The Ignorant Investor

Gretchen Morgenson of the New York Times writes:

Enormous losses at one of the nation’s largest hedge funds resurrected worries yesterday that major bets by these secretive, unregulated investment partnerships could create widespread financial disruptions.

The hedge fund, Amaranth Advisors, based in Greenwich, Conn., made an estimated $1 billion on rising energy prices last year. Yesterday, the fund told its investors that it had lost more than $3 billion in the recent downturn in natural gas and that it was working with its lenders and selling its holdings “to protect our investors.”

The clients of the firm include all kinds of "pension funds, endowments and large financial firms like banks, insurance companies and brokerage firms" who have basically been chasing outsized returns in a sideways market. What happens when people get desperate to promise high returns? They start taking more risks. They start betting. And while some people are going to win their big bets, some have got to lose, too. Charles H. Winkler, chief operating officer at Amaranth, recently noted to clients that the fund was up 25 percent for the year, according to a source cited by the Times. But days later rumors started cropping up that the fund was bleeding cash in a losing bet on movements in the price of natural gas (when markets are moving sideways, that's really the only way to make money).

Now rumors are that the funds losses are even bigger than they're letting on publicly. But the best is way down in the story:

Amaranth employs a so-called multistrategy approach to investing that allows nimble portfolio managers to seize opportunities in whatever markets seem to be most promising at the time.

Now that Amaranth has owned up to huge losses in a single sector, “multistrategy’’ seems to have been a misnomer at the fund.

. . . according to its Web site. The firm deploys capital “in a highly disciplined, risk-controlled manner,” it noted.

The advertising doesn't reflect the reality? What a surprise. The thing is, anyone who promises huge returns without high risk is usually a weasel. Yet behind every huge loss with pension funds and other big entities are sophisticated managers falling for the promises of huge returns. These guys aren't dumb. It's just they have to make big money even when the market is fully priced and stable.

The article goes on to note that the firm's energy portfolio is run by Brian Hunter, a trader who joined the fund from Deutsche Bank in 2004. Hunter made so much for the firm in 2005, the Times notes -- an estimated $75 million to $100 million-- that he was listed among the 30 most highly paid traders in Trader Monthly magazine.

Who wouldn't take huge risks with other people's money when they payoff is $75 million a year? You'd be insane not to. The worst that will happen to Hunter, absent any fraud, is that he goes looking for a new job in another profession. Or just retires to sit his ass on his big pile of money.

The article wraps up by implying that more regulation may be needed in hedge funds because of their increasing power in the markets. About 9,000 hedge funds now manage more than $1.2 trillion in assets (maybe a little under a tenth of the money in mutual funds). I'm not holding my breath. An SEC effort at rulemaking in the area recently got tossed out by a federal judge, and a Republican Congress isn't going to be rushing intoregulate the industry any time soon.

How important is it to keep expenses low when buying mutual funds? I've been fretting over having money in one of Schwab's index funds because its 0.37% expense ratio is far higher than equivalent funds offered by Fidelity and Vanguard, which come in at .10% and .18%, respectively. But the difference in the realized gain between funds with a .10% or .37% expense rate seems minor when compared to the 1% or 1.5% charged by many managed funds.

Assuming an initial $100,000 investment (Yeah, I could have used $10,000- BUT LET'S THINK BIG TODAY!), and a seven percent average annual real increase in stock prices (i.e., inflation stripped out) after ten years the investment grows to:

Expense
Ratio
.10% - 182,305
.18% - 181,081
.37% - 178,203
.50% - 176,257
1.0% - 155,133
1.5% - 148,610

As you can see, the differences between the Schwab fund and the Vanguard or Fidelity funds is pretty minor. A few thousand dollars, which we'd rather have, but nothing we can't live with. The same can't be said for the average mutual fund, which is going to be worth about $20,000-$30,000 less in today's dollars. That's not chump change. That's a good years worth of income for many retired folk.

A better way to look at it is in a chart. Taking out the initial $100,000 investment and looking only at gains, that blue area there is what you get to keep and play with after 10 years. It's pretty clear that the person who went with the mutual fund with higher fees is going to have a whole lot less to play with. All that empty gray space that is a beautiful blue on the left? That's the barren spot where your money would have been if you'd stayed away from that high-fee fund.



Active managers will say that they can grow money faster than the averages, but every one of them is fighting an uphill battle because of those high fees. But those fees are why they work. They have to take a big share of your gain every year in order to buy the houses in Greenwich, the new BMW, the trips to Bermuda and Europe. They can't live otherwise. These guys aren't priests, and they don't take a vow of poverty.

I wouldn't mind if they actually could deliver on the promises of superior gains, but all but a very few can't. As David Swenson as often says, what you get from active management is usually worth far less than what you pay for.

So the rule is: stick with mutual funds with expense ratio's under .50%. There are good funds out there, even actively managed ones, that deliver quality service without costing the mutual fund equivalent of an arm and a leg.

Marcy Gordon of the Associated Press recently wrote that home prices inched up in the second quarter of this year, citing just released government statistics for the end of the second quarter.

Note that these were small price increases, not the price declines anticipated in the now expected housing de-bubbling. Yet what made the report newsworthy, and justifiably so, was that during the same period last year we saw huge increases in home prices. So we've got some kind of leveling off in house prices, but no big scary drops to fret over yet.

Note also that although these are the latest stats we have from the government on home sales, the information is months old. We now know what happened back in April, May, and June. But what we'd all like to know is what is happening to home prices right now.

The investing strategy known as the "Dow 10" or the "Dogs of the Dow" is having a banner year. A chart provided by the Wall Street Journal shows it far outperming the rest Dow overall. The strategy involves buying the 10 stocks in the Dow with the highest dividend yields, though the Journal doesn't point out when they get sold. (Do you simply replace them every January with the new dogs?)

The strategy is not a guaranteed winner- it's had positive returns in only 2 of the past 6 full years (2000-2006). However, this was during a miserable time for the Dow overall, a period that included a major crash and a recovery in which investors favored small caps, foreign stocks, gold, and real estate over the mega-caps.

If you compare it to the Dow overall, you'll see that it lost less value than the Dow by small margins during the bear market of 2000-2002, topped it in 2003, and was just barely behind it in 2004. In 2006 it's been trouncing the Dow overall because GM's recent outperformance. The only really bad year for strategy in the past six years was in 2005. Which was a stinker.

Problem is, everyone is talking about it now. In the past when the Dogs of the Dow became popular it quietly lost its performance advantage. Expect the same now.

Down, but not out:

SAN JOSE, Calif. - Hewlett-Packard Co. said Tuesday that Patricia Dunn will step down as chairwoman of the computer and printer maker in January amid a widening scandal involving a possibly illegal probe into media leaks. She will be succeeded by CEO Mark Hurd.

Hurd will retain his existing positions as chief executive and president and Dunn will remain as a director.

See the amazing power of this blog? Yesterday I called for her dismissal. Today she's gone. Fear my wrath, corporate America. I am like, the Punisher of investment blogging or something.

Two stories caught my eye in today's Wall Street Journal.

BAITING HOLLOW, N.Y. -- Federal regulators are trying to hit the brakes on commercial real-estate lending. That annoys Bradley Rock, the chief executive officer of Smithtown Bancorp Inc.

Wheeling his black Lexus sedan toward the clubhouse of the Fox Hill Golf & Country Club, Mr. Rock gazed at the lush fairways of the 175-acre property, appraised at more than $15 million. The owners of the club owe $2.7 million to his bank. "You could sell the property for massively more than the debt," Mr. Rock said. "It's impossible for the bank to lose money."

"It's impossible for the bank to lose money. "

Is there anything more to say about the current attitude of bankers? Although it does seem hard to worry about a $2.7 million debt secured by property currently worth $15 million, the important think to note is that when commercial banks start tightening credit standards a lot less money flows into the system. Fewer new businesses start up, less equipment is bought, fewer construction workers building developments. The froth is harder to work up. The story is no big deal, but it does signal that the federales are beginning to worry about their companeros in the banking system.

FRANKFURT -- After years of sluggish spending, Europeans are finally snapping up a range of imports -- including running shoes and construction cranes -- stepping in to prop up the global economy just as economists expect American consumers to start closing their wallets. . . . European consumers have started spending again, boosting the region's imports to $871 billion in the first half of this year, up 18.3% from a year earlier. That compares with import growth of 13.6% in the U.S. over the same period.

Good news for business, until you read the details: Growth in Europe is expected to slow next year. And, by the way, the U.S. won't be getting a huge part of the new action. Instead that's going to China.

One additional item of interest in the article is that China is beginning to move up the manufacturing train, from shoes and clothing on up to machinery and transport equipment. Last may, China's sales of machinery to the region accounted for half of the $14.5 billion of its goods sold in Europe. In fact, China has quietly become the world's No. 4 maker of machinery, behind the U.S., Japan and Germany, after it left Italy and Britain in the dust. Chinese machinery production used to be about building for Chinese companies, says one economist, now it's competing with European and American firms for international orders.

SAN FRANCISCO/AP - Hewlett-Packard Co.'s board adjourned an emergency phone conference Sunday without announcing whether it would oust Chairwoman Patricia Dunn for ordering an investigation that may have used illegal means to spy on colleagues and journalists.

Why does Patricia Dunn still have her job? She went out and hired private investigators who appear to have committed a crime. She took the information from them and used it against other directors and journalists. This should be a no brainer.

The argument I've heard from the company, i.e., that upper management didn't know or sanction any law breaking by the investigators it hired, is just disingenous. The moment private phone records started getting faxed into HP headquarters, it would have been utterly clear what was going on. What's more, it's hard to see how you hire private investigators to conduct a leak investigation without expecting them to attempt to retrieve or intercept communications or invade people's privacy. It's like hiring carpenters to build an addition to your house and then exclaiming you had no idea they'd have to cut wood.

So Patricia Dunn should have been gone by Saturday. That she is still at HP can be ascribed to the performance of HP's stock over the past year. When everyone is getting rich off company stock options, nobody in management or the board is going to leap to punish someone for a little lawbreaking. This is corporate America we're talking about, remember.

Just found out that every index fund at Vanguard charges a $10 fee on holders with under $10,0000 in a fund, regardless of how big your account with them is overall. Have $50,000 spread across 6 funds, you'll be paying $60 or more a year to them in account maintenance fees.

The company advertises low fee structures for its mutual funds, but as far as I'm concerned, any fees you're going to charge for owning a mutual fund should be tossed in with the standard fees. Breaking out "special" fees is the kind of thing one expects from discount brokers or the phone company, not Vanguard.

I can't help but be a Microsoft shareholder given the number of index fund shares I own, but when I see something like this I begin to see dark forces in why the S&P 500 has been stuck in a range for years:

Microsoft (MSFT) yesterday granted 37 million shares to 900 executives under its shared performance stock award program. The plan, which was installed after the company stopped issuing stock options to employees, has a three-part vesting schedule, with a third vested immediately, another third in a year and the rest in two years. Based on today’s closing price of $25.94, the shares are worth $956 million.

Remember all that talk about how options ensure that the interests of management and shareholders are aligned? Problem is, it doesn't work in practice.

Here's almost a billion dollars going to executives who have presided over an operation that 1) sits on a ton of cash, 2) whose stock is been trading in a range for years, and 3) pays a pathetic 8-9 cent per share dividend. They defend this by pointing to billion dollar share buybacks, saying that buybacks are more tax efficient. But that argument lost a lot of weight back when dividends got new treatment under the tax law. They now cost investors far less than ordinary income from interest on bonds and money markets.

What kills me is that after the shares are bought back, the company then distribute those shares to executives under lavish compensation programs. The executives then sell them back to the market. The result? The number of outstanding shares stay basically the same over time, and the money is now comfortably resting in the officers' pockets. And it's all approved by the board of directors. Directors who are essentially selected by management and paid handsomely by the corporation.

So what's left for shareholders of Microsoft here? Tiny dividends. A limp, uninspired (but wealthy) management team. And a big fat screwing from the board of directors.

This sort of behavior isn't confined to Microsoft. It's a problem for a lot of other "growth" companies that essentially stopped growing years ago. Traditionally much of the stock markets total return to investors has been in the form of dividends. So at what point does our long nightmare as shareholders end? If I could talk to tech executives, all I'd say is pay a decent dividend, you greedy jerks.