Personal Investment Tips And Guide

Martin Barnes' Response

2011-05-31T10:24:00.000-07:00

As far as the global picture is concerned, I suppose one question is whether the crisis that started in Asia represents a failure of the free-market system, as some have contended. I do not believe so and I would argue that the move to more open markets simply exposed the fault lines created in economies where market forces were being suppressed or distorted by government intervention, crony capitalism and a lack of financial transpar ency. One could further argue that the growth of information technology will force governments to be more open to the benefit of long-run economic prospects. Perhaps there is no room for the middle ground. Governments will have to decide to either fully embrace a free-market model or impose a closed siege economy, with all that entails. The latter will be increasingly hard to do, however, in an information age of e-cash, the internet etc.

Perhaps it is not so much a new global financial architecture that is needed as a more open endorsement of free-trade principles. Of course, there will always be lots of volatility in capital flows and often these can be destabilizing to individual economies. I would have thought that such problems could be dealt with by micro-policies aimed at controlling certain types of short-term capital flows.

I continue to be struck by the growing divergence between the US and overseas economies. It has long struck me that Europeans have always misunderstood and underestimated the strength of America. They find the US political system chaotic compared with a parliamentary system, but fail to take account of the checks and balances. They mistakenly think that many of the new jobs are hamburger flippers, they are obsessed with the US crime rate and income inequalities. Yet look at the record: who has fast growth, low unemployment, a budget surplus, a lead in high-tech innovation, etc., etc.? Certainly not Europe!

Yes, the United States cannot remain an island of prosperity in a global sea of depression, but the benefits of having a flexible and dynamic economic structure will become increasingly important in the new global economy and the United States has a big advantage on that score. Could the United States remain in a long-wave upturn while the rest of the world flounders? It would not seem possible yet we cannot rule it out. Most likely, I suppose that building global deflationary forces would eventually crush the US stock market and that could unleash a very bearish cycle of negative feedback loops.

Counterpoint to Martin Barnes' Theory ''

2011-05-31T10:21:00.000-07:00

Money makes the world go round," went the song from The Threepenny Opera and it does. But the theory of money is often misunderstood. Many of us think of money as a thing, as a constant, as capital, as something that can be preserved. We forget that money is not a thing. It is a promise a promise amid a chain of other promises. And if any part of that chain breaks and cannot be replaced by some stronger action or force, or replaced within the chain itself, then all the promises are broken. Money is now shrinking on a global basis, and shrinking very drastically because we are doubtful that the promises can be kept.

Old ideas are abandoned only when they have proven faulty, and surely many of the premises of the international monetary system have given a resounding signal that they are no good. Despite the work and the money spent in studying global economics, we know very little. Largely, we are studying old, outmoded precepts. We can do no harm by accepting the challenge to use complexity to find new ones. When we incorporate the principles of complexity, we have a chance, just a chance, to understand this adaptive world better.

For example, the conventional IMF view of development says that sound policies tight money, balanced budgets, flexible labor markets will attract capital, boost exports and help promote non-inflationary economic growth. Indeed, much of the work of the IMF is offering macroeconomic policy advice that politicians can sell as their own, and promoting microeconomic reforms that might otherwise be politically unacceptable. A complexity view, in contrast, suggests that economies are not necessarily homogeneous and that growth can come in many forms: through internal demand as in China as well as through exports as in the Asian tigers prior to the crisis.

There is an idea on the part of developing countries that prescribed behavior democracy, human rights, environmental concerns will lead to cheap, long-term money. It is quite possible that the advice of the post-war period for development of war-ravaged areas was good for the early days of developing markets, coupled with large amounts of money when none other was available. But it may be that growth, at whatever cost, is more necessary. And post-war Japan under General MacArthur and Chile under Pinochet were hardly paragons of democratic virtue. The advice prescription from complexity is to adapt to the times.

The financial collapse in Russia has further lessons. The IMF has come to be viewed as global lender of last resort during a liquidity crunch, though this role was not spelled out at Bretton Woods. And the crisis has shown the institution to be no longer effective on the global scene. It is out of money, with the US Congress, among others, refusing to give it more, and it is unable to stop the flow of crisis from Asia to Japan to Russia, potentially back to China, Eastern Europe, and maybe even back to the United States. The system is broken and it seems unlikely that we can fix it at the same time as we are putting out fires. Building a new "international financial architecture" is a global issue and it will take a global

Martin Barnes, the International Money Expert

2011-03-31T10:52:00.000-07:00

Martin Barnes has a tough job. He took over the editorship of the Bank Credit Analyst, the leading newsletter of international monetary commentary, from Tony Boeckh, who put the publication on the map. Following Boeckh, who in turn had succeeded the newsletter's founder, Hamilton Bolton, was no simple task. Barnes had to be balanced but appeal to the generally conservative, absolute return clientele that he served. And he did it in a masterly way so that now the BCA, as the monthly publication is informally called, carries his stamp.

Barnes is the serious Scot of literature. But talking about finance and global figures brings forth a twinkle. He finds global finance a world of amazement and wonder. And his charge is to survey it all, to sort and make something of the pieces he likes. He brings a classicist's range of intellect to the task. And numbers are the language of his choice. Give him a set of data, and he is likely to produce a chart, perhaps going back fifty years, illustrating a parallel to the conditions he sees today.

Barnes is a real long-termer in a market where the long term typically means a week or a little longer over holidays. Thus he has trouble with the market demands of hour-by-hour trading insights. His tools are not that fine but rather suited to cycles: one of his favorites, for example, is long-wave dynamics, which have a periodicity of about 60 years. But Barnes balances the demand for nowism with perspective. And he, Boeckh and their colleagues have broadened the geographic coverage of the BCA and its stablemate publications in the BCA group to cover with equal intensity every developed market, most major developing ones and all instruments. If you had to choose between a daily chart book or the BCA, you would be better off taking Barnes' work. It not only tells you where you are on the investment map but, more importantly, which map you have.

Barnes' research and writing cover a broad spectrum of subjects of relevance to investors. In the past few years, he has written extensively about new technologies and long-wave cycles, the financial market implications of low inflation and trends in corporate profitability.

What is International Money ?

2011-03-31T10:49:00.000-07:00

Investment decisions must increasingly be made with an eye on what is happening throughout the world economy. As barriers to trade and financial flows between countries have come down, the global movement of goods, services and capital has made national economies more and more interdependent. Daily currency flows approximate four months of world trade. A single country's long-term financial plans can be swamped in a few days by ravenous traders sensing weakness. And watertight doors of credit agreements and domestic central banks collapse under the weight of collective monetary movements.

In these circumstances, it is no longer possible for governments and central banks to conduct monetary policy at the national level: policy cooperation through international bodies like the IMF and the G-7 has become essential. And it seems certain that a crisis in one part of the world will ultimately affect everyone else. One senses that the private view of government officials and bankers is that something has to be done. But what? Disagreements that were previously guarded now flare in public. Yet all that can be agreed is to form a new committee or meeting group.

The forces of globalization and liberalization have led to major changes in the way central banks go about their principal tasks. Markets have become much more powerful: they discipline unsustainable policies; and they give participants ways to get round administrative restrictions on their freedom of action. This means that central banks have to work with rather than against market forces. Maintaining low inflation requires the credibility to harness market expectations in its support. And effective prudential supervision involves incentive-compatible regulation.

In monetary policy, attempts to exploit a supposed trade-off between inflation and unemployment have given way to a focus on achieving price stability as the best environment in which to pursue
sustainable growth. The intermediate goals of monetary policy have also changed. Monetary targets and exchange-rate pegs have proved difficult to use in practice, and an increasing number of countries have adopted inflation targets, backed up by transparency in the policy-making process and independence of action for central banks.

The objective of financial stability has acquired much more prominence in recent years, following various high-profile mishaps at individual institutions and severe problems in some financial systems. It has become harder to segment different types of financial activity or to apply restrictions to the activities of individual institutions. Systemic stability requires ensuring that financial institutions properly understand and manage the risks they acquire, and hold an appropriate level of capital against them.

The international monetary system has been through a major transformation in the past 25 years. The Bretton Woods system developed at the end of World War II was government-led: official bodies decided on exchange rates and the provision of liquidity, and oversaw the international adjustment process. Now, the system is market-led: major exchange rates are floating; liquidity is determined by the market; and the adjustment mechanism operates through market forces. The job of central banks is to see that market forces work efficiently and that any instability is counteracted. This seems to mean stable and sustainable macroeconomic policies, and, where possible, action to ensure that inevitable changes in the direction and intensity of capital flows do not destabilize financial systems.

Changes in interest rates, inflation rates and exchange rates across the international monetary system are likely to have a significant impact on investments of all kinds. But of overriding importance at this turn of the century is what has become known as the global crisis. What started in the summer of 1997 as a regional economic and financial crisis in Asia had developed into global financial turmoil by the summer of 1998. The troubles spread to Russia with its debt default and currency devaluation; and they have since threatened Latin America. Meanwhile, Japan, the number two
economy in the world, has sunk into a depression from which it seems powerless to recover.

Despite the respite seemingly provided by coordinated interest rate cuts led by the US Federal Reserve, the global crisis is still with us. It seems unlikely that the United States can continue for long to be "an island of prosperity in a sea of depression." In a new and increasingly unstable system, the benefits gained by quickly grasping the dynamics are huge. A scholarly and instinctive approach is needed.

The Future of IPO

2011-03-31T10:47:00.000-07:00

Research shows that IPOs are far more likely when valuations are high than when they are average or low. They seem to be fixtures of a bull market an offensive strategy, often cynical though some would say that IPOs follow up markets more than they forecast down markets.

But why, for example, did Goldman Sachs decide to cancel its planned IPO as the market turned down in the late summer of 1998? Because the market no longer supported a valuation above what the insiders considered the investment bank to be worth. But as with any IPO, that implies that they were previously planning to sell it for more than they thought it was really worth and that potential buyers were getting carried away on a wave of overconfidence and overselling.

So IPOs should be treated as suspect. A simple trading rule is that if they start selling below the offer price on the first day of settlement, you should stop buying them. And if you are unable to acquire them at the offer price, the deck is stacked against you.

Otherwise, flip to your heart's and wallet's content. But buying new issues should be no different from investing in existing quoted companies, with decisions made on the basis of as much knowledge as you can accumulate on company and price. Supply is always likely to outweigh demand, so you can be highly selective.

Will IPOs be launched over the internet in future, and might that make them more accessible at a reasonable price to the private investor? Certainly, electronic trading is growing many times faster than conventional trading. But the potential for electronic IPOs will be greater when electronic brokers can overcome the traditional resistance of blending conventional selling groups with electronic commerce specialists. At the moment, there are regulatory impediments in the United States that presume new issues will be offered state by state to meet blue sky regulations rather than globally; and paper prospectuses have to be issued, which contain outmoded information compared to what a machine could do in real time.

Electronic IPOs today look more like regular issues with machines rather than telephones. They present only a modest adaptation of the old-fashioned system and maintain the normal agency price structure. However, when there is a combination of market pressure for lower costs, a regulatory framework designed for the advantages of computers and high quality issuers who demand the best technology for their issues, we shall see global electronic IPOs with an open market book, fully disclosed interests and real-time corporate information at issue costs at tiny fractions of money raised.

Counterpoint to IPO

2011-02-28T18:42:00.000-08:00

In The Intelligent Investor, Benjamin Graham describes new issues as having a special kind of salesmanship behind them, which calls for a special degree of sales resistance. Brokers are typically rewarded with double and triple commissions for pushing new issues, and their firms earn handsome fees for advice, structure, pricing and support of the aftermarket.

Brokerage firms almost always push their own IPOs, and usually rather aggressively. In the aftermarket support function, advice to customers who have bought the stock is often one-sided. There is little evidence that issuing houses will make sale recommendations to customers who have bought the new issue even if such recommendations are warranted. And if an analyst forgets and does recommend an action counter to the distribution, that analyst will have new opportunities to explore the job market.
Studies have shown that expense control can be an important determinant of long-term investment return. But expenses tend to be ignored during exuberant markets, despite their importance, only attracting attention when markets are declining. And expenses are especially high for IPOs. By the time all underwriting and service expenses are accumulated, charges of 510% of an offering price are the norm. High sales charges are one of the incentives for sales people to push new issues and there are all the legal, accounting and corporate expenses that must be covered.

While privatizations around the world might seem attractive following investors' positive experiences with the UK, there are numerous complications with overseas IPOs on top of the regular difficulties of global investing. These include international differences in accounting practices and settlement arrangements; the identity and reputation of the sponsor; the language in which the prospectus is written; whether some issues are not available to non-residents; and the procedures for scaling down an application in the event of oversubscription. For example, if a German stock is oversubscribed, a non-euroland investor may suffer considerable exchange losses converting in and out of euros. In a great many countries, investors will have difficulty in getting the information needed, and a good broker heavily involved in this kind of business will often be hard to find.

New issues and privatizations in developing markets can cause additional conflicts. Brokering and banking may be combined so that an investment banking manager may have to offer interim financing to win the IPO business. Sometimes this link can bring down a top-notch firm like Peregrine in Hong Kong, which failed because it tied a $250 million loan guarantee to an Indonesian taxi company to tide it over until a share offer could be arranged. In between the loan guarantee and the planned share offer, Indonesia had a currency crisis and Peregrine had a balance sheet crisis.

It is conceivable that similar problems may arise as US banks get back into the new issues market. After the Depression, banking and securities were separated, but now they have come back together to meet international competition. It is possible that Goldman Sachs was close to going bankrupt in the British Telecom IPO because of a guarantee similar to that provided by Peregrine in Indonesia.

IPO analysis Guru: Ivo Welch

2011-02-28T18:40:00.000-08:00

Finance professor Ivo Welch has an excellent ''resource page" of IPO data, literature and links on his website. One feature is an assessment of the twin phenomena of short-run underpricing and long-run underperformance of new issues. On the first point, Welch notes that the typical IPO underpricing the return from the offer price to the price when the market starts trading is about 10%, an astonishing figure for an average daily return. He asks why issuers "leave so much money on the table" and suggests a number of reasons:

When applying for shares in an IPO, you will typically get all the shares you requested if it is overpriced you are a victim of the winner's curse. But when an IPO is underpriced, you will only get shares on rare occasions, especially if you are not a favored client of the underwriters. As a result, you come out down on average and are unlikely to apply for shares in a fair-priced offering. So to get you to participate at all, issuers set a lower price, and while it appears that the average IPO leaves money on the table, the typical investor cannot profit from it.

Issuers like to donate some money to investors since they may want to return later for further funds. Investors will remember how good a deal they got with the IPO.

Underpricing solicits information from investors about their potential interest. Why would investors tell underwriters they like an offering unless they know that by doing so, the underwriter will give them more shares for a better price?

If one important investor defects, maybe all investors will follow. Hence, to ensure the first investor does not defect, it is better to play it safe and underprice.

There is an agency problem for the issuer: because underwriters naturally prefer easier to harder work (especially when the price is high, which makes selling difficult), it is best to make selling a little easier for them and underprice.

While IPOs can be very profitable for institutions with relatively short investment horizons and which have access to them at their offer price, this is rather like a quick payback for early support. For in the longer term, new issues are not attractive investments. A significant body of evidence indicates that on aggregate, they have underperformed the market, typically 3050% below comparable companies over three- to five-year periods. A study by Tim Loughran and Jay Ritter discusses some of that research and presents their own findings, which confirm IPOs' poor performance.

How can this long-run underperformance be explained? Welch explores the two most prominent explanations, the first of which is that corporate managers are smarter than the market and thus good at timing, taking advantage of overpriced stock. The second is that managers manipulate earnings, past and forecast, dressing IPOs up for sale. While analysts advising investors should spot these exaggerated figures, they are paid by firms in the business of selling IPOs.

Understanding IPO

2011-02-28T18:30:00.000-08:00

One of the most seemingly attractive areas of investment is that of initial public offerings (IPOs). Buying shares the first time they are offered to the public has considerable natural appeal, especially in a bull market, tempting investors with potentially phenomenal short-term returns as well as exposure to exciting new companies and industries. And since the early 1980s, privatizations of state-owned enterprises around the world have become an additional source of new issues, providing investors with the opportunity to get low-priced stakes in big, stable businesses, often the dominant incumbents in core sectors of the global economy.

The objective of any new issue is to achieve the highest value for the issuer, while ensuring a buoyant start to secondary trading. Shares are generally offered at a fixed price, set by the sponsors of the issue, and based on multiples, forecasts of likely future profits, or a combination of multiples and forecasts. Alternatively, in countries outside the United States, like the UK, there might be a tender offer, where no price is set in advance, leaving it to the market forces of demand and supply.

Fixed-price IPOs are frequently underpriced, providing opportunities for stags, investors who buy in anticipation of an immediate price rise. Big instant profits may often be made if shares can be purchased at the offer price and sold soon after dealing begins returns in the order of 515% in one day, but with high variance across offerings. Understandably, such offers are often oversubscribed, leaving the sponsors to decide on the appropriate equity allocation: by ballot, by scaling-down large applications, or by giving preferential treatment to certain investors, typically their favored clients though in some cases the private investor. The method varies by country: in some countries, like the United States, it is discretionary; in others, it is mandated equal for equal submissions.
The UK privatization issues of the 1980s and 1990s tended to be markedly underpriced, sometimes coming with incentives for the private investor, and positively discriminating against the institutions in terms of allocation and even price. They have generally been regarded as a success in terms of investor returns, government revenues and improvement in corporate performance. Certainly, the UK program has inspired numerous other governments around the world to begin turning their public-sector companies into publicly quoted ones, though perhaps this is more inspired by the real performance of companies post-IPO than the amount raised at the IPO.

Like privatizations, private sector new issues are often viewed as a route to quick and easy profits, but for every ten or so successes, there is usually one that goes wrong or seriously fails to perform. Indeed, one study of the US market reveals that of nearly 5000 IPOs initiated between May 1988 and July 1998, nearly a third no longer trade their stock and 44% sell at a market price below their original offering price.

So private investors must always show great caution, being careful to study the prospectus, balance sheet and profit and loss account of any potential investment. Investing in IPOs is intrinsically risky and not for the faint of heart. Companies that have recently reported very good results or which are in fashionable industries with their best results at an indeterminate point in the future should be scrutinized especially diligently.

Investors should also note that conflicts of interest and potential abuses are rife in the distribution of new issues. IPOs are inevitably timed to benefit the seller not the buyer, aiming to extract the maximum value from the market. Indeed, several studies indicate that IPOs are usually not good investments, underperforming the market over the longer term. This may be a reflection of companies preparing the numbers for a couple of years, and underwriters overhyping and sales people overselling the shares. Such activities may be particularly prevalent in the late stages of a bull market.

The Future of Indexing

2011-01-31T18:10:00.000-08:00

Today, indexing might be 20% of total US institutional equity. And now indexing is done on a number of indices like emerging markets, industry groups and other security classes. It is rather surprising that it is not greater. One feature that may have been restraining growth is the agency cover of indexing, which is not as great as with an active manager: more of the responsibility of investment selection may, under some interpretations, reside with the index client than with active managers. Furthermore, if equity markets have an extended decline, indexing may be arrested in its growth.

Indexing lends itself well to being packaged with other services like performance measurement, custody and administration and corporate governance monitoring (see Performance Measurement and Corporate Governance). Thus, the management cost of indexing is often bundled with services customarily offered by large integrated banks.

Indexing is a strategy that has been applied to many different categories of investing. It provides an efficient way for investors to participate in broadly diversified portfolios. Nevertheless, many investors will continue to be attracted to the distinctive investment philosophies and strategies offered by the wide range of actively managed funds (see Active Portfolio Management). A suitable compromise may be to build equity and bond portfolios (or even combine them through a balanced approach) with a core holding in an appropriate index fund. Around that core investment, an investor may select specific actively managed funds that appear likely, in the investor's judgment, to add incremental investment performance over the long run.

Critics on Indexing

2011-01-31T18:08:00.000-08:00

Indexing derives originally from the concept of market efficiency (see Market Efficiency). But markets are efficient only if investors study all available information and move prices to reflect the published data. This implies that as the market share of indexers rises, institutions will employ fewer and fewer analysts, the market will become less efficient, and this will give active managers the chance to outperform the index and index managers.

Of course, there will always be actively managed funds that outpace index funds over long periods. But is it luck or skill? Probability indicates that some investment managers may provide exceptional returns over lengthy winning streaks. But there may also be some investment managers with truly outstanding abilities who can earn superior returns over time. The problem in selecting actively managed funds is how to identify in advance those that will be consistently superior over time.

On the surface, all stock index funds should have identical total returns. But they do not because their expenses vary. Expense ratios (the percentage of costs to assets) generally range from 0.2-0.6%. The average for actively managed funds is 1.3%. Since many index funds began only in the past few years, the high-cost ones usually justify themselves by saying there was a significant start-up
expense. And some index managers admit privately that high expenses exist because the funds feel they can get away with it.

Another potential problem with indexing relates to corporate governance. As indexing took off, proxy voting slowly became an issue when the normal tool for expressing dissatisfaction with corporate behavior liquidation of a stock position was unavailable.

Part of the index fund advantage has resulted from being 100% invested in stocks at all times in a bull market buying stocks going up and selling those going down because of companies going in and out of the index. Indeed, this drives up the market as trackers are fully invested and do not allocate assets between equities, bonds and cash. Since most equity funds maintain cash reserves of 5-10% of net assets, they lost ground to index funds in the bull market in stocks during the 1980s and 1990s.

Of course, in periods of market declines, index funds can be expected to have somewhat larger declines than funds maintaining cash reserves. Yet they may convey the illusion of safety. Stock picking may work better in a flat or bear market another justification for active managers.

Wells Fargo and Indexing

2010-12-31T21:55:00.000-08:00

Early proponents of indexing were Wells Fargo, American National Bank and Batterymarch. Each had a slight variation that was designed to be superior; each had a booster or two from academia and each garnered a small percentage of some of the large pension funds in the United States. Curiously, university endowment funds, run by successful alumni, not faculty, were not among the early entrants.

Timing of the acceptance of indexing was critical. Following the nearly 50% US market decline in 19734, new ideas which might have been rejected just a few years earlier were sought. Ideas that challenged convention were readily accepted since conventional ideas had just demonstrated they could be costly in a decline. Each market phase brings forth its selection of new strategies to support hope and expectations. Indexing was right for the time and the time was right for indexing.

Wells Fargo endorsed investment in the full S&P 500 stock index with only a handful of de-selectees for prudence (reputedly, these handily outperformed even a risk-adjusted measure). American National had a sophisticated sampling technique to reduce transaction costs, a likely source of underperformance. And Batterymarch, thinking that index investors would ignore month to month wiggles of sampling error that would cancel in time, just bought the largest 250 stocks, which were 90% of the total. Batterymarch also tried, and failed, to promote the notion that low cost mechanical replication of any index, not just the S&P, was the goal.

Early clients were happy with the results, which kept pace with active managers even when small stocks pulled ahead in the new, quantitatively-driven market then just beginning. And more money came into the strategy in the billions. Meanwhile, the debates between passive managers, as the indexers were called in error

What is Indexing?

2010-12-31T21:52:00.000-08:00

Indexing is an investment practice that aims to match the returns of a specified market benchmark. An indexing manager or tracker attempts to replicate the target index by holding all or, with very large indexes, a representative sample of the securities in the index. Traditional active management is avoided with no investments made in individual stocks or industry sectors in an effort to beat the index. The indexing approach is often described as passive, emphasizing broad diversification, low trading activity and low costs.

Indexing as an investment practice has won acceptability in the last two decades as the mechanical outgrowth of a body of academic insights about markets and managers. Indeed, it was one of the first ideas to be propounded by finance academics from their empirical studies. These pointed out that the average manager would produce sub-average results due to expenses and above average managers would be identified and given more assets until they too became less than average. The system was the trap. After all, index accounts have prices set by all managers. In a sense, these accounts are the most managed of portfolios.

Indexing seems dull. Stock selection is done by a nameless committee at Standard & Poor's (S&P) or elsewhere for other indexes. Proportions are set by market prices, which are the aggregate wisdom of all participants. And administration is relatively simple because transactions are bunched together at the very instant at month end when the index composition may be rearranged.

In the late stages of the one-decision bull market of the 1960s, the idea of mechanically investing in the average just because it was the average would have failed. But in the mid-1970s, when a sharp market correction slayed the old gods and raised up new ones, it was just the thing. Nothing could challenge a roster of active, aggressive managers better than to have a mechanical bunny running the performance race with them and the bunny did not require dog food.

The Future of Hedge Funds

2010-12-31T21:50:00.000-08:00

Hedge funds and their appetite for risk continue to appeal to investors, perhaps reflecting the late stages of a bull market, where attitudes to risk shift in two complementary ways: the future appears less risky; and, at the same time, investors' appetite for risk rises. But their bad experiences in 1998, the possibility of worse in the future, and the potential regulatory backlash suggest that their fashionable status as high-end mutual funds may wane.

But one hedge fund manager definitely worth continuing to be aware of is James Cramer of Cramer, Berkowitz & Co., who is also co-founder, co-chairman and contributing editor of TheStreet.com, an online financial publication self-described as "dedicated to providing investors with timely, insightful, and irreverent reporting and bringing accountability to the markets and the media that cover them." This is one of the most entertaining investment sites on the internet.

Problems of Hedge Funds

2010-11-30T17:22:00.000-08:00

Hedge funds deal in a paradoxical private language worthy of the worlds of Lewis Carroll or George Orwell. Words seem to be able to mean whatever managers want them to mean: market-neutral positions can bankrupt a fund; long-term capital means a small amount of short-term capital leveraged to the hilt; and to hedge means to take wildly risky positions. Sometimes, even the investors do not know what strategies their funds are using. The rules of LTCM, for example, forbade investors asking what it was that gave the fund its promised edge, ostensibly because of fears of secret investment strategies leaking to competitors.

What is more, it is often not clear if, when hedge funds perform spectacularly well, their high returns owe more to investment judgment, to leverage or to the chance outcomes of purely speculative bets. After all, when a bet is risky, it will make a lot of money if the outcome is as hoped; but when it is relatively safe, the profit is meager unless the bet is big.

Hedge funds claim to be arbitrageurs rather than speculators. But it is generally agreed that there are relatively few real arbitrage opportunities even LTCM returned money to investors in early 1998 claiming lack of opportunities so when you find them, you have to bet big. And when the bets go wrong, you need enough capital or credit lines to stay at the table. Of course, the richer and more powerful a fund becomes, the greater its ability to influence the market in which it deals, often leading to self-fulfilling prophecies. As has been pointed out about Soros, it is not that difficult to move markets when you back your bet with $2 billion and can ride roughshod over markets and governments.

Indeed, hedge funds offer potentially high returns for the lucky few but considerable dangers when their heavy borrowing can damage a whole financial system, and their trading strategies can destabilize whole countries and markets that are not equipped to cope with mass selling of their currencies and equity markets. There is some dispute about the real impact of hedge funds but it seems indisputable that they are powerful and dominant in many markets, including emerging markets, high-yielding debt and mortgage derivatives. And the LTCM bailout suggests that there were real fears that its collapse and the fire sale of its positions would send the global markets into a tailspin. Soros himself provides this counterpoint to some degree in his 1998 book, where he argues that markets have grown so large and powerful they can destroy countries; and markets have become so frightened that they will withdraw capital from most countries in the world. He calls for more international regulation of markets, perhaps through an international central bank or an agency to guarantee loans a cry from the heart that MIT economics professor Paul Krugman has amusingly if harshly translated as "stop me before I speculate again."

In a different article, this one carried by Slate magazine, Krugman discusses LTCM and the possibility that hedge fund compensation arrangements create the incentives to take inordinate risks since managers share in the upside but not the downside. He points out that if someone lends you a trillion, they have effectively given you a put option on whatever you buy: since you can always declare bankruptcy and walk away, it is as if you owned the right to sell those assets at a fixed price whatever happens to the market. He argues that the rational way to maximize the value of the options is to invest in the riskiest, most volatile assets since if you win, you win massively, and if you lose, you merely get some bad press and lose the money you yourself put in.

George Soros and Hedge Funds

2010-11-30T17:18:00.000-08:00

A number of energetic people fled from behind the Iron Curtain in the years after World War II. One, George Soros, carried with him a European's sense of philosophy that he applied to understanding markets. Although not trained as an economist or accountant perhaps because of this gap Soros took a psychological and cultural approach to predicting markets. Through his flagship fund, the Quantum Fund, registered outside the United States for flexibility, he would take major positions for or against foreign exchange, derivatives, emerging markets, bonds, private markets or almost anything. Any market was fair game for his group. And he would use leverage to amplify his wagers when called for. Results were outstanding although the volatility was not for the faint.

More recently, he has been writing about his investment style. Coverage in news reverses his trading desk mentality never to discuss his trading positions. And his model book on reflexivity, The Alchemy of Finance, explains his investment approach, which factors investment expectation into structure to make things that seem obvious actually occur. Indeed, the Quantum Fund's name is a reference to Heisenberg's Uncertainty Principle, which describes our inability to predict the behavior of sub-atomic particles.

But Soros's main skill is as a guerrilla investor willing to explore any market, study it more than others, strike with style and quietly withdraw, most often with a profit. In 1992, he became known as "the man who broke the Bank of England" after his attack on sterling forced its exit from the European Union's fixed exchange rate system and reputedly netted the Quantum Fund $1 billion in a day.

George Soros is a complete person and public figure, described variously as hard-nosed financier, philosopher-king, and latter-day Robin Hood. The activities of his charities are well-covered and substantial, especially in the former Soviet sphere, where his Soros Foundation has been more generous than all but two other entities, both of which are big countries. He claims that over half his time now is spent giving money away. So his life is making the transition to that which could be called a private statesman.

Nevertheless, in 1998, Soros suffered some serious setbacks. Not only was his new book on global capitalism poorly received and the Quantum Fund forced into restructuring, but his August letter to the Financial Times on the economic chaos in Russia seemed to trigger the country's debt default and currency devaluation. As the Moscow Times noted, Soros issued what was perhaps the most humiliating statement of his career: "The turmoil in Russian financial markets is not due to anything I said or did. We have no intention of shorting the currency. In fact our portfolio would be hurt by any devaluation." But it was too late: the theory of reflexivity played a cruel joke on its creator and on the ruble.

Understanding Hedge Funds

2010-11-30T17:10:00.000-08:00

Highwaymen of the global economy was Malaysian prime minister Mahathir Mohamad's description of hedge funds after the devastation of his country's currency and stock market in 19978, which he blamed on them, particularly the fund led by George Soros. The near-collapse and $3.6 billion bailout of John Meriwether's Long Term Capital Management (LTCM) by fourteen Wall Street banks and brokerage houses in the late summer of 1998 did little to restore the reputation of these shadowy investment vehicles. What are they all about?

Hedge funds typically pool the capital of no more than a hundred high net worth individuals or institutions under the direction of a single manager or small team. Their name originally comes from the fact that unlike most institutional investors, they were able to deal in derivatives and short selling in theory to protect or ''hedge" their positions. But having begun as a way of minimizing risk, the conservative activity of hedging has become the least important of their pursuits.

Usually based in offshore tax havens like the Cayman Islands to escape the regulators and the standard reporting requirements of mutual funds, hedge funds use their freedom to borrow aggressively, to sell short, to leverage up to 20 times their paid-in capital (though LTCM had somehow borrowed over 50 times its capital base) and generally to make big but highly risky bets. They tend to focus on absolute rather than relative returns, aiming simply to make money rather than to beat an index.

But the only real difference between hedge funds and other funds are their compensation strategies. Hedge fund managers tend to be paid for performance, with a modest management fee but a substantial share of the profits the fund makes typically 15-20% though LTCM charged 25%. Otherwise, hedge funds are a diverse grouping of independent asset managers pursuing a variety of investment strategies, usually with minimal disclosure to investors and regulators, and most operating in a niche where they feel they understand the "rules of the game" better than anyone else. Consultancy Financial Risk Management categorizes them into four main groups in a comprehensive overview of the hedge fund market produced with investment bank Goldman Sachs.

First, there are the macro-funds of which Soros's fund is a leading example. These indulge in tactical trading, one-way speculation on the future direction of currencies, commodities, equities, bonds, derivatives or other assets. Their most-publicized activities involve speculation on exchange rate movements, usually shorting the currencies of countries whose economic policies look questionable and whose ability to maintain an exchange rate peg is weak (see Short Selling). Macro-funds constitute the most volatile hedge fund sector in performance terms and their correlation with traditional bench-marks is low.

Second, there are the market-neutral or relative value funds, the kind of fund LTCM described itself as. These funds are supposedly low risk because they do not depend on the direction of market movements. Instead, they try to exploit transitory pricing anomalies, regardless of whether markets rise or fall, through an arbitrage technique called convergence trading: spotting apparently unjustified differences in prices of assets with similar risks and betting that the prices will revert to their normal relationship. For example, LTCM was betting that historically wide spreads between emerging market and US assets and between corporate bonds and US Treasuries would narrow. Of course, as it turned out, history proved no guide to the future as spreads widened and everything moved in the wrong direction at once.

Third, there are event-driven funds, which invest in the arbitrage opportunities created by actual or anticipated corporate events, such as mergers, reorganizations, share buybacks and bankruptcies. Merger arbitrage, for example, involves trading in the stocks of both bidder and target on the assumption that their prices will converge if the deal goes ahead.

Lastly, there are long-short strategy funds, which combine equities and/or bonds in long and short positions to reduce market exposure and isolate the performance of the fund from the asset class as a whole.

Given the lack of a strict definition of hedge funds and the fact that they file no reports, it is difficult to estimate the extent of their activity. Figures for 1998 from the Hedge Fund Association suggest there are between 4000 and 5000 funds with total assets in excess of $250 billion; while according to TASS, a performance measurement firm, there are only 3000 funds but with over $300 billion in assets. But as the experience of LTCM shows, the total assets may not be a true representation of the amount of money dedicated to short-term trading activity since the funds frequently borrow substantially in order to make leveraged bets.

Future of Growth Investing

2010-10-31T10:56:00.000-07:00

The epitome of growth investing was the one-decision stock era of the bull market of the early 1970s. The notion was that growth of earnings per share could be projected as a straight line on semi-log paper for the most durable, well managed companies. Predictable growth would be valued richly by investors, which would make equity capital cheaper and easier to raise. In turn, this equity could be invested at higher than average rates of return on capital, which cycled into more earnings per share. And so the money machine would turn. The proper investment strategy was to buy the right companies and hold them forever.

The index funds of the late 1990s get some of the same influence although not by overtly selecting highly regarded stocks (see Indexing and Mutual Funds). But the index tends to be more heavily weighted in those stocks. The one-decision phenomenon of the 1970s and the indexing craze of the 1990s may end up at the same place: ownership of a handful of richly valued companies whose history is not a precursor of their future. And the indexer, like the one-decision investor, is disciplined to stay invested no matter what.Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co. LLC comments:

Historically, at the stock levels in the United States, equity investors have over-paid for comfort (stability, information, size, consensus, market domination, brand names). Historically, equity investors have over-paid for excitement and sex appeal (growth, profitability, management skills, technological change, cyclicality, volatility, and most of all, acceleration in the above).

Paying-up for comfort and excitement as growth managers do for example, is not necessarily foolish, for clients also like these characteristics. Conversely, when a value manager is very wrong as he will be sooner or later he will be fired more quickly than a growth manager. To add insult to injury, the data indicates that the best growth managers add more to growth than the best value managers can add to value, probably because the fundamentals and the prices are more dynamic for growth stocks.

Finally, beyond the financial details of potential growth companies and growth stocks, what are the broad requirements of a successful business? And conversely, what are the features of business failure? We suggest three characteristics which, if found together, will guarantee success for failure. If a business has a combination of passion, authenticity and integrity, it will succeed. In contrast, whenever you find together the three ingredients of mediocrity, arrogance and isolation, the business or indeed the country concerned will fail.

Critics on Peter Lynch

2010-10-31T10:53:00.000-07:00

Why not? Of course, the purpose of equity investing is growth, is it not? So the two words seem to be inseparably linked. But perhaps we confuse growth with appreciation. And perhaps we automatically associate past growth with future appreciation. They can differ.

Marc Faber, our guru for Manias, Panics and Crashes, points out, there are two reasons why highly popular stocks, which have become viewed as growth stocks, usually end up as costly disappointments:
First, exciting new markets often fail to keep growing as rapidly and profitably as expected. Second, when a business achieves great success, competitors are attracted into the field, slowing growth and shrinking profit margins for the early leaders. Gottaown stocks are very likely to be losers.

Certainly, when growth stocks start to decelerate, when momentum ends, the price of failure is high. Once a growth stock starts to fall, it loses its momentum attractions, followers of the trend start to desert, forcing the price down further and creating a downward spiral. In such circumstances, there can be high penalties for earnings disappointments. Eventually, growth stocks fail to fulfill their original promise and disappoint investors. Then, as fallen angels they become potential seeds for future value stocks.

Some growth industries never produce any growth stocks: competition is so fierce that no one makes any money. And in a classic article published in the Harvard Business Review over 40 years ago, Peter Bernstein (see Economic Forecasting), makes the important distinction between growth stocks and growth companies:

Growth stocks are a happy and haphazard category of investments which, curiously enough, have little or nothing to do with growth companies. Indeed, the term growth stock is meaningless; a growth stock can only be identified with hindsight it is simply a stock which went way up. But the concept of growth company can be used to identify the most creative, most imaginative management groups; and if, in addition, their stocks are valued at a reasonable ratio to their increase in earnings power over time, the odds are favorable for appreciation in the future.

While Peter Lynch likes growth companies, out of self-professed lack of understanding, he has tended to avoid the high-tech area, where many of the biggest individual growth stock gains of the 1990s have been made (see Internet Investing). His style is also limited to investing in US equities. Of course, it is true that the concept of investment in growth companies as a distinct style of equity investing seems to emerge only in maturing economies. Growth is assumed to be an integral element of any stock selection criteria in many other parts of the world

Peter Lynch, Growth Investing Expert

2010-10-31T10:50:00.000-07:00

Peter Lynch is one of the best-known names in investing. He ran Fidelity's Magellan Fund for thirteen years from 1977 and in that period, Magellan was up over 2700%. Lynch managed a vast portfolio, containing over fourteen thousand stocks at any time, and turned over the whole portfolio on average once a year. Yet even in difficult markets, he was almost always opposed to assets sitting in bonds and cash. Instead, he advocated holding good quality stocks with low volatility when going defensive.

Lynch's basic message is that an individual investor can actually find great stocks before Wall Street does: using a combination of intelligence, reflection, perseverance and discipline, it is possible for the average person to uncover great investments. His central point is that products and services you use and enjoy are often provided by excellent companies. If you research these companies and find out whether or not the stock that corresponds to them is priced favorably, you have an outstanding chance at compounding market-beating returns industries and businesses; investigating how a company treats its customers and vice versa. This is the only way I know to find great companies, and nothing beats the feeling when it pays off.

While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there's a decent chance one of them will turn out to be a ten-, a twenty- or even a fifty-bagger, where you can make ten, twenty or fifty times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

So what advice does Lynch give to the typical individual investor? Writing in his regular column in Worth magazine, he recommends:

Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.

Pay attention to facts, not forecasts.

Ask yourself: what will I make if I'm right, and what could I lose if I'm wrong? Look for a risk-reward ratio of three to one or better.

Before you invest, check the balance sheet to see if the company is financially sound.

Don't buy options, and don't invest on margin. With options, time works against you, and if you're on margin, a drop in the market can wipe you out.

When several insiders are buying the company's stock at the same time, it's a positive.

Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

Enter early but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the line-up is announced, you're taking an unnecessary risk. There's plenty of time (ten to fifteen years in some cases) between the third and the seventh innings, which is where the ten- to fifty-baggers are made. If you buy in the late innings, you may be too late.

Don't buy cheap stocks just because they're cheap. Buy them because the fundamentals are improving.

Buy small companies after they've had a chance to prove they can make a profit.

Long-shots usually backfire or become no shots.

If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

Investigate ten companies and you're likely to find one with bright prospects that aren't reflected in the price. Investigate fifty and you're likely to find five.

What Is Growth Investing?

2010-09-30T18:38:00.000-07:00

Growth investing is one of the two classical styles of investment. There are numerous different definitions of the style and some confusion about the precise relationship between growth companies and growth stocks. But a focus on growth is generally contrasted with value investing, which tends to rely more on quantitative methods of analysis. Growth investing tends to be based more on qualitative judgments about the kind of companies that will offer remarkable growth rates and exceptional returns performance.

Growth stock investing arose as a definable concept in the United States of the 1930s the counterpoint to the safe, secure income investing of the depression years. It was presumed that companies with a past record of growth in revenues and earnings had the momentum to carry them into the future. And they had to go farther into the future or at greater rates of growth than the market had already accorded in its discounting through current prices. T Rowe Price, who first set out the principles of growth stock valuation in the 1930s, wrote:

Growth stocks can be defined as shares in business enterprise that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in the future.

In order to turn a capital commitment into appreciation, the growth investor needs prescience about earnings or rate of growth or the market's willingness to pay for future events. At certain times in the market for example, in the late 1960s and early 1970s and, more recently, in the late 1990s the growth investor has been rewarded with handsome returns. Those returns have in part been the result of an increase in the number of growth investors rather than a change in the valuation systems used by an existing population of investors.

And the agreement runs backwards in that those equities that have appreciated are assumed to have growth characteristics. Almost any list of the best managed companies a popular and recurring article in business publications will be composed of those stocks that have had an unusually favorable price performance for some past period. Growth stocks may see the future through the rear view mirror.

Future of Global Investing

2010-09-30T18:35:00.000-07:00

Recent research indicates that Americans are more likely to invest in their local regional Bell operating company than in any other. Considering that everyone's local operator cannot be a better investment choice than any of the other six, this finding suggests the importance of investors' psychological need to feel comfortable with where they put their money. Perhaps it relates to the endowment effect, a phenomenon noted by behavioral finance, where people set a higher value on something they already own than they would be prepared to pay to acquire it.

But if people still do have a predilection for investing in familiar stocks, they are likely to leave largely unexploited international investment opportunities and hold sub-optimally diversified portfolios. It is tempting to conjecture that such a psychological attitude might be even more pronounced in the highly diverse cultural contexts of European countries. Such an attitude could explain the lack of cross-country portfolio investments within Europe, and suggest that the internationalization of European individual portfolios will be a slow process even in the wake of the euro.

On the other hand, the potential development of a European identity and the increasing tendency to think European rather than French or German a tendency that is likely to be enhanced by the advent of a shared currency could make European investors less reluctant to hold equity stakes in companies residing in a European state different from their own. Perhaps European home bias will fade.

Of course, none of the reasons for home bias apply to the individual global investor with the funds, access to broking services and time to conduct research on the opportunities in the international equity market. It seems likely that home bias and low market correlation will diminish over time as the interconnections of the global economy become closer and the confidence of investors in overseas markets grows. But in the meantime, by leaving some lower risk and higher return possibilities relatively unexplored, they might help an investor to formulate an international investment strategy that can beat the market consistently.

There is also now a vast amount of information on global investment opportunities available on the internet. Any point on the globe is as accessible as next door. It is cheap and often free. It shifts control of time, depth of information and source to empower the user. And it is open: anyone can come in taking its knowledge and offering skills. Financial centers are described on a satellite connection, not geographic coordinates or proximity to other financial talent centers. Work takes a different form in time and space with email, videoconferencing and the internet, all of which are available at a price for the single user at his or her own site. Location becomes irrelevant.

A visit to South Africa from the United States, for example, requires probably a week of preparation, a week there, and a week of decompression on the other side a total of three weeks, assuming we are efficient. Compare that with a day on the internet. How much information could one get on South Africa in the course of a few hours on the web? The information might be different, but it is going to be a large volume in a short period of time. You would understand the culture and the issues, and you could gain a lot of information that is hard to find out otherwise.

According to that well-known fan of investment management, Bill Gates: ''Anyone who is not intimately involved with the internet and the web does so at extreme peril." This statement applies with particular force to investment analysts and private investors. For those of us who are dedicated to moving our craft forward, being ahead of others and using the best tools available, the internet is our mandate.

Critics on Gary Brinson' Theory

2010-09-30T18:30:00.000-07:00

If global investing is superior to investing in only one market, why do so many investors hold disproportionate amounts of their portfolios in equities of their own domestic markets? Even sophisticated institutional investors, such as pension funds and insurance companies, tend to concentrate well over three-quarters of their equity funds in domestically quoted shares, a phenomenon known as home bias. Evidence of wide discrepancies between national market performances over certain periods of time suggests that these investors would maximize their returns and minimize their risks more effectively by diversifying more fully across stocks in different countries.

Various explanations for home bias have been advanced. These include IMF officials' arguments that it is, in large part, due to the substantial risks of adverse exchange rate changes, which cannot be guarded against with standard hedging techniques. Currency risks may be compounded by the different supervisory environments in particular markets, by fears that capital controls may be instituted, by taxes on international trading or simply by a wish to avoid the time and expense of maintaining and researching a more widely spread international portfolio.

Such reasoning is supported by arguments that the benefits of international diversification arise merely from the fact that different stock markets have their shares concentrated in different industries. For example, the UK privatization program of the 1980s means that utilities are a more important part of the London market than elsewhere. Similarly, investment in the Swiss market implies a disproportionate bet on banking stocks, and investment in the Swedish market a commitment to basic industries. The implication is that global investing offers nothing more than exposure to additional industries.

Yet home bias on the part of institutional investors seems to be more a result of government restrictions on the amount of foreign assets pension funds and insurance companies in any given country are allowed to hold. It also may arise from the way in which fund managers' performance is assessed through reference to a local market index: even if passive indexing is not their dominant strategy, there is inevitably a strong incentive to own a good slice of the index's components. And industry analysts are often more prevalent than country analysts in fund managers' offices, suggesting a disposition to choose industrial over international diversification.

There is evidence that the covariances of global markets may be sliding closer, though Japan may be a special case. For the other members of the G-7, coordinated banking policies and facilitated information flows should tend to drive markets into a more steady alignment. On the surface, such an increase in stability could be seen as beneficial for business but would be a lessened benefit for portfolio investors attempting to diversify risk.

For example, closer links between European economies following the introduction of the euro will increase the incentive for US investors to diversify into European markets. At the same time, this may also strengthen the relationship between different European stock markets, reducing the incentive for diversification within Europe.

Gary Brinson an Expert on Global Investing

2010-08-31T21:43:00.000-07:00

Gary Brinson is a staunch advocate of asset allocation techniques and a pioneer of global investing. In 1974, the firm now known as Brinson Partners (then a unit of First Chicago) was one of the first to invest overseas. Brinson led a management buyout of the unit in 1989 and the firm was later acquired by Swiss Bank Corporation. The latter has since merged with Union Bank of Switzerland and as a result, Brinson directs over $300 billion in institutional assets, making it one of the world's largest money managers. Brinson is also co-author with Yale finance professor Roger Ibbotson of a book about asset classes, investment theory and international investing.

The Swiss banks were interested in Brinson Partners for its money management business but perhaps even more for its ability to bring North American investment techniques to Europe and elsewhere in its network. Features that are taken for granted in the United States like performance measurement, incentive compen sation, quantitative tools and hedging are less familiar in Europe (see Performance Measurement, Quantitative Investing and Risk Management). At first, the relationships were rather loose with interns coming to the Chicago headquarters for training and management coordination with the Swiss management largely by encrypted videoconferencing. More recently, the risk management and tighter controls at headquarters have dictated closer ties.

Brinson has promoted the professionalism of investment management by taking an active part in its industry association, the Association of Investment Management & Research (AIMR) and its Research Foundation. He is an advocate of small, steady incremental gains in improvement of standards. Similarly, he is an advocate for small changes in asset allocation. Consistent with the Swiss style of investing, major swings are generally unlikely to take place.

Brinson argues strongly that investment decisions should focus first and foremost on markets or asset classes since that explains roughly 90% of returns. The key is to consider overall portfolio risk rather than the risk of individual assets: a sound asset allocation combines diverse asset classes in ways that increase returns without an equal increase in risk or reduce risk without sacrificing returns.

His global asset allocation strategy rests on four basic principles:

Think global.
The value of asset classes should not rise and fall together.
Focus on the long term.
Monitor and adjust allocations to accommodate changed investment climates.

Brinson believes that in a relatively short time, it will seem as odd to most investors to discuss a Europe fund's country allocations as it does now to discuss a US fund's relative exposure to each of the fifty states. In his mind, country concerns will be minimal in comparison with company concerns.

What is Global Investing?

2010-08-31T21:41:00.000-07:00

Don't put all your eggs in one basket, the principle of portfolio diversification, is widely accepted by investors. It is normally thought of in terms of the number of assets, industries or companies across which an investor is spread: a well-diversified portfolio contains equities (as well as bonds, cash, etc.) in industries whose returns do not move together. And the lower the correlation between the returns on the various equities or other assets, the less wildly the value of the whole portfolio should swing.
Less frequently is diversification considered in relation to owning equities and other assets from different countries. But with many national markets often highly uncorrelated, this form of diversification would seem to offer the strongest potential for reducing risk, while at the same time promising enhanced returns. Particularly for investors in one of the highly valued markets of the developed world, buying foreign equities uncorrelated with their domestic market should, in principle, make their overall equity portfolios less risky and more valuable.

So global investing is in the first instance about asset allocation between equities, bonds, cash and other instruments; and second, about investing in global markets. Asset allocators benefit by diversifying across asset classes; international investors benefit by diversifying their portfolio across assets in a range of different countries. The key factor for the latter is the degree of integration of the real economies of the countries concerned. It is important to understand co-movements among different markets: the more markets move together, the fewer the benefits of international diversification.

Global data for 1998 reveals significant performance differentials between regions. The MSCI World Index rose 19.7% but only two regions Europe at 26.5% and North America at 27.1% ex ceeded that. Across the emerging markets, performance ranged from a spectacular 137.5% gain in South Korea to an 83.2% decline for Russia (see Emerging Markets). Though somewhat narrower, differences in the developed world are just as striking: Finland gained 119.1% while Norway declined 31.2%. This large regional performance differential underscores the importance of a global portfolio strategy. An asset allocation strategy that on average correctly anticipated these differences would have added significant value.

Global investment provides a security hedge and a currency hedge. Frequently, investors do not separate the two (see Foreign Exchange). Nearly all academic studies suggest that the question of currency hedging should be dealt with explicitly and should not be treated as incorporated automatically within the overall global allocation. And it is important to recognize that currency hedging may be costly and can increase risk. The Asian meltdown in 1998, for example, led to the double whammy of currency devaluation and stock market collapse.

Richard Olsen’s Reactions on Critics (Part 2)

2010-08-31T21:39:00.000-07:00

Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.

Olsen comments:
We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market that is, the market makers, the medium and long-term investors interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.
For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance-of-payments. current account. If there is a surplus in the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.

A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it. So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the fundamentals are wrong.

Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium-term movements of a currency. But a key factor determining short-term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 19923 and the Asian and Russian crises of 19978, that a currency is overvalued or simply that there are speculative gains to be made by selling it.

Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack attacks are self-fulfilling. The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a fullfledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.

Self-fulfilling attacks may affect any country with a fixed exchange rate and high capital mobility that is in the gray area between fully safe and sure to be attacked. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself the growing phenomenon of contagion in foreign exchange markets.

Richard Olsen’s Reactions on Critics

2010-07-31T17:43:00.000-07:00

Why have we focused on studying the forex markets? Researching these markets is like doing research in a nuclear reactor, where basic processes can be studied in states of high energy. In such an environment it is easier to identify the forces that drive financial markets and distinguish them from random market effects.

People fail to realize the importance of forex markets to support the globalization of the "investment business." Relative to trade flows, investments across borders have increased much more dramatically. The forex markets have to be able to accommodate the demands of these international investors, who want to sell their foreign holdings at a moment's notice. Even though the forex markets have grown, the growth has been insufficient to support the requirements of an international investment community.

The introduction of electronic transaction systems has speeded up transactions in forex dramatically during the past six years. There is a side effect that has been neglected by many of the commentators. Similar to the money multiplier, there is a market liquidity multiplier. If the efficiency of the transaction system increases, then transactions are settled much more quickly. This has the effect that liquidity dries up much more rapidly than in the past.

My inference is that today's forex markets are far too small to support our globalized financial community. The effect will be erratic price movements, as we saw on 7 October 1998 with the 20% shift in the dollaryen exchange rate.

The introduction of the euro will make things worse. I think that we have to look at the euro as a merger of the European countries. Europe will thus become like one big football stadium with a strong US counterpart. The world will thus have two big football stadia. The stadia need wide roads, that is, highly liquid forex markets. Unfortunately, the new dollar euro exchange rate will not be sufficiently liquid to absorb the large shifts of capital that will occur between the dollar and the euro.

Professor Amartya Sen, who received the 1998 Nobel Prize for Economics, explained in great detail that starvation is not a problem of a lack of food, but deficiencies in the distribution system. We face a similar situation with the financial markets, where the fundamental economy is in satisfactory shape, but the allocation system, that is, the financial markets and in particular the forex markets and the balance sheets of the banks, are in deep trouble.

Critics on Richard Olsen

2010-07-31T17:41:00.000-07:00

Smart as it is, there are times when the approach of Olsen and his colleagues has failed to work. Like other more simple data mining and historically based methods, it works in periods when currency movements are following a trend but gets whipsawed with penaliz-ing transaction costs in trendless markets. And during a change in the trend, O&A might identify a turn but not know the difference between a minor and a major turn.

Yet this group comes closer to modeling how the foreign exchange world really works than others. When there are new academic insights, they are likely to note them early.

A broader social counterpoint to today's forex markets is that with this daily volume of electronic, invisible money flowing throughout the world, a single nimble trader can drive a monetary institution to the wall. A trader is often compensated by a share of the trading profit, which can put tens of millions into his or her pocket. The trading institution takes the risk and the trader takes the profit: a true asymmetrical payoff scheme operates to pyramid risks. A central bank seeking to dampen its currency swings may come forward with a few billion but this is typically something that a single trader could command. In these circumstances, a central bank attempting to influence a currency is like sending a bicycle onto a superhighway.

The size of forex trade has played its part in the series of currency crises in emerging nations during the 1990s. The capacity for massive daily foreign currency flows to take place made possible the almost overnight collapses of the currencies of Thailand, Indonesia and Russia in 1997-8. As confidence in the economies of these countries fell away, demand for their currencies dried up as investors took their capital out or stopped bringing it in. Governments had tried to buy their own currencies to underpin their value but could not keep up with the sellers. When they stopped their own forex activity, the forces of demand and supply saw the baht, rupiah and ruble in turn crash in value, deepening the crisis of confidence and economic slowdown.

Some commentators are now recommending a tax on forex dealings: for example, Nobel Laureate James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a ''devastating impact on specific industries and whole economies." To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the Tobin tax.

There are three rationales for the proposed Tobin tax: the first is that the volume of foreign exchange transactions is excessive fifty to a hundred times greater than that required to finance international trade; the second is related to the first reducing volatility offers more independence to national economic policy-makers; and the third is simply the tax-raising abilities of such a tax, which is linked with the view that the financial sector is relatively undertaxed.

Foreign exchange guru: Richard Olsen

2010-07-31T17:35:00.000-07:00

In the pre-radio and telephony days, information about markets moved by post, horses and even by carrier pigeons. Investors with information in one market would send their instructions to other markets and success was often an outcome of the speed of transferring the messages.

Today's global environment also puts a premium on speed, but it is not measured in days or hours but nanoseconds. Currency-trading departments are decentralized so that individuals, usually young, nimble and quick, can make massive decisions on their own. The trading rooms of major institutions trading currencies for their own accounts often contain no one over the age of 35, none with bonus possibilities less than multiple millions and all eager to take risks to achieve personal gain.

It is perhaps not surprising that currency markets trading in hundreds of billion dollars a day, open 24 hours and with information moving so fast that there is always the chance of an information advantage, would attract speculative attention. And not surprising either that the value of speed and ability to grasp all the markets' information at once would attract academics building new models. One of these, and one of the best, is Richard Olsen of Olsen and Associates (O&A), a high-frequency data processing firm in Zurich in which Dean LeBaron has personally invested.

A visit to O&A, in a refurbished flour mill alongside Zurichsee is like a visit to Silicon Valley. Attire is California casual, tee shirts and jeans, though Olsen does wear a tie to see clients. Dogs and bikes sit outside offices while their owners are huddled over computer keyboards. Conversation is usually in English though it is hardly the first language for the majority. Academic disciplines are mathematics, economics or almost anything else. The common characteristic of the people is smart, very smart.

Olsen and his colleagues are the best at acquiring and analyzing high-frequency data, using very advanced mathematical techniques to forecast currency movements. By high frequency, they mean second by second, and forecasting might be for an hour or so ahead, perhaps even a week if long-term the value of high-frequency forecasts decay rapidly as the information that produced it is disseminated.

Foreign Exchange Investing

2010-06-30T19:47:00.000-07:00

Foreign exchange (forex or FX) markets form the core of the global financial market, a seamless twenty-four hour structure dominated by sophisticated professional players commercial banks, central banks, hedge funds and forex brokers and often extremely volatile. Many investors, particularly American ones, tend to ignore currency movements, and few financial analysts are trained to analyze the details of forex markets. But this is a mistake. As the 1997 Asian crisis and its aftermath vividly reveal, foreign exchange these days tends to lead economic activity. And the foreign exchange markets are huge, growing and increasingly powerful.

According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world's foreign exchange markets reached almost $1,500 billion ($1.5 trillion) in April 1998, 26% higher than when it last measured forex flows in 43 different countries three years earlier. Transactions in-volving dollars on one side of the trade accounted for 87% of that forex business. Almost a third of all forex trading takes place in London, by far the world's largest center, with New York and To-kyo second and third. Although London forex trading grew more slowly than New York over the three years to 1998, its average daily turnover remains greater than New York and Tokyo combined, having risen from $464 billion to $637 billion.

To put these figures in perspective, daily trading volume on the New York Stock Exchange (NYSE) is only about $20 billion; activity in short-term US government securities is around ten times that at $200 billion; and so at $1,500 billion, foreign exchange trading is seven and a half times the volume of trading in short-term US government securities and seventy-five times NYSE trading. This volume is far greater than the size of foreign currency reserves held by any single country. The forex markets cannot be ignored: for their size and forecasting ability; and for the potential that developments in these markets have for the future of the dollar as the world's dominant currency.

In the past, trading in the real economy controlled relative currency relationships. Since most currency flows were to settle trading patterns, there was a balance as goods and capital moved at about the same speed. But now the leads and lags are the other way around. While in name, forex markets exist to facilitate international trade, in practice, the bulk of turnover in these markets is attributable to speculation. Because financial flows are many times the size of trade flows and because financial flows are nearly instantaneous, currency market levels now tend to set trade: if a country's currency becomes low relative to others, domestic producers find it easier to export. The market sets the economy.

Where next on emerging market?

2010-06-30T19:44:00.000-07:00

While it is true that fixed-income management is different from hedge funds, the issue of SEC registration is not really significant since it is more an issue of paperwork than a review of investment precepts. Hedge funds operating in bond markets have the same theories and practices as the most advanced fixed-income people, so there is a direct connection between the development of active bond management and LTCM. The latter is an extreme case but it comes with overconfidence in the models, and with a large segment of bond and derivative managers using the same models at the same time since they share the same education and same data-bases.

While historically stocks have provided substantially greater returns than bonds, there still may be good arguments for fixed-income investing. As the ads for investment products are all obliged to say, past performance is no guarantee of future performance, and many believe that bonds may outperform stocks over the next few years as stocks' recent strong performance makes them less attractive and as deflation becomes a more potent force than inflation.

Indeed, much of the recent interest on the plus side has been in the fixed-income market. While the stock market has been demonstrating volatility and generally crashing in emerging markets, the US bond market has been steadily strong. There have been two unusual circumstances: one is an inverted yield curve, where long-term rates are lower than short-term rates; the other is a flight to quality, with the quality preference spread widening dramatically. These previously occurred together in 1981, a highly inflationary period, and in 1990, when inflation was declining yet clearly positive. But to find a precedent for both happening for a sustained period, we need to look back to deflationary times almost a century ago.

It seems to be conventional wisdom that the US and European economies are in a healthy state of moderate inflation. But perhaps instead, they are mixed economies with some features still experiencing inflation, principally wages and salaries, and others experiencing deflation, principally those associated with materials and commodities. Today's forecasts are that there is likely to be even more competition from lower wages from the developing countries, which are experiencing extremely heavy deflationary pressures and that these pressures may spread to the developed world. With the reality of deflation plus relatively high real interest rates, bonds become very attractive.

The bond markets may also be boosted by the expansion of the eurobond market in Europe in the wake of the single currency. All new government debt in the eleven euroland countries will be issued in euros, market practices will be harmonized giving incentives for more corporate bond issues in euros, and the market may become more transparent, liquid and efficient. It seems likely that the euro fixed-income market will come to resemble the US bond market.

Finally, it is often valuable to challenge unchallenged precepts. One of the most widely accepted assumptions is that US govern ment short-term debt is the riskless base against which all other returns are measured. But is that always so? Not necessarily: since US debt is almost perpetual and refinanced, what happens when the debt holders, often non-US lenders today, have other uses for their funds? The largest holders of US Treasuries are Japanese and it is not difficult to imagine that they would have other uses for their funds than holding short-term US instruments. And if they and others withdraw from this market, the riskless security could become quite risky.

Critics on Andy Carter's Theory

2010-06-30T19:41:00.000-07:00

One of the major disadvantages of investing in bonds is that they seem to underperform equities over the long term. This conventional wisdom is strongly expressed by Wharton finance professor Jeremy Siegel, who argues for the vast superiority of the equity markets as an investment vehicle. Siegel calculates that a dollar invested in a representative group of US stocks in 1802 would have grown to $559,000 in 1997 after adjustment for inflation (which reduced the value of the dollar to seven cents over that period). In contrast, a dollar invested in long-term government bonds, short-term bills or gold would have grown after inflation to $803, $275 and $0.84 respectively.

So while bonds are usually thought to be less risky than equities, in terms of inflation-adjusted returns, they have actually been more risky for most of the nineteenth and twentieth centuries. Siegel estimates that the real return on equities over almost two hundred years was 7% a year compounded, compared to 3.5% for bonds and 2.9% for bills. What is more, the superiority of stocks grows and their riskiness falls the longer they are held: they outperform bonds and bills 60% of the time over a single year, 70% over five years, 80% over ten years and 90% over twenty years.

The credit risk of bonds is a further downside, particularly during bull markets as investors become more willing to accept risk, which tends to reduce the spread or risk premium that poorer risks pay. When the market is jolted by bad news, the spread invariably widens again dramatically, causing the poorer risks to fail. Notorious recent examples include the aftermaths of the December 1994 Mexican devaluation and the August 1998 Russian default and devaluation. The latter led to the flight to quality and widening of spreads that was such a problem for LTCM.

The old argument in favor of investing in bonds is that they provide current income and some degree of stability of capital. It is generally agreed that the shorter your investment horizon and the lower your risk tolerance, the higher the percentage of bonds you should have in your portfolio. But should the bond portion of a portfolio really be actively managed? Research suggests that professional forecasters find it difficult to beat a simple approach that always predicts that future interest rates are equal to current rates, and that after accounting for management fees, bond funds tend to underperform simple passive investment strategies.

Is the whole of active fixed-income management a fraud perpetuated by managers to increase fee income more than the gains, even if achieved, that could result? Certainly, bond markets are thought to be very efficient and fees should be examined carefully and, ideally, avoided entirely if possible. For example, it is hard to see how management can increase returns when the yield spread between thirty-year corporate bonds and thirty-year Treasuries is under 1%.

Then again, for individual investors, trading in the bond markets can be difficult since in many cases, the markets are not very transparent. While the bid-ask spread on US Treasuries is small because of the very liquid market, the spreads on corporate and foreign bonds can be as high as 56%. This is because bonds are usually traded over the counter with no real marketplace. Investors must rely on brokers who have a big incentive to give the bond seller and buyer the worst possible price in both directions as they make the difference.

Fixed Income According Andy Carter

2010-05-31T02:18:00.000-07:00

"If Andy Carter did not invent active fixed-income management, he is one of its very earliest practitioners," comments Peter Bernstein, someone well qualified to observe fixed-income history. And perhaps nothing epitomizes the development of investment management more than the changes in fixed-income practice in the last 30 years. Classic investment finance reserves the function of providing funds to run a business to equity. Borrowing, whether short-term or long-term, is matched to the payment flows of specific projects for interest and repayment of principal.

We have come a long way since this basic early understanding. Today, fixed-income instruments have rather little to do with specific projects but are another device, like equity, to raise permanent capital. As such, bonds are expected to be refinanced and bond quality is as much a measure of the likelihood of new investors to step forward to replace those who wish to move on to other investments as it is a measure of the profitability of business projects.

Bonds in the 1950s and 1960s were purchased by institutional investors for the major part of their portfolios and were normally held to maturity. These investors might have occasionally altered their quality preference, using rating agencies to attest to bond quality and covenants, but the modest changes they made were almost entirely through their selection of new issues. It was a slow, deliberate process. And expected bond returns were likely to be the coupon return to maturity and the repayment of principal. Many fixed-income portfolios were carried on an institution's accounts at par or purchase price, unadjusted for fluctuations in market value. After all, there was unlikely to be a sale before maturity so recognition of market fluctuations by changes in interest rates or creditworthiness was immaterial.

But then came the emergence of active fixed-income management. Sometime around the bull market excesses of the late 1960s and the collapse of equities in mid-1970s, the thought occurred to Andy Carter and a few others that bonds presented an opportunity for swaps. By studying the underlying characteristics of one bond, it might be possible to find a comparable instrument at a cheaper price. And with the knowledge that a trade could be done with someone who lacked this insight, perhaps a small but promising gain could be captured. Thus, the bond trading business and bond capital gain business were born.

Andy Carter looks like a flashy, dour Scot. Wearing a signature bow tie, he is totally immersed in the full range of fixed-income active management, having been there from day one. It tells us much about Carter that he followed his father as the top student at Loomis School and donated a residence hall there in his family's name.

Carter started in the investment business at Irving Trust in 1964. But his exploration into active fixed-income management began with the Harvard University endowment in the mid-1960s. Just as interest rates began a huge rise, the opportunity was available to show how a bond portfolio could be energized by trading compared with the historic strategy of buy-and-hold.

Carter took active bond management to a new firm, Thorndike, Doran, Paine & Lewis in Boston and then started his own operation in 1972. At both places, he collected a blue chip roster of institutional clients who expected, and received, a different style of bond management and paid equity-like fees for the service. He collected mandates of billions from demanding clients for management. Currently, he is chief executive officer of Hyperion, a bond management firm based in New York City.

Today, fixed-income management is the most quantitative of investment disciplines, incorporating the most extensive use of sophisticated derivatives and advanced statistical techniques of risk management (see Quantitative Investing and Risk Management). However, the well-publicized near demise of LTCM was active fixed-income management carried to its extreme. And Andy Carter can take the credit or blame for starting it all.

Understanding Fixed Income

2010-05-31T02:16:00.000-07:00

Fixed-income securities or bonds are generally thought of as safe rather boring investments, lacking the risks associated with equities. After all, no one seems to worry about the US government defaulting on its debt and US Treasuries make up a significant proportion of the bond market. In practice, though, it is possible to lose vast amounts of money by getting the bond markets wrong. Because bonds appear to have a more definable risk profile than equities, leverage tends to be more easily obtainable. And high confidence in understanding fixed-income relationships may lead to excessive leverage and unexpected out-comes, as the case of Long-Term Capital Management (LTCM) in the late summer of 1998 vividly illustrates.

Bonds are debt instruments, securities sold by governments, companies and banks in order to raise capital. They normally carry a fixed rate of interest, known as the coupon (usually paid every six months), have a fixed redemption value (the par value) and are repaid after a fixed period (the maturity). Some deep-discount and zero-coupon bonds carry little or no interest, instead rewarding the buyer with a substantial discount from their redemption value and hence, the prospect of a sizeable capital gain.

As Michael Lewis explains in Liar's Poker, his entertaining account of life among Salomon's bond traders in the 1980s, the one thing you need to know about bonds is the relationship between their prices and interest rates. In short, as one goes up, the other goes down. This is because the fixed income paid by a bond which when calculated as a percentage of its market price is its current yield is equivalent to the rate of interest. If rates go up, the relative attractiveness of newly issued bonds over existing bonds increases. And since coupons are fixed, for yields to be comparable to those on new bonds, the price of existing bonds must fall.In most developed countries outside the United States, government bonds issued in the domestic market have traditionally dominated fixed-income investors' portfolios. But with the opening of markets around the world, the range of choices has increased enormously in recent years. There are now markets not only in the government bonds of developing and transition countries (see Emerging Markets) but also for numerous other debt instruments: corporate bonds, junk bonds, stripped bonds, mortgage-backed securities, convertibles, and so on. In the United States, the Treasury bond market is now significantly smaller than the mortgage and corporate bond markets.

Credit quality has become a key issue. For example, emerging market and corporate bonds generally carry a risk premium over US government bonds, with higher yields to reflect the more variable creditworthiness of their issuers and the greater risk of default. Periodically, bonds of an entire category sovereign debt, real estate, junk become nearly worthless. Under these conditions, there is a preference for liquidity and quality, making refinancing difficult or impossible for less than top quality issuers.

Interest rates and credit risks are crucial considerations in fixed-income investing but perhaps most important of all is the expected future path of inflation. Inflation is bad for bonds, eroding their value as prices and yields, unless index-linked, fail to keep pace with rising prices. What is more, higher inflation or the prospect of higher inflation is usually associated with higher interest rates, as policy-makers tighten monetary conditions in order to try to contain inflation or protect a weakening currency (see Foreign Exchange and International Money). This makes cash more attractive, pushing down bond returns.

The yield curve is a means of comparing rates on bonds of different maturities, as well as an indication of the tightness of monetary conditions. Longer term yields are usually higher because of the greater degree of time and inflation risk. They are a good indicator of expected trends in the rate of interest and the rate of inflation. When short-term rates are higher, there is an inverted yield curve. It is vital for active fixed-income investors to look for changes in expectations about the future rates of interest and inflation. Key indicators of these are the strength of the economy and the frame-work of fiscal and monetary policy (see Economic Forecasting and Politics and Investing). Bond markets tend to like signs of economic weakness since strong growth might trigger inflation. They also like fiscal policies that dampen the economy, squeezing out inflation.

Indeed, bond traders have become increasingly effective in preventing governments from introducing policies that may reignite inflation, hence driving interest rates higher and bond prices down. Their actual or implied threat to flee the markets in response to such policies has led to them being called vigilantes, and to presidential adviser James Carville's famous remark, ''I used to think that if there was reincarnation, I wanted to come back as the President or the Pope. But now I want to be the bond market: you can intimidate everybody."

The Future of Financial Engineering

2010-05-31T02:15:00.001-07:00

Andrew Lo's research results and the implication that there are pockets of predictability in the stock market lend support to contrarian strategies of buying losers and selling winners (see Contrarian Investing). But he is less convinced by investment strategies based on the insights of behavioral finance into psychological biases inherent in human cognition, which aim to take advantage of individual "irrationality" As financial engineering attempts to define itself as a field with connections closer to the engineering disciplines than more traditional finance, associations are being set up, and the general engineering community does not quite know what to do. Patenting is becoming a big issue. Recent changes in patent laws and interpretations, along with encouragements for universities to do more patenting have led to an explosion of new patents. Some of these are in financial engineering but it is not clear which can be defended. Certainly, financial patents will have an impact on the efficiency of markets and the rate of financial innovation.

Financial engineering is also having an impact on banking. Innovation in combination with electronic technology is creating a world in which maturity transformation turning short-term deposits into long-term loans, the central function of banks is unnecessary. Economic agents individuals, households, companies will no longer require this service. Their portfolios of assets and liabilities will be broadly matched in maturity terms: short-term assets will match short-term liabilities, longer-term liabilities will offset longer-term assets. As a result, as Peter Martin of the Financial Times suggests, "traditional banking is dying. But the grieving throng around the deathbed face a long and expensive vigil."

Finally, what about market innovations? Financial innovations have been fast and furious over the past two decades. But why are market innovations so slow in coming? We have known for a long time what to do: integrate global markets electronically; pay shares in decimals not fractions; open the specialist books and stock exchanges like the New York Stock Exchange; record and display publicly the questions and answers exchanged by companies and analysts. Indeed, we could even go further and encourage insider trading, bringing insiders' wisdom into the market sooner rather than holding out, waiting for culprits to take advantage of us. It could be done, merely by identifying fewer insiders and letting them trade, at which point they would identify themselves. All of these things and more could be done in a stroke.

Counterpoints to financial engineering

2010-04-30T02:27:00.000-07:00

It includes traditional market efficiency arguments against active management, such as Bill Sharpe's arithmetic (see Active Portfolio Management). And even if it is possible to beat the market, and notwithstanding the fact that past performance should not be the sole criterion for judging investment managers, the riskiness of active strategies can be very different from passive strategies (see Indexing). Such risks do not necessarily average out over time, and investors' risk tolerance should be part of the process of selecting an investment strategy to match their goals (see Investment Policy).

A second counterpoint is the set of arguments against quantitative investing, and notably its reliance on backtesting and data mining (see Quantitative Investing). Engineering, by the very nature of its development and application, builds on whatever is accepted theory at any given stage of the cycle. Investment theories tend to lurch forward in leaps, usually after the disappointment of a prolonged bear market. New theories emerge, correcting the ills exposed by a calamitous decline and engineering applies the new wisdoms.

It should not surprise us that the applications of today's financial engineer seem internally consistent, sound and almost unassailable. That would always be found after decades of reconfirmation of market and portfolio theory. But we should not be lulled into complacency by a catechism built on data of only a few decades. Nor should we imagine that portfolio theory, as we know it today, is the end of investment knowledge. There will be new theory and new engineering to apply it. But it may have a different label than the contemporary financial engineering. Finally, one of the consequences of the development of computer and financial technologies (as well as the long bull market) is the incredible growth in electronic trading. This has both good and bad implications for ordinary investors. On the positive side, the tools developed by cutting-edge financial institutions over two decades ago are now available to the individual household. Yet as with most technologies, the tools are more advanced than the general population's understanding of how to use them properly. Although trading costs have come down dramatically for the individual investor, the possibility of doing serious damage to one's nest egg is even greater.

Andrew Lo and Financial Engineering

2010-04-30T02:20:00.000-07:00

Where else but the Massachusetts Institute of Technology (MIT) would you expect to find a course track called Financial Engineering? For a while the Sloan School of Management was not really accepted at MIT though its graduates were among the most sought-after in the job market for newly-minted MBAs. But within the science-oriented faculty, business education was hardly taken as seriously as Alfred Sloan, the donor of the facilities, hoped it would be.

Now that has changed. Finance has gone quant: higher mathematics is a regular feature of security pricing, risk management and business strategy. Professor Andrew Lo is one of the key people responsible. He is a first-rate scholar who, like others in this volume, can straddle academe and business. His research output is huge, often in collaboration with other leading lights who appear in the Journal of Finance, the Journal of Financial Economics, the Journal of Econometrics, the Review of Financial Studies and the many other publications still being added to the reading lists of professors and practitioners.

The burgeoning field of financial economics has produced a group of young professors who now hold endowed chairs. Just a decade or so ago, they were pre-tenured stars full of research ideas sprung from the basic efficient market hypothesis. They were going on to the next level or two, testing and applying these theories to specific valuation, portfolio strategy and risk problems. They showed their students, who were to become the star practitioners in institutions, how to do investments the modern way. Many of this group won a coveted Batterymarch Fellowship for research when little other funding was available. Andrew Lo, of course, was one of the most promising of that group as a winner in 1989.
Lo's research interests run the gamut of today's financial interests and his papers are among the most thoroughly researched of the field. Students call him an inspired teacher, perhaps because he believes in the worth of his subject matter. And in addition to his heavy teaching load, he carries an administrative burden as the director of the Laboratory for Financial Engineering, in fact its founder, at MIT. Somehow, he also finds time to help leading investment firms through consulting projects as well as steadily maintaining active parenting of a young toddler.

In addition to being the co-author of the first major financial econometrics textbook, Lo has a book published in early 1999 entitled A Non-Random Walk Down Wall Street, an obvious counterpoint to Burton Malkiel's classic book of almost the same name (see Market Efficiency). As his title suggests, Lo's research indicates that there are some elements of short-term predictability in stock returns and that it may be possible for disciplined active managers to seek them out, exploit them and "beat the market."

Financial engineering is the key to superior performance. Lo uses the analogy of the exceptional profitability of a pharmaceutical company, which may be associated with the development of new drugs via breakthroughs in biochemical technology. Similarly, even in efficient financial markets, there can be exceptional returns to breakthroughs in financial technology. Of course, barriers to entry are typically lower, the degree of competition much higher and most financial technologies are not as yet patentable so the half-life of profitability of financial innovation is considerably smaller.

Understanding Financial Engineering

2010-04-30T02:18:00.000-07:00

Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations from adjustable rate preferred stock to zero-coupon convertible debt but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.

All these innovations are implemented using a few basic techniques, such as increasing or reducing risk (options, futures and other more exotic derivatives see Risk Management), pooling risk (see Mutual Funds), swapping income streams (interest-rate swaps), splitting income streams (stripped bonds), and converting long-term obligations into shorter-term ones or vice versa (maturity transformation). But to be truly innovative, a new security or process must enable issuers or investors to accomplish something they could not do previously, in a sense making markets more efficient or complete.

Finnerty describes ten forces that stimulate financial engineering. These include risk management, tax advantages, agency and issuance cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.

The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training, but had previously been fed from a haphazard network of different programs. Universities began to re spond to the demand by setting up masters programs in financial engineering and they were helped by the fact that the physics job market was at an all-time low due to the end of the Cold War.

The Future Trends of Emerging Markets

2010-03-30T03:41:00.000-07:00

Perhaps rather it was a natural consequence of the modern portfolio theory taught in the United States, to diversify and take higher risks, coming on the back of what wsa then a ten-year-old bull market. From the developing countries' position, private investors were offering capital at no annual interest rate (we called it equity; they called it free, without management strings), which was more attractive than bank or government lending. It was a meeting of lovers and there was a love fest. And now, they have matured with all of the obligations and responsibility that come from the next age level.

Mobius selects the largest countries as the ones with best future potential presumably for the attractiveness of their domestic markets. The first rush of emerging markets was for export sales and that is now over. He is right to emphasize places like Nigeria and Egypt. And he is right in the sense that if he is wrong, these overpopulated countries will not tolerate a world with such huge disparities of communications and living standards.

But before we get to 2010, we must deal with the traumas of the late 1990s. Since the beginning of the Asian crisis in July 1997, there has been an approximately 50% decline in emerging markets. It started in Asia, became most visible and most illustrative in Russia, with about a 90% decline, approximately the same as in Indonesia, the fourth largest country in the world in terms of population. And pressure built up in Latin America.
rates, in higher markets, to take them out. And even if not at higher levels, they take them out anyway because emerging markets on the whole look like a considerably less attractive place to invest than they did five years ago. This is a world-wide phenomenon, not just limited to Indonesia, Russia and Latin America.

What is it all about? The mixture of rising nationalism and deflation is very potent negative medicine for emerging markets. Reform of banking systems means banks have to recognize bad loans. Interconnectivity means that when something happens in one part of the world, the rest of us all feel it. This is not necessarily a dramatic buying opportunity except for those people who can watch the hourly news. And yet, we are setting up the conditions by which the long struggle of the workout period can take place. It is probably some distance into the future, but the early dramatic decline has certainly been felt.

In the meantime, there will be continual turmoil in these countries, promoting more nationalism, more separation from the international community and yet more necessity on the part of the developed nations, especially the United States, to support them.

China may be different in the sense that it has a high surplus of dollars with its very positive trade balance with the United States, and it may come out of this phase as the dominant emerging market. Mobius is right about the necessity for structural reform but this country seems destined to dominate its region and possibly to be the next sole superpower. It is a tremendously powerful force in the region and in the world, and the group that is running China now and in the next decade is very competent. We should pay careful attention to them.

Meanwhile, the United States itself looks increasingly like an emerging market. As with most emerging markets, it depends entirely on an inflow from outside its own borders in order to survive. There is a negative savings rate, and debt cannot be liquidated on its own but only rolled over, a characteristic of an emerging market. And it is very much an overbought emerging market having extended a very great boom for essentially the last 18 years. But more than that, the United States is an emerging market that has turned over its financial responsibility to the rest of the world. The degree to which the country borrows in dollars is helpful. But the degree to which dollars are held by foreigners is harmful since foreigners can start liquidating those dollars in order to meet their own demands. As an emerging market, it is not clear that the United States would meet the IMF requirements for borrowing, a strange concept given the extent to which it is perceived to be the safest
Think of a swamp fire, or a fire in a coal mine, where underneath the ground there is a common smoldering heat source, which every once in a while flares up to the surface where it must be put out. Firemen come in and douse it with water and fire extinguishers and that flame goes away. Six months later, it comes up again.

This is what the conditions are today in emerging markets. In Indonesia, South Korea, Thailand, Malaysia, Brazil, Russia, Mexico one after another we get a flare-up. But it is all the same thing. It is a preference for risk-averse investing. It is a preference for guaranteed returns. And it is an aversion to the downside risk of a free market that extracts a penalty for over-exuberance. We have to treat the basic fire, rather than just the flare-ups.

Each emerging market considers itself unique in attempting to solve its own problems. But the problems are quite common. In order to rebuild their economies, most emerging markets have borrowed heavily in dollars in this capital-plentiful period. Investors have also invested dollars in those economies and now plan, at higher

The Trend of Investing Mindset

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The ability to move from market to market assumes that investments and their environments are disconnected, that market movements are not strongly correlated. But in these days of global banking and instant communication, that condition is less likely. Markets and investments in those markets may be increasingly synchronized.
In the past two decades, as emerging market investment grew dramatically, globalization permeated our financial systems. Now there are some clues of a cyclical return to local and national interests. If so, investments by foreigners in any market may be treated harshly.

For example, some now argue that the rapid expansion of emerging stock markets in recent years is likely to hinder rather than assist faster industrialization. According to this view, while stock markets may be potent symbols of capitalism, paradoxically, capitalism often flourishes better without their dominance. The inherent volatility and arbitrariness of stock market pricing in developing countries make it a poor guide to efficient investment allocation. Portfolio capital inflows from overseas lead to interactions between two inherently unstable markets: the stock and currency markets. Such interactions in the wake of unfavorable economic shocks may exacerbate macroeconomic instability and reduce long-term growth.

Emerging market investment depends on steadily growing liquidity to be able to pay back investors at higher levels in a foreign currency. This works when the market is going up and money is coming in. But in the reverse, liquidity is tight; the ability to pay foreign creditors is lacking and confidence plummets.

Thus, emerging market investing may be a long-term cyclical phenomenon and not a steady, one-way path to riches. Certainly, the emerging market investment phase of more than the last decade is over. Not only has capital been destroyed and confidence shattered, but the idea of capital flows for superior return from developed countries to needy, developing ones is gone. The latter do not want the funds on anything like the terms that would be required.

A common theme of this book is that investment success is most often observed where the market requirements and investor personality are one. The old shibboleth that "investors don't pick markets, markets pick investors" is more true in emerging markets than elsewhere. And Mark Mobius's style, hard work and tough mind are exactly what was needed in emerging markets. These markets may undergo a change. Will he?

Five Central Investment Attitudes

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Diversification: this is particularly important in emerging markets where individual country or company risks can be extreme. Global investing is always superior to investing solely on the investor's home market or one market. Searching world-wide leads an investor to find more bargains and better bargains than by studying only one nation.

Timing and staying invested: as Sir John Templeton says, "the best time to invest is when you have money." In other words, equity investing is the best way to preserve value rather than leaving money in a bank account. As a corollary, an investment should not be sold unless a much better investment has been found to replace it.

Long-term view: by looking at the long-term growth and prospects of companies and countries, particularly those stocks that are out of favor or unpopular, the chances of obtaining a superior return are much greater.

Investment averaging: investors who establish a program from the very beginning to purchase shares over a set period of intervals have the opportunity to purchase at not only high prices, but also low prices, bringing their average cost down.

Accepting market cycles: any study of stock markets around the world will show that bear or bull markets have always been temporary. It is clear that markets do have cyclical behavior with pessimistic, skeptical, optimistic, euphoric, panic and depressive phases (see Manias, Panics and Crashes). Investors should thus expect such variations and plan accordingly.

In assessing emerging market investments, Mobius stresses the importance of constantly being aware of influences and biases. These are strongest in the places where you spend most of your working and leisure hours and from where you obtain most information. For this reason, the emerging market investor must continually visit all the countries in the emerging market areas and read news and research reports originating from all over the world. (However, as a counterpoint, the internet now makes available a wealth of information on individual markets and countries perhaps better and less costly in time and effort than that obtainable on the ground.)

Emerging markets theory

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As a category of equity investment, emerging markets may be considered to have begun in 1986 under the sponsorship of the International Finance Corporation (IFC), an arm of the World Bank. David Gill, then head of its Capital Markets Division, convinced the IFC to invest in equities in some of the strongest countries the World Bank was financing with debt, initiating private involvement in what had largely been a public domain. The Emerging Market Fund, which Gill started, gave its investment mandate to Capital Group in Los Angeles, a firm that now manages $75 billion in these markets. David Fisher has successfully managed this group since the early days.

But no one epitomizes the emerging market manager better than Mark Mobius of the Templeton Emerging Markets Group. Mobius meets the requirement for physical stamina of an emerging market investment guru. Now in his sixties, he is in top physical shape to maintain the pace of fifteen-hour days, seven days a week. From a childhood in the United States, he has been based in Hong Kong since the 1960s and travels on a German passport. His scope is global with more emphasis on the fast-growing economies, like Asia, that especially challenge an investor when reminded that volatility is two-way.

Mobius is a hard-headed investor in markets that do not usually inspire confidence. His tough valuation bottom-up discipline demands that investments sell at no more than five times earnings five years hence. And the cheaper the better for him. He is a fundamental investor who visits companies and studies the businesses, while fretting little over the country's macro issues (see Value Investing, Economic Forecasting and Politics and Investing). Since his techniques are common to the well-schooled analyst, he has to find different markets and different industries from other analysts. He is often out of step, buying investments that look like they may continue to decline. It is discipline the old-fashioned kind.

Mobius is a frequent commentator on emerging market investing and has written a well-received book, Mobius on Emerging Markets, which summarizes his keys to success:

Hard work and discipline: the more time and effort put into researching investments, the more knowledge will be gained and wiser decisions will be made.

Common sense: the clarity and simplification required to integrate successfully all the complex information with which investors are faced.

Creativity: looking at investments from a multi-faceted approach, considering all the variables that could negatively or positively affect an investment. Creative thinking is also required to look forward to the future and forecast the outcome of current business plans.

Independence: when making investments, it is most unlikely that committee decisions can be superior to a well thought-out individual decision.

Risk-taking: investment decisions always require decisions based on insufficient information. There is never enough time to learn all there is to know about an investment and even if there were, equity investments are like living organisms undergoing continuous change. There always comes the time when a decision must be taken and a risk acquired.

Flexibility: it is important for investors to be flexible and not permanently adopt a particular type of asset or selection method. The best approach is to migrate from the popular to the unpopular securities, sectors or methods.

Understanding Emerging Markets

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"Emerging markets may be a euphemism but it is also a declaration of hope and faith," Mark Mobius has said. "Although some of the stock markets of developing nations may sometimes seem `submerged,' they are generally emerging into bigger and better things."

Such a definition of emerging markets expresses the typically optimistic view of people specializing in this branch of equity investment. Certainly, this relatively new focus of investor enthusiasm is always exciting with something happening all the time, somewhere in the world, with the opportunity for huge profits. Investment returns in some emerging markets have the potential to exceed those in the developed world.

But equally, for the dedicated emerging market investor, there are considerable challenges: the frequent frustrations of a lack of common standards and a lack of information, grueling travel schedules, language problems and cultural suspicions. And, of course, as the Asian crisis and subsequent global economic events have confirmed, stock markets and currencies in the developing and formerly communist worlds can be highly volatile, reacting strongly to international investor sentiment and economic and political changes.

Investments in emerging markets can result in spectacular returns, positive or negative. But picking potential winners, at the level of either country or company, is very difficult. There are frequently problems in comparing the relative merits of companies across markets: financial reporting and accounting standards vary, and indicators such as price-to-earnings ratios are often unreliable for international comparisons. Countries employ a variety of accounting conventions in their treatment of corporate profits.

It is clear that emerging markets carry considerable risks, including illiquidity, lack of transparency and sharp swings in prices. Individual investors seeking a stake in these markets should be either thinking long-term or prepared to take substantial risks. They should also consider carefully what proportion of their portfolios they can reasonably afford to commit to such markets.

Where Forecasting Goes Next?

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Forecasting is a key task in financial institutions because of the profound effects economic developments can have on potential profits. And while leading economic indicators might provide a hint as to what the economic future holds, they do not anticipate what the additional effects of powerful economic agents like government policy and the financial markets themselves might be. To try to get ahead of the competition, companies will aim to model more accurately, and with more consideration of possible discontinuities in the markets.

One way to make forecasts more useful though not necessarily better might be to follow the principle of truth-in-labeling used on food packages and elsewhere. We could describe the kind of forecast we are making more accurately. For example, if we are using backtesting, we should say that that is exactly what we are doing and which of two varieties.

One form of backtesting is momentum: the forecast is derived from a view that the past momentum will continue in roughly the same direction often straight line as it has in the past. The other form is regression to the mean: we think things will not go back or up or down, but return to average conditions. This is like a series of coin flips that goes ninety-nine times in one direction, and we think the next event is related to the preceding one.

Alternatively, we can say that our forecast comes from our own insight or novelty, and label it that way so it is known as essentially out of our head and our own creativity or lack of creativity, which will be known in time. Sometimes different techniques like high-frequency forecasting come from this. Or it can come from news and our response to new news. This is not necessarily insider information but news that is not necessarily generally recognized by others a form of forecasting derived from information.

Finally, the most common form of forecasting is waffle: we do benchmark investing or stick to the middle because we do not know what else to do. That is perfectly all right, but we should label it as such. Let us say that is what we are doing, so people can understand what they are getting when they listen to us. Most of the time, a waffle is the right thing to do, but at all times, we can make our forecasts better by correctly labeling them.

Counterpoint for Peter Bernstein Theory

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Financial analysts are professional forecasters. But why study the economy, a traditional lagging indicator, if you want to forecast investment measures? The investment record of this process is only rarely better than random and when you take account of the expenses of achieving these results, they come out a little bit less than chance. Why do it at all with that unconvincing record of success?

Economic forecasts are supposed to be meaningful. But if you believe that asset prices reflect a forecast of future outcomes, it would seem quite difficult to use a technique that reaches back into the past to get an idea of the future. But that is what economic forecasting does. It is teased for forecasting three recessions for every one hat actually happens. No wonder it is called the dismal science.

Financial Times economics columnist Sir Samuel Brittan makes a pointed reflection on the practice of forecasting: ''The golden rule for economic forecasters is: forecast what has already happened and stay at the cautious end. Forecasts tell us more about the present and the recent past than about the future."

Poor methods, bad models and inaccurate data are all blamed for the recurrence of serious forecast errors. But according to Oxford economics professor David Hendry, these are not the primary cause of systematic mistakes. Rather, unanticipated large changes within the forecast period are the culprit. The primary fault of economic forecasting is in not rapidly adjusting the forecasts once they go wrong.

Hendry uses an analogy from rocket science: a rocket to the moon is forecast to reach there at a precise time and location, and usually does so. But if it is hit by a meteor and knocked off course or destroyed the forecast is systematically badly wrong. That outcome need not suggest poor engineering or bad forecasting models and certainly does not suggest that Newtonian gravitation theory is incorrect.

Peter Bernstein and Economic Forecasting

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Despite the pressures for early and often forecasts, a number of Wall Street and City economists do as good a job as any forecasters, among them Abby Joseph Cohen, Stephen Roach and Edward Hyman. Most such investment economists are good students of market conditions careful keepers of useful data, and on occasion creative in extracting some kind of signal out of the noise. Ed Yardeni, for example, the chief economist at Deutsche Bank Securities, turns his website into a cyber-chart room. If you want to access data and view charts, Yardeni's site is an essential stop. He also makes his commentary available in a section for clients that is password protected, but a substantial amount of the content is openly accessible.

One economic commentator stands amid the few that many of us would class as the best: Peter Bernstein. He grew up heading his father's investment firm, Bernstein MacCauley, in New York. He was the first editor of the Journal of Portfolio Management, founded by Gilbert Kaplan, and has received many awards, among them the
highest honor granted by the investment management industry's professional body, the Association of Investment Management & Research.

Bernstein is able to walk on both streets with practitioners and academics. He writes a newsletter, Economics and Portfolio Strategy, to test and disseminate his analyses. And writing is one of his main strengths: his two books on the history of risk and on how capital ideas came to Wall Street have been regulars on the business best-seller lists during the 1990s.

Like a good academic, Bernstein marshals all the arguments, especially those that are counter to his own position. His mid-February 1998 letter, for example, examined the case for exuberant stock prices in the United States, giving particular emphasis to the market's reliance upon an all-knowing Federal Reserve for economic management. Bernstein concluded that "stocks are a risky investment and should be managed accordingly." Since that analysis was approximately the same as his November 1997 conclusion, he was ahead of the wave and for the right reasons. Bernstein is also faster than most to admit where he has been wrong and to try to examine what led him astray or, as he jokes, "what led the market astray when it failed to act the way I thought it would."

Understanding Economic Forecasting

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Almost every financial services firm has an extensive economic forecasting effort. It is usually part of a so-called top-down investment process, which starts with an outlook for the economy and monetary conditions, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies (see Politics and Investing).

Economic forecasts derive from models usually of the aggregate national or global economy, but sometimes of parts of those economies: particular industrial sectors, regions of the world or even single products or firms. Basic approaches to forecasting simply extrapolate the past; more sophisticated models attempt to understand the sources of past changes and build them into their forecasts. The latter requires knowledge of economic history and economic principles, though, even then, forecasting is by no means an exact science. But while the accuracy of economists' predictions is frequently a target of jokes, forecasting remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic institutions, thinktanks, governments, central banks and international organizations like the OECD and the IMF. In these places, modeling can, to a certain extent, be conducted free of the constraint of producing quick and usable data on a daily basis. But in the investment world, forecasts are required to be done early and often. A relatively short-term outlook is normally the limit of their aspirations what will happen to interest rates within the next month? with decision-makers demanding rapid output that they hope will be directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded in the hope that it may bring advantage to its owners and their clients. But, at the same time, investment economists like to maintain a public profile for marketing purposes, and are often called on by the media to give their opinion on the latest macroeconomic developments. Their interpretations of economic data may give some clues as to how the financial markets will react, though more often than not, they are explaining why the markets have already reacted as they did. Invariably too, there are disagreements about what various indicators mean, depending on different beliefs about the economy, and whether the firm is taking an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates the average of their predictions for real GDP growth, consumer price inflation and current account balances in a variety of countries. More specialized services like Consensus Economics survey over three hundred economists each month and offer details on average private sector predictions.

Bruce Wasserstein and Corporate Restructuring

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In the mid-1980s, there was an avalanche of takeovers of underperforming companies, the targets of institutions and arbitrageurs who suspected that, with the help of plentiful leverage, they could increase corporate values by mobilizing assets. Often that term meant disposal of non-performing assets. In this earlier age of corporate restructuring, Bruce Wasserstein was an enfant terrible. M&A deals were being done at premiums of 3040% above market prices and Wasserstein would be in the middle designing strategies to make them happen.

This was also the heyday of shark repellents and poison pills. Often, the other side would be lawyers and PR people trying to set defenses against shareholders who had corporate control in mind, artfully removing shareholder rights whenever they might be exercised to change corporate control. But the SEC formed an advisory committee to evaluate many of these activities and concluded that the market mechanisms must be left unimpeded.

Wasserstein's youthful energy tapped intensity suited to the pulsing business of deals. Always very well prepared, he worked with arbitrageurs, lawyers, accountants and regulators to move business combinations forwards over institutions dedicated to thwart combinations, which, in the light of hindsight, seemed to favor one group of investors over another. He went on to found his own successful investment banking firm, his personality skills leading him on the correct path.

In his 1998 book Big Deal, Wasserstein surveys "the battle for control of America's leading corporations," including his own role in the past two decades or so. He describes five waves of mergers beginning in the mid-1800s: the first involved the building of the railroad empires; the second, in the 1920s, saw merger mania fueled by a frothy stock market and rapid industrial growth; the third happened during the go-go years of the 1960s and featured the rise of the conglomerate; the fourth occurred with the hostile takeovers of the 1980s, driven by names such as Icahn, Boesky and Milken; and finally, a fifth wave happening today. Wasserstein attributes the explosion of M&A activity at this turn of the century to the need for companies to reposition themselves in today's ever changing competitive environment:

Corporate Restructuring

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One of the most high profile features of the business and investment worlds is corporate restructuring the mergers and acquisitions (M&A), leveraged buyouts, divestitures, spin-offs and the like that are contested in the ''market for corporate control." These recombinant techniques of corporate finance often have an impact on the financial markets far beyond the individual companies and sectors they involve and, in theory, all return real control of companies to shareholders. Virtually without exception, stock prices of participating companies rise in response to announcements of corporate restructuring. But are such events good for investors beyond the very short term?

The late 1990s have seen yet another wave of M&A activity. Indeed, the number and value of mega-mergers in 1998 set new records, a 50% increase on activity in 1997, itself a record year. This has reawakened the populist cry that such mergers do not create new wealth, that they merely represent the trading of existing assets rearranging the deck chairs on the Titanic. What is more, it is argued, the threat of takeover means that managements take too short-term a view, bolstering stock prices where possible, investing inadequately for the future and, where a company has been taken over in a leveraged buyout, perhaps burdening it with excessive debt.

On the other side of the debate, the primary argument in favor of M&A is that they are good for industrial efficiency: without the threat of their companies being taken over and, in all likelihood, the loss of their jobs, managers would act more in their own interests than those of the owners. In particular, this might imply an inefficient use of company resources, overinvestment, lower productivity and a general lack of concern about delivering shareholder value. Feeble supervision of corporations often leads to mismanagement, it is argued, and while increased shareholder activism is one option Certainly, a takeover bid is frequently beneficial to the shareholders of the target company in terms of immediate rises in the stock price (though acquisitions often have a negative effect on the profitability and stock price of the acquirer). And managements that resist takeover may be doing it for their own interests rather than those of their investors. Senior executives may use such bizarre devices as shark repellents and poison pills, which make it extremely costly for shareholders to replace the incumbent board of directors.

The next steps for investor relations are straightforward:

2009-12-31T11:37:00.000-08:00

First, companies, funds and countries that wish to inform their constituency should maintain and publish FAQs (frequently asked questions), a common practice in industry. All questions with whatever favorable or unfavorable answer can be made available on a bulletin board. It is the next step to the ultimate in transparency, the ultimate being when the answers are created automatically regardless of the questions asked.

Second, companies should actively trade their own shares with open disclosure of transactions on an instantaneous basis. Companies would reveal their own interplay between business conditions, availability of capital and their assessment of prospects by their actions.

Third, and in the same vein, insiders would be encouraged to trade with no reservations on when, except that they would have to be identified as an insider.

Technology makes all these possible, and investor relations would be advanced, providing the user with live, real and significant information individually customized for each. It is possible today. But no one has done it.

Corporate governance: What Next?

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Corporate governance is all about the relationship between investors and the companies in which they invest. But what does investor relations really mean? To the practitioner, it means a craft of communication striving to be a profession. To a shareholder receiving its output, it is a necessary way to understand markets and companies. To corporate officials, it is a convenience to fend off the time-consuming quest for information that is often a distraction from running a business. All these views are correct but they are far from the story of investor relations today.

An unprecedented eighteen-year bull market has multiplied all financial service tasks. Abby Joseph Cohen of Goldman Sachs notes that compensation for financial service workers has been the only area of wage inflation in the present business cycle. And many others note that financial assets are the only inflating assets in a deflationary economy. It is reasonable to look at the macro-influence of a bull market creating the need for ever more competent and ever more highly paid investor relations people. But that is not the whole story either.

At its base, investor relations is about communication of fact. Usually, it is what is today called "push" through releases, attractive venues and targeted sources. Investor meetings and lunches have given way to conference calls and internet group emails in turn to global videoconferences. Facts are still distilled by lawyers but, curiously, with the most important facts withheld during blackout periods when the most significant developments are taking place.

With computer databases and search capabilities, remarkable things can be done to turn masses of data into information. Most of the innovations have already taken place in the corporate world, especially in comparative retail sales. Now, they are finding their way into finance: for example, screening of the type used at www.fortuneinvestor.com can survey sixteen thousand securities on six hundred variables; and charts of historical activity on almost anything are available at www.bigcharts.com and www.yardeni.com. Hundreds of tools like these are converting the "push" from investor relations into a "pull" by users in control of what they want, what they do with it and the conclusions to be reached.

Investor persuasion is moving to the user through the empowerment of technology. The nub of judgment remains in an elusive corner of agency finance, behavioral sciences and computation. But each single user has access to machinery to do the chores, which is low-cost, readily available, global and instantaneous. Like Microsoft endorsing the internet, which may ultimately be its downfall, so the alert investor-relations person will provide these tools to make the user's job easier and better.

Understanding Corporate Governance

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Shareholders demand high returns on their equity investments, while executives of public companies typically want a peaceful life with good remuneration and minimal outside intervention. These conflicting interests and how to achieve some kind of alignment between them to give corporate managers the incentives to act in the best interests of corporate owners are the central questions of corporate governance. They have become increasingly important in the 1990s as instead of choosing exit simply selling their holdings in underperforming companies investors are beginning to exercise their voice telling managements to change their ways.

In the 1980s, the most powerful external pressure on executives for stock market performance was the threat from corporate raiders, poised to bid for companies with underperforming shares. Latterly, challenges have come more from institutional investors, the activist shareholders who demand long-term value creation from the companies whose shares they own. This activism has been most dramatic in the United States, and has been supported by regulation: for example, the SEC has mandated the reporting of value creation in the proxy statement.

In the UK too, the pressures have shifted from the threat of takeovers to shareholder activism, often around the subject of top managers' pay and its weak relationship to corporate performance. For example, guidelines on remuneration published by the investing institutions' professional bodies (the National Association of Pension Funds and the Association of British Insurers) demand a clearer link between performance and pay. In turn, many UK companies now explicitly target the creation of shareholder value.

Understanding Counterpoint

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If contrary thinking is so good, why doesn't everyone do it? In the first place, if everyone did it, then it would not work because there would be fewer panics and speculative orgies. Second, it can be very uncomfortable to be wrong and contrary at the same time: the humiliation of going against the crowd when the crowd is right and that can happen is devastating. And third, much of our training and socialization teaches us that the majority is right, or at least, Is contrarian strategy profitable? There is some indication that former loser stocks perform better than winners, but is this because they are riskier? And what about the transactions costs of a short-run contrarian strategy? The quantitative evidence on these questions, as in most investment documentation, seems to depend on the case the researcher wishes to support more than the case itself. Nowhere is the adage, "if you torture the data long enough, it will confess to anything," more clearly observed than in the examination of investment techniques. But a mixture of contrary instincts and investment skills seems to be a part of most investors we admire.

Finally, is contrarian strategy inconsistent with the concept of market efficiency (see Market Efficiency)? The efficient market hypothesis (EMH) in its strong form contends that security prices are always correctly assimilating information. Today, investors generally expect that the weak form of EMH is operative, which means that sometimes it is possible, with generally available information, to gain an advantage over other investors. Contrarians look for these small opportunities by noting where the consensus seems to be clustered and they examine the other, independent alternatives.

Contrary thinking can be a challenge to assumptions that are so deeply embedded in our understanding of the world that we often do not even realize they are there. Three contrary questions in particular may be helpful in guiding us to contrary answers. Contrarians should ask questions like these that are often not even being considered.

The first is, why do investment markets assume that growth should be the sole objective of economic enterprise? Primarily, because of a fifty-year expansion in bull markets, but in most cases, the pursuit of growth comes with the possibility of volatility and risk. Stability and survivability can also, under some conditions, be worthwhile objectives. Contrarians are likely to value these features, which are considered valueless by other investors. Corporate control through proxy voting, for example, is often considered valueless and even a potential conflict for a manager in his client relations. And yet, in a merger or acquisition environment, proxy power is quite valuable: some studies have estimated it at about 15% of total share price. Contrarians might be quicker to identify these underlying mispricings.

Second, we are raised on the notion of continuous time. Nobel Laureate Robert Merton (see Risk Management) wrote a fundamental text with that idea in the title. We learn that time is a horizontal axis on a time chart with each unit of time connected to its neighbor and all units of equal space and importance time is continuous, time flows, time moves on, time in any one period is connected with any other period, time reveals trends. But in the physical world, time may be discontinuous and unconnected with any other time period sometimes coming in bursts, separate packets of information, unique in themselves. And investment time could be like that: Humphrey Neill wrote "sudden events quickly crystallize opinion." Our assumptions about time having a root in the past leading to clues about the future may be wrong.

Third, there is the built-in notion of an equity premium. After a fifty-year period of expansion, we take it for granted that equities produce higher returns, and we think that this is because they have higher degrees of risk. Are we prepared for the time when risk produces lower returns for equities? Or that on closer examination, risk itself becomes something other than volatility but risk of loss and risk of being knocked out of the game?

Understanding Contrarian Investing

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Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their intrinsic value (see Value Investing). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism

To a third group, contrarian investing is the reverse, a steadfast adherence to value- or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as "buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield."Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit. He uses traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the nifty fifty growth stock era of his apprenticeship in investments

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a herd or crowd, the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of the empty file drawer idea than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.

Predicting market

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The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are pockets of predictability. This offers some hope to "disciplined" active managers if they can come up with innovative techniques to achieve superior long-term returns

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of nearly an eighteen-year bull market in equities by some counts, a fifty-year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see Value Investing).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see Initial Public Offerings), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, the quality stocks have done much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good if nothing happens or bad because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.

Bill Miller's Advices

2009-10-29T09:53:00.000-07:00

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there and it is but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.
One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go technology stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.

Active Portfolio Management

2009-09-28T10:30:00.000-07:00

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing buying diversified portfolios of all the securities in an asset class is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds ).

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments. These decisions, often referred to as market timing as investors try to reallocate between equities and bonds in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements. Then there is security selection picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.

Active investing involves being overweight in securities and sectors that you believe to be undervalued and underweight in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market. Compared with passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (. And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.

The right venue, the right style

2009-09-28T10:29:00.000-07:00

It is an old adage of investment cynics that "managers do not pick markets, markets pick managers." This attitude suggests that brilliance is about evenly distributed, but that markets select their own heroes rather than vice versa.

With the construction of investment styles according to the radiation approaches I have described, that limitation is not quite true. Rather, managers can freely roam the world looking for an investment style that suits them a growth manager could have a period of successful investing in the United States, become a non-US manager, and then find a suitable venue in emerging markets: three investment lives all engaged in approximately the same principle. One can invest in all traditional ways and change location, or one can change investment techniques and invest in the same location.

How did you know a growth company in the 1945 and later period? I knew it when I saw it. When I see it again, now, in an emerging market, I say, "this company can compete on a world-wide basis, regardless of the fact that it is ... wherever."

The US style is now flexible, fast and fuzzy. The developed (ex-US) market style is structured, systematic and suited to individual customization. And despite the global economic crisis, emerging markets are the places where there is the greatest potential for growth if we hark back to the high-quality investment styles of yore.

Market students must look geographically outwards to see familiar, repeated patterns and inwards to see what is next.

Investing in US in 1970-1990

2009-09-28T10:10:00.000-07:00

The post-World War II era and its corollary in other markets of the world ended after a generation, almost simultaneously, with academic studies on efficient markets achieving prominence in the United States. Firms capitalized on this phase shift by introducing index products and popularizing valuation shifts and new valuation techniques that are all price-related. As the dictum shifted to "buy low, sell high," it was characterized by the emergence of new investment folk heroes like Warren Buffett. A few firms, Batterymarch among them, popularized valuation techniques for institutional investors, giving voice to this newly emerged market style in the United States.

In Europe and Asia, internationally dominant companies, which looked very much like the nifty fifty, appeared popular for investing. Siemens, Hitachi, Sony, Philips, Bayer and their counterparts became components of more venturesome US institutional portfolios and appeared as the first equity holdings of some of the more fixed-income-oriented institutional holdings outside the United States.

And exactly the same pattern seen in the United States during 194570 was repeated, except in different places, in different markets.

Development institutions then shifted their attention from the devastated areas of World War II to the poorer countries suffering from population explosion. In many cases, these were agrarian-based economies with little ability to soften the shocks and cycles inherent in farming. These markets that had previously been worrying about subsistence began to establish the basis for market economies. Largely influenced by government programs, some of these countries began developing market structures.

Investing after WW2

2009-08-29T22:39:00.001-07:00

Right after World War II, a widely anticipated global depression was expected a common occurrence after nearly every major world conflict. Surprisingly, in the United States, a major interest in equities prompted the success of a handful of companies that became known as the nifty fifty. These companies dominated in managerial skills, product R&D and financial resources. Investors remained skeptical about economic progress throughout this growth era, and markets faced the traditional wall of doubt, the trellis up which green investment ivy must climb.

''Buy high, sell higher" dominated investment styles over this period. Supply and demand for equities became the watchword more than underlying valuation. To adapt a phrase from a quantum physicist, "there appeared to be an underlying price spin tilted in the direction of the positive" other things being equal, something that had gone up would go up more. Another description might be the economics of increasing returns. Eventually, the era ended with the shock of 1967 and the subsequent decline of growth funds in the sharp market downturn in the United States during the 19734 period.

The developed (ex-US) markets essentially those of the advanced countries that were the major protagonists in World War II, whether victor or vanquished during this period were dominated by international reconstruction programs. The Marshall Plan in Europe and its counterpart under the administration of General MacArthur in Japan and Asia led the way. These programs were typically centered around infrastructure improvement and, with the exception of the UK, did not produce much in the way of private equity development until the second half of the period, when government programs became directly supportive of private development activities.

Style radiation

2009-08-29T22:28:00.000-07:00

The spread of investment insights may be visualized as waves radiating outwards in concentric circles from pebbles falling into water. The source of these investment pebbles is the United States. The dynamic force behind the rise of post-World War II equity markets has been academic research coming out of US universities. The availability of cheap computer time, cheap graduate student labor and creative senior professors (six of whom have now received the Nobel Prize in Economics) has contributed to the development of concepts like the capital asset pricing model, the efficient market hypothesis and performance measurement, as well as the growth of derivatives markets.

Not every investment technique is appropriate at every place around the world at the same time. Ideas radiate, interfere with one another and produce new patterns, then reach the periphery at the same time as new stimuli occur at the origin. Technology and communications accelerate the speed of ideas radiating outwards until, finally, the impact reaches emerging markets. As the process is repeated, it is accelerated further.

We can divide the investment world into three parts the United States, developed (ex-US) markets and emerging markets. Most US institutional investors have dedicated teams covering each of these segments. In some cases, they have specialized teams within each team segmented by geography.

The investment world was reshaped immediately after World War II. In fact, if we go back farther, we can gauge the present long-wave bull market from the Battle of Midway in 1942. If we look at equity styles since then, we see that there have been two
major waves, each lasting one or two decades. And a third may have begun.

Paying down debt: the delicate dilemma

2009-08-29T20:01:00.000-07:00

As we close our discussion of debt, we must address one of the more delicate dilemmas of modern marriage: how to handle debts each of you may have accumulated before the nuptials. Years ago, such a discussion hardly would have been necessary. People married young, well before they had accumulated significant debts—or assets, for that matter. Today, the opposite is often true. When people wed today, it may be after a decade or longer as professionals, plenty of time to borrow plenty of money. The same is true of people in second or third marriages. It would be hard to imagine people in that situation without some debt burden. When couples bring individual assets to the marital table, that’s a cause for joy. When the baggage includes debts, the issue is more complex and more volatile. Broadly, there are two approaches you can take to premarital debt. You may decide to reduce your debt as individuals, or you may elect to pay down premarital debt as a couple. Each approach brings advantages and disadvantages. Paying down premarital debt as individuals can prevent conflict, particularly if one party incurred substantially more debt than the other. With this approach, the partner with the smaller debt load doesn’t feel financially strapped by decisions made before the marriage. This approach also permits each spouse to maintain a significant level of independence. But there are disadvantages as well. For one, the debt might not be paid down as quickly or as efficiently as possible, because only one partner is focusing on it. In addition, that partner may feel resentment at being abandoned on Debt Island. That could promote continued use of debt, resulting in financial hardships and marital discord.
If you elect to pay down premarital debt as a couple, you can develop an efficient game plan that emphasizes quick payment of high-interest debt. You can get out of debt more quickly and focus on your goals as a couple. This joint process also implies regular communication about debt, an activity that will help you many times over.
The principal disadvantage to this approach is that the partner who kept the slate relatively debt-free may feel exploited; the good spending habits he or she developed might appear to have come to naught.
As we mentioned, this is a sensitive matter, and we don’t recommend one approach over the other. What we do recommend is talking about any premarital debt and developing a game plan that pays off all debts quickly while keeping both partners satisfied with the strategy.

Comfort Zone Investing Case Study

2009-07-28T21:50:00.000-07:00

Michael and Susan have been saving for retirement for 10 years. They are a composite from interviews and people I have worked with during the past 21 years. Since Michael’s major promotion 10 years ago, they have invested about $50,000 a year. Prior to that, they had less than $10,000 in investments. Now, stockbrokers, realtors, insurance salespeople, venture capitalists, hedge fund vendors, and other investment product peddlers have their number and routinely call them. Michael and Susan have compiled investments worth $450,000 during the past 10 years: half in a 401(k) and half in an online brokerage account. Immediately, you might notice the math. If they have invested $50,000 a year for the past 10 years, achieving a zero total return on their money, they should have $500,000 in investments. You might do the math, but Michael and Susan have not. You would also think that Michael and Susan would be happy with the size of their nest egg. Sill in their mid-40s, they are in the top 1 percent of wealth in the world. But they are miserable. Michael losses sleep over his investments regularly. Though he works 60 hours a week, he finds time several months a year to shift between $100,000 and $300,000 from one investment fad to another, believing he will increase his returns and then be happier with his portfolio. Among the other high-income employees where he works, this is routine practice. In fact, the main non-work-related topic among these employees is investing. Though not one of them has ever calculated their annual returns, they all constantly chase high returns and lose sleep worrying about the market. Susan, a stay-at-home mom and part-time consultant, is equally unhappy with their investments. She wants Michael to work less, even take early retirement, and consult part-time so he does not miss his children’s childhood years. She is certain they were happier before Michael’s big promotion. She is angry that their portfolio is in constant flux. She has no understanding of why one year they seem to have all their money in small cap stocks, the next year in municipal bonds, then in tech stocks, and now in hedge funds. She is convinced that they are on the verge of losing it all any minute and she will have to go to work full-time. You might think the case of Michael and Susan is unusual. It is not. Studies by Dalbar Inc. and others show that as many as 90 percent of individual investors underperform stock market averages because they buy and sell too often. In fact, studies by Brad M. Barber, Terrance Odean, Moringstar, and others have shown that individual investors make returns about half as high as the stock market. During 1970-2000 period when the market made 12 percent a year, individual investors made 6 percent. Individuals even underperformed the bond market by a significant margin. However, hiring professional money management does not solve the problem. Studies by Mark Hulbert and others show that professional money managers also trade too often and underperform the stock market 80 percent of the time. Unfortunately, all these studies focus on investment return.

Investing is not about numbers

2009-07-28T21:47:00.001-07:00

Few investors realize that investing is not a numbers game. Making buy-and-sell decisions based solely on price movements is a strong indication you are outside your comfort zone. Buy at 5 and sell at 10 or buy at 10 and sell at 5 is trouble both financially and emotionally. Buy-and-sell decisions need to be made on the basis of knowledge of who you are as an investor, a fundamental understanding of the investment, and a determination of whether the underlying fundamentals of the investment meet your investment needs. If a company or mutual fund is having a bad quarter or a bad year or a great quarter or a great year, you need to understand how it is reacting to that situation and if its reaction indicates that it fits your investment needs. Price movements are external factors that tell you little about the company, the mutual fund, or yourself.
An emotionally mature adult would not make personal relationship decisions based solely on external factors. If you are in a new romantic relationship and your lover’s mother suddenly dies, do you end the relationship immediately (sell) or watch how your lover reacts to the loss of a mother and watch how you react to your lover’s loss. If your lover then inherits half a million dollars, do you make a decision to marry (buy) or do you watch how your lover reacts to new wealth and how you react to your lover’s financial gain. In a romantic relationship, your goal is to build a long-term positive relationship. Breaking up or staying together based on external factors such as a death or inheritance is clearly immature. The internal factors, your lover’s emotional development and your own, are the real basis for judging the long-term potential for marriage or a parting. The internal factors, your emotional makeup and investment policy, and the company’s reaction to success or failure, are the real basis to determine buy-and-sell decisions.
Investing outside the comfort zone is exemplified by basing trading decisions solely on price. Other external factors also influence investors when they are outside their comfort zone.

Investing is not about numbers

2009-07-28T21:47:00.000-07:00

Comfort zone investing is…

2009-07-28T21:45:00.000-07:00

Comfort zone investing consists of knowledge of how different investments affect your emotions, knowledge of who you are in relation to investments, and choosing investments that match your personality.
The comfort zone is tested most often by large increases and decreases
in investment values. Studies of stock investors show that most investors react to declines in stock values by holding on too long-hoping the price will
improve. Investors also sell winners too soon to lock-in profits, missing even greater gains, and avoid purchases of bargain stocks that have declined in price fearing the declines will continue indefinitely. The net result is individual and professional investors consistently fail to make even half the stock market averages.
Many studies describe these phenomena. These self-defeating behaviors are attributed to thinking patterns such as “loss aversion,” the “disposition effect,” and “mental accounting.” Unfortunately, the studies only describe the patterns and the resulting low returns. The studies do not tell you why you are reacting dysfunctionally nor how to act maturely.
The comfort zone has three elements:
self-knowledge, investment knowledge, and matching yourself to the proper investments. If any of these three elements is out of place, your reaction to your investments will be dysfunctional. If you are in the right investments, you will act maturely. For example, many investors think that investing is solely about numbers. Unfortunately, focusing on numbers ignores both who you are and the nature of investments.

Risk tolerance: The sales tool

2009-06-28T08:27:00.000-07:00

Some investment promoters claim they have all this covered. They ask you a series of questions about your risk tolerance before they sell you their products:

“If the market declines 25 percent in one year, will you take your money out?”
“Are you able to keep the long-term in mind when markets

fluctuate or are you more comfortable with investments that do not fluctuate?”
These tests determine your so-called “risk tolerance.” Risk tolerance is your ability to handle volatility. Risk tolerance tests are supposed to match you to compatible investments. Unfortunately, they don’t. Risk tolerance is not a good measure of investment compatibility. At best, it measures a narrow aspect of your personality: your theoretical ability to handle volatility. Even if your broker happens to sell the product that is theoretically right for your risk profile and you buy it, studies show that how people think they will react under adverse market conditions and how they actually react are quite different. In fact, few of us know ourselves well enough to know how we would really react in future unknown situations. The real problem is that risk tolerance tests do not touch the crucial issues: who you are as an investor and how investments interact with your personality. For example, they do not address the issue of the adverse relationships you have with the investment seller and others. In fact, they disguise this issue. These tests lead you to believe that you and the salesperson have the same interest. The tests do not address the issue of overconfidence. Overconfident investors believe they have high risk tolerance when they do not. The tests do not address the issue of people pleasing. People pleasers are often aware that they have low risk tolerance but they buy high risk investments to make their broker or their coworkers happy. In fact, risk tolerance tests do not accurately address any of the issues that will lead you to purchase incompatible investments.
Risk tolerance tests are equally ineffective for average personalities and for extreme personalities such as workaholics, gamblers, and compulsive debtors. Extreme personalities typically have little or no self-knowledge. They will fill out risk profiles identical to those of average investors. Yet once sold an investment product, they will abuse it to a degree unimaginable by the average public. Risk tolerance tests do not pick up money addicts of any kind and lead to no help for these people or those affected by them.
While money addiction is more prevalent in our society than most people realize, the vast majority of investors suffer from less extreme forms of investment incompatibility. The more common symptoms include loss of sleep, irritability, unexplained anger or depression, random resentments, a sense that investing is meaningless, money arguments with a spouse or partner that neither can comprehend, a dim view of retirement possibilities, and a thousand forms of fear.
The major investment fears are that you do not have enough investments now, won’t have enough in the future, or will lose what you already have. Then these fears lead to further fears. If you don’t have enough savings, then how could you have enough money for travel, clothes, restaurants, a new car, a better house, a real life? Or you fear you cannot and will not ever grasp the mathematical complexities of compound interest and probability theory and you cannot trust those who do understand these concepts. Then there is the underlying fear that investing is irrational and no amount of study will help.
The premise of this book is that these feelings and fears are normal and healthy; understanding them and understanding the emotional hooks of different investments will lead to a greater sense of peace and contentment in your life. They don’t sell peace and contentment on Wall Street. You have to find it within yourself first and then look for the investments that enhance it, rather than disturb it.
When you know more about yourself and about the products that are out there, no risk tolerance tests with hidden agendas will sell you incompatible investments anymore. Investing will become an area of great satisfaction in your life.

Understanding investment compatibility

2009-06-28T08:24:00.000-07:00

Investment compatibility becomes a possibility when you first admit that investing triggers difficult emotions. Try this series of questions and see if you relate to any part of the emotional dilemma:

Have you ever found yourself losing sleep over the market, angry with your broker, unsatisfied with your returns, yet unable to pull out of the market?
Are you jealous of your business associate who has turned it all over to a money manager and has no idea how he is doing?
Does the woman across the street with her string of singlefamily houses irritate you?
How did you react when that 35-year-old coworker retired?
Do you value honesty yet find you have lied to several people about your investments and investment returns?
Do you seek serenity over financial security?
Will high returns bring you serenity or just increase your craving for more high returns?

The more you look at it, the more emotionally charged investing becomes. Financial advisors discuss risk as risk of losing money. Isn’t the real risk emotional? If you are not in the stock market, you risk being an outcast at the beach gatherings this summer. But if you are in the market, you risk losing sleep and losing time trying to keep up with how you are doing, how the market is doing, and how well everyone else is doing compared to how you are doing.
If you knew yourself better and knew more about the emotional aspects of different investments, investing would be more satisfying. Try this question. Is it easiest for you to trust people, financial markets, or the U.S. Treasury?
Those who have a hard time trusting people will find that turning their assets over to a money manager or a stockbroker creates fear. Many independent business people founded and built up their own businesses because they only really trust themselves. That is fine. If you are like that, yet you have turned your money over to a money manager, you will be uncomfortable even if the money manager produces outstanding financial results. You will be happier making all your own investment decisions even if it costs you money.
Some people cannot trust financial markets. Perhaps you saw your parents lose a fortune in stocks. In that case, you may be more comfortable receiving interest payments from Treasury bonds, even if you could make more money in stocks.

Investing triggers many emotions

2009-06-28T08:19:00.000-07:00

To be comfortable saving for retirement and spending savings in retirement, your investments must satisfy both your financial and emotional needs. When your investments are lucrative, but you and your investments are not emotionally compatible, you will either get rid of them and look for something new and possibly more incompatible or stew in your misery. Yet it is difficult to even know what your needs are in this relationship. You are subject to great cultural pressure today to own U.S. stocks, especially the latest fad stocks. It is not just that everybody at the office claims to own them and is checking the results online all day. There are whole institutions devoted to this: CNBC, The Nightly Business News, The Wall Street Journal, a thousand Web sites, and chat rooms. The pressure to own stocks so you can converse about them is high. But are you happy with them? Is anybody happy with them? How many of your colleagues have stopped to ask what their emotional needs are in their investment relationships? Do they act like they know what their emotional needs are? Let’s return to the question that started this chapter and look at the emotional dilemma apart from the financial. What emotions are triggered by having to choose between retirement savings and vacations? Do you find yourself feeling guilty when you go to Hawaii instead of putting the money in an IRA? Or do you get depressed when you cannot go to Hawaii because all your extra savings are tied up in IRAs and other retirement plans?

How to Evaluate Whether Changes in the Budget Are Necessary?

2009-05-29T08:45:00.000-07:00

If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.For example, if your actual utility bills are consistently greater than the amounts budgeted, then you need to either reduce your utility usage, if possible, or increase the amount budgeted for this item.When you increase planned spending, you will need to find items where you can make corresponding cuts to compensate for the increases. If you don’t, the amounts set aside for personal goals or savings will be reduced. There are certain expenditures over which you have some degree of control. These are your variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food are the most common areas of overspending, particularly when they involve eating out at restaurants. By contrast, fixed expenditures such as rent, mortgage payments, taxes, and insurance premiums cannot be easily trimmed without undue consequences. Deficit spending may be more difficult to remedy when you have already reduced many of your unnecessary and variable expenditures. It then becomes more difficult to cut essential spending items. If spending still exceeds income after revising spending amounts, you need to reevaluate your entire budget. Perhaps you have created too tight a straitjacket for yourself.Revise your goals and set aside amounts to attain them before allocating the rest of your income to your expenditures. You may need to prioritize your expenditures to see which are necessary and which can wait.
The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and set aside more of your money to savings. Following your budget will help you achieve what you want most from your resources.

How to Record Actual Income and Expenditures for the Period Budgeted?

2009-05-29T08:42:00.000-07:00

Actual amounts earned and spent are not always the same as those projected. By recording the actual amounts and comparing them with the budgeted amounts, you can immediately see the differences, called variances. Spending more than a budgeted amount for one item can be offset by spending less than the budgeted amount for another item.
Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash. The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other assets in order to pay for the deficit spending.

How to Determine Whether There Is a Surplus or a Deficit?

2009-05-29T08:40:00.000-07:00

If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts needed to fund personal goals added together equal the total expected expenditures. It is a good idea to incorporate goals into a budget so that monthly or periodic income is set aside to address them. When projected income exceeds projected expenditures, there will be additional amounts of cash, which can then be added to savings/investment plans or used to pay down liabilities.
When projected expenditures exceed projected income, there is a deficit. This means additional amounts will have to be withdrawn from savings/ investment plans to pay for these additional expenditures. In such a case, it may be necessary to review projected expenditures and reduce some of them, or look for ways to increase projected income.

Determine Your Financial Goals

2009-04-27T10:59:00.000-07:00

In order to set aside money for your financial future, you need to estimate the expenditures that go toward your savings and investments. Financial goals vary from person to person over time. Some financial goals are:
• Saving for an emergency fund
• Increasing savings and investments
• Buying a new car
• Paying off a loan
• Buying a house
• Buying a larger house
• Saving to fund children’s education
• Providing retirement income
• Saving for annual vacations
Some of these are short-term goals while others are longer term. It is often easier to concentrate on the short-term goals and neglect longerterm goals. By assigning priorities to each of the goals and quantifying their cost, you can determine the amount of savings needed to fund them.

Determine Your Expected Expenditures

2009-04-27T10:58:00.001-07:00

The second step is to estimate all expenditures during the period of the budget. Certain expenditures such as rent, mortgage, and auto loan payments are fixed in amount and do not vary from month to month, whereas other expenditures such as food, clothing, and utilities do vary in amount from month to month. Anticipating these variable expenditures with accuracy may be difficult. The purpose of budgeting is not to put you in a straitjacket in which you cannot maneuver. On the contrary, its purpose is to provide you with flexibility in your financial planning so you can achieve your financial goals.

How to Estimate Your Future Income?

2009-04-27T10:56:00.000-07:00

Estimated income includes all anticipated receipts of money, such as future salary, estimated profits (or losses, which are deductions from income) from a business, bonuses, commissions, interest, dividends, rent, gains, tax refunds, loans, and other sources of income.
Wages, salary, and/or partnership/corporate income should be included net of payroll taxes. Payroll tax deductions can be shown in the income section or the expenditure section. Mr. X is expecting a 5 percent increase in salary for the coming year and Mrs. X expects her business income to be $36,000 for the coming year. The expected gross income for Mr. X is shown, along with the deductions withheld to give his net monthly income. Payroll tax withholdings are the amounts deducted by an employer from employees’ paychecks to pay their taxes. The amount of income earned and the number of exemptions filed by the employee on Form W-4 determines how much is withheld for federal income taxes. Self-employed workers receive income that is not subjected to payroll tax withholdings. This does not mean that they do not have to pay taxes on this income. The tax laws require such taxpayers to estimate their tax liability and pay it in quarterly installments by April 15, June 15, September 15, and January 15 for the tax year. The amount of these payments depends on a person’s total income from all sources, deductions, exemptions, and credits, which determine taxable income.
Mrs. X estimates that her monthly gross budgeted income will be $3,000.
Mrs. X would have to make quarterly estimated tax payments to the U.S. Treasury
on this business income and, depending on the requirements of the state
in which she lives, to the state as well. Income from sales commissions may be difficult to estimate, as they may
be irregular or seasonal. Being conservative by underestimating budgeted income may be prudent in order to avoid overspending and, consequently, having to dip into cash accounts.

Understanding Net Worth

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Your net worth is the difference between the totals of your assets and liabilities. In other words, if you sold all your assets for the values stated and paid off all your debts, the amount left over would be your net worth. Your net worth should not be thought of as cash to be spent. Rather, it is a measure of a person’s financial position as of the date of the personal balance sheet. Can your net worth be a negative number? Yes, this is possible. If you have more debt than total assets, you are technically insolvent. A continuation of this position may make it difficult for you to pay off all your debts on a timely basis, which could necessitate a declaration of bankruptcy.

Understanding Liabilities

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Begin by listing your most current debts, such as utility bills, telephone bills, and
others.Next, list the balances outstanding on your credit card debts and loans. For most people, a home mortgage is their largest single debt outstanding.The amount to include is not the original amount of the loan but the current outstanding balance. The reason is because a part of the monthly payments made to the lender over the duration of the mortgage reduce the outstanding balance of the loan. The current outstanding balance of the loan may be obtained directly from the lender or from mortgage statements from the lender. You can also determine the balance yourself. See the financial calculator in section 20, which explains how to determine your mortgage balance. Add up all the amounts owed to others and you have the total of your liabilities.

Understanding Assets

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Assets are arranged in order of liquidity; that is, the ability to convert them into cash without losing much in the conversion. The most liquid are at the top of the list and include cash, checking accounts, money market securities, and money market mutual funds.
Determining the value of your stocks, bonds, and mutual funds is easy. The prices can be found in the financial pages of a newspaper or obtained from brokerage and mutual fund statements.
Determining the current value of pension funds may be more difficult if the pension fund provides amounts of future income to be received. This means that for this type of plan, you would need to determine the present value of the plan. The human resources or benefits department of your company can provide this information.
If the cash surrender values of your whole life insurance policies and annuities are not shown on the latest statements you receive, call your insurance agent for this information.
Your home is likely to be your largest asset, so its value should not be overinflated or underinflated. The figure that you are looking for is the current market value; that is, what someone would be willing to pay for your house. Generally, the cost of the property is not particularly relevant if you have owned your house for a long period of time. The most recent selling prices of houses similar to yours in your area are a good indicator of the likely market value of your house. Real estate brokers can also provide you with an estimate of the value of your house.
The value of cars can be obtained from used car price guides such as the N.A.D.A. Official Used Car Guide and the Kelley Blue Book (www.kbb.com). These guides can be found in most public libraries, or you can obtain the price of your car from your bank, which should have copies of these guides. Household furniture, clothing, and personal effects should be more conservatively valued so as not to overstate their value. In an actual sale of these items, you might get far less than the estimated values. Add the estimates of the value of all the items that you own and you will have the total of your assets.

Advisory services

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Most mutual fund investors are self-directed: They educate themselves through books like this one, personal finance magazines and TV programs, and brochures and prospectuses offered by the fund companies. Then they make their fund selections and monitor the growth of their investments in order to make sure that they perform as expected. One reason for the popularity of mutual funds is that they lend themselves to just this kind of do-it-yourself investing. However, the bigger fund companies do offer free, personalized advisory services to their higher-dollar clients — especially those with assets of $500,000 or more. Most people who give advice are Certified Financial Planners (look for the CFP designation after their names). Their expertise covers asset allocation approaches, investment strategies, and economic and business trends, and they’re qualified to give specific recommendations on funds to consider. They may also talk about the tax implications of your investment.
If you are not (yet) a part of this investment stratosphere, you may be able to gain some of the same advice from a broker, accountant, insurance agent, or other professional. Be sure you understand exactly how your advisor derives his compensation. An advisor who receives a fee directly from you for his services — either in the form of a straight payment or as a percentage of the assets you invest — is likely to give relatively unbiased advice (how knowledgeable or helpful this guidance proves to be is another matter). On the other hand, advisors who receive all or part of their payments in the form of sales commissions may recommend that you buy the investment products from which they stand to benefit personally. A stockbroker may urge you to invest in stocks; an insurance agent may direct you toward insurance company products such as annuities. Before you buy into any sales pitch, carefully consider the source and what he or she has to gain from your investment.

Retirement-related services

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Many fund firms offer retirement planning services. You may be able to consult a staff member who is familiar with retirement planning issues by telephone, or you may have access to retirement-planning brochures, worksheets, and other literature through the mail or online.
Typically, the retirement topics covered include the following:

How to calculate the amount of money you can expect to require for a comfortable and secure retirement
How much you need to save and invest each month in order to reach your retirement goals
How your asset allocation should change over time as your investment time horizon and risk tolerance change
The pros and cons of various kinds of tax-advantaged retirement accounts: IRAs, Roth IRAs, 401(k)s, Keogh plans, and so on
Options for taking distributions from your retirement account

Social Security plays a role in retirement planning for most Americans. Despite concerns over the long-term viability of the government funding for Social Security, most people can expect to derive at least part of their retirement income from this source.
Your Social Security income will be based largely on how much money you’ve earned (and paid Social Security taxes on) throughout your life. To determine how much you’re probably going to receive from the government after retirement, request Form SSA-7004, the Personal Earnings and Benefit Estimate Statement, from the Social Security Administration, by calling toll-free 1-800-772-1213 or by logging onto their Web site at www.ssa.gov.
When you receive the statement (in four to six weeks), you can develop some perspective on your expected monthly Social Security payments — and how much more retirement income you’ll need to provide through your own savings and investments.

Check-writing

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If you own shares in a bond fund, such as a money market fund, you probably have the option of writing checks against the money in your account on special checks from the fund company. (Check-writing is normally not an option with a stock fund.)
Most funds establish a minimum amount for the checks you write (typically $500), and you may have a small per-check charge. Writing a check can be a convenient way of redeeming shares.
When you write a check against a mutual fund, whether to raise some cash or to pay a bill, you are redeeming shares of your investment. Thus, you may be realizing capital gains or other profits, which subjects you to a tax liability at the end of the year. Don’t forget this potential for taxable profit when the time comes to perform your tax calculations.

Automatic investment and reinvestment plans

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Most fund families make it easy to set up an automatic investment plan, which is an excellent way for you to develop a consistent practice of saving. When you opt for automatic contributions to an investment account, you can also take advantage of the benefits of dollar cost averaging.
Ask your fund company for information about how to establish an automatic investment plan. You determine the amount that you want to designate — $100, $300, $1,000 — and the sum automatically comes out of your bank account each month and is invested in the fund of your choice. Plan to complete an application form and send in a (voided) check from your bank account.
You can also have the dividends and capital gains income from your funds automatically reinvested, buying you additional shares. I strongly recommend reinvesting, because it allows you to enjoy the benefits of compounding.
Most fund families will allow you to have your dividend and capital gains income reinvested in a different fund, which can be an easy way of diversifying your portfolio. Suppose Jacob has $5,000 invested in an index fund — a conservative, low-cost form of stock investment. He can arrange to have the dividends and capital gains from this fund invested in the fund family’s Aggressive Growth fund. As this amount gradually builds up, the growing investment gives Jacob the opportunity to participate in the profit potential of a more risky and volatile but often lucrative sector of the stock market — without taking any money out of his lower risk index fund investment.

Online information and transactions

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With the advent of the Internet, most mutual fund companies now offer the same information online that you receive in your printed account statements. In addition, you can access many other types of data and services online, which relieves much of the time and effort involved in doing research via multiple phone calls, letters, or office visits.
For example, at the Vanguard Web site (www.vanguard.com), you can find such information as

Historical data on how particular funds have performed
The largest stock or bond holdings of particular funds
Specific data about your accounts

Most of the things you do over the phone, you can also do online. For example, you can make investment exchanges between funds, request redemptions, and buy shares.
You can also download application forms and fund prospectuses, plus you can locate other literature on Web sites. Typically, you can access marketing brochures, articles on retirement investing, and speeches by officials at the fund company. With each passing month, fund families are offering more and more interesting online perks. You can look forward to finding retirement calculators, reports on the economy, glossaries of investment terms, mini-courses on investment fundamentals, and other services.
Vanguard, for example, offers WebTurboTax tax-return software free to its online shareholders. Many fund Web sites feature message boards and chat rooms where you can share information and questions with other investors or with the company guru who can respond to your inquiries. The Resource Center at the back of this book lists some of the more useful mutual fund Web sites, including those sponsored by fund companies and those established by independent companies or organizations.

24-hour phone lines

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You don’t need to wait for a quarterly statement to get answers about your mutual fund account. Today, most fund families make information about your account as near as your telephone.
Some major fund families offer 24-hour phone lines staffed by real human beings — a welcome convenience for the millions of investors who find themselves living such busy lives that the only time they have to check their investments may be at 11:00 on a Wednesday night or 8:30 Sunday morning. Other fund families have phone lines with live representatives only during business hours; however, they usually provide a 24-hour automated response phone system that gives you access to your account balance and the current NAV of your shares and enables you to make exchanges between funds simply by using your telephone keypad. Your own coded personal identification number (PIN) protects your privacy, so only you can access the account.
On occasion, you may need to open a mutual fund account in a hurry. For example, you may want to make a qualifying IRA deposit on April 15 so that you meet the annual deadline for saving on your taxes.
Many mutual fund companies are willing to let you open an account and make a deposit by phone, even without a completed application on file, provided you submit the application soon thereafter. Call the fund of your choice, explain the situation, and provide the information the company requests, including the number of your bank account where the necessary investment money is on deposit. Then have your bank wire the money to the fund.

Why most fund investors are dissatisfied with their account statements?

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Dalbar says that most fund investors are dissatisfied with their account statements for several basic reasons:

The statement provides too much information. Although investors need complete data on their accounts, a fine line exists between comprehensiveness and overkill. When too much information appears on the account statement, an investor may feel overwhelmed. Fund companies are beginning to refine and improve their presentation of information by selectively eliminating less-useful data and by making the data they retain easier to read through intelligent design and use of graphics. For example, many funds now show an investor’s current asset allocation percentages using a pie chart rather than simply listing a set of numbers.
The report requires investors to translate tricky mathematical terminology. For example, some fund companies provide statistics like “average cost per share” (a number that may be useful when calculating the taxes due on mutual fund shares you’ve sold), but they don’t describe how it was derived. This lack of information forces you to figure it out yourself. The best account statements explain the source and meaning of every number presented.
The statement overestimates the investor’s knowledge. Fund companies often use language that the typical investor doesn’t understand. The best account statements include a brief glossary with definitions of technical terms.

When you invest in a new fund, study the first account statement carefully. Make sure that you understand every piece of data it includes. If you don’t, call the fund company’s information line and ask the representative to walk you through the statement, number by number. Jot down notes as you go. And don’t be afraid to ask “silly questions”! Having read this blog, you know more than the average investor, so your questions are probably not foolish at all. After all, your money is at stake here — you deserve to know exactly what it’s doing.

Account statements

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Although every mutual fund provides shareholders with periodic reports on their investments, the quality, understandability, and comprehensiveness of these reports vary widely. Most mutual fund families provide quarterly statements that let you know what your current investment balance is, how many shares you own in each fund you’ve invested in, and your current asset allocation (that is, what percentage of your money is invested in which types of funds). In addition, the statement lists the transactions on your account since the last statement — new share purchases and redemptions; switching of money from one fund to another; dividend reinvestments; capital gain distributions, and so on.
If you have more than one mutual fund investment with the same family, you typically receive a combined statement showing all of your holdings rather than a separate statement for each fund. You also get a year-end statement for tax purposes, which shows balances and account activity for the entire year. The account statements provided by most mutual fund companies provide the basics; only a few offer the luxuries. Dalbar, Inc., an independent financial research company located in Boston, has developed quality rankings for account statements from various mutual fund companies. According to Dalbar, the top account statements, in ranking order, come from the following fund companies:
_ The WM group of funds
_ Kemper Funds
_ Montgomery Funds
_ The Dreyfus family of funds
_ The MFS family of funds
Why did Dalbar rank the WM Funds at the top of its list? Beyond the basics, WM provides investors with such data as their beginning and ending account balance for the statement period, the total account value, and the total return percentage per fund.
For investors who participate in the company’s asset allocation advisory services program, WM Funds reports the total return on investors’ asset allocation portfolios — a collection of investments in various categories that shifts over time in response to changes in market and economic conditions. Eventually, WM hopes to provide investors with personalized returns under this program, showing total return on a shareholder’s own asset allocation account. Like most good fund companies, WM is constantly looking for ways to apply new information technology to communicate data to investors more quickly and usefully.

Understanding Basic Services from any mutual fund company

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The basic services that you can expect from any mutual fund company include the following:

Regular written reports on the performance of your investments
24-hour, toll-free customer service
The ability to exchange money between funds in the same family with relative ease and at little or no cost
The ability to make additional investments easily and quickly
The choice between having dividends and capital gains paid directly to you or reinvested in additional mutual fund shares
Check-writing capabilities
Professional advisory services

Beyond these basics, however, more and more mutual fund families are offering services that go above and beyond the call of duty. For some investors, the variety and quality of shareholder services provided is an important factor in choosing a fund or fund family in which to invest. It’s also important to keep in mind that the quality of basic services varies from one fund company to another. For example, account statements highlight the differences among various companies’ approaches.

401(k)s

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Like an IRA, a 401(k) account enables you to save and invest for retirement with no current taxation either on the money you set aside or on the profits that accumulate over the years. You pay taxes on the money in your account only when you withdraw it after retirement.
The main difference is that your employer must sponsor your 401(k) account. Most for-profit companies today offer 401(k) plans; in fact, the 401(k) plan has become the most common substitute for the traditional company-paid pension plan, which fewer and fewer firms now provide. As soon as you start any new job, ask about whether your employer offers a 401(k) plan and how you can begin to participate. Generally, this kind of plan is a wonderful deal for you. You can usually save any amount up to 10% or 15% of your salary, tax-free, with the money automatically deducted from your paycheck. (And,, this form of automatic saving is a great way to make regular investing a habit.)
Many employers match all or part of the employee contribution:
For example, if you set aside 10% of your weekly paycheck for your 401(k) account, your company may kick in half that amount on top of your own contribution. You can invest your 401(k) money in any investment vehicle offered by your employer. Most companies today make arrangements with large financial firms, including mutual fund companies, to provide an array of investment choices for their employees.
You’re likely to have stock funds, bond funds, money market funds, and other options to choose from, and you can divide your contributions among two or more fund types if you want. You receive regular statements about the growth of your account, just as with any mutual fund or brokerage account. If you leave your job, you will probably have the option of maintaining your 401(k) account, letting your money continue to grow tax-free until you retire. However, if you choose to receive the money in your account instead, you have to pay taxes and an IRS penalty on it — unless you roll your investment over into a rollover IRA, a new 401(k), or another type of tax-deferred account. Any fund company, broker, banker, or other financial professional can help you with the paperwork and other details.
A 403(b) is a similar type of account offered to employees of nonprofit organizations — schools, hospitals, and so on. If you have the option of participating in a 401(k) or 403(b) plan at your place of work, sign up as soon as you can. For almost every investor, these plans are a great way to grow your money tax-free, usually with help from your employer. Your 401(k) account can become the backbone of your savings plan for a happy and secure retirement.

SEP-IRAs

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This is a special type of IRA for people who run their own small businesses (the acronym SEP stands for “self-employed person”). If you’re a freelancer, a temporary worker, or a selfemployed professional of any kind, look into a SEP-IRA account. This account enables you to invest up to 15% of your annual earnings in a retirement account free of current taxes — a significant advantage over the ordinary IRA. Another similar type of account is called the Keogh plan. The plan enables self-employed people to set aside even more tax-free income — usually up to 20% of your annual earnings — but the process involves a significant amount of paperwork, which may not sound particularly appealing to you.

Roth IRAs

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The Roth IRA is a new type of retirement account with significant advantages for most investors. Unlike a traditional IRA, the money you contribute to a Roth IRA is taxable at the time you invest it.
However, the income enjoyed by your Roth IRA account is not taxed, nor is the money in the account when you withdraw and spend it after retirement. This is a huge tax break, because your $2,000 annual contribution is likely to have grown into tens of thousands of dollars by the time you retire — all of which will be yours to use, tax-free. Generally speaking, the only people for whom a traditional IRA is probably a better deal than the Roth IRA are those who are less than ten years away from retirement. For them, the immediate deductibility of this year’s contribution may be worth more than the back-end deductibility of the Roth IRA.
Your broker, banker, or mutual fund company can help you with the calculations if you’re unsure which type of account is better for you.

Individual Retirement Accounts (IRAs)

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Any American whose income is below a legally specified level can save up to $2,000 per year in an IRA account tax-free. This means that you pay no income taxes on the money you invest in your IRA, and the interest, dividends, and other income enjoyed by the money continues to be tax-free for as long as you let the investment grow. When you retire and begin withdrawing the IRA money, the funds are taxed as ordinary income at your applicable tax rate — which is likely to be lower than your current tax rate, because you no longer earn a salary.
Check current tax law to find out whether you’re eligible for an IRA account. The answer will depend on your income and on whether you’re covered by your employer’s pension plan. If you’re not covered by such a plan, you’re fully eligible for the IRA tax deduction; if you are covered, the income limits kick in.
Any mutual fund company, brokerage firm, bank, or other financial company can help you set up an IRA account. You can then fund it with whatever investment you choose, including your choice of mutual fund.
When investing in an IRA or any other tax-deferred retirement plan, don’t invest in a municipal bond fund or in any other fund type that specializes in low-tax or no-tax investing. Remember, such funds generally produce a lower rate of return than similar taxable funds, and because you are not paying any taxes on the income you enjoy from the fund, you have no reason to settle for that lower rate.

Tax-Deferred Retirement Accounts

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If your primary investment goal is retirement, taxes need not be a major issue. Thanks to federal laws designed to encourage retirement savings, several special kinds of investment accounts are currently available that enable you to save on current taxes as you invest for retirement. Any mutual fund investment can enjoy major tax benefits if it is placed in one of these tax-deferred retirement accounts. Every smart investor who is putting away money for a comfortable old age owes it to himself or herself to open such an account. Your money grows much faster in a tax-deferred account than in an ordinary

Municipal bond funds

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A municipal bond fund is another kind of tax-advantaged mutual fund. A municipal bond fund invests in bonds issued by state, county, city, and other local government agencies. Most income from these bonds is exempt from federal income taxes (although you must report the income on your federal income tax return). If you live in a state that levies a high state income tax, such as New York, California, or Massachusetts, you may want to consider a single-state fund, which invests in municipal bonds issued only in that state. Income from such a fund is exempt from state taxes as well as federal taxes, and may even be exempt from local taxes in a city (like New York) that levies a local income tax. Over 600 such single-state funds are currently available, covering some 30 states.
Despite the tax advantages of single-state funds, they’re not for every investor. Some single-state portfolios are relatively risky. Because the fund manager is restricted to buying bonds issued in one state only, he may be forced to invest in some counties or government agencies whose credit is shaky. If the agency defaults on its obligations — that is, if it fails to make timely payment of the interest due on its bonds — the value of the portfolio may suffer significantly. Study the prospectus of any municipal bond fund you are considering buying, and make sure you understand the degree of safety or risk involved with the bond investments held in the portfolio.
If safety is especially important to you, consider a municipal bond fund that invests only in insured bonds. These are bonds guaranteed by an independent agency that promises to make timely interest payments if the issuing agency runs into financial difficulties.
The prospectus for any fund you’re considering states whether the portfolio includes insured bonds. The safety does come at a cost; generally speaking, an insured bond fund has a return that is 0.1% to 0.4% lower per year than an uninsured bond fund. You have to decide whether this lower return is a reasonable trade-off for you.
Although interest and dividends from municipal bond funds are not taxable, capital gains (if any) generally are. Be careful to distinguish the different forms of income and treat them correctly on your tax return.

Tax-advantaged mutual funds

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Tax-advantaged mutual funds are funds whose investment holdings are designed to minimize the investor’s tax liability. They may or may not be tax-managed, but their approach tends to be tax-efficient over time, resulting in overall lower tax payments by investors.
Index funds are the premier form of tax-advantaged investment. Index funds feature a passive style of investing, in which the fund manager buys and sells stocks only as needed to ensure that the fund continues to mirror the index on which it’s modeled. Because the manager of an index fund doesn’t do a lot of trading, relatively low amounts of capital gains are realized during any given year, minimizing the tax bite you must pay. Perhaps the most tax-efficient fund type available today is an index fund that is specifically managed to minimize capital gains distributions. This involves certain accounting practices that the fund manager must be careful to follow, including identifying for the Internal Revenue Service the bought and sold specific shares of a given company. By selling first all shares bought at a higher price and holding on to those bought at a lower price, a fund manager can reduce taxable distributions to investors significantly. If you’re interested in a tax-advantaged mutual fund, contact Charles Schwab and Vanguard. These two mutual fund companies are among those that offer tax-efficient index funds specifically designed to keep capital gains taxes as low as possible.

Understanding Tax-Managed Funds

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Tax-managed funds are those in which tax effects are incorporated in the fund manager’s decision-making process. The manager of such a fund is guided in her buying and selling decisions, in part, by considerations of how to avoid incurring excessive capital gains taxes in any given year. For example, suppose that Jane Goodbucks is the manager of Fund T, a tax-managed fund. Jane may be contemplating selling the fund’s shares of Microsoft, the giant software company, because she and her research staff expect the value of Microsoft stock to increase at a rate of just 10% a year during the next several years — a little lower than Jane would like. Jane is considering replacing her Microsoft stock with shares of Amazon.com, the online retailer, which she expects to grow at 11% a year.
If Jane ignores tax effects, she is likely to sell the Microsoft stock and buy Amazon.com. But because Fund T is a tax managed fund, Jane first considers the cost her shareholders can expect to incur for capital gains. The taxes due will depend on the amount of the gains realized, which will depend, in turn, on how long Fund T held Microsoft and how far the stock increased during that time. Based on these considerations, Jane may or may not decide to sell Microsoft. Due to the effect of taxes, trading Microsoft for Amazon.com may result in lower returns for investors, so holding the Microsoft shares may be the better choice. You can find out whether a fund is tax-managed by reading the fund prospectus. Unless the prospectus states otherwise, assume the fund is not tax-managed. If tax considerations are important to you, consider focusing your fund choices specifically on those that are managed with tax effects in mind.

Tax on mutual funds capital gains

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Capital gains — profits from an increase in the value of the securities held by the mutual fund — may be either realized or unrealized. Their tax status differs accordingly, with only realized profits being eligible for taxation. Here’s how it works.
Capital gains are realized when the fund manager sells stocks (or, less commonly, bonds) at a price greater than their purchase price. When stocks held by the fund increase in price but are still held, the capital gains are unrealized.
Capital gains are taxed only when they are realized. For example, suppose Sharon owns shares of Fund M, whose net asset value increases by 10% during the course of a year due to a 10% increase of the value of the stocks owned by the fund. If the fund manager sold no securities during the year, the investor would receive no realized gains in the current year — therefore, no taxes due on capital gains. However, suppose Sharon decides to sell her shares of Fund M. (Maybe she needs to cash in her investment in order to make a down payment on a new house.) When she does so, she is realizing (literally “making real”) the profits earned by the fund due to the increase in the value of the stocks it owns. These profits are now capital gains on which Sharon is obligated to pay taxes.
If you plan to sell your mutual fund shares, consider the tax implications of your timing. If the value of your shares has grown significantly, so that you can expect a large tax payment, consider whether you want to accelerate the transaction (making the sale by December of the current year) or to delay it (pushing it back into next January), depending on which year your income may be greater. Realizing your profits and paying taxes on them may be less painful during a year when your income is smaller and your tax rate is therefore lower.
Current tax law also distinguishes between short-term and long-term capital gains. Short-term capital gains are profits from sales of securities held by the fund for 18 months or less. The government taxes these gains at the same rate as ordinary income, just like dividends. In fact, you will actually find short-term capital gains listed in the “dividend income” box on your Form 1099-DIV because the tax rate is the same.
Long-term capital gains, on the other hand, are profits from the sale of securities held by the fund for longer than 18 months. These profits are taxed at a more favorable rate. If you are in the 15% tax bracket, the government taxes any long-term capital gains you enjoy taxed at just 10%; if you are in the 28% bracket or higher, your long-term capital gains are taxed at 20%.
As you can see by its design, federal tax law encourages investors — including fund managers — to hold on to securities for a longer time. Taxing long-term capital gains less heavily than short-term capital gains is another reason why a mutual fund with a lower turnover rate may be more beneficial for the investor than a fund that buys and sells stocks rapidly.

Tax on mutual funds dividends

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Unless you invest your money in a tax-deferred retirement account (as explained later in this chapter), dividends you receive in the form of a distribution are generally treated as taxable income. Currently, the government taxes dividends at the ordinary federal income tax rate of 15% to 39.6%, depending on your overall taxable income. You generally have a choice (selected when you open your mutual fund account) of receiving dividend distributions in the form of a payment by check or reinvesting them in the purchase of additional shares of the fund. Don’t fall for the myth that if you reinvest the dividends you receive, the dividends are not taxable.
Unfortunately, that wishful thinking is not true. Although you never actually see the dividends in the form of cash, the dividends reinvested on your behalf during the year appear on your 1099-DIV form, and the IRS expects payment of all taxes due on these dividends.
If you want to avoid paying taxes on dividend income, you can opt to invest in a growth fund or a small cap fund. Such funds generally pay lower dividends than large cap funds or income funds, because they invest in small companies that use their profits to finance business expansion rather than paying dividends to investors. As a result, you’re likely to receive lower dividends while enjoying greater profits in the form of net asset value growth.
However, the positive tax effect of lower dividends may be spoiled if the fund’s rate of turnover is unusually high. If the fund manager buys and sells stocks frequently, the fund is likely to experience greater than average capital gains, on which the individual investor must also pay taxes. So, if you choose a fund partly to avoid heavy tax payments, make sure to check its turnover rate before investing. You can also delay or avoid some tax liabilities for dividend income by choosing a tax exempt municipal bond fund or by putting your mutual fund investments in a tax-deferred account, such as an IRA or 401(k).

Tax Consequences of Mutual Fund Profits

2008-12-14T22:23:00.000-08:00

You can profit in three ways when you own a mutual fund: through any increase in the net asset value (NAV) of the fund shares; through dividends; and through capital gains. Each of these kinds of profit has a potential impact on the taxes you have to pay. For most investors, tax considerations are not worthy of top ranking on the list of concerns that may affect decisions about buying or selling a mutual fund. Most people are wise to buy and sell mutual funds based on their changing financial goals and their perceptions of the investment markets and the overall economy rather than worrying too much about the relatively small tax consequences of their decisions. However, if you’re in a higher tax bracket (31% to 39.6%), you may want to take the tax implications of your mutual fund investment decisions more seriously. Here are the things you need to know.
At least annually, a mutual fund must distribute to investors the dividends and capital gains that the fund’s portfolio has generated over the course of the year. As Dividends are a portion of the profits generated by a company and shared with those who own stock in the company, and capital gains represent the difference between the price at which you purchased a security and the higher price at which you sold it — the profits.
Bond funds usually distribute the income received from their investments in the form of a monthly dividend. Stock (equity) funds and balanced funds, which hold both stocks and bonds, may distribute dividends quarterly, annually, or semiannually. Capital gains are distributed once a year. Around the end of the calendar year, the mutual fund company sends you a 1099-DIV form detailing the taxable distributions that you received during the year. You use this information when preparing your income tax return for submission by the following April 15.

Dollar Cost Averaging

2008-12-14T22:19:00.000-08:00

Dollar cost averaging is a technique whereby an investor puts a fixed amount of money into the same investment vehicle at regular intervals. For example, if Ian invests $500 a month into a mutual fund every month, he is dollar cost averaging. Dollar cost averaging offers a number of benefits. For many investors, the habit of investing regularly is a difficult one to develop and maintain. Setting aside the same amount of money from each paycheck is a good way to develop this discipline. Many mutual fund companies can arrange automatic deductions from your checking or savings account which make it even easier to invest regularly. You’ll soon find that you hardly miss the money which is going to build a steadily increasing investment nest egg.
Dollar cost averaging also increases the rate of return on your investment dollar. Here’s how it works. Suppose Ian invests his $500 a month into a mutual fund whose net asset value per share varies between $20 and $40. During months when the NAV is lower, Ian’s $500 will enable him to buy more shares; when the NAV is higher, he’ll buy fewer shares. The beauty of dollar cost averaging is that, over time, by investing the same amount each month, Ian will buy more shares at a relatively lower price. Therefore, his average price per share will be lower, meaning that his investment profits will be greater.
See Table 8-2 for an illustration of how this works. Over the year shown, with the NAV of Ian’s Fund F varying between $20 and $40 per share, the average NAV is $30.08 per share (calculated simply by adding the average monthly NAV — $20 in January, $24 in February, and so on — and then dividing the sum by 12). But Ian has been able to buy a total of more than 208 shares for $6,000. Thus, the average per share price Ian has actually paid is just $28.83 — more than a dollar less than the average NAV for the period.
Dollar cost averaging always works this way: By buying more shares when the price goes down, you reduce your per-share purchase price and so stretch your investing dollar. Dollar cost averaging enables the investor to regard a decline in NAV not as a loss of value but rather an opportunity to buy more fund shares at a discount price. I strongly recommend it to all new investors — and to experienced ones who’ve never enjoyed its benefits.

Deciphering Differences in Share Classes

2008-11-29T06:16:00.000-08:00

If you buy a mutual fund from a broker, financial planner, or banker rather than directly from the mutual fund company, you may run into a confusing variety of share classes. These different classes of shares have varying fee structures, and choosing among them can be tricky. You can avoid this complication by sticking to a no-load fund and buying direct. But if buying a load fund from a broker, planner, or banker interests you, you may need to know the differences in class shares:

Class A shares: These usually involve paying a sales charge (load) up front. The typical front-end load is in the neighborhood of 5.75%, but it may be higher or lower.
Class B shares: You don’t have a front-end sales charge on these shares, but you do have a 12b-1 fee, which is usually 1% a year. In addition, expect a declining back-end charge (sometimes called a redemption fee). For example, if you sell between one and two years after buying, you may be charged 4%; between years three and four, 3%, and so on. Typically, after year six, you may have no charge.
Class C shares: These involve a so-called level load, which means they may charge a front-end charge of 1% plus a 1% annual 12b-1 fee.

Which class of shares offers the best deal? No single right answer exists. Although the high front-end load of the Class A shares sounds scary, paying the 5% once may be cheaper than paying 1% annually over (say) a 10-year investment period.
To further complicate matters, in many cases, a B share or C share automatically converts to Class A after a period of time. The quicker B shares convert to A, the better, because this conversion eliminates the annual 1% fee. Unfortunately, share classes are not regulated and may vary from one fund company to another. Sometimes, only specific groups of investors are able to invest in special share classes.
For example, a certain share class may be designed for those who participate in 401(k) retirement plans. When buying a mutual fund through a broker, financial planner, or banker, be sure to ask about share classes and make certain you know what fees you will be charged.
If you want to avoid the confusing share classes, opt for a noload fund. No-load funds have no front-end sales charges or other loads to figure out.

Deciding When to Buy

2008-11-29T06:12:00.000-08:00

Be careful about buying shares in a mutual fund during the last quarter of the year (that is, during the months of October, November, and December). Most funds announce their dividends, capital gains, and other such profits for the year during this quarter. The actual payment of these profits to shareholders (called the distribution) usually doesn’t take place until January.
However, according to Internal Revenue Service rules, these profits are considered paid on December 31, and anyone who is a shareholder as of that date must pay taxes on them. Thus, you’re probably better off waiting until after the January distribution to invest. You can receive the benefits of the profits, but you won’t have to pay a tax bill on them because you were not a shareholder as of December 31.