Another Bad Reason To Invest In Hedge Funds

I know, we need bad arguments for hedge fund investing like we need...bad advice from big banks?

In an May 2nd "Eye on the Market" piece from J. P. Morgan's Private Bank, Michael Cembalest suggests that investing in hedge funds in a low yield/low spread/low everything environment might be an interesting idea. He bases this argument on this very pretty picture:

This picture shows the annualized performance of randomly generated portfolios of five hedge funds that happen to have a ten year history. Cembalest argues that because the volatility of these portfolios apparently falls below the volatility of BBB bonds, and the returns fall pretty reliably in the 4%-7% range, this might be a good time to invest in smartly constructed portfolios of hedge funds.

Here's the thing: Hedge fund managers trade spreads, they don't perform alchemy.

So-called "arbitrage" strategies earn a spread over cash returns! The annualized return on three month Treasury Bills over this period plotted above is about 3.1%.  So, at least we should knock 3.1% off the annualized returns because even hedge fund managers aren't making that return in today's environment.

Now, 1% - 4% returns with slightly lower than BBB corporate volatility doesn't look as good anymore, does it?

I guess we should rethink randomly picking portfolios of hedge funds.


P.S. Yes, I should recalculate the vol measures as spreads too.

P.P.S. You disagree that hedge fund managers earn spreads over cash?  Please send me an example.  I probably disagree!

Conflicts and College Savings...and Brookings Fellow Proposes Zero Taxes on Savings!!

Suppose I worked for Harvard, and I wrote that the education crisis in America had reached new levels, and that the federal government needed to act now(!) to help people realize the American Dream of going to college because, it's in the public interest, after all, people with a college education have far lower unemployment than those without, and our nation benefits.

You'd call me a hero, right?

Or, would you cry foul because I'm the direct beneficiary of such Federal Government largess?

Robert Pozen, courtesy of Harvard

That's exactly what's going on over at Yahoo!, in a piece written by Robert Pozen, a lecturer at Harvard, and senior fellow at Brookings. 

First, he proposes that the U.S. Department of Education should take a more active role in marketing 529 Plans, the tax protected investment vehicles used to save for college.  In other words, the U.S. government should work harder to sell you mutual funds destined to pay his salary.  Second, he wants unused balances in 529 Plans to convert to IRAs, traditional retirement savings vehicles.

Three years ago, I wrote we should do away with 529 plans.  They're a terrible waste of resources, that even Pozen acknowledges only benefit wealthy people.  They also subsidize Pozen and his colleagues because they lessen the real impact of tuition increases. 

But Pozen wants you to have the added benefit of the IRA conversion if your child doesn't go to college.  That sounds good, right?  Of course the reason people who are saving for neither college nor retirement is that they're worried they'll have too much saved for college!  What??

In fact, Pozen's proposal is the greatest tax break for the wealthy in the history of...well, in the history of the Brookings Institution! 

Here's a secret: All you need to sock away $250,000 tax free in a 529 Plan is the social security number of the beneficiary.  You don't need to tell the beneficiary.  You don't need to tell the parents.  The IRS doesn't care.  No limit on the number of kids.  You can play shell games with the beneficiaries, as long as they're first cousins.  By Pozen's proposal, one of those first cousins doesn't go to college and PRESTO! one giant IRA.  Take that, IRS!

If Pozen gets his way, here's my advice to the extremely wealthy: Find yourself a nice, large Hasidic Jewish family, and pretend you're the rich grandparent!  You could easily have 50 or more first cousins, and chances are someone isn't going to college.

It's Only Money

I have a secret for you: U.S. dollars aren't really worth anything.  It's magic.  Economists call it fiat money.


You already knew this.  You don't like thinking about it.  The debt ceiling debate makes you acknowledge our currency has no value.

From TPM.com via Krugman at NYT

In this Op-Ed in the New York Times,  Edward Kleinbard suggests the Treasury adopt the solution California used when they ran out of money: Issue scrip.  He writes:

To avoid any confusion with actual Treasury debt, and to be consistent with the law governing claims against the United States more generally, the scrip would not pay interest in most cases. And unlike debt, it would have no fixed maturity date but rather would become redeemable in cash only when the secretary of the Treasury was able to certify that there’s enough money available in the Treasury’s general fund to cover it.

Finally, the scrip would be transferable, allowing financial institutions to buy it at a high percentage of its face value, knowing that the political crisis would almost certainly be resolved before long.

 

Did you read that carefully?  Kleinbard defines "scrip" as pieces of paper with serial numbers that change hands freely, and do not bear interest.  Guess what: That's fiat money!

[Yes, California issued its own currency in 2011, in theory backed by U.S. currency, which is backed by air...but only in theory.]

The Grinch Who Mispriced Volatility

In my very first post, I hit on the annual ritual of  Grinch economists explaining the inefficiencies of Christmas (and other) gift giving, and my personal disgust with the concomitant trade in gift cards instead of cash.  (That's my second post this week using the word "concomitant", by the way!)

I even confessed to my personal failure to adequately monitor my accumulated gift card credit risk following the Border's bankruptcy.

In a beautifully titled piece How Terrible Is Christmas? Megan McCardle proposes two arguments in favor of inefficient giving, giving a slightly less Grinch-y approach to economic analysis of gift giving.   Unfortunately, her arguments don't hold up.

First, she argues, building social networks requires inefficient allocation of resources.  Short term, seemingly irrational, commitments of time, money and effort shows commitments to new, long term relationships.  That makes sense.

However, most Christmas gift-giving focuses on existing relationships, not building new ones.  She turns to her own grandmother as an example, but grandmothers cannot buy long term relationships.

In fact, I'd guess Christmas gift-giving etiquette tends toward much more modest gifts for new relationships, to specifically avoid the risk of "over-commitment" to new relationships.

Weekend at Bernie's III

Bernie Madoff has a lot to say about insider trading and other fun stuff. In his year end letter (hmm...even jailed, fund-less hedge fund managers write them...how quaint!) Madoff expresses concerns over dark pools, high frequency trading and concomitant insider trading.  I have concerns too, but not for the same reasons.

Madoff explains that dark pools obscure information (that's good...that's what smart buyers and sellers do,) fast execution prevents leakage of information (that's good too!) but leakage inevitably happens.  This leakage, he tags as insider trading. 

[Side note: This insider trading argument about leakage is complicated stuff!  Maybe this set of rules helps you understand.  If your information is bad and it leaks, you are dumb money being outsmarted.  If your information is irrelevant but your trades leak, you're being front run.  If your information is good and your trade leaks, you are insider trading.  Got that?]

Is information leakage really insider information?  Of course not!  Why is anyone interested in the financial market prognostications of a convicted felon who completely failed to successfully manage anyone's money??