ETFs, Indexation Threaten Mutual, Hedge Funds: Michael R. Sesit (Bloomberg)

It's interesting every now and then to see what really are the primary questions facing investors grappled with in the mainstream financial media commentary, which is usually so fixated on the latest financial markets "noise". Here's a little commentary of my own. It's helpful article and a good read. A link is below.

The article is generally right on. Quibbles? Yes, I have a few. Sesit refers to ETFs as an "asset class". No. No. No. ETFs are no more an asset class than open end mutual funds are, despite the dumb pie chart you see each month on your brokerage statement! They are a financial investing vehicle which can be used to invest in one or more particular asset classes, i.e., US large-cap stocks, emerging market stocks, various types and duration ranges of bonds, or also quite usefully, investment "styles" in a particular asset class, such as US small-cap value stocks, or even economic sectors, such as consumer durables companies.

More recently, the field has widened to include more diverse approaches, still useful and well worthy of acceptance, such as the "fundamental indexing" approach used by WisdomTree. But it's come to the point that you can get ETFs built to invest in companies with left-handed Sagittarian CEOs, companies with cute corporate logos, companies in industries not yet discovered, and companies most likely to be acquired by extraterrestrials. Well, not yet. Wait a while. ETFs have been created for fanciful "indexes" that are neither asset classes, sectors, or investment styles. In other words, a mixed bag, just like mutual funds. Good and bad ETFs exist. ETFs are just not an asset class.

Are ETFs somehow a "threat" to open-end mutual funds and hedge funds? No more than open-end actively-managed mutual funds are a "threat" to investors! Yes, they are gaining market share, presumably at the expense of the worst of the active funds. If so, thank God. The article suggests that hedge fund replication ETfs are a threat to hedge funds. May it be so. One can hope. How much money do investors have to lose to learn that lesson?


Bloomberg.com: Opinion

ETFs, Indexation Threaten Mutual, Hedge Funds: Michael R. Sesit

Most Penetrating Comment I've Seen on Jerome Kerviel and Societe Generale Yet

David Weidner of Marketwatch: "Kerviel, the bad apple who was smart enough to fool a banking empire but not enough to beat the markets...."

Brilliant. No sarcasm at all intended. Smart enough to utterly defeat whatever passes for internal risk controls at an ostensibly world-class institution, but not smart enough to beat the market. Who's next for a similar story? Goldman? Some other firm? Just a matter of time. It seems these guys are given ambitious goals to meet; they are, when you get down to it, told to win or else at what is rather like a very big ongoing coin-flipping contest. So what do you think is going to happen?


A rogue ruined the financial system? Which one? - MarketWatch

The other side: TheStreet.com's James Altucher rebuts Barron's, sort of...

Yes, it is a cute response. Meaningless, but cute! Altucher's test period is too short, ridiculously so, to "prove" anything. But I do believe him as to Cramer's picks being better than those of Barron's! Oh, well.

Both, using Altucher's methodology, underperformed the S&P 500 over the chosen "sample period". You would have done better with one buy of SPY. Better still, probably, if you then held it for a year and a day. Any of these people ever hear of transaction costs? Spreads? Income tax on short-term capital gains? The value of your own time, which could be spent having a life? Active investment management? Just another way of saying "negative alpha"? Has anyone ever started a recovery group for Street Addicts stock pickers?

Putting Cramer's Mad Money Picks to the Fire

Cramer's picks haven't beaten the market--Barron's

No kidding!

I credit Jim Cramer with working very hard at what he loves. And with being a fine communicator, and an under-appreciated writer. And he is likable, when he is not being completely nutty. But the market is just too efficient for him. No argument exists on this, the numbers are in. Only trading "true believers" are willing to commit money to trading approaches for which there is no rational basis to expect bigger gains after taxes as a result.

Because he is on after the markets close, and because the more naive of his viewers are immediately buying his picks, in after-hours trading, a number of day traders will be right there in after hours action, catching those market orders, shorting his picks as those folks buy in. I know that he says not to do that. They do it anyway. Guess how that works out.


Cramer's picks haven't beaten the market--Barron's: Financial News - Yahoo! Finance

Do-Or-Die Time Nears for Old Investment Indicator -- Bloomberg

Chet Currier has some interesting thoughts on how much cash mutual fund managers have, and other old 'market indicators'.

Pretty nifty one-liner from the article: "Fund managers are good stock pickers but poor market timers". I love it. If most actively managed mutual funds fail in the longer run to keep up with their index benchmarks through stock-picking, then how bad would they be when attempting market timing?


Bloomberg.com: Opinion

Unease at Fidelity? - WSJ

One thing which sort of quietly astonished me, several months ago, when I last looked, was the paucity of Fidelity funds coming up at Morningstar when I screened for "Fidelity" and "5 stars". After counting out the plethoras of share classes and marketing variations, there just were not as many as I would have expected. They do have some! But given the presence Fidelity has in the industry, and the huge number of funds Fidelity operates -- I refuse to count my way through all those share classes, etc. -- and the immense amounts of money they manage, where were the standout funds? Where are the category killers? When you review Morningstar's "Analyst Picks", at this date you see eleven Fidelity funds, six of which are bond funds. What does that say?

Fidelity obviously has the resources, commitment, decent people, and the brainpower to be a performance leader -- and they are indeed committed to active management, even though they have some good indexed funds and ETFs. But if they cannot make active fund management work, and I mean really work, for the investors, then can it work for any firm with mega-gazillions under management? And if it cannot work, then is active management, at least with monster mutual funds, a false premise, or even as one financial advisor has rather unkindly labeled it, "a hoax"? That is, not at all just speaking of Fidelity, but for any firm with such massive funds to invest?

Now just for the record, I am not the one who referred to active management as a "hoax". That's chutzpah, to put it politely!

"For the third time in two years, Fidelity Investments announced a major shift at the top of its core money-management unit, signaling what analysts see as continuing unease with the mutual-fund giant's investment and asset-gathering performance."



Fidelity Again Shifts Course In Fund Unit - WSJ.com - $subscription only

"Academics fail to find stock picking skills" -- in Hedge Fund Managers: Financial News Online US

Via the always interesting (even for a non-trader like me,) Kirk Report.

Nope. No alpha there. Just appalling high fees. A suggested rule of thumb for you: High fees correlate inversely with your long-term results.



Financial News and Information from Financial News Online US

Very Interesting Bloomberg Piece on Dimensional Fund Advisors -- DFA

Not enough is written about DFA. "D" does not stand for "different", but it really could. Nobody else is quite like them. Their approach is quite intriguing. Nope, I'm not a DFA advisor. To this point.



Bloomberg.com: Exclusive

What do You Think of the Dow Theory? What do the Researchers Think?

For those who are into the Dow Theory version of technical analysis, Mark Hulbert at MarketWatch has a bit of a review, which I've linked to below, including the interesting note that the three Dow Theory newsletters do not agree on what it says about the present state of the market and the outlook. two are bullish, and the third is bearish. Now stop and think on that for a moment.

Hmmm. Academic researchers pretty much "busted" the Dow Theory decades and decades ago. Mark does refer to one Journal of Finance article all the way back in 1998 which argues for its validity. I don't know if anyone other than the authors was convinced! The Dow theory, like technical analysis generally, has pretty much been in the academic dumper for a generation now. When you test it, it consistently fails to succeed any more often than dart-throwing at the Wall Street Journal.

So, why do people cling to ideas after they are tried in the crucible of research and found to fail? Is it a matter of human nature? Of needing something on which to base decisions? Two things are definitely true. First, the folks who sell newsletters have a conflict of interest. They make a lot of money selling those newsletters. Second, Wall Street's brokerages like clients who trade a lot, be they big hedge funds or little guys investing on their own with newsletter in hand. They have a conflict also. Trading is money, commissions and/or spreads (discounts or premiums, technically,) on crossing transactions to them. Applying a technical analysis-based approach requires a lot of trading, generally. Being as gentle about this as possible, they are self-interested, and the consequences of conceding the failure of technical analysis would be somewhat difficult, particularly for the newsletter writers.

Also, what do you base investment decisions on, if this old, once-popular approach is not really any good? I have advocated in this blog a globally-diversified, multiple asset class approach, using indexed vehicles at least as the default choice. This approach has excellent research support. Well, you may ask, it this idea is so good, why isn't everybody doing it?

Mr. Roger Gibson wrote one of the most remarkable books on investing, primarily for financial advisors, Asset Allocation - Balancing Financial Risk. (3rd. ed., Mcgraw-Hill, 2000.) He writes of what he calls a "quadrant 4 worldview of investing", where the investor, after reviewing what is known about the realities of investing, concludes that neither market timing nor active security selection (stock-picking, for us,) will succeed over time in beating the market. The quadrant 4 worldview is in good accord with the consensus of a mountain of objective financial research. So he writes on the implications of a quadrant 4 view:

"First, a quadrant 4 worldview undercuts to a large degree the reason for the existence of the money management profession." It means that the billions and billions of dollars in fees and expenses investors pay to keep up the lifestyles of the cast of thousands employed in attempts to beat the market are largely wasted. Worse than wasted actually, as what you get for trying to beat the market these ways is that usually you do worse than the market, when all the costs are counted. So, who at your local wirehouse brokerage or online broker is going to tell you that!

They don't even typically talk about that to each other. What newsletter writer is going to want to face that, much less tell you?

The beauty of the "quadrant 4 worldview" is that it lets you, knowing the score, knowing the reality of risk, use market forces rather than fight them. it lets you invest in hope based on what is real! Market returns over time have been good enough to be really worth going after. And wouldn't you, when you think about it expect it to be that way when all is said and done?





What the Dow Theory has to say about current stock market - MarketWatch

FT - "Investment vehicle could be a ‘better mousetrap’ for managers"

It's interesting, but I am still somewhat skeptical. 'Actively managed ETFs can perform better than open-end mutual funds because the managers are freed from the need to make purchases of stocks to deploy cash inflows'? But someone, the arbitrageur, has to buy the stocks, the 'creation units', exchanged for the the ETF shares, right? That's how ETFs work. It's formulaicly-driven, rather than analyst-driven, as to which stocks are purchased, but stocks get bought, by someone, when people want to buy the actively-managed ETF, at least while the ETF is ramping up in trading volume, and as buyers outnumber sellers. I just don't see that the conclusion, enhanced performance, necessarily follows from the reasoning in the article.

Anyway, watch for a lot of hype when the actively-managed ETFs begin to show up en masse. If what has happened with ETFs already is any indicator, there will be some really strange and useless critters evolving in this part of the financial arena. Hype will trump real utility for building portfolios. I can see it now, the 'Best-performing Small-cap Flashlight Makers' ETF; and its derivative concept for those feeling a little down on that group, the Double-inverse Worst-performing Small-cap Flashlight Makers ETF, etc. Boy, won't that be great!



FT.com / Wealth - Investment vehicle could be a ‘better mousetrap’ for managers

Importance of Wise Choices of Mutual Funds

One choice, 35 years, two outcomes.

Can you look at the chart above and get it? Can you see the cost to you of a lifetime of underperforming investments? What you see in the chart is two outcomes, one of which is much, much better.

This is not intended to kick Fidelity Contrafund around. Contrafund is certainly better than many other funds that are out there. But you have a strong interest in getting it right. Getting it right with excellence.

How not to get it right: If you watch TV to learn how to invest, all you will hear is some character yelling and jumping up and down making simian sounds telling you how to trade too much in going after short-term gains. And I am not referring to the commercials! Or you may see some less-diverting version of the same thing. A few exceptional programs exist. If you get lucky and make some short-term gains, then Speaker of the House Rep. Nancy Pelosi will want to tax them away from you. (Sorry, Madam Speaker!) That isn't investing, it is speculating on the stock price. Investing is a bigger, better thing, that even regular people can do well. So, what is real investing? Rummage around in the old posts here. Subscribe to the RSS feed. Come back for more. Bring a friend. We'll get there.

Parting thought: The really stunning thing isn't on the chart. The evidence is in and the research has been done. There is something even more important than what fund you choose. It is which and how many asset classes your portfolio holdings include and how you allocate your money among them. Then, you flesh out the portfolio with excellent holdings. That's getting into investing. But some things come even before those. [mostly involving the customization for each client's needs, and they can't all be dealt with in one blog post.]

Post edited 1/21/07 to correct Ms. Pelosi's title. My mistake. And to add the last few bracketed words.

Bloomberg's Article on Fidelity Contrafund & Some Thoughts

Updated to fix the link below!

Fidelity's Contrafund (FCNTX, closed to new investors) is a behemoth. At sixty-nine billion dollars, that's with a "b", under management, it is Fidelity's biggest fund, larger now than Magellan, and it trailed the S&P 500 by a noteworthy 4 percentage points last year. It's also significantly behind the S%P over the last ten years, as you can see above. That is a long enough time to mean something.

It has to be extremely problematic to manage such a fund without it just becoming in essence the proverbial "closet index fund", taking active management expenses for index fund performance. To their credit, the fund's managers evidently work hard to set themselves apart, and the fund is well regarded. In general, with such a fund, the manager must, to differentiate it from the index, make not just company picks, but industry or sector picks, or in some funds, perhaps even country picks. To significantly impact the fund's returns, you must put a monstrous amount of money into or out of a sector or industry, let alone a single company's stock. As I said above, Contrafund has worked well in the past, and it is successfully marketed as a choice in many 401(k) plans and variable products.

The key, the point of this post, really the ultimate question about such a huge fund (and it is a fair question, too) is whether the open-end actively-managed mutual fund model itself breaks down, performance-wise, with such a brontosaurus of a mutual fund. The whole idea of active management, to beat the market, when you grow so very large, can reasonably be questioned, even if someone is not a "hard core indexer". It isn't enough to point even at a record of beating a fund's index bogey, but the investor is owed something of a rational basis for the idea of how active management can work on such a scale over a significant time period. Perhaps it exists, I just haven't encountered it yet. Appealing to the supposed very large and highly-advanced brains of the fund managers (I'm quite willing to concede them that,) isn't enough either, when it is mostly having a hard time keeping up with the bogey.


Here's the article:

Bloomberg Exclusive