Friday, September 11, 2009

Fancy Universities Are Bad At Financial-Market Math

Two posts ago, in one entitled "Do Economists See The Light About Their Crappy Math. I explained that Benoit Mandelbrot's (image above) work with fractals would suit them better.

Today in the WSJ there is a pretty extensive article (reprinted in its entirety below) about Harvard's loses in particular last year...nearly $10B. But Yale too lost big bucks from their endowment along with Harvard because of (1) market turmoil, (2) asset classes became (and remain) correlated with one another (3) some asset classes evaporated all together (4) both institutions (especially Harvard used too much leverage, sometimes even borrowing so as to remain 105% invested in often illiquid elements and (4)they both failed to protect against their catastrophic risks. Columbia which has a much smaller endowment (~=$5.5B) than either giants mentioned above lost about 16% which they claim was all about earlier, more active and more conservative risk management. Incredibly enough, Cooper Union, the tuition-free (if you can get in!) college down here in Greenwich Village says it actually managed to break even.

Now here comes the part that is filled with delicious irony. I believe that Benoit Manelbrot will eventually win a Nobel Prize either for Physics or for Economics and maybe for both; his work in these two fields has been more than seminal it has been a breakthrough.

Now these two schools might claim that they aren't familiar with Mandelbrot's work and advice which, if followed might have avoided $$$billions in losses. Yale shed only half as much as Harvard, but their endowment is only half the size so what's the big surprise in that?

Or they may say that they didn't read his book because it wasn't available soon enough. "The (Mis) Behavior of Markets--A Fractal View of Risk, Ruin and Reward" was published, for God's sake, in 2004. Their academics, students and administration must at least be partly interested in this stuff.

Maybe they couldn't locate him? That's hard to believe because he once taught at Harvard and until he retired in 2005, he was a tenured, endowed-chair mathematics professor at Yale.

So why did these schools put their constituents (thousands, including whole towns) at risk? Why didn't they phone up Benoit and ask him for his opinion about their portfolios? He might have taken up a deep-digging project bro bono for them and analyzed their market situations from a fractal-math perspective. Why didn't they ask Benoit? This is inexplicable to me, except for one obvious reason...hubris.

Money managers often get so confident that they don't listen to any others...not even Benoit Mandelbrot. The shame here as I see it is that innocent folks and even whole towns can get crushed by this behavior. If you don't believe me, just swim across the river from Cambridge and you won't see a pretty site at all.

Here's the article:

Harvard, Yale Are Big Losers in 'The Game' of Investing Yahoo! Buzz By JOHN HECHINGER It's a tie in the Harvard-Yale investment game. Both schools were thrown for colossal losses. The universities on Thursday said their endowments, higher education's two largest, each lost 30% of their value in the year ended June 30. Combined, the pair of investment pools shrank by a staggering $17.8 billion. Declines in the endowments have forced the two schools to cut budgets and delay plans to expand facilities and hire staff, as even the country's top colleges are being forced by the financial crisis to retrench. The pain is being felt widely across higher education. While many private colleges are getting less help from their endowments, public universities are suffering because of state budget cuts. Harvard University and Yale University, such fierce rivals that their fall football contest is known to both sides simply as "The Game," badly trailed the results of the typical college in the latest year. The dismal returns have exposed weaknesses in their exotic approach to investing, which after turning in chart-topping performance for years has proved to be highly risky. The schools were hurt by investments in assets that can't readily be sold, such as private-equity partnerships, which were pummeled in the past year after stellar results over the previous decade. In the category Harvard calls "real assets," including timber, commodities and real estate, annual losses neared 40%. Harvard was already budgeting for a 30% decline, but hadn't released a final tally. On Thursday, it said its endowment shrank to $26 billion on June 30 from $36.9 billion a year before. The decline also reflects spending from the endowment and donations. The Cambridge, Mass., university's investment loss itself was 27%, dwarfing the 18% drop in the median return for large endowments calculated by Wilshire Associates, an investment consulting firm. Yale said its endowment fell to $16 billion on June 30 from $22.9 billion a year before. The New Haven, Conn., university didn't break out its investment results. Yale had projected a drop of only 25% and Thursday warned of further budget cuts. In a letter to Yale faculty and staff, Richard Levin, the school's president, and Peter Salovey, its provost, said it now projects an annual deficit of $150 million each year from 2010-11 through 2013-14. Last winter, Yale cut staff and nonsalary expenses by 7.5% for the 2009-10 academic year and signaled it would ask for further cuts in nonsalary expenses of 5% for 2010-11. On Thursday, the university said it would ask for the 5% cut this year instead. The administrators pledged to preserve financial aid, but said otherwise "no area of expenditure will be immune from close scrutiny." Messrs. Levin and Salovey said most major construction would be halted until donor support could be found or financial markets recovered. They said Yale would also slow the pace of faculty recruitment. Facing a cash crunch last fall, Harvard has laid off staff, suspended some faculty searches and delayed a major expansion of its campus. Other wealthy schools, including Stanford University, Princeton University and Massachusetts Institute of Technology, have predicted losses similar to Harvard and Yale's. They all follow an investment model that de-emphasizes traditional stocks and bonds and instead loads up on alternatives unavailable to the average investor. Yale and Harvard pioneered the approach, arguing they could afford to take big risks, because they were investing for decades, even centuries. Many copied the schools, saying they had found a high-return, low-risk strategy. But Eric Bailey, managing principal of CapTrust Financial Advisors LLC, a Tampa, Fla., firm that advises college endowments, says, "If it looks too good to be true, it probably is." Mr. Bailey says typical colleges outperformed Harvard last year, because they stuck to a plain-vanilla approach, typically allocating 60% of their holdings to stocks and 40% to bonds. That strategy would have generated a loss of roughly 13% in the year ended June 30. Harvard aims to have only 4% of its investments in U.S. bonds, which were one of the few safe havens over the last year. It has cut by more than half its target for investments in U.S. bonds since 2005. The University of Pennsylvania's endowment, by contrast, loaded up on Treasury securities in 2008 and reported a more moderate 15.7% decline. In New York City, Cooper Union for the Advancement of Science and Art, which charges no tuition, ratcheted down the risk of its investment portfolio three years ago and expects its endowment to hold steady for the year. Yale and Harvard say their long-term results justify the strategy. Harvard's endowment remains the largest in higher education. In fact, the $10.9 billion it lost last year is bigger than the 2008 value of the endowments of all but six colleges. In Thursday's report, Jane Mendillo, Harvard's endowment manager, noted that Harvard achieved an average annual return of 8.9% over 10 years, three times its peers' -- adding $18 billion in value over what would have been earned by a 60%-stock, 40%-bond portfolio. Ms. Mendillo said the school is better off than it would have been if it had "pursued a more conservative investment strategy over the longer term." In Thursday's report, Harvard said its private-equity funds, which generally represent about 13% of its endowment model, fell almost 32%. Its real-asset segment, representing nearly a quarter of the endowment, lost 38%. Investments in "absolute return" hedge funds, designed to generate positive results in good times and bad, instead posted a 19% loss. The report showed Harvard trimmed its endowment's risk profile by raising cash, cutting by $3 billion its future commitments to invest in private-equity and other investment funds, and reducing its real-asset category to 23% from 26% of its model portfolio. Harvard also said the school now aims to hold 2% of its assets in cash. Previously, it targeted a negative-5% cash position, reflecting its use of borrowed money to expand its investments. Ms. Mendillo said endowment managers had learned to better reflect "the risk tolerance of the university." Ms. Mendillo pledged to manage more of the school's money in-house, giving it readier access to securities to sell for cash. Currently, 70% is farmed out to outside managers. That move could focus more attention on its managers' multimillion-dollar paychecks, which have provoked controversy on campus. Ms. Mendillo said "a substantial number of portfolio managers" had portions of their bonuses, awarded for past years, "clawed back" into the endowment because of poor performance. Harvard and Yale, like other schools, also signed contracts that committed them to huge future investments in private-equity and other funds at exactly the time they could ill afford them. In Thursday's report, Ms. Mendillo said Harvard cut its "uncalled capital commitments" to $8 billion from $11 billion.

Wednesday, September 9, 2009

Has It All Really Come To All This

The following was submitted by my friend (one of the last ones) Tim W. who received it anonymously.

Some time this year, we taxpayers may again receive an Economic Stimulus payment. This is a very exciting program. I'll explain it using the Q and A format:

Q. What is an Economic Stimulus payment?

A. It is money that the federal government will send to taxpayers.

Q. Where will the government get this money?
A. From taxpayers.

Q. So the government is giving me back my own money?
A. Only a smidgen.

Q. What is the purpose of this payment?
A. The plan is for you to use the money to purchase a high-definition TV set, thus stimulating the economy.

Q. But isn't that stimulating the economy of China ?
A. Shut up.

Below is some helpful advice on how to best help the US economy by spending your stimulus check wisely:

• If you spend the stimulus money at Wal-Mart, the money will go to China

• If you spend it on gasoline, your money will go to the Arabs.

• If you purchase a computer, it will go to India.

• If you purchase fruit and vegetables, it will go to Mexico, Honduras and Guatemala .

• If you buy a car, it will go to Japan or Korea.

• If you purchase useless stuff, it will go to Taiwan.

• If you pay your credit cards off, or buy stock, it will go to management bonuses and they will hide it offshore.

Instead, keep the money in America by:

1 spending it at yard sales, or

2 going to ball games, or

3 spending it on prostitutes, or

4 beer or

5 tattoos.

(These are the only American businesses still operating in the US .)


Go to a ball game with a tattooed prostitute that you met at a yard sale and drink beer all day.

Tuesday, September 8, 2009

Economists Finally See The Light About Their Crappy Math

I am totally sorry that the text below is unformatted, but you can thank the WSJ for that. In order for me to report the full story, you would have to pay for a subscription so I grabbed it on my Blackberry for you.

Here is the gist. On January 22,2009 in an article entitled "Who Knows What Is Going To Happen To The Economy?" I questioned the math that all the idiots have used to predict financial futures. Here's the nugget: Nobel Prize winner Markowitz thirty years ago entirely absorbed the Gaussian curve...and that's what won him the (dubious) prize. Yet as I wrote on February 25, 2009, "Why I Hate Economists," I explained that their math was horrific and I pointed you to Mr. Mandelbrot's work which I have studied extensively.

Finally, on May 4, 2009 I displayed that Buffett and Munger had disdain for all this "high-order math." In another installment I will display my utter distaste for Mr. Buffett's achievements and intellectual capacity but that will have to wait. In the meantime, please read the junk that follows, courtesy of my Blackberry.


John A.

SEPTEMBER 8, 2009 Some Funds Stop Grading on the Curve Yahoo! Buzz By ELEANOR LAISE Last year, a typical investment portfolio of 60% stocks and 40% bonds lost roughly a fifth of its value. Standard portfolio-construction tools assume that will happen only once every 111 years. With once-in-a-century floods seemingly occurring every few years, financial-services firms ranging from J.P. Morgan Chase & Co. to MSCI Inc.'s MSCI Barra are concocting new ways to protect investors from such steep losses. The shift comes from increasing recognition that conventional assumptions about market behavior are off the mark, substantially underestimating risk. Mark Brewer Though mathematicians and many investors have long known market behavior isn't a pretty picture, standard portfolio construction assumes returns fall along a tidy, bell-curve-shaped distribution. With that approach, a 5% or 6% stock-market return would fall toward the fat middle of the curve, indicating it happens fairly often, while a 2008-type decline would fall near the skinny left tail, indicating its rarity. Recent history would suggest such meltdowns aren't so rare. In a little more than two decades, investors have been buffeted by the 1987 market crash, the implosion of hedge fund Long-Term Capital Management, the bursting of the tech-stock bubble and other crises. Investors using standard asset-allocation approaches have been hammered. Last year, all their supposedly diversified investments plummeted in unison. In short, the underlying assumptions failed. "We got blindsided by some developments that weren't accounted for by the models we were using," says Clark McKinley, a spokesman for the giant pension fund California Public Employees' Retirement System, or Calpers. As a result, the fund is looking at incorporating an extreme-events model into its risk-management approach. Many of Wall Street's new tools assume market returns fall along a "fat-tailed" distribution, where, say, last year's nearly 40% stock-market decline would be more common than previously thought. Fat-tailed distributions are nothing new. Mathematician Benoit Mandelbrot recognized their relevance to finance in the 1960s. But they were never widely used in portfolio-building tools, partly because the math was so unwieldy. Morningstar's Ibbotson Associates unit in recent months built fat-tailed assumptions into its Monte Carlo simulations, which estimate the odds of reaching retirement financial goals. More than nine million individual retirement-plan participants have access to Ibbotson's Monte Carlo tool. The new assumptions present a far different picture of risk. Consider the 60% stock, 40% bond portfolio that fell about 20% last year. Under the fat-tailed distribution now used in Ibbotson's tool, that should occur once every 40 years, not once every 111 years as assumed under a bell-curve-type distribution. (The last year as bad as 2008 was 1931.) Insulation from extreme market events doesn't come cheap. Allianz SE's Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds. "You're spending some of your upside to buy the insurance" against catastrophic losses, says Vineer Bhansali, a Pimco managing director. Among the Pimco products applying the hedges are target-date funds, aimed at retirement savers. The firm plans to launch more funds that employ the approach in the next few years, Mr. Bhansali says. Another potential pitfall: Number-crunchers have a smaller supply of historical observations to construct models focused on rare events. "Data are intrinsically sparse," says Lisa Goldberg, executive director of analytic initiatives at MSCI Barra. Even so, the firm this year offered pension plans and other large clients a beta, or prerelease, version of its new risk-management model, which seeks to account for more extreme market events. The company plans to include the model in risk-management products to be released next year. As Wall Street relies on ever-more-complex mathematical models to manage money, a new breed of uber-wonks is gaining influence. Pimco's Mr. Bhansali, for example, holds a doctorate in theoretical particle physics from Harvard University and runs 50-mile to 100-mile super-marathons. And MSCI's Ms. Goldberg, an inventor of the firm's credit-risk and extreme-risk models, is also a professor at the University of California, Berkeley and has a penchant for the "beautiful mathematical subject" of extreme value statistics. The fat-tailed assumptions sometimes lead to quite conservative portfolios that cushion investors on the downside but also sharply curtail the upside. Smart Portfolios LLC last year launched the Aston Dynamic Allocation Fund, which uses fat-tailed distributions and other complex formulas to assume more-frequent occurrence of market shocks. In the 12 months ending Sept. 4, the fund is down 0.5%, compared with a 16% decline for the Standard & Poor's 500-stock index, thanks to hefty allocations to Treasurys and cash. But as markets have rallied in the past three months, it has risen only 4%, compared with 8% for the S&P. In times of upheaval, "we don't sit there and take it like a man. We run for the hills," says Bryce James, the firm's president. Many of the new tools also limit the role of conventional risk measures. Standard deviation, proposed as a risk measure by Nobel Prize-winning economist Harry Markowitz in the 1950s, can be used to gauge how much an investment's returns vary over time. But it is equally affected by upside and downside moves, whereas many investors fear losses much more than they value gains. And it doesn't fully gauge risk in a fat-tailed world. A newer measure that gained prominence in recent decades ignores potential gains and looks at downside risk. That measure, called "value at risk," might tell you that you have a 5% chance of losing 3% or more in a single day, but doesn't home in on the worst downside scenarios. To focus on extreme risk, many firms have begun using a measure called "conditional value at risk," which is the expected portfolio loss when value at risk has been breached. In other words, if value at risk says you have a 5% chance of losing 3% or more in a single day, but you have lost 4% before lunch, conditional value at risk helps estimate your expected loss on this very bad day. Firms such as J.P. Morgan and MSCI Barra are employing the measure. Pimco's Mr. Bhansali is unimpressed. Since it is so difficult to forecast extreme events, investors should focus on their potential consequences rather than the probability they will occur, Mr. Bhansali says. As for comprehensive measures of risk, he says, "they fail you in many cases when you need them the most." Write to Eleanor Laise at

Diogenes Redux

I think that I have finally found an honest politician (man.) David Walker is profiled in a WSJ interview with John Fund, entitled "The Deficits Are Coming." Previously Mr. Walker was a top executive at Arthur Anderson and most recently, he spent 10 years running the General Accounting Office (GAO) which is widely considered to be exempt from the oxymoron phrase, "competent government agency."

Mr. Walker performed wonderfully at GAO but he left his term five years years early, because I suspect that he was fed up with all the nonsense.

The interview is too articulate and profound for me to adequately paraphrase it so if you are at all interested in a very well-reasoned, plausible view for our financial future, I strongly recommend that you devour it.


John A.

Thursday, September 3, 2009

Thinking About Eating

I have never before seen something like this. Okay, you can accost me for living in fancy neighborhoods and under relatively privileged circumstances, but remember, I have been in and around Manhattan (arguably the richest large city on Earth) since I was 18, and that was a LONG time ago.

The other morning, on my way to Penn Station, in a hurry to catch the 7:14 train to Princeton Junction to (I hoped) finalize the major oral surgery that has plagued me for more than a decade, I saw a huge phalanx gathered outside Saint Francis of Assisi Church on 31st Street just east of 7th Avenue. I ordinarily take the subway but early in the morning and/or when running late I optimize my cab ride by having the driver drop me off at "31 and 7." This usually takes less than 10 minutes from my place at Broadway and 11th Street and I have taken this route at least 100 times throughout the years.

So back to the long line waiting at the church. My first presumption was that all these, relatively well-dressed people were waiting to attend early-morning Mass. But this seemed strange since I had never witnessed it before. And the crowd was definitely not your usual street mongers, who often look like rejects from a leper colony. My curiosity was intense, so risking missing my train, I asked a well-dressed gentleman why such a large group (hundreds) was congregating this particular morning. I was expecting any answer other than the one I heard from him. "Sandwiches" he said. "Sandwiches." For Christ's sake, this was a genuine food line with more than a hundred patrons, right in Manhattan's mid-section. Let me remind you that a giant bagel with butter costs a whopping $1.17 at Zaro's in Penn Station across the street. I went and boarded my train, but I promised myself that on my return trip, I would investigate further, which I did.

I returned to the church at about 2PM, with my left cheek swollen like a pumpkin from the implant surgery, which incidentally, probably cost more than it takes to feed these people for a month (no insurance applies on this.) I spoke with the bookstore manager who explained that St. Francis operates chronologically the longest-running breadline...since the city. He admitted that many patrons are mental patients, but they sure didn't look that way to me...I didn't see a single shopping cart loaded with myriad belongings and I did indeed espy some very well-dressed people. The manager confessed that "yes, there are some people with $400 Brooks Brothers suits" and that the line has grown four-fold during the past year. Apparently, St. Francis now serves 300-500 people per day. And there is another place, further uptown that provides lunch. Yet another, even further uptown that handles supper.

To conclude this chapter, I am seriously considering not only donating my money to this endeavor but also my time. Candidly, I was absolutely shocked by my observations.

No great lesson can exist without extrapolation. If our government, our President, our economists want to proclaim wonderful economic victories, we can let them try to convince us, but not without having them stand and beg for food in New York; and yes, despite my previous naivete, I now realize that there are profoundly large (and growing?) food lines in New York, and if so, most likely everywhere else. The people standing in these queues are not indigent slackers; they are just hungry. To put this into perspective, New York can be the most expensive place on Earth to eat (Le Cirque) or it can be extremely cheap. This morning, I just bought a bialy with a fried egg on it for less than $2. I can get a totally loaded falafel pita for less than $4 and I won't suffer a nutritional breakdown on that...besides, I don't require many calories. If you think that I have gone totally nuts, please read the recent pieces about people waiting in places all over the country for food handouts...I don't even need to provide links...these stories are all over the place.

But our country is suffering economic meltdown and nutritional stress. Let the obstreperous BS politicians from Washington step aside and join me at 31st and 7th, with very decent people, and then we can calibrate how well this country is doing. Pretty crappy is my assessment...wait in line for an hour for what Zaro's will give you for $1.17...that's a pretty low minimum wage.

Boy am I hot about this one.