“A rising tide lifts all boats”—that is the best way to begin this edition of The Thoughtful Arbitrageur, as we explore the uses and misuses of the beta coefficient. Commonly referred to as beta, this statistic measures systematic risk. Put more simply, beta measures a security’s correlation to the general market.
To review, going back to our B-school days, a stock with a beta of 1 will move directly and equally with market fluctuations. Therefore, if the market is up 10%, we should expect a 10% return from this asset. By extension, a security with a beta of 0 is perfectly uncorrelated to the market and a -1 beta implies that a security should move in an equally opposite direction to the overall market. Since beta also measures magnitude, a security’s beta can be much greater than 1 or -1 depending on how dramatic its movements are relative to the market averages.
Other logical caveats when applying this tool are that securities that trade in different markets are not comparable because their correlations will be different. A security that moves at a +1 to the Bovespa for instance, might have a .25 versus the S&P. Another conundrum is that a high beta stock may be less risky than one with a lower beta. While generally high beta implies greater volatility, a security with a low beta may be highly subject to risk, as its ultimate standard deviation may be much greater.
Put another way, the high standard deviation implies a stock with a much more aggressive profile away from general securities movements. An example of this may be a biotech company awaiting an FDA approval. Its beta may be close to 1 for a period of time, yet may ultimately move wildly when approval time nears. This deviation is categorized as alpha and explains an equity’s unsystematic variations, or those not explained by the market.
Managers who capture alpha in a low-risk fashion are, of course, highly sought-after since they should over time outperform their peers. Along with other measurements such as Sharpe ratios and variance modeling, investors attempt to predict fund performance, and therein lays the rub. An investor simply cannot rely on a statistical black box. There are too many cautionary tales warning against these systems. In fact, one must clearly understand what comprises a securities beta or any measure of fund performance. These are just some of the cautions when applying beta, a topic we will definitely be visiting again.
Perhaps our use of and attraction to beta comes from the fact that it is relatively easy to understand. Going back to our high school algebra days, we are simply correlating two sets of variables, one tracking an asset and the other the overall market. In fact, our brain is wired to decipher information in this configuration. We constantly compare sets of events to mentally adapt to new situations. Human beings will readily try a gelato because it looks and is served just like ice cream. We associate eating ice cream with joyful and satisfying experiences. Thus, our correlating brain signals a cause and response. In this case, it is reaffirmed when we taste that delicious gelato. However, that type of thinking can fool us at times. Like a mouse that gets caught in a trap by reaching for the alluring aroma of a piece of cheese.
More germane to the subject, is the complaint that many money managers are “beta chasers.” Asset management is a tough job—if it was easy, the rewards would not be so great. Fund executives learn early on that performance that matches an index is much more tolerated than performance that lags an index. This holds true even if the latter eventually produces better long-term returns. Since we live in a world that demands constant response to clientele, many managers overtly, or subliminally, chase beta. Ironically, it is that pursuit that sometimes leads to underperformance. With that said, here are some of the important considerations when applying the beta coefficient:
Beta is in the eye of the beholder
One can find many variations of a security’s beta, it all depends on where you look. For example, the beta you find in Value Line may vary from one reported on Yahoo Finance. Nonetheless, if you are using beta in a serious fashion, you had better start with an understanding of what you are dealing with. Some services use weekly prices, other use daily. There are variations in the time frame a service considers, and then there is the more pressing concern, what your asset is being compared to. Is the S&P representative or would the Nasdaq 100 be more suitable? At least a baseball manager who relies on a player’s batting average knows that in the abstract that .300 means 3 hits out of 10 at bats. With beta, the foul lines may change on every pitch.
Managers need to create their own versions of beta and constantly retest their assumptions. It all starts with these basic questions: Are the prices I am looking at representative? Is the sample large enough? How accurate is the sample? What are the correct benchmarks? A fund that invests in large liquid industrial companies will give a more accurate picture of beta than one where prices are more subjective, such as in private equity. A larger sample is almost always better than a smaller one. Applying these types of disciplines, one sees the caution of investing in assets with a brief, or unreliable, however stellar return.
Yet another issue is what I call the “dog walking the owner syndrome.” This is where an equity or group of equities becomes such a large part of an index, that it overwhelms the performance. At that point it begs the question, “is the market affecting my investment or is it the other way around?” These matters require a great deal of insight and repeated appraisal, and to ignore them would be foolish.
Finding the proper benchmark looms large when viewing beta. An investor needs to continually test his sample versus different indices. In this way, the manager learns just what drives performance. The chairperson of Pepsi may be more interested in her performance relative to Coca Cola, than the Russell 2000. That information, though painstakingly derived, proves invaluable.
Beware of special situations
Investors treat stocks differently at various stages of the life cycle of a company. A recent IPO may react in a contrary fashion to a well-established company. There are also different investor behaviors in a penny stock when compared to one with a $500 handle. The same company, in this case, displays different reaction to the markets depending on factors absent the fundamentals.
More crucial are special situations such as M&A, spinoffs or the potential of a securities addition or subtraction from a particular index. Not factoring in these possibilities can cause the beta watcher a great deal of angst. This argument can be logically followed by the admonition that man does not live by fundamental analysis alone. To discount external or special situations can render statistical examinations meaningless.
Low Beta may mask risk
As we mentioned earlier, a beta below 1 may be a function of a company that tracks the market in a less varying fashion, yet still has the potential for outsized returns. This is due to its unsystematic or security specific risk. Professionals, as well as the weekend investor, need to be vigilant for risks that are indigenous to a particular well-loved stock. The “Tylenol Scare” that affected the share price of Johnson & Johnson comes to mind. Until that point, JNJ was viewed as a typical “widows and orphans” stock. The vulnerability of a staple product like Tylenol, in such an unusual fashion, greatly disturbed the investing and general public. Some may argue that this type of risk is unknowable; however, that is exactly what “Black Swans” are made of. The astute investor considers the entire range of possibilities. I remember hearing a famous chief executive relaying that it was “monsters unforeseen” that kept him awake at night. In this case, a bit of paranoia is a good thing.
Lastly, the most significant reflection should be on the projection of an equity’s future beta coefficient. Smart business people understand that the past, while it may be prologue, can be nothing more than yesterday’s weather report. When assessing an investment’s potential, where it fits in one’s definition of the beta continuum is essential.
For now, we will stop here. However, beta, Sharpe ratios and other types of arithmetic based measurements will be a recurring theme, since they clearly drive markets and our ability to decide.
A brief follow-up on our Real Estate piece
We received many comments on our recent piece on Real Estate. Given how central it is to the global asset base, it does not surprise us. In fact, in the last few days there have been reports that signal lower real estate prices. One in particular from Zillow offers a dramatic reassessment of downside in the housing market. Until the entire foreclosure crisis is solved, this may continue to be the case.
Another topic mentioned was our comment of more real property ultimately finding itself in the hands of REITS or Trusts. Again, we caution that our views take into account a macro assessment. What happens in places like Manhattan or Beverly Hills is not particularly indicative. This vision is more based on what goes on in the many counties that make up the backbone of the United States. The fact is that less of a real estate burden to these folks means a more comfortable overall lifestyle. This is especially so given a declining real estate market.
The “Tara effect” was our view that many of the Baby Boom generation were influenced in their desire for “bigger and better” by popular media. Popular culture in the form of movies like “Gone with the Wind” or television shows such as “Dallas” or “Dynasty” inspired a desire for the grand entrance. These stories implied that “success and smarts” are directly equal to square footage. In fairness to “GWTW”, it is truly an American classic. Still “Tara” deserves as much onscreen credit as Vivien Leigh. In fact, look at how many of our homes are of the “Center Hall Colonial” fashion. The National Association of Builders should pay the creators of “GWTW” a royalty for every Colonial sold. The sober reality is that you cannot appreciate the upkeep and commitment through a television screen.
Encouragingly, it seems that the millennial generation may be displaying an opposite feeling toward this type of conspicuous consumption, and this may be a good thing. According to a recent New York Times article, “As Young Lose Interest in Cars, G.M. Turns to MTV for Help”, General Motors executives are dealing with the fact that most young people do not care about automobiles as much as generations past. Their ambivalence can be summed up in the following quote: “They think of a car as a giant bummer. Think about your dashboard. It’s filled with nothing but bad news.”
The piece also provided empirical evidence backing these claims. It seems that a generation that values material goods such as fancy cars and expensive housing as less important, is an inspiring sign. We well know how these “toys” can literally sap our asset base and wear us out mindlessly. Considering what our economy is currently going through, impulsive consumption seems akin to puffing away on tobacco, given what we know now about the health risks. Quite possibly, in an inadvertent way, we have taught our offspring a valuable lesson that may significantly affect future spending—”all that glitter is not necessarily gold.”
Until the next time…. The Thoughtful Arbitrageur.
Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.
In many ways, Wednesday’s House Financial Services subcommittee hearing on the eighth largest bankruptcy in US history was as much about what was not said than what was said.
Much attention was focused on MF Global assistant treasurer Edith O’Brien and her widely anticipated move of declining to answer questions during the hearing. Ms O’Brien has been at the center of questions surrounding her role in questionable money transfers of nearly $1 billion during the final days of MF Global’s existence. Speculation is Ms O’Brien received instructions from top officers at MF Global to transfer the money, a charge which has been denied by the executives, who generally claim either to not be aware of “where the money went” or claim they did not provide specific instructions to dip into customer segregated funds. A handful of money transfers were sent to the likes of JP Morgan and related MF Global overseas brokerage units in the final days of the firm’s existence. The staggering size of the money transfers makes it impossible for such transfers to have occurred without dipping into customer segregated funds, as the reported $1.6 billion “missing” from MF Global far exceeds the company’s net worth at the time.
While O’Brien was up-front about not answering questions, the remaining panelists might have just taken “the fifth” because their responses often didn’t answer questions.
In a contest for the most absurd answer of the hearing, MF Global chief financial officer Henri Steenkamp may be the winner. When asked about the historic money transfers in the final week of existence, Mr. Steenkamp claimed he was unaware of fund transfers due to his “global role” and he was engaged in “other serious matters” that apparently took his attention away from the draining of $1.6 billion in assets from the firm.
While the transfers were initially painted by quotes in news reports as due to “chaos” and implications were made that money vanished due to clerical errors, questions remain as to how $1.6 billion in cash – an amount in excess of MF Global’s total liquidation value at the time – could have escaped the notice of top executives. In fact, testimony highlighted how the bankruptcy trustee clearly identified October 26 as the date the segregated funds short fall was officially identified, while in testimony Mr. Steenkamp claimed learning of the transfers several days later.
“The height of absurdity is thinking that $1.6 billion simply vanished without the CFO’s knowledge,” noted Stanley Haar, who runs a managed futures hedge fund and has been a leader in bringing the MF Global issue to the attention of Congress.
When asked an obvious question regarding the role of creditor’s bankruptcy trustee Louis Freeh and his stated motivation to deliver assets to creditors as opposed to customers, Steenkamp answered with “I’m not an expert in bankruptcy.” Mr. Freeh is effectively Mr. Steenkamp’s employer and has authorized bonuses be paid to MF Global executives such as Steenkamp who have remained at the firm while it is being liquidated.
If Mr. Steenkamp was consistent in one area, it was avoidance of questions – and this drew the ire of Committee Chairman Randy Neugebauer, who flatly questioned Mr. Steenkamp’s honesty. At one point Congressmen queried Mr. Steenkamp regarding relatively arcane details of his college life, which he remembered. Then the Congressman proceeded in asking why the CFO of a financial firm couldn’t remember details regarding what were likely the most significant money transfers in MF Global’s 224 year history.
Ferber Confirms Investigators Finally Questioning Top Executives
While MF Global chief legal officer Laurie Ferber was generally evasive, one interesting piece of information to emerge is that investigators are beginning to question the firm’s top executives. Unlike MF Global’s back office, which had been questioned by executives early in the process, Ms. Ferber acknowledged that she will be questioned for the first time in April – close to six months after the fact. Mr. Steenkamp confirmed that he has not spoken to investigators, although his lawyers have answered questions. MF Global’s chief financial officer for North America, Christine Serwinski, who worked in the Chicago back office, confirmed in testimony she had been previously questioned twice by investigators. “I’m shocked,” said Congressman William Posey, speaking of the fact investigators have not interviewed MF Global’s top executives until long after the potential crime had occurred.
Ferber also made statements confirming that Mr. Corzine was involved in MF Global’s questionable money transfers to JP Morgan and she acknowledged she was responsible for compliance and disclosure to regulators. One issue in the MF Global case is that proper disclosure of segregated account balances was not made to regulators during the final week of the firm’s life.
Finger Pointing to Steenkamp, Serwinski, O’Brien
During a rare moment of candor, at one point Mr Steenkamp was asked who would have authority over money transfers and he apparently pointed a finger at Ms Serwinski, who proceeded to point the finger at an absent Ms. O’Brien. When Ms Serwinski was asked if she would have approved the wire transfer in question had she been in the office, she said she would not have approved the transfer.
Committee Treats JP Morgan to Soft Questions
Among other panelists was JP Morgan, which played a number of reported conflicting roles as MF Global’s primary lender, provided clearing services and was custodian of certain MF Global customer funds. Questions that might point more specifically to JP Morgan’s intimate knowledge that such money transfers took place from customer funds were left alone in the testimony.
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Mark Melin is author of three books, including HIgh Performance Managed Futures.He taught managed futures at Northwestern University in Chicago and has consulted for a variety of futures exchanges, hedge funds and professional traders. He can be reached at: markhmelin(at)yahoo.com
Contents Copyright (C) 2012 Mark H. Melin all rights reserved.
Under the Securities Act of 1933, the U.S. Securities and Exchange Commission allows companies to offer securities for sale without having to register those securities or file periodic reports, provided the companies meet exemptions laid out in Regulation D. For hedge funds’ purposes, those securities are limited partnerships. When a hedge fund firm sells its first securities, it is required by Reg D to file a Form D, which includes names and addresses of the company’s executive officers and stock promoters and the date of the first sale in the offering. As such, Form D filings can be a useful tool to find new hedge fund launches.
Not content with Yahoo!’s proposal to add one of its four nominees to the company’s board of directors, hedge fund Third Point LLC is moving ahead with a proxy fight. The intent is to get Third Point’s Chief Executive, Daniel S. Loeb, and three other nominees onto Yahoo!’s board.
On Monday, Yahoo! named three independent directors to the board, and proposed that one of Loeb’s four nominees, Harry Wilson, join one other mutually-acceptable person on the board. That didn’t sit well with Loeb. On Wednesday (March 28) Loeb and Third Point sent a letter to Yahoo! saying, in essence, “It’s On.”
Consider this letter the first step in Loeb’s stated strategy of taking the campaign straight to shareholders. Here’s the letter, which Third Point released via PRNewswire. Follow the rest of the fun here.
Mr. Scott Thompson
Chief Executive Officer
Yahoo! Inc.
701 First Avenue
Sunnyvale, CA 94089
March 28, 2012
Dear Scott:
As we discussed, Third Point LLC (”Third Point”), Yahoo!’s largest outside shareholder, was disappointed that you and the Board of Directors did not agree to the reasonable compromise we proposed regarding nominees to the Board.
We were pleased that the Board acknowledged that Harry Wilson would be a valuable Director. However, the way you treated our other nominees confirmed Third Point’s fear that the Board’s evaluation of our candidates would make a mockery of good principles of corporate governance. You will hear more on that from us in the future.
Our view of the nomination process is further reinforced by your explanation on Sunday as to why I would not be an acceptable Director. You told me that the Board felt my experience and knowledge “would not be additive to the Board” and that as Yahoo!’s largest outside shareholder, I would be “conflicted” as a Director.
Am I conflicted to advocate for the interests of other shareholders because we are owners of 5.8% (over $1 billion) of Yahoo! shares (unlike the non-retiring and proposed board members who have never purchased a single share of Yahoo! except for subsidized shares issued through option exercises and shares “paid” by the Company in lieu of fees)? Only in an illogical Alice-in-Wonderland world would a shareholder be deemed to be conflicted from representing the interests of other shareholders because he is, well, a shareholder too. This sentiment further confirms that Yahoo!’s approach to Board representation is “shareholders not welcome”.
When asked to explain this apparent “conflict”, you theorized that as a large shareholder, Third Point’s interest might be focused only on the short-term. This theory appears, seemingly like many of the Board’s conclusions, to have been arrived at by whimsy and emotion. I have never been asked about this alleged short-term bias nor was there any evidence to indicate that our investment model is predicated on short-term trading. On the contrary, a review of our record would indicate that we frequently hold positions for many years at a time (we have held our current position in Delphi Automotive since June 2008 and we held our Dade Behring position for nearly half a decade before it was sold to Siemens in 2007, as just two examples of many long-term investments). In any event, this “long-term vs. short-term” excuse is a canard and particularly inapt in the case of Yahoo!. If there ever was a company in need of a sense of urgency, it is this one.
Was it “short-term” thinking that led Third Point to push for the resignations of Jerry Yang, Roy Bostock, Arthur Kern and Vyomesh Joshi? If so, is there a Yahoo! shareholder on the planet who thinks this “short-term” thinking was bad for the Company? Was it “short-term” thinking that led Third Point to speak up for shareholders by questioning the fairness of the attempt by the Company to give away control to private equity funds – without receiving a premium – to entrench Roy Bostock and Jerry Yang? Or to suggest, as Third Point has, that the Company’s stake in Alibaba is more valuable than generally understood, and that the Company should hold on to it unless it can get fair value? Was it “short-term” thinking to point out the lack of media and advertising expertise on the Board and nominate extraordinarily qualified nominees to fill that gaping hole?
To the contrary, an unbiased observer might find Third Point’s thinking quite “additive”. Third Point has been a driving force standing up for shareholders since we disclosed our position in Company shares in September. In fact, the Company’s own actions are inconsistent with your assertions, since Yahoo! has adopted many of our recommendations.
At the risk of beating a dead horse, we suppose that, by the Board’s analysis, it would have been this dreaded “short-term” thinking to have allowed Microsoft’s $31 per share offer four years ago to be presented to shareholders.(1) The real issue is not short-term versus long-term but about Board representatives who have skin in the game and will exercise sound business judgment.
By seeking four seats, Third Point does not look to control the Board, and any individual voice in the room would be only one of 11 or 12. If one director has too “short-term” an approach for other members, a healthy debate will ensue and all directors as a group will decide the issue in a fully informed and deliberative manner. It is absurd to assert a “conflict” that would render a Board Member unqualified based either on ownership or a sense of urgency to repair a company that has been – by your own admission – languishing for years.
We remain willing to engage further with you but will not deviate from our demand for badly-needed shareholder representation.
Sincerely,
Daniel S. Loeb
Chief Executive Officer
Third Point LLC
cc: Yahoo! Board of Directors
(1) See Bloomberg article, September 12, 2008: “Yahoo! Inc. will generate a five-year stock return that shows it was right to reject Microsoft Corp.’s $47.5 billion offer, co-founder David Filo said. `’Five years from now, we’ll be in a much stronger position,’ said Filo, who with Chief Executive Officer Jerry Yang failed to negotiate a higher price. ‘There’s a lot of value here.’”
Is it capital? Creative thinking? Brilliant investment strategies? Or something else entirely?
While all of those things are important to every hedge fund manager, there might be one thing they need more: a strong community.
“Whether they’re aspiring or successful hedge fund managers, I think we all need a network and a community, such as 100WHF, to learn from each other and share ideas, no matter what stage your business is in,” Mary Beth Hamilton, the Marketing Chair for 100 Women in Hedge Funds Boston Conference, told StreetID.
“100WHF is a community of like-minded individuals,” adds Amanda Pullinger, the Executive Director of 100 Women in Hedge Funds. “I think to some extent we created a safe haven for people who were dealing with volatility in many, many different ways. Some of our biggest growth years as an organization came during these difficult times. I think that’s a testament that we really are providing something that people in the location didn’t have before.”
Hamilton said that hedge funds tend to be “somewhat fragmented, where there are a lot of smaller or medium-sized firms.”
“What we have in groups like 100 Women in Hedge Funds is a chance to come together and learn from each other,” Hamilton explained. “We put on educational events that perhaps wouldn’t happen within the structure of a hedge fund firm itself.”
“And it’s a community locally, but increasingly our members are traveling from one location to another, and are able to join 100 Women in Hedge Funds events and meet up with other members,” Pullinger continued. “We have an online web site called target=”_blank”>100 Women in Hedge Funds Connect. And we really encourage people to search the database there and look for people in a location they’re traveling to. It’s a place where you know you’re going to walk into the event and it’s going to be an interesting topic, there are going to be interesting people, and you’re not going to waste your time by going.”
Supporting the Cause
100 Women in Hedge Funds wasn’t born out of nothing. There were several generous women who are responsible for helping the organization become what it is today.
“When we first started the organization, we were completely volunteers,” said Pullinger. “But very quickly we realized that we needed to set up some legal structures and some governing processes, so the founding board of the organization needed to be developed so we could have some structure around what we were doing from a legal standpoint. But at the time we weren’t charging for events. We weren’t charging an access fee or a membership due. But we needed certain costs met in terms of setting up these legal structures and the web site costs and things.”
This inspired 100 Women in Hedge Funds organizers to reach out to its most senior members in what Pullinger refers to as an “experiment.”
“They really came through for us,” Pullinger boasted. “We asked if our senior members could donate $1,000 each. We could use that money to really take the organization to the next level and set up a legal structure and have some cushion in terms of the end-of-the-line costs of the organization, which were very small at the time.”
100 Women in Hedge Funds ultimately received donations from roughly 60 women, each of which provided the organization with $1,000. “We called them our Charter Angels, the notion being that they are angel investors in 100 Women in Hedge Funds,” Pullinger explained. “And Charter Angels have a very special place in 100 Women in Hedge Funds. They are kind of revered by the organization because they really did give back at a time when we needed their financial support.”
Due to the success of the Charter Angels program, Pullinger said that 100 Women in Hedge Funds decided to develop the Sustaining Angels program. “These are angels that give in any particular calendar year $1,000 or more,” said Pullinger, adding that the donations help the organization ensure its financial sustainability as it grows globally. “We’ve been able to build … not a large infrastructure—it’s basically myself and I have two part-time employees that are the paid components of 100 Women in Hedge Funds. It’s not like we’ve built a huge staff. But we have enough resources financially now that we can do things that we need to do when we need to do them. That’s the angels. And we’re continually seeing new senior practitioners that want to sign up as angels.”
This content originally appeared on StreetID, a financial career networking, matchmaking and news site. To learn more about StreetID, visit StreetID.com. StreetID’s financial career news can be found on its blog, streetid.com/newsblog/.
Janet Tavakoli, president of Tavakoli Structured Finance Inc., spoke with Lauren Lyster on her “Capital Account” program about too-big-to-fail banks, the financial oligarchy and how MF Global fits into the web of derivatives-inspired meth lab of shadow liquidity and off-balance sheet risk.
MF Global “sort of epitomizes a lot of the issues that occurred that led to our financial crisis,” Tavakoli says. “The fact that this can happen after the financial crisis, after Dodd-Frank, after Sarbanes-Oxley, just shows you how lax and hypocritical we’re being in the United States about financial regulation … and the world is watching.”
Under the Securities Act of 1933, the U.S. Securities and Exchange Commission allows companies to offer securities for sale without having to register those securities or file periodic reports, provided the companies meet exemptions laid out in Regulation D. For hedge funds’ purposes, those securities are limited partnerships. When a hedge fund firm sells its first securities, it is required by Reg D to file a Form D, which includes names and addresses of the company’s executive officers and stock promoters and the date of the first sale in the offering. As such, Form D filings can be a useful tool to find new hedge fund launches.
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