Friday, November 21, 2008

The Case for Stocks and Bonds

Is anyone ever going to want to own an old fashioned portfolio of stocks and bonds again?  I think it is back to the future -- a 1974 Ben Graham sort of future where people think of stocks and bonds as a place to invest one's savings.  

Stocks are little slices of businesses.  Bonds are little slices of loans.  People know what businesses are and understand them.  At least some of them.  They work for them, buy from them, sell to them.  People can also get their mind around a loan.  They have loans - car loans, mortgages, student loans.  It does not take a lot of abstraction to see that these familiar things can be sold in small chunks.  Stocks and Bonds.

In addition, people have an idea about what makes a good business and what makes a bad business.  Same for loans.  They have been around for a long time and there are methods, tools, and processes to evaluate them, buy them, sell them, and deal with the sorts of issues that have arisen over the last 70 years.  

There is an economic reason for their existence.  Firms need to borrow money and bonds are an efficient way for large firms to borrow.  They also need capital, and the stock market is once again, an efficient way for large firms to raise capital.

Although this financial Eden never really existed outside of a textbook, a messier version did exist and work pretty well in the United States from the establishment of the SEC in 1934 and the Securities Act of 1940.  No need to go over the familiar history of publicized failures and the far more frequent plodding successes.  

Against the backdrop of this familiar system, two strands of innovation began slowly developing.  The first being the idea of diversification and the second being that of, for lack of a better word, fungibility.  The benefits of diversification have been obvious since someone first recommended not to put all of one's eggs in a single basket.  I will skip the well known evolution of products based on this concept, and go to its logical extreme.  The Yale Model popularized by David Swensen.  The Yale Daily News reported:
Yale School of Management professor Roger Ibbotson said Yale's endowment does not closely follow the overall equity market, which means that it was better equipped to weather the economic downturn. Goetzmann said other schools have started following Yale's innovative investment strategies, and attributed much of the success to Yale's Chief Investment Officer David Swensen -- an expert in alternative investments.

"A few years ago, other schools saw the success of Yale and started to imitate Yale's strategy," he said. "The larger schools tended to do this extended diversification into smaller investments. The smaller schools didn't do it as quickly."

The Yale Model consists broadly of dividing a portfolio into five or six roughly equal parts and investing each in a different asset class. One should avoid asset classes with low expected returns like bonds and that liquidity is an expensive luxury that simply isn't needed for an endowment.  So far so good.

According to the New York Times:
His target asset allocation for fiscal 2008 is fairly similar to the allocation for 2007. The biggest allocation — 28 percent of Yale’s funds — is in real assets. Last year, those included real estate, oil and gas and timberland, Yale’s report showed.

The second-largest allocation is to what Yale calls absolute return investments, which generally means hedge funds. Yale is slightly reducing that stake to 23 percent, from 25 percent, according to Mr. Swensen.

The endowment is also planning a slight reduction in domestic equities to 11 percent, from 12 percent. Fixed-income and foreign stocks will remain at 4 percent and 15 percent respectively.
We don't know how things turned out this year, but we do know it has been rough on virtually all the asset classes.  The fund operates on a fiscal year ending in June, but by October, the benefits of foreign stocks, oil and gas, hedge funds and Real Estate were all losers.  The exceptions being hedge funds that were truly hedged and not highly leveraged.  It is also likely that Yale and the top foundations had the best managers and were starting from a string of highly profitable years.  It is likely that the copy cats did not fare as well.  

It is also possible that Yale's illiquid investments will not be fully marked down to reflect this year's carnage in the markets.  And what Yale did well, others may have done much more poorly.  Prior to the Fall, virtually any of the alternatives to the US equity markets would have significantly improved returns.   There is a saying that in a bear market, the only thing that goes up is correlation.  This was proven in October in a way that will significantly reduce the perceived benefits of diversification.

There is also a shortage of a number of alternative investments.  Pension funds manage well over an order of magnitude more assets then the Universities.  There simply isn't that much Timberland.  Hedge funds performance decreases with size at some point, if for no other reason then their fee structure.  There is simply not enough positive alpha to go around.

The second trend, what I referred to above as fungibility, is better known now as structured finance.  The fundamental idea is that cash is simply cash, and all financial assets can be chopped up as finely as one wants and aggregated in any way imaginable.  Further, they can be chopped by risk (tranches) or time so that an investor can find a product that meets any imaginable cash flow need.  The CDO^2 or CDO squared is this year's example of structured finance run amok.  

A combination of the two trends is seen in the various "portable alpha" strategies.  I think it is safe to say that most bankers would prefer to never hear the word, "CDO."

Which brings us back to individuals.  Residential real estate was the man on the street's hedge fund of this century.  Never have so many people had access to so much leverage.  The man on the street may have never studied finance, but he understood cash flow.  And when you could borrow for 4% on property that was appreciating at 10%, he wasn't interested in financial theory.  He just signed up.

Alternative investments for individuals included emerging market mutual funds, precious metals, REITs, mutual funds specializing in energy, currency funds, and ETF's to bet for or against just about any financial asset.  Not to mention access to various types of derivatives.

What will individuals want in the future?  I believe they will want the features of traditional investment grade stocks and bonds.  In this new paradigm, people will favor tradition over innovation and simplicity to complexity.  Well established, deep, liquid markets.  Relatively low, standard fees.  The transparency and tangibility of a security issued by leading public companies and governmental entities.  And things like dividend checks.  

Finally, given the decline in stock prices, once (or if) we are through this recession, the financial prospects may be quite favorable.  


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