Guest Post: The Investment Labyrinth?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

A few weeks ago, Susan Eng, Vice President Advocacy at the Canadian Association of Retired Persons (CARP), asked me to write an article on investing.

At first I hesitated. I simply do not believe a “once size fits all” approach to investing. Moreover, I am a risk-taker and my risk profile is certainly not the same as most investors out there. I can stomach huge swings in volatility because when I have conviction on a trade, I remain focused and ride out the storm.

I have already written some investment comments like Boy Plunger’s Pivotal Point Theory and in January, I wrote an extensive comment on Outlook 2009: Post-Deleveraging Blues?

I want to follow-up here and give you my approach to investing my money. I typically start by looking at the big picture. Last week I wrote comments on the “W” recovery and followed up by asking whether inflation is inevitable.

I like to constantly read on what are the big secular trends and have broken them down to the following key themes:

  • Inflation/ deflation
  • Alternative energy (solar, wind, nuclear)
  • Chindia (China & India)
  • Demographics (healthcare, biotech, etc.)
  • New technologies (nanotech, etc.)

You might ask why I think thematically. When I was investing with the top hedge funds, I noticed the best ones were not only great stock pickers, but they also typically related their stock picks to broader themes. In other words, they combined a bottom-up approach with a top-down approach.

I still like to track what hedge funds are buying and selling because they have strong incentives to outperform. Remember, unlike a mutual fund manager, a hedge fund manager does not get paid if they do not perform.

This does not guarantee they will not make mistakes. Most hedge funds are poor performers in down markets and that’s why most got clobbered in 2008. Still, I like to spy on the top hedge funds to gain some insight into what they are buying and selling.

The other investors I like to spy on are people like Bill Miller of Legg Mason. Mr. Miller beat the S&P 500 for many years because he wasn’t afraid to take concentrated bets in sectors. He too got clobbered in 2008 but at least he invests with conviction which is more than I can say for the majority of mutual fund managers who charge fees and under-perform index funds.

Importantly, when selecting a fund manager, ask tough questions on fees and do not place too much emphasis on one year performance. Even the best fund managers can have a bad year and conversely, the worst ones can have a good year.

Again, Legg Mason is an excellent example. They got clobbered last year but if you understand their style – taking more concentrated bets to outperform the index – then you understand why they lost money in a year where everything blew up.

In a comment I wrote back in October, looking beyond the 2008 stock market crash, I wrote that I track the following funds from MFFAIS website (data is lagged but fairly recent):

AQR Capital Management

Atticus Capital

Bridgewater Associates

Caxton Associates

Citadel LP

Clarium Capital Management

Farallon Capital Management

Greenlight Capital Inc

Golden Tree Asset Management

Goldman Sachs Group

Hussman Strategic Growth Fund

Legg Mason

Letko Brosseau and Associates

Kingdon Capital Management

Maverick Capital

Quantum Capital Management

Spinnaker Capital LP

Sprott Asset Management

Tiger Global Management

Viking Global Investors LP

[Note: John Hussman of Hussman funds writes an excellent weekly market comment on the web which you should all be reading.]

Another good source of information on what hedge funds are buying and selling is Seeking Alpha’s comments on hedge fund activity.

The reason I track what some of the better known hedge funds and mutual funds are buying and selling is that I learned long ago to ignore what most analysts think and to pay attention to what the big funds are buying and selling.

It is important to remember that the stock market is its own beast. One of the most humbling experiences of my life was trading to make a living on my own. I would spend the whole day looking at how prices swung from opening bell to the closing bell.

I learned about gaps and filling the gaps before a stock would move higher. I paid attention to the highs, lows and closing prices of the day and of the week. I also paid attention to unusual swings in volume which could signal accumulation was going on.

For the most part, I keep my technical analysis simple. I like to see stocks moving above their 50 and 200 day moving averages, but I often buy stocks in sectors that got pummeled where I feel there is a long-term secular trend (for example, solar stocks make up most of my long-term holdings. When they got decimated, I doubled down and bought as much as I possibly could).

I also use technicals to see if this is another sucker’s rally or the start of a great new bull market. Looking at the 50 day and 200-day moving averages of the Dow Jones, I see that we are at a point where we might break out higher or break down lower. In other words, there might be more follow through after this Q2 rally which I have been calling for or there might be another “sell in May and go away” ending to this latest rally.

I don’t know the future, but I am better prepared to deal with it. For those of you who swing trade, there are ways to make money in down markets by buying Proshares ETFs or Direxion ETFs. In Canada, it ‘s called Horizon Betapro ETFs.

[Note: Hedge funds love to play these leveraged ETFs, but most investors should avoid them because they will lose their shirts. Moreover, these products need tighter standards for disclosure].

So what are the most important things to remember about your personal portfolio? I would tell you that secular trends can last for a long, long time. We have come off a long secular bull market for financials and I believe that it will be followed by a long secular bear market that could last a decade or longer.

I know that banks rallied sharply from the March 9th lows, but I consider this a strong technical rally, not the beginning of a secular upswing. I just do not see what will propel banks higher in the coming years. Leverage has been cut, securitization, private equity and real estate are in the doldrums, trading profits are down and the only thing banks have to survive is the spread they have on borrowing at a low interest rate and lending at prime rate.

There are other sectors of the economy that should do well. Tech inventories have been slashed to bear bones so expect tech companies to come out strong on any signs of a global recovery (just buy Nasdaq index shares like QQQs).

As far as a global recovery goes, keep an eye on shipping stocks like DryShip (DRYS), Eagle Bulk Shipping (EGLE) and Excel Maritime (EXM). A pick-up in global trade will first be seen in these stocks.

If deflation sets in, you need to have a strong allocation to government bonds to weather the storm. Even a low yield is better than a negative yield when dealing with the ravages of deflation.
If inflation picks up, you’ll see gold shares being bid up. Keep an eye on spot gold prices over the next few years to see if inflation expectations are shifting.

I end this comment on the investment labyrinth with another article by Luc Vallée that appeared in the Financial Post over the weekend, Broker model needs repair:

There are segments of the financial industry that can be easily and immediately reformed. On the heels of recent investment scandals, it is pressing to review the business model of the retail fund manager.

As it stands today, the model stifles competition, favours large firms and leads to pricing abuse, low-quality information and substandard services. Most people I have talked to are not satisfied with their brokers, nor with their exorbitant fees. Yet, most clients won’t switch for lack of a better alternative.

Who can blame them? Switching to a possibly better broker often means transaction fees, headaches due to interrupted service and running a higher risk of being the victim of a fraud. Here are the facts:

-Most money managers do not beat the markets. The median money manager’s performance is well below that of an indexed portfolio. In other words, after fees, the average broker loses money when compared with a market index.

-It is more difficult to choose a money manager based on his knowledge and performance than it is to choose a stock portfolio. Indeed, most money managers rely on other people you don’t even know and whose performance is unknown in order to manage your money.

-By charging you 1% annually to manage your money, a large portion of your wealth ends up in his or her pocket.

Let me elaborate on the third point: Assume that a balanced portfolio will yield annually a 5% nominal return for the foreseeable future. After 15 years, if you reinvest your 5% return every year, without the help of a broker, the value of your portfolio will have slightly more than doubled. If, instead, you pay your broker 1% of your assets, your annual return will be 4% and it will take you 3½ more years to reach the same performance. And remember you still have to pay your broker even if you lose money.

How do you know if your broker is of the good variety? As the investment process of most brokers is a total black box, its outcome should be considered pure luck.

One way to solve the problem is to force the separation of fund management and “custodian” services. You grant your broker the permission to make the investment decisions in your portfolio but never allow him or her to touch your money sitting at the custodian of your choice.

Granting “custodian” status to a few large institutions and providing a government guarantee against fraud in exchange for regulation of the custodian industry would provide investors with many benefits. First, you would sleep at night knowing that you won’t be the victim of the next Bernard Madoff. Second, you could change your broker at will since all ancillary services, such as money transfers to your regular bank account, paying taxes and so on, could be performed by the custodian for a minimal fee.

Competition in the brokerage business would then increase dramatically, which would, in turn, help to lower prices. Fees would probably migrate from a percentage of assets under management to a structure based on a fixed fee for each service that you would purchase. The quality and diversity of services would also improve as tax strategy and estate-planning services would probably be the kind of value-added services that would attract investors to a brokerage firm.

Finally, information about the quality of the brokers would increase and be more widely available.

I couldn’t agree more. We need more competition, better disclosure and better enforcement on existing products to protect retail investors from sharks peddling snake oil.

Only then will the investment labyrinth be a little easier to navigate through.

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  1. JO

    Hi Leo, good write up. I work in financial services for many years and on the front lines as a compliance officer. I have to say you hit the nail on the head.

    The vast majority of mutual fund investors need to scrutinize managers more closely. As you know in Canada, the fees related to MF are bizarre. These fund companies need to be held more accountable for the information they produce and investment results they generate (or fail to generate is more apt in most cases). I am bothered at times by the slick marketing pieces they come out with convincing retail investors the stock market is the best place always for long term investors, buy and hold it will come back,etc..and fee/MER disclosure is lacking.

    As for index funds, I like them. I am planning to buy some index ETF as part of core holdings if and when SP500 hits 400’s as I expect within 12-18 mts…but i can’t shake the concerns about counter party risk in most of these products. I would appreciate your opinion on what risks investors face (counter party risks) in the QQQQ/SPY, etc if we go into a more intense systemic meltdown that takes out the likes of BofA, C, and many others in 2010-2011.

    Good post as always.

  2. Aki_Izayoi

    I think the securities markets are largely zero-sum games. The commodity and Forex markets are obviously zero-sum, but also the stock market and bond market if your count opportunity cost. The way one outperforms in the securities markets is if they have an information edge over other market partcipants. Also, having lower discount rates (i.e. a longer time horizon) would help too.

    I do not see why everyone whould have a right to a money manager that beats the market. Doesn’t asset management have a zero-sum component to it. Not everyone can hae an asset manager that outperforms the market.

    It is much more humane to accept social democracy and much higher taxes to fund pensions than try to rationalize social Darwinism through “personal responsibility,” “choice,” “freedom” or whatever bullshit the neoliberals put out. Those people are easy prey for competent hedge fund managers and speculators who do have an information edge and have the superior capacity to bear risk. Giving people the choice to pick investments, mutual funds, etc. when they do not know what the “Gordon model” is, will lead to disaster.

  3. carol765

    Leo, some question:

    – “Most hedge funds are poor performers in down markets and that’s why most got clobbered din 2008.”

    But why would that be?
    Hedge funds are free to invest as they wish, right? So, in contrast to a mutual fund manager who is bound to be say 96% invested, a hedge fund manager can go cash, or go short. If hedge funds had sold their equities and bond holdings, had gone short, or bought Treasuries or had stayed in cash, they would have done pretty well last year. E.g. hedge fund Paulson had betted heavily on defaults in mortgages and shorted many banks and made huge profits a.o. with CDS on Lehman.

    – You mention Bill Miller as potentially a good one to follow.

    As I mentioned last week in cooment regarding the Mark Patterson statements:
    Yves introduced him as an unexpected source.
    Well not really as Patterson appears to have heavily shorted last 8 weeks rally. So he needs banks to fail (the quotes from Patterson have been withdraw without any explanation by the author Ambrose EP).

    Bill Miller in an interview with Bloomberg was highly critical of statements by Meredith Whitney: his fund has heavily invested in US banks! Please be aware of investemnt capture.

    – You do not mention that the equities market seems to be rigged. A lot of insider trading (last week some insurance companies rallied the day before taxpayers’ largesse was announced) and ‘leaked’ emails (remember Pandit’s we made tons of money borrowing cheap and lending high email). Goldman Sachs being the ‘Single Liquidity Provider’ for NYSE. Bernanke refusing to tell how the trillions dollars have been spent. Etc. (for all clarity: i am not a conspiracy believer; just read some worried traders accounts, and notice strange spikes).
    How can one sincerely invest for the longer term in a rigged (or guided by powerful hands) system?

  4. NickJenkins

    The way you invest fits in well with my “the power of small” way of thinking. You have to pay attention to the macro trends, but even more important is the little details. If you can see the trees for the forest, it doesn’t matter so much whether the market as a whole is up or down.

  5. Aki_Izayoi

    Fine John Paulson made a lot of money by buying credit default swaps on BBB rated securities. So, Paulson gave his clients in the credit opportunities fund wealth.

    Did John Paulson create any wealth? Or did he merely find an opportunity to transfer wealth from people who bought the synthetic CDOs (essentially people who bought fixed-income instruments that had some of their coupons funded from the premium that Paulson paid from the credit default swaps) to his fund? Paulson did a good job enriching his clients. However, could every hedge fund manager achieve the same success for their clients.

    Essential, “talent” in the hedge fund industry is basically people with information asymmetries that could exploit unsophisticated mutual fund managers, retail investors, and horrible traders for their own gain. John Paulson, to me, is one example of the social Darwinist and zero-sum aspect of “investing.” Some exceptions such as venture capital and producers using futures markets to offset risk do exist as possible counterexamples. But for the most part, the securities market is mostly comprised of zero-sum transactions.

  6. juan


    it’s not all so difficult for an investor to create his/her own ‘hedge fund’ with the unequally combined use of inverse index funds such as those from Rydex or Profunds, long positions in different markets and cash. [i would though stay away from the 2x and 3x leveraged funds]

    imo, there’s been way too much attention paid to finding some ‘magic formula’ when the whole process is, or can be, quite simple and also handily beat benchmark indices.

    i’d say that leo’s emphasis on themes, on combined top down/bottom up is very good advice and would add that a good dose of skepticism and patience can also play a part.

  7. Leo Kolivakis


    Hedge funds have more degrees of freedom than mutual funds because they can short stocks. The problem is that most hedge fund managers in long/short equity hedge funds are closet long-only guys and gals who came from the mutual fund industry and were attracted by the big performance fees of hedge funds.

    The truth is that shorting stocks is not easy, especially in a bull market (it was easy last year which is why short sellers made a killing).

    Very few long/short equity managers can produce alpha both on the long side and on the short side.

    Is trading a zero sum game? It depends, there are managers who consistently rank among the top decile but they are extremely rare.

    Let’s be honest. It’s hard to always be right about where markets are heading. This is why I like using a combined approach, understanding macro risks, and then combine it with technical and fundamental analysis of a stock and a stock sector.

    I learned a lot by losing a lot of money. I am not ashamed to say that I did stupid things in the past like play earnings using out of the money options which was just pure gambling.

    The way I think markets are heading, I am going to go in and out and try to pick my spots. I let my profits run and I try to limit my losses.

    However, when markets really tanked, I took advantage to load up on solar stocks because I like the secular story behind the sector.

    As far as banks, Bill Miller made money, but I was not courageous (or smart) enough to trade them. Looking back, I should have understood the game is rigged and tilted towards the banksters. My mistake was also not to understand that the spread was in favor of banks.

    But I am not a big fan of banks. Some are better than others but I still think they are hiding a few more cockroaches.

    The purpose of this comment was also to tell you that small is beautiful. I use my knowledge of hedge funds, pension funds and mutual funds to my advantage.

    I hope you do too, which is why I want to share some of my thoughts with you.

    This was an incomplete post but I do not want to inundate you with every single thing I look at.



  8. Leo Kolivakis


    Just to correct a little mistake. hedge funds have 2 more degrees of freedom than muttual funds: they can short AND they can leverage their portfolios.

    Of course, more leverage means more volatility.

    Also note that most hedge funds are long small caps, short large caps.



  9. zak822

    “protect retail investors”? Why would the management class do that, and risk smaller bonus’s? Same with competition. Why compete, when you can partner on the down low and keep everyone making their bonus?

    It would be unnatural. The management class will not, can not, work for the best interests of the investor because it’s not in the managers best interests to do so.

    That is one of the most important and least discussed aspects of the current crisis. Sure, it gets a bit of chatter from time to time, but the misaligned motives are slowly slipping under the radar.

  10. carol765


    My comments re hedge funds were triggered by what you said:
    You: "Most hedge funds are poor performers in down markets …., I like to spy on the top hedge funds to gain some insight …"

    I tried to convey that hedge funds could have done OK, also in last years down market, if they had gone to cash or treasuries or shorts, i.e. if they had seen this coming (reading this blog and others). Apparently, most of them did not see this coming…. so why pay attention to their 'insights'?!
    Please be careful!

    Also, re my rhetorical question about investing for the long term (as opposed to intra-day trading) in a system that appears to be rigged:
    I just came across this link at zerohedge:
    (underneath frontrunning 19 Mai)

    "Something strange happened during the last 7 or 8 weeks — there was a power underneath the market that kept holding it up and trading the futures. I watch the futures every day and every tick, and a tremendous amount of volume came in a several points during the last few weeks, when the market was just about ready to break and shot right up again. Usually toward the end of the day – it happened a week ago Friday, at 7 minutes to 4 o’clock, almost 100,000 S&P futures contracts were traded, and then in the last 5 minutes, up to 4 o’clock, another 100,000 contracts were traded, and lifted the Dow from being down 18 to up over 44 or 50 points in 7 minutes. That is 10 to 20 billion dollars to be able to move the market in such a way. Who has that kind of money to move this market?

    On top of that, the market has rallied up during the stress test uncertainty and moved the bank stocks up, and the bank stocks issues secondary – they issues stock – they raised capital into this rally. It was perfect text book setup of controlling the markets – now that the stock has been issued…” "

    Perhaps better not to be part of it.

  11. Aki_Izayoi

    I do not know if “investing” can be profitable for everyone. I suppose one mutual fund might be long a stock and another hedge fund is short that stock. They both cannot make money at the same time. I though the market was zero-sum.

    Of course, if the trade is crowded, where both the hedge and mutual fund are long… it would fall if it unwinds.

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