Felix Salmon

The Dangers of Listening to David Swensen

Reuters Staff
Mar 18, 2009 18:17 UTC

Dan Golden profiles David Swensen for Portfolio magazine:

On the other hand, Swensen points out, he’s still beating the stock market, which has slid by an even greater amount. When critics deride the performance of alternative investments, “they aren’t asking, ‘Relative to what?’ Hedge fund returns are negative. That’s very disappointing, but they’re still far superior to equity returns,” he insists, spinning the numbers like a campaign manager.

Is this just spin, or is there something to it? The fact is, as Dan told me, that it really doesn’t make sense to compare Swensen’s returns to a hypothetical endowment invested wholly in the stock market — because his big idea of picking up illiquidity premiums by investing permanent capital in highly-illiquid investments has been pretty much universally adopted by endowments at this point.

And besides, endowments were never invested 100% in equities, even long before Swensen arrived on the scene.

As Aaron Pressman points out, Swensen’s investment advice when it comes to retail investing hasn’t done so well of late:

If you take a simple mix of exchange-traded funds, allocate per Swensen’s book and look at the results over the past year, the bottom line is pretty ugly: -32%. That beats the S&P 500, but it’s much worse than a simple mix of say 70% U.S. stocks and 30% bonds, which lost only 25%. A 60/40 mix dropped 19%.
And a year-end rebalancing wouldn’t have helped — at least not yet. If you set Swensen’s allocations up at the beginning of 2008 (and lost 23%) and then rebalanced at the beginning of 2009, you’d be down 17% so far this year. But if you let your winners ride, so to speak, and went with the portfolio as it stood, you’d only be down 12%.

Swensen does seem to be a very good portfolio manager when it comes to managing his own billions. Whether or not he’s a good person to listen to when it comes to investment advice, however, is another matter entirely. If your name isn’t David Swensen, there’s very little chance that the Swensen technique will do as well for you as it does for him.

Reprinted from Portfolio.com


there is a really big problem with this column
you compare ONE known thing (swenson’s picks) with two things (70% U.S. stocks and 30% bonds, which lost only 25%. A 60/40 mix dropped 19%.) that are picked out of an infinite variety of things.
so, the correct logic is
If you had a choice of Swensens asset allocation, or you had had to choose from an infinite vareity, what is the chance thatyou would have done better then swenson ?
Mr Salmon provides no clarity to the reader with his column.

Posted by ezra567 | Report as abusive

Taxing the $5 Million-a-Year Brigade

Reuters Staff
Mar 18, 2009 12:13 UTC

David Leonhardt wants to hike taxes on the very highest earners:

Today’s tax code makes no distinction between income above $373,000 and income above, say, $5 million. Both are taxed at 35 percent.
That is a legacy of the tax changes of the early 1990s, when far less of the nation’s income went to millionaires. Today, you can make a good argument for a new, higher tax bracket on the very largest incomes. In the past, the economist Thomas Piketty says, higher marginal tax rates tended to hold down salaries and bonuses, because executives had less incentive to angle for multimillion-dollar pay.
Do these ideas stem in part from anger and bitterness? Of course they do. How can you not be a little angry and bitter about the role that huge, unjustified pay played in causing the worst recession in a generation?
In fact, that’s sort of the point. Given the damage that’s been caused by our decidedly unmeritocratic system of paying executives, the most irrational course of all would be the status quo.

Creating a new tax bracket for people making more than $5 million a year wouldn’t raise a huge amount of money for the government, but that’s not the point — just as the reason that people like me want to claw back bonuses from AIG has nothing to do with recouping any significant portion of the money that the government has poured into the insurer.

The point is that incentives matter, and that if you skew people’s incentives with horribly-designed winner-takes-all pay structures, you’re liable to get extremely nasty consequences.

I’m reminded of Dan Ariely’s TED talk on cheating: if you create an atmosphere where large sums of money start to lose all meaning, people are going to cheat more. And when pay soars past the $5 million-a-year mark, it no longer has any connection to expenditures: it’s just a race, really, to see who can make the most money.

One person infected by such a mindset is Evan Newmark, who’s nicely stilettoed by Ryan Chittum:

Think about your own behavior in the giddy pre-Crash years. Did you bully a raise from your boss when one of your colleagues left? Did you buy a little condo in Miami to cash in on the boom? Did you throw more money into brokerage stocks as they rose higher and higher?

Well, outside the bubble the answers for 99 percent of us are : No, no, and no.

Is it the job of fiscal policy to create a tax regime which mitigates against the formation of devastating bubbles? I don’t see why not; it might even fit in with the behavioral-economics bent of the Obama team. But still, I doubt this is going to happen: it’s quite un-American. Many people work very hard, in this country, because they dream of one day pulling down a spectacular seven-or eight-figure income. Does Obama really want to kill that highly-motivating dream?

Reprinted from Portfolio.com

Kanjorski Meme Update

Reuters Staff
Mar 18, 2009 10:59 UTC

The Investment Company Institute, the mutual-fund industry group, today released a massive 228-page report on what has happened to the money markets over the course of this crisis and how they should change in future. There are lots of recommendations, most of which make perfect sense to me. But I’m particularly interested in Section 6 of the report, which gives a very detailed 22-page history of what exactly happened to the money-market industry in September 2008.

If you recall, according to the Kanjorski meme (both Mark 1 and Mark 2), there was significant direct intervention by Hank Paulson in the week of September 15 to prevent hundreds of billions of dollars of redemptions from money-market funds. But there’s no hint of any such intervention in the ICI report.

The report gives great credit to the government actions which did take place that month: bailing out AIG, implementing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility, and announcing the Temporary Guarantee Program for money market funds. Concludes the report:

The U.S. government’s programs were highly successful in shoring up confidence in the money market and money market funds. Immediately following the difficulties of Primary Fund, assets in institutional share classes of prime money market funds dropped sharply as institutional investors, seeking the safest, most liquid investments, moved into institutional share classes of Treasury and government-only money market funds and bank deposits. Within a few days of the announcements on September 19 of the Treasury Guarantee Program and the Federal Reserve’s AMLF program, however, outflows from institutional share classes of prime money market funds slowed dramatically. Indeed, by mid-October, the assets of prime money market funds began to grow and continued to do so into 2009, indicating a return of confidence by institutional investors in these funds.

There’s nothing here about personal intervention by Paulson — and indeed everybody I’ve spoken to who knows about the workings of the money-market fund industry says that it’s basically impossible that Paulson could have even gotten the information about the redemptions before they occurred, let alone phoned anybody up and persuaded them to change their mind.

The ICI report is at this point the definitive history of what happened to money-market funds in September 2008; if it says nothing about phone calls from Treasury to prevent a meltdown, I’m inclined to conclude that such phone calls never happened. It’s pretty much impossible to prove a negative, and I’m still interested in learning where Robert O’Quinn, the author of the House Economic Committee report making the assertion, got his information. But for the time being I think we can lay the Kanjorski Meme to rest.

Reprinted from Portfolio.com

Sorkin Smackdown Watch, Anna Gelpern Edition

Reuters Staff
Mar 18, 2009 08:57 UTC

Andrew Ross Sorkin used his column yesterday to push "the sanctity of contracts" in general — and of AIG guaranteed-bonus contracts in particular. Lawyers, in general, were not impressed. John Carney responded quickly:

I don’t see anything about voiding the contracts on the grounds of public policy as violating the sanctity of contracts.

And now Anna Gelpern gives chapter and verse:

Enforcing contracts where private parties have no money means either suffering default and firm failure, or using public funds to pay up on the parties’ behalf. The alternative is using government power to rewrite the contracts.
There is no doubt that the U.S. Congress has such power aplenty. In an article coming out in the Southern California Law Review, Adam Levitin and I examine Supreme Court jurisprudence assessing the veritable extravaganza of contract rewriting in the New Deal. In opinions spanning over two decades, the Court was unequivocal: the government’s power to regulate the economy, not just to manage economic emergency, trumps private contracts.

It’s pretty obvious that in the midst of a financial crisis, there are lots of things more important than the sanctity of contracts entered into by a company which, were it not for hundreds of billions of dollars of government cash, would by now not only be in liquidation, but which might well have dragged a large part of the global financial system down with it. To put it bluntly, those contracts ain’t worth shit.

But even then l like the idea of simply applying a surtax to the bonus payments rather than abrogating the contracts. If there’s a way of clawing back the bonuses which doesn’t involve abrogating contracts, then why not use it?

Reprinted from Portfolio.com

Extra Credit, Tuesday Edition

Reuters Staff
Mar 17, 2009 23:44 UTC

Should Yuppies Take Food Stamps?

Andrew Ross Sorkin: We Have To Pay The AIG Bonuses: Carney disagrees.

Betting your views, follow-up: The main reason not to bet your views, I think, is that in doing so you artificially exaggerate the overconfidence bias that all of us are already prone to.

Reprinted from Portfolio.com

AIG Non-Story of the Day, Hedge Fund Edition

Reuters Staff
Mar 17, 2009 23:43 UTC

Serena Ng has the non-story of the day, but given the general brouhaha surrounding AIG, you can be sure that all manner of noise will surround it. AIG was a net seller of credit protection on mortgages; it lost a lot of money. Credit default swaps are a zero-sum game, so that means the net buyers of credit protection on mortgages made a lot of money. Among those buyers of credit protection were hedge fund mangers like Steve Eisman, who was famously profiled by Michael Lewis.

Follow the string far enough, then, and you can quite easily manage to justify a headline like "Hedge Funds May Get AIG Cash". But the crazy thing is that the hedge funds didn’t even buy their protection off AIG. They bought it from a special-purpose vehicle as part of a deal to create synthetic CDOs; AIG was then brought in to insure the most senior parts of the structure. The connections here are tenuous, and boring. But of course that won’t stop the pro-forma expressions of outrage.

Reprinted from Portfolio.com

IM Outtake of the Day, CDS Edition

Reuters Staff
Mar 17, 2009 15:41 UTC

From an IM conversation between me and Jesse Eisinger, in the wake of my post earlier today:

Jesse Eisinger: Of course a cause of the financial meltdown is the CDS market. Just because it didn’t START there and that there are OTHER causes doesn’t mean the CDS market functioned fine and didn’t fail. Of course it failed. Miserably. And if the government didn’t have its head up its ass, it would have given all those wildly irresponsible AIG counterparties a massive haircut.

Felix Salmon: The CDS market failed (only) insofar as triple-A monolines wrote more protection than they were able to cover — AIG being by far the most egregious offender in this respect. The US government stepped in to backstop the insurance that AIG wrote, and as a result there were no further systemic consequences of AIG’s irresponsibility.
What’s more, AIG’s CDS contracts were generally large bespoke deals with commercial banks; they didn’t conform to ISDA documentation and were pretty much outside what most of us considered to be the two-way CDS "market". That market didn’t fail at all. In any case, I fail to see how the CDS market — even broadly understood to include AIG — was in any way responsible for the financial meltdown. Maybe it would have been, had AIG not been bailed out. But AIG was bailed out, so it wasn’t.

I have a copy of Gillian Tett’s new book in galleys; I’m reading it right now, and I’ll have more on this subject when I’m done. Tett and Eisinger are both smart and astute journalists who are convinced that the CDS market really did cause a large part of the financial and economic crisis that we find ourselves in today. I can half see it: is it that the existence of the CDS market gave banks false confidence that they could lay off credit risk in huge quantities, even while nominally keeping hundreds of billions of dollars worth of assets on their books? But I’m not fully convinced. More anon.

Reprinted from Portfolio.com

Caribbean Leverage Datapoint of the Day

Reuters Staff
Mar 17, 2009 15:20 UTC

Alea finds a speech from the governor of the Trinidadian central bank, which reveals that the country’s largest financial-services company, Clico, had assets of $24 billion but that local regulators required it hold just $3 million in capital. "This is what I call real leverage," notes Alea, drily: "8000/1".

Shortly after the Stanford scandal broke, I had brunch with a Trinidadian friend who was worried that just about all of Trinidad’s banks were offering CDs paying suspiciously high rates of interest — not just in local currency, but in pounds and US dollars too.

After taking a quick look at what was going on, I reckoned that Trinidad’s financial institutions, while they might have been unwise, were not criminal Ponzi schemes: the rates of interest they were paying, while high, weren’t substantially higher than the Trinidadian government’s own cost of funds. A Trinidadian depositor is naturally taking sovereign risk, and is being compensated for the fact that risk is high.

In general, it has never been riskier to have your deposits in a small country with its own currency — just look what happened to Iceland. When the currency is pegged to the dollar or the euro (eg Trinidad or Latvia) you’re not much safer: as we saw during the Asian crisis and in Argentina, currency pegs tend to disappear overnight in times of crisis.

It’s also worth noting that most of Citibank’s deposits are held in its foreign branches, are not insured by the FDIC, and are subject to the sovereign risk of the country where they’re deposited. Those depositors aren’t just taking Citibank risk: they’re taking increasingly-perilous country risk on top. If they decide to move their money somewhere safer, that could be a serious liquidity problem for Citi. It has built up a global franchise by being seen as something of a safe haven in small countries. As that reputation wanes, the value of its franchise likely wanes with it.

Reprinted from Portfolio.com

The Bonus Surtax

Reuters Staff
Mar 17, 2009 12:58 UTC

Chuck Schumer wants to tax "virtually all" of the bonuses being paid to AIG employees. The surtax being proposed by Gary Peters is 60%; presumably that comes on top of the regular federal income tax. But why stop there? If you set the surtax at, say, 150% of all bonus payments, then that would pretty much guarantee that the recipients would decline to receive them. Seems like an elegant solution to me.

Reprinted from Portfolio.com