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Attention shifts to credit funds

Friday, March 14th 2008, 9:26AM 19 Comments

by Philip Macalister

As I mentioned in today’s Weekly Wrap the indefinite closure of ING’s credit funds is likely to galvanise attention onto this sector of the market and away from finance companies (unless we have another big one fall over). All these credit products have been having trouble for a while and what is possibly not recognised is the amount of money in these products, or the size of the hits being taken. The list of firms who played in this space is lengthy and filled with some well-respected brands. Besides ING, there is Macquarie, NZ Funds, Absolute Capital, Forsyth Barr and Basis Capital. In total, there is many hundreds of millions of dollars. Up until now the status of the listed funds such as Macquarie’s Fortress, Absolute Capital’s PINS funds and others, has been apparent. The ING announcement this week brings the unlisted offerings into the light. One comment made to me yesterday was worrying. It was from someone with a quasi-finance company type product, and he said to the public all these things look the same. That is, the public doesn’t make much of a distinction between credit funds and finance companies. That doesn’t surprise me as it had been clear for sometime than many of these credit funds were sold as alternatives to finance companies and in many cases term deposits. In the early days many stories were told that ANZ had been selling credit funds to customers who wanted term deposits. This is a worrying story that has been sitting below the surface for some time now. In reading today’s Business Herald it is clear that the story will gain prominence. Judging from the mainstream media reports, the credit fund issues maybe dealt with in the same manner as finance companies. If there is a plus to this, this is it. I imagine most of the money that went into credit funds was adviser-directed. Consequently, the client should have a well-diversified portfolio and credit funds will only have a small allocation, as opposed to the horror stories we have heard of punters having all their money spread across three or four of the worst finance companies. Let’s hope I’m right on that!
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Comments from our readers

On 17 March 2008 at 9:53 am Maurizio Piglia said:
This is just the outcome of assessing, pricing and calculating risk in the wrong way.
I still have to understand how institutions could fall on the story that packaging under a giant umbrella a bunch of wobbly mortgage loans all together will make , all of a sudden, an AAA security.

I saw this approach the first time 5 years ago, I didn't fell for it because the bright 30something investment banker backed by the bright 30something analyst of a rating agency could not come out with an explanation about that and would not come out with details on how that could happen.
But a bunch of Institutions, gatekeepers and layers and layers of Risk guardians and committees fell for that baseless story, first for the rich commissions this structures paid ( a serious tight risk run structure cannot pay out much...it will be against the final investors interest), then for track records that could NOT simply have been true.

The Bear Stearns Credit Fund that melted first and started it all, sported over 36 months (3 years and more) of monthly returns WITHOUT a single negative month. And that is a statistical impossibility, anybody with a quant background would have told you to drop such a table of returns as it was burning...because you can obtain that only writing a naked option at out of the market strikes. The truth is such a strategy blows with a 95% level of confidence within the 60 months (5 years) mark.

One of the assesment I made when I came here and had to look at competitive credit based structures, was that NO ONE of them issued by the institutions you named had underlying funds with a story longer than 3.5 years.Extremely dangerous.

Who controls the gatekeepers, risk guardians and committes parameters for assessing risk and their hidden or not so hidden conflicts of interests when deciding what should and should not reach the wide public distribution?

"QUIS CUSTODIET IPSOS CUSTODES ?"
On 17 March 2008 at 6:36 pm Kimble said:
"I still have to understand how institutions could fall on the story that packaging under a giant umbrella a bunch of wobbly mortgage loans all together will make , all of a sudden, an AAA security."

It actually makes a lot of sense. Just as a rough example: If you have a portfolio of 100 assets and each of those assets has a 5% chance of failing, then you can assume that 5% will fail and the portoflio loses 5%.

Lets say the portfolio is paying 10%pa.

Now someone says to you that they will buy the bottom 20% of the portfolio, as in, they will absorb the first 20% of losses.

But they want to be paid 11% instead of 10%.

That sounds like a good deal for you, doesnt it? You give up 1% of your return but also give up the riskiest portion of your portfolio. For you to lose any of your capital over 20% of the total portfolio would have to default.

The person buying that bottom portion is shielding the upper portion from losses. So this improves the quality of the upper portion.

Of course you dont know which assets will default before the fact, but you dont need to, because if they default they are automatically included in the bottom 20%.

A big problem arose when the estimates of the default rates turned out to be well wrong. They may not have been paying much attention to what was going into the portfolio. Previously, it may have been pretty bad loans, but then (thanks to a range of factors) it started to be really, really bad loans.

You will find that the CDO's and CMO's are sometimes refered to as different vintages. For example, the 2005 CDO may be better than the 2006 CDO, because the loans that were going into the 2005 CDO were actually much better/sound.
On 18 March 2008 at 5:26 am Barrington Smythe said:
I suspect that you are right about the diversification aspect Phil, in as much as it applies to the non-ING and NZ Fund Management funds. The listed vehicles (PINS, Fortress, Generator, HY-Fi etc) were largely sold by sharebrokers (not financial planners) as the commissions were clearly far too low for most planners. Sharebrokers will generally (I hope!) have allocated only a small percentage of client assets to these types of products.

However, the ING funds paid as much as 5% up front commission (which came out the the client's investment, of course) and 0.5% p.a. trail, so I believe there are many financial planners who have loaded clients up with these funds, including 'award winning' firms which also had large amounts of cash in Bridgecorp, C&M, MFS etc....

Indeed, some 'independent' planning firms are contractually required to give ING a large percentage of their business, either because ING has a stake in the business or because ING is the buyer of last resort. I suspect an awful lot of the money that went into DYF and RIF was as a result of this arrangement. NZ Funds has a similar arrangement with Money Managers.

I agree with Kimble's point about vintage. For example, Generator was issued in 2003 and matures this year. It was recently upgraded by S&P. There is almost no chance that it won't repay investors in full and on time.

That said, as far as I know NZ is about the only market in the world where CDOs have been sold to mums and dads; and indeed it's the only country I know of where a finance company debenture market exists.

Hopefully the events of the last couple of years have taught all players in the NZ financial advice market that there is a fundamental need to think about risk as well as return, and to make sure that anything that is recommended to clients is fully understood!
On 18 March 2008 at 10:57 am Pondering said:
My mother is in her late 60's (we as a family are relatively uneducated in the intracacies of investment vehicles) and over the last 3 years has requested a low risk investment portfolio (which exludes equities) - I imagine she woudl be the stereotypical babyboomer investor, in the last year she has seen 30% or so of her portfolio caught up in: MFS, Provincial and now ING. Her advisor has taken great lengths to "advise" her that these investments did not carry great risk, as apposed to the use of term deposits which she repeatedly requested or asked for comment on. With regard to Barrington Smythe's comments above, that "investors need to think about risk as well as return," I'd pose that to the masses who pay for financial advice, that this at the forefront of their mind and the reason why they seek an advisor, but they are "advised" by professionals and institutions, that the risk is not material for the returns over and above a typical and easily understood bank term deposit. NZ really is the Wild West
of investing.

Rant over - other than from an emotional perspective i'd really like to have a go at my mothers advisor, any tips?
On 19 March 2008 at 1:37 am Red Dog The pirate Guy said:
Admin makes the comment that the public does not make the distinction between credit funds and finance companies.
I might comment that that is why they trust their investment product salesman to make the correct decision for them.
I recall standing at my weekend sporting event just after Bridgecorp collapsed .
I raised the subject with two people standing next to me[There were only 20 of us there].
I was taken aback when they both said We've got money in Bridgecorp".
But I spluttered,didn't you know it had always been a dog,a joke for many many years ?
Don't you look at the internet to see the negative media going back years ?
How on earth did you end up in there.
Well each said,it was through our financial planner[two different ones].
One guy then walked away to talk to someone else,and the other said "I'm just the man in the street,I don't know what is what,I haven't got a computer,I trust my financial adviser,He's got a university degree after all.I'm just a worker'.But I can't afford to lose $30,000''.
Talking of ING,I must say that I have found it most educational to read the recent media articles informing the reader that some ING funds had a 5% entry fee deducted from the capital sum,and that 0.5% trailer commissions were paid each year.
Now I understand why some clippers tend to like buying and holding certain managed funds and don't tend to encourage things like orthodox capital notes.
They can't clip the ticket to the same degree.
And if I didn't know that,Joe Public certainly didn't.
I was labouring under the delusion that clippers received a front end fee plus an annual fee to manage the portfolio.
I didn't factor in the trails.
I recently sat down with an advisor and some investors,at the investors request.
Now,I said How come this sizeable investment in an international equities fund is only worth two thirds of the original sum invested nine years ago?
What is the point of getting minus 33% for nine years ?
AAH he said,yes it did go way down at one stage but then did 35% one year and 15% the next.
OK I said,at that stage,why not cash it up ?
Oh no he said,we can't do that,as we have to have 30% of the portfolio in equities.
And besides he said,we can't be looking at these portfolios all the time,and then we have to get all that paperwork signed to get the funds out.
I asked the clients how often they heard from the guy.
Once a year they said.
On 19 March 2008 at 12:41 pm Kimble said:
If you WANT a portfolio focussed on absolute returns, if you want every fund to have an absolute return focus, or if you want to ignore the funds benchmark when deciding on the performance of the fund manager, then invest in absolute return funds.
On 19 March 2008 at 7:19 pm Freddy M said:
Is this the real price?
Is this just fantasy?
Financial landslide
No escape from reality

Open your eyes
And look at your buys and see.
I'm now a poor boy
High-yielding casualty

Because I bought it high, watched it blow Rating high, value low Any way the Fed goes Doesn't really matter to me, to me

Mama - just killed my fund
Quoted CDO's instead
Pulled the trigger, now it's dead
Mama - I had just begun
These CDO's have blown it all away

Mama - oooh
I still wanna buy
I sometimes wish I'd never left Goldman at all.

I see a little silhouette of a Fed
Bernanke! Bernanke! Can you save the whole market?
Monolines and munis - very very frightening me!
Super senior, super senior
Super senior CDO - magnifico

I'm long of subprime, nobody loves me

He's long of subprime CDO fantasy
Spare the margin call you monstrous PB!

Easy come easy go, will you let me go?

Peloton! No - we will not let you go - let him go Peloton! We will not let you go - let him go Peloton! We will not let you go - let me go Will not let you go

- let me go (never) Never let you go - let me go Never let me go - ooo Oh mama mia, mama mia, mama mia let me go S&P had the devil put aside for me For me, for me, for me

So you think you can fund me and spit in my eye?
And then margin call me and leave me to die Oh PB - can't do this to me PB Just gotta get out - just gotta get right outta here

Ooh yeah, ooh yeah

No price really matters
No liquidity
Nothing really matters - no price really matters to me

Any way the Fed goes.....
On 19 March 2008 at 10:08 pm Peanut H said:
I'm sure Kimble didn't mean investing all your hard earned and saved cash into absolute return funds. Absolute return funds were introduced to NZ investors with the promise of reduced portfolio volatility and enhanced returns. You should be careful about how much exposure you have to absolute return funds. You should also be careful the absolute return fund does not give you exposure greater than the amount you invested. Your portfolio will also need an exposure across a range of absolute return funds. From experience the promise of reduced portfolio volatility and enhanced returns is not always what happens. Do your home work well or go get some good advice.
On 20 March 2008 at 9:55 am Kimble said:
"You should also be careful the absolute return fund does not give you exposure greater than the amount you invested."

Absolute return funds cannot give you exposure to more than you invest on the downside. You can never owe the fund money.

RD keeps going on about his international equity fund; that it has lost money and that it doesnt move into cash to avoid all downturns. Treating with contempt the managers and advisers who are, correctly, ignoring short term deviations.
On 21 March 2008 at 7:26 pm Peanut H said:
Kimble is right in that absolute return funds cannot give you exposure to more than you invest on the downside. You can never owe the fund money.

However the point I wanted to make is the absolute return funds who use borrowing to provide additional exposure. These funds are subject to movements in the Libor rate as well as the margin charged by the credit provider. Interest charged by the credit providers are not fixed and therefore have the potential to adversely affect returns should the abolute return funds performance not increase commensurately.
On 24 March 2008 at 9:17 pm Maurizio Piglia said:
RD keeps going on about his international equity fund; that it has lost money and that it doesnt move into cash to avoid all downturns. Treating with contempt the managers and advisers who are, correctly, ignoring short term deviations.

And Red Dog is right. Why Are you empowered to stick a label of correctness or not?
Why there should be an orthodoxy ?

And who should administer it?
Again, if the Fund manager is only required to pick a portfolio, buy and hold it, in the 90% of the cases it will do worse than the index, and just remember that you cannot know if your fund manager is a Warren Buffet BEFORE it becomes a Warren Buffet...and AFTER, the good part of the extra returns have been made.

What you call short terms deviations, I repeat, are bear markets lasting years and wiping out ALL the benefits accumulated in bull market times...and more rendering your so called long term so long that it outlasts the investor natural life.

I repeat again, the 94 years average return of the shares, in US$ is about 6.4%....and bonds are just slightly above 4%, but if you can avoid just one of the bear markets of the cycle, that usually happen every 6 or 7 years, then your average returns shoot well above 13%.
Making a serious difference.

I can prove you, bear markets CAN be spotted timely avoided with relatively simple trend following techniques, but those tec
On 24 March 2008 at 9:34 pm Maurizio Piglia said:
Sorry, cut in half...

but those techniques imply quantitative knowledge, and the willingness to use this knowledge.
I can also show you track records of a New Zealand product launched in September 2007 that returned exceptionally well in the so called volatile market.Distributed to punters that just happily received their quartely coupons and saw their money also grow in capital appreciation.

Again, the endowments of the major American Universities are regularly using allocations of more than 50% of their large funds to total return funds, and the fairy tale that you should be careful in allocating money to these funds is linked only to horror stories, like the ones of credit based funds, that could be EASILY avoided spotting the nature of the undelying instrument, thanks again Kimble for explaining me again the nature of those mortgage based funds, but the maths you are referring were flawed from the beginning, and if you know EVT Extreme Valuation Theory, it would have showed you the flaws exactly from day 1...skipping, at least for your investors, the pain.
I did it for mine....

Reality showed you that the elegant theory you rexplained me was a bunch of BS.

Red is right, there is nothing better than to separate wheat from chaff than a good strong bear market, and I don t see why the fairy tale that you should buy , hold and go down with the ship, and moreover ignore the damage, should be propagated again as the correc orthodoxy.

I can prove to anyone, with solid numbers, that there is another way to manage that can be used to stick to the primary fiduciary duty.
Do NOT loose the money you have been entrusted with....they are not just money, they are Joe Public future and dreams.
On 25 March 2008 at 11:35 am Kimble said:
The maths i used were just for the example to make it easier to understand. The concept behind asset backed securities isnt that difficult to comprehend.

Look, if you are investing for retirement or another long-term goal then it means nothing if you lose money with a particular manager in the short term. Nothing. It doesnt mean that manager is bad, and it certainly doesnt mean that another manager that made money in the same period is better and will protect you from downturns in the future.

If you are going to abandon ship every time a manager doesnt beat benchmark for the quarter you will end up needlessly turning over your portfolio at a stupid rate.

I am always going to be naturally wary of people that claim to have a perfect investing system, expecially if they claim that the system should be obvious to anyone truly wanting to be proper fiduciaries. Usually, if someone has a system that will generate higher returns with lower risk, it will be copied, exploited and the advantage/signal will disappear.

"I repeat again, the 94 years average return of the shares, in US$ is about 6.4%..."

Where are you getting this from? The S&P500 has returned around 10% since inception.

"if the Fund manager is only required to pick a portfolio, buy and hold it, in the 90% of the cases it will do worse than the index"

The score isnt much better for active managers.
On 25 March 2008 at 4:36 pm Maurizio Piglia said:
The concept behind asset backed securities is elementar, thank you.

What all the people behind the elementar maths you espoused did miss, was that the probability of the extreme events that flawed from the beginning your risk control was much much higher than what appeared in the elementar and insufficient basic maths you, some managers and the mighty rating agencies used.
EVT, Extreme Valuation Theory, is used by quants when you want to realistically calculate the risk, and therefore do not limit yourself to model a curve of probabilities and then guess the tails with gross, very gross estimates, like the childish math that was used to deem the subprime mortgage backed securities as safe and rate them AAA.
When you really want to know what kind of probability and effects an extreme event will have, you model directly the tail and analyze it.

That kind of analysis, would have allowed you to totally skip the asset backed securities you, and others like you with relatively limited tools had deemed safe and low volatility securities.

You have no defence whatsoever on that, as reality proved that your basic description and the perfunctory risk analysis performed by you, in the good company of the rating agencies, led to the disaster that is under everyones eyes.
You just sold a naked option, and when the extreme event came...it blew the whole house apart. As it happens when selling far out of the money naked options to cash the premium....till the option comes to strike, and you cannot deliver the underlying.

That was the substance of the asset backed securities played by many blue blooded managers...that now hide and hush as much as they can.
On 25 March 2008 at 4:57 pm Kimble said:
As I said, I only used the maths to explain the idea behind asset backed securities like CDOs and CMOs.

I was not offering any method to calculating their specific risk, I never said they were safe, I never said the rating was correct, I was just explaining the concept. So I dont know what you are going on about.
On 25 March 2008 at 5:34 pm Maurizio Piglia said:
Then lets go to changing underperforming managers. No one has EVER mentioned to you the frequency of change, and the frequency of changing a manager every quarter is a rethoric expedient you use.....since nobody else did mention it in any intervention before.

I can give you the methodology used by the University Endowments Funds, or the serious Funds of Hedge Funds, that before selecting a manager, rely on a giant heap of quantitative analysis on the performances of a single manager.
First of all, to be able to discern talent by luck, you need 5 years of track record. After 60 months, you can, with appropriate, complex, but valid analysis, tell a manager produces alfa due to a talent, and not massaging numbers and/or buying and holding CDOs (Is not casual the CDOs blew before the 5 year time limit, is a well known threshold..).

Secondly, the manager has a benchmark he himself incorporates in the Fund's Offering Memorandum. therefore he is confident he will beat the chosen benchmark.
He can fail it for one year...no problem, you don't change the manager for a bad year...provided the bad year is just underperforming the benchmark, because if the bad year has been a draw down out of proportions and destroyed one third of the capital...your argument of not changing it immediately has no substance whatsoever.

But in case of a single bad year, no problem. But you start monitoring his numbers very closely..and after further six months check again...if a second bad year comes to grief...take the money out and go back to the drawing board. This works very well in practice, and is SOP (Standard Operating Procedure) for many ultra billion Endowments, and Pension Funds. If you have better approaches, I'm sure Harvard and Yale Endowments will be happy to listen to you and incorporate them in their SOPs.

Oh, pls, do not forget an honest manager will NOT cash performance fees in case of NOT beating the benchmark, and will have a highwatermarck clause not to have the client have to pay fees only to return his money at the level it was before a draw down.

Remain wary of the perfect systems...mine is not perfect, involves continuous work to keep the hedge, and involves carefully monitoring heaps of numbers to keep the competitive advantage...but it works.

About delivering better returns...I have the numerical evidence Hedge Funds enhance the efficient frontier on traditional investments, and have been doing it for 15 years now...of course you also need a lot of number crunching to select the right ones...but having a rigorous methodology and a discipline helps, and the numerical evidence is conducted on groups of funds styles and methodologies therefore taking in the good and the bad...and the averages still largely advance the traditional efficient frontier.
If you pick the best ones the result is just amplified...furthermore.

“I repeat again, the 94 years average return of the shares, in US$ is about 6.4%…”

Where are you getting this from?

A study on risk and returns published in Europe by ABN AMRO that carries statistics much longer than the existing S&P 500 index...when you need to know what the real long term delivers, you go as long as possible. The S&P 500 index is just too short. I'll publish here in a couple of days the web reference of the study, might be an interesting reading for many.

"The S&P500 has returned around 10% since inception." Around is below 10 %, has produced a 9.5% return with a volatility around 13.4%.
I can demonstrate track records that have produced average returns of 10% with a volatility around 6%....That means that conveniently using a modest and controlled amount of leverage, you can beat by far the performances of that index, bringing your returns around 16% averages with volatilities that reach barely the 9% just leveraging a modest 50 cents per dollar, returns NET of commissions to the Clients, and including a generous (for the lender) 1% spread on the US LIBOR as cost of the leverage...for the past 7 years regardless of the level of that LIBOR.

And producing positive returns in the bear market years of 2000, 2001 and 2002.

"The score isnt much better for active managers."
Agreed...but for your type of active managers, the discretional ones that still think that meeting the management is an important component of picking a stock...my type of active managers are driven by rigorously numerical disciplined approaches, in the portfolio selection (like the one I have illustrated and you choose to ignore...Oh...sorry, I should have known that looking in a telescope, being an empirical instrument that endangers your conception of a Tolemaic universe governed by Aristotelic theories; showing you the truth..is not contemplated!)
and in the trend analysis to keep that portfolio from being destroyed by ludicrous draw downs that wipe out excessive amounts of capital...oh, those managers DO beat the benchmark constantly.

They live and die cashing the performance fee....not mismanaging large assets for fees unbound by the real results.
On 25 March 2008 at 8:09 pm Kimble said:
Dude, you are losing it. You seem to think I am making the argument for a certain type of asset management, when I am really not. Or that I am arguing against shorting the market or adjusting a portfolio, which again, I am not.

Look back over what I have said. I gave a simple explanation for asset backed securities, made the case for absolute return funds, and complained that RD was being too short term in his thinking, and was in a fund that obviously didnt suit him.

I dont know who it is you are arguing here, but it aint me. Now you have just pissed me off.

"No one has EVER mentioned to you the frequency of change, and the frequency of changing a manager every quarter is a rethoric expedient you use"

It was simply to emphasise my point that short term fluctuations dont mean that much, and making decisions based on them would have you jumping ship every quarter. But even changing managers each year is probably too much. You said it yourself, it takes 5 years to see if a manager has added value through skill.

"the numerical evidence is conducted on groups of funds styles and methodologies therefore taking in the good and the bad…"

So you are controlling for survivorship bias, backfill bias, and the smoothing of returns that many hedge funds do thereby reducing their apparant volatility. Otherwise, big surprise, an index which probably has upward biased returns and downward biased volatility manages to look appealing on a risk-return basis.

"discretional ones that still think that meeting the management is an important component of picking a stock"

These managers are obvioulsy buying COMPANIES not stocks. Dont you think it takes a leap of faith to assume that everything that needs to be known about a company is contained within a single piece of data: the price.

"The S&P 500 index is just too short."

82 years is too short. There must be some really important stuff that went on in 1914-1926, that has so much relevance to investment markets in the future.

Oh and the return I have is 10.2% from Jan 1926. Which, last time I checked, and bear in mind this is without the benefit of a magical numerical telescope, is more than 10%.
On 25 March 2008 at 9:36 pm Kimble said:
"(like the one I have illustrated and you choose to ignore…Oh…sorry, I should have known that looking in a telescope, being an empirical instrument that endangers your conception of a Tolemaic universe governed by Aristotelic theories; showing you the truth..is not contemplated!)"

Did you ever stop to think the reason I "choose to ignore" your illustration is because I dont have an issue with it? Where have I said that quant management doesnt work? Where did I say that there is only one correct style of management? I am not the one making sweeping generalisations about fund management styles.

You say Red Dog is right, and that I am wrong in asserting that short term fluctuations oughtn't be driving long term investment decisions. But you have demonstrated that you completely misunderstand what I was saying.

In fact you go on to tell me that what I call "short terms deviations ... are bear markets lasting years and wiping out ALL the benefits accumulated in bull market times…"

Wow, I didn't realise that by short term I meant MULTI YEAR BEAR MARKETS. Gosh. Thanks for clearing that up for me.

In fact I will sign off now because you are able to provide all my arguments, including the ones I never gave a hint of making.
On 28 March 2008 at 9:13 am Phil’s Blog » Blog Archive » The lighter side of the credit crunch said:
[...] sent a number of humorous takes on how the credit markets work, from a ditty to the lyrics of a Queen song, through to a very funny slide [...]
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