More Bailout News

While no-one was paying attention the US Congress agreed to lend $25 billion to the three big US car manufacturers at 4% interest to help them develop fuel efficient and alternative energy vehicles. The US Treasury has added about $450 billion to the national debt since June already apparently (can't find the link for this now).

In the meantime, the FDIC seized Washington Mutual and sold the good assets to J.P. Morgan already. This deal means no loss to depositors and the shareholders wiped out. Not clear what happens to preferred stock etc. yet.

The Republican Plan that has derailed the financial bailout talks makes no sense at all. It calls for the Treasury to charge insurance premia to insure mortgage back securities a la FDIC. Yeah, let's take more money out of the banks, rather than vice versa. There is increasing talk of a emergency Fed rate cut in the next few days.

The proposed bailout plan might not be the best and it has been explained very poorly if at all to the public. But it seems that something needs to be done to stop the banking system in the US completely collapsing. Most people have no idea why the Great Depression happened. Primarily, it was due to bad policy allowing 1/3 of US banks to collapse. The economy still had the same real assets in terms of factories, land, machines, workers, and ideas, but they couldn't be put to work without the ability to borrow money. And that is what is in danger of happening again.

Up till now the Federal Reserve and the Treasury have been battling a potential collapse. They've made a lot of mistakes and now they're running out of firepower or realize they need bigger guns. The Democrat suggestion to reduce the package size while leaving the door open to granting more spending ability might be a good move as is adding oversight for sure. The other $350 billion might be needed for buying stakes in banks to recapitalize them. If the goal is to increase bank's net worth it is far more efficient for the government to buy new shares from them where each dollar goes 100% into recapitalization than to buy assets from them at a small premium where only the premium goes towards increasing net worth. But the Paulson plan is primarily for the government to act as market maker and it seems to jack up the value of mortgage related assets on the balance sheets of banks that don't actually participate in the scheme, which is a good thing.

BTW, the U.S. Government made money on the post 9/11 bailout of U.S. airlines. So it is possible and it's definitely a misinterpretation to think that the whole $700 billion represents government spending.

Lehman Bankruptcy Filing

The first part of this post was revised on 17th September

Here it is. The majority of the money is in bonds that apparently Citibank and Bank of New York Mellon administer. So we don't know who holds them. None of the other debts look like they are going to bankrupt anyone. Some Japanese banks are owed a few hundred million each. National Australia Bank and ANZ are each owed about $25 million. Wells Fargo is already writing off Lehman related losses .

I'm about $1,000 into the margin buffer now with CommSec and it will get worse yet. I also sold some bond funds and bought stock funds in my retirement accounts, however nuts that seems...

S&P futures are down 20 points post close on the downgrading of AIG. Yves is bullish though. And he's been pretty good recently:

U.S. Clearly in Recession

For anyone out there who still thinks the U.S. is not in recession this chart pretty clearly refutes that view. It's a view only held by some business economists anyway, I think. U.S. GDP increased by more than 3% y.o.y. in the second quarter of this year. But GDP growth is only one of the factors that the National Bureau of Economic Research takes into account in declaring recessions. The chart shows that in terms of unemployment the U.S. is now clearly in recession. The recent upward trend clearly broke the previous downtrend in terms of any signal to noise test you'd want to construct. And upward trend defines an unemployment recession. This isn't a case of some indicator that is coincident with recessions. I've seen a lot of those charts with commentary that says "in 8 out of the 9 last recessions this indicator rose ". Which isn't much of a statistical sample. I don't think this chart is that kind of an example.

Snork Maiden's Taxable Income

I've computed Snork Maiden's 2007-8 income for her Australian tax return (the tax year runs from July 1st to June 30th). I can't complete the return or work out how big a refund she should receive until I've done my tax return, which is the next project. The first two sections of the table should be pretty self explanatory. Income distribution from trusts is Australian source income, not including capital gains from managed funds (mutual funds). For some reason this has its own special section in the tax return (well combined with partnership income) while capital gains and foreign income from managed funds is reported in other relevant sections of the return together with income in those categories from ordinary shares and other assets. Net income at $48,629 is firmly in the 30% marginal tax rate bracket (31.5% including the Medicare levy). Income is reduced this year by only being in the country for nine months of the tax year. Rather than applying a lower rate to long-term capital gains, Australia only requires taxpayers to report half the gain. I've added back the "concession" in the line "net income without CGT discount". On the other hand you have to report dividends in terms of the gross dividend before the company paid Australian corporation tax on it. You then get to claim the tax they paid back to avoid double taxation of dividends. These credits are called "franking credits". I've deducted this notional income in the final line of the table. Neither of these changes make much difference to Snork Maiden's return, but will make a big difference to mine. Snork Maiden had $11,272 in tax withheld (including franking credits). I estimate she should have paid from $7,962 (if my net income is zero) to $10,062 (if my net income is above the maximum threshold for a "spouse offset" to apply). Her refund should, therefore, be between $1,209 and $3,309. The effective tax rate is, therefore, between 16.3% and 20.6%. There are no state income taxes in Australia. Unlike the US, Australia does not require you to compute your tax yourself. All you need to do is report income, deductions, credits etc. They do show you how to compute the tax at the end of the "Taxpack". There is also a calculator on the ATO website.

Which Type of Hedge Funds Give the Most Diversification Benefits?

I recently read a very interesting article about using hedge funds to diversify that was discussed by AllAboutAlpha. Adding hedge funds to a portfolio can both increase returns and reduce variability. Even if a hedge fund's returns were perfectly correlated with your existing portfolio's, if it had a positive alpha, allocating some money to the hedge fund might increase return and reduce drawdown relative to your existing portfolio. See my discussion of alpha-beta separation. But usually what is meant by diversification is adding assets whose returns are imperfectly correlated to the returns of the original portfolio. But you can go beyond that to also take into account "the higher moments" of the return distribution.

So what are "higher moments"?

The first moment of a distribution is the mean or in ordinary English the average. The second moment is the variance or its square root the standard deviation, which captures how tightly packed values of the variable are around the average. The "normal distribution" - the classic bell curve - can be entirely captured by these first two moments:



The mean is at zero and the numbers on the x-axis are standard deviations from the mean. The normal distribution always looks exactly like this, though the actual numerical value of a standard deviation could be larger or smaller and the mean might be different to zero.

The third moment of a distribution is skewness. A distribution is skewed if one side of the distribution is much more stretched out than the other:



A positively skewed distribution has a long-tail to the upside. The fourth moment is kurtosis which measures how sharply the distribution peaks and how fat the tails are:



The distribution marked in red is the most kurtotic. No longer is there a plateau of many values clustered around the mean, but values are dispersed towards the extremes.

An investment with negatively skewed and positively kurtotic returns is prone to "crashes". The MSCI world index has negative skewness and positive kurtosis.

The standard "beta" in the finance literature measures how much an investment's returns change when the returns on another investment change. Usually we are measuring how much a security's or an asset class' returns change in relation to the returns of the "market portfolio" or a stock index like the S&P 500. But we could also measure the relationship between the variances of two investments and the relations between the higher (3rd and 4th) moments of the distributions.

An investment with a low (less than one) or negative conventional beta to an existing portfolio will reduce the volatilty of that portfolio. A low variance beta means that when the volatility of the portfolio rises due to market conditions the additional investment will mitigate that increase in volatility by contributing less or even a negative amount to the increase in volatility. As is well known, the correlation between most investments seems to rise when market volatility rises. It would be really nice if we could find investments that reduced the tendency of our portfolio to experience extreme negative events. Investments with low and negative skewness and kurtosis betas will be best at achieving this.

Finally getting to the point :), the paper computes these higher order betas for a variety of hedge fund indices with respect to the MSCI index (the estimates are for monthly data from January 1994 to February 2006):



Any betas below one have diversification benefits. By far the best diversifier is managed futures. Fixed Income Arbitrage, Equity Market Neutral, and Convertible Arbitrage are also good diversifiers. The least good diversifier is long-short equity, which includes the likes of 130/30 strategies. Only managed futures and equity market neutral have normal returns, though Global Macro and Long-Short Equity also both have zero or positive skewness:



The author adds a mixture of the best diversifying hedge fund indices to a 60% equities and 40% bonds portfolio and finds increased returns and reduce variance for all mixes up to a 35% allocation to diversifiers. I have a feeling that if he tried pure managed futures the gains would be even better.

Given these results, and the high returns to some managed futures funds a large allocation to managed futures could be very advantageous (subject to tax considerations). For more on the advantages of commodities and managed futures see the Ibbotson-Pimco study.

BTW, another new category today: "Hedge Funds".

Listed Private Equity Newsletter

LPX is a global index of listed private equity firms and funds. Though I can't find a public source for the fifty stocks composing the LPX50 Index, they do have a monthly newsletter, linked at the left of their homepage which inlcudes the ten largest firms in the index and the top 5 and bottom 5 performers for the month. Going through a bunch of these, one might be able to get most of the index components except the smaller persistently mediocre ones :) The recent performance of the index has been rather poor and it has been volatile over its history. So it is important to pick good stocks, if one can:

Architecture of Australia's Tax System

The first stage of the Commonwealth Government's tax review was released today. The 366 page document describes Australia's tax and transfer payment system and compares it to other countries. These comparisons make it a worthwhile read for non-Australians too. Hard to imagine the US Federal Government doing something as systematic as this. There's so much here that I really can't begin to summarize!

But here's an interesting chart that surprised me:



According to this, only about half a million employees or 5% of the workforce make pretax contributions to their retirement accounts ("salary sacrificing to superannuation" in Australian jargon) in addition to money contributed by their employer. Employers have to contribute 9% by law. Many in the public sector contribute more than this for example 15.4% at one quasi-governmental employer. So there is less incentive to make extra contributions than would be the case in the US. We don't have the "matching contribution" approach that is common in the US. And you really can't get it out again until you are in the 55-65 age bracket (depending on circumstances and when you were born). I've commented before that to simplify the system they could just get rid of pre-tax contributions. Makes even more sense when we see the low percentage of people that would be affected.

Only around 2% have a company car included in their salary package. I'm not surprised about that.

Another similarity with 1990-91

Record levels of bearishness. As I write, oil just spiked to a new all time high. Seems to me this was a reaction to a bad Empire State Report (NY Fed report on NYS economy) which caused US bonds to rise and therefore the USD to fall. This started a rise in the oil price that then set off a cascade of stop losses at $137, $138, and $139. At least that's what the charts look like... Dow Jones commented on the price spike but didn't report any news except the Saudi decision to raise output which was already known and bearish for the oil price.

Reverse Adverse Selection

Interesting article in Freakonomics on "pay as you drive insurance". In the case of health insurance, those people who most need insurance are most likely to pay for it, while young healthy people are not. This adverse selection pushes up the price of insurance for those that have it (and is one advantage of a government mandated system or government provision). In this car insurance example, people who drive less would be given a discount, which will encourage low mileage drivers to sign up with the company who gives the discount, especially if they raised rates on high mileage drivers. Not all insurance risks are proportional to miles driven. The risk of the car being stolen for example only declines a little. Drivers who drive very little are likely to be more dangerous, but so are those that drive a lot if they are more likely to fall asleep etc on long distance journeys.

I wish we could pay less insurance for not driving much. Here third party damage insurance is paid through the government with our annual vehicle registration, though a private insurer covers the policy. Registration cost us $A760 or so for the year. We have separate insurance for loss or damage of our car, which cost a similar amount. It would be nice if the registration could be proportional to kilometres driven.

On other externalities discussed in our article, our car is not very fuel efficient. It has a 4 litre engine. As we don't drive much - Snork Maiden walks to work - I've joked that we are doing society a service by taking this large high carbon emissions vehicle off the road for most of the time :)

The Best Market-Timers are Bullish

The best market-timers are bullish on average and the worst are bearish on average currently. Yes, some market-timing gurus do beat the market. And those ones are currently bullish. However, they are fewer in number than all those bearish commentators out there who generally don't beat the market. So what does that tell you? :)

Today the Australian market was down. The only catalyst I could find was Brambles (BXB.AX) saying that Walmart might reduce its contract or something. Gold remained strong, oil remained strong. The Japanese and Hong Kong markets were up and U.S. futures, especially of the Q variety were strongly up following Google's earnings announcement, which I got up before 6am this morning Australian time to follow (just wish I had more GOOG :)). Given all this, I didn't see much risk in buying some SPI (ASX 200 Index) call warrants near the bottom today. I plan to sell them Monday either way. My model is pointing down for the Australian market but it looks like another double-peaked stochastic wave is taking shape, which has been pretty common lately. My position is only a fifth of the size of a SPI futures contract. So I feel very little fear trading this in comparison.

More on Excess Returns

If you can estimate your portfolio beta it is pretty simple to compute your excess return:



In the equation, e(t) is the percentage excess return in month t. r is your portfolio return, m is the market percent return given by your benchmark index, and f is the risk free rate. The normal return is a mix of the market return and the risk free return weighted by beta. I use the MSCI index as my benchmark. Specifically, the All Country Gross Index. Make sure when you choose a benchmark to include dividends. The net and gross MSCI indices do include dividends - the gross is pre-tax and the net post-tax. Total return data for the S&P 500 can be found here. I use the 90-day Treasury Bill rate as the risk free rate (you'll need to compute the monthly rate from this annual rate).

You can estimate beta in more or less sophisticated ways. If you are 100% in stocks and guess your stocks are average and you are using no leverage, you can use a default of one. In this case, the excess return is just your return minus the market return. A more sophisticated approach is to compute the weighted average of the betas of all your stocks and funds, which you can find on Yahoo Finance for example. More sophisticated still is doing some kind of regression analysis - you need a track record of your monthly returns to do that. My preferred method is a time series model that allows my alpha and beta to vary over time.

To find how much your actual excess income is per month, you then need to multiply the percentage excess return by your net worth. I've done it here, using the S&P 500 as the benchmark:



The bars are the monthly "risk-adjusted excess incomes (or losses)" while the light green line is the total of the last 12 months. A strong cycle is very clear - I've gone through periods of above and below par performance fairly regularly. Alpha smoothes all this out into an estimate of the average excess return. The following chart does this using the MSCI instead as the benchmark:



There is no guarantee though that this level of performance can be maintained. The huge fluctuations on the SPX chart above make that clear. In this post, I was wondering out loud whether I could maintain that performance in the coming year by looking at where the returns would come from. I wasn't saying I could maintain that indefinitely. I don't know.

Wealth Much More Evenly Distributed in Australia

Wealth appears to be much more evenly distributed in Australia than the US. The lowest 10% of households have a median net worth of $A175k, which is greater than the US median for all households (around $US100k). I think the Australian figures include cars and household effects which pushes the numbers up a little. One important factor is probably compulsory superannuation - employers must contribute at least 9% of salary towards a retirement account and cashing those accounts out before age 60 or so is near impossible. The median for all households is $A340k and for the top 10% $A975k. This probably places us ($A470k) a little lower in the continuum than we would be in the U.S. According to recent taxation data we live in the 8th richest (out of 26 in terms of income) district of the Australian Capital Territory. About where we fall in the national net worth spectrum too.

Recession is Local Too

USA Today has a nice map of economic conditions across the US - I've see a similar map somewhere else recently. Some parts of the US economy are doing fine, others are clearly in recession, which is one reason why it is hard to say whether the country as a whole is in recession and maybe if it is the recession could be mild?

Portfolio Performance

In my ongoing evaluation of my Mom's portfolio I've calculated some annualised rate of return * performance figures:



I don't have data for every month but I do have data for four out of the last five Marches, which allows me to calculate the numbers in the table. In the last one, two, or three years we have performed favorably compared to the S&P 500 index. It's not surprising that the portfolio underperforms the SPX over five years due to its low equity content. In the first two years of the bull market we gained 11% p.a. which was below the SPX performance in those years. 8% p.a. is probably an acceptable return for a portfolio of this sort in the long-term, but it would be nice if we can increase it. OTOH we nicely beat the average hedge fund, which only earned 6.5% p.a. in 2003-2007.

* Rate of return for Moominmama's portfolio is simply the growth rate of the portfolio - so this is an after tax and net spending/saving figure. Moominmama receives some pension income which covers day to day expenses so usually there isn't much draw on the portfolio. Moom's rate of return is pre-tax and obviously doesn't include saving or spending effects.

U.K. Stock Research - Listed Private Equity

Digital Look is a great source for research on UK stocks. Far better than Yahoo's offering. I haven't invested in the UK yet, but been looking up info on a couple of companies and was recommended to check this site out by a poster on a Yahoo message board.

I was using the site today because of the takeover of a listed Australian private equity fund by the London listed Bear Stearns Private Equity Limited (BPLE). IPE is edging up today, presumably in reaction. BPLE itself looks like an interesting investment. I'll add it to the watchlist. My main concern is the Bear Stearns name. The biggest position is in a Bear Stearns private equity fund (8%).

Israeli Finance Comedy

This guy is funny, he also has a video in English. Israel is an important location for high tech startups.

NASDAQ 100 / Russell 2000 Divergence and the CBI Indicator

Rob Hanna presents lots of interesting studies on his blog Quantifiable Edges. His latest analysis has highly bullish implications. His CBI - capitulative breadth indicator - indicator is also on a buy signal still. My Nikkei model switched to short today but at the moment I think these models are not very reliable - they are often getting stopped out.

U.S. Tax Rebate Calculator

I found a link to this tax rebate calculator on Boston Gal's blog. It calculates how much of a rebate you should get under the U.S. stimulus plan. Snork Maiden and I should each get $600 unless there is a clause preventing them mailing a check outside the United States.

Ten Year Low in Bullishness

Ten year low in bullishness. As you'll see these low levels of bullishness tend to be at market bottoms not tops. The contrarian approach fades the crowd and the crowd is bearish now. Investment newsletter writers are too.

Cramer Revisionism

Cramer's revisionism. Cool video pastiche.