Byron Wien Announces The Ten Surprises For 2011

The Surprises of 2011 1. The continuation of the Bush tax cuts coupled with the extension of unemployment benefits has put all working Americans in a better mood. Real Gross Domestic Product rises close to 5% in 2011 driven by improved trade and capital spending in addition to stronger retail sales. Unemployment drops below 9%.

2. The prospect of increasing Federal budget deficits and rising government debt finally begins to weigh on the bond market. The yield on the 10-year U.S. Treasury approaches 5% as foreign investors become more demanding. Spreads with corporate fixed income securities narrow.

3. Encouraged by renewed economic momentum the Standard & Poor’s 500 rises close to its old high of 1500. A broad range of sectors participate, but telecommunications and utilities lag. With earnings improving, valuations seem low and individual investors return to equities for the first time since the financial crisis. Merger and acquisition activity becomes intense and the market reaches a blow-off euphoria. Stocks correct in the second half as interest rates rise.

4. Although inflation remains benign, the price of gold rises above $1600 as investors across the world place more of their assets in something they consider “real.” Sovereign wealth funds of countries with significant dollar reserves also become big buyers. Hedge funds keep thinking the price rise is becoming parabolic and sell their positions and some even short the metal but gold keeps climbing and they scramble back in.

5. Worried about inflation and excessive growth, the Chinese decide to use their currency as a policy tool. They manage the value of the renminbi aggressively to keep the growth of the economy below 10% and to prevent consumer prices from increasing above the 4%–5% range. The move is viewed as a precursor to the world-wide adoption of a basket including the renminbi as an alternative to the use of the dollar as the principal reserve currency.

6. Rising standards of living in the developing world seriously increase the demand for agricultural commodities. The price of corn rises to $8.00, wheat to $10.00 and soybeans to $16.00. Commodities become a component of more institutional portfolios.

7. The housing situation improves. Although the inventory of unsold homes remains high, the oversupply is drawn down substantially, contrasting with an increase in 2010. The Case-Shiller gradually heads higher and housing starts exceed 600,000.

8. Continuing demand from the developing world and a failure to bring onstream new supply causes the price of oil to rise to $115 per barrel. The higher price at the pump fails to discourage driving, increase sales of hybrid vehicles or cause Congress to initiate conservation measures.

9. Frustrated by the lack of progress against the Taliban and the corruption of the Karzai government, President Obama concludes that whenever American troops return home, Afghanistan will once again become a tribal state ruled by warlords. He accelerates the withdrawal of most military personnel to the end of 2011. Coupled with the pullout of forces in Iraq, this will leave the Middle East without a major Western presence in the face of rising fears of terrorism.

10. Under duress Angela Merkel leads the way in European financial reform. The weaker countries, having pledged to cut their budget deficits in half by 2014, are provided additional transitional aid by the European Union (with Germany’s backing) and the International Monetary Fund as long as they implement their austerity programs, increase some taxes and still show modest growth. The European financial crisis becomes less of a concern. The policies put in place prove psychologically satisfying to the financial markets but harmful in the longer term because they are palliative and do not represent solutions.

“ALSO RANS”

11. While Afghanistan and Iraq cool down as trouble spots, Pakistan and North Korea flare up. The former continues to be a troublesome breeding ground for terrorists and the latter initiates further hostile attacks on South Korea. China does not become involved in a major way and the international community seems helpless.

12. The broad international sanctions on Iran finally begin to work. Mahmoud Ahmadinejad enters into negotiations to scale back the country’s nuclear weapons development program in exchange for financial aid and foreign investment. Pressure from the country’s youth to provide more economic opportunity is the key factor in the change in policy. Talk about bombing by Israel or the U.S. subsides.

13. Rising interest rates and a strong economy allow the dollar to strengthen against the euro and the yen. Although the European financial crisis abates as austerity programs and higher taxes are put in place and Japan avoids falling back into recession, America becomes the developed market of choice for global investors.

14. Sarah Palin announces she will seek the Republican nomination for President amidst the cheers of Tea Party supporters. More moderate Republicans fear her candidacy will diminish the chances of their party winning in 2012 and try to blunt her efforts. Rick Perry, governor of Texas becomes a contender. Mike Bloomberg is mentioned. On the Democratic side, liberals feel Obama has betrayed them and desperately try to find a challenger. With the economy improving the prospect of a second term for Obama becomes more likely.

15. The Russian government decides it is the laggard of the emerging markets and steps up its efforts to become more investor friendly. The Kremlin agrees to further nuclear weapons reduction and provides assurance to companies willing to invest there that the rule of law will prevail. The Russian equity market soars.

16. Laws related to marijuana usage are liberalized in more states. Recognizing that the drug may not be addictive, the public’s attitudes have evolved over the last thirty years, and this, along with a desire to alleviate the over-crowding of jails, causes state legislatures to take a more liberal position. Drug abuse groups are outraged.

17. Infrastructure problems in the United State become serious. New York subways are inoperative for days as a result of an electrical problem in the signal system. Gridlock snarls Los Angeles freeways, and to encourage cooperative commuting, high-occupancy vehicles are required to carry three or more people. State and local governments complain they lack the funds to deal with the problems and Washington refuses to help.

18. A major state fails to pay interest on a municipal bond issue because of a lack of funds, causing havoc in the municipal bond market.

19. In spite of fears of tenth anniversary terrorist attacks, 9/11/11 becomes a peaceful non-event because of excellent intelligence and surveillance.

20. While climate change activists remain shrill, the issue recedes in importance in the United States. Cold weather prevails during the winter and the summer heat is not oppressive. Support increases for a broader use of natural gas by utilities and public transportation and its price rises to $6.00 per mcf. In Europe and Asia however, environmental initiatives continue to move ahead.

Is it time to invest in Real Estate in US?

Very tempting but not yet. imho

Facebook vs. Groupon

With all of the hubbub about Facebook and Mark Zuckerberg these days, I want to remind you guys that they are not the only game in town.

In fact, there's another hottie at the dance who may not win homecoming queen, but could turn out to be better marriage material down the road.

Now that I have the attention of the feminazis and Facebook groupies, I crack open my umbrella and await the rainfall of hate and ridicule.

Groupon > Facebook...by a Country (wide) Mile

As most of you guys guffaw over Goldman's bucket shop production with Facebook as the lead, I am not impressed.

As Goldman does battle with Stanley over the coveted Groupon IPO,however, I am all eyes and ears.

This is the hot ticket in town, kids.

It's no secret that I am not a Facebook fan, not only due to the fact that I feel it is creating an even more socially retarded generation than the currently vegetative one. I am highly skeptical of Facebook's ability to monetize on all those hundreds of millions of users to the extent that the great hype machine would have us believe.

Groupon, on the other hand is a real deal old time, brick and mortar business. A cash cow, with a focused yet expansive niche.

Where Facebook is the silicone enhanced, makeup laden 10 with a fetish for cocaine, cowboys and the liquid diet.

Groupon's the solid 8 with great genetics, an angel's attitude, cooks, cleans, raises the kids, makes her own cash and has her head on straight.

Yeah...I just went there.

Groupon's recent rebuff of Google's $6 billion dollar takeover offer have sent (reasonable) IPO spec figures into the $15 billion range.

Though that is far beneath the (unreasonable) $50 billion Facebook valuation of a few weeks back, Groupon can actually back its valuation with a sea of revenue streams and (most importantly) a specific proven scalable business model.

I am going on the record. I like Groupon better than Facebook, as an investment vehicle.

In fact, I don't think Facebook is even in Groupon's league from the individual investor's perspective as far as returns go.

Of all the IPOs in recent memory, I think Groupon has the potential to be the greatest value play.

Facebook's not even in its league.

Let the hate...I mean debate begin!

Art Funds as Alternative Investment

According to Friedrich Kiradi, head of Merit Alternative Investments GmbH and director of the world-wide first Art Photography Fund. “Investments in material assets such as real estate, commodities, as well as art, continues to be an area that investors seem to be focusing on, with the growing importance of ‘art investment’ as bridge between the art and finance world.” In addition to the financial gains as an investor in the Art Photography Fund, holders are by request able to experience an “emotional yield” in receiving actual works held within the fund upon redemption. The Art Photography Fund has gained more than 15% since inception in March 2008.

“We are convinced that there are better opportunities for investing in sectors or artists that are currently not being ‘hyped’; but rather recognised pieces equalling the standard of works displayed in museums by ‘blue chip’ artists”, according to Johannes Faber, gallery owner and advisor to the fund. The performance of the Art Photography Fund has supported his argument, with the fund closing the rump year 2008 up 11.68% and gaining +3.11% in 2009 as of the end of May. With this, the fund was not only able to outperform equity and fixed income markets, but also various art market indices.

Blue Chip Art Works

The qualitative goal of the fund is to become the most important collection of icons in art photography of the classical modern period (approximately 1890 – 1960). The focus is on so-called Vintage Quality, in other words original prints, that the respective artists produced themselves or under their supervision. Of these prints, only a very limited number of copies are available in the open market, as many of these unique works are already held in museums or collections. This means that the supply is limited and continuously shrinking, while the demand is steadily rising.

Next to Johannes Faber, the art photography specialist and collector, Alexander Spuller, was also put in place as advisor to the fund. Their combined experience and network enables them to identify purchasing opportunities of undervalued pieces, while the portion of the fund held in cash enables them to react quickly to such opportunities.

“Our approach tends to be a buy and hold strategy, as investment in art always requires a longer-term investment horizon”, according to Spuller, “but selling of art works does occur on a regular basis”. Up to 50% of the annual performance should come from realised sales, so as to confirm the estimated values of holdings and also increase the cash reserves for further purchases. To date, actual sales prices achieved were approximately 10% above their respective last estimates given by the two independent valuers.

Besides the encouraging performance of +15.16% since inception in March 2008, the trio is excited about the first important exhibition. The Albertina Museum in Vienna has scheduled to display works of August Sander in January 2010. 70 pieces of works will be on display that the artist, one of the most important photographers of the 20th century, had chosen himself for his last exhibition. This mixed lot was purchased by the fund in the fall of 2008.

Broadly Diversified Portfolio

The collection of the fund is currently made up of over 1,100 works from 130 artists originating from the USA , Europe and Japan. The oldest piece is by Henry Fox-Talbot from 1843, while the youngest works by William Eggleston, Lee Freedlander and William Wegman are from the 1980s. The scope of works covers all epochs of photography and includes early salted paper prints to more recent “dye-transfer prints”. The majority of photographers represented in the fund’s holdings are considered by art historians and critics as “Old Masters of Photography”, such as Man Ray, Henri Cartier-Bresson or Ansel Adams (please see list of artists). In addition, the fund also includes several works and artists with growth potential.

Plans for an Advisory Committee

“We are currently in discussion with representatives of the financial community as well as the international art scene, as we want to have a balanced composition of members advising and supporting the fund”, according to Spuller regarding the future. The fund’s current capacity is around EUR 70 million, at which point the fund will be closed for new investments, so as to ensure that the performance targets will not be affected. The aim is to reach this target by 2011.

Art Photography Fund

The world-wide first fund investing in art photography targets institutional investors such as banks, insurance companies and foundations. Today, subscriptions into the fund can be made at most Austrian banks, in some cases with smaller denominations, as well as being used by asset managers and private bankers. Subscriptions and redemptions can be made on a quarterly basis, with the next date for investment on 30.06.2009. Up-to-date information and monthly estimated NAVs of the Art Photography Fund can be found on the homepage: www.artphotographyfund.com

Johannes Faber

Born 1952 in Vienna , lives in Vienna as gallery owner and curator. In 1983 founded a gallery for photography that has been active in international art dealing since 1995. Since then, advising national and international private collectors and museums in putting together photography collections. His activities exclusively focus on dealing in vintage prints of photography of the classical modern period of the 20th century, that are, among others, presented at world-wide renowned art fairs such as Art-Basel, ArtCologne, ARCO-Madrid, Paris-Photo, Photography-Show New York and Viennafair. The Gallery Johannes Faber is a member of AIPAD (The Association of International Photography Art Dealers) and the Association of Austrian Galleries of Modern Art, of which Mr. Faber was Chairman between 2004 and 2006.

Alexander Spuller

Born in Vienna in 1970. After graduating with a degree in construction engineering and law, Mr. Spuller worked in his family construction business. Since 1990, A. Spuller completed various property projects in Austria , the Czech Republic and Vietnam . In 1998 Mr. Spuller began collecting art photography, and from 1999 started specializing on works of the classical modern period. In 2005 he was appointed Vice Director of the Gallery Johannes Faber.

Friedrich Kiradi

Friedrich Kiradi is Managing Partner of the Merit-Group and Chief Executive of MERIT Alternative Investments GmbH, a fully licensed investment company by the Austrian Financial Market Authority (FMA), that specialises on the management of funds in managed futures, absolute return/equity hedged and real assets (commodity, art). Further areas of business of companies within the Merit-Group include asset management for foundations and risk management for corporations. Merit is regarded as independent competence centre for all applications of financial derivative instruments, and has specialised on structuring innovative and customised products for banks, fund management companies and industrial clients. The company was founded in 1988 and currently employs 40 professionals in their office in Austria , Malta and the USA.

A Review of Predictions of the Last Decade

Jeffrey came to the new year eve party last night and mentioned his latest post, quite impressive predictions, I especially like/respect his resolution, though wonder how accurate Econ prediction can be, without thinking politically.

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December 31 is technically the end of the first decade of the 21st century. It is perhaps an appropriate time to review one’s predictions. It seems to me that I got some things right over the last decade. Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market” (Nov. 20, 1999). This was four months before the bubble burst in 2000. So far so good.

Exchange rate Also at the start of the decade, I thought the euro was undervalued. My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000). Over the next eight years the euro in fact rose 60% in value.

TIPS I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value. (Feb. 2009.)

The big economic story of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it. A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right). I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini. 12 are identified in a 2009 paper.

What parts did I get right?

Severity of recession After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

”Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…” (Oct. 30, 2003. Also Dec.2003 and Nov.2004).
That seems to me precisely what has happened.

Budget deficits Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible. The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.” (May 24, 2006.)

Market underestimation of risk I was dubious of the “Great Moderation.” By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high. (May 24, 2006.) The markets were underestimating this risk:
”How can the implied volatility in options prices be so low? Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.” (Nov. 2006.) “The implicit volatilities in options prices are substantially too low, and will rise. … market estimates of risk are lower than they should be. … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies. Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.” (Jan.12, 2007.)
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written. It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.) Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)

International crises When asked “Have financial developments made the international Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.” (March 1, 2007)

The coming financial crash The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look pretty good now:

”The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…” (In Responding to Crises, Cato Journal, Spring 2007.)

Housing Of the various asset markets, housing was the area where policy had most clearly gone awry. I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.” (March 26, 2007.) “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.” (April 28, 2007.)

The start of the recession I never tried to guess the starting date of the crisis. Once it had begun, some of the economists first out of the gates were Roubini, Summers, and Feldstein. I was not as quick. But at least I had figured out by May 2008 that a recession was probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.

Banking crisis resolution When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work. (March 23, 2009.) I felt pretty isolated. Others attacked the plan, from both left and right. They expected Tim Geithner’s stress tests to be phony. The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks. They wanted either to nationalize the banks or leave everything to the free market. As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.

The trough Financial markets stabilized in the first half of 2009. Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then. This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong Needless to say, I got plenty wrong in the decade as well. For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came. For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar by 2015 or 2022. Those dates are still aways off. But it now seems unlikely. I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar. Yet flows into the U.S. showed that the dollar is still a safe haven. For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics. I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College. (This did not happen after January 2001.) I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise. (Not!) In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president. (Wrong again.)

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

Stranded in Airport Hotel

More flights got canceled tonight, I am getting sick of the crowd. This is too much!

Off to the Caribbean

Merry Christmas and Happy New Year to all!

Madoff's son found hanged

NEW YORK - Disgraced financier Bernard L. Madoff's eldest son hanged himself in his apartment Saturday, exactly two years after his father's arrest in a multibillion-dollar Ponzi scheme that swindled thousands of investors of their life savings.

Mark Madoff, 46, was found hanging from a ceiling pipe in the living room of his SoHo loft apartment as his 2-year-old son slept in a nearby bedroom, according to law enforcement officials.

Madoff, who reported his father to authorities, has never been criminally charged in the biggest investment fraud in U.S. history and has said he and his brother Andrew never knew of their father's crimes.

Although Mark Madoff was not known to be facing arrest, he and other relatives have remained under investigation and been named in investor lawsuits accusing them of profiting from the scheme.

"This is a terrible and unnecessary tragedy," Madoff's lawyer, Martin Flumenbaum, said in a written statement. "Mark was an innocent victim of his father's monstrous crime who succumbed to two years of unrelenting pressure from false accusations and innuendo."

A lawyer for Mark's mother, Ruth Madoff, said, "She's heartbroken."

Mark Madoff's body was discovered - hanging from a black dog leash - after he sent an e-mail early Saturday morning to his wife, Stephanie, saying that someone should check on their 2-year-old son, law enforcement officials said, speaking on the condition of anonymity because they weren't authorized to speak publicly about the death.

Madoff's wife, who was visiting Disney World in Florida with her 4-year-old daughter, sent her stepfather to the home. The toddler was found unharmed.



Bernard Madoff, 72, swindled a long list of investors out of billions of dollars. He admitted to running his scheme for at least two decades, cheating thousands of individuals, charities, celebrities and institutional investors. Losses are estimated at about $20 billion, making it the biggest investment fraud in U.S. history. He was arrested on Dec. 11, 2008, after confessing his crimes to his sons.

Just days ago, a court-appointed trustee filed a lawsuit seeking to recover any money from the fraud scheme that had been paid to members of the Madoff family, including Mark Madoff's two young children.

Calls to the FBI and U.S. Attorney's office were not immediately returned. Previously, spokesmen for the brothers had repeatedly denied that they had any knowledge of their father's crimes.

Bernard Madoff is serving a 150-year prison sentence in North Carolina. Bureau of Prisons spokeswoman Traci Billingsley said Saturday she didn't have specific information on whether he had been informed of his son's death or would be allowed to attend a service.

Correlated or diversified?

Correlation? Markets moving together? Correlation is a misleading metric of little help in measuring or achieving diversification. Highly correlated assets CAN diversify portfolios but some "uncorrelated" managers are too dependent on the market. Below is a hypothetical hedge fund with +1.00 correlation to the S&P 500. Absolute returns in all years and CAGR +17.65% but PERFECTLY correlated to a risky index fund which lost money. It diversified despite that pesky correlation.

The diversification "free lunch" has been arbitraged away, at least in mainstream risky asset classes. The best way to diversify a long is with a short NOT another long. Diversify the right way not diworsify the old way but correlation is STILL used as a critical input for portfolio construction and risk management. Why? During meltdowns correlations rise but now it occurs in "normal" market conditions as well, adding to risk rather than reducing it. Securities may move together more due to herding, ETFs and algorithmic trading. The passive mania forces benchmark components up or down regardless of value whether stocks, bonds or commodities. Hasn't everyone learnt the danger of "cheap" index tracking and its expensive cost?

Beta is often cited as a measure of volatility. But it's really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta security that is high risk and a high beta fund LESS risky than the market. Idiosyncratic risk isn't a risk; it's the idiosyncratic alpha you want. Alpha and absolute returns aren't the same. The textbook calculations of beta and alpha are based on correlation which, as the example above shows, isn't useful. The identification of true beta - dependence on underlying risk factors - and true alpha - value added through skill rather than luck - is much more complicated.

The omnipotent correlation matrix drives much portfolio "optimization". A bunch of inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On "up days" most stocks go up but they don't all rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don't mind if an investment has correlation of +1.00, 0.00, -1.00 or anything in between. It's irrelevant. I do care it has minimal sensitivity to anything else in the portfolio. Sadly for investors MVO and CAPM have been shown to be simple, elegant and completely useless. MPT is pronounced EMPTY and is better called Medieval Portfolio Theory.

"Modern" portfolio theory requires lots of wild guesses known as capital market assumptions, including expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor "results" speak for themselves. Those variables aren't robust, stable or likely to be accurate in constructing a long term portfolio. I've kept track of such facile forecasts and the tea leaf reading so-called "experts" who made them. Pretty bad outcomes but those fortune teller predictions keep being used. We are ALL affected by assets being (mis) allocated in this failed framework. Unlike the crystal ball gazers, I find mispriced securities and safer strategies whose returns outweigh the risks. Is that so radical? At least it works.

Severe drawdowns are unacceptable. It is not surprising conventional wisdom has performed so badly with fake "Nobel" prizes awarded for such "efficient", mean variance "optimized" nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random, right? CMA causes almost as many problems as absurd actuarial assumptions. If you keep doing what you always do, you receive what you always get: growing liabilities AND declining assets. Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.

Dispersion? Every month reports emerge on how AVERAGE "hedge funds" performed. Those numbers are meaningless with such disparity of skills and zero-sum nature of alpha. Many public domain strategies are too well-known now so it is not surprising AGGREGATE alpha tends to zero. Skill is rare. The average hides a range of numbers from managers performing very well to many that did not. 2008 saw huge dispersion. The typical hedge fund lost -20% but 3,000 MADE money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of R-squareds, covariances and variances just don't make the grade.

The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don't allocate to this reliable source of alpha. Last decade was great and returns have also been good this so-called "challenging" year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Despite many years of superior returns most investors avoid high frequency strategies! Perhaps "buy and hold for milliseconds" is the natural evolution from the archaic "buy and hold for years". Everything operates on short time horizons nowadays which is a mismatch with so-called "long term" investing. Instead I favor long term performance.

Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term "emerging markets" is often semantic arbitrage for countries that are actually developed. The big BRIC has lost badly to my BRIC but the SLIME has been the star this year. Sri Lanka, Iran, Mongolia and Estonia were missed by almost all international strategists. Could the geographic diversification strategy nowadays be to invest in places that don't offer ETFs? Don't asset allocate X% to emerging market beta. Invest 100% in alpha WHEREVER it can be found.

Unlike that unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistical parameters, I know that a properly diversified portfolio of the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver over time in all possible scenarios. Changing markets and crowded trades are no excuse for not being able to deliver absolute returns. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important.

Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on underlying markets and focus on skill-based strategies. I prefer calculating co-relation and association metrics not coRRelations. High correlations show the markets are even more inefficient. But REAL strategy diversification is what investors actually need.

Warren Buffett or George Soros?

Who's best? Warren Buffett or George Soros? Why risk hard-earned capital with managers who are not the best in the world at what they do? Warren runs the largest hedge fund but George is the top performer. They searched for successors only from hedge funds and all their liquid net worth is in absolute return strategies. The top sportspeople play in major leagues not minors and where do you find the best portfolio managers? George and Warren's edges were clear long ago so there was plenty of time to invest. Their success has brought major social benefits and secure retirements for clients.

Some even claim Warren isn't a hedge fund manager but his arbitrage, leverage, derivatives, event-driven and macro trading added much to returns and he short sold cocoa futures in a special situations deal as far back as 1954. George and Warren generated alpha from low frequency trading in various fund structures. Double Eagle - Quantum, Buffett Partnership - Berkshire Hathaway. Like many hedge funds, they don't report to databases. Neither has a PhD or CFA but both have exceptional quantitative skills. I have never found a good manager that doesn't even if they run "discretionary" styles. Skilled hedge funds do deliver reliable high returns at low risk. And prove that market prices are always wrong.

Portfolio performance is determined by MANAGER mix not ASSET mix. The more people believing in efficient markets the more inefficient markets become. Trillions in index funds creates more alpha capture opportunities for those with skill. Mid-career professionals like Warren and George are thriving while hedge fund managers aged under 80 are building up experience. Pensions worried about "longevity risk" can benefit from investment talent working longer. Over 41 years George has turned $1,000 into $14 million after fees and Warren to $3 million from his actively managed ETF. He charges LOWER fees than "cheap" unskilled long only funds.



George's track record is better but Warren is richer. Why? The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. But Warren got into currency trading and global philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.

Alpha thrives off beta. Warren ran the partnership from 1957-1969 and has since implemented his absolute return strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. Gross returns of 29.5% were net 23.8% to investors after his 25% incentive fee on 6% hurdle. What if, instead of "retiring" in 1970, Warren had continued the partnership and performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's fine since I'd have $99.9 million more than wasting time gambling on "low cost" index funds.



Academics say Warren is just an ex-post lucky outlier but some talent spotters DID seed his fund ex-ante. The S&P 500 also began in 1957 but has performed poorly by comparison - $1,000 would now be $100,000, a huge opportunity cost. Investing for absolute return using competitive edges and outside the box thinking has existed for centuries. Long only relative return is the fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 and bullseye but you also tie up precious cash in 1s and 2s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to identify the Phil Taylor of each strategy. How many darts must you throw to show skill? George and Warren have hit many treble 20s.

Hard to prove a conjecture but to disprove it ONE counterexample suffices. Warren, George and many others have destroyed efficient market hypotheses, random walk assumptions and the myth that long term policy asset allocation drives portfolio returns. BHB Brinson, Hood, Beebower, Singer and their acolytes have cost too many investors too much money and wrecked retirement plans. Prudent investors in fact want 100% of their capital in attractive opportunities. George and Warren's alpha capture from security selection worked better than static beta bets. No-one says it's easy but if you work hard enough it is possible. Such investment teams CAN be identified at an early stage and can charge whatever hedge fund fees clients are prepared to pay.

Some hedge funds shut due to SUCCESS. Warren closed his in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when Benjamin Graham decided to end his Graham-Newman hedge fund, operating decades before AW Jones' "first" hedge fund. Warren is correct that the best investment book ever written in English is the Intelligent Investor. The second best is Alchemy of Finance though fortunately hardly anyone else bothers to try to understand it. The top hedge fund book in any language is of course Fountain of Gold written by the best hedge fund manager ever. I re-read them all every year and every year my self-directed pension ends up with double-digit ABSOLUTE RETURNS. Coincidence?

Warren wants to be judged on book value not stock price but you can't eat book value and I evaluate fund managers by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to irrational public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. George made money that allegedly "challenging" year. While the stock has returned more than book value due to the valuation premium, volatility has been high. Warren's actual Sharpe ratio is lower than book value "Sharpe ratio", dropping sharply from 1.4 to 0.6.



The Oracle of Omaha and the Brain of Budapest have "quit" before and been searching for "successors" for a long time. George has been hiring "replacements" since 1981 and the extent of his fund management involvement has fluctuated since though never without close knowledge of and implied oversight of the portfolio. For each Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong colleagues and talented employees from early on. Jim Rogers and Charlie Munger added significantly. Accredited investors - anyone with $80 - can access Warren and Charlie's abilities through BRKB, a listed closed-end hedge fund. The active stockpickers at benchmark construction firms missed 45 years of massive growth but then add it to their "unmanaged" index!

Would Warren and George have bothered managing outside money if they hadn't been incentivized to do so and perform? It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's fee structure was actually cheaper. Jim Simons and team have outperformed both for the past 20 years with much higher fees but the net returns of Medallion Fund were superior. The technological and personnel infrastructure requirements for high frequency trading cost more than for low frequency. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds supply of alpha. But it's expensive and dangerous waiting to find out WHETHER bargain beta might one day deliver.

Those "outrageous" fees? George charged 1% and 20% no hurdle whereas Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with Soros Fund Management in 1969 and paying those "high" fees than you would with BRKA. I am delighted for people to be well compensated for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when manager interests are aligned with clients by them being the largest investor in their fund. When George or Warren has a bad month, they PERSONALLY lose more than any client. That INCENTIVIZES them to do their best to minimize the downside.



You CAN eat absolute returns and I'll take $100 million over $100,000 every time. I assume you would too. So what if the manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "discount" funds are available but at what performance? Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary. I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter?

The chart above assumes fees compound without the manager needing any profits to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the 2 and 20 mode. Two people, a computer and a phone do not get institutional money today. Sad though to see an Omaha pension fund deep in a $600 million deficit when they could so easily have hired a local hedge fund run by Warren Buffett get them into surplus. The Hungary retirement system is not in good shape either but they could have invested with George Soros and would now be doing fine. Why avoid the top absolute return managers when you have ABSOLUTE LIABILITIES to fund?

No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some outliers even say alpha doesn't exist! For those "surprised" by the Euro crisis in Spain, Ireland, Greece, Belgium, Portugal etc., George saw the dangers long ago. Yet macroeconomic "stability" maven Robert Mundell keeps his "Nobel" Prize for now. Optimum currency areas aren't optimal so he should give it to George. If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 1,000,000 coins and get 800,000 heads. Warren and George have flipped too many coins for their returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving their wealth away for the social benefit of the world. A rare financial win/win/win.

Equity is a buy here, by Marc Faber

Equity Markets--Last month, Faber was somewhat cautious on US stocks, saying that sentiment was overly bullish and vulnerable to a correction. So far, we have seen a slight decline in stocks as the QE euphoria fades and worries mount in the PIIGS. Faber thinks the correction could continue as things in Europe worsen. However, he does not expect the market to fall below the 1010-1050 range on the S&P 500 because of the Bernanke. Of all the developed markets, Faber likes Japan the most. He thinks a declining yen will help Japanese equities. Furthermore, Japan is under owned by institutions.

Emerging Markets--Those who are investing in emerging markets are late to the party. The market has mostly priced emerging markets to perfection, which makes further gains difficult. Faber favors frontier markets (especially those levered to natural resources) whose valuations are more favorable. Faber even likes developed markets (US, Europe, Japan) more than he likes emerging markets right now.

Gold & Silver--Faber still likes gold and continues to accumulate ounces, but he says a correction to $1200 would not surprise him. Gold bull market remains intact as the majority of individual investors and institutions remain under invested.

Bonds--Continues to hate US government bonds.The risk versus reward is not favorable as Faber does not believe bond yields will make new lows. However, he does like Russian and Central Asian corporate bonds, even though he expects interest rates to rise in the future.

Currencies--Euro is going down against the dollar and will likely fall further because of the EU debt crisis. Generally, a higher dollar leads to lower stock prices. Long-term the dollar will weaken but for now it continues to benefit as the world reserve currency.

Overall, Faber expects world equity markets to remain well supported in the medium-longer term because people have nowhere else to put their money. Once bond yields start to rise, all of those people who piled into bonds will redeploy funds into equities. Also, all of those people sitting in cash are getting tired of zero percent returns and equities make the most sense.

There you have it: Faber's outlook for December. Good luck trading!

This time, the Oscar goes to.... ME

Take-Knowledge to Protect-Knowledge, the ever-evolving Technology

--mattewho

While the entire world is blaming Greenspan for bringing down the financial world single-handedly, I find myself having a soft spot for him. The poor guy was not only over-criticized; he was over-credited for his ability. It was the technology, the robust computers and sophisticated applications, which developed innovative derivative and structured products, that played a significant role in the 2008 financial tsunami. With 13 investment banks vanishing in six months, the long- standing US financial system, built by our founding fathers, and designed to be idiot-proof, was brought to the brink of collapse. Apparently, our genius didn’t foresee technology being the potential beast. In the middle of the crisis, I had lunch with a retired former colleague, who called computer “the sewing machine”; she was once ranked among the top 100 financial analysts on Wall Street. We were reverse engineering one derivative fund using rainbow option. She grasped the concept quickly and then bursted out: “This is too complex to calculate, how can one price it daily?” “Certainly not by your slide rule.” I replied. Of course, my rude comment almost cost us our friendship.
Not to challenge Einstein’s Twin Paradox, but time in Technology dimension does travel at a different speed. When I first joined the firm, the number of employees was about 35% of current size, but the number of servers was less than 1% of what we have now. Surprisingly, despite the fact we are an old fashion behind-the-curve investment firm, we had a State-Of-Art server at that time, a Net-FRAME server. (See news attached at bottom). The server was wrapped in large black steel; you would have to be a professional heavy weight wrestler to lift it. It had 128MB memory, and, not to scare you, 1GB hard drive! With the price tag at $30K of current money, it was the Holy Grail at the time. Fast forward 16 years, servers with 1000% more capacities are either invisible (virtualized) or built like a pizza box, and at fractional cost. Wall Street has classified the computer hardware sector as commodity. In a mere 16 years, the exquisite piece of Art in Sotheby has turned into the framed Art in Costco. It is quite an insult to the Industry; luckily, in a nice way.
The rapid growth of Internet since 1995 has become the vital force for the world economy; it has enabled business accessing, storing, and processing information, worldwide, all in split second; Aided by fast growing robust infrastructure, business was turning the vast amount of information collected from Internet into massive innovative products. By the same channel, it was marketing, selling, and distributing the products within real time of producing. In a nutshell, Internet and information technology have made information extremely fluid. As professionals in the financial industry, we all know how powerful the word “liquidity” is. In retrospect, financial service industry has benefited from Technology more than any other sectors of the world economy. Powerful combination of rapid growth infrastructure and sophisticated financial applications enabled firms to develop innovative, structured and highly complex products to meet customers’ needs. High-speed Internet pushed Finance into twenty-four-hour, seven-day-a-week global activity with vast sums flashing between markets. The ability to instantaneously interpret the financial markets and anticipate their movement has brought huge profits to Financial Service Industry.

Entering new millennium, as more information is disseminated electronically, the ability to manipulate is also growing, the vital force (Simultaneous Information sharing and transmission) that drove the world economy in the last decade, has recently started to show its dark side. After growing incidences of malicious virus attacks and identity theft, people’s sense of privacy and security is diminishing. A recent Wall Street Journal survey indicated that privacy is the issue that concerns Americans most in the twenty-first century, ahead of overpopulation, racial tensions, and global warming. Businesses can’t talk enough about privacy, and are rushing to pass laws to protect it; during an IT leader conference held in past May, the majority of the topics were about privacy regulations and security enforcement; technology for business productivity and innovation received little interest and mention. Obviously, technology is shifting towards a more defensive strategy: to secure data, to protect knowledge, and to reduce complexity.
One way to protect privacy is to set regulations. While I have no doubt about the necessity of regulations, I am less confident about the efficacy. Let’s take the corruption Index; it is higher in highly regulated countries. Let alone the lengthy process of regulation creation: Who picks and chooses the data to protect and not protect? What about information shared globally? Who would the new regulations apply to? What data are protected? What’s considered commerce? Lots of questions; few answers. This is surely just the beginning.
The other way to solve the problem of data security is to spend money on technology, for instance, applying secure web gateways to prevent employee exchange of web based email and postage on social network sites. The tools are useful, but only up to a certain degree, and to a certain point. You don’t have to be technologically savvy to register a free logmein account, which would enable you to connect to home PC from work and perform all the activities blocked by employer. So ultimately, the problem cannot be solved by technology alone because it is not purely technical in nature. Although technical defense is vital, systems are inherently vulnerable to both negligent and malicious acts by people. The real challenge for IT today is learning how to influence people’s behavior; security needs to shift towards being an influential mechanism. To achieve the approach, we need first to understand the business, and then enable the business to achieve its objectives in a way that is secure.
Every revolution has its challenges; that is part of the evolution. The original date of early human use of fire for cooking was about 1.6 million year ago, yet the evidence of their ability to control fire was dated only around 400,000 years ago. For over a million years, they faced the threat of fire but never gave up cooking. If history repeats itself, as it always does, we will find the solution for privacy and security successfully.

North Korea Attack Impact

Global stock markets have recovered after North Korea launched a barrage against South Korea on Tuesday. Yet military tensions are rising: the U.S. has dispatched warships into the Yellow Sea for exercises with its ally Seoul. What’s ahead for business relations between China, which has close political ties to North Korea, and South Korea?

We exchanged by email yesterday with, Yong-Tack Cho, an editor at Forbes Korea, the licensed Korean-language edition of Forbes magazine. Excerpts follow.

Q. Before this week’s attack on South Korea by the North, economic relations between South Korea and China had been expanding despite China’s close political ties to North Korea. Why have economic and business ties managed to grow despite China’s cozy relationship with the North?

A. Indeed, South Korea and China’s trade relations have developed greatly. Currently, 31% of South Korean exports are shipped to China. This is possible because both countries want to see their trade and political relations as two different things. China has wanted to grow its economy and has needed the investment and technology South Korea can provide. On the other hand, South Korea has wanted entry into the Chinese market and its natural resources. While the two countries do not share the same beliefs about North Korea diplomatically, it would have been unwise trade policy to let that get in the way of trade growth.

Q. What’s ahead for business between China and South Korea, in light of North Korea’s attack?

A. It is unlikely the recent attack will get in the way of trade between South Korea and China, as both governments do not wish for it to get in the way of business. If the situation does not escalate, the impact on economic and trade relations will be meager, as there is no proof or indication that China was involved in the attacks.

Q. What South Korean companies, if any, would be most affected by this week’s developments?

A. We expect that this week’s events will have a large impact on the tourism industry, especially from Japan and China. The Korea Tourism Organization held a meeting with its Japan and China offices on the 24th. While they deny any massive wave of travel cancelations, local travel agencies have been reporting significant losses and falling prices for travel packages to Korea. We expect prices to continue to fall for now.

Q. Before this week’s event, what would you say would likely be the outlook for China-Korean business and economic growth in 2011?

A. Before this week, China was seen as a great economic opportunity for Korea. “How to approach the Chinese economy?” was a question that local companies contemplated 10 years ago. (Since then,) Korean conglomerates such as Samsung, LG, Hyundai Motors, and Posco have regularly increased their investment and built production sites in the region. The two governments are currently formulating an FTA agreement. Even after the attack, we do not believe that it will overly impact our business outlook with China.

Q. What’s the outlook for South Korea’s stock market and currency in light of this week’s attacks?

A. The day after the Yeonpyeong Island attack, the KOSPI dropped 45.02 points (2.33%) in the morning. However, the KOSPI jumped back and closed only 2.96 points (0.15%) lower than the previous day. The Korean stock market has been able to regain its stability despite the attacks because we’ve learn from our past experiences. This isn’t the first time we’ve been attacked by North Korea, and foreign investors have been able to build a certain level of tolerance. As Lee Sung-Woo, an analyst from Daewoo Securities, says: “North Korea’s attack may have influenced the liquidity of the global market momentarily, but they can’t get in the way of a rising nation like South Korea from flourishing in the long haul.”

Devaluing History

Menzie Chinn goes after Paul Ryan’s challenge: “Name me a nation in history that has prospered by devaluing its currency.” But why go back to the 1930s?

How about:

-Britain, which recovered strongly from its early 90s doldrums after it devalued the pound against the mark in 1992. (At the time, some wags suggested putting a statue of George Soros in Trafalgar Square.)

- Sweden, which recovered from its early 90s banking crisis with an export boom, driven by a devalued kronor.

- South Korea, which roared back from the 1997-1998 crisis with an export boom, driven by a depreciated won.

- Argentina, which roared back from its 2002 crisis with an export boom, driven by a depreciated peso.

And more. The truth is that every recovery from financial crisis I know of since World War II was driven by currency depreciation. In fact, that’s the biggest reason for pessimism now: because of the global scope of this crisis, the usual exit is blocked.

Now, I’m sure that the goldbugs will come up with ways to explain away all of these events. But at that point we’re not learning from history; on the face of it, history seems to suggest many cases of countries prospering through devaluation.

So what’s going on with Ryan? First, it’s a good bet that he doesn’t actually know much about monetary history. Beyond that, though, what you often see among hard-money types is a sort of Lives of the Saints approach to history: they’ve got their iconic examples (Weimar Germany! Zimbabwe!) which they pull out on every occasion, while remaining utterly ignorant of all the examples that go the other way.

And no, it’s not symmetric: people like me have heard about hyperinflation, while people like Ryan apparently have never heard about post-crisis Korea or Argentina.

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Top 10 Business Etiquette

1. First and foremost, having good manners is a must. Please and thank you never go out of style. Common courtesy towards others should be second nature.

2. Be on time, or better yet be a little bit early. Be certain that you have allotted enough time for the meeting so you won't be concerned about another place that you have to be.

3. Dress appropriately. If you are uncertain of what to wear, it is always better to err on the conservative side. Business casual is generally the rule of thumb to follow.

4. Prepare yourself ahead of time for both things that you may want to contribute to the meeting, and any information that was given to you ahead of time to read or make notes on. Come prepared to participate in discussions and activities.

5. Upon entering the meeting, glance around the room and acknowledge other attendees. Familiarize yourself with colleagues and managers and make a note of the person who is chairing the meeting. Try to put names to faces if you've met previously and try to remember names of people who have been newly introduced to you.

6. Although it's hard to live without text messages, cell calls and emails, you can do it for the duration of a meeting. It is good etiquette to present the attitude that this meeting is the most important thing on your agenda right now. Leave word ahead of time with the necessary contacts that you will be in a meeting and then switch everything off when you arrive.

7. Don't interrupt the chair when the meeting is in progress. Take notes so you will be prepared to speak up when the time is right.

8. When you do speak out, be clear, concise, and stay on topic. Don't be afraid to present your point of view, but always be respectful of the point of view of others.

9. Information exchanged in a meeting is generally considered confidential among those attending the meeting. Unless you are certain that the subject matter is common knowledge, it is best not to discuss issues with those that were not in attendance.

10. Bring your positive attitude. You'll accomplish a lot more and gain a lot more respect than you will if you are negative and critical.

The Rise Of The Modern Investment Bank

From Clipper Ships to KKR
Adam Smith famously described capitalism as an invisible hand guiding the market in its allocation of goods and services. The financial engines of this hand during the 18th and 19th centuries were European merchant banks, such as Hope & Co., Baring Brothers and Morgan Grenfell. For a time, the Netherlands, and later Great Britain, ruled the waves of global commerce in far-flung ports of call such as India and Hong Kong. The merchant banking model then crossed the Atlantic and served as the inspiration for the financial firms founded by prominent families in what could perhaps be called the emerging market of the day - the United States. The structure and activities of early U.S. firms such as JP Morgan & Co. and Dillon Read and Drexel & Co. reflected those of their European counterparts and included financing new business opportunities through raising and deploying investment capital. (For related reading, see The Evolution Of Banking.)

Over time, two somewhat distinct models arose from this. The old merchant banking model was largely a private affair conducted among the privileged denizens of the clubby world of old European wealth. The merchant bank typically put up sizable amounts of its own (family-owned) capital along with that of other private interests that came into the deals as limited-liability partners. Over the 19th century, a new model came into popular use, particularly in the United States. Firms seeking to raise capital would issue securities to third-party investors, who would then have the ability to trade these securities in the organized securities exchanges of major financial centers such as London and New York. The role of the financial firm was that of underwriter - representing the issuer to the investing public, obtaining interest from investors and facilitating the details of the issuance. Firms engaged in this business became known as investment banks. (To learn more about these functions, read Brokerage Functions: Underwriting And Agency Roles.)

Firms like JP Morgan didn't limit themselves to investment banking, but established themselves in a variety of other financial businesses including lending and deposit taking (i.e. commercial banking). The stock market crash of 1929 and ensuing Great Depression caused the U.S. government to reach the conclusion that financial markets needed to be more closely regulated in order to protect the financial interests of average Americans. This resulted in the separation of investment banking from commercial banking (the Glass-Steagall Act of 1933). The firms on the investment banking side of this separation - such as Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston - went on to take a prominent role in the underwriting of corporate America during the postwar period; the largest gained fame as the so-called "bulge bracket". (For more on this, read What Was The Glass-Steagall Act?)

The term "merchant bank" came back into vogue in the late 1970s with the nascent private equity business of firms like Kohlberg, Kravis & Roberts (KKR). Merchant banking in its modern context refers to using one's own equity (often accompanied by external debt financing) in a private transaction, as opposed to underwriting a share issue via publicly traded securities on an exchange - the classic function of an investment bank. Many of the large global firms today conduct both merchant banking (private equity) and investment banking.

The Regulatory Infrastructure
In the United States, investment banks operate according to legislation enacted at the time of Glass-Steagall. The Securities Act of 1933 became a blueprint for how investment banks underwrite securities in the public markets. The act established the practices of due diligence, issuing a preliminary and final prospectus, and pricing and syndicating a new issue. The 1934 Securities Exchange Act addressed securities exchanges and broker-dealer organizations. The 1940 Investment Company Act and 1940 Investment Advisors Act established regulations for fiduciaries, such as mutual funds, private money managers and registered investment advisors. In Wall Street parlance, the investment banks represent the "sell side" (as they are mainly in the business of selling securities to investors), while mutual funds, advisors and others make up the "buy side".

Anatomy of an Offering
A company selects an investment bank to be lead manager of a securities offering; responsibilities include leading the due diligence and drafting the prospectus. The lead manager forms a team of third-party specialists, including legal counsel, accounting and tax specialists, financial printers and others.

In addition, the lead manager invites other banks into an underwriting syndicate as co-managers. The lead and co-managers will allot portions of the shares to be offered among themselves. Because their underwriting fees derive from how much of the issue they sell, the competition for lead manager and senior allotment positions is quite intense.

When a company issues publicly traded securities for the first time through an initial public offering (IPO), the lead manager appoints a research analyst to write a research report and begin ongoing coverage of the company. The report will contain an economic analysis of the business and its prospects given the market for its products and services, competition and other factors. Once the analyst initiates coverage, he or she will make ongoing recommendations to the bank's clients to buy, hold or sell shares based on the perceived fair value relative to current share price. (For more on this, read IPO Basics.)

Distribution begins with the book-building process. The underwriting syndicate builds a book of interest during the offering period, usually accompanied by a road show, in which the issuer's senior management and syndicate team members meet with potential investors (mostly institutional investors such as pension funds, endowments and insurance companies). Potential investors receive a red herring, a preliminary prospectus that contains all materially significant information about the issuer but omits the final issuing price and number of shares.

At the end of the road show, the lead manager sets the final offering price based on the prevailing demand. Underwriters seek to have the offering oversubscribed (create more demand than available shares). If they succeed, they will exercise a 15% overallotment option, called a greenshoe, which is named after the Green Shoe Company, the first issuer of such an option. This permits the underwriters to increase the number of new shares issued by up to 15% (from the number stated in the prospectus) without going through any additional registration.

The new issue market is called the primary market. The Securities and Exchange Commission (SEC) registers the securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.)

Wall Street's Chinese Wall
Investment banking is fraught with potential conflicts of interest. This problem has intensified through the consolidation that has swept through the financial services industry, to the point where a handful of large concerns - the fabled bulge bracket banks - account for a disproportionate share of business on both the buy and sell side.

The potential conflict arising from this is simple to understand. Buy-side agents - investment advisors and money managers - have a fiduciary obligation to act solely in the best interests of their investing clients, without regard for their own economic incentives to recommend one product or strategy versus another. Investment bankers on the sell side seek to maximize the results to their clients, the issuers. When a firm in which the main line of business is sell side, investment banking acquires a buy-side asset manager, and these incentives can be at odds.

Unfortunately for investors, the economics of the business are such that a disproportionate amount of an investment bank's profits derive from its underwriting and trading businesses. The competition for mandates is intense, and the pressure is high on all participants - the bankers, research analysts, traders and salespeople - to deliver results.

One example in particular is research. The research analyst is supposed to reach independent conclusions irrespective of the investment bankers' interests. Regulations mandate that banks enforce a separation between research and banking, popularly referred to as a Chinese Wall. In reality, however, many firms have tied research analysts' compensation to investment banking profitability. Scrutiny following the collapse of the dotcom bubble in 2000 has led to some attempts to reform some of these flawed practices. (To learn more, read The Chinese Wall Protects Investors Against Conflicts Of Interest.)

What About Compensation?
A discussion on investment banking wouldn't be complete without addressing the enormous sums of money that investment bankers are paid. Essentially, a bank's main income-producing assets walk out of the office building every evening. Deals are completed and money is made based solely on the relationships, experience and clever thinking of the professionals who work there.

As such, an investment bank has little to do with the profits it earns except to pay the folks who produced them. It is not unusual for 50% or more of top-line revenues to go into the salaries and bonuses for an investment bank's employees. Most of this goes to the principal architects of the deals, but is also goes to the associates and analysts who toil over discounted cash flow spreadsheets and comparables models until the early hours of every morning.

The catch is that most of this compensation is paid as bonuses. Fixed salaries are by no means modest, but the big seven-figure payoffs come through bonus distributions. The risk for an investment banker is that such payouts can quickly vanish if market conditions turn down or the firm has a bad year. (For more on the life of an investment banker, read Is Investment Banking For You?)

Investment bankers spend an inordinate amount of time trying to figure out new ways to make money - in good times and bad. Business areas like M&A, restructuring, private equity and structured finance, most of which were not part of an investment bank's repertoire prior to the mid to late 1970s, provide evidence of this profession's ability to continually find new ways to make money.

The Bottom Line
For all the mystery surrounding investment banks, the role they have played throughout the evolution of modern capitalism is fairly straightforward. These institutions provide the financial means to enable Adam Smith's invisible hand to function.

Investment banks have flourished in a variety of economies, from the merchant traders of 18th-century London and Amsterdam to the behemoths of today, whose influence spans the globe. As long as there is a market economy, there are likely to be investment bankers coming up with new ways to make money, while the rest of us marvel at how they manage to do it.

Madoff Trustee Sues UBS For $2 billion

Irving Picard, the court-appointed trustee for Bernard Madoff’s bogus investment firm, has gone after a big bank in his expensive two-year quest to retrieve funds for some Madoff investors.

Picard filed a complaint against UBS in Manhattan’s federal bankruptcy court yesterday, accusing the Swiss bank of fraud and misconduct in connection with feeder funds that funneled investor cash into the Ponzi scheme. The lawsuit seeks to recover at least $2 billion.

In a press release, Picard claims UBS actively assisted the Madoff Ponzi scheme by sponsoring and administrating Luxalpha SICAV and Groupement Financier, two feeder funds. Picard says that UBS’s own due diligence revealed “indicia of fraud” with the UBS feeder funds, but that UBS nevertheless made Bernard Madoff the subcustodian of the feeder fund assets, allowing Madoff to “run the operation with no checks and balances.” Picard says that UBS enabled Madoff to be the “only source of information for valuing the funds.”

In the complaint, Picard claims the UBS-sponsored feeder funds withdrew $1.12 billion in the six years before the the Ponzi scheme collapsed and resulted in a bankrtupcy filing, making those funds potentially recoverable under federal bankruptcy and state law. Picard claims UBS and its affiliates made some $80 million in fees from the feeder funds.

“Madoff’s scheme could not have been accomplished unless UBS had agreed not only to look the other way, but also to pretend that they were truly ensuring the existence of assets and trades when in fact they were not and never did,” David Sheehan, Picard’s lawyer, said in a statement.

Sheehan said that Picard has “battled” with UBS over disclosure of information regarding Bernard Madoff Investment Securities.

The lawsuit is the latest effort in Picard’s controversial effort, which has included attempts to clawback funds from some of Madoff’s victims. So far Picard has recovered some $1.5 billion, but the vast majority of that sum was simply recovered by grabbing the cash that remained on hand in Madoff’s investment company following the exposure of the fraud. It has been a rich business for Picard and his firm, Baker Hostetler, yielding more than $85 million in fees.

But Picard and Sheehan claim they are on the right track. Said Sheehan: “Without UBS’s serving as promoter, custodian, manager and administrator for the feeder funds, [Madoff] would have been deprived of more than a billion dollars in investments, and Madoff’s fraud would have been diminished.”

George Soros Raises InterOil (IOC) Stake

Soros Fund Management just filed an amended 13G with the SEC regarding their position in InterOil (IOC). Per activity on October 25th, George Soros' hedge fund now shows an 11.9% ownership stake in IOC with 5,257,422 shares. This comes after we just disclosed that Soros boosted stakes in two other positions.

Of this total, 1,200,000 shares are represented by call options. Since the second quarter ended, Soros has increased their position size by 53.5%. Interestingly enough, InterOil just yesterday afternoon announced that they would offer convertible senior notes due 2015 and common shares to raise proceeds of up to $280 million.

InterOil has been somewhat of a controversial stock in the hedge fund world. While Soros has amassed a hefty long position, Whitney Tilson's hedge fund T2 Partners has been an ardent detractor of the company as they are short IOC. Soros has clearly been the winner on this play thus far and we'll have to see what happens in the future.

Taken from Google Finance, InterOil is "an integrated energy company operating in Papua New Guinea and its surrounding Southwest Pacific region. The Company operates in four business segments: upstream, midstream, downstream and corporate."

Thank the Pilgrims for eBay

The story of the Pilgrims' first years in America shows how a change from common ownership to private property led to the feasting celebrated today at Thanksgiving. Similar tales of expanding harvests and benevolence are told wherever people can keep the fruits of their labor and trade them as they please.

The story illuminates why eBay and Chicago Mercantile Exchange Holdings, the owner of the Chicago Mercantile Exchange, were among the two best-performing stocks in their class during each of the last two years, and it provides a useful signal that other markets now preparing to go public might be good investments.

After landing at Plymouth in November 1620, the Pilgrims endured a cold, hungry winter during which half of them died. Promised supplies failed to arrive from London. The 1621 harvest wasn't as big as hoped, nor was the 1622 harvest. More famine seemed inevitable.

And then the colony began to talk through the problem. The London merchants who financed the Pilgrims' settlement specified "that all such persons as are of this colony are to have their meat, drink, apparel, and all provisions out of the common stock and goods of the said colony." In 1621, the Pilgrims planted 26 acres, according to Judd W. Patton, an economics professor at Bellevue University in Nebraska. In 1622, they planted 60 acres, but that wasn't enough to keep hunger away.

People began to steal by night and day, "although many were well whipped," Gov. William Bradford reported.

The system made no sense to anyone. The hard-working subsidized the slackers. The young and ambitious didn't want to do work for anyone else and get nothing for their trouble. The wives of some of the men objected to be commanded to wash clothes, dress meat or do other tasks for other men.

As Bradford would later write in "Of Plymouth Plantation 1620-1647," "At length, after much debate of things, the Governor (with the advice of the chiefest amongst them) gave way that they should set corn every man for his own particular, and in that regard trust to themselves, in all other things to go on in the general way as before."

In what's known today as the Land Division of 1623, each family was allotted land at the rate of one acre per family member and told to go out and produce. More than 184 acres were planted that year. And, Bradford reported, "This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn."

What is apparent from this history is what we all know from our experience: When you can benefit from working hard, you work harder. Under the system of common ownership, there was stealing, shirking and malevolence. Under the incentive system, there was good feeling, hard work and benevolence.

News of the success at Plymouth and other settlements like it attracted more and more immigrants to the New World. And everyone who lives in America today has a personal story that is part of that great continuing tale.

The impulse to improve one's conditions through greater effort and trade is as natural as breathing, and this has been so since the beginning. New York University economist Haim Ofek, in "Second Nature: Economics Origins of Human Evolution, argues that trade helped spur the growth of the brain.

"Exchange requires certain levels of dexterity in communication, quantification, abstraction, and orientation in time and space, all of which depend on the lingual, mathematical and even artistic faculties of the human mind," Ofek writes in the introduction to his 2001 book. "Exchange, therefore, is a pervasive human predisposition with obvious evolutionary implications."

Relatively flexible and acute people had an edge in trading. They survived and prospered, they had bigger, healthier families, and their descendants became dominant.

The success of eBay since its founding in 1995 shares many similarities with the Pilgrim story. Now a public company with a market value of around $75 billion, eBay has created an electronic network of niche markets that takes account of the infinity of human tastes and aptitudes and specializations. The stock is up 72-fold since its September 1998 IPO, from a price-adjusted initial price of $1.50 to $109.42 as of Nov. 15. That is after a 77% drop in the tech crash of 2000.

Like the Pilgrims, eBay gives each of its sellers a piece of land (though in virtual space) to carry out his or her business. A spirit of benevolence is apparent in the company's feedback system; in almost half the transactions, both buyer and seller rate each other, with almost all them highly favorable. But to us, there is one overriding reason for eBay's success: It unleashes the desire and provides a forum for buyers and sellers to improve themselves by trade in a million ways every day.

The CME, odd as it sounds, also bears some similarities to Plymouth Colony. Founded in 1897 as a member-owned organization, the Merc started out as a market for the trading of foodstuffs. Its activities and goals were torn between the interests of the members and the interests of the public. A low point was reached in 1989, when a widely publicized sting operation uncovered conflicts of interest and failures to give the public a fair shake.

For years, the Merc had been content to play a sleepy second fiddle to the Chicago Board of Trade both in volume and number of products traded. In 1972, an inspirational governor — in this case, Leo Melamed — decided it was in everyone's interest to match members' interests with the growing public interest in financial products such as currencies, Treasury bills, Eurodollars and stock market futures. Growth exploded in 2000 as the CME prepared for the shift to public ownership by converting members' interests to shares. Since the Merc went public in December 2002 with its shares listed on the New York Stock Exchange, the stock has risen nearly six-fold, and it has stayed in the top 10 of NYSE performers.

In effect, the CME transformed itself from a tradition-bound club with the image of a raucous den where men shouted at each other to get an edge on the public in trading pork bellies. Instead, it became a pioneering company that lets hardly a week go by without introducing a new electronic product designed to give the public more ability to improve and hedge their ownership of stocks and debt.

The table below shows how acreage planted and revenues grew at Plymouth, the CME and eBay.The Plymouth, Chicago Merc and eBay experiences
Year Plymouth acres planted CME revenue* eBay revenue*
(1621/2000) 26 $226.6 $431.4
(1622/2001) 60 $387.2 $749.8
(1623/2002) 184 $453.2 $1,214.1
(2003) $526.1 $2,165
(2004)** $743.8 $3,260
* In millions **Analysts' estimates


The Pilgrims originally agreed with the London merchants who financed their settlement to hold their land and its products in common, a sort of forced socialism, much as the communists imposed on Russia after the 1917 revolution.

And the Pilgrims learned, as the Russians would, that the system led to misery and poverty. Whenever trade and its rewards are permitted, well-being and output improve across the board. The principle is so mundane that it's hard to believe that it could ever be forgotten. But it was. The Soviet economy broke down because people had no incentive to reduce costs, to produce a quality product, to provide the kind of gracious service that an American expects from even a humdrum retailer.

If it weren't for those who risked death — literally — to start private enterprises on the black market, the Soviet system would have collapsed long before it finally did.

Everyone knows a million examples of how people respond to incentives. It's no accident that when President Bush won a reduction in taxes on capital gains and stock dividends in May 2003, the S&P 500 ($INX) responded with a 27% rise. Incentives to buy stock increased, so prices rose. The after-tax returns from stocks increased, so the public decided to place more dollars into stocks versus the alternatives.

In Plymouth, thanks to the gift of the Land Division of 1623, trade was created, and it did what it has always done:
It allowed economic freedom. The Pilgrims borrowed the money to start their colony. Their decision to redistribute the land allowed rapid repayment and the freedom to practice their beliefs as they wished.
It financed new enterprises. The Virginia Company of Plymouth served its own interests by lending to farmers, giving the company a chance to increase its agricultural imports.
It increased output. When each Pilgrim family gained the freedom to labor as they wished in exchange for the freedom to keep their crop, yields increased.

We believe the successes of the Pilgrims, the CME and eBay are not anomalies. And we will predict success for any company or country that lets people trade as they are predisposed to do by instinct and common sense. If the International Securities Exchange and Chicago Board of Trade follow through on plans to offer shares to the public and if the New York Stock Exchange ever goes public, we'd recommend buying those stocks.