My wife just showed me her mutual fund statements and reports which she received from the manager. After 15 years, this much vaunted fund manager had generated a nominal return of… zero.

After inflation, living in Singapore, her investment wouldn’t be able to buy a bicycle let alone pay the downpayment on a retirement home in Southern Malaysia.

I also noticed that there had been a forced redemption. The manager had shut down one of their funds. Well, thanks. So after a decade of managing her money, the manager finally decided that they were not very good at it after all, and decided to hand the money back to her. “Here, you manage it,” is not really acceptable after you’ve taken a decade of fees off the investor.

Why did my wife invest in the fund? Well, she didn’t. In my earlier days, and in my folly, I decided to give her a birthday present which was not something she could carry, wear, eat or ride around in. So I bought her units in a mutual fund. Romantically, this is equivalent to shooting oneself in the temple. Twice.

I do invest in funds. I think its the smart thing to do, if you do it in a smart way. I don’t just invest in brand names. When it comes to fund managers, brand names are often asset gatherers who are better at getting your money than they are at managing it. I avoid brand names unless I can meet and interview the specific managers managing the relevant funds. Meeting and interviewing the managers is a necessary condition for me to invest with any fund. I need to assess for myself if the track record they have achieved is the product of skill or luck. I will only pay management (and or performance fees) for skill.

I invest in funds for a number of reasons.

– I can’t get the diversification I need for the amount I’d like to invest. Funds pool investors’ money into a bigger pot which can be deployed in assets which the hapless retail investor may not have the scale to access.

– I don’t have the time to dedicate to a particular strategy. I only have 24 hrs a day. I cannot engage in arbing interest rates, hedging converts, investing in mergers, trading credit correlation and structuring reg cap relief solutions all by myself.

– I may not have sufficient skill. This will most often be the case. Understanding an investment strategy and being able to execute it with the requisite skill are two different matters. If one doesn’t understand a strategy, the best advice is to not invest. It is irrational to invest in any scheme or strategy that one doesn’t understand. On the other hand, just because you understand a strategy doesn’t mean you can do it. It just means you know how its done. That’s all.

– I don’t have the scale for certain strategies. Not every day trader in his basement can obtain the necessary terms to trade the instruments that a strategy may require.

What I never do is invest in funds for silly reasons such as:

– A good track record. A good track record is never enough. One needs to understand how the track record was achieved, and if it can be repeated. One also has to know if the track record is real. Bernie Madoff had an excellent but fake track record. Yet so many clever investors invested with him.

– A clever trade. A clever trade does not a fund make. There are specialized closed ended private equity funds that take advantage of very specific opportunities but open ended mutual funds need to be based on more than a single opportunity. And I’m fine with those, in fact I think they are very interesting vehicles that are often launched to capture phenomenal opportunities. It worries me when managers launch funds to take advantage of the recovery post 2008. What happens when the trade is done? The manager is typically unwilling to return capital and will likely try their luck in another trade, one that you didn’t sign up for, one that the manager may not be experienced at. I want strategies that can last at least 7-8 yrs, because that’s how long, at least, I expect to leave my money in their hands.

– The market is running and I want exposure. If you want market returns, use an ETF, or buy the underlying instruments yourself. Funds are not cheap. You shouldn’t be using them as trading vehicles but as long term investments. If you want exposure to a particular segment of the market and no ETFs are available, using funds is a legitimate way of buying exposure. Luxury goods companies for example are not represented by an ETF and can be accessed through a fund.

– A brand name. A brand name is not a bad thing but it shouldn’t be the only thing, and the brand should add no additional comfort. Each fund must be assessed on its merits and this means due diligence. I have never given my trust freely, and I certainly don’t give it to brand names per se. Trust has to be earned, and it takes time. Brands are often good from a due diligence perspective, however, since they provide the basis for the question: how did they build a successful brand? Usually, a high quality product or service is the answer. Due diligence seeks to confirm and verify the answer. There are no assumptions in due diligence, or at least there are very few. I have very strong views about due diligence and how it is to be conducted. You have to identify the manager, meet the manager, his team, his ops, his service providers, speak to them about what they do. Cutting and pasting an AIMA DDQ into the file is a gross dereliction of duty, and something I’ve seen done even by institutional investors. It is for these types of investors that funds like Madoff were designed.

– I don’t know the strategy well and I want to outsource it to a professional. This is an excellent way to lose money. If you don’t know the strategy well, how do you know whom to outsource it to? If one doesn’t know a strategy well, the first and best course of action is to learn all about it. The second best and quite frankly lazy course of inaction is to stay away.

Investing is not easy. Whether one invests in funds or directly in securities, one is responsible for one’s own decisions. Using consultants is one way of delegating the research and due diligence but it means one has to research and perform due diligence on the consultant or intermediary.

You can’t have your cake and eat it. The economy is a complex system and like most systems it has a number of variables or parameters. Some of these you can control. Others are the consequence of what you control. It isn’t always possible to choose all the controls and consequences. Choosing a bunch of controls automatically render other variables as consequences. Some variables are mutually exclusive controls. Attempting to arbitrarily define sets of controls and states, either by design or accident often leads to unintended consequences.

Hedge funds have been some of the most successful money makers since hedge fund records have been available. Since 2008, even the best managers with long track records have stumbled. Things just don’t work the same way as they used to anymore.

The approach to solving the problems that continue to ripple from the 2008 financial crisis is an example of trying to have your cake and eat it. The Euro is a specific example. You cannot have a single currency and expect to have convergence in factor prices. Not unless you have a convergence in factor productivity, economic policy and political and social ideology. You might be able to get convergence in interest rates or other factor prices but you will need multi currencies since exchange rates will automatically become system determined variables. (An interest rate peg, how interesting. I wonder how many crazy ideas we can conjure up.)

So far no one has been able to profit from the Euro crisis. Why? In a recession when credit default rates rise, distressed debt funds are able to step in to assume risks that other investors cannot or will not. The rule of law, chapter 7 or chapter 11 in the US for example, guides the process and assigns the rights and obligations of the different claims. There is no equivalent law or regulation governing countries who default. Neither is the balance sheet of a country sufficiently defined that one can value a country let alone one of its claims. Investing in distressed sovereign debt is thus risky and highly uncertain business.

The investment landscape has become doubly difficult. Pre 2008, fundamentals were fairly straightforward, and once they were estimated, investor behavior was fairly straightforward as well. Markets have always been moved by investor psychology and how it interprets fundamentals. But now fundamentals have become dependent on more than just commercial realities and cold rationality. As the economic pie has shrunk so strategic concerns have increase in importance. The world has become more protectionist and mercantilist as peoples and their leaders seek to avoid loss and disadvantage. Hedge fund managers who have found their fundamental approach to investing confounded point to increased macro risks. This can arise from strategic policy impacting macro variables in unexpected ways which in turn impact industry conditions. As the world adjusts to this new reality, so too has the psychology of investors changed. The same information finds different interpretations. The problem for traders is that the prevailing interpretations are just not what they used to be. Investors are reacting differently to how they used to react to the same pieces of information.

The minor question is, how do we invest and profit from this new reality? We have seen relative value strategies in infinite duration assets fail miserably while arbitrage strategies within capital structures in finite duration assets have obtained encouraging results. Arbitrage it seems is the only safe play, and as we all know, arbitrage is rare, difficult to identify, difficult to implement, and often requires pre-defined gestation periods.

The bigger question is, as policy attempts the impossible, what are the consequences? Can a debt bubble induced depression be solved by the creation of more debt? Can fundamentally insolvent organizations continue to fund themselves ad infinitum? What is the final solution to the problem of excess debt?

Even more fundamentally, is today’s capitalism capitalism? Will the rolling legacy of moral hazard ever be addressed?

PS

Government Policy Put.

Governments the world over, in an effort to avert recession and disaster have written government policy puts (QEs, LTROs, Optwists) in such vast notional size that their negative gamma must be killing them.

Equities continue to rise or at the very least are resilient in the face of good and bad news., Sovereign bond yields head for zero. Meanwhile economic data seem to indicate a synchronized global slowdown. What gives?

1. Economic growth has fully recovered. The current tepid growth is a function of the necessary debt repayment and deleveraging which the world is undergoing. It is a mistake to anticipate a stronger recovery.

1. If you accept the above, then because the market doesn’t read current growth as having fully recovered, it is misinterpreting the impact of the short term business cycle. Current growth is inclusive of a peak in the short term business cycle. Hence, earnings expectations are too high and equities will be vulnerable over the next couple of reporting periods.

 I am wary of equities and other risk assets.

The world’s major central banks need to buy the debt issued by their governments. This is not just to boost the economy by increasing money supply. It is mostly because no one else will buy their junk bonds.

Most countries are able to do this, except the Eurozone. In the Eurozone, there are a number of countries who need to have their junk bonds bought by their central bank and there are also a few countries who don’t. These countries, understandably, don’t want the central bank to go about buying any junk bonds, even, or especially those issued by their fellow members. The ECB is not allowed to buy government bonds. So in December last year, the ECB came up with a clever plan. It lent money to private commercial banks in such a way that they had no choice but to buy the junk bonds issued by their respective national treasuries. This was the LTRO. The countries that are not so broke and don’t issue junk were not too happy about this. In the meantime, the countries that are broke have, under austerity measures, seen their economies get a bit worse, which is no good for tax revenues, and no good for debt service, and therefore no good for their creditors. So they need to refinance themselves and roll over their junk bonds. Once again, no one will buy this PIKable junk. So they look to their central bank to buy them. But the ECB cannot.

So here is the cunning plan. The ESM is established with a banking licence so it can borrow from the ECB. The ESM is basically the proposed successor to the EFSF and the EFSM. Don’t ask me what those are, I’m not sure I know. The ESM will basically be a hedge fund domiciled in Luxembourg, (one wonders if they will make it a UCITS and offer it to retail investors,) whose equity capital will be funded by the Eurozone member states, including (and one wonders quite how this works) the broke member states, and which will additionally be levered by the ECB. Technically, the ESM is a hedge fund and the ECB its prime broker.

It will be interesting to see if the Germans will invest in this hedge fund. They are being asked to seed it and be the largest investor with 27% of the equity capital. Not only that, Germany is a significant owner (19%) of the prime broker as well.

It is hard enough to get the Germans to invest in a for profit hedge fund but one has the feeling the ESM will be a not-for-profit hedge fund, the only one if its kind.

And what of the prime broker agreements? What leverage is being offered? At what cost? What are the margin requirements? Its going to be a long night.

Interest rates will stay low for a long time. The implications for higher interest rates are sufficiently dire that policy has no choice but to ensure low rates across the major currency curves for the foreseeable future. OK, longer than that.

Stocks look undervalued on a yield gap basis. The implication of yield gap analysis must be either that stocks are cheap or that government bonds are much too expensive. From our thoughts on interest rates above, we must conclude that stocks are cheap.

Stocks look undervalued relative to corporate bonds. A corporate bond yield to equity yield gap analysis leads one to the conclusion that either stocks are cheap or bonds are very expensive. The rationale for corporate credit has been that since governments have basically bailed out the private sector, it pays to invest in the private sector instead of in government securities. Since risk aversion is still high, investors seek a senior claim on corporate earnings and assets. Hence corporate bonds and in particular high yield.

The interest rate policy and the parlous state of sovereign balance sheets has led to a perplexing phenomenon. Credit could be a bubble relative to stocks and treasuries. Corporate yields are too low and equity valuations are even lower, but only if interest rates continue to remain low for a long time.

What could change all this? The major developed world central banks will likely keep interest rates low until they cannot. They will be able to continue unless inflation confounds the strategy, and the only threat to inflation (for various reasons I shall defer to another article) is the exchange rate. Japan has had low rates for this long in great part because inflation has been so low, and in greater part because the high savings rate internally funds the public sector. A weak JPY would require a costly defence which would see higher rates and bankrupt (further) the country. Without a high savings rate or foreign reserves, the currency would have weakened and rates would rise, all other things being equal.

All major economic regions therefore need to be able to keep rates low to avert a major repricing of equities and bonds. To do so, exchange rates cannot trend too far from where they currently are. Stationary volatility, even if elevated, is not a problem.

Exchange rates are therefore as important as LIBOR to the central banks. How much more transparent are FX markets than rates?

The problem with the wholesale and long term suppression of interest rates is that it can be inflationary, costly, distort funding markets, and plays fast and loose with relative prices in the economy. It also encourages excessive leverage, which was one of the fundamental problems leading up to the financial crisis in the first place.

The coherence of policy must be questioned. We began with excessive debt which we transferred to more stable hands and which we now hope to pay down over time. As we pay it down we want interest burdens to remain low, so we suppress interest rates. For all the public and private pensions and any institution with long term liabilities which it needs to fund, or indeed any investor wishing to preserve future purchasing power, this creates a yield drought which drives them into riskier investments for a given level of return. In 2001, the Greenspan induced yield drought drove the financial industry to create the instruments tailored to the yield junkies, triple A high yield. In less than a decade these instruments have failed. In the current yield drought, human ingenuity will without a trace of doubt find a way and a product to feed the yield junkie.

In each yield drought, the correct response and indeed the initial intention was to delever the system. The final result, once the symptoms of the initial condition were addressed, has been either a resumption or acceleration of credit creation. Because this time its different.