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Is Systemic Risk Truly Declining?

(September 3, 2009)

Important Notes: We are pushing back the publication date of our weekend commentary by one day to Monday evening, as this weekend will be a Holiday weekend (“Labor Day” Weekend) in the US.  We wish all our US subscribers a safe and happy holiday weekend.  We have also just published our “favorite books” review of David Swensen's (Yale Endowment CIO) second edition of “Pioneering Portfolio Management: An Conventional Approach to Institutional Management.”  In many ways, this book review is one of our most important in awhile – as I am very much a “fan” of the perpetual endowment investment model and investment process – along with its inherently long timeframe/focus of investing over a time period spanning centuries.  We have reproduced our book review in its entirety at the end of this commentary.

Dear Subscribers and Readers,

A moment of reflection: Wall Street exists only because its clients have something to sell.  Its primary job is to drum up demand for the vast array of products that it creates year in and year out, including shares issued in primary offerings (i.e. the IPO), corporate bonds, asset-backed securities, leveraged ETFs, and so forth.  From a true investor's perspective, only a small minority of these products are worth buying for the long run as part of a prudent investment portfolio.  For example, David Swensen has this to say about asset-backed securities in the 2009 edition of his book: “Pioneering Portfolio Management: An Conventional Approach to Institutional Management” (note that Swensen penned this before the most serious part of the financial crisis occurred):

Holders of asset-backed securities stand opposite some of the marketable securities world's most sophisticated financial engineers.  At best, asset-backed security investors buying newly minted securities should anticipate low returns from the issuer's use of a complex structure to further the corporate objective of generating low-cost debt.  At worst, the complexity of asset-backed securities leads to an opacity that prevents investors from understanding the intrinsic character of investment positions.  In extreme situations, the Rube Goldberg nature of asset-backed security arrangements causes serious damage to investor portfolios.

One of the worst “scams” (I hate to turn this commentary into a rant but we need to call it as we see it) in recent years has been the wide array of ETF products that have been pushed to retail investors.  Touted as a low-cost and to diversify and to gain exposure to other asset classes, many ETFs have failed to do their jobs for those that have invested in them (and I use the term “invest” very loosely).  One of the worst perpetrators is USO – the ETF vehicle to buy crude oil directly on the futures market.  Marketed as a low-cost way to gain long exposure to crude oil prices, USO's fund managers do so by purchasing the front-month futures oil contract on the NYMEX and rolling it on a monthly basis.  Unfortunately, the immense size of the ETF and the steep contango over the last 12 months has made this monthly process very cost prohibitive.  Worst yet, the sheer size of the product and its mechanical strategy of rolling over its monthly contracts has made the product very vulnerable to issues such as front running and liquidity costs.  If a large hedge fund holds a significant size of all outstanding crude oil contracts in the front-month, and if it telegraphs its positions and strategy to the rest of Wall Street in advance, what would the Wall Street houses and other hedge funds do?  At the end of the day, USO investors are not just providing liquidity to oil producers, but front-running opportunities for the hedge fund community on a monthly basis.  Buyers beware.

If USO can be classified as a scam, then the creation and proliferation of UNG (the natural gas ETF with a similar strategy) among retail investors is truly criminal.  I worked as a natural gas analyst from 2001 to 2003 and have been following the domestic natural gas market ever since – and I have never witnessed anything like that we have seen over the last few months.  The combination of retail speculation in UNG, the record gas inventory glut (natural gas storage should be bumping up against its limit by the end of October), and the small size of the natural gas futures market has created significant distortions, resulting in a historic collapse of the natural gas spot price and record steep contango.  Even as natural gas prices have been plummeting, retail investors continue to get into UNG.  Earlier this week, UNG traded at a 19% premium to its net asset value.  By the close yesterday, it still traded at a 13% premium despite the severe (short-term) bearish fundamentals.

As we mentioned in our commentaries over the last few weeks, we are starting to turn long-term bullish on natural gas given the record drop in gas drilling activity and a projected pickup in economic activity later this year and into early 2010.  Despite the former, however, this has not translated into a significant decline in natural gas production.  Many producers have hedged their positions and are thus producing and selling as much gas as they could at still very profitable prices.  The CEO of Chesapeake Energy in particular has mentioned that the company will keep on producing until natural gas storage hit its limit.  Combined this with a “dud” hurricane season, it is thus no surprise that both the spot price and the front-month price for natural gas has collapsed.  Make no mistake: With the steep contango (approximately 40%) between the October and November contracts, UNG investors stand to lose a lot more over the next 30 days assuming that production isn't interrupted by any hurricane activity (note that the impact of a shut-in in the Gulf of Mexico is much less than it was four years ago, as producers have diversified their supply to onshore shale plays in the last couple of years).  In fact, since UNG represents about a third of the open interest in the NYMEX front-month contract, the monthly roll itself may be costing UNG investors millions.  Assuming storage injections continue as expected, our base line projection suggests that the price of the November contract should continue to converge to both the October contract and the spot price over the next 30 days. That is – even should the spot price remain stagnant – UNG investors stand to lose more than 30% just from this contango alone.  Taking into account the 13% premium to NAV, UNG investors could decline another 40% should UNG converge to its NAV (i.e. a decline to $6 or below).  If natural gas storage runs out, then there would be hell to pay as the spot price and the price of the November contract will most likely collapse in a dramatic fashion (in such a scenario, there would be no option but for producers to dump their gas on the spot market at fire-sale prices).  In such a scenario, I would not be surprised if the spot price decline to $1.50/MMBtu or below.

Let us now get to the gist of our commentary.  Last Friday, the IMF injected US$250 billion into the global financial system through a “special allocation” of SDRs (IMF “Special Drawing Rights”) into member countries' official reserves.  Another injection amounting to $33 billion will be made to IMF members on September 9th.  As stated by the IMF, this special allocation (the individual allocation size of which is based roughly on the countries' relative size in the global economy) is “designed to provide liquidity to the global economic system by supplementing the Fund's member countries' foreign exchange reserves.”

Nearly $100 billion will be provided to emerging market countries – making the overall allocation of SDRs more equitable and to “correct for the fact that countries that joined the Fund after 1981 – more than one fifth of the current IMF membership – had never received an SDR allocation.”  Not only does the latest allocation make the SDR system more equitable, it is also a very timely allocation as this will increase global liquidity in a very efficient and fair manner.  Of course, none of the countries that are receiving these SDRs has to put it to active use.  In fact, many countries (such as Latvia and Turkey) may simply hoard the SDR allocation to shore up their balance sheets.  But that is beside the point.  If countries can shore up their balance sheets with this SDR allocation and as a result, don't need to devalue their currencies or cut back on their fiscal spending, then this latest SDR allocation would've done its job.  It is supposed to be an incremental tool – not a panacea – although every little bit helps at this stage.  With this latest SDR allocation, the amount of systemic risk within the global economy has again turned lower, although as subscribers know, there are still many balance sheet and potential write-down issues in the European banking system – and as such, we remain relatively bearish on the European banking system pending new developments.

An Update on Japanese Liquidity

The newly elected Democratic Party of Japan has vowed to work more closely with the Bank of Japan, although it won't directly ask the institution to monetize its debts.  As mentioned, the DPJ has put an emphasis on increasing domestic consumption by putting more money in households (such as through childcare payouts and scrapping highway tolls).  I thus expect the Bank of Japan to ease its monetary policy further over the next few months.  In the meantime, the Bank of Japan has still been rather timid in expanding liquidity, as indicated by the following monthly chart showing the year-over-year growth in the Japanese monetary base, the change in the year-over-year rate of growth (the second derivative), and the year-over-year change in the Nikkei 225 Index from January 1991 to August 2009:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to August 2009) - The y-o-y growth in the monetary base declined from 8.2% at the end of April to just 6.1% by the end of July - and has stayed at 6.1% at the end of August. On an absolute basis, the Japanese monetary base has been declining for the last four months - suggesting that liquidity conditions in Japan are no longer elevated, and confirming that the world's central banks (at least in Asia) are no longer being as accommodative as they have been during 2Q 2009.

As shown in the above chart, the year-over-year growth in the Japanese monetary base reached a five-year high of 8.2% in April.  Since then, the year-over-year growth in the Japanese monetary base has shrunk to 6.1% at the end of July, and remained at 6.1% at the end of August.  On an absolute basis, the Japanese monetary base has been in a downtrend for the last four months.  However, subscribers should note that the divergence between the growth in the monetary base and the change in the Nikki Index is still very wide.  Moreover, there is ample reason to expect the Bank of Japan to increase its monetary base now that the election is over – which will no doubt support both the Japanese and the global financial markets going forward.  Combined with the ongoing credit easing policies by the Federal Reserve, the Bank of England, and the latest IMF SDR liquidity injection, we thus remain long-term bullish on the US stock market and most other risky assets.  Subscribers please stay tuned.

Following is our latest book review of David Swensen's second edition of “Pioneering Portfolio Management!”

Book Review: Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment

Every investment strategy, process, and philosophy has its “day in the sun.” Prior to the establishment of the SEC, the early 20th century speculators such as Bernard Baruch, Jesse Livermore, and Joseph Kennedy found financial success through government connections, trading on inside information, operating investment pools, and plain, shrewd speculation.  John Maynard Keynes – one of the most influential economists of the 20th century and the architect of the post World War II Bretton Woods System – was also a very successful investor and speculator.  At one point, Keynes (successfully) speculated in his personal account while investing on behalf of various investment trusts and the King's College Endowment Fund.  Benjamin Graham, through Graham-Newman Corporation, achieved similar success through a thoroughly different strategy – by buying and holding securities selling at less than intrinsic value, or sometimes even less than cash value (what folks call a “deep value” strategy today; see our review of “The Intelligent Investor”), although Graham-Newman also engaged in arbitrage and hedging strategies when the times warranted (see its 1946 letter to shareholders).

Warren Buffett, on the other hand, took advantage of everything he learned under Benjamin Graham at Columbia and Graham-Newman Corporation.  But perhaps more importantly, Buffett recognized that the investment paradigm has shifted by the 1950s, as an ideological shift among public policy makers compelled the Federal Reserve and the US government to adopt financial and economic intervention policies that, for the first time, greatly tampered the boom/bust cycles that characterized the US investment environment prior to World War II (Benjamin also discussed this investment paradigm shift in the 1962 edition of “Security Analysis”).  Such policies also increased transparency by mandating better disclosure of corporate financial data, which in turn elevated the security analysis profession to one that is based more on investing for the long-run rather than short-term speculation. Under the partial influence of Philip Fisher (author of “Common Stocks and Uncommon Profits,” published in 1958), Buffett took this investment philosophy to heart.  Many of his latter individual investments – such as American Express, Coca-Cola, and Freddie Mac were made solely on their “franchise value” and long-term earnings power.  Combined with an unprecedented bull market in US stocks (especially small caps), the relatively inefficient markets at that time, his unique investment intelligence and temperament, and in his later years, his exclusive access to invest in superior private businesses and other deals (what private equity investors label as “deal flow”), Buffett arguably became the single most successful investor in modern history.

Other investors who made their mark have also done so by bringing to bear a new, unique, and valuable investment process.  George Soros, for example, was able to implement his “Theory of Reflexivity” to the newly floating foreign exchange market starting in the 1970s – culminating with his fund's spectacular gains in the aftermath of the 1985 Plaza Accord and in 1992 when the UK government took the Pound Sterling off the ERM.  Jim Simons of Renaissance Technologies inspired a whole generation of “quants” through his successful implementation of a quantitative/automated trading platform that was made possible by the increased availability and adoption of computing power for investment purposes.

Long-time subscribers should understand why I am so interested in the perpetual endowment space – and why I believe David Swensen (Chief Investment Officer at the Yale University Endowment) ranks in the top echelons of all-time great investors – right up there with Keynes, Graham, Buffett, Soros, and Simons.  Swensen's genius does not manifest itself in specific investment ideas or new investment platforms, but in having the vision to invest (unconventionally) in more inefficient markets and creating an investment process that ensures long-term success with accompanying investment discipline.  In other words, Swensen has left a great legacy in the form of a flexible but disciplined investment process at Yale – one that will still be in place long after he is gone.  The vast majority of past great investors were never able to create lasting investment institutions.  Certainly, Keynes, Graham, and Soros could not and it remains to be seen whether Buffett or Simons could do so once they leave their respective institutions.

Published in January 2009, the second edition of “Pioneering Portfolio Management” is a timely refresher on the institutional endowment investment “model” and various asset classes that have become more “mainstream” since the publication of the first edition in 2000.  This book – along with “Foundation & Endowment Investing: Philosophies and Strategies of Top Investors and Institutions” by Lawrence Kochard (CIO of the Georgetown University Endowment) and Cathleen Rittereiser – is no doubt “the bible” of the endowment investing world.  That said, “Pioneering Portfolio Management” does have something for everyone – including high net worth and accredited investors interested in adopting a long-term investment process that has worked in all kinds of market cycles.

All the important topics, such as liquidity and asset-liability management, investment philosophy, asset allocation, the characteristics of the most popular asset classes (traditional and “alternative”), and the all-important investment process are covered.  There is even a great (timely) appendix discussing why many fixed income asset classes – such as foreign government bonds, junk bonds and asset-backed securities – are unattractive in the long-run.  The book begins with an introduction in “the world of endowment management” – outlining the vast array of challenging investment issues (such as a investment timeline measured in centuries) as well as operational and agency issues.

Chapter 4 deals with a topic that is close to all investors' hearts – the concept of having a prudent and appropriate investment philosophy that aligns with one's investment temperament and long-term spending goals.  All the sub-topics that every investors needs to deal with – such as the roles of asset allocation, security selection, and market-timing in driving one's portfolio returns, as well as their perils – are covered in this chapter.

The next two chapters discuss how to derive the initial asset allocation and the management of that allocation.  Specifically, Swensen discusses the pitfalls of mean-variance optimization when attempting to create an “effective investment portfolio” (an issue which should be familiar to endowment professionals and consultants alike), reasonable return/risk/correlation assumptions of various asset classes, the importance of qualitative and quantitative assessments when simulating portfolios, rebalancing, the use of leverage, and securities lending.  Swensen then goes on to discuss the characteristics and drivers of both traditional and alternative asset classes in the next two chapters, including the relationship between stock prices and inflation, the trickiness of emerging market investing, the challenges behind short-selling, and the secular increase in the institutional ownership of timberland.  Coming on the heels of the largest LBO craze in history, Swensen's six-page – sometimes scathing – discussion on the performance and risk characteristics of LBOs is also very timely.  While Yale has experienced great success in its buyout portfolio – primarily through investing in managers that implement operationally oriented strategies – the historically performance of the median buyout fund suggests otherwise.  Quoting Swensen: “While the value added by operationally oriented buyout partnerships may, in certain instances, overcome the burden imposed by the typical buyout fund's generous fee structure, in aggregate buyout investments fail to match public market alternatives.  After adjusting for the higher level of risk and the greater degree of illiquidity in buyout transactions, publicly traded equity strategies gain a clear advantage.”  The message is clear: Deal flow is all-important; and buyer beware.

Finally, Swensen details how various asset classes should be managed (e.g. passive or active) and the all-important investment process of a large endowment in the last two chapters.  Specifically, Swensen discusses the importance of “the people” – as well as the size, client base, and the entrepreneurial attitude of an investment organization when picking investment managers.  Having a sound process for selecting managers is very important in actively-managed strategies, especially within distressed debt, hedge funds, private real estate, and private equity strategies. Swensen ends the book with an emphasis on the need to create an appropriate operating environment and organization structure that pushes the day-to-day investment responsibilities to the investment professionals, with the trustees simply providing guidance similar to a Board of Directors at a corporation.  The need to have a strong investment committee and investment staff – both of which are needed to drive the portfolio management process in a disciplined and rigorous manner – is also emphasized, as all these will combine to help an endowment achieve peer-beating returns in an economically efficient manner.  This book should be on the bookshelf of every investor – endowment CIO and individual investor alike!

Signing off,

Henry To, CFA

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