The Boom in Absolute Return Strategies Mutual Funds

By: Henry To | Fri, Nov 3, 2006
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Dear Subscribers,

Before we begin our commentary, I would first like to introduce Mr. Rick Konrad as one of our regular guest commentators going forward. Rick is author of the excellent investment blog "Value Discipline." Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. Rick: Here's hoping that you never came across one of my papers because my handwriting is just horrible!

One more note: We are now at the one-year anniversary juncture of our subscription-based newsletter. As I have mentioned many times before, I am indeed humbled and honored to be writing for you all. You - our subscribers - have set me straight many times over the last 12 months and I have also learned a lot from many of your emails (please keep those coming even though I may be tardy in responding to them). My partner and friend, Rex Hui, and I remain excited by the prospects of this website going forward. I intend to write for you all as long as the market is still here and functioning well - so please continue to stay with us and grow with us as we march forward. We would not be here today without your support.

Let us now do some "laundry work" before getting to the gist of our commentary. On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 705.26 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 585.26 points in the black. Real-time "special alert" emails were sent to our subscribers informing them of these changes. Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on October 29th, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. We are also bullish on both Yahoo and Amazon. We are also very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward. At this point, the breadth of the market is still strong - despite Friday's correction. Even should breadth top out here, the major market indices typically should still have four to six months to run being forming a significant top (based on action in a typical bull market). Moreover, many of the major hedge funds out there are underinvested and underexposed to U.S. equities in general - and as the end of 2006 approaches, many of these hedge funds will be in an unenviable position of trying to beat the S&P 500 - by either buying "high beta" stocks (such as growth stocks) or by leveraging up on S&P 500 futures.

So again, while it may be tempting to take quick short-term profits here, I urge our readers not to get "cute" and to try to time this market on a short-term basis. I assure you - no trader on the face of this Earth can do this successfully on a consistent basis - not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital - who have actually just recently sworn off short-term trading (effectively forever) in his fund.

Let us now get on with our commentary. Make no mistake - the boom in solar energy technologies is real, especially out here in sunny California. The price of solar as an electricity source is still two to three times to that of fossil fuels (i.e. coal and natural gas) but companies like Google is already setting an example and encouraging more investments in solar technology. By installing 9,200 solar panels on "the Googleplex," the company aims to supply 30% of its electricity needs via these solar panels over time. It also expects to recoup the cost of installing these panels via energy savings in five to ten years. While Germany and Japan are still global leaders when it comes to solar technology and manufacturing, Silicon Valley is definitely poised to catch up. The emergence of Applied Materials - which has the necessary background in materials science and manufacturing techniques from its many years of silicon manufacturing - as an advocate of solar technologies has been the industry's major recent trump card. If things go their way - and I would imagine so given the increasing amount of VC funding in this area - then the cost of producing electricity from solar sources could conceivably approach the cost from fossil fuels in five to ten years time. At least, in California anyway. We definitely live in "interesting times."

That being said, the growth in solar power or alternative forms of energy sources will definitely not replace fossil fuels anytime soon, if ever. From an investment standpoint, this author still believes we are in a secular bull market for energy, metals, and other commodities - even though I believe the commodity market is in a cyclical bear market at this time. To refresh, this secular bull market in commodities has its basis in the confluence of the following four factors:

  1. General severe underinvestment in exploration, production, and transportation facilities and equipment from the early 1980s to the early part of this century.

  2. Globalization and unprecedented growth in the world's emerging markets, especially China, India, Brazil, and Vietnam. With the outsized economic growth in these countries, and given that these countries (on a per capita basis) are still consuming minuscule amounts of energy and raw materials, there is no question that demand for commodities will continue to exponentially increase going forward.

  3. The securitization and the ease to trade many of these commodities for retail investors today, as exemplified by investments such as the GSCI, the United States Oil Fund, ,the Barclay's Gold and Silver ETFs, and the continued decrease in commission costs for futures and options on commodities.

  4. The concept of a supply "peak" in many of these commodities just as demand is exploding in the emerging markets.

Whether point number four is correct or not is not important from an investment standpoint. In the short-run, market movements are all driven by psychology, and if investors start believing in hyperinflation (such as in January 1980 when gold rose from $550 to $850 an ounce in three weeks) or a "new era" (such as the late 1999 to early 2000 period), then you better get the heck out of the way. A big part of my belief in a secular bull market for commodities is based on the late 1960s to 1980 experience - but while history "does rhyme," it often does not repeat itself in the exact manner. In today's globalized financial markets where the dissemination of information is instantaneous, investment themes and trends can die out very quickly. In other words - while this author is still "sold" on the secular bull market theme for commodities, I am definitely always watching my back and reviewing and revising my views as new information comes in. I certainly would not be surprised one single bit if this theme turns out to be false, especially given the pace of innovation in alternative energy technology - in no small part thanks to the pouring of VC funds into this sector out here in sunny California. Do not underestimate the power of Silicon Valley - especially when huge sums of money and the lure of profits are involved. For now, we continue to be short and intermediate term bearish on commodities (see last weekend's commentary for a big reason why) - readers please stay tuned.

Readers who are keen market traders or followers should read the most recent Marketwatch.com article on the "boom" in "absolute return strategies" among the mutual fund industry for retail investors. Just like the boom in hedge funds, private equity funds, and the real estate market in recent years, the boom in mutual funds that specialize in absolute return strategies is mostly as a response to the 2000 to 2002 bear market in U.S. large caps, technology, and telecom stocks. However, unlike the institutional market, there was really no effective way to gauge retail investor demand for these types of funds. More importantly, the technology and the financial education required to implement these strategies have been significantly lowered in recent years - thus allowing significantly reduced expenses (although they are still very expensive relative to traditional mutual fund styles). Year-to-date so far, retail investors have invested approximately $1.3 billion into these funds so far (with the Rydex Absolute Return Strategies Fund making up a significant portion of that at $200 million in total assets).

So Henry, what do you mean by an "absolute return strategy" mutual fund?

Following is the definition directly quoted from the Marketwatch.com article: "Absolute Return funds aim to stem investment losses in volatile markets by playing the long, or bullish, side of the stock market, but also selling some shares short in case prices decline. In fact, the category, or at least a subset, is sometimes referred to as long-short equity funds. Although most of these funds stick to stocks, some add exposure to exchange-traded funds, equity options and distressed debt, depending on specific strategies."

That means that while some absolute return mutual funds aim to be market-neutral, not all are quite that way. Some of these funds are just more diversified and invest in more exotic securities, such as emerging markets, currencies, and real estate (similar to a multi-strategy hedge fund). It is always good to have more options when it comes to investing. And on the surface, investing in these funds sounds like a good way to diversify risk - and in the meantime, get some kind of consistent return that is somewhat higher than bond returns in the long-run (as many of these funds strive to do). However, as many of our subscribers should know, there is no such thing as a free lunch when it comes to the financial markets. In a sense, when one is investing in one of these funds, you are essentially investing on the basis that these managers (or computers in many cases) have the ability to pick better-performing stocks in the long-run, if one is trying to be market-neutral. Then there are other such funds involved in convertible arbitrage, merger arbitrage, currency carry trades, etc. Many of these funds operate on a "reversion to the mean" basis - but just like the Fall 1998 period, what if recent relationships do not revert to the mean? And what if - just like the Fall 1998 period - the Yen again experiences a crushing rally? Or what if there is some kind of "blow out" in the credit default swaps market - a blow out that is preceded by a GM or Ford debt default or another frenzy in the private equity markets (since bonds tend to fall dramatically in value in an LBO)? Given that hedge funds account for approximately 58% of the CDS market (usually selling default protection in order get a consistent revenue stream from these premiums) - one can surely bet that many of these absolute return funds would be in trouble as well if there is some kind of systematic fall-out in the CDS market. Now you know why both Chairman Greenspan and Bernanke -unlike the 1994 to 1995 rate hike campaign - has been so clear in that Fed rate hike intentions over the last few years (anyone who didn't know what they were going to do in advance definitely fell asleep at the wheel).

However, it is to be noted that an inflow amount of $1.3 billion is hardly a bubble - given that it represents less than two days of mutual fund inflows during a typical rip-roaring bull market. Sure, the space is certainly getting crowded in the hedge fund world (according to Hedge Fund Research Inc, total hedge fund assets approximate $1.34 trillion at the end of the 3Q 2006), but don't forget that a typical hedge fund nowadays also charges 2% of assets and a 20% incentive fee - meaning that hedge funds in general today have an inherent disadvantage given that the typical expense ratio of these absolute return mutual funds are less than 2% a year. In other words, hedge funds in general will need to outperform these absolute return funds by over 25% each year in order to both justify their fees and to survive in the hedge fund world going forward. The implications of this severe disadvantage are two-fold:

  1. Retail investors who make good manager selections (or who got lucky) within the absolute return mutual fund world still have a very good chance of beating most hedge fund managers - even as the space in the hedge fund world gets more crowded by the day. In other words, as long as the retail space does not get crowded, many retail investors still have a good chance of making satisfactory returns by investing in mutual funds that engage in these kind of absolute return strategies. For the first time in history, retail investors will have an advantage over institutional investors - primarily because of this 25% performance "advantage."

  2. Going forward (perhaps in two to three years?), the absolute return strategy mutual funds are going to drive general hedge fund returns, and not the other way around. The implication of this is huge: As long as the absolute return space continues to grow in popularity among retail investors - there is bound to be a HUGE shakeout in the hedge fund industry sooner or later. Most hedge fund managers would tell you that their performance and skills justify a 2%/20% fee structure - but if they are really that great, they will most likely have a fee structure similar to SAC Capital where they are charging 3% of assets and 50% of profits instead. Just like the investment bankers in the 1980s and venture capitalists in the 1990s, many hedge fund managers will ultimately fall by the wayside.

For subscribers who are market practitioners and who follow many of these absolute return strategies in the mutual fund world, there are still definitely outsized performance returns (relative to hedge fund returns?) going forward. Unfortunately for the layman, many of these funds also look too much like a black box - as both the prospectus and annual reports of these funds contain little or no information on the managers or the "systems" that these funds use. Buyers beware!

Getting back to the stock market - it is important to note that while many major U.S. market indices made new rally highs last Thursday and that breadth remains very respectable - Friday's action was definitely discouraging. Given that the S&P 500 has been up 11 out of the last 13 sessions, and given that the Dow Industrials has been up for five consecutive weeks, readers should not be surprised if the stock market endures a correction sometime over the next two to three weeks. This is especially concerning given that Jim Cramer - who has had a bad history of macro market calls since early 2000 - is now wildly bullish on the stock market. Correction just up ahead? There is now a good chance.

This "contrarian signal" coming from Jim Cramer is all the more significant given that our MEM indicator has continued to deteriorate in the latest week - showing that speculators are still very overstretched and overleveraged given the dismal growth of the St. Louis Adjusted Monetary Base and the hawkishness of not only the Fed, but the European Central Bank and Bank of Japan as well (the fact that the Nikkei has just closed down 317 points and has underperformed during the third quarter is definitely telling you that liquidity in Japan is not strong right now).

As I mentioned last week, readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary, but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages). The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve. One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base. By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity). On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking. If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing. Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3. Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has just stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly. Instead of using M-3, we are now choosing to use a monetary indicator that most closely resembles the usefulness of M-3 - that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy. We went back and found one measurement which is very close - that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis). That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator. Following is a new weekly chart showing our new MEM indicator vs. the St. Louis Adjusted Monetary Base vs. M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - Speculators continue to be aggressive in recent months despite the slowdown of the U.S. economy. Especially when it comes to *negative carry* speculations such as commodities or high yield corporate and emerging market debt, subscribers should continue to tread carefully here. Despite this, however, this indicator of speculation in the markets continues to be substantially more muted than where it was in early 2001.

As can be seen in the above chart, our MEM indicator is still significantly in negative territory and actually declined again from negative 4.25% to negative 4.42% - meaning that the Fed has continued to more or less tighten (lack of growth in the St. Louis adjusted monetary base) even as speculators and investors alike continue to take on risks (increasing pseudo M-3). That is, the Fed has not been loose at all - and in fact is now as hawkish as they were during early 2001. Most of the recent monetary growth has come from commercial banks and the private financial sector - meaning that investors have again been "fighting against the Fed."

As I mentioned last week, in a liquidity-constrained environment - the most dangerous investments are "negative carry" assets - assets such as money-losing real estate or investments that don't give you any dividends or interest - such as gold. Another class of dangerous investments is foreign currencies that have a lower yield than the U.S. dollar - such as the Canadian dollar, the Euro, and possibly the Japanese Yen (the only thing going for the Yen is that it is very undervalued on a purchasing power parity basis). I then discussed that by far the most dangerous investments in such an environment are assets which have a hugely "negative roll return," such as what we are experiencing in many of the commodities today such as gold crude oil, and corn.

More follows for subscribers...

 


 

Henry To

Author: Henry To

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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