Finance Clippings

Facebook's stock symbol

2012-01-30T19:00:00.000-05:00

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

2012-01-30T18:00:00.000-05:00

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?

2012-01-30T10:02:00.003-05:00

Not entirely - they tend to have fatter tails.

Weaning off alternative investments

2012-01-30T09:53:00.001-05:00

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

Hedge Fund Returns since 1998: 2.1% per year.

2012-01-26T16:04:00.001-05:00

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/,

Private Equity Fees

2012-01-25T16:22:00.000-05:00

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.

We're on facebook...

2012-01-23T20:59:00.001-05:00

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

2012-01-23T20:41:00.000-05:00

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?

2012-01-23T18:26:00.002-05:00

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.

GOOG down 9%

2012-01-19T21:12:00.000-05:00

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).

Fed Transcripts for 2006

2012-01-13T12:03:00.001-05:00

Did the Fed see the impending financial train wreck coming?

Nope, in fact they thought things were going swimmingly.

An MBA is still a good investment

2012-01-12T12:15:00.002-05:00

...and especially so for women.

A new contrarian indicator - skyscrapers

2012-01-12T12:11:00.001-05:00

Apparently the height of new skyscrapers predicts financial crashes.

Private equity and job creation

2012-01-11T05:00:00.003-05:00

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

Corporate psychopaths...

2012-01-11T05:00:00.002-05:00

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.

2012-01-11T05:00:00.001-05:00

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

2012-01-11T05:00:00.000-05:00

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.

Presidential Elections and Stock Returns.

2012-01-10T19:00:00.003-05:00

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

A new (to me) finance blog

2012-01-10T19:00:00.002-05:00

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??

2012-01-10T19:00:00.001-05:00

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

2012-01-10T19:00:00.000-05:00

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!"

http://www.marketwatch.com/story/oj-futures-surge-as-fda-tests-for-fungicide-2012-01-10

Note that Video contains some bad words.

High Frequency Trading explained.

2011-12-20T13:20:00.002-05:00

The Finance Professor Blog links to some videos on HFT. The Paddy Hirsch video is excellent. Highly recommended.

How fees are destroying pension wealth in the UK

2011-12-19T21:32:00.000-05:00

As readers of my blog will know, I frequently rant about fees charged by investment advisors. In most cases, the people getting ripped off are individual investors. But in a recent report on the UK pension system, it is revealed that fees paid to City advisors (the City is the UK equivalent of "Wall Street") are so high that in many cases the pension funds are paying all their gains out in fees. And it's getting worse.

The average equity fund manager makes explicit that they are charging about 1.5% a year of the sum invested for their services, but additional hidden expenses average 0.3% a year and trading costs cut a further 1.4% off an investment. And the situation is getting worse, according to the analysis, which found that charges had increased by 9% in the last decade. The presentation added: "If the trend of diminishing returns and increasing costs continues we could soon expect negative returns on average."

The mind boggles. There is absolutely no reason why fees should be increasing, furthermore, management fees should not exceed 0.5% for large funds. The trustees of these pension plans need to start shopping around more. I'll give them one piece of advice for free. Try indexing. It's cheap and it works.

How much has Buffet lost on BofA?

2011-12-19T20:28:00.003-05:00

In typical NewsCorp form, a Wall Street Journal headline states that:

"Warren Buffett Is $1.5 Billion Underwater on His Bank of America Stock

Huh? I said to myself, I didn't think Warren had bought B of A common - his recent deal involved preferred stock and warrants.

Reading a bit further into the article reveals that in fact that author is talking about Warren's position in warrants and not in common stock. The headline is not only misleading, it's pretty inaccurate as well.

As a side note, the funny thing though is that the Business Insider Blog presumably didn't read it all the way through when this post first appeared. The article was rewritten with the apology that "This article originally stated that Buffett had lost money on his investment. We apologize for the error."

Anyhow, back to Warren's warrants. To state that he is $1.5 Billion underwater is a bit of a stretch. He bought 700 million warrants at a strike price of $7.14. The current B of A stock price is currently about $5.00. So (7.14-5)*700 million = $1.5 Billion.

But this doesn't mean that he has lost $1.5 Billion on the options. As my MBA students should know, how much an option changes in value for a $1 change in the underlying stock price is given by the option's delta. Only if the delta equaled 1 would Warren's warrants have declined by $1.5 Billion.

Valuing these long term options is pretty tricky, but if we assume a delta of say 0.5 (which is probably reasonably close) then the decline in value of Warren's warrants is about (7.14-5)*700*0.5 = $ 750 Million. Still a lot of money, but not as much as reported before.

For extra credit - under what circumstances could these warrants have actually increased in value? Hint (we'd need to see a major increase in one of the other Black Scholes inputs). For even more extra credit - how would this change have affected his other investment in the preferred stock?

Managing debt is like dieting...

2011-12-14T19:09:00.002-05:00

My colleague, Melissa Hart, talks about debt management and bankruptcy.

IPO outlook

2011-12-13T21:01:00.004-05:00

Jay Ritter (my dissertation chair) talks about the IPO outlook.

Economists and their charts

2011-12-13T20:38:00.003-05:00

A great article from the Beeb showing the favorite charts of various economists. In each case the charts show how the euro economy in particular has declined. Sounds a little dull, but this is a great way to see the Euro crisis in pictures.

LNKD has a forward PE of 300.

2011-12-13T19:00:00.000-05:00

Via counterparties: LNKD is trading off 300 times forward earnings. Either profits have to increase a whole lot or the stock price will have to fall. I know which one I'd bet on.

Two must read articles on active management and fees.

2011-12-12T18:00:00.001-05:00

Articles on active management and fees may sound a little boring, but let's be very clear here: two of the three most reliable ways to increase your retirement wealth involve 1) avoiding actively managed funds and picking index funds, and 2) never paying someone a fixed fee to manage your money.

Ron at the InvestorCookbooks blog has two great posts on these topics. First, more compelling evidence on the futility of active management. And second, the effects of paying a 1% management fee to your financial planner.

And, in case you were wondering, the third way to increase your retirement wealth is to save more.

Evernote - Inc. Company of the year.

2011-12-12T18:00:00.000-05:00

Inc Magazine has just announced that Evernote is its "Company of the Year". The article is a great account of the perils of running a startup.

I am a huge fan of Evernote. For those who don't know, it is a multi-platform app that basically allows you to remember everything. Check it out.

Is the Administration's mortgage refinancing plan working?

2011-12-06T19:00:00.001-05:00

Back in October, the Obama Administration extended the HARP (Home affordable refinance program) to allow homeowners to refinance if even if their mortgages were underwater. This change had a direct effect on the mortgage market. Specifically, mortgage securities with high coupons (where the homeowners were paying high interest rates) fell in value. This was because the market anticipated that a greater number of these homeowners would be able to refinance their loans at lower rates. Previously they had been unable to do so because their loans exceeded the value of their homes. I blogged about this back then and it appeared to be a classic case of negative convexity in the MBS market.

Now comes the news that the market has largely recovered. The amount of expected refinancings will fall far below those initially predicted, apparently in large part due to the decreased credit scores of many homeowners.

(note link to FT website will require you create a free account to view the article).

Why Apple's cheap

2011-12-06T19:00:00.000-05:00

Felix has a good analysis of the current relatively low valuation of Apple stock. The key problem that Apple faces is the problem that all very large companies face - sustaining a high growth rate becomes much more difficult when you become huge. Unlike many other large companies, Apple's source of profits changes from one year to the next - which means that the stock is really only as good as its next big product.

Put another way, at some point Apple will stop being a growth stock and become something more boring - like perhaps another past member of the large cap growth club - Microsoft.

Battle for the soul of capitalism

2011-12-06T18:19:00.001-05:00

InvestorCookbooks really likes John Bogle's book - Battle for the soul of capitalism. It's on my reading list.

Pigs will fly?

2011-12-03T20:56:00.001-05:00

Investor cookbooks on PIGS. (European countries that are at the heart of the debt crisis).

A few from around the web

2011-12-03T20:48:00.001-05:00

From Counterparties: Five problems with capitalism. and Robert Shiller ignores advice from celebrities.

And from Mankiw - "death to pennies". I hate pennies. To me it seems utterly bizarre that the USA still uses pennies.

Only 1 in 4 beat the market this year

2011-12-03T20:45:00.001-05:00

So says an article posted by Finance Professor.

I fully believe it. That's why I index.

The winning portfolio?

2011-11-29T17:03:00.001-05:00

Apparently a passive portfolio of 50% bonds and 50% stocks wins out in most markets.

There are probably a few things going on here: First bonds and stocks provide great diversification. Second, because the weights are fixed, there is no market timing going on here. Market timing, as we know is a fast way to loose wealth. Third, the stock portfolio is indexed.

In otherwords: diversify, don't market time and index. Simple.

CEO Pay and value added

2011-11-29T17:00:00.001-05:00

Tyler Cowen with a nice post on what we know about CEO pay and performance.

Downgrade Rampage

2011-11-29T16:58:00.001-05:00

Not a good day for banks... S&P goes on a "downgrade rampage"

Ratings changes lag the market.

2011-11-22T19:00:00.003-05:00

An important aspect of bond ratings is that when they are changed they usually lag the market. In other words, investors usually price the declining credit quality of the bond into yields before the ratings agencies get around to issuing a new rating. Case in point: France.

IGM Forum - what economists think.

2011-11-22T19:00:00.002-05:00

The IGM forum is a group of economists that publish opinion pieces on major policy issues. It all sounds very academic - but the topics that they address are pretty interesting and very relevant.

For example:

Buy American requirements in the 2009 stimulus bill did not have a big impact on US manufacturing employment.
Investors cannot reliably forecast stock prices.
A 1% increase in the top Federal tax bracket would half cumulative budget shortfalls.

GE's tax return.

2011-11-22T19:00:00.001-05:00

Apparently GE's tax return is 57,000 pages long. The Marginal Revolution blog makes an excellent argument as to why this is not efficient.

The Warning

2011-11-22T19:00:00.000-05:00

InvestorCookbooks blog talks about the must see Frontline documentary "The Warning" which looks at how policy makers avoided calls to regulate the derivatives market. I'll be adding it to my Netflix queue.

Luck or a brilliant value strategy?

2011-11-21T20:33:00.001-05:00

Was Bill Miller's 15 year streak at the helm of the Legg Mason Value Trust luck or a skilled implementation of the value strategy (picking cheap stocks)?

An article in the FT claims that there must have been something to his ability because even though the fund completely tanked in 2007 and hasn't recovered, it did post 15 years of outstanding returns.

The probability of beating the market 15 years in a row is 0.5 raised to the power of 15 which is about 0.003%. This is equivalent to about 1 in 33,000. Obviously he was very very lucky if it wasn't skill. But I think the FT makes a simple flaw in the analysis. The fact that we are talking about this guy is because he beat the market for 15 years. If it wasn't Bill Miller it would have been someone else.

The point is that we only know he was a 15 year winner after the event. This is the fundamental problem with active portfolio management - it is easy to pick the winners after the race is over, but impossible beforehand.

Given that Miller's case is so rare, I am inclined to think that he was just a lucky outlier rather than a skilled stock picker. I have nothing against Mr Miller, I just don't believe that skilled stock pickers exist.

Without sounding like a broken record, indexing is the only way to go.

Note: with the FT if you want to see the article, you need to register for a free account. Sorry.

Why are higher education costs rising?

2011-11-21T20:22:00.001-05:00

The answer, according to Felix, is pretty obvious really.

First it isn't because of Professor's salaries! As Felix points out the real culprit causing higher tuition is smaller state subsidies. Case in point, my own institution has responded to continued cuts in state support by increasing in tuition.

While there is plenty of evidence of some administrative bloat in higher education, I think what we are observing is a move towards a more tuition supported model.

Money Science

2011-11-18T19:00:00.002-05:00

My blog feeds are now being syndicated on the moneyscience site. Check out the site - it has a lot of cool finance related material including blogs, news feeds etc.

B school students don't study as much as engineers

2011-11-18T19:00:00.001-05:00

So says a recent study.

OWS at Wharton

2011-11-18T19:00:00.000-05:00

An attempt to bring OWS to the cradle of all evil - the Wharton School. Sounds like it was a pretty entertaining event.

"Everyone dies...you do the math"

2011-11-17T19:00:00.005-05:00

An amusing picture... I'll admit, it took me a minute to get it.

How to make trades in an open outcry market

2011-11-17T19:00:00.004-05:00

You've seen the videos of traders waving their hands around frantically and somehow ending up buying or selling securities. Well here is the simple guide to what those hand signals mean.

What to do if you have a bad 401k

2011-11-17T19:00:00.003-05:00

InvestorCookbooks talks about how to tell if your 401k isn't good.

Corporate Income Tax

2011-11-17T19:00:00.002-05:00

Felix Salmon has a couple of charts showing how much income tax corporations pay. The amount has been declining pretty steadily over time.

What I found particularly interesting is that firms are not required to report exactly the dollar amount that they paid to the IRS. Understandably, firms appear reluctant to reveal this number.

Academic Earth

2011-11-17T19:00:00.001-05:00

Academic earth is a pretty cool site that contains lots of free lectures about a range of topics, including quite a few finance lectures.

How emotions impact financial decisions..

2011-11-17T19:00:00.000-05:00

A webcast from Vanguard featuring Meir Statman (an expert of behavioral finance). It's a bit long but worth listening to if you have time.

Insider trading on capital hill - mostly harmless...

2011-11-15T21:00:00.000-05:00

So says a recent article. Basically, the practice is harmless in the big picture and is probably not worth worrying about.

Personally, I take a different view - seeing our elected leaders use their positions to make money off other investors doesn't really create confidence in our democratic process.

Remember that when someone profits from insider trading, someone else is loosing out - in this case the people who voted these leaders into office.

Borrowing Groupon stock costs 100% per year!

2011-11-15T19:26:00.001-05:00

I knew it would cost a lot to borrow GRPN to short, but 100% per year? Wow.

My experience of google adsense...(Blogger related material)

2011-11-15T10:48:00.001-05:00

I am involved in a small charity, "the Haiti Tree Project". We try to raise money to send to a couple of villages in Haiti so that they can plant trees and create a sustainable tree-based agriculture that helps reforest the country (we've planted over 10,000 so far). As with most small charities, raising money is always the issue and so I thought I'd give google adsense a go. For the uninitiated, google adsense is a program that will automatically insert ads into your blog. You get paid when someone clicks on the ads.

I thought that this might be an easy way to make a few hundred dollars for the charity. But, as my colleague Craig is fond of saying; "there are always tradeoffs". I soon found that the ads that my blog was getting were either for gold investing or for MBA programs (not the one I teach in). I didn't feel very comfortable with either of these ads and so I've stopped adsense. I think I made $4.51 - which will plant a couple of trees!

Anyway, if you've been wondering where the gold ads have been coming from, rest assured that they won't be back.

Gene Fama on volatility

2011-11-14T19:00:00.001-05:00

Gene Fama, Chicago Professor and the father of the efficient markets theory, talks about recent volatility to a group of students. Well worth reading.

60 minutes on insider trading by congress.

2011-11-14T19:00:00.000-05:00

Last night, the CBS news program - 60 minutes - "exposed" legal insider trading by members of Congress. Apparently it is entirely legal for members of congress to trade on private information - you can read a nice summary on the InvestorCookbooks blog.

Basically our elected officials on either side of the aisle are trading using information that they gathered in their capacity as lawmakers. However, this actually isn't really new news. Several academic finance studies have shown that congressmen and women earn abnormal returns on their stock trades.

This story got me thinking about a blog post that I read on another academic finance blog recently. The basic gist of that post was that the Occupy Wall Street crowd are misguided in their claims that the system isn't fair. The blogger's view was that this is much like a child complaining about fairness.

But I think that the blogger was wrong - the issue of fairness is a serious issue. Whether you support the OWS movement or not, it seems that we should have a system that is a fair and level playing field. The system should not grant a select few the ability to trade and invest at the majority's expense. This type of fairness is not about everyone winning, or everyone getting a fair share, but is about a fair game where the rules are the same for everyone.

.

NCSU Jenkins MBA is in the Businessweek Top 30

2011-11-11T19:00:00.002-05:00

Great news about our part-time MBA program.

Most of Groupon's float is being shorted.

2011-11-11T19:00:00.001-05:00

Investors could short Groupon on Thursday. Apparently 100% of the float of GRPN shares is now being shorted.

Even when a stock like GRPN is widely believed to be overvalued, shorting is still a very risky enterprise. First, the cost of borrowing shares to short is no doubt very high. At one point it cost 50% per year to borrow shares of Krispy Kreme (another overpriced IPO). Second, just because you are short, there is no guarantee that you'll make money from your position. Invariably you need a catalyst - such a missed earnings target or other such news to cause a price correction. Finally I'd argue that we really don't know anything more about GRPN than we did when it went public and in effect the shorts are just sitting and waiting for the train wreck which may or may not happen. They may be correct that GRPN is overvalued and they still may end up loosing their shirts.

Leverage...

2011-11-11T19:00:00.000-05:00

Jon Stewart on MF Global, regulation and the effects of leverage. (via Greg Mankiw's blog).

If there is one repeated lesson from virtually all financial disasters it is that it is not bad bets that are the problem, but the amount of leverage used to make those bets.

Reducing leverage would be the simplest way to prevent future financial disasters. But, as the case of MF Global shows, even when there were limits to leverage, a well connected ex-regulator could circumvent them.

Reading lists of Vanguard Fund Managers

2011-11-10T10:00:00.001-05:00

Vanguard is a mutual fund company known for its devotion to the concept of indexing rather than active management (although they do have some actively managed funds). It should be no surprise then that "A Random Walk Down Wall Street" is a popular book with Vanguard Fund Managers. Here is a full list of their favorite finance reads. This list would be a good starting point for any finance student wanting to broaden his or her knowledge of the subject.

How much do different college majors earn?

2011-11-09T05:00:00.002-05:00

From the WSJ - a sortable list by pay, employment and popularity. As my colleague, Craig Newmark points out, a lot of the highest paid majors contain the word "engineering".

Pension plan day of reckoning is 15 years away...

2011-11-09T05:00:00.001-05:00

I've talked about how state pension plans are underfunded in both obvious and not so obvious ways. The obvious way is that even with their return assumptions, they are often unable to meet their promised obligations. The not so obvious way is that they use a high rate of return (usually about 8%) to find the present value of what they owe. Because their obligations are virtually riskless, they should use a much lower rate, which would result in these obligations having a much higher present value.

In this article - Josh Rauh, who has done a lot of work on this topic, predicts that we've got about 15 years to go before this all blows up.

Wall Street doesn't want financially literate investors

2011-11-09T05:00:00.000-05:00

An interesting article that argues that the last thing Wall Street wants is investors that know what they are doing.

What the equity risk premium is not...

2011-11-07T20:46:00.001-05:00

Today's Financial Times had an article titled "What the equity risk premium tells us today" authored by Jason Voss of the CFA Institute. I had high hopes for the article, but unfortunately it makes two fundamental errors.

1. The article defines the equity risk premium as the difference between the earnings yield on stocks and the 10 year treasury yield. The earnings yield on stocks is the inverse of the P/E ratio. It is designated as E/P.

ERP = E/P - 10 year ytm

This is incorrect. The equity risk premium is the amount by which investors expect the return on stocks to exceed the return on riskless bonds. Roughly computed it would be the expected return on the S&P 500 less the treasury rate. Edit: The formula as shown above is merely a very rough method of estimating the ERP. It implicitly assumes stocks pay all excess cash as dividends, grow at a constant rate, don't require external financing, and exist in a world of zero or unchanging inflation. For all practical purposes, this is a not a realistic method of estimating the ERP. Far better methods exist.

To compute the equity risk premium one must try to extract the premium implied by the current level of a market index (such as the S&P 500). I won't do it here because Aswath Damodaran does an excellent job of it each month on his site. Aswath estimates the current premium to be about 5.20%. We can also estimate what the realized risk premium is by looking at the past difference between stock returns and bond returns. Depending on what time frame you look at, this number is about 6%.

So why is this article interested in the difference between E/P and the treasury rate? Well what is really going on here is that Mr Voss is invoking the long discredited (and I thought dead and buried) "Fed Model". (Note: despite the name, the Fed Model has nothing to do with the Fed). The Fed Model argues that the earning yield on stocks should be about equal to the yield to maturity on bonds. If E/P is greater than the YTM on bonds, then stocks are cheap. If E/P is less than the ytm on bonds, then stocks are expensive.

This appears to be the argument that is being made in the article. But let's be really clear here - despite its simplicity, the Fed Model makes no sense whatsoever and this represents the second mistake in the article. The Fed Model is garbage for at least two reasons:

1. Stocks are real assets, bonds are nominal assets. When inflation is high the ytm on bonds will be higher, but the E/P ratio for stocks should be unaffected because both the numerator and the denominator are measured in real dollars. This means that the Fed Model is very easily distorted by inflation. In fact the reason that it is positive now is precisely because inflation is so low.

2. E/P is not a valid measure of return. E/P is merely the accounting earnings over price - a number easily manipulated that doesn't reflect the true cash flow of the firm and certainly does not come close to measuring the return of a stock.

I've posted on the Fed Model before - its a flawed model because it compares apples to oranges.

Groupon IPO

2011-11-04T11:06:00.000-04:00

Of relevance to my undergraduate students in BUS 420 - Groupon has just conducted its IPO. We'll be talking in class about issuing securities to the public next week - so pay attention!

Here are a few links related to Groupon.

Aswath Damodaran has a crack at valuing the stock. His valuation came in around $14 - somewhat less than the offer price of $20. He notes that his valuation makes some pretty optimistic assumptions.

The actual IPO of Groupon raised $700M. This values the overall company at 12.7Bn. But what is important to note here is that the IPO only sold a fraction of the company's equity (5%). In essence Groupon is testing the waters with a small sale. As Jay Ritter of the University of Florida notes - the initial price pop is largely due to the very restricted initial supply of stock.

If the price holds up then I would expect Groupon to follow up the IPO with several much larger secondary equity offerings in the coming months. Google raised far more money in secondary offerings than in the initial IPO.

Investors also shouldn't read much into the initial price pop for Groupon. Of 25 recent hot IPOs, 20 tanked later.

Finally what about IPOs in general? In most countries around the world, IPOs underperform in the long run when compared to similar non-IPO stocks. For example US IPOs underperform by about 20% after three years. (See page 15 of this article).

Update: Trading of Groupon has started and the price is up 40%.

Treasury considering floating rates notes.

2011-10-31T22:01:00.000-04:00

Very interesting. Yet another thing to cover in the bond lecture! Of course higher interest rates mean that the Government's liability would increase (As Campbell Harvey of Duke notes in the article), but this is already the case with TIPS, so I would wonder to what degree investors would actually just substitute these new bonds for TIPS.

(reposted from financeprofessor)

Bank of America - up to no good.

2011-10-31T21:51:00.000-04:00

Bank of America apparently just shifted a huge block of Merrill Lynch derivatives to a bank unit funded by federally insured deposits. In other words, moral hazard reared its ugly head again and B of A took advantage of the Governments deposit insurance program to placate some counter-parties. Nice work B of A.

In unrelated news, I've transferred all my bill pay stuff from my previously bankrupt bank to the local credit union. I'll be closing my bank account this week.

Where are new freshman from?

2011-10-31T21:41:00.000-04:00

An interesting web site that shows where freshman at major universities are from. Link should take you to the NCSU page.

Best month in a decade

2011-10-31T21:36:00.000-04:00

Turns out this past October was one of the best months for stocks in a decade. Popular wisdom holds however that October is usually a bad month for investors. However, I subscribe to Mark Twain's view of stock investing:

"October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February."

Negative convexity in mortgage bonds

2011-10-25T09:50:00.002-04:00

I love it when the real world behaves in just the way that I wrote on the class room white board!

Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates. This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond. The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond. As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond. Interest rates matter here because lower interest rates result in more refinancing.

OK, so what is happening today? Well, there are a lot of homeowners who can't refinance because they have negative equity. So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now. President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.

The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.

As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.

Lionization of small business

2011-10-25T09:37:00.000-04:00

Much is made of how small businesses are the main source of job growth in the economy. Turns out this is not really true. Start ups create jobs (and also destroy jobs if the fail), but existing small businesses as a group don't contribute that much to the overall jobs picture. As usual, my favorite finance blogger, Felix Salmon has the scoop.

Dropbox

2011-10-25T09:34:00.000-04:00

Finance Professor raves about Dropbox - a great product and a very successful company that has mastered the freemium model.

I am one of the 4% paying customers - $100 per year to have all (I repeat ALL) my work instantly backed up and accessible anywhere is a great value. I'm also a huge fan of evernote (another freemium service).

Target date funds

2011-10-24T09:40:00.000-04:00

Target date funds are good in theory - but in practice they often fall short. The investor cookbooks blog has a great analysis.

More on externalities

2011-10-20T22:25:00.000-04:00

Greg Mankiw cites a paper talking about taxes on externalities. (something I blogged about recently).
Taxes on negative externalities are a good thing.

Stock market liquidity and volatility.

2011-10-18T18:54:00.000-04:00

Felix Salmon asks "should we be worried about stock market liquidity?". He cites a Wall Street Journal article that claims that as volatility increases liquidity decreases. Felix correctly recognizes that this isn't really anything to worry about. In fact the positive relation between spreads and volatility is very well documented (even in my own work - see table 5).

The question then seems to relate to high frequency trading and whether algorithmic trading is perhaps eating up liquidity. Recent academic work in this area provides evidence that this is not the case.

Finally Felix notes that a investor who was trying to buy a $250 Million chunk of a $4 Billion company was apparently surprised when his buying pushed up the stock price. Again, this is to be expected when you are trying to buy a 6%+ stake in a company.

I agree with Felix here - there really doesn't seem to be much of a story - despite what the WSJ thinks.

Capitalists of the world unite

2011-10-16T11:32:00.000-04:00

There's been a lot of talk about the Occupy Wall Street movement recently, but today, the Wall Street Journal Sunday edition printed a great article on why capitalists should be mad at Wall Street also.

(The article defines capitalists as anyone who invests money - which would include pretty much anyone with a 401K or retirement plan).

Why should capitalists be mad? Well it all boils down to fees. The finance industry is basically a fee based business. When investment firms make loads of money it is usually because they earned fat fees. (The other way they make money is by making levered bets). Most investors are either clueless about the fees that they are paying or they think that higher fees somehow translate into better performance (they don't).

Time to wake up and pay attention people. The only reason to pay higher fees is because you want to put someone else's kids in a fancy private school. As the article states at the end "you can search in vain for the customer's yachts."

The solution is simple - indexing.

You shouldn't pay more than 0.6% of your wealth in fees. This includes mutual fund expense ratios.

State pension funds - more underfunded.

2011-10-15T12:40:00.000-04:00

The degree to which state pension funds are underfunded has increased, in part due to lower bond rates. This is because the present value of the liability faced by a state should be estimated by discounting the promised retirement payments at something close to a risk free rate. The risk free rate is very low so the present value of these liabilities is high.

Of course states continue to use 8% to present value these liabilities.

Market volatility and drug use.

2011-10-14T10:17:00.000-04:00

Apparently Berlusconi (the Italian PM) wants to start drug testing traders. He thinks cocaine use is causing market volatility.

More on News Corp.

2011-10-13T08:48:00.000-04:00

Felix Salmon talks about the latest News Corp scandal which I blogged about yesterday.

Mutual funds without morals.

2011-10-12T15:20:00.000-04:00

A must read for anyone who buys actively managed mutual funds. Ron Elmer explains how mutual funds game the system by merging, closing or changing style to make their bad returns look good.

Yet another reason to index. You do index don't you????

The Wall Street Journal has been running a circulation scam

2011-10-12T15:08:00.000-04:00

I used to subscribe to the Wall Street Journal - it was an excellent newspaper. Then Rupert Murdoch took it over in 2007. I now get my financial news at breakfast time from the Financial Times. I got tired of the pseudo sensationalism that started to dominate the paper.

Murdoch's company, News Corporation, is without a doubt, one of the most crooked, ethically bankrupt companies in existence. The latest scandal that has emerged is the finding that the Wall Street Journal was buying up copies of its own paper to boost circulation numbers. Full details are here. In classic News Corp style, the initial reaction of the company was to deny it, and then, when this didn't work, go ahead and fire someone.

Let's not forget that News Corp is also still embroiled in the phone hacking scandal in the UK in which the "sister" publication of the WSJ, the News of the World, hired hackers to hack and delete phone messages from the cell phone voice mail of a missing girl. In doing so, the parents thought that their daughter was still alive, because she was accessing her voice mail. News Corp employees also hacked the phones of the relatives of deceased British soldiers, and also victims of the July 7 London terrorist attacks, as well as numerous phones of celebrities and politicians. All this occurred with the full knowledge of senior News Corp officials.

Recently Rupert Murdoch has said that the focus by shareholders on the hacking scandal is "disproportionate".

It's hard becoming an investment banker.

2011-10-12T11:26:00.002-04:00

My Colleague, Craig Newmark, links to a great post on what it takes to become an investment banker.

Executive Stock Options

2011-10-10T15:35:00.000-04:00

Ron Elmer who writes "Investor Cookbooks" has posted a lengthy discussion of why executive stock options are bad, and why, in his opinion, they should be outlawed.

He makes some very good points. I have a few comments.

First, I fully agree that the big problem with Wall Street firms is that they converted from being partnerships to being publicly traded. As Ron points out, when they were partnerships, risk management was everyone's business. The banks became public largely because the existing partners wanted a way to cash out. They benefited and risk management suffered.

Second, I disagree that options do not align incentives. The example given assumes that a manager will exercise his options at some future date and convert the gains straight to cash. The important thing to remember here, is that up to the time when he cashed in his options, his incentives were very much aligned. In fact, well in the money options are very much like stock.

Third, I agree that options represent a huge unknown in compensation because we really don't have any idea what they will be worth 5 or 10 years. But I think the issue here is with the quantity of options that are being issued, not the option per-se. Firms seem to make very large option grants that end up being worth huge amounts in the future.

Finally, Ron alludes to the bigger question of whether US CEOs should make 300 to 400 times what the rank and file worker makes. This ratio is higher in the US than for most developed countries and I am also pretty sure it is higher now than it was, say 30 years ago. I don't know what the correct ratio should be, but 400 seems high. Having said that, I note that movie stars and professional athletes make stupid amounts of money for doing stuff that seems pretty unimportant in the big scheme of things.

B of A needs a new PR firm

2011-10-06T13:51:00.000-04:00

Chief Exec of Bank of America states that "we have the right to make a profit" in charging a $5 debit card fee. Sure you do B of A. Your customers also have the right to change to another bank (or credit union).

Given the press that the Occupy Wall Street crowd has been getting recently, this probably wasn't the right time to say this. B of A really needs to find a new PR outfit.

Damadoran on the current low risk free rate.

2011-10-06T09:20:00.000-04:00

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation. His main point is that the risk free rate must be considered with the current expected risk premium. When these are combined the result is relatively low valuations. He also touches on another point which I'd like to emphasize. In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation. But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows. A low risk free rate implies low real growth and also low inflation. Thus it will also reduce the level of future cash flows. Failure to account for the two edges of the risk free sword is an example of inflation illusion.

Dilbert on MBAs

2011-10-06T08:47:00.000-04:00

All I can say is that I have a Finance PhD and an MBA and I'm not making any money in the market either.

Externalities in energy production

2011-09-30T12:09:00.000-04:00

OK - today a slightly non-finance post.

There has been much hand wringing recently over the Solyndra Solar scandal in which it is alleged that the solar company received government support without proper controls. Solyndra filed chapter 11 and is now being investigated by the FBI.

In the same way that I don't think subsidies for agriculture make sense, I don't think that subsidies for certain industries make sense either. The government shouldn't subsidize solar power. But it also shouldn't subsidize fossil fuels either. Turns out that fossil fuel subsidies are a lot larger than the solar subsidies. A whole lot larger. This of course, doesn't get Solyndra, its management or the government off the hook in the current scandal.

(graphic from the Environmental Law Institute )

But the Solyndra case is a distraction to the bigger issue. Even ignoring federal subsidies of fossil fuels, these industries are able to provide low cost energy because they impose negative externalities on other parties. These externalities are primarily airborne pollution which have a very significant effect on the economy overall. A recent paper published in the American Economic Review (the very top journal in Economics) finds that the magnitude and costs of these externalities are huge. If the article is a bit dense, Paul Krugman gives a nice summary of the article.

The solution is to impose a Pigovian Tax - a tax on carbon. A carbon tax works by raising the cost of carbon fuels towards a point that more accurately reflects their true cost (externalities included). The key element of such a tax is that it is revenue neutral. This means that all proceeds are rebated back to tax payers. The most obvious way of doing this would be to reduce payroll taxes. Greg Mankiw, the noted Harvard economist, who will admit to being on the opposite side of many debates to Paul Krugman, is a huge fan of a Pigou Tax.

With such a tax in place, and the removal of federal fossil fuel subsidies, the playing field would then be fully leveled for alternative fuels to compete based purely on their merits.

Price risk in the junk bond market

2011-09-28T21:08:00.000-04:00

In one of my classes we've been talking about price risk and reinvestment risk for bonds. These occur when market rates move from the initial YTM that an investor purchased the bond off of. A great example is the current junk bond market where yields have risen very high and resulted in prices falling dramatically. As a result year to date returns on these bonds are now negative.

Article here, HT Felix Salmon

Why do firms break up?

2011-09-28T15:37:00.002-04:00

Aswath Damodaran has put together a really fantastic post on why firms break up or spin off divisions. This is well worth a read.

Berkshire Hathaway to buy back shares

2011-09-28T15:33:00.000-04:00

This story is a few days old, but Berkshire Hathaway is planning to start a share buyback. This is pretty big news in that the company has never distributed cash to shareholders before. Warren Buffet claims that the stock is significantly undervalued. If this is so, then the buy back probably makes sense. The evidence on buy backs is a little mixed, but in general there it supports the view that firms that do buy backs usually do so when their stock is undervalued. We know this from two observations. First buyback announcements are usually greeted with a positive stock price reaction, and second, valuation models show that firms that commence buybacks are, on average, undervalued compared to other firms.

Goodbye Wachovia

2011-09-28T15:28:00.000-04:00

Here in Raleigh NC, the Wachovia building has long dominated the downtown skyline. Not anymore. It's now the Wells Fargo building. My local newspaper has a nice set of pictures showing the transformation.

Robert Shiller on Stock Valuations

2011-09-28T15:25:00.000-04:00

From Greg Mankiw: Robert Shiller thinks stocks aren't that cheap.

Pension fund returns

2011-09-27T10:21:00.000-04:00

My colleague, Craig Newmark, links to an article on why Public Pension Plans can't be expected to earn returns of greater than 8% in the future.

The article argues that because the real risk free rate of interest is very low - close to zero, the expected return on pension assets should be reduced also. I agree, but I would also point out that a non-trivial part of the historic return earned by pension funds comes in the form of inflation. A far more sensible approach would be to create pension plan return expectations in real, not nominal terms.

I've posted on this topic before. Aside from over optimistic return assumptions, the other problem of state pension plans is that they discount their liabilities at the same return that they use for their assets. Pension plan liabilities are virtually risk free and should be discounted at a much lower rate. The net result of doing this would be to increase the value today of those liabilities and most likely reveal that most pension plans are horribly underfunded.

Dairy subsidies

2011-09-27T09:52:00.000-04:00

A new proposal for dairy industry basically makes dairy producers pay premiums in good times in order to get a bailout in bad times - basically this an insurance policy. The proposal would be voluntary.

I have some concerns...
First, I don't really understand why the government needs to insure farmers. Why can't they buy private insurance?
Second, and probably the explanation for the first point - I bet this program will loose money.
Third, as someone who doesn't consume dairy products, I fail to see why dairy is so important to our nation. I
think beer subsidies would be a much better idea.
And finally, this quote cracked me up:

Some farmers objected to the federal government limiting how much milk they could produce, saying the answer to problems facing the dairy industry was less government interference, not more.

I completely agree - but if you want less government interference you also have to take less handouts.

HT: Vegan blog

Is high frequency trading causing market volatility?

2011-09-27T09:35:00.000-04:00

No - according to the founder of a HFT trading shop. He makes a valid point - that a large amount of the movement in prices is from close to open - in other words after the market closes and before it opens the next day.

The HP 12c is 30 years old.

2011-09-23T10:52:00.000-04:00

Most finance students use newish calculators like the HP BAii, but the granddaddy of them all, the HP 12c turns 30 this month.

The 12c is a quirky calculator, but as the Financial Times says this morning: "By slapping the old HP 12c down on the table, you’re saying: ‘I’m a complex thinker, I can handle detail and I mean business”.

Apparently the 12c and the BAii are the only calculators permitted on the CFA exams.

Markets are down and the 10 year bond rate is at 1.77%

2011-09-22T10:14:00.000-04:00

Not good (unless you want to refinance your mortgage).