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August 15, 2005

Bonds, Future Bonds

Great. Just when you thought it was safe to go back in the bond market. The Wall Street Journal has covered this story for the last couple of days, but there's kind of a technical component here, so hold on. (Hugh, I'll try to explain it so even you can understand. Stop laughing, Duane.)

It turns out that there's an ongoing, periodic liquidity crisis in the 10-year Treasury Bond Market. Why does this matter? We'll get to that in a moment, but first, let's explain how this could possible happen in someplace where the word "republic" isn't preceded by the name of a fruit.

The problem is a shortage of actual bonds available to deliver when futures contracts close. It came to light in June, when a huge bond fund, PIMCO, found itself with very, very large position in 10-year futures contracts. Normally, it has no interest in taking delivery of these bonds, so it would just sell the contracts to close, and buy September contracts to replace them. But the September contracts were expensive, so PIMCO decided to hold onto the June positions, and go ahead and take delivery of the bonds. (They informed the Chicago Board of Trade of this, in order to avoid the appearance of manipulating the market.)

Here's the problem: there aren't enough bonds to fill the deals. Bond futures holders normally only take delivery about 10% of the time. (In fact, the CBOT, when it discovered the problem, implemented a rule that futures holders couldn't ask for more than 10% of bond in delivery, immediately driving down the price of those September futures and costing traders even more money.) So when PIMCO signaled that it reallly was going to expect those bonds at the end of June, it set off a scramble to find bonds to deliver.

There's another bond market that doesn't get as much play in the press - the repurchase, or repo market. That market is basically a short-term lending house for bonds, much like your credit card is, or should be. Naturally, with all these 10-year bonds out on loan, PIMCO's sudden need for bonds created a shortage, or squeeze, in the repo market, too.

This means a couple of things. First of all, look at the 10-year interest rate.
There's a noticeable, half-point drop bottoming out at the end of June. But there's still plenty of downward pressure on 10-year rates, because everyone knows the same thing is going to happen in September. People are holding onto those bonds, because 1) they want to be sure they have enough to deliver, and 2) they expect the price to rise, and thus the yield to fall. It also means that for the time being, the repo market is likely to be less liquid, putting downward pressure on short-term rates.

It's likely that this will work itself out to some degree, but it also means that the massive foreign appetite for our Treasuries is responsible for that flattening yield curve everyone's worried about. This time, though, it may not presage a recession.

Posted by joshuasharf at 04:58 PM | TrackBack

August 09, 2005

Hedging's Limits

The Wall Stree Journal reports this morning that airlines are getting hit extra-hard by rising oil prices:

With crude-oil prices soaring, refiners are taking advantage of tight supplies to fatten the margins that they earn from turning oil into jet fuel. And cash-strapped airlines are picking up the mounting tab.

The widening gaps between the price of crude oil and various types of fuel -- known in the industry as crack spreads -- are dealing a one-two punch to an industry that can ill afford it, where fuel is the second-biggest expense after labor. The average crack spread for jet fuel topped $11 per barrel in the first half of this year. That is up from an average $2.59 per barrel in 2002...

The bottom line: About one-fifth of the increase in jet fuel prices is coming from a widening crack spread, while the other four-fifths reflect higher oil prices.


Blame diesel cars in part for the widening crack spread. Jet fuel and diesel fuel have similar components, and soaring demand for diesel-powered vehicles, particularly in Europe, is pushing up prices for both fuels. Greater industrial demand for diesel in China also has played a role. Airline executives complain that refiners, which in the past decade came off a long period of weak profit margins, have been slow to add new refining capacity, which is contributing to the high prices.


A few carriers, including Southwest Airlines and America West Holdings' America West, have partially insulated themselves from higher prices with fuel hedges. The hedges, executed before prices surged, effectively locked in lower prices. But most airlines have little or no hedges in place, and now it is too late and costly to find attractive prices.

A couple of points. First, as I've mentioned before, when your second-largest operating expense is one of the most volatile, politically-sensitive commodities available for sale, you might think a little about hedging your risk.

I don't have much sympathy for airlines who let unions in on the Great Barbecue of their own finances, create long-term obligations that their highly-cyclical business model can't possibly meet, and then fail to consider that maybe, just maybe, the world isn't fated to have $10-a-barrel oil for the rest of our lives.

Apparently there's no liquid market (so to speak) directly in diesel, so the airline probably hedge with oil futures. MarkWest did a similar thing with natural gas, modeling the change in gas prices as oil moved. But if jet fuel moves more than the model predicts, the hedge won't give as much cover as anticipated. So even those airlines that hedged may have some problems.

That said, while it's too late for United and American to avoid $60-a-barrel oil, it's never too late to hedge. "Attractive prices" are always relative. Even if China's thirst really is slowing down (and the commodities section of the latest ISM report suggests that it is), and oil prices may not be headed up anytime soon, the risk to the airlines is on the upside.

The airlines need to hedge their risk anyway, possibly through futures options. If the options expire unused, they'll have to add that as a cost of doing business. But you'd think they'd have learned the lesson of not having them around when they need them.

Posted by joshuasharf at 08:36 AM | TrackBack

July 29, 2005

Can Markets Both Be Efficient and Make Mistakes?

Personally, I think this is one of those questions that answers itself. If one believes in efficient markets, one has to admit that something very mistake-like happened in 1929, 1987, 1998, 2000, and 2001.

And yet, many of us would still argue that it's difficult-to-impossible for most investors to beat the market.

How can this be true?

First off, let me point out that you don't have to believe in Modern Portfolio Theory to believe in Efficient Markets. These really are two separate things. I personally think Modern Portfolio Theory is largely a crock, based on a distribution of returns that just doesn't hold long enough to be useful.

That, however, is an argument for another day. For the moment, let me just reiterate that one can dismiss MPT, and still believe in Efficient Markets.

Not perfectly efficient markets, mind you. Data clearly shows leakage prior to major announcements, it shows momentum, mean reversion, and all sorts of other tantalizing bits that people have been following for years. That few, if any of these turn out to be investable doesn't refute their existence, and may in fact account for their persistence.

Still, how can an efficient market overshoot targets time after time?

I think the answer comes from another book that's awaiting review: The Wisdom of Crowds by James Surowiecki. He points out two things about collective, aggregated, independent crowds. First, that they are consistently smarter than even their smartest members; although individual members will inevtiable beat the crowd each time, these winners will invariably differ from run to run. And second, the decisions, the valuations, if you will, have to be independent.

The first observation results from efficiency under normal conditions. You and I may beat the market from time to time, but on the whole, the market is smarter than either of us.

The second observation is what causes mistakes. Since at any given moment, we assume that the market is smarter than we are, the tendency is to go along for the ride. And most of the time that's the right thing to do. The warning sign is when people stop looking ahead, and start looking side-to-side at what everyone else is doing.

That's when decisions stop being independent. First, people start looking for a greater fool. Then, they all head for the exits. That's what happened in 2000 during the tech bubble, and it's also what happened in stages to Long-Term Capital Management in 1998.

Even during a run, the market is smarter than we are. Even during Tulipmania, the market at each point is probably smarter than we are. There's a point where decisions stop being independent. But since nobody really knows when the fever breaks, it's hard for even the smart, cold-blooded investors to forgo certain profits and get off the merry-go-round before he's thrown off.

Posted by joshuasharf at 07:49 PM | TrackBack

July 21, 2005

How Not to Diversify

Welcome Hugh Hewitt listeners. Scroll down if you're looking for the posting of the mosque pictures. Start here if you want to learn something about investing.

What follows is the blogger's digest version of this Word working paper.

For generations now, investors have been told to diversify on the basis of size and value-growth. There's no question that 1) value tends to outperform growth, 2) small tends to outperform large, and 3) it's good to diversify.

But size and value-growth do not denote asset classes. Instead, US Equities should be seen as a single asset class. Diversification is still a good idea, but the differences in returns among cap sizes, and between value and growth stocks, are not great enough for them to define asset classes.

Who says otherwise? Lots of people. Fund managers, advisors, journalists, researchers.

I'd like to propose three requirements for asset classes:

  1. Orthogonality in Performance. Different asset classes should have low correlations in their returns. Individual stocks may be exposed to interest rates or commodities, but in general will not rise or fall solely in response to those factors. This quality is necessary to make sure that different asset classes actually contribute to return while lowering risk and volatility.
  2. Mutually-Exclusive Definition. An asset should not be able to live in more than one asset class. A corollary to this is that an assetís class should be clear and generally agreed-upon. Different analysts should not be able to classify the same asset differently.
  3. Stability. Assets should not be changing class frequently, if at all. While this follows from No. 2, it isnít the same thing. An asset could change characteristics in such as a way that analysts agree it should be re-classified, but this should be rare. Still, for definitions to have integrity, assets shouldnít be popping in and out of them, or drifting across class lines easily.

There are a number of large indexing firms that break US stocks down into these categories. They don't fit any of these requirements.

Orthogonality in Performance

There is very high correlation among these various indices. Here, for instance, is a scatterplot of the daily returns of the Morgan-Stanley Large-Cap Value vs. Small-Cap Growth for the last 13 years.

If I use the following list of asset classes as a baseline,

  • Cash Equivalents
  • Foreign Cash
  • Government Bonds
  • Tax-Exempt Bonds
  • Corporate Bonds
  • Large Stocks
  • Small Stocks
  • Foreign Stocks
  • Investment Real Estate Unlevgd
  • Residential Real Estate Unlevgd
  • Farm Real Estate
  • Energy
  • Precious Metals

The average correlation in annual returns is 0.068. Here's what that looks like:

These high correlations hold across countries, indexing services, decades, value-growth, and size. Once in a while, you'll get something as low as 0.444, such as the Morgan-Stanley Value and Growth indices for Ireland. But those are anomalies, serious outliers, which probably show that whatever metric their overlaying on the stocks doesn't work all the time.

If you believe in modern portfolio theory, CAPM, and the Efficient Frontier, this is a problem. Because if you add in any sub-class by itself, you end up moving the frontier to the right, not to the left. The risk contribution, as measured by standard deviation, adds up faster than the return contribution, because the correlations are higher within US equities than between US equities and anything else in the list.

If you don't believe in modern portfolio theory, because returns aren't normally distributed, you should still come up short, because correlations still matter in normal times, and correlations within US equity "asset classes" dwarf anything else in the list.

Mutually-Exclusive Definition

If you're going to draw lines, draw lines. It's no good having the same stock rated as Value by Mr. Morgan and Growth by Mr. Stanley. It's no good having the same stock rated as Large by Morning and Small by star. It's also no good having your mid-cap range cover the same ground as your small-cap.

Guess what.

Here's how five different indexing services define Small, Medium, and Large:

Now we know where shirt-makers have been taking their cue from. Note that one of them doesn't even believe that "mid" exists, slicing it off as the smaller part of "large."

Comparing the latest S&P and Morningstar index components, and looking only at the components they have in common, we also see a fair amount of disagreement:


What's really problematic is that the indexers aren't even internally consistent:

This may overstate the amount of overlap, since the distributions aren't flat. But still. Now part of this is a result of drift. Indexing services are reluctant to reclassify stocks just because they happen to float over the line between "Large" and "Mid." Maybe they just swam into the lane markers, and are really still behaving like a Large stock. Which brings us to


Every six months, S&P reconstitutes their 1500 index, comprised of the Large 500, the Mid 400, and the Small 600. Each of those is broken into Value and Growth. Over the course of six months, they'll have more than 1500 stocks in the list. Here's how many of the total 1500 change categories every six months:

Again, these are only the stocks that stay in the 1500, but change index. It averages more than 1 stock in 9.

Now, indexers will argue that it's not fair to expect mutual-exclusivity and stability. I would argue that that's an excellent reason why you can't break US equities down into separate asset classes, at least not by size and value-growth.

This means that while you still want to diversify your portfolio, maybe by industry, maybe by Barra risk factors, you don't gain anything by diversifying across size and value-growth.

Posted by joshuasharf at 07:01 PM | TrackBack

June 17, 2005


As part of my research, I've been looking at something called Returns Based Style Analysis. Reading through the papers and the technique, I can't believe anyone ever took this stuff seriously at the style-box level.

RBSA purports to be a way of determining if a Growth manager really is doing what he says he's doing. The idea is that you take a Growth Index and a Value Index, and then maybe a large-, a small-, and maybe a mid-cap index, and see how well the manager's returns correlate with each of them.

The actual equation is this:

R = a + b1R1 + b2R2 + ... + e

where R is the fund's return, a is the manager's alpha, e is an error term. Each R is the return for a given index, and each b is the fund's exposure to the style represented by that index. If you do this for a series of quarters or years, you can solve for the b's, and find out the manager's actual (as opposed to advertised) style.


This is like trying to figure out whether a pitcher is a power pitcher or not by looking at his ERA.

Now, RBSA was originally invented by the Nobel Prize Winner William Sharpe, a founder of modern portfolio theory, CAPM, and the Sharpe Ratio, so naturally I'm a little reluctant to call it bunk. Still, "Nobel Prize Winner" probably had a lot more heft to it before two of them almost crashed the world financial system in 1998. Secondly, it's far from clear that these relationships actually are linear.

One thing, though, that distinguishes Sharpe's idea from current usage is that he was using actual asset classes. We know what a stock is, and we know what gold is, and it's unlikely that someone's going to mix up the two. But there are at least five different indexing services out there (Wilshire, S&P, Morningstar, Russell, Morgan-Stanley), and they can't agree from quarter-to-quarter what's a growth stock and what's a value stock. Heck, they can't even agree what large, mid, and small mean, and some can't even agree that there is such a thing as mid-cap. The granddaddy of risk factor exposure, Barra, even admits that a firm definition is impossible.

So now, it's like trying to figure out whether a pitcher is a power pitcher or not by looking at his ERA, only the official scorer routinely tries a little too hard to support the sponsor (you know, Coors, Busch, Milwaukee), and can't figure out what an error is.

Finally, we have something better. We can actually look at mutual funds' holdings, and decide for ourselves what this manager is up to.

So really, what RBSA is trying to do is figure out a pitcher's style by using an inconsistent definition of an earned run, when two columns over, we can see his strikeouts and walks, fly-outs and ground-outs.

We can do better than this. Really, we can.

Posted by joshuasharf at 08:23 PM | Comments (0) | TrackBack

June 10, 2005

New CFA Blog

With the end of academics, it's time to...start studying! For the CFA, or Chartered Financial Analyst Exam Level I, in December. Since I don't want this blog to get drowned in exam talk, I'm starting another blog dedicated to that pursuit.

*Sigh* It never ends, does it?

Posted by joshuasharf at 01:20 PM | Comments (0) | TrackBack

June 08, 2005

Laboratories of Finance

The Wall Street Journal reported this morning on the proposed impending regulation of hedge funds ("Hedge Funds Brace for Regulation"):

Last year, amid the growing surge of interest from investors in hedge funds, William Donaldson, the outgoing chairman of the Securities and Exchange Commission, championed a staff recommendation that most hedge-fund managers register with the SEC as investment advisers. More pension plans, endowments and charities have shifted into hedge funds, which more directly impacts smaller investors. Sparking additional concern, more investors today meet the wealth requirements to invest in hedge funds -- set to be raised to $1.5 million of net worth, from $1 million. An estimated 8,000 hedge funds worldwide manage about $1 trillion in assets.

Even more important, the growth of hedge funds and the fact that they often use borrowed money to expand their investments means that the funds play a bigger part in daily movements of the market. Mr. Donaldson last year said the agency "needs to have a means for examining hedge-fund advisors and monitoring their activity."

The rule change, which doesn't have the support of certain officials, including Federal Reserve Chairman Alan Greenspan, is scheduled to take effect in February 2006 and would subject hedge-fund firms to regular audits and inspections. Funds also will have to provide the backgrounds of their executives, details of their trading strategies and how they value their portfolios, among other things. About 35% or so of hedge-fund managers currently are registered with the SEC.

Hedge funds were exempted from the 1940 regulation because of two assumptions: 1) people with net worth of $1 million didn't need to be protected - a somewhat patronizing assumption perhaps, for the rest of us, and 2) no individual fund could move the market.

Now, just because pension funds are foolish enough to invest in these things doesn't mean that they should be regulated. After all, Schwab doesn't consider roulette to be suitable investment for my IRA money, but Vegas still stays lit at night. Thanks to my water, of course. Ahem. But I digress.

The better reason for some hedge fund regulation is that the assumptions aren't operative any more. While $1 million isn't chicken feed, many many middle-class families can aspire to that goal within their lifetimes. And if Meriwether and his Meri Band of Academics at LTCM taught us anything about letting them outside the classroom, it was that one well-placed, poorly-timed, over-leveraged, under-supervised group of kids can spoil it for everyone.

Here's the problem, though:

Hundreds, if not thousands, of firms manage less than $100 million, and they might not be able to bear these burdens, some say. A $50 million firm, for example, likely charges its investors about 1% of assets a year as a management fee to cover the running of the fund. With the cost of registering so high, at least in the first year, some might think twice about starting their own funds.

A good compliance officer can pretty much eat up the entire fee of a small fund. While the Wild West mentality of most hedge fund managers will lead them to rebel at first, the larger funds will soon find, like their bretheren in other industries, that regulation is a swell barrier to entry.

Why do we need smaller funds? As the laboratories of finance. They're more nimble, can liquidate positions more easily without moving the market, and often represent the newer, more innovative uses of modern finance theory. If someone has a creative way of combining derivatives, they ought to be free to pursue that without having to tell the whole world what they're doing.

So instead of simply regulating the entire industry, which can only stifle innovation, the SEC should consider either one threshold, or a series of them as the fund increases in value, leverage, and impersonality.

Posted by joshuasharf at 10:42 PM | Comments (0) | TrackBack

June 02, 2005

Finance Fault Line?

Steve Liesman wrote his last Macro Investor column for the Wall Street Journal yesterday, musing on the current state of hedge funds. At the end, comes this:

Former New York Federal Reserve Bank President Gerald Corrigan ... doesn't believe another meltdown like Long Term Capital Management is likely. Mr. Corrigan is now at Goldman Sachs and heads a private-sector group, The Counter-Party Risk Management Group II, set up to offer guidelines for assessing risk in the derivatives market that is often the playing field for hedge funds. He believes the finance world has learned much from the LTCM meltdown and that leverage in the hedge-fund industry is not as great as it was.

Yet he acknowledges that there is simply no way for any individual banker or regulatory agency to know and he wouldn't rule out a significant shock from a hedge-fund blowup. The best regulators can do is try to limit both the concentration of a single banks' lending to a single fund and into a single asset class or trade.

This is curious, because massive leverage was only one reason for the LTCM meltdown that gave financial markets a glimpse at the abyss. As important was the fact that there were, by 1998, many players in the same game, all using the same exit criteria. Leverage itself, even without the Archimedean levels required by LTCM's bets, was enough to close the feedback loop. Once prices began to fall or, in this case, once spreads began to widen, the only way out was to unwind positions, the effect of which was to further widen spreads.

This is exactly the same dynamic that caused the 1929 crash and the 1987 crash. In 1929 it was people buying on margin, using the stocks as collateral; in 1987 it was people shorting stocks as insurance. Both of these crashes occurred not because the magnitude of the leverage was particularly large, but because too many people were playing the same game at the same time.

I'll have much more to say about hedge funds in general, and LTCM in particular, in succeeding posts. I've just finished reading both Inventing Money and When Genius Failed, and am working my way through a raft of academic papers on the subjects raised. But for the moment, I'll just say that Mr. Corrigan's statement leaves me less than comforted.

Posted by joshuasharf at 01:52 PM | Comments (0) | TrackBack

A Civil War

Supreme Command

The (Mis)Behavior of Markets

The Wisdom of Crowds

Inventing Money

When Genius Failed

Blink: The Power of Thinking Without Thinking

Back in Action : An American Soldier's Story of Courage, Faith and Fortitude

How Would You Move Mt. Fuji?

Good to Great

Built to Last

Financial Fine Print

The Balanced Scorecard: Measures that Drive Performance

The Balanced Scorecard: Translating Strategy into Action

The Day the Universe Changed


The Multiple Identities of the Middle-East

The Case for Democracy

A Better War: The Unexamined Victories and Final Tragedy of America's Last Years in Vietnam

The Italians

Zakhor: Jewish History and Jewish Memory

Beyond the Verse: Talmudic Readings and Lectures

Reading Levinas/Reading Talmud