A Quick Primer on Leveraged ETFs

Seeking Alpha had a short article on the mathematics of leveraged ETFs.  It has a demonstration of the classic upside/downside dichotomy (i.e. it takes 100% gain to overcome a 50% decline).  It also mentions, without going into detail, the effect of constant rebalancing to maintain the advertised leverage position.

What is not is that these two mechanisms conspire to frustrate the use of leveraged ETFs as a long term position.  the daily re leveraging of the portfolio exacerbates the tyranny of the upside/downside dichotomy. 
The portfolio sheds leverage after a decline in order to maintain its ratio, just when that leverage would work in the investor's favor in any reversion to the mean.  On the other side, while the portfolio naturally de-levers on an upside move, daily rebalancing adds leverage, to the portfolio's detriment when the markets mean-revert.  Thus, the observation that over a long term holding period, a leveraged ETF will tend to underperform the the underlying asset simply multiplied.

Commodities Are Not For Diversification?

The Maverick Investors Rally Site has a post that refers to a paper by Charoula Daskalaki and George S. Skiadopoulos that investigates whether commodities add value to a portfolio of traditional investment assets.  The professors found that, while there are periods in which commodities holdings provide benefits to portfolios, these benefits are not persistent or predictable.

I have discussed this in an earlier post.  The Maverick Investors Rally put it better than I have: "there is no theoretical basis for commodities per se to provide any return, never mind 'enhance' a portfolio’s return."  Commodities are consumed in the economic process of creating value.  Any return on holding  commodities is the result of price speculation, not economic wealth creation.

Are commodities an asset class?  If defined by a distinct return pattern driven uniquely by economic factors, I would have to say yes.  But the results of the study suggest that it is not an asset class that is worthy of consideration as a permanent part of an investment portfolio.

The Daskalaki and Skiadopoulos paper is the latest to demonstrate that an allocation to commodities does not add value to an investment portfolio.  There  will be more research that will suggest that the conclusion is misplaced.  It will be beneficial to be skeptical.

Treasuries Beat Hedge Funds

Investment News ran this piece, summarizing a book by Simon Lack, a former hedge fund executive at J.P. Morgan.   Other publications ran similar articles, often with a more scandalized tone.

Mr. Lack's headline grabbing finding is that the capital that went into hedge funds would have reaped higher returns if had been invested in Treasury bonds.  He identifies the primary culprit as the "2 and 20" cost structure of the typical hedge fund, aided by difficult capital markets over the last ten years and a highly competitive environment.

I haven't read the book yet, but I would guess that another factor is the amount of dishonesty the industry attracted in the first decade of the 21st century.  Investors that had become accustomed to 20%+ returns of the 1990s realized that they really did not have a high tolerance for risk.  These investors came to believe that a lower risk portfolio should be able to return 12% annually, and a number of shady characters were willing to promise it to them.  100% loss of that capital would have a profound effect on the return on the total capital invested in hedge funds.

At the end of he day, a hedge fund is just an investment vehicle, and an expensive one at that.  Anyone investing in a hedge fund should expect such an high expense ratio be accompanied by a strategy that can not be duplicated in a lower cost form, such as a mutual fund , ETF, REIT, or Unit Investment Trust.  Sophistication could be indicated by high velocity trading, illiquid or privately negotiated investment or derivative contracts, or leverage.  What all of these strategies involve is additional risk.  Not necessarily the risk that we recognize and talk about every day, but incremental risk nonetheless.  And that should come as no surprise, since no investment provides a return unless the investor is willing to assume some level of risk.

Five Trends For Advisors

This article in Financial Advisor magazine does not contain anything new.  Rather, it collects ion one place a number of trends in the advisory community that have been tacking place and developing momentum over the past few years, and discusses them in one place.  That the business of advising is evolving is both obvious and good, and these rends are serving to improve the practice of advising individual investors.  The five trends:

• Fee compensation rather than commissions - This has been on its way for a long time, and the changeover may never be complete.  There are certain clients for whom a gee-based relationship is not the most beneficial.  However, for most clients, a fee-based model works better than one based on commission for so many reasons - alignment of interest, taxes, transparency - that it seems a natural way of doing business.
•  A fiduciary standard of care - Another trend that has been developing for a long time, but in a much more covert manner.  Nearly all of the pressures on practitioners, from regulatory to competitive, have been pointing the industry in this direction. The codes of conduct promulgated by the professional organizations all promote behavior worthy of a fiduciary, even of they do not name it.  Service providers, such as broker/dealers and custodians, are offering packages that address the demands of clients for assurances that their interests are primary.  Even the trend toward fee compensation supports such a rigorous standard.  The major factor delaying a full scale adoption is the lack of mechanisms for managing the tort risk of the heightened responsibility.
• Comprehensive financial planning - Providing comprehensive planning for clients is not so much a trend as it is the realization of a vision.  The leaders of the industry have always conducted their business in a way that promotes sound financial decisions across the entirety of a client's life, not just investments, insurance, or taxes.  Technology is allowing  practitioners to access specialized expertise  in a cost-effective manner to deliver advice that considers all facets of a client's financial life, both currently and in the future.  Clients and other professionals are more willing to form teams to help the client achieve his goals.
• Setting reasonable expectations - There was a time when advisors competed on performance - the highest yield product, the best performing mutual fund, the most recognizable research staff - and a good portion of the market was willing to follow the lead.  More recently, the marketing thrust has shifted, and managing expectations and keeping promises weighs much more heavily in the decision making process. 
• Outstanding service - Really, any advisory firm that is fulfilling the first four points can be described as providing outstanding service.  Setting achievable holistic goals, meeting them while putting the client's best interest first, and getting paid a reasonable and transparent fee reflecting the time, effort and expertise of the advisor is the very model of an effective relationship.

I can';t say that I agree that advisors must adapt their practices to these trends.  Carriage manufacturers and buggy whip makers are still in business and make some money.  But they are now specialty products made for a small market niche, rather than a mass market operation.  Likewise, there will likely be a market for commission based, product oriented advisors for a select group of individuals.  However, the larger market will be attracted to sophisticated professionals whose practices reflect the above characteristics.