http://www.amazon.co.uk/gp/bestsellers/books/268194/ref=pd_zg_hrsr_b_1_4_last

The overall investment experience for hedge fund investors has been so abysmal that most industry professionals are sensibly keeping their heads down. There are great hedge funds to be sure, and happy clients, but the data shows indisputably that these are not the norm. Hedge fund managers themselves of course aren’t responsible for the industry, only their own fund. So they have no reason to comment or even care about my book – and quite right too, because it’s not directed at them anyway, but at their clients. Hedge fund managers don’t need my help.

However, Mr. Andrew Baker is CEO of the Alternative Investment Management Association (AIMA), whose website says it is the,”global representative of the hedge fund industry”. It’s Mr. Baker’s job to promote hedge funds as a good investment, and he embraces the mantle, as he showed in a letter last August to the Financial Times in which he chastised writer Jonathan Davis for promoting “hoary old myths” about hedge funds. Mr. Baker goes on to note that, “Far from being disappointing, hedge fund performance has been impressive. During 1999-2010, the major hedge fund indices achieved overall returns (net of fees) of more than 8 per cent per annum.” As Mr. Baker may not have known then, but may learn if he reads my book, the good years for investors were when the industry was small.  8% per annum may sound good, but it’s far higher than what the average investor earned. The Absolute Return business has failed to deliver investors an Absolute Return but has instead retained at least 84% of the trading profits earned on client capital during this time; their money would have been better off in treasury bills. I wish Mr. Baker’s letter had been published in time to make it into my book.

http://www.economist.com/node/21542452

Those of us who traded Foreign Exchange in the early 90s will have noticed something familiar today. A country is attempting to fend of a speculative attack on its currency by raising interest rates. Hungary, on the edge of the Euro-zone and its current recession, is expecting barely positive GDP growth this year of 0.5% and has policy rates at 7% with expectations that they will have to rise. The risk is that GDP will be lower than expected, and that the central bank will raise rates higher. Inflation is currently running at 4%, but that is not the main problem facing the country.

Hungarian homeowners took out mortgages in Swiss Francs because interest rates there were lower than domestic ones. Unfortunately, the Swiss Franc has appreciated against the Euro beyond all expectations as investors have fled the Euro (a currency and region with whom Hungary’s shares an almost umbilical attachment). So the debt owed by many Hungarians has soared in their own currency, since the Forint has also weakened against the Swiss Franc.

Back in the 90s when European countries were attempting to maintain stable FX rates as they proceeded towards eventual monetary union, occasionally they would raise short-term rates when their currency was weakening. It rarely worked; Hungary could double its short term rates and that would scarcely deter an investor seeking to exit the currency – indeed, it might strengthen his resolve given the risk to domestic growth.

So it’s deja vu all over again (as Yogi Berra memorably said). There doesn’t appear to be a Forint ETF to be short, but being short the Euro works nearly as well.

Disclosure: Author is Short FXE

Morningstar reported through the Wall Street Journal that PIMCO’s $244BN Total Return Fund (PTRRX) suffered the first outflow on its history last year. $5BN left the fund in 2011 including $1.4BN in December as investors soured on PIMCO’s mis-timed trades in U.S. government bonds. Bill Gross hasn’t achieved what he has by accident, and no doubt many more good years lie ahead. But the Federal Reserve’s distortion of interest rates, through Quantitative Easing (QE) Versions 1 and 2 and more recently Operation Twist illustrate the problem. Bond yields today do not reflect the private market’s appetite to lend money; they are being held down by the Fed’s buying. Consequently, ten year treasuries offering a yield of less than 2% are guaranteed to slowly erode the real value of the money invested in them even in a tax-deferred or tax-exempt account. For a taxable investor the erosion takes place more quickly.

Last Summer PIMCO publicly spurned U.S. debt as offering an insufficient return, and after lagging the indices badly while a Fed-induced rally took hold they reversed course. PIMCO no longer hates government bonds and a look a the holdings of PTRRX on Morningstar reveals several positions in long term government bonds. 2.3% is invested in the 3.5/8 of 2/2021; 1.5% in the 2.1/8% of 8/2021, and so on. 27% is in government debt – and yet, since the hold to maturity real return will most assuredly be negative, the justification for these holdings is that they will zig when other things zag. In a flight to quality, “risk off” trade (in which the market engages fairly often) holdings of treasuries can be relied on to retain their value or even appreciate. The negative return is in exchange for reduced volatility, and extracting real value from such holdings therefore requires that they be sold by a nimble PM at precisely the time of crisis. This is increasingly what active bond managers are faced with – they need to be good at market timing to justify some of their holdings.

PIMCO may well be good at that too, last year notwithstanding. As the government stealthily imposes loss of purchasing power on savers, successful bond managers will be those who are nimble enough to keep time to the music.

That the world’s a risky place has not escaped the recent attention of investors. The potential demise of the European single currency and perhaps with it European banks and the European project itself looms large over every investment decision, and has for many months. Economic slowdown in China, the uncertain consequences of the Arab Spring and more recently Iran’s nuclear ambitions all add to the global uncertainty. Within the U.S. a highly partisan Congress has led to legislative gridlock and no certainty about long term fiscal policy. It makes you wonder how investors get out of bed in the morning. And when they do, they are confronted with a choice of risky assets (such as equities) which may lose value immediately, or less risky assets (such as bonds) which will lose real value with certainty. That investors are choosing the certainty of lost purchasing power over the available alternatives reflects the seemingly poor choices on offer. Thus is the equity risk premium, the difference between the earnings yield (inverse of the P/E ratio) on the S&P500 and the ten year U.S. treasury yield, at its widest since 1974, a year that closed with the Dow Jones Industrial Average having dropped 45% from its peak only eighteen months earlier, and inflation at 12.3%.

Start with bonds. Today’s ten year treasury yield of around 2% assures even the tax-exempt hold-to-maturity investor of a loss in purchasing power if inflation over ten years exceeds 2%. The taxable investor of course will fare even worse. Even a portfolio of blue chip corporate bonds yielding around 4% will struggle to overcome the twin headwinds of taxes and inflation. But bonds have a big thing going for them, which is momentum. For those who draw comfort from investing with a tailwind, bonds are a warm and cozy place. The Dow Jones Corporate Bond Index has returned 10% per annum for the past three years including 8.5% in the most recent one.  Who’s to say that this won’t continue? And of course it may, although such forecasts will struggle mightily to overcome the Math; for bonds to return more than their current yield, their yields need to fall causing prices to rise. Corporate bond yields could drop from 4% to 3%, although such would presumably require a similar drop in treasury yields, to 1%. The world in which 1% ten year treasuries draws buyers is unlikely to be a friendly one for corporate credit, and at such a time credit spreads might be substantially wider, depressing the prices of corporate bonds. So, much as bonds investors might draw comfort from looking backwards, their best plausible outcome is that they’ll earn the current yield and suffer a steady depreciation in the real value of their assets.

In fact, relative pricing between stocks and bonds is such that $20 invested in the S&P500 yielding 2% will, assuming 4% dividend growth (and the 50 year average is 5%) generate the same increase in after-tax wealth as $100 in ten year treasuries. This assumes the $80 not invested in stocks earns 0% by sitting in cash, although holding cash provides the option to do something with it that might well earn a return later on. The Math works for corporate bonds as well (just change the $20 in stocks to $40).

So bonds have been good, but past performance is highly unlikely to be repeated. In fact, we believe there’s a strong case to be made for all investors to reduce their asset allocation to fixed income. Government policy is to maintain ruinously low interest rates while debtors rebuild their balance sheets. The Federal government is effecting a transfer of real wealth from investors to borrowers. This policy is likely to continue for quite a long time, not least because it’s popular (with those voters who contemplate such things). There are many more debtors than creditors, and regardless of how independent you think the Federal Reserve is, monetary policy is unambiguously populist, designed for the masses. The appropriate response is to allow the government’s voracious appetite free rein. If Chairman Bernanke likes bonds that much he can have the lot.

As a result, identifying alternatives sources of investment income is a task that consumes much energy on a daily basis at SL Advisors.

The stock market offers a risk to suit every taste. For those who like to wake without first worrying whether their holdings are solvent, many reasonably priced large cap companies with low levels of debt and a history of steady earnings growth are available. Kraft (KFT), Microsoft (MSFT) and Berkshire Hathaway (BRK-A) are all examples in our Deep Value Equity Strategy, along with less well-known names such as Corrections Corp (CXW) and Republic Services Group (RSG). Domestic energy exposure adds volatility and return potential through Devon Energy (DVN) and Comstock Resources (CRK). The former bond investor can allocate his new funds to a combination of stocks and cash (depending on risk appetite), or to other income generating strategies.

There are even examples of stocks whose dividend yield exceeds that on their own bonds – not because their fortunes have suffered and a high dividend yield reflects expectations of a cut, but because price-insensitive bond investors have driven bond yields low in their flight from equities. Johnson and Johnson (JNJ) is one such example. Our Dividend Capture Strategy consists of a diversified portfolio of such names combined with a hedge to eliminate most of the daily market moves. The result is a portfolio exposed to dividend paying stocks and dividend growth that is hedged against excessive moves in stocks.

Master Limited Partnerships (MLPs) are another attractive asset class for taxable investors tolerant of K-1s. I won’t repeat here the well-worn arguments that are familiar to regular readers, except to note that the sector’s unique structure renders it worth having in many income-seeking portfolios. MLPs offer tax-deferred distribution yields of 5-6% combined with growth expectations of 4-6% (suggesting a total return potential of 9-12% with no change in earnings multiples).

Disclosure: Author is Long KFT, MSFT, BRK-B, CXW, RSG, DVN, CRK, JNJ

From my book, with apologies to Sir Winston Churchill whose speech following the Battle of Britain in 1940 inspired this line. Fees have, without doubt been part of the problem for hedge fund investors. The financial press is picking up the story and some of the articles are linked on the book’s website. Meanwhile, sales have now reached the top 0.1% of books available on Amazon both in the U.S. and the UK.

Last week the Environmental Protection Agency  (EPA) issued emission standards tightening the rules surrounding the output of mercury and other harmful pollutants. These standards will have the practical effect of making natural gas relatively more attractive than coal for electricity generation since coal-burning plants require the installation of expensive “scrubbers” to clean the emissions they generate. Converting older plants to operate more cleanly often fails to make economic sense and as a result new power plants are increasingly burning natural gas. The Wall Street Journal noted this in an article on Friday.

Of course the shale revolution in natural gas has produced a glut of the stuff, and at $3.13 per MCF it’s barely possible to drill for it profitably. That the price has fallen so low at the onset of Winter when demand typically picks up is testament to the success of the drillers. But it does emphasize the importance of being invested in companies with low costs of production since there’s little near term prospect of higher prices.

But the longer term outlook is increasingly positive. U.S. based natural gas is now cheaper than anywhere in the world outside the Middle East, and that is drawing interest from other industries that rely on cheap sources of energy. States that sit atop the Marcellus Shale (such as Pennsylvania and West Virginia) are competing with one another to attract ethylene production facilities. And a Brazilian textile company recently chose Texas over Mexico to build a new denim factory because of a 30% cost advantage in electricity. Over time cheap natural gas will lead to cheap electricity, drawing in additional industries and creating manufacturing jobs. And this increased demand will no doubt help support prices.

It’s not a sector to own for a trade, but companies with low operating costs and minimal debt are best positioned to benefit from what’s happening. We recently added Southwestern Energy (SWN) to our Deep Value Equity strategy since it meets these criteria. We continue to own Devon Energy (DVN) whose liquids business provides a usefully profitable offset to today’s soft natural gas prices. The natural gas story continues to have many chapters.

Author is Long SWN, DVN

I’ll be discussing my book.

It’s taken many observers including me longer than it might to comprehend, but ECB chairman Mario Draghi has done something that should be very bullish for U.S. stocks. Floyd Norris noted some of the ramifications in today’s New York Times. The Long Term Repurchase Operation (LTRO) in effect is an extension of credit from the ECB to EU sovereigns.

How can this be, when Mr. Draghi said all along he would not lend directly to governments? Because of the symbiotic relationship that exists between EU governments and their banks. The banks own most of the debt. If the banks can’t afford to roll over maturing bonds governments will default. If governments default banks will go with them. Both are locked together, and we believed that the ECB was holding off from proving needed sustenance while the politicians showed some evidence of imposing fiscal austerity. They (sort of) did at the last summit, and now the ECB has taken a path from which it will be difficult to turn.

Eurozone banks took down 489 billion Euros of three year loans at 1% this week. Whether they choose to buy sovereign debt or not is really not the point. They can, and now whenever the banks appear sufficiently shaky that they won’t be able to finance what their sovereigns need, the ECB can be relied upon to provide it. There will no doubt be more brinkmanship and dire warnings about delaying needed economic reforms in the south, but the problem has always been the absence of a credible punishment to wavering countries. The Maastricht Treaty incorporated enormous fees (1% of a country’s GDP) that were soon shown to be implausible when Germany and France were among the first to breach the 3% deficit/GDP criteria. Forcing a country to default is clearly unacceptable. The Eurozone’s countries are all roped together, and the ECB recognizes that pushing one off the cliff endangers them all. The ECB is the lender of last resort to banks. It has become the lender of last resort to EU governments as well, and Germany as a guarantor of the ECB’s balance sheet is now part of this solution.

This is not necessarily bullish for the Euro, although the tail risk of a disorderly collapse has been removed. But it is assuredly bullish for U.S. equities. By far the single biggest question mark hanging over stocks has been Europe, and now the roped-together have stepped away from the cliff. Equities are attractively priced compared with bonds and have been for some time. This may just be the development that nudges investors off the fence.

Dislocure: Author is long diversified equities equivalent to SPY, and is long EUO