Poverty, SWFs and Oil

An article from The Economist raises the issue of which countries with SWFs also have large numbers of people living below or near the poverty line. 

ECONOMISTS Abhijit Banerjee and Esther Duflo describe the results of a number of household surveys they carried out in developing countries in their new book “Poor Economics”. Their data allow comparisons of the full distribution of consumption per person in a number of developing countries, in addition to the more commonly available figures on the fraction of people living on less than $2 a day. In some of these countries, many of those who consume enough to ensure they do not count as “poor” are in fact only a bit better off than those who do. Nearly 80% of the 30.6% of Bangladeshis who consume more than $2 a day in fact consume only between $2 and $4 a day—still very little indeed. A little bit of bad luck—a single bad harvest, for example—may be all it takes to send them back to living below the poverty line.

Here are same countries showing their SWF status (data from the SWF Institute or fund websites) and an indication of each country's oil production (noting of course that SWFs also arise from non-oil wealth):

Country	SWF status	Oil Production bbl/day
India	None	878,700
Ghana	New SWF March 2011	7,081
Pakistan	None	59,140
Bangladesh	None	5,733
Tanzania	None	No oil
Timor-Leste	US$7.7 billion ($7,600 per capita)	96,270
Cote d'Ivoire	None	58,950
Indonesia	US$0.3 billion ($1 per capita)	1,023,000
Morocco	None	4,053
Nicaragua	None	No oil
Guatemala	None	13,530
Papua New Guinea	None	35,090
Mexico	None	3,001,000
Peru	None	148,000
Brazil	$8.6 billion ($45 per capita)	2,572,000
Ecuador	None	485,700
South Africa	None	191,000
Panama	None	2

If you add them up, these countries between them produce just short of 10% of the world's oil. Because oil is a non-renewable resource it can be viewed as the property of both current and future generations.  Only Timor-Leste amongst The Economist's list of poor nations seems to be taking serious steps towards viewing oil as an intergenerational resource.  Then again, its people are still living in poverty.  But so are those in countries that have far greater petroleum wealth. 

How should we define a Sovereign Wealth Fund?

This question is posed by the SWF Institute in a recent post.  The Institute offers the following definition:

A Sovereign Wealth Fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets. These assets can include: balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports. Sovereign Wealth Funds can be structured as a fund, pool, or corporation. The definition of sovereign wealth fund exclude, among other things, foreign currency reserve assets held by monetary authorities for the traditional balance of payments or monetary policy purposes, state-owned enterprises (SOEs) in the traditional sense, government-employee pension funds, or assets managed for the benefit of individuals.
Some funds also invest indirectly in domestic state-owned enterprises. In addition, they tend to prefer returns over liquidity, thus they have a higher risk tolerance than traditional foreign exchange reserves.

This definition raises some issues.  First, are these funds necesssarily "state-owned", i.e. by national governments?  The SWF Project, in a recent article, Who is the King of SWFs?, identifies a number of qualifying funds at the individual state level.  Further, is an SWF defined by the nature of its target investments, in this case restricting SWFs to those that own financial assets and financial instruments (though generously including real estate under that umbrella and leaving infrastructure somewhat out of the picture). 

In the search for a brief definition most sources, including the definition above, feel the need for some explanatory material, such as what types of assets should be excluded, e.g. central bank reserves.  Is is possible to find a better definition?  Unsurprisingly, the experts have been working on the subject.

Wikipedia offers the following definition:

A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments.

The Santiago Principles provides a fairly general definition,

Sovereign wealth funds (SWFs) are special purpose investment funds or arrangements that are owned by the general government.

The European Central Bank, in its Occasional Paper No 91, July 2008, suggests:

Sovereign wealth funds (SWFs) [are] broadly defined as public investment agencies which manage part of the (foreign) assets of national states.

Although there exists no commonly accepted definition of SWFs, three elements can be identified that are common to such funds: First, SWFs are state-owned. Second, SWFs have no or only very limited explicit liabilities and, third, SWFs are managed separately from official foreign exchange reserves.

The International Monetary Fund, which has an interest in ascertaining what pools of money exist and who controls them in the context of international financial management and balances of payments, keeps to the definition in the Santiago principles:

SWFs are defined as a special purpose investment fund or arrangement, owned by the general government. Created by the general government for macroeconomic purposes, SWFs hold, manage, or administer financial assets to achieve financial objectives, and employ a set of investment strategies which include investing in foreign financial assets.  SWFs are commonly established out of balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports.

And what is this 'general government' whereof the IMF speaks?  The European Central Bank provides this definition:

A sector defined in the ESA 95 as comprising resident entities that are engaged primarily in the production of non-market goods and services intended for individual and collective consumption and/or in the redistribution of national income and wealth. Included are central, regional and local government authorities as well as social security funds. Excluded are government-owned entities that conduct commercial operations, such as public enterprises.

So, there we are.  While there seems to be a focus on the assets and mentions of purposes, none of the definitions seems to capture the idea that sovereign wealth funds have beneficiaries.

The Sovereign Investor therefore offers its tuppenceworth with this definition:

A Sovereign Wealth Fund is a special purpose fund or arrangement set aside from official foreign exchange reserves and maintained by a central, regional or local government authority, whereby funds are invested at least partially in international assets over the longer term for the benefit of current or future generations. 

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UK Pensions Industry disapproves of IFRS accounting proposals

From Global Pensions

Just a quarter of the UK pensions industry supports plans to make all schemes compliant with International Financial Reporting Standards, a poll shows.

A poll - conducted by Deloitte - revealed 75% of trustees, administrators and accountants did not support the Accounting Standards Board's plans to classify pension schemes as ‘publicly accountable' entities to comply with IFRS.

The poll of 80 respondents also showed a further 43% said pension schemes' financial reporting requirements did not need changing at all.

Deloitte audit partner Sue Barratt said: "We are surprised that all pension schemes are being proposed as publicly accountable entities, given that there are many small schemes with few members.
"It is doubtful whether such schemes hold assets for a ‘broad group of outsiders', which is part of the ASB's definition of ‘publicly accountable'."

Under the proposals, pension schemes would be classified as tier 1 in the ASB tier structure, putting them on par with a listed company in their accounting requirements.

The survey also found 29% thought accounting standards needed changing, with 28% saying they were unsure.

A concern expressed by many respondents was that the potential administrative burden and expense of changing existing frameworks may not lead to a greater understanding of pension scheme accounts by members.

Barratt added: "While the ASB has indicated minimal changes in reporting by pension schemes, examples from other countries that have adopted the equivalent IFRSs for pension scheme accounts have led to significant, additional disclosures in financial statements.

"Considering this, there is likely to be more debate as to which accounting standards would be most relevant for pension schemes, in advance of the ASB's consultation period closing on 30 April."

Sovereign Investor:   The great majority of UK trustees, administrators and accountants believes that managing money on behalf of others does not make them publicly accountable.  It seems worth exploring the possible reasons why, because the same principles may apply - in a more general way - to sovereign funds.

The Chartered Accountants in Canada have this definition of 'publicly accountable':

A publicly accountable enterprise is an entity, other than a not-for-profit organization, or a government or other entity in the public sector, that:

• has issued, or is in the process of issuing, debt or equity instruments that are, or will be, outstanding and traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or  

• holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. 

In the United Kingdom, the definition provided by the Financial Reporting Council is very similar:

An entity has public accountability if:

• (a) at its reporting date, its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over‐the‐counter market, including local or regional markets); or
• (b) as one of its primary businesses, it holds assets in a fiduciary capacity for a broad group of outsiders and/or is a deposit taking entity for a broad group of outsiders. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks.

In both cases, the holding of assets in a fiduciary capacity for a group of outsiders is expressly included in the definition of public accountability, and so it ought to be.  The Sovereign Investor wonders, then, whether the trustees have a problem with IFRS per se or, whether having taken hold of their members' money, they regard the funds as somehow being their own property, at least for the time being.


They wouldn't understand more comprehensive reporting, anyway

The argument that more comprehensive reporting may not be understood by members is an old chestnut.  In many countries sovereign funds hold assets on behalf of people who may not even be literate, and this should make them more accountable, if anything.  The fact that not everyone is financially literate merely provides an excuse for the trustees and their colleagues to try and avoid accountability to those members, other stakeholders and industry commentators, who do understand these matters.  In finance, as we know and was proved during the GFC, the devil is always in the details. 

Yes, IFRS reporting can be bulky.  It's just as well that in December 2010 the International Accounting Standards Board issued a Practice Statement about having a management commentary.  The Practice Statement provides a broad, non-binding framework for the presentation of management commentary that relates to financial statements prepared in accordance with IFRS.

Management commentary is a narrative report that provides a context within which to interpret the financial position, financial performance and cash flows of an entity. It also provides management with an opportunity to explain its objectives and its strategies for achieving those objectives. Management commentary encompasses reporting that jurisdictions may describe as management’s discussion and analysis (MD&A), operating and financial review (OFR), or management’s report.

We don't have to understand the technicalities of air bags, advanced braking systems and other safety features before being allowed to drive our cars.  The Sovereign Investor would, however, like to think that its ignorance on these matters shouldn't be used as an excuse by car manufacturers to avoid accountability to the relevant authorities for compliance at a technical level with safety standards.

Linaburg-Maduell Transparency Index Ratings - Q1Y2011

For the record.  

 

(Click for full sized image)

For more information on the Linaberg-Maduell Index, see the SWF Institute.

Proxy firms move to centre stage

From the Financial Times

Annual meeting season is in full swing on both sides of the Atlantic. This year, a new player is being dragged onstage to perform alongside traditional characters such as the generously-paid-off former executive and the lone campaigning investor. The proxy adviser’s moment is here.

Proxy firms’ reluctant move from their behind-the-scenes role has two causes.

In the US, it stems from reaction to the first annual meetings to be subject to advisory “say on pay” votes. As shareholders have persuaded some companies to change pay policies and voted against the remuneration reports of a handful who were not listening hard enough, attention has shifted to the firms such as ISS and Glass Lewis & Co which advise institutional investors how to vote.

In Europe, meanwhile, regulators have started looking at proxy firms because institutional shareholders are becoming more dependent on them. This reliance comes as investors must respond to criticism that they were too dozy during the financial crisis, while managing widely diversified portfolios: Norges Bank Investment Management, the Norwegian state fund manager, has holdings in more than 8,000 companies, for example.

Sovereign Investor: Only the beginning of the FT's article on proxy voting companies has been reproduced here.  Email ftsales.support@ft.com to buy additional rights or use this link to reference the original FT article - http://www.ft.com/cms/s/0/976fd594-6e89-11e0-a13b-00144feabdc0.html#ixzz1KVhxoMSZ

The primary issue with transparent sovereign funds, and Norway is an example, is that the funds' voting records may be published.  Relying on proxy advisors is a useful administrative measure for sovereign investors, but efforts would seem to be justified in understanding the published policies of the proxy advisors (see, for example, the ISS policies) to be sure that stakeholders understand the reasons for the voting record.  Note that these policies, again looking to ISS for example, are subject to an annual consultation process and perhaps those institutions who rely on proxy voting companies should consider advising stakeholders to participate in that process.  

Reflecting on Ghana's new Sovereign Funds

By Ashby Monk, from Oxford SWF Project

Back in March, Ghana’s Parliament passed the Petroleum Revenue Management Act, formally creating two new Ghanaian sovereign funds: the Ghana Heritage Fund and the Ghana Stabilization Fund. I’ve finally had the time to read the Act in its entirety, and I found it rather interesting. Given Ghana’s consistent high scores for good governance, you won’t be surprised to learn that the Act has many of the ‘best principles’ of design and governance. Still, there were a few aspects of the Act that have caused controversy. But before I get into that, let me catch you up.

As their names imply, the Stabilization Fund will help smooth petroleum revenues, while the Heritage Fund will be an inter-generational savings fund. The Minister of Finance will be responsible for overall management of the funds, but the Central Bank will be responsible for the day-to-day operations. If this setup sounds familiar, it’s because this is pretty much a carbon copy of the Norwegian design: the NBIM manages the money (Central Bank) and the GPF-G has oversight for policy (Ministry of Finance).

In Ghana’s case, the Central Bank will be constrained in its investment options. Basically, the new SWFs can only invest the assets in investment grade fixed income securities (although the Act does offer quite a bit more detail as to what that actually means). This reminds me of the approach adopted by Timor-Leste, which decided to start slow (with fixed income) and diversify over time (which it is doing now). It’s a sensible way to go about things, as top notch institutional investors do not emerge overnight.

And yet, while the Act is quite sophisticated and solid, it has not been without controversy. For example, there is a provision that allows the government to borrow against the oil assets in the funds. That’s not something I would have included because it reduces the disciplining effect the funds should have on politicians’ spending habits. In short, while the Act does a good job of defining what the fiscal rules are for fund contributions and withdrawals, the ability to borrow unconstrained money (even if it is backed by a highly constrained, rule-bound SWF) undermines the power of the SWF’s rules and governance practices.

In addition, many were against the Heritage Fund, on the grounds that the country faces serious developmental challenges that require capital investment today. And it’s a fair point. I’ve noted before that (setting aside capacity constraints and Dutch Disease) there is a very good case to spend the money on domestic infrastructure with lasting economic benefits for developing countries.

Whatever the case, all credit to Ghana for taking some initial steps to prevent the resource curse. But there are many more steps to come. Next up on the agenda: implementation and operation.

Sovereign Investor:  It is interesting to compare the new Ghana Act with the equivalent law in Timor-Leste, on which the Ghana Act appears to have drawn heavily.  Both provide strong division of duties between the investment policy role (Ghana's Advisory Committee and Timor-Leste's Investment Advisory Board), the overall management (Ministry of Finance), and the operational management (central bank).  This structure has the effect of removing (as far as possible) political influence in both the setting of the investment policy (by the Advisory Board) and the implementation of the investment objectives (by the central bank).  Both laws have transparency as a fundamental principle.  Both countries have a committee (Ghana - Accountability Committee; Timor-Leste - Consultative Council) that assists parliament and the population monitor compliance with the relevant laws.  Both countries require the detailed publication of who has paid into the fund - Ghana requires quarterly publication, Timor-Leste requires the information to be published annually.  There are a number of other parallels too. 

By adopting robust governance structures and transparency, both countries appear committed to avoiding the inevitable risks associated with a large fund being solely and opaquely under the influence of a single person or ministry, and have instead adopted a system of institutional checks and balances at the highest level as an effective means of overall governance.  

The Characteristics of Factor Portfolios

From MSCI Factor and Risk Modelling Insights

Research from MSCI's Jose Menchero was recently published in The Journal of Performance Measurement. This paper provides an intuitive foundation for understanding and interpreting factor models. It shows every factor can be represented by a factor-mimicking portfolio, whose return exactly replicates the payoff to the factor. Pure factors provide a way of placing surgical bets and disentangling the often confounding effects of multi-collinearity. Read this paper.

Abstract:

 A key to deeper understanding of factor models lies in the concept of factor-mimicking portfolios, whose returns exactly replicate the payoffs to the factors. Factor-mimicking portfolios can be used to generate real-time factor returns and in principle could serve as the basis for exchange traded funds for capturing passive alpha or hedging risk. Simple factor portfolios are obtained by considering each factor in isolation, whereas pure factor portfolios are constructed by treating all factors jointly. In this paper, we derive the holdings of simple factor portfolios for the World factor, as well as for countries, industries, and styles. We also discuss the characteristics of pure factor portfolios and how differences between simple and pure factor portfolios arise due to collinearity between factors.

We introduce several intuitive measures of collinearity in factor models and present their empirical distributions in the context of a global equity model. Finally, we describe how collinearity can be reduced through factor rotation and discuss the interpretation of such factors.

AsianInvestor picks its 2011 winners

AsianInvestor is currently announcing its 2011 award-winners over a period of four days.  

Awards with a global theme include:  

Distributor of the year, commercial bank
HSBC

Global fixed income, hedged
Credit Suisse Asset Management

Global fixed income, unhedged
Amundi

Global equity
Schroder Investment Management

Real-estate investment trusts, global
LaSalle Investment Management Securities

There are regional and country awards too.  Find out who all the winners are at AsianInvestor. 

India opening up to Sovereign Wealth Funds

From  SWF Institute

Historically, investment access to India’s equity markets has created several problematic issues and headaches for sovereign wealth funds. Currently, sovereign wealth funds are grouped under the category foreign institutional investor or FII defined by the Securities and Exchange Board of India (SEBI).

A few current sovereign-entity FIIs registered include:

• Abu Dhabi Investment Authority
• Abu Dhabi Investment Council
• Australian Future Fund
• Provincial Government of Alberta (AIMCo)
• China’s National Social Security Fund
• Fullerton Fund Management Company LTD (SWE of Temasek Holdings)
• Kuwait Investment Authority
• New Zealand Superannuation Fund
• Norges Bank
• Queensland Investment Corporation
• Singapore’s GIC

Sovereign entities can also invest as a Foreign Venture Capital Investor. FII’s are under strict regulation and cannot hold large positions in listed Indian companies. Times have changed, India wants to increase foreign investment in companies and attract foreign capital. There is a heavily-debated plan underway to create a new defined class of investor for sovereign funds which will be fundamentally different from the FII classification. This new class for sovereign funds would allow them to hold a much larger stake within a publicly traded Indian firm. The plan must be approved by SEBI and receive permission from the Reserve Bank of India. India’s fear was that foreign governments could create numerous sovereign entities to bypass the 10% rule and thus effectively control the company for geopolitical reasons.

Recently, the Government of Singapore Investment Corporation opened up an investment office in Mumbai. This was after India and Singapore signed an economic agreement. The Indian Government would also treat Temasek Holdings and GIC as separate investors, not acting in concert in potential large stake undertakings. Sovereign wealth funds are warming to investing in the Indian equity markets as the Government of India begins to warm up to foreign investments.

How to survive stock market crashes without getting screwed

By Mark Hebner, President, Index Fund Advisors. 

It happens every time.

Toward the end of long bull markets, when stocks finally begin to feel safe and everyone’s making money, folks that are nervous about investing in the stock market finally begin to relax. They put their money in the market and, lo and behold, for a little while, they do well. They tell themselves they’re in it for the long haul. They promise themselves that they won’t be scared off by the inevitable “dip.”

Then the “dip” finally comes. And they lose 10%-15% of their money. They don’t feel great about that, and stocks don’t seem like such a good idea anymore, but they hang in there. Stocks for the long run! But then the dip becomes a “bear market” — down 20%. And then it becomes a bad bear market — down 30%. And then it becomes a once-in-a-generation bear market — down 40%. And suddenly everyone is saying that stocks are going to fall another 50% from there because the world’s headed to hell in a handbasket.

And, eventually, the folks who put their money in the market near the top can’t take it anymore. So they yank their money out. Better to save what little they have left, they think, than to see all of their hard-earned savings get flushed down the drain.

For a few weeks or months, they feel vindicated: The stock market drops some more. But then it turns around and rallies, and a year later, disgusted, they note that if they had only hung in there, they’d be back to even. And they vow never to invest in stocks again.

This, unfortunately, happens to lots of casual investors. It happens, in part, because investors get bad investment advice. It also happens because investors haven’t learned the history of the stock market and prepared themselves for its gut-wrenching volatility.

But the good news is, it doesn’t have to happen. As long as investors understand how the market behaves and have a concrete plan for dealing with this volatility, they can actually benefit from market crashes rather than get destroyed by them.

In this video, I talk with advisor Mark Hebner of Index Funds Advisors about how IFA has handled the past decade. Like other disciplined asset managers, IFA constructs portfolios designed to match the risk-tolerance of each individual investor and then uses portfolio rebalancing to keep this risk constant, regardless of what the market is doing.

IFA’s funds have done very well over the past decade, despite the S&P 500 having been down over the period. Because IFA prepared its clients for the market volatility, they did not freak out and sell everything at the bottom.

Source: http://finance.yahoo.com/blogs/daily-ticker/survive-stock-market-crashes-without-getting-screwed-according-143507867.html#more-id


Sovereign Investor:   With the rise of dynamic asset allocation, will sovereign/institutional investors really be any better off, or will they and up (supported by weighty presentations and recommendations from asset advisors) behaving like the individuals described in this article as they try to pick market trends?  To what extent is the dynamic asset allocation approach funadamentally in conflict with developing and sticking to a long-term strategy supported by periodic rebalancing? 

Diversification by omission

From Fama/French Forum

Can investors build a better portfolio by combining asset classes that have low correlations? It is possible, explains Ken French, but not in the way that most investors attempt it. Some think they can enhance diversification by eliminating mid caps and concentrating on only large and small cap stocks because these asset classes are less correlated. Ken explains that portfolio variance is determined not only by correlation, but also by variance of the individual asset classes and, critically, by their weighting in the portfolio. He emphasizes that throwing out mid caps is equivalent to doubling up on the risk of large and small caps, which is the opposite of diversification.

 (View the video)

IMF echoes ETF concerns

From Global Pensions:

The International Monetary Fund has become the latest financial body to express concerns about the growth of the ETF industry.

The IMF's warnings, made in its latest Global Financial Stability paper, centred on the risks involved with synthetic replication and securities lending. They echo similar concerns expressed recently by the Financial Stability Board and the FSA.

The report acknowledges these "enhancements" reduce costs, but increase counterparty and liquidity risks. ETFs are as yet a relatively small market in Europe in comparison with the US. However, despite this there are strong signs that pension funds, hedge funds and other investors are beginning to embrace these products.(Global Pensions: 08 December 2010)

Part of the IMF's unease stems from the growing size of the synthetic ETF market in Europe, which it argues increases the potential for contagion.

The report says: "The gross exposures of these funds raises some concerns on whether current restrictions on derivative contracts are sufficient to curtail counterparty risks from becoming systemic under stressed market conditions."

The IMF also alleges that investors are unhappy with current regulation that requires ETF providers to be able to recall lent securities and provide collateralisation.

It reveals: "Participants claim this process currently lacks transparency and that the cash reinvestment guidelines have not been clearly laid out by regulators."

The report also calls into question the ability of ETF issuers to maintain normal creation and redemption mechanisms at times of market stress, and reiterates concerns that heavy ETF trading could disrupt prices in small markets and commodities.

Sovereign Investor:   Exchange Traded Funds (ETF) are used by transition managers, amongst others, to obtain market exposure as part of a cost-efficient transition strategy.  In light of regulator and IMF concerns, is this approach wise?  What is your experience?  The IMF paper (10.50 MB) can be downloaded here.  Annex 1.7 (page 69) is the place to find a useful discussion on ETFs.  The introduction to the Annex reads,

Exchange-traded funds (ETFs) have become increasingly popular over the past few years.  They give investors increased access to emerging market assets while also offering flexibility and leverage to specialized investors. Traditionally, ETFs have physically held underlying assets, but a new breed of ETFs have emerged in Europe that use synthetic replication techniques and derivatives to reduce costs and thereby boost returns.  A small percentage of these funds also use leverage to cater to the hedging needs and speculative positions of their nonretail client base. While these enhancements have reduced costs, they add a layer of complexity and increase counterparty and liquidity risks. The disproportionately large size of some ETFs compared with the market capitalization of the underlying reference indices poses a risk of disruptions in some markets from heavy ETF trading. This annex surveys the growth and mechanics of ETFs and highlights some of the key risks pertaining to synthetic replication and the use of leverage and derivatives in ETFs.

Complexity?  The following diagram from the report provides some hints

 Risk?  The report describes the following menu, for those so inclined:

• Counterparty and mark-to-market risk for the ETF provider
• Leverage risk for investors
• Liquidity risk
• Market disruptions
• Legal and policy risks

Graham's 50-year study -- foolproof?

Extracted from The Graham Investor.

In 1976, Hartman L. Butler spent an hour with Benjamin Graham and the interview is recorded within a fine study of Graham’s life published by The Financial Analysts Research Foundation. During the interview, Graham describes buying groups of stocks that meet some simple criterion for being undervalued, regardless of the industry and without detailed investigation of the individual company. This was anathema to his earlier method – as described in Security Analysis – of going through each stock with a fine-tooth analytical comb.
In the interview Graham mentions an article on three simple methods applied to selecting common stocks which was published in a 1975 seminar proceedings. In connection with this statement, he also mentions a 50 year study he had just completed:

“I am just finishing a 50-year study–the application of these simple methods to groups of stocks, actually, to all the stocks in the Moody’s Industrial Stock Group. I found the results were very good for 50 years. They certainly did twice as well as the Dow Jones. And so my enthusiasm has been transferred from the selective to the group approach.”

… “Imagine–there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up. I would try to get other people to criticize it.”

Basically the three simple methods (tested separately) were:

1. Look for stocks with Earnings Yield, i.e. E/P twice the prevailing AAA Corporate Bond interest yield (albeit limiting P/E no greater than 10, and no lower than 7, regardless of the bond rate).
2. Look for stocks making a low around 50% of their two year high.
3. Price at two-thirds of book value.

In the article, Graham tabulates the results for all three methods; each method beats the index by a considerable margin, with the P/E method being the best, the 2-year low being second-best.

I found it interesting to read about the 2-year high/low study, because I have previously mentioned the need to pick stocks from the screen that are well off their previous highs – so we know there is sufficient upside potential to make a serious profit. In other words, if a stock on the screen is at $2, but only ever got as high as $2.50 in its history, it would not apparently have as much upside potential as a similarly-priced stock that once hit $10. It would seem from reading these studies that Graham himself also found this to be true and allowed himself room for at least a 50% return.

It’s also important to remember that in this study, Graham was advising the purchase of a basket of around 30 stocks matching any one criteria of undervaluation, e.g. 2/3 of book. He even went so far as to say “You can’t lose when you do that.” His experience proved that buying a stock at such a criteria was a dependable indication of group undervaluation.

Sovereign Investor:  A normal institutional or SWF wouldn't restrict itself to such a portfolio, but the underlying drivers may nonetheless of interest to investors seeking exposure to the value factor. The original article at The Graham Investor has sparked off a lively discussion.

US should "give up on the dollar"

The push to replace the U.S. dollar as the world's reserve currency has been gaining steam, with one expert arguing that America "must give up on the dollar."

In a Financial Times op-ed, Michael Pettis, a finance professor at Peking University, said U.S. policymakers should lead the charge to create a more diverse reserve system, "in which the dollar is simply first among equals."

The dollar has been the dominant reserve currency for decades, with central banks and other institutions around the world amassing vast reserves.

Pettis argues that this has resulted in dangerous trade imbalances that threaten to destabilize the global economy. He contends that countries such as China have been able to "game the system" by stockpiling dollars, which has allowed them to grab a larger share of global demand for goods and services.

Read the rest of this article at CNN Money.

Sovereign Investor:   Is it really doom and disaster for the US dollar?  If so, how are you gearing up for the inevitable changes the fall of the world's reserve currency would bring?  If not, what makes you so convinced?  Here's a graph of exchange rates over the past decade (Source:  IMF World Economic Outlook, April 2011):

Santiago Compliance Index - 2011 Update

Ashby Monk, from the Oxford SWF project, reports that Sven Behrendt has released the second edition of his “Santiago Compliance Index” for 2011. Ashby notes that this year’s edition is definitely a provocative read. For example, it shows that some of the SWF signatories still have not managed to implement any of the Santiago Principles (i.e., zero percent compliance).

Click graphic for bigger view

Download the Santiago Compliance Index here.

Sovereign Investor:  The management of public funds should be transparent.  After all, it's money managed on behalf of your stakeholders, and they have a right to know what you're doing with it.  Do you agree?  Where does your SWF fit on this scale?  What steps can you take to make it more transparent?  Share your views, even if you feel there are good reasons why the Santiago Principles go too far.

The Evolving Role of Technology in Financial Services

State Street has published a report, "The Evolving Role of Technology in Financial Services".

Technology has long been an essential behind-the-scenes partner in the financial services industry, providing the innovative incremental advances necessary for the industry to upgrade and expand its services. Improvements in storage capacity and processing speed, for example, have had a profound impact on data management and transactional capabilities, with accompanying reductions in cost. Yet despite these and other advances, the industry has struggled to fully leverage the power and promise of technology,with market participants eager for solutions that are not only faster and cheaper, but that also offer greater security and efficiency.

Click here to download the full report

Source: Top1000Funds.com

Sovereign Investor:   Technology makes the world of investing go around.  Imagine if we had to go back to a world of sailing ships and exchanges of letters under seal.  But how prepared are you if the power goes off for a week or two, or a tsunami bursts through your front door?  Do you even have a DRP?  Even if so, would it really work, or has its author simply filled it with comforting phrases? 

Global equities: Dealing with currency volatility

By James Wood-Collins, from Pensions & Investments.

Whether they represent developed or emerging economies, currencies can create a substantial element of volatility in a global equity portfolio. This may not be apparent when international stocks represent, say a third of the total but, as that share rises, so does the potential for currency-induced volatility. More alarmingly, sudden currency shocks — such as the dramatic rise in the yen that followed Japan's disastrous earthquake — can leave investors highly exposed.
Currency management: time for a change?

Techniques for handling currency exposure such as hedging through forward contracts have been available to investors for many years. The traditional approach uses a symmetrical offsetting portfolio of forward contracts — a passive form of hedging — that does reduce volatility over time. Even this established approach should be implemented in the light of currency management best practices. These practices apply to four key areas:

Pricing or best execution.

Any pension fund engaged in currency hedging should ask the institution responsible what safeguards are in place to ensure best execution. Elsewhere, in the U.K. for example, passive currency programs have often been handed off to the plan custodian but recent lawsuits by several state pension plans in the U.S. alleging that custodian banks overcharged in routine foreign exchange transactions have raised serious doubts as to whether custodians should be entrusted with hedging mandates.

Counterparty diversification.

The most efficient and most liquid instrument for hedging currency exposure is the forward contract, traded over the counter. Assuming that forward contracts continue to trade in this way (provisions in the Dodd-Frank Act may subject them to centralized counterparty clearing, raising the cost of hedging), pension funds need to know who their counterparties are and how many they have. If the fund has a mark-to-market currency loss in dollar terms offset by hedges that are “in the money,” it needs to be sure the hedges are widely diversified, minimizing counterparty credit exposure.

Program design and efficiency.

Hedging is intended to act as a proportional offset to the underlying currencies, typically representing between 50% and 75% of total exposure (the “hedge ratio”). Only very rarely does it approach 100% because there is no linear decrease in volatility as the hedge is increased. To illustrate a traditional program, take a situation where the U.S. dollar is weakening: a U.S. pension plan will have a mark-to-market currency gain but it also has forward contracts that mature with an offsetting cost. The market gain is unrealized but cash payments on the contracts have to be met.

Cash flow management.

These payments may be relatively small, year to year, and they may be offset by contracts realizing a gain. However, as indicated earlier, very large currency movements can occur that might necessitate payments reaching 10% to 15% of the total equity program covered, according to research by Record Currency Management. This carries more serious implications for the fund's cash management. Because pension plans typically do not hold large cash balances, securities might have to be sold. While this discrepancy cannot be eliminated in a passive program, the program can be designed to minimize the burden placed on the plan.

Consider a more dynamic approach

There is an alternative to the traditional hedging technique, one that is asymmetric in nature and executed in an active manner rather than passively. Active, or dynamic, hedging is any hedging activity that involves discretion to deviate from the benchmark hedge ratio. Specialist currency managers who take on dynamic hedging mandates almost always have a formal investment process, and operate more or less systematic techniques designed to exploit inefficiencies — such as momentum, or mean reversion — which they have identified in the market. These strategies permit payments to a pension plan through hedging when foreign currencies weaken but reduce the hedging program when these currencies strengthen, allowing the plan to benefit without meeting large forward contract costs. This approach is analogous to insurance, offering U.S. investors the benefit from foreign currencies strengthening against the U.S. dollar while maintaining some protection against periods of weakness.

As U.S. pension plans continue to expand their horizons away from home and pursue opportunities in global equity markets, the issue of effective currency management becomes ever more critical. This is especially true now that investor appetite for emerging market equities has added a wide range of underlying currencies to the mix. In this climate, plan sponsors need as much thought and flexibility in their hedging programs as they can possibly muster.

James Wood-Collins is CEO of Record Currency Management, a specialist currency management firm based in the U.K.

Read more: http://www.pionline.com/article/20110413/REG/110419974#ixzz1JjL8XJIb

Sovereign Investor:   The old adage is that there isn't value to be had from trying to manage currency exposures in a global portfolio.  Agree? Disagree?  Is there evidence that custodian banks overcharge for routine FX services?  How can this be controlled?

Institutional Investment Managers Anticipate Inflation Risk

Approximately 70% of institutional investment managers believe that the risk of inflation will increase over the next six months, according to a quarterly survey conducted by Northern Trust.

In addition, a majority of managers (62%) expect market volatility, as measured by the VIX Index, to increase over the next six months. Responses on both questions were at their highest points since the Northern Trust survey began in the third quarter of 2008, according to a press release.

Read the full report at PlanSponsor.

Sovereign Investor:  Is inflation going to take off or not?  Someone got a coin?

Regulatory Requirements Top Concern for Investment Managers

A poll released by SEI reveals that meeting new regulatory requirements remains the top challenge among investment managers.

One in three respondents (33%) identified this as the most significant challenge to the industry over the next 12-18 months. Participants were split on the effect of new financial regulation; half of those polled believe new regulations will have a significant effect on the profitability of their firms while 41% of participants expect insignificant impact.

According to a press release, managers were not split, however, on the top channels for growth for the next 12-18 months, as nearly half of respondents (46%) ranked the institutional channel as the greatest opportunity for asset growth among client segments and distribution channels. Other respondents named RIAs/IFAs (20%), retirement plans (18%), and sovereign wealth funds (11%) as top growth opportunities.

A summary of the poll is available for download at http://www.seic.com/managerpoll.

This article is extracted from a report at PlanSponsor.

Sovereign Investor:  Are asset managers to be trusted if we don't have strict regulations?  If you're a sovereign/institutional investor, to what extent are you prepared for that 11% of the industry that's out to win your  mandate? Will managers in more highly regulated markets be more or less likely to get your business, or is it not an issue?  Is regulatory compliance an important factor in your evaluation process?