in the market. The carry trade and proliferation of leverage vehicles makes it very difficult for the Fed to tighten aggressively. David Rolley, the global guy, sees appreciation potential in Asian currencies but thinks timing is an issue, Global growth otherwise not so hot. Risk of bond bear markets all over. Both these guys very facile in their market intellect and straightforward thinkers and communicators. Some good material and detail at L&S.

PBS transcript of Social Security smackdown with Paul Krugman and Jim Lovell interview detailing his votes for best managers..not surprised to see Bill Nygren on it.

DC Rules

If you have a pension plan you should be discussing the final automatic rollover rules with your plan provider. Most providers seem rather late to the party in addressing these requirements..probably because it doesn't provide an opportunity to make a milli0n bucks! Essentially the final regulations ( initial requirement was part of the Economic Growth And Tax ReconciliationAct of 2001) provide a safe harbor for sponsor fiduciaries enaged in automatic rollovers of certain mandatory distributions into individual IRA accounts. I have talked to several large providers who are looking to outsource this business since the economics of small balance IRA's are so poor. The regulation is effective March 28, 2005.

By the way, apparently someone thinks the CALPERs (nuke the DB) Pension Debate Information site, referenced in yesterdays post is a wee bit biased.

Thursday, January 20, 2005

Pensions are for Girlie Men

Arnuld bids hasta la vista to California public defined benefit plans but the public employees think it's a raw deal. They have created an Information Center to alert employees to the collateral damage associated with DC plans. It will be the end of days before the citizen laborers will allow the predator's true lies to go uncontested. The terminator better get his eraser out before there is another total recall in the Golden State.

Lawnmowers Go Under

First it was the Steel industry, then came the Lawnmowers!? They call it the PBGC put and it seems to be coming in handy. The way things are going, PBGC will be the only place left to get an old fashioned pension benefit.

  • The Pension Benefit Guaranty Corporation today announced it will assume responsibility for the pensions of about 4,500 workers and retirees of Murray Inc., a maker of outdoor power equipment based in Brentwood, Tenn. Murray Inc. filed for bankruptcy protection on November 8, 2004. The Murray Inc. Pension Plan for Hourly Paid Employees and The Murray Inc. Employees’ Retirement Fund Plan are 53 percent funded, with $131 million in assets to cover $246 million in promised benefits. The PBGC estimates it will be liable for about $103 million of the $115 million shortfall. RecentlyThe Pension Benefit Guaranty Corporation announced that it would assume responsibility for the pensions of more than 14,000 active and retired pilots at United Airlines. The United Airlines Pilot Defined Benefit Pension Plan is 49 percent funded on a termination basis, with $2.8 billion in assets to cover $5.7 billion in benefit liabilities, according to PBGC estimates. Of the $2.9 billion in underfunding, the PBGC expects to be liable for approximately $1.4 billion in guaranteed benefits, making the United pilots plan the third-largest claim in the history of the insurance program.

Mutual Fun(ds)

If you like investment data these lists are always fun to review. BusinessWeek published their annual Mutual fund review and the "A" list is linked. I believe a thorough quantitative review is the first step in isolating a universe of investment funds that one would consider for further review. The issue with the rating process is the informational "cost" of oversimplification. Proprietary fund ranking processes, and everyone has got one, tend to focus on historical returns and risk by category. The ranking formula's will weight each factor based on the sponsor's perception of the importance of each factor. For instance, most formulas will weight a three year historical return more heavily than a five year return. Logic suggests more recent returns are more relevant than those further back in time. Unfortunately, while this makes common sense, there is little to no evidence suggesting a higher correlation between prior 3 year results and future results. On the other hand, one would like to think that using some rational and disciplined basis for investment evaluation, even if oversimplified, might add value over randon selection. I think this may be true. Given the limitations implicit in these ranking models, they may be useful in stratifying an investment population into two groups; those with possible merit vs those without.

Wednesday, January 19, 2005

Hedge Funds: The End of the Beginning

Greenwich Associates issued the folowing press release about their latest study on Hedge Funds

  • Tuesday, Jan. 18, 2005 Greenwich, CT USA — A new report from Greenwich Associates reveals several trends suggesting that hedge funds are moving out of the realm of the "alternative" and into the mainstream:
    Institutionalization — Institutional capital is making up a growing portion of hedge fund inflows, and allocations to hedge funds by institutional investors around the globe are reaching levels at which they could have a noticeable impact on overall performance. Over a quarter of large institutional investors in the U.S., Japan, and continental Europe use hedge funds, broadly defined.
    Professionalization — Hedge funds are "professionalizing" in order to meet the transparency, servicing, and other requirements of large institutional investors. They are also diversifying their strategies and adding long-only options that appeal to many institutions. At the same time, the line between so-called "traditional" investment management firms and hedge fund managers is blurring as established asset-management organizations add hedge funds to their own product offering.
    Regulation — The cost of compliance with new U.S. Securities and Exchange Commission rules will weed out some smaller hedge funds by increasing the barriers to entry and the perceived break-even threshold for hedge fund assets.
    Return Moderation — Hedge fund returns appear to be moderating — at least for now. As more money flows into the sector and hedge funds proliferate, arbitrage opportunities are diminishing. The consultants at Greenwich Associates view it as unlikely that hedge funds as a broad-based industry of hundreds of billions of dollars will be able to replicate the robust returns generated by a relatively small number of funds in recent years.
    Talent Migration — As some of the brightest minds in investing continue to migrate to hedge funds from traditional asset managers, institutions may already see hedge funds as a high-priced mechanism for accessing alpha generation opportunities and the top talent in the industry.
    "Although their initial appeal might have been the promise of home-run returns," says Greenwich Associates consultant Chris McNickle, "hedge funds are maturing into a mainstream institutional investment product or asset-class, and a cadre of firmly established hedge fund managers has the potential to evolve into something of a second-generation asset-management industry." Hedge Funds: Asset Management 2.0?The new Greenwich report suggests that institutional investment in hedge funds is transforming what began as a niche category catering mainly to high-net worth individuals and U.S. endowments and foundations into a permanent fixture within institutional portfolios.
    Gross institutional allocations to hedge funds throughout the world have yet to break free of a narrow range surrounding 1% of total portfolio assets. However, as global institutional investors implement strategies aimed at shoring up and maintaining solvency ratios, and opportunities in other alternatives like private equity remain capacity constrained, an increasing number are incorporating hedge funds for their potential to deliver incremental returns, portfolio diversification, and other perceived benefits.
    In Japan, the percentage of institutional investors using hedge funds more than doubled from 18% in 2003 to nearly 40% in 2004. Among European institutions, the proportion using hedge funds jumped to 32% in 2004 from 23% a year earlier. For U.S. institutions, 23% used hedge funds in 2003 and preliminary data from Greenwich's 2004 research indicates that usage for this year has reached 28%. The Half-Life of OpportunityThis exponential expansion suggests that the growing number and influence of hedge funds could itself have an impact on future performance levels. Hedge fund returns were disappointing through the first three-quarters of 2004 — a performance that could be a simple reflection of changing conditions and decreasing market volatility, but could also be suggestive of a more secular shift. Institutional rate-of-return expectations for hedge funds over the next five years range from 9.1% in the United States to 5.6% in Japan. Average actuarial rate-of-return assumptions declined from 2003 to 2004 in the United States (from 8.6% to 8.3%) and Japan (from 4.7% to 4.2%), while increasing in Canada (7.1% to 7.4%), the United Kingdom (6.1% to 6.5%), and continental Europe (6.1% to 6.2%).
    As hedge funds proliferate and accumulate capital, they are making up a larger portion of trade flows in a variety of markets. For example, hedge funds this year made up 82% of trade volume in U.S. distressed debt and almost 30% of volume in U.S. below-investment grade bonds and credit derivatives. In fact, hedge funds accounted for more than half of the listed or vanilla OTC options contracts and almost a third of the total number of futures contracts traded in the United States in 2004. In exchange traded funds, hedge funds accounted for more than 70% of U.S. trade volume.
    "The half-life of opportunity in any of these markets is short," says Chris McNickle. "As hedge funds generate a larger portion of overall trading volume, they are wearing down arbitrage opportunities in some strategies. However, even if returns moderate, Greenwich believes that hedge funds will remain a permanent part of institutional portfolios."

Hedge funds - the "smart" money is going there

Hedge funds impacts on investors and the markets is growing. New hedge fund inflows amounted to $75 billion in 2004 with arbitrage and event driven strategies receiving the majority of the new money. Hedge funds, numbering about 8000, now manage about $1 Trillion vs. an estimated $8 Trillion in mutual funds. Individual investors and family offices still account for the majority of total hedge fund capital with pension funds holding an estimated 9% of industry assets. Hedge funds have been estimated to account for up to 30% of the daily volume on the NYSE and another estimate suggest at least 75% of hedge funds employ leverage in their process. Hedge funds typically thrive in volatile markets. The VIX index, a measure of the amount of volatility that options traders expect the Standard & Poor's 500-stock index to experience in the near future, recently fell to its lowest level since 1996, dipping below 12. With the equity market volatility being so low, it seems reasonable to conclude that hedge funds were attracted to and hence partially responsible for the large volatility we saw in currency and commodities this year.

The Financial Times reports that the average Morningstar mutual fund return of 8.35% surpassed major hedge fund indicies such as the CSFB /tremendous index , which posted 7.9%. Hedge fund performance has been impacted by lower than usual volatility and returns dispersion in the capital markets and a likely reduction in real capacity as more and more players enter the market. Based on their profitability and allure as an asset gathering tool, hedge funds will no doubt continue their extraordinary growth. However, the inevitable signs of excess are beginning to emerge. Hedge funds are going mainstream Street is buying or building their own capabilities. JP Morgan and Citigroup have joined UBS, Deutche Bank and Morgan Stanley in acquiring or building hedge fund capabilities. Long only hedge funds have emerged. Investors lack of due diligence, very reminiscent of the technology era, was highlighted in a Wall Street Journal last week on Eric Mindich, a new hedge fund manager. His fund ,Eton Street Capital opened with $3 billion, is believed to be the largest launch on record. According to the Journal, Mindich had to turn money away despite a $5 million minimum, a 4.5 year lock up and the fact that he didn't divulge details about his trading strategy and acknowledged he hadn't managed money for several years. If it is difficult to assess manager skill versus luck with relatively full transparency what possible basis will investors have to discriminate between hedge fund managers? Apparently it does'nt matter! We will no doubt be reading about these issues in the months to come.

US Equity Indexing Wins in 2004

As is often the case, indexing is hard to beat. especially in up markets. Benchmark indices outperformed the actively managed mutual fund avarage in all but one style box in 2004 (the exception being large-cap growth), according to Standard & Poor's 4th Quarter SPIVA Scorecard. Those results stand in contrast to 2003, where a majority of active funds outperformed indices in 5 out of 9 style boxes, indices outperformed active funds in 3 style boxes, and where one category was a tie. Year-to-date, through December 2004, the S&P 500 outperformed 61.6% of actively managed large-cap funds, the S&P MidCap 400 outperformed 61.8% of actively managed mid-cap funds, and the S&P SmallCap 600 outperformed 85.0% of actively managed small-cap funds.

Tuesday, January 18, 2005

The Third Rail

Regarding the third leg of the retirement stool.... Roger Lowenstein writes a great article on the origins and issues around Social Security reform in the New York Times.

"Prudence dictates taking steps now to minimize the possible shortfall. This could include raising the cap, some modest cuts and tax increases and a gradual redeployment of the trust fund into assets that may not be tapped, willy-nilly, for whatever legislative purpose. But only a real crisis would dictate undoing an institution that has provided a safety net for retirees, that has helped to preserve in the social fabric some minimum of shared responsibility and that has been supported by workers in good faith. And, in looking at Social Security today, the crisis is yet to be found."

Private Pension Reform

Secretary of Labor Elaine Chao released an overview of the Presidents new pension reform proposal on January 10th. The proposal is designed to: reform funding rules, incent plan providers to adequately fund plans, improve pension funding status disclosure to participants, investors and regulators, raise premiums for risky plans to deter sponsors from inadequately funding their plans and to stabilize the finances of the Pension Benefit Guaranty Corporation (PBGC).

The proposal would require employers sponsoring defined-benefit plans to:
Pay a higher annual insurance premium of $30 per covered employee, which would then be adjusted upward based on an index tied to wages. Today's premium is $19.
Pay additional risk-adjusted premiums if they are operating under bankruptcy protection and have underfunded pension plans. The premium would be determined by the size of the shortfall. Adequately fund their plans based on more accurate measures of the value of their investments and obligations. The new rules would require companies to value investments closer to current market conditions. Long-term obligations would be calculated using a yield curve tied to current corporate bonds.
Disclose more details on a timely basis about the condition of their pension plans and their funding history to workers, investors and regulators.

Absent the details it is difficult to evaluate the proposal but the industry will be closely watching how the legislation develops.

Monday, January 17, 2005

the goal of fiduciaryinvestor

The purpose of this blog is to provide practical information and insights on investment and fiduciary topics primarily for pension plan sponsors and trustees. This information should be generally relevant to either defined benefit (the increasingly rare plan which calculates and pays benefits based on length of service/compensation levels and where investment risk resides with the employer) or defined contribution pension plans (plans where employers contributions are limited to a designated annual amount and investment risk is passed to the participants.. i.e. 401(k) plans). It may also be relevant to other investment fiduciaries as well as the general investing public who would like to understand and adopt the principles and investment process used to manage literally billions of dollars in institutional pension assets. Though many fiduciary standards require expertise in this area, many fiduciaries receive little formal or informal training in either investment theory or the regulatory standards of practice required of a fiduciary. The information provided may help interested fiduciaries recognize and execute prudent investment fiduciary decision making.