Turn to Your Left at the End of the Sky

Volatility Increases in Times of Crisis

Many people have pointed out that stocks all become perfectly correlated in times of crisis. That’s not strictly true but correlations do increase dramatically. Over the past six months (August 4th, 2008 to January 30th, 2009) notice how correlations (for a portfolio containing a selection of the Dow components) have averaged 0.67 and volatility across the portfolio has been 3.1% for the daily return standard deviation.
Bk Of America Cp BAC                             -95.8% 9.8%
Gen Electric Co GE 0.63                           -80.9% 4.8%
Intl Business Mac IBM 0.66 0.68                         -48.1% 3.0%
Intel Corporation INTC 0.57 0.64 0.74                       -66.9% 4.1%
Johnson And Johns JNJ 0.50 0.58 0.67 0.69                     -28.4% 2.5%
Coca Cola Co The KO 0.39 0.45 0.56 0.66 0.72                   -35.8% 2.8%
Mcdonalds Cp MCD 0.54 0.62 0.66 0.66 0.69 0.66                 -5.5% 2.7%
3 M Company MMM 0.56 0.66 0.68 0.68 0.77 0.66 0.75               -39.3% 3.0%
Merck Co Inc MRK 0.55 0.62 0.71 0.75 0.80 0.66 0.73 0.72             -23.6% 3.5%
Microsoft Corpora MSFT 0.58 0.55 0.75 0.80 0.72 0.68 0.68 0.68 0.73           -54.0% 4.0%
Pfizer Inc PFE 0.61 0.60 0.66 0.70 0.76 0.64 0.67 0.71 0.80 0.70         -37.5% 3.2%
Procter Gamble PG 0.53 0.62 0.68 0.69 0.84 0.70 0.73 0.78 0.82 0.72 0.77       -30.1% 2.6%
At&T Inc. T 0.60 0.57 0.72 0.72 0.77 0.64 0.69 0.69 0.79 0.75 0.75 0.76     -29.7% 3.6%
Wal Mart Stores WMT 0.44 0.51 0.57 0.57 0.75 0.61 0.72 0.66 0.71 0.61 0.64 0.73 0.66   -34.4% 2.7%
Exxon Mobil Cp XOM 0.49 0.56 0.71 0.72 0.81 0.64 0.71 0.72 0.78 0.76 0.76 0.78 0.81 0.67 1.9% 4.3%
Portfolio -44.6% 3.1%

Historically, the same portfolio has exhibited correlations between the various components which have been considerably lower. In fact, over the past twenty years (February 2nd, 1989 to Jan 30th, 2009), correlations have averaged 0.32, approximately half the correlation we have seen recently. The standard deviation of the daily returns was only 1.1%

Bk Of America Cp BAC                             3.2% 2.5%
Gen Electric Co GE 0.49                           8.4% 1.8%
Intl Business Mac IBM 0.31 0.41                         7.3% 1.9%
Intel Corporation INTC 0.31 0.40 0.45                       15.4% 2.7%
Johnson And Johns JNJ 0.27 0.39 0.23 0.22                     14.5% 1.5%
Coca Cola Co The KO 0.28 0.38 0.21 0.22 0.41                   12.4% 1.6%
Mcdonalds Cp MCD 0.27 0.36 0.24 0.22 0.30 0.34                 12.9% 1.7%
3 M Company MMM 0.35 0.45 0.28 0.29 0.31 0.34 0.28               9.1% 1.5%
Merck Co Inc MRK 0.27 0.36 0.23 0.22 0.51 0.35 0.26 0.28             8.2% 1.9%
Microsoft Corpora MSFT 0.31 0.41 0.41 0.55 0.28 0.27 0.23 0.26 0.26           21.5% 2.3%
Pfizer Inc PFE 0.30 0.40 0.25 0.23 0.52 0.35 0.27 0.29 0.54 0.29         12.0% 1.8%
Procter Gamble PG 0.27 0.37 0.19 0.20 0.41 0.43 0.33 0.34 0.35 0.21 0.36       14.3% 1.6%
At&T Inc. T 0.32 0.37 0.26 0.25 0.32 0.32 0.27 0.29 0.29 0.28 0.29 0.30     8.4% 1.8%
Wal Mart Stores WMT 0.32 0.45 0.29 0.30 0.34 0.36 0.32 0.35 0.31 0.33 0.33 0.34 0.32   13.8% 1.8%
Exxon Mobil Cp XOM 0.29 0.37 0.26 0.24 0.33 0.34 0.25 0.37 0.31 0.28 0.32 0.27 0.35 0.29 13.5% 1.5%
Portfolio 13.2% 1.1%

 All these results were created using the tools at AssetCorrelation.com


February 1, 2009 Posted by | Economics, Investing | Leave a comment

The Roots of a Financial Crisis

Stats from Howard Marks’ letter to Oaktree clients:

  • Consumer credit outstanding grew 260 times from 1947 to 2008 (4% of GDP to 18%)
  • Bank indebtedness: 21% of GDP in 1980, 116% in 2007
  • Federal debt: $1 trillion in 1980, $11 trillion in 2008
  • State debt: $1.2 trillion in 2000, $1.85 trillion on 2005 (9.2% CAGR)
  • Solvency became contingent on the continuous availability of credit
  • An upward sloping yield curve promotes short term borrowing to cover investing long.

Question: how should one invest in 2009? A global reflation seems the most likely path. Does the US have any option other than inflating its way out of its troubles…

January 15, 2009 Posted by | Economics, Investing | Leave a comment

Calculating daily volatility

Volatility is usually expressed as the annualized standard deviation of returns. Volatility is proportional to the square root of time. That means one can approximate a volatility over a smaller time period than one year by dividing the annual vol by the square root of the number of trading periods one is interested in.

So, to convert annual volatility to a daily vol, divide by 16, which is the square root of 256 — about the number of trading days in the year.

Back in the days when vol was 15-20% annually (way back in 2007), a daily vol was about 1%. These days, the VIX is closer to 80 which implies a daily return of +- 5%.

On Sept 15th, 2008, when Lehman was allowed to go bankrupt (“Lehman is not too big to fail” – Paulson), the VIX went up to 80 and has been in that region ever since. The Lehman bankruptcy has turned out to be a massive event in financial history.

November 19, 2008 Posted by | Economics, Government, Investing | , , | Leave a comment

Is Volatility an Asset Class?

Others have weighed in on whether volatility should be considered an asset class. From the point of view of a long term investor it clearly doesn’t make sense to buy and hold volatility. (In that sense, it is the ultimate cyclical asset class and we should be glad we don’t live in a world of ever increasing volatility!). However, in terms of the diversification benefit for a portfolio, the VIX does exhibit low (and negative) correlation with many of the major asset classes. The table below shows the correlation matrix for major asset classes over the past 750 days, a period during which the VIX had negative correlation with US stocks and real estate and no correlation with European stocks. Notice, though, that a similar diversification benefit could probably have been achieved with a combination of treasuries and bonds.

Ishares Lehman Ti TIP                
Ishares Leh Agg F AGG 0.95              
Ishares Gsci Cmdt GSG 0.90 0.78            
Vanguard Sf Reit VNQ -0.78 -0.69 -0.69          
Ishares Msci E.M. EEM 0.56 0.68 0.52 -0.37        
Ishares Msci Eafe EFA -0.14 0.05 -0.14 0.25 0.70      
Vanguard Sm Cap E VB -0.54 -0.38 -0.47 0.63 0.25 0.75    
Vanguard Lg Cap E VV -0.32 -0.12 -0.32 0.39 0.56 0.94 0.89  
Cboe Volatility I ^VIX 0.78 0.81 0.60 -0.80 0.55 0.00 -0.39 -0.14

Note: this chart was generated on the AssetCorrelation website which is an excellent resource for monitoring the diversification of your own portfolio.

September 23, 2008 Posted by | Economics, Investing | , , , , , , | Leave a comment

Choose your commodity exposure carefully

Until recently, the best way for individuals to gain exposure to commodities was through exchange-traded index funds such as IGE. Unfortunately, the exposure was indirect as you were essentially investing in the equity of companies that dealt in commodities. In the case of IGE, you were mostly holding the stocks of oil-companies. As of 2008, there are better commodity index funds, such as GSG (the Goldman Sachs Commodity Index) which gives you direct exposure to a broad array of commodities. Even better, GSG exhibits less correlation with almost every asset class when compared to IGE.

July 31, 2008 Posted by | Economics, Investing | , , , , , | Leave a comment

100,000 ft View of Government Spending

In very rough numbers (good enough for government work) for 2009:

US GDP: $15 trillion

Federal Government spends 20% = $3 trillion

Breakdown of the $3 trillion

  • 20% Defense
  • 20% Medicare/Medicaid
  • 20% Social Security
  • 10% Interest on Debt
  • 30% Everything else

The full budget (and historical trends) is available online. Despite the din, not much has changed. The inexorable rise of medicare / social security continues, though. Medicare and social security represented 20% of the federal budget in 1971. Today they represent 40% and growing…

July 26, 2008 Posted by | Economics, Government, Investing, Politics | , , , , | Leave a comment

Do Country Index Funds Add Diversification?

I have to question the need for the wide variety of international country index funds. The AssetCorrelation website has an excellet correlation matrix which covers exchange-traded index funds from various countries around the world.

Take a careful look at the matrix for the various countries. Other than Brazil and Israel (with correlations of 0.73 and 0.35 respectively versus the S&P 500) the rest of the countries’ index funds are all tracking the S&P 500 with >0.90x correlation coefficients.

It might be that the time period is only 90 trading days (about 4 months) and this represents a time in the market which has seen a greater herd mentality than usual. Or it might be that global inflation fears do justify a simultaneous downward revision in global equity asset prices. Either way, lately it has been hard to see the benefits of international equity exposure. Even emerging markets like Turkey, Mexico and Chile have been strongly correlated recently. Inflation really is the great leveller.

July 14, 2008 Posted by | Economics, International Affairs, Investing | , , , | Leave a comment

Correlation between Asset Classes

There is a promising new website called Asset Correlation which shows the correlation matrix for a host of different asset classes over the past 90 trading days. I have been tracking it for a few months and it is amazing how all the asset classes exhibited far higher correlation during the recent panic. As normalcy has gradually returned to the markets it is interesting to see how the historical scenario of lower correlation between asset classes has returned. A few months ago almost all the cells in the matrix were green and correlations were hovering around 80-90% for most of the major classes. As of today, there is far lower correlation between the classes (indicated by the larger number of yellow and red cells). It will be interesting to keep an eye on this website over the next few months.

June 19, 2008 Posted by | Economics, Investing | , , , , , , | 3 Comments

The Rise of the Rest

Newsweek has a fascinating article by Fareed Zakaria. Some of the interesting points he makes:

  • 20 years ago the US had the lowest corporate taxes in the world. Today the US has the 2nd highest.
  • Only three countries in the world don’t use the metric system: Liberia, Myanmar, and the US.
  • In 2006 and 2007, 124 countries grew their economies faster than 4%.
  • The share of people living on $1 a day has plummeted from 40 percent in 1981 to 18 percent in 2004
  • The global economy has more than doubled in size over the last 15 years and is now approaching $54 trillion. Global trade has grown by 133 percent in the same period.
  • In World War II Germany suffered 70 percent of its casualties on the eastern front yet the American narrative is one in which the United States and Britain heroically defeat the forces of fascism.

May 6, 2008 Posted by | Economics, Investing, Politics | , , | Leave a comment

The 15bp Portolio

I have long held that one of the pillars of long term investing success is not lining the pockets of mutual fund managers. Matthew Hougan recommends an extremely simple, low cost portfolio with a blended expense ratio of 0.148%.  This would represent an excellent start for any beginner investor. I haven’t calculated the blended expense ratio of my recommended portfolio but it is probably close to 15bp and slightly more complex.

October 24, 2007 Posted by | Investing | Leave a comment

The 2-and-20 Crowd

Buffett’s annual letter to Berkshire Hathaway’s shareholders is always compelling investment insight. His 2006 letter contains this gem:

In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive his bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee. […]

Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the  money.

I have written about this broad daylight heist before but it continues to astonish me that people aren’t aghast at the inequity of the system.

March 20, 2007 Posted by | Economics, Investing, Thoughts | 1 Comment

Opportunity International

The advent of Christmas is always a great time to count your blessings and review your charitable giving. I highly endorse Opportunity International. They make a significant difference in the lives of the poor by loaning them capital with the training and spiritual support that they need to lift themselves out of poverty. Opportunity is close to making their millionth loan to the poor. The average first time loan amount is $84 and the loans have an astonishing repayment rate of 98%. Best of all, it’s a gift that keeps on giving as your contributions are recycled again and again as Opportunity builds up a larger and larger base of capital to loan out.

December 8, 2006 Posted by | Economics, Investing, Philanthropy, Spirituality | Leave a comment

Keep the Change Yourself

Bank of America (with a horde of other banks on its heels) launched its Keep the Change promotion a year ago. Since then, 2.5 million people have been suckered into this folly. Unless you lack even the basest levels of discipline, this is a bad way to save. These days even checking accounts pay interest and there is virtually no reason for your money to languish in a savings account. Even if you do like to keep a rainy day emergency fund in cash, a money market account is a far better option for temporary savings.

Interestingly enough, the Keep the Change promotion was the cunning invention of IDEO (an outsourced design operation) after Bank of America approached them with a request for “ethnography-based innovation opportunities” (an alarming choice of words even if unintelligible). Apparently the target market was boomer-age women with kids.

Most people should have cash lying around in no more than 3 accounts:

  1. A checking account [day to day cash needs]
  2. A money market account or CD [ 3 – 6 month reserve fund for when disaster strikes ]
  3. A brokerage account [ cash sitting in a money market fund waiting for deployment into your stock/bond portfolio ]

Stashing a few cents a day into a savings account which pays an interest rate below inflation is a recipe for the cat food you will be eating in your old age unless you take charge of your financial life.

November 27, 2006 Posted by | Investing | 1 Comment

Asset Allocation in 30 Minutes a Year

Many people, after finally saving up a modest nest egg, are faced with the dilemma of what to invest it in. For those who don’t have any interest in spending the rest of their lives following stock tickers and listening to analyst conference calls, the following approach can be implemented extremely easily, is very cost effective, and should take less than 30 minutes each year to maintain.

This approach is suitable for people who a) have saved at least $5,000 and b) are aged 10-60. If you are older than 60 you should probably adopt a more conservative approach. If you have less than $5,000 you should spread your investments over fewer funds else trading fees will dampen your returns considerably.

At a high level, you allocate your investments as follows:

60% stocks

20% real estate

10% bonds

10% commodities

There’s no real magic to this. It just depends on how risky you want your portfolio to be. If you already own a house, I would probably halve the real estate section and increase the rest.

Then the allocation to stocks I break down as follows:

60% US stocks

40% International stocks

That is a good mix given the increased participation in the global economy of the rest of the world and helps guard against currency fluctuations of the dollar.

The US stocks I break down as follows:

33% Large cap stocks

33% Medium cap stocks

33% Small cap stocks

The international equity allocation I break down into:

50% Emerging markets (South Africa, China, India, Brazil, Russia etc.)

50% Developed markets (Europe, Japan, etc.)

For the bond allocation, I recommend a broad-based bond index fund (a mix of long-term and short-term bonds). For real estate you can only really invest in commercial real estate (office buildings, shopping centers, apartment complexes). You then round out your portfolio with an allocation to commodities: oil and precious metals.

Putting that all together works out to the following target portfolio (with ticker symbols and fees of representative index funds in brackets):

12% Large cap US stocks [ VV, 0.07% ]

12% Medium cap US stocks [ VO, 0.13% ]

12% Small cap US stocks [ VB, 0.10% ]

12% International : Emerging market stocks [ VWO, 0.25% ]

12% International : Developed markets stocks [ EFA, 0.35% ]

20% Commercial real estate [ VNQ, 0.12% ]

10% Bonds [ AGG or VBMFX, 0.20% ]

10% Commodities [ IGE, 0.48% ]

If anyone finds a comparable fund with lower expense ratios, please leave a comment and I’ll update this list. For instance, in the emerging markets I have substituted VWO for EEM. The former has fees of 0.25% versus 0.75% for the latter. It should be possible to create a portfolio with a blended fee of 0.14% or less.

I generally prefer the exchange-traded funds as it makes it easier to keep all your investments in one place. I recommend E*Trade for a good blend of low fees, ease of use, and reasonable service. The disadvantage is that you have to pay a fee each time you trade whereas at Vanguard you can add money whenever you feel like without paying a broker fee.

Arranging the list in order of decreasing risk would give:

12% International : Emerging market stocks [ VWO ]

12% International : Developed markets stocks [ EFA ]

12% Small cap US stocks [ VB ]

12% Medium cap US stocks [ VO ]

12% Large cap US stocks [ VV ]

10% Bonds [ AGG or VBMFX ]

20% Commercial real estate [ VNQ ]

10% Commodities [ IGE ]

In the long run, the more risk you take, the higher your returns. The key term is “in the long run”. That’s why as you approach retirement you gradually make your portfolio less risky and weight it more and more towards bonds and fixed income securities. There is plenty of evidence that asset allocation is far more important in determining your eventual return than picking the exact stocks or countries to invest in.

The Barclays iShares web site (www.ishares.com) is the best thing since sliced bread and has pretty much everything you need to get started. Most of the funds are index funds which can be traded through an online brokerage like E*Trade.

Always try to find the funds with the lowest fees. High management fees are a vastly underestimated destroyer of long term wealth. You will always pay higher fees for international stocks and the more esoteric funds. You should definitely never pay more than 0.50% in annual fees. The highest fees are for emerging markets funds and specialty funds which should be around 0.45%. The lowest cost funds, like standard S&P 500 index funds, have fees below 0.1%. Fees tend to come down in the long run so keep reevaluating your choices. Always read the entire prospectus for any funds that you invest in so that you know what you actually own.

One slightly tricky part is balancing your asset allocation across your retirement/non-retirement/tax-deferred accounts. Thanks to the complexities of the US tax code there is no way around having three or four investment accounts. A good rule of thumb is to have the investments which pay dividends in the tax-sheltered accounts and the high-risk, high growth assets in the taxable accounts.

Finally, once you have got your asset allocation set up, you need to rebalance it once or twice a year. Since the various funds grow at different rates, eventually your carefully assigned percentages will be all out of whack. One solution is to add your latest contributions to whichever fund is the furthest off at the time. That way you end up investing new money in the funds which have performed poorly recently (buying low). At the beginning of each year, you can spend 30 minutes rebalancing your portfolio to make sure you remain on target. Resist the temptation to go with the latest fad sector. Investing is a long term discipline.

One last comment:

Your investing will dramatically improve if you read a few solid books that lay the theoretical groundwork for choosing where to put your hard-earned cash. I have read scores of books on investing and I would say that the ones that have most shaped my investing philosophy and have enabled me to outperform the S&P 500 for over 15 years are:

  1. Reminiscences of a Stock Operator by Edwin Lefevre
  2. The Intelligent Investor by Benjamin Graham
  3. Common Stocks and Uncommon Profits by Philip Fisher

Buffet describes his investment philosophy as 80% Benjamin Graham and 20% Philip Fisher. Reminiscences is a classic that has stood the test of time because it so accurately describes the emotional traps that lay in wait for the investor.

Advanced Topic

Finally, there is an excellent website, Asset Correlation, which dynamically calculates a correlation matrix for the major asset classes. It is important to check that you are suitably diversified if you decide to tweak my recommended asset allocation.

November 15, 2006 Posted by | Economics, Investing | , , , , , , , , , , , , | 5 Comments

Why Engineers Are Not Wealthy

I am an engineer at heart. Now, however, I work in the world of finance. I once asked why engineers in start up companies earn so little despite creating so much of the value. My partner’s answer was disturbing. Engineers, he said, want credit for being smart and that’s what we give them. Everyone else wants money, and that’s what they get.

I have another theory too. I have observed that engineers in private companies often have no idea how much of a company they own. They know how many stock options they have, but they have never thought to ask how many shares there are in the company. I once encouraged an engineer to ask the HR manager what fraction of the company she was being granted with her options. She was told that that information isn’t typically divulged and was advised to treat her options like a lottery ticket. I haven’t bought a lottery ticket recently but I understand that they’re only worth a dollar or so!

If you work for a private company, here’s how you can estimate the economic value of your stock options.

First, you need to answer the following questions (ask your friendly CFO for the answers):

  1. How many shares are outstanding
  2. What was the share price of the last financing
  3. How much common stock is outstanding
  4. How much preference there is in the company and if there is any multiple
  5. Whether the preference has participation.

Ideally, all this information is contained in a one page document called the “cap table” but the company probably won’t just hand it over to you.

What you really want to know is how much preference there is ahead of you. Basically, it works as follows:

Assume there have been 3 financings, series A, B and C. Those 3 financings are all preferred stock and will get paid out before any of the common stock (which is your options). So, as an example, let’s assume that the following financing’s happened:

A: $ 8M
B: $11M
C: $16M

The total is $35M. This is the preference which is “ahead of your options”. Thus, if the company is sold for $50M, the investors in Series A, B, C will first be paid out their $35M and then the remaining $15M will be split amongst the common stock. This is why you need to know what percentage you are of the common stock. Typical %’s of the total stock are

  • CEO: 6-8%
  • VP: 1-2%
  • Dir: 0.5 – 1%
  • Eng: 0.2-0.5%

Sometimes, though, the investments are structured with what is called a “multiple” (1.5x, 2x etc). For instance, a 2x multiple on all 3 rounds of investment would mean that there is actually $70M ahead of you, in which case, the company will have to be sold for $70M before the common stock will start to get paid out since the investors will first get double their money before any of the management team and employees get anything.

The other term often specified is something called “participation”. If the preferred stock has full participation, then, (assuming the 2x multiple) after the first $70M is paid out to the investors, what is remaining is then split between the common stock as well as the preferred stock.

If you’ve read this far and know engineers in a private company who can’t answer the question: “How much will you make if your company is sold for $150M?” then please refer them to this article. There’s no need to unionize. But there is a need to demand information.

November 10, 2006 Posted by | Engineering, Investing | 2 Comments

Peer-to-peer Lending

The internet continues to exhibit an untrammeled elimination of the middleman. A new company, Prosper.com, now allows direct person-to-person lending. I have set up standing orders (one of the best features of the site as it allows automatic bidding on the loan requests) and have created a loan portfolio with an even risk distribution. People submitting loan requests are graded with a risk rating from AA all the way down to HR (high risk) and NC (no credit rating). The risk ratings are based on the credit scores obtained from the credit agencies.

As of writing, Prosper has 90,000 members and has originated over $18 million in loans.

It appears that there is currently a far greater demand for loans than there is a supply of capital bidding on each loan. The implications for my risk-adjusted return are not yet clear, but I think it’s a great idea. 

October 21, 2006 Posted by | Internet, Investing | Leave a comment

Hedging your House

The Chicago Mercantile Exchange recently introduced housing futures and options. This is a long overdue idea and I look forward to the day when it is accessible to individual investors who don’t have membership on the exchange. The derivatives are based on the S&P Case Shiller Home Price Index, which tracks housing prices in ten major US cities. Interestingly enough, you can buy housing futures for 2007 at a considerable discount to today’s price.

September 18, 2006 Posted by | Housing, Investing | Leave a comment

Management Fees Kill

If you don’t believe that high management fees represent a massive transfer of wealth from the public to the investment bankers who charge the fees then consider the following: You leave college at the age of 21 with a hard-earned engineering degree and your head full of Maxwell’s equations, the Church-Turing thesis and Graham’s Law of Diffusion. Your starting salary is $75,000 per year, grows with inflation, and you dutifully save 5% each year until you retire at the age of 65. By the age of 78 you will have $1,500,000 if you invest in mutual funds which return 7% (a conservative, long-term equity return) and charge you a fee of 2%.

If, instead, you bought a low-cost index fund which returned an identical 7% but only levied an annual fee of 0.2%, you would have $3,000,000 at the age of 78. And your mutual fund manager’s trust fund kid wouldn’t be driving past you in a Ferrari.

September 11, 2006 Posted by | Engineering, Investing | 10 Comments

Why Investment Bankers are Wealthy (cont.)

I wrote last week about the issues of fees in the investment industry. Now it appears that state governments are so enamored with the venture industry that they are investing on margin. According to VentureWire:

Deutsche Bank AG is emerging as a leading source of capital for private equity funds of funds sponsored by state governments.

In the latest instance, Michigan Gov. Jennifer Granholm announced this week that Deutsche Bank had ponied up $200 million to finance the state’s Venture Michigan Fund, which is a fund of funds earmarked for regional venture capital funds.

The Venture Michigan Fund is the second state-sponsored fund of funds that Deutsche Bank has financed. Deutsche also supplied Utah with $100 million for its Utah Fund of Funds in March. That vehicle invests more broadly in in-state venture capital and buyout funds.

Deutsche is said to be negotiating with other states that are also in the process of setting up funds of funds, a person close to the issue said. Deutsche declined to comment.

The Venture Michigan Fund is managed by Credit Suisse’s Customized Fund Investment Group, while the Utah Fund of Funds is overseen by Ft. Washington Capital Partners.

Rather than serve as a traditional investor, Deutsche acts more like a lender to the funds of funds. Both Michigan and Utah pay interest on the value of the bank’s commitment. In the case of the Venture Michigan Fund, the state pays Deutsche more than 6.5% interest on the $200 million it is supplying. And if the fund of funds’ investments fail to generate enough profits to cover the interest payments, Deutsche receives tax vouchers for the full amount as a backstop.

This is the kind of crass stupidity from politicians that bolsters the argument for limited government.

August 29, 2006 Posted by | Investing, Politics | Leave a comment

Why Investment Bankers are Wealthy

A large amount of the money flowing into private equity and venture capital comes from pension funds. Typical venture funds charge 2.5% fees annually. The pension fund managers also charge a fee (around 0.3%) to manage the entire pension fund. Often, there is an additional layer of fees if the pension fund manager decides to access the venture capital asset class through a fund-of-funds. Fund-of-fund managers typically charge 1% for their services (picking the underlying venture funds). The total fees that an 85-year old nurse is being charged on her pension is therefore close to 4%. And this does not even take into account the 20% of any profits which are allocated to the VC’s, the 5% of profits added to the fund-of-funds manager and the bonus allocated to the pension fund manager.

All this leads me to my broader point: why are people content to give up almost 5% of their life savings annually. The long term returns on stock investing is 8-9% depending on the time frame and those returns are easily accessible to anyone through low cost (<0.2%) exchange-traded index funds. It is unlikely that venture funds will return in excess of 15% annualized IRR over the next few decades. And even if they do, all the compensation for taking on the additional risk goes to the finance industry.

There is a similar phenomenon in the public markets. Mutual fund fees are often as high as 2%. Why are people willing to pay those fees when there is an abundance of evidence that the vast majority of fund managers underperform the indices they are attempting to track?

August 25, 2006 Posted by | Investing | 3 Comments