The Fund seeks to provide qualified investors with an opportunity to achieve long-term capital appreciation through investment in Emotional Assets. Its objective is to deliver a stable target growth rate of 15% per annum, with predictable volatility - at the same time preserving capital.

This is not satire. It’s real, and the fund manager is even giving quotes to the FT:

“Most fund managers over-promise and under-deliver. With emotional assets, there are no synthetic assets or fancy structures.”

Somehow the irony of a fund manager denigrating over-promising while still pledging to deliver stable 15% returns is never remarked upon.

In any event, I have it on good authority that next up will be the Emotional Liabilities Fund. Go ahead and monetize those neuroses!

Last Friday, Jason Kelly put up a very funny blog entry about his launch of a pair of fictional 100x levered ETFs, with the ticker symbols SOAR and SINK:

Kelly Capital will reset and relaunch the funds at the beginning of each trading day. The company is in talks with the Security and Exchange Commission (SEC) about the possibility of relaunching the funds after lunch should they go bust in the morning session, but the SEC is balking. SEC spokesperson Ben Meriwether remarked, “We recognize the right of investors to employ as much leverage needed to find fortune or ruin in a day, we just aren’t sure of the need to extend that right twice per day.”

By Wednesday, Kelly was depressed enough about the email traffic he got in response that he posted an update:

A full 65% of people expressed an interest in owning products that would “go bankrupt within the course of most trading days.” A stunning 5% thought they already owned them. Only 30% of respondents got the humor.

John Carney picked up the datapoint in a blog entry headlined “Is It Possible To Invent An Investment Product Too Stupid To Find Buyers?” — something I then tweeted.

What none of us appreciated, however, is that products much like these already exist. As Amy Nauiokas Sean Park rightly notes, in the spread betting market, which is huge in the UK and elsewhere, 50-1 leverage is common. IG Index, for instance, gives an example of how a £10-a-point bet on the FTSE can generate a gain of £560 — or a loss of £480 — in one day.

Spread bets don’t exist in ETF form, but they’re essentially the same thing, just much more highly leveraged than any fund. They’re hugely popular in the UK — which just goes to prove that yes, if you offer an insanely leveraged way of betting on intraday moves in stock indices, there’s no shortage of people who will flock to your door. Even in boring old England.

Bill Gross isn’t earning much interest on his cash: in fact, he’s only earning 0.01%. Tell us, Bill, what’s an appropriate metaphor to explain how it feels to earn such a low interest rate?

My point is to recognize, and to hope that you recognize, that an effective zero percent interest rate, as a price for hiding in a foxhole, is prohibitive. Like the American doughboys near France’s Maginot line in WWII – slumping day after day in a muddy, rat-infested pit – when the battalion commander finally blew his whistle to charge the enemy lines, it probably was accompanied by some sense of relief; anything, anything but this! Anything but .01%!

I’m not sure this is entirely fair. Think of the camraderie in those muddy foxholes! Think of all those meaningful religious conversions! Frankly, earning 0.01% interest on your money-market funds is much worse than that!

Or, you know, it could be a sign of how incredibly short memories are. A year ago — even six months ago — people thought that losing 30% or 40% or 50% of your money constituted something extremely painful. Now, it seems, making a small amount of money is analogous to fighting in the bloodiest war of all time.

Kid Dynamite today translates Gross’s column into Sensible, explaining that opportunities paying say 5% annualized become a lot more attractive when rates are at zero than they are when you can get 5% just by investing in Treasury bills. Hence assets yielding anything at all — even stocks — have become pretty popular of late, accounting for the impressive price rise since March. Still, he concludes, “this can only end one way… badly”. People aren’t asking that yields compensate for risk any more, they’re just asking that they pay more than nothing. Which is probably not the smartest manner of allocating capital ever invented.

As for Gross, his best advice is to buy utility stocks:

Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom.

Is that the new Goldilocks Scenario, I wonder?

Update: The quote above — which mangles history in unspeakable ways, as many commenters noted — has been changed on the Pimco website, which now talks about “the American doughboys near France’s future Maginot line in WWI”.

I was confused yesterday about currency ETCs; after a detailed conversation with Nik Bienkowski of ETF Securities, I think I understand them a bit better.

The answer to my central question about whether you can try to play the carry trade with these things is quite clear: it’s yes. The mechanism is just as commenter Daniel described it: the funds essentially buy currency forwards expiring tomorrow, sell them just before expiry, and roll over into a new short-dated forward. These forwards are extremely liquid, and since that constant rolling one-day exposure in the forwards market does an excellent job of reflecting the differences in local interest rates.

As a result, says Bienkowski, if the Aussie dollar ETC had existed for the past five years, holding it would have returned 4.8% per annum, before fees, over and above whatever you would have got from holding Aussie dollars alone. Fees are 39bp per year, accrued daily, so you genuinely can get a bit of carry out of these things.

So what’s all this about T-bill interest rates? It all comes down to the nature of the derivatives market. If I’m buying a forward expiring tomorrow and then selling it just before it expires, I don’t actually pay cash for the forward in one transaction and receive cash in a separate transaction when I sell it. Instead, the transaction gets netted out. If the currency has moved in my favor, I get paid a small amount of money; if it has moved against me, I pay a small amount of money. If it hasn’t moved at all, I get a tiny amount of money, corresponding to one day’s interest in local currency. Annualize that tiny amount of money, and you’re looking at the carry.

The investors, meanwhile, have put up an amount of money corresponding to the full notional amount of the underlying currency. That money needs to be invested somewhere, so it gets invested in T-bills. Hence the added T-bill interest rate. The T-bill interest rate isn’t large, but it’s the only actual interest paid on these instruments. The local-currency interest, by contrast, is basically an arbitrage condition: the forwards markets always reflect local interest rates because if they didn’t there would be a no-brainer arbitrage there. (This kind of arbitrage can fall apart during something as chaotic as the Icelandic devaluation, which was accompanied by the default of all the local Icelandic banks, but the currency ETCs invest only in G10 currencies, where that kind of thing hasn’t ever happened. Yet.)

The ETCs are dollar-denominated, and they all include either a long-dollar or a short-dollar position. The two facts cancel each other out, so if you’re a UK or euro investor who buys say the long Aussie-dollar ETC, you’re essentially getting direct exposure to the Aussie dollar in pounds or euros or whatever the currency is that you’re using to buy and sell the ETCs.

The ETCs are guaranteed to underperform their index, thanks to those 39bp in fees. But they shouldn’t underperform more than that, since Morgan Stanley has promised to pay the index return. “If Morgan Stanley didn’t pay us the index, they would be in default,” says Bienkowski. On top of that, much of the added complexity of the instruments is essentially designed to hedge precisely that Morgan Stanley counterparty risk.

Bienkowski is a fan of the instruments. “If you want to get access to foreign currency, I think these products are pretty good,” he says. “They aren’t leveraged, they’re not a CFD or a warrant. They’re basically bringing institutional money-market interest rates and spreads to the average investor. “

That said, currency ETCs are complex, and not easy to understand. There’s language in the prospectus about not buying them without talking to an independent financial advisor, but the fact is that most independent financial advisors aren’t going to be able to understand this prospectus very easily either. (Izabella Kaminska and I are at least as good at understanding these things as most independent financial advisors are, and we got very confused by them.)

If you’re a fan of the UK Financial Services Authority, you might take some solace in the fact that it has signed off on these currency ETCs; they fulfill its listing requirements as debt securities. “We’re bringing the wholesale currency market to a regulated exchange,” says Bienkowski. But the fact is that there’s still a lot of complexity here. In general it’s a good idea not to buy things you don’t understand, and there’s a lot of stuff in the prospectus which is difficult to understand.

On the other hand, historically it has been almost impossible for retail investors to play the carry trade, invest in foreign exchange, or in general diversify into fx as an asset class. If you’re worried that your investment currency is going to implode (be it dollars or pounds or anything else), then buying a few of these ETCs will give you some kind of hedge against that, helping to preserve international purchasing power. The underlying mechanics of them are not particularly pretty, but if you’re going to rely on the continued liquidity of any financial market in the world, the fx market is probably the best one to rely on: it’s incredibly liquid and robust.

Currency ETCs are very new and untested things, and so a sensible investor will probably hold off for a little while longer to see how they do. It might also be interesting to see whether and when a similar product might list on a US exchange. But in principle I can see why these things were invented, and I can also see why a certain class of globally-focused retail investor might be interested in buying them.

I got two smart responses to my assertion that there’s no safe haven for investors these days. Jared Woodard at Condor Options responded with 1,500 words on how investors in an S&P index fund can buy put options to protect their downside: “any hedging at all is better than none,” he writes. Meanwhile, maynardGkeynes left a much shorter comment:

TIPS are both easy and obvious.

Of the two, I prefer the TIPS. Why gamble in the stock market at all, if you don’t need to? Jared’s options strategy is akin to buying insurance that your bet won’t pay off, without stopping to wonder why you’re making the bet in the first place. The main advantage to the options strategy is that if things really blow up, and there’s a major stock-market crash on the order of 60% or so, you could actually end up making a profit. But I think an investor who was invested in TIPS during such a chaotic time would be perfectly happy with her choice.

There are two small problems with the TIPS strategy. One is that the tax implications of investing in TIPS can be extremely complicated, and taxpayers might want to consider the cost in accountancy fees before going down that road. The second is that it doesn’t scale: the whole point of financial markets is that they turn savings into investments, and we actually want people with savings to be willing to take a little bit of downside risk.

In that sense, Jared’s strategy of buying long-dated puts and selling them six months before expiry is better. It brings with it most of the upside associated with stock-market investments, it helps move money into equities (which, over the long term, is something society prefers to having it create bubbles in the debt market), and it helps the investor sleep at night with regards to black-swan events. What’s more, it involves a little bit of work: that’s a good thing, since investing shouldn’t be brainlessly easy. On the other hand, it also involves a significant transfer of funds from the Main Street investor to Wall Street, which always makes money on options trading.

Still, both strategies are worth considering for people with investments. In general, I’d recommend the TIPS approach to people who are likely to be able to make money the best way, by earning it: in that case TIPS are a safe place to put your hard-earned cash. (Especially if you are very unlikely to move abroad, and aren’t worried about a falling dollar except insofar as it feeds through into inflation.) On the other hand, people who are looking to earn money through capital rather than labor will probably not be happy with the modest return on TIPS and might be happier with Jared’s approach.

What happened to mutual-fund fees and expenses in the wake of the financial crisis? Lipper has crunched the numbers, and it seems that the tumble in the stock market didn’t have much effect on expenses:

Surprisingly, the median management expense for most asset classes was largely unchanged from 2008 levels; most exhibited changes of +/- a few tenths of a basis point.

Fees, on the other hand, are a different kettle of fish entirely:

70% of equity funds realized increases in total expense ratios from their most-recent annual report to their most recent semiannual report. Of those funds with increases, the average increase was +8.2 bps, while for the funds with expense decreases the average decrease was only -2.4 bps.

There’s even a helpful chart:

The reason for the fee hike becomes clear at the end: it’s being implemented in a desperate attempt to keep income from plunging along with the stock market.

Despite the increase in management fee ratios for many asset classes, the revenue derived from those fees has plummeted. We estimate that total revenue over the period examined by this report is down more than 40%…

The total dollar amount of fees collected by open-end funds appears to have declined by approximately 31% over the period examined by this report. This value is in spite of increases in realized expense ratios for many funds.

The lesson here is simple: Stop trying to beat the market, and move to index funds or ETFs instead. (Index funds weren’t included in the Lipper survey.) Mutual funds are moving away from being a mass-market product, and becoming more of a niche product aimed at elderly investors who don’t know any better and who don’t worry much about total expense ratios. The smart money’s moving out of mutual funds, to the extent that it was ever invested in those funds in the first place, and the dumb money that’s left over is largely price-insensitive. Expect these fees to continue to rise for years to come.

Charles Schwab has an interesting new idea: ETFs which are commission-free for Schwab brokerage clients. Ron Rowland is enthusiastic:

Just as no-load no-transaction fee mutual funds changed the mutual fund landscape, commission-free ETFs will forever alter the way that ETFs are perceived. With this one change, nearly every argument in favor of mutual funds instead of ETFs goes away. Dollar cost averaging? No longer costly with commission-free ETFs. Small account size? Not a problem anymore.

This isn’t entirely true. There are two main costs involved when you buy or sell equities, including ETFs. One, yes, is the commission. But the other is the bid-offer spread. And if the new Schwab funds remain relatively small and illiquid, it’s still going to be a bad idea to buy them, just as it’s a bad idea to buy any ETF with less than a billion dollars or so in assets.

That said, Schwab is big enough that it should be able to get there pretty quickly. And at that point, if you’re a Schwab client, these things will look very attractive indeed.

Michael Osinski has an interesting article on nymag.com about how he, a CMO-structurer-turned-oyster-farmer, is playing in the riskier end of the distressed-debt market.

I have no illusions about the risk of what I’m doing. Buying mortgage-backed bonds today is putting your finger to the wind in a storm, like you’re standing on a seawall facing a nor’easter. You know the second wave of defaults is coming. It’s forming out past Montauk, swelling in Gardiners Bay, about to smash into your seawall. Will it knock you down, rip your boat from its cleats, and scatter your oyster cages all along the rock pile?…

I buy my bonds through a former colleague named T…

You have to treat every bond like a time bomb, carefully assessing how much time you’ve got before it blows up in your face.

T. is selling me CMO bonds. I’ve bought seven of them in the last three months.

It’s a good, well-balanced piece, which shows how a sophisticated financial market professional is taking very careful and calculated risks with money he can afford to lose. He also knows, of course, that if he does end up losing that money, he has no one but himself to blame.

And then, at the end, it goes horribly, horribly wrong:

So how can you consider joining Michael Osinski and invest in toxic assets?

No!!!

The answer to that question is Do Not consider joining Michael Osinski. Do Not invest in toxic assets. And, whatever you do, Do Not start buying shares in things like BKT and HSM and TSI and FMY and HTR — ticker symbols all helpfully provided by nymag.com — especially if you think that in doing so you’re somehow replicating what Osinski is doing. You’re not.

Osinski is buying a very small number of very carefully-vetted bonds. This is the classic “PA” trade, where financial market professionals buy obscure instruments for their personal account in sizes which simply don’t scale up to the sort of money thrown around by institutional investors. Osinski’s bought seven bonds in three months, and I’m sure he went over each and every one in great detail with his friend T. That’s small-scale, highly-informed investing — the exact opposite of throwing your money at the Helios Total Return fund and hoping for the best.

Yes, the website does urge its readers to “be especially careful here”. But that doesn’t excuse spending 600 words on what you should do if, in a moment of recklessness, you decide that you want to ape the investing strategy of an oyster farmer who has just written a feature article for nymag.com, and who knows much more about what he’s doing than you ever will.

The WSJ’s Eleanor Laise finds that the market in bond ETFs is rather messy, to say the least:

State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%. Part of the problem: The index contained some lower-quality bonds that the ETF couldn’t get, and when those bonds rallied, the fund got left behind, says Jim Ross, senior managing director at State Street.

The benchmark in question, it’s worth noting, is the Barclays Capital High Yield Very Liquid Index. That’s evidently “Very Liquid” as in “can’t find these bonds to buy no matter how hard we try”.

The lesson of this story is that ETFs don’t work when they’re investing in instruments which aren’t exchange-traded:

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market. For most bonds, there is no centralized exchange matching bond buyers and sellers, and different market players can assign very different prices to the same bonds. Many bonds don’t trade for days at a time, and when they do, they can be costly to buy and sell.

It’ll be interesting to see whether anybody tries to launch an ETF based on a liquid, exchange-traded CDS index. That might solve most of these problems, but I know a lot of people who would be dead-set against such a product, since its very existence would imply the dreaded “naked shorting” of CDS by dastardly speculators. Is a failed investment product better than a liquid derivatives market?

Most investors have a significant exposure to bond funds. But according to S&P’s latest SPIVA report — by far the best comparison of fund performance to underlying indices — nearly all of those bond funds have underperformed their indices:

In case you can’t see this clearly, it says, among other things, that over the five-year period ending June 2009, 92% of investment-grade long funds have underperformed the index, 98% of mortgage-bond funds have underperformed the index, and 94% of general muni funds have underperformed the index. If you bought a California or New York muni fund, you had a 100% chance of underperforming the index.

Sam Mamudi, reporting on these results for the WSJ, puts them in the context of “the debate over passive versus active mutual-fund investing” — but he leaves out a crucial piece of information: passive investing in bonds is non-trivial. If you look at the performance of equity funds against the S&P 500, say, you can do so in the knowledge that it’s pretty trivial to buy an index fund or an ETF which will give you something very, very close to the performance of the index. With these bond indices, however, that’s not the case.

There are some bond ETFs: iShares, for instance, has a pretty broad suite of them. Most of them are pretty young, having been launched in 2007 or later, but there are a couple of older ones, such as the 20+ year Treasury bond fund (TLT). If you look at the information iShares provides, however, it’s really hard to tell how good the fund is at replicating the return of the index. We know that on June 30 its net asset value stood at 94.62, up from 83.41 five years previously; we can also find out that over that time the fund paid out 20.435 in dividends. You don’t want dividends, or you find them expensive to reinvest? Tough luck. We also know that the benchmark index increased from 237.77 to 388.29 over that time.

The index, then, increased over the course of those five years by an annualized 10.3%. If you just add the dividends onto the net asset value for the fund, you get an increase from 83.41 to 115, or 6.6% annualized. That’s pretty much in line with the 6.94% weighted average annualized return for long government bond funds generally.

What happens if you run the same exercise for IVV, iShares’ S&P 500 index fund? The index went from 1661.53 to 1498.94. The fund, meanwhile, went from 113.26 to 92.24 with 12.3185 in dividends. The index’s annualized return was -2%, while adding the dividends to the NAV of the fund gives an annualized return of -1.6%. The index fund outperformed the index, on this methodology, partly because you weren’t reinvesting dividends in a falling asset, but also because dividends are lower on stocks than on bonds, even government bonds.

But all of that is just doodling, really. The important thing to remember when it comes to bond funds is that realistically you should only be comparing managed bond funds to index bond funds, rather than to indices directly. After all, your choice isn’t between investing in a managed bond fund and investing in an index, it’s between investing in a managed bond fund and investing in an index bond fund. So while it’s true that a startlingly high percentage of managed bond funds underperform their index, it’s not necessarily true that the same percentage of those funds underperforms an index fund linked to the same benchmark.

Update: Wcw, in the comments, points me to this document, in which iShares says that the five-year return to end-June 2009 of the TLT fund was 7.25%, while the index return was 7.32%. The return on IVV was -2.28%, while the return on the S&P 500 was -2.24%. Even the TIPS bond fund, which Pimco disparages so, returned 4.80% to the index’s 4.94%. I would assume, of course, that these returns assume no commissions or bid-offer spreads when buying or selling the funds, or reinvesting dividends.