A Gift From The Oldies

By Chris at www.CapitalistExploits.at

I bumped into a friendly bloke at my local gym last week. Jim is his name.

Jim tells me he just started because, and I quote, "my doctor says I"m going to die unless I do something".

Now, I assure you it doesn"t take a doctor to figure this out.

One glance in Jim"s direction and you can tell that underneath all that weight there"s a big struggling heart in there... just ready to explode. He was surprisingly frank and tells me it"s so bad that he can only do little bits of exercise because if he pushes it too hard, there is a very serious risk that his ticker just says, "You know what... f*ck it," and gives up.

Jim"s 52, which is really a ripe old age and about normal life expectancy — if we lived in the 1700"s. But we don"t.

I feel for Jim, told him so, and naturally we all hope that he can bring himself back from the brink. But the fact is many people aren"t like Jim. As mentioned in a previous article on pensions, they"re living longer and stronger.

Years ago it seemed that when you hit 65 you’d retire, receive a gold watch, and proceed to spend your pension money on a rocking chair and pot plants. Ten years later you’d be in a box and, since pot plants are cheap, the cost of keeping you alive wasn’t prohibitive.

 

Not anymore. Today things are different. My wife belongs to a running club and there are a bunch of octogenarians there who put us both to shame. Nope, today you retire and spend your pension on kickboxing classes and second wives, with no plan of dying anytime soon.

Now, this second group (our kickboxing oldies) pose a grave problem.

You see, unlike Jim, these folks, who’ve spent their life exercising, go on and on and on.

70 is spring chicken young for them, and many make it well into their 80"s and 90"s when inevitably they need nappies, nursing care, accommodation, and mushy food to eat. And then finally machines on wheels need to be wheeled in and they end up with tubes in their noses. Don"t laugh. We"re all going to get there, unless we"re fortunate enough to just drop dead quick and fast. The point is this all costs a boatload of money.

Now, I"m aware that this topic isn"t rosy Friday red or shampoo advert fresh and clean, but there are some serious implications that I think you"ll thank me for so hear me out.

Demographics and Pensions

Demographics is an elephant in the room we shouldn"t ignore. It"s stomped around, defecated in the corner, and is now proceeding to knock over all the furniture. Ignore it at your peril. Rather, there are a number of ways to invest.

Let"s explore a few...

Old people (Mabel and Bob) pay for their retirements with pensions, and those pensions are held in pooled accounts at the DTC and managed by folks with pointy shoes and Tom Ford suits.

And because old Mabel and Bob are closer to the box than younger folks, the pointy shoed gents are extremely risk averse (as they should be), and this is where it gets exciting because you know what?

They"re presently engaged in the worst possible leveraged speculation you can think of.

Nope, it"s not Bitcoin.

First, to understand the insanity we have to take a step back and examine how these pointy shoed gents think.

They like fixed income because it"s far less volatile and ostensibly less risky than equities.

They hate small caps and frankly can"t invest in them due to their size, and they have a disdain for commodity markets. That volatility thing again...

In fact, volatility is like a barometer in their world by which everything else is measured.

The problem is with central banks shatbit crazy interest rate policies none of them have been able to make any money in a yield starved world and so they"re, wait for it, selling volatility.

Either through tailor made products from the investment banks or by buying any number of the low volatility ETPs out there.

Volatility isn"t even an asset.

In fact, the VIX is an index of volatility on 1 month to expiry ATM puts and calls on stocks in the S&P 500.

But now the geniuses on Wall Street have figured that they can actually package this animal, which as you can see, is a derivative of a derivative, and treat it like a bond. Fun, heh?

In all fairness, hats off to the asset managers who"ve had the balls to do this. They believed in the central banks" liquidity machine, and they backed their belief and for that they deserve to be paid. I sure wouldn"t have been able to do it.

Now, I"m not some miserable jealous git here to tell you that armageddon is coming and I"ve the answers.

God knows there"s enough of that nonsense in the financial publishing blogosphere for you to get your fill elsewhere. What we do know, however, is that this entire game: the selling of vol, the passive indexing — all of it is predicated on one thing. The central banks keeping rates low and pumping liquidity into the market. It"s why BTFD has become a meme.

The problem that I have with it, other than the distortions made, is that when so many are on one side of the boat like right now and that boat has many moving pieces, then I begin to wonder.

I"m reminded that markets change at the margin, where the slightest hiccup can act like a spark to light the fire of volatility, and these poor suckers who"ve managed to earn steady incomes selling puts find out what "unlimited risk" actually looks like as they"re forced to cover in a market that"s gapping the other way.

I"ve thought about this a lot and, in fact, we recently published how we are going "long vol" for members. And no, it"s not buying puts on VIX because that is, in my humble opinion... how do I say this politely, like begging to be stabbed in the eyes. repeatedly.

In any event that"s just one angle to this market. Here"s another.

Redemptions

I would be remiss in mentioning that as retirees retire, these pension funds will be drawn down.

It"s what Mabel and Bob do to pay for their mushy food, viagra, and bingo nights.

Now, I"m sure you"re all sharp enough to figure out what can happen to the assets these guys have been buying when they have to go from flat out full throttle, to stall, to reverse.

How big is this problem?

Well, for some context global institutional pension fund assets in 22 major markets stood at US$36.4 trillion at year end 2016, amounting to 62% of global GDP.

That is a staggeringly large amount of money.

Pension funds are big cumbersome dumb money. And they"re all allocated in equally dumb indexes, passive strategies, and bonds. So what happens when pensioners draw down on their funds?

You tell me...

Talking of staggeringly large amounts of money, the passive bubble grows bigger as I write this because this beast is fuelled not just by our pointy shoed friends but by Joe Sixpack himself.

Bloomberg just ran a piece:

BlackRock and Vanguard Are Less Than a Decade Away From Managing $20 Trillion

Two towers of power are dominating the future of investing.

Dominating indeed. Here"s how come the pointy shoed crowd can afford Tom Ford suits.

The article goes on to say:

Investors from individuals to large institutions such as pension and hedge funds have flocked to this duo, won over in part by their low-cost funds and breadth of offerings. The proliferation of exchange-traded funds is also supercharging these firms and will likely continue to do so.

Sometimes when everyone is zigging and you zag, you just get run over. But think about it...

We don"t need to go the other way. All we need to do is look where others are no longer.

These behemoths don"t do battle in the little unloved sectors or with stocks that don"t make it into an index. They can"t because they"re too big.

This means that there are a lot of orphans out there and here"s the good news. If it"s not in an index, passives aren"t buying it. And if passives aren"t buying it, it"s only active money that"s even looking at it.

Which brings me to the double helping of good news.

Here"s your competition in active with the accompanying passive.

Right now, it"s a mosh pit food fight to grab and create the next index or ETF so that more capital can be attracted, earning more fees, buying more suits.

This is all well and good.

Markets do what markets do, and I"m not here to grumble about it. I"m here to make money. And indeed if I was in the passive business, I"d be enjoying the steady stream of fees and hoping like hell the market keeps going up.

QE more? Yes, please.

But I"m not.

I"m a humble squirrel searching for nuts in the forest. And gosh, with all this moshing going on it"s wonderful how few other squirrels there are about. The same Bloomberg article makes a good point on this.

While bigger may be better for the fund giants, passive funds may be blurring the inherent value of securities, implied in a company’s earnings or cash flow.

Nah. You think?

Stocks in the index funds no longer trade on fundamentals but rather on asset flows, which sucks the oxygen out of the small guys who don"t make it into the indexes where brain dead passive money is playing.

It means we can gladly play in a sandpit with all the toys and there are very few we have to share them with.

The Cracks Have Already Appeared

Nothing lasts forever, and as I argued when discussing the impact of the incoming strong men on the global economy, there are 3 critical points worth thinking about:

1. Political cohesion and stability can no longer be relied upon as politics becomes inward looking with everything from trade deals to central bank swap lines being renegotiated or cancelled altogether.


2. Global coordinated central bank action. The era of global coordinated monetary policy which we’ve been experiencing since the GFC, especially with the three largest players (ECB, FED and BOJ), will be looked back upon with nostalgia by the current clutch of central bankers who muddy the halls of power. Policy will increasingly be driven with greater sensitivity to nationalist rather than international concerns, which brings me to…


3. Liquidity in the financial system which has stemmed from easing monetary policy is already contracting. In a world where derivatives traverse borders, connecting financial systems like never before, a liquidity crisis presents enormous tail risk in a leveraged world.

Invest accordingly, and thank you for reading.

- Chris

“If you can’t take a small loss, sooner or later you will take the mother of all losses.” — Ed Seykota

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Liked this article? Then you"ll probably like my other missives on

this topic as well. Go here to access them (free, of course).

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"This Is A Paralyzed Market": Hedge Fund Turnover Drops To All Time Low

Back in July, Canaccord analyst Brian Reynolds put out a contrarian piece which broke with numerous conventional wisdom norms about the state of the market, key among which was that traders are not complacent, but rather - in light of collapsing trading volumes, something which has plagued bank income statements in the past 2 quarters - simply paralyzed, as they no longer have a grasp of financial "logic" when it is all superceded by central bank liquidity injections, and as such most trades feel fake, forced and just part of the FOMO charade to avoid losing one"s job.

As Reynolds explained, "Investors are not complacent. Their stances range from extremely aggressive to bearish" and added that these "opposing forces have led to a compression of volatility. When stocks have rallied strongly, they have then been met with investor selling. When stocks sell off, the buybacks have picked up after the selling runs its course. That has been the case for more than eight years. Those forces have led to an equity bull market that moves higher in fits and starts, with some brief pullbacks from time to time. Given the positioning of equity investors and continued flows into credit, we do not see that pattern changing for some time." Meanwhile, sandwiched inbetween these two trends, investors - both retail and institutional - find themselves in trade limbo, and the outcome is a gradual decline in trading volumes "which is more reflective of paralysis than complacency among equity investors."

And while one can posit theories explaining this bizarre market until one is blue in the face, the most vivid confirmation of Reyonld"s "paralysis" thesis emerged in the latest batch of hedge fund 13Fs, which was analyzed by Goldman earlier this week, and noted here in "These Are The Top 50 Hedge Fund Long And Short Positions."

In the report, Goldman highlighted various notable outliers, such as the latest record high in hedge fund leverage...

... coupled with the recent plunge in short interest (which as a share of S&P 500 market cap sits just below 2.0%, matching January of this year as the lowest level since 2012)...

... even as hedge fund "crowding" in a handful of top names hits an all time high:

But the most interesting to us, and the hedge fund community, we believe is the following chart, which shows that hedge fund portfolio turnover continued its downward trend and reached a new record low in the third quarter Across all portfolio positions, turnover registered 26% in 3Q. Turnover of the largest quartile of positions, which make up the vast majority of fund portfolios, fell to just 13%.

This means that once hedge funds have established positions, they no longer trade in and out, but simply lean back and let it ride. And why not: with the most popular hedge fund positions this year being also the best performing ones, namely Facebook, Amazon, Alibaba, Alphabet and Microsoft, why ever both selling.  Indeed, as the next chart shows, the bulk of the collapsing turnover is largely due to tech stocks:

Of course, this strategy of loading up on winner and letting them ride is a two-edged sword. while it is the best strategy on the way up, it also becomes a quasi private equity strategy, in which the price formation is created on the margin with increasingly less volume. And, since such tech holdings are becoming ever more illiquid, the threat is what happens once the narrative shifts and instead of buying, hedge funds start to sell these most concentrated of growth names. One could say that a tech selloff is emerging as one of the more concerning black - or at least gray - swans in the market. In fact, we are did say just that...

Facebook, Amazon, Alibaba, Google, Microsoft are the 5 most widely held HF stocks. Tech selloff = black swan pic.twitter.com/XXJ6PRbwUP

— zerohedge (@zerohedge) November 22, 2017

Signs Of The Top? Chinese Demand For 10x Levered Structured Products Surges In US... Again

In the run up to the "great recession" of 2008/2009, it was unsuspecting European and Asian buyers that supplied the marginal capital required to turn America"s plain vanilla, fed-induced housing bubble into a turbo-charged, global financial time bomb by indiscriminately scooping up highly-levered structured mortgage products with absolutely no idea what was behind those products.

Now, it seems that China"s lust for levered returns in U.S. structured products has returned and is focused this time around on the CLO market.  Per Bloomberg: 

Now, a new set of buyers from China are hoping things turn out differently. Instead of snapping up packages of risky derivatives tied to U.S. home loans, they’re buying collateralized loan obligations that bundle together corporate loans to highly leveraged companies. And while such CLOs weathered the last crisis relatively well, there’s already concern that these investors are being tempted to deploy leverage to amplify their returns.

 

On a recent trip to China, potential new investors expressed interest in the idea of applying leverage for the purchase of CLOs, even at the riskier BB level, Chan said. He estimates levered returns for the BB-rated CLO slice may be almost 20 percent. Leverage is employed using the repo financing market, where short-term loans allow investors to borrow money by lending securities.

 

"Over the last 18 months, Chinese investors have shown a marked increase in interest, awareness, and desire to be educated about CLOs, and they’re a pretty sophisticated audience,” said John Popp, global head and chief investment officer of the Credit Investments Group at Credit Suisse Asset Management. The company has $46 billion in assets under management, including CLOs that have a market value of $18.3 billion.

 

“They’ve really learned the product quickly and engage in extensive due diligence,” Popp said. “I expect to see them as steady and growing participants in the CLO market, not as tourists.”

Even though Chinese investors have yet to enter the CLO market en masse, Mitsubishi UFJ believes they could effectively double the demand for CLO new issues in a matter of just 5 years.

In some cases, investment banks and CLO managers have made as many as five trips to Asia this year, adding on special CLO-focused investor conferences in mainland China for the first time ever to raise the product’s profile. The demand to diversify into dollar assets has grown from a wide range of investors, despite Chinese-government capital controls limiting deployment of capital abroad.

 

While Japanese, Korean, Singaporean and Taiwanese investors have been buyers of U.S. CLOs for many years -- even pre-crisis deals, in the case of Japan and Korea -- mainland China is still a relatively nascent, untapped market.

 

“Mainland China is the last market for us to focus on, and we’ve been there four times already this year,” CIFC’s Wriedt said.

 

In contrast to other Asian investors, the Chinese are more willing to invest deeper down the capital structure, or even in the riskiest equity piece.

 

The Chinese investor base for CLOs may be equal to the U.S. in five years’ time if capital controls are relaxed, MUFG’s Khan said. More than $106 billion of new U.S. CLOs have priced so far this year, and the vast majority of investors are still U.S.-based. Potential Chinese investors include quasi-sovereign or insurance companies, so "even a small percentage of what they will do will lead to a large capital infusion," Khan said.

Of course, not everyone is convinced that investing in 10x levered structured products is such a great idea with yields on highly-levered bank debt hovering around all-time lows...

“It wouldn’t be wise for the Chinese to use leverage at this stage,”
said Asif Khan, head of CLO origination and distribution at MUFG. “It’s

dangerous territory. Leveraging BB-rated bonds - is that a good idea?

Any potential use of leverage by Chinese investors could pose potential

risk in case of severe volatility.”

...but what"s the worst that can happen?  It"s not as if Lehman Brothers can liquidate again...

These Are The Top 50 Hedge Fund Long And Short Positions

In its latest quarterly hedge fund trend monitor - a survey of 804 hedge funds with $2.1 trillion of gross equity positions ($1.4 trillion long and $704 billion short) - which analyzes hedge fund holdings as of Sept 30, Goldman makes some interesting observations about the current state of the hedge fund industry. First and foremost, it finds that the average equity long/short hedge fund has posted a 10% YTD return, which while the strongest since 2013 is once again underperforming the S&P for the 7th consecutive year.

In terms of holdings, it"s a continuation of what we discussed the last two quarters - everyone and their kitchen sink is plowing into high beta, "growty" and "momentum" tech names, and since most funds still underperform the S&P, the average net leverage is at all time high. Here"s Goldman:

Fund performance has been lifted by sector (Information Technology) and factor (growth, momentum, large-cap) exposures. Our Hedge Fund VIP list of the most popular long positions,  whose top five stocks are FB, AMZN, BABA, GOOGL, and MSFT, has outperformed the S&P 500 by 770 bp YTD (25% vs. 17%).

Also notable, while at least on paper hedge funds are expected to diversify, in reality the average HF carries 68% of its long portfolio in its top 10 positions, just below the record high reached in early 2016. Meanwhile, confirming that the market is afflicted by a creeping paralysis, portfolio position turnover fell to a new record low last quarter, at just 13% for the largest fund positions. Oh yes, and nobody is short: hedge fund short interest as a percent of S&P 500 market cap remained close to 2%, near the lowest level in five years.

Below are Goldman"s 5 key observations from this edition of the HF Trend monitor:

1. PERFORMANCE: The average equity long/short hedge fund has returned +10% YTD on the strength of the most popular long positions, high exposure to Information Technology, and atypical factor tilts toward large-caps and away from value stocks. This ranks as the strongest return since 2013 and compares with 17% for the S&P 500, 16% for the average large-cap core mutual fund, and 2% for macro hedge funds.


2. SECTORS: Information Technology remains the largest net sector exposure, accounting for 27% of fund portfolios. However, the 307 bp overweight tilt relative to the Russell 3000 is 100 bp smaller than at the start of 3Q. Materials represents the largest sector overweight. Financials is the largest underweight and a major source of disagreement with large-cap mutual funds, which are overweight the sector. Current overweights in Energy and Consumer Discretionary are nearly the smallest tilts in recent history, as is the underweight in Utilities.


3. LEVERAGE: Hedge funds increased net leverage in 3Q 2017 as the most popular positions continued to outperform a rising equity market. Short interest as a percent of S&P 500 market cap remained close to 2%, near the lowest level in five years.


4. VERY IMPORTANT POSITIONS: Our Hedge Fund VIP list (ticker: GSTHHVIP) of the most popular long positions has outperformed the S&P 500 by 770 bp YTD. The VIP list contains the 50 stocks that appear most often among the top 10 holdings of fundamentally-driven hedge fund portfolios. The basket’s absolute and risk-adjusted YTD returns rank as the strongest since 2013. The list’s top 5 stocks are FB, AMZN, BABA, GOOGL, and MSFT. The basket has outperformed the S&P 500 in 65% of quarters since 2001, generating an average quarterly excess return of 62 bp. 10 new constituents entered the basket this quarter, compared with a quarterly average of 16 stocks since 2001: EQIX, GDDY, IAC, IQV, MGM, MPC, NRG, SBAC, TTWO, and XPO.


5. CROWDING AND TURNOVER: Hedge funds continue to demonstrate high conviction in their favorite positions. The typical hedge fund has 68% of its long equity assets in its top 10 positions, just below the record high of 69% in 1H 2016. Similarly, our crowding index increased but remains shy of its 2016 extremes. Quarterly turnover of the largest portfolio positions fell to new historical lows, at 13%, declining in all sectors but Health Care.

The biggest component of the favorable hedge fund return in Q3 was a result of the outperformance of the Goldman Hedge Fund VIP basket, also known as the "hedge fund hotel"index, a list of 50 names which are the most widely held hedge fund stocks. Good luck selling them during a firesale, as happened in early 2016 when the GSTHHVIP basket crashed, wiping out four years of gains in a few months.

With no crash yet, and despite softness during the last month, Hedge Fund VIP names outperformed the broad market YTD both in absolute and risk-adjusted terms according to Goldman.

The basket’s strong  return has more than made up for its higher volatility (8 vs. 6 for S&P 500), combining for a YTD ratio of return/volatility of 3.0, above the ratio of 2.8 for the S&P 500 and the best since 3.2 in 2013.

What is more concerning is that as discussed the past two quarters, the trend of growing hedge fund leverage (to make up for loss of alpha), continues, and according to Goldman, funds added net leverage entering 4Q. Data calculated by Goldman Sachs Prime Services on exposures in their business show that net leverage has risen in recent months and is near cycle highs.

Meanwhile, everyone has given up on shorting: in fact, short interest as a share of S&P 500 market cap sits just below 2.0%, matching January of this year as the lowest level since 2012. Relative to trading volumes, the short interest ratio (days to cover) ranks higher compared with history but still far below the cycle high in 2015.

Predictably, with market leadership increasingly more concentrated, and with fewer leaders, the density of hedge fund portfolios is near all time highs.

Hedge fund crowding in the most popular positions rose slightly in 3Q 2017 but remains below the extremes reached in 2016. The average hedge fund holds 68% of its long portfolio in its top 10 positions, just below the record “density” of 69% in 1H 2016. The increase in hedge fund portfolio density mirrors the growing share of S&P 500 market cap accounted for by the 10 largest index constituents, which has risen steadily for two years but even now sits near the average level since 1990.

As a tangent, those who were long tech, remained long tech as the average infotech portfolio turnover dropped to the lowest on record.

So putting it all together, here are the 50 positions which make up the latest GS VIP list, i.e., the 50 most popular hedge fund longs...

... and the list of 50 stocks representing the most important short positions.

Finally, here are the 20 stocks with the highest positive and negative changes in popularity.

As a reminder: traditionally, being long the most shorted hedge fund names and shorting the most favored ones has been a source of double digit alpha ever since 2011, and while this year that may have been different, for now, there is no reason to assume this normalcy will persist especially once the revulsion with tech names reappears once more.

Tech Stocks Accounted For 75% Of The Market"s October Return

For some context on the unprecedented dominance of the tech sector on the overall market, here is some perspective from BofA"s Savita Subramanian on October returns, when Tech continued to lead the other ten sectors, generating +7.8% on a total return basis. This translates into a whopping 75% of the S&P 500"s return last month!

Furthermore, with virtually every lagging hedge fund rushing to buy the tech sector, chasing such activist central banks as the SNB, the sector"s 24.5% weight in the S&P 500 is now the highest since October 2000.

That said, considering tech companies reported some of the strongest 3Q earnings results, the best revision trends, and rank at the top of BofA"s quant model, is there anything to be concerned about?

According to BofA, the biggest risk is the extreme crowding and positioning by fund managers. As Subramanian expains: "we hear frequently from clients, "you don"t want to sell Tech until year end." And funds certainly reflect this sentiment: Tech is the most overweighted sector by large cap active managers, displacing Discretionary whose relative weight dropped for the sixth consecutive month." As noted above, the recent Tech rally means the sector now represents 24% of the S&P 500 index - a post-tech bubble high - and a remarkable 30% of all active fund holdings today, the highest levels in BofA data history since 2008 (Chart 1).

What about other sectors: in addition to Tech, Utilities (+3.9%), Materials (+3.9%), and Financials (+2.9%) outperformed last month. Laggards were generally defensive: Telecom (-7.6%), Staples (-1.4%) and Health Care (-0.8%) underperformed the most, while Energy (-0.7%) was also in the red despite the rally in oil prices.

YTD, Tech maintains its dramatic lead (+37.2%), contributing just under half of the S&P 500"s 16.9% total return, followed by Materials (+20.3%) and Health Care (+19.4%). Telecom (-11.9%) and Energy (-7.2%) remain in the red.

To be sure, the impact of tech on underlying financial metrics is also staggering, as the following charts from Credit Suisse show: with tech, EBITDA margins are near all time high. Ex tech, they are roughly 3% lower and in secular decline, courtesy of high barriers to entry.

The next chart shows that while tech holds the highest share of S&P market cap, it is also the fastest growing sector.

And while the massive crowding in the tech sector is a red flag for Bank of America, for Credit Suisse this is perfectly normal, and in a report released today, its analyst Andrew Garthwaite writes that "many clients cite data indicating that just a handful of stocks (largely tech) account for almost half of returns. However, we don"t find such analysis to be particularly informative; such dynamics are far from unusual – in fact, it is often the case that a small number of stocks account for an outsized share of market gains, as shown in the chart below."

Of course, it is also that same small number of stocks that gets hammered once the tide reverses. For now, however, with vol at all time lows, traders have yet to express any concerns that the tremendous tech rally of 2017 is in dangers of ending. Ironically, the single biggest threat to the US tech sector may be the US government itself, which is starting to realize that it is leaving just a little too many pounds of flesh on the table...

5. But it splits along two lines. This is a sticker board of attendees at #FooCamp. Most wanted to see action against tech platforms. pic.twitter.com/sfbUek5vYV

— Matt Stoller (@matthewstoller) November 6, 2017

"The World"s Largest Sovereign Wealth Fund Is Investing With No Valuation Model"

There are several quotable observations in Eric Peters" latest Weekend Notes, in which the One River Asset Management CIO looks at last week"s melt-up euphoria in markets...

Hope all goes well… Abe wins landslide, Nikkei soars to 21yr high. Xi Jinping is named in China’s constitution, cementing his place alongside Mao, equities jump. House Republicans pass $4trln budget resolution, lifting hopes for a $1.5tlrn tax cut/reform. Despite devastating hurricanes, US Q3 GDP expands 3%, S&P 500 hits record high. VIX 9.80. Biggest Nasdaq 100 daily gain in 2yrs. Bezos becomes world’s richest man, +$10bln on Friday to a $93bln net worth. Such a stunning rise, a synchronized global triumph, unrecognizable from the 2008 cataclysm that produced so many waves.

.... muses on Albert Einstein"s philosophy of happiness, observes the dilemma facing Elon Musk when it comes to auto sales in China, but most notable is his take on modern capital allocation and investing by the $14 trillion pool of 401(k)s and IRAs, which he calls "the world"s largest sovereign wealth fund", and which finds itself forced to invest in such assets as Tajikistan and Iraqi bonds because the traditional framework preached by the MPT is no longer applicable, and as a result "the largest SWF on earth is investing with no valuation model but for the rear-view mirror."

Here is the full excerpt:

Fallujah

 

“It’s a monolith,” he said. “It essentially operates as a single investor, like a sovereign wealth fund,” he continued.

 

“In fact, the US 401k and IRA savings is collectively the world’s largest SWF.” From the 1978 creation of the 401k, that pool has grown to $14trln. The early adopters were baby boomers, and their holdings dwarf all others; a combination of decades of contributions and capital gains.

 

“The firms that help Americans invest their retirement savings use the same models. They all utilize the same inputs, and produce the same outputs.”

 

“Walk into Schwab, or any competitor, and ask for your target asset allocation,” he said. “You’ll discover that the dominant input is your age. It’s a robo-advisor style of investing.”

 

The older you become the more bonds you should own relative to stocks. “They boast thousands of portfolio simulations, stress tests.” They explain how the methodology is scientifically proven and based on Modern Portfolio Theory.

 

“But MPT requires that you build a robust framework for estimating future asset class returns and correlations. And they have no such framework.”

 

“Without a robust framework for estimating future returns, these 401 advisors turn to the past to estimate future returns,” he explained.

 

“Do you want to know why money is flowing into emerging market bond funds?” And I nodded. “Because the machine tells retirees that they return 13% a year.”

 

Grandpa tucked a little Tajikistan into his portfolio last month (10yr bonds auctioned at 7.12%).

 

Grandma loaded up on Fallujah (Iraq auction yielded 6.75%).

 

“The largest SWF on earth is investing with no valuation model but for the rear-view mirror.”

Norway"s $1 Trillion Wealth Fund Gains 3.2% In Q3 As 70% Equity Allocation Pays Off

Last December we joked that the Norwegian sovereign wealth fund had responded to sinking returns and withdrawals required to fund budget deficits by allocating another $130 billion in assets to what appeared to be an already massively overpriced equity bubble in return for an extra 40bps of "expected average annual real returns" (see: Norway Buying $130 Billion In Global Equities As Sovereign Wealth Fund Continues To Bleed Cash).  The extra equity purchases pushed the fund"s total equity allocation to a staggering 70% of their $860 billion in assets under management.

Alas, with global equity bubbles becoming ever more bubblier with each passing day, the bet on equities has paid off "bigly" for Norway so far this year and grew their $1 trillion in AUM by another 3.2%, or a mere $32 billion, in Q3 2017 alone. 

As Bloomberg notes this morning, the staggering size of Norway"s wealth fund and their seemingly reckless allocation to equities, implies they now own roughly 1% of global stocks.

Norway’s sovereign wealth fund, which owns more than 1 percent of global stocks, is treating its $300 billion bond portfolio as a hedge for what it now essentially views as a stock fund.

 

“60 to 70 percent in equities -- imagine it was 60 to 80 or 90 percent -- the whole thing is that this fund is actually to a large extent now a public equity fund,” CEO Yngve Slyngstad told reporters in Oslo. “We don’t think about this as two separate asset classes that have their distinct dynamics, the real risk of the fund is in the equity market.”

 

The $1 trillion Government Pension Fund Global, which started out as a pure bond portfolio before adding stocks, returned 3.2 percent in the third quarter, or 192 billion kroner ($24 billion), the Oslo-based investor said on Friday. Equities drove returns gaining 4.3 percent, while bonds rose 0.8 percent and real estate investments grew 2.7 percent.

So what does Norway"s wealth fund own?  Aside from the obvious answer of "literally all the things," they have roughly $360 billion in U.S. stocks, with Apple being their largest bet of course and $100 billion in emerging market equities with the remainder spread between Euro equities and U.S., Japanese and German bonds.

Emerging stocks, which make up 10.2 percent of the fund’s equity holdings, returned 6.4 percent, while U.S. stocks, its single largest market with 35.9 percent, returned 3.2 percent. Oil and gas shares were the best preforming sector in the quarter with a 8.7 percent increase as increased demand for oil, OPEC’s quota discipline and lower production of shale oil in the U.S. boosted crude prices, the fund said.

 

Owning close to 1.5 percent of all large listed companies globally, the Norwegian fund largely follows indexes, but is allowed some active management of its portfolio.

 

The fund held 65.9 percent in stocks in the quarter, 31.6 percent in bonds and 2.5 percent in real estate. Its mandate is to keep about 70 percent in stocks, 30 percent in bonds, with about 7 percent in real estate that’s now separate from the main portfolio.  The fund beat its benchmark by 0.1 percentage point.

 

The fund’s biggest equity investments in the quarter are Apple, Nestle and Royal Dutch Shell, while its largest fixed income holdings are U.S., Japanese and German government bonds.

Meanwhile, the fund"s record AUM comes despite taking withdrawals for the first time ever in 2016 and expectations that another 70 billion kroner will be withdrawn this year to help offset budget deficits.

Norway’s government last year made direct withdrawals from the fund for the first time in its history and is expected to take out about 70 billion kroner this year. Meanwhile, Norway has lowered the fund’s expected return to 3 percent from 4 percent.

 

The fund has been given permission to raise its stock holdings to 70 percent from 60 percent, with an equivalent cut in bonds. That could help it eke out higher returns, or at least maintain the 8 percent annualized real return it’s had over the past five years.

 

But Slyngstad also recently said he sees fundamental issues with the global economic system and trade, which is being buffeted by increasing global political risk. And that’s not good for a fund that owns 1.3 percent of global stocks.

So, it appears that Norway"s reckless equity bet has paid off for now...but, what is the saying about "he who laughs last?"

How A Quant Hedge Fund Surpassed Renaissance And DE Shaw To Become A $50 Billion Behemoth

In a time when traditional long/short, macro and other fundamental-analysis based hedge funds are losing the war to ETFs and passive investing...

... one group of funds is thriving, and none more so than quant powerhouse Two Sigma which according to the FT, has quietly grown assets under management mark over $50 billion "putting it on a par with Renaissance Technologies as the biggest global quantitative hedge fund, as investors continue to pile into computer-powered investment strategies."

Putting Two Sigma"s staggering growth rate in context, the New York-based hedge fund, which was launched in 2001 by computer scientist David Siegel and mathematician John Overdeck, had $6bn in 2011 but soared past the $50bn mark earlier this month, according to FT sources:

"That puts it roughly level with Renaissance Technologies, which manages just over $50bn, and more than DE Shaw’s $45bn. Both are older than Two Sigma."

The reason for the unprecedented growth rate is that while the rest of the hedge fund industry has struggled with poor performance and outflows, investor demand for lower-cost, quant and algorithmic investing has exploded in recent years.  Morgan Stanley recently estimated that various quant strategies, ranging from cheap next-generation exchange traded funds to pricey sophisticated hedge fund vehicles, have grown at 15 per cent annually over the past six years, and now control about $1.5tn.

As MS reported in early October:

"$1.5 trillion of AuM currently managed under quantitative guidelines could continue its double-digit growth over the next five years. Part of this growth is a  ‘pull’ from investors broadening their search for risk premium and uncorrelated returns at lower fees than traditional alternatives. Part of this is a ‘push’, as asset managers see systematic strategies that lend themselves well to automation and scale, offering value over pure ‘beta’ in a traditional active management framework. Relatively small further reallocation by asset owners towards these strategies could still drive significant growth."

To be sure, this invasion of Math Ph.D will harldy come as a surprise to regular readers: back in 2009 we predicted that with central banks obviating fundamentals, it was only a matter of time before the mathematicians and physicists took over. Well, they have:

Quants tend to have a different background to typical hedge funds. More than half of Two Sigma’s 1,200 staff come from outside the finance industry, with most educated in mathematics and computer science. They include the winner of a Japanese backgammon tournament and the “world’s first open-source software artist”, according to a graphic novel handed to new recruits.

As programmers and data scientists have taken advantage of ever-cheaper computing power and ravenous investor appetite, a flurry of new start-ups have emerged in the quant investing field in recent years, But the biggest growth is happening at the largest, most-respected players, according to Emma Bewley, head of fund investment at Connection Capital.

“The big firms are getting bigger,” she said. “There’s a real sense that while a lot of hedge funds are building out their quantitative side, they don’t have the know-how of the established quant firms.”

There are pros and cons to this substantial reallocation to quant funds away from conventional, fundamental "active" managers: on one hand, "the rapid growth of quantitative investing has sparked a ferocious war for talent, with banks, traditional asset managers and hedge funds desperate to attract more coders." But, as the FT"s Robin Wigglesworth observes, such clustering creates a risk of all "traders" being on the same side at the same time:

The greater worry for investors and the industry is that the inflows of money into the space is ramping up risks to markets.  While strategies can vary greatly, there is concern that with more money gushing in some trades can become “crowded”, and unravel quickly if the market environment shifts.

To avert such concerns, many quant funds are careful to monitor for signs of crowding, and limit how much money a strategy or fund manages at any time.

For example, Two Sigma’s equity and macro hedge funds, which manage about $35bn, have long been closed to outside investors.

And while quants claim their strats are now less aggressive, and use less leverage and deploy more varied strategies, there is no way to know until the next downturn, a downturn which refuses to occur precisely because of quants, whose primary directive it appears is to Buy The Dip, Any Dip before the other Math PhD does, and not only ask questions later, but ideally never ask anything as more greater fools emerge to bid up risk even higher, which luckily these days also includes central banks.

How Much Is Equity Research Actually Worth? Probably Less Than You Thought

Over the past several months, investment banks all across Europe have scrambled to put a price tag on their equity research after years of giving it way as a "freebie" in return for trading commissions.

Of course, for wall street"s titans of finance, you know, the same guys who will look you straight in the eyes and tell you that they know with relative certainty the precise value of the synthetic CDO squared they"re selling you, we figured this would be a relatively simplistic task. Therefore, you can imagine our surprise now that the market has established a fairly wide bid-ask spread with JP Morgan on the low end at $10,000 and Barclays on the rich side at $455,000.

Luckily, since wall street"s finest don"t seem to have a clue, Bloomberg Gladfly has decided to take a look at some comps to help shed some light on the true value of equity research.

First, of course, it"s important to define what institutional clients are actually buying when they sign a research contract.  As Bloomberg points out with the chart below, and contrary to popular belief, equity research demand actually has very little to do with analyst forecasts and trade ideas but rather is dependent upon which banks provide the greatest access to those highly coveted management 1x1s.

The dirty little secret on Wall Street -- and why it"s so difficult to price research -- is that star analysts aren"t really valued for their research at all. Ask any money manager, hedge fund or research shop, and they"ll tell you it"s all about the contacts.

 

Many senior analysts spend only 10 percent of their time conducting research and writing reports. Teams of junior associates (or sometimes robots) maintain financial models and blast out notes. Some use pre-recorded voice mails to alert clients to new research.

 

Gadfly estimates that between 50 and 70 percent of a senior analyst"s time is spent on corporate access. Things like arranging lunch with a CFO or connecting a client with a lawyer, supplier or other industry expert to delve into what the data doesn"t. For this reason, analysts are often required to log the number of phone calls, meetings and events arranged each month.

 

The final 20 percent of an analyst"s time is spent on pre-IPO research, conferences and bespoke projects, such as flying a drone over a retailer"s parking lot to track how full it is; scoping the laundry outside apartment blocks; or conducting so-called channel checks to see how much oil"s being pumped through a particular pipeline.

So, what does that mean for the "value" of equity research?  Well, Bloomberg figures those actual "research" reports that flood your inbox all day long are worth basically nothing while the corporate access component of "research" (i.e. those annual trips to Miami Beach where 24-year-old hedge fund analysts get to interview CEO"s between binge drinking sessions at Story) should be valued at roughly the same price as an expert network service.

Access to independent research network Smartkarma starts at $7,500 a year per user for a Spotify-like subscription that opens the door to reports from more than 400 analysts. Customers can also buy additional packages of analysts" time, similar to the way lawyers or consultants get paid.

 

We reckon the closest approximation to corporate access is so-called expert networks, companies that maintain a stable of industry experts to match with fund managers and other financiers when they need quick access to esoteric information.

 

Industry leader Gerson Lehrman Group Inc. charges $100,000 a year, with the heaviest users paying millions of dollars, according to the Financial Times.

 

As for bespoke research projects, Morgan Stanley said it plans to charge $2,500 an hour for private meetings with its stock analysts, almost twice the rate of some of the best corporate lawyers. Partners at big management consulting firms such as Deloitte LLP or McKinsey & Co. charge clients anywhere from $800 to $1,300 an hour, according to career consulting guide Rocketblocks.

Then again, maybe those hedge fund managers could just ask young Trevor Worthington IV to stay home from Miami Beach and read a 10-K for free...just a thought.

Institutions Are Selling To Retail Investors At An Unprecedented Pace

According to the latest EPFR fund flow data compiled by BofA"s Michael Hartnett, the great "institutional to equity" stockholding rotation is accelerating, with another $8.8bn allocated to equities, more than all of it from retail investors, and another $5.8bn going into bonds, offset by a $0.4bn outflows from gold.

Ironically, the one place where active investors are still putting back at least a token fight against the robots is in bonds, where $3.6bn went into active bond funds this week vs "only" $2.2bn into passive bond ETFs. And, as Hartnett writes, active AUM is fighting back, if only in bondland, where there have been $1.04tn in active bond inflows past 10 yrs vs. $0.93tn into passives...

.... a very different trend from what has taken place in stocks in the past decade (Chart 2) where institutions are delighted to dump to "low-cost" passive alternatives.

Of course, this particular "great rotation" is no surprise: earlier this week we were surprised to report that on its conference call, Morgan Stanley reported that the cash levels in its clients (retail) accounts, is the lowest it has ever been:

... we"ve been talking about our deposit deployment strategy for quite sometime, and we"ve been investing excess liquidity into our loan product over the last several years. In the beginning of the year, we told you that, that trend would come to an end. We did see that this year. It happened a bit sooner than we anticipated as we saw more cash go into the markets, particularly the equity markets, as those markets rose around the world. And we"ve seen cash in our clients" accounts at its lowest level.

Meanwhile we also showed that institutions continue to sell at a torrid pace, and as BofA reported, in the last week when the S&P hit new all time highs, its clients were net sellers of US equities for the fourth consecutive week. Large net sales of single stocks offset small net buys of ETFs, leading to overall net sales of $1.7bn. Net sales were led by institutional clients, who have sold US equities for the last eight weeks; hedge funds were also (small) net sellers for the sixth straight week.

The best way to visualize the institutional selling? This chart from BofA:

 

Who bought? Why retail"s favorite investment product of course, ETFs: "Private clients were net buyers, which has been the case in four of the last five weeks, but with buying almost entirely via ETFs. Clients sold stocks across all three size segments last week."

* * *

Going back to the latest fund flows report, BofA reports that for all the talk about an imminent surge in interest rates, yields are still winning: $6.3bn inflows to IG+HY+EM bonds this week; investors continue to discount low-rate environment. This happens as the 5s30s yield curve (88bps) is the flattest since GFC, a fact Mike Hartnett finds "remarkable given the Philly Fed Employment outlook hit a 50-year high today." Just as surprisng: bond funds have now seen 31 straight weeks of inflows, as investors continue to overwhelmingly pick yield over capital appreciation.

Across the globe, Japan is losing (for a change), with a record $4.4bn outflows from Japan equities (86% ETF redemptions, possibly via BoJ); which is odd considering the Nikkei hasn"t had a down day in the past 14 days: the longest stretch of gains on record! It likely won"t last however, with BofA predicting that after Sunday"s election "we expect Japan TOPIX to revert to tracking US bond yields (Chart 4)."

In the US, where the S&P just hit all time highs, there was a solid week of $7.5bn US in equity inflows.

Some more bad news for professional investors:  while there have been inflows in 17 of past 19 weeks, all of this continues to go into passive funds, with $11.1bn flowing into ETFs offset by another $2.2bn outflow from mutual funds.

As a result, Hartnett concludes that robots continue to win, especially since this week"s launch of the 1st ETF in which stocks will be selected by robots (AIEQ) comes as tech funds see biggest inflows in 38 weeks; AIEQ outperforming SPX thus far.

As for the retail equity euphoria, nowehere is it more obvious than in BofA"s high net worth client tracking where YTD flows show a decisive cyclical shift by private clients, who are buying bank loans, financials, EAFE ETFs, while shunning quality, utilities, large caps & dividends (Chart 6). And as the next chart shows, equity allocations among BofA private clients are just shy of all time highs, and well above where they were during the last market peak.

BofA"s takeaways:

• Alpha in bonds; inflows to active funds continue to outstrip passive


• AIpha in stocks: first ETF where stocks selected by robots launches amidst biggest Tech inflows in 38 weeks
   


• Tick-tock: risk-on equity & bond flows push B&B indicator up to 7.6

To which we can only add: the rush by institutions to dump their equity holdings to retail investors - courtesy of "low-cost" ETFs - has never been greater. The only question now is when does the Fed pull the trapdoor, as it always does just when the market peaks...