In The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True (Wiley, 2012) Simon Lack draws on a long career in the hedge fund industry. The result is a chatty, personal history of hedge funds and a critical look at what they offer (and mostly don’t offer) investors.
The very first sentence of the book is a stunner: “If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.” Contrast this stark reality with the money earned by hedge fund managers. In 2009 the top 25 hedge fund managers collectively earned $25.3 billion. No wonder one of Lack’s chapters is entitled “Where Are the Customers’ Yachts?” referencing the classic book of that title.
Lack set up JPMorgan’s incubator funds that provided early stage funding, or seed capital, to new hedge fund managers. Typically, they would offer $25 million of capital in exchange for 25 percent of the business. “The business share would come, not through a direct equity stake in the manager’s company, but through carving off 25 percent of the fees earned from all the other clients.” (p. 40) That is, they would earn a share of the top line, before expenses, and be at least in part protected from investing losses.
Even JPMorgan occasionally suffered from hedge fund practices that, though presumably legal, are detrimental to investors. Transaction costs, for instance, can be substantial when the fund invests new money. Some hedge funds claim to value their holdings on the bid side to be conservative. But “this should be false comfort because it also means that new investors come into the fund at a ‘conservative’ (which means low) NAV. Since the new capital received will have to be deployed, the manager will either have to buy more of the securities already owned, incurring transaction costs shared by all the investors, or use the cash for new opportunities which has the effect of diluting the existing investors’ share of current holdings at the bid side of the market. In effect, existing investors sell a pro-rata share of their holdings to the new investors at the bid side of the market.” (p. 110)
Moreover, Lack encountered a firm that played fast and loose with the valuation of its portfolio. When Lack’s group decided to exercise its escape clause in the face of a deteriorating convertible bond market and withdraw half of its capital, the fund switched from valuing its holdings at mid market to using the “Bid NAV.” The group felt they’d been had. “Fortunately,” Lack writes, “we were able to turn the trick back on them two months later” when the fund managers artificially boosted their performance as the market bounced back by using the “Ask NAV” to value their bond portfolio. Lack’s group cashed out the rest of its holdings at the higher valuation.
In this book Lack names names—the good, the bad, and the slouches. He offers pointers on how to invest wisely in hedge funds, his best idea being to opt for a small, new hedge fund. And, of course, do lots of due diligence.
Lack’s experience shines through on every page of The Hedge Fund Mirage. Hedge fund investors, and anyone who is even contemplating investing in a hedge fund, would do well to take advantage of it.
Tuesday, January 3, 2012
Friday, December 23, 2011
Merry Christmas
What do you do with all those books you bought and now consider useless?
Following up on my 2009 post on unusual Christmas trees but becoming increasingly lazy, this year I direct you to a site that pictures twelve Christmas trees made out of books.
Wednesday, December 21, 2011
Cortés, Against the Herd
Those of you who watch Fast Money on CNBC (I don’t) are undoubtedly familiar with Steve Cortés since he’s one of the regulars. He is also the founder of Veracruz, a market research firm. In Against the Herd: 6 Contrarian Investment Strategies You Should Follow (Wiley, 2012), itself a fast-paced book, he shares some of the fruits of his and his firm’s research.
The themes are (and with one exception I won’t be a spoiler and tell you which way he positions himself) China, Japan, gold, the housing market, market volatility, and the U.S.
Here I’ll share Cortés’s take on Japan. In a chapter entitled “Dolls Are Meant for Children” he predicts a “severe demographic and fiscal implosion” for Japan, arguing that the country’s problems “are utterly terminal [and] there is literally no escape from the death spiral.” (p. 35) The chapter’s title, by the way, refers to the doll Yumel, which serves “as a fake grandchild for the massively growing legions of lonely, geriatric, grandchildless Japanese.” (p. 34)
In the 1980s Japan seemed unstoppable economically. The Nikkei reached a closing high of 38,916 in 1989 and eight of the ten largest companies in the world by market cap were Japanese. Super-low rates and a strong yen created “the tinder for a classic bonfire of reckless investment.” (p. 41) As we know, the bubble popped. The Nikkei declined over 80% to a 2009 low of 7,055, in the early 1990s values of commercial real estate fell 87%, and deflation set in.
Japan is now in an “inescapable” bond trap, with a debt-to-GDP ratio over 200% and a debt-to-private GDP ratio at 240%. For the past 20 years Japan has been able to sell its bonds to domestic insurance companies, individual Japanese savers, and public pension plans. “But the famously thrifty Japanese are fast drawing down savings and the trajectory is certain and points toward an aging nation of net spenders, not savers. Japan began the two lost decades with a savings rate at 16 percent. It has slowly dipped to 2 percent and will soon likely head to negative territory.” (p. 46)
If Japan has to tap the international fixed income market, rates will have to rise. “According to hedge fund titan Kyle Bass, every 1 percent increase in the Japanese government’s cost of capital will consume an astounding 25 percent of total government revenue. He states, ‘For context, if Japan had to borrow at France’s rate, the interest burden alone would bankrupt the government.’” (p. 48) Japan would have to roll out its printing presses and devalue its currency.
Cortés offers some ideas on how to capitalize on Japan’s impending doom, the simplest being shorting the yen and buying the U.S. dollar.
Cortés’s writing is fine in small doses, formulaic for the length of a book. He tries to ease the reader into investing concepts by invoking pop culture images. For instance, in the chapter on gold, he starts with MC Hammer, moves on to John Travolta, then the Bible (well, I guess that wouldn’t qualify as pop culture), Richard Simmons, John L. Sullivan, Three’s Company, and finally A Man for All Seasons. This goes on chapter after chapter after chapter after chapter…. It starts to wear thin pretty quickly.
But for those who like to think in macro terms Cortés’s book offers six contrarian (or semi-contrarian) theses supported by well-reasoned arguments and sufficient though not overwhelming data.
The themes are (and with one exception I won’t be a spoiler and tell you which way he positions himself) China, Japan, gold, the housing market, market volatility, and the U.S.
Here I’ll share Cortés’s take on Japan. In a chapter entitled “Dolls Are Meant for Children” he predicts a “severe demographic and fiscal implosion” for Japan, arguing that the country’s problems “are utterly terminal [and] there is literally no escape from the death spiral.” (p. 35) The chapter’s title, by the way, refers to the doll Yumel, which serves “as a fake grandchild for the massively growing legions of lonely, geriatric, grandchildless Japanese.” (p. 34)
In the 1980s Japan seemed unstoppable economically. The Nikkei reached a closing high of 38,916 in 1989 and eight of the ten largest companies in the world by market cap were Japanese. Super-low rates and a strong yen created “the tinder for a classic bonfire of reckless investment.” (p. 41) As we know, the bubble popped. The Nikkei declined over 80% to a 2009 low of 7,055, in the early 1990s values of commercial real estate fell 87%, and deflation set in.
Japan is now in an “inescapable” bond trap, with a debt-to-GDP ratio over 200% and a debt-to-private GDP ratio at 240%. For the past 20 years Japan has been able to sell its bonds to domestic insurance companies, individual Japanese savers, and public pension plans. “But the famously thrifty Japanese are fast drawing down savings and the trajectory is certain and points toward an aging nation of net spenders, not savers. Japan began the two lost decades with a savings rate at 16 percent. It has slowly dipped to 2 percent and will soon likely head to negative territory.” (p. 46)
If Japan has to tap the international fixed income market, rates will have to rise. “According to hedge fund titan Kyle Bass, every 1 percent increase in the Japanese government’s cost of capital will consume an astounding 25 percent of total government revenue. He states, ‘For context, if Japan had to borrow at France’s rate, the interest burden alone would bankrupt the government.’” (p. 48) Japan would have to roll out its printing presses and devalue its currency.
Cortés offers some ideas on how to capitalize on Japan’s impending doom, the simplest being shorting the yen and buying the U.S. dollar.
Cortés’s writing is fine in small doses, formulaic for the length of a book. He tries to ease the reader into investing concepts by invoking pop culture images. For instance, in the chapter on gold, he starts with MC Hammer, moves on to John Travolta, then the Bible (well, I guess that wouldn’t qualify as pop culture), Richard Simmons, John L. Sullivan, Three’s Company, and finally A Man for All Seasons. This goes on chapter after chapter after chapter after chapter…. It starts to wear thin pretty quickly.
But for those who like to think in macro terms Cortés’s book offers six contrarian (or semi-contrarian) theses supported by well-reasoned arguments and sufficient though not overwhelming data.
Sunday, December 18, 2011
My picks of the year
Last year I wrote a post in which I highlighted some books that I personally found valuable. One of my readers requested a 2011 update. So here it is—my brief, admittedly very idiosyncratic list presented in alphabetical order. Clicking on the book title will with any luck take you to my review.
Aaron Brown, Red-Blooded Risk: The Secret History of Wall Street
William Byers, The Blind Spot
Emanuel Derman, Models.Behaving.Badly
Scott E. Page, Diversity and Complexity
Among the books that deal more directly with investing I almost always enjoy titles in the “little book” series. Here are two, both particularly useful for value investors: Aswath Damordaran, The Little Book of Valuation and Vitaliy N. Katsenelson, The Little Book of Sideways Markets.
Lots of runners-up this year, but I’ll stop for now. I may need to pull them out of the hat for next year’s picks.
Aaron Brown, Red-Blooded Risk: The Secret History of Wall Street
William Byers, The Blind Spot
Emanuel Derman, Models.Behaving.Badly
Scott E. Page, Diversity and Complexity
Among the books that deal more directly with investing I almost always enjoy titles in the “little book” series. Here are two, both particularly useful for value investors: Aswath Damordaran, The Little Book of Valuation and Vitaliy N. Katsenelson, The Little Book of Sideways Markets.
Lots of runners-up this year, but I’ll stop for now. I may need to pull them out of the hat for next year’s picks.
Thursday, December 15, 2011
Brooks, Trading Price Action Trends
In 2009 Al Brooks wrote Reading Price Charts Bar by Bar, a book I struggled with, as I explained in my review. It seems I was not alone. Brooks therefore re-engineered his project instead of simply writing a second edition. The result is a three-book series, of which Trading Price Action Trends: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012) is the first volume. The other two, forthcoming in January, will deal with trading ranges and reversals.
Trading Price Action Trends is still no spine-tingling thriller, but it’s a tremendous improvement over Brooks’s first effort. For starters, the prose is cleaner and the charts are larger. And instead of merely describing bars, individually and as parts of patterns, he explains what they may reveal about the intentions and expectations of traders, both bulls and bears.
Brooks himself trades primarily off of 5-minute e-mini S&P 500 candlestick charts using only price action—no indicators (with the exception of a 20-bar EMA and hand-drawn trend lines), news, or multiple time frames. He sees everything “in shades of gray” and thinks “in terms of probabilities.” (p. 12) He recognizes that “everything can change to the exact opposite in an instant, even without any movement in price.” (p. 37) When he looks at a chart, he is “constantly thinking about the bullish case and the bearish case with every tick, every bar, and every swing.” (p. 39) He dissects bars but also realizes that ultimately they have meaning only contextually. If he were dealing with animals instead of charts he would be both an anatomist and an ecologist.
About half of this volume is devoted to the fundamentals of price action, the other half to trends. Of course, there is no clear demarcation line between the two. It’s impossible to write about the fundamentals of price action without discussing trends. At the level of individual bars, for instance, Brooks differentiates between trend bars and dojis (where the bulls and bears are in balance).
Who should read this book? Novices who think that trading is easy; this book should definitely dissuade them and perhaps prevent yet another account from being blown out. Serious traders, as Brooks himself suggests—and I would add serious traders with a penchant for detailed analysis who are willing to log thousands of hours of screen time and after-hours study in order to stand a chance of becoming a successful discretionary trader.
Trading Price Action Trends is a tough book to absorb. One pass is certainly not enough. But even on the first pass I found some extremely useful pointers. So it goes on to the shelf awaiting a second read.
Trading Price Action Trends is still no spine-tingling thriller, but it’s a tremendous improvement over Brooks’s first effort. For starters, the prose is cleaner and the charts are larger. And instead of merely describing bars, individually and as parts of patterns, he explains what they may reveal about the intentions and expectations of traders, both bulls and bears.
Brooks himself trades primarily off of 5-minute e-mini S&P 500 candlestick charts using only price action—no indicators (with the exception of a 20-bar EMA and hand-drawn trend lines), news, or multiple time frames. He sees everything “in shades of gray” and thinks “in terms of probabilities.” (p. 12) He recognizes that “everything can change to the exact opposite in an instant, even without any movement in price.” (p. 37) When he looks at a chart, he is “constantly thinking about the bullish case and the bearish case with every tick, every bar, and every swing.” (p. 39) He dissects bars but also realizes that ultimately they have meaning only contextually. If he were dealing with animals instead of charts he would be both an anatomist and an ecologist.
About half of this volume is devoted to the fundamentals of price action, the other half to trends. Of course, there is no clear demarcation line between the two. It’s impossible to write about the fundamentals of price action without discussing trends. At the level of individual bars, for instance, Brooks differentiates between trend bars and dojis (where the bulls and bears are in balance).
Who should read this book? Novices who think that trading is easy; this book should definitely dissuade them and perhaps prevent yet another account from being blown out. Serious traders, as Brooks himself suggests—and I would add serious traders with a penchant for detailed analysis who are willing to log thousands of hours of screen time and after-hours study in order to stand a chance of becoming a successful discretionary trader.
Trading Price Action Trends is a tough book to absorb. One pass is certainly not enough. But even on the first pass I found some extremely useful pointers. So it goes on to the shelf awaiting a second read.
Wednesday, December 14, 2011
Smith and Shawky, Institutional Money Management
Institutional Money Management: An Inside Look at Strategies, Players, and Practices, edited by David M. Smith and Hany A. Shawky (Wiley, 2012) is the most recent addition to the Kolb Series in Finance. As is the custom with books in this series, it includes contributions by both academics and practitioners and is designed for professionals in the field as well as those aspiring to enter the field. It is a well-edited volume that anyone with a modicum of market experience should have no difficulty reading.
The book has four main themes that are explored in 22 chapters: market regulation, performance evaluation, and reporting; key individuals to the investment process; major investment approaches; and types of institutional investors.
In this post, rather than attempting an overview, I’m going to zero in on a single point that I think is potentially important for the individual investor.
The editors, in their chapter “Investment Buy and Sell Decision Making,” analyze data from Informa’s plan sponsor network (PSN) database, which is updated quarterly through surveys of money managers. They examine 5,410 equity portfolios and 1,494 fixed income portfolios from 1979 to the November 2009 release.
What criteria, they ask, do portfolio managers use when buying equities? About 60% reported using a bottom-up method. The next most popular criteria were quantitative/research (14%), fundamental analysis (11%), computer screening/models (4%), and top-down/economic analysis (4%). Only 20 portfolios of the 5,410 relied on technical analysis although, as the authors note, “the criteria most closely related to technical analysis—quantitative analysis, computer screening, and momentum—also enjoy widespread usage by portfolio managers.” (p. 125)
As we know, the more important question is usually when to sell. The PSN database recognizes six sell-discipline criteria: down from cost, up from cost, target price, valuation level, fundamental deterioration overview, and opportunity cost. The most popular among managers was fundamental, followed by valuation level; target price came in third.
The authors analyze returns by equity class (and the overall average) for each of these sell-discipline criteria. The best-performing criterion was down from cost, followed by target price. The worst performance, by a large measure, was logged by those who used no sell-discipline criterion. Here are the overall average numbers for the arithmetic average benchmark-adjusted returns (percent annualized): fundamental 2.17%, valuation level 2.00%, target price 2.47%, opportunity cost 1.76%, down from cost 2.59%, and none 1.22%.
There’s a lesson here.
The book has four main themes that are explored in 22 chapters: market regulation, performance evaluation, and reporting; key individuals to the investment process; major investment approaches; and types of institutional investors.
In this post, rather than attempting an overview, I’m going to zero in on a single point that I think is potentially important for the individual investor.
The editors, in their chapter “Investment Buy and Sell Decision Making,” analyze data from Informa’s plan sponsor network (PSN) database, which is updated quarterly through surveys of money managers. They examine 5,410 equity portfolios and 1,494 fixed income portfolios from 1979 to the November 2009 release.
What criteria, they ask, do portfolio managers use when buying equities? About 60% reported using a bottom-up method. The next most popular criteria were quantitative/research (14%), fundamental analysis (11%), computer screening/models (4%), and top-down/economic analysis (4%). Only 20 portfolios of the 5,410 relied on technical analysis although, as the authors note, “the criteria most closely related to technical analysis—quantitative analysis, computer screening, and momentum—also enjoy widespread usage by portfolio managers.” (p. 125)
As we know, the more important question is usually when to sell. The PSN database recognizes six sell-discipline criteria: down from cost, up from cost, target price, valuation level, fundamental deterioration overview, and opportunity cost. The most popular among managers was fundamental, followed by valuation level; target price came in third.
The authors analyze returns by equity class (and the overall average) for each of these sell-discipline criteria. The best-performing criterion was down from cost, followed by target price. The worst performance, by a large measure, was logged by those who used no sell-discipline criterion. Here are the overall average numbers for the arithmetic average benchmark-adjusted returns (percent annualized): fundamental 2.17%, valuation level 2.00%, target price 2.47%, opportunity cost 1.76%, down from cost 2.59%, and none 1.22%.
There’s a lesson here.
Tuesday, December 13, 2011
McDowell, Survival Guide for Traders
So you want to become an independent trader, either to supplement your income or eventually to have trading be your sole source of income? Bennett A. McDowell has written Survival Guide for Traders: How to Set Up and Organize Your Trading Business (Wiley, 2012) for the novice who wants to get started but doesn’t quite know how to go about it. If the wannabe trader doesn’t feel quite ready to plunge into the markets after reading this book, McDowell is more than ready to sell him a range of pricey products on his website TradersCoach.com.
Like all start-up businesses, trading is difficult and prone to failure. What will give the novice a shot at being successful? McDowell offers six pointers: (1) understand it will be a lot of work, (2) get adequate financing, (3) plan, plan, and plan some more, (4) start your business for the right reasons, (5) be resilient and persevere, and (6) create a model that can be profitable. And, he adds, reduce your expenses because with taxes a penny saved is closer to a penny and a half earned.
McDowell covers a lot of territory in this book, from how to choose the best data feed, broker, and front-end platform for your needs to money management and financial psychology. He offers a detailed business plan template. He lists some technical analysis signals and tools (those included in his own software are at the top of the list) and five popular scanning tools (again, his scanner heads the list).
What is the holy grail of trading? McDowell suggests that is perseverance: “those who survive and prosper for the long term are the traders who can persevere through thick and thin and just keep going with new solutions and strategies.” (p. 132)
Survival Guide for Traders is a good primer with an abundance, sometimes an overabundance, of information, but of course the reader won’t go from “See Spot run” to “Sleep that knits up the ravelled sleave of care” in one fell swoop. There’s a lot of work and practice in between.
Like all start-up businesses, trading is difficult and prone to failure. What will give the novice a shot at being successful? McDowell offers six pointers: (1) understand it will be a lot of work, (2) get adequate financing, (3) plan, plan, and plan some more, (4) start your business for the right reasons, (5) be resilient and persevere, and (6) create a model that can be profitable. And, he adds, reduce your expenses because with taxes a penny saved is closer to a penny and a half earned.
McDowell covers a lot of territory in this book, from how to choose the best data feed, broker, and front-end platform for your needs to money management and financial psychology. He offers a detailed business plan template. He lists some technical analysis signals and tools (those included in his own software are at the top of the list) and five popular scanning tools (again, his scanner heads the list).
What is the holy grail of trading? McDowell suggests that is perseverance: “those who survive and prosper for the long term are the traders who can persevere through thick and thin and just keep going with new solutions and strategies.” (p. 132)
Survival Guide for Traders is a good primer with an abundance, sometimes an overabundance, of information, but of course the reader won’t go from “See Spot run” to “Sleep that knits up the ravelled sleave of care” in one fell swoop. There’s a lot of work and practice in between.
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