Tuesday, January 31, 2012

Monday, January 30, 2012

Facebook's stock symbol

So the question of the day - at least on Twitter, is what should Facebook's stock symbol be when it goes public?  POKE was suggested, but I am guessing something more boring like "FB".

Note that F is already taken by Ford.   An interesting point of comparison, the expected market cap for Facebook is around $100 Billion, and for Ford: around $47 Billion.

Assuming a valuation similar to GOOG, and a PE of 20, Facebook would need to generate around $5 Billion of earnings per year to justify a $100 Billion market cap.

Pension return denial

Quants at Soc Gen conclude that most S&P 500 pension funds are operating in a state of denial based on their return assumptions.  As I noted before, the math simply doesn't hold up.  You can't get a 7.5% return and have reasonable assumptions about equities.

Key quote:
So why are plan managers taking such an optimistic view? Doing otherwise would require higher pension contributions from both employers and employees. That is painful. “But rather than accept the notion of lower returns and adjust behavior accordingly, the path of least resistance appears to be total denial,” the SocGen analysts write. They properly add that neither CEOs, fund managers nor politicians have much incentive to act differently.
Via Wall Street Journal Blogs

Are stock returns normally distributed?

Not entirely - they tend to have fatter tails.

Weaning off alternative investments

Apparently South Carolina is trying to reduce the amount of alternative investments it holds.   The State Treasurer cites concerns over fees.  Hmm ... sounds familiar.

Thursday, January 26, 2012

Hedge Fund Returns since 1998: 2.1% per year.

A recent study shows that Hedge Fund Investors earned about 2.1% since 1998.   That would be after the 2/20 fees, and probably doesn't include funds of funds fees etc.

Everything that I said in my rant yesterday about private equity applies here also.

Read the article, it's a good one.

The key paragraph:
Mr Lack’s book suggests the blind faith displayed by many institutional investors in hedge funds needs to be reconsidered. Individual managers may be brilliant but it is hard to spot them in advance. John Paulson was not particularly well-regarded before he made a fortune betting against subprime bonds—and his performance has slumped since. Investing in hedge funds will enable some lucky managers to enjoy an early retirement on their yachts. It will not enable pension funds to eliminate their deficits.

Link via http://financeii-tepper.tumblr.com/,

Wednesday, January 25, 2012

Private Equity Fees

There's been much talk about Private Equity recently.   Yesterday, an article in the FT (behind paywall) talked about the fee structure underlying typical PE funds.  The article was based on recent research done by researchers at Yale and Maastricht Universities.

A few findings in the article and my thoughts:
1. Most PE funds are on a 2/20 basis.  2% annual fee plus 20% of any fund gains.   Compared this to your typical Vanguard fund which probably has an annual expense ratio of about 0.21%.

2. The 2% fee is based on committed capital, not invested capital.  This means that if a pension fund commits, say $100 million to a PE fund, but only ponies up $10 in the first year, the first year fee is 2% of the $100 million - or $2 million.  So in the first year, the pension fund could actually be paying a 20% fee on invested capital.  Furthermore, the 2% fee is on the total amount before the manager also takes 20% of the profits.

3. While PE was very profitable in the early years (pre 2000), in the past decade, the average PE fund made 4.5% per year after fees.  This number is also questionable because of the way that most managers compute returns.  If returns are computed on a time-weighted basis, then early returns from a PE fund are likely to be based on smaller investments.  These early returns are also likely to be higher than later returns.  As a result, I'd speculate that the actual dollar weighted returns are lower, not higher than 4.5%.

4. In the past decade, the average pension fund paid 4% a year in PE fees.  According to one of the researchers, about 70% of the investment gains have been paid in fees over the past 10 years.

So who invests in PE?  Well, just about everyone.  Most state pension funds have loads of private equity, as do most university endowments (including the university that I work for).  And these fees are just the beginning.  Frequently private equity is managed as a "Fund of Funds" which charges an additional fee to manage the portfolio of PE funds.  Add to that the overall cost of picking the "Fund of Funds" managers and the result is a huge amount of pension and endowment wealth is being squandered on fees related to PE.

Aside from fees, PE has some other very troubling properties.  First of all it is very illiquid - it is difficult to divest PE.  Second, the risk in PE is chronically understated because there is not market based evidence on how much the portfolio is worth.  The normal practice is for the PE fund manager to assign a value every quarter.  This means that the year to year fluctuation in value in PE is massively understated because of the smoothing effect of the manager's self reporting.  As my students will know, if you have a low volatility asset with a apparently high (overstated) return, a portfolio optimizer will overweight in this asset.  So the smoothing of the volatility gives the false appearance that PE is an attractive asset class.

Most state pension funds and university endowments seem to be so locked into the model that they must have PE and also hedge funds that they seem blind to these fees.  Of course, the fact that the providers of these products frequently contribute to state election campaign funds just makes the issue more troubling.

Here's my suggestion to endowments and pension funds.  Fire all your managers, experts, advisers, fund of fund pickers, tactical allocation experts and consultants and hire maybe one smart person to put together a well diversified portfolio of global index funds.   The administrative costs will be tiny, and the fund management fees will be reduced to a few basis points.  Your portfolio won't be very glamorous, but in the long run it will outperform.

Monday, January 23, 2012

We're on facebook...

I've started reposting my blog posts on a dedicated facebook page.  Check it out, post a comment or a link and remember to "like" the page!  We'll see how this goes.

More on pension fund return assumptions

The PBS Newshour reports that state pension funds are faced with a dilemma - most have based their promises to retirees on an unrealistic 8% portfolio return, but as funds have failed to earn this return, states have been left with ever larger pension plan shortfalls.

The NPR video shows the State of RI Treasurer debating with various consultants and interested parties over what that state's new return assumption should be.  The advisors are calling for 7.5%, but representatives of the retirees oppose a lower rate.  They argue that this lower rate will result in either more taxes, more contributions from workers and lower promised benefits.   But their position is fundamentally flawed.  By setting the assumed investment return rate too high they are guaranteeing a more severe funding deficit in the future.  Just covering their ears and shouting "8%" won't change reality.

The article interviews two economists.  The first, Zvi Bodie, argues that 7.5% is too high and the fund should use 4.5% - basically a risk free rate.  His rationale is based on the fact that the liabilities of the pension fund are guaranteed  - they are riskless.  Therefore, the funding of a certain liability should be done with very low risk assets.   Bodie is correct.

The second Economist, Dean Baker, argues that because State funds are infinitely lived they should use a higher rate - at least 7.5%.  He goes on to say that because most investors assume some risk, so should the state.  But this argument misses the point.  An individual who invests in risky assets bears the risk that his or her portfolio won't cover his/her retirement needs.  If that individual's portfolio falls short, then he/she will have to suffer the consequences.  In effect the individual is funding a risky liability with risky cashflows.   The state however, has promised retirees a certain payout.  If the fund falls short, then the state must either renege on that promise or tax the children of those retirees at a much higher rate.

I've blogged on this quite a few times, and I think that it is a very serious problem that nobody wants to deal with.  This problem can either be fixed now or later.  But either way, it is going to have to be dealt with.  Just assuming a higher rate of return won't make it go away.

link to PBS video via Zvi Bodie's tweet 

Stocks for the long run?

A recent post on the Fama French Forum asks "over what time period can you be reasonably assured of earning a positive premium for investing in small stocks?"  In other words, how long do you have to wait for the extra risk of small stocks to pay off?  F&F state that like the equity premium overall, you probably have to wait 35 years to be reasonably confident of seeing a positive premium.  But they add that of course, there is still a possibility that after 35 years equities could still trail bonds.

What does this mean for a typical investor?  First of all, most investors look to stocks to provide a higher return  to enable them to reach their retirement goals.  But such a return isn't guaranteed and indeed, may never materialize, particularly over shorter time horizons.  The second issue is that while we know what the historical risk premium is, i.e. the amount by which stocks beat bonds, we really don't have much idea what the future premium will be.   Therefore, investing for the long run in stocks is doubly risky.  First there is uncertainty about whether you will actually earn a positive risk premium, and second, we don't know what that premium should actually be.

Zvi Bodie (Finance Prof at Boston U) makes this point.  He argues that what investors should do is buy TIPs and treat saving for retirement as just that - saving, and not investing.  I think Prof Bodie is perhaps taking an extreme view, because the return on TIPs is likely to be pretty low in real terms for most investors, meaning that they will have to save a lot more to reach their goals.

The other extreme is the case of the investor who assumes a 12% return on stocks and invests the minimum amount, hoping that massive gains in the market will build most of his wealth.  Even worse is the investor who keeps rearranging his allocation in his 401K plan because he thinks he can time the market.  And don't get me started on the person who borrows against their 401K to buy a new car...

My strategy is to take a middle of the road approach.  We should invest in a diversified portfolio of index funds and work under the assumption that the risk premium is very low - say 2%.  This premium would translate into, maybe a 5% portfolio return.  Then based on this low performance, we should invest more today to meet our goals.   If the market does well, you'll be able to sail the world in your retirement.  If it doesn't, you should at least be able to avoid living with your kids.

Thursday, January 19, 2012

GOOG down 9%

Google missed its earnings forecast today and the stock fell 9% in after hours trading.   This is significant because at some point growth stocks become boring stocks.  It happened to Microsoft, Home Depot, and many others.  Sooner or later it will happen to Google (and Apple).

Wednesday, January 11, 2012

Private equity and job creation

Steve Allen has a great discussion of recent research that show the effect private equity firms have on job creation (and destruction).

Corporate psychopaths...

In an unregulated world, the least-principled people rise to the top. And there are none who are less principled than corporate psychopaths.
Interesting - full article here

Seeking the inefficient asset class.

Great post on the Fama French forum and a must read for my current MBA students.  The article discusses the extent to which some markets may or may not be as efficient in terms of pricing as other markets.

Pigovian taxes - drunk driving edition

Greg Mankiw links to some research that shows that the increase in the federal alcohol excise tax in 1991 may have save 7,000 lives because of less drunk driving.

Tuesday, January 10, 2012

Presidential Elections and Stock Returns.

Want to know how the market does in an election year.   Here's your answer

A new (to me) finance blog

http://financeii-tepper.tumblr.com/  is more of an aggregating blog of interest finance links.  I've added it to my reader.  It appears to be run out of Carnegie Mellon University.

Dumbest idea in the world - maximizing shareholder value??

In a new book, Roger Martin argues that the idea of maximizing shareholder value is the dumbest idea in the world.  I haven't read the book, but Forbes gives a detailed review and discussion of it here.

Martin's thesis seems to be that in focusing on shareholders, we are not paying attention to the business, and as a result we see the perverse effects of shareholder value maximization in the form of short term earnings management and high executive compensation.
“We must shift the focus of companies back to the customer and away from shareholder value,” says Martin. “The shift necessitates a fundamental change in our prevailing theory of the firm… The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.”
The article then cites a few firms that follow the customer model, which, in case you hadn't guessed, includes Apple (of course).  It then offers up some of his recommendations for the making things better which include eliminating stock based compensation and also hedge funds, as both, according to Martin, are bad.  Very bad.

So to take this to its logically conclusion, Apple should start selling Mac Pro computers for $100.  That would truly delight customers.  I'd buy a couple of them, so what they didn't make in profit, they could make up in market share.

After reading the article I have a new idea of what the dumbest idea in the world might be.

OJ at an all time high

From my friend Ron (of InvestorCookbooks):

OJ futures are at their highest since 1977, as Ron said to me
"I'll bet you that Eddie Murphy and Dan Akroyd are making a killing!"

Note that Video contains some bad words.