Market Musings Blog

Some years ago, Wall Street decided that Brazil, Russia, India and China would be ‘hot’ markets, with all that growth and development happening. These countries in aggregate were called the BRIC, an acronym coined by Goldman Sachs’ Jim O’Neill. Every conference we attended, we heard BRIC BRIC BRIC. Inevitably, BRIC mutual funds and ETFs proliferated. We checked several well known versions recently – Templeton’s TABRX, iShares CBQ, iShares BKF, and Guggenheim’s EEB. None of these funds have produced returns even close to 1% per year over the last five years. In order to harvest a decent return out of these funds, you would have had to be as nimble as a cat on a hot tin roof, skipping in and out year by year. No one can do that effectively.

Next was hedge funds. Technically we can’t really call these a Wall Street invention. Some hedge funds are run by people who want nothing to do with Wall Street. Still, Wall Street has been more than happy to jump on the bandwagon, spurring the proliferation of these funds beyond all reason. Outrageous fees have aided the trend towards more offerings. Why work for 1% of assets when you can get 2% and then 20% of profits (shorthand: two and twenty). The hedge fund trend has sucked managers from mutual fund companies where they felt they were underpaid, so they can trade in the same securities but pocket more at the expense of the investor. CALPERS, the big California pension fund, came to its senses first, and is excising hedge funds from its investment program. More pension funds will follow. The funds have struggled to beat a plain old 60/40 stock/bond mix. This may be due to the sheer number of funds now picking over every opportunity, and thus arbitraging away all excess return.

What’s next? “Liquid Alts.” This refers to a fund containing investments in normally illiquid, exotic instruments like merger arbitrage, private credit issues, derivatives, and packaged hedge funds. Of course, these cost an arm and a leg, too. The trend to liquid alts was supported by the ‘failure’ of diversification in the ’08/’09 credit crisis. (We’re not going to take up the notion that diversification ‘failed’ here, except to say it didn’t. Most investors, after a long bull market, were simply positioned with too much risk.) Billions of dollars have flowed to these strategies, alarming the SEC, which is conducting examinations of big liquid alt providers to figure out if they will actually be liquid in a very bad market. We bet they won’t. We were completely shocked to read an article in one of the worst publications put out by our industry which very nearly declared that any advisor not using liquid alts was as good as committing malpractice, and that – according to a Goldman rep, who conveniently sells liquid alts – at least 19% of client assets should be in liquid alts.

Don’t fall for this crap. View it like it is: Wall Street’s effort to make you part with more of your money to line their pockets. And possibly, more dangerously, a sore spot that will turn to gangrene when the next bear market visits.

Today, Venezuela begged OPEC to convene a meeting to curtail production and boost oil prices. OPEC turned a deaf ear. In case you hadn’t heard, Venezuela is not doing so well. Inflation is rampant, the poor are getting poorer, basic household goods aren’t available – in short, the ‘revolution’ is failing. Things were good when oil prices were high: the big revenue allowed for handouts, public takeovers of private companies, and most importantly, luxury goods for the political elite. With revenue falling like a rock, politicians are desperate. One answer? Pump oil like mad.

Meanwhile, Russia, struggling with a recession, budget deficits, and a war, is one of the world’s largest oil producers. Oil makes up a third to a half of government revenues. Russia really needs oil to stay above $100 a barrel. But, a short term answer to falling prices is… more oil.

What about ISIS? Apparently, this terror group scrapes money from oil fields, which helps fund its operations. We have no particular confidence economic principals play much of a role in the thought process of ISIS. If you can compel workers to operate the wells, you can merely collect the revenue no matter what it cost to extract. So to keep terrorizing, you pump oil.

It will be interesting how despots react to lower oil prices. In an ironic twist, a reaction geared towards keeping revenues up will benefit the West in a big way. Probably not what they had in mind.

Risk is inextricably tied to return. It is not true that taking higher risk means you will see higher returns, What is true is that higher risk raises the probability that you will harvest higher returns. It also raises the probability of losses (see our last post).

Part of any investment manager’s job is to gauge the potential risk of an asset. If you accept a ‘lock up’ on an investment preventing you from selling it for a time, risk increases. If debt is used to finance the asset, risk increases. If operating results are lousy, risk is high. If an investment has multiple partners, risk can be high depending on entity structure. Merging companies present risk, even building a new plant can be risky. Once you identify sources of risk, the next rule is to get paid for accepting that risk.

You can’t know what future returns will be, but many assets offer clues. A stock that pays a 6% dividend yield when everything else is yielding 3% is probably riskier than normal, but that upfront payment is a good start towards a healthy return – if the payout can persist. Real estate investments that offer net cash flow of 3% or 4% in addition to future rent increases and modest appreciation; bonds that sell at a discount and also pay cash flow of 5% to 6%; private equity investments with ever growing valuations at each new investment round; these are examples of assets that could deliver above average returns.

What’s ‘average’? We benchmark most assets to long term stock returns, which are roughly 9.5% per year since 1926; bad years can shave 45% off your portfolio value. If you are taking stock-like risk in some exotic asset, with potential losses on the table, there had better be a potential return above 9.5%. Bond returns since 1926 – using intermediate corporate issues as our benchmark – are between 5% and 6% per year on average; bad years are not really very bad in the bond department, with losses only amounting to about 5% in the worst year for these maturities. If you finance a real estate development for your buddy, you are essentially issuing a private bond, and you’d better insist on more than 6%.

Using comparisons to historical returns and losses lets you approach risk with eyes wide open.

Countless words have been writ about risk. The topic grows in popularity when markets crash (avoidance), and fades when markets rise. Then, when markets hit new highs, risk becomes popular in another way – people embrace it.

Most of the definitions of risk are of limited usefulness. Technical definitions talk about volatility, components of return, and so forth, but depend on assumptions that can blow apart when markets change suddenly. Meanwhile, the media has brainwashed investors into believing that taking more risk means more return.

It’s not that simple.

What does risk really means to the lay investor who has limited funds and is trying to achieve or maintain a certain lifestyle with his investment program? We explain it this way: risk is the possibility that you will have to make a change to how you live your life in the short term in order to obtain a certain goal in the long term, ‘long term’ being perhaps useless to you in that it exceeds your lifetime. In other words, you could be forced to make a short term sacrifice to no good end. This is the ‘losing’ side of risk, and it happens every day.

An investor who has a portfolio allocated 50/50 between stocks and bonds wants ‘more risk’ now that the market is up but also wants to retire in five years or less. He thinks that increasing his risk will get him to his goal faster. Instead, moving to 70% stocks increases the probability that he will not achieve retirement in even five years. If the market corrects like it did in ’08/’09, it could be five years before he’s recovered his value, let alone earned more.

Higher risk is not consistent with short term goals. Those goals must ‘give way’ to achieve the longer term benefit.

Stay tuned for our next entry, which will discuss getting paid for the risk you are taking.

This week, JP Morgan Chase revealed that hackers invaded its customer records. On the heels of that announcement, many banks assured customers that ‘security is important to us’. No doubt. The problem is that the evolution of hackers is just a fast as, if not faster than the evolution of defenses. Someday, hackers may not simply steal your social security number or account records. They will steal your money too, right out of your bank account.

You’re thinking that your deposits are insured, right? Aha, that is true, but only in the event of bank failure. Theft is not covered by FDIC insurance. Certain types of terrorism insurance exist, but exactly what they cover is somewhat open to interpretation. There’s no question that if a large bank were swept clean of deposits, its insurer would claim that the event fell outside the coverage in the insurance contract. In the meantime, there you are, with no funds.

The best defense is a good offense. It might be time to ask your bank exactly what happens in the event of a security breach that brings your deposit balances to zero. We don’t advocate any bank over any other, but put yourself in the hacker’s shoes: if you were reaching for the brass ring, wouldn’t you go where the money is – ie, the biggest bank you could reasonably hack? You probably would not bother with a small community bank. On the other hand, does your community bank have the resources to stand up to cyber crime?

We have the uneasy feeling that the various hacks, identity thefts, data breaches, and so forth over the past several years are practice. Eventually someone somewhere is going to figure out how to make a massive funds transfer from a very large bank. Better hope it’s not yours.