Barron’s Red Flags: Do They Actually Work?

Via SSRN:

Investors are often concerned that managers might hide negative information in the maze of mandated SEC filings. With advances in textual analysis and the availability of documents on EDGAR, individuals can quite easily search for phrases that might be red flags indicating aggressive accounting practices or poorly monitored management. We examine the impact of 13 suspicious corporate phrases identified by a recent Barron’s article in a sample of 50,115 10-Ks during 1994-2008. There is evidence that red flag phrases like related party and unbilled receivables signal a firm may subsequently be accused of fraud. At the 10-K filing date, phrases like substantial doubt are linked with significantly lower filing date excess stock returns, higher stock return volatility, and greater analyst earnings forecast dispersion.

Stocks Ben Graham Might Buy If He Were Alive Now

Via John Dorfman in Bloomberg:

Each year from 2001 through 2006 I wrote a column on stocks I believed Graham would have liked were he still alive. This year I revive the tradition.

I have designed a few criteria that I believe reflect the spirit, and to some extent the letter, of the maestro’s methods.

Channeling Graham

What I call Graham stocks have a share price that’s less than book value (corporate net worth) and less than 12 times earnings, as well as debt less than 50 percent of stockholders’ equity.

Graham’s own metrics were vastly more complex and numerous, and he allowed room for judgment. Also, because he did much of his investing in the 1930s and 1940s, Graham was able to find some bargains the likes of which do not exist today.

Nonetheless, I think Graham would find some stocks to like if he were an active investor now.

One example is Tutor Perini Corp., a general contractor that specializes in large construction projects. It is based in Sylmar, California.

I like Tutor Perini’s ability to tackle big and diverse projects. It has built hotels and convention centers, airport runways, solar plants, the police headquarters building in Los Angeles. The ability to take on difficult projects often confers some pricing power.

Read the full article here

Interview with Paul Tudor Jones II

Via Absolute Return+Alpha:

What’s so special about macro hedge fund managers?
I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form. The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

Is it possible to teach someone to be a tape reader — what some might call a trend follower or technical analyst?
Certain people have a greater proclivity for it because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.

What’s your take on the next generation of managers?
I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!

Read the full interview here

Staying Calm in a World of Dark Pools, Dark Doings

Via Jason Zweig in WSJ:

Last week, the Securities and Exchange Commission accused the Galleon Group of hedge funds of trading on inside information. Tens of millions of shares move each day through “dark pools,” where quotes aren’t displayed until after the trade is done. “Flash orders,” appearing for a split second, give some customers a sneak peak at potential trades. More than two-thirds of stock-market volume comes from high-frequency traders, who can buy or sell in less than 400 microseconds, or nearly a thousand times faster than you can blink your eye.

When markets move so maniacally fast, and firms like Galleon seem to have such an informational edge, how can small investors possibly stand a chance? The game seems rigged to favor the hyperactive giants of Wall Street.

In one sense, that is true. If you try to play Wall Street’s new game on Wall Street’s terms, you will probably come off the field on a gurney. But you are under no obligation to churn your own portfolio just because other people juggle stocks for only minutes or seconds at a time. Paradoxically, their frenzy renders you a service as a buy-and-hold investor: On the very rare occasions when you do need to trade, you will be able to do so more efficiently than ever before.

Read the full article here

Perspective on Performance

Via Condor Options:

Investors are notorious for chasing performance. If a mutual fund or advisor or trading strategy has done well recently, chances are much greater that traders will commit money to that strategy or product, often independently of the long term performance, general suitability, or distinguishing features of the strategy or product.  I’ve seen the same behavior among the audience for our paid newsletters: after a winning month, new subscribers are more likely to rush in, and if we have a flat or down month, interest from new readers drops. This is exactly the kind of backwards thinking that dooms most investors to underperform even basic market benchmarks: most investors would literally be better off allocating every cent to a plain vanilla index fund, rather than jumping around from one strategy to the next like insects in the lighting section of a hardware store. I get frustrated on behalf of smaller and newer traders in particular, because while they tend to have low risk tolerance and tend to face higher transaction costs – i.e., they’re the group who can least afford to chase performance – they’re also the most likely to do exactly that. You don’t see smart, profitable institutions switching from following commodity trends to selling volatility to trading fixed income every time one of those asset classes has a nice run.

Read the full post here

An Empirical Examination of Fund Investor Timing Ability

Via SSRN:

Interesting paper from Geoffrey C. Friesen and Travis Sapp. From the Abstract:

We examine the timing ability of mutual fund investors using cash flow data at the individual fund level. Over 1991-2004 equity fund investor timing decisions reduce fund investor average returns by 1.56% annually. Underperformance due to poor timing is greater in load funds and funds with relatively large risk-adjusted returns. In particular, the magnitude of investor underperformance due to poor timing largely offsets the risk-adjusted alpha gains offered by good-performing funds. Investors in both actively managed funds and index funds exhibit poor investment timing. We demonstrate that our empirical results are consistent with investor return-chasing behavior.

Read the paper here

Successful Market Timing

Via World Beta:

If you have the emotional makeup for it, timing can reduce your risks and enhance your returns. If you’re satisfied that you have what it takes to be a market timer, here are the best tips I know for doing it successfully. They aren’t necessarily listed in order of priority. In fact, I suggest that you regard each one of them as the top priority.

1. Use mechanical strategies.
Timing financial markets is already plenty hard without worrying about making predictions or (even worse) thinking you have to decide who is right when smart economists and savvy analysts make conflicting forecasts and draw different conclusions. If you leave the final decisions to subjective factors, you will never be sure what you are supposed to do at any given moment. That will cause you anxiety and delay. And you’ll have a system you can’t count on. Rely primarily on trend-following systems that are based mainly on trends that are impacted by actual prices in the market. There’s nothing speculative about prices. They reflect what buyers and sellers are doing, and that’s about as reliable an indicator of the direction of the market as you can find.

2. Do not — repeat DO NOT — pay much attention to the effect of every trade.
The majority of individual trades will be irrelevant to your long-term results. If you feel you must focus on each trade and agonize over what it means, that’s a sure sign you are not cut out to be a successful timer. Dwelling on each trade is a sure way to drive yourself nuts, and it won’t improve your results at all.

3. Use timing systems that are right for you and your temperament.
The perfect strategy for you will match your time horizon, will respect your emotional needs and will operate within your tolerance for risk and change. There are short-term systems that trade frequently, long-term systems that trade infrequently and intermediate-term systems that typically trade two to six times a year. Over long periods of time, no group has an inherent return advantage over the others. But the practical and emotional differences are important. If you have a strong desire to perform closely in synch with the market, use short-term systems, which are good at quickly reacting to today’s highly volatile market swings. However, short-term systems demand that you make many trades, and each trade has potential tax consequences unless you are investing in a tax-sheltered account. The volume of trades demands a lot of attention, produces a lot of paperwork and tests the patience of many mutual funds, which sometimes won’t accept accounts from very active timers. If on the other hand you have a strong aversion to whipsaws, you can use long-term systems. But doing so will sometimes make you wait for a move of 20 percent or more before you buy or sell. For the best compromise, do as we do: Use intermediate-term systems. This level of activity is likely to be accepted by most mutual funds and is not too demanding emotionally.

4. Use multiple timing systems, stick with them and let them act independently in your portfolio.
Even the most productive system from the past may be a mediocre performer in the future, and the reverse could also be the case. We use four U.S. equity timing models, each of which governs 25 percent of our portfolio. We have faith in the systems as a group. But we don’t have enough faith in any one system to let it govern the whole portfolio. You shouldn’t either. Just as you should not chase recent performance in your choice of mutual funds or asset classes, do not chase recent high-flying timing systems. One of the smartest timers in this business, a fellow newsletter publisher whose work I respect, has averaged about 9 percent over the past decade. He chooses good timing systems, which have produced average returns of more than 18 percent before he adopts them. But he doesn’t stick with those systems. Whenever the system he has been using disappoints him, he finds another one that would not have done so, based on real or hypothetical past performance, and then he switches to that system. In theory, this may seem like a valid way to search for the very finest system on the planet. But in truth, such “superstar” timing models simply do not exist. They are a myth. Good performance one year doesn’t mean anything about performance the next year – not anything. This is one of the hardest facts for investors to accept, but it’s true. Therefore, we believe your best bet is to find several robust timing models and stick with them.

5. Remember that whether you use a buy-and-hold approach or market timing, asset allocation is the most important investment decision you will make as an investor.
Use many assets or asset classes that move up and down at different times and at different speeds. Include international diversification, whether you invest in equities, bonds or both. Just as you never know which timing model will be the star performer in a given quarter or year, you never know which asset class will be the overachiever and which will be the laggard.

6. Follow your systems and your strategy.
Put them into action without fail and without exception. Remember this Chinese proverb: “He who knows but does not act, still does not know.” If you do only one thing right and everything else wrong, make sure this is the one thing you do right. This is the most essential key of all. If buying diet books and exercise equipment took off pounds, obesity would not be a major health concern. You can devise the greatest portfolio in the history of investing, but it will do you no good unless you commit your money to it. The greatest timing models do you no good unless you apply them. Therefore, do whatever is necessary to get it done.

7. Before you start timing, take off the rose-colored glasses, if you are wearing them.
Focus in advance on the difficulties you can expect as well as the ultimate rewards you hope to achieve. Accepting the rewards of success will be easy. But you’ll never get to the finish line unless you can deal with the hurdles along the track. Know the level of interim losses you are likely to encounter with your strategy, and make sure you are willing to accept them. In the early 1970s, buy-and-hold investors in the Standard & Poor’s 500 Index suffered a 39 percent loss in one year. Even timing can be ugly. In our Worldwide Equity strategy, all our back-testing has failed to produce a decline as high as 15 percent in any 12-month period. Yet we believe that any strategy with the potential to produce returns of 13 to 15 percent a year also has the potential to lose 15 percent in a year, so that’s the figure we use when we project the expected worst-case scenario. Bottom line: Do not expect magic from any timing system.

8. Give timing enough time to work. In the short term, anything can happen.

In the long term, if you have chosen a strategy carefully and you follow the discipline, you should be rewarded accordingly. But how long is long enough? There are two places to look for the answer. The first is in your own psychology. Do you normally undertake long-term projects or strategies, comfortable knowing that you’ll have to wait for any payoff? If so, you may be a good candidate for market timing. But if on the other hand you are usually quick to judge the success or failure of something you start, and if you need instant gratification, you’ll probably have trouble being a successful market timer. The second place to look for the answer is in statistics and history. Arm yourself (or have your manager do this for you) with the past statistical performance, either real or hypothetical, of your proposed investment. Over the longest period for which you have data, determine the depth of the largest drawdown. Find out how long it took to return to break-even. One of our most aggressive timing programs, which we call by the shorthand of +2 to -1, meaning it attempts to double the performance of large U.S. stocks when the market is rising and to do the opposite of the market during declines, once took nearly two years to recover from a 20 percent drawdown. Are you prepared to endure that in order to make returns of more than 20 percent? Here’s an even tougher example of the extraordinary patience required of investors: In 1973 and 1974, the S&P 500 declined by 44.9 percent. The index eventually regained its pre-decline level. But it took 66 months for some investors just to break even. Unless you are sure you’d stick with a strategy through the longest historical drawdown for which you have data, don’t embark on that strategy.

9. Unless you are absolutely committed to being a market timer, use both timing and buy-and-hold.
This gives you two non-correlated approaches that will have differing results in any given period. Over long periods, carefully chosen investments in similar assets may generate similar returns with buy-and-hold and market timing. But in the meantime, the average of the two may give you lower losses, less risk and (perhaps most important) less anxiety than either market timing or buy-and-hold alone. This combination may be more appealing to many people than the peaks and valleys of each approach separately.

10. Make sure you understand in advance the realities of market timing.
And make sure you are prepared for them. I cannot emphasize this point too much, so I hope you’ll read the following overview. If you invest money that’s governed by timing and you’re surprised by everything that happens to your investment, you will always feel off balance. You’ll come to dislike and distrust timing. And even if you follow your system, timing will produce anxiety for you. That is just the opposite of what it’s intended to do.

Measuring the Timing Ability and Performance of Bond Mutual Funds

Via CXOAG Investing Notes:

Do managers of bond mutual funds generate value for fund holders by successfully timing the market? In the September 2009 update of their paper entitled “Measuring the Timing Ability and Performance of Bond Mutual Funds”, Yong Chen, Wayne Ferson and Helen Peters evaluate the ability of U.S. bond fund managers to time nine common factors related to bond returns. The nine factors reflect the term structure of interest rates, credit and liquidity spreads, currency exchange rates, mortgage spread and equity market returns. The authors also define seven benchmarks matching different bond fund styles. Using monthly returns for more than 1,400 U.S. bond mutual funds and contemporaneous bond market factor and benchmark data during January 1962 through March 2007, they conclude that:

• Across all bond mutual funds over the entire sample period, the mean monthly return is 0.62% and the standard deviation of monthly returns is 1.51%.
• After controlling for return series non-linearities unrelated to timing, the evidence for market timing ability is on average neutral to weak.
• With these controls, 75% of bond funds significantly outperform style-matched benchmarks before fund costs (average expense ratio of each fund plus an assumed round trip trading cost associated with the fund style), but there is no evidence of net outperformance on average after costs.

In summary, evidence provides weak support for a belief that managers of U.S. bond mutual funds can on average time the bond market, but fund costs/fees offset any associated net outperformance of reasonable benchmarks.

Size Really Does Matter…for ETFs

Via Abnormal Returns:

We are no strangers to the world of ETFs, but the following observation took us by surprise.  A single fund, the iShares MSCI Emerging Markets Index Fund (EEM) generates some $240 million in revenue per annum for its sponsor.  Ian Salisbury at WSJ goes on to note how lower trading costs have kept EEM on top against its much thriftier competitor the Vanguard Emerging Markets Stock ETF (VWO).  In short, size matters in the ETF industry.  And by industry, we mean industry.

There certainly are benefits to size in the ETF world, but there is a downside as well. Funds that were originally thought to be niche products have in some cases have seen explosive growth.  This growth has put pressure on their ability to produce the returns they set out to generate.  Therefore owning an ETF that invests in gold, commodities, or junk bonds is not the same thing as holding the underlying asset(s).

In some of these cases the ETF industry has tried to take something that is complex and make it seem simple.  Unfortunately something can get lost in the translation.  In addition the issuance of an ETF can change the dynamics of a market, something not always contemplated prior to a fund launch.

That is not to say that being too small in world of ETFs is not a problem as well.  We have written about the risks of so-called orphan or “zombie ETFs” that are too small and illiquid.  One need not look far to see that a broad swath of the ETF industry is potentially on the chopping block.

…ETFs can be a wonderful tool for investors, but ETFs are also a business.  A big business.  If you want to continue playing in the ETF sandbox make sure you know the distinction between a good ETF and a bad ETF.  Because the ETF sponsors are not going to tell you which is which.

Read the full post here

Do You Have the Mental Fortitude to Accept Huge Gains?

I am not a follower of Elliott Wave Theory, but this is a very accurate passage from Robert Prechter:

“Do you have the mental fortitude to accept huge gains?”

“This comment usually gets a hearty laugh, which merely goes to show how little most people have determined it actually to be a problem. But consider how many times has the following sequence of events occurred? For a full year, you trade futures contracts, making $1000 here, losing $1500 there, making $3000 here and losing $2000 there. Once again, you enter a trade because your (trading) method told you to do so. Within a week, you’re up $4000. Your friend/partner/acquaintance/broker/advisor calls you and, looking out only for your welfare, tell you to take your profit. You have guts, though, and you wait. The following week, your position is up $8000, the best gain you have ever experienced. ‘Get out!’ says your friend. You sweat, still hoping for further gains. The next Monday, your contract opens limit (down) against you. Your friend calls and says, ‘I told you so. You got greedy. But hey, you’re still way up on the trade. Get out tomorrow.’ The next day, on the opening, you exit the trade, taking a $5000 profit. It’s your biggest profit of the year, and you click your heels, smiling gratefully, proud of yourself. Then, day after day for the next six months, you watch the market continue

to go in the direction of your original trade. You try to find another entry point and continue to miss. At the end of six months, your method finally, quietly, calmly says, ‘Get out.’ You check the figures and realize that your initial entry, if held, would have netted $450,000.”

“So what was your problem? Simply that you had allowed yourself, unconsciously, to define your ‘normal’ range of profit and loss. When the big trade finally came along, you lacked the self esteem to take all it promised . . .who were you to shoot for such huge gains? Why should you deserve more than your best trade of the year? Then you abandoned both (trading) method and discipline. To win the game, make sure that you understand why you’re in it. The big moves in markets only come once or twice a year. Those are the ones which will pay you for all the work, fear, sweat and aggravation of the previous years. Don’t miss them for reasons other than those required by your objectively defined method. The IRS categorizes capital gains as ‘unearned income’ that’s baloney. It’s hard to make money in the market. Every dime you make, you richly deserve. Don’t ever forget that.”

. . . Robert Prechter – the Elliott Wave Theorist (1992)