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Quant Fund performance down..Effects of computerized investing!

 

Why They’ve Stunk It Up
Many quant funds rely primarily on models that pick stocks based on value, momentum, and quality factors. Those that do have been hit by a double whammy lately. Value models let quants down first. Stocks that looked attractive to value models just kept getting cheaper in the depths of the October 2007-March 2009 bear market. “All kinds of value signals let you down, and they’re a key part of many quant models,” said Sandip Bhagat, Vanguard’s head of equities and a longtime quant investor. Also, many quant funds that emphasize earnings or stock-price momentum were still following trends that had lasted for several years in the middle of the decade, such as the rise of energy and other economically sensitive firms–and these stocks were quickly crushed in the latter half of 2008.

As the bear market wore on, many quant funds’ models steered them to steadier firms that held up well in the downturn. Such companies looked attractive to both quality measures, such as balance-sheet strength, and earnings momentum because they were posting stronger earnings growth (or smaller declines) than most companies. Unfortunately, quant funds typically moved into these stocks just in time for March 2009’s sharp reversal. Investors started bidding up economically sensitive stocks in anticipation of an improving economy rather than on solid company financial results. Many quant funds that include earnings momentum in their models missed the initial (and strongest) stages of last year’s rally because the models didn’t pick the cyclical stocks until the improvement showed up in the companies’ results. So far in 2010’s choppy market, quant funds’ performance has been mixed.

 What Now?
It’s difficult to say when quant funds will mount a comeback. Some argue that they face a difficult future if they don’t make big changes to the way they invest. Robert Jones, former longtime head of Goldman Sachs Asset Management’s large quant team and now a senior advisor for the team, recently asserted in the Journal of Portfolio Management that both value and momentum signals have been losing their effectiveness as more quant investors managing more assets have entered the fray. Instead, he calls for quant managers to search for more-sophisticated and proprietary measures to add value by looking at less-widely available nonelectronic data, or data from related companies such as suppliers and customers. Other quants have their doubts about the feasibility of such developments. Vanguard’s Bhagat, for example, thinks quant managers need more secondary factors to give them the upper hand, but he also wonders how many new factors exist. “There are so many smart people sorting through the same data,” he said. Ted Aronson of quant firm Aronson+Johnson+Ortiz is more blunt: “We’re not all going to go out and stumble on some new source of alpha.”

There is reason to believe quant strategies have simply been temporarily out of favor. A number of quant managers–most notably Bridgeway founder John Montgomery–have said a big reason for their underperformance since the market bottom is that stock prices have followed big macroeconomic news instead of earnings. That trend isn’t sustainable, he contends. Indeed, in recent quarters, many of Bridgeway’s funds have had more money than their benchmarks in companies that have beaten earnings estimates, yet the funds have still lagged the indexes. At times, those Bridgeway funds that have done the best job of this have posted the worst relative performance. 

Another reason for optimism: Despite all the lost revenue, quant funds have lost very few personnel. True, Bhagat left Morgan Stanley for Vanguard, and the quant team he left behind has lost some of its fund assignments. But both Bridgeway and Bogle, for example, report they haven’t lost any investment professionals since the market’s peak. In fact, Bridgeway has hired a couple of academics and engineers to assist with further research.

Bridgeway also is nearly finished reengineering its 17 quant models, which may result in the scrapping of one or two models and adding others. Goldman Sach’s quant group says it, too, might tweak its strategy. The changes may not be cause for alarm. Most quant managers adjust their models over time as their research uncovers new ideas. To be sure, there is a risk that managers focus too closely on the recent past. Both Bhagat and Montgomery warned against fighting the last war by designing and relying too heavily on models that would have worked very well in the recent bear market.

It is premature to write off quant funds altogether, based on the evidence we’ve seen. But now more than ever, as their risks have been exposed, it pays to be selective. Investors should keep in mind that macroeconomic shocks may continue to overwhelm stock-specific data from time to time.

In Part 2, we’ll discuss the merits of certain quant funds.

Source:- Morning Star

What banks do with our money?

There have been lots of seminars, discussions and numerous articles on the recent “liquidity” crisis in our banking system. Rising imports, stagnating exports, capital flight and unspent capital expenditures, among others, have been identified as the primary reasons for the current crisis. Some have also identified the currency note shortage last Dashain when depositors could not withdraw adequate amounts of cash from their respective banks as being another critical reason for the current liquidity problems because many depositors could have lost faith in the commercial banks’ ability to meet their demand for deposits.

In this article, I will try to shed some light on the role of banks as financial intermediaries where they take short-term deposits and provide long-term loans, and the potential liquidity crisis that banks could face from this inherent mismatch between their assets and liabilities. A commercial bank is primarily involved in mobilising deposits and providing loans, i.e., they channel deposits from individuals into loans for borrowers. In the process, they earn a profit from the spread between the average cost of their deposit aka “cost of funds” and the average lending yield. The higher the spread between the lending yield and the cost of funds, the higher will be the bank’s profit. Banks can mobilise deposits either through low-cost current and savings accounts (CASA) or through high cost fixed deposit (FD) accounts. So it’s in a bank’s interest to mobilise as much deposits as possible from low-cost CASA to widen their interest spread. However, since there is no withdrawal limit on CASA (as they are demand deposits), the average deposit on such accounts can be highly volatile. FD accounts, on the other hand, have fixed tenures, so banks can plan beforehand when and by how much there could be potential deposit withdrawals from these accounts. Because of the respective trade-offs between the cost and volatility of both CASA and FD accounts, commercial banks try to find the optimum balance between the two whereby they can minimise their cost of funds.

When a commercial bank mobilises deposits, it can invest that amount either in liquid assets such as government bonds or lend it out to borrowers who are interested in either meeting their working capital needs or investing in manufacturing businesses, real estate, hydro power and so forth. Generally, government bonds (read T- bills) have a lower yield than the average lending rate on the loan portfolio of commercial banks. So it’s in a bank’s interest to allocate as much of their assets to higher yielding loans than government bonds. However, because most of these capital intensive manufacturing plants, hydro projects and real estate ventures have long durations, banks have to wait for a substantial period before they get their principal back. T-bills, on the other hand, have a lower maturity period, and they can even be used as collateral to borrow funds from the central bank. Hence, like in the case of deposits, banks try to find the optimum balance between high yielding but longer duration loans with low yielding but liquid government bonds.

Now, as mentioned above, it’s in a bank’s interest to mobilise as much deposits from low-cost CASA as possible. As a demand deposit, funds in CASA have immediate maturity; however, banks believe that depositors’ unpredictable needs for cash are unlikely to occur at the same time. With this belief, they are able to make loans to projects with a long duration. In the process, banks are borrowing short-term and lending long, which results in an asset-liability mismatch. Almost all banks have some sort of an asset-liability mismatch on their balance sheets. When banks do lend out demand deposits for long-term projects, a systemic risk can arise in the banking system if an individual bank cannot meet the withdrawal demand of its depositors. Trust is paramount in the banking system. Every depositor trusts banks to deliver cash when they come forward with a withdrawal slip. If the depositors feel that their savings is at risk, then a sudden surge in deposit withdrawals and the bank’s inability to meet the unexpected demand can lead to the self- fulfilling crisis of “bank run”.

One way out for banks would be to follow a “narrow bank” concept, i.e., invest all their demand deposits in short-term assets. However, this not only affects the profitability of a bank due to lower yields on short-term assets but also reduces its ability to lend out to productive sectors such as manufacturing, and that affects the overall economy. Hence, the concept of narrow banking has been discredited in most countries (however, because of the recent financial crisis, voices have emerged to move towards narrow banking).

In the context of the ongoing liquidity crisis in Nepal, the trust of depositors in the banking system has been undermined due to the currency shortage last Dashain. As a result, many depositors who had to haggle with bank officials to withdraw their own savings during the festival haven’t channelled their savings back into the banking system. According to Diamond and Dybvig’s seminal research on banking crises, one of the most potent tools to build the general public’s trust in the banking system is deposit insurance. As of now, there is no provision of deposit insurance from the government side although the last budget did mention it.

To address the problem of an asset-liability mismatch in Indian banks, which is stifling infrastructure development, the Indian government announced the concept of “take-out” financing during the last budget of 2009/10. Under the Indian government’s take-out financing scheme, India Infrastructure Finance Company Limited (IIFCL) – an Indian government owned entity – will buy out long- term loans from banks. Minimising asset-liability mismatches, this scheme enables banks to enter into long-term project financing as they can sell their loans to the IIFCL after a certain time frame. Though the recent initiative of Nepal Rastra Bank to provide refinancing is a welcome step, a similar kind of take-out financing scheme is necessary to mitigate the liquidity problems that arises from an asset-liability mismatch in banks as well as encourage banks to lend towards productive sectors.

From the bank’s side, there should also be proper and rigorous focus on asset-liability management. Most commercial banks in Nepal don’t follow the concept of duration management in their balance sheets. Much of their senior management’s focus is towards increasing the absolute volume of deposits and loans rather than properly managing asset-liability to maximise profits. When mangers focus only on increasing the deposit or loan volume, adverse interest rate movements can seriously undermine a bank’s profitability and its asset quality.

However to be fair to bankers, they also don’t have tools to properly manage the mismatch between assets and liabilities. Generally, interest rate derivatives, currency derivatives and swaps are used extensively by foreign banks to match their assets with their liabilities. With Nepal Rastra Bank’s recent decision to allow commercial banks to use derivative instruments, I am hopeful that in the days ahead, banks will be better equipped to deal with asset- liability mismatch problems.

Courtesy:- GARP

Risks faced by an investor

– Capital Risk

– possibility of loss of some of the original capital :- this is becoz, the value of investments linked to stock market can vary, and although the long term trend tends to be upwards, at any particular time the market might dip so that the investment is worth less than that was originally invested. it may however, be necessary to accept some capital risk to offset other risks.

– Shortfall Risk

– The amount invested in order to reach a financial goal at some time in the future may not reach the target amount. The problem is that if the investor is over cautious, choosing investments with no or low risk, the returns are likely to be lower or could fall short of the amount targeted.

–Interest Risk

– The risk that either the capital value of the income from an investment will change as a result of changes in market interest rates. for e.g the income from a variable rate account can fall or rise which is bad for savers and borrowers. Fixed rates will lock into a return, which is bad for savers but good for borrowers when interest rates rise and vice versa.

– Inflation Risk

-The purchasing power of the investment is reducing

Over time, rising prices reduce the buying power of an investment. This is a main problem where income is being paid out so that the real value of the capital fails. offsetting inflation risk usually means taking on some capital risk

Portfolio Construction Considerations

1. Efficient investors will tend to move their money to those areas where it will achieve the best results. higher returns can be expected if:-
– funds are committed to a particular investment for a longer period
– the risk of capital loss is higher
-larger funds are committed

2. Although there are seperate financial markets in each of the main types of investments (cash deposits, fis, equities), economic and political changes tend to have an impact on all of them, and changes in one can affect another market place. For e.g fall in interest rates could encourage a rise in both FI and equity markets, but lower returns from deposits.

Each investment has a role to play:

1. deposits are good for protection of capital, atleast in nominal terms and over shorter periods, and are a safe haven when times are bad economically.

2. fixed interest securities are good for secure levels of nominal income, with some scop of capital gains if interest rates fall. they are usually less volatile than equities.

3. equities are good for long-term real growth of capital and/or income, although the risk of loss is high than for either fixed interest securities or cash deposits

India Value fund

When cash is no problem in Indian private equity

As a poor 2009 has left limited partners more discerning about the hundreds of new Indian private-equity firms, India Value Fund has emerged as capable of attracting new investments.

“We understand that other private-equity firms in India are adding operational expertise to their team,” says Vishal Nevatia, a principal at the $1.5 billion India Value Fund (IVF) in Mumbai. “This business is now about creating efficiencies in companies. Before the financial crisis, for most companies in India, sales and business development just happened. Now there’s a focus on sales, conserving cash and being profitable.”

Most atypically of all, it successfully closed its fourth fund in April 2009, at a time when hardly any other Indian PE shop could raise capital. The fourth fund began investing in January — not only was it oversubscribed, but the team was not required to go on roadshows.

This is thanks to IVF’s ability to generate steady net annualised returns of 25-30%, including last year, regardless of market conditions. Its portfolio ranges widely, from FM radio networks to hospital chains. The common factor is that they are already-profitable mid-sized companies in business segments without established leaders.

IVF was founded in 1999 by Gary Wendt, the man who built GE Capital into a financial powerhouse in the 1970s and 1980s, along with Nevatia and other Indian partners. Wendt left soon thereafter but the other partners carried on.

More on:- http://www.asianinvestor.net/News/166910,when-cash-is-no-problem-in-indian-private-equity.aspx

Types of Funds

Low risk funds

– invests in cash, international fixed interest securities, or balance of both.

– Money Market Funds

All investors need liquidity. This is an essential part of a well-managed portfolio. MMF are liquidity funds invested in international, short-term interest earning securities, such as certificates of deposit. Available in sterling, USD, euros, japanese yen, swiss francs etc. But the interest earned maybe lower than the rate of inflation. The objective is to provide steady income flow. The funds offer better form of stability and high degree of liquidity.

Annual Management Charges : 0.75% (for Zurich Intl)

Guaranteed Accumulation Funds (GAFs)

– invest in govt and corporate debt. mainly in bonds with excellent credit ratings.
-available in GBP, dollar, euros.
-protect against risk of loss
–interim dividend is credited to your investment account on monthly basis. the interim dividend is declared for each of the GAFs at begining of each year depending on the fund’s currency. once added the divident cannot be reduced or taken away as long as the policy is maintained to maturity or a permitted withdrawal point.
– if the annual dividend > interim dividend the short fall is credited as interim dividend once received cannot be reduced.

Market Level Adjustment (MLA):-

– MLA is levied if funds moved out of GAFs before permitted withdrawal point. generally permitted withdrawal point is 10 yrs

Annual Management Charges:-0.5%

Managed funds

– invest in cash, intl fixed interest securities listed in world stock markets, whilst minimizing risk through diversification.

5 levels:-

Defensive funds:-
-lowest risk
-fixed interest securities/corporate/govt bonds
-long term capital growth
-least volatility over short-term

Cautious funds:-
-less exposure to fixed interest securities
-more into equities than defensive funds
-long term capital growth

Blue Chip funds:-
-fixed interest securities (40%)
-but high proportion of international equities/ large well known companies (60% of fund)
–risk profile:-medium is between balanced split between bonds and equities

Performance funds:-
– higher concentration on intl equities
–risk profile:- lower than blue chip funds

Adventurous funds:-
-emerging market equities and smaller companies
-benchmark asset allocation possible
– higher level of risk

e.g: Threadneedle and Black Rock funds

Automatic Investment Strategy (AIS) at Zurich

– investments switched automatically from equity based funds to liquidity and bond-based funds as you move closer to policy maturity.

– 5 investment portfolios
-available in Zurich Vista

Mirror funds

– access to range of specialist funds with more specific investment criteria than managed funds
-concentrate mainly on a single region, asset class or sector
– over 150 mirror funds available from zurich intl.

Factors Affecting investment returns

– Inflation

This is major concern and is measured by an inflation index for. e.g Retail Prices Index (uk) and CPI (usa)

The inflation rate for few countries

courtesy: CIA

– Fiscal Policy / Tax rules of different countries

– Interest Rates – maintained by respective country’s regulatory agency. (FSA(uk), RBI (India), Federal Reserve (usa)

http://en.wikipedia.org/wiki/Financial_regulation

Key facts

– Redeemable Govt Stocks provide guaranteed income and capital gain for longer period of time. These are purchased at falling interest rates to obtain quick capital gain.

– Corporate loan stocks often provide higher rate of interest than govt stocks bcoz companies are less risk category as compared to governments of countries. Convertible loan stocks allow you to convert the coporate loan stocks to ordinary shares at a fixed guaranteed price on a future date.

Risk Ranking of share holders of companies (high to low)

– Preference Share holders/cumulative preference share holders (fixed dividend)
– Corporate loan stocks share holders
– Ordinary Share holders (equal share share of company’s net asset, an increase if companies make exceptional profits)

* The concept of a basket of shares in a number of different companies is v imp. in equity investment.

– Endowment Policies are packaged investments with built in life cover. These have fixed payment of premium for number of yrs, contributions cannot be missed and the payment/sum assured goes out on maturity date. These are long term savings plan and are not protected against inflation. Due to which these don’t exisit in the modern day.

– With profit policies pay out the sum assured and bonuses on the maturity date or death of life assured. The bonuses may cover reversionary and terminal bonuses and sometimes even constitute well over 50% of the maturity payment.

– with profit endowment policies are generally better option but these do share their level of criticisms as their are inflexible and low returns if the policies are surrendered early. SV turn out to be lower than the contributions made by the client towards the policy even if the policy has been infested over half of its term.

– unit linked endowment policies are more preferable, becoz these concentrate on developing the investment/lump sum more than the life cover element for policy holder’s own use at maturity date. The amt payable is the value of the units of the invested fund. The surrendar values are nil for the initial 2 yrs. This may vary with product providers.

**Most UL policies have the advantage of an extension option so that the encashment can be deffered at maturity date until depressed stock markets recover.

– Regular preimum policies claim life assurance costs and investment costs. These are included into premium for with profit policies but for UL policies these are spelt out seperately. Regular premium with profit and ul policies are used as long term savings plans with an increasing amt of built in life cover. These can be used when clients want to <strong>repay a large debt or education cost for children. These are also covered against inflation. ul policies are more flexible than with profit policies becoz the charges are transparent and surrendar values are more closely related to policy holder’s investment. however they have lower guaranteed retunrs at maturity or death and are higher risk plans as compared to with profit policies.

with profit policies can be used for repaying house purchase loans

if the sum outweighs the loan then the bonuses can be used for private expenditure. hence the sum assured plus bonus can be made to equal to repay the loan at maturity.

Single premium endowments – Guaranteed Growth Bond/Guaranteed income bond. GGB will have FIR for 3/5 yrs and interest accumulated + capital is paid at maturity date.

GIB- guarantees income for period.

High Income bonds – high income guaranteed but the value of investor’s capital reduces.

Guaranteed equity bonds – guaranteed return of capital at end of 5yrs plus a bonus as per performance of se index.

Single premium ul endowment policies/ Investment bonds have greater flexibility. Client can choose the investment fund. life cover for these bonds are negligible it’s usually 1%. These are developed to avoid tax.

low risk funds
– Cash
– FIS

Medium Risk

– Property
-Intl blue chip companies

High Risk

– small/private companies
-single industry/single geographical area

Managed Funds

– mix of loans
-FIS
-property
-equities

How to obtain better returns on your investments?

Asset allocation is a time-tested strategy that can help you reduce risk by spreading your money among many different kinds of investments, such as stocks, bonds, and short-term investments. Diversified portfolios tend to provide less volatile returns over the long term and can help minimize downside risk.

In addition to balancing your overall portfolio, it is important to diversify within each investment asset class. In the case of fixed income, bond funds (or money market funds, for short term needs) invest in multiple individual securities that can provide asset class diversification. By diversifying within an asset class, you can mitigate your risk and are less likely to be affected by the performance of one single investment.

Long term investment and diversification

Source: Ibbotson, June, 2002
Note: Tech Heavy = 50% S&P 500/50% S&P Information Technology Sector; Equity=S&P 500; Diversified=60% S&P 500/40% Lehman Brothers Government/Credit Index; Bond=Lehman Brothers Government/Credit Index

Past performance is no guarantee of future results. Performance of an index is not illustrative of any particular investment and an investment cannot be made in an index.
Diversification does not insure a profit or guarantee against loss in declining markets.

The diversified portfolio had a smoother ride than the tech-heavy and equity portfolios. Note: Under certain unique economic conditions a portfolio of 100% bonds may outperform both a diversified and equity portfolio. However, performance of any one asset class cannot be predicted over an extended period of time.

A diversified portfolio often has its investments divided over three asset classes:
Stocks represent the most aggressive portion of your portfolio. Stocks provide the opportunity for higher growth over the long-term. But this greater potential reward carries a greater risk, particularly in the short-term, because market volatility may mean your investment is worth less when you sell it.
Bonds provide regular income and lower volatility (relative to stocks) and can act as a cushion against the unpredictable ups and downs of the stock market. Often, bonds do not move in the same direction as stocks. Investors who are more concerned about safety rather than growth often allocate more of their portfolio toward US Government or insured bond investments rather than stocks.
Short-term investments include money market funds* and short-term certificates of deposit. Money market funds provide you easy access to your money. They are considered conservative investments and offer stability of principal, but they usually have lower returns compared to bond funds or individual bonds.

* An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

Plan Your Portfolio
Deciding how to allocate your investments across the three asset classes – stocks, bonds, and short-term investments – will depend on your investment goals.

In general, the amount of time you have until you need the money you are investing will help determine your asset allocation and your risk tolerance. The graphics to the right depict several examples of asset allocation models. Each of the four target asset mixes has a different mix of investments, so each will strike a different balance between risk and return potential.

For an investor who has a longer time horizon and is willing to take on additional risk in pursuit of long-term growth, a higher weighting in stocks may be appropriate (i.e., growth portfolio). Keep in mind that even the most aggressive asset allocation model has a fixed income component to help reduce the overall volatility of the portfolio.

As you get closer to your goal, you may want to shift your investments into more conservative securities, like fixed income mutual funds or certain individual bonds such as Treasury bonds. Adding more conservative fixed income investments to a portfolio can help to modulate potential ups and downs found in equity investments.
In retirement, a good portion of your portfolio should be in stable, income-producing investments, but you should also continue to invest for appreciation to combat inflation.

Regardless of the asset allocation model that you choose, a diversified portfolio can help ensure success in meeting your future goals. A well thought-out plan is critical: your money is too important to invest without a plan.

Types of Portfolios