Global Investing

Active vs passive debate: the case of “monkeys”

As CalPERS considers switching all of its portfolios to passive investing,  questioning the effectiveness of active equity investment, there have been some interesting findings that would stir up the active vs passive debate.

Researchers at Cass Business School find that equity indexes constructed randomly by “monkeys” would have produced higher risk-adjusted returns (ie return adjusted by measuring how much risk is involved in producing that return) than an equivalent market capitalisation-weighted index over the last 40 years.

How does this work? Using 43 years of U.S. equity data, researchers programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample, effectively simulating the stock-picking abilities of a monkey.The process was repeated 10 million times over each of the 32 years of the study.  Nearly all 10 million indices weighted by chance delivered vastly superior returns to the market cap approach. Andrew Clare, co-author of the paper, says:

“The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques.  However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index.”

But investment advisers are not fully convinced that active is the way. A survey by housing investment specialist Castle Trust shows one in three advisers do not believe they can beat the index over five years. Sean Oldfield, chief executive officer, Castle Trust says:

Here comes the real

Inflation is finally biting Brazilian policymakers. The real strengthened around 1.5 percent last week without triggering the usual shrill outcries from government ministers. Nor did the central bank intervene in the currency market even though the real is the best performing emerging currency this year. The bank in fact shifted towards a more hawkish policy stance during its March meeting, a move that seems to have had the blessing of the government.

Friday’s data showed the benchmark consumer price index, IPCA,   up 0.6 percent for a year-on-year inflation rate of 6.31 percent. President Dilma Rousseff, who faces elections next year, took to the airwaves soon after to reassure voters about her commitment to taming inflation, announcing a series of tax cuts. That effectively is a signal that there is now no political constraint on raising interest rates. According to the political risk consultancy, Eurasia:

If the government doesn’t enact measures during the first half of this year to anchor inflationary expectations, Rousseff would run one of two risks. She would either run the risk of inflation starting to eat into the disposable income of families in a manner that could hurt her politically, or relatedly, put the central bank in a position of having to raise interest rates more aggressively later in the year to control inflation with more negative repercussions to growth.

Pension funds’ hedging dilemma

Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.

But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the  pension plan for employees – could go bust. Yet 84% of respondents fail to manage the sponsor risk.

So how do you hedge against such a risk?

You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”

Market exhaustion?

It’s curious to see so many asset managers reaffirm their faith in a bullish 2012 for world markets just as a buzzing first quarter comes to a close on Friday with hefty gains in equities and risk assets.  Whether or not there is a mechanical review of portfolios at quarter end, it’s certainly a reasonable time for review. The euro zone crisis has of course eased, the ECB has pumped the banks full of cash and the U.S. recovery continues.  So, no impending disaster then (unless you subscribe to the increasingly-prevalent hard-landing fears in China). But after 11+ percent gains in world equities in just three months on the back of all this information, you have to wonder where the “new news” is going to come from here. The surprise factor looks over and we’re highly unlikely to get 10%+ gains in global stocks every quarter this year.  So, is it time for tired markets to sober up for a while or maybe even reconsider the risk of reversal again? Strategists at JPMorgan Asset Management, at least, reckon the economic news has just lost its oomph.

There are broad signs of exhaustion in markets, which is coinciding with a softening in the data, suggesting that in the short term the moderation in the “risk on” environment may continue.

JPMAM cite the rollover in the Citigroup economic surprises indices, shown below, and also say their own propietary Risk Measurement index — a 39-factor model built on data from money markets, equities, economic data, commodities etc — is flagging more caution.

Three snapshots for Thursday

The VIX volatility index has fallen below the average level seen during the 2003-2008 pre-crisis period.

The low level of the VIX is also being matched by moves down in other ‘safe haven’ assets. The dollar is near an 11-month high against the yen, and a rise in U.S. Treasury yields is pushing up the spread between U.S. and Japanese bond yields.

President Barack Obama and British Prime Minister David Cameron discussed the possibility of releasing emergency oil reserves during a meeting on Wednesday, two sources familiar with the talks said.

Emerging Markets: the love story

It is Valentine’s day and emerging markets are certainly feeling the love. Bank of America/Merrill Lynch‘s monthly investor survey shows a ‘stunning’ rise in allocations to emerging markets in February. Forty-four percent of  asset allocators are now overweight emerging market equities this month, up from 20 percent in January — the second biggest monthly jump in the past 12 years. Emerging markets are once again investors’ favourite asset class.

Looking ahead, 36 percent of respondents said they would like to overweight emerging markets more than any other region, with investors saying they would underweight all other regions, including the United States. Meanwhile investor faith in China has rebounded  with only 2 percent of investors believing the Chinese economy will weaken over the next year, down from 23 percent in January. China also regained its crown of most favoured emerging market in February.

Last year, the main EM index plummeted more than 20 percent as emerging assets fell from favour. So what is the reason for this renewed passion in 2012?

Currency hedging — should we bother?

Currency hedging — should we bother?

Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.

Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).

For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).

from Davos Notebook:

Groundhog Day in Davos

groundhog

The programme may strike a different  note -- this year's Davos is apparently all about Shared Norms for the New Reality -- but much of the discussion at the 41st World Economic Forum annual meeting in Davos this month will have a distinctly familiar ring to it.

Last January, the five-day talkfest in the Swiss Alps was dominated by Greece's near-death experience at the hands of the bond market and recriminations over the role of bankers in the financial crisis, as well as worries about China's rapid economic ascent and a lot of calls for a new trade deal.

Fast forward 12 months and not much has changed.

Ireland has joined Greece in the euro zone's intensive care unit and Portugal and  Spain are getting round-the-clock monitoring. The annual round of bankers' bonuses is once again stirring up trouble. China looms larger than ever on the global stage, after overtaking Japan in 2010 to become the world's second-biggest economy. And trade ministers who signally failed to make headway last year say they really must get down to business when they meet on the sidelines of Davos this time round.

Act now or forever hold your (b)-piece, Obama

It appears the penny has finally dropped in Washington. Bank bailout watchdog Elizabeth Warren, chair of the Congressional Oversight Panel, has unveiled a report that outlines the shocking state of the U.S. commercial mortgage sector, which left unaided could spark “economic damage that could touch the lives of nearly every American”. The Havard Law School Professor and her panel colleagues are talking the kind of apocalyptic language that may just shake the White House and its star policy advisers into facing problems we have now rather simply obsess about those we may or may not encounter in the future. The global banking system may well need some kind of Volcker-esque guidelines to curb the next generation of excessive risk-takers but Obama is putting the cart before the horse in his efforts to haul the economy back on track. Certainly, his and the previous administration has toiled long and hard to stabilise the U.S. housing market, propping up Fannie and Freddie and their dysfunctional offspring, but the subprime mess has distracted attentions from the toxic commercial market, where the clean-up task is no less important. Warren reckons there is about $1.4 trillion worth of outstanding commercial real estate loans in the U.S that will need to be refinanced before 2014, and about half of them are already “underwater,” an industry term that refers to loans larger than the property’s current value. But bank brains are wasting too much time figuring out how the so-called “Volcker rule” might affect their operations and future profitability, instead of getting their arms around underwater real estate loans that could break their institutions in two long before the anti-risk measures even take hold. Obama’s premature challenge to their investment autonomy, which he says cultivated the collapse of banks like Lehmans, is like suturing a papercut while your jugular gapes wide open. Maybe now, as Warren’s report hammers home the threat posed by unperforming commercial real estate debt, Obama will give Wall Street a chance to refocus on the “now” and worry about “tomorrow”, tomorrow.

It appears the penny has finally dropped in Washington.

Bank bailout watchdog Elizabeth Warren, chair of the Congressional Oversight Panel, has unveiled a report that outlines the perilous state of the U.S. commercial mortgage sector, which left unaided could spark “economic damage that could touch the lives of nearly every American”.

The Havard Law School Professor and her panel colleagues are talking the kind of apocalyptic language that may just shock the White House and its star policy advisers into facing problems banks have now rather simply obsess about those they may or may not encounter in the future.

What worries the BRICs

Some fascinating data about the growing power of emerging markets, particularly the BRICs, was on display at the OECD‘s annual investment conference in Paris this week. Not the least of it came from MIGA, the World Bank’s Multilateral Investment Guarantee Agency, which tries to help protect foreign direct investors from various forms of political risk.

MIGA has mainly focused on encouraging investment into developing countries, but a lot of its latest work is about investment from emerging economies.

This has been exploding over the past decade. Net outward investment from developing countries reached $198 billion in 2008 from around $20 billion in 2000. The 2008 figure was only 10.8 percent of global FDI, but it was just 1.4 percent in 2000.