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Diversification

Uhhhhh…. ya that all looks good. LET IT RIIIIIDE

Playing off of my last post on mutual funds, I wanted to say something about diversification. Wall Street, FA’s, and basically anyone involved with finance has increasingly banged into us the idea of diversification. It’s the old theory of “don’t put all your eggs in one basket”. While this is a great way to reduce risk, it’s also a great way to put a ceiling on returns. Take a minute to think about some of the richest people in the world, many of which happen to be in finance. Bill Gates–Microsoft. Carlos Slim–Mexican Telecoms. Warren Buffett–Berkshire Hathaway. The list is long as fuck, but you get the idea. All these guys were/are FAR from diversified. They focused on one area, and crushed it. While diversification is good for someone who can’t afford to lose, it’s not very useful for those looking to really make some money.

Why do you invest your savings? Not to have the smallest losses, but to have the biggest returns. If you hand your money off to a broker who is WILD good at trading options, why would you want him to invest some of your money in commodities? This isn’t to say you shouldn’t keep some money invested in safe assets, such as Treasuries/gold/low-volatility currencies, but if you think the tech industry is going to skyrocket, what’s the point of having 50% exposure to tech stocks and 50% exposure to say, utility stocks? Like life in general, you should stick to what you’re good at with investing. You can’t allow emotions to dictate your trades, and you can’t be good at every strategy. Speaking of which, just handed in some homework for an econ class, part of which was a problem about diversification. If I split my exposure to half China and half US, my expected utility is greater than just investing in the US! Dope! I think Jing Zhang woulda been pissed if I wrote “fuck that” as my answer.

Summer Journal 8/26: Problems with Mutual Funds/ETFs

yo….. yo…. YO!….. hit this shit man. We’ve got like… no more work to do

During my job this summer I kept a notebook and wrote about 3-5 pages of notes each day. The thing is about 200 pages front and back and I got to about 170 by the end of it, so there’s a shitload of my thoughts on paper. It’s funny reading some of the earlier notes compared to my later ones. One of those things where you go into the summer thinking “alright I know a solid amount let’s crushingtons”. Then you end the summer and all you can think is “wow I learned so much… and I didn’t know DICK coming in”. But ya I’m gonna start posting some of the better notes I took and maybe see if my opinion has changed since.

This note is from one of my last days when I was having a conversation with my boss about different types of careers. We started talking about mutual funds, and how they differ from say, a broker like him. To preface, my boss is an extremely hard worker, the kind of guy who gets 4 hours of sleep a night because he’s got trade strategies running through his head non-stop. More than that, he’s extremely old school. Doesn’t pay attention to P/E ratios or any technical indicators like that. And to his defense, he’s good as HELL at what he does… making money for other people. But back to my main point, he has a strong anti-mutual fund opinion. And here’s why.

Let’s say you want to get into bonds right now. While there are tons of strategies you can use for bond exposure, the two most basic are buying your own bonds straight up or investing in a bond fund. For most people, the latter means your broker will purchase shares in whatever bond mutual fund it is you want. Right off the bat you should notice something. You’re paying a broker to manage your money, but the asset you hold (shares of the bond fund) is being managed by someone else entirely. Seems stupid to me at least.

The next issue is the mutual fund managers’ motives, which have to be tilted toward the fund investors. Most investors who want to get into a bond mutual fund are curious about one thing: what is their yearly return? When you buy your own bond(s), you know the YTM, call protection status, maturity date, etc. All of these things let you know exactly what your total return is, not just what your coupon rate is. If you’re not following, this is what I mean. An investor buys into a fund because he sees it gives a 5% semi-annual return, in other words the fund’s structure is made up of 5% coupon bonds that pay every 6 months. This sounds great to the investor, but the actual return isn’t going to be 5%. If all the investors care about is that 5% coupon, the managers will have no problem paying premiums on those bonds when structuring the fund just to get that 5% coupon (not a 5% YTM). So in reality, when you sell your shares or the fund closes you won’t be making a total return of 5%/6-months.

The last part shows how mutual fund management can be bad (obviously there’s a ton of good mutual funds out there with great managers, but I’m speaking in general right now). The main goal of the fund is that % return, while brokers and FA’s must also worry about their clients retirement goals, whether or not they need to send kids to college, etc. So, mutual fund managers can apply one single strategy to every investor, whether or not that strategy applies to that investor. The managers don’t have to speak directly to the investors, and only have to worry about the structure of the fund (making sure they’re solvent enough to pay out investors who want out). In the end, mutual fund managers don’t have too much incentive to actively manage the fund for higher returns. They know that they can load up on coupon bonds paying out what people want, and that’s good enough. I’ll expand on that point in my next post.

The last problem goes back to the fund structure. Money is always coming in and going out of these funds. Therefore, the structure of the fund is always being changed (i.e., diversification %, maturity structure, etc.). Unlike a broker, where you know exactly what you hold at all times, it’s much more difficult finding out the funds exact holdings, and therefore your own holdings (as a % of the fund). All in all, it’s a pretty lazy way to invest your money. There are plenty of ways to find higher returns, more income/cash flow, or whatever your personal strategy should be.

The state of the muni market

I’m not an anti-Obama extremists who hopes he gets assassinated… just an unreal pic

In a recent Fortune article, Meredith Whitney is holding onto her position of a bear market in municipal bonds. Back in December on 60 Minutes, she said that there’d be “50 to 100 sizeable defaults” worth “hundreds of billions of dollars” over the next 12 months. The muni market is worth around $2.9 trillion right now, so hundreds of billions of dollars is… a fuckin’ shitload. While there have been 29 straight weeks of withdrawals from muni-bond mutual funds, actual muni-bond defaults have fallen. From January 1 through April, there were 14 defaults worth around $605 million. That same period in 2010 saw 43 defaults worth around $1.7 billion. So, naturally, a lot of people don’t (and don’t wanna) believe her.

Even though Whitney’s forecast has been condemned for some time, the extent of her firm’s new research might make your ballsack shrink a bit. For instance, since 2003 state outlays have risen from some $1.5 trillion to $2.2 trillion, while tax revenues have increased from $1 trillion to $1.4 trillion. Uh… that is not good. What makes this market different than say, treasury securities, is a muni-bond default is much different than a corporate-bond default. A bondholder can’t force a city into foreclosure, you kind of just have to accept the bond haircut and restructuring if there is no bailout by the federal gov’t. Especially when the economy is in a position like it is now, this uncertainty can more than offset the tax-free attribute of munis. So, if anything, Meredith Whitney telling everyone that there’s gonna be hundreds of billions of dollars worth of defaults could end up being a self-fulfilling prophecy (fuckin’ hate those, right?). Rates are already ridiculously low and we’re not seeing much growth. What happens when they rise due to defaults, and we haven’t even gotten out of the gutter? Don’t expect state debt problems to be solved anytime soon.