Tuesday, June 29, 2010

Past Performance Does Not Matter

Yes, it sounds like something from the mouths of market efficiency fanboys. Yes, it’s something one would expect in this space, given this blog’s recent proclivity to bash the art of active fund management and the oft-maligned school of technical analysis.

We’re all guilty of it, at one time or another: using what happened in the past to predict, or at least have some idea of, what will happen in the future. In school we learned how to use historical sales to forecast a firm’s future demand, how to use past data to assign probabilities to events that can happen in the future, and how technical analysis is based on the premise that historical stock prices produce patterns that are bound to repeat in the future.

In the real world, we are confident that we’ll earn big from investing in the stock market because we know more than a handful of people who’ve done it before. Also, we base our investment decisions on how well a particular fund has performed in recent years, despite reading this qualification in the fine print of fund reports, something that’s required by law for mutual funds, UITFs, and other similar instruments.

A new study from Standard & Poor’s presents stronger evidence against fund managers who try to lure investors with the implied promise that a strong recent performance will happen again in the future. The study looks at top mutual fund performers over three-and five-year periods, how the funds performed each year in those periods and whether a top-performing fund in one period was able to repeat the same performance in the next period.

The major findings of the study include:
  • Very few funds manage to consistently repeat top half or top quartile performance. Over the five years ending March 2010, only 1.7% of large-cap funds, 2.2% of mid-cap funds, and 4.6% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
  • Looking at longer term performance, 18.5% of large-cap funds with a top quartile ranking over the five years ending March 2005 maintained a top quartile ranking over the next five years. Only 12.7% of mid-cap funds and 25.0% of small-cap funds maintained a top quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
It must be said, though, that these results against actively-managed funds like mutual funds and UITFs greatly favor S&P since it’s in the business of selling passive index funds. But still, the numbers present very strong evidence that, indeed, it would be foolish to base investment decisions solely on past performance.

Sunday, June 27, 2010

Luck Is The Key To Success For Most Top Mutual Funds

IN THE NEWS from Forbes.com

A new study by Eugene Fama and Kenneth French shows that actively managed funds are not able to consistently outperform passive market indices, and that these actively managed funds consistently result inferior returns for investors because of their high fees.

The study shows that the reason why some funds outperform benchmarks sometimes is not because fund managers are highly skilled, but because of luck. The article further points out that since there are thousands of actively managed equity funds, even if all fund managers were randomly picking their portfolios by throwing darts at a stock page, a large number of funds would still soundly beat market averages.

The main point of the article is that it does not make sense to pay professional fund managers to construct a portfolio that will not even consistently beats the market, and that investors would be better off investing in passive, low-cost index funds instead.

What does this mean for Ange and her ilk? Does this mean their crusade to beat the market is futile and all for naught? We’ll, here’s a ray of sunshine for the steadfast believers among you, something you can hold on to for a little bit of hope: Fama and French are pioneers of market efficiency, and while I have yet to see the full text of their study, I’ll bet that it is founded heavily on this school of thought. There are strong arguments against the efficiency of the US stock market set forth by advocates of behavioral finance like Robert Shiller and Richard Thaler, and I’m pretty sure that the evidence against the efficiency of the Philippine stock market is significantly more damning. So if the Philippine stock market is far from efficient, then maybe there’s a way to consistently beat it.

So Ange and your ilk, let’s see you guys do it. Or at least try to. Before I burst your bubble in my next post where I show further evidence against consistently beating the market. :P

Thursday, June 24, 2010

Dissecting East West Bank's Latest Public Offering


Got this from yesterday's issue of the Philippine Daily Inquirer. Thanks to Sam for the heads up: you’re turning out be a very reliable partner in looking for the best investment deals out there.

Okay, so what's this? All we see is financial gobbledygook that seems to make little sense. Which is what I'm here for--to try to make sense of things like this, things that matter, things that we should understand.

1. What is it?

In a nutshell, what it is is debt. Yes, for whatever reason, East West Bank (EWB) needs additional financing, 1.5 billion pesos worth, and it decides to raise this by borrowing from you, the investing public.

2. 7.5% p.a.?

If ever you decide to get in on the action, you’ll receive 7.5% of your investment or principal every year (“p.a.” stands for per annum or per year) as interest. That means if you buy 1 million pesos of this “note” or “bond” (or lend EWB 1 million pesos, same banana), you’ll receive 75,000 pesos interest per year, or 37,500 pesos every six months.

3. Unsecured?

It means that this debt is not secured by collateral—which is an asset provided by the borrower that the lender can claim when the former is unable to pay its financial obligations on time, or not at all. Secured debt—or loans or debt with collateral—thus tend to be safer than the unsecured kind, and should feature a relatively lower interest rate. Housing loans, car loans, even pawning a piece of jewelry, are all examples of secured debt.

4. Subordinated notes?

This means as a creditor or lender of EWB, you’re not top honcho, some other creditor is more important than you, and you’ll have to wait in line in case the shit hits the fan and the firm becomes insolvent or unable to pay its debt obligations, or if it enters bankruptcy.

5. Lower Tier II Capital?

This one’s a bit trickier than the other features, and it’s specific to banks.

Banks have two levels of capital: Tier I and Tier II. Tier I consists of money from the pockets of the owners (equity capital), money from the bank’s operations (retained earnings), and some kinds of preferred stock. Tier II capital comes from everyone else, like the bank’s depositors and creditors. The qualifier “lower” just means you have a lower claim than the banks depositors, meaning they’ll get paid first in case the bank gets into financial trouble. But of course, as a creditor, you still have higher priority than the bank’s owners and preferred stockholders.

6. Due 2021?

This means the note will mature in 2021, some 11 years from now (if I count my years right); on that date, you’ll get back your entire principal as the note is retired or redeemed. So in all, if you buy 1 million pesos worth of the note and hold on to it until the due date, you’ll get a total of 11 x 75,000 pesos or 825,000 in interest payments and 1 million pesos lump sum at the end of 11 years.

7. Callable?

It means the issuer, EWB in this case, has an option to “call” or buy back the note anytime from 2016 until the note matures in 2021. Why the hell would EWB want to do that? Well, if interest rates fall in that period to a level below 7.5%, it’s to the borrower’s benefit to buy back the note and issue another one at a lower interest rate. So what’s in it for you, the lender? Why the hell would you want to buy something with a feature that benefits the issuer? Well, compared to similar notes without this call feature, EWB’s note should have a relatively higher interest rate. And if ever EWB does decide to exercise its option, it will pay you back a higher amount, something equal to the principal plus an extra called the call premium.

8. With Step-Up in 2016?

No, this has nothing to do with your favorite street dance movie (“If you wanna be with someone who doesn't appreciate what a good thing he's got that's 100% your business. I just thought you'd be smart enough to know you deserve better.”). What this feature means is that EWB promises to increase the interest rate from 7.5% starting 2016 up to 2021. The exact schedule and amount of the increases should be detailed by the selling agents. Sounds good, right? But remember, the bond is callable. So there’s a chance EWB will retire the debt even before the first round of interest rate increase.

9. Should you buy into the issue?

Well, Sam wouldn’t. She’s turned off by the 11-year tenor, the call feature, and the “low” interest rate (which is already net of taxes, according to one of the selling agents).

One other important factor that you should consider is the reputation of the issuer, East West Bank. Unlike other, bigger banks that are awash with depositors’ money, EWB has to rely on other financing sources. What are the chances that EWB will default? To answer that question, you’ll have to try to know the firm better, maybe take a look at its financials, if you can.

If you’re not too impressed by EWB, maybe you can just wait and park your money in a temporary vehicle like a 30-day time deposit, like what Sam did. I’m sure a better deal is just around the corner.

By the way, I almost forgot: if you're interested in buying the notes, you have to make up your mind soon because the deadline is tomorrow. Just contact any one of the two mentioned selling agents in the ad to subscribe.

Tuesday, June 22, 2010

4 Things You Need to Know Before You Invest Your Hard-earned Money (Part 2)

3. Your investment horizon

Time horizon, or your investment planning period, is just as important as risk and return are in making investment decisions. It varies from individual to individual and is one of the things that defines the mix of securities that you should invest in.

On the one hand, younger investors would typically have a long horizon; they would be more immune to short term fluctuations of risky investments like equities. Younger investors would also have less need for near-term income and would instead prefer to receive the fruits of their investments later in life. On the other hand, more mature investors like retirees would have a shorter horizon and would prefer less risky investments; these investors would also most probably look for investments that provide adequate periodic income like corporate bonds and other fixed-income securities.

4. Your attitude towards risk

What “kind of person” are you? Are you someone who cannot stand to go out unless you are covered by some kind of insurance policy? Are you someone who regularly buys lottery tickets? Are you a conservative poker player, waiting for at least a pocket pair of nines before you make a significant bet, or are you someone who goes all in as soon as you get flush outs on the flop? In other words, do you consider yourself risk-averse or risk-seeking?

In a previous post, we already defined investment risk as the possibility of losing money in an investment, or the possibility of earning less than what you expect. Risk-averse individuals would try to avoid this possibility as much as they can; the only way you can make a risk-averse individual take on risk is if you promise to provide “adequate” additional returns called risk premium. Risk-averse individuals would also even pay just to get out of a risky situation and get insurance, even if the insurance premium is greater than the “expected value” of the claim (the probability of getting into an accident times the value of the claim; since the probability than an individual will get into an accident is usually very small, the expected value of the claim is also usually just a small amount). Conversely, risk-seeking individuals would pay a certain amount to get into a risky situation; as long as there’s a possibility of earning big bucks, no matter how remote, these people seldom care about the very real possibility of a significant loss. For risk-seeking investors, the possibility of losing principal in investing in risky portfolios is acceptable, as long as there’s a chance of earning big rewards.

A retired investor is typically seen as a risk-averse investor since he neither has the time nor the earning power to make up for possible losses. In contrast, a younger, aggressive entrepreneur who has sufficient sources of income and many years to recoup losses may be described as risk-seeking.

Traditional financial and economic theory assumes that investors, in general, are risk averse; this assumption is the basis of the assumed positive correlation between risk and return. But when I ask my students if they think they are risk-averse or risk-seeking, quite a number of them declare with enthusiasm that they are risk seekers. Why do you think this happens? It’s because some of us often mistake risk aversion for cowardice, and interpret risk-seeking behavior as a sign of courage or (pardon my French) balls. We must remember, though, that more often than not, risk-aversion is just another form of common sense, and risk seeking is not risk taking but just a glorified and macho-fied version of being an idiot and not knowing any better.

Click here for Part 1.

Sunday, June 20, 2010

4 Things You Need to Know Before You Invest Your Hard-earned Money (Part 1)

5-year relative historical prices of BDO UITFs
Image from Bloomberg.com

1. Your investment objectives

While in general, every investor should choose an investment vehicle that provides the biggest potential return for a given level of risk, an individual’s unique, personal circumstances and preferences define a more specific investment goal that would, in turn, lead to a specific mix of securities.

Traditionally, investors choose among the following four goals:

a) Stability of income
b) Growth in current income
c) Preservation of capital
d) Capital appreciation

These goals are by no means mutually exclusive, although the natural tradeoff between risk and return makes it difficult to achieve the four goals simultaneously.

Goals (a) and (c) involve more investments in safer instruments like bank deposits, treasury securities, and corporate bonds, which feature reliable periodic income (e.g. coupon or interest payments of bonds) or strong or guaranteed principal protection (e.g. PDIC insured bank deposits), or both. Meanwhile, goals (b) and (d) require higher exposure to risky securities like common stock and speculative investment vehicles. And because both (b) and (d) involve the possibility that you’ll lose a portion of your capital, the amount of money are you able and willing to lose will define which of these two pairs of goals you would prioritize.

The choice between income (either with coupons or dividends) and capital appreciation (or capital gains) will be defined by your need for cash flows and how long you can afford to part ways with your cash. It is important to settle this issue especially if you’re planning to invest in stocks: while some stocks do pay out dividends consistently (referred to as “income” stocks and are characterized by low price-to-earnings ratio), some only rarely pay dividends (if at all) and consistently reinvest their earnings to spur growth (referred to as “growth” stocks and are characterized by high price-to-earnings ratio).

2. Your liquidity requirements

Liquidity is the ease by which an asset can be turned to cash at or near the asset’s market value: for example, a bank deposit can easily be converted to cash with an ATM withdrawal or a check issue, while it might take some time, and substantial cost, to cash in investments in real estate or personal property.

It’s important to set aside a certain amount of funds in highly liquid vehicles like savings and/or checking accounts for daily purchases and emergency expenses. The problem is that if you invest too much in traditional liquid investments like bank deposits or money market funds, you’ll lose out on the higher returns provided by less liquid investment vehicles. That is why it is often advised that individuals set aside an amount equal to six months worth of salary or expenses as an “emergency fund,” and invest additional savings in better-yielding securities.

What many of us don’t realize is that bond and stock investments are actually also pretty liquid, with the continuing popularity and growth of “markets” where these securities are actively bought and sold (the Philippine Stock Exchange or PSE for stocks, and the Philippine Dealing and Exchange Corporation or PDEX for government securities and corporate bonds).

Click here for Part 2.

Thursday, June 17, 2010

4 Reasons Why I Decided to Change the Look of the Site

1. Only "old bloggers" still use the Minima template.

With all due respect to Professor Mankiw, of course. But those old Blogger templates always make me want to jump ship to Word Press.

2. I got sucked into trying Blogger's new Template Designer.

I always try out new Google features whenever they come out, being the hardcore Google fanboi that I am. Nevertheless, I was quite impressed by the functionality, simplicity, and elegance of the new Blogger Template Designer. It's perfect for every kind of blogger out there: those who don't care too much for full customization can just choose from a number of new templates, automatically see a preview at the bottom pane, and finalize changes with a click of a button; more meticulous individuals can knock themselves out trying out an infinite number of fully-customized looks by tweaking design parameters like layout, background, and page element attributes. 

3. The Awesome Inc. Watermark Picture Window Awesome Inc. (this one's final... for now) template (the one you see now) just seemed like a perfect fit for Investor Juan.

Don't you think so?

4. Changing the look of the blog might help get me out of this writing slump.

Yes, some of you might have already noticed that I've been having trouble writing new articles since late May, either because I've been too busy with school work or because I've been going out too frequently on weekends. We're it not for Sam's questions last week, I don't know where I would have gotten the inspiration and material for June posts.

Fortunately, I think this strategy of changing the look of the blog to stimulate my thinking is starting to work. I have spent most of last night mentally planning my next few posts; I just hope that I can successfully translate these "mental plans" into actual articles in the next few days.

Wednesday, June 16, 2010

The Subprime Primer

I have promised several times in the past that I'll talk about the 2008 financial crisis in one of my posts, how it started and why I think it happened. Then I remembered that at the height of the recession, one of my colleagues sent me a Powerpoint file entitled "The Subprime Primer" a couple of years ago, a simple, stick-figure rendition of what was happening back then. As you'll see when you view the very same slideshow below, the presentation captures the highlights of the meltdown better than any explanation I can come up with. I have, in fact, used the same presentation to explain the crisis to my past classes, to some degree of success; unfortunately, more than a few were turned off by the crass metaphors and unapologetic cursing scattered throughout the presentation. But I know that you guys are above all those things, so here we go. Enjoy!

Update! June 16, 2010, 5:10 PM

Courtesy of our good friend, Ange, here's a similar and more professional (and less crass and profane) version of what happened in 2008. Enjoy!

Tuesday, June 15, 2010

Bright outlook seen for RP equities

IN THE NEWS from Inquirer.net

Image from Bloomberg.com

This article runs against most of the things I said about what can happen to the stock market in the near future; maybe the optimists among you can use this to justify holding on to your investments, or even buying additional shares. However you would want to use this article, remember that it comes from Abacus Securities Corporation, a brokerage firm that makes money from transaction fees in buying and selling stocks.

The brokerage firm cites strong economic fundamentals like the currently high consumption levels as the primary basis of the optimistic outlook. “Government consumption expenditure usually plays the dominant role during the first half of an election year, with election spending contributing the bulk of the economy’s output,” it said. “The year’s first quarter GCE figure does not disappoint on this end, growing by double digit at 18.5 percent compared to the same period in 2009.”

Abacus goes on to say that while the recovering consumption level was a “welcome development,” we should expect government spending to decline in the coming quarters. “With the absence of election spending, and as the deficit-to-GDP ratio has neared historical highs, government-funded economic stimuli may no longer be sustainable over the long-term,” it said.

Meanwhile, personal consumption expenditure returned to pre-crisis growth levels, having been boosted still by the continued growth in remittances and supported by employment generation during the quarter, Abacus added.

Wednesday, June 9, 2010

A Conversation with Sam


Note: This conversation took place while I was waiting for Al Gore’s “An Inconvenient Truth” Philippine run to start yesterday, conveniently while I was reading Robert Shiller’s “Irrational Exuberance.” So don’t be surprised if my replies seem slant ever so slightly towards the idea that stocks are currently overpriced.

I don’t know where Sam was since everything happened using text messages. All messages were translated to straight English and filtered of all traces of jejemonism. Statements in parentheses are my rants.

SAM: Sir! I need money investment advice. Where is it good to invest 1 million pesos? Equities market? Corporate bonds? Or mutual funds? I’m also okay to diversify.

INVESTOR JUAN: Hi Sam! It depends on several factors. For example, are you okay with the possibility of losing money in exchange for higher possible returns? Or do you want principal protection? How long can you afford to part ways with your money?

SAM: No! I don’t want to lose money! According to my “friend”, equities provide long-term returns of 10% per year. But that’s long term. Anyway, I think I won’t need the money for at least five more years since I still have mommy and daddy (classic Sam). I’m already talking to someone about my options (the “friend” quoted earlier), but of course I trust you more. Hahahaha. (The laughter was really there, with an unmistakable hint of sarcasm, if I might add)

INVESTOR JUAN: Sam, remember that equities are very risky. Even if you invest for ten years, there’s no guarantee that you’ll be able to keep your investment intact, much less earn 10% per year consistently. Most especially if you invest in individual stocks. But if you really want to invest in equities, you might want to try BPI’s PSEi index fund. The minimum investment is 100,000 pesos. Much better than investing in individual stocks, in my opinion.

SAM: Really? My “friend” said it’s okay: the stock market was down two years ago, but up 40% this year. Hahaha. But I can lose my principal? Hmph. I have been talking to a multinational investment house, but it was my “friend” (who evidently works for this firm) who offered the options they have.

INVESTOR JUAN: Remember Sam, you cannot be 100% sure that what happened in the past will also happen in the future. Also, what your friend said is precisely what you should look out for: the current good performance of the stock market just means that stock prices are now very high, which means it’s not really a good time to buy stocks. And I’m just saying that there’s a possibility that you’ll lose money: nothing is ever certain when it comes to these things. If your “friend” tells you there’s no such possibility, either he’s lying or he does not know what he’s talking about. :)

SAM: It’s a “trend”, according to my him (or her). He (or she) was insisting that returns are high in the long run. But he’s only been working there for six years. So you have more experience, sir. Hahahaha. (Notice the not-so-subtle jab at my age.) So you suggest I go for corporate bonds? Do you think PNOC is a secure corporation?

INVESTOR JUAN: Yes, if you don’t want to risk losing principal, I suggest corporate bonds. That’s 8 to 10% interest from 7 to 10 years; not bad, considering the relative safety of the investment. Just make sure that the issuer is trustworthy. I believe PNOC is well managed enough, but of course you still have to do your homework and do a bit more research about the company.

SAM: PNOC’s bond has a tenor of 5 years, with a coupon rate of 6.91%, net (of taxes and transaction fees, I would guess). It’s tempting; I can buy 500,000 pesos worth. Aboitiz, two years at 6% per year.

INVESTOR JUAN: Yeah, the coupons are lower because of the shorter tenors. But that’s 60,000 to 70,000 pesos per year for your 1 million, not bad at all.

Moral of the story: Be wary of the advice of someone who’s trying to sell you something.

Maybe I should start a business based on this: financial consulting and advisory services through text, only 5 pesos per message. What do you think?

Nah. Maybe some other time.
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